FINA 663: Seminar in Corporate Finance Fall Semester 2007 Exam 1 October 29 GM 302 11:45 14:15

Name: ____________________________

Student ID: ____________

Instructions

Answer on the exam itself. Do not remove the staples. Write you name and ID on the exam and the formula sheet. Use the formula sheet that has been provided. You are not allowed to use your own formula sheet. This is a closed book exam. Partial credit will be given provided your answer reflects a reasonable understanding of what is asked in the question. All work that produced your answer must be clearly shown. You may lose credit even if your final answer is correct but work is not clearly shown. Thus, when you use the calculator, you must indicate the basic steps and the data used in your computations. You have 2 hours to complete the exam.

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

Multiple Choice Questions (2 points each) Circle the best answer in each case. You will not receive any credit if more than one answer is selected.

1. Which of the following statement is true with firms financing viewed as options? A) Equity can be regarded as a call option on the firms assets with the total assets as the exercise price. B) Bondholders own the firm and have bought a call option from the stockholders. C) Stockholders own the firm and have sold a call option to the bondholders. D) Stockholders and bondholders own the firm in equal amounts. E) Stockholders own a call option on the firms assets with an exercise price equal to the face value of the debt owed. 2. In a Dutch-auction tender offer stock buyback, the shareholders who sell their shares back to the firm: A) Are guaranteed to receive the price they asked for. B) Receive the share-weighted average price of all the bids that are accepted. C) Have to specify only the price in their bids. D) Receive a smaller premium on their shares compared to what they would receive if it was an open market buyback. E) Receive the same price as in a fixed price tender offer. 3. Consider a one period world. Next year, a firm expects to earn a cash flow of $400 with a probability of 35% and $250 with a probability of 65%. If zero coupon bonds with a face value of $300 are due one year later, what is the total market value of the firm today using a one period risk neutral rate of 10%? A) $31.82 B) $270.09 C) $275 D) $44.35 E) $302.50 4. The total value of an unlevered firm if $1,250. If shareholders require a return of 20% on their investment, corporate tax is 39% and there are 115 shares outstanding, what are the earnings per share? Assume that the firms earnings are a perpetuity. A) $3.56 B) $2.17 C) $10.87 D) $6.63 E) Cannot be determined from the information provided.

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

5. Agency costs of equity: A) Increase as the proportional amount of equity owned by managers increases. B) Will not be affected whether or not a firm uses stock options to compensate its managers. C) Are low for firms with low levels of debt and high for firms with high levels of debt. D) Are higher for firms with more dispersed ownership. E) Have no impact on the firms capital structure choice.

6. In an economy, corporate tax rate is 36.7% and the personal tax rate paid by individual investors on interest income is 48.5%. If Millers extension of the capital structure model with personal taxes holds, at what personal tax rate on equity income will the gain from leverage be zero? A) 22.91% B) 18.64% C) 24.33% D) 81.36% E) 17.55% 7. According to the static trade-off theory of capital structure: A) External equity is the best source of financing. B) Optimal level of debt is chosen where the trade off between tax shield benefits of debt and the financial distress costs maximize firm value. C) Debt is never a good choice when seeking external funds. D) Debt financing is better than external equity financing but not compared to internally generated funds. E) Firms with significant growth options should always use debt.

8. Which of the following is NOT CORRECT? I. There has been an increase in the proportion of firms that pay regular cash dividends in the past 20 years. II. The cost of equity increases as the leverage ratio increases. III. Managers of firms with stock options prefer to pay cash dividends to buying back shares. IV. In the absence of taxes of any kind, in a Modigliani-Miller world the cost of equity will be always equal to the weighted average cost of capital. A) B) C) D) E) I and III I and IV II and IV I only I, III and IV
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FINA 663 Seminar in Corporate Finance

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October 29, 2007

9. You are interested in creating a hedged portfolio using call and put options on the stock of Alcana Corp. The options have the same exercise price and time to expiration. The value of the hedged portfolio on the expiration date of the options equals to their exercise price. Which of the following combinations will help you achieve your objective? A) Buy one share, buy one call and buy one put. B) Sell one share, sell one call and sell one put. C) Sell one call, buy one share and buy one put. D) Buy one share, buy two puts and sell one call E) Sell two puts, buy one share and buy two calls.

10. The fair market values of five firms are as displayed in the table below. Firm Fair market value A) B) C) D) E) A $120 B $145 C $86 D $95 E $164

In a pooling equilibrium, Firm B will sell for less than $145 but more than $125. Firm E has the most to gain from a pooling equilibrium. Firm A has the least to lose in a pooling equilibrium while firm C has the most to lose in a pooling equilibrium. Firms B and E will work to establish a separating equilibrium while firms A, C and D will prefer a pooling equilibrium. All firms will prefer a pooling equilibrium.

11. The stock of Century Enterprises is expected to either rise to $78 or drop to $42 a year from today. It is currently trading at $51. You currently own 450 shares of the companys stock. How many call options, with an exercise price of $60, can you sell to have a completely hedged portfolio? A) 900 B) 450 C) 225 D) 0.5 E) 100 12. Which of the following situations will result in shareholders expropriating wealth from bondholders? A) A change in corporate strategy that lowers overall firm risk. B) The decision by managers to issue new debt that has the same priority as existing outstanding debt. C) The decision by managers to issue new equity if they believe that the firms equity is undervalued. D) A and B will both lead to bondholder wealth expropriation. E) A, B and C will all result in bondholder wealth expropriation.
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FINA 663 Seminar in Corporate Finance

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October 29, 2007

13. Computer Graphics has $21,000 of debt at an interest rate of 7.2%. The total market value of the firm is $57,445. The firm earns a perpetual EBIT of $15,890 and is subject to a corporate tax rate of 33.5%. What is the weighted average cost of capital of the firm? A) 18.39% B) 27.66% C) 7.2% D) $50,410 E) 20.96%

14. Select the correct statement from the following: A) Higher quality firms will signal their quality by using less debt. B) Growth oriented firms finance their operations by issuing risky debt instruments. C) The greater the level of free cash flow, the lower the incentive for managers to consume excessive perks. D) Financial distress costs offset some of the interest tax shield benefits when firms use more than the optimal level of debt. E) Both A and D are correct.

15. What is the annual rate of return on a 3-year zero-bond that currently sells for $761.75 and has a par value of $1,000? A) 10% B) 7.66% C) 12.41% D) 9.49% E) 31.28%

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

Problems: All work must be clearly shown.

16. The Hawaiian Nut Company currently has the following capital structure: Bonds at an interest rate of 7 percent $250,000 23,550 shares at $26.45 per share $622,898 Montana Nut Inc., which is in the same line of business as Hawaiian Nut Company, is an all-equity firm whose shareholders require a return of 14.15% Both firms pay taxes at a rate of 40% and earn a perpetual EBIT. a) What is the rate of return required by shareholders of Hawaiian Nut Company? (4)

b) The managers of Hawaiian Nut announce that they will issue an additional $120,000 of debt that pays the same interest rate and will use the proceeds to buy back some of their outstanding shares. What would be the new market price per share immediately after the announcement is made? (4)

c) If Montana Nut earns exactly the same EBIT as Hawaiian Nut, what is the total market value of Montana Nut? (4)

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

17.

Shrek 3 Entertainment currently has a market value of $33.6 million. Since the firm operates in a fairly risky industry, analysts expect that one year from today, the firm will either have a total market value of $28.5 million (62% probability) or $41 million (38% probability). The firm currently has zero coupon bonds outstanding with a face value of $26 million that are due in a year and are yielding 5.7%. a) What is the current market value of debt and equity? (4)

b) What is the expected return and standard deviation of return on the firms equity over the next one year? (4)

c) What would be the new market values of debt and equity if the projected values of the firm are $22 million and $50 million, the associated probabilities remaining unchanged? Assume the current market value of the firm remains unchanged at $33.6 million. (5)

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

18.

The stock of Nantucket Nugget is currently trading at $430.40 per share. The expected return and the standard deviation of return on the firms equity in the next one year are estimated at 22.15% and 38.65%, respectively. The risk free rate in the market is 7.5%. Compute the price, intrinsic value and time premium on a call option on the companys stock with an exercise price of $400 and 136 days to expiration? Work with the assumption that there are 365 days in a year. (12)

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

19.

4M Inc. has a total current market value of $288 million. There are 22 million shares outstanding. The firm also has zero-coupon 5-year bonds outstanding with an aggregate face value of $350 million that mature in 5 years. Based on the current return on its assets the firms value is expected to be either $465 million (with a 75% probability) or $320 million (25% probability) five years from now. The annualized risk free rate over the next 5 years is estimated at 5.85%. The firm pays no taxes. a) What is the expected annualized return on the firms assets? (4)

b) What is the firms debt-to-equity ratio today? (5)

c) If the firms managers issue an another series of 5-year zero-coupon bonds that have the same priority as existing bonds for a total par value of $50 million and buyback some of the firms outstanding equity, what is the total amount of equity bought back? Is there any wealth expropriation from existing bondholders? If yes, how much? If no, why? (8)

FINA 663 Seminar in Corporate Finance

Exam 1

October 29, 2007

20.

Compute the price of a put option on the stock of ABC Corp. given the following information: The shares currently trade at $40 per share, the put option has an exercise price of $45, the risk free rate of interest is 10%, the option expires in 2 months, and the stock is expected to either rise to $54 or drop to $36 in 2 months. (8)