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Questions and Answers of
Corporate Finance
In each of the following situations, explain the extent to which the empirical results offer reliable evidence for (or against) market efficiency. (a) A research study using data for firms
In the context of the Ross [1977] model, assume that managers are paid 20% of the time 0 and time 1 values of the firm. Further assume good firms are worth 250, bad firms are worth 150, and the
In the context of the Bhattacharya [1979] model, assume that the personal tax rate is 25%, the penalty associated with a shortfall is 50%, the project cash flows are uniformly distributed over
In the context of the Stein [1992] paper, show that (1) a bad firm will not mimic a good firm by issuing straight debt and (2) a medium firm will not mimic either a bad or good firm?
Assume that both the principal and agent have negative exponential utility and that the actions of the agent are observable. What is the optimal contract?
Consider a risk-neutral principal and an agent with utility functionAssume that the contract being provided to the agent is based on the final outcome only and that the outcome density satisfies the
Assume that the opportunity cost of capital is 25%. Provide a plot of the relation between the hurdle rate used by a manager for projects and the manager's tenure?
Prove the following theorem: "The present value of forecasted economic profit, when discounted at the weighted average cost of capital, plus the book value of assets, equals the DCF value of the
Suppose that a firm has a project that was started last year, and it is expected to earn less than its cost of capital if left unchanged. Management comes up with these suggestions.(a) Invest in a
Some companies measure performance by requiring both "top line" growth and "bottom line" growth (i.e., growth in revenues and growth in net income). Is this performance measure consistent with
Why are EPS, the percent change in EPS, EVA®, and the change in EVA® unrelated to TRS (total return to shareholders) in Table 13.2?
Management has informed the market that it expects to earn 30% on project A and 40% on project B, and these expectations are already baked into the firm's current stock price. The cost of capita] for
Jensen criticizes "kinked" relationships between pay and performance (see Fig. 13.6). How well do the following compensation schemes fit a linear relationship? (a) Stock option growth (b) Stock
When corporations issue liabilities (debt at a bank or bonds to the public), we assume that they do so at fair market rates. This implies that, on the day the liability is issued, the cash received
Look at the spreadsheet for Coca-Cola. (a) Does the ratio of excess cash marketable securities to total current assets make sense (compare 2003 to 2010)? (b) How would you change the model forecasts
Compute the ratio of entity value to EBIT for Coca-Cola in 2000 and again in 2010.(a) Do the ratios make sense?(b) What do they tell you about the company?
Substitute reasonable numbers for Coca-Cola (see the suggestions below) into Eq. (14.21).(a) What value does the equation provide?(b) How do you explain the differences between the formula result and
The XYZ company is growth oriented, and their return on invested capital is just equal to their cost of capital. Suppose that the company has no debt and NOPLAT10 = $1,000 EBIT = 1,667 T = 4 g =
The Modigliani-Miller theorem assumes that the firm has only two classes of securities, perpetual debt and equity. Suppose that the firm has issued a third class of securities-preferred stock-and
Community Bank must decide whether to open a new branch. The current market value of the bank is $2,500,000. According to company policy (and industry practice), the bank's capital structure is
A not-for-profit organization, such as a ballet company or a museum, usually carries no debt. Also, since there are no shareholders, there is no equity outstanding. How would you go about determining
Firms A and B are each considering an unanticipated new investment opportunity that will marginally increase the value of the firm and will also increase the firm's level of diversification. Firm A
In a world without taxes or transactions costs the Modigliani-Miller model predicts share holders' wealth invariant to changes in capital structure, whereas the OPM predicts increased shareholder
The Sharpe version of the CAPM results in the principle of two-fund separation. Every individual holds the same portfolio of risky assets, namely, the market portfolio. Therefore individuals will be
Consider a levered firm with $10 million face value of debt outstanding maturing in one year. The riskless rate is 6%, and the expected rate of return on the market is 12%. The systematic risk of
(a) True or false? The Modigliani-Miller model of cost of equity is equivalent to the OPM definition of cost of equity for an all-equity firm. Explain.(b) If we assume that N(d1) = 1 in the OPM,
Assume the following: (a) We are dealing with a world where there are no taxes. (b) The changes in the parameters affecting value are unanticipated; therefore redistribution effects are possible. (c)
Make the same assumptions as in Problem 15.17. Firm A decides to use some of its cash in order to purchase marketable securities. This has the effect of leaving its value, VA, unchanged but
What are the empirical problems involved in testing for the effect of capital structure on the value of the firm?
The Acrosstown Company has an equity beta, (L, of .5 and 50% debt in its capital structure. The company has risk-free debt that costs 6% before taxes, and the expected rate of return on the market is
During recent years your company has made considerable use of debt financing, to the extent that it is generally agreed that the percentage of debt in the firm's capital structure (either in book or
Southwestern Electric Company36 John Hatteras, the financial analyst for Southwestern Electric Company, is responsible for preliminary analysis of the company's investment projects. He is currently
The XYZ Company has a current market value of $1,000,000, half of which is debt. Its current weighted average cost of capital is 9%, and the corporate tax rate is 40%. The treasurer proposes to
Given a world with corporate taxes, (c, a personal tax rate paid on bonds, (pB, and a personal tax rate on income from equity, (pS, what would be the effect of a decrease in the corporate tax rate on
Congress has proposed to eliminate "double taxation" on dividends by reducing the personal tax on dividend income. At the same time, a compensating increase in taxes on capital gains (traditionally
Consider firm B as an unlevered firm and firm C as a levered firm with target debt-to-equity ratio (B/S)* = 1. Both firms have exactly the same perpetual net operating income, NOI - 180, before
A firm with $1,000,000 in assets and 50% debt in its capital structure is considering a $250,000 project. The firm's after-tax weighted average cost of capital is 10.4%, the marginal cost of debt
The firm's cost of equity capital is 18%, the market value of the firm's equity is $8 million, the firm's cost of debt capital is 9%, and the market value of debt is $4 million. The firm is
Susan Varhard, treasurer of the Gammamax Company, has proposed that the company should sell equity and buy back debt in order to maximize its value. As evidence, she presents the financial statements
Under what conditions might dividend policy affect the value of the firm?
Prove the following for a firm with no supernormal growth (in a world with only corporate taxes):
How does an increase in the investment (retention rate) affect the anticipated stream of investments that a company will undertake?
It was suggested that if a firm announces its intention to increase its dividends (paid from cash), the price of common stock increases, presumably because the higher dividend payout represents an
According to federal tax law, corporations need not pay taxes on 80% of dividends received from shares held in other corporations. In other words, only 20% of the dividends received by a corporate
Empirical evidence supports the existence of a clientele effect. This implies that every time a company revises its dividend policy to pay out a greater (or smaller) percentage of earnings, the
Miller and Scholes [1978] suggest that it is possible to shelter income from taxes in such a way that capital gains rates are paid on dividend income. Furthermore, since capital gains need never be
The Pettit study suggests an increase in the price per share of common stock commensurate with an increase in dividends. Can this be taken as evidence that the value of the firm is in fact affected
Assume that the XYZ firm has the following parameters in a world with no taxes: ( = .2................... instantaneous standard deviation, T = 4 years ............ maturity of debt, V = $2,000
The chairman of the board of Alphanull Corporation has announced that the corporation will change its dividend policy from paying a fixed dollar dividend per share. Instead, dividends will be paid
The XYZ Company (an all-equity firm) currently has after-tax operating cash flows of $3.00 per share and pays out 50% of its earnings in dividends. If it expects to keep the same payout ratio, and to
The balance sheet of the Universal Sour Candy Company is given in Table Q16.9. Assume that all balance sheet items are expressed in terms of market values. The company has decided to pay a $2,000
Your firm is considering lease financing for a computer that is expected to have a five-year life and no salvage value (it is a strict financial lease). You have the following facts: • Your firm's
Giveaway State Teacher's College is trying to decide whether to buy a new computer or to lease it from Readi Roller Leasing. The computer costs $500,000. Giveaway has a zero tax rate, whereas Readi
This question involves a more realistic set of facts and therefore requires a more detailed analysis of cash flows than contained in the chapter. Your company is going to negotiate a lease contract
Your firm has been approached to become an equity participant in a leveraged leasing deal. You need to estimate the minimum rate of return on equity that is acceptable. You have collected the
The Mortar Bored Company was considering whether to buy a new $100,000 reduction machine or to lease it. It was estimated that the machine would reduce variable costs by $31,000 per year and have an
Differential P/E games: This is a problem that illustrates how the differential P/E games have been played by companies like Tyco. We first present the basic input data in Table Q18.1.(a) Complete
Changes in ownership structure: Five alternative changes in ownership structure strategies are listed at the top of the columns in Table Q18.10. The seven rows are identified as strengths or benefits
The Watro Personal Computer Company is considering merger to achieve better growth and profitability. It has narrowed potential merger candidates to two firms. The Alber Company, a producer of PBXs,
The Jordan Corporation is a manufacturer of heavy-duty trucks. Because of a low internal profitability rate and lack of favorable investment opportunities in the existing line of business, Jordan is
For this problem and the next, assume the following:(a) We are dealing with a world where there are no taxes.(b) The changes in the parameters affecting value are unanticipated; therefore
Given the results of Problem 18.2, suppose that the merged firm has 1,000 shares outstanding. Furthermore, suppose that the shareholders decide to issue $1,000 of new debt (which is not subordinate
You are given the following information:In addition, the value of equity for firm A equals the value of equity for firm B, and the variance of returns for firms A and B are also equal. Using a
Empirical studies have established that the betas of conglomerate firms have been significantly above 1. What does this imply about diversification as a strong motive for conglomerate mergers?
Over a long period of time would you expect the risk-adjusted performance of conglomerate firms to be significantly different from the risk-adjusted performance of a broad market index? Explain.
Some argue that if two firms merge and thus decrease the probability of default on their debt, the stockholders are actually hurt, since they have assumed some of the risk previously borne by the
Alternative strategies for growth: Six alternative strategies for growth are listed at the top of the columns in Table Q18.8. The seven rows are identified as strengths or benefits for each of the
Asset restructuring: Four alternative asset restructuring strategies are listed at the top of the columns in Table Q18.9. The five rows are identified as strengths or benefits for each of the
Interest rate parity for FC/$: With the input data in Table Q19.1:(a) Using Case A, illustrate interest rate parity conditions as in the text.(b) Using Case B, illustrate interest rate arbitrage
In January 2004 (when FC3 = $1) it was expected that by the end of 2004 the price level in the United States would have risen by 10% and in the foreign currency by 5%. The real rate of interest in
Agrimex, S.A., a Mexican corporation, borrowed $ 1 million in dollars at a 10% interest rate when the exchange rate was 10 pesos per dollar. When the company repaid the loan plus interest one year
An American manufacturing company has imported industrial machinery at a price of FC4.6 million. The machinery will be delivered and paid for in six months. For planning purposes, the American
A foreign company buys industrial machinery from a U.S. company at a price of $10 million. The machinery will be delivered and paid for in six months. The foreign company seeks to establish its costs
Globalcorp makes a sale of goods to a foreign firm and will receive FC3 80,000 three months later. Globalcorp has incurred costs in dollars and wishes to make definite the amount of dollars it will
Transcorp has made a purchase of goods from a foreign firm that will require payment of FC380,000 six months later. Transcorp wishes to make definite the amount of dollars it will need to pay the
Empirical studies find a forward exchange rate bias, which means that future spot rates are different from those predicted by current forward rates. For example, if country B has a higher nominal
Considerable progress has been made toward a European Monetary Union (EMU). A European Central Bank has been established seeking to influence member nations toward convergence of their economic and
Since the parity conditions do not generally hold in the short run, do they fail to add' to our understanding of the behavior of foreign exchange rates?
You are given the prices of products in two countries as shown below:At an exchange rate of 5 foreign currency units per dollar, describe the pattern of exports and imports between countries A and
Country A and country B are each on a full gold standard with fixed exchange rates. Country A runs an export surplus, whereas country B runs an export balance deficit. Describe the adjustment process
Consider two countries C and D operating in a world with completely flexible exchange rates. Country C runs a substantial export surplus to country D, which experiences a substantial trade deficit.
Keep in mind Table Q19.9 listing the effects of individual transactions on the balance of payments. Indicate the plus entry and the minus entry for the following transactions. For example, the
Renaldo's Boutiques, Inc., has 14 stores located in a midwestern part of the United States. Renaldo, the president of the company, has set budgets for each store that do not allow for lost, stolen,
Harry Blackmun, manager of the Dry Goods Department at Goodright's Grocery, has a budget of $6,000 per month for the current year. This budget includes the allocation of $500 of storewide common
Cheri Standish, the controller at Harmonics International, overheard the following conversation among two of her product line department heads, Bob, manager of Pianos and Keyboards, and Fran, manager
The purpose of this problem is to demonstrate some of the interrelationships in the budgeting process. Shown below is a very simple balance sheet at January 1, along with a simple budgeted income
The importance of cash budgets for all types of businesses and individuals cannot be overemphasized. The following six steps to cash flow control are critical. 1. Create a monthly cash flow budget.
Explain the relationship between the management functions of planning and controlling costs.
Some expenses that appear in the income statement do not require a direct cash payment during the period. List at least two such expenses.
Explain why it is necessary to distinguish between cash bud get estimates and operating budget estimates.
When evaluating the performance of a manager, why should fixed costs be divided into the categories of controllable costs and committed costs?
What is a rolling budget? Why do some companies choose to use rolling budgets?
Why is the preparation of a sales forecast one of the earliest steps in preparing a master budget?
What are responsibility budgets? What responsibility centers would serve as the basis for preparing responsibility sales budgets in a large retail store, such as Sears or Nordstrom?
Explain why companies that undergo periods of rapid growth often experience cash flow problems.
Explain how to compute the average collection period and why it is a critical factor in creating the collections of receivables budget (see Exhibit 23-13).Exhibit 23-13
Sam's Gardening Centers has multiple stores in the northeastern United States. Sam's is considering investing in an "online" store. In addition to the identifiable cash flows such as increased sales
A particular investment proposal has a positive net present value of $20 when a discount rate of 8 percent is used. The same proposal has a negative net present value of $2,000 when a discount rate
A company is trying to decide whether to go ahead with an investment opportunity that costs $35,650. The expected incremental cash inflows are $78,000, while the expected incremental cash outflows
Ron Jasper manages a factory for Frombees Inc. A salesperson for new factory equipment has persuaded Ron that the new equipment offered by her company would be less dangerous for the employees and
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