Finance II: Homework Assignments

Corporate Finance

Finance II (441)

Professor Matsa

Homework Assignments

As an additional opportunity for you to test your understanding of the materials covered in lecture, you should complete the homework assignments and supplementary exercises. Only Homework assignments 1 and 4 will be graded for credit. You may work in groups of up to 6 individuals on Homework assignment 1; each group should submit only one set of answers. Homework 4 must be completed online individually (I will explain in class what I mean by individually).

Homework assignments 2, 3, 5, and 6 are strictly for your benefit. I strongly recommend that you attempt these assignments prior to looking at the answers. The due date shown in the syllabus for these assignments is the date I will hand out the answers in class. Answers will also be made available on the web page (see below).

The homework assignments and related materials are posted here:

Homework Solutions

Suggested solutions will be posted here after each assignment’s due date:

Supplementary Exercises

Supplementary exercises for most lectures are included at the end of the lecture notes in the course packet. Answers follow each exercise. Additional supplementary exercises, which are not in the course packet, are included at the bottom of this page. Many of these are more challenging than those in the course packet. Supplementary exercises are optional; I do not expect you to complete all of them. These exercises are meant to serve as an additional opportunity for you to test or challenge your understanding of the material covered in lecture. Similar to the homework assignments, I recommend that you try to solve the supplementary exercises before looking at the solutions.

Lecture 2

§ Risk and return of government bonds. Working through the enclosed numerical example will help you understand how the risk and return on government bonds and the risk free rate are related. These questions should also provide some practice for calculating discounted values and rates of return. If you would like to see how the term structure has changed over time (1970-1996), you can watch a "movie" of the term structure.

§ Bond pricing. This exercise works through an example of how to price bonds given the term structure of interest rates (similar to the supplementary exercise in Lecture 1). It is also a good review of forward rates (from Lecture 2). This exercise is also good practice for understanding interest rates which we will use when we do the GM case.

§ Asset, debt, and equity betas. As you lever up the firm, the debt and equity change. These exercises let you explore the mechanics of how this works. As you increase the leverage of the firm, you will see how the promised rate on debt, the expected rate on debt, as well as the debt and equity change. You will need the enclosed spreadsheet. Only after you have calculated your own numbers, you can look at my written answers and spreadsheet.

§ Discount rates for leases. Xerox recently was forced to restate their earnings and revenues. Their use of discount rates had allowed them to increase the revenues they reported from their Mexican copier leasing business. This question examines the numbers reported in this Wall Street Journal article.

Lecture 3

§ This spreadsheet shows the calculations underlying the pro-formas and free cash flows for ABP discussed in class. If you want to follow along in class, download the spreadsheet and bring your computer to class.

Lecture 5

§ This exercise asks you to value the coffee cafe example from Lecture 5. However, as part of the valuation you need to estimate the project beta. If you are unclear on why we used different discount rates at different points of the valuation, this exercise should help. To complete it, use the companion spreadsheet.

Lecture 6

§ Dividend announcements. This exercise lets you calculate a numerical example illustrating concepts covered in Lecture 6. You can use it to see how the stock price responds to dividend announcements. You can change how this year's earnings surprise is related to next year's earnings surprise and see how this changes the stock price reaction. You can use the enclosed spreadsheet to check your answers.

Lecture 7

§ Capital Structure Irrelevance when Debt is Risky. In class we increased the firm's debt from 0 to $30. In the supplementary exercise, you can increase the leverage to $60. You should work through this assignment before Lecture 10. You can use the companion spreadsheet to check your answers.

§ Betas. As a firm changes its leverage, its equity and debt change. This spreadsheet and exercise let you calculate the asset, debt, and equity for different level of debts. If you are still having trouble with promised return, return in default, and the expected return on debt, this exercise might help. This is the same exercise as listed under Lecture 2. Once you have completed it, you can check your answers.

Lecture 8

§ Liquidation assumption. This exercise changes the assumption of what happens when the firm defaults. In this exercise, I assume the firm is liquidated if it defaults.

Lecture 10

§ Capital budgeting and the cost of underpricing. If managers have information has information which the market does not, sometimes the equity will be mispriced. This means that sometimes managers will optimally choose not to issue securities and invest in positive NPV projects, because the losses on the equity sale swamp the gains on the investment project. We looked at one such example in Lecture 12. This exercise allows you to work through two additional examples. You will also need the companion spreadsheet to complete this assignment.

§ Capital budgeting for firms with a debt over hang We have examined the effect on equity holders wealth from taking on a new project financed by new equity. In this exercise, I want you to look at a similar problem. The new project can be financed by equity or debt -- your choice. However, the firm currently has debt outstanding. This makes the problem more interesting.

§ Nash Equilibrium. In your micro economics and/or game theory classes you studied Nash equilibrium. The equilibrium we derived in class (where the firm bypasses a positive NPV project) is a Nash equilibrium. This exercise will help you figure out the strategies and demonstrate that there is a unique Nash equilibrium in this game.

Lecture 13

§ PERCS. In class, we discussed how to think of exotic securities - such as convertible bonds - as portfolios of the firm's debt, equity, and options on the firm. In this example, you construct an exotic security with these building blocks. This way you can actually 'issue' a security without the help of the firm.

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