THE INTERNATIONAL UNIVERSITY (IU) – VIETNAM NATIONAL UNIVERSITY – HCMC

MIDTERM EXAMINATION
Date: from November 10, 2021, 3:15 pm to November 11, 2021, 3:15 pm
Duration: 1 day
Student ID: BAFNIU18223 Name: Nguyễn Lê Hoàng Long
SUBJECT: CORPORATE FINANCE

Question 1: (20 points)

a. Were U.S. nonfinancial corporations on average issuing new equity or buying their shares
back? Provide evidence from the article.
In the Financial Accounts, net equity issuance is calculated as the difference between gross
equity issuance and equity retirements. The value of cash obtained via the sale of equity by
publicly and privately owned nonfinancial enterprises is referred to as gross equity issuance. The
IPO series tracks cash raised by new public share offerings by enterprises trading publicly for the
first time. The SEO series includes cash raised from fresh equity issuances by publicly listed
corporations at the time of issuance.
The value of nonfinancial enterprises' equity that is retired each quarter is measured by equity
retirements. This series' retirement channels include equity repurchases and retirements through
mergers and acquisitions (M&A). The value of equity repurchased by public nonfinancial
corporations through share buyback schemes is represented by repurchases. The value of equity
retirements through M&A activity is calculated by adding the value of cash-financed transactions
by domestic acquirers to the value of both cash- and equity-financed transactions by overseas
acquirers.
To address the issue, buyback activity is shown to vary between 0.5 percent (the lowest) and 2.5
percent (the highest), which is substantially higher than issuing activity, which remains steady at
approximately 0.5 percent on average. As a result, it is reasonable to assume that nonfinancial
firms in the United States are, on average, buying back their shares during the time under
consideration.
b. The pattern of corporate financing is discussed in the textbook (Figure 15.2 page 487 and
the discussion on page 488). Explain the reasons for this pattern of financing using all
relevant topics/theories of capital structure.
The graph highlights several points. For starters, domestically produced cash flow has been the
primary source of funding. Second, this dominance has grown across the study period, with
domestic funding exceeding 100% for the majority of the years from 2002 to 2010. A figure
greater than 100 percent indicates that foreign financing is negative. In other words, firms are
redeeming more stocks and bonds than they are issuing in terms of dollars. Third, from 2002 to
2007, net stock buybacks appear to have increased. A figure greater than 100 percent indicates
that foreign financing is negative. In other words, firms are redeeming more stocks and bonds
than they are issuing in terms of dollars. Third, from 2002 to 2007, net stock buybacks appear to
have increased. Firms, it is suggested, were flush with cash at the time and found stock
repurchases more appealing than dividend payments. However, the economic downturn that
began in 2008 significantly lowered the dollar amount of stock repurchases.

Question 2: (20 points)

A. (10 points) A company has three open seats on its board of directors. There will be a single
election to determine the winner of all open seats. As the owner of 50,000+(5,000xA) shares of
stock (with A: the last digit of your student ID; for example, if the last digit of your student
ID is 2, you own 60,000 shares), you will receive one vote per share for each open seat. You
decide to cast all of your votes for a single candidate.
a. What is this type of voting called? What is the number of votes you can cast?
This is cumulative voting. Because the directors are elected all at once.
The number of votes you can cast:
¿ [ 50,000+ ( 5,000 ×3 ) ] ×3=195,000(votes)
b. With this type of voting, suppose the company has 1 million+(100,000xA) shares
outstanding (with A defined above), how many more shares must you buy to be
assured of earning a seat on the board?
Outstanding shares of the company ¿ [ 1,00 0,000+ ( 100 , 000× 3 ) ] =1,300,000 ( shares )
The number of shares you need to be assured of earning a seat on the board:
1 1 1
At least : = = ∨25 % of 1,300,000 ( shares )¿ 325,000 ( shares ) .
( N +1 ) ( 3+1 ) 4
So 325,001 shares are minimum.
The number of more shares you must buy to be assured of earning a seat on the board:
¿ 325,001−[ 50,000+ ( 5,000 ×3 ) ] =260,001 ( shares ) .
B. (10 points) How does the following feature of a bond affect the required rate of return on the
bond? Explain.
a. Call provision
By purchasing a bond, an investor creates a long-term source of interest income through regular
coupon payments. However, because the bond is callable (according to the terms of the
agreement), the investor will lose the long-term interest income if the provision is exercised.
Although the investor does not lose any of the initial investment principle, future interest
payments are no longer payable.
With callable bonds, investors may potentially suffer reinvestment risk. If the business calls the
bond and returns the principal, the investor must reinvest the cash in a different bond. When
current interest rates have declined, it is improbable that they will be able to locate another,
comparable investment paying the higher rate of the earlier, so-called, debenture.
 b. Put provision
The bondholder will not get the entire anticipated return, or yield-to-maturity (YTM), if the put
provision is exercised. It does, however, safeguard bondholders from incurring unfavorable
losses on their investment. For example, if the bond's value falls owing to increased interest rates
or a decrease in the issuer's credit rating, a put provision will protect the bondholder against
potential losses. This security is provided by the bond's setting of a floor price, which is its
principal value.
However, if the bondholder acquired the bond when interest rates were high and interest rates
have subsequently fallen, the bondholder is unlikely to desire to exercise the put provision
because their fixed-income investment is still generating the same higher rate of return. If they
redeemed the bond and reinvested in another fixed-income asset, the yield would most likely be
lower owing to reduced available interest rates. Furthermore, the investor may elect to continue
receiving the bond's payment coupons rather than simply collecting the one-time principal
payment by redeeming.
c. Sinking fund
For investors, a sinking fund adds a layer of security to a corporate bond issue. There is less risk
of default on the money owed at maturity because funds will be set aside to pay off the bonds at
maturity. In other words, if a sinking fund is formed, the amount owing at maturity is
significantly reduced. As a result, a sinking fund provides some protection to investors in the
case of a company's insolvency or default. A sinking fund also assists a corporation in assuaging
default risk and, as a consequence, attracting additional investors for bond issuance.
Because a sinking fund increases security and reduces default risk, interest rates on bonds are
often lower. As a result, the firm is typically seen as creditworthy, which might result in
favorable credit ratings for its debt. Good credit ratings improve investor demand for a firm's
bonds, which is especially useful if the company has to issue further debt or bonds in the future.
Lower debt-servicing expenses when interest rates fall can increase cash flow and profitability
over time. If the firm is operating well, investors are more inclined to invest in its bonds,
resulting in higher demand and the possibility that the company may need to raise extra
financing.

Question 3: (20 points)

Baker Corporation expects an EBIT of $31,000+($200xA) every year forever (with A: the last
digit of your student ID; for example, if the last digit of your student ID is 2, EBIT is
$31,400 every year forever). The company currently has no debt and its cost of equity is 14%.
The corporate tax rate is 26%+(1%xA) (with A defined above; for example, if the last digit of
your student ID is 2, the corporate tax rate is 28%).
a. What is the current value of the company?
EBIT¿ $ 31,000+ ( $ 200× 3 )=$ 31,600,
Corporate tax rate is 26%+(1%xA) = 29%
The current value of the unlevered company:
V U =EBIT × ( 1−tax rate ) ÷ cost of equity=31,600× ( 1−29 % ) ÷ 14 %=$ 160 , 257.14
 b. Suppose the company can borrow at 7%. What will the value of the company be if it
takes on debt equal to 30 percent of its unlevered value?
Debt equal to 30 percent of its unlevered value:
B=30 % × V U =30 % × $ 160 ,257.14=$ 48 , 077.142
The value of the levered company is:
V L=V U + ( T c × B )=$ 160257.14+ ( 29 % × $ 48 , 077.142 )
¿ $ 174,199.514.
c. What will the value of the company be if it takes on debt equal to 30 percent of its
levered value?
Debt equal to 30 percent of its levered value:
B=30 % × V L
V L=V U + ( T c × B )≤¿ V L =V U + ( T c ×30 % × V L )≤¿V L =V U + ( 0.087 V L )
VU $ 160 , 257.14
≤>V L= = =$ 175,528.08 .
( 1−0.087 ) ( 1−0.087 )

Question 4: (20 points)

Mercer Inc. has a debt-to-equity ratio of 0.40. The required return on the company’s unlevered
equity is 12%, and the pretax cost of the firm’s debt is 8%. Sales revenue for the company is
expected to remain stable indefinitely at last year’s level of $18,000,000+($100,000xA) (with A:
the last digit of your student ID; for example, if the last digit of your student ID is 2, sales
revenue is $18,200,000 every year forever). Variable costs (including SG & A expenses) are 65
percent of sales. The corporate tax rate is 26%+(1%xA) (with A defined above). The company
distributes all its earnings as dividends at the end of each year.
a. If the company were financed entirely by equity, how much would it be worth?
Sales revenue: $18,300,000
Variable cost: 65% x $18,300,000 = $11,895,000
EBIT ¿ $ 18,300,000−$ 11,895,000=$ 6,405,000
Tax ¿ 29 % × $ 6,405,000=$ 1,857,450
Net cash flow ¿ $ 6,405,000−$ 1,857,450=$ 4,547,500
PV = Net cash flow/cost of equity¿ $ 4,547,500 ÷12 %=$ 37,896,250
b. What is the required return on the company’s levered equity?
According to Mercer Inc. Proposition II with corporate taxes:

R S=RO + ( BS )× ( R −R ) × ( 1−T )¿ 0. 12+ [ 0.4 × ( 0.1 2−0. 08 )( 1−0. 29) ] =0.1314∨13.14 %

O B C
 c. Use the weighted average cost of capital (WACC) approach to calculate the value of
the company. What is the value of the company’s equity? What is the value of the
company’s debt?
In a world with corporate taxes, a firm’s weighted average cost of capital (rwacc) equals:
B S
[ ]
RWACC =
B+S
× ( 1−T C ) × RB +[
B+ S
]× R S

0.4 S S
¿ [ ](
0.4 S+ S
× 1−T C ) × R B +[
0.4 S+ S
]× RS

2 5
¿ []( )
7 7 []
× 1−0.29 × 0.08+ × 0.1314=0.1101∨11.01 %

Use the weighted average cost of capital to discount the firm’s unlevered after-tax earnings:
$ 4,547,500
V L= =$ 41,303,360.58
0.1101
Therefore, the value of Mercer Inc. is $41,303,360.58.
Since the firm’s equity-to-value ratio is 5/7, the value of Mercer Inc.’s equity is:
5
¿ × $ 41,303,360.58=$ 29,502,400.4 2
7
Since the firm’s debt-to-value ratio is 2/7, the value of Mercer Inc.’s debt is:
2
¿ × $ 41,303,360.58=$ 11,800,960.17
7
d. Use the flow to equity (FTE) approach to calculate the value of the company’s
equity (Hint: use the value of debt calculated in part c to calculate interest expense).
Sales revenue: $18,300,000
Variable cost: 65% x $18,300,000 = $11,895,000
Interest ¿ $ 11,800,960.17 ×8 %=$ 944,076.813
EBIT ¿ $ 18,300,000−$ 11,895,000−$ 944,076.813=$ 5,460,923.187
Tax ¿ 29 % × $ 5,460,923.187=$ 1 , 583 , 667.724
Net cash flow ¿ $ 5,460,923.187−$ 1 ,583 , 667.724=$ 3 ,87 7 ,255.463
Since the firm pays all of its after-tax earnings out as dividends at the end of each year, equity
holders will receive $3,877,255.463 of cash flow per year in perpetuity.
$ 3 , 877 ,255.463
S=Cash Flows Available ¿ Equity Holders ¿ = =$ 29,507,271.41
RS 0.1314
The value of Mercer Inc.’s equity is $ 29,507,271.41.
Question 5: (20 points)
A. Discuss the static trade-off theory and the pecking order theory of capital structure. What are
the main differences between these two theories? (10 points)
The static trade-off theory is a financial theory that was developed in the 1950s by economists
Modigliani and Miller, two academics who researched capital structure theory and cooperated to
produce the capital-structure irrelevance thesis. According to this notion, in ideal markets, a
company's capital structure is unimportant since the market value of a corporation is decided by
its earning potential and the risk of its underlying assets.
According to a static trade-off hypothesis, debt financing is initially cheaper than equity
financing since debt payments are tax-deductible and there is less risk associated in taking out
debt over stock. This suggests that a corporation can decrease its weighted average cost of capital
by adopting a debt-over-equity capital structure.
However, raising the amount of debt raises a company's risk, somewhat offsetting the fall in
WACC. As a result, static trade-off theory finds a debt-equity combination in which the
declining WACC compensates the increased financial risk to a corporation.
According to the pecking order theory, a corporation should seek to fund itself internally first,
using retained earnings. If this source of funding is unavailable, a business should finance itself
through debt. Finally, as a last option, a corporation should fund itself by issuing additional
shares.
This pecking order is significant since it informs the public about the company's performance.
When a firm funds itself internally, it indicates that it is robust. When a firm funds itself through
debt, it indicates that management is confident in the company's ability to make its monthly
obligations. If a firm supports itself by issuing additional stock, it is usually a bad indicator since
the corporation believes its stock is overvalued and wants to earn money before its share price
falls.
B. Global Production (GP) is a large conglomerate thinking of entering the smart alarm business,
where it plans to finance a project with a debt-to-value ratio of 20 percent. GP expects to borrow
for its smart alarm venture at an interest rate of 10%. There is currently one firm in the smart
alarm industry, American Smart Alarm (ASA). This ASA firm is financed with 25 percent debt
and 75 percent equity. The beta of ASA’s equity is 1+(0.1xA) (with A: the last digit of your
student ID; for example, if the last digit of your student ID is 2, ASA has an equity beta of
1.2). ASA has a borrowing interest rate of 9%. The corporate tax rate for both firms is 26%
+(1%xA) (with A defined above). The market risk premium is 8%, and the risk-free rate is 5%.
What is the appropriate discount rate (RWACC) for GP to use for its smart alarm venture? (10
points)
GP:
Debt-to-value ratio of 20 percent
 Debt-to-equity is 1/4
RB = 10%
ASA:
25 percent debt
75 percent equity
 Debt-to-equity = 1/3
The beta of ASA’s equity is 1+(0.1xA) = 1.3
RB = 9%
The corporate tax rate for both firms is 26%+(1%xA) = 29%
The market risk premium is 8% = RM
The risk-free rate is 5%. = Rf
ASA’s Cost of Equity Capital:
R S=R f + β × ( RM −Rf )=0.089
ASA’s Cost of Capital if All Equity:

R S=RO + ( BS )× ( R −R ) × ( 1−T )¿> R =0.09

O B C O

At this point, firms in the real world generally make the assumption that the business risk of their
venture is about equal to the business risk of the firms already in the business. Applying this
assumption to our problem, we assert that the hypothetical discount rate of ASA’s smart alarm
venture if all equity financed is also 0.09. This discount rate would be employed if WWE uses
the APV approach because the APV approach calls for R0, the project’s cost of capital in a firm
with no leverage.
Cost of Equity Capital for GP’s smart alarm venture:

R S=RO + ( BS )× ( R −R ) × ( 1−T ) =0.088

O B C

RWACC for GP to use for its smart alarm venture:

B S
RWACC = [ ]
B+S
× ( 1−T C ) × RB + [ ]
B+ S
× R S=0.0846