Corporate Finance Spring
9A - Two Sisters Dresses has net working capital of $43,800, net fixed assets of $232,400, net income of $43,900, and current liabilities of $51,300. The tax rate is 21 percent and the profit margin is 9.3 percent. How many dollars of sales are generated from every $1 in total assets? $1.44 $1.32 $1.73 $.97 $1.06
$1.44 The question how many dollars of sales are generated per dollar of total assets is total asset turnover. This is calculated by dividing total sales by total assets. In this case, we aren't given either total sales or total assets, but we have detail that can help us find them. Since profit margin = profit/sales and we have the level of profit and the margin, we can back into sales. 0.093 = 43,900/Sales. So sales = $472,043. Total assets would be current assets plus fixed assets. We don't know current assets, but we know that net working capital = CA-CL. So we know $43,800 = CA-$51,300. So, CA must be $95,100. Therefore total assets = $95,100 + $232,400 = $327,500. Sales / Assets = $472,043 / $327,500 = 1.44. We generate $1.44 in sales for every dollar of assets.
8A- The Montana Hills Co. has expected earnings before interest and taxes of $17,100, an unlevered cost of capital of 12.4 percent, and debt with both a book and face value of $25,000. The debt has an annual 6.2 percent coupon. If the tax rate is 21 percent, what is the value of the firm? $91,016 $137,903 $114,194 $106,667 $146,403
$114,194 The problem is asking us for the value of the firm. From MM we know that the value of a levered firm is the value of an unlevered firm plus the value of the tax shield. The formula is: Vl = ((EBIT x (1-Tc))/Ro)) + TcB So, EBIT of 17,100 x (1-.21) = 13,509 / .124 = 108,943.55 (this is Vu). The value of the tax shield is 25,000 x 0.21 = 5,250. Add these together and you get 114,193.55, which rounds to 114,194.
6A - Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.89 a share. ABC stock pays a quarterly dividend of $.10 a share. Today, you sold all your shares for $45.13 per share. What is the total amount of your capital gains on this investment? $1.24 $1.64 $40.00 $124.00 $164.00
$124.00
8B- The Winter Wear Company has expected earnings before interest and taxes of $3,800, an unlevered cost of capital of 15.4 percent and a tax rate of 22 percent. The company also has $2,600 of debt with a coupon rate of 5.7 percent. The debt is selling at par value. What is the value of this firm? $15,585 $19,819 $12,115 $12,055 $17,700
$19,819
8A- Juanita's Steak House has $12,000 of debt outstanding that is selling at 101.2 percent of par and has a coupon rate of 8 percent and a current yield of 7.91 percent. The tax rate is 21 percent. What is the present value of the tax shield on debt? $3,188 $3,887 $2,520 $2,500 $2,550
$2,520 Please watch the solution video to see the solution for this problem. The present value of the tax shield is TcB. In this case, that is (0.21) x (12,000) = $2,520.
6B - A year ago, you purchased 300 shares of New Tech stock at a price of $49.03 per share. The stock pays an annual dividend of $.10 per share. Today, you sold all your shares for $58.14 per share. What is your total dollar return on this investment? $2,755 $2,733 $2,703 $2,763 $3,006
$2,763
8A- The Wiz Co. owes $60 to its bondholders for the payment of principal and interest. The company expects to have a cash flow of $136 if the economy continues as it is but that cash flow will decrease to $54 if the economy enters a recession. Should the company ever face the real possibility of bankruptcy, it will incur legal and other fees of $30. What amount will the bondholders be paid in the case of a recession? $30 $60 $54 $24 $0
$24 This question requires you to understand that Bondholders will have first claim on the assets of the firm, but after the legal and other fees are paid. In the event of a recession, the cash flows will be $54 less the legal fees of $30. Once those are paid the remaining $24 will be paid to satisfy the debt obligations of the firm to the bondholders.
9B - Cado Industries has total debt of $6,800 and a debt-equity ratio of .36. What is the value of the total assets? $18,889 $24,480 $23,520 $25,689 $25,360
$25,689
8B- TL Company has outstanding debt of $50 that is due in one year. However, given the financial distress costs, the debtholders will only receive $40 if the firm does well and $15 if it does poorly. The probability the firm will do well is 60 percent with the 40 percent probability assigned to poor conditions. What is the current value of the debt if the discount rate is 8 percent? $27.78 $27.50 $30.00 $26.67 $28.40
$27.78
8B- Your firm has a bond issue with a face value of $250,000 outstanding. These bonds have a coupon rate of 7 percent, pay interest semiannually, and have a current market price equal to 103 percent of face value. What is the amount of the annual tax shield on debt given a tax rate of 21 percent? $3,675 $6,309 $4,500 $47,500 $52,500
$3,675
8B- You own 25 percent of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this closely held, all-equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm if you ignore taxes? $4.8 million $5.1 million $5.4 million $5.7 million $6.0 million
$6.0 million
8A- Thompson & Thomson is an all-equity firm that has 280,000 shares of stock outstanding. The company is in the process of borrowing $2.4 million at 5.5 percent interest to repurchase 75,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? $8,960,000 $9,240,000 $10,710,000 $12,500,000 $11,360,000
$8,960,000 If $2.4M will repurchase 75,000 shares, then we know the current price of the stock is $32/share. Since the value of the firm is the value of the debt (none) plus the value of the equity, we just need to calculate the value of the equity. The stock price is $32 and there are 280,000 shares outstanding. Multiply those together and you get $8,960,000.
9A - New Metals has depreciation of $28,300, interest expense of $11,400, EBIT of $62,700, a price-earnings ratio of 8.6, a profit margin of 7.2 percent, a tax rate of 21 percent, and 37,500 shares of stock outstanding. What is the market price per share? $13.48 $7.09 $9.29 $12.48 $10.92
$9.29 To find the share price for New Metals we know the P/E and the number of shares, so if we have the earnings per share, we can multiply by the P/E ratio to get the market price. The earnings for the company can be found starting with EBIT ($62,700) and subtracting interest expense ($11,400) to find taxable income of $51,300. To get net income or earnings, we must first deduct our taxes at a rate of 21%. We can either calculate the tax (0.21 x $51,300 = $10,773) and subtract it from taxable income to get $40,527, or we could just multiply the taxable income by (1-0.21) to get the same answer $40,527. This is the total earnings, dividing it by the number of shares (37,500) gives $1.08072 in earnings per share. That number times the P/E multiple or a P/E ratio of 8.6 gives us a share price of $9.29.
6B - Winslow, Inc., stock is currently selling for $40 a share. The stock has a dividend yield of 3.8 percent. How much dividend income will you receive per year if you purchase 600 shares of this stock? $152 $790 $329 $912 $1,053
$912
6B - The range of possible correlations between two securities is defined as: 0 to +1. 0 to −1. ≧ 0. ≦ 1. +1 to −1.
+1 to −1.
Correlation values and what they mean
---Correlation primer.... when two things have strong inverse relationship (one goes up when the other goes down and vise versa) then the correlation is very close to -1. ---When they move together (one goes up then so does the other and vise versa) then the correlation is closer to 1. ---0 means they're not correlated. Can't predict the movement of one by the movement of the other.
What is the order of who receives money first if a firm goes into liquidation (bankrupt)? -preferred stockholders -common stockholders -unsecured bondholders -secured bondholders
-secured bondholders -unsecured bondholders -preferred stockholders -common stockholders
6A - If the covariance of Stock A with Stock B is .20, then what is the covariance of Stock B with Stock A? .20 .80 −.20 4 −1.20
.20
8B- Bigelow has a levered cost of equity of 14.29 percent and a pretax cost of debt of 7.23 percent. The required return on the assets is 11 percent. What is the firm's debt-equity ratio based on MM Proposition II with no taxes? .67 .87 .72 .75 .81
.87
6A - The common stock of CTI has an expected return of 14.48 percent. The return on the market is 11.6 percent and the risk-free rate of return is 3.42 percent. What is the beta of this stock? .95 1.49 1.31 1.42 1.35
1.35
6B - Terry owns a stock that is expected to earn 8.7 percent in a booming economy, 9.2 percent in a normal economy, and 12.6 percent in a recessionary economy. Each economic state is equally likely to occur. What is his expected rate of return on this stock?
10.17
7A - Consolidated Construction has a beta of 0.7. The risk-free rate of return is 2.4 percent and the expected market return is 13.5 percent. What is Consolidated's cost of equity? (Rounded to two decimal place)
10.17 Cost of equity and return on that equity are the same and are calculated using the CAPM. CAPM = Rf + b(Rm-Rf). So, 2.4+0.7(13.5-2.4)=10.17.
6B - Today, you sold 300 shares of SLG stock and realized a total return of 12.5 percent. You purchased the shares one year ago at a price of $27.43 a share. You have received a total of $192 in dividends. What is your capital gains yield on this investment? 14.80 percent 9.39 percent 6.67 percent 10.17 percent 11.67 percent
10.17 percent
6A - Three years ago, you purchased a stock at a price of $33.48. The stock paid annual dividends of $.60 per share. Today, the stock is worth $35.20 per share. What is your holding period return? 10.03 percent 6.93 percent 10.51 percent 5.14 percent 6.59 percent
10.51
6A - Zelo stock has a beta of 1.23. The risk-free rate of return is 2.86 percent and the market rate of return is 11.47 percent. What is the amount of the risk premium on Zelo stock? 9.47 percent 12.60 percent 11.54 percent 10.59 percent 12.30 percent
10.59
9B - DL Motors has sales of $22,400, net income of $3,600, net fixed assets of $18,700, inventory of $2,800, and total current assets of $6,300. What is the common-size statement value of inventory? 10.07 percent 13.67 percent 11.20 percent 12.50 percent 9.84 percent
11.20 percent
8B- Anderson's Furniture Outlet has an unlevered cost of capital of 10.3 percent, a tax rate of 21 percent, and expected earnings before interest and taxes of $1,900. The company has $4,000 in bonds outstanding that have an annual coupon of 7 percent. If the bonds are selling at par, what is the cost of equity? 11.33 percent 9.34 percent 10.72 percent 9.99 percent 11.21 percent
11.21 percent
8B- A firm has a debt-equity ratio of 1, a cost of equity of 16 percent, and a cost of debt of 8 percent. If there are no taxes or other imperfections, what is its unlevered cost of equity? 8 percent 10 percent 12 percent 14 percent 16 percent
12 percent
8A- Rosita's has a cost of equity of 13.76 percent and a pretax cost of debt of 8.5 percent. The debt-equity ratio is .60 and the tax rate is 21 percent. What is Rosita's unlevered cost of capital? 11.83 percent 12.07 percent 13.97 percent 14.08 percent 14.60 percent
12.07 percent We can use the M&M II formula and solve for the unlevered cost of capital. In this case we must assume taxes since we are given a tax rate, and we are not told we can ignore taxes. Rs = Ro + (B/S)(Ro-Rb)(1-Tc). We know: 13.76=Ro + .6(Ro-8.5)(1-.21). Step 1: Combine .6 and (1-.21)... 13.76 = Ro + .474 Ro - 4.029 Step 2: Add 4.029 to both sides and gather terms... 17.789 = 1.474 Ro Step 3: Divide both sides by 1.474.... 12.0685, or rounded = 12.07 More Detail: This question gives you a tax rate and the elements necessary to calculate a firm's unlevered cost of equity (Ro). This would be a problem to use the formula like the one from question 7, but this time we are factoring in taxes. This is the formula for MM II with taxes and looks like this: RS = R0 + (B/S)×(1-TC)×(R0 - RB) The question gives you Rs, B/S, Tc and Rb, so input the known variables and solve for Ro. 13.76 = Ro + (.6)(1-.21)(Ro-8.5). I solve this for Ro and I get 12.0685%, rounding to two decimals, the answer is 12.07%.
6B - The stock of Big Joe's has a beta of 1.38 and an expected return of 16.26 percent. The risk-free rate of return is 3.42 percent. What is the expected return on the market? 7.60 percent 8.04 percent 9.30 percent 12.72 percent 12.16 percent
12.72 percent
6B - Zoom stock has a beta of 1.46. The risk-free rate of return is 3.07 percent and the market rate of return is 11.81 percent. What is the amount of the risk premium on Zoom stock? 8.09 percent 12.76 percent 9.59 percent 10.25 percent 17.24 percent
12.76 percent
8A- A firm has zero debt in its capital structure and has an overall cost of capital of 10 percent. The firm is considering a new capital structure with 60 percent debt at an interest rate of 8 percent. Assuming there are no taxes or other imperfections, what would be the cost of equity with the new capital structure? 9 percent 10 percent 13 percent 14 percent 11 percent
13 percent Please watch the solution video for a solution to this problem. Apply the MM II without taxes formula to find the levered cost of equity (Rs). The formula is Rs=Ro+(B/S)(Ro-Rb). Rs=0.10 + (.6/.4)(0.10-0.08) = 13%
7B - What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9 percent and the expected market return is 11.4 percent? 13.1 percent 10.8 percent 12.8 percent 14.4 percent 13.6 percent
13.1 percent
9B - Southern Foods has net income of $39,900, net sales of $318,600, total assets of $663,000, common stock of $106,800 with a par value of $1 per share, and retained earnings of $224,400. The stock has a market value of $5.45 per share. What is the price-earnings ratio? 17.12 19.94 12.82 14.59 16.64
14.59
8B- Wild Flowers Express has a debt-equity ratio of .60. The pretax cost of debt is 9 percent while the unlevered cost of capital is 14 percent. What is the cost of equity if the tax rate is 23 percent? 7.52 percent 8.78 percent 16.31 percent 16.83 percent 17.30 percent
16.31 percent
7B - Consolidated Construction has a beta of 1.3. The risk-free rate of return is 2.7 percent and the expected market return is 14.2 percent. What is Consolidated's cost of equity?
17.65
8A- A firm has a debt-equity ratio of .55 with a cost of debt of 6.7 percent. If it had no debt, its cost of equity would be 14.5 percent. What is its levered cost of equity assuming there are no taxes or other imperfections? 18.96 percent 15.82 percent 17.94 percent 18.79 percent 13.67 percent
18.79 percent Because this question tells us there are no taxes or other market imperfections, we can use the M&M II formula without taxes to calculate the cost of equity with the specified level of leverage. In this case, the formula is: Rs=Ro + (B/S)(Ro-Rb). Rs = 14.5 + .55(14.5-6.7) Rs = 18.79 More Detail: Question 7 is asking you for the levered cost of equity assuming no taxes or market imperfections. This is what MM II without taxes is about. That view tells us that the cost of equity rises as leverage (debt) increases because the risk to equity rises with leverage. The formula derived in the text (pp. 494-497) and in the second lecture of module 8 should be applied. I give you an example calculation in the lecture video as well. The formula is: Rs = Ro + (B/S)(Ro-Rb) Where: Rs = return on (levered) equity (cost of equity) R0 = return on unlevered equity (cost of capital) RB = interest rate (cost of debt) B = value of debt (Bond = Debt) S = value of levered equity (Stock = Equity) (B/S = the debt to equity ratio of the firm) Since the problem tells you B/S = 0.55, Rb= 6.7%, and Ro = 14.5%, you just calculate what the levered cost of equity (Rs) is 18.79%.
9A - Weston's has sales of $38,900, net income of $2,400, total assets of $43,100, and total equity of $24,700. Interest expense is $830. What is the common-size statement value of the interest expense? 2.13 percent 3.08 percent 1.93 percent 2.49 percent 3.46 percent
2.13 percent For a common size income statement, each element of the income statement is expressed as a percentage of revenue (or sales). In this case the revenue is $38,900. So interest expense ($830) divided by sales is 830/38,900=0.0213 or 2.13 percent.
7B - Acme Inc has debt outstanding with a coupon rate of 5 percent and a yield to maturity of 3.8 percent. What is the after-tax cost of debt if the tax rate is 21 percent? Assume all interest is tax deductible.
3
6A - You recently purchased a stock that is expected to earn 12.6 percent in a booming economy, 8.9 percent in a normal economy, and lose 5.2 percent in a recessionary economy. Each economic state is equally likely to occur. What is your expected rate of return on this stock?
5.4
7A - Acme Inc has debt outstanding with a coupon rate of 4 percent and a yield to maturity of 7.2 percent. What is the after-tax cost of debt if the tax rate is 21 percent? Assume all interest is tax deductible. (Rounded to two decimal place)
5.69 The pre-tax cost of debt is the bond's YTM. We know that is 7.2% from the problem statement. The after-tax cost of debt (which is used in the WACC formula) reflects the fact that the interest payments provide a tax benefit because they are deductible. So the interest does not cost the firm 7.2%, once we factor in the tax benefits it is something less. This is just like the fact that when mortgage interest is tax deductible, you don't acutally pay the full interest rate. The AFTER-TAX cost of debt = pre-tax cost of debt x (1-tax rate). In this case, 7.2 x (1-.21) = 5.6880. Rounded to two decimals, the answer is 5.69.
9B - Flo's Restaurant has sales of $418,000, total equity of $224,400, a tax rate of 23 percent, a debt-equity ratio of .37, and a profit margin of 5.1 percent. What is the return on assets? 6.93 percent 9.50 percent 11.08 percent 7.13 percent 13.13 percent
6.93 percent
9A - Catherine's Consulting paid dividends of $3,300 and total equity of $39,450. The debt-equity ratio is 1 and the plowback ratio is 40 percent. What is the return on assets? 6.24 percent 6.09 percent 7.23 percent 6.97 percent 5.72 percent
6.97 percent To get the return on assets, I need to divide net income by the total assets. However, the problem provides neither of these. We must find net income by realizing that if we are given the addition to retained earnings or dividends along with the plowback or payout ratio, we can derive NI. In this case the plowback ratio = 1 - dividends / NI. So, 0.40 = 1 - (3,300 / NI) --> -0.6 x NI = -3300 or NI = $5,500. I don't have total assets, but I know that D+E = Total assets and I know that the amount of debt and equity are equal (the D/E ratio is 1). Since equity is $39,450, I know that debt is also $39,450 ( 1 = D/$39,450, so D=$39,450). Therefore, total assets is $78,900. ROA = $5,500 / $78,900 = 0.06970849 or 6.97 percent.
7B - Jack's Construction Co. has 70 bonds outstanding that are selling at their par value of $1,000 each. Bonds with similar characteristics are yielding a pretax 8.2 percent return. The firm also has 4,500 shares of common stock outstanding. The stock has a beta of 1.3 and sells for $50 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 11 percent, and the firm's tax rate is 26 percent. Assuming its earnings are sufficient to classify all interest as a tax deductible, What is the pre-tax cost of debt? What is the weighting for debt? What is the after-tax cost of debt? What is the cost of equity? What is the weighting for equity? What is the WACC?
8.2% 23.73% 6.07% 18.3% 76.27% 15.4%
7A - Jack's Construction Co. has 80 bonds outstanding that are selling at their par value of $1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent return. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. Assuming its earnings are sufficient to classify all interest as tax deductible, What is the pre-tax cost of debt? What is the weighting for debt? What is the after-tax cost of debt? What is the cost of equity? What is the weighting for equity? What is the WACC?
8.6% 33.33% 6.79% 12.8% 66.66% 10.8%
6A - Eight months ago, you purchased 400 shares of Winston stock at a price of $46.40 a share. The company pays quarterly dividends of $1.05 a share. Today, you sold all your shares for $48.30 a share. What is your total percentage return on this investment? 10.12 percent 4.09 percent 8.62 percent 12.08 percent 7.34 percent
8.62
7B - The Shoe Box pays an annual dividend of $3.80 on its preferred stock. What is the cost of preferred if the stock currently sells for $42.70 a share and the tax rate is 21 percent? 7.94 percent 11.87 percent 6.68 percent 9.39 percent 8.90 percent
8.90 percent
8A- Aspen's Distributors has a levered cost of equity of 13.84 percent and an unlevered cost of capital of 12.5 percent. The company has $5,000 in debt that is selling at par. The levered value of the firm is $14,600 and the tax rate is 25 percent. What is the pretax cost of debt? 7.92 percent 9.07 percent 8.16 percent 8.84 percent 9.00 percent
9.07 percent Please watch the solution video for the solution to this problem. Since this is asking the pre-tax cost of debt (Rb) and we are given a tax rate and we are not told we can ignore taxes, we should solve the question using MM II with taxes. Rs=Ro + (B/S)(Ro-Rb)(1-Tc). 13.84 = 12.5 + (5,000/14,600-5,000)x(1-.25)x(12.5-Rb) Note, the term B/S is the debt-equity ratio. We know the value of the debt and the value of the firm, so we must derive the value of the equity by subtracting the value of the debt from the total value. Answer: 9.07%.
7A - Consolidated Transfer is an all-equity financed firm. The beta is .75, the market risk premium is 7.78 percent, and the risk-free rate is 3.84 percent. What is the expected rate of return on this stock? 6.80 percent 8.22 percent 9.54 percent 9.68 percent 8.46 percent
9.68 percent The expected return is found using the CAPM model and formula. It is = Rf + b(Rm-Rf). The term (Rm-Rf) is also referred to as the market risk premium. In this case we are not given Rm (though we could calculate it), but instead we are given the market risk premium (Rm-Rf). So, the expected return on the stock is 3.84 + .75(7.78) = 9.6750 which rounds to 9.68.
What is a pro forma statement?
A hypothetical statement. A "what if" statement, that can be helpful for planning the future.
Arithmetic average vs. Geometric average
Arithmetic average ---return earned in an average period over a particular period ---overly optimistic for long horizons ---e.g. same as AVERAGE excel function Geometric average ---Average compound return per year over a particular period ---overly pessimistic for short horizons ---always less than arithmetic average unless returns are the same in all periods -arithmetic average says in the average year I've earned 10%. Geometric says that over the time period I've earned a compound annual return of 9.58%. -example: started with $100, ended with $100. Lost 50% first year, made 100% second year. 0% average return would be geometric. 25% average return would be arithmetic. -geometric useful for describing historical investments, arithmetic is useful for making estimates of the future.
6B - Which one of these is a measure of the interrelationship between two securities? Covariance Duration Standard deviation Alpha Variance
Covariance
What is beta?
Beta is a measure of a stock's sensitivity to the market systematic risk. Beta of average securities on the market is 1. 1.5 means it is more sensitive to market, so if market moves, it moves more. Less than 1 means it moves less than market. Beta of 0 is risk-free rate. Beta with 1 is expected return on market.
Value of a firm is by definition the sum of the value of the debt and equity (V = B + S). What do B and S stand for?
Bonds and Stock.
We find the cost of equity using which formula?
CAPM. Cost of equity is the left side of this equation.
CAPM - what's it stand for and what is equation?
Capital Asset Pricing Model. -Rf + b(Rm-Rf) -return on risk-free asset + beta(return on market - return on risk-free asset) If beta is 0, then expected return is Rf. If beta is 1, then expected return is Rm.
9B - You would like to compare your firm's cost structure to that of your competitors. However, your competitors are much larger in size than your firm. Which one of these would best enable you to compare costs across your industry? Pro forma balance sheet Common-size income statement Statement of cash flows Pro forma income statement Common-size balance sheet
Common-size income statement
7B - When computing the weighted average cost of capital, which of these are adjusted for taxes? Cost of equity Cost of preferred stock Both the cost of equity and the cost of preferred stock The costs of debt and preferred stock Cost of debt
Cost of debt
8B- The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as: MM Proposition I with no tax. MM Proposition II with no tax. MM Proposition I with tax. MM Proposition II with tax. both MM I with and without tax.
MM Proposition I with no tax.
Market risk premium is the same as which portion of the CAPM? Stock risk premium is the same as which portion of CAPM?
Market risk premium is the same as (Rm - Rf) Stock risk premium is the same as b(Rm-Rf)
More leverage (debt) means (more/less) costs of financial distress?
More.
More leverage makes EPS (more/less) variable?
More. Lower low and higher high.
Can systematic risk be eliminated? If so, how?
No! Systematic risk can't be eliminated. Systematic risk is the minimum risk that exists across all stocks.
Dupont Identity Equation
ROE = PM * TAT * EM profit margin is measure of the firms operating efficiency - how well it controls costs total asset turnover is a measure of the firms asset use efficiency - how well it manages assets equity multiplier is a measure of the firms financial leverage
You need these three things to calculate the equity cost of capital.
Risk-free rate, market risk premium, beta.
Difference between standard deviation and variance?
Standard deviation is the square root of the variance.
What is the risk premium?
The Risk Premium is the added return (over and above the risk-free rate) resulting from bearing risk. You can calculate this based on the "risk-free" rate of treasury bills. e.g. the expected rate of return on small company stocks is 13.1%, and t bills is 3% or something like that, so you subtract, and say the risk is 10.1%.
6B - Which one of the following statements is correct concerning the expected rate of return on an individual stock given various states of the economy? The expected return is a geometric average where the probabilities of the economic states are used as the exponential powers. The expected return is an arithmetic average of the individual returns for each state of the economy. The expected return is a weighted average where the probabilities of the economic states are used as the weights. The expected return is equal to the summation of the values computed by dividing the expected return for each economic state by the probability of the state. As long as the total probabilities of the economic states equal 100 percent, then the expected return on the stock is a geometric average of the expected returns for each economic state.
The expected return is a weighted average where the probabilities of the economic states are used as the weights.
7A - Which one of these statements related to beta is correct? Firm betas have less error than industry betas. Firms should always rely on their own beta rather than their industry's beta. Beta is unaffected by a firm's capital structure. The sample size used to compute beta may be too small to yield a reliable result. Firm betas rarely vary over time.
The sample size used to compute beta may be too small to yield a reliable result.
6B - Which one of the following types of securities has tended to produce the lowest real rate of return for the period 1926 through 2017? U.S. Treasury bills Long-term government bonds Small-company stocks Large-company stocks Long-term corporate bonds
U.S. Treasury bills
Can unsystematic risk be eliminated? If so, how?
Yes, through diversification.
7A - The cost of capital used to compute the present value of a project should be the rate that can be earned on: the overall market portfolio. the sponsoring firm's return on assets. a financial asset of comparable risk. a riskless asset with a similar life span. the sponsoring firm's return on equity.
a financial asset of comparable risk.
9B - The sustainable growth rate will be equivalent to the internal growth rate when, and only when: a firm has no debt. the growth rate is positive. the plowback ratio is positive but less than 1. a firm has a debt-equity ratio equal to 1. the retention ratio is equal to 1.
a firm has no debt.
8B- MM Proposition II is the proposition that: supports the argument that the capital structure of a firm is irrelevant to the value of the firm. the cost of levered equity depends solely on the return on debt, the debt-equity ratio, and the tax rate. a firm's cost of equity capital is a positive linear function of the firm's capital structure. the cost of equity is equivalent to the required return on the total assets of a levered firm. the cost of debt is inversely related to a firm's debt-equity ratio.
a firm's cost of equity capital is a positive linear function of the firm's capital structure.
7A - Assume LK Metals is similar to its industry with one exception; it has low fixed costs relative to all other firms in that industry. Given this, you should expect LK Metals to have: a lower beta than its industry. the same beta as the industry but a lower beta than the other firms in the industry. a higher beta than its industry. a higher beta than the industry and all the firms within that industry. the same beta as the industry but a higher beta than the other firms in the industry.
a lower beta than its industry. Lower financial leverage would reduce the beta of the firm, all other elements assumed constant.
9B - Puffy's Pastries generates five cents of net income for every $1 in equity. Thus, Puffy's has ________ of 5 percent. a return on assets a profit margin a return on equity an EV multiple a price-earnings ratio
a return on equity
8A- Conflicts of interest between stockholders and bondholders are known as: trustee costs. financial distress costs. dealer costs. agency costs. underwriting costs.
agency costs.
Common size balance sheet vs common-size income statement
balance sheet: accounts as a percent of total assets income statement: line items as a percent of sales
What is capital gains yield?
capital gains yield = capital gains/initial investment
6B - The variance of a portfolio comprised of many securities is primarily dependent upon the: variances of the securities held within the portfolio. beta of the portfolio. portfolio's correlation with the market. covariance between the overall portfolio and the market. covariances between the individual securities.
covariances between the individual securities.
3 primary determinants of beta
cyclicality of revenues as business cycle fluctuates, revenues increase and decrease dramatically (e.g. retailers) high cyclicality means higher beta transportation and utility don't have high betas. Cyclicality is not the same as variability, e.g. movie studios can have high variability depending on successful or bad movie or flop. Doesn't mean this has a high beta. operating leverage High degree of fixed costs. increases beta financial leverage high level of debt in its capital structure
8A- Covenants restricting additional borrowings primarily protect the: shareholders' residual interests in the firm. debtholders from the added risk of dilution of their claims. debtholders from changes in market interest rates. managers by avoiding agency costs. shareholders from agency costs.
debtholders from the added risk of dilution of their claims.
8B- Assume that for the next two weeks, the bondholders of Western Markets have the option of exchanging their bonds for common shares of the firm's stock. As a result of these exchanges, you should expect the firm's debt-equity ratio to: decline and the stock's price to also decline. decline and the stock's price to remain constant. decline and the stock's price to increase. increase and the stock's price to increase. increase and the stock's price to remain constant.
decline and the stock's price to also decline.
What is dividend yield?
dividend yield = dividend/initial investment
7B - Comparing two otherwise equivalent firms, the beta of the common stock of the levered firm is ________ the beta of the common stock of the unlevered firm. roughly equivalent to significantly less than slightly less than greater than equal to
greater than
6A - Based on the period of 1926 through 2017, U.S. Treasury bills have produced annual rates of return that: ranged from −1 percent to +15 percent. ranged from −1 percent to +5 percent. were negative only during the Great Depression. have always been positive. never exceeded 6 percent.
have always been positive.
7B - A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project will: have the same level of risk as the firm's current operations. be financed solely with new debt and internal equity. be managed by the firm's current managers. be financed based on the firm's current debt-equity ratio. be financed solely with internal equity.
have the same level of risk as the firm's current operations.
8B- Assuming the interest on the debt is fully tax deductible, when firms issue more debt, the present value of the tax shield on debt ________ while the present value of the financial distress costs ________. decreases; decreases increases; increases decreases; remains constant decreases; increases increases; remains constant
increases; increases
7B - Companies will generally have a ________ beta if their: low; stock price is relatively low. high; sales are highly dependent on the market cycle. high; sales are growing at a steady rate of increase. high; sales are high compared to other firms in their industry. low; production costs are primarily fixed in nature.
high; sales are highly dependent on the market cycle.
8A- Studies have found that firms with large investments in tangible assets tend to have: higher financial distress costs than firms with comparable investments in intangible assets. zero debt. higher target debt-equity ratios than firms that primarily invest in intangible assets. the highest financial distress costs of any firm per dollar of debt. the same capital structure as firms that specialize in intangible asset investments.
higher target debt-equity ratios than firms that primarily invest in intangible assets.
High degree of fixed cost means (highly/lowly) leveraged, which means (high/low) beta. Variable costs drive a (high/low) beta.
highly; high; low
8A- In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of: taxes. the interest tax shield. the relationship between dividends and earnings per share. the effects of leverage on the cost of equity. homemade leverage.
homemade leverage.
8B- The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: homemade leverage. dividend recapture. the weighted average cost of capital. private debt placement. personal offset.
homemade leverage.
9B - The sustainable rate of growth for a firm can be increased by: decreasing the debt-equity ratio. decreasing the profit margin. increasing the dividend payout ratio. increasing the capital intensity ratio. increasing the total asset turnover.
increasing the total asset turnover.
Internal growth rate vs sustainable growth rate
internal growth rate tells us how much the firm can grow assets using retained earnings as the only source of financing. sustainable growth rate tells us how much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio
7A - The cost of preferred stock: should be adjusted for taxes when computing WACC. is ignored by all firms when computing WACC. is generally calculated using the overall firm's beta. is equal to the stock's dividend yield. is set equal to the pretax cost of debt since it is a fixed income security.
is equal to the stock's dividend yield.
6A - The expected return on a portfolio: can be greater than the expected return on the best performing security in the portfolio. can be less than the expected return on the worst performing security in the portfolio. is independent of the performance of the overall economy. is limited by the returns on the individual securities within the portfolio. is an arithmetic average of the returns of the individual securities when the weights of those securities are unequal.
is limited by the returns on the individual securities within the portfolio.
8A- MM Proposition I without taxes proposes that: the value of an unlevered firm exceeds that of a levered firm. there is one ideal capital structure for each firm. leverage does not affect the value of the firm. shareholder wealth is directly affected by the capital structure selected. the value of a levered firm exceeds that of an unlevered firm.
leverage does not affect the value of the firm.
8B- The reason that MM Proposition I without taxes does not hold in the presence of corporate taxation is because: levered firms pay less taxes compared with identical unlevered firms. bondholders require higher rates of return than stockholders do. earnings per share are no longer relevant with taxes. dividends become a tax shield. debt is more expensive than equity.
levered firms pay less taxes compared with identical unlevered firms.
9A - Ratios that measure a firm's ability to pay its bills over the short run without undue stress are known as: asset management ratios. long-term solvency measures. liquidity measures. profitability ratios. market value ratios.
liquidity measures.
6A - The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free asset is referred to as the: market rate of return. market risk premium. systematic return. total return. real rate of return.
market risk premium
9A - Enterprise value is based on the: market value of interest-bearing debt plus the market value of equity minus cash. book values of debt and assets, other than cash. market value of equity plus the book value of total debt minus cash. book value of debt plus the market value of equity. book values of debt and equity less cash.
market value of interest-bearing debt plus the market value of equity minus cash.
6B - When computing the expected return on a portfolio of stocks the portfolio weights are based on the: number of shares owned in each stock. price per share of each stock. market value of the total shares held in each stock. original amount invested in each stock. cost per share of each stock held.
market value of the total shares held in each stock.
6B - Another term that refers to the average rate of return is the: variance. standard deviation. real return. mean. histogram.
mean
9A - In the financial planning model, the external financing needed (EFN) as shown on a pro forma balance sheet is equal to the changes in assets: plus the changes in liabilities minus the changes in equity. minus the changes in both liabilities and equity. minus the changes in liabilities only. plus the changes in both liabilities and equity. minus the change in retained earnings.
minus the changes in both liabilities and equity.
8A- The firm's capital structure refers to the: mix of current and fixed assets a firm holds. amount of capital invested in the firm. amount of dividends a firm pays. mix of debt and equity used to finance the firm's assets. amount of cash versus receivables the firm holds.
mix of debt and equity used to finance the firm's assets.
6B - The standard deviation for a set of stock returns can be calculated as the: positive square root of the average return. average squared difference between the actual return and the average return. positive square root of the variance. average return divided by N minus one, where N is the number of returns. variance squared.
positive square root of the variance.
9A - The financial ratio measured as net income divided by sales is known as the firm's: profit margin. return on assets. return on equity. asset turnover. earnings before interest and taxes.
profit margin.
8B- According to MM Proposition II with no taxes, the: return on assets is determined by financial risk. required return on equity is a linear function of the firm's debt-equity ratio. cost of equity in inversely related to the firm's debt-equity ratio. cost of debt must equal the cost of equity. required return on assets exceeds the weighted average cost of capital.
required return on equity is a linear function of the firm's debt-equity ratio.
7B - If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the: return on the stock minus the risk-free rate. return on the market minus the risk-free rate. beta times the market risk premium. beta times the risk-free rate. market rate of return.
return on the market minus the risk-free rate.
8A- MM Proposition II with taxes: explains how a firm's WACC increases with the use of financial leverage. reveals how utilizing the tax shield on debt causes an increase in the value of a firm. supports the argument that business risk is determined by the capital structure employed by a firm. supports the argument that the cost of equity decreases as the debt-equity ratio increases. reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.
reveals how utilizing the tax shield on debt causes an increase in the value of a firm.
7B - A firm with cyclical earnings is characterized by: revenue patterns that vary with the business cycle. high levels of debt in its capital structure. high fixed costs. high costs per unit. low contribution margins.
revenue patterns that vary with the business cycle.
9B - The total asset turnover ratio measures the amount of: total assets needed for every $1 of sales. sales generated by every $1 in total assets. fixed assets required for every $1 of sales. net income generated by every $1 in total assets. net income that can be generated by every $1 of fixed assets.
sales generated by every $1 in total assets.
9A - The maximum rate at which a firm can grow while maintaining a constant debt-equity ratio is best defined by its: rate of return on assets. internal rate of growth. average historical rate of growth. rate of return on equity. sustainable rate of growth.
sustainable rate of growth.
6A - Risk that affects a large number of assets, each to a greater or lesser degree, is called ________ risk. idiosyncratic diversifiable systematic asset-specific total
systematic
8A- The tax savings of the firm derived from the deductibility of interest expense is called the: tax shield from debt. depreciable basis. financing umbrella. current yield. tax-loss carryback.
tax shield from debt.
8A- The unlevered cost of capital is: the cost of capital for a firm with no equity in its capital structure. the cost of capital for a firm with no debt in its capital structure. the interest tax shield times pretax net income. the cost of preferred stock for an all-equity firm. equal to the profit margin for a firm with some debt in its capital structure.
the cost of capital for a firm with no debt in its capital structure.
6A - The capital gains yield plus the dividend yield on a security is called the: variance of returns. geometric return. average period return. current yield. total return.
total return.
8B- A general rule for managers to follow is to set the firm's capital structure such that the firm's: size is maximized. value is maximized. bondholders are secured. suppliers of raw materials are satisfied. dividend payout is maximized.
value is maximized.
6A - The average squared difference between the actual return and the average return is called the: volatility return. variance. standard deviation. risk premium. excess return.
variance.
8B- The value of a firm is maximized when the: cost of equity is maximized. tax rate is zero. levered cost of capital is maximized. weighted average cost of capital is minimized. debt-equity ratio is minimized.
weighted average cost of capital is minimized.
What is the cost of debt on a bond?
yield to maturity
7A - The beta of debt is commonly considered to be: equal to the market beta. one-half of the equity beta. equal to the asset beta. zero. one.
zero.