Corporate Financial Policy Final

All else constant, which one of the following will increase a firm's cost of equity if the
firm computes that cost using the security market line (CAPM) approach? Assume the
firm currently pays an annual dividend of $2.10 a share and has a beta of 1.1.
a. a reduction in the dividend amount
b. an increase in the dividend amount
c. a reduction in the market risk premium
d. a reduction in the firm's beta
e. an increase in the market rate of return

e. an increase in the market rate of return

The capital structure that maximizes the value of a firm also:
a. minimizes financial distress costs.
b. minimizes the cost of capital.
c. maximizes the present value of the tax shield on debt.
d. maximizes the value of the debt.
e. maximizes the value of the unlevered firm

b. minimizes the cost of capital.

Evidence that a firm has high business risk would be provided by its volatile:
A) operating profit.

B) fixed costs.
C) sales

A) operating profit. Business risk is one component of Ra, the required rate of return.

The capital structure that maximizes the value of a firm also:
a. minimizes financial distress costs.
b. minimizes the cost of capital.
c. maximizes the present value of the tax shield on debt.
d. maximizes the value of the debt.
e. maximizes the value of the unlevered firm

b. minimizes the cost of capital.

Which of the following statements are correct in relation to M&M Proposition II with
no taxes?
I. The return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
a. I and III only
b. II and IV only
c. I and II only
d. III and IV only
e. I and IV only

c. I and II only

Which one of the following is an underlying assumption of the dividend growth model?
A. A stock has the same value to every investor.
B. A stock's value is equal to the discounted present value of the future cash flows which it generates.
C. A stock's value changes in direct relation to the required return.
D. Stocks that pay the same annual dividend have equal market values.
E. The dividend growth rate is inversely related to a stock's market price

B. A stock's value is equal to the discounted present value of the future cash flows which it generates.

Answer this question based on the dividend growth model. If you expect the market rate of return to increase across the board on all equity securities, then you should also
expect:
A. an increase in all stock values.
B. all stock values to remain constant.
C. a decrease in all stock values.
D. dividend-paying stocks to maintain a constant price while non-dividend paying stocks decrease in value.
E. dividend-paying stocks to increase in price while non-dividend paying stocks decrease in value.

C. a decrease in all stock values.

Capital restructuring involves changing the
amount of leverage a firm has without changing
the firm’s assets: The firm can ….

increase leverage by issuing debt and repurchasing outstanding shares & decrease leverage by issuing new
shares and retiring outstanding debt

We can maximize stockholder wealth by

maximizing the value of the firm or minimizing the WACC

Modigliani and Miller Theory of Capital Structure
– Proposition I – firm value
– Proposition II – WACC

The value of the firm is determined by the cash flows to the firm and the risk of the assets

Case I

No corporate or personal taxes, no optimal capital structure
– No bankruptcy costs

Case II

Corporate taxes, but no personal taxes
– No bankruptcy costs

Optimal capital structure is almost 100% debt
– Each additional dollar of debt increases the cash flow of the firm

Case III

Corporate taxes, but no personal taxes
– Bankruptcy costs

Optimal capital structure is part debt and part equity
– Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

Case I Propositions I & II

Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not change;
therefore, value doesn’t change
• Proposition II
– The WACC of the firm is NOT affected by
capital structure

Case II Cash Flow

interest is tax deductible
• Therefore, when a firm adds debt, it reduces taxes, all else equal
• The reduction in taxes increases the cash flow of the firm

Case II Prop I

The value of the firm increases by the present value of the annual interest tax shield

Case II Prop II

The WACC decreases as D/E increases because of the government subsidy on interest payments

Case III

As the D/E ratio increases, the probability of bankruptcy increases
This increased probability will increase the expected bankruptcy cost

Bankruptcy Costs

direct costs- legal and administrative

financial distress- Significant problems in meeting debt obligations

indirect costs- The cost of avoiding bankruptcy filing

The greater the risk of financial distress

the less debt will be optimal for the firm

P/E ratios are a function of two factors

required rate of return, expected growth in dividends

If firm has no good investment opportunities

better to distribute all earnings as dividends

Firms with less growth opportunities typically have

less growth in earnings and price per share, along with lower P/E values for price per share

riskier stocks will have

lower P/E multiples