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Q:

What is a short sale?

A:

The person who intends to sell the security first borrows it from someone who already owns it. Later, that person must either return the security by buying it back or pay the owner the cash flows he or she would have received.

Q:

What is meant by asset substitution?

A:

being close to default can give the manager (and shareholders) the incentive to take excessive risk.

Q:

What form of financing is the least informationally sensitive?

A:

Debt

Q:

What are the assumptions of the Modigliani-Miller Theorem?

A:

1. There are no taxes.

2. There are no contracting costs (costs of writing or enforcing contracts such as issuance costs, default costs,...).

3. The ﬁrm’s investment policy is ﬁxed (the ﬁrm invests in the same assets independently of its ﬁnancing policy).

Q:

Is the following statement correct. The fact that the firm can default on its debt makes capital structure relevant.

A:

True

Q:

According to the trade-off theory of capital structure. If a firm’s marginal corporate tax rate increases then its optimal leverage ratio goes:

A:

Up

Q:

A firm generates a free cash flow of 1 next year. Starting at the beginning of next year, the free cash flow is expected to grow at a rate of 0.05 a year. The rate of return the unlevered asset should earn is 0.1. The risk-free rate is 0.05 and the corporate tax rate is 0.3. The firm decides to issue debt today and won’t change its capital structure in the future. The firm’s debt is worth 5. The firm forever only pays interest on this debt. What is the value of the levered firm?

A:

The unlevered firm value is

1/(0.1 − 0.05) = 20.

Since the firm only issues debt today the expected present value of the tax benefits to debt are

PV (Tax benefits) τC D = 0.3 ∗ 5 = 1.5.

The levered firm is worth 20 + 1.5 = 21.5.

Q:

A firm has assets in place which generate a cash flow of 1 in one year. Furthermore, the firm has debt that comes due next year and requires a repayment of 2. Today, shareholders can invest I from their own money into the firm and this increases the cash flow the firm generates in one year from 1 to 2.55. For what value of I are shareholders indifferent between investing or forgoing the investment? Assume all cash flows are risk-less and the risk-free rate is 10%. Let I∗ be the solution to the previous question. Assume that I ∈ (I∗, 2.55/1.1). What form of agency conflict arrises in this case?

A:

Asset substitution

Q:

Assume you’re buying a car from a seller. The seller know’s his car’s value X and he is only willing to sell it if he gets at least this value. You do not know X but you believe its somewhere between [1000, 2000]. Furthermore, you value the car at X + 500 and don’t want to pay too much for the car. What offer would you make for the seller’s car such that you have the highest chance of buying it?

A:

Let P be any offer you would make. If P > 1500 then the seller would accept the offer if X = 1000 and you would lose money since P > 1000 + 500. Therefore, you would never make an offer larger than 1500. You are okay with offering P ≤ 1500 since X +500−P > X +500−1500 ≥ 0. To maximize the chances of the seller accepting an offer you would offer P = 1500.

Q:

Today, Firm A has a debt-equity ratio of 1. It’s return on equity is 0.10 and it’s debt is risk-free. The risk-free interest rate is 0.05 and there are no corporate taxes. The firm wants to increase its debt-equity ratio to 2. After this leverage increase the firm’s debt is still risk-free. Furthermore, its assets are unaffected by this leverage change. What is the firm’s return on equity after this leverage change? Report %/100, i.e. 5.5% ⇒ 0.055.

A:

The unlevered cost of capital is

rU = 0.1∗ 1/2 +0.05∗ 1/2 = 0.075.

This result implies that after changing the debt-equity ratio to 2 the firm’s return on equity is

rE =rU +(D/E)(rU −rD)=0.075+2(0.075−0.05)=0.125.

Q:

What are capital market frictions that make capital structure choice relevant?

A:

1. Tax beneﬁts.

2. Bankruptcy costs.

3. Agency costs and beneﬁts.

4. Asymmetric information.

Q:

What is meant by debt overhang?

A:

Being close to default can give the manager (and shareholders) the incentive not to undertake positive NPV projects as beneﬁts accrue to the debt holders.

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