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CF dividend policy - Opdrachten

30 important questions on CF dividend policy - Opdrachten

Is it true that MM's propositions assume perfect financial markets, with no distorting taxes or other imperfections?

Yes, this is true

Is it true that MM's proposition 1 says that corporate borrowing increases earnings per share but reduces the price-earnings ratio?

Yes, this is true. As long as the return earned by the company is greater than the interest payment, earnings per share increase, but the P Falls to reflect the higher risk.

Is it true that MM's proposition 2 says that the cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value?

This is False. The cost of equity increases with the ratio D/E.

Is it True that MM's proposition 2 assumes that increased borrowing does not affect the interest rate on the firm's debt

False the formula rE = rA + (D/E)(rA - rD) does not require rD to be constant p.p1 {margin: 0.0px 0.0px 0.0px 0.0px; font: 10.0px Helvetica} span.s1 {font: 6.5px Helvetica}

Is it true that borrowing does not increase the financial risk and the cost of equity if there is no risk of bankruptcy?

False, Debt amplifies variations in equity income. (By taking on debt, a company increases its assets, thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks)

Is it true that borrowing increases firm value if there is a clientele of investors with a reason to prefer debt?

False

Is it a valid objection that MM's totally ignore the fact that as you borrow more, you have to pay higher rates of interest?

This is not a valid objection. Mm's proposition 2 explicitly allows for the rates of return for both debt and equity to increase as the proportion of debt in the capital structure increases. The rate for debt increases because the debtholders are taking on more of the risk of the firm; the rate for common stock increases because of increasing financial leverage.

What is wrong with the following argument: As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio, we can reduce both the cost of debt and the cost of equity, making everybody better off.

Under Proposition 1, the firm's cost of capital (rA) is not affected by the choice of capital structure. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller proportion of the firm is financed by equity. The overall effect is to leave the firm's cost of capital unchanged

What is wrong with the following argument: Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders

Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average return to stockholders.

Why is the following statement false or misleading?: A capital investment opportunity offering a 10% DCF rate of return is an attractive project if it can be 100% debt-financed at an 8% interest rate.

If the opportunity were the firm's only asset, this would be a good deal. Because stockholders would put up no money and, therefore, would have nothing to lose. However, rational lenders will not advance 100% of the asset's value for an 8% promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for a particular investment. Such investments do not support all of the additional debt; lenders are protected by the firm's other assets too.

Why is the following statement false or misleading?: The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels.

This is not an important reason for conservative debt levels. So long as MM's proposition 1 holds, the company's overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increased probability of financial distress-- and that can be important.

Can you invent any new kinds of debt that might be attractive to investors? Why do you think they have not been issued?

Examples of such securities are given in the text and include unbundled stock units (contain separate
securities that represented various attributes of a share), preferred equity redemption cumulative
stock (is a convertible preferred stock with an enhanced dividend that is limited in term and
participation) and floating-rate notes (bonds that have a variable coupon, equal to a money market
reference rate, like LIBOR or federal funds rate, plus a quoted spread). Note that, in order to succeed,
such securities must both meet regulatory requirements and appeal to an unsatisfied clientele

Imagen a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to the ratio of the market value of the firm to income before interest if MM are right?

Assume MM are correct. The market value of the firm is determined by the income of the firm, not how it is divided among the firm's security holders. Also, the firm's income before interest is independent of the firm's financing. Thus, both the value of the firm and the value of the firm's income before interest remain constant as leverage is increased. Hence, the ratio is aconstant.

A Firm can't use interest tax shield unless it has (taxable) income to shield. What does this statement imply for debt policy?

A firm with no taxable income saves no taxes by borrowing and paying interest.
The interest payments would simply add to its tax-loss carry-forward. Such a firm would have little tax incentive to borrow

What are the costs of going bankrupt?

Direct costs of financial distress are the legal and administrative costs of bankruptcy. Indirect costs include possible delays in liquidation or poor investment or operation decisions while bankruptcy is being resolved. Also the threat of bankruptcy can lead to costs.

A company can incur costs of financial distress without ever going bankrupt. How can this happen?

If financial distress increases the odds of default, managers' and shareholders' incentives change. This can lead to a poor investment or financing decisions

What are Tangible assets?

.A tangible asset is an asset that has a finite monetary value and usually a physical form. Examples are the furniture, inventory etc.

What is meant with the market value?

.Market value is the value derived by multiplying the stock price by the number of outstanding shares. In simple words, we can also call it market capitalization.

What is meant with the book value?

book value is a value derived from the latest available balance sheet of a company.

Book Value = Total Assets – Total Liabilities – Preferred Stock – Intangible Assets

Rajan and Zingales identified four variables that seemed to explain differences in debt ratios in several countries. What are the four variables?

The four variables are size, tangible assets, profitability, and market-to-book ratios.
Debt ratios tend to be higher for larger firms and those with more tangible assets. Conversely, more profitable firms and firms with higher market-to-book values have lower debt ratios.

Pecking-order theory: Why does asymmetric information push companies to raise external funds by borrowing rather than by issuing common stock?

When a company issues securities, outside investors worry that management may have unfavorable information. If so the securities can be overpriced. This worry is much less with debt than equity. Debt securities are safer than equity, and their price is less affected if unfavorable news comes out later.
A company that can borrow (Without incurring substantial costs of financial distress) usually does so. An issue of equity would be read as "bad news" by investors, and the new stock could be sold only at a discount to the previous market price.

According to the pecking-order theory, the firm's debt ratio is determined by........

The cumulative requirement for external financing.

According to the pecking-order theory, debt ratios depend on past profitability, because..........

More profitable firms can rely more on internal cash flow and need less external financing.

What is meant with financial slack?

.Extra money that a company has available in case of a downturn in sales, revenue, or profit. Financial slack may help a company make it through a difficult period. It is the equivalent of a company's savings.

For what kinds of companies are financial slack most valuable? Is there situation in which financial slack should be reduced by borrowing and paying out the proceeds to the stockholders?

Financial slack is most valuable to growth companies with good but uncertain investment opportunities. Slack means that financing can be raised quickly for positive-NPV investments. Too much financial slack can tempt mature companies to overinvest. Increased borrowing can force such firms to pay out cash to investors.

Agency costs: The SOS company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.

SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under these conditions, the benefits of the project accrue (komen ten goede) to the bondholders.

.Agency costs: The SOS company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain Why sos stockholders could gain by investing in a negative NPV project financed by cash

If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder wealth by more than the money invested. This is a result of the fact that, for a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders.

.Agency costs: The SOS company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain why SOS stockholders could gain from paying out a large cash dividend.

Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend. Stockholders geta ll of the assets and the bondholders are left with nothing (Note: Fraudulent conveyance laws may prevent this outcome.)

What is meant with the "fine print" in terms of contracts?

.The "fine print" is a term that refers to contract terms and conditions, disclosures, or other important information that is not included in the main body of a document but placed in footnotes or a supplemental document. Reading and understanding the fine print is essential when entering into an agreement.

Who benefits from the fine print in bond contracts when the firm gets into financial trouble?

The bondholders may benefit; the fine print limits actions that transfer wealth from the bondholders to the stockholders.

The question on the page originate from the summary of the following study material:

Corporate Finance, Investments and Risk Managment | 9781307263855

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