Key to Exam II; F5360; Summer 2004; page 1 of 2
Short answer questions/problems
Note: Except possibly for questions in which you are required to provide a list, your answers to the following short-
answer questions should be no more than a sentence or two. If you write more, you will likely run out of time.
1. Assume that you previously purchased a call on Microsoft that you have just decided to throw away. What
conditions have exist for this to be a rational decision on your part (to throw it away)?
1) out of the money, and 2) expired
2. How is the payoff on a bond issued by General Motors related to the payoff on options?
The payoff on a risky bond issued by General Motors is the same as the payoff on a risk-free Treasury and
selling a put on General Motor’s assets with an exercise equal to the maturity value of the bond.
3. Paying dividends to a firm’s stockholders changes the firm in such a way that the firm’s bondholders are worse
off. List (but do not discuss) these changes.
1) Reduction in firm’s assets, 2) payout of riskless assets leaves firm’s assets riskier.
4. List (but do not discuss) two reasons that the project with the highest internal rate of return may not increase firm
value the most.
Two of: projects may differ in scale, project with higher NPV may be dominated by LT cash flows and thus
have a lower IRR, in some cases need to accept project with lowest IRR, projects may have different risk.
5. Spidy2 Inc. is considering expanding it production capacity by building a 3rd assembly line for its Spidywear
clothes. The line would cost $350,000 to build. While its expected useful life is 10 years, it falls into the 5-year
MACRS depreciation class. If Spidy2’s marginal tax rate is 35%, what is the impact of the $350,000 cost on
cash flows today and 3 years from today (Note: write a “+” to indicate a cash inflow/increase and a “-“ to
indicate a cash outflow/reduction)?
CF0 = -$350,000; CF3 = +$350,000(.192)(.35) = +23,520
6. Shrinking Telephone and Telegraph (ST&T) is thinking about selling its facilities in Arkansas, Louisiana,
Missouri, New Hampshire, Ohio, Tennessee, and Washington. Revenues in these states were $2 billion in
ST&T’s fiscal year 2004 (which just ended) but were expected to fall by 9% per year. If ST&T’s marginal tax
rate is 35%, how should the loss of revenues in fiscal year 2005 be factored into the decision on whether or not
to sell the facilities (Note: write a “+” to indicate a cash inflow/increase and a “-“ to indicate a cash
CF1 = -$2,000,000,000(.91)(1-.35) = -$1,183,000,000
7. Kellogg is considering building a new factory in Waco to produce a new line of low-carb cereals. Briefly discuss
how options inherent to the project might need to be included in the analysis of whether or not to build the
Option to expand if successful is a call option, option to abandon if unsuccessful is a put option.
8. What do we call the debt contract?
Key to Exam II; F5360; Summer 2004; page 2 of 2
9. Who is eligible to purchase shares being issued via a rights offering?
10. List (but do not discuss) two ways in which debt can help resolve conflicts of interest between stockholders and
Two of: takes cash out of management’s hands so won’t waste it, keeps management’s back to the wall, allows
management to own larger % of firm’s equity.
Key to Exam II; F5360; Summer 2004; page 3 of 2
1. Assume you have decided to purchase a put on GE with an exercise price of $30 per share that expires two
months from today. However, you are also intrigued by the possibility of creating what is called an artificial
put with the same characteristics. Assume that the current stock price for GE is $32.18 and that the historical
standard deviation of returns on GE’s stock is 23%.
a. Sketch a graph of the payoff you can expect to receive on the put as a function of GE’s stock price. Label
the payoffs if GE’s stock ends up being $20 and $35 per share. Discuss what happens in each case to
create this payoff.
b. Discuss how you would create an artificial put on GE with an exercise price of $30 per share that expires
two months from today.
c. Sketch a graph of the component parts as a function of GE’s stock price for both the individual parts of the
artificial put and for the combined payoff. Label the payoffs if GE’s stock ends up being $20 and $35 per
share and discuss what happens to create these payoffs.
Payoff Payoff Payoff Buy T-bill
Combined Buy call on GE
GE price 10
20 30 35 5 GE price
a. If $20: buy stock for $20, sell stock for $30 by exercising put, net payoff is $10.
If $35: do nothing, net = $0.
b. Buy a call on GE with an exercise price of $30 that expires in 2 months, short-sell GE now, buy a treasury that
expires in 2 months for $30.
c. If $20: $30 from T-bill, throw away call, pay $20 to purchase stock, give stock to broker, net = $10
If $35: $30 from T-bill, exercise call to buy stock for $30, give stock to broker: net = $0
or, $30 from T-bill, exercise call to buy stock for $30, sell stock for $35, buy stock for $35, give to broker.
Key to Exam II; F5360; Summer 2004; page 4 of 2
2. TownGroup Inc. is considering building a new bank in Waco at a cost of $2,500,000. In analyzing whether or
not to build the new bank, TownGroup has collected the following information:
Present value of expected cash flows for: TownGroup as a whole: $242,000,000; new bank = $2,600,000
Standard deviation of returns for: TownGroup as a whole before new bank built = 38.1%; new bank = 45%;
TownGroup as a whole after new bank built = 38%.
Maturity value of TownGroup’s debt before new bank built = $180,000,000
Funding for project: new debt that matures for $1,000,000; cash of $200,000; issue stock
Time horizons: Life of existing assets = 15 years; life of new bank = 20 years; maturity of TownGroup’s
existing and new debt = 8 years.
Other costs: cost to replace existing assets = $160,000,000
Risk-free rates (all APRs assuming continuous compounding): 1-month = 1.22%; 1-year = 1.92%; 4-year =
3.58%; 6-year = 4.28%; 8-year = 4.66%; 15-year = 5.13%; 20-year = 5.36%
a. What is the value of TownGroup’s stock after the project is undertaken?
b. Without doing more calculations than are necessary to answer part “a”, discuss why stockholders might not
want TownGroup to undertake the project.
c. What TownGroup might change from what they have planned in order for the project to become acceptable.
a. V0 = 242,000,000 + 2,300,000 – 2,500,000 + 2,600,000 = 244,400,000
Dt = 180,000,000 + 1,000,000 = 181,000,000
d 2 1.163 .382 8 0.089
S 0 244,400,0000.87698 181,000,000e .04668 0.53586 147,526,456.39
b. the funds stockholders contribute benefit both stockholders and bondholders, the drop in risk hurts
c. more new debt can be issued to fund project.
3. Assume that PepsiCo is considering whether or not to build a new factory to produce chips. What method or
methods might PepsiCo use to estimate the risk of the new factory? Under what conditions would this (these)
approaches be most likely to give good estimates of the risk of the factory?
1) Estimate from historical returns on similar assets
Conditions for good estimate: asset actively traded in secondary market, risk of asset hasn’t changed
2) Estimate using beta of securities issued by PepsiCo
Conditions for good estimate: project’s risk is similar to existing assets, plenty of data, risk of firm’s
existing assets hasn’t changed recently.
3) Estimate using betas of securities issued by firms in same industry as project
Conditions for good estimate: new project has similar risk to assets of established firms (not riskier), can
find comparable firms
Key to Exam II; F5360; Summer 2004; page 5 of 2
4. Assume that during George Bush’s 2nd term he gets Congress to eliminate all personal taxes on investment
income. Based on the discussion of personal taxes and capital structure, discuss what will change if the taxes
on personal investment income were eliminated. Note: you should limit your discussion to those issues raised
in our discussion of capital structure.
Key => personal taxes on interest exceed personal taxes on dividends
Implications of the existence of personal taxes:
1) Firms issue less debt because of rise in personal taxes as issue debt
2) Bondholders demand higher pre-tax return on bonds than equity (of same risk) to compensate for
higher personal taxes
3) In equilibrium, low tax-bracket investors own bonds and high tax-bracket investors own stocks
Without personal taxes on investment income:
1) Amount of debt issued by firms rises
2) Pre-tax return on debt falls relative to equity
3) Investors no longer sort themselves by tax bracket.