Strayer FIN 540 Week 3 – Homework Chapter 20

FIN 540 – Homework Chapter 20

1. 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.

2. 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.

3. 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.

4. 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.

5. 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%

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.