Midterm Finance540 Quiz Solution

Question 1

10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.

		$453,443
		$476,115
		$499,921
		$524,917
		$551,163

6 points

Question 2

 Which of the following statements about listing on a stock exchange is most CORRECT?

		Any firm can be listed on the NYSE as long as it pays the listing fee.
		Listing provides a company with some “free” advertising, and it may enhance the firm’s prestige and help it do more business.
		Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
		The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.
		Listing is a decision of more significance to a firm than going public.

6 points

Question 3

 In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker’s required return on such arrangements is 15%, and ignore taxes.

		$1,235,925
		$1,300,973
		$1,369,446
		$1,441,522
		$1,517,391

6 points

Question 4

 Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.

		$278,606
		$292,536
		$307,163
		$322,521

6 points

Question 5

 Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?

		A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.
		The flotation costs associated with issuing new bonds rise.
		The firm’s CFO believes that interest rates are likely to decline in the future.
		The firm’s CFO believes that corporate tax rates are likely to be increased in the future.

6 points

Question 6

 To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?

		$79,425
		$83,606
		$88,006
		$92,406
		$97,027

6 points

Question 7

 Which of the following statements is most CORRECT?

		Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
		Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
		The SEC requires that all private placements be handled by a registered investment banker.
		Private placements can generally bring in funds faster than is the case with public offerings.
		In a private placement, securities are sold to private (individual) investors rather than to institutions.

6 points

Question 8

 Heavy use of off-balance sheet lease financing will tend to

		make a company appear less risky than it actually is because its stated debt ratio will appear lower.
		affect a company’s cash flows but not its degree of risk.
		have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.
		affect the lessee’s cash flows but only due to tax effects.
		make a company appear more risky than it actually is because its stated debt ratio will be increased.

6 points

Question 9

 From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee’s

		capital budgeting project cash flows.
		debt cash flows.
		pension fund cash flows.
		sales.
		equity cash flows.

6 points

Question 10

 Which of the following statements is most CORRECT?

		Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
		The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
		Capital, or financial, leases generally provide for maintenance by the lessor.
		A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.
		Firms that use “off balance sheet” financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.

6 points

Question 11

 To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm’s tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

		$96
		$106
		$112
		$117
		$123

6 points

Question 12

 Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)

		$5,734
		$6,023
		$6,324
		$6,640
		$6,972

6 points

Question 13

 A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased

		is financed with long-term debt.
		is financed with debt whose maturity matches the term of the lease.
		is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at the WACC.
		is financed with retained earnings.
		is financed with short-term debt.

6 points

Question 14

 Operating leases often have terms that include

		full amortization over the life of the lease.
		very high penalties if the lease is canceled.
		restrictions on how much the leased property can be used.
		much longer lease periods than for most financial leases.
		maintenance of the equipment by the lessor.

6 points

Question 15

 Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?

		6.66%
		6.99%
		7.34%
		7.71%
		8.09%

6 points

Question 16

 The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?

		$707.33
		$744.56
		$783.75
		$825.00
		$866.25

6 points

Question 17

 Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

		$40.00
		$42.00
		$44.10
		$46.31
		$48.62

6 points

Question 18

 The “preferred” feature of preferred stock means that it normally will provide a higher expected return than will common stock.

		True
		False

6 points

Question 19

 Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

		True
		False

6 points

Question 20

 Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

		True
		False

6 points

Question 21

 Which of the following statements about convertibles is most CORRECT?

		One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
		Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
		At the time it is issued, a convertible’s conversion (or exercise) price is generally set equal to or below the underlying stock’s price.
		For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm’s otherwise similar straight debt and the expected return on its common stock.
		The coupon interest rate on a firm’s convertibles is generally set higher than the market yield on its otherwise similar straight debt.

6 points

Question 22

 Sallie’s Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie’s beta is 2.0, and its tax rate is 34%. The risk-free rate is 8%, and the market risk premium is 4%. Using the data for Sallie’s Sandwiches and the compressed adjusted present value model, what is the total value (in millions)?

		$72.37
		$73.99
		$74.49
		$75.81
		$76.45

6 points

Question 23

 Sallie’s Sandwiches is financed using 20% debt at a cost of 8%. Sallie projects combined free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 value includes the combined horizon values of FCF and tax shields.) All cash flows are expected to grow at a 3% constant rate after Year 4. Sallie’s beta is 2.0, and its tax rate is 34%. The risk-free rate is 8%, and the market risk premium is 4%. Using the data for Sallie’s Sandwiches and the compressed adjusted present value model, what is the appropriate rate for use in discounting the free cash flows and the interest tax savings?

		12.0%
		13.9%
		14.4%
		16.0%
		16.9%

6 points

Question 24

 Glassmaker Corporation has a current capital structure consisting of $5 million (market value) of 11% bonds and $10 million (market value) of common stock. Glassmaker’s beta is 1.36. Glassmaker faces a 40% tax rate. Glassmaker plans on making big changes in operation and capital structure during the next several years. (Its tax rate will remain unchanged.) Under these plans, the free cash flows for Glassmaker are estimated to be $3.0 million for each of the next 4 years; the horizon value of the free cash flows (discounted at the rate assumed by the compressed adjusted present value (CAPV) approach) is $10.0 million at Year 4. The estimated tax savings due to interest expenses are estimated to be $1 million for each of the next 4 years; the horizon value of the tax shields (discounted at the rate assumed by the CAPV approach) is estimated to be $5 million at Year 4. Glassmaker has no nonoperating assets. Currently, the risk-free rate is 6.0% and the market risk premium is 4.0%. Refer to data for Glassmaker Corporation. According to the compressed adjusted present value model, what discount rate should you use to discount Glassmaker’s free cash flows and interest tax savings?

		10.01%
		10.06%
		11.29%
		11.44%
		13.49%

6 points

Question 25

 Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. Refer to data for Kitto Electronics. According to the compressed adjusted present value model, what is Kitto’s unlevered value?

		$1,296,000
		$1,440,000
		$1,600,000
		$1,760,000
		$1,936,000

6 points

Question 26

 Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

		The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
		The horizon value is calculated by discounting the expected earnings at the WACC.
		The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
		The horizon value must always be more than 20 years in the future.
		The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

6 points

Question 27

 In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

		True
		False

6 points

Question 28

 The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm’s operations if it had no debt.

		True
		False

6 points

Question 29

 Which of the following statements is most CORRECT?

		The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
		Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
		Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what’s probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
		Operating economies are never a motive for mergers.
		Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

6 points

Question 30

 Holland Auto Parts is considering a merger with Workman Car Parts. Workman’s market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Workman’s required rate of return on equity be after it is acquired?

		7.4%
		8.9%
		9.3%
		9.6%
		9.7%

6 points

Question 31

 Which of the following statements is most CORRECT?

		A defensive merger is one where the firm’s managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover.
		Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition.
		Cash payments are used in takeovers but never in mergers.
		Managers often are fired in takeovers, but never in mergers.
		If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

6 points

Question 32

 Which of the following statements is most CORRECT?

		Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm’s capital structure, it will not affect its overall required rate of return.
		The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis.
		In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms.
		The primary rationale for most operating mergers is synergy.
		The acquiring firm’s required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

6 points

Question 33

 Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT?

		The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
		The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
		The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
		The CAPV approach stands for the accounting pre-valuation approach.
		The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

6 points

Question 34

 Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers expects Fast Fruit’s NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Fast Fruit is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Fast Fruit will need $10 million of net new investment in operating capital. Fast Fruit’s marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Fast Fruit to Juicers will both grow at a constant rate of 4%. Juicers has determined that Fast Fruit’s cost of equity is 17.5%, and Fast Fruit currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Juicers must pay $45 million to acquire Fast Fruit. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Juicers of Fast Fruit’s equity.

		$45.0 million
		$68.2 million
		$86.5 million
		$113.2 million
		$133.0 million

6 points

Question 35

 Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses.

		True
		False

6 points

Question 36

 A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?

		Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
		Purchase principal only (PO) strips that decline in value whenever interest rates rise.
		Enter into a short hedge where the bank agrees to sell interest rate futures.
		Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.
		Buying inverse floaters.

6 points

Question 37

 Which of the following statements is most CORRECT?

		Futures contracts generally trade on an organized exchange and are marked to market daily.
		Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
		There are futures contracts for currencies but no forward contracts for currencies.
		Futures contracts don’t have any margin requirements but forward contracts do.
		One advantage of forward contracts is that they are default free.

6 points

Question 38

 A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?

		The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
		Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
		A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
		A company can swap fixed interest payments for floating interest payments.
		A swap involves the exchange of cash payment obligations.

6 points

Question 39

 Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. What is the implied annual interest rate inherent in the futures contract?

		6.86%
		7.22%
		7.60%
		8.00%
		8.40%

6 points

Question 40

 Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

		True
		False

6 points

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