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Chapters 7 Through 15
Part 1: Chapters 7 Through 11
Part 2: Chapters 12 Through 15
CHAPTER 7
TYPES
AND COSTS OF FINANCIAL CAPITAL
True-False
Questions
1. The accounting emphasis on accrued revenue
and expenses and depreciation is the same emphasis as that of finance managers.
2. Traditional accounting does not focus on the
implicit cost of equity that is the required capital gains to complement
dividends. However, evaluation methods
exist to determine this value by financial managers.
3. Formal historical accounting procedures
include explicit records of debt (interest and principal) and dividend capital
costs.
4. Public financial markets are markets for the
creation, sale and trade of illiquid securities having less standardized
negotiated features.
5. A venture’s “riskiness” in terms of poor
performance or failure is usually very high during the maturity stage of its
life cycle.
6. A venture’s “riskiness” in terms of poor
performance or failure is usually high to moderate during the rapid-growth
stage of its life cycle.
7. First-round financing during a venture’s
survival stage comes primarily from venture capitalists and investment banks.
8. Startup financing usually comes from
entrepreneurs, business angels, and investment bankers.
9.
Commercial banks provide liquidity-stage
financing for ventures in the rapid-growth stage of their life cycles.
10. A venture’s “riskiness” in terms of the
likelihood of poor performance or failure decreases as it moves from its
development stage through to its rapid-growth stage.
11. A nominal interest rate is an observed or
stated interest rate.
12. The “real interest rate” (RR) is the interest
one would face in the absence of inflation, risk, illiquidity, and any other
factors determining the appropriate interest rate.
13. The risk-free interest rate is the interest
rate on debt that is virtually free of inflation risk.
14. Inflation premium is the rising prices not
offset by increasing quality of goods being purchased.
15. “Default-risk” is the risk that a borrower
will not pay the interest and/or the principal on a loan.
16. The “prime rate” is the interest rate charged
by banks to their highest default risk business customers.
17. Bond ratings reflect the inflation risk of a firm’s
bonds.
18. The relationship between real interest rates
and time to maturity when default risk is constant is called the term structure
of interest rates.
19. The graph of the term structure of interest
rates, which plots interest rates to time to maturity is called the yield
curve.
20. Liquidity premiums reflect the risk
associated with firms that possess few liquid assets.
21. Subordinated debt is secured by a venture’s
assets, while senior debt has an inferior claim to a venture’s assets.
22. Early-stage ventures tend to have large
amounts of senior debt relative to more mature ventures.
23. Investment risk is the chance or probability
of financial loss on one’s venture investment, and can be assumed by debt,
equity, and founding investors.
24. A venture with a higher expected return
relative to other ventures will necessarily have a higher standard deviation or
returns.
25. Historically, large-company stocks have
averaged higher long-term returns than small-company stocks.
26. The coefficient of variation measures the
standard deviation of a venture’s return relative to its expected return.
27. Closely held corporations are those companies
whose stock is traded over-the-counter.
28. Typically, the stocks of closely held
corporations aren’t publicly traded.
29. Organized exchanges have physical locations
where trading takes place, while the over-the-counter market is comprised of a
network of brokers and dealers that interact electronically.
30. Market cap is determined by multiplying a
firm’s current stock price by the number of shares outstanding.
31. The excess average return of long-term
government bonds over common stock is called the market risk premium.
32. The weighted average cost of capital is simply
the blended, or weighted cost of raising equity and debt capital.
33. Venture capital holding period returns (all
stages) for the 10-year period ending in 2012 were about the same as the
returns on the S&P 500 stocks.
Multiple-Choice
Questions
1. Which one of the following markets involve
liquid securities with standardized contract features such as stocks and bonds?
a. private financial market
b. derivatives market
c. commodities market
d. real estate market
e. public financial market
2. Which of the following markets involve direct
two-party negotiations over illiquid, non-standardized contracts such as bank
loans and direct placement of debt?
a. primary market
b. secondary market
c. options market
d. private financial market
e. public financial market
3. Which of the following is an example of rent
on financial capital?
a. interest on debt
b. dividends on stock
c. collateral on equity
d. a
and b
e. a,
b, and c
4. Which of the following describes the observed
or stated interest rate?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
5. Which of the following describes the interest
rate in addition to the inflation rate expected on a risk-free loan?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
6. Which of the following describes the interest
rate on debt that is virtually free of default risk?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
7. Which of the following describes the interest
rate charged by banks to their highest quality customers?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate
8. Which of the following is not a component in
determining the cost of debt?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. interest rate premium
9. The additional interest rate premium required
to compensate the lender for the probability that a borrower will not be able
to repay interest and principal on a loan is known as?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
10. The additional premium added to the real
interest rate by lenders to compensate them for a debt instrument which cannot
be converted to cash quickly at its existing value is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
11. The added interest rate charged due to the
inherent increased risk in long-term debt is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium
12. Suppose the real risk free rate of interest
is 4%, maturity risk premium is 2%, inflation premium is 6%, the default risk
on similar debt is 3%, and the liquidity premium is 2%. What is the nominal interest rate on this
venture’s debt capital?
a. 13%
b. 14%
c. 15%
d. 16%
e. 17%
13. A venture has raised $4,000 of debt and
$6,000 of equity to finance its firm.
Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity
capital is 8%. What is the venture’s
weighted average cost of capital?
a. 8.0%
b. 7.2%
c. 7.0%
d. 6.2%
e. 6.0%
14. Your venture has net income of $600, taxable
income of $1,000, operating profit of $1,200, total financial capital including
both debt and equity of $9,000, a tax rate of 40%, and a WACC of 10%. What is your venture’s EVA?
a. $400,000
b. $200,000
c. $
0
d. ($180,000)
e. ($300,000)
15.
The “risk-free” interest rate is the sum of:
a. a real rate of interest and an
inflation premium
b. a real rate of interest and a
default risk premium
c. an inflation premium and a
default risk premium
d. a default risk premium and a
liquidity premium
e. a liquidity premium and a maturity
premium
16. Venture investors generally use which one of
the following target rates to discount the projected cash flows of ventures in
the “startup” stage of their life cycles:
a. 20%
b. 25%
c. 40%
d. 50%
17. Which one of the following components is not
used when estimating the cost of risky debt capital?
a.
real
interest rate
b.
inflation
premium
c.
default
risk premium
d.
market
risk premium
e.
liquidity
premium
18. Which of the following components is not
typically included in the rate on short-term U.S. treasuries?
a.
liquidity premium
b. default risk premium
c. market risk premium
d. b
and c
e. a, b, and c
19. The word “risk” developed from the early
Italian word “risicare” and means:
a. don’t care
b. take a chance
c. to dare
d. to gamble
20. The difference between average annual returns
on common stocks and returns on long-term government bonds is called a:
a. default risk premium
b. maturity premium
c. risk-free premium
d. liquidity premium
e. market risk premium
21. What has been the approximate average annual
rate of return on publicly traded small company stocks since the mid-1920s?
a. 10%
b. 16%
c. 25%
d. 30%
e. 40%
22. Venture investors generally use which one of
the following target rates to discount the projected cash flows of ventures in
the “development” stage of their life cycles:
a. 15%
b. 20%
c. 25%
d. 40%
e. 50%
23. Corporate bonds might involve which of the
following types of “premiums.”
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. all of the above
none of the above
24. Which of the following venture life cycle
stages would involve seasoned financing rather than venture financing?
a. Development stage
b. Startup stage
c. Survival stage
d. Rapid-growth stage
e. Maturity stage
25. A venture’s “riskiness” in terms of possible
poor performance or failure would be considered to be “very high” in which of
the following life cycle stages:
a. Startup stage
b. Survival stage
c. Rapid-growth stage
d. Maturity stage
26. Which of the following types of financing
would be associated with the highest target compound rate of return?
a. public and seasoned financing
b. second-round and mezzanine financing
c. first-round financing
d. startup financing
e. seed financing
27. The cost of equity for a firm is 20%. If the
real interest rate is 5%, the inflation premium is 3%, and the market risk
premium is 2%, what is the investment risk premium for the firm?
a. 10%
b. 12%
c. 13%
d. 15%
28. Use the SML model to calculate the cost of
equity for a firm based on the following information: the firm’s beta is 1.5;
the risk free rate is 5%; the market risk premium is 2%.
a. 4.5%
b. 8.0%
c. 9.5%
d. 10.5%
29. Calculate the weighted average cost of
capital (WACC) based on the following information: the capital structure weights are 50% debt
and 50% equity; the interest rate on debt is 10%; the required return to equity
holders is 20%; and the tax rate is 30%.
a. 7%
b. 10%
c. 13.5%
d. 17.5%
e. 20%
30. Calculate the weighted average cost of
capital (WACC) based on the following information: the equity multiplier is 1.66; the interest
rate on debt is 13%; the required return to equity holders is 22%; and the tax
rate is 35%.
a. 11.5%
b. 13.9%
c. 15.0%
d. 16.6%
31. Calculate the after-tax WACC based on the
following information: nominal interest
rate on debt = 16%; cost of common equity = 30%; equity to value = 60%; debt to
value = 40%; and a tax rate = 25%.
a. 10%
b. 16%
c. 19.8%
d. 22.8%
e. 30%
32. Calculate the after-tax WACC based on the
following information: nominal interest
rate on debt = 12%; cost of common equity = 25%; common equity = $700,000;
interest-bearing debt = $300,000; and a tax rate = 25%.
a. 15%
b. 16.4%
c. 20.2%
d. 22.8%
e. 30%
33. Venture capital holding period
returns (all stages) for the 20-year period ending in 2012, had a compound
average return of approximately:
a. 35%
b. 28%
c. 21%
d. 14%
e. 7%
Supplemental Problems related to
Chapter 7 Appendix A (and Chapter 4 Appendix A)
1. Estimate a firm’s NOPAT based on: Net sales =
$2,000,000; EBIT = $600,000; Net income = $20,000; and Effective tax rate =
30%.
a. $600,000
b. $420,000
c. $150,000
d. $70,000
e. $40,000
2. Estimate a firm’s economic value added (EVA)
based on: NOPAT = $400,000; amount of financial capital used = $1,600,000; and
WACC = 19%.
a. $26,000
b. $36,000
c. $96,000
d. $54,000
e. $64,000
3. Find a venture’s “economic value added” (EVA)
based on the following information: EBIT
= $200,000; financial capital used = $500,000; WACC = 20%; effective tax rate =
30%.
a. $20,000
b. $25,000
c. $30,000
d. $40,000
e. $50,000
CHAPTER 8
SECURITIES LAW CONSIDERATIONS
WHEN OBTAINING VENTURE FINANCING
True-False
Questions
1. The securities Exchange act of 1934 provides
for the regulation of securities exchanges and over-the-counter markets.
2. The Investment Company Act of 1940 defines investment
companies and excludes them from using some of the registration exemptions
originating in the 1933 Ac
3. The Investment Advisers Act of 1940 provides
a definition of an investment company.
4. According to the Investment Advisers Act of 1940,
a bank would not be classified as an “investment advisor”.
5. The Securities Act of 1933 is the main body
of federal law governing the creation and sale of securities in the U.S.
6. The Securities Exchange Act was passed in
1933 and the Securities Act was passed in 1934.
7. The trading of securities is regulated under
the Securities and Exchange Act of 1954.
8. Regulation of investment companies (including
professional venture capital firms) is carried out under the Investment Company
Act of 1940.
9. State laws designed to protect high net-worth
investors from investing in fraudulent security offerings are known as blue-sky
laws.
10. Offerings and sales of securities are
regulated under the Securities Act of 1933 and state blue-sky laws.
11. Blue-sky laws are federal laws designed to
protect individuals from investing in fraudulent security offerings.
12. The typical business organization for a
venture in its rapid-growth stage is a partnership or LLC.
13. Investor liability in a limited liability
company (LLC) is limited to the owners’ investments.
14. Investor liability in a proprietorship or
corporation is unlimited.
15. The life of a proprietorship is determined by
the owner.
16. It is usually easier to transfer ownership in
a proprietorship relative to a corporation.
17. The two basic types of exemptions from having
to register securities with the SEC are security and transaction exemptions.
18. The Securities Act of 1933 provides a very
narrow definition as to what constitutes a security.
19. SEC Rule 147 provides guidance on the
issuer’s diligent responsibilities in assuring that offerees are in-state and
that securities don’t move across state lines.
20. A private placement, or transactions by an
issuer not involving any public offering, is exempt from registering the
security.
21. Accredited investors are specifically
protected by the Securities Act of 1933 from investing in unregistered
securities issues.
22. The typical business organization for a
venture in its rapid-growth stage is a partnership or LLC.
23. In SEC
v. Ralston Purina (1953), the U.S. Supreme Court took an important step
toward defining a public offering for the purposes of Section 4(2) of the
Securities Act of 1933.
24. SEC Regulation D requires the registration of
securities with the SEC.
25. An early stage venture that is not an
investment company and has written compensation agreements can structure
compensation-related securities issues so they are exempt from SEC registration
requirements.
26. SEC Regulation D took effect in 1932 and
provides the basis for “safe harbor” as a private placemen
27. Rule 504 under Regulation D has a $2 million
financing limit (i.e., applies to sales of securities not exceeding $2
million).
28. A Rule 504 exemption under Regulation D has
no limit in terms of the number and qualifications of investors.
29. A Regulation D Rule 505 offering cannot
exceed $5 million in a twelve-month period.
30. A Regulation D Rule 505 offering is limited
to 35 accredited investors.
31. A Regulation D Rule 506 offering has no limit
in terms of the dollar amount of the offering but is limited to 35 unaccredited
investors.
32. Regulation A, while technically considered an
exemption from registration, is a public offering rather than a private
placemen
33. Regulation A allows for registration
exemptions on private security offerings so long as all investors are
considered to be financially sophisticated.
34. Regulation A issuers are allowed to “test the
waters” before preparing the offering circular (unlike almost all other
security offerings).
35. Regulation A offerings are allowed up $10
million and do not have limitations on the number or sophistication of
offerees.
36. The objective of the Jumpstart Our Business
Startups Act of 2012 is to stimulate the initiation, growth, and development of
small business companies.
37. Title II of the JOBS Act of 2012 eliminates
the general solicitation and advertising restriction for Regulation D 506
offerings.
Note: Following are true-false questions relating
to materials presented in Appendix B of Chapter 8.
1. The definition of an “accredited investor,”
initially defined in the Securities Act of 1933, was expanded in Rule 501 of
Reg D.
2. One of the monetary requirements for
individuals or natural persons as accredited investors as defined in Regulation
D Rule 501 is a net worth greater than $1,000,000.
3. One of the monetary requirements for
individuals or natural persons as accredited investors as defined in Regulation
D Rule 501 is individual annual income greater than $500,000.
4. Regulation D Rule 502 focuses, in part, on
resale restrictions imposed on privately-placed securities.
5. Rule 503 of Regulation D states that a Form D
should be filed with the SEC within six months after the first sale of
securities.
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