Finance 3701 Exam 1 Test With Correct Solutions
A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision? - Ther...
A company is contemplating a long-term bond issue. It is debating whether to include a
call provision. What are the benefits to the company from including a call provision?
What are the costs? How do these answers change for a put provision? - There are two
benefits. First, the company can take advantage of interest rate declines by calling in an
issue and replacing it with a lower coupon issue. Second, a company might wish to
eliminate a covenant for some reason. Calling the issue does this. The cost to the
company is a higher coupon. A put provision is desirable from an investor's standpoint,
so it helps the company by reducing the coupon rate on the bond. The cost to the
company is that it may have to buy back the bond at an unattractive price.
.A controversy erupted regarding bond-rating agencies when some agencies began to
provide unsolicited bond rating. Why do you think this is controversial? - Companies
charge that bond rating agencies are pressuring them to pay for bond ratings. When a
company pays for a rating, it has the opportunity to make its case for a particular rating.
With an unsolicited rating, the company has no input.
.A firm's enterprise value is equal to the market value of its debt and equity, less the
firm's holdings of cash and cash equivalents. This figure is particularly relevant to
potential purchasers of the firm. Why? - Enterprise value is the theoretical takeover
price. In the event of a takeover, an acquirer would have to take on the company's debt
but would pocket its cash. Enterprise value differs significantly from simple market
capitalization in several ways, and it may be a more accurate representation of a firm's
value. In a takeover, the value of a firm's debt would need to be paid by the buyer when
taking over a company. This enterprise value provides a much more accurate takeover
valuation because it includes debt in its value calculation.
.Are there any circumstances under which an investor might be more concerned about
the nominal return on an investment than the real return? - Yes. Some investors have
obligations that are denominated in dollars; that is, they are nominal. Their primary
concern is that an investment provide the needed nominal dollar amounts. Pension
funds, for example, often must plan for pension payments many years in the future. If
those payments are fixed in dollar terms, then it is the nominal return on an investment
that is important.
.As you increase the length of time involved, what happens to future values? What
happens to present values? - Future values grow (assuming a positive rate of return);
present values shrink.
.As you increase the length of time involved, what happens to the present value of an
annuity? What happens to the future value? - Assuming positive cash flows, both the
present and the future values will rise.
, .Companies often try to keep accounting earnings growing at a relatively steady pace,
thereby avoiding large swings in earnings from period to period. They also try to meet
earnings targets. To do so, they use a variety of tactics. The simplest way is to control
the timing of accounting revenues and costs, which all firms can do at least some
extent. For example, if earnings are looking too low this quarter, then some accounting
costs can be deferred until next quarter. This practice is called earnings management. It
is common, and it raises a lot of questions. Why do firms do it? Why are firms even
allowed to do it under GAAP? Is it ethical? What are the implications for cash flow and
shareholder wealth? - In general, it appears that investors prefer companies that have a
steady earnings stream. If true, this encourages companies to manage earnings. Under
GAAP, there are numerous choices for the way a company reports its financial
statements. Although not the reason for the choices under GAAP, one outcome is the
ability of a company to manage earnings, which is not an ethical decision. Even though
earnings and cash flow are often related, earnings management should have little effect
on cash flow (except for tax implications). If the market is "fooled" and prefers steady
earnings, shareholder wealth can be increased, at least temporarily. However, given the
questionable ethics of this practice, the company (and shareholders) will lose value if
the practice is discovered.
.Companies pay rating agencies such as Moody's and S&P to rate their bonds, and the
costs can be substantial. However, companies are not required to have their bonds
rated; doing so strictly voluntary. Why do you think they do it? - Companies pay to have
their bonds rated simply because unrated bonds can be difficult to sell; many large
investors are prohibited from investing in unrated issues.
.Could a company's cash flow to stockholders be negative in a year? Explain how this
might come about. What about cash flow to creditors? - If a company raises more
money from selling stock than it pays in dividends in a particular period, its cash flow to
stockholders will be negative. If a company borrows more than it pays in interest, its
cash flow to creditors will be negative.
.Could a company's change in NWC be negative in a year? Explain how this might
come about. What about net capital spending? - For example, if a company were to
become more efficient in inventory management, the amount of inventory needed would
decline. The same might be true if it becomes better at collecting its receivables. In
general, anything that leads to a decline in ending NWC relative to beginning would
have this effect. Negative net capital spending would mean more long-lived assets were
liquidated than purchased.
.How does a bond issuer decide on the appropriate coupon rate to set on its bonds?
Explain the difference between the coupon rate and the required return on a bond. -
Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such
bonds are used to establish the coupon rate necessary for a particular issue to initially
sell for par value. Bond issuers also simply ask potential purchasers what coupon rate
would be necessary to attract them. The coupon rate is fixed and simply determines
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