Questions Flashcards
The DTA and ROA valuations suggest different optimal execution of the option to contract in project 1.
DTA: wrong
ROA: right
On what does the value of an switching option depend?
On the switching strategy
How does equity behave?
Behaves like a call option on the firm value and thus increase if the volatility of its underlying increases
What is the debt overhang problem
equity holders know that financial distress: profitable investments will not be undertaken anymore.
if the company has sufficient cash in order to finance the project but at the same time there is the alternative to pay out this cash as a dividend, the same reasoning as under c) would lead the equity holders to prefer the dividend payment.
What are the empirical problems involved in testing for the effect of capital structures on the value of the firm?
firms typically change their capital structure at the same time that they change their portfolio of assets by taking on new investments.
If the capital structure changes slowly over time it would be difficult to capture a statistically significant effect in a regression.
measurement error when estimating the expected return on equity
a lot of other factors that influence a firm’s value and it will be difficult to control for all of these different factors.
What is the cost of equity most likely equal to?
The rate of return required by stockholders
Which ist mostly less:
After tax cost of equity
After tax cost of debt
For a given company, the after-tax cost of debt is generally less than the cost of common equity.
What are the WACC’s economic determinants
Cost of financial distress increases with higher leverage
Equity becomes more risky as leverage increases which increases the cost of equity.
Value of tax shield increases with higher leverage
What, most likely, needs to be constant over a project’s period of life when using the WACC formula in a DCF valuation of that project?
The project’s debt to equity ratio
With perfect capital markets, what will the share price be after the announcement of an increase in leverage?
Perfect capital markets
- > no frictions, i.e. no taxes, no transaction costs, no information asymmetry, etc
- > financial transactions do not create value
- > share price remains the same
What are the main advantages and disadvantages of going public?
Two main advantages are:
- Liquidity for the firm’s owners.
- Access to capital.
Two main disadvantages are:
- Once a company becomes a public company, it must satisfy all of the requirements of being a public company such as regulatory filings and listing requirements of the securities exchanges.
- Transaction costs of going public are high.
Under what conditions might dividend policy affect the value of the firm?
If managers allow dividend policy to affect the investment decision, then the value of the firm will be affected, not because of dividend policy per se, but because improper use of dividend policy causes the firm to alter its investment decisions.
- Taxes: e.g. if dividends are taxed at a higher rate than capital gains.
- Asymmetric information: e.g. if a higher dividend signals improved firm prospects.
- Agency costs: e.g. a higher dividend increases the need for external capital which reduces agency costs.
The Pettit study suggests an increase in the price per share of common stock commensurate with an increase in dividends. Can this be taken as evidence that the value of the firm is in fact affected by dividend policy?
If the price of common stock increases when a dividend increase is announced, it is because the higher dividend payout is interpreted as an unambiguous message that future cash flows from investment are expected by management to be permanently higher. The dividend per se has no effect on shareholders’ wealth.
