Chapter 5 & 6 Corporate Finance

Market capitalization is a measure of a company's value and is calculated by multiplying the number of shares outstanding by the price per share. This means that the market capitalization reflects the total market value of a company's outstanding shares. Therefore, the statement that market capitalization is obtained by multiplying the number of shares outstanding by the price per share is true.

The cost of equity can indeed be calculated by more than one method. One common method is the dividend discount model (DDM), which calculates the cost of equity based on the present value of expected future dividends. Another method is the capital asset pricing model (CAPM), which calculates the cost of equity based on the risk-free rate, market risk premium, and the stock's beta. These are just a few examples, but there are other methods available as well. Therefore, the statement "The cost of equity can be calculated by more than one method" is true.

The coupon rate of a bond is the fixed interest rate that the issuer pays to the bondholder. It is determined at the time of issuance and remains constant throughout the life of the bond. Therefore, as the price of a bond increases or decreases, the coupon rate does not change. The coupon rate is only affected by factors such as market interest rates and the creditworthiness of the issuer.

A firm can generate equity through both earnings and the issuance of stock. Earnings refer to the profits made by the firm, which can be reinvested back into the company and increase its equity. On the other hand, the issuance of stock involves selling shares of the company to investors, which also increases the equity of the firm. Therefore, both options A and B are correct.

When a bond is valued at par, it means that its current market price is equal to its face value. The yield to maturity (YTM) is the total return anticipated on a bond if it is held until it matures. In the case of a bond valued at par, the YTM is equal to its coupon rate. The coupon rate is the annual interest rate that the bond pays to the bondholder, expressed as a percentage of the face value. Therefore, when a bond is valued at par, the YTM is equal to the coupon rate because the bond is expected to provide a return that matches the interest payments received by the bondholder.

Higher dividends do not necessarily result in higher costs of equity because the cost of equity is determined by the return that investors expect to receive on their investment. Dividends are just one component of the return that investors consider. Other factors such as the company's growth prospects, risk profile, and overall market conditions also play a role in determining the cost of equity. Therefore, even if a company pays higher dividends, if it is able to generate strong returns and maintain a favorable risk profile, the cost of equity may not increase.

The efficient market theory suggests that the prices of securities in the market already incorporate all available information about a company's future prospects. This means that it is not possible for an investor to consistently outperform the market by identifying undervalued or overvalued securities. According to this theory, the market is efficient and any new information is quickly reflected in the prices, making it difficult to gain an advantage. Therefore, the statement that the prices of securities reflect all that is or can be known about a company's future is true according to the efficient market theory.

Book value is based on historical cost because it represents the original cost of an asset when it was acquired. This value does not change over time, regardless of any changes in the market value or depreciation of the asset. The historical cost is recorded in the accounting books and is used to calculate the book value, which is an important metric for assessing the financial health and value of a company.

Earnings dilution is a concept that takes into account the potential impact of acquiring a target firm on the acquirer's net income. It calculates the number of shares that could be issued without diluting the earnings per share (EPS) for the existing shareholders. This means that the target firm's income would be added to the acquirer's net income without negatively affecting the EPS for the existing shareholders. Therefore, the statement is true.

The book value of a firm refers to the value of its assets minus its liabilities, which represents the net worth of the firm. Similarly, the net worth of an individual refers to the value of their assets minus their liabilities. Both concepts essentially measure the financial worth or value of an entity, whether it is a firm or an individual. Therefore, the statement that the book value of the firm is a similar concept to the net worth of an individual is true.

When Company B acquires Company A, it gains access to Company A's unused debt capacity. This means that Company B can now borrow more money and increase its financing capability. This can be beneficial for Company B as it can use the additional funds to invest in growth opportunities, expand its operations, or pay off existing debts. Therefore, the correct answer is a. financing capability.

During a recession, firms with high fixed costs and low variable costs are riskier because they have higher operating expenses that cannot easily be reduced or adjusted to match decreased demand. Similarly, firms with significant manufacturing overhead are also riskier as they have higher fixed costs associated with production facilities and equipment. In both cases, these firms may struggle to cover their fixed costs and maintain profitability during an economic downturn, making them more vulnerable to financial distress.

Company B acquiring Company A to obtain unused production capacity is an example of horizontal integration. Horizontal integration refers to the merger or acquisition of companies operating in the same industry or producing similar products. In this case, Company B is expanding its operations by merging with or acquiring a company that produces a similar product, thereby increasing its production capacity and market share.

When the price of a bond decreases, it means that the bond is being sold at a discount. This discount is usually due to changes in interest rates or perceived risk. However, the coupon rate of a bond is fixed at the time of issuance and does not change with market conditions. Therefore, the coupon rate remains the same even when the bond price decreases.

The acquiror begins the negotiation with both the maximum price it can pay without post-merger earnings per share dilution and the present value of the target's enhanced cash flows in mind. This means that the acquiror takes into consideration both the financial impact on their own company (avoiding dilution of earnings per share) and the potential value that the target company can bring through its cash flows. By considering both factors, the acquiror can determine the optimal price they are willing to pay for the target company.

The target firm determines its liquidation value and the present value of its relevant stand alone cash flows and selects the higher value. This indicates that the target firm is looking for the lowest possible price that it is willing to accept, which is the minimum acceptable price.

To calculate the yield to maturity of a bond, you use the Internal Rate of Return (IRR) technique. IRR is a capital budgeting technique that calculates the discount rate at which the net present value (NPV) of an investment becomes zero. In the case of a bond, the yield to maturity represents the discount rate that equates the present value of all future cash flows (coupon payments and the bond's face value) with the current market price of the bond. Therefore, the correct answer is b. IRR.

The market capitalization is not obtained by multiplying the number of shares outstanding by the earnings per share. Market capitalization is calculated by multiplying the current market price of a company's stock by the total number of outstanding shares. The earnings per share is a measure of a company's profitability and is calculated by dividing the total earnings by the number of outstanding shares.

The Capital Asset Pricing Model (CAPM) is a financial model that relates the historical returns of a company to the market as a whole. It assumes that the risk and return of an investment are determined by the overall market, rather than specific industry or company factors. The CAPM calculates the expected return of an investment based on its beta, which measures the investment's sensitivity to market movements. Therefore, option b is the correct answer as it accurately describes the relationship between the historical returns of a company and the market as a whole according to the CAPM.

The replacement cost refers to the amount of money required to replace or reproduce an asset with a similar one in the current market. It takes into account the current market conditions and prices. Therefore, it represents the maximum price that a target could hope to obtain based solely on its assets. The book value represents the value of the asset as recorded in the company's books, which may not reflect the current market value. The liquidation value represents the value of the assets if they were sold in a forced liquidation scenario.