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Week 9 Discussion Qs (Payout Policy)

Discussion questions and answers for an article that was covered in the exam
Course

Advanced Corporate Finance (FINA803)

22 Documents
Students shared 22 documents in this course
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kayla czar
Auckland University of Technology
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Discussion Questions for Morgan Stanley Roundtable on Capital Structure and Pay out Policy

  1. According to Cliff Smith, what are the 3 main assumptions of the Modigliani and Miller capital structure irrelevancy theory? What’s the basic insight of this theory?  No taxes  No transaction costs  No effect on management decisions

Then, differences in leverage and the kinds of securities issued are no more than different ways of dividing up operating cash flows

  1. Under the framework of Modigliani and Miller irrelevancy theory, can firms increase firm value by issuing debt instead of equity because this can increase the firms’ EPS or ROE as long as it earns a return on the new capital that is higher than its borrowing rate? Explain your answer.

Yes, under the framework this is possible, issuing debt will maintain the earnings of the company but reduce the amount of equity on the balance sheet, therefore EPS and ROE will definitely go up, reflecting this change. However, in reality, having more debt increases risk, therefore equity holders will require a greater return for their investment which will decrease EPS.

  1. There are 3 potentially important considerations or goals in capital structure decision: reducing taxes; preserving adequate financial flexibility to avoid distress and invest in all positive NPV opportunities; and paying out excess capital to encourage mangers to operate efficiently and walk away from bad investment. Of these 3 goals, which seems to be the most important in corporate decision making?

The most important of the three goals depends on the type of company we are talking about

Growth companies, who have a lot of future opportunities to invest in positive NPV projects to increase their value will value financial flexibility in order to achieve value creation.

Value companies who have a lot of cash on hand but not a lot of positive NPV projects to invest in will value paying out excess cash. They can increase the distributed amount by decreasing the tax paid, they achieve this by increasing the amount of debt.

  1. Discuss the four main motivations for companies to buy back their own stocks. Some companies buy back their own shares mainly to boost their EPS. Is it a valid reason? If yes, why? If not, why not?  Provide companies with a way to adjust their capital structure and restore the debt/equity ratio they feel is optimal  Restrict managers ability to waste FCF by paying out FCF

 Buy backs are more attractive than dividends in terms of tax  Signals management’s confidence about firm’s future earning power – signal that the stock is undervalued

It is not a valid reason, although it may increase EPS, the market sees through this effect as it basically represents simple algebra, no value is created which is what investors really care about.

  1. What are the reasons for companies to prefer share buybacks to dividends?  Buybacks are taxed less than dividends  Stock options: the value of an option increases when price increases. With buybacks, the price does not move, however with dividends the price decreases.  Dividends are less flexible because they can always be cancelled.

  2. What is the main reason for companies to prefer paying dividends to buying back shares, especially given the tax disadvantage of dividend payment?

Signals a stronger commitment from the company – which comes from the expectation of shareholders. Dividends there is an expectation. Shareholders expect a stable dividend policy and the amounts should not be significantly lower the next year. If you stop paying dividend or there is a decrease this is a negative signal to shareholders. Future earnings will be stable if dividends are continually paid.

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Week 9 Discussion Qs (Payout Policy)

Course: Advanced Corporate Finance (FINA803)

22 Documents
Students shared 22 documents in this course

University: Auckland University of Technology

Was this document helpful?
Discussion Questions for Morgan Stanley Roundtable on Capital Structure and Pay out Policy
1. According to Cliff Smith, what are the 3 main assumptions of the Modigliani and Miller capital
structure irrelevancy theory? What’s the basic insight of this theory?
No taxes
No transaction costs
No effect on management decisions
Then, differences in leverage and the kinds of securities issued are no more than different ways of
dividing up operating cash flows
2. Under the framework of Modigliani and Miller irrelevancy theory, can firms increase firm
value by issuing debt instead of equity because this can increase the firms’ EPS or ROE as long
as it earns a return on the new capital that is higher than its borrowing rate? Explain your
answer.
Yes, under the framework this is possible, issuing debt will maintain the earnings of the company but
reduce the amount of equity on the balance sheet, therefore EPS and ROE will definitely go up, reflecting
this change. However, in reality, having more debt increases risk, therefore equity holders will require a
greater return for their investment which will decrease EPS.
3. There are 3 potentially important considerations or goals in capital structure decision:
reducing taxes; preserving adequate financial flexibility to avoid distress and invest in all
positive NPV opportunities; and paying out excess capital to encourage mangers to operate
efficiently and walk away from bad investment. Of these 3 goals, which seems to be the most
important in corporate decision making?
The most important of the three goals depends on the type of company we are talking about
Growth companies, who have a lot of future opportunities to invest in positive NPV projects to increase
their value will value financial flexibility in order to achieve value creation.
Value companies who have a lot of cash on hand but not a lot of positive NPV projects to invest in will
value paying out excess cash. They can increase the distributed amount by decreasing the tax paid, they
achieve this by increasing the amount of debt.
4. Discuss the four main motivations for companies to buy back their own stocks. Some
companies buy back their own shares mainly to boost their EPS. Is it a valid reason? If yes,
why? If not, why not?

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