FIN 634 Fall 2002Exam 1 Answers – Questions 1 - 9Calculation of Adjusted Score:Adjusted Score = (Raw Score + 5) x 1.05Final Score = Adjusted Score + email contest extra credit1. The Investment (or Allocation) Decision: How does the firm select appropriate investments and allocate scarce resources? Invest in projects that have an expectedrate of return that exceed the hurdle rate (risk-adjusted cost of capital) for the project.The Financing Decision: How should the mix of debt and equity in the capital structure be determined? Select the capital structure that minimizes the cost of capital and match the maturity of the financing sources to the maturity of the assets.The Dividend Decision: How does the firm decide on the amount and timing of dividends? The firm should retain earnings to reinvest in the company’s projects if the expected rate of return on the retained funds exceeds the rate of return that shareholders could earn on similar-risk investments (the cost of equity) if the fundswere paid out as dividends.2. Cost: The rate of return that a company must pay on its debt financing is always less than the rate it must pay on its equity. Debt is cheaper than equity. This is because (1) debt is always less risky than common stock from the investor’s point of view, and (2) debt interest is tax deductible, which in effect places a governmentsubsidy on interest payments.Risk: Debt increases the risk of the shareholders’ cash flows and of the company. Shareholders are in the safest position when the company has no debt.Flexibility: Debt reduces the decision-making flexibility of managers since it imposes limits and restrictions on management. Equity imposes no such limits.Control: Issuing equity dilutes owners’ control in the company. Debtholders do notexert direct control on a company’s decision unless the company is in bankruptcy proceedings.3. Stockholders have only a residual claim on the firm’s cashflows; thus, they gain from upside risk. Bondholders have a fixed claim on the firm’s cashflows; thus, they are exposed to downside risk while gaining little from upside risk. Not surprisingly, bondholders are much less willing to have the firm be exposed to risk (even if the risk can lead to significant upside gains for the firm and its shareholders) and are concerned about protecting their claims on the assets of thefirm. Stockholders can take advantage of bondholders by investing in riskier projects, paying out large dividends (or executing large stock buybacks), and borrowing against assets that they have used to secure prior debt. These actions result in a direct transfer of wealth from the bondholders to the stockholders. Bondholders can at least partially protect themselves by writing covenants into the bond indenture that prevent such actions or by making their debt convertible.4. Conditions:The firm creates no social costs in the process of maximizing valueMarkets are efficient (the stock price accurate reflects all relevant information, andmanagers do no or cannot mislead investors or delay information)Bondholders are protected (shareholders cannot increase their wealth at the expenses of the bondholders)The agency problem is controlled (managers are responsive to the owners)5. $10,000,000 8% bank loan: Since this was just issued, its actual market value can be assumed to be the same as its face value. (Would also accept $10,800,000 which would include the interest due, or more correctly $10,014,811 which is the discounted value of $10,800,000 for 51 weeks.) However, as explained on page 82in Chapter 4, the simple face value of the current liability would be acceptable.$20,000,000 5-year 9% term loan: The current market value can be calculated asPV = $20,000,000FV = 0N = 5I = 9PMT = ? = $5,141,849.14 (Annual payment on loan)FV = 0PMT = $5,141,849.14N=3 (Remaining number of years on the loan)I = 8 (Current market rate for the company’s debt)PV = ? = $13,251,043.93 (Current market value of the loan)$15,000,000 10-year 10% bond: Current market value of this issue is calculated asFV = $15,000,000PMT = $1,500,000/2 = $750,000N=10 (Remaining number of semi-annual payments)I = 8/2 = 4 (Current market rate for the company’s debt)PV = ? = $16,216,634.37 (Current market value of the loan)The total market value of the three issues (using $10,000,000 for the first one) is $39,467,678.296. The deviation is likely to be greater in the older firm. It would generally be expected that the book value would be much lower than market value because book values are not adjusted for inflation. Also, when fixed assets for a company includes real estate, significant appreciation in market value could have occurred while the book value remained at the purchase price.7. See Question 1, page 111. Answer from Chapter 4, pages 68-69Balance Sheet: Summarizes the assets owned by a firm, the book value of the assets, and the mix of debt and equity used to finance these assets at a point in time.Income Statement: Provides information on the revenues and expenses of the firm,and the resulting income produced by the firm during a particular period.Statement of Cash Flows: Specified the sources of cash to the firm from both operations and new financing, and also the uses of the cash during a particular period. Can be viewed as an attempt to explain how much the cash flows were during a period and why the cash balance changed during the period.8. See Question 3, page 111. Answer from Chapter 4, page 74Firms often adopt the LIFO approach for its tax benefits during periods of high inflation. The cost of goods sold is then higher because it is based on prices paid for inputs toward the end of the accounting period. This, in turn, will reduce the reported taxable income and net income, while increasing cash flows. 9. Answer from Chapter 4, page 88When a lease is classified as an operating lease, the lease expenses are treated as operating expenses in the income statement and the lease does not appear on the balance sheet. When the lease is classified as a capital lease, the present value of the lease expenses is treated as debt on the balance sheet (and as a corresponding asset), and interest is imputed on that amount and listed on the income statement asinterest expense (rather than as an operating