Purchase Analysis

Purchase Analysis

FIN 650 GC Week 8 Exam 3 Latest

Question 1. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased

A. is financed with short-term debt.

B. is financed with long-term debt.

C. is financed with debt whose maturity matches the term of the lease.

D. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at the WACC.

E. is financed with retained earnings



Question 2. In the lease versus buy decision, leasing is often preferable

A. because it has no effect on the firm’s ability to borrow to make other investments.

B. because, generally, no down payment is required, and there are no indirect interest costs.

C. because lease obligations do not affect the firm’s risk as seen by investors.

D. because the lessee owns the property at the end of the least term.

E. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.



Question 3. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.

A. $453,443

B. $476,115

C. $499,921

D. $524,917

E. $551,163

In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker’s required return on such arrangements is 15%, and ignore taxes.






Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the

residual value as a fixed asset.

residual value as a liability.

present value of future lease payments as an asset and also showing this same amount as an offsetting liability.

undiscounted sum of future lease payments as an asset and as an offsetting liability.

undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.



Question 4. A central question that must be addressed in bankruptcy proceedings is whether the firm’s inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values.

• True False


Question 5. Operating leases often have terms that include

A. maintenance of the equipment by the lessor.

B. full amortization over the life of the lease.

C. very high penalties if the lease is cancelled.

D. restrictions on how much the leased property can be used.

E. much longer lease periods than for most financial leases.


Question 6. The primary test of feasibility in a reorganization is whether the firm’s fixed charges after reorganization can be covered by its projected cash flows.

• True False


Question 7. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?

A. The yield to maturity on the company’s outstanding bonds increases due to a weakening of the firm’s financial situation.

B. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.

C. The flotation costs associated with issuing new bonds rise.

D. The firm’s CFO believes that interest rates are likely to decline in the future.

E. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.



Question 8. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations¾assume that the firm’s tax rate is zero.

The company’s decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

A. 9.57%

B. 10.07%

C. 10.60%

D. 11.16%

E. 11.72%



Question 9. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm’s tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)

A. $96

B. $106

C. $112

D. $117

E. $123



Question 10. Which of the following statements is most CORRECT?

A. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.

B. The key benefits associated with refunding debt are the reduction in the firm’s debt ratio and the creation of more reserve borrowing capacity.

C. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.

D. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen.

E. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings.



Question 11. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee’s

A. equity cash flows.

B. capital budgeting project cash flows.

C. debt cash flows.

D. pension fund cash flows.

E. sales.



Question 12. Chapter 7 of the Bankruptcy Act is designed to do which of the following?

A. Protect shareholders against creditors.

B. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.

C. Ensure that the firm is viable after emerging from bankruptcy.

D. Allow the firm to negotiate with each creditor individually.

E. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt



Question 13. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm’s income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants.

• True False


Question 14. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT?

A. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

B. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market.

C. Listing a large firm’s stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm.

D. Stockholders have the right to elect the firm’s directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management’s performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer.

E. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called “market pressure,” and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue.



Question 15. Which of the following statements about listing on a stock exchange is most CORRECT?

A. Listing is a decision of more significance to a firm than going public.

B. Any firm can be listed on the NYSE as long as it pays the listing fee.

C. Listing provides a company with some “free” advertising, and it may enhance the firm’s prestige and help it do more business.

D. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.

E. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.



Question 16. Heavy use of off-balance sheet lease financing will tend to

A. make a company appear more risky than it actually is because its stated debt ratio will be increased.

B. make a company appear less risky than it actually is because its stated debt ratio will appear lower.

C. affect a company’s cash flows but not its degree of risk.

D. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

E. affect the lessee’s cash flows but only due to tax effects.



Question 17. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.

A. $177,169

B. $196,854

C. $207,215

D. $217,576

E. $228,455



Question 18. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?

A. $79,425

B. $83,606

C. $88,006

D. $92,406

E. $92,406



Question 19. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.

A. $278,606

B. $292,536

C. $307,163

D. $322,521

E. $338,647



Question 20. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority.

• True False



Question 21. Which of the following is generally NOT true and an advantage of going public?

A. Facilitates stockholder diversification.

B. Increases the liquidity of the firm’s stock.

C. Makes it easier to obtain new equity capital.

D. Establishes a market value for the firm.

E. Makes it easier for owner-managers to engage in profitable self-dealings.



Question 22. Which of the following statements is NOT CORRECT?

A. When a corporation’s shares are owned by a few individuals who own most of the stock or are part of the firm’s management, we say that the firm is “closely, or privately, held.”

B. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will always exist for the firm’s shares.

C. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC.

D. When stock in a closely held corporation is offered to the public for the first time, the transaction is called “going public,” and the market for such stock is called the new issue market.

E. It is possible for a firm to go public and yet not raise any additional new capital.



Question 23. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) Trustees’ costs to administer and operate the firm.

(2) Common stockholders.

(3) General, or unsecured, creditors.

(4) Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan.

(5) Taxes due to federal and state governments.

A. 1, 4, 3, 5, 2

B. 5, 4, 1, 3, 2

C. 4, 1, 5, 3, 2

D. 5, 1, 4, 2, 3

E. 1, 5, 4, 3, 2



Question 24. Which of the following statements is most CORRECT?

A. In a private placement, securities are sold to private (individual) investors rather than to institutions.

B. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.

C. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.

D. The SEC requires that all private placements be handled by a registered investment banker.

E. Private placements can generally bring in funds faster than is the case with public offerings



Question 25. Which of the following statements is most CORRECT?

A. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.

B. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.

C. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what’s probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.

D. Operating economies are never a motive for mergers.

E. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.



Question 26. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual “breakeven rate”?

A. 9.29%

B. 9.78%

C. 10.29%

D. 10.81%

E. 11.35%



Question 27. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes.

• True False



Question 28. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC’s tax rate is 40%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.)

• $849

• $896

• $945

• $999

• $1,047

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