Introduction to Corporate Finance, 5th Canadian Edition Laurence Booth Solution Manual

Type:

Solution Manual

Resource:

Introduction to Corporate Finance

Edition:

5th Edition

Author(s):

Laurence Booth Sean Cleary Ian Rakita

Chapter 1 Lecture Topics 1. What is finance? Finance in its broadest terms is the study of how and under what terms savings (money) are allocated between lenders and borrowers. The key phrase in the above definition is allocated, and some will recognize the similarity with economics, which studies how scarce resources are allocated in an economy. This similarity is not an accident, since finance in many ways is closely related to economics. However, finance is distinct from economics, since it is not just about how resources are allocated, but also under what terms and through what channels.

2. Financial system. In Canada, the household sector is the primary provider of funds to business and government, with the non-resident sector traditionally being net providers of funds, despite the fact that all three domestic sectors do invest outside of Canada. The basic financial flow is “intermediated” through the financial system, which is comprised of: (1) financial intermediaries (hard box), who transform the nature of the securities they issue versus what they invest in; and, (2) market intermediaries, who simply make the markets work better. The whole package of institutions is the Canadian financial system.

3. Financial instruments, financial markets and global financial markets. Financial assets are formal legal documents that set out the rights and obligations of all of the parties involved. The two major categories of financial securities are debt instruments and equity instruments. Financial markets permit the issuing and trading of these financial instruments, which include primary markets and secondary markets. In addition to the domestic financial markets discussed above, global financial markets represent important sources of funds for borrowers, and provide investors with important alternatives.

Chapter 2 Lecture Topics 1. The four major forms of business organizations are sole proprietorships, partnerships, trusts and corporation. The big advantage of a sole proprietorship is that setting one up is easy, however, the critical thing is unlimited liability. The two main partnership forms are limited liability partnerships (LLP) and limited and general partnerships. Limited and general partnerships are generally used for tax reasons.

2. The Role of Management and Agency Issues. The costs associated with agency problems are referred to as agency costs. There are two major types of agency costs: (1) direct costs (2) indirect costs

3. What is Corporate Finance? Corporate Finance is the financial management of assets and corporate financing decisions represent the area of corporate finance.

4. In 2007, Michael Lazaridis received $79.17 million dollars in compensation as the co-CEO of RIM. However, not all of this compensation is bourne by the shareholders. Both co-CEOs, Lazaridis and Balsille received $.63 million in salary and the balance of their compensation came from shares/options on RIM—Balsille received $38.48 million and Lazardidis received $78.54 million. The idea of using shares and options is to align the best interests of the CEO and senior management with the interests of the shareholders.

Chapter 3 Lecture Topics 1. Accounting principles. In Canada, generally accepted accounting principles (GAAP) are contained in the Handbook of the Canadian Institute of Chartered Accountants (CICA). The Handbook has the force of law in Canada in that statements have to be prepared in accordance with these principles when the firm raises money from Canadian investors. Since 2011, the Canadian GAAP is aligned to the International Financial Reporting Standards (IFRS), now the primary standards for publicly accountable enterprises. In addition to IRFS, Canadian GAAP also include standards for private firms and for not-for-profit organizations. In the U.S., GAAP consists of the principles of the Financial Accounting Standards Board (FASB). Japan and China have yet to adopt IFRS standards.

2. Balance sheet, income statement, and cash flow statement. Balance sheet is simply a snapshot of the financial position of the firm. Income statement is a firm’s financial statement showing the sales, expenses and net profit for a given period. The net income figure increases when a firm’s accountants make more aggressive accounting assumptions. However, cash flow statements alleviate the impact of most major accounting assumptions.

3. Canadian corporate taxes. Canada’s corporate tax system has a unique feature, which applies cost of capital allowance (CCA) in depreciation. CCA is usually the beginning-of-year UCC multiplied by the CCA rate. In year 1, the beginning-of-year UCC is half the assets. The beginning-of-year UCC is the endof-prior-year UCC. Since 2018 the new Accelerated Investment Incentive (AII) program changed the CCA rules over the period 2018-2027, such as charging CCA on an amount equal to the net acquisition cost plus 50 percent, or writing off assets entirely upon acquisition, for classes 53, 43.1, 43.2. The program has two phases, 2018-2023 and 2024-2027. When an asset is sold, there is either a CCA recapture or a terminal loss, depending on the salvage value and the remaining UCC.

Lecture Topics Chapter 4 1. Du Pont decomposition. ROE is a critical measure of the performance of a firm and overall performance analysis is enhanced by the DuPont decomposition where: ROE = Net Income x Sales

Sales x Total Assets Total Assets Shareholders’ Equity

(ROE = Net Profit Margin x Asset Turnover x Leverage)

2. Liquidity ratios measure the ability of a firm to meet its financial obligations from its current assets.

The current ratio and quick ratio measure a firm’s liquidity.

3. Financial forecasting is the use of a firm’s financial statements to project future financing needs if sales increase by projected percentages. The percentage of sales method is used to project a firm’s external financing requirements (EFR). The EFR can also be computed mathematically using a formula that relates EFR to sales growth rates, the firm’s retention rate, profitability, and the invested capital requirement. The sustainable growth rate can be derived from this formula.

Lecture Topics Chapter 5 Lecture Topics 1. Simple interest rates and compound interest rates. Simple interest arises when interest is paid or received based “only” on the initial investment (or principal). Compound interest refers to a process whereby interest is earned on the principal amount invested and on any accrued interest. It can result in dramatic growth in the value of an investment over time.

2. Future value and present value. The values at the current time period are present values and the values in the future are future values. The present value and the future value can be converted into each other with FVn = PV0 (1 + k)n.

3. Valuation of future cash flows, such as annuities, perpetuities, loans, and mortgages. An annuity is a series of payments or receipts, which we will simply call cash flows, over some period that are for the same amount, and paid over the same time interval, that is, for example, they are paid annually, monthly, or weekly. Sometimes annuities are structured so that the cash flows are paid at the beginning of a period, rather than at the end. Perpetuities are special annuities in that they go on forever so n goes to infinity in the annuity equation. Mortgages and loans involve “blended” payments for equal amounts that include both an interest and principal repayment component.

Chapter 6

Lecture Topics 1. Bond valuation. The price of a bond equals the present value of the future payments on the bond, which is the present value of the interest payments and the par value repaid at maturity.

2. Determinations of the discount rate or yield. The discount rate used to evaluate bonds is referred to as the yield to maturity (YTM). Technically, it is the yield that an investor would realize if they bought the bond at the current price, held it to maturity, received all the promised payments on their scheduled dates, and reinvested all the cash flows received at the YTM.

3. Determinations of interest rate. Important topics include the difference between nominal rates and real rates, the causes of the different interest rate across countries, term structure of interest rate, and corporate spreads.

Chapter 7 Lecture Topics 1. Common shares and preferred shares. By far, the most common type of equity security is the common share, which are the residual claimants of the corporation, which means that they are entitled to income remaining only after all creditors and preferred shareholders have been paid. The other major category of equities is preferred shares, which have preference over common shares with respect to income and assets, but rarely have any voting rights.

2. Dividend discount model. Common share valuation by using the dividend discount model assumes that common shares are valued according to the present value of their expected future cash flows. In addition to the discount rate, investors must estimate the size and timing of the expected cash flows associated with an equity security. Based on the estimated pattern of dividend growth, zero growth, constant growth and multiple stage growth versions are applied.

3. Using multiples to value shares. Relative valuation approaches determine the value of common shares by comparing the market prices of “similar” companies, relative to some common variable such as earnings, cash flow, book values or sales. One basis approach is to multiple the estimated earnings per share by the justified P/E ratio. Additional multiples are the market-to-book ratio, the price-to-sales ratio, the price-to-cash-flow ratio, the market value to EBITDA ratio, and etc.

Chapter 8 Lecture Topics 1. Expected return and risk of a portfolio. The expected return is simply a weighted average of the expected return of the underlying securities. A portfolios standard deviation depends on weights, standard deviations, and correlations between the individual securities. If the correlation between the underlying securities is not 1, the standard deviation is less than a weighted average of the standard deviations of the underlying securities. If they are perfectly negatively correlated, you can always remove all risk in a two security portfolio.

2. Efficient frontier. Efficient portfolios are portfolios that offer the highest expected return for a given level of risk, or offer the lowest risk for a given expected return. In identifying the efficient frontier, we first identify the minimum variance frontier which is a curve produced when determining the expected return-risk combinations available to investors from a given set of securities by allowing the portfolio weights to vary. Then segment of the minimum variance frontier above the global minimum variance portfolio is the efficient frontier.

3. Diversification effect. Risk can be categorized as diversifiable and non-diversifiable risk. The part of the total risk that is eliminated by diversification is the company-specific unique (or non-systematic) or diversifiable risk. The part that is not eliminated by diversification is the market (or systematic) or nondiversifiable risk. It is logical to believe that international diversification will provide benefits to investors, since we would expect the returns among stock returns on different global markets to have lower correlation coefficients than those in the same market.

Chapter 9

Lecture Topics 1. New Efficient Frontier. When there is a risk-free asset, the efficient frontier is defined as the line connecting the risk-free asset and the tangent portfolio. We can generate a portfolio with a higher expected rate of return than that on the tangent portfolio with more than 100% invested in the tangent portfolio (w > 100%) and thus a negative or short position in the risk free asset.

2. CAPM and Market Risk. CAPM states that k i = RF + ( ERM − RF ) i . In CAPM, only the market risk is compensated and all other risks can be diversified away in a widely-diversified portfolio. It has got many critics in practice, and there are many alternatives such as the Fama-French model and the arbitrage pricing model.

3. Alternative models. It has got many critics in practice, and there are many alternatives such as the Fama-French model and the arbitrage pricing model. However, the alternatives have their strengths and weakness too.

Chapter 10

Lecture Topics 1. Definition and Forms of Market Efficiency. An efficient market is defined as one in which the prices of all securities accurately reflect all relevant and available information about the securities. This implies that security prices, as determined in the capital markets, are “correct.” The efficient market hypothesis is broken down to three levels that are based on the extent to which prices reflect different types of available information. The three levels include weak, semi-strong, and strong form.

2. Empirical Evidence of Market Efficiency. The weak form EMH is well supported by empirical evidence with exceptions including over-reaction, momentum, seasonal patterns like January effect, Friday defect, and end-of-month effect. Most studies support the semi-strong EMH; however, some do not. The strong form EMH is not well supported by empirical evidence.

3. Does the Stock Market Overreact? (See the following discussion, which may be of interest: www.stockexchangesecrets.com/does-the-stock-market-overreact.html). The over and under reaction of prices in the market have led to the introduction of behavioural finance and the influences of the herding effect. The issuance of Facebook in 2012 is a prime example of the hype and over-reaction of prices in the market.

Chapter 11 Lecture Topics 1. Forward Contracts. These are over-the-counter legally binding agreements where a price is set today for future delivery. They are flexible but involve credit risk. They are used to hedge exposure to an underlying risk.

2. Futures Contracts. They are conceptually similar to forward contracts but are standardized, and are traded on formal exchanges. They do not carry credit risk because a clearinghouse imposes margins on the parties and marks to market the futures at the end of each trading day.

3. Swaps. There are interest rate swaps and currency swaps. The typical swap is the plain vanilla interest rate swap that converts floating- into fixed- rate payment debt and vice-versa.

4. The Credit Default Swap Market. This agreement involves the swapping of the payments of a risk free government bond with the proceeds of a risky bond. The investor pays the difference between the coupon interest on the risky bond and the risk free bond. In return, the counterpart of the agreement agrees to provide the par value of the risky bond in the event of default of the risky bond. The buyer pays for default protection and the seller provides protection.

5. Forward Rate Agreements. With two years to maturity and interest rates fixed at a set rate for only one year may leave a bank open to the risk of increasing interest rates at the end of the year. By entering a forward rate agreement, the bank may fix the interest rate that will be paid in the last year. Whether the market rate is higher or lower than the forward interest rate, the bank will have locked into the interest rate of the forward rate agreement.

Chapter 12 Lecture Topics 1. Call option and put option. Call option is the right, but not the obligation, to buy an underlying asset at a fixed price for a specified time. Put option is the right, but not the obligation, to sell an underlying asset at a fixed price for a specified time. Both their payoff functions are non-linear.

2. American options can be exercised at any time up to and including the maturity date; while, European options can on be exercised on the maturity date. By exercising the American option prior to the expiry date, the investor is able to capture the intrinsic value of the option. On the other hand, if the investor takes the opposite position from their investment (sell the option if they bought or buy the option they sold) and close out their position, the investor is able to capture the intrinsic and the time value of the option contract.

3. The put-call parity. A long put position and a long underlying asset have the same payoff as a long call position and a deposit of the present value of the strike price. Without arbitrage opportunity, the two portfolios should have the same price. Thus we derive the put-call parity, i.e., the sum of the prices of a put option and an underlying asset equals the price of a call option with the same strike and term to maturity and the present value of the strike.

4. Option pricing. Both binomial trees and the Black-Sholes model are used for option pricings. In binomial trees, one way is to first calculate the hedge ratio, which is the number of and the other way involves the risk-neutral probability. The Black-Scholes equation is a simple “plug-in” formula for option pricing, which only needs the input variables of current asset price, strike price, term to maturity, risk-free interest rate, and volatility.

Chapter 13 Lecture Topics 1. Evaluating investment alternatives. Besides NPV rules, other methods in investment decisions include IRR, payback period, discount payback period, and profitability index. When applying NPV method, we can use the risk-adjusted discount rate (RADR), which is set based on the overall riskiness of the project.

2. Independent and mutually exclusive projects. Among independent projects, a firm’s decision to accept one project has no impact on a firm’s decision to accept another project that is independent of it. In contrast, among mutually exclusive projects, the decision to accept one project excludes other projects.

3. Unequal Lives. Mutually exclusive projects that have unequal live—different planning horizons— need to be compared on a consistent basis. To provide a consistent time frame, projects are repeated until both projects have the same number of cash flow periods and the NPVs of the projects are compared. A second method is to divide the NPV of the project by the annuity factor of the project to calculate the equivalent annual benefit the project is providing and the annual benefits can be compared.

4. Capital Rationing. There are two forms of capital rationing—soft capital rationing and hard capital rationing. Soft capital rationing occurs when management places an arbitrary limit on the amount of capital expenditure the company will undertake for a period. Hard capital rationing occurs when the markets will not or cannot support the new financial instruments that are being sold to the market. In either case, the size of the capital budget will be restricted or rationed.

5. The appropriate discount rate. If a project is a typical investment, and will not substantially change the asset mix of the company, then we can use WACC. However, if a company is considering a project that is “atypical” in the sense that it is either more or less risky than the average investment for that company, this fact should be reflected in the discount rate used to evaluate that project.

Chapter 14 Lecture Topics 1. Guidelines of capital budgeting decisions. Only the after-tax incremental cash flows enter the capital budgeting decision. Taxes affect both the annual cash flows and the terminal cash flows. The capital budgeting decisions are sensitive to the changes in input variables.

2. Capital Budgeting Projects. Capital budget decisions come in various forms - the expansion project, the replacement project and the continuation or abandonment project. The expansion project examines the value of a new project for the shareholder. The replacement project examines the additional value of the project if the company replaces existing assets. The continuation or abandonment examines the value for the shareholder is the company continues with a project, if the company abandons a project or if the company sells the project or even a division to another company. The last area involves the on-going monitoring of the activities of the firm after the implementation of a project or projects.

3. Sensitivity to inputs. This section describes four approaches to examine the sensitivity to inputs: sensitivity analysis, scenario analysis, real-option analysis, and NPV break-even analysis. Real-option analysis addresses the limitation of scenario analysis by allowing firms to respond to different circumstances and change operating characteristics.

4. Inflation. In principle, we can use either nominal cash flows discounted by nominal discount rates, or real cash flows discounted by real discount rates. However, it is usually more précis to use nominal items because the CCA tax savings estimates represent the actual amount of CCA that can be charged in a given year.

Chapter 15

Lecture Topics 1. Types of takeovers. Takeovers can occur in several manners. An acquisition occurs when one firm (the acquiring firm or bidder) completely absorbs another firm (the target firm). In contrast, a merger is usually the combination of two firms into a new legal entity. The transaction in takeovers can take the form of cash, equity, or both. M&A can be friendly or hostile. M&A can also be classified as horizontal merger, vertical merger, and conglomerate.

2. Motivations for Mergers and Acquisitions. Acquisitions are made because the acquirer thinks that it enhances the firm’s long-run value. Motivations for M&A include operating synergies, efficiency increases, financing synergy, and strategic realignment.

3. Valuation and Accounting Issues. Values and prices may differ because value is the willingness to sell or buy while price is the value at which a deal is consummated. The valuation methods in M&A include multiples, liquidation values, and discounted cash flow models. The accounting method in M&A is the purchase method.

Chapter 16

Lecture Topics 1. Operating leasing versus financing leasing. They differ in the transfer of ownership, causing differences in accountings such as assets, expenses, and depreciations. Financial leases versus operating leases lead to lower current ratios, higher debt, higher leverage ratios, lower asset turnover, and lower profitability ratios at least in the early years.

2. Valuation of leasing. The general approach is to value the NPV with appropriate discount rate applied to the incremental or changes in the cash flows. The valuation differs in situations such as leasing versus buying, leasing versus buying with monthly payment, leasing and CCA tax shields, and financial leasing versus borrowing.

3. Maximum Lease Payments. A firm can evaluate the maximum payment that they would be willing to make or receive for a leased asset. For the lessee, the maximum payment that the firm should be willing to make is the before tax payment that makes the NPV of leasing equal to zero. On the other hand, the lessor will require a minimum before tax payment that will make their NPV of leasing to zero. As long as the maximum payment is higher than the minimum payment, both parties can benefit from the leasing arrangement. If the maximum payment is less than the minimum required payment, leasing of the asset will not occur.

4. Motivations of leasing. The motivations include cheaper financing, lower the risks of asset ownership because the lessees do not need to sell the asset, implicit fixed interest rates, no or lower maintenance costs, convenience because the lessees can lease for a relatively short period and/or if it is a very specialized or illiquid asset that may be hard to sell in the future, flexibility with the option to cancel a lease or a seasonal payment, low capital budgeting restrictions because leases requires only a very limited initial capital outlay, and better financial statement effects

Introduction to Corporate Finance, Fifth Edition

Booth, Cleary, Rakita

Chapter 17: Investment Banking and Securities Law Multiple Choice Questions 1. Section: 17.1 Conflicts between Issuers and Investors Learning Objective: 17.1 Level of difficulty: Basic Solution: D Due diligence is very time-consuming and expensive to implement.

2. Section: 17.1 Conflicts between Issuers and Investors Learning Objective: 17.1 Level of difficulty: Intermediate Solution: B Some issuers know what they are selling is not worth what the investors are paying.

3. Section: 17.1 Conflicts between Issuers and Investors Learning Objective: 17.1 Level of difficulty: Intermediate Solution: B

4. Section: 17.2 A Primer on Securities Legislation in Canada Learning Objective: 17.2 Level of difficulty: Intermediate Solution: D Provincial securities commissions have a multitude of requirements dictating what has to be included in a prospectus, but it excludes the CEO’ resume.

5. Section: 17.2 A Primer on Securities Legislation in Canada Learning Objective: 17.2 Level of difficulty: Basic Solution: C There is no federal securities regulator; this area is a provincial responsibility.

6. Section: 17.3 Security Offerings Learning Objective: 17.3 Level of difficulty: Intermediate Solution: A An IPO is assumed to have the greatest information asymmetry.

7. Section: 17.3 Security Offerings Learning Objective: 17.3 Level of difficulty: Basic Solution: D

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The market for non-registered securities is called the exempt market. The primary market is the market for new securities, which investors purchase from the issuer. The secondary market is the market where investors purchase securities from other investors, not the issuer. Securities in the primary and secondary markets are registered.

8. Section: 17.3 Security Offerings Learning Objective: 17.3 Level of difficulty: Intermediate Solution: B In the exempt market, the issuer prepares an offering memorandum, not a prospectus.

9. Section: 17.3 Security Offerings Learning Objective: 17.3 Level of difficulty: Intermediate.

Solution: D Private issuers, or closely held issuers, are exempt only if there is no promotion, less than $3 million is raised, and the securities are sold to no more than 35 individuals with the approval of the board of directors.

10. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: C Most IPOs are firm commitments offerings.

11. Section 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate CPA: Finance Solution: B 12. Section 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate CPA: Finance Solution: • Access to capital from the public markets • Greater public visibility • Opportunity to cash out for founders and early investors (provides liquidity) • Gain the ability to motivate managers and key employees with stock options • Possibly lower the cost of capital • Ability to use shares as a currency (e.g., in M&A transaction) 13. Section: 17.5 Post-IPO Regulation and Seasoned Offerings Learning Objective: 17.5 Level of difficulty: Basic Solutions Manual ..

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Solution: D The main components of continuous disclosure are the filing of quarterly and annual financial statements, an annual information form (AIF), and proxy and information circulars.

14. Section: 17.5 Post-IPO Regulation and Seasoned Offerings Learning Objective: 17.5 Level of difficulty: Intermediate Solution: A During the IPO, a large amount of information is released. Since seasoned equity offerings occur after an IPO, the firm need not repeat information that had been previously released.

Practice Problems Basic 15. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Basic Solution: A lock-up period prevents the founders of the company from selling their shares for a given time.

16. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of Difficulty: Basic Solution: The waiting period occurs after the preliminary prospectus has been drafted and sent to the securities commission to be examined for deficiencies. During this “wait” time, the investment dealer and the issuer must await final clearance before selling the securities.

17. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Basic Solution: The net proceeds were $25 million × (1 – 0.028) – $150,000 = $24,150,000.

Winnipeg Water & Gas paid a total of $25 million – $24.15 million = $850,000 in fees (gross proceeds less the net figure above), which is $850,000/$25,000,000 = 3.4% of the total issue amount.

Intermediate 18. Section: 17.1 Conflicts between Issuers and Investors Learning Objective: 17.1 Level of difficulty: Intermediate Solution: a. Arthur pays $0.85 x 100,000 = $85,000 for the stamps. He sells them for $0.86 × 100,000 = $86,000, so his profit is $1,000. b. Arthur sells the stamps for $0.8525 × 100,000 = $85,250 and pays shipping and insurance, leaving $85,250 – $249 = $85,001. Therefore, his profit is exactly $85,001 – $85,000 = $1. A “quick buck” indeed!

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c. He makes $86,000 – $85,000 – $249 = $751.

19. Section: 17.2 A Primer on Securities Legislation in Canada Learning Objective: 17.2 Level of difficulty: Intermediate Solution: The OSC is involved in the areas of primary market offerings (IPOs), secondary market trading, activities of investment professionals, insider trading, and takeover bids.

20. Section: 17.2 A Primer on Securities Legislation in Canada Learning Objective: 17.2 Level of difficulty: Intermediate Solution: The OSC determined three types of security distribution as follows: distribution by the issuer (who knows best the true value of the security), distribution by a control block, and distribution of restricted shares to the public for the first time.

21. Section: 17.3 Security Offerings Learning Objective: 17.3 Level of difficulty: Intermediate Solution: Three major categories of exempt purchasers are: First, accredited investors, such as banks, governments, wealthy investors, investment dealers, and individuals owning control blocks.

Second, government debt issues are exempt, as are debt issues by many financial institutions.

Third, securities issued as part of takeovers and corporate reorganizations are exempt because they are covered by corporate law requirements to provide proxy circulars and similar documents.

22. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: Stage 1: Initial discussion with the investment bank, which forms the formal IPO process.

Stage 2: Drafting an initial prospectus (the preliminary prospectus) Stage 3: Finalization of the prospectus; the waiting period for final clearance from the securities commission.

Stage 4: Pricing and distribution of the issue and after-market stabilization.

23. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: Limit orders are expressions of interest, but not firm orders. Investors enter into limit orders when they are willing to indicate how much of a certain security they would be willing to buy or sell at a certain price level. Institutional investors are usually interested in limit orders. Investors

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enter into market orders when they want a fixed amount of the security, at whatever the final price is. Retail investors are usually interested in market orders.

24. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: During the quiet period, the investment dealer cannot issue an analyst report recommending the shares. The underwriter and issuer cannot hype the stock to help sell it, and the underwriters as a group cannot drop the price. The lead underwriter has the right to trade in the shares to maintain an orderly market during this period to ensure the success of the issue.

25. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: The four types of public offerings are a best efforts offering, a firm commitment offering, a bought deal, and a standby or rights offering. The last two can only be used with seasoned offerings, and most IPOs are firm commitment offerings.

Best efforts offering: shares that are sold by investment dealers through an agency agreement to do their best, with no guarantee of success; investment dealers are paid an amount for each share they sell.

Firm commitment offering: an offering in which the investment dealer buys the new securities from the issuer and guarantees the sale of a certain number.

Bought deal: an offering in which the underwriter buys all the shares of a seasoned issue to resell later, even before the drafting of the preliminary prospectus.

Standby or rights offering: an offering of common shares at a discount to investors who already own shares; can only be used with seasoned offerings.

26. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: Disaster “out” clause: if the state of the financial markets deteriorates so much that the underwriter cannot market the issue profitably, then the issue can be cancelled. Clearly, this is a huge safety net for the underwriter.

27. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: An overallotment or green-shoe option gives the underwriter the option of buying more shares from the issuer (usually 15 percent more) if investor demand is strong.

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28. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: The lead underwriter may trade in the shares to maintain an orderly market and help make the issue successful. By buying shares in the market, the underwriter helps to support the price during the distribution period. If the underwriter is able to oversell the offering, the overallotment option permits them to acquire more shares from the offeror.

29. Section: 17.5 Post-IPO Regulation and Seasoned Offerings Learning Objective: 17.5 Level of difficulty: Intermediate Solution: The main components of continuous disclosure are the filing of quarterly and annual financial statements, annual information forms (AIFs), and proxy and information circulars.

Challenging 30. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: There are 500,000 shares outstanding before the IPO, and 250,000 new shares are being issued, bringing the total to 750,000. Of these, the brothers will retain 250,000 (half of their original holdings). Therefore, they will own (250,000/750,000) = 33.33% of the shares (and of the company).

31. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: The IPO is intended to sell 250,000 + 250,000 = 500,000 shares. When investor demand is strong, the “green-shoe” standard overallotment clause means that 500,000 × 15% = 75,000 additional shares will have to be issued by the company. This would raise the total outstanding shares to 750,000 + 75,000 = 825,000. The Finn brothers will still own 250,000 shares, which would then represent (250,000/825,000) = 30.30% of the company.

32. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Intermediate Solution: a. To raise $4 million, the equity offering, before fees, will have to be $4,000,000/(1 – 0.06) = $4,255,319.15. The flotation costs will be this gross figure less the net $4 million, or $255,319.15. b. To raise $4 million, the equity offering, before fees, will have to be $4,000,000/(1 – 0.05) = $4,210,526.32. The flotation costs will be this gross figure less the net $4 million, or $210,526.32. It saves $255,319.15 – $210,526.32 = $44,792.83 on flotation costs.

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33. Section: 17.1 Conflicts between Issuers and Investors Learning Objective: 17.1 Level of difficulty: Challenging Solution: $7 (1 + k) = $8 (1.08) (1 + k) = 1.2343 k= 23.43% 34: Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Challenging CPA: Finance Solution: a) Number of shares outstanding x number of rights per shareholder x rights offering price = 60 million x 1 x $20 = $1.2 billion b) Total market capitalization = Original market capitalization + rights offering proceeds = $2.7 billion Total shares outstanding = Original shares outstanding + new shares = 60 million + 60 million = 120 million Price per share = Total market capitalization/Total shares outstanding = $2.70 billion/120 million = $22.50 35. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of difficulty: Challenging Solution: There is too little competition for business in Canada, and Canadian firms do not need to tolerate high underpricing, because they want the best price for their shares.

A large number of reasons have been given for the underpricing in the U.S. First, (the most obvious) is that it lowers the risk of the underwriter losing money on the issue.

However, this answer implies that the U.S. investment banks are more powerful than their equivalents in Canada and although there is anecdotal evidence of this, it is difficult to prove.

Second, is the litigious nature of the U.S. economy: if the share price falls someone may mount a class action suit against the underwriter for misleading the purchaser.

Third, a well-received public offering paves the way for subsequent offerings by the firm and builds momentum into the share price. However, the relative rarity of the equity issue makes this rationale dubious.

Fourth, spinning: the underwriter allocates IPOs to favoured clients, which is essentially a way of bribing them with millions of dollars to get future investment banking business.

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36. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of Difficulty: Challenging Solution: With fees of 4 percent, Lansdowne Ltd. will receive 96 percent of the offer price for each share, or $50 × 0.96 = $48. To raise $20 million, the company must issue $20,000,000/$48 = 416,667 shares (rounding up to an integer number of shares).

If investors think that firms only issue new equity if the stock is overpriced, in order to attract investors, the investment dealer suggests a lower offering price. Also, it is less risky for the underwriters since it will be easier to sell the issue at a lower price.

37. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of Difficulty: Challenging Solution: Under Plan I, you will gross $11 × 1 million shares = $11 million and will pay $11 million × 0.07 = $770,000 in fees. The net proceeds are therefore $11,000,000 – $770,000 = $10,230,000.

Under Plan II, only 95 percent, or 950,000 shares are expected to be sold, so the gross proceeds will be $12 × 950,000 = $11,400,000. After the dealer’s fee of $850,000, net proceeds will be $11,400,000 –$850,000 = $10,550,000.

Plan II appears to be better as you will receive more money and have sold fewer shares doing so.

However, this option entails more risk for you and the company: if the IPO doesn’t go very well, you may raise far less money (and you will still pay the fixed fee).

38. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of Difficulty: Challenging Solution: a. On the undervalued shares, your profit will be 1,000 shares × $3 = $3,000. On the overvalued shares, you will lose 1,000 × $2 = $2,000. Your net gain is $1,000. b. You will only receive 500 shares of the undervalued issue, so your profit will be 500 × $3 = $1,500. On the overvalued shares, you will still lose $2,000. In this situation, you will have a net loss of $500. c. You will only receive 200 shares or one-fifth of the undervalued issue, so your profit will be 200 x $3 = $600. On the overvalued shares, you will still lose $2,000. In this situation, you will have a net loss of $1,400.

39. Section: 17.4 IPOs and Investment Banking Learning Objective: 17.4 Level of Difficulty: Challenging Solution: a. Working down from the top of the list (highest limit price), selling 800,000 shares means that investors A, B, C, D, and E would buy the shares (with a partial allotment of 100,000 shares for investor E.) For all these investors to buy the shares, the price can be no higher than $19.00 (the lowest of this group’s indicated limit prices).

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b. Two-times oversubscription means that expressions of interest for 1,600,000 shares are needed. To get expressions totalling this number of shares involves investors A through H (with a partial allotment of 150,000 shares for investor H), and the lowest limit price for this group is $18.00. c. According to Table 17-1 in the text, the historical underpricing in Canada has been 6.5%.

Therefore, you would expect the stock to rise to $18.00 × 1.065 = $19.17 on the first day of trading. In the U.S., the first-day return has averaged 16.9%, so you might expect the price to rise to $18.00 × 1.169 = $21.04.

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Answers to Concept Review Questions 17.1 Conflicts between Issuers and Investors Concept Review Questions 1. How does the existence of asymmetric information lead to market inefficiencies?

Information asymmetry means that people frequently have different information about the same future stream of cash flows, and thus they value the securities differently. In fact, they can disagree so much that a market may not exist and a firm cannot find anyone to buy its securities and experiences a “financing gap.”

2. Why can increases in interest rates not be used to solve the “lemons problem” in financial markets?

Let us take a typical example of a “lemons problem.” Suppose bad money drives out good. If the interest rates increase, people are lured to circulate more bad money. Thus, increases in interest rates make the “lemons problem” even worse.

3. Why are securities legislation and corporate laws essential for markets to perform properly?

Asymmetric information causes market inefficiencies, which may cost investors big money.

Securities legislation and corporate laws aim to reduce the information asymmetry.

17.2 A Primer on Securities Legislation in Canada Concept Review Questions 1. What are some of the more important issues arising from the fact that securities regulation is a provincial and territorial, but not a federal, responsibility in Canada?

Securities regulation is designed to protect investors in that jurisdiction, so the provincial and territorial authorities exert authority whenever its citizens are involved. In contrast, a security is national in scope. A federal regulation will foster more responsive policy-making, improve market efficiency, eliminate duplication, provide common standards of investor protection, and strengthen Canada’s voice in international discussions on regulatory standards.

17.3 Security Offerings Concept Review Questions1. Why are prospectuses so important for public market issues?

The assumption here is that the issuer, controlling shareholders, or the restricted shareholders know more about the true value of the securities than the investors do. Hence, the prospectus is designed to remedy this information asymmetry.

2. Explain how offering memorandums differ from prospectuses and how exempt markets differ from public markets.

First, memorandums and prospectuses differ in content. Memorandums are short, have much less information, and have a lower cost of preparation. Second, they are used in different situations.

Memorandums may have more sophisticated investors such as offerings to banks and wealthy investors. Prospectuses must supply full, true and plain disclosure of all material facts concerning the securities. The market for non-registered securities is called the exempt market

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while the public market requires a prospectus for most distributions of securities, and in the process the securities are registered, which means that trades in the securities can be made by a securities firm that is registered with the appropriate securities commission.

3. What is a reverse takeover and a backdoor listing?

A reverse takeover occurs when a takeover firm is acquired that has reduced its operating activities to bypass the IPO process and thereby avoid the long-form prospectus. If the acquisition is by a private firm and the acquired firm is an actively traded firm, the private firm has acquired a backdoor listing on the exchange.

17.4 IPOs and Investment Banking Concept Review Questions 1. Briefly discuss the possible motivation for firms to enter into IPOs, and relate these motivations to the five stages of firm development discussed by Myers (1999).

The motivations are to “cash out” and have access to a more diversified set of financing options.

Myers (1999) points out five stages of firm development: 1. technological experimentation; 2. pilot studies and sales; 3. improvement in production and scaling up manufacturing; 4. full-scale marketing and production; 5. expansion into other lines. In Myers’ view, the entrepreneur is essential at stages 1 and 2, valuable at stage 3, useful but replaceable at stage 4, and not needed at all at stage 5. The entrepreneur, as well as the partner, then needs a commitment to go public at stage 3 and certainly by stage 4, as the proportion of intellectual or human capital versus real capital in the value of the firm goes down. That is when the entrepreneur cashes out.

2. List and briefly describe the four basic stages of the IPO process.

The four basis stages are: i. Discussion triggers IPO ii. The firm issues preliminary prospectus, which takes three to five months iii. Waiting period and road shows take another one to two months iv. Pricing, distribution, and after-market stabilization, which takes another month.

3. List and briefly describe some possible reasons for the existence of IPO underpricing.

First, it lowers the risk of the underwriter losing money on the issue. Second, underpricing in the U.S. is understandable given the litigious nature of the U.S. economy. If the share price falls, then the risk is high that someone will mount a class action suit against the underwriter for misleading the purchasers. Third, a well-received public offering paves the way for subsequent offerings by the firm and builds momentum into the share price. Fourth, the underwriter allocates IPOs to favoured clients, knowing that they will make a large profit on the first day and making some people very wealthy.

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17.5 Post-IPO Regulation and Seasoned Offerings Concept review questions 1. Explain why the lock-up period is an important consideration for investors, especially for issues that are still largely held by insiders.

Insiders want to cash out their shares. Without the lock-up period, stock prices may drop sharply right after IPO because of the selling from large shareholders. The lock-up period requirement prevents investors from suffering this loss.

2. How do continuous disclosure requirements protect investors?

The prospectus is out of date after the IPO. Continuous disclosures reduce information asymmetry and thereby protect investors.

3. Briefly explain why short-form prospectuses are permitted by regulators for a large percentage of seasoned issues, and explain why they have led to the growth in popularity of bought deals.

Essentially, any reporting issuer with an outstanding Annual Information Form can issue securities under a short-form prospectus, which indicates the nature and pricing of the securities, omits all corporate information, and incorporates existing documents by reference. As long as the securities are not “novel,” they can be cleared by the OSC in a matter of days, so that issues can be brought to market very quickly.

Short-term prospectuses led to the growth of the bought deal, in which the underwriting contract is signed even before the drafting of the preliminary prospectus. The OSC allows this because it knows that the prospectus now only includes details of the offering, rather than of the issuer, and that the prospectus will follow within two days. This allows the investment dealer to market the issue to major institutions and close the transaction usually within two to three days from the initial discussions with the issuer.

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Chapter 18: Debt Instruments Multiple Choice Questions 1. Section: 18.1 What Is Debt?

Learning Objective: 18.1 Level of difficulty: Intermediate CPA: Finance Solution: B 2. Section: 18.1 What Is Debt?

Learning Objective: 18.1 Level of difficulty: Basic CPA: Finance Solution: B After-tax cost of debt = 6% (1 – 0.4) = 3.6% 3. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: D 1 + kTB 1.01 R= −1 = − 1 = 3.06% P 0.98 4. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: C Use the equivalent maturity T-bill yield: 5% – 1% = 4% 5. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: B Only firms with very good credit ratings can issue CP, while firms without good ratings can seek bankers’ acceptances.

6. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: C

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While both treasury bills and treasury bonds are issued by the government, the shorter term of Tbills makes them relatively safer.

7. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: A 8. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Intermediate CPA: Finance Solution: D 9. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Intermediate CPA: Finance Solution: D 10. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Intermediate CPA: Finance Solution: D 11. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Intermediate CPA: Finance Solution: B A revolver adds more stability than a line of credit.

12. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Basic CPA: Finance Solution: B Practice Problems Basic 13. Section: 18.1 What Is Debt?

Learning Objective: 18.1 Level of difficulty: Basic CPA: Finance

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Solution: Interest is compensation for the use or retention of money owed to another.

Interest must be referable to a principal sum.

Interest accrues from day to day.

14. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Basic CPA: Finance Solution: $1,000 $1,000 Price = = = $997.05 (1 + 𝐾) (1 + .012 × 90/365) 15. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Basic CPA: Finance Solution: The yield spread is the difference between the promised yield (not the expected yield) and the Tbill rate: Yield spread = 10% – 1% = 9%.

16. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Basic CPA: Finance Solution: The total cost of issuing the commercial paper is 10% + 0.125% + 0.125% = 10.25%. For the BAs, the total cost is 9.75% + 0.325% = 10.075%. The bankers’ acceptances are the better choice as they are slightly less costly overall.

17. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Basic CPA: Finance Solution: The annual interest payment, at the current rate, is 10.75% x $25 million = $2,687,500. To stay onside with the covenant, Collingwood must earn at least: EBIT = 2 x $2,687,500 = $5,375,000 this year.

Intermediate 18. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solutions Manual .

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Solution: The borrower receives a net amount of $10,000 – $75 = $9,925. A year later, he must repay $10,000 plus interest of $10,000 (0.08) = $800. Therefore, the effective interest paid by the borrower is: $10,800 − $9,925 = 8.82% $9,925 Thus, service fees and other costs increase the effective interest rate of a loan.

19. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: k = 3.8(91)/365 = 0.9474% (0.009474) 𝑃=

$1,000,000 = $990,615 1.009474

20. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: Using equation 18.2 $2,000,000(1.04)(0.97) + 0(1 − 0.97) 𝑃= = $1,769,825 1.14 21. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate Money market debt instruments are high quality (low default risk), liquid, and short-term (low interest rate risk).

To complete the answer, the student can reflect on the desirability (on behalf of lenders and borrowers) of each of these characteristics.

22. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.1, 18.2 Level of difficulty: Intermediate CPA: Finance Solution: Interest on loan = $125,000(0.06) = $7,500

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EBIT Interest Taxable income Tax (30%) Net income

No Debt $143,500 0 143,500 43,050 $100,450

Booth, Cleary, Rakita

$125,000 loan at 6% $143,500 7,500 136,000 40,800 $95,200

The net income for Jackie’s company will fall by ($100,450 – $95,200) = $5,250, as shown in the table above. Although the company will pay $7,500 in interest on the loan, these payments are tax deductible. The result is that the company really pays only (1 – Tax Rate) = (1 – 30%) = 70% of the interest cost ($7,500 x 70% = $5,250), with the remainder being offset by lower taxes.

23. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Intermediate CPA: Finance Solution: Yes; Jackie is correct. The tax-deductibility of interest payments means that the after-tax cost of borrowing is lower than the actual amount of interest paid. Using Equation 18-1, K = Kd(1 – T) = (6%)(1 – 0.30) = 4.2% We could also obtain this result by noting that the impact of the interest payment on net income was $5,250. For a $125,000 loan, this amounts to an interest rate of $5,250/$125,000 = 4.2% 24. Section: 18.3 Bank Financing Learning Objective: 18.3 Level of difficulty: Intermediate CPA: Finance Solution: Collingwood can borrow up to: 75% x Accounts receivable + 50% x Inventory = 0.75 x $8,536,000 + 0.50 x $80,196,000 = $46.5 million.

25. 18.4 Long-Term Debt and the Money Market Learning Objective: 18.4 Level of difficulty: Intermediate CPA: Finance Solution: A bond’s seniority level indicates the bondholder’s priority in claiming the assets in the event of default. For example, senior bondholders rank above (have a higher priority claim over) regular bondholders, who in turn rank ahead of junior bondholders.

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26. Section: 18.4 Long-Term Debt and the Money Market Learning Objective: 18.4 Level of difficulty: Intermediate CPA: Finance Solution: By issuing long-term debt (as opposed to short-term debt), the issuer is betting on interest rates either remaining the same or rising in the future. Long-term financing is less risky for the business as it represents permanent funding, as opposed to short-term financing, which is temporary.

27. Section: 18.4 Long-Term Debt and the Money Market Learning Objective: 18.4 Level of difficulty: Intermediate CPA: Finance Solution: The “bullet” payment pays off the entire principal amount of the loan so the annual payments consist of interest only: $2.65 million/$25 million = 10.6% per year.

This annual interest rate is somewhat higher than the yield on commercial paper or BAs, even including the extra fees for those alternatives (see Problem 15). There are many reasons why longer-term loans may have a higher interest rate than short-term commercial paper (which they usually do). One possibility is that Collingwood’s bank believes the 10-year term increases the risk that the company will default, and the extra yield is compensation for this risk.

28. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Intermediate CPA: Finance Solution: Core Profitability This is an assessment based on standard profit measures such as the return on equity; return on assets; the “quality” of a firm’s earnings; its cost structure (i.e., whether it is the low-cost producer, etc.); its growth opportunities; and its pricing structure.

Asset Quality Assets are made up of many different types, so DBRS looks at the importance of intangibles (for example, how valuable is the goodwill on the firm’s balance sheet); the market value of the firm’s assets; and its use of derivatives and risk management to see whether it is managing its operational and market risks effectively.

Strategy and Management Strength Ultimately a firm is comprised of assets and management, so that an assessment of a firm’s credit risk is vitally concerned with the capabilities of the senior management group. This is particularly important if the firm is actively involved in mergers and acquisitions where a clear strategic approach and skills at integration of acquired companies is valuable.

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Balance Sheet Strength If the lenders have to initiate bankruptcy proceedings, it is important to understand where they stand in the overall liabilities of the firm, so standard debt ratios, coverage tests, and the amount of financial flexibility available to the firm are important. The latter includes an assessment of the firm’s reliance on short-term debt, its commitment to a capital expenditure program that cannot be easily stopped, and the support potentially available from other parties such as affiliated companies. Size is important since larger firms are usually less risky and have more market power.

Business Strength Standard issues such as market share; growth prospects for the industry; a defensible base of diversified operations; up-to-date management information systems; key intangibles such as the quality of its workforce; and industry issues such as the degree of unionization and competition.

Miscellaneous Issues This is a “catch-all” category, including such issues as the quality of the firm’s accounting statements and whether there have been consistent restatements, the structure of the bond indenture, and the importance of the firm and industry to the province or territory or to Canada.

Challenging 29. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Challenging CPA: Finance Solution: Michael will pay only his “expected value” for the Collingwood commercial paper, not the full par value amount. Over 60 days, approximately one-sixth of a year, the paper promises a return of (10%/6) = 1.67%, and Michael requires a (14%/6) = 2.33% return. Thus, his expected value is (not rounded):

Par  (1 + R)  P + Recover  (1 − P) $1,000  (1.0167)  0.99 + $750  0.01 = = $990.88 (1 + K ) (1.0233) 30. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Challenging CPA: Finance Solution: At 10% per year, the promised return is 1.67% (approximately) for the 60-day life of the commercial paper. Using a $1,000 figure for the par value (and hence the issue price), the amount recovered in the event of a default is $750. Using Equation 18-2, we find: $1,000 × (1.0167) × 𝑃 + $750 × (1 − 𝑃) (1.01) $1,000 × (1.01) − $750 $260 𝑃= = = 0.9749 $1,000 × (1.0167) − $750 $266.7 $1,000 =

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This is the probability of NOT defaulting. Therefore, the probability of a default is (1 – 0.9749) = 0.0251, or 2.51% 31. Section: 18.2 Short-Term Debt and the Money Market Learning Objective: 18.2 Level of difficulty: Challenging CPA: Finance Solution: A 1 percent chance of default means that the probability of not defaulting is P = 99%. As in Problem 28, the promised yield is 1.67 percent over the 60-day life of the paper, and the T-bill yield is 1 percent. With V = $1,000, the par-value amount using equation 18.2 is: $1,000 × (1.0167) × 0.99 + Recover × (1 − 0.99) $1,000 = (1.01) $1,000 × (1.01) − $1,000 × (1.0167) × 0.99 $3.4670 Recover = = = $346.70 (1 − 0.99) 0.01 Thus, investors expect to recover $346.70 for every $1,000 invested, or 34.67% if Collingwood were to default on the commercial paper.

32. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Challenging CPA: Finance Solution: a. Table 18-5 shows that the average default rate for BB-rated bonds over 10 years is 8.99%; the probability of not defaulting is therefore 91.01%. b. Using equation 18-2 $1,000 × (1.09) × 0.9101 + 0 𝑉= = $935.86 1.06 Collingwood’s bonds are worth $935.86 per $1,000 of face value, or 0.93586 x $25 million = $23,396,500 in total.

33. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Challenging CPA: Finance Solution: From Table 18-6, the default recovery rate on senior unsecured bonds has averaged 46.37%.

Using this in conjunction with the solution to Problem 32 and equation 18.2, 𝑉=

$1,000 × (1.09) × 0.9101 + 0.4637 × $1,000 × 0.0899 = $975.18 1.06

The bonds are worth $975.18 per $1,000 of face value, or 0.97518 x $25 million = $24,379,500 in total.

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34. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Challenging CPA: Finance Solution: This is a somewhat open-ended question that will force students to think of other factors in the market that might affect the desirability of a particular bond vis-à-vis another. Some of the reasons are: i. Liquidity ii. Interest rate risk iii. How much the investor is likely to get in case of default 35. Section: 18.5 Bond Ratings Learning Objective: 18.5 Level of difficulty: Challenging CPA: Finance Solution: EBIT/Interest Expense = [$130/($500 x 5%)] = 5.2x [BBB] EBITDA/Interest Expense = ($214/$25) = 8.6x [BBB] Debt/(Debt + Equity) = $500/($500 + $970) = 34% [A] Total Debt/EBITDA = $500/$214 = 2.3x [BBB] Bond rating would be BBB.

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Answers to Concept Review Questions 18.1 What Is Debt?

Concept Review Questions 1. Distinguish debt from equity.

First, debt is a fixed contractual commitment, but shareholders can only claim residuals. Second, interest payments from debt are paid before taxes, but dividends from equity are paid after taxes.

2. Explain how to estimate the after-tax cost of debt.

The after-tax cost of debt is the before-tax interest cost of debt multiplied by one minus the tax rate.

3. What three characteristics does the CRA look for to determine whether interest payments are tax deductible?

The three characteristics are: i. Interest is compensation for the use or retention of money owed to another ii. Interest must be referable to a principal sum iii. Interest accrues from day to day 18.2 Short-Term Debt and the Money Market Concept Review Questions 1. Explain how interest is received on most money market instruments.

There are three major money market instruments: T-bills, commercial papers, and bankers’ acceptances. T-bills are sold at discounts. The CRA regards the increase from the purchase price to the par value as interest and not capital gains. Most money market issues are traded on a discount basis but some commercial paper is issued in interest-bearing form. The actual yield on commercial papers is less than the quoted interest rate because of its credit risk. If an issuer does not have a good enough credit rating to access the CP market, it can have its bank guarantee or “accept” its commercial paper by selling the CP to the bank, which then accepts it by stamping “accepted” on it and selling it from its own money market desk. Thus the yield on bankers’ acceptances is lower than commercial paper.

2. Contrast treasury bills, commercial paper, and BAs in terms of who issues them, their basic structure and default risk, and the yields they provide.

They differ in the following ways. First, who issues them? T-bills are issued by the government, but commercial papers and BAs are issued by corporations. Second, basic structure and default risk. T-bills are risk free, commercial papers are unsecured and risky, and BAs are backed up by major banks. Third, yields. T-bill has the lowest yields, BAs have medium yields, and commercial papers have the highest yields.

3. Define yield spreads and explain how they arise.

Yield spreads are the difference between the yield of a corporate debt security and the T-bill. The spreads arise mainly because of firms’ default risk. T-bills are risk-free.

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18.3 Banking Financing Concept Review Questions 1. Briefly describe operating LCs, revolving LCs, and term loans.

Bank financing includes lines of credit (LCs) and term loans. LCs fall into two types: operating LCs and revolving LCs. Operating LCs are lending facilities that are made available by the bank for the firm’s operating purposes and that generally cannot be used to back up a CP program; these demand loans can be cancelled at any time.

Term or revolving LCs are usually at least 364 days and often out to five years, renewable every six months. Often a five-year “revolver” is renewed at the end of each year, making it an “evergreen” five-year line of credit. Because the revolver is a commitment of credit, the bank has to provide capital against these commitments to ensure the liquidity of the bank. The common 364-day LC occurs because more capital is required against a one-year or 365-day LC. Term loans differ from lines of credit because they have a fixed maturity, require repayment to be made on a fixed schedule, and are made to finance longer-term requirements such as equipment purchases.

2. Why do banks typically impose debt covenants on their borrowing customers?

The covenants allow the bank to pull the loan (i.e., demand payment) and prevent the firm from drawing it down beyond a certain amount as its credit quality deteriorates.

3. Why is it reasonable to assume that most firms will have a banking relationship?

For large-amount financing, CPs require the line-of-credit backups from a bank, and BAs require the credit support from a bank. For smaller, irregular-sized financing requirements, firms rely more on traditional bank financing. Thus, regardless of firm size, most firms have a banking relationship.

18.4 Long-Term Financing Debt and the Money Market Concept Review Questions 1. Define mortgage bonds, secured debentures, unsecured debentures, and subordinated debt.

Mortgage bonds are similar to residential mortgage arrangements, in which the lender has registered a claim on the underlying real property that is financed. Secured debentures mean that the investor has underlying assets to seize in the event of a default. Unsecured debentures mean that the investor has no underlying assets to seize in the event of a default. Subordinated debts are paid after other senior debts in the event of a default.

2. Discuss the rationale for including debt covenants in a public issue.

Unlike a bank who can monitor the operation and financing of a firm, the investors in a public issue are diversified and do not have the capability to monitor a firm. Thus, a covenant is necessary to ensure that a firm cannot hurt the investors’ right to claim the principal and interest payments.

3. Briefly describe negative pledge and cross-default clauses.

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Negative pledge is a clause that stipulates that a borrower may not create higher-priority debt without giving the other debt holders the same security. A cross-default clause means that default on one obligation also constitutes default on another.

18.5 Bond Ratings Concept Review Questions 1. Differentiate investment-grade debt from junk debt.

The lowest investment-grade bond rating is BBB (low), and below this the bonds are commonly referred to as junk bonds, although they are more politely referred to as high-yield bonds.

2. Briefly describe the main factors DBRS considers in determining its debt ratings.

In determining its rating, DBRS looks at six basic factors: core profitability, asset quality, strategy and management strength, balance sheet strength, business strength, and miscellaneous issues.

3. Briefly summarize the evidence regarding how well debt ratings work.

DBRS tracked the default probability after 5, 10, and 20 years after the original rating. The most noteworthy evidence is that the default rates clearly increases as the DBRS rating goes down, so their ratings provide a good indicator of credit risk.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Chapter 19: Equity and Hybrid Instruments Multiple Choice Questions 1. Section: 19.1 Shareholder Rights Learning Objective: 19.1 Level of difficulty: Basic CPA: Finance Solution: D All of them may appear in a share structure.

2. Section: 19.3 Preferred Shares Learning Objective: 19.3 Level of difficulty: Intermediate CPA: Finance Solution: C Preferred shares are considered a part of equity; owners cannot bankrupt the firm.

3. Section: 19.43 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Basic CPA: Finance Solution: C 4. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: A The exercise price is paid in cash when warrants are exercised. Debt is not exchanged to common shares when its attached warrant is exercised. A conversion ratio is specified in convertibles.

5. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: C 6. Sections: 19.2 Different Classes of Shares and 19.4 Warrants and Convertible Securities Learning Objectives: 19.2 and 19.4 Level of difficulty: Intermediate CPA: Finance Solution: D 7. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: A (Number of shares)(Price – Exercise) = 2 x ($30 – $20) = $20 Solutions Manual .

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8. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: B CV = (CR)(Price) = 20($55) = $1,100 > market price, so convert 9. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: A At the time of issuance, the convertible security will be priced higher than its conversion value.

10. Section: 19.5 Other Hybrids Learning Objective: 19.5 Level of difficulty: Basic CPA: Finance Solution: D Permanence, subordination, legal, and subjective are the four factors.

11. Section: 19.5 Other Hybrids Learning Objective: 19.5 Level of difficulty: Intermediate CPA: Finance Solution: D Preferred securities are different from preferred shares because payments of preferred securities are tax-deductible.

12. Section: 19.5 Other Hybrids Learning Objective: 19.5 Level of difficulty: Intermediate CPA: Finance Solution: D See Figure 19-4.

Practice Problems Basic 13. Section: 19.1 Shareholder Rights Learning Objective: 19.1 Level of difficulty: Basic CPA: Finance Solution: To vote at any meeting of the shareholders of the corporation To receive any dividend declared by the corporation To receive the remaining property of the corporation on dissolution

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14. Sections: 19.3 Preferred Shares and 19.4 Warrants and Convertible Securities Learning Objectives: 19.3, and19.4 Level of difficulty: Basic CPA: Finance Solution: From Equation 19-3, Conversion Price (CP) = Par/Conversion Ratio (CR), therefore CR = Par/CP =$100 / $20 = 5. This means that each preferred share will be converted into 5 common shares.

15. Sections: 19.2 Preferred Shares, 19.4 Warrants and Convertible Securities Learning Objectives: 19.2 and 19.4 Level of difficulty: Basic CPA: Finance Solution: The conversion price of the common shares is $10. A 20 percent premium means the price would have to be 0.20 x $10 = $2 higher, or $12 per share before the firm would call (and force conversion of) the preferred shares.

Intermediate 16. Section: 19.3 Preferred Shares Learning Objective: 19.3 Level of difficulty: Intermediate CPA: Finance Solution: i. Preferred shares can be a means of raising equity capital without diluting control. ii. Firms issuing preferred shares can avoid the bankruptcy risk that is associated with debt issuance. iii. Firms paying low taxes have little use for the tax shields generated by debt. Preferred shares are attractive to these firms because preferred dividends are a significantly lower financial cost (preferred dividends are lower than interest) and do not have bankruptcy costs.

17. Section: 19.1 Shareholder Rights Learning Objective: 19.1 Level of difficulty: Intermediate CPA: Finance Solution: a. i. The equity holders will receive the “equity”: $1.7 million less $1.5 million owed to creditors, or $200,000. a. ii. The creditors will receive the $1.2 million proceeds from liquidating the assets (and lose the remaining $300,000 they are owed). Equity holders will get nothing. b. i. Without limited liability, the situation in part A will not change. ii) Now the equity holders would actually have to pay (that is, they would be liable for) an extra $300,000 to satisfy the creditors’ claims.

18. Section: 19.1 Shareholder Rights Learning Objective: 19.1 Level of difficulty: Intermediate CPA: Finance Solution:

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a. You own 500 out of 1 million shares, or 500/1,000,000 = 0.05% b. You will purchase 500/5 =100 extra shares, giving you 600. In total, the company will sell an additional 1,000,000/5 = 200,000 shares, so there are 1.2 million outstanding. Your percentage ownership in the firm will remain at 0.05%. c. If you do not buy the new shares, you will have 500 shares, but there will be 1.2 million outstanding. Your percentage share of the firm’s equity has fallen to 500/1,200,000 = 0.04167% 19. Section: 19.1 Shareholder Rights Learning Objective: 19.1 Level of difficulty: Intermediate CPA: Finance Solution: The founder will own 250,000 shares. The total number of shares outstanding will be 250,000 + 750,000 (sold in the IPO) = 1,000,000. Therefore, the founder will own 250,000/1,000,000 = 25% of the firm.

The Class A shares owned by the founder give him 2 votes per share, or 500,000 votes in all.

The common shares will have 1 vote each, or 750,000 votes in total. Thus, the founder will have 500,000/1,250,000 = 40% of the total votes available.

20. Section: 19.1 Shareholder Rights and 19.3 Preferred Shares Learning Objectives: 19.1 and 19.3 Level of difficulty: Intermediate CPA: Finance Solution: As the preferred shares are cumulative, all the missed dividends must be paid on them before any are paid on the common shares. In six months (2 quarters), dividends of 2% x $50 (par) x 2 = $2 would have accumulated for each preferred share. In total, $2 x 2 million shares = $4 million will have to be paid to the preferred shareholders, leaving $7 – $4 million = $3 million for the common shareholders. Therefore, a dividend of $3 million/50,000,000 shares = $0.06 per share will be paid on each common share.

21. Section: 19.2 Different Classes of Shares Learning Objective: 19.2 Level of difficulty: Intermediate CPA: Finance Solution: Collingwood Corp. will receive 4.5% x $10 million = $450,000 in dividends, before paying tax.

Corporations receive dividends from other corporations tax-free, so the net income after-tax is also $450,000.

22. Sections: 19.3 Preferred Shares and 19.4 Warrants and Convertible Securities Learning Objectives: 19.3 and 19.4 Level of difficulty: Intermediate CPA: Finance Solution: The conversion value, CV = CR x P (where P = the price of the common shares).

From Problem 14, CR =5, therefore CV = 5 x $15 = $75.

The conversion premium uses the price of the preferred shares and the conversion value: Premium = (P – CV)/CV = ($100 – $75)/$75 = 33.33%

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This figure may be interpreted to mean that the value of the preferred shares is 33.33% more than what they would be without the conversion privilege, or that the common shares must increase in value by 33.33% before conversion would make sense.

23. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: Warrants are usually issued with long-term maturities, while call options have very short-term maturities. Warrants are issued by firms to raise capital, while call options are independent of the underlying asset and involve two parties: one buyer and one seller.

24. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: Convertible bonds are bonds that can be converted into a specific number of common shares at the option of the bondholder, while bonds with warrants simply give bondholders the right to acquire some number of shares at a specified price within a given amount of time.

Should a bond be converted it will no longer be outstanding, and the bond is exchanged for common shares without any new funds flowing to the firm. In contrast, in the case of bonds with warrants, the bond remains outstanding and the exercise price is paid in cash to the issuer representing additional financing for the firm and an increase in the number of shares outstanding.

25. Section 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: Conversion ratio (CR) = 56.9 Conversion price (CP) = Par/CR = $1,000/56.9 = $17.57 Conversion value (CV) = CR x market price = 56.9 x $18.52 = $1,053.79 26. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Intermediate CPA: Finance Solution: Conversion price = $100/5 = $20 Conversion value = $18(5) = $90 Because $90 < $102 or $18 < $20, the convertible bonds will not be converted.

27. Section: 19.5 Other Hybrids Learning Objective: 19.5 Level of difficulty: Intermediate CPA: Finance Solution: Solutions Manual .

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The interest payable is 8% × $30 million (par value) = $2.4 million For normal bonds, this interest payment would be tax deductible. However, income bonds are more like equity (which pays dividends, not interest) than debt, and the interest is therefore not deductible.

EBIT = $4 million; Tax payable =30% x $4 million = $1.2 million; Earnings after tax = $4 million – $1.2 million = $2.8 million. The “interest” will have to be paid out of this figure leaving just $2.8 million – $2.4 million = $0.4 million or $400,000 in net earnings for the firm.

Challenging 28. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Challenging CPA: Finance Solution: Conversion price: CP = Par/CR = $1,000/25.32 = $39.49 Conversion value: CV = CR x P = 25.32 x $34 = $860.88 Value as a straight bond: 1 1 1− 1− 𝐹 $1,000 (1 + 𝑘𝑏 )𝑛 (1.09)10 𝑆𝐵𝑉 = 𝐼 𝑥 [ ]+ = $57.50 𝑥 [ ] + 𝑘𝑏 (1 + 𝑘𝑏 )𝑛 0.09 (1.09)10 = $791.43 Floor value: FV = Max (SBV, CV) = $860.88 Thus, these bonds cannot trade at a price lower than $860.88 Conversion premium = (MV – CV)/CV = ($1,051 – $860.88)/$860.88 = 22.1% 29. Section: 19.43 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Challenging CPA: Finance Solution: 𝑚 𝑃𝑎𝑦𝑜𝑓𝑓 = (𝑉 + 𝑚𝑋) − 𝑚𝑋 𝑚+𝑛 150,000 ($10,000,000 + $150,000 𝑥 $10) − 150,000 𝑥 $10 = 150,000 + 950,000 = $68,181.82 𝐷𝑖𝑙𝑢𝑡𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 =

𝑚 150,000 = = 0.1364 𝑚 + 𝑛 150,000 + 950,000

30. Section: 19.4 Preferred Shares Learning Objective: 19.4 Level of difficulty: Challenging CPA: Finance Solution: a. The market value of Orion’s equity is: V = nP = 12,000,000 x $5 = $60 million b. The warrant holders will pay mX = 2,000,000 x $4.25 = $8.5 million

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c. The new shares will be purchased from the company, so its value will increase to (V + mX) = ($60 million + $8.5 million) = $68.5 million. The warrant holders will own [m/(m + n)] = 2 million/14 million = 14.29% of the shares. Therefore, in total they will own shares worth 0.1429 x $68.5 million = $9,788,650. d. The payoff to the warrant holders is their total value less their cost: $9,788,650 – $8,500,000 = $1,288,650. On a per share basis this is $1,288,650/2 million = $0.64. Thus, the fair value (the amount you should be willing to pay) for each warrant is $0.64.

31. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Challenging CPA: Finance Solution: a. We have share price: S= $20, Exercise price of the warrants: X = $18, Number of shares that can be purchased using the warrant: n=2 Floor value = n  (S − X ) = 2  (20 − 18 ) = $4 b. Suppose that the warrant traded for less than $4, say at $3. An investor would buy a warrant for $3, exercise it, and purchase two shares for a total of 2 x 18=$36, and immediately sell these shares for 2 x $20 = $40, for a riskless profit of $40 – $36 –- $3=$1. Ignoring transactions costs, this arbitrage process would continue until the price of the warrants reached at least $4. c. The minimum value of the warrants: Share Price (+/– 10%) Floor Value % change $18 (Share price = exercise price) $0 –100% $20 (Share price now) 2 x ($20– $18) = $4 0% $22 2 x ($22 – $18) = $8 100% 32. Section: 19.4 Warrants and Convertible Securities Learning Objective: 19.4 Level of difficulty: Challenging CPA: Finance Solution: With a 4 percent yield, the convertible preferred shares are paying 0.04 x $25 = $1.00 per year in dividends. The price of a straight preferred share paying this same amount of dividends would be: SPV = Dividend/k = $1/0.08 = $12.50. We know that the conversion value for these preferred shares is $15. Thus, the floor value = Max (SPV, CV) = Max ($12.50, $15) = $15.

These convertible preferred shares will not sell for less than $15.

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Answers to Concept Review Questions 19.1 Shareholder Rights Concept Review Question 1. What are the basic rights associated with equity securities? How do these differ across different categories or classes of equities?

There are three basic rights associated with equity securities: the right to vote, the right to receive dividends, and the right to receive the remaining property of the corporation on dissolution.

Different classes may have different voting rights, fixed or variable dividends, or different seniorities in receiving the residual value of the firm.

19.2 Different Classes of Shares Concept Review Questions 1. Why do voting rights affect the prices of some common shares and not others?

The value of these voting rights very much depends on who has control of the company and whether it is good or bad for shareholder value creation. Empirical studies reveal that differential voting rights may not affect value when the founder runs the company, but they do when that founder ceases to be involved. Regardless, the limited or non-voting shares usually have a slight premium in terms of the right to a dividend to offset the lost value of control.

2. Why is dividend income preferred by both corporations and individual investors?

Dividends are very attractive in Canada for tax reasons, both for corporations and for individuals.

Dividends received by one Canadian corporation from another Canadian corporation are not taxed to avoid double taxation of income at the corporate level. In contrast, interest income is taxable between corporations because, as we discussed before, interest expense is tax deductible.

Dividend income is also attractive for individuals because of the dividend tax credit system in Canada. Traditionally, this system was structured so that the effective tax rate paid was the same for owners of a small private corporation whether they withdrew their compensation as dividends or as salary. However, in the May 2006 budget, the federal government reformed the tax rates to reduce the overall tax rate on dividend income from public corporations, and since then most of the provinces have also reformed their taxation of dividend income.

19.3 Preferred Shares Concept Review Questions 1. Briefly describe the following types of preferred shares: straight, retractable, and floating rate.

Straight preferred shares do not have a maturity date and pay a fixed dividend at regular intervals. Retractable preferred shares give investors the right to sell them back to the issuer, thus creating an early maturity date. Floating rate preferred share generally have a long maturity date, but every three or six months their dividend is reset by an auction mechanism so that the dividend yield will be in line with current market interest rates. Alternatively, many of the floating rate preferred shares issued by the major banks have their dividend rate float with 75 percent of the prime rate, usually to some maximum rate. The result is that they always sell very close to their par value, because their dividend rate is always very close to the current market rate.

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2. Briefly describe the following features that may be associated with preferred shares: cumulative provision, callable feature, and purchase funds.

Cumulative provision means that no dividends can be paid on common shares until preferred share dividends, both current and arrears, are paid in full. This ensures that the common shareholders, who have voting rights, don’t just suspend payment on the preferred share dividends, while continuing to make dividend payments on the common shares.

Callable feature means that at the company’s option, it can call the preferred shares away from their owners by paying the fixed price.

Purchase funds require the company to buy back a certain number of shares each year, which produces a “two-edged” sword: in the short run, it increases the number of purchasers and ensures a ready market for the shares, but in the long run, as the number of shares goes down, it has the opposite effect.

3. Why are preferred shares sometimes called hybrid securities?

Preferred shares have many characteristics with debt; for example, they usually have fixed dividend payments, and are rated by the rating agencies. They are commonly regarded as a hybrid security: part debt and part equity.

4. Why would you want a cumulative feature when purchasing preferred shares?

The payoff on shares is not a fixed contractual commitment similar to interest on a bond, so the firm can omit a dividend without any direct legal consequences. Without the cumulative feature, it would be legally possible to omit the preferred share dividend for years and then simply pay it when the common shareholders are paid a dividend. Such a policy would be challenged by the preferred shareholders but the cumulative feature makes it clear that the unpaid dividends to the preferred shareholders need to be paid prior to any future dividend to the common shareholders.

19.4 Warrants and Convertible Securities Concept review questions 1. Explain why issuing debt or preferred shares with warrants attached, or issuing convertible bonds or convertible preferred shares, may represent attractive sources of financing for higherrisk firms.

When the warrants are exercised, the warrant holder pays the exercise price to the company in return for shares. Warrants thus provide primary financing because the issuing company raises capital from their sale. Convertible bonds or preferred shares can be converted to common shares, resulting in a reduced debt ratio.

2. Define and explain how to determine the following for a convertible: conversion price, conversion value, straight bond value, floor value, and convertible premium.

Convertible price is the strike price at which a convertible security can be converted into common shares based on its conversion ratio. Conversion value is the value of a convertible security if it is immediately converted into common shares. Straight bond value is the price that the convertible bonds would sell for if they could not be converted into common shares. Floor value is the lowest price a convertible bond will sell for, which is equal to the larger of its straight bond value and its conversion value. Convertible premium is the market price minus the conversion value, divided by the conversion value.

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19.5 Other Hybrids Concept review questions 1. Name and discuss the four criteria used by DBRS to classify a security as debt versus equity.

DBRS looks at four major factors to determine whether a security is debt or equity: (1) the permanence factor, (2) the subordination factor, (3) the legal factor, and (4) the subjective factor.

The permanence factor relates to whether or not the security will be outstanding for a long period. Common shares are the gold standard because they have no maturity date and no requirement to redeem them at any point. BAs, conversely, are the ultimate debt instrument because they have a very limited 30- or 60-day life and then have to be redeemed. The subordination factor refers to the priority of the claim on the firm’s assets and income stream.

Again, common shares are the gold standard and BAs are obvious debt because they have an absolute claim to be paid off in 30 or 60 days. The legal factor means the legal rights of the investors—that is, whether they have a contractual right to receive income or whether it is in some way discretionary, such as the declaration of a dividend by the board of directors. Finally, the major subjective factor is the intention of the company when it issues the securities.

2. Define the following types of hybrids: income bonds, commodity bonds, Real Return Bonds, original issue discount bonds, LYONs, ARCs, preferred securities, and COINS. Income bonds are generally issued after a re-organization, so that the “interest” is tied to some cash flow level for the firm.

Commodity bonds are bonds whose interest or principal is tied to the price of an underlying commodity, such as gold.

Real Return Bonds are issued by the Government of Canada to protect investors against inflation. The face value is pegged to the CPI rate of inflation and the coupon rate applies to this inflation-adjusted face value.

Original issue discount bonds (OIDs) or low-yield notes are bonds that sell at a discount from par value when issued by firms.

Liquid Yield Option Notes (LYONs) are low-yield notes that are combined with a convertible feature and are accretive convertibles, because the principal accretes or increases over time.

Adjustable Rate Convertible Subordinated Securities (ARCS) have a fixed principal and maturity, and the interest normally comprises two parts: a fixed interest rate, and some function of the dividend paid in the prior six months. These securities are almost all convertible into common shares, so the dividend is expressed as a percentage of the conversion price.

Preferred securities are not preferred shares. They are generated by a company by creating a 100 percent owned subsidiary that issues the shares and then loans the proceeds to the parent company, for whom the interest is tax deductible; interest flows to the subsidiary, where it is not taxed, and is used to make dividend payments.

Canadian optional interest notes (COINS), or prepaid bonds, are 99-year bonds that are sold at their par values of $100, on which the firm immediately prepays the interest from years 11 to 99 on issue, leaving it with a net inflow and allowing it to continue to deduct annual interest payments of $100, even though it has effectively borrowed less.

3. Relate the costs of various financing options to their equity-like characteristics.

The costs of financing options differ according to how much equity weight they have. The more the equity weight is, the higher the cost is.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

MMXX ii F1

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Booth, Cleary, Rakita

Chapter 20: Cost of Capital Multiple Choice Questions 1. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Intermediate CPA: Finance Solution: D Invested capital = all interest-bearing liabilities + total equity The invested capital is $50,000 if the invested capital (all interest-bearing liabilities + total equity) is $50,000, which is not necessarily equal to total assets.

2. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Basic CPA: Finance Solution: D 𝑉=

𝑋 $2.25 = = $22.50 𝐾𝑒 0.10

3. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Intermediate CPA: Finance Solution: D $55,000 𝐸𝑃𝑆 = = $5.50 10,000 𝐸𝑃𝑆 $5.50 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑 = = = 0.275 𝑃 $20.00 4. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Intermediate CPA: Finance Solution: C To satisfy the bondholders, $50,000 (5%) = $2,500 To satisfy the equity holders, $115,000 (10%) = $11,500 Total minimum earnings = $2,500 + $11,500 = $14,000 5. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Intermediate CPA: Finance Solution: C When ROE > ke, management is adding value to the firm and the market price goes above the book value of the investment.

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When ROE = ke, management is neither increasing nor destroying the firm’s value.

When ROE < ke, management is destroying the firm’s value.

6. Section: The Cost of Capital Learning Objective: 20.2 Level of difficulty: Intermediate CPA: Finance Solution: A Market values are used to calculate the weights of equity and debt, not book values.

7. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: B D1 EPS ( Payout) EPS (1 − b) P= = = ke − g ke − g ke − g To increase P, increase payout, or decrease retention ratio, or decrease cost of equity, or increase g.

8. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Challenging CPA: Finance Solution: C $6 − $3.60 $450,000 𝑔 = 𝑏 × 𝑅𝑂𝐸 = × = 0.4 × 0.25 = 0.1 $6 $1,800,000 𝐷1 $3.60(1.1) 𝑃= = = $198.00 𝑘𝑒 − 𝑏 × 𝑅𝑂𝐸 0.12 − 0.1 9. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: A A growth firm is the one that adds value to the firm and has growth opportunities: ROE > ke.

10. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: C Cash cows do not have significant growth opportunities.

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Practice Problems Intermediate 11. Section: 20.6 Risk-Based Models and the Cost of Common Equity Learning Objective: 20.6 Level of difficulty: Intermediate CPA: Finance Solution: ke = RF +  ( ERM − RF ) = 0.03 + 1.4(0.10 − 0.03) = 12.8% 12. Section: 20.5 Growth Models and the Cost of Common Equity Level of difficulty: Intermediate Learning Objective: 20.5 CPA: Finance Solution: 𝐷1 𝐸𝑃𝑆1 (1 − 𝑏) 𝐸𝑃𝑆1 (1 − 0) 𝑁𝐼/# $1,056,020 = = = = = $16.50 𝑘𝑒 𝑘𝑒 𝑘𝑒 𝑘𝑒 500,000 × 0.128 (𝑔 = 𝑏 × 𝑅𝑂𝐸 = 0%) 𝑃 𝑅𝑂𝐸 𝑁𝐼/𝐸 $1,056,020 = = = = 6.76 𝐵𝑉𝑃𝑆 𝑘𝑒 𝑘𝑒 ($1,040,000 + $180,000)(0.128) 𝑃=

13. Section: 20.1 Financing Sources Learning Objective: 20.1 Level of difficulty: Intermediate CPA: Finance Solution: Invested capital = short-term debt + long-term debt + total equity = $210,000 + $780,000 + $1,040,000 + $180,000 = $2,210,000 EBIT = EBT + Interest = $1,508,600 + $66,400 = $1,575,000 Before-tax ROI=EBIT/Invested capital = $1,575,000/$2,210,000 = 71.3% 14. Section: 20.3 Estimating the Non-Equity Component Costs Learning Objective: 20.3 Level of difficulty: Intermediate CPA: Finance Solution: Two reasons are: i) Flotation costs: Issuing expenses on new securities have to be paid from the gross proceeds of an issue, so the firm’s initial cash inflow does not match the funds provided by investors. ii) Taxes: The tax deductibility of interest payments made by the firm separates the cost of debt from the corresponding market yield.

15. Section: 20.2 The Cost of Capital Learning Objective: 20.2 Level of difficulty: Intermediate CPA: Finance Solutions Manual .

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Solution: $8/$90 = 8.9% 16. Section: 20.2 The Cost of Capital Learning Objective: 20.2 Level of difficulty: Intermediate CPA: Finance Solution: kE = RF + β[MRP] = 3.5% + 1.5 x 8% = 15.5% kD*(1 – T) = 5% x (1 – 0.3) = 3.5% Weight (equity) = $12,500,000/($12,500,000 + $7,500,000) = 62.5% Weight (debt) = 1 – weight (equity) = 37.5% WACC = Weight (equity) x kE + Weight (debt) x kD x (1 – T) = 0.625 x 15.5% + 0.375 x 3.5% = 11.00% 17. Section: 20.2 The Cost of Capital Learning Objective: 20.2 Level of difficulty: Intermediate CPA: Finance Solution: 𝑘𝑒 = 𝑅𝐹 + 𝛽(𝐸𝑅𝑀 − 𝑅𝐹) = 0.03 + 1.08(0.08) = 11.64% $750,000 $250,000 𝑊𝐴𝐶𝐶 = 11.64% + 6%(1 − 0.25) = 9.86% $750,000 + $250,000 $750,000 + $250,000 18. Section: 20.5 Growth Models and the Cost of Common Equity Level of difficulty: Intermediate Learning Objective: 20.5 CPA: Finance Solution: 𝐸𝑥𝑝(𝐸𝑃𝑆) $23.50 𝑉𝑓𝑒𝑑 = = = $626.67 𝑘𝑇𝑏𝑜𝑛𝑑 − 1% 4.75% − 1% 19. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: D1 = D0 (1 + g1) = EPS0 (1 – b)(1 + g1) = ($5)(1 – 0.4)(1.1) = $3.30 𝑃0 =

$3.30 = $30 . 16 − .05

20. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solutions Manual .

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Solution: 𝐷1 +𝑔 𝑃(1 − 𝐹) $3.75(1.04) = + 0.04 $50(1 − 0.06) = 12.3% 𝑘𝑒 =

21. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: P0 = D1/( r – g) = D0(1 + g)/(r – g) P0(r – g) = D0(1 + g) P0r – P0g = D0 + D0g (D0 + P0)g = P0r – D0 g = (P0r – D0)/( D0 + P0) = ($25 x 0.105 – $1.20)/($1.20 + $25) g = 5.44%

22. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: 𝑁𝐼 𝐸𝑃𝑆 $12 = = = 0.24 𝐸 𝐵𝑉𝑃𝑆 $50 $12 − $9 𝑔 = 𝑏 × 𝑅𝑂𝐸 = × 0.24 = 0.06 $12 𝐷1 $9 𝑃= = = $120 𝑘𝑒 − 𝑔 0.135 − 0.06 𝑉 = $120 × 15,000 + $600,000 = $2,400,000 𝑅𝑂𝐸 =

23. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance

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Solution: 𝑔 = 𝑏 × 𝑅𝑂𝐸 = (1 − 𝑝𝑎𝑦𝑜𝑢𝑡) × 𝑅𝑂𝐸 = (1 − 0.5)12% = 0.06 𝐷1 $3(1.06) 𝑘𝑒 = +𝑔= + 0.06 = 19.25% 𝑃 $24 𝑅𝑂𝐸 = 12% < 𝑘𝑒 = 19.25% Therefore, management is reducing the shareholders’ value.

24. Section: 20.5 Growth Models and the Cost of Common Equity Learning Objective: 20.5 Level of difficulty: Intermediate CPA: Finance Solution: 𝑅𝑂𝐸1 × 𝐵𝑉𝑃𝑆 𝐼𝑛𝑣 𝑅𝑂𝐸2 − 𝑘𝑒 + [ ] 𝑘𝑒 (1 + 𝑘𝑒 ) 𝑘𝑒 0.15 × $25 $200 0.2 − 0.12 = + [ ] 0.12 1.12 0.12 = $31.25 + $119.05 = $150.30 PVGO = $119.05, PVEO = $31.25 ROE1 and ROE2 are both greater than the cost of equity, therefore this firm has both high PVGO and PVEO. It is a star. 𝑃𝑜 =

25. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.7 Level of difficulty: Intermediate CPA: Finance Solution: The statement is false. The cost of capital for a new project depends on the use of funds, not the source. Even if this particular project will be funded with debt, it is probably only one of many projects that the firm undertakes. No firm is 100% debt financed. Over time, the firm will raise financing through a number of sources, including internal funds, new equity, new preferred shares, and new debt. The source of funding for this project is from the pool of available funds.

Therefore the cost of capital for the project should be the WACC, appropriately adjusted for the risk of this particular project.

26. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.7 Level of difficulty: Intermediate CPA: Finance Solution: The appropriate discount rate should be based on the risk of the project, not on the risk of the individual companies undertaking the project. In this case, the development of a software package would be more closely associated with the risk of the software development firm.

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Therefore, the appropriate discount rate would be 2 + 2.3(10) = 25%. At this discount rate, the NPV of the project is negative and neither party should proceed with the project.

27. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.7 Level of difficulty: Intermediate CPA: Finance Solution: The firm will make both type 1 and type 2 errors. In the first case, it will tend to accept high-risk projects that it should have rejected. Since the project has high risk, using the WACC (which is too low a discount rate given the risk of the project) will overestimate the NPV and will lead management to accept projects that should be rejected. In the second case, the firm may reject low-risk projects that it should have accepted. Again, using the WACC (in this case a discount rate that is too high given the risk) will underestimate the NPV and lead management to reject projects it should have accepted.

Challenging 28. Sections: 20.5 Growth Models and the Cost of Common Equity, 20.6 Risk-Based Models and the Cost of Common Equity, and 20.7 The Cost of Capital and Investment Learning Objectives: 20.5, 20.6, and 20.7 Level of difficulty: Challenging CPA: Finance Solution: First determine the firm’s cost of equity. We have enough information to estimate ke using either the CAPM or the constant dividend growth model.

CAPM ke= RF + B (ERM – RF) = 0.03 + 2.15(0.1 – 0.03) = 18.05% Dividend Growth ke= D1 ÷ P0 + g = $4(1.05)/$30 + 0.05 = 19.00% Estimate the after-tax cost of debt from the information given. kb = (1 – T) × (RF + 3%) = (1 – 0.3) x (3% + 3%) = 4.2% From the ranges of costs we have derived, solve for the firm’s weighted average cost of capital. k = B × Ki ÷ V + E × Ke ÷ V k = 0.4 × 4.2% + 0.6 × 18.05% = 12.51% or k = 0.4 × 4.2% + 0.6 × 19% = 13.08% We can now perform a net present value calculation: NPV = –$15,000,000 + $2,250,000/0.1251 = $2,985,612 NPV = –$15,000,000 + $2,250,000/0.1308 = $2,201,835

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The net present value calculations indicate that the project should be undertaken at both discount rates.

29. Sections: 20.5 Growth Models and the Cost of Common Equity, 20.6 Risk-Based Models and the Cost of Common Equity, and 20.7 The Cost of Capital and Investment Learning Objectives: 20.5, 20.6, and 20.7 Level of difficulty: Challenging CPA: Finance Solution: First compute the costs of each source of funds: Debt: NP = $972; Assuming annual coupons I = (0.07)($1,000) = $70; n = 15 So we have: 1 1− 1 (1 + 𝑘𝑖 )15 $972 = $70 × (1 − .3) [ ] + $1,000 × 𝑘𝑖 (1 + 𝑘𝑖 )15 Solving for ki, as shown in Chapter 6, we get: By financial calculator: PMT = 70(1 –0.3) = $49; PV = -972; FV = 1,000; N = 15 Then compute I/Y will give 5.17%, which is the firm’s annual after-tax cost of debt.

Preferred: kp = Dp/NP = 0.055/0.95 = 5.79% Equity: kne = ke × P0/NP = (0.16) x ($10/(1 – 0.12)/($10) = 18.18% We next compute the market value of each component: Debt: The market value of debt outstanding is: 1 1− 1 (1 + 0.07)15 𝐵 = $80 [ ] + $1,000 × = $1,091.08 × 2,000 = $2,182,160 0.07 (1 + 0.07)15 Preferred: The market value is the total dividend payments divided by the market capitalization rate.

P = 0.06 × ($1,500,000)/0.055 = $1,636,364 Equity: Shares are currently trading at $10/(1 – 0.12)= $11.36 E = 400,000 x $11.36 = $4,544,000 Note the value of retained earnings is incorporated into the current market price of equity.

Total market value =V=B+P+E = $2,182,160 + $1,636,364 + $4,544,000 = $8,362,524 Now compute the weighted average cost of capital: 𝐵 𝑃 𝐸 𝑊𝐴𝐶𝐶 = 𝑘𝐵 + 𝑘𝑃 + 𝑘𝐸 𝑉 𝑉 𝑉 $2,182,160 $1,636,364 $4,544,000 𝑊𝐴𝐶𝐶 = (0.0517) + (0.0579) + (0.1818) = 12.36% $8,362,524 $8,362,524 $8,362,524

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30. Sections: 20.5 Growth Models and the Cost of Common Equity, 20.6 Risk-Based Models and the Cost of Common Equity, and 20.7 The Cost of Capital and Investment Learning Objectives: 20.5, 20.6, and 20.7 Level of difficulty: Challenging Solution: a. The current price of the outstanding bonds, assuming $1,000 face value, is:

$80 1 $1,000 [1 − ]+ = $1,107.83 10 0.065 (1.065) (1.065)10 Market value of debt securities is MVD = $4,000,000/$1,000 x $1,107.83 = 𝑃𝐵 =

$4,431,320 Market value of equity securities is $3.14 x 2,000,000 = $6,280,000 Combined value = $4,431,320 + $6,280,000 = $10,711,320 Weight (debt) = $4,431,320 / $10,711,320 = 41.37% Weight (equity) = 1 – Weight(debt) = 58.63% b. kD(New) = 0.065/(1 – 0.02) = 6.63% WACC = [0.4137 x 6.63% x (1 – 0.34)] + [0.5863 x 9.75%] = 7.53% c. $500,000/0.5863 = $852,806

31. Sections: 20.5 Growth Models and the Cost of Common Equity, 20.6 Risk-Based Models and the Cost of Common Equity, and 20.7 The Cost of Capital and Investment Learning Objectives: 20.5, 20.6 and 20.7 Level of difficulty: Challenging CPA: Finance Solution: a.

Cost of Debt: NP = $960; Assuming annual coupons I = (0.06)($1,000) = $60; n = 20 So we have: 1 1− (1 + 𝑘𝑖 𝑖 )20 1 $960 = $60 × (1 − .30) + $1,000 × 𝑘𝑖 (1 + 𝑘𝑖 𝑖 )20 [ ] Solving for ki, as shown in Chapter 6, we get: By financial calculator: PMT = 60(1 – .30) = $42; PV = –960; FV = 1,000; N = 20 Then compute I/Y will give 4.51%, which is the firm’s annual after-tax cost of debt.

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Cost of preferred shares: k= $2/$23.50 = 8.51% Cost of common shares: k= 0.03 + 1.18(0.10 – 0.03) = 11.26% ke= 0.1126($30/$27) = 12.51% b.

Since they need $5m in total financing, all of the common equity financing ($5m x 0.5 = $2.5m) can be raised from internal funds. So, we should use the cost of common equity using internal funds.

WACC= 0.3(0.0451) + 0.2(0.0851) + 0.5(0.1126) = 8.69% c. Since they need $8m in total financing, the common equity financing needed ($8m x 0.5 = $4m) exceeds the $3m internal funds, and the MCC would be computed using the cost of new equity, or 12.51%: MCC = 0.3(0.0451) + 0.2(0.0851) + 0.5(0.1251) = 9.31% 32. Sections: 20.5 Growth Models and the Cost of Common Equity, 20.6 Risk-Based Models and the Cost of Common Equity, and 20.7 The Cost of Capital and Investment Learning Objectives: 20.5, 20.6 and 20.7 Level of difficulty: Challenging CPA: Finance Solution: a. Cost of Debt: NP = $965; Semi-annual coupons I = (0.07/2)($1,000) = $35; n = 25 x 2 = 50 So we have: 1 1− 1 (1 + 𝑘𝑖 )50 $965 = $35 × (1 − .30) [ ] + $1,000 × 𝑘𝑖 (1 + 𝑘𝑖 )50 Solving for 𝑘𝑖 , as shown in Chapter 6, we get: By financial calculator: PMT = 35(1 – .30) = $24.50; PV = –965; FV = 1,000; N = 50.

Then compute I/Y will give 2.58%, which is the firm’s semi-annual after-tax cost of debt.

So, their annual after-tax cost of debt = (1.0258)2 – 1 = 5.23% b. Cost of Preferred Shares: 𝑘𝑝 =

𝐷𝑝 4 = = 8.42%. 𝑁𝑃𝑝 47.5

c. and d.

Cost of Common Equity Financing: (i) Dividend Growth Model Approach: 𝐷 $2 𝐷 $2 𝑘𝑒 = 𝑃1 + 𝑔 = $32 + 0.04 = 10.25%, 𝑎𝑛𝑑𝑘𝑛𝑒 = 𝑁𝑃1 + 𝑔 = $29 + 0.04 = 10.90%.

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(ii) CAPM Approach: 𝑘𝑒 = 𝑅𝐹 + [𝐸𝑅𝑀 − 𝑅𝐹]𝛽𝑖 = 0.04 + 0.95(0.12 − 0.04) = 11.6% 𝑃0 $32 𝑘𝑛𝑒 = [ ] 𝑘𝑒 = [ ] (0.116) = 12.8% 𝑁𝑃 $29 33. Section: 20.7 The Cost of Capital and Investment Learning Objective: 20.7 Level of difficulty: Challenging CPA: Finance Solution: a. Using ke, we get:

B P CE ki + k p + ke V V V = (0.2)(0.0586) + (0.2)(0.0612) + (0.6)(0.15) = 11.40%

WACC =

b.

Break InternalFundsAvailable $4m = = = $6.67m.

CE Po int 0.6 V If the investment is less than or equal to $6.67 million, then all equity can be raised internally. c. Since $10m > break point of $6.67m, kCE = kCS , and we obtain, MCC =

B P CE ki + kp + k ne = (0.2)(0.0586) + (0.2)(0.0612) + (0.6)(0.2) = 14.40% V V V

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Answers to Concept Review Questions 20.1 Financing Sources Concept Review Questions 1. Why is the earnings yield not usually an adequate measure of the investor’s required return on equity?

Since most firms have some expectation for growth, the stock price reflects these growth opportunities as well as the current earnings. The earnings yield cannot capture the growth opportunities.

2. How are the ROE and ke related to a firm’s growth opportunities and its M/B ratio?

If ROE exceeds ke, then the price goes above the book value of the investment, so M/B is more than 1. The increase of price is positively related to the growth opportunities.

20.2 The Cost of Capital Concept Review Questions 1. Why is the weighted average cost of capital (WACC) so important?

The cost of capital is a way of calculating the overall required rate of return needed to meet investor expectations. Thus, it is very important.

2. What are the steps involved in estimating a firm’s WACC? There are three steps involved in estimating the WACC: i. Estimate market values for the sources of capital, since our focus is on how to increase the market value of the funds invested in the firm and we need these to estimate the weights of the different sources of capital in the total firm value. ii. Estimate the current required rates of return for the various sources of capital invested in the firm. iii. Put them all on the same corporate tax basis to recognize that interest on debt is tax deductible, whereas the return to the equity holders is not.

3. How can we estimate the market value of common equity, preferred equity, and long-term debt?

The market value of common equity is simply the price per share multiplied by the number of shares outstanding. The market value of preferred equity is the dividend divided by the required return on preferred shares. The market value of a bond equals the present value of all future cash payments.

20.3 Estimating the Non-Equity Component Costs Concept Review Questions 1. How do flotation costs affect the cost of capital sources for a firm?

One complication that arises with respect to all sources of capital, except for internally generated funds, is that the firm incurs issuing or flotation costs when new securities are issued. These include any fees paid to the investment dealer and/or any discounts provided to investors to entice them to purchase the securities. As a result, the cost of issuing new securities will be

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higher than the return required by investors, since the net proceeds to the firm from any security issue will be lower than that security’s market price.

2. Explain how to estimate the cost of debt and preferred equity for a firm.

The cost of debt is obtained by using Equation 20-13. The left-hand side is the after-tax afterflotation proceeds of debt. The right-hand side is the present value of the after-tax interest payments and the present value of the principal. The cost of preferred equity is the dividend divided by the after-flotation net proceeds.

20.4 The Effects of Operating and Financial Leverage Concept Review Questions 1. Distinguish between operating and financial leverage.

Operating leverage measures the increased volatility in operating income caused by fixed operating costs. Financial leverage measures the increased volatility in earnings caused by interest-bearing debt (a fixed interest cost), resulting in increased risk.

2. Why do we say that equity holders bear the brunt of the effects of leverage?

Common shareholders claim the residual in the income statement. As the firm’s sales drop and its debt increases, everyone has a higher priority claim than that of the common shareholders, so they see much greater volatility in their return than either the debt holders or others with a stake in the firm’s operations.

20.5 Growth Models and the Cost of Common Equity Concept Review Questions 1. Explain how we can use the constant growth DDM to estimate the cost of firms’ internal common equity, as well as the cost of new common share issues.

The cost of firms’ internal common equity is the dividend yield plus the growth rate of dividends. The cost of new common share issues is the dividend divided by after-flotation net proceeds plus the growth rate of dividends.

2. Explain the relationship among ROE, retention rates, and firm growth.

The firm growth rate equals ROE multiplied by the retention rate.

3. How can we relate the existence of multiple growth stages to four commonly used firm classifications?

Assume that a firm earns current earnings in the first stage and starts to grow with a constant rate in the second stage. Then a firm’s value has two components, one for the present value of the existing opportunity (PVEO), and another for the present value of the growth opportunities (PVGO). If we classify these four cases as types of firms, we have the following: A, High PVEO and high PVGO; B, High PVEO and low PVGO; C, Low PVEO and high PVGO; D, Low PVEO and low PVGO. 4. Describe the Fed model and how it may be used to estimate the required rate of return of the market as a whole.

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The Fed model was used to estimate whether the stock market was over- or undervalued and whether the U.S. Fed should “talk down” market values that might be excessive and cause problems if they collapsed. The exact equation used is the actual price divided by the Fed price, and the Fed price is the expected earnings per share on the Standard & Poor’s 500 Index as reported by security market analysts (Exp(EPS)), divided by the yield on the long-term U.S. treasury bond (kTBond) minus 1.0 percent.

20.6 Risk-Based Models and the Cost of Common Equity Concept Review Questions 1. Explain how we can use the CAPM to estimate the cost of common equity.

DCF performs poorly when applied to growth stocks, which pay low dividends and/or display high growth rates. In these situations, it makes sense to rely more heavily on risk-based models.

The most important risk-based model is the capital asset pricing model (CAPM). The risk-free rate used in corporate applications of the CAPM is usually the yield on 30-year Government of Canada bonds. The market premium can be obtained by using a long term for the historical data.

The beta estimation is period specific.

2. Explain why beta estimates are “period specific,” and outline the potential problems that may arise. Allude to problems with recent beta estimates.

Beta estimation is time varying. In the past few years, one sub index showed rapidly increasing beta coefficients (the IT sub index), whereas most of the other beta coefficients show a constant or decreasing trend. In fact, Consumer Staples actually had negative beta estimates, indicating that they moved in the opposite manner to the stock market as a whole, and reduced the risk of a diversified portfolio. Beta estimation using an inappropriate period causes mistakes in calculating WACC. 20.7 The Cost of Capital and Investment Concept Review Questions 1. Explain the importance of using the WACC as a hurdle rate for making investment decisions.

If investors want an overall WACC, this suggests that the firm should not reinvest funds within its operations that earn a rate of return less than this hurdle rate. Consequently, the WACC is not just a valuation tool—it is also used going forward as a tool to evaluate investments.

2. Why does the MCC suddenly jump up and become expensive?

When the common equity portion of financing comes entirely from reinvested earnings, the firm’s cost of equity will equal the return required by its shareholders. However, when the firm is forced into issuing new common shares, it must pay flotation costs for issuing these shares, so the cost to the firm is higher than the cost of using internally generated funds. It is clear the most common cause of this increase in the MCC occurs when the firm cannot supply all of its required common equity financing from reinvested earnings (i.e., internal funds). Therefore, it must issue new common shares and bear the brunt of issuing costs, in addition to providing common shareholders with their required rate of return. This causes the cost of common equity to increase, meaning the MCC increases at this point.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Chapter 21: Capital Structure Decisions Multiple Choice Questions 1. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: B Invested capital = short-term debt + long-term debt + shareholders’ equity = $90,000 + $200,000 + $450,000 = $740,000 2. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Basic CPA: Finance Solution: D ROE represents financial risk and business risk.

3. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: B ROE = ROI if a firm is 100 percent financed by equity, not debt; i.e., B = 0. ROE = ROI. 4. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: A The use of debt increases the expected ROE. 5. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: D −𝑅 𝐵(1−𝑇) 𝐸𝐵𝐼𝑇(1−𝑇) 𝐸𝑃𝑆 = 𝐷 # + # The EPS-EBIT line is steeper if there are fewer shares outstanding. Its slope = (1 – T)/#. Its intercept = –RD B (1 – T)/#. Only D is true.

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6. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Basic CPA: Finance Solution: C There are no transactions costs.

7. Section: 21.2 Determining Capital Structure Learning Objective: 21.2 Level of difficulty: Intermediate CPA: Finance Solution: D Recall WACC = were + wdrd (1 - Tc) A decrease in the tax rate, an increase in the cost of debt, and an increase in the cost of equity will increase WACC. However, since the cost of equity is usually higher than the cost of debt, WACC decreases when the weight of equity decreases.

8. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Intermediate CPA: Finance Solution: D WACC stays the same regardless of the debt-equity ratio in the M&M irrelevance world.

9. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Intermediate CPA: Finance Solution: A 𝑘𝑒 = 𝑘𝑢 + (𝑘𝑢 − 𝑘𝑑 )(1 − 𝑇)𝐷/𝑆𝐿 = 10% + (10% − 6%)(1 − 0.25)0.5 = 11.5% 10. Section: 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Intermediate CPA: Finance Solution: D 11. Section: 21.7 Capital Structure in Practice Learning Objective: 21.7 Level of difficulty: Intermediate CPA: Finance Solution: B Profitability, riskiness of the underlying business, firm size, and stock price performance affect the firm’s ability to raise debt from creditors. A large firm with stable earnings and cash flows

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would be the most creditworthy and able to raise debt in the capital market without paying a substantial risk premium.

Practice Problems Basic 12. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Basic CPA: Finance Solution: Rule 1: For value-maximizing firms, the use of debt increases the expected ROE so shareholders expect to be better off by using debt financing, rather than equity financing.

Rule 2: Financing with debt increases the variability of the firm’s ROE, which usually increases the risk to the common shareholders.

Additional rule: Financing with debt increases the likelihood of the firm running into financial distress and possibly even bankruptcy.

13. Section: 21.3 The Modigliani and Miller (M&M) Irrelevance Theorem Learning Objective: 21.3 Level of difficulty: Basic CPA: Finance Solution: M&M’s key assumptions are as follows: i) There exist two firms in the same “risk class” with different levels of debt. ii) The earnings of both firms are perpetuities. iii) Markets are perfect in the sense that there are no transactions costs or asymmetric information problems. iv) There are no taxes. v) There is no risk of costly bankruptcy or associated financial distress.

14. Section: 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Basic CPA: Finance Solution: The static trade-off model balances the benefit of a lower WACC through the use of less-costly debt with the increased risk of financial distress and bankruptcy caused by taking on more leverage. Although the cost of equity increases as a firm adds more debt, initially the WACC will decline as long as the cost of debt is lower than the cost of equity. However, at some point, as more debt is added, the trend in WACC will reverse and it will begin to increase as the financial distress and bankruptcy risk of the incremental change in debt begins to outweigh any capital cost advantage. The point where the WACC stops decreasing and begins to increase is the optimal capital structure.

15. Section: 21.6 Other Factors Affecting Capital Structure Learning Objective: 21.6

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Level of difficulty: Basic CPA: Finance Solution: Firms usually finance by internal cash flow, then debt, and finally common equity. Myers’ argument is based on divulging information. Issuing common shares involves revealing privileged information to the public, while issuing debt only involves revealing privileged information to the lender. Using internal cash flow does not involve divulging information.

16. Section: 21.7 Capital Structure in Practice Learning Objective: 21.7 Level of difficulty: Basic CPA: Finance Solution: The first question you should ask is whether or not the firm is profitable. If it is, you could take advantage of the tax shield from issuing debt. If not, the firm has to be financed by all equity.

The second question you should ask is whether or not the firm has the ability to issue debt. This will depend on the type of assets the firm holds, i.e., are they tangible to be used as the collateral for secured loans? You should also assess the firm’s underlying business risk, i.e., the ability to generate consistent cash flows to pay interest. If your firm has significant business risk, you should not consider a large debt portion in the capital structure. Moreover, you should consider the size of your firm. The larger the firm size, normally, the more diversified it is (this implies smaller business risk). The smaller the business risk, the larger the financial risk tolerance the firm could take. Finally, you should balance all the above factors with the growth rate and profitability of your firm. Growing firms need cash, whereas profitable firms generally spin off cash. You need to take into consideration the current equity market if the firm currently has common shares outstanding. If you observe that the firm’s stock is over-valued by the market, you probably want to take advantage of equity financing.

These are some of the basic factors you should consider. You must also ensure that the WACC is at the lowest possible level to maximize shareholders’ wealth.

Intermediate 17. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: EBIT = $480,000 – $100,000 – $55,000 – $60,000 = $265,000 I = 0.09 x $500,000 = $45,000 Tc = $66,000/($265,000 – $45,000) = 30% 𝑅𝑂𝐸 =

(𝐸𝐵𝐼𝑇 − 𝑅𝐷 𝐵)(1 − 𝑇) ($265,000 − 0.09 × $500,000)(1 − 0.3) = = 19.25% 𝑆𝐸 $800,000 (𝐸𝐵𝐼𝑇)(1 − 𝑇) $265,000(1 − 0.3) 𝑅𝑂𝐼 = = = 14.27% 𝑆𝐸 + 𝐵 $800,000 + $500,000

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18. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: 𝐵 𝑆𝐸 $300,000 = 15% + [15% − 10%(1 − 0.3)] $500,000 = 15% + 4.8% = 19.8% 𝑅𝑂𝐸 = 𝑅𝑂𝐼 + [𝑅𝑂𝐼 − 𝑅𝐷 (1 − 𝑇)]

ROI represents business risk, which is 15 percent, while the second part of the equation represents financial risk, which is 4.8 percent.

19. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: 𝐵 𝐵 ) − 𝑅𝐷 (1 − 𝑇) 𝑆𝐸 𝑆𝐸 $300,000 $300,000 = 𝑅𝑂𝐼(1 + ) − (0.10)(1 − 0.3) $500,000 $500,000 = −0.042 + 1.6𝑅𝑂𝐼 𝑅𝑂𝐸 = 𝑅𝑂𝐼(1 +

Intercept: –4.20% Slope: 1.6 The higher the debt-equity ratio, the steeper (the higher the slope of) the financial leverage line.

If ROI increases/decreases by 1 percent, ROE increases/decreases by 1.6 percent.

20. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: 𝐵1 𝐵1 ) − 𝑅𝐷 (1 − 𝑇) 𝑆𝐸1 𝑆𝐸1 𝐵2 𝐵2 𝑅𝑂𝐸2 = 𝑅𝑂𝐼(1 + ) − 𝑅𝐷 (1 − 𝑇) 𝑆𝐸2 𝑆𝐸2 𝑅𝑂𝐸1 = 𝑅𝑂𝐼(1 +

ROE1 = ROE2 𝑅𝑂𝐼(1 + 0.6) − 8%(1 − 0.25)(0.6) = 𝑅𝑂𝐼(1 + 1.5) − 8%(1 − 0.25)(1.5) 𝑅𝑂𝐼 = 6% When ROI is 6 percent, the ROEs of the two strategies are the same, regardless of how the firm finances.

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21. Section: 21.1 Financial Leverage Learning Objective: 21.1 Level of difficulty: Intermediate CPA: Finance Solution: Method 1 𝐸𝐵𝐼𝑇 = 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆 = $400,000 − $120,000 = $280,000 𝐼𝐶 = 𝑆𝐸 + 𝐵 = 𝐵/25% = $250,000/0.25 = $1,000,000 𝐸𝐵𝐼𝑇(1 − 𝑇) $280,000 × (1 − 0.25) 𝑅𝑂𝐼 = = = 21% 𝑆𝐸 + 𝐵 $1,000,000 Method 2 IC = SE + B = B/25% = $250,000/0.25 = $1,000,000 𝑆𝐸 = 𝐼𝐶 − 𝐵 = $1,000,000 − $250,000 = $750,000 (𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑂𝐺𝑆 − 𝐼)(1 − 𝑇𝐶 ) ($400,000 − $120,000 − $20,000)(1 − 0.25) 𝑅𝑂𝐸 = = 𝑆𝐸 $750,000 = 26% 𝐵 𝑅𝑂𝐸 = 𝑅𝑂𝐼 + (𝑅𝑂𝐼 − 𝑅𝐷 (1 − 𝑇)) 𝑆𝐸 26% = 𝑅𝑂𝐼 + (𝑅𝑂𝐼 − 6%)($250,000/$750,000) 𝑅𝑂𝐼 = 21% 22. Section 21.2 Determining Capital Structure Learning Objective: 21.2 Level of difficulty: Intermediate CPA: Finance Solution: EBITDA = EBIT + D&A = $680,000 + $66,000 = $746,000 𝐸𝐵𝐼𝑇𝐷𝐴 𝐼 + (𝑃𝑟 𝑒 𝑓. 𝐷𝑖𝑣. +𝑆𝐹)/(1 − 𝑇) $746,000 = = 9.49 0 + ($40,000 + $15,000)/(1 − 0.3) 𝐸𝐵𝐼𝑇𝐷𝐴 $746,000 𝐶𝐹𝑇𝐷 = = = 3.39 𝐷𝑒𝑏𝑡 $220,000

𝐹𝑖𝑥𝑒𝑑 𝐵𝑢𝑟𝑑𝑒𝑛 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =

Analysts use EBITDA more often because it adds back the non-cash deductions for depreciation and amortization to EBIT and is therefore a “better” estimate of the firm’s cash flow.

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23. Section: 21.2 Determining Capital Structure Learning Objective: 21.2 Level of difficulty: Intermediate CPA: Finance Solution: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5 𝑊𝐶 𝑅𝐸 𝐸𝐵𝐼𝑇 𝑀𝑉𝐸 𝑆 = 1.2 + 1.4 + 3.3 + 0.6 + 0.999 𝑇𝐴 𝑇𝐴 𝑇𝐴 𝐵𝐿 𝑇𝐴 = 9.4 Compared with the Moody’s rating list, we get 9.4 > 2.17, therefore this company is an IG firm.

24. Section: 21.2 Determining Capital Structure Learning Objective: 21.2 Level of difficulty: Intermediate CPA: Finance Solution: Higher working capital: more receivables and inventory Retained earnings: the firm earned money in the past EBIT: measures operating profitability MVE/BL: market-valued debt ratio Sales/TA: the extent of the productivity of the firm using its assets 25. Section: 21.2 Determining Capital Structure Learning Objective: 21.2 Level of difficulty: Intermediate CPA: Finance Solution: (𝐸𝐵𝐼𝑇 − 𝑅𝐷 𝐵)(1 − 𝑇) ((𝐸𝐵𝐼𝑇) − (0.1)($675,000))(1 − 0.2) 𝐸𝑃𝑆75%𝐷/𝐸 = = # 30,000 0.8𝐸𝐵𝐼𝑇 − $54,000 = 30,000 ((𝐸𝐵𝐼𝑇) − (0.06)($420,000))(1 − 0.2) 0.8𝐸𝐵𝐼𝑇 − $20,160 𝐸𝑃𝑆30%𝐷/𝐸 = = 65,000 65,000 0.8𝐸𝐵𝐼𝑇 ∗ −$54,000 0.8𝐸𝐵𝐼𝑇 ∗ −$20,160 = 30,000 65,000 𝐸𝐵𝐼𝑇 ∗= $103,757.14 This point is where the two EPS-EBIT lines intersect. When EBIT > EBIT*, the 75 percent D/E option is preferred since it produces a higher EPS. When EBIT < EBIT*, the 30 percent D/E option is preferred. At an EBIT level of $125,000, which is above EBIT*, the 75 percent D/E option is preferred because it produces a higher EPS.

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26. Section: 21.3 The Modigliani and Miller (M&M) Irrelevance Theorem Learning Objective: 21.3 Level of difficulty: Intermediate CPA: Finance Solution: VL = VU = EBIT/kU = ($480,000 + 0.08 x $500,000)/0.16 = $3,250,000 𝐷

SL = VL – D = $3,250,000 – $500,000 = $2,750,000𝑘𝑒 = 𝑘𝑢 + (𝑘𝑢 − 𝑘𝐷 ) 𝑆 = 16% + (16% − 𝐿

$500,000

8%) $2,750,000 = 17.45%

27. Section: 21.3 The Modigliani and Miller (M&M) Irrelevance Theorem Learning Objective: 21.3 Level of difficulty: Intermediate CPA: Finance Solution: 𝑉𝑈 =

𝐸𝐵𝐼𝑇 $2,100,000 = = $14 million 𝐾𝑈 0.15

VL = VU = $14 million SL= VL – D = $14 million – $5 million = $9 million 28. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Intermediate CPA: Finance Solution: VU = EBIT(1 – T)/kU = ($480,000 + 0.08 x $500,000)(1 – 0.30)/0.16 = $2,275,000 VL = VU + DT = $2,275,000 + $500,000 (0.30) = $2,425,000 SL = VL – D = $2,425,000 – $500,000 = $1,925,000 𝐷 $500,000 = 16% + (16% − 8%)(1 − 0.3) = 17.45% 𝑆𝐿 $1,925,000 𝐷 $500,000 𝑘𝑒 = 𝑅𝐹 + 𝑀𝑅𝑃𝛽𝑈 [1 + (1 − 𝑇) ] = 3% + 𝑀𝑅𝑃(1.2)[1 + (1 − 0.3) ] = 17.45% 𝑆𝐿 $1,925,000 MRP = 10.19% 𝑘𝑒 = 𝑘𝑢 + (𝑘𝑢 − 𝑘𝐷 )(1 − 𝑇)

29. Section: 21.4 The Impact of Taxes Learning Objective: 21.4 Level of difficulty: Intermediate CPA: Finance Solution:

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𝑉𝑈 =

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𝐸𝐵𝐼𝑇(1 − 𝑇) $3(1 − 0.3) = = $13.125 million 𝑘𝑈 0.16

VL = VU + DT = $13.125 + ($5)(0.3) = $14.625 million SL= VL – D = $14.625 – $5 = $9.625 million 𝑘𝑒 = 𝐾𝑈 + (𝑘𝑢 − 𝑘𝐷 ⬚ )(1 − 𝑇) 𝐷⁄𝑆 = 0.16 + (0.16 − 0.08)(1 − 0.3)($5/$9.625) = 18.91% 𝐿

WACCL = ($9.625/$14.625)(18.91%) + ($5/$14.625)(8%)(1 – 0.3) = 14.36% 30. Section: 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Intermediate CPA: Finance Solution: The static trade-off model ignores two important issues: information asymmetry problems and agency problems. Information asymmetry problems arise when shareholders, creditors, and management have access to and base their decisions on different information, while agency problems can arise when management's incentives are not well aligned with shareholder interests.

31. Section 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Intermediate CPA: Finance Solution: Profitability, the type of assets a firm has, the risk of the firm's underlying business, the size of the firm, and the firm's growth rate are important practical considerations. Generally, larger, more profitable firms with tangible assets that can be pledged as security and stable, reliable cash flows are able to borrow more funds at a lower cost. Firms with these characteristics that do not need large infusions of capital for growth can borrow on even more generous terms. Conversely, smaller, less profitable firms with intangible assets, hard-to-predict cash flows, and a need for capital infusions for growth will be able to borrow less and must pay higher borrowing costs.

32. Section: 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Intermediate CPA: Finance Solution: There are two ways bankruptcy occurs. The first way is when the firm commits an act of bankruptcy, such as the non-payment of interest, and creditors enforce their legal rights as a result. This form of bankruptcy is involuntary. The other way is when the firm voluntarily declares itself unable to meet its financial obligations.

Under the CCAA, the court will appoint a monitor, who is normally a trustee in bankruptcy working for one of the larger accounting firms. The monitor reports back to the court. The monitor has considerable flexibility in preventing creditors from exercising their claims against the firm, in restructuring contracts, and in allowing the management of the firm to develop a plan to reorganize in the hope of continuing operations.

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The main differences between bankruptcy under the CCAA and the Business Insolvency Act (BIA) are the size of the scope for preventing creditors from seizing assets, the ability to raise debtor-in-possession (DIP) financing, and the possibility of a settlement on all creditors given a majority agreement. The BIA is more rigid, but more predictable and simpler. It has much less scope for preventing creditors from seizing assets than the CCAA. Under the BIA, the firm cannot raise DIP financing and has no provision for imposing a settlement on all creditors.

The BIA is used mainly by smaller companies, while the CCAA is used mainly by larger companies.

33. Section: 21.5 Financial Distress, Bankruptcy, and Agency Costs Learning Objective: 21.5 Level of difficulty: Intermediate CPA: Finance Solution: As Figure 21-8 indicates, under the bankruptcy world, distress costs rise as the firm increases its debt ratio. Firm value is the sum of unlevered firm value and financial distress costs. It increases with the increasing debt ratio.

However, agency costs tend to rise when a firm is approaching bankruptcy when the interests of the debt holders and shareholders diverge. Shareholders are actually holding a call option on the underlying firm. If the firm value exceeds the debt outstanding, they pay off the debt and keep the residuals. However, shareholders are also protected by their limited liability against the downside risk if the firm value falls below the debt outstanding. Furthermore, shareholders tend to gamble in the event of bankruptcy by accepting poor and more risky projects. In either case, the resulting agency costs may be huge. Creditors can choose not to lend long term to risky firms by using short-term debt or including sinking fund payments that create a continuous cash payment to the creditors.

34. Section: 21.7 Capital Structure in Practice Learning Objective: 21.7 Level of difficulty: Intermediate CPA: Finance Solution: In an efficient market (semi-strong form), the share price reflects all publicly available information. The problem here is the information asymmetry between the firm and the investors.

Gus knows that the project is a positive NPV and if he could credibly convince investors of that fact, the share price would rise. However, investors have no way of knowing whether the new issue is to invest in a positive NPV project or because Gus thinks his stock is overvalued and is trying to sell new shares at inflated prices. Investors take these two possibilities into account when determining the new share price.

35. Section: Appendix 21A: Personal Taxes and Capital Structure Learning Objective: 21.8 Level of difficulty: Intermediate CPA: Finance Solution: Your cousin is mixing corporate and personal taxes. If the investor does not pay taxes, then, with corporate taxes, we want the firm to maximize the tax shield earned from debt.

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However, with personal taxes there is a trade-off between the tax shield earned by the corporation and the tax paid by the investor on the interest income. If the investor pays more tax than the shield earned, then the investor would prefer the firm to pay dividends or create capital gains rather than use debt. In this way, if there are personal and corporate taxes, an investor may prefer the firm to use no debt.

Example: corporate tax = 35%, personal taxes: dividends and capital gains = 10%, interest income 60%. Compare two firms (both earn $1,000 before interest and taxes, and interest is $ 250):

Operating income Interest Corporate taxes Net corporate income

Unlevered $1,000.00

Before-tax distributions Debt holders Equity holders Total before-tax distributions After personal taxes Debt holders Equity holders Total after-tax distributions

(350.00) $650.00

Levered $1,000.00 (250.00) (262.50) $487.50

$650.00 $650.00

$250.00 $487.50 $737.50

$585.00 $585.00

$100.00 $438.75 $538.75

We can see in the above example that when there are no personal taxes, the total cash flows to investors (equity and debt) is greater with debt (“total before-tax distributions”) which is expected given the value of the tax shield. However, we also see that with this set of personal taxes, the total cash flows to investors is greater when the firm is unlevered (“total after-tax distributions”) due to the high personal tax rate on interest.

Challenging 36. Section: 21.3 The Modigliani and Miller (M&M) Irrelevance Theorem Learning Objective: 21.3 Level of difficulty: Challenging CPA: Finance Solution: $480,000 𝑎)𝑉𝑈 = = $4,000,000 0.12 $4,000,000 𝑃= = $20 200,000 $480,000 + 0.18 × $3,000,000 − 0.08 × $3,000,000 𝑏)𝐸𝑃𝑆𝑛𝑒𝑤 = = $3.90 200,000

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0.18 × $3,000,000 = $4,000,000 + $4,500,000 = $8,500,000 0.12 𝑆𝐿 = 𝑉𝐿 − 𝐷 = 𝑁𝑒𝑤𝑉𝐿 − 𝐷 = $8,500,000 − $3,000,000 = $5,500,000 $3,000,000 𝑑)𝑘𝑒 = 12% + (12% − 8%) = 14.18% $5,500,000 $3.90 𝑒)𝑁𝑒𝑤𝑃 = = $27.50 0.1418 𝑐)𝑁𝑒𝑤 𝑉𝐿 = 𝑉𝑈 +

37. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: a. OPI: value of debt = $100,000/0.1 = $1.0 million –> value of equity is $2 million (using D/E = 0.5) and therefore, value of the firm is $3 million.

Obtaining the value of the debt from the D/E ratio:

x = D / E then E = D / x V = D+E = D+D/ x Vx = D(1 + x) Vx =D (1 + x ) Step 1: Determine what the cash flows from OPI would be if the firm had the desired D/E ratio: Desired by Susan

Desired by Celia

Value of firm

OPI with D/E = .5 $3,000,000

OPI with D/E = .2 $3,000,000

OPI with D/E = 1.1 $3,000,000

Value of debt Value of equity

$1,000,000 $2,000,000

$500,000 $2,500,000

$1,571,429 $1,428,571

EBIT Interest Cash flows to equity

$750,000 $100,000 $650,000

$750,000 $50,000 $700,000

$750,000 $157,143 $592,857

b. Step 2: Use the arbitrage approach of the M&M proof to determine how much each sister has to borrow/lend to end up with the desired cash flows.

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Assume each sister buys 50% of the equity of OPI. Each will invest $1 million and will receive cash flows of $325,000 from OPI. However, Susan wants a cash flow from the investment of $350,000 (50% of the cash flows to equity from OPI if it had a D/E ratio of .2) for an investment of $1,250,000 (50% of the value of the equity of OPI if it had a D/E ratio of .2); Celia is also not happy; if OPI had the desired D/E ratio of 1.1, her cash flows would only be $296,429 and her investment would be $714,286.

Susan: Would like OPI to have less debt; therefore, to undo the leverage decision of OPI Susan will need to lend Susan will lend $250,000.

She will receive interest income of $25,000 per year.

Celia: Would like OPI to have more debt; therefore, to increase the leverage of OPI Celia will need to borrow Celia will borrow $285,714.

She will pay $28,571 interest on her loan Check that each has the desired cash flows (50% of the cash flows to equity from the desired OPI) and that each has invested the desired amount (50% of the value of the equity of the desired OPI).

Susan $1,000,000 250,000

Investment in 50% of equity of OPI Lend Borrow Net investment Cash flow from OPI investment Interest from lending/borrow Net cash flows

Celia $1,000,000

$1,250,000

285,714 $714,286

$325,000 25,000 $350,000

$325,000 (28,571) $296,429

38. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: a. To value Saskatchewan Botanicals we need the cash flows that are available to the shareholders (the cash flows after paying all other claimants and capital expenditures). Note: If given EBIT, deduct taxes to obtain the free cash flow (assuming CAPEX = 0).

Value of Saskatchewan Botanicals with zero debt = $1,080,000/0.18 = $6 million b. Firm value adjusts upon announcement of a share repurchase financed by debt even before the debt is issued. The value of equity before repurchase is equal to the value of the firm.

SL = VL = VU + DT = $6 + $3(0.3) = $6.9 million

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Share price before repurchase = value of equity before repurchase/number of shares = $6,900,000/1,000,000 = $6.90 Proceeds of $3 million from debt issue will repurchase $3 million/$6.90 = 434,783 shares.

Shares outstanding after repurchase = 1,000,000 – 434,783 = 565,217 shares.

Value of equity after repurchase = $6.90 × 565,217 = $3.9 million or, value of the equity after repurchase = $6.9 million – $3 million = $3.9 million Price per share after repurchase = $3.9 million/565,217 = $6.90 c. 𝐷

$3

𝑘𝑒 = 𝑘𝑈 + (𝑘𝑢 − 𝑘𝐷 ⬚ )(1 − 𝑇) 𝑆 = 0.18 + (0.18 − 0.08)(1 − 0.3) $3.9 = 23.38% 𝐿

d. We know from part (a) that EBIT (1 – T) = $1,080,000 per year. To obtain the cash flows available to equity, we need to deduct the after-tax cost of debt (1 – T) x 8% x $3 million = $168,000. Therefore, cash flows available for equity holders = $1,080,000 – $168,000 = $912,000.

Value of the equity is then $912,000/0.2338 = $3.9 million 39. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: a. Assuming that all cash flows are permanent, then the new value of Athabascan Drilling is $11.2 million. 𝑉𝐿 = 𝑉𝑈 + 𝐷𝑇 = $10 + $4(0.3) = $11.2 million b. To calculate the WACC, calculate: • The value of equity: ➢ value of firm = $11.2 million, value of debt = $4 million ➢ value of equity = $7.2 million • Cost of debt: given as 12% • Cost of equity = 23.11% 𝑘𝑒 = 𝑘𝑈 + (𝑘𝑢 − 𝑘𝐷 ⬚ )(1 − 𝑇)

𝐷 $4 = 0.2 + (0.2 − 0.12)(1 − 0.3) = 23.11% 𝑆𝐿 $7.2

The WACC is then: 𝑊𝐴𝐶𝐶 =

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𝑆𝐿 𝐷 $7.2 $4 𝑘𝑒 + 𝑘𝐷 (1 − 𝑇) = (0.2311) + (0.12)(1 − 0.3) = 17.86% 𝑉𝐿 𝑉𝐿 $11.2 $11.2

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40. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: a.

As the number of shares is unspecified, assume there are N shares (as we are examining the change in EPS, the number of shares is not critical).

Value of the firm = EBIT (1 – T)/WACC = $8.4 million. D/E = 2/3 so the value of debt = $3.36 million and the value of the equity is $5.04 million. Interest is 0.05 x 3.36 million = $168,000 before tax. Earnings or net income after tax is (EBIT – I)*(1–T) = ($1,200,000 – $168,000) x (1 – 0.3) = $722,400.

EPS (before) = $722,400/N Price per share is $5.04 million/N To determine the new value of debt after the change in D/E ratio: Value of the firm with no leverage: 𝑉𝐿 = 𝑉𝑈 + 𝐷𝑇 $8,400,000 = 𝑉𝑈 + $3,360,000(0.3) 𝑉𝑈 = $7,392,000 Value of the firm with a D/E of 1/3 D = V*(1/3)/(1+1/3) = V/4 𝑉𝐿 𝑉𝐿 = 𝑉𝑈 + 𝐷𝑇 = 𝑉𝑈 + 𝑇 4 𝑉𝐿 𝑉𝐿 = $7,392,000 + (0.3) 4 𝑉𝐿 = $7,991,351 D = V/4 = $7,991,351/4 = $1,997,838 Value of the debt is $1,997,838 resulting in interest of $99,892 per year.

New value of equity is $7,991,351 – $1,997,838 = $5,993,513.

Value of debt has changed from $3.36 million to $1,997,838 million—shares worth $1,362,162 must be issued to retire this debt. Therefore, it is necessary to issue $1,362,162/ ($5.04 million/N) = 0.27027 x N shares Earnings after the restructuring is $(1,200,000 – 99,892) x (1 – 0.3) = $770,076

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770,076 1.27027N 722,400 EPS OLD = N EPS NEW 770,076 1 = * = 0.8392 EPS OLD 722,400 1.27027 EPS NEW =

We can see from above that the EPS declined by 16.08% and that this change was caused by a combination of an increase in income and an increase in the number of shares outstanding. b.

To determine the cost of equity of Straightforward Theatre Company, obtain the cost of unlevered equity (remember this does not change as the capital structure changes):

VU = 7,392,000 =

EBIT (1 − T ) KU 1,200,000(1 − 0.3) KU

K U = 11.36% Then, using the cost of levered equity formula, obtain the old cost of equity (before the change in capital structure): 𝐷 2 𝑘𝑒 = 𝑘𝑢 ⬚ + (𝑘𝑢 − 𝑘𝐷 ⬚ )(1 − 𝑇) = 0.1136 + (0.1136 − 0.05)(1 − 0.3) = 14.33% 𝑆𝐿 3 Double check using WACC = ($5.04/$8.4) x 14.33% + ($3.36/$8.4) x 5% x (1–0.3) = 10% Calculate the cost of equity with the new D/E ratio of 1/3: 𝐷 1 𝑘𝑒 = 𝑘𝑈 + (𝑘𝑢 − 𝑘𝐷 ⬚ )(1 − 𝑇) = 0.1136 + (0.1136 − 0.05)(1 − 0.3) = 12.84% 𝑆𝐿 3 Summary: Cost of equity with D/E of 2/3 is 14.33% Cost of equity with D/E of 1/3 is 12.84% As expected, decreasing the level of leverage (D/E) has resulted in a decrease in the cost of equity.

41. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: 𝑘𝑈 = 18.5%, TC = 20%, and 𝑘𝐷 = 7% and WACC must be ≤ IRR to make NPV +, so set WACC= 15.2% Solutions Manual .

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Step 1: define WACC equation to be solved: 𝐷 𝐸 𝑊𝐴𝐶𝐶 = 15.2% = 𝑘𝐷 𝑥 (1 − 𝑇𝐶 ) 𝑥 + 𝐾𝐸𝐿 𝑥 𝐷+𝐸 𝐷+𝐸 Step 2: solve for cost of Levered Equity in terms of the D/E ratio, where D/E = WD/(1-WD) and D / D+E = WD 𝐷 𝐾𝐸𝐿 = 𝑘𝑈 + (𝑘𝑢 − 𝑘𝐷 ⬚ )𝑥 (1 − 𝑇𝐶 ) 𝑥 𝐸 𝐷 𝐿 𝐾𝐸 = 18.5% + (18.5% − 7%) 𝑥 (1 − 20%) 𝑥 𝐸 𝑊𝐷 𝐿 𝐾𝐸 = 18.5% + 9.2% 𝑥 (1 − 𝑊𝐷 ) Step 3: insert the equation from above into the WACC equation and solve for WD and D 𝑊𝐷 15.2% = 7% 𝑥 (1 − 20%) 𝑥 𝑊𝐷 + [18.5% + 9.2% 𝑥 ] 𝑥 (1 − 𝑊𝐷 ) (1 − 𝑊𝐷 ) 15.2% = 5.6% 𝑥 𝑊𝐷 + [18.5% 𝑥 (1 − 𝑊𝐷 ) + 9.2% 𝑥 𝑊𝐷 ] 15.2% = 5.6% 𝑥 𝑊𝐷 + 18.5% − 18.5% 𝑥 𝑊𝐷 + 9.2% 𝑥 𝑊𝐷 −3.3% = −3.7% 𝑥 𝑊𝐷 𝑊𝐷 = 89.19% 𝑫 = $222,975 Given the high cost of personal equity capital (20%), it is not surprising that most of the holding company’s capital structure would be debt based.

42. Section: 21.4 The Impact of Taxes on Capital Structure Learning Objective: 21.4 Level of difficulty: Challenging CPA: Finance Solution: a) VL = EBIT x (1 – TC) / WACC = [$4,000,000 x (1 – 0.25)]/0.1 = $30,000,000 b) D/E = 2/3, so D/(D+E) = 2/5, and original debt = $30,000,000 x 2/5 = $12,000,000 Equity = VL – D = $18,000,000 c) VL = VU + TCD $30,000,000 = VU + 0.25 x $12,000,000 VU = $27,000,000, so $30,000,000 – $27,000,000 = $3,000,000 worth of firm value was created by taking on debt. d) VL = VU + TCD VL = $27,000,000 + [VL/5 x 0.25] VL – 1/20VL = $27,000,000 VL = $28,421,053 e) Since D/E = 1/4, therefore D/(D+E) = 1/5, so Debt (New) = $28,421,053 x 1/5 = $5,684,211 Decrease in debt = $5,684,210.53 – $12,000,000 = $6,315,789

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Answers to Concept Review Questions 21.1 Financial Leverage Concept Review Questions 1. Define business risk and financial risk.

Business risk is the variability of a firm’s operating income caused by operational risk. Financial risk is the variability in a firm’s net income caused by the use of financial leverage 2. How does financial leverage affect the relationship between ROI and ROE? ROE = ROI (1+ B/SE) – Rd(1-T)B/SE. ROE linearly increases with ROI. 3. What are the three rules of leverage?

First, for value-maximizing firms, the use of debt increases the expected ROE so shareholders expect to be better off by using debt financing rather than equity financing. Second, financing with debt increases the variability of the firm’s ROE, which usually increases the risk to the common shareholders. Third, financing with debt increases the likelihood of the firm running into financial distress and possibly even bankruptcy.

4. Describe how we determine the ROE and EPS indifference points for a firm based on various financing alternatives, and explain why this analysis provides the firm with useful information.

The EPS indifference point is the EBIT level at which two financing alternatives generate the same EPS. We can solve for this indifference point in terms of EBIT by setting the EPS equal for two alternative financing plans under consideration. Then we merely solve for this indifference EBIT level, which we denote as EBIT*. This will provide the firm with some useful direction in choosing between financing alternatives since firms will generally want to maximize their “bottom line” as measured by EPS, and they will usually have an estimate of their expected EBIT. The ROE indifference point works the same way as the EPS indifference point.

21.2 Determining Capital Structure Concept Review Questions 1. What are the main determinants of capital structure?

The main determinants are analysis of cash flows, consultations, risk considerations, impact on profits, and industry comparisons.

2. Explain how ratios may be used to assess a company’s ability to assume more debt.

First, interest ratio is EBIT divided by interest. EBIT is not cash flow. This ratio cannot measure a firm’s ability to cover other commitments. Second, fixed burden coverage ratio uses EBITDA in the denominator. EBITDA is a better estimate of the firm’s cash flow. The denominator includes after-tax preferred share dividends and sinking funds. This ratio measures a company’s ability to pay other commitments. Third, cash-flow-to-debt ratio (CFTD) is a direct measure of the cash flow over a period that is available to cover a firm’s stock of outstanding debt. CFTD combines capital and stock variables.

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3. What is Altman’s Z score and what does it measure?

Altman’s Z-score is due to the work of Professor Ed Altman, and is a weighted average of several key ratios that he found were useful for predicting a firm’s probability of bankruptcy. His prediction equation is as follows: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5. Where, X1 = working capital divided by total assets, X2 = retained earnings divided by total assets, X3 = EBIT divided by total assets, X4 = market values of total equity divided by non-equity book liabilities, and X5 = sales divided by total assets. The larger the score, the better.

21.3 The Modigliani and Miller (M&M) Irrelevance Theorem Concept Review Questions 1. State the assumptions underlying the M&M irrelevance theory.

M&M’s key assumptions are as follows. (1) There exist two firms in the same “risk class” with different levels of debt. (2) The earnings of both firms are perpetuities. (3) Markets are perfect in the sense that there are no transactions costs or asymmetric information problems. (4) There are no taxes. (5) There is no risk of costly bankruptcy or associated financial distress.

2. Explain the importance of this theory.

Unfortunately, the “M&M results” are only as good as their assumptions, and most of them have been shown to poorly reflect the “real” world. However, in looking at how their assumptions affect their result, their research has pointed the way for many of the significant developments in corporate finance theory and practice over the past 60 years.

3. What is the basic argument that M&M use to arrive at the irrelevancy result?

M&M proved their proposition by means of an arbitrage argument that there is no such thing as “free money” and that investors prefer more money to less. So let’s think about what this means to two firms with the same business risk, but different levels of debt. There are two strategies.

One is to buy a percentage share of the un-levered firm, and the payoff is αEBIT. The other is to buy a percentage share of the levered firm, and a percentage of its debt. The payoff is α(EBIT – kDD) + αkDD = αEBIT. By the no arbitrage argument, since the two strategies have the same payoff and the same risk, the value of the two firms at present must be the same. Thus VL=VU. 4. In this ideal M&M world, what will affect firm value?

In this ideal M&M world, only EBIT and un-levered equity cost affect firm value.

21.4 The Impact of Taxes on Capital Structure Concept Review Questions 1. How do taxes affect the M&M argument?

VL = VU + DT. Leverage increases firm value. The difference between VL and VU is the tax shield of debt.

2. What are the practical difficulties associated with the implications of M&M’s corporate tax model?

This model contains a crucial flaw, which is that the adjustment is based on the M&M equation, which implies that 100 percent debt financing is optimal: since there is always more tax shield

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value to using more debt, why stop? While it seems obvious on an intuitive level that firms should not finance with 100 percent debt, we can address the issue more formally by relaxing M&M’s assumptions that there are no costs related to the risk of financial distress or bankruptcy.

21.5 Financial Distress, Bankruptcy, and Agency Costs Concept Review Questions 1. Explain the impact of financial distress and agency costs on M&M’s conclusions regarding capital structure.

The probability of financial distress increases with debt. Financial distress brings both direct and indirect costs to a firm. When a firm is in distress, the equity holders (who get to vote) may undertake measures to try to get something for themselves, at the expense of the debt holders, for example, by way of a large dividend. Because of the cost with financial distress and the agency problem, firms do not use 100 percent debt.

2. Why can the firm’s debt be viewed as the exercise price to the shareholders’ option to purchase the firm?

If a firm’s value is greater than its debt, shareholders can access the difference between the firm value and debt. Otherwise, shareholders get nothing. The payoff function for the shareholders are max[0, V – D], which is exactly the payoff function of a call option with debt being the exercise price.

3. Explain the static trade-off theory.

The static trade-off model states that the firm uses debt to maximize its tax advantages up to the point where these benefits are outweighed by the associated estimated costs of financial distress and bankruptcy.

21.6 Other Factors Affecting Capital Structure Concept Review Question 1. Explain how the existence of informational asymmetries and agency problems may lead firms to follow a pecking order to financing.

Myers’ argument that firms follow a pecking order is based on divulging information. If the firms use internal cash flow, then they do not need anyone’s permission. For example, even the shareholders can’t force the firm to pay a dividend. Similarly, the firm can talk to a bank and divulge privileged information to secure a loan. However, when it issues new common shares, as we have seen, the firm has to file a prospectus and reveal all material facts that affect the share price. In the process, the firm has to be careful not to reveal facts to a competitor that may give it a jump start and allow it to compete away the NPV benefits of the project.

The pecking order was also discussed in a different context by Gordon Donaldson.

Donaldson justified the pecking order through what we would now call agency arguments. He showed that managers’ commitment to the firm was through their human capital, versus the “short-term” financial commitment of shareholders. As a result, they were more concerned about the long-term survival of the firm and less inclined to take risks. For these agency reasons, he also argued that managers had a preference for internal cash flow (retained earnings), then debt,

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and finally issuing new common equity. In an agency model, this financing hierarchy imposes the least risk on the firm and requires the least justification by managers.

21.7 Capital Structure in Practice Concept Review Question 1. Explain four of the most important factors influencing capital structure decisions, as indicated in the survey results, and how they relate to the conceptual discussion of an optimal capital structure.

The four most important factors in the Deutsche Bank survey were: 1) Credit rating 2) Tax shield 3) The ability to continue making investments 4) The ability to maintain dividends The credit rating reflects the ability of the firm to maintain its credit and raise capital. The tax shield value reflects the tax advantage to using debt financing. It is the firm’s underlying business risk that might restrict the firm’s ability to pay dividends or make investments if it has “too much” debt. The latter two concerns reflect the fact that the underlying M&M assumption that capital is always available, does not in reality hold.

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The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Chapter 22: Dividend Policy Multiple Choice Questions 1. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Basic CPA: Finance Solution: B 2. Section: 22.1 Forms of Dividend Payments Learning Objective: 22.1 Level of difficulty: Intermediate CPA: Finance Solution: C Retained earnings remain unchanged.

3. Section: 22.1 Forms of Dividend Payments Learning Objective: 22.1 Level of difficulty: Intermediate CPA: Finance Solution: B Ex-dividend date is the second business date before the holder of record date.

4. Section: 22.1 Forms of Dividend Payments Learning Objective: 22.1 Level of difficulty: Intermediate CPA: Finance Solution: A 5. Section: 22.2 Historical Dividend Data Learning Objective: 22.2 Level of difficulty: Intermediate CPA: Finance Solution: C 6. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Intermediate CPA: Finance Solution: B 7. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Intermediate CPA: Finance Solution: C

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𝑃=

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𝑋1 − 𝐼1 + 𝑉1 $400,000 − $200,000 + $1,200,000 = = $1,217,391 1+𝑘 1 + 0.15

8. Section: 22.5 Dividend Policy in Practice Learning Objective: 22.5 Level of difficulty: Intermediate CPA: Finance Solution: C β=1 means that the firm adjusts immediately to the target dividend. ΔD = 1($4.50 – $3.75) = $0.75 9. Section: 22.5 Dividend Policy in Practice Learning Objective: 22.5 Level of difficulty: Intermediate CPA: Finance Solution: A The stock with the lower dividend yield will have higher capital gains (given that the pre-tax returns of the two stocks are the same).

10. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Intermediate CPA: Finance Solution: D 11. Section: 22.7 Share Repurchases Learning Objective: 22.7 Level of difficulty: Intermediate CPA: Finance Solution: D 12. Section: 22.7 Share Repurchases Learning Objective: 22.7 Level of difficulty: Intermediate CPA: Finance Solution: C 13. Sections: 22.1 Forms of Dividend Payments 22.5 Dividend Policy in Practice 22.6 Relaxing the M&M Assumptions: Welcome to the Real World! and 22.7 Share Repurchases Learning Objectives: 22.1, 22.5, 22.6, and 22.7 Level of difficulty: Intermediate CPA: Finance Solution: C

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Practice Problems Basic 14. Section: 22.1 Forms of Dividend Payments Learning Objective: 22.1 Level of difficulty: Basic CPA: Finance Solution: A cash dividend plus a DRIP gives the investor a choice to decide whether to buy more shares with the cash distributed, while a stock dividend does not distribute cash to investors at all. A stock dividend is fully taxable, despite the fact that no cash is received.

15. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Basic CPA: Finance Solution: Given the M&M assumptions (no taxes, perfect market, all firms maximize value, and no debt), investors can buy or sell shares in an underlying company to meet their own cash flow needs.

The underlying company’s dividend policy is irrelevant. Investors willing to receive no dividends could use dividends to buy shares or participate in a DRIP, while investors willing to receive more cash flows could simply sell a portion of their holdings.

16. Section: 22.4 The “Bird in the Hand” Argument Learning objective: 22.4 Level of difficulty: Basic CPA: Finance Solution: Investors consider current (in hand) dividends more valuable than future capital gains.

17. Section: 22.5 Dividend Policy in Practice Learning Objective: 22.5 Level of difficulty: Basic CPA: Finance Solution: According to Lintner, the adjustment factor β measures how quickly a firm’s actual dividend moves towards its target dividend in a given period, with a value of 1 indicating immediate and full adjustment, and 0 representing no adjustment. An adjustment factor of 0.50 indicates that a firm only moves 50% of the way towards its target dividend in each period.

18. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Basic CPA: Finance Solution:

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Investors in a lower tax bracket tend to hold high-dividend yielding stocks, while investors with longer horizons tend to hold low-dividend yielding stocks to defer taxes.

19. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Basic CPA: Finance Solution: With transactions costs, the firm may have no cash or decreased cash available for dividend payout and consequently decrease its value. The payment of transactions costs also decreases the firm’s ability to accept positive NPV projects.

Intermediate 20. Section: 22.2 Historical Dividend Data Learning Objective: 22.2 Level of difficulty: Intermediate CPA: Finance Solution: D Payout Ratio = Earnings D = Payout Ratio x Earnings = 36% × $22,000,000 = $7,920,000 Div $7,920,000 Dividends per share = = = $1.32 6,000,000 nheld

We use the dividend yield formula at this point to find the price per share: Div Per Share Div Yield = P Therefore: P =Div per share/Div Yield=$1.32/3.8%=$34.74 21. Section 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Intermediate CPA: Finance Solution: P0 =

d1 + P1 1+k

=

$2.50 + $30 = $28.02 1.16

22. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Intermediate CPA: Finance Solution:

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𝑚𝑃0 = 𝑉0 =

𝑚(𝐷1 + 𝑃1 ) (1 + 𝑘𝑒 )

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$1,800,000 × (1.06)) 150,000 (1 + 𝑘𝑒 )

$150,000(1.80 + $1,800,000 = 𝑘𝑒 = 21%

23. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning objective: 22.3 Level of difficulty: Intermediate CPA: Finance Solution: a. New proceeds required: 𝑛𝑃1 = 𝑚𝐷1 − (𝑋1 − 𝐼1 ) = $5 × 5𝑚 − ($42𝑚 − $30𝑚) = $13 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 b. Current equity market value = $64 × 5m = $320 million As the firm equity market value is not changed: 5P1 + nP1 = $320 5P1 = $320 – $13 = $307 P1 = $307/5 = $61.40 c. This implies the firm will need to issue the following number (n) of new shares: n = $13m/$61.40 = 211,726 new shares 24. Section: 22.4 The “Bird in the Hand” Argument Learning Objective: 22.4 Level of difficulty: Intermediate CPA: Finance Solution: D 25. Sections: 22.4 The “Bird in the Hand” Argument 22.5 Dividend Policy in Practice Learning Objectives: 22.4 and 22.5 Level of difficulty: Intermediate CPA: Finance Solution: - First, the dividend itself is not that significant because a 60% cut down to $0.02 per share means that the original dividend was only $0.05 per share, representing a yield of only $0.05/$8.67 = 0.58%, where $8.67 = price before the 6.46% increase] The decreased dividend is primarily to use the cash in other ways, such as paying down debt.

- Second, the news itself was probably not entirely unexpected because it follows the prior 75% cut in 2013. Moreover, Barrick’s problems stem from the decline in the price of gold, which is public knowledge. In this sense, the stock price increased in recognition that management was focused on a clear strategy to reduce the company’s debt burden to make it more competitive.

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The stock market reaction is essentially short-term pain for long-term gain, where Barrick is more valuable conserving cash than paying the $0.03 cents a share cut in the

26 Section: 22.5 Dividend Policy in Practice Learning Objective: 22.5 Level of difficulty: Intermediate CPA: Finance Solution: Number of shares outstanding = $5,600,000/$32 = 175,000 Residuals this year = $800,000 – $600,000 = $200,000 Dividend per share = $200,000/175,000 = $1.14 per share The biggest shortcoming is the volatility of the dividend payout. With the residual dividend policy, dividend payout fluctuates with profits, especially for cyclical stocks. A stable dividend payout is optimal.

27. Section: 22.5 Dividend Policy in Practice Learning Objective: 22.5 Level of difficulty: Intermediate CPA: Finance Solution: Setting dividend payout as a portion of profits increases the volatility of the dividend payments, which is taken as a negative signal by the market and consequently decreases firm value.

Particularly for firms in cyclical industries, dividend payout volatility could place significant downward pressure on the equity price. In practice, firms do not increase dividends until they are certain the new level could be maintained or could be increased to another new level, rather than having dividend payout fluctuate with profits.

28. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Intermediate CPA: Finance Solution: We can calculate the after-tax dividend amount by multiplying the dividend by (1–T) where T is the personal tax rate.

Investor A’s after-tax dividend amount: D*(1–T) = nheld x(Dividend per share) x(1 – T) = 1,000 x$1.75 x(1 – 0.30) = $1,225 Investor B’s after-tax dividend amount: D*(1–-T) = nheld x(Dividend per share)x (1 – T) = 1,000 x $1.60 x (1 – 0.22) = $1,248 Investor B receives the larger after-tax dividend amount.

29. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Intermediate CPA: Finance Solution:

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a. Dividend initiation is usually a positive signal to the market, and pushes the equity price up. b. A dividend increase could be viewed as a positive signal or a negative signal depending on the perspective of the market. If the firm increases the dividend payout due to the lack of available investment and/or has no growth prospects, the equity value will decrease. If the firm is profitable, and is confident about keeping the increased dividend payout at the new level, then its equity value increases. c. A decrease of dividend is normally viewed negatively by the market.

30. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Intermediate CPA: Finance Solution: The amount of the per share dividend increase is: Dividend per share increase = Dividend per share new – Dividend per share original = $0.42 – $0.30 = $0.12 Therefore, the annual amount by which the dividend payment to the investor would increase is: Dividend = nheld*Dividend per share increase = 1,500 x $0.12 = $180 Finally, calculating the increase in taxes: Tax effect = Div*t = $180 x 25% = $45 31. Section: 22.7 Share Repurchases Learning Objective: 22.7 Level of difficulty: Intermediate CPA: Finance Solution: Firms repurchase shares to: • Offset the exercise of executive stock options (ESOs).

• Return the firm to its optimal capital structure after debt is raised.

• Send a signal; management often indicates that it repurchased shares to signal to the market that it thinks the stock is undervalued.

• Repurchase dissident shares; when there is substantial disagreement among shareholders about the future of the firm, a share repurchase program gives the dissidents an opportunity to sell their shares without depressing the market price, thereby removing an “overhang” of shares.

• Remove cash without generating expectations for future distributions.

• Take the firm private.

Challenging 32. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Challenging CPA: Finance Solution:

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a. Currently the firm has free cash flows of $2 million a year which could be paid in dividends and has a value of $50 x 2 million shares = $100 million. This valuation implies a discount rate of 2%. This discount rate is not expected to change as George buys or sells stock—the business itself does not change. To receive $20 million, George will need to sell 400,000 shares at $50.

The result of this transaction is that George will now own 1.2 million – 400,000 = 800,000 shares or 40% of the company. The impact on CGC is minimal unless George is a critical participant in the management of the firm and his decision signals that he may be planning on leaving the firm. The impact on George’s control of the firm may be important—he is going from owning 60% of the firm to owning 40%. For most firms this is still sufficient to maintain effective control of the firm, but he will no longer have absolute control. This may be a major issue for George. b. (i) From the Modigliani-Miller dividend irrelevance theorem, we know that the value of the firm will not be changed. For George to receive a dividend of $20 million, the firm will need to pay a total dividend of $33.33 million (remember George only owns 60% of the firm). CGC will need to issue $33.33 million/$50 = 666,667 shares. If they issue more shares, the dividend will need to go higher than $33.33 million because of George’s reduced ownership (see next part). ii) The total value of CGC will remain at $100 million as the operating cash flows and capital expenditure needs have not changed. To see this: $2 million of continuing free cash flows divided by 2% = $100 million. We are assuming that the $33.3 million is a one-time special dividend.

The impact of the firm issuing stock is that George will now own 1.2 million shares but there are now 2.67 million shares outstanding. He will own 45% of the firm after the new issue. Once again, George’s level of control of the firm will be diluted.

33. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Challenging CPA: Finance Solution: 𝐷 $8 a. Price = 𝑘 = 0.15 = $53.33 𝑒

b. If the firm undertakes the project, there will be no dividend in the current year. Starting next year, the dividend will be $8.80 (if return is 10%), or $9.20 (if return is 15%), or $9.60 (if return is 20%).

Therefore: $8.80 1 10% return would imply: Share Price = 0.15 × 1.15 = $51.01 $9.20

1

$9.60

1

15% return would imply: Share Price = 0.15 × 1.15 = $53.33 20% return would imply: Share Price = 0.15 × 1.15 = $55.65 Given a 15% return on the new investment, shareholders are indifferent between receiving a dividend this year or receiving increased dividends from next year. At 20%, they prefer the new investment. At 10%, the new investment should not be undertaken.

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c. If investments for the kind of business the firm is in typically provide a rate of return of 15% (as required by the shareholders), it is not reasonable to assume that the firm can continually find enough positive NPV opportunities yielding at least 20 percent.

34. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Challenging CPA: Finance Solution: a. If the firm pays out all earnings in dividends, D $10 $10 (1 – 0.3) Price = = or = $66.67 ke 0.15 0.105 b. If the firm retains the current dividend for reinvesting at 15%, then the dividends from next year will be $11.50, which after tax will be (1-0.3) x $11.50 = $8.05 To provide an expected after-tax return of 10.5% at the end of the current year, the shares should 8.05 trade at: = = $76.67 0.105 which provides a $10 capital gain over the current share price of $66.67. Thus, if earnings are reinvested in new projects that provide a 15% rate of return, then the current shareholder trades off a $10 dividend against a $10 capital gain. The desirability of this new project will now depend on the relative tax rate levied on dividends vs. capital gains. Investors will prefer the investment if capital gains are taxed at a lower rate than dividends. If dividends are taxed at a lower rate than capital gains, the project should not be undertaken.

35. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Challenging CPA: Finance Solution: a. Paying cash dividends: P0 = (P1+ D1)/(1+k) = ($30 + $6)/(1+0.12) = $32.14 b. Share buyback: Number of shares outstanding after buyback = 100,000 – ($600,000/$36) = 100,000 – 16,666.67 = 83,333.33 c. Po = [$3,000,000/83,333.33]/(1.12) = $32.14 The price would be the same either way.

36. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Learning Objective: 22.3 Level of difficulty: Challenging CPA: Finance Solution: Each share pays a dividend of $2,000 a year. The value of a share is $2,000/.05 = $40,000. Note that because the dividends are a perpetuity, the value of the shares will not change over time.

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Each person (Marie, Charlie, and Radha) owns 10% of the company or 100 shares. Assume that they all sell their shares at the end of year two, although that is not a necessary scenario.

Marie: wants $400,000 at the end of year 1.

• At the end of year one, she will receive 100 x $2,000 = $200,000 of dividends.

• She will need to sell ($400,000 – $200,000)/$40,000 = 5 shares • Net effect: receive $400,000 at the end of year 1, which she consumes and now owns 95 shares • At the end of year 2: receives $190,000 of dividends and sells the remaining 95 shares at $40,000 for $3,800,000 • Value at the end of year 2: $190,000 + $3.8 million = $3.99 million.

Value at time 2 = $3.99 million. PV at 5% = $3.62 million. Note: this is less than the value of the shares at time zero because her consumption of the dividends at time 1 was a negative NPV project. The value of the shares was based on the assumption that the dividends would be reinvested at 5%.

Charlie: • Receives $200,000 dividend and sells 5 shares • Invests $400,000 at 15% for one year ▪ At the end of year 2: value of this investment = $460,000 • At the end of year 2, receives $190,000 dividends and sells the remaining 95 shares at $40,000 for a total of $3.99 million • Value at the end of year 2: $460,000 + $190,000 + $3.99 million = $4.64 million.

PV at 5% of $4.64 million at the end of year 2 = $4.21 million. Note: this is greater than the value of the shares because Charlie reinvested the dividend at a rate that was greater than 5%.

Radha: • Receives $200,000 dividend and buys 5 more shares • At the end of year 2, receives 105 x $2,000 = $210,000 dividends and sells the remaining 105 shares at $40,000 for a total of $4,410,000 • Value at the end of year 2 = $4.410 million.

PV at 5% of $4.410 million at the end of year 2 = $4 million. Note: this is equal to the value of the shares at time zero because Radha reinvested the dividend at 5%.

37. Section: 22.4 The “Bird in the Hand” Argument Learning Objective: 22.4 Level of difficulty: Challenging CPA: Finance Solution: a. The “bird in the hand” argument is consistent with Client A. She prefers to have the “sure thing,” the dividend, rather than the potential capital gain. b. Essentially these two investors are interested in different aspects of the stock: Client A wants the dividends while Client B wants the capital gains. If Alice were to buy the stock and then sell Client A a claim to the dividends and sell Client B a claim to whatever is left over (i.e., the capital gain), then Alice would be able to satisfy the needs of both investors. Client A would get Solutions Manual 10 Chapter 22 Copyright © 2016 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited

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their desired pattern of steady cash flows and Client B would not have to pay taxes on the dividends as they would only have the capital gains.

38. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Challenging CPA: Finance Solution: a. If the change in dividends was unexpected, then I would expect the price of Abacus to increase on July 26. The amount of the increase should be more than $1 if I expect the increased dividend to continue in the future. If the change in the dividends was expected, then I would not expect the price of Abacus to change on July 26. The price would already have incorporated the change in dividends, so it would not be news when the announcement was made. b. If the shareholders do not pay taxes, I would expect the stock price to decline by the amount of the dividend. On the day before the ex-dividend date, the stock’s value = X + dividend. On the ex-dividend date, the stock’s value no longer includes the dividend, so as long as there was not information released on the ex-dividend date, the stock price should change from X + dividend to X, a decline equal to the value of the dividend. c. The stock price reaction will be less than the value of the dividend. Investors buying the stock prior to the ex-dividend date will only be willing to pay X + the after-tax value of the dividend.

On the ex-dividend date, the stock will drop to X and the decline will be equal to the after-tax value of the dividend. As long as tax rates are greater than 0, the decline should be less than the before-tax value of the dividend. Consider an extreme example: tax rate on dividends = 100%.

There should be no stock price reaction on the ex-dividend date. There is no change in the cash flows to the investors as the government will take the entire dividend, so the investor would not have paid “extra” for the stock prior to the ex-dividend date.

39. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Learning Objective: 22.6 Level of difficulty: Challenging CPA: Finance Solution: Kumar has not considered the impact of the information asymmetry between investors (the market) and management (the firm). Kumar knows he has a good project and that this project will increase shareholder wealth; however, investors do not know this. Kumar could tell investors this news, but why should they believe him? If Kumar could credibly signal the value of the project, then the dividend cut would be positively received by the market. However, as he cannot do so, the investors form an expectation about what type of firm it is—good or bad.

Based on this expectation, the investor reacts.

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Answers to Concept Review Questions 22.1 Forms of Dividend Payments Concept Review Questions 1. Define four important dates that arise with respect to dividend payments.

The four dates are the declaration date, ex-dividend date, holder of record date, and payment date in the time order.

2. Explain the similarities and differences of DRIPs, stock dividends, and stock splits.

A cash dividend along with a DRIP is similar to a stock dividend because investors receive shares rather than cash payments. However, there is one very significant difference between them. With the cash dividend plus DRIP, the cash is distributed first and it is up to the investor to decide whether they want to buy more shares. Regardless of the investors’ decisions, the firm has to have the cash to make the distribution. With the stock dividend, on the other hand, firms often do not have the cash and simply issue a stock dividend to give the investor “something.”

An extreme version of a stock dividend is a stock split. In this case, there is a greater than 25 percent increase in the number of shares outstanding. Both stock dividends and stock splits simply divide the value of the common shares among more shares and all else constant, reduce the price per share. There are some accounting advantages to this since the retained earnings account is not altered, but the number of shares outstanding is simply increased. In addition, unlike stock dividends, investors face no tax implications arising from a stock split, except that the average purchase price will be adjusted downward to reflect the split.

22.2 Historical Dividend Data Concept Review Questions 1. What obvious question arises when we examine historical patterns in aggregate dividend payouts?

This naturally raises an important question (1): Why are dividends smoothed and not matched to profits? Or another way of saying this is: why don’t firms just pay a constant proportion of profits out as dividends and cut them when their profits and cash flows drop as they do during recessions?

2. What obvious question arises when we examine cross-sectional patterns in the dividend payouts of individual companies?

This raises another important question (2): Why is there such a substantial difference in dividend yields (and payouts) across major Canadian companies? Why do some firms have very high dividends and some very low or non-existent?

22.3 Modigliani and Miller’s Dividend Irrelevance Theorem Concept Review Questions 1. Explain how, and under what assumptions, M&M show that dividends are irrelevant.

The assumptions are as follows: (1) There are no taxes; (2) Markets are perfect; (3) All firms maximize value; (4) There is no debt. Without any debt, the sources and uses of funds identity (i.e., sources = uses) can be expressed as: X1+nP1=I1+nD1. Substituting this identity into

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mP0=V0=m (D1+P1)/(1+Ke), the price becomes the sum of the discounted future (X-I). Dividends do not enter the pricing formula.

2. Explain the relationship between M&M’s argument and the use of a residual dividend policy.

According to M&M’s argument, stock value equals the present value of future (X-I). According to the discount dividend model, stock value equals the present value of future dividends. These two arguments should give the same price. Obviously these two approaches must give exactly the same value, which implies that the dividend is equal to the free cash flow each period. In this way the dividend is the residual that remains after the firm has taken care of all of its investment requirements, so we call this the residual theory of dividends.

3. Briefly describe the notion of homemade dividends as it relates to M&M’s irrelevancy argument.

The example above illustrates that investors can buy or sell shares in an underlying company to create their own cash flow patterns, or simulated dividend streams. Investors who don’t like dividends can sign up for a DRIP and undo the effects of a firm’s dividend policy. Conversely, investors who like dividends can create a cash flow from the firm simply by selling part or all of their shares. What the example illustrates is that under the M&M assumptions, the investor is indifferent as to a firm’s dividend policy.

22.4 The “Bird in the Hand” Argument Concept Review Questions 1. Explain the “bird in the hand” argument about dividends.

The “bird in the hand” argument is a notion that a cash dividend is worth more than an equivalent capital gain. The intuition is that firms that pay cash dividends are less risky than ones where the investors’ return comes by way of a capital gain. It then seems to follow that firms that do not pay a cash dividend will be seen as riskier, causing the cost of equity capital to increase and the stock price to fall. This idea is called the bird in the hand argument on the basis that a “bird in the hand” (cash dividend) is worth more than “two in the bush” (twice as much in capital gains).

2. Reconcile the predictions of M&M with Gordon’s arguments about dividend policy.

Gordon is right in arguing that the dividend yield does indicate the risk of the firm and firms that pay large amounts of dividends are less risky than non-dividend-paying firms. However, M&M are also right because changing the dividend cannot change the underlying risk of the firm; this comes from its underlying operations. In this sense, the dividend should reflect the firm’s operations through the residual value of dividends and the firm cannot change these underlying operational characteristics by merely changing the dividend.

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22.5 Dividend Policy in Practice Concept Review Question 1. What does real-world evidence imply about how firms manage their dividend payments?

M&M suggests that a firm can cut the dividend if it is short of cash and increase it when it has surplus in cash. However, the real world evidence implies that firms smooth dividends and are reluctant to cut dividends.

22.6 Relaxing the M&M Assumptions: Welcome to the Real World!

Concept Review Questions 1. Explain why dividend policy will be relevant in the presence of transactions costs, informational asymmetry and agency problems, and taxes.

(1) Transactions costs are important because in the M&M model, it is assumed that the firm can pay a dividend and then issue shares to raise the money needed to make the required level of investment. Let’s take an extreme situation where transactions costs are very high and the firm cannot raise new capital. In this case, the payment of the cash dividend reduces the amount of money available to invest and causes the firm to forgo positive NPV projects. The value of the firm would go down since it is not creating value by accepting positive NPV projects. Thus, growth firms do not pay dividends and dividend-paying firms smooth dividends.

(2) Information asymmetry. M&M assumes perfect markets where all market participants have access to the same information. In practice, management usually knows more than external investors. Investors tend to view firms’ information releases with a great deal of skepticism. One way of signalling is to only increase the dividend when the firm believes that it will not have to cut it in the future. The fact that paying the cash dividend reduces the funds available to the firm means that they will only do so when they think that their internal funds are increasing and are enough to support the dividend payment. Otherwise, it will impose more transactions costs on the firm in having to raise more funds in the future. This signalling model explains why share prices tend to increase on unexpected dividend initiations or increases. In both cases, the dividend increase indicates good news because it suggests that management believes it can support the dividend out of future earnings.

(3) Agency costs. Investors are worried that senior management may waste corporate resources in over-investing in poor (negative NPV) projects, since it is not “their” money but the shareholders’. Paying a large dividend and forcing the firm to justify future expenditures creates value by controlling management. However, while an agency perspective justifies the stock market’s reaction to dividends, it cannot explain the dividend smoothing phenomena.

(4) Tax. Investors with a low tax rate on dividends buy high-dividend stocks, but investors with high tax rates on dividends buy low-dividend stocks. So, although the payment of a dividend may not have an impact on the general level of share prices, it will be an important influence on the type of investors that a firm attracts.

2. Describe split shares and explain what their popularity implies about investor preferences for dividends in the real world.

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The popularity of split shares has two major implications. First, there are investor dividend clienteles and dividends do matter to some investors. This emphasizes the need for companies to consider dramatic dividend changes as a serious event not to be taken lightly. Second, the capital shares are marketed as a leveraged investment and can be considered an application of the “homemade” leverage theorem advanced by M&M. 22.7 Share Repurchases Concept Review Questions 1. Why can share repurchases be viewed as an alternative to paying a cash dividend?

A share repurchase is simply another form of payout policy. It is an alternative to a cash dividend where the objective is to increase the price per share rather than paying a dividend and forcing the shareholders to immediately pay tax on the dividend.

2. What factors may influence a firm’s decision to enter into share repurchases?

Several other reasons may motivate share repurchases, including offsetting the exercise of executive stock options (ESOs); leveraged recapitalizations; information or signalling effects; repurchase dissident shares; removing cash without generating expectations for future distributions; and take the firm private.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

MMXX ii F1

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Chapter 23: Working Capital Management – General Issues Multiple Choice Questions 1. Section: 23.1 The Importance of Working Capital Management Learning Objective: 23.1 Level of difficulty: Intermediate CPA: Finance Solution: C 2. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: C 3. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: D As sales increase, cash, inventory, accounts receivable, and trade credit normally increase. Shortterm debt does not necessarily increase as sales increase.

4. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: C 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =

𝐶𝐴 $500,000 + $800,500 + $700,000 + $1,003,000 = = 3.34 𝐶𝐿 $100,000 + $800,000

𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =

$500,000 + $800,500 + $700,000 = 2.22 $100,000 + $800,000

5. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: D ACP = 365/(Rev/AR) = 365/($1,287,555/$700,000) = 198 days

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6. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: C Operating cycle = ACP + ADRI = ACP + [365/(CGS/Inventory)] = 198 + 365/($550,000/$1,003,000) = 198 + 666 = 864 days

7. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: C 8. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: D 9. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: A 10. Sections: 23.3 Analyzing Cash Inflows and Outflows and 23.4 Working Capital Management Learning Objectives: 23.3 and 23.4 Level of difficulty: Intermediate CPA: Finance Solution: B 11. Section: 23.3 Analyzing Cash Inflows and Outflows and 23.4 Working Capital Management Learning Objectives: 23.3 and 23.4 Level of difficulty: Intermediate CPA: Finance Solution: D 12. Section: 23.3 Analyzing Cash Inflows and Outflows and 23.4 Working Capital Management Learning Objectives: 23.3 and 23.4 Level of difficulty: Intermediate CPA: Finance Solution: A

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13. Section 23.4: Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: D

Practice Problems Basic 14. Section: 23.1 The Importance of Working Capital Management Learning Objective: 23.1 Level of difficulty: Basic CPA: Finance Solution: Characteristics of sound net working capital management include: • Maintenance of optimal cash balances • Investment of any excess liquid funds in marketable securities that provide the best return possible, considering any liquidity and/or default risk constraints • Proper management of accounts receivable • An efficient inventory management system • Obtaining an appropriate level of short-term financing, in the least expensive and most flexible manner possible 15. Section: 23.1 The Importance of Working Capital Management Learning Objective: 23.1 Level of difficulty: Basic CPA: Finance Solution: Net working capital is current assets – current liabilities. Both items are taken from the firm’s balance sheet.

16. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Basic CPA: Finance Solution: CCC = Operating cycle (OC) – Average days of revenues in payables (ADRP) = OC – [365/(Rev/AP)] = 864 – [365/($1,287,555/$800,000)] = 864 – 227 = 637 days Intermediate 17. Section: 23.1 The Importance of Working Capital Management Learning Objective: 23.1 Level of difficulty: Intermediate CPA: Finance Solutions Manual 3 Chapter 23 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited

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Solution: Businesses that allow a customer long periods of time to pay their bills are, in effect, providing short-term financing to their customers by allowing them to use the cash necessary to pay its invoices for other purposes in the short-term. For example, if a customer is allowed 60 days to pay an invoice instead of 30, it can use the cash amount of the invoice for alternative purposes during the extra 30 days.

18. Section: 23.1 The Importance of Working Capital Management Learning Objective: 23.1 Level of difficulty: Intermediate CPA: Finance Solution: Net working capital (NWC) is defined as the difference between current assets and current liabilities. Both current assets and current liabilities represent a significant component of the balance sheet in an absolute and relative sense for the majority of firms. Therefore, efficient management of NWC is vital for the overall success of most firms.

19. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: Cash inflows come primarily from cash sales and collections of accounts receivable. Cash outflows come from expenses that are paid in cash and the payment of accounts payable.

20. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: Cash budgets are in effect detailed (i.e., constructed monthly, weekly, or daily) pro forma cash flow statements and can be used to construct longer term aggregate pro forma cash flow statements, as well as income statements and balance sheets.

21. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate Solution: Advance knowledge of expected cash positions allows management to change course before any of their operating plans are implemented to produce a more favourable cash result. Further, the knowledge would allow management to make more informed investment decisions pertaining to any expected surpluses, and to arrange the most appropriate financing solution in the case of forecast deficits.

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22. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: a. Sources of funds using the indirect method described in Chapter 2: Net operating income Depreciation Sale of land Total sources of funds

$60,000 10,000 25,000 $95,000

Purchase of equipment Retirement of long-term debt Dividends paid Purchase of long-term investments Total uses of funds

$15,000 30,000 15,000 10,000

b. Uses of funds:

$70,000

c. Increase in cash: $95,000 – $70,000 = $25,000 23. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Intermediate CPA: Finance Solution: Cash inflows: $50,000 + $100,000 + $70,000 = $220,000 Cash outflows: $35,000 + $20,000 + $80,000 + $35,000 = $170,000 Ending cash = $20,000 + $220,000 – $170,000 = $70,000 24. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.3 Level of difficulty: Intermediate CPA: Finance Solution: a. Decrease b. Decrease c. Increase d. Increase e. Increase f. Decrease

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25. Sections: 23.1 The Importance of Working Capital Management and Section 23.3 Analyzing Cash Inflows and Outflows Learning Objectives: 23.1 and 23.3 Level of difficulty: Intermediate CPA: Finance Solution: Their suppliers might be less than receptive to this extension and they may subsequently change payment terms (e.g., require cash on delivery). Such a change could place the company into an extremely illiquid position requiring a working capital injection just to stay afloat and solvent.

26. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.3 Level of difficulty: Intermediate CPA: Finance Solution: a. If a firm’s planned sales growth exceeds its break-even sales growth rate, then the firm will require an infusion of cash from external sources in order to achieve its planned sales growth. b. If a firm’s planned sales growth rate is less than its break-even sales growth rate, then the firm is not growing as fast as it potentially could. There may be economic reasons that the firm is not making substantial reinvestments in its business, such as mature products, substantial market penetration, and decreasing returns to scale from further growth.

27. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: The receivables turnover ratio and the average collection period both measure the efficiency of a firm’s credit policy. The receivables turnover ratio indicates the number of times the average dollar of receivables is collected during a year. The average collection period measures the average number of days it takes for the average dollar of receivables to be collected from customers.

28. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.3 Level of difficulty: Intermediate CPA: Finance Solution: Measures to improve working capital management include: • Scenario analysis to show the potential impact on cash flow of unforeseen events, such as market cycles, loss of a prime customer, or actions by competitors • Contingency planning and risk-management procedures to keep the company solvent when unexpected events occur

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Addressing the issue of working capital on a corporate-wide basis, so that cash generated at one location or by one business unit can be utilized by another. Integrated financial reporting and decision making are essential for this to succeed.

An innovative approach to management that combines operational and financial skills to identify and implement strategies that generate short-term cash Effective dispute management procedures and improved customer service that result in reduced operating costs Integrated planning with customers and suppliers, particularly where it involves matching production with their inventory requirements to reduce inventory levels

29. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: The operating cycle is the average time required to acquire inventory, sell it, and collect the proceeds. The cash conversion cycle is an estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales (the average number of days of revenues a firm must finance outside the use of trade credit). The operating cycle and the cash conversion cycle are related: to determine the cash conversion cycle, we subtract the average number of days it takes to discharge payables from the operating cycle.

30. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: The current ratio compares current assets to current liabilities, while the quick ratio compares only cash and near-cash current assets to current liabilities. Generally, this means that while the current ratio includes inventories, the quick ratio excludes inventories. While marketable securities and receivables can usually be collected quickly without a loss of value, it is often necessary to discount (sometimes heavily) inventories in order to sell them quickly.

31. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: ACP = AR/(Annual Sales/365), so originally AR = ACP × (Annual Sales/365) = 32 × ($125,000/365) = $10,958.90 New AR = 30 × ($140,000/365) = $11,506.85 So, the change in NWC = $10,958.90 – $11,506.85 = –$547.95

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32. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: Before: OC = ADRI + ACP = 98 + 90 = 188 days CCC = OC – ADRP = 188 – 58 = 130 days After: OC = 82 + 90 = 172 days CCC = 172 – 48 = 124 days The operating cycle will decrease by 16 days and the cash cycle will decrease by 6 days.

33. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution:

ADRI = 365/IT = 365/6.25 = 58.4 days ACP = 365/RT = 365/8 = 45.6 days OC = ADRI + ACP = 58.4 + 45.6 = 104.0 days CCC = OC – ADRP = 104.0 – 40.0 = 64.0 days So, on average this firm must finance 64.0 days of purchases.

34. Section: 23.4 Working Capital Management Learning Objective: 23.4 Level of difficulty: Intermediate CPA: Finance Solution: a. CR = CA/CL = ($250+$150+$300)/($250+$100) = $700/$350 = 2.00 QR = (CA – Invent) / CL = ($700–$300)/$350 = $400/$350 = 1.14 NWC = CA – CL = $700 – $350 = $350 b. IT = Rev/Invent = $2,000/$300 = 6.67 RT = Rev/AR = $2,000/$150 = 13.33 PT = Rev/AP = $2,000/$250 = 8.00 c. ADRI = 365/IT = 365/6.67 = 54.7 days ACP = 365/RT = 365/13.33 = 27.4 days ADRP = 365/PT = 365/8.00 = 45.6 days d. OC = ADRI + ACP = 54.7 + 27.4 = 82.1 days CCC = OC – ADRP = 82.1 – 45.6 = 36.5 days

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Challenging 35. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Challenging CPA: Finance Solution: October $43,000 20,000 63,000

November $15,000 30,000 45,000

December $ 0 85,000 85,000

40,000

40,000

40,000

8,000

12,000

34,000

Closing cash balance Line of credit

15,000 0

– 7,000 7,000

11,000 – 7,000

New opening cash balance

$15,000

$

0

$4,000

Line of credit used (paid)

0

7,000

(7,000)

Opening cash balance Total cash receipts Cash on hand Less: Operating expenses – fixed – variable

36. Section: 23.2 An Integrated Approach to Net Working Capital (NWC) Management Learning Objective: 23.2 Level of difficulty: Challenging CPA: Finance Solution: Cash Inflows: Sales Current month sales Previous month’s sales Sales from two months ago Total cash inflows Cash Outflows: Purchases Two months ago Total purchase outflows Wages and miscellaneous Other cash outflows

January

February

March

April

50,000 25,000

51,000 25,000

52,500 25,500

55,000 26,250

25,000

25,000

25,000

25,500

100,000

101,000

103,000

106,750

60,000 60,000

60,000 60,000

60,000 60,000

70,000 70,000

20,000

30,000

35,000

25,000

*40,000

0

**20,000

0

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Total cash outflows Net cash flow

120,000 –20,000

90,000 11,000

115,000 –12,000

95,000 11,750

Beginning cash Ending cash Surplus/deficit *Dividend Payment **Equipment Purchase

30,000 10,000 0

10,000 21,000 11,000

21,000 9,000 –1,000

9,000 20,750 10,750

37. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.3 Level of difficulty: Challenging CPA: Finance Solution: a. With the data α = 0.60; b = 0.80; β = 0.4 and γ = 2.0.

Plugging these values into Equation 23.4 we get: 1− b 1 − 0.80 g= = = 0.1515 = 15.15% b(  +  ) −  0.80(0.4 + 2) − 0.60 b. With the new policy, γ = 3 and α = 0.4, so the growth rate decreases to: 1 − 0.80 g= = 0.0862 = 8.62% 0.80(0.4 + 3.0) − 0.4 38. Section: 23.3 Analyzing Cash Inflows and Outflows Learning Objective: 23.3 Level of difficulty: Challenging CPA: Finance Solution: a. With the data α = 0.75; b = 0.60; β = 0.5 and γ = 4.0 Plugging these values into Equation 23.4 we get:

g=

1− b 1 − 0.6 = = 0.2051 = 20.51% b(  +  ) −  0.6(0.5 + 4) − 0.75

b. With the new policy, γ = 3 and b = 0.55, so the growth rate increases to:

g=

1 − 0.55 = 0.3830 = 38.30% 0.55(0.5 + 3) − 0.75

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CPA: Finance Solution: CCC = OC – ADRP = ADRI + ACP – ADRP CCC = 365/15 + 365/10 – 365/5 = 24.3 + 36.5 – 73 = 60.8 – 73 = –12.2 days A negative cash conversion cycle can be achieved, for example, when a company has an efficient inventory policy and collects from customers before it pays its suppliers. These are extremely advantageous business conditions, and usually require some sort of market power over either customers or suppliers or both in order to sustain them in the long run. Notice that, in this case, MB Corporation turns its receivables over twice as fast as it turns its payables over.

–

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Answers to Concept Review Questions 23.2 An Integrated Approach to Net Working Capital (NWC) Management Concept Review Questions 1. What is the difference between profit and cash flow from operations?

The basic difference is that profits are not cash and a firm can only pay its bills with cash.

In accounting items, depreciation and amortization are non-cash charges and need to be added to net income to get cash flow. Moreover, sales on credit are income, but not cash. Also, unsold goods are inventories in accounting, but they require a cash outflow. The increase in receivables and inventory, net of payables, are the most important net working capital items.

2. Why should all firms prepare a cash budget?

The important thing about the cash budget is that it forecasts cash inflows and outflows over a forecast horizon and their cumulative impact on the firm’s cash balances. Typically, firms prepare a cash budget for at least the upcoming year, on at least a monthly (and sometimes even a weekly or daily) basis. These cash budgets are important planning tools for the firm. For example, they indicate when and for how long a firm can expect to have excess cash balances that can be invested in marketable securities. Cash budgets also show when and for how long a firm may require some additional borrowing to cover any cash shortfalls, so it can arrange for some short-term borrowing.

23.3 Analyzing Cash Inflows and Outflows Concept Review Questions 1. What is the relationship between the break-even sales growth rate and a firm’s collection policy, payables policy, and inventory policy?

The relationship is given in Equation 23.4. g = (1–b)/((b*(beta + gamma) – alpha), where g is the break-even sales growth rate, b is the percentage of cost of goods sold, alpha is the percentage of sales collected this month, beta is the proportion of this month’s production costs that are paid this month, gamma is the percentage of the firm’s monthly sales tied up in inventory, and 1/gamma is the monthly inventory turnover ratio.

2. Why does cash flow from operations increase if the firm speeds up the collection of receivables, delays paying its bills, or increases its inventory turnover ratio?

The cash change formula is given in Equation 23.3. That is change in cash/previous sales = (1 – b) + [alpha–b(beta + gamma)]*g, where g is the sales growth rate, b is the percentage of cost of goods sold, alpha is the percentage of sales collected this month, beta is the proportion of this month’s production costs that are paid this month, gamma is the percentage of the firm’s monthly sales tied up in inventory, and 1/gamma is the monthly inventory turnover ratio. As seen in this equation, cash increases with the percentage of sales collected this month (alpha), decreases in the percentage of this month’s production cost that is paid this month (beta), and increases in the inventory turnover ratio (1/gamma).

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23.4 Working Capital Management in Practice Concept Review Questions 1. What are the limitations of the current ratio and the quick ratio as measures of working capital management?

A high current ratio or a high quick ratio does not necessarily mean that the firm is practicing effective working capital management. In fact, it could indicate quite the opposite—that is, perhaps the firm is being too conservative and maintaining excessive liquidity, or perhaps it has high ratios because its credit policy is too lenient, which has left it with high levels of receivables outstanding.

2. What are the operating cycle and the cash conversion cycle, and how are they related to working capital policy?

The operating cycle (OC) measures the average number of days a firm holds items in inventory before they are sold, plus the average time it takes to collect on sales. Large OC figures indicate that a firm has a long operating cycle that requires large average investments in receivables or inventory. The cash conversion cycle (CCC) represents the average number of days of sales that a firm must finance outside the use of trade credit. As such, it is an important measure that firms and their creditors consider when arranging financing.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

MMXX ii F1

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Chapter 24: Working Capital Management – Current Assets and Current Liabilities Multiple Choice Questions 1. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Basic CPA: Finance Solution: D 2. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Intermediate CPA: Finance Solution: D Near-cash is virtually default free, i.e., little credit risk.

3. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Intermediate CPA: Finance Solution: A Historically, mailing time is the longest.

4. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Intermediate CPA: Finance Solution: A

 n − day financing cost   k = 1 + Purchase price  

365

n

20   − 1 = 1 +   980 

365

45−30

− 1 = 63.49%

5. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: D The accounts receivable collection cycle suggests that on average they are collected within 37 days. With a payment due date of 30 days, this implies that the average customer is 7 days late.

6. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: D

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Delaying payment, all else equal, would decrease the cost of credit, i.e., of not paying on time, rather than increase it.

7. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: D Sometimes a factor will purchase a firm’s receivables.

8. Section: 24.3 Inventory Learning Objective: 24.3 Level of difficulty: Basic CPA: Finance Solution: D 9. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Basic CPA: Finance Solution: D The cost of operating loans is relatively low.

10. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: C k= (1+0.06/12)12 –1 = 6.17% 11. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Basic CPA: Finance Solution: D Only large firms with top-notch credit ratings can issue CP.

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Practice Problems Basic 12. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: Three major sources of float are: • The time it takes the cheque to reach the firm after it is mailed by the customer (longest).

• The time it takes the receiving firm to process the cheque and deposit it in their account after the cheque is received.

• The time it takes the cheque to clear through the banking system so that the funds are available to the firm.

Common methods include post-dated cheques, debit cards, pre-authorized payment, electronic funds transfer (EFT) and electronic data interchange (EDI), and concentrated banking arrangement.

13. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: A factor acts as an independent credit department outside of a firm by checking the credit of new customers, authorizing credit, handling collections, and bookkeeping. A factor may also purchase accounts receivable from its clients at a discount. However, we should always evaluate the cost and benefits of hiring a factor. A similar example is a pension buyout in the UK, where insurance firms purchase pension liabilities from various pension plans.

14. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: The purpose of credit analysis is to assess the creditworthiness of potential customers and the corresponding risk of late payments or default. Credit analysis consists of: • Gathering information about the potential customer.

• Analysis of this information to derive a credit decision that establishes the terms of payment and the maximum amount of trade credit to be granted.

15. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Basic CPA: Finance Solution: 1. The applicant’s liquidity to determine the ability to meet short-term obligations.

2. The applicant’s attitude and character to determine the willingness to pay.

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16. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Basic CPA: Finance Solution: Discount = $25 million – $24.5 million = $0.5 million or $500,000 Market price = $24.5 million Discount 365 $500,000 365 × = × = 4.14% Market price Days to maturity $24,500,000 180 Intermediate 17. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Intermediate CPA: Finance Solution: The transactions motive refers to the cash required for a firm’s normal operations. Manufacturing firms keep cash to pay invoices. Pension plans keep cash on hand to pay monthly pensions and refunds. Retailers keep actual cash to run their business.

18. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Intermediate CPA: Finance Solution: An optimal cash balance means a balance between the risks of illiquidity and expected return that is associated with maintaining cash. It differs across firms. Firms that do not need a large amount of cash on hand have lower risks of not meeting their liquidity needs and those firms keep a lower level of cash compared to the firms that need a large amount of cash on hand to handle normal business.

19. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Intermediate CPA: Finance Solution: Four main motives for firms to hold cash are: Transaction motive – to support normal operations Precautionary motive – to support unexpected cash outlays Finance motive – to support any major outlays Speculative motive – to take advantage of “bargains” 20. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Intermediate Solutions Manual 4 Chapter 24 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited

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CPA: Finance Solution: The ability to delay payments to suppliers based on credit terms offered is essentially a form of borrowing. The cost of this borrowing depends on the level of discounts offered, if any. The decision to utilize trade credit should depend on the implied costs of borrowing.

21. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Intermediate CPA: Finance Solution: Firms that sell or manufacture high-cost equipment occasionally establish wholly owned financing subsidiaries known as captive finance companies. The purpose of captive finance companies is to provide customers with term financing in the purchase of the company’s products.

22. Section: 24.3 Inventory Learning Objective: 24.3 Level of difficulty: Intermediate CPA: Finance Solution: Advantages of carrying inventories include: • Larger purchases of inventory allow for bulk purchases at lower prices.

• Higher in-process inventory can permit more efficient production.

• Larger finished goods inventory result in lower stock-outs and improved customer service.

• Firms that face seasonal demands often carry seasonal inventories in order to level out production, utilizing fixed assets and labour more efficiently.

23. Section: 24.3 Inventory Learning Objective: 24.3 Level of difficulty: Intermediate CPA: Finance Solution: Disadvantages of carrying inventories include: • Expense of warehousing and handling • Insurance costs • Obsolescence • Spoilage • Financing costs 24. Section: 24.3 Inventory Learning Objective: 24.3 Level of difficulty: Intermediate CPA: Finance Solution: The four inventory management approaches are: Solutions Manual 5 Chapter 24 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited

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1. The ABC Approach: inventory is divided into several categories. The higher the priority of the inventory item, the more time and effort are devoted to its management.

2. The Economic Order Quantity (EOQ) Model: an optimal inventory level is assumed when total shortage costs = carrying costs.

3. Materials Requirement Planning (MRP): a detailed computerized system that orders inventory in conjunction with production schedules.

4. Just-in-Time (JIT) Inventory Systems: It fine tunes the receipt of raw materials so that they arrive exactly when they are required in the production process.

25. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: Unlike commercial paper, bankers’ acceptances are “stamped” by a bank as accepted in return for a fee that is usually 0.25 percent to 1.00 percent of the face value of the bankers’ acceptance.

The fee paid to the bank obtains its guarantee that the payments associated with the stamped security will be made to the holder. In this way, bankers’ acceptances have the credit risk of the financial institution that stamped them instead of the credit risk of the company that is borrowing funds. Commercial paper, by contrast, carries the credit risk of the issuing company.

26. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: Discount = $100 million – $99 million = $1 million Standby fee = 0.0015 × $100 million = $150,000 Total financing cost = $1 million + $150,000 = $1,150,000 365⁄ 𝑛

𝑛 − 𝑑ay financing cost ) 𝑘 = (1 + Purchase price

365⁄ 90

$1,150,000 − 1 = (1 + ) $99,000,000

− 1 = 4.80%

27. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: a.

Foregone discount = $800 x 2% = $16 True price = $800 – $16 = $784 k = (1 + $16/$784)365/(60-15) −1 = 17.81%

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b. Forgoing discount of another supplier = $820 – $784 = $36 $36 365/(90−15) 𝑘 = (1 + ) − 1 = 24.42% $784 You should take advantage of credit terms of 2/15 net 60 and finance your purchase by using loans at 10%.

28. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: Special purpose vehicles (SPVs) are conduits for packaging portfolios of receivables and selling them to investors in the money market. The advantage of using SPVs is the credit risk of the seller of receivables or loans is not directly involved. Over-collateralization, issuing subordinated debt to absorb further defaults on termination of SPVs, and issuing different classes of securities to let the prepayment risks be allocated to different securities are all forms of credit enhancement.

29. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: Loan amount = $900,000×90% = $810,000 Commission = 0.005×$900,000 = $4,500 Interest = $810,000 × 0.06 × (45/365) = $5,991.78 Net cost = $4,500 + $5,991.78 – $8,000 = $2,491.78 $2,491.78 The effective annual cost = 𝑘 = (1 + $810,000 )365/45 − 1 = 2.52% 30. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Intermediate CPA: Finance Solution: Discount = $5,000,000 – $4,850,000 = $150,000 Standby fee = 0.001 × $5,000,000 = $5,000 Total financing cost = $150,000 + $5,000 = $155,000 $155,000 365 𝑘 = (1 + ) 90 − 1 = 13.61% $4,850,000

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31. Sections: 24.2 Accounts Receivable and 24.4 Short-Term Financing Considerations Learning Objectives: 24.2 and 24.4 Level of difficulty: Intermediate CPA: Finance Solution: $1,000×0.01

365

$1,100×0.03

365

A: 𝑘 = (1 + $1,000×(1−0.01))30−10 − 1 = 20.13% B: 𝑘 = (1 + $1,100×(1−0.03))60−10 − 1 = 24.90%

Supplier A has a lower effective annual cost.

Challenging 32. Section: 24.1 Cash and Marketable Securities Learning Objective: 24.1 Level of difficulty: Challenging CPA: Finance Solution: Receivables decrease by 2 days x $100,000 = $200,000 Savings = annual cost of financing $200,000 in receivables = $200,000 x 0.02 = $4,000 Cost = $100 x 12 =$1,200 Therefore, the company should adopt the arrangement because it will save $4,000 – $1,200 = $2,800 per year.

33. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Challenging CPA: Finance Solution: CF0 = 30 days × sales per day = 30 × [($50 + 2) × (10,000 + 1,000) /365 days] = 30 days × $1,567.12 /day = $47,013.70 Future CFs = 1,000 × ($52 – $25) + 10,000 × $2 – $3,000 = $27,000 + $20,000 – $3,000 = $44,000 k = 5% (1 – 0.20) = 4% PV (Future CFs) = [$44,000 × (1 – 0.20)]/0.04 = $880,000 NPV = PV (Future CFs) – CF0 = $880,000 – $ 47,013.70 = +$832,986.30 Since the NPV of the cash flow is positive, the firm should begin extending credit under the terms described above.

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34. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Challenging CPA: Finance Solution: The new average collection period (ACP) = [0.80 × 10 days + 0.20 × 30 days] = 14 days The old ACP = 30 days Change in receivables = (14 × $53 × 11,000/365) – (30 × $52 × 11,000/365) = $22,361.64 – $47,013.70 = –$24,652.06 PV (Future CFs) = [11,000 × ($53 – $52) – (0.80 × 11,000) × (0.03 × $53 per unit)] × (1 – 0.40)/[0.05 (1 – 0.4)] = –$59,840 NPV = PV (Future CFs) – CF0 = –$59,840+ $24,652.06 = –$35,187.94 Since the NPV of the cash flow is negative, the firm should not offer the discount under consideration.

35. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Challenging CPA: Finance Solution: A/R = ACP × daily credit sales = 60 × $75,000 = $4,500,000 Loan amount = 0.9 × $4,500,000 = $4,050,000 Commission = 0.015 × $4,500,000 = $67,500 Interest = 0.10 × 60/365 × $4,050,000 = $66,575.34 Savings = $3,000 + 0.01 × $500,000 = $8,000 Net cost = Interest – Savings + Commission = $66,575.34 – $8,000 + $67,500 = $126,075.34 $126,075.34 365 𝑘 = (1 + ) 60 − 1 = 20.50% $4,050,000 36. Section: 24.2 Accounts Receivable Learning Objective: 24.2 Level of difficulty: Challenging CPA: Finance Solution: CF0 = A/R(new) – A/R(old) = [20 days × ($45 × 10,000)/365] – [25 days × ($45 × 12,000)/365] = –$12,329 Incremental before-tax CFs = (–2,000)($45 – $37) + $1,000 = –$15,000 PV (future CFs) = –$15,000(1 – 0.3)/0.05 = –$210,000 NPV = PV (future CFs) – CF0 = –$210,000 + $12,329 = –$197,671 < 0 Therefore the firm should not switch to the new policy.

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Introduction to Corporate Finance, Fifth Edition

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37. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Challenging CPA: Finance Solution:

F − P 365  P 270 10M − P 270 = 5%  P 365 P = $9,643,328.93

5% =

Discount = $10,000,000 – $9,643,328.93 = $356,671.07 Stamping fee = $10,000,000×0.006 = $60,000 Total financing cost = $356,671.07 + $60,000 = $416,671.07 $416,671.07 365 𝑘 = (1 + )270 − 1 = 5.89% $9,643,328.93 38. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Challenging CPA: Finance Solution: Effective monthly rate = 0.09/12 = 0.0075 Interest (months 1 to 6) = $100,000 × 75% × 0.0075 × 6 = $3,375 Interest (months 7 to 12) = $100,000 × 60% × 0.0075 × 6 = $2,700 Total interest = $3,375 + $2,700 = $6,075 Commitment fee (months 1 to 6) = $100,000 × 25% × 0.0025 × 6 = $375 Commitment fee (months 1 to 6) = $100,000 × 40% × 0.0025 ×6 = $600 Total commitment fee = $375 + $600 = $975 Total cost = $6,075 + $975 = $7,050 Avg. net financing = [(1/2) $75,000 + (1/2) $60,000] = $67,500 $7,050 1 𝑘 = (1 + ) − 1 = 10.44% $67,500 39. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Challenging CPA: Finance Solution: Effective monthly rate = 0.06/12 = 0.0050 or 0.50% Total interest = $1,200,000×0.0050×4 + $500,000×0.0050×8 = $24,000 + $20,000 = $44,000 Solutions Manual 10 Chapter 24 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited

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Total commitment fees = ($2,000,000–$1,200,000) ×0.008×4 + ($2,000,000–$500,000)×0.008×8 = $121,600 Avg. net financing = (4/12) × $1,200,000 + (8/12) × $500,000 = $733,333.33 Effective annual cost = ($44,000 + $121,600)/$733,333.33 = 22.58% 40. Section: 24.4 Short-Term Financing Considerations Learning Objective: 24.4 Level of difficulty: Challenging CPA: Finance Solution: For bankers’ acceptances: $10,000,000 − 𝑃 365 × 𝑃 180 𝑃 = $9,735,929.58 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = $10,000,000 − $9,735,929.58 = $264,070.42 𝑆𝑡𝑎𝑚𝑝𝑖𝑛𝑔 𝑓𝑒𝑒 = 0.004 × $10,000,000 = $40,000 ($264,070.42 + $40,000) 𝑘=[ + 1]365/180 − 1 = 6.43% $9,735,929.58 5.5% =

For commercial paper: Discount = $10,000,000 – $9,748,000 = $252,000 Standby fee = 0.004 x $10,000,000 = $40,000 365 $252,000 + $40,000 𝑘=( + 1)180 − 1 = 6.17% $9,748,000

The 180-day bankers’ acceptance incurs a higher effective annual cost.

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Introduction to Corporate Finance, Fifth Edition

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Answers to Concept Review Questions 24.1 Cash and Marketable Securities Concept Review Questions 1. Why do firms hold cash?

The reasons include transaction motive, precautionary motive, finance motive, and speculative motive.

2. What is float and why is it important to the firm?

Float is the time that elapses between the time the paying firm initiates payment, for example, mails the cheque, and when the funds are available for use by the receiving firm. During this float period, the receiving firm does not have the funds available for use.

24.2 Accounts Receivable Concept Review Questions 1. Why is trade credit different from bank credit?

First, the firm’s cost is the cost of goods sold, rather than the amount that it charges for the widgets, because it has to factor a profit margin into the calculation. If the customer does not pay, the firm loses the cost of goods sold. If the customer does pay, it becomes an established customer that may make further purchases, generating further profit margins for the firm. The fact that the firm thinks in terms of future profit margins from developing a good customer and loses only its production cost in the case of default means that trade credit is granted to customers who could not secure credit from a bank on the same terms.

2. What are the four C’s of credit?

The four C’s are capacity, character, collateral, and conditions. All four are interrelated.

3. What does 2/10 net 30 mean, and what is the implicit interest cost?

Credit terms of 2/10 net 30 offer customers a 2 percent discount if they pay the full amount due by day 10, with the full amount being due by day 30 if the discount is not taken. The implicit interest cost is k = (1+2/98)365/20 - 1= 44.59% annually.

4. What is an aged accounts receivable report?

An aged accounts receivable report categorizes the balances in receivables according to how long they have been outstanding.

24.3 Inventory Concept Review Questions 1. Identify the costs and benefits of holding inventory.

One reason firms hold large amounts of inventory is that they may have received discounts on large-volume purchases. However, the more important benefits of holding inventory are that holding sufficient levels of raw materials minimizes disruptions in the production process, while

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maintaining adequate levels of finished goods on hand helps minimize lost sales (and lost customer goodwill) because of shortages.

The benefits of holding inventory do not come without significant costs. Aside from the obvious cost of financing the funds tied up in inventory, a number of other costs are important, including storage, handling, insurance, spoilage, and the risk of obsolescence.

2. What are the drawbacks to using the turnover ratio to measure inventory policy?

First, it does not measure shortage costs or explicitly measure financing costs, and so on. Second, turnover ratios cannot be compared across companies that use different methods of accounting for inventory (i.e., LIFO, FIFO, average cost), because the reported inventory levels will differ substantially. Finally, inventory turnover says nothing about the breakdown of inventory in terms of raw materials, work-in-process inventory, and finished goods, which can make a big difference in establishing the market value of inventory.

24.4 Short-Term Financing Considerations Concept Review Questions 1. What is the cost of 3/15 net 60 trade credit?

The cost is k = (1 + 3/97)365/45 – 1 = 28.03% annually.

2. What is the difference between a bank operating line of credit and a traditional loan?

The difference is that a bank operating line of credit is generally set up so that the firm makes “interest only” payments. The amount of borrowing can be reduced at the firm’s discretion, and many companies will have the bank automatically “revolve” the loan for them (for a fee). This involves paying down the amount of the loan whenever there is sufficient cash in the current account, or increasing the borrowing level when there is insufficient cash. Having the bank revolve the loan therefore reduces unnecessary interest costs, because the loan will be paid down whenever the firm has sufficient funds available.

3. What additional services does a factor provide over a bank?

It checks the credit of new customers, authorizes credit, handles collections and bookkeeping, and sometimes will purchase a firm’s receivables (at a discount). In practice, various arrangements are possible, with factors providing various combinations of these services. Factors provide the ultimate in convenience; however, there is a cost, and the costs are typically quite high.

4. What is the difference between a BA and commercial paper?

BAs differ from CP because they are “stamped” by a bank as accepted in return for a fee that is usually 0.25 percent to 1 percent of the face value of the BAs. In return, the bank guarantees the payments associated with these instruments. Therefore, BAs carry the credit risk of the bank that stamps them and not the company that borrows by using them. Most of the firms that issue BAs are large, well-known firms with excellent credit ratings. However, because of the bank guarantee, some firms that are not able to issue CP may be able to borrow by using BAs— provided they can find a bank that is willing to guarantee their payments.

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5. Why do securitizations require credit enhancements?

If a portfolio of receivables or loans is simply sold to investors, in all likelihood the credit quality would not be high enough to get an investment-grade rating. As a result, credit enhancements have to be made, such as requiring collateral, insurance, or other agreements, to reduce credit risk.

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The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.

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Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 01 Shuffle: No

Questions type: Multiple Choice 1. Finance is essentially the management of an entity’s: a) income statement. b) balance sheet. c) cash flow statement. d) cash budget. e) net profit.

Answer: b

3. The largest item, in terms of dollar value, on the national balance sheet of Canadian households in 2018 was a) Houses b) Land c) Debt d) Savings and deposits e) Pensions and insurance Answer: b

4. Institutions that transform the securities they issue and invest in are called _______. a) Underwriters b) Investment dealers c) Financial intermediaries d) Market intermediaries e) Corporations Answer: c

5. The financial system brings lenders and borrowers together in a process called _______. a) brokering b) acquisition

c) loan remediation d) intermediation e) underwriting Answer: d

6. The transactions carried out by market intermediaries are often called ________. a) agency transactions b) direct transactions c) principal transactions d) underwriting transactions e) indirect transactions Answer: a

7. The three most important types of financial intermediaries in Canada are: a) pension funds, mutual funds, and hedge funds b) chartered banks, mutual funds, and pension funds c) mutual funds, insurance companies and chartered banks d) pension funds, chartered banks and insurance companies e) income funds, chartered banks and mutual funds Answer: d

8. In Canada, the largest borrower is: a) Canadian businesses b) Government of Canada c) Province of Ontario d) Crown Corporations e) International Conglomerates Answer: a

9. The market in which new securities are issued by borrowers in return for cash from investors is called the __________. a) debt market b) equity market c) primary market

d) secondary market e) money market Answer: c

10. Money market instruments trade in the __________. a) primary market b) over-the-counter markets c) auction markets d) stock markets e) futures market Answer: b

11. In Canada, financial derivatives are traded on the ________. a) Toronto Stock Exchange b) Vancouver Stock Exchange c) TSX Venture Exchange d) Alberta Stock Exchange e) Montreal Stock Exchange Answer: e

12. In terms of market value, the Toronto Stock Exchange (TSX) was the ________ largest in the world in 2018. a) third b) sixth c) ninth d) eleventh Answer: d

14. When we multiply the market share price by the number of shares outstanding, we get ______________. a) market price b) total assets c) total owners’ equity d) market capitalization

Answer: d

15. Why were Canadian banks less affected by the credit crunch crisis of 2008 than banks in other countries? a) Canadian banks had better financial backings. b) Canadian banks did not invest as heavily in U.S. securities. c) Canadian banks performed due diligence when arranging mortgage loans. d) Canadian banks were isolated from the credit crunch by the Canadian Mortgage and Housing Corporation Answer: c

Package Title: Clicker Questions Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 02 Shuffle: No

Question type: Multiple Choice

1. Which of the following is NOT a form of business organizations? a) Partnership b) Corporation c) Sole proprietorship d) Mutual fund e) Trust Answer: d

2. When a business owner is liable to the extent of their investment as well as any other assets they own, this is called _____________. a) unlimited partnership b) sole proprietorship c) unlimited liability d) limited liability Answer: c

5. Which type of trust structure is usually set up to invest in the shares and debt obligations of a company? a) Income trust b) Royalty trust c) Mutual fund d) Pension fund e) Both A and B Answer: e

6. Which of the following forms of business organization reduces income tax? a) Partnerships

b) Sole proprietorships c) Income trusts d) Limited partnerships Answer: c

7. Which of the following is NOT an advantage of the corporate form of business organization? a) It offers separation of ownership and control. b) It offers its owners limited liability. c) It has the ability to obtain financing beyond that of a partnership. d) Ownership is easily transferable. e) It has an infinite lifespan.

Answer: a

8. In finance, the primary goal of financial management is to __________________. a) maximize a firm’s net profits. b) minimize a firm’s costs. c) maximize a firm’s market value. d) maximize a firm’s market share. e) satisfies the interests of its stakeholders.

Answer: c

9. The relationship between financial managers and shareholders is an example of a/an ____________ relationship. a) limited liability b) agency c) adversarial d) stakeholder e) legal Answer: b

10. Which of the following is an indirect agency cost? Choose the best answer. a) Cost of auditing a firm’s financial statements. b) Issuance of stock options as part of a firm’s executive compensation. c) The acquisition of a corporate jet as a perk for the CEO.

d) A and B only. e) A, B, and C. Answer: d

11. Shareholders would prefer to use _____________ in investment analyses, whereas managers would choose to use ____________. a) required rate of return; return on debt b) internal rate of return; weighted average cost of capital c) return on equity; return on debt d) market prices; return on investment e) weighted average cost of capital; internal rate of return Answer: e

12. Which of the following will ultimately ensure that shareholder value creation is the objective of a firm’s management? a) Moral hazard b) Market for corporate control c) Managerial compensation d) Effective monitoring e) Government regulations Answer: b

13. The framework for analyzing investment opportunities is called ______________. a) financial management b) corporate structure c) capital budgeting d) capital rationing Answer: c

14. The two key areas in the study of corporate finance are: a) corporate financing and financial engineering b) capital budgeting and asset management c) asset management and corporate financing d) management of daily operations and maximization of share value

e) managerial compensation and stock prices Answer: c

15. Which of the following is NOT a responsibility of a corporate treasurer? a) Ensuring that the firm meets its statutory legal responsibilities with regulatory bodies. b) Ensuring that the firm files the necessary financial statements. c) Ensuring that the firm pays its taxes. d) Ensuring that the firm has adequate internal control systems to reduce or eliminate fraud. e) All of the above.

Answer: e

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Question type: Multiple Choice 2. Which of the following financial statements gives a snapshot of a firm’s financial position at a particular point in time? a) Income Statement b) Balance Sheet c) Statement of Changes in Financial Position d) Statement of Cash Flows e) Cash Budget Answer: b

3. The ease with which an asset can be converted into cash is called its __________. a) value-added b) premium c) liquidity d) discounted value e) convertibility Answer: c

4. Accounting conventions dictate that items in the balance sheet are listed in the order of their a) value. b) discounted value. c) importance to the company’s survival. d) liquidity. e) age.

Answer: d

5. Which of the following is a basic principle of IFRS and/or ASPE? a) Matching principle

b) Going concern c) Period of analysis d) Revenue recognition e) All of the above Answer: e

6. The accounting principle which maintains that revenues must be recognized only when the sale can be verified is called the _____________. a) Matching principle b) Revenue recognition principle c) Going concern principle d) Disclosure principle e) Materiality principle Answer: b

7. The recognition of the use of an asset over time is called ______________. a) discounting b) derivation c) underestimation d) depreciation e) erosion Answer: d

8. Which of the following is a source of cash? a) An increase in deferred taxes b) An increase in inventory c) An increase in machinery d) A decrease in owners’ equity e) A decrease in retained earnings Answer: a

9. Net income plus non-cash expenses such as depreciation is often referred to as ______________. a) free cash flow

b) traditional cash flow c) conventional cash flow d) nominal cash flow e) real cash flow Answer: b

10. How are cash flow statements calculated? a) By subtracting non-cash items from net income. b) By adding up all cash inflows and then subtracting all cash outflows. c) By taking out depreciation from the Income Statement. d) By analyzing changes in the Balance Sheet. e) A and D are both correct methods of calculating cash flow statements.

Answer: e

11. Given the following information, calculate the net income of Possum Ltd. Cost of Goods sold = 65% of Sales Depreciation = $21,000 Interest expense = $12,000 Sales = $120,000 Tax rate = 35% a) $3,150 b) $5,850 c) $9,000 d) $19,500 e) $56,550 Answer: b 12. Given the following information, what is the total shareholders’ equity of Possum Ltd.?

Accounts payable = $5,600 Accounts receivable = $16,000 Accumulated depreciation = $41,000 Cash and cash equivalents = $10,000 Capital assets at cost = $100,000 Inventory = $35,000 Long-term debt, net of current portion = $50,000 Retained earnings = $7,000 Current portion of long-term debt = $7,400

a) $50,000 b) $57,000 c) $57,400 d) $91,000 e) $100,000 Answer: a

13. Very Berry Inc. purchased a berry picking machine for $1,000,000 exactly five years ago.

This machine has a CCA rate of 30%, and the half-year rule applies. What is the UCC balance on this asset today, assuming that this is the only asset in the pool? a) $850,000 b) $595,000 c) $291,550 d) $204,085 e) $142,860 Answer: d

14. When the selling price of equipment is greater than its original cost, this will result in a a) CCA recapture b) Capital gain c) Capital loss d) Terminal loss e) Terminal gain Answer: b

15. Very Berry Inc. purchased a berry picking machine for $1,000,000 exactly three years ago.

This machine has a CCA rate of 30%, and the half-year rule applies. The company has just sold the equipment for $500,000. What is the tax consequence of this asset sale, assuming that this is the only asset in the pool? a) A taxable capital gain of $83,500. b) A taxable capital gain of $41,750. c) A tax deductible terminal loss of $95,000. d) A taxable recapture of $83,500. e) There are no tax consequences.

Answer: d

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Question type: Multiple Choice 1. What is the main purpose behind the harmonization of accounting standards? a) For ease of regulations and monitoring by government. b) For taxation purposes. c) For ease of comparisons between financial statements of companies. d) Because it looks good to be uniform. e) For ease of obtaining loans from banks.

Answer: c 2. Lex L. Bones Company has total assets of $250,000, total shareholders’ equity of $150,000, total long-term debt of $50,000, net income of $37,000, and sales revenues of $300,000. What is its return on equity? a) 12.33% b) 14.80% c) 18.50% d) 24.67% e) 120% Answer: d 3. The DuPont system measures a firm’s performance on a) Financial leverage and efficiency b) Efficiency and productivity c) Productivity, profitability and efficiency d) Profitability, efficiency and leverage e) Financial leverage, productivity and efficiency Answer: e

4. Invested capital is a) Total interest-bearing debt plus shareholders’ equity

b) Total shareholders’ equity c) Total assets less current assets d) Total liabilities plus total shareholders’ equity e) Total long-term debt plus total notes payable Answer: a

5. XYZ Ltd. has sales revenues of $100,000, variable costs of $60,000, fixed operating costs of $20,000, and interest expense of $10,000. The company is subject to corporate tax rate of 40%.

What will happen to net income if the company’s sales revenues were to increase by 10%? a) Decrease by 10% b) Increase by 10% c) Decrease by 20% d) Increase by 30% e) Increase by 40% Answer: e

6. Calculate the degree of total leverage for a company with the following information: Sales = $100,000 Variable costs = $60,000 Fixed operating costs = $20,000 Interest expense = $10,000 Tax rate = 40% a) 2 b) 3 c) 4 d) 5 e) 6 Answer: c

7. ABC Inc. has a degree of total leverage of 3. What does this mean? a) Net income will increase by 3% for every $1 increase in revenue. b) Net income will increase by 3% for every 1% increase in revenue. c) Taxable earnings will increase by 3% for every 1% increase in revenue. d) Taxable earnings will increase by $3 for every $1 increase in sales. e) EBIT will increase by 3% for every 1% increase in sales.

Answer: c

8. Which of the following is NOT considered a period cost? a) Advertising expenses b) Sales and general administrative costs c) Research and development costs d) Raw material costs e) None of the above Answer: d

9. A supplier who is thinking of granting credit to a company will be most interested in that company’s a) Liquidity ratios b) Productivity ratios c) Efficiency ratios d) Valuation ratios Answer: a

10. Inventory is excluded when calculating which of the following ratios? a) Current b) Working capital c) Quick d) Accounts receivable Answer: c

11. Accruals and accounts payables that arise in the normal course of business are sometimes called a) Current portion of long-term debt b) Short-term debt c) Net working capital d) Current assets e) Spontaneous liabilities Answer: e

12. Which of the following items is normally not adjusted for sales growth when producing the initial forecast using the percentage of sales method? a) Accounts payable b) Accounts receivable c) Net fixed assets d) Long-term debt e) Accruals Answer: d

13. Retained earnings for the year, as a percentage of sales is calculated as a) Contribution margin x Dividend payout b) Net profit margin x (1 – Dividend payout) c) Net profit margin x Dividend payout d) Net profit margin x (1 – Dividend yield) e) Net income x (1 – Dividend yield) Answer: b

14. In the external financing requirements (EFR) formula based on the percentage of sales method (EFR = a x S x g – b x PM x (1 – g) x S), the EFR will increase when sales growth increases as long as which of the following conditions hold? a) a > (b x PM) b) a < (b x PM) c) a > S x g d) g > (b x PM) e) g < (b x PM) Answer: a

15. Given the following information, calculate the sustainable growth rate.

Invested capital = $1,090,000 Sales = $1,000,000 Net income = $99,000 Dividends = $33,000 a) 3.12% b) 6.44% c) 7.66% d) 8.22%

e) 9.99% Answer: b

Package Title: Clicker Questions Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 05 Shuffle: No

Question type: Multiple Choice

1. The ___ is the opportunity cost of money. a) inflation rate b) GDP growth rate c) interest rate d) exchange rate Answer: c

2. When calculating the future value by compounding interest, it is assumed that a) it is better to invest money earlier than later. b) simple interest is no longer used in practice. c) the concept of time value of money applies. d) both principal and accrued interest are reinvested.

Answer: d

3. You just received a bonus of $10,000 from your boss. You decide to invest this money in a 4year investment that will yield a compound interest rate of 6% per year. How much interest will you have earned in total from year 1 to year four? a) $11,910.16 b) $12,624.77 c) $2,624.77 d) $1,910.16 Answer: b

4. Jim Smith just turned 20 today. He wants to retire at age 67 with $2 million. He figures that he can achieve this by investing $X today at an annual interest rate of 9%. How much does Jim have to invest today to achieve his goal? a) $7,384.27

b) $34,832.50 c) $41,384.49 d) $44,444.44 Answer: b

5. Aunt Tee has $100,000 today and she wants to make an investment that will help her purchase a house for $120,000 in five years’ time. What interest rate must this investment yield? a) 2.71% b) 3.71% c) 4.71% d) 5.71% Answer: b

6. With seed money of $10,000 and investment yield of 5%, how long will it take us to accumulate $50,000? a) less than 10 years b) less than 20 years c) between 32 and 33 years d) between 30 and 31 years Answer: c

7. Ms. Lady is currently renting an apartment in Edmonton for $1,500 per month. The rental payments are due at the beginning of each month. If, instead, Ms. Lady moved back into her parent’s house (not that we are advocating this course of action) and put the $1,500 at the beginning of each month into a RRSP account that yields 0.5% per month, how much will Ms. Lady have in 4 years’ time? a) $24,183 b) $81,552.48 c) $91,834 d) $92,752 Answer: b

8. Mr. Guy had borrowed some money from a pay day loan company, which charges an interest rate of 10% per week. Mr. Guy must pay back $1,000 at the end of each week for the next 12 weeks. How much had Mr. Guy originally borrowed?

a) $4,536 b) $5,209 c) $6,814 d) $11,532 Answer: c

9. You just won the jackpot in a lottery. You have a choice of receiving $1,000 per week for 20 years, or receiving $650 every week forever. Which one would you choose, assuming that the market rate is 0.1% per week? a) Indifferent between the two choices because they both yield $1,040,000. b) Choose the $650 perpetuity because it has an infinite value. c) Choose the $650 perpetuity because it has a higher present value. d) Choose the $1,000 per week annuity because it has a higher present value.

Answer: c

10. Calculate the present value of a growing perpetuity of $100 per year with a market interest rate of 15% and a growth rate of 8%. Assume that the cash flow stream starts at the end of the year. a) $667 b) $700 c) $1,250 d) $1,429 Answer: d

11. An investment has an effective annual return of 15.67%. What is the effective return on this investment over a six-month period? a) 6.31% b) 7.55% c) 7.84% d) 5.10% Answer: b

12. Your local bank is advertising a low, low annual mortgage rate of 5.5%. Which of the following conditions must apply for the effective annual rate to be 5.5%?

a) Interest is compounded annually. b) Interest is compounded monthly. c) Interest is compounded the same number of times as the number of payments per year. d) The annual percentage rate is also 5.5%.

Answer: a

13. Mr. Brown has just obtained a 30-year mortgage of $350,000 from his bank. The quoted rate on this mortgage is 7.5% compounded semi-annually. Mr. Brown is required to make a mortgage payment at the end of each month. What amount must Mr. Brown pay each month? a) $3,072.22 b) $2,419.85 c) $2,447.25 d) $2,250.00 Answer: b

14. Mr. Pink has just obtained a 5-year loan of $3,500 from his bank. The quoted rate on this loan is 8.5% compounded quarterly. Mr. Pink is required to make a loan payment at the end of each year. What are the interest payment and principal repayment in the third year? a) $145.56; $699.69 b) $192.82; $695.36 c) $199.50; $695.07 d) $201.07; $695.00 Answer: c

15. The amount of periodic payments on mortgage loans depends on the a) amortization period. b) mortgage term. c) effective annual rate. d) a and c.

Answer: d

Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 06 Shuffle: No

Question type: Multiple Choice

1. Debt instruments with maturities of between one to seven years are called __________. a) bills b) notes c) bonds d) consols e) loans Answer: b

2. Debt instruments that are secured by real assets are often called ______________. a) coupon bonds b) debentures c) collateral trust bonds d) mortgage bonds e) protected covenants Answer: d

3. The amount paid at maturity for a traditional bond is called its ______________. a) collateral b) present value c) protective covenant d) indenture e) par value Answer: e

4. Bonds which give the issuer the right to buy them back at a predetermined price are called __________ bonds. a) callable

b) retractable c) coupon d) extendible e) convertible Answer: a

5. Bonds which give the investor the right to exchange them for common shares at predetermined prices are called __________bonds. a) callable b) retractable c) coupon d) extendible e) convertible Answer: e

6. We say that a bond is trading at a discount when a) its face value is lower than its market price. b) its market yield is lower than its coupon rate. c) its market yield is higher than its coupon rate. d) its par value is lower than its market price. e) its coupon payments are very low.

Answer: c

7. Most Canadian bonds make coupon payments every _________. a) year b) six months c) four months d) three months e) month Answer: b

8. What is the price of a 10-year bond with a coupon rate of 8% on par value of $1,000 and a market interest rate of 10%? Assume that the bond makes semi-annual coupon payments. a) $498.49

b) $875.38 c) $877.11 d) $1,135.90 e) 1,196.36 Answer: b

9. In general, bond durations will be higher when which of the following conditions occur? a) Market yields are higher. b) Bonds have shorter maturities. c) Bonds have lower coupons. d) The economy is booming. e) None of the above.

Answer: c

10. Today is January 23. A bond with 12-years remaining until maturity pays semi-annual coupons on June 30 and December 31. It has a coupon rate of 9% on par value of $1,000 and the market interest rate of 7%. What is the total cash amount to be paid for this bond? a) $855.05 b) $860.72 c) $1154.91 d) $1160.58 e) $1166.26 Answer: e

11. XYZ Ltd. has just issued an 8-year bond with a coupon rate of 6%, face value of $1,000, for a price of $1,050. The bond will make coupon payments twice a year. What is the yield to maturity on this bond? a) 2.61% b) 3.00% c) 4.62% d) 5.23% e) 6.00% Answer: d

12. XYZ Ltd. has just issued an 8-year callable bond with a coupon rate of 6%, face value of $1,000, for a price of $1,050. The bond will make coupon payments twice a year and is callable in 5 years for a price of $1,100. What is the yield to call on this bond? a) 3.55% b) 5.62% c) 7.10% d) 7.98% e) 9.27% Answer: c

13. What is the current yield on a 12-year bond with a coupon rate of 6% on par value of $1,000 and a market interest rate of 8%? Assume that the bond makes semi-annual coupon payments. a) 3.54% b) 4.05% c) 6.00% d) 7.08% e) 8.08% Answer: d

14. Investors may demand a higher yield on debt issued by a company that has a previous history of non-payment of loans. This is an example of a a) Liquidity premium b) Default risk premium c) Market risk premium d) Issue specific premium e) None of the above Answer: b

15. A Treasury bill has a quoted yield of 5%, a face value of $1,000, and 60 days to maturity.

How would the price of this T-Bill be quoted? a) 9.92 b) 99.18 c) 991.85 d) 1,000 e) 1,050

Answer: b

Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 07 Shuffle: No

Question type: Multiple Choice

1. Which of the following is NOT a correct statement about equity securities? a) No fixed maturity date. b) Dividends are a tax-deductible expense for the issuer. c) Shareholders pay lower taxes on dividends than they would on interest payments. d) Ownership interests in an underlying entity.

Answer: b

2. What is the appropriate discount rate for equity valuation? a) Risk-free rate b) Risk-free rate + risk premium c) Risk-free rate – risk premium d) The discount rate of bond from the same company Answer: b

3. Determine the market price of a $100 par value preferred share that pays annual dividends based on a 5% dividend rate when market rates are 8%. a) $100.00 b) $50.00 c) $62.50 d) $80.00 Answer: c

4. A firm is going to pay a dividend of $1 in the next year. Investors expect dividends to grow at an annual rate of 3% indefinitely, and require an 8% return on the shares. Determine the price of these shares. a) $33.33 b) $20.00 c) $25.00 d) $12.50 Answer: b

5. Gadgets, Inc. just paid a dividend of $1.55. It expects its earnings and dividends to decline at a rate of 3% per year indefinitely. What is the value of the stock today if the required return is 12.5%? a) $9.70 b) $10.00 c) $16.32 d) $16.81 Answer: a

6. The market price of a company’s shares is $72 per share, the estimated dividend at the end of this year (D1) is $3.37, and the estimated long-term growth rate in dividends is 4%. Estimate the implied required rate of return on these shares. a) 8.68% b) 4.68% c) 8.00% d) 6.22% Answer: a

7. A company’s shares are selling for $72 each in the market. The company’s EPS is expected to be $6.06 next year, and the required return on the shares is estimated to be 10%. Estimate the per share present value of growth opportunities (PVGO).

a) $11.40 b) $72.00 c) $60.60 d) $20.00 Answer: a

8. A firm has an ROE of 17.76%, and its dividend payout ratio is 25%. Use this information to determine the firm’s sustainable growth rate. a) 17.76% b) 13.32% c) 25.00% d) 10.00% Answer: b

9. Macaroni, Inc. announced that it would pay the following dividends over the next five years: $0.50, $0.75, $1.50, $3, and $4. Afterwards, dividends will decline at a rate of 3% per year indefinitely. What is the firm's current stock price if the required rate of return is 13%? a) $30.33 b) $24.25 c) $19.24 d) $17.73 Answer: c

10. A company just paid a dividend of $2 per share. An investor estimates that dividend will grow at 15% per year for the next three years and then grow at an annual rate of 4% to infinity.

Determine the market price of this company’s market shares if the required rate of return is 12%. a) $34.47 b) $35.28 c) $8.55 d) $43.73

Answer: a

11. For which companies does Dividend Discount Model work well? a) Firms that do not pay dividends b) Firms that repurchases stocks c) Small firms d) Firms that wish to maintain a stable dividend payout history and are growing at a steady and sustainable rate Answer: d

12. Suppose a firm's Price/Earnings ratio is 16. It has just paid a dividend of $1.80 per share to maintain a 45% payout ratio. What is the firm's current market price if its return on equity is 12%? a) $68.22 b) $67.46 c) $66.54 d) $65.78 Answer: a

13. Assume that a firm expects to maintain a 30% payout ratio. Estimate the firm’s Price/Earnings (PE) ratio assuming its Return on Equity (ROE0 is 12% and investors require a 9% return on their shares. a) 50 b) 5 c) 22.22 d) 5.55 Answer: a

14. The additional multiples used to valuate stocks do not include

a) Price-to-sales ratio b) Price-to-cash flow ratio c) Market value to EBITDA ratio d) Payout ratio Answer: d

15. A firm’s expected earnings are $8 per share. The industry average Price/Earnings (PE) ratio is 11. What is the per share price using the PE multiple? a) $8 b) $11 c) $88 d) Not enough information to answer the question.

Answer: c

Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 08 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true? a) ex post returns are past or historical returns b) ex ante returns are past or historical returns c) mutual funds usually show ex ante return in their main reports d) ex post returns are equal to ex-ante returns.

Answer: a

2. Estimate the income yield, capital gain (or loss) yield, and total return for the following securities over the past year: A $1,000 par value, 7% coupon bond that was purchased one year ago for $900 and is currently selling for $950. Answers are shown as income yield, capital gain (or loss) yield, and total return respectively. a) 7.00%, 5.00%, 12.00% b) 7.00%, 5.56%, 12.56% c) 7.00%, 9.00%, 16.00% d) 7.78%, 5.56%, 13.34% Answer: d

3. Estimate the annual arithmetic mean (AM) return and the geometric mean (GM) return on an investment that is purchased for $100, rises to $120 after one year, and falls to $100 by the end of the second year. Assume the investment provided no income during the two-year period. a) AM=1.67% and GM=0%. b) AM=0% and GM=1.67% c) AM=20% and GM=-16.67% d) AM=20% and GM=0%

Answer: a

4. Estimate the arithmetic average (AM) and geometric mean (GM) for the following returns: 4.3%, -3.2%, 5.6%, and 10.5%. a) AM=4.30%, GM=1.06% b) AM=5.90%, GM=1.44% c) AM=4.30%, GM=1.44% d) AM=5.90%, GM=1.06% Answer: a

5. The probability of high growth state and recession is 0.3 and 0.7 respectively. The return will be 10% in high growth state and -20% in recession. What is the expected return? a) 10% b) -20% c) -5% d) -11% Answer: d

6. The probability of high growth state and recession is 0.3 and 0.7 individually. The return will be 10% in high growth state and -20% in recession. What is the standard deviation? a) 13.75% b) 10.00% c) 12.45% d) -13.75% Answer: a

7. Calculate the standard deviation of returns: -4.3%, -3.2%, 5.6%, and 10.5%. a) 2.15%

b) 1.97% c) 7.11% d) 5.00% Answer: c

8. Which of the following statements is false about risk and returns when securities are combined in a portfolio? a) expected return of a portfolio equals the weighted average of security returns. b) the standard deviation of a portfolio depends on the correlation coefficients. c) the standard deviation of a portfolio is 0 when the correlation coefficient is 0 d) the higher the correlation coefficient, the higher the standard deviation of a portfolio, if other items remain the same.

Answer: c

9. The probability of high growth state and recession is 0.3 and 0.7 respectively. Share A’s return will be 10% in high growth state and -20% in recession. Share B’s return will be 5% in high growth state and -5% in recession. What is the covariance of the two shares? a) 13.75% b) 0.00% c) 12.45% d) -13.75% Answer: b

10. A portfolio has 20% in Share A and 80% in Share B. Share A has standard deviation of 0.1 and Share B has standard deviation of 0.15. The shares are perfectly positively correlated. What is the standard deviation of the portfolio? a) 14% b) 0 c) 12 % d) 10 %

Answer: a

11. A portfolio has 20% in Share A and 80% in Share B. Share A has standard deviation of 0.1 and Share B has standard deviation of 0.15. The shares are perfectly negatively correlated. What is the standard deviation of the portfolio? a) 14% b) 0 c) 12 % d) 10 % Answer: d

12. Share A has standard deviation of 0.1 and Share B has standard deviation of 0.15. They are perfectly negatively correlated. What is the appropriate weight in A and B to reduce all the risk of a portfolio of A and B? a) 1 and 0 b) 0.8 and 0.2 c) 0.6 and 0.4 d) 0.5 and 0.5 Answer: c

13. Which of the following statements is FALSE about the efficient frontier of two risky securities? a) an efficient frontier does not exist. b) it is the set of portfolios that offer the highest expected return for their given level of risk; the only portfolios that rational, risk-averse investors will want to hold. c) the first step in the Markowitz analysis is to determine the expected return-risk combination d) finally, the particular portfolio chosen by an investor will depend on his or her risk preferences.

Answer: a

14. Which of the following combinations of expected return and standard deviation are on the efficiency frontier given all of them are attainable? a) 0.2 and 0.3 b) 0.2 and 0.2 c) 0.1 and 0.2 d) 0.15 and 0.2.

Answer: b

15. Which of the following statements is FALSE about diversification? a) average portfolio risk usually is decreasing in the number of stocks in portfolio. b) market (systematic) risk can be diversified. c) unique (non-systematic) risk can be diversified. d) portfolios with international stocks have lower risk than those with US only stocks.

Answer: b

Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 09 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true about the efficient frontier once the possibility of risk-free borrowing and investing is introduced? a) the efficient frontier is a curve b) The origin is the point with a zero expected rate of return and risk of 1.0% c) we use the market index as an example of risk-free asset d) the efficienct frontier is a straight line Answer: d

2. Assume that portfolio T has an expected return of 12%, with a standard deviation of 20%, and the risk-free rate is 2%. Estimate the expected return and standard deviation, respectively for a portfolio that has 10% invested in the risk-free asset and 90% in T. a) 8.35%, 17.5% b) 11%, 18% c) 11%, 17.5% d) 11%, 20% Answer: b

3. Assume that portfolio T has an expected return of 12%, with a standard deviation of 20%, and the risk-free rate is 2%. Assume that an investor invests all of their wealth ($1,000) in portfolio T and borrows an additional $700, which is also invested in T. Estimate the expected return and standard deviation for this portfolio. a) 8.35%, 17.5% b) 11%, 18% c) 19%, 34%

d) 19%, -34% Answer: c

4. Which of the following statements is true about the market portfolio? a) the market portfolio is observable b) the market portfolio should contain all risky assets worldwide, including stocks, bonds, options, futures, gold, real estate, and so on. c) the market portfolio is different for people with different financing decisions d) the market portfolio depends on risk-free rate Answer: b

5. Which of the following statement is FALSE about how modern portfolio theory is extended to develop the capital market line (CML)? a) the extension depends on several critical assumptions. b) all risk inverse investors want to be on this line. c) the choice of the risky portfolio depends on risk-preferences d) the origin is the point with risk free return and 0 risk Answer: c

6. Assume the risk-free rate is 2%. The expected return on the market is 8%, and it has a standard deviation of 20%. Determine the required rate of return necessary for investors to hold an efficient portfolio with a standard deviation of 25%. a) 11.375% b) 9.5% c) 12% d) 7.5% Answer: b

7. Which of the following statements is NOT true about capital market line (CML) and security market line (SML)? a) CML is a straight line and SML is a curve b) CML is applied to portfolios only and SML is applied to both portfolios and single securities c) CML has sigma of portfolio on the X-axis and SML has beta on the X-axis. d) Both CML and SML intercept Y-axis at risk-free rate.

Answer: a

8. Which of the following statements is FALSE about the capital asset pricing model’s (CAPM) security market line (SML)? a) unique risks can be diversified but systematic risk cannot. b) rational investors should not be compensated for unique or diversifiable risk, because it can be eliminated through diversification. c) beta is typically estimated by first plotting the returns on an individual security on the vertical axis relative to the returns for the market, which are plotted along the horizontal axis, and then fitting a line through the observations d) SML depends on risk preference.

Answer: d

9. The returns on stock X have a standard deviation of 25% and a correlation coefficient of -0.5 with market returns, which have a standard deviation of 20%. Estimate the beta for stock X. a) -0.625 b) -0.5 c) 0.65 d) 0.234 Answer: a

10. The covariance between stock A and the market is 0.2 and the variance of the market is 0.1 Estimate the beta for stock X. a) 2

b) 0.5 c) 0.2 d) 0.1 Answer: a

11. An investor has a portfolio that consists of $10,000 invested in stock B, which has a beta of 1.2; $20,000 in stock C, which has a beta of -0.8; and $20,000 in stock D, which has a beta of 1.3. Estimate the beta of this portfolio. a) 0.44 b) 0.76 c) 1.00 d) 1.08 Answer: a

12. Given that the expected return on the market is 10% and the risk-free rate is 2%, estimate the market risk premium and the required return for security X with a beta of 0.875. Answers are shown as market risk premium and required return respectively. a) 8%, 8.75% b) 8%, 9% c) 10%, 8.75% d) 10%, 9% Answer: b

13. Which of the following statements is true about alternative risk-based pricing models? a) CAPM model is the only asset-pricing model b) CAPM model is the least used asset-pricing model c) Arbitrage pricing model is the most commonly used asset-pricing model d) CAPM model is the most commonly used asset-pricing model Answer: d

14. What factors are included in the Fama-French model? a) market, market value of equity, and liquidity b) market, market value of equity, and current ratio c) market value of equity, and book-to-market ratio d) market, market value of equity, and book-to-market ratio Answer: d

15. Which of the following statements is true about the arbitrage pricing model? a) Expected return is a linear function of factors. b) The factors are determined by CAPM. c) It specifies the number of risk factors d) It specifies the most important factors.

Answer: a

Package Title: Clicker Course Title: Booth, Cleary, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 10 Shuffle: No

1. Which of the following statements is FALSE about importance of the concept of market efficiency? a) Without market efficiency, managers will have no idea whether their owners agree or disagree with their decisions. b) For shareholder value maximization to mean anything, there has to be a connection between the decisions made by managers and the level of share prices. c) The closer the link between the actions of managers and stock price reaction, the more informationally efficient the capital market. d) market efficiency does not matter for managers or investors.

Answer: d

2. Which definition is true about “informational efficiency”? a) a market condition in which transaction costs are low b) a market condition in which there are enough securities to efficiently allocate risk c) a market condition in which important information is reflected in share prices d) a market condition in which investors are diligent and efficient.

Answer: c

3. Which of the following statements is FALSE about the efficient market hypothesis (EMH)? a) Nothing would challenge the hypothesis more than finding a sustainable anomaly that would lead to an investment strategy. b) Many anomalies are due to bad statistical work, or mistaking rewards for risk with abnormal returns. c) Academics and practitioners agree on the efficient market hypothesis. d) Momentum profit challenges the existence of efficient market.

Answer: c

4. Which level of efficiency is implied by the statement: “stock prices reflect the surprises in earnings announcements”. a) weak-form efficiency b) semi-strong efficiency c) strong efficiency d) operational efficiency Answer: b

5. Which level of efficiency is implied by the statement: “we can forecast future stock prices by examining the historical stock prices”. a) weak-form efficiency b) semi-strong efficiency c) strong efficiency d) operational efficiency Answer: a

6. Which level of efficiency is implied by the statement: “stock prices reflect both public information and insider information”. a) weak-form efficiency b) semi-strong efficiency c) strong efficiency d) operational efficiency Answer: c

7. Which level of efficiency is implied by the statement: “we can make money by buying stocks which has already increased for three days”. a) weak-form efficiency b) semi-strong efficiency

c) strong efficiency d) operational efficiency Answer: a

8. Which level of efficiency is implied by the statement: “we can make money by buying stocks with a low P/E ratio and a lot of cash”. a) weak-form efficiency b) semi-strong efficiency c) strong efficiency d) operational efficiency Answer: b

9. Which level of efficiency is implied by the statement: “we can make money by spying on the conversations of corporate executives”. a) weak-form efficiency b) semi-strong efficiency c) strong efficiency d) operational efficiency Answer: c

10. Which of the following statements is FALSE regarding empirical evidence of market efficiency a) One approach is to test whether price changes are, in fact, independent of one another b) An alternative method of testing weak form efficiency is to examine specific trading rules that attempt to exploit historical trading data c) No evidence supports the notion that markets are weak form efficient. d) There is no guarantee that any trading strategy based on exploiting anomalies would prove fruitful.

Answer: c

11. Which of the following statements is true regarding technical analysis? a) Technical analysis studies executive turnover. b) Technical analysis studies inside information. c) Technical analysis studies the financial statements. d) Technical analysis studies the price and volume of stocks.

Answer: d

12. Which of the following statements is true regarding the performance of fund managers? a) All fund managers beat the market in one year. b) All fund managers beat the market in 10 years c) No fund manager can beat the market in any given year. d) It is difficult to beat the market over a long period.

Answer: d

13. Which of the following is an anomaly to the efficient market hypothesis? a) contrarian strategies b) the correlations between successive price changes are not related in an economically significant manner c) the signs test of stock price changes supports return independence. d) most of the evidence suggests that technical trading rules, on average, have not been able to outperform a simple buy-and-hold strategy, after accounting for risk and trading costs.

Answer: a

14. Which of the following statements is FALSE about the differences between behavioural finance and the traditional view of finance? a) behavioural finance has found extremely loss aversion, but traditional view of finance assumes risk aversion that investors are willing to assume risk if they are adequately compensated in the form of higher expected returns.

b) behavioural finance suggests that investors may invest too conservatively, especially if they have experienced losses recently while traditional finance suggests that investors will hold welldiversified portfolios that are consistent with their investing objectives in terms of return requirements and risk tolerance. c) behavioural finance suggests that investors tend to weight recent information more heavily than more distant information while traditional finance suggests investors consider all available information and place the appropriate rational weight on each item, regardless of when it was received. d) behavioural finance suggests that investors are rational while traditional finance suggests that investors practice price anchoring and mental accounting.

Answer: d

15. Which of the following is implied by the market efficiency hypothesis? a) Technical analysis, which involves examining trading data for patterns, is not likely to be rewarded by substantial abnormal returns, because markets appear to be weak form efficient. b) Fundamental analysis based on various forms of publicly available information is likely to be successful at generating abnormal profits c) active trading strategies are going to outperform “passive” portfolio management strategies on a consistent basis d) corporate managers should issue stocks when their stocks are high in an efficient market.

Answer: a

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 11 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true regarding a forward contract? a) in a forward contract, a price is established today for future delivery. b) in a forward contract, the quantity and delivery date are uncertain today. c) the forward price equals the future spot price. d) the forward foreign exchange price is always greater than the current spot price.

Answer: a

2. Suppose the spot exchange rate is C$1.3538 per 1 euro, while the six-month forward rate is C$1.3481 per euro. What will be the profit for an investor who assumes a 125,000-euro long position in the forward contract if the spot rate in six months equals C$1.55 per euro? a) -25,237.50 b) 25,237.50 c) 18,978.50 d) -18978.50 Answer: b

3. Suppose the spot exchange rate is C$1.3538 per 1 euro, while the six-month forward rate is C$1.3481 per euro. What will be the profit for an investor who assumes a 125,000-euro short position in the forward contract if the spot rate in six months equals C$1.55 per euro? a) -25,237.50 b) 25,237.50 c) 18,978.5 d) -18978.5

Answer: a

4. A firm has to pay a foreign supplier 100,000 euros in six months and decides to eliminate the foreign exchange risk by entering a six-month forward contract. The future spot rate is C$1.4 per euro. Should the firm enter into a long or short position? What is the cost in Canadian dollars? a) long; C$140,000 b) long; C$71,429 c) short; C$140,000 d) short; C$71,429 Answer: a

5. A firm will receive 100,000 euros in six months and decides to eliminate the foreign exchange risk by entering a six-month forward contract. The future spot rate is C$1.4 per euro. Should the firm enter into a long or short position? What is the cost in Canadian dollars? a) long; C$140,000 b) long; C$71,429 c) short; C$140,000 d) short; C$71,429 Answer: c

6. Find the forward price for a one-year forward contract for a metal that is selling for $90 spot, if storage costs are $5 for the year and financing costs are 15% per year. a) $108.50 b) -$108.50 c) $18.50 d) -$18.50 Answer: a

7. Which of the following statements is true regarding the trading of future contracts?

a) Weather derivatives do not exist b) Future contracts are more transparent than private, over-the-counter deals c) The underlying assets of future contracts are commodities only d) Toronto Stock Exchange is the largest future contract exchange.

Answer: b

8. Which of the following statements is true regarding the marking-to-market in the trading of future contracts? a) Marking-to-market is required in the trading of forwards, but not futures. b) Initial margin and maintenance margin are equal. c) If an investor fails to make a margin call, the position will automatically be closed out. d) if an investor’s equity is higher than the initial margin, a margin call is triggered.

Answer: c

9. Which of the following statements is true about the differences between forward and future contracts? a) forwards are standardized, but futures are customized b) forwards are traded on exchanges, but futures are traded on dealer or over-to-counter market c) default (credit risk) is important in futures, but unimportant in forwards, d) an initial deposit is not required on forwards, but is required on futures.

Answer: d

10. An investor enters into a long position in 10,000 future contracts that require a 50% initial margin and a 40% maintenance margin. The future price associated with the contract is $20.

Assume the spot price of the underlying assets the next day is $23. What is the margin balance?

Is there a margin call? a) $130,000; margin call b) $100,000; margin call c) $130,000; no margin call d) $100,000; margin call

Answer: c

11. An investor enters into a short position in 10,000 future contracts that require a 50% initial margin and a 40% maintenance margin. The future price associated with the contract is $20.

Assume the spot price of the underlying assets the next day is $23. What is the margin balance?

Is there a margin call? a) $130,000; margin call b) $100,000; margin call c) $70,000; no margin call d) $70,000; margin call Answer: d

12. Company C enters into a two-year, $1-million, plain vanilla interest rate swap and agrees to pay a fixed rate of 5% and receive LIBOR. Payments are exchanged every six months, based on LIBOR at the beginning of the six-month period. Determine the amount of the required semiannual payments that C must make, assuming that 6-month LIBOR is 0.48% now. a) Company C pays $22,600 b) Company C receives $22,600 c) Company C pays $45,200 d) Company C receives $45,200 Answer: a

13. Which of the following statements is true about the development of swaps? a) the first swap was a currency swap. b) all bond issues in the international Eurobond market end up being used to finance projects in foreign countries. c) All swaps are customized. d) Forward rate agreement (FRA) and swaps are not integrated Answer: a

14. Which of the following statements is true about the financial crisis and the credit default swap (CDS) market? a) Investors did not enter an interest rate swaps and subsequently total return swaps prior to the 2008 financial crisis b) Credit default swaps were traded on the Chicago Mercantile Exchange (CME) prior to the 2008 financial crisis c) The CDS market was worth less than the value of the US stock market prior to the 2008 financial crisis d) after the 2008 financial crisis, there was a push to convert the CDS over-the-counter market into an exchange-listed market to normalize risk.

Answer: d

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 12 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true about call options? a) The strike price in call options is always the current spot price. b) All call options are traded over the counter. c) The payoff of a call option is a straight line with the underlying price on the horizontal axis. d) The payoff of longing a call option (ignoring option cost) is never negative.

Answer: d

2. In which of the following situations will the price on a call option increase? a) The price of underlying assets increases. b) The strike price increases. c) The underlying asset is less risky. d) The dividend payments of the underlying assets increases.

Answer: a

3. Which of the following statements is true about put options? a) The strike price in put options is always the current spot price. b) All put options are traded over the counter. c) The payoff of a put option is a straight line with the underlying price on the horizontal axis. d) The payoff of longing a put option (ignoring option cost) is never negative.

Answer: d

4. In which of the following situations will the price on a put option increase?

a) The price of underlying assets decreases. b) The strike price decreases. c) The underlying asset is less risky. d) The dividend payments of the underlying assets decreases.

Answer: a

5. Assume a call option with strike price of $50 is selling for $3 in the market. Determine the intrinsic value and time value, respectively of this call option, assuming the price of the underlying asset is $47. a) $0, $3 b) -$3, $6 c) $0, $53 d) $0, -$3 Answer: a

6. Assume a put option with strike price of $50 is selling for $3 in the market. Determine the intrinsic value and time value, respectively of this call option, assuming the price of the underlying asset is $47. a) $0, $3 b) -$3, $6 c) $0, $53 d) $3, $0 Answer: d

7. A company’s common shares are selling for $20, and a one-year European put option on those shares, with a $20 strike price, is selling for $0.50. If the risk-free rate is 3 percent, find the value of a one-year European call on the same stock with a $20 exercise price. a) $1.08 b) $1.45 c) 0

d) -$1.08 Answer: a

8. A company’s common shares are selling for $20, and a six-month European call option on those shares, with a $20 strike price, is selling for $0.90. If the risk-free rate is 3 percent, find the value of a six-month European put on the same stock with a $20 exercise price. a) $0.60 b) $0.65 c) 0.70 d) $0.95 Answer: a

9. Which of the following statements is true about the price call and put options with the same strike and maturity? a) C=P b) C=-P c) C=P+S-PV(X) d) C=P+S Answer: c

10. How is a synthetic call option created? a) Long a put option with the same strike price and maturity, long underlying security, and invest the present value of strike price b) Short a put option with the same strike price and maturity, long underlying security, and borrow the present value of strike price c) Long a put option with the same strike price and maturity, long underlying security, and borrow the present value of strike price d) Long a put option with the same strike price and maturity, short underlying security, and borrow the present value of strike price Answer: c

11. Which of the following is an arbitrage opportunity given the following situation. P=3, S=30, PV(X)=10, C=24. Put option and Call option have the same underlying asset, the same strike, and the same maturity. a) Long a call, short a put, short the underlying asset and invest PV(X). The profit is $1. b) Long a call, long a put, short the underlying asset and invest PV(X). The profit is $1. c) Spend $23 in longing a put, buying the underlying asset, and borrowing PV(X). Also, short a call to make $24. The arbitrage profit is $1. d) Long a put, long the underlying asset, invest PV (X) and short a call. The profit is $1.

Answer: c

12. Which of the following statements is true about the Greeks? a) Delta measures the change in the price of an option for a given change in the price of underlying asset. b) Theta measures the change in delta with respect to a change in the underlying asset. c) Gamma measures the change in the price of option for a given change in the price of underlying asset. d) Rho measures the change in option value with time Answer: a

13. Which of the following statements is true about implied volatility? a) It is calculated as the standard deviation of historical stock return. b) It is calculated from observed option prices. c) It is constant at any time. d) It does not contain any useful information.

Answer: b

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 13 Shuffle: No

Question type: Multiple Choice

1. Which of the following is true about the capital budgeting process? a) It is the record of a corporation’s past capital spending. b) It usually involves large amounts of money and the decisions are frequently irrevocable. c) It only involves tangible assets. d) It does not affect the risk of a corporation.

Answer: b

2. Which of the following is true about capital expenditures? a) a firm’s investments in long-lived assets, which are tangible. b) a firm’s investments in long-lived assets, which are intangible. c) a firm’s investments in long-lived assets, which may be tangible or intangible. d) a firm’s investments in short-lived assets, which may be tangible or intangible.

Answer: c

3. Which of the following is true about bottom-up analysis? a) Capex decisions are considered in isolation, without regard for whether the firm should continue in this business or for general industry and economic trends. b) Capex decisions focus on strategic decisions, such as which industries or products the firm should be involved in, looking at the overall economic picture. c) Capex decisions are made by entry-level analysis, but not supervised by upper-level managers. d) Capex decisions are made by entry-level analysis and supervised by upper-level managers.

Answer: a

4. Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax net cash inflows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. Using a 10% discount rate, determine the project’s net present value (NPV). a) $1,389 b) $2,688 c) $2,555 d) $1,555 Answer: b

5. A project that requires an initial investment of $30,000 is expected to generate after-tax net cash inflows of $5,000 per year for the next 10 years. Estimate the NPV using a 12% discount rate. a) -$1,749 b) $1,749 c) -$1,427 d) $28,573 Answer: a

6. Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax net cash inflows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. Determine the internal rate of return. a) 21.31% b) 12.31% c) 13.31% d) 14.31% Answer: a

7. A project that requires an initial investment of $30,000 is expected to generate after-tax cash flows of $5,000 per year for the next 10 years. Determine the internal rate of return. a) -10.22% b) -11.56% c) 10.56% d) 10.84% Answer: c

8. Which of the following statements is true about applying NPV or IRR in capital budgeting? a) They both work in any situations. b) Multiple NPV values may result when future cash flows change sign c) IRR measures the absolute measure of wealth. d) NPV works when future cash flows change sign, while IRR does not.

Answer: d

9. The following information has been provided for two projects: Project A has IRR of 12%, Project B has IRR of 15%, the crossover rate is 9%, and the discount rate is 16%. Which project should be accepted? a) Accept both. b) Accept A; reject B. c) Reject A; accept B. d) Reject both.

Answer: d

10. The following information has been provided for two projects: Project A has IRR of 12%, Project B has IRR of 15%, the crossover rate is 9%, and the discount rate is 13%. Which project should be accepted? a) Accept both. b) Accept A; reject B. c) Reject A; accept B.

d) Reject both.

Answer: c

11. The initial cash outlay for a project is $20,000. The net cash inflow in the next three years is expected to be $0, $10,000, and $30,000 respectively. What is the payback period? a) 2.00 years b) 3.00 years c) 2.25 years d) 2.33 years Answer: d

12. The initial cash outlay for a project is $20,000. The net cash inflow in the next three years is $0, $10,000, and $30,000. The discount rate is 10%. What is the discounted payback period? a) 2 years b) 3 years c) 2.33 years d) 2.52 years Answer: d

13. Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax net cash inflows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. The discount rate is 10%. What is the profitability index? a) 1.116 b) 0.884 c) 1.500 d) 1.224 Answer: d

14. Which of the following approaches is true when comparing projects with unequal lives? a) The project with the highest NPV is selected. b) The project with the highest IRR is selected. c) The project with the lowest initial cash outlay is selected. d) The chain replication approach should be applied.

Answer: d

15. Which of the following statements is true about investing inside and outside Canada? a) Foreign direct investments into Canada have been constant for decades. b) Political risk insurance is not available. c) There are no practical difficulties when applying NPV analysis to foreign investments. d) An adjustment for foreign exchange risk should be made if cash flows are denominated in a foreign currency.

Answer: d

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 14 Shuffle: No Question type: Multiple Choice

1. Which of the following statements is a correct guideline when estimating project cash flows? a) Estimate before-tax cash flows only. b) Include interest and dividend payments. c) Exclude any changes in working capital. d) Exclude sunk costs.

Answer: d

2. Which of the following statements is true about treating opportunity cost in estimating cash flow? a) Opportunity cost is included. b) 80 % of opportunity cost is included c) 50% of opportunity cost is included. d) Opportunity cost is excluded.

Answer: a

3. Which of the following amounts are included in a capital expenditure analysis? a) Earnings before taxes. b) Externalities. c) Intangibles. d) Marginal cash flows.

Answer: d

4. Brennan Co. is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $20,000, and it would cost another $500 to modify it for special use by the firm. To use the machine, the firm will need to maintain additional raw materials inventory of $1,000.

Estimate the firm’s cash outlay. a) $20,000 b) $20,500 c) $21,000 d) $21,500 Answer: d

5. In a five-year project, the year 1 operating income is $125,000, capital cost allowance is $97,500, and tax rate is 45%. What is the net cash flow for year 1? a) $27,500 b) $15,125 c) $-15,125 d) $112,625 Answer: d

6. In a five-year project, after-tax net cash inflow is $10,000, $11,000, $12,000, $13,000, $14,000. The discount rate for projects with the same risk is 10%. What is the PV of annual after-tax net cash inflow? a) $60,000 b) $44,770 c) $37,908 d) $24,000 Answer: b

7. A project has initial cash outlay of $20,000. The present value of the annual cash inflows for next 10 years is $400,000. The present value of the final cash inflow is $1000. What is the NPV of the project?

a) $381,000 b) $421,000 c) $420,000 d) none of the above Answer: a

8. A project has initial cash outlay of $20,000. The present value of after-tax annual cash inflows is $200,000. The present value of the CCA tax shield is $12,000. The present value of the final cash inflow is $1000. What is the NPV of the project? a) $233,000 b) $192,000 c) $193,000 d) $169,000 Answer: c

9. What is the difference between sensitivity analysis and scenario analysis in capital budgeting? a) They are identical. b) Sensitivity analysis examines what if one input is changed and scenario analysis examines what if more than one inputs are changed. c) Sensitivity analysis examines what if more than one input are changed and scenario analysis examines what if one input is changed. d) Sensitivity analysis examines what if two inputs changed and scenario analysis examines what if more than two inputs are changed.

Answer: b

10. Which of the following statements is true about the real option approach? a) It can be illustrated with a decision tree. b) It is never used in capital budgeting. c) An NPV analysis does not need to be done when using the real option approach. d) It cannot be applied to the decision to terminate a project if cash flows do not materialize.

Answer: a

11. A 5-year project has initial cash outlay of $20,000. The present value of CCA tax shield is $12,000. The present value of ending cash flow is $1,000. The discount rate is 10%. What is the NPV break-even point for annual after-tax operating cash flow? a) $1,847 b) $1,836 c) $7,000 d) $1827 Answer: a

12. Which of the following statements are true when we consider replacing an old machine with a new machine? a) The initial cash outlay is only the cost spent on the new machine. b) The annual cash outlay is the cash generated by the new machine. The forgone cash flow that could be generated by the old machine is not considered. c) The ending cash flow is only the salvage value of the new machine. The change in net working capital is not considered. d) Only the incremental cash flow is considered.

Answer: d

13. A firm is considering the purchase of a new machine price at $50,000 to replace an existing machine. The present market value of the existing machine is $20,000. What is the initial net cash outlay? a) $50,000 b) $30,000 c) $20,000 d) $70,000 Answer: b

14. Which of the following statements is true about inflation and capital budgeting? a) Inflation is not considered in capital budgeting. b) We discount nominal cash flow by nominal discount rate. c) We discount nominal cash flow by real discount rate. d) We discount real cash flow by nominal discount rate.

Answer: b

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 15 Shuffle: No Question type: Multiple Choice

1. Which of the following statements is true about the types of takeovers? a) An acquisition is the combination of two firms into a new legal entity. b) A merger is the purchase of one firm by another. c) A cash transaction is the receipt of cash for shares by shareholders in a target company d) A share transaction is the receipt of cash for shares by shareholders in a target company Answer: c

2. Which of the following statements is true about the types of takeovers? a) A merger is the combination of two firms into a new legal company. b) An acquisition is the combination of two firms into a new legal company. c) A merger is the purchase of one firm by another. d) An acquisition is done only be the exchange of shares.

Answer: a

3. Which of the following is a critical shareholder percentage that investors should be aware of? a) 10%: takeover bid b) 20%: early warning c) 50.1%: control d) 66.7%: minority squeeze out Answer: c

4. Which of the following statements is true about security legislation in Canada?

a) Security legislation is a provincial responsibility b) Security legislation is a federal responsibility c) Security legislation is a municipal responsibility d) Canadian Security legislation exactly replicates all legislation in the U.S. Answer: a

5. Once a shareholder holds __________ of the common shares of a corporation, they cannot buy any more shares in the open market without making a takeover bid. a) 5% b) 10% c) 15% d) 20% Answer: d

6. Which of the following takeovers is exempt from the Ontario Securities Act (OSA)? a) A large company acquires a small company b) When all shareholders are residents of Ontario c) Takeovers of private companies d) Friendly takeovers.

Answer: c

7. Which of the following statements is true about a friendly takeover? a) It is the acquisition of a target company that is willing to be taken over. b) Due diligence is waived in a friendly takeover. c) For a firm with public shareholders, the last step in a friendly takeover is to have the final sale agreement reached and ratified. d) For a private firm, the last step in a friendly takeover is to goes to the shareholders for approval.

Answer: a

8. Which of the following statements is true about a hostile takeover? a) In a hostile takeover, the target has no desire to be acquired, actively rebuffs the acquirer, and refuses to provide any confidential information. b) If the market price immediately jumps above the tender offer price, then the market is saying that a competing offer is unlikely or that the bid is too high c) If the market price stays close to the tender offer price, then the market is saying that a competing offer is unlikely or that the bid is too high d) A large amount of trading indicates shareholders are sitting on the shares and are reluctant to sell.

Answer: a

9. Which of the following actions is NOT a defensive tactic used by a target company? a) poison pill b) selling the crown jewels c) white Knight d) accepting the offer Answer: d

10. Which of the following statements is NOT a motivation for mergers and acquisitions? a) economies of scale b) economies of scope c) destroy shareholder’s wealth d) complementary strengths Answer: c

11. Estimate the value of the target company using PE multiples. The industry PE is 18 and the target company’s earnings are $2 million. a) $18 million b) $36 million

c) $9 million d) $18.2 million Answer: b

12. Which of the following is NOT an accounting difference to be considered when preparing valuations? a) Firm A uses LIFO to account for inventory, while firm B uses FIFO. b) Firm A uses accelerated depreciation method, while firm B uses straight-line depreciation. c) Firm A fully funds pension costs, while firm B reports an unfunded pension liability. d) Firm A is a sandwich company, while firm B is a soft drink company.

Answer: d

13. The potential takeover target is expected to have annual cash flows of $200,000 next year.

The cash flow will grow at 5% a year. The appropriate beta is 2. The expected return on the market is 10% and the risk-free rate is 2%. Estimate the target firm’s value. a) $1,538,462 b) $1,176,471 c) $1,111,111 d) $4,000,000 Answer: a

14. Which accounting method is permitted to account for mergers and acquisitions in Canada? a) the purchase method b) the resale method c) the replacement method d) the pooling-of-interest method Answer: a

15. The fair market value of the target firm’s equity is $10 million. The purchase price is $11 million. What is reported in the balance sheet of the post-merger company? a) $1 million goodwill as liability. b) $1 million goodwill as an asset. c) $-1 million goodwill as an asset d) no goodwill is reported.

Answer: b

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 16 Shuffle: No Question type: Multiple Choice

1. What is the difference between operating leases and financial (capital) leases? a) In financial leases, some of the benefits of ownership do not transfer to the lessee but remain with the lessor. b) In operating leases, essentially all the benefits of ownership transfer to the lessee. c) In financial leases, the lessee is assumed to own the asset. d) In operating leases, the lessee is assumed to own the asset.

Answer: c

2. Which of the following statements is FALSE regarding financial leases? a) the lessee is assumed to own the asset. b) the lessee claims depreciation on the firm’s income statement c) the lessee records the value of the leased asset as an asset and the financing obligation as a liability on its balance sheet. d) the lessee does not assume any benefits of the ownership of the asset.

Answer: d

3. Which of the following was viewed by Canada Revenue Agency (CRA) as a sale of equipment? a) if the lessee automatically acquires ownership at some point during the term of the lease. b) financial lease. c) operating lease. d) lease on cars.

Answer: a

4. Which of the following statements is true about the reporting of an operating lease on the balance sheet? a) the asset is on the balance sheet of the lessee. b) the asset is on the balance sheet of the lessor. c) the asset is not on the balance sheet of the lessee or the balance sheet of the lessor. d) the asset is on both the balance sheet of the lessee and the balance sheet of the lessor.

Answer: b

5. Which of the following statements is true about the reporting of a financial lease on the balance sheet? a) the asset is on the balance sheet of the lessee. b) the asset is on the balance sheet of the lessor. c) the asset is not on the balance sheet of the lessee or the balance sheet of the lessor. d) the asset is on both the balance sheet of the lessee and the balance sheet of the lessor.

Answer: a

6. Which of the following statements is true about the reporting of a financial lease on the income statements? a) the whole lease payment is expensed on the income statement of the lessee. b) the principal portion of the lease payment is expensed on the income statement of the lessee. c) the interest portion of the lease payment is expensed on the income statement of the lessee. d) the interest portion of the lease payment is expensed on the income statement of the lessor.

Answer: c

7. Which is NOT a main difference in the cash flows for a company that leases an asset instead of buying it? a) It does not have to pay for the asset up front. b) If it is an operating lease, or if title is not transferred through a financial lease, the company does not get to sell the asset when it is finished with it.

c) It makes regular lease payments. If the lease is an operating lease, the full amount of the lease payments is tax deductible; if it is classified as a financial lease, then only the interest portion of the payments is deductible. d) It does get to depreciate the asset for if it is an operating lease. If it is a financial lease, it does not get to charge depreciation.

Answer: d

8. A firm is looking for a new limousine and can either lease or purchase the vehicle. The lease option is a three-year operating lease with lease payments of $100,000 per year. Each payment would be due at the beginning of the year. The firm’s effective tax rate is 40%. What are the after-tax cash flows from year 0 to year 3, respectively? a) -$60,000, -$60,000, -$60,000, 0 b) 0, -$60,000, -$60,000, -$60,000 c) -$100,000, -$100,000, -$100,000, 0 b) 0, -$100,000, -$100,000, -$100,000 Answer: a

9. A firm is looking for a new limousine and can either lease or purchase the vehicle. The limousine would cost $0.5 million to buy (it is very luxurious and also bulletproof). The limousine would be eligible for a capital cost allowance (CCA) deduction of $50,000 per year.

The firm’s effective tax rate is 40%. What is the cash flow on the firm’s forgone tax shield from year 0 to year 3, respectively? a) -$20,000, -$20,000, -$20,000, 0 b) 0, -$20,000, -$20,000, -$20,000 c) -$50,000, -$50,000, -$50,000, 0 b) 0, -$50,000, -$50,000, -$50,000 Answer: b

10. A firm is looking for a new limousine and can either lease or purchase the vehicle. The limousine would cost $1 million to buy (it is very luxurious and also bulletproof). The firm’s effective tax rate is 40%. What is the initial cash flow to the firm in order to evaluate the operating leasing option?

a) $0 b) -$1 million c) -$0.6 million d) -$0.4 million Answer: b

11. A firm is looking for a new limousine and can either lease or purchase the vehicle. The IRR of leasing is 4%. The firm’s effective tax rate is 40%. Determine whether or not the firm should lease the limousine, assuming its before-tax cost of borrowing is 6%. a) Lease the limo because its IRR is higher than the after-tax cost of borrowing. b) Lease the limo because its IRR is lower than the before-tax cost of borrowing. c) Do not lease the limo because its IRR is higher than the after-tax cost of borrowing. d) Do not lease the limo because its IRR is lower than the before-tax cost of borrowing.

Answer: c

12. A firm is looking for a new limousine and can either lease or purchase the vehicle. The firm can lease the limousine for five years with lease payments of $10,000 a month, due at the beginning of each month. The annual effective discount rate is 8%. What is the present value of before-tax lease payments? a) $496,472. b) $600,000. c) $400,000. d) $350,000.

Answer: a

13. A firm is considering whether to purchase or lease a machine that costs $100,000 and is subject to a 20% CCA rate, and the half-year rule applies. Tax rate is 35%. The firm’s before-tax borrowing cost is 8%. What is the present value of the forgone CCA tax shield in year 1? a) $3,500 b) $3,327

c) $10,000 d) $9,505 Answer: b

14. A firm has the option to enter a 5-year, financial lease that calls for monthly payments of $35,000 based on a 5% lease rate paid at the beginning of each month, or borrowing $10,000 through a 5-year loan that calls for monthly payment based on 5.12% lending rate with payments due at the end of each month. Which option should the firm choose (ignore income taxes for this question)? a) lease because it costs less than $35,000. b) lease because it costs more than $35,000 a) loan because it costs less than $35,000. b) loan because it costs more than $35,000 Answer: a

15. Which of the following is NOT a motivation for leasing? a) Cheaper financing. b) Reduce the risks of asset ownership. c) Implicit fixed interest rate. d) The CCA tax deduction available from an operating lease.

Answer: d

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 17 Shuffle: No Question type: Multiple Choice

1. Which of the following statements is true about information asymmetries? a) the investor and the issuer always agree on the value of the expected stream of cash flows b) the investor and the issuer frequently have different information about the same future stream of cash flows c) the investor and the issuer always agree on the size of future cash flows d) the investor and the issuer always agree on the risk of future cash flows Answer: b

2. Which of the following statements is NOT an example of information asymmetries? a) the market for lemons b) the investor and the issuer frequently have the same information about the same future stream of cash flows c) bad money drives out good d) the market for used cars Answer: b

3. Calculate the interest rate of a corporate bond. The risk-free rate is 2%. The default probability is 10% and the investors get nothing upon default. a) 2% b) 10% c) 12% d) 13.33% Answer: d

4. Which of the following is not a major area of the OSC? a) primary market offerings b) secondary market trading c) activities of investment professionals d) all investors are a CFA chart holder Answer: d

5. Which elements are not required to be included in the prospectus as required by the British Columbia Securities Commission (BCSC)? a) a description of the securities being issued and who can buy them b) the price of the securities, the fees to the investment dealer involved with the distribution, and the net proceeds c) summary financial information d) the details of each transaction in the past five years regardless of the transaction amount Answer: d

6. Which of the following statements is true about the exempt market? a) It is for smaller issues b) It is for retirees. c) It is for high-risk securities d) A prospectus is required in the exempt market.

Answer: a

7. Which of the following issues is NOT exempt from registering securities? a) small issues b) institutional investors c) low-risk securities d) well-established companies.

Answer: d

8. What is a possible motivation of an IPO? a) Some investors want to cash out. b) The corporation wants to raise money only by bank lending. c) The corporation wants to prevent original investors from cashing out. d) The corporation wants to raise money only by issuing debt.

Answer: a

9. What is NOT a stage in an IPO process? a) Discussion triggers an IPO. b) Preliminary prospectus. c) Initial filling. d) Filing a memorandum.

Answer: d

10. Which is NOT a type of IPO? a) a best efforts offering b) a firm commitment offering c) a bought deal d) a seasoned equity offering Answer: d

11. Which is the most popular type of IPO? a) a best efforts offering b) a firm commitment offering c) a bought deal d) a rights offering

Answer: b

12. Which of the following statements is true about the green-shoe option in an IPO? a) It gives the underwriter the obligation of buying more shares from the issuer (usually 15 percent more) if investor demand is weak. b) It gives the underwriter the option of buying more shares from the issuer (usually 15 percent more) if investor demand is strong. c) It gives the issuer the option of issuing more shares from the issuer (usually 15 percent more) if investor demand is strong. d) It gives the underwriter the obligation of buying more shares from the issuer (usually 15 percent more) if investor demand is strong.

Answer: b

13. Which of the following statements is true about IPO under-pricing? a) IPO under-pricing only occurs in the US. b) The first day trading price is always lower than the offering price. c) The possible explanation of the IPO under-pricing in the U.S includes the power of the investment banks, the litigious nature, a following seasoned equity offering, and spinning. d) The IPO first-day return in Canada is in general higher than that in the US. Answer: c

14. Which of the following statements is true about the continuous disclosure requirement? a) The issuing firm must file a long-form prospectus every year. b) The issuing firm must file a short-form prospectus every year. c) The issuing firm must file monthly financial statements. d) The issuing firm must file proxy and information circulars.

Answer: d

15. Which document should issuers file with the OSC in seasoned equity offering?

a) short-term prospectus b) prospecturs c) offering memorandum d) proxy and information circulars.

Answer: a

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 18 Shuffle: No Question type: Multiple Choice

1. Which of the following statement is true about debt? a) Interest payment is at the discretion of the management. b) Interest is paid before corporate tax is paid. c) Debt holders get the residual value of the company. d) Interest is not tax deductible.

Answer: b

2. Which of the following is true about the difference between debt and equity? a) Interest is an obligation, dividends are at the discretion of the management. b) Interest is paid after corporate tax, and dividends are paid before corporate tax. c) Debt holders get the residual value of the company, while equity holders claim the principal and interest. d) Interest is not tax deductible, while dividend payments are tax deductible.

Answer: a

3. What is the after-tax cost of debt if the before cost of debt is 7% and the corporate tax rate is 35%. a) 2.45% b) 4.55% c) 7% d) 35% Answer: b

4. Which is an example of short-term debt issued in the money market? a) equity b) bank loan c) 10-year bond d) commercial paper Answer: d

5. Consider a commercial paper: On a $100-million investment, if the issuer does not default, the investor gets $100.5 million after one month; if the issuer defaults, the investor gets nothing.

The default probability is 2 percent. What is the expected payoff in one month? a) 100 million b) $102.9million c) $105 million d) $98.49 million Answer: d

6. Consider a commercial paper: On a $100-million investment, if the issuer does not default, the investor gets $100 million plus promised yield after one month; if the issuer defaults, the investor gets nothing. The default probability is 2 percent. The risk-free rate in a month is 0.167%. What is the monthly promised yield on the commercial paper? a) 2.211% b) 2% c) 0.167% d) 49 times Answer: a

7. Consider a commercial paper: On a $100-million investment, the expected payoff in one month is $102.9 million. The required return is 3 percent monthly compounding. What is the present value of the commercial paper? a) 104,738,155

b) $102,900,000 c) $102,643,392 d) $99,750,623 Answer: c

8. Which of the following statements is true about money market instruments? a) Commercial paper yields are constant in time series. b) T-bills have higher yield than commercial papers. c) T-bills are riskier than commercial papers. d) T-bills are default risk free.

Answer: d

9. Which is an example of bank financing? a) line of credit b) commercial paper c) banker’s acceptance d) bond Answer: a

10. Which of the following statements is true about line of credit in Canada? a) The standard cost is LIBOR. b) The standard cost is T-bill rate c) The standard cost is fixed interest rate. d) The standard cost is prime lending rate.

Answer: d

11. Which of the following statements is true about long-term debt? a) The market for long-term debt is the money market.

b) The market for long-term debt is the capital market. c) Issuers of a bond file an offering memorandum. d) Issuers of a bond file a long prospectus.

Answer: b

12. Which is an example of cross-default clauses? a) Nonpayment of principal when due triggers default. b) Nonpayment of interest after 30 days triggers default c) An order for the winding up or liquidation of the firm triggers default. d) The company defaulting on its first mortgage bonds triggers default on a second mortgage Answer: d

13. Which of the following statements is true about investment grade bond rating? a) BBB and below is an investment grade. b) BB and below is an investment grade. c) BBB and above is an investment grade. d) BB and above is an investment grade.

Answer: c

14. Which of the following statements is true about the empirical evidence on bond rating? a) AA-rated bonds never default b) CCC-rated bonds definitely default in one year. c) The default probability is independent of the holding period. d) AAA-rated bonds have lower default probability than CCC-rated bonds when the holding periods are equal.

Answer: d

15. Which of the following are factors that DBRS uses for rating debt securities?

I. core profitability; asset quality;

II. Strategy and management strength; balance sheet strength; III. Business strength; miscellaneous issues. a) I only b) II and III. c) I and II d) I, II, and III. Answer: d

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 19 Shuffle: No Question type: Multiple Choice

1. Which of the following is NOT a basic right of common shareholders? a) to vote at any meeting of shareholders of the corporation. b) to receive any dividend declared by the corporation. c) to receive the remaining property of the corporation on dissolution. d) to decide the amount of dividends.

Answer: d

2. Which of the following statements is true about the pre-emptive right of common shareholders? a) It is the right to maintain proportional ownership in a company when new shares are issued b) Since the 1950s, Canadian firms increased the issue of shares with pre-emptive rights. c) Shareholders with pre-emptive right cannot prevent their ownership share being diluted by the sale of new shares to other investors. d) Shareholders with pre-emptive right cannot buy newly-issued shares.

Answer: a

33 A firm has A, B, and C type of shares. B Shares have the following characteristics: full voting rights; no dividends if dividends on class C shares are in arrears; an equal share with class A shares in any residual receipts on the winding up of the company. Which class does B share belong to? a) common shares b) restricted non-voting shares c) preferred shares d) debt

Answer: a

4. A firm has A, B, and C type of shares. A shares have no voting rights as long as dividend payments are made; a $0.05 dividend in addition to any dividend paid to class B shares, but only if class C dividend are not in arrears; an equal share with class B in any residual receipts on the winding up of the company. Which class does A share belong to? a) common shares b) restricted non-voting shares c) preferred shares d) debt Answer: b

5. A firm has A, B, and C type of shares. C Shares have the following characteristics: no voting rights unless dividends are in arrears for two years, after which each share gets one vote; a dividend of $0.3 per share every quarter when declared by the board of directors; no dividends on class A and B shares can be paid if these dividends are in arrears. Which class does C share belong to? a) common shares b) restricted non-voting shares c) preferred shares d) debt Answer: c

6. Which of the following statements is true about the dividend yields of the S&P/TSX index? a) It is always 0. b) It is constant at 2.5 percent for all years. c) The dividend yield decreases as market prices increase as well as when the dividend per share is reduced. d) The dividend yield increases as market prices increase as well as when the dividend per share is reduced.

Answer: c

7. Which of the following statements is true about straight preferred shares? a) Dividends are tax deductible. b) Dividend payout ratio is usually constant. c) In terms of tax, dividends are more favourably treated than bond interest. d) The usual term to maturity is usually 10-30 years.

Answer: c

8. Which of the following is NOT a type of preferred share? a) straight preferred shares b) retractable preferred shares c) floating rate preferred shares d) ambivalent preferred shares Answer: d

9. Which of the following features is NOT associated with preferred shares? a) cumulative provision b) callable feature c) purchase funds d) full voting rights in any circumstances Answer: d

10. Which of the following statements is true about warrants? a) They are the corporate finance equivalent of call options, with some major differences. b) They are the corporate finance equivalent of put options, with some major differences. c) They are the corporate finance equivalent of call options without any differences. d) They are the corporate finance equivalent of put options without any differences.

Answer: a

11. What is the difference between warrants and call options? a) New shares are created when call options are exercised; but no new shares are created when call options are exercised. b) Call options are deals between the issuing firm and the investors; but warrants are deals between external investors. c) Call options usually have longer maturity term than warrants. d) New shares are not created when call options are exercised; but new shares are created when call options are exercised.

Answer: d

12. A firm has 10 million shares outstanding that are trading at $30 per share. The company has 1 million warrants outstanding that have an exercise price of $28 each. What is the payoff to the warrant holders if all of the warrants are exercised? a) $1.818 million b) $2 million c) $28 million d) 0 Answer: a

13. A convertible bond has straight bond value of $1,000 and conversion value of $1,200. What is the floor value? a) $1000 b) $1200 c) the future value of $1000 d) the future value of $1200 Answer: b

14. A convertible bond has straight bond value of $1,000 and conversion value of $1,200. The convertible bond is trading at $1300. What is the conversion premium?

a) $8.33% b) 7.69% c) 10% d) 0 Answer: a

15. Please rank the risk of securities from the highest to the lowest. a) common equity, straight preferred shares, convertible preferred shares. b) convertible preferred shares, straight preferred shares, common equity. c) straight preferred shares, common equity, convertible preferred shares. d) common equity, convertible preferred shares, straight preferred shares.

Answer: a

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 20 Shuffle: No

Question type: Multiple Choice

1. How are valuation, cost of capital, and the forecast of future cash flows related? a) Valuation is the expected future cash flows discounted by cost of capital. b) Valuation is cost of capital divided by the expected future cash flow. c) Valuation is the expected future cash flows multiplied by cost of capital. d) Valuation is the expected future cash flows compounded by cost of capital.

Answer: a

2. Which of the following are not financing sources for a firm? a) Accruals b) Accounts payables c) Short-term debt d) Inventory Answer: d

3. What is the weighted average cost of capital (WACC) if the required rate of return on equity of 10%, the cost debt is 6%, the corporate income tax rate is 40% and the market value debt-toassets ratio is 20%. a) 9.2 %. b) 8.7% c) 8.0% d) 12.4% Answer: b

4. When calculating the weighted average cost of capital (WACC) for a firm which of the following should be used when calculating the capital structure weighting? a) Only book values are used b) Only market values are used. c) Common share capital is based on book values and all others are based on market values. d) Common share capital is based on market values and all others are based on book values.

Answer: b

5. Suppose a firm can issue new 10-year, 8% annual coupon bonds at par value of $100. The before-tax issuing costs are 2% of par value. The corporate tax rate is 40%. What are the net proceeds from issuing bonds? a) $100 b) $98.8 c) $98 d) $92 Answer: b

6. Suppose a firm can issue new 10-year, 8% annual coupon bonds at par value of $100. The net proceeds from issuing the bonds is $98.8. The corporate tax rate is 40%. What is the after-tax cost of debt? a) 4.91%. b) 9.92% c) 4.00% d) 2.48%.

Answer: a

7. Suppose a firm can issue new preferred shares at a stated value of $100 that pay annual dividends at a 5% rate, and that the net after-tax flotation costs are 1% of par. What are the per share net proceeds from this share issue?

a) $99 b) $98 c) $95 d) $101 Answer: a

8. Suppose a firm can issue new preferred shares at a stated value of $100, which pay annual dividends at a 5% rate, and the net proceeds are $98. What is the cost of preferred stock? a) 5.00% b) 5.05% c) 5.10% d) 5.20% Answer: c

9. Which of the following statements is true about operating leverage? a) It is generated by issuing debt. b) It is caused by issuing equity. c) It is created by incurring fixed costs. d) It is generated by issuing account receivables.

Answer: c

10. Assume a firm paid a dividend per common share last year of $4, which is expected to grow at 3% per year indefinitely. The current share price is $74. What is the cost of common equity using internal funds. a) 8.57% b) 5.57% c) 8.41% d) 5.1%.

Answer: a

11. Assume a firm paid a dividend per common share last year of $4, which is expected to grow at 3% per year indefinitely. The current share price is $74. Assume the firm can issue new shares with net after-tax flotation costs of 5% of the share price. Estimate the cost of new common equity to the firm. a) 8.57% b) 5.57% c) 8.41% d) 8.86%.

Answer: d

12. Which of the following is the correct method of calculating the sustainable growth rate for a firm? a) dividend payout ratio multiplied by ROE. b) retention ratio multiplied by ROE. c) dividend payout ratio multiplied by ROA. d) retention ratio multiplied by ROA. Answer: b

13. A firm has dividend yield of 4% and growth rate of 10%. What is its cost of equity? a) 4% b) 10% c) 14% d) No enough information for analysis.

Answer: c

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 21 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true about business risk and financial risk? a) ROI reflects business risk; ROE reflects financial risk. b) ROI reflects business risk; ROE reflects business risk and financial risk. c) ROI reflects financial risk; ROE reflects business risk. d) ROI reflects business and financial risk; ROE reflects financial risk.

Answer: b

2. Two firms have the same ROI and are in the same industry. Firm A has a 70% debt-to-equity ratio and Firm B has no debt. Which firm will have a larger variation in their return on equity (ROE)? a) Firm A b) Firm B c) Firm A’ ROE variation is the same as ROI variation. d) Firm A’s ROE variation is the same as Firm B’s ROE Variation.

Answer: a

3. Which of the following is NOT a determinant of capital structure? a) cash flow b) risk c) profit d) the capital structure of firms not in the same industry Answer: d

4. Which of the following statements is true about weighted average cost of capital (WACC) and the cost of debt? a) WACC is always higher than the cost of debt b) WACC is always lower than the cost of debt c) WACC is always equal to the cost of debt d) None of the above Answer: a

5. Which of the following is NOT a determinant of capital structure? a) Profit b) Risk c) Cash Flow d) Fixed cost Answer: d

6. Which of the following statements is FALSE about Moody’s evidence on investment-grade and non-investment-grade firms? a) Investment-grade firms have higher coverage ratio than non-investment-grade firms. b) Investment-grade firms have lower leverage than non-investment-grade firms. c) Investment-grade firms have higher cash flow-to-debt ratio than non-investment-grade firms. d) Investment-grade firms have lower sales stability than non-investment-grade firms.

Answer: d

7. Which of the following statements is NOT an assumption by Franco Modigliani and Merton Miller (M&M)? a) There exist two firms in the same “risk class” with different levels of debt. b) Markets are perfect in the sense that there are no transaction costs or asymmetric information problems. c) There are no taxes.

d) There is risk of costly bankruptcy or associated financial distress.

Answer: d

8. A firm has an EBIT of $2 million, which is expected to remain constant indefinitely. Its cost of capital is 8% and it has $10 million in debt outstanding. What is the value of this firm, and what is the value of its equity (respectively), assuming there are no taxes? a) $25 million and $15 million b) $25 million and $10 million c) $10 million and $15 million d) $10 million and $25 million Answer: a

9. An unlevered firm has an EBIT of $2 million, which is expected to remain constant indefinitely. Its cost of capital is 8%. A levered firm has the same risk and EBIT and has $10 million in debt outstanding. What is the value of the levered firm, assuming there are no taxes? a) $25 million b) $10 million c) $15 million d) no enough information for analysis.

Answer: a

10. The cost of capital in a un-leveraged firm is 8%, the cost of debt is 6%, and the Debt/Equity ratio is 0.3333. What is the cost of equity in a leveraged firm with identical risk, assuming there are no taxes? a) 8% b) 8.67% c) 6% d) 5.67% Answer: b

11. The cost of capital in a non-leveraged firm is 8%, the cost of debt is 6%, and the Debt/Equity ratio is 1/3. What is the weighted average of cost of capital in a leveraged firm with identical risk, assuming there are no taxes? a) 8% b) 8.67% c) 6% d) no enough information for analysis.

Answer: a

12. A firm has an EBIT of $2 million, which is expected to remain constant indefinitely. Its cost of capital is 8% and the corporate tax rate is 30%. The firm has no debt. What is the value of the firm? a) $25 million b) $17.5 million c) $2 million d) $20 million Answer: b

13. A firm has an EBIT of $2 million, which is expected to remain constant indefinitely. Its cost of capital is 8% and the corporate tax rate is 30%. The firm also has $10 million in debt outstanding. What is the value of this firm, and what is the value of its equity, respectively? a) $25 million and $15 million b) $20.5 million and $10.5 million c) $10 million and $15 million d) $10 million and $25 million Answer: b

14. Which factors affect a firms capital structure? a) financial distress risk

b) information asymmetry c) agency cost d) none of the above Answer: d

15. Assume the personal tax rate is 43.42%, corporate tax rate is 35%, and dividend tax rate is 25.40%. Which is the relation between the value of a levered firm and an unlevered firm with the same business risk? a) VL>VU b) VL=VU c) VL<VU d) no enough information for analysis Answer: a

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 22 Shuffle: No

Question type: Multiple Choice

1. Which of the following statements is true about the difference between a cash dividend plus dividend reinvestment plan (DRIP), and a stock dividend? a) They are identical b) With a cash dividend plus DRIP, the cash is distributed first and it is up to the investors to decide whether they want to buy more shares. c) With a cash dividend plus DRIP the firm does not need to pay cash. d) With a stock dividend the firm’s retained earnings are not affected.

Answer: b

2. What is the correct order of dates when a firm declares and pays a dividend? a) declaration date, record date, ex-dividend date, payment date. b) declaration date, ex-dividend date, record date, payment date. c) declaration date, payment date, record date, ex-dividend date. d) ex-dividend date, declaration date, record date, payment date.

Answer: a

3. Which of the following statements is true about the difference between a stock dividend and a stock split? a) They are identical. b) With a stock split the firm’s retained earnings are not affected. c) With a stock split the firm’s earnings per share are not affected. d) With a stock split there is a tax complication similar to stock dividend.

Answer: b

4. Which of the following statements is true about the aggregate cash dividend in Canada? a) Firms never smooth dividends. b) Firms keep the dividend payout ratio constant. c) The historical trend of aggregate dividend is smoother than that of profit. d) All firms keep the same dividend payout ratio.

Answer: c

5. Which of the following is NOT an assumption of Modigliani and Miller (M&M)’s dividend irrelevance theorem? a) There are no taxes. b) Markets are imperfect. c) All firms maximize value. d) There is no debt.

Answer: b

6. A firm has cash flow from operations of $100 million and needs $120 million for investment purposes. Assume that the firm has 10 million shares outstanding and wants to maintain a dividend of $2 a share. If the firm wishes to raise capital with a new share issue what is the new issue worth? a) $100 million b) $120 million c) $40 million d) $22 million.

Answer: c

7. How did Modigliani and Miller (M&M) derive the dividend irrelevance theorem? a) Individuals create (or eliminate) dividends through their own behaviour in a perfect M&M world

b) Individuals create cannot create homemade dividends by themselves. c) Individuals pay tax on dividends d) Dividends are tax deductible in M&M world.

Answer: a

8. What is the “bird in the hand” argument? a) Dividend-paying firms are riskier than non-dividend-paying firms. b) A cash dividend is worth more than an equivalent capital gain. c) Dividend is irrelevant in stock evaluation. d) Dividend is just a residual of investment.

Answer: b

9. Which of the following statements is true about the trade-off between dividend yield and capital gain yield. a) The Modigliani and Miller (M&M) theory indicates that they are perfect substitutes. b) The “Bird in the hand” theory indicates that they are perfect substitutes. c) The Modigliani and Miller (M&M) theory indicates that investors prefer dividend yields over capital gains. d) The “Bird in the hand” theory indicates that investors prefer capital gains over dividend yields.

Answer: a

10. Which of the following arguments is NOT used by researchers to try to explain the fact that firms are reluctant to cut their dividends and why they smooth their dividends? a) transaction costs b) signalling and information asymmetry c) tax d) Modigliani and Miller (M&M)’s dividend irrelevance theorem Answer: d

11. Which of the following is NOT a possible reason for a firm to exercise a share repurchase? a) distribute cash b) offset the exercise of executive stock options c) carry out a leveraged recapitalization d) increase cash Answer: d

12. A firm currently has 1 million shares outstanding and has an expected value of $40 million in the next year. It will have expected free cash flow of $5 million next year and will distribute a $5 per share cash dividend. The appropriate discount rate is 10%. What is the share price in the next year and the current year, respectively? a) $55 and $50 b) $45 and $40.91 c) $45 and $40 d) $45 and $42.32 Answer: b

13. A firm currently has 1 million shares outstanding and has an expected value of $40 million in the next year. It will have an expected free cash flow of $5 million next year and will use it to repurchase 111,111 shares. The appropriate discount rate is 10%. What is the share price in the next year and the current year, respectively? a) $55 and $50 b) $45 and $40.91 c) $45 and $40 d) $45 and $42.32 Answer: b

14. What is NOT a motivation for a share repurchase? a) pay out earnings

b) offset the exercise of executive stock options c) carry out a leverage recapitalization d) raise equity Answer: d

15. Which of the following is true about the tax on dividends? a) Canadian corporations do not pay taxes on dividends they receive from Canadian corporations. b) Individuals do not pay taxes on dividends they receive. c) Corporate tax on dividends is higher than corporate tax on operating income. d) Corporate tax on dividends is higher than personal tax on dividends.

Answer: a

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 23 Shuffle: No

Question type: Multiple Choice

1. Which statement is true about the importance of net working capital management? a) It is irrelevant to the insolvency of a firm b) Only the ratio of total asset and total liability matter for the survival of a firm. c) It is critical for the survival of a firm. d) Maintaining adequate liquidity is only important in economic booms.

Answer: c

2. What is a characteristic of good working capital management? a) The maintenance of zero cash balances b) The investment of any excess liquid funds in marketable securities that provide the best return possible, considering any liquidity or default-risk constraints c) Stop collecting accounts receivable d) Not maintaining an inventory management system Answer: b

3. What is working capital management? a) management of current asset b) management of current liabilities c) management of current asset and current liabilities d) management of cash and marketable securities.

Answer: c

4. What is the difference between profit and cash flow from operations? a) They are identical. b) Profit is greater than cash flow from operations. c) Profit is less than cash flow from operations. d) Cash flow from operations is profit plus non-cash expenses plus/minus changes in net working capital.

Answer: d

5. Which of the following statements is true about the cash budget? a) All firms need cash budget. b) Only firms with cash deficit in the current year need cash budget. c) Only firms with cash surplus in the current year need cash budget. d) Only firms without growth opportunities need cash budget.

Answer: a

6. A firm has cash inflow of $1000, cash outflow of $1500. The start cash is $1250. The minimum required cash balance is $300. How much is the cash surplus (deficit)? a) $450 b) $150 c) ($450). d) ($150).

Answer: a

7. What is the break-even sales growth rate? a) The sales growth rate that makes the change in cash zero. b) The sales growth rate that makes cash deposit zero. c) The sales growth rate that makes net income zero. d) The sales growth rate that makes the gross profit margin zero.

Answer: a

11. A firm collects 100% of its monthly sales immediately. Its production costs are 60% of sales.

It holds two months’ worth of sales in inventory, and it pays 80% of its bills immediately and the balance after 30 days. What is its break-even sales growth rate? a) 58.82% b) 24.56% c) 33.44% d) 23.65% Answer: a

12. A firm’s average days of revenue in inventory is 30 days and the average collection period is 5 days. What is the operating cycle? a) 25 days b) 30 days c) 35 days d) 5 days Answer: c

13. A firm’s operating cycle is 40 days, and the average days revenues in payables is 10 days.

What is the cash conversion cycle? a) 30 days b) 40 days c) 50 days d) 10 days Answer: a

14. A firm’s revenue is $100 million, and average accounts receivable is $20 million. What is the average collection period? a) 5 days

b) 73 days c) uncertain based on the information above d) 50 days Answer: b

15. A firm’s revenue is $100 million, and inventory is $80 million. What is the average days of revenues in inventory? a) 5 days b) 73 days c) uncertain based on the information above d) 292 days Answer: d

Package Title: Clicker Course Title: Booth, Introduction to Corporate Finance, Fifth Canadian Edition Chapter Number: 24 Shuffle: No

Question type: Multiple Choice

1. What is NOT a motivation for holding cash? a) transaction motive b) precautionary motive c) motive to pay loans and dividends d) motive to earn one hundred% return on cash deposits Answer: d

2. Which is NOT a source of float in cash management? a) the time it takes the cheque to reach the firm after it is mailed by the customer b) the time it takes the receiving firm to process the cheque and deposit it in an account c) the time it takes the cheque to clear through the banking system so that the funds are available to the firm d) the time it takes to generate sales from inventory.

Answer: d

3. Which is NOT an example of cash and cash equivalent? a) checking account b) real estate c) commercial papers d) bankers’ acceptance Answer: b

4. Which of the following is an example of the precautionary motive for holding cash? a) cash required for a firm’s normal operations. b) cash used to take care of unanticipated repairs. c) cash used to pay lump-sum loan repayment d) cash used to invest in junk bonds.

Answer: b

5. Which of the following statements is true about optimal cash balance? a) It is zero cash. b) It is 100% asset in cash c) It balances the risks of illiquidity against the sacrifice of expected returns d) It is 50% asset in cash Answer: c

6. Which of the following is NOT one of the four C’s of credit? a) Capacity b) Character c) Collateral d) Country Answer: d

7. What does “2/20 net 45” mean? a) The firm offers customers a 20% discount if they pay the full amount due by day 2 with the full amount being due by day 45. b) The firm offers customers a 2% discount if they pay the full amount due by day 20 with the full amount being due by day 45. c) The firm offers customers a 2% discount if they pay the full amount due by day 45 d) The firm offers customers a 20% discount if they pay the full amount due by day 45.

Answer: b

8. A firm’s credit policy is “1/10 net 30”. What is the effective annual interest rate for not paying on time? a) 23.45% b) 12.34% c) 20.13% d) 23.56% Answer: c

9. A firm’s credit policy is “1/30 net 60”. What is the effective annual interest rate for not paying on time? a) 13.00% b) 12.34% c) 20.13% d) 23.56% Answer: a

10. A firm is considering change credit policy. The present value of future cash flow caused by the change is $2 million, and the initial outlay associated with the change is $1.5 million. What is the net present value of the change? a) $0.5 million b) $1.5 million c) $2 million d) $3.5 million Answer: a

11. A firm is considering the purchase of one of its inputs from supplier A. The selling price is $1,200 and the credit terms are 1/20 net 30. What is the effective annual cost of forgoing the discount?

a) 44.32% b) 20.13% c) 33.23% d) 23.54% Answer: a

12. A firm is considering extending its credit policy. The current sales are 10,000 units at $100 per unit and the cost is $90 per unit. With the new credit policy, sales will increase by 1,000 units and the price will increase to $105 per unit. The incremental bad debts from the new credit policy is expected to be $6,000. What is the annual before-tax incremental cash flow? a) $9,000 b) $15,000 c) $99,000 d) $174,000 Answer:a

13. Estimate the effective annual cost to a firm of issuing 90-day commercial paper with a $10million face value, for net proceeds of $9.90 million. The firm must maintain a $10 million credit line, on which it must pay a standby fee of 0.05%. a) 4.10% b) 4.05% c) 3.97% d) 6.29% Answer: d

14. A firm is issuing 90-day commercial paper with a $10-million face value, for net proceeds of $9.90 million. The firm must maintain a $10 million credit line, on which it must pay a standby fee of 0.05%. What is the quoted yield for the commercial paper? a) 4.10% b) 4.05% c) 3.97%

d) 4.37% Answer: a

15. Which of the following is NOT an inventory management approach? a) ABC approach b) Economic Order Quantity (EOQ)Model c) Materials Requirement Planning (MRP) d) Dividend Discount Model (DDM).

Answer: d

Bloomberg Video Activity for Part 1 (Chapter 1 and 2), Booth Corporate Finance Video Title: Bank of Canada's Poloz Says Trade War Effects Have Been Modest Video Summary: Stephen Poloz, Bank of Canada Governor speaks to broadcasters about the impact that the trade wars have on financial stability, investment and corporate debt, and what the future outlook might be.

Multiple Choice Questions and Answers: 1) If the trade war referred to in the video were to continue or escalate, which of the following would be most directly impacted? a) Households – Net financial assets b) Non-residents – Net financial assets c) Business – Real assets d) Business – Net financial assets Answer: d Difficulty: Easy Learning Objective 1: List the major financial and real assets held by Canadians.

Section Reference 1: Financial Assets Feedback: Refer to section 1.2 Real versus Financial Assets Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) Of the four areas analyzed by Gordon Donaldson which would be most directly and immediately impacted by the trade war should it continue or escalate? a) Performance appraisal b) Investment analysis c) Financing d) Risk Answer: a Difficulty: Easy Learning Objective 1: Explain the importance of aligning the interests of management with the interests of shareholders in a corporation.

Feedback: Refer to section 2.4 Aligning Managers’ and Owners’ Interest.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

3) If the trade war were to continue or escalate, which of the following would be the least risky source of capital for a corporation? a) Bank debt b) Issuing bonds through the debt market c) Equity d) Using only internally generated funds Answer: c Difficulty: Medium Learning Objective 1: Identify the main corporate finance decisions involving the financial management of a firm’s assets and its liabilities (corporate financing).

Feedback: Refer to section 2.5 Corporate Finance.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

4) Which of the following positions in a non-financial company would be most directly involved in managing the risks associated with a continuing trade war? a) Chief financial officer (CFO) b) Senior vice-president of finance c) Treasurer d) Controller Answer: c Difficulty: Medium Learning Objective 1: List some finance jobs available with financial and non-financial companies.

Section Reference 1: Positions in Non-Financial Companies Feedback: Refer to section 2.6 Finance Careers and the Organization of the Finance Function.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

5) Which of the following is an example of the ‘headwinds’ that Stephone Poloz referred to that are impacting economic stimulus policy? a) Household debt b) Investment slowdown c) U.S. trade war d) Taking a long position in US dollar forward contracts when you are medium in Canadian dollars Answer: b Difficulty: Easy Learning Objective 1: Describe forward contracts including how they are used and priced.

Section Reference 1: Forward Contracts Feedback: Refer to section 11.1: Forward Contracts of the text.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. What are the three ‘headwinds’ that Stephone Poloz referred to that are impacting economic stimulus policy?

Answer: Household debt, investment slowdown and the U.S. trade war with virtually everyone.

LOD: Easy LO: Learning Objective: Explain how money is transferred from lenders to borrowers and the role played by market and financial intermediaries Blooms: Knowledge AACSB: Analytic

2. Which type of business organization, if any would likely be the least affected by trade war referred to in the video?

Answer: Depending on the industry the entity is in, all business forms would be affected to at least some degree. This is in large part due to the extent of globalization in the economy.

LOD: Medium LO: List the four forms of business organizations and describe the advantages and disadvantages of each.

Feedback: Refer to section 2.1 Types of Business Organizations Blooms: Comprehension AACSB: Reflective Thinking

3. Which of position(s) in a financial company would most be directly involved in managing the risks associated with a continuing trade war?

Answer: The position of account manager is the one that extends credit and manages the overall relationship between the bank and the customer. Given that level of risk will increase as the level of debt increases, and that a continued trade war would increase overall risk, the most likely position would be that of account manager.

Difficulty: Medium Learning Objective 1: List some finance jobs available with financial and non-financial companies.

Section Reference 1: Positions in Non-Financial Companies Feedback: Refer to section 2.6 Finance Careers and the Organization of the Finance Function.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

4. In terms of corporate fiannce, what is a covenant and how does it impact a corporations ability to raise capital ?

Answer: A covenant is a promise made by a company when it borrows money. A covenant will outline what the corporation may or may not do, or place limits on borrowing amounts. If the covenants are too restrictive then the company may not be able to take full advantage of an investment opportunity.

LOD: Medium LO: Explain how money is transferred from lenders to borrowers and the role played by market and financial intermediaries.

Section Reference 1: Intermediaries Feedback: Refer to section 1.3 The Financial System Blooms: Evaluation AACSB: Reflective Thinking

5. What impact has the trade war had on investment?

Answer: Investment has slowed due to the trade war.

LOD: Easy LO: List the four forms of business organizations and describe the advantages and disadvantages of each.

Feedback: Refer to section 2.1 Types of Business Organizations Blooms: Comprehension AACSB: Analytic

Bloomberg Video Activity for Part 2 (Chapter 3 and 4), Booth Corporate Finance Video Title: Democratizing Financial Analysis Video Summary: Justin Zhen, Co-founder of Thinknum, discusses alternative corporate data analysis versus traditional data and financial analysis when analyzing investment choices and options.

Multiple Choice Questions and Answers: 1) In which part of a corporations’ financial statements is one most likely to find data or information similar to the alternative data referred to in the video? a) Auditor’s Report b) Financial Statements c) Notes to the Financial Statements d) Management Discussion and Analysis (MD&A) Answer: d Difficulty: Medium Learning Objective 1: Analyze a firm’s financial statements.

Section Reference 1: Accompanying Statements Feedback: Refer to section 3.4 Canadian Pacific Accounting Statements.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) Which of the following best describes the difference between alternative data analysis and traditional financial statement analysis? a) Alternative data analysis is forward looking and traditional analysis is historically based b) Alternative data analysis is historically based and traditional analysis is forward looking c) Both alternative data analysis and traditional analysis are forward looking d) Both alternative data analysis and traditional analysis are historically based

Answer: a Difficulty: Medium Learning Objective 1: Identify the issues to consider in applying consistent financial analysis.

Feedback: Refer to section 4.1: Consistent Financial Analysis.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

3) Which of the following groups of users would most likely NOT realize any significant value from alternative data analysis? a) Current investors b) Potential investors c) Internal management d) Banks and other creditors Answer: d Difficulty: Easy Learning Objective 1: Identify the issues to consider in applying consistent financial analysis.

Feedback: Refer to section 4.1: Consistent Financial Analysis.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

4) Which of the following group of ratios would link most directly with alternative data analysis? a) Leverage ratios b) Efficiency ratios c) Productivity ratios d) Valuation ratios Answer: d Difficulty: Medium Learning Objective 1: Calculate, interpret, and evaluate the key ratios relating to the valuation of a company.

Feedback: Refer to section 4.7 Valuation Ratios.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

5) Which of the following are examples of alternative data? a) product pricing b) location c) weather patterns d) all of the above Answer: e Difficulty: Easy Learning Objective 1: Identify the issues to consider in applying consistent financial analysis.

Feedback: Refer to section 4.1: Consistent Financial Analysis.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. In terms of the video content, what is meant by the term democratizing financial analysis?

Answer: A democracy implies that ‘the people’ have the power to govern themselves and/or make decisions for themselves. So to democratize financial analysis, in the context of this video, means that the information needed to effect a comprehensive analysis of a corporation is within the peoples hand, through social media platforms and no longer strictly limited to traditional financial statement ratio analysis.

LOD: Medium Learning Objective 1: Identify the issues to consider in applying consistent financial analysis.

Feedback: Refer to section 4.1: Consistent Financial Analysis.

Blooms: Comprehension AACSB: Reflective Thinking

2. In your view, should alternative data analysis replace traditional financial statement analysis when making investment decisions?

Answer: Answers will vary, and rather than a strict yes or no answer, ideally the two forms of analysis can and should work together.

LOD: Medium Learning Objective 1: Identify the issues to consider in applying consistent financial analysis.

Feedback: Refer to section 4.1: Consistent Financial Analysis.

Blooms: Comprehension AACSB: Reflective Thinking

3. Which group or groups of users are most likely to realize value from alternative data analysis?

Answer: External users who would benefit most from this information would include current and potential investors, an entity looking to acquire or merge with the firm (as per the example of the potential Cabela’s takeover from the video). Internally, management would be able to benefit from this type of information about their competitors and suppliers. All of these users would also use this information along with financial data.

LOD: Medium Learning Objective 1: Calculate, interpret, and evaluate the key ratios relating to the valuation of a company.

Feedback: Refer to section 4.7 Valuation Ratios.

Blooms: Comprehension AACSB: Relfective Thinking

4. Can alternative data analysis be used to assess or determine the overall value of a company?

Answer: No as the value of a company is a quantitative value derived from financial information.

LOD: Medium Learning Objective 1: Calculate, interpret, and evaluate the key ratios relating to the valuation of a company.

Feedback: Refer to section 4.7 Valuation Ratios.

Blooms: Comprehension AACSB: Reflective Thinking

5. Can alternative data analysis be used to assess or determine sales growth and/or profitability of a company?

Answer: Alternative data analysis would be of benefit to determinin sales gowth and/or profitability if used in conjunction with the quantitative financial analysis.

LOD: Medium LO: Explain how external financing requirements are related to sales growth, profitability, dividend payouts, and sustainable growth rates.

Feedback: Refer to section 4.9 Formula Forecasting Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 3 (Chapter 5, 6 and 7), Booth Corporate Finance Video Title: Hedge Fund Shorting Tesla Bonds Video Summary: Bloomberg journalists speak about the market valuation of Tesla shares and bonds, and how the bonds may not be reflecting their true value. For clarification, to short a bond means that you are selling a bond, at the current market price, that you do not currently own. Once you sell the bond at the current market price, you are hoping to be able to buy the bond at a future date at a lower price.

Multiple Choice Questions and Answers: 1) If an investor shorts a Tesla bond, what is their expectation for the future interest rate? a) The expect the yield rate to go up b) The expect the yield rate to go down c) The expect both the coupon and the yield rate to go up d) The expect both the coupon and the yield rate to go down Answer: b Difficulty: Medium Learning Objective 1: Explain how to value a bond given an appropriate discount rate.

Section Reference 1: Bond Valuation Feedback: Refer to section 6.2 Bond Valuation.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic 2) At the time of the video, Tesla bonds with a coupon rate of 5.3% were selling above par. Which of the following is correct regarding the market rate of interest? a) Market rate was greater than the coupon rate b) Market rate was less than the coupon rate c) Market rate was equal to the coupon rate d) Not enough information provided in the video to answer the question Answer: a Difficulty: Easy Learning Objective 1: Explain how to value a bond given an appropriate discount rate.

Section Reference 1: Bond Valuation Feedback: Refer to section 6.2 Bond Valuation.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

3) Given that the yield rate on Tesla bonds was approximately 4% at the time of the video, and the coupon rate is 5.3%, which of the following actions might Tesla consider, assuming the provisions are available in that bond issue? a) Calling in the bonds and replacing them with one that has a lower coupon rate b) Calling in the bonds and replacing them with one that has a lower coupon rate and are convertible c) Either of the two options d) Neither of the two options Answer: c Difficulty: Easy Learning Objective 1: Describe the basic structure and the various features of different types of bonds.

Section Reference 1: Additional Bond Features Feedback: Refer to section 6.1: The Basic Structure of Bonds.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

4) Assume that Tesla were to call in their bond issue and replace it with on that could be issued, and remain at par. What impact would this have on their market value to EBIT ratio, all else held equal? a) It would decrease b) It would increase c) There would be no change d) There is not enough information provided to answer the question Answer: a Difficulty: Medium Learning Objective 1: Explain how to value common shares using additional relative value ratios.

Feedback: Refer to section 7B: Additional Multiples or Relative Value Ratios.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

5) If the yield rate on Tesla bonds continues to decline, what would you expect to see happen to the price of the bond? a) It should increase b) It should decrease c) There should be no impact d) The price will change only if the coupon rate changes Answer: a Difficulty: Easy Learning Objective 1: Explain how to value a bond given an appropriate discount rate.

Section Reference 1: Bond Valuation Feedback: Refer to section 6.2 Bond Valuation.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. If investors are shorting the Tesla bonds, what does that say about their perception of the yield curve?

Answer: Investors are then expecting the yield curve to slope downward.

LOD: Easy Learning Objective 1: List and describe the factor, both domestic and global, that affect interest rates.

Section Reference 1: The Term Structure of Interest Rates Feedback: Refer to section 6.4 Interest Rate Determinants.

Blooms: Knowledge AACSB: Analytic

2. The 5.3% Tesla bonds, were issued when Tesla had a triple C+ Bloomberg credit rating. Credit ratings range from AAA (highest rating) to D (lowest rating). This was considered a very low coupon rate for a company with such a rating. Why, in your opinion would Tesla issue bonds with such a low coupon given their rating?

Answer: Answers will vary, however some points that should be considered include impact on the price of the bond and future bond issues; depending on the market or yield rate how does the coupon rate compare, given that the bonds are trading at a above par the yield must still be below the coupon rate.

LOD: Medium Learning Objective 1: Describe the basic structure and the various features of different types of bonds.

Section Reference 1: Basic Bond Terminology Feedback: Refer to section 6.1 The Basic Structure of Bonds.

Blooms: Comprehension AACSB: Reflective Thinking

3. Is there a correlation between Tesla bonds trading at a premium and the increase in market price of Tesla shares?

Answer: All else being equal, there is generally no correlation between the movement of a company’s share price and the bond price. In theory, the two should move in opposite directions which is not the case with Tesla at the time of the video. As noted in the text, there are three main factors affecting share price, none of which relate to bond pricing.

LOD: Medium Learning Objective 1: Equity Valuation.

Section Reference 1: Introduction

Feedback: Refer to section 7.1 Equity Securities.

Blooms: Comprehension AACSB: Relfective Thinking

4. What does the discussion panel mean when they say that Tesla bonds have moved “beyond what fair value should be”?

Answer: Bond price is based on the market rate of interest, or the yield rate, the return that bondholders will realize if they hold the bond to maturity and receive all payments due them. If a bond is perceived to be trading a above fair value, then the premium being paid by investors is too high. A premium results when a yield rate is less than the coupon rate. For Tesla bonds then this means the yield rate is too low relative to the market.

LOD: Medium Learning Objective 1: Determine the discount rate or yield for a given market value of a bond.

Section Reference 1: Yield to Maturity Feedback: Refer to section 6.3 Bond Yields.

Blooms: Comprehension AACSB: Reflective Thinking

5. At the time of the video the Tesla bonds were yielding approximately 4.0%. As of April 2020 the bonds were yielding 5.99% and trading below par. Based on this information, and if you had shorted these bonds, would you have made a profit?

Answer: Yes, a profit would have been made if you sold the bonds at above par and then bought them when the price declined, which is what someone who shorts the bond is hoping for.

LOD: Medium Learning Objective 1: Explain how to value a bond given an appropriate discount rate.

Feedback: Refer to section 6.2 Bond Valuation.

Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 4 (Chapter 8, 9 and 10), Booth Corporate Finance Video Title: Insider Trading Fairness Video Summary: Bloomberg analysts discuss when does insider trading begin and end? When is it fair to trade on obtained information? While no concrete answers are provided, which is often the case with insider trading, it does provide a starting point for discussion on the topic.

Multiple Choice Questions and Answers: 1) Which of the four assumptions underlying the existance of efficient markets is violated by the scenarios described in the video? a) There are a large number of rational, well-informed and profit maximizing investors participating in the market b) Information is costless and widely available to participants at the same time c) Information arrives randomly d) Investors react quickly and fully to new information Answer: b Difficulty: Easy Learning Objective 1: Explain what market efficiency is and why it is important.

Section Reference 1: Assumptions Underlying Market Efficiency Feedback: Refer to section 10.1 Defining Market Efficiency.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) Insider trading is NOT an example of which of the following market efficiency components? a) Operational efficiency b) Allocational efficiency c) Informational efficiency d) Material facts Answer: c Difficulty: Easy Learning Objective 1: Explain what market efficiency is and why it is important.

Section Reference 1: The Components of Market Efficiency Feedback: Refer to section 10.1 Defining Market Efficiency.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

3) In which efficient market hypothesis (EMH) can it be said that no investor can take advantage of insider information? a) Weak form b) Semi-weak form d) Semi-strong form d) Strong form Answer: d Difficulty: Easy Learning Objective 1: Differentiate among the different levels of efficiency.

Feedback: Refer to section 10.2 The Efficient Market Hypothesis (EMH).

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

4) Which of the following persons have been charges and/or convicted of insider trading? a) Gene Levoff b) Ivan Boesky c) Martha Stewart d) All of the above Answer: d Difficulty: Easy Learning Objective 1: Discuss the general consensus based on empirical evidence of market efficiency, as well as the existence of some well-known anomalies.

Section Reference 1: Strong Form Evidence Feedback: Refer to section 10.3 Empirical Evidence Regarding Market Efficiency.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

5) Insider trading is not part of which of the following concepts or theories? a) Behavioural finance b) Traditional finance c) Speculative bubbles d) None of the above Answer: a Difficulty: Easy Learning Objective 1: Differentiate between behavioural finance and the traditional view of finance Feedback: Refer to section 10.4 Behavioural Finance.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. Define ‘insider trading’ and provide an example of insider trading, either fictional or factual?

Answer: An insider is any party that has access to private information about a security as a result of a special relationship with the underlying entity and based on that information makes a trade. An example (and student answers will vary) might be overhearing a conversation at a dinner party between two corporate executives talking about an upcoming expansion that has not yet been announced. Before the announcement is made publically you purchase shares in the company, in the hopes that the news will cause the share price to increase.

LOD: Medium Learning Objective 1: Explain what market efficiency is and why it is important.

Section Reference 1: The Components of Market Efficiency Feedback: Refer to section 10.1 Defining Market Efficiency.

Blooms: Comprehension AACSB: Reflective Thinking

2. The video provided an example of what may, or may not be insider trading by comparing the position of the person privy to the information. Provide an example of something that is not insider trading, similar to the video example, and explain why it is not insider trading?

Answer: Student answers will vary. An example is a lawyer speaking to a client about their organizational structure and how certain key management positions are likely to be terminated. If the lawyer acts on that information, that is insider trading. However if you happen to overhear and act on that information that would not be insider trading LOD: Medium Learning Objective 1: Explain what market efficiency is and why it is important.

Section Reference 1: The Components of Market Efficiency Feedback: Refer to section 10.1 Defining Market Efficiency.

Blooms: Comprehension AACSB: Reflective Thinking

3. The strong form EMH conveys that “no investor can take advantage even of “inside” information that has not yet been released to the stock market.” Based on the video

example of the doctor and the bystander, is strong form EMH possible?

Answer: Under the strong form EMH such information would not provide an opportunity for profit, as all information both public and private is available to everyone not just the doctor and the bystander.

Theoretically it is possible that all such information would be public, and that share prices would

reflect this knowledge immediately, however this is usually not the case. Typically markets operate somewhere between weak and semi-strong form EMH. LOD: Medium Learning Objective 1: Differentiate among the different levels of efficiency.

Feedback: Refer to section 10.2 The Efficient Market Hypothesis (EMH).

Blooms: Comprehension AACSB: Relfective Thinking

4. Can an investor, over the long-term realize abnormal profits from insider trading Answer: Over the long-term the answer is no as the market price should adjust to reflect any and all information.

LOD: Medium Learning Objective 1: Discuss the general consensus based on empirical evidence of market efficiency, as well as the existence of some well-known anomalies.

Section Reference 1: Strong Form Evidence Feedback: Refer to section 10.3 Empirical Evidence Regarding Market Efficiency.

Blooms: Comprehension AACSB: Reflective Thinking

5. If an investor were to ‘practice’ insider trading as part of their investment strategy, ethics and legalities aside, is this a sustainable long-term investment strategy? Why, or why not?

Answer: A successful investment strategy is one that the investor “focus on the basics of good investing by defining their objectives in terms of expected return and acceptable risk levels, and by maintaining an adequately diversified portfolio” for long-term investment success.

LOD: Medium LO: Explain the implicastion of market efficiency Feedback: Refer to section 10.5 Implications of Market Efficiency.

Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 5 (Chapter 11 and 12), Booth Corporate Finance Video Title: Bank of Canada's Poloz Says Trade War Effects Have Been Modest Video Summary: Daniel Vesterbaek Pedersen, CIO of Asgard Credit Fund speaks to their long and short positions with Tesla, and addresses the differences between the credit market and equity market for Tesla and the risks each of these markets presents..

Multiple Choice Questions and Answers: 1) Which of the following describes the position that Asgard has taken in the auto sector? a) Asgard has a short position in Tesla balanced with a long position in other auto firms b) Asgard has a short position in Tesla balanced with a short position in other auto firms c) Asgard has a long position in Tesla balanced with a short position in other auto firms d) Asgard has a long position in Tesla balanced with a long position in other auto firms Answer: a Difficulty: Easy Learning Objective 1: Describe forward contracts including how they are used and priced.

Section Reference 1: Forward Contracts Feedback: Refer to section 11.1: Forward Contracts.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) Which of the following positionsdoes Mr. Pederson recommend NOT taking because of the high risk? a) Taking a short position stocks and convertible bonds b) Taking a long position stocks and convertible bonds c) Taking a short position on CDS d) Taking a short position stocks, CDS and convertible bonds Answer: a Difficulty: Easy Learning Objective 1: Describe forward contracts including how they are used and priced.

Section Reference 1: Forward Contracts Feedback: Refer to section 11.1: Forward Contracts of the text.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

3) Which of the following describes Asgard’s position on Tesla CDS’s?

a) Asgard owns the CDS’s outright b) Asgard has a call option for the CDS’s outright c) Asgard has a put option for the CDS’s outright d) Asgard does not have a CDS position Answer: a Difficulty: Easy Learning Objective 1: Describe the basic nature of call options and the factors that influence their value Section Reference 1: Call Option Basics Feedback: Refer to section 12.1: Call Options.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

4) Where does Asgard see as the catalyst to the financial value in the position they have taken on Tesla and the auto market? a) The catalyst is their positive view on the pricing in the credit market of the overall auto market. b) The catalyst is their positive view on the pricing in the equity market of the overall auto market. c) The catalyst is their positive view on the pricing in the credit and equity markets of the overall auto market. d) The catalyst is their positive view on the pricing in the CDS market of the overall auto market.

Answer: a LOD: Medium Learning Objective: 11.3: Describe the mechanics of simple swap structures, including interest rate swaps and currency swaps.

Section Reference 1: Swaps Feedback: Refer to section 11.3: Swaps.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

5) The Tesla credit default swaps (CDS) are likely which of the following? a) Interest rate swap b) Currency swap c) Debt, or credit swap d) Equity swap Answer: a LOD: Medium Learning Objective: 11.3: Describe the mechanics of simple swap structures, including interest rate swaps and currency swaps.

Section Reference 1: Swaps Feedback: Refer to section 11.3: Swaps.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

Discussion Questions and Answers: 1. Asgard Credit has a short position on CDS of Tesla. Why is a short position preferred on Tesla CDS rather than a long position?

Answer: To take a long position means that Asgard Credit would have to own the CDSs of Tesla outright. Because Asgard believes there is limited upside to holding these CDSs, and because the credit curve is tight, a short position is preferred. They do not own the CDSs until settlement, as which point they are betting on the price going down.

LOD: Medium LO: Learning Objective: 12.2 - Describe the basic nature of call options and the factors that influence their value.

Blooms: Comprehension AACSB: Reflective Thinking

2. How is Asgard Tesla hedging their overall position in this industry?

Answer: They are hedging or balancing their risk position by holding a long position in 4 to 5 low risk companies; with holding in Tesla and Hartz taking the other side of the risk position.

LOD: Easy Learning Objective: 12.6 – Explain, using the simplest option pricing model, what factors affect the value of a call option.

Blooms: Comprehension AACSB: Reflective Thinking

3. What are the credit default swaps (CDS) of Tesla likely made up of?

Answer: The CDSs of Tesla are credit (or debt) related, or interest rate swaps so a CDS position would be on where the purchaser is betting that the Tesla will either go bankrupt or face financial distress and therefore unable to meet its credit obligations.

LOD: Medium Learning Objective: 11.3: Describe the mechanics of simple swap structures, including interest rate swaps and currency swaps.

Blooms: Comprehension AACSB: Relfective Thinking

4. What is the ‘credit curve’ and what does it mean when Mr. Pedersen indicated that the curve is tight?

Answer: The credit curve is the yield curve, which is a graphical representation of the relationship between the return offered by a security, in this case a CDS and the time to maturity of the security. It is a measurement of investors’ feelings about risk and can affect the rate of return on investments.

When such a curve is tight, or steep long-term bond yields are rising faster than short-term yields.

LOD: Medium Learning Objective: 11.4 – Explain how the credit default swap market contributed to the financial crisis.

Blooms: Comprehension AACSB: Reflective Thinking

5. A short squeeze, and mentioned towards the end of the video is a situation where a heavily shorted stock or commodity moves sharply higher which then forces short sellers to close out their positions. This then adds to the upward pressure on the stock. Short squeezes are generally triggered by a positive development that suggests the stock may be embarking on a turnaround? What reasons were given for the increase in the value of Tesla shares?

Answer: The major reason for this share price rally given by Mr. Pederson is the perspective that electric cars may not be run by battery but by some other mechanism; and the long-term horizon needed to analyze Tesla and its industry.

LOD: Medium Learning Objective: 12.5 – Explain how options are traded and what is meant by implied volatility.

Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 6 (Chapter 13, 14, 15 and 16), Booth Corporate Finance Video Title: Traton offers to buy Navistar Video Summary: Mr. Benedikt Kammel of Bloomberg Berlin speaks to the Volkswagon/Traton acquisition of Navistar addressing such issues as motive and market impact.

Multiple Choice Questions and Answers: 1) Which type of takeover is Volkswagon/Traton attempting with Navistar? a) Acquisition b) Merger c) Amalgamation d) Takeover Answer: a Difficulty: Easy Learning Objective 1: Describe different types of takeovers.

Section Reference 1: Types of Takeovers Feedback: Refer to section 15.1: Types of Takeovers.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) At which critical threshold is Volkswagon/Traton at with regards to Navistar? a) Early warning b) Takeover bid c) Between early warning and takeover bid d) Control Answer: c Difficulty: Easy Learning Objective 1: Explain securities legislation as it applies to takeovers.

Section Reference 1: Securities Legislation and Takeovers Feedback: Refer to section: Critical Thresholds.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

3) To which merger and acquisition classification does the Volkswagon/Traton/Navistar fall in? a) Horizontal merger b) Vertical merger

c) Conglomerate merger d) None of the above Answer: a Difficulty: Easy Learning Objective 1: Explain the various motivations underlyng mergers and acquisitions.

Section Reference 1: Classifications of Mergers and Acquisitions Feedback: Refer to section 15.4 Motivations for Mergers and Acquisitions.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

4) Which of the “value creation” motives would the Volkswagon/Traton/Navistar acquisition fall in? a) Operating synergies b) Financing synergies c) Tax benefits d) Strategic realignments Answer: d Difficulty: Easy Learning Objective 1: Explain the various motivations underlyng mergers and acquisitions.

Section Reference 1: Value Creation Motivations for M&As Feedback: Refer to section 15.4 Motivations for Mergers and Acquisitions.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

5) Of those presented, which capital budgeting analysis tool would be most appropriate for deciding whether to acquire Navistar? a) Discounted payback b) Qualitative analysis c) Net present value analysis d) Payback Answer: c Difficulty: Easy Learning Objective 1: Identify and apply the main tools used to evaluate investments.

Section Reference 1: Net Present Value (NPV) Analysis Feedback: Refer to section 13.2 Evaluating Investment Alternatives.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers:

1. Which group of shareholders would likely see an immediate increase in their share value on news of the Volkswagon/Traton/Navistar acquisition?

Answer: Evidence suggests that the shareholders of Navistar will gain the most from this merger as they would likely see a premium in their stock price. This is further supported by the 51.42% increase in Navistar shares as noted in the video LOD: Medium Learning Objective 1: Explain the various motivations underlyng mergers and acquisitions.

Section Reference 1: Gains resulting from mergers: Empirical Evidence Feedback: Refer to section 15.4 Motivations for Mergers and Acquisitions.

Blooms: Comprehension AACSB: Reflective Thinking

2. We can typically think of merger and acquisition purchasers as belonging to one of four broad groups. Which type of purchaser is Volkswagon/Traton?

Answer: Volkswagon/Traton would be considered a ‘strategic investor’ as they are acquiring Navistor to integrate that firm’s operations, and market, with their own.

LOD: Easy Learning Objective: Identify the valuation issues involved in assessing mergers and acquisitions Section Reference 1: The concept of fair market value Feedback: Refer to section 15.5 Valuation Issues.

Blooms: Knowledge AACSB: Analytic

3. Which valuation method would Volkswagon/Traton likely have used to evaluate whether or not to acquire Navistar?

Answer: A discounted cash flow analysis, similar to the net present value (NPV) analysis applied to capital budgeting project analysis and security valuations.

LOD: Easy Learning Objective: Identify the valuation issues involved in assessing mergers and acquisitions Section Reference 1: Discounted Cash Flow Analysis Feedback: Refer to section 15.5 Valuation Issues.

Blooms: Knowledge AACSB: Analytic

4. Does the capital budgeting process apply to a merger and acquisition problem. If so, briefly outline the steps and apply them to the Volkswagon/Traton/Navistar acquisition?

Answer: The fours steps in the capital budgeting process, and how they relate to the Volkswagon/Traton/Navistar acquisition are (note that student answers for the right hand column may differ from those presented): Identify investment alternatives

Evaluate these alternatives

Implement the chosen investment decision

Monitor and evaluate the implemented decisions

Volkswagon/Traton likely considered other firms in the commercial vehicle industry before deciding upon Navistar By considering the factors that were most important to them, such as market share and applying some form of discounted cash flow analysis to each alternative Once the decision had been made Volkswagon/Traton would then have to acquire Navistar either through a cash transaction or a share transaction As time goes on Volkswagon/Traton will monitor to ensure, for example, that market share expectations are met

LOD: Medium Learning Objective: Describe the capital budgeting process and explain its importance to corporate strategy Section Reference 1: The Importance of the Capital Expenditure Decision Feedback: Refer to section 13.1 Capital Expenditures.

Blooms: Comprehension AACSB: Reflective Thinking

5. Of the two managerial motives noted in the text, which would most likely apply to the Volkswagon/Traton/Navistar acquisition?

Answer: The “reduced firm risk through diversification” motive would be most applicable in this situation. As noted in the video, the acquisition is being considered in order to expand market share and to increase their presence in the trucking industry, which is an industry that Volkswagon/Triton is not current a part of.

Learning Objective 1: Explain the various motivations underlyng mergers and acquisitions.

Section Reference 1: Managerial Motivations for M&As Feedback: Refer to section 15.4 Motivations for Mergers and Acquisitions.

Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 7 (Chapter 17, 18, 19 and 20), Booth Corporate Finance Video Title: Casper Seeks $159M in IPO Video Summary: Bloomberg analysts discuss various aspects of Casper Sleeps IPO including valuation and motives.

Multiple Choice Questions and Answers: 1) At the time of the video, what development stage is Casper Sleeps at? a) Stages 1 and 2 b) Stage 3 c) Stages 3 and 4 d) Stage 5 Answer: c Difficulty: Medium Learning Objective 1: Outline the basic stages in taking affirm public through an initial public offering (IPO) of securities.

Section Reference 1: The Motivation for IPOs

Feedback: Refer to section 17.4 IPOs and Investment Banking.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic 2) At the time of the video, at what stage in the IPO was Casper Sleeps most likely at? a) The Second Stage b) The beginning of the Third Stage c) The end of the Third Stage d) The Fourth Stage Answer: c Difficulty: Medium Learning Objective 1: Outline the basic stages in taking affirm public through an initial public offering (IPO) of securities.

Section Reference 1: The Stages of the IPO Process

Feedback: Refer to section 17.4 IPOs and Investment Banking.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic 3) Which of the following best describes the initial offering price of Casper Sleeps shares? a) Underpriced

b) Overpriced c) Fair value price d) None of the above Answer: a Difficulty: Medium Learning Objective 1: Outline the basic stages in taking a firm public through an initial public offering (IPO) of securities.

Section Reference 1: IPO Underpricing

Feedback: Refer to section 17.4 IPOs and Investment Banking.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic 4) What type of shares is Casper Sleep issuing in their IPO? a) Common shares b) Preferred shares c) Convertible shares d) Non-voting shares Answer: a Difficulty: Easy Learning Objective 1: Describe the various classes of shares and the shareholders’ rights associated with each.

Feedback: Refer to section 19.2 Different Classes of Shares.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic 5) For purposes of this question, assume that the price of Casper Sleeps shares fell from their initial offering price of $17 to $10 per share. All else remaining equal, what should happen to Casper Sleeps return on invested capital (ROIC)? a) It should increase b) it should decrease c) It should remain unchanged d) Insufficient information to answer the question Answer: a Difficulty: Medium Learning Objective 1: Explain how the three major problem areas in finance – valuation, cost of capital, and determining cash flows-are related.

Section Reference 1: Deriving the Required Income Statement

Feedback: Refer to section 20.1 Financing Sources.

Bloom’s Taxonomy : Application ACCSB: Analytic Discussion Questions and Answers: 1. What are the two key motives for Casper Sleep going public?

Answer: The two motives are access to cash, as the company is “burning cash” and needs financing; and second the company is not profitable and needs capital to continue to grow and eventually become profitable.

Difficulty: Easy Learning Objective 1: Outline the basic stages in taking affirm public through an initial public offering (IPO) of securities.

Section Reference 1: The Motivation for IPOs

Feedback: Refer to section 17.4 IPOs and Investment Banking.

Bloom’s Taxonomy : Comprehension ACCSB: Analytic

2. A prospectus requires full and clear disclosure of all material facts about the company and the price of their shares. What was not addressed in Casper Sleeps’ prospectus, and what impact does that have on the share price?

Answer: The prospectus did not address the profitability, or lack of profitability of the company and the impact this has on the share price is that the market price had to be set at a price that appeals to investors given the lack of profitability.

LOD: Medium Learning Objective: Explain what a prospectus is, what it contains, and why it is critical for initial public offerings (IPOs) Feedback: Refer to section 17.3 Security Offerings Blooms: Comprehension AACSB: Reflective Thinking

3. What are some advantages and disadvantages to Casper Sleeps raising capital via an IPO rather than via debt instruments?

Answer: Advantages include the ability to raise a larger amount of capital through the IPO, and there is no contractual obligation to make either interim payments (interest) or repayment of principal. Disadvantages include potential loss of control and a target for a takeover; and any interim payments made to investors in the form of dividends are not tax deductible.

LOD: Medium Learning Objective: Define “debt” and identify the basic features that distinguish debt from equity financing.

Feedback: Refer to section 18.1 What is Debt?

Blooms: Comprehension AACSB: Relfective Thinking

4. Given the facts provided about Casper Sleeps, what type of investor would likely purchase these shares?

Answer: The type of investor likely to purchase these shares would be on who is risk averse.

Given Casper Sleeps. As Casper Sleeps has not provided a path or plan to profitability, and the substantial decrease in their overall market value from $1 billion to $159 million, this would be viewed as a risky investment. Therefore institutional investors, and individual investors with a well balanced portfolio would be likely purchasers. These investors however would also pay close attention to determine if they should continue to hold the shares or sell them in the secondary market.

LOD: Medium Learning Objective: Explain why continuous disclosure requirements are important for investors and how they affect secondary offerings.

Feedback: Refer to section 17.5 Post-IPO Regulation and Seasoned Offerings.

Blooms: Comprehension AACSB: Reflective Thinking

5. Casper Sleeps initial share offering was expected to be priced in the $17 to $19 per share range.

Assuming the shares were issued at $17 per share, and subsequently the price fell to $6 per share, what impact would this likely have on the Cost of Capital for Casper Shares, all else remaining equal?

Answer: Typically, the cost of equity is the most expensive component of the cost of capital. If the share price fell by $11 per share, then one would expect the cost of capital to decrease as well, assuming that the rate of return required by the investor remains the same. However, it is likely that Casper Sleeps would have to issue more shares, at the lower price, which should then bring their cost of capital back to the original level, all else remaining equal.

For example.

Cost of Capital Weighting K Capital Debt 10,000,000 0.0658 0.0325 0.0021 Common Equity* 141,950,000 0.9342 0.1 0.0934 151,950,000 0.0956 Initial offering was 8.35 million shares at $17 = $141,950,000 Cost of capital with share price of $6 Capital Debt

Weighting 10,000,000

K 0.1664

Cost of Capital 0.0325 0.0054

Common Equity*

50,100,000 60,100,000 =8,350,000 shares*$6.00

0.8336

0.1

0.0834 0.0888

LOD: Medium Learning Objective: Calculate the weighted average cost of capital (WACC) and explain its significance.

Feedback: Refer to section 20.2 The Cost of Capital.

Blooms: Evaluation AACSB: Analytic

Bloomberg Video Activity for Part 8 (Chapter 21 and 22), Booth Corporate Finance Video Title: Nissan Dividend Blow to Renault Video Link: Video Summary: David McCombs of Bloomberg News discusses the overall impact of Nissan’s recent dividend policy decision amidst a downturn in earnings forecasts and market backlash.

Multiple Choice Questions and Answers: 1) Which type of risk is Nissan facing as a result of their debt committments? a) Business risk b) Financial risk c) Operations risk d) Investment risk Answer: b Difficulty: Easy Learning Objective 1: Explain how business and financial risk affect a firm’s ROE and EPS, and identify the financial break-even proints.

Section Reference 1: Risk and Leverage Feedback: Refer to section 21.1: Risk and Leverage.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) The market share value for Nissan shares has seen a steady and rapid decline during 2019. Which of the following are the major reasons for this decline? a) Uncertainty about the dividend payment policy b) Earnings forecasts not meeting market expectations c) Both the dividend uncertainty and earnings forecast expectations d) Not enough information provided in the video to answer the question Answer: c LOD: Medium LO: Learning Objective: 22.6 – Explain why dividends are not a residual, as impled by M&M. Feedback: Refer to section 22.6: Dividends and Signalling Blooms: Knowledge AACSB: Analytic

3) Which of the following other factors, as described in the text, relate most to Nissan and their position as described in the video? a) Is the firm profitable? b) What type of assets does the firm have? c) How big is the firm? d) How high is the stock price, how much has it appreciated over the last year, and how cheap is it to borrow?

Answer: a Difficulty: Easy Learning Objective 1: Describe other factors that can affect a firm’s capital structure in practice.

Feedback: Refer to section 21.7: Capital Structure in Practice.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

4) According to Modigliani and Miller (M&M), which of the following statements best applies to Nissan? a) Any negative effects of Nissan’s current debt structure can be removed by investors buying some of their position in Nissan’s debt b) Any negative effects of Nissan’s current debt structure can be removed by investors buying some of their position in Nissan’s equity c) Any negative effects of Nissan’s current debt structure can be removed by investors selling some of their position in Nissan’s debt d) Any negative effects of Nissan’s current debt structure can be removed by investors selling some of their position in Nissan’s equity Answer: a Difficulty: Easy Learning Objective 1: Explain how Midigliani and Miller (M&M) “proved” their irrelevance conclusion that the use of debt does not change the value of the firm.

Feedback: Refer to section 21.3: M&M and Firm Value.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

5) Which of the following would best describe Renault’s position regarding the payment of Nissan dividends? a) Bird in the Hand b) Homemade Dividends c) Residual Theory of Dividends d) Equity Capitalization Theory Answer: a Difficulty: Easy

Learning Objective 1: Explain why dividend payments generally reflect the business risk of the firm.

Feedback: Refer to section 22.4: The “Bird in the Hand” Argument.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. Has Nissan and/or Renault exhibited any agency theory characteristics in the Nissan dividend payment decision?

Answer: Because Renault has three members on the Board of Directors, including key leadership positions, and because Renault counts on the cash flow from any dividend income to augment their cash flows and increase their earnings position, they are demonstrating agency theory. They are acting in their own interests rather than the interests of the Nissan shareholders.

LOD: Medium LO: Learning Objective: 22.6 – Explain why dividends are not a residual, as impled by M&M. Feedback: Refer to section 22.6: Dividends and Signalling Blooms: Comprehension AACSB: Reflective Thinking

2. To which rule of financial leverage is David McCombs most referring to when he speaks about the $12 billion in debt that Nissan has coming due in 2020?

Answer: He is most referring to the third rule of financial leverage: financing with debt increases the likelihood of the firm running into financial distress and possibly even bankruptcy.

LOD: Easy Learning Objective: 21.1 – Explain how business and financial risk affect a firm’s ROE and EPS, and identify the financial break-even points.

Feedback: Refer to section 21.1 The Rules of Financial Leverage Blooms: Comprehension AACSB: Reflective Thinking

3. What factor, or factors contributed most to the sharp decline in Nissan share value?

Answer: The most immediate impact on the share value was the profit expectation, which fell short of not only management expectations, but the market as well. The dividend payment decision also had an impact although not as great as the profit expectation.

LOD: Easy Learning Objective: 21.1 – Explain how business and financial risk affect a firm’s ROE and EPS, and identify the financial break-even points.

Feedback: Refer to section 21.1 The Rules of Financial Leverage Blooms: Comprehension

AACSB: Reflective Thinking

4. Which two key areas did David McCombs suggest that Nissan should focus on going forward?

Answer: The two areas are operations/profitability and smoothing their dividend policy.

LOD: Easy Learning Objective: 22.5 – Explain why firms are reluctant to cut their dividends and why they smooth their dividends Feedback: Refer to section 22.5 Dividend Policy in Practice.

Blooms: Comprehension AACSB: Reflective Thinking

5. Based on the information provided by David McCombs in the video, has Nissan applied the pecking order to raising capital for Nissan?

Answer: The pecking order is internal cash flow, debt and lastly common equity. Given that Nissan has a significant debt load coming due in 2020, and demands for dividend payments, it would appear that Nissan has not been able to apply the pecking order.

LOD: Medium Learning Objective: 21.6 – Explain how information asymmetries and agency problems lead firms to fillow a pecking-order approach to financing Blooms: Comprehension AACSB: Reflective Thinking

Bloomberg Video Activity for Part 9 (Chapter 23 and 24), Booth Corporate Finance Video Title: The Hedge Fund World of Fine Art Video Link:

https://mercury.bloomberg.com/videos/44260738 Video Summary: Bloomberg journalists speak with Katya Kazakina about the growing trend to use collectible artworks as collateral for lines and credit and working capital.

Multiple Choice Questions and Answers: 1) Using the collectible artwork as collateral against lines of credit and other financing arrangements is an example of which of the following? a) Securitization b) Credit enhancements c) Special purpose vehicles d) Prepayment Answer: b Difficulty: Easy Learning Objective 1: Describe the major sources of short-term financing.

Section Reference 1: 24.4 Short-term Financing Considerations Feedback: Refer to section: Securitizations.

Bloom’s Taxonomy : Knowledge ACCSB: Analytic

2) Which type of loan are typically being granted with collaterized artwork? a) Operating loan b) Line of Credit c) Factor loan d) Mortgage Answer: b Difficulty: Easy Learning Objective 1: Describe the major sources of short-term financing.

Section Reference 1: 24.4 Short-term Financing Considerations Feedback: Refer to section: Bank Loans.

Bloom’s Taxonomy : Knowledge

ACCSB: Analytic

3) What impact would holding and collaterizing collectible artwork have, if any, on an entities cash conversion cycle, all else held equal? a) The cycle will increase b) The cycle will decrease c) There will be no change in the cycle d) The operating cycle only will change Answer: c LOD: Medium Learning Objective: Describe some common ways to analyze a firm’s management of its net working capital.

Section Reference 1: 23.4 Working Capital Management in Practice Feedback: Refer to section: Operating and Cash Conversion Cycles Blooms: Comprehension AACSB: Reflective Thinking 4) Which of the following is NOT a valid motive for holding onto the cash that is acquired by collaterizing collectible artwork? a) Transaction b) Precautionary c) Speculative d) Income Tax Answer: d Difficulty: Easy Learning Objective 1: Explain the motivation for holding cash and the methods used to implement effective cash management techniques.

Section Reference 1: 24.1: Cash and Marketable Securities Feedback: Refer to section. Reasons for Holding Cash Bloom’s Taxonomy : Knowledge ACCSB: Analytic

5) Which of the following inventory management approaches applies to the collectible artwork referred to in the video? a) ABC approach b) EQO model c) MRP model d) None of the above Answer: d

Difficulty: Easy Learning Objective 1: Describe how inventory is managed.

Section Reference 1: Inventory Management Approaches Feedback: Refer to section 24.3: Inventory Bloom’s Taxonomy : Knowledge ACCSB: Analytic

Discussion Questions and Answers: 1. How does holding and collaterizing collectible artwork help an entity manage their working capital position?

Answer: By collaterizing their artwork, entities are able to secure low-interest lines of credit to use to finance day-to-day working capital needs and/or to finance further investments.

LOD: Medium LO: Learning Objective: Describe the major sources of short-term financing Section Reference 1: 24.4 Short-term Financing Considerations Feedback: Refer to section: Bank Loans.

Blooms: Comprehension AACSB: Reflective Thinking

2. What impact would holding and collaterizing collectible artwork have, if any, on an entities working capital ratios, all else held equal?

Answer: If the artwork is used to acquire an operating line of credit, then the current ratio and the quick ratio will decrease. If however, the artwork is used to acquire a long term bank loan then the current and quick ratios should both increase.

LOD: Medium Learning Objective: Describe some common ways to analyze a firm’s management of its net working capital.

Section Reference 1: 23.4 Working Capital Management in Practice Feedback: Refer to section: Working Capital Ratios Blooms: Comprehension AACSB: Reflective Thinking

3. How might the scheme of collaterizing collectible artwork help an entity with liquidity and solvency issues?

Answer: By collaterizing their collectible artwork an entity can either prevent, or slow a progression to illiquidity and/or solvency by providing immediate and short-term financing in the form of a line of credit. As the collectible artwork is not a current asset, the entity is able to protect their remaining current assets, and by using a line of credit, repayments are based only on actual usage of the capital.

LOD: Medium Learning Objective: Explain why the management of net working capital is critical for the survival of a firm Section Refernece 1: 23.1 The Importance of Working Capital Management Blooms: Evaluation AACSB: Reflective Thinking

4. What type of asset might the collectible artwork be considered and how does it apply to working capital management?

Answer: Typically the artwork would be considered a long-term asset, and would only be considered as Inventory if the entity was in the business of selling artwork. As a long-term asset, held for investment purposes, it applies to working capital management in how it can be used to acquire short-term financing and support an entities working capital position and operations.

Difficulty: Medium Learning Objective 1: Describe how inventory is managed.

Section Reference 1: Inventory Management Approaches Feedback: Refer to section 24.3: Inventory Bloom’s Taxonomy : Comprehension ACCSB: Reflective Thinking

5. If an entity were to use the funds acquired by collaterizing their collectible artwork, other than financing day to day operations, what might the funds be used for?

Answer: The funds might be used for any of the reasons noted in the text, other than transaction motive, which deals mainly with the day to day operations. The other reasons are all applicable and might include something like expansion plans.

Difficulty: Medium Learning Objective 1: Explain the motivation for holding cash and the methods used to implement effective cash management techniques.

Section Reference 1: 24.1: Cash and Marketable Securities Feedback: Refer to section. Reasons for Holding Cash Bloom’s Taxonomy : Comprehension ACCSB: Analytic