5. Indicate that the statement is true or false for T/F questions. Fill in the b

Question

5. Indicate that the statement is true or false for T/F questions. Fill in the blank for the other questions. a. In the presence of flotation costs, the cost of external equity is greater than the cost retained earnings. (T/F) b. If the overall stock market is expected to be booming soon, then one should increase the proportion of (high/low)-beta stocks in one’s portfolio. c. If Debt = $1,000, average tax rate = 30% and interest rate = 10%, then the dollar value of tax savings equals ( ). d. In the two-stage DCF method, the present value of the second-stage cash flows is called ( ). e. If a firm’s CEO and key employees hold stock options, then the firm is likely to distribute excess cash using (dividends/share repurchases) f. The degree of operating leverage is defined as the percent change in ( ) over the percent change in ( ). g. If a firm’s operating leverage is high, then its optimal debt ratio is likely to be (higher/lower) than that of the average firm according to the trade-off theory. h. Two advantages of triangular merger(vs. direct merger) are (1) that the buying firm does not need to hold shareholders’ meeting and (2) that ( ). i. Suppose that A (aggressor) intends to use ‘stock’ as consideration in purchasing T (target) in a triangular merger. When A creates an SPV( i.e., a paper company), it will capitalize the SPV with ( ).

Explanation / Answer

Since, there are multiple parts to the question and each question is not related to each other, I have answered the first four (part a to part d) with all the relevant details.

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Part a)

The statement is "True".

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Explanation:

Use of retained earnings will not result in any flotation cost as the company incurs no charges with respect to usage of internal equity. However, cost of raising external equity may involve flotation costs (in the form of legal charges, underwriting fees, etc.). Therefore, the cost of external equity will be higher than the cost of retained earnings in the presence of flotation costs.

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Part b)

If the overall stock market is expected to be booming soon, then one should increase the proportion of high-beta stocks in one’s portfolio

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Explanation:

In a booming stock market, high beta stocks provide greater returns to the investors. It is because such stocks appreciate (on an individual basis) more than the overall market. For Instance, a stock with a beta of 1.5 will provide 1.5 (case of high beta stock) times of the market return. A stock with a beta of 1 will provide the same return as the market. Similarly, a stock with a beta of .5 (case of low beta stock) will provide .5 times of the market return.

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Part c)

If Debt = $1,000, average tax rate = 30% and interest rate = 10%, then the dollar value of tax savings equals $30.

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Explanation:

The value of tax savings will be equal to the amount of tax saved on the amount of interest. It is calculated as below:

Value of Tax Savings = (Amount*Interest Rate)*(Taxes) = (1,000*10%)*30% = $30

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Part d)

In the two-stage DCF method, the present value of the second-stage cash flows is called Terminal Value.

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Explanation:

The two-stage DCF method requires calculation of present value of two types of cash flows as outlined below:

1) Cash flows upto a particular year/period - Also referred to as Interim Cash Flows.

2) Cash flows expected to occur at a constant growth rate after the occurence of interim cash flows - Also referred to as Terminal Value.

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