PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
expand_more
expand_more
format_list_bulleted
Videos
Textbook Question
Chapter 18, Problem 15PS
Agency costs The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain:
- a. Why SOS stockholders could lose by investing in a positive-
NPV project financed by an equity issue. - b. Why SOS stockholders could gain by investing in a negative-NPV project financed by cash.
- c. Why SOS stockholders could gain from paying out a large cash dividend.
Expert Solution & Answer
Want to see the full answer?
Check out a sample textbook solution
Students have asked these similar questions
The Salad Oil Storage Company (SOS) has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet.
a. explain why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.
b. explain why SOS stockholders could gain by investing in a highly risky, negative-NPV project.
Finance
Companies A and B are each considering an unanticipated new investment opportunity that will marginally increase the value of the company and will also increase the company’s level of diversication. Company A is unlevered, and company B has a capital structure of 50% debt. Assume that the shareholders control the company, which one of the following statements is correct.
a) Since NPV of the investment is positive both company A and B will accept the project.
b) Since the project only marginally increase company values but decreases return variance of the company’s assets both companies will reject the project.
c) It is more obvious that Company B invests since for levered company the diversication benefits are more important.
d) None of the given alternative.
1) When investors disregard their own information which is incomplete and follow the momentum activities of other market participants, they could inadvertently cause a financial bubble by transmitting inaccurate information with each additional trade. This phenomenon is called ______________.
Multiple Choice
Asymmetric information.
Attribution bias.
Systematic bias.
Overconfidence.
Information cascade.
2) Canada Revenue Agency requires firms to claim only one-half of the incremental capital cost of a new project in its first year for tax purposes. This rule is called the _________.
Multiple Choice
CCA rule.
Half-CCA rule.
Two-year rule.
Half-year rule.
Incomplete CCA rule.
3)Alternative ways of calculating operating cash flows are the bottom-up approach, the top-down approach, and the tax shield approach.
True/False?
Chapter 18 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 18 - Prob. 1PSCh. 18 - Tax shields Compute the present value of interest...Ch. 18 - Tax shields Here are book and market value balance...Ch. 18 - Tax shields Look back at the Johnson Johnson...Ch. 18 - Prob. 5PSCh. 18 - Tax shields The firm cant use interest tax shields...Ch. 18 - Prob. 7PSCh. 18 - Tax shields The trouble with MMs argument is that...Ch. 18 - Bankruptcy costs On February 29, 2019, when PDQ...Ch. 18 - Financial distress This question tests your...
Ch. 18 - Prob. 12PSCh. 18 - Agency costs Let us go back to Circular Files...Ch. 18 - Agency costs The Salad Oil Storage (SOS) Company...Ch. 18 - Agency costs The possible payoffs from Ms....Ch. 18 - Prob. 17PSCh. 18 - Prob. 18PSCh. 18 - Prob. 20PSCh. 18 - Pecking-order theory Fill in the blanks: According...Ch. 18 - Financial slack For what kinds of companies is...Ch. 18 - Financial slack True or false? a. Financial slack...Ch. 18 - Debt ratios Rajan and Zingales identified four...Ch. 18 - Leverage targets Some corporations debtequity...Ch. 18 - Prob. 26PSCh. 18 - Trade-off theory The trade-off theory relies on...
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- WACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analysis the risk-free rate is 5%, the market risk premium is 6%, and the companys tax rate is 40%. F. Pierce estimates that its beta now (which is unlevered because it currently has no debt) is 0.8. Based on this information, what is the firms optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure?arrow_forwardWhich of the following statements are incorrect regarding how much debt a company should borrow? Choose all that apply. Question 9 options: A As long as the company can generate higher returns on its new projects than its borrowing interest rate, borrowing more debt will enhance the company's ROE. B Borrowing more debt will increase a company's distress level. C The bigger the company, the more it should borrow D Debt is considered a more expensive capital source.arrow_forwardA firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? (compare NPVs for projects)WACC: 6.75%Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380CFL -$2,150 $765 $765 $765 $765arrow_forward
- (a) Identify and briefly describe two phases of the capital budgeting process. (b) Would saving time by skipping one of these phases in the capital budgeting process make sense financially? Financially, why would a company: (a) increase its dividend; (b) buy back some of its common stock shares; (c) pay down some of its debt; (d) increase its use of internal financing; (e) take the public firm private? Explain how a company could: (a) avoid a backlog of orders when sales exceed expectations; (b) avoid product defects on new products; (c) offer more credit to its customers when it already has a bad debt problem; (d) improve its credit rating with suppliers after paying some late; (e) lower its cost of financing when the market interest rate has increased. FE5 Describe a business practice that would help a company manage each of the following financial risks: (a) liquidity risk; (b) interest rate risk; c) credit risk.arrow_forwardA firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 3.00% Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 Hint: NPV = PV inflows – Cost IRR: Internal Rate of Return IRR is the discount rate that forces PV inflows = cost. A. $272.51 B. $306.08 C. $377.26 D. $340.98 E. $240.19 PLEASE SHOW YOUR WORK USING BA II CALCULATOR. THANK YOU.arrow_forwardThe financial manager of a large national firm was overheard making the following statement: 'We try to use as much retained earnings as possible for capital budgeting purposes because there is no explicit cost to these funds, and this allows us to invest in relatively low yielding projects that would not be feasible if we had to use new common stock. We actually use retained earnings to invest in projects with yields below the coupon rate on our bonds." Comment on the validity of this statement from your point of view.arrow_forward
- If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows: The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.50 and it expects dividends to grow at a constant rate g = 4.3%. The firm's current common stock price, P0, is $20.00. If it needs to issue new common stock, the firm will encounter a 6%…arrow_forwardIf a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows:The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $1.70 and it expects dividends to grow at a constant rate g = 4.7%. The firm's current common stock price, P0, is $23.60. If it needs to issue new common stock, the firm will encounter a 5.2%…arrow_forwardThe net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions. Consider the case of Cute Camel Woodcraft Company: Last Tuesday, Cute Camel Woodcraft Company lost a portion of its planning and financial data when both its main and its backup servers crashed. The company’s CFO remembers that the internal rate of return (IRR) of Project Lambda is 13.8%, but he can’t recall how much Cute Camel originally invested in the project nor the project’s net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Lambda. They are: Year Cash Flow Year 1 $1,600,000 Year 2 $3,000,000 Year 3 $3,000,000 Year 4 $3,000,000 The CFO has asked you to compute Project Lambda’s initial investment using the information currently available to you. He has offered the following suggestions and observations: • A…arrow_forward
- A company should accept for investment all positive NPV investment alternatives when which of the following conditions is true?a. The company has extremely limited resources for capital investment.b. The company has excess cash on its balance sheet.c. The company has virtually unlimited resources for capital investment.d. The company has limited resources for capital investment but is planning to issue new equity to finance additional capital investment.arrow_forwardExecutives at XYZ Corporation realize that they have too much liquid assets. They want to use this cash to buy a company that has decent returns to maximize their asset utilization. They find two companies they can buy, and want to decide if they should acquire company A or Company B. The expected returns from both companies depending on the state of the economy are shown in the table below. Each state of the economy is equally likely to happen. State of the economy Return on company A(%) Return on company B (%) Worse than expected 7.3% -4.7% Expected 11.5% 5.4% Better than expected 16.6% 24.3% Calculate the expected rate of return, and standard deviation of each company. [Note: you are supposed to show every step of your calculation and interpret the result.] without using excelarrow_forwardExecutives at XYZ Corporation realize that they have too much liquid assets. They want to use this cash to buy a company that has decent returns to maximize their asset utilization. They find two companies they can buy, and want to decide if they should acquire company A or Company B. The expected returns from both companies depending on the state of the economy are shown in the table below. Each state of the economy is equally likely to happen. State of the economy Return on company A(%) Return on company B (%) Worse than expected 7.3% -4.7% Expected 11.5% 5.4% Better than expected 16.6% 24.3% Calculate the expected rate of return, and standard deviation of each company. [Note: you are supposed to show every step of your calculation and interpret the result.] Critically evaluate the importance of the standard deviation factor in comparing investments. [Note: remember to use Harvard referencing to reference your sources]arrow_forward
arrow_back_ios
SEE MORE QUESTIONS
arrow_forward_ios
Recommended textbooks for you
Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning
Fundamentals Of Financial Management, Concise Edi...FinanceISBN:9781337902571Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage Learning
Intermediate Financial Management (MindTap Course...
Finance
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Cengage Learning
Fundamentals Of Financial Management, Concise Edi...
Finance
ISBN:9781337902571
Author:Eugene F. Brigham, Joel F. Houston
Publisher:Cengage Learning
Financial leverage explained; Author: The Finance story teller;https://www.youtube.com/watch?v=GESzfA9odgE;License: Standard YouTube License, CC-BY