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Questions and Answers of Corporate Finance

Look at the example in Section 24.4 of the Treasury bill and the medium- and long-term bonds. Now assume that the price of the medium-term bond can either fall by $10.75 or rise by $14.0. What can
Explain carefully what factors determine the yield on corporate bonds.
Companies sometimes issue floating-rate bonds. In this case the interest rate might be set at (say) 1 percent above the Treasury bill rate. Would you expect the price of a company’s floating-rate
Company A has issued a single zero-coupon bond maturing in 10 years. Company B has issued a coupon bond maturing in 10 years. Explain why it is more complicated to value B’s debt than A’s.
Company X has borrowed $150 maturing this year and $50 maturing in 10 years. Company Y has borrowed $200 maturing in five years. In both cases asset value is $140. Why might X not default while Y
It has been suggested that the Fisher theory is a tautology. If the real rate of interest is defined as the difference between the nominal rate and the expected inflation rate, then the nominal rate
Find the arbitrage opportunity (opportunities?). Assume for simplicity that coupons are paid annually. In each case the face value of the bond is $1,000.
The duration of a bond which makes an equal payment each year in perpetuity is (1 + yield)/yield. Prove it.
What is the duration of a common stock whose dividends are expected to grow at a constant rate in perpetuity?
(a) What spot and forward rates are embedded in the following Treasury bonds? The price of one-year (zero-coupon) Treasury bills is 93.46 percent. Assume for simplicity that bonds make only annual
Look back at our example in Section 24.4 of the short-, medium-, and long-term bonds. Remember that we said that the prices must stand in a particular relationship or there would be an arbitrage
Bond rating services usually charge corporations for rating their bonds.(a) Why do they do this, rather than charge those investors who use the information?(b) Why will a company pay to have its
Look back to the first Backwoods Chemical example at the start of Section 24.5. Suppose that the firm?s book balance sheet is The debt has a one-year maturity and a promised interest rate of 9
Refer again to question 9. Suppose that the continuously compounded return on Backwoods?s assets over the next year is normally distributed with a mean of 10 percent. What is the probability that
Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north and west of Fort Liard. Magna will have a firm one-year contract with the mining company and expects
Suppose that the Ralston Purina bond was issued at face value and that investors continue to demand a yield of 9.5 percent. Sketch what you think would happen to the bond price as the first interest
Here is a variation on challenge question 1. Suppose Magna Charter is offered a five-year cancelable lease at an annual rate of $125,000, paid in advance. How would you go about analyzing this lease?
Bond prices can fall either because of a change in the general level of interest rates or because of an increased risk of default. To what extent do floating-rate bonds and puttable bonds protect the
Proctor Power has fixed assets worth $200 million and net working capital worth $100 million. It is financed partly by equity and partly by three issues of debt. These consist of $250 million of
Elixir Corporation has just filed for bankruptcy. Elixir is a holding company whose assets consist of real estate worth $80 million and 100 percent of the equity of its two operating subsidiaries. It
(a) Residential mortgages may stipulate either a fixed rate or a variable rate. As a borrower, what considerations might cause you to prefer one rather than the other?(b) Why might holders of
After a sharp change in interest rates, newly issued bonds generally sell at yields different from those of outstanding bonds of the same quality. One suggested explanation is that there is a
Suppose that a company simultaneously issues a zero-coupon bond and a coupon bond with identical maturities. Both are callable at any time at their face values. Other things equal, which is likely to
(a) If interest rates rise, will callable or noncallable bonds fall more in price?(b) Sometimes you encounter bonds that can be repaid after a fixed interval at the option of either the issuer or the
A puttable bond is a bond which may be repaid before maturity at the investor?s option. Sketch a diagram similar to Figure showing the relationship between the value of a straight bond and that of a
What restrictions are imposed on a company’s freedom to issue further debt? Be as precise as possible. Explain carefully the reasons for such restrictions.
Does the issue of additional junior debt harm senior bondholders? Would your answer be the same if the junior debt matured before the senior debt? Explain.
Alpha Corp. is prohibited from issuing more senior debt unless net tangible assets exceed 200 percent of senior debt. Currently the company has outstanding $100 million of senior debt and has net
Explain carefully why bond indentures place limitations on the following actions:(a) Sale of the company’s assets.(b) Payment of dividends to shareholders.(c) Issue of additional senior debt.
In Section 25.8 we referred to Christiania Bank’s exotic bond. Explain how you would value tranche B. Assume that the principal repayment is fixed at 100 percent of par.
Explain when it makes sense to use project finance rather than a direct debt issue by the parent company.
The appendix summarizes several problems with Chapter 11 bankruptcy. Which of these problems could be mitigated by negotiating a prepackaged bankruptcy?
Dorlcote Milling has outstanding a $1 million 3 percent mortgage bond maturing in 10 years. The coupon on any new debt issued by the company is 10 percent. The finance director, Mr. Tulliver, cannot
Refer back to the Hub Power project in Section 25.7. There were many other ways that the Hubco project could have been financed. For example, a government agency could have invested in the power
A lessee does not have to pay to buy the leased asset. Thus it’s said that “leases provide 100 percent financing.” Explain why this is not a true advantage to the lessee.
In quiz question 5 we assumed identical lease rates for old and new desks.a. How does the initial break-even lease rate change if the expected inflation rate is 5 percent per year? Assume that the
Look at Table 26.1. How would the initial break-even operating lease rate change if rapid technological change in limo manufacturing reduces the costs of new limos by 5 percent per year?
Why do you think that leasing of trucks, airplanes, and computers is such big business? What efficiencies offset the costs of running these leasing operations?
Recalculate the value of the lease to Greymare Bus Lines if the company pays no taxes until year 3. Calculate the lease cash flows by modifying Table 26.2. Remember that the after-tax borrowing rate
Look again at the bus lease described in Table 26.2. a. What is the value of the lease if Greymare's marginal tax rate is Tc = .20? b. What would the lease value be if Greymare had to use
In Section 26.4 we showed that the lease offered to Greymare Bus Lines had a positive NPV of $820 if Greymare paid no tax and a +$700 NPV to a lessor paying 35 percent tax. What is the minimum lease
In Section 26.5 we listed four circumstances in which there are potential gains from leasing. Check them out by conducting a sensitivity analysis on the Greymare Bus Lines lease, assuming that
In Section 26.5 we stated that if the interest rate were zero, there would be no advantage in postponing tax and therefore no advantage in leasing. Value the Greymare Bus Lines lease with an interest
In Section 26.5 we stated that if the interest rate were zero, there would be no advantage in postponing tax and therefore no advantage in leasing. Value the Greymare Bus Lines lease with an interest
Nodhead College needs a new computer. It can either buy it for $250,000 or lease it from Compulease. The lease terms require Nodhead to make six annual payments (prepaid) of $62,000. Nodhead pays no
The Safety Razor Company has a large tax-loss carry forward and does not expect to pay taxes for another 10 years. The company is therefore proposing to lease $100,000 of new machinery. The lease
The overall gain from leasing is the sum of the lease’s value to the lessee and its value to the lessor. Construct simple numerical examples showing how this gain is affected bya. The rate of
Why might a large, multinational company choose to insure against common events, such as vehicle accidents, but not against rare events which could cause large losses? Explain briefly.
Large businesses spend millions of dollars annually on insurance. Why? Should they insure against all risks or does insurance make more sense for some risks than others?
What is meant by “moral hazard” and “adverse selection”? Explain why these effects tend to increase insurance premiums.
On some catastrophe bonds, payments are reduced if the claims against the issuer exceed a specified sum. In other cases payments are reduced only if claims against the entire industry exceed some
“The farmer does not avoid risk by selling wheat futures. If wheat prices stay about $2.80 a bushel, then he will actually have lost by selling wheat futures at $2.50.” Is this a fair comment?
Explain the chief differences between futures and forward contracts, e.g., for foreign exchange.
List some of the commodity futures contracts that are traded on exchanges. Who do you think could usefully reduce risk by buying each of these contracts? Who do you think might wish to sell each
What is a currency swap? An interest rate swap? A default swap? Give an example of how each swap might be used.
In August 2001, six-month futures on the Brazilian Bovespa stock index traded at 15,330. Spot was 13,743. The interest rate was 19 percent and the dividend yield was about 4 percent. Were the futures
If you buy a nine-month T-bill future, you undertake to buy a three-month bill in nine months? time. Suppose that Treasury bills and notes currently offer the following yields: What is the value of
Table 27.5 contains spot and six-month futures prices for several commodities and financial instruments. There may be some money-making opportunities. See if you can find them, and explain how you
The following table shows gold futures prices for varying contract lengths. Gold is predominantly an investment good, not an industrial commodity. Investors hold gold because it diversifies their
In September 2001 swap dealers were quoting a rate for five-year euro interest-rate swaps of 4.5 percent against euribor (the short-term interest rate for euro loans). Euribor at the time was 4.1
Firms A and B face the following borrowing rates for making a five-year fixed-rate debt issue in U.S. dollars or Swiss francs: Suppose that A wishes to borrow U.S. dollars and B wishes to borrow
What is meant by “delta” in the context of hedging? Give examples of how delta can be estimated or calculated.
A gold-mining firm is concerned about short-term volatility in its revenues. Gold currently sells for $300 an ounce, but the price is extremely volatile and could fall as low as $280 or rise as high
Legs Diamond owns shares in Vanguard Index 500 mutual fund worth $1 million on July 15. (This is an index fund that tracks the Standard and Poor’s 500 Index.) He wants to cash in now, but his
Refer back to question 17. Suppose that the nearest index futures contract matures in seven months rather than in six. Show how Legs Diamond can still use index futures to hedge his position. How
Your investment bank has an investment of $100 million in the stock of the Swiss Roll Corporation and a short position in the stock of the Frankfurter Sausage Company. Here is the recent price
Price changes on two gold-mining stocks have shown strong positive correlation. Their historical relationship is Changes in B explain 60 percent of the variation of the changes Aa. Suppose you
In Section 27.5, we stated that the duration of Potterton’s lease equals the duration of its debt.a. Show that this is so.b. Now suppose that the interest rate falls to 3 percent. Show how the
Line 1 of the following table shows cash payments that your company has just promised to make. Below that are the cash flows on a blue-chip corporate note. The interest rate is 10 percent. Your
Petrochemical Parfum (PP) is concerned about possible increases in the price of heavy fuel oil, which is one of its major inputs. Show how PP can use either options or futures contracts to protect
Explain the difference between insurance and hedging. Give an example of how options can be used for each.
“Speculators want futures contracts to be incorrectly priced; hedgers want them to be correctly priced.” Why?
Phillip’s Screwdriver Company has borrowed $20 million from a bank at a floating interest rate of 2 percentage points above three-month Treasury bills, which now yield 5 percent. Assume that
Hoopoe Corporation wants to borrow 100 million Canadian dollars at a fixed rate with a maturity of five years. It calculates that it can make an international bond issue with the following terms:•
Consider the commodities and financial assets listed in Table 27.6. The risk-free interest rate is 6 percent a year, and the term structure is flat. a. Calculate the six-month futures price for
Table 28.1 shows the 90-day forward rate on the Thai baht. a. Is the dollar at a forward discount or premium on the baht? b. What is the annual percentage discount or premium? c. If you have no
Look at Table 28.1. If the three-month interest rate on dollars is 3.5 percent, what do you think is the three-month interest rate on South African rands? Explain what would happen if the rate were
What do our four basic relationships imply about the relationship between two countries’ interest rates and the expected change in the exchange rate? Explain why you would or would not expect them
Ms. Rosetta Stone, the treasurer of International Reprints, Inc., has noticed that the interest rate in Japan is below the rates in most other countries. She is, therefore, suggesting that the
What considerations should an American company take into account when deciding how to finance its overseas subsidiaries?
Suppose you are the treasurer of Lufthansa, the German international airline. How is company value likely to be affected by exchange rate changes? What policies would you adopt to reduce exchange
Companies may be affected by changes in the nominal exchange rate or in the real exchange rate. Explain how this can occur. Which risks are easiest to hedge against?
A Ford dealer in the United States may be exposed to a devaluation of the yen if this leads to a cut in the price of Japanese cars. Suppose that the dealer estimates that a 1 percent decline in the
You have bid for a possible export order that would provide a cash inflow of €1 million in six months. The spot exchange rate is $.9094 = €1 and the six-month forward rate is $.9070 = €1.There
In August 2001, an American investor buys 1,000 shares in a Mexican company at a price of 500 pesos each. The share does not pay any dividend. A year later she sells the shares for 550 pesos each.
Table 28.4 shows the foreign exchange rate for the Australian dollar and the Australian and U.S. inflation rates. Using these data, plot the nominal and real exchange rates. Which was more volatile,
Look again at Table 28.4. George and Bruce each have an equal share in a trust fund that provides them with an income of US$100,000 a year. George lives in Seattle, but Bruce emigrated to Sydney in
In 1992 a liter of scotch cost $22.84 in New York, S$69 in Singapore, and 3,240 roubles in Moscow.a. If the law of one price held, what was the exchange rate between U.S. dollars and Singapore
Table 28.5 shows the annual interest rate (annually compounded) and exchange rates against the dollar for different currencies. Are there any arbitrage opportunities? If so, how would you secure a
“Last year we had a substantial income in sterling, which we hedged by selling sterling forward, in the event sterling rose, and our decision to sell forward cost us a lot of money. I think that in
In 1985 a German corporation bought $250 million forward to cover a future purchase of goods from the United States. However, the dollar subsequently depreciated and the company found that, if it had
Carpet Baggers, Inc., is proposing to construct a new bagging plant in Europe. The two prime candidates are Germany and Switzerland. The forecasted cash flows from the proposed plants are as follows:
If investors recognize the impact of inflation and exchange rate changes on a firm’s cash flows, changes in exchange rates should be reflected in stock prices. How would the stock price of each of
Alpha and Omega are U.S. corporations. Alpha has a plant in Hamburg that imports components from the United States, assembles them, and then sells the finished product in Germany. Omega is at the
Respond to the following comments.a. “Our cost of debt is too darn high, but our banks won’t reduce interest rates as long as we’re stuck in this volatile widget-trading business. We’ve got
Explain how you would estimate the gain and cost of a merger financed by stock. What stock price should be used to calculate the cost?
Sometimes the stock price of a possible target company rises in anticipation of a merger bid. Explain how this complicates the bidder’s evaluation of the target company.
Suppose you obtain special information—information unavailable to investors— indicating that Backwoods Chemical’s stock price is 40 percent undervalued. Is that a reason to launch a takeover
As treasurer of Leisure Products, Inc., you are investigating the possible acquisition of Plastitoys. You have the following basic data: You estimate that investors currently expect a steady growth
The Muck and Slurry merger has fallen through (see Section 33.2). But World Enterprises is determined to report earnings per share of $2.67. It therefore acquires the Wheelrim and Axle Company. You

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