Business and Finance Homework
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Once each question is answered I can view the next one. I will post the first one and so forth. There are 4 questions and a 4 hr period to answer all of them, so from now to 4 hrs all questions need to be answered. As i said before I need to submit each answer to view the next question.
Q1> How is capital structure linked to firm valuation, capital budgeting and evaluation of merger/acquisition targets? How do we define and estimate the optimal capital structure, (hint: the relationship of optimal structure and WACC).
Capital structure comprises of debt and equity financing. It shows the sources through which resources have been provided. The company purchases assets by using these sources of financing, therefore initially, the value of assets is equal to debt and equity. But as the times goes on, the value of assets increases due to their earnings power and market value. The difference between value of assets and sources of finance describes the value of the company. As each source of financing has the cost, without which it cannot be acquired. The interest is the cost of debt financing and the dividend is the cost of equity financing. The interest is the expense, therefore tax shield is available, while the dividend is the distribution of profit, and therefore not tax shield is available. If a company acquires debt and pays interest of 5%, and the tax rate is 20%, the after tax cost of debt is 4% and if the dividend on common stock is to be paid $2 per share and the market value of common stock is $20 per share, the cost of equity financing is 10%. If company uses 40% of debt financing and 60% of equity financing, the weighted average cost of capital will be (4*.4+10*.6) = 7.6%. The optimal capital structure is the combination of debt and equity financing at which the WACC is the lowest among different options available.
Discuss the pricing of stock options? Answer the following in your essay:
i. Which authors are influential in valuation options
ii. what is the name of the model.
iii. Why is the model useful
iv. what are the factors in the model of option pricing (i.e., for a call option describe the input variable and what effect an increase in the variable has on the option price.)
v. Discuss the put call parity, what it is and why parity exists?
Do not simply answer these topics; write in essay format the answers but cover all the above.
Option is the right to the buyer of option either to exercise or not. The seller of option is obliged and committed to fulfill the option, if buyer wants to exercise it. The pricing of stock option is very technical and it was developed by Fischer Black and Myron Scholes. Therefore it is known as Back-Scholes Model of pricing stock option. The model is useful as it generates hedge parameters mandatory for effective risk management. The factors are considered in finding the price of stock options are current price of underlying stock, risk free rate of return during the life of option, the period remaining for the maturity of option and the vulnerability in the price of the stock. The stock with high vulnerability in stock price will have the higher price for the stock option and vice versa. If the maturity period is longer, it will also be priced on higher side. The put call parity option shows the relationship of European put and European call option of stock of same maturity period and same strike price. It helps in reducing the risk of investor by using the arbitrage opportunity. The stock option with put call parity will also have the same rate of return.
Discuss dividend theories of the firm. Are dividends irrelevant, and if so, then why do firms pay or not pay dividends? Are there other more tax-efficient ways a firm can distribute cash to shareholders? If so, what are they and what is the tax advantage?
The major dividend theories are dividend irrelevance theory, bird in hand theory and tax preference theory. Under the first theory, the investor assume that the dividend has no affect on their earnings as the stocks of the firm can be sold out in the stock market and cash can be obtained, this type of investor do not buy stocks for dividend, rather for capital gain. Under the second theory, the investor gives a weight to dividend as the total return on stock is the combination of both dividend earned and the difference in the stock price. Therefore this type of investor would like to invest in a company stock which pays dividend. In the last theory the investor like the opportunity which can reduce the tax burden, normally, the capital gain is taxed at lower rate than dividend, therefore this type of investor invest in stocks for capital gain. The first and last theories do resemble to each other. The tax efficient ways through which tax can be lowered by shareholders is the capital gain. The company can distribute stock dividend instead of cash dividend, then the investor can get cash from stock market by selling those stock dividend at will and can earn capital gain. As described earlier the capital gain is taxed at lower rate as compared to cash dividend.
Is there another term for tax preference theory?
Yes, I couldn't find it in my book.
Discuss capital structure theories of the firm; in your answer, state whether capital structure affects firm valuation. If structure affects valuation, then are there trades-offs available to managers in selecting a capital structure? Why or why not do bankruptcy costs play a role in capital structure?
The main theories of capital structure are Pecking Order Theory, Trade off Theory and Irrelevance Proposition Theory. Under the first theory, the internally generated financing is used in the form of retained earnings, then the debt financing is used, if needed and finally the equity financing is used if other two options are exhausted. Under the second theory, the company takes maximum advantage of debt financing as the cost of debt financing provides the tax shield and the after tax cost of debt financing is always lower than equity financing. But at the same time the increase in debt increases the financial leverage of the company, therefore there is a tradeoff between the increased chances of bankruptcy in the form of debt financing and the increase in tax shield, which will ultimately increase the earnings of the business, thus the market price of stocks. Under the third and last theory the weight of each element of source of capital structure is irrelevant, at any point the company does not increase its WACC, therefore there is no increase in tax shield as the same proposition of capital structure is being used as earlier. The capital structure plays a very vital role in valuation of the business, optimal capital structure provides the lowest WACC, thus the earnings power of the company increase which increases the market price of company stock, but the company has to face the increase in bankruptcy cost, therefore there is tradeoff between increase in earnings of the company and the bankruptcy cost.
Hi, can you discuss more the Modigliani and Miller theory?