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Terms in this set (152)
Proposition I deals with...
the value of a firm
Proposition II deals with...
Cost of equity with taxes
Value of levered firm with taxes
D = value of debt
Cost of equity no taxes
Two components of financial distress:
direct and indirect costs of financial distress and bankruptcy
probability of financial distress
Three components of net agency cost of equity:
Value of levered firm with financial distress
V(levered) = V(unlevered) + (TxD) - PV(cost of distress)
Cost of asymmetric information is higher with:
poor financial statements
incurred by shareholders to supervise the managers
incurred by management to assure shareholders that they are working for shareholders' interests
incurred even though there are monitoring and bonding systems in place as these systems are not flawless
Factors an analyst should consider when evaluating a firm's capital structure should include:
changes in the firm's capital structure over tome
capital structure of competitors with similar business risk
factors affecting agency costs such as the quality of corporate governance
The capital structure that maximizes EPS will generally contain _______ than the capital structure that maximizes firm value and minimizes WACC
At the optimal capital structure the firm will minimize the WACC, maximize the...
share price of the stock
(value of the firm)
The topic review specifically mentions using _________ to assess how changes in a firm's debt ratio may impact the firm's WACC and then evaluate what happens to a firm's value if the company moves toward its optimal capital structure
Differences in capital structure could reflect differences in business risk (T/F)
The changes that occur in a company's capital structure over time are irrelevant for assessing the impact of capital structure on valuation because changes in market conditions mean that only the current capital structure is relevant for analysis (T/F)
Miller (of Modigliani and Miller) concluded that if investors face different tax rates on dividend and interest income, the advantage for debt financing may be...
Types of regular cash dividends
periodic cash payments
shareholders to acquire additional shares, sometimes at a discount, without transaction costs and allow dollar cost averaging
How is a liquidating dividend size determined
paid in excess of cumulative retained earnings
What dividend irrelevance theory assume
MM's argument of dividend irrelevance is based on their concept of...
What is the concept of homemade dividends
investors wanting more (less) dividends can sell (buy) shares
Dividend preference theory says...
investors prefer the certainty of current cash to future capital gains
What is the result of dividend preference theory
higher dividends leads to higher stock prices (lower cost of equity)
Tax preference Theory
Investors prefer small dividend payments to large payments
Reasoning for tax preference theory
Capital gains are:
Sometimes taxed at a lower rate
Not taxed until realized
The Bird-in-the-Hand theory
evidence shows cost of equity decreases as payout ratio increases
investors are rewarding certainty of near-term dividends with a lower level of risk
Tax Aversion theory
investors prefer NOT to receive dividends due to their higher tax rates
Dividend payout =
Div / NI
Div Coverage =
NI / Div
FCFE coverage =
FCFE / (Divs + share repurchases)
Factors Affecting Dividend Payout Policy
Expected volatility of future earnings
Contractual and legal restrictions
Effective tax rate for double taxation =
tax corporate + (1 - tax corporate)*(tax individual)
A split-rate corporate tax system taxes earnings distributed as...
dividends at a lower rate than earnings that are retained
Effective tax rate for imputation system =
shareholder's tax rate
Expected increase in dividend =
adjustment factor = 1 / # years in period
Advantages of residual dividend policy
Management can identify investment opportunities without considering dividends
Disadvantages of residual dividend policy
Dividend payments may be unstable
Uncertainty about future dividend signals higher-risk; potentially raises Capital cost
Target payout adjustment model
dividends paid out as a percentage of total earnings
Long-Term Residual Dividend Model
Remove the year-to-year fluctuation from residual dividend model
Types of share repurchase models
fixed-price tender offer
flexible, allows the company to time the repurchase and by when the price is attractive
Fixed-price tender offer
offers premium over market price, quick execution, shareholders not selling are at a disadvantage, Pro rata acceptance in case of higher than needed number of shares are tendered
Justified a range of prices, invites bids and accepts lowest bid first, and continues until Target achieved
All sellers receive the highest accepted bid price
Cheaper than fixed-price tender but slower
with a single large holder
common in greenmail transactions
Impact on EPS from stock buybacks depends on whether...
the repurchase is financed with excess cash or new borrowing
A stock repurchase financed with idle cash will lead to an increase in EPS post-repurchase, as long as...
the earnings yield exceeds the yield on idle cash
A stock repurchase funded through additional debt will lead to an increase in EPS if the after-tax borrowing cost is...
less than the earnings yield
If the price for a stock repurchase is higher than the pre-purchase BVPS, the BVPS will increase (T/F)
Rationales for share repurchase:
potential tax advantages
share price support/signaling
increases financial leverage
Financial managers utilize stock splits and stock dividends because they perceive that:
an optimal trading range exists.
"Optimal" means that if the price is within this range, the...
price/earnings ratio, price/sales and other relevant ratios will be maximized
EPS after buyback =
(total earnings - after-tax cost of funds) / shares outstanding after buyback
When a firm pays a cash dividend, the dividend payment is most likely to cause financial leverage ratios to decrease (T/F)
A company is most likely to use a Dutch auction when repurchasing shares with a...
a single shareholder or a group of shareholders have control over the corporation
Conflict with dispersed ownership and dispersed voting power
Conflict with concentrated ownership and concentrated voting power
Conflict with dispersed ownership and convectrated voting power
Conflict with concentrated ownership and dispersed voting power
State-owned enterprises (SOE) seek to provide...
societal benefits rather than focus on shareholder wealth maximization
What does a tier 1 board consist of
internal (executive) and external (nonexecutive) directors
What does a tier 2 board consist of
management board is overseen by a supervisory board
Institutional investors provide...
expertise and wield their influence to reduce the principal-agent problem
Private equity firms reduce principal-agent problem by...
linking management compensation to performance
Foreign investors typically benefit minority shareholders in emerging markets by...
demanding greater management accountability
Managers and directors: align the interests of insiders with that of investors
Stewardship codes seek to...
engage investors in corporate governance by exercising their legal rights
"comply or explain" provisions require firms to...
follow best practices in in corporate governances codes - or explain why they have not
The CEO doubles as a chairman of the board.
Characteristics of ESG disclosures
Fixed-income analyst usually will focus on ESG factors...
_______ analysts consider both the upside and downside impact of ESG factors
What is share-on-pay
shareholder vote on executive renumeration
Materiality in ESG refers to...
an issue that could impact a firm's securities, performance, or operations
There are three main approaches for identifying a company's ESG factors:
ESG data providers
Environmental, social, and governance ("ESG") risk exposures are the...
nontraditional business factors that are now recognized as critical to a company's long-term sustainability
In the process of identifying and evaluating ESG-related risk exposures and investment opportunities, there is greatest consistency across companies in considerations related to:
One company buys part of another company
one company absorbs another company entirely
acquiring company obtains all of the target's assets and liabilities; the target ceases to exist
the target company becomes a subsidiary of the acquirer; often used when target has strong brand identity
acquirer and Target cease to exist in their prior form but come together to form a completely new company
two businesses operate in the same or similar Industries
Target company is a long supply chain of the acquiring company
two companies form completely separate Industries
What is Bootstrapping EPS
increased EPS that occurs when a high P/E firm requires a low P/E firm using stock
Common mergers for embryonic
Common mergers for growth
Common mergers for shakeout
Common mergers for mature
Common mergers for decline
Types of pre-offer defenses
Reincorporating in a state with
restrictive takeover laws.
Staggered board elections.
Restricted voting rights.
Fair price amendments.
Types of post-offer defenses
"Just say no" defense.
"Crown jewel" defense.
Finding a white knight or white squire.
When an acquirer is negotiating with a target over the method of payment, there are three main factors that should be considered:
Distribution between risk and reward for the acquirer and target shareholders.
Relative valuations of companies involved.
Changes in capital structure.
What is a bear hug
acquirer submits a merger proposal directly to the target's board of directors
acquirer offers to buy the shares directly from the target shareholders, and each individual shareholder either accepts or rejects the offer
acquirer seeks to control the target by having shareholders approve a new "acquirer approved" board of directors
A proxy solicitation is approved by...
regulators and then sent to the target's shareholders
shareholders given right to purchase more shares at a discount
buy target shares
by acquiring shares
bondholders can demand immediate repayment in case of a takeover
Restricted voting rights
Equity ownership above threshold level causes loss of voting rights unless approved by the board
Fair price amendment
requires a fair price to be offered to shareholders based on an independent appraisal (wastes time)
managers receive lucrative cash payouts if they leave the target company after a merger
"Just say no" defense
refuse takeover, and then convince shareholders to do the same
target repurchases shares from the acquirer at a premium
target assumes a large amount of debt to repurchase shares
NI + NCC + INT(1-t) - FCinv - WCinv
Advantages of discounted cash flow method
easy to model
based on forecasts of fundamental conditions
easy to customize
Disadvantages of discounted cash flow method
when free cash flows are negative
cash flows and earnings are highly subject to error
discount rate changes over time
Comparable transaction Analysis uses...
relative valuation metrics from recent takeover transactions so there is no need to calculate a separate takeover premium
Advantages of comparable company analysis
data is easy to access
estimates derived directly from the market
Disadvantages of comparable company analysis
assumes valuations are accurate
must determine takeover separately
historical data used to derive takeover estimated may not be timely
may not reflect current conditions
difficult to incorporate merger synergies or changing capital structures
Comparable company Analysis uses...
relative valuation metrics for similar firms to determine a market value for the target, and then adds a takeover premium to this value
Advantages pf comparable transaction analysis
no need to estimate a separate takeover premium
estimates derived recently from recent prices
reduce the risk that the target's shareholders could file a lawsuit
Disadvantages pf comparable transaction analysis
assumes that the M&A market valued past transactions correctly
not enough comparable transactions
difficult to incorporate merger synergies or transaction capital structures into analysis
post-merger value of an acquirer
Gains accrued to the target
Gains accrued to the acquirer
Adjustment for stock payment
Pt = (N x Pat)
N = number of new shares target receives
Pat = price per share after merger announced
selling, liquidation, or spinning off a division or subsidiary
Creates a new, independent company
Sell shares to outside stockholders through a public offering
Create a new, independent company
Distribute shares to parent company shareholders - no cash for parent
Existing shareholders must exchange shares for shares of new division
Major Reasons for Divestitures
Division no longer fits long-term strategy
lack of profitability
individual parts are worth more than the whole
infusion of cash
If you are selling your firm to another firm that is similar to yours, is a divestiture or a equity carve out more likely
Which type of merger is most likely when the motivation for merging is to bootstrap earnings per share (EPS), and what does this imply about the lifecycle stage of the acquirer and the target?
Horizontal and different stages
Initial investment outlay =
FCinv + NWCinv
change in noncurrent assets - change in non-debt current liabilities
After tax operating cash flow =
Terminal Year After-Tax Non-Operating Cash Flow (TNOCF) =
Initial cash outflow (for replacement projects) =
FCinv + NWCinv - Sal0 + T(Sal0 - B0)
cost of new machine + proceeds/loss form old machine + Change in NWC
Δ annual operation cash flow (replacement project) =
(ΔS - ΔC)*(1-T) + ΔDT
terminal year non-operating cash flow
except put a Δ infront of all the variables
What is hard capital rationing
funds cannot be increased
What is soft capital rationing
funds can be increased with justification
How to rank projects using capital rationing (formula)
1 + NPV / outlay
With respect to capital budgeting, expected inflation is accounted for in a net present value calculation by:
Adjusting expected cash flows and using a nominal WACC in response to changes in inflation
Replacement decisions are not necessarily mutually exclusive projects (T/F)
F, they always are
Because the WACC is adjusted for inflation, the analyst must adjust...
project cash flows upward to reflect inflation
With an equity carve out, the selling corporation usually doesn't maintain any control of the business that has been split out into a separate entity (T/F)
F, it maintains some control
Shares are not automatically issued to existing shareholders under a carve-out (T/F)
Shareholders will be more easily able to link executive compensation to the performance of the business involved under an equity carve out (T/F)
When valuing target's and acquirer's gains from an acquisition do you use the value of the target to its current owners or the value of the target as a stand-alone business for the pre-acquisition value of the target
value of the target to its current owners
Shareholders' and managers' interest are better aligned with higher leverage (T/F)
Weak legal systems offer poor protection to...
Is use of debt more popular in strong legal system countries or weak
The value of the nominal tax savings is affected by inflation (T/F)
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