FRl Midterm 2 chp 13,14 & 16

Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $42 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes. A. $35,910 B. $38,516 C. $42,000 D. $44,141 E. $45,020

A. $35,910 EBIT/9,000 = [EBIT - ($120,000 0.095)]/[9,000 - ($120,000/$42)]; EBIT = $35,910

. Highway Express has paid annual dividends of $1.16, $1.20, $1.25, $1.10, and $0.95 over the past five years respectively. What is the average dividend growth rate? A. -4.51 percent B. -3.60 percent C. 2.28 percent D. 2.47 percent E. 4.39 percent

A. -4.51 percent g = (0.034483 + 0.041667 - 0.12 - 0.136364)/4 = -4.51 percent

The returns on the common stock of New Image Products are quite cyclical. In a boom economy, the stock is expected to return 32 percent in comparison to 14 percent in a normal economy and a negative 28 percent in a recessionary period. The probability of a recession is 25 percent while the probability of a boom is 10 percent. What is the standard deviation of the returns on this stock? A. 19.94 percent B. 21.56 percent C. 25.83 percent D. 32.08 percent E. 39.77 percent

A. 19.94 percent E(r) = (0.10 0.32) + (0.65 0.14) + (0.25 -0.28) = 0.053 Var = 0.10 (0.32 - 0.053)2 + 0.65 (0.14 - 0.053)2 + 0.25 (-0.28 - 0.053)2 = 0.039771 Std dev = 0.039771 = 19.94 percent

Wind Power Systems has 20-year, semi-annual bonds outstanding with a 5 percent coupon. The face amount of each bond is $1,000. These bonds are currently selling for 114 percent of face value. What is the company's pre-tax cost of debt? A. 3.98 percent B. 4.42 percent C. 4.71 percent D. 5.36 percent E. 5.55 percent

A. 3.98 percent

You own the following portfolio of stocks. What is the portfolio weight of stock C? Stock # number of shares Price p/ Share A 500 $14 B 200 $23 C 600 $18 D 100 $47 A. 39.85 percent B. 42.86 percent C. 44.41 percent D. 48.09 percent E. 52.65 percent

A. 39.85 percent Portfolio weightC = (600 $18)/[(500 $14) + (200 $23) + (600 $18) + (100 $47)] = $10,800/$27,100 = 39.85 percent

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes. A. $1.46 B. $1.50 C. $1.67 D. $1.88 E. $1.94

B. $1.50 Number of shares repurchased = $30,000/$15 = 2,000 EBIT/5,000 = [EBIT - ($30,000 .0.10)]/(5,000 - 2,000); EBIT = $7,500 EPS = [$7,500 - ($30,000 0.10)]/(5,000 - 2,000); EPS = $1.50

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? A. $2.5 million B. $4.0 million C. $5.0 million D. $5.5 million E. $6.0 million

B. $4.0 million Firm value = 80,000 ($600,000/12,000) = $4 million

If the economy is normal, Charleston Freight stock is expected to return 15.7 percent. If the economy falls into a recession, the stock's return is projected at a negative 11.6 percent. The probability of a normal economy is 80 percent while the probability of a recession is 20 percent. What is the variance of the returns on this stock? A. 0.010346 B. 0.011925 C. 0.013420 D. 0.013927 E. 0.014315

B. 0.011925 E(r) = (0.80 0.157) + (0.20 -0.116) = 0.1024 Var = 0.80 (0.157 - 0.1024)2 + 0.20 (-0.116 - 0.1024)2 = 0.011925

Tidewater Fishing has a current beta of 1.48. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.60? A. 0.88 percent B. 1.07 percent C. 1.50 percent D. 2.10 percent E. 2.26 percent

B. 1.07 percent Increase in cost of equity = (1.60 - 1.48) 0.089 = 1.07 percent

You are comparing stock A to stock B. Given the following information, what is the difference in the expected returns of these two securities? State of Econ Prob state of Econ Rate of return if state ocr -Normal 45% 14% 17% -Recession 55% -22% -28% Stock A Stock B A. -0.85 percent B. 1.95 percent C. 2.05 percent D. 13.45 percent E. 13.55 percent

B. 1.95 percent E(r)A = (0.45 0.14) + (0.55 -0.22) = -5.80 percent E(r)B = (0.45 0.17) + (0.55 -0.28) = -7.75 percent Difference = -5.80 percent - (-7.75 percent) = 1.95 percent

. What is the standard deviation of the returns on a stock given the following information? State of Econ Prob State of Econ Rate Return If State ocrs -Boom 30% 15% -Normal 65% 12% -Recession 5% 6% A. 1.57 percent B. 2.03 percent C. 2.89 percent D. 3.42 percent E. 4.01 percent

B. 2.03 percent E(r) = (0.30 0.15) + (0.65 0.12) + (0.05 0.06) = 0.126 Var = 0.30 (0.15 - 0.126)2 + 0.65 (0.12 - 0.126)2 + 0.05 (0.06 - 0.126)2 = 0.000414 Std dev = 0.000414 = 2.03 percent

You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected return of 8.7 percent. Stock A has an expected return of 11.4 percent while stock B is expected to return 6.4 percent. What is the portfolio weight of stock A? A. 39 percent B. 46 percent C. 54 percent D. 61 percent E. 67 percent

B. 46 percent 0.087 = [0.114 x] + [0.064 (1 - x)]; x = 46 percent

The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over the last four years, respectively. The stock is currently selling for $26 a share. What is this firm's cost of equity? A. 7.56 percent B. 7.93 percent C. 10.38 percent D. 10.53 percent E. 11.79 percent

B. 7.93 percent ($0.70 - $0.65)/$0.65 = 0.076923 ($0.72 - $0.70)/$0.70 = 0.028571 ($0.75 - $0.72)/$0.72 = 0.041667 g = (0.076923 + 0.028571 + 0.041667)/3 = .049054 Re = [($0.75 1.049054)/$26] + .049054 = 7.93 percent

The rate of return on the common stock of Lancaster Woolens is expected to be 21 percent in a boom economy, 11 percent in a normal economy, and only 3 percent in a recessionary economy. The probabilities of these economic states are 10 percent for a boom, 70 percent for a normal economy, and 20 percent for a recession. What is the variance of the returns on this common stock? A. 0.002150 B. 0.002606 C. 0.002244 D. 0.002359

C. 0.002244 E(r) = (0.10 0.21) + (0.70 0.11) + (0.20 0.03) = 0.104 Var = 0.10 (0.21 - 0.104)2 + 0.70 (0.11 - 0.104)2 + 0.20 (0.03 - 0.104)2 = 0.002244

You recently purchased a stock that is expected to earn 22 percent in a booming economy, 9 percent in a normal economy, and lose 33 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock? A. -3.40 percent B. -2.25 percent C. 1.25 percent D. 2.60 percent E. 3.50 percent

C. 1.25 percent E(r) = (0.05 0.22) + (0.75 0.09) + (0.20 -0.33) = 1.25%

Southern Home Cookin' just paid its annual dividend of $0.65 a share. The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity? A. 9.98 percent B. 10.04 percent C. 10.12 percent D. 10.37 percent E. 10.45 percent

C. 10.12 percent Re = 0.025 + (1.12 0.068) = 10.12 percent

Henessey Markets has a growth rate of 4.8 percent and is equally as risky as the market. The stock is currently selling for $17 a share. The overall stock market has a 10.6 percent rate of return and a risk premium of 8.7 percent. What is the expected rate of return on this stock? A. 8.7 percent B. 9.2 percent C. 10.6 percent D. 11.3 percent E. 11.7 percent

C. 10.6 percent Re = (0.106 - 0.087) + (1.00 0.087) = 10.6 percent

Boulder Furniture has bonds outstanding that mature in 13 years, have a 6 percent coupon, and pay interest annually. These bonds have a face value of $1,000 and a current market price of $1,040. What is the company's aftertax cost of debt if its tax rate is 32 percent? A. 2.97 percent B. 3.24 percent C. 3.78 percent D. 5.21 percen

C. 3.78 percent

Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $87,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes. A. 300 shares B. 350 shares C. 375 shares D. 425 shares E. 500 shares

C. 375 shares

Miller's Dry Goods is an all equity firm with 45,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes. A. 35.6 shares B. 40.0 shares C. 44.4 shares D. 47.5 shares E. 50.1 shares

C. 44.4 shares

Handy Man, Inc. has zero coupon bonds outstanding that mature in 8 years. The bonds have a face value of $1,000 and a current market price of $640. What is the company's pre-tax cost of debt? A. 2.55 percent B. 5.09 percent C. 5.66 percent D. 7.31 percent E. 7.48 percent

C. 5.66 percent

Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75 percent and the market rate of return is 9.80 percent. What is the risk premium on this stock? A. 6.47 percent B. 7.03 percent C. 7.68 percent D. 8.99 percent E. 9.80 percent

C. 7.68 percent Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent

The common stock of Manchester & Moore is expected to earn 13 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 5 percent while the probability of a recession is 45 percent. What is the expected rate of return on this stock? A. 8.52 percent B. 8.74 percent C. 8.65 percent D. 9.05 percent E. 9.28 percent

C. 8.65 percent E(r) = (0.45 0.13) + (0.50 0.06) + (0.05 -0.04) = 8.65 percent

You want your portfolio beta to be 0.95. Currently, your portfolio consists of $4,000 invested in stock A with a beta of 1.47 and $3,000 in stock B with a beta of 0.54. You have another $9,000 to invest and want to divide it between an asset with a beta of 1.74 and a risk-free asset. How much should you invest in the risk-free asset? A. $4,316.08 B. $4,425.29 C. $4,902.29 D. $4,574.71 E. $4,683.92

D. $4,574.71

You have a $12,000 portfolio which is invested in stocks A and B, and a risk-free asset. $5,000 is invested in stock A. Stock A has a beta of 1.76 and stock B has a beta of 0.89. How much needs to be invested in stock B if you want a portfolio beta of 1.10? A. $3,750.00 B. $4,333.33 C. $4,706.20 D. $4,943.82 E. $5,419.27

D. $4,943.82

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest? A. 120 shares B. 150 shares C. 180 shares D. 200 shares E. 250 shares

D. 200 shares

Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity? A. 7.58 percent B. 7.91 percent C. 8.24 percent D. 8.57 percent E. 9.00 percent

D. 8.57 percent Re= $.80/$22.40 + .05= 8.57%

Sweet Treats common stock is currently priced at $19.06 a share. The company just paid $1.15 per share as its annual dividend. The dividends have been increasing by 2.5 percent annually and are expected to continue doing the same. What is this firm's cost of equity? A. 6.03 percent B. 6.18 percent C. 8.47 percent D. 8.68 percent E. 8.82 percent

D. 8.68 percent e = [($1.15 1.025)/$19.06] + 0.025 = 8.68 percent

The common stock of Metal Molds has a negative growth rate of 1.5 percent and a required return of 18 percent. The current stock price is $11.40. What was the amount of the last dividend paid? A. $2.07 B. $2.11 C. $2.19 D. $2.22 E. $2.26

E. $2.26 D1 = [(0.18 - (-0.015)) $11.40] = $2.223; D0 = $2.223/(1 - 0.015) = $2.26

The Jean Outlet is an all equity firm that has 146,000 shares of stock outstanding. The company has decided to borrow the $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes? A. $18,387,702 B. $18,500,000 C. $19,666,667 D. $21,000,000 E. $21,413,333

E. $21,413,333 Firm value = 146,000 ($1.1m/7,500) = $21,413,333

Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes. A. $42,208 B. $44,141 C. $46,333 D. $49,667 E. $52,267

E. $52,267 EBIT/40,000 = [EBIT - ($280,000 0.07)]/25,000; EBIT = $52,267

National Home Rentals has a beta of 1.38, a stock price of $19, and recently paid an annual dividend of $0.94 a share. The dividend growth rate is 4.5 percent. The market has a 10.6 percent rate of return and a risk premium of 7.5 percent. What is the firm's cost of equity? A. 7.05 percent B. 8.67 percent C. 9.13 percent D. 10.30 percent E. 11.56 percent

E. 11.56 percent Re = (0.106 - 0.075) + (1.38 0.075) = 0.1345 Re = [($0.94 1.045)/$19] + 0.045 = 0.0967 Re Average = (0.1345 + 0.0967)/2 = 11.56 percent