Question 1

Suppose a firm's initial parameter values are: V=500, X=300, T=3, r_f=2%, $\mathrm { V } _ { 3 } ^ { \mathrm { u } }$ =750, and $\mathrm { V } _ { 3 } ^ { \mathrm { d } }$ =333.33.Compute the current values of the firm's debt and levered equity, D and E_L, respectively.
D , E_L

A)282.7 , 217.3
B)252.7 , 247.3
C)222.7 , 277.3
D)200.7 , 300.3

282.7 , 217.3

Accepted Answer

The correct answer is A because D = V - E = 500 - 217.3 = 282.7 and EL = V - D = 500 - 282.7 = 217.3.

Question 2

An individual investor has either sufficient wealth or sufficient borrowing capacity to purchase or sell a substantial proportion of a given firm's securities, so that investor's trades may affect the market value of these securities.This is an example of the violation of which of the assumptions of an ideal capital market?

A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Atomistic competition

Accepted Answer

This scenario violates the assumption of atomistic competition, where it is assumed that all investors are price takers and cannot influence the price of securities through their individual transactions. An investor with the capacity to purchase or sell a substantial proportion of a firm's securities can affect the market value, contradicting this assumption.

Question 3

Briefly discuss the effects of violations of each of the assumptions of the Ideal Capital Market listed below.

Accepted Answer

(a) Assumption 1: Frictionless Markets;&#10;(b) Assumption 2: All market participants share homogeneous expectations;&#10;(c) Assumption 3: Atomistic competition;&#10;(d) Assumption 4: The firm's capital investment program if fixed and known;&#10;(e) Assumption 5: Once chosen, the firm's financing is fixed.

Question 4

A firm initially finances its assets with specified proportions of debt and equity, and then later issues additional debt, using the proceeds to pay a dividend to shareholders.If the new debt has the same priority as the original debt, the value of the original debt will probably fall, an effect called claim dilution.Which of the assumptions of an ideal capital market is violated in this example?

A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Accepted Answer

The assumption that is violated is that once chosen, the firm's financing is fixed. By issuing additional debt, the firm changes its capital structure, which affects the value of the original debt.

Question 5

Variation in personal tax rates and transaction costs across both investors and securities may differentially affect the values of corporate securities.Also a firm faces substantial transaction costs in issuing securities, which may inhibit its ability to undertake otherwise profitable capital investments.These are examples of the violation of which of the assumptions of an ideal capital market?

A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Accepted Answer

The scenarios described violate the assumption that capital markets are frictionless. In an ideal, frictionless market, there would be no transaction costs or taxes affecting the values of securities, and firms would not face substantial costs in issuing securities.

Question 6

Information asymmetry is chief among violations of which of the assumptions of an ideal capital market?&#10;A)Capital Markets are frictionless&#10;B)Homogeneous expectations&#10;C)Atomistic competition&#10;D)The firm has a fixed investment program&#10;E)Once chosen, the firm's financing is fixed

Accepted Answer

The answer of Information asymmetry is chief among violations of...

Question 7

Transaction costs and personal taxes may affect investors' ability to undertake arbitrage.Also, a firm's earnings are taxed, and interest payments are deductible while dividends are not.These are examples of the violation of which of the assumptions of an ideal capital market?

A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Accepted Answer

These examples illustrate the violation of the assumption that capital markets are frictionless. In an ideal, frictionless market, there would be no transaction costs, taxes would not affect investment decisions, and all forms of income would be treated equally.

Question 8

One principal-agent conflict is that between a firm's creditors (as a principal) and its shareholders (as agent).For example, after issuing risky debt, stockholders have an incentive to increase the riskiness of the firm's assets (e.g., by changing operating strategy), which would tend to expropriate wealth from creditors to stockholders.Which of the assumptions of an ideal capital market is violated in this example?

A)Capital Markets are frictionless
B)Homogeneous expectations
C)Atomistic competition
D)The firm has a fixed investment program
E)Once chosen, the firm's financing is fixed

Accepted Answer

EThe conflict described violates the assumption that the firm has a fixed investment program (D) because shareholders might change the firm's operating strategy to increase risk after issuing debt. It also violates the assumption that once chosen, the firm's financing is fixed (E) because the change in strategy can affect the firm's risk profile and thus its financing conditions.

Question 9

The two most fundamental aspects of a corporation (as a form of business organization) that lead to not only tremendous economies of scale and scope (as a positive) but also are linked to the financing problems that we address in the course (as a negative) are:

A)the separation of ownership and control AND private ownership.
B)limited liability AND private ownership.
C)the separation of ownership and control AND limited liability.
D)private ownership AND leverage.

Accepted Answer

The separation of ownership and control allows for professional management, which can lead to economies of scale and scope by efficiently managing resources. However, this separation can also lead to agency problems, where the interests of the managers and the owners diverge. Limited liability encourages investment by protecting investors' personal assets, contributing to economies of scale by making it easier to raise capital. However, it can also lead to moral hazard, where the promise of limited liability might encourage excessively risky projects.

Question 10

All of the following were mentioned in the text as means by which the manager of a firm may increase his or her compensation (on a self-serving basis) EXCEPT:&#10;A)having the firm purchase his-her principal private residence.&#10;B)excessive consumption of perquisites.&#10;C)manipulation of earnings and dividends.&#10;D)maximizing the size of the firm, rather than its value.

Accepted Answer

The text does not mention having the firm purchase the manager's principal private residence as a means for a manager to increase compensation. This option is not typically associated with self-serving ways to increase compensation compared to the other options, which involve direct benefits to the manager through the firm's resources or manipulation of financial outcomes.

Question 11

List and briefly discuss the self-serving actions that management may take to:

Accepted Answer

The answer of List and briefly discuss the self-serving actions...

Deck 3: Separation of Ownership and Control, Principal-Agent Conflicts, and Financial Policies