BFF 3140 – Corporate Finance 2
Mid-Semester Test – Practice Exam
Note that due to copyright issues, the MST practice questions
(some of which are designed by the publisher or by other
academics) cannot be made public. Please, keep the
questions strictly to yourself.
1. (BONUS, NOT MANDATORY) What is the main finding of the Almeida and
Philippon 2007 paper titled “The Risk-Adjusted Cost of Financial Distress”?
A. Financial distress is more likely to happen in bad times
B. Financial distress costs are significantly smaller than marginal tax benefits
of debt derived by Graham (2000)
C. Financial distress has both direct and indirect costs
D. Financial distress costs can be as large as the marginal tax benefits of debt
derived by Graham (2000)
Answer: D
2. Which of the following statements is FALSE?
A. Because the cash flows of the debt and equity sum to the cash flows of the
project, by the Law of One Price the combined values of debt and equity
must be equal to the cash flows of the project.
B. Leverage decreases the risk of the equity of a firm.
C. Franco Modigliani and Merton Miller argued that with perfect capital
markets, the total value of a firm should not depend on its capital
structure.
D. It is inappropriate to discount the cash flows of levered equity at the same
discount rate that we use for unlevered equity.
Answer: B
Explanation: Leverage increases the risk of the equity of a firm.
Section: 14.1 Equity Versus Debt Financing
Skill: Conceptual
3. Which of the following statements is FALSE?
A. Given a 21% corporate tax rate, for every $1 in new permanent debt that
the firm issues, the value of the firm increases by $0.79.
B. The firm's marginal tax rate may fluctuate due to changes in the tax code
and changes in the firm's income bracket.
C. Many large firms have a policy of maintaining a certain amount of debt on
their balance sheets.
D. Typically, the level of future interest payments varies due to changes the
firm makes in the amount of debt outstanding, changes in the interest rate
on that debt, and the risk that the firm may default and fail to make an
interest payment.
Answer: A
Explanation: Given a 21% corporate tax rate, for every $1 in new
permanent debt that the firm issues, the value of the firm increases by
$0.21.
Section: 15.2 Valuing the Interest Tax Shield
Skill: Conceptual
4. Which of the following statements is FALSE?
A. After deciding to go public, managers of the company work with an
underwriter, an investment banking firm that manages the offering and
designs its structure.
B. The shares that are sold in the IPO may either be new shares that raise
new capital, known as a primary offering, or existing shares that are sold
by current shareholders (as part of their exit strategy), known as a
secondary offering.
C. Many IPOs, especially the larger offerings, are managed by a group of
underwriters.
D. At an IPO, a firm offers a large block of shares for sale to the public for the
first time.
Answer: B
Explanation: The shares that are sold in the IPO may either be new shares
that raise new capital, known as a primary offering, or existing shares that
are sold by current shareholders (as part of their exit strategy), known as a
secondary offering.
Section: 23.2 The Initial Public Offering
Skill: Conceptual
5. BU Industries is in the process of selling shares of stock in an auction IPO. At the
end of the bidding period, Luther's investment bank has received the following
bids:
Price ($)
Number of
Shares Bid
$19.50 50,000
$19.25 25,000
$19.10 25,000
$19.00 100,000
$18.75 125,000
$18.50 75,000
$18.25 150,000
$18.00 240,000
$17.75 80,000
$17.50 130,000
$17.25 150,000
$17.00 100,000
$16.90 60,000
$16.75 80,000
$16.50 75,000
$16.25 200,000
What will be the offer price of these shares be if BU is selling 1 million shares?
A. $17.00
B. $17.50
C. $17.25
D. $16.75
Answer: B
Explanation:
Price ($)
Number
of Shares
Bid
Cumulativ
e Demand
$19.50 50,000 50,000
$19.25 25,000 75,000
$19.10 25,000 100,000
$19.00 100,000 200,000
$18.75 125,000 325,000
$18.50 75,000 400,000
$18.25 150,000 550,000
$18.00 240,000 790,000
$17.75 80,000 870,000
$17.50 130,000 1,000,000
$17.25 150,000 1,150,000
$17.00 100,000 1,250,000
$16.90 60,000 1,310,000
$16.75 80,000 1,390,000
$16.50 75,000 1,465,000
$16.25 200,000 1,665,000
By looking at cumulative demand, we see that a cumulative demand of 1 million
shares
corresponds to a price of $17.50.
Section: 23.2 The Initial Public Offering
Skill: Analytical
6. Which of the following statements is FALSE?
A. Equity holders expect to receive dividends and the firm is legally
obligated to pay them.
B. A firm that fails to make the required interest or principal payments on
the debt is in default.
C. In the extreme case, the debt holders take legal ownership of the firm's
assets through a process called bankruptcy.
D. After a firm defaults, debt holders are given certain rights to the assets of
the firm.
ANSWER: A
Explanation: While equity holders hope to receive dividends, the firm is
not legally obligated to pay them.
Section: 16.1 Default and Bankruptcy in a Perfect Market
Skill: Conceptual
7. Which of the following statements is FALSE?
A. Whether paid by the firm or its creditors, the indirect costs of bankruptcy
increase the value of the assets that the firm's investors will ultimately
receive.
B. In addition to the money spent by the firm, the creditors may incur costs
during the bankruptcy process.
C. The bankruptcy code is designed to provide an orderly process for settling
a firm's debts.
D. To ensure that their rights and interests are respected, and to assist in
valuing their claims in a proposed reorganization, creditors may seek
separate legal representation and professional advice.
ANSWER: A
Explanation: Whether paid by the firm or its creditors, the indirect costs
of bankruptcy reduce the value of the assets that the firm's investors will
ultimately receive.
Section: 16.2 The Costs of Bankruptcy and Financial Distress
Skill: Conceptual
8. Which of the following is NOT a step in the valuation process using the flow to
equity method?
A. Determine the equity cost of capital, rE.
B. Compute the equity value, E, by discounting the free cash flow to equity
using the equity cost of capital.
C. Determine the free cash flow to equity of the investment.
D. Determine the before-tax cost of capital, rU.
ANSWER: D
Section: 18.4 The Flow-to-Equity Method
Skill: Conceptual
9. Wyatt Oil has 8 million shares outstanding and is about to issue 10 million new
shares in an IPO. The IPO price has been set at $15 per share, and the
underwriting spread is 6%. The IPO is a big success with investors, and the share
price rises to $35 on the first day of trading. The amount that Wyatt Oil raised
during the IPO is closest to:
A. $350 million.
B. $141 million.
C. $150 million.
D. $329 million.
ANSWER: B
Explanation: Wyatt is issuing 10 million shares at $15 per share for a total
of $150 million. However, the underwriter will take the 6% underwriting
spread or 6% × $150 million = $9 million leaving only $141 million for
Wyatt Oil.
Section: 23.3 IPO Puzzles
Skill: Analytical
10. Which of the following statements is FALSE?
A. The WACC can be used throughout the firm as the company wide cost of
capital for new investments that are of comparable risk to the rest of the
firm and that will not alter the firm's debt-equity ratio.
B. A disadvantage of the WACC method is that you need to know how the
firm's leverage policy is implemented to make the capital budgeting
decision.
C. The intuition for the WACC method is that the firm's weighted average
cost of capital represents the average return the firm must pay to its
investors (both debt and equity holders) on an after-tax basis.
D. To be profitable, a project should generate an expected return of at least
the firm's weighted average cost of capital.
Answer: B
Explanation: An advantage of the WACC method is that you do not need
to know how the firm's leverage policy is implemented to make the capital
budgeting decision.
Section: 18.2 The Weighted Average Cost of Capital Method
Skill: Conceptual
11. Which of the following statements is FALSE?
A. Modigliani and Miller's conclusion verified the common view, which
stated that even with perfect capital markets, leverage would affect a
firm's value.
B. We can evaluate the relationship between risk and return more formally
by computing the sensitivity of each security's return to the systematic
risk of the economy.
C. Investors in levered equity require a higher expected return to
compensate for its increased risk.
D. Leverage increases the risk of equity even when there is no risk that the
firm will default.
Answer: A
Explanation: Modigliani and Miller's conclusion went against the
common view that even with perfect capital markets, leverage would
affect a firm's value.
Section: 14.1 Equity Versus Debt Financing
Skill: Conceptual