BUS303. Study guide 2. Chapter 14

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1 BUS303 Study guide 2 Chapter An efficient capital market is one in which: A. all securities that investors want are offered. B. all transactions are closed within 2 days. C. current prices reflect all current information. D. the lowest interest rates are offered. 2. Which of the following is a source of cash for a firm? A. Retained earnings B. Issuing new debt C. Issuing new equity D. All of these 4. A stock's par value is represented by: A. the maturity value of the stock. B. the price at which each share is recorded. C. the price at which an investor could sell the stock. D. the price received by the firm when the stock was issued. 5. Additional paid-in capital refers to: A. a firm's retained earnings. B. a firm's treasury stock. C. the difference between the issue price and the par value. D. funds borrowed from a bank or bondholders. 7. If 100 million shares of common stock are issued with a par value of $2 and additional paid-in capital of $800 million, the total par value of the issued shares is: A. $200 million. B. $600 million. C. $800 million. D. $1 billion. 8. Which of the following bonds is likely to be viewed by investors as the riskiest? A. Subordinated debt B. Indexed (inflation-adjusted) bond C. Secured bond D. Asset-backed bonds

2 9. The purpose of a sinking fund is to: A. reduce the par value of stock over time. B. take advantage of the tax break on preferred stock. C. periodically retire debt prior to final maturity. D. allow risky corporations to avoid bankruptcy. 11. Protective covenants prevent bond issuers from irresponsible overborrowing behavior and are offered for the benefit of: A. common shareholders. B. preferred shareholders. C. bondholders. D. both common and preferred shareholders. 12. The value of retained earnings on the corporate balance sheet represents the amount of earnings: A. not paid out in dividends this period. B. that remains in cash. C. over and above corporate income taxes. D. reinvested in the firm since its inception. 13. If a corporation has more shares issued than outstanding, then: A. the Board of Directors is holding shares. B. there are preferred shares outstanding. C. the corporation has treasury stock. D. unexercised stock warrants exist. 14. A warrant has an exercise price of $40, and the current stock price is $38. An investor holding this option will purchase the stock only if: A. the dividend yield on the stock exceeds 10%. B. the stock price falls below $38. C. the stock price rises above $40. D. the stock price falls to $20 or below. 15. A corporation's net worth is composed of the: A. book value of common equity. B. par value plus additional paid-in capital. C. retained earnings less treasury stock. D. book value of common equity plus preferred stock. 16. Discuss what effect you would expect the following debt provisions to have on the yield that corporations must offer investors: funded (versus unfunded) debt, sinking fund, call provision, subordinated debt, secured debt

3 Chapter Issue costs for equity are higher than those for debt for all of the following reasons except: A. equity issues have higher administrative costs. B. underwriting stock is riskier than underwriting bonds. C. equity issues involve significantly more time to sell. D. equity issues have lower economies of scale. 2. In return for providing funds, venture capitalists receive: A. long-term bonds of the firm. B. short-term bonds of the firm. C. an equity position in the firm. D. ownership of the entire firm. 3. Which of the following statements is generally true concerning the costs of security issue? A. Underpricing is rarely a significant cost. B. Equity is cheaper to issue than debt. C. Debt is cheaper to issue than equity. D. There are no economies of scale in security issuance. 4. Firms go public to: A. raise additional capital. B. diversify public debtholders' risk. C. avoid second-stage financing. D. increase their leverage. 5. If an underwriter charges the public $40 per share for a new issue after having promised the issuer $38 per share, the spread per share is: A. $1.00. B. $2.00. C. $ D. $ When underwriters offer a firm commitment on a stock issue, they: A. employ their best efforts in selling the stock. B. guarantee the proceeds to the issuing firm. C. agree to purchase the venture capitalists' shares. D. assure purchasers that the stock will appreciate. 7. One strategy that appears to be used by certain underwriters to reduce the risk of marketing a stock is to: A. offer a firm commitment on the issue. B. set the initial stock price below its true value.

4 C. sell the securities in foreign countries. D. offer price rebates on the stock purchases. 8. Some investors believe that the decision by management to issue equity as opposed to issuing debt is a signal that: A. the stock is currently undervalued. B. the stock is currently overvalued. C. the firm will avoid dilution of stock value. D. a shelf registration of securities will occur. 9. Underwriters are more likely to oversell new stock issues during: A. a bear market or market crash. B. a stable period. C. a bull market or market boom. D. all of these. 10. Discuss the market's reaction to new stock issues. 12. How do firms make initial public offerings and what are the costs of such offerings? 13. Discuss the functions conducted by security underwriters. Chapter A firm's capital structure is represented by its mix of: A. assets. B. liabilities and equity. C. assets and liabilities. D. assets, liabilities, and equity. 2. MM's proposition II states that the: A. expected return on equity increases as financial leverage increases. B. expected return on assets decreases as expected return on debt decreases. C. firm's capital structure is irrelevant to value determination. D. greater the proportion of equity, the higher the expected return on debt. 3. As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches: A. the expected return on debt. B. the expected return on assets. C. its maximum. D. zero.

5 4. Leverage will shareholders' expected return and their risk. A. increase; decrease B. decrease; increase C. increase; increase D. increase; do nothing to 5. Which of the following is a safe assumption for a firm in which the PV of the tax shield is approximately equal to the costs of financial distress? A. The tax shield has been calculated incorrectly. B. The firm is too heavily levered financially. C. The firm has reached its optimal debt level. D. The firm appears to have low risk of financial distress. 6. According to the trade-off theory, the capital structure is a trade-off between: A. tangible and intangible asset risk. B. high and low target debt ratios. C. tax savings and financial distress costs. D. tax shields and equity financing. 7. What is meant by investors being able "to undo" the effects of corporate restructuring? Investors: A. repay their portion of the firm's debt. B. purchase securities only in unlevered firms. C. will pay more for unlevered shares. D. borrow in their name and replicate the effects of restructuring. 8. What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes. A. 54.0% B. 60.0% C. 66.7% D. 75.0% 9. What is the return on equity for a firm with 15% return on assets, 10% return on debt, and a. 75 debt-equity ratio? A % B % C % D % 10. What is the expected rate of return to equityholders if the firm has a 35% tax rate, a 10% rate of interest paid on debt, a 15% WACC, and a 60% debt-asset ratio? A % B %

6 C % D % 11. Ignoring taxes, a firm's weighted-average cost of capital is equal to: A. its expected return on assets. B. its expected return on equity. C. the sum of expected return on equity and expected return on debt. D. its expected return on assets times the debt-equity ratio. 12. With a tax rate of 35%, calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, and finances 45% of assets with debt. A % B % C % D % 13. Firms facing financial distress may pass up positive-npv projects rather than commit new equity because: A. they prefer to finance with debt. B. the benefits may be shared with the bondholders. C. no cash is available for dividends. D. there is no interest tax shield associated with equity. 14. The optimal capital structure is met when: A. additional borrowing results in lower financial distress costs. B. additional borrowing is offset by the interest tax shield. C. the tax savings from additional leverage are offset by the costs of distress. D. the present value of the tax shield is greater than the value of an all-equity-financed firm. 15. Equity, Inc. is currently an all-equity-financed firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock. Show the value of the firm, EPS, and rate of return on the stock before and after the proposed restructuring. What changed? 16. Explain the pecking order theory of capital structure. How will this affect the "optimal" capital structure for a firm? 17. In the year ending October 2007, Walmart paid out $1,929 million as debt interest. How much more tax would Walmart have paid if the firm had been entirely equity-financed? What would be the present value of Walmart's interest tax shield if the company planned to keep its borrowing permanently at the 2007 level? Assume an interest rate of 6% and a corporate tax rate of 35%.

7 18. Calculate the WACC for a firm with a debt-equity ratio of 1.5. The debt pays 10% interest and the equity is expected to return 16%. Assume a 35% tax rate and risk-free debt. 19. Explain MM proposition II under conditions of corporate taxes and risk-free debt. How does the analysis change when debt can be risky? 20. Does firm value increase when more debt is used? 21. Is there a rule for finding optimal capital structure? Answer Key Chapter C 2. D 3. A 4. B 5. C 6. B 7. A 8. A 9. C

8 10. C 11. C 12. D 13. C 14. C 15. D 16. In times of a positively sloped yield curve, or even with mere uncertainty over future interest rates, one would expect that funded (i.e., long-term) debt would require a higher yield than liabilities that will be paid off in one year. An investor should expect to receive a lower yield if the debt has a sinking fund provision. Basically, this reduces the riskiness of the debt by eliminating the uncertainty over whether the firm can raise the full amount of the principal for repayment at the time of final maturity. Debt that has a call provision will be likely to increase the yield that issuers must offer to investors to hold the bonds. This is because investors can no longer be certain that they will collect the expected yield until the final maturity. In return for uncertainty of return, investors will likely require more in initial yield. Investors who hold subordinated debt should expect to receive higher yields because their investment is less secure than others. In the case of bankruptcy, subordinated debtholders will join the general creditors of the firm rather than having claims on some specific assets. For the same reason, secured debt would be expected to offer a lower yield than subordinated debt, due to the collateral value that, in effect, places a floor under which the value of the security should not go. Chapter D 2. C 3. C 4. A 5. B 6. B 7. B

9 8. B 9. C 10. It is widely believed that a large number of new shares being issued into the market all at one time will temporarily depress the stock price. If the issue is large enough, it may cause the price to drop to a level that makes it nearly impossible to raise money. This belief implies that a new issue depresses the stock price below its true value, but only temporarily. 12. The initial public offering is the first sale of shares in a general offering to investors. The sale of the securities is usually managed by an underwriting firm which buys the shares from the company and resells them to the public. The underwriter helps prepare a prospectus, which describes the company and its prospects. The costs of an IPO include direct costs such as legal and administrative fees, as well as the underwriting spread the difference between the price the underwriter pays to acquire the shares from the firm and the price the public pays the underwriter for those shares. Another major implicit cost is the underpricing of the issue that is, shares are typically sold to the public somewhat below the true value of the security. This discount is reflected in abnormally high average returns to new issues on the first day of trading. 13. Underwriters perform three basic functions. First, they operate as advisor to firms that contemplate new security issues. It is doubtful in this function that there exists much of an agency problem; reputation is quite important to underwriters and if they encouraged issues that were ultimately unsuccessful, they would rapidly see their business going to other underwriters. Second, underwriters, acting either on a firm commitment or best efforts basis, will purchase the issue of securities from the firm. This is without recourse under the firm commitment basis. Finally, underwriters will sell the securities to the general public. This effort is conducted either alone or in syndication with other underwriters in the case of a large issue. A portion of the success of the sale can come from whichever underwriter was selected, which of course deals with issues such as reputation and sales network. In return for these services, the underwriter earns a spread on the securities that are underwritten. Chapter B 2. A 3. B 4. C 5. B

10 6. C 7. D 8. C 9. A 10. D 11. A 12. A 13. B 14. C 15. The EPS and return on equity increased after restructuring, but this did not change the share price since it is now viewed as riskier. Thus, the required rate of return increased on the equity so that the total value of the firm remains constant. 16. The pecking order theory says that firms prefer internal financing (that is, earnings retained and reinvested) over external financing. If external financing is needed, they prefer to issue debt rather than issue new shares. The pecking order theory starts with the observation that managers know more than outside investors about the firm's value and prospects. Managers who are choosing between debt and equity to finance a project realize that investors will assume projects to be equity financed only when the equity is overvalued. Thus, the market may penalize the value of equity when it is announced that new equity will be issued. To the extent that investors are correct in assuming overvalued equity, this is a rational response. To avoid this market penalty, managers will first finance with internal equity (i.e., retained earnings), then issue debt as more funds are needed, and finally issue equity if and only if retained earnings and new debt are insufficient. This pecking order may upset the trade-off theory of capital structure, because firms may be reluctant to add debt to capital structure even if there is additional value from the interest tax shield. Thus, firms may operate with less than the "optimal" amount of debt in their capital structure as long as they can fund projects with retained earnings. 17. Walmart's borrowing reduced taxable profits by $1,929 million. With a tax rate of 35%, tax was reduced by.35 $1,929 = $675.2 million. If the borrowing is permanent, Walmart will save this amount of tax each year. The present value of the tax savings would be $675.2/.06 = $11,253 million.

11 Under MM proposition II, the expected return on equity rises in a linear manner as the debtequity ratio increases. The linearity assumes that the debt is riskless regardless of the changing debt ratio. The expected return on assets remains constant regardless of the debt. And, again assuming riskless debt, the expected return on debt also remains constant. Therefore it is the increased expected return on the equity that allows the return on assets to remain stable. The increase in expected return for equity makes sense because the equity base is shrinking and must assume the increasing risk of financial leverage. When debt is allowed to be risky, the analysis changes such that, after a certain debt-equity ratio, the expected return on debt increases to compensate for the risk of default. Since the expected return on assets is still constant, this implies that the expected return on equity is increasing at a decreasing rate as this amount of debt appears in the capital structure. Thus, the bondholders are bearing a larger portion of the total risk of the firm. 20. Not necessarily. Modigliani and Miller's (MM's) famous debt irrelevance proposition states that firm value can't be increased by changing capital structure. Therefore, the proportions of debt and equity financing don't matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off. Of course MM's argument rests on simplifying assumptions. For example, it assumes efficient, well-functioning capital markets, and ignores taxes and costs of financial distress. But even if these assumptions are incorrect in practice, MM's proposition is important. It exposes logical traps that financial managers sometimes fall into, particularly the idea that debt is "cheap financing" because the explicit cost of debt (the interest rate) is less than the cost of equity. Debt has an implicit cost too, because increased borrowing increases financial risk and the cost of equity. When both costs are considered, debt is not cheaper than equity. MM show that if there are no

12 corporate income taxes, the firm's weighted-average cost of capital does not depend on the amount of debt financing. 21. There are no simple answers for capital structure decisions. Debt may be better than equity in some cases, worse in others. But there are at least four dimensions for the financial manager to think about. Taxes. How valuable are interest tax shields? Is the firm likely to continue paying taxes over the full life of a debt issue? Safe, consistently profitable firms are most likely to stay in a tax-paying position. Risk. Financial distress is costly even if the firm survives it. Other things equal, financial distress is more likely for firms with high business risk. That is why risky firms typically issue less debt. Asset type. If distress does occur, the costs are generally greatest for firms whose value depends on intangible assets. Such firms generally borrow less than firms with safe, tangible assets. Financial slack. How much is enough? More slack makes it easy to finance future investments, but it may weaken incentives for managers. More debt, and therefore less slack, increases the odds that the firm may have to issue stock to finance future investments.

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