AK Final Exam

ADM 335 M&N

Corporate Finance
Winter 2008

Professors: Kaouthar Lajili

Devinder Ghandi

Time: Three hours

Date: April 30th, 2008

NAME: ___________________________________________

STUDENT NUMBER: ______________________________

SIGNATURE: ____________________________________

GENERAL INSTRUCTIONS: Hand in everything at the end of the exam period. Use the
space provided in the exam for your answers and relevant work; do not re-write the
question in the solution space; identify the solutions clearly. Always keep three decimals for
all calculated results. No books or notes permitted. The use of calculators is permitted.

PART I Problems 50
PART II MCQ 50
TOTAL 100

Statement of Academic Integrity

The School of Management does not condone academic fraud, an act by a student that may
result in a false academic evaluation of that student or of another student. Without limiting
the generality of this definition, academic fraud occurs when a student commits any of the
following offences: plagiarism or cheating of any kind, use of books, notes, mathematical
tables, dictionaries or other study aid unless an explicit written note to the contrary appears
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recorders, pagers, cell phones, or any other communication device which has not been
previously authorized in writing.

Statement to be signed by the student:

I have read the text on academic integrity and I pledge not to have committed or attempted
to commit academic fraud in this examination.

Signed:______________________________________

Note: an examination copy or booklet without that signed statement will not be graded and
will receive a final exam grade of zero.

1
PART I (45 points total)

Instructions: Do problem 1 (mandatory) and pick one problem the following five and solve
only that problem (total 2 problems: one mandatory and one a choice among five)

PROBLEM 1 (mandatory) (25 points) MERGERS & ACQUISITIONS

As the financial manager of Global Toys, Inc., you are examining the possible acquisition of a
smaller toy company called Games for All. You have the following basic financial information
about both companies:

Global Toys Games for All

Price-earnings ratio 15 12
Number of shares 1,000,000 250,000
Earnings $1,000,000 $750,000

You also know that investors and analysts expect the earnings and dividends (currently $1.80
per share) of Games for All to grow at a constant rate of 5% each year. However, your research
indicates that the acquisition should provide Games for All with some economies of scale which
would raise this growth rate to 7% per year.

A) What is the value of Games for All to Global Toys? (8 points)

B) If Global Toys offers $40 in cash for each outstanding share of Games for All, what
would the NPV of the acquisition be? (4 points)
C) If instead Global Toys offers 600,000 of its shares in exchange for the outstanding stock
of Games for All, what would the NPV of this acquisition be? (8 points)
D) Interpret your results in B) and C) above and make your recommendation with regard to
how the acquisition should be made (cash or stock)? (5 points)

Answer:
a. The value of Games for All before the merger is $9,000,000 (=750,000x12). This value is also the
discounted value of the expected future dividends.
($1.80  250,000)1.05
$9,000,000 = Games for All
(r  0.05)
r = 0.1025 = 10.25%
r is the risk-adjusted discount rate for Games for All ‘s expected future dividends.
The value of Newfoundland Industries after the merger is
($1.80  250,000)1.07
V
(0.1025  0.07)
 $14,815,385
This is the value of Games for All to Global Toys.
b. NPV = Gain - Cost
= $14,815,385 - ($40x250, 000)
= $4,815,385
c. If Global Toys offers stock, the value of Games for All to Global Toys is the same, but the cost
differs.
Cost = (Fraction of combined firm owned by Games for All ‘s stockholders)
x(Value of the combined firm)
Value of the combined firm = (Value of Global Toys before merger)
+ (Value of Games for All to Global Toys’s)
= $15x1,000,000 + $14,815,385
= $29,815,385

600,000
Fraction of ownership   0.375
1,000,000  600,000
Cost = 0.375x$29,815,385
= $11,180,769
NPV= $14,815,385 - $11,180,769
=$3,634,616
d. The acquisition should be attempted with a cash offer since it provides a higher NPV.

2
3
PROBLEM 2 (optional) (25 points) CAPITAL STRUCTURE: Limits to the use of
debt

Big Star Company is a regional chain department store. It will remain in business for one
more year. The probability of a boom year is 60% and of a recession is 40%. It is
projected that Big Star will generate a total cash flow of $250 million in a boom year and
$100 million in a recession. The firm’s required debt payment at the end of the year is
$150 million. The market value of Big Star’s outstanding debt is $108.93 million.
Assume a one-period model, risk neutrality and an annual discount rate of 12% for both
the firm’s debt and its equity. Big Star pays no taxes.

a) What is the value of the firm’s equity? (4 points)

b) What is the promised return on Good Time’s debt? (4 points)
c) What is the value of the firm? (4 points)
d) How much would Good Time’s debt be worth if there were no bankruptcy
costs? (4 points)
e) What payoff, after bankruptcy costs, do bondholders expect to receive in
the event of a recession? (4 points)
f) What cost do bondholders expect Good Time to incur should bankruptcy
arise at the end of the year? (5 points)
Answer
a. The value of a firm’s equity is the discounted expected cash flow to the firm’s
stockholders.

If there is a boom, Good Time will generate cash flow of $250 million. Since Good
Time owes its bondholders $150 million, the firm’s stockholders will receive $100
million (= $250 million - $150 million) if there is a boom.

If there is a recession, Good Time will generate a cash flow of $100 million. Since
the bondholder’s have the right to the first $150 million that the firm generates,
Good Time’ stockholders will receive $0 if there is a recession.

The probability of a boom is 60%. The probability of a recession is 40%. The

appropriate discount rate is 12%.

The value of Good Time’s equity is:

{(0.60)($100 million) + (0.40)($0)} / 1.12 = $53.57 million

The value of Good Time’s equity is $53.57 million.

b. Promised Return = (Face Value of Debt / Market Value of Debt) – 1

Since the debt holders have been promised $150 million at the end of the year, the
face value of Good Time’s debt is $150 million. The market value of Good Time’s
debt is $108.93 million.

The promised return on Good Time’s debt is:

Promised Return = (Face Value of Bond / Market Value of Bond) – 1

= ($150 million / $108.93 million) – 1
= 0.3770

The promised return on Good Time’s debt is 37.70%.

c. The value of a firm is the sum of the market value of the firm’s debt and equity. The
value of Good Time’s debt is $108.93 million. As shown in part a, the value of Good
Time’s equity is $53.57 million.

The value of Good Time is:

VL = B + S
= $108.93 million + $53.57 million

4
 = $162.5 million

The value of Good Time Company is $162.5 million.

d. The market value of a firm’s debt is the discounted expected cash flow to the firm’s
debt holders.

If there is a boom, Good Time will generate cash flow of $250 million. Since Good
Time owes its debt holders $150 million, the firm’s bondholders will receive $150
million if there is a boom.

While the firm’s debt holders are owed $150 million, Good Time will only generate
$100 million of cash flow if there is a recession. The firm’s debt holders cannot
receive more than the firm can afford to pay them. Therefore, Good Time’s debt
holders will only receive $100 million if there is a recession.

The probability of a boom is 60%. The probability of a recession is 40%. The

appropriate discount rate is 12%.

If no bankruptcy costs are priced into the debt, the value of Good Time’s debt is:

{(0.60)($150 million) + (0.40)($100)} / 1.12 = $116.07 million

Therefore, in a world with no bankruptcy costs, Good Time’s debt would be worth
$116.07 million.

e. The market value of a firm’s debt is the discounted expected cash flow to the firm’s
debt holders. We know that the debt holders will receive $150 million in a boom
and that the market value of the debt is $108.93 million.

Let X be the amount that bondholders expect to receive in the event of a recession:

$108.93 million = {(0.60)($150 million) + (0.40)(X)} / 1.12

X = $80 million

Therefore, the market value of Good Time’s debt indicates that the firm’s
bondholders expect to receive $80 million in the event of a recession.

f. Since the firm will generate $100 million of cash flow in the event of a recession but
the firm’s bondholders only expect to receive a payment of $80 million, Good
Time’s cost of bankruptcy is expected to be $20 million (= $100 million - $80
million), should bankruptcy occur at the end of the year.

Good Time expects bankruptcy costs of $20 million, should bankruptcy occur at
the end of the year.

5
PROBLEM 3 (optional) (25 points) OPTIONS AND CORPORATE FINANCE

Maverick Manufacturing Inc. must purchase gold in three months to use in its operations.
Maverick’s management has estimated that if the price of gold were to rise above $375 per
ounce, the firm would go bankrupt. The current price of gold is $350 per ounce. The firm’s
CFO believes that the price of gold will either rise to $400 per ounce or fall to $325 per ounce
over the next three months. Management wishes to eliminate any risk of the firm going
bankrupt. Maverick can borrow and lend at the risk-free interest rate of 16.99% per annum
(effective annual yield).

a) Would Maverick be interested in buying a call option or a put option on the price
of gold? In order to avoid bankruptcy, what strike price and time to expiration
would the firm like this option to have? (7 points)
b) How much should such an option sell for in the open market? (7 points)
c) If no options currently trade on gold, is there a way for Maverick to create a
synthetic option with identical payoffs to the option described above? If there is,
how would the firm do it? (5 points)
d) How much does the synthetic option cost? Is this greater than, less than, or equal
to what the actual option costs? Does this make sense? (6 points)

Answer

a. Maverick would be interested in purchasing a call option on the price of gold with a
strike
price of $375 per ounce and 3 months until expiration. This option will compensate
Maverick for any increases in the price of gold above the strike price and places a
cap on the amount the firm must pay for gold at $375 per ounce.

b. In order to solve a problem using the two-state option model, first draw a price tree
containing both the current price of the underlying asset and the underlying asset’s
possible values at the time of the option’s expiration. Next, draw a similar tree for the
option, designating what its value will be at expiration given either of the 2 possible
stock price movements.

The price of gold is $350 per ounce today. If the price rises to $400, Maverick will
exercise its call option for $375 and receive a payoff of $25 at expiration. If the price
of gold falls to $325, Maverick will not exercise its call option, and the firm will

Price of Gold (per ounce) Maverick's Call Option with a Strike of 375

Today 3 months Today 3 months

400 25 = max(0, 400-375)

350 ?

325 0 = max(0, 325-375)

receive no payoff at expiration.

If the price of gold rises, its return over the period is 14.29% [= (400/350) – 1]. If
the price of gold falls, its return over the period is -7.14% [= (325/350) –1]. Use the
following expression to determine the risk-neutral probability of a rise in the price of
gold:

Risk-Free Rate = (ProbabilityRise)(ReturnRise) + (ProbabilityFall)(ReturnFall)

= (ProbabilityRise)(ReturnRise) + (1 - ProbabilityRise)(ReturnFall)

6
 The risk-free rate over the next three months must be used in the order to match the
timing of the expected price change. Since the risk-free rate per annum is 16.99%,
the risk-free rate over the next three months is 4% [= (1.1699)1/4 –1].

0.04 = (ProbabilityRise)(0.1429) + (1 – ProbabilityRise)(-0.0714)

ProbabilityRise = 0.5198

ProbabilityFall = 1 - ProbabilityRise
= 1 – 0.5198
= 0.4802

The risk-neutral probability of a rise in the price of gold is 51.98%, and the risk-
neutral probability of a fall in the price of gold is 48.02%.

Using these risk-neutral probabilities, determine the expected payoff to Maverick’s

call option at expiration.

Expected Payoff at Expiration = (.5198)($25) + (.4802)($0) = $13.00

Since this payoff occurs 3 months from now, it must be discounted at the risk-free rate
of 16.99% per annum in order to find its present value:

PV(Expected Payoff at Expiration) = [$13.00 / (1.1699)1/4 ] = $12.50

Therefore, given the information Maverick has about gold’s price movements over the
next three months, a European call option with a strike price of $375 and three
months until expiration is worth $12.50 today.

b. Yes, there is a way for Maverick to create a synthetic call option with identical
payoffs to the call option described above. In order to do this, Maverick will need to
buy gold and borrow at the risk-free rate.

The amount of gold that Maverick should buy is based on the delta of the option,
where delta is defined as:

Delta = (Swing of option) / (Swing of price of gold)

Since the call option will be worth $25 if the price of gold rises and $0 if it falls, the
swing of the call option is 25 (= 25 – 0).

Since the price of gold will either be $400 or $325 at the time of the option’s
expiration, the swing of the price of gold is 75 (= 400 - 325).

Given this information:

Delta = (Swing of option) / (Swing of price of gold)

= (25 / 75)

7
 = 1/3

Therefore, Maverick’s first step in creating a synthetic call option is to buy 1/3 of an
ounce of gold. Since gold currently sells for $350 per ounce, Maverick must pay
$116.67 (= 1/3 * $350) to purchase 1/3 of an ounce of gold.

In order to determine the amount that Maverick should borrow, compare the payoff of
the actual call option to the payoff of delta shares at expiration.

Call Option
If the price of gold rises to $400: payoff = $25
If the price of gold falls to $325: payoff = $0

Delta Shares
If the price of gold rises to $400: payoff = (1/3)($400) = $133.33
If the price of gold falls to $325: payoff = (1/3)($325) = $108.33

Maverick would like the payoff of his synthetic call position to be identical to the
payoff of an actual call option. However, buying 1/3 of a share leaves him exactly
$108.33 above the payoff at expiration, regardless of whether the price of gold rises
or falls. In order to decrease the firm’s payoff at expiration by $108.33, Maverick
should borrow the present value of $108.33 now. In three months, the firm must pay
$108.33, which will decrease its payoffs so that they exactly match those of an actual
call option.

Maverick should buy 1/3 of an ounce of gold and borrow $104.17 [= $108.33 /
(1.1699)1/4] in order to create a synthetic call option with a strike price of $375 and
3 months until expiration.

d. Since Maverick pays $116.67 in order to purchase gold and borrows $104.17, the
total cost of the synthetic call option is $12.50 (= $116.67 – $104.17). This is exactly
the same price that Maverick would pay for an actual call option. Since an actual call
option and a synthetic call option provide Maverick with identical payoff structures,
the firm should not expect to pay more for one than the other.

8
PROBLEM 4 (optional) (25 points) DIVIDEND POLICY

An all-equity company pays no dividends and its earnings for the year are $20,000. The market
value balance sheet at the end of the year is given below:

Excess cash $100,000 Debt $ 0

Other assets $400,000 Equity $500,000

Total $500,000 Total $500,000

The firm has 5,000 shares outstanding and is considering the following alternative uses of excess
cash: (1) pay out dividends; (2) repurchase its own stock. Suppose you own 300 shares of the
firm’s common stock:

A) In absence of taxes and transaction costs, how will you create “home-made
dividend” for yourself if the firm elects to repurchase its own stock. Support your
answer with calculations. (9 points)
B) Suppose the effective tax rate on your dividend income (after using the dividend
tax credit) will be 30%, and your realized capital gain will be taxed at 50% of
your personal marginal tax rate of 40%. Also suppose your shares were originally
bought at a price of $80 per share.

Will your tax liability be greater or lower with the creation of home-made dividends
in part a), compared to the tax liability you will have if the firm were to pay out
dividends instead of repurchasing its own stock? By how much? Support your answer
with calculations. (9 points)

C) Will the price-earnings ratios differ under the firm’s dividend payout and stock
repurchase alternatives, assuming no taxes and transaction costs? Support your
answer with calculations. (4 points)

Answer

a. The firm has 5,000 shares outstanding, so the current market price per share is
$500,000
 $100 . Your position as an owner of the firm’s 300 shares is currently
5,000
worth 300 X $100 = $30,000. If the firm uses $100,000 excess cash to repurchase its
$100,000
own stock,  1,000 shares will be repurchased, and there would be
$100
(5,000 – 1,000) = 4,000 shares outstanding, each with a market value of
$400,000
 $100 , which equals the market price per share prior to the
4,000
repurchase. Your position as an owner of 300 shares is worth 300 x $100 = $30,000
which is the same as it was prior to the repurchase.

 $100,000
You will have received   x 300  $6,000 in dividends if the firm had elected
 5,000 
to pay dividends. With the shares repurchase, you will have 300 shares, each with a
market value of $100 per share. Thus, you can create the $6,000 home-made dividend
 $6,000 
by selling    60 shares, and retaining (300-60) = 240 shares. Your
 $100 
position will be worth 240 x $100 = $24,000 in stock plus $6,000 in cash, a total of
$30,000 (the same as prior to creating home-made dividends).

b. If the firm pays out dividends, your tax liability on the $6,000 dividend you will
receive equal $6,000 x .30 = $1,800.

9
 By creating the $6,000 home-made dividend with the sale of your 60 shares that were
originally bought at a price of $80 per share, you will realize a capital gain of ($100 -
$80) x 60 = $1,200. This will result in a tax liability of $1,200 x .50 x .40 = $240.

Thus your tax liability will be ($1,800 - $240) = $1,560 greater with your creation of
home-made dividend if the firm elects the repurchase alternative.

c. No, the P-E ratio will be the same under both alternatives.

Proof:
Under dividend payout:

$20,000
EPS   $4
5,000

$400,000
Price per share =  $80
5,000

$80
P/E ratio =  20
$4

Under Stock Repurchase

$20,000
EPS   $5
4,000

$400,000
Price per share =  $100
4,000

$100
P/E ratio =  20
$5

10
PROBLEM 5 (optional) (25 points) LEASING

An asset costs $86.87. The CCA rate for this asset is 20%. The asset’s useful life is 3
years. It will have no salvage value. The corporate tax rate is on ordinary income is
40%. The interest rate on risk-free cash flows is 5%. Assume the asset pool is not
terminated at the end of the project.

A. What set of lease payments will make the lessee and the lessor equally well off?
(10 points)
B. Show the general condition that will make the value of a lease to the lessor the
negative of the value to the lessee. (8 points)
C. Assume that the lessee pays no taxes and the lessor is in the 40% tax bracket. For
what range of lease payments does the lease have a positive NPV for both parties?
(7 points)

Answer
The lease payment which makes both parties equally well off is the payment which equates
the NPVs for the firms. Since the tax rates of the two firms are equal, the
perspective of the lessor is the opposite of the perspective of the lessee. This
condition ensures that the NPV is zero.

Assuming that the asset pool is not terminated at the end of the project.
The after-tax riskless rate is 5%(1-0.4) = 3%.

Since the CCA asset pool is not terminated at the end of the project, we can use
the formula for the PVCCATS.

InvestmentxTcxCCArate 1  0.5(discountrate)
PVCCATS  [ ]x[ ]
CCArate  discountrate 1  discountrate
$86.87 x0.4 x0.20 1  0.5(0.03)
PVCCATS  [ ]x[ ]
0.20  0.03 1  0.03
PVCCATS  $29.78

From the lessee's perspective, (the lessor would have an equation equal to
negative this amount)

NPV=0=Investment –PVCCATS-[PV(leasing)
= 86.87 – 29.78-[L(1-0.4)+L(1-0.4)/1.03 +L(1-0.4)/(1.03)2 ]
=86.87-29.78-1.7481L
L = $32.66

b. Generalize the result from part a.

Let T1 denote the lessor’s tax rate.
Let T2 denote the lessee’s tax rate.
Let P denote the purchase price of the asset.
Let d denote the annual CCA rate.
Let N denote the length of the lease in years.
Let r denote the discount rate

N 1
L(1  T1 ) PdT1 1  0.5(r (1  T1 ))
Value to the lessor =  P   + x
t 0 [1  r (1  T1 )]
t
r (1  T1 )  d 1  (r (1  T1 ))

N 1 L(1  T2 ) PdT2 1  0.5(r (1  T2 ))

Value to the lessee = P  - x
t 0 [1 r(1 T2 )]t r (1  T2 )  d 1  (r (1  T2 ))

The values of the lease to its two parties will be opposite in sign only if T1 =
T2.

11
c. Since the lessor’s tax bracket is unchanged, the lease has a zero NPV to the
lessor when the lease payment is $32.66.

If the lessee pays no taxes, the pre-tax and after-tax lease payment are the
same; i.e., there is no tax shield available on the lease payment. Also, with a
tax rate of zero, the CCA tax shield is zero. The cost of debt is now 5%
instead of 3% (.05*.6).

NPV = 0 = $86.87 – [L + L/(1.05)+L/(1.05)2]

L = $86.87 / 2.8594
= $30.38

If L>$30.38 NPV to lessee is <0

If L< $30.38 NPV to lessee is >0
If L<$32.66 NPV to lessor is <0.
If L>$32.66 NPV to lessor is >0.

Leasing is now more expensive for the lessee and he is willing to make lower
payments (under $30.38). The lessor won’t find an agreement as there is no
price for which the lease has a positive NPV for both parties.

12
PART II Multiple Choice Questions Total: 50 points
Answer on the machine readable sheet attached (each correct answer worth one point)

1. According to the static theory of capital structure, ____________________.

A) a firm's choice of assets and operations is fixed for all time
B) a firm will borrow up to the point where the benefit from an extra dollar of
debt is just equal to the tax benefit associated with that debt
C) the value of the firm will differ from the M&M value without taxes by the
gain from leverage
D) the optimal WACC is the same as it is in M&M with taxes
E) the value of the firm in M&M with taxes is overstated by the amount of
financial distress costs

2. When the value of a firm's assets exactly equals the value of its debt, the firm:
A) Is economically bankrupt.
B) Is technically insolvent.
C) Is legally bankrupt.
D) Is in liquidation.
E) Is in default.

3. When shareholders pursue selfish strategies such as taking large risks or

paying excessive dividends, these will result in:
A) no action by debtholders since these are equity holder concerns.
B) positive agency costs, as bondholders impose various restrictions and
covenants, which will diminish firm value.
C) investments of the same risk class that the firm is in.
D) undertaking scale enhancing projects.
E) lower agency costs, as shareholders have more control over the firm's assets.

4. Which of the following defensive tactics to resist a merger involve a firm’s

repurchase of its own shares?

A) Poison pill
B) Golden parachutes
C) Exclusionary self-tender
D) Standstill agreement
E) c and d
Answer E
5. When graphing firm value against debt levels, the debt level that maximizes
the value of the firm is the level where:
A) the increase in the present value of distress costs from an additional dollar of
debt is greater than the increase in the present value of the debt tax shield.
B) the increase in the present value of distress costs from an additional dollar of
debt is equal to the increase in the present value of the debt tax shield.
C) the increase in the present value of distress costs from an additional dollar of
debt is less than the increase of the present value of the debt tax shield.
D) distress costs as well as debt tax shields are zero.
E) distress costs as well as debt tax shields are maximized.

6. Inclusion of bond covenants in the bond contract leads to

A) higher agency costs
B) higher bankruptcy costs
C) higher interest costs
D) none the above

13
7. The increase in the stock price after a dividend increase is called the information
content effect because:
A) the change in dividend was expected by shareholders.
B) the dividend increase signaled investors to adjust the expectations of future
earning upward.
C) the dividend change signaled investors to adjust the risk of the firm
downward.
D) the dividend change signaled shareholders that the firm could now payout
more as they enter the mature phase of their business.
E) none of the above.

8. What are some of the possible consequences of financial distress?

A) Debtholders, who face the prospect of getting only part of their money back,
are likely to want the company to take additional risks.
B) Debtholders would like equity holders to put up more money, even if it is
invested in zero-NPV projects.
C) Equity investors would like the company to cut its dividend payments to
conserve cash
D) Equity investors would like the firm to shift toward less risky lines of business

9. Lucky Mike's, Inc. has a target debt/equity ratio of 0.75. After-tax earnings for
2003 were $850,000 and the firm needs $1,150,000 for new investments. If the
company follows a residual dividend policy, what dividend will be paid?
A) 0
B) 67,240
C) $192,857
D) $213,164
E) $337,500

10. The acquisition of stock has the advantage of:

A) no shareholder meeting to vote is necessary.
B) minority shareholders may exist.
C) opening the bidding to others.
D) all of the above.
E) none of the above.

11. Which of the following factors influence the choice between merger and an
acquisition of stock?
A) Shareholders are dealt with directly to bypass target management and board
of directors.
B) In a tender offer, usually some minority shareholders do not tender stopping
complete firm absorption.
C) Target management may be unfriendly and resist an offer. Resistance usually
make the stock price higher.
D) all of the above.
E) none of the above.

12. Which of the following are features of the purchase method of accounting?
I. The balance sheets of the acquirer and the acquired are just added together.
II. Since the new firm is jointly owned by the shareholders of the old firms, no
goodwill exists.
III. The assets of the target firm must be shown at their fair market value on the
books of the bidder.
IV. The difference between the purchase price and the estimated fair market
value of the net assets of the target firm must be classified as goodwill and
recorded on the balance sheet.
A) I and II only
B) II and IV only
C) III and IV only
D) II and III only
E) I and IV only

14
 Use the following to answer questions 13-22:

Both firms are 100% equity-financed. Firm A can acquire firm B for $82,500 in
the form of either cash or stock. The synergy value of the deal is $12,500.
Firm Firm B
A
Number of Shares 10,000 7,500
Price per Share $25.00 $10.00

13. What is the merger premium over firm B's stock price?
A) 8.50%
B) 9.25%
C) 10.00%
D) 10.25%
E) 11.50%

14. What is the value of firm B to firm A?

A) $12,500
B) $57,500
C) $75,000
D) $87,500
E) $125,000

15. What is the NPV of the acquisition if cash is used?

A) $2,500
B) $5,000
C) $7,500
D) $10,000
E) None of the above.

16. What is the value of the post-merger firm following a cash acquisition?
A) $255,000
B) $262,500
C) $337,500
D) $650,000
E) $672,525

17. What is the price per share of the post-merger firm following a cash
acquisition?
A) $25.38
B) $25.50
C) $25.62
D) $25.76
E) $27.30

18. What is the value of the new firm if firm B's stockholders are paid in stock?
A) $255,000
B) $262,500
C) $337,500
D) $650,000
E) $672,525

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 19. How many shares will be given to firm B's stockholders in the stock-financed
deal?
A) 3,000
B) 3,300
C) 3,667
D) 4,250
E) 5,762

20. What will the price per share be of the post-merger firm if payment is made
in stock?
A) $25.00
B) $25.38
C) $25.50
D) $25.76
E) $27.30

21. What is the cost of acquisition when stock financing is used?

A) $75,126
B) $80,000
C) $81,555
D) $82,500
E) $83,754

22. What is the NPV of acquiring firm B when stock financing is used?
A) $3,746
B) $3,925
C) $4,122
D) $5,000
E) $5,510

23. A financial lease is likely to be most beneficial to both parties when:

A) the lessor's tax rate is lower than the lessee's.
B) the lessor's tax rate is higher than the lessee's.
C) the lessor's tax rate is equal to the lessee's.
D) a financial lease cannot be beneficial to both parties.
E) a financial lease always has zero NPV, so both parties always break even.

24. The price or lease payment that the lessee sets as their bound is known as:
A) the present value of the tax shields. D) the reservation payment,
LMAX.
B) the reservation payment, LMIN. E) none of the above.
C) the present value of operating savings.

25. Prior to CICA 3065, "Accounting for Leases", lease activity was only
reported in financial footnotes. This off-balance-sheet-financing made firms with
A) operating leases appear healthier than those with no leases.
B) financial leases appear to have greater liabilities than firms using operating
leases.
C) operating leases appear to have greater liabilities than firms using financial
lease.
D) financial leases appear to be financially stronger than if the leases were on-
balance-sheet-financing.
E) all of the above.

26. For accounting purposes, which of the following conditions would not
automatically cause a lease to be a financial lease?
A) The lessee can purchase the asset for its fair market value at the end of the
lease.
B) The lease transfers ownership of the asset to the lessee by the end of the lease.
C) The lease term is more than 75% of the asset's economic life.
D) The PV of the lease payments is more than 90% of the asset's market value at
lease inception.
E) All of the above would lead to the lease being considered a financial lease.

16
 27. Which of the following is probably not a good reason for leasing instead of
buying?
A) Leasing may provide off-balance sheet financing.
B) Leasing may reduce transactions costs.
C) Leasing may provide a beneficial reduction of uncertainty.
D) All of the above are good reasons.
E) All of the above are not good reasons.

28. Which of the following is probably a good reason for leasing instead of
buying?
A) Leasing provides 100% financing.
B) Leasing preserves capital.
C) Leasing may increase EPS relative to buying.
D) All of the above are good reasons.
E) None of the above is a good reason.

29. Given realistic estimates of the probability and cost of bankruptcy, the future
costs of a possible bankruptcy are borne by:
A) by all investors in the firm.
B) debtholders only because if default occurs interest and principal payments are
not made.
C) equityholders because debtholders will pay less providing less cash for the
equityholders.
D) management because if the firm defaults they will lose their jobs.
E) none of the above.

30. ________________ it is impossible for a tax-free acquisition to take place.

A) If an acquisition is for business purposes
B) If the purchasing firm exchanges its own stock for the selling firm's equity
C) If an acquisition is being undertaken with the express purpose of avoiding
taxes
D) If the stockholders in the target firm will retain an equity interest in the
bidder
E) If the selling shareholders will be considered to have exchanged their old
shares for new ones of equal value

17
 31. Generally speaking, if an acquiring firm offers the target firm cash for its stock, it
will be a __________ acquisition; if the acquirer offers its own shares in return
for the target firm's stock, it will be a _____________ acquisition.
A) taxable; taxable
B) taxable; tax-free
C) tax-free; taxable
D) tax-free; tax-free
E) none of the above

32. All of the following are possible cash flow benefits from mergers and acquisitions
EXCEPT:
A) Revenue enhancement.
B) Cost reductions.
C) Lower taxes.
D) Marketing gains.
E) Diversification benefits.

33. Which of the following types of acquisitions is (are) least likely to result in
synergistic increases in value?
I. Horizontal acquisitions
II. Vertical acquisitions
III. Conglomerate acquisitions
A) I only
B) I and II only
C) I and III only
D) II and III only
E) III only

34. In general, a leveraged buyout:

A) Is limited to smaller, non-public firms.
B) Is used to take a private firm public.
C) Is used by current managers or financiers to take a firm private.
D) Involves the sale of equity securities to pay off outstanding debt.
E) Significantly lowers the leverage of the firm.

35. A successful merger requires that the:

A) P/E ratio maintains its pre-merger value.
B) Debt-equity ratio of the firm remains at its pre-merger level.
C) Book value per share must remain constant.
D) Book value per share must increase.
E) Value of the whole exceeds the value of the sum of the parts.

36. The value of firm B to firm A is equal to the value of:

A) Firm B as a stand-alone firm plus the synergy value.
B) The incremental benefit of the merger or acquisition.
C) The incremental cash flows from the merger or acquisition.
D) The incremental cash flows minus the value of firm B as a stand-alone firm.
E) The firm AB plus the incremental gain.

Use the following to answer questions 37-44:

Alex, Inc. is financed 100% with equity. The firm has 100,000 shares of stock
outstanding with a market price of $5 per share. Total earnings for the most recent year
are $50,000. The firm has cash of $25,000 in excess of what is necessary to fund its
positive NPV projects. The firm is considering using the cash to pay an extra dividend of
$25,000 or, alternatively, to repurchase $25,000 of stock. The firm has other assets worth
$475,000 (market value). For each of the questions that follow, assume there are no
transaction costs, taxes, or other market imperfections.

18
37. Assume the firm pays the $25,000 excess cash in the form of a cash dividend.
What will be the firm's earnings per share once the dividend is paid?
A) $0.25
B) $0.39
C) $0.45
D) $0.50
E) $0.53

38. Assume the firm pays the $25,000 excess cash in the form of a cash dividend.
What will be the firm's price/earnings ratio once the dividend is paid?
A) 9.00
B) 9.25
C) 9.50
D) 9.75
E) 10.00

39. Assume the firm pays the $25,000 excess cash in the form of a cash dividend.
What will be the market price per share of Alex's stock once the dividend is paid?
A) $4.50
B) $4.75
C) $5.00
D) $5.25
E) $5.50

40. Assume the firm pays the $25,000 excess cash in the form of a cash dividend.
You own 1,000 shares and this comprises your total wealth. Once the dividend is
paid, what is your total wealth?
A) $4,500
B) $4,750
C) $5,000
D) $5,250
E) $5,500

41. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share.
What will be the firm's earnings per share after the repurchase?
A) $0.25
B) $0.39
C) $0.45
D) $0.50
E) $0.53

42. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share.
What will be the firm's price/earnings ratio after the repurchase?
A) 9.00
B) 9.25
C) 9.50
D) 9.75
E) 10.00

43. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share.
What will be the market price per share of Alex's stock after the repurchase?
A) $4.50
B) $4.75
C) $5.00
D) $5.25
E) $5.50

19
44. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share.
You own 1,000 shares before the repurchase and this comprises your total wealth.
If you sold none of your shares back to the firm, what is your total wealth after the
repurchase is completed?
A) $4,500
B) $4,750
C) $5,000
D) $5,250
E) $5,500

45. The payoff diagram for a put with the same exercise price and premium as the
call on the same underlying asset with the same maturity is:
A) the inverse of the call diagram along the put price.
B) unrelated to the call diagram no matter what the exercise price.
C) the mirror image of the call diagram around the exercise price.
D) exactly the same as the call diagram for the given exercise price.
E) None of the above.

46. A forward contract is an agreement between two parties for a sale:

A) Of goods delivered today and the price determined in the future.
B) Of an unspecified quantity in the future at a price set today.
C) At some future date with both the quantity and the price determined on that
future date.
D) At some future date with the quantity determined today and the price
determined in the future.
E) At some future date with both the quantity and price determined today.

47. Investing in combinations of options may result in:

A) no difference in payoff patterns.
B) a mirror image of past results.
C) offsetting positions resulting in a riskless return.
D) a and b.
E) b and c.

48. In which of the following does money NOT change hands when the contract is
created?
I. Futures contracts
II. Options contracts
III. Forward contracts
A) I only
B) II only
C) III only
D) I and II only
E) I and III only

49. Which of the following arrangements is a zero sum game?

I. Futures contracts
II. Options contracts
III. Forward contracts
A) I only
B) II only
C) I and II only
D) III only
E) I, II, and III

20
50. Which one of the following conditions when combined with long-term, fixed-
rate, low interest loans would tend to increase the financial risk of lending institutions
the most?
A) Volatile short-term rates that are relatively low
B) Volatile short-term rates that are relatively high
C) Fixed short-term rates that are relatively low
D) Volatile long-term rates that are relatively low
E) Fixed long-term rates that are relatively low

21
Final Exam Formula Sheet (ADM 3350)

1. R E  D1 P0  g

2. RE  R f  E  R M  R f 
3. WACC   E V   RE   D V   RD  1  TC 
4. Vu  EBIT REu  VL  E L  DL
5. RE  R A   R A  RD    D E 
6. V L  VU  TC  D
EBIT  1  TC 
7. VU  EBIT  1  TC   and VL 
WACC
8. RE       RD    D E   1  TC 
9. P/E ratio = Price per share / Earnings per share
10. Dividend payout ratio = Dividends / Net income
 n Lt  (1  T )   I  d  T  1  0.5k   1   SV  d  T  
     
  t 1 (1  k )t   k  d   1  k   (1  k ) n   k  d  
11. NPVLea sin g  I   
 
n
SV
   n 
 t 1 (1 k ) 

12. V AB  V A  VB

13. V  V AB  (V A  VB )

14. VB*  VB  V

15. NPV  VB*  Cost to Firm A of the acquisitio n

  P  vRQ  Q

'
16. NPV   PQ  v(Q '  Q) 

17. APR = periodic rate* 365/(net period – discount period)

18. EAR = (1 + (periodic rate) to the power [(365/(net period-discount period)]- 1

 1 
1 - (1 + r) n 
19..PV of an Annuity = PV(A, r, n) = A  
 r 
 

22