High price-low volume strategy

Fin 325, 10/1/2020                                                   QUIZ 3—in class version

30 pts. total

 

You will get this quiz paper back.  Please insert your note page(s) behind this page when done.  You MUST enter all your responses in writing (below) AND electronically in your iClicker.  (Remember to scroll forward to the next question, after entering each response.)

 

True/False (2 points for each question, 6 questions, 12 points total)

Indicate whether the sentence or statement is true (write “T” below) or false (“F”).  Choose “A” on your iClicker for True responses and “B” for False responses.

 

1. Consider the following Beacon simulation competition in the Sigma product market.

 

From the data above, it appears that a high price-lov volume strategy generates less gross profit than a low-price high-volume strategy.  (Note that there are 5 teams competing in the Directions world, but all other aspects of the simulation were the same as for your class.)

 

2. Consider a levered firm with no taxes.  As earnings before interest and taxes (EBIT) increase, the earnings per share (EPS) also increase, but at a faster rate than EBIT.

 

3. A rights offering consists of intentionally underpriced, newly-issued equity.  However, the underpriced new equity is offered equally to all shareholders.  This represents a fair deal to all shareholders.

 

4. Consider the impact of the payment of a dividend on a levered firm’s market value balance sheet.  (Recall V=D+E.)  All else equal, the firm’s leverage ratio should decrease at least a small amount on the ex-dividend date.

 

(Assume the payment of the dividend equals the dividend expected by investors and thus imparts no additional information to investors. )

 

5. Recall the scene from the movie “The Social Network” that we reviewed in class.  The main idea of the scene that we reviewed was that raising capital by issuing additional Facebook shares hurt all the existing investors as their shares were equally diluted by the additional capital raised.

 

6. Generally, investors view the cancellation of an open-market repurchase program as good news and the stock price increases.

 

 

Multiple Choice (3 points for each question, 6 questions, 18 points total)

Identify the letter of the choice that best completes the statement or answers the question.  For numerical problems, choose the response closest to the number you calculate.

 

7. In Year 9 of the Beacon Simulation, our class had 22 missed forecasts (for revenue and net income) and 2 “beats,” indicating that actual results for our class were significantly worse than our forecasts.  Which economic problem predicts this situation?

a.	Asymmetric information	d.	Adverse selection bias
b.	Moral hazard	e.	Rational herding
c.	Overconfidence bias

 

 

8. Which of the following statements regarding the dividend payout controversy is not correct?

a.	The middle-of-the-road position is supported by the idea that there do not exist any unsatisfied clienteles who desire either lower or higher dividends.	d.	The leftists believe in low or no dividend payouts.
b.	The rightist position is a more “show me the money!” approach.	e.	All of the other statements are correct.
c.	The rightists are very concerned with the tax impact of dividends.

 

 

9. Suppose that tax rates on ordinary income increase substantially while capital gains tax rates decrease.  Which of the following dividend theories becomes stronger as a result?

a.	The Leftists	c.	The Rightists
b.	The Centrists	d.	None of the theories becomes stronger.

 

 

10. Hardmon Enterprises is currently an all-equity firm with an expected return of 10%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares.

 

Suppose Hardmon borrows to the point that its debt-equity ratio is 0.40. With this amount of debt, the debt cost of capital is 5%. What will the expected return of equity be after this transaction?

 

a.	11%	d.	14%
b.	12%	e.	15%
c.	13%

 

 

 

 

11. Consider the situation that Rubio’s restaurants was in prior to its pre-packaged bankruptcy.  Which of the following would NOT be considered costs of financial distress?

a.	For a given pay grade, Rubio’s is likely to lose the best employees who seek to work at a more financially solid firm.	d.	Existing lenders will be less willing, or unwilling, to rollover any debt that matures.
b.	Rubio’s would have greater difficulty maintaining or acquiring credit terms from its suppliers.	e.	All of the other choices represent costs of financial distress.
c.	Customers–despite press releases from Rubio’s–may begin to doubt whether Rubio’s will remain open.

 

 

12. An all-equity firm has a market value of $1,000M. Expected annual earnings (EBIT) is $100M.  (Assume no taxes.) There are two equally likely cases for EBIT, either $150M or $50M.

You can verify (if you have a lot of extra time) that the expected return (net income/market value of equity) for this firm is 10%.

Now assume that the firm takes out $100M of debt at 5% and uses that debt to repurchase shares.

Given the same two equally likely outcomes for EBIT, what now is the expected return for this firm?  (Note that this question has 6 answer responses, responses a) through f),  i.e. 1 more than the usual 5 answers responses.)

 

 

 

a.	9.5%	d.	11.0%
b.	10.0%	e.	11.5%
c.	10.5%	f.	12.0%

 

 

 

Finance 325, Fall 20, Quiz 3

Answer Section

 

TRUE/FALSE

 

1. ANS:   T

The two teams with the slightly higher price had the lowest unit sales (34 and 36) and the lowest Gross Profit ($11.3M and $11.5M).

 

PTS:    1

 

2. ANS:   T

In a levered firm, EPS reacts more strongly than EBIT.  (See the chart in Chapter 17.)

 

PTS:    1

 

3. ANS:   T                      PTS:    1

 

4. ANS:   F

Payment of the dividend reduces both V and E, leaving D unchanged (all else equal).

 

That means, since V’<V, the debt ratio has increased at least somewhat.

 

(Since there is no informational content to the dividend, the amount of E is not changing due to the payment of the dividend.)

 

PTS:    1

 

5. ANS:   F

As mentioned in the movie clip, Mr. Saverin’s shareholding was reduced by a factor of 1000, from 30% shareholder to 0.03%.  Meanwhile, the other shareholders (Zuckerberg, Thiel, Parker, Moskovitz) were not diluted.

 

Would be nice to own 30% of FB, wouldn’t it?

 

PTS:    1

 

6. ANS:   F

The announcement of a new share repurchase program would be viewed as good news.

 

PTS:    1

 

MULTIPLE CHOICE

 

7. ANS:   C                     PTS:    1

 

8. ANS:   C                     PTS:    1

 

9. ANS:   A

The leftists propose low dividend rates to take advantage of the lower capital gains tax rates.

 

PTS:    1

 

10. ANS:   B

r_e = 10% +0.4*(10%-5%) = 12%

 

You can check that a D/E ratio of 0.4 implies  a debt ratio of 0.4/1.4 = 28.6% debt and thus an equity ratio of 71.4%.  Thus the r_A = 0.286*5% + 0.714*12% = 10%.

 

PTS:    1

 

11. ANS:   E                     PTS:    1

 

12. ANS:   C

V         = D + E

1,000   = 0 +                1,000

After taking on debt

1,000   = 100   +          900

 

Net Income will now equal either 150-5=145 or 50-5 = 45.  Expected net income is now 95.

 

Expected return is now 95/900 = 10.55%

 

You can also verify: r_e=r_a + (D/E)(r_a – r_d) = 10% + (1/9)(10%-5%) = 10.55%.

 

PTS:    1