FIN 325 - Quiz 5

Too Young, Incorporated, has a bond outstanding with a coupon rate of 7.2 percent and semiannual payments. The bond currently sells for $1,863 and matures in 21 years. The par value is $2,000. What is the company's pretax cost of debt?

7.87% Explanation $1,863 = $72.00{1 − [1/(1 + R)42]}/R + $2,000/R42R = .0394, or 3.94%YTM = 3.936% × 2YTM = 7.87%

Which one of the following statements is accurate?

A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio.

Which of the following yields on a stock can be negative?

Capital gains yield and total return.

Which of the following statements regarding a firm's pretax cost of debt is accurate?

It is based on the current yield to maturity of the company's outstanding bonds.

Which one of the following statements related to market efficiency tends to be supported by current evidence?

Markets tend to respond quickly to new information.

The historical record for the period 1926-2016 supports which one of the following statements?

Small-company stocks have lost as much as 50 percent and gained as much as 100 percent in a single year.

Which of the following statements best describes the principle of diversification?

Spreading an investment across many diverse assets will eliminate some of the total risk.

Which one of the following best defines the variance of an investment's annual returns over a number of years?

The average squared difference between the actual returns and the arithmetic average return

Vanessa purchased a stock one year ago and sold it today for $3.15 per share more than her purchase price. She received a total of $2.60 per share in dividends. Which one of the following statements is correct in relation to this investment?

The capital gains yield is positive.

Which one of the following is the most likely reason why a stock price might not react at all on the day that new information related to the stock's issuer is released? Assume the market is semistrong form efficient.

The information was expected.

Standard deviation is a measure of which one of the following?

Volatility

Which form of market efficiency would most likely offer the greatest profit potential to an outstanding professional stock analyst?

Weak

Which one of the following is most indicative of a totally efficient stock market?

Zero net present values for all stock investments

The return earned in an average year over a multiyear period is called the _____ average return.

arithmetric

For the period 2009-2019, U.S. Treasury bills had an annual rate of return that was:

between 0-2.5%

A firm's aftertax cost of debt will increase if there is a(n):

decrease in the company's tax rate.

To calculate the expected risk premium on a stock, one must subtract the ________ from the stock's expected return.

expected market rate of return

The average compound return earned per year over a multiyear period is called the _____ average return.

geometric

Assume Barnes' Boots has a debt-equity ratio of .52. The firm uses the capital asset pricing model to determine its cost of equity. Accordingly, the firm's estimated cost of equity:

is dependent upon a reliable estimate of the market risk premium.

Assume the market rate of return is 10.1 percent and the risk-free rate of return is 3.2 percent. Lexant stock has 2 percent less systematic risk than the market and has an actual return of 10.2 percent. This stock:

is underpriced

The most important reason to diversify a portfolio is to:

lower both returns and risk.

For any given capital project proposal, the discount rate should be based on the:

risks associated with the use of the funds required by the project.

The U.S. Securities and Exchange Commission periodically charges individuals with insider trading and claims those individuals have made unfair profits. Given this, you would be most apt to argue that the markets are less than _____ form efficient.

strong

Inside information has the least value when financial markets are:

strong form efficient

What is the beta of the following portfolio? Stock / Amt Invested / Security Beta A / $6,000 / 1.37 B / $17,900 / 0.95 C / $2,750 / 1.48

1.10

Assume a firm employs debt in its capital structure. Which of the following statements is accurate?

The WACC would most likely decrease if the firm replaced its preferred stock with debt.

Grill Works has 6 percent preferred stock outstanding that is currently selling for $49 per share. The market rate of return is 14 percent and the tax rate is 21 percent. What is the cost of preferred stock if its stated value is $100 per share?

12.24% Explanation RP = .06($100)/$49RP = .1224, or 12.24% Cost of preferred stock = (0.06 × $100)/$49 Cost of preferred stock = $6/$49 Cost of preferred stock = 12.24%

One year ago, you purchased a stock at a price of $38.22 per share. Today, you sold the stock and realized a total loss of 11.09 percent on your investment. Your capital loss was −$4.68 per share. What was your dividend yield?

$1.15% Explanation Dividend yield = −.1109 − (−$4.68/$38.22)Dividend yield = .0115, or 1.15%

You own 850 shares of Bennett Trading stock valued at $53.15 per share. What is the dividend yield if your total annual dividend income is $1,256?

2.78% Explanation Dividend yield = ($1,256/850)/$53.15Dividend yield = .0278, or 2.78%

The rate of return on the common stock of Luna Lights is expected to be 11.5 percent in a boom economy and 4.5 percent in a normal economy. The probability of a boom is 23 percent. What is the standard deviation of the returns on this common stock?

2.95%

Based on the period 1926-2019, the actual real return on large-company stocks has been around:

9%

Which one of the following statements correctly applies to the period 1926-2019?

Long-term corporate bonds outperformed long-term government bonds.

Which one of the following is a correct ranking of securities based on the volatility of their annual returns over the period of 1926-2019? Rank from highest to lowest.

Long-term government bonds, long-term corporate bonds, intermediate-term government bonds

Which of the following is the main advantage of using the dividend growth model to estimate a firm's cost of equity?

the simplicity of the model.

A stock had the following year-end prices and dividends: Year / Price / Dividend 0 / $58.87 / — 1 / 68.82 / $1.15 2 / 61.86 / 1.35 3 / 70.42 / 1.50 What was the arithmetic average return for the stock?

8.99% Explanation Year 1 return = ($68.82 − 58.87 + 1.15)/$58.87Year 1 return = .1886, or 18.86%Year 2 return = ($61.86 − 68.82 + 1.35)/$68.82Year 2 return = −.0815, or −8.15%Year 3 return = ($70.42 − 61.86 + 1.50)/$61.86Year 3 return = .1626, or 16.26%Arithmetic average return = (.1886 − .0815 + .1626)/3Arithmetic average return = .0899, or 8.99%

An unexpected post on social media caused the prices of 22 different companies' stocks to immediately increase by 10 to 15 percent. This occurrence is best described as an example of ________ risk.

unsystematic

When evaluating any capital project proposal, the cost of capital:

depends upon how the funds raised for that project are going to be spent.

One year ago, you purchased a stock at a price of $43.20 per share. The stock pays quarterly dividends of $.18 per share. Today, the stock is selling for $45.36 per share. What is your capital gain on this investment?

$2.16 Explanation Capital gain = $45.36 − 43.20Capital gain = $2.16

A stock experienced returns of 5 percent, −17 percent, and 15 percent during the last three years. What is the standard deviation of the stock's returns for the three-year period?

16.37% Explanation Average return = (.05 − .17 + .15)/3Average return = .0100, or 1% σ = {[1/(3 − 1)][(.05 − .01)2 + (−.17 − .01)2 + (.15 − .01)2]}.5 σ = .1637, or 16.37%

Suppose you bought a $1,000 face value bond with a coupon rate of 5.6 percent one year ago. The purchase price was $987.50. You sold the bond today for $994.20. If the inflation rate last year was 2.6 percent, what was your exact real rate of return on this investment?

3.65%

Last year, you purchased 500 shares of Ayala, Incorporated, stock for $25.20 per share. You have received a total of $400 in dividends and $17,000 in proceeds from selling the shares. What is your capital gains yield on this stock?

34.9% Explanation Capital gains yield = [($17,000/500) − $25.20]/$25.20Capital gains yield = .349, or 34.9%

Espy Hotels has bonds outstanding that mature in 9 years, pay interest semiannually, and have a coupon rate of 5.5 percent. These bonds have a face value of $1,000 and a current market price of $989.28. What is the company's aftertax cost of debt if its tax rate is 22 percent?

4.41% (excel using RATE fxn) Explanation $989.28 = [.055($1,000)/2][(1 − {1/[1 + (r/2)]9(2)})/(r/2)] + $1,000/[1 + (r/2)]9(2)Using trial and error, a financial calculator, or a computer:r = 5.6536%Aftertax cost of debt = 5.6536%(1 − .22)Aftertax cost of debt = 4.41% Semi annual coupon=1000*(5.5/2)% =27.5 N would be=(9*2)=18 Putting into a financial calculator; N=18 PV=-989.28 PMT=27.5 FV=1000 Solving for I/Y;we get I/Y=2.827% Hence since these are semi annual;YTM would be=2.827*2 =5.654% Cost of debt after tax=YTM*(1-tax rate) =5.654*(1-0.22) =4.41%(Approx)

A stock has annual returns of 5 percent, 21 percent, −12 percent, 7 percent, and 6 percent for the past five years. The arithmetic average of these returns is _____ percent while the geometric average return for the period is _____ percent.

5.40; 4.86 Explanation Arithmetic average = (.05 + .21 − .12 + .07 + .06)/5Arithmetic average = .054, or 5.4%Geometric return = [1.05(1.21)(.88)(1.07)(1.06)].20 − 1Geometric return = .0486, or 4.86%

Galvatron Metals has a bond outstanding with a coupon rate of 6.4 percent and semiannual payments. The bond currently sells for $1,912 and matures in 16 years. The par value is $2,000 and the company's tax rate is 21 percent. What is the company's aftertax cost of debt?

5.42% Explanation $1,912 = $64.00{1 − [1/(1 + R)32]}/R + $2,000/R32R = .0343, or 3.43%YTM = 3.430% × 2YTM = 6.86%RD = 6.86%(1 − .21)RD = 5.42% CHART Enter32 −$1,912$64.00$2,000 N I/Y PV PMT FV Solve for 3.43%

Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 per share. The common stock has a beta of 1.32 and sells for $41 per share. The preferred stock has a stated value of $100. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital?

8.09% Explanation RE = .022 + 1.32(.106 − .022) = .13288, or 13.288%RP = (.055)($100)/$64 = .08594, or 8.594%E = 75,000($41) = $3,075,000P = 48,000($64) = $3,072,000D = 6,500(.965)($1,000) = $6,272,500V = $3,075,000 + 3,072,000 + 6,272,500V = $12,419,500WACC = ($3,075,000/$12,419,500)(.13288) + ($3,072,000/$12,419,500)(.08594) + ($6,272,500/$12,419,500)(.067)(1 − .21)WACC = .0809, or 8.09% Assuming face value of bond to be $1,000 Price of bond = 0.965 * 1000 = 965 Market value of bond = 6,500 * 965 = 6,272,500 Market value of preferred stock = 48,000 * 64 = 3,072,000 Market value of common stock = 75,000 * 41 = 3,075,000 Total market value = 6,272,500 + 3,072,000 + 3,075,000 = 12,419,500 Annual preferred dividend = 0.055 * 100 = 5.5 Cost of preferred stock = (Annual dividend / price) * 100 Cost of preferred stock = (5.5 / 64) * 100 Cost of preferred stock = 8.5938% Cost of equity = Risk free rate + beta (market return - risk free rate) Cost of equity = 0.022 + 1.32 (0.106 - 0.022) Cost of equity = 0.13288 or 13.288% Weighted average cost of capital = Weight of debt*after tax cost of debt + weight of preferred stock*cost of preferred stock + weight of equity*cost of equity Weighted average cost of capital = (6,272,500 / 12,419,500)*0.067*(1 - 0.21) + (3,072,000 / 12,419,500)*0.085938 + (3,075,000 / 12,419,500)*0.13288 Weighted average cost of capital = 0.02673 + 0.02126 + 0.0329 Weighted average cost of capital = 0.0809 or 8.09%

Take It All Away has a cost of equity of 10.81 percent, a pretax cost of debt of 5.45 percent, and a tax rate of 21 percent. The company's capital structure consists of 77 percent debt on a book value basis, but debt is 37 percent of the company's value on a market value basis. What is the company's WACC?

8.40% Explanation WACC = .63(10.81%) + .37(5.45%)(1 − .21)WACC = 8.40%

Smathers Corporation stock has a beta of .85. The market risk premium is 6.80 percent and the risk-free rate is 2.85 percent annually. What is the company's cost of equity?

8.63% Explanation RE = .0285 + .85(.0680)RE = .0863, or 8.63% a.Cost of equity=risk free rate+Beta*market risk premium =2.85+(0.85*6.8) =8.63% b.Cost of equity as per CAPM=risk free rate+Beta*market risk premium =2.91+(0.88*7.1)=9.158% Cost of equity as per growth model=(D1/Current price)+Growth rate =[(3.57*1.0325)/68.91]+0.0325 =8.59904223% Best estimate of Cost of equity=(9.158+8.59904223)/2 =8.88%(Approx).

Countess Corporation is expected to pay an annual dividend of $4.51 on its common stock in one year. The current stock price is $73.07 per share. The company announced that it will increase its dividend by 3.65 percent annually. What is the company's cost of equity?

9.82% Explanation RE = ($4.51/$73.07) + .0365RE = .0982, or 9.82% Stock Price = Expected Dividend/(Cost of Equity - growth rate) 73.07 = 4.51/(Cost of Equity - 3.65%) Cost of Equity = 9.8222% i.e. 9.82%

Which one of the following statements related to capital gains is correct?

An increase in an unrealized capital gain will increase the capital gains yield.