Principles of Corporate Finance_ 12th Edition

Appendix Answers to Select Basic Problems A-5

bre44380_app_A1-A10 5 10/09/15 08:14 PM

CHAPTER 20

1. Call; exercise; put; European.


2. a. The exercise price of the put option.
   b. The stock price.


3. Buy a call and lend the present value of the exercise
   price.


4. (a) See Figure 3; (b) stock price − PV(EX) = 100 − 100/
   1.1 = $9.09.


5. (a) Zero; (b) Stock price less the present value of the
   exercise price.


6. a. All investors, however risk-averse, should value more
   highly an option on a volatile stock. For both Exxon
   Mobil and Google the option is valueless if final
   stock price is below the exercise price, but the option
   on Google has more upside potential.
   b. American options can be exercised anytime.
   However, we know that in the absence of dividends
   the value of a call option increases with time to
   maturity. So, if you exercised an American call
   option early, you could needlessly reduce its value.
   The investor is better off selling the Fava Farms call
   than exercising it.

CHAPTER 21

1. a. Using risk-neutral method,
   (p × 20) + (1 − p)(− 16.7) = 1, p = .48.

Value of call =

(.48 × 8) + (.52 × 0)

_________________

1.01

= 3.8

5. a. Direct costs of financial distress are the legal and
   administrative costs of bankruptcy. Indirect costs
   include possible delays in liquidation (Eastern Air-
   lines) or poor investment or operating decisions
   while bankruptcy is being resolved. Also the threat
   of bankruptcy can lead to costs.
   b. If financial distress increases odds of default, man-
   agers’ and shareholders’ incentives change. This can
   lead to poor investment or financing decisions.
   c. See the answer to 5(b). Examples are the “games”
   described in Section 18-3.


6. More profitable firms have more taxable income to
   shield and are less likely to incur the costs of distress.
   Therefore the trade-off theory predicts high (book) debt
   ratios for more profitable companies. In practice the
   more profitable companies borrow less.


7. When a company issues securities, outside investors
   worry that management may have unfavorable informa-
   tion. If so the securities can be overpriced. This worry
   is much less with debt than equity. Debt securities
   are safer than equity, and their price is less affected if
   unfavorable news comes out later.
   A company that can borrow (without incurring
   substantial costs of financial distress) usually does so.
   An issue of equity would be read as bad news by inves-
   tors, and the new stock could be sold only at a discount
   to the previous market price.


8. Financial slack is most valuable to growth companies
   with good but uncertain investment opportunities. Slack
   means that financing can be raised quickly for positive-
   NPV investments. But too much financial slack can
   tempt mature companies to overinvest. Increased bor-
   rowing can force such firms to pay out cash to investors.

CHAPTER 19

1. Market values of debt and equity are
   D = .9 × 75 = $67.5 million
   and E = 42 × 2.5 = $105 million. D/V = .39.
   WACC = .09(1 − .35).39 + .18(.61) = .1325, or 13.25%.


2. (a) False; (b) True; (c) True.


3. (a) True; (b) False, if interest tax shields are valued
   separately; (c) True.


4. a. 12%, of course.
   b. rE = .12 + (.12 − .075)(30/70) = .139;
   WACC = .075(1 − .35)(.30) + .139(.70) = .112, or
   11.2%.


5. No. The more debt you use, the higher rate of return
   equity investors will require. (Lenders may demand
   more also.) Thus there is a hidden cost of the “cheap”
   debt: it makes equity more expensive.

Payoff

Stock

100 price

◗ FIGURE 3 Chapter 20, Problem 7.