Fin 414 sample exam #1 (this is an old exam of the instructor from a previous semester)

Your exam will have 50 questions! Most questions will be MC but some short answer or essay questions may occur!
Be sure you do the following before taking the exam:
1. Go back to PS1 & PS2 be sure you understand all Q&A
2. Be sure you understand all Q&A in the sample exam
3. Be sure you read the textbook
4. Be sure you have reviewed the lecture notes
5. There will be no case questions on the exam

Correct answer

1.Which type of bond is a city or state most likely to use as a means of offsetting its cost of damages
caused by a hurricane?
a.Convertible bond
b.Sustainability bond
c.Cat bond
d.Put bond
e.CoCo bond

2.A ________ is when a group other than the current management team solicits the authority to vote
shares as part of an effort to replace the current management team.
a.proxy fight
b.stockholder derivative action
c.tender offer
d.vote of confidence
e.seniority turnover

3.Which type of bond grants the bondholder the right to force the bond’s issuer to repay the bond at a
stated price given that a certain situation(s) occurs?
a.Put bond
b.Cat bond
c.NoNo bond
d.Income bond
e.Warrant bond

4.Why might a firm prefer to issue cumulative preferred stock rather than?
a.If there is no current taxable income, preferred stock dividends are automatically voided.
b.Preferred stock has no voting rights but debt does.
c.Preferred dividends provide a tax shield but debt does not.
d.Corporate investors can receive a tax break on dividends received.
e.Dividend payments are tax deductible, interest on debt is not.

5.Duncan owns 100 percent of a gift shop with an equity value of $150,000. If he keeps the shop open 5
days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to $92,000
annually. Duncan needs an additional $50,000 which he can raise today by either selling stock or issuing
debt at an interest rate of 7 percent. The principal amount would be repaid in equal annual payments at
the end of the next five years. Ignore taxes. What will be the cash flow for the next year to Duncan if he
issues stock to another individual, remains open 6 days a week, and distributes all the residual cash flow
to the shareholders?
a.$58,750
b.$61,333
 c.$92,000
d.$42,000
e$69,000

Cash flow to Duncan = $92,000[($150,000)/($150,000 + 50,000)]

Cash flow to Duncan= $69,000

6.Assume Johnson Enterprises is indifferent between issuing equity and issuing debt. The corporate tax
rate is 21 percent and dividends are taxed at the personal level at 20 percent. What is the personal tax on
interest income?
a.20 percent
b.42 percent
c.40 percent
d.14 percent
e.37 percent

(1 − TB) = (1 − TC)(1 − TS)

(1 − TB) = (1 − .21)(1 − .20)
TB = .37, or 37%

7.Bloomdahl and Hansen owes $96 to its bondholders for the payment of principal and interest. The
company expects to have a cash flow of $224 if the economy continues to be normal, but $88 if the
economy enters a recession. If the company ever faces the real possibility of bankruptcy, it will incur legal
and other fees of $22. What amount will the bondholders be paid in the case of a recession?
a.$22
b.$96
c.$88
d.$0
e.$66

Bondholder payment = $88 − $22

Bondholder payment = $66

8.Rachel owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop open 5
days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to $92,000
annually. Rachel needs an additional $50,000 which she can raise today by either selling stock or issuing
debt at an interest rate of 7 percent. The principal amount would be repaid at the end of the fifth year.
Ignore taxes. What will be the cash flow for this year to Rachel if she issues debt, remains open 6 days a
week, and distributes all the residual cash flow to the shareholders?
a.$46,125
b.$88,500
c.$65,000
d.$71,500
e.$81,500

Cash flow to Rachel = $92,000 − .07($50,000)

Cash flow to Rachel = $88,500

9.A 40 percent owner of Park Medical Group is electing to retire. The other shareholders in this closely
held, all-equity firm have agreed that the firm will borrow $1.8 million to purchase the retiring owner’s
3,000 shares of stock. Ignoring taxes, what is the total value of this firm?
 a.$4.8 million
b.$4.5 million
c.$5.4 million
d.$3.0 million
e.$6.0 million

Firm value = $1.8 million/.40

Firm value = $4.5 million

10.Of the following statements about preferred stock, which one is correct?
a.Unlike dividends paid on common stock, dividends paid on preferred stock are a tax-deductible
expense.
b.Dividends on preferred stock payable during the next twelve months are considered to be a
corporate liability.
c.If preferred dividends are non-cumulative, then preferred dividends not paid in a particular year will
be carried forward to the next year.
d.There is no significant difference in the voting rights granted to preferred and common
shareholders.
Preferred stock usually has a stated liquidating value of $100 per share.

11.Ideally, corporations try to create securities that have the tax benefits:
a.of equity but the bankruptcy benefits of debt.
b.and bankruptcy benefits of debt.
c.and bankruptcy benefits of equity.
d.of debt and the equity benefits of dividends.
e.of debt but the bankruptcy benefits of equity.

12.Since 1975, U.S. nonfinancial corporations have tended to have debt-equity ratios that are:
a.steadily rising due to the low interest rate environment.
b.less than 1.0.
c.averaging in the .8 to .9 range.
d.relatively stable over time.
e.relatively unaffected by stock market movements.

12.Butler and Butler has 200 shares of common stock outstanding at a market price of $37 per share. The
firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend growth rate of
4 percent. The firm also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at
99 percent of par. The bonds have a coupon rate of 6 percent and a yield to maturity of 6.7 percent. All
interest is tax deductible. If the tax rate is 21 percent, what is the weighted average cost of capital?
a.5.93%
b.6.87%
c.6.37%
d.6.54%
e.7.08%

Debt = 5($1,000)(.99)
Debt = $4,950

Common stock = 200($37)

Common stock = $7,400
Total debt and equity = $4,950 + 7,400
Total debt and equity = $12,350

RE = $1.20(1.04)/$37 + .04
RE = .07373, or 7.373%

WACC = ($7,400/$12,350)(.07373) + [($4,950/$12,350)(.067)(1 − .21)]

WACC = .0654, or 6.54%

13.Beta, Incorporated, has an overall cost of capital of 11.6 percent and a beta of 1.31. The firm is
contemplating a new project that is unrelated to the firm’s current operations. Omega Corporation is a firm
that operates similarly to the new project and Omega has a cost of capital of 10.7 percent. Beta knows
that it will be less efficient than Omega and thus feels that an adjustment of +1 percentage point should
be added to the project’s discount rate to allow for this inefficiency. What discount rate should be
assigned to the new project?
a.10.7%
b.11.3%
c.11.7%
d.11.6%
e.12.6%

The pure play approach applies, so:

RProject = .107 + .01

RProject = .117, or 11.7%

14.The expected net cash flows of Rebock Homes for the next three years are $42,000, $49,000, and
$64,000, respectively. After three years, the growth rate of the cash flows will be a constant 2 percent
annually. The WACC is 8 percent. What is the present value of the terminal value?
a.$881,822
b.$863,689
c.$959,259
d.$910,444
e.$828,406
PVTerminal value = [$64,000(1.02)/(.08 − .02)]/1.083
PVTerminal value = $863,689

15.A firm has an equity beta of 1.2, the risk-free rate is 3.4 percent, the market return is 15.7 percent, and
the pretax cost of debt is 9.4 percent. The debt-equity ratio is .47. If you apply the common beta
assumptions, what is the firm’s asset beta?
a..82
b..61
c..67
d..58
e.73
βAsset = (1/1.47)(1.2)
βAsset = .82

16.Dowecheatem & How Company has debt outstanding with a coupon rate of 4.5 percent and a yield to
maturity of 7.5 percent. What is the aftertax cost of debt if the tax rate is 22 percent? Assume all interest
is tax deductible.
 a.7.02%
b.3.51%
c.5.85%
d.2.93%
e.11.70%

RD = .075(1 − .22)
RD = .0585, or 5.85%

17. We argued in class that, on average, when a firm announces that it will issue debt stock price goes _____ . The
reasons for this result may involve ____________ and a _____________ value from a /an __________ in the tax
shield.
a. up, a positive signaling effect, positive , increase
b. down, negative signaling effect, negative, decrease
c. up, negative signaling effect, positive, increase
d. down, negative signaling effect, positive, increase
e. none of the above

18. A Fallen Angel is?

a. A junk bond such the company previously had an investment grade bond rating
b. An equity security that now has negative book value
c. An investment that has gone sour
d. A bond that is in default
e. none of the above

19. In the Marriott case we argued that repurchasing shares when the stock price was less than warranted equity
value was ____________.
(a) a bad idea if Marriott was using only public information in its calculations
b. consistent with the efficient market hypothesis (semi-strong form) if managers have better information than
outside investors
c. consistent with the efficient market hypothesis (strong form) if managers have better information than outside
investor
d. inconsistent with the EMH
e. “a” and “b”
f. “a” and “c”

20. In the Marriott case, when Marriott attempts to calculate a discount rate for a new restaurant we recommended
that they use:
(a) the estimated overall weighted-average-cost-of-capital for the entire Marriott corporation which we calculated
to be 11.94%
(b) the risk-free interest rate
(c) the expected return on the market
(d) none of the above

21. In the Marriott case, we suggested that the beta of the assets in the contract service division of the firm could be
estimated
(a) in the same manner as the cost of capital in the hotel division of the firm
(b) by utilizing portfolio theory and the beta of assets in the other divisions
(c) by averaging the asset betas from the other divisions in Marriott
(d) None of the above

22. In a M&M world with no taxes or bankruptcy risk if two firms have identical assets and identical expected
future EBIT if VL>VU then investors will buy shares in the _______ and sell shares in the __________ until VL=VU.
a. unlevered, levered
b. levered, unlevered
c. None of the above

23. Modigliani and Miller’s Proposition 2 in a world with no taxes or financial distress costs states that _________.
a. the total value of a firm’s bonds is independent of capital structure
b. the total value of the sum of all of a firm’s securities is independent of capital structure
c. a firm’s rwacc is increases when the debt equity ratio increases
d. None of the above

24. According to the Modigliani and Miller theory with corporate taxes but no personal taxes or financial distress
costs which of the following is true?
a. the weighted average cost of capital decreases as a firm increases its debt-equity ratio
b. total tax revenues to the IRS increase as a firm increases its debt-equity ratio
c. total firm value is independent of capital structure
d. a and b
e. b and c
f. a and c
g. a and b and c

25. Homemade leverage is a term used to describe:

(a) a firm borrowing at the risk-free rate
(b) individuals borrowing on their own account to buy shares in an unlevered firm
(c) individuals borrowing on their own account to buy shares in a levered firm
(d) a type of homemade lemonade with a slightly bitter taste
(e) None of the above

26. The expected return on a firm’s stock is 15% and currently the firm has no debt. The firm is contemplating
changing its debt-equity ratio to 1.0. There are no corporate or personal taxes and the risk-free interest rate is 5%.
Under the new capital structure rWACC will equal ________.
(a) 10.0%
(b) 12.5%
(c) 15.0%
(d) 20.0%
(e) 25.0%

27. no computation necessary r0 = WACC

28. A firm currently operates in industry A and it is considering starting a division that operates in industry B. In
calculating the NPV of entering this new industry, the firm should use _________ as the discount rate.
a. the firm’s current rwacc
b. an estimate of rwacc calculated using data from other firms operating in industry A
c. an estimate of rwacc calculated using data from other firms operating in industry B
d. the firm’s borrowing rate rdebt

29. Which of the following is a problem in estimating the beta on a firm’s stock?
a. betas can vary over time
b. there may be insufficient data to estimate beta precisely
c. a and b

30. In using the formula for the weighted average cost of capital (rwacc), we argued that one should use _________.
a. the book value of debt and the book value of equity always
b. the market value of debt and the market value of equity always
c. the book value of debt and the book value of equity only when these are greater than the corresponding market
values, otherwise use market values
31. A firm’s current debt-equity ratio is 3.0. The firm’s borrowing rate is 10% and the expected return on the firm’s
stock is 30%. The corporate tax rate is .40. What is this firm’s weighted average cost of capital?
a. 12%
b. 15%
c. 17%
d. 18%
e. 20%
f. 30%
g. 36%

WACC = .75(.1)(1-.4) + .25(.3) = 12%

32. A firm currently has $50 million in stock and $50 million in bonds and the beta on the firm’s stock is currently
estimated to be 1.0. If the firm changes its capital structure so that is has $25 million in stock and $75 million in
bonds, what will the new beta on the firm’s stock be? There are no taxes.
a. 12.0
b. 21.0
c. 11.5
d. 12.0
e. 12.5

equity = [1 + (1-TC)Debt/Equity]unlevered
4.0 = [1+(1-0)1]Bu Bu = 2.0 new D/E = 75/25 = 3
Be=[1+(1-0)3](3) = 12

33. A firm currently has no debt and its equity has a beta of -.5. The risk-free rate is 3% and the market risk
premium is 7%. The corporate tax rate is 40%. What is this firm’s rwacc?
a. 3%
b. 6.5%
c. .5%
d. -.5%
e. none of the above
WACC = re=3% - .5(7%) = -.5%

34. A firm currently has $25 million in stock outstanding and $75 million in bonds outstanding. There are no
corporate taxes, no personal taxes and no financial distress costs. If a firm announces it is selling $15 million in
bonds and using the proceeds to repurchase shares, what will be the total value of the firm’s stock after the
transaction is complete?
a. $10 million
b. $11.5 million
c. $100 million
d. $18.5 million
e. $20 million
f. $25 million

25-15=10

35. A firm currently has $25 million in stock outstanding and $75 million in bonds outstanding. The corporate tax
rate is 35% and there are no personal taxes and no financial distress costs. If a firm announces it is selling $10
million in bonds and using the proceeds to repurchase shares, what will be the total value of the firm’s stock after
the transaction is complete?
a. $10 million
b. $11.5 million
c. $15 million
d. $18.5 million
e. $20 million
f. $25 million

25M – 10M + (.35)(10M) = 18.5

36. A firm currently has $50,000 in debt outstanding and $450,000 in equity outstanding. The interest rate on the
outstanding debt is 10% and the corporate tax rate is 35%. If the firm sells $50,000 in stock and uses the proceeds to
repurchase all of the outstanding debt, by how much will the firm’s income tax bill in the following year change?
(a) no change
(b) tax bill will increase by $350
(c) tax bill will decrease by $350
(d) tax bill will increase by $700
(e) tax bill will decrease by $700
(f) tax bill will increase by $1,750
(g) tax bill will decrease by $1,750

(50,000)(.1)(.35) = 1,750

37. A firm currently has 100 shares outstanding and the market price of each share is currently $10. The firm
announces it will be issuing $300 in stock and using the proceeds to Bonds. The corporate tax rate is 30% and there
are no personal taxes or financial distress costs. When the announcement of this financial change becomes public
we expect the stock price to __________.
a. not change
b. decrease to $9.00
c. decrease to $9.10
d. increase to $10.90
e. increase to $11.00

10 – (.3)(300)/100 = 9.10

38. From the perspective of the typical CEO, CFO, changes in personal tax rates are rarely a problem to worry about
because such changes have little effect on the typical firm:
(a) True
(b) False

39. The agency costs of equity include?

a. The over-investment in risk assets
b. The under-investment in safe projects
c. a and b
d. None of the above

40. When a firm announces that it will issue debt the stock price usually __________ because ________.
a. up; of a positive signal regarding future firm cash flows
b. down; of a negative signal regarding future firm cash flows
c. up; of an increase in the debt tax shield
d. down; of an increase in the debt tax shield
c. a and c
d. unkown; b and c are true
e. b and d

41. The violation of a bond indenture agreement almost always produces a legal challenge from the bondholder of a
publicly held company
(a) true
(b) false
42. The legal and accounting fees arising from bankruptcy proceedings are part of the _________ costs of financial
distress while the propensity for firms near bankruptcy to take on excessive risks are part of the ________ costs of
financial distress.
a. direct, direct
b. indirect, direct
c. direct, indirect
d. indirect, indirect

43. The Ex-Ante costs of bankruptcy are borne principally by___________ and the Ex-Post costs are borne
by______________:
(a) Bondholders, Stockholders
(b) Stockholders, Bondholders
(c) Stockholders, Stockholders
(d) Bondholders, Bondholders
(e) The IRS, Bondholders

44. By adding covenants to a bond agreement, we expect that the bonds will __________ and thus shareholders
_____________.
a. sell for a higher amount, are willing to agree to the covenants
b. sell for a lower amount, are willing to agree to the covenants

45. A benefit of debt financing is that ____________.

a. ownership will be concentrated in the hands of managers and thus they have an incentive to work harder
b. firms have an incentive to take on excessive risks
c. firms will underinvest in safe projects
d. the return on a firm’s stock will increase thus making the stock more valuable
e.none of the above

46. A firm currently has no debt and its equity has a market value of $200 million. The firm is contemplating
selling $20 million in bonds and using the proceeds to repurchase shares of stock. The corporate income tax rate is
30%, the effective personal tax rate on equity income is 10%, and the personal income tax rate on interest income is
40%. Given these tax parameters, what should be the total value of the firm after the repurchase is complete?
(a) $190 million
(b) $199 million
(c) $200 million
(d) $201 million
(e) $210 million
(f) $220 million

Vl = 200M + [1- (1-.3)(1-.1)/(1-.4)]20M = 199

47. If the capital gains tax rate increases while all other tax parameters are held constant, we expect the tax benefits
of debt financing to ________.
a. increase
b. decrease
c. remain unchanged
e.none of the above

48. A firm’s current equity value is 200 million and its current debt value is $2,000 million. The firm is
contemplating using $160 million of the firm’s cash and investing this cash in a very risky project. If the firm were
an all equity firm, the NPV of the project would be -$60 million (i.e., the project costs $160 million and generates a
cash flow down the road with a present value of only $100 million). If the firm undertakes the project, the bonds
will go down in value to $1,920 million. Do shareholders want the managers to take this project?
(a) no
(b) yes
Section 2- Long Answer Problems- Each of the 2 problems is worth 10 points. Show your work clearly as partial
credit will be awarded.

49. Here is some data for three firms in the hotel industry:

Hotel Firm #1: $300 million in debt, $600 million in equity, current estimated equity beta of 3.0
Hotel Firm #2: $600 million in debt, $600 million in equity, current estimated equity beta of 3.0
Hotel Firm #3: $900 million in debt, $300 million in equity, current estimated equity beta of 4.0

There are no corporate or personal taxes

a. For each Hotel Firm, calculate unlevered

b. Using your answer in part a. and the methods presented in the Marriott case, what would you predict the equity
beta to be for a firm in Hotel industry with $900 million in debt and $1,800 million in equity?

a. (2 points each answer)

Use the formula E = (1+(D/E)(1-Tc)) x unlevered
Firm 1: 3.0 = [1 + (300/600)] x unlevered  unlevered = 2.0
Firm 2: 3.0 = [1 + (600/600)] x unlevered  unlevered = 1.5
Firm 3: 4.0 = [1 + (900/300)] x unlevered  unlevered = 1.0

b. (4 points)
In the Marriott case we argued one should average the unlevered betas to arrive at a more precise estimate of a
typical unlevered beta in this industry. The average of 2.0, 1.5, and 1.0 is 1.5. Thus we will use this as our
estimate of the unlevered beta in this industry. We now need to “relever” the beta to reflect a debt-equity ratio
of 300/600.

Again using the formula: E = (1+(D/E)(1-Tc)) x unlevered

E = [1 + (900/1800)] x 1.5 = 2.25

So our predicted equity beta is 2.25.

50. A firm currently is an all equity firm with a market value of $200,000,000. The firm is contemplating
dramatically increasing its leverage by selling $50,000,000 in bonds and using the proceeds to repurchase equity.
The bonds promise a 10% interest payment at the end of each year. The bonds are structured so that the firm will
pay exactly $16,666,666.66 of the principal back at the end of the third year, sixth year, and ninth year, and thus the
bonds will be fully retired at the end of the ninth year. The corporate tax rate is 30% and there are no personal taxes.
What will the market value of the firm be the moment after this deal is announced?

We know that the market value of the firm will increase by the value of the tax shield. We generally value these
interest tax savings at the firm’s borrowing cost, which in this case is 10%.

Year 1 tax savings: .10 x 50,000,000 x .30 = 1,500,000

Year 2 tax savings: .10 x 50,000,000 x .30 = 1,500,000
Year 3 tax savings: .10 x 50,000,000 x .30 = 1,500,000
Year 4 tax savings: .10 x 33,333,333.33 x .30 = 1,000,000
Year 5 tax savings: .10 x 33,333,333.33 x .30 = 3,000,000
Year 6 tax savings: .10 x 33,333,333.33 x .30 = 3,000,000
Year 7 tax savings: .10 x 16,666,666.67 x .30 = 500,000
Year 8 tax savings: .10 x 16,666,666.67 x .30 = 500,000
Year 9 tax savings: .10 x 16,666,666.67 x .30 = 500,000

If you take these annual tax savings and discount them at a 10% annual rate, the total present value of the tax shield
on the debt is 6,300,568.33. Thus the market value should increase from $200,000,000 to $206,300,568.3

#2.
We know that the market value of the firm will increase by the value of the tax shield. We generally value these
interest tax savings at the firm’s borrowing cost, which in this case is 10%.

Year 1 tax savings: .10 x 50,000,000 x .30 = 1,500,000

Year 2 tax savings: .10 x 50,000,000 x .30 = 1,500,000
Year 3 tax savings: .10 x 50,000,000 x .30 = 1,500,000
Year 4 tax savings: .10 x 33,333,333.33 x .30 = 1,000,000
Year 5 tax savings: .10 x 33,333,333.33 x .30 = 3,000,000
Year 6 tax savings: .10 x 33,333,333.33 x .30 = 3,000,000
Year 7 tax savings: .10 x 16,666,666.67 x .30 = 500,000
Year 8 tax savings: .10 x 16,666,666.67 x .30 = 500,000
Year 9 tax savings: .10 x 16,666,666.67 x .30 = 500,000

If you take these annual tax savings and discount them at a 10% annual rate, the total present value of the tax shield
on the debt is 6,300,568.33. Thus the market value should increase from $200,000,000 to $206,300,568.3