Section A: Capital Structure $(55$ points$)($BRIEF$,$ CLEAR AND DIRECT ANSWERS PLEASE!$)$

Q$1)($Capital Structure and Trade$-$offs$)$ The trade$-$off theory of optimal capital structure states that firms trade

off corporate interest tax shields against the possible costs of financial distress due to borrowing.

What does this theory predict about the direction of relationship between the profitability of acorporation and

the debt ratio of a corporation$2($ignoring agency costs$/$benefits$)(5$ pts$.)$

Q$2)($Capital Structure and Trade$-$offs$)$ You are considering a firm under three separate scenarios: $1)$ no debt,

no taxes and no bankruptcy costs, $2)$ with debt and taxes but no bankruptcy costs, and $3)$ with debt, taxes,

and bankruptcy costs. Under which one of these three scenarios will the firm have the highest value

according to the trade$-$off theery$-$of capital structure? Explain briefly using graphs. $(10$ pts$.)$

Q$3)($Capitat Structure and Taxes$)$ Assume that the only market imperfection is taxation. Use the following

information to answer the sections below.

Google Corporation has no debt on its balance sheet in $2008,$ but paid $$1\mathrm{.}6$ billion in taxes. Assume that

Google's marginal corporate tax rate is $35\%$ and Google's borrowing cost is $7\%.$

$($a$)$ Assume that investors hold Google stock in retirement accounts that are free from personal taxes. If

Google were to issue sufficient debt to reduce its taxes by $$1$ billion per year, then calculate the amount that

Google needs to borrow. $(10$ pts$.)$

$($b$)$ Assume that investors hold Google stock in retirement accounts that are free from personal taxes. If

Google were to issue sufficient debt to reduce its taxes by $$1$ billion per year permanently, calculate the

incremental value that would be created by this borrowing decision. $(10$ pts$.)$

$($c$)$ Assume that investors in Google pay a $15\%$ tax rate on income from equity and a $35\%$ tax rate on

interest income. If Google were to issue sufficient debt to reduce its taxes by $$1$ billion per year

permanently, then calculate the effective tax advantage of this debt and calculate the incremental value that

would be created by this borrowing decision. $(10$ pts$.)$

Q$4)($Capital Structure and Asymmetric Info$)$ Why does asymmetric information push companies to raise

internal funds first and then external funds? Please answer briefly and name the theory. $(10$ pts$.)$

Section B: Dividend Policy $(45$ points$)($BRIEF$,$ CLEAR AND DIRECT ANSWERS PLEASE!$)$

Q$5)($a$)$ As it is empirically shown in many studies, why does an announcement of a share repurchase result

in a stock price increase on average? $(5$ pts$.)($b$)$ How does it differ from the market reaction to a cash

dividend increase? $(5$ pts$.)$

Q$6)$ Consider the following tax rates:

The tax rates shown are for financial assets held for one year.

$($a$)$ Using the available tax information for $2001-2002,$ calculate the effective dividend tax rate for a $($i$)$ one$-$

year individual investor, $($ii$)$ corporations $($Note: Corporations need not pay taxes on $50\%$ of dividends

received from shares held in other corporations. In other words, only $50\%$ of the dividends received by a

corporate holder are taxable at the corporate tax rate$)($iii$)$ buy and hold individual investor, $($iv$)$ pension

fund. $(16$ pts$.)$

$($b$)$ By analyzing your calculations in section $($a$),$ is there a dividend clientele effect? $(5$ pts$.)$

$($c$)$ For the one$-$year individual investor $($section $($a$)($i$)$ above$),$ how much must the price of a stock change

the ex$-$dividend date to prevent a corporate holder from making arbitrage profits? $(10$ pts$.)$

$($d$)$ In general, what happened to the taxation policy in $2003$ and afterwards? What is the impact on the

dividend clientele effect? $(4$ pts$.)$