Exercises for Corporate finance

for 3rd year undergraduate

Semester 6, 2011
By Jianyu YU
Research Institute of Economics and Management
Southwestern University of Finance and Economics

Multiple Choice Questions

1.

Corporations try to create hybrid securities that look like equity but are called debt because:
A. debt interest expense is tax deductible.
B. bankruptcy costs are eliminated or reduced.
C. these securities have lower risk than debt.
D. Both A and C.
E. Both A and B.
Difficulty level: Medium
Topic: HYBRID SECURITIES
Type: CONCEPTS

2. If a debenture is subordinated, it:

A. has a higher priority status than specified creditors.
B. is secondary to equity.
C. must give preference to the specified creditor in the event of default.
D. has been issued because the company is in default.
E. None of the above.
Difficulty level: Medium
Topic: SUBORDINATED DEBENTURE
Type: CONCEPTS

3. Financial economists prefer to use market values when measuring debt ratios because:
A. market values are more stable than book values.
B. market values are a better reflection of current value than historical value.
C. market values are readily available and do not have to be calculated like book values.
D. market values are more difficult to calculate which makes financial economists more valuable.
E. None of the above.
Difficulty level: Medium
Topic: MARKET VALUE OF DEBT
Type: CONCEPTS

4.

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for
high levels of EBIT because:
A. interest payments on the debt vary with EBIT levels.
B. interest payments on the debt stay fixed, leaving less income to be distributed over less
shares.
C. interest payments on the debt stay fixed, leaving more income to be distributed over less
shares.
D. interest payments on the debt stay fixed, leaving less income to be distributed over more
shares.
E. interest payments on the debt stay fixed, leaving more income to be distributed over more
shares.
Difficulty level: Medium
Topic: EPS-EBI ANALYSIS
Type: CONCEPTS

5.

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is
now utilizing debt in its capital structure. To unlever his position, Bryan needs to:
A. borrow some money and purchase additional shares of Bryco stock.
B. maintain his current position as the debt of the firm did not affect his personal leverage
position.
C. sell some shares of Bryco stock and hold the proceeds in cash.
D. sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity
ratio equal to that of the firm.
E. create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the
firm.
Difficulty level: Medium
Topic: HOMEMADE LEVERAGE
Type: CONCEPTS

6.

Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible
bankruptcy are borne by:
A. all investors in the firm.
B. debtholders only because if default occurs interest and principal payments are not made.
C. shareholders because debtholders will pay less for the debt providing less cash for the
shareholders.
D. management because if the firm defaults they will lose their jobs.
E. None of the above.
Difficulty level: Medium
Topic: COST OF BANKRUPTCY
Type: CONCEPTS

7.

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When
following this strategy:
A. the firm will rank all projects and take the project which results in the highest expected value
of the firm.
B. bondholders expropriate value from stockholders by selecting high risk projects.
C. stockholders expropriate value from bondholders by selecting high risk projects.
D. the firm will always take the low risk project.
E. Both A and B.
Difficulty level: Medium
Topic: INDIRECT COSTS OF FINANCIAL DISTRESS
Type: CONCEPTS

8.

Studies have found that firms with high proportions of intangible assets are likely to use
____________ debt compared with firms with low proportions of intangible assets.
A. more
B. the same amount of
C. less
D. either more or the same amount of
E. any amount of debt
Difficulty level: Medium
Topic: INTANGIBLES AND DEBT
Type: CONCEPTS

9.

The introduction of personal taxes may reveal a disadvantage to the use of debt if the:
A. personal tax rate on the distribution of income to stockholders is less than the personal tax
rate on interest income.
B. personal tax rate on the distribution of income to stockholders is greater than the personal
tax rate on interest income.
C. personal tax rate on the distribution of income to stockholders is equal to the personal tax
rate on interest income.
D. personal tax rate on interest income is zero.
E. None of the above.
Difficulty level: Medium
Topic: PERSONAL TAXES
Type: CONCEPTS

10.

Which of the following may tend to keep dividends low?

I. a state law restricting dividends in excess of retained earnings
II. a term contained in bond indenture agreements
III. the desire to maintain constant dividends over time
IV. flotation costs
A. II and III only
B. I and IV only
C. II, III, and IV only
D. I, II, and III only
E. I, II, III, and IV
Difficulty level: Medium
Topic: FACTORS FOR LOW DIVIDENDS
Type: CONCEPTS

11.

An investor is more likely to prefer a high dividend payout if a firm:

A. has high flotation costs.
B. has few, if any, positive net present value projects.
C. has lower tax rates than the investor.
D. has a stock price that is increasing rapidly.
E. offers high capital gains which are taxed at a favorable rate.
Difficulty level: Easy
Topic: FACTORS FOR HIGH DIVIDENDS
Type: CONCEPTS

12.

The dividend-irrelevance proposition of Miller and Modigliani depends on the following

relationship between investment policy and dividend policy:
A. The level of investment does not influence or matter to the dividend decision.
B. Once dividend policy is set the investment decision can be made as desired.
C. The investment policy is set before the dividend decision and not changed by dividend policy.
D. Since dividend policy is irrelevant there is no relationship between investment policy and
dividend policy.
E. Miller and Modigliani were only concerned about capital structure.
Difficulty level: Medium
Topic: DIVIDEND IRRELEVANCE
Type: CONCEPTS

13.

A rights offering is:

A. the issuing of options on shares to the general public to acquire stock.
B. the issuing of an option directly to the existing shareholders to acquire stock.
C. the issuing of proxies which are used by shareholders to exercise their voting rights.
D. strictly a public market claim on the company which can be traded on an exchange.
E. the awarding of special perquisites to management.
Difficulty level: Medium
Topic: RIGHTS OFFERING
Type: DEFINITIONS

14.

Which of the following are uses of cash?

I. marketable securities are sold
II. the amount of inventory on hand is increased
III. the firm takes out a long-term bank loan
IV. payments are paid on accounts payable
A. I and III only
B. II and IV only
C. I and IV only
D. II and III only
E. II, III and IV only
Difficulty level: Medium
Topic: SOURCES AND USES OF CASH
Type: CONCEPTS

15.

Which one of the following will decrease the operating cycle?

A. Decreasing the days sales in inventory
B. Decreasing the days in accounts payable
C. Decreasing the cash cycle by increasing the accounts payable period
D. Decreasing the accounts receivable turnover rate
E. Decreasing the speed at which inventory is sold
Difficulty level: Medium
Topic: OPERATING CYCLE
Type: CONCEPTS

16. The Lory Bookstore used internal financing as a source of long-term financing for 80% of its total
needs in 2008. The company borrowed an additional 27% of its total needs in the long-term
debt markets in 2008. What were Lory's net new stock issues in that year?
A. -20%
B. -7%
C. 7%
D. 20%
E. 27%
Net new issues = - 7%, as more stock was repurchased than issued. (100% - (80 + 27)) = (100 107) = -7%.
Difficulty level: Medium
Topic: NET NEW ISSUE
Type: PROBLEMS

17. Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding
with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail
is considering adding $1 million of debt with a coupon rate of 8% to her capital structure. The
debt will be sold at par value. What is the levered value of the equity?
A. $2.4 million
B. $2.7 million
C. $3.3 million
D. $3.7 million
E. $3.9 million
VL = (80,000 $42) + (.34 $1m) = $3.36m + .34m = $3.7m; VE = $3.7m - $1m = $2.7m
Difficulty level: Medium
Topic: MM PROPOSITION I, WITH TAX
Type: PROBLEMS

18. Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio
is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital?
A. 8.83%
B. 12.30%
C. 13.97%
D. 14.08%
E. 14.60%

.138 = RU + (RU - .085) .60 (1 - .34); .17166 = 1.396RU; RU = .12297 = 12.30%

Difficulty level: Medium
Topic: MM PROPOSITION II, WITH TAX
Type: PROBLEMS

19. The Aggie Company has EBIT of $50,000 and market value debt of $100,000 outstanding with a
9% coupon rate. The cost of equity for an all equity firm would be 14%. Aggie has a 35%
corporate tax rate. Investors face a 20% tax rate on debt receipts and a 15% rate on equity.
Determine the value of Aggie.
A. $120,000
B. $162,948
C. $258,537
D. $263,080
E. $332,143
Unlevered firm = [$50,000 (.65)]/ .14 = $232,142.86
Miller leverage tax shield value = [1 - ((1 - Tc)(1 - Ts)/(1 - Tb))]B = [1 - ((1 - .35)(1 - .15)/1 .20))]*$100,000 = $30,937.50
Total Value = $232,142.86 + $30,937.50 = $263,080.36
Difficulty level: Challenge
Topic: FIRM VALUE WITH TAXES
Type: PROBLEMS

20. The flow-to-equity approach has been used by the firm to value their capital budgeting projects.
The total investment cost at time 0 is $640,000. The company uses the flow-to-equity approach
because they maintain a target debt to value ratio over project lives. The company has a debt to
equity ratio of 0.5. The present value of the project including debt financing is $810,994. What is
the relevant initial investment cost to use in determining the value of the project?
A. $170,994
B. $267,628
C. $372,372
D. $543,366
E. $640,000
D/E = .5/1 D + E = 1.5 D/E = .5 D/V = .5/1.5 = .33
$Debt Financing = .33($810,994) = $267,628
Initial Investment for Equity Valuation = $640,000 - $267,628 = $372,372
Difficulty level: Challenge
Topic: FLOW-TO-EQUITY APPROACH
Type: PROBLEMS

21. The Tip-Top Paving Co. has a beta of 1.11, a cost of debt of 11% and a debt to value ratio of .6.
The current risk free rate is 9% and the market rate of return is 16.18%. What is the company's
cost of equity capital?
A. 7.97%
B. 8.96%
C. 16.97%
D. 17.96%
E. 26.96%
rs = .09 + 1.11*(.1618 - .09)
rs = .1697 = 16.97%
Difficulty level: Medium
Topic: LEVERED COST OF EQUITY
Type: PROBLEMS

22. Imagine Inc. has an equity cost of capital of 16.97%. The debt to value ratio is .6, the tax rate is
34%, and the cost of debt is 11%. What is the cost of equity if Imagine Inc. was unlevered?
A. 0.08%
B. 3.06%
C. 14.0%
D. 16.97%
E. None of the above.
.1697 = r0 + (.6/.4)*(r0 - .11)*(.66)
r0 = .14 = 14%
Difficulty level: Challenge
Topic: UNLEVERED COST OF EQUITY
Type: PROBLEMS

23. The Telescoping Tube Company is planning to raise $2,500,000 in perpetual debt at 11% to
finance part of their expansion. They have just received an offer from the Albanic County Board
of Commissioners to raise the financing for them at 8% if they build in Albanic County. What is
the total added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic
raises it for them?
A. $850,000
B. $1,200,000
C. $1,300,000
D. $1,650,000
E. There is no value to the scheme; Albanic is just conning Telescoping Tube into moving.
NPVLOAN = $2,500,000 - [.08($2,500,000)(1 - .34)]/.11 = $2,500,000 - ($200,000(.66))/.11 =
$2,500,000 - $1,200,000 = $1,300,000

Difficulty level: Challenge

Topic: VALUE OF DEBT FINANCING
Type: PROBLEMS

24. Brad's Boat Company, a company in the 40% tax bracket, has riskless debt in its capital structure
which makes up 30% of the total capital structure, and equity is the other 70%. The beta of the
assets for this business is .9 and the equity beta is:
A. 0.54
B. 0.90
C. 1.13
D. 1.20
E. 1.49
E = .9(1 + (1 - .40)(.3/.7)) = 1.13
Difficulty level: Medium
Topic: EQUITY BETA
Type: PROBLEMS

25. Murphy's, Inc. has 10,000 shares of stock outstanding with a par value of $1.00 per share. The
market value is $8 per share. The balance sheet shows $32,500 in the capital in excess of par
account, $10,000 in the common stock account and $42,700 in the retained earnings account.
The firm just announced a 10% (small) stock dividend. What will the market price per share be
after the dividend?
A. $7.20
B. $7.27
C. $7.33
D. $8.00
E. $8.80
Market price per share = (10,000 shares $8) (10,000 shares 1.10) = $7.27; Note that the
total market value of the firm does not change.
Difficulty level: Medium
Topic: SMALL STOCK DIVIDEND
Type: PROBLEMS

26. For a particular stock the old stock price is $20, the ex-rights price is $15, and the number of
rights needed to buy a new share is 2. Assuming everything else constant, the subscription price
is ______ .
A. $5
B. $13
C. $17
D. $18
E. $20
(PO - S)/(N + 1) = (PX - S)/N
($20 - S)/3 = ($15 - S)/2
$15/3 = $10/2 = $5
Difficulty level: Medium
Topic: SUBSCRIPTION PRICE
Type: PROBLEMS

27. A firm has sales of $720,000. The cost of goods sold is equal to 70% of sales. The firm has an
average inventory of $6,500. How many days on average does it take the firm to sell its
inventory?
A. 3.30 days
B. 4.71 days
C. 67.29 days
D. 77.54 days
E. 110.77 days
Inventory turnover = ($720,000 .70) $6,500 = 77.54; Inventory period = 365 77.54 = 4.71
days
Difficulty level: Medium
Topic: INVENTORY PERIOD
Type: PROBLEMS

28. A firm has an inventory turnover rate of 16, a receivables turnover rate of 21 and a payables
turnover rate of 11. How long is the operating cycle?
A. 37.00 days
B. 40.19 days
C. 42.87 days
D. 63.08 days
E. 73.37 days

Inventory period = 365 16 = 22.81 days; Accounts receivable period = 365 21 = 17.38 days;
Operating cycle = 22.81 + 17.38 days = 40.19 days
Difficulty level: Challenge
Topic: OPERATING CYCLE
Type: PROBLEMS

29. Your firm receives 10 checks per month. Of these, 6 are for $1,000 and 4 are for $500. The delay
for the $1,000 checks is 5 days, and the $500 checks are delayed 8 days. Calculate the average
daily float.
A. $1,533.33
B. $1,486.87
C. $1,500.00
D. $1,530.35
E. $1,590.04
Total Float = $1,000 (6) (5) + $500 (4) (8) = $46,000
Average Daily Float = $46,000/30 = $1,533.33
Difficulty level: Medium
Topic: AVERAGE DAILY FLOAT
Type: PROBLEMS

30. Weisbro and Sons purchases its inventory one quarter prior to the quarter of sale. The purchase
price is 60% of the sales price. The accounts payable period is 60 days. The accounts payable
balance at the beginning of quarter one is $27,500. What is the amount of the expected
disbursements for quarter two given the following expected quarterly sales? Assume that a year
has 360 days.

A. $19,200
B. $20,400
C. $22,000
D. $25,200
E. $32,000
Quarter 2 disbursements = [(60 90) $34,000 .60] + [(30 90) $42,000 .60] = $22,000
Difficulty level: Challenge
Topic: CASH DISBURSEMENTS
Type: PROBLEMS

Essay questions
The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether
including debt in its capital structure would increase its value. The current cost of equity is 12%. Under
consideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase
$300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding
and effective marginal tax bracket is zero.
a. What will Nantucket's new WACC be?
New Firm Value: $640,000 + (.0) ($300,000) = $640,000
Capital Structure = D + E = 300,000 + 340,000
rs = .12 + (300/340) * (.12 - .08) = .12 + .0353 = .1553 = 15.53%
WACC = (300/640) * (.08) + (340/640) * (.1553) = .0375 + .0825 = .12 = 12%
The value of the firm stays at $640,000 (MM I), the cost of levered equity rises to 15.53% and the WACC
remains at 12%.
b.

Assume the effective marginal tax bracket is 34%. What will Nantucket's new WACC be?

New Firm Value: $640,000 + (.34) ($300,000) = $742,000

Capital Structure = D + E = $300,000 + $442,000
rs = .12 + (300/442) * (.12 - .08) * (1 - .34) = .12 + .0179 = .1379 = 13.79%
WACC = (300/742) * (.08) * (1 - .34) + (442/742) * (.1379) = .0213 + .0821 = .1034 = 10.34%
The value of the firm increases to $742,000 (From Value of the Tax Shield), increasing the relative weight
of equity and the cost of levered equity rises to 13.79% and the WACC falls to at 10.34% consistent with
the increase in firm value.

Topic: WACC
Type: ESSAYS