Fin 510 Ch 10-19 Homework

The range of possible correlations between two securities is defined as:

+1 to -1

Every stock has a beta associated with each of these systematic risks

1. inflation 2. GNP 3. interest rate

Assume you own 300 shares of Sycamore stock. The firm plans on issuing a dividend of $2.10 per share one year from today and then issuing a final liquidating dividend of $36.45 per share two years from today. Your required rate of return is 14.5 percent. Ignoring taxes, what is the value of one share of this stock to you today?

29.64 Current value = future dividends * Present value of discounting factor (rate%, time period) =2.1/1.145 +36.45/1.145^2 =29.64

The stock of Cain & Campos is currently selling for $28 per share. The stock has a dividend yield of 2.6 percent. How much dividend income will you receive per year if you purchase 500 shares of this stock?

364 $28.00 *500 shares = $14000 .026*14000

Andrews has a current debt-equity ratio of .52 and a target debt-equity ratio of .45. The cost of floating equity is 9.5 percent and the flotation cost of debt is 6.6 percent. What should the firm use as its weighted average flotation cost?

8.6%

13 to determine the appropriate cost of capital to employ when computing the present value of a project, an analyst should use the rate that is earned on:

A financial asset of comparable risk The appropriate cost of capital which will be used for computing the present value of project should always be reflecting the project specific required rate of return and we should be calculating the project specific required rate of return by looking at the financial asset which is having similar type of risk because we will focus upon the risk adjusted rate of return for that particular project in order to arrive at the present value. we will not be looking upon the overall market portfolio or riskless asset with similar lifespend.

Market Model

A one-factor model for returns where the factor is an index of the returns on the whole market. R= E(R) + B[Rm - E(Rm)] + E E(Rm) = expected return on market portfolio B = beta coefficient

APV stands for

Adjusted present value

If a bond has a make-whole call provision, the:

Call price will increase as interest rates decrease

Assume the corporate tax rate is 22 percent, the personal tax rate on interest income is 15 percent, and the personal tax rate on dividends is 10 percent. Also assume the firm earns $5 per share in taxable income and pays out 40 percent of its earnings. How much will a shareholder receive per share in aftertax income?

Co's after tax income = firm earnings/share x (1-tax) = $5 x (1-.22)= 3.9 Co pays 40% of after tax income as dividend =0.40 x 3.9 = 1.56 dividend Shareholders pay 10 tax on dividends = 1.56 x (1-0.10) = $1.404 per share

Inflation beta Zero

Companys stock is uncorrelated with inflation (companies that have few assets and act as prokers buying items in competitive makrets and reselling them in other markets)

Which one of the following choices is the best means of creating a valuable financing opportunity?

Create a new security to meet the needs of an unsatisfied clientele The best way to create a valuable financing opportunity is to target the unsatisfied clientele by issuing a security as per their requirements in terms of repayment structure, distribution of income, periodicity of repayments, etc. This will motivate them to invest ,thereby generating the financing opportunities. Targeting the unsatisfied clientele is the best way to generate finances as they are looking for attractive investing opportunities.

The Floor Store is valued at $8.6 million and has debt of $2.1 million outstanding. The unlevered firm beta is 1.72, and the tax rate is 21 percent. What is the levered equity beta?

D/e = Debt / Equity(value) - debt =2.1/8.6-2.1 = 0.323 Levered equity beta = unlevered beta * (1+(1-tax)*D/E) =1.72*(1+(1-.21)*0.323 =2.158 = 2.16 levered beta

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? Multiple Choice 9 percent 10 percent 13 percent 14 percent 11 percent

Debt equity ratio = weight of debt / weight of equity =0.60-0.40 = 1.5 Cost of equity with new cap structure = Overall cost of capital + [debt/equity ratio x (overall cost of capital - interest rate) = .10 + [1.5 x (.10-.08)] =.10 + [1.5 x 0.02] =0.13 13%

Which one of the following choices reports dividend events in the correct chronological order, from earliest to latest?

Declaration date, ex-dividend date, date of record

Houston Homes has outstanding debt of $78 that is due in one year. Given the financial distress costs, debtholders will receive only $62 if the firm does well and $24 if it does poorly. The probability that the firm will do well is 75 percent and the probability that it will do poorly is 25 percent. Assuming a discount rate of 9.6 percent, what is the current value of the debt?

Expected payment to debtholders = (amt if do well * probability do well) + (amt if do poorly * probability do poorly) = (62 x .75) + (24 x .25) = 52.5 Current value of debt = expected payment to debt holders / (1+discount rate)^n 52.5/(1+.096)^1 =47.90

TB MC Qu. 11-91 The risk-free rate of return is... The risk-free rate of return is 1.9 percent and the market risk premium is 6.6 percent. What is the expected rate of return on a stock with a beta of 1.16?

Expected rate return = risk free rate + beta * market risk premium = 1.9% + 1.16% * 6.6% = 9.56%

Analysts estimate that one year from today, a bond has a probability of 40 percent of being priced at $950 and a probability of 60 percent of being priced at $1,050. The bond is also callable at any time at $1,010. What is the expected value of this bond in one year? Multiple Choice $995 $980 $1,000 $1,010 $986

Expected value of bond in one year = (probability x price of bond) + (probability x callable price of bond) = (.40 x 950) + (.60 x1010) =380 + 606 =986

Geometric vs arithmetic average return

Geometric tells what you actually earned per year on average, compounded annually Geometic useful in describing historical investment experiencce arithmetic tells you what you earned in a typical year and is an unbiased estimate of the true mean of the distrubution Arithmetic average is useful in making estimates of the future

TB MC Qu. 12-25 Assume the single-factor model is... Assume the single-factor model is applied to a security that has a negative factor beta. The security will:

Have an actual rate of return that can be positive, negative, or zero

Standard Error

Helps with the issue of how much confidence we can have in historical average. Standard deviation of the historical risk premium and is given by SE = SD(R_) = SD(R) / square root of number of observations 95.4% probability the true mean return is within two SE's of the historical average (95.4% confidence interval ) = historical average return +/- (2 x standard error) = 7.2 +/- 3.76 read as we can be 95.4% confident that our estimate of US equity risk premium from historical data is in the range from 3.44 to 10.96% P. 320

In 2008, which country experienced a decline in its stock market value in excess of 90 percent?

Iceland

Which one of the following represents a difference between business entities in Japan and the US?

Lenders in Japan Frequently also take ownership positions in firms to which they lend

Variance and standard deviation

Many ways to assess the volatility of security's return. The most common is variance, which measures the squared deviations of a security's return from the expected return. Standard deviation is the square root of the variance.

Factor model

Moden in which each stock's return is generated by common factors derived from systematic sources of risk *systematic sources of risk (inflation, GNP, interest rates) are F factors Systematic risk factor model = B1F1 + BGNP * FGNP + BrFr + E

Desert Adventures has a target debt-to-value ratio of .6. The pretax cost of debt is 8.4 percent, the tax rate is 21 percent, and the unlevered cost of equity 13.2 percent. A project the firm is considering has a cash flow to the levered equityholders of $48,700 each year for the foreseeable future and an initial unborrowed cost of $216,000. What is the NPV of the project?

NPV = PV of future cash flows - initial cost PV of future cash flows = cash flow to levered equity holders / levered cost of equity 1. levered cost of equity = unlevered cost of equity + D/E ratio x (unlevered cost equity) x (1-tax) D/E ratio = Debt/ (1-Debt) =0.6 / (1-0.6* = 1.5 Levered cost of equity =32.2% + 1.5 x (13.2% - 8.4$) x (1-0.21) =18.888% NPV = (48700 /.18888) - 216,000 =257,836 -216,000 =$41,836

Risk of any stock can be broken down into systematic and unsystematic

R = E(R) + m + ε m = systematic risk ε = unsystematic risk

Covariance and Correlation

Returns on individual securities are related to one another. Covariance is a statistic measuring the interrelationship between two securities. The relationship can be restated in terms of the correlation between the two securities. Covariance and correlation are building blocks to understanding the beta coefficient

Rosco's has 15,000 shares of stock outstanding with a market price of $6 per share. What will be the market price per share if the firm does a 1-for-3 reverse stock split?

Reverse stock split means merging of stocks 1 for 3 reverse stock split means merging 3 shares into 1 share Thus share price after reverse split = market price of share before reverse split * no share merged into 1 share =$6.00*3 =$18.00

One factor model for systematic risk

Ri = E(Ri) + εi

TB MC Qu. 11-81 Noel has decided to invest... Noel has decided to invest $6,800 in a risky asset that has an expected return of 11.3 percent and a standard deviation of 21.2 percent. He will also invest $3,200 in a risk-free asset with an expected return of 4.2 percent. The market risk premium is 7.1 percent. What is the standard deviation of his portfolio?

Standard Deviation of the portfolio=6800*21.2%/(6800+3200)=14.416%

River & Wood is an outdoors-focused firm with excellent prospects for growth. The firm's management wants to acknowledge the loyalty of its shareholders but must use all of the firm's available cash to fund its rapid growth. The market price of its stock is currently at the upper end of its preferred trading range. Given this situation, a(n) ________ is the firm's best choice.

Stock dividend

If markets are ________ form efficient, market prices reflect all forms of available information. Multiple Choice open strong semistrong weak stable

Strong

Normal distribution

Symmetric bell-shaped frequency distribution that can be completely defined by its mean and standard deviation Probability of having a return that is above or below the mean by a certain amount depends only on the standard deviation

Which type of risk is unaffected by portfolio diversification?

Systematic risk. p 377

Rembrandt bonds are associated with:

The Netherlands

Which of the following statements are true about the expected return?

The actual return can be higher or lower than the expected return. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. The expected return can be calculated as the average of the returns in previous periods.

Beta coefficient

The amount of systematic risk present in a particular risky asset relative to that in an average risky asset. Tells the response of the stocks return to systematic risk.

Arithmetic average return

The return earned in an average year over a multiyear period. Answers question "what was average return in an average year over a particular period"

Sharpe ratio

The risk premium of an asset divided by the standard deviation A measure of return to the level of risk taken as measured by the standard deviation (volatility measure)

Why are the deviations of returns squared when computing variance?

This ensures that the sum of the deviations is a positive number.

Pineda Gallery is currently an all-equity firm with earnings before interest and taxes of $338,000 and a cost of equity of 14.2 percent. Assume the tax rate is 22 percent. The firm is considering adding $400,000 of debt with a coupon rate of 7 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

Unlevered value = [EBIT x (1-tax)] / cost of equity Levered value = unlevered value + (debt value x tax) Value of equity = value of firm - value of debt 1,544,619.72

TB MC Qu. 10-66 Suppose you own a risky asset... Suppose you own a risky asset with an expected return of 12.6 percent and a standard deviation of 18.2 percent. If the returns are normally distributed, the most accurate probability that the stock will return more than 50 percent in any one given year is best described as less than:

Using Excel=1-NORMDIST(50%,12.6%,18.2%,TRUE)=1.9942% = less than 2.5%

The studies conduced by Fama and French show that:

Value stocks have higher average returns than growth stocks around the world

A project has an unlevered NPV of $1.5 million. To finance the project, debt is being issued with associated flotation costs of $60,000. The flotation costs can be amortized over the project's 5-year life. The debt of $10 million is being issued at the market interest rate of 10 percent paid annually, with principal repaid in a lump sum at the end of the fifth year. If the firm's tax rate is 21 percent, calculate the project's APV.

WTF

Negative inflation beta

a company's stock is negatively related to inflation (think car manufacturer with foreign competition)

Positive inflation beta

a company's stock is positively related to the risk of inflation (think gold mines)

When calculating a firm's weighted average cost of capital, the appropriate cost of debt to employ is the:

aftertax market borrowing rate

The Cameron Company is paying a dividend of $.76 per share today. There are 180,000 shares outstanding with a par value of $1 per share. As a result of this dividend, the:

any dividends declared will cause a decrease in retained earnings account while during the dividend payment, it will decrease in common stock account Dividends per share = .76 Number of shares = 180000 Total dividend amount = dividend amt * shares =.76*180000 = $136,800 Retained earnings will decrease by $136,800

vaiance (Var or σ')

average squared deviation from the mean = (1/T-1) [(R1-R_)^2) + ((R2 - R_)^2) .....]

13 If a firm applies its overall firm beta to projects with varying levels of risk, the firm will tend to:

become riskier over time.

average return

calculated as normal average = sum divided by total observations

13 Monitor 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 per share and the tax rate is 21 percent?

cost of preferred equity = dividend / price =3.80/42.70 = 8.90&

The ________ measures the interrelationship between two securities.

covariance

Excess return on risky asset

difference between risky returns and risk free returns

13 Assume a firm increases its use of both operating leverage and financial leverage. Accordingly, an analyst should expect the firm's:

equity beta to increase when a firm increases its use of both operating and financial leverage

Shareholders are not generally granted the: right to elect individuals to the board of directors. right to purchase shares of any new stock issue. right to receive proportional dividends. right to vote to approve or reject a merger offer. first right to liquidation proceeds.

first right to liquidation proceeds

One factor Model

frequently used in practice, do not use all sorts of economic factors we used in previous examples (ie inflation, GNP, interest rates), instead they use an index of stock market returns like the S&P 500, or an even more broadly based index with more stocks in it, as the single factor R=E(R) + B [Rs&p500 - E(Rs&p500)] + E Market model.

A growth-stock portfolio is probably best characterized as having a:

high PE(price to earnings) ratio relative to the overall market.

Studies have found that firms with large investments in tangible assets tend to have:

higher target debt-equity ratios than firms that primarily invest in intangible assets

If a firm were to ____________-, the firms cash flows woul decrease

incur costs associated with bankruptcy

A key underlying assumption of MM proposition 1 without taxes is that

individuals and corporations borrow at the same rate

The standard deviation of small-company stocks:

is over ten times as large as the standard deviation of U.S. Treasury bills. p. 311

Empirical evidence suggest that

managers cannot boost stock prices by changing their accounting methods

A firms ______ is referred to as its capital structure

mix of debt and equity used to finance its assets

frequency distribution

organization of data to show how often certain values or ranges occur

Return of any stock

r = E(R) + U R= actual return E(R) = expected return U = Unexpected return

Expected return

return an individual expects a stock to earn over the next period. expectation may be the average return per period a security has earned in past. May be based on analysis of firm's prospects, on computer based model, or on special/inside information.

MM Proposition II with taxes

reveals that the tax shield on debt causes an increase in the value of a firm

TB MC Qu. 11-101 Clarity Homes stock has a beta of... Clarity Homes 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 the stock?

risk premium = beta (Rm-Rf) =1.46 (11.81-3.07) =12.76%

Ultimately it is the _______ who has (have) control over a corporation

shareholders

standard deviation (SD or σ'^2)

square root of the variance. standard statistical measure of the spread of a sample.

Geometric average return

the average compound return earned per year over a multi-year period Answers question "what was average compound return per year over a particular period =[(1+R1) * (1+R2) * ....* (1+Rt)] ^(1\T) - 1 1. Take each of the T annual returns and add 1 to each (after converting to decimals) 2. Multiply all numbers from Step 1 together 3. Take the result from step 2 and raise to the power of 1/T 4. Subtract one from the result of step 3 smaller than arithmetic average return

Event studies attempt to determine:

the influence of information released to the market on stock prices in days surrounding the information's release

Bi = 0

the ith stock's returns are unaffected by the factor F

For any given stock, the capital gains yield plus the dividend yield equals the:

total return