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fundamentals of corporate finance

Questions and Answers of Fundamentals Of Corporate Finance

What is the difference between the principles of multiplication and comparative advantage?
What are the three reasons shareholders may prefer stakeholder capitalism to shareholder capitalism?
b. List the mechanisms that are used around the world to keep agency problems under control.
17. Do these differences matter? (S19-7) Agency problems are inevitable. That is, we can never expect managers to give 100% weight to shareholders’ interests and none to their own.a. Why not?
16. Do these differences matter? (S19-7) Do large blockholders increase company value? Does your answer depend on the structure of the financial system?
15. Governance regimes around the world (S19-6) What is tunneling? Why does the threat of tunneling impede the development of financial markets?
14. Governance regimes around the world (S19-6) Suppose that a shareholder can gain effective control of a company with 30% of the shares. Explain how a shareholder might gain control of company Z by
13. Governance regimes around the world (S19-6) Do Japanese investors play an important role in corporate financial policy and governance? If not, could they?
12. Governance regimes around the world (S19-6) What is a keiretsu? Give a brief description.What are some of their advantages and disadvantages?
11. Management compensation (S19-5) In recent years, several large banks have paid management bonuses partly in bonds and partly in stock. What do you think is the reason for this? Do you think it is
c. Compensation schemes that depend on stock returns do not depend on accounting data. Is that an advantage? Why or why not?
b. Stock returns depend on factors outside the managers’ control—for example, changes in interest rates or prices of raw materials. Could this be a serious problem? If so, can you suggest a
10. Management compensation (S19-5) Here are a few questions about compensation schemes that tie top management’s compensation to the rate of return earned on the company’s common stock.a.
9. Management compensation (S19-5) We noted that management compensation must, in practice, rely on results rather than effort. Why? What problems are introduced by not rewarding effort?
8. Management compensation (S19-5) True or false?a. U.S. CEOs are paid much more than CEOs in other countries.b. A large fraction of compensation for U.S. CEOs comes from grants of restricted shares
7. Monitoring (S19-2–S19-4) What is the role of acquisitions in ensuring managers pursue shareholders’ interests?
6. Monitoring (S19-2–S19-4) What are the ways in which auditors and lenders ensure managers do what they are supposed to be doing?
5. Monitoring (S19-2–S19-4) What are the main ways in which shareholders monitor managers?
4. Monitoring (S19-2–S19-4) Explain how the system of codetermination works in Germany.
3. Monitoring (S19-2–S19-4) How do European boards of directors differ from U.S. and U.K.boards of directors?
2. Monitoring (S19-2–S19-4) Who monitors the top management of public U.S. corporations?
1. Agency problems (S19-1) Explain the following types of agency problemsa. Reduced effortb. Private benefitsc. Overinvestmentd. Risk takinge. Short-termism
What are some of the advantages and disadvantages of market- and bank-based financial systems?
Describe how ownership and control in Germany and Japan are different from in the United States.
b. What factors affect shareholders’ willingness to do so?
a. What are the ways in which shareholders can hold managers to account?
b. What actions can the board undertake to improve company performance?
a. Which board characteristics are typically associated with superior company performance?
2. You are considering a five-year lease of office space for R&D personnel. Once signed, the lease cannot be canceled. It would commit your firm to six annual $100,000 payments, with the first
1. The U.S. government has settled a dispute with your company for $16 million. The government is committed to pay this amount in exactly 12 months. However, your company will have to pay tax on the
27. WACC and Rebalancing (S18-4) The WACC formula assumes that debt is rebalanced to maintain a constant debt ratio D/V. Rebalancing ties the level of future interest tax shields to the future value
26. Horizon value (S18-2) Modify Table 18.1 on the assumption that competition eliminates any opportunities to earn more than WACC on new investment after year 7 (PVGO = 0). How does the valuation of
25. Miles-Ezzell formula (S18-1) In footnote 14, we referred to the Miles–Ezzell discount rate formula, which assumes that debt is not rebalanced continuously, but at one-year intervals.Derive this
24. WACC and APV (S18-1 and S18.4) Take another look at the valuations of Rio in Tables 18.1 and 18.2. Now use the live spreadsheets in Connect to show how Rio’s value depends on:a. The forecasted
23. APV and limits on interest tax shields (S18-4) Take another look at the APV calculation for the perpetual crusher project in Section 18-4. This time assume that the corporation investing in the
22. APV and issue costs (S18-4) The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is
21. APV and debt capacity (S18-4) Suppose KCS Corp. buys out Patagonia Trucking, a privately owned business, for $50 million. KCS has only $5 million cash in hand, so it arranges a $45 million bank
b. How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million of required equity?
20. APV (S18-4) Consider a project to produce solar water heaters. It requires a $10 million investment and offers a level after-tax cash flow of $1.75 million per year for 10 years. The opportunity
What’s right or wrong with the treasurer’s approach? Should the university invest? Should it borrow? Would the project’s value to the university change if the treasurer financed the project
19. Opportunity cost of capital (S18-1) Suppose the project described in Problem 18 is to be undertaken by a university. Funds for the project will be withdrawn from the university’s endowment,
18. APV (S18-4) Consider another perpetual project like the crusher described in Section 18-1. Its initial investment is $1,000,000, and the expected cash inflow is $95,000 a year in Historical
17. APV (S18-4) Digital Organics (DO) has the opportunity to invest $1 million now (t = 0) and expects after-tax returns of $600,000 in t = 1 and $700,000 in t = 2. The project will last for two
16. APV (S18-4) To finance the Madison County project (see Problem 10), Wishing Well needs to arrange an additional $80 million of long-term debt and make a $20 million equity issue.Underwriting
b. What is its APV if the firm borrows 30% of the project’s required investment?
15. APV (S18-4) Consider a project lasting one year only. The initial outlay is $1,000, and the expected inflow is $1,200. The opportunity cost of capital is r = 0.20. The borrowing rate is rD =
b. If the firm invests, there are no issue costs, but its debt capacity increases by $500,000.The present value of interest tax shields on this debt is $76,000.
14. APV (S18-4) A project costs $1 million and has a base-case NPV of exactly zero (NPV = 0).What is the project’s APV in the following cases?a. If the firm invests, it has to raise $500,000 by a
c. Is especially useful when debt is to be paid down on a fixed schedule.
b. Calculates the base-case value by discounting project cash flows, forecasted assuming allequity financing, at the WACC for the project.
13. APV (S18-4) True or false? The APV methoda. Starts with a base-case value for the project.
12. Flow-to-equity valuation (S18-2) What is meant by the flow-to-equity valuation method?What discount rate is used in this method? What assumptions are necessary for this method to give an accurate
11. Company valuation (S18-2) Chiara Company’s management has made the projections shown in Table 18.5. Use this table as a starting point to value the company as a whole.The WACC for Chiara is
10. Forecasting cash flow (S18-1) Suppose Wishing Well (see Problem 6) is evaluating a new motel and resort on a romantic site in Madison County, Wisconsin. Explain how you would forecast the
9. WACC (S18-1) Nevada Hydro is 40% debt-financed and has a weighted-average cost of capital of 10.2%:WACC = ( 1 − Tc ) r D D / V + r E E / V = ( 1−0.21 ) ( 0.085 ) ( 0.40 ) + 0.125 ( 0.60 ) =
8. WACC (S18-1) See Problem 7. How will Rensselaer’s WACC and cost of equity change if it issues €50 million in new equity and uses the proceeds to retire long-term debt? Assume the company’s
7. WACC (S18-1) Table 18.4 shows a simplified balance sheet for the Dutch manufacturer Rensselaer Felt. Calculate this company’s weighted-average cost of capital. The debt has just been refinanced
6. WACC (S18-1) Table 18.3 shows a book balance sheet for the Wishing Well Motel chain.The company’s long-term debt is secured by its real estate assets, but it also uses short-term bank loans as a
b. Suppose the company issues debt, repurchases shares, and moves to a 30% debt-to-value ratio (D/V = 0.30). What will be the company’s WACC at the new capital structure? The borrowing rate is 7.5%
5. WACC (S18.1) Whispering Pines Inc. is all-equity-financed. The expected rate of return on the company’s shares is 12%.a. What is the opportunity cost of capital for an average-risk Whispering
4. WACC (S18-1) Suppose Federated Junkyards decides to move to a more conservative debt policy. A year later, its debt ratio is down to 15% (D/V = 0.15). The pre-tax cost of debt has dropped to 8.6%.
3. WACC (S18-1) Calculate the weighted-average cost of capital (WACC) for Federated Junkyards of America, using the following information:• Debt: $75,000,000 book value outstanding. The debt is
2. WACC (S18-1) The WACC formula seems to imply that debt is “cheaper” than equity—that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.
1. WACC (S18-1) True or false? Use of the WACC formula assumesa. A project supports a fixed amount of debt over the project’s economic life.b. The ratio of the debt supported by a project to
True or false? Explain briefly.a. In an APV calculation, you need to use the WACC to discount any tax shields if debt is constantly rebalanced.b. The APV is higher when debt is fixed than when it is
Look back to your answer to Self-Test 18.1. Serial has accumulated $40 million of surplus cash, which is earning a 1.5% after-tax interest rate. It can use the cash to pay for a new synthesizer line.
2. Select three or four companies from the Yahoo! Finance database. Estimate how much more these companies could borrow before they would exhaust taxable profits.
c. How much has the company spent to repurchase its own shares? Would the trade-off theory predict share repurchases for a conservatively financed company like Johnson &Johnson?
b. Track Johnson & Johnson’s long-term debt and debt ratio over the last five years (you will need to go to the company’s website to do this). How have they changed? Does it appear that the
1. Look up Johnson & Johnson on Yahoo! Finance.a. Recalculate book- and market-value balance sheets using the most recent available financial information. Use the same format as for Table 17.3.
28. Leverage measures (S17-3–S17-4) Most financial managers measure debt ratios from their companies’ book balance sheets. Many financial economists emphasize ratios from marketvalue balance
27. Trade-off theory (S17-3) The trade-off theory relies on the threat of financial distress. But why should a public corporation ever have to land in financial distress? According to the theory, the
26. Evidence (S17-5) A study of capital structure in several developed countries found that debt ratios were positively related to firm size and the proportion of tangible versus intangible assets
25. Market timing (S17-5) Suppose financial managers can use inside information to time equity issues when stock price is unrealistically high. How would capital structure evolve?Explain briefly.
24. Leverage targets (S17-4) Some corporations’ debt–equity targets are expressed not as a debt ratio but as a target debt rating on the firm’s outstanding bonds. What are the pros and cons of
c. Managers with excessive financial slack may be tempted to spend it on poor investments.
b. Financial slack is most valuable to firms with few investment opportunities and poor prospects.
23. Financial slack (S17-4) True or false?a. Financial slack means having cash in the bank or ready access to the debt markets.
22. Financial slack (S17-4) For what kinds of companies is financial slack most valuable? Are there situations in which financial slack should be reduced by borrowing and paying out the proceeds to
b. Debt ratios depend on past profitability, because .
21. Pecking-order theory (S17-4) Fill in the blanks: According to the pecking-order theory,a. The firm’s debt ratio is determined by .
20. Pecking-order theory (S17-4) Why does asymmetric information push companies to raise external funds by borrowing rather than by issuing common stock?
b. Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread? Respond to the quote that begins this question.Use your answer to part
19. Pecking-order theory (S17-4) “I was amazed to find that the announcement of a stock issue drives down the value of the issuing firm by 20–30%, on average, of the proceeds of the issue.That
18. Trade-off theory (S17-3) The traditional theory of optimal capital structure states that firms trade off corporate interest tax shields against the possible costs of financial distress due to
b. Who benefits from the fine print when the bonds are issued? Suppose the firm is offered the choice of issuing (1) a bond with standard restrictions on dividend payout, additional borrowing, and so
17. Covenants (S17-2)a. Who benefits from the fine print in bond contracts when the firm gets into financial trouble?Give a one-sentence answer.
b. What is the maximum amount the bank could lend that would induce Ms. Crane to take project 1?
16. Agency costs (S17-2) The possible payoffs from Ms. Crane’s projects (see Example 17.2) have not changed but there is now a 40% chance that project 2 will pay off $24 and a 60% chance that it
c. Why SOS stockholders could gain from paying out a large cash dividend.
b. Why SOS stockholders could gain by investing in a negative-NPV project financed by cash.
15. Agency costs (S17-2) The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the
e. The lenders agree to extend the maturity of their loan from two years to three in order to give Circular a chance to recover.
d. Suppose that the new project has NPV = +$2 and is financed by an issue of preferred stock.
c. Circular encounters an acceptable investment opportunity, NPV = 0, requiring an investment of $10. The firm borrows to finance the project. The new debt has the same security, seniority, and so
b. Circular halts operations, sells its fixed assets, and converts net working capital into$20 cash. Unfortunately, the fixed assets fetch only $6 on the secondhand market. The$26 cash is invested in
14. Agency costs (S17-2) Let us go back to Circular File’s market value balance sheet:Net working capital $20 $27 Bonds outstanding Fixed assets 10 3 Common stock Total assets $30 $30 Total value
13. Agency costs (S17-2) In Section 17-2, we briefly referred to three games: playing for time, cash in and run, and bait and switch.For each game, construct a simple numerical example (like the
c. When a company borrows, the expected costs of bankruptcy come out of the lenders’pockets and do not affect the market value of the shares.
b. If the probability of default is high, stockholders may refuse to contribute equity even if the firm has safe positive-NPV opportunities.

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