Bus 330 Name Spring 2015 Final Exam id# Part I: 3 points each. Instructions

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BUS 330 Name________________________

Spring 2015

Final Exam ID# __________________________
Part I: 3 points each. Instructions: Select the ONE BEST response to each question below.
Note: In the questions below, the phrase “in a perfect world” means that there are no taxes that distort a firm’s or investor’s decisions and there are no transactions costs associated with bankruptcy -- or issuing debt or shares (no lawyers).

Remember: I like to give questions where “none of the above” is the correct answer.

  1. "Preferred stock combines the disadvantages of debt with the disadvantages of equity." The person who says this means that preferred stock has the disadvantage of debt because (X) and preferred stock has the disadvantage of equity because (Y).

  1. preferred stock dividends are subject to double taxation.

  2. non-payment (arrearages) of preferred dividends trigger expensive and wasteful bankruptcy procedures.

  3. if the company's gross earnings (EBIT) grow as much as management hopes, payments to preferred shareholders dilute the earnings to common shareholders.

  4. preferred shareowner claims have priority over payments to common shareholders, and preferred shareholders impose restrictions on distributions to common shareholders.

  1. (X) is (i); and (Y) is (ii)

  2. (X) is (ii); and (Y) is (iii)

  3. (X) is (iii); and (Y) is (i)

  4. (X) is (iv); and (Y) is (ii)

  5. (X) is (iv); and (Y) is (i)

  1. An expenditure that the firm has made in the past which cannot be recovered by any of the available actions or decisions taken today is a _____.

  1. Opportunity cost

  2. Fixed cost

  3. Real option

  4. Business risk

  5. Sunk cost

  1. Production processes with high fixed costs and low variable costs have _____

  1. high operating leverage

  2. low operating leverage

  3. high financial leverage

  4. low financial leverage

  5. high stand-alone risk

  1. The rights or abilities of a firm’s managers to take actions or decisions which can alter the cash flow stream of a project are:

  1. real options.

  2. financial options.

  3. systematic risks.

  4. operating leverages.

  5. opportunity costs.

  1. The graph above shows the required return on debt (the bottom line, starting at 2%) and the required return on equity (the top line, starting at 8%) of a firm operating in an imperfect world. If the debt ratio is 0.75, the firm's WACC is:

  1. 10%

  2. 8%

  3. 7%

  4. 13%

  5. 16%

  1. Suppose a firm invests in new capital that changes the production process for its product. With the new capital installed, the firm's fixed costs are higher, and variable costs are lower. (Assume the break-even quantity is unchanged.) This will have the effect of:

  1. decreasing the firm's operating leverage, regardless of how the capital was financed.

  2. increasing the firm's operating leverage only if the capital was financed with debt.

  3. increasing the firm's operating leverage, regardless of how the capital was financed.

  4. decreasing the firm's financial leverage, regardless of how the capital was financed.

  5. none of the above.

  1. A firm that has issued preferred stock may choose not to pay the dividend to preferred stock holders. In this case, the firm _____ pay interest on debt contracts, _____ pay dividends to holders of common stock, and _____ pay preferred shareholders the arrearages prior to paying dividends to common stock holders.

  1. must not must must

  2. must not must not must

  3. must must not must not

  4. must must not must

  5. none of the above.

  1. The world we actually live in is imperfect due to (1) higher taxes applied to income used to pay dividends than applied to income used to pay interest on debt; and (2) high transactions costs associated with any bankruptcy procedure. The effect of (1) is to make the WACC _____ as the firm's debt ratio rises. The effect of (2) is to make the WACC ____ as the firm's debt ratio rises.

  1. rise rise

  2. fall rise

  3. fall fall

  4. rise fall

  5. rise ambiguous

  1. Assume that investors believe the management of a company has better information about the firm's future profits than the general public, AND investors expect that the managers will act to maximize the wealth of their existing shareholders. When the management decides to fund a capital expansion project by issuing new shares, investors view the decision as a signal that management thinks that:

  1. the intrinsic value of the new shares will be greater than the intrinsic value of the existing shares.

  2. the capital expansion project is too risky to be funded by debt.

  3. the intrinsic value of the capital expansion project is less than the cost of the project.

  4. the intrinsic value of the current shares is less than the current market price.

  5. the capital expansion project will decrease the intrinsic value of the shares.

  1. If the firm's managers are compensated substantially by being given options to purchase the company's shares at a fixed price, then the managers have a reason to prefer:

  1. stock dividends instead of cash dividends.

  2. cash dividends instead of share repurchases.

  3. to make acquisitions funded by shares rather than acquisitions funded by debt.

  4. share repurchases instead of cash dividends.

  5. Stock splits rather than cash dividends.

  1. The management of company Z knows that current market price of company Z's shares exceeds the shares' intrinsic value by a significant degree. If the management wants to maximize the wealth of its current shareholders, which action is most likely?

  1. disclosing to the general public the information about the firm's intrinsic value

  2. spending money on making an acquisition so that the managers have a bigger business, more employees reporting to them, and probably higher salaries.

  3. issuing new debt to re-purchase some of the outstanding shares on the open market and drive up the price.

  4. acquiring another company by issuing new shares.

  5. paying current shareholders a special dividend equal to the difference between the market price and the intrinsic value.

  1. The debt-to-assets ratio that minimizes the firms weighted-average-cost-of-capital is ____ the level that maximizes expected earnings per share and _____ the level that maximizes shareholder wealth.

  1. greater than less than

  2. greater than equal to

  3. less than equal to

  4. equal to greater than

  5. none of the above.

  1. Company X has a “beta” of 4.5. Company X’s capital structure is 1/3 debt and 2/3 equity. The business risk of company X would result in a beta of _____, and the financial leverage causes the value of beta resulting from the business risk to _____.

  1. 3 double

  2. 1 triple

  3. 2 triple

  4. 1.5 quadruple.

  5. None of the above.

14. The highest (strongest) claim on the cash flow from the firm’s operations is to make payments on _____. The next highest claim is to make payments on _____. The lowest claim is to make payments on _____.

a.  common stock debt preferred stock

b. debt common stock preferred stock

c. preferred stock common stock debt

d. debt preferred stock common stock

e. common stock preferred stock debt

15. A firm is considering whether to invest in new capital that will allow it to expand into a new industry. The firm currently is financed 50% with debt (cost of 4%) and 50% by equity (required return on shares is 10%). The typical firm in the new industry has a WACC of 12%. The firm should evaluate the cash flows from this investment using a required IRR of:

a. 4%

b. 7%

c. 10%

d. 8%

e. 12%


16. A benefit or net cash flow that the firm will NOT have it makes a specific decision or action is a _____.


a. sunk cost.

b. opportunity cost.

c.  firm-level externality.

d. social cost.

e. real option.

17. Greater uncertainty about the outcomes of decisions (such as major capital investments) _____ the value of projects that preserve the ability to change direction in the future and _____ the value of projects that lower the ability of the firm to change strategic direction in the future.


a. raise   do not affect

b. raise   lower

c. do not affect    raise

d.  lower   do not affect

e. do not affect   do not affect


18. A firm’s operating break-even occurs where (using the same abbreviations as the text):

  1. P ▪ Q – V ▪ Q = F

  2. P ▪ Q =F

  3. EBIT = F

  4. Net Income = 0

  5. None of the above.

19. An announcement of an increase in the regular dividend is often viewed as a _____ signal by investors who assume the announcement indicates that management believes that:

  1. Positive the stock’s current market price is more than its intrinsic value.

  2. Positive the management expects future cash flow to be sufficient to maintain the dividend and fund required investment.

  3. Negative the firm’s borrowing costs are greater than the firm’s IRR.

  4. Negative the reduction in beta will make the firm less risky

  5. Positive the firm has no profitable investment opportunities.

20. Suppose Boeing wishes to diversify out of commercial aircraft and move into the hamburger business. It is considering purchasing McDonald’s. Boeing is financed entirely by equity, has stable earnings, and a price-to-earnings ratio of 10, meaning that the shareholders of Boeing require a 10% return on their shares. The acquisition would double the total amount of Boeing’s assets. McDonald’s current balance sheet shows 50% debt (interest rate of 5%) and 50% equity (required return on equity of 9%). When Boeing’s management evaluates the expected cash flows from the McDonald’s acquisition to compute the net present value of the acquisition, the discount rate is should use is:

  1. 10%

  2. 5%

  3. 9%

  4. 7%

  5. 8.5%

Part II. (5 points for each) Solve the questions below sequentially. They are designed to start off relatively easy and get progressively harder.
Suppose one of Bulgaria’s mobile phone operators “M-Vivatelenor” is considering a large investment project to launch 6th generation (6G) mobile phone technology in Bulgaria. The cost will be $22 billion in period zero to purchase the necessary capital and inform the possible customers of this service. The pay-back will come in periods one and two. The firm has a weighted-average-cost-of-capital of 10%.
If the acceptance of the new technology (based on the number of paying subscribers) is STRONG, then the firm will receive a net cash flow of $22 billion in period one and $24.2 billion in period two.
If the acceptance of the new technology (based on the number of paying subscribers) is WEAK, then the firm will receive a net cash flow of $11 billion in period one and $12.1 billion in period two.

  1. If M-Vivatelenor believes there is a 50% chance of acceptance being STRONG and a 50% chance of acceptance being WEAK, what is the expected NPV of the project?

  1. Suppose the technology was just launched in Serbia by another telecom company, which has proprietary (meaning “secret”) data on how well the technology was accepted there. Suppose M-Vivatelenor believes that the response of Bulgarians is likely to be the same as the response of Serbians. If the response of Serbians is STRONG, then M-Vivatelenor believes that the chance of the STRONG response of Bulgarians is 66-2/3% (and the chance of WEAK response is 33-1/3%.) If the response of Serbians was WEAK, then the chance of a STRONG response by Bulgarians is 33-1/3%.

If M-Vivatelenor can pay money to the Serbian operator to find out what the response was to the new technology in Serbia, what is the maximum amount it should consider paying for this information?

  1. Suppose the 7th generation (7G) of mobile technology is also under development. The technology will be ready to launch in period one. Running a 7G system will require the use of the same radio spectrum as 6G, so therefore launching 7G will require cancellation of 6G service. If M-Vivatelenor decides that it wants to launch 7G after it has 6G up and running, it will incur cancellation and compensation costs of $5 billion associated with the termination of 6G service, and it will not receive the 6G revenues from period 2. (It will not incur these costs if it launches 7G without launching 6G.)

In words, describe how does the prospect of 7G service affects the valuation of the launch of 6G.

  1. Suppose that if M-Vivatelenor wants to switch from a 6G system to a 7G system, the extra capital expenditure will be $10 billion in period one with a 50% chance of a net cash flow of $33 billion in period 2 and a 50% chance of a net cash flow of $44 billion in period 2. (No cash flows beyond period two.) The net cash flow from 7G is independent of the launch or not-launch of 6G, and is independent of whether the response of consumers to 6G was STRONG or WEAK.

If M-Vivatelenor has no information from the Serbian operator about the response of Serbian customers to 6G, what is the new NPV of the 6G project?

  1. Suppose M-Vivatelenor decides not to launch 6G at all (and has zero expenditures and zero income in period zero) and launches 7G in period one. In this case there are no cancellation and compensation costs, but the capital expenditure will be $20 in period one. What is the NPV (from period zero) of the project “do-not-launch-6G-but-launch 7G-in-period-one”?

  1. Suppose the data from the Serbian telecom company just happened to fall into the hands of M-Vivatelenor management, so that the updated probabilities (from question 2) apply. What is the value of the information from the Serbian telecom company?

Part III Extra Credit (1 point each)
Instructions: Don’t waste time on these until you are sure that you can’t usefully spend any more time on Part I and Part II.

  1. Above are photos of 3 famous figures in finance – Franco Modigliani, Myron Scholes, Fisher Black, plus professional wrestler Randy “Macho Man” Savage. Which is which?

  1. (1) Macho Man; (2) Scholes; (3) Modigiliani; (4) Black

  2. (1) Black; (2) Macho Man; (3) Modigiliani; (4) Scholes;

  3. (1) Modigiliani; (2) Black; (3) Macho Man; (4) Scholes;

  4. (1) Scholes; (2) Modigiliani; (3) Black; (4) Macho Man

  5. (1) Macho Man; (2) Modigiliani; (3) Scholes; (4) Black

  1. Which of the following is funniest? (Most popular answer is correct.)

  1. When you dream in color, it’s a pigment of your imagination. 

  2. Bakers trade bread recipes on a knead-to-know basis. 

  3. When she told me I was average, she was just being mean.

  4. Four fonts walk into a bar. The barman says “Hey get out! We don’t want your type in here!”

  5. A cartoonist was found dead in his home. Details are sketchy.

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