FIN 540 Week 5 Midterm Exam – Strayer University NEW

FIN/540 Week 5 Midterm Exam – Strayer NEW

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Midterm Exam Chapter 18 Through 23

CHAPTER 18—PUBLIC AND PRIVATE FINANCING: INITIAL OFFERINGS, SEASONED OFFERINGS, AND INVESTMENT BANKS

TRUE/FALSE

1. If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement.

2. Going public establishes a market value for the firm’s stock, and it also ensures that a liquid market will continue to exist for the firm’s shares. This is especially true for small firms that are not widely followed by security analysts.

3. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public.

4. The term “leaving money on the table” refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm’s new stock offering. The banker is, in effect, “buying the job” with the low bid and thus not getting all the money his firm would normally earn on the job.

5. Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another.

6. The term “equity carve-out” refers to the situation where a firm’s managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it “carves out” some of their value.

7. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.

8. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings.

9. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate.

10. When a firm refunds a debt issue, the firm’s stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond.

MULTIPLE CHOICE

11. Which of the following is generally NOT true and an advantage of going public?
a. Increases the liquidity of the firm’s stock.
b. Makes it easier to obtain new equity capital.
c. Establishes a market value for the firm.
d. Makes it easier for owner-managers to engage in profitable self-dealings.
e. Facilitates stockholder diversification.

12. Which of the following statements about listing on a stock exchange is most CORRECT?
a. Any firm can be listed on the NYSE as long as it pays the listing fee.
b. Listing provides a company with some “free” advertising, and it may enhance the firm’s prestige and help it do more business.
c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.
e. Listing is a decision of more significance to a firm than going public.

13. Which of the following statements is most CORRECT?
a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
c. The SEC requires that all private placements be handled by a registered investment banker.
d. Private placements can generally bring in funds faster than is the case with public offerings.
e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

14. Which of the following statements is most CORRECT?
a. The key benefits associated with refunding debt are the reduction in the firm’s debt ratio and the creation of more reserve borrowing capacity.
b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.
c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen.
d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings.
e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.

15. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?
a. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.
b. The flotation costs associated with issuing new bonds rise.
c. The firm’s CFO believes that interest rates are likely to decline in the future.
d. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.
e. The yield to maturity on the company’s outstanding bonds increases due to a weakening of the firm’s financial situation.

16. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT?
a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market.
b. Listing a large firm’s stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm.
c. Stockholders have the right to elect the firm’s directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management’s performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer.
d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called “market pressure,” and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue.
e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

17. Which of the following statements is NOT CORRECT?
a. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will always exist for the firm’s shares.
b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC.
c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called “going public,” and the market for such stock is called the new issue market.
d. It is possible for a firm to go public and yet not raise any additional new capital.
e. When a corporation’s shares are owned by a few individuals who own most of the stock or are part of the firm’s management, we say that the firm is “closely, or privately, held.”

18. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker’s required return on such arrangements is 15%, and ignore taxes.
a. $1,235,925
b. $1,300,973
c. $1,369,446
d. $1,441,522
e. $1,517,391

19. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?
a. $79,425
b. $83,606
c. $88,006
d. $92,406
e. $97,027

20. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.
a. $453,443
b. $476,115
c. $499,921
d. $524,917
e. $551,163

21. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.
a. $278,606
b. $292,536
c. $307,163
d. $322,521
e. $338,647

22. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯assume that the firm’s tax rate is zero.

The company’s decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?
a. 9.57%
b. 10.07%
c. 10.60%
d. 11.16%
e. 11.72%

23. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual “breakeven rate”?
a. 9.29%
b. 9.78%
c. 10.29%
d. 10.81%
e. 11.35%

24. Refer to Exhibit 18.1. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding?
a. $5,049,939
b. $5,315,725
c. $5,595,500
d. $5,890,000
e. $6,200,000

25. Refer to Exhibit 18.1. What will the after-tax annual interest savings for NWW be if the refunding takes place?
a. $664,050
b. $699,000
c. $768,900
d. $845,790
e. $930,369

26. Refer to Exhibit 18.1. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?
a. $6,480
b. $7,200
c. $8,000
d. $8,800
e. $9,680

27. Refer to Exhibit 18.1. What is the NPV if NWW refunds its bonds today?
a. $1,746,987
b. $1,838,933
c. $1,935,719
d. $2,037,599
e. $2,241,359

CHAPTER 19—LEASE FINANCING

TRUE/FALSE

1. Many leases written today combine the features of operating and financial leases. Such leases are often called “combination leases.”

2. A sale and leaseback arrangement is a type of financial, or capital, lease.

3. Operating leases help to shift the risk of obsolescence from the user to the lessor.

4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.

5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines.

6. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm’s income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm’s balance sheet.

7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget.

8. A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease.

9. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

10. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company’s books.

11. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value.

12. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee’s viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

MULTIPLE CHOICE

13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee’s
a. capital budgeting project cash flows.
b. debt cash flows.
c. pension fund cash flows.
d. sales.
e. equity cash flows.

14. Operating leases often have terms that include
a. full amortization over the life of the lease.
b. very high penalties if the lease is canceled.
c. restrictions on how much the leased property can be used.
d. much longer lease periods than for most financial leases.
e. maintenance of the equipment by the lessor.

15. Which of the following statements is most CORRECT?
a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
c. Capital, or financial, leases generally provide for maintenance by the lessor.
d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.
e. Firms that use “off balance sheet” financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.

16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the
a. residual value as a liability.
b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability.
c. undiscounted sum of future lease payments as an asset and as an offsetting liability.
d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.
e. residual value as a fixed asset.

17. Heavy use of off-balance sheet lease financing will tend to
a. make a company appear less risky than it actually is because its stated debt ratio will appear lower.
b. affect a company’s cash flows but not its degree of risk.
c. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.
d. affect the lessee’s cash flows but only due to tax effects.
e. make a company appear more risky than it actually is because its stated debt ratio will be increased.

18. In the lease versus buy decision, leasing is often preferable
a. because, generally, no down payment is required, and there are no indirect interest costs.
b. because lease obligations do not affect the firm’s risk as seen by investors.
c. because the lessee owns the property at the end of the least term.
d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.
e. because it has no effect on the firm’s ability to borrow to make other investments.

19. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased
a. is financed with long-term debt.
b. is financed with debt whose maturity matches the term of the lease.
c. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at the WACC.
d. is financed with retained earnings.
e. is financed with short-term debt.

20. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.
a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455

21. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm’s tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
a. $96
b. $106
c. $112
d. $117
e. $123

22. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC’s tax rate is 40%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.)
a. $849
b. $896
c. $945
d. $999
e. $1,047

23. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
a. $5,734
b. $6,023
c. $6,324
d. $6,640
e. $6,972

CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES

TRUE/FALSE

1. The “preferred” feature of preferred stock means that it normally will provide a higher expected return than will common stock.

2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible.

3. A warrant is an option, and as such it cannot be used as a “sweetener.”

4. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

5. The problem of dilution of stockholders’ earnings never results from the sale of call options, but it can arise if warrants are used.

6. A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued. Most traded warrants are originally attached to bonds or preferred stocks.

7. The owner of a convertible bond owns, in effect, both a bond and a call option.

8. A convertible debenture can never sell for more than its conversion value or less than its bond value.

9. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder.

10. Firms generally do not call their convertibles unless the conversion value is greater than the call price.

11. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters.

12. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

13. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

14. Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

15. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax exemption on preferred dividends received.

MULTIPLE CHOICE

16. Which of the following statements is most CORRECT?
a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm’s common stock.
b. From the issuer’s point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.
e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.

17. Which of the following statements about convertibles is most CORRECT?
a. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
b. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertible’s conversion (or exercise) price is generally set equal to or below the underlying stock’s price.
d. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm’s otherwise similar straight debt and the expected return on its common stock.
e. The coupon interest rate on a firm’s convertibles is generally set higher than the market yield on its otherwise similar straight debt.

18. Which of the following statements concerning warrants is correct?
a. Warrants are long-term put options that have value because holders can sell the firm’s common stock at the exercise price regardless of how low the market price drops.
b. Warrants are long-term call options that have value because holders can buy the firm’s common stock at the exercise price regardless of how high the stock’s price has risen.
c. A firm’s investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock’s price increases. However, if the option is exercised, the issuing company’s debt declines if warrants were used but remains the same if it used convertibles.

19. Which of the following statements is most CORRECT?
a. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
b. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
d. Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
e. Warrants have an option feature but convertibles do not.

20. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
e. $866.25

21. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62

22. Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?
a. 6.66%
b. 6.99%
c. 7.34%
d. 7.71%
e. 8.09%

23. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm’s straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?
a. 7.83%
b. 8.24%
c. 8.65%
d. 9.08%
e. 9.54%

24. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?
a. 6.75%
b. 7.11%
c. 7.48%
d. 7.88%
e. 8.27%

25. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
e. $4.56

26. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of the convertible at the end of Year 3?
a. $794.01
b. $835.81
c. $879.80
d. $926.10
e. $972.41

27. Refer to Exhibit 20.1. What is the bond’s conversion ratio?
a. 27.14
b. 28.57
c. 30.00
d. 31.50
e. 33.08

28. Refer to Exhibit 20.1. What is the bond’s conversion value?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

29. Refer to Exhibit 20.1. What is the bond’s straight-debt value?
a. $684.78
b. $720.82
c. $758.76
d. $798.70
e. $838.63

30. Refer to Exhibit 20.1. What is the minimum price (or “floor” price) at which the Neuman’s bonds should sell?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

CHAPTER 21—DYNAMIC CAPITAL STRUCTURES

TRUE/FALSE

1. In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

2. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

3. MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.

4. MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.

5. The Miller model begins with the MM model with taxes and then adds personal taxes.

6. The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

7. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient.

8. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

9. The MM model is the same as the Miller model, but with zero corporate taxes.

10. In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

11. In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

12. In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

13. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

14. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

MULTIPLE CHOICE

15. The major contribution of the Miller model is that it demonstrates that
a. personal taxes decrease the value of using corporate debt.
b. financial distress and agency costs reduce the value of using corporate debt.
c. equity costs increase with financial leverage.
d. debt costs increase with financial leverage.
e. personal taxes increase the value of using corporate debt.

16. Which of the following statements concerning capital structure theory is NOT CORRECT?
a. Under MM with zero taxes, financial leverage has no effect on a firm’s value.
b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
e. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

17. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is less than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the unlevered cost of equity.

18. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the cost of debt.

19. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm is independent of the amount of debt it uses.
e. The tax shields should be discounted at the unlevered cost of equity.

20. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L’s cost of equity?
a. 11.4%
b. 12.0%
c. 12.6%
d. 13.3%
e. 14.0%

21. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what would Firm L’s total value be if it had no debt?
a. $358,421
b. $377,286
c. $397,143
d. $417,000
e. $437,850

22. A local firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is the value of your firm’s tax shield, i.e., how much value does the use of debt add?
a. $92,571
b. $102,857
c. $113,143
d. $124,457
e. $136,903

23. Refer to Exhibit 21.1. What is the value of the firm according to MM with corporate taxes?
a. $475,875
b. $528,750
c. $587,500
d. $646,250
e. $710,875

24. Refer to Exhibit 21.1. What is the firm’s cost of equity?
a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%

25. Refer to Exhibit 21.1. Assume that the firm’s gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
a. 16.4%
b. 18.2%
c. 20.2%
d. 22.5%
e. 25.0%

26. Refer to Exhibit 21.2. According to the MM extension with growth, what is the value of Kitto’s tax shield?
a. $156,385
b. $164,616
c. $173,280
d. $182,400
e. $192,000

27. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s unlevered value?
a. $1,296,000
b. $1,440,000
c. $1,600,000
d. $1,760,000
e. $1,936,000

28. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s value of equity?
a. $1,492,000
b. $1,529,300
c. $1,567,533
d. $1,606,721
e. $1,646,889

29. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s equity if it is viewed as an option?
a. $228.77
b. $254.19
c. $282.43
d. $313.81
e. $345.19

30. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s debt if its equity is viewed as an option?
a. $167.57
b. $186.19
c. $204.81
d. $225.29
e. $247.82

31. Refer to Exhibit 21.3. What is the yield on Wilson Dover’s debt?
a. 6.04%
b. 6.36%
c. 6.70%
d. 7.05%
e. 7.42%

CHAPTER 22—MERGERS AND CORPORATE CONTROL

TRUE/FALSE

1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies’ pre-merger values.

3. A spin-off is a type of divestiture in which the assets of a division are sold to another firm.

4. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

5. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price.

6. Most defensive mergers occur as a result of managers’ actions to maximize shareholders’ wealth.

7. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in agreeing on the terms of a merger.

8. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy.

9. Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action.

10. Currently (2012), mergers can be accounted for using either the purchase method or the pooling method.

11. Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge “golden parachutes” that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as “poison pills.”

12. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.

13. The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary’s stock.

14. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers.

15. The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share.

16. Since managers’ central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm’s stockholders.

17. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive.

18. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

19. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship.

20. Since a manager’s central goal is to maximize the firm’s stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

21. Only if a target firm’s value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

22. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

23. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently.

24. Coca-Cola’s acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

25. A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

26. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger.

27. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

28. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

29. Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

30. The three main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

31. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

32. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm’s operations if it had no debt.

MULTIPLE CHOICE

33. Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s?
a. A profitable firm acquires a firm with large accumulated tax losses that may be carried forward.
b. Attempts to stabilize earnings by diversifying.
c. Purchase of assets below their replacement costs.
d. Reduction in competition resulting from mergers.
e. Synergistic benefits arising from mergers.

34. Firms use defensive tactics to fight off undesired mergers. These tactics do not include
a. getting a white squire to purchase stock in the firm.
b. getting white knights to bid for the firm.
c. repurchasing their own stock.
d. changing the bylaws to eliminate supermajority voting requirements.
e. raising antitrust issues.

35. Which of the following statements is most CORRECT?
a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
b. Defensive mergers are designed to make a company less vulnerable to a takeover.
c. Hostile mergers always create value for the acquiring firm.
d. In a tender offer, the target firm’s management always remain after the merger is completed.
e. A conglomerate merger is one where a firm combines with another firm in the same industry.

36. Which of the following statements is most CORRECT?
a. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
b. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
c. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what’s probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
d. Operating economies are never a motive for mergers.
e. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

37. Which of the following statements is most CORRECT?
a. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm’s capital structure, it will not affect its overall required rate of return.
b. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis.
c. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms.
d. The primary rationale for most operating mergers is synergy.
e. The acquiring firm’s required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

38. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
b. The horizon value is calculated by discounting the expected earnings at the WACC.
c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
d. The horizon value must always be more than 20 years in the future.
e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

39. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
d. The APV approach stands for the accounting pre-valuation approach.
e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

40. Which of the following statements is most CORRECT?
a. A defensive merger is one where the firm’s managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover.
b. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition.
c. Cash payments are used in takeovers but never in mergers.
d. Managers often are fired in takeovers, but never in mergers.
e. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

41. A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can’t be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent’s marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?
a. 10.2%; $2,245,000
b. 10.2%; $2,135,000
c. 23.8%; $1,905,000
d. 10.2%; $1,750,000
e. 34.0%; $1,650,000

42. A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally’s Sandwiches, which is currently financed using 20% debt at a cost of 8%. Club Café’s analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Sally’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?
a. 12.0%
b. 13.9%
c. 14.4%
d. 16.0%
e. 16.9%

43. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller chain. Arthouse’s analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Craftworks is 16%. Craftworks has 4 million shares outstanding and no debt. Craftworks’ current price is $16.25. What is the maximum price per share that Arthouse should offer?
a. $16.25
b. $16.97
c. $17.42
d. $18.13
e. $19.00

44. Holland Auto Parts is considering a merger with Workman Car Parts. Workman’s market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Workman’s required rate of return on equity be after it is acquired?
a. 7.4%
b. 8.9%
c. 9.3%
d. 9.6%
e. 9.7%

45. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP). Raymond’s analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Raymond?
a. $53.40 million
b. $61.96 million
c. $64.64 million
d. $76.96 million
e. $79.64 million

46. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers expects Fast Fruit’s NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Fast Fruit is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Fast Fruit will need $10 million of net new investment in operating capital. Fast Fruit’s marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Fast Fruit to Juicers will both grow at a constant rate of 4%. Juicers has determined that Fast Fruit’s cost of equity is 17.5%, and Fast Fruit currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Juicers must pay $45 million to acquire Fast Fruit. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Juicers of Fast Fruit’s equity.
a. $45.0 million
b. $68.2 million
c. $86.5 million
d. $113.2 million
e. $133.0 million

47. Refer to Exhibit 22.1. What is Glassmakers’ pre-merger WACC?
a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

48. Refer to Exhibit 22.1. What discount rate should you use to discount Glassmakers’ free cash flows and interest tax savings?
a. 10.01%
b. 10.06%
c. 11.29%
d. 11.44%
e. 13.49%

49. Refer to Exhibit 22.1. What is the value of Glassmakers’ equity to Best? (Round your answer to the closest thousand dollars.)
a. $16,019,000
b. $17,111,000
c. $18,916,000
d. $22,111,000
e. $22,916,000

CHAPTER 23—ENTERPRISE RISK MANAGEMENT

TRUE/FALSE

1. One objective of risk management can be to reduce the volatility of a firm’s cash flows.

2. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

3. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses.

4. In theory, reducing the volatility of its cash flows will always increase a company’s value.

5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words “long” and “short” refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

MULTIPLE CHOICE

6. Which of the following are NOT ways risk management can be used to increase the value of a firm?
a. Risk management can help a firm maintain its optimal capital budget.
b. Risk management can reduce the expected costs of financial distress.
c. Risk management can help firms minimize taxes.
d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.
e. Risk management can increase debt capacity.

7. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?
a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
b. Interest rate price risk can be eliminated by holding zero coupon bonds.
c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.
d. Interest rate risk can never be reduced.
e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.

8. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?
a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
d. A company can swap fixed interest payments for floating interest payments.
e. A swap involves the exchange of cash payment obligations.

9. Which of the following statements is most CORRECT?
a. Futures contracts generally trade on an organized exchange and are marked to market daily.
b. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
c. There are futures contracts for currencies but no forward contracts for currencies.
d. Futures contracts don’t have any margin requirements but forward contracts do.
e. One advantage of forward contracts is that they are default free.

10. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?
a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
b. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
c. Enter into a short hedge where the bank agrees to sell interest rate futures.
d. Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.
e. Buying inverse floaters.

11. Company A can issue floating-rate debt at LIBOR + 1% and can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5% and can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B?
a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%.
b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%.
c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%.
d. A pays a fixed rate of 7.95%, B pays LIBOR.
e. None of the above answers is correct.

12. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89’09. What is the implied annual interest rate inherent in this futures contract?
a. 6.32%
b. 6.65%
c. 7.00%
d. 7.35%
e. 7.72%

13. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. What is the implied annual interest rate inherent in the futures contract?
a. 6.86%
b. 7.22%
c. 7.60%
d. 8.00%
e. 8.40%

14. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the nearest whole dollar.)
a. −$78.00
b. −$82.00
c. −$86.00
d. −$90.00
e. −$95.00