The Phoenix CFA Society Wendell Licon, CFA

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The Phoenix CFA SocietyWendell Licon, CFA

• CFA Level I Exam Tutorial 2013
• Corporate Finance
• Online Video Power Point Slides

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Financial Management

• Agency Problems
• Bondholders vs. stockholders (managers)
• Occur when debt is risky
• Managerial incentives to transfer wealth
• Management vs. stockholders
• Occur when corporate governance system does not
  work perfectly
• Managerial incentives to extract private benefits

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Financial Management

• Agency Problems
• Mechanisms to align management with shareholders
• Compensation
• Threat of firing
• Direct intervention by shareholders (CalPERS)
• Takeovers

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Cost of Capital

• WACC

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Cost of Capital

• kd(1-Tc)
• Where do we get kd from?

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Cost of Capital (debt)

• Example First find the market determined cost of
  issued debt
• 10-yr, 8 coupon bond, trades at 1,050, TC .4
• 1,050
• kd/2 3.644, so kd 7.288
• kd/2(1-Tc) 3.644(1-.4) 2.1864 (semi-annual
  rate)
• kd(1-Tc)2.1864 2 4.3728 (annualized)

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Cost of Capital (debt with flotation costs)

• Flotation Costs
• Example 2 of issue amount, coupon 7.288 if
  issued at par (which is usually safe to assume),
  then
• coupon rate investors YTM
• 980
• kd/2 3.7885
• kd/2(1-Tc) 3.7885(1-.4) 2.2731 (semi-annual
  rate)
• kd(1-Tc)2.2731 2 4.5462 (annualized)

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Cost of Capital (Preferred Shares)

• Already in after-tax form
• Flotation Costs (F) kps Divps/P(1-F)
• Example P 100, Divps 10, F 5
• kps 10/100(1-.05) 10.526

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Cost of Capital (Common)

• Discounted Cash Flow (DCF)
• Simple g assumption?
• Cost of CS Dividend Yield Growth
• Example D1 3/yr, P0 100, g 12
• kcs 15
• What about flotation costs? Multiply P0 by (1 F)

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Cost of Capital (Common)

• What about g?
• g ROE x (plowback ratio) or
• g ROE x (1 payout rate)

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Cost of Capital (Common)

• Capital Asset Pricing Model (CAPM)
• kcs krf ?cs(km krf)

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WACC

• The market is impounding the current risks of the
  firms projects into the components of WACC
• Say Coca Colas WACC is 15, which would be the
  rate associated with non-alcoholic beverages
• Can Coke use 15 to discount the cash flows for
  an alcoholic beverage project?

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WACC

• Coke Example contd
• Say alcoholic beverage projects require 22
  returns
• Security market line

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WACC

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WACC

• Can be used for new projects if
• New project is a carbon copy of the firms
  average project
• Capital structure doesnt materially change
  look at the WACC formula

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WACC

• Dont think of WACC as a static hurdle rate of
  return which, if cleared, then the project
  decision is a go
• If the firm changes its project mix, the WACC
  will change but the risk level of the projects
  already in progress will not neither do the
  required rates of return for those projects

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Cost of Capital- MCC

• Step 1 Calculate how far the firms retained
  earnings will go before having to issue new
  common stock (layer 1)
• Example Simple capital structure
• LT Debt 60 (yielding 8)
• CS 40 (Kcs 15)
• New Retained earnings (RE) 1,000,000 (over
  and above the 40)
• Marginal Tax Rate 40
• Debt Flotation Costs 1 per year
• CS Flotation Costs 1 per year

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Cost of Capital- MCC

• Concept Keep our capital structure of 60/40
  in balance while utilizing our retained earnings
  slack matched with new debt, which is not in a
  slack condition
• Current WACC
• .6(.08)(1-.4) .4(.15) 8.8

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Cost of Capital- MCC

• How far can we go with Layer 2?
• 1,000,000/.4 2,500,000 of new projects costs
  of which
• 2,500,000 .6 1,500,000 in new issue debt
• and 1,000,000 use of retained earnings
• Layer 2 WACC
• .6(.09)(1-.4) .4(.15) 9.24
• Layer 3 would include new projects over 2,500,000
  with flotation costs for equity and flotation
  costs for debt

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Cost of Capital- MCC

• Layer 3 WACC
• .6(.09)(1-.4) .4(.16) 9.64

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Cost of Capital Factors

• Not in the firms control
• Interest rates
• Tax rates
• Within the firms control
• Capital structure policy
• Dividend policy
• Investment policy

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Capital Budgeting

• Payback Period
• The amount of time it takes for us to recover our
  initial outlay without taking into account the
  time value of money.
• The decision rule is to accept any project that
  has a payback period lt critical payback period
  (maximum allowable payback period), set by firm
  policy.

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Capital Budgeting

• Payback Period
• Assume our maximum allowable payback period is 4
  years (nothing magical about 4 years as it is set
  by management)
• Year Accum. Cash Flows
• 1 5MM lt 20MM
• 2 5MM 7 MM 12MM lt20MM
• 3 12MM 7MM 19 MM lt20MM
• 4 19MM 10MM 29 MM gt20MM

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Capital Budgeting

• Payback Period
• Get paid back during the 4th year. We need 1MM
  entering yr 4, and get 10MM for the whole year.
  If we assume 10MM comes evenly throughout the
  year, then we reach 20MM in 1MM/10MM or .1
  yrs.
• So, payback 3.1 years.
• Do we accept or reject the project?
• Accept, since 3.1 lt 4.

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Capital Budgeting

• Discounted Payback Period
• Discount each years cash flow to a present day
  valuation and then proceed as with Payback
  Period.

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Capital Budgeting Net Present Value

• NPV PV (inflows) - PV(outflows)
• NPV ? ACFt / (1 k)t - IO ,
• where,
• IO initial outlay
• ACFt after-tax CF at t
• k cost of capital (cost of capital for the
  firm)
• n projects life
• Decision rule Accept all projects with NPV gt 0

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Capital Budgeting - NPV

• Accepting NPV projects increases the value of
  the firm (higher stock value/equity), kind of
  like you are outrunning the cost of capital

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Capital Budgeting - NPV

• Invest 100 in your 1-yr business. My required
  rate of return is 10. What would be the CF be
  at the end of year 1 such that the NPV 0?
• ACF1 100(1.1) 110 (just the FV!)
• If NPV gt 0, it is the same as ACFt gt 110.

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Capital Budgeting - NPV

• Ex 120. Now, whats the investment worth?
• Just PV of 120 120/1.1 109.09.
• My stock is now worth 109.09, a capital gain of
  9.09 due to you accepting the project. (the 9.09
  is the NPV 120/1.1 - 100 9.09)

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Capital Budgeting - IRR

• IRR is our estimate of the return on the project.
  The definition of IRR is the discount rate that
  equates the present value of the projects
  after-tax cash flows with the initial cash
  outlay.
• In other words, its the discount rate that sets
  the NPV equal to zero.
• NPV ? ACFt / (1 IRR)t - IO 0, or
• ? ACFt / (1 IRR)t IO
• The decision criterion is to accept if IRR gt
  discount rate on the project.

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Capital Budgeting - IRR

• Are the decision rules the same for IRR NPV?
  Think about a project that has an IRR of 15 and
  a required rate of return (cost of capital) of
  10. So, we should accept the project.

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Capital Budgeting - IRR

• What is the NPV of the project if we discount the
  CF at 15?
• Zero - by definition of IRR. Is the PV of the
  CFs going to be higher or lower if the rate is
  10? Higher - lower rate means higher PV. So,
  the sum term is bigger at 10, so the NPV is
  positive gt accept.
• NPV and IRR will accept and reject the same
  projects the only difference is when ranking
  projects.

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Capital Budgeting - IRR

• Computing IRR Case 1 - even cash flows
• Ex. IO 5,000, Cft 2,000/yr for 3 years
• IO CF(PVIFA IRR,3) gt 5,000 2,000(PVIFA
  IRR,3)
• Just find the factor for n3 that 5,000/2,000
  2.5
• For i9, PVIFA 2.5313
• For i10, PVIFA 2.4869
• Its between 9 10 additional work gives 9.7

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Capital Budgeting - IRR

• Case 2 Uneven CFs - even worse
• Trial and Error!
• Ex above IO 20,000, CF1 5,000, CF2 7,000,
  CF3 7,000, CF4 10,000, CF5 10,000
• We have to find IRR such that
• 0 5,000 (PVIF IRR,1) 7,000 (PVIF IRR,2)
  7,000 (PVIF IRR,3) 10,000 (PVIF IRR,4)
  10,000 (PVIF IRR,5) 20,000

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Capital Budgeting - IRR

• NPV at 25 is -563. So, should we try a higher or
  lower rate?
• Lower (gt higher NPV)
• If we try 24, we get NPV -102.97, at 23, we
  get NPV 375
• gt its between 23 24. A final answer gives
  23.8.

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Capital Budgeting - IRR

• IRR has same advantages as NPV and the same
  disadvantages, plus
• Multiple IRRs IRR involves solving a polynomial.
  There are as many solutions as there are sign
  changes in the cash flows. In our previous
  example, one sign change. If you had a negative
  flow at t6 gt 2 changes gt 2 IRRs. Neither
  one is necessarily any good.
• 2. Reinvestment assumption IRR assumes that
  intermediate cash flows are reinvested at the
  IRR. NPV assumes that they are reinvested at k
  (Required Rate of Return). Which is better?
  Generally k. Can get around the IRR problem by
  using the Modified IRR, MIRR.

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Capital Budgeting - IRR

• Multiple IRRs
• 2. Reinvestment assumption

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Capital Budgeting - MIRR

• Used when reinvestment rate especially critical
• Idea instead of assuming a reinvestment rate
  IRR, use reinvestment rate k (kind of do this
  manually), then solve for rate of return.
• 1st separate outflows and inflows
• Take outflows back to present at a k discount
  rate
• Roll inflows forward - reinvest them - at the
  cost of capital, until the end of the project (n)
  - now just have one big terminal payoff at n.
• The MIRR is the rate that equates the PV of the
  outflows with the PV of these terminal payoffs.

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Capital Budgeting - MIRR

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Capital Budgeting - MIRR

• ? ACOFt/(1 k)t (? ACIFt (1 k) n-t) / (1
  MIRR) n
• where ACOF after-tax cash outflows,
• ACIF after-tax cash inflows.
• Solve for MIRR.
• MIRR gt k (cost of capital) gt accept

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Capital Budgeting - MIRR

• Notice, now just one sign change with no multiple
  rate problems
• one positive MIRR
• Plus, no reinvestment problem
• Still expressed as a which people like
• Also, much easier to solve

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Capital Budgeting - MIRR

• Ex Initial outlay 20,000, plus yr. 5 CF
  -10,000. Well use k12
• Draw timeline
• 1. PV of outflows 20,000 10,000(1/1.12)5
  25,674
• 2. FV of inflows yr. 1 CF 5,000 yr. 2 and 3
  CF 7,000 yr. 4 CF 10,000
• YR FV
• 1 5,000(1.12 ) 5-1 5,000(1.12 )4 7,868
• 2 7,000 (1.12 ) 5-2 7,000(1.12 )3 9,834
• 3 7,000 (1.12 ) 5-3 7,000(1.12 )2 8,781
• 4 10,000(1.12 ) 5-4 10,000(1.12 )1 11,200
• -------------
• Sum 37,683

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Capital Budgeting Decision Criteria

• So, NPV and IRR all give same accept/reject
  decisions. But, they will rank projects
  differently
• When is ranking important?
• Capital rationing - firm has fixed investment
  budget, no matter how many NPV projects there
  are out there.

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Capital Budgeting Decision Criteria

• Ex. firm has 5MM
• If firm used IRR to rank, would pick highest IRR
  projects, next highest, etc., until spent 5MM.
  With NPV, pick projects to maximize total NPV
  subject to not spending more than 5MM.
• Mutually exclusive projects - just means cant do
  both. Which do we pick - highest NPV or IRR?

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Capital Budgeting Decision Criteria

• Its easiest to see ranking problems through NPV
  profile - just a graph of NPV vs. discount rates
• By NPV for k lt 10, pick A. For k gt 10 pick B

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Capital Budgeting Decision Criteria

• IRR always pick B
• NPV better it incorporates our k, its how much
  were adding to shareholder value. If k lt 10,
  IRR gives wrong decision.

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Capital Budgeting Post-Audit

• Compare actual results to forecast
• Explain variances

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Cash Flows in Capital Budgeting

• Cash flow is important, not Accounting Profits
• Net Cash Flow NI Depreciation

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Cash Flows in Capital Budgeting

• Incremental Cash Flows are what is important
• Ignore sunk costs
• Dont ignore opportunity costs (think of next
  best alternative)
• What about externalities (the effect of this
  project on other parts of the firm), and
  cannibalization
• Dont forget shipping and installation
  (capitalized for depreciation)

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Cash Flows in Capital Budgeting

• Changes in Net Working Capital
• Remember to reverse this out at the end of the
  project
• Example think of petty cash

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Cash Flows in Capital Budgeting

• Projects with Unequal lives 2 solutions
• Replacement Chain like finding lowest common
  denominator
• Equivalent annual annuity like finding how fast
  the cash is flowing in to the firm

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Cash Flows in Capital Budgeting

• What if projects have different lives?
• Machine 1 cost 24,000, life 4 yrs, net
  benefits 8,000/year
• Machine 2 cost 12,000, life 2 yrs, net
  benefits 7,400/year
• k 10
• NPV1 -24,000 8,000 PVIFA( 10,4) 1,359
• NPV2 -12,000 7,400 PVIFA(10,2) 843
• We cannot compare these like this, since have
  unequal lives.

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Cash Flows in Capital Budgeting

• 1. Replacement chain approach. Construct a chain
  of 2s to get the same number of years of
  benefits (like finding least common denominator)
• Year 0 1 2 3 4
• Inflows 7400 7400 7400 7400
• Outflows -12000 -12000
• Net CF -12000 7400 -4600 7400 7400
• NPV2 1,540
• - so we choose machine 2, not 1

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Cash Flows in Capital Budgeting

• 2. Equivalent annual annuity. Find the annual
  payment of an annuity that lasts as long as the
  project whose PV equals the NPV of the project
• Project 1 NPV EAA (PVIFA 10,4) gt
• EAA 1,359/(PVIFA 10,4)
• 1359/3.1699 428.72
• Project 2 NPV EAA (PVIFA 10,2) gt
• EAA 843/1.7355 485.74

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Cash Flows in Capital Budgeting

• Dealing with Inflation
• As long as inflation is built into your cash flow
  forecast, you are OK because your discount rates
  should already take expected inflation into
  account

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Risk Analysis

• Types of Risk
• Stand-alone risk think total risk or variance
  (or standard deviation)
• Corporate (within firm) risk think of the firm
  as a portfolio of projects but not a completely
  diversified portfolio
• Market risk think systematic or beta

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Risk Analysis

• Modeling Methods
• Sensitivity Analysis
• Find the effect of a change due to a single
  variable change at a time
• Scenario Analysis
• Find the effect of many simultaneous changes
  (brought on by different scenarios)
• Monte Carlo Simulation
• Find the distributional effect of a number of
  random changes on repeated attempts

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Risk Analysis

• Market Risk
• Security Market Line
• kcs krf ?cs(km krf)
• Measuring Beta
• The pure play method
• Find a market traded firm whose only business is
  what you are interested in
• Accounting beta method
• Accounting ROA of firm versus Average Accounting
  ROA for market construct (Text says SP 400)

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Risk Analysis

• Investment Opportunity Schedule vs Marginal Cost
  of Capital

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Capital Structure and Leverage

• Factors influencing a firms decision
• Business risk - DOL
• Taxes
• Financial flexibility - DFL
• Managerial conservatism risk aversion

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Capital Structure and Leverage

• Business Risk
• Break-even Operating Quantity
• Degree of Operating Leverage (DOLS)
• A measure of the degree to which fixed costs are
  used
• High Fixed Costs gt High Operating Leverage

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Capital Structure and Leverage

• Financial Risk
• Degree of Financial Leverage (DFLEBIT)
• A measure of the degree to which debt is used
• The higher the firm relies on debt, the greater
  the DFL will be

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Capital Structure and Leverage

• Combined Risk
• Degree of Total Leverage (DTLS)
• Measure of the combined leverage utilized by a
  firm
• DCLS DOLS X DFLEBIT

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Capital Structure and Leverage

• Miller and Modigliani 1958
• The value of the firm is independent of its
  capital structure, i.e., the financing mix is
  irrelevant (Miller and Modigliani 1958)
• Proposition VU VL

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Capital Structure and Leverage

• Assumptions
• Perfect capital markets
• No taxes
• No transaction costs
• Borrow and lend at the same rate
• No bankruptcy costs
• Homogenous preferences and beliefs
• Firm issued debt is risk-free (no chance of
  bankruptcy)

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Capital Structure and Leverage

• Relax the Assumptions
• Introduce Taxes more debt is better
• Relax no bankruptcy assumption at some point,
  more debt reduces the value of the firm
• The above is really trade-off theory

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Capital Structure and Leverage

• Effect of WACC

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Capital Structure and Leverage

• Signaling Theory
• Signals must be costly
• New equity issue signal
• New debt issue signal

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Dividend Policy

• Dividend policy must strike a balance between
  future growth and the need to pay investors cash
• MM irrelevance (homemade dividends)
• g ROE x (1 payout ratio)
• Signaling through dividends

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Dividend Policy

• Residual Dividend Model
• Dividend policy set to pay out cash that is not
  need for investment or for reserve cash reasons

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Dividend Policy

• Timing
• Declaration date declared by the board
• Holder-of-record-date the last date that a
  person can hold the stock and still receive the
  dividend
• Ex-dividend date the first date that a stock
  trades without rights to the dividend
• Payment date

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Dividend Policy

• Stock Dividends and Splits
• Splits increasing the number of shares by a
  multiple
• Dividends the dividend is paid in stock instead
  of cash
• Price effects of stock dividends and splits
• Prices generally rise after the announcement
• Signal? Higher cash dividends in the future?

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Dividend Policy

• Repurchases
• Advantages
• Positive signal to repurchases shares
• Targeted dividends
• Remove a large block
• Get cash in investors hands without future
  expectations
• Capital structure changes
• Disadvantages
• Investor indifference, informational asymmetry
  among investors, paying to high a price for shares