Fi 414 Practice Exam

Exam #1- Finance 414 – Spring 2011

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You have 1 hour and 20 minutes to complete this exam. Section I has 32 multiple choice questions worth 2.5 points each for a total of 80 points. Section II has 2 long problems worth 10 points each. Plan your time accordingly. Read each question carefully and show all of your work clearly on the long problems as partial credit will be given. If you run out of space use the back of the page to complete your answer. Good Luck!

Section 1- Multiple Choice- Circle the single best answer to each question

1. If an investor purchases shares in an unlevered firm and borrows on their own account to purchase some of these shares, the investor is pursuing the ______________ strategy.
(a) milking the property
(b) homemade leverage
(c) excessive risk taking
(d) Enron

2. Which of the following are true according to the Modigliani and Miller theory in a world with no taxes and no financial distress costs.
a) Total firm value is independent of capital structure
b) A firm’s weighted-average-cost-of-capital is independent of capital structure
c) The expected return on a firm’s stock is independent of capital structure
d) a and b
e) b and c
f) a and b and c

3. Which of the following are true according to the Modigliani and Miller theory in a world with corporate taxes but no financial distress costs or personal taxes.
(a) Firm value increases with the amount a firm borrows
(b) A firm’s weighted-average-cost-of-capital increases with the amount a firm borrows
(c) The expected return on a firm’s stock is independent of capital structure
(d) a and b
(e) b and c
(f) a and b and c

4. The expected return on a firm’s stock is 20% and currently the firm has no debt. The firm is contemplating changing its debt-equity ratio to 1 There are no corporate or personal taxes and the risk-free interest rate is 10%. Under the new capital structure rWACC will equal ________.
a) 15.0%
b) 16.0%
c) 19.0%
d) 20.0%
e) 30.0%

5. The expected return on a firm’s stock is 20% and currently the firm has no debt. The firm is contemplating changing its debt-equity ratio to 1. The corporate tax rate is 50% and there are no personal taxes or financial distress costs. The risk-free interest rate is 10% and the firm’s borrowing cost is also 10%. Under the new capital structure rWACC will equal ________.
(a) 15.0%
(b) 16.0%
(c) 19.0%
(d) 20.0%
(e) 30.0%

6. A firm currently has $20 million in stock outstanding and $80 million in bonds outstanding. The corporate tax rate is 40% and there are no personal taxes and no financial distress costs. If a firm announces it is selling $10 million in bonds and using the proceeds to repurchase shares, what will be the total value of the firm’s stock immediately after the announcement of the transaction (but before the transaction is complete)?
(a) $10.0 million
(b) $14.0 million
(c) $20.0 million
(d) $24.0 million
(e) $26.0 million
(f) $30.0 million

7. A firm currently has $20,000 in debt outstanding and $80,000 in equity outstanding. The interest rate on the outstanding debt is 10% and the corporate tax rate is 40%. If the firm sells $20,000 in stock and uses the proceeds to repurchase all of the outstanding debt, by how much will the firm’s income tax bill in the following year change?
a) no change
b) tax bill will increase by $400
c) tax bill will decrease by $400
d) tax bill will increase by $800
e) tax bill will decrease by $800
f) tax bill will increase by $4,000
g) tax bill will decrease by $4,000

8. A firm currently has 10,000 shares selling for $10 a share. The firm currently has no debt. The corporate tax rate is 50% and there are no personal taxes or financial distress costs. If the firm announces it is issuing $10,000 in bonds and using the proceeds to repurchase shares, what will the share price be after the repurchase is complete?
a) 10.00
b) 10.25
c) 10.50
d) 11.00
e) 12.00

9. In the American Home Products (AHP) case we examined plans for AHP to issue debt and repurchase stock. After announcing it was pursuing one of these plans, we argued that AHP’s stock price would ___________.
a) increase immediately after the announcement to reflect tax benefits
b) not change immediately after the announcement, but would later increase after the repurchase was completed
c) decrease after the announcement to reflect the costs of financial distress

10. In the American Home Products (AHP) case we argued that a high coverage ratio indicates that a firm is in danger of defaulting on its debt.
(a) true
(b) false
(c) cannot tell since the answer depends on the corporate tax rate

11. In the American Home Products (AHP) case we argued that the announcement that a firm is using cash to repurchase shares would ___________ the stock price because ___________.
a) decrease, the market is worried that the firm will not have enough cash to conduct its business
b) decrease, the interest income on the cash would be more heavily taxed after the repurchase
c) increase, the stock will become less risky in the future
d) increase, the interest income on the cash would be less heavily taxed after the repurchase

12. In the American Home Products (AHP) case we argued that our calculations on share prices after a stock repurchase announcement may be incorrect because:
(a) we ignored investment banking costs
(b) we ignored the possibility that the repurchase price may be artificially inflated above its true value if the market misinterprets the announcement
(c) American Home Product’s is in a low tax bracket
(d) a and b
(e) a and c
(f) b and c
(g) a and b and c

13. Which of the following is a problem associated with debt financing?
a) underinvesting in safe projects that would be taken by an all-equity firm
b) overinvesting in risky projects that would not be taken by an all-equity firm
c) concentrating ownership in the hands of management
(d) a and b
(e) a and c
(f) b and c
(g) a and b and c

14. A firm signs a loan agreement in which it agrees to provide financial statements to the lender on a quarterly basis. This is an example of __________.
a) a negative covenant
b) a positive covenant
c) the “playing for time” strategy

15. According to our class discussion, which of the following types of firms should have a relatively high debt-equity ratio?
(a) a firm with lots of growth opportunities in the future
(b) a firm in a very risky industry
(c) a firm with a high level of taxable income
(d) a firm with lots of intangible assets

16. Recall from class that TS represents the effective personal tax rate on each dollar of corporate earnings. Firm A is a firm that pays no dividends while firm B pays a very high dividend. Which firm will generally have a greater TS?
(a) Firm A
(b) Firm B

17. A firm’s current equity value is $10 million and its current debt value is $100 million. The firm is contemplating using $8 million of the firm’s cash and investing this cash in a very risky project. If the firm were an all equity firm, the NPV of the project would be -$3 million (i.e., the project costs $8 million and generates a cash flow down the road with a present value of only $5 million). If the firm undertakes the project, the bonds will go down in value to $98 million. Do shareholders want the managers to take this project?
a) no
b) yes

18. A firm currently has no debt and its equity has a market value of $300 million. The firm is contemplating selling $20 million in bonds and using the proceeds to repurchase shares of stock. The corporate income tax rate is 40%, the effective personal tax rate on equity income is 10%, and the personal income tax rate on interest income is 40%. Given these tax parameters, what should be the total value of the firm after the repurchase is complete?
a) $296 million
b) $298 million
c) $300 million
d) $302 million
e) $304 million
f) $310 million

19. If the personal tax rate on interest income increases while all other tax parameters are held constant, we expect the tax benefits of debt financing to __________.
a) increase
b) decrease

20. Which of the following problems were illustrated by the Massey-Ferguson case?
a) the risks associated with changes in exchange rates
b) the risks associated with changes in interest rates
c) the difficulty of getting many lenders to agree to a refinancing plan
d) a and b
e) b and c
f) a and c
g) a and b and c

21. The ratio of short term debt to long term debt for Massey-Ferguson in the 1976-1979 period was _________ than its main competitors. As a consequence of this financial choice, their risk exposure to changes in interest rates was ________________ their competitors.
(a) less than, less than
(b) less than, greater than
(c) greater than, less than
(d) greater than, greater than

22. We argued in class that stockholder’s should have pushed Massey-Ferguson to issue new equity in 1979 or 1980 to alleviate the firm’s financial crisis and lower their leverage ratio.
(a) true
c) false

23. To calculate the Net Present Value (NPV) of an investment project that has the same risk as a firm’s existing assets, we argued in class that one should use ___________ as the appropriate discount rate.
a) the expected return on the firm’s stock (rE)
b) the weighted average cost of capital (rWACC)
c) the expected return on the firm’s bonds (rD)

24. Which of the following factors will affect the beta of a firm’s stock?
a) operating leverage
b) financial leverage
c) the cyclicality of the firm’s revenues
d) a and b
e) a and b and c

25. To calculate a firm’s beta, we often take averages of beta estimates for other firms ____________. We do this because ___________.
(a) of the same size, the statistical precision of our estimates is enhanced
(b) of the same size, financial leverage can artificially increase a beta estimate
(c) in the same industry, the statistical precision of our estimates is enhanced
(d) in the same industry, financial leverage can artificially increase a beta estimate

26. A firm has $200 million in stock and $600 million in bonds. The firm’s borrowing rate is 4% and the expected return on the firm’s stock is 10%. The corporate tax rate is 30%. What is this firm’s weighted average cost of capital?
a) 4%
b) 4.4%
c) 4.6%
d) 6%
e) 8%
f) 10%

27. A firm’s current debt-equity ratio is .5 (that is D/E=.5). The beta on the firm’s stock is currently estimated to be 1.5. The corporate tax rate is 0. What will the beta on the firm’s stock be if the firm changes its debt-equity ratio to 1.0?
a) 1.33
b) 1.5
c) 1.8
d) 2.0
e) 2.25
f) 2.5
g) 3.0

28. A firm’s target debt-equity ratio is .5. The firm is currently unlevered and currently the firm’s stock has a beta of 1.0. The risk-free rate is 6%, the corporate tax rate is 0, and the market risk premium is 8%. What will be the expected return on the firm’s stock at its target debt-equity ratio?
(a) 14%
a) 16%
b) 18%
c) 20%
d) 22%

29. In the Marriott case, when Marriott is calculating the expected return on equity for a hotel project, we argued that their final calculation of rWACC should reflect:
(a) the firm’s current debt-equity and debt-value ratios for hotel projects
(b) the firm’s target debt-equity and debt-value ratios for hotel projects
(c) the average debt-equity and debt-value ratios for other firms in the hotel industry

30. In the Marriott case we argued that in calculating rWACC one should use as the risk free rate of return ____________.
a) the return on a government bond with a maturity similar to that of the assets being discounted
b) the historical average return on short-term T-bills
c) the return calculated from the CAPM on an asset with a beta of 1.0
d) the interest rate Marriott pays on its corporate bonds

31. A firm currently has no debt and its equity has a market value of $200 million. The firm is contemplating selling $20 million in bonds and using the proceeds to repurchase shares of stock. The corporate income tax rate is 30%, the effective personal tax rate on equity income is 10%, and the personal income tax rate on interest income is 40%. Given these tax parameters, what should be the total value of the firm after the repurchase is complete?
a) $190 million
b) $199 million
c) $200 million
d) $201 million
e) $210 million
f) $220 million

32. If the capital gains tax rate increases while all other tax parameters are held constant, we expect the tax benefits of debt financing to ________.
(a) increase
(b) decrease
(c) remain unchanged

Section 2- Long Answer Problems- Each of the 2 problems is worth 10 points. Show your work clearly as partial credit will be awarded.

#1. Goblue Corporation estimates that there is 35% chance of a recession economy next year, a 30% chance of a normal economy next year, and a 35% chance of a boom economy next year. The corporation will exist until the end of next year and then it will cease to exist. Goblue has $160 of debt that must be repaid next year. Assume a 10% discount rate for all cash flows..

a) Goblue has a low risk project that yields a cash flow of $140 in a recession, $200 in a normal economy, and $260 in a boom. If Goblue chooses this low risk project:
h) what is the value of Goblue’s debt?

(ii) what is the value of Goblue’s equity?

b) Goblue has a high risk project that yields a cash flow of $20 in a recession, $200 in a normal economy, and $360 in a boom. If Goblue chooses this high risk project:
i) what is the value of Goblue’s debt?

(ii) what is the value of Goblue’s equity?

c) Which project will Goblue choose? Given your answers to (a) and (b), when Goblue sells the bonds would it like to include a covenant that would prohibit it from taking the high-risk project? Explain your answer.

Long Problem 2:
Valuable Enterprises (VE) is an all-equity firm that is considering issuing $18,750,000 in 8% debt. The firm will use the proceeds of the bond sale to repurchase equity. VE pays out all of its earnings as dividends. Because VE is a nongrowth firm, its earnings and debt would be perpetual. VE’s income statement under each of the financial structures is shown below.

All Equity Debt EBIT 5,000,000 5,000,000 Interest 0 1,500,000 EBT 5,000,000 3,500,000 Corp. Taxes (TC=0.35) 1,750,000 1,225,000 Net Income 3,250,000 2,275,000

a) If the personal tax rate on interest income and dividend income is 30 percent, which plan offers the investors the highest cash flows? Why?

b) Which plan does the IRS prefer? Calculate the increase in revenue to the IRS of the preferable plan over the less preferable plan.

c) Suppose stockholders in the all-equity firm demand a 24.48% return. What is the value of the firm under each plan?

Exam #1- Finance 414-Answers and Grades

Multiple Choice Questions

1.B, 2.D, 3.A, 4.D, 5.A, 6.D, 7.D, 8.C, 9.A, 10.B, 11.D, 12.D, 13.D, 14.B, 15.C, 16.B, 17.A, 18.D, 19.B, 20.G, 21.D, 22.B, 23.B, 24.E, 25.C, 26.C, 27.D, 28.B, 29.B, 30.A, 31.B, 32 A

Long Problem #1

a) (4 points) Debt Value = [ (.25) x (140) + (.50) x (160) + (.25) x (160) ]/1.1 = 140.91 Equity Value = [(.25) x (0) + (.50) x (40) + (.25) x (100) ]/1.1 = 40.91 Total Firm Value = 181.82

(b) (3 points) Debt Value = (.25) x (60) + (.50) x (160) + (.25) x (160) = 122.73 Equity Value = (.25) x (0) + (.50) x (40) + (.25) x (160) = 54.55 Total Firm Value = 177.28

(c) (3 points) The ability to control the project is held by Goblue’s equityholders and they will want to take the high-risk project since it yields a greater equity value (note that 54.55 > 40.91). When Goblue sells the bonds the bondholders will anticipate that Goblue will take the high risk project and thus they will pay less for the bonds compared to what they would pay if the firm guaranteed that it would take the low risk project. Since total firm value is higher with the low-risk project (note that 181.82 > 177.28) Goblue would want a covenant prohibiting them from taking this value destroying high-risk project. Stockholders total wealth would be 181.82 if they initially sell the bonds with a covenant, while their wealth would be 177.28 if they initially sold the bonds without a covenant.

Long problem #2 Equity Plan Debt Plan
Stockholders
Dividends 3,250,000 2,275,000
Personal Taxes 975,000 682,500 2,275,000 1,592,500
Bondholders
Interest income 0 1,500,000
Personal Taxes 0 450,000 0. 1,050,000

Total cash flow to stakeholders (i.e. debtholders plus equityholders)

Equity Plan: 2,275,000 + 0 = $2,275,000
Debt Plan: 1,592,500 + 1,050,000 = $2,642,500

More cash ends up in investor’s pockets under the debt plan. Since personal taxes on interest income and equity income are the same in this example, there is no personal tax advantage or disadvantage to leverage. However, the corporate tax savings from leverage are present in this example, and that is what results in larger cash flows to investors when the firm takes on debt.

(b) The IRS will prefer the all equity plan. This plan results in more taxes, less cash to investors, and more cash to the IRS compared to the plan where the firm takes on debt.
The equity plan brings in $367,500 more in taxes than the debt plan. Equity plan taxes: 1,750,000 + 975,000 = 2,725,000 Debt plan taxes: 1,225,000 + 682,500 + 450,000 = 2,357,500

(c) All equity plan: VU = [EBIT x (1-TC)] / r0 = [5,000,000 x (1- .35)] / .2448 = $13,276,144

Debt plan: VL = VU + [1 – (1-TC)(1-TS)/(1-TB) ] x B = 13,276,144 + [1 – (.65 x .7)/.7] x 18,750,000 =$19,838,644