StudyGuideForMidterm2 FRL3671 Spring2020

FRL3671 Spring 2020 Instructor: Dr.
Ekaterina Chernobai
STUDY GUIDE FOR

MIDTERM #2
Midterm #1: April 16 (Thur)
Review:
- Ch. 17, 18, 19, 21 in the textbook

- Lecture notes covering these chapters (see Blackboard)
- Homework set #3 and solutions (see video solutions on Blackboard)
- To be better prepared to the exam, you can also look at the end-of-chapter
problems. The Solutions Manual for each chapter is on Blackboard.
Bring:
- Scantron (narrow, green, form #882-E)

- Calculator
Will be attached to your exam:
- Formula sheet – see highlighted formulas in this Review Sheet. I will also
provide all formulas given on Midterm #1 (just in case!)
1
FRL3671 Spring 2020 Instructor: Dr. Ekaterina Chernobai
Chapter 17
 Does “Pie” = Total Firm Value? What are marketable & what are nonmarketable claims on
Firm’s assets?
 Risk neutrality and return on equity (see lecture notes example)
 4 theories on why Firms may decide to change their debt-to-equity ratios:

(1) Trade-off Theory
 It is a trade-off between what and what?
 Financial distress costs:
 Direct costs – examples?
 Indirect costs – examples?
 Agency costs:
- Stockholders have incentive to take large risks (see numerical example)
- Stockholders have incentive toward underinvestment (see numerical example)
- Stockholders have incentive to “milk” the property
 What does this theory suggest about Firm’s optimal debt amount?
(2) Signaling Theory
 What signal does Firm’s announcement regarding a change in debt send to investors?
 Based on this theory, why do Firms issue debt?
(3) Pecking Order Theory
 Based on this theory, why do Firms issue debt?
(4) Personal Taxes Theory
 Personal taxes (TS and TB) and their effects on Firm’s optimal capital structure (see
numerical example)
VPIE = VM + VN
VPIE = S + B + G + L
2
Chapter 18:
 3 approaches to levered capital budgeting:

(1) Adjusted Net Present Value approach (APV)
 Cash flows: unlevered
 Discount rate: unlevered
 Other: for the initial investment use total initial investment. Need to add net
present value of financing side effects (NPVF), such as present value of tax
savings (tax shield), etc.
(2) Flow-to-Equity approach (FTE)
 Cash flows: levered
 Discount rate: levered
 Other: for the initial investment use only the amount invested by stockholders
(3) Weighted Average Cost of Capital approach (WACC)
 Cash flows: unlevered
 Discount rate: RWACC
 Other: for the initial investment use total initial investment
 Equity beta and leverage (with or without corporate taxes, with riskless or risky debt)
 Calculation of equity rate of return using C.A.P.M formula
APV = NPV + NPVF

T
cash flow to stockholders
NPV =−Initial Investment by stockholders+ ∑
t=1 (1+R S )t
T
UCF t
NPV =−Initial Investment + ∑
t=1 (1+RWACC )t
B
β EQUITY =β UNLEVERED (1+(1−T C ) )
SL
B B
β EQUITY =β UNLEVERED (1+(1−T C ) )−β DEBT (1−T C )
SL SL
REquity = Rf + βEquity x (E[RMarket] – Rf)
3
Chapter 19: Dividend Policy
 2 types of dividends
o Cash dividend (examples?)
o Stock dividend (examples?)
 Dividend payment related terminology: declaration date, date of record, ex-dividend date,
date of payment
 How does stock price change before / on / after the ex-dividend date?
 Dividend policy: does it matter whether Firm pays higher (lower) dividend today and lower
(higher) dividend in the future?
o “Homemade dividend” argument (see numerical example) explains why it doesn’t matter
 What a Firm can do with excess cash: stock repurchase vs. cash dividend
o Comparison of balance sheet changes (see numerical example)
o Comparison of total Firm value after stock repurchase & dividend payout (see
numerical example)
o Comparison of stock prices after stock repurchase & dividend payout (see numerical
example)
o Why do many firms prefer repurchases over paying dividends?
o Why, with personal taxes, should individuals also prefer stock repurchase over dividends?
(see numerical example)
 “Clientele effect”: High (low) tax bracket investors prefer lower (higher) dividends
 How Firms smooth dividends (Lintner’s model)
o Idea: in real world, a jump in firm’s earnings will not result in an immediate equal jump
in dividends
o How to calculate new dividend amount every year in the future using the “Lintner’s
model” formula (see numerical example)
o 2 special cases: full adjustment in dividends in current year, no change in dividends in
current year
Δ Div = s x (t x EPSthis year – Divlast year)

t = Div / EPS
4
Chapter 21: Leasing
 Definition of “lease”
 Buying vs leasing an asset: who buys it? Who owns it? Who uses it?
 2 types of leases (to practitioners)
(1) Operating leases
(2) Financial leases
 Special case: Sale-and-leaseback
 Special case: Leveraged leases
 2 types of leases (to accountants)
(1) Operating leases
(2) Capital leases
 4 criteria
 Calculations of NPV of leasing-instead-of-buying
o Incremental cash flows = cash flow from leasing – cash flow from buying
 What are the components of the cash flows from leasing in years 0, 1, …?
 What are the components of the cash flows from buying in years 0, 1, …?
o What is the correct discount rate?
 What does NPV of leasing-instead-of-buying “> 0” or “< 0” mean?
 Calculation of NPV to Lessor (It equals NPV to Lessee, EXCEPT with opposite sign, AND
THE SAME $$$ AS TO LESSEE ONLY IF the tax rates are the same to Lessor and Lessee)
 If Lessee’s and Lessor’s tax rates are the same -------------- Calculation of “break-even
before-tax annual lease payment” (i.e., at which NPVLessee=0 and NPVLessor=0)
 If Lessee’s and Lessor’s tax rates are NOT the same ------ Calculation of “break-even
before-tax annual lease payment” to Lessee, and calculation of “break-even before-tax annual
lease payment” to Lessor
o Calculating the lease payment range that would be acceptable to both Lessee & Lessor
(i.e., NPVLessee>0 and NPVLessor>0)
 What are 3 main reasons for leasing?
(1) Eliminates uncertainty regarding asset’s “residual value” at the end of lease term
(2) If reduction in “transaction costs” outweighs increase in “agency costs”
(3) Tax reduction, since entire lease payment is tax-deductible
 Bonus Homework & solutions – see Blackboard. Please review the solutions!!!
Year 0: +Price
Years 1~N: –(Lease (1 – TLessee) + Depr TLessee)
R = RDebt (1 – TLessee)
NPVLessee = Price – (Lease (1–TLessee) + Depr. TLessee) AN R Debt (1–T Lessee)
Lmax = [Price – Depr. TLessee AN RDebt (1–T Lessee)] / [(1–TLessee) AN R Debt (1–T Lessee)]
Year 0: –Price
Years 1~N: Lease (1 – TLessor) + Depr TLessor
R = RDebt (1 – TLessor)
NPVLessor = –Price + (Lease (1–TLessor) + Depr. TLessor) AN R Debt (1–T Lessor)
Lmin = [Price – Depr. TLessor AN RDebt (1–T Lessor)] / [(1–TLessor) AN R Debt (1–T Lessor)]

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FRL3671 Spring 2020 Instructor: Dr.

STUDY GUIDE FOR

- Ch. 17, 18, 19, 21 in the textbook

- Scantron (narrow, green, form #882-E)

Will be attached to your exam:

 4 theories on why Firms may decide to change their debt-to-equity ratios:

 3 approaches to levered capital budgeting:

APV = NPV + NPVF

Chapter 19: Dividend Policy

Δ Div = s x (t x EPSthis year – Divlast year)

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