FINAN 303 TEST#3

What is the weighted average cost of capital for a firm with a debt to equity ratio of 1.0 if their bonds yield 8.5%, the stock has a required rate of return of 14.5% and the marginal tax rate for the firm is 40%? A. 12.8% B. 9.8% C. 8.8% D. 11.5%

B. 9.8%

Which one of the following is the equity risk arising from the daily operations of a firm? A. Industry Risk B. Business Risk C. Strategic Risk D. Financial Risk E. Liquidity Risk

B. Business Risk

a measure of risk for a stock; it measures how a firm's returns are related to the market's returns. This is the relevant measure of risk (not standard deviation).

Beta

Two risks that make up the total risk a firm faces

Business risk & Financial risk

What is the estimated cost of equity if the risk free rate is 2.1%, the beta for the company is 1.45 and the expected return on the market is 8.9%? A. 12.91% B. 10.97% C. 11.96% D. 15.01%

C. 11.96%

Which one of the following is correct based on the static theory of capital structure? A. A debt-equity ratio of 1 is considered to be the optimal capital structure. B. The more debt a firm assumes, the greater the incentive to acquire even more debt until such time as the firm is financed with 100 percent debt. C. The costs of financial distress decrease the value of a firm. D. A firm receives the greatest benefit from debt financing when its tax rate is relatively low.

C. The costs of financial distress decrease the value of a firm.

Which one of the following statements concerning financial leverage is correct? A. Financial leverage increases profits and decreases losses. B. Financial leverage has no effect on a firm's return on equity. C. Financial leverage refers to the use of common stock. D. Financial leverage magnifies both profits and losses. E. Increasing financial leverage will always decrease the earnings per share.

D. Financial leverage magnifies both profits and losses.

Which one of the following is a direct bankruptcy cost? A. Loss of customer goodwill resulting from a bankruptcy filing B. Costs a firm spends trying to avoid bankruptcy C. Management time spent on a bankruptcy proceeding D. Legal and accounting fees related to a bankruptcy proceeding E. Any financial distress cost

D. Legal and accounting fees related to a bankruptcy proceeding

The level of financial risk to which a frim is exposed is dependent on the firm's: A. level of EBIT B. return on assets C. operational risk D. debt to equity ratio

D. debt to equity ratio

Everything else being equal, the higher the weighted average cost of capital, A. the more likely the firm will use debt B. the more likely the firm will use equity C. the higher the present value of a project's cash flows D. the lower the present value of a project's cash flows

D. the lower the present value of a project's cash flows

What is the cost of common stock if the dividend just paid was $2.00, the growth rate in dividends is expected to be 6.5% and the price of the stock is currently $35.50? A. 12.5% B. 6% C. 12.16% D. 13.1%

D1/P0 + g D1=D0(1+g) > 2(1+.065) = 2.13 2.13/35.50 + .065 A. 12.5%

Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms? A. The levered firm has higher EPS than the unlevered firm at the break-even point. B. The levered firm will have higher EPS than the unlevered firm at all levels of EBIT. C. The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT. D. The EPS for the unlevered firm will always exceed those of the levered firm. E. The unlevered firm will have higher EPS at relatively low levels of EBIT.

E. The unlevered firm will have higher EPS at relatively low levels of EBIT.

Glass Ornaments, Inc. is an all-equity firm with a total market value of $386,000 and 15,000 shares of stock outstanding. Management is considering issuing $75,000 of debt at an interest rate of 8 percent and using the proceeds on a stock repurchase. As an all-equity firm, management believes the earnings before interest and taxes (EBIT) will be $31,000 if the economy is normal, $11,000 if it is in a recession, and $37,000 if the economy booms. Ignore taxes. What will the earnings per share (EPS) be if the economy falls into a recession and the firm maintains its all-equity status? A. $0.73 B. $0.68 C. $1.21 D. $1.67 E. $2.07

EBIT/shares outstanding 11000/15000 A. $0.73

"weighted average" of the possible outcomes.

Expected return

T/F If the risk of a particular project is higher than the risk of average projects for a firm, then the firm should use the unadjusted WACC to evaluate the risky project.

F

risk that you can't get rid of. A well-diversified portfolio will still have fluctuation and uncertainty. Affects all firms General economic conditions Oil Price Shocks Interest Rates

Market risk (systematic risk)

a measure of the business risk that a firm has - it is an indicator of how volatile the cash flows for a firm are based on its business/operations.

Operating leverage

the marginal benefits of adding debt are equal to the marginal costs of using more debt.

Optimal Capital Structure

weighted average of individual asset betas.

Portfolio beta

takes into consideration how assets are related to each other - their correlations. To the extent there is low correlation, there is high diversification - reduction of overall risk

Portfolio risk

shows the likelihood of various outcomes. The more widely spread out, the more uncertainty (risk)

Probability distribution

Assume that IBM has a beta of 1.25. If the market risk premium is 5.5% and the risk-free rate is 1.05%, what is the expected return for IBM?

RIBM = Risk free rate + beta x market risk premium 1.05% + 1.25(5.5%) = 7.925%

Find the beta for a stock that has an expected return of 9.5% if the risk-free rate is 1.5% and the expected return on the market is 8.0%.

Ri = Risk free rate + bi (return on market - risk free rate) 1.5% + bi(8.0% - 1.5%) = 9.5% Solve for bi = 1.2308

Probability Return Expected Return 0.10 -0.05 .158 0.25 0.12 .158 0.35 0.18 .158 0.25 0.22 .158 0.05 0.30 .158

Variance > Probability*(Return-Expected return)^2 + ... = (.1)*(-.05-.158)2 + (.25)*(.12-.158)2 + (.35)*(.18-.158)2 + (.25)*(.22-.158)2 + (.05)*(.3-.158)2 = .006826 Std Deviation = .08262 or 8.262%

Calculate weighted average Probability Return 0.10 -0.05 0.25 0.12 0.35 0.18 0.25 0.22 0.05 0.30

Weighted average = (.1)*(-.05) + (.25)*(.12) + (.35)*(.18) + (.25)*(.22) + (.05)*(.3) Weighted average = .158 (or 15.8%)

What is the after tax cost of debt if the marginal tax rate is 30% and the yield to maturity on long-term bonds is 8.0%? A. 8.0% B. 8.1% C. 2.4% D. 5.60%

bondx(1-tax) .8x(1-.30) D. 5.60%

Calculate the Levered Beta for a firm that has a debt to equity ratio of 120%, a tax rate of 30% and an Unlevered Beta of 1.25.

bu = b / 1 + (1-t)xe 1.25 = b / 1 + (1-.30) x 1.20 b=2.30

What is the price of preferred stock if the cost of preferred stock is 9.5% and the dividend is $3 per share? A. 12.95 B. 31.58 C. 34.76 D. 28.50

cost per share/preferred stock 3/.095 B. 31.58

weighted average of the returns for the individual investments. Weights are the proportions and add up to 1

expected return for a portfolio

leverage magnifies the gains and losses of the

shareholders

the larger the standard deviation, the more spread out

(and the higher the risk).

If the Debt to Equity ratio is 350%, what is the Debt to Assets ratio?

.7778/(1-.7778) 77.78

Steps to find portfolio beta for pool of investments:

1. Add investment 2. Find proportion 3. Multiply proportion by beta 4. Add answers

Suppose you have 4 investments: Stock Investment Beta X $1,000,000 1.25 Y $700,000 0.5 Z $850,000 2.0 AA $950,000 1.1 What is the portfolio beta? If the risk free rate is 1.0% and the expected return on the market is 8%, what is the required rate of return for the portfolio?

1. Find weight of investment > Investment/Total Investment 2. Find average of Beta 3. Find required rate of return Weight X = $1,000,000 / $3,500,000 = 28.57% Weight Y = $700,000 / $3,500,000 = 20.00% etc. Weighted average beta (bi) of the portfolio is 1.241 The expected return is Rp > risk free rate + bi (expected return on market- risk free rate) = 1.0% + 1.241(8% - 1%) = 9.687%

Which one of the following is minimized when the value of a firm is maximized? A. WACC B. Debt C. Taxes D. Bankruptcy costs E. Return on Equity

A. WACC

Which one of the following is the equity risk arising from the capital structure selected by a firm? A. Liquidity Risk B. Strategic Risk C. Industry Risk D. Business Risk E. Financial Risk

E. Financial Risk

number between -1 (perfectly negatively correlated) and 1 (perfectly positively correlated). A number of 0 would indicate there is no linear relationship between the assets.

Correlation

statistical measure of how two things move in relation to each other. It is an unscaled number and therefore hard to make sense of.

Covariance

(idiosyncratic risk, firm-specific risk) can be eliminated (or greatly reduced) by combining stocks together into a diversified portfolio Affected by things that affect a company or an industry Lawsuit Fraud

Diversifiable risk

What is the cost of preferred stock if it is priced at 29.50 per share and pays a dividend of 1.75 per year? A. 8.43% B. 2.95% C. 16.86% D. 5.93%

Dividend/Price per share 1.75/29.5 D. 5.93%

Investment Amount Expected Return Google $1000 (1/8) 16.5% Exxon $1500 (1.5) 9.2% Treasuries $2500 (2.5) 2.5% Ford $3000 (3) 6.7% Total $8000

E(Rp) > Proportion * Expected Return = (1/8)*(.165) + (1.5/8)*(.092) + (2.5/8)*(.025) + (3/8)*(.067)

A firm has to invest $100 million in a plant if they want to expand. The unit price of the output is $39 and the variable costs per unit are $9. How many units must be sold to break-even?

Solve for Break Even Quantity: Q = F / (P-V) Q = 100 million / (39-9) = 3.33 million units

Investment $50 million; price $39, variable costs $20 per unit. What is the break even quantity?

Solve for Break Even Quantity: Q = F / (P-V) Q = 50 million / (39-20) = 2.63 million units