Corporate Finance Exam 2
Firms can pay out cash to their shareholders in the following way(s): I) dividends; II) share repurchases; III) interest payments
I and II only
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
Consider the following data for Kriya Company: Year: 1 2 3 4 Free Cash Flow (FCF) (in millions):4 5 6 6.24 A constant growth rate of 4 percent is sustained forever after year 3. The weighted average cost of capital is 10 percent.Calculate the value of the firm.
1. 6.24/0.10-0.04 = 104 4/1.10 + 5/1.10^2 + (6+104)/1.10^3 $90.4
A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?
14 = (1/3) *10 + (2/3)*X Solve for X 42 = 10 + 2X X=16%
The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) debt is more risky than equity; II) bankruptcy and its attendant costs are a disadvantage to debt; III) the payment of personal taxes may offset the tax benefit of debt
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
Which of the following dividends are never in the form of cash? I) regular dividend; II) special dividend; III) stock dividend; IV) liquidating dividend
III only
_________ tax rate is the amount of tax payable on the next dollar earned.
Marginal
If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 21 percent
PV (int tax shield) = (0.21)(100) = $21 million
Bombay Company's book and market value balance sheets are as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value): Book Values Market Values NWC 200 500 DNWC 200 500 DLTA 2,300 2,00 ELTA 2,800 2,500 E 2,500 2,500 V 3,000 3,000 V According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 21 percent marginal corporate tax rate.
PV of tax shield : -$200 (0.21) = -$42
Given are the following data for Outsource Company: PV (of FCFs for years 1-3) = $35 million; PV (horizon value) = $65 million. Calculate the value of the firm.
PV(firm) = 35 + 65 = 100
The equation for M & M Proposition I, without taxes, is best shown as:
VL=VU
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
According to behavioral finance, investors prefer dividends because
investors prefer the discipline that comes from spending only the dividends
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
While calculating the weighted average cost of capital, which values should one use for D, E, and V?
market values
To calculate the total value of the firm (V), one should rely on the
market values of debt and equity
According to the trade-off theory of capital structure,
optimal capital structure occurs when the PV of tax savings on account of additional borrowing just offsets the increase in the PV of cost distress
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.
1. 20 * 1.05 / .12 - 0.05 = 300 2. 20/1.12 + 20/1.12^2 + 20 + 300 /1.12^3 $261.57m
Benson Company has 150,000 outstanding shares @ $20/share. The company has declared a two-for-one stock split. How many shares will be outstanding and at what value after the split?
300,000 shares at $10/share. Notice that the total market value is unchanged after the split. The market value is 3,000,000
Dividend Reinvestment Plans have the option of:
Automatically reinvesting some or all of their cash dividends in shares of stock.
Which of the following lists events in chronological order from earliest to latest?
Declaration date, ex-dividend date, record date
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
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 are the following data for year 1:Profits after taxes = $14 million; Depreciation = $6 million; Interest expense = $6 million; Investment in fixed assets = $12 million; Investment in working capital = $3 million. The corporate tax rate is 25 percent. Calculate the free cash flow (FCF) for year 1.
FCF = 14 + 6 + (1-.25) *6 -12 -3 = $9.5m
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.
FCF = 20 +6 + (1-0.25)*4-12-4 $13m
Given are the following data for year 1:Profit after taxes = $5 million; Depreciation = $2 million; Investment in fixed assets = $4 million; Investment net working capital = $1 million. Calculate the free cash flow (FCF) for year 1.
FCF =5+2-4-1 = 2
On January 2, Michigan Mining declared a $2-per-share quarterly dividend payable on March 9th to stockholders of record on Friday, February 9. What is the latest date by which you could purchase the stock and still get the recently declared dividend?
February 6
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.)
Firm borrows $10/share Interest per share = $10 * .06 = $0.60 New EPS = (6-0.60)/0.75 = $7.20/share
When financial distress is a possibility, the value of a levered firm is a function of: I) value of the firm if all-equity-financed; II) present value of tax shield; III) present value of costs of financial distress; IV) present value of omitted dividend payments
I + II - III
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: I) 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; II) the carry-forward provision allows corporations to carry forward the loss and use it to shield income in subsequent years
I and II
MM Proposition I with corporate taxes states that: I) capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; II) by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value; III) firm value is maximized by using an all-equity capital structure
I and II
When using the weighted average cost of capital (WACC) to discount cash flows from a project, we assume the following: I) The project's risks are the same as those of the firm's other assets and remain so for the life of the project. II) The project supports the same fraction of debt to value as the firm's overall capital structure, and that fraction remains constant for the life of the project. III) The cash flows from the project occur in perpetuity.
I and II only
Dividend policy may affect firm value because I) there is an unsatisfied clientele that prefer dividends to capital gains; II) there are sufficient loopholes in the tax system that wealthy shareholders can avoid taxes on dividends; III) well-managed companies prefer to signal their worth by paying high dividends
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
When a firm has no debt, then such a firm is known as I) an unlevered firm; II) a levered firm; III) an all-equity firm
I and III only
Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) meet interest and principal payments, which if not met can put the company into financial distress; II) make dividend payments, which if not met can put the company into financial distress; III) meet both interest and dividend payments, which when met increase the firm cash flow; IV) meet increased tax payments, thereby increasing firm value
I only
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
MM Proposition II states that I) the expected return on equity is positively related to leverage; II) the required return on equity is a linear function of the firm's debt to equity ratio; III) the risk to equity increases with leverage
I, II and III
The following are indicators that the firm has a cash surplus:. I) Free cash flow is reliably positive. II) The firm has a low debt ratio compared to similar firms. III) The firm has sufficient debt capacity to cover unexpected opportunities or setbacks.
I, II and III
The following statements are true of dividend reinvestment plans (DRIPs): I) They are offered by the companies to their shareholders. II) Generally, new shares are issued at a discount. III) The dividends are taxable as ordinary income.
I, II and III
When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) favor high-risk, high-return projects even if they have negative NPV; II) refuse to invest in low-risk, low-return projects with positive NPVs; III) delay the onset of bankruptcy as long as they can
I, II and III
When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) issue large quantities of low-quality debt versus low quantities of high-quality debt; II) favor paying high dividends to shareholders; III) delay the onset of bankruptcy as long as they can
I, II and III
Which of the following are true? I) Firms have long-run target dividend payout ratios. II) Dividend changes follow shifts in long-term, sustainable earnings. III) Managers are reluctant to make dividend changes that might have to be reversed.
I, II and III
Firms can repurchase shares in the following ways: I) open market repurchase; II) tender offer; III) Dutch auction; IV) direct negotiation with a major shareholder
I, II, III and IV
Free cash flow (FCF) and net income (NI) differ in the following ways: I) Net income accrues to shareholders, calculated after interest expense; free cash flow is calculated assuming all flows go to equity holders. II) Net income is calculated after various noncash expenses, including depreciation; FCF adds back depreciation. III) Capital expenditures and investments in working capital do not appear in net income calculations; they do reduce free cash flows. IV) Net income is never negative; free cash flows can be negative for rapidly growing firms, even if the firm is profitable, because investments can exceed cash flows from operations.
I, II, and III only
The capital structure of the firm can be defined as I) the firm's mix of different debt securities; II) the firm's mix of different securities used to finance assets; III) the market imperfection that the firm's managers can exploit
II 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
Dividend policy changes are decided and announced by I) the managers of a firm; II) the government; III) the board of directors
III 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
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.
NPV= -25 + (2.25/0.09) 0
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.
PV (firm) = PV (FCF for yr 1-3) + PV (horizon value) --> 35 +65 = 100 Total value of equity = 100-30 = 70
Consider the following data for Kriya Company: Year: 1 2 3 4 Free Cash Flow (FCF) (in millions):4 5 6 6.24 A constant growth rate of 4 percent is sustained forever after year 3. The weighted average cost of capital is 10 percent.Calculate the present value of the horizon value. (Assume that the horizon value includes the 6.24M FCF in year 4.)
PV(horizon value) = 6.24/(.10-.04) / 1.10^3 78.14
A stock split is characterized by all of the following, except:
Paid in cash to outstanding shareholders.
If a firm permanently borrows $50 million 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.
Pv of interest tax shield = (0.21)(50) = $10.5 million
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. The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?
Sell 50 shares and purchase $3,000 of 8% debt (bonds): Refinancing results in a D/E ratio of 1 The new expected return on the stock increases from 20% to 32% With 50 shares (worth $3,000) and $3,000 of 8% debt, the expected return remains at 0.5 * 32% + 0.5 * 8% 20%
Company X has 100 shares outstanding. It earns $1,000 per year and announces that it will use all $1,000 to repurchase its shares in the open market instead of paying dividends. Calculate the number of shares outstanding at the end of year 1, after the first share repurchase, if the required rate of return is 10 percent.
Share price beginning of year = [$1000/0.1]/100 = $100 per share share price at end of year (before repurchase) = $100*1.10 = $110 NUmber of shares purchased = $1000/$110 = 9.09 100-909 = 90.91 shares remain
A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)
Solve for BA 1.2 = bA + 0.7 * (bA-0) 1.2 = 1.7bA bA = 1.2/1.7 .706
Which of these dates, when arranged in chronological order, occurs last?
dividend payment date
The effect of financial leverage depends on the company's _____________.
earnings before interest and taxes
The effect of financial leverage on the performance of the firm depends on the
firm's level of operating income
Generally, investors interpret the announcement of an increase in dividends as
good news, and the stock price increases
Generally, investors view the announcement of an open-market repurchase program as
good news, and the stock price increases
Consider the following data:FCF1 = $7 million; FCF2 = $45 million; FCF3 = $55 million. Assume that free cash flow grows at a rate of 4 percent for year 4 and beyond. If the weighted average cost of capital is 10 percent, calculate the value of the firm.
horizon value in yr 3 = 55(1.04) / (.10-.04) = $953.33m PV=(7/1.10) + 45/(1.10^2) + 55 +953.33 / 1.10^3 $801.12m
If a firm has preferred stock, the after-tax weighted average cost of capital (WACC) equals
rD (1-Tc)(D/V) + rP (P/V) + rE (E/V) (where V = D+E+P)
Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?
rE = 0.2 + (0.5/0.5) * (0.2-0.08) 32%
A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be
rE = 10 + (60/40) *(10-8) 13
A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?
rE = 12 + 1.0 * (12-9) 15%
A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)
rE = 9 + 2*(9-7) 13%
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.)
rE = rA + (D/E)*(rA-rD) 15 = (0.25/0.75) * (15-6) 18%
If dividends are taxed more heavily than capital gains, then investors
should be willing to pay more for stocks with low dividend yields
What signal is sent to the market when a firm decides to issue new stock to raise capital?
stock price is too high
Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the
stockholders of the firm
Modigliani and Miller's Proposition I states that
the market value of any firm is independent of its capital structure
One possible reason that shareholders often insist on higher dividends is
they do not trust managers to spend retained earnings wisely
According to financial executives' views on dividend policy, which of the following statements is most frequently cited?
we try to avoid reducing the dividend
Two corporations A and B have exactly the same risk, and both have a current stock price of $100. Corporation A pays no dividend and will have a price of $120 one year from now. Corporation B pays dividends and will have a price of $113 one year from now after paying the dividend. The corporations pay no taxes and investors pay no taxes on capital gains, but pay a 30 percent income tax on dividends. What is the value of the dividend that investors expect corporation B to pay one year from today?
The after tax returns must be the same Return stock A = 20% (or $20) Return stock B = 20% (or $20) Stock B delivers $13 cap gains and therefore must deliver an after-tax dividend of $7 Pre-tax dividend is (120-113) / 0.7 = $10
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 and the number of shares outstanding = 5 million. Calculate the share price.
Tota value of equity = 100-30 = 70 (from previous problem) Value per share = 70/5m outstanding = $14
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).
Use market values E = (12)*100 = $1,200 D= (800)*1 = $800 V=D+E = $2,000 D/V = 800/2,000 = 0.4 E/V = 1,200/2,000 = 0.6
The equation for M & M Proposition I, with taxes, is best shown as:
VL = VU + Tc * D
Lollipop Corp. provides the following information: EBIT = $286.50 Tax (TC )= 35% Debt= $810 Cost of debt capital = 10% RU = 15% What is the value of the firm?
VU = $1,241.53 VL = VU + Tc * D VL = $1,241.53 + 0.35 *$810 $1,525.03
Assume the marginal corporate tax rate is 21 percent. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 million in perpetual debt and repurchased the same amount of equity?
VU = 100 Tc = 0.21 * 50 = 10.5 VL = VU + TcB =100 + 10.5 = $110.5
Samuel Corp. provides the following information: EBIT = $286.50 Tax (TC ) = 35% Debt = $810 RU = 15% What is the value of the firm?
VU = EBIT *(1-Tc) / Ru $286.50*(1-.35) / .15 $1,241.53
Samuel Corp. provides the following information: EBIT = $386.50 Tax (TC ) = 35% Debt = $810 RU = 15% What is the value of Samuel's equity?
VU = EBIT *(1-Tc) / Ru $386.50 * (1-.35) / .15 =$1,674.83 Equity is worth the difference between total firm with and debt worth Vu-D 1,674.83 - 810 =$864.83
Given are the following data: Cost of debt = rD = 6.0%; Cost of equity = rE = 12.1%; Marginal tax rate = 21%; and the firm has 50 percent debt and 50 percent equity. Calculate the after-tax weighted average cost of capital (WACC).
WACC = (0.5)(1-.21)(6.0) + (0.5)(12.1) = 8.42%
One calculates the after-tax weighted average cost of capital (WACC) as
WACC = rD(1-Tc)(D/V) + rE(E/V)
Which of the following entities likely has the highest cost of financial distress?
a pharmaceutical development company
For a levered firm,
as EBIT increases, EPS increases by a larger percentage
For an all-equity firm,
as EBIT increases, the EPS increases by the same percentage
When one uses the after-tax weighted average cost of capital (WACC) to value a levered firm, the interest tax shield is
automatically considered because the after-tax cost of debt is included within the WACC formula
The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)
bE = 1.1 + 0.5 (1.1-0.3) 1.5
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.)
bE = 1.2 + (0.5/0.5) *(1.2-0.2) 2.2
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]
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?
bE = bA + (D/E) *(bA-bD) 1.9 + 0.75 * (1.9 - 0.2) =3.175
Generally, investors interpret the announcement of a decrease in dividends as
bad news, and the stock price drops
