Corporate Finance Quiz: Debt and Equity Valuation
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Questions and Answers

What happens to debt holders when a firm’s equity value falls to zero under the MM assumption?

Debt holders take over the firm at no cost.

What are the two main outcomes of bankruptcy proceedings?

Liquidation and reorganization.

What are two types of bankruptcy costs that affect firms?

Direct costs and indirect costs.

In the context of financial distress, who bears the costs when a firm's value decreases?

<p>Shareholders bear the costs of financial distress.</p> Signup and view all the answers

How does the Trade-off Theory relate to a firm's use of debt?

<p>It balances the tax benefits of debt against the costs of financial distress.</p> Signup and view all the answers

What is the leverage ratchet effect in the context of agency costs?

<p>It refers to the buildup of excessive leverage over time.</p> Signup and view all the answers

Why is it challenging to enforce shareholder actions in a firm?

<p>Shareholders' actions are unobservable and not contractible.</p> Signup and view all the answers

What does the value-additivity principle state about project NPVs?

<p>The NPV of a project is the sum of the NPVs of its individual cash flows.</p> Signup and view all the answers

What are two advantages of going public through an IPO?

<p>Greater liquidity for investors and improved access to large amounts of capital for the firm.</p> Signup and view all the answers

What is the primary difference between a 'best efforts' basis and a 'firm commitment' in an IPO?

<p>'Best efforts' means the underwriter tries to sell the stock but doesn't guarantee sales, while 'firm commitment' guarantees that all stock will be sold at the offer price.</p> Signup and view all the answers

What is the role of an underwriter during an IPO?

<p>The underwriter manages the security issuance and designs its structure.</p> Signup and view all the answers

What challenges arise from the dispersion of equity holders in a public company?

<p>It becomes more difficult to monitor management effectively.</p> Signup and view all the answers

Describe the road show in the context of an IPO.

<p>A road show involves the company's management and underwriters promoting the company to institutional investors.</p> Signup and view all the answers

What does MM proposition 2 imply about a firm's WACC and its capital structure?

<p>MM proposition 2 implies that a firm's weighted average cost of capital (WACC) is independent of its capital structure.</p> Signup and view all the answers

How does increasing leverage affect the cost of equity according to the MM theory?

<p>Increasing leverage raises the riskiness of the remaining equity, which leads to an increase in the cost of equity.</p> Signup and view all the answers

Explain the 'debt is cheap fallacy' and its implications on a firm's capital costs.

<p>The 'debt is cheap fallacy' suggests debt is cheaper than equity due to low interest rates; however, increased leverage ultimately raises both the cost of equity and debt.</p> Signup and view all the answers

Discuss the relationship between earnings per share (EPS) and leverage as stated in MM's propositions.

<p>While using debt can increase EPS, this does not enhance share price because the underlying risk has also increased, leading to a higher required return on equity.</p> Signup and view all the answers

What is the fallacy regarding equity dilution as it pertains to cost comparisons with debt?

<p>The equity dilution fallacy claims equity is more expensive than debt due to dilution; however, the value of shares remains stable, and original shareholders are not worse off.</p> Signup and view all the answers

How do share repurchases and dividends impact a firm's value according to the MM theory?

<p>Both share repurchases and dividends result in equivalent decreases in cash balance and share price, thus not altering the firm's overall value.</p> Signup and view all the answers

Describe the cash hoarding fallacy and its implications for a company's investment strategies.

<p>The cash hoarding fallacy suggests firms should pay out cash instead of investing in low-yield government bonds; however, this can lead to missed investment opportunities.</p> Signup and view all the answers

What does MM theory suggest happens when a firm uses debt to buy back shares?

<p>While this action increases EPS, it does not change the share price as the associated risks and required returns on equity also escalate.</p> Signup and view all the answers

What does the Modigliani-Miller theorem suggest about the relevance of capital structure in a frictionless market?

<p>The Modigliani-Miller theorem suggests that in a frictionless market, the choice of capital structure is irrelevant for the value of a firm.</p> Signup and view all the answers

Why might excessive debt lead to potential bankruptcy according to pre-Modigliani-Miller views?

<p>Excessive debt may lead to high interest payments that could become unsustainable, resulting in potential bankruptcy.</p> Signup and view all the answers

Explain the concept of homemade leverage as presented in the Modigliani-Miller propositions.

<p>Homemade leverage refers to the idea that if investors prefer a different capital structure, they can adjust their personal borrowing and lending to replicate their desired results independently of the firm's structure.</p> Signup and view all the answers

In the context of firm value, what is the relationship between bond value, stock value, and firm value?

<p>Bond value and stock value combined equal the total firm value.</p> Signup and view all the answers

How does the value of equity function as an option in relation to a company's assets?

<p>Equity functions like a call option on the company's assets with a strike price equal to the face value of the debt.</p> Signup and view all the answers

What is one potential reason that makes 'debt is cheaper than equity' intuition misleading?

<p>One reason is that excessively high debt could lead to financial distress and increased bankruptcy risk, countering the initial cost benefits.</p> Signup and view all the answers

What is meant by the weighted average cost of capital in relation to levered equity?

<p>The weighted average cost of capital is equal to the expected return on unlevered equity and increases with the firm’s debt-to-equity ratio.</p> Signup and view all the answers

Identify two assumptions of the Modigliani-Miller propositions about a world without friction.

<p>Assumptions include no taxes and no financial distress costs.</p> Signup and view all the answers

What is the mental accounting fallacy in relation to prospect theory?

<p>The mental accounting fallacy occurs when individuals compare their wealth to a reference point and integrate gains from that point with losses from money left on the table, possibly leading to suboptimal financial decisions.</p> Signup and view all the answers

What is a possible positive signal for the market regarding payouts?

<p>Payouts, such as dividends, may signify a firm's financial health and commitment to returning value to shareholders.</p> Signup and view all the answers

Why could dividend policy be considered irrelevant according to some theories?

<p>Dividend policy might be irrelevant because investors can create their own cash flow through homemade dividends by selling shares as needed.</p> Signup and view all the answers

In the example of Investor Bob, how does he achieve his preferred dividend income?

<p>Bob achieves his desired dividend income by selling shares to convert the cash into his preferred amount.</p> Signup and view all the answers

What are the agency costs associated with dividend payments?

<p>Dividend payments can help mitigate agency costs by preventing managers from misusing excess cash for personal interests or poor investments.</p> Signup and view all the answers

What tax advantage do share repurchases have over dividend payments?

<p>Share repurchases allow investors to pay capital gains tax, which is typically lower than the dividend tax incurred on cash distributions.</p> Signup and view all the answers

Why might firms choose to pay dividends despite the tax disadvantages?

<p>Firms may pay dividends as a signaling mechanism to convey confidence in their financial stability and to reassure investors of future cash flows.</p> Signup and view all the answers

What role does transaction cost play in why investors may prefer dividends?

<p>Transaction costs associated with selling shares to create homemade dividends can make receiving cash dividends more appealing to investors.</p> Signup and view all the answers

What is the main reason underwriters set the offer price too low during an IPO?

<p>Underwriters set the offer price too low to reduce risk and charge high commissions on underpriced shares.</p> Signup and view all the answers

How do rights offerings protect existing shareholders compared to cash offerings?

<p>Rights offerings ensure existing shareholders can purchase new shares, preventing dilution of their ownership.</p> Signup and view all the answers

What generally happens to the stock price following the announcement of a seasoned equity offering (SEO)?

<p>The stock price typically declines following the announcement of an SEO.</p> Signup and view all the answers

What do the cyclicality puzzles in IPOs indicate about market conditions?

<p>Cyclicality in IPOs suggests that the number of issues increases in good times and decreases in bad times.</p> Signup and view all the answers

What is one of the implications of adverse selection on firm financing choices?

<p>Firms may prefer to issue less-information sensitive securities to minimize adverse selection risks.</p> Signup and view all the answers

How does underpricing in IPOs affect pre-IPO shareholders?

<p>Pre-IPO shareholders bear the costs of underpricing, resulting in a non-optimal share price.</p> Signup and view all the answers

Why do financial firms engage in costly signaling, such as posting collateral?

<p>Firms signal quality to investors to reassure them of their value amidst asymmetric information.</p> Signup and view all the answers

What is the typical spread (bank fees) for an initial public offering (IPO)?

<p>The typical spread for an IPO is around 7% of the issue price.</p> Signup and view all the answers

In what scenario is investor demand at the issue price typically rationed?

<p>Investor demand is typically rationed when an IPO is perceived as successful, leading to high demand exceeding supply.</p> Signup and view all the answers

What do firms often do prior to announcing an SEO to influence market reaction?

<p>Firms often allow their stock price to rise before announcing an SEO to create a favorable perception.</p> Signup and view all the answers

Flashcards

Frictionless World Assumption

A model that assumes no taxes, financial distress costs, asymmetric information, transaction costs, and everyone borrows and lends at the same rate.

Modigliani-Miller Theorem

In a frictionless market, the company's value is independent of how it finances itself (debt or equity).

Modigliani-Miller Proposition 1

The total value of the company is equal to the market value of its assets' cash flows, not affected by its capital structure.

Homemade Leverage

Investors can create their desired leverage by borrowing or lending on their own, achieving the same outcome as a company's chosen capital structure.

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Modigliani-Miller Proposition 2

The weighted average cost of capital (WACC) remains constant regardless of the company's debt-to-equity ratio.

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Increased Cost of Equity with Leverage

The cost of equity for a levered company increases as the company takes on more debt.

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Pre-Modigliani-Miller View

A traditional view that assumes debt is cheaper than equity due to lower interest rates and dilution effects in equity offerings.

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Modigliani-Miller Propositions as a Benchmark

The Modigliani-Miller propositions provide a benchmark for understanding how capital structure impacts company value. It highlights the fact that the traditional 'debt is cheap' intuition is misleading in a frictionless world.

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Initial Public Offering (IPO)

When a private company becomes a publicly traded company by selling stock to the public for the first time.

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Default

When a firm fails to make required payments to its debt holders, leading to legal action by debt holders.

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Liquidation

A process where a company's assets are sold to pay off its debt. This is often costly, especially for larger firms.

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Underwriter

An investment bank that manages the process of issuing securities to the public.

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Reorganization

A process where a company proposes a plan to restructure its operations and continue operating. Creditors receive cash and new securities in the company.

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Firm Commitment IPO

The underwriter guarantees to buy all the stock offered by the company, regardless of whether it can sell it all to investors.

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Bankruptcy Costs

Costs associated with bankruptcy proceedings, including legal fees, administrative expenses, and lost opportunities.

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Syndicate

A group of underwriters that work together to manage the issuance of securities and share the risks and responsibilities.

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Trade-off Theory

The theory that firms weigh the tax benefits of debt against the cost of financial distress when determining their capital structure.

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Road Show

A series of presentations given by a company's management and underwriters to potential investors, highlighting the company's business and its IPO offering.

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Agency Costs

Costs arising from conflicts of interest between shareholders and bondholders.

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Excessive Risk-Taking

A situation where excessive leverage leads to increased risk-taking by managers.

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Under-investment

When a company with high debt levels avoids new profitable investments due to the risk of bankruptcy.

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MM Proposition 2

MM Proposition 2 states that a company's weighted average cost of capital (WACC) remains unaffected by its capital structure. This means that whether a company uses more debt or equity financing, its overall cost of capital stays the same.

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Cost of Equity and Leverage

The cost of equity rises as leverage increases, offsetting any perceived benefits from cheaper debt. This means even though debt may have a lower initial cost, the increased risk for equity holders balances it out.

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Debt is Cheap Fallacy

The fallacy believes that debt is always cheap as it has a lower interest rate than equity. However, the fallacy ignores the increasing cost of equity as leverage rises. This increase in cost of equity offsets any perceived advantage of cheaper debt.

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EPS Fallacy

The fallacy suggests that increasing leverage (debt) can improve earnings per share (EPS). However, while debt can initially increase EPS, it also increases risk, leading to a higher required rate of return on equity. This higher required return cancels out the perceived benefit of higher EPS.

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Equity Dilution Fallacy

The fallacy assumes that issuing equity dilutes value because EPS might decrease. However, this ignores that EPS is simply a reflection of risk. In a levered firm, higher EPS is a compensation for higher risk. Releasing new shares doesn't negatively impact original shareholders.

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Repurchases vs. Dividends Fallacy

The fallacy asserts that repurchasing shares is better than paying dividends as repurchases prop up the share price. While repurchasing shares does reduce cash balance, it doesn't automatically increase value. Both repurchases and dividends lower cash balance, and their impact on value is similar.

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Cash Hoarding Fallacy

The fallacy suggests that a company should always spend cash rather than holding it, even if it means investing in low-yield assets like government bonds. This ignores potential future investment opportunities that may be more profitable.

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MM Bottom Line: WACC and Capital Structure

The bottom line of MM Proposition 2 is that a company's WACC should not change as its capital structure changes. However, this only applies in a perfect market without taxes or transaction costs. In reality, WACC can be affected by factors like taxes and financial distress.

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Mental Accounting Fallacy

A cognitive bias where individuals treat gains and losses differently based on a reference point, evaluating outcomes relative to their starting point.

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Payout Policy

A firm's strategy for distributing cash to shareholders, either through dividends or share repurchases. This reduces equity and increases a firm's leverage.

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Dividend Irrelevance Theory

The belief that investors can create their own desired dividend income by buying or selling shares, making a company's dividend policy unimportant for valuation.

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Why Investors Like Dividends

The idea that investors prefer dividends because of potential tax benefits, transaction costs, and signaling effects.

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Share Repurchase

A firm's decision to repurchase its own outstanding shares, reducing the number of outstanding shares and increasing earnings per share. Tax treatment favors share repurchases over dividends.

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Signaling with Dividends

Paying dividends signals to the market that the company is profitable and confident in its future prospects, making dividends a positive signal for investors.

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Rights Offer

A firm offers new shares to existing shareholders, protecting them from underpricing.

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IPO Underpricing

When underwriters set the IPO price too low, resulting in a positive first-day return for investors.

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First-day IPO Return

The difference between the IPO price and the first day's closing price, typically resulting in a gain for investors.

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IPO Share Allocation

The process of allocating shares in an IPO to investors, often rationed due to high demand and limited supply.

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Seasoned Equity Offering (SEO)

A public company issues new shares to raise additional equity. This is a more common and less costly financing method than an IPO.

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Equity Issuance Cost and Market Breakdowns

A situation where investors perceive a company announcing an equity offering as overvalued, leading to a negative stock price response.

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Pecking Order Theory

Firms prefer to issue securities that reveal the least amount of information about the company's health, as this minimizes adverse selection.

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Signaling

A firm may engage in actions to convince investors of their quality, such as posting collateral to reduce information asymmetry.

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Study Notes

Corporate Finance Lecture Notes

  • Lecture 4 (12/11/2024): Approach in finance academia. Clearly state assumptions in a mathematical model. Formal analysis based on those assumptions.

  • Payoff Diagram: Bond value and stock value sum to firm value. Equity is a call option on the company's assets, with a strike price equaling the debt's face value. Understanding the general payoff diagram simplifies the rest.

  • Pre-Modigliani-Miller (MM) View: Common pre-MM view states that debt is cheaper than equity due to lower interest rates on debt compared to required returns on equity. Equity issues dilute earnings per share, potentially leading to bankruptcy. However, excessive debt can cause high interest payments and ultimately lead to bankruptcy. This contrasts with MM theory.

  • MM Propositions (Without Taxes): Modigliani-Miller Theorem, where total firm value is equal to the market value of the firm's assets (total cash flows generated by assets), unaffected by the capital structure. In a perfect capital market, the choice of capital structure is irrelevant for the firm's value.

Assumptions Behind MM Propositions (Frictionless World)

  • No taxes and financial distress costs, no asymmetric information, no transaction costs, consistent maximization of value by employees, consumers, and firms borrowing and lending at the same rates.

Fallacies Debunked by MM

  • Debt is cheap: While debt has a lower required return (theoretically equal to the risk-free rate), increasing leverage increases the cost of equity.

  • EPS fallacy: Increasing debt to buy back shares increases earnings per share, but share price remains unchanged as risk has also increased, leading to higher required return on equity.

  • Equity Issue Dilution: Equity is more expensive than debt because equity issues, diluting earnings per share, drive down stock value. However, this value remains the same. Shareholder value is not diminished in levered firms.

Trade-off Theory**

  • Trade-off: Firms balance tax benefits of debt (interest tax shields) against financial distress costs.

  • Total Value: The total value of a levered firm equals the unlevered firm's value plus the present value of interest tax shields, minus the present value of financial distress costs.

  • Leverage Difference: Differences in the use of leverage across industries stem from differences in the magnitude of financial distress costs and volatility of cash flows.

Modigliani-Miller with Taxes

  • Value of Levered Firm: Value of the levered firm is greater than the unlevered firm's value due to the interest tax shield.

  • Weighted Average Cost of Capital (WACC): Effective after-tax borrowing rate is (1-t). The weighted average cost of capital (WACC) changes.

Bankruptcy Costs

  • Default: Firm failure to make required payments to debt-holders.
  • Bankruptcy Costs: Bankruptcy proceedings include liquidation or reorganization. Liquidation is costly for large firms; reorganization involves management plans, and cash payments to creditors.
  • Direct Costs: Expenses and fees associated with bankruptcy and legal proceeding
  • Indirect Costs: Missed opportunities, loss of assets, and costs to creditors.
  • Financial Distress Costs: Distressed firms face competitive disadvantage due to reduced R&D or investments.

Individual Cash Flows of a Project

  • NPVs: Value-additivity principle states that the NPV of a project is the sum of the individual cash flows' NPVs.

Other Costs and Benefits of Debt

  • Agency Costs: Leverage Ratchet effect, excessive risk-taking(risk shifting), under-investment due to debt overhang.
  • Agency Benefits: Effort incentivization through equity financing.

Economic Frictions (Deviations from MM)

  • Moral Hazard: Shareholders have control over firm actions, and these are unobservable, making them uncontractible.

Leverage Ratchet Effect

  • Incentives: Shareholders may have no incentive to decrease leverage despite its value-increasing effect. They might increase leverage even if it diminishes firm value.

Risk Shifting

  • Limited Liability: Shareholders' payoffs are capped at 0 in the event of default, enabling risk shifting onto the debt-holders.

Underwriter Incentives & Prospect Theory

  • Underpricing: Underwriters have an incentive to underprice IPOs to attract more investments and earn higher commissions.
  • Mental Accounting: Issuers do not mind leaving money on the table, as prospect theory argues that managers focus on changes to wealth rather than the overall wealth.

IPO Process Stages

  • Stage 1: The firm announces the initial public offering (IPO). Investors place orders.
  • Stage 2: Share allocation to investors, either pro-rata in case of excessive demand or fully met by the initial demand. Investors trade after the IPO.

IPO Underpricing & Winner's Curse

  • Firms offer an initial public offering (IPO) price lower than the perceived market value due to asymmetry of information.
  • Informed investors buy shares at the lower, undervalued price.

Underwriter Incentives & Prospect Theory

Underwriters have an incentive to underprice IPOs to earn higher commissions from the buy-side clients.

Dividend & Share Repurchase Signals

  • Dividend Signals: Increases indicate positive return, while decreases indicate negative return.
  • Repurchase Signals: Announcements increase and suspension reduces return.

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Description

This quiz covers key concepts in corporate finance, focusing on the implications of debt and equity valuation under the Modigliani-Miller theorem. It addresses bankruptcy outcomes, costs associated with financial distress, and aspects of initial public offerings (IPOs). Test your understanding of leverage, agency costs, and the role of underwriters in public offerings.

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