02/03/2011 FM212: Quiz to week 6 Lent

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FM212 - Principles of Finance
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Quiz to week 6 Lent

Review of attempt 1
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Started on Wednesday, 2 March 2011, 02:24 PM

Completed on Wednesday, 2 March 2011, 02:55 PM
Time taken 31 mins 17 secs
Grade 8 out of a maximum of 10 (80%)

1
Which of the following statements is false?
Marks: 1

Choose one a. If there were no costs of financial distress, the value of the firm would continue
answer. to increase with increasing debt until the interest on the debt exceeds the firm’s
earnings before interest and taxes and the tax shield is exhausted.

b. The costs of financial distress reduce the value of the levered firm, VL. The
amount of the reduction decreases with the probability of default, which in turn
increases with the level of the debt D.

c. The tradeoff theory states that firms should increase their leverage until it
reaches the level D* for which VL is maximized.

d. Firms with steady, reliable cash flows, such as utility companies, are able to
use high levels of debt and still have a very low probability of default.

Incorrect
Marks for this submission: 0/1.

2 The idea that managers who perceive the firm's equity is under-priced will have a preference to fund
investment using retained earnings, or debt, rather than equity is known as the
Marks: 1

Choose one a. lemons principle.

answer.
b. credibility principle.

c. pecking order hypothesis.

d. signaling theory of debt.

Incorrect
Marks for this submission: 0/1.

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3 The pecking order theory of capital structure predicts that:

Marks: 1
Choose one a. Firms prefer equity to debt financing
answer.
b. Risky firms will end up borrowing less

c. Risky firms will end up borrowing more

d. If two firms are equally profitable, the more rapidly growing firm will borrow
more, other things equal

Correct
Marks for this submission: 1/1.

4 The pecking order theory of capital structure implies that: I) Risky firms will end up borrowing more II)
Firms prefer internal finance III) Firms prefer debt to equity when external financing is required
Marks: 1

Choose one a. II and III only

answer.
b. III only

c. I only

d. II only

Correct
Marks for this submission: 1/1.

5
Use the information for the questions b elow.
Marks: 1
Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00, with 25 million shares
outstanding and no debt. Suppose that Big Blue Banana announces plans to lower its corporate taxes by
borrowing $100 million and using the proceeds to repurchase shares. Suppose that BBB pays corporate
taxes of 35% and that shareholders expects the change in debt to be permanent. Assuming that capital
markets are perfect except for the existence of corporate taxes, the share price for BBB after this
announcement is closest to:

Choose one a. $10.85

answer.

b. $8.60

c. $10.00

d. $11.40
V U = $10.00 × 25 million shares = $250 million

V L = VU + τ c B = $250 + .35($100) = $285 million / 25 million shares

= $11.40

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Correct
Marks for this submission: 1/1.

6 Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be
permanent. Assume that capital markets are perfect except for the existence of corporate taxes and
Marks: 1
financial distress costs. If the price of BBB's stock rises to $10.85 per share following the announcement
, then the present value of BBB's financial distress costs is closest to:

Choose one a. $21.25

answer. million

b. $11.40
million

c. $13.75
V U = $10.00 × 25 million shares = $250 million
million

V L = V U + τ c B = $250 + .35($100) = $285 million / 25 million

shares = $11.40

PV of financial distress costs = ($11.40 - $10.85) × 25 million

shares = $13.75 million

d. $35.00
million

Correct
Marks for this submission: 1/1.

7 Rose Industries has a $20 million loan due at the end of the year and its assets will have a market value
of only $15 million when the loan comes due. Currently Rose has $2 million in cash. Rose is
Marks: 1
considering two possible alternative uses for this cash. One possibility is to pay the $2 million out to
shareholders in the form of a special dividend. The second possibility is to invest the $2 million into a
project that offers a $4 million NPV. Which of the following statements is false?

Choose one a. Debt holders

answer. prefer second
possibility.

b. Debt holders
Case #1 Pay special dividend
prefer first
possibility. Payoff to equity holders = $2 million

Payoff to debt holders = $15 million - $2 million = $13 million

Case #2 Invest in Positive NPV project favor

Payoff to equity holders = $0

Payoff to debt holders = $15 million + $4 million = $19 million

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So debt holders prefer + NPV project and equity holders prefer
special dividend.

This is an under investment problem, where a firm does not

engage in a + NPV project because of agency costs between
shareholders and debt holders.

c. Firm will choose

in favor of equity
holders.

d. Equity holders
prefer first
possibility.

Correct
Marks for this submission: 1/1.

8 Which of the following statements is false?

Marks: 1
Choose one a. Costs of reduced effort and excessive spending on perks are another form of
answer. agency cost.

b. Managers also have their own personal interests, which may differ from those
of both equity holders and debt holders.

c. The separation of ownership and control creates the possibility of

management entrenchment; facing little threat of being fired and replaced,
managers are free to run the firm in their own best interests.

d. One disadvantage of using leverage is that it does not allow the original
owners of the firm to maintain their equity stake.

Correct
Marks for this submission: 1/1.

9
Use the information for the questions b elow.
Marks: 1
You own your own firm and you need to raise $50 million to fund an expansion. Following the expansion,
your firm will be worth $75 million in its unlevered form. You want to go ahead with the expansion, but you
are concerned that you may not be able to maintain ownership of over 50% of your firm's equity. In other
words, you are concerned that if you use equity to finance the expansion, you may loose control of your
firm. Assume that capital markets are perfect except for the existence of corporate taxes. Your firm pays
40% of earnings in taxes and you decide to issue $25 million in new debt and $25 million in new equity.
You ownership stake in the firm following these new issues of debt and equity is closest to:

Choose one a.
answer. 55%

b.
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02/03/2011 FM212: Quiz to week 6 Lent
50%

c. VU = $75 million, VL = VU + τcD = $75 + .40($25) = $85 million, Owner's

58% equity = value - debt - new equity = 85 - 25 - 25 = $35 million, Total equity =
owners equity + new equity = $35 + $25 = $60 million, Owner's stake = =
.5833 or 58.33%

d.
33%

Correct
Marks for this submission: 1/1.

10 Assume that capital markets are perfect except for the existence of corporate taxes and that your firm
pays 35% of earnings in taxes. If you want to maintain ownership of at least a 50%, then the minimum
Marks: 1
amount of debt that you must issue to fund the expansion is closest to:

Choose one a. $29

answer. million

b. $15
million

c.
$24million

d.
VU = $75 million,
$19million

% Ownership = (VL-new debt-new equity)/(VL-new debt),

Given: VL = VU + τcD, New equity = $50 million needed for expansion

- the amount of new debt,

% Ownership = (75-0.35(debt)-debt-(50-debt))/(75-0.65(debt)) = .50

(given we want 50% ownership),

25 + .35(debt) = .50(75 - .65(debt))

Debt = $18.52 million

Correct
Marks for this submission: 1/1.

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