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principles corporate finance

Questions and Answers of Principles Corporate Finance

WACC Discuss both the qualitative and quantitative implications and design of WACC.
Cost of preferred stock Your firm has 250,000 shares of $50 preferred stock currently selling at $23.56 per share. If these stocks pay a 3.5 % dividend, what is the cost of these preferred shares?
Cost of debt How do taxes influence the cost of debt? Why? Can you create a personal financial analogy to extend the answer?
Cost of zero-coupon bonds Consider a zero-coupon bond that has a face value of $100 and 13 years left until maturity. If the current price is $54.86, what is the current YTM of this bond?
Capital structure theories Briefly describe the primary findings of the capital structure theories discussed in the text. How do we incorporate those findings into capital structure policies?
Capital structure weights Firm X has a WACC of 9.43 %. They only have one type of debt and one type of equity. The cost of their debt is 8.4 % and the cost of equity is 11.3 %. What is the weight of
Financial distress Bob from accounting just barged into your office and screams “We’re about to go bankrupt! Do something!” Why is Bob so upset?Why is financial distress such a concern for a
Capital structure weights If the debt-to-equity ratio for a firm is .38, what is the weight of debt in the firm’s capital structure?
Source of funds Evaluate the statement “the cost of funds depends upon the use of the funds.” What does that mean? Assume you are talking to your supervisor in relation to a project you are
Capital structure weights Your firm has an odd capital structure made up of only coupon bonds and preferred stock. The coupon bonds have a YTM of 5.61 %. The preferred stock pays a dividend of $1.12
Weighted average cost of capital Your firm has two types of bonds. First, there are 3,000 bonds outstanding with a 7 % coupon rate and a yield to maturity of 6.5 %. These bonds are selling at
Optimal capital structure Suppose a firm has four pieces of capital structure.They are as follows:• Common stock that a beta of 1.21. In addition, the market risk premium is 9.1 % and the risk-free
Weighted average cost of capital Suppose your firm has five sources of funding. They are as follows:• 400,000 shares of stock currently selling at $12.33 per share. The firm has experienced an
Optimal capital structure Bobby’s Beer Barn just paid a dividend of $1.06 and has seen their stock price rise to $27.48. However, they are attempting to purchase a new plant that needs capital of
Optimal capital structure You are in charge of the finance department at Johnny’s Kawasaki, Inc. The firm is considering expanding to Europe and will build a plant in London. The plant will cost
Optimal capital structure Your current capital structure is made up of 500,000 shares of common stock and $4 million in private debt. The common stock is currently selling for $27.14 per share. The
Capital budgeting and capital structure Discuss the relationship between the capital budgeting and capital structure decisions. Are they made independently or simultaneously? Why? How?
Payback period Suppose you have a project that has a NINV of $825,000. The project is expected to generate net cash flows of $76,000 each year for 20 years.What is the payback period?
Capital budgeting tools Your boss, Mad Man Mike, just said that you screwed up because the NPV calculation that you provided turned out to be wrong. How do you respond to this?
Payback period Joe’s Beef Barn is planning to purchase a new meat grinding machine. They have two options. Option A is expected to generate net cash flows of $35,000 for the next 10 years and has a
Payback period What are the strengths and weaknesses of the payback period method of capital budgeting?
Discounted payback period A firm is considering a 15-year project that is expected to return NCFs of $12,000 in each of the first 7 years and then $8,000 in each of the remaining 8 years. If the NINV
Average accounting return What are the strengths and weaknesses of the average accounting return method of capital budgeting?
Discounted payback period Netty’s Cow Barn, Inc. is considering a new milking system. They have calculated the NPV of this project to be $68,524.The project is an 8-year project where each year is
Net present value Your brilliant finance instructor just made the following comment: “The NPV incorporates everything we have done all semester long.”Is she/he crazy? Why would she/he make such a
Average accounting return Consider a project that is expected to generate$45,800 in net income for each of its 10 years. In addition, it is going to cost$389,000 to get started. What is the average
Profitability index You have the NPV of a project. In order to get the PI, what other piece of information do you need? What does this tell you about the two methods?
Average accounting return The AAR of a project has been calculated to be 98.43 %. The project is a 5-year project and is expected to generate net income of $126,440 in each of those 5 years. If the
Profitability index What are the strengths and weaknesses of the profitability index method of capital budgeting?
Internal rate of return You have calculated an IRR of 8.5 % on a project.What does this mean? If the WACC is 7.5 %, what is your decision based upon the IRR?
Average accounting return A firm is considering a 3-year project. It is believed that the first year’s sales will be $21,000 and that this number will increase by $2,000 (over each previous year)
Net present value What is the NPV of a project that is expected to generate NCFs of $450,500 each year for the next 32 years? The project has a NINV of$6 million and WACC of 7 %.
Internal rate of return What are the strengths and weaknesses of the internal rate of return method of capital budgeting?
Net present value Suppose you are considering a 3-year project that is expected to generate NCFs of 24,000 in each of the first 2 years and then$36,000 in the last year. If the IRR is 6.47 % and
Net present value An investment project has an installed cost of $518,297. The cash flows over the 4-year life of the investment are projected to be $287,636,$203,496, $103,802, and $92,556,
Net present value Suppose you have a project with IRR of 11.3 %. The project is expected to generate NCFs of $44,900 in each of its 8 years. What is the firm’s NPV if their WACC is 10.4 %?
Net present value Hattie’s Hat Company, Inc. is considering a project that has a NCS of $256,000, an increase in NWC of $125,000, and NCF of $85,542 during each year of the project. Hattie has
Internal rate of return Billy’s Bean Barn is thinking of purchasing a new shucking machine that costs $126,000. They expect to generate NCFs of$26,000 each year for the 7 years of the project. What
Internal rate of return Consider a project that is expected to generate NCFs of 75,000 in each of the 4 years of the project. In order to get the project up and running, the firm will have to have
Breakeven analysis Suppose you are evaluating a 4-year project, where each year is projected to be identical. The NINV of the project is $897,000, and the company’s WACC is 7.6 %.a. What level of
Net present value You are considering a 4-year project that has the following pro forma statement:In addition, you have estimated the project will require an increase in net capital spending of $1.8
Sensitivity analysis In #18 above, suppose you wanted to conduct sensitivity analysis where actual sales can deviate by +/ 10 % from those projected.What is the “best”-/”worst”-case scenario
Capital budgeting tools Scotty’s Pickle Factory is considering purchase of a new machine to supplement his operations. After a long, drawn-out process, his financial team has come up with estimates
What kind of assumptions do we need if the firm is a nexus of contracts? Can a family be regarded as a nexus of contracts?
Use the concept of choice set to explain the existence of interest rate. Explain the meaning of the negative interest rate.
"With no transaction costs, maximizing profits is equivalent to maximizing resource providers' wealth." Comment on this statement. Who owns the property rights of excess profits?
Some scholars argue that 'check and balance' is needed in corporation. Is this argument correct?
Suppose that under uncertainty, the risk-free annual interest rate of banks is 10%. You have a patent (a particular technology) so that if you invest $10,000 now, you will receive certain $2,000
Explain that in the multi-period case, why the discount rate is also the reinvestment rate.
Suppose that a five-year investment project needs $1,200 initial investment and at the end of each year will give $50 payoff and $1,200 at the end of the fifth year. The annual interest rate is 4%.
In the previous question, if the annual interest rate is 8%, will you invest in this project?
Suppose that today is September 1 and you need to pay tuition $10,000 in the next four years starting from next year’s September 1.With annual interest rate 4%, how much money do you need now?
A young worker is twenty years old and plans to work until sixty years old. She hopes that after she retires, she can receive $60,000 annuity until she is eighty years old. With 4% annual interest
Explain the difference between balance sheet and income statement.
Explain the difference between free cash flow and cash flows statement.
What is economic value added (EVA) method? What are the limitations of this method?
In the income statement, is the depreciation expense a real expenditure?
What are the limitations of using financial ratios?
Give an investment example to explain cost, budgeting, and accounting numbers.
What is cash flow? Why is the firm’s depreciation expense needed to be included in cash inflows?
Is the net present value (NPV) analysis for equityholders equivalent to the NPV analysis for capital providers?
Suppose that you need to choose one project from a group of mutually exclu-sive investment projects which have different investment horizons. What kind of assumptions do you need to do the cost and
With 10% annual discount rate, calculate the NPV of the following dam construction project. Explain which number(s) is opportunity cost. 1=0 t=1 1=2 1=3 1=4 Cash flow -510 -50 700 800 400
With 10% annual discount rate, calculate the NPV, IRR and MIRR of the following mining project. Explain which number(s) is opportunity cost. 1=0 t=1 1=2 1=3 1=4 Cash flow -400 -100 300 360 -50
In the profitability index analysis, what is its denominator? Is the denominator of the profitability index analysis an opportunity cost or accounting expense?
In the one-period model, the internal rate of return (IRR) analysis is consistent with the net present value (NPV) analysis. But in the multiperiod model, the internal rate of return (IRR) analysis
Some investors suggest choosing stocks with low price-earning ratios. Do they use high or low discount rate?
Explain why the payoff period method is very popular in high-tech industry.
Are the assumptions of the capital asset pricing model (CAPM) different from those of the arbitrage theory (APT)?
When a petrochemical company acquires a retail company, how to calculate the beta of this acquisition?
Explain why the market portfolio of the CAPM and the market portfolio of the two-factor model are efficient portfolios.
If an asset pricing model can correctly predict future stock prices, what will the capital market equilibrium be?
Explain the differences between the three-factor model and the CAPM?
Can you give an example of first claim and residual claim in a corporation?
The Modigliani-Miller first proposition is about the irrelevancy of using equity or debt to finance a firm. Can this irrelevancy proposition also hold in the case of using equity, senior and junior
Some scholars argue that under certainty, in a perfect market, production decision is independent of financing decision. True or false?
In 'a tale of two cows', what assumptions do we need?
In Sect. 2.4 of Chap. 2, we have shown that under certainty, the Modigliani-Miller second proposition does not hold. Under uncertainty, can the Modigliani-Miller second proposition hold?
Comment on the following statements17 :(a)Wilmott (2007, p. 77): Assume: “(1) two stocks A and B; (2) both have the same value, same volatility and are denominated in the same currency; (3) both
With zero interest rate, do the arbitrage for the following two assets: Asset I S = 9 (good time) S = 2 (bad time) 48. = S270 (good time) Asset 2 S = 32 (bad time)
Explain under what conditions an American put option will not be early exercised. How to use these conditions to determine the best time to liquidate a firm?
Explain how to use the p-index to invest in stocks. What are the limitations of the p-index?
Explain why the Black–Scholes-Merton option pricing model has:and the binomial option pricing model has:
Suppose you’re on a game show, and you’re given the choice of three doors: Behind one door is $1,000,000; behind the others, $0. You choose a door, say No. 1, and the host, who knows what’s
(1)How many choices do you have in this game?(2)If the host opens two other doors, how many choices do you have in this game?(3)If the host opens no door and asks you to choose again, how many
Suppose that an individual is offered a bet: ($100,000, 0.50; $50,000, 0.50). Mankiw and Zeldes (1991) argue that a person with a coefficient of relative risk aversion of 30 would be indifferent
Some researchers claim that most common errors among individuals are: under-diversification, holding onto losers, chasing winners, buying stocks that catch their attention, systematically ignoring
Explain why firms in the same industry usually have similar capital structure.
In both government and business, they usually intend to expand their sizes. Why?
What are the assumptions of the pecking order theory and the trade-off theory?
List the possible conflicts between shareholders and managers. Some sharehold-ers complain that the high-ranking officials get too much compensations. Is this complaint reasonable?
Explain why a firm has a lot of cash in hand but still issues corporate bonds to borrow from the markets.
Comment on the following statement. When a firm announces cash dividends, it is equivalent to the case that the firm changes part of its equity into a senior debt, and the original debt becomes
Some people argue that cash dividend can reduce free cash flow so that it will not only lessen the management team’s shirking problem but also may reduce the chance to invest in positive NPV
What are the assumptions of the bird-in-the-hand hypothesis?
When a firm announces share repurchases, does it mean that the firm’s stock price is over-or undervalued?
Explain why firms usually provide constant cash dividends.
After mergers and acquisitions, firms on average do not perform well. Explain why?
Mergers and acquisitions usually do not benefit the acquiring firm’s equityholders. Why will mergers and acquisitions still exist?
What are the benefits and costs of a regulated monopoly and an unregulated monopoly?

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