Module 6

What kind of corporate debt can be secured by any specified assets?

Asset-backed bonds

The current spot exchange rate, S, is $1.8862/£. Suppose that the yield curve in both countries is flat. The risk-free rate on dollars, r$, is 5.35% and the risk-free interest rate on pounds, r£, is 4.80%. Using the covered interest parity condition, the calculated one-year forward rate F1 is closest to:

$1.8961/£

The current spot exchange rate, S, is $1.8862/£. Suppose that the yield curve in both countries is flat. The risk-free rate on dollars, r$, is 5.35% and the risk-free interest rate on pounds, r£, is 4.80%. Using the covered interest parity condition, the calculated three-year forward rate F3 is closest to:

$1.9161/£

In January 2010, the U.S. Treasury issued a $1000 par, ten-year, inflation indexed note with a coupon of 4%. On the date of issue, the consumer price index (CPI) was 200. By January 2020, the CPI had increased to 300. The principal payment that was made in January 2020 is closest to:

$1500 CPI Appreciation x principal

In January 2010, the U.S. Treasury issued a $1000 par, ten-year, inflation indexed note with a coupon of 4%. On the date of issue, the consumer price index (CPI) was 200. By January 2020, the CPI had increased to 300. The coupon payment that was made in January 2020 is closest to:

$30 The CPI appreciated by 300/200 = 1.50. Consequently the principal amount of the bond increases by this amount so the new principal = $1000 × 1.5 = $1500. Therefore, with a 4% coupon and semiannual compounding this bond would pay $1500 × .04/2 = $30

Rearden Metal, a U.S. manufacturer, has made a purchase from d'Anconia Copper and is expecting a cash outflow of 2 million ARS (Argentine Pesos) in six months. The currency spot rate is $0.2500/ARS and the six-month forward rate is F6months = $0.2470/ARS. The appropriate annual discount rate for the Argentine Peso is 6.5% and the annual discount rate for the U.S. dollar is 4%. The present value of Rearden Metal's cash outflow computed by using the forward contract to lock in the future exchange rate and then discounting the cash flow at the appropriate US dollar rate is closest to:

$484,500

Rearden Metal, a U.S. manufacturer, has made a purchase from d'Anconia Copper and is expecting a cash outflow of 2 million ARS (Argentine Pesos) in six months. The currency spot rate is $0.2500/ARS and the six-month forward rate is F6months = $0.2470/ARS. The appropriate annual discount rate for the Argentine Peso is 6.5% and the annual discount rate for the U.S. dollar is 4%.The present value of Rearden Metal's cash outflow computed by first discounting the cash flow at the appropriate Argentine Peso rate and then converting to dollars with the spot rate is closest to:

$484,500

You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return. Assuming that this is the venture capitalist's first investment in your firm, the post-money valuation of your shares are closest to:

$5m Price Per share x # of Shares

The dollar cost of debt for John Galt Industries is 8.0%. The firm faces a tax rate of 40% on all income, no matter where it is earned. Galt needs to know its Yen cost of debt. The risk-free interest rates on dollars and yen are r% = 6% and r¥ = 2%, respectively. Galt is willing to assume that capital markets are internationally integrated and that its free cash flows are uncorrelated with the yen-dollar spot rate. Galt's after-tax cost of debt in yen is closest to:

.9%

From the two previous questions, what conclusions can you make about the degree of international integration between the U.S. and Argentine markets?

The markets are integrated since the PV of investing dollars today and converting them with a forward contract is approximately equal to converting into Pesos today and investing those Pesos for six months.

Which of the following statements is FALSE? a. By including more covenants, issuers increase their costs of borrowing. b. Once bonds are issued, equity holders have an incentive to increase dividends at the expense of debt holders. c. Covenants may restrict the level of further indebtedness and specify that the issuer must maintain a minimum amount of working capital. d. If the covenants are designed to reduce agency costs by restricting management's ability to take negative NPV actions that exploit debt holders, then the reduction in the firm's borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants.

a. By including more covenants, issuers increase their costs of borrowing.

Which of the following statements is FALSE? a. If the issuer fails to live up to any covenant, the issuer goes into bankruptcy. b. The stronger the covenants in the bond contract, the less likely the issuer will default on the bond, and so the lower the interest rate investors will require to buy the bond. c. Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. d. Bond agreements often contain covenants that restrict the ability of management to pay dividends.

a. If the issuer fails to live up to any covenant, the issuer goes into bankruptcy.

Which of the following statements is FALSE? a. The process of selling stock to the public for the first time is called a seasoned equity offering (SEO). b. Public companies typically have access to much larger amounts of capital through the public markets. c. By going public, companies give their private equity investors the ability to diversify. d. The two advantages of going public are greater liquidity and better access to capital.

a. The process of selling stock to the public for the first time is called a seasoned equity offering (SEO).

The largest sector of the asset-backed security market is the ________ market.

mortgage-backed security

A part of the registration statement, called the preliminary prospectus, circulates to investors before the stock is offered. This preliminary prospectus is also called a(n):

red herring

Which of the following statements is TRUE? a. Before the issue price (or offer price) is set, underwriters may invoke another mechanism to protect themselves against a loss—the overallotment allocation. b. Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm. c. Before an IPO, the company prepares the final registration statement and final prospectus containing the details of the IPO, but excluding the number of shares offered and the offer price. d. A "road trip" is where senior management and the lead underwriters travel around the country (and sometimes around the world) promoting the company and explaining their rationale for the offer price to the underwriters' largest customers—mainly institutional investors such as mutual funds and pension funds.

b. Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm.

Which of the following statements regarding international projects is FALSE? a. Interest rates and costs of capital will likely be different in the foreign country as a result of the macroeconomic environment. b. The project will most likely generate foreign currency cash flows, although the firm cares about the foreign currency value of the project. c. Under internationally integrated capital markets, the value of an investment does not depend on the currency we use in the analysis. d. The firm will probably face a different tax rate in the foreign country and will be subject to both foreign and domestic tax codes.

b. The project will most likely generate foreign currency cash flows, although the firm cares about the foreign currency value of the project.

Which of the following statements regarding firm commitment IPOs is FALSE? a. If the entire issue does not sell out, the remaining shares must be sold at a lower price and the underwriter must take the loss. b. The underwriter purchases the entire issue (at the offer price) and then resells it at a slightly higher price to interested investors. c. It is the most common underwriting arrangement. d. The underwriter guarantees that it will sell all of the stock at the offer price.

b. The underwriter purchases the entire issue (at the offer price) and then resells it at a slightly higher price to interested investors.

Hammond Motors is considering an investment in the Euro area. The expected free cash flows, in Euros, are uncorrelated with the spot exchange rate and are as follows: Year FCF 0 -100 1 45 2 50 3 55 4 60 The new project, which Hammond is considering, has similar dollar risk to Hammond's other projects. Hammond knows that its overall dollar WACC is 10%, so it feels comfortable using this WACC for the project. The riskfree interest rate on dollars is 4% and the risk-free interest rate on Euros is 6%. Hammond is willing to assume that capital markets in the United States and the Euro area are internationally integrated. Hammond's Euro WACC is closest to:

12.1% (1+risk free rate Foreign/1+risk free US) x (1 + US wacc) - 1

You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return. The post-money valuation of your firm is closest to:

12.5 million Total shares outstanding = 2M (yours) + 1M (angels) + 2M (Venture) = 5 million shares The venture capitalist would be paying 5/2 = $2.50 per share Post-money valuation = $2.50 × 5 million shares = million

Luther Industries, a U.S. Corporation, is considering a new project located in Great Britain. Year FCF 0 -20 1 10 2 14 3 18 You know that the spot exchange rate is S = 1.8862/£. In addition, the risk-free interest rate on dollars and pounds is 5.4% and 4.6% respectively. Assume that these markets are internationally integrated and the uncertainty in the free cash flow is not correlated with uncertainty in the exchange rate. You have determined that the dollar WACC for these cash flows is 10.2%. What is the pound present value of the project?

14.613

You founded your own firm three years ago. You initially contributed $200,000 of your own money and in return you received 2 million shares of stock. Since then, you have sold an additional 1 million shares of stock to angel investors. You are now considering raising capital from a venture capital firm. This venture capital firm would invest $5 million and would receive 2 million newly issued shares in return. Assuming that this is the venture capitalist's first investment in your firm, what percentage of the firm will the venture capitalist own?

40% Total shares outstanding = 2M (yours) + 1M (angels) + 2M (Venture) = 5 million shares Percentage Owned = 2/5=40%

Hammond Motors is considering an investment in the Euro area. The expected free cash flows, in Euros, are uncorrelated with the spot exchange rate and are as follows: Year FCF 0 -100 1 45 2 50 3 55 4 60 The new project, which Hammond is considering, has similar dollar risk to Hammond's other projects. Hammond knows that its overall dollar WACC is 10%, so it feels comfortable using this WACC for the project. The riskfree interest rate on dollars is 4% and the risk-free interest rate on Euros is 6%. Hammond is willing to assume that capital markets in the United States and the Euro area are internationally integrated. Hammond's Euro WACC is closest to:

57m -100+(45/Euro WACC) + (50/Euro WACC2) + (55/EuroWACC3) + (60/EuroWACC4)

Which of the following statements regarding municipal bonds is/are FALSE? I) A single municipal bond issue will often contain a number of different maturity dates. Such issues are often called multi-muni bonds because the bonds are scheduled to mature over a multiple number of years. II) Revenue bonds are where the local government pledges specific revenues generated by projects that were initially financed by the bond issue. III) Municipal bonds are not exempted from federal income tax. IV) Bonds backed by the full faith and credit of a local government are known as general obligation bonds and are not as secure as bonds backed by the full faith and credit of the federal government.

I and III only.

Which of the following statements is TRUE regarding venture capitalists? I) They can provide substantial capital for young companies. II) They offer limited partners a number of advantages over investing directly in start-ups themselves as angel investors. III) They use their control to protect their investments, so they may therefore perform a key nurturing and monitoring role for the firm. IV) They might invest for strategic objectives in addition to the desire for investment returns.

I, II and III only

Which of the following statements is/are TRUE? I) Almost all bonds that are issued today are registered bonds. II) The trust company represents the bondholders and makes sure that the terms of the indenture are enforced. III) For private placements, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company. IV) In the case of default, the trust company represents the bondholders' interests.

I, II and IV only

Which of the following statements is/are FALSE? I) After deciding to go public, managers of the company work with an underwriter, an investment banking firm that manages the offering and designs its structure. II) The shares that are sold in the IPO may either be new shares that raise new capital, known as a secondary offering, or existing shares that are sold by current shareholders (as part of their exit strategy), known as a primary offering. III) IPOs are usually managed by only one underwriter. IV) At an IPO, a firm offers a large block of shares for sale to the public for the first time.

II and III only

What kind of corporate debt must be secured by real property?

Mortgage bonds

Treasury securities that are standard coupon bonds where the outstanding principal is adjusted for inflation are called:

TIPS.

Which of the following statements is NOT true regarding Angel Investors? a. They are typically arranged as limited partnerships. b. For many start-ups, the first round of outside private equity financing is often obtained from them. c. Because their capital investment is often large relative to the amount of capital already in place at the firm, they typically receive a sizeable equity share in the business in return for their funds. d. These investors are frequently friends or acquaintances of the entrepreneur.

a. They are typically arranged as limited partnerships.

Packaging a portfolio of financial securities and issuing an asset-backed security backed by this portfolio is known as:

asset securitization.

Which of the following statements is FALSE? a. A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms. b. Venture capitalists typically control about three-quarters of the seats on a start-up's board of directors, and often represent the single largest voting block on the board. c. The initial capital that is required to start a business is usually provided by the entrepreneur herself and her immediate family. d. Individual investors who buy equity in small private firms are called angel investors.

b. Venture capitalists typically control about three-quarters of the seats on a start-up's board of directors, and often represent the single largest voting block on the board.

The share of any positive return generated by venture capital firms that is taken by the firm's partners is known as:

carried interest

When banks resecuritize other asset-backed securities, the new asset backed security is known as a:

collateralized debt obligation.

Which of the following statements regarding exit strategies is FALSE? a. An alternative way to provide liquidity to its investors is for the company to become a publicly traded company. b. An important consideration for investors in private companies is their exit strategy or how they will eventually realize the return from their investment. c. Often large corporations purchase successful start-up companies. In such a case, the acquiring company purchases the outstanding stock of the private company, allowing all investors to cash out. d. About only 5% of venture capital exits from 2002-2012 occurred through mergers or acquisitions.

d. About only 5% of venture capital exits from 2002-2012 occurred through mergers or acquisitions.

Which of the following statements is FALSE? a. Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously. b. In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public corporation c. A term loan is a bank loan that lasts for a specific term. d. Eurobonds are international bonds that are denominated in the local European currency of the country in which they are issued.

d. Eurobonds are international bonds that are denominated in the local European currency of the country in which they are issued.

Which of the following does NOT issue asset-backed securities? a. Government National Mortgage Association b. Federal National Mortgage Association c. Student Loan Marketing Association d. Federal Reserve

d. Federal Reserve

Which of the following statements is FALSE? a. If the foreign project is owned by a domestic corporation, managers and shareholders need to determine the home currency value of the foreign currency cash flows. b. The most obvious difference between a domestic project and a foreign project is that the foreign project will most likely generate cash flows in a foreign currency. c. The risk of the foreign project is unlikely to be exactly the same as the risk of domestic projects (or the firm as a whole), because the foreign project contains residual exchange rate risk that the domestic projects often do not contain. d. In an internationally integrated capital market, two equivalent methods are available for calculating the NPV of a foreign project: Either we can calculate the NPV in the foreign country and convert it to the local currency at the forward rate, or we can convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows.

d. In an internationally integrated capital market, two equivalent methods are available for calculating the NPV of a foreign project: Either we can calculate the NPV in the foreign country and convert it to the local currency at the forward rate, or we can convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows.