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business
theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

A business produces 100,000 gadgets that cost $1 each to produce and sell for $1.80 each (last year and just now). To produce another 100,000 gadgets requires running the machine at night, which
Recall as many items from the NPV checklist as you can remember. Which are you most likely to forget?
Contrast Google andWal-Mart.Which agency conflicts are likely to inflict Google worse than Wal-Mart, and vice versa? Discuss.
Should you suppress all agency conflicts?Discuss.
Are agency problems worse in upstart firms?Discuss.
Describe a manifestation of an agency problem, where it is worse, and what can be done to remedy it.
Explain how you can exploit human biases in attracting signups for your new health club.
You have to purchase $600 worth of staples.You have just found out that the stationery store across from you charges $300 more than the warehouse outlet 20 miles away. Would you spend the 40 minutes
What are the types of real options that firms need to take into account in their project valuations?
Your factory can stamp 150,000 CDs at a cost of $5 per CD, or 500,000 CDs at a cost of $8 per CD. If your CD has a hit song, you can sell it to retailers for $10 per CD. If it is a moderate success,
Comment on, “It is best to allocate costs to divisions that benefit from a resource.”
Comment on, “It is best to allocate costs only to divisions that request a resource.”
A perpetual firm’s headquarters consumes $1 million per year. It has six divisions of equal size, but not equal profitability. The annual profitabilities (in thousands of dollars) are as
A firm can produce goods for an average per-unit cost of $5 + $10/(Q . $1 + 2). For example, to produce 10 goods would cost 10 . ($5 + $10/12) ≈ $58.33. The market price per good is $7 − Q .
As a manufacturer, you have to decide how many regional distributors to sign up. Serving a distributor costs more the farther away it is from the factory, and different distributors have different
What are the main sources of positive externalities?What are the main sources of negative externalities?
As the CEO of an expanding airlines cargo division, would you acknowledge that an increase in your operations would be harmful to the passenger division? Should you be charged for the increased use
What are the arguments for and the arguments against discounting every project by its own cost of capital?
Assume that the risk-free rate is 5% and the equity premium is 2%. A $1 billion firm with a beta of 2 has just sold one of its divisions for a fair price of $200 million. The CEO is concerned that
A $300 million firm has a beta of 2. The risk-free rate is 4%; the equity premium is 3%. Assume that the firm can easily tap a perfect capital market to obtain another$95 million. The firm can also
A machine that costs $2,000 is likely to break irreparably with 20% probability at the end of each year (assuming it worked the previous year). You can neither replace it nor use it for more than 5
A zero-bond has a stated rate of return of 8%.Its price today is $92,593. What is its expected payoff?
Does it make sense to distinguish between a promised and an expected internal rate of return?What do issuers provide?What do you usually need?
Can you compare a project’s internal rate of return to its expected rate of return?
First, the CEO’s projected figures probably represent the most likely outcome, not the expected outcome. It is probably more likely that the firmwill go bankrupt due to totally unforeseen
Agency problems are the subject of Section 12.8. The text discussed eagerness for capital, employment concerns, desire for perks, desire for power, desire to work less, desire not to take risks, and
The average student does not get one question wrong, but five questions wrong.
Mental decision biases are the subject of Section 12.7. The text discussed overconfidence, relativism, and compartmentalization.
Relativism may induce you to make mistakes on both types of projects (and it is not clear which one is worse): For small projects, you may chase a large percentage increase too vigorously. For large
(a) The expected per-CD selling price is $6 . 90% + $10 . 10% = $6.40.(b) If $6.40 was the price, you would gear your factory to produce 150,000 CDs. Without flexibility, your factory would be worth
Yes, the firm should expand. The PV of the division’s profits will be $50,000/10% = $500,000. The division costs are $210,000 for new equipment and $20,000 per year in increased overhead. The PV of
(a) The profit of the firm is Profit(x = 10) = 10 . [$20 − $5 − $15/(10 + 1)] ≈ $136.36.(b) With 11 goods, the cost to produce is $5 + $15/(11 + 1) = $6.25. With 10 goods, it was $5 +$15/(10 +
(a) Either purchasing the desktop or the notebook would be a positive-NPV project. However, you should purchase the desktop, because it is cheaper (more bang for the buck).(b) You should still
The firm should not purchase the press, because it earns $2,000/10% = $20,000. But the press costs$10,000 to purchase and eliminates $1,500/10% = $15,000 of profits from the screw machines. The total
Without taking the externality into account, the NPV of division A’s move would be negative. The$120,000 of costs would be higher than the benefit of $10,000/10% = $100,000. However, the correct
Zero externalities are convenient for valuation, because they allow you to add up NPVs. If there are nonzero externalities, the total NPV is larger or smaller than the sum of its part.
(a) The new project’s value is $11/1.15 ≈ $9.57. At a cost of $10, the net present value is −$0.43.(b) The value today of the new project is $11/1.15 ≈ $9.57. Therefore, the weight of the new
The merged firm has a lower standard deviation (it is safer), but this adds no value.
For the $900,000 machine, the probabilities of different outcomes are as follows:(a) The single most likely outcome (with 65.6% probability) is that the machine will operate for all 5 years (because
You cannot determine this, because you do not know the expected bond payoff.
The Amazon.com bond’s stated 8% is a promised rate of return. It is not the expected rate of return.Therefore, it is not the cost of capital.
Comparing a project’s cost of capital to its hurdle rate would be silly, because your hurdle rate is just another name for your cost of capital in a perfect market.
Yes, it makes sense to compare the project’s IRR to a hurdle rate. Indeed, if the hurdle rate is the cost of capital, the IRR rule tells you what you should do.
The CEO projects earnings of $100 million next year. List three reasons why this might not be a good input into an NPV valuation.
Describe common agency problems and explain how they are likely to bias corporate NPV calculations.
Take the overconfidence quiz at www.prenhall.com/welch.
Describe commonmental decision biases, and how they are likely to bias NPV calculations.
Is relativism a bigger problem when evaluating small projects or large projects?
Your factory can stamp 150,000 CDs at a cost of $5 per CD, or 500,000 CDs at a cost of $8 per CD. If your CD has a hit song, you can can sell it to retailers for $10 per CD. Otherwise, you can only
A company rents 40,000 square feet of space and is using 30,000 square feet for its present operations. It wishes to add a new division that will use the remaining 10,000 square feet. If it adds the
A firm faces diseconomies of scale in both production and sales. It can produce goods for an average per-unit cost of $5 + (Q . $1 +$20)/100, where Q is the number of units. For example, to produce
The average production cost per good is estimated at $5 + $15/(x + 1).The firm can currently sell 10 units at $20 per unit.(a) What is the current total profit of the firm?(b) How much should the
A notebook computer costs $2,500; a desktop computer costs $1,500. If you buy either the notebook or the desktop, you can increase your productivity to $9,000. If you buy both, you can increase your
A firm can purchase a new punch press for $10,000. The new press will allow the firm to enter the widget industry, thereby earning $2,000 per year in profits forever. However, the punch press will
A company must decide if it should move division A to a new location.If division A moves, it will be housed in a new building that reduces its operating costs by $10,000 per year forever. The new
Why are zero externalities so convenient for a valuation problem?
Some companies believe they can use the blended post-acquisition cost of capital as the appropriate discount rate. However, this also leads to incorrect decisions. Let’s explore this in the context
When two unrelated firms with uncorrelated rates of return merge, is the resulting conglomerate riskier or safer? Does this add value?
A machine that costs $900,000 is likely to break irreparably with 10%probability at the end of each year (assuming it worked the previous year). (Many electric devices without moving parts have such
A zero-bond promises $100,000 and has a beta of 0.3. If the risk-free rate is 5%, and the equity premium is 3%, and the CAPM holds, then what is the bond’s price?
An Amazon.com bond quotes an internal rate of return of 8% per annum.Assuming the market is perfect, is this its cost of capital?
Can you compare a project’s cost of capital to its hurdle rate in a perfect market?
Can you compare a project’s internal rate of return to its hurdle rate?
Use a financial website to conduct an event study of big corporate acquisitions over the last 12 months. How did their announcements impact the value of the acquirer and the value of the target? Was
Which of the following are good candidates for ascertaining the value effects with an event study, and why?(a) An acquirer wants to buy the firm.(b) The CEO dies.(c) The CEO ages.(d) Positive
At http://biz.yahoo.com/p/510mktd.html, Yahoo!Finance classifies “DrugManufacturers—Major.” Compute the average rate of return of 10 of these firms from the day before to the day after the 2006
For convenience, assume a zero discount rate.You know that your current projects cost $400 today and will truly return $500 next year—but your investors believe they will return only$400. In
Give an example of how the cost of capital for taking a project can be too high if the market has undervalued your firm.
If a corporation acquires another firm, it can lower the firm’s uncertainty. This should lower its cost of capital. This should create value. Is this correct?
Do you expect fund managers with high ability to prefer compensation that is more performance based? How good an “insurance”is this for fund investors?
Why does the average mutual fund in the market today appear to have been a great performer? Does this evidence suggest that these funds will be good performers in the future, at least on average?
The typical hedge fund investor evaluates its fund based on the most recent 3 years of performance. What do you think of this practice?
What kind of costs should you consider when evaluating whether an opportunity is an arbitrage?
Would it make sense for a model of the financial world to assume that there is no arbitrage? Would it make sense for a model of the financial world to assume that there are no great bets?
Define arbitrage. How is it different from a great bet? Is one always better than the other?
Assume that the typical day-to-day noise(standard deviation) is about 100 basis points.Assume that you have the kind of stock-picking ability that earns you an extra 400 basis points per annum.
Does a random walk imply that the expected rate of return on a stock is zero?
Describe the fundamentals-based classification of the strength of belief in market efficiency.Explain how one individual can be at one level but not in the level above or below.
Comment on the following statement: “An efficient market seems like an impossible concept.In an efficient market, no one can earn excess returns. Therefore, no one collects information.Therefore,
What are the three main categories in the traditional market efficiency classification?Give an example of what each excludes.
A paper by Frieder and Zittrain looks at spam email touting a particular stock. Such distributions increased the trading volume and resulted in a 4–5% gain over the 2 days following the spam
Evaluate the following statement: It does not matter what portfolio you are holding in a perfect and efficient stock market.
Peter Lynch, a famous former fund manager for Fidelity, suggested that it is wise to invest in stocks based on “local knowledge”—you invest in the stock of your local supermarket if you notice
Define “efficient market” and explain how it differs from a perfect market.
What kind of evidence would heretics against market efficiency ideally want to muster? If they fail to find this kind of evidence, does it mean that you should conclude that markets are efficient?
Good news: becoming an acquisition target; the announcement of new dividends, share repurchases, and stock splits; earnings significantly higher than analysts’ projections; FDA approvals; and CEO
An event study is likely to be more informative if the value impact of the event is big and unanticipated, and if you can study many companies that have had such events in the past.
The CAPM is practically irrelevant. Over a 1-, 2-, or 3-day window, the expected rate of return does not matter much.
Event studies are better suited to studying events that occur on different days for different companies. This reduces the probability of “event contamination.”For example, let’s presume that
No. The average value change on the announcement date is only a good measure of the unexpected average value consequence of an event.
The immediate share price response to the news that you have struck oil would be positive. Over the following month, you would not expect any unusual upward or downward drift: It should be about
(a) This project has a negative NPV, −$200 + $180 = −$20, at the zero interest rate. (A positive interest rate would make it even more negative.)(b) If you do take this second newer project, all
Survivorship bias means that you, as an investor, will only see the funds that were ex-post successful. Most unsuccessful funds do not show up in the historical statistics of funds in existence
If each of the 10,000 analysts has a 50-50 chance to beat the market in any given year, then the answer is that 10,000/210 ≈ 10 analysts beat the market 10 years in a row.
Yes, it makes sense to look for high-ability managers among historical high performers. However, many high-ability managers will have underperformed historically, and many low-ability managers will
Good topics to consider when thinking about how plausible an arbitrage is include: time and execution risk, direct and indirect transaction costs, price impact of trades, and fixed costs.
If the true arbitrage opportunity can only be done once and gains $10, it is probably worse than a risk(y)arbitrage that loses 1 cent with 1% probability, and gains $1,000,000 with 99% probability.
No! Treasuries earn money without risk, but they are not an arbitrage, because investing in them requires a negative net cash flow up front.
With 100 basis points per day of noise and 200 basis points per year of excess performance:(a) With 1 day’s performance, you would expect 200/255 ≈ 0.7843 basis points per day.(b) The noise was
If you want to be a superstar trader who outperforms by, say, about 4% per year, you would have to earn an extra 255√1.04 − 1 ≈ 1.54 basis points per day.

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