Exam #1 Review Answers

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1 xam #1 Review Answes 1. Given the following pobability distibution, calculate the expected etun, vaiance and standad deviation fo Secuity J. State Pob (R) % xpected etun = 0.2*10% + 0.6*15% + 0.2*20% = 15% aiance = 0.2*(10%-15%) *(15%-15%) *(20%-15%) 2 2. Why does the cost of debt incease as the D/ atio inceases? The expected cost of bankuptcy incease, inceasing the isk to bondholdes. 3. If the stock maket is semi-stong efficient, which of the following statements is most coect? a. All stocks should have the same expected etuns; howeve, they may have diffeent ealized etuns. b. In equilibium, stocks and bonds should have the same expected etuns. c. Investos can outpefom the maket if they have access to infomation which has not yet been publicly evealed. d. If the stock maket has been pefoming stongly ove the past seveal months, stock pices ae moe likely to decline than incease ove the next seveal months. e. None of the statements above is coect. 4. The Secuity Maket Line (SML) measues: The etun fo systematic isk

2 5. Cuently, you ae invested in only one stock, Geman Luxuy Sedans Cop. Having head about the benefits of divesification you d like to split you potfolio evenly between Geman Luxuy Sedans Co. and anothe fim. Afte much consideation, you ve naowed you investment choices to Cannes Yachts, Inc. and Ameican Movie Theates. Assume the fim names epesent the coe business. Which choice is bette given you goal? Biefly state why. Ameican Movie Theates non-luxuy good 6. The Pake Company s stock has a beta of 1.2. The isk-fee ate is pesently 5 pecent and the maket isk pemium is 4%. a. Calculate the equied ate of etun. 5% + 1.2*4% = 9.8% b. If the isk-fee ate ises to 6 pecent, what will be the new equied etun? 6% + 1.2*4% = 10.8% c. If investos intepet the incease in the isk-fee ate to mean tighte money and theefoe become pessimistic, the SML will shift. Calculate the new equied etun if the slope of the SML is now % + 1.2*5% = 12% 7. Fo investment I, β I = 1 and I = 11%, what is M (the etun on the maket)? If othe infomation is equied to solve this, list what is needed. The etun on the maket is 11%. 8. What ae the expected etun, vaiance, and standad deviation fo a potfolio with an investment of $10000 in Technology and $10000 in Manufactuing? State Pob. Tech Manufactuing Gowth.25 16% 12% Nomal.50 12% 6% Recession.25 4% 6% R in gowth =.5(16%) +.5(12%) = 14% R in nomal =.5(12%) +.5(6%) = 9% R in ecession =.5(4%) +.5(6%) = 5% Potfolio etun =.25(14%) +.5(9%) +.25(5%) = 9.25% aiance =.25(14%-9.25%) 2 +.5(9%-9.25%) (5%-9.25%) 2 = Standad deviation = squae oot of the vaiance

3 9. The stock of Italian Mechants has a beta of 1.34 and an expected etun of pecent. The iskfee ate of etun is 3.7 pecent. What is the expected maket isk pemium? () = = *(RP); RP = 7.9% 10. The ewad to isk atio is constant acoss secuities because a. Inside tading is illegal b. WACC c. Govenment egulation d. Buying and selling maket pessues 11. Should we accept o eject negative NP pojects? Ae thee any exceptions? Geneally, we eject negative NP pojects. Howeve, thee may be eputation concens o othe factos that ae not eflected in the cash flows but will affect shaeholde wealth. 12. Tue o false: Scenaio analysis assues a fim that the actual esults of a poject will lie within the ange of etuns as computed unde the best and the wost case scenaios. Biefly explain why. False. Scenaio analysis only povides a easonable ange of expected outcomes. 13. Which one of the following is an example of an incemental cash flow? a. the annual salay of the company pesident which is a contactual obligation b. the ent on a waehouse which is cuently being utilized c. the ent on some new machiney that is equied fo an upcoming poject d. the popety taxes on the cuently owned waehouse which has been sitting idle but is going to be utilized fo a new poject e. the insuance on a company-owned building which will be utilized fo a new poject 14. Which of the following statements is most coect? a. CAPM estimates a discount ate than is intechangeable with the discount ate b. The CAPM appoach is typically used to estimate a fim s cost of pefeed stock. c. CAPM depends on all secuities having the same ewad-to-isk atio. d. The statements above ae all false. 15. What is the cost of equity if β L = 1.2, β U = 1.0, f = 3%, and M = 9%? e = 3% + 1.2*(6%) = 10.2%

4 16. Glacie Pue Wate Inc. has a capital stuctue of 40 pecent debt, 10 pecent pefeed stock, and 50 pecent common equity. The fim s YTM is 6 pecent and both the isk fee ate and the isk pemium ae 5.5%. The fim s pefeed stock has a cost of 12.5% and the tax ate is 20%. The common stock cuently sells fo $40 pe shae. The beta is 2 and investos expect the dividend to gow indefinitely at a constant ate of 10 pecent pe yea. What is the fim s cost of newly issued common stock? R e = *.055 =16.5% What is the fim's weighted aveage cost of capital? WACC =.06*.4 *(1-.2) +.165* * What is the net pesent value of a poject that has an initial cash outflow of $34,900 and the following cash inflows? The equied etun is pecent. Yea (cash flow) 1 $12,500 2 $19, $10,400 A. -$3, B. -$2, C. -$2, D. $52, $66, You fim would like to invest in an intenational telecommunications infastuctue poject. Thee ae two options fo you to conside: the fist has a highe NP and highe IRR but a 25 yea payback peiod, the second has a lowe (but still positive) NP and lowe IRR with a 5 yea payback. Does the politically stability of the investment s location matte fo you decision? Yes. Fo poject with paticulaly time-sensitive uncetainty, such as in political unstable egions o the health-cae industy, payback often is the pefeed capital budgeting decision method. 19. The optimal capital stuctue will tend to include moe debt fo fims with: a. the most skilled labo. b. the lowest maginal tax ate. c. substantial tax shields fom othe souces. d. lowe pobability of financial distess. e. less taxable income.

5 20. What is an equity beta? The equity beta is the leveed beta and it measue the combined poject and financial isk to equityholdes. 21. You cuently have 30,000 shaes tading at $10/shae and $100,000 in debt with a 10% cost of debt. You ae consideing issuing an additional $100,000 in debt to epuchase shaes. How many shaes would you epuchase? What is the beakeven BIT at which shaeholdes ae indiffeent between the cuent and poposed capital stuctue? Repuchase 10,000 shaes Beakeven BIT = $40, Sally s has debt of $12,000 and equity of $18,000. The cost of debt is 8 pecent and the cost of equity is 13 pecent. The tax ate is 34 pecent. What is the fim s weighted aveage cost of capital? [18k (12k + 18k).13] + [12k (12k + 18k).08 (1.34)] = = 9.91% 23. Big Bill s Yachts has a debt-equity atio of.75. The cost of debt is 8 pecent and the unleveed cost of capital is 13 pecent. What is the cost of equity if the tax ate is 35 pecent? R =.13 + (.13.08).75 (1.35) = = 15.44% 24. The Winte Wea Company has expected eanings befoe inteest and taxes of $2,100, an unleveed cost of capital of 14% and a tax ate of 34%. The company also has $2,800 of debt that caies a 7% coupon. The YTM is also 7%. What is the value of this fim? U = [$2,100 (1.34)].14 = $9,900; L = $9,900 + (.34 $2,800) = $10, Walte s Distibutos have a cost of equity of pecent and an unleveed cost of capital of 12%. The company has $5,000 in debt that is selling at pa value. The leveed value of the fim is $12,000 and the tax ate is 34%. What is the cost of debt? = $12,000 $5,000 = $7,000;.1384 =.12 + (.12 R D ) ($5,000 $7,000) (1.34);.0184 = R D ; R D = = 8.10% 26. If a company uses the same discount ate fo evaluating all pojects, which outcome is likely? a. Accepting poo, high-isk pojects. b. Rejecting good, low-isk pojects. c. Accepting only good, low-isk pojects. d. Accepting no pojects. e. Answes a and b ae coect.

6 27. Descibe the value of a fim as debt inceases - in a pefect maket (without taxes and distess), with taxes, and with both taxes and distess. In a pefect maket, fim value is unaffected by the level of debt. With taxes, the value inceases with the level of debt. And with both taxes and distess, the benefits of debt (tax shields) ae eventually outweighed by the costs of debt (potential distess) so the value initially ises and then deceases with highe level of debt. 28. Giggs Inc. has debt with both a face and a maket value of $3,000. This debt has a coupon ate of 7% and pays inteest annually. The expected eanings befoe inteest and taxes is $1,200, the tax ate is 34%, and the unleveed cost of capital is 12%. What is L? What is the fim s cost of equity? U = [BIT (1 T c )] R U = [$1,200 (1.34)].12 = $6,600 L = U + (T c D) = $6,600 + (.34 $3,000) = $7,620 L D = = $7,620 $3,000 = $4,620 R = R U + (R U R D ) D/ (1 T C ) =.12 + [(.12.07) ($3,000 $4,620) (1.34)] = = 14.14% 29. You have a health food stoe with has a D/ atio of 2/3. A simila fim, Oganic Oats, has a cost of equity of 16% and a D/ atio of 4/3 while the local lage gocey stoe, Big Box, has a cost of equity o 17% and a D/ if 5/3. The isk-fee ate is 4% and the equied ate of etun on the maket is 10%. Assume a tax ate of 25%. What is you cost of equity? 16% = 4% + beta(10% - 4%) ~ 12% = beta*6% ~ beta=2 Unlev beta = 2/[1+(1-.25)*(4/3)]=2/2 = 1 Releve = 1*[1+(1-.25)*(2/3)]=1.5 Cost of equity = 4%+1.5*6% = 13% 30. The optimal capital stuctue: a. will be the same fo all fims in the same industy. b. will emain constant ove time unless the fim does an acquisition. c. of a fim will vay ove time as taxes and maket conditions change. d. values opeational decision moe than potential tax shields e. is unaffected by changes in the financial makets. 31. Kantishna Ai is tying to decide whethe to open a lodge in Denali National Pak. The beta fo Kantishna is 1.0. Howeve, othe national pak backcounty lodges have betas aveaging 3 with a debt to equity value of 2/3. Assume the tax ate is 25%. The Kantishna lodge will have a D/ atio of 1/3 (so the D/=1/4) and the cost of debt is 8%, the isk pemium is 4%, and the isk fee ate is 2%, what is the poject s weighted aveage cost of capital? β U = β L /(1+(1-t)D/) = 3/(1+(1-.25)(2/3) = 3/(1+(3/4)(2/3)) = 3/1.5 = 2 β L = β U *(1+(1-t)D/) = 2*(1+(1-.25)(1/3) = 2*(1+(3/4)(1/3)) = 2*1.25 = 2.5 (R) = R F + β*maket Risk Pemium = 2% + 2.5*4% = 12% WACC = (1-.25)(1/4)8% + (3/4)12% = 10.5%

7 QUATIONS t P ( 1 P C / F ) ) p ( ) a w ( ( )) ( i i i i 2 e ( RF ) RF M WACC ( 1 t) D D P P D L U D U ( U D )( )(1 Tc ) (1 (1 t) ) D P( Tax Shield) Tc * D U L Afte tax BIT U U P(TaxShields) L Afte tax BIT WACC BIT d * DOLD BIT d * D # Sh # Sh OLD NW NW