FIN 300 Quiz 2
Maxwell Mining Company's ore reserves are being depleted, so its sales are falling. Also, because its pit is getting deeper each year, its costs are rising. As a result, the company's earnings and dividends are declining at the constant rate of 6% per year. If D0 = $3 and rs 10% what is the value of Maxwell Mining's stock?
Constant growth rate (g) = -6% Required rate of return (rs) = 10% P0 = D0(1+g)/ rs -g Where P0 = Price/ value of stock today D0 = Dividends paid today D0 (1+g) = Expected value of dividends after 1 year g = growth rate P0 = D0(1+g)/ rs -g = $3( 1 + (-6%))/ 10% - (-6%)) = $3( 1 + (-0.06%))/ 10% - (-6%)) = $3( 1 + (-0.06%))/ 16% = $3(0.94)/ 0.16 = $2.82/ 0.16 = $17.63
Porter Inc's stock has an expected return of 12.50%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 2.00%, what is the market risk premium? Do not round your intermediate calculations. a.10.50% b.8.40% c.6.80% d.7.98% e.8.48%
Expected return = Risk-free rate + Beta(Market risk premium) Expected return: 12.50% Risk free rate: 2.00% Beta: 1.25 Market risk premium: 0.1250 = 0.0200 + 1.25(Market risk premium) 0.1250 - 0.0200 = 1.25(Market risk premium) 0.1050 = 1.25(Market risk premium) Market risk premium = 0.1050 / 1.25 Market risk premium = 0.0840 or 8.40%
A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. True False
False
Holtzman Clothiers's stock currently sells for $38.00 a share. It just paid a dividend of $2.00 a share (i.e., D0 = $2.00) The dividend is expected to grow at a constant rate of 5% a year. What stock price is expected 1 year from now? What is the required rate of return?
P0 = $38 D0 = $2 G = 5% constant a.) P1 = ? P1 = P0 *( 1 + g) P1 = 38 * ( 1 + 0.05) P1 = 39.9 b.) r = ? P0 = D0 * (1 + g)/ r -g 38 = 2 * ( 1 + 0.05)/ r - 0.05 38 = 2.10/ r - 0.05 38* (r - 0.05) = 2.10 38r -1.9 = 2.10 38r = 4 4/ 38r = 0.1053 0.105* 100 = 10.53%
Nesmith Corporation's outstanding bonds have a $1,000 par value, an 8% semiannual coupon, 14 years to maturity, and an 11% YTM. What is the bond's price? What would it be if this bond paid quarterly?
Par Value of Bond (FV) = $1,000 Interest/ Coupon Payment (INT) = $40 ($1,000 * (0.08/2 = $40) Market Rate or yield to maturity (r) = 11% Years to Maturity (t) = 14 years Number of compounding periods per year (n) = Semiannually N = 2 x 14 = 28 I/YR = 11%/2 = 5.5% PMT = (0.08/2) x 1,000 = 40 FV = 1000 CPT PV = 788.18 What would it be if this bond paid quarterly? N = 4 x 14 = 56 I/YR = 11%/4 = 2.75% PMT = (0.08/4) x 1,000 = 20 FV = 1000 CPT PV = $786.97 The number is less because you receive the money faster and you will pay more interest.
"Capital" is sometimes defined as funds supplied to a firm by investors. True False
True
According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. True False
True
For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. True False
True
If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. True False
True
One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant. True False
True
The risk that interest rates will decline, and that decline will lead to a decline in the income provided by a bond portfolio as interest and maturity payments are reinvested, is called "reinvestment rate risk." True False
True
The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk." True False
True
If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. True False
True as cost of debt = k*(1-t)as t increase cost decrease
A firm's bonds have a maturity of 8 years with a $1,000 face value, have an 11% semiannual coupon, are callable in 4 years at $1,154, and currently sell at a price of $1,283.09. What are their nominal yield to maturity and their nominal yield to call? What return should investors expect to earn on these bonds?
YTM N = 16 (8*2 = 16) PV = 1,283.09 PMT = -55 ($1,000 * (0.11/2) = $55) FV = -1,000 CPT I/Y = 3.21 YTM = 2 * 3.21 = 6.42% YTC: N = 8 (4*2 = 8) PV = 1,283.09 PMT = -55 ($1,000 * (0.11/2) = $55) FV = -1,154 CPT I/Y = 3.16% YTC = 2 * 3.16 = 6.32% FV and PMT must have the same sign, and PV with the opposite sign. Make sure that the formula is set to End for ordinary annuity. Since the YTC is less than the YTM, investors would expect the bonds to be called and to earn the YTC. (The bonds sell at a premium indicating that interest rates have declined since the bonds were issued; therefore, the bonds would likely be called if interest rates remain lower than the coupon rate.)
A share of common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investors' required rate of return is 14.2%, then what is the stock price? a.$10.66 b.$12.70 c.$12.10 d.$11.98 e.$14.61
d.$11.98 D1/ (r -g) D1 = D0(1 + g) D0 = 1 (last divided) R = 0.142 (required rate of return) G = 0.054 (growth rate) D0(1 + g)/ (r -g) = 1(1 + 0.054)/ ( 0.142 - 0.054) = 1.054/ 0.088 = 11.98
If D 1 = $1.25, g (which is constant) = 4.7%, and P 0 = $22.00, then what is the stock's expected dividend yield for the coming year? a.5.40% b.6.08% c.6.25% d.5.68% e.4.26%
d.5.68% D1 = Next years expected dividend P0 = Current Price D1 = $1.25 G = 4.7% P0 = $22.00 Dividend Yield = D1/ P0 Dividend Yield = 1.25/ 22 5.68%
Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.65%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds? a.0.86% b.1.34% c.1.20% d.1.10% e.1.22%
e. 1.22% T-bond yield= 5.30% Corporate yield= 6.65% LP, corporate bond only= 0.25% USE formula: rT-bond= r + IP + MRP + DRP + LP re-arrange because you are trying to find DRP: DRP= rCORP- rT-bond- LP 1.10% Or = 10 year corporate bond yield - 10 year T bonds yield - corporate bond's liquidity premium = 6.65% - 5.30% - 0.25% = 1.10%
According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. True False
False
Weston Corporation just paid a dividend of $1.00 a share (i.e., D0 = $1.00). The dividend is expected to grow 12% a year for the next 3 years and then at 5% a year thereafter. What is the expected dividend per share for each of the next 5 years?
D0 = $1 g1 = 12% for the next 3 years g2 = 5% for years 4 and 5 D1 = D0 * (1 + g1) D1 = 1 *( 1 + 0.12) = $1.12 or 1 * (1 + 0.12)^1 D2 = 1.12 (1 + 0.12) = 1.2544 or 1 *(1 + 0.12)^2 D3 = 1.2544 ( 1 + 0.12) = 1.404828 or 1 * (1 + 0.05)^3 D4 = 1.404828 ( 1 + 0.05) = 1.4751744 or 1 *(1 + 0.12)^3 * (1 + 0.05) D5= 1.4751744 ( 1 + 0.05) = 1.54893312 or 1 *(1 + 0.12)^3* ( 1 + 0.05)^2
For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm. True False
False
Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. True False
False
If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill. True False
False
One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant. True False
False
The corporate valuation model cannot be used unless a company pays dividends. True False
False
The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) the skill level of the economy's labor force. True False
False
The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions. True False
False
A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms. True False
False Beta of a stock measures its volatility with respect to the market risk.
The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. True False
False The statement is False that The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. When the marginal tax rate of a firm is increased then the othr factors are held constant.
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. True False
False To calculate the after-tax cost of debt, we need to use the interest rate (yield to maturity) on the bonds and marginal tax rate. Coupon rate is not used in the calculation of cost of debt. The formula for calculating after-tax cost of debt After-Tax Cost of Debt = Interest Rate or Yield to Maturity*(1-Marginal Tax Rate)
The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. True False
False because we use after tax cost of debt in the WACC as it is the true cost for WACC calculations. Effective after-tax cost of debt: After-tax cost of debt = Pre-tax cost of debt x (1 - Tax rate). Pre-tax cost of debt will be greater than the after-tax cost of debt.
The corporate valuation model can be used only when a company doesn't pay dividends. True False
False corporate valuation model can be used in both cases when company pay dividend and company does not pay dividend
An individual has $20,000 invested in a stock with a beta of 0.6 and another $75,000 invested in a stock with a beta of 2.5. If these are the only two investments in her portfolio, what is her portfolio's beta?
Investment Beta $20,000 0.6 75,000 2.5 Total $95,000 bp = ($20,000/$95,000)(0.6) + ($75,000/$95,000)(2.5) = 2.10.
Madsen Motors's bonds have 23 years remaining to maturity. Interest is paid annually; they have a $1,000 par value; the coupon interest rate is 9%; and the yield to maturity is 11%. What is the bond's current market price?
Par Value of Bond (FV) = $1,000 Interest/ Coupon Payments (INT) = $90 ($1,000 * 9% = $90) Market Rate or yield to maturity (r) = 11% Years to Maturity (t) = 23 years Number of Compounding Periods Per year (n) = Annually Set Calculator to End n = 23 (Maturity) PMT = 0.09*1000 = 90 (Coupon Interest Rate * Par Value = Coupon Payment) FV = 1000 (Par Value) R = 0.11 (Interest Rate or Yield) PV = (0.11,23,-90,-1000,0) = 834.67 is the bond's current market price
Jim Angel holds a $200,000 portfolio consisting of the following stocks: Stock Investment Beta A $50,000 1.20 B $50,000 0.80 C $50,000 1.00 D $50,000 1.20 Total $200,000 What is the portfolio's beta? Do not round your intermediate calculations. a. 1.040 b. 1.239 c. 0.809 d. 0.861 e. 1.050
Portfolio's beta = Weighted Average Beta Portfolio's beta = 50,000/200,000 * 1.20 = 0.30 50,000/200,000 * 0.80 = 0.20 50,000/200,000 * 1 = 0.25 50,000/200,000 * 1.20 = 0.30 0.30 + 0.20 + 0.25 + 0.30 = 1.050 Portfolio's beta = 1.050
Rebello's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return?
Quarterly Dividend is $1 Annual Dividend will be $4 ($1 *4) Preference share Price $55 Nominal cost of Preference Share = 4/55 = 7.27% Effective Annual Rate = (1 + r/n)^n-1 where r is the nominal rate that is 7.27% n is the number of compounding periods that is 4 EAR = (1 + 0.0727/ 4) ^ 4 -1 = 7.47% Therefore, the effective annual rate is 7.47%
The real risk-free rate is 2.25%. Inflation is expected to be 2.5% this year and 4.25% during the next 2 years. Assume that the maturity risk premium is zero. What is the yield on 2-year Treasury securities? What is the yield on 3-year Treasury securities?
Real Risk free rate (r*) = 2.25% Inflation premium (IP) = 2.5% (this year); 4.25% (next 2 years after this) Maturity risk premium (MRP) = 0% rT2 = ? rT3 = ? Tt = r* + IPt + MRP Average Inflation Rate for the next 2 years and 3 years Average inflation for the next 2 years (IP2) rT2 = r* + IP2/2 IP2 = (2.5% + 4.25%)/2 = 3.375%. Average inflation for the next 3 years (IP3) rT3 = r* + IP3/3 IP3 = (2.5% + 4.25% + 4.25%)/3 = 3.67%. The yield of the 2 year and 3 year treasury security Yield on 2 year treasury security (T2) Ts = r* + IP2 + MRP rT2 = 2.25% + 3.375% = 5.625%. Yield on 3 year treasury security (T3) T3 = r* + IP3 + MRP rT3 = 2.25% + 3.67% = 5.92%.
Stock A's stock has a beta of 1.30, and its required return is 13.75%. Stock B's beta is 0.80. If the risk-free rate is 2.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.) Do not round your intermediate calculations. a.10.66% b.11.33% c.9.52% d.9.33% e.8.57%
Required rate = Risk free rate + Beta of stock × (market risk premium) Required rate: 13.75 (Stock A) ? (Stock B) Risk free rate: 2.75% Beta: 1.30 (Stock A) and 0.80 (Stock B) Market risk premium: ? Stock A : 13.75% = 2.75% + 1.30(market risk premium) 0.1375 = 0.0275 + 1.30(market risk premium) 0.1375 - 0.0275 = 1.30(Market risk premium) 0.11 = 1.30(Market risk premium) Market risk premium = 0.11 / 1.30 Market risk premium = 0.084615 or 8.4615% Stock B: Required rate = 2.75% + 0.8 × 8.4615% = 0.0275 +( 0.8 × 0.084615) = 0.0275 + (0.067692) = 0.095192 = 9.52%
Consider the following information and then calculate the required rate of return for the Global Investment Fund, which holds 4 stocks. The market's required rate of return is 17.50%, the risk-free rate is 3.00%, and the Fund's assets are as follows ( Do not round your intermediate calculations.): Stock Investment Beta A $ 200,000 1.50 B 300,000 -0.50 C 500,000 1.25 D $1,000,000 0.75 a.14.76% b.15.18% c.15.46% d.13.35% e.14.06%
Required rate of return = risk free return + beta * (market return - risk free return) Risk free return: 3.00% Market return: 17.50 Beta: ? Required rate of return: ? Beta: 200,000/2,000,000* 1.50 = 0.15 300,000/2,000,000* -0.50 = -0.075 500,000/2,000,000* 1.25 = 0.3125 1,000,000/2,000,000* 0.75 = 0.375 0.15 + -0.075 + 0.3125 + 0.375 = 0.7625 Beta: 0.7625 = 0.03 + (0.7625 * (17.50 - 3)) = 0.03 + (0.7625 * 0.145) = 0.03 + 0.1106 =14.06
Carson Inc.'s manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.) Do not round your intermediate calculations. Economic Conditions Prob. Return Strong 30% 40.0% Normal 40% 10.0% Weak 30% -16.0% a.21.71% b.24.75% c.22.58% d.25.18% e.17.59%
Step 1: Expected return Strong: 0.30 * 0.40 = 0.12 Normal: 0.40 * 0.10 = 0.04 Weak: 0.30 * -0.16 = -0.048 0.12 + 0.04 + -0.048 = 0.112 or 11.2% Expected return: 11.2% Step 2: Expected return difference Strong: 40 - 11.2 = 28.8 Normal: 10 - 11.2 = -1.2 Weak: -16 - 11.2 = -27.2 Step 3: Expected return to the power of 2 Strong: (28.2)^2 = 829.44 Normal: (-1.2)^2 = 1.44 Weak: (-27.2 )^2 = 739.84 Step 4: Multiply prob by Expected return square Strong: 829.44 * 0.30 = 248.832 Normal: 1.44 * 0.40 = 0.576 Weak: 739.84 * 0.30 = 221.952 Step 5: Add all numbers and square 248.832 + 0.576 + 221.952 = 471.36 Square it __________ I 471.36 = 21.71
You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.8%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums: Inflation premium=3.25%. Liquidity premium=0.6%. Maturity risk premium=1.85%. Default risk premium=2.15%. On the basis of these data, what is the real risk-free rate of return?
The T - bill yield is equal to the risk free rate of return. This is a given assumption. Only the T - bill yield and inflation premium are relevant for this problem. T - bill Yield (Rrf) = 5.8% Rrf = r* + IP 5.8% = r* + 3.25% 5.8% - 3.25% = r* r = 2.55%
"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. True False
True
A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. True False
True
According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio. True False
True
An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal." True False
True
During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining. True False
True
The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. True False
True
The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities. True False
True
The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. True False
True
The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. True False
True When the firm is using more than one kind of source of fund an average cost of funds to the firm needs to be computed. This average cost is also weighted average cost of capital (WACC). Using this WACC firm investment decisions will be evaluated and decisions are taken thereupon.
Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC). True False
True the weighted average cost of capital decreases when the debt ratio is increased from 50% to 60%. In this question we would have to calculate the WACC before and after change in debt ratio Initially, the debt ratio is 50% and the remaining 50% will be the equity ratio After increasing the debt ratio to 60%, the equity ration will be 40% after change Equity Ratio: 50% Debt Ratio: 50% Cost Of Equity: 16% Cost Of Debt: 8% Tax Rate: 40% WACC (Before change) = (Equity ratio * Cost of equity) + (Debt ratio * Cost of debt * (1 - Tax rate)) = (50% * 16%) + (50% * 8% * (1 - 40%)) = 8% + 2.40% = 10.40% WACC (After change) = (Equity ratio * Cost of equity) + (Debt ratio * Cost of debt * (1 - Tax rate) = (40% * 16%) + (60% * 8% *(1 - 40%) = 6.40% + 2.88% = 9.28% From the above calculation it can be observed that the WACC has decreased by increasing the debt ratio
A bond has a $1,000 par value, 12 years to maturity, and an 8% annual coupon and sells for $980. a. What is its yield to maturity (YTM)? b. Assume that the yield to maturity remains constant for the next three years. What will the price be 3 years from today?
a. What is its yield to maturity (YTM)? Input in the financial calculator: FV = -1,000 PMT = 0.08 * 1,000 = -80 PV = 980 n = 12 CPT I/Y = 8.27% b. Assume that the yield to maturity remains constant for the next three years. What will the price be 3 years from today? N = 9 (12 -3) I/Y = 8.27 PMT = 80 (1,000 * 0.08) FV = 1,000 CPT PV = 983.32
An investor has two bonds in his portfolio that have a face value of $1,000 and pay an 11% annual coupon. Bond L matures in 12 years, while Bond S matures in 1 year. a. What will the value of each bond be if the going interest rate is 6%, 8%, and 12%? Assume that only one more interest payment is to be made on Bond S at its maturity and that 12 more payments are to be made on Bond L. b. Why does the longer-term bond's price vary more than the price of the shorter-term bond when interest rates change?
a. What will the value of each bond be if the going interest rate is 6%, 8%, and 12%? Assume that only one more interest payment is to be made on Bond S at its maturity and that 12 more payments are to be made on Bond L. Bond L Years = 12 Coupon = 110 (1,000 * 11% = 110) FV = 1,000 6% N = 12 I/Y = 6 PMT = -110 FV = -1,000 CPT PV = $1,419.19 8% N = 12 I/Y = 8 PMT = -110 FV = -1,000 CPT PV = $1,226.08 12% N = 12 I/Y = 12 PMT = -110 FV = -1,000 CPT PV = $938.06 Bond S Years = 1 Coupon = 110 (1,000 * 11% = 110) FV = 1,000 6% N = 1 I/Y = 6 PMT = -110 FV = -1,000 CPT PV = $1047.17 8% N = 1 I/Y = 8 PMT = -110 FV = -1,000 CPT PV = $1,027.78 12% N = 1 I/Y = 12 PMT = -110 FV = -1,000 CPT PV = $991.07 b. Why does the longer-term bond's price vary more than the price of the shorter-term bond when interest rates change? Long - term bonds have greater interest rate risk than do short - term bonds
Grossnickle Corporation issued 20-year, noncallable, 7.4% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity? a.$1,220.55 b.$1,281.57 c.$1,196.13 d.$1,000.85 e.$1,013.05
a.$1,220.55 Maturity: 19 years Face Value: $1,000 Coupon Rate: 7.4% Interest Rate: 5.5% N = 19 I/Y = 5.5 PV = ? PMT = 74 FV = 1,000 CPT PV = 1,220.55
Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for $29.00 per share. Goode's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D 0? a.$1.22 b.$1.37 c.$1.38 d.$0.95 e.$1.06
a.$1.22 P0 = $29.00 G = 7.00% R = 11.50% D0 = ? P0 = D0 * (1 + g)/ r -g 29 = D0 * (1 + 0.07)/ 0.1150 - 0.07 29 = D0 * (1.07) / 0.045 29 * 0.045 = D0 * 1.07 1.305 = D0 * 1.07 1.305/ 1.07 = D0 1.22 = D0
Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for $87.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D 1? a.$3.72 b.$3.90 c.$3.16 d.$2.79 e.$4.65
a.$3.72 P0 = D1/ r -g P0 = Price of Stock D1 = Estimated Dividend for Next Period R = Required Rate of Return G = Growth Rate 87.50 = D1/ 0.1025 - 0.06 87.50 = D1/ 0.0425 D1 = 87.50 * 0.0425 D1 = 3.72
Investors require an 8% rate of return on Mather Company's stock (i.e., rs 8%) a. What is its value if the previous dividend was D0 $1.25 and investors expect dividends to grow at a constant annual rate of (1) -2%, (2) 0%, (3) 3%, or (4) 5%? b. Using data from part a, what would the Gordon (constant growth) model value be if the required rate of return was 8% and the expected growth rate was (1) 8% or (2) 12%? Are these reasonable results? Explain. c. Is it reasonable to think that a constant growth stock could have g> rs ? Why or why not?
a.) r = 8% D0 = $1.25 G = -0.2%, 0%, 3%, 5% P0 = ? Po = Do (1 + g) /( r - g) (1) Po = Do (1 + g) /r - g) Where = r = 8% , g= -2% Po = 1.25(1 + 2%) / ( 8% - 2%) = 1.225 / 10% = $12.25 Po = 1.25(1 + 0%) / ( 8% - 0%) = 15.63 Po = 1.25(1 + 3%) / ( 8% - 3%) = 25.75 Po = 1.25(1 + 5%) / ( 8% - 5%) = 43.75 b.) r = 8% D0 = $1.25 G = 8%, 12% P0 = ? Po = Do (1 + g) /( r - g) Po = 1.25(1 + 8%) / ( 8% - 8%) = 1.25 (1 + 8%)/ 0 Undefined because you can't divide by 0 Po = 1.25(1 + 12%) / ( 8% - 12%) = $-35 Not reasonable because it is negative. c.) In order to be reasonable you need to have the required rate of return be greater than the growth rate. We would expect to earn a return greater than the dividend growth rate.
Kay Corporation's 5-year bonds yield 5.90% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds? a.0.20% b.0.23% c.0.25% d.0.19% e.0.17%
a.0.20% Risk Free rate (RF) = 2.5% Inflation premium (IP) = 1.5% Default risk premium (DRP) = 1.3% Maturity risk premium (MRP) = (t - 1) × 0.1% = (5 - 1) × 0.1% = 0.4% 5 year Year Bond yield = 5.9% 5-year T-bonds yield = 4.40% Liquidity Risk Premium (LP) for 5 year Bond yield is calculated below: Bond Yield = RF + IP + DRP + MRP + LP 5.90% = 2.5% + 1.5% + 1.3% + 0.4% + LP 5.90% = 5.7% + LP LP = 5.90% - 5.70% LP = 0.2% Hence, Liquidity Risk Premium for Kay's bonds is 0.2%.
Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 5.80%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 1.3% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds? a.1.80% b.1.51% c.1.46% d.2.12% e.2.00%
a.1.80% Risk Free rate (RF) = 2.50% Inflation premium (IP) = 1.50% Liquidity Risk Premium (LP) = 1.30% Default risk premium (DRP) = 0.40% 5 year Year Bond yield = 7.50% 5-year T-bonds yield = 5.80% Maturity risk premium (MRP) = ? MRP = rT.bond − r* − IP MRP = 5.80% - 2.5% - 1.5% MRP = 1.8%
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a.Accounts payable. b.Long-term debt. c.Retained earnings. d.Common stock. e.Preferred stock.
a.Accounts payable. Accounts payable is not a capital component when calculating the weighted average cost of capital for use in capital budgeting. Accounts payable are the outstanding amounts due on the invoice and bills one receives from vendors and service providers. it is an obligation which generates during the course of business for the short period of time and involve only the payment of invoice amount. where as WACC is basically the opportunity cost of investor which provides them the minimum required rate of return, which they can earn if they had not invested the fund in the business. it involves payment of principle amount as well as return and the investment is generally for the long term.
Which of the following statements is CORRECT? a.Its cost of retained earnings is the rate of return stockholders require on a firm's common stock. b.The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c.In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. d.We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. e.The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
a.Its cost of retained earnings is the rate of return stockholders require on a firm's common stock. So cost of retained earnings [Kr] is the minimum required return on firm's common stock. The cost of retained earnings is nothing but the external criterion which is equal to the Ke [ Cost of equity]. Practically speaking, Ke is more than the Kr due to the floatation cost involved in the process of issue of shares.
Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a.The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. b.The required rate of return will decline for stocks whose betas are less than 1.0. c.The required rate of return on the market, rM, will not change as a result of these changes. d.The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium. e.The required rate of return on a riskless bond will decline.
a.The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a.re > rs > WACC > rd. b.rd > re > rs > WACC. c.WACC > rd > rs > re. d.WACC > re > rs > rd.e.rs > re > rd > WACC.
a.re > rs > WACC > rd.
Ryngaert Inc. recently issued noncallable bonds that mature in 15 years. They have a par value of $1,000 and an annual coupon of 5.7%. If the current market interest rate is 7.0%, at what price should the bonds sell? a.$775.81 b.$881.60 c.$1,040.28 d.$802.25 e.$1,013.84
b.$881.60 Maturity: 15 years Face Value: $1,000 Coupon Rate: 5.70% Interest Rate: 7.00% N = 15 I/Y = 7.00 PV = ? PMT = 57 (0.057 * 1,000) FV = 1,000 CPT PV = 881.60
Which of the following statements is CORRECT? a.WACC calculations should be based on the before-tax costs of all the individual capital components. b.If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. c.An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. d.A change in a company's target capital structure cannot affect its WACC. e.Flotation costs associated with issuing new common stock normally reduce the WACC.
b.If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. Reason: With the increase in tax, the cost of debt will decrease which will decrease the WACC.
LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a.Project C, which is of above-average risk and has a return of 11%. b.Project B, which is of below-average risk and has a return of 8.5%. c.All of the projects should be accepted. d.Project A, which is of average risk and has a return of 9%. e.None of the projects should be accepted.
b.Project B, which is of below-average risk and has a return of 8.5%. Project B is accepted because required return is 8% and its return is 8.5%. A company should accept a project if it has a return greater thanthe weighted average cost of capital. This is because theproject has a higher return than the company needs. These aredesirable.Project A has too low a returnProject B has a return that is higher than the appropriate WACCProject C has too low a returnThe company should accept only project B, as it is the only projectwhose return is higher than the appropriate WACC
Which of the following statements is CORRECT? a.The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. b.There is an "opportunity cost" associated with using retained earnings, hence they are not "free." c.The WACC as used in capital budgeting would be simply the before-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. d.The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. e.The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
b.There is an "opportunity cost" associated with using retained earnings, hence they are not "free."
Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $57.50, what is its nominal (not effective) annual rate of return? a.7.03% b.8.56% c.5.84% d.6.96% e.6.75%
d.6.96% Annual Dividend = 1$ Quarterly = 4 Price of Stock = 57.50 Nominal Required Return = Annual Dividend/ Price of Stock = 1 * 4 / 57.50 = 4/ 57.50 = 0.695652174 or 6.96%
For a stock to be in equilibrium—that is, for there to be no long-term pressure for its price to change—the a.required return must equal the realized return in all periods. b.expected future return must be equal to the required return. c.expected future return must be less than the most recent past realized return. d.expected return must be equal to both the required future return and the past realized return. e.past realized return must be equal to the expected return during the same period.
b.expected future return must be equal to the required return. The Stock is considered in an equilibrium when the expected return is equal to the required return. The required return is the return that the stock needs to generate in accordance to it's beta and the expected return is the actual return that the share gives to the shareholders.
Kay Corporation's 5-year bonds yield 5.90% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds? a.0.23% b.0.19% c.0.20% d.0.17% e.0.25%
c. 0.20% Risk Free rate (RF) = 2.5% Inflation premium (IP) = 1.5% Default risk premium (DRP) = 1.3% Maturity risk premium (MRP) = (t - 1) × 0.1% = (5 - 1) × 0.1% = 0.4% 5 year Year Bond yield = 5.9% 5-year T-bonds yield = 4.40% Liquidity Risk Premium (LP) for 5 year Bond yield is calculated below: Bond Yield = RF + IP + DRP + MRP + LP 5.90% = 2.5% + 1.5% + 1.3% + 0.4% + LP 5.90% = 5.7% + LP LP = 5.90% - 5.70% LP = 0.2%
Which of the following statements is CORRECT, other things held constant? a.Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills. b.Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. c.If expected inflation increases, interest rates are likely to increase. d.If individuals increase their savings rate, interest rates are likely to increase. e.If companies have fewer good investment opportunities, interest rates are likely to increase.
c. If expected inflation increases, interest rates are likely to increase.
If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a.The yields on the two securities would be equal. b.It is impossible to tell without knowing the coupon rates of the bonds. c.The yield on a 10-year bond would be less than that on a 1-year bill. d.It is impossible to tell without knowing the relative risks of the two securities. e.The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium.
c. The yield on a 10-year bond would be less than that on a 1-year bill.
Which of the following statements is CORRECT? a.The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. b.The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. c.The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. d.The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity. e.The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.
c. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 10.7% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a.$874.74 b.$721.44 c.$901.80 d.$1,000.99 e.$910.81
c.$901.80 Maturity: 20 years Face Value: $1,000 Coupon Rate: 9.5% Interest Rate: 10.7% N = 40 (20 *2) semiannual I/Y = 5.35 (10.7/2) semiannual PV = ? PMT = 47.5 (0.095/2 = 0.0475 *1,000) FV = 1,000 CPT PV = 901.80
Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.45%. The real risk-free rate is r* = 2.80%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What inflation premium (IP) is built into 5-year bond yields? a.1.11% b.1.10% c.1.25% d.1.33% e.1.40%
c.1.25% Risk Free rate (RF) = 2.80% Default risk premium (DRP) = 1.00% Liquidity Risk Premium (LP) = 0.90% Maturity risk premium (MRP) = (t - 1) × 0.1% = (5 - 1) × 0.1% = 0.4% 5 year Year Bond yield = 6.35% 5-year T-bonds yield = 4.45% Inflation premium (IP) = ? Bond Yield = RF + IP + DRP + MRP + LP 6.35 = 2.80 + IP + 1.00 + 0.40 + 0.90 6.35 = 5.1 + IP IP = 6.25 - 5.1 IP = 1.40
If D 1 = $1.50, g (which is constant) = 2.1%, and P 0 = $56, then what is the stock's expected capital gains yield for the coming year? a.1.66% b.2.50% c.2.10% d.2.39% e.2.08%
c.2.10% D1 = 1.50 G = 2.10% P0 = $56 P1? P1 = P0 (1 + g) P1 = 56 (1 + 0.021) P1 = 56(1.021) P1 = 57.176 Stocks capital gain yield for the coming years = (P1 - P0/ P0) * 100 Capital Gains Yield = (57.176 - 56/ 56) * 100 = (1.176/ 56) * 100 = 2.1%
If D 0 = $1.75, g (which is constant) = 3.6%, and P 0 = $40.00, then what is the stock's expected total return for the coming year? a.7.48% b.9.92% c.8.13% d.6.42% e.7.64%
c.8.13% P0 = 40.00 D0 = 1.75 G = 3.6% R = ? P0 = D0 * (1 + g)/ r -g $40.00 = 1.75 ( 1 + 0.036) / r - 0.036 r - 0.036 = 1.75( 1.036) / 40 r - 0.036 = 1.813/ 40 r - 0.036 = 0.45325 r = 0.036 + 0.45325 r = 0.81325 or 8.13%
Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? a.If a stock's beta doubled, its required return under the CAPM would more than double. b.If a stock's beta doubled, its required return under the CAPM would also double. c.If a stock has a negative beta, its required return under the CAPM would be less than 5%. d.If a stock's beta were 1.0, its required return under the CAPM would be 5%. e.If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%.
c.If a stock has a negative beta, its required return under the CAPM would be less than 5%.
Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? a.The return on "the market" will increase. b.The return on "the market" will remain constant. c.The required return on a stock with a positive beta < 1.0 will decline. d.The required return on a stock with beta > 1.0 will increase. e.The required return on a stock with beta = 1.0 will not change.
c.The required return on a stock with a positive beta < 1.0 will decline.
Which of the following statements is CORRECT? a.Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. b.Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. c.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. d.If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. e.When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c.When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
Tresnan Brothers is expected to pay a $1.80 per share dividend at the end of the year (i.e., D1 5 $1.80). The dividend is expected to grow at a constant rate of 4% a year. The required rate of return on the stock, rs, is 10%. What is the stock's current value per share?
current stock value = dividend / (required rate of return - dividend growth rate) current stock value = $1.80 / (10% - 4%) = $1.80 / 6% = $30
Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a.Real risk-free rate differences. b.Tax effects. c.Inflation differences. d.Default and liquidity risk differences. e.Maturity risk differences.
d. Default and liquidity risk differences.
Dyl Inc.'s bonds currently sell for $870 and have a par value of $1,000. They pay a $65 annual coupon and have a 15-year maturity, but they can be called in 5 years at $1,100. What is their yield to maturity (YTM)? a.8.66% b.9.71% c.6.66% d.8.02% e.7.38%
d.8.02% Maturity: 15 years Face Value: $1,000 Coupon Payment: $65 Interest Rate: ? Present Value: $870 N = 15 PV = -870 PMT = 65 FV = 1,000 CPT I/Y = 8.02
If D 0 = $1.75, g (which is constant) = 3.6%, and P 0 = $40.00, then what is the stock's expected total return for the coming year? a.7.48% b.9.92% c.6.42% d.8.13% e.7.64%
d.8.13% P0 = 40 D0 = 1.75 G = 3.6% R = ? P0 = D0(1 + g) / (r -g) 40 = 1.75 ( 1 * 0.036) / (r - 0.036) 40 = 1.75 * 1.036/ (r - 0.036) 40 = 1.813/ (r - 0.036) r - 0.036 = 1.813/ 40 r - 0.036 = 0.45325 r = 0.45325 + 0.036 r = 0.81325 or 8.1325% or r = D0(1 + g)/ P0 + g r = 1.75(1 + 0.036)/ 40 + 0.036 r = 1.813/ 40 + 0.036 r = 0.81325 or D1 = D0(1 + g) 1.75(1 + 0.036) = 1.813 Total return = rs = D1/P0 + g 1.813/ 40 + 0.036 = 0.81325
You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.00%. The firm will not be issuing any new stock. What is its WACC? a.7.68% b.6.96% c.6.69% d.8.93% e.7.59%
d.8.93% The calculation of the Weighted Average Cost of Capital ( WAAC ) can be done using the following formula: Weighted Average Cost of Capital = (Cost of debt * Weight of debt) + (Cost of Preferred* Weight of Preferred) +( Cost of equity * weight of equity) Cost of debt = 6% Weight of debt = 40% Cost of Preferred = 7.50% Weight of Preferred = 15% Cost of equity or retained earnings = 12% Weight of equity = 45% Weighted Average Cost of Capital = (6%*40%) + (7.5%*15%) + (12%*45%) = 8.925%
Adams Enterprises' noncallable bonds currently sell for $910. They have a 15-year maturity, an annual coupon of $85, and a par value of $1,000. What is their yield to maturity? a.11.21% b.7.34% c.9.95% d.9.66% e.8.60%
d.9.66% Maturity: 15 years Face Value: $1,000 Coupon Payment: $85 Interest Rate: ? Present Value: $910 N = 15 PV = -910 PMT = 85 FV = 1,000 CPT I/Y =
A stock is expected to pay a year-end dividend of $2.00, i.e., D 1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, then which of the following statements is CORRECT? a.The company's current stock price is $20 .b.The company's expected capital gains yield is 5%. c.The constant growth model cannot be used because the growth rate is negative. d.The company's expected stock price at the beginning of next year is $9.50. e.The company's dividend yield 5 years from now is expected to be 10%.
d.The company's expected stock price at the beginning of next year is $9.50. D1 = 2.00 G = -0.05 R = 0.15 P0 = ? P0 = D1/ r -g P0 = 2/ 0.15 - (0.050) P0 = 2/ 0.20 P0 = 10 Growth rate next year 1- 0.05 = 0.95 10 * 0.95 = 9.5
For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a.The WACC exceeds the cost of equity. b.The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. c.The WACC is calculated on a before-tax basis. d.The cost of equity is always equal to or greater than the cost of debt. e.The cost of retained earnings typically exceeds the cost of new common stock.
d.The cost of equity is always equal to or greater than the cost of debt. WACC is the weighted average cost of capital. It is the rate that the company pays to the equity holders in return to finance its assets. The WACC rate is set according to the weights of the debt and equity of the firms If the capital structure is 50% debt and 50% equity, it will result in the increased cost of equity than the cost of debt The cost of equity will always be greater than the cost of debt because, the equity shareholders take more risk than the debt holders
Which of the following factors would be most likely to lead to an increase in nominal interest rates? a.Households reduce their consumption and increase their savings. b.The Federal Reserve decides to try to stimulate the economy. c.There is a decrease in expected inflation. d.The economy falls into a recession. e.A new technology like the Internet has just been introduced, and it increases investment opportunities.
e. A new technology like the Internet has just been introduced, and it increases investment opportunities.
Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT? a.In equilibrium, long-term rates must be equal to short-term rates. b.Consumer prices as measured by an index of inflation are expected to rise at a constant rate. c.An upward-sloping yield curve implies that future short-term rates are expected to decline. d.Inflation is expected to be zero. e.The maturity risk premium is assumed to be zero.
e. The maturity risk premium is assumed to be zero.
If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT? a.An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future. b.If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds. c.The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope. d.A 5-year T-bond would always yield less than a 10-year T-bond. e.The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
e. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
Which of the following statements is CORRECT? a.The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond. b.If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond. c.The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d.The real risk-free rate should increase if people expect inflation to increase. e.The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is r s = 10.5%, and the expected constant growth rate is g = 8.2%. What is the stock's current price? a.$38.80 b.$27.07 c.$29.02 d.$27.39 e.$32.61
e.$32.61 D1 = $0.75 G = 8.2% R = 10.5% P0 = 0 P0 = D1 / r -g P0 = 0.75 / (0.105 - 0.082) P0 = 0.75 / 0.023 P0 = 32.61
Kern Corporation's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.30%. The real risk-free rate is r* = 2.5%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds? a.1.64% b.1.19% c.1.06% d.1.32% e.1.40%
e.1.40% Risk Free rate (RF) = 2.50% Default risk premium (DRP) = 1.90% Liquidity Risk Premium (LP) = 1.30% Maturity risk premium (MRP) = (t - 1) × 0.1% = (5 - 1) × 0.1% = 0.4% 5 year Year Bond yield = 7.50% 5-year T-bonds yield = 4.30% Inflation premium (IP) = ? Bond Yield = RF + IP + DRP + MRP + LP 7.50 = 2.50 + IP + 1.90 + 0.40 + 1.30 7.50 = 6.1 + IP IP = 7.50 - 6.1 IP = 1.40
Koy Corporation's 5-year bonds yield 8.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds? a.2.12% b.2.18% c.2.48% d.2.16% e.2.10%
e.2.10% Risk Free rate (RF) = 3.00% Inflation premium (IP) = 1.75% Liquidity Risk Premium (LP) = 0.75% Maturity risk premium (MRP) = (t - 1) × 0.1% = (5 - 1) × 0.1% = 0.4% 5 year Year Bond yield = 8.00% 5-year T-bonds yield = 5.15% Default risk premium (DRP) = ? Bond Yield = RF + IP + DRP + MRP + LP 8.00 = 3.00 + 1.75 + DRP + 0.40 + 0.75 8.00 = 5.90 + DRP DRP = 8.00 - 5.90 DRP = 2.10
Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a.If a stock has a negative beta, its required return must also be negative. b.An index fund with beta = 1.0 should have a required return greater than 11%. c.An index fund with beta = 1.0 should have a required return less than 11%. d.If a stock's beta doubles, its required return must also double. e.An index fund with beta = 1.0 should have a required return of 11%.
e.An index fund with beta = 1.0 should have a required return of 11%. Calculation of the required rate of return using CAPM: Required rate of return = Risk free rate + beta x Market risk premium = 6% + 1 x 5% = 6% + 5% = 11%
Which of the following statements is CORRECT? a.For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. b.The WACC is calculated using before-tax costs for all components. c.Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d.The after-tax cost of debt usually exceeds the after-tax cost of equity. e.The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
e.The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. The weighted average cost of capital (WACC) is ALWAYS calculated using AFTER-tax costs for all components
Assume that the risk-free rate, r RF, increases but the market risk premium, (r M - r RF), declines with the net effect being that the overall required return on the market, r M, remains constant. Which of the following statements is CORRECT? a.The required return of all stocks will fall by the amount of the decline in the market risk premium. b.The required return of all stocks will increase by the amount of the increase in the risk-free rate. c.Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. d.The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. e.The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
e.The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
An increase in a firm's expected growth rate would cause its required rate of return to a.increase. b.decrease. c.fluctuate less than before. d.fluctuate more than before. e.possibly increase, possibly decrease, or possibly remain constant.
e.possibly increase, possibly decrease, or possibly remain constant.
The real risk-free rate is 2.5% and inflation is expected to be 2.75% for the next 2 years. A 2-year Treasury security yields 5.55%. What is the maturity risk premium for the 2-year security?
r* = 2.5% IP2 = 2.75% rT2 = 5.55% MRP2 = ? rT2 = r* + IP2 + MRP2 = 5.55% 5.55% = 2.5% + 2.75% + MRP2 5.55% = 5.25% + MRP2 5.55% = 5.25% = MRP2 MRP2 = 0.3%
A Treasury bond that matures in 10 years has a yield of 5.75%. A 10-year corporate bond has a yield of 8.75%. Assume that the liquidity premium on the corporate bond is 0.35%. What is the default risk premium on the corporate bond?
rT10 = 5.75% rC10 = 8.75% LP = 0.35% DRP = ? rC10 = 8.75% = r* + IP10 + DRP + 0.35% + MRP10. Because both bonds are 10-year bonds the inflation premium and maturity risk premium on both bonds are equal. The only difference between them is the liquidity and default risk premiums. rC10 = 8.75% = r* + IP10 + MRP10 + 0.35% + DRP. But we know from above that r* + IP10 + MRP10 = 5.75%; therefore, rC10 = 8.75% = 5.75% + 0.35% + DRP = 8.75% = 6.10% + DRP 2.65% = DRP.
