Sample Final Exam Questions - Advanced Corporate Finance | FINA 7330, Exams of Corporate Finance

Download Sample Final Exam Questions - Advanced Corporate Finance | FINA 7330 and more Exams Corporate Finance in PDF only on Docsity! SAMPLE FINAL EXAM Name ________________________ Finance 7330 Social Security Number xxx-xx-____ Advanced Corporate Finance Fall, 2006 Ronald F. Singer You are to have no aids in this exam other than a calculator, pens and/or pencils. Cheating in this exam will not be tolerated.  Show all work. If I cannot see how you got to an answer you will get no credit even if the answer is correct.  The exam will run for 2 hours.  Anything you want me to read must be on the exam paper.  Carry all percentages (like returns) to two decimal places. (e.g. 15.32%)  No programmable calculators. If you have one, you will have to prove to me that you have erased the memory. 1. There are three basic theories of capital structure decisions: The irrelevance theorem, the static tradeoff theory and the pecking order theory. a. What is the difference between these three theories? b. Explain how managers would act differently if they believe in the static tradeoff theory versus the pecking order theory. c. What empirical evidence do you have regarding these theories and what theory do you think prevails in the real world? 2. Two important empirical regularities have been discovered with respect to the firm’s financing decision. a. Explain what these are and give theoretical reasons to explain them. b. Tell me what you would expect the stock price reaction to be for the following decisions, and how it relates to the above empirical regularities: (1) A repurchase of debt financed with a new equity issue. (2) A reduction in the dividend payout (3) The repurchase of common stock (4) Sale of a new debt issue. 3. Management of XYZ Corporation believes that long run earnings will be about $2.50 per share and it wants to payout about 40% of its long run earning in the form of a dividend. The firm’s “partial adjustment coefficient is .25. Currently its earnings are $2.00, and its dividend is $0.78. a) If expectations don’t change, predict its dividend payments in years 2007 through 2010. b) Suppose management revised its estimate of long run earnings to $2.25 as of the 2008 reporting period. Give the revised dividend announcements at 2008 and thereafter. c) Do you think that the stock price will increase, decrease or remain unchanged once the dividend is announced in 2008. Explain. 2006 2007 2008 2009 2010 Target Dividend >>>>> Actual Dividends 0.85 Permanent Earnings $2.50 $2.50 $2.50 $2.50 $2.50 Revised Permanent Earnings Estimate>>>> $2.25 $2.25 $2.25 Revised Target Dividend >>>>>>>>>>>>> Actual Dividends after the revision>>>>>> d) Why would you NOT recommend that dividends simply be 40% of earnings each quarter? e) If instead of paying a dividend you decided to repurchase shares, what impact would that have on the stock price and why? 4. What do you expect the stock price reaction to be of the following capital structure changes, and why: a. Issuance of a Convertible Debt b. Issuance of a new equity offering c. Call of an existing bond issue financed with new debt d. Call of an existing bond issue financed internally e. Exchange of a new debt issue for existing equity f. Repurchase of equity financed internally 5. Tubey Tools is considering investing in a profitable investment opportunity. Unfortunately, the firm is unable to finance the $3 million investment internally. It therefore will have to obtain the funds by issuing either debt or equity. In the most recent meeting of the Board of Directors, there were a number of suggestions made by the Board that may (or may not) help in making the decision. Currently the leverage ratio is 50% and the debt is yielding 5.3%, about comparable to the yield on A rated debt. Comment on each of these suggestions: NOTE: Assume a perfect capital market setting. a. Michael Mayberry: If we issue debt, this will impose additional risk on stockholders, as well as on the existing bondholders. As a result, the required return on both equity and debt will rise causing the Cost of Capital to increase, and thus a reduction in the value of the firm. b. Paul Musgrave: No, by issuing additional debt we are obtaining debt more cheaply compared to equity. In particular, we can obtain additional debt financing by paying a yield of 7.5%, whereas our stockholders require a return of over 25%. So, by using debt financing, the weighted average cost of capital will decrease, and thus the value of the firm will increase. (c) What do you expect to happen to the perceived value of a firm, if the firm announces that it will finance a new investment opportunity with a reduction in dividends? (d) What do you expect to happen to the perceived value of a firm, if the firm announces that it will finance a new investment opportunity with debt? (e) Explain why your answer to (c) differs from your answer to (d) 4. You are an advisor to the Board of XYZ Corporation. The Board members are concerned that the firm may be “over-leveraged”. About 15 years ago, the firm issued $600 million of long-term (30 year) debt at a coupon rate of 10%. At that time, the equity value of the Firm was $3 billion (So that its total value was 3.6 billion). However, due to a shift in demand and changing technology in the international widget industry, the firm’s equity value declined to only $300 million, and the market value of the debt has declined (due to increased risk) to $500 million. The debt is now priced to yield over 12.5% to maturity. What will you tell the Board regarding the following issues raised by some Board members; a. The increased yield to bondholders is hurting the stockholders. The firm should repurchase some of the debt so that the remaining debt will increase in value sufficiently to yield only about 10% again. b. By reducing leverage, we will be showing the stockholders that we remain conservative financially, and this will be rewarded by an increase in the value of the stock. c. There is currently so much debt in the capital structure that the possibility of bankruptcy is so high, stockholders are suffering because of the increased risk. d. The debt is good in that it is providing a tax shield which goes to the benefit of the stockholders. 5. You have a very profitable investment opportunity that will require $10 million initial investment, and has a net present value of $6 million, discounted at the standard cost of capital. You are considering issuing debt, issuing equity, or financing the investment internally, by eliminating the current dividend. Give the pros and cons of each source of financing possibility. Include both theoretical and empirical arguments in your analysis 6. The firm should not be concerned about the cost of financial distress because in general, this is borne by Bondholders not Stockholders. Explain why this statement is false. 11. Discuss the information implications of the following announcements. (a) A Firm announces an exchange of $10 million of equity for $10 million of debt. (b) A Firm announces a new equity issue to finance a new investment project (c) A Firm announces a new debt issue to finance a new investment project (d) A Firm announces an exchange of $10 million in debt to repurchase $10 million in equity. (e) A Firm announces a reduction in dividends to finance a new investment opportunity (f) A Firm announces a call of convertible debt as soon as the price of the equity reaches the conversion price. 12. As CFO of ASD International, you are considering a major restructuring that will substantially increase the firm’s leverage. Relevant financial information is given as follows: The Firm’s After Tax Free Cash Flow (FCFF) is expected to be $15 million over this year, and the firm expects this free cash flow to grow at a rate of 3% per year forever. There is no debt in the firm’s capital structure. The Corporate Tax Rate is 35% The firm’s equity Beta is 1 The Risk Free Rate is 3% The expected return on the market is 8.5% forever Find: (1) The firm’s Value (2) Stockholders’ Wealth Now suppose that you decide to establish and maintain a Leverage ratio (Debt to the total market value of the firm’s securities) of 50%. The new debt would carry a yield of 7%. Find: (1) The required return to equity (2) The firm’s WACC (3) The new value of the Firm (4) Stockholders’ wealth after the capital structure change. (5) The tax shield on the debt (6) The Costs associated with the debt issue. 13. It is well known that dividends impose additional taxes on investors that can be avoided if the firm retained more of its Free Cash Flow. Nevertheless on average, firms that announce unusual increases in dividends end up with higher stock prices. How do you explain this? 14. What do you think the impact of the following announcements will be on firm value? Explain fully (a) A debt for equity swap (that is reduced debt financed by an increase in equity). (b) A new equity issue used to finance a new investment project (c) A new equity issue used to finance a reduction in debt (d) The issuance of convertible debt 15. Suppose there is a firm XYZ Corporation with the following cash flows: Good State Bad State Cash Flow 6 1 Assume each state is equally likely, the Firm has a pure discount (zero coupon) bond with a promised payment of 5 maturing in one period. At the end of the period, the firm is liquidated and the claimants to the cash flow are paid. Assume perfect capital markets, and for simplicity that the world is risk neutral, and the riskless interest rate is zero . (a) What is the total value of the firm, the value of the equity and the value of the debt. Now suppose that the firm has two investment opportunities available to it. They can finance either, both, or none with debt that is Junior to the existing debt (That is, there is a bond indenture which forbids the firm from issuing debt which is senior to the existing debt). The projects are: Good State Bad State Cash Flow from Project A 4.2 3.8 Cash Flow from Project B 6.5 0 Each project would require an initial investment of 2.5 financed by junior debt (The firm cannot finance the investment internally). (b) What is the NPV of each project? (c) What would the promised payment to the Junior debt be to finance the project? (d) If the managers were acting in the interest of the Current Stockholders, what project(s) would the firm manangers take?