MBA 504 Exam 216 Questions with Verified Answers
To which questions does corporate finance attempt to answer? - CORRECT
ANSWER 1. INVESTMENT decision: What investments should the business take
on?
2. FINANCE decision: How can finance be obtained to pay for the required
investments? (equity vs. debt)
3. CASH FLOW decision: How should a company manage its short term assets and
liabilities? Should dividends be paid? If so, how much? How much short-term cash
flow does a company need to pay its bills?
What do financial managers do? - CORRECT ANSWER - corporate treasurer or
financial manager: oversee cash management, credit management, capital
expenditures, and financial planning
- accountant: oversees taxes, cost accounting, financial accounting, and data
processing
What are some possible goals of financial managers? - CORRECT ANSWER -
survive
- beat the competition
- maximize sales
- maximize net income
- maximize market share
- minimize costs
- *maximize the value of (stock) shares*
What is the appropriate goal of financial managers? Why? - CORRECT ANSWER
Maximize the (fundamental or economic) value of (stock) shares is the right goal
- shareholders own shares and managers, as agents, ought to act in a way to
benefit shareholders (i.e. enhance the value of the shares)
-> limitation of this goal is that value is not directly observable (Ex: CEO fails to lift
stagnant stock price and abruptly resigns but still receives huge compensation
package)
,Describe the agency relationship - CORRECT ANSWER - principals (citizens) hire an
agent (the president) to represent their interest
- principals (stockholders) hire agents (managers) to run the company
Describe the agency problem - CORRECT ANSWER Conflict of interest between
principals and agents
- this occurs in a corporate setting whenever the agents do not hold 100% of the
firm's shares
- source of agency problems is the separation of (owners') control and
management
What are the net present value rules? - CORRECT ANSWER NPV = Total PV of
Future CFs + Initial Investment
- accepting positive NPV projects benefits shareholders
- minimum acceptance criteria: accept if NPV > 0
- ranking criteria: choose highest NPV
Describe the steps of estimating net present value? - CORRECT ANSWER 1.
Estimate future cash flows: How much? When?
2. Estimate discount rate
3. Estimate initial costs
What is the basic feature of debt? - CORRECT ANSWER It is a promise by the
borrowing firm to repay a fixed dollar amount by a certain date
What is the shareholder's claim on firm value? - CORRECT ANSWER The residual
amount that remains after the debt-holders are paid
- if value of the firm is less than the amount promised to the debt holders, the
shareholders get nothing
How can you think of the value of the firm? - CORRECT ANSWER As a pie - the goal
of the manager is to increase the size of the pie
- capital structure decision can be viewed as how to best to slice up the pie
- if how you slice the pie affects the size of the pie, then capital structure decision
matters
,Describe the payoff to debt holders - CORRECT ANSWER Debt holders are
promised $F.
- if the value of the firm is less than $F, they get whatever the firm is worth
- if the value of the firm is $X, the debt holder gets a maximum of $F
-> Min($F, $X)
Describe the payoff to shareholders - CORRECT ANSWER Assume firm has $F
promised to debt holders:
- if value of firm is less than $F, shareholders get nothing
- if value of firm is $X which is more than $F, shareholders get everything above
$F
- Max(0, $X-$F)
What is the value of the firm's assets equal to? - CORRECT ANSWER Debt + equity
What is the Modigliani-Miller Theorem? - CORRECT ANSWER In the absence of
taxes, bankruptcy costs, agency costs, and asymmetric information, and in an
efficient market, the value of the firm is not affected by its capital structure.
-> with the presence of tax and bankruptcy costs: tax shield increases value of
levered firm and financial distress costs lower the value of the levered firm, so
two offsetting factors produce an optimal amount of debt B*
Describe the pecking order theory - CORRECT ANSWER Rule #1: Use internal
financing
Rule #2: Issue safe securities first
-> equity financing is more expensive than debt because the required rate of
return is higher (residual claimants)
How does the capital structure of businesses vary? - CORRECT ANSWER There are
differences in the capital structures of different industries
- a number of firms use no debt
- radio and television have highest leverage while biological products have lowest
leverage
Empirically, how do businesses decide on debt-equity ratios? - CORRECT ANSWER
Most companies use target debt-equity ratios
, - 37% have a flexible target, 34% have a somewhat tight target/range, 19% have
no target ratio, and 10% have a very strict target
-> but capital structure of individual firms can vary significantly over time
What are forms of payouts by companies? - CORRECT ANSWER Cash dividend,
stock dividend, stock repurchase
What are some real world factors favoring a high dividend policy? - CORRECT
ANSWER - desire for current income
- behavioral argument (self-control)
- agency cost
- dividend signaling effect: indication of positive future profits
What do we know about dividend policy? - CORRECT ANSWER 1. Corporate
dividends are substantial
- ratio of dividends to earnings has increased over last 30 years
2. Fewer companies pay dividends
- % of publicly held industrial firms that pay dividends dropped significantly from
1973-2002 with a rebound over the next 2 years
3. Corporation smooth dividends
When valuing derivative securities, what kind of interest rate is usually most
convenient? - CORRECT ANSWER Continuously compounding interest rates
- trading strategy underlying valuation often needs to be rebalanced continuously
over time and thus the interest earned on the strategy also needs to be
recognized continuously
What's the general formula for the future value of $x you invest today? -
CORRECT ANSWER FV($x) = x(1 + r/n)^(nT)
where:
r is the annualized interest rate
T is the length of the holding period in years
n is the number of compounding periods per year
What happens to the future value of an investment as you increase the
compounding frequency? - CORRECT ANSWER The future value and effective
annual interest rate both increase
To which questions does corporate finance attempt to answer? - CORRECT
ANSWER 1. INVESTMENT decision: What investments should the business take
on?
2. FINANCE decision: How can finance be obtained to pay for the required
investments? (equity vs. debt)
3. CASH FLOW decision: How should a company manage its short term assets and
liabilities? Should dividends be paid? If so, how much? How much short-term cash
flow does a company need to pay its bills?
What do financial managers do? - CORRECT ANSWER - corporate treasurer or
financial manager: oversee cash management, credit management, capital
expenditures, and financial planning
- accountant: oversees taxes, cost accounting, financial accounting, and data
processing
What are some possible goals of financial managers? - CORRECT ANSWER -
survive
- beat the competition
- maximize sales
- maximize net income
- maximize market share
- minimize costs
- *maximize the value of (stock) shares*
What is the appropriate goal of financial managers? Why? - CORRECT ANSWER
Maximize the (fundamental or economic) value of (stock) shares is the right goal
- shareholders own shares and managers, as agents, ought to act in a way to
benefit shareholders (i.e. enhance the value of the shares)
-> limitation of this goal is that value is not directly observable (Ex: CEO fails to lift
stagnant stock price and abruptly resigns but still receives huge compensation
package)
,Describe the agency relationship - CORRECT ANSWER - principals (citizens) hire an
agent (the president) to represent their interest
- principals (stockholders) hire agents (managers) to run the company
Describe the agency problem - CORRECT ANSWER Conflict of interest between
principals and agents
- this occurs in a corporate setting whenever the agents do not hold 100% of the
firm's shares
- source of agency problems is the separation of (owners') control and
management
What are the net present value rules? - CORRECT ANSWER NPV = Total PV of
Future CFs + Initial Investment
- accepting positive NPV projects benefits shareholders
- minimum acceptance criteria: accept if NPV > 0
- ranking criteria: choose highest NPV
Describe the steps of estimating net present value? - CORRECT ANSWER 1.
Estimate future cash flows: How much? When?
2. Estimate discount rate
3. Estimate initial costs
What is the basic feature of debt? - CORRECT ANSWER It is a promise by the
borrowing firm to repay a fixed dollar amount by a certain date
What is the shareholder's claim on firm value? - CORRECT ANSWER The residual
amount that remains after the debt-holders are paid
- if value of the firm is less than the amount promised to the debt holders, the
shareholders get nothing
How can you think of the value of the firm? - CORRECT ANSWER As a pie - the goal
of the manager is to increase the size of the pie
- capital structure decision can be viewed as how to best to slice up the pie
- if how you slice the pie affects the size of the pie, then capital structure decision
matters
,Describe the payoff to debt holders - CORRECT ANSWER Debt holders are
promised $F.
- if the value of the firm is less than $F, they get whatever the firm is worth
- if the value of the firm is $X, the debt holder gets a maximum of $F
-> Min($F, $X)
Describe the payoff to shareholders - CORRECT ANSWER Assume firm has $F
promised to debt holders:
- if value of firm is less than $F, shareholders get nothing
- if value of firm is $X which is more than $F, shareholders get everything above
$F
- Max(0, $X-$F)
What is the value of the firm's assets equal to? - CORRECT ANSWER Debt + equity
What is the Modigliani-Miller Theorem? - CORRECT ANSWER In the absence of
taxes, bankruptcy costs, agency costs, and asymmetric information, and in an
efficient market, the value of the firm is not affected by its capital structure.
-> with the presence of tax and bankruptcy costs: tax shield increases value of
levered firm and financial distress costs lower the value of the levered firm, so
two offsetting factors produce an optimal amount of debt B*
Describe the pecking order theory - CORRECT ANSWER Rule #1: Use internal
financing
Rule #2: Issue safe securities first
-> equity financing is more expensive than debt because the required rate of
return is higher (residual claimants)
How does the capital structure of businesses vary? - CORRECT ANSWER There are
differences in the capital structures of different industries
- a number of firms use no debt
- radio and television have highest leverage while biological products have lowest
leverage
Empirically, how do businesses decide on debt-equity ratios? - CORRECT ANSWER
Most companies use target debt-equity ratios
, - 37% have a flexible target, 34% have a somewhat tight target/range, 19% have
no target ratio, and 10% have a very strict target
-> but capital structure of individual firms can vary significantly over time
What are forms of payouts by companies? - CORRECT ANSWER Cash dividend,
stock dividend, stock repurchase
What are some real world factors favoring a high dividend policy? - CORRECT
ANSWER - desire for current income
- behavioral argument (self-control)
- agency cost
- dividend signaling effect: indication of positive future profits
What do we know about dividend policy? - CORRECT ANSWER 1. Corporate
dividends are substantial
- ratio of dividends to earnings has increased over last 30 years
2. Fewer companies pay dividends
- % of publicly held industrial firms that pay dividends dropped significantly from
1973-2002 with a rebound over the next 2 years
3. Corporation smooth dividends
When valuing derivative securities, what kind of interest rate is usually most
convenient? - CORRECT ANSWER Continuously compounding interest rates
- trading strategy underlying valuation often needs to be rebalanced continuously
over time and thus the interest earned on the strategy also needs to be
recognized continuously
What's the general formula for the future value of $x you invest today? -
CORRECT ANSWER FV($x) = x(1 + r/n)^(nT)
where:
r is the annualized interest rate
T is the length of the holding period in years
n is the number of compounding periods per year
What happens to the future value of an investment as you increase the
compounding frequency? - CORRECT ANSWER The future value and effective
annual interest rate both increase
