Question

1.A firm has a significant amount of debt outstanding and its operations hit a rough patch. If it appears that bankruptcy is imminent, the firm’s management may invest in high-risk projects having a negative NPV because:

A.the firm’s equity beta is now negative.

B.the firm’s debt beta is now negative.

C.corporate income taxes are no longer a concern.

D.the firm’s debt holders bear most of the project’s downside risk.

2.Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine whether to build and open the new store. Which of the following should not be included as part of the incremental free cash flows for evaluating the proposed new retail store?

A.The cost of demolishing the abandoned warehouse and clearing the lot.

B.The expected loss of sales at its existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead.

C.The $10,000 in market research spent to evaluate customer demand.

D.Construction costs for the new store.

E.The value of the land if sold. There is currently an offer of $250,000 from an interested buyer

3.The pecking order theory of capital structure predicts that firms will fund positive NPV projects first with internally generated funds, then with debt, and finally with new equity. What is the primary insight of the pecking order story theory that leads to this funding ordering in which equity is only issued as a last resort?

A.Issuing debt is always superior to issuing equity because interest paid to debtholders is tax deductible whereas dividends paid to shareholders are not.

B.The opportunity cost of internally generated funds is low in comparison to issuing new debt or equity because the alternative to retaining the funds and investing in new projects is to pay the funds out as dividends.

C.Issuing equity dilutes earnings per share.

D.Investors and managers are asymmetrically informed about the firm’s operations and value. There is an adverse selection cost of issuing equity because investors believe a firm is likely to issue equity when management believes the firm’s stock is overpriced.

Answer 1

Q-1) Firm may consider project even when the bankruptcy is imminent and the risk of the project is high because now the risk of loosing is more for debt holders. After bankruptcy and insolvency equity shareholders receive very small proportion because major part is used to pay off debt obligation so the correct answer is

D. the firm’s debt holders bear most of the project’s downside risk.

Equity and debt beta will not be negative and income tax will continue to be a concern if the profits are coming up from the projects.

Q-2) when considering the incremental cost related to a project, we consider the revenue and expenditure associated with the project, the opportunity cost is also considered but sunk cost is not considered.

A) This will be included as it is an expenditure on the project

B) This will also be included as it will be treated as opportunity cost which is arising because of new store

C) This is a sunk cost and will not be considered or not be included.

D) This is a direct expenditure and will be included.

E) This is again an example of opportunity cost and will be included.

Q-3) In pecking order theory, the equity is a last resort because it is believed that management is more aware about the company then outsider and management will issue equity when it is believed the shares are overvalued, so it acts as a information signaling to the equity and equity share price falls. So, the correct answer is

D. Investors and managers are asymmetrically informed about the firm’s operations and value. There is an adverse selection cost of issuing equity because investors believe a firm is likely to issue equity when management believes the firm’s stock is overpriced.