Chapter 11
Return & Risk
The Capital Asset Pricing Model (CAPM)
Page 1 of 56
Q1: What are the characteristics of individual securities?
1. Expected Return.
The return that an individual expects a stock to earn over the next period. Thee
expected return is simply the average historical return.
∑𝑅
𝑅̅ =
𝑛
2. Variance and Standard Deviation.
To assess the volatility of a security’s return.
∑(𝑅 − 𝑅̅ )2
2
𝑉𝐴𝑅 𝜎 =
𝑛
𝑆𝑡𝑑 𝜎 = √𝑉𝐴𝑅
3. Covariance and Correlation.
To measure the interrelationship between two securities. These two measures are
building blocks to an understanding of the beta coefficient.
∑[(𝑅𝑥 − ̅𝑅̅̅𝑥̅) × (𝑅𝑦 − ̅̅̅̅
𝑅𝑦 )]
𝐶𝑂𝑉𝑥,𝑦 𝜎𝑥,𝑦 =
𝑛
𝐶𝑂𝑅𝑅𝑥,𝑦 𝜌 =
𝐶𝑂𝑉𝑥,𝑦
𝑆𝑡𝑑𝑥 × 𝑆𝑡𝑑𝑦
Q2: How to calculate the variance and standard deviation of a portfolio
of two stocks?
̅̅̅𝑥̅ ̅̅̅̅
𝜎𝑝2 = ̅𝑅̅̅𝑥̅𝜎𝑥2 + 2𝑅
𝑅𝑦 𝜎𝑥,𝑦 + ̅̅̅̅
𝑅𝑦 𝜎𝑦2
𝑆𝑇𝐷𝑝 = √𝜎𝑝2
NOTE (1):
as long as the correlation (𝜌 < 1), the standard deviation of a portfolio of
two securities is less than the weighted average of the standard deviation of
the individual securities.
Page 2 of 56
Q3: Differentiate between systematic and unsystematic risks.
•
A systematic risk: is any risk that affects a large number of assets, each to a greater
or lesser degree. This risk represents the uncertainty about general economic
conditions.
Examples of systematic risk: GNP, GDP, inflation rate, interest rates.
•
Unsystematic risk: is the risk that specifically affect a single asst or a small group
of assets.
Example of unsystematic risk: any announcement of a small oil strike will impact
the oil companies only. Sometimes called idiosyncratic risk.
NOTE (2):
Diversification minimize the unsystematic risk only. The total risk is the
systematic risk plus the unsystematic risk. The standard deviation of returns
is a measure of total risk.
Q4: Define homogenous expectation.
This term refers to the assumption where all investors have the access to the similar sources
of information. In other words, all investors possess the same estimates of expected returns,
variances, and covariances.
Q5: What is Beta? And how its calculated?
Beta measures the responsiveness of a security to movements in the market portfolio.
𝛽=
𝜎𝑥,𝑀
2
𝜎 (𝑅𝑀 )
Q6: What is the Capital Assets Pricing Model (CAPM)?
The CAPM implies that the expected return on a security is linearly and positively related
to its beta. The CAPM use the Security Market Line to express this relationship.
̅̅̅̅
𝑅̅ = 𝑅𝐹 + [𝛽 × (𝑅
𝑀 − 𝑅𝐹 )]
NOTE (3):
if Beta is 0, the return will be the risk-free rate. If Beta is 1, the return will
be the market rate of return.
Page 3 of 56
Q7: Differentiate between the Capital Market Line (CML) and Security
Market Line (SML).
Comparison
Full Form
Definition
Uses
Portfolios
Functioning
Agenda
CML
Capital Market Line
Determines the average return in
the market share
Standard deviation of the portfolio
Defines functioning portfolios
SML
Security Market Line
Determines the market risk of the
investments
Beta
Defines both functioning and nonfunctioning portfolios
More efficient
Less Efficient
Describe only market portfolios Describe overall security factors
and risk-free investment
Page 4 of 56
Chapter 11 Problems
Page 5 of 56
Page 6 of 56
Page 7 of 56
Page 8 of 56
Page 9 of 56
Chapter 13
Risk, Cost of Capital, and Valuation
Page 10 of 56
Q1: What does the firm do if it has extra cash? How about the investors?
Whenever the firm has extra cash, it can either pay cash dividends to investors on invest it
in a project. Investors might invest the cash they would receive in other financial assets
such as stocks or bonds. If the project the firm intend to invest in has the same level of risk,
investors will always prefer the option with the highest expected returns.
Q2: What are the components of the cost of capital?
The cost of capital, also called discount rate and required rate of return, refers to the cost
of issuing new stock and the cost of acquiring new debts. The sum of these two refers to
the total return to new shareholders and debtholders. From firm perspective, the sum
represents the amount of cash it has to pay to the new shareholders and debtholders.
Q3: How to estimate the cost of equity?
The cost of equity (𝑅𝑆 ) can be determined using two methods, the Capital Asset Pricing
Model (CAPM) and the Dividend Discount Model (DDM).
Using the CAPM:
̅̅̅̅
𝑅𝑆 = 𝑅𝐹 + [𝛽 × (𝑅
𝑀 − 𝑅𝐹 )]
Using the DDM:
𝑅𝑆 =
𝐷𝑖𝑣
+𝑔
𝑃
Q4: What are the determinants of Beta?
1. The cyclical nature of revenues: depending on the business cycle. High cyclical
stock has higher beta. Example, retailers and automotive firms fluctuate with
business cycle, while transportation firms and utilities are less dependent on
business cycle.
2. Operating leverage: the sensitivity to the firm’s fixed costs of production. Firms
with high fixed costs and low variable costs are said to have high operating leverage
3. Financial leverage: the sensitivity to the firm’s fixed costs of financing. It always
increases the equity beta relative to the asset beta.
NOTE (1):
we can say that the determinant of beat are business risk (cyclicity of
revenues and operating leverage) and financial risk (financial leverage).
Page 11 of 56
Q5: How to determine the beta of an asset (portfolio)?
Asset beta with equity and debt:
𝛽𝐴𝑠𝑠𝑒𝑡 = [(
𝑆
𝐵
) × 𝛽𝐸𝑞𝑢𝑖𝑡𝑦 ] + [(
) × 𝛽𝐷𝑒𝑏𝑡 ]
𝐵+𝑆
𝐵+𝑆
Asset beta with 0 beta of debt
𝛽𝐴𝑠𝑠𝑒𝑡 = [(
𝑆
) × 𝛽𝐸𝑞𝑢𝑖𝑡𝑦 ]
𝐵+𝑆
The equity beta then will be
𝐵
𝛽𝐸𝑞𝑢𝑖𝑡𝑦 = 𝛽𝐴𝑠𝑠𝑒𝑡 (1 + )
𝑆
NOTE (2):
because ]S/(B+S)[ must be below 1 for a levered firm, the equity beta will
always be greater than the asset beta with financial leverage. In other words,
the equity beta of a levered firm will always be greater than the equity beta
of an otherwise identical all-equity firm.
Q6: How to determine the dividends growth rate?
There are three major ways to determine the dividends growth rate:
1. Historical growth rate in dividends.
2. Sustainable growth rate.
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 × 𝑅𝑂𝐸
3. Using analysts’ reports and estimates.
NOTE (3):
both DDM and CAPM are internally consistent models, but academics
favored CAPM over DDM. A recent study reported that slightly fewer than
three/fourths of companies use the CAPM to estimate the cost of equity
capital, while slightly one-sixth of companies use the DDM.
Page 12 of 56
Q7: What are the major advantages of CAPM?
The CAPM has two primary advantages:
1. It explicitly adjusts for risk.
2. It is applicable for companies that do not pay dividends and those whose dividends
growth rates are difficult to estimate.
Q8: What is the advantage and disadvantage of DDM?
The primary advantage of DDM is that it is simple to calculate. The first disadvantage of
DDM is that it is not applicable for firms that do not pay dividends, those who pay fixed
and steady dividends, and those whose dividends growth rates are difficult to estimate.
Another disadvantage of DDM is that it does not explicitly adjust for risk.
Q7: How to estimate the discount rate for a project whose risk differs
from that of the firm?
Each project should be discounted at a rate commensurate with its own risk.
Q8: How to calculate the cost of debts?
It is the interest rate required on new debt issuance such as yield to maturity on debt
outstanding.
𝑅𝐵 = (1 − 𝑡) × 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑅𝑎𝑡𝑒
Q9: What is the feature of preferred stocks? And how the cost of
preferred stock is calculated
The preferred stock is similar to bonds than to common stock. Preferred stock pays a
constant dividend in perpetuity.
𝑅𝑃 =
𝐶
𝑃𝑉
Q10: Why cost of preferred stock does not adjust for tax?
Because dividends on preferred stocks are not tax deductible.
Page 13 of 56
Q11: How to calculate the weighed average cost of capital?
𝑅𝑊𝐴𝐶𝐶 = [
𝑆
𝑃
𝐵
× 𝑅𝑆 ] + [
× 𝑅𝑃 ] + [
× 𝑅𝐵 × (1 + 𝑡)]
𝐵+𝑆+𝑃
𝐵+𝑆+𝑃
𝐵+𝑆+𝑃
Q12: How can we use the WACC in estimating project’s value?
𝑃𝑉0 =
𝐶𝐹1
𝐶𝐹2
𝐶𝐹3
𝐶𝐹𝑇
+
+
+⋯+
2
3
1 + 𝑅𝑊𝐴𝐶𝐶 (1 + 𝑅𝑊𝐴𝐶𝐶 )
(1 + 𝑅𝑊𝐴𝐶𝐶 )
(1 + 𝑅𝑊𝐴𝐶𝐶 )𝑇
Q13: How can we use the WACC in estimating firm’s value?
𝑃𝑉0 =
𝐶𝐹1
𝐶𝐹2
𝐶𝐹3
𝐶𝐹𝑇 + 𝑇𝑉𝑇
+
+
+
⋯
+
1 + 𝑅𝑊𝐴𝐶𝐶 (1 + 𝑅𝑊𝐴𝐶𝐶 )2 (1 + 𝑅𝑊𝐴𝐶𝐶 )3
(1 + 𝑅𝑊𝐴𝐶𝐶 )𝑇
The Terminal Value can be calculated as follows:
𝑇𝑉𝑇 =
𝐶𝐹𝑇 (1 + 𝑔𝐶𝐹 )
𝑅𝑊𝐴𝐶𝐶 − 𝑔𝐶𝐹
Q14: How to determine the Cash Flow (CF) for a project/firm?
Sign
=
+
=
Component
Earnings Before Interest and Taxes (EBIT)
Taxes
Net Profits After Tax (NOPAT)
Depreciation
Capital Spending
Increases in The Net Working Capital
Net Cash Flows
Q15: What are floatation costs?
The floatation costs are incurred when projects are funded by stocks and bonds, and they
are the issue costs.
NOTE (4):
the required return on an investment depends on the risk of the investment,
not the source of the funds.
Page 14 of 56
Q16: How to calculate the dollar amount of floatation costs?
To calculate the cash flow after floatation costs:
𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑎𝑖𝑠𝑒𝑑
1 − 𝑓%
To calculate the dollar amount of floatation costs:
𝑓=
𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑎𝑖𝑠𝑒𝑑
− 𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑎𝑖𝑠𝑒𝑑
1 − 𝑓%
Q17: How to calculate the weighted average floatation costs (%)?
𝑓0 = [𝑓𝑠 ×
𝑆
𝐵
] + [𝑓𝐵 ×
]
𝐵+𝑆
𝐵+𝑆
Page 15 of 56
Chapter 13 Problems
Page 16 of 56
Page 17 of 56
Page 18 of 56
Page 19 of 56
Page 20 of 56
Chapter 14
Efficient Capital Markets and Behavioral
Challenges
Page 21 of 56
Q1: How can firms create value through capital budgeting?
1.
2.
3.
4.
Locate an unsatisfied demand for a particular product or service.
Create a barrier to make it more difficult for other firms to compete.
Produce products or services at a lower cost than the competition.
Be the first to develop a new product.
Q2: What are the three ways of creating valuable financing
opportunities?
1. Fool investors
2. Reduce costs or increase subsidies
3. Create a new security
Q3: Define the efficient market hypothesis (EMH).
The efficient capital market refers to the market where stock prices fully reflect the
available information about the underlying value of the stock.
NOTE (1):
The efficient market hypothesis has implications for investors and for firms.
Because information is reflected in prices immediately, investors should
only expect to obtain a normal rate of return. Awareness of information
when it released does an investor no good. The price adjusts before the
investor has time to trade on it.
NOTE (2):
valuable financing opportunities that arise from fooling investors are
unavailable in efficient capital market, because firms should only expect
fair value for securities that they sell.
Q4: What are the conditions that cause market efficiency?
1. Rationality: all investors are rational and when new information is released in the
marketplace, all will adjust their estimates of stock prices in a rational way.
2. Independent deviations from rationality: equal countervailing irrationalities
which will offset each other.
3. Arbitrage: if arbitrage professionals dominates the speculation of amateurs,
markets would still be efficient.
Page 22 of 56
Q5: What are the different types of efficiency?
1. Weak Form:
When capital market fully reflects and incorporates the information in past stock
prices. It can be represented in a mathematical way:
𝑃𝑡 = 𝑃𝑡−1 + 𝑅̅𝑡 + 𝜀𝑡
In other words, in the weak form, the price today is the price yesterday, last week,
or last month, plus the expected return. If stock prices follow the above equation, it
is said that it follows random walk. In this form, the technical analysis is useless.
2. Semi-strong Form:
When the prices reflect and incorporate all publicly available information, such as
published financial statements, historical price information. In this form, most
financial analysis is useless.
3. Strong Form:
When the prices reflect all information, public or private. In this form, nobody
makes superior profits.
Q6: Compare the three forms of market efficiency.
Weak
Semi-strong
Page 23 of 56
Strong
Q7: What are the common misconceptions about the EMH?
1. The efficacy of dart throwing.
2. Price fluctuations.
3. Stockholder disinterest.
Q8: What are the behavioral challenges to market efficiency?
1. Rationality:
- people are not always rational.
- Many investors fail to diversify, trade too much, and seem to try to maximize
taxes by selling winners and holding losers.
2. Independent deviations from rationality
- Representativeness: drawing conclusions from too little data, which can lead to
bubbles in security prices.
- Conservatism: people are too slow in adjusting their beliefs to new information.
Therefore, security prices seem to respond too slowly to earnings surprises.
3. Arbitrage.
Q8: What are the empirical challenges to market efficiency?
1. Limits to arbitrage: risk considerations may force arbitragers to take positions
which are too small to move price back to parity.
2. Earnings surprises: stock prices adjust slowly to earning announcements.
3. Size: small stocks outperform large stocks.
4. Value vs. growth: value stocks outperform growth stocks.
5. Crashes and bubbles.
Q9: What are the implications of efficiency in corporate finance?
1. Accounting choices, financial choices, and market efficiency: managers cannot
fool the market through creative accounting.
2. The timing decision: firms cannot successfully time issues of debt and equity.
3. Speculation and efficient markets: managers cannot profitably speculate in
foreign currencies and other instruments.
4. Information in market prices: managers can reap many benefits by paying
attention to market prices.
Page 24 of 56
Chapter 14 Problems
Page 25 of 56
Page 26 of 56
Page 27 of 56
Page 28 of 56
Page 29 of 56
Page 30 of 56
Page 31 of 56
Chapter 16
Capital Structure: Basic Concepts
Page 32 of 56
Q1: Define the pie model?
The pie model is the capital structure approach where firms should choose their debt-equity
ratio.
NOTE (1):
Managers should choose the capital structure that they believe will have the
highest firm value because this capital structure will be most beneficial to
the firm’s stockholders, which is the optimal capital structure. The optimal
capital structure is the mix of debt and equity at which the firm value is
maximized.
Q2: What is MM1and MM2?
MM1 is a theory that have a convincing argument made by Modigliani and Miller. It states
that firms’ capital structures do not impact its value. Since the value of a company is
calculated as the present value of future cash flows, the capital structure cannot affect it. In
this proposition, MM stated that the cost of capital is the same of firms regardless of the
capital structure.
𝑉𝐿 = 𝑉𝑈
In MM2, Modigliani and Miller posit a positive relationship between the expected return
on equity and leverage. This result occurs because the risk of equity increases with
leverage. In this proposition, the cost of equity capital 𝑅𝑆 is positively related to the firm’s
debt-to-equity ratio. The firm’s weighted average cost of capital 𝑅𝑊𝐴𝐶𝐶 is invariant to the
firm’s debt-to-equity ratio.
𝑅𝑆 = 𝑅0 +
𝐵
(𝑅 − 𝑅𝐵 )
𝑆 0
NOTE (2):
MM Proposition I (no taxes): The value of the levered firm is the same as
the value of the unlevered firm. Modigliani and Miller showed a blindingly
simple result: If levered firms are priced too high, rational investors will
simply borrow on their personal accounts to buy shares in unlevered firms.
This substitution is often called homemade leverage.
NOTE (3):
MM1 is about the firm value. MM2 is about the cost of equity. In MM2,
𝑅𝑊𝐴𝐶𝐶 must always equal to 𝑅𝑆 in a world without corporate taxes.
Page 33 of 56
Q3: What are the assumptions and intuitions of Modigliani and Miller
propositions without taxes?
Assumptions
•
•
•
No taxes.
No transaction costs.
Individuals and corporations borrow at same rate.
Intuitions
•
•
Proposition I: Through homemade leverage individuals can either duplicate or
undo the effects of corporate leverage.
Proposition II: The cost of equity rises with leverage because the risk to equity
rises with leverage.
Q4: What are the unrealistic assumptions of MM?
1. Taxes are ignored.
2. Bankruptcy costs and other agency costs were not considered.
Q5: How to calculate the present value of the tax shield?
𝑡𝐶 𝑅𝐵 𝐵
𝑅𝐵
Q6: How to calculate the present value of an unlevered and levered firm
under the MM1 (corporate Taxes)?
𝑉𝑈 =
𝐸𝐵𝐼𝑇 × (1 − 𝑡𝐶 )
𝑅0
𝑉𝐿 = 𝑉𝑈 + 𝑡𝐶 𝐵
Q7: How to calculate the return on equity under the MM2 (corporate
Taxes)
𝑅𝑆 = 𝑅0 +
𝐵
× (1 − 𝑡𝐶 ) × (𝑅0 − 𝑅𝐵 )
𝑆
Page 34 of 56
Q8: What are the assumptions and intuitions of Modigliani and Miller
propositions with corporate taxes?
Assumptions
•
•
•
Corporations are taxed at the rate 𝑡𝐶 , on earnings after interest.
No transaction costs.
Individuals and corporations borrow at same rate.
Intuitions
•
•
Proposition I: Because corporations can deduct interest payments but not dividend
payments, corporate leverage lowers tax payments.
Proposition II: The cost of equity rises with leverage because the risk to equity rises
with leverage.
Page 35 of 56
Chapter 16 Problems
Page 36 of 56
Page 37 of 56
Page 38 of 56
Page 39 of 56
Page 40 of 56
Page 41 of 56
Chapter 19
Dividends and Other Payouts
Page 42 of 56
Q1: Differentiate between dividends and distributions.
Dividends refer to cash distributed from the retained earnings. Distribution refers to cash
distributed to shareholders from sources other than earnings, such as capital, which is also
called liquidating dividends. When public companies pay dividends, they usually pay
regular cash dividends four times a year. Sometimes firms will pay a regular cash dividend
and an extra cash dividend. Paying a cash dividend reduces corporate cash and retained
earnings—except in the case of a liquidating dividend (where paid-in capital may be
reduced).
Q2: What are the types of dividends?
1. Cash dividends
2. Stock dividends.
Q3: Define stock splits and stock repurchases.
Stock split is when a company increases the number of shares outstanding by splitting its
shares at a particular split ratio. As of stock repurchase, the company uses cash to buyback
shares of its stock and hold them as treasury stock.
Q4: Who decide whether to pay dividends or not?
The decision to pay a dividend rests in the hands of the board of directors of the corporation.
Q5: what are the three dividend expressions?
1. Dividends per share
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒𝑠
2. Dividend yield
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
3. Dividend payout
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Page 43 of 56
Q6: What is the dividend payment mechanism?
1. Declaration Date
The board o directors declares a payment of dividends.
2. Record Date
The declared dividends are distributable to shareholders of record on a specific date.
The corporation prepares a list on January 30 of all individuals believed to be
stockholders as of this date. The word believed is important here: The dividend will
not be paid to individuals whose notification of purchase is received by the
company after January 30.
3. Ex-dividend Date
A share of stock becomes ex dividend on the date the seller is entitled to keep the
dividend; under NYSE rules, shares are traded ex dividend on and after the second
business day before the record date. all brokerage firms entitle stockholders to
receive the dividend if they purchased the stock three business days before the date
of record. Obviously, the ex-dividend date is important because an individual
purchasing the security before the ex-dividend date will receive the current
dividend, whereas another individual purchasing the security on or after this date
will not receive the dividend. The stock price will therefore fall on the ex-dividend
date. It is worthwhile to note that this drop is an indication of efficiency, not
inefficiency, because the market rationally attaches value to a cash dividend. In a
world with neither taxes nor transaction costs, the stock price would be expected to
fall by the amount of the dividend
4. Payment Date
The dividend checks are mailed to shareholders of record.
Q7: Define homemade dividends
It refers to the investment income that investors receive from selling a portion of their
portfolio.
Q8: What is Modigliani and Miller dividend irrelevance proposition?
The investment policy of the firm is set ahead of time and is not altered by changes in
dividend policy. Firms should never give up a positive NPV project to increase a dividend
(or to pay a dividend for the first time).
Page 44 of 56
Q9: What are the three different ways a company can repurchase its own
stocks?
1. Open market purchases
Companies may simply purchase their own stock. The firm does not reveal itself as
the buyer. Thus, the seller does not know whether the shares were sold back to the
firm or to just another investor.
2. Tender offer
The firm announces to all of its stockholders that it is willing to buy a fixed number
of shares at a specific price. It is similar to the Dutch Auction where the firm
conducts an auction in which it bids for shares and does not set a fixed price for the
shares to be sold. The firm announces the number of shares it is willing to buy back
at various prices, and shareholders indicate how many shares they are willing to
sell at the various prices. The firm will then pay the lowest price that will achieve
its goal.
3. Targeted purchase
Firms may repurchase shares from specific individual stockholders. Companies
engage in targeted repurchases for a variety of reasons. In some rare cases, a single
large stockholder can be bought out at a price lower than that in a tender offer. The
legal fees in a targeted repurchase may also be lower than those in a more typical
buyback. In addition, the shares of large stockholders are often repurchased to avoid
a takeover unfavorable to management.
NOTE (1):
Stock repurchases are not always a substitute for paying dividends but rather
a complement to it.
Page 45 of 56
Q10: Why do some firms choose repurchases over dividends?
1. Flexibility
Firms often view dividends as a commitment to their stockholders and are quite
hesitant to reduce an existing dividend. Repurchases do not represent a similar
commitment. Thus, a firm with a permanent increase in cash flow is likely to
increase its dividend. Conversely, a firm whose cash flow increase is only
temporary is likely to repurchase shares of stock.
2. Executive Compensation
Existing stock options will always have greater value when the firm repurchases
shares instead of paying a dividend because the stock price will be greater after a
repurchase than after a dividend.
3. Offset to Dilution
the exercise of stock options increases the number of shares outstanding. In other
words, exercise causes dilution of the stock. Firms frequently buy back shares of
stock to offset this dilution.
4. Undervaluation
Many companies buy back stock because they believe that a repurchase is their best
investment. This occurs more frequently when managers believe that the stock price
is temporarily depressed. some empirical work has shown that the long-term stock
price performance of securities after a buyback is better than the stock price
performance of comparable companies that do not repurchase.
5. Taxes
The repurchases provide a tax advantage over dividends.
NOTE (2):
In a world without taxes and other frictions, the timing of dividend payout
does not matter if distributable cash flows do not change.
NOTE (3):
Financial economists generally agree that in a world of personal taxes, firms
should not issue stock to pay dividends.
Q11: Define wash case.
It takes place when a transaction has no economic effect.
Page 46 of 56
Q12: What are the alternatives of dividends when firms have excess cash?
1.
2.
3.
4.
Select additional capital budgeting projects
Acquire other companies
Purchase financial assets
Repurchase shares
NOTE (4):
Because of personal taxes, firms have an incentive to reduce dividends. they
might increase capital expenditures, acquire other companies, or purchase
financial assets. However, due to financial considerations and legal
constraints, rational firms with large cash flows will likely exhaust these
activities with plenty of cash left over for dividends.
Q13: Despite the advantages of repurchasing shares, why firms pay its
shareholders high dividends even in the presence of personal taxes on
these dividends?
Desire for current income, Behavioral finance, Agency costs, and Information content of
dividends and dividend signaling
Q14: What is the information content effect?
It is the rise in the stock price following the dividend signal.
Q15: What is dividend signaling?
This theory implies that company announcements of dividend increases indicate positive
future cash flows. When a firm makes a commitment to pay a cash dividend now and into
the future, it sends a two-part signal to the markets. one signal is that the firm anticipates
being profitable, with the ability to make the payments on an ongoing basis. Second, the
firm signals that it won’t be hoarding cash (or at least not as much cash), thereby reducing
agency costs and enhancing shareholder wealth.
Q16: What is the Clientele Effect?
it states that different policies attract different types of investors, and changes to the policies
will cause a shift in demand for the company’s stock by investors, impacting its share price.
In other words, it states that investors are attracted to investing in companies with specific
policies.
Page 47 of 56
Q17: In a world where many investors like high dividends, a firm can
boost its share price by increasing its dividend payout ratio.” True or
false?
The statement is likely to be false. As long as there are already enough high-dividend firms
to satisfy dividend-loving investors, a firm will not be able to boost its share price by paying
high dividends. A firm can boost its stock price only if an unsatisfied clientele exists. In
fact, tax brackets vary across investors. If shareholders care about taxes, stocks should
attract clienteles based on dividend yield.
NOTE (5):
Dividends are tax disadvantaged relative to capital gains because dividends
are taxed upon payment whereas taxes on capital gains are deferred until
sale.
Q18: What is dividend smoothing?
This theory implies that firms adjust their dividends gradually in response to changes in
earnings.
Q19: What are the pros and cons of paying dividends?
Pros
May appeal to investors who desire stable
cash flow but do not want to incur the
transaction costs from periodically selling
shares of stock.
Behavioral finance argues that investors
with limited self-control can meet current
consumption needs with high-dividend
stocks while adhering to the policy of
never dipping into principal.
Managers,
acting
on
behalf
of
stockholders, can pay dividends in order to
keep cash from bondholders.
The board of directors, acting on behalf of
stockholders, can use dividends to reduce
the cash available to spendthrift managers.
Managers may increase dividends to signal
their optimism concerning future cash
flow.
Cons
Dividends have been traditionally taxed as
ordinary income.
Dividends can reduce internal sources of
financing. Dividends may force the firm to
forgo positive NPV projects or to rely on
costly external equity financing.
Once established, dividend cuts are hard to
make without adversely affecting a firm’s
stock price.
Page 48 of 56
Q20: What are the drawbacks of a fixed repurchase strategy?
1. Verifiability
Repurchasing shares needs monitoring and have expenses associated to them.
2. It forces management into making negative NPV investments.
Q21: Define stock dividend. What are the impacts of a stock dividend?
It is a method where dividends are paid in the form of stocks to shareholders. It is not a
true dividend because it is not paid in cash. It is commonly expressed as a percentage. The
impacts of stock dividend are:
1. Increase in the number of shares outstanding.
2. Decrease in the worth of shares.
Stock dividends of 20 to 25% are called small stock dividends. Any larger stock dividend
is called large stock dividend.
To estimate the number of shares each shareholder will receive after stock dividend:
1
𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 %
Therefore, the shareholder will receive 1 share for each # of shares resulted in the above
equation.
Q22: Define stock split and reverse stock splits. Compare the impacts.
Stock split is when a company declares a split in its shares to create additional shares. the
split majorly expressed as a ratio. Firms do stock splits to increase the company’s investors
base and to enhance the marketability and liquidity of the share. the disadvantages of the
stock splits are the volatility in prices, risk of price fall, complexity, and costs.
Reverse stock split is the opposite of the conventional stock splits. Firms do reverse stock
splits to reduce shareholders transaction costs and bring back stock to minimum price
requirements. The disadvantages are value fall, reduced liquidity, and minority rights.
Market capitalization
Demand for the stock
Share price
Number of shares
Earnings per share
Dividends per share
Stock Splits
Constant
Increase
Decrease
Increase
Decrease
Decrease
Page 49 of 56
Reverse Stock Splits
Constant
Decrease
Increase
Decrease
Increase
Increase
Q23: Compare the stock dividend and stock split.
Both have the same impacts where shares outstanding increases and the share worth
decrease. Yet, the accounting treatment is not the same.
NOTE (6):
The dividend policy of a firm is irrelevant in a perfect capital market
because the shareholder can effectively undo the firm’s dividend strategy.
If a shareholder receives a greater dividend than desired, he or she can
reinvest the excess. Conversely, if the shareholder receives a smaller
dividend than desired, he or she can sell off extra shares of stock. This
argument is due to MM and is similar to their homemade leverage concept,
discussed in a previous chapter.
NOTE (7):
Stockholders will be indifferent between dividends and share repurchases
in a perfect capital market.
NOTE (8):
Forms of cash dividends are regular cash dividends, extra dividends, special
dividends, and liquidating dividends. While alternatives of cash dividends
are stock repurchase, stock dividends, and stock splits.
NOTE (9):
The irrelevance of dividends policy states that dividend policy will have no
impact over the value of the firm because investors can create whatever
income stream they prefer by homemade dividends. Therefore, firms should
never forgo positive NPV projects to increase/pay dividends.
NOTE (10): The clientele effect separate investors into different categories in terms of
dividend preferences. Once the clientele effect has been satisfied, a
corporation is unlikely to create value by changing its dividend policy.
Page 50 of 56
Page 51 of 56
Chapter 19 Problems
Page 52 of 56
Page 53 of 56
Page 54 of 56
Page 55 of 56
Page 56 of 56