FIN 3603 Mid Term - CONCEPTIUAL QUESTIONS
Boeing has decided that the Dreamliner has a positive NPV. How does pursuing this decision affect shareholder value?
It increases shareholder value.
Which of the following is the most relevant metric for Boeing to consider in determining whether or not to develop and build the Dreamliner?
Its impact on value (net present value).
Assume capital markets are perfect. In what way does a firm's value and/or WACC change by relying more on debt capital? A. WACC and value are unaffected. B. WACC decreases, and value increases. C. WACC and value increase. D. WACC increases and value decreases.
WACC and value are unaffected.
In a world with corporate taxes, but no other market frictions, how does increasing leverage affect firm value and WACC? A. WACC and value are unaffected. B. WACC decreases, and value increases. C. WACC and value increase. D. WACC increases and value decreases.
WACC decreases, and value increases.
If you buy a house at $500 with a $100 down payment and $400 of mortgage, and the house price drops down 20% later, what is your ROE?
-100% You spent 100 borrow 400. House = 500. So your part is 1/5 = 20%. If House Price drop 20%. Your ROE = -100. Since you lose you part and still gotta pay that 400.
Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than their own. What strategies are available to shareholders to help ensure that managers are motivated to act this way?
. Ensure that employees are paid with company stock and/or stock options. + . Write contracts that ensure that the interests of the managers and shareholders are closely aligned. + . Ensure that underperforming managers are fired. + Mount hostile takeovers.
What is the most important difference between a corporation and all other organization forms?
A corporation is a legal entity separate from its owners.
What is beta?
A measure of how much the stock moves with the market
Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. Google, Inc., plans to purchase real estate to expand its headquarters. A. A real estate investment to expand a firm's headquarters is a normal business activity; therefore, it would be appropriate to assume that this investment risk is equal to the average risk of the firm. B. A real estate investment does not have a market risk that is different from that of Google's investments in Internet search technology and advertising; therefore, it would be appropriate to assume this investment risk is equal to the average risk of the firm. C. A real estate investment is a risk-free investment since real estate tends to appreciate over time. D. A real estate investment is likely to have market risk that is very different from that of Google's investments in Internet search technology and ad
A real estate investment is likely to have market risk that is very different from that of Google's investments in Internet search technology and advertising; therefore, it would not be appropriate to assume this investment risk is equal to the average risk of the firm.
At current tax rates, which investors are most likely to hold a stock that has a high dividend yield? A. Corporations B. Individual investors C. Pension funds D. Mutual funds
A. Corporations
Empire Industries forecasts net income this coming year as shown here (in thousands of dollars):. Approximately $250,000 of Empire's earnings will be needed to make new, positive-NPV investments. Unfortunately, Empire's managers are expected to waste 10% of its net income on needless perks, pet projects, and other expenditures that do not contribute to the firm. All remaining income will be returned to shareholders through dividends and share repurchases. What are the two benefits of debt financing for Empire? A. Interest cost benefits and reducing wasteful investment B. Dividend and tax benefits C. Tax and interest cost benefits D. Tax benefits and reducing wasteful investment
A. Interest cost benefits and reducing wasteful investment
Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers. A. The market risk of the cash flows from this new product is likely to be similar to that of Clorox's other household products; therefore, assuming it has the same risk as the average risk of the firm is reasonable. B. The market risk of the cash flows from this new product is likely to be similar to that of Clorox's other household products; therefore, assuming it has the same risk as the average risk of the firm is not reasonable. C. The market risk of the cash flows from this new product is not similar to that of Clorox's other household products; therefore, assuming it has the same risk as the average risk of the firm is not reasonable. D. The market risk of the cash
A. The market risk of the cash flows from this new product is likely to be similar to that of Clorox's other household products; therefore, assuming it has the same risk as the average risk of the firm is reasonable.
Which of the following is part of a firm's capital structure? A.Debt B.Preferred Stock C.Equity D.All answers are correct
All answers are correct
Which of the following factors should Cisco consider when making a financing decision? A. Its tax rate. B. The volatility of the its cash flows. C. The magnitude of business disruption costs if it were to face financial distress. D. All answers are correct.
All answers are correct.
In 2015, Intel Corporation had a market capitalization of $134 billion, debt of $13.2 billion, cash of $13.8 billion, and EBIT of nearly $16 billion. If Intel were to increase its debt by $1 billion and use the cash for a share repurchase, which market imperfections would be most relevant for understanding the consequence for Intel's value? Why? A. Intel's debt is a tiny fraction of its total value. Indeed, Intel has more cash than debt, so its net debt is negative. Intel is also very profitable; at an interest rate of 6%, interest on Intel's debt is only $792 million per year, which is less than 4.95% of its EBIT. B. The risk that Intel will default on its debt is extremely small. This risk will remain extremely small even if Intel borrows an additional $1 billion. Thus, adding debt will not really change the likelihood of financial distress for Intel (which is near
All of the above.
Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. Target Corporation decides to expand the number of stores it has in the southeastern United States. A. An expansion that is not in the same line of business is likely to have risk equal to the average risk of the business. B. An expansion in the same line of business is not likely to have risk equal to the average risk of the business. C. An expansion that is not in the same line of business is not likely to have risk equal to the average risk of the business. D. An expansion in the same line of business is likely to have risk equal to the average risk of the business.
An expansion in the same line of business is likely to have risk equal to the average risk of the business.
Assets with negative betas
Are a safe harbor for the times when the market is moving down
Natsam Corporation has $300 million of excess cash. The firm has no debt and 500 million shares outstanding with a current market price of $16 per share. Suppose the board decided to do a one-time share repurchase, but you, as an investor, would have preferred to receive a dividend payment. Which of the following is true regarding the effect of a one-time share repurchase on the stock price? A. An open-market share repurchase has no effect on the stock price, but the stock price is not the same as the cum-dividend price if a dividend were paid instead. B. An open-market share repurchase has no effect on the stock price. C. An open-market share repurchase increases the stock price due to the decrease in shares in the marketplace. D. An open-market share repurchase decreases the stock price because the firm's assets decline by the amount of the purchases of the shares.
B. An open-market share repurchase has no effect on the stock price.
Explain, intuitively, why Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC. A. The equity cost of capital exceeds the unlevered cost of capital because leverage makes the equity risk greater than the overall risk of the firm. The WACC is less than the unlevered cost of capital because the WACC excludes the benefit of the interest tax shield. B. The equity cost of capital exceeds the unlevered cost of capital because leverage makes the equity risk greater than the overall risk of firm. The WACC is less than the unlevered cost of capital because the WACC includes the benefit of the interest tax shield. C. The equity cost of capital exceeds the unlevered cost of capital because leverage makes the equity risk less than the overall risk of the firm. The WACC is less than the unlevered cost of capital because the WACC includes the benefit of the interest tax shiel
B. The equity cost of capital exceeds the unlevered cost of capital because leverage makes the equity risk greater than the overall risk of firm. The WACC is less than the unlevered cost of capital because the WACC includes the benefit of the interest tax shield.
When might it be advantageous to undertake a reverse stock split? A. There is no good reason to do a reverse stock split—just ask Warren Buffet. B. To avoid being delisted from an exchange because the price of the stock has fallen below the minimum share price required to stay listed. C. In bad times, to signal future good times. D. When the stock price is over $100.
B. To avoid being delisted from an exchange because the price of the stock has fallen below the minimum share price required to stay listed.
You own a share of Costco stock. You are worried that its price will fall and would like to insure yourself against this possibility. How can you purchase insurance against this possibility? A. To protect against a fall in the price of Costco stock, you can sell a put with Costco as the underlying asset. B. To protect against a fall in the price of Costco stock, you can buy a put with Costco as the underlying asset. C. To protect against a fall in the price of Costco stock, you can sell a call with Costco as the underlying asset. D. To protect against a fall in the price of Costco stock, you can buy a call with Costco as the underlying asset.
B. To protect against a fall in the price of Costco stock, you can buy a put with Costco as the underlying asset.
Explain whether each of the following projects is likely to have risk similar to the average risk of the firm. GE decides to open a new Universal Studios theme park in China A. Because the theme park is not likely to be sensitive to the growth of the Chinese economy, its market risk may not be very different from that of GE's other divisions and from the company as a whole. Therefore, it would be appropriate to assume this risk is equal to the average risk of the firm. B. Because the theme park will likely be sensitive to the growth of the Chinese economy, its market risk may be very different from that of GE's other divisions and from the company as a whole. Therefore, it would not be appropriate to assume this risk is equal to the average risk of the firm. C. All of GE's theme parks are sensitive to the growth of the economy in which they operate. Therefore, it would be appropriate to
Because the theme park will likely be sensitive to the growth of the Chinese economy, its market risk may be very different from that of GE's other divisions and from the company as a whole. Therefore, it would not be appropriate to assume this risk is equal to the average risk of the firm.
Why is an announcement of a share repurchase considered a positive signal? A. Share repurchases increase demand for the stock. By the law of supply and demand, when demand increases, prices must rise, which is good news. B. By choosing to do a share repurchase, management credibly signals that it believes the stock is undervalued. C. Share repurchases reduce dilution, which is a good thing for investors. D. Share repurchases are a capital structure decision. According to Modigliani-Miller, financial policy should not matter; therefore, even when markets are not perfect, share repurchases should not affect value, hence they are neither a positive or negative signal.
By choosing to do a share repurchase, management credibly signals that it believes the stock is undervalued
Explain the difference between an S corporation and a C corporation.
C corporations must pay corporate income taxes S corporations do not pay corporate taxes but must pass through the income to shareholders to whom it is taxable. + S corporations are limited to 100 shareholders and cannot have corporate or foreign stockholders.
What is the difference between an European option and an American option? Are European options available exclusively in Europe and American options available exclusively in the United States? B. European options can be exercised only on the exercise date and are exclusively available in Europe, while American options can be exercised on any date prior to the exercise date and are exclusively available in America. C. European options can be exercised only on the exercise date, while American options can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America.
C. European options can be exercised only on the exercise date, while American optionterm-38s can be exercised on any date prior to the exercise date. Both types of options are traded in Europe and in America.
A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument? A. True, because this will result in a higher market value for the stock. B. True, because this would also lead to the highest earnings per share. C. False, returns are higher because risk is higher and the return fairly compensates for the risk. D. False, it is in the best interest of shareholders to choose the capital structure that leads to the lowest expected return for the stock.
C. False, returns are higher because risk is higher and the return fairly compensates for the risk.
How does the NPV calculated using the FTE method compare with the NPV based on the WACC method? A. The NPV computed using the FTE method is always lower than the NPV based on the WACC method. B. The NPV computed using the FTE method cannot be compared to the NPV based on the WACC method. C.The NPV computed using the FTE method is the same as the NPV based on the WACC method. D. The NPV computed using the FTE method is always higher than the NPV based on the WACC method.
C. The NPV computed using the FTE method is the same as the NPV based on the WACC method.
Explain the difference between a long position in a put and a short position in a call. B. When a party has a long position in a put, it has the right to sell the underlying asset at the strike price; when it has a short position in a call, it has the right to buy the underlying asset at the strike price if exercised. C. When a party has a long position in a put, it has the right to sell the underlying asset at the strike price; when it has a short position in a call, it has the obligation to sell the underlying asset at the strike price if exercised.
C. When a party has a long position in a put, it has the right to sell the underlying asset at the strike price; when it has a short position in a call, it has the obligation to sell the underlying asset at the strike price if exercised
_______________: An option that gives its holder the right to buy an asset.
Call
Which of the following explains why most companies choose to pay stock dividends (split their stock)?
Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs.
Which of the following explains why most companies choose to pay stock dividends (split their stock)? A. There is no good reason to do a stock split—just ask Warren Buffet. B. Stock splits increase the amount of stock each investor holds, thus increasing investor welfare. C. Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs. D. By splitting the stock, investors get a stock dividend which increases value.
Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs.
Which organization forms give their owners limited liability?
Corporations and limited liability companies give owners limited liability. + Limited partnerships provide limited liability for the limited partners, but not for the general partners.
Describe the benefits and costs of delaying an investment opportunity. A. By delaying, you delay the benefits of taking on the project and your competitors might take advantage of this delay. B. There are no benefits to delaying a project. You are simply allowing the competition to get ahead you. C. Delaying a project can resolve uncertainty so you can become better informed and make better decisions. D. In most cases, you should delay decisions about a project until you are certain that the project will succeed.
Costs: By delaying, you delay the benefits of taking on the project and your competitors might take advantage of this delay. Benefits: Delaying a project can resolve uncertainty so you can become better informed and make better decisions
Explain under which conditions an increase in the dividend payment can be interpreted as a signal of: Good News A. By increasing dividends managers signal that they have cash to pay out, which is good news. B. By increasing dividends managers signal higher future growth prospects, which is good news. C. Raising dividends gives investors more cash, so the stock price increases, which is good news. D. By increasing dividends managers signal that they believe that future earnings will be high enough to maintain the new dividend payment.
D. By increasing dividends managers signal that they believe that future earnings will be high enough to maintain the new dividend payment.
Explain under which conditions an increase in the dividend payment can be interpreted as a signal of: Bad News A. Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news. B. Raising dividends means paying out more cash, leaving less cash in the firm, and thus reducing value, which is bad news. C. Raising dividends requires borrowing money and increasing debt, which is bad news. D. Raising dividends for no reason signals management's desire to manipulate investors, which is a waste of managerial resources, which is bad news.
D. Raising dividends signals that the firm does not have any positive NPV investment opportunities, which is bad news.
Home Depot, a home improvement supply store, issued $2 billion in debt in late 2016. What is the main difference between debt and other liabilities, like accounts payable?
Debt carries an explicit interest rate
What is the main difference between debt and accounts payable?
Debt carries an explicit interest rate
_______________: The last date on which the holder still has the right to exercise the option. If the option is American, the right can be exercised until the exercise date; if it is European, the option can be exercised only on the exercise date.
Expiration Date
What was the first historic measure of the firm's performance?
Revenue
Since debt has a lower cost than equity, the firm can reduce its capital costs by simply replacing equity with debt. T/F
False
Which of the following would be considered a goal of capital budgeting?
Identify projects that add the most to the firm's value.
You are concerned about the funding gap in the cash conversion cycle of your retail grocery company. Which of the following will NOT reduce the funding gap?
Increasing sales
Which type of firm is more likely to experience a loss of customers in the event of financial distress: a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)? b. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports equipment)?
Intuit, and Allstate
Initial public offerings are normally sereviced by
Investment banks
The optimal capital structure
Is firm and time specific
How can a company with sustainable returns to capital of 15% and a cost of capital of 22% maximize its value?
Liquidate the company as soon as possible
Which ratio is a distinguishing feature of retail companies?
Low receivables collection period
Companies with lower betas have
Lower cost of equity
You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, "If we go bankrupt, we don't have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt." Is he right? A. No, customers will anticipate the effect of leverage on the soundness of the warranty and will be less likely to purchase cars, thereby imposing costs on the firm. B. Yes, you are essentially increasing the value of equity at the expense of the bondholders. C. Yes, warranties are a cost that firms can get out of in bankruptcy. D. No, warranty owners are just another claimant and the Modigliani Miller proposition implies that this is merely a transfer between claimants.
No, customers will anticipate the effect of leverage on the soundness of the warranty and will be less likely to purchase cars, thereby imposing costs on the firm.
When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of bankruptcy? A. No, only loss in excess of what was expected is a cost of bankruptcy. B. No, only loss in excess of the economic loss that would have occurred whether or not the firm was bankrupt is a cost of bankruptcy. C. No, there is no cost of bankruptcy. D. Yes, debt-holder loss is a cost of bankruptcy.
No, only loss in excess of the economic loss that would have occurred whether or not the firm was bankrupt is a cost of bankruptcy.
Are hostile takeovers necessarily bad for firms or their investors?
No. They are a way to discipline managers who are not working in the interests of shareholders.
_______________: A contract that gives one party the right, but not the obligation, to buy or sell an asset at some point in the future.
Option
Although the major benefit of debt financing is easy to observelong dash—the tax shieldlong dash—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.
Overinvestment: investing in negative NPV projects. Overinvestment: Not investing in positive NPV projects Cashing out: paying out dividends instead of investing in projects with positive NPVs Employee job security: Highly leveraged firms run the risk of bankruptcy and so cannot write long term employment contracts and offer job security.
What does the phrase limited liability mean in a corporate context?
Owners' liability is limited to the amount they invested in the firm. + Stockholders are not responsible for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.
What options does a firm have to spend its free cash flow (after it has satisfied all interest obligations)?
Pay it out as dividends. Use it to repurchase shares. Use it to make investments.
Which of the following is part of a firm's capital structure?
Preferred Stock, Equity, Debt
_______________: An option that gives its holder the right to sell an asset.
Put
Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the trade-off theory. A. The tax savings from debt are likely to be much higher for real estate transactions than for corporations. B. It is impossible to finance real estate purchases using equity. C. Real estate assets can generally be easily resold at their full market value, whereas corporations typically face much higher distress costs. D. The financial distress costs of corporations are low because corporate assets are easy to liquidate, whereas real estate assets are difficult to resell.
Real estate assets can generally be easily resold at their full market value, whereas corporations typically face much higher distress costs.
How can too much debt lead to excessive risk-taking? A. Shareholders capture upside benefits, but don't suffer from downside losses. B. Debt covenants encourage excessive risk taking by equity holders. C. Risky projects become attractive to debt holders. D. None of the answers represents a reason why too much debt can lead to excessive risk taking.
Shareholders capture upside benefits, but don't suffer from downside losses.
______________: The price at which the holder of the option has the right to buy or sell the asset.
Strike Price
Which of the following constituencies care most about a company's current ratio?
Suppliers
What is the difference between a public and private corporation?
The shares of a public corporation are traded on an exchange (or "over the counter" in an electronic trading system) while the shares of a private corporation are not traded on a public exchange.
Explain what is wrong with the following argument: "If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm's equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity."
The argument is wrong because any leverage raises the equity cost of capital. Risk-free leverage raises it the most because it does not share any of the risk.
Beta equal to 1 means that
The asset price moves similar to the market
Why would managers of Cisco choose a different capital structure than those in a different industry? A. The costs and benefits of debt vary across firms and industries. B. The level of managerial risk aversion varies across industries. C. Banks are more willing to loan money to firms in certain industries than in others. D. Industries have different norms for which they need to comply.
The costs and benefits of debt vary across firms and industries
The CEO of XYZ asked customers to buy the XYZ product in advance for a discount, before announcing his resignation. Which problem of capital markets might this be a manifestation of?
The principal-agent problem
Assume Cisco increases its leverage. How does this affect the risk its equity holders face and its cost of equity? A. If markets are frictionless, then Cisco's cost of equity is unaffected by leverage. B. The risk faced by Cisco's equity holders and its cost of equity rise with leverage. C. The risk faced by Cisco's equity holders and its cost of equity fall with leverage. D. The risk faced by Cisco's equity holders rises and its cost of equity falls with leverage.
The risk faced by Cisco's equity holders and its cost of equity rise with leverage.
Suppose that if Boeing introduces the Dreamliner, the number of 737s they sell will go down as customers choose the Dreamliner instead of the 737. Should these costs be considered in evaluating the attractiveness of the Dreamlinerproject?
Yes, these are opportunity costs.
Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress: a. An office building or a brand name? b. Product inventory or raw materials? c. Patent rights or engineering "know-how"?
a. An office building is more likely to be liquidated for close to its full market value. b. Raw materials are more likely to be liquidated for close to its full market value. c. Patent rights are more likely to be liquidated for close to its full market value.
ABC Corporation announced that it will pay a dividend to all shareholders of record as of Monday, April 2, 2012. It takes three business days of a purchase for the new owners of a share of stock to be registered. a. When is the last day an investor can purchase ABC stock and still get the dividend payment? b. When is the ex-dividend day?
a. March 29th b. March 30th
If your friend decides to invest in a startup, what form of ownership would you recommend him to pick?
a. Preferred stock, because it combines the opportunities of ownership on the upside, and benefits of debt financing on the downside.
Firm A purchased Firm B. As a result Firm A market value increased $100 million, and Firm B market value dropped $25 million Which of the following describes the situation is the best way: a. Value was created and transferred from Firm B to Fitm A b. Value was created and transferred from Firm A to Firm B c. Value was destroyed and transferred from Firm B to Firm A d. Value was destroyed and transferred from Firm A to Firm B
a. Value was created and transferred from Firm B to Fitm A
Which one of the following statements is correct concerning a corporation with taxable income of $125,000?
an increase in depreciation will increase the operating cash flow
The book value of a firm is:
based on historical cost
Short selling a stock means
borrowing a stock to sell it on the bearish market
What industries would you expect to be targets of LBOS?
companies with stable business models and committed customers
What is the model that determines the market value of a stock based on its next annual dividend, the dividend growth rate, and the applicable discount rate?
constant-growth model
What is sunk costs?
costs that have already been incurred and can't be recovered
Which of those are non-cash expenditures?
depreciation and amortization
The higher discount rates lead to
faster decrease of present value with time
Endowment funds are
funds retained and invested by non-profit organizations
Which on of the following statements related to liquidity is correct?
liquid assets are valuable to a firm
Hedging means
long the firm you expect to grow the most, short an underperforming firm from the same industry
Which one of the following statements concerning net working capital is correct?
net working capital increases when inventory is sold for cash at a profit
If the industry median ROE is 12.3. and the firm's ROE is 11.9, then the firm's riskiness is:
not possible to identify without DuPoint analysis
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the
payback period
Hedge funds are
pooled investment funds, usually a private partnership, that seeks to maximize absolute returns
The sources and uses of cash over a stated period of time are reflected on the:
statement of cash flows
All else constant, the net present value of a project increases when:
the rate of return decreases
The price sensitivity of a bond increases in response to a change in the market rate of interest as the:
time to maturity decreases