FIN 3403 Final Exam Conceptual Questions

Operating Leverage

Increases Operating Income

Increases business risk

Business Risk

The volatility of EBIT

Financial Leverage

Increases EPS

Increases financial risk

Financial Risk

Risk driven by the presence of fixed finance costs in the firm's capital structure (as opposed to variable finance costs such as dividends declared and paid)

You can increase Operating Leverage by...

Increasing fixed operating costs (rent, salaries, etc.)

You can increase Financial Leverage by...

Increasing fixed financing costs (debt and preferred stock)

Examples of fixed costs:

Rent, salaries, insurance, property tax

Examples of variable costs:

Materials, labor, energy, packaging, sales commissions

With high Operating Leverage, an increase in sales produces a relatively larger increase in...

Operating Income

With high Financial Leverage, an increase in operating income produces a relatively larger increase in...

Earnings per share

With high Combined Leverage, an increase in sales produces a relatively larger increase in...

Earnings per share

What is Capital Structure?

The mix of debt and equity a firm uses

What is the EBIT-EPS Analysis used for?

It's used to determine if it would be better to finance a project with debt or equity

Capital Structure affects which kinds of leverage?

Financial Leverage

The Optimal Capital Structure does what?

Minimizes the firms' cost of capital and maximizes firm value

The Modigliani-Miller Hypothesis is also called the...

Independence hypothesis and the Irrelevance hypothesis

What does the Modigliani-Miller Hypothesis say?

In a "perfect market" environment, capital structure is irrelevant.

Assumes there are no taxes or transaction costs

In other words, changes in capital structure do not affect firm value

What are Agency costs?

Costs associated with protecting bondholders

Bond convenants:

Require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases

Moderate View on Capital Structure

Another name for Internal Financing is...

Retained Earnings

What kind of firm is more likely to pay out high dividends?

Mature firms

Three viewpoints:

1) Dividends are irrelevant:

If we assume perfect markets (no taxes, transaction costs, etc) dividends do not matter. If we pay a dividend, shareholders' dividend yield rises, but capital gains decrease

Three viewpoints:

2) High Dividends are Best:

Some investors may prefer a certain dividend now over a risky expected capital gain in the future

Three viewpoints:

3) Low Dividends are Best:

Dividends are taxed immediately. Capital gains are not taxed until the stock is sold.

Therefore, taxes on capital gains can be deferred indefinitely

Risidual Dividend Theory:

The firm pays a dividend only if it has retained earnings left after financing all profitable investment opportunities.

This would maximize capital gains for stockholders and minimize flotation costs of issuing new common stock.

Unstable dividend payouts.

Clientele Effects:

Different investor clienteles prefer different dividend payout levels.

Some firms, such as utilities, pay out over 70% of their earnings as dividends. These attract a clientele that prefers high dividends.

Growth-oriented firms which pay low (or no) dividends attract a clientele that prefers price appreciation to dividends.

Information Effects:

Unexpected dividend increases usually cause stock prices to rise, and unexpected dividend decreases cause stock prices to fall.

Dividend changes convey information to the market concerning the firm's future prospects.

Agency Costs:

Paying dividends may reduce agency costs between managers and shareholders.

Paying dividends reduces retained earnings and forces the firm to raise external equity financing.

Raising external equity subjects the firm to scrutiny of regulators (SEC) and investors and therefore helps monitor the performance of managers.

Expectations Theory:

Investors form expectations concerning the amount of a firm's upcoming dividend.

Expectations are based on past dividends, expected earnings, investment and financing decisions, the economy, etc.

The stock price will likely react if the actual dividend is different from the expected dividend