SECTION A. [60 marks. Each question is equally weighted.]

1) A firm has an average investment of $1,000 during the year. During the same time, the     firm generates after-tax earnings of $150. Calculate the economic value added (EVA) for the firm. (The cost of capital is 10 percent.)

A) $100

B) $50

C) $120

D) $150

2) A positive NPV forecast for a new project is reliable only if it is based on

A) forecasts of cash flows.

B) Michael Porter's theories.

C) identifiable sources of economic rents.

D) results from Monte Carlo analysis

3) What is the NPV of a project in a perfectly competitive environment?

A) Positive

B) Negative

C) Zero

D) The answer cannot be determined.

4) In the principal-agent framework, the ultimate principals in a corporation are

I) managers;

II) board of directors;

III) shareholders;

IV) governments

A) I and II only

B) IV only.

C) III only

D) I, II, and III only

5) A factory manager can unambiguously improve EVA by

A) increasing earnings and increasing capital employed.

B) increasing capital employed and reducing earnings.

C) reducing earnings and reducing capital employed.

D) increasing earnings and reducing capital employed

6) If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the   present value of the interest tax shield? (Assume that the applicable corporate tax rate is 21 percent.)

A) $8.00 million

B) $5.60 million

C) $21.00 million

D) $26.67 million

7) A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

A) 13 percent

B) 16 percent

C) 15 percent

D) 18 percent

8) In order to calculate the tax shields provided by debt, the tax rate used is the

A) average corporate tax rate.

B) marginal corporate tax rate.

C) average of shareholders' equity tax rates.

D) average of bondholders' personal tax rates.

9) What is the relative tax advantage of debt? (TC= corporate tax rate; TpE= personal tax rate on equity income; and Tp= personal tax rate on interest income.)

A)  

B)

C)

D)

10) Firms often calculate a project's break-even sales using accounting profit. However, the break-even level of sales based on NPV analysis is generally

A) higher than the one calculated using accounting profit.

B) lower than the one calculated using accounting profit.

C) equal to the one calculated using accounting profit.

D) not related to the one calculated using accounting profit.

11) If an investor buys a portion (X) of both the debt and equity of a levered firm, then his/her payoff is

A) (X) × (profits).

B) (X) × (interest).

C) (X) × (profits − interest).

D) None of these options.

12) Learn and Earn Company is financed entirely by common stock that is priced to offer a

20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing? (Ignore taxes.)

A) 32 percent

B) 28 percent

C) 20 percent

D) 14 percent

13) The Miller Modigliani theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

I) debt is more risky than equity;

II) bankruptcy and its attendant costs are a disadvantage to debt;

III) the payment of personal taxes may offset the tax benefit of debt

A) I only

B) II only

C) III only

D) II and III only

14) What does "risk shifting" imply?

A) When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.

B) When faced with bankruptcy, managers do not invest more equity capital.

C) When faced with bankruptcy, managers may make accounting changes to conceal the true extent of the problem.

D) When faced with bankruptcy, managers invest in low risk projects to conserve capital.

15) Suppose that a company can direct $1 to either debt interest or capital gains for equity  investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The marginal corporate tax rate is 21 percent.)

A) Investors paying personal tax of 17.5 percent

B) Investors paying personal tax of 21 percent

C) Investors paying personal tax of 53 percent

D) Tax-exempt personal investors

16) Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to:

I) meet interest and principal payments, which if not met can put the company into financial distress;

II) make dividend payments, which if not met can put the company into financial distress;

III) meet both interest and dividend payments, which when met increase the firm cash flow;

IV) meet increased tax payments, thereby increasing firm value

A) I only

B) II only

C) II and III only

D) III and IV only

17) What signal is sent to the market when a firm decides to issue new stock to raise capital?

A) Bond markets are overpriced.

B) Bond markets are underpriced.

C) Stock price is too low.

D) Stock price is too high.

18) The following are agency problems in capital budgeting except

A) empire building.

B) entrenching investments.

C) avoiding risks.

D) accepting all positive NPV projects

19) Capital structure is irrelevant if

I) capital markets are efficient;

II) each investor can borrow/lend on the same terms as the firm;

III) there are no tax benefits to debt

A) I only

B) II only

C) III only

D) I, II, and III

20) Miller-Modigliani's Proposition I corrected for the inclusion of corporate income taxes is expressed as

A) VL = VU.

B) VL = VU + D(1 − TC).

C) VL = VU + (TC)(D).

D) VU= VL + (TC)(D).

SECTION B. [40 marks, each question is equally weighted]

LONG ANSWER TYPE QUESTIONS (MAX 350 WORDS EACH)

21) Is the following statement True or False. Discuss why. The company cost of capital is the correct discount rate for all projects because the high risk projects are offset by the low risk   projects.

22) Discuss why the NPV break-even and accounting break-even level of fixed costs are, in general, different for a project. Provide an instance when the two approaches result in the    same break-even level of fixed costs.

23) Briefly explain the trade-off theory of capital structure.