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Financial Leverage and Beta, Exams of Advanced Education

Catholic University of Eastern AfricaAdvanced Education

Various concepts related to financial leverage and its impact on a firm's beta. It covers topics such as the calculation of dividend growth rate, the advantages of the capital asset pricing model (capm) over the dividend discount model (ddm), the concept of pure plays, the implications of a negative net present value (npv) project, the efficient market hypothesis (emh), the modigliani-miller (mm) propositions, the costs of debt, the optimal amount of debt, the signaling effect of leverage changes, the pecking order theory, the factors to establish a target debt-equity ratio, the types of financial distress, the procedures for dividend payment, the reasons for paying dividends, the clientele effect, the dividend smoothing formula, the characteristics of venture capitalists (vcs), the stages of vc financing, the underwriting process, the quiet period, the partial adjustment phenomenon, the costs of issuing securities, and the concept of options.

Typology: Exams

2023/2024

Available from 08/18/2024

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FIN 357 Exam 3 With 100% Correct And
Verified Answers
Determinants of Beta - Correct Ansswer-Cyclicality of Revenues (more cyclical -> higher
beta)
Operating Leverage (more OL -> higher beta) ((fixed costs of PRODUCTION))
Financial Leverage and Beta (more FL -> higher beta) ((extent to which a firm relies on
debt))
3 ways to calculate growth rate of dividends - Correct Ansswer-use the historical growth
rate
g = retention ratio X ROE
forecasts of future growth
2 Advantages of CAPM over DDM - Correct Ansswer-explicitly adjusts for risk
applicable to firms that pay no dividends
pure plays - Correct Ansswer-companies that specialize in the same kinds of projects
that my firm does [books a million (yes) vs. amazon (nope) for books]
A project with a negative NPV means that financial markets offer (superior/inferior)
investments in the same risk class. - Correct Ansswer-superior
What 3 conditions cause market efficiency (in theory)? - Correct Ansswer-Rationality (all
investors are perfectly rational)
Independent deviations from rationality (equal amounts of irrationally optimistic and
pessimistic people; everything cancels out)
Arbitrage (rational professionals profit off of irrational amateurs)
3 Different Types of Efficiency - Correct Ansswer-Weak Form (past info) [technical
analysis is useless]
Semistrong Form (past + public info) [most financial analysis is useless]
Strong Form (past + public + private info) [nobody consistently makes superior profits]
Representativeness - Correct Ansswer-drawing conclusions from insufficient data
leads to overreaction in stock returns
conservatism - Correct Ansswer-people are too slow in adjusting their beliefs to new
information
leads to underreaction in stock returns
Why the theoretical underpinnings of the Efficient Market Hypothesis don't hold in reality
- Correct Ansswer-- investors may be irrational
- their irrationality may be related and not cancel out
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FIN 357 Exam 3 With 100% Correct And

Verified Answers

Determinants of Beta - Correct Ansswer-Cyclicality of Revenues (more cyclical -> higher beta) Operating Leverage (more OL -> higher beta) ((fixed costs of PRODUCTION)) Financial Leverage and Beta (more FL -> higher beta) ((extent to which a firm relies on debt)) 3 ways to calculate growth rate of dividends - Correct Ansswer-use the historical growth rate g = retention ratio X ROE forecasts of future growth 2 Advantages of CAPM over DDM - Correct Ansswer-explicitly adjusts for risk applicable to firms that pay no dividends pure plays - Correct Ansswer-companies that specialize in the same kinds of projects that my firm does [books a million (yes) vs. amazon (nope) for books] A project with a negative NPV means that financial markets offer (superior/inferior) investments in the same risk class. - Correct Ansswer-superior What 3 conditions cause market efficiency (in theory)? - Correct Ansswer-Rationality (all investors are perfectly rational) Independent deviations from rationality (equal amounts of irrationally optimistic and pessimistic people; everything cancels out) Arbitrage (rational professionals profit off of irrational amateurs) 3 Different Types of Efficiency - Correct Ansswer-Weak Form (past info) [technical analysis is useless] Semistrong Form (past + public info) [most financial analysis is useless] Strong Form (past + public + private info) [nobody consistently makes superior profits] Representativeness - Correct Ansswer-drawing conclusions from insufficient data leads to overreaction in stock returns conservatism - Correct Ansswer-people are too slow in adjusting their beliefs to new information leads to underreaction in stock returns Why the theoretical underpinnings of the Efficient Market Hypothesis don't hold in reality

  • Correct Ansswer-- investors may be irrational
  • their irrationality may be related and not cancel out
  • arbitrage strategies may require too much risk to eliminate market inefficiencies EMH Does Not Say: - Correct Ansswer-prices are uncaused investors are too foolish/stupid to be in the market all shares of stock have the same expected returns investors should throw darts to select stocks there is no upward trend in stock prices EMH Does Say - Correct Ansswer-prices reflect underlying value financial managers cannot time stocks and bond sales managers cannot profitably speculate in foreign currencies managers cannot boost stock prices through creative accounting Evidence against efficiency - Correct Ansswer-- two different but identical classes of the same stock selling for different prices
  • earnings surprises
  • small vs large stocks
  • value vs growth stocks
  • crashes and bubbles Pie Model Equation - Correct Ansswer-V = B + S value of the firm = market value of debt + market value of equity MM Proposition 1 (no taxes) - Correct Ansswer-The value of the levered firms is the same as the value of the unlevered firm. (Rwacc is constant regardless of the capital structure) V(L) = V(U) [value of levered firm equals the value of the unlevered firm] MM Proposition 2 (no taxes) - Correct Ansswer-Rs = Ro + (B/S)(Ro - Rb) Rs = cost of equity Ro = cost of capital for an all equity firm B = value of the firms debt S = value of the firms equity Rb = cost of debt Assumptions of Modigliani-Miller Propositions (no taxes) - Correct Ansswer-no taxes no transaction costs individuals and corporations borrow at the same rate Tax Shield From Debt Equation - Correct Ansswer-tcRbB corporate tax rate * interest rate * amount borrowed [ dollar amount of interest ]

T or F: managers signal information when they change leverage - Correct Ansswer-True Change in value of firm when debt is substituted for equity - Correct Ansswer-Tax shield on debt

  • reduction in agency costs of equity
  • increase in costs of financial distress (including agency costs of debt) Free Cash Flow Hypothesis - Correct Ansswer-we might expect to see more wasteful activity in a firm with a capacity to generate large cash flows than in one with a capacity to only generate small flows Free Cash flow hypothesis argues that a shift from debt to equity will (raise/lower) firm value - Correct Ansswer-raise New equity dilutes the holdings of managers with equity interests, (increasing/decreasing) their motive to waste corporate resources - Correct Ansswer- increasing Rules of the Pecking Order Theory - Correct Ansswer-1. Use internal financing
  1. Issue the safest securities first (debt should be issued before equity) Financial slack - Correct Ansswer-extra money that a company has available in case a downturn or to fund future profitable projects Capital Structure in the Real World - Correct Ansswer-- Most nonfinancial corporations have relatively low debt-asset value ratios
  • A number of firms use no debt
  • There are differences in the capital structure of different industries
  • Most corporations employ target debt-equity ratios
  • Capital structures of individual firms can vary significantly over time 4 Factors to establish a target debt-equity ratio - Correct Ansswer-flexibility taxes types of assets
    • firms with large investments in tangible assets are more likely to have higher target debt-equity ratios than firms with large investments in R&D (resale value) uncertainty of operating income (more uncertainty -> less debt) 4 different types of financial distress - Correct Ansswer-business failure (firm is dead; creditors take a loss) legal bankruptcy (firm is liquidated or reorganized) technical insolvency (unable to meet its financial obligations) accounting insolvency (liabilities > assets)

reorganization - Correct Ansswer-keeping the firm alive; issuing new securities and replacing old securities liquidation - Correct Ansswer-termination of the firm; selling off assets Procedure for dividend payment - Correct Ansswer-1. Declaration Date - dividend is announced

  1. Ex-Dividend Date - stockholders are entitled to receive dividend if they purchase by this date
  2. Record Date
  3. Payment Date - checks are mailed to stockholders targeted repurchase - Correct Ansswer-firms repurchase shares from specific individual stockholders 3 ways to accomplish share repurchases - Correct Ansswer-- open market purchase
    • tender offer - announce to stockholders that the firm is willing to buy X number of shares at $Y per share
    • dutch autction Why choose repurchases over dividends? - Correct Ansswer-- flexibility (dividends are seen more as a commitment)
    • executive compensation (stock price is greater after a repurchase than after a dividend)
    • offset to dilution
    • undervaluation (buy back stock if its undervalued)
    • taxes (repurchases have a tax advantage over dividends) reasons for paying dividends - Correct Ansswer-- desire for current income
    • behavioral finance (less self control is required to accept dividends than to sell off equivalent amounts of stock each period)
    • agency costs
    • information content effect (rise in stock price following the dividend signal - a result of increased expectations of future CFs) The stock price of a firm will generally (rise/fall) when the firm announces an increase in the dividend and will generally (rise/fall) when a dividend reduction is announced. - Correct Ansswer-rise, fall clientele effect - Correct Ansswer-the factors of personal taxes (favor low dividend policy) and other factors (favor high dividends) cancel each other out Dividend Smoothing Formula - Correct Ansswer-dividend change = div1 - div0 = s(teps1 - div0) div1 = div next year

bookbuilding (done on road shows) - Correct Ansswer-soliciting (asking and obtaining) information about buyers and the prices and quantities they would demand Green Shoe Provision - Correct Ansswer-underwriters can purchase 15% more shares than there are in order to cover excess demand and stabilize price lockup agreement - Correct Ansswer-specify how long insiders must wait after an IPO before they can sell some of their shares Quiet Period - Correct Ansswer-time company seriously considers IPO - 40 days after IPO firm and underwriters must limit their communication w/ the public to ordinary announcements; reason - all relevant information should be contained in the prospectus partial adjustment phenomenon - Correct Ansswer-IPO underpricing is much more severe when an offer is priced above the file range (estimated price range, filed with SEC) Why do stock prices go down when new equity is issued? - Correct Ansswer- managerial information - shares must be overvalued, right? debt usage - the company must be using too much debt issue costs - it cost lots of money to issue new equity! Costs of Issuing Securites - Correct Ansswer-Spread - difference between issuers received price and the offer price Other Direct Expenses - filing & legal fees, taxes Indirect Expenses - time Abnormal Returns - for SEOs, stock prices drop ~3% on announcement Underpricing - for IPOs, lots of $$$ is left on the table Green Shoe Option subscription price - Correct Ansswer-price that existing shareholders are allowed to pay for a share of stock in a rights offering; should be less than market value Kinds of dilution (loss of existing shareholder's value) - Correct Ansswer-- percentage ownership

  • market value
  • book value and EPS Shelf Registration - Correct Ansswer-permits a corporation to register an offering that it reasonably expects to sell within the next two years and then sell the issue whenever it wants during that two-year period

option - Correct Ansswer-a contract giving its owner the right, but not the obligation, to buy or sell an asset at a fixed price on or before a given date call option - Correct Ansswer-gives owner the right to BUY an asset at a fixed price during a particular time period; most common type of option put option - Correct Ansswer-opposite of call; gives owner the right to SELL an asset at a fixed price at a particular time