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Corporate Finance Mock Exam Questions 1: Discuss the implications of the existence of asymmetric information on the capital

structure (Debt to equity ratio) of a Pharmaceutical company like Merck in half a page.

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Questions 2: Michael Jensen has suggested that highly indebted companies may enjoy a corporate

governance advantage over companies with low levels of debt. Explain and critique

his argument.

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Questions 3:

There are two types of electric calculator producers. High quality manufacturers

produce very good calculators that consumers value at 14 Euros. Low quality

manufacturers produce less good ones that are valued at 8 Euros. At the time of

purchase, customers cannot distinguish between a high quality product and a low

quality product; nor can they identify the manufacturer. However, they can determine

the quality of the product after the purchase. The consumers are risk-neutral: if they

have probability p of getting a high quality product, they value this prospect

14p + 8(1 - p)

Each type of manufacturer can produce the product at a constant unit

cost of 11.

a) Suppose that the sale of low quality calculators is illegal, so that the only items

allowed to appear on the market are of high quality. What will be the equilibrium

price?

b) Suppose that there are no high quality sellers. How many low quality calculators

would you expect to be sold in equilibrium?

c) Could there be an equilibrium in which equal (positive) quantities of the two types of

calculators appear in the market?

d) For which range of p do we observe calculators to be sold on the market?

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Questions 4: In class we discussed several explanations why we observe underpricing in IPOs. In particular we discussed the Rock model. (Hint: the two companies in the model were named Opaque industries and Bright industries)

1. What is key assumption?

2. When is it realistic?

3. Who pays the cost of the winners curse?

4. So, should the issuer/investment banker do anything about it? What?

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Question 5: If managed efficiently, Company A will have assets with a market value of $48.6

million, $99.5 million, or $148.1 million next year, with each outcome being equally

likely.

Managers may also increase the risk of the firm, changing the probability of each

outcome to 45%, 17%, and 38%, respectively.

A. What is the expected value of Company A assets if it is run efficiently?

Now suppose that managers may engage in wasteful empire building, which will

reduce the market value by $5.3 million unless that behavior increases the likelihood

of bankruptcy. They will choose the risk of the firm to maximize the expected payoff

to equity holders.

B. Suppose Company A has debt due in one year as shown below. For each case, indicate whether managers will engage in empire building, and whether they will increase risk. What is the expected value of Company A assets in each case? a) $40.2 million b) $47.1 million c) $92.1 million d) $94.3 million

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Multiple Choice:

Circle the correct answer

Question 6

Which of the following statements is false?

A. We can use Modigliani and Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital.

B. Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

C. The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.

D. While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.

Question 7

Which of the following statements is false?

A. The levered equity return equals the unlevered return, plus an extra "kick" due to leverage.

B. If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

C. The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

D. By holding a portfolio of the firms equity and its debt, we can replicate the cash flows from holding its levered equity.

Question 8

LCMS Industries has $70 million in debt outstanding. The firm will pay only interest

on this debt (the debt is perpetual). LCMS' marginal tax rate is 35% and the firm pays

a rate of 8% interest on its debt.

LCMS' annual interest tax shield is closest to:

A) $5.6 million B) $3.6 million

C) $2.8 million D) $2.0 million

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Question 9

Which of the following statements is false?

A. The optimal level of debt D*, balances the costs and benefits of leverage. B. As the debt level increases, the firm faces worse incentives for management,

which increase wasteful investment and perks. C. If the debt level is too large firm value is reduced due to the loss of tax

benefits (when interest exceeds EBIT), financial distress costs, and the agency costs of leverage.

D. As the debt level increases, the firm benefits from the interest tax shield (which has present value *D).

Question 10

Which of the following statements is false?

A. In the extreme case, the debt holders take legal ownership of the firm's assets through a process called bankruptcy.

B. After a firm defaults, debt holders are given certain rights to the assets of the firm.

C. A firm that fails to make the required interest or principal payments on the debt is in default.

D. Equity holders expect to receive dividends and the firm is legally obligated to pay them.

Question 11

Which of the following statements is false?

A. With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value.

B. The tradeoff theory explains how firms should choose their capital structures to maximize value to current shareholders.

C. Proponents of the management entrenchment theory of capital structure believe that managers choose a capital structure to avoid the discipline of debt and maintain their own job security.

D. Firms with high R&D costs and future growth opportunities typically maintain high debt levels.