All thoughts must be original. You are not allowed to copy and paste material from anywhere when answering your questions. You are not allowed to borrow thoughts or ideas from others; that would be considered plagiarism. If you do you need to cite the source but you are still not allowed to just cut and paste. I have a software that helps check for plagiarism. I will be using it so make sure that nothing written in the exam is plagiarized. If you are caught plagiarizing you will receive a zero in the exam.
You must work on your own at all times. You are not allowed to exchange ideas or use anyone as a sounding board. You must not communicate with anyone in your class with regards to this exam. You are not allowed to ask or communicate to others which question (number) you are answering or working on. If I see similar answers in different exams I will consider it cheating and you will receive a zero in the exam and an F in the class.
Make sure the exam is typed as a Word document.
Make sure that you return the exam in electronic form to me before 6:00 pm on December 11, 2012. You can submit it via Canvas Inbox or at [email protected].
If you have any questions please e-mail me. However, please note that I will only be able to clarify points but answer questions related to the questions found in the exam or answers you wish to provide.
When appropriate please make reference to cases we covered in class.
Questions
Section 1.
Define, compare and contrast stock repurchases and stock dividends. What are the advantages and disadvantage of each? When would it be more advantageous for a company to use one over the other?
Both stock dividends and stock repurchases deal with the movement of ownership within a company. In a stock dividend, additional shares of stock in the company are offered up as payment to shareholders. This is usually done as a fraction of the shares held by an individual. A stock repurchase means that the outstanding shares held by the stockholders are repurchased by the company that issued them. Both of these actions share a common objective, to maximize the value to the shareholders. The stock dividend has an economic value but doesn't actually pay anything to the investor and can be repeated as desired. Companies will do this when they have limited cash on hand as it has no effect on total equity, only the number of shares. The stock repurchase enhances value by creating demand in the market place for the company's stocks. This happens because they are showing interest in their own stocks, artificially pushing up the price. This one-time transaction reduces the number of shares available to the market, which elevates the earnings per share. Management will usually do this when they feel that their own stock is undervalued. It is another way of saying that top management sees their company as the "best investment".
Stock repurchases and stock dividends are similar in that no money is changing hands only changing locations within the company. The funds needed for a repurchase come from retained earnings and get moved to common stock. When stock dividends are given, it is the number of shares that increases. The existing funds located in equity do not change. Therefore, regardless of the action taken, the total amount of equity stays the same.
Stock repurchases have many advantages as well as a few disadvantages. Some good effects of a repurchase are the increased stock price due to the increased demand. This increases company value as seen through higher earnings-per-share. This method also decreases the amount of cash in retained earnings. This is a good thing as companies' rich in cash are at risk of takeover. This is also good as the returns on retained earnings are rather low and can have a negative effect on the company's performance. This also gives the company a chance to give extra funds to shareholders without declaring or increasing a cash dividend. Once cash dividends are declared, it has a negative effect on market expectations to decrease or stop them. Once a company starts paying cash dividends, the dividends become an expectation into the future. The unfortunate thing about stock repurchases is that the individuals who sold the stock back to the company are no longer invested in said company. There can also be issues with corporate governance here. The company needs to manage how much control top management and the company has as a whole as compared to the other shareholders. Many companies pay their upper management in part based on the price of the stocks. This can lead to potential ethical issues. Stock dividends could be seen as a good thing in that an individual will now hold more shares. Unfortunately, that is balanced out by the fact that those shares are now worth less than before as they still have the same amount of money behind them. This also decreases earnings per share.
Stock repurchases are a good idea when management feels that the stock may be undervalued as stated above but there are some other things that can influences management. When there is a significant bundle of the stock hanging over the market this method can be used to break it up or remove it completely. This is also a good idea if an increase in earnings in the short run may not be able to be maintained. Repurchases do well in that situation as they represent a one-time commitment and not a more permanent one like a cash dividend. A company may choose to do a stock dividend as a cosmetic fix to alter perceptions in the market.
If a firm went from zero debt to successively higher level of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline? What would happen to the cost of equity and the WACC of the corporation? Provide formulas, examples, etc. if appropriate.
Section 2.(pick one)
What is the relationship between prices and dividends? Discuss the most relevant theories. Do shareholders generally prefer firms that pay dividends? Discuss in some detail the reasons for paying (or not paying) out dividends?
There exist different dividend theories. Enumerate and explain each one. If you had to rank them based on your opinion of its relevancy in today's world, what would this ranking be and why?
There are thee notable dividend theories: Dividend Irrelevance, Bird-in-the-Hand, and Tax-Preference theory. Modigliani and Miller created the dividend irrelevance theory in the late 1950s. This theory states that a lack of taxes and bankruptcy costs show that the dividend policy is also irrelevant. This is due to that fact that a company's dividends have no effect on the price of the stock nor the capital structure of the company. This theory is focusing on the fact that a firm's value comes from its total earnings and associated risk. How well the assets are generating income for the company is what determines value. To Modigliani and Miller, dividends have no influence in this respect. Basically, changing the amount paid to investors does not change the value. This theory revolves around the idea that investors can generate their own dividends to their expectations by actively managing their investments based on desired dividend payouts. For example, if an investor feels that the dividend is too large, they can choose to reinvest in that or another stock using the surplus of cash.
The next theory, Bird-in-Hand, suggests that dividends have relevance. This theory is concerned with capital gains. Gordon and Lintner felt that the total return to the investor would decrease proportionately with increases in dividend payout. This creates concerns regarding a company's future capital gains as the combination of capital gains and dividend yield equal total return. Thus the decrease in total return and increase in dividend yield have an adverse effect on capital gains. The reason for the decrease in capital gains is due to the decrease overtime of the reinvested portion from the retained earnings account. The idea here is that an investor is adverse to risk and money now (cash dividends) verses money later (capital gains) can be considered less risky. With cash dividends the rewards are immediate without having to factor in future uncertainty. Some feel that the value of a firm is maximized through high dividend payouts, as there is a reduction in possible agency problems and high dividend payouts potentially decrease the cost of equity. This is also an incentive to managers to not waste cash.
The last theory is the tax-preference theory. When Modigliani and Miller came up with the irrelevance theory the model made assumptions that there were no taxes, transaction costs, or associated uncertainty with regards to dividends. At the time the tax rate for capital gains was lower than the tax rate associated with dividends for the individual investor. This was a motivation for investors to invest long run in pursuit of the capital gains. Capital gains were also not taxed until they were realized. Basically this theory states that the investors will go where they can pay fewer taxes later. Tax laws have changed over the years affecting the preference in favor of cash dividends or for capital gains.
First, would be Modigliani and Miller. The reason for them being located here is that they assume the people will make up their portfolio investments along the lines of how they would like to invest. This means that long-term (capital gains) and short-term (dividends) will be what the individual investor desires for their portfolio. If a company should change its policy to something that the investor does not desire, the investor will make changes to their portfolio. The next most relevant one I see is the tax-preference theory. This is the only one that is fluid as it changes with any change in tax law affecting how an individual is taxed. I would put the bird-in-hand theory last because I my view, investors are adverse to risk and the longer you look into the future of a company, the more uncertain any assumptions made today will hold true. In that respect it is a good idea to receive funds sooner rather than later. However, many people investing for retirement and other long-term goals would still have a preference for the long-term as it will earn them more.
In general, stockholders, in my view, appreciate a cash dividend because they lack the information on the future expectations of said company. They have no way of knowing how it is doing without this "signal" to the market. To an investor, an increase in a cash dividend sends positive signals and a decrease, negative ones. This in turn affects the price of the stock and the value of the company. However, if the investor is focused in capital gains, then all they need to do is invest in a company that is in alignment with their goals.
One position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investments. Explain what a residual policy implies (assuming that all distributions are in the form of dividends), illustrating your answer with a table showing how different investment opportunities could lead to different dividend payout rations.
Section 3.
Describe in some detail M&M propositions? How do corporate and personal taxes affect their models/propositions? Do you feel this model is appropriate in today's world? Explain why or why not.
What do you think is the effect of leverage on risk and return of the equity holder? How does it differ from M&M Propositions I & II?
As an equity holder, your risk increases as leverage increases resulting in an increase in the cost of equity for the company. In bankruptcy for example, a company has an obligation to pay off its debts before any shareholders. This means that with increased debt, it is unlikely that a shareholder will see any funds in the event of a bankruptcy. The fact that leverage adds a tax shield to the company, helping them save some money to put toward projects, company infrastructure improvements, or dividend payouts is a minor bonus. The company may pay a lower amount for the debt but the resulting risk for the stockholders increases the cost associated with equity. Once everything is weighed, the total cost for the company is essentially the same but there is now there is a higher cost of equity due to the risk of default. The risk has increased and the resulting returns could be radically different than anticipated. If default occurs then the stockholders basically do not see a return or see a minimal one based on the action taken to rectify the situation.
Modigliani and Miller's argument 1 & 2 still makes sense here. The capital structure is not affecting the company's combined cost of capital. This means that even though we added debt, the rate used to discount cash flows remains the same. The value of the firm also remains the same as it is still determined by cash flow generated by assets. This means that WACC is independent of capital structure, as the company's value remains the same regardless of the chosen capital structure. This cost will be the same as if the firm chose to use no debt. The company's securities and assets are equal to each other because the total cash flow given to security holders is the same as what the assets generate. This also means that regardless of how a company is levered, or not, the value of the company remains the same.
"MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest." Explain carefully whether this is a valid objection.
Section 4.
How would recapitalization and taxes affect value and the cost of capital? Enumerate and describe the tax advantages and limitations of issuing debt as well as the limitations of the tax benefits.
Discuss in some detail how bankruptcy affects the cost of capital. Make sure to include information regarding the cost of bankruptcy.
Argue in favor or against the following statement: "When personal taxes are introduced, the firm's objective is no longer to minimize the corporate tax bill; the firm should try to minimize the present value of all taxes paid on corporate income."**
In corporations, it is said that the money is taxed twice. The first time is when the company earns it. The second time it is taxed is when it is given to stakeholders in the form of dividends, or interest payments. The interest payments from company debt to individuals are taxed as income. This happens to investors as well, as dividends and any capital gains are also treated like income. Since any investor will only pay based on the cash flows that will be received after taxes are taken out, it makes more since for me to argue in favor of this statement. It would help a firm more to try to minimize the present value of all taxes paid on corporate income. This will maximize investor wealth, as the cash flows will be the highest they could be for the individual since both corporate and individual taxes have been minimized. The increased cash flows will give the company increased value, as the amount the investors will be prepared to pay will be higher. Due to the fact that individual taxes reduce investor funds, the resulting tax shield (the tax benefit) seen by the company will decrease. Both sets of taxes need to be taken into account when calculating the benefit from the tax shield. The personal taxes seen by investors also effect the calculation of the WACC. WACC gets adjusted to compensate investors for the increase in debt. This is why the cost of equity increases and why the WACC will decrease more slowly now that the company holds debt.
Section 5.
Why is the appropriate method to value a firm the Discounted Cash Flow Approach? Please be very specific.**
No two companies are the same. There are also differences in accounting standards for public and private companies that make them hard to valuate and compare. Using net present value (NPV) is the best way here to come up with a more-or-less accurate valuation of a company. The reason why it's not perfect is that people can end up using various different inputs that will affect the end result. The calculation of the cash flows (CFs) as well as the calculation of the WACC can be different depending on the available information. The same holds true from within a company and their calculations of their CFs and WACC.
To figure out the inputs for WACC the CAPM formula will have to be used as well as market information on rates. After the cash flows are calculated the next step is to use the discounted cash flow method (DCF). It is important to use this method the future CFs are not worth as much as that amount of money would be today. The DCF discounts the values with the WACC, taking them back the necessary number of years to bring that CF into the present. By adding the present values of all the cash flows together, the value of the company today is found. Since finance is interested in future opportunities, the cash flows are your estimates on the future of that company. As such, this will be different for different individuals in the process of valuation.
There are two other frequently used methods that value equity or assets to stock price. These methods tend to have their positives too but I can't get over the fact that they are based on someone else's calculations. This makes them difficult to use as someone trying to valuate a business. You don't know was included in their valuation and if it also holds true to the one you are attempting.
Explain how it is possible for sales growth to decrease the value of a profitable company.
