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Corporate Finance Topics (C15.0008)Summer 2006Final ExamInstructor: Amrut NashikkarName:___________________________Instructions: The exam is for TWO HOURS and has five parts. Read all questions CAREFULLY before you answer them. Not all the parts have the same points, so allocate your time accordingly.Please show your workings, including any formulae you use. Write your answers in the space provided. I will not give any credit if you do not show your workings. You may use blue books if you need additional paper. At the end, return this paper, as well as any blue books you have used. You may only use the formula sheet that has been handed out along with the exam.Multiple Choice Questions: (2 points each)1. Lower dividends are good whena. Managers have incentives to waste free cash flowb. The firm has high future earningsc. Dividends are taxed in the hands of the share-holdersd. The firm has been paying high dividends in the past2. Which of the following is not an assumption behind the original Modigliani Miller propositionswithout taxes?a. There are no information/announcement effects in the issuance of new debt or equity.b. There are no distress costs.c. Investment policies of the firms are fixed.d. Share-holders and Bond-holders have the same preferences.3. A targeted repurchase is a. an arrangement to buy back short term financial instruments sold to an investment dealerat a fixed price. b. the buying back of shares from a particular group, usually large shareholders hostile management. c. the buying back of shares because management has few profitable investment opportunities. d. used to buy a company in the open market. 4. The fundamental difference between the flow-to-equity method of valuation and the APV method of valuation is that:a. In adjusted present value neither the cash-flows nor the discounting rate are adjusted for leverage. The adjustments are made separately.b. In adjusted present value, the adjustment for leverage is done in the discounting ratec. In adjusted present value, the adjustment for leverage is done in the cash flowsd. In Flow to Equity, the adjustment for leverage is done in the discounting rate by using thecost of unlevered equity as a discounting rate.5. As part of its dividend policy, the firm pays a cash dividend of 10 in a given year. An investor would rather just receive a dividend of 5, and would prefer to keep the remaining invested in shares of the firm. The share price of the firm is 50. How many shares does the investor need to buy to create his preferred dividend stream?a. 1/10b. 1/20c. 1/5d. 16. Which of the following is not an example of a phenomenon that gives rise to an agency cost?a. The CEO of a company buys a corporate jetb. Shareholders of firm take risky negative NPV projects when there is debt on the balance sheetc. Shareholders of a firm refuse to invest in positive NPV projects if they have to raise money for it through equityd. Shareholders of a firm issue equity when they think the stock is over-valued.7. Which of the following statements is true in the context of M&A activity?a. Cash takeovers tend to have better long-term performance than takeovers paid for in stockb. Friendly mergers tend to have better long-term performance than hostile takeoversc. The acquirer’s NPV in a cash takeover is hard to determine because part of the ownershipin the acquirer is transferred to the target stock-holders.d. Conglomerate acquisitions are the most valuable kind of mergers because they bring together companies with widely different risks.8. Which of the following trends cannot be explained by the trade-off theory of optimal capital structure?a. Firms in industries with a higher degree of business risk tend to have lower amounts of debtb. Firms try to achieve a capital structure that gives them the highest rating for their debt.c. Firms in countries which have higher tax rates tend to have higher amounts of debtd. Firms in industries with a greater amount of tangible assets tend to have higher amounts of debt9. Which of the following statements regarding debt and equity as options on the underlying firm is false?a. Equity is like a call option on the assets of the firmb. Debt is like a risk free bond and a short position in a put option on the assets of a firmc. Debt is like owning the underlying firm and having a short position in a call option on the assets of the firmd. Equity is like short put option on the assets of the firm along with an investment in a risk-free bond.10. In an efficient market, ignoring taxes and time value, the price of stock should a. decrease by the amount of the dividend immediately on declaration date. b. decrease by the amount of the dividend immediately on ex-dividend date. c. increase by the amount of the dividend immediately on declaration date. d. increase by the amount of the dividend immediately on ex-dividend date. Question 1 (25 points)You are a star equity research analyst specializing in the Widget Industry. (Widgets are fictitious devices that only find use in finance classrooms in business schools). You are asked to estimate the share price for Gudgeon Inc., the leading manufacturer of Widgets. In the year that just ended,Gudgeon had sales of 50 million dollars. Based on estimates of enrolment in Business School programs, you think that sales will grow at the rate of 5% forever. In addition, you expect Gudgeon to make capital expenditures of 4% of sales, and have a depreciation of 5% of sales. Gudgeon’s margins (EBIT/Sales) have been healthy at 10%, and you expect them to remain the same. In any year, you also expect the change in net working capital to be 0.5% of the sales for that year. Gudgeon Inc. is currently levered with a debt to equity ratio (B/S), which is expected to remain constant at 0.5. In addition, you have the following information:1. The beta for Gudgeon’s equity is 1.5.2. The spread of its debt over the risk free rate (Rb-Rf) is 2%.3. The risk free rate (Rf) is 5%.4. The market risk premium (Rm-Rf) is 6%.5. The company has 1 million shares outstanding.6. The corporate tax rate is 35%.Because you took C15.0008, you know exactly (well, hopefully) how to find the share price of Gudgeon Inc.1. The first step is to find next year’s sales, EBIT, Cap-ex, Depreciation and the change in net working capital. Find each of these values.2. The next step is to find unlevered cash flows. Based on your answers in 1, find the unlevered cash flow for next year.3. Now that you have the


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