Question: Some individuals are eager to spend income

> Suppose the current price of gold is $1,200 an ounce. Hotshot Consultants advises you that gold prices will increase at an average rate of 12% for the next two years. After that the growth rate will fall to a long-run trend of 3% per year. What is the p

> The traditional theory of optimal capital structure states that firms trade off corporate interest tax shields against the possible costs of financial distress due to borrowing. What does this theory predict about the relationship between book profitabil

> True or false? a. If the probability of default is high, managers and stockholders will be tempted to take on excessively risky projects. b. If the probability of default is high, stockholders may refuse to contribute equity even if the firm has safe pos

> This question tests your understanding of financial distress. a. What are the costs of going bankrupt? Define these costs carefully. b. “A company can incur costs of financial distress without ever going bankrupt.” Explain how this can happen. c. Explain

> Look at some real companies with different types of assets. What operating problems would each encounter in the event of financial distress? How well would the assets keep their value?

> On February 29, 2019, when PDQ Computers announced bankruptcy, its share price fell from $3.00 to $.50 per share. There were 10 million shares outstanding. Does that imply bankruptcy costs of 10 × (3.00 – .50) = $25 million? Explain.

> What is the relative tax advantage of corporate debt if the corporate tax rate is Tc = .21, the personal tax rate is Tp = .37, but all equity income is received as capital gains and escapes tax entirely (TpE = 0)? How does the relative tax advantage chan

> Look back at the Johnson & Johnson example in Section 18-1. Suppose Johnson & Johnson increases its long-term debt to $45 billion. It uses the additional debt to repurchase shares. Reconstruct Table 18.4B with the new capital structure. How much addition

> People often convey the idea behind MM’s proposition 1 by various supermarket analogies, for example, “The value of a pie should not depend on how it is sliced,” or, “The cost of a whole chicken should equal the cost of assembling one by buying two drums

> Consider the following three tickets: Ticket A pays $10 if is elected as president, ticket B pays $10 if is elected, and ticket C pays $10 if neither is elected. (Fill in the blanks yourself.) Could the three tickets sell for less than the present value

> Gamma Airlines has an asset beta of 1.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 25%. Draw a graph plotting Gamma’s cost of equity and

> There is an active, competitive leasing (i.e., rental) market for most standard types of commercial jets. Many of the planes flown by the major domestic and international airlines are not owned by them but leased for periods ranging from a few months to

> Omega Corporation has 10 million shares outstanding, now trading at $55 per share. The firm has estimated the expected rate of return to shareholders at about 12%. It has also issued long-term bonds at an interest rate of 7% and has a debt value of $200

> Hubbard’s Pet Foods is financed 80% by common stock and 20% by bonds. The expected return on the common stock is 12% and the rate of interest on the bonds is 6%. Assuming that the bonds are default-risk-free, draw a graph that shows the expected return o

> Look back to Section 17-1. Suppose that Ms. Macbeth’s investment bankers have informed her that since the new issue of debt is risky, debtholders will demand a return of 12.5%, which is 2.5% above the risk-free interest rate. a. What are rA and rE? b. Su

> “MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest.” Explain carefully whether this is a valid objection.

> What is wrong with the following arguments? a. As the firm borrows more and debt becomes risky, both stock- and bondholders demand higher rates of return. Thus, by reducing the debt ratio, we can reduce both the cost of debt and the cost of equity, makin

> Suppose that new security designs could be patented.14The patent holder could restrict use of the new design or charge other firms royalties for using it. What effect would such patents have on MM’s capital-structure irrelevance theory?

> Reliable Gearing currently is all-equity-financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy ba

> Here are key financial data for House of Herring Inc.: House of Herring plans to pay the entire dividend early in January 2026. All corporate and personal taxes were repealed in 2024. a. Other things equal, what will be House of Herringâ€&#153

> Go back to the first Rational Demiconductor balance sheet. Now assume that Rational wins a lawsuit and is paid $1 million in cash. Its market capitalization rises by that amount. It decides to pay out $2 per share instead of $1 per share. Explain what ha

> Go to the Apple website or to a financial source such as Yahoo! Finance. a. Has Apple’s dividend increased from the initial quarterly rate of $2.65? b. What was the announcement date of the most recent dividend? c. When did Apple stock last go ex-dividen

> Suppose that you are considering investing in an asset for which there is a reasonably good secondary market. Specifically, your company is Delta Airlines, and the asset is a Boeing 757—a widely used airplane. How does the presence of a secondary market

> In 2017, Entergy paid a regular quarterly dividend of $.89 per share. a. Match each of the following dates. b. On one of these dates, the stock price fell by about $.89. Which date? Why? c. Entergy’s stock price in November 2017 was abo

> In April 2019, Van Dyck Exponents offered 100 shares for sale in an IPO. Half of the shares were sold by the company and the other half by existing shareholders, each of whom sold exactly half of their existing holding. The offering price to the public w

> Find the prospectus for a recent IPO. How do the issue costs compare with, a. Those of the Marvin issue? b. Those shown in Table 15.3? Can you suggest reasons for the differences?

> Refer to Section 15.1 and the Marvin Prospectus Appendix at the end of this chapter to answer the following questions. a. If there is unexpectedly heavy demand for the issue, how many extra shares can the underwriters buy? b. How many shares are to be so

> Complete the passage using the following terms: limited partners, venture capital, private, underwriters, general partners, private equity, corporate ventures, partnerships, private, angel investors. (Note: Not all terms will be used) Equity capital in y

> True or false? a. Venture capital companies know that managers are more likely to work hard if they can be assured of a good steady salary. b. Venture capital companies generally advance the money in stages. c. Venture capital companies are generally pas

> Look at Marvin’s first attempt to raise financing. (Refer to Section 15.1 and the Marvin Prospectus in the appendix at the end of this chapter.) Suppose that First Meriam decides that Marvin’s shares are worth only $0.80 each. a. How many shares will Ma

> Ethelbert.com is a young software company owned by two entrepreneurs. It currently needs to raise $400,000 to support its expansion plans. A venture capitalist is prepared to provide the cash in return for a 40% holding in the company. Under the plans f

> True or false? a. Venture capitalists typically provide first-stage financing sufficient to cover all development expenses. Second-stage financing is provided by stock issued in an IPO. b. Underpricing in an IPO is only a problem when the original invest

> Problem 23 contains details of a rights offering by Pandora Box. Suppose that the company had decided to issue new stock at €4. How many new shares would it have needed to sell to raise the same sum of money? Recalculate the answers to questions (b) to (

> Your brother-in-law wants you to join him in purchasing a building on the outskirts of town. You and he would then develop and run a Taco Palace restaurant. Both of you are extremely optimistic about future real estate prices in this area, and your broth

> Spike Equino is the CEO of a private medical equipment company that is proposing to sell 100,000 shares of its stock in an open auction. Suppose the company receives the bids in the following table. a. What will be the company’s total r

> Fishwick Enterprises has 200,000 shares outstanding, half of which are owned by Jennifer Fishwick and half by her cousin. The two cousins have decided to sell 100,000 shares in an IPO. Half of these shares would be issued by the company to raise new cash

> Having heard about IPO underpricing, I put in an order to my broker for 1,000 shares of every IPO he can get for me. After three months, my investment record is as follows: a. What is the average underpricing in dollars of this sample of IPOs? b. What is

> Each of the following terms is associated with one of the events beneath. Can you match them up? a. Best efforts b. Bookbuilding c. Shelf registration d. Rule 144A Events: A. Investors indicate to the underwriter how many shares they would like to buy i

> Which of the following features would increase the value of a corporate bond? Which would reduce its value? a. The bond is convertible into shares. b. The bond is secured by a mortgage on real estate. c. The bond is subordinated.

> In 2018, Beta Corporation earned gross profits of $760,000. a. Suppose that Beta was financed by a combination of common stock and $1 million of debt. The interest rate on the debt was 10%, and the corporate tax rate in 2018 was 21%. How much profit was

> Suppose that East Corporation has issued voting and nonvoting stock. Investors hope that holders of the voting stock will use their power to vote out the company’s incompetent management. Would you expect the voting stock to sell for a higher price? Expl

> Saga City has a declassified board with nine directors. a. How many directors come up for election each year? b. Would Saga be more or less vulnerable to a hostile takeover if it had a classified board?

> What do we mean when we say that stockholders have control rights and residual cash flow rights? How in practice do they exercise their control rights?

> True or false? a. Banks are huge investors in corporate equity. b. Insurance companies are huge investors in corporate debt. c. Rather than investing directly in corporate equities, most households prefer to pool their risk in a hedge fund. d. Many indiv

> Look back to the cash flows for projects F and G in Section 5-3. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from eac

> True or false? a. Net stock issues by U.S. nonfinancial corporations in most years are small but positive. b. Most capital investment by U.S. companies is funded by retained earnings and reinvested depreciation. c. Debt ratios in the United States are lo

> True or false? a. In the United States, most common shares are owned by individual investors. b. An insurance company is a financial intermediary. c. Investments in partnerships cannot be publicly traded.

> We mention several causes of the financial crisis. What other causes can you identify? You will probably want to review some of the entries under Further Reading before you answer.

> Construct a timeline of the important events in the financial crisis that started in the summer of 2007. When do you think the crisis ended? You will probably want to review some of the entries under Further Reading before you answer.

> Explain briefly how each of the following allow individuals or companies to spread their risk: a. An exchange traded fund. b. Commodity markets. c. A life insurance company.

> Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes: a. Investor to financial intermediary, to finan

> True or false? a. Exchange traded funds are hedge funds that can be bought and sold on the stock exchange. b. Hedge funds provide small investors with low-cost diversification. c. The sale of insurance policies is a source of financing for insurance comp

> Which of the following are financial markets? a. NASDAQ. b. Vanguard Explorer Fund. c. JP Morgan Chase. d. Chicago Mercantile Exchange.

> True or false? a. Financing for public corporations must flow through financial markets. b. Financing for private corporations must flow through financial intermediaries. c. Almost all foreign exchange trading occurs on the floors of the FOREX exchanges

> The Finance in Practice box in Section 1-2 describes three corporate practices that have been criticized as unethical. Select one of these and discuss at what point (if any) the practice slide into unethical behavior does.

> Fill in the blanks, using the following terms: floating rate, common stock, convertible, subordinated, preferred stock, senior, warrant. a. If a lender ranks behind the firm’s general creditors in the event of default, his or her loan is said to be. b.

> Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semistrong, or strong form of the efficient-market hypothesis. a. Tax-exempt municipal bonds offer lower pretax re

> Fama and French show that average stock returns on firms with small market capitalizations have been significantly higher than average returns for “large-cap” firms. What are the possible explanations for this result? Does the result disprove market effi

> Reliable Electric, a major Ruritanian producer of electrical products, is considering a proposal to manufacture a new type of industrial electric motor that would replace most of its existing product line. A research breakthrough has given Reliable a two

> “If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin.” Explain why this is not so.

> Explain why setting a higher discount rate is not a cure for upward-biased cash-flow forecasts.

> Draw up an outline or flowchart tracing the capital budgeting process from the initial idea for a new investment project to the completion of the project and the start of operations. Assume the idea for a new obfuscator machine comes from a plant manager

> Explain how each of the following actions or problems can distort or disrupt the capital budgeting process. a. Overoptimism by project sponsors. b. Inconsistent forecasts of industry and macroeconomic variables. c. Capital budgeting organized solely as a

> True or false? a. The approval of a firm’s capital budget allows managers to go ahead with any project included in the budget. b. Capital budgets and project authorizations are mostly developed “bottom up.” Strategic planning is a “top-down” process. c.

> You are considering a proposal to produce and market a new sluffing machine. The most likely outcomes for the project are as follows: Expected sales: 30,000 units per year Unit price: $50 Variable cost: $30 Fixed cost: $300,000 The project will last for

> What is the NPV of the electric scooter project under the following scenario? Unit sales are 20% below expectations. Unit price is 10% below expectations. Unit variable cost remains at 50% of revenue. Fixed costs increase by 5%. Investment in plant and e

> A project currently generates sales of $10 million, variable costs equal 50% of sales, and fixed costs are $2 million. The firm’s tax rate is 21%. What are the effects of the following changes on cash flow? a. Sales increase from $10 million to $11 milli

> Emperor’s Clothes Fashions can invest $5 million in a new plant for producing invisible makeup. The plant has an expected life of five years, and expected sales are 6 million jars of makeup a year. Fixed costs are $2 million a year, and variable costs ar

> Use the spreadsheet for the guano project in Chapter 6 to undertake a sensitivity analysis of the project. Make whatever assumptions seem reasonable to you. What are the critical variables? What should the company’s response be to your analysis?

> The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $9 million (the existing equipment has zero salvage value). The attraction of the new machinery is that it is expected to cu

> Respond to the following comments: a. “The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets.” b. “If everyone believes you can make money by charting stock prices,

> Decision trees Magna Charter is a new corporation formed by Agnes Magna to provide an executive flying service for the southeastern United States. The founder thinks there will be a ready demand from businesses that cannot justify a full-time company pla

> Monte Carlo simulation Look back at the guano project in Section 6-3. Use the Crystal Ball™ software to simulate how uncertainty about inflation could affect the project’s cash flows.

> Project analysis New Energy is evaluating a new bio fuel facility. The plant would cost $4,000 million to build and has the potential to produce up to 40 million barrels of synthetic oil a year. The product is a close substitute for conventional oil and

> Otobai’s staff (see Section 10-1) has come up with the following revised estimates for the electric scooter project: Conduct a sensitivity analysis using the spreadsheets (available in Connect). What are the principal uncertainties in t

> Decision trees look again at the example in Figure 10.4. The R&D team has put forward a proposal to invest an extra $20 million in expanded phase II trials. The object is to prove that the drug can be administered by a simple inhaler rather than as a liq

> Decision trees Look again at the decision tree in Figure 10.4. Expand the possible outcomes as follows: 1. Blockbuster: PV = $1.5 billion with 5% probability. 2. Above average: PV = $700 million with 20% probability. 3. Average: PV = $300 million with 40

> Decision trees* Your midrange guess as to the amount of oil in a prospective field is 10 million barrels, but there is a 50% chance that the amount of oil is 15 million barrels and a 50% chance of 5 million barrels. If the actual amount of oil is 15 mill

> Decision trees Look back at the Vegetron electric mop project in Section 9-4. Assume that if tests fail and Vegetron continues to go ahead with the project, the $1 million investment would generate only $75,000 a year. Display Vegetron’s problem as a dec

> Real options An auto plant that costs $100 million to build can produce a line of flex-fuel cars. The investment will produce cash flows with a present value of $140 million if the line is successful but only $50 million if it is unsuccessful. You believ

> A silver mine can yield 10,000 ounces of silver at a variable cost of $32 per ounce. The fixed costs of owning the mine are $40,000 per year regardless of whether the mine is open or closed. In half the years, silver can be sold for $48 per ounce; in the

> How would you respond to the following comments? a. “Efficient market, my eye! I know lots of investors who do crazy things.” b. “Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market.” c. “The trouble wi

> Real options True or false? a. Decision trees can help identify and describe real options. b. The option to expand increases PV. c. High abandonment value decreases PV. d. If a project has positive NPV, the firm should always invest immediately.

> Real options describe the real option in each of the following cases: a. Moda di Milano postpones a major investment. The expansion has positive NPV on a discounted cash-flow basis, but top management wants to get a better fix on product demand before pr

> Real options Explain why options to expand or contract production are most valuable when forecasts about future business conditions are most uncertain.

> Monte Carlo simulation Suppose a manager has already estimated a project’s cash flows, calculated its NPV, and done a sensitivity analysis like the one shown in Table 10.2. List the additional steps required to carry out a Monte Carlo simulation of proje

> True or false? a. Sensitivity analysis is unnecessary for projects with asset betas that are equal to zero. b. Sensitivity analysis can be used to identify the variables most crucial to a project’s success. c. If only one variable is uncertain, sensitivi

> A project has fixed costs of $1,000 per year, depreciation charges of $500 a year, annual revenue of $6,000, and variable costs equal to two-thirds of revenues. a. If sales increase by 10%, what will be the increase in pretax profits? b. What is the degr

> Operating leverage What is the lowest possible value for the degree of operating leverage for a profitable firm? Show with a numerical example that if Modern Artifacts (see Problem 12) has zero fixed costs and zero depreciation, then DOL = 1 and, in fact

> Operating leverage Look again at Modern Artifacts in Problem 12. a. What is the degree of operating leverage of Modern Artifacts when sales are $7,000? b. What is the degree of operating leverage when sales are $12,000? c. Why is operating leverage diffe

> Operating leverage You estimate that your cattle farm will generate $1 million of profits on sales of $4 million under normal economic conditions and that the degree of operating leverage is 8. a. What will profits be if sales turn out to be $3.5 million

> Fixed and variable costs In a slow year, Deutsche Burgers will produce 2 million hamburgers at a total cost of $3.5 million. In a good year, it can produce 4 million hamburgers at a total cost of $4.5 million. a. What are the fixed costs of hamburger pro

> Supply the missing words: “There are three forms of the efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the form

> Break-even analysis A financial analyst has computed both accounting and NPV breakeven sales levels for a project using straight-line depreciation over a six-year period. The project manager wants to know what will happen to these estimates if the firm c

> Break-even analysis Define the cash-flow break-even point as the sales volume (in dollars) at which cash flow equals zero. a. Is the cash-flow break-even level of sales higher or lower than the zero-profit (accounting) break-even point? b. If a project o

> Modern Artifacts can produce keepsakes that will be sold for $80 each. Non depreciation fixed costs are $1,000 per year, and variable costs are $60 per unit. The initial investment of $3,000 will be depreciated straight-line over its useful life of five

> Dime a Dozen Diamonds makes synthetic diamonds by treating carbon. Each diamond can be sold for $100. The materials cost for a synthetic diamond is $40. The fixed costs incurred each year for factory upkeep and administrative expenses are $200,000. The m

> Break-even analysis Break-even calculations are most often concerned with the effect of a Short fall in sales, but they could equally well focus on any other component of cash flow. Dog Days is considering a proposal to produce and market a caviar-flavor

> Match each of the following terms to one of the definitions or descriptions listed below: sensitivity analysis, scenario analysis, break-even analysis, operating leverage, Monte Carlo simulation, decision tree, real option, tornado diagram. a. Recalculat

> Refer to the top-right panel of Figure 9.2. What proportion of U.S. Steel’s returns was explained by market movements? What proportion of risk was diversifiable? How does the diversifiable risk show up in the plot? What is the range of possible errors in