1. Capital Structure Question: When we analyze a firm’s financial condition, we
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Question
1. Capital Structure Question: When we analyze a firm’s financial condition, we usually treat its business risk and financial risk separately.
a) Describe what is meant by business risk and discuss the possible measures a firm can take to make an adjustment on this. [5 Marks]
b) Describe how can a direct bankruptcy cost influence a firm’s future cash flows and explain why it is categorized as a type of financial risk. [5 Marks]
c) Briefly describe on how indirect bankruptcy costs could impact a firm’s market value.
2. . Dividend Policy Question: Benartzi et al. (1997, p. 1032) conclude, “Lintner’s model of dividends remains the best description of the dividend setting process available.”
a) Describe the Lintner’s model of dividends. [8 Marks]
b) Describe the major differences between residual dividend theory and managed dividend policy.
3.Corporate Mergers Question:
The underlying principle behind mergers and acquisitions (M&A) is simple: 2 + 2 = 5.
a) Describe the meaning of synergy in your own words. [5 Marks]
b) The firm value is determined by the present value of future net profits. From this formula we classify synergy value into three forms. Briefly describe these three forms. [5 Marks]
c) Many mergers are driven by the need to cut costs. Provide your explanation on why this is true.
Explanation / Answer
Answer(1): (a): Yes, when we analyze a firm’s financial condition, we usually treat its business risk and financial risk separately, there are some difference between business risk and financial risk those are as following:
How to make adjustment for business risk- Companies should make budget and do proper forecasting so that they can compare the actual results with the budgeted results and variance can be known and company can come to know where the cost is increasing and how to reduce it to increase the profit.
(b): A direct bankruptcy cost can affect a company's capital structure because its cost of capital will increase. Higher cost of company decreases the future cash flow of the company because company has to pay heavy interest amount out of the profits.
Answer(3): Yes, The underlying principle behind mergers and acquisitions (M&A) is simple: 2 + 2 = 5.
(a): Synergy- It means the same energy, this is a strategy of working together when two firms work together to achieve their goals so that it may be a win win situation for both the firms, this is called synergy. Synergy is not 1+1 = 2 rather it is 1+1 = 11.
(c): Yes, this is true, merger reduce the cost of companies because combined value of merged companies is generally higher than their previous value due to synergy. Synergy increases the profits and decreases cost. Companies get economies of scale when merged.
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