Student name:__________

TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.
1) In the steps a company takes to prepare for an IPO, the “road show” precedes the “bake-
off”.

⊚ true
⊚ false

2) The only reason why the price would fall on a corporate bond is if market interest rates
increase.

⊚ true
⊚ false

3) After issue, the market price of a fixed-rate bond can differ substantially from its par
value.

⊚ true
⊚ false

4) Bond investors should be more concerned with real returns than with nominal returns.

⊚ true
⊚ false

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5) Investment–grade bonds are usually defined as bonds with ratings of BBB– or higher.

⊚ true
⊚ false

6) Private equity firms comprise a relatively insignificant portion of the American economy.

⊚ true
⊚ false

7) Shelf registration is possible for both debt and equity issues.

⊚ true
⊚ false

8) In a strong-form efficient market, insider trading is not profitable.

⊚ true
⊚ false

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9) Principal is exchanged in interest rate swaps but not in currency swaps.

⊚ true
⊚ false

10) Valuing a call option requires an accurate estimate of the future value of the underlying
asset.

⊚ true
⊚ false

11) The evidence indicates that, on average, a company’s stock price declines when it
announces a new issue of equity.

⊚ true
⊚ false

12) Debt financing results in lower after-tax earnings relative to equity financing.

⊚ true
⊚ false

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13) The interest tax shield reduces a firm’s taxes by the amount of interest on its debt.

⊚ true
⊚ false

14) If the return on invested capital is greater than the after-tax interest rate, then a higher
debt-to-equity ratio increases return on equity.

⊚ true
⊚ false

15) The M&M irrelevance proposition assures financial managers that their choice between
equity and debt financing will ultimately have no impact on firm value.

⊚ true
⊚ false

16) In some instances, additional debt financing can encourage managers to act more in the
interests of owners.

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 ⊚ true
⊚ false

17) If the maturity of a company’s liabilities is less than that of its assets, the company incurs
a refinancing risk.

⊚ true
⊚ false

18) A company incurs costs of financial distress only after declaring bankruptcy.

⊚ true
⊚ false

19) When a company is in financial distress, its shareholders may have an incentive to
undertake excessively risky investments.

⊚ true
⊚ false

20) Inflation benefits borrowers only if the inflation is unexpected.

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 ⊚ true
⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or
answers the question.
21) Which one of the following statements is false?

A) Financial executives must design financial securities to meet the needs of the firm
and its investors.
B) Financial instruments are subject to full disclosure requirements.
C) The design of financial instruments is greatly constrained by law and regulation.
D) Financial instruments are claims against a company’s cash flows and assets.
E) None of the options are correct.

22) Which of the following securities has a purely fixed claim against a firm’s cash flows?

A) bonds
B) options
C) common stock
D) None of the options are correct.

23) Which of the following securities has a purely residual claim against a firm’s cash flows?

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 A) preferred stock
B) callable bonds
C) common stock
D) non-callable bonds
E) None of the options are correct.

24) Mike just purchased a bond which pays $40 every six months in interest. The $40 interest
payment is also called the

A) coupon.
B) par value.
C) discount.
D) call premium.
E) yield.
F) None of the options are correct.

25) A $1,000 par value bond with a fixed 10% rate of interest pays coupons semiannually.
What amount will the bondholder receive on the bond’s maturity date?

A) $50
B) $100
C) $500
D) $1,000
E) $1,050
F) $1,100

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26) Zack owns a bond that will pay him $35 each year in interest plus a $1,000 principal
payment at maturity. The $1,000 principal payment is called the

A) coupon.
B) par value.
C) discount.
D) yield.
E) call premium.
F) None of the options are correct.

27) Which one of the following statements is true?

A) Debt instruments offer residual claims to future cash payouts.

B) Bonds with call provisions will have lower coupon rates than otherwise identical
bonds.
C) Bondholders enjoy a direct voice in company decisions.
D) Bonds are low-risk investments that do well in inflationary periods.
E) Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F) None of the options are correct.

28) Which one of the following accurately orders the rate of return on financial securities
from highest to lowest over most of recorded market history (the 1928-2016 period)?

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 A) Short-term government bills, long-term corporate bonds, long-term government
bonds, common stocks
B) Long-term corporate bonds, long-term government bonds, common stocks, short-
term government bills
C) Common stocks, long-term government bonds, long-term corporate bonds, short-
term government bills
D) Common stocks, long-term corporate bonds, long-term government bonds, short-
term government bills
E) Long-term corporate bonds, common stocks, short-term government bills, long-term
government bonds
F) None of the options are correct.

29) Which one of the following statements is true?

A) Equity securities offer fixed claims on future cash payouts.

B) Unlike bondholders, for their returns, shareholders rely entirely on price
appreciation.
C) In theory, common shareholders exercise very little control over company decisions.
D) Historically, common shareholders have earned a risk premium as compensation for
risk borne in excess of government bonds.
E) Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F) None of the options are correct.

30) You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. What holding
period return, measured in yen, did you earn on the bond?

A) 3%
B) 7%
C) 10%

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 D) 13%
E) 30%
F) None of the options are correct.

31) You bought a yen–denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The exchange
rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What holding period
return, measured in U.S. dollars, did you earn on the bond?

A) −18.03%
B) −7.38%
C) −5.03%
D) 3.0%
E) 10.0%
F) None of the options are correct.

32) You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The exchange
rate was $1 = ¥100 at the beginning of the year and $1 = ¥97 at year-end. What holding period
return, measured in U.S. dollars, did you earn on the bond?

A) 3.09%
B) 6.09%
C) 13%
D) 16.49%
E) 30%
F) None of the options are correct.

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33) What is the holding period return for the year on a bond with a par value of $1,000 and a
coupon rate of 8.5% if its price at the beginning of the year was $1,215 and its price at the end of
the year was $1,020? Assume interest is paid annually.

A) −11.00%
B) −10.78%
C) −9.05%
D) 10.50%

34) Which of the following statements regarding junk bonds is true?

A) Junk bonds typically offer lower yields to maturity than investment-grade bonds.

B) Junk bonds have higher priority in bankruptcy than preferred stock.

C) Junk bonds offer no coupon payments to investors.
D) Junk bonds are typically defined as bonds with default probabilities of 25% or
higher.

35) Which of the following statements regarding preferred stock is true?

A) Holders of preferred stock have the same voting rights as common stockholders.

B) Preferred stock dividend payments are a deductible expense for corporate tax
purposes.
C) Almost all public corporations are at least partly financed with preferred stock.
D) None of the options are correct.

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36) What would be the carried interest (at 20%) on a private equity portfolio with an initial
value of $500 million that was subsequently liquidated for $750 million?

A) $50 million
B) $100 million
C) $150 million
D) $250 million

37) Which of the following statements are true?

I. Underwriters help private companies access public stock markets through IPOs.
II. Shelf registrations and private placements are examples of seasoned security issues.
III. Issue costs for debt are typically greater than issue costs for equity.
IV. Bearer bonds make it easier for investors to avoid paying taxes on interest income.

A) I and II only
B) I and III only
C) I, II, and IV only
D) I, III, and IV only
E) I, II, III, and IV
F) None of the options are correct.

38) Carbon8 Corporation wants to raise $120 million in a seasoned equity offering, net of all
fees. Carbon8 stock currently sells for $28.00 per share. The underwriters will require a fee of
$1.25 per share, and indicate that the issue must be underpriced by 7.5%. In addition to the
underwriter’s fee, the firm will incur $785,000 in legal, administrative, and other costs. How
many shares must Carbon8 sell in order to raise the desired amount of capital?

A) 4.3 million
B) 4.5 million

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 C) 4.6 million
D) 4.9 million

39) At the end of 2016, Crane Industries, Inc.’s stock price was $30.75. A year later, it was
$34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What
rate of return did the common stockholders earn in fiscal year 2017?

A) 1.79%
B) 4.33%
C) 13.43%
D) 15.22%
E) 17.76%
F) None of the options are correct.

40) At the end of 2016, Crane Industries, Inc.’s stock price was $30.75. A year later, it was
$34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What
was the dividend yield in fiscal year 2017?

A) 1.79%
B) 4.33%
C) 13.43%
D) 15.22%
E) 17.76%
F) None of the options are correct.

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41) At the end of 2016, Crane Industries, Inc.’s stock price was $30.75. A year later, it was
$34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What
was the percentage change in the share price in fiscal year 2017?

A) 1.79%
B) 4.33%
C) 13.43%
D) 15.22%
E) 17.76%
F) None of the options are correct.

42) Which of the following would allow a corporation to issue a bond at a lower coupon rate,
all else equal?

A) The addition of a call provision to the bond

B) The removal of protective covenants from the bond
C) A deterioration in the corporation’s credit quality
D) An increase in the expected inflation rate
E) None of the options are correct.

43) Which of the following statements related to market efficiency tend to be supported by
current evidence?
I. Markets tend to respond quickly to new information.
II. It is difficult for the typical investor to earn above-average returns without taking above-
average risks.
III. Short-run prices are difficult to predict accurately based on public information.
IV. Markets are most likely strong-form efficient.

A) I and III only

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 B) II and IV only
C) I and IV only
D) I, III, and IV only
E) I, II, and III only
F) None of the options are correct

44) Individuals who continually monitor the financial markets seeking mispriced securities

A) earn excess profits over the long term.

B) make the markets increasingly more efficient.
C) are never able to find a security that is temporarily mispriced.
D) are overwhelmingly successful in earning abnormal profits.
E) are always quite successful using only historical price information as their basis of
evaluation.
F) None of the options are correct.

45) Which of the following are the most likely reasons for why a stock price might not react
at all on the day that new information related to the stock issuer is released?
I. Insiders knew the information prior to the announcement.
II. Investors need time to digest the information prior to reacting.
III. The information has no bearing on the value of the firm.
IV. The information was anticipated.

A) I and II only
B) I and III only
C) II and III only
D) II and IV only
E) III and IV only
F) None of the options are correct

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46) In March, with the spot price of wheat at $5.75 per bushel, Hollywood Bakery longs 100
July wheat futures contracts (5,000 bushels each) on the CBOE at a futures price of $5.90 per
bushel. In June, Hollywood Bakery closes out its futures contracts when the futures price is
$5.80 per bushel. What is Hollywood Bakery’s gain (or loss) on the futures contracts?

A) A gain of $50,000
B) A gain of $25,000
C) A loss of $25,000
D) A loss of $50,000
E) None of the options are correct.

47) Which of the following variables does NOT affect the value of a stock option?

A) The predicted future price of the underlying stock

B) The current price of the underlying stock
C) The option’s time to maturity
D) The option’s strike price
E) The interest rate

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48) What type of financial instrument is depicted in the position diagram shown below?

A) Forward sale
B) Forward purchase
C) Call option
D) Put option

49) The price of a call option tends to be lower when which of the following is higher (all
else equal)?

A) The expected volatility of the underlying stock

B) The price of the underlying stock
C) The time to maturity
D) The strike price
E) None of the options are correct.

50) Which of the following factors, when increased, will tend to cause the value of a put to
decrease (all else equal)?

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 A) The expected volatility of the underlying stock
B) The price of the underlying stock
C) The time to maturity
D) The strike price
E) None of the options are correct.

51) Suppose you purchase a call option on XYZ stock when the stock price is $81. The
option premium is $3, and the strike price is $85. What is your net profit on the call option if the
stock price is $89 at maturity?

A) −$7
B) −$3
C) $1
D) $4
E) $5

52) Suppose you purchase a put option on XYZ stock when the stock price is $40. The option
premium is $2, and the strike price is $39. What is your net profit on the put option if the stock
price is $41 at maturity?

A) −$2
B) −$1
C) $0
D) $1
E) $2

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53) Principal amounts are usually exchanged

A) in currency swaps.
B) in interest rate swaps.
C) in both currency swaps and interest rate swaps.
D) in neither currency swaps nor interest rate swaps.

54) Financial leverage

I. increases expected ROE but does not affect its variability.
II. increases breakeven sales, like operating leverage, but increases the rate of earnings per
share growth once breakeven is achieved.
III. is a fundamental financial variable affecting sustainable growth.
IV. increases expected return and risk to owners.

A) I and II only
B) I and III only
C) II and IV only
D) II, III, and IV only
E) I, II, III, and IV
F) None of the options are correct.

55) The best financing choice is the one that

A) sets the debt-to-assets ratio equal to 1.

B) trades off the tax disadvantage of debt against the signaling effects of equity.
C) maximizes expected cash flows.
D) ignores the false comfort of financial flexibility.
E) results in the lowest possible financial distress costs.

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56) Homemade leverage is

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.

B) the exclusive use of debt to fund a corporate expansion project.

C) the borrowing or lending of money by individual shareholders as a means of
adjusting their level of financial leverage.
D) best defined as an increase in a firm’s debt-equity ratio.
E) the term used to describe the capital structure of a levered firm.
F) None of the options are correct.

57) The basic lesson of the M&M theory is that the value of a firm is dependent upon

A) the firm’s capital structure.

B) the total cash flow of the firm.
C) minimizing the marketed claims.
D) the amount of marketed claims to that firm.
E) the size of the stockholders’ claims.
F) None of the options are correct.

58) The term "financial distress costs" includes which of the following?
I. Direct bankruptcy costs
II. Indirect bankruptcy costs
III. Direct costs related to being financially distressed but not bankrupt
IV. Indirect costs related to being financially distressed but not bankrupt

A) I only

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 B) III only
C) I and II only
D) III and IV only
E) I, II, III, and IV
F) None of the options are correct.

59) Which of the following is/are helpful for evaluating the effect of leverage on a company’s
risk and potential returns?
I. Estimated pro forma coverage ratios
II. The recognition that financing decisions do not affect firm or shareholder value
III. A range of earnings chart and proximity of expected EBIT to the breakeven value
IV. A conservative debt policy that obviates the need to evaluate risk

A) I only
B) III only
C) I and III only
D) II and III only
E) IV only
F) None of the options are correct.

60) In general, the capital structures used by non-financial U.S. firms

A) typically result in debt-to-asset ratios between 60 and 80 percent.

B) tend to converge to the same proportions of debt and equity.
C) tend to be those that maximize the use of the firm’s available tax shelters.
D) vary significantly across industries.
E) None of the options are correct.

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61) Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Tax benefits
IV. Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) I, II, and III only
E) I, II, and IV only
F) None of the options are correct.

62) Which of the following factors favor the issuance of equity in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) II, III, and IV only
E) I, II, and IV only
F) None of the options are correct.

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63) Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility

A) I and II only
B) I and III only
C) II and IV only
D) I, II, and III only
E) I, II, and IV only
F) None of the options are correct.

64) Which of the following is NOT likely to be a prudent financing policy for a rapidly
growing business?

A) Adopt a modest dividend payout policy that enables the company to finance most of
its growth internally.
B) Borrow funds rather than limit growth, thereby limiting growth only as a last resort.
C) Maintain a conservative leverage ratio to ensure continuous access to financial
markets.
D) If external financing is necessary, use debt to the point it does not affect financial
flexibility.
E) None of the options are correct.

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65) According to the pecking order theory proposed by Stewart Myers of MIT, which of the
following are correct?

I. For financing needs, firms prefer to first tap internal sources, such as retained profits and
excess cash.
II. There is an inverse relationship between a firm’s profit level and its debt level.
III. Firms prefer to issue new equity rather than source external debt.
IV. A firm’s capital structure is dictated by its need for external financing.

A) I and III only

B) II and IV only
C) I, III, and IV only
D) I, II, and IV only
E) I, II, III, and IV
F) None of the options are correct.

66) Which of the following is NOT an implication of the pecking order theory of capital
structure?

A) On average, a firm’s stock price drops when it announces an equity issue.

B) Firms may want to maintain a reserve of cash or unused borrowing capacity.
C) More-profitable firms (all else equal) should have higher debt ratios.
D) Firms may fail to undertake positive-NPV projects if they would have to be financed
with a new issue of equity.

67) Salinas Corporation has net income of $15 million per year on net sales of $90 million
per year. It currently has no long-term debt but is considering a debt issue of $20 million. The
interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%.
What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt
issuance?

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 A) $560,000
B) $1,400,000
C) $8,000,000
D) $20,000,000

68) Which of the following statements regarding interest tax shields is correct?

A) Taxes are reduced by the amount of a firm’s interest-bearing debt.

B) Taxable income is reduced by the amount of a firm’s interest-bearing debt.
C) Taxes are reduced by the amount of the interest on a firm’s debt.
D) Taxable income is reduced by the amount of the interest on a firm’s debt.

69) Which of the following would NOT be considered a cost of financial distress?

A) Lack of interest tax shields

B) Bankruptcy costs
C) Excessive risk-taking by shareholders
D) Loss of customers or suppliers

70) When considering the impact of distress costs on capital structure, which of the following
facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all
else equal)?

A) ABC’s cash flows from operations are less volatile than XYZ’s.
B) ABC is a computer software firm, and XYZ is an electric utility.

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 C) ABC operates in a more competitive industry than XYZ.
D) ABC’s assets have lower resale values than XYZ’s assets.

71) According to the pecking order theory of capital structure, why do firms avoid issuing
equity?

A) Because fees associated with issuing new equity are so high

B) Because they want to avoid dilution of earnings per share
C) Because they don’t want to commit to paying dividends on the new equity
D) Because equity issuance signals that managers believe their stock is overvalued,
which causes the price of the stock to fall

72) Under the simplifying assumptions of Modigliani and Miller, an increase in a firm’s
financial leverage will

A) increase the variability in earnings per share.

B) reduce the operating risk of the firm.
C) increase the value of the firm.
D) decrease the value of the firm.

73) JKL Corporation has a projected times-interest-earned ratio of 4.0 for next year. What
percentage could EBIT decline next year before JKL’s times-interest-earned ratio would fall
below 1.0?

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 A) 3%
B) 30%
C) 75%
D) 90%
E) 300%
F) Insufficient information is provided.

74) The interest tax shield has no value when a firm has:
I. no taxable income.
II. debt-equity ratio of 1.
III. zero debt.
IV. no leverage.

A) I and III only

B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, and IV only
F) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or
answers the question.
75) Chapter 5 presents evidence that the average annual rate of return on common stocks over
many years has exceeded the return on government bonds in the United States, while returns on
common stocks have also exhibited more volatility than returns on U.S. government bonds.
Suppose that last year, the realized rate of return on government bonds exceeded the return on
common stocks. Your colleague suggests that "last year shows us that investors are now willing
to settle for lower returns on stocks than on bonds." How would you interpret this result?

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76) Himmel Corp. wants to raise $100 million in a new stock issue. Its investment banker
indicates that the sale of new stock will require 12 percent underpricing and a 7 percent spread.
a. Assuming Himmel’s stock price does not change from its current price of $50 per share, how
many shares must the company sell and at what price to the public?
b. How much money will the investment banking syndicate earn on the sale?
c. Is the 12 percent underpricing a cash flow? Is it a cost? If so, to whom?

77) If the stock market in the United States is efficient, how do you explain the fact that some
people make very high returns? Would it be more difficult to reconcile very high returns with
efficient markets if the same people made extraordinary returns year after year?

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78) You believe interest rates will soon fall.
a. Would you rather own a three-year, 6 percent coupon, fixed-rate bond or an equivalent-risk,
three-year, floating-rate bond currently paying 6 percent interest?
b. Would your answer to (a) change if you were contemplating issuing a bond rather than
owning one? If so, how?
c. Would your answer to (a) change if, as an investor, you believed interest rates would soon
rise? If so, why?

79) Houston Corp., an American company, has a payment of ¥500 million due to Osaka
Corp. one year from today. At the prevailing spot rate of 100 ¥/$, this would cost Houston $5
million, but Houston faces the risk that the ¥/$ rate will fall in the coming year, so that it will end
up paying a higher amount in dollar terms. To hedge this risk, Houston has two possible
strategies. The first strategy is to buy ¥500 million forward today at a one-year forward rate of 98
¥/$. The second strategy is to pay a premium of $100,000 for a one-year call option on ¥500
million at an exchange rate of 0.96 ¥/$.
a. Suppose that in one year, the spot exchange rate is 95 ¥/$. What would be Houston’s net
dollar cost for the payable under each strategy?
b. Suppose that in one year, the spot exchange rate is 105 ¥/$. What would be Houston’s net
dollar cost for the payable under each strategy?
c. Which hedging strategy would you recommend to Houston Corp., if any? Why?

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80) ABC Corp. has an outstanding debt of $50 million on which it pays a 4 percent fixed
interest rate annually. ABC just made its annual interest payment and has three years remaining
until maturity. ABC wants to swap its fixed rate payments for floating rate payments. A bank
offers ABC a three-year interest rate swap with annual payments in which ABC will pay LIBOR,
currently at 4.2 percent, and receive a 3.8 percent fixed rate on $50 million notional principal.
Suppose that LIBOR turns out to be 4.3 percent in one year, 4.4 percent in two years, and 4.5
percent in three years. Including interest payments on ABC’s outstanding debt and payments on
the swap, what will be ABC’s net interest payments for the next three years?

81) "A firm can’t use interest tax shields unless it has (taxable) income to shield." What does
this statement imply for capital structure? Explain briefly, comparing the following two
examples: a start-up biotech firm and an electric utility company.

82) Can a company incur costs of financial distress without ever going bankrupt? Explain.
What is the nature of these costs?

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83) Kahuku Corporation has 100 million shares outstanding trading at $20 per share. The
company announces its intention to raise $150 million by selling new shares.

a. What do market signaling studies suggest will happen to Kahuku’s stock price on the
announcement date? Why?
b. How large a gain or loss in aggregate dollar terms do market signaling studies suggest
existing Kahuku shareholders will experience on the announcement date?
c. What percentage of the value of Kahuku’s existing equity prior to the announcement is this
expected gain or loss?
d. At what price should Kahuku expect its existing shares to sell immediately after the
announcement?

84) An all-equity business has 200 million shares outstanding selling for $30 a share.
Management believes that interest rates are unreasonably low and decides to execute a leveraged
recapitalization (a recap). It will raise $750 million in debt and repurchase 25 million shares.

a. What is the market value of the firm prior to the recap? What is the market value of equity?
b. Assuming the irrelevance proposition holds, what is the market value of the firm after the
recap? What is the market value of equity?
c. Do equity shareholders appear to have gained or lost as a result of the recap? Please explain.

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SECTION BREAK. Answer all the part questions.
85) [The following information applies to the questions displayed below.]

Squamish Equipment
Selected financial information
Expected net income after tax next year before new $ 40 million
financing
Sinking-fund payments due next year on existing debt $ 14 million

Interest due next year on existing debt $ 15 million

Company tax rate 36 %

Common stock price, per share 20.00

Common shares outstanding 18 million

85.1) Please refer to the financial information for Squamish Equipment above. For next
year, calculate Squamish’s times-burden-covered ratio if Squamish sells 2 million new
shares at $20 a share.

A) 1.03
B) 1.38
C) 1.60
D) 1.89
E) 2.10
F) None of the options are correct.

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 85.2) Please refer to the financial information for Squamish Equipment above. For next
year, calculate Squamish’s earnings per share if Squamish sells 2 million new shares at $20
a share.

A) 1.28
B) 1.39
C) 2.00
D) 2.22
E) 4.00
F) None of the options are correct.

85.3) Please refer to the financial information for Squamish Equipment above.
Calculate Squamish’s times-interest-earned ratio for next year assuming the firm raises $40
million of new debt at an interest rate of 7 percent.

A) 2.00
B) 3.09
C) 3.66
D) 4.35
E) None of the options are correct.

85.4) Please refer to the financial information for Squamish Equipment above.
Calculate Squamish’s times-burden-covered ratio for the next year assuming the firm
raises $40 million of new debt at an interest rate of 7 percent, and that annual sinking fund
payments on the new debt will equal $8 million.

A) 1.01
B) 1.08
C) 1.38

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 D) 1.49
E) 1.95
F) None of the options are correct.

85.5) Please refer to the financial information for Squamish Equipment above.
Calculate Squamish’s earnings per share next year assuming Squamish raises $40 million
of new debt at an interest rate of 7 percent.

A) 1.28
B) 2.00
C) 2.12
D) 2.22
E) 3.06
F) None of the options are correct.

86) [The following information applies to the questions displayed below.]

Nile Holdings
Selected financial information as of Dec. 31, 2017
Last year's EBIT (2014) $ 175.0 million
Expected EBIT (2015) $ 189.8 million
Current portion of existing long-term debt, due $ 34 million
2015
Interest due in 2015 on existing debt $ 36 million
Tax rate 35 %

Common stock price per share $ 50.00

Common shares outstanding 20 million

Dividends per share $ 2.00

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 86.1) Please refer to the financial information for Nile Holdings above. Nile must
decide how to finance a $100 million investment. Assume Nile raises $100 million of new
debt at the end of 2017 at an interest rate of 7%.
a. Calculate the firm’s pro forma 2018 times-interest-earned (TIE) ratio.
b. Calculate the percentage EBIT can fall (below expected EBIT) before interest
coverage dips below 1.0.

86.2) Please refer to the financial information for Nile Holdings above. Nile must
decide how to finance a $100 million investment. Assume Nile raises $100 million of new
debt at the end of 2017 at an interest rate of 7%.
a. Assuming Nile must make a $20 million payment on the new debt next year, calculate
the firm’s times-burden-covered ratio and times-common-covered ratio (i.e., the number of
times EBIT could cover interest, principal payments, and dividends).
b. As Nile’s banker, would you be comfortable loaning the company this new debt?
Briefly explain why, or for what reasons you’d be comfortable or uncomfortable.

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 86.3) Please refer to the financial information for Nile Holdings above. Nile must
decide how to finance a $100 million investment. Calculate next year’s earnings per share
assuming Nile raises $100 million of new debt.

86.4) Please refer to the financial information for Nile Holdings above. Nile must
decide how to finance a $100 million investment. Calculate next year’s times-burden-
covered ratio and earnings per share if Nile sells 2 million new shares at $50 a share
instead of raising new debt.

86.5) Please refer to the financial information for Nile Holdings above. Nile must
decide how to finance a $100 million investment. Suppose Nile expects $4.52 in EPS next
year if it does not go through with the investment and associated financing. As a
shareholder, to satisfy its funding needs for the investment opportunity, do you prefer the
company issue $100 million in new debt at an interest rate of 7% and a payment of $20
million due on the debt next year or issue 2 million shares of equity at a target price of
$50? Show supporting calculations and provide arguments and potential counter-
arguments for your recommendation.

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Version 1 37
Answer Key

Test name: Module 3 Guided formatives

1) FALSE

2) FALSE

3) TRUE

4) TRUE

5) TRUE

6) FALSE

7) TRUE

8) TRUE

9) FALSE

10) FALSE

11) TRUE

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12) TRUE

13) FALSE

14) TRUE

15) FALSE

16) TRUE

17) TRUE

18) FALSE

19) TRUE

20) TRUE

21) C

22) A

23) C

24) A

25) E

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26) B

27) F

28) D

29) D

30) D

The holding period return in yen was (3% × 100,000 + 10,000)/100,000

= 13%.

31) B

You paid $1,000 for the bond (¥100,000/100). At the end of the year,
you had interest income and a yen bond worth a total of $926.23
(¥113,000/122). Your dollar return was ($926.23 − $1,000)/$1,000 =
−7.38 percent.

32) D

You paid $1,000 for the bond (¥100,000/100). At the end of the year,
you had interest income and a yen bond worth a total of $1,164.95
(¥113,000/97). The U.S. dollar holding period return would be
($1,164.95 − $1,000)/$1,000 = 16.49%.

33) C

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(85 + 1,020 − 1,215)/1,215 = −0.0905

34) B

35) D

36) A

37) C

38) D

The price will be set at 7.5% below the current price, or at 0.925 × 28.00
= $25.90. The underwriters will take $1.25 per share, leaving
$24.65/share for Carbon8. Carbon8 needs to earn $120,785,000 at
$24.65/share, so it must sell 120.785mil/24.65 = 4.9 million shares.

39) D

Rate of return = (34.88 + 0.55 − 30.75)/30.75 = 15.22%

40) A

Dividend yield = 0.55/30.75 = 1.79%

41) C

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Percentage change in share price = (34.88 − 30.75)/30.75 = 4.13/30.75 =
13.43%.

42) E

43) E

44) B

45) E

46) D

Gain on futures = ($5.80 − $5.90) × 500,000 bushels = −$50,000

47) A

48) C

49) D

50) B

51) C

The gain on the call is 89 − 85 = $4; less the option premium of $3 gives
a net profit of $1.

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52) A

The put option is out of the money at maturity, so the net profit is −$2.

53) A

54) D

55) C

56) C

57) B

58) E

59) C

60) D

61) B

62) C

63) B

64) B

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65) D

66) C

67) A

Interest tax shield = interest rate × amount of debt × tax rate = 0.07 ×
20,000,000 × 0.40 = $560,000

68) D

69) A

70) A

71) D

72) A

73) C

% EBIT can fall = (4.0 − 1)/4.0 = 0.75

74) C

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75) The fact that government bonds earned a higher rate of return than
common stocks in one year is not evidence that investors are suddenly
willing to settle for lower returns on stocks than bonds. It means that
investors’ expectations were not met or, alternatively, that investors
were surprised. To take on additional risk, risk-averse investors require
additional expected return. But expected returns are not the same as
realized returns. Because stocks and bonds are risky, their returns will
fluctuate from year to year, and bonds will earn higher returns than
stocks in some years. But the expected returns of common stocks should
always be higher than the expected returns of government bonds.

76) a.

Stock Price $ 50.00

− 12% underpricing 6.00

Issue price 44.00

− 7% spread 3.08

Net to company $ 40.92

Desired revenue (millions) $ 100

Number of shares (millions) $ 2.444

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b. Investment bankers’ revenue = $3.08 × 2.444 million = $7.528
million.
c. Underpricing is not a cash flow. It is, however, an opportunity cost
to current owners because it means that more shares must be sold to
raise $100 million and each share will represent a smaller ownership
interest in the company.

77) Earning high returns in an efficient market is like winning at

roulette. In any random process, there will be winners and losers, and
some winners might win big. Earning consistently high returns over time
is also possible in an efficient market, just like a gambler on a lucky
streak might win repeatedly at roulette. The relevant question is whether
the very high returns or the length of the winning streak is inconsistent
with blind luck or not.

78) a. I would rather own a fixed-rate bond because the interest income
I receive from a floating-rate bond will fall as interest rates decline.
Equivalently, the market value of the fixed-rate bond will rise as rates
fall, but that of the floating-rate bond will not. (This presumes the fixed-
rate bond is not callable.)
b. My answer would change. I would rather issue a floating-rate bond
now because future interest payments will fall as rates decline.
c. My answer would change. As an investor, I would want to hold a
floating-rate bond because interest income will rise as interest rates rise.
Equivalently, the price of the fixed-income bond will fall as rates rise,
while that of the floating-rate bond will not.

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79) a. In the first strategy, the net cost in dollars is ¥500 million/98 =
$5.102 million. In the second strategy, Houston Corp. exercises its
option to exchange at 96 ¥/$ for a cost of ¥500 million/96 = $5.208
million. Including the cost of the option, the net cost is $5.308 million.
b. In the first strategy, the net cost in dollars is again ¥500 million/98 =
$5.102 million. In the second strategy, Houston Corp. allows its option
to expire and exchanges at the spot rate of 105 ¥/$ for a cost of ¥500
million/105 = $4.762 million. Including the cost of the option, the net
cost is $4.862 million.
c. The first strategy allows Houston to lock in an exact cost without
paying a premium up front. The second strategy requires a premium
payment, but Houston retains the possibility of having a much lower net
dollar cost if the dollar strengthens enough relative to the yen. The
correct strategy for Houston depends on its risk tolerance, its
expectations for exchange rate movements, and its cash availability.

80) The table below shows ABC’s net interest payments for years 1
through 3. Negative signs indicate cash flows paid by ABC and positive
signs indicate cash flows received by ABC, all in dollars.

Year LIBOR Outstanding debt Fixed leg of Floating leg Net payment
payment swap of swap
0 4.2 %

1 4.3 % -2,000,000 1,900,000 - 2,100,000 - 2,200,000

2 4.4 % -2,000,000 1,900,000 - 2,150,000 - 2,250,000

3 -2,000,000 1,900,000 - 2,200,000 - 2,300,000

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81) The corporate tax shield of debt is only valuable to a company that
has taxable income to shield. This implies that companies that do not
have a lot of taxable income (i.e. startups), or companies that have
highly variable taxable income (e.g., younger tech or biotech firms)
should not have as much debt, because the benefits of the corporate tax
shield are less. The statement also implies that if a company has a lot of
debt, it may exhaust its taxable income. At this stage, the marginal
benefit of additional debt is zero, and the probability of financial distress
grows. The (typical) utility’s more stable cash flows and profitability
imply greater tax benefits, and lower costs of financial distress.
(Note that the current tax code allows firms to carry forward and carry
back their income/losses, for purposes of computing taxes. The
argument given above still holds, with "taxable income" incorporating
carryforwards or carrybacks.)

82) Yes. As discussed in the text, there are costs of financial distress
even before the company actually defaults on the debt. These costs arise
as the company, customers, and suppliers become aware that there is a
possibility the company may default soon. These costs may include
managers’ time and effort, disruption of supplies and customer service,
drastic sales decreases for sellers of durable goods, and delay of research
or capital improvement projects. The firm’s competitors can also sense a
firm in trouble, and could engage in predatory pricing to weaken or
eliminate the firm as a competitor. Moreover, detrimental conflicts of
interest among owners, creditors, and managers can also arise when a
company gets into financial difficulty.

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83) a. Market signaling studies suggest that the price of existing
Kahuku shares will fall.One explanation for the decline is that managers
know more about their company than outsiders do and that the
announcement of an equity sale signals they are worried about the
company’s prospects.Alternatively, they believe the company’s stock is
overvalued at the current price.
b. Expected loss = 30% of issue size = 0.3 × ($150 million) = $45
million.
c. 45/($20 × 100) = 2.25 percent
d. Price per share = $20 × (1 − 0.025) = $19.50.

84) a. Because there is no debt outstanding, Firm value = Equity value

= 200 million × $30 = $6 billion.
b. Firm value is unchanged at $6 billion.Debt outstanding is $0.75
billion, so equity value is $5.25 billion. (Equity value = firm value −
debt value.)
c. Equity investors neither gain nor lose from the recap.Before the
recap, equity value is $6 billion for 200 million shares, or $30 per
share.After the recap, equity value is $5.25 billion for 175 million
remaining shares, or $30 per share.(Equity investors that sold shares in
the repurchase also received $30 cash for each share.)

85) Section Break

85.1) E

EBIT = 40/(1 − 0.36) + 15 = $77.5

Times burden covered = 77.5/[15 + 14/(1 − 0.36)] = 2.10 times

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 85.2) C

EPS = 40/(18 + 2) = $2.00

85.3) D

EBIT = 40/(1 − 0.36) + 15 = $77.5

Interest = 15 + 0.07(40) = $17.8
Times interest earned = 77.5/17.8 = 4.35 times

85.4) D

EBIT = 40/(1 − 0.36) + 15 = $77.5

Interest = $15 + 0.07(40) = $17.8
Burden of interest and sinking fund before tax = 17.8 + (14 + 8)/(1
− 0.36) = $52.175
Times burden covered = 77.5/52.175 = 1.49 times

85.5) C

EBIT = 40/(1 − 0.36) + 15 = $77.5

Interest = $15 + 0.07(40) = $17.8
EPS = (77.5 − 17.8)(1 - 0.36)/18 = $2.12

86) Section Break

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 86.1) a. Interest expense = $36 + 0.07($100) = $43
Pro forma TIE = EBIT/Int. Exp. = 189.8/43 = 4.41
b. EBIT can fall (189.8 − 43)/189.8 = 77.34% before interest
coverage dips below 1.0.

86.2) a.
Interest expense = $36 + 0.07($100) = $43
Upcoming payments on debt = existing + new = 34 + 20 = 54
Times burden covered = EBIT/(interest + debt pmts./(1 − t)) =
189.8/(43 + 54/(1 − 0.35)) = 1.51
Times common covered = EBIT/(interest + (debt pmts. +
dividends)/(1 − t)) = 189.8/(43 + (54 + 40)/(1 − 0.35)) = 1.01
b.
Debt (both principal and interest) coverage is relatively strong at
1.5 times, but if the company continues to pay its dividend, its
expected ability to pay its pro forma fixed financing charges (or
burden) including dividends is right at the edge. Although EBIT can
fall 33.6% ((189.8 − 126.08)/189.8 = 33.6%) before TBC falls
below 1, Nile has a quite low TCC (1.01) including the burden.
There is risk here, and a prudent lender will require covenants that
restrict dividend payouts to certain situations, if at all. Covenants
(restrictions set in the debt contract) impose additional costs on the
firm; this fact should be considered by management as they weigh
the costs and benefits of new debt. Nile’s banker will compare
Nile’s coverage ratios to the industry’s average of these ratios. If the
company has strong and relatively stable CFs, and the ratios are
above or within industry averages, the banker will be more
comfortable with the added debt.

86.3)

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 EBIT 189.80

Interest expense 43.00

Pre-tax income 146.80

Tax 51.38

Net income 95.42

Shares outstanding 20.00

EPS 4.77

86.4) Times burden covered = EBIT/(interest + debt pmts.//(1 − t))

= 189.8/(36 + 34/(1 − 0.35)) = 2.15

EBIT 189.80

Interest expense 36.00

Pre−tax income 153.80

Tax 53.83

Net income 99.97

Shares outstanding 22.00

EPS 4.54

86.5) First compare Nile’s EPS and coverage ratios under the two
scenarios.
Debt Issuance:

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 EBIT 189.80

Interest expense 43.00

Pre−tax income 146.80

Tax 51.38

Net income 95.42

Shares outstanding 20.00

EPS 4.77

Upcoming payments on debt = existing + new = 34 + 20 = 54

Times burden covered = EBIT/(interest + debt pmts./(1 − t)) =
189.8/(43 + 54/(1 − 0.35)) = 1.51
Times common covered = EBIT/(interest + (debt pmts. +
dividends)/(1 − t)) = 189.8/(43 + (54 + 40)/(1 − 0.35)) = 1.01
Equity issuance:

EBIT 189.80

Interest expense 36.00

Pre−tax income 153.80

Tax 53.83

Net income 99.97

Shares outstanding 22.00

EPS 4.54

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 Times burden covered = EBIT/(interest + debt pmts./(1 − t)) =
189.8/(36 + 34/(1 − 0.35)) = 2.15
Times common covered = EBIT/(interest + (debt pmts. +
dividends)/(1 − t)) = 189.8/(36 + (34 + 44)/(1 − 0.35)) = 1.22
The EPS calculations above indicate that, while both debt and
equity issuances are expected to increase EPS compared to no
issuance and subsequent investment, the debt issuance results in the
highest EPS, although the higher EPS is accompanied by a higher
level or risk. Depending on the volatility of the company’s EBIT,
the issuance of debt presents risk to the shareholders. If the
company issues debt and its EBIT falls below $126 million [$43 +
54/(1 − 0.35)], then the company could default on its borrowings.
On the other hand, if financing needs were met with equity, EBIT
could fall to $88 million [$36 + 34/(1 − 0.35)] and Nile could still
make the interest and loan payments. Defaulting on its loans would
cause a catastrophic decrease in Nile’s stock price. Raising equity
poses much less risk of financial distress in this case. The issuance
of debt also presents the risk that the company will be forced to
miss (or reduce) future dividend payments, causing the stock price
to fall.
As indicated in Chapter 6, debt can increase shareholders’ returns
in good times, but decrease them in bad times; i.e., the increase in
expected return comes at the cost of higher risk. Management must
weigh these trade−offs. Other considerations:
● The issuance of equity has a negative signaling effect. Evidence
indicates that the stock market on average reacts negatively to
announcements of secondary, or seasoned public stock offerings
(SEOs). Debt avoids this result.
● In fact, debt issuance often has positive signaling and
managerial incentive effects.

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 ● Equity issuance retains more future financing flexibility.

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