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TEST BANK

Policies and Strategies

Southern Utah University

Prentice Hall, Upper Saddle River, New Jersey 07458

Acquisitions Editor: Mickey Cox

Associate Editor: Kevin Hancock

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ISBN

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P REFACE

This test bank has been prepared for professors using the textbook, Advanced Corporate

Finance: Policies and Strategies , by Ogden, Jen, and O’Connor, Prentice Hall, 2000 The test bank provides, for each chapter, sets of multiple-choice questions and essay questions For each multiple-choice question, the correct answer is highlighted with an asterisk (*), and if the

question involves numerical calculations, the applicable formula is provided.

Joseph P Ogden

Chapter 1……… 5

Chapter 2……… 8

Chapter 3……… 12

Chapter 4……… 17

Chapter 5……… 20

Chapter 6……… 22

Chapter 7……… 26

Chapter 8……… 30

Chapter 9……… 34

Chapter 10……… 38

Chapter 11……… 43

Chapter 12……… 45

Chapter 13……… 48

Chapter 14……… 51

Chapter 15……… 53

Chapter 16……… 56

Chapter 17……… 61

Chapter 18……… 64

Chapter 19……… 67

C H A P T E R 1

Multiple Choice Questions

_ 1 For public U.S nonfinancial firms in composite, the fractions of current assets and non-current

assets (all in book values; year-end 2000) are approximately:

_ 2 For public U.S nonfinancial firms in composite, the fractions of liabilities (current plus

non-current), and equities (all in book values, year-end 2000) are approximately:

Liabilities Equities

a 1/3 2/3

b 1/2 1/2

c 2/3 1/3 *

_ 3 Over the years 1981-2000, 4,770 nonfinancial firms exited the U.S markets for publicly traded

equity Which of the following was the most frequent reason for a firm’s exit?

a Merger or acquisition *

b Bankruptcy or liquidation

c The firm reverted to private equity ownership

d The firm changed its listing to a foreign stock exchange

_ 4 What average annual proportion of the total number of public U.S nonfinancial firms at year-end

1980 exited over the years 1981-2000 (i.e., the average attrition rate)?

a 5.9% *

b 15.9%

c 25.9%

d 35.9%

_ 5 Which category of composite assets (for public U.S nonfinancial firms) showed the largest

proportional decrease over the years 1980-2000?

a cash and equivalents

b inventories

c net PP&E *

d other non-current assets

_ 6 Throughout the period 1980-2000, the composite proportion of the TA of U.S nonfinancial firms

accounted for by net PP&E generally _(i) , and the proportion of TA financed by

equity _(ii) _ fairly steadily

_(i) _ _(ii) _

a decreased increased

b increased decreased *

c increased also increased

d decreased also decreased

_ 7 Which category of liabilities & equities had the smallest proportion in every year from 1980-

_ 8 For public U.S nonfinancial firms over the years 1980-2000, the composite market-to-book

equity ratio generally:

a increased from 1980-2000 *

b decreased from 1980-2000

c remained stable from 1980-2000

_ 9 Which groups of U.S nonfinancial firms have the highest composite proportions of PP&E to TA?

a S&P Industrials

b S&P MidCaps

c S&P SmallCaps

d S&P Transports and Utilities *

_ 10 According to the composite sources-and-uses data presented in Chapter 1, the main net source of

funds for U.S nonfinancial firms over the years 1980-2000 is:

a proceeds from debt offerings

b proceeds from equity offerings

c retained earnings (net cash flow from operations) *

d sales of investments (net of increases in investments)

_ 11 Over the 20-year period of 1980-2000, the composite dividend yield of public U.S nonfinancial

firms has generally:

C H A P T E R 2

Valuation and Financing Decisions in an Ideal Capital Market

Multiple Choice Questions

_ 1 Which of the following assumptions of an ideal (or perfect) capital market most closely relates to

the assumed symmetry of information set shared by all firms and all investors?

a Capital Markets are frictionless

b Homogeneous expectations *

c Atomistic competition

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed

_ 2 Until now, Delaware East, Inc has been an all-equity firm; its most recent market equity value

was $100 mn., and its cost of equity (and cost of assets) is 15% Now, the firm decides to increase its leverage by issuing $40 mn in debt, with the proceeds being used to pay a dividend to shareholders The cost of the debt is rD=7% What is the firm’s new cost of equity capital, according to Modigliani and Miller’s Proposition II?

_ 3 Until now, Delaware East, Inc has been an all-equity firm; its most recent market equity

value was $80 mn., and its cost of equity (and cost of assets) is 15% Now, the firm

decides to increase its leverage by issuing $40 mn in debt, with the proceeds being used

to pay a dividend to shareholders The cost of the debt is rD=7% What is the firm’s new cost of equity capital, according to Modigliani and Miller’s Proposition II?

_ 4 Firm XYZ is currently financed entirely with equity The market value of the firm’s assets and

equity is VU=EU=500, and the expected return on the firm’s assets and equity is rA=rE=12.5% Suppose the firm issues debt with a value of DL= 200, and uses the proceeds to retire equity The market value of the firm remains the same, VL=EL+DL=500 If the expected return on the debt is rD=7%, what is the expected return on the firm’s levered equity?

_ 5 For the equity of Delaware East, β=1.25 If the expected return on the market is 15% and the

risk-free rate is 5%, what is the expected return on the firm’s equity?

_ 6 The market value of Delaware East’s assets is $100 mn The firm has one issue of pure-discount

debt outstanding which promises to pay $60 mn in 5 years If the standard deviation of the firm’s assets is 22% and the risk-free rate is 5%, what are the values of the firm’s equity and debt, based on the Black-Scholes model?

value of equity value of debt

σ

2 2

(Also need Cum Normal Distr Fn table)

_ 7 Suppose you develop a mutual fund that includes 500 NYSE stocks, all with equal weights in

the fund’s portfolio The average standard deviation of the stocks is 36%, and the average pair-wise correlation among the stocks is 0.40 What is your estimate of the standard deviation of the fund’s portfolio?

*N

1

=σ

_ 8 Suppose you develop a mutual fund that includes 78 stocks, all with equal weights in the fund’s

portfolio The average standard deviation of the stocks is 44%, and the average pair-wise correlation among the stocks is 0.30 What is your estimate of the standard deviation of the fund’s portfolio?

*N

1

=σ

_ 9 Using the Binomial Model, find the value of a firm’s levered equity (EL) given the following

values: V=100, u=1.3, d=1/u, p=0.7, rf=5%, X=100, and T=3

u 1 L

d 1

u 1

EE

VV

−

)XV,0max(

E);

XV,0max(

LT

d LT

u LT

u

_ 10 Using the Binomial Model, find the values of a firm’s levered equity (EL), and the expected return

on the equity, rLE, given the following values: V=100, u=1.3, d=1/u, p=0.7, rf=5%, X=100, and T=3

u 1 L

d 1

u 1

EE

VV

−

)XV,0max(

E);

XV,0max(

LT

d LT

u LT

d T L

L

u T

EE)p1(E

EEpr

_ 11 The expected returns on the debt and equity of a levered firm are rE=15% and rD=7%, and the

current market value of the debt and equity are E=66 and D=44, respectively What is the firm’s weighted average cost of capital (WACC)?

a 7.8%

b 9.8%

c 11.8% *

d 13.8%

FORMULA: WACC=rD(D/V)+rLE(E/V)

_ 12 The expected returns and standard deviations for stocks A and B are rA=14% and rB=19%,

respectively, and σA=23% and σB=34%, respectively The correlation of the returns on the two stocks is ρAB=0.3 What is the expected return, rP, and standard deviation, σP, of a

portfolio with weights of wA=0.60 and wB=0.40 in stocks A and B, respectively?

2 A

2

w σ + σ + σ σ ρ ]1/2

_ 13 For your retirement fund, you have decided to place 40% of your contributions into a riskfree

asset that pays 4% interest per annum, and the remaining 60% of your contributions will

be placed in an available stock mutual fund that approximates the holdings of the mythical

market portfolio You expect this fund to provide an average return of rP=9%, but will expose you to risk, measured in terms of an estimated standard deviation of σP=20% What is your estimate of the expected return and standard deviation of your complete portfolio, rC and σC, respectively?

_ 14 Suppose the beta of the stock of Microsoft, Inc is βmsft=1.45 If rf=4% and rM=9%, what is the

equilibrium expected return on Microsoft stock, rmsft, according to the CAPM? As an analyst

of the firms in the high-technology industry, you expect Microsoft to provide a return of 10% over the next year Comparing your estimate with equilibrium expected return on Microsoft that you just calculated, would you recommend to your investors that they buy Microsoft stock?

a Yes: Microsoft is underpriced

b No: Microsoft is overpriced *

FORMULA: rf + βi[rM-rf]

Essay Questions

1 Firm XYZ is currently a privately held, all-equity firm The firm’s shareholders are about to sell

all of the firm’s shares to the pubic in an initial public offering (IPO) Assuming that an optimal capital structure that involves a finite proportion of debt exists for firm XYZ, present an argument that, even though the current shareholders will present an all-equity firm to the public, the

proceeds that the current shareholders will receive will be equal to the value of the firm at its optimal capital structure

2 Suppose a firm is financed entirely with equity, and the current market value of its assets and

equity is VU=EU=100 As an arbitrageur, you know that if the firm was capitalized with 50% equity and 50% debt, the market values of the debt and equity of this levered version of the firm would be EL=60 and DL=50, respectively What would you do?

ANSWER: Purchase the fraction α of the equity of the unlevered firm at a cost of 100α Place these shares in a trust, and issue debt with a value of αDL=50α that is a claim against the shares in the trust, keeping the proceeds of this debt offering Then sell this ‘levered’ trust for a price of αEL=60α Your profit will be α(50+60-100)=10α

3 Suppose a firm is financed with 50% equity and 50% debt, and the current market value of the

firm is VL=100, with EL=50 and DL=50 As an arbitrageur, you know that if the firm was

financed entirely with equity, the market value of its assets and equity would be VU=EU=125 What would you do?

ANSWER: Purchase the fraction α of both the equity and debt of this levered firm at a total cost

of αEL+αDL=100α, place these securities in a trust, and sell unlevered equity securities against this trust, which would yield proceeds of 125α Thus, your profit will be α(125-100)

C H A P T E R 3

Separation of Ownership and Control, Principal-Agent Conflicts, and Financial Policies

Multiple Choice Questions

_ 1 Transaction costs and personal taxes may affect investors’ ability to undertake arbitrage Also, a

firm’s earnings are taxed, and interest payments are deductible while dividends are not These are examples of the violation of which of the assumptions of an ideal capital market?

a Capital Markets are frictionless *

b Homogeneous expectations

c Atomistic competition

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed

_ 2 Variation in personal tax rates and transaction costs across both investors and securities may

differentially affect the values of corporate securities Also a firm faces substantial

transaction costs in issuing securities, which may inhibit its ability to undertake otherwise profitable capital investments These are examples of the violation of which of the

assumptions of an ideal capital market?

a Capital Markets are frictionless *

b Homogeneous expectations

c Atomistic competition

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed

_ 3 Information asymmetry is chief among violations of which of the assumptions of an ideal capital

market?

a Capital Markets are frictionless

b Homogeneous expectations *

c Atomistic competition

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed

_ 4 An individual investor has either sufficient wealth or sufficient borrowing capacity to purchase or

sell a substantial proportion of a given firm’s securities, so that investor’s trades may affect the market value of these securities This is an example of the violation of which of the

assumptions of an ideal capital market?

a Capital Markets are frictionless

b Homogeneous expectations

c Atomistic competition *

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed

_ 5 One principal-agent conflict is that between a firm’s creditors (as a principal) and its

shareholders (as agent) For example, after issuing risky debt, stockholders have an incentive

to increase the riskiness of the firm’s assets (e.g., by changing operating strategy), which would tend to expropriate wealth from creditors to stockholders Which of the assumptions of an ideal

capital market is violated in this example?

a Capital Markets are frictionless

b Homogeneous expectations

c Atomistic competition

d The firm has a fixed investment program *

e Once chosen, the firm’s financing is fixed

_ 6 A firm initially finances its assets with specified proportions of debt and equity, and then later

issues additional debt, using the proceeds to pay a dividend to shareholders If the new debt has the same priority as the original debt, the value of the original debt will probably fall, an effect called claim dilution Which of the assumptions of an ideal capital market is violated in

a Capital Markets are frictionless

b Homogeneous expectations

c Atomistic competition

d The firm has a fixed investment program

e Once chosen, the firm’s financing is fixed *

_ 7 The two most fundamental aspects of a corporation (as a form of business organization) that lead

to not only tremendous economies of scale and scope (as a positive) but also are linked to the financing problems that we address in the course (as a negative) are:

a the separation of ownership and control AND private ownership

b limited liability AND private ownership

c the separation of ownership and control AND limited liability *

d private ownership AND leverage

_ 8 Nutrition, Inc., a vitamin supplement manufacturer, is financed entirely with equity that is

currently privately owned by its managers The firm is expected to generate earnings of $5 million per year into perpetuity, and all earnings are paid out in dividends The owner-managers receive no additional compensation For all of the owner-managers, their shares of the firm’s equity account for the bulk of their personal wealth As a result, in determining their personal valuation of the firm they apply a high discount rate of 33% to their future expected dividends, and thus they value the firm at $15.15 mn (=$5 mn./0.33)

The management team has recently consulted with an investment-banking firm about selling all

of the firm’s equity publicly; that is, about going public with the firm’s shares Assuming

that the current management will continue to operate the firm, the investment banker estimates that the market will value the firm’s equity by applying a 25% discount rate to expected future dividends However, expected dividends to public shareholders will be only $4 mn., because managers will now be paid a total of $1 mn per year in salaries Ignoring taxes and transaction costs: the market value of the firm’s public shares is _(i) _; the present value of management’s salaries (discounted at 33% into perpetuity) is _(ii) _ ; and therefore the management team’s wealth gain (or loss) from going public is _(iii) _

_(i) _ _(ii) _ _(iii) _

a $12 mn $3.03 mn -$0.12 mn

b $16 mn $3.03 mn $4.12 mn *

c $16 mn $4 mn $4.85 mn

d $12 mn $4 mn $0.85 mn

_ 9 All of the following were mentioned in the text as means by which the manager of a firm may

increase his or her compensation (on a self-serving basis) EXCEPT:

a having the firm purchase his-her principal private residence *

b excessive consumption of perquisites

c manipulation of earnings and dividends

d maximizing the size of the firm, rather than its value

_ 10 All of the following were mentioned in the text as means by which the manager of a firm may

decrease the his or her personal exposure to the firm’s risk (on a self-serving basis) EXCEPT:

a excessive corporate diversification

b bias toward investments with near-term payoffs

c securing his or her lifetime compensation with a property-casualty insurance policy

purchased by the firm *

d underemployment of debt

e management entrenchment

f packing the board

_ 11 Suppose a firm’s initial parameter values are: V=500, X=300, T=3, rf=2%, u

3

V =750, and

d 3

V =333.33 Compute the current values of the firm’s debt and levered equity, D and

d T

u T

EE

VV

−

)XV,0max(

E);

XV,0max(

LT

d LT

u LT

conditions, such that V*=1,000, *

d T

u T

EE

VV

−

)XV,0max(

E);

XV,0max(

EuLT = LTu − dLT = LTd −

_ 13 The current value of levered firm ABC, Inc is $100 million Its capital structure consists of

equity and pure discount debt on which a payment of $80 mn is due in 5 years The risk-free rate

is 5% Using the Black-Scholes Option Pricing Model, the value of the firm’s equity is _(i) _

if σ=20%, and is _(i) _ if σ=40% Assuming that the increase in σ was a deliberate action of the firm’s management designed to expropriate wealth from bondholders to stockholders, what was the value of this expropriation?

_(i) _ _(ii) _ (iii)

(a) Assumption 1: Frictionless Markets;

(b) Assumption 2: All market participants share homogeneous expectations;

(c) Assumption 3: Atomistic competition;

(d) Assumption 4: The firm’s capital investment program if fixed and known;

(e) Assumption 5: Once chosen, the firm’s financing is fixed

2 Explain the two major benefits to shareholders of the separation of ownership and control

3 List and briefly discuss the self-serving actions that management may take to:

(a) increase their compensation

(b) decrease the risk of their personal portfolios

4 List and briefly discuss three actions that management can take to expropriate wealth from the firm’s debtholders to the firm’s shareholders

5 How do limited liability and the separation of ownership and control reflect risk aversion on the part

of the owners of (equity) capital?

6 Why is the separation of ownership and control a virtual necessity for the successful financing of large corporations?

7 Explain the two major benefits to shareholders of the separation of ownership and control

8 What are the three positive effects of shareholders’ diversification across firms on the market value of

a firm’s shares?

9 Why is the separation of ownership and control particularly important for a firm that operates in an extremely competitive product market? That is, what is a critical role of management under such circumstances?

10 Define the classical objective function of management, and describe a set of circumstances in which it

is the appropriate objective for management to follow in order to act in the shareholders’ interest

11 How does the stakeholder theory of the firm influence our understanding of the objective function of management? What is the revised objective under these circumstances?

12 List and briefly discuss three self-serving actions that management may take to increase their

15 What is empire building? Why does it seem to be such a compelling goal for managers?

16 Explain the underinvestment problem for a firm that has risky debt outstanding, otherwise known as the debt-overhang problem.

C H A P T E R 4

Information Asymmetry And the Markets for Corporate Securities

Multiple Choice Questions

_ 1 As Akerlof argues, sellers who have a lemon, of course, know they have lemon but are not

willing to tell the truth about the condition of their auto and, for the short selling period involved, can put their auto in a satisfactory condition that approximates the normal condition

of the auto that are not lemons In subsequent literature, this problem called the problem

a informational asymmetry

b agency

c moral hazard *

d certification

_ 2 Akerlof also discusses the problem of _ in the health insurance market Health insurers

attempt to estimate, for each individual insurance applicant, the probability that they will file

an insurance claim, and price insurance premiums accordingly However, this is an imperfect process, so the insurer must offer a common premium to a specified group of individuals that

reflects the average health of the individuals in the group, even though the individuals in the

group differ in terms of their health and thus the probability of a claim Each individual knows their own health better than the insurer, so those members of the group who are less healthy (and thus more likely to file a claim) will be more likely to purchase insurance policy, and thus the premium set by the insurer to reflect the average health of the entire group will be inadequate to

compensate the insurer for the ex post sub-group of individuals that actually purchase a policy.

_ 4 According to the finance literature related to informational asymmetry, one of the most important

roles of an investment-banking firm (in terms of assisting a firm in issuing securities to the public) is to vouch for the value of the security, after it has obtained confidential information from the firm’s management about its business strategy This vouching is known as:

a certification *

b using a costly signal

c private negotiation

d establishing a reputation

e contract enforcement

_ 5 Leland and Pyle (1977) examine the effect of informational asymmetries on equilibrium

corporate valuation and financial structure The authors develop a signaling model and work through a specific example, focusing on optimal debt levels under conditions of

asymmetric information In their signaling model, an entrepreneur seeks financing for a project whose true value is known only to him Clearly, direct transfer of information to lenders

is impossible Information may, however, be transferred by a credible signal Here, the signal is:

a the entrepreneur’s willingness to include debt in the firm’s capital structure

b the willingness of the entrepreneur to invest in his own project *

c the entrepreneur’s ability to attract private equity capital

d the entrepreneur’s expressed willingness to remain as a manager of the firm

_ 6 Miller and Rock (1985) developed an ingenious signaling model in which by a firm

serve as powerful signals of the firm’s earnings capacity, and thus its value Any such _ reveal that the firm has been generating, and is expected to continue to generate, high net cash inflows

a cash payouts *

b debt issuance

c equity issuance

d earnings announcements

_ 7 The leading piece of theoretical research in corporate finance is Myers and Majluf (1984) They

showed that when there is information asymmetry between the market and managers, a

pecking order emerges in terms of how the firm should obtain funds for capital investments

Specifically, a firm would prefer to use:

a debt, then retained earnings, and finally outside equity

b retained earnings, then debt, and finally outside equity *

c retained earnings, then outside equity, and finally debt

d debt, then outside equity, and finally retained earnings

Essay Questions

1 Briefly explain the lemons problem as presented by Akerlof.

2 Briefly explain the usefulness of each of the following means of mitigating the effects of

informational asymmetry in the credit markets:

3 In Leland and Pyle’s model of the effects of informational asymmetry on ownership structure:

a What is the costly signal employed by the entrepreneur?

b In what sense is this a costly signal for the entrepreneur? and how does this signal lead to

separating equilibria that mitigates the informational asymmetry problem?

4 Briefly explain the lemons problem as presented by Akerlof.

5 In economic models focusing on informational asymmetry, how do we generally interpret the price of

a given asset in a pooling equilibrium? How would you describe the set of prices in a separating equilibrium?

6 Describe the problem of moral hazard in the market for an asset fraught with informational

asymmetry and unobservable variations in the quality of the asset

7 Describe the problem of adverse selection in the insurance market.

8 Briefly explain the usefulness of each of the following means of mitigating the effects of

informational asymmetry in the credit markets:

9 List and briefly explain the three conditions required in order for ex post contract enforcement to be

an effective means to mitigate the lemons problem in credit markets.

10 In Leland and Pyle’s model of the effects of informational asymmetry on ownership structure:

a What is the costly signal employed by the entrepreneur?

b In what sense is this a costly signal for the entrepreneur, and how does this signal lead to

separating equilibria that mitigates the informational asymmetry problem?

11 Discuss the pecking order hypothesis of corporate financing as Myers (1984) defined it.

12 Discuss Myers and Majluf’s (1984) theoretical model that rationalizes the pecking order hypothesis in the context of informational asymmetry

C H A P T E R 5

The Roles of Government, Securities Markets, Financial Institutions, Ownership Structure, Board Oversight, and Contract Devices

Multiple Choice Questions

_ 1 Under the Securities Exchange Act of 1934, Congress created the Securities and Exchange

Commission (the ‘SEC’) The SEC’s mission is to administer federal securities laws and issue rules and regulations to provide protection for investors and to ensure that the securities markets are fair and honest This is accomplished primarily by:

a creating a national system of securities brokers and dealers

b requiring public firms to disclose accurate and timely information to the investing public *

c creating a system of arbitration boards to provide judgments on investors’ complaints

d regulating the trading procedures in U.S securities markets

_ 2 Means by which the securities markets serve to mitigate principal-agent or information

asymmetry problems include all of the following EXCEPT:

a Management realizes that its reputation with investors is valuable, and can be sustained only

if accurate information is provided on a timely basis

b Various market mechanisms exist to discipline a firm’s management, and thus to mitigate

conflicts of interest between management and shareholders One of the most powerful is the threat of a hostile takeover of the firm, after which management is fired

c Exchanges such as the NYSE regularly publish lists of firms that appear to be overvalued

because their management is poor * _ 3 Financial institutions (such as commercial banks and finance companies) play an important role

in mitigating information asymmetry problems in financial markets because:

a they require a potential borrower to disclose confidential information about their project to

the public before they are approved for a loan

b they regularly receive private information from the firm about the quality of the firm’s

projects, and yet will keep such information confidential *

c they lend only to firms that do not suffer from information asymmetry problems

_ 4 A firm’s board of directors has a variety of tools at its disposal to control management’s

activities, including all of the following EXCEPT:

a Controlling the firm’s capital structure

b Requiring board approval of major capital expenditures, acquisitions, divestitures, security

offerings, etc

c requiring board approval of all mergers and acquisitions

d hiring outside consultants to scrutinize major projects

e firing the CEO

f ALL OF THE ABOVE ARE TOOLS AVAILABLE TO THE BOARD *

_ 5 To mitigate deadweight costs associated with the shareholder-management principal-agent

conflict, some investors become major shareholders and attempt to influence management to act in the best interest of shareholders This is an example of:

(a) shareholders and management; and

(b) shareholders and bondholders

6 Briefly discuss the content of the Securities Acts of 1933 and 1934 and their relationship to the fundamental corporate finance problems (i.e., principal-agent conflicts and information asymmetry)

7 Describe various means by which the securities markets themselves mitigate agency and

informational asymmetry problems

8 How do financial institutions help to resolve informational asymmetry problems associated with a firm’s issuance of securities?

9 How do financial institutions help to mitigate conflicts of interest between a firm’s (diffuse)

shareholders and its management?

10 Discuss the role of confidentiality in the context in which a firm seeks the assistance of a financial institution to raise debt or equity capital

11 How does the information-production function of a financial institution serve to monitor a firm’s management?

12 Describe the tools available to a firm’s board of directors to discipline management in order to mitigate conflicts of interest between the shareholders and management of a firm

13 Describe various means by which contract specifications can be used to mitigate corporate related problems

financing-C H A P T E R 6

The Leverage Decision

Multiple Choice Questions

_ 1 Compute the present value of the tax shield generated when Smith Company issues $100 mn in

perpetual debt with an 8% coupon rate, and uses the proceeds to retire equity The corporate tax rate is 34%

a $2.72 mn

b $8 mn

c $34 mn *

d 272 mn

_ 2 In this problem, we admit only one real-world factor in an otherwise ideal capital market This

real world factor is corporate taxation; specifically that interest payments on debt are

deductible while dividend payments are not deductible Suppose Delaware East, Inc has until now been an all-equity firm with a market value of $100 mn Now, the firm decides to

increase its leverage by issuing $40 mn in debt, with the proceeds being used to pay a dividend

to shareholders Assuming that this debt will be a permanent part of the firm’s capital structure, and that the firm’s tax rate is 34%, and accounting for the deductibility of the interest on the debt, what is the total market value of the firm after the recapitalization?

_ 3 The value of Jones Company as an unlevered firm is VU=300 However, Jones Company has

perpetual debt outstanding with a value of D=150 The rate on the firm’s debt is rD=7% The firm’s tax rate is τC=34% The firm’s expected annual after-tax cash flow to shareholders and bondholders combined is ATCF=$40, into perpetuity Compute the firm’s value, *

L

V , adjusted cost of capital, *

ED

D

+ * LE

* LEDE

_ 4 The value of Jones Company as an unlevered firm is VU=200 However, Jones Company has

perpetual debt outstanding with a value of D=90 The rate on the firm’s debt is rD=7% The firm’s tax rate is τC=34% The firm’s expected annual after-tax cash flow to shareholders and bondholders combined is ATCF=$25 Calculate the firm’s value, *

ED

D

+ * LE

* LEDE

_ 5 The tradeoff in the traditional tradeoff theory of optimal capital structure is between:

a agency costs of debt and information asymmetry costs of debt

b the tax benefit of debt and the expected costs of future financial distress *

c the tax benefit of debt and agency costs of debt

_ 6 Firm XYZ is currently financed entirely with equity that has a total market value of $900 mn

The firm’s management is considering engaging in a debt-for-equity swap to add leverage to the firm’s capital structure Management recognizes two factors that would affect the value of the firm as leverage is added First, the addition of permanent debt in the amount

of D would provide a tax shield that has a value of τcD, where for firm XYZ τc=0.34,

or 34% The second, and offsetting, factor is the present value of expected costs of future financial distress, PV[E(CFFD)], which increases at an accelerating rate with leverage

Management decides that the relationship of PV[E(CFFD)] to leverage can be

approximated with the following equation: PV[E(CFFD)]=αD2, where α=0.0005 Given these specifications, find the value of debt, D*, that would maximize the value of firm XYZ What is the market value of the firm, *

_ 7 Firm XYZ is currently financed entirely with equity that has a total market value of $900 mn

The firm’s management is considering engaging in a debt-for-equity swap to add leverage to the firm’s capital structure Management recognizes two factors that would affect the value of the firm as leverage is added First, the addition of permanent debt in the amount

of D would provide a tax shield that has a value of τcD, where for firm XYZ τc=0.34,

or 34% The second, and offsetting, factor is the present value of expected costs of future financial distress, PV[E(CFFD)], which increases at an accelerating rate with leverage

Management decides that the relationship of PV[E(CFFD)] to leverage can be

approximated with the following equation: PV[E(CFFD)]=αD2, where α=0.001 Given these specifications, find the value of debt, D*, that would maximize the value of firm XYZ What is the market value of the firm, *

_ 8 According to the _ hypothesis, short-term assets should be financed with short-term

capital and long-term assets with long-term capital

a maturity matching *

b hedging

c risk-return

d capital asset

_ 9 The _ hypothesis is stated as follows: Among long-term assets, the firm should finance

long-term tangible assets, such as PP&E, with long-term debt, while other long-term assets, such as investments and intangibles, must be financed with equity

a tangible asset

b debt-equity

c collateral *

d Fisher

_ 10 The current market value of the assets of levered firm ABC, Inc is $100 million The annual

standard deviation of returns on the assets is 30% The firm’s capital structure consists of equity and pure discount debt for which payment of $80 million is due in 5 years The risk-free rate is 5% Using the Black-Scholes Option Pricing Model to calculate the value of the firm’s debt

3 In a world with corporate taxes, explain how the government becomes a stakeholder in each firm how risky is the government’s claim on a firm’s earnings?

4 Describe the underinvestment, or debt-overhang, problem, and specify the circumstances under which it can affect a firm’s use of debt financing

5 List and briefly explain the real-world factors that:

a induce a positive relationship between firm value and leverage; and

b induce a negative relationship between firm value and leverage.

6 Discuss (in words) and describe (with equation(s) and a graph) the Miller Equilibrium.

7 Explain why the correct formula for a firm’s after-tax WACC is given by equation (1) below rather than equation (2) below:

ED

D

+ * LE

* LED

E

E

c L

D

+  LE

* L

ED

E

8 Below is the list of firm characteristic and policy and decision variables that were used as

independent variables in our cross-sectional regression of year-end 1998 firm debt ratios

a In the space provided beside each variable, indicate the sign of the relationship found in the

DUMMY[=1 if D/TA(3 yrs ago)>50%]

C H A P T E R 7

Analysis of the Firm and the Valuation of Equity and Debt

Multiple Choice Questions

_ 1 Economies of scale are present where the cost of producing each unit declines as the quantity of

product produced increases In this environment, large-scale firms have a cost advantage Thus, economies of scale serve to _ the cost of entry into an industry

_ 3 In a theoretical paper, Williams (1995) develops a model of industry equilibrium that

incorporates agency costs due to both creditor-shareholder and management-shareholder conflicts His model has implications for the distribution of firms within an industry in equilibrium Which of the following statements correctly describes Williams’ depiction of industry equilibrium?

a Each industry has a core of large, profitable, secure, capital-intensive firms, each with at least some external debt, and a competitive fringe of small, marginally profitable or unprofitable, risky, labor-intensive firms *

b All firms in an industry will ultimately be large, labor-intensive firms with large proportions

of debt in their capital structures

c All firms in an industry will ultimately be small, capital-intensive firms with no debt

d All firms in an industry will ultimately be large, capital-intensive firms with large proportions

of debt in their capital structures

_ 4 The standard deviation of a firm’s stock returns is generally greater than the standard deviation of

its accounting return on equity

a True

b False

_ 5 The _ hypothesis posits that a firm may choose high leverage as a competitive strategy to

either win market share from rivals or to deter entry into the industry

a long-purse

b strategic capital structure

c competitive leverage

d leverage aggressiveness *

_ 6 The _ hypothesis posits that a firm may choose low leverage as a competitive strategy to

squeeze other, more highly levered, firms out of its industry

a having a long-purse *

b strategic capital structure

c competitive leverage

d leverage aggressiveness

_ 7 Empirical evidence indicates that the market equity value of a multiple-segment firm generally

is _(i) _ than the sum of the imputed market values of its individual segments, a

phenomenon called the _(ii) _

_(i) _ (ii)

a lower diversification discount *

b lower segment effect

c higher diversification premium

d higher segment effect

The next three problems require the data shown below for a large firm (Pfizer) and a

smaller firm (Immunogen) in the Chemicals & Allied Products industry:

FORMULAS: ROEt=(NIt/BEQt-1)=(NIt/Salest)(Salest/TAt-1)(TAt-1/BEQt-1)

_ 8 Calculate each firm’s 2000 ROE

_ 9 Conduct a DuPont ROE breakdown analysis for each firm Which breakdown ratio is most

important in explaining ROE differential between the two firms?

a differential ability to secure debt financing

b differential economies of scale *

c the difference in the number of business segments

No.

Bus.

Company Seg PP&E TA Debt BEQ Sales Net.Inc BEQ MEQ

PFIZER 3 5,343 20,574 5,526 8,887 29,574 3,718 16,076 290,216IMMUNOGEN 1 1.58 7.17 0.07 5.3 11.18 -0.24 15.4 822.3

Values ($ mn.) Values ($ mn.) at Y-E 1999 1999 Values ($ mn.) at Year-End 2000

Essay Questions

1 Discuss the effects of industry competition on a firm’s optimal leverage

2 Briefly discuss the theoretical papers that focus on principal-agent conflicts from an industry

perspective

3 Briefly discuss the information asymmetry problem from an industry perspective, including a

discussion of disclosure policies

4 Discuss the use of financing decisions as part of a firm’s competitive strategies within an industry

5 Summarize the reasoning behind, and the various predictions of, Williams’ theoretical model of industry equilibrium Comment on the extent to which these predictions are supported by empirical evidence presented in the chapter

6 Discuss Maksimovic’s (1990) arguments about the importance of the type of loan contract that a firm receives from a bank, with respect to its ability to compete in its industry

7 Fries, Miller, and Perraudin (1993) argue that the optimal initial capital structure for a firm within a

competitive industry depends crucially on the demand elasticity for industry output, and may

generally be relatively low However, firms maintain valuable options to increase their leverage

over time Discuss their argument, and argue whether or not the historical evidence presented in Figures 7.4 and 7.5 supports their argument

8 Explain Maksimovic and Zechner’s (1991) argument that a firm’s leverage decision must be

addressed in an industry framework

9 Explain Shleifer and Vishny’s (1992) argument about the relationship between liquidation value and debt capacity, which is set in an industry context Could their argument explain why the empirical

evidence for the Petroleum Refining and Related Inds industry so severely violates the collateral

12 Define and differentiate the leverage aggressiveness hypothesis and the long-purse hypothesis.

13 Explain how the asset substitution problem can create a leverage dichotomy among the firms in a given industry in which some firms adopt leverage and pursue riskier projects, while other firms are less levered and pursue less risky projects

14 Explain how the dynamics of asset liquidity in an industry creates circumstances in which the optimal leverage of an individual firm depends on the leverage of other firms in its industry

15 Explain hoe a firm’s optimal leverage may be determined by a tradeoff between managerial agency costs and costs of rivals’ product-market aggressiveness.

16 From the perspective of industry competition, explain the value to a firm of retaining debt capacity (i.e., retaining the option to increase leverage at any time)

17 How can an incumbent firm in a given industry use leverage to deter entry?

18 Discuss the possible interactions between a firm’s production and product-market decisions and its financing decisions

19 Explain how provisions in a CEO’s compensation contract can affect the firm’s competitive strategy

20 Compare and contrast joint ventures and strategic alliances as means by which a firm can compete more effectively in its industry

C H A P T E R 8

The Firm’s Environment, Governance, Strategy, Operations, and Financial

Structure

Multiple Choice Questions

_ 1 For which of the periods below was U.S macroeconomic performance poorest?

c both labor and capital *

_ 3 The most fundamental services that governments provide to firms are:

a the establishment of product and financial markets

b the regulation of industries

c the establishment of property rights and the enforcement of legal contracts.

d building infrastructure and monitoring managers *

_ 4 Scrutiny by the media and analysts has at least two important implications for a firm, but does

NOT include:

a information they generate reduces information asymmetry

b their oversight of a firm’s management serves shareholders’ interest

c they accurately forecast the returns on individual firms based on private information they

generate * _ 5 A typical involves a campaign among competing groups for the right to cast

shareholders’ votes on their behalf in elections for a focal firm’s board directors

a proxy contest *

b shareholder-initiated proposal

c initiation procedure

d takeover contest

_ 6 A typical involves changing some aspect the firm’s internal corporate governance, such

as the structure or composition of a firm’s board of directors

a proxy contest

b shareholder-initiated proposal *

c initiation procedure

d takeover contest

_ 7 Shareholders have sued board directors for losses arising from alleged mismanagement Over the

years 1984-87, a director liability crisis emerged in the U.S because of accelerating litigation

against corporate directors The threat of litigation severely decreased the supply of qualified outside directors nationwide In response to this crisis, many states have passed _(i) _ statutes, which allow firms to adopt new _(ii) _ that protect directors from shareholder suits

_(i) _ _(ii)

a directors’ immunity liability limitation provisions (LLPs)

b liability limitation directors’ immunity provisions (DIPs)

c corporate immunity directors’ indemnity provisions (DIPs)

d liability limitation liability limitation provisions (LLPs) *

_ 8 The _ of a firm’s management hierarchy is defined in terms of the allocation of

decision-making power among senior managers versus lower-level managers

a steepness *

b composition

c sharpness

d structure

_ 9 A firm’s provides valuable services in terms of ensuring that: (i) all parties involved in a

project are working on coordinated and timely bases; (ii) original plans and specifications are followed, or alternatively that necessary changes are approved by senior management; (iii) effective product quality and cost controls are instituted at every stage of the process; and (iv) reports on all activities are accurate

a internal auditing team *

b inspection team

c external governance committee

d internal governance committee

_ 10 Empirical studies have found that, across firms, Tobin’s Q ratio initially increases with

managerial ownership fraction, but beyond a critical level, the ratio decreases with further increases in managerial ownership One argument for why this ratio decreases at higher managerial ownership levels is that:

a board directors no longer believe that they need to monitor management’s incentives

b fewer passive shareholders own the firm’s stock

c outside blockholders tend to be attracted to firms with high managerial ownership, and

outside blockholder ownership generally destroys firm value

d management can use their shares to leverage their entrenched position *

_ 11 Lang, Ofek, and Stulz (1996) analyzed the relationship between leverage and growth

opportunities They focus on the market’s assessment of the ability of the firm to generate

profitable growth Their measure of profitable growth opportunities is Tobin’s q ratio,

the ratio of the market value of the firm’s equity to its book value They summarize their results as follows: “We show that there is a negative relation between leverage and future growth This negative relation between leverage and growth holds for firms with (i) Tobin's q ratio, but not for firms with (ii) Tobin’s q

(i) (ii)

a low high *

b high low

_ 12 At the end of year 1 firm XYZ has TA=$325 bn., and it is financed with debt with a book value

of $125 mn and equity with a book value of $200 mn The firm must pay 10% interest annually on its debt In year 2, the firm had a net income of $55 mn The firm’s year 2 ROA was _(i) _, and the firm’s year 2 ROE was _(ii) _

FORMULAS: ROA=NI/TA; ROE=NI/BEQ

_ 13 For firm XYZ in the previous problem, suppose the firm’s business risk is defined in terms of

σ(ROA), and σ(ROA)=19% Assuming that the debt is default-free, compute σ(ROE)

1 List and briefly discuss the four elements that define a firm’s business environment

2 List the external governance groups that influence a firm, and how they curb self-serving decisions by

a public firm’s management

3 List the internal governance groups that influence a firm, and how they curb self-serving decisions by

a public firm’s management

4 Explain how the current and expected future states of the economy may affect a firm’s capital

investment decisions by affecting (i) expected profits; (ii) risk; and (iii) the firms’ cost of capital

5 How does a firm’s internal governance structure interact with its business strategy?

6 Briefly discuss the governance role of a firm’s board of directors, and factors that might make a board weak or strong in this respect

7 Define and briefly discuss the notion of the steepness of a firm’s managerial hierarchy.

8 Discuss the various advantages of being a large (vs small) firm

9 Several studies have studied the relationship between the percentage of a firm’s shares held by

executives and the firm’s performance What did they find? How would you explain the results?

10 Denis, Denis, and Sarin (1997) conducted an empirical investigation to determine whether the

likelihood of top executive turnover is related to the firm’s ownership structure Briefly discuss their findings

11 According to Agrawal and Nagarajan (1990), why do many small firms have no debt in their capital structures?

12 Lang, Ofek, and Stulz (1996) test two competing hypotheses about the relationship between leverage and growth List these hypotheses and summarize their findings

13 Discuss the use of incentive devices in managerial compensation contracts

14 Briefly discuss the effects of each of the following on a firm’s business risk: (a) the firm’s chosen industry; (b) the firm’s size; and (c) the firm’s capital intensity

15 List and briefly describe the primary elements of a firm’s operational structure

16 List and briefly describe the primary elements of a firm’s financial structure

17 Define business risk and financial risk What is the relationship between them?

18 Why is the standard deviation of a firm’s stock returns, σ(R), generally much greater than the

standard deviation of its return on equity, σ(ROE)?

C H A P T E R 9

Market Efficiency, Event Studies, Cost of Equity Capital,

and Equity Valuation

Multiple Choice Questions

_ 1 If the securities markets are efficient, the market’s reaction to new information about a firm’s

value (such as an earnings announcement) should be:

a gradual, as investors rationally deliberate the effect of the information on the stock’s value

b immediate and unbiased *

c slow or fast, depending on the amount of ‘surprise’ contained in the new information

d negligible (the information would have already been impounded into the firm’s stock price). _ 2 In the (i) of the efficient market hypothesis (EMH), a security’s price reflects all

publicly available information In the _(ii) form of the EMH, a security’s price reflects all information that may be contained in the historical prices of a security In the

(iii) of the EMH, a security’s price reflects all information, whether it is public

information or information held privately

(i) (ii) (iii)

a weak semistrong strong

b strong semistrong weak

c weak strong semistrong

d semistrong strong weak

e semistrong weak strong *

_ 3 In an event study, what two steps does a researcher take to adjust for the valuation effects of other

new (and simultaneously-revealed) value-relevant information, in order to isolate the valuation effect of a specific event?

a (i) using the market model to remove the effects of other firm-specific factors; and (ii)

averaging abnormal returns across many firms with a similar event to wash out the effect

of the market

b (i) using the market model to remove the effect of the market; and (ii) averaging abnormal

returns across many firms with a similar event to wash out the effects of other specific factors *

firm-c (i) averaging returns on ‘event’ stocks over several days to ‘smooth’ the information impact;

and (ii) washing out the effect of the market by including only days when the market return was small

d (i) averaging returns on ‘event’ stocks over several days by including only days when the

market return was small; and (ii) washing out the effect of the market to ‘smooth’ the information impact

_ 4 Over the weekend prior to April 3, 2000, a U.S District Court ruled that Microsoft Corp is a

monopoly On Monday, April 3, Microsoft’s stock return was -14.47%, while the return on the S&P500 (the ‘market’) was 0.49% For the two years leading up to this date, the ‘market model’ relationship between Microsoft’s daily returns and the market’s daily returns was as given below Using this market model relationship, compute the ‘abnormal return’ on

Microsoft’s stock on April 3, 2000

a a higher *

b a lower

c the same

FORMULA: VE=Dt/(rE-g)=Dt-1(1+g)/(rE-g)

_ 6 The following information on the stock of Avon, Inc was obtained on Thursday, November

11, 1999: P/E ratio = 24.36, and the latest annual earnings is Et = 1.17 per share If we assume that the expected return on Avon stock is rE=9%, what is the present value of Avon’s profitable future investment opportunities (PVPFIO)?

1E

V

E

E = +

_ 7 In recent years, Sears, Roebuck & Co has paid out only 32% of its earnings in dividends

Retained earnings have been invested in expansion projects that have yielded an average ROE of 20% If Sears’ cost of equity capital is 16% and next year’s expected dividend is $1 per share, compute the value of Sears’ shares using the constant dividend growth model as interpreted through the sustainable growth model