Questions & explanations
1. What is an anomaly to market efficiency related to dividends?
One anomaly is the 'dividend clientele effect,' where different groups of investors prefer different dividend policies. For example, retirees may prefer high-dividend stocks, while younger investors prefer growth stocks. This creates a clientele that reacts to dividend changes not just for information but for their personal tax situation. If markets were perfectly efficient, all investors would see through taxes and preferences, but in reality, stock prices may react more to dividend announcements than the pure information content suggests. Another anomaly is that stock prices sometimes continue to drift after dividend announcements, contradicting instantaneous adjustment. So these anomalies challenge the strong form of market efficiency.
2. Compare using WACC versus using the required return from the Capital Asset Pricing Model (CAPM) for a project's discount rate.
WACC is the overall cost of the firm's capital, blending debt and equity costs. CAPM gives the required return on equity based on the project's beta. For a project, the appropriate discount rate is its own cost of capital, which may differ from the firm's WACC. If the project is financed with the same mix as the firm, the project's WACC equals the firm's WACC only if project risk matches firm risk. CAPM can compute a project-specific cost of equity, then combine with after-tax debt cost to get a project WACC. Both methods require estimating risk; WACC is simpler for average-risk projects, while CAPM is better for projects with different risk. The choice depends on the project's risk relative to the firm.
3. Compare a mine with high fixed costs vs high variable costs: which is more risky when commodity prices fall?
A mine with high fixed costs is more risky when commodity prices fall. Fixed costs like equipment leases and salaries must be paid regardless of production. If prices drop, revenue declines but fixed costs stay the same, so losses increase quickly. A mine with high variable costs can reduce production or shut down more easily because variable costs go away if no ore is mined. High variable costs mean profit margins are lower, but the mine can adjust. In a downturn, high-fixed-cost mines may operate at a loss for a long time. High-variable-cost mines can cut output to survive. Therefore, investors prefer flexible cost structures in volatile commodity markets.
4. Why might a company's WACC calculated using book values differ from one using market values, and which is better?
Book values come from the balance sheet and reflect historical costs, while market values reflect what investors currently think the firm is worth. Since capital markets determine the actual cost of raising new funds, market values are theoretically superior. Using book values can under- or overstate the true weights, especially if market values differ greatly. For instance, a firm with old debt at low rates has a low book value of debt, but its market value might be higher due to interest rate changes. The correct approach is to use market values for both equity and debt to compute WACC. Most finance textbooks recommend market values for decision-making.
5. Compare the impact of leverage on EPS when a company has high operating income versus low operating income. Give a simple example.
If operating income is high, leverage can boost EPS. For instance, if a company has $2 million operating income, $500,000 interest, and 500,000 shares, EPS = ($2M - $0.5M)/500k = $3.00. With no debt and same income, EPS = $2M/500k = $4.00? Wait, no debt means more shares? Actually, if borrowing to buy back shares, same shares count? Let's adjust: originally no debt, 1M shares, $2M income -> EPS=$2. After borrowing $5M at 5% to buy back 200k shares, net income=$1.75M, shares=800k -> EPS=$2.1875, higher. But if income is low, say $0.5M operating income, then after interest net income=$0, EPS=$0 worse than no debt's $0.50. So leverage magnifies EPS swings.
6. Explain how flotation costs affect the marginal cost of equity.
Flotation costs are fees paid to investment bankers, lawyers, and accountants when issuing new equity. These costs reduce the net proceeds the company receives from the sale. For example, if a company issues shares worth $100 but pays 5% flotation costs, it only gets $95. To achieve a given required return for investors, the company must earn a higher return on the net proceeds. This increases the marginal cost of equity compared to the cost calculated without flotation costs. The adjustment is usually made by dividing the expected dividend or required return by (1 - flotation cost percentage). Thus, flotation costs make new equity more expensive.
7. What is a risk in project management according to the PMBoK guide?
In project management, a risk is an uncertain event or condition that, if it happens, has a positive or negative effect on a project's objectives. Positive risks are opportunities that can bring benefits, while negative risks are threats that can cause harm. For example, a team member getting sick is a threat, but finding a cheaper material is an opportunity. Risks are part of every project and must be managed throughout the project lifecycle. The PMBoK guide provides a structured process to handle risks. This includes planning, identifying, analyzing, responding, and monitoring risks. The goal is to increase the chance of project success.
8. Compare dividend policy in family-owned firms vs widely-held firms.
In widely-held firms with many small shareholders, dividends are used to reduce agency costs by distributing free cash flow. Managers may otherwise waste cash. In family firms, the family often has a long-term view, so they may reinvest more and pay lower dividends. Widely-held firms tend to pay higher dividends to satisfy diverse shareholders. Family firms can afford to be more flexible with dividends because the family understands the business better. However, family firms may have conflicts with minority shareholders over dividend amounts. So the key difference is the balance between control, reinvestment, and shareholder pressure.
9. If a drug costs $1 billion to develop and has a 10% chance of success, what is the expected cost?
The expected cost is not simply $1 billion because the drug may fail. But in financial modeling, the development cost is a sunk cost regardless of outcome. However, to account for risk, you might calculate expected value. The expected value of the drug's returns is probability times payoff. But the question is about cost. Actually, the cost is fixed at $1 billion spent. But if you consider multiple drugs, the expected cost per successful drug is development cost divided by success probability. So for one drug, the expected cost to get one success is $1 billion / 0.1 = $10 billion. This highlights why drug development is so expensive.
10. How does increasing the proportion of debt in the capital structure affect WACC, assuming no taxes?
In a world with no taxes, increasing debt initially lowers WACC because debt is usually cheaper than equity. However, as debt increases, the financial risk rises, making equity more expensive. According to Modigliani-Miller Proposition I without taxes, WACC remains constant regardless of capital structure. The benefit of cheaper debt is exactly offset by the higher cost of equity. So WACC does not change. For example, if you replace expensive equity with cheap debt, the risk to remaining equity holders increases, raising the cost of equity enough to keep WACC the same. Therefore, leverage does not affect firm value in a no-tax world.
11. What working capital challenges do multinationals face?
Multinationals operate in many countries with different currencies, laws, and payment customs. They must manage cash across borders, which can be slow and costly due to exchange rates and transfer fees. They face currency risk that can change the value of receivables and payables. Different countries have different payment terms, so a multinational may have to wait longer for cash in some markets. They also need to coordinate working capital among subsidiaries to avoid excess cash in one place and shortage in another. They use treasury centers to pool cash and optimize netting. Technology helps them monitor working capital globally.
12. Give an example of a strategy to mitigate reputational risk before a crisis happens.
One strategy is to build a strong corporate culture focused on ethics and quality. For instance, a company can have a clear code of conduct and train employees to follow it. Another is to monitor social media and customer feedback to catch issues early. Companies can also develop a crisis communication plan so they respond quickly if something goes wrong. Being transparent about mistakes and taking responsibility helps maintain trust. Additionally, having good relationships with stakeholders like customers and the community builds a 'reputation buffer'. These proactive steps reduce the chance of a reputational crisis and its impact.