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?
a. $113.6 mn.
b. $100 mn.
c. $73.6 mn.
d. $13.6 mn.
FORMULA: VL=VU+cD
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
Which of the following is NOT generally considered a cost of going public?
a. Underpricing: IPOs appear to be substantially underpriced.
b. Competition: Now that the firm is more visible, industry rivals will compete more
intensively.
c. Issuance Costs: The typical underwriter spread for an IPO is 7% of the offering
proceeds.
d. Management’s time in preparing for the offering.
e. Loss of Control: New equityholders may press the firm to change its investment,
financing, or dividend policies, and may also attempt to replace the firm’s original
management team.
The price of GE stock is $38, and its latest annual earnings per share was $1.37. If the
appropriate discount rate for GE stock is rE=10%, what is the present value of GE’s
profitable future investment opportunities (PVPFIO)?
a. $14.30
b. $19.30
c. $24.30
d. $34.30
FORMULA: PVPFIO=V-Et/r
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.
_________ obtains if a merger results in improvements in any business function,
including: (i) management; (vii) labor costs; (ii) production or distribution; etc.
a. Operating synergy
b. Financial synergy
c. Business synchronization
d. Economies of scope
In complete voluntary liquidations, the sum of the firm’s parts is worth more than the
whole, for all of the following reasons EXCEPT:
a. the assets (or divisions) may be worth more in the hands of more competent
managers.
b. liquidated assets always sell at a premium to their fair value.
c. the special tax treatment afforded liquidations provides a source of value over and
above the firm’s value as a going concern.
d. any diseconomies associated with excessive diversification can be eliminated by
piecemeal sale through liquidation.
The _________ is a convertible bond in which the date of conversion is fixed in
advance.
a. managed convertible.
b. mandatory convertible.
c. fixed convertible.
d. dated convertible.
The ownership structures of most publicly traded U.S. nonfinancial firms is better
characterized by the term:
a. closely held
b. diffuse
At date 0, the market’s expectation for the year 1 dividend on firm XYZ’s stock is
D1=$1.45. The market also expects dividends to grow at an annual rate of gS=2% in the
following 3 years (i.e., years 2, 3, and 4) after which dividends will grow at an annual
rate of gN=6% into perpetuity. If the firm’s cost of equity capital is rE=1%, the value of
XYZ stock is:
a. $31.52
b. $25.52
c. $19.52
d. $13.52
The purchasers in a buyout often obtain financial and strategic assistance from a
_______ who, as a sponsor, usually finances the transaction with equity contributed by
a number of investors and debt borrowed from several sources.
a. buyout specialist.
b. LBO intermediary
c. finance company
d. venture capital firm
A well-documented anomaly associated with IPOs is evidence that IPOs ______ other
stocks in the aftermarket for up to 3 years.
a. outperform
b. underperform
Bond contracts generally include restrictive covenants, designed to protect the interests
of the bondholders. Typical covenants restrict all of the following EXCEPT:
a. the borrowing firm’s investment activities.
b. the borrowing firm’s ability to issue additional debt.
c. the borrowing firm’s dividend policy.
d. the firm’s hiring of management personnel.
How does Jensen’s free cash flow hypothesisrelate to a firm’s dividend policy?
a. Dividends discipline management by forcing free cash flow to be disgorged to
shareholders, thus mitigating management’s tendency to engage in empire building.
b. Dividends act as a signal of firm value.
c. Dividends solve the principal-agent problem between shareholders and creditors.
d. Dividends solve the underinvestment problem.
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)?
a. $ 7.25
b. $13.25
c. $20.25
d. $27.25
FORMULA:
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
Conflicts of interest between a borrowing firm and its creditors. This problem is
exacerbated in the case of a public bond, because the ownership of public bonds is
generally dispersed among many bondholders. For these reasons, the interests of the
investors in a public corporate bond are protected in part by the appointment of a
_______, who is charged with monitoring the firm’s compliance with the various terms,
covenants, and provisions in the contract.
a. liaison officer
b. trustee
c. security officer
d. compliance guardian
One shortcoming of the traditional capital budgeting paradigm is that:
a. it does not recognize that projects must be evaluated on the basis of their NPVs.
b. it does not recognize that the firm may face capital rationing.
c. it does not deal with why capital rationing is necessary
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. a takeover.
b. shareholder activism.
c. packing the board.
d. principal intervention.
In many cases a firm that has gone private via an LBO subsequently re-emerges as a
publicly traded firm (via another IPO). This transaction is called a
a. reprise IPO.
b. resumption.
c. reverse LBO.
d. rollover.
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
TRUE or FALSE: Among publicly traded U.S. nonfinancial firms, most bankruptcy
announcements are complete surprises to the market, as indicated by the fact that, for
over 90% of such firms, their announcement-month market equity value (MEQ) is at
least as high as their MEQ at month “12 relative to the announcement.
a. TRUE
b. FALSE
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.