Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

1. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.

2. 1. What is business risk? What factors influence a firm’s business risk?

   2. What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

• Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.

• 1. What is business risk? What factors influence a firm’s business risk?

  2. What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

a)The yields of four zero-coupon bonds of varying maturities are as follows: Maturity YTM 1 6.1% 2 6.2% 3 6.3% 4 6.4% If you expect the implied term structure to be the same next year as it is this year, what is the expected return on the 2-year zero coupon bond over the coming year? Please express your answer in percent, rounded to the nearest basis point.

b)The maturities and yields of three zero-coupon bonds are as follows:

Next year, you expect the yields on zero-coupon bonds to be as follows:

c)What is your expectation of the rate of return on a 3-year zero-coupon bond over the coming year? Please express your answer in percent rounded to the nearest basis point.

d)The 1-year rate is currently 2%, and the expected 1-year rate a year from now is 1%. If the liquidity preference theory holds and the liquidity premium for the 2-year rate is 1.0%, what should the 2-year rate be? (Assume that the liquidity premium for the 1-year rate is 0.0%) Please express your answer in percent rounded to the nearest basis point.

If the 1-year rate is currently 3%, and the 2-year rate is 4.5%, what is the expected 1-year rate a year from now if the expectations hypothesis holds? Please express your answer in percent rounded to the nearest basis point.

You are being consulted as a young forensic investigator. Here are the facts:

Your client, Mr. Clean, comes to you with the following true story.

• Mr. Clean owned with a partner, Mr. Dirty, a coin-operated laundry. Mr. Dirty recently passed away and his family discovered over $1,000,000 worth of coins in Mr.Dirty's two-bedroom apartment. Mr. Clean is astounded to hear this and immediately goes back to the business to check some business statistics that he heretofore never bothered checking and discovered that indeed for the past 20 years of their partnership a material amount of income was missing each week.
• Mr. Clean assumes that Mr. Dirty's $1.0 million plus of coins and the statistics of missing money at the business is no coincidence...Mr. Dirty's coins were stolen from the business by Mr. Dirty.
• The problem - how to prove this to be the truth? How to prove that Mr. Dirty did it? In order for Mr. Clean to have a claim on his insurance policy and on Mr. Dirty's estate, some amount of proof is needed.

Try to propose answers to the following questions:

1. What sort of statistics at the business did Mr. Clean look at to see that money was missing every week?
2. What steps could you undertake to prove that Mr. Dirty stole the money? In other words, what types of evidence could you develop that points the finger at Mr. Dirty in a way that would convince most people that Mr. Dirty did steal the money from the business.  REMEMBER: CIRCUMSTANTIAL EVIDENCE IS OFTEN HOW FRAUD IS PROVEN.

The Dunley Corp. plans to issue 5-year bonds. It believes the bonds will have a BBB rating. Suppose AAA bonds with the same maturity have a 5% yield. If the market risk premium is 4% using the data in the tables:

a. Estimate the yield Dunley will have to pay, assuming an expected 55% loss rate in the event of default during average economic times. What spread over AAA bonds will it have to pay?

b. Estimate the yield Dunley would have to pay if it were a recession, assuming the expected loss rate is 80% at that time but the beta of debt and market risk premium are the same as in average economic times. What is Dunley's spread over AAA now?

c. In fact, one might expect risk premia and betas to increase in recessions. Redo part (b ) assuming that the market risk premium and the beta of debt both increase by 20% , that is they equal 1.20 times their value in recessions.

Questions on Lecture and D2L Readings

5. The distinction of nominal vs. real GDP is necessary to

a. adjust GDP for the actual quality of life.

b. account for inflation.

c. distinguish exports from imports.

d. determine if the economy is in a recession.

e. both a) and b) are correct.

6. A often used indicator of a recession is two consecutive quarterly falls in ______. The official determination is made, however, by _________.

a. either nominal or real GDP // the Federal Reserve Bank

b. real GDP // NBER (National Bureau of Economic Research)

c. nominal GDP // BLS (Bureau of Labor Statistics)

d. real GDP // BEA (Bureau of Economic Analysis)

e. real GDP // a consensus of economic commentators of the major news channels

7. Deflation is the converse of inflation. In deflation the CPI would be declining and the real value of money would increase. Therefore deflation

a. would benefit everyone.

b. makes debtors better off and creditors worse off.

c. make creditors better off and debtors worse off.

d. help corporate profits at the expense of wage earners.

8. Buying a U.S. treasury bond is lending money to the government. In the last month the nominal interest rate has declined by about 1.5 percentage points from 2.5 to 1.0 percent. It’s still a better buy then before as long as the inflation rate

a. Is steady

b. falls by more than 1.5 percentage points

c. rises moderately.

d. falls at any rate greater than 0.

1. The mean cholesterol level of 40 to 60 year-old women surveyed in a particular country was found to be 5 mmol/l with a standard deviation is 1 mmol/l. The random variable is

2. Which of the following statements is correct regarding the standard normal distribution?

3. A survey of Canadians showed the mean number of hours spent volunteering at any activity was 11 hours per year with a standard deviation of 1.5 hours. If the number of hours spent volunteering is normally distributed, what is the probability that a randomly selected person will have spent more than 15 hours volunteering over a one-year period?

4.For a uniform continuous probability distribution, the probability of observing any single observation of the random variable is equal to 1/(b-a).

5.To compute the median of a continuous uniform probability distribution we sum the minimum and maximum observations and divide the sum by 2.

6.A normal distribution refers to any symmetric probability distribution, whether discrete or continuous.

7. The total area under the normal curve

CASE: On January 1, CBU installed a new computer system for tracking and calculating inventory costs. On December 31, at years-end closing, CBU’s system reported inventory at $4.5 million for financial statement purposes. At midnight, the auditors performed a physical inventory count and found the inventory total to be $3.5 million. To correct the discrepancy, CBU’s accounting staff processed an adjusting entry to reduce inventory by $1.0 million. The next day, 2 accountants were discussing the events of the previous night. Accountant A was proud of the audit and said it illustrated a benefit of having a good system of internal control. CBU had followed good internal control procedures by having a regular physical inventory count to safeguard a valuable enterprise resource. Accountant A was relieved that the problem was resolved: the financial numbers were corrected before they were reported. In short, he felt successful and thought CBU should feel fortunate to have his accounting staff as control advisors. Accountant B felt differently. She was concerned about the bad decisions that were made throughout the year based on the incorrect inventory numbers. She felt that she and the other accountants should have helped develop more timely and effective system controls. With which accountant’s philosophy do you agree? How can you explain the diverse opinions? What policies or procedures, if any, should CBU develop to avoid such problems in the future? Your response should also include a Biblical perspective.

Sunrise, Inc., has no debt outstanding and a total market value of $230,400. Earnings before interest and taxes, EBIT, are projected to be $39,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 24 percent lower. The company is considering a $125,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 7,200 shares outstanding. The company has a tax rate of 22 percent, a market-to-book ratio of 1.0, and the stock price remains constant. a-1. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) a-2. Calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) b-1. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)b-2. Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Iconic memory is a type of memory that holds visual information for about half a second (0.5 seconds). To demonstrate this type of memory, participants were shown three rows of four letters for 50 milliseconds. They were then asked to recall as many letters as possible, with a 0-, 0.5-, or 1.0-second delay before responding. Researchers hypothesized that longer delays would result in poorer recall. The number of letters correctly recalled is given in the table.

(a) Complete the F-table. (Round your values for MS and F to two decimal places.)

(b) Compute Tukey's HSD post hoc test and interpret the results. (Assume alpha equal to 0.05. Round your answer to two decimal places.)

The critical value is _____________ for each pairwise comparison.

(c) Which of the comparisons had significant differences? (Select all that apply.)

Recall following no delay was significantly different from recall following a one second delay.

The null hypothesis of no difference should be retained because none of the pairwise comparisons demonstrate a significant difference.

Recall following no delay was significantly different from recall following a half second delay.

Recall following a half second delay was significantly different from recall following a one second delay.