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Questions and Answers of
Corporate Finance
Differentiate between direct and indirect costs of bankruptcy. Which of the two is generally more significant?
How can restrictive covenants in bonds be both an agency cost of debt and a way to prevent agency costs of debt?
What are the trade-offs in the agency cost/tax shield trade-off model? How is the firm’s optimal capital structure determined under the assumptions of this model? Does empirical evidence support
What industrial and national capital structure patterns are exhibited globally? What factors seem to be driving these patterns?
What is the observed relationship between debt ratios and profitability and the perceived costs of financial distress? Why does the relationship between leverage and profitability imply that capital
How influential are corporate and personal taxes on capital structure? Historically, have changes in American tax rates greatly affected debt ratios?
How do stock prices generally react to announcements of firms’ changes in leverage? Why is this result perplexing and seemingly contradictory?
As Chief Financial Officer of the Magnificent Electronics Corporation (MEC), you are considering a recapitalization plan that would convert MEC from its current all-equity capital structure to one
The All-Star Production Corporation (APC) is considering a recapitalization plan that would convert APC from its current all-equity capital structure to one including some financial leverage. APC now
As Chief Financial Officer of the Campus Supply Corporation (CSC), you are considering a recapitalization plan that would convert CSC from its current all-equity capital structure to one including
An unlevered company operates in perfect markets and has net operating income (EBIT) of $250,000. Assume that the required return on assets for firms in this industry is 12.5 percent and that the
Assume that capital markets are perfect. A firm finances its operations with $50 million in stock, with a required return of 15 percent, and $40 million in bonds with a required return of 9 percent.
A firm operates in perfect capital markets. The required return on its outstanding debt is 6 percent, the required return on its shares is 14 percent, and its WACC is 10 percent. What is the firm’s
Assume that two firms, U and L, are identical in all respects except that Firm U is debt free and Firm L has a capital structure that is 50 percent debt and 50 percent equity by market value. Further
Hearthstone Corp. and The Shaky Image Co. are companies that compete in the luxury consumer goods market. The two companies are virtually identical, except that Hearthstone is financed entirely with
In the mid-1980s, Michael Milken and his firm, Drexel Burnham Lambert, made the term “junk bonds” a household word. Many of Drexel’s clients issued junk bonds (bonds with low credit ratings) to
Herculio Mining has net operating income of $5 million; there is $50 million of debt outstanding with a required rate of return of 6 percent; the required rate of return on the industry is 12
An all-equity firm is subject to a 30 percent tax rate. Its total market value is initially $3,500,000. There are 175,000 shares outstanding. The firm announces a program to issue $1 million worth of
Intel Corp. is a firm that uses almost no debt and had a total market capitalization of about $179 billion in April 2004. Assume that Intel faces a 35 percent tax rate on corporate earnings. Ignore
Soonerco has net operating income of $2.5 million per year, and $15 million of debt outstanding with a required return (interest rate) of 8 percent. The required rate of return on assets in this
You are the manager of a financially distressed corporation with $1.5 million in debt outstanding that will mature in three months. Your firm currently has $1 million cash on hand. Assume that you
A firm has the choice of investing in one of two projects. Both projects last one year. Project 1 requires an investment of $11,000 and yields $11,000 with a probability of 0.5 and $13,000 with a
An all-equity firm has 100,000 shares outstanding worth $10 each. The firm is considering a project requiring an investment of $400,000 and has an NPV of $50,000. The company is also considering
You are the manager of a financially distressed corporation that has $5 million in loans coming due in 30 days. Your firm has $4 million cash on hand. Suppose that a long-time supplier of materials
Magnum Enterprises has net operating income of $5 million; there is $50 million of debt outstanding with a required rate of return of 6 percent; the required rate of return on the industry is 12
Slash and Burn Construction Company currently has no debt and expects to earn $10 million in net operating income each year for the foreseeable future. The required return on assets for construction
Slash and Burn Construction Company currently has no debt and expects to earn $10 million in net operating income each year, for the foreseeable future. The required return on assets for construction
1. What is capital structure? 2. What is financial leverage? 3. How does financial leverage relate to firm risk and expected returns? 4. Modigliani and Miller demonstrated that capital structure
Comment on the following proposition: The use of floating-rate debt eliminates interest rate risk (the risk that interest payment amounts will change in the future) for both the borrower and the
List and briefly discuss the key features that distinguish long-term debt issues from each other.
Define the following: term loan, balloon payment, collateral, and stock purchase warrants.
What is a project finance (PF) loan? What role does a stand-alone company play in the typical project finance deal?
What is a debenture? Why do you think that this is the most common form of corporate bond in the United States, but is much less commonly used elsewhere?
How do sinking funds reduce default risk?
What is a trustee? Why do bondholders insist that a trustee be included in all public bond offerings? Why are these less necessary in private debt placements?
What impact has adoption of Rule 144A had on debt-issuance patterns in the United States?
Why are most corporate bonds callable? Who benefits from this feature, and what is the cost of adopting a call provision in a public bond issue?
Why do corporations have their debt rated? Compare the role played by rating agencies and a company’s outside auditors.
What does investment grade mean in the context of corporate bond issues? How do these bonds differ from junk bonds, and why have the latter proven so popular with investors?
What is a Eurobond? Why did these bonds come into existence? Why do Eurobond investors like the fact that these are typically “bearer bonds”? What risk does an investor run from holding bearer
Explain how uncertainty concerning future interest rates would affect the decision to refund a bond issue.
Define the following: direct lease, sale-leaseback arrangement, leveraged lease, and financial (capital) lease. What elements must be included in a lease in order for it to be considered a financial
How would the availability of floating-rate debt affect the lease-versus-purchase decision?
For acquiring an asset, what are the key advantages of leasing as compared to borrowing? What are the key disadvantages of leasing?
The initial proceeds per bond, the size of the issue, the initial maturity of the bond, and the years remaining to maturity are shown in the following table for a number of bonds. In each case the
For each of the callable bond issues in the following table, calculate the after-tax cost of calling the issue. Each bond has a $1,000 par value, and the various issue sizes and call prices are shown
The floatation cost, the initial maturity, and the number of years remaining to maturity are shown in the following table for a number of bonds. The firm is in the 40% tax bracket.a. Calculate the
The principal, coupon interest rate, and interest overlap period are shown in the following table for five different bonds.Calculate the dollar amount of interest that must be paid for each bond
Schooner Company is contemplating offering a new $50 million bond issue to replace an outstanding $50 million bond issue. The firm wishes to take advantage of the decline in interest rates that has
High-Gearing Incorporated is considering offering a new $40 million bond issue to replace an outstanding $40 million bond issue. The firm wishes to take advantage of the decline in interest rates
Web Tools Company is considering using the proceeds from a new $50 million bond issue to call and retire its outstanding $50 million bond issue. The details of both bond issues are outlined in what
Given the lease payments and terms shown in the following table, determine the yearly after-tax cash outflows for each firm. Assume that lease payments are made at the beginning of each year. The
GMS Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40% tax bracket, and its after-tax cost of debt is currently 6%. The terms of the lease
Eastern Trucking Company needs to expand its facilities. In order to do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 40% tax
Given the lease payments, terms remaining until the leases expire, and discount rates shown in the following table, calculate the capitalized value of each lease. Assume that lease payments are made
1. What types of debt covenants might managers consider?2. What are the major factors that affect the cost or interest rate of a debt instrument?3. What are term loans, and what are their
Compare and contrast the following dividend policies: constant payout ratio dividend policy and the constant dollar payout dividend policy. Which policy do most public companies actually follow? Why?
What is a low-regular-and-extra-dividend payout policy? Why do firms pursuing this policy explicitly label some cash dividend payments as “extra”?
What is a stock dividend? How does this differ from a stock split?
What factors have contributed to the growth in share repurchase programs by U.S. public companies? What effect did the Jobs and Growth Tax Relief Reconciliation Act of 2003 have on share repurchase
What is the average stock market reaction to: (a) A dividend initiation; (b) A dividend increase; (c) A dividend termination; (d) A dividend decrease? Are these reactions logically consistent?
What are the key assumptions and predictions of the agency cost/contracting model of dividend payments? Are these predictions supported by research findings?
Around the world, utilities generally have the highest dividend payouts of any industry, yet they also tend to have massive investment programs which they finance using external sources. How do you
Why do firms with diverse shareholder bases typically pay higher dividends than private firms or public firms with more-concentrated ownership structures? How are fixed dividends used as a bonding
How is the residual theory of dividends used to explain observed dividend payments? How is this theory in conflict with evidence suggesting that corporate managers smooth dividends?
Beta Corporation has the following shareholders’ equity accounts Common stock at par ........... $ 5,000,000 Paid-in capital in excess of par ....... 2,000,000 Retained earnings ............
What are alternative ways in which investors can receive a cash return from their investment in the equity of a company? From a tax standpoint, which of these would be preferred, assuming that
Delta Corporation earned $2.50 per share during fiscal year 2011 and paid cash dividends of $1.00 per share. During the fiscal year that just ended on December 31, 2012, Delta earned $3.00 per share,
Advanced Vehicle Enterprises (AVE) follows a policy of paying out 50% of its net income as cash dividends to its shareholders each year. The company plans to do so again this year, during which AVE
General Manufacturing Company (GMC) follows a policy of paying out 50% of its net income as cash dividends to its shareholders each year. The company plans to do so again this year, during which GMC
Specialty Chemicals Company (SCC) pays out 50% of its net income as cash dividends to its shareholders once each quarter. The company plans to do so again this year, during which SCC earned $100
Twilight Company’s stock is selling for $60.25 per share, and the firm’s managers have just announced a $1.50 per share dividend payment. a. What should happen to Twilight Company’s stock price
Global Financial Corporation (GFC) has 10 million shares outstanding, each currently worth $80 per share. The firm’s managers are considering a plan to split the company’s stock 2-for-1, but they
The net income for a firm is currently $1,000,000 and is projected to grow annually for the next four years as follows: $1,200,000, $1,300,000, $1,500,000, and $1,700,000. Assuming the dividend
A firm’s shares currently sell for $32.48, with 5 million shares outstanding. The firm is considering a 20% stock dividend, in which 100 shares become 120 shares. After the stock dividend, at what
A firm’s shares currently sell for $3.50 with 4 million shares outstanding. The firm plans to reverse split its stock by combining two shares into one share. If the price after this reverse split
Sunshine Pageants decides that it will use a Dutch auction to repurchase 2 million shares. Investors have submitted the following bids on the price and quantity they are willing to sell shares to the
Investor A recognizes $100 in dividend income that is taxed at a rate of 20%. Investor B also wants to recognize the same after-tax revenue as investor A, but investor B owns stock that does not pay
Maggie Fiduciary is a shareholder in the Superior Service Company (SSC). The current price of SSC’s stock is $33 per share, and there are 1 million shares outstanding. Maggie owns 10,000 shares, or
Stately Building Company’s shares are selling for $75 each and its dividend yield is 2.0%. What is the amount of Stately’s dividend per share?
The stock of Up-and-Away Inc. is selling for $80 per share and is currently paying a quarterly dividend of $0.25 per share. What is the dividend yield on Up-and-Away stock?
Well-Bred Service Company earned $50,000,000 during 2012 and paid $20,000,000 in dividends to the holders of its 40 million shares. If the current market price of Well-Bred’s stock is $31.25,
It is January 1, 2012, and Boomer Equipment Company (BEC) currently has assets of $250 million and expects to earn a 10% return on assets during the year. There are 20 million shares of BEC stock
Swelter Manufacturing Company (SMC) currently has assets of $200 million and a required return of 10% on its 10 million shares outstanding. The firm has an opportunity to invest in minimally
Assume it is now January 1, 2012, and you are examining two unlevered firms that operate in the same industry that have identical assets worth $80 million that yield a net profit of 12.5% per year,
Investors anticipate that Sweetwater Manufacturing Inc.’s next dividend, due in one year, will be $4 per share. Investors also expect earnings to grow at 5% in perpetuity, and they require a return
Super-Thrift Pharmaceuticals Company traditionally pays an annual dividend equal to 50% of its earnings. Earnings this year are $30,000,000. The company has 15 million shares outstanding. Investors
Casual Construction Corporation (CCC) earned $60,000,000 during 2012. The firm expects to earn $63,000,000 during 2013, in line with its long-term earnings growth rate. There are 20 million CCC
Hole Foods Donuts, Inc. has generated profits of $2 per share for many years and has consistently paid 100% of those profits to shareholders via a dividend. Investors do not expect Hole Foods Donuts
Jasper Metals, Inc. just announced that it will pay its regular quarterly dividend of $3.50 per share. a. Does the stock price fall to reflect this payment on the announcement date, the record date,
Go to the home page of Cisco Systems, Inc. (www.cisco.com) and link to its financial reports page. Download the most recent annual report and observe the capital investment and dividend policies of
Universal Windmill Company (UWC) currently has assets worth $50 million and a required return of 10% on its 2 million shares outstanding. The firm has an opportunity to invest in (minimally)
A publicly traded firm announces an increase in its dividend with no other material information accompanying the announcement. What information is this announcement likely to convey, and what is the
Sam Sharp purchased 100 shares of Electric Lighting Inc. (ELI) one year ago for $60 per share. He also received cash dividends totaling $5 per share over the past twelve months. Now that ELI’s
1. What are the different types of dividend policies? Provide examples of situations in which each of these dividend policies could be used. 2. Describe the difference between cash dividends, stock
What is the financial planning process? What is a strategic plan? Describe the roles that financial managers play with regard to strategic planning.
Briefly describe the following popular growth targets: (1) Accounting-based return on investment (ROI), (2) Economic value added (EVA®), (3) Target growth rate of sales or assets. Which is most
In the sustainable growth model, what does the word sustainable mean? In what ways can the sustainable growth model highlight conflicts between a firm’s competing objectives?
With reference to Equation, explain how each of the variables influences the firm’s sustainable growth rate. If high leverage allows a firm to increase its sustainable growth rate, does that mean
A firm chooses to grow at a rate above its sustainable rate. What changes might we expect to see on the firm’s financial statements in the next year? What changes would result from growing at a
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