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标题: Corporate Finance【 Reading 29，Reading30】 [打印本页]
作者: invic    时间: 2012-3-30 10:02     标题: [2012 L2] Corporate Finance【Session 8- Reading 29，Reading30】

Which of the following statements regarding how different capital structure theories impact managers’ capital structure decisions is most accurate? According to:
A)
the static trade-off theory, debt will not be used if a company is in a high corporate tax bracket.
B)
pecking order theory, issuing new debt is preferable to issuing new equity.
C)
MM’s propositions (assuming no taxes), companies have an optimal level of debt financing.


Pecking order theory is related to the signals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visible and most preferred, and issuing new equity as the most visible and least preferred. Under static trade-off theory, higher tax brackets result in greater tax savings from using debt financing. Under MM’s propositions (assuming no taxes), capital structure is irrelevant and there is no optimal level of debt financing.
作者: invic    时间: 2012-3-30 10:02

According to pecking order theory, which of the following lists most accurately orders financing preferences from most to least preferred?
A)
Retained earnings, debt financing, and raising external equity.
B)
Debt financing, retained earnings, and raising external equity.
C)
Retained earnings, raising external equity, and debt financing.


Financing choices under pecking order theory follow a hierarchy based on visibility to investors with internally generated capital being the most preferred, debt being the next best choice, and external equity being the least preferred financing option.
作者: invic    时间: 2012-3-30 10:03

Tad Bentley, CFA, is the chief financial officer (CFO) for Industrial Inc., a manufacturer and distributor of cleaning supplies designed for commercial applications. Industrial Inc.’s current target market spans the entire United States, and possesses a large percentage of the national market. Senior management has formulated a strategy for expansion into Europe and Asia in the near future. The success of the expansion plans lay in large part upon the firm’s ability to raise additional capital in the marketplace to finance the expansion. According to the preliminary time schedule for expansion into Europe and Asia, funds would need to be made available to the firm within the next eighteen to twenty four months.
Bentley is in charge of the team that is evaluating all financing options available to Industrial Inc. to determine which method would minimize the firm’s weighted average cost of capital (WACC) while providing a capital structure that will maximize firm value and that is attractive to outside investors. The firm is considering either issuing additional debt or issuing a secondary equity offering to finance the venture. The firm’s target capital structure will be utilized to determine what the specific advantages and disadvantages associated with the different methods of raising capital.
Industrial currently has $450 million of shareholders’ equity outstanding. The company also has $100 million of 10-year notes issued with 4 years remaining to maturity. Industrial Inc.’s current rating is Aa by Moody’s and AA by Standard and Poor’s (S&P). Bentley is aware that any financing strategy must be considered in light of the potential impact the decision could have upon the company’s current rating.
Any new acquisition of capital will be carefully analyzed in relation to Industrial Inc.’s current capital structure as well. Bentley is familiar with the different theories of capital structure and intends to determine which one is most applicable to Industrial Inc.’s current situation. Industrial Inc. is publicly traded on the New York Stock Exchange, and several analysts at large brokerage firms provide research on the stock. Bentley wants to ensure that the company’s approach to raising additional capital will be acceptable to analysts and investors alike.
Top management of Industrial, Bentley included, collectively own a 20% equity stake in the firm, through either direct purchase of the stock or the receipt of executive stock options. This group is placing pressure on Bentley to recommend a strategy that would not significantly dilute their ownership position. Bentley realizes that he must recommend a strategy that will most effectively utilize the company’s assets and that will be in the best interest of all of the company’s stakeholders.Under a strict set of assumptions, Modigliani and Miller (MM) proposed a capital structure theory in 1958 in which Proposition I proves that:
A)
capital markets are perfectly competitive.
B)
the cost of debt is lower than the cost of equity, so a firm should issue the maximum amount of debt before issuing equity.
C)
the value of a firm is unaffected by its capital structure.


MM’s underlying assumptions are that capital markets are perfectly competitive (no transaction costs) and that investors have homogenous expectations with respect to cash flows. Under these two “perfect world” assumptions, the value of a firm is unaffected by its capital structure because the value of a firm’s assets will always be the same regardless of its debt to equity ratio. (Study Session 8, LOS 29.a)

Under MM’s Proposition II of their capital structure theory, will a firm that increases its use of debt most likely affect default risk, cost of equity, or both?
A)
Increases both.
B)
Does not affect either.
C)
Increases only one.


The increased use of debt has no impact on expected default rates under MM, because it is assumed to be risk-free. The cost of equity does increase because the firm's business risk is concentrated on a smaller proportion of equity as leverage increases. (Study Session 8, LOS 29.a)

Bentley anticipates that whatever method of financing choice is utilized, it will be interpreted by investors as a signal of the firm’s strategy and overall economic health. In accordance with the pecking order theory, which of the following methods are least likely and most likely to send “signals” to investors?
Least LikelyMost Likely
A)
External equityDebt
B)
External equityInternally generated equity
C)
Internally generated equityExternal equity


Internally generated equity is the method least visible to investors, while external equity is the most visible. (Study Session 8, LOS 29.a)
Which of the following statements regarding the role of debt ratings is least accurate?
A)
Any rating Ba (from Moody’s) or BB (from S&P) or higher is considered to be “investment grade”.
B)
Historically, the difference in yield between an AAA-rated bond and a BBB-rated bond has averaged 100 basis points.
C)
The lower the debt rating, the higher the level of default risk for both shareholders and bondholders alike.


Bonds must be rated at least Baa (Moody’s) or BBB (S&P) to be considered investment grade. (Study Session 8, LOS 29.c)
As a result of Industrial expanding its operations into Europe and Asia, Bentley anticipates an increase in foreign investors in the firm. Which of the following statements regarding international differences in leverage is least accurate?
A)
Companies in Japan and France tend to have more debt in their capital structure than firms in the U.S.
B)
Companies operating in countries that have active institutional investors tend to have less financial leverage than firms in countries with less of an institutional presence.
C)
Companies in the U.S. tend to use shorter maturity debt than companies in Japan.


Debt levels vary by country. For example, companies in the U.S. tend to use longer maturity debt than companies in Japan. More generally, companies in developed countries tend to use more debt with longer maturities than firms in emerging markets. (Study Session 8, LOS 29.e)
In any firm, managers who do not have a stake in the company do not bear the costs of taking on too much or too little risk. The costs associated with the conflicts of interest between managers and owners are referred to as:
A)
bonding costs.
B)
agency costs of equity.
C)
monitoring costs.


Monitoring costs and bonding costs are components of the net agency cost of equity. (Study Session 8, LOS 29.a)
作者: invic    时间: 2012-3-30 10:03

According to pecking order theory, which financing choice is most preferred, and which is least preferred?
Most preferredLeast preferred
A)
Internally generated fundsNew equity
B)
New debtNew equity
C)
Internally generated fundsNew debt


Pecking order theory is related to the signals management sends to investors through its financing choices. Financing choices follow a hierarchy based on visibility to investors with internally generated funds being the least visible and most preferred, and issuing new equity as the most visible and least preferred.
作者: invic    时间: 2012-3-30 10:04

John Harrison is discussing the implications for Modigliani and Miller (MM’s) propositions (assuming no corporate or personal taxes) for manager’s decisions regarding capital structure with his supervisor, Harriet Perry. In the conversation, Harrison makes the following statements:
Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero.
Statement 2: Since MM’s propositions assume that there are no taxes, equity is the preferred method of financing.
What is the most appropriate response to Harrison’s statements?
A)
Agree with both.
B)
Agree with neither.
C)
Agree with one only.


Perry should agree with the first statement. MM asserts that the use of debt financing, although it is cheaper than equity, will increase in the cost of equity, resulting in a zero net change in the WACC. Perry should disagree with the second statement. Although MM’s propositions assume that there are no taxes, the conclusion is that the mix of debt and equity financing is irrelevant and that there is no preferred method of financing.
作者: invic    时间: 2012-3-30 10:04

Global Development expects to earn $6 million next year. 40% of this amount, or $2.4 million, has been allocated for distribution to common shareholders. There are 2.4 million shares outstanding, and the market price is $30 a share. If Global uses the $2.4 million to repurchase shares at the current price of $30 per share, its share price after the repurchase will be closest to:
A)
$29.00.
B)
$31.00.
C)
$30.00.


Market value of equity before the repurchase is $30 × 2.4 million = $72 million.
Shares Repurchased = $2.4 million / $30 = 80,000 shares.
Shares remaining = Shares outstanding − Shares repurchased = 2,400,000 − 80,000 = 2,320,000.
Share price after the repurchase = ($72 million − $2.4 million) / 2,320,000 = $30.
作者: invic    时间: 2012-3-30 10:04

Which of the following best describes the shape of the line depicting the value of a levered firm when plotted according to the static trade-off theory? Assume that the percentage of debt in the capital structure is the independent variable.
A)
U shaped.
B)
Always upward sloping.
C)
Upside down U shaped.


The line depicting the value of a levered firm according to the static trade-off theory looks like an upside down U. The value of the firm will initially increase due to the tax savings provided by taking on additional debt financing, and then will decline as the costs of financial distress exceed the tax benefits of taking on additional debt financing.
作者: invic    时间: 2012-3-30 10:05

According to the static trade-off theory:
A)
new debt financing is always preferable to new equity financing.
B)
there is an optimal proportion of debt that will maximize the value of the firm.
C)
the amount of debt used by a company should decrease as the company’s corporate tax rate increases.


The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Under the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt that will maximize the value of the firm.
作者: invic    时间: 2012-3-30 10:05

Katherine Epler, a self-employed corporate finance consultant, is working with another new client, Thurber Electronics. Epler is discussing the static trade-off capital structure theory with her client, and makes the following comments:
Comment 1: Under the static trade-off theory, the graph of a company’s weighted average cost of capital has a U shape.
Comment 2: According to the static trade-off theory, every firm will have the same optimal amount of debt that maximizes the value of the firm.With respect to Epler’s comments:
A)
only one is correct.
B)
both are correct.
C)
both are incorrect.


Epler’s first comment is correct. When graphing a company’s WACC according to the static trade-off theory, the WACC will initially decline as a company increases its tax savings through the use of debt. However, as more debt is added, the WACC will reach a point where it increases due to the increasing costs of financial distress. Note that when graphing the static trade-off theory, the WACC looks like a U shape, while the value of the firm looks like an upside down U shape. This makes sense because the value of the firm is maximized when the WACC is minimized. Epler’s second comment is incorrect. Every firm will have a different optimal capital structure that will depend on the firm’s operating risk, tax situation, industry influences, and other factors.
作者: invic    时间: 2012-3-30 10:06

Bhairavi Patel, an analyst for major brokerage firm, is considering how to incorporate the static trade-off capital structure theory into her valuation models for companies she covers. Patel is discussing the static trade-off theory with her colleagues, and makes the following statements:
Statement 1: If a firm maintains a high debt rating, the firm cannot be at its optimal capital structure based on the static trade-off theory.
Statement 2: The static theory implies that differences in the optimal capital structure across similar firms in different countries must be the result of different tax rates in those countries.
With respect to Patel’s statements:
A)
both are correct.
B)
only one is correct.
C)
both are incorrect.


Neither of Patel’s statements is correct. Firms seek to maintain a high debt rating because it implies a lower probability of financial distress, which reduces the cost of debt and equity capital and leads to a higher value for the firm. Although a firm would not be at its optimal capital structure if it were not using enough debt, a firm can certainly have a large proportion of high quality debt that keeps the firm at its optimal capital structure while maintaining a high credit rating. The second statement is also incorrect. Although differences in tax rates can play a role in having different optimal capital structures for similar firms, differences in costs of financial distress will play a role as well. Differences in legal structure, liquidity, and other factors will result in different perceived costs of financial distress in different countries, which will in turn, contribute to different optimal capital structures according to the static trade-off theory.
作者: invic    时间: 2012-3-30 10:06

Which of the following is least likely to be categorized as a cost of financial distress?
A)
Legal fees paid to bankruptcy lawyers.
B)
Having a potential merger partner pull out of a proposed deal.
C)
Premiums paid for bonding insurance to guarantee management performance.


Premiums paid for bonding insurance to guarantee management performance is an example of an agency cost. Agency costs are costs associated with the fact that all public companies are not managed by owners and the conflict of interest created by that fact. Costs of financial distress can be direct or indirect. Direct costs would include cash expenses associated with bankruptcy, such as legal and administrative fees, while indirect costs would include foregone business opportunities, inability to access capital markets, or loss of trust from customers, suppliers, or employees.
作者: pacmandefense    时间: 2012-3-30 10:09

Which of the following companies is most likely to have the greatest expected cost of financial distress?
A)
An airline company with strong management.
B)
A steel manufacturer with an average debt to equity ratio for the industry.
C)
An information technology service provider with a weak corporate governance structure.


The expected cost financial distress is related to the combination of the cost and probability of financial distress. Firms who have a ready secondary market for their assets such as airlines or steel manufacturers, have lower costs from financial distress due to the marketability of their assets. Firms with fewer tangible assets, such as information technology service providers, have less to liquidate and therefore have higher costs related to financial distress. The probability of financial distress is positively related to the amount of leverage on the balance sheet, and negatively related to the quality of a firm’s management and corporate governance structure
作者: pacmandefense    时间: 2012-3-30 10:09

Rupert Jones, a manager with Oswald Technologies, is confused about agency costs of equity and how they can be managed at his firm. To try to gain a better understanding about agency costs, Jones asks Karrie Converse, a well known consultant for an explanation. In their conversation, Converse makes the following statements:
Statement 1: Costs related to the conflict of interest between managers and owners of a business can be eliminated through a combination of bonding provisions and adequate monitoring through a quality corporate governance structure.
Statement 2: The less a company depends on debt in its capital structure, the lower the agency costs the company will tend to have.
Are Converse’s statements concerning the agency costs of equity correct?
A)
Both are correct.
B)
Both are incorrect.
C)
Only one is correct.


Both of Converse’s statements are incorrect. With regard to elimination of agency costs, residual losses may occur even with adequate monitoring and bonding provisions, because such provisions do not provide a perfect guarantee against losses. Also, if you read the statement carefully, it is contradictory because the costs associated with bonding insurance and monitoring are actual agency costs! The second statement is also incorrect because, according to agency theory, the use of debt forces managers to have discipline with regard to how they spend cash. This discipline causes greater amounts of leverage to correspond to a reduction in agency costs.
作者: pacmandefense    时间: 2012-3-30 10:12

Modigliani and Miller demonstrated that if corporate taxes are introduced into an otherwise perfect world, the optimal capital structure would be:
A)
an equal amount of debt and equity.
B)
all debt.
C)
all equity.


In this almost perfect world, the tax deductibility of interest payments encourages firms to use more debt in their capital structures. Since the more the firm borrows the greater the tax write-offs, the firm is encouraged to hold the maximum amount of debt possible. There could essentially be a single equity share, making up a very small portion of the financing, and the remainder, essentially 100%, would be financed with debt.
作者: pacmandefense    时间: 2012-3-30 10:12

Modigliani and Miller demonstrated that if corporate taxes and bankruptcy costs are introduced into an otherwise perfect world the weighted average cost of capital (WACC) will:
A)
fall continuously as more debt is added to the capital structure.
B)
fall, then bottom out, and finally start to rise.
C)
rise, then plateau, and finally start to fall.


The WACC first falls because bondholders take less risk and, consequently, have a lower required rate of return. In addition, interest expenses are tax deductible. However, as the amount of debt rises, financial risk rises, and the chance for bankruptcy increases. If there are positive bankruptcy costs, both bondholders and stockholders will require increasingly higher rates of return as financial risk increases causing the WACC to rise. This rise offsets the benefits of using the cheaper source of financing.
作者: pacmandefense    时间: 2012-3-30 10:13

Joseph Palmer is discussing the impact of the tax shield provided by debt with his supervisor, Ming Chou. During the course of their discussion, Palmer makes the following statements:
Statement 1:   The value of the tax shield provided by debt can be calculated by multiplying the pre-tax cost of debt by (1 – tax rate).
Statement 2:   If a company is profitable, the value of its tax shield will be positive and its value will increase as its leverage increases, all else equal.

With respect to Palmer’s statements:
A)
both are correct.
B)
both are incorrect.
C)
only one is correct.


Palmer’s first statement is incorrect. The calculation Palmer describes is the calculation for the after-tax cost of debt. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure. Palmer’s second statement is correct. The tax shield adds value to the firm so that the value of a levered firm is greater than the value of an unlevered firm, all else equal.
作者: pacmandefense    时间: 2012-3-30 10:13

Davis Streng, the corporate controller for the Cannizaro Corporation has been researching Modigliani and Miller’s (MM) theories on capital structure. Streng would like to apply the theories to his firm’s capital structure, but does not agree with MM’s assumption of no taxes, since Cannizaro has a 40% tax rate. If Streng removes the assumption of no taxes, but keeps all of MM’s other assumptions, which of the following would be the optimal capital structure for maximizing the value of the firm?
A)
The capital structure Streng chooses is irrelevant.
B)
100% equity.
C)
100% debt.


If MM’s other assumptions are maintained, removing the no tax assumption means that the value of the firm is maximized when the value of the tax shield is maximized, which occurs with a capital structure of 100% debt.
作者: pacmandefense    时间: 2012-3-30 10:14

Katherine Epler, a self-employed corporate finance consultant, is working with her newest client, Harbor Machinery. Epler is discussing various capital structure theories with her client, and makes the following comments.
Comment 1: If we remove the assumption of no taxes from Modigliani and Miller’s theory regarding capital structure, and if the firm holds some proportion of debt, increases in the corporate tax rate will increase the value of the firm.
Comment 2: If we also include the costs of financial distress in Modigliani and Miller’s assumptions, the optimal capital structure will not contain any debt financing.With respect to Epler’s comments:
A)
both are correct.
B)
both are incorrect.
C)
only one is correct.


Epler’s first comment is correct. The tax deductibility of interest payments provides a tax shield that adds value to the firm. The value of a tax shield is equal to the marginal tax rate times the amount of debt in the capital structure, so the higher the tax rate, the greater the value of the tax shield and the value of the firm, all else equal. Epler’s second comment is incorrect. If the costs of financial distress are also included in MM’s assumptions, we get the static-tradeoff theory, where the firm will have debt in its capital structure up to the point where the marginal cost of financial distress exceeds the marginal value provided by the tax shield.
作者: pacmandefense    时间: 2012-3-30 10:14

Which of the following statements about capital structure theories is most accurate?
A)
Based on signaling theory, if a firm issues new common stock it means that the firm thinks future investment prospects are better than normal.
B)
In a Modigliani and Miller (MM) world with taxes, but no bankruptcy cost, you would expect to see firms taking on very little debt.
C)
In a world with taxes and bankruptcy costs one would expect there to be an optimal capital structure where the cost of capital is minimized and share price is maximized.


It is true that in a world with taxes and bankruptcy costs there will be an optimal capital structure where the cost of capital is minimized and share price is maximized. The other statements are false. In a tax world without bankruptcy the optimal capital structure is 100% debt. When firms issue new equity, it may suggest investment prospects look poor
作者: pacmandefense    时间: 2012-3-30 10:15

Which of the following statements about a firm's capital structure is least accurate?
A)
The optimal capital structure is the one that minimizes the weighted average cost of capital and consequently maximizes the value of the firm's share price.
B)
The firm's share price is maximized when the firm maximizes its earnings per share while it minimizes its cost of capital.
C)
If bankruptcy costs were included into the M&M analysis of capital structure in a tax world there would be an optimal capital structure between no debt and all debt.


The optimal capital structure is the one that maximizes stock price and minimizes the WACC. The optimal capital structure is not the one that maximizes the firm’s EPS.
作者: pacmandefense    时间: 2012-3-30 10:15

Which of the following firms is most likely to utilize additional debt the next time it raises capital? The firm:
A)
that has many new fixed assets.
B)
firm that has experienced significant losses in recent years.
C)
in a high tax bracket.


The value of tax deductibility rises with tax rates. Of course, there are other ways to reduce taxes. Firms with many new assets are probably also benefiting from high levels of depreciation. Firms with recent losses may be avoiding taxes by writing off those losses
作者: pacmandefense    时间: 2012-3-30 10:16

Which of the following is likely to encourage a firm to increase the amount of debt in its capital structure?
A)
The personal tax rate increases.
B)
The corporate tax rate increases.
C)
The firm's earnings become more volatile.


An increase in the corporate tax rate will increase the tax benefit to the corporation, because interest expense is not taxable. An increase in the personal tax rate will not impact the firm’s cost of capital. More volatile earnings increase the risk of the firm and therefore the firm would not desire to increase financial risk as a result of these changes.
作者: pacmandefense    时间: 2012-3-30 10:17

Frank Collins, CFA, is managing director for Brisbane Capital Resources, an Australian fund manager. The firm has had great success through the years with its growth-oriented investment strategy, but has suffered when the markets change in favor of value investment strategies. Consequently, Collins is exploring how the firm might increase its presence in the value sector of the market.
Many of the firms that reside in the value sector are those that have fallen on hard times, and have underperformed their peers. During his examination of firms meeting various value criteria, Collins has noted that while falling sales and the lack of profits are sometimes the obvious causes of the substandard performance, in other cases sales and profits do not appear to be the root cause. He wonders if the way that these firms have been capitalized is having a negative impact on their values.
Collins recalls from his days of studying finance at the University of Queensland, that a Nobel Prize was awarded for one of the theories in the capital structure area. His recollection of the details is sketchy, so he has contacted Dr. Martin Gray from UQ’s Department of Commerce to discuss capital structure in theory and in practice.
Gray tells Collins that his memory is indeed correct, that a Nobel Prize was awarded to Miller and Modigliani for their work in explaining the capital structure decision. Interestingly, he notes that their theories say that, under the right circumstances, capital structure is irrelevant. Obviously, the key is whether or not the right circumstances are relevant to what is observed in the real world.
Gray continues to tell Collins that there are a variety of matters that complicate the MM theory in practice. Firms pay taxes, managers may be motivated by their own self-interests, and adjustments to a firm’s capital structure are not costless. All of these factors affect the MM theories, and have given rise to other theories that attempt to explain why firms finance themselves as they do.
Collins also wonders if capital structure decisions are affected in any way by the country in which the firm is domiciled. He knows that Australia tends to follow the Anglo-American financial model, but that firms in continental Europe, Japan, and other countries are more accustomed to relying upon banks for capital. He wonders if this affects the capital structures observed across firms, even when the firms have the same underlying business risk.
Finally, Collins asks Gray about corporate debt ratings. Gray tells him that ratings fall broadly across two classes—investment grade and speculative—with a variety of ratings within each class. Moreover, Gray advises that firms usually seek to maintain a credit rating in the investment grade class, since some fiduciary investors are precluded from holding debt in the speculative class. Collins wonders if a firm’s debt ratings have any bearing upon the choice of capital structure.Which of the following statements most accurately characterizes the static trade-off theory of capital structure?
A)
Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.
B)
Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.
C)
Increasing the use of relatively lower cost debt causes the required return on equity to increase such that the overall cost of capital is unchanged.


The static trade-off theory of capital structure states that firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress. In other words, the capital structure is determined by the trade-off between these two factors. (Study Session 8, LOS 29.a)
Which of the following statements most correctly characterizes the pecking order theory of capital structure?
A)
Regardless of how the firm is financed, the overall value of the firm and aggregate value of the claims issued to finance it remain the same.
B)
Firms will seek to use debt financing up to the point that the value of the tax shield benefit is outweighed by the costs of financial distress.
C)
Firms have a preference ordering for capital sources, preferring internally-generated equity first, new debt capital second, and externally-sourced equity as a last resort.


The pecking order theory of capital structure assumes that firms have a preference ordering for capital sources. They prefer to use internally-generated equity first. When the internally-generated equity is exhausted, they issue new debt capital. As a last resort they will rely on externally-sourced equity. The reason that new equity is the last resort is that the issuance of new stock is assumed to send a negative signal to investors regarding firm value. (Study Session 8, LOS 29.a)
When taxes are incorporated into the capital structure decision, the main result is that:
A)
the firm derives a tax shield benefit from using debt because the interest expense is tax-deductible.
B)
firms should increase the use of equity financing because of its inherent tax advantages.
C)
the costs of financial distress become relevant to the analysis.


The main impact of incorporating corporate income taxes is that the firm derives a tax shield benefit because interest is a tax-deductible expense. (Study Session 8, LOS 29.a)
Which of the following reasons is least accurate regarding why a firm’s actual capital structure may deviate from its target capital structure?
A)
The book values of outstanding debt and equity are different from their market values.
B)
Management may believe that now is an opportune time to issue equity.
C)
There may be economies of scale in issuing debt securities.


The book values of equity and debt are generally not relevant to assessing a firm’s capital structure. It is the market values of equity and debt that determine the current capital structure. (Study Session 8, LOS 29.b)
Which of the following statements most accurately characterizes how debt ratings may affect a firm’s capital structure policy?
A)
Because credit ratings are based upon cash flow coverage of interest expense, they are not influenced by the firm’s capital structure.
B)
Firms that have their credit ratings reduced below investment grade are not able to issue additional debt.
C)
A firm may be deterred from increasing the use of debt to avoid having its credit rating reduced below some minimum acceptable level.


Credit ratings can be factored into management’s capital structure policy if a firm has a minimum rating objective, and this is likely to be adversely affected by issuing additional debt. (Study Session 8, LOS 29.c)
Which of the following statements concerning the use of leverage is most accurate?
A)
The use of leverage in capital structures is broadly consistent in most developed economies.
B)
Companies in countries where the use of bank debt (as opposed to issuing bonds) is more prevalent tend to use more leverage.
C)
A high degree of information asymmetry tends to reduce the use of debt in the capital structure.


Companies in countries where the use of bank borrowing is relatively more prevalent than the issuance of corporate bonds tend to use more leverage. The other statements are incorrect, based upon observations across countries. (Study Session 8, LOS 29.e)
作者: pacmandefense    时间: 2012-3-30 10:18

Schwarzwald Industries recently issued new equity to help fund a new capital project. What type of signal is Schwarzwald’s choice of financing sending to investors about the future prospects of the firm under the information asymmetry signaling theory and pecking order theory respectively?
A)
Negative signal under both theories.
B)
Positive signal under both theories.
C)
Positive signal under only one theory.


Signaling theory results from asymmetric information, which refers to the fact that managers have more information about a company’s future prospects than the firm’s owners and creditors. Since managers are reluctant to sell new stock if they think the stock is undervalued, but very willing to sell stock if they think the stock is overvalued, selling stock sends a negative signal about a firm’s future prospects. Pecking order theory, which is related to signaling theory, suggests that managers choose methods of financing based on the visibility of signals they send. Raising equity is the least preferred method of financing under pecking order theory, and it sends a negative signal.
作者: pacmandefense    时间: 2012-3-30 10:18

Which of the following is least likely to be a reason why a firm’s actual capital structure may vary from the target capital structure?
A)
The firm decides to issue additional equity because management believes the firm’s stock is overpriced.
B)
The firm decides to finance a low risk project with 100% debt to improve the project’s profitability.
C)
The firm decides to issue additional debt due to a temporary discount in underwriting fees for corporate debt.


A firm should always finance a project based on the firm’s weighted average cost of capital, although when evaluating a project, the firm may apply a risk factor to adjust the risk of the project. A corporate manager generally cannot deem some projects as being financed by debt and some by equity as all projects are effectively financed proportionately based on the firm’s capital structure. In practice, a firm’s actual capital structure will float around its target. For a firm that does have a target capital structure, the actual structure may vary from the target due to market value fluctuations, or management’s desire to exploit an opportunity in a particular financing source.
作者: pacmandefense    时间: 2012-3-30 10:18

Katherine Epler, a self-employed corporate finance consultant, is conducting a seminar for executive management teams regarding issues related to a company’s capital structure. In the morning session of the seminar, Epler makes the following two statements:
Statement 1: Management teams will have a target capital structure for their firm because of an awareness of how competing firms finance their operations and a desire to keep their financial ratios close to industry averages.
Statement 2: In order to reap the benefits that come with having a target capital structure, management must always raise capital in the exact proportions called for by the target.
With respect to Epler's statements:
A)
both are correct.
B)
only one is correct.
C)
both are incorrect.


Both of Epler’s statements are incorrect. Management teams will have a target capital structure because they are aware that their firm as an optimal capital structure that will maximize the value of the firm. It is the desire to keep the capital structure close to the optimal structure that leads to a target capital structure, not a desire to keep financial ratios close to industry averages. The second statement is also incorrect. The target capital structure is more of a floating range, and the firm may deviate slightly from the target when raising capital to exploit short-term opportunities in a particular financing source.
作者: pacmandefense    时间: 2012-3-30 10:19

Zoltan DeJainus is the Chief Financial Officer of Hilliard Veterinary Products (HVP). In a discussion with HVP’s management team about the firm’s capital structure, DeJainus makes the following comments:
Comment 1: HVP’s target capital structure is the same as its optimal capital structure.
Comment 2: If market value fluctuations cause the firm’s actual capital structure to vary from the target capital structure, HVP should buy or sell its own stock or bonds as necessary to make sure that the capital structure remains at its optimal level.
Should the members of HVP’s management team agree or disagree with each of DeJainus’ comments?
A)
Agree with both.
B)
Disagree with both.
C)
Agree with only one.


The management team should agree with DeJainus’ first comment. For managers trying to maximize the value of the firm, the target capital structure will be the same as the optimal capital structure. The management team should disagree with the second comment. In practice, a firm’s actual capital structure will float around its target. One of the reasons for floating around the target is market value fluctuations. The target capital structure serves as a guide for making decisions about how to raise additional capital, but unless there is an extreme circumstance, there is no need for a firm to make transactions to keep the capital structure exactly on target.
作者: pacmandefense    时间: 2012-3-30 10:19

Jayco, Inc. currently has a Debt/Assets ratio of 33.33% but feels its optimal Debt/Assets ratio should be 16.67%. Sales are currently $750,000, and the total assets turnover (Sales / Assets) is 7.5. If Jayco needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Finance it with:
A)
all equity.
B)
25% debt, 75% equity.
C)
all debt.


Sales / Assets = 7.5 = 750,000 / Assets, so Assets = 100,000. Debt / 100,000 = 33.33%. Therefore, Debt must be 33,333. You want to change Debt/Assets to 16.67%, so you must double Assets (without increasing Debt) by adding 100,000 to equity.
作者: pacmandefense    时间: 2012-3-30 10:20

The firm's target capital structure is consistent with which of the following?
A)
Minimum risk.
B)
Maximum earnings per share (EPS).
C)
Minimum weighted average cost of capital (WACC).


At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm.
作者: pacmandefense    时间: 2012-3-30 10:20

firm’s capital structure affects:
A)
return on equity but not default risk.
B)
default risk but not return on equity.
C)
return on equity and default risk.


A firm’s capital structure affects both its return on equity and its risk of default.
作者: pacmandefense    时间: 2012-3-30 10:21

A firm's optimal debt ratio:
A)
minimizes risk.
B)
maximizes return.
C)
is the firm's target capital structure.


The optimal debt ratio for a firm balances the influences of risk and return, leading to a maximization of share price. As such, the optimal debt ratio serves as a target level of debt financing for the value-maximizing firm. A debt ratio of 1.0 would be possible only if one hundred percent of the firm were financed with debt, eliminating equity ownership. Such a scenario is impossible.
作者: pacmandefense    时间: 2012-3-30 10:21

Katherine Epler, a self-employed corporate finance consultant, is preparing a new seminar concerning debt ratings and how they impact capital structure policy. As she is working on her presentation, Epler prepares two presentation slides that contain the following:
Slide 1: Lower debt ratings will increase the cost of debt as well as the cost of equity financing.Slide 2: Managers would prefer to have the highest possible debt ratings.
With respect to Epler’s slides:
A)
both are incorrect.
B)
both are correct.
C)
only one is correct.


The information on both of Epler’s slides is correct. Lower debt ratings signifies higher risk to both debt and equity capital providers and will cause both to demand higher returns on their investment. Also, managers will always prefer the highest possible debt rating because higher debt ratings will result in lower costs of capital.
作者: pacmandefense    时间: 2012-3-30 10:22

Assume that the debt rating given by Standard and Poor’s for Oswald Technologies drops from AAA to BBB. Which of the following reflects the most likely increase in the cost of debt for Oswald Technologies?
A)
100 basis points.
B)
500 basis points.
C)
10 basis points.


Historically, the average spread between AAA rated bonds and BBB rated bonds has been 100 basis points, so 100 basis points is the most likely answer. Note however that the actual spread may fluctuate due to market conditions, and may be wider in recessions.
作者: pacmandefense    时间: 2012-3-30 10:23

Gervase Jackson is a student in corporate finance class. Jackson is unsure how debt ratings tie into a company’s capital structure and decides to talk to his professor after class. In their discussion, the professor makes the following statements:
Statement 1: The most common way that firms use debt ratings in conjunction with capital structure is to set a certain minimum debt rating that the firm strives to stay above at all times.
Statement 2: A change in debt rating from investment grade to speculative grade will significantly increase the firm’s cost of debt capital.
With respect to the statements made by Jackson’s professor:
A)
both are incorrect.
B)
both are correct.
C)
only one is correct.


Both of the statements made by Jackson’s professor are correct. Managers generally want to maintain the highest debt rating possible because higher debt ratings will result in lower costs of capital. Managers are aware that a drop in debt rating may increase capital costs, so that is generally something the managers will avoid. Also, a change in debt rating from investment grade to speculative grade is particularly harmful for the firm’s cost of capital because a drop to speculative grade will classify the debt as “junk” which will generally result in a significant increase in capital costs.
作者: pacmandefense    时间: 2012-3-30 10:23

Which of the following changes in debt ratings is most likely to have the greatest negative impact on a firm’s weighted average cost of capital (WACC)? A change in debt rating from:
A)
AA to A.
B)
BBB to BB.
C)
BB to BBB.


Since the cost of capital is tied to debt ratings, many managers have goals for maintaining certain minimum debt ratings when determining their capital structure policies. Lower debt ratings mean higher level of credit risk, and a higher cost of capital. Managers want to avoid drops in bond ratings in any case, but a bond rating drop from investment grade to speculative grade (BBB to BB) tends to cause a significant increase in the cost of debt and the WACC.
作者: pacmandefense    时间: 2012-3-30 10:24

Steve Cooley, the Chief Financial Officer for Canberra Corporation, decides that he wants to use as much debt as possible in his firm’s capital structure. Cooley knows that to use more debt, he will need to make a persuasive argument to his board. Which of the following arguments used by Cooley to help with his goal of raising large amounts of additional debt is least supported by empirical evidence?
A)
The cost of debt is always cheaper than the cost of equity.
B)
Increasing the amount of debt has an insignificant impact on our credit risk premium.
C)
Raising additional debt provides a signal to our shareholders that our firm’s future prospects are positive.


Athough it is not the only factor, increasing the amount of debt will put downward pressure on the company’s credit rating, resulting in an increase in the credit risk premium. This will in turn increase the costs of both debt and equity capital. Note that raising additional debt does provide a positive signal about future prospects. Also, saying that the cost of debt is always cheaper than the cost of equity is an accurate statement, but the static trade-off theory shows how balancing debt and equity capital can lead to lower costs for both components
作者: pacmandefense    时间: 2012-3-30 10:24

Jeffery Pyle, a health care analyst for a major brokerage firm, is trying to determine how capital structure policy impacts the valuation of firms he covers. Which of the following factors is likely to be the least useful for his analysis?
A)
How often management uses internally generated capital versus raising new capital in the capital markets.
B)
Quality of corporate governance.
C)
Differences in capital structure across firms in his coverage universe.


The three main factors that a financial analyst must consider when evaluating how a firm’s capital structure impacts valuation are changes in the firm’s capital structure over time, differences in capital structure between competitors with similar business risk, and company specific factors such as quality of corporate governance that may impact agency costs.
作者: pacmandefense    时间: 2012-3-30 10:25

Vernon Hurd is an analyst that is covering Oswald Technologies. Hurd does not have the privilege of knowing the firm’s exact target capital structure, but would like to determine whether or not the capital structure policies followed by Oswald’s management is maximizing the value of the firm. Which of the following approaches would be most useful to Hurd to determine whether management’s current capital structure policy is maximizing Oswald’s value?
A)
Cross-sectional ratio analysis with firms that have similar business risk to Oswald.
B)
Dupont analysis.
C)
Scenario analysis.


The topic review specifically mentions using scenario analysis 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.
作者: pacmandefense    时间: 2012-3-30 10:25

Michael Sherman is a finance professor at the University of Tuskaloosa. In a recent lecture concerning the factors an analyst should consider when evaluating the impact of capital structure on the valuation of a firm, Sherman makes the following statements:
Statement 1: 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.
Statement 2: If an analyst is comparing the capital structure of one firm to the capital structure of a competitor firm, it is important to adjust the analysis for differences in business risk.
Sherman’s students should agree with:
A)
both statements.
B)
only one statement.
C)
neither statements.


Sherman’s students should disagree with his first statement. Changes in capital structure for a firm over time is essential for evaluating whether or not management’s decisions have worked to improve the firm’s value. Sherman’s second statement is correct. Differences in capital structure could reflect differences in business risk, so the analyst should try to make comparisons based on similar business risk characteristics in order to have a true apples to apples comparison.
作者: JoeyDVivre    时间: 2012-3-30 10:32

Which one of the following statements about a firm's capital structure is most accurate? The optimal capital structure:
A)
maximizes the stock price, minimizes the weighted average cost of capital (WACC).
B)
maximizes expected earnings per share (EPS), maximizes the price per share of common stock.
C)
minimizes the required rate on equity, maximizes the stock price.


The firm's optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm's stock price. Return: this optimal capital structure will maximize the firm's stock price. Risk: at the optimum level, the cost of capital (as reflected in WACC) is also minimized.A firm’s target capital structure is the debt to equity ratio that the firm tries to maintain over time. Should the firm’s current debt ratio fall below the target level, new capital needs will be satisfied by issuing debt. On the other hand, if the debt ratio is greater than the target level, the firm will raise new capital by retaining earnings or issuing new equity. When setting its target capital structure, the firm must weigh the tradeoff between risk and return associated with the use of debt. The use of debt increases the risk borne by shareholders. However, using debt leads to higher expected rates of return by shareholders. The higher risk associated with debt will depress stock prices, while the higher expected return will increase stock prices. Thus, the firm’s optimal capital structure is the one that balances the influence of risk and return and thus maximizes the firm’s stock price. The optimal debt ratio will be the firm’s target capital structure.
作者: JoeyDVivre    时间: 2012-3-30 10:32

Financial leverage ratios tend to be to low in countries that have:
A)
a high reliance on the banking system for raising debt capital.
B)
a large institutional investor presence.
C)
inefficient legal systems.


Firms operating in countries with an active, large institutional investor presence tend to have less financial leverage. Large institutional investors tend to have greater resources to analyze companies and reduce information asymmetries, which reduces the use of debt. By contrast, companies with weak legal systems and a high reliance on the banking system will all tend to have higher debt ratios.
作者: JoeyDVivre    时间: 2012-3-30 10:33

The maturity structure for corporate debt is typically shorter in countries that have:
A)
more liquid stock and bond markets.
B)
low rates of GDP growth.
C)
lower rates of inflation.


Firms operating in countries with higher GDP growth tend to use longer maturity debt, so firms with weaker economic growth will tend to use shorter maturity debt, all else equal. Note that low inflation means that longer maturity debt will do a better job holding its value, and that countries with highly liquid stock and bond markets will tend to use long maturity debt.
作者: JoeyDVivre    时间: 2012-3-30 10:33

Katherine Epler, a self-employed corporate finance consultant, is conducting a seminar concerning differences in financial leverage across different countries. In her seminar, Epler makes the following statements:
Statement 1: Companies in developed countries tend to use less long-term debt when financing their operations compared with companies in emerging markets.
Statement 2: Companies operating in Japan tend to have a greater reliance on shorter term debt financing than companies operating in the United States.
With respect to Epler’s statements:
A)
both are correct.
B)
both are incorrect.
C)
only one is correct.


Epler’s first statement is incorrect. Companies in developed countries tend to use more long-term debt than emerging market countries. This makes sense because countries with more liquid capital markets (which would favor developed markets) tend to use more long-term debt. Epler’s second statement is correct. Japan relies on more short-term debt than the United States, which makes sense as the legal system and institutional investor presence tends to be greater in the U.S., which favors longer maturity debt.
作者: JoeyDVivre    时间: 2012-3-30 10:33

Katherine Epler, a self-employed corporate finance consultant, is having a discussion with friends that are also in the corporate finance field. After talking about their families, the discussion turns to factors that tend to impact capital structure. During the course of the conversation, Epler makes two statements.
Statement 1: Favorable tax rates on dividend income relative to interest income will reduce the value of the tax shield provided by debt in the static trade-off theory of capital structure.
Statement 2: Evidence indicates that reductions in the net agency costs of equity tend to lead to lower financial leverage ratios.
With respect to Epler's statements:
A)
both are correct.
B)
both are incorrect.
C)
only one is correct.



Epler’s first statement is correct. 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 reduced somewhat. This conclusion is supported by international capital structure differences as countries with favorable dividend tax rates tend to use less debt in their capital structure. Epler’s second comment is also correct. When looking at international differences in capital structure, countries that have factors in place such as stronger legal systems and a greater presence of analysts and auditors tend to reduce agency costs and therefore also have lower financial leverage ratios. Note that higher leverage ratios tend to reduce agency costs, but reducing agency costs does not lead to higher leverage ratios.
作者: JoeyDVivre    时间: 2012-3-30 10:34     标题: [2012 L2] Financial Reporting and Analysis【Session 8- Reading 30】Sample

If Modigliani and Miller’s dividend irrelevancy theory is correct, what is the impact on a firm’s cost of capital and share price if its dividend payout increases?
Cost of CapitalShare Price
A)
An increaseA decrease
B)
NoneNone
C)
NoneA decrease


If investors do not consider dividends to be relevant, the dividend payout will not affect the required rate of return. If the required rate of return does not change, the value of a firm will be unchanged despite the change in its dividend payout rate.
作者: JoeyDVivre    时间: 2012-3-30 10:35

In a world with taxes and brokerage costs:
A)
dividend policy may be relevant.
B)
Modigliani and Miller say that dividend policy is irrelevant.
C)
Modigliani and Miller say that dividend policy is relevant.


Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the “bird-in-the-hand” theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains.
作者: JoeyDVivre    时间: 2012-3-30 10:35

According to Modigliani and Miller’s dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a “dividend” on that company by:
A)
contacting the firm and asking for a dividend payment.
B)
selling a portion of the company's stock each year.
C)
buying additional shares each year.


Miller and Modigliani’s dividend irrelevancy theory states that shareholders can in theory construct their own dividend policy. If a firm does not pay dividends, a shareholder who wants a 4% dividend can “create” it by selling 4% of his or her stock. Note that Modigliani and Miller’s theory does not allow for transaction costs or taxes. In actuality, shareholders will have to pay a brokerage commission on the sale and tax on any capital gains.
作者: JoeyDVivre    时间: 2012-3-30 10:36

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:
A)
9.6%.
B)
6.3%.
C)
5.2%.


Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. The inflation rate is calculated using the formula:Inflation = (Price Indexthis year – Price Indexlast year) / Price Indexlast year
Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.
Thus, the real return = 7.4% - 2.2% = 5.2%.
作者: JoeyDVivre    时间: 2012-3-30 10:37

In a recent lecture at a seminar titled “Dividends – Do They Really Matter?”, Matthew Janowski, CFA, made the following two statements regarding the information content in dividend policy changes across countries:
Statement 1: In the U.S., investors infer that small changes in dividends do not send a major signal about a company’s future prospects to existing and potential shareholders.
Statement 2: In Asian countries such as Japan, investors are unlikely to assume that even a large change in dividend policy signals anything about a company’s future prospect.
With respect to Janowski's statements:
A)
only one is correct.
B)
both are correct.
C)
both are incorrect.


The information content in dividend policy changes is viewed differently across countries. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. Thus, Statement 1 is incorrect. However, in Asian countries such as Japan, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future prospect. As a result, Asian companies are freer to raise and lower their dividends as circumstances change without concerns over how investor reactions may affect the stock price. Therefore, Statement 2 is correct.
作者: JoeyDVivre    时间: 2012-3-30 10:38

At a recent conference, “Dividends − Are They Increasing?”, several lecturers were discussing the signaling effect and their opinions on how changes in a company’s dividend policy are often viewed by investors. Linda Travis, an equity analyst at Girthmore Capital Management and one of the guest lecturers at the conference, made the following observations:
Observation 1: A dividend initiation is always viewed as a positive signal by investors. It is an indication that the company has so much cash at its disposal that it can afford to pay it out to shareholders.
Observation 2: A dividend decrease is typically a positive signal by a company’s management to its shareholders. It indicates that management has a variety of positive NPV projects in its capital budget and would like to finance as many of them as possible with retained earnings.
With respect to Travis' observations:
A)
both are incorrect.
B)
both are correct.
C)
only one is correct.


A dividend initiation is often viewed differently by different investors. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders – a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities – a negative signal. Dividend decreases or omissions are typically negative signals that current and future earnings prospects are not good and that management does not think the current dividend payment can be maintained.
作者: JoeyDVivre    时间: 2012-3-30 10:38

David Johnson, Karim Baghwani, and Marlon Fitzpatrick are equity research associates at Carp National Investments. Over lunch in the cafeteria, they began discussing the information content of dividends. Baghwani made the following statements to his colleagues:
Statement 1: There is no doubt that shareholders perceive changes in dividend policy as conveying important information about the firm. However, it is viewed differently in the U.S. and in Japan. In the U.S., investors infer that even a small change in a dividend sends a major signal about a company’s prospects.
Statement 2: In Japan, however, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s prospects. Thus, Japanese companies are more free to increase and decrease their dividends than their U.S. counterparts without concerns over investor reactions. With respect to Baghwani's statements:
A)
both are incorrect.
B)
both are correct.
C)
only one is correct.

Both statements are correct. In the U.S., investors infer that even small changes in a dividend send a major signal about a company’s future prospects. However, in Asian countries such as Japan, investors are less likely to assume that even a large change in dividend policy signals anything about a company’s future prospect.
作者: JoeyDVivre    时间: 2012-3-30 10:40

Faltys Asset Management (FAM) follows a dividend growth investment strategy. The Faltys Dividend Growth Fund only invests in companies that have a dividend yield greater than the S&P 500 and have the potential to increase that dividend each year at a rate that exceeds inflation. Warren Berlin, Director of Marketing for FAM has been developing a presentation book to present the fund to prospective clients. These prospective clients include retired individuals who want dividend income and trust companies who manage trust accounts which provide income to be distributed to beneficiaries. Which of the following dividend theories best describes the investment strategy and the marketing strategy of the fund?
Investment StrategyMarketing Strategy
A)
Stable dividendClientele effect
B)
Signaling effectBird-in-the-hand
C)
Bird-in-the-handModigliani and Miller


The investment strategy would best be described as a stable dividend strategy. A stable dividend policy means that a company’s dividend payout is aligned with company’s long-term growth rate such that there is stability in the rate of increase for the dividend. The marketing strategy would best be described as the clientele effect. Berlin is pursuing specific groups of investors that prefer dividends. Note that the bird-in-in-the-hand theory states that investors prefer the certainty of dividends now to uncertain capital gains in the future, while Modigliani and Miller proposed that dividend policy has no impact on the price of a firm’s stock.
作者: JoeyDVivre    时间: 2012-3-30 10:42

According to the “clientele effect” of dividend policy, which of the following groups is most likely to be attracted to low dividend payouts?
A)
High-income individual investors.
B)
Corporations exempt from taxes on 85% of dividend income.
C)
Tax exempt pension funds.


High-income individuals in high tax brackets would prefer capital gains over dividends as they have the greatest benefit from deferral of taxes.
作者: JoeyDVivre    时间: 2012-3-30 10:43

Which of the following statements about dividend policy and capital structure is most accurate?
A)
Investors view a stock repurchase as a positive signal and a stock issue as a negative signal.
B)
A person who believes in the clientele effect and a proponent of the "bird-in-hand" theory would have similar views on dividend payout policy.
C)
Monte Carlo simulation is used to estimate market risks; scenario analysis measures stand-alone risk.


Investors view a stock repurchase as a positive signal and a stock issue as a negative signal. A repurchase may mean that management believes the stock is undervalued. To understand why a stock issue is viewed negatively, consider the following circumstances: A biotech company has a new blockbuster drug that will increase its profitability, but to produce and market the drug, the company needs to raise capital. If the company sells new stock, then as sales (and thus profits) occur, the price of the stock will rise. The current shareholders will do well but not as well as they would have had the company not sold more stock before the share price increased. Thus, it is assumed that management will prefer to finance growth with non-stock sources.
The other statements are false. A person who believes in the clientele effect and a proponent of the “bird-in-hand” theory would not have similar views on dividend policy. The clientele effect suggests that different groups of investors want different dividend levels (often based on tax status), and through the law of supply and demand, investors will select companies that meet their needs. Thus, dividend payout policy does not matter. According to the “bird-in-hand” theory, investors prefer dividends to capital appreciation because they view the former (D1 / P0) as less risky than the latter (g, or growth rate).
作者: JoeyDVivre    时间: 2012-3-30 10:44

The clientele effect predicts that investors with high marginal tax rates and low desire for current income will be attracted to companies whose dividend policies promote:
A)
low levels of share repurchase.
B)
low dividends levels.
C)
low reinvestment of earnings.


The clientele effect states that companies with low dividends will attract a clientele of investors with high marginal tax rates and low desires for current income.
作者: JoeyDVivre    时间: 2012-3-30 10:44

Dividend payments are least likely to be associated with:
A)
increased agency conflict between bondholders and managers.
B)
increased agency conflict between bondholders and shareholders.
C)
increased agency conflict between shareholders and managers.


Paying dividends can be helpful in reducing agency conflicts between shareholders and managers because dividend payouts constrain managers’ ability to invest in negative NPV projects that benefit the managers at the expense of shareholders.
Paying dividends is likely to intensify the agency conflict between bondholders and shareholders, as it represents a transfer of wealth from bondholders to shareholders.
A dividend payment is not usually associated with an increase in agency conflict between bondholders and managers, but can be.
作者: JoeyDVivre    时间: 2012-3-30 10:44

Which of the following is most likely to prompt a company to increase dividend payments? A company’s management foresees:
A)
an immediate lack of profitable investment opportunities.
B)
reduced availability of credit in the market.
C)
continued volatility of the company's earnings.


When earnings are volatile, companies are more hesitant to increase dividends, as there are greater chances that a higher dividend may not be covered by future earnings. When there is reduced availability of credit in the market, a strong cash position—such as might be gained from cutting dividends—is a benefit. A company that foresees few profitable investment opportunities tends to pay out more in dividends, since these opportunities would otherwise be funded with cash flows from earnings.
作者: JoeyDVivre    时间: 2012-3-30 10:45

Tecnolotronix is an equipment manufacturer in a volatile, cyclical industry that employs a long-term residual dividend approach. A surprise increase in quarterly profits would be most likely to have which of the following immediate effects on the actual measured payout ratio?
A)
A decrease in the ratio.
B)
An increase in the ratio.
C)
No change in the ratio.


If a profit increase is seen by management to be a temporary increase, it is unlikely to prompt an increase in the level of dividend payout: a firm using the long-term residual dividend approach would not generally raise dividends in response to a short-run profit increase. Since the payout ratio is calculated as Dividend / Earnings, and earnings have temporarily increased, the calculated payout ratio should fall in the short term.
作者: JoeyDVivre    时间: 2012-3-30 10:45

Which of the following would be least likely to prompt a decline in a company’s overall payout ratio?
A)
A decrease in the capital gains tax rate.
B)
A permanent decrease in company profitability.
C)
An increase in interest rates.


A permanent decrease in profits is expected to result in a decrease in the dividend payment level; however this would probably not lead to a decrease in the payout ratio. If interest rates were to increase, it would make retained earnings a more attractive way of financing new investment; as a result, the payout ratio would be more likely to decline. A decrease in the capital gains tax rate would (for investors that pay tax) make capital gains more appealing; accordingly, aggregate payout ratios would be expected to decline
作者: JoeyDVivre    时间: 2012-3-30 10:45

Which of the following is least likely to discourage a company from making high dividend payouts? The company’s:
A)
bondholders are protected by strong debt covenants.
B)
shareholders are primarily tax-exempt institutions.
C)
flotation costs are high.


Taxes on dividends are one factor that sometimes discourages companies from paying dividends, however if most shareholders are tax exempt, tax considerations are unlikely to discourage a company from making dividend payouts. A company with high flotation costs is less likely to pay out high dividends, to ensure that projects can be financed through earnings and to thus avoid the expense of issuing new shares. Bondholders are often contractually protected from high dividend payouts; strong debt covenants are likely to prevent the company from making high dividend payouts.
作者: JoeyDVivre    时间: 2012-3-30 10:46

Laura’s Chocolates Inc. (LC) is a maker of nut-based toffees. LC is considering a cash dividend, but is concerned about the “double taxation” effect on their shareholders. If the corporate tax rate is 35%, and the tax on dividends is 20%, what is the effective tax rate on a dollar of corporate earnings?
A)
55%.
B)
48%.
C)
42%.


0.35 + (1 − 0.35)(0.20) = 48%
作者: JoeyDVivre    时间: 2012-3-30 10:46

International Pulp, a Swiss-based paper company, has annual pretax earnings (in Swiss francs) of SF 600. The corporate tax rate on retained earnings is 55%, and the corporate tax rate that applies to earnings paid out as dividends is 30%. Furthermore, International Pulp pays out 30% of its earnings as dividends, and the individual tax rate that applies to dividends is 40%.
What is the effective tax rate on corporate earnings paid out as dividends?
A)
70%.
B)
48%.
C)
58%.


This is an example of a split-rate corporate tax system. The calculation of the effective tax rate on a Swiss franc of corporate income distributed as dividends is based on the corporate tax rate for distributed income.

The effective tax rate on income distributed as dividends = 30% + [(1 − 30%) × 40%] = 58%.
作者: JoeyDVivre    时间: 2012-3-30 10:46

David Drakar and Leslie O’Rourke both own 100 shares of stock in a German corporation that makes €1.00 per share in pre-tax income. The corporation pays out all of its income as dividends. Drakar is in the 30% individual tax bracket while O’Rourke is in the 40% individual tax bracket. The tax rate applicable to the corporation is 30%. Drakar and O’Rourke live in the United Kingdom, which uses an imputation tax system for corporate dividends. What is the effective tax rate on the dividend for each shareholder, assuming no effects from the exchange rate?
DrakarO’Rourke
A)
40%48%
B)
30%40%
C)
38%44%


Under an imputation tax system, taxes are paid at the corporate level, but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate.
作者: JoeyDVivre    时间: 2012-3-30 10:46

Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.39, what time period is Calfee most likely using in order to bring its dividend up to the target payout?
A)
4 years.
B)
8 years.
C)
3 years.

The formula to determine the expected dividend in a target payout approach is:
Expected dividend = (previous dividend) + [(expected increase in EPS) × (target payout ratio) × (adjustment factor)], where the adjustment factor is 1 / number of years over which the adjustment will take place.
Using the numbers given:
$0.39 = $0.30 + [($5.20 - $4.00) × (0.30) × (1 / n)]
$0.39 = $0.30 + [($1.20) × (0.30) × (1 / n)]
$0.09 = $0.36 × (1 / n)
0.25 = (1 / n)
n = 4
作者: JoeyDVivre    时间: 2012-3-30 10:47

A company is all equity financed, has a capital budget of $2.0 million and earnings of $1.8 million. If the company follows a residual dividend policy, the amount it will pay out in dividends is closest to:
A)
$0.1 million.
B)
$0.2 million.
C)
$0.


In the residual dividend model, dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget. The model is based on the firm’s (1) investment opportunity schedule (IOS), (2) target capital structure, and (3) access to and cost of external capital. In this case, the capital budget exceeds earnings so there is no residual.
作者: JoeyDVivre    时间: 2012-3-30 10:47

Under the residual dividend model, firms financed with 100% equity would do all of the following EXCEPT:
A)
pay dividends only if more earnings are available than needed to support the optimal capital budget.
B)
borrow money to maintain the dividend payout schedule.
C)
determine their optimal capital budgets.


Under the residual dividend model the optimal dividend payout is a function of four factors: investors' preferences for dividends vs. capital gains, the firm’s investment opportunity schedule (IOS), the firm’s target capital structure, and the availability and cost of external capital to the firm. The firm will pay dividends only if more earnings are available than are needed to support the optimal capital budget.
作者: JoeyDVivre    时间: 2012-3-30 10:48

Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure that consists of 30% debt and 70% equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?
A)
30%.
B)
40%.
C)
35%.


In order to maintain the optimal capital structure, new projects will be financed with the same mix of debt and equity. Therefore, if the capital budget is $3,000,000 for next year the equity portion will be 70% of $3,000,000, or $2,100,000. The remainder will be financed with debt. If Net Income is $3,500,000 then dividends will be $1,400,000. (Dividends = Net Income − equity portion of capital budget = $3,500,000 − $2,100,000). The dividend payout ratio is equal to dividends divided by net income. $1,400,000 / $3,500,000 = 0.40 or 40%.
作者: JoeyDVivre    时间: 2012-3-30 10:48

Tina Donaldson is the Chief Financial Officer for Outback Supply Corporation (OSC). OSC is considering revising its dividend payout policy and Donaldson has been asked by the board of directors to suggest alternatives for the board to consider. Donaldson prepares a memo listing the benefits of a residual dividend model. The memo includes three key points:
Point 1: A residual dividend policy is simple for the company to use and easy to implement.
Point 2: The residual dividend approach allows management to determine investment opportunities without having to take dividends into consideration.
Point 3: Because the firm is maximizing its positive net present value opportunities with a residual dividend model, investors are likely to perceive the firm as having less risk.
Which of Donaldson’s points describing advantages of the residual dividend approach are most accurate?
A)
Points 1 and 2 only.
B)
Point 2 only.
C)
Points 1, 2, and 3.


The residual dividend approach is easy for a company to use and implement – the company simply reinvests earnings needed to maintain and grow the business, and pays out any left over earnings out as dividends. The residual dividend approach also allows management to determine investment opportunities without having to take dividends into consideration. Note that the residual dividend approach is likely to lead to dividends that fluctuate dramatically from year to year. Since investors prefer stable dividends, they are likely to perceive a firm following a residual dividend approach as having greater risk, which is one of the disadvantages of the approach.
作者: JoeyDVivre    时间: 2012-3-30 10:49

The following financial data relates to the Carmichael Beverage Company for 2005:Carmichael Beverage Company is considering the following investment projects:

Project A: $2,500,000 value; IRR of 11.50%
Project B: $1,000,000 value; IRR of 13.00%
Project C: $2,000,000 value; IRR of 9.50%
Project D: $500,000 value; IRR of 10.50%
Project E: $1,500,000 value; IRR of 8.00%
If the company follows a residual dividend policy, its payout ratio will be closest to:
A)
35%.
B)
0%.
C)
12%.


First determine the WACC. WACC = wd × kd(1 − t) + we × ks, where ks is the required return on retained earnings. WACC = (0.65)(0.12) + (0.35)(0.07) = 0.078 + 0.0245 = 0.1025 = 10.25%. Second, decide to accept projects A, B, and D since they are all greater than the WACC. Accepting these projects will result in a total capital budget of ($2,500,000 + $1,000,000 + $500,000) = $4,000,000. The equity portion is 65% × 4,000,000 = $2,600,000. From Carmichael’s net income, $4,000,000 − $2,600,000 = $1,400,000 will be left over for dividends, which implies a payout ratio of $1,400,000 / $4,000,000 = 35%.
作者: rgonzalez    时间: 2012-3-30 10:53

Hikaru Takei is the portfolio manager for the Reliant Dividend Focused Fund. Takei wants to add a firm to his portfolio that follows a stable dividend policy. Takei is considering investing in one of three companies:
Which stock best meets Takei’s criteria?
A)
Barrett Satellite Systems.
B)
Kelley Medical Devices.
C)
Kirk Beauty Supplies.


Due to inflation considerations, a company with a stable dividend policy will have stability in the rate of increase for its dividend each year. This typically means aligning the company’s dividend growth rate with its long-term growth rate. Although the company with the fixed per share dividend is a tempting choice, once inflation is considered, a fixed $2.00 per share dividend is actually declining each year in terms of spending power.
作者: rgonzalez    时间: 2012-3-30 10:54

Which of the following statements regarding dividend policies is CORRECT?
A)
Companies using a longer-term residual dividend policy pay a steady dividend based on long-term forecast of their capital budget.
B)
A constant payout ratio approach is likely to result in a lower risk premium assigned to a company by investors.
C)
Companies following a dividend stability policy seek to pay a constant dollar amount per share over a long period of time.


Companies following a longer-term residual dividend approach forecast their capital budget over a longer time frame (5–10 years). Leftover earnings over this period are allocated as dividends and paid out in relatively equal amounts each year. The other statements are incorrect. With a stable dividend policy, companies seek to increase their dividend each year at a constant rate. A constant payout approach means that dividends will vary in proportion with earnings, likely resulting in volatile dividends and a higher risk premium.
作者: rgonzalez    时间: 2012-3-30 10:54

Which of the following dividend policies would a firm with long-term excess cash flows most likely use? A share repurchase program:
A)
and no payout of dividends.
B)
in conjunction with a residual dividend model.
C)
and a growing dividend model.


The residual dividend model allows firms to pay out dividends only if more earnings are available than are needed to support the optimal capital budget. Because dividend payouts can be unstable, a firm can supplement a low, stable dividend with a share repurchase program or with an extra dividend when times are good. Stock repurchases allow management to distribute cash without signaling information about future earnings. Abnormally good years could be followed with the purchase of shares, while selling shares would provide liquidity during temporary cash shortages.
作者: rgonzalez    时间: 2012-3-30 10:54

Belden Engineering Corporation (BEC) is considering a share repurchase program. David Gudzanski, the firm’s executive vice president prepares a memo to the board of directors detailing reasons why a share repurchase would be favorable at this time. Reasons listed in the memo are as follows:
Reason 1: The resulting capital structure from the share repurchase would be more favorable for investors in BEC’s bonds.
Reason 2: BEC’s stock is currently selling at $37 in the marketplace. Our discounted cash flow analysis values the company at $48 per share.
Reason 3: The share repurchase could be used to offset dilution caused by the exercise of employee stock options.
Reason 4: BEC can use the repurchase to send a signal to investors that management has a positive future outlook for the company.
Reason 5: The share repurchase could be used to implement a residual dividend policy while diminishing the potential increase in perceived risk that such a policy would cause for investors.
Which of Gudzanki’s reasons in favor of the share repurchase is most accurate?
A)
Reasons 2 and 3 only.
B)
Reasons 2, 3, 4, and 5.
C)
Reasons 1 and 3 only.


A share repurchase would decrease the percentage of equity in a firm’s capital structure, which would in turn increase the percentage of debt. An increase in debt would add more leverage to the firm which would be negative for the firm’s bondholders. The other reasons listed are all rationales for a share repurchase.
作者: rgonzalez    时间: 2012-3-30 10:55

Which of the following statements about a stock repurchase is least accurate?
A)
A stock repurchase occurs when a large block of stock is removed from the marketplace.
B)
Disgruntled stockholders are forced to sell their shares, improving management's position.
C)
Management can distribute cash to shareholders without signaling about future earnings.


A repurchase gives stockholders a choice. They can sell or not sell.
作者: rgonzalez    时间: 2012-3-30 10:55

The following information is from the 10-k of Laura’s Chocolates, Inc.(LC), a maker of nut-based toffees.
Cash25,000,000
Share price40.00
Shares outstanding (prior to transaction)20,000,000
LC decides to spend $20 million repurchasing common stock. What is the value of a share of stock after the share repurchase?
A)
40.00.
B)
35.00.
C)
45.00.


作者: rgonzalez    时间: 2012-3-30 10:56

Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives?
Cash dividendShare repurchase
A)
$34.00$34.00
B)
$31.25$37.00
C)
$31.25$34.00


If the company pays a cash dividend, the dividend per share will be $22 million/8 million = $2.75. The value of its shares will be:

So the total wealth from owning one share will be $31.25 + $2.75 = $34.00.
If the company repurchases shares, it can buy $22 million/$34 = 647,058 shares. The value of one share would then be:

If you remember that both a cash dividend and a share repurchase for cash leave shareholder wealth unchanged, this question does not require calculations of the amounts.
作者: rgonzalez    时间: 2012-3-30 10:58

What is the impact on shareholder wealth of a share repurchase versus cash dividend of equal amount when the tax treatment of the two alternatives is the same?
A)
A share repurchase will sometimes lead to higher total shareholder wealth than a cash dividend of an equal amount.
B)
A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same.
C)
A share repurchase will always lead to higher total shareholder wealth than a cash dividend of an equal amount.


Assuming that the tax treatment of a share repurchase and a cash dividend of equal amount is the same, a share repurchase is equivalent to a cash dividend payment, and shareholder wealth will be the same.
作者: rgonzalez    时间: 2012-3-30 10:58

Which of the following statements about differences observed in payout trends in US and Europe is most accurate?
A)
A higher proportion of US companies pay dividends as compared to their European counterparts.
B)
A lower proportion of US companies pay dividends as compared to their European counterparts.
C)
The percentage of companies making stock repurchases has been trending downwards both in the US and Europe.


A lower proportion of US companies pay dividends as compared to their European counterparts. The percentage of companies making stock repurchases has been trending upwards in the US (since 1980s), the UK and continental Europe (since 1990s).
作者: rgonzalez    时间: 2012-3-30 10:59

Dan Bridges, head of equity strategies for Paca Inc. a consultant to institutional investors makes the following statement:
Globally, the developed markets have seen a decline in dividend payout ratios over time. Lately, we have also seen an increase in the proportion of companies engaging in share repurchases.
Bridges’ statement is most likely:
A)
Incorrect as to dividend payout ratios.
B)
Incorrect as to companies engaging in share repurchases.
C)
Correct.


Bridges’ statement is correct.
作者: rgonzalez    时间: 2012-3-30 10:59

Grommetco produces plastic insulators for the electrical appliance industry. Excerpts from Grommetco’s financial results for 2010 are as follows:
Net Income (earnings)$10
Free Cash Flow to Equity$8
Dividends Paid$1
Stock Repurchases$3

Which of the following statements is most accurate? Grommetco’s:
A)
dividend payout ratio is 0.4.
B)
FCFE coverage ratio is 2.0.
C)
dividend coverage ratio is 2.5.


Dividend coverage ratio = Net Income / Dividends = $10 / $1 = 10.
FCFE coverage ratio = FCFE / (dividends + share repurchases) = $8 / ($1 + $3) = 2.0.
Dividend payout ratio = Dividends / Net Income = $1 / $10 = 0.1.
作者: rgonzalez    时间: 2012-3-30 11:00

Dividend safety is most likely evidenced by:
A)
Increase in dividend coverage ratio but not by FCFE coverage ratio.
B)
Increase in dividend and FCFE coverage ratios
C)
Increase in FCFE coverage ratio but not be dividend coverage ratio.


Both dividend and FCFE coverage ratios are indicators of dividend safety. FCFE coverage is simply more comprehensive measure and takes into account all cash distributed to shareholders
作者: rgonzalez    时间: 2012-3-30 11:00

Which of the following is most likely to be a symptom of a company that is able to sustain its cash dividend?
A)
Issuing new debt to fund projects and cover capital expenditures.
B)
A high dividend payout ratio compared to the industry average.
C)
A low dividend yield compared to the company's historic average.


High dividend yields compared to the company’s record suggest that investors are expecting dividends to be cut. Net borrowings are not sustainable, and will eventually require a cut in share repurchases and dividends. A higher-than-average dividend payout ratio creates the risk that dividends may be cut if earnings decline
作者: c5j4dd0i    时间: 2012-4-17 18:51     标题: The fresh new computer system will include what ex

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