Part III. Other General Questions:

15. The common stock of Siegfried, Inc, a metal refining company, currently trades at $72 per share. The firm is expected to earn $5.92 per share this year and is forecast to pay a dividend of $3.42 in one year. The company is thought to be in a mature industry and is expected to have constant growth in the future. If investors require an 8.5% return, what is the consensus growth rate for the firm?

a. 3.75%

b. 4.75%

c. 9.50%

d. 12.25%

e. 13.25%

16. Rheingold Inc., a manufacturer of inexpensive land mines used in civil wars, has a target capital structure of 45% debt and 55% common equity. The yield to maturity of the companys outstanding bonds is 7% and the companys tax rate is a relatively low 15% because it is incorporated in an offshore tax haven. If the company estimates its weighted cost of capital at 7.70%, what is the companys cost of common equity?

a. 1.75%

b. 8.27%

c. 8.56%

d. 9.13%

e. 9.41%

17. It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

True b. False

18. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.

True b. False

19. The Modigliani and Miller (MM) articles implicitly assumed, among other things that outside stockholders have the same information about a firm's future prospects as its managers. That was called "symmetric information," and it is questionable. The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

True b. False

20. Which of the following statements is CORRECT?

a. A firm's business risk is determined solely by the financial characteristics of its industry.

b. The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.

c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.

d. A firm's financial risk can be minimized by diversification.

e. The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

21. Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

a. Its sales are projected to become less stable in the future.

b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.

c. Management believes that the firm's stock is currently overvalued.

d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.

e. The corporate income tax rate is increased.

22. You work for the CEO of a new company that plans to acquire long-forgotten songs, like Lets Do Something Cheap and Superficial, and promote them to increase their popularity to earn royalties. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROE_L ROE_U?

	0% Debt, U	60% Debt, L
Oper. income (EBIT)	$400,000	$400,000
Required investment	$2,500,000	$2,500,000
% Debt	0.0%	60.0%
$ of Debt	$0.00	$1,500,000
$ of Common equity	$2,500,000	$1,000,000
Interest rate	NA	10.00%
Tax rate	35%	35%

a. 5.85%

b. 6.14%

c. 6.45%

d. 6.77%

e. 7.11%

23. A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?

a. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.

b. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.

c. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate.

d. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond.

e. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.

24. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures from historical book values to market values. KJM Corporation's balance sheet [book values] as of today is as follows:

Long-term debt (bonds, at par)	$23,500,000
Preferred stock	2,000,000
Common stock ($10 par)	10,000,000
Retained earnings	4,000,000
Total debt and equity	$39,500,000

The bonds have a 7.0% coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 11%, so the bonds now sell below par. What is the current market value of the firm's debt?

a. $17,436,237

b. $17,883,320

c. $18,330,403

d. $ 7,706,000

e. $ 7,898,650