Practice Exam Questions

Question 1

MM ignores the fact that as you borrow more you have to pay higher rates of interest, explain if this is true or not?

Answer 1

• not true Klevered = Kunlevered + D/E(Kd-Ku)(1-tc)
• Klevered increase as debt increases
• both debt holders and equity holders are impacted.
• K-levered increases because debt holders bare more risk
• K-unlevered increases because the firm has more leverage.

Question 2

What does the initial return of an IPO represent?

Answer 2

the underpricing

Question 3

what is another term for prevailing equilibrium interest rate? how is it found?

Answer 3

the rate on bonds

r-bond x (1-Tc) = r-equity
therefore
r-bond = r-equity / (1-Tc)

Question 4

if investors have 10%, 20% and 40% tax rate, what are they more likely to invest in?

Answer 4

10%, 20% equity

40% debt

Question 5

does bankruptcy risk impact the value of a firm?

Answer 5

no the cost of bankruptcy does

Question 6

Stulz 1990 states debt reduced investment in all states, explain what is meant.

How is the cap structure impacted?

Answer 6

High CFs and lower than expected Investment opps, management will be self interested and try to retain funds, resulting in over investment. If debt repayments equal excess CFs this reduces over-investment.

Cost on the other hand is if CFs lower than expected and debt repayments do not leave any funds for investment there will be under investment. Because it already has high debt it can’t request external funding.

Optimal cap structure is one where debt increases when CFs increase and decreases when investment opps increase

Question 7

when should a company issue convertible debt?

Answer 7

when it has high growth opps but not enough internal finance. Straight debt is more expensive and issuing equity would be undervalued

Question 8

Is convertible debt cheaper?

Answer 8

not always

Stock increases:
convert to equity: debt would have been cheaper, issuing equity at a discount

Stock Decreases:
keep bond: equity would have been cheaper, as could have raised funds at an inflated value.

Question 9

Stulz 1990, what happens with agency cost of managerial discretion and without it if there are excess cashflows to the firm? how does debt help?

Answer 9

• without
  if still FCF amount would be paid out in dividends
• with
  retain FCF and over investment will occur

Debt: if repayment equal to FCF then it disciplines managers

Question 10

List literature that refers to Exec Compensation

Answer 10

Yermack 1997- 1. timing of awards coincide with favourable movements in company stock prices

2. stock options create incentive effect, CEOs make better decisions
3. CEOs time option grants to before issue of good news

Question 11

Why to share prices react positively to news of a stock option issue to CEOs?

Answer 11

CEOs unlikely to issue themselves stock options before bad news Yermack 1997

Question 12

What effect do stock options create?

Answer 12

incentive effect

-incentive for CEO to make better business decisions

Question 13

what are the main reasons for takeovers?

Answer 13

synergies, target poorly managed, if taken over remove mgmt and increase stock value.

Question 14

What is the free rider problem?

Answer 14

• shareholders from target firm that do not tender, do not invest time and effort, however still receive post take over share price, so bidding firm looses all profit generated from takeover

Question 15

what literature discusses internal capital markets?

Answer 15

Gertner, Scharfstein and Stein 1994 - 2 benefits and 1 cost

• higher monitoring than banks
• better asset redeployment if a project is performing badly
• no incentive for divisional managers to act in an entrepreneurial manner as they do not control fund allocations.

Stein 1997 - winner picking

Question 16

What is the equilibrium market interest rate formula?

Answer 16

rb (1-tc) = re

Question 17

if the bond is callable by the issuer how does this affect the convertible bond value?

Answer 17

decreases the value to the holder as early conversion reduces possible gains.
however it could also be argued that the CB is worth more because it displays issuer confidence in their stock increasing therefore they want to reduce their losses.

Question 18

the volatility increases how does this impact the value of a convertible bond?

Answer 18

decreases value of bond because bondholder is risk adverse, increased value of the conversion option

Question 19

If you are in financial distress and there is still cash to invest, and you are acting in the existing shareholders best interests, what would you do?

Answer 19

invest in highly risky projects with low probabilities of high payoffs.

Question 20

if given choice of two projects and you are in financial distress and there is still cash to invest, and you are acting in the existing shareholders best interests, which project would you invest in?

Answer 20

project with the higher potential pay off, even if it is a negative payoff loss would go towards bondholders value not equity holders.

Question 21

explain what happens in takeovers when there is synergies, hubris and agency costs/mistakes?

Answer 21

• if reason for take over is synergies all parties win
• in hubris bidder wrongly believes it can add value then there is wealth transfer to the target and the overall value added is zero
• if there is agency cost/mistake wealth is transferred to the target and value is destroyed

Question 22

discuss financial slack

Answer 22

Firms like to maintain financial slack. They do not want to issue new equity at a discount, which would transfer wealth from old shareholders to new shareholders. They will want to maintain sufficient financial reserves to pay their dividend and not be forced into the position of needing to issue new equity at the expense of existing shareholders