Financing and Bankruptcy: Understanding Cash Flows, Pecking Order, and Tax Implications - , Exams of Corporate Finance

Download Financing and Bankruptcy: Understanding Cash Flows, Pecking Order, and Tax Implications - and more Exams Corporate Finance in PDF only on Docsity! _______________________________________________ FIN 3154, Exam 2, Easterwood June 22, 2007 Instructions: 1. For each problem, first write down the formula or equation that you will use to solve the problem using the variable notation. Next, fill in the equation with the numbers given in the problem. Then solve it, and indicate your answer. Please write time lines for cash flows where appropriate. Do not write keystrokes down for your calculator. 2. Show as much of your work as you can. 3. For short answer questions, you may write answers in bullet or outline format as well as in paragraph form. 4. Do not look at another student’s paper. 5. DO NOT talk about this exam with classmates who have not yet taken it. 6. The test is closed note and closed book. You may use only the formula sheet that I have provided and a financial calculator. 7. The Honor Code is in effect. Please sign the pledge below stating that you have neither given nor received help from another student in completing this test. Signature __________________________________ 3 points each 1. According to the pecking order view of financial structure, the preferred type of financing a firm would want is A. preferred stock B. internal equity C. external (common) equity D. debt 2. Default happens when A. a borrower is having difficulty generating enough cash to make the scheduled payments of principal and interest. B. the value of a firm’s assets are less than the present value of the payments that it owes to its creditors. C. a borrower fails to make a scheduled payment of either principal or interest. D. a borrower seeks court protection from its creditors following a missed payment. 3. Debtor-in-possession financing (DIP financing) refers to A. describes the ranking of debt holders in bankruptcy proceedings. B. is the term used to describe debt that has been replaced through a Chapter 11 reorganization. C. is the term used to describe whether a debt instrument has collateral or not. D. refers to debt that is issued by firms under bankruptcy protection so that they can finance their working capital. 4. In bankruptcy filings, A. a majority of firms end up liquidating to resolve the claims of creditors. B. the federal bankruptcy courts requires that the bankrupt firm immediately pay the outstanding principal to all creditors upon filing for protection. C. firms no longer have access to any additional financing after a bankruptcy filing which leads the firm to shut down in a short period of time. D. liquidations always follow the absolute priority rule. 5. In evaluating investment projects for firms, which of the following is incorrect? A. the IRR method gives equivalent rankings to the NPV and profitability index for mutually exclusive projects. B. the NPV and profitability index both assume that cash flows can be reinvested at the required return for the project. C. you should not incorporate cash flows from financing because the cost of financial resources is reflected in the required return. D. the IRR method, the profitability index method, and the NPV method will all lead to the same ranking of independent projects. 6. Chapter 7 A. is the legal status of firms seeking a workout agreement with their lenders. B. contains procedures to follow during a firm’s liquidation. C. contains procedures to follow during a firm’s reorganization. D. is a set of procedures that firms in financial distress use to avoid default. 16. Consider a project with the following cash flows: -$1,500 at time 0, -$500 at time 1, +$500 at time 2, +$1,200, and +$2,500 at time 4. If the required return is 12%, find the straight payback, the NPV, and the profitability index? For the NPV and PI, indicate whether or not you would undertake the project. (18 points) Payback: CF0 + CF1 = -$2,000 CF0 + CF1 + CF2 = -$1,500 CF0 + CF1 + CF2 + CF3 = -$300 CF0 + CF1 + CF2 + CF3 + CF4 = $2,200 Payback = 3 + ($300/$2,500) = 3.12 years 10895 121 5002 121 2001 121 500 121 500 5001 432 .$ ).( ,$ ).( ,$ ).( $ ).( $ ,$NPV    ACCEPT   ACCEPT,.. ,$ .,$ ),$( ] ).( ,$ ).( ,$ ).( $ ).( $ [ CF )r( CF PI T t t t 0159671 5001 103952 5001 121 5002 121 2001 121 500 121 500 1 432 0 1                       17. With reference to the trade-off view of financing mix, what kind of mix would you expect for a firm with few assets in place, a small and very unpredictable cash flow from operations in the current and recent time periods, and a relatively large number of potentially valuable future investments opportunities? Explain your answer and make reference to tax considerations, the incentive effects of debt, and the costs of financial distress. (12 points) Considerations: (i) firms with low internal funds and many valuable investment projects already have plenty of incentives to manage assets to achieve the highest long-run cash flow from operations and to make value maximizing investment decisions. Firms with these characteristics don’t need substantial debt to manage themselves to maximize value. (ii) with a small cash flow from operations there isn’t much income to shield so this firm does not need a lot of interest tax shields to protect income from taxation. Thus this firm probably has a limited need for debt. (iii) a firm with few assets in place, low current CFO, and many positive NPV projects will likely have a large part of its value come from growth prospects. Firms with this profile will have high costs of financial distress because bankruptcy costs could be high and because there is a significant chance that the firm will face distress. In a state of distress, a firm like this might depart from the NPV rule in making its investment choices. Since a large part of the firm’s value comes from investment opportunities, departures from the NPV rule could substantially reduce firm value. Weighing these considerations against each other suggests that this firm has limited benefits to leverage and potentially large costs. Thus this firm is likely to use a relatively small % of debt and finance with mostly equity. 18. You need to produce diggle bricks. There are two different diggle brick-making machines available. The Deluxe Brick Maker will cost you $45,000 today and have annual operating and maintenance expenses of $5,000. These expenses are tax deductible, your required rate of return is 12%, and your tax rate is 30%. You plan to depreciate this project over 3 years for tax purposes using straight line depreciation and no salvage value. Depreciation is also tax deductible. (a) What is the equivalent annual cash flow for the Deluxe Brick Maker? (13 points) 3 cash flows: initial investment (-), annual operating expenses (-), and depreciation tax shields (+) Annual operating expenses: 414068401823010005 1 1 1 3 1 0 .,$.*).(*,$ )r( *)T(*Cost .OperPV t tC      PV of tax shields:      3 10 1080810401823000015 121 1 00015 t tC .,$.*).*,($).( *)T*,($PV PV of all cash flows = -$15,000 + (-$8,406.41) + ($10,808.10) = -$42,598.20 EAC = PV of all cash flows/AF(r,T) = -$42,598.20/2.4018 = -$17,735.95 (b) Your alternative investment is in the machine made by Price’s Fork Technologies which has an expected life of 6 years. If the equivalent annual cash flow for the PFT machine is -$21, 902.58, which machine should you use? (3 points) Pick the least costly machine. PVPFT = -$21, 902.58 vs PVDBM = -$17,735.95 Choose DBM