Question

1. Capital Structure Question:

a) Provide a definition of financial risk. [4 Marks]

b) Under the perfect market conditions that there is no corporate tax, no bankruptcy costs and agency costs, what will happen to the equity return when a firm increases its debt level? [6 Marks]

c) Describe the possible types of bankruptcy costs covered in capital structure theory.

2. Dividend Policy Question

a) Describe the economic nature of dividend payment and the most popular ways of paying dividend. [6 Marks]

b) Explain why “stock dividend” is not a real dividend payment in nature. [4 Marks]

c) Describe how an equity holder’s income tax rate level might influence his/her preference between cash dividend and share repurchasing programs

Answer 1

1. a) Financial risk is the possibility that shareholders or other financial stakeholders will lose money when they invest in a company that has debt if the company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors are repaid before shareholders if the company becomes insolvent.

Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money.

b) The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock.

c) The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore a highly levered firm has a higher risk of bankruptcy. Bankruptcycosts vary for different types of firms, but they typically include:

1. legal fees,

2. losses incurred from selling assets at distressed fire-sale prices,

3. increased borrowing costs due to poorer credit, and the departure of valuable human capital.

4. Bankruptcy costs can also affect intangible assets and include indirect costs. For example, bankruptcy could tarnish a company’s reputation and brand equity, causing it to lose market share and competitive positioning.

5. It can also cause suppliers to tighten trade credit terms and cause the loss of customers.

The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on. Debt can destroy a company, but it can be managed.

2. a) Definition: Dividend refers to a reward, cash or otherwise, that a company gives to its shareholders. Dividends can be issued in various forms, such as cash payment, stocks or any other form. A company’s dividend is decided by its board of directors and it requires the shareholders’ approval. However, it is not obligatory for a company to pay dividend. Dividend is usually a part of the profit that the company shares with its shareholders.

Description: After paying its creditors, a company can use part or whole of the residual profits to reward its shareholders as dividends. However, when firms face cash shortage or when it needs cash for reinvestments, it can also skip paying dividends. When a company announces dividend, it also fixes a record date and all shareholders who are registered as of that date become eligible to get dividend payout in proportion to their shareholding. The company usually mails the cheques to shareholders within in a week or so. Stocks are normally bought or sold with dividend until two business days ahead of the record date and then they turn ex-dividend.

2. b) A stock dividend is not a real dividend payment in nature because it is a dividend payment made in the form of additional shares rather than a cash payout. Companies may decide to distribute this type of dividend to shareholders of record if the company's availability of liquid cash is in short supply. These distributions are generally acknowledged in the form of fractions paid per existing share, such as if a company issued a stock dividend of 0.05 shares for each single share held by existing shareholders.