John Bro. LLC is a gold mining company operating a single mine. The present price of gold is $300 an ounce and it costs the company $250 an ounce to produce the gold. Last year, 50,000 ounces were produced and engineers estimate that at this rate of production the mine will be exhausted in seven years. The required rate of return on gold mines is 10 percent.
a. What is the value of the mine?
b. Suppose inflation is expected to increase the cost of producing gold by 10 percent a year but the price of gold does not change because of large sales of stock-piled gold by foreign governments. Furthermore, imagine that the inflation raises the required rate of return to 21 percent. Now, what is the value of the mine?
5. Which of the following statements is most CORRECT?
a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm’s common stock.
b. From the issuer’s point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.
e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.
8. Which of the following statements concerning capital structure theory is NOT CORRECT?
a. Under MM with zero taxes, financial leverage has no effect on a firm’s value.
b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
e. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt.
11. Which of the following statements is most CORRECT?
a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
b. Defensive mergers are designed to make a company less vulnerable to a takeover.
c. Hostile mergers always create value for the acquiring firm.
d. In a tender offer, the target firm’s management always remain after the merger is completed.
e. A conglomerate merger is one where a firm combines with another firm in the same industry.
13. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?
a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
b. Interest rate price risk can be eliminated by holding zero coupon bonds.
c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.
d. Interest rate risk can never be reduced.
e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.
14. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?
a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
d. A company can swap fixed interest payments for floating interest payments.
e. A swap involves the exchange of cash payment obligations.
16. Chapter 7 of the Bankruptcy Act is designed to do which of the following?
a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.
b. Ensure that the firm is viable after emerging from bankruptcy.
c. Allow the firm to negotiate with each creditor individually.
d. 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.
e. Protect shareholders against creditors.
17. Which of the following statements is most CORRECT?
a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
b. The basic doctrine of fairness states that all debtholders must be treated equally.
c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely.
e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its assets if they are sold off individually.
18. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.
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