Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

  Courses/ FIN 647  

Summer 2009 Exams, FIN 647





  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  • You must explain all your answers.

1. (15 points) Read the following WSJ article from June 15, 2009 and answer the question below:

We had discussed in class how stock prices would drop when a firm announced an equity issue. In the case of Tom Tom, the company is raising money in two different ways -- one, it is planning to sell a €100 million stake to Cyrte Investments BV; and two, it is planning a rights issue. Would you say that the stock price should drop in this case, as well? Explain.

GPS-Device Maker TomTom to Sell New Shares By DANA CIMILLUCA

TomTom NV, a Dutch navigation-products maker, plans to raise about €430 million ($607 million) by selling new shares to alleviate a heavy debt burden.

TomTom said in a statement late Sunday that it plans to sell a roughly €100 million stake to Cyrte Investments BV, a Dutch technology investor, and Janivo Holding BV, an early investor in a predecessor of the company. It will also tap existing shareholders in a so-called rights issue.

The company is saddled with €1.4 billion in debt following its agreement to purchase fellow navigation firm Tele Atlas for €2.9 billion near the height of the merger boom in 2007. Amid slumping demand brought on by the global recession and increasing competition, investors have grown concerned that the company could violate the terms of its loans.

The proceeds of the share sales will be used to repay debt, the company said. Cyrte and Janivo will end up with a total stake of 8% in TomTom, whose lenders have agreed to relax the terms of its remaining debt.

TomTom's decision to invite investments from sophisticated investors with experience in the sector is aimed at increasing the odds that the rights issue will be well received by other shareholders.

Janivo is the investment vehicle of Holland's de Pont family, which made its fortune in the auto-import business and was an early investor in Tele Atlas. It sold its stake to TomTom for much more than the stake would now be worth.

The new investment is a bet by the family and Cyrte that in spite of current difficulties, demand for the company's navigation services will grow over the long term.

TomTom has been seeking to expand beyond its core market of personal GPS-navigation devices, or portable electronic units that provide maps and directions. It already has a deal with Renault SA to install navigation gear in the French auto maker's cars, and last week it said it will provide software for Apple Inc.'s iPhone.

The investment from Janivo and Cyrte also represents a bet that TomTom will benefit from the broadening use of its products for services such as traffic and weather reports. TomTom's maps are expensive to compile and maintain, making it difficult for new competitors to enter the business.

TomTom reported €213 million of sales in the first quarter, a decline of 31% assuming that the Tele Atlas deal had been completed in the year-earlier period. It had a net loss in the quarter of €33 million.

Investor concerns have hammered TomTom shares, which have recently traded at around €7, down from nearly €70 in late 2007. The stock surged 22% Friday in Amsterdam to €7.48 on enthusiasm over the Apple deal and hopes that the U.S. computer maker will buy a stake in TomTom. A person familiar with the matter said that doesn't appear likely. The share price gives the company a market value of €934 million.

2. (25 points) Answer any five of the following questions:

  1. What is the rationale behind paying a firm's management with stock options?
  2. How might societal objectives conflict with stockholder objectives?  How are these conflicts handled?
  3. True or false: Industry-specific risk cannot be diversified away.  Explain your answer; no credit without explanation.
  4. If the beta of a stock is 2, then it's return volatility will be twice the return volatility of the market portfolio. Is this statement true? Explain why or why not.
  5. Consider a strategy that buys stocks that have done well in the previous year. According to some studies, such strategies earn an abnormally high return after adjustment for market beta risk. Provide an argument that this is not necessarily evidence against the efficient market hypothesis.
  6. Provide two examples of conflicts between firm value maximization and societal value maximization. How might such conflicts be resolved?

3. a. (10 points) You are thinking of buying a piece of art that costs $473,565.20. The art dealer is proposing the following deal: you can take the art home with you today, provided you are willing to sign an agreement that you will pay $50,000/month for the next few months. The one question still to be determined is for how many months you are going to make payments. The art dealer is looking for a return of 1% per month. That seems like a not unreasonable deal to you because at 1% per month, the cost of the loan is more or less what you make on your investments elsewhere. Assuming that this is correct, what would be a fair value for the number of months?

b. (10 points) Subsequently, you realize that the comparison is not really correct because you are taking a risk on your investments and in comparing the return on your investments to the interest rate that the art dealer is charging, you are assuming that the risk is comparable, as well. You feel that you have a lot of assets that the art dealer could lay claim to, if you defaulted on the art loan and so, the art dealer should be willing to lend you the money at a rate that is 1 percentage point less per annum on an effective annual rate of return basis. You also want to spread out the payments over a different number of months. What would your counteroffer be to the art dealer in terms of what you would be willing to pay each month for the next 20 months?

4. You have the following data on end-of-day prices for Ford stock on the NYSE from Yahoo.

Date Close
5/1/2009 5.88
4/1/2009 5.98
3/2/2009 2.63
2/2/2009 2
1/2/2009 1.87
12/1/2008 2.29
11/3/2008 2.69
10/1/2008 2.19
9/3/2008 5.2
  1. (5 points) Using this information, what is your estimate of the expected monthly return on Ford?
  2. (5 points) What is your estimate of the standard deviation?
  3. (5 points) How confident are you about your estimate of the expected monthly return?
  4. (5 points) If you used your results to predict the stock price for June 1, 2009, what would that prediction be?

5. Suppose you have estimated the following Fama-French-Carhart (FFC) factor betas:

Factor GE

You have also estimated the average monthly return on the four (FFC) factor portfolios over the last eighty-odd years (as given in the table below). However, you believe that investors are much more risk-averse today and you increase each of the factor premiums by 10 basis points over and above the historical average. The risk free rate is assumed to be 12.486%

Factor Average Monthly Return
Mkt - rf
  1. (10 points) What is the required rate of return on GE according to the FFC model?
  2. (10 points) Your friend Yevgeny believes that the CAPM is a much better model than the FFC model because the FFC is an empirical model, as opposed to the CAPM, which makes sense from a theoretical point of view. Suppose his estimate of the market beta of GE is the same as your estimate and he shares your views on the estimation of the market risk premium? If you believe that GE is currently properly priced, would Yevgeny believe that GE is properly priced, overvalued or undervalued?
  3. (Bonus: 10 points) Do you agree with Yevgeny as to the superiority of the CAPM over the FFC model? Explain.

Solution to Midterm

1. When a firm announces a new equity issue, this usually causes the stock price to drop. The reason is information asymmetry. Since sellers usually want to sell when the price is high, the desire of the company to issue stock implies that the price is too high. This piece of information causes the price to adjsut downwards. Selling at an overly high price would transfer value from the new stockholders to the old stockholders.

In the case of the article, though, one could argue that the situation is different. For one, part of the money is to be raised through a rights issue. Hence the new shareholders are exactly the same as hte old shareholders. Hence this should not cause any effect on the market price of the stock. There would be no point in making a rights issue when the stock was overpriced (or underpriced, for that matter).

For another, the stock is being sold to a private investor. Normally, the firm can alleviate the information asymmetry -- it cannot reveal private information because anybody is allowed to buy shares -- even competitors. However, in this case, the firm could reveal more information to the private investor (and would, in general. If the firm refused to reveal the information, the private investor would not buy any equity). Hence the issue of new stock could not be related to stock price overvaluation.

Finally, the firm has a good reason to issue new equity -- to pay off debt and reduce the probability of bankruptcy -- and so investors would not read anything sinister into the firm's decision to issue new equity. For all these reasons, the announcement of issuance of new equity should not cause the stock price to drop.


  1. The reason is that this aligns managerial welfare with stock-holder welfare. Another alternative might have been to require managers to hold stock. However, it would be necessary for the manager to invest a large portion of his wealth in the firm's equity to provide the same kind of sensitivity of managerial wealth to share price as for shareholders. Stock options are much more sensitive to changes in the stock price. Hence managerial and stockholder incentives can be aligned to a much greater extent by having the manager hold a much smaller proportion of his wealth in the firm's stock options .
  2. When there are positive or negative externalities, stockholder objectives deviate from societal objectives. These occur when the cost or benefit to society is not experienced by the firm's stakeholders. For example, if pollution emissions are not taxed, it would be optimal for the firm to emit more pollution; but this would not be good for society because of the costs in terms of public health. Similarly, locating a firm or a factory in a depressed area might reduce crime in that area and thus reduce public costs of fighting crime and maintaining safety. However, if those savings are not passed on to the firm, it will not choose to spend as much on depressed areas, as it otherwise would. In both these cases, the internalization can occur by society's taking actions. In the case of pollution, the state could tax pollution; in the case of locating firms in depressed areas, the state could provide tax or other incentives to the firm.
  3. Some industry-specific risk is correlated with the market; that portion cannot be diversified away.  However, the portion that is uncorrelated with the market can be diversified away in a portfolio that is diversified across industries.
  4. If the beta is two, then the variance of the non-diversifiable component will be four times the variance of returns on the market portfolio.  However, you still have the diversfiable component.  Hence the answer is -- no; the return volatility will generally be more than twice the return volatility of the market portfolio.
  5. The success of such a momentum strategy is not necessarily proof against market efficiency. For example, if the beta risk of a firm changed over time with a positive autocorrelation; in that case, price changes would tend to be positive autocorrelated, as well. For that reason or some other reason, empirical studies have consistently found that momentum strategies work in a replicable manner. This suggests that the reason is not market inefficiency, since investors could exploit the inefficiency if that is what it was, but have chosen not to.
  6. Same as (b) above.

3.a. Suppose the number of months is k. Then, we know that 473,565.2 = (50000/.01)(1-(1.01)-k). Simplifying, we find that we need to solve 0.905287 = (1.01)-k. Taking the log of both sides, we get -k(ln(1.01)=ln(0.905287). Solving, we find k=10.

b. The art dealer is charging you effectively, an annual interest rate of 1.0112 or 12.6825%. You suggest 11.6825% or a monthly rate of (1.116825)-12 - 1 = 0.925%. Using this, we can compute the new monthly payment by solving 473,565.2 = (C/.00925)(1-(1.00925)-20) or C = $26,044.88 for 20 months.


  1. The closing prices can be used to compute returns as in column 3, as Pt/Pt-1-1. The average return is then computed as 0.119865 or 11.9865%
  2. Column 4 contains the deviations of the returns each month from this mean. The last column is the square of these deviations. The variance of the underlying distribution is then computed as the sum of these squared deviations divided by 7, which is the number of observations less 1. This estimated variance works out to 0.2935 and the square root of the estimated variance constitutes an estimate of the standard deviation, which is 0.5418 or 54.18%
  3. My confidence regarding the estimate can be expressed in terms of the 95% confidence interval for the mean. For this, I need to know the standard error of the mean, which is the standard deviation divided by the square root of 8, i.e. 0.5418/√8 = 0.1916. The 95% confidence interval, then, is 0.119865 ± 1.96(1.1916) = (-0.2556,0.4953). I can then say that the true underlying mean is within this range with a probability of 95%.
  4. My prediction would be 5.88(1.119865) = $6.5848. (5.88 is the price on May 1, and 11.98% is the average monthly return.
Sq Dev
5/1/2009 5.88 -0.01672 -0.13659 0.018656
4/1/2009 5.98 1.273764 1.153899 1.331484
3/2/2009 2.63 0.315 0.195135 0.038078
2/2/2009 2 0.069519 -0.05035 0.002535
1/2/2009 1.87 -0.18341 -0.30327 0.091973
12/1/2008 2.29 -0.1487 -0.26856 0.072127
11/3/2008 2.69 0.228311 0.108446 0.01176
10/1/2008 2.19 -0.57885 -0.69871 0.488197
9/3/2008 5.2

5. a. In order to provide the required rate of return, we need to use the risk free rate of return. The annual 12.486% risk-free rate is equivalent to (1.12486)(1/12) -1 = 0.00985 or 0.985% per month; the required rate of return according to the FFC model would be 0.985 + 0.747(0.74) - 0.478(0.27) - 0.232(0.63) - 0.147(0.86) = 0.011361% per month or (1.011361)12 = 14.52% p.a. (Note the risk premia have been increased by 10 bp.)

b. If we use the CAPM and we use the same market beta and the same market risk premium, the required rate of return would be 0.985 + 0.747(0.64) = 1.46308% or 19.04%; hence according to Yevgeny, GE is probably underpriced (assuming that you and Yevgeny share views regarding GE's future cashflows as well).

c. The CAPM is a model based on clearly-stated theory. The FFC model is an empirical model; its success may simply be limited to a particularly sample -- it may not work next year. Furthermore, since we don't know under what circumstances it will work, we don't know under what circumstances it won't work, either.

It is not even clear that the FFC model does better than the CAPM in practice; however, according to Berk and DeMarzo, the FFC factor specification does better than the CAPM in measuring the risk of actively managed funds. Since the FFC model has more degrees of freedom -- the risk measure is four-dimensional, it makes sense to expect it to do better with complex securities and portfolios.

Final Exam


  • If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  • If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  • You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  • You must explain all your answers.

1. (30 points) In the following article titled "Wendy's/Arby's Gets Cooking With New Management Team " from the July 4 issue of Barron's Insight towards the end, we read:
As for the bond offering, some investors say the company didn't need the money, as it will generate more than $100 million of free cash flow this year. But "our philosophy is that when money is available, you take it, and take the risk out of your balance sheet," says Mr. Peltz. Wendy's will use $132.5 million of the offering proceeds to repay some of its bank debt. The company says the remainder will be used for general corporate purposes, which could mean working capital, acquisitions, dividends or stock buybacks. Mr. Peltz says it would be foolish to pay a special dividend. But he doesn't rule out a buyback as he, too, thinks the shares are cheap.
Here are some viewpoints; comment on each one of them:

  1. Tiffany says: "According to Modigliani-Miller, the value of the firm is independent of the capital structure of the firm. Hence this bond issue only decreased the value of the firm because of issuance costs."
  2. Maria says: "Mr. Peltz clearly doesn't know what he's talking about! Increasing leverage increases the risk of the equity! How could taking on debt decrease risk?"
  3. Tsung-Wei says: "Bank debt is always better than corporate bonds! The firm has a long-term relationship with its bank. It doesn't have to worry about information asymmetry -- the firm can reveal information without having to worry about the information getting to its competitors. This allows the bank to offer better terms than outside bond investors. Furthermore, if things are going bad, it's easier to negotiate better terms with a bank. On the other hand, with corporate bonds, the only alternative is bankruptcy and all its attendant legal costs!"
  4. Andrey says: "I can understand that Mr. Peltz doesn't want to increase regular dividends. After all, an increase in regular dividends would lead investor to expect higher dividends in the future -- and this is clearly a one-time cashflow. But there is really no difference between a special dividend and a share buyback because investors expectations of future dividends are not affected in either case!"
  5. Yasmin says: "Mr. Peltz is out of his mind! What about the free cashflow hypothesis? With all this extra cash lying around, management will simply have more of an incentive to take unprofitable projects and build up an empire! It's never good to have too much cash!"
  6. Junfeng says: "I can understand using corporate debt, which is long-term capital to fund acquisitions, which are long-term investments. But to use corporate debt to fund working capital, which is short term? I think Mr. Peltz needs to take MBA 648, 'Introduction to Finance,' once again!"

Shares of Wendy's/Arby's Group have slid more than 30%, to around $4, since April, amid worries about declining sales at Arby's and management's reluctance to reveal how it will use the proceeds from the company's recent $565 million bond offering.

But the prospects for greater operating efficiencies and rapid growth in the restaurant chain's cash flow suggest the shares could be worth at least $6 apiece -- and maybe as much as $9 in the next few years.

Founded 40 years ago by the late Dave Thomas, Wendy's is the third-largest fast-food chain in the U.S., behind McDonald's and Burger King. The company has long prided itself on serving hamburger patties that weren't previously frozen. And it was way ahead of the pack in featuring salads. Mr. Thomas, who starred in Wendy's commercials and became its public face, died in 2002.

[Wendy/Arby share price]Today, the company is controlled by Nelson Peltz and Peter May, who have built a substantial record as investors in the food-services industry.

Messrs. Peltz and May were investors in Wendy's, and their investment company, Triarc, owned Arby's. The two chains merged last September, giving the pair a 22% stake in the combined entity.

Arby's, which specializes in roast-beef sandwiches, contributed one-third of the company's 2008 revenue of $3.7 billion, and about 35% of operating income. Last year, Wendy's/Arby's lost $3.05 a share, largely due to merger-related costs. The company is expected to earn 19 cents a share this year, and 28 cents in 2010.

Roland Smith, Wendy's/Arby's CEO, is aiming to save $60 million through post-merger cost-cutting, and another $100 million by boosting Wendy's operating margins, now just 12%. Last year, he hired David Karam, the head of one of Wendy's largest and most-successful franchisees, as Wendy's president, a move praised by Pamela Thomas Farber, Mr. Thomas's daughter.

Mr. Smith sees Arby's expanding to 5,000 outlets from today's 3,500, and Wendy's adding another 1,000 stores to its current 6,000. A new store can provide a 20% return on invested capital.

As for the bond offering, some investors say the company didn't need the money, as it will generate more than $100 million of free cash flow this year. But "our philosophy is that when money is available, you take it, and take the risk out of your balance sheet," says Mr. Peltz.

Wendy's will use $132.5 million of the offering proceeds to repay some of its bank debt. The company says the remainder will be used for general corporate purposes, which could mean working capital, acquisitions, dividends or stock buybacks.

Mr. Peltz says it would be foolish to pay a special dividend. But he doesn't rule out a buyback as he, too, thinks the shares are cheap.

2. Wendy's (WEN) is a company owning a chain of fast-food restaurants. It has a debt-equity ratio of 0.4536 (based on data from Mergent Online). Its current stock price is $4 per share with 467.5m shares outstanding (Source: Yahoo Finance). The firm enjoys a stable clientele (remember, its product is in demand in good markets and bad) and consequently it has a low beta of 0.81. Given its low beta and medium leverage, its borrowing rate is of 5% p.a. compared to the risk-free rate of 3.47% (Source: WSJ) (Note: WEN's latest debt was issed at a much higher YTM, but in the current lower-rate environment, it is estimated that WEN would only have to pay 5%). The market risk premium is 8% (estimated using historical data) and WEN's tax rate is 35%.

  1. (7 points) WEN had free cash flow of $83.547m this past year (estimated using data from Mergent Online) and is estimated to have free cash flow of $89.22m in the coming year. What constant expected growth rate in free cash flows is consistent with the current stock price of $4?
  2. Suppose WEN increases its debt-equity ratio from the current 0.4536 to a much higher ratio of 1. In this case, its cost of debt would increase substantially. Assume that the new cost of debt would be 6%. Assume that the free cash flows are expected to decrease by about $5m. because of the increased financial distress costs under the new highly levered capital structure.
    1. (5 points) What would the new cost of equity be?
    2. (3 points) What would the new WACC be?
    3. (5 points) What would WEN's new stock price be

3. Colonial Industries forecasts net income this coming year as shown below:

  Amount (in thousands)
Interest expense
Taxes (40% tax rate)
Net Income

Approximately $200,000 of Colonial's earnings are needed for new, profitable investment (capital expenditures and increases in working capital). However, Colonial's managers do not own much equity in the firm and, as a result, they are expected to invest an additional 10% of its net income on pet projects that have zero NPV. All remaining cash flow will be paid to shareholders as dividends.

  1. (4 points) If Colonial issued additional debt and incurred additional interest expense of $100,000 per year. By how much would dividends drop?
  2. (3 points) By how much would the total payout to investors (debt and equity) change?
  3. (3 points) Is it worthwhile for Colonial to use debt? Explain.
  4. (5 points) You are chairman of the Board of Directors of Colonial. The CFO of the company tells you that Colonial's covenants on its existing debt do not allow it to raise additional debt. Can you achieve the benefits of debt in any other way?

4. (20 points) Answer any five of the following questions:

  1. What are the advantages of share repurchases over dividends as a way of returning cash to shareholders?
  2. What are the advantages of private debt placement, other than lower issuance costs? What are the disadvantages?
  3. What are the three characteristics of IPOs that puzzle economists? Explain why the characteristics are puzzles.
  4. Which of these two companies would have higher financial leverage, and why --
    1. Deere & Co. (DE) -- DE manufactures and distributes farm equipment, machines used in construction, earthmoving and forestry, and equipment for commercial and residential uses.
    2. AMN Healthcare Services is a temporary healthcare staffing company and a nationwide provider of travel nurse staffing services to hospitals and healthcare facilities throughout the United States.
  5. Just as issuing equity dilutes earnings, buying back stock is good because it increases earnings per share.  Comment.
  6. What is the pecking order hypothesis? Can you explain such a pecking order exists?

5. Consider a firm which has a vacant plot of land. If left vacant, the land will be worth $12m. with certainty in one year. Alternatively, the firm can develop the land at an upfront cost of $20m. The developed land will be worth $40m. in one year. Suppose the required rate of return on the development project is 15% and that there are no taxes. The firm also has $20m. cash, which is invested in securities earning 5% per annum. The firm cannot raise external funds. The firm's only liability is debt of $40m due in one year.

  1. (2 points) Is the development of the land worthwhile from an NPV point of view?
  2. (4 points) What is the value of the equity today, if the market believes that the firm will not develop the land and will keep the cash invested in riskfree securities?
  3. (4 points) What is the value of the equity today if the market believes that the firm will use the cash to develop the land?
  4. (5 points) What would you do if you were the CEO of the company, and you wanted to maximize shareholders' wealth? Assume there are no covenants at all on the debt and there are no other investment opportunities available to the firm. (You are free to think of strategies other than the ones discussed in the problem, but you can't change the assumptions made here.)
  5. (5 points) If you were the trustee for the bondholders, and you wanted to maximize bondholder wealth, what sort of proposals might you make to the company's CEO?

Solution to Final Exam


  1. Tiffany would be correct if the firm could do all that it is proposing to do without the bond issue. In other words, MM says that, keeping investment policy constant, the value of the firm cannot be changed by changes in capital structure. However, in this case, Wendy's might be able to use the money profitably in new acquisitions and investments. Furthermore, the assumptions of MM don't really apply in this case because there are frictions present. Thus, if the firm's current bank debt has too high an interest rate and the new debt represents cheaper debt financing, the firm would be better off paying off the bank with the proceeds of the new debt.
  2. Maria is right; it's not clear how borrowing money could reduce risk. On the other hand, if much of the money is kept as cash or reinvested in less risky investments, that would reduce the risk of the equity. It's not clear that this would raise equity values.
  3. What Tsung-Wei says is often true. However, not always. If a firm has been around for a while and has established a reputation as a repayer of loans, it has a high level of cashflows and there is not that much information asymmetry, public debt could very well be cheaper.
  4. It is true that share buybacks and special dividends are similar in that neither one will cause investors to expect higher payouts in future. However, share buybacks have advantages that special dividends don't. With a share repurchase, those investors with lower tax rates can choose to sell shares, while shareholder with higher tax rates can keep their capital gains unrealized. With a special dividend, everybody is forced to pay tax on additional disbursed income.
  5. What Yasmin says is right. Whether Wendy's actions are desirable or not depends on the quality of Wendy's management. In this case, the company is controlled by a small number of shareholders with large percentage stakes. Hence they probably will run the business well and not undertake unprofitable projects.
  6. Taken in isolation, Junfeng's comments are correct. However, it is possible that Wendy's was underleveraged to begin with; that is, it's possible that the maturity of Wendy's assets was previously too high compared to the maturity of Wendy's liabilities. Furthermore, the money is not going to be used for working capital alone but for long-term investments as well.

2.a. The current stock price is $4. The number of shares outstanding is 467.5m. Hence the market value of equity is 4(467.5) = $1870m. The debt-equity ratio is 0.4536. Hence the value of debt is (0.4536)(1870) = $848.232 for a total firm value of 1870+848.232 = $2718.232m.

The cost of equity, using the CAPM is 3.47+0.81(8) = 9.95%; the cost of debt is 5%. Hence the WACC is (0.4536/1.4536)(5)(1-0.35)+(1/1.4536)(9.95) = 7.8592%. Using the growing perpetuity model, we see that 2718.232 = 89.22/(0.078592-g). Solving, we find that g = 4.577%.

b. i. Since WEN has a target debt-equity ratio, the unlevered cost of equity is given by the pre-tax WACC, i.e. (1/1.4536)(7.8592)+(0.4536/1.4536)(5) = 8.4053%. If the debt-equity ratio rises to 1, then the new cost of equity can be computed by using the pre-tax WACC formula, once again -- that is, 8.4053 = (1/2)(6) + (1/2)(cost of equity). Hence the new cost of equity works out to 10.8106%.
ii. The new WACC is (1/2)(10./8106) + (1/2)(60(1-0.35) = 7.3553%
iii. The new firm value is (89.22-5)/(0.073553-0.04577) = $3031.35; hence the new equity value is half of this (D/E=1), i.e.1515.675. If the number of shares outstanding remain the same, the stock price would be 1515.675/467.5, i.e. $3.24. In fact , the price per share would drop to $3.24 as soon as the new restructuring plans were announced.

3. At the moment, before the issuance of debt, FCFE that is available to be distributed as dividends can be computed as Net Income + Depreciation - New Investment - Pet Projects = 720,000(NI)+100,000(Depr)-200,000(New Inv) -72,000(Pet Projects) = $548,000. Along with payment of $100,000 in interest, we have a total payout to contributors of capital of $648,000.

a. If Colonial issued new debt and interest payments doubled, Net Income would decrease to 1300,000(EBIT) - 200,000(Int) - 440,000(Tax) = 660,000. FCFE available for payment to shareholders becomes 660,000(NI)+100,000(Depr)-200,000(New Inv)-66,000(Pet Projects) = $494,000. Hence dividends would drop from $548,000 to $494,000. (I am assuming that the new debt increase would be offset by an equity buyback so that the debt issuance itself does not increase FCFE.)

b. Along with $200 of interest, total payout becomes $694,000, an increase from $648,000 previously.

c. It seems worthwhile for Colonial to use debt since total payouts increase; this assumes that financial distress costs and agency costs are not going to increase substantially. The reason for the increase in payouts is twofold -- one, taxes drop; and two, the existence of debt reduces free cashflow, imposes discipline on managers and mitigates the overinvestment problem.

d. The tax benefits may not be obtainable in any other way. However, it may be possible to obtain the discipline benefits of debt by changing the compensation policies of the firm to include stock ownership for the managers.


  1. With share repurchases, only shareholders with lower tax rates need sell their shares and recognize their gains; shareholders with higher tax rates can keep unrealized gains and postpone the payment of taxes. With dividends, all shareholders have to pay taxes. On the other hand, dividends are better as a commitment device.
  2. Private placement can be tailored to the potential purchaser in terms of payment terms, covenants etc. Furthermore, information asymmetry is less of a problem -- the firm can share more information with private buyers of debt. On the other hand, since there are fewer buyers, the interest rate may be higher. A firm without an information asymmetry problem might, therefore, prefer to go to the broader public debt market.
  3. One, IPOs appear to be underpriced -- the price at the end of trading on the first day is often substantially higher than the IPO price. Two, the number of issues is highly cyclical -- when times are good, the number of issues is much greater than when times are bad. One would have expected prices to adjust, but there doesn't seem to be such an adjustment. Three, IPO costs are high and it is unclear why competition does not drive prices down. Finally, the long-run performance of IPOs seem to be bad. Hence it looks like investors overestimate firm value on the first day of trading.
  4. Deere & Co. should have higher leverage because it has more tangible assets -- hence agency costs of debt are less.
  5. Issuing equity does not necessary dilute earnings -- it depends on what is done with the issue proceeds. If the proceeds are invested in positive NPV projects, then earnings are not diluted. Similarly, buying back stock is not profitable either unless the stock is under valued.
  6. The pecking order hypothesis says that firms use internal funds first, then raise funds using debt issuance and turn to equity last. This can be explained as the result of information asymmetry. Since investors do not know if the firm's securities are overvalued or undervalued, they will assume the worst since they are buyers. If the firm is not overavalued, then it will want to avoid issuing securities at low prices. Bonds are less affected than stocks since their value is less dependent on the performance of the firm's investments.


  1. The investment required for land development is $20m. The PV of the land's value one year from now is 40/1.15 = $34.78m. Hence the NPV is $14.78m. The alternative is to keep the land vacant, in which case, it will be worth $12m. The riskfree rate of return is 5%. Hence the present value of the alternative is 12/1.05 or $11.428m., which is less than the NPV of the development. Hence the development of the land is worthwhile.
  2. If the market believes that the firm will not develop the land, the firm will be worth $20m (cash) + $11.428(PV of the land if kept vacant) less the market value of the debt. Now, in one year's time, the cash will be worth 20(1.05) = $21m.and the land will be worth $12m. for a total of $33m. and a debt repayment of $40m. Hence the firm will be bankrupt. Consequently, the equity is worth zero today.
  3. If the market believes that the firm will develop the land, the firm will be worth $35 on average, but the debt repayment required will still be $40 (assuming that there are no states of the world in which the land would be worth more than $35). Hence the firm will still be bankrupt in one year. Consequently, the value of the equity today is $0.
  4. If there are no covenants on the debt, you'd want to pay the $20m. cash out in dividends. (I assume that the land could not be sold and paid out in dividends as well.) If the land is developed, then the equity holders will end up with nothing; hence the CEO would rather pay out the cash in dividends right now.
  5. From the trustee's point of view, it's better to develop the land. In this case, the In this case, the trustee might try and convince the CEO to use the $20 for development of the land and agree to a reduced face value of the debt. For example, if the developed land would be worth at least $21 in one year, the bondholders might agree to allow the CEO to pay the shareholders something more than a $21 dividend in one year before paying the debtholders. Since the land would be worth at least $21 in one years time, the equityholders would be a little better off than taking the $20 in cash today. The bondholders would be better off because they would be getting something with a present value of a little less than $34.78m. - $20m. or a little less than $14.78. The alternative would be to get $12 in one year's time, which would have a present value of 12/1.05 or $11.428, as already discussed.