CITY UNIVERSITY OF HONG KONG

Course code & title : EF4313 Corporate Finance

Session : Semester B 2021/22
Time allowed : Two hours

This paper has SEVEN pages (including this cover page).

1. This paper consists of 12 questions.

2. Answer ALL questions.
3. Useful hotlines during the Exam:

Course Leader Dr. Ji YAN 3442 9843

TA Miss Wei SHAN 6405 9572
e-learning Team 3442-6727
Computer Services Centre (CSC) 3442-6488
Departmental hotline 3442-2688

Academic Honesty (*Students must reaffirm the honesty pledge by writing “I pledge to
follow the Rules on Academic Honesty and understand that violations may lead to severe
penalties” onto the first examination answer sheet.)

I pledge that the answers in this examination are my own and that I will not seek or
obtain an unfair advantage in producing these answers. Specifically,
• I will not plagiarize (copy without citation) from any source;
• I will not communicate or attempt to communicate with any other person during the
examination; neither will I give or attempt to give assistance to another student taking
the examination; and
• I will use only approved devices (e.g., calculators) and/or approved device models.
• I understand that any act of academic dishonesty can lead to disciplinary action.

This is a open-book examination.

Students are allowed to use the following materials/aids:

Digital and/or hard copies of the text books, lecture notes, practice
problems, calculator, Excel.

Materials/aids other than those stated above are not permitted. Students will
be subject to disciplinary action if any unauthorized materials or aids are
found on them.

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Attempt ALL questions.

Question 1 (5 points) An election is being held to fill three seats on the board of directors of a
firm in which you hold stock. The company has 19,600 shares outstanding. If the election is
conducted under cumulative voting and you own 500 shares, how many more shares must you
buy to be assured of earning a seat on the board?

Question 2 (5 points) What is a callable bond? Do you agree or disagree with the following
statement: “In an efficient market, callable and noncallable bonds will be priced in such a way
that there will be no advantage or disadvantage to the call provision.” Why?

Question 3 (10 points) Brown Manufacturing, Inc., plans to announce that it will issue $4
million of perpetual debt and use the proceeds to repurchase common stock. The bonds will
sell at par with a coupon rate of 5 percent. Brown is currently an all-equity firm worth $10
million with 500,000 shares of common stock outstanding. After the sale of the bonds, Brown
will maintain the new capital structure indefinitely. Brown currently generates annual pretax
earnings of $2 million. This level of earnings is expected to remain constant in perpetuity.
Brown is subject to a corporate tax rate of 20 percent.
a. What is the expected return on Brown's equity before the announcement of the debt issue?
(2 points)
b. What is the price per share of the firm's equity with its original capital structure? (2 points)
c. What is Brown's stock price per share immediately after the repurchase announcement? (2
points)
d. How many shares will Brown repurchase as a result of the debt issue? How many shares of
common stock will remain after the repurchase? (2 points)
e. What is the required return on Brown's equity after the restructuring? (2 points)

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Questions 4 (10 points) When personal taxes on interest income and bankruptcy costs are
considered, the general expression for the value of a levered firm in a world in which the tax
rate on equity distributions equals zero (𝑡𝑆 = 0) is:
1 − 𝑡𝐶
𝑉𝐿 = 𝑉𝑈 + (1 − ) × 𝐵 − 𝐶(𝐵)
1 − 𝑡𝐵

where:
𝑉𝐿 = The value of a levered firm.
𝑉𝑈 = The value of an unlevered firm.
𝐵 = The value of the firm's debt.
𝑡𝐶 = The tax rate on corporate income.
𝑡𝐵 = The personal tax rate on interest income.
𝐶(𝐵) = The present value of the costs of financial distress.

a. In their no-tax model, what do Modigliani and Miller assume about 𝑡𝐶 , 𝑡𝐵 , and 𝐶(𝐵)? What
do these assumptions imply about a firm's optimal debt–equity ratio? (2 points)
b. In their model with corporate taxes, what do Modigliani and Miller assume about 𝑡𝐶 , 𝑡𝐵 ,
and C(B)? What do these assumptions imply about a firm's optimal debt–equity ratio? (2
points)
c. Consider an all-equity firm that is certain to be able to use interest deductions to reduce its
corporate tax bill. If the corporate tax rate is 34 percent, the personal tax rate on interest
income is 20 percent, and there are no costs of financial distress, by how much will the
value of the firm change if it issues $1 million in debt and uses the proceeds to repurchase
equity? (3 points)
d. Consider another all-equity firm that does not pay taxes due to large tax loss carryforwards
from previous years. The personal tax rate on interest income is 20 percent, and there are
no costs of financial distress. What would be the change in the value of this firm from
adding $1 of perpetual debt rather than $1 of equity? (3 points)

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Question 5 (10 points) Star Industries just issued $250,000 of perpetual 8 percent debt and
used the proceeds to repurchase stock. The company expects to generate $120,000 of earnings
before interest and taxes in perpetuity. The company distributes all its earnings as dividends at
the end of each year. The firm's unlevered cost of capital is 15 percent, and the corporate tax
rate is 30 percent.
a. What is the value of the company as an unlevered firm? (2 points)
b. Use the adjusted present value method to calculate the value of the company with leverage.
(2 points)
c. What is the required return on the firm's levered equity? (3 points)
d. Use the flow to equity method to calculate the value of the company's equity. (3 points)

Question 6 (5 points) Dividends and other payout

a. How is it possible that dividends are so important, but at the same time dividend policy is
irrelevant? (2 points)
b. On Tuesday, December 8, Hometown Power Co.'s board of directors declares a dividend
of 75 cents per share payable on Wednesday, January 17, to shareholders of record as of
Wednesday, January 3. When is the ex-dividend date? If a shareholder buys stock before
that date, who gets the dividends on those shares—the buyer or the seller? (Follow the
definition on slides and textbook) (3 points)

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Question 7 (10 points) Summit Corp.'s stock is currently selling at $32 per share. There are 1
million shares outstanding. The firm is planning to raise $2 million to finance a new project.
What are the ex-rights stock price, the value of a right, and the appropriate subscription prices
under the following scenarios?
a. Two shares of outstanding stock are entitled to purchase one additional share of the new
issue. (4 points)
b. Four shares of outstanding stock are entitled to purchase one additional share of the new
issue. (4 points)
c. How does the stockholders' wealth change from part (a) to part (b)? (2 points)

Question 8 (10 points) Super Sonics Entertainment is considering buying a machine that costs
$600,000. The machine will be depreciated over five years by the straight-line method and will
be worthless at that time. The company can lease the machine for five years with year-end
payments of $140,000. The company can issue bonds at a 8 percent interest rate. If the
corporate tax rate is 20 percent, should the company buy or lease?

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Question 9 (10 points) Last month, CUEF Airline announced that it would stretch out its bill
payments to 45 days from 30 days. The reason given was that the company wanted to “control
costs and optimize cash flow.” The increased payables period will be in effect for all of the
company's 4,000 suppliers.
a. What impact did this change in payables policy have on CUEF's operating cycle? Its cash
cycle? (2 points)
b. What impact did the announcement have on CUEF's suppliers? (2 points)
c. Is it ethical for large firms to unilaterally lengthen their payables periods, particularly when
dealing with smaller suppliers? (2 points)
d. Why don't all firms simply increase their payables periods to shorten their cash cycles? (2
points)
e. CUEF lengthened its payables period to “control costs and optimize cash flow.” Exactly
what is the cash benefit to CUEF from this change? (2 points)

Question 10 (5 points) Your neighbor goes to the post office once a month and picks up two
checks, one for $11,000 and one for $3,400. The larger check takes four days to clear after it is
deposited; the smaller one takes five days.
a. What is the total float for the month? (2 points)
b. What is the average daily float? (1 point)
c. What are the average daily receipts? (2 points)

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Question 11 (10 points) Happy Times currently has an all-cash credit policy. It is considering
making a change in the credit policy by going to terms of net 30 days. Based on the following
information, what do you recommend? The required return is .95 percent per month.

Current Policy New Policy

Price per unit $295 $302
Cost per unit $230 $234
Unit sales per month 1,105 1,125

Question 12 (10 points) Consider the following pre-acquisition information about a bidding
firm (Firm B) and a target firm (Firm T). Assume that both firms have no debt outstanding.

Firm B Firm T
Shares outstanding 5,000 1,500
Price per share $40 $30

Firm B has estimated that the value of the synergistic benefits from acquiring Firm T is
$10,000.
a. If Firm T is willing to be acquired for $35 per share in cash, what is the NPV of the merger
to Firm B? (2 points)
b. What will the price per share of the merged firm be assuming the conditions in (a)? (3
points)
c. In part (a), what is the acquisition premium? (2 points)
d. Suppose Firm T is agreeable to a merger by an exchange of stock. If B offers four of its
shares for every five of T's shares, what will the price per share of the merged firm be? (3
points)

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