Capital Structure and dividend policy

Question 1

Types of dividend

Answer 1

Cash dividend (regular or special)
Stock dividend

Question 2

Types of stock repurchases

Answer 2

• Buy shares on the market (open-market purchase)
• Tender offer to shareholders
• Dutch auction
• Private negotiation (green mail)

Question 3

how often do dividend payments occur vs stock repurchases

Answer 3

Dividend payments usually happen on a regular basis (every quarter)
while stock repurchases are typically a one-off event.

Question 4

A stock repurchase announcement also tends to result in a positive stock price reaction because;

Answer 4

• Signals that the firm does not want to spend cash on unprofitable projects
• Signals firm undervaluation

Question 5

what does a strong dividend policy signal to the market

Answer 5

Signal positive information about a company’s financial health and future prospects.
Stock price will usually increase when the company announces an (unexpected) increase in dividend payouts.

Question 6

According to Miller and Modigliani how does dividend policy effect firm value

Answer 6

dividend policy is irrelevant if
- Perfect capital markets (perfect competition, no taxes, no asymmetric information, no transaction costs).
- Investment and borrowing are kept constant.

Question 7

What is corporate finance

Answer 7

Addressing what long-term investments should the firm make?
= capital budgeting question
What is the optimal amount of debt for the firm? = capital structure question

Question 8

Discuss the key differences between debt and equity

Answer 8

• Debt is not an ownership interest in the firm. Creditors usually do not have voting power
• interest on debt is fully tax deductible (cost of doing business). dividends are paid out of after-tax dollars

Question 9

Why can we address maximising firm value and shareholder value as the same

Answer 9

changes in capital structure benefit stockholders if and only if the value of the firm increases.

Question 10

Features of Perfect capital markets:

Answer 10

Perfect competition
Firms and investors can borrow/lend at the same rate

Equal access to all relevant information
No transaction costs
No taxes

Question 11

Modigliani-Miller (MM) Model assume

Answer 11

Homogeneous expectations
Perpetual cash flows
Perfect capital markets

Question 12

Under MM assumptions capital structure

Answer 12

capital structure has no impact on firm value

Question 13

MM proposition 1 with /without corporate taxes

Answer 13

Without - firm value is not affected by leverage
With - firm value increases with leverage

Question 14

MM proposition 2 with / without taxes

Answer 14

without - Leverage increases the return to stockholders
with - Some of the increase in equity risk and return is offset by interest tax shield

Question 15

Financial distress for a firm refers to

Answer 15

a situation where the company is struggling to meet its financial obligations, such as paying debts
can lead to bankruptcy

Question 16

In theory, bankruptcy should not affect firm value as it is only a transfer of ownership of the firm. In practise?

Answer 16

bankruptcy entails significant costs
Direct costs: lawyers, consultants, investment banks
Indirect costs: loss of customers, suppliers, employees, fire sale of assets

Question 17

who ultimately bears the financial distress costs

Answer 17

Stockholders

Question 18

Agency costs are

Answer 18

Costs arising from conflicts of interest between stakeholders of the firm

Question 19

Agency costs of debt are magnified when financial distress is incurred.
Why?

Answer 19

When a firm is in financial distress, investment strategies that maximize firm value may no longer maximize stockholder value.

Question 20

two theories that describe how asymmetric information may affect a firm’s capital structure:

Answer 20

Signalling theory of debt
Pecking order theory

Question 21

Signalling theory of debt

Answer 21

Firms with high future profits can easily repay the debt. firms with low future profits cant mimick this

Question 22

Pecking order theory

Answer 22

When a firm announces it will issue equity, investors are likely to infer that the firm is overvalued.
The stock price then declines, called the adverse selection problem

Question 23

Due to the adverse selection problem, firms resort to a pecking order when financing projects:

Answer 23

1) Use retained earnings
2) Issue debt instruments
3) Issue equity
no target debt level

Question 24

testable implications of POT

Answer 24

Firms time equity offerings to occur when there is a small amount of asymmetric information
Stock price declines less at debt announcements than at equity announcements.

Question 25

Agency benefits of debt

Answer 25

Debt financing reduces the agency problem between managers and ownership: - Reduces cash flow available for wasteful investments - Imposes the threat of bankruptcy → Makes managers less entrenched.