JoeyDVivre

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.

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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 Capital

Share Price

A) An increase A decrease

B) None None

C) None A decrease

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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.

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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.

JoeyDVivre

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%.

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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%.

JoeyDVivre

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.

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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.