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Questions and Answers of
Corporate Finance
Explain the distinction between a tax-free and a taxable merger. Are there circumstances in which you would expect buyer and seller to agree to a taxable merger?
Look again at Table 33.3. Suppose that B Corporation?s fixed assets are reexamined and found to be worth $1.2 million instead of $.9 million. How would this affect the AB Corporation?s balance sheet
What was the common theme in Boone Pickens’s attempts to take over Cities Service, Gulf Oil, and Phillips Petroleum? Did his efforts create value for these companies’ shareholders? How? Was
In July 1994 the top managers of Sovereign Bancorp were at loggerheads:48 • Jay Sidhu, president and chief executive officer of the $5 billion bank, wants to be an acquirer. Only by
In December 1995 NatWest, one of the largest British banks, sold its U.S. retail banking operations to Fleet Financial for about $3.5 billion. This price was much less than industry observers had
In Italy the first firm to bid for a target is allowed to revise its offer, but subsequent bidders may enter only one bid and they are not allowed to revise it. What do you think is the reason for
True, false, or “It depends on . . .”?a. Most large corporations are controlled by families, governments, or financial institutions.b. Top managers in Germany are much more secure in their jobs
For what kinds of companies would an LBO or MBO transaction not be productive?
What was the common theme in both the Phillips Petroleum restructuring and the RJR Nabisco LBO? Why was financial leverage a necessary part of both deals?
Outline the similarities and differences between the RJR Nabisco LBO and the Sealed Air leveraged restructuring. Were the economic motives the same? Were the results the same? Do you think it was an
Read Barbarians at the Gate (Further Reading). What agency costs can you identify?
Explain the financial architecture of a private-equity partnership. Pay particular attention to incentives and compensation. What types of investments were such partnerships designed to make?
Traditional conglomerates are now rare in the United States, but in many other countries, conglomerates are the dominant firms. Explain why.
What is meant by an internal capital market? When would you expect such a market to add value? When and why would it be expected to misallocate capital?
We devoted considerable space in this chapter to the problems encountered in the financial management of conglomerates. Could these problems be cured by basing performance measurement and
Define each of the following terms:a. Optimal distribution policyb. Dividend irrelevance theory; bird-in-the-hand theory; tax effect theoryc. Information content, or signaling, hypothesis; clientele
How would each of the following changes tend to affect aggregate payout ratios (that is, the average for all corporations), other things held constant? Explain your answers.a. An increase in the
What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declare a 100% stock dividend or a 2-for-1 split? Assume that either action
One position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investments. Explain what a residual policy implies (assuming that
Indicate whether the following statements are true or false. If the statement is false, explain why.a. If a firm repurchases its stock in the open market, the shareholders who tender the stock are
Axel Telecommunications has a target capital structure that consists of 70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be $3 million. If Axel
Petersen Company has a capital budget of $1.2 million. The company wants to maintain a target capital structure which is 60% debt and 40% equity. The company forecasts that its net income this year
The Wei Corporation expects next year’s net income to be $15 million. The firm’s debt ratio is currently 40%. Wei has $12 million of profitable investment opportunities, and it wishes to maintain
A firm has 10 million shares outstanding with a market price of $20 per share. The firm has $25 million in extra cash (short-term investments) that it plans to use in a stock repurchase; the firm has
Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming the stock split will have no effect on the total market value of its equity, what will be
Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 40% with a $10
Suppose you own 2,000 common shares of Laurence Incorporated. The EPS is $10.00, the DPS is $3.00, and the stock sells for $80 per share. Laurence announces a 2-for-1 split. Immediately after the
After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new share, which represents a 9% increase over last year’s pre-split dividend. What was last year’s dividend per
The Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects
In 2010, the Keenan Company paid dividends totaling $3.6 million on net income of $10.8 million. The year was a normal one, and earnings have grown at a constant rate of 10% for the past 10 years.
Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain
Bayani Bakery’s most recent FCF was $48 million; the FCF is expected to grow at a constant rate of 6%. The firm’s WACC is 12% and it has 15 million shares of common stock outstanding. The firm
What is meant by the term “distribution policy”? How have dividend payouts versus stock repurchases changed over time?
The terms “irrelevance,” “bird-in-the-hand,” and “tax effect” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain what
What do the three theories indicate regarding the actions management should take with respect to dividend payout?
What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?
Discuss (1) The information content, or signaling, hypothesis, (2) The clientele effect, and (3) Their effects on distribution policy.
Assume that SSC has a $112.5 million capital budget planned for the coming year. You have determined its present capital structure (80% equity and 20% debt) is optimal, and its net income is
In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?
What are the advantages and disadvantages of the residual policy? (Hint: don’t neglect signaling and clientele effects.)
Describe the procedures a company follows when it make a distribution through dividend payments.
What is a stock repurchase? Describe the procedures a company follows when it make a distribution through a stock repurchase.
Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.
Suppose SSC has decided to distribute $50 million, which it presently is holding in very liquid short-term investments. SSC’s value of operations is estimated to be about $1,937.5 million. SSC has
Now suppose that SSC has just made the $50 million distribution in the form of dividends. What is SSC’s intrinsic value of equity? What is its intrinsic per share stock price?
Suppose instead that SSC has just made the $50 million distribution in the form of a stock repurchase. Now what is SSC’s intrinsic value of equity? How many shares did SSC repurchase? How many
Describe the series of steps that most firms take in setting dividend policy in practice.
What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?
What is a dividend reinvestment plan (drip), and how does it work?
Define each of the following terms:a. Capital structure; business risk; financial riskb. Operating leverage; financial leverage; break-even pointc. Reserve borrowing capacity
Why is the following statement true? Other things being the same, firms with relatively stable sales are able to carry relatively high debt ratios.
Why do public utility companies usually have capital structures that are different from those of retail firms?
Why is EBIT generally considered to be independent of financial leverage? Why might EBIT actually be influenced by financial leverage at high debt levels?
If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
Counts Accounting has a beta of 1.15. The tax rate is 40%, and Counts is financed with 20% debt. What is Counts’s unlevered beta?
Ethier Enterprise has an unlevered beta of 1.0. Ethier is financed with 50% debt and has a levered beta of 1.6. If the risk-free rate is 5.5% and the market risk premium is 6%, how much is the
Lee Manufacturing’s value of operations is equal to $900 million after a recapitalization (the firm had no debt before the recap). Lee raised $300 million in new debt and used this to buy back
Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm’s fixed costs, F, are $2 million, 50 earth stations are produced and sold each year, profits total
Now calculate the corporate value.Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not
Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company’s
Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2
Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure,
Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.
What is business risk? What factors influence a firm's business risk?
What is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10.
Now, to develop an example which can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing,
Now calculate ROE for both firms.Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not
What does this example illustrate about the impact of financial leverage on ROE?Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The
Explain the difference between financial risk and business risk.
What happens to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?
What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.
What does the empirical evidence say about capital structure theory? What are the implications for managers?
With the above points in mind, now consider the optimal capital structure for PizzaPalace. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the
Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting the value of the debt that will be issued, the resulting market value of equity, the price per share, the
Define each of the following terms:a. PV; I; INT; FVN; PVAN; FVAN; PMT; M; INOMb. Opportunity cost ratec. Annuity; lump-sum payment; cash flow; uneven cash flow streamd. Ordinary (or deferred)
What is an opportunity cost rate? How is this rate used in discounted cash flow analysis, and where is it shown on a time line? Is the opportunity rate a single number that is used to evaluate all
An annuity is defined as a series of payments of a fixed amount for a specific number of periods. Thus, $100 a year for 10 years is an annuity, but $100 in Year 1, $200 in Year 2, and $400 in Years 3
If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain Briefly.
If you deposit $10,000 in a bank account that pays 10% interest annually, how much will be in your account after 5 years?
What is the present value of a security that will pay $5,000 in 20 years if securities of equal risk pay 7% annually?
Your parents will retire in 18 years. They currently have $250,000, and they think they will need $1 million at retirement. What annual interest rate must they earn to reach their goal, assuming they
If you deposit money today in an account that pays 6.5% annual interest, how long will it take to double your money?
You have $42,180.53 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals $250,000. You expect to earn 12% annually on the
What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year? If this were an annuity due, what would its future value be?
An investment will pay $100 at the end of each of the next 3 years, $200 at the end of Year 4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of equal risk earn 8%
You want to buy a car, and a local bank will lend you $20,000. The loan would be fully amortized over 5 years (60 months), and the nominal interest rate would be 12%, with interest paid monthly. What
Find the following values, using the equations, and then work the problems using a financial calculator to check your answers. Disregard rounding differences. a. An initial $500 compounded for 1 year
Use both the TVM equations and a financial calculator to find the following values. a. An initial $500 compounded for 10 years at 6%b. An initial $500 compounded for 10 years at 12%c. The present
To the closest year, how long will it take $200 to double if it is deposited and earns the following rates? [Notes: (1) See the Hint for Problem 4-9. (2) This problem cannot be solved exactly with
Find the future value of the following annuities. The first payment in these annuities is made at the end of Year 1, so they are ordinary annuities. a. $400 per year for 10 years at 10%b. $200 per
Find the present value of the following ordinary annuities (see the Notes to Problem 4-12).a. $400 per year for 10 years at 10%b. $200 per year for 5 years at 5%c. $400 per year for 5 years at 0%d.
a. Find the present values of the following cash flow streams. The appropriate interest rate is 8%. b. What is the value of each cash flow stream at a 0% interestrate?
Find the interest rate (or rates of return) in each of the following situations.a. You borrow $700 and promise to pay back $749 at the end of 1 year.b. You lend $700 and receive a promise to be paid
Find the amount to which $500 will grow under each of the following conditions.a. 12% compounded annually for 5 yearsb. 12% compounded semiannually for 5 yearsc. 12% compounded quarterly for 5
Find the present value of $500 due in the future under each of the following conditions.a. 12% nominal rate, semiannual compounding, discounted back 5 yearsb. 12% nominal rate, quarterly compounding,
Find the future values of the following ordinary annuities.a. FV of $400 each 6 months for 5 years at a nominal rate of 12%, compounded semiannuallyb. FV of $200 each 3 months for 5 years at a
Universal Bank pays 7% interest, compounded annually, on time deposits. Regional Bank pays 6% interest, compounded quarterly.a. Based on effective interest rates, in which bank would you prefer to
a. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the end of each of the next 5 years. The interest rate is 10%.b. How large must each annual payment be if
Sales for Hanebury Corporation’s just-ended year were $12 million. Sales were $6 million 5 years earlier.a. At what rate did sales grow?b. Suppose someone calculated the sales growth for Hanebury
Washington-Pacific invested $4 million to buy a tract of land and plant some young pine trees. The trees can be harvested in 10 years, at which time W-P plans to sell the forest at an expected price
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