Corporate Finance Final Exam

Corporate Finance 1.Long term residual dividend - Answer- Some companies try to mitigate the disadvantages of residual dividend approach by forecasting their capital budget over a longer time frame. The leftover earnings over this longer time frame are allocated as dividends and are paid out in relatively equal amounts each year. Any excess CFs are distributed through share repurchases. 1/2 Year convention (MACRS) - Answer- Assumes asset is put into service in the middle of first year. This extends the recovery period to more calendar years. 5 common rationales for share repurchases vs. dividends - Answer- 1.) Potential tax advantages 2.) share price support/signaling: when companies buy their own stuck signaling to the market it's a good investment. Commonly used when stock price is down and management wants to convey confidence 3.) added flexibility: since paying a cash dividend/repurchasing shares are economically equivalent, a company could declare a small dividend and then repurchase shares with leftover earnings 4.) offsetting dilution from employee stock options 5.) increasing financial leverage: share repurchases increase leverage. management can change company's capital structure by decreasing % of equity *a share repurchase using borrowed funds will increase EPS if the after tax cost of debt used to buy back shares is less than earnings yield of shares before the repurchase Agency costs of equity - Answer- Costs associated with conflict of interest between managers/owners. Net agency costs of equity have 3 components: 1.) Monitoring costs: supervising management and include expenses associated with making reports to shareholders and paying board of directors 2.) Bonding costs: assumed by management to assure shareholders that managers are working in shareholder's best interests 3.) Residual losses: may occur even with adequate monitoring/bonding/provisions because they do not provide a perfect guarantee. *greater amounts of leverage tend to decrease agency costs Agency Issues (shareholders vs. bondholders) - Answer- when there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bond holders with a lower asset base as collateral. Usually resolved via bond indentures. Agency Issues (shareholders vs. managers) - Answer- agency costs reflect the inefficiencies due to divergence of interests between managers and shareholders. empire building: mangers may have incentive to over-invest, possibly in - NPV projects. Solution: reduce agency costs by increasing payout of FCF as dividends Asset purchase - Answer- Acquirer purchases target's assets and payment is made directly to target company. Unless assets are substantial (50% company), shareholder approval generally not required. Since payment is made to company, no direct tax consequences for shareholders. Target company will pay any capital gain taxes @ corporate level. Asset purchase acquisitions usually focus on specific parts of a company that are of particular interest to acquirer, rather than entire company, which means acquirer generally avoids assuming target's liabilities. An asset purchase for sole purpose of avoiding assumption of liabilities is illegal. Beta - Answer- Using a project's beta to determine discount rates is important when risk of a project is different from risk of overall company. Using firm's WACC will overstate required return for a conservative (low beta) project or vice versa. Bird in hand argument for dividend policy - Answer- Investors don't care about dividends since they can create their own. Gordon and Litner however argue that cost of capital decreases as dividend payout increases because investors place a higher value on a dollar of dividends they are certain to receive than on a $ of expected capital gains. Bootstrap effect - Answer- occurs when a high P/E firm acquires a low P/E firm in a stock transaction. Post merger, earnings of new combined firm are the sum of the respective earnings prior to merger. By purchasing the low P/E firm, the acquiring firm is essentially exchanging higher-priced shares for lower-priced shares. As a result, the # of shares outstanding for acquiring company increases but at a ratio less than 1:1. Bootstrapping - Answer- a way of packaging the combined earnings from two companies after a merger so that the merger generates an increase in EPS of the acquirer, even when no real economic gains have been achieved. Capital Rationing - Answer- Ideally, firms will continue to invest in + NPV projects until marginal return = marginal cost of capital. If a firm has insufficient capital, it must allocate its funds among the best possible combination of acceptable projects. Capital rationing violates markets efficiency because society's resources are not allocated to best use. Cash payment vs. stock payment - Answer- ultimate gain to acquirer or target is affected by choice of payment. For a stock deal, we must adjust formula for target price: Pt = (N x Pat) = # of new shares target receives x price/share of combined firm after merger announced Categories of Capital Budgeting Projects - Answer- Replacement projects to maintain business (normally done without much analysis) Replacement projects for cost re