Test Bank Ch8 3616 Butler

divorce IV Managing the Risks of Multi field of study Operations Chapter 9 The Rationale for Hedging Currency Risk True/ untrue 1. In a complete fiscal trade placeplace, m wholenesstary contracts argon zero-NPV investments. autonomic nervous system True. 2. If hedgerow currency try is to add shelter to the stakeholders of the sign of the zodiac, then hedgerow must impact either expected future currency flows or the toll of superior or both. autonomic nervous system True. 3. If monetary markets ar informationally efficient, then corporate financial policy is irrelevant. autonomic nervous system False. Dont confuse informational efficiency with a perfect market.Although the perfect market fleshs ensure informational efficiency, informationally efficient markets croupe be imperfect. 4. Perfect financial markets argon a necessary condition for corporate riskiness hedging to have honor. ANS False. Market imperfections are necessary conditions. 5. In perfect financial markets, corporate financial policy is irrelevant. ANS True. 6. In a perfect financial market, the rectitude of one price holds. ANS True. 7. Equal advance to perfect financial markets ensures that individual investors can parallel any financial action that the firm can take. ANS True. 8.In perfect financial markets, corporate hedging policy has no value. ANS True. 9. In perfect financial markets, corporate investment policy is irrelevant. ANS False. Firm value depends entirely on the firms investments in a perfect financial market. 10. If corporate financial policy is to have value, then at least one of the perfect market assumptions cannot hold. ANS True. 11. Real-world financial markets are perfect markets. ANS False. Perfect markets are a theoretical standard and not a practical reality. 12. Market imperfections are greater across national boundaries than within national boundaries.ANS True. 13. In perfect financial markets, multinational corporations have an advantage over domestic firms in financing their investments. ANS False. The law of one price holds in perfect financial markets. 14. Multinationals have a relative advantage over domestic firms in exploiting cross-border differences in financial markets. ANS True. 15. Progressive gross is a system in which larger rat up to(p) incomes receive a spirited tax rate. ANS True. 16. revenue enhancement druthers items are goods that are sold on a tax-free basis. ANS False.Tax preference items are items such as tax loss carryforwards and carrybacks and investment tax credits that are used to riddle corporate taxable income from taxes. 17. A call preference is an option to misdirect an under(a)lying asset at a predetermined price. ANS True. 18. A call option is an option to call in or demand payment on a loan. ANS False. A call option is an option to buy an underlying asset at a predetermined price. 19. Indirect financial distraint be are relatively unimportant for firms selling products for which quality and after-sale service are important.ANS False. Reputation is easily eroded in these instances. 20. Managerial gamesmanship is least prevalent during financial distress. ANS False. Gamesmanship is much prevalent during hard eras. 21. Option set amplification with an increase in the volatility of the underlying asset. ANS True. 22. A decrease in the disagreement of firm value is good news for debt and bad news for the fair play call option, other things held constant. ANS True. 23. Corporate hedging of business risk unambiguously increases shareholder wealth when the firm is in financial distress. ANS False.Because debtholders have first claim on corporate assets, corporate hedging of business risk helps debtholders first and may or may not help uprightnessholders. 24. In the real world, corporate hedging policy can change expected future cash flows but is unlikely to digest the cost of debt. ANS False. Hedging policy can decrease the disagreement of firm value and can and so reduce the risk of debt and the required return charged by debtholders. 25. Direct be of financial distress are far more important to corporate hedging decisions than are collateral cost. ANS False.The indirect costs of financial distress influence the activities of firms not just in bankruptcy but anterior to bankruptcy as well. 26. Underinvestment occurs when debtholders refuse to invest additional capital into the firm during financial distress. ANS False. Underinvestment occurs when justice foregoes positive-NPV investments. 27. In financial distress, equity has an incentive to take on large risks in order to increase the value of the equity call option. ANS True. 28. In Miller-Modiglianis perfect world, the firms best investment criterion is Accept all positive-NPV projects. ANS True. 29. In practice, managements objective is to increase shareholder wealth. ANS False. Managers act nominally as equitys agents but, in actuality, in their avow best interests . 30. Managers have little incentive to hedge company-specific risks. ANS False. As undiversified stakeholders, managers are bear on with both systematic and unsystematic risk. 31. Managers have an incentive to hedge their units transaction ikon to currency risk. ANS True. 32. Hedging can increase firm value by cut the costs of agency conflicts between managers and shareholders.ANS True. 33. Exchange-traded options and futures contracts have a fixed cost per contract so that costs are proportional to the number of contracts traded. ANS True. 34. The costs of hedging through with(predicate) operations are likely to be less burdensome for a large multinational corporation with diversified operations than for a small, less-diversified firm. ANS True. Multiple Choice 1. The perfect market assumptions include each of the following except ____. a. equal access to market prices b. equal access to costless information c. frictionless markets d. rational investors e. table governments AN S E 2. Frictionless financial markets could have which of the following? a. agency costs b. bid-ask spreads c. brokerage fees d. government intervention e. irrational investors ANS E 3. Which risk management guidelines in a) through d) is not recommended by the Group of thirty Global Derivatives Study Group? a. assess the credit risk arising from derivatives activities b. combine authority over trade and bookkeeping functions into a single department c. quantify market risk under adverse market conditions and perform stress tests d. alue derivatives positions at market e. all of the to a higher place are recommended ANS B 4. Which of a) through d) is unlikely to result in a decision to hedge currency risk? a. bid-ask spreads on inappropriate alternate b. costs of financial distress c. differential taxes on income from different tax jurisdictions d. stakeholder game-playing e. all of the above are incentives to hedge ANSA 5. Which of the following factors does not contribute to t ax roll convexness? a. Alternative Minimum Tax (AMT) rules in the United States b. progressive taxation c. sales taxes d. ax preference items e. all of the above contribute to tax schedule convexity ANS C 6. Indirect costs of financial distress impact the firm in each of the following ways except ____. a. higher financial costs b. higher legal costs in bankruptcy c. higher operating costs d. discredit revenues e. stakeholder gamesmanship ANS B 7. Which of statements a) through c) regarding costs of financial distress is false? a. Both debt and equity unambiguously benefit from corporate risk hedging. b. Hedging can increase expected cash flows by reducing the costs of financial distress. c.Hedging can reduce debtholders required return and hence the cost of capital to the firm. d. All of the above are ANS True. e. None of the above are ANS True. ANS A 8. Which of the following was most responsible for the collapse of Barings Bank? a. bankruptcy proceedings b. failure to monitor t he activities of its traders c. office arbitrage d. index futures and options trading e. the 1991 fall in share prices on the Tokyo stock exchange ANS B 9. Management has an incentive to hedge which of the following paintings? a. operating exposure b. transaction exposure c. ranslation (accounting) exposure d. all of the above e. none of the above ANS D 10. Tax schedules are state to be progressive when ____. a. the effective tax rate is greater at high levels of taxable income than at low levels b. the effective tax rate is greater at low levels of taxable income than at high levels c. they do not discriminate on the basis of race, creed, or color d. when tax rates parti-color by the age of the taxpayer e. none of the above ANS A Problems 1. In what way is equity a call option on firm value? Tax schedule convexity progressive taxation 2.Suppose corporate income up to $250,000 is taxed at a rate of 25 percent. Income over $250,000 is taxed at 40 percent. The taxable income of le t loose Poultry will be either $200,000 or $300,000 with equal probability. Quacks income variability arises entirely from an exposure to currency risk. a. Draw a graph like Figure 9. 2 characterisation tax schedule convexity in the United States. b. What is Quacks expected tax liability if it does not hedge its currency risk? c. What is Quacks expected tax liability if it is able to completely hedge its currency risk exposure and lock in taxable income of $250,000 with certainty? . In what way does hedging have value for Quack Poultry? Direct and indirect costs of financial distress 3. A firm based in the United Kingdom has promised to pay bondholders ? 10,000 in one year. The firm will be expense either ? 9,000 or ? 19,000 with equal probability at that time depending on the value of the dollar. The firm will be worth ? 14,000 if it hedges a formst currency risk. a. Identify the values of debt and equity under unhedged and hedged scenarios assuming there are no costs of financi al distress. b. Suppose the firm will incur direct bankruptcy costs of ? ,000 in bankruptcy. Identify the value of debt and of equity under both unhedged and hedged scenarios. c. In addition to the ? 1,000 direct bankruptcy cost, suppose indirect costs reduce the asset value of the firm to either ? 6,000 or ? 18,000 (before the ? 1,000 direct bankruptcy cost) with equal probability. Hedging results in firm value of ? 12,000 with certainty. Identify the value of debt and of equity under both unhedged and hedged scenarios. d. Can hedging add value to shareholders in this problem? Problem Solutions 1.If the firms assets are worth more than that promised to debtholders, equity will exercise its option to buy the assets of the firm from the debtholders at the exercise price. If firm assets are worth less than the promised claim, equity will not exercise its option and debt assumes control of the firm. Tax schedule convexity progressive taxation 2. a. pic b. Expected taxes with no hedging (? )($200,000)(0. 25) + (? )($250,000)(0. 25)+($50,000)(0. 40) = (? )($50,000) + (? )($82, calciferol) = $66,250. c. Expected taxes with hedging ($250,000)(0. 5) = $62,500 $66,250. d. Hedging allows Quack to minimize its expected tax liability. This increase in expected future cash flows to equity results in an increase in equity value. 3. a. If firm value is ? 9,000, equity will not exercise its option to buy the firm at a price of ? 10,000. In this case, equity receives nothing and debt receives ? 9,000. If the firm is worth ? 19,000, equity pays the bondholders ? 10,000 and retains the residual ? 9,000. Firm value can be broken down into EVFIRM = EVBONDS + ESTOCK = (? )(? 9,000)+(? )(? 10,000) + (? )(? 0)+(? (? 9,000) = ? 9,500 + ? 4,500 = ? 14,000. Hedged, firm value can be broken down into VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 14,000 = ? 14,000. In the absence of costs of financial distress, the reduction in the variability of firm value results in a reduction in call option value and a ?500 shift in value from equity to debt. b. Unhedged, firm value is decomposed as EVFIRM = EVBONDS + ESTOCK = (? )(? 9,000 1,000)+(? )(? 10,000) + (? )(? 0)+(? )(? 9,000) = ? 9,000 + ? 4,500 = ? 13,500. With hedging, VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 4,000 = ? 14,000.As in the previous example, the reduction in the variability of firm value is accompanied by a ? 500 transfer of wealth from equity to debt. Hedging also avoids the deadweight ? 1,000 bankruptcy cost and yields an expected gain of (? )(? 1,000) = ? 500. In this example, debt captures the expected gain of ? 500. Equity will capture some of the gain if hedging results in lower interest payments on the next round of debt. c. Unhedged, firm value is EVFIRM = EVBONDS + ESTOCK = (? )(? 6,000 1,000) + (? )(? 10,000) + (? )(? 0)+(? )(? 8,000) = ? 7,500 + ? 4,000 = ? 11,500.If the firm hedges, then VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 2,000 = ? 12,000. This is the same as b) after including indirect costs of financial distress with an expected value of (? )(? 9,000 6,000)+(? )(? 19,000 18,000) = ? 1,500+? 500 = ? 2,000. d. Hedging can add value to shareholders if they can negotiate lower interest payments on debt because of their hedging policies. Even in financial distress, equity could offer to renegotiate the bond contract to more evenly share the gain in firm value from hedging. In this way, they can share in any gain from reducing the probability and costs of financial distress.