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a. 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.
b. 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.
c. 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.
d. 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 whats probably a lower cost,
diversification benefits are generally not a valid motive for a publicly held firm.
ANS: D PTS: 1 DIF: MEDIUM REF: 696698 | 706707
OBJ: (24.1 and 24.8) Merger motivation and setting the bid price
BLM: Higher Order
14. Which statement best describes mergers?
a. The purchase of Red Lobster Restaurants initiated by Remax Realty is an example of
conglomerate mergers.
b. A merger can be blocked either by a firms customers or its suppliers, not the government.
c. The existence of golden parachutes is a reason that the management of a target company
tries to block a takeover.
d. In a hostile takeover, the target companys management makes a tender offer asking its
shareholders to sell their shares to the acquiring company.
ANS: A PTS: 1 DIF: MEDIUM REF: 698701
OBJ: (Comp. 24.2, 24.4) Aspects of mergers BLM: Higher Order
19. Kelly Tubes is considering a merger with Reilly Tires. Reillys market-determined value is $3.75 million,
and Kellys market value as a stand-alone company is $4.50 million. Both firms are all equity-financed.
Kelly acquires Reilly for $4.25 million because it believes the combined firm value will increase to $9.25
million. What will the synergy from this merger be?
a. $0.50 million
b. $1.00 million
c. $4.75 million
d. $5.00 million
ANS: B
Given combined firm value VK + R = $9.25m, stand-alone values of VK = $4.5m and VR = $3.75m, synergy
= V = 9.25 (4.5 + 3.73) = $1 million.
ANS: A
The net benefit of a merger to the acquirer is synergy minus premium paid for the target. With premium =
$11,500 $10,000 = $1,500, and synergy = $30,000 $15,000 $10,000 = $5,000, merger benefit
(NPV) = $5,000 $1,500 = $3,500.
22. Brau Auto, a national auto parts chain, is considering purchasing a smaller chain, South Georgia Parts
(SGP). Braus analysts project that the merger will result in the following incremental free cash flows, tax
shields, and horizon values:
Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32
Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate
of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current
$15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would
remain the same. SGPs pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free
rate is 8% and the market risk premium is 4%. What is the value of SGP to Brau?
a. $53.40 million
b. $61.96 million
c. $64.59 million
d. $76.96 million
ANS: C
rsL = rRF + b(RPM) = 8% + 2.0(4%) = 16%
WACC = wdrd (1 T) + wsrs = 0.30(10%)(1 34%) + 0.70(16%) = 13.18%
Since all of the cash flows are to be discounted at the same rate, we dont need to separately calculate the
values of the tax shield and unlevered value of operations. We can simply add the tax shields and free
cash flows together each year to input in the financial calculator:
Some students will calculate separately the value of the tax shield and the unlevered value of
operations and add them together. In that case, the separate calculations are:
Value of operations = Value of tax shields + Unlevered value of operations = $55.23 + $24.36 =
$79.59 million.
FCFE: Year 1 = $9 million, Year 2 = $25 $10 $5(1 40%) = $12 million, HV = [$25 $5(1
40%)](1 + 4%) / (17.5% 4%) = $169.48 million
Scenario Maritime
TV Emporium, a national retailer of flat panel screens, is investigating an opportunity to purchase
Maritime TV and Sound Inc. An acquisition is expected to lower overhead costs, improve distribution
efficiencies, and improve ordering volumes from the major manufactures. If those improvements
(synergies) are implemented, TV Emporium financial staff estimates the following incremental net cash
flows to be $5 million, $5.6 million, and $6.9 million for the first three years. Cash flows would grow at
3% thereafter. Maritime TV and Sounds tax rate is 30%. Its cost of equity is 10%.
30. Refer to Scenario Maritime. What is the horizontal value of Maritimes operation as of year 3?
a. $101.53 million
b. $98.57 million
c. $86.66 million
d. $71.07 million
ANS: A
.
31. Refer to Scenario Maritime.What is the highest price TV Emporium pays for Maritime?
a. $67.75 million
b. $76.28 million
c. $81.10 million
d. $90.64 million
ANS: D
14.Based on the corporate valuation model, the value of a companys operations is $900 million. Its balance
sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term
investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes
payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings,
and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what
is the best estimate of the stocks price per share?
a. $23.00
b. $25.56
c. $28.40
d. $31.24
ANS: C
Value of operations: $900
Short-term investments: $30
Notes payable: $110
Long-term debt: $90
Preferred stock $20
Shares outstanding: 25
Assuming that the book value of debt is close to its market value, the total market value of the company
is:
= +
= $900 + $30 = $930
Value of Equity = Total MV - Long- and Short-term debt and preferred = $710
Stock price = Value of Equity/Shares outstanding = $28.40
The book values of equity figures are irrelevant for this problem. Also, the working capital account
numbers are not relevant because they were netted out when the FCF was calculated.
16.Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of
capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as
from Year 2 to Year 3, what is the Year 0 value of operations, in millions?
Year: 1 2 3
Free cash flow: $20 $42 $45
a. $586
b. $617
c. $648
d. $680
ANS: B
Year: 1 2 3
Free cash flow: $20 $42 $45
WACC: 13%
First, find the growth rate: g = $45/$42 1.0 = 7.14%
7. Who or what is (are) the legal asset owner(s) behind home mortgage securitization?
a. special purpose vehicles (SPV)
b. individual investors
c. banks that originate the mortgages
d. Canada Mortgage and Housing Corporation (CMHC)
ANS: A PTS: 1 DIF: MEDIUM REF: 485
OBJ: (16.5) Securitization BLM: Remember
13. Orient Airlines common stock 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 2017. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
ANS: D
Stock price: $33.00 Coupon rate: 8.00%
Bond price: $850.00 Par value: $1,000.00
Conversion ratio: 25.00
Conversion value = Conversion ratio Stock price = $825
Total value = Straight-debt value + Warrant value = $1,000 = Bond value + $150
VB = $1,000 $150 = $850
Now set N = 20, I/YR = 10, PV = 850, FV = 1000 and solve for PMT: $82.38
To get this payment on a $1,000 bond, the coupon rate must be: 8.24%
PTS: 1 DIF: MEDIUM REF: 476 OBJ: (16.1) Bonds with warrants
BLM: Higher Order
18. Upstate Water Company just sold a bond with 50 warrants attached. The bonds have a 20-year maturity
and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar
straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
ANS: A
Bond par value: $1,000 No. of warrants: 50
Bond maturity: 20 Convertible coupon: 12.0%
Straight-debt yield: 15.0%
Find the straight-debt value: N = 20, I/YR = 15, PMT = 120, and FV = 1000. PV = $812.22
PTS: 1 DIF: MEDIUM REF: 476 OBJ: (16.1) Bonds with warrants
BLM: Higher Order
13
46.Pavlin Corp.s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity,
and its forecasted net income is $1,000,000. If the company follows a residual dividend policy, how much
will it pay in dividends or, alternatively, how much new stock must it issue?
a. Choice W
b. Choice X
c. Choice Y
d. Choice Z
ANS: D
Capital budget $2,000,000
% Equity 60%
Net income (NI) $1,000,000
Dividends: or new stock:
Dividends paid = NI - [% Equity(Cap. Bud)], stock issued if dividends zero or neg $0 $200,000
44. Sheehan Corp. is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of
stock. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per
share. It finances with debt and common equity, but it wants to avoid issuing any new common stock
during the coming year. Given these constraints, what percentage of the capital budget must be financed
with debt?
a. 32.15%
b. 33.84%
c. 35.63%
d. 37.50%
ANS: D
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS Shares outstanding = $1,500,000
Dividends paid = DPS Shares outstanding = $1,000,000
Retained earnings available $500,000
Capital budget - 2- Retained earnings = Debt needed $300,000
Debt needed/Capital budget = % Debt financing 37.5%
43.Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If
the firms total market value increased by 5% as a result of increased liquidity caused by the split, what
was the stock price following the split?
a. $24.00
b. $30.00
c. $31.50
d. $33.50
ANS: C
New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%
Post-split stock price = (P0/New per old)(% Value increase) $31.50
40. Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a
target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the
company follows the residual dividend policy, how much in dividends, if any, will it pay?
a. $42,869
b. $45,125
c. $47,500
d. $50,000
ANS: D
% Debt 30%
% Debt 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Cap Bud % Equity = $350,000
Dividends = NI - 2- Equity requirement = $50,000
36. Brooks Corp.s projected capital budget is $2,000,000, its target capital structure is 60% debt and 40%
equity, and its forecasted net income is $600,000. If the company follows a residual dividend policy, what
total dividends, if any, will it pay out?
a. $228,000
b. $216,600
c. $205,770
d. $0
ANS: D
Capital budget $2,000,000
% Equity 40%
Net income (NI) $600,000
Dividends paid = NI [% Equity(Capital Budget)] $0
33. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $150 per
share. The firms total market value was unchanged by the split. Other things held constant, what is the
best estimate of the stocks post-split price?
a. $50.00
b. $52.50
c. $55.13
d. $57.88
ANS: A
Number of new shares 3
Number of old shares 1
Pre-split stock price $150
Post-split stock price: P0/New per old = $50.00
34. Ting Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35%
debt and 65% equity, and it also wants to pay a dividend of $400,000. If the company follows a residual
dividend policy, how much net income must it earn to meet its capital budgeting requirements and pay the
dividend, all while keeping its capital structure in balance?
a. $904,875
b. $952,500
c. $1,000,125
d. $1,050,131
ANS: B
Capital budget $850,000
Equity ratio 65%
Dividends to be paid $400,000
Required net income = Dividends + (Capital budget % Equity) $952,500
30.Pate & Co. has a capital budget of $3,000,000. The company wants to maintain a target capital structure that
is 15% debt and 85% equity. The company forecasts that its net income this year will be $3,500,000. If
the company follows a residual dividend policy, what will be its total dividend payment?
a. $205,000
b. $500,000
c. $950,000
d. $2,550,000
ANS: C
The amount of new investment that must be financed with equity is
$3,000,000 85% = $2,550,000.
Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 $2,550,000 will be left for
dividends.
Cap stru
2.Business risk is affected by a firms operations. Which of the following is NOT associated with (or does not
contribute to) business risk?
a. demand variability
b. input price variability
c. the extent to which operating costs are fixed
d. the extent to which interest rates on the firms debt fluctuate
D
31. Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual
sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors royalties are
reduced, the variable cost per book will drop by $1. Assume authors royalties are reduced and sales
remain constant; how much more money can the publisher put into advertising (a fixed cost) and still
break even?
a. $600,000
b. $466,667
c. $333,333
d. $200,000
ANS: D
$7(200,000) - $5(200,000) - F = 0; F = $400,000
$7(200,000) - $4(200,000) - F = 0; F = $600,000
$600,000 - $400,000 = $200,000.
5. Which of the following statements best describes WACC?
a. Since debt financing raises the firms financial risk, increasing a companys debt ratio will
always increase its WACC.
b. Since debt financing is cheaper than equity financing, raising a companys debt ratio will
always reduce its WACC.
c. Increasing a companys debt ratio will typically reduce the marginal cost of both debt and
equity financing. However, this action still may raise the companys WACC.
d. Increasing a companys debt ratio will typically increase the marginal cost of both debt
and equity financing. However, this action still may lower the companys WACC.
ANS: D PTS: 1 DIF: EASY REF: 364366
OBJ: (12.2) Capital structure and WACC BLM: Understand
49. Vafeas Inc.s capital structure consists of 80% debt and 20% common equity, it has a beta of 1.60, and its
tax rate is 35%. However, the CFO thinks the company has too much debt, and he is considering moving
to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk
premium is 6.0%. By how much would the firms cost of equity change as a result of altering its capital
structure?
a. 5.20%
b. 5.78%
c. 6.36%
d. 6.99%
ANS: B
bL = 1.60
Current Debt% 80%
Target Debt% 40%
Current D/E = D%/(1 D%) 4.00
Target D/E = D%/(1 D%) 0.67
Tax rate = 35%
bU = bL/(1 + (D/E)(1 T)) 0.4444
new bL = bU (1 + (D/E) (1 T)) 0.6370
rRF = 5.00%
RPM 6.00%
rs 80% D = rRF + b80% D(RPM) = 14.60%
rs 40% D = rRF + b40% D (RPM) = 8.82%
Change in equity cost 5.78%
29.Which of the following statements is correct?
a. If corporate tax rates were decreased while other things were held constant, and if the
ModiglianiMiller tax-adjusted trade-off theory of capital structure were correct, this
would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms capital structure decisions.
c. Business risk is differentiated from financial risk by the fact that financial risk reflects
only the use of debt, while business risk reflects both the use of debt and such factors as
sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the
firms stock, (2) minimizes its WACC, and (3) maximizes its EPS.
ANS: A PTS: 1 DIF: MEDIUM | HARD
REF: 383385 OBJ: (12.8) Miscellaneous capital structure concepts
BLM: Evaluate
30. Which of the following statements is correct?
a. Generally, debt-to-total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are
more volatile than those of firms in most other industries.
c. Prescription drug companies generally have high debt-to-equity ratios because their
earnings are very stable, and therefore they can cover the high interest costs associated
with high debt levels.
d. Wide variations in capital structures exist both between industries and among individual
firms within given industries. These differences are caused by differing business risks and
also managerial attitudes.
ANS: D PTS: 1 DIF: HARD REF: 381383
OBJ: (12.7) Variations in capital structures BLM: Evaluate