Corporate Finance Session 8 - Reading 29 - Reading 30

CFA Level 2 - Corporate Finance Session 8 - Reading 29 - Reading 30 (Practice Questions, Sample Questions) 1. 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. {Explanation: 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.} 2. 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. {Explanation: 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.} 3. 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. {Explanation: 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. {Explanation: 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 Likely Most Likely A) External equity Debt B) External equity Internally generated equity C) Internally generated equity External equity {Explanation: 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. {Explanation: 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. {Explanation: 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. {Explanation: Monitoring costs and bonding costs are components of the net agency cost of equity. (Study Session 8, LOS 29.a)} 4. According to pecking order theory, which financing choice is most preferred, and which is least preferred? Most preferred Least preferred A) Internally generated funds New equity B) New debt New equity C) Internally generated funds New debt {Explanation: 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.} 5. 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. {Explanation: 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.} 6. 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. {Explanation: 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.} 7. 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? Drakar O’Rourke A) 40% 48% B) 30% 40% C) 38% 44% {Explanation: 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.} 8. 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. {Explanation: 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} 9. 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. {Explanation: 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.} 10. 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. {Explanation: 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.} 11. 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%. {Explanation: 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%.} 12. 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. {Explanation: 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.} 13. The following financial data relates to the Carmichael Beverage Company for 2005: The target capital structure is 65% equity and 35% debt. After-tax cost of debt is 7%. Cost of retained earnings is estimated to be 12%. Cost of equity is estimated to be 13.5% if the company issues new common stock. Net income is $4,000,000. 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%. {Explanation: 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%.} 14. 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: Kirk Beauty Supplies maintains a constant dividend payout of 25 to 30%. Kelley Medical Devices increases its dividend each year in accordance with the company’s long run growth rate of 4%. Barrett Satellite Systems has maintained a dividend of $2.00 per share over the last 6 years. Which stock best meets Takei’s criteria? A) Barrett Satellite Systems. B) Kelley Medical Devices. C) Kirk Beauty Supplies. {Explanation: 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.} 15. 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. {Explanation: 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.} 16. 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. {Explanation: 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.} 17. 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. {Explanation: 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.} 18. 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. {Explanation: A repurchase gives stockholders a choice. They can sell or not sell.} 19. 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. {Explanation: 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.} 20. 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. {Explanation: 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).} 21. 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. {Explanation: Bridges’ statement is correct.} 22. 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. {Explanation: 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.} 23. 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. {Explanation: 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.} 24. 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. {Explanation: 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}