PID #______________

UNC SCHOOL OF LAW

FINAL EXAMINATION

BUSINESS BASICS
Professor Gregg D. Polsky
Fall 2013

DATE: Tuesday, December 3, 2013 TIME: 9:00 am

TIME LIMIT: 3 hours (180 minutes)

Instructions

1. This examination consists of 16 questions. There are six (6) total pages. Make sure that you have all
of the pages. The last two pages include copies of the present values, future values, and annuity
tables from the assigned text for this course.

2. There are 100 total points. The points for each question are indicated on the exam. For each
question, provide your answer and also an explanation of how you arrived at your answer.

3. This is a closed book exam. You may use a hand-held calculator.

4. When finished with the exam, you must return this entire exam as well as any scrap paper you used. I
will discard the scrap paper.

5. Because students may be taking the exam at different times, you may not discuss the exam with
anyone in the course who has not yet taken the exam.

6. You may not duplicate, copy, or reproduce this exam in any manner. The exam, together with any
scrap paper, must be returned at the conclusion of the exam period.

7. For all questions, you should assume the background assumptions stated on page 2 unless a question
indicates or suggests otherwise.

8. Read each question carefully, and be sure to answer the question that is asked.

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 BACKGROUND ASSUMPTIONS

Unless a question indicates or suggests otherwise, you should assume the following background
assumptions in answering questions:

1. The appropriate discount rate is 5 percent.

2. “Preferred stock” means cumulative, non-participating preferred stock.
3. Tax considerations do not affect any decision (i.e., you should ignore tax consequences).

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Questions 1-2 (2 points each)

1. Suppose you have $500 in a savings account earning 2 percent interest a year. After five years, how
much would you have in the account? Explain.

2. True or False: Buying a single company's stock usually provides a safer return than a mutual fund that
holds stock in a variety of companies. Explain.

Questions 3-14 (5 points each)

3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no
relationship? Explain.

4. True or False: While a company’s book value is often not a good estimate of the company’s value as a
going concern, it is often a good estimate of the company’s liquidation value. Explain.

5. Define the accounting terms “depreciation,” “goodwill,” “accounts payable,” and “retained earnings.”

6. Explain the principle behind GAAP’s use of the accrual method, rather than the cash method, in
accounting for revenue and expenses.

7. True or False: By capitalizing an expenditure (rather than expensing it), the company’s earnings in the
current accounting period will increase and its earnings in future accounting periods will also increase.
Explain.

8. True or False: An out-of-the-money stock option has no value. Explain.

9. Identify the T-accounts affected, and whether they are debited or credited, by the following
transactions:

a. Services are provided by the company, and a bill is sent to the client.
b. Services are provided to the company, and a bill is received by the company.
c. The bills in (a) and (b) are paid in cash in full.

10. A corporate executive has earned, from her employer, the right to annual payments of $100,000 per
year beginning at age 55 (on her birthday) and ending upon her death. Executive just turned 46 years old,
and she is expected to live until age 84. What is the value of this right on this date? Explain.

11. Many years ago, you purchased a bond for $50,000. The bond pays annual interest of $5,000 on
December 31 of each year until principal is repaid. The principal is due on December 31, 2018 (the last
$5,000 interest payment is also due that same day, so the issuer will pay you a total of $55,000 on that
day). Today is January 1, 2014. On this date, the issuer is selling to the public new 5 year bonds with an
interest rate of 6 percent. How much is your bond worth today? Explain.

12. While stock options that are purchased on the market (“purchased options”) are rarely exercised until
maturity, stock options that are granted as compensation (“compensatory stock options”) are often
prematurely exercised by the employee-holder.1 Explain why this is so.

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Note that compensatory stock options are not transferable by the employee-holder, while purchased
options may be sold by the holder.

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13. In some instances, a loan will include a prepayment penalty, which requires the borrower to pay a
premium (i.e., an extra amount) if it wants to repay principal earlier than the stated maturity date.

a. Why would a lender desire to include a prepayment penalty in its loan terms?

b. Why would a borrower ever choose to prepay a loan despite the existence of a prepayment
penalty?

14. High quality companies that have preferred stock outstanding typically pay the full amount of the
dividend preference on their preferred stock, because failing to do so would indicate financial distress to
the market. Given that, what would you expect the yield on these companies’ preferred stock to be,
relative to the yield on these companies’ unsecured bonds of similar maturity? “Much lower,” “slightly
lower,” “the same as,” “slightly higher,” or “much higher”? Explain.

Question 15 (12 points)

15. A company has substantial retained earnings. It is deciding whether to use the retained earnings to
grow its business, to make substantial dividend payments, or to engage in a stock repurchase plan
(pursuant to which it will periodically offer to redeem shares of its common stock at market prices).

a. Which course of action would holders of the company’s debt prefer? Explain.

b. Which course of action would holders of the company’s common stock prefer? Explain.

c. Which course of action would holders of call options on the company’s common stock prefer?
Explain.

Question 16 (24 points)

16. Company is the plaintiff in a patent litigation case and is paying its attorney on a contingent fee basis.
Per the contingent fee contract, the attorney will receive 50 percent of any pre-trial settlement or, if the
case proceeds to trial, 55 percent of any judgment. Company expects that, at trial, it has a 50 percent
chance of winning a $100,000,000 judgment, a 25 percent chance of winning a $50,000,000 judgment,
and a 25 percent chance of a defense verdict. Company further expects that it will take 4 years for the
case to work its way through the court system, though it expects that the defendant (whose bonds are
rated AA by S&P) will promptly pay any judgment once it is rendered. Assume that Company is risk-
neutral and that the case will either settle now or else proceed all the way to trial.

a. How much should Company settle the case for now? Explain.

b. Would such a settlement maximize the attorney’s expected value from the case? Explain.

c. If your answer to (b) was “no,” might the attorney nevertheless still prefer the settlement?
Explain.

d. Why is the defendant’s credit rating an important factor in making the decision as to whether
to settle now or proceed to trial?