Sample Exam #1- Finance 414

Name:_________________________________

Student PID Number ____________________

You have 1 hour and 20 minutes to complete this exam. Section I has 28 multiple choice questions
worth 2.5 points each for a total of 70 points. Section II has 2 long problems worth 15 points each.
Plan your time accordingly. Read each question carefully and show all of your work clearly on the
problems as partial credit will be given. Good Luck!
Section 1- Multiple Choice Name__________________________
Yellow = my answer
Green = correct answer

1. In the UST Corp case we observed that which of the following was not true?
(a) Firm had very little debt
(b) Firm was in a dominant market position
(c) Firm had low free cash flow
(d) The firms probability of bankruptcy was relatively low
(e) None of the above

2. In the UST case we argued that if the recapitalization plan was followed it would not provide very much value to
the shareholders because the increase in the tax shield would be largely offset by the increase in expected
bankruptcy costs. This is true because the probability of bankruptcy increases at an increasing rate.
(a) True
(b) False

3. In the UST case it could be argued that many of UST’s shareholders would fall into a specific tax clientele. Are
stockholders likely to be mostly:
(a) young (25-35 years old)
(b) middle-aged (35-65 years old)
(c) elderly (65-90 years old)

4. In the UST case we ____________.

(a) Used Gordon’s Growth model to conclude that the market’s view of UST was such that the market expected the
firm to grow between 10 and 12%.
(b) Concluded that the assets had substantial litigation risk.
(c) Saw that after the case, as the firm’s financial position weakened, it stopped repurchasing stock.
(d) a and c
(e) b and c
(f) none of the above

5. In the Ms. Pagell example we discussed the possible agency costs of equity finance which potentially entails:
(a) Under investment in safe projects.
(b) Overinvestment in risky projects.
(c) All of the above.
(d) None of the above.

6. In the Marriott case, we suggested that the beta of the assets in the contract service division of the firm could be
estimated
(a) in the same manner as the cost of capital in the hotel division of the firm
(b) by utilizing portfolio theory and the beta of assets in the other divisions
(c) by averaging the asset betas from the other divisions in Marriott
(d) None of the above
7. In class we discussed Kodak’s bankruptcy proceedings and potential reorganization. We argued that Kodak’s
attempt to sell assets was an example of __________.
(a) The large loss in value that firms often experience in bankruptcy if the firm has many intangible assets
(b) The large loss in value that firms often experience in bankruptcy if the firm has many tangible assets
(c) The poor timing of managers who wish to sell the firm’s assets.
(d) The loss of tax shield that occurs when firms go bankrupt
(e) None of the above

8. Modigliani and Miller’s value proposition in a world with corporate taxes and financial distress costs but no
personal implies that _________.
(a) the total value of a firm’s bonds is independent of capital structure
(b) the total value of the sum of all of a firm’s securities is independent of capital structure
(c) a firm’s rwacc at first increases and eventually decreases as the debt equity ratio increases
(d) a firm’s rwacc at first decreases and eventually increases as the debt equity ratio increases
(e) None of the above

9. According to the Modigliani and Miller theory with corporate taxes but no personal taxes or financial distress
costs which of the following is true?
(a) the weighted average cost of capital decreases as a firm increases its debt-equity ratio (because of tax shield
increasing as smaller payments to IRS)
(b) total tax revenues to the IRS decrease as a firm increases its debt-equity ratio
(c) total firm value is independent of capital structure
(d) a and b
(e) b and c
(f) a and c
(g) a and b and c

10. We concluded that when a firm announces that it will increase the dividend payment to shareholders that the
reaction to the announcement may be complicated by the potential signaling effect that would tend to
___________________ the stock price and the change in the tax shield that would _________ the stock price.
(a) Increase; decrease
(b) increase; increase
(c) decrease; increase
(d) decrease; decrease
(e) None of the above

11. The expected return on a firm’s stock is 15% and currently the firm has no debt. The firm is contemplating
changing its debt-equity ratio to 1.0. The marginal corporate or tax rate is 25% and the risk-free interest rate is 5%
and there are no financial distress costs. Under the new capital structure r WACC will equal ________(round to the
nearest 1%).
(a) 10%
(b) 13%
(c) 15%
(d) 20%
(e) None of the above

With no bankruptcy: Rf = Rb = 5%
Rs = 15% + (1) * (1-.25) * (15%-5%) = 22.5%
rWacc = .5(5%)(1-.25) + .5(22.5) = 13.13%
12. A firm currently operates in industry A and it is considering doubling the size of their operations in industry A.
In considering this investment they should use
(a) the firms current rwacc
(b) an estimate of rwacc that is slightly lower than current rwacc
(c) an estimate of rwacc calculated using data from other firms operating in industry A
(d) an estimate of rwacc that is higher than current rwacc
(e) None of the Above

13. Which of the following is not a problem in estimating the beta on a firm’s stock?
(a) betas can vary over time
(b) there may be insufficient data to estimate beta precisely
(c) equity betas difficult to estimate for privately held corporations
(d) all of the above are potential problems in estimating beta on a firm’s stock

14. In using the formula for the weighted average cost of capital (rwacc), we argued that one should use _________.
(a) the book value of debt and the book value of equity always
(b) the market value of debt and the market value of equity always
(c) the book value of debt and the book value of equity only when these are greater than the corresponding market
values, otherwise use market values

15. A firm’s current debt-equity ratio is 1.0 (that is D/E=1.0). The firm’s borrowing rate is 10% and the expected
return on the firm’s stock is 30%. The corporate tax rate is .40. What is this firm’s weighted average cost of
capital?
(a) 10%
(b) 15%
(c) 17%
(d) 18%
(e) 20%
(f) 30%
(g) 36%
rWACC = .5(10%) * (1-.4) + .5(30%) = 18%

16. A firm currently has $50 million in stock and $50 million in bonds and the beta on the firm’s stock is currently
estimated to be 1.0. If the firm changes its capital structure so that is has $25 million in stock and $75 million in
bonds, what will the new beta on the firm’s stock be? There are no taxes.
(a) .5
(b) 1.0
(c) 1.5
(d) 2.0
(e) 2.5
Unlever then lever back up
Beta levered = (1+(D/E) * (1-Tc)) * beta unlevered
1 = (1+(1) *(1-0)) * Beta unlevered
Beta unlevered = .5
New B/S = 75/25 = 3
Beta levered = (1+3) * .5 = 2

17. A firm currently has a debt to equity ratio of 2.0 and its equity has a beta of zero. The risk-free rate is 5% and
the market risk premium is unknown. The corporate tax rate is 50%. The firm has zero probability of bankruptcy.
What is this firm’s rwacc?
(a) 3.3%
(b) 6.5%
(c) .5%
(d) -.5%
(e) none of the above
18. A firm currently has $25 million in stock outstanding and $75 million in bonds outstanding. There are no
corporate taxes, no personal taxes and no financial distress costs. If a firm announces it is selling $15 million in
equity and using the proceeds to repurchase debt, what will be the total value of the firm’s stock after the transaction
is complete?
(a) $10 million
(b) $11.5 million
(c) $100 million
(d) $18.5 million
(e) $20 million
(f) $40 million
25+15 = 40

19. A firm currently has $25 million in stock outstanding and $75 million in bonds outstanding. The corporate tax
rate is 35%, the personal taxe rate on equity income is zero, the personal tax rate on interest income is 35% and
there are no financial distress costs. If a firm announces it is selling $10 million in bonds and using the proceeds to
repurchase shares, what will be the total value of the firm’s stock after the transaction is complete?
(a) $10 million
(b) $11.5 million
(c) $15 million
(d) $18.5 million
(e) $20 million
(f) $25 million

20. A firm takes out a 3-year loan to finance a new positive npv project. The new loan will have an initial loan
amount of $12 million dollars. After year one the corporation must repay 1/3 of the loan. After the second year the
corporation must repay 1/3 of the initial loan and then repay the remaining amount at the end of the third year. Each
year the corporation must pay 8% interest on the remaining loan balance. The marginal corporate tax rate is 30%.
What is the present value of the tax shield created by the loan?
(a) 507,483
(b) 502,792
(c) 1,920,000
(d) 3,600,000
(e) 288,000
(f) 2,880,000
(g) None of the above is even close

. PV = (.3)(.08)(12M)/(1.08)1 + (.3)(.08)(8M)/(1.08)2 + (.3)(.08)(4M)/(1.08)3 =

=266,666.66 + 164,609.05 + 76,207.90 = 507,483

21. A firm currently has 100 shares outstanding and the market price of each share is currently $10. The firm
announces it will be issuing $300 in long-term bonds and using the proceeds to repurchase stock. The corporate tax
rate is 30% and there are no personal taxes or financial distress costs. When the announcement of this financial
change becomes public we expect the stock price to __________.
(a) not change
(b) decrease to $9.00
(c) decrease to $9.10
(d) increase to $10.90
(e) increase to $11.00
P = 10 + (300*.3)/100 = 10.9

22. Based on our bankruptcy cost discussions we would expect that firms with many talented employees should
have:
(a) Low debt to equity ratios
(b) High debt to equity ratios
(c) None of the above
23. The legal and accounting fees arising from bankruptcy proceedings are part of the _________ costs of financial
distress while the propensity for firms near bankruptcy to take on excessive risks are part of the _________
________ costs of financial distress.
(a) direct, indirect
(b) indirect, direct
(c) direct, direct
(d) indirect, indirect

24. The Ex-Ante costs of bankruptcy are borne principally by___________ and the Ex-Post costs are borne
by______________:
(a) Bondholders, Stockholders
(b) Stockholders, Bondholders
(c) Stockholders, Stockholders
(d) Bondholders, Bondholders
(e) The IRS, Bondholders

25. By adding covenants to a bond agreement, we expect that the bonds will __________ and thus shareholders
_____________.
(a) sell for a higher amount, are unwilling to agree to the covenants
(b) sell for a lower amount, are willing to agree to the covenants
(c) None of the above

26. A benefit of debt financing is that ____________.

(a) ownership will be concentrated in the hands of managers and thus they have an incentive to work harder
(b) firms have an incentive to take on excessive risks
(c) firms will underinvest in safe projects
(d) the return on a firm’s stock will increase thus making the stock more valuable
(e)none of the above

27. A firm currently has no debt and its equity has a market value of $200 million. The firm is contemplating
selling $20 million in bonds and using the proceeds to repurchase shares of stock. The corporate income tax rate is
30%, the effective personal tax rate on equity income is 10%, and the personal income tax rate on interest income is
40%. Given these tax parameters, what should be the total value of the firm after the repurchase is complete?
(a) $190 million
(b) $199 million
(c) $200 million
(d) $201 million
(e) $210 million
(f) $220 million
Value levered = 200 + (1-(1-.3)(1-.1)/(1-.4)) * 20 = 199

28. If the personal tax rate on interest income decreases while all other tax parameters are held constant, we expect
the tax benefits of debt financing to ________.
(a) increase
(b) decrease
(c) remain unchanged
(d)none of the above
Section 2- Long Answer Problems- Each Problem is worth 15 points.
#1. Here is some data for three firms in the hotel industry:

Hotel Firm #1: $200 million in debt, $600 million in equity, current estimated equity beta of 3.0
Hotel Firm #2: $600 million in debt, $600 million in equity, current estimated equity beta of 3.0
Hotel Firm #3: $700 million in debt, $300 million in equity, current estimated equity beta of 4.0

There are no corporate or personal taxes

(a) For each Hotel Firm, calculate unlevered

(b) Using your answer in part (a) and the methods presented in the Marriott case, what would you predict the equity
beta to be for a firm in Hotel industry with $900 million in debt and $1,800 million in equity?

(c) Ignoring your answers to “a” and “b” and the information provided above… Assume the following information
for Marriott Corporation;

Division Asset Value in Equity Value Debt Value Beta of the

Each Division of Investment in Investment in assets, Beta
Marriott stated in Each Division Each Division unlevered
Millions of stated in stated in
Dollars Millions of Millions of
Dollars Dollars
Hotel 1,250 750 500 1.0
Restaurant 550 300 250 .75
Contract 350 100 250
Services
Entire Firm 2,150 1,150 1,000 1.25

Determine the weighted average cost of capital for the contract services division where:
Target D/E = 2.0; Rd = .08; Rf = .06; (Rm-Rf) = .07; tc=.40
#2. Svenska BK corporation is a prosperous company that is currently all equity financed. Svenska currently has a
return on assets of 12%. Expected annual earnings from existing assets are anticipated to be 20 million per year in
perpetuity. The firm currently has 15 million shares of stock outstanding. Svenska now finds that it can invest in a
positive NPV project (a new plant) that will have an initial investment cost of $10 million at t=0 and is anticipated
to provide an annual cash flow of 1.8 million in perpetuity. You are to consider the effects of stock finance for the
investment. In part B below, you are to consider the effects of debt financing the project. Rd=6% and tc = 0.

(i) Provide the market value balance sheet for Svenska before the market is aware of the new plant.

(ii) Provide the market value balance sheet for Svenska after the market is aware of the new plant but before the
sale of stock to finance the new plant.

(iii) What is the stock price after the announcement?

(iv) How many shares of stock must you issue?

(v) provide the market value balance sheet after project completion
 Exam #1- Finance 414-Answers

Multiple Choice Questions

1.C, 2.B, 3.C 4.E, 5.D, 6.B, 7.A, 8.D, 9.D, 10.B, 11.B, 12.D, 13.D, 14.B, 15.D, 16.D, 17.A, 18.F,
19.C, 20.A, 21.D, 22.A, 23.A, 24.B, 25.C, 26.A, 27.B, 28.A

11. with no bankruptcy Rf = Rb=5% so…

Rs = 15% + (1)(1-.25)(15%-5%) = 22.5%
Rwacc = .5(5%)(1-.25) + .5(22.5) = 13.13%

15. rwacc = .5(10%)(1-.4) + .5(30%) = 18%

16. Current B/S = 1.0; B/V=S/V=.5; tc=0

E = (1+(D/E)(1-Tc)) x unlevered
1 = (1+(1)(1-0))Bu; Bu = .5
New B/S = 75/25 = 3
Be = (1+3)(.5) = 2

17. rs =5% since beta=0, with no bankruptcy rb=rf=5% ; D/E=2  D/V=2/3  E/V=1/3
rwacc = (2/3)(5%)(1-.5) + (1/3)(5%) = 3.33%

18. 25+15 = 40

19. note that the value of the net debt tax shield is zero because the net effect is such that
(1-.35)(1-0)=(1-.35); so value of the equity = 25-10

20. PV = (.3)(.08)(12M)/(1.08)1 + (.3)(.08)(8M)/(1.08)2 + (.3)(.08)(4M)/(1.08)3 =

=266,666.66 + 164,609.05 + 76,207.90 = 507,483

21. p = 10 + (300)(.3)/100 = 10.9

27. Vl = 200 + [1- (1-.3)(1-.1)/(1-.4)] 20 = 199

Long Problem #1

a. (5 points)
Use the formula E = (1+(D/E)(1-Tc)) x unlevered
Firm 1: 3.0 = [1 + (200/600)] x unlevered  unlevered = 2.25
Firm 2: 3.0 = [1 + (600/600)] x unlevered  unlevered = 1.5
Firm 3: 4.0 = [1 + (700/300)] x unlevered  unlevered = 1.2

b. (5 points)
 In the Marriott case we argued one should average the unlevered betas to arrive at a more
precise estimate of a typical unlevered beta in this industry. The average of 2.0, 1.5, and 1.0
is 1.65. Thus, we will use this as our estimate of the unlevered beta in this industry. We now
need to “relever” the beta to reflect a debt-equity ratio of 900/1800.

Again using the formula: E = (1+(D/E)(1-Tc)) x unlevered

E = [1 + (900/1800)] x 1.65 = 2.475

So, our predicted equity beta is 2.475.

c.

Answer:
1.25 = (1250/2150)(1) + (550/2150)(.75) + (350/2150)(X)
1.25 = (.5814)(1) + (.2558)(.75) + (.1628)(X)  X= 2.92

D/E = 2  D/V =2/3 and E/V = 1/3

Be = (1 + (1-.4)(2)) (2.92) =6.42

Re = .06 + 6.42(.07) = 50.97%

WACC = (2/3)(.08)(1-.4) + (1/3)(.51) = .20

Long Problem #1

Part A

(i)

Assets Liabilities and owners’ equity

Old assets 20/.12 = 166.67 Equity 166.67

(ii)

Assets Liabilities and owners’ equity

Old assets 166.67 Equity 171.67
NPV = -10 + (1.8/.12) = 5
Total = 171.67 171.667

(iii)

171.67/15 = 11.44

(iv)
10m/11.44 = 874,125

(v)

Assets Liabilities and owners’ equity

Old assets = 166.67 Equity 181.67
PV= 15
Total= 181.67