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business
theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

No. The “homemade leverage restructuring” argument misses the aspect of control rights.
Work out the following:You would purchase 3.3% of the LD equity and sell (issue) 0.3% of the equivalent of the LD debt. The equity would cost you e . $50 = $1.65; the debt issue would give you $0.15
The risk-neutrality assumption really buys nothing. We do not need it. We only use it because it makes the tables simpler to compute.
Capital structure does not matter in a perfect market: No transaction costs, perfect competition, no taxes, and no differences in opinion and information.
The idea is to explain it really simply. Milk, cream, pizza, and pockets are handy metaphors.
Clearly, managers in the future would want not to pay debt if they can avoid doing so. However, such behavior could have repercussions for their future attempts to borrow money. The firm would have
Yes, an ex-post maximizing choice can be bad from an ex-ante perspective. The example of the $3-for-$1 transaction in the text shows that you would want to restrain yourself.
Ex-ante means “before the fact”; ex-post means “after the fact.” To the extent that the original ownerentrepreneur can set up a situation (charter) that encourages best (i.e., from the
If you observe a firm with nonfinancial claims that have a zero marginal cost of capital (such as delayed income tax obligations), does it make sense to compute a cost of capital based only on the
In a world of perfect financial markets, is the value of the firm’s financial claims independent of how it is financed?
In a world of perfect financial markets, is the value of the firm independent of how it is financed if there are also nonfinancial liabilities?
How can it be possible for a firmwith a positive cost of project capital to have a negative cost of equity capital? How high can the cost of project capital be in this case?
If a firm has a 5% cost of debt capital, a 10% cost of project capital, and a 20% cost of equity capital, what is its debt/equity ratio?
Is a firm that uses a weighted average cost of capital that is lower than the interest rate that it has to pay to the bank making a mistake?
Assume the risk-free rate of return is 3% and the equity premium is 4%.A firm worth $100 million has a market beta of 3. A new project that costs $10 million appears. It is expected to pay off $11
Compared to hypothetical firmB, hypothetical firmA has both a higher cost of capital for its debt and a higher cost of capital for its equity. Does this necessarily imply that firmA has a higher
Work the example from page 589 if the debt promises $75,000 and E(˜rDebt) = 8.64%. Confirm that the weight of the debt in the capital structure is 77.14%.
Confirmall the numbers in the contingent claims table on page 590. For example, you do not need to work out wDebt≈ 53.72% independently, but you should confirm it.
Assume that you have access to a project worth $100 that you cannot fully finance yourself. Moreover, you have only 20% of the project that you can finance and you need the money back next year,
Work out the standard deviation of the rates of return—the standard measure of risk—for each of the three possible types of claims (full ownership, debt, and levered equity) in the building
A firm can be worth $50 million, $150 million, or $400 million, each with equal probabilities. The firm is financed with one bond, promising to pay $100 million at an interest rate of 5%. If the
Under M&M, if contracts cannot be renegotiated, could existing managers destroy shareholder value? Does this change the value of the firm?
Is the “homemade leverage restructuring” a full proof of the M&M proposition that capital structure is irrelevant? If not, what is missing?
In the example from Table 16.1, how would you purchase the equivalent of 5% of the equity of a hypotheticalMDfirmif all that was traded were the claims of the LD firm?
What does the assumption of risk neutrality “buy” in the M&M proof?
Under what assumptions does capital structure not matter?
Explain the M&M argument to your 10-year-old sibling, using Merton Miller’s analogies.
If a firm has just learned of a legal loophole that allows it to renege on its obligations to pay back its creditors, should it do so?
Can an ex-post maximizing choice be bad from an ex-ante perspective?If you could, would you want to restrain yourself from acting in such a way later on?
Explain the difference between ex-ante and ex-post, especially in the capital structure context. Give an example where the two differ.
Explain how the capital structure of IBM changed from 2003 to 2005.
What are the main categories of short-term liabilities?
What is commercial paper?
What are the main categories of long-term liabilities?
What are financial notes?
Is common stock or preferred stock more common? Does the name “preferred” mean it is better to own preferred stock than common stock?
What are the main control rights for common equity, preferred equity, and debt?
What is the main control mechanism through which shareholders increase the likelihood of ever receiving cash?
Write down all bond features (variations) that you remember.
A convertible zero-bond that promises $20,000 can be converted into 100 shares of equity at its maturity date. If there are 8,000 such bonds and 1,200,000 shares outstanding, what would the payoff
What are the main mechanisms through which creditors can increase the likelihood of being repaid? Give some examples.
What are the two uses of the abbreviation“APR”?
What can payoff diagrams illustrate well?Where do they fail?
Draw a final payoff diagram for a stock and a bond, where the bond promises to pay off $500 in 1 year.
Write down the payoff table and graph the payoff diagram for an insurance contract with a deductible of $100,000, a coverage of 80% of the loss, and a maximum payout of $1,000,000.
What is a cash flow right? How does it differ from a control right?
The value of equitymoves around a lot more, primarily because it is a “levered value,” which ismore sensitive to changes in the value of the underlying firm. In contrast, debt changes drastically
You cannot purchase all issued shares, because the firm holds treasury shares, which are a component of all issued shares. Instead, you need to purchase all outstanding shares. This gives you
Liabilities consists of long-term debt (bonds and notes), short-term debt (financial, taxes, payables, etc.), pension debt, and other debt. Equity consists of common and preferred stock.
Preferred equity is like a bond in that it does not participate in the upside, and in that preferred equity is usually de facto senior to common equity. This applies both in bankruptcy and in respect
The Bush dividend tax cuts reduced the double taxation of individuals. Because corporations always had some form thereof, they made corporations and individuals more similar.
Shareholders indeed enjoy limited liability, which is the fact that they can only lose their actual investment.They do not forfeit their personal possessions if the corporate managers act badly.
The various bond features are fully described in Section 15.2A. Here is a short description:Most bonds make interest payments on a regular basis (e.g., semiannually or annually) and repay the
The question seems difficult, but it does become easy once you realize the following:If the junior does not convert, then the senior’s 50 million in new equity shares would represent 50/150 or
For the 2,000 convertible $10,000 zero-bonds that can be converted into 50 shares of equity each (with 300,000 shares outstanding): If the firm is worth less than 2,000 . $10,000 = $20 million, the
For the $100 senior bond, the $200 junior bond, and equity: Firm Senior Junior Equity $0 $0 50 $0 $0 $50 $50 60 $0 $0 $100 $100 $0 $0 $150 $100 $50 $0 $200 $100 $100 $0 $250 $100 $150 $0 $300 $100
No, you cannot draw a good payoff diagram for a coupon bond with so many remaining payments—at least not easily without making a lot of extra assumptions. Payoff diagrams only work well for a
For the medical insurance reimbursement example, consider an example. If you submit annual claims of$750, you first have to pay the deductible of $500 yourself. On the remaining $250, you get a
Yes, you can add up payoffs. It is basically stacking up lines. The sum total must be one diagonal line (i.e., slope of 1)—it is the value of the firm. Perhaps this is easiest to see if you draw it
The payoff table for the $300 million zero-bond is as follows (in million dollars):The bond is a diagonal line until firm value is $300, and then a horizontal line. The stock is a horizontal line at
Individuals can never really own everything. The IRS and community have inalienable property rights over every firm in existence.
A control right is the right to influence decisions, specifically by changing management and/or the board.
From year to year, does the market value of debt or equity tend to move around more?
To purchase all common equity in a firm, do you need to purchase all outstanding or all issued shares?
List some of the bigger categories that can go into the firm’s capital structure.
In what sense is preferred equity like bonds? In what sense is preferred equity like stocks?
Did the Bush dividend tax cuts make corporate and individual holders of shares more similar or more dissimilar in terms of their dividend income tax treatments?
Do shareholders enjoy limited liability?
Write down all bond features (variations) that you remember.
Write down the equity payoff table and draw the payoff diagram if the firm has the following capital structure:1,000 senior bonds with promised payoffs for a total of $100 million, convertible into
A convertible zero-bond that promises $10,000 can be converted into 50 shares of equity at its maturity date. If there are 2,000 such bonds and 300,000 shares outstanding, what would the payoff table
A firmis financed with a senior bond that promises to pay $100, a junior bond that promises to pay $200 (of lower seniority but of equal maturity to the senior bond), and equity. Write down the
Can you draw a payoff diagram for a semiannual coupon bond with 15 remaining 10% coupon payments until maturity?
To gain some practice with payoff diagrams, assume your medical insurance pays 90% of your medical expenses, subject to a $500 deductible and an annual limit of $10,000 payout.Write down your
Can you add payoff functions graphically in the payoff diagrams (if you ownmultiple claims), or do you first need to write down a revised payoff table? How? If so, what does the sum of all added
Write down a payoff table for a stock and a zero-bond with a promised payoff of $300 million.What does the graph look like?
Is it ever possible for a private individual to fully own a firm?
What is a control right? Give some examples.
What ingredients are in the DuPont model?What are its problems?
What is the “quick ratio”? Is a firmmore or less precarious if this ratio is high?
How could you value a biotech start-up that has no sales or earnings?
Is there a problem with using a book value–based equity measure? If so, why, and when does it matter?
Is it reasonable to compare IBM’s P/E ratio based on equity to that ofMicrosoft? Is it more or less reasonable to compare IBM’s P/E ratio based on total firm value to that of Microsoft?
What are the main problems of comparables?Give an example of each, preferably real-world or numeric examples.
Compute a TTM earnings number for Microsoft.
A firm with a P/E ratio of 10 wants to take over a firm half its size with a P/E ratio of 25. What will be the P/E ratio of the merged firm?
Use Ford’s P/E ratio to value General Motors today. If Ford still has negative earnings, then use Google to value Microsoft.
Redo Shiller’s value analysis today. Find the current P/E ratio of the S&P 500 on the Web.Assume that the expected real growth rate of GDP is 2.5% per annum. What does the stock market suggest is
A firm has earnings of $200, and a price/earnings ratio of 20.What is its implied growth rate, if its cost of capital is about 10%?
If the P/E ratio on the S&P 500 is 10, given historical earnings growth patterns, what would be a reasonable estimate of long-run future expected rates of return on the stock market? Assume a
Pick 8 firms in the “department stores” sector.Using a financial website (e.g., Yahoo!Finance), graph next year’s expected growth of earnings against the firms’ earnings/price yield. Is there
Assume that the prevailing interest rate is 8%per year for value firms and 12% per year for growth firms. A growth firm with earnings of$100,000 has a market value of $100,000,000, while a value firm
Consider a growing firm that produces cash of $10 million next year. The firm’s cash flow growth rate is 15% per annum. The firm’s cost of capital is 20%.(a) What is the market value of this
Which is likely to have a higher price/earnings ratio: Google or Exxon?
Is it better to use cash flows or earnings in your valuation multiple?Why?
Is it better to compute a price/earnings ratio on a per-share basis or on an aggregate (total value) basis?
When negotiating house prices, would you value your next residence by the method of comparables or by the method of NPV? If comparables, what kind of ratio might you use?
What are the three main requirements for a comps-based valuation?
The dividend/price ratio divides dividends by price; the dividend payout divides dividends by net income.
Its receivables turnover is $30,000/$6,000 = 5 times per year. DRO is 365 . $6,000/$30,000 = 73 days.

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