FINANCIAL MANAGEMENT II - PRACTICE SET FOR EXAM 3

1. Operating leases often have terms that include

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

2. Which of the following is most CORRECT?

a. 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.
b. 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.
c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments
associated with a loan.
d. Capital, or financial, leases generally provide for maintenance by the lessor.
e. 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.

3. Heavy use of off-balance-sheet lease financing will tend to

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

4. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are
noncallable, are as follows:
1. T-bond = 7.72% A = 9.64%
2. AAA = 8.72% BBB = 10.18%
The differences in rates among these issues were most probably caused primarily by:
a. Real risk-free rate differences.
b. Tax effects.
c. Default and liquidity risk differences.
d. Maturity risk differences.
e. Inflation differences.

5. Which of the following statements is CORRECT?

a. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to
occur if interest rates decline after the bond was issued.
b. A sinking fund provision makes a bond more risky to investors at the time of issuance.
c. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the
company to reduce its debt over time.
d. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less
likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in
at the sinking fund call price.

6. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies' pre-merger
values.
a. True
b. False

7. Most defensive mergers occur as a result of managers' actions to maximize shareholders' wealth.
a. True
b. False

8. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.
a. True
b. False
*A conglomerate merger is a merger of two firms that have completely unrelated business activities
 9. A spin-off is a type of divestiture in which the assets of a division are sold to another firm.
a. True
b. False
*In a "spin-off," a parent company distributes shares of a subsidiary to the parent company's shareholders so that the subsidiary
becomes a separate, independent company.

10. Which of the following statements is CORRECT?

a. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.
b. An indenture is a bond that is less risky than a mortgage bond.
c. The expected return on a corporate bond will generally exceed the bond's yield to maturity.
d. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed
its yield to maturity.
e. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and
then be liquidated.

11. Which of the following statements is CORRECT? *senior debt is repaid first in case of bankruptcy
a. Senior debt is debt that has been more recently issued, and in bankruptcy, it is paid off after junior debt
because the junior debt was issued first.
b. A company's subordinated debt has less default risk than its senior debt.
c. Bonds with a sinking fund generally have lower yields than the company’s bonds without a sinking fund.
d. Junk bonds typically provide a lower yield to maturity than investment-grade bonds.
e. A debenture is a secured bond that is backed by some or all of the firm’s fixed assets.

12. Which of the following statements is NOT true regarding venture capitalists?
a. They can provide substantial capital for young companies.
b. The firms offer limited partners a number of advantages over investing directly in start-ups themselves as
angel investors.
c. They use their control to protect their investments, so they may therefore perform a key nurturing and
monitoring role for the firm.
d. They might invest for strategic objectives in addition to the desire for investment returns.
e. Venture capitalists typically control about one-third of the seats on a start-up's board of directors, and
often represent the single largest voting block on the board.

13. Which of the following best describes a firm commitment IPO?

a. The underwriter purchases the entire issue at a small discount and then resells it at the offer price.
b. The underwriter sells new issues directly to the public in an online auction.
c. The underwriter tries to sell the stock for the best possible price but does not guarantee that the stock will
be sold.
d. The underwriter solicits bids from investors and chooses the highest price at which there is sufficient
demand to sell the entire issue.
e. The underwriter solicits bids from investors and chooses the lowest price at which there is sufficient
demand to sell the entire issue.

14. Which of the following statements is FALSE?

a. Underwriters appear to use the information they acquire during the book-building stage to intentionally
underprice the IPO, thereby reducing their exposure to losses.
b. The Bluetooth option allows the underwriter to issue more stock, amounting to 15% of the original offer
size, at the IPO offer price.
c. The lead underwriter usually makes a market in the stock and assigns an analyst to cover it.
d. In most cases, the preexisting shareholders are subject to a 180-day lockup; they cannot sell their shares
for 180 days after the IPO. Once the lockup period expires, they are free to sell their shares.
e. “Bandwagon effect” is one of several explanations of high first-day returns.

15. Which of the following statements is FALSE?

a. Chief among the costs associated with the size is that larger firms are more difficult to manage.
b. Synergies usually fall into two categories: cost reductions and revenue enhancements.
c. Diversification benefits are by far the most common justification that bidders give for the premium they
pay for a target.
d. An acquirer might be able to add economic value, as a result of an acquisition, that an individual investor
cannot add.
e. There may also be costs associated with the size.

16. When it comes to project financing, the project’s income goes to servicing the debt, covering operating expenses,
and generating a return on the investors’ equity. Therefore, managers are generally not able to make reinvestment
decisions.
a. True
b. False
17. The project company (SPV) can provide financing on a project basis by issuing debt only.
a. True
b. False

18. Which of the following statements regarding poison pills is FALSE?

a. Companies with poison pills are easier to take over, and when they are taken over, the premium that
existing shareholders receive for their stock is lower.
b. Because a poison pill increases the cost of a takeover, all else equal, a target company must be in better
shape to justify the expense of waging a takeover battle.
c. Poison pills also increase the bargaining power of the target firm when negotiating with the acquirer
because poison pills make it difficult to complete the takeover without the cooperation of the target
board.
d. By adopting a poison pill, a company effectively limits the ownership by any single investor.

19. Firms use defensive tactics to fight off undesired mergers. These tactics do NOT include
a. raising antitrust issues.
b. developing poison pills.
c. getting white knights to bid for the firm.
d. repurchasing their own stock.
e. engaging in risk arbitrage.

20. Which of the following statements is most CORRECT?

a. 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.
b. 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.
c. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt
capacity is rarely relevant consideration when considering a merger.
d. Managers who purchase other firms often assert that the newly 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, research of U.S. firms suggests that in most cases,
diversification through mergers does not increase the firm's value.
e. Research of U.S. firms suggests that managers' personal motivations have had little, if any, impact on
firms' decisions to merge.

21. Which of the following statements is FALSE?

a. There are two primary mechanisms by which ownership and control of a public corporation can change:
Either another corporation or group of individuals can acquire the target firm, or the target firm can
merge with another firm.
b. Merger activity is greater during economic contractions than during expansions.
c. Mergers and acquisitions are part of what is often referred to as "the market for corporate control."
d. The takeover market is also characterized by merger waves–peaks of heavy activity followed by quiet
troughs of few transactions.

22. Which of the following statements is FALSE?

a. In practice, most acquirers pay a substantial acquisition premium, which is the percentage difference
between the acquisition price and the premerger price of the target firm.
b. When a bid is announced, the target shareholders enjoy a gain on average in their stock price.
c. On average, when a bid is announced, the stock price of the target drops.
d. A bidder is unlikely to acquire a target company for less than its current market value.

23. What feature is generally NOT attributable to the project finance transactions:
a. high capital intensity
b. long-term orientation
c. low level of leverage
d. special purpose vehicle (project company) has a finite life
e. controlled dividend policy

24. Non-recourse or limited recourse financing refers to all except:

a. Since these newly formed entities do not have their own credit or operating histories, it is necessary for
lenders to focus on the specific project’s cash flows.
b. It takes an entirely different credit evaluation or investment decision process to determine the potential
risks and rewards of project financing as opposed to corporate financing.
c. If the project was to fail, the debt holder’s claims would be against the project company alone and not
against the parent company.
d. If the project was to fail, the debt holder’s claims would be against the parent company exclusively.
 e. By allowing separate (project) company to issue debt, project financing is more expensive than corporate
financing.

25. Which of the following is NOT an advantage of project financing:

a. Increased borrowing capacity
b. Governement concessions
c. Risk management tool
d. Interest tax shield
e. High flexibility

26. Varying degrees of political risk insurance can be obtained through the use of financing products available from:
a. multilateral institutions and export credit agencies
b. investment bankers
c. credit rating agencies
d. bank syndicate
e. International Monetary Fund

27. Chambers Industries has a market capitalization of $800 million and 250 million shares outstanding. The
management of this firm plans to raise further capital through a rights issue. Which of the following rights schemes
will raise the most money, if all shareholders exercise their rights?
a. two rights to purchase one share at $1.60 per share (250m/2) x 1 x 1.60 = 200m
b. three rights to purchase two shares at $1.80 per share (250m/3) x 2 x 1.80 = 300m
c. four rights to purchase three shares at $2.00 per share. (250m/4) x 3 x 2.00 = 375m
d. five rights to purchase two shares at $1.50 per share (250m/5) x 2 x 1.50 = 150m

Problem 1
You are the CFO of a company that has a market capitalization of $5 billion. The firm has 250 million shares outstanding, so
the shares are trading at $20 per share. You need to raise $500 million and have announced a rights issue. Each existing
shareholder is sent one right for every share he or she owns. You have not decided how many rights you will require to
purchase a share of new stock. You will require either five rights to purchase one share at a price of $10 per share, or ten
rights to purchase three new shares at a price of $6.45 per share. Which approach will raise more money?

5R : 1S at $10.0 = (250m / 5R ) x 1 x $10 = $500m.

10 : 3S at $6.45. = (250m / 10R) x 3 x $6.45 = $483.75m

Problem 2
Apilado Appliance Corporation is considering a merger with the Vaccaro Vacuum Company. Vaccaro is a publicly traded
company, and its current beta is 1.30. Vaccaro has been barely profitable, so it has paid an average of only 20% in taxes
during the last several years. In addition, it uses little debt, having a debt ratio of just 25%.
If the acquisition were made, Apilado would operate Vaccaro as a separate, wholly owned subsidiary. Apilado would pay
taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Apilado also would increase the debt
capitalization in the Vaccaro subsidiary to 40% of assets, which would increase its beta to 1.47. Apilado’s acquisition
department estimates that Vaccaro, if acquired, would produce the following net cash flows to Apilado’s shareholders (in
millions of dollars):

These cash flows include all acquisition effects. Apilado’s cost of equity is 14%, its beta is 1.0, and its cost of debt is 10%.
The risk-free rate is 8%.
a. What discount rate should be used to discount the estimated cash flows? (Hint: Use Apilado’s rs to determine the
market risk premium.)
b. What is the dollar value of Vaccaro to Apilado?
c. Vaccaro has 1.2 million common shares outstanding. What is the maximum price per share that Apilado should
offer for Vaccaro? If the tender offer is accepted at this price, what will happen to Apilado’s stock price?