Finance Exam 2
Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.
$ 536.38
Delta Corporation has a bond issue outstanding with a 7% coupon, semiannual payments, and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.
$ 791.00
Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return.
$ 796.04
The Canning Company has been hard hit by increased competition. Analysts predict that earnings (and dividends) will decline at a rate of 5% annually into the foreseeable future. If Canning's last dividend (D0) was $2.00, and investors' required rate of return is 15%, what will be Canning's stock price in 3 years?
$ 8.15
A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. Its' yield to maturity is 6.53%. Assume that the yield to maturity remains constant for the next two years. What will be the price of the bond two years from today?
$ 964.61
Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond's price?
$1,101.58
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 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?
$1,105.69
Grossnickle Corporation issued 20-year, noncallable, 7.5% 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?
$1,232.15
Based on the corporate valuation model, Morgan Inc.'s total corporate value is $300 million. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share?
$14.00
Emerging Technologies Inc.'s total corporate value is $300 million according to the corporate valuation model. The balance sheet shows $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of Emerging Technologies Inc. stock's price per share?
$14.00
Chadmark Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Chadmark to begin paying dividends, with the first dividend of $0.75 coming 2 years from today. The dividend should grow rapidly, at a rate of 40% per year, during Years 3 and 4. After Year 4, the company should grow at a constant rate of 10% per year. If the required return on the stock is 16%, what is the value of the stock today?
$16.93
Some investors expect Endicott Industries to have an irregular dividend pattern for several years, and then to grow at a constant rate. Suppose Endicott has D0 = $2.00; no growth is expected for 2 years; then the expected growth rate is 8% for 2 years; and finally the growth rate is expected to be constant at 15% thereafter. If the required return is 20%, what will be the value of the stock?
$31.31
Stability Inc. has maintained a dividend rate of $4 per share for many years. The same rate is expected to be paid in future years. If investors require a 12% rate of return on similar investments, determine the present value of the company's stock.
$33.33
A stock is expected to pay a dividend of $2.25 at the end of the year (D1 = $2.25). The dividend is expected to grow at a constant rate of 4% a year. The stock has a required return of 11%. What is the expected price of the stock five years from today?
$39.11
Today is December 31, 2013. The following information applies to Harrison Corporation: After-tax operating income [EBIT(1 - T)] for 2014 is expected to be $950 million. The company's depreciation expense for 2014 is expected to be $190 million. The company's capital expenditures for 2014 are expected to be $380 million. No change is expected in the company's net operating working capital. The company's free cash flow is expected to grow at a constant rate of 4% per year. The company's cost of equity is 13%. The company's WACC is 9%. The market value of the company's debt is $5.2 billion. The company has no preferred stock. The company has 250 million shares of stock outstanding. Using the corporate valuation model, what should be the company's stock price today?
$40.00
You have been assigned the task of using the corporate, or free cash flow, model to estimate Petry Corporation's intrinsic value. The firm's WACC is 10.00%, its end-of-year free cash flow (FCF1) is expected to be $75.0 million, the FCFs are expected to grow at a constant rate of 5.00% a year in the future, the company has $200 million of long-term debt and preferred stock, and it has 30 million shares of common stock outstanding. What is the firm's estimated intrinsic value per share of common stock?
$43.33
Hidden Technologies Inc. (HTI) is expected to generate $75 million in free cash flow next year, and it is expected to grow at a constant rate of 6% per year. The firm has no debt or preferred stock and has a WACC of 9%. HTI has 50 million shares of stock outstanding. Using the corporate valuation model, what is the value of the company's stock per share?
$50.00
The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first dividend (D1) to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What is the current equilibrium stock price?
$8.75
The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first dividend (D1) to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What will Club's stock price be at the end of the first year ()?
$9.57
Assume that Steed & Associates' bonds have a par value of $1,000, mature in 8 years, and make an annual coupon interest payment of $65. If the market requires an interest rate of 8.2% on these bonds, what is the bond's price?
$903.04
Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?
.37%
What is the coefficient of variation of the expected dollar returns given the following distribution of returns?
0.6383
View each of the below-listed provisions that are often contained in bond indentures alone. Which of these provisions would tend to REDUCE the yield to maturity that investors would otherwise require on a newly issued bond? 1.Fixed assets are used as security for a bond. 2.A given bond is subordinated to other classes of debt. 3.The bond can be converted into the firm's common stock. 4.The bond has a sinking fund. 5.The bond has a call provision. 6.The indenture contains covenants that restrict the use of additional debt.
1, 3, 4, 6
Jan Middleton owns a 3-stock portfolio with a total investment value equal to $300,000. What is the weighted average beta of Jan's 3-stock portfolio?
1.0
You are managing a portfolio of 10 stocks that are held in equal dollar amounts. The current beta of the portfolio is 1.8, and the beta of Stock A is 2.0. If Stock A is sold and the proceeds are used to purchase a replacement stock, what does the beta of the replacement stock have to be to lower the portfolio beta to 1.7?
1.0
A stock has a required return of 12%. The risk-free rate is 6% and the market risk premium is 5%. What is the stock's beta coefficient?
1.20
The Apple Investment Fund has a total investment of $450 million in five stocks. What is the fund's overall, or weighted average, beta?
1.46
Assume that the real risk-free rate, r*, is 4% and that inflation is expected to be 7% in Year 1, 4% in Year 2, and 3% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 - MRP2?
1.5%
Lucas Laboratories' last dividend was $1.50. Its current equilibrium stock price is $15.75, and its expected growth rate is a constant 5%. If the stockholders' required rate of return is 15%, what is the expected dividend yield and expected capital gains yield for the coming year?
10%; 5%
Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising?
10.40%
Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?
10.44%
You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%. What is the nominal risk-free rate, rRF?
11%
Consider the following information for the Alachua Retirement Fund, with a total investment of $4 million. The market required rate of return is 12%, and the risk-free rate is 6%. What is its required rate of return?
11.01%
O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?
11.30%
You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?
11.33%
Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re?
11.50%
Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)?
11.77%
A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?
12.60%
If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what is rX, the required rate of return for Stock X?
12.8%
Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield?
13.05%
Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?
13.37%
Acme Products has a bond issue outstanding with 8 years remaining to maturity, a coupon rate of 10% with interest paid annually, and a par value of $1,000. If the current market price of the bond issue is $814.45, what is the yield to maturity, rd?
14%
Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of retained earnings, rs?
14%
If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what would rX be if investors expected the inflation rate to increase by 2 percentage points? Assume that investors' risk aversion has not changed.
14.8%
Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
2% 5.05-2.15-.90=2%
A Treasury bond that matures in 20 years has a yield of 8%. A 20-year corporate bond has a yield of 11%. Assume that the liquidity premium on the corporate bond is 1.0%. What is the default risk premium on the corporate bond?
2.00%
McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM)
2.62%
If all interest rates in the economy fall by 1%, which of the following bonds would have the greatest percentage increase in value?
20-year, zero coupon bond.
The Apple Investment Fund has a total investment of $450 million in five stocks. If the risk-free rate is 12% and the market risk premium is 6%, what is the required rate of return on the Apple Fund?
20.76%
Stock A has a beta of 1.2, Stock B has a beta of 0.6, the expected rate of return on an average stock is 12%, and the risk-free rate of return is 7%. By how much does the required return on the riskier stock exceed the required return on the less risky stock?
3.00%
Taussig Corp.'s bonds currently sell for $1,150. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds?
4.20%
Helen's Pottery Co.'s stock recently paid a $1.50 dividend (D0 = $1.50). This dividend is expected to grow by 15% for the next 3 years, and then grow forever at a constant rate, g. The current stock price is $40.92. If rs = 10%, at what constant rate is the stock expected to grow following Year 3?
5%
Stock A has the following probability distribution of expected returns. What is Stock A's expected rate of return and standard deviation?
5.0%; 9.5%
To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
5.08%
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
5.14%
The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities?
5.7%
A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's current yield?
5.79%
Porter Inc.'s stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?
5.80%
The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 5-year Treasury securities?
6.2% 3%+3%+5%+5%+5%/5=4.2+2
Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?
6.20%
A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's yield to maturity, rd?
6.53%
Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,120. What is the bond's nominal yield to call?
6.53%
The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?
6.812%
Hanebury Manufacturing Company (HMC) has preferred stock outstanding with a par value of $50. The stock pays a quarterly dividend of $1.25 and has a current price of $71.43. What is the nominal annual rate of return on the preferred stock?
7%
A bond that matures in 8 years has a 10% coupon rate, semiannual payments, a face value of $1,000, and an 8.5% current yield. What is the bond's nominal yield to maturity (YTM)?
7.1%
Hanebury Manufacturing Company (HMC) has preferred stock outstanding with a par value of $50. The stock pays a quarterly dividend of $1.25 and has a current price of $71.43. What is the effective annual rate of return on the preferred stock?
7.19%
Interest rates on 4-year Treasury securities are currently 6.5%, while 6-year Treasury securities yield 6.8%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Use the geometric average to arrive at your answer.
7.4%
Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate?
7.40%
Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
7.70%
Carter's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return?
8.89%
Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?
9.00%
Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?
9.04%
Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?
9.08%
Hooper Printing, Inc. has a bond issue outstanding with 14 years left to maturity. The bond issue has a 7% annual coupon rate and a par value of $1,000, but due to changes in interest rates, each bond's value has fallen to $749.04. The capital gains yield earned by investors over the last year was 25.10%. What is the expected current yield for the next year on this bond issue?
9.35%
You have been managing a $3 million portfolio. The portfolio has a beta of 1.10 and a required rate of return of 10%. The current risk-free rate is 5.6%. Assume that you receive another $600,000. If you invest the money in a stock that has a beta of 0.60, what will be the required return on your $3.6 million portfolio?
9.67%
Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a −28% return. What is the firm's expected rate of return?
9.90%
Bond market data show the following information: The Treasury yield curve is downward sloping. Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT?
A 5-year corporate bond must have a higher yield than a 10-year Treasury bond
Of the following, identify the CORRECT statement.
A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate.
Which of the following would be most likely to lead to increases in nominal interest rates?
A new technology such as the Internet has just been introduced, and it increases investment opportunities
When stockholders assign their right to vote to another party, this is called
A proxy.
Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Accounts payable.
All else being equal, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par?
Adding a call provision
Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely:
Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
Which of the following statements is correct?
Both the SML and a company's position on it change over time due to changes in interest rates, investors' aversion to risk, and individual companies' betas.
Which of the following situations would be most likely to lead to an increase in interest rates in the economy?
Corporations step up their expansion plans and thus increase their demand for capital
If interest rates on 20-year Treasury and corporate bonds are as follows: T-Bond: 6.27% AAA:9.72% A:10.34% BBB: 11.42% Then differences in these rates were probably caused primarily by:
Default and liquidity risk differences.
Interest rates on 20-year Treasury and corporate bonds with different ratings, all noncallable, are as follows: T he differences in rates among these issues were most probably caused by:
Default and liquidity risk differences.
Assume interest rates on 30-year government and corporate bonds were as follows: T-bond = 7.72%; AAA = 8.72%; A = 9.64%; BBB = 10.18%. The differences in rates among these issues are caused primarily by:
Default risk differences.
A preemptive right gives stockholders the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.
False
A zero coupon bond pays no interest. It is offered at par value, which is where it sells initially. These bonds provide compensation to investors in the form of capital appreciation.
False
An investor using the DCF stock valuation model would assign a value based on the length of time he or she plans to hold the stock
False
As a general rule, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects. After all, most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
False
Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC.
False
If a stock has a beta of zero, it will be riskless when held in isolation.
False
If the appropriate rate of interest on a bond is greater than its coupon rate, the market value of that bond will be above par value.
False
If the debt ratio is 50%, the interest rate on new debt is 8%, the tax rate is 40%, and the current cost of equity is 16%, then an increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).
False
Of the many factors that affect the cost of money, one of the four most fundamental factors is the expected rate of inflation. A predictable correlation between inflation and interest rates is this: If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.
False
The "penalty" for having a low bond rating is less severe when the Security Market Line is relatively steep than when it is not so steep. True
False
There is a direct relationship between bond ratings and the required rate of return on bonds; that is, the higher the rating, the higher is the required rate of return.
False
To find the total return on a share of stock, find the dividend yield and subtract any commissions paid when the stock is purchased and sold.
False
We should expect to see interest rates decline if the federal deficit increased sharply from one year to the next, the Federal Reserve kept the money supply constant, and all other things held constant.
False
Which of the following statements is false? In all of the statements, assume that "other things are held constant."
For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.
Which of the following statements about interest rates is CORRECT, all other things held constant?
If expected inflation increases, interest rates are likely to increase.
Which of the following statements about the yield curve is CORRECT?
If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.
A noncallable 10-year T-bond has a 12% annual coupon, the yield curve is flat, and it has a10% yield to maturity. A 15-year noncallable T-bond has an 8% annual coupon, the yield curve is flat, and is has a 10% yield to maturity. Which of the following statements is CORRECT?
If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.
Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project.Now assume that the two companies merge and form a new company, New York Modern, Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock?
Increase the percentage of debt in the target capital structure.
Which of the following statements about bond price risk is CORRECT, assuming that all else is equal?
Long-term bonds have less reinvestment risk than short-term bonds.
Family Traditions Home Fashions would call its outstanding callable bonds if:
Market interest rates decline sharply.
Imagine that you see a yield curve for a current corporate bond that is upward sloping. What can you determine from this information?
Maturity risk premiums could help to explain the yield curve's upward slope.
Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:
Not buy the stock; it is overvalued by $3.00.
If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what would be the most likely effect on short-term securities' prices and interest rates? Assume that other factors are held constant.
Prices would decline and interest rates would rise.
The preemptive right is important to shareholders because it:
Protects the current shareholders against a dilution of their ownership interests.
Assume that a company's dividends are expected to grow at a rate of 25% per year for 5 years and then to slow down and to grow at a constant rate of 5% thereafter. The required (and expected) total return, rs, is expected to remain constant at 12%. Which of the following statements is correct?
Right now, it would be easier (require fewer calculations) to find the dividend yield expected in Year 7 than the dividend yield expected in Year 3.
Which of the following statements about sinking funds is CORRECT?
Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued.
Which of the following statements about stock classes is CORRECT?
Some classes of common stock are entitled to more votes per share than other classes.
Apply the pure expectations theory to the following: Assume that the real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future but that inflation is expected to increase steadily over the next 30 years, giving the Treasury yield curve an upward slope. You are considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity, both of which have the same default and liquidity risks. Again, assuming the pure expectations theory holds, which of these statements is CORRECT?
The 10-year corporate bond must have a higher yield than the 5-year corporate bond
If investors expected inflation to increase in the future, and they also became more risk averse, what could be said about the change in the Security Market Line (SML)?
The SML would shift up and the slope would increase.
The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
In a portfolio of three different stocks, which of the following could not be true?
The beta of the portfolio is less than the beta of each of the individual stocks.
Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted?
The company will take on too many high-risk projects and reject too many low-risk projects.
Which of the following statements could be true concerning the costs of debt and equity?
The cost of retained earnings for Firm A is less than its cost of debt. The cost of debt for Firm A is greater than the cost of equity for Firm B. The cost of retained earnings for Firm A is less than its cost of new outside equity. The cost of debt for Firm A is greater than the cost of equity for Firm A. Both statements b and c could be true.- CORRECT
Eagle Enterprises Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. On the other hand, Eagle Enterprises could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Eagle Enterprises would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par?
The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%.
Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.
Assume that the rate on a 1-year bond is now 6%. Investors expect 1-year rates to be 7% one year from now and then 8% two years from now. If the pure expectations theory holds, so that the maturity risk premium equals zero, which of the following statements would be CORRECT?
The interest rate today on a 3-year bond should be approximately 7%.
Which of the following assumptions would cause the constant growth stock valuation model to be invalid? The constant growth model is given below:
The required rate of return is less than the growth rate.
Reinvestment Risk
The risk that a decline in interest rates wild lead to a decline in income from a bond portfolio
Which of the following statements about bond markets is CORRECT?
The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond
Suppose that a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, the real risk-free rate is expected to remain constant at 3% in the future, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?
The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond.
"Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds.
True
A 20-year, annual coupon bond with one year left to maturity has the same price risk as a 10-year, annual coupon bond with one year left to maturity. Both bonds are of equal risk, have the same coupon rate, and the prices of the two bonds are equal.
True
A common provision in a bond indenture is a sinking fund. Sinking funds require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value.
True
A document that gives one party the authority to act for another party is a proxy. This includes the power to vote shares of common stock. Proxies can be important tools relating to control of firms.
True
A predictable correlation between the demand curve for funds and the supply curve is this: If the demand curve for funds increases but the supply curve remains constant, then the total amount of funds supplied and demanded increase and interest rates in general also increase.
True
An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant.
True
Because most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets, the relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders
True
Because stock has a residual claim rather than a contractual obligation, the cash flows associated with common stock are more difficult to estimate than those related to bonds.
True
Because they are based on investors' required returns, the component costs of capital are market-determined variables.
True
Classified stock is the differentiation of different shares of common stock. It gives companies a way to meet special needs such as when owners of a start-up firm need additional equity capital but do not want to relinquish voting control.
True
Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward.
True
If management is sure that the economy is at the peak of a boom and is about to enter a recession, a firm that needs to borrow money should probably use short-term rather than long-term debt.
True
In capital budgeting, the cost of capital should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.
True
In order to prevent dilution of control or dilution of value, shareholders use preemptive rights to purchase, on a pro rata basis, any new shares issued by the firm. True
True
Of the many factors that affect the cost of money, one of the four most fundamental factors is the availability of production opportunities and their expected rates of return. A predictable correlation between production opportunities and interest rates is this: If opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.
True
Of the many factors that affect the cost of money, one of the four most fundamental factors is the risk inherent in a given security. A predictable correlation between risk and required return is this: The higher the risk, the higher the security's required return, other things held constant.
True
One definition of "capital" is funds supplied to a firm by investors.
True
Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.
True
Suppose the Fed takes actions that lower expectations for inflation this year by 1 percentage point, but these same actions raise expectations for inflation in Years 2 and thereafter by 2 percentage points. Other things held constant, the yield curve becomes steeper.
True
The marginal investor determines the price at which a new issue of stock will trade when it is brought to market.
True
The type of classified stock where the shares are owned by the firm's founders is called founder's shares. With founders' shares, shareholders generally have more votes per share than with other classes of common stock.
True
To find the cost of perpetual preferred stock, divide the preferred's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.
True
To find the firm's total corporate value, discount projected free cash flows at the firm's weighted average cost of capital.
True
Two investors each hold a portfolio, which is their only asset. Mr. Luca's portfolio has a beta of minus 2.0, while Ms. Johnson's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then Mr. Luca and Ms. Johnson face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0.
True
When the U.S. economy is very strong, the Federal Reserve tends to take action to increase interest rates, but when the U.S. economy is weak, the Federal Reserve tends to decrease interest rates.
True
Of the following statements about default risk, which one is CORRECT?
Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act.
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)
Yes; the expected return is 2.5 percentage points higher than the cost of capital.
Bond
a long-term debt instrument
Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure.
re > rs > WACC > rd.
Price Risk
the risk of a decline in a bond price due to an increase in interest rates
