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Circle One Answer That Is the Best. (2.5 Points Each) 1 AFM 372 Fall 2006 Key Midterm Examination I. Multiple choice questions: Circle one answer that is the best. (2.5 points each) 1. A bond issued by Owers Divestiture Corporation on July 1, 2005 has the following features: face value $1,000, annual interest rate of 8%, maturity date July 1, 2010, semi-annual interest payments on July 1 and January 1 each year. How much is the accrued interest if an investor buys the bond on Sept. 1, 2006? A) $13.33 B) $26.67 C) $40.00 D) $80.00 E) $120.00 1. Answer: A. Accrued interest on Sept 1 = (.08/12) (2) (1000) = $13.33 Use the information below to answer questions 2 and 3: The shareholders of the Unicorn Company need to elect five new directors. There are one million shares outstanding. 2. At least how many shares should you own to be certain that you can elect two directors if the company has straight voting? A) 500,001 B) 500,000 C) 1 million D) 333,334 E) 166,667 3. At least how many shares should you own to be certain that you can elect one director if the company has cumulative voting? A) 500,001 B) 500,000 C) 1 million D) 333,334 E) 166,667 4. Consider two corporations, G and H, that have exactly the same risk. They both have a current stock price of $60. Corporation G pays no dividend and will have a price of $66 one year from now. Corporation H pays dividends and will have a price of $63 one year from now after payment of a dividend. Corporations pay no income taxes. Investors pay no taxes on capital gains, but they pay a 30% income tax on dividends. What is the value of the dividend that investors expect Corporation B to pay? A) $4.29 (66-60)/60 = 10% = [63 + X(1-.3)]/60 -1 Æ X = 4.29 B) $3.00 C) $3.15 D) $3.30 E) It is impossible to calculate expected dividend without the discount rate. 5. Preferred stock may exist because: A) losses before income taxes prevent a company from enjoying the tax advantages of debt interest while none exist for preferred dividends. B) an advantage exists for the firm; preferred shareholders can not force the company into bankruptcy because of unpaid dividends. C) corporations get a tax exemption on preferred dividends received. D) all of the above. E) none of the above. 1 6.A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections? A) 21%. B) 18%. C) 15%. D) 10%. E) None of the above. R_0 = r_0 + B/S (r_0 – r_B) = .15 + 1.2 (.15-.10) = .21 7. The pecking-order theory of capital structure is at odds with the tradeoff theory of capital structure in that pecking-order theory says A) There should be no target book/equity ratio. B) Profitable firms should use less debt. C) One should take advantage of tax shield of debt. D) Both A) and B). E) Both B) and C). 8. Your aunt is in a high tax bracket and would like to minimize the tax burden of her investment portfolio which is subject to high taxes. She is willing to buy and sell in order to maximize her after-tax returns and she has asked for your advice. There are several choices for her: i). Buy high dividend yield stocks because high dividend stocks are safer with cash in hand. ii) Buy low dividend yield stocks to avoid paying high taxes on dividends. iii) Sell low dividend yield stocks because those stocks tend to be overpriced. iv) Move high dividend yield stocks that are currently in her portfolio to a tax-deferred account such as retirement account. You think she should do: A) Both i) and ii). B) Both ii) and iv). C) i) only. D) Both i) and iii). 9. A firm commitment arrangement with an investment banker occurs when: A) the syndicate is in place to handle the issue. B) The spread between the buying and selling price is less than one percent. C) The issue is solidly accepted in the market evidenced by a large price increase. D) When the investment banker buys the securities for less than the offering price and accepts the risk of not being able to sell them. E) When the investment banker sells as much of the security as the market can bear without a price decrease. 10. You estimate that Canadian Tire’s stock beta is 0.35. Its current debt has market value of $1.25 billion, and its equity value is $10 billion. From past market data, you estimate that the riskfree interest rate is 5%, and the market return is 20%. Current yield on Canadian Tire’s bonds is 8%. The corporate tax rate is 36%. Ignore personal taxes and financial distress costs. What’s Canadian Tire’s cost of equity if it were an all-equity firm? A) 10.25% B) 10.08% C) 10.00% D) 9.86% E) Not enough information. r_s = .05 + .35 (.20 - .05) = .1025 = r0 + 1.25/10 (1-.36) (r0 - .08) r0 = 10.0833% 2 II. Short answer questions (5 points each.) 1. If Miller-Modigliani Proposition II (with corporate taxes) is correct, every firm should take (almost) 100% debt to maximize the firm value. But you do not observe that in real life. Give three reasons that why firms do not follow Miller-Modigliani Proposition II and brief explain your reasons. Possible reasons: 1. Financial distress—more debt, higher bankruptcy risk. 2. Agency cost of equity in financial distress—bondholders know that they will be taken advantage of by distressed firms and may ask for higher interest rates Æ less debt. 3. Financial flexibility: Firms want to preserve financing flexibility for future opportunities. 4. Pecking-order of financing: Firm may follow pecking order theory in financing, i.e., internal cash first. Therefore, if they have enough internal cash, no need for debt. 5. Credit ratings concern: The more you borrow, the less credit worthiness you are. 6. Not able to take advantage of tax shield –e.g., firms in red. 2. You just read the following from The Financial Post on Thursday, October 12, 2006: “Gannett Co. Inc. the largest U.S. newspaper publisher, reported a lower third-quarter profit yesterday because of weak advertising growth and lower-than-expected revenues, sending shares down 3.4%. Revenue rose 2.7% to US$1.91-billion, but fell short of analysts’ views ranging from US$1.92-billion to US$1.99-billion, according to Reuters Estimates.” Assume nothing happens before the event. Comment whether this event is consistent with, against, or uncertain with the efficient markets hypothesis. This event is consistent with semi-strong form EMH. Analysts were forecasting a higher earnings but the firm did not reach the expectation. This is a bad news. If nothing happens before bad news, then EMH says that price will drop. The stock price action is consistent with semi-strong form EMH. 3 III. True or false. Choose only one true/false question to answer. If you answer both questions, you will get the average mark of the two. Assess whether each of the following statements is true, false, or uncertain. Justify your answer. All marks are based on the quality of your arguments supporting your answer. 1. (4 points) If the efficient–market hypothesis is true, then the pension fund manager might as well select a portfolio with a pin. False. The efficient markets hypothesis does not imply that portfolio selection should be done with a pin, for several reasons: (1) The manager still must make sure that the portfolio is well diversified. It should be noted that a large number of stocks alone is not enough to ensure diversification; they could all be in similar industries. (2) Second, she must make sure the risk of the diversified portfolio is appropriate for her clients. In the case of pension fund, she should choose “safe” investments, i.e., choose those stocks/bonds or combined portfolios with lower beta. 2. (4 points) As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt equity ratio we can reduce both the cost of debt and the cost of equity, making everybody better off. False. Borrowing has some benefits, such as tax shield of interest, added discipline to the management. It has costs as well, such as financial distress costs, agency costs of debt, and loss of financial flexibility. If the marginal benefit of adding debt is greater than the marginal cost, firms should borrow. In this case, borrowing will reduce the cost of capital for the whole firm, generally through a higher portion of debt whose cost is less than the cost of equity. (This question can also be answered in the following ways: 1. You can use MM-I without tax. In this world, the cost of capital of the firm is not affected by the choice of capital structure under Proposition I in the no tax scenario. As the debt-equity ratio decreases, it is true that the cost of equity decrease, but a smaller proportion of the firm is financed by the lower cost debt. Hence, the overall effect is to leave the firm’s cost of capital unchanged.
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