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essentials corporate finance

Questions and Answers of Essentials Corporate Finance

11 Sale and Leaseback Why might a firm choose to engage in a sale and leaseback transaction?Give two reasons. Is a sale and leaseback good for firms in financial distress? What does the empirical
12 Lease or Buy A company could purchase a machine for £100,000. The machine has annual maintenance costs of £10,000 and an anticipated useful life of five years, after which it will have zero
13 Leasing Cash Flows You work for an airline that is contemplating leasing a new-design plane geonavigational system. The system costs €22 million and will be depreciated using the straight line
14 Finding the Break-even Payment Using the information from question 13, what would the lease payment have to be for the lessee to be indifferent buying or leasing the system? Assume that the tax
15 Taxes and Leasing Cash Flows Using the information in question 13, assume your company does not contemplate paying taxes for the next several years. What are the annual cash flows to the lessee
16 Setting the Lease Payment In the previous question, over what range of lease payments will the lease be profitable for both parties? What are the minimum and maximum amounts?
17 Lease or Buy Super Sonics Entertainment is considering buying a machine that costs NKr3,500,000.The machine will be depreciated straight line to zero over 4 years. The company can lease the
18 Lease or Buy What is the net advantage to leasing (NAL) for Wildcat?
19 Reservation Payment What is the maximum lease payment that would be acceptable to Wildcat Oil Company?
20 Reservation Payment What is the minimum lease payment that would be acceptable to Lambert Leasing Company?
21 Setting the Lease Price An asset costs £360,000 and will be depreciated using the straight line method.At the end of its three-year life it will be worthless. The corporate tax rate is 18 per
22 Lease or Buy Wolfson plc has decided to purchase a new machine that costs £4.2 million. The machine will be depreciated on a straight line basis and will be worth nothing at the end of four
23 Lease or Buy High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking
24 Debt Capacity Many researchers are now coming to the conclusion that leasing has benefits from increasing the debt capacity of financially constrained firms. Explain why this is so and provide a
25 Moral Hazard Schneider (2010) argues that moral hazard in leasing is a major contributor to the level of accidents that New York taxi drivers experience. Explain what is meant by moral hazard and
26 Asset Liquidity Gavazza (2010) finds that ‘more-liquid assets (1) make leasing, operating leasing in particular, more likely; (2) have shorter operating leases; (3) have longer capital leases;
27 Leasing and Accounting Quality Beatty et al. (2010) argue that low accounting quality firms increase the likelihood that a firm will lease assets instead of buying them. Provide a critique of this
28 Leasing and IFRS 16 The new leasing standard IFRS 16 made a number of fundamental changes in 2019 to the recording of leases in the financial statements. Review these changes. Do you think leasing
1 Andrew and Gilstad (2005) write that ‘business schools typically teach that leasing is a zero-sum game.However, the economic assumptions that lead to this belief often are not true. These
2 Parklead Leasing is a successful leasing company, specializing in the highest-quality excavation equipment.It has a fleet of 300 vehicles, and a repair and maintenance section. It purchases a new
3 Ibro Tinmines plc requires the use of excavation machinery. It could lease the equipment for six years from Parklead Leasing for €22,000 per year, with a balloon payment at the end of the lease
11 Warf Computers has decided to proceed with the manufacture and distribution of the virtual keyboard (VK)the company has developed. To undertake this venture, the company needs to obtain equipment
11 Download the financial accounts of five companies in your country. Look for information on operating leases, financial leases, and sale and leasebacks. In each case, decide whether the financing
12 Because of its importance, leasing has an accounting standard all to itself, titled IFRS 16 Leases. This is a new standard as of 2019 and should be consulted when considering the use of any type
1 Why should the shareholders in the firm care about maximizing the value of the entire firm? After all, the value of the firm is, by definition, the sum of both the debt and the equity. Instead, why
2 What ratio of debt to equity maximizes the shareholders’ interests?
3 Wasserprodukte GmbH has a corporate tax rate, tC, of 35 per cent and expected earnings before interest and taxes (EBIT) of €1 million each year. Its entire earnings after taxes are paid out as
1 Ignoring costs of financial distress, what is the firm’s optimal capital structure if dividends and interest are taxed at the same personal rate – that is, tE = tD?The firm should select the
2 Under what conditions will the firm be indifferent between issuing equity or debt?The firm will be indifferent if the cash flow to shareholders equals the cash flow to bondholders. That is, the
3 What should companies do in the real world?Although this is clearly an important question, it is, unfortunately, a hard one – perhaps too hard to answer definitively. Nevertheless, let us begin
1 We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value of the firm is also the one that provides the most benefit to the
2 In a world of no taxes, the famous Proposition I of Modigliani and Miller proves that the value of the firm is unaffected by the debt–equity ratio. In other words, a firm’s capital structure is
3 MM’s Proposition II in a world without taxes states that R E  =  R A  + D __ E( R A  −  R D )This implies that the expected rate of return on equity (also called the cost of equity
4 Although the above work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that the capital structure decision is a matter of indifference,
5 In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage.The formula for the value of the firm is V L  =  V U  +  t C D Expected return on
1 Capital Structure, the Pie Theory and MM Use a pizza analogy to explain why capital structure should not influence firm value in a world with no taxes, transaction costs or financial distress
2 Maximizing Firm Value versus Maximizing Shareholder Interests Explain why, in a world with no taxes, transaction costs or financial distress costs, maximizing firm value is the same as maximizing
3 Financial Leverage and Firm Value In a world with no taxes, no transaction costs and no costs of financial distress, is the following statement true, false or uncertain? If a firm issues equity to
4 Financial Leverage and Firm Value: An Example In a world with no taxes, no transaction costs and no costs of financial distress, does moderate borrowing increase the required return on a firm’s
5 Corporate Taxes How do corporate taxes affect the Modigliani–Miller theory of capital structure?Illustrate your answer with a practical example.
6 Personal Taxes Show the impact of personal taxes on the firm value in an MM universe. When would a firm be indifferent between issuing debt or equity? Illustrate your answer with a practical
7 Return on Equity Explain, using an example, how a change in the capital structure of a firm can affect the company’s return on equity.
8 Capital Structure What is the basic goal of financial management with respect to capital structure?Is there an easily identifiable capital structure that will maximize the value of the firm? Why,
9 Return on Equity Mayou plc currently has no debt in its capital structure but has decided to issue new debt to replace the equity so that the debt to equity ratio is 1:1. On the firm’s accounting
10 EBIT and Gearing Penybont plc is planning to raise funds to finance a major new development, and its management is considering borrowing on a long-term basis for the first time. It has been
11 EBIT, Taxes and Leverage Fresenius SE & Co has no debt outstanding and a total market value of€12.68 billion. Earnings before interest and taxes (EBIT) are projected to be €2.56 billion if
12 ROE and Leverage Using the information in the question above on Fresenius SE & Co, suppose Fresenius has a book value of €12.68 billion.(a) Calculate return on equity, ROE, under each of the
13 Break-even EBIT Hammerson plc is comparing two different capital structures: an all-equity plan(Plan I) and a levered plan (Plan II). Under Plan I, Hammerson would have 712 million shares of
14 MM and Share Value In problem 13, use MM Proposition I to find the share price under each of the two proposed plans. What is the value of the firm?
15 Break-even EBIT and Leverage Taiyuan Coal Gasification Ltd is comparing two different capital structures. Plan I would result in 1.62 billion shares of equity and 798 million yuan in debt. Plan II
16 Leverage and Share Value ABC plc is comparing two different capital structures. Plan I would result in 1,100 shares of stock and €16,500 in debt. Plan II would result in 900 shares of stock and
17 Homemade Leverage Star plc, a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 per cent debt. Currently there are 2,000
18 Homemade Leverage and WACC ABC AG and XYZ AG are identical firms in all respects except for their capital structure. ABC is all equity financed, with NKr600,000 in equity shares. XYZ uses both
19 MM Nina plc uses no debt. The weighted average cost of capital is 13 per cent. If the current market value of the equity is £35 million and there are no taxes, what is EBIT?
20 MM and Taxes In the previous question, suppose the corporate tax rate is 28 per cent. What is EBIT in this case? What is the WACC? Explain.
21 Calculating WACC Strade plc is an all equity financed company. The finance director suggested in a recent meeting with the board of directors a capital restructuring to introduce some debt in the
24 MM and Taxes In problem 23, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm’s capital structure decision?
25 MM Proposition I Levered plc and Unlevered plc are identical in every way except their capital structures.Each company expects to earn £96 million before interest per year in perpetuity, with
28 MM Proposition I with Taxes Bigelli SpA is financed entirely with equity. The company is considering a loan of €1 million. The loan will be repaid in equal instalments over the next two years,
29 MM Proposition I without Taxes Alpha NV and Beta NV are identical in every way except their capital structures. Alpha NV, an all-equity firm, has 5,000 shares of equity outstanding, currently
30 Cost of Capital Acetate SA has equity with a market value of €20 million and debt with a market value of€10 million. Treasury bills that mature in one year yield 8 per cent per year, and the
31 Homemade Leverage The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Company’s 6 per cent bonds is SKr1
32 MM Propositions Locomotive plc is planning to repurchase part of its ordinary share equity by issuing corporate debt. As a result, the firm’s debt–equity ratio is expected to rise from 40 per
33 Share Value and Leverage Green Manufacturing plc plans to announce that it will issue £2 million of perpetual debt and use the proceeds to repurchase equity. The bonds will sell at par with a 6
34 MM with Taxes Williamsen GmbH has a debt–equity ratio of 2.5. The firm’s weighted average cost of capital is 15 per cent, and its pre-tax cost of debt is 10 per cent. Williamsen is subject to
35 Weighted Average Cost of Capital In a world of corporate taxes only, show that the RWACC can be written as RWACC = RA × [1 – tC (B/V)].
36 Cost of Equity and Leverage Assuming a world of corporate taxes only, show that the cost of equity, RS, is as given in the chapter by MM Proposition II with corporate taxes.
38 Shareholder Risk Suppose a firm’s business operations mirror movements in the economy as a whole very closely – that is, the firm’s asset beta is 1.0. Use the result of the previous problem
39 Unlevered Cost of Equity Beginning with the cost of capital equation – that is:R WACC  = E ____ _ D + E R E  + D ____ _ D + E R D show that the cost of equity capital for a
1 Calculate the return on equity of Sapphire before and after the restructuring. (20 marks)Sapphire is an all-equity financed company, which is valued at €250 million. The firm’s shares are
2 Write a brief report to the management of Sapphire explaining why the return on equity has changed as a result of restructuring. (20 marks)Sapphire is an all-equity financed company, which is
3 What is meant by gearing? How does gearing affect the financial risk of a firm? (20 marks)Sapphire is an all-equity financed company, which is valued at €250 million. The firm’s shares are
4 Assume that the corporate tax rate is 35 per cent, capital gains tax is zero and the personal income tax rate is 45 per cent. What is the value of Sapphire before the restructuring? What is its
5 What would the personal rate of tax on interest income have to be to push the tax advantage of debt to zero? (20 marks)Sapphire is an all-equity financed company, which is valued at €250 million.
1 If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.Stephenson Real Estate was founded 25 years ago by
2 Construct Stephenson’s market value balance sheet before it announces the purchase.Stephenson Real Estate was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases
4 Suppose Stephenson decides to issue debt to finance the purchase.(a) What will be the market value of the Stephenson company if the purchase is financed with debt?(b) Construct Stephenson’s
5 Which method of financing maximizes the per-share price of Stephenson’s equity?Stephenson Real Estate was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real
1 Locate the annual balance sheets for three firms from your country. For each company calculate the long-term debt–equity ratio for the prior two years. Why would these companies use such
2 Download the annual income statements for another country. For the most recent year, calculate the average tax rate and EBIT, and find the total interest expense. From the annual balance sheets
1. The Cost of Equity Capital Explain what is meant by the cost of equity capital. How is the cost of equity capital linked to the risk of the assets of a firm? How would you use cost of equity in a
1. Determinants and Estimation of Beta What factors determine the beta of a security? Define and describe each. Explain why an equity’s beta is important in capital budgeting. How do you calculate
1. The Capital Budgeting Process What are the six major steps involved in the capital budget process?
1. Extensions of the Basic Model How would you estimate the cost of capital for a project if its risk is different from the rest of the company? Similarly, how would you estimate the cost of capital
1. Practical Concerns What are the main issues you need to consider when estimating the cost of capital of a project in practice? State any potential problems or challenges you may face.
1. Reducing the Cost of Capital Why would a firm wish to reduce its cost of capital? Review different ways in which this can be done. Which way do you think is the most effective? Explain.
1. Estimating the Cost of Capital in Practice Corporations use many methods to estimate the cost of capital. Why do you think there is no consensus on the best method? If you were estimating the cost
1. EVA Explain what is meant by economic value added and show how it can be used to evaluate the performance of a firm.REGULAR
1. Project Risk ‘My company can borrow at 5 per cent so it means that its cost of capital for all new projects is 5 per cent.’ Do you agree with this statement? Explain.
1. Company Beta The beta of Ericsson, the Swedish communications technology firm, is 0.38. What do you think is the main determinant of Ericsson’s beta and why? Why do you think Ericsson’s beta
1. SML Cost of Equity Estimation If you use the equity beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making? What are the
1. Industry Beta What are the benefits of using an industry beta instead of a company beta when undertaking a capital budgeting analysis? Explain, using an example.
1. Cost of Capital How would a manager of a new stock exchange-listed company reduce its cost of equity capital?
Company Risk versus Project Risk Both AstraZeneca plc, a large pharmaceutical firm, and Takeda plc, a major prescription medicine manufacturer, are thinking of investing in an Indian generic drugs
SML and Cost of Capital An all-equity firm is considering the following projects:Project Beta Expected Return A 0.6 11%B 0.9 13%C 1.2 14%D 1.7 16%The expected return on the market is 12 per cent, and
1. Calculating Cost of Equity The Dybvig Corporation’s equity has a beta of 1.3. If the risk-free rate is 4.5 per cent and the expected return on the market is 12 per cent, what is Dybvig’s cost
1. Calculating Cost of Debt Advance plc is trying to determine its cost of debt. The firm has a debt issue outstanding with seven years to maturity that is quoted at 92 per cent of face value. The
1. Calculating Cost of Debt Shanken NV issued a 30-year, 10 per cent bond seven years ago. The bond currently sells for 108 per cent of its face value. The company’s tax rate is 35 per cent.(a)
1. Calculating Cost of Debt For the firm in the previous problem, suppose the book value of the debt issue is €20 million. In addition, the company has a second debt issue on the market, a zero
1. Calculating WACC Mullineaux Corporation has a target capital structure of 55 per cent equity and 45 per cent debt. Its cost of equity is 16 per cent, and the cost of debt is 9 per cent. The

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