7211AFE Corporate Finance – Practice Questions for Final Exam Question 1 The risk-free rate of return is 4% and the market risk premium i...

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Question 8 What is the market return if the expected return on asset A is 15% and the 10-year government bond rate is 6%. Beta for asset A is .9. Answer: 16% Question 9 What is the portfolio variance if 30 percent is invested in stock S and 70 percent is invested in stock T? State of Probability of Returns if State Occurs Economy State of Economy Stock S Stock T Boom 40% 12% 20% Normal 60% 6% 4% Answer: 0.004056 We now have the payoffs in each state: Use equation (28) E(RP ) = pr(boom) ×payoff(boom) + pr(normal) ×payoff(normal) = 0.4×0.176+0.6×0.046 = 0.098 Now use equation (29) Var(R P) = 0.4 × (0.176-0.098) 2 + 0.6 × (0.046-0.098)2 = 0.004056 Question 10 Starfish limited has a WACC (unadjusted) of 12%. It can borrow at 8%. Assuming that the company has a target capital structure of 80% equity and 20% debt, what is its cost of equity? Answer: 13% Question 11 Merlo, Inc. maintains a debt-equity ratio of .40 and follows a residual dividend policy. The company has after-tax earnings of $1,600 for the year and needs $1,400 for new investments. What is the total amount Merlo will pay out in dividends this year? Answer: $600 Question 12 You recently purchased a stock that is expected to earn 12 % in a booming economy, 8 % in a normal economy and lose 5 % in a recessionary economy. There is a 15 % probability of a boom, a 75 % chance of a normal economy, and a 10 % chance of a recession. What is your expected rate of return on this stock? Answer: 7.30 % Question 13 Shares are currently selling for $4.4625. At the beginning of the year you bought them for $4.25 and during the year a dividend of 21.25 cents per share was paid. What is the return? Answer: 10% Question 14 Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5 percent and the market risk premium is 8 percent?

Stock A B C D E

Beta .68 1.42 1.23 1.31 .94

Expected Return 8.2% 13.9% 11.8% 12.6% 9.7%

Answer: B The market risk premium is E(R m)-Rf = 0.08, Rf = 0.025 E(R A) = Rf + b (E(R m)-R f) = 0.025 + 0.68×0.08 = 0.0794 E(R B) = 0.1386 E(R C) = 0.1234 E(R D) = 0.1298 E(R E ) = 0.1002 Stock B is correctly priced (assuming the CAPM holds).

Question 15 Using the following information, calculate the portfolio beta and expected return: Event Wealth invested Expected return Beta 0.80 A $1,000 8% 0.95 B $2,000 12% C $3,000 15% 1.10 D $4,000 18% 1.40 Answer: 1.16, 14.9% Question 16 Shoes’R’Us is an unlevered firm. Cost of capital for the firm is 10%. The firm’s cash flows are $700 every year forever. What is the value of the firm? Answer: $7000 Question 17 Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 % and the market rate of return is 10 %. What is the amount of the risk premium on Zelo stock? Answer: 6.77 % Question 18 If the economy booms, RTF Inc. stock is expected to return 10 %. If the economy goes into a recessionary period, then RTF is expected to only return 4 %. The probability of a boom is 60 % while the probability of a recession is 40 %. What is the variance and standard deviation of the returns on RTF Inc. stock? Answer: 0.000864, 2.9% Question 19 The Lingo Co. has a debt-equity ratio of .60. The firm is analyzing a new project which requires an initial cash outlay of $450,000 for new equipment. The flotation cost for new equity is 10 percent and for debt 5 percent. What is the true cost of the project? Answer: $489,796

Question 20 You own 300 shares of Abco, Inc. stock. The company has stated that it plans on issuing a dividend of $.60 a share at the end of this year and then issuing a final liquidating dividend of $2.20 a share at the end of next year. Your required rate of return is 9 percent. Ignoring taxes, what is the value of one share of this stock today? Answer: $2.40 Question 21 Astra limited company sells a slice of pizza for $1.20. The variable cost is 80 cents per slice and the marketing operation has fixed costs of $360 000 per year. Depreciation is $60 000 per year. What is the accounting break-even? Answer: 1 050 000 slices of pizza

Question 22 Rosie’s Grill has a beta of 1.2, a stock price of $26 and an expected annual dividend of $1.30. The dividend growth rate is 4 %. The market has a 10 % rate of return and a risk premium of 6 %. What is the average expected cost of equity for Rosie’s Grill? Answer: 10.10 % Question 23 What are the arithmetic and geometric average returns for a stock with annual returns of 21 %, 8 %, -32 %, 41 %, and 5 %? Answer: AM 8.6 %; GM 5.6 %

Question 24 Sparkle Inc has a debt-equity ratio of 1. Its weighted average cost of capital is 11%, and its cost of debt is 9%. The corporate tax is 35%. a) What is Sparkle’s cost of equity capital? b) What is Sparkle’s unlevered cost of equity? c) Sparkle is increasing its debt proportion in the firm (at the same cost) so that the debtequity ratio is 1.5? What is the cost of capital then? Answers: a) 16.15%; b) 13.33%; c) 10.53% Question 25 The Lakeside Inn is considering expanding their operations. Fixed costs are estimated at $92,000 a year. The variable cost per unit is estimated at $22.50. The estimated sales price is $37.50 per unit. What is the cash break-even point of this project? (Round to whole units) Answer: 6,133 Question 26 Tom’s Ventures has a zero coupon bond issue outstanding that matures in thirteen years. The bonds are selling at 48 % of par value. The company’s tax rate is 34 %. What is the company’s after-tax cost of debt? Answer: 3.83 %

Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target D/E is 0.60 and the tax rate is 35%, what is the firm’s WACC? Answer: 13.2% Question 28 A stock had returns of 8 percent, -2 percent, 4 percent, and 16 percent over the past four years. What is the standard deviation of this stock for the past four years? Answer: 7.5% Question 29 Your firm has earnings before interest and taxes of $160,000. Both the book and the market value of debt is $300,000. Your unlevered cost of equity is 12% while your cost of debt is 8%. The tax rate is 35%. What is your weighted average cost of capital? Answer: 10.7% Question 30 A company has preferred stock outstanding which pays a dividend of $6 per share a year. The current stock price is $75 per share. What is the cost of preferred stock? Answer: 8% Question 31 You are considering a new project. The project has depreciation of $720, fixed costs of $6,000, and selling price per unit of $9.80. The variable cost per unit is $4.20. What is the accounting break-even level of production? Answer: 1,200 units Question 32 Douglass Enterprises has a capital structure which is based on 40 percent debt, 10 percent preferred stock, and 50 percent common stock. The after-tax cost of debt is 6 percent, the cost of preferred is 7 percent, and the cost of common stock is 9 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $125,000 and cash inflows of $76,000 a year for two years. What is the projected net present value? Should this project be accepted or rejected? Answer: $11,275.07, yes Question 33 Katie’s Boutique has zero-coupon bonds outstanding that mature in four years. The bonds have a face value of $1,000 and a current market price of $820. What is the company’s pretax cost of debt? Answer: 5.09 % Question 34 Spartan Co. has earnings of 25 million per year every year. Currently the firm has no debt and the cost of capital is 13%. If tax is 35% what is the value of the firm? Answer: $125m Earnings are $25m/year; no debt WACC = 0.13, t=0.35 V = EBIT(1-t) / R = (25m) (1-0.35) / 0.13 = $125m

Question 35 Spartan Co decides to undergo a capital restructuring by issuing bonds that have a market value of 65 million at a cost of 9.5%. What is the weighted average cost of capital? Answer: 11% You issue bonds with a market value of $65m, value of leverage firm: V L= V U+ T C×D = 125m + 0.35×65m = 147.75m => E = 147.75m 65m = 82.75m; wD =65/147.75 = 0.44; w E= 0.56 Hence D/E = 65.0/82.75 = 0.785 Recall (46): Cost of equity R E = R A + (RA R D ) ×(D/E) ×(1-t) = 0.13 + (0.13 0.095) (65/82.75) (0.65) = 0.1479 Recall (37): WACC = w ER E + wDR D (1-t) = 0.56 (0.14787) + 0.44 (0.095)(1-0.35) = 0.11 Question 36 After successful operating for a number of years, Spartan Co decides to increase even further the leverage so that the debt-to-equity ratio becomes 1.2. What is the cost of capital? Answer: 10.52% R E = 0.13 + (0.13 0.095)(1.2)(0.65) = 0.1573 If D/E = 1.2, D=1.2 & E=1.0, => w D= 1.2/2.2, wE=1/2.2 WACC = w ER E + wDR (1-t) = (1.0/2.2) (0.1573) + (1.2/2.2) (0.095) (0.65) = 0.10518 Question 37 Calculate the expected return of the portfolio: Asset Wealth invested E(Ri) 15% A 200 B 100 20% C 500 10% Answer: 12.5% Question 38 ABC limited have 50 000 shares outstanding that sell in the market for $17.50 each. Share’s beta coefficient is 1.2. The market risk premium is 8% and the risk-free rate is 5%. What is ABC limited’s cost of equity capital and the market value of equity? Answer: 14.6%, $875 000 Question 39 Uptown Interior design has the same market value as the book value of its balance sheet accounts. The firm has declared a dividend of $0.35 per share that will be paid in two days time. The company has 8,000 shares of stock outstanding trading in the market. The balance sheet is presented in the following table: Cash Fixed Assets Total

Balance Sheet 25,000 Equity 165,000 190,000 Total

190,000 190,000

b) What will it sell in two days time after the ex dividend date? c) What are the accounts affected after the dividends are paid and what will be their new balance? Answers: a) $23.75; b) $23.40 c) Cash $22 200 and Equity $187 200 Question 40 Uptown Interiors has decided to consider an alternative to cash dividend. Instead of paying a dividend, the firm will repurchase $5 200 worth of stock. a) What effect will this transaction have on the equity of the firm? b) How many shares were repurchased? (round your answer) c) How many shares will be outstanding? d) What is the new equity value? e) What will the price per share be after the repurchase? Answer: a) reduce; b) 219; c) 7 781; d) $184 800; e) same $23.75 a) If you repurchase the stock, this is similar to a cash dividend; your cash account falls by $5200 and so does your equity account. b) Since the price is 23.75 then you retire 219 shares Shr repurchased =cash/P= $5200/23.75 = 219 c) The number of shares outstanding falls from 8000 to 7781 (=8000-219). d) New equity value, E = E cash = 190,000 5200 = 184,800 e) Since stock repurchases do not impact the value of the firm, price/share remains unchanged at $23.75 Question 41 Shirley’s and Son have a debt-equity ratio of .60 and a tax rate of 35 %. The firm does not issue preferred stock. The cost of equity is 10 % and the cost of debt is 8 %. What is Shirley’s weighted average cost of capital? Answer: 8.2 % Question 42 You are an investor in BHP and own 100 shares. BHP shares sell for $41. The company is about to pay a $1 dividend but you prefer a $3 dividend. What will you do to receive the desired income of $300? Answer: sell 5 shares ex dividend Question 43 Today, you sold 200 shares of SLG Inc. stock. Your total return on these shares is 12.5 percent. You purchased the shares one year ago at a price of $28.50 a share. You have received a total of $280 in dividends over the course of the year. What is your capital gains yield on this investment? Answer: 7.59 % -1 0 28.5 P0+1.4 DPS = Div/shares = 280/200 = 1.4 ret = (DPS+ch_P)/P_1 => 12.5% = (1.4 + P0-28.5)/28.5 => P0=30.66 ch_P/P_1 = (P0-P_1)/P_1 = (30.6-28.5)/28.5 = 7.59% Question 44 Caterpillar Inc. has 8 million shares of common stock outstanding, and 1.5 million 8% percent semi-annual bonds outstanding, par value $100 each. The common stock currently sells for $25 per share, and has a beta of 1.25, and the bonds have 10 years to maturity and sell for

93% of par. Cost of debt is 9.08%. The market risk premium is 10%, the return on risk free rate is 4.5%, and tax rate is 30%. a) What is the firm’s market value of debt and equity? b) Caterpillar is evaluating a new investment project that has the same risk as the overall firm, what is the rate that the firm should use to discount the project’s cash flows? Answer: a) 139.5m, 200m; b) 12.63% MV of equity = #shares × price = 8m × 25 = $200m MV of debt = 1.5m × $93 = $139.5 E(Rm )-Rf = 0.10; R f= 0.045; Beta= 1.25 CAPM: E(R) = 0.045 + 1.25(0.10) = 0.17 Cost of debt = YTM = 9.08% WACC = (200/339.5)(0.17) + (139.5/339.5)(0.0908)(1-0.3) = 0.1263 Question 45 The fixed costs of a project are $8,000. The depreciation expense is $3,500 and the operating cash flow is $20,000. What is the degree of operating leverage for this project? Answer: 1.40 Question 46 Jack’s Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5 %. Face value of a bond is $1000. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4 % and the market risk premium is 8 %. Jack’s tax rate is 35 %. What is Jack’s weighted average cost of capital? Answer: 10.38 % Question 47 Stark company has decided to restructure its capital. Currently, it uses no debt financing. Following the restructuring, debt will be $1 million. The interest rate on the debt will be 9%. The company currently has 200 000 shares outstanding and the price per share is $20. If the restructuring is expected to increase EPS, what is the minimum level of EBIT that the firm’s management must be expecting? Answer: $360 000

Question 48 Strip Tavern has the cost of equity at 14% and the cost of debt at 6.5%. Assuming that the target debt/equity ratio is 50% and the company tax rate is 34%, calculate the overall cost of capital. Answer: 10.7% Question 48b The Can-Do Co. is analysing a proposed project. The company expects to sell 12,000 units, plus or minus 4 percent. The expected variable cost per unit is $7 and the expected fixed cost is $36,000. The fixed and variable cost estimates are considered accurate within a plus or minus 6 percent range. The depreciation expense is $30,000 per year, over the 5 year life of the project, using the straight line. The tax rate is 34 percent. The sale price is estimated at $14 a unit, plus or minus 5 percent. a) What is the earnings before int and under the base case scenario?

b) What is the earnings before interest and taxes under a best case scenario? c) What is the net income under the worst case scenario? d) What is the NPV under the base case scenario if required rate of return is 12%? Answer: a) $18 000; b) $37,497.60; c) -$278.78; d) $968.03 Question 49 You purchased 200 shares of stock at a price of $36.72 per share. Over the last year, you have received total dividend income of $322. What is the dividend yield? Answer: 4.4% Question 50 Printing Equip Co. are considering a project that costs $180 000, has a 6 year life, and no salvage value. Assume that depreciation is straight line. The required return of Printing Equip is 10.5% on such projects. Sales are estimated at 28 000 units per year. Price per unit is $9, variable cost per unit is $3.20, and fixed costs are $35 000 per year. The tax rate is 35%. What is the accounting break-even point? Calculate the base case cash flow and NPV What is the degree of operating leverage? Suppose that you think that the sales projection is accurate only to within 15%. Evaluate the sensitivity of NPV to changes in that projection by showing the NPV in the best and worst case. Suppose the projections given are all accurate to within 4% except for sales volume, which is only accurate to within 10%. What are the upper and lower bounds for these projections? Answer: a) 11,207 units; b) $93,310, $220,503; c) 1.375; d) $288 466, $152 541 e) Apply 10% to sales and 4% to the rest of variables. Question 51 The Auto Group has 1,200 bonds outstanding that are selling for $980 each. Face value is $1000. The company also has 7,500 shares of preferred stock at a market price of $40 each. The common stock is priced at $32 a share and there are 32,000 shares outstanding. What is the weight of the preferred stock as it relates to the firm’s weighted average cost of capital? Answer: 12%

Question 52 Telco Inc. has a beta of 1.3 and an expected return of 18%. Woollies Co. has a beta of 0.80 and an expected return of 9.5%. If Treasury Bills yield a return of 5% and the market return is 11.75%, which stock is under/overvalued relative to the other? Show why. Answer: Telco is undervalued relative to Woollies. Reward to risk ratio for each stock: [ E(r) R f ] / Telco: ( 0.18 0.05 ) / 1.3 = 0.10 Woolies: ( 0.095 0.05 ) / 0.8 = 0.05625 => Woolies is overvalued, Telco is undervalued Examples of Short Questions in the exam:

Investors prefer the portfolio with the highest expected return for a given variance, or, the lowest variance for a given expected return Discuss the information effect or the signalling effect of dividends.

Dividends and Signals Asymmetric information – managers have more info about the health of the company than investors Information Content Effect > Changes in dividends convey information > Cause market reaction - Dividend increases: Management believes it can be sustained, Expectation of higher future dividends, increasing present value, Signal of a healthy, growing firm - Dividend decreases: Management believes it can no longer sustain the current level of dividends, Expectation of lower dividends indefinitely; decreasing PV, Signal of a firm that is having financial difficulties

Explain and graphically show, together with the associated formulas, the M&M proposition I and II with taxes. Optimal capital structure is almost 100% debt, each additional dollar of debt increases the CFA of firm What are some examples of direct bankruptcy costs? Administrative and legal costs According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return. 1. The risk-free rate, Rf 2. The market risk premium, E( RM) Rf 3. The systematic risk of the asset relative to average, which we called its beta coefficient,

Explain the concept of ‘homemade dividend policy’.

Homemade Dividend Policy Investors will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends. Homemade Dividend Policy = Tailored dividend policy created by individual investors to undo corporate dividend policy

Discuss and graphically show with the associated formulas the capital structure">Capital Structure Theory when the firm has debt but not taxes. There is no optimal capital structure in this case, as the capital structure has no influence on the firms value, without taxes, the total value is unaffected by its capital structure What are some real-world factors that may cause one dividend policy to be preferable to another? Different Tax rates, flotation costs, dividend restrictions, desire for current income, uncertainty resolution What is diversification? What is the variable that plays the most important role in reducing the portfolio risk? The Principle of Diversification:

states that spreading an investment across many assets will eliminate some but not all of the risk. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns Size of risk reduction depends on covariances between assets in the portfolio there is a minimum level of risk that cannot be diversified away and that is the systematic portion Unsystematic risk is essentially eliminated by diversification, but systematic risk cannot be reduced by a portfolio

Define the three forms of market efficiency. What do we mean when we say the markets are efficient? capital market">Capital Market Efficiency

Efficient Capital Markets: A market in which security prices reflect available information based on available information, there is no reason to believe that the current price is too low or too high. efficient markets hypothesis (EMH): The hypothesis that actual capital markets, such as the NYSE, are efficient. It means that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns 3 forms: - weak form efficiency: - Prices reflect all past market information such as price and volume - investors cannot earn abnormal returns by trading on market information - Implies that technical analysis will not lead to abnormal returns - Empirical evidence indicates that markets are generally wfe - semistrong form efficiency: - Prices reflect all publicly available information including trading information, annual reports, press releases, etc. - investors cannot earn abnormal returns by trading on public information fundamental analysis will not lead to abnormal returns - strong form efficiency: - Prices reflect all information, including public and private - investors could not earn abnormal returns regardless of the information they possessed - Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns

What are the lessons learned from capital market history? Lessons from Capital Market History

- Data reflects two features often observed in financial markets: - There is a reward for bearing risk. - The larger the potential reward, the larger the risk. - This is called the risk-return trade-off - There is a positive relationship between risk and return

Explain the meaning of the dividend clientele effect and why it is important.

Clientele Effect Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts If a firms changes the dividend policy from low to high or vice versa, it doesn’t matter, it just changes its structure of investors

What are the components of total risk? Give examples of each.

Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well-diversified portfolios, unsystematic risk is very small almost = to the systematic risk

Systematic or unsystematic Risk

Systematic or Non-Diversifiable Risk, market risk: That portion of an asset’s risk attributed to the market factors that affect all firms and cannot be eliminated through the process of diversification. Unsystematic or Diversifiable Risk asset-specific risk: That portion of an asset’s risk which is firm specific and can be eliminated through the process of diversification

What is CAPM? In equilibrium, what does CAPM implies?

Shows the relationship between systematic risk and expected return Positive slope The higher the risk, the higher the return According to the CAPM, all stocks must lie on the SML, otherwise they would be under or overpriced. In equilibrium, all assets and portfolios must have the same reward-to-risk ratio and they all must equal

What are other approaches of estimating the cost of capital of a project when the project is not of the same risk as the overall risk of the firm? Other approaches to estimating a discount rate: - divisional cost of capital—used if a company has more than one division with different levels of risk; - pure play approach —a discount rate that is unique to a particular project is used; Look at companies in the same line of business as the new project Calculate an average WACC for all the companies and use this rate as the discount rate of the new project - subjective approach —projects are allocated to specific risk classes which, in turn, have specified discount rates Consider the project’s risk relative to the firm overall risk If the project risk > firm risk, use a discount rate > WACC If the project risk < firm risk, use a discount rate < WACC