Question 1

(a) (i) Explain the meaning of the terms "residual payout policy" and "managed payout policy".

(ii) Does the empirical evidence suggest that U.S. and European companies follow a residual or a managed payout policy?

(b) Explain the term "payout clientele", and outline explanations of corporate payout policy (i.e. repurchase and dividend payout decisions) focusing on tax clientele effects

Question 2

Giving examples where possible, discuss any threeof the following

(a) Analysts' valuation of stocks

(b) Fisher's separation theorem

(c) Long term performance of initial public offerings (IPOs)

(d) Going private and the role of private equity

Question 3

(a) Sports Plc's shares are currently trading at 130 pence per share. Security analysts are forecasting a long-term earnings growth rate of 9%. The company has just paid a dividend of 8 pence per share.

(i) Assume dividends are expected to grow along with earnings at 9% per year in perpetuity. What rate of return are investors expecting?

(ii) Sports is expected to earn about 9% on book equity and to pay out 30% of earnings as dividends. Based on these forecasts, what is the growth rate of dividends? What is the rate of return that investors expect?

(b) Consider three Government bonds (with a face value of £100): (i) 8 percent, 3 year; (ii) 8 percent, 5 year; and (iii) 5 percent, 5 year. Assume coupons are paid annually. If interest rates are a constant 6 percent, calculate the values of these bonds and, for each possible pairwise comparison, state which bond will show the greater percentage change in value if interest rates change.

(c) On a bank loan, Bank Alpha quotes you 12 percent compounded weekly, Bank Beta quotes you 12.1 percent compounded quarterly, while Bank Gamma quotes you 12.25 percent compounded annually. Calculate these banks' effective annual rates (EARs) and comment on your answers.

Question 4

(a) What were the main findings of Lintner's 1956 study on the dividend policy of US corporations, and how have they been interpreted?

(b) Consider the typical time line of the cash dividend payment of a US company from the decision to pay out a dividend to the actual payment date. Sort the following four events into chronological order and explain what happens at each of the four dates.

Ex-dividend date

Payment date

Record date

Declaration or announcement date

(c) Briefly explain what is meant by ANY THREE of the following four terms:

Open-market repurchase

Fixed-price tender offer

Dutch-auction self-tender offer

Targeted repurchase

Question 5

(a) ModiglianiInc. is a company that operates in a world with perfect capital markets (including no taxation). Its annual net operating income (NOI) is $1,000,000, and it is financed entirely by equity with a market value of 5 million.

The company is planning to buy back a substantial part of its own shares from its shareholders at the current market value of its shares. The buyback is to be funded entirely by the proceeds of a corporate bond issue. After the bond issue and buyback the company expects to have an equal amount of debt (D) and equity (E), i.e., D/E = 1.

Required:

(i) Calculate the rate of return on equity given the present capital structure of the company (entirely equity-financed). Briefly explain your method and result.

(ii) Calculate the rate of return on equity following the proposed capital-structure change assuming that (at the new D/E ratio) the company faces a cost of debt of 10 percent. Briefly explain your method and result, and comment on your assumptions.7 marks

(iii) The company management approaches you for advice on its capital structure. Can you suggest an optimal capital structure that maximises the company value and minimises the cost of capital faced by the company?

(b) Explain why companies tend to prefer internal to external funds when financing profitable investment projects. Draw on existing theories and relevant empirical findings.