Advanced Financial Management
M. Gombola Mid-term Exam Name...........…………………...
Short-answer Questions are 18 points each
Multiple Choice are 4 points each
Problems are 18 points each.
Make sure that you answer the question that is asked!!!!!!
Multiple choice questions may have more than one correct answer.
1. Comment on the following statement: “In an efficient capital market all information is
available to all investors”.
2. In this class we have examined several fallacies, including the technical analysis fallacy of
stock pricing, the “bird in hand” fallacy and the “dilution” fallacy of stock offerings. In the
former, shareholders prefer dividends to capital gains because dividends are less risky than
capital gains. Explain the flaw in the logic of this fallacy.
3. Dividing a cash flow of $X by a discount rate or interest rate of i% provides:
a. The present value of a single sum of $X
b. The future value of a single sum of $X
c. The present value of an annuity of $X
d. The present value of a perpetuity of $X
4. On the announcement of a private equity offering, the stock price of the announcing firm:
a) Decreases by an amount greater that 3%
b) Decreases by an amount between 1 and 3%
c) Decreases by an amount less than 1%
d) Increases by an amount between 1 and 3%
5. As a shareholder you might prefer to get a higher dividend rather than a higher stock price and
capital gain because:
a. dividends are less risky that capital gains
b. dividend payments can help shareholders avoid transactions costs
c. Investors can more easily avoid taxes on dividend payments.
d. Both a) and b) above.
6. From the standpoint of transactions costs, which of the following sources of funding presents
the lowest cost?
a. Mortgage bonds
b. Convertible bonds
d. Internal equity
7. Academics have studied the relative valuation of a dollar of retained earnings versus a dollar of
dividends. Relative to one dollar of dividends, how much is a dollar of retained earnings and
stock price worth?
a. Between 40 and 60 cents
b. Between 60 and 75 cents
c. Between 75 and 90 cents
d. Between 90 cents and $1.05
8. A Corporation with no debt has a rate of return on its assets and equity of 12 percent. If it
changes its capital structure to finance 50 percent of its assets by debt that costs 6 percent, what
will be the company's new cost of CAPITAL?
9. Which of the following is inconsistent with Miller and Miller’s propositions on debt financing?
a. Taxes and bankruptcy costs don’t matter in determining capital structure
b. There is an optimal risk level and an accompanying minimum in the cost of capital
c. The optimal capital structure depends on shareholder preferences.
d. All of the above are inconsistent with M&M
e. Both a. and b. are inconsistent with M&M.
10. Consider two companies, A and B, which are equivalent except for their capital structure.
Both have $1000 of assets and earn a rate of return of 15 percent on those assets. Company
A has $300 of debt whereas Company B has $100 of debt. The cost of debt for both
companies is 8 percent. Both have 100 shares of stock outstanding. Mr. X owns 1 share of
Company A stock. The return on this stock is 18 percent. Show how Mr. X could create an
investment equivalent to 1 share of A, that also earns 18 percent, from investing instead in
11. The current price of the Charles River Corp. is $25.00. Next year’s earnings and dividends per
share are $2.00 and $1.00 per share, respectively. Investors expect perpetual growth at 10
percent per year. Investors expect a 14 percent return on the stock. Suppose that Charles River
announces that it will switch to a 100 percent payout policy - this means that the company will
increase its dividend to $2.00 per share. Its investment policy is unchanged as a result of the
dividend increase - it will issue new shares as necessary to finance its planned investments.
a) Not considering information effects, demonstrate the dividend growth rate and stock price
after the change in payout policy. In this demonstration account for the increase in shares
necessary to finance investments.
b) Find Charles River's present value of growth opportunities (PVGO) if
1. The firm pays a $1.00 dividend
2. The firm pays a $2.00 dividend