Dr. P.V. Viswanath

 

pviswanath@pace.edu

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Important Terms and Concepts: Corporate Finance

 
 
 
 
 
   
 
 
 

Question Pool for Exams

Corporate Governance:

  1. What are the salient characteristics of a corporation?
  2. Who controls a corporation?
  3. What happens to the control of the firm in bankruptcy?
  4. What is the relevance of the stock market to the concept of a corporation?
  5. Why is it important to maximize firm value?
  6. If firm value is paramount, why is stockholder value relevant?
  7. What is the agency problem in a corporation?
  8. How can the agency problem vis-a-vis corporate managers be resolved? Can it be fully resolved? Why or why not?
  9. Is the market for corporate control, part of the solution or the problem?
  10. What is the purpose of the Annual Meeting from a Corporate Governance point of view?
  11. What is the purpose of the Board of Directors from a Corporate Governance point of view? Why does it not always work well?
  12. How is the role of the stock market in stock value maximization?
  13. How might one argue against using stock prices as measures of stockholder wealth?
  14. What are some of the potential social costs and benefits of the operation of a firm that do not accrue to or borne by the firm?
  15. What is the problem with not having these social benefits accrue to the firm or having these costs affecting the firm? How are some of these costs and benefits internalized?

Arbitrage and Time Value of Money

  1. How does the market ensure that the Law of One Price holds?
  2. What can prevent the operation of the law of one price?
  3. How can the existence of bid and ask prices be consistent with the notion of the law of one price?
  4. What is an asset?
  5. What is the role of primary assets in the Law of One Price?
  6. How is a discount rate similar to a price?
  7. Why is an effective annual rate of return greater than the corresponding Annualized Percentage Rate?
  8. What are the determinants of expected rates of return on assets in an economy?
  9. What is the difference between the nominal rate of interest and the real rate of interest?
  10. What information do we get from a yield curve?

Capital Markets:

  1. How is beta different from standard deviation of returns as a measure of risk?
  2. If you regress expected returns of portfolios of large asset classes against their standard deviations of returns, they tend to line up. However, if you do the same for individual stocks, they don't. Why? Explain.
  3. Why is an asset's idiosyncratic risk irrelevant for determination of that's asset's market price?
  4. What does the CAPM say?
  5. How would you measure the beta of an asset that is traded?
  6. How would you measure the beta of a new project that is under consideration for adoption?
  7. Consider the following set of industries and rank them in order of their market beta magnitudes. Explain:
    1. Food Processing
    2. Semiconductors
    3. Auto and Truck Manufacturers
    4. Electric Utilities
  8. Why is better to use data from a longer period to estimate mean returns?
  9. Are forecasts of average multi-year returns more accurate than forecasts of single-year returns? Why or why not?
  10. What evidence suggests that the market portfolio may not be efficient?
  11. According to the Fama-French-Carhart model, do small stocks earn higher or lower returns, on average?
  12. According to the Fama-French-Carhart model, do stocks with higher book-to-market ratios earn higher or lower returns, on average? Why do you think such a situation exists?

Quantitative and Conceptual Problems:

  1. Computing expected return, standard deviation of return, variance of return.
  2. Computing 95% confidence intervals
  3. Questions testing your ability to understand the difference between diversifiable and non-diversifiable risk.
  4. Questions testing your understanding of the CAPM
  5. Questions testing your understanding of the Efficient Markets Hypothesis

Stock Pricing:

  1. When will it be true that all investors will value a stock in the same way independent of their investment horizons?
  2. Can we say that the stock price is the discounted present value of the firm's future earnings?
  3. What are the determinants of the rate of growth of a firm's earnings?
  4. How would you modify the dividend discount model to take into account share repurchases?
  5. What is the enterprise value of a firm?
  6. How would you go about using comparables to value a firm? Show this in the context of valuing Dell Computers (DELL).
  7. How would you evaluate the multiples approach in relation to the DCF approach to valuation?
  8. Explain the Efficient Markets Hypothesis.
  9. Stock prices typically rise when the firm makes an announcement of a new product. Why should this be so, according to the Efficient Market Hypothesis?
  10. What should happen, according to the Efficient Markets Hypothesis, when a firm announces a dividend cut. Explain.
  11. Your friend has spotted the following pattern -- if the market goes up on two successive days, it always goes up on the third day, as well. Do you believe that it would be possible to make money off this pattern? Why or why not?
  12. Your friend has spotted the following pattern -- if a stock goes down on a given day, it tends to go down on the following day, as well. This happens to be particularly true of small stocks. Explain how this might be possible, even if investors are on the lookout for mispricings?
  13. What are the implications of the Efficient Markets Hypothesis for CEOs?

Quantitative Problems:

  1. Using the DDM to compute the value of the equity of a firm.
  2. Using the FCF model to compute the value of the equity of a firm.
  3. Computing stock price given some combination of information about dividends, ROE, reinvestment rates, etc.

Capital Structure:

Questions:

  1. Under what circumstances is capital structure irrelevant for the value of a firm? Explain.
  2. What is the cost of capital of the firm under perfect capital markets? How does it change if interest payments are tax deductible?
  3. Under Perfect Capital Markets, we know that Capital structure is not irrelevant for firm valuation. Now, the cost of equity capital increases when the firm's leverage increases. So does the cost of debt capital. If so, how could the WACC, the weighted average of the costs of equity and debt capital remain constant when leverage increases?
  4. "Issuance of new equity dilutes earnings. Hence it's bad." Is true or false? Explain.
  5. Interest payments are deductible for corporate tax purposes. Hence, one would think that debt should increase the value of a firm. However, your friend is convinced that if all taxes are taken into account, debt could actually decrease the value of a firm. How could this be?
  6. What is the most important source of capital for firms? Can you explain why this might be so?
  7. Name two industries that use a lot of debt relative to equity? Explain why these firms use so much debt.
  8. Name two industries that use very little debt relative to equity? Explain why these firms use so little debt.
  9. What are some of the advantages of debt?
  10. "All firms with the same marginal tax rates have the same tax advantages of debt." Comment.
  11. What are the advantages of private debt placement, other than lower issuance costs? What are the disadvantages?
  12. What are the three characteristics of IPOs that puzzle economists? Explain why the characteristics are puzzles.
  13. Which of these two companies would have higher financial leverage, and why --
    1. Deere & Co. (DE) -- DE manufactures and distributes farm equipment, machines used in construction, earthmoving and forestry, and equipment for commercial and residential uses.
    2. AMN Healthcare Services is a temporary healthcare staffing company and a nationwide provider of travel nurse staffing services to hospitals and healthcare facilities throughout the United States.
  14. Just as issuing equity dilutes earnings, buying back stock is good because it increases earnings per share.  Comment.

Quantitative and Conceptual Problems:

  1. Questions testing your ability to understand the irrelevance of capital structure in perfect markets. (That is, capital structure becomes relevant only to the extent that it affects "leakages" or payments to non-security holders of the firm.)
  2. Problems requiring you to compute the value of tax-shields.
  3. Questions testing your understanding of how the tax advantage of debt affects a firm's capital structure.
  4. Questions testing your understanding of what agency costs are and how they affect a firm's optimal capital structure.
  5. Questions testing your understanding of how bankrutpcy and bankruptcy costs are important in a firm's capital structure decision.

Financial Distress, Managerial Incentives and Information

  1. Explain the underinvestment problem.
  2. What are agency costs? What are the agency costs of debt?
  3. Suppose financial restructuring could be achieved costlessly in bankruptcy. Would the prospect of bankruptcy affect the optimal choice of capital structure under these circumstances? Explain.
  4. What are the direct costs of bankruptcy?
  5. Name five different categories of indirect costs of bankruptcy? Explain each of them.
  6. What sorts of firms should have less debt, from the bankruptcy cost point of view?
  7. What is the pecking order hypothesis? Can you explain why such a pecking order exists?

 

Payout Policy:

  1. What are the advantages of share repurchases over dividends as a way of returning cash to shareholders?
  2. What does it mean to say that dividends act as a signal? Explain.
  3. What is the behavioral or psychological theory of dividends?
  4. Explain the life-cycle theory of dividends.
  5. Name three factors that are relevant in the determination of a firm's dividend policy. Explain.
  6. What is likely to happen if a firm consistently pays dividends much below Free Cash Flow to Equity?
  7. Is there a relationship between a firm's leverage and a firm's dividend policy? Explain.
  8. Explain how dividend capture works.
  9. How might you be able to estimate the marginal tax rate of a firm's stockholders?
  10. Under what assumptions are dividends irrelevant for firm value?

 

The Objective Function in Corporate Finance (Chapter 1)

Terms

  • Agency Costs
  • Board of Directors
  • Golden Parachute
  • Poison Pills
  • Super-majority Amendment
  • Capital Market Efficiency
  • Bond covenants
  • Greenmail
  • leveraged buyout
  • social costs

Short Questions

  • What is the rationale behind paying a firm's management with stock options?
  • Stockholders of a firm with a lot of debt prefer to take riskier projects than stockholders of a comparable firm with less debt.  Why?
  • What are the advantages and disadvantages of firm value maximization as a corporate objective?
  • What are the advantages and disadvantages of stock price maximization as a corporate objective?
  • What is the purpose of the annual meeting?
  • What is the role of the Board of Directors?
  • Why does the Board of Directors often fail in its efforts to monitor managers?
  • What steps can be taken to improve the performance of the Board of Directors as a monitoring mechanism?
  • How could there be a conflict of interests between stockholders and bondholders?  How might this conflict manifest itself?
  • What are some of the ways in which bondholder-stockholder conflicts are sought to be minimized?
  • Why might managers want to provide information to the markets?
  • Does the objective of stock price maximization depend upon capital market efficiency?
  • How might societal objectives conflict with stockholder objectives?  How are these conflicts handled?
  • How might managerial objectives conflict with stockholder objectives?  What are some of the ways that these conflicts could be minimized?
  • What is the role of a market for corporate control in corporate governance?
  • What is the role of stock analysts in corporate governance?
  • Is it good to make insider trading illegal?  Can you think of reasons why insider trading should be made legal?

 

Present Value and Valuation (Chapter 3 and 5)

Terms

  • annuity
  • cost of equity
  • cost of debt
  • cost of capital
  • free cashflow to equity investors
  • free cashflow to the firm
  • Gordon Growth Model
  • terminal price

Short Questions

  • How do you come up with a terminal price in valuing a stock?


Quantitative Problems

1. (Spring 2005 Midterm) You wish to buy a car.  Unfortunately, you donít have any ready cash.  On the other hand, you just recently invested $200,000 in a private equity fund.  The fund manager will not give you your money back right away, unfortunately.  However, according to your calculations, your investment in the fund should grow at the average rate of 15% a year for the next 5 years, at the end of which you can cash out.

Of course, you still want your car right now!  What to do?  Luckily for you, your friendly banker is willing to lend you some money using your investment as collateral.  Your banker believes that your investment has a beta of 1.5, the market risk premium is 6% and that the current five-year T-bond rate is 4.5%.  He is willing to lend you 80% of the estimated market value of your investment so that you can buy your car.  The APR on the loan is 18% and the money is to be repaid in monthly installments, starting 13 months from now.  If there are 48 payments in all, what is the size of each payment?

2. (Fall 2004 midterm) Altria (http://finance.yahoo.com/q/ks?s=MO) has an equity beta of 0.289. You estimate the market risk premium to be 6% per annum. If the yield on the 10-year T-bond is 4.22% (http://www.bloomberg.com), should Altria invest in a project that will have after-tax cashflows to equity of $20b. a year for the first 5 years, and then increasing at the rate of 2% per annum forever? This project will require an initial investment of $500b.

3. (Fall 2004 midterm) You have been asked to value a 30-year, $1000 face value bond, issued by CVS with the following features. The coupon rate for the first 10 years will be 6%of the face value. The coupon rate for the second 10 years will be 7% of face value. Thereafter, the coupon payment will increase at the rate of 5% per annum (coupon growth will be based on the dollar coupon the previous year). Write out the time line of cashflows, and estimate the value of this bond, if CVS is rated AA. (AA-rated bonds are trading at a default spread of 0.25% over the 10-year treasury bond rate of 4.50%.)

4. (Fall 2003 midterm) Lear Corporation, a manufacturer of automotive supplies, generated $650 million in free cash flow to the firm (prior to debt payments, but after reinvestment needs and taxes) last year. The firm has a cost of capital of 8.5% and debt outstanding of $3.88 billion. The firm has 66.5 million shares outstanding. The cash flows are expected to grow at the rate of 4.5% a year in perpetuity. Estimate the value of Lear Corporation (as a firm).

5. (FIN 320 Spring 2002 midterm; Source: StockVal) Net Income per share for Thor Industries, Inc. (THO) for 2001 was $2.23, with 11.963 million shares outstanding.  The firm had capital expenditures of $17.2 million last year, and depreciation of $4.9 million.  Current liabilities were $87.3 million, current assets were $238 million, and cash was $107.2 million.  Interest expense was 0.8 million.  Thor Industries has a beta of 0.76 based on the last 60 months of data . Assume that noncash working capital, net income, depreciation and capital expenditures will all increase by 10% for the next five years, and then by 5% for ever.  Thor Industries does not have any long-term debt or current debt, and there is no expectation that debt will be used in the future.

 The current yield on 10-year T-bonds is 5.31% (source: http://www.bloomberg.com/markets/C13.html?sidenav=front).  Assume that the market risk premium is 6% per annum.

  1. What is the required rate of return on Thor stock? (10 points)
  2. Estimate the free cash flow to equity in 2001.  (Assume that non-cash working capital increased 10% in 2001 over 2000.) (10 points)
  3. Estimate the price of Thor stock at the end of 2005. (10 points)
  4. Estimate the per share price for THO as of the end of 2001.  (10 points)
  5. Estimate the price of THO as of March 31, 2002, assuming that Thor pays no dividends between Dec. 31, 2001 and March 31, 2002.   (10 points)
  6. If I told you that Thor stock traded at $46.31 on March 18, 2002, what would you say regarding market efficiency?   (10 points)

Chapter 3: Understanding Financial Statements

Terms

  • Free Cash Flow to Equity
  • Deferred Tax Asset
  • Call market
  • Assets-in-place
  • Growth Assets
  • Intangible assets
  • FIFO
  • LIFO
  • Marking to Market
  • Capital Lease
  • Operating Lease
  • Treasury Stock

 

Short Questions

  • From a financial analyst's point of view, Research and Development expenses of a pharmaceutical firm should be amortized over a longer period than those of a software firm.  Why?
  • Assume that all of the debt on your books was borrowed three years ago, when the treasury bond rate was 7% and you were borrowing at 7.5%.  If the treasury bond rate today is 6%, and you are a riskier firm than you used to be, will the market value of your debt be greater than or less than your book value?  Explain.
  • What is the balance sheet and what is its purpose?
  • What is the income statement and what is its purpose?
  • What is the Statement of Cash Flows and what is its purpose?
  • What are some examples of intangible assets?  Why is it important to consider intangible assets separately, from the point of view of a financial analyst?
  • How would you value assets-in-place?
  • How would you value growth assets?
  • What is the difference between purchase accounting and pooling accounting?
  • When is an obligation recognized as a liability according to GAAP?
  • What is the difference between a capital lease and an operating lease?
  • How would you categorize financing into debt and equity?  How would you deal with convertible debt?
  • What is goodwill?
  • How would you value the research asset?

 

Risk and Return

Terms

  • Marginal Investor
  • Free Cash Flow to Equity
  • hurdle rate
  • cost of capital
  • cost of equity
  • cost of debt
  • implied market risk premium
  • historical risk premium
  • geometric average
  • arithmetic average
  • beta
  • Jensen's alpha
  • market portfolio
  • operating leverage
  • fundamental beta
  • asset beta
  • unlevered beta
  • levered beta
  • equity beta
  • bottom-up beta
  • accounting beta
  • synthetic rating
  • preferred stock
  • convertible bond
  • hybrid security
  • standard error of the beta estimate

 

Short Questions

  • What is the required rate of return on a lottery ticket according to the Capital Asset Pricing model, and why?
    Ans: The risk-free rate of return. The beta of the lottery ticket is zero, because all of the uncertainty on a lottery ticket's return is diversifiable.
  • Why does diversification reduce firm-specific risk?
    Ans: Firm specific risk is specific to that firm; this means that it is uncorrelated with firm-specific risk of other stocks.  As a result, if a portfolio contains many different stocks, some stocks have positive firm-specific shocks, while other stocks have negative firm-specific stocks, and the two will tend to cancel out, more or less.  This is why diversification reduces firm-specific risk. 
  • What are the two characteristics that a risk-free rate must have?  Illustrate your answer with reference to the 10 year Treasury bond.
    Ans: A risk-free rate must have two characteristics -- one, there must be no default risk; and two, there must be no reinvestment risk.  If we are talking about the 10-year Treasury bond, condition one is satisfied.  However, condition two is not satisfied perfectly, even if the investor has a ten-year risk horizon.  The reason for this is that the 10-year bond will have coupons that are paid before ten years are past, and they will need to be reinvested at a rate that is currently unknown.  Hence, even for an investor with a ten-year horizon, the yield on the ten-year T-bond is an imperfect measure of the risk-free rate.
  • True or false: Industry-specific risk cannot be diversified away.  Explain your answer; no credit without explanation.
    Ans: Some industry-specific risk is correlated with the market; that portion cannot be diversified away.  However, the portion that is uncorrelated with the market can be diversified away in a portfolio that is diversified across industries.
  • What is the only measure of asset risk that is considered relevant, in the CAPM?
    Ans: Beta risk.  This is because only non-diversifiable risk is relevant in the CAPM world, and the beta measures that.
  • When would you use a geometric average and when would you use an arithmetic average to estimate a historical market risk premium?
    Ans: You would use a geometric average if you were interested in a summary statistic regarding past performance.  However, if you wanted an estimate of the future one-year rate of return, an arithmetic average of past annual rates of return would be better.  Nevertheless, if you were interested in an estimate of a long-term rate of return, you would still use a geometric average. 
  • When would you use a bottom-up beta?
    Ans: You could use a bottom-up beta, if you did not have information about historical returns of the stock, as, for example, if the stock related to a new company, or if the stock had not been traded for a long time, but you felt that the underlying company was a typical one for the industry.
  • When would you use an accounting beta?
    Ans: You could use an accounting beta, if you had a sufficiently large history of accounting earnings for the company, but if you didn't have a history of stock returns.
  • How would you measure a beta for a new firm in a new industry?
    Ans: You could use scenario analysis, if the industry, itself, were new.  If you could make comparisons between this new industry and existing industries, you could use the betas of those existing industries as base estimates, as well.
  • If you know that a new firm uses more labor per unit of finished product than the average firm in the industry, how would you go about computing an adjusted beta, using the bottom-up method?
    Ans: You would use the bottom-up beta and then adjust downwards (since a higher amount of labor implies a lower operating leverage), in a way similar to the adjustment used with financial leverage that varies from company to company.
  • Two firms, A and B, are in the same industry.  Firm A has a higher financial leverage than firm B.  Which firm's stock will have a higher beta, A or B?  Why?
    Ans: All other things being the same, a firm with higher financial leverage will have a higher beta. The reason is that financial leverage increases the stock beta, for a given asset beta. Firms in the same industry will probably have the same asset beta.
  • If firm A has a higher stock beta than firm B, can you definitely conclude that firm A has higher financial leverage than firm B?  Why or why not?
    Ans: If both firms are in the same industry that may very well be true, but it is not necessarily so -- this is because not all firms in an industry have the same asset beta. Firms not in the same industry need not have the same asset beta, or the same ability to support debt; hence we cannot make any conclusions regarding a firm's financial leverage from its stock beta.
  • A firm with higher idiosyncratic risk will necessarily have a higher beta.  True or False?
    Ans: If anything, the opposite; however, logically the two are not so closely connected. Higher idiosyncratic risk is diversifiable risk, and only non-diversifiable risk contributes to beta.
  • If the beta of a stock is close to 1, then its volatility will be similar to that of the market.  True or False?
    Ans: If the beta is one, then the variance of the non-diversifiable component will be similar.  However, you still have the diversfiable component.  Hence the answer is -- no.  
  • We usually estimate the variance of an asset's return by looking at historical (past) returns.  Under what conditions may this approach not be appropriate for estimating variance for use in a risk-and-return model?
    Ans: This would not be appropriate if, for any reason, the analyst feels that the current situation of the firm is not comparable to its historical experience.  For example, if the firm has radically changed its product line, or its operating or financial strategy, historical betas may not have any relevance to current beta.  For example, IBM, according to some, has reinvented itself as an innovative firm; if this is true, then its historical beta may be more stable (closer to one) than its current beta.
  • A stock with a high return variance will have a higher beta than one with lower return variance.  True or False?
    Ans: This is not necessarily true because the higher return variance stock could have more diversifiable risk.
  • How is beta different from standard deviation of returns as a measure of risk?
  • If you regress expected returns of portfolios of large asset classes against their standard deviations of returns, they tend to line up. However, if you do the same for individual stocks, they don't. Why? Explain.
  • Why is an asset's idiosyncratic risk irrelevant for determination of that's asset's market price?
  • What does the CAPM say?
  • How would you measure the beta of an asset that is traded?
  • How would you measure the beta of a new project that is under consideration for adoption?
  • Consider the following set of industries and rank them in order of their market beta magnitudes. Explain:
    1. Food Processing
    2. Semiconductors
    3. Auto and Truck Manufacturers
    4. Electric Utilities

 

Estimation of Discount Rates

Terms

  • opportunity cost of capital

Short Questions

  • How do you unlever a firm's stock beta to get its asset beta?

 

Capital Structure: Tradeoffs and Theory

Terms

  • venture capital
  • offering price
  • tracking stock: shares issued against specific assets or portions of a firm; they entitle their owners to a share of the assets and cash flows of that portion of the business.
  • warrants
  • contingent value rights
  • line of credit
  • callable debt
  • puttable bonds: bonds, whose buyers can put (sell) their bonds back to the firm and receive face value in the even of an occurrence such as a leveraged buyout.
  • extendible bonds
  • original-issue deep discount bonds
  • floating rate bonds
  • caps
  • floors
  • step-up or step-down floating rate bonds
  • debentures
  • negative pledge clause: a covenant included in the bond indenture that prevents bondholders' claim on the assets from being superseded by future debt that the firm might issue.
  • subordinated debt: debt, that is subordinated to other debt, whose holders have priority in claim over the holders of the subordinated debt.
  • mortgaged bond
  • asset-backed borrowing
  • principal exchange linked bonds
  • dual currency bond
  • eurobond
  • skinking bond
  • serial bond
  • balloon payment bond
  • operating lease
  • capital lease
  • convertible debt
  • conversion ratio: the number of shares of stock for which each convertible bond may be exchanged.
  • conversion premium
  • conversion price
  • DECs
  • preferred stock
  • convertible preferred stock
  • internal equity: financing obtained from cashflows generated from the existing assets of a firm -- in contrast to funds raised from private sources or from financial markets.
  • seed-money venture capital
  • start-up venture capital
  • exit value

Short Questions

  • What is the pecking order theory of capital structure?
  • What is the Modigliani-Miller theorem of Capital Structure Irrelevance?

 

Capital Structure: Models and Applications

Terms

  • normalized operating income

Short Questions

  • When would you use the cost of capital approach and when would you use the adjusted present value approach to figure out the optimal capital structure for a firm?
  • How does the return differential approach work?
  • What are the shortcomings of the return differential approach?
  • When is it important to consider the impact of capital structure choice on the firm's bond rating?
  • Explain the operating income approach to determining a firm's optimal capital structure.

 

The Determinants of Dividend Policy

Terms

  • dividend declaration date
  • ex-dividend date
  • holder-of-record date
  • dividend payment date
  • stock dividends
  • regular dividend
  • special dividend
  • liquidating dividends
  • dividend yield
  • dividend payout ratio
  • Dividend Irrelevance Hypothesis
  • dividend capture
  • dividend arbitrage
  • clientele effect

Short Questions