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Questions and Answers of
Financial Markets Institutions
Understand the difference between the classical tax system, which exists in the United States, and the imputation system, which exists in a number of other countries, and how these differences affect
Understand empirical evidence about how expected stock returns relate to dividend yields.AppendixLO1
Describe how personal taxes on dividend distributions can lead to distortions in both investment and financing decisions.AppendixLO1
Explain why the proportion of earnings distributed in the form of a share repurchase has increased substantially over the past 25 years.AppendixLO1
You are considering buying IBM stock which is trading today at $98 a share. IBM is going exdividend tomorrow, paying out $2.00 per share. If you believe the stock will drop to $96.50 following the
The Tax Reform Act of 1986 removed the tax preference for capital gains. Does this eliminate the tax preference for share repurchases over dividends?AppendixLO1
Hot Shot Uranium Mines is issuing stock for the first time and needs to determine an initial proportion of debt and equity. In its first years, the firm will have substantial tax write-offs as it
Suppose you are a manager who wants to retain as much as possible of the firm’s earnings in order to increase the size of the firm. How would you react to proposals to repurchase shares that would
Hunter Industries has generated $1 million in excess of its investment needs. The firm can invest the excess cash in Treasury bonds at 8 percent or distribute the cash to shareholders as a
Suppose that the capital gains tax rate is expected to increase in three years. How would this affect Bill Gates’s decision on whether Microsoft should use some of the company’s excess cash to
The XYZ Corporation has an expected dividend of$4 one period from now. This dividend is expected to grow by 2 percent per period.a. What is the value of a share of stock, assuming that the
Alpha Corporation earned $150 million in beforetax profits in 1996. Its corporate tax rate is 35 percent. Daniel Reptella, who owns 20 percent of the firm’s shares, has a personal marginal tax rate
You are engineering an LBO of Acme Industries, an industrial bottle maker. After the LBO, the firm will be financed 90 percent with debt and 10 percent with equity. Fred Farber, the CEO, will own 30
Understand the effect of direct bankruptcy costs on borrowing rates and capital structure choices.AppendixLO1
Describe the factors contributing to the conflicts of interest between debt holders and equity holders.AppendixLO1
Explain how debt can cause equity holders to take on projects that are too risky and to pass up positive NPV projects.AppendixLO1
Identify various situations in which debt holders and equity holders may disagree on the liquidation decision.AppendixLO1
Understand how bond covenants, bank loans, privately placed debt, project finance, and convertible bonds can mitigate some of these debt holder–equity holder conflicts.AppendixLO1
Describe how conflicts between debt holders and equity holders affect capital structure choices.AppendixLO1
A firm has $100 million in cash on hand and a debt obligation of $100 million due in the next period. With this cash, it can take on one of two projects—A or B—which cost $100 million each.Assume
Nigel decides he can make zippers at night for one period and will have cash flows next period of$210 if the economy is favorable, and $66 if the economy is unfavorable. One-third of these proceeds
A firm has a senior bond obligation of $20 due this period and $100 next period. It also has a subordinated loan of $40 owed to Jack and Jill and due next period. It has no projects to provide cash
Hiroko Fashion Corporation (HFC) can pursue either project Dress or project Cosmetic, with possible payoffs at year-end as follows:Each project costs $6 million at the beginning of the year. Assume
Sigma Design, a computer interface start-up firm with no tangible assets, has invested $50,000 in R&D. The success of the R&D effort as well as the state of the economy will be observed in one year.
Describe the relation between the zero-beta expected return on common stock and the zerobeta expected return on corporate bonds in an economy where stock returns are taxed more favorably than bond
ABC Corp., which currently has no assets, is considering two projects that each cost $100.Project A pays off $120 next year in the good state of the economy and $90 in the bad state of the economy.
Suppose you are hired as a consultant for Tailways, Inc., just after a recapitalization that increased the firm’s debt-to-assets ratio to 80 percent. The firm has the opportunity to take on a
In the event of bankruptcy, the control of a firm passes from the equity holders to the debt holders.Describe differences in the preferences of the equity holders and debt holders and how decisions
Why are debt holder–equity holder incentive problems less severe for firms that borrow short term rather than long term?AppendixLO1
Consider the case of Ajax Manufacturing which just completed an R&D project on widgets that required a $70 million bond obligation. The R&D effort resulted in an investment opportunity that will cost
Assume now that if Ajax Manufacturing (see exercise 16.12) uses a more capital-intensive manufacturing process, it can produce a greater number of widgets at a lower variable cost. Given the greater
With debtor in possession (DIP) financing, bankrupt firms are able to obtain additional amounts of debt that is senior to the firm’s existing debt. Explain how the firm’s existing debt holders
You have been hired as a bond analyst for Bull Sterns. A highly leveraged firm, Emax Industries, has switched to a more flexible management process that enables it to change its investment strategy
Atways Industries is involved in two similar mining projects. The Wyoming project was financed through the firm’s internal cash flows and appears as an asset on its balance sheet. The Montana
Describe how a firm’s financial situation is likely to affect its sales and its ability to attract employees and suppliers.AppendixLO1
Understand how financial distress can benefit some firms by inducing employees, suppliers, and governments to make financial concessions to the firm.AppendixLO1
Explain how a firm’s financial condition affects the way its competitors price their products.AppendixLO1
Describe how the past profitability of a firm affects its current capital structure.AppendixLO1
Understand empirical research relating a firm’s characteristics to its capital structure choices.AppendixLO1
What are the differences between direct and indirect bankruptcy costs? Who bears these costs?Explain your answer by referring to a real situation from the recent past.AppendixLO1
As a potential employee, why might you be interested in the employer’s capital structure?AppendixLO1
Compare qualitatively the indirect bankruptcy costs of operating a franchised hotel to that of running a high-tech start-up computer firm.AppendixLO1
You are the manager of a company that produces automobiles. A union contract will come up for renegotiation in two months and you wish to increase your firm’s bargaining power prior to hearing the
BCD Manufacturing is considering repurchasing 40 percent of its common stock. Management estimates the tax savings from such a move to be$48 million, based on the addition of $1 billion of debt at a
Carcinogens-R-Us and Lung Decay, two cigarette producers of comparable size, are struggling for market share in a declining market. Carcinogens-R-Us has just undergone a leveraged buyout and is able
Comparing the indirect costs of bankruptcy, explain why Apple includes very little debt in its capital structure while Marriott International uses a fairly large amount of debt.AppendixLO1
Describe the trade-offs involved when firms decide how to price their products. What are the costs and benefits of raising prices? How do interest rates affect the decision? How do leverage ratios
Weston Tractor is a cyclical business that is forced to lay off workers during downturns. The CEO estimates that they saved $50 million during the last recession by laying off excess labor.However,
Compass Computers has suffered an unexpected loss and is currently having financial difficulties.Explain why Compass may choose not to issue equity to solve its financial problems. If Compass does
As the CEO of Mega Corp., which do you prefer:a competitor with high leverage or one with low leverage? Under what conditions will you act more or less aggressively if your competitor is highly
Compton Industries currently has 2 million shares outstanding at $3 per share. Because the company is having financial difficulties, it also has $50 million in face value of long-term outstanding
You have been hired by Dell Computer Corporation to advise it on its capital structure.This $75 billion company would like to raise an additional $25 billion to acquire the assets of one of its
In 1999 Chrysler had close to $10 billion in cash on its balance sheet invested in short-term securities. Kerkorian, Chrysler’s largest shareholder, wanted Chrysler to use the cash to buy back
Explain why grocery store prices tended to increase in markets where one or more of the main competitors initiated an LBO. (Hint: Think of market share as an investment.)AppendixLO1
Over the past 20 years, the transaction costs associated with issuing and repurchasing debt and equity securities have declined. What effect do you think this change has had on capital structure
Understand how financial decisions are affected by managers who are better informed than outside shareholders about firm values.AppendixLO1
Identify situations in which managers have an incentive to distort accounting information.AppendixLO1
Explain how financial decisions about the firm’s dividend choice, capital structure, and real investments affect stock prices.AppendixLO1
Interpret the empirical evidence about the reaction of stock prices to various financing and investing decisions.AppendixLO1
Describe how a firm’s investment decisions might be made differently if its management is highly concerned about the firm’s current stock price.AppendixLO1
Why might a firm choose to increase its debt level in response to favorable information about its future prospects?AppendixLO1
Exhibit 19.5 shows that stock prices of industrial firms react more negatively to stock issues than do utilities. Why do you think this is the case?AppendixLO1
Classical finance theory suggests that firms take projects with positive NPVs regardless of the amount of cash the firm has available. However, empirical evidence suggests that the amount that firms
Why might a manager close to retirement select a higher debt ratio than a manager far from retirement?AppendixLO1
ABC Industries is considering an investment that requires the firm to issue new equity. The project will cost $100, but will add $120 to the firm’s value. Although management believes the firm’s
As economies develop, disclosure laws generally get tougher and accounting information becomes more informative. Briefly describe how such changes in the quality of information affect the incentives
If it was known that management was selling shares at the same time as it was increasing leverage, how would this affect the credibility of the signal? Why? What other actions or motivations by
The following table describes management’s view of Abracadabra Corporation’s future cash flows along with the consensus view of outside analysts.Cash Flows State of the Economy: Low Average High
Analysts project that Infotech, an information services company, will have the following financial data for equally probable high and low states:Value State: Low High Cash $100 $100 Fixed asset value
Mr. Chan and Mr. Smith are the CEOs of similar textile manufacturing firms. Chan is 64 years old and plans to retire next year. Smith is 52 years old and expects to remain with the firm for some
Gordon Wu (the largest shareholder of Hopewell)has just announced that he is planning to issue outof-the-money covered warrants on 10 percent of Hopewell’s outstanding stock. Does this announcement
When firms increase leverage with exchange offers, what generally happens to their stock prices? Why might this be?AppendixLO1
Innovative Technologies produces high-tech equipment for the agriculture industry. This is a very risky firm since the technology is not completely established and demand for farm equipment is very
Divided Industries recently announced a substantial increase in its dividend payout.Stockholders complained because the increased dividend would place an added tax burden on them. Subsequent to the
Explain why the threat of hostile takeovers can make firms more short-term oriented.AppendixLO1
Show in Example 19.7 that it never pays to issue debt in excess of $400 million.AppendixLO1
Understand how taxes, operating synergies, and management incentive conflicts provide motives for mergers and acquisitions.AppendixLO1
Discuss the advantages and disadvantages of corporate diversification.AppendixLO1
Know how and why the stock prices of bidders and targets react around the time of acquisition announcements.AppendixLO1
Describe the empirical evidence regarding the gains from mergers and acquisitions.AppendixLO1
Apply the tools developed in Chapters 9–13 to value potential acquisitions and the ideas developed in Chapters 14–19 to understand how such acquisitions should be financed.AppendixLO1
Describe how acquiring firms determine their bidding strategies and how the targets of unwanted takeovers defend themselves.AppendixLO1
Jacobs Industries is currently selling for $25 a share and pays a dividend of $2 a share per year. Analysts expect the earnings and dividends to grow 4 percent per year into the foreseeable future.
Refer to exercise 20.1. Explain why John Jacobs is likely to make these changes following an LBO, but would not make the changes in the absence of an LBO.AppendixLO1
What type of firm would you prefer to work for: a diversified firm or a very focused firm? What does your answer to the above question tell you about one of the advantages or disadvantages of
Diversified Industries has made a bid to purchase Cigmatics Inc., offering to exchange two Diversified shares for 1 share of Cigmatics. When this bid is announced, Diversified Industries’ shares
Leveraged buyouts are observed mainly in industries with relatively stable cash flows and products that are not highly specialized. Explain why.AppendixLO1
When a firm with an extremely high price/earnings ratio purchases a firm with a very low price/earnings ratio in an exchange of stock, its earnings per share will increase. Do you think firms are
Tobacco companies have a large potential liability.In the future, they may be subject to extremely large product liability lawsuits. Discuss how this affects the incentives of tobacco companies to
One of the stated benefits of a management buyout is the improvement in management incentives. In many cases, however, the top managers do not change after the buyout. Explain why.AppendixLO1
Why do think AT&T was willing to spend $500 million to get pooling of interest accounting treatment in its acquisition of NCR?AppendixLO1
Understand the different motivations for corporate hedging.AppendixLO1
Explain which firms should be the most interested in hedging.AppendixLO1
Understand which risks firms should hedge.AppendixLO1
Understand the different motivations for foreign currency and interest rate risk management.AppendixLO1
Small firms currently hedge less than large firms.Why is this? Do you expect smaller firms to start hedging more in the future? Explain.AppendixLO1
Why is it harder to hedge currency risks in countries with volatile inflation rates?AppendixLO1
Whistler Resorts is a Canadian ski resort just north of Vancouver, British Columbia. Discuss the resort’s exposure to exchange rate risk.AppendixLO1
It is now much easier to hedge risks than it was in the past. How should this af fect a firm’s optimal capital structure? Why?AppendixLO1
The XYZ corporation manufactures in both Turkey and Japan for export to the United States. Japan has a stable monetary policy and, as a result, its inflation is easy to predict. Monetary policy in
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