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[QUESTION]
[Problem 17.7]
Art Wyatt Pool Company wishes to finance a $15 million expansion program and is trying to
decide between debt and external equity. Management believes that the market does not
appreciate the company’s profit potential and that the common stock is undervalued. What type
of security (debt or common stock) do you suppose that the company will issue to provide
financing, and what will be the market’s reaction? What type of security do you think would be
issued if management felt the stock were overvalued? Explain.
[ANSWER]
According to the notion of asymmetric information between management and investors, the
company should issue the overvalued security, or at least the one that is not undervalued in its
mind. This would be debt in the situation described in the problem. Investors would be aware of
management’s likely behavior and would view the event as “good news”. The stock price might
rise, all other things being the same, if this information was not otherwise conveyed.
In contrast, if the common stock were believed to be overvalued, management would want to
issue common stock. This assumes it wishes to maximize the wealth of existing stockholders.
Investors would regard this announcement as “bad news”, and the stock price might decline.
Information effects through financing would assume that the information is not otherwise known
by the market. Management usually has a bias in thinking that the common stock of the company
is undervalued.
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Related Questions
Question 18
The pecking order states that firms should:
issue debt first.
issue new equity first.
always issue debt then the market won't know when management thinks the security is overvalued.
use internal financing first.
arrow_forward
Ch. 14. Which one of the following is NOT an implication of market efficiency for corporate finance?
Group of answer choices
Managers can reap many benefits by paying attention to market prices
Firms cannot successfully time issues of debt and equity
Managers cannot profitably speculate in foreign currencies and other instruments
Firms can successfully time issues of debt and equity
Managers cannot fool the market through creative accounting
arrow_forward
[multiple choice questions]
INDO Inc. always pays all of its earnings as dividends, and therefore has no retained earnings. The same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. The targeted capital structure consists of: common stock, preferred stock, and debt. Which of the following events will reduce WACC?
a. The market risk premium is decreasing.
b. Flotation costs associated with issuing new common stock increase.
c. The company's beta is increasing.
d. Inflation is expected to increase.
e. The flotation costs associated with issuing preferred stock increase.
arrow_forward
1)How does a profitable capital market help reduce the prices of goods and services?
2) The SEC attempts to protect investors who purchase newly issued securities by requiring issuers to provide relevant financial information to potential investors. The SEC does not provide an opinion on the actual value of the securities.Therefore, a reckless investor could pay too much for some shares and consequently lose a lot. Do you think the SEC should, as part of every new offering of stocks or bonds, give investors an opinion on the appropriate value of the securities being offered? Explain.
arrow_forward
Discuss the factors that affect the WACC. Also discuss how these factors may differ somewhat from country to country. For example, if a company has a stronger balance sheet than other companies in its industry, investors will likely be willing to accept a lower interest rates on its bonds and this will lower the company’s overall cost of capital.
arrow_forward
Financial slack is the amount of unused access to debt markets or bank financing. Which theory of capital structure would place the highest value on maintaining financial slack for a firm that is not in financial distress?
Question 10 options:
a)
Trade-off theory
b)
Debt financing as a managerial constraint
c)
Pecking order theory
d)
Modigliani & Miller irrelevance theory
arrow_forward
5.What is the major drawback of debt financing?
Select one:
You have to pay back the money
Increasing debt changes the gearing ratio of the firm
Interest payments must be made before shareholder dividends and irrespective of fluctuations in profits
Lenders often require security of the loan against assets of the company
arrow_forward
What comment or conclusion can be made about this?
Large amounts of national debt can lead to higher interest rates and lower stock prices. Stocks are a reflection of investor confidence. If those investors lose confidence in where those companies operate then their stock price will take a hit.
arrow_forward
Explain how capital adequacy requirements may affect a commercial bank’s dividend payout and growth potential. If the bank anticipates a decrease in its capital adequacy ratio (capital to total asset ratio), what options are available to prevent the decline? What risks, if any, are there in each strategy...
Banks’ managers do not want to mmaintain much capital because they do not bear fully the costs of their failure. In addition to this reason others claim that banks’ managers do not want to maintain higher levels of capital because higher levels of capital attract greater scrutiny from bank regulators. Comment on this claim.
The two most pressing demands for liquidity from a bank come from, first, customers withdrawing their deposits. Identify and discuss the second demand on the bank for liquidity.
arrow_forward
Hello,
I'm not sure how to solve this corporate finance question
Thanks
arrow_forward
If ABC Bank’s ALCO targets the market value of shareholders’ equity in its interest rate risk management, is the bank positioned to gain or lose if interest rates fall?
If interest rates rise by 1% for all assets and liabilities, what is the approximate expected change in the bank’s economic value of equity?
Provide a specific transaction that the bank could implement in order to immunize its interest rate risk exposure.
arrow_forward
2. If the value of the financial sector is in terms of reducing the individual
risk in the economy, how could you measure the value of the financial
sector without using information on loan payments (broadly construed
to include any interest payment necessary to measure an interest rate
or any payment that looks like a return on an investmemt)? If we
think of the amount of individual risk remaining after individuals buy
portfolios is a measure of the ineffectiveness of the financial sector [or
its imperfections], what do you think accounts for these imperfections?
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27.
One reason for using a sales and lease-back arrangement is to create an infusion of cash into the company.
Group of answer choices
True
False
32.
Securities sold by companies in an IPO are shares in companies that were already public but are looking to raise more money in an additional offering.
Group of answer choices
True
False
33
A company wants to gather daily balance reporting from its international subsidiaries bank accounts. Which of the following systems would allow the company's bank to gather the balance positions from the local banks?
Group of answer choices
FSLIC
SWIFT
CHIPS
FHA
FCIC
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- Question 18 The pecking order states that firms should: issue debt first. issue new equity first. always issue debt then the market won't know when management thinks the security is overvalued. use internal financing first.arrow_forwardCh. 14. Which one of the following is NOT an implication of market efficiency for corporate finance? Group of answer choices Managers can reap many benefits by paying attention to market prices Firms cannot successfully time issues of debt and equity Managers cannot profitably speculate in foreign currencies and other instruments Firms can successfully time issues of debt and equity Managers cannot fool the market through creative accountingarrow_forward[multiple choice questions] INDO Inc. always pays all of its earnings as dividends, and therefore has no retained earnings. The same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. The targeted capital structure consists of: common stock, preferred stock, and debt. Which of the following events will reduce WACC? a. The market risk premium is decreasing. b. Flotation costs associated with issuing new common stock increase. c. The company's beta is increasing. d. Inflation is expected to increase. e. The flotation costs associated with issuing preferred stock increase.arrow_forward
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- Hello, I'm not sure how to solve this corporate finance question Thanksarrow_forwardIf ABC Bank’s ALCO targets the market value of shareholders’ equity in its interest rate risk management, is the bank positioned to gain or lose if interest rates fall? If interest rates rise by 1% for all assets and liabilities, what is the approximate expected change in the bank’s economic value of equity? Provide a specific transaction that the bank could implement in order to immunize its interest rate risk exposure.arrow_forward2. If the value of the financial sector is in terms of reducing the individual risk in the economy, how could you measure the value of the financial sector without using information on loan payments (broadly construed to include any interest payment necessary to measure an interest rate or any payment that looks like a return on an investmemt)? If we think of the amount of individual risk remaining after individuals buy portfolios is a measure of the ineffectiveness of the financial sector [or its imperfections], what do you think accounts for these imperfections?arrow_forward
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