Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash.
Luther has decided to use this cash to repurchase shares from its investors, and has
already announced the stock repurchase plan. Currently Luther is an all equity firm with
1.25 billion shares outstanding. Luther’s shares are currently trading at $20 per share.
After the repurchase how many shares will Luther have outstanding?
A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion
Which of the following statements is false?
A) In recent years, the investment banking firm of W.R. Hambrecht and Company has
attempted to change the IPO process by selling new issues directly to the public using
an online auction IPO mechanism called Open IPO.
B) The lead underwriteris the primary banking firm responsible for managing the deal.
The lead underwriter provides most of the advice and arranges for a group of other
underwriters, called the syndicate, to help market and sell the issue.
C) Because of the potential conflict of interest, the underwriter will not make a market
in the stock after the issue.
D) The SEC requires that companies prepare a registration statement, a legal document
that provides financial and other information about the company to investors, prior to
an IPO. Company managers work closely with the underwriters to prepare this
registration statement and submit it to the SEC.
If you buy shares of Coca-Cola on the secondary market,
A) Coca-Cola receives the money because the company has issued new shares.
B) you buy the shares from another investor who decided to sell the shares.
C) you buy the shares from the New York Stock Exchange.
D) you buy the shares from the Federal Reserve.
When the value of one project depends on the outcome of one or more other projects,
this is known as
A) mutually independent investments.
B) equivalent annual investments.
C) staged dependent investments.
D) mutually dependent investments.
Which of the following statements is false?
A) Options also allow investors to speculate, or place a bet on the direction in which
they believe the market is likely to move.
B) Options where the strike price and the stock price are very far apart are referred to as
deep in-the-moneyor deep out of-the-money.
C) Call options with strike prices above the current stock price are in-the-money, as are
put options with strike prices below the current stock price.
D) European optionsallow their holders to exercise the option only on the expiration
date holders cannot exercise before the expiration date.
Use the following information to answer the question(s) below.
Taggart Transcontinental is considering adding a trucking division to expand the
coverage of its existing rail lines. The trucking division will cost $1,000,000 and is
expected to generate free cash flows of $100,000 for each of the next five years.
Taggart Transcontinental forecasts that future free cash flows after year 5 will grow at
2% per year, forever. Taggart Transcontinental’s cost of capital is 10%.
The NPV for the trucking division is closest to:
A) 170,750
B) 200,000
C) 212,550
D) 250,000
E) 312,500
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the
success of this product, MI will have a value of either $100 million, $150 million, or
$191 million, with each outcome being equally likely. The cash flows are unrelated to
the state of the economy (i.e. risk from the project is diversifiable) so that the project
has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
Assume that the capital markets are perfect.
Assume that in the event of default, 20% of the value of MI’s assets will be lost in
bankruptcy costs and suppose that MI has zero-coupon debt with a $125 million face
value due next year. The initial value of MI’s equity is closest to:
A) $30 million
B) $29 million
C) $15 million
D) $24 million
Use the information for the question(s) below.
Shepard Industries is evaluating a proposal to expand its current distribution facilities.
Management has projected the project will produce the following cash flows for the
first two years (in millions).
The incremental unlevered net income Shepard Industries in year two is closest to:
A) $355
B) $415
C) $600
D) $510
Use the information for the question(s) below.
Consider the following tax rates:
*The current tax rates are set to expire in 2008 unless Congress extends them. The tax
rates shown are for financial assets held for one year. For assets held less than one year,
capital gains are taxed at the ordinary income tax rate (currently 35% for the highest
bracket); the same is true for dividends if the assets are held for less than 61 days.
The effective dividend tax rate for a one-year individual investor in 1999 is closest to:
A) 0%
B) 20%
C) 25%
D) 40%
You are offered an investment that pays 8% APR compounded continuously. The
effective annual rate for this investment is closest to:
A) 7.70%
B) 8.00%
C) 8.33%
D) 8.50%
Which of the following is not a step in valuation using the flow to equity method?
A) Determine the equity cost of capital, rE.
B) Compute the equity value, E, by discounting the free cash flow to equity using the
equity cost of capital.
C) Determine the free cash flow to equity of the investment.
D) Determine the before-tax cost of capital, rU.
Which of the following statements is false?
A) Once the issue price (or offer price) is set, underwriters may invoke another
mechanism to protect themselves against a loss”the over-allotment allocation.
B) Before the offer price is set, the underwriters work closely with the company to
come up with a price range that they believe provides a reasonable valuation for the
firm.
C) Before an IPO, the company prepares the final registration statement and final
prospectuscontaining all the details of the IPO, including the number of shares offered
and the offer price.
D) A “road trip” is where senior management and the lead underwriters travel around
the country (and sometimes around the world) promoting the company and explaining
their rationale for the offer price to the underwriters’ largest customers”mainly
institutional investors such as mutual funds and pension funds.
Use the information for the question(s) below.
Iota Industries Market Value Balance Sheet ($ Millions) and Cost of Capital
Iota Industries New Project Free Cash Flows
Assume that this new project is of average risk for Iota and that the firm wants to hold
constant its debt to equity ratio.
The Debt Capacity for Iota’s new project in year 0 is closest to:
A) $263.25
B) 87.75
C) $50.25
D) $118.00
Use the information for the question(s) below.
Luther Industries needs to raise $25 million to fund a new office complex. The
company plans on issuing ten-year bonds with a face value of $1000 and a coupon rate
of 7.0% (annual payments). The following table summarizes the YTM for similar
ten-year corporate bonds of various credit ratings:
Assuming that Luther’s bonds receive a AAA rating, the price of the bonds will be
closest to:
A) $1021
B) $1014
C) $1000
D) $937
Which of the following statements is false?
A) Often, the decision to abandon a project entails costs, which may be either positive
or negative.
B) Mortgage interest rates are higher than Treasury rates because mortgages have an
abandonment option that Treasuries do not have: You can prepayyour mortgage at any
time, while the U.S. government can repay its debt only according to the schedule
outlined in the bond contract.
C) A popular option gives holders of the bond the option to convert the bond into
equity. These kinds of bonds are termed callable bonds.
D) More often than not, there is an opportunity cost of abandoning a project: If you shut
down the project and later decide to start it up again, you have to pay the costs of
restarting the project.
Which of the following statements regarding mergers and taxes is false?
A) Because it may be easier to measure performance accurately in a conglomerate,
agency costs may be reduced and resources may be more efficiently allocated.
B) Because these employees are obligated to hold idiosyncratic risk, they benefit when
the firm reduces that risk by conglomerating.
C) Like a large portfolio, large firms bear less idiosyncratic risk, so often mergers are
justified on the basis that the combined firm is less risky.
D) Because most stockholders will already be holding a well-diversified portfolio, they
get no further benefit from the firm diversifying through acquisition.
Dagny Taggart is a graduating college senior and she is considering the costs of going
to medical school. Beginning next fall, Dagny expects medical school tuition to run
$45,000 for the first year and she estimates that tuition will increase by 6% each year. If
Dagny is able to invest her money in an account paying 8% interest per year, then the
present value to Dagny of four years of medical school tuition is closest to:
A) $149,045
B) $155,930
C) $162,095
D) $180,000
Directors who are not as directly connected to the firm but who have existing or
potential business relationships with the firm are called
A) gray directors.
B) independent directors.
C) advising directors.
D) inside directors.
Use the information for the question(s) below.
The Sisyphean Corporation is considering investing in a new cane manufacturing
machine that has an estimated life of three years. The cost of the machine is $30,000
and the machine will be depreciated straight line over its three-year life to a residual
value of $0.
The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes
have a cost per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will
require an increase in various net working capital accounts. It is estimated that the
Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual
sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual
sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital
of 10%.
The incremental unlevered net income in the first year for the Sisyphean Corporation’s
project is closest to:
A) $8,000
B) $18,000
C) $5,200
D) $11,700
Use the following information to answer the question(s) below.
Consider the price paths of the following stocks over a six-month period:
None of these stocks pay dividends.
Assume that you are an investor with the disposition effect and you bought each of
these stocks in January. Suppose that it is currently the end of March, which stocks are
you most inclined to hold?
1. Taggart Transcontinental
2. Rearden Metal
3. Wyatt Oil
4. Nielson Motors
A) 1 only
B) 1 & 3 only
C) 2 only
D) 2 & 4 only
Which of the following statements is false?
A) Many managers make the mistake of focusing on accounting earnings as opposed to
free cash flows.
B) Given accurate information about any two of these variables (a firm’s future cash
flows, its cost of capital, and its share price) a valuation model allows use to make
inferences about the third variable.
C) A valuation model will tell us the most about the variable for which our prior
information is the least reliable.
D) The idea that investors are able to identify positive NPV trading opportunities is
referred to as the efficient markets hypothesis.
Use the following information to answer the question(s) below.
Incorporated Tool, a U.S. firm, is considering its international tax situation. The
corporate tax rate in the U.S. is currently 39%. Incorporated Tool has major operations
in Ireland, where the tax rate is 12.5%, Japan where the tax rate is 40.7%, and Mexico,
where the tax rate is 30.0%. Incorporated Tool’s profits, which are fully and
immediately repatriated, and foreign taxes paid for the current year are as follows:
Assuming that the Irish and Japanese subsidiaries did not exist, the U.S. tax liability on
the Mexican subsidiary would be closest to:
A) $0
B) $9 million
C) $39 million
D) $106 million
Use the following information to answer the question(s) below.
Suppose that you have received two job offers. Rearden Metal offers you a contract for
$75,000 per year for the next two years while Wyatt Oil offers you a contract for
$90,000 per year for the next two years. Both jobs are equivalent. Suppose that Rearden
Metal’s contract is certain, but Wyatt Oil has a 60% chance of going bankrupt at the end
of the year. In the event that Wyatt Oil files for bankruptcy, it will cancel your contract
and pay you the lowest amount possible for you to not quit. If you do quit, you expect
you could find an new job paying $75,000 per year, but you would be unemployed for
four months while searching for this new job.
Assuming your cost of capital is 6 percent, the present value of your expected wage if
you accept Rearden Metal’s offer is closest to:
A) $133,000
B) $138,000
C) $140,000
D) $144,000
Use the table for the question(s) below.
Consider the following top federal tax rates in the United States:
Personal Tax Rates
In 2000, assuming an average dividend payout ratio of 50%, the effective tax rate for
equity holders was closest to:
A) 69%
B) 65%
C) 55%
D) 30%
Use the information below to answer the following question(s):
The owner of the Krusty Krab is considering selling his restaurant and retiring. An
investor has offered to buy the Krusty Krab for $350,000 whenever the owner is ready
for retirement. The owner is considering the following three alternatives:
1. Sell the restaurant now and retire.
2. Hire someone to manage the restaurant for the next year and retire. This will require
the owner to spend $50,000 now, but will generate $100,000 in profit next year. In one
year the owner will sell the restaurant.
3. Scale back the restaurant’s hours and ease into retirement over the next year. This will
require the owner to spend $40,000 on expenses now, but will generate $75,000 in
profit at the end of the year. In one year the owner will sell the restaurant.
If the interest rate is 7%, the NPV of alternative # 3 is closest to:
A) $350,000
B) $357,196
C) $370,561
D) $401,121
Use the information for the question(s) below.
You are presently invested in the Luther Fund, a broad based mutual fund that invest in
stocks and other securities. The Luther Fund has an expected return of 14% and a
volatility of 20%. Risk-free Treasury bills are currently offering returns of 4%. You are
considering adding a precious metals fund to your current portfolio. The metals fund
has an expected return of 10%, a volatility of 30%, and a correlation of -.20 with the
Luther Fund.
The beta of the precious metals fund with the Luther Fund is closest to:
A) -0.3
B) -0.6
C) 0.3
D) 0.6
Which of the following statements is false?
A) We say a portfolio is long those stocks that have negative portfolio weights.
B) The efficient portfolios are those portfolios offering the highest possible expected
return for a given level of volatility.
C) When two stocks are perfectly negatively correlated, it becomes possible to hold a
portfolio that bears absolutely no risk.
D) The lower the correlation of the securities in a portfolio the lower the volatility we
can obtain.
Which of the following is not one of Modigliani and Miller’s set of conditions referred
to as perfect capital markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security
trading.
C) A firm’s financing decisions do not change the cash flows generated by its
investments, nor do they reveal new information about them.
D) Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows.
Use the information for the question(s) below.
Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and
that all earnings are paid out as dividends. RC is currently an all equity firm. It expects
to generate earnings before interest and taxes (EBIT) of $6 million over the next year.
Currently RC has 5 million shares outstanding and its stock is trading for a price of
$12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the
proceeds to repurchase shares at the current price of $12.00.
Following the borrowing of $12 and subsequent share repurchase, the number of shares
that RC will have outstanding is closest to:
A) 4.0 million
B) 6.0 million
C) 4.9 million
D) 4.5 million
If ECE reported $15 million in net income, then ECE’s Return on Equity (ROE) is:
A) 5.0%
B) 7.5%
C) 10.0%
D) 15.0%
Which of the following statements is false?
A) The lease-equivalent loan is the loan that is required on the purchase of the asset that
leaves the purchaser with the same obligations as the lessor would have.
B) Lease obligations themselves could trigger financial distress.
C) When a firm enters into a lease, it is committing to lease payments that are a fixed
future obligation of the firm.
D) When a firm leases an asset, it is effectively adding leverage to its capital structure
(whether or not the lease appears on the balance sheet for accounting purposes).
Suppose that you want to use the 10 year historical average return on Stock B to
forecast the expected future return on Stock B. Calculate the 95% confidence interval
for your estimate of the expect return.
You work for a levered buyout firm and are evaluating a potential buyout of Boogle Inc.
Boogle’s stock price is $18, and it has 3 million shares outstanding. You believe that if
you buy the company and replace its dismal management team, its value will increase
by 50%. You are planning on doing a levered buyout of Boogle and will offer $25 per
share for control of the company. Assuming you get 50% control, what will your gain
from the transaction be?
You are purchasing a new home and need to borrow $325,000 from a mortgage lender.
The mortgage lender quotes you a rate of 6. 5% APR for a 30-year fixed rate mortgage
(with payments made at the end of each month). The mortgage lender also tells you that
if you are willing to pay 1 point, they can offer you a lower rate of 6.25% APR for a
30-year fixed rate mortgage. One point is equal to 1% of the loan value. So if you take
the lower rate and pay the points you will need to borrow an additional $3250 to cover
points you are paying the lender. Assuming that you do not intend to prepay your
mortgage (pay off your mortgage early), are you better off paying the 1 point and
borrowing at 6.25% APR or just taking out the loan at 6.5% without any points?
Luther Industries needs to borrow $50 million in cash. Currently long-term AAA rates
are 9%. Luther can borrow at 9.75% given its current credit rating. Luther is expecting
interest rates to fall over the next few years, so it would prefer to borrow at the
short-term rates and refinance after rates have dropped. Luther management is afraid,
however, that its credit rating may fall which could greatly increase the spread the firm
must pay on new borrowings. How can Luther benefit from the expected decline in
future interest rates without exposure to the risk of the potential future changes to its
credit ratings bring?
Explain the main differences between the NYSE and NASDAQ stock markets.
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Calculate the interest tax shield, the total amount available to payout to all the investors,
and the income that would be available to equity holders if Kroger was not levered all
for the year 2004.
Use the information for the question(s) below.
You expect DM Corporation to generate the following free cash flows over the next five
years:
Beginning with year six, you estimate that DM’s free cash flows will grow at 6% per
year and that DM’s weighted average cost of capital is 15%.
If DM has $500 million of debt and 14 million shares of stock outstanding, then what is
the price per share for DM Corporation?
Use the information for the question(s) below.
Martin Manufacturing has earnings per share (EPS) of $3.00, 5 million shares
outstanding, and a share price of $32. Martin is considering buying Luther Industries,
which has earnings per share of $2.50, 2 million shares outstanding, and a share price of
$20. Marin will pay for Luther by issuing new shares. There are no expected synergies
from the transaction.
If Martin pays no premium to acquire Luther, what will the earnings per share be after
the merger?
Use the information for the question(s) below.
Omicron Technologies has $50 million in excess cash and no debt. The firm expects to
generate additional free cash flows of $40 million per year in subsequent years and will
pay out these future free cash flows as regular dividends. Omicrons unlevered cost of
capital is 10% and there are 10 million shares outstanding. Omicron’s board is meeting
to decide whether to pay out its $50 million in excess cash as a special dividend or to
use it to repurchase shares of the firm’s stock.
Assume that you own 4000 shares of Omicron stock and that Omicron uses the entire
$50 million to pay a special dividend. Suppose you are unhappy with Omicron’s
decision and would have preferred that Omicron used the excess cash to repurchase
stock. Detail exactly how you could undo the dividend in a way that will provide you
with the same combination of cash and stock that you would have received if Omicron
had not paid the special dividend.
What is the price today of a two-year, default-free security with a face value of $1000
and an annual coupon rate of 5.75%? Does this bond trade at a discount, premium, or at
par?
Explain how having different interest rates for borrowing and lending affects the CAPM
and the SML.
Use the information for the question(s) below.
Aardvark Industries is considering a project that will generate the following free cash
flows:
You are also provided with the following market value balance sheet and information
regarding Aardvark’s cost of capital:
Suppose that to fund this new project, Aardvark borrows $150 with the principal to be
paid in three equal installments at the end each year. Calculate the present value of
Aardvark’s interest tax shield.
Describe the key steps in the flow to equity method for valuing a levered investment.
Explain the benefits of incorporation.
Use the table for the question(s) below.
Consider the following information on options from the CBOE for Merck:
You have decided to sell (write) 5 January 2009 put options on Merck with an exercise
price of $45 per share. How much money will you receive and are these contracts in or
out of the money?
Use the information for the question(s) below.
Suppose that a young couple has just had their first baby and they wish to ensure that
enough money will be available to pay for their child’s college education. Currently,
college tuition, books, fees, and other costs, average $12,500 per year. On average,
tuition and other costs have historically increased at a rate of 4% per year.
Assuming that college costs continue to increase an average of 4% per year and that all
her college savings are invested in an account paying 7% interest, then the amount of
money she will need to have available at age 18 to pay for all four years of her
undergraduate education is closest to:
Using the income statement above and the following information:
Calculate Ideko’s Free Cash Flow to the Firm and Free Cash Flow to Equity in 2007.
Use the information for the question(s) below.
Monsters Incorporated (MI) in ready to launch a new product. Depending upon the
success of this product, MI will have a value of either $100 million, $150 million, or
$191 million, with each outcome being equally likely. The cash flows are unrelated to
the state of the economy (i.e. risk from the project is diversifiable) so that the project
has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
Assume that the capital markets are perfect.
Suppose that MI has zero-coupon debt with a $140 million face value due next year.
Calculate the value of levered equity, the value of debt, and the total value of MI with
leverage.
