Corporate Finance Exam #2

The BSC Co. was planning to raise $2.5 million in perpetual debt at 11 percent. However, they just received an offer from the governor of a nearby state to raise the financing for them at 8 percent if they locate a new facility in that state. What is the total value added from debt financing if the tax rate is 34 percent and the state subsidizes the loan for the company?

$1.3 million

Given are the following data for year 1:Profits after taxes = $20 million; Depreciation = $6 million; Interest expense = $4 million; Investment in fixed assets = $12 million; Investment in working capital = $4 million. The corporate tax rate is 25 percent. Calculate the free cash flow (FCF) for year 1.

$13 Million

A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14 percent. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV?

$148,350

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?

$19.20

Consider the following data:FCF1 = $20 million; FCF2 = $20 million; FCF3 = $20 million. Assume that free cash flow grows at a rate of 5 percent for year 4 and beyond. If the weighted average cost of capital is 12 percent, calculate the value of the firm.

$261.57 Million

The Granite Paving Company is all-equity financed and has the following free cash flows in years 1−4: $3 million ($3M); $3.7M; $4M; $4.2M. After year 4, the firm is expected to grow at a sustainable rate of 3 percent per annum. With a WACC of 12 percent, what is the horizon value in year 4 of Granite Paving Co?

$48.1 Million

Wealth and Health Company is financed entirely by common stock that is priced to offer a 15 percent expected return. The common stock price is $40/share. The earnings per share (EPS) is expected to be $6. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

$7.20

Given are the following data for Outsource Company: PV (of FCFs for years 1-3) = $35 million; PV (horizon value) = $65 million. Suppose that the market value of the debt = $30 million. Calculate the total market value of equity of the firm.

$70 Million

Suppose that your firm's current unlevered value, V*, is $800,000, and its marginal corporate tax rate is 21 percent. Also, you model the firm's PV of financial distress as a function of its debt level according to the relation: PV of financial distress = 800,000 × (D/V*)2. What is the firm's levered value if it issues $200,000 of perpetual debt to buy back stock?

$792,000

A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating WACC, what should one use for the value of the firm's preferred stock?

$9.50

If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is

(X) * (profits)

Which of the following is NOT a sensible reason for a firm to rely on internal funds?

- Equity Issues are generally expensive - A new bond issue may drive the firm's debt ratio too high - Financial markets interpret issuance of equity unfavorably

What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by: TC = (corporate tax rate) = 21 percent; TpE = personal tax rate on equity income = 15 percent; and Tp = personal tax rate on interest income = 37 percent.

0.94

Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; rD = 6%; rE = 12%; and TC = 30%. Calculate the after-tax weighted average cost of capital (WACC):

10.05 percent

A firm has $100 million in current liabilities, $200 million in long-term debt, $300 million in stockholders' equity, and total book assets of $600 million. There are 100 million shares outstanding with a share price of $16. Calculate the debt ratio for the firm.

11.1 percent

Health and Wealth Company is financed entirely by common stock that is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing? (Ignore taxes.)

18 Percent

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

2.2

A firm has debt beta of 0.2 and an asset beta of 1.9. If the debt-equity ratio is 75 percent, what is the levered equity beta?

3.18

Given are the following data for Golf Corporation:Market price/share = $12; Book value/share = $10; Number of shares outstanding = 100 million; Market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the proportions of debt (D/V) and equity (E/V) for Golf Corporation that you should use for estimating its weighted average cost of capital (WACC).

40 percent and 60 percent equity

Which of the following entities likely has the highest cost of financial distress?

A pharmaceutics development company

According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases.

False

The flow-to-equity method uses: I) cash flows to equity, after interest and after taxes; II) the cost of equity capital as the discount rate; III) the weighted average cost of capital for discount rate; IV) after-tax cash flows without considering interest and dividend payments

I and II only

An investor can undo the effect of leverage on his/her own account by I) investing in the equity of an unlevered firm; II) borrowing on his/her own account; III) investing in risk-free debt like T-bills

I and III

An investor can create the effect of leverage on his/her account by I) buying equity of a levered firm; II) investing in risk-free debt like T-bills; III) borrowing on his/her own account

I and III only

The costs of financial distress depend on the: I) probability of financial distress; II) corporate and personal tax rates; III) magnitude of costs encountered if financial distress occurs

I and III only

In the case of Facebook, which has issued Class A and Class B shares, I) both classes of shares have the same cash-flow rights; II) both classes of shares have the same control rights; III) both classes of shares have different cash-flow rights; IV) both classes of shares have different control rights

I and IV only

Given corporate taxes, why does adding debt to the capital structure increase firm value? I) Extra cash flow goes to the firm's investors rather than the tax authorities. II) Earnings before interest and taxes are fully taxed at the corporate rate. III) Personal tax rates are the same as marginal corporate tax rates.

I only

The following are debts in disguise: I) accounts payable II) leases III) underfunded pensions

I, II and III

Lowering the debt-equity ratio of the firm can change the firm's I) financial leverage; II) cost of equity; III) cost of debt; IV) effective tax rate

I, II, III, and IV

Capital structure is irrelevant if I) capital markets are efficient; II) each investor can borrow/lend on the same terms as the firm; III) there are no tax benefits to debt

I, II, and III

Generally, managers of corporations prefer internally generated cash to finance their capital expenditures because I) they can avoid the discipline of financial markets; II) the costs of issuing new securities are high; III) the announcement of a new equity issue is usually bad news for investors

I, II, and III

The following situations typically require that the financial manager value an entire business: I) If firm A is about make a takeover offer for firm B, then A's financial managers have to decide how much the combined business A + B is worth under A's management. II) If firm C is considering the sale of one of its divisions or a business line, it has to decide what the division or the business line is worth in order to negotiate with potential buyers. III) When a firm goes public, the investment bank must evaluate how much the firm is worth in order to set the price.

I, II, and III

The law of conservation of value implies that I) the mix of common stock and preferred stock does not affect the value of the firm; II) the mix of long-term and short-term debt does not affect the value of the firm; III) the mix of secured and unsecured debt does not affect the value of the firm

I, II, and III

One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in: I) the firm always choosing projects with positive NPVs; II) stockholders turning down low-risk, low-return but positive NPV projects; III) the firm declaring and paying high cash dividends

II and III only

The pecking order theory of capital structure implies that: I) high-risk firms will end up borrowing more; II) firms prefer internal finance; III) firms prefer debt to equity when external financing is required

II and III only

The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issues; II) interest expenses are tax deductible; III) unlevered firms have higher value than levered firms

II only

What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, will likely want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business.

III only

Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The marginal corporate tax rate is 21 percent.)

Investors paying personal tax of 21 percent

To calculate the total value of the firm (V), one should rely on the

Market values of debt and equity

If a bond is junior or subordinated, it

Must give a preference to senior creditors in the event of default

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 cost of distress.

The rare event in which a firm's existing directors and management compete with outsiders for the effective control of the corporation is called a:

Proxy contest

Preference in position among creditors when it comes to repayment is called

Seniority

As a provider of funds to a corporation, owning which of the following corporate securities will give you the strongest rights to cash flow?

Short-term bank loan

Project M requires an initial investment of $25 million. The project is expected to generate $2.25 million in after-tax cash flow each year forever. If the weighted average cost of capital (WACC) is 9 percent, calculate the NPV of the project.

Zero

Generally, which of the following is true?

rE > rA > rD

The WACC formula calculates the cost of capital for the "average risk" project.

True

U.S. firms, in general, have been repurchasing shares and thus net equity issues have been negative.

True

If a firm borrows $50 million for one year at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate.

$0.95 million

For a levered firm,

As EBIT increases, EPS increases by a larger percentage

Modigliani and Miller's Proposition I states that

The market value of any firm is independent of its capital structure

Compared to normal bondholders, convertible bondholders have a greater interest in seeing the firm's stock price increase.

True

Financial intermediaries provide the following important functions for the economy: the payment mechanism, borrowing and lending, and pooling of risks.

True

Financial leverage increases the expected return and risk of the shareholder.

True

Risk shifting, refusing to contribute equity, and playing for time are some of the consequences of firms facing bankruptcy.

True