fin22 2-4(2)

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

The market value of equity equals

(Market price) × (# of shares outstanding)

If an investor buys a portion (X) of the equity of a levered firm, then his/her payoff is

(X) × (profits - interest).

If an investor buys a portion (X) of both the debt and equity of a levered firm, then his/her payoff is

(X) × (profits)

The market value of equity equals

(market price) * (# of shares outstanding)

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

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

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%

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%

For each additional 1 percent change in market return, the return on a stock having a beta of 2.2 changes, on average, by

2.20 percent

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%

One would expect a stock with a beta of 1.25 to increase in returns

25% more than the market in up markets

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%

Which of the following is NOT a potential result from financial distress? A. Due to interest tax shields, the firm's effective tax rate is very low. B. Suppliers refuse to extend terms to the firm. C. Key employees leave the firm, fearing the firm won't last. D. The firm has difficulty issuing additional bonds.

A

The following are debts in disguise:

Accounts payable leases, and underfunded pensions

Market portfolio

All assets in economy, usually uses broad stock market index to represent market

The cost of capital for a firm, in a tax-free environment is: I) equal to the market value weighted average of the return on equity and the return on debt; II) equal to rA, the rate of return for that business risk class; III) equal to the overall rate of return required on the levered firm

All three

Information exchange ge

Allows estimation of expected rates of return

Payment mechanism

Allows individuals to make and receive payments quickly and safely over long distances

Pooling risk

Allows individuals to share risk, ex. insurance companies

On a graph with common stock returns on the y-axis and market returns on the x-axis, the slope of the regression line represents

Beta

In the case of Google, which has issued Class A and Class B shares,

Both classes of shares have the same cash-flow rights and both classes of shares have different control rights.

How do mutual funds raise money?

By selling shares to investors

Hence market value of company does not depend on

Capital structure

Borrowing and lending

Channels savings towards those who can best use them

As a provider of funds to a corporation, owning which of the following corporate securities will give you the most control rights?

Common Stock

Costs of financial distress

Costs arising from bankruptcy or distorted business decisions before bankruptcy

Beta =

Covariance with market / variance of market

Which of the following is not a potential result from financial distress?

Due to interest tax shields, the firm's effective tax rate is very low

Market risk

Economy-wide sources of risk that affect the overall stock market; also called "systemic risk"

Eurobonds are almost always denominated in euros.

False

If two investments offer the same expected return, then most investors would prefer the one with higher variance.

False

Issuing common stock drives up stock prices

False

Who, for the most part, holds common stock?

Financial intermediaries

Which of the following is not a sensible reason for a firm to rely on internal funds?

Financial markets interpret the issuance of equity unfavorably, Equity issues are generally expensive, and a new bond issue may drive the firm's debt ratio too high.

Firm A and Firm B are identical except that A is incorporated while B is an unlimited liability partnership. Both have assets worth $500,000 ($500K) funded with a debt ratio of 40%. Suppose that the assets suddenly become worthless, what is the maximum possible loss to the equityholders of each company?

Firm A: $300K; Firm B: $500K Recall the definition of limited liability: equity holders are only liable to the extent of their total equity investment. Firm A's equityholders can declare bankruptcy resulting in a maximum loss of their original $300K of equity. Firm B's equityholders cannot escape their debt position. Their equity position has deteriorated from $300K to -$200K, a loss of $500K.

According to pecking-order theory what do firms do id external financing is required

Firms issue the safest security first, debt is better than equity

When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to:

I) favor high-risk, high-return projects even if they have negative NPV;II) refuse to invest in low-risk, low-return projects with positive NPVs;III) delay the onset of bankruptcy as long as they can

How do preferred stock holders gain voting rights?

If corporation fails to pay dividend

The pecking order theory of capital structure predicts that

If two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal.

Which of the following are not usually regarded as investment funds?

Insurance companies

The main advantage of debt financing for a firm is that

Interest expenses are tax deductible

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%

Why does MM Proposition I not hold in the presence of corporate taxes?

Levered fires pay lower taxes when compared with identical unlettered firms

If a bond is junior or subordinated, it

Must give preference to senior creditors in the event of default

For a portfolio of N-stocks, the formula for portfolio variance contains

N(N - 1)/2 different covariance terms.

Theory that states adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends

Pecking-order theory

How do you firms raise funds?

Plowback profits, seek external financing (debt and equity)

When securities are sold by a firm, this is termed a(n):

Primary Issue

The following functions, provided by financial intermediaries, enable the smooth functioning of the economy:

Processing of payments, borrowing and lending, and pooling risks.

Financial intermediaries

Raise money from in vectors, provide financing

Shares repurchased =

Repurchase amount / share price

What is common stock?

Residual claim on assets and cash flow

Unique risk

Risk factors affecting only that firm; also called "diversifiable risk"

The trade-off theory of capital structure predicts that

Safe firms should borrow more than risky ones

Two classes of stock have

Same cash-flow right but different control rights

Beta

Sensitivity of stock's return on market portfolio

MMF invest in?

Short term safe securities

Standard deviation

Square root of variance; measures volatility

Trade-off theory

States that capital structure is based on trade-off between tax savings and distress costs of debt

Pecking-order theory

States that firms prefer to issue debt over equity if internal finances are insufficient

What signal is sent to the market when a firm decides to issue new stock to raise capital?

Stock price is too high

Stock price falling

Stock-for-debt exchange offer results

Stock price rising

Stock-for-debt exchange offers results

Diversification

Strategy designed to reduce risk by spreading the portfolio across many investments

Preferred stock

Takes priority over common stock when receiving dividends

After tax WACC

Tax benefit from interest-expense deductibility must include cost of funds

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.

If a firm is financed with both debt and equity, the firm's equity is known as

levered equity.

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.

The costs of financial distress depend on the

probability of financial distress and the magnitude of costs encountered if financial distress occurs.

A grant of authority allowing someone else to vote shares of stock that you own is called

proxy voting

Cost of debt formula

rd = r free + default spread

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 change in a firm's retained earnings is

The difference between the net income earned and the dividends paid during a year.

Diversification can reduce portfolio risk even in the case when correlations across stock returns equal zero.

True

LIBOR stands for London Interbank Offered Rate.

True

Portfolios that offer the highest expected return for a given variance (or standard deviation) are known as efficient portfolios.

True

Repurchasing shares increases stock price

True

The market price of the stock is not affected by the announcement.

True

The portfolio risk that cannot be eliminated by diversification is called market risk.

True

U.S. firms, in general, have been repurchasing shares and thus net equity issues have been negative.

True

Financial markets

Used to raise money through primary issues

No difference if firm borrows or individual shareholders borrow

When firm pays no taxes and capital markets function well

Which of the following portfolios has the least risk?

a portfolio of Treasury bills

If a stock were underpriced, it would plot

above the security market line.

Variance

average value of squared deviations from mean; measures volatility

For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta (bE) equals

bE = bA + (D/E) × [bA - bD]

If a stock were overpriced, it would plot

below the security market line