Q#1 A diversified company has decided to use its overall firm WACC as a performance benchmark for rating its divisional projects and managers for its three divisions. The firm WACC is 12%. The divisional WACCs for its high risk, average risk, and low risk divisions are 16%, 12%, and 8%, respectively. Please explain: (a) What will happen to the firm’s overall risk and market value if the firm WACC (12%) is used to evaluate projects and managers of high risk division; (b) What will happen to the firm’s overall risk and market value if the firm WACC is used to evaluate projects and managers of low risk division; and (c) How would managers of high-risk and low-risk divisions react to using firm WACC as a performance benchmark for managers and divisional investment projects. Remember that WACC can be interpreted as the minimum acceptable return.
Q#2. Some publicly traded firms do stock splits. For example, Apple, Inc. (AAPL) announced a 4 to 1 stock split in August 2020. Nvidia announced a 10 to 1 stock split in May 2024. You read in chapter 14 that, in theory, a 4:1 stock split would increase the number of outstanding shares four fold and cut down the post-split stock price to 1/4 of pre-split price, thus leaving the wealth of Apple’s shareholders unchanged. Unlike Apple, many other successful firms such as Berkshire Hathaway with per share stock prices much higher than Apple’s have not done stock splits. Also, some brokerage firms have cut down the stock trading commission to zero and allowed investors to buy fractional shares of firms. So you are puzzled why some shareholders, traders, and analysts adamantly believe that stock splits benefit shareholders. Please explain whether or not stock splits in general would benefit a firm’s current shareholders with at least a 5-year investment (holding) horizon. You would want to use your understanding of chapter 14 stock split material in your explanation.
Q#3 (Chapter 14). After the 2018 tax law which lowered corporate tax rate from 35% to 21%, an increasing number of U.S. publicly traded firms announced stock buyback (repurchase) programs. Congress prohibited firms from using the 2020 Coronavirus $2.3 trillion stimulus package for stock buybacks. Further, the Inflation Reduction Act of 2022 imposed a 1% tax on the firm’s stock buyback transactions. Please explain what benefits or rationale firms see in stock repurchases and how would investors react to these repurchase programs.
Q#4 (Chapter 15). The M&M capital structure theories in chapters 15 and 21 persuasively argue that the optimal long-term debt is not 0.0% debt due to the tax shield benefit of debt. Table 15-1 in the text shows that, consistent with M&M theories, the average long-run debt to equity ratio in many different industries is positive (e.g., 55% for hotels, 86% for industrial companies, and only 9% for tech sector). Yet many large technology firms, such as Alphabet (Google), Microsoft, and Apple, do not use any long-term debt (or little debt) to finance their operations and new investments. Please explain whether it makes financial sense for big technology firms (do not mix it with start-up tech firms) to use no debt and give up the tax shield benefit of debt. You would want to use your understanding of signaling theory, R&D under asymmetric information theory, financial distress costs, and debt tax shield in your answers.
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