MAN 321 Corporate Finance

Midterm Examination I

Fall 1999

There are two sections on this examination. Section I contains 10 multiple choice questions. Answer these questions by circling the correct answer. Section II contains 5 problems. Answer the problems in the spaces provided on the exam. Good luck

SECTION I. Multiple Choice Questions (1 point each)

1. Which of the following statements is most correct?

a. A good goal for a corporate manager is maximization of expected EPS.

b. Most business in the US is conducted by corporations; corporations’ popularity results primarily from their favorable tax treatment.

c . A good example of an agency relationship is the one between stockholders and managers.

d. Corporations and partnerships have an advantage over proprietorships because a sole proprietor is subject to unlimited liability, but investors in the other types of businesses are not.

e. Firms in highly competitive industries find it easier to exercise social responsibility than do firms in oligopolistic industries.

2. Which of the following statements is most correct?

a. The major disadvantage of organizing as a corporation is that it does not provide its owners with limited liability.

b. Bond covenants are an important device to reduce agency conflicts between stockholders and bondholders.

c. The threat of a hostile takeover serves to reduce agency conflicts between stockholders and bondholders.

d. Compensation packages are designed, in part, to reduce agency conflicts between shareholders and managers.

e . Both answers b and d are correct.

3. Which of the following statements is most correct? Other things held constant,

a . the liquidity preference theory would generally lead to an upward sloping yield curve.

b. the market segmentation theory would generally lead to an upward sloping yield curve.

c. the expectations theory would generally lead to an upward sloping yield curve.

d. the yield curve under normal conditions should be horizontal (i.e. flat.)

e. a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

4. Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%. 6%. and 7%, respectively. Assume that the pure expectations theory holds and that the market is in equilibrium. Which of the following statements is most correct?

a. The maturity risk premium is positive.

b. Interest rates are expected to rise over the next two years.

c. The market expects one-year rates to be 5.5% one year from today.

d . Answers a, b, and c are all correct.

e. Only answer b and c are correct.

5. Which of the following statements is most correct?

a. If beta doubles, the required return doubles.

b. If a stock has a negative beta, its required return is negative.

c. Higher beta stocks have more company-specific risk, but do not necessarily have more market risk.

d. If a portfolio’s beta increases from 1.2 to 1.5, its required rate of return will increase by an amount equal to its market risk premium.

e . If two stocks have the same standard deviation and the correlation coefficient between the returns of two stocks equals zero, an equally weighted portfolio of the two stocks will have a standard deviation lower than that of the individual stocks.

6. Which of the following statements is Most correct?

a. If the returns from two stocks are perfectly positively correlated (i.e. the correlation coefficient is +1) and the two stocks have equal variance, an equally weighted portfolio of the two stocks will have a variance which is less then that of the individual stocks.

b. If a stock has a negative beta, its expected return must be negative.

c. According to the CAPM, stocks with higher standard deviations of returns will have higher expected returns.

d. A portfolio with a large number of randomly selected stocks will have less market risk than a single stock which has a beta equal to 0.5.

e . None of the above statements are correct

7. The simplest, most commonly used, and least expensive procedure for dissident shareholders to gain control of a firm and to oust the current management is a

a. Leveraged buyout.

b. Poison pill.

c. Takeover bid.

d. Greenmail offer.

e . Proxy fight.

8. Taking poison pills and offering greenmail are

a. Ways stockholders protect themselves and their interest from management’s conflicting interests.

b. Tactics used by creditors to make their position more favorable when resolving agency problems between stockholders and creditors.

c . Two actions managers might take to ward off hostile takeovers.

d. Both commonly practiced methods used by firms’ managers to increase stockholders’ wealth.

9. You have just purchased shares in the Hi-Tech Long-Term Bond Fund, a mutual fund that invests in long-term corporate bonds. Your purchase constitutes

a. A direct transfer of funds.

b. An indirect transfer through an investment banker.

c . An indirect transfer through a financial intermediary.

d. A money market transaction.

10. Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle’s criteria?

SECTION II — Problems

Question 1 (20 points)

Better mousetraps has come out with an improved product, and the world is beating a path to its door. As a result, the firm projects growth of 20 percent per year for four years. By then, other firms will have copycat technology, competition will drive down profit margins, and the sustainable growth rate will fall to 5 percent and remain at that level thereafter. The most recent annual dividend was D₀ = $1.00 per share.

P₀ = 1.20/(1.10) + 1.44/(1.10) 2 + 1.73/(1.10) 3 + 2.07/(1.10) 4 + 43.55/(1.10) 4

P₀ = 34.74

Capital Gains = k — Div. Yield = 10 -3 = 7%

Question 2 . (20 points)

Your friend is celebrating his 35 th birthday today and wants to start saving for his anticipated retirement age of 65. He wants to be able to withdraw $10,000 from his savings account on each birthday for ten years following his retirement; the first withdrawal will be on his 66 th birthday. Your friend intends to invest his money in the local bank, which offers 8 percent interest per year. He wants to make equal, annual payments on each birthday in a new savings account he will establish for his retirement fund.

1. If he starts making his deposits on his 36 th birthday and continues to make deposits until he is 65 (the last deposit will be on his 65 th birthday), what amount must he deposit annually to be able to make the desired withdrawals on retirement?

PMT x FVIFA_8%,30 = 10,000 x PVIFA_8%,10

PMT = 67,101/113.28 = $592.35

PV = 67,101 x PVIF_8%,10 = $7,200

Question 3 : (15 points)

Your firm is contemplating selling some 10-year bonds to raise funds for a planned expansion. The firm currently has an issue outstanding with $60 annual coupon, paid semiannually. These bonds currently sell for $864.10, a discount relative to their $1,000 par value, and they have 10 years remaining to maturity. What coupon rate must the new issue have if it is to sell at par when it is issued?

Find YTM of old issue:

864.10 = 30 x PVIFA_k/2%,10 + 1000 x PVIF_k/2%,10

With semiannual coupons, if we try k/2 = 4% we find YTM.

The coupon rate of the new issue should be equal to its YTM if it is to sell at par. Hence annual coupon rate = 8%.

Question 4 : (20 points)

There are two assets, Stock A and Stock B, and three states of nature: