Semisecret form MME says that rises not only reflect the history of prices but all publicly available information. 3. Strong form MME contends that prices reflect all available information, public and private (or “inside”). What could make markets inefficient? 1 . Large costs of acquiring and skillfully utilizing information 2. The existence of private information 3. Large transactions costs Does market efficiency mean you can throw darts at a Financial Post listing of Toronto Stock Exchange stocks to pick a portfolio? No. All it says is that, on average, a portfolio manager will not be able to achieve excess returns on a risk-adjusted basis.
What does it mean to say the price you pay for a stock is fair? It means that the stock has been priced taking into account all publicly available information. 14. 4 Chat conclusions about market efficiency can be drawn from available evidence? Evidence supports the weak form and semi strong form, but not the strong form, efficient market hypothesis. 14. 8 Chat are three implications of the efficient-market hypothesis for corporate finance? 1 . The prices of stocks and bonds cannot be affected by the company’s choice Of accounting method. 2. Financial managers cannot time issues of stocks and bonds. 3.
A firm can sell as many stocks and bonds as it wants without depressing prices. CONCEPT QUESTIONS – CHAPTER 15 15. 10 What is a company’s book value? It is the sum of the common shares, capital surplus and accumulated retained earnings. [1 What rights do stockholders have? 1. Voting rights for board members 2. Proxy rights 3. Asset Participation in case of liquidation 4. Voting rights for mergers and acquisitions 5. Preemptive rights to new shares issued. 0 What is a proxy? It is the grant Of authority by a shareholder to someone else to vote his or her shares. Why do firms issue nonvoting shares? How are they valued?
Management of a firm can raise equity capital by issuing non-voting or limited-voting stock while maintaining control. Market prices of U. S. Stocks with superior voting rights were found to be about 5 percent higher than the prices of otherwise identical stocks. 15. 20 What is corporate debt? Describe general features. Corporate debt is a security issued by corporations as a result of borrowing money and represents something that must be repaid. Its main features are: 1. It does not represent ownership interest in the firm. 2. Payment of interest on debt is tax deductible because it is considered a cost of doing business. . Unpaid debt is a liability of the firm. C] Why is it sometimes difficult to tell whether a particular security is debt or equity? Because it has characteristics that are particular to both. Companies are very adept at creating hybrid securities that are considered debt by CRA but have equity features such as being repaid in common 15. 30 What are preferred shares? Preferred stock is a security that has preference over common stock in the payment of dividends and in the distribution of assets in the case of liquidation. Why are preferred shares arguably more like debt than equity?
Preferred stock is similar to both debt and common equity. Preferred shareholders receive a stated dividend only, and if the corporation is liquidated, preferred stockholders get a stated value. However, unpaid preferred dividends are not debts of a company and preferred dividends not a tax deductible business expense. Why is it attractive for firms that are not paying taxes to issue preferred shares? Such low-tax companies can make little use of the tax deduction on interest. However, they can issue preferred shares and enjoy lower financial costs since preferred dividends are sign efficiently lower than interest aments. What are three reasons, unrelated to taxes, why preferred shares are issued? 1. Because of the way utility rates are determined in regulatory environments, regulated public utilities can pass the tax disadvantage of issuing preferred stock on to their customers. 2. Since preferred shareholders often cannot vote, preferred may be a means Of raising equity without surrendering control. 3. Firms issuing preferred stock can avoid the threat of bankruptcy that exists with debt financing. 15. 5 Chat is the financial gap? The financial gap is the difference between total spending and internal enhancing.
II What are the major sources of corporate financing? What trends have emerged in recent years? 1. Internal financing 2. External financing (new long-term borrowing, and equity) Debt/equity ratios Of Canadian industrial corporations have remained relatively stable in contrast with increased reliance on debt financing in the U. S. In the 1 9805. However, in recent years, with the cheap interest rates on debt financing, the debt levels of companies has increased. In addition to fixed assets, these financing sources will likely be used for investment in affiliates or acquisitions.
The increasing pace of globalization of markets and international competition will force companies to become larger and more international. CONCEPT QUESTIONS – CHAPTER 16 16. 1 Chat is the pie model of capital structure? It is a model in which the value Of the firm is pictured as a pie cut into debt and equity slices. 16. 2 Chewy should financial managers choose the capital structure that maximizes the value of the firm. Because this capital structure also maximizes the value of equity. 16. 3 Cicatrices financial leverage. It is the extent to which a company relies on debt in its capital structure.
D What is levered equity? The equity of a firm that has debt in its capital structure. D How can a shareholder of Trans Can undo the company’s financial leverage? By selling shares of Trans Can and buying bonds or investing the proceeds in another company’s debt. 16. 4 Achy does the expected return on equity rise with firm leverage? Because developers must be paid first, the cash flows to the shareholders become more variable, increasing the risk for the shareholders. 0 What is the exact relationship between the expected return on equity and firm leverage? RSI=ro + (ro – rub) (B/S)
C] How are market-value balance sheets set up? They are set up the same way as historical accounting balance sheets with assets on the left side and liabilities on the right side. However, instead of valuing assets in terms of historical values, market values are used. 16. 5 That makes a levered firm more valuable than an otherwise-identical unleavened firm? Interest payments are tax deductible and dividend payments are not. Therefore, there is a tax benefit with interest which can be retained by the shareholders. C] What is MM Proposition I under corporate taxes?
FL -VIC +ETC 0 What MM Proposition II under corporate taxes? S= ro+ (B/S)(1-Etc)(ro – rub) CONCEPT QUESTIONS – CHAPTER 1 7 17. 1 Chat does risk-neutrality mean? Investors are indifferent to the presence of risk. L] Can one have bankruptcy risk without bankruptcy costs? Yes. When a firm takes on debt, the risk of bankruptcy is always present but bankruptcy cost may not be. Why do we say that stockholders bear bankruptcy costs? Because in the presence of bankruptcy costs, bondholders would pay less for any debt issued. This then will reduce the value of potential future dividends. 7. 20 What is the main direct cost of financial distress? Legal and administrative costs of liquidation or reorganization. L] What are the indirect costs of financial distress? Those that arise because of an impaired ability to conduct business – such as loss of reputation, loss of customers, low employee morale, etc. [1 Who pays the costs Of selfish strategies? Ultimately, the stockholders. 17. 3 DHOW can covenants and debt consolidation reduce debt agency costs? Covenants can increase the value of the firm which is favored by shareholders as well as protecting bondholders.
They offer the lowest-cost solution to the shareholder-bondholder conflict. 17. Cellist all the claims to the firm’s assets. Payments to stockholders and bondholders, payments to the government, payments to lawyers, and payments to any and all other claimants to the cash flows Of the firm. Describe marketed claims and marketed claims. Marketed claims are claims that can be sold or bought in capital markets. Marketed claims are claims that cannot be sold in capital markets. C] How can a firm maximize the value of its marketed claims?
By minimizing the value of marketed claims such as taxes. 17. 5 DOD managers have an incentive to fool investors by issuing additional bet? Mangers may be able to fool investors to think that the firm is more valuable by increasing the level of debt. According to this theory, investors would then push up the price of the shares. However, since there are costs to this extra debt in the form of interest payments, the investors will quickly see through this and the share may actually fall below what it would have been if the debt was never issued in the first place.
Is there a cost to issuing additional debt? Yes, there is a cost in that the share price may fall below where the price should have been if the debt had never been issued. What empirical evidence suggests that managers signal information through debt levels? The empirical evidence concerning exchange offers supports the theory that an increase in leverage is viewed as a positive signal for the firm, and the share price increases. 17. 6 Chat are agency costs? Costs that arise from conflicts of interest between managers, bondholders and stockholders.
C] Why are shirking and perquisites considered an agency cost of equity? Because managers will act in their own best interests rather than those of C] How do agency costs of equity affect the firm’s debt-equity ratio? The optimal debt-equity ratio is higher in a world with agency costs than in a world without such costs. L] What is the Free Cash Flow Hypothesis? We might expect to see more wasteful activity in a firm capable Of generating large cash flows. 17. 7јWhat is the pecking-order theory? This theory states that when a firm seeks new capital it faces ‘timing’ issues of new stock.
The company will choose its form of financing going through a specific order of courses starting with the cheapest ( internal) to the most expensive. What are the problems of issuing equity according to this theory? The theory implies that only overvalued firms have an incentive to issue equity and given market reactions to a stock issue, virtually no firm will issue equity. The model results in firms being financed virtually entirely by debt. Moderating the pure theory, we would predict that debt should be issued before equity. What is financial slack?
If a firm expects to fund a profitable project in the future it will start to accumulate a cash reservoir today, thus avoiding the need to go to the capital markets. 17. 8 CHow do growth opportunities decrease the advantage of debt financing? Growth implies significant equity financing, even in a world with low bankruptcy costs. To eliminate the potential Increasing tax liability resulting from growing BIT, the firm would want to issue enough debt so that interest equals BIT. Any further increase in debt would, however, lower the value of the firm in a world With bankruptcy costs. 7. 9 Chow do personal taxes change the conch scions of the Modeling-Miller model about capital structure? Let TTS and TAB be personal tax rate on equity distributions and ordinary income, respectively. When TTS < TB , the gain from everage is reduced when Ts = TB , the MM with corporate tax result is unchanged. 17. 100 List the empirical regularities we observe for corporate capital structure? 1 . Most corporations have low debt ratios. 2. Changes in financial leverage affect firm value. 3. There are differences in the capital structure of different industries.
C] What are the factors to consider in establishing a debt-equity ratio? 1. Taxes 2. Financial distress costs 3. Pecking order and financial slack. CONCEPT QUESTIONS – CHAPTER 18 18. 10 How is the APP method applied? APP is equal to the NP of the project (i. E. He value of the project for an unleavened firm) plus the NP of financing side effects. L] What additional information beyond NP does one need to calculate NP of financing side effects (NEFF). 18. 2 the FÊTE Method applied? FÊTE calls for the discounting of the cash flows of a project to the equity holder at the cost Of equity capital.
What information is needed to calculate FÊTE? Levered cash flow and the cost of equity capital. 18. 30 How is the WAC method applied? WAC calls for the discounting of unleavened cash flows of a project (JIFF) at the weighted average cost of capital, WAC. 18. 0 What is the main difference between APP and WAC WAC is based upon a target debt rate and APP is based upon the level of debt. What is the main difference between the FÊTE approach and the two other approaches? FÊTE uses levered cash flow and other methods use unleavened cash flow. C] When should the APP method be used?
When the level of debt is known in each future period. 0 When should the FÊTE and WAC approaches be used? When the target debt ratio is known. 18. 50 What adjustments are required in capital budgeting for projects with beta differences from the firm’s? It requires adjustments on the discount rate o properly match the discount rate with the risk of the project. 18. 60 How do flotation costs and subsidized financing affect APP? Flotation costs reduce the APP, but subsidized financing enhances it substantially; the overall effect is enhancing. 18. 0 How is beta adjusted for leverage and corporate taxes? Leverage and corporate taxes increase beta. CONCEPT QUESTIONS – CHAPTER 19 19. 2 Cicatrices the procedure of a dividend payment. 1. Dividends are declared: The board of directors passes a resolution to pay dividends. 2. Date of record: Preparation of the list of shareholders entitled to dividends. 3. Ex-Dividend date: A date before the date of record when the brokerage firm entitles stockholders to receive the dividend if they buy before this date. 4. Date of payment: Dividend checks are sent to stockholders.
L] Why should the price of a stock change when it goes ex-dividend? Because in essence the firm is reducing its value by the amount paid out in cash for the dividend. 19. 3 њHow can an investor make homemade dividends? By selling shares of the stock. N Are dividends irrelevant? If we consider a perfect capital market, dividend policy, and therefore the timing of dividend payout, should be irrelevant. L] What assumptions are needed to show that dividend policy is irrelevant? 1. Perfect markets exist. 2. Investors have homogeneous expectations 3.
The investment policy and borrowing policy of the firm is fixed. 19. 4 Olin a perfect capital market, are repurchases preferred to dividends? In a perfect capital market, the firm is indifferent between a dividend and a repurchase. If the repurchase is financed with cash, the total value to the shareholder is the same under dividend payment strategy as under the repurchase strategy. What are five reasons for preferring repurchases to dividends in the real oral? 1 . Flexibility – The firm is not committed to repurchasing shares each year, as it is with dividends. 2.
Executive compensation – Firms with significant stock option plans will repurchase shares to maintain their float of shares within a desirable range. 3. Offset dilution- Firms will repurchase shares to offset other sources of dilution, other than just stock options. 4. Repurchase investment – If managers believe that their share is undervalued in the market, they will repurchase shares. 5. Taxes ? Repurchases attract a lower rate of tax than dividends for the shareholders. 19. Cyclist four alternatives to paying dividends with excess cash. 1 . Invest in capital projects 2. Purchase other companies 3. Purchase financial assets 4.
Repurchase shares of the company 0 Indicate a problem with each of these alternatives 1. Invest in capital projects – if the firm has already taken all the positive NP projects available, then it will end up investing in negative NP projects that will reduce firm value. 2. Purchase other companies ? premiums are required to be paid on acquisitions, and there are significant up front costs for an acquisition. 3. Purchase financial assets – The result of this depends on the arsenal tax rates, and will only be beneficial to the firm when personal tax rates are higher than corporate rates on dividends. . Repurchase shares of the company – We showed earlier that there are 5 potential reasons why a repurchase may be better than the payment of dividends for the firm. 19. 6 Chat are the tax benefits of low dividends? Because the tax rate on dividends at the personal level is higher than the effective rate on capital gains, shareholders demand higher expected returns on high-dividend stocks than on low-dividend stocks. D Explain the relationship between a stock’s dividend yield and its pretax turn.
The expected pretax return on a security with a high dividend yield is greater than the expected pretax return on an thinness identical security with a low dividend yield. 19. 7 Chat are the real world factors favoring a high-dividend policy? 1. Desire for current income 2. Resolution of uncertainty 3. Brokerage and other transaction costs 4. Fear of consumption out of principal 19. 8 њ How does the market react to unexpected dividend changes? What does this tell us about the dividends? About dividend policy? The market reacts to unexpected dividend changes.