Lecture 5

Question 1

What is one advantage of debt financing?

Answer 1

Interest payments are deducted before tax

Question 2

What are the opposing forces in deciding the payment of dividends?

Answer 2

• Residual theory of dividends
• Information content of dividends / signalling

Question 3

In theory, why should a company’s gearing not matter to investors?

Answer 3

Because they can adjust their own leverage by borrowing

Question 4

What does it mean when preferred stock is cumulative?

Answer 4

No common dividends may be paid until preferred dividends in arrears are paid

Question 5

What is a circuit breaker?

Answer 5

Market halts trading when index makes dramatic / disorderly moves

Question 6

What is a market order?

Answer 6

Transacted as soon as possible at the prevailing price

Question 7

What is a limit order?

Answer 7

Transacts at specified price or better

Question 8

What are some examples of stock market indices?

Answer 8

• FTSE 100
• Dow Jones Industrial Average
• NASDAQ

Question 9

What is the relationship between stock market indices?

Answer 9

May be strongly correlated over short term but diverge over long term

Question 10

What is an example of an index that is not market cap weighted?

Answer 10

Dow Jones

Question 11

In an index, what does GBX indicate?

Answer 11

Prices are in pence, not pounds

Question 12

If a company’s market cap is 1% of the index and its price rises 5%, how does that affect the index?

Answer 12

1% of 5% = index rises 0.05%

Question 13

Principal-agent problems occur when…

Answer 13

1. Managers do not act in shareholders’ interests
2. Shareholders incur costs in monitoring managers

Question 14

What is one way to reduce principal-agent problems?

Answer 14

Managers hold shares / options

Question 15

What are the types of corporate takeover?

Answer 15

• Friendly (via board)
• Hostile (directly to shareholders)

Question 16

How do hostile takeovers work?

Answer 16

‘Tender offer’ to purchase certain number of shares at set price + date, in exchange for cash or shares in aggressor firm

Question 17

What are possible motives for a corporate takeover?

Answer 17

• Strategic (economies of scale/scope)
• Financial acquisition / asset stripping
• Conglomerate / diversifying acquisition
• Tax / regulatory advantages

Question 18

What is a horizontal vs vertical merger?

Answer 18

• Horizontal: competitors merge
• Vertical: different stages in supply chain

Question 19

What is a ‘poison pill’?

Answer 19

Mechanism to make hostile takeovers prohibitively expensive - benefits managers, not shareholders

Question 20

What are drawbacks of mergers & acquisitions?

Answer 20

• Expensive
• May be motivated by empire-building / overconfidence
• Misallocates capital - boosts target firm’s share price but lowers acquisitor
• May be pushed by investment banks to earn fees

Question 21

How is ROI calculated?

Answer 21

net income / investment

Question 22

How is net ROI calculated?

Answer 22

ROI - cost of capital

Question 23

What are advantages of going public?

Answer 23

• Access to capital markets
• Liquidity for investors
• Original owners can diversify
• External monitoring & information by capital markets = increased credibility

Question 24

What are disadvantages of going public?

Answer 24

• Expensive process
• Costs of dealing with shareholders
• Info revealed to competitors

Question 25

What are drawbacks of debt financing?

Answer 25

• Inflexible
• Lower credit rating

Question 26

What is EVA?

Answer 26

Economic Value Added

Question 27

How is EVA calculated?

Answer 27

return - (investment x cost of capital)

Question 28

What does EP stand for?

Answer 28

Economic profit

Question 29

How is EP calculated?

Answer 29

investment x (ROI - cost of capital)