FIN448-Final-Exam-Fall2020-Review - MC

Advanced Financial Management
Review for
Final Exam
Professor Jian Cai

Help for the Exam
Optional review session

This Sunday, December 20, 1:30 – 2:30 p.m.
Zoom meeting link:
https://wustl.zoom.us/j/91277289103?pwd=aW5INzQyY
nFBVVoyMHFpeUQ2Z0M1QT09
Extra office hours

Next Monday, December 21, 3:00 – 5:00 p.m.
Zoom meeting link:
https://wustl.zoom.us/j/96977389186?pwd=Nk1BYSszK
3RuSTRkK1RFTDQ1TmVUQT09
2 FIN 448 / Jian Cai / Fall 2020

Two Alternative Exam Times
Before the holiday:

Tuesday, December 22, 2020, 12:30 p.m. – 3:30 p.m.
https://wustl.zoom.us/j/97008893230?pwd=TG02WUROQ2x
KZDlZaEd6RTY0d1BNUT09
After the holiday (original exam date):

Monday, January 4, 2021, 3:30 p.m. – 6:30 p.m.
https://wustl.zoom.us/j/92033256940?pwd=QkN3aEZzNWZV
WVRMclZLTk15eEpCUT09
Choose your exam time by midnight on Sunday, December 20.

If no response, take the exam after the holiday on January 4.

When, Where, How?
Final Exam
Tuesday, December 22 or Monday, January 4
Start by clicking “Final Exam” under “Quizzes”
on our course site in Canvas
Open-book and open-notes
Individual effort, collaboration not permitted
Join the Zoom meeting for your chosen exam
time, turn on webcam video during the exam
BEST OF LUCK!

Advice on Online Exam Taking
Study for the exam as it were closed-book, closed-notes
Familiarity with the topics/steps is the key
Maintain a steady speed; don’t spend too much time on any
individual questions
Choose one way to deliver your answers and stick to it

Type answers inside the exam, or write down answers and
upload files/images, not both
Use all available tools if they help; be prepared & organized

Self-prepared notes with formulas and important processes
Excel can facilitate calculations and model building, but don’t
spend too much time perfecting your Excel file; make it self-
contained and easy to understand if submitting Excel

What to Study?
1. Lecture notes for Modules 8 – 14 with

all the solutions to in-class examples
2. Lecture notes for Cases #4 – #6
3. Group Assignments #4 – #6
Practice Problem Sets #6 – #9
Practice Final Exam
A mind with clear and correct timelines, cash

flows, discount rates, and frictions!

What NOT to be Covered?
Topics that are discussed only before the

midterm exam: Focus on the topics in the 2nd
half of the course, but valuation concepts and
methods covered in the 1st half of the course
may still be needed to solve financing problems
Case-specific information: No need to retell the

“stories,” but learn the methods & analyses

Outline
Review for final exam

Financing: From perfect markets to market
frictions, from capital structure to payout policy
List of examples for various topics/applications
Study guide based on key takeaways

Role of Finance Function
Finance function manages flow of cash to/from investors
and investment projects
“Real” Invested
Investment capital
Firm’s Financial Capital

Operations Manager Markets
Operating cash Return to financial

flows asset holders
Valuation Financing

Valuation vs. Financing
Conceptually, just flip the signs:
Valuation: Evaluate an investment project
NPV = – CF0 + PV[CF1 + CF2 + CF3 + …]
Up-front Future free

investment cash flows
Financing: Evaluate a financial policy

NPV = + CF0 – PV[CF1 + CF2 + CF3 + …]
Capital Return to
raising investors
Financing’s key differences from Valuation:
Sources of value relevance less clear
No easy formula for optimal policies

Valuation Roadmap
𝑁𝑁
𝐸𝐸 𝑊𝑊𝐶𝐶𝑡𝑡
Market Value Price = 𝑃𝑃𝑃𝑃 Cash Flows = � 𝑡𝑡
1 + 𝑟𝑟𝑡𝑡
𝑡𝑡=1
Cash Flows Discount Rate

Coupons 𝑟𝑟𝑡𝑡
Bonds Face Value 𝑌𝑌𝑌𝑌𝑌𝑌
Dividends
Stocks or FCFE
𝑟𝑟𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡𝐸𝐸
Free Cash Flow 𝑟𝑟𝐹𝐹𝐸𝐸𝐹𝐹𝐹𝐹

Firms (to the firm) or FCFF 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
Incremental Project 𝑟𝑟𝑃𝑃𝐹𝐹𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡
Projects (Free) Cash Flow 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝐷𝐷𝐸𝐸𝐷𝐷𝐸𝐸𝐷𝐷𝐸𝐸𝑃𝑃𝐷𝐷𝐷𝐷𝐷𝐷

Present Value Formulas
The General PV Formula:
𝑊𝑊𝐶𝐶1 𝑊𝑊𝐶𝐶2 𝑊𝑊𝐶𝐶1
𝑃𝑃𝑃𝑃0 = + 2
+ ⋯+ 𝐷𝐷
+⋯
1 + 𝑟𝑟1 1 + 𝑟𝑟2 1 + 𝑟𝑟𝐷𝐷
Cash Flow Stream PV Formula
𝑊𝑊𝐶𝐶1
Perpetuity Constant cash flows forever 𝑃𝑃𝑃𝑃𝑃𝑃0 =
𝑟𝑟
𝐷𝐷
Constant cash flows for 𝑛𝑛 𝑊𝑊𝐶𝐶1 1
Annuity 𝑃𝑃𝑃𝑃𝑊𝑊0 = 1−
periods of time 𝑟𝑟 1 + 𝑟𝑟
𝐷𝐷
Growing Cash flows for 𝑛𝑛 periods of time 𝑊𝑊𝐶𝐶1 1 + 𝑔𝑔
𝑃𝑃𝑃𝑃𝑊𝑊0 = 1−
Annuity growing at a constant rate 𝑔𝑔 𝑟𝑟 − 𝑔𝑔 1 + 𝑟𝑟
Growing Cash flows growing at a 𝑊𝑊𝐶𝐶1

𝑃𝑃𝑃𝑃𝑃𝑃0 =
Perpetuity constant rate 𝑔𝑔 forever 𝑟𝑟 − 𝑔𝑔

What Have We Learned since Midterm Exam?
Financing
Perfect Information Payout

Markets Asymmetry Policy
Taxes and Agency

Bankruptcy Conflicts

Market Frictions and Financial Policy
Market Varies with which Firm Leverage Debt or Equity Payout Policy
Friction Characteristics: Solutions Structure Solutions
Solutions
Corporate Taxes • Corporate tax rate High debt High payout if τi < τc
• Expected taxable income Low payout to delay
• Non-debt tax-shields repatriation tax
Personal Taxes • Country and time-specific Low debt Repurchases
tax code
Financial • Cash flow uncertainty Low debt ABS debt Low payout
Distress Costs • Nature of assets (e.g., Repurchases
real estate vs. brand)
Asymmetric • Firm reputation Internal funds Short-term debt Low payout to build
Information • Nature of assets (e.g., Debt Private/bank debt internal funds
real estate vs. R&D) Rights offers Private equity Signaling
Manager- • Extent of “free” cash flow High debt Private/bank debt High payout
Shareholder • Corporate governance (e.g., covenants) Dividends
Agency Conflicts • Investor power Private equity
Debtholder- • Value of future growth Low debt Covenants
Equityholder opportunities Convertible debt
Agency Conflicts

Perfect Markets
Module 8
Group Assignment #4
Practice Problem Set #6

What Is the Difference between Debt and Equity?
Debt Equity
Cash Flow Fixed Residual

Rights Contractual
Control Rights “Contingent control” Voting

- Covenants Board representation
- Default

Book vs. Market Value Balance Sheets
Book-value balance sheet (backward looking)
What I bought How I paid for it
Book assets D: Borrowed money
E: Contributed & earned capital
Market-value balance sheet (forward looking)

Cash these assets will generate Who gets it
D: PV(E[CFD])
V = PV(E[FCFF])
E: PV(E[FCFE])
Implies: V = D + E

Perfect Capital Markets
1. Investors and firms can trade the same set of

securities at competitive market prices equal to the
present value of their future cash flows.
2. There are no taxes, transaction costs, or issuance

costs associated with security trading.
3. A firm’s financing decisions do not change the cash

flows generated by its investments, nor do they reveal
new information about them.

The Modigliani-Miller Propositions
In a perfect capital market:
M&M I: Firm value is unaffected by financing choices.

Investment decisions create NPV, financing decisions just split
up the pie.
M&M II: Both equityholders’ risk and expected return

increase with financial leverage
𝐸𝐸 𝐷𝐷
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝑟𝑟𝑈𝑈 (or 𝑟𝑟𝐴𝐴 ) = 𝑟𝑟𝐸𝐸 + 𝑟𝑟𝐷𝐷
𝐸𝐸 + 𝐷𝐷 𝐸𝐸 + 𝐷𝐷
𝐷𝐷
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷
𝐸𝐸
Key Takeaways (I)
The market value of an asset is the present value of the future

free cash flows that asset can generate.
Financing an asset involves promising a portion of those future
cash flows to the capital provider.
Debt and equity contracts differ on two key dimensions: Cash
flow rights and control rights.
In the absence of market frictions (i.e., perfect capital markets):
Firm value is equal to the sum of the market values of all financial
claims on the firm.
Firm value is not affected by the way the assets were financed.
Increasing financial leverage has two offsetting effects on the
firm’s equity: Increases Risk & Increases Expected Return

M&M Applications & Examples
Book and market value balance sheets before and after

financing: Example 8.1 (Bob the Entrepreneur)
Financial policy and shareholder value: Example 8.2 (HP

paying down debt)
Equity issuance and dilution: Example 8.3 (JCPenney

issuing more stock, EPS, and P/E ratio)
Debt issuance, cost of equity, and WACC: Example 8.4

(cheap debt at HMA?)

Key Takeaways (II)
We can’t usually get (or lose) something for nothing:
1. Value comes primarily from a firm’s investments. Financing

transactions simply allocate future cash flows in different ways.
2. If we want to claim that financial policy choices create value, we
must identify the specific market friction(s) that are addressed.
3. Equity issuance should not lead to dilution of value per share as
long as shares are sold for a fair market price.
4. Debt financing leads to higher EPS, but this is (at least partly)
compensation for risk – does not mean debt financing is
necessarily better for shareholders.
5. Simply comparing costs of debt and equity without adjusting for
risk is not a reliable way of making optimal financing choices.

Taxes and Bankruptcy
Modules 9-10, Case #4
Group Assignments #4, #5

The Tax Benefit of Debt Formalized
Capitalizing the tax shield value
Every dollar of interest paid saves the firm τc dollars in taxes, where τc is
the corporate tax rate.
The increase in firm value is equal to the present value of all future
expected tax shields (PVTS).
∞
𝐸𝐸 Tax Shield𝑡𝑡
PVTS = � = 𝜏𝜏𝑃𝑃 𝐷𝐷
1 + 𝑟𝑟𝑇𝑇𝑇𝑇 𝑡𝑡
𝑡𝑡=1
Under what assumptions?

1. Debt is kept at a fixed level
2. “Perpetual debt” (continually rolled over) ⇒ PV = CF/r
3. 𝑟𝑟𝑇𝑇𝑇𝑇 = 𝑟𝑟𝐷𝐷 Why?
Under these assumptions:
𝐸𝐸 Tax Shield 𝜏𝜏𝑃𝑃 ∗ 𝐷𝐷 ∗ 𝑟𝑟𝐷𝐷
PVTS = = = 𝜏𝜏𝑃𝑃 𝐷𝐷
𝑟𝑟𝑇𝑇𝑇𝑇 𝑟𝑟𝐷𝐷

The Tax Benefit of Debt and Firm Value
Revised M&M I
Adjusted present value (APV) approach:
In perfect markets: 𝑃𝑃𝐿𝐿 = 𝑃𝑃𝑈𝑈
With taxes: 𝑃𝑃𝐿𝐿 = 𝑃𝑃𝑈𝑈 + PVTS ≈ 𝑃𝑃𝑈𝑈 + 𝜏𝜏𝑃𝑃 𝐷𝐷
Cost of capital (WACC) approach:
Effective cost of debt = 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑃𝑃
𝐷𝐷 𝐸𝐸
After-tax WACC (𝑟𝑟𝐿𝐿 ) = 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑃𝑃 + 𝑟𝑟𝐸𝐸
𝑉𝑉 𝑉𝑉
(!) Implications for firm value:

Assume D/VL = 30% ⇒ D = 0.30 × VL
and 40% federal + state tax rate
⇒ τc × D = 0.40 × 0.3 × VL = 0.12 × VL
Yet, about 20% of publicly traded firms have no debt!

Discount Rate for Tax Shields with a Target D/V
Ratio (or Target Interest Coverage) Policy
Implications for calculating PVTS

What is the right discount rate?
Future Firm Value
Biggest source of uncertainty is ______________________.
rU
What discount rate reflects this uncertainty? ___________.
rU
Therefore, set rTS = __________ when the firm’s policy is to
maintain a target D/V ratio.
What if firm value is expected to grow over time?
In this case, with a target D/V ratio, the level of debt will grow over
time. We can take this into account by dividing the expected initial
tax shield by (rU – g) when calculating present value of tax shields.
Putting these ideas together, we have
𝐷𝐷 ∗ 𝑟𝑟𝐷𝐷 ∗ 𝜏𝜏𝑃𝑃
PVTS =
𝑟𝑟𝑈𝑈 − 𝑔𝑔

PVTS under Different Debt Policies
Rule of thumb: What discount rate to use for tax shields?

Fixed dollar level of debt:
rTS = rD
Target D/V (or similar) policy:
rTS = rU
(and account for growth)

Example 9.2: PVTS under Different Debt Policies
You have the following information for Olin Mfg:

All-equity firm, rE = 10%, τc = 35%
Considering issuing $100 million in debt, rD = 4%
Calculate PVTS assuming:

They will maintain a fixed level of debt:
PVTS = τc × D = 35% × 100 = $35 million
They will maintain their new D/V going forward, no growth:
PVTS = τc × D × rD / rU = 35% × 100 × 4% / 10% = $14 million
They will maintain their new D/V going forward, 2% growth:
PVTS = τc × D × rD / (rU – g) = 35% × 100 × 4% / (10% – 2%)
= $17.5 million

Examples
rTS and the Cost of Equity Capital 9.2 & 9.3
Intuition:
Tax shields become part of the firm’s (and equityholders’)
cash flows.
If rTS = rU, then adding tax shields does not change the
riskiness of the firm’s overall cash flows.
But, if rTS = rD, then the tax shields are less risky than the
firm’s operating cash flows. This should be reflected in a
lower cost of equity.
Two formulas for rE, depending on your tax-shield discount
rate assumption:
𝐷𝐷
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 Assumes rTS = rU
𝐸𝐸
𝐷𝐷
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑃𝑃 Assumes rTS = rD
𝐸𝐸

Example 9.3: PVTS with target D/E
Two (Equivalent) Approaches (Continued)
Approach 1:
PVTS = VL – VU
𝐷𝐷 𝐸𝐸
Pre-tax WACC = rU = 𝑟𝑟 + 𝑟𝑟
𝐷𝐷+𝐸𝐸 𝐷𝐷 𝐷𝐷+𝐸𝐸 𝐸𝐸
0.5 1
= × 6% + × 10% = 8.67%
0.5+1 0.5+1
𝐷𝐷 𝐸𝐸
After-tax WACC = rL = 𝑟𝑟 1 − 𝜏𝜏𝑐𝑐 + 𝑟𝑟
𝐷𝐷+𝐸𝐸 𝐷𝐷 𝐷𝐷+𝐸𝐸 𝐸𝐸
0.5 1
= × 6% × 1 − 0.35 + × 10% = 7.97%
0.5+1 0.5+1
VL = 4.25 / (7.97% – 4%) = $107 mm

VU = 4.25 / (8.67% – 4%) = $91 mm
PVTS = 107 – 91 = $16 million

Example 9.3: PVTS with target D/E
Two (Equivalent) Approaches (Continued)
Approach 2:
Now use our result:
Note that a D/E ratio of 0.5 implies an initial debt level of

107 × [0.5/(0.5+1)] = $35.6 million
Suppose we did not have information on expected free cash flows,

but only the initial debt level ($35.6 million). Then,
𝐷𝐷 ∗ 𝑟𝑟𝐷𝐷 ∗ 𝜏𝜏𝑐𝑐 35.6 × 6% × 35%
PVTS = = = $16 million
𝑟𝑟𝑈𝑈 − 𝑔𝑔 8.67% − 4%

Examples
PVTS with Personal Taxes 9.1 & 9.4
Define the effective tax advantage of debt as: The % difference in after-
tax cash flows received by investors when the firm pays $1 of EBIT to
investors as dividends/capital gains relative to interest.
After Corporate Tax After Personal Tax
$1 interest 1 1 − 𝜏𝜏𝐸𝐸
$1 dividend/capital gain 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
Difference (annual CF benefit
𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝐸𝐸 − 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
per dollar of interest)
% difference (effective tax 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝐸𝐸 − 1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
advantage) 1 − 𝜏𝜏𝐸𝐸
1 − 𝜏𝜏𝑃𝑃 1 − 𝜏𝜏𝑃𝑃
=1− ≡ 𝜏𝜏 ∗
1 − 𝜏𝜏𝐸𝐸
Ignoring personal taxes: PVTS = 𝐷𝐷 � 𝜏𝜏𝑃𝑃

With personal taxes: PVTS = 𝐷𝐷 � 𝜏𝜏 ∗
Calculating Cost of Capital when τi > τe
𝐷𝐷 𝐸𝐸
No change to the WACC formula: 𝑟𝑟𝐿𝐿 = 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑐𝑐 + 𝑟𝑟𝐸𝐸
𝑉𝑉 𝑉𝑉
Recall, debt investors will increase their required 𝑟𝑟𝐷𝐷 to
compensate themselves for the extra tax burden
Does impact levering/unlevering cost of equity (i.e.,

calculating rU)
Recall, 𝑟𝑟𝑈𝑈 represents what the cost of equity would be if the
firm were all-equity financed
But, if the firm were all-equity financed, they would no longer
have to pay the premium to compensate debt investors for their
high personal tax rate

Calculating Cost of Capital when τi > τe
How to adjust for this:

Define 𝑟𝑟𝐷𝐷∗ as the expected return debt investors would demand
if they faced the same personal tax rate as the equity investors:
𝑟𝑟𝐷𝐷∗ 1 − 𝜏𝜏𝑒𝑒 = 𝑟𝑟𝐷𝐷 1 − 𝜏𝜏𝑖𝑖
1 − 𝜏𝜏𝑖𝑖
𝑟𝑟𝐷𝐷∗ = 𝑟𝑟𝐷𝐷
1 − 𝜏𝜏𝑒𝑒
Use 𝑟𝑟𝐷𝐷∗ to lever/unlever the cost of equity
𝐷𝐷 ∗ 𝐸𝐸
𝑟𝑟𝑈𝑈 = 𝑟𝑟𝐷𝐷 + 𝑟𝑟𝐸𝐸
𝑉𝑉 𝑉𝑉 Constant
𝐷𝐷 D/V
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + 𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷∗
𝐸𝐸

Key Takeaways (III)
Two extreme views of the tax benefit of debt:
Modigliani and Miller: Zero
Standard textbook formula: τcD
The truth is somewhere in the middle.
Factors that limit the value of interest tax shields:

Policies that tie the level of debt to the value of the firm (or cash
flows) make the future tax shields riskier, but also may imply they will
grow over time.
There is a personal tax disadvantage for debt.
The incremental tax benefit of an increase in a firm’s debt is lower:
The more debt a firm already has outstanding
The more volatile is a firm’s earnings
The more non-debt tax shields the firm has access to (for example,
depreciation, investment tax credits, offshore tax havens, etc.)

Applications in the Swedish Match Case (#4)
Book and market value balance sheets before and after the
recapitalization
Impact of additional borrowing on share price, credit rating,

and cost of debt
Estimating debt capacity by industry benchmark, target

credit rating, and cash flow method (worst-case scenario,
with and without dividend)

SM’s Book Value Balance Sheet
Step 1: Announce planned recapitalization
Step 2: Issue debt (assume SEK 4 billion for now)
Step 3: Use proceeds to buy back equity shares
Currently (see Exhibit 2) After Step 1 (announcement)
Assets: 14,898 D: 3,529 Assets: 14,898 D: 3,529
Other Liab: 6,309 Other Liab: 6,309
E: 5,060 E: 5,060
After Step 2 (issue debt) After Step 3 (repurchase equity)
Assets: 18,898 D: 7,529 Assets: 14,898 D: 7,529
Other Liab: 6,309 Other Liab: 6,309
E: 5,060 E: 1,060

SM’s Market Value Balance Sheet
Step 1: Announce planned recapitalization
Step 2: Issue debt (assume SEK 4 billion for now)
Step 3: Use proceeds to buy back equity shares
Currently (see Exhibit 2) After Step 1 (announcement)
Assets (V): D: 3,529 Assets (V): D: 3,529

3,529 + 28,454 = 31,983 + PVTS =
E: 28,454 (P x N) E: 33,103 – 3,529
31,983 31,983 + 1,120 =
= 29,574
33,103
After Step 2 (issue debt) After Step 3 (repurchase equity)
Assets (V): D: 7,529 Assets (V): D: 7,529

33,103 + 4,000 37,103 – 4,000 =
E: 37,103 – 7,529 E: 33,103 – 7,529
(new debt) = 33,103
= 29,574 = 25,574
37,103

Debt Capacity: Cash Flow Perspective
What about Dividends?
2004 Dividends Paid = 558 (1.70 per share)
If we are recapitalizing, what effect does an increase in debt have on the
required total dividend payment?
Impact on share price
P = PVTS / initial shares = D c / 322.1 = D 0.28 / 322.1
Change in shares outstanding
N = # shares repurchased = D / P = D / (Initial P + P)
Total dividend payment (keeping DPS constant)
= 1.70 (322.1 – N)
Note dividends are paid with after-tax dollars, so convert to pre-tax dollars:
(Dividends) / (1 – c)
With a SEK 4 billion recap:
P = 4,000 0.28 / 322.1 = 3.48 P = 88.34 + 3.48 = 91.82
N = 4,000 / 91.82 = 43.56
Total dividend payment = 1.70 (322.1 – 43.56) = 473.5
Pre-tax = 473.5 / (1 – 0.28) = 658

Key Takeaways (IV)
Borrowing can be supported by assets or by cash flow (in the case

of Swedish Match, primarily cash flow)
Effects of recapitalizations:
Don’t affect total book value, just allocation between debt and equity
Increase total market value by PV of tax shields
Equity stock price should increase by approximately PV of tax shields
divided by shares (based on pre-transaction # of shares)
Guidelines for appropriate debt levels can come from:

Target an industry average leverage ratio
Estimate debt level consistent with the desired credit rating
Evaluate ability to meet interest payments, with enough buffer to
accommodate cash flow volatility

Bankruptcy in Imperfect Markets (Real World)
Definitions:
Economic distress: Value of assets is impaired
Financial distress: Firm is unable to meet debt obligations

Economic distress plus high leverage
Cost of financial distress: Difference in firm value between

an all-equity firm in economic distress, and
the same firm in economic distress with high debt

Why is Financial Distress Costly?
Sale of assets for less than “full value”
Most likely buyers may also be distressed, and they know you are
desperate to sell
Strategic costs
Constraints on investment allows competitors to take market share
Direct costs of bankruptcy
Legal and administrative fees (lawyers, court costs, etc.)
Consultants
Indirect costs of bankruptcy
Time and attention of senior management
Loss of key employees
Loss of customer confidence
Unwillingness of suppliers to extend trade credit
Disruption in investment projects
“Fire sales” in liquidation

The Tax-Bankruptcy Tradeoff
M&M I: 𝑃𝑃𝐿𝐿 = 𝑃𝑃𝑈𝑈

M&M with taxes: 𝑃𝑃𝐿𝐿 = 𝑃𝑃𝑈𝑈 + 𝑃𝑃𝑃𝑃𝑌𝑌𝑃𝑃
Tax-bankruptcy tradeoff: 𝑃𝑃𝐿𝐿 = 𝑃𝑃𝑈𝑈 + 𝑃𝑃𝑃𝑃𝑌𝑌𝑃𝑃
−𝑃𝑃𝑃𝑃 𝐸𝐸 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑟𝑟𝐷𝐷𝐷𝐷𝐷𝐷 𝑊𝑊𝐶𝐶𝐷𝐷𝐷𝐷
Requires three elements:

1. How costly is financial distress when it happens (realized
distress costs)?
2. How likely is financial distress (for a given amount of debt)?
3. How should we think about present values?
Valuing Expected Distress Costs
E(Distress Cost) = Realized Cost × Probability of Distress
Realized cost (conditional on financial distress):
Direct + Indirect Cost (10-20% of pre-distress firm value)
Average annualized default probabilities (source: Moody’s, 1970-2011)
Present values: (see derivation next)

Annual (marginal) default probability = p
Realized financial distress cost = c
Discount rate = r f
𝑝𝑝
𝑃𝑃𝑃𝑃 𝐸𝐸 Distress Cost = 𝑐𝑐
𝑝𝑝 + 𝑟𝑟𝑓𝑓

Example 10.2: Putting it Together for UST, Inc.
Data on UST, Inc.:
$1 billion in debt
“A” credit rating
Market Value ≈ $6.5 billion
EBITDA = $785 million
Potential realized distress costs for UST (c in the formula)

= cost (% of V) × VU = 20% × $6.5 billion = $1.3 billion
Rating: AAA AA A BBB BB B CCC

Annualized default prob. 0.05% 0.09% 0.23% 0.47% 2.13% 5.38% 12.08%
Avg. Yield (10-yr bonds) 5.60% 5.84% 6.12% 6.84% 8.72% 11.19% --
Avg. EBITDA Interest coverage 18.7 14 10 6.3 3.9 2.3 0.2
Annualized probability of default (“A” rating): 0.23%

Example 10.2: Tax-Bankruptcy Tradeoff
PV of expected distress cost (assuming r f = 5%):
𝑝𝑝
𝑃𝑃𝑉𝑉 𝐸𝐸 Distress Cost = 𝑐𝑐
𝑝𝑝 + 𝐷𝐷𝑓𝑓
0.23%
= × $1.3 billion ≈ $57 million
0.23% + 5%
Tax benefit (assuming perpetual debt, τc = 38%, τe = 15%, τi =35%):

1 − 𝜏𝜏𝑐𝑐 1 − 𝜏𝜏𝑒𝑒
PVTS = 𝐷𝐷 1 −
1 − 𝜏𝜏𝑖𝑖
1 − 38% 1 − 15%
= $1 billion × 1 − ≈ 189 million
1 − 35%
Net value gain from leverage ≈ 189 – 57 = $132 million

Example 10.2: Optimal Credit Rating
Step 1: Estimate Debt levels for each credit rating
Based on Average Credit Avg. Int. Debt

EBITDA Interest Coverage: Rating Coverage Int. Rate ($mm)
AAA 18.7 5.60% 750
EBITDA / (D × Int. Rate) = Rating Avg.
AA 14.0 5.84% 960
D = EBITDA / (Rating Avg. × Int. Rate) A 10.0 6.12% 1,283
BBB 6.3 6.84% 1,822
BB 3.9 7.70% 2,614
B 2.3 8.72% 3,914
Or, based on Average D/V Ratio: Credit Rating Avg. D/V Debt ($mm)
AAA 0.5% 33
D / VL = D / (VU + D × τ*) = Rating Avg.
AA 8.1% 527
D = Rating Avg. × (VU + D × τ*) A 17.2% 1,118
BBB 27.2% 1,768
BB 43.2% 2,808
B 55.9% 3,634

Key Takeaways (V)
Financial distress is costly as it reduces the value of assets beyond the
effects of economic distress, but we don’t really know how costly
Empirical estimates range from 10 to 20% loss of firm value
What firm characteristics would make bankruptcy more/less costly:

Asset tangibility/re-deployability
Importance of long-term relationships with customers, suppliers,
employees
Importance of brand image/reputation
Importance of investment opportunities
Relevant measure for financial policy is the present value of expected

distress costs; default probabilities are modest until debt gets below
investment-grade
This cost needs to be weighed against the potential tax benefits of debt

Optimal Leverage with Taxes
and Financial Distress Costs
See Example 10.2 (UST) &

Example 10.3 (Google) for
Optimal Credit Rating

Key Takeaways (VI)
We combine the effect of taxes and bankruptcy into a theory of capital structure.
Leverage increases the value of debt interest tax shield but it also increases
financial distress costs.
For low levels of debt, the risk of default is low and the main effect of an increase
in debt is an increase in interest tax shield.
As the level of debt increases, the probability of default increases; consequently,
the costs of financial distress increase, reducing the value of the levered firm.
Both the tax benefit and the distress cost are borne by existing shareholders.
Shareholders would prefer if we balance the two effects.
Ex-ante, this maximizes shareholder value as well as firm value.
Tradeoff theory: Firms should increase their leverage until it reaches the level
for which the firm value is maximized.
At this point, the tax savings that result from increasing leverage are perfectly
offset by the increased probability of incurring the costs of financial distress.

Information Asymmetry
Modules 11-12, Case #5
Group Assignment #6

Information Asymmetry and Its Example
Implications for Securities Issuance 11.1
In a given industry, there are good quality firms (“stars”) and bad quality firms
(“duds”).
As an outside investor, it’s hard to tell which is which.

Information
As a result, “stars” are likely to be undervalued, and “duds” likely to be
overvalued. Asymmetry
But insiders probably know more about the firm’s true value than you do.
One of these firms announces they will issue equity. What’s your assessment of
the likelihood this firm is a star/dud?
The star firm may not be willing to issue since they will be forced to sell shares for
less than fair value, which will lead to real dilution. On the other hand, dud firms
will be happy to issue at inflated prices. If this is the case, if I see a firm willing to
issue new equity, it is more likely they are a dud firm.
So why is it costly for good firms to issue equity?

Investors protect themselves from the possibility of buying a dud firm by
discounting the price they are willing to pay for new securities. This lower price
effectively raises the cost of capital, especially for firms whose true value is high.

Solution #1: The “Pecking Order”
Recall: The cost of asymmetric information is that outside investors will discount the price
they are willing to pay for risky securities.
1. Motivation for retaining internal funds: Avoid (less informed) outside investors
2. What if a firm needs external finance: Why is debt better than equity?
Debt is less informationally sensitive than equity, that is, the value of debt securities are less
sensitive to (unknown) information about the firm than are equity securities.
Payoff to
Equity
investor
Debt
VDud VStar
Intuition: Suppose the lottery ticket in our earlier example paid off $51 if heads, $49 if tails.
What would happen to the price when the seller announced he was willing to sell?
Pecking order financing policy:

1. First use internal funds.
2. If no more internal funds, issue debt.
3. Only issue equity as a last resort.

Example
Solution #2: Rights Offers 11.2
MONTREAL, June 17 /CNW Telbec/ - Cancor Mines Inc. is pleased to announce that
it will be offering rights to holders of its common shares of record at the close of
business on June 27, 2008 (the "Record Date")… Under the offering, each eligible
shareholder will receive, for each common share held as of the Record Date, one
right evidenced by a fully transferable certificate. Four rights and $0.14 will entitle
the holder to subscribe for one common share of the Company at any time up to
4:00 p.m. on July 31, 2008. A fully subscribed rights offering would raise gross
proceeds of approximately $1,486,680. The proceeds of the offering will be used
for general working capital.
Each shareholder issued an option to buy additional shares at a price below the
current market price ($0.18/share at time of announcement).
Are shareholders giving away value?

No, whatever value they lose on their old shares, they gain on the new shares.
They are just transferring wealth to themselves.
What if I don’t want more shares?

“Fully transferable certificate” ⇒ The rights can be sold.

Solution #3: Choice of Lender
Suppose your firm is concerned about getting a fair price for your securities
because of information asymmetry. Which source of debt might be best?
Debt Type Possible Lender Characteristics
Public bonds Dispersed investors
Private placement One or several large out-of-state

pension funds
Bank loan Relationship bank that also
handles my checking and cash
management services
One advantage of a bank (or “relationship lender”) over dispersed (or “arms-length”) lenders is their
ability to gather information about the firm before making a loan. Since they will typically make a
larger investment than a smaller investor, they have greater incentives to spend resources gathering
information. And the firm may be more willing to let one bank come in and do their due diligence
rather than disseminating private information to the broader market (where competitors will also see
it). Finally, banks develop expertise in gathering information about firms by specializing in credit
evaluation and may already have information about the firm as a result of their existing relationship.

Solution #4: Choice of Maturity
Suppose your firm is concerned about getting a fair price for your securities
because of information asymmetry. Which debt maturity might be best?
Short Term Long Term
There is likely to be less uncertainty about a firm’s ability to pay back a loan next year than
over their ability to pay back a loan 10 years from now. In that sense, the price investors
are willing to pay for short-term debt is likely to be less sensitive to asymmetric information
than the price of long-term debt.

Key Takeaways (VII)
When insiders know more than outsiders about the value

of a firm, risky securities will be discounted in the market
(potentially severely enough to limit investment).
Potential solutions:
Issue the least informationally sensitive securities.
Use a rights offer to issue new shares to existing shareholders.
Issue debt to signal you are a strong firm.
Access private sources of capital (i.e., bank debt).
Use short-term debt.

Understand IPOs
IPO terminology & overview in Module 12
Google IPO (Case #5), LinkedIn IPO (Group Assignment #6,

Problem 1), King Digital Entertainment IPO (Practice Final
Exam, Problem 5)
Overview of the IPO process

Over-allotment (the Olin’s Olives example)
IPO cost: Underwriting fee and underpricing
Control rights after IPO
Underwriting process: Auction vs. book building
(the IPO auction example)
The role of investment banks

Key Takeaways (VIII)
Things to remember about IPOs:
Information asymmetry is the key market friction at work
Major costs
Underwriter spreads: Traditionally 7%, cheaper for larger deals
Underpricing: 15 – 20% left on the table on average
Types of shares issued
Primary: New shares, generate cash for the firm
Secondary: Existing shares, generate cash for old shareholders
Types of underwriter arrangements
Best efforts: Firm bears the risk of weak demand
Firm commitment: Underwriter bears the risk
Potential price mechanisms
Auctions offer an interesting alternative, but Book-building is dominant
Suggest that firms value the role of investment banks in the process
including certification, eliciting information from firm and investors, and
price stabilization
Agency Conflicts
Module 13, Case #6
Group Assignment #6

Control Rights and Agency Conflicts
I. Manager-Shareholder Agency Conflicts:
What happens when we issue equity?
In practice, equityholders hire a team of professional managers to run the
business on their behalf. → separation of ownership and control.
Managers’ incentives are not always aligned with those of shareholders.
How can financial policy help address this?
High debt may help.
II. Debtholder-Equityholder Agency Conflicts:

What happens when we issue debt?
Debtholders only have contingent control (covenants, default) while most
of the time, equityholders have control over how the assets are managed.
Equityholders may make decisions that benefit themselves, but don’t
maximize firm (or debtholders’) value.
How can financial policy help address this?
Low debt may help.

Examples of Conflicts and Solutions
High debt as solution to manager-shareholder agency

conflicts: Example 13.1
Debtholder-equityholder agency conflicts 1 – under-

investment due to debt overhang: Example 13.2
Debtholder-equityholder agency conflicts 2 – wrong

investment due to risk shifting: Example 13.3
Low debt as solution to risk shifting: Example 13.4
Convertible debt as solution to risk shifting:

Examples 13.5, 13.6
Manager-Shareholder Agency Conflicts:
High Debt as Solution
How does the financing choice affect Bob’s effort incentives?

Debt financing results in more concentrated equity ownership. As a
result, Bob’s wealth is more sensitive to his effort than it would be if
he were sharing gains and losses with an outside equity investor.
2. Larger firms: The disciplinary role of debt

excess cash
Debt payments limit ________________.
efficiency
Commitment to meet debt payments forces ______________.

Overview: Agency and Capital Structure
Raising capital creates two types of agency conflicts:
1. Manager–Shareholder agency conflicts
Arising from separation of ownership and control
2. Debtholder-Equityholder agency conflicts
Option-like feature of equity payoffs creates two distortions
a. Debt overhang: Less willing to contribute new equity capital when
debtholders have the first claim on cash flows
b. Risk shifting: Willing to sacrifice firm value to increase risk
Agency tradeoff:
1. High debt mitigates incentive conflicts between managers and
outside investors
2. But high debt exacerbates conflicts between debt and equity
⇒ Need to think about which types of firms are more/less
exposed to each friction

Overview: Agency and Capital Structure
Which types of firms might be more concerned about

manager-shareholder agency conflicts? That is,
candidates for high debt
High cash flow
Low investment opportunities
Weak governance
Examples: Sealed Air, UST

debtholder-equityholder agency conflicts? That is,
candidates for low debt
Valuable future investment opportunities (high M/B)
Ability to change the riskiness of assets (R&D intensive firms)

Agency and Capital Structure
Raising capital creates two types of agency conflicts:
1. Manager–Shareholder agency conflicts
Arising from separation of ownership and control
2. Debtholder-Equityholder agency conflicts
Option-like feature of equity payoffs creates two distortions
a. Debt overhang: Less willing to contribute new equity capital when
debt holders have the first claim on cash flows
b. Risk shifting: Willing to sacrifice firm value to increase risk
Agency tradeoff:
1. High debt mitigates incentive conflicts between managers and
outside investors
2. But high debt exacerbates conflicts between debt and equity
⇒ Need to think about which types of firms are more/less
exposed to each friction

Agency and Capital Structure

manager-shareholder agency conflicts? That is,
candidates for high debt
High cash flow
Low investment opportunities
Weak governance
Examples: Sealed Air, UST

debtholder-equityholder agency conflicts? That is,
candidates for low debt
Valuable future investment opportunities (high M/B)
Ability to change the riskiness of assets (R&D intensive firms)

Key Takeaways (IX)
Financial contracts create two layers of agency conflicts:
Managers make decisions on behalf of outside investors
Equityholders make decisions that affect debt holders
How to limit manager-shareholder agency costs?

High debt
Limits “free cash” at management disposal
Preserves incentives for effort and efficiency
Private (e.g., bank) debt
Provides monitoring
How to limit debtholder-shareholder agency costs?

Low debt
Private (e.g. bank) debt - provides monitoring & covenants
Convertible debt limits “risk shifting” incentives

Case #6: Hertz LBO
Sources of value from LBO:
Change in capital structure (high leverage)
Corporate tax shield value
Disciplinary role of debt generates operating improvements
Force disposal of (or reduced investment in) underperforming assets
Change in ownership structure (concentrated private

equityholders)
Closer management oversight leads to operating improvements
Avoid costs of being public (disclosure, regulatory requirements)
Reduce information asymmetry costs in the transaction price
ABS debt
May increase debt capacity or lower cost of debt

Case #6: IPO vs. LBO
Comparing sources of value:
Market Friction Addressed by IPO? Addressed by LBO?
Corporate taxes High debt
Financial distress costs Lower leverage ABS debt
Asymmetric information Private equity buyer

- Concentrated private
Agency costs ownership
(manager-shareholder) - High debt level
Other considerations:
% of Hertz sold Small 100%

Advantages of ABS Financing for Hertz:
Market Frictions and Debt Capacity
Expand capital supply by gaining access to investment-grade bond market
Several classes of investors are restricted (by choice or regulation) from
investing in below-investment-grade debt
Reduce expected costs of financial distress
Distress probability: “as Hertz acquired (deposed of) cars, it had agreements to
increase (decrease) the ABS debt” (case page 8)
The flexibility to increase (decrease) the level of debt as demand increases
(decreases) reduces the probability of default, especially in a highly cyclical
industry
Legal separation can reduce realized bankruptcy costs
SPV classified as “bankruptcy remote”
“The originator conveyed the assets to the SPV, which transferred ownership of
the assets from the originator to the trust.” (case page 7)
ABS lenders less concerned about losing value in a Hertz bankruptcy (than they
would be if Hertz owned the cars)
In the event of bankruptcy, the assets in the SPV (cars) do not become part of
the bankruptcy estate of Hertz. In that case, the ABS lenders can avoid having
their assets lose value in the bankruptcy process. This reduces the lenders’
perceived cost of financial distress and thereby expands debt capacity.

LBO Valuation: PE perspective
Initial 3 – 7 years Exit
Equity Equity
Purchase V2010
Price Debt Debt
Often use interim cash flows to start paying down debt

⇒ From PE firm’s perspective, only 2 “cash flows”:
Initial equity investment
Value of equity at exit
1⁄
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡𝐸𝐸 𝑉𝑉𝐷𝐷𝐷𝐷𝐸𝐸𝑃𝑃 𝐷𝐷𝑡𝑡 𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡 𝑁𝑁
PE firm’s IRR = −1
𝐼𝐼𝐷𝐷𝐸𝐸𝑡𝑡𝐸𝐸𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡𝐸𝐸 𝐼𝐼𝐷𝐷𝐷𝐷𝑃𝑃𝐷𝐷𝑡𝑡𝐹𝐹𝑃𝑃𝐷𝐷𝑡𝑡

All equity FCFE + net debt issuance – interest × (1 – τc)
A Few Details behind the Projections…

2006 (year 1) 2007 (year 2)
From deal financing Debt (beginning of year) Debt (beginning of year)
EBITDA EBITDA
Assumptions about
operating EBIT EBIT
improvements - Interest expense - Interest expense
EBT EBT
2) do not add back after-tax
interest expenses (which - Taxes - Taxes
1) start with Net Income (not NOPAT)
goes to the debtholders
= Net income = Net income
+ Depreciation & amortization + Depreciation & amortization
+ Δ deferred taxes + Δ deferred taxes

Calculating free cash
flow to equity - Δ Net working capital - Δ Net working capital
- Capital expenditures - Capital expenditures
+/- other non-cash changes +/- other non-cash changes
Assume they use all = CF available to pay down debt = CF available to pay down debt
available FCFE to pay
down debt Debt (end of year) Debt (end of year)

Key Takeaways (X)
LBOs simultaneously change capital structure and ownership structure.
Can create value by simultaneously addressing several market frictions.
ABS financing can create additional value by increasing debt capacity.
PE firm exit horizon can limit scope for value creation through tax shields and
private ownership.
Summary of value sources:
Impact to firm (cash flows) Relevant market friction Relevant financial policy change
Interest tax shields Corporate taxes High debt level
Operating improvements Agency costs • High debt level (disciplinary role)
(mgr-shareholder) • Concentrated private ownership
(monitoring)
Higher sales price Information asymmetry Sale to a large private investor (rather
than public investors)
Increased debt capacity Financial distress costs, Change in debt structure (use of ABS
access to investment- financing)
grade credit market

Payout Policy
Module 14

What is Payout Policy?
Free cash flow to equity (FCFE) is what’s left over after the firm:
Earns (after-tax) profits from past investments
Pays obligations to debt holders
Makes necessary new investments
FCFE is the equityholders’ money. What do we do with it?

Three options:
Keep it in the firm (excess cash)
Pay it out to shareholders (dividend)
Repurchase shares
Dividends Repurchase Retain cash
Timing of payout Now Now Later
Form of payout Cash Capital gain Capital gain

Example
Dividend Timing 14.2
Dividend is ultimately a decision of the board of directors

Declaration date: Date after which the dividend becomes an
obligation
Payment date: When the checks are sent out
Record date: Determining who gets the dividend
In practice, based on whether you bought the stock before or on/after the
ex-dividend date, which is 2 trading days before the record date
Contrast between dividends and repurchases (few specifics given
on timing or amount of repurchases)
Anticipated price effects
Informational impact (value impact of the financial policy decision):
declaration date
On _____________
Mechanical impact (stock should fall by approximately the value of the
dividend, all else equal): On ___________
ex-dividend date

Perfect Markets: Payout Policy Irrelevance
Example 14.1 (three options for the cash)
Example 14.4 (payout level at Apple Inc.)

Friction 2: Personal Taxes and Payout Form
Implications for Payout Form:
Change in price on the ex-dividend day (Pcum – Pex) represents the market value of a
dividend
Investors often pay different tax rates on dividends (τd) and capital gains (τe)
Prices should adjust so one can’t make a profit by simply buying the stock the night before
the ex-date and selling it the next morning
Cost of this trade: Pcum
Return from this trade: Pex + DIV × (1–τd) + (Pcum – Pex) × τe
Set them equal and solve for the price difference:
1 − τd <1: cost of paying dividend
Pcum − Pex = DIV
1 − τe >1: paying dividend prefered
1−τd τd −τe
1− = represents the “tax cost” of paying dividends (rather than repurchases)
1−τe 1−τe
Two main implications:

When the effective personal tax rate on dividends is higher than that on capital gains,
there is a tax cost of paying dividends, and the firm can increase market value (all else
equal) by shifting to share repurchases
With effective capital gains tax rates less than rates on dividend income, we should expect
the price drop on the ex-dividend day to be slightly less than the value of the dividend

Payout Level and Market Frictions
Market Friction Payout level Why?
Corporate and Depends on - Cash generates taxable interest income
personal taxes τc and τi - Want to earn interest in the lowest tax setting
Financial Distress costs Low Retaining cash builds equity cushion
Manager-shareholder Gets excess cash back to investors before any
High
agency conflicts value can be destroyed
Asymmetric information Preserve cash to be able to finance projects
Low
– “Pecking order” view with internal funds
Asymmetric information High payout can be a credible signal of
High
– “Signaling” view strength and confidence in future cash flows
Most important tradeoff in practice:

Precautionary savings vs. Return cash to shareholders
(Low payout reduces likelihood (High payout mitigates agency
of financial distress and reduces costs of free cash flow)
need for external finance )

Payout Form and Market Frictions
Market Friction Payout Form Why?
Personal taxes Repurchases τdividend often > τcapital gain
Delay tax payment on capital gain
Financial Distress costs Repurchases Flexibility of repurchases
Manager-shareholder Dividends Implied commitment of dividends
agency conflicts
Asymmetric information Repurchases Flexibility of repurchases
– “Pecking order” view
Asymmetric information Either - Mgrs repurchase when shares under-valued
– “Signaling” view - High dividend sign of confidence in future CFs
Most important tradeoff in practice:

Discipline of Dividends vs. Tax advantage and
(Limit manager-shareholder flexibility of repurchases
agency conflicts) (Limit financial distress,
information costs)

Friction 5: Information Asymmetry
What would the “pecking order” view of capital structure suggest for
payout policy?
Level: High vs. Low
Financing investment with internal funds avoids information asymmetry
costs. To accumulate internal funds, a firm needs to keep payouts low.
Form: Dividends vs. Repurchases
Again, due to the flexibility of repurchases. If investment needs arise, a
firm can temporarily reduce the level of share repurchases in order to
finance the investment with internally generated cash.
Using payout to “signal” firm quality:

Signaling with high dividends (why is it credible?)
If the firm did not have strong future earnings, the high dividend would
increase distress risk and require it to fund future investments with
external security issues (thus bearing the transaction and information
costs associated with issuance).
Signaling with repurchases (why is it credible?)
If the firm is low quality (i.e., overvalued), they would be buying shares for
more than what they are worth.

Clientele Effects
Idea: A high dividend policy can attract a certain type of investor clientele
1. Tax clienteles
Different investors face different personal tax rates
Progressive personal tax rates
Tax-exempt institutions (e.g., pension funds, university endowments)
Corporate “dividends received deduction” (70% or more of dividend income is tax
deductible for corporations)
2. Consumption/cash-flow oriented investors

What would M&M say?
In perfect markets, if they held a non-dividend paying stock, they could create a
“homemade dividend” by selling off a fraction of their shares each quarter.
Why is this costly in the real world?
Frequent stock sales incur transaction costs. This creates a preference for
dividend-paying stocks among investors who want to get a regular stream of cash
out of their investments.
3. Institutional investors
Some institutions (e.g., pension funds) are reluctant to invest in non-dividend
paying stocks

Key Takeaways (XI)
“The most important determinants of a company’s financial

strategy are its business strategy and the nature and extent
of its investment opportunities”
Firms that (appropriately) pay the highest dividends are:

Low growth
Profitable
Mature, large, and stable
Firms that (appropriately) pay the least dividends are:

High growth
Volatile
Small and young

Course Evaluation
evals.wustl.edu

FIN448-Final-Exam-Fall2020-Review - MC

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FIN448-Final-Exam-Fall2020-Review - MC

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Advanced Financial Management

Professor Jian Cai

Optional review session

Extra office hours

2 FIN 448 / Jian Cai / Fall 2020

Before the holiday:

After the holiday (original exam date):

Choose your exam time by midnight on Sunday, December 20.

3 FIN 448 / Jian Cai / Fall 2020

4 FIN 448 / Jian Cai / Fall 2020

Choose one way to deliver your answers and stick to it

Use all available tools if they help; be prepared & organized

5 FIN 448 / Jian Cai / Fall 2020

1. Lecture notes for Modules 8 – 14 with

2. Lecture notes for Cases #4 – #6

A mind with clear and correct timelines, cash

6 FIN 448 / Jian Cai / Fall 2020

Topics that are discussed only before the

Case-specific information: No need to retell the

7 FIN 448 / Jian Cai / Fall 2020

Review for final exam

8 FIN 448 / Jian Cai / Fall 2020

Firm’s Financial Capital

Operating cash Return to financial

9 FIN 448 / Jian Cai / Fall 2020

Up-front Future free

Financing: Evaluate a financial policy

10 FIN 448 / Jian Cai / Fall 2020

Cash Flows Discount Rate

Free Cash Flow 𝑟𝑟𝐹𝐹𝐸𝐸𝐹𝐹𝐹𝐹

11 FIN 448 / Jian Cai / Fall 2020

Cash Flow Stream PV Formula

Growing Cash flows growing at a 𝑊𝑊𝐶𝐶1

12 FIN 448 / Jian Cai / Fall 2020

Perfect Information Payout

Taxes and Agency

13 FIN 448 / Jian Cai / Fall 2020

14 FIN 448 / Jian Cai / Fall 2020

15 FIN 448 / Jian Cai / Fall 2020

Cash Flow Fixed Residual

Control Rights “Contingent control” Voting

16 FIN 448 / Jian Cai / Fall 2020

Market-value balance sheet (forward looking)

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1. Investors and firms can trade the same set of

2. There are no taxes, transaction costs, or issuance

3. A firm’s financing decisions do not change the cash

18 FIN 448 / Jian Cai / Fall 2020

In a perfect capital market:

M&M I: Firm value is unaffected by financing choices.

M&M II: Both equityholders’ risk and expected return

The market value of an asset is the present value of the future

20 FIN 448 / Jian Cai / Fall 2020

Book and market value balance sheets before and after

Financial policy and shareholder value: Example 8.2 (HP

Equity issuance and dilution: Example 8.3 (JCPenney

Debt issuance, cost of equity, and WACC: Example 8.4

21 FIN 448 / Jian Cai / Fall 2020