Exam Two Practice Problems

Managerial Finance II

1. Modigliani and Miller show that corporate capital structure does not affect the value of the firm under certain assumptions. A firm has a debt-equity ratio of 0.80 and a weighted average borrowing cost of 13%. The firm is considering issuing additional debt which would increase the debt-equity ratio to 0.90. The new yield to maturity on the bonds would be 11%. Determine the new cost of equity predicted by MM.

2. Determine the price of the bonds and the price of the shares of a firm that has a zero coupon bond maturing in two years for $800 million. Current market value of the assets is $1.2 billion and the risk-free rate is 5.6%.

3. Calculate the value of a firm that is expected to have a perpetual net operating income of $20,000 per year. This firm has a capital structure of 50% debt and 50% equity and pays taxes at the marginal rate of 25%. This firm pays its bondholders a 10% return and pays its shareholders a 20% return. The current debt level is $40,000 and this level carries a bankruptcy cost of 12%.

4. Glacial Corp currently has a floating rate bond that pays LIBOR plus 2.5% on an annual basis. The bonds have a maturity value of $900 million and mature in exactly 5 years. It will use an interest rate swap to hedge the interest rate risk of the bond. Draw a diagram showing the direction of the payment. Show the payments and the net payments for the next three years if the fixed swap rate is 8% and LIBOR is 4%, 8% and 9% over the next 3 years.

5. Determine the price of the following call option: Exercise price of $125; Stock price of $108; Risk-free rate of 4.3%; 273 days until expiration; Underlying asset standard deviation of 27%.