THEORIES DIVIDENDS (CHAP 15)

Dividends are the basis of value for stocks.

Valuation can be based on a series of dividends and an eventual selling price or an
infinite stream of dividends.
The dividend payout ratio states dividends as a fraction of earnings.
The dividend decision is whether to pay cash dividends or retain earnings for
growth, both of which benefit stockholders.
The dividend controversy is whether paying or not paying dividends affects stock
price.
Under dividend irrelevance the value of eliminated dividends is offset by growthcreated value in the future.
Investors can tailor their income stream by selling off shares of a growing stock that
doesnt pay dividends.
Transaction costs tend to make tailoring an income stream impractical.
Firms prefer not paying dividends if it avoids selling new stock, because retained
earnings cost less than new equity.
Under dividend preference investors prefer immediate cash to uncertain future
benefits.
Under dividend aversion investors prefer future capital gains to current dividends
because of lower tax rates.
The clientele effect maintains that investors choose stocks for dividend policy, so
any change in payments is disruptive.
Under the residual view, dividends are paid from earnings only after all viable
projects are funded.
Dividends cant be paid by an insolvent firm and must come from current or prior
earnings.
Loan indentures and covenants may limit dividend payments to protect
creditors interests.
The cumulative feature of preferred stock limits dividend payments.
A stable dividend is non-decreasing.
Typical policies include a target payout ratio, a stable dividend, and year end
extras.
Dividends are authorized on the declaration date for owners as of the date of
record and are sent on the payment date.
An investor who buys a stock on or after the ex-dividend date does not receive the
pending dividend.
Large companies offer automatic dividend reinvestment plans to shareholders.
Stock splits and dividends issue new shares to existing stockholders in proportion to
the number already held.
Stock splits and dividends dont change ownership or control and have no real
value to shareholders.
A stock split simply changes par value and the number of shares. The capital
accounts are unaffected.
In a stock dividend, money is moved from RE into the stock accounts to give the
appearance of a sale at market price.
Splits keep stock prices in a trading range.
Stock dividends are an attempt at signaling.
o Stock dividends tend to be used as signaling devices. Theyre often employed
when companies want to send a positive message, but for some reason cant give
as large a cash dividend as theyd like.

Repurchasing shares is an alternative to paying a dividend.

Repurchases are appropriate (beneficial) when a stock is temporarily undervalued or
the firm has excess cash.

THEORIES MERGERS AND ACQUISITIONS (CHAP 17)

A merger is loosely defined as any combination of two or more businesses under one
ownership.
o A merger is a combination of two or more businesses in which all but one legally
cease to exist, and the combined organization continues under the original name
of the one surviving firm.
In an acquisition or takeover one firm acquires the stock of another called the target
o A consolidation occurs when all of the combining legal entities dissolve, and a
new one with a new name is formed to continue into the future.
A majority of the targets stockholders must accept the price offered by the acquiring
company.
In a friendly merger, the targets management approves of the deal and
cooperates with the acquiring company.
In an unfriendly merger the targets management resists and may take defensive
measures to stop the deal.
An acquiring firm can bypass a targets management by making a tender offer directly
to shareholders.
A targets management may resist a merger in its own self-interest or because the
price offered is too low.
Types of mergers
o Merger relationships verticalsuppliers and customers;
o Horizontalcompetitors;
o Congenericrelated fields;
o Conglomerateunrelated fields.
Strategic mergers enhance acquiring firms business positions.
o A strategic merger is one thats undertaken to enhance the business position of
the acquiring company.
The antitrust laws prohibit mergers that significantly reduce competition.
o The antitrust laws limit the freedom of companies to merge. Proposed mergers
over a certain size must be reviewed by the federal governments Justice
Department, and/or the Federal Trade Commission (FTC), both of which evaluate
whether or not they constitute an excessive reduction in competition.
o If a court decides a mergers effect is too detrimental, the merger will be blocked
by the government.
A synergy exists when performance together is better than the sum of separate
performances.
External growth through acquisition is usually much faster than internal growth.
A firm with diversified operations is more stable than a company that does a single
thing.
Acquiring a firm with a tax loss can shelter the acquirers earnings

Critics maintain that empire building is behind many mergers that dont seem to make
sense otherwise.
o Although its impossible to prove, powerful people at the top of large organizations
sometimes seem to make acquisitions for the sake of making their empires larger.
o Part of the reason may be that executive pay tends to be more a function of the
size of the organization managed than of its success.
o It is argued that the ego/empire phenomenon has led to a number of acquisitions
in which the prices paid for target companies were inflated far above what the
firms were reasonably worth.
o This phenomenon is a windfall (a bonus/advantage) for the stockholders of the
target at the expense of the acquirers owners.
There have been several periods of intense merger activity in the United States in the
last 115 years. Theyre often referred to as merger waves.
o Wave 1: The Turn of the Century, 18971904
The mergers at the turn of the century had a profound effect on the
structure of American industry. They were largely horizontal and occurred
in primary industries such as mining, metals production, food products,
transportation, and energy.
o Wave 2: The Roaring Twenties, 19161929
The second merger wave began during the First World War and ended with
the stock market crash of 1929. It was fueled by postwar prosperity and
the general boom climate of the 1920s. Mergers in this period also tended
to be horizontal and resulted in the concentration of several industries
into oligopolies.
o Wave 3: The Swinging Sixties, 19651969
The late 1960s was the era of the conglomerate merger. Companies like
ITT, Litton Industries, and LTV acquired firms in totally diverse fields that
had absolutely nothing to do with one another.
At the turn of the century a wave of horizontal mergers transformed the U.S. into a
nation of industrial giants.
Many of the conglomerate mergers of the 1960s were stock market phenomena
without economic substance.
The hostile takeover became an acceptable financial maneuver during the 1970s.
Merger pricing is a capital budgeting exercise, but cash flows are hard to estimate,
and theres a tendency to overpay.
Most acquisitions are made at price premiums, which lead to speculation on in play
stocks, which drives prices up.
o Because of acquisitions at a premium, this opportunity causes the market price of
a companys stock to increase rapidly as soon as the fact that the firm is an
acquisition target becomes known. Such a firm is said to be in play.
A reluctant targets management can use defensive tactics to avoid being acquired.
o Challenge the Price
o Claim an Antitrust Violation
o Issue Debt and Repurchase Shares
o Seek a White Knight

A white knight is an alternate acquirer with a better reputation for its

treatment of acquired firms.
o Greenmail
Essentially management buys off the attacker with the companys money
in a process known as paying greenmail.
Tactics in Anticipation of a Takeover
o Staggered Election of Directors
o Approval by a Supermajority
o Poison Pills
Are legal devices embedded in corporate bylaws that are designed to
make it prohibitively expensive for outsiders to take control without the
support of management.
o Golden Parachutes
o Accelerated Debt
o Share Rights Plans (SRPS)
Golden parachutes are exorbitant severance packages for a targets management.
Other kinds of takeovers
o In a leveraged buyout (LBO), investors take a company private by buying its
stock with borrowed money.
The result of an LBO is usually a risky, debt burdened company.
o In a proxy fight, opposing groups solicit shareholders proxies for the election of
directors.
A divestiture is the opposite of an acquisition. A company decides that for some reason
it would be better off without a particular business operation, and gets rid of it in one of
several ways.
Companies divest operations to raise money, or because of poor performance or lack
of strategic fit.
A spinoff creates a new company owned by the same shareholders that can be
separately traded.

INTERNATIONAL FINANCE THEORIES (CHAP 18)

An exchange rate states the price of one currency in terms of another.

The exchange rate is part of the cost of product paid by an importing firm
Exchange rates affect the quantity of foreign product demanded in an importing
country.
The exchange rate between two foreign currencies is across rate.
Exchange rate risk is the chance of gain or loss from exchange rate movement that
occurs during a transaction.
Forward rates quote prices for future delivery of currencies.
Exchange rate risk can be eliminated by hedging with a forward contract.
The supply/demand for foreign exchange is derived from each countrys demand for the
others goods and investments.
Exchange rates move in response to changes in the demand for imported goods
within the two countries.
Speculation
o Changes in exchange rates create speculative opportunities just like changes in
the prices of stocks. If a foreign currency is strengthening against the dollar,
holding it results in a gain. Hence, some people trade in currencies for profit rather
than to do international business. The transactions made by such speculators can
be significant in size and sometimes have a noticeable effect on overall demand
and supply.

A strong dollar makes imports cheaper, but has a negative effect on

employment because it reduces exports.
In a floating exchange rate system, market forces set rates with little intervention
from governments.
A currency that isnt convertible cannot be exchanged for other currencies at marketdetermined rates.
o For its currency to be convertible, a nation must allow it to be traded on foreign
exchange markets and be willing to accept the resulting value. The currencies of
Russia and China have traditionally not been convertible, but have moved toward
convertibility in recent years.
If we import more from a country than we export to it, a trade deficit exists and our
currency accumulates in that country.
A widely traded currency that can be used as a stable, reliable store of value is known as
a hard currency. A soft currency, on the other hand, is one whose value may fall
quickly or is difficult to convert to other currencies.
o The value of a hard currency is stable and reliable.
o A soft currency is unreliable in value and may be difficult to convert.

UNANSWERED QUESTIONS

A project has an IRR of 16% and is being considered by a firm with $5 million in debt and $15
million in equity. Assuming the debt costs 12% (after-tax value), what is the most equity can cost
for the project to be acceptable to the firm? (hint: set the IRR equal to WACC)
a. 17.33%
b. 16.89%
c. 17.83%
d. 18.25%