Mid-Term Exam Review
Choose the BEST answer to each of the following questions.
1. According to the efficient market hypothesis, financial markets fluctuate daily because they:
a. are inefficient.
b. slowly react to new information.
c. are continually reacting to new information.
d. offer tremendous arbitrage opportunities.
e. only reflect historical information.
Efficient market is defined as a market in which any relevant information is immediately impounded in asset prices
2. According to the efficient capital market (ECM) theory, studying historical prices in order to identify mispriced stocks will work in __________________.
a. inefficient markets
b. weak form efficient markets
c. semistrong form efficient markets
d. strong form efficient markets
e. both semistrong and strong form efficient markets
Strong-form efficiency: asset prices should reflect all private and public information. Extreme profit opportunities would exist for anyone that could persistently and successfully exploit publicly available information, hence the intense competition among investors should largely winnow away the mispriced stocks.
3. Financial managers can create value through financing decisions that:
a. reduce costs or increase subsidies.
b. increase the product prices.
c. increase accounting earnings, even if they artificial.
d. time financial markets.
e. all of the above.
All of the above can impact expected cash flows
4. In examining the issue of whether the choice of accounting methods affects stock prices, studies have found that:
a. accounting depreciation methods can significantly affect stock prices.
b. switching depreciation methods can significantly affect stock prices.
c. accounting changes that increase accounting earnings also increases stock prices.
d. accounting changes can affect stock prices if the company were either to withhold information or provide incorrect information.
e. All of the above.
Depreciation expense has tax shield effect, hence the depreciation method can impact expected cash flows, hence the value of the stock
5. Which of the following provision(s) may not be included in bond covenants?
a. maintenance of security provision.
b. collateral restriction.
c. limit on cash dividends.
d. minimum level of working capital.
e. issuance of preferred stocks.
Bond covenants can restrict the issuance of additional debt financing, but not for equity financing.
6. Based on historical experience, which of the following best describes the "pecking order" of long-term financing strategy in the U.S.?
a. Long-term debt first, new common equity, internal financing last.
b. Long-term debt first, internal financing, new common equity last.
c. Internal financing first, new common equity, long-term borrowing last.
d. Internal financing first, long-term borrowing, new common equity last.
e. New common equity first, long-term borrowing, internal financing last.
Internal financing, new debt, new stock from http://www.financeprofessor.com/mba610/chapt14.htm
7. Which of the following is not true regarding zero-coupon bonds?
a. They are issued at a deep discount from par value.
b. Investors are taxed annually on the amount of interest earned, even though the interest will not be received until maturity.
c. The issuing firm is permitted to deduct the amortized discount as interest expense for federal income tax purposes, even though it does not pay interest.
d. Zero-coupon bonds are purchased mainly for tax-exempt investment account, such as pension funds and individual retirement accounts.
e. All of the above are true.
Lee, C. & Lee, A. (2006). Encyclopedia of Finance. Springer: New York, p. 295.
8. MM Proposition I without taxes is used to illustrate:
a. the value of an unlevered firm equals that of a levered firm.
b. that one capital structure is as good as another.
c. leverage does not affect the value of the firm.
d. capital structure changes have no effect stockholder's welfare.
e. All of the above.
Proposition I states that the market value of a company is not affected by the capital structure of the company
9. Shareholders in a leveraged firm might wish to accept a negative net present value project if:
a. it increases the standard deviation of the returns on the firm’s assets.
b. it lowers the variance of the returns on the firm’s assets.
c. it lowers the risk level of the firm.
d. it diversifies the cash flows of the firm.
e. it decreases the risk that a firm will default on its debt.
The lower the variance the more accurate the forecasting or the asset’s returns.
10. Which of the following industries would tend to have the highest leverage?
a. Drugs
b. Computer
c. Paper
d. Electronics
e. Biological products
Leverage is defined as the “The degree to which an investor or business is utilizing borrowed money.”
Biotech industry given that it is relatively new.
11. Which of the following is true?
a. A firm with low anticipated profit will likely take on a high level of debt.
b. A successful firm will probably take on zero debt.
c. Rational firms raise debt levels when profits are expected to decline.
d. Rational investors are likely to infer a higher firm value from a zero debt level.
e. Investors will generally view an increase in debt as a positive sign for the firm's value.
Increase in debt means that there are available opportunities for the firm which have expected returns higher than the cost of debt
12. Studies have found that firms with high proportions of intangible assets are likely to use ____________debt compared with firms with low proportions of intangible assets.
a. more
b. the same amount of
c. less
d. either more or the same amount of
e. any amount of debt
Kwapong, O. (2003). MBA Concepts and Frameworks. Songhai Group, p. 225.
13. What three factors are important to consider in determining a target debt to equity ratio?
a. Taxes, asset types, and pecking order and financial slack
b. Asset types, uncertainty of operating income, and pecking order and financial slack
c. Taxes, financial slack and pecking order, and uncertainty of operating income
d. Taxes, asset types, and uncertainty of operating income
e. None of the above.
According to Fama and French the three factors are taxes, type of assets and uncertainty of operating income
14. The free cash flow hypothesis states:
a. that firms with greater free cash flow will pay more in dividends reducing the risk of financial distress.
b. that firms with greater free cash flow should issue new equity to force managers to minimize wasting resources and to work harder.
c. that issuing debt requires interest and principal payments reducing the potential of management to waste resources.
d. Both A and C.
e. Both B and C.
Jensen's (1986) free cash flow hypothesis suggests that market pressures (e.g., the market for corporate control) will encourage managers to distribute free cash flow to shareholders or risk losing control of the firm. Consequently, Jensen's hypothesis suggests that stock prices of firms with positive free cash flow should increase over time as management is pressured to increase payouts to corporate shareholders. Conversely, if management fails to increase payouts and instead wastes free cash flow on unprofitable investment spending, the free cash flow hypothesis predicts further deterioration of firm value.
15. In Miller's model, when the quantity [(1-Tc)(1-Ts) = (1-Tb)], then:
a. the firm should hold no debt.
b. the value of the levered firm is greater than the value of the unlevered firm.
c. the tax shield on debt is exactly offset by higher personal taxes paid on interest income.
d. the tax shield on debt is exactly offset by higher levels of dividends.
e. the tax shield on debt is exactly offset by higher capital gains.
This equates the model
16. The APV method is comprised of the all equity NPV of a project and the NPV of financing effects. The four side effects are:
a. tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing.
b. cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies to debt financing.
c. cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing.
d. subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities.
e. None of the above.
The financing side effects are interest rate tax shields, financial distress costs, issuance costs, subsidies and guarantees, and hedges
17. When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because:
a. interest payments on the debt vary with EBIT levels.
b. interest payments on the debt stay fixed, leaving less income to be distributed over less shares.
c. interest payments on the debt stay fixed, leaving more income to be distributed over less shares.
d. interest payments on the debt stay fixed, leaving less income to be distributed over more shares.
e. interest payments on the debt stay fixed, leaving more income to be distributed over more shares.
Degree of financial leverage is a “leverage ratio summarizing the affect a particular amount of financial leverage has on a company's earnings per share (EPS). Financial leverage involves using fixed costs to finance the firm, and will include higher expenses before interest and taxes (EBIT). The higher the degree of financial leverage, the more volatile EPS will be, all other things remaining the same.”
Less shares because financing came from debt instead of equity which would have increased the number of shares
18. Ex-dividend date means the date on which
a. the dividend action is taken by the board of directors
b. the shareholders no longer carry the right to receive the dividend
c. the board of directors decides to omit dividend
d. the shareholders must be recorded on the firm's book
e. the company must send dividend checks to shareholders
Ex-dividend date means the “date on or after which the seller and not the buyer will retain the right to receive a dividend.”
19. What is the most likely prediction after a firm reduces its regular dividend payment?
a. Earnings are expected to decline.
b. Investment is expected to increase.
c. Retained earnings are expected to decrease.
d. Share price is expected to fall.
e. ROE is expected to increase.
Decrease in dividends sends negative signaling effect which usually result to decrease in share prices.
20. Which one of the following is the prime objective of a residual dividend policy?
a. maintaining a stable dividend
b. increasing the dividend at a steady pace
c. adhering to a constant dividend payout ratio
d. decreasing the debt-equity ratio at a steady pace
e. meeting the firm’s investment needs
Residual dividend approach is a dividend payout policy under earnings in excess of funds necessary to finance the equity portion of company’s capital budget are paid out in dividends.
21. A stock dividend:
a. reduces both the cash balance and the equity in a firm.
b. increases the number of shares outstanding, but does not affect shareholder wealth.
c. is generally expressed as a ratio.
d. increases shareholder wealth without creating any tax liabilities by doing so.
e. is basically the same as a stock repurchase.
Journal entry for a stock dividend:
Debit: Retained earnings
Credit: Common stock
Generally stock dividend results to the decrease in the stock price relative to the increase in the number of shares
22. Which of the following is a sensible reason to pay (or increase) cash dividends to shareholders?
a. Since a share price is the present value of expected future dividends, higher dividends payout increases a share price.
b. Since cash dividends are the shareholders' wages, a firm should pay dividends to shareholders like it pays wages to workers.
c. Cash dividends are safer than future capital gains.
d. Expected return on a new project is lower than return on a diversified portfolio in the capital market.
e. Capital loss should be compensated by additional dividends.
Hence the project would not be funded and the excess cash be distributed to the shareholders.
23. A firm commitment arrangement with an investment banker occurs when:
a. the syndicate is in place to handle the issue.
b. the spread between the buying and selling price is less than one percent.
c. the issue is solidly accepted in the market evidenced by a large price increase.
d. when the investment banker buys the securities for less than the offering price and accepts the risk of not being able to sell them.
e. when the investment banker sells as much of the security as the market can bear without a price decrease.
In a firm commitment, underwriters act as a dealer and are responsible for any unsold inventory. The dealer profits from the spread between the purchase price and the public offering price. Also known as a "firm commitment underwriting."
24. Empirical evidence suggests that upon announcement of a new equity issue, current stock prices generally:
a. drop, perhaps because the new issue reflects management's view that common stock is currently overvalued.
b. remain about the same since an efficient market anticipates a new equity issue.
c. increase, perhaps because the issues are associated with positive NPV projects.
d. increase, because the market supply is always less than demand.
e. increase, because underwriters exercise their green shoe option.
This is the negative signaling effect
25. The six components that make up the total costs of a new issues are:
a. the spread; other direct expenses such as filing fees; indirect expenses such as management time; economies of scale; abnormal returns and the Green Shoe option.
b. the discount; other direct expenses such as filing fees; indirect expenses such as management time; due diligence costs; abnormal returns and the Green Shoe option.
c. the spread; other direct expenses such as filing fees; indirect expenses such as management time; abnormal returns; underpricing and the Green Shoe option.
d. the spread; other direct expenses such as filing fees; economies of scale; due diligence costs; abnormal returns and underpricing.
e. None of the above.
Green-shoe option: Green Shoe option means an option of allocating shares in excess of the shares included in the public issue and operating a post-listing price stabilising mechanism for a period not exceeding 30 days. This Permission is granted to a company to be exercised through a Stabilising Agent. This is an arrangement wherein the issue would be over allotted to the extent of a maximum of 15 per cent of the issue size. From an investor's perspective, an issue with green shoe option provides more probability of getting shares and also that post listing price may show relatively more stability as compared to market.
This is usually included in the underwriting agreement hence it has no cost.
You must show your work (set-up equations or Excel work) for 26 ~ 31.
26. Common stocks of the Travis Company which currently has no debt in its capital structure are trading for $50 a share. Threes has 2 million shares outstanding now. Travis Co. uses the CAPM in estimating costs of capital. The (unlevered) equity beta for Travis Co. is 1.25, and the risk-free rate and the market portfolio return are expected to be 5% and 13%, respectively. Its income tax rate is 35%.
Mr. James, the Vice-President of Finance, is considering changing its financing policy to actively maintain a target debt ratio of 20% (or 25% debt-to-equity ratio) of the levered firm. An investment bank informed him that Travis may be able to issue 10-year $1,000 par bonds for $922.05 per bond if it offers 4.0% annual coupons, or for $1,116.92 per bond if it offers 6.5% annual coupons. Coupons will be paid semi-annually. Travis plans to keep refinancing bonds at maturity to effectively make bonds perpetual.
Compute: i) cost of equity at the target leverage ratio, ii) cost of debt, and iii) the WACC of the Travis Co.
27. A project has a NPV, assuming all equity financing, of $1.5 million. To finance the project, debt is issued with associated flotation costs of $60,000. The flotation costs can be amortized over the project's 5 year life. The debt of $10 million is issued at 10% interest, with principal repaid in a lump sum at the end of the fifth year. If the firm's tax rate is 34%, calculate the project's APV.
28. How would Modigliani & Miller (MM) respond to the following statements?
"Dividends are the shareholder's wages. Therefore, if a government adopts a minimum wage policy, it should establish a minimum dividend policy too."
President of the USA (United Shareholders Alliance
You must show work: set-up equations and answers are required.
29. Suppose your company needs to raise $10 million by issuing 10-year zero coupon bonds. Your firm’s cost of debt is 8%. Compute the total implicit interests for the first year (i.e., year 1) and the last year (i.e., year 10).
30. Drake Company is issuing $10 million debt ($1,000 par per bond) with 10-year bonds with 16% annual coupon rate, even though its cost of debt is only 8%. The firm’s tax rate is 40%. Compute the present value of tax shields.
31. You just bought a 10 year bond with 5% annual coupon, payable semiannually, on $1,000 par for $1,025. The bond has put provisions that the issuing firm should retire bonds for $950 per bond if the YTM rises to 7% or higher in three years. Compute the yield-to-maturity (YTM) and the yield-to-put (YTP) of your investment.
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