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business
theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

A cash-cow firm, susceptible to agency issues, might hit short-term financial difficulties in a recession.What kind of financial security would maximize the firm’s value?
Does the lack of a personal income tax rate in the APV and WACC formula mean that the personal tax rate does not matter to the valuation of the firm?
If the firm is not in an M&M perfect-markets situation, how will this be reflected in the relation between its cost of capital and its leverage?
List the main effects pulling capital structures toward equity. List the main effects pulling capital structures toward debt. Are all these forces working through the desire of entrepreneurs and
Give an example of transaction costs that favor more equity in the capital structure. Give an example of transaction costs that favor more debt.
Does concern with inside information suggest that firms should issue debt or equity?Why?
What is the pecking order? (Thinking question: In a real-world firm, will a pecking order lead to a financing pyramid, in which firms tend to be financed mostly by debt [the bottom of the pyramid]
A house up for auction can be worth either $500,000 or $1,000,000 with 50-50 probability. The other bidders know the true value; you do not.If you bid for the house in an auction, what should you
What is an advantage of adding a convertibility feature to a bond?
In a market in which bond covenants are priced at what they are worth, can their presence still increase firm value? When could covenants reduce firm value?
Does managerial risk aversion mitigate or exacerbate the fear of creditors to be expropriated in favor of shareholders?
Describe the two basic mechanisms whereby unprotected bondholders can be expropriated by shareholders. Can you illustrate your arguments with numerical examples?
Return to a project similar to the firm in Table 18.3. The risk-neutral required interest rate is 10%. The firmis worth either $100 or $120. The bond promises $90.We shall consider two cases: one in
Do managerial agency concerns induce firms to be more debt-financed or more equity-financed?
Give some examples of perks that management might have to give up if they work at a firm with more debt.
Is debt always a strategic advantage? Describe the arguments on both sides.
What kinds of firms are most likely to be influenced by possible reluctance-to-liquidate costs when choosing a capital structure?
Give an example of a reluctance-to-liquidate problem. Is this an issue that could hurt only the creditors, or only the shareholders?
What kinds of firms are most likely to be influenced by underinvestment costs when choosing a capital structure?
Give an example of an underinvestment problem.
Give examples of bankruptcy costs. Distinguish between direct and indirect costs.
What do U.S. managers usually mean by Chapter 11 and Chapter 7?
Do deadweight bankruptcy costs favor debt or equity?Why?
In Atlantis, all firms are tax exempt. Only investors pay income taxes.How should firms be financed? How would theWACC formula work?
In a risk-neutral world, would a high-tax investor be satisfied with a lower rate of return on capital gains?
Is it more critical for the high-tax firm or the low-tax firm to finance itself correctly?
From a tax perspective, would you expect large, stable firms to be predominantly held by pension funds or by high-tax individuals? Would you expect young, growing firms to be predominantly held by
Would Uncle Sam be better off if our puppeteer forced low-tax investors to hold equity and high-tax investors to hold debt? Refer back to Figures 18.2 and 18.3.
Would Uncle Sam be better off if our puppeteer forced the low-tax firm to be financed with debt and the high-tax firmwith (share-repurchasing)equity? Refer back to Figures 18.2 and 18.3.
Explain the (personal and corporate) tax treatments if a company pays out its operating cash flow through interest payments, repurchased shares, or dividend payments.
What kinds of income do investors like and dislike from a tax perspective?
Why should a CFO be concerned with taxes that he and his firm are not paying?
Is the high debt risk and equity risk when the firm has too much debt a force away from debt and toward equity? Can this higher risk counterbalance the corporate income tax benefits of debt?
If you wanted to be more exact about the appropriate discount rate for the tax shelter in APV, what kind of discount rate would you apply to a firm with a decreasing debt target? What would you apply
For a firm without default, are the tax obligations from debt a risky asset?
For a firm without default, are the tax savings from debt a risky asset?
A firm has a current debt/equity ratio of 2:3. It is worth $10 billion, of which $4 billion is debt.The firm’s overall cost of capital is 12%, and its debt currently pays an (expected) interest
Can you use the CAPM with the tax-adjusted WACC formula?
Estimate how PepsiCo’s value would have changed in 2003 if it had announced that it planned to increase its debt-asset target by an additional 5% and that it would use the generated funds to
Estimate how PepsiCo’s value would have changed in 2003 if it had announced that it planned to take on and maintain an additional$10 billion in debt in order to repurchase equity. Assume that
Compute the 2005 tax shield for PepsiCo, using information from Yahoo! Finance.
Chapter 13 Appendix on page 488 contains the financials for Coca-Cola. What were the tax shields that debt provided in 2001, 2000, and 1999?
Construct a pro forma for the following firm: A 4-year project costs $150 in year 1 (not year 0)and produces $70 in year 1, $60 in year 2, $50 in year 3, and $40 in year 4. (All numbers are
A multibillion-dollar corporation is undertaking an R&D project. It costs $1 million in R&D.Because it is risky, the appropriate cost of capital for R&D is 15%. Next year, if it succeeds(probability
A firm would have to invest $1 million to earn a net return of $500 million next year. The firm estimates its debt cost of capital to be E(˜rDebt) = 5% + 10% . w2 Debt. (This may be the case for
You can take a $1 million project. However, this kind of project is ordinary income for you, and it will produce either nothing or $3 million next year, both with equal probabilities.Assume that your
Your firm is in a 40% combined federal and state marginal income tax bracket. Your annual income is $500,000 per year for 2 years. If you finance some project with a $1,300,000 mortgage at an
If there are no market imperfections except for corporate income taxes, what should the firm’s optimal capital structure be?
A firm will have before-tax cash flows of $3 million. It can invest in equally risky cash flows that earn a before-tax expected rate of return of 14%.What assumption do you have to make to allow
Assume a 20% corporate income tax. Does a project that returns 16% before-tax have a negative NPV if it costs $100 today and if the appropriate after-tax cost of capital is 11%?
For the $20 earnings firm in the 25% tax bracket:(a) The weighted average cost of capital (WACC) is WACC = 50% . 5% . (1 − 25%) + 50% . 10% = 6.875%WACC = wDebt . E(˜rDebt) . (1 − τ) + wEquity
In 2001, with $1,691 million in taxes on $5,670 million income before the corporate income tax, Coca-Cola was in a 30% income tax bracket. The $289 million that Coca-Cola paid in interest therefore
For our 3-year project firm:(a) The pro forma for a 100% equity-financed firm is shown below.(b) The IRR of our project solvesThus, the IRR of a purely equity-financed project is 15.69%.(c) The NPV
This project will offer $200 before-tax profit in year 1. Discounted back at the firm’s cost of capital (don’t worry if this is exact), the NPV without taxes is −$300 + $500/1.2 ≈ $116.67.
The firm’s overall cost of capital today is 6% . 1/3 + 12% . 2/3 = 10%. Because 4% + 3% . β = 10%, the beta is 2. The easy way is to recognize that the firmis sheltering $500 . 6% = $30 through
Figure 17.1 draws theWACC as a function of the debt ratio with only corporate income tax distortions.
You would prefer to use WACC if you follow a constant ratio-based debt target, and APV if you follow a dollar-based debt target. Look at the previous two questions. You cannot figure out the APV in
For the $100 debt financing, the APV valuation isTherefore, the $100 debt is 43.3% of the firm’s value today. TheWACC valuation is $256 APV = + 1 + 12% E(C) APV + 1+ (Firm) 30% 8.7% $100 1 + 12%
For the 25/75 debt/equity financing, theWACC valuation is PV = E(C) $256 $229.80 1+WDebt TE(Debt) 1+12% 25% 30% 8% The firm has $229.80 25% = $57.45 of debt (and $172.35 in equity value today). Its
For the $1 million construction project:(a) With a $200,000 return, Uncle Sam would receive $200,000 . 45% = $90,000 if you pay out cash.(b) If you finance with 80% debt, you will have $800,000 . 5%
For this debt/equity hybrid, the firm has to earn $500 if the security is designated as debt with an interest payment. But if the security is designated as equity with a dividend distribution, then
This 17% and 12% scenario is the example in the text, slightly amplified: NPV = −$100 + ($117.00 −$17.00 . 30%)/1.12 ≈ −$0.09 < 0.
A firm has expected before-tax earnings of $20 per year forever, starting next year. The firm is in the 25% tax bracket.(a) If the firm is financed with half debt (risk-free, at 5% per year) and half
Compute the 2001 tax shield for Coca-Cola, using the information on page 488.
Construct a pro forma for the following firm: A 3-year project costs$150 in year 1 (not year 0) and produces $70 in year 1, $60 in year 2, and $55 in year 3. (All numbers are year-end.) Depreciation,
A firm in the 40% income tax bracket has an investment that costs$300 in year 0, and offers a before-tax return (cash flow) in year 1 of $500. Assume that the firm’s before-tax opportunity cost of
A firm in the 20% marginal tax bracket is currently financed with $500 debt and $1,000 equity. The debt carries an interest rate of 6%; the equity’s cost of capital is 12%. The risk-free rate is
From memory, draw theWACC of the firmas a function of its debt ratio if the only market imperfection is the corporate income taxes.
If you are thinking of debt in terms of a (constant) fraction of firmvalue, would you preferWACC or APV? If you are thinking of debt in terms of a (constant) dollar amount, would you preferWACC or
Consider financing your firm with $100 debt: The before-tax return is$280, the investment cost is $200, the tax rate is 30%, the overall cost of capital is 12%, and this debt must offer an expected
Consider a 25/75 debt/equity financing case for your firm. Your firm will produce a before-tax return of $280, the investment costs $200, the tax rate is 30%, the overall opportunity cost of capital
A $1 million construction project is expected to return $1.2 million in 1 year. Your company is in a 45% combined federal and state marginal income tax bracket.(a) If you finance the project with
A debt/equity hybrid security would like to pay out $500 to its holders.The firm is in the 33% corporate income tax bracket. How much would the firm have to earn if the IRS designates the payment an
Assume a 30% corporate income tax. Show that a project that returns 17% before-tax would have a negative NPV if it cost $100 today and if the appropriate after-tax cost of capital is 12%.
In a world of perfect financial markets (but not necessarily product markets), is the cost of capital of the firm independent of how it is operated and financed?
In a world of perfect financial markets, is the cost of capital of the firm’s financial claims independent of how it is financed?
Does the standard M&M proposition apply to nonfinancial liabilities?
Show how a firm can increase its cost of equity capital and its cost of debt capital, and still come out with an overall cost of capital that is unchanged.
Compute a graph similar to Figure 16.1. Use a spreadsheet. Your firm will be worth either$50,000 or $100,000 with equal probabilities.The cost of capital on your debt is given by the formula
When both debt and equity become riskier due to an increase in the firm’s leverage, the firm remains worth exactly the same and stays exactly as risky (in a perfect market).Conceptually, what would
Work the example from page 590 if the debt promises $65,000. Confirm that the weight of the debt in the capital structure is 67.85%.
If a change in capital structure increases the risk of the firm’s equity and the risk of the firm’s debt, and there are no other financial claims, does it imply the firm’s risk has increased?
A firm can be worth $100 million (with 20%probability), $200 million (with 60% probability), or $300 million (with 20% probability).The firm has one senior bond outstanding, promising to pay $80
In a world that is not perfect but risk neutral, assume that the firmhas projects worth $100 in the down-state, $500 in the up-state. The cost of capital for projects is 25%. However, if you could
Comment on the following statement: “New shareholders would be worse off if management destroyed wealth by capturing the board and paying themselves much higher executive compensation without
Explain when “shareholder maximization” is the right goal and when it is the wrong goal for management.
Yes, it may still make sense to compute a cost of capital based only on the firm’s financial capital (debt and equity) if the firm has exhausted all its nonfinancial low-cost sources of capital. It
Yes, the value of the firm’s financial claims is independent of how the financial claims are arranged in an M&M world. This is because no financial security offers a positive or negative NPV—all
No, the value of the firm may be linked to its financing, because its financing is linked to its projects. You also need to break the link between nonfinancial liabilities and operations.
Though obscure, a firm with a very negative beta can indeed be in this situation. It must be the case then that the firm’s project cost of capital is lower than the risk-free rate. (For example, a
In a perfect market, the cost of capital under a 100% equity financing strategy with cost 10% must be the same as it is under a mixed debt and equity strategy. Therefore, wDebt . 0.05 + (1 − wDebt)
No, it is quite possible that the weighted average cost of capital is lower than the interest rate that it has to pay to the bank. After all, the bank rate is promised, not expected.
The solution proceeds the same way as in the text on page 396 (Chapter 12):(a) The project should have an appropriate rate of return of E(˜r) = 3% + 4% . 0.5 = 5%. It is immediately obvious that the
No. Firm A need not have a higher overall cost of capital than firm B. The example in the “How Bad Are Mistakes?” section illustrates this fallacy. The relative weights of debt and equity also
For the example from page 589, in which the debt promises $75,000, to confirm that the weight of the debt in the capital structure is 77.14%, construct the full payoff table: Bond Levered Equity 100%
Please rework the examples for yourself. For example, for the promised debt of $50,000: If the weight is 53.72%, then the expected rate of return on the debt should be 4.053% + 5.947% . 53.72% ≈
Most likely, you can fund the project. In a perfect market, you can hold low-risk debt that has first dibs on all proceeds.
You need to recall the standard deviation formula (Formula 8.1) on page 204: Full Ownership: Sdv = 0.20 (-73.81% Debt: Sdv = Levered Equity: Sdv = 0.20 (-100% - 10%)2+0.80 (+30.95% -10%) 2 41.9%
To work out the firm’s equity cost of capital and the debt’s promised rate of return, imitate the payoff tables from the text (dollars are in millions):The debt’s promised rate of return is
Yes, they can destroy shareholder value. If existing management gives away debt claims at too low a price, creditors will own more of the firm having paid less money. New management cannot undo this,

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