Corporate Finance

Jun Young 420 (iykyk)

What is the most important difference between a corporation and all other organization​ forms?  

A corporation is a legal entity separate from its owners.

What does the phrase limited liability mean in a corporate​ context?

​Owners' liability is limited to the amount they invested in the firm.

Stockholders are not responsible for any encumbrances of the​ firm; in​ particular, they cannot be required to pay back any debts incurred by the firm.

p/e ratio

share price/ earnings per share

most common valuation ratio

The intuition behind the use of the​ P/E ratio is that when you buy a​ stock, you are in a sense buying the rights to the​ firm's future earnings and differences in the scale of the​ firms' earnings are likely to persist.

Explain why the yield of a bond that trades at a discount exceeds the​ bond's coupon rate.

The bond can be purchased for a​ discount, which gives it an​ "extra return";​ hence, the yield exceeds the coupon.

Why does the expected return of a corporate bond not equal its yield to​ maturity?

The expected return of a bond with risk is less than the​ bond's yield to maturity because the yield is calculated using the promised cash​ flows, which are not necessarily the actual or expected cash flows.

It is suggested that you use the yield on a Florida State bond to estimate the State of​ Florida's cost of capital. Why might this estimate overstate the actual cost of​ capital?

If there is some chance the State of Florida might​ default, then the yield on the bond exceeds its expected return. The expected return would be a more appropriate estimate for the cost of capital.

levered equity.

Equity in a firm with debt

Explain what is wrong with the following​ argument: "If a firm issues debt that is risk​ free, because there is no possibility of​ default, the risk of the​ firm's equity does not change.​ Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of​ equity."

The argument is wrong because any leverage raises the equity cost of capital.​ Risk-free leverage raises it the most because it does not share any of the risk.

If the risk of the debt​ increases, would the expected return of the stock be higher or lower than when debt is issued to repurchase stock earlier

lower

For the same increase in interest​ expense, how will free cash flow​ change?

Free cash flow is not affected by interest expense.

You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your​ manager, "If we go​ bankrupt, we​ don't have to service the warranties. We therefore have lower bankruptcy costs than most​ corporations, so we should use more​ debt." Is he​ right?

​No, customers will anticipate the effect of leverage on the soundness of the warranty and will be less likely to purchase​ cars, thereby imposing costs on the firm.

Facebook, Inc. has no debt. By issuing​ debt, Facebook can generate a very large tax shield potentially worth nearly $ 2 billion. Given​ Facebook's success, one would be hard pressed to argue that​ Facebook's management are​ naïve and unaware of this huge potential to create value. A more likely explanation is that issuing debt would entail other costs. Which of the following costs of debt is unlikely to explain​ Facebook's policy?

Asset substitution

Dynron​ Corporation's primary business is natural gas transportation using its vast gas pipeline network.​ Dynron's assets currently have a market value of $150 million. The firm is exploring the possibility of raising​ $50 million by selling part of its pipeline network and investing the​ $50 million in a​ fiber-optic network to generate revenues by selling​ high-speed network bandwidth. While this new investment is expected to increase​ profits, it will also substantially increase​ Dynron's risk. If Dynron is​ levered, would this investment be more or less attractive to equity holders than if Dynron had no​ debt?

More​ attractive: Equity holders in a levered firm will benefit from an increase in the risk of the​ firm's investments.

What options does a firm have to spend its free cash flow​ (after it has satisfied all interest​ obligations)?

Use it to make investments.

Pay it out as dividends.

Use it to repurchase shares.

Describe the different mechanisms available to a firm for repurchasing shares.

​1) In an open market​ repurchase, the firm repurchases the shares in the open market. This is the most common mechanism in the United States.

​2) In a tender​ offer, the firm announces the intention to all shareholders to repurchase a fixed number of shares for a fixed​ price, conditional on shareholders agreeing to tender their shares. If not enough shares are​ tendered, the deal can be cancelled.  

​3) A targeted repurchase is similar to a tender offer except that it is not open to all​ shareholders; only specific shareholders can tender their shares in a targeted repurchase.

Why is an announcement of a share repurchase considered a positive​ signal?

By choosing to do a share​ repurchase, management credibly signals that it believes the stock is undervalued.

Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.

a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers.

The market risk of the cash flows from this new product is likely to be similar to that of​ Clorox's other household​ products; therefore, assuming it has the same risk as the average risk of the firm is reasonable.

Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.

b.​ Google, Inc., plans to purchase real estate to expand its headquarters.

A real estate investment is likely to have market risk that is very different from that of​ Google's investments in Internet search technology and​ advertising; therefore, it would not be appropriate to assume this investment risk is equal to the average risk of the firm.

Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.

c. Target Corporation decides to expand the number of stores it has in the southeastern United States.

An expansion in the same line of business is likely to have risk equal to the average risk of the business.

Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.

d. GE decides to open a new Universal Studios theme park in China.

Because the theme park will likely be sensitive to the growth of the Chinese​ economy, its market risk may be very different from that of​ GE's other divisions and from the company as a whole.​ Therefore, it would not be appropriate to assume this risk is equal to the average risk of the firm.

In​ 2018, Mastercard Incorporated had a market capitalization of $ 200 ​billion, debt of $ 6.5 ​billion, cash of $ 8.2 ​billion, and EBIT of nearly $ 7 billion. If Mastercard were to increase its debt by $ 1 billion and use the cash for a share​ repurchase, which market imperfections would be most relevant for understanding the consequence for​ Mastercard's value?​ Why?

​Mastercard's debt is a tiny fraction of its total value.​ Indeed, Mastercard has more cash than​ debt, so its net debt is negative. Mastercard is also very​ profitable; at an interest rate of 6 % interest on​ Mastercard's debt is only $390 million per​ year, which is around 5.57% of its EBIT.

The risk that Mastercard will default on its debt is extremely small. This risk will remain extremely small even if Mastercard borrows an additional​ $1 billion.​ Thus, adding debt will not really change the likelihood of financial distress for Mastercard​ (which is nearly​ zero), and thus will also not lead to agency conflicts.

The most important financial friction for such a debt increase is the tax savings Mastercard would receive from the interest tax shield. A secondary issue may be the signaling impact of the​ transaction-borrowing to do a share repurchase is usually interpreted as a positive signal that management may view the shares to be underpriced.

c.​ Explain, intuitively, why​ Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC. ​

The equity cost of capital exceeds the unlevered cost of capital because leverage makes the equity risk greater than the overall risk of firm. The WACC is less than the unlevered cost of capital because the WACC includes the benefit of the interest tax shield.

Suppose a ten-year bond with annual coupons and $1000 face value has a price of $1,071.06 and a yield to maturity of 7%. This bond's coupon rate is closest to:

8%

Which of the following statements is FALSE?

(A) When a bond trades at a price equal to its face value, it is said to trade at par.

(B) As interest rates and bond yields rise, bond prices will fall.

(C) When a bond is trading at a discount, the price drop when a coupon is paid will be larger than the price increase between coupons, so the bond's discount will tend to decline as time passes.

(D) Ultimately, the prices of all bonds approach the bond's face value when the bonds mature and their last coupon is paid

C

Which of the following statements is FALSE?

(A) The equity cost of capital for a stock is the expected return of other investments available in the market with equivalent risk to the firm's shares.

(B) The price of a share of stock is equal to the present value of the expected future dividends it will pay.

(C) If the current stock price were less than (Div 1 + P1)/(1+rE), it would be a negative NPV investment, and we would expect investors to rush in and sell it.

(D) To value any security, we must determine the expected cash flows an investor will receive from owning it.

C

Luther Industries has a dividend yield of 4.5% and a cost of equity capital of 12%. Luther Industries dividends are expected to grow at a constant rate indefinitely. The growth rate of Luther's dividends is closest to:

7.5%

Which one of the following statements is FALSE?

(A) A higher yield to maturity does not necessarily imply that a bond's expected return is higher.

(B) By consulting bond ratings, investors can assess the credit-worthiness of a particular bond issue.

(C) Because the cash flows promised by the bond are the most that bondholders can hope to receive, the cash flows that a purchaser of a bond with credit risk expects to receive may be less than that amount.

(D) Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be lower than that of otherwise identical default-free bonds

D

Wyatt Oil presently pays no dividend. You anticipate Wyatt Oil will pay an annual dividend of $0.56 per share three years from today and you expect dividends to grow by 4% per year thereafter. If Wyatt Oil's equity cost of capital is 12%, then the value of a share of Wyatt Oil today is:

5.58

As a manager, you are trying to increase your firm's P/E ratio by changing ONE of the following elements while keeping everything else constant. Which one cannot achieve your goal?

(A) Increase dividends.

(B) Increase future growth rate.

(C) Lower the level of risk.

(D) Being more aggressive in the accounting practice.

D

Which of the following statements is FALSE?

(A) Dividend discount model is more reliable when the payout policy is clear and stable.

(B) Multiple valuation methods implicitly embed estimates of discount rates and growth rates.

(C) Multiple valuation methods help us compare firms across different industries and indicate which industry is over/under-valued.

(D) P/E ratio is affected by leverage and thus EV multiples are more reliable when we compare firms with different capital structures

C

Which of the following statement is FALSE?

(A) Increase Sales will increase FCF, holding everything else constant.

(B) Decrease depreciation will increase FCF, holding everything else constant.

(C) Decrease capital investment will increase FCF, holding everything else constant.

(D) Decrease COGS will increase FCF, holding everything else constant

B

Which of the following statements is FALSE?

(A) The discounted free cash flow model begins by determining the value of the firm's free cash flows.

(B) We can interpret the enterprise value as the net cost of acquiring the firm's equity, taking its cash and paying off all debts.

(C) Free cash flow measures the cash generated by the firm after payments to debt or equity holders are considered.

(D) When using the discounted free cash flow model, we should use the firm's WACC

C