FIN 4424: Exam 2
Who first developed portfolio theory?
Harry Markowitz
Assume the marginal corporate tax rate is 30 percent. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 million in perpetual debt and repurchased the same amount of equity?
$115 million
If a firm permanently borrows $50 million at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.
$15 million
If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 30 percent.)
$30 million
For every dollar of operating income paid out as interest, the bondholder realizes
(1-Tp)
What is the relative tax advantage of debt? (TC = corporate tax rate; TpE = personal tax rate on equity income; and Tp = personal tax rate on interest income.)
(1-Tp)/(1-TpE)(1-Tc)
The market value of equity equals
(market price) * (# of shares outstanding)
The Sharpe ratio is defined as
(rp-rf)/stdev of p
If the correlation coefficient between Stock A and Stock B is +0.6, what is the correlation coefficient between Stock B with Stock A?
+0.6
The beta of the market portfolio is
+1.0
What range of values can correlation coefficients take?
-1 to +1
For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals
-1.0
The correlation coefficient between a stock and the market portfolio is +0.6. The standard deviation of return of the stock is 30 percent and that of the market portfolio is 20 percent. Calculate the beta of the stock.
.9
What is the beta of a security where the expected return is double that of the stock market, there is no correlation coefficient relative to the U.S. stock market, and the standard deviation of the stock market is .18?
0.00
The covariance between YOHO stock and the S&P 500 is 0.05. The standard deviation of the stock market is 20 percent. What is the beta of YOHO?
1.25
What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by TC = (corporate tax rate) = 35 percent; TpE = personal tax rate on equity income = 30 percent; and Tp = personal tax rate on interest income = 20 percent.
1.76
Suppose you invest equal amounts in a portfolio with an expected return of 16 percent and a standard deviation of returns of 18 percent and a risk-free asset with an interest rate of 4 percent. Calculate the expected return on the resulting portfolio.
10%
Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; rD = 6%; rE = 12%; and TC = 30%. Calculate the after-tax weighted average cost of capital (WACC):
10.05%
Suppose the beta of Exxon-Mobil is 0.65, the risk-free rate is 4 percent, and the expected market rate of return is 14 percent. Calculate the expected rate of return on Exxon-Mobil.
10.5%
A firm has a total market value of $10 million while its debt has a market value of $4 million. What is the after-tax weighted average cost of capital if the before-tax cost of debt is 10 percent, the cost of equity is 15 percent, and the tax rate is 35 percent?
11.6%
Assume the following data: Risk-free rate = 4.0 percent; average risk premium = 7.7 percent. Calculate the required rate of return for the risky asset.
11.7%
Suppose the beta of Microsoft is 1.13, the risk-free rate is 3 percent, and the market risk premium is 8 percent. Calculate the expected return for Microsoft.
12.04%
A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be
13%
A firm's return on assets is 12 percent and the cost of the firm's debt is 7 percent. Given a 0.7 debt-equity-ratio, what is the levered cost of equity? Assume that there are no taxes.
15.5%
Stock A has an expected return of 10 percent per year and stock B has an expected return of 20 percent. If 40 percent of a portfolio's funds are invested in stock A and the rest in stock B, what is the expected return on the portfolio of stock A and stock B?
16%
The M&M Company is financed by $10 million in debt (market value) and $40 million in equity (market value). The cost of debt is 10 percent and the cost of equity is 20 percent. Calculate the weighted average cost of capital, assuming no taxes.
18%
Suppose the beta of Amazon is 2.2, the risk-free rate is 5.5 percent, and the market risk premium is 8 percent. Calculate the expected rate of return for Amazon.
23.1%
Suppose the beta of Amazon is 2.2, the risk-free rate is 5.5 percent, and the market risk premium is 8 percent. Calculate the expected rate of return for Amazon. Group of answer choices
23.1%
One would expect a stock with a beta of 1.25 to increase in returns
25% more than the market in up markets
If the average annual rate of return for common stocks is 11.7 percent, and 4.0 percent for U.S. Treasury bills, what is the average market risk premium?
7.7%
Given are the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50 percent debt and 50 percent equity. Calculate the after-tax weighted average cost of capital (WACC).
8%
The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5 percent and the cost of equity is 10 percent. Calculate the weighted average cost of capital. (Assume no taxes.)
8%
Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The marginal corporate tax rate is 35 percent.)
Investors paying personal tax of 35%
The total market value (V) of the securities of a firm that has both debt (D) and equity (E) is
V = D + E
MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as
VL = VU + (TC)(D)
Which of the following portfolios has the least risk?
a portfolio of Treasury bills
One should determine the after-tax weighted average cost of capital by
adding the weighted average after-tax cost of debt to the weighted average cost of equity
The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because
bankruptcy and its attendant costs are a disadvantage to debt, and the payment of personal taxes may offset the tax benefit of debt
If a stock were overpriced, it would plot
below the security market line
Capital structure is irrelevant if
capital markets are efficient, each investor can borrow/lend on the same terms as the firm, and there are no tax benefits to debt
As a provider of funds to a corporation, owning which of the following corporate securities will give you the most control rights?
common stock
Assume the following data for a stock: Beta = 0.9; risk-free rate = 4 percent; market rate of return = 14 percent; and expected rate of return on the stock = 13 percent. Then the stock is
correctly priced
A statistical measure of the degree to which securities' returns move together is called a
correlation coefficient
In order to find the present value of the tax shields provided by debt, the discount rate used is the
cost of debt
The cost of capital for a firm, rWACC, in a tax-free environment is
equal to the market value weighted average of the return on equity and the return on debt; equal to rA, the rate of return for that business risk class; and equal to the overall rate of return required on the levered firm
Unique risk is also called
firm-specific risk
The pecking order theory of capital structure implies that
firms prefer internal finance and firms prefer debt to equity when external financing is required
Compared to a firm with unlimited liability, the limited liability feature of common equity results in a
higher value to equityholders
The pecking order theory of capital structure predicts that
if two firms are equally profitable, the more readily growing firm will end up borrowing more, other things equal
Recently, which of the following sources of funds has played the greatest role in the financing of U.S. non-financial firms?
internal funds
Generally, non-financial U.S. corporations have financed their capital expenditures through
internally generated cash
Shares held by investors are known as
issued and outstanding
If a firm is financed with both debt and equity, the firm's equity is known as
levered equity
Beta is a measure of
market risk
If MM's Proposition I holds, minimizing the weighted average cost of capital (WACC) is the same as maximizing the
market value of the firm
Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to
meet interest and principal payments, which if not met can put the company into financial distress
According to the trade-off theory of capital structure,
optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress
Assume the following data for a stock: Beta = 1.5; risk-free rate = 4 percent; market rate of return = 12 percent; and expected rate of return on the stock = 15 percent. Then the stock is
overpriced
Which of the following portfolios will have the highest beta?
portfolio of U.S. common stocks
Which portfolio had the highest average annual return in real terms between 1900 and 2014?
portfolio of U.S. common stocks
Investments A and B both offer an expected rate of return of 12. The standard deviation of A is 30 percent and that of B is 20 percent. If an investor wishes to invest in either A or B, then the investor should
prefer B to A
Investments A and B both offer an expected rate of return of 12. The standard deviation of A is 30 percent and that of B is 20 percent. If an investor wishes to invest in either A or B, then the investor should Group of answer choices
prefer B to A
Investments B and C both have the same standard deviation of 20 percent and have the same correlation to the market portfolio. If the expected return on B is 15 percent and that of C is 18 percent, then the investors would
prefer C to B
Under the trade-off theory, how will a government loan guarantee impact financing?
prefer to issue debt
The trade-off theory of capital structure predicts that
safe firms should borrow more than risky
The graphical representation of the CAPM (capital asset pricing model) is called the
security market line
When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt
stay fixed, leaving more income to be distributed over fewer shares
What signal is sent to the market when a firm decides to issue new stock to raise capital?
stock price is too high
Market risk is also called: I) systematic risk II) undiversifiable risk III) firm-specific risk.
systematic risk & undiversifiable risk
MM Proposition II states that
the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage
The capital structure of the firm can be defined as
the firm's mix of different securities used to finance assets
Modigliani and Miller's Proposition I states that
the market value of any firm is independent of its capital structure
One would expect a stock with a beta of zero to have a rate of return equal to
the risk-free rate
In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then
the tax shield on debt is exactly offset by higher personal taxes paid on interest income
Assume the following data for a stock: Beta = 0.5; risk-free rate = 4 percent; market rate of return = 12 percent; and expected rate of return on the stock = 10 percent. Then the stock is
underpriced
The type of the risk that can be eliminated by diversification is called
unique risk
As the number of stocks in a portfolio is increased,
unique risk decreases and approaches zero
When a firm has no debt, then such a firm is known as a(n)
unlevered firm and all-equity firm
When financial distress is a possibility, the value of a levered firm is a function of the
value of the firm if all-equity-financed plus the present value of tax shield minus the present value o costs of financial distress
If a firm borrows $50 million for one year at an interest rate of 9 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.
$1.24 milion
If a firm borrows $50 million for one year at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 30 percent marginal corporate tax rate.
$1.36 million