Agency Theory and Dividend Policy Quiz

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Questions and Answers

What happens to a bond's price if its coupon rate is lower than the market interest rate?

The bond's price will remain unchanged.

The bond will trade at a premium.

The bond will trade at a discount. (correct)

The bond will trade at par value.

Which of the following best describes the Dividend Discount Model (DDM)?

It only evaluates stock based on its price-to-earnings ratio.

It assesses a company's growth based solely on historical earnings.

It determines the intrinsic value based on expected future dividends. (correct)

It focuses on the company's total assets to evaluate stock prices.

Which capital budgeting technique calculates the difference between present value of cash inflows and outflows?

Profitability Index (PI)

Payback Period

Net Present Value (NPV) (correct)

Internal Rate of Return (IRR)

What does the Internal Rate of Return (IRR) measure in capital budgeting?

The discount rate that results in a net present value of zero. Signup and view all the answers

Which capital budgeting method prioritizes projects based on the value of cash inflows to outflows when resources are limited?

Profitability Index (PI) Signup and view all the answers

What are the core issues addressed by Agency Theory?

Conflicts of interest and information asymmetry Signup and view all the answers

Which dividend policy promotes growth but may deter income-focused investors?

Residual policy Signup and view all the answers

What is a significant drawback of a stable dividend policy?

It requires careful management of finances during low earnings Signup and view all the answers

Which approach to dividend policy combines stability with flexibility?

Hybrid policy Signup and view all the answers

What does the Time Value of Money (TVM) principle suggest about a dollar received today?

It is worth more due to its earning potential Signup and view all the answers

What is the main objective of behavior-based monitoring in the context of Agency Theory?

To enhance direct oversight of agent actions Signup and view all the answers

How is future value (FV) calculated in relation to the Time Value of Money?

By adding expected interest to the present value Signup and view all the answers

What challenge is primarily faced by principals in an agency relationship?

Ensuring agents act in their best interest Signup and view all the answers

What is the primary purpose of calculating the present value of future cash flows?

To evaluate project viability. Signup and view all the answers

Which of the following is NOT a characteristic of primary markets?

Securities are traded among investors. Signup and view all the answers

How does financial ratio analysis generally categorize metrics?

Liquidity, leverage, efficiency, and profitability. Signup and view all the answers

What does the Payback Period method primarily focus on?

The liquidity of an investment. Signup and view all the answers

Which type of risk cannot be diversified away?

Systematic risk. Signup and view all the answers

What does Net Present Value (NPV) measure?

The value added by a project. Signup and view all the answers

Which financial statement provides a snapshot of financial position at a given time?

Balance Sheet. Signup and view all the answers

In ratio analysis, which ratio assesses a company’s ability to meet short-term obligations?

Current Ratio. Signup and view all the answers

What is generally a drawback of financial ratio analysis?

It can be misleading due to accounting practices. Signup and view all the answers

Which aspect does the calculation of a portfolio's standard deviation address?

Individual stock volatilities and correlations. Signup and view all the answers

In bond valuation, what do periodic interest payments represent?

The bond's coupon payments. Signup and view all the answers

What is the focus of the Profitability Index (PI)?

The ratio of cash inflows to outflows. Signup and view all the answers

What is a key component in determining expected returns for an individual stock?

The weighted average of possible returns. Signup and view all the answers

What does systematic risk impact in investment decisions?

The entire market or asset class. Signup and view all the answers

Study Notes

Agency Theory

Explores principal-agent relationships, focusing on conflicts of interest when a principal delegates work to an agent.
Key issues include information asymmetry and ensuring agents act in principals' best interest.
Eisenhardt emphasizes balancing outcome-based incentives with behavior-based monitoring to mitigate agency problems, considering the costs and benefits of each.
Integrates economic, organizational, and sociological perspectives to understand how contracts and governance mechanisms shape relationships.
Aligning goals and reducing information asymmetry are crucial for effective organizational structures and incentives.

Dividend Policy

Defines how firms distribute profits to shareholders, with three typical policies: Residual, Stable, and Hybrid.
Residual Policy: Dividends paid only after funding investments; promotes growth, but unpredictable payouts deter income-focused investors.
Stable Policy: Consistent or gradually increasing dividends; attracts long-term investors, but potentially strains finances during low earnings.
Hybrid Policy: Maintains a baseline dividend with occasional extras during profitable periods; offers stability and flexibility, but needs careful management to meet shareholder expectations.

Time Value of Money (TVM)

A dollar today is worth more than a dollar in the future due to its earning potential.
Uses present value (PV) and future value (FV) calculations to assess investments, loans, savings.
PV of future cash flows evaluates project viability.
FV calculations show investment growth with compound interest.
Applicable to comparing investments, planning retirement, or structuring loan repayments.

Capital Markets

Financial systems where individuals, institutions, and governments trade securities (stocks, bonds) to raise or invest capital.
Primary Markets: New securities sold directly to investors (IPOs).
Secondary Markets: Existing securities traded among investors (stock exchanges).
Fund flow from investors seeking returns to entities needing funds for growth.
Efficient capital markets allocate resources effectively.

Financial Ratio Analysis

Evaluates company performance and health by comparing key metrics across liquidity, profitability, leverage, and efficiency.
Ratios like the current ratio assess short-term solvency, while ROE measures profitability.
Identifies trends, industry benchmarks, supports decision-making.
Pros: Simplicity, versatility, insights into operational strengths/weaknesses.
Cons: Reliance on historical data, potential for misleading results, lack of context without industry/temporal comparisons.

Risk and Return

Higher potential returns typically require acceptance of greater risk.
Earnings Volatility Determinants: firm's revenue variability, operating leverage, and financial leverage.
Risk categorized into systematic (market-wide, cannot be diversified) and unsystematic (firm-specific, can be diversified).
Understanding these concepts balances risk tolerance with optimal returns.

Capital Budgeting Techniques

Evaluates investment projects to maximize value using four techniques.
Net Present Value (NPV): Measures added value—positive NPV favored.
Internal Rate of Return (IRR): Discount rate where NPV=0; prioritizes projects above required return.
Payback Period: How quickly investment is recovered (focuses on liquidity, ignores long-term gains).
Profitability Index (PI): Ratio of inflows to outflows, useful for constrained budgets.
Ranking challenges include size, time, unequal life, and complex decision-making.

Financial Statements

Income Statement: Profitability over time (revenues, expenses, net income).
Balance Sheet: Financial position at a point in time (assets, liabilities, equity).
Cash Flow Statement: Cash inflows/outflows (operating, investing, financing activities)—liquidity.
Statement of Shareholders' Equity: Changes in equity (retained earnings, stock).

Ratio Analysis based on Financial Statements

Uses financial statement data to evaluate company performance and health.
Liquidity, profitability, and leverage ratios provide insights.
Comparing ratios over time or against industry benchmarks helps identify strengths/weaknesses.

Expected Returns and Portfolios

Expected return is the weighted average of possible returns.
Standard deviation measures return volatility.
Portfolio expected return: weighted average of individual stock expected returns.
Portfolio standard deviation considers individual volatilities and correlations; diversification can reduce overall risk.

Bond Valuation

Calculates the present value of future bond cash flows (coupon payments, face value).
Bond price is sum of discounted cash flows.
Discount rate reflects required return or market interest rate.
Higher coupon rate than market rate = premium; lower coupon rate = discount.

Stock Valuation (with Dividends)

Determines intrinsic value based on future cash flows (dividends, growth).
Dividend Discount Model (DDM): Stock value as the present value of expected future dividends, discounted at a required rate of return.
Accounts for constant growth in dividends if applicable.
Aids in assessing whether stocks are overvalued, undervalued, or fairly priced.

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Description

This quiz covers the fundamental concepts of Agency Theory, exploring principal-agent relationships and how conflicts of interest arise when delegating tasks. It also examines different Dividend Policies such as Residual, Stable, and Hybrid, and their implications for firms and investors. Test your knowledge on how these theories impact organizational structures and profit distribution.