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business
principles corporate finance

Questions and Answers of Principles Corporate Finance

16.21 Consider an economy in which there are four groups of people:All investors can earn a tax-free return of 6 percent by investing in foreign real estate.Interest payments are taxable at the
17.3 MEO Foods, Inc., has made cat food for over 20 years. The company currently has a debtequity ratio of 25 percent, borrows at a 10-percent interest rate, and is in the 40-percent tax bracket. Its
17.7 Value Company has compiled the following information on its financing costs:Value is in the 34-percent tax bracket and has a target debt-equity ratio of 100 percent. Value’s managers would
17.14 Schwartz & Brothers Inc. is in the process of deciding whether to make an equity investment in a project of holiday gifts production and sales. Arron Buffet is in charge of the feasibility
17.16 North Pole Fishing Equipment Corp. and South Pole Fishing Equipment Corp. would have identical of 1.2 if both of them were all-equity financed. The capital structures of the two firms are as
17.15 Brenda Lynch, CFO of Hunter Enterprises, is evaluating a 10-year, 9-percent loan. The projected net proceeds after flotation costs to be raised by the loan are $4,250,000. The flotation costs
17.13 Folgers Air Transport (FAT) is currently an unleveraged firm. It is considering a capital restructuring to allow $500 in debt. The company expects to generate $151.52 in cash flows before
17.12 Kinedyne, Inc., has decided to divest one of its divisions. The assets of the group have the same operating risk characteristics as those of the parent firm. The capital structure for the
17.11 ABC, Inc., is an unlevered firm with expected perpetual annual before-tax cash flows of$30 million and required return on equity of 18 percent. It has 1 million shares outstanding. ABC is
17.10 Refer to question 17.8.Baber Corporation has chosen to purchase the additional equipment. If Baber funds the project entirely with debt, what is the firm’s weighted average cost of capital?
17.9 National Electric Company (NEC) is considering a $20 million modernization expansion project in the power systems division. Tom Edison, the company’s chief financial officer, has evaluated the
17.8 Baber Corporation’s stock returns have a covariance with the market of 0.031. The standard deviation of the market returns is 0.16, and the historical market premium is 8.5 percent.Baber bonds
17.6 The overall firm beta for Wild Widgets, Inc., (WWI) is 0.9. WWI has a target debt-equity ratio of 1/2. The expected return on the market is 16 percent, and Treasury bills are currently selling
17.5 Milano Pizza Club owns a chain of three identical restaurants popular for their Milan style pizza. Comparable stores have an equity value of $900,000 and debt-to-equity ratio of 30 percent. The
17.4 Roller and Decker Corp. has established a joint venture with Malaysia Road Construction Company to build a toll road in Malaysia. The initial investment in paving equipment is$20 million.
17.2 Peatco, Inc., is considering a $2.1 million project that will be depreciated according to the straight-line method over the three-year life of the project. The project will generate pretax
17.1 Honda and GM are competing to sell a fleet of cars to Hertz. Hertz’s policies on its rental cars include use of straight-line depreciation and disposing of the cars after five years.Hertz
3. The J. Lowes Corporation, which currently manufactures staples, is considering a$1 million investment in a project in the aircraft adhesives industry. The corporation estimates unlevered after-tax
2. C. F. Lee Incorporated is considering a scale-enhancing project. The market value of the firm’s debt is $100 million, and the market value of the firm’s equity is $200 million. The debt is
1. World-Wide Enterprises (WWE) is a large conglomerate thinking of entering the widget business, where it plans to finance projects with a debt-to-value ratio of 25 percent (or, alternatively, a
• How is the WACC method applied?
• What information is needed to calculate FTE?
• How is the FTE method applied?
• What additional information beyond NPV does one need to calculate APV?
• How is the APV method applied?
16.19 Consider an economy with three investor groups with marginal personal tax rate of 10 percent, 20 percent, and 40 percent, respectively. The corporate tax rate is 35 percent.Assume zero personal
16.17 The Gulf Power Company is an electric utility planning to build a new power-generating plant of conventional design. The company has traditionally paid out all earnings to the stockholders as
16.16 Melvin Clark, CFO of the Matsushita Corp., is evaluating the value of the firm’s current capital structure. Being conservative, he expects that Matsushita will have a perpetual EBIT of
16.15 Mueller Brewing Company has been ordered by the EPA to stop polluting the Menomenie River. It must now spend $100 million on pollution-control equipment. The company has three alternatives for
16.14 The EXES Company is assessing its present capital structure and that structure’s implications for the welfare of its investors. EXES is currently financed entirely with common stock, of which
16.13 Because of the large cash inflows from the sales of its cookbook, Fear of Frying, the Overnight Publishing Company (OPC) has decided to retire all of its outstanding debt.The debt is made up of
16.10 What are the sources of the agency costs of equity?
16.9 How would the consideration of financial distress costs and agency costs affect the MM proposition in a world where corporations pay taxes?
16.8 What measures do stockholders undertake to minimize the costs of debt?
16.7 Refer to the selfish strategy in section 16.5. Suppose the bondholders are fully aware of the discrepancy between maximizing the firm value and the stock value. To minimize the agency costs,
16.6 Do you agree or disagree with the following statement? Explain your answer.A firm’s stockholders would never want the firm to invest in projects with negative NPVs.
16.3 What are the direct and indirect costs of bankruptcy? Briefly explain each.
16.2 VanSant Corporation and Matta, Inc., are identical firms except that Matta, Inc., is more levered than VanSant. The companies’ economists agree that the probability of a recession next year is
• What are the factors to consider in establishing a debt-equity ratio?
• List the empirical regularities we observe for corporate capital structure.
• How do growth opportunities decrease the advantage of debt financing?
• What is financial slack?
• What are the problems of issuing equity according to this theory?
• What is the pecking-order theory?
• What is the free cash flow hypothesis?
• How do agency costs of equity affect the firm’s debt-equity ratio?
• Why are shirking and perquisites considered an agency cost of equity?
• How can a firm maximize the value of its marketed claims?
• Describe marketed claims and nonmarketed claims.
• List all the claims to the firm’s assets.
• Who pays the costs of selfish strategies?
• What are the indirect costs of financial distress?
• What is the main direct cost of financial distress?
• Why do we say that stockholders bear bankruptcy costs?
• Can one have bankruptcy risk without bankruptcy costs?
• What does risk neutrality mean?
15.21 AT&B has a debt-equity ratio of 2.5. Its rWACC is 15 percent and its cost of debt is 11 percent. The corporate tax rate is 35 percent.a. What is AT&B’s cost of equity capital?b. What is
15.19 Green Manufacturing, Inc., plans to announce that it will issue $2,000,000 of perpetual bonds.The bonds will have a 6-percent coupon rate. Green Manufacturing currently is an all-equity firm.
15.17 Streiber Publishing Company, an all-equity firm, generates perpetual earnings before interest and taxes (EBIT) of $2.5 million per year. Streiber’s after-tax, all-equity discount rate is 20
15.16 An all-equity firm is subject to a 30-percent corporate tax rate. Its equityholders require a 20-percent return. The firm’s initial market value is $3,500,000, and there are 175,000 shares
15.13 Old Fashion Corp. is an all-equity firm famous for its antique furniture business. If the firm uses 36-percent leverage through issuance of long-term debt, the CFO predicts that there is a
15.11a. List the three assumptions that lie behind the Modigliani-Miller theory.b. Briefly explain the effect of each upon the conclusions of the theory for the real world.
15.9 The Gulf Power Company is an electric utility that is planning to build a new conventional power plant. The company has traditionally paid out all earnings to the stockholders as dividends, and
15.4 Levered, Inc., and Unlevered, Inc., are identical companies with identical business risk.Their earnings are perfectly correlated. Each company is expected to earn $96 million per year in
15.3 You invest $100,000 in the stock of the Liana Rope Company. To make the investment, you borrowed $75,000 from a friend at a cost of 10 percent. You expect your equity investment to return 20
• What is MM Proposition II under corporate taxes?
• What is MM Proposition I under corporate taxes?
• What is the quirk in the tax code making a levered firm more valuable than an otherwise identical unlevered firm?
• How are market-value balance sheets set up?
• What is the exact relationship between the expected return on equity and firm leverage?
• Why does the expected return on equity rise with firm leverage?
• How can a shareholder of Trans Am undo the company’s financial leverage?
• What is levered equity?
• Describe financial leverage.
1. Suppose the market value of the J. J. Sprint Company is $1,000. The company currently has no debt, and each of J. J. Sprint’s 100 shares of stock sells for $10. A company such as J. J. Sprint
• What is the pie model of capital structure?
12.11 What factors determine the beta of a stock? Define and describe each
12.10 Is the discount rate for the projects of a levered firm higher or lower than the cost of equity computed using the security market line? Why? (Consider only projects that have similar risk to
12.7 If you use the stock beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making?
12.1 Furniture Depot, Inc., is an all-equity firm with a beta of 0.95. The market-risk premium is 9 percent and the risk-free rate is 5 percent. The company must decide whether or not to undertake
• What can a corporation do to lower its cost of capital?
• What is the relation between liquidity and expected returns?
• What is liquidity?
• What is the difference between an asset beta and an equity beta?
• What are determinants of equity betas?
• What is the disadvantage of using the industry beta as the estimate of the beta of an individual firm?
• What is the disadvantage of using too many observations when estimating beta?
• What is the disadvantage of using too few observations when estimating beta?
1. Suppose the stock of the Quatram Company, a publisher of college textbooks, has a beta () of 1.3. The firm is 100-percent equity financed; that is, it has no debt. Quatram is considering a number
4.52 Ernie Els wants to save money to meet two objectives. First, he would like to be able to retire 30 years from now with a retirement income of $300,000 per year for 20 years beginning at the end
4.51 Southern California Publishing Company is trying to decide whether or not to revise its popular textbook, Financial Psychoanalysis Made Simple. They have estimated that the revision will cost
4.50 A 10-year annuity pays $900 per year, with payments made at the end of each year. The first $900 will be paid 5 years from now. If the APR is 8% and interest is compounded quarterly, what is the
4.49 You want to lease a set of golf clubs from Pings Ltd. for $4,000. The lease contract is in the form of 24 months of equal payments at a 12% annual percentage rate (APR). Suppose payments are due
4.48 Justin Leonard has just arranged to purchase a $400,000 vacation home in the Bahamas with a 20% down payment. The mortgage has an 8% annual percentage rate (APR) and calls for equal monthly
4.47 Ms. Adams has received a job offer from a large investment bank as an assistant to the vice president. Her base salary will be $35,000. She will receive her first annual salary payment one year
4.46 In January 1984, Richard “Goose” Gossage signed a contract to play for the San Diego Padres that guaranteed him a minimum of $9,955,000. The guaranteed payments were$875,000 for 1984,
4.45 Your younger brother has come to you for advice. He is about to enter college and has two options open to him. His first option is to study engineering. If he does this, his undergraduate degree
4.44 When Marilyn Monroe died, ex-husband Joe DiMaggio vowed to place fresh flowers on her grave every Sunday as long as he lived. A bunch of fresh flowers that the former baseball player thought
4.42 You are saving for your retirement. You have decided that one year from today you will deposit 2 percent of your annual salary in an account which will earn 8 percent per year.Your salary last
4.41 Your company is considering leasing a $120,000 piece of equipment for the next 10 years.Your company can buy the equipment outright or lease it. The annual lease payments of$15,000 are due at

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