AI2246 - Corporate Finance

Exam 20-03-09 → E-C Questions

Multiple Choice Questions 1-8 (8p)

1. Which of the following statements is CORRECT?

a) The volatility of the price of a bond is not affected by its time to maturity.

b) The yield curve for a particular bond shows the bond’s sensitivity to interest rate changes.

c) The yield curve is most often upward sloping.

d) Real interest rates can never be negative.

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Solution ✅ 
2. Which of the following statements is FALSE?

a) At maturity the price of a bond equals the face value minus the sum of all coupon payments.

b) The yield to maturity of a bond is affected by the coupon rate as well as the timing of the coupon payments.

c) A default‐free zero coupon bond that matures one year from now provides a risk‐free return over that period.

d) The price of a bond equals the present value of all future coupon payments plus the present value of the face value.

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Solution ✅
3. Which of the following statements is CORRECT?

a) In a perfect capital market the value of a firm is not dependent on the risk of its expected cash‐flow.

b) In a market with imperfections the value of a firm is not dependent on the risk of its expected cash‐flow.

c) In a perfect capital market the WACC of an unlevered firm equals the WACC of the same firm if it was 50 percent equity financed.

d) In a perfect capital market the required rate of return on debt is not dependent of the firm’s capital structure.

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Solution ✅
4. Which of the following statements is CORRECT?

a) Tax at personal investor level does not affect the value of interest tax‐shield for a firm.

b) The majority of stock owners prefer levered firms since the expected return on equity is higher than for unlevered firms.

c) The value of a levered firm (with debt and equity securities only) may be lower or higher than the sum of the value of the debt and the value of the equity.

d) If corporate tax is the only market imperfection, the increase in value of an unlevered firm that takes on debt equals the present value of all future expected tax shields.

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Solution ✅
5. Which of the following statements is FALSE?

a) Because the cash flows promised by the bond are the most that bondholders can hope to receive, the cash flows that a buyer of a bond with credit risk expects to receive may be less than that amount.

b) By consulting bond ratings, investors can assess the credit‐worthiness of a particular bond issue.

c) Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bond’s with credit risk will be lower than that of otherwise identical default‐free bonds.

e) A higher yield to maturity does not necessarily imply that a bond's expected return is higher.

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Solution (2p) ✅
6. Consider a bond with three years to maturity that pays a coupon of 12 at the end of each year. The face value is 80 and the price of the bond is 80. The yield to maturity is closest to:

a) 11%

b) 13%

c) 15%

d) 17%

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Solution ✅

8. Which of the following statements is CORRECT?

a) The details of a corporate bond offering can be found in the prospectus.

b) A senior bond issue is an offering aimed at elderly people.

c) The details of a credit rating can be found in a bond covenant.

d) None of the above alternatives.

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Solution ✅

9. Carefully Explain the following terms (6p)

a) Weighted average cost of capital (2p)

b) Financial Distress (2p)

c) Yield to maturity (2p)

🤙 10. Calculate the yield to maturity of a semi annual bond (6p)

A bond that matures in two years pays semiannual coupons. The first coupon payment is 6 months from now. The face value of the bonds is 100 MSEK and the coupon rate is 5%. The price of the bond is 93 MSEK. What is the yield to maturity?

11. Calculate the marginal corporate tax (10p)

The current debt‐to‐equity ratio for Prime Properties is 2.5. The interest rate on debt is 5% and the required rate of return for an unlevered firm with assets identical to those owned by Prime Properties is 6.5%. The after‐tax WACC for Prime Properties is 5.75%. What is the marginal corporate tax rate?

C1. Valuing a amortising firm with flow to equity and WACC method

Explain thoroughly why the WACC method and the Flow-to-equity method are not suitable for valuing a firm when the firm’s debt will be fully amortised over the next five years and how you should value the firm in this scenario.

🌸 C2. Perfect Capital Markets

Logistic Properties (LP) is a property company with a current share price of 6 SEK and 20 million shares outstanding. Suppose LP announces plans to lower its corporate taxes by borrowing 80 MSEK.

a) With perfect capital markets, what will the share price be after this announcement? (2p)

Suppose that LP pays a corporate tax rate of 25%, and that shareholders expect the change in debt to be permanent.

b) If the only imperfection is corporate taxes, what will the share price be after this announcement? (4p)

c) Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to 6.5 SEK after this announcement, what is the PV of financial distress costs LP will incur as the result of this new debt? (If you have not been able to calculate the share price in question b) you may denote the answer to b) with an X.) (4p)

E & C Questions - Exam 2022-03-16

🍭1. Yield to Maturity (YTM) - Five year corporate bond

Consider a five-year corporate bond with a face value of 1100 SEK and with a 7% coupon rate paid as annual coupons. What is the yield to maturity of the bond if the price today is 985 SEK?

2. Balance a balance sheet after selling shares to raise cash to pay off debt

Large City Properties (LCP) has the following market value balance sheet:

	Assets	Liabilities
Cash	10 MSEK	30 MSEK	Debt
Real Assets	80 MSEK	60 MSEK	Equity
Sum Balance Sheet	90 MSEK	90 MSEK

LCP has decided to raise 15 MSEK in cash by selling new shares. The cash will be used to amortize 15 MSEK of the debt. Show what the market value balance sheet will look like after the debt has been amortized assuming that Modigliani-Miller’s proposition 1 holds true.

🌻 3. Calculate Return on Equity and WACC given 4 inputs

The current debt-to-equity ratio for Prime Properties is 2. The interest rate on debt is 6% and the required rate of return for an unlevered firm with assets identical to those owned by Prime Properties is 9%. What is the after-tax WACC if the marginal corporate tax rate is 25%?

4. Calculate Annual Tax Shield on 500 MSEK of Debt amoritized over 20 years

City Limit Properties (CLP) has just borrowed 500 MSEK that will be amortized with an equal amount over 20 years. The interest, paid in the end of each year, is 5%. What is value of the tax-shield that this financing arrangement provides assuming that the corporate tax-rate is 25%? For this question, assume one would like to know the annual taxshield caused by the debt.

5. Calculate the firm value, constant debt-to-value ratio and using the WACC Method

Following is a 3-year forecast of the cash flows from the properties of a property firm:

Year	1	2	3
Rent
Operating Cost
NOI

Marginal corporate tax rate:	25%
Debt-to-value ratio of the firm:	70%
Interest rate on the debt	7.0%
Pre-tax WACC for the firm	11%
Perpetual growth rate of NOI from the end of year three:	1.0%

Calculate the firm value assuming a constant debt-to-value ratio and using the Weighted Average Cost of Capital (WACC) method.

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This question was used during a Covid Exam where students had access to excel. This is horrible to calculate by hand. Hence I’ve excluded it from here this solution.

🐝 6C. The stupidity of using WACC or FTE to value a amortising firm

A firm currently has a debt-to-value ratio of 60%. Explain carefully why the WACC method and the Flow-to-equity method are not suitable for valuing the firm when the firm’s debt will be fully amortized over the next five years and what would be a better method to value the firm in this scenario assuming that the only market imperfection is corporate taxes. (7.5p)

🐘 7C. Calculate a new required rate of return given a new capital structure

The current debt-to-equity ratio for CBD Properties is 1.5. The required rate of return on debt is 5%. The after-tax WACC for CBD Properties is 6.65%. The marginal corporate tax rate is 25%. Assume that CBD Properties wants to change its capital structure so that the debt-to-value ratio equals 0.8. At this debt-to-value ratio the required rate of return on debt is 6%. Assuming perfect capital markets, what is the required rate of return on the firm’s equity at the new debt-to-value ratio?

Misc Questions that I think are good, but have not yet answered

C-Questions - 2. Explain how financial distress affects new positive-NPV investments

Explain thoroughly why it may not be in the interest of shareholders of a firm that faces financial distress to finance new positive-NPV investments.

A8. Calculate

Coworking Space (CS) is a 100% equity financed property company with a current share price of 5 SEK and 25 million shares outstanding. Suppose CS announces plans to lower its corporate tax payments by borrowing 70 MSEK. The debt will be constant in perpetuity. Suppose the only market imperfections are corporate taxes and financial distress costs. If the share price rises to 5.25 SEK after this announcement, what is the present value of financial distress costs that are incured as a result of this new debt? The marginal corporate tax rate is 30%. (5p) (from 2022-03 exam)

Re-Exam 2022

C-Questions

Explain carefully the trade-off theory of capital structure including the effects of agency costs and agency benefits. (7.5p)

The Trade-Off Theory of Corporate Capital Structure

"The Trade-Off Theory of Corporate Capital Structure" published on by Oxford University Press.

oxfordre.com

Trade-off theory of capital structure

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the trade-off theory and its supporting evidence is provided by Ai, Frank, and Sanati.

en.wikipedia.org