Finance exam 4 (just the last two chapters)

The Cost of Preferred Stock

-Some firms issue preferred stocks, which are usually just a small portion of the total capital of the firm. -Recall: -Preferred generally pays a constant dividend every period -Dividends are expected to be paid forever -Using Zero-Growth dividends model... P = D/R. -the cost of preferred stock: Rp=D/P0

The rate of return on the common stock of Flowers by Flo is expected to be 14% in a boom economy, 8% in a normal economy, and only 2% in a recessionary economy. The probabilities of these economic states are 20% for a boom, 70% for a normal economy, and 10% for a recession. What is the variance of the returns on the common stock of Flowers by Flo?

. E(r) = (.20 ´ .14) + (.70 ´ .08) + (.10 ´ .02) = .028 + .056 + .002 = .086Var = .20 ´ (.14 - .086)^2 + .70 ´ (.08 - .086)^2 + .10 ´ (.02 - .086)^2 = .0005832 + .0000252 + .0004356 = .001044

If it is a rainy summer this year, the stock of Umbrella Inc. is expected to return 10%. If the summer is dry, then Umbrella's stock is expected to only return 4%. The probability of a rainy summer is 60% while the probability of a dry summer is 40%. What is the variance of the returns on Umbrella Inc. stock?

0.000864 E(r) = (.60 ´ .10) + (.40 ´.04) = .06 + .016 = 0.076 Var = .60 ´ (.10 - .076)^2 + .40 ´ (.04 - .076)^2 = .0003456 + .0005184 = 0.000864

Fire Hydrant Pet Supply just paid its first annual dividend of $0.75 a share. The firm plans to increase the dividend by 2.9 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $16.90 per share?

7.47% RE = 0.77175/16.9 + .029 = .074666 RE = 7.47%

City Rentals has 44,000 shares of common stock outstanding at a market price of $32 a share. The common stock just paid a $1.50 annual dividend and has a dividend growth rate of 2.5 percent. There are 7,500 shares of $9 preferred stock outstanding at a market price of $72 a share. The outstanding bonds mature in 11 years, have a total face value of $825,000, a face value per bond of $1,000, and a market price of $989 each, and a pretax yield to maturity of 8.3 percent. The tax rate is 35 percent. What is the firm's weighted average cost of capital?

7.76% Common stock: 44,000 × $32 = $1,408,000 Preferred stock: 7,500 × $72 = $540,000 Debt: $989 / $1,000 × $825,000 = $815,925 Value = $1,408,000 + 540,000 + 815,925 = $2,763,925 RE = [($1.50 × 1.025) / $32] + .025 = .073047 Rp = $9 / $72= .125

Peter's Audio Shop has a cost of debt of 7%, a cost of common stock of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop?

9.14% Debt: $500,000 ´ 1.02 = $.51mPreferred: 40,000 ´ $34 = $1.36mCommon: 104,000 ´ $20 = $2.08mTotal = $.51m + $1.36m + $2.08m = $3.95m WACC=2.08/3.95*11% + 1.36/3.95*8% + 0.51/3.95*7%*(1-0.34) = 9.14%

Which of the following is the best example of a sunk cost?

Historical research and development costs.

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do which one of the following?

Reduce the portfolio's unique risks

Which of the following investment classes had the greatest variability in returns according to recent historical data?

Small U.S. Stocks

variance

Variance measures the dispersion of possible outcomes around the expected value

Which of the following statements is most correct?

When choosing between two investments that have the same level of risk return, investors prefer the investment with the higher return.

Spartans has 6.5 percent bonds outstanding that mature in 18 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $985 each. What is the firm's pretax cost of debt?

YTM = 3.32205 × 2 = 6.64%

Three years ago, the Fairchildress Co. issued 20-year, 7.75 percent semiannual coupon bonds at par. Today, the bonds are quoted at 102.6. What is this firm's pretax cost of debt?

YTM = 3.73865 × 2 = 7.48%

When compared to the straight-line depreciation method, MACRS has

a greater proportion of its depreciation early in the life of the asset

Which one of the following is the best example of unsystematic risk?

a warehouse fire

A firm's overall cost of capital is

a weighted average of the costs of capital from its financing methods.

An increase in which one of the following will increase the operating cash flow?

equipment depreciation

variance equation

p1(X1-E(X))^2 + p2(X2-E(X))^2 + p3(X3- E(X))^2

standard deviation

sqrt (Variance) = %

The preferred stock of Dolphin Pools pays an annual dividend of $5.25 a share and sells for $48 a share. What is the firm's cost of preferred stock?

10.94% Rp = $5.25 / $48 = .1094, or 10.94 percent

Healthy Snacks has a target capital structure of 60 percent common stock, 3 percent preferred stock, and 37 percent debt. Its cost of equity is 16.8 percent, the cost of preferred stock is 11.4 percent, and the pretax cost of debt is 8.3 percent. What is the company's WACC if the applicable tax rate is 34 percent?

12.45% WACC = .60(.168) + .03(.114) + .37(.083)(1 − .34) = .1245, or 12.45 percent

S&W has 21,000 shares of common stock outstanding at a price of $29 a share. It also has 2,000 shares of preferred stock outstanding at a price of $71 a share. The firm has 7 percent, 12-year bonds outstanding with a total market value of $386,000. The bonds are currently quoted at 100.6 percent of face and pay interest semiannually. What is the capital structure weight of the firm's preferred stock if the tax rate is 34 percent?

12.49% Common stock = 21,000 × $29 = $609,000 Preferred stock = 2,000 × $71 = $142,000 Debt = $386,000 Value = $609,000 + 142,000 + 386,000 = $1,137,000 Weight of preferred = $142,000 / $1,137,000 = .1249, or 12.49 percent

You are analyzing the cost of capital for a firm that is financed with $300 million of equity and $200 million of debt. The cost of debt is 9 percent, while the cost of equity is 19 percent. What is the overall cost of capital for the firm?

15% WACC = (200/500 * 0.09) + (300/500 *0.19) = 0.15

Blue Bell stock is expected to return 18.4 percent in a boom, 8.9 percent in a normal economy, and 1.2 percent in a recession. The probabilities of a boom, normal economy, and a recession are 6 percent, 92 percent, and 2 percent, respectively. What is the standard deviation of the returns on this stock?

2.54 percent Expected return = (.06 × .184) + (.92 × .089) + (.02 × .012) = 0.0932 Variance = .06(.184 − .0932)^2 + .92(.089 − .0932)^2 + .02(.012 − .0932)^2 = 0.00064277 Standard deviation = (0.00064277) 0.5 = 0.025353, or 2.54 percent

The WACC for PineApple Corp is 19.75 percent. The firm is financed with $75 million of equity and $25 million of debt. The cost of debt is 7 percent. What is the cost of equity for the firm?

24% XD = 25/100 = 0.25, XE = 75/100 = 0.75 WACC = XD *RD + XE* RE ==> .1975 = (0.25 * 0.07) + (0.75 * RE) ==> RE = 0.24

Zinga Corp. has a zero-coupon bond that trades for $680 and matures in 12.5 years. The tax rate is 21%. What is the yield to maturity of this bond?

3.13% PV = FV/(1 + i)t => i = (FV / PV)1/t - 1 So Kd=(1000/680) 1/12.5 - 1 = 3.133% Tax rate doesn't affect yield.

Santa clause Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share. The firm also has two bond issues outstanding. The first bond issue has a total face value of $230,000, pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value. The second bond issue consists of 5,000 bonds that are selling for $887 each. These bonds pay 6.5 percent interest annually and mature in eight years. The tax rate is 35 percent. What is the capital structure weight of the firm's debt?

57.93% Common stock = 87,000 × $39 = $3,393,000 Debt = (1.031 × $230,000) + (5,000 × $887) = $4,672,130 Weight of debt = $4,672,130 / ($3,393,000 + 4,672,130) = .5793, or 57.93 percent

You own a stock with the following expected returns given the various states of the economy. What is the stock expected return?

6.8% (15% ´ 18%) + (60% ´ 11%) + (25% ´ -10%) = 2.7% + 6.6% - 2.5% = 6.8%

KellyAnne Public Relations just paid an annual dividend of $1.27 on its common stock and increases its dividend by 3.4 percent annually. What is the rate of return on this stock if the current stock price is $38.56 a share?

6.81 percent RE = 1.27 *(1+0.034) /38.56 + .034 = 1.31318/38.56 + .034 RE = .068055 or 6.81%

Dee's Dress Emporium has 50,000 shares of common stock outstanding at a price of $27 a share. It also has 1000 shares of preferred stock outstanding at a price of $20 a share. There are 800 bonds outstanding that have a semiannual coupon payment of $25. The bonds mature in four years, have a face value of $1,000, and sell at 97 percent of par. What is the weight of the common stock?

62.91% Common stock = 50,000 × $27 = $1,350,000 Preferred stock = 1000 × $20 = $20,000 Debt = 800 × (.97 × $1,000) = $776,000 Value = $1,350,000 + 20,000 + 776,000 = $2,146,000 Weight of common stock = $1,350,000 / $2,146,000 = .6291, or 62.91 percent

The NuPress Valet Co. has an improved version of its hotel stand. The investment cost is expected to be $72 million and will return $13.5 million for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. The appropriate discount rate is

9.47% Weight for equity and debt is both 50%. (cash flow is of no use) WACC =50%* 9%*(1 - .34) + 50%*13% = 9.47%

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

A decrease in the probability of an economic boom

Kurt's Adventures, Inc. stock is quite cyclical. In a boom economy, the stock is expected to return 30% in comparison to 12% in a normal economy and a negative 20% in a recessionary period. The probability of a recession is 15%. There is a 30% chance of a boom economy. The remainder of the time, the economy will be at normal levels. What is the standard deviation of the returns on Kurt's Adventures, Inc. stock?

E(r) = (.30 ´ .30) + (.55 ´ .12) + (.15 ´ -.20) = .09 + .066 - .03 = .126Var = .30 ´ (.30 - .126)^2 + .55 ´ (.12 - .126)^2 + .15 ´ (-.20 - .126)^2 = .0090828 + .0000198 + .0159414 = .025044Std dev = Ö.025044 = .15825 = 15.83%

Midwest Fastener Supply stock is expected to return 16 percent in a booming economy, 12 percent in a normal economy, and −3 percent in a recession. The probabilities of an economic boom, normal state, or recession are 12 percent, 80 percent, and 8 percent, respectively. What is the expected rate of return on this stock?

E(r) = (0.12´ 0.16) + (0.80´ .12) + (0.08´ 0.03) = 11.28%

North Around, Inc. stock is expected to return 36 percent in a boom, 14 percent in a normal economy, and −75 percent in a recession. The probabilities of a boom, normal economy, and a recession are 2 percent, 93 percent, and 5 percent, respectively. What is the standard deviation of the returns on this stock?

Expected return = (.02 × .36) + (.93 × .14) + [.05 × (−.75)] = .0999 Variance = .02(.36 − .0999)^2 + .93(.14 − .0999)^2 + .05 (−.75 − .0999)^2 = .038965 Standard deviation = .038965^.5= .1974, or 19.74 percent

When using the cost of debt, the relevant number is the:

after-tax cost of debt since interest is tax deductible.

Which one of the following is the best example of unsystematic risk?

an oil tanker runs aground and spills its cargo

Old Town Industries has three divisions. Division X has been in existence the longest and has the most stable sales. Division Y has been in existence for five years and is slightly less risky than the overall firm. Division Z is the research and development side of the business. Given this, the firm should probably:

assign the highest cost of capital to Division Z because it is most likely the riskiest of the three divisions.

Unsystematic risk:

can be effectively eliminated through portfolio diversification.

. Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

cost of equity

The weighted average cost of capital is defined as the weighted average of a firm's:

cost of equity, cost of preferred, and its aftertax cost of debt.

An increase in a firm's tax rate will__________ if the firm has debt capital in its capital structure:

decrease the firm's WACC.

Total risk can be divided into:

systematic risk and unsystematic risk.

portfolio

the collection of assets an investor owns

When estimating the cost of debt for the firm, we are primarily interested in

the cost of long-term debt.

diversification

the investment in several different asset classes or sectors

Systematic risk is defined as:

the risk that affects a large number of assets.

Portfolio diversification eliminates

unsystematic risk.

Cost of Capital of a Project

•Firms do not issue public shares for individual projects. •What does a financial manager use in practice? •estimating the cost of capital for the firm as a whole •then using this cost of capital for new projects •with some adjustment •A real-world example of Ford Motor Co.

The cost of debt

•The cost of debt = the required return on a company's debt ₋Compute the yield to maturity on existing debt The cost of debt is NOT the coupon rate

Cost of Capital and Expected Return

•The cost to a firm for capital funding = the return to the providers of those funds ₋It is the required rate from an investor's perspective. ₋An asset's return depends on the asset's risk. ₋It is the appropriate discount rate.

Systematic/Market risk

₋Economy-wide sources of risk that affect the overall stock market, inherent in the market or economy. ₋Examples: business cycle, inflation shocks, and interest rates -non-diversifiable

Idiosyncratic/Unsystematic/Unique risk

₋Risk factors affecting only individual stocks or a small group of stocks (e.g. an industry) -Examples: lawsuits, strikes, technological innovations -diversifiable

Lesson from capital market history

₋There is a reward for bearing risk ₋The greater the potential reward, the greater the risk ₋This is called the risk-return trade-off