Which of the following is the explanation of why the market generally reacts negatively
to the announcement of a SEO offered in the pecking order hypothesis?
a. Management is taking a self-serving action.
b. Management is signaling that the shares are overpriced.
c. Creditors are forcing the firm to increase its equity base.
d. The firm is revealing that it has not generated as much earnings as the market
expected.
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 mn. 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 accounts 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 percent to their future expected dividends, and therefore they value the firm
at $15.15mn. (=$5mn./0.33). The firm’s 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-banking firm estimates that the market will
value the firm’s equity 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. (Ignore taxes and
transaction costs.) The total market value of the firm’s public shares is ___(i)___.
Accounting for both the present value of management’s salaries (discounted into
perpetuity at 33%) and the proceeds from the public sale of shares, management’s
wealth gain from going public is ___(ii)___.
In a ________ the bidder’s intention is to acquire the target and replace the target’s
incumbent management, who vigorously resist the attempt.
a. merger
b. acquisition
c. buyout
d. hostile takeover
Masulis (1980) documented evidence that the market generally reacts favorably to a
leverage- increasing debt-for-equity swap, and unfavorably to a leverage decreasing
equity-for-debt swap. Which of the following is NOT a legitimate theoretical
explanation for these market reactions?
a. Increasing leverage increases the tax shield of debt, while extinguishing debt
decreases it. b. Increasing leverage induces an expropriation of wealth from existing
creditors, while extinguishing debt accomplishes the opposite.
c. Increasing leverage via a swap involves paying a dividend to shareholders while
decreasing leverage via a swap forces the firm to issue equity.
d. Increasing leverage disciplines management to act in shareholders’ interest by
absorbing free cash flow, while decreasing leverage increases management’s ability to
pursue self-serving activities.
In undertaking a seasoned equity offering (SEO), why do firms almost always hire an
underwriter via negotiation rather than competitive bidding?
a. The SEC mandates negotiation for SEOs (except in rare cases).
b. The selling process can be problematic because of informational asymmetry
problems.
c. Negotiation actually results in a lower underwriter spread.
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?
a. 15.33%
b. 18.20%
c 20.33%
d. 22.50%
FORMULA: rE= rA+ (D/E)[rA– rD].
TRUE or FALSE. Yield spreads on new convertible bonds generally are negative.
a. TRUE
b. FALSE
Simulations based on the Black-Scholes model indicate that, for all combinations of
leverage (D/V) and firm risk ( ), debt risk:
a. increases as debt maturity increases.
b. decreases as debt maturity increases.
c. remains fairly constant as debt maturity increases.
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.
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.
Suppose Firm XYZ paid a dividend of $1 per share last year, and this year’s earnings
per share was $3. The firm’s target payout ratio is =0.50, and the value of the firm’s
speed of adjustment parameter is =0.3. What is the firm’s expected dividend
for this year?
a. 0.85
b. 1.00
c. 1.15
d. 1.30
FORMULA: DIVt– DIVt-1= DIVt= ( EARNt-DIVt-1)
In an IPO, the ______ option allows the underwriter to sell additional shares if it is
profitable to do so.
a. overallotment
b. offer extension
c. continuance
d. prolongation
Under what circumstances would a firm engage in share repurchases rather than
increasing dividends?
a. If the firm has excess free cash flow that management expects will continue
indefinitely.
b. If the firm has excess free cash flow that management expects will be only
temporary.
c. If shareholders are in a lower tax bracket for dividends than for realized capital gains.
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)
Which of the following factors most likely explains the difference in the profitabilities
of these two firms?
a. differential ability to secure debt financing
b. differential economies of scale
c. the difference in the number of business segments
The expected returns and standard deviations for stocks A and B are rA=14% and
rB=19%, respectively, and A=23% and B=34%, respectively. The
correlation of the returns on the two stocks is AB=0.3. What is the expected return, rP,
and standard deviation, P, of a portfolio with weights of wA=0.60 and
wB=0.40 in stocks A and B, respectively?
FORMULAS: rp = wArA+ wB rB; p= [ ]1/2
A ______ is a seasoned equity offering (SEO) of a firm that has recently gone public.
a. follow-on
b. supplemental IPO
c. lockup offering
d. quasi-seasoned equity offering
With a make whole call provision:
a. the firm to pay a call price that is sufficient to provide bondholders an ex post return
equal to the return they would have received on a noncallable Treasury bond with the
same original maturity as the called bond.
b. the firm must retire either the entire (or whole) bond issue or none of the bonds.
c. bondholders are allowed to redeem their bonds at par value.
d. the firm has the option to restore bondholders’ wealth by issuing new bonds, that
would sell at par value, in exchange for the original bonds.
TRUE or FALSE: According to empirical studies, the combination of secured private
debt and numerous public debt issues (in a distressed firm’s capital structure) impedes
out-of-court debt restructuring and increases the probability of a Chapter 11 filing.
a. TRUE
b. FALSE
State legislation designed to thwart takeovers has been enacted in recent years,
including _______, which restrict the voting power of a controlling shareholder.
a. business combination laws
b. voting share reprisal laws
c. takeover postponement laws
d. control share laws
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.
FORMULAS: ; EL = ;
;
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.
The Financial Accounting Standards Board (FASB) has recently voted to eliminate
___(i)___ accounting for mergers, and henceforth will allow only the ___(ii)___.
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?
a. 15.33%
b. 18.20%
c 20.33%
d. 23.00%
FORMULA: rE= rA+ (D/EL)(rA– rD)
Which of the following is NOT a theory that has been suggested to explain empirical
evidence that IPOs are initially underpriced?
a. litigation risk
b. the winner’s curse
c. signaling (i.e., strategic underpricing)
d. the IPO market is inefficient
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.
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
State legislation designed to thwart takeovers has been enacted in recent years,
including _______, which can delay the consummation of business combinations for
years.
a. business combination laws
b. voting share reprisal laws
c. takeover postponement laws
d. control share laws
A problem with the tender offer mechanism in a takeover is the ______. The term refers
to a situation in which rational behavior by each individual shareholder results in
shareholders as a group being worse off. If individual target shareholders (correctly)
foresee that the value of their shares will be worth more after the takeover than they
will receive in the tender offer, they will choose not to tender their shares.
a. holdover problem
b. free rider problem
c. holdout problem
d. non-tender problem
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
Futures trading features daily ____(i)____ in cash and ____(ii)____.
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)
Conduct a DuPont ROE breakdown analysis for each firm. Which breakdown ratio is
most important in explaining ROE differential between the two firms?
a. profit margin
b. total asset turnover
c. leverage
The value of a convertible bond is relatively insensitive to changes in the riskiness of
the firm, because the value of the underlying bond is inversely related to changes in the
firm’s risk, while the value of the implicit call option is directly related to changes in the
firm’s risk. Consequently, with a convertible bond the firm’s management no longer has
an incentive to engage in _________ to expropriate value from the bondholders, and
therefore one of the major agency problems associated with debt is resolved.
a. excessive consumption of perquisites.
b. risk shifting.
c. excessive dividend payments.
d. excessively conservative investment policies.