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Unformatted text preview: Economics 181: Corporate Finance Solutions: FINAL Wadia Haddaji May 3, 2008 Part I: Multiple Choice Questions (5 points per question for a total of 30 points). For each statement, state whether the statement is true or false and provide an explanation. A. Which of the following statements are true? I. As a result of the tension that exists between the shareholders and the bondholders of a firm, agency costs play a role in the search for the firms optimal capital structure. II. Firms with intangible assets should, on average, have lower debt-to-value ratios. III. According to the trade-off theory of capital structure, firms that have a low marginal tax rate should be highly levered (i.e., finance their operations with debt mainly). SOLUTIONS: (I) TRUE. Agency costs are an integral part of the trade-off theory of capital structure. As debt financing increases, aligning the interests of the shareholders with those of the bondholders becomes difficult, and the increased tension between the two groups result in suboptimal decision-making that negatively affects the value of the firm. (II) TRUE. Firms with intangible assets have higher bankruptcy costs and so, accord- ing to the trade-off theory of capital structure, should not finance their operations with much debt. (III) FALSE. Firms that have a low marginal tax rate cant benefit much from the tax shields that debt financing offers. As such, they should keep their debt-to-value ratios relatively low. 1 B. Which of the following statements are true? I. In a leveraged buyout, the debt-to-value ratio is usually kept constant right after the transaction takes place. II. After a management buyout takes place, we can expect the managements incentives to work hard to be quite strong. III. The risk of bankruptcy is always negligible in a leveraged buyout. SOLUTIONS: (I) FALSE. The large initial debt is usually repaid fairly rapidly. (II) TRUE. Because the management owns a large portion of the firm after an LBO, its incentives are such that it should work towards maximizing the value of the firm. (III) FALSE. Because LBOs involve large issues of debt, the risk of bankruptcy can be very large. C. Corporations pay no taxes. Investors pay no taxes on capital gains, but they pay a 28% income tax on dividends. The operations of two all-equity-financed corporations have the same risk, and both have a current stock price of $100. Corporation A pays no dividend and will have a price of $110 one year from now. Corporation B pays dividends and will have a price of $105 one year from now after payment of a dividend. What is the amount of the dividend that investors expect Corporation B to pay? A) $3 . 60 B) $4 . 54 C) $5 . 00 D) $5 . 50 E) $6 . 94 SOLUTIONS: The expected return from holding the first corporations stock is 10%. The expected return from holding the second corporations stock should be identical: 10% = 5+ D 1 (1- . 28) 100 ⇒ D 1 = 6 . 94....
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This note was uploaded on 09/29/2008 for the course ECON 181 taught by Professor Haddaji during the Spring '07 term at Duke.
- Spring '07