MAAC MBT
GSBA 548 Corporate Finance -- J. K. Dietrich – MAAc MBT
Midterm Examination – October 19, 2006
A N S W E R S
1) Market capitalization is
a)
b)
c)
d)
e)
total assets.
Price per share times number of shares outstanding.
average price times authorized shares
book value of equity.
all of the above.
2) The differential growth rate model of share prices described in Chapter 5 of the text and discussed in
class can be used to value the present value of dividends except when
a)
b)
c)
d)
e)
There is a high-growth period followed by a low-growth or average-growth period for earnings.
Dividends are paid in the initial period.
The later growth period discount rate is lower than the assumed growth rate.
Dividend payout rates change between and early and late discount rate period.
The differential growth rate model can handle all of the above conditions.
Use the following list in answering the following five multiple-choice questions using the indicated letter as
you choice of answer on the Scantron sheet for each question:
a) perpetuity formula
b) growing perpetuity formula
c) annuity formula
d) growing annuity formula
e) sum of present values of individual cash flows
3) The best formula to use in calculating constant or level retirement payments from accumulated savings.
(c)
4) A good formula to use to calculate the present value of a savings plan over a career where income is
growing at a constant rate. (d)
5) Which formula calculates a meaningful answer when the growth rate is larger than the discount rate?
(d)
6) A formula that can always be used to estimate the present value of the cash flows from an investment.
(e)
7) The appropriate formula for most preferred stocks. (a)
8) From the point of view of finance, Time Warner is poorly managed because it
a)
b)
c)
d)
e)
failed to integrate America On-Line operations into its publishing business.
Purchased America On-Line and was unable to increase market share of on-line users.
considered and rejected a strategy advocated by a dissident shareholder, Carl Icahn.
has a five-year accumulated total return of -63.3%
none of the above.
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page1/6
MAAC MBT
9) U.S. Treasury strip prices, for example 61:19 for the November 2016 on October 16, 2006, are
a)
b)
c)
d)
e)
the discounted value of dollars payable by U.S. Treasury in the future.
discount factors for default risk-free cash flows on the given payment dates.
present value factors for corresponding yields, in this case 4.87% for ten years.
traded in percent and 32-nds of percent.
all of the above.
10) The U.S. Treasury 7-5/8 Nov 22 bond, priced to yield 4.99% on October 16, 2006,
a)
b)
c)
d)
e)
is selling at a premium.
pays 3.8125% percent of face value in interest in February and August until maturity.
will pay off at 100% of par value at maturity.
has a net present value of zero.
All of the above.
11) Any dollar-denominated taxable bond issued by a corporation with a maturity equal to the U.S.
Treasury described in question (10) above has
a)
b)
c)
d)
e)
A yield to maturity higher than 4.99%.
A risk premium over the yield on the Treasury.
A non-zero probability of non-payment of interest or principal in the future.
A detailed debt indenture agreement or bond or loan contract specifying other conditions and
terms.
All of the above.
12) Which of the following projects’ discounted cash flows has the higher present value?
Project A
Project B
Period 1
0
$25
Period 2
0
$25
Period 3
$100
$50
a) A
b) B
c) The present values are equal.
d) The project with the higher present value depends on the discount rate used
e) Not enough information to determine the answer.
13) Which of the following projects, each costing $100, has discounted cash flows the higher present
value?
Project A
Project B
Period 1
0
$110
Period 2
$ 121
0
a)
b)
c)
d)
e)
A
B
The present values are equal at 10%
The project with the higher present value depends on discount rate
Both c) and d) are correct.
14) A callable bond protects the investor from
a) Losses due to increases in market interest rates.
b) Reduced interest income from decreases in market interest rates.
c) Adverse market changes and is a benefit to bondholders reflected in higher bond valuation.
d) Attempts by the issuer to exercise flexibility in controlling its costs of debt.
e) None of the above.
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page2/6
MAAC MBT
15) Changes in net working capital are important in estimating incremental cash flows because they are a
a)
b)
c)
d)
e)
use of cash necessary to support sales and operations.
legitimate allowance for losses due to fraud.
Factor in the tax liability of firms.
Required by GAAP accounting rules for income statement.
All of the above.
16) The goal of management and the board of directors is to
a)
b)
c)
d)
e)
Maximize share value.
Maximize the ability of investors to consume.
Increase market value added.
Maximize economic value added.
All of the above are true and equivalent.
17) For purposes of Sarbanes-Oxley Act, a financial expert
a)
b)
c)
d)
e)
Must be named as CEO or chairman of the board of a public corporation.
Is defined as a business-school finance professor.
Must chair the compensation and nomination committees of boards of public corporations.
Should not be allowed to talk to the auditors of the firm.
None of the above.
18) A preferred stock paying $ .25 per quarter valued at 10% annual discount rate is worth
a)
b)
c)
d)
e)
$1.00
$2.50
$10.00
$25.00
Cannot be valued with information provided
19) The first eight years of the preferred dividends from the stock in question (19) account about what
percent of the stock’s value?
a)
b)
c)
d)
e)
11%
22%
33%
44%
55%
20) Corporate bonds can be all of the following except
a)
b)
c)
d)
e)
Callable
Convertible
Risk-free
Repurchased by the corporate issuer.
Sold before maturity at a loss or gain.
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page3/6
MAAC MBT
USE THIS SPACE ONLY
IF NECCESSARY
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page4/6
MAAC MBT
GSBA 548 Corporate Finance -- J. K. Dietrich – MAAc MBT
Midterm Examination – October 19, 2006
A N S W E R S
1. A company is considering production of a product for four years requiring the acquisition of a machine.
Use the following information on revenues, costs, tax rates and discount rate in answering this question:
Year 0
Year 1
Year 2
Year 3
Year 4
$60,000
$60,000
$60,000
$60,000
Revenues
Machine cost:
$
250,000
Depreciable life (straight line): Years
20.00
Sale value in Year 4
$
500,000
Income Tax rate:
40%
Capital Gains Tax Rate:
20%
Opportunity cost of capital:
15%
Inventory Turns (COG)
4.00
COG = percent of sales
50%
a. Calculate the free cash flows from this investment including necessary investments in inventories.
Show all details of calculations so that partial credit can be given for all parts of the answer. Label
your calculations carefully.
Year 0
Year 1
Year 2
Year 3
Year 4
$ 60,000 $
60,000 $ 60,000 $ 60,000
Revenues
$ 30,000 $
30,000 $ 30,000 $ 30,000
Costs
Depreciation
$ 12,500 $
12,500 $ 12,500 $ 12,500
EBT
$ 17,500 $
17,500 $ 17,500 $ 17,500
Tax
$
7,000 $
7,000 $
7,000 $
7,000
EAT
$ 10,500 $
10,500 $ 10,500 $ 10,500
+ Depr
$ 12,500 $
12,500 $ 12,500 $ 12,500
- Chg Inv
$
$
$
7,500
$
(7,500) $
- Machine
$ (250,000)
+ Sale
$ 430,000
- Maintenance
$
Cash Flow
($257,500)
$23,000
$23,000
$23,000
$460,500
Net proceeds from sale of machine = $500,000 minus tax on recovered depreciation
(=.40*$50,000) minus capital gains tax (=($500,000 - $250,000)*(.40/2)) = $500,000-$20,000$50,000=$430,000
b. Should the firm make this investment? Show all calculations and give explicit reasons for your
answer.
NPV  $257,500 
$23,000 $23,000 $23,000 $460,500



 $58,307
1.15
(1.15) 2
(1.15) 3
(1.15) 4
Yes, since the NPV for the investment is positive and will add value to investors at the assumed
opportunity rate.
c. The machine is assumed to double in value in four years. Is this a critical assumption? Why or why
not? Defend your answer carefully.
Yes, since the after-tax capital gain is $430,000 with a present value of $430,000/(1.15) 4 =
$245,854 the positive net present value calculation above depends critically on the sale value.
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page5/6
MAAC MBT
2. Last week, a Delta Airlines bond, the 10.375% bond maturing in December 2022, was priced at
29.75 (from NASD Bondinfo). The bond’s yield to maturity was 35.2%. At about the same time, the
U.S. Treasury 7-5/8 Nov 22, was priced to yield 4.99% on October 16, 2006, with roughly the same
maturity as the Delta bond (the Treasury is described in multiple choice question (10)). Delta is
currently in bankruptcy. The Delta bond was not rated by S&P (NR) and has a “C” rating from Fitch.
.
a. Describe and discuss the difference in the yields of these two bonds (the Delta and Treasury bond)
and explain why they are so different.
Delta bond yield = 35.2%
Treasury yield = 4.99%
Yield differential=30.21% or 3,021 basis points. The difference is the default-risk premium
and is this large because Delta is already in bankruptcy and in default. This higher discount rate
applies to possible future cash flows from interest and principal payment or other cash flows
made by Delta after bankruptcy, which are very risky cash flows.
b. What determines the value of the Delta bond? In answering this part of the question, given the
information available to you, what sources of value would entice bond investors to pay 30¢ for a claim
on a bankrupt airline.
The value of the Delta bond is the expected future cash flows discounted at the risk-adjusted
discount rate. Future cash flows could consist of some bond payments in the form of interest
and/or principal or the value of equity claims or other cash distributions given to the
bondholders after bankruptcy.
c. What is NASD Bondinfo? Discuss the source of the data it provides and why it is useful.
NASD Bondinfo is based on the National Association of Securities Dealers “TRACE” computer
base of transactions in bonds traded by NASD members. Thus this data reflects actual
transaction prices on risky corporate debt that is useful in estimating the values of non-traded
debt of corporate issuers.
d. What are ratings for bonds and who provides them? What is an investment-grade rating and does
Delta have one? Why is an investment-grade rating important to firms?
Ratings are provided by rating agencies like Standard and Poor’s (S&P), Moody’s, and others,
and reflect the default risk of the corporate issuers. Investment grade bonds are rated from
AAA to BBB (by S&P) and can be purchased by regulated institutional investors like insurance
companies and banks. Delta is rated C, well below BBB, is in default and is not investment
grade. Investment grades bonds have lower yields, making borrowing cheaper for lower risk
firms.
e. Assume changes in Delta’s situation reduces its risk premium to 10% over comparable Treasuries.
What would the above bond be priced at? (Show all calculations.)
Treasury
p
yield  10%  4.99%  10%  15%
.10375 
1 
1
1 

 .617752  .10687  .7246  72.46%
16 
.15  (1.15)  (1.15)16
Thus Delta bond would be priced at 72.46
GSBA 548 (MAAC MBT) -- Corporate Finance Midterm Examination – October 19, 2006 -- Page6/6