Points for FM Exam

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Economics

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Feb 20, 2024

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Question 1.1  Discuss M&M Case 1, that is, no corporate taxes, no personal taxes, no bankruptcy costs.  The value of the firm is not affected by the changes in the capital structure.  Deciding how much leverage the firm uses doesn’t really matter when there are no taxes.  Two propositions: 1) The value of the firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. This is why the financial manager should not take too much time analyzing the capital structure of the firm (simplicity of the capital structure when there is no taxes). WACC= RA=RE, Value of the levered firm is equal to the value of the unlevered firm.  Proposition 2 says that the WACC is not affected by the capital structure. WACC=RE (cost of equity) because there is no debt.  There is no optimal capital structure.  Discuss M&M case 2, that is, corporate taxes present, no personal taxes and no bankruptcy costs.  With taxes present, when the firm adds debt, taxes are reduced and this reduction in taxes increases the cash flow of the firm.  Value of the unlevered firm and the levered firm is different owing to the value of the levered firm will be the value of the unlevered + present value of the interest tax shield. So really and truly, the difference is the PV of the interest tax shield. This is because as more debt is added, with taxes, the firm is able to increase its value through the reduction in taxes from the interest tax shield.  According to proposition 2, as more debt is added, the WACC will decrease. The RE would increase.  The optimal capital structure is 100% debt.  The financial manager would opt for a 100% debt capital structure because it would be more costly to use equity and high risk means higher return when using debt. They would also benefit from a higher value for the firm when using more debt due to the interest tax shield.  Because of trade-off, they cannot get the best out of both sources of capital (debt or equity), so it doesn’t make sense deciding which capital structure to use because you cannot get the best out of both so deciding which one to use doesn’t matter. Question 1.2  What is homemade dividend?- Homemade dividend is a personal decision instead of a firm’s decision. If a firm does not follow your preferred dividend policy, you as a shareholder/investor can do something on your own to fill in the gap. This means that it does not matter what a firm does. Investors don’t depend on the dividend policy of the firm; they can use homemade dividends to get the outcome of their preference. Therefore, they don’t need to impose their preference on the firm itself, and by extension, the firm does not need to follow investors’ preferences, the investor could make their homemade dividends and render the firm’s dividend policy irrelevant. The statement was incorrect here.

 What is bird in hand theory? Definition from Textbook: We have just pointed out that investors with substantial current consumption needs will prefer high current dividends. In another classic treatment, Myron Gordon has argued that a high-dividend policy also benefits stockholders because it resolves uncertainty.5 According to Gordon, investors price a security by forecasting and discounting future dividends. Gordon then argues that forecasts of dividends to be received in the distant future have greater uncertainty than do forecasts of near-term dividends. Because investors dislike uncertainty, the stock price should be low for those companies that pay small dividends now in order to remit higher, less certain dividends at later dates. Gordon and Lintner claimed that Modigliani and Miller made a mistake assuming lack of impact of dividend policy on firm’s cost of capital. They argued that lower payouts result in higher costs of capital. The authors indicated that the higher capital gains/dividends ratio is, the larger total return is required by investors due to increased risks. Lower dividend payout leads to increased cost of capital and vice versa. Investors are risk averse and believe that income from dividends are certain are certain rather incomes from future capital gains, therefore they predict future capital gains to be risky propositions. (they prefer dividends payments now rather than later due to the risk of uncertainty in capital gains). The statement in the question is incorrect (by Mary).  This statement is true. Stock prices will increase with an increase in dividend payout. As shareholders are receiving money and dividends, the stock price will increase. However, this is temporary as the increase in stock price will last from the declaration of the stock dividends until the ex-dividend date, when the dividend component of the stock is dropped. IT WILL ALWAYS INCREASE. There is also a signaling effect to investors when there is a high dividend payout as it shows corporate health and earnings growth to the investors.  Since there is a decline in profitable investments, the company would choose to pay dividends now. The company increased is since in the future there is no opportunity for investments. There is no necessity to keep dividends from shareholders to reinvest for the future since there is decline in profitable investments. Therefore, the company would pay shareholders now with an increased dividend so as to increase shareholder wealth. If the company does have profitable investment opportunities, the company will pay a lower dividend to shareholders now and reinvest in future profitable opportunities to return higher dividends to shareholders in the future. This follows the concept of dividend policy which states that dividends will always matter, what is of concern is the timing of dividend payments.  Clientele Effect- The clientele effect says that dividend policy is irrelevant because investors that prefer high payouts will invest in firms that have high payouts; and investors that prefer low payouts will invest in firms with low payouts. If a firm changes

its payout policy, it will not affect the stock value; it will just end up with a different set of investors. This is true as long as the “market” for dividend policy is in equilibrium. In other words, if there is excess demand for companies with high dividend payouts, then a low payout company may be able to increase its stock value by switching to a high payout policy. This is only possible until the excess demand is met. >Therefore, the stock price will not be affected, as investors would switch between companies that are changing their dividends policy and go to the company whose policy they prefer. Therefore, the stock price or value of the firm is not affected because the company will not lose investors, they will just get a different set of investors/clients that prefer their policy. Question 1.3 Inflation are highly correlated to interest rates where higher inflation means higher interest rates. However, the discussion remains between the interest rate and exchange rate. Increase interest rate is required to stabilize the exchange rate depreciation and restrain inflationary pressure. Inflation is a major factor that impacts the exchange rate. Low inflation will result in high currency rate as the purchasing power the currency will increase when compared to other currencies. Purchasing Power Parity is when one country’s inflation rate rises relative to that of another country. Quantifies the inflation and exchange rate relationship. Exchange rate movements are caused by interest rate differentials. Relative PPP accounts for market imperfections and states that the rate of price changes should be similar. Concludes that exchange rates depend on relative inflation between countries. It states that the value of currency and inflation are inversely related while the interest rate parity states that value of currency and nominal interest rates are inversely related. It is important to note that the relationship between inflation differentials and exchange rate is not perfect even in the long run, however, inflation differentials is used to forecast long-run movements. International Fisher effect- Interest rates have real rate of return and anticipated inflation therefore if the same real return is required, differentials in interest rates may be due to differentials in expected inflation. Higher interest rates reflect higher expected inflation. If id < Ffc then invest in a country with a lower IR and borrow from a country with a higher IR. This depends on exchange rates and the relative inflation between currencies that investing in a country with a higher IR would result in paying less interest in that currency relative to your own currency than if you were to borrow from a country with a lower IR where you would end up paying more in that country’s currency relative to your own. Therefore, if we borrow from a country with a higher IR, we are borrowing from one whose currency has a higher value. When converted back, it means we would get more of our own currency and thus would be able to invest more.

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