PAD 505 exercise 4 Questions

Exercise 1: This exercise is intended to make sure that we are all familiar with terms used debt financing. (10 points)Fill the blanks by choosing the appropriate term from the following list: lease, funded, floating-rate, Eurobond, convertible, subordinated, call, sinking fund, prime rate, private placement, global bond, public issue, senior, unfunded, Eurodollar rate, warrant, debentures, term loan.a. Debt maturing in more than 1 year is often called _________________ debt.b. An issue of bonds that is sold simultaneously in several countries is traditionally called a(n) ___________________.c. If a lender ranks behind the firm’s general creditors in the event of default, the loan is said to be ______________________.d. In many cases, a firm is obliged to make regular contributions to a(n) _____________, which is then used to repurchase bonds.e. Most bonds give the firm the right to repurchase or ________________ the bonds at specified prices.f. The benchmark interest rate that banks charge to their customers with good credit is generally termed the _____________________.g. The interest rate on bank loans is often tied to short-term interest rates. These loans are usually called _________________ loans.h. Where there is a(n) ____________________, securities are sold directly to a small group of institutional investors. These securities cannot be resold to individual investors. In the case of a(n) __________________, debt can be freely bought and sold by individual investors.i. A long-term rental agreement is called a(n) ______________.j. A(n)__________________ bond can be exchanged for shares of the issuing corporation.k. A(n) _________________ gives its owner the right to buy shares in the issuing company at a predetermined.Exercise 2: (18 points)Empirical evidence shows that stock market in the United States is efficient.a. Explain the three forms of market efficiency (see chapter 5, pages 178 – 183).b. How do you explain the fact that some people make very high returns on stock markets?c. How does competition among investors lead to efficient markets?Exercise 3: (18 points)In 1987 RJR Nabisco, the food and tobacco giant, had $5 billion of A-rated debt outstanding. In that year the company was taken over, and $19 billion of debt was issued and used to buy back equity. The debt ratio skyrocketed, and the debt was downgraded to a BB rating. The holders of the previously issued debt were furious, and one filed a lawsuit claiming that RJR had violated an implicit obligation not to undertake major financing changes at the expense of existing bondholders. Why did these bondholders believe they had been harmed by the massive issue of new debt? What type of explicit restriction would you have wanted if you had been one of the original bondholders?Exercise 4:(18 points) Explain how a company can incur costs of financial distress without ever going bankrupt. What is the nature of these costs?Exercise 5: (18 points) An all equity business has 100 million shares outstanding selling for $20 per share. Management believes that interest rates are unreasonably low and decides to execute a dividend recapitalization (a recap). It will raise $1 billion in debt and repurchase 50 million shares.A) what is the market value of the firm prior to the recap? What is the market value of equity?B) Assuming the Irrelevance Proposition holds, what is the market value of the firm after the recap? What is the market value of the equity?C) Do equity shareholders appear to have gained or lost as a result of the recap? Please explainD) Assume now that the recap increases total firm cash flows, which adds $100 million to the value of the firm. Now what is the market value of the firm? What is the market value of equity?E) Do equity shareholders appear to have gained or lost as a result of the recap in this revised scenario?Exercise 6: (18 points)Equity, Inc. is currently an all-equity financed firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock. Show the value of the firm, EPS, and rate of return on the stock before and after the proposed restructuring. What changed?