The Chinese University of Hong Kong

CUHK Business School

FINA3070 Corporate Finance: Theory and Practice

Name:
Student ID:
Lecture: FINA 3070A (Wed) / FINA 3070B (Tue)

DO NOT TAKE AWAY

Midterm Quiz (Two Hours Closed Book)

Instructions:
1. Please answer all questions in the answer book. Any answers written on this
question paper will not be graded.

2. There are 4 questions and the total mark of this midterm is 90.

3. You are allowed to bring ONE A4 formula sheet.

1
Question 1 (25 Marks)

(a) In a world with no taxes, no transaction costs, and no costs of financial distress,
is the following statement true, false, or uncertain? If a firm issues equity to
repurchase some of its debt, the price per share of the firm’s stock will rise
because the shares are less risky. Explain. (10 marks)

(b) Do you agree or disagree with the following statement? A firm’s shareholders
will never want the firm to invest in projects with negative net present values.
Why? (10 marks)

(c) When managers are better informed than outside investors, the pecking order
theory predicts that there would be a price drop at equity issue announcement.
How would you suggest the managers to minimize the adverse effect if they
must issue equity? (5 marks)

2
Question 2 (30 Marks)

Jason is the CEO of CU Café. Jason is considering opening a new café. He has
examined the potential for the company’s expansion and determined that the success
of the new café will depend critically on the state of the economy over the next few
years.

CU Café has a bond issue outstanding with a face value of $25 million that is due in
one year. Covenants associated with this bond issue prohibit the issuance of any
additional debt. The restriction means that the expansion will be entirely financed
with equity at a cost of $9 million. Jason has summarized his analysis in the
following table, which shows the value of the firm in each state of the economy next
year, both with and without expansion:

Economic Growth Probability Without Expansion With Expansion

Low 30% $20,000,000 $24,000,000
Normal 50% $34,000,000 $45,000,000
High 20% $41,000,000 $53,000,000

(a) What is the expected value of the firm in one year (i.e., at t = 1), with and
without expansion? (4 marks) Would the firm’s shareholders be better off with
or without expansion? (2 marks) Why? (2 marks)

(b) What is the expected value of the firm’s debt in one year, with and without
expansion? (4 marks)

(c) One year from now, what is the firm’s equity with and without expansion? (4
marks) Do you think Jason would expand the café or not? (3 marks) Why? (3
marks)

(d) If the firm announces that it is not expanding, what do you think will happen to
the price of its bonds? (2 marks) What will happen to the price of the bonds if
the company does expand? (2 marks) Briefly explain in words.

(e) If the firm opts not to expand, what are the implications for the firm’s future
borrowing needs? (2 marks) What are the implications if the firm does expand?
(2 marks) Briefly explain in words.

3
Question 3 (15 Marks)

A firm has debt with both a face value and a market value of $3,000. This debt has a
coupon rate of 7% and the interest is paid annually. The expected earnings before
interest and taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is
12%.

(a) Assume perpetual cash flows, what is the value of this firm? (8 marks)

(b) What is the firm’s cost of equity? (7 marks)

4
Question 4 (20 Marks)

The WHAT Company and the WHY Company are identical in every respect except
that WHAT is not levered. The market value of WHY Company’s 6% bonds is $1
million. Financial information for the two firms appears here. All earnings streams
are perpetuities. Neither firm pays taxes. Both firms distribute all earnings
available to common shareholders immediately.

WHAT WHY
Projected Operating Income $300,000 $300,000
Year-end Interest on Debt --- $60,000
Market Value of Stock $2,400,000 $1,714,000
Market Value of Debt --- $1,000,000

(a) What are the values of WHAT Company and WHY Company? (2 marks) Do
you think the results violate the MM Propositions? (1 mark)

(b) An investor who can borrow at 6% per year wishes to purchase 5% of WHY’s
equity. Can he increase his dollar return by purchasing 5% of WHAT’s equity if
he borrows so that the initial net costs of the two strategies are the same? (13
marks)

(c) Given the two investment strategies in part (b), which will investor choose?
When will this process cease? (4 marks)