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theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

Use a financial website to identify three firms that are currently undertaking an auctionbased repurchase program. What fraction of the shares are they repurchasing?
Use a financial website to identify the company with the highest dividend yield today. What is it?
Search the Web to find a company that has recently announced a stock split.What happened to its stock price on the day of the announcement?
In a survey, CFOs indicated that they feel more pressure to continue dividends.
The stock price does not seem to react fully to dividend initiations (or dividend eliminations), because the positive (negative) instant reaction is followed by more of the same, on average. Thus,
A stock split should not create value in a perfect market. Logically, it is just a change in numeraire. It should make no difference to investors whether they own 1 stock worth $100 or 2 stocks worth
The tax rate implied by the average drop from the cum-date to the ex-date seems to be about 20%.
If the stock price is the same on the cum-day and the ex-day, then the marginal income tax rate is τ = 100%, because every investor who would purchase the stock on the cum-day afternoon and sell it
Definitely no. Net-payout ratios are not very different in the 2000s than they were in the 1960s.
Yes. D/P ratios in the 2000s are generally lower than they were in the 1960s. D/P ratios have declined to about 1–2%.
No. D/E ratios in the 2000s are generally similar to what they were 40 years ago.
The remaining differences are as follows: Dividends tend to be more regular than share repurchases;executives and insiders may often not tender into a repurchase, but they will enjoy the relatively
The remaining tax advantage of share repurchases comes from the fact that capital gains can be realized mostly by those investor clienteles who face low capital gains taxes, perhaps because they have
Basically, yes: Dividends and share repurchases are indeed mostly the opposite of equity issuing. They reduce the equity investment in a firm—the opposite of what equity issues accomplish.
If the firm uses money for share repurchases that previously was used to fund negative-NPV projects, then the firm’s EPS should go up.
The firm was worth $1,000, so shares are currently worth $10 each. If the firm repurchases my shares, it pays out 20 . $15 = $300 and has $700 left, to be split among 80 shares. Thus, the remaining
No! Even a normal investor is as well off with a share repurchase as with a dividend payout in a perfect market. Neither a share repurchase nor a dividend payout changes the investor’s wealth. (The
Yes, a firm undertaking an open-market repurchase program could be accused of manipulating its stock price. This is why the SEC has laid down rules (i.e., Rule 10b-18) that allow firms to escape such
The two kinds of programs are auction-based repurchases and open-market repurchases.
In a perfect market, a stock split should not change anything value-wise. It is merely a change in numeraire, which does not affect anything fundamental about the company (such as earnings, cash
The two important dividend dates are the declaration date (when the dividend payment is announced) and the cum- versus ex-dividend date (when the stock trades with versus without dividends).
Do CFOs feel more pressure to continue dividends or share repurchase programs?
Do stock price announcement responses to dividend initiations (or dividend eliminations) tend to be underreactions or overreactions?
Should a stock split create value? Does it?
What is the implied tax rate suggested by the real-world cum-/ex-drop?
If the stock price is not expected to drop from the cum-day to the ex-day, what is the marginal income tax rate?
Are net-payout ratios in the 2000s much lower than they were in the 1960s?
Are dividend/price ratios in the 2000s much lower than they were in the 1960s?
Are dividend/earnings payout ratios in the 2000s much lower than they were in the 1960s?
What are the differences, other than personal income tax differences, between a share repurchase and a dividend payment?
Since the 2003 tax cuts, what is the most important remaining tax advantage that share repurchases enjoy over dividends?
Can you think of dividend payouts and equity share repurchases as the opposite of issuing equity shares? If so, do the forces from Table 18.6 page 688 apply here, too?
Under what circumstances do share repurchases increase the firm’s EPS?
Consider a firmwith 80 shareholders, including yourself, who each own$10 worth of shares. In addition, I own 20 shares (for a firm total of 100 shares) and I am trying to fire the management. To
In a perfect market, if a normal investor cannot participate in a share repurchase program, would she be better off with a dividend payout than with a share repurchase?
Could a firm undertaking an open-market repurchase program be accused of manipulating its stock price?
What are the two kinds of repurchase programs?
What should be the stock market reaction to the announcement of a split in a perfect market?
What are the two important dates when it comes to dividends?
Is the ability of a firm to stave off financial distress always optimal from the firm-value perspective?
If you could design a novel security at the inception of a growth firm that you expect to turn into a cash-generating value firm in 5 years, what would it look like?
Where do agency considerations appear in the WACC formula? Do agency costs influence the firm’sWACC?
What forces can change the shape of the graph of cost of capital versus leverage?
If the firm maximizes its value in an imperfect financial market, how would this change its cost of capital?
Explain three forces that can make equity cheaper than debt for corporate financing.
Explain three forces that can make debt cheaper than equity for corporate financing.
When private equity firms take over publicly traded firms, they usually increase the leverage tremendously. Discuss what effect this capital structure policy should have on the firm’s value and why.
If investors are rational and managers are overoptimistic, how would the value of the firm change if management were to raise more money for new projects? Would it be worse if the firm raised equity?
Repeat the last question but now assume that this seller has personal savings of $200. With this extra capital and bargaining power, what can the seller expect to raise and at what price?
A stake in an oil field is for sale. It can be worth either $500 or $1,000 with equal probabilities.It costs $250 to develop. The seller knows the true value; you do not. The seller has no personal
Are shareholders better off if they can expropriate bondholders?
ADVANCED: A firm has $100 in cash and debt of $80. Assume that the time value of money is zero. A novel project comes along that costs$60 and that will either deliver $0 or x with equal
What are the advantages and disadvantages of unit offering bundles?
A firm has debt with a face value of $100.Its projects will pay a safe $80 tomorrow.Managers care only about shareholders. A new quickie project comes along that costs $30, earns either $0 or $70
What kind of firms are most likely to be influenced by free cash flow issues when choosing a capital structure?
Rent and watch the movie Other People’s Money. Pay close attention to Danny DeVito’s speech at the shareholders’ meeting. What capital structure–related issue is he talking about? What kind
A firm has debt with a face value of $100. Its projects will pay a safe $80 tomorrow. Managers care only about shareholders. A new quickie project comes along that costs $20, earns either $10 or $40
Does it appear as if financial distress costs should be a significant determinant of Fortune 100 firms’ capital structures? What about for small growth firms?
In what types of firms would you imagine financial distress costs to be high?
When is financial distress neutral, with regard to capital structure?When is it not neutral?
In Nirvana, all investors are tax exempt. Only firms pay income taxes. How should firms be financed? How would the WACC formula work?
What does a corporate manager have to do to assign high-tax investors to his equity securities and low tax investors to his debt securities?
Let’s work a problem that shows how investors and firms sort themselves. Assume that taxable and tax-exempt firms each earn $1 of income.Assume that the financial markets offer 8%for tax-exempt
From an income tax perspective, what kind of investments should a high net-income investor hold? What should a tax-exempt pension fund hold?
From a joint income tax perspective, how should a high-tax value firm be financed? How should a low-tax growth firm be financed?
Go to the IRS website. Look up the highest marginal income tax rates for investors and corporations today on the different types of income that they might earn.
Is the negative effect of debt on the price/earnings ratio a force that pushes firms toward equity?
A cash-cow firm would best be financed by something that looks like a bond until a recession comes around.You could design a novel kind of bond that has the ability to cancel or delay bond payments
No, the personal income tax rate is still value relevant. However, it works through its influence on the cost of capital that enters theWACC formula, not through its own term.
In an imperfect market, the costs of debt and equity capital (and thus of the firm’s capital) can be affected by the firm’s leverage ratio. Thus, theWACC function is no longer a horizontal line.
See Table 18.6 for these forces. Not all forces are value optimizing for the overall firm (e.g., unmitigated agency conflicts).
An example of transaction costs favoring equity is market segmentation in the corporate debt market that might prevent selling corporate debt cheaply to many institutions and retail investors. An
Firms that are concerned about inside information issues (i.e., that investors infer the quality of the projects from their behavior) should issue debt, because issuing equity would send a bad signal
The “pecking order” refers to a scenario in which firms first issue as many senior securities (debt) as they can, before they issue more junior securities (equity). As to the thinking question,
You should not bid anything above $500,000 for this house. If you bid $750,000, then you will get the house only if it is worth $500,000, and you would therefore earn $500,000/$750,000 −1 =−33%.
The convertibility feature can reduce the need for some bond covenants and thus give the firm more flexibility in case a great project were to appear suddenly. Bondholders would be happy because they
Bond covenants can help reduce the incentives of equity shareholders to expropriate bondholders. This can increase the firm value if it prevents managers from taking negative-NPV projects whose main
Managerial risk aversion usually mitigates the fear of creditors that they will be expropriated by risk shifting because managers dislike the same kind of risk. After all, if the firm were to go
First, shareholders can expropriate bondholders by issuing other claims that have an earlier or equal priority on the firm’s cash flows in distress. This could be other bonds of equal or higher
1. For the firm worth $100 or $120 with debt promising $90:The shareholders are now no longer better off if project “BAD” is undertaken, because they now receive $18.18 either way. (If we made
It depends. If the firm is not yet under the firm control of management—for example, if it is under the control of a large value-maximizing shareholder-entrepreneur—then this entrepreneur would
Management in firms with a lot of debt to service may have to forgo corporate airplanes, large headquarters, and/or large staff.
Debt is not always a strategic advantage. It could commit the firm to undertake more risky projects. In some cases, this could deter competitive entry into the firm’s markets. However, debt could
Firms in declining industries are more likely to suffer reluctance-to-liquidate problems, especially if their managers are well entrenched.
Here are two examples of reluctance-to-liquidate problems:Entrenched managers may not want to sell off the remaining assets, because they would rather run down the firm and keep their jobs. This can
To be influenced by underinvestment issues, assets must be very maintenance intensive (such as boats), and the firm must be reasonably likely to go bankrupt so that underinvestment considerations
As an example of an underinvestment problem, think of neglected maintenance that reduces the value of assets relative to the first-best behavior.
Direct bankruptcy costs are legal fees and management time. Indirect costs are, for example, reluctance of customers to purchase goods from firms that could go bankrupt (e.g., if the good requires
U.S. managers usually mean the chapters of the bankruptcy code: Reorganization is Chapter 11; liquidation is Chapter 7.
Deadweight bankruptcy costs, both direct and indirect, favor equity: In the extreme, with no debt, the firm would never incur them.
In Atlantis, investors should never receive the tax liability. Firms should therefore be always fully equityfinanced.In the WACC formula, τ would be equal to zero, and E(˜rDebt) would be relatively
Yes—a high-tax investor would be willing to accept a lower rate of return on capital gains in a risk-neutral world. The alternative is to receive interest income, which would be too heavily taxed.
It is usually more critical for the high-tax firm to do the right thing, because it has to try to avoid its own corporate income taxes.
Old, stable firms typically have large profits and would issue debt to minimize their tax liabilities. Because pension funds are largely tax exempt, they like the interest receipts that they receive
Assuming that the high-tax firm still borrows and pays out $100, and the low-tax firm still finances with equity and pays out $98 (the answer is qualitatively the same if you assume that they pay out
If the puppeteer forced low-tax firms to finance with debt, and high-tax firms to finance with equity:The IRS would collect no corporate income tax from the low-tax firm. Low-tax investors who do not
The firm must pay corporate income tax on cash used for repurchases and dividends, but it can use beforetax cash to pay interest. When the firm repurchases shares, investors receive the gains as
Investors like capital gains best, then dividend income, then (equally) ordinary income and interest income.
A CFO should be concerned with the taxes that his investors are paying because he is supposed to act on behalf of the owners of the firm. This includes the task of minimizing any taxes that these
Higher debt and equity risk when the firm is more levered is not necessarily a force against leverage. Even in an M&M world with unchanging firm value, debt and equity have higher risk when the firm

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