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Questions and Answers of Corporate Finance

Term loans usually require firms to pay a fluctuating interest rate. For example, the interest rate may be set at “1 percent above prime.” The prime rate sometimes varies by several percentage
Every day, Consolidated Blancmange writes checks worth $100,000. These checks take an average of five days to clear. The company also receives payments of $150,000 every day. These take three days to
On January 25, Coot Company has $250,000 deposited with a local bank. On January 27, the company writes and mails checks of $20,000 and $60,000 to suppliers. At the end of the month, Coot’s
Knob, Inc., is a nationwide distributor of furniture hardware. The company now uses a central billing system for credit sales of $180 million annually. First National, Knob’s principal bank, offers
Explain why companies use zero-balance accounts to make disbursements.
A parent company settles the collection account balances of its subsidiaries once a week. (That is, each week it transfers any balances in the accounts to a central account.) The cost of a wire
The financial manager of JAC Cosmetics is considering opening a lock box in Pittsburgh. Checks cleared through the lock box will amount to $300,000 per month. The lock box will make cash available to
Some years ago, Merrill Lynch increased its float by mailing checks drawn on west coast banks to customers in the east and checks drawn on east coast banks to customers in the west. A subsequent
The processing cost of making a payment through the ACH system is roughly half the cost of making the same payment by check. Why, therefore, do firms often rationally choose to make payments by check?
How would you expect a firm’s cash balance to respond to the following changes?a. Interest rates increase.b. The volatility of daily cash flow decreases.c. The transaction cost of buying or selling
A firm maintains a separate account for cash disbursements. Total disbursements are $100,000 per month, spread evenly over the month. Administrative and transaction costs of transferring cash to the
Suppose that the rate of inflation accelerates from 5 to 10 percent per year. Would firms’ cash balances go up or down relative to sales? Explain.
Suppose that interest rates double.a. What, according to the Baumol model, would happen to the firm’s average cash balances?b. Recalculate the gain from operating the lock-box system described in
A three-month Treasury bill and a six-month bill both sell at a discount of 10 percent. Which offers the higher annual yield?
In Section 31.3 we described a six-month bill that was issued on an annually compounded yield of 5.19 percent. Suppose that one month has passed and the investment still offers the same annually
Look again at question 14. Suppose another month has passed, so the bill has only one month left to run. It is now selling at a discount of 5 percent. What is the yield calculated on a simple
In February 2002 high-grade corporate bonds sold at a yield of 5.89 percent, while tax-exempts of comparable maturity offered 3.99 percent annually. If an investor receives the same after-tax return
The IRS prohibits companies from borrowing money to buy tax-exempts and also deducting the interest payments on the borrowing from taxable income. Should the IRS prohibit such activity? If it
Suppose you are a wealthy individual paying 39.1 percent tax on income. What is the expected after-tax yield on each of the following investments?a. A municipal note yielding 6.5 percent pretax.b. A
Most floating-rate preferreds have both a floor and a ceiling on their dividend rate. (See Section 31.5, footnote 28.) How do these limits affect the behavior of the prices of these securities as
The first floating-rate preferreds were successfully issued at initial yields below yields on Treasury bills. How was this possible? The preferreds were clearly riskier than the bills. What would you
Listed below are some common terms of sale. Can you explain what each means?a. 2/30, net 60.b. net 10.c. 2/5, EOM, net 30.
Some of the items in question 1 involve a cash discount. For each of these, calculate the rate of interest paid by customers who pay on the due date instead of taking the cash discount.
Phoenix Lambert currently sells its goods cash on delivery. However, the financial manager believes that by offering credit terms of 2/10 net 30 the company can increase sales by 4 percent, without
As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his bad debt ratio, which is currently running at 6 percent. He believes that imposing a more stringent credit
Jim Khana, the credit manager of Velcro Saddles, is reappraising the company?s credit policy. Velcro sells on terms of net 30. Cost of goods sold is 85 percent of sales, and fixed costs are a further
Look again at question 5. Suppose(a) That it costs $95 to classify each new credit applicant and(b) That an almost equal proportion of new applicants falls into each of the four categories. In what
Until recently, Augean Cleaning Products sold its products on terms of net 60, with an average collection period of 75 days. In an attempt to induce customers to pay more promptly, it has changed its
Look back at question 7. Assume that the change in credit terms results in a 2 percent increase in sales. Recalculate the effect of the changed credit terms.
Financial ratios were described in Chapter. If you were a credit manager, to which financial ratios would you pay most attention? Which do you think would be the least informative?
Discuss the problems with developing a numerical credit scoring system for evaluating personal loans. You can only test your system using data for applicants who have in the past been granted credit.
Discuss ways in which real-life decisions are more complex than the decision illustrated in figure. How do you think these differences ought to affect the credit decision?
How should your willingness to grant credit be affected by differences in(a) The profit margin,(b) The interest rate,(c) The probability of repeat orders? In each case illustrate your answer with a
Why do firms grant “free” credit? Would it be more efficient if all sales were for cash and late payers were charged interest?
Sometimes a firm sells its receivables at a discount to a wholly owned captive finance company. This captive finance company is partly financed by the parent, but it also issues substantial amounts
Reliant Umbrellas has been approached by Plumpton Variety Stores of Nevada. Plumpton has expressed interest in an initial purchase of 5,000 umbrellas at $10 each on Reliant?s standard terms of 2/30,
Galenic, Inc., is a wholesaler for a range of pharmaceutical products. Before deducting any losses from bad debts, Galenic operates on a profit margin of 5 percent. For a long time the firm has
“Risky companies tend to have lower target payout ratios and more gradual adjustment rates.” Explain what is meant by this statement. Why do you think it is so?
Which types of companies would you expect to distribute a relatively high or low proportion of current earnings? Which would you expect to have a relatively high or low price–earnings ratio?(a)
Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to
We stated in Section 16.4 that MM’s proof of dividend irrelevance assumes that new shares are sold at a fair price. Look back at question 4. Assume that new shares are issued in year 1 at $10 a
Respond to the following comment: “It’s all very well saying that I can sell shares to cover cash needs, but that may mean selling at the bottom of the market. If the company pays a regular cash
In footnote 21 we referred to the Miles?Ezzell formula: Derive this formula as the adjusted discount rate ( ) for a one-period project. Then show that the formula correctly values projects of any
Refer to the first balance sheet prepared for Rational Demiconductor in Section 16.4. Again it uses cash to pay a $1,000 cash dividend, planning to issue stock to recover the cash required for
?Many companies use stock repurchases to increase earnings per share. For example, suppose that a company is in the following position: The company now repurchases 200,000 shares at $200 a share.
Hors d’Age Cheeseworks has been paying a regular cash dividend of $4 per share each year for over a decade. The company is paying out all its earnings as dividends and is not expected to grow.
An article on stock repurchase in the Los Angeles Times noted: “An increasing number of companies are finding that the best investment they can make these days is in themselves.” Discuss this
It is well documented that stock prices tend to rise when firms announce increases in their dividend payouts. How, then, can it be said that dividend policy is irrelevant?
Comment briefly on each of the following statements:(a) Unlike American firms, which are always being pressured by their shareholders to increase dividends, Japanese companies pay out a much smaller
Suppose the Miller–Modigliani (MM) theory of dividend policy is correct. How would a government-imposed dividend freeze affect(a) Stock prices?(b) Capital investment?
Formaggio Vecchio has just announced its regular quarterly cash dividend of $1 per share.(a) When will the stock price fall to reflect this dividend payment—on the record date, the ex-dividend
Refer back to question 15. Assume no taxes and a stock price immediately after the dividend announcement of $100.(a) If you own 100 shares, what is the value of your investment? How does the dividend
The shares of A and B both sell for $100 and offer a pretax return of 10 percent. However, in the case of company A the return is entirely in the form of dividend yield (the company pays a regular
(a) The Horner Pie Company pays a quarterly dividend of $1. Suppose that the stock price is expected to fall on the ex-dividend date by $.90. Would you prefer to buy on the with-dividend date or the
In the United States, where there is a two-tier tax system, which investors are indifferent to the dividend payout ratio? How about investors in Australia, where there is an imputation tax system?
The middle-of-the-road party holds that dividend policy doesn’t matter because the supply of high-, medium-, and low-payout stocks has already adjusted to satisfy investors’ demands. Investors
Table 16.4 lists the dividends and earnings per share (EPS) for Merck and International Paper. Estimate the target payout for each company and the rate at which the dividend is adjusted toward the
Consider the following two statements: ?Dividend policy is irrelevant,? and ?Stock price is the present value of expected future dividends. They sound contradictory. This question is designed to show
Suppose management is expected to make a fixed-price tender offer to repurchase half of the stock at a 20 percent premium. How, if at all, would that affect today’s market price of the company’s
Adherents of the “dividends-are-good” school sometimes point to the fact that stocks with high yields tend to have above-average price–earnings multiples. Is this evidence convincing? Discuss.
Companies A and B differ only in their capital structure. A is financed 30 percent debt and 70 percent equity; B is financed 10 percent debt and 90 percent equity. The debt of both companies is
Here is a limerick:There once was a man named Carruthers,Who kept cows with miraculous udders.He said, “Isn’t this neat?They give cream from one teat,And skim milk from each of the others!”What
Hubbard’s Pet Foods is financed 80 percent by common stock and 20 percent by bonds. The expected return on the common stock is 12 percent and the rate of interest on the bonds is 6 percent.
“MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest.” Explain carefully whether this is a valid objection.
Indicate what's wrong with the following arguments:(a) As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt
Each of the following statements is false or at least misleading. Explain why in each case.(a) “A capital investment opportunity offering a 10 percent DCF rate of return is an attractive project if
Can you invent any new kinds of debt that might be attractive to investors? Why do you think they have not been issued?
It has been suggested that one disadvantage of common stock financing is that share prices tend to decline in recessions, thereby increasing the cost of capital and deterring investment. Discuss
Figure shows that rD increases as the debt?equity ratio increases. In MM?s world rE also increases but at a declining rate. Explain why. Redraw Figure, showing how rD and change for increasingly high
Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to(a) The ratio of the market value of the equity to income after interest?(b)
Archimedes Levers is financed by a mixture of debt and equity. You have the following information about its cost of capital: Can you fill in the blanks?
Look back at question 11. Suppose now that Archimedes repurchases debt and issues equity so that D/V = 3. The reduced borrowing causes rD to fall to 11 percent. How do the other variables change?
Look back at question 11. Suppose now that Archimedes repurchases debt and issues equity so that D/V = 3. The reduced borrowing causes rD to fall to 11 percent. How do the other variables change?
Schuldenfrei a.g. pays no taxes and is financed entirely by common stock. The stock has a beta of .8, a price–earnings ratio of 12.5, and is priced to offer an 8 percent expected return.
Gamma Airlines is currently all-equity-financed, and its shares offer an expected return of 18 percent. The risk-free interest rate is 10 percent. Draw a graph with return on the vertical axis and
Two firms, U and L, are identical except for their capital structure. Both will earn $150 in a boom and $50 in a slump. There is a 50 percent chance of each event. U is entirely equity-financed, and
Consider the following three tickets: ticket A pays $10 if ____ is elected as president, ticket B pays $10 if ____ is elected, and ticket C pays $10 if neither is elected. (Fill in the blanks
People often convey the idea behind MM’s proposition I by various supermarket analogies, for example, “The value of a pie should not depend on how it is sliced,” or, “The cost of a whole
Consider a project generating a level, perpetual stream of cash flows. The project is financed at an initial debt-to-value ratio L. The debt is likewise perpetual. But the company follows Financing
“The trouble with MM’s argument is that it ignores the fact that individuals can deduct interest for personal income tax.” Show why this is not an objection. What difference would it make if
Look back at the Pfizer example in Section 18.1. Suppose that Pfizer moves to a 40 percent book debt ratio by issuing debt and using the proceeds to repurchase shares. Consider only corporate taxes.
Tables 18.3(a) and 18.3(b), although pertaining to a real company, are really just a simplified numerical example. What factors would you expect to determine the value of interest tax shields in
“The right of shareholders to default is a valuable privilege.” Explain.
In Section 18.3, we briefly referred to three games: Playing for time, cash in and run, and bait and switch. For each game, construct a simple numerical example (like the example for the
Summarize the evidence pro and con the trade-off theory of capital structure.
The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain:(a) Why
(a) Who benefits from the fine print in bond contracts when the firm gets into financial trouble? Give a one-sentence answer.(b) Who benefits from the fine print when the bonds are issued? Suppose
Caldor, the retailing chain, filed for bankruptcy in September 1995. Shortly after the bankruptcy its stock traded at $5.25 per share, down from about $20 earlier in the year. How much of this drop
Ronald Masulis42 has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned
Suppose the trade-off theory of capital structure is true. Can you predict how companies’ debt ratios should change over time? How do these predictions differ from the pecking-order theory’s?
Summarize the evidence pro and con the pecking-order theory of capital structure.
“Why are personal taxes on bond interest important? They are the bondholder’s problem.” Explain why they are also indirectly the shareholder’s problem.
The possible payoffs from Ms. Ketchup’s projects (see Section 18.3) have not changed but there is now a 40 percent chance that project 2 will pay off $24 and a 60 percent chance that it will pay
In Section 19.3 we proposed a three-step procedure for calculating WACC at different debt ratios. The Miles–Ezzell formula can be used for the same purpose. Set up a numerical example and use these
Table 19.2 shows a book balance sheet for the Wishing Well Motel chain. The companys long-term debt is secured by its real estate assets, but it also uses short-term bank financing. It pays 10
Table 19.3 shows a simplified balance sheet for Rensselaer Felt. Calculate this company?s weighted-average cost of capital. The debt has just been refinanced at an interest rate of 6 percent (short
How will Rensselaer Felt’s WACC and cost of equity change if it issues $50 million in new equity and uses the proceeds to retire long-term debt? Assume the company’s borrowing rates are
Look one more time at practice question 4. Renssalaer Felt’s pretax operating income is $100.5 million. Assume for simplicity that this figure is expected to remain constant forever. Value the
Rapidly growing companies may have to issue shares to finance capital expenditures. In doing so, they incur underwriting and other issue costs. Some analysts have tried to adjust WACC to account for
Digital Organics (DO) has the opportunity to invest $1 million now ( ) and expects after-tax returns of $600,000 in and $700,000 in . The project will last for two years only. The appropriate cost of
You are considering a five-year lease of office space for R&D personnel. Once signed, the lease cannot be canceled. It would commit your firm to six annual $100,000 payments, with the first

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