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Corporate Finance

Mock Exam

Questions 1:
Discuss the implications of the existence of asymmetric information on the capital
structure (Debt to equity ratio) of a Pharmaceutical company like Merck in half a page.

Questions 2:
Michael Jensen has suggested that highly indebted companies may enjoy a corporate
governance advantage over companies with low levels of debt. Explain and critique
his argument.

Questions 3:
There are two types of electric calculator producers. High quality manufacturers
produce very good calculators that consumers value at 14 Euros. Low quality
manufacturers produce less good ones that are valued at 8 Euros. At the time of
purchase, customers cannot distinguish between a high quality product and a low
quality product; nor can they identify the manufacturer. However, they can determine
the quality of the product after the purchase. The consumers are risk-neutral: if they
have probability p of getting a high quality product, they value this prospect
14p + 8(1 - p)
Each type of manufacturer can produce the product at a constant unit
cost of 11.
a) Suppose that the sale of low quality calculators is illegal, so that the only items
allowed to appear on the market are of high quality. What will be the equilibrium
b) Suppose that there are no high quality sellers. How many low quality calculators
would you expect to be sold in equilibrium?
c) Could there be an equilibrium in which equal (positive) quantities of the two types of
calculators appear in the market?
d) For which range of p do we observe calculators to be sold on the market?

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

What is key assumption?

When is it realistic?
Who pays the cost of the winners curse?
So, should the issuer/investment banker do anything about it? What?

Question 5:
If managed efficiently, Company A will have assets with a market value of $48.6
million, $99.5 million, or $148.1 million next year, with each outcome being equally
Managers may also increase the risk of the firm, changing the probability of each
outcome to 45%, 17%, and 38%, respectively.
A. What is the expected value of Company A assets if it is run efficiently?

Now suppose that managers may engage in wasteful empire building, which will
reduce the market value by $5.3 million unless that behavior increases the likelihood
of bankruptcy. They will choose the risk of the firm to maximize the expected payoff
to equity holders.
B. Suppose Company A has debt due in one year as shown below. For each case,
indicate whether managers will engage in empire building, and whether they
will increase risk. What is the expected value of Company A assets in each
a) $40.2 million
b) $47.1 million
c) $92.1 million
d) $94.3 million

Multiple Choice:
Circle the correct answer
Question 6
Which of the following statements is false?
A. We can use Modigliani and Miller's first proposition to derive an explicit
relationship between leverage and the equity cost of capital.
B. Although debt does not have a lower cost of capital than equity, we can
consider this cost in isolation.
C. The total market value of the firm's securities is equal to the market value of
its assets, whether the firm is unlevered or levered.
D. While debt itself may be cheap, it increases the risk and therefore the cost of
capital of the firm's equity.
Question 7
Which of the following statements is false?
A. The levered equity return equals the unlevered return, plus an extra "kick"
due to leverage.
B. If a firm is unlevered, all of the free cash flows generated by its assets are
available to be paid out to its equity holders.
C. The cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the market value
debt-equity ratio.
D. By holding a portfolio of the firms equity and its debt, we can replicate the
cash flows from holding its levered equity.
Question 8
LCMS Industries has $70 million in debt outstanding. The firm will pay only interest
on this debt (the debt is perpetual). LCMS' marginal tax rate is 35% and the firm pays
a rate of 8% interest on its debt.
LCMS' annual interest tax shield is closest to:
A) $5.6 million

B) $3.6 million

C) $2.8 million

D) $2.0 million

Question 9
Which of the following statements is false?
A. The optimal level of debt D*, balances the costs and benefits of leverage.
B. As the debt level increases, the firm faces worse incentives for management,
which increase wasteful investment and perks.
C. If the debt level is too large firm value is reduced due to the loss of tax
benefits (when interest exceeds EBIT), financial distress costs, and the agency
costs of leverage.
D. As the debt level increases, the firm benefits from the interest tax shield
(which has present value *D).
Question 10
Which of the following statements is false?
A. In the extreme case, the debt holders take legal ownership of the firm's
assets through a process called bankruptcy.
B. After a firm defaults, debt holders are given certain rights to the assets of the
C. A firm that fails to make the required interest or principal payments on the
debt is in default.
D. Equity holders expect to receive dividends and the firm is legally obligated to
pay them.

Question 11
Which of the following statements is false?
A. With tangible assets, the financial distress costs of leverage are likely to be
low, as the assets can be liquidated for close to their full value.
B. The tradeoff theory explains how firms should choose their capital structures
to maximize value to current shareholders.
C. Proponents of the management entrenchment theory of capital structure
believe that managers choose a capital structure to avoid the discipline of
debt and maintain their own job security.
D. Firms with high R&D costs and future growth opportunities typically maintain
high debt levels.