FIN325 Practice Final
For every dollar of operating income paid out as interest, the bondholder realizes
(1 - Tp).
For every dollar of operating income paid out as equity income, the shareholder realizes
(1- TpE)(1- TC).
If an investor buys a portion ( X) of the equity of a levered firm, then his/her payoff is
(X) × (profits - interest)
If an investor buys a portion ( X) of both the debt and equity of a levered firm, then his/her payoff is
(X) × (profits).
The average yield spread based on promised yield on Aaa bonds rated by Moody's and the yield on Treasuries is about
1 percent.
According to the Cambridge Associates, venture capital funds earn an average annual rate of return (after expenses) of about
13 percent.
Generally, which of the following is true? ( b = beta)
A) bD< bA< bE
An example of a real option is
A) the option to make follow-on investments. B) the option to abandon a project. C) the option to wait before investing. D) All of the options are correct.
Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions is co-firing equipment most valuable? Let ac be the annual standard deviation of coal prices, and let an be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices.
Ac high, An high, P low
The following are indicators that the firm has a cash surplus:
Competitors' stock prices are dropping, the firm has a low debt ratio compared to similar firms, and the firm has sufficient debt capacity to cover unexpected opportunities or setbacks.
What term might be used to describe an underwriter who influences an analyst in the same firm to modify a report so as to create a favorable impression of a securities issue?
Conflict of interest
Which of the following investors has the strongest tax reason to prefer dividends over capital gains?
Corporations
Which of the following lists events in chronological order from earliest to latest?
Declaration date, ex-dividend date, record date
Which of the following is not a potential result from financial distress?
Due to interest tax shields, the firm's effective tax rate is very low.
Suppose that there are no taxes, transactions costs, or other market imperfections. Which of the following actions is most likely to make shareholders better off?
Eliminate negative-NPV projects.
Given corporate taxes, why does adding debt to the capital structure increase firm value?
Extra cash flow goes to the firm's investors rather than the tax authorities.
If investors do not like dividends because of the additional taxes that they have to pay, how would you expect stock prices to behave on the ex-dividend date?
Fall by less than the amount of the dividend
Which of the following statement(s) regarding financial distress is (are) true?
Firms can postpone bankruptcy for many years, and, ultimately, the firm may recover from financial distress and avoid bankruptcy altogether.
The underwriter's spread is the highest for
IPOs.
Under what conditions would a policy of maximizing the value of the firm not be the same as a policy of maximizing shareholders' wealth?
If an issue of debt affects the market value of existing debt
The dividend-irrelevance proposition of Miller and Modigliani depends on the following relationship between investment policy and dividend policy:
Investment policy is independent of dividend policy.
What is the likely impact on a typical individual investor if a firm undertakes a stock repurchase in lieu of a cash dividend?
Lower income taxes, if capital gains tax rates are less than dividend tax rates
If an oil well allows the investor the option to drill later, what must happen for the option to be exercised?
Oil prices must be high relative to possible future prices.
Under the trade-off theory, how will a government loan guarantee impact financing?
Prefer to issue debt
The following are practical challenges in applying real-options analysis:
Real options can be complex, the real options problems may not be well structured, and competition may reduce or change the value of real options.
A general cash offer involves the following processes:
Register the issue with the SEC, sell the securities through an underwriter or a syndicate of underwriters, have an underwriter build up a book of likely demand for the securities, fix the price of the issue, and sell the securities to the public.
The SEC provision under which qualified institutional investors can trade privately placed securities among themselves is called
Rule 144A.
What are the tax consequences of a taxable merger?
Selling shareholders must recognize any capital gain.
What signal is sent to the market when a firm decides to issue new stock to raise capital?
Stock price is too high.
Who usually gains the most in a merger?
Target firm's shareholders
Which of the following actions by an acquiring firm signals its belief that postmerger gains will be substantially larger than expected?
The acquiring firm makes a cash offer, since this allows the acquirer to solely benefit from gains not yet reflected in the market.
The "Bootstrap Game" may mislead investors regarding the prospects for a merged firm. How are investors potentially misled?
The firm acquires a target with low a P/E ratio, which generates short-term earnings per share growth without any true economic advantage.
Which of the following is a possible exception to the efficient-market theory?
The long-run returns of IPOs tend to underperform the market.
Suppose an investor sells (writes) a put option. What will happen if the stock price on the exercise date exceeds the exercise price?
The owner will not exercise the option.
The following statements are true of dividend reinvestment plans (DRIPs):
They are offered by the companies to their shareholders; generally, new shares are issued at a discount; and the dividends are taxable as ordinary income.
In an EPS-operating income graph, such as Figure 17.1, the slope of the line is steeper when the debt ratio is higher. The debt line has a negative intercept because
a fixed interest charge must be paid even at low earnings.
The rightist position is that the market will reward firms for having
a high dividend yield.
As a defensive maneuver, a firm issues deep-discount bonds that are redeemable at par in the event of an unfriendly takeover. These bonds are an example of
a poison pill.
Consider an electric utility that may use either coal or natural gas to generate electricity. Under which of the following conditions is co-firing equipment least valuable? Let ac be the annual standard deviation of coal prices, and let an be the annual standard deviation of natural gas prices and p the correlation between coal prices and natural gas prices.
ac low, an low, p high
If a shareholder or an investor wants to acquire a new share of stock under a rights issue, he or she must
acquire the appropriate number of rights per share and subscription price per share and submit them to the subscription agent.
The following are examples of "disguised options":
acquiring growth opportunities, ability of the firm to terminate a project when it is no longer profitable, and covenants within corporate securities that provide flexibility to change the terms of the securities.
In a uniform-price auction,
all winning bidders pay a price that is the lowest winning bid.
The very first public equity sold by a company is referred to as
an initial public offering (IPO).
For a levered firm,
as EBIT increases, EPS increases by a larger percentage.
For an all-equity firm,
as earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percentage.
The value of a corporate bond can be thought of as
asset value - value of call option on assets.
Miller and Modigliani's indifference proposition regarding dividend policy
assumes that investors can sell their stock at a fair price.
Which of the following is true?
bE> bA> bD
SEC registration is not required when a company makes
both a private placement of securities and a public offering of securities issue having a value less than $5 million and a maturity less than nine months. .
A put option gives the owner the right
but not the obligation to sell an asset at a given price.
An investor can create the effect of leverage on his/her account by
buying equity of a levered firm and borrowing on his/her own account.
Capital structure is irrelevant if
capital markets are efficient, each investor can borrow/lend on the same terms as the firm, and there are no tax benefits to debt.
MM Proposition I with corporate taxes states that
capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; and, by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.
Financial slack includes
cash, marketable securities, readily salable real assets, and ready access to debt markets or bank loans.
Value additivity works for
combining assets, splitting up of assets, and the mix of debt securities issued by the firm.
Large firms like Intel that provide equity capital to new innovative companies are called
corporate venturers.
In order to find the present value of the tax shields provided by debt, the discount rate used is the
cost of debt.
According to evidence from surveys of CFOs, the top-most motive for firms to go public is to
create public shares for use in future acquisitions.
The following are dubious reasons for mergers:
diversification, increased earnings per share (EPS), and lower financing costs.
The following are sensible motives for mergers except
diversification.
Even if both dividends and capital gains are taxed at the same ordinary income tax rate, the effect of each type of tax is different because
dividends are taxed when distributed, while capital gains are deferred until the stock is sold.
In terms of real options, the cash flows from the project play the same role as
dividends.
Venture capitalists provide start-up companies
enough money at each stage so that they can reach the next stage or major checkpoint.
The cost of capital for a firm, rWACC, in a tax-free environment is
equal to the market value weighted average of the return on equity and the return on debt; equal to rA, the rate of return for that business risk class; and equal to the overall rate of return required on the levered firm.
The U.S. government agrees to guarantee a bond issue planned by Demurrage Associates (DA). The value of this guarantee
equals the value of the guaranteed loan minus the value of the loan without a guarantee, is a subsidy to DA's equity investors, and equals the value of a put option on the firm's assets with an exercise price equal to the bond's promised payments.
If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by
equity beta = (1 + debt-equity ratio)(beta of assets).
The value of a put option is positively related to the
exercise price, time to expiration, and volatility of the underlying stock price
The value of a call option is negatively related to the
exercise price.
The effect of financial leverage on the performance of the firm depends on the
firm's level of operating income.
An EPS-operating income graph, such as Figure 17.1, shows the
greater risk associated with debt financing, which is evidenced by a greater slope, the break-even point where EPS of two different debt ratios are equal, and the minimum operating income needed to pay the interest for a given level of debt.
The value of a put option at expiration equals the
higher of the exercise price minus market price of the share and zero.
The U.S. federal government has guaranteed loans to the following industries
housing, airlines, ship owners and shipyards, steel companies, and oil and gas companies.
The pecking order theory of capital structure predicts that
if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal.
The main advantage of debt financing for a firm is that
interest expenses are tax deductible.
When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to
issue large quantities of low-quality debt versus low quantities of high-quality debt, favor paying high dividends to shareholders, and delay the onset of bankruptcy as long as they can.
A poison pill defense may be implemented by
issuing rights at a cheap price.
The par value of the outstanding shares is known as
legal capital.
When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these will result in
positive agency costs, as bondholders act on various restrictions and covenants, which will diminish firm value.
When a company sells an entire issue of securities to a small group of institutional investors like life insurance companies, pension funds, and so forth, it is called a(an)
private placement.
The costs of financial distress depend on the
probability of financial distress and the magnitude of costs encountered if financial distress occurs.
When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt
stay fixed, leaving more income to be distributed over fewer shares.
The value of a put option is negatively related to the
stock price.
Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the
stockholders of the firm.
If an acquisition is completed using a cash payment, then the acquisition is
taxable.
If a corporation cannot use its interest payments as a tax shield for a particular year because it has suffered a loss, it is still possible to use the tax shield because
the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years and allows corporations to carry forward the loss and use it to shield income in subsequent years.
In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then
the tax shield on debt is exactly offset by higher personal taxes paid on interest income.
The law of conservation of value implies that
the value of any asset is preserved regardless of the nature of the claims against it.
A rational manager may be reluctant to commit to a positive net present value project when
the value of the option to wait is high.
Dividend policy may affect firm value because
there is an unsatisfied clientele that prefers dividends to capital gains, and well- managed companies prefer to signal their worth by paying high dividends.
One possible reason that shareholders often insist on higher dividends is
they do not trust managers to spend retained earnings wisely.
The following are sensible motives for mergers:
to prevent the target firm from wasting surplus funds, to eliminate target firm inefficiencies, and to acquire complementary resources.
The winner's curse is reduced in a(an)
uniform-price auction.
The value of any option (both call and put options) is positively related to the
volatility of the underlying stock price and time to expiration.
Which of the following features increase(s) the value of a call option?
A high interest rate, a long time to maturity, and a higher volatility of the underlying stock price
Which of the following entities likely has the highest cost of financial distress?
A pharmaceuticals development company
Consider the procedure whereby the firm states a series of prices at which it is prepared to repurchase stock. Shareholders then submit offers indicating how many shares they wish to sell and at which price. The firm then calculates the lowest price at which it is able to buy the desired number of shares. This procedure is known as a(n)
Dutch auction.
What are some of the possible consequences of financial distress?
Equity investors would like the firm to shift toward riskier lines of business.
Which of the following answer is true?
Firms have long-run target dividend payout ratios, dividend changes follow shifts in long-term sustainable earnings, and managers are reluctant to make dividend changes that might have to be reversed.
Consider the payout policies of U.S. firms from 2003-2013. Which category had the highest percentage of firms?
Firms that paid no dividends and did not repurchase shares
According to survey data, which is the least-often cited dividend policy consideration?
Firms would prefer to raise new funds rather than reduce dividends.
Which of the following is not an important piece of U.S. antitrust legislation?
Garn-St. Germain Act
Which of the following conditions might lead a financial manager to decide to expedite a positive net present value investment project?
Investment required for the project is expected to increase in the near future.
The three main bond rating agencies in the United States are
Moody's, Standard and Poor's, and Fitch.
The stock exchange that specializes in trading the shares of young and rapidly growing companies is the
NASDAQ.
According to the graph of WACC for Union Pacific, which of the following is (are) true?
The cost of equity is an increasing function of the debt-equity ratio, the cost of debt is an increasing function of the debt-equity ratio, and the weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.
Which of the following statements best describes shelf registration?
The provision that allows large companies to file a single registration statement covering financing plans up to three years into the future
Which of the following conditions might lead a financial manager to delay a positive- NPV project? (Assume that project NPV—if undertaken immediately—is held constant.)
Uncertainty about future project value increases.
What costs in an IPO generally exceed all other costs?
Underpricing
Arrange the following in chronological order for a typical start-up firm:
VC financing; stage 1, 2, 3, 4, and so forth, financing; mezzanine financing; and IPO.
Which of the following statements is generally true of venture capital (VC) firms?
VCs generally provide management advice and contacts in addition to capital.
MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as
VL= VU+( TC)( D).
If firm U is unlevered and firm L is levered, then which of the following is true?
VU= EUand VL= EL+ DL.
The after-tax weighted average cost of capital (WACC) is given by (corporate tax rate =TC):
WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)
What does "risk shifting" imply?
When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.
The following are methods available to change the management of a firm:
a successful proxy contest in which a group of shareholders vote in a new board of directors, who then pick a new management team; a takeover of one firm by another firm; and a leveraged buyout of the firm by a private group of investors.
The discounted cash flow (DCF) approach should be
augmented by added analysis if a decision has significant imbedded options.
For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta ( bE) equals
bE= bA+( D/ E)×[ bA- bD].
The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because
bankruptcy and its attendant costs are a disadvantage to debt, and the payment of personal taxes may offset the tax benefit of debt.
State laws that regulate sales of securities within the state are called
blue-sky laws.
The value of a corporate bond can be thought of as
bond value without default - value of put.
Generally, firms engage in stock repurchases during
boom times as firms accumulate excess cash.
Generally, you can insure corporate bonds through a(n)
credit default swap.
Firms regularly use the following to reduce risk:
currency options, interest-rate options, and commodity options.
When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to
favor high-risk, high-return projects even if they have negative NPV, refuse to invest in low-risk, low-return projects with positive NPVs, and delay the onset of bankruptcy as long as they can.
The pecking order theory of capital structure implies that
firms prefer internal finance and firms prefer debt to equity when external financing is required.
According to an EPS-operating income graph, such as Figure 17.1, EPS is higher when expected operating income is
greater than the break-even income.
The writer (seller) of a regular exchange-listed put-option on a stock
has the obligation to buy 100 shares of the underlying stock at the exercise price.
The writer (seller) of a regular exchange-listed call-option on a stock
has the obligation to sell 100 shares of the underlying stock at the exercise price.
The owner of a regular exchange-listed call-option on a stock
has the right to buy 100 shares of the underlying stock at the exercise price.
The owner of a regular exchange-listed put-option on a stock
has the right to sell 100 shares of the underlying stock at the exercise price.
Beaver, McNichols, and Rhie have developed the following model to predict the chance of failing during the next year relative to the chance of not failing for firms: log(relative chance of failure) = -6.445 - 1.192 ROA + 2.307 (liabilities/assets) - 0.346(EBITDA/liabilities), using
hazard analysis.
Most financial economists attribute the drop in the price of equity subsequent to the announcement of a new issue to
information effect.
If an individual wants to borrow with limited liability, he/she should
invest in the equity of a levered firm.
An investor can undo the effect of leverage on his/her own account by
investing in the equity of an unlevered firm and investing in risk-free debt like T- bills.
According to behavioral finance, investors prefer dividends because
investors prefer the discipline that comes from spending only the dividends.
Generally, venture capital funds are organized as
limited private partnerships.
Inclusion of restrictions in a bond contract leads to
lower agency costs.
Takeover defenses appear to favor
managers.
In order to calculate the tax shield of interest payments for a corporation, always use the
marginal corporate tax rate.
In order to calculate the tax shields provided by debt, the tax rate used is the
marginal corporate tax rate.
If MM's Proposition I holds, minimizing the weighted average cost of capital (WACC) is the same as maximizing the
market value of the firm.
Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to
meet interest and principal payments, which if not met can put the company into financial distress.
The market for corporate control includes
mergers, spin-offs and divestitures, leveraged buyouts (LBOs), and privatizations.
The Z-score model was developed by Altman using
multiple discriminant analyses.
A key assumption of the Miller and Modigliani (MM) dividend irrelevance argument is that
new shares are sold at a fair price.
Firms can repurchase shares in the following ways:
open market repurchase, tender offer, Dutch auction, and direct negotiation with a major shareholder.
According to the trade-off theory of capital structure,
optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.
Many mergers that appear to make economic sense fail because managers cannot handle the complex task of integrating two firms with different
production processes, accounting methods, and corporate cultures.
Figure 1 depicts the{MISSING IMAGE}
profit diagram for the buyer of a call option.
A dissident group solicits votes in an attempt to replace existing management. This is called a
proxy fight.
Generally, which of the following is true?
rD< rA< rE
For a levered firm where bA = beta of assets and bD = beta of debt, the return on equity ( rE) is equal to
rE= rA+( D/ E)×[ rA- rD].
Generally, which of the following is true?
rE> rA> rD
Production facilities that are flexible, in terms of the potential to use different combinations of raw material inputs, are most valuable when
raw material prices are highly volatile.
Managers who hold real options should view
real options as opportunities to alter management decisions in the future.
An equity issue sold to the firm's existing stockholders is called a
rights offer.
The trade-off theory of capital structure predicts that
safe firms should borrow more than risky ones.
A new public equity issue from a company with public equity previously outstanding is called a(an)
seasoned equity offering (SEO).
The following are advantages of shelf registration except
securities can be issued in dribs and drabs without incurring excessive transaction costs, can be issued on short notice and can be timed to take advantage of market conditions.
If dividends are taxed more heavily than capital gains, then investors
should be willing to pay more for stocks with low dividend yields.
According to Rajan and Zingales, debt ratios of individual companies depend on
size: Large firms have higher debt ratios; tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios; profitability: More profitable firms have lower debt ratios; and market to book: Firms with higher ratios of market-to-book value have lower debt ratios.
One of the indirect costs to bankruptcy is the incentive toward under investment. Following this strategy may result in
stockholders turning down low-risk, low-return but positive NPV projects, and the firm declaring and paying high-cash dividends.
A modification of the corporate charter that requires 80 percent shareholder approval for a takeover is called a(n)
supermajority amendment.
Examples of shark-repellent charter amendments include
supermajority, waiting period, restricted voting rights, and staggered board.
The main reason for the recent migration of a large number of firms from public-to- private ownership is
the Sarbanes-Oxley Act.
All else equal, as the underlying stock price increases,
the call price increases.
MM Proposition II states that
the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage.
A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that
the firm's investment policy is settled, there are no taxes, and an issue of new debt does not affect the market value of existing debt.
Modigliani and Miller's Proposition I states that except
the market value of any firm is independent of its capital structure.
The law of conservation of value implies that
the mix of common stock and preferred stock does not affect the value of the firm, the mix of long-term and short-term debt does not affect the value of the firm, and the mix of secured and unsecured debt does not affect the value of the firm.
The law of conservation of value implies that
the mix of senior and subordinated debt does not affect the value of the firm, the mix of convertible and nonconvertible debt does not affect the value of the firm, and the mix of common stock and preferred stock does not affect the value of the firm.
A firm in the mining industry whose major assets are cash, equipment, and a closed facility may sell at a premium to the market value of its assets. This premium is most plausibly attributed to
the option to open the facility when prices rise dramatically.
All else equal, as the underlying stock price increases,
the put price decreases.
If projects have implied options, then
the shorter the forecasted life of the project, the less valuable the option is.
The value of a call option is positively related to the following:
underlying stock price, risk-free rate, time to expiration, and volatility of the underlying stock price.
When financial distress is a possibility, the value of a levered firm is a function of the
value of the firm if all-equity-financed plus the present value of tax shield minus the present value of costs of financial distress.
The possibility that the winner (highest bidder) in an auction process may have bid a price that is very high (far above the value) is called
winner's curse.
