Test Bank Ch.3 Conservation Of Value And The Role Of Risk 6e

Chapter: Chapter 03: Conservation of Value and the Role of Risk

True/False

1. The conservation of value principle states that anything that does not increase cash flows does not increase value.

Response: []

2. There are no exceptions to the principle of conservation of value.

Response: [One exception to the principle of conservation of value could be actions that reduce a company’s risk and, therefore, its cost of capital. Technically, only risk reductions that reduce a company’s nondiversifiable risk will reduce its cost of capital.]

3. Changes in accounting techniques that decrease reported profits will necessarily decrease the value of a firm.

Response: [Changing the appearance of cash flows without actually changing the cash flows (say, by changing accounting techniques) doesn’t change the value of a company. For example, in the 1990s, FASB proposed a change to the accounting rules requiring companies to record an expense for the value of options when issued. It was claimed by many that the entire venture capital industry would be decimated because young start-up companies provide much of their compensation through options and thus would then show low or negative profits. Despite dire predictions, the stock prices of companies didn’t change when the new accounting rules were implemented, because the market had already reflected the cost of the options in its valuations of these companies.]

Multiple Choice

4. Which of the following most accurately describes the conclusion of Franco Modigliani and Merton Miller as it relates to the conservation of value principle?

a) Managers can create value by adjusting the capital structure of a firm, which is congruous with the conservation of value principle.

b) Managers cannot create value by adjusting the capital structure of a firm, which is congruous with the conservation of value principle.

c) Managers can create value by adjusting the capital structure of a firm, which is a violation of the conservation of value principle.

d) Managers cannot create value by adjusting the capital structure of a firm, which is a violation of the conservation of value principle.

Response: []

True/False

5. If one uses free cash flows to value a firm, then value may be created through a lower cost of capital.

Response: [If one uses free cash flows to value a firm, then value may be created through a lower cost of capital, assuming that the interest tax shield benefit outweighs the costs of using additional debt.]

6. Because interest expense is tax deductible, share repurchases can have the beneficial effect of increasing earnings per share, which will definitely lead to a share price increase.

Response: [Share repurchases can have the beneficial effect of increasing earnings per share, but this may not increase share price, because the price-to-earnings (P/E) ratio may decline.]

7. Firms should engage in share repurchases only if they do not have available investments with sufficiently high ROIC.

Response: [If a firm cannot achieve a return on its free cash that is above its cost of capital, it should return these funds to shareholders.]

Multiple Choice

8. Which of the following is true concerning the practice of repurchasing shares when the managers correctly determine that the price of the stock is low?

a) The practice does not benefit either the stockholders who do not sell or those who do sell.

b) The practice benefits the stockholders who do sell more than those who do not sell.

c) The practice benefits stockholders who do not sell and those who do sell equally.

d) The practice benefits the stockholders who do not sell more than those who do sell.

Response: []

True/False

9. Studies of share repurchases have shown that companies are very good at timing share repurchases.

Response: [Studies of share repurchases have shown that companies aren’t very good at timing share repurchases, often buying when their share prices are high, not low.]

Multiple Choice

10. Which of the following is NOT true concerning application of the conservation of value principle to acquisitions?

a) An acquisition will create value if it increases cash flows sufficiently by reducing costs.

b) An acquisition will create value if it increases cash flows sufficiently by increasing revenue growth.

c) An acquisition will create value if it increases cash flows sufficiently by improving the use of fixed or working capital.

d) An acquisition will create value if it grows revenues.

Response: [Growing revenues alone does not guarantee value creation. The revenue growth must translate into adequate cash flow increases.]

True/False

11. Multiple expansion is one way that firms can create value through acquisitions.

Response: [The concept of multiple expansion is that the P/E multiple of the low-P/E company will expand to the level of high-P/E company after the acquisition. However, multiple expansions do not create value in themselves. If there aren’t specific sources of increased cash flow, there will be no long-term value creation.]

12. Financial engineering includes the use of derivatives, structured debt, securitization, and off–balance-sheet financing. In some cases financial engineering can create value.

Response: []

13. The primary way that financial engineering can create value is by lowering firm taxes.

Response: [Financial engineering is the use of tools other than straight debt and equity to manage a company’s capital structure and risk profile. As with any change in capital structure, it creates value only if it increases cash flows or reduces the cost of capital, usually STET accomplished by lowering tax obligations.]

14. A company cannot create value through sale-leaseback transactions.

Response: [If a company intends to use the asset for its remaining life (by renewing the lease as it expires), then it will create no value. In fact, it will destroy value because the implied cost of the lease would be higher than the cost of borrowing. However, the transaction may create value if the company wants the ability to stop using the asset before its remaining life expires and wants to eliminate the risk that the value of the asset will be lower when it decides to stop using the asset. Sale-leaseback transactions may also create value if the lessor is better able to use the tax benefits associated with owning the asset, such as accelerated depreciation. In this case, value is created as the total cash flows of the company involved have increased (at the expense of the government).]

15. Risk enters valuation both through a company’s cost of capital and through its cash flows.

Response: [Risk enters into valuation through a company’s cost of capital (which is the price of risk), and in the uncertainty surrounding future cash flows.]

16. Investors demand returns for nondiversifiable risks only.

Response: [If diversification reduces risk to investors and it is not costly to diversify, then investors will not demand a return for any risks they take that they can easily eliminate through diversification. Investors require compensation only for risks they cannot diversify away.]

17. Diversifiable or firm-specific risks, such as the ability to retain talented management and rising input costs, affect a company’s cost of capital.

Response: [For publicly traded companies, nondiversifiable risk affects the cost of capital, and diversifiable risk does not. Diversifiable risk arises from firm-specific factors, such as fluctuations in demand for a firm’s products, the ability to retain talented management, and rising input costs. Since investors can diversify these risks by holding a broad portfolio of stocks, only the nondiversifiable risk affects the cost of capital.]

18. Since diversifiable risks are not priced into the cost of capital, executives can ignore such risks.

Response: [Although undiversifiable risks affecting all companies are the risks that are priced into the cost of capital, executives cannot ignore unique risks that any particular company faces, as those risks can clearly destroy shareholder value. For example, a firm needs to do the best it can to retain top talent, as there may be a negative impact on firm cash flows if they take jobs at other firms.]

19. Managers should hedge cash flow risk whenever possible.

Response: [Managers should hedge cash flow risk only when it has a measurable probability of bankrupting the company. If the existing cash flow risk is sufficient that it could lead to bankruptcy, the managers should employ hedging to eliminate or significantly lower the chances of that possible outcome.]

20. Managers should hedge risks in their core business, as this helps eliminate some risk to investors without any reduction in returns.

Response: [Managers should hedge only risks that are not part of the core business. Investors invest in the company to earn a return from the core business of the company; therefore, managers should not hedge those risks. If those risks were hedged, the potential return would not be obtainable.]