Financial Management Exam #2

Acme Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate is 6.20%, based on semiannual compounding. What is the bond's price? $1,047.19 $1,074.05 $1,101.58 $1,129.12 $1,157.35

$1,101.58

Molen Inc. has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, at what price should the stock sell? $104.27 $106.95 $109.69 $112.50 $115.38

$115.38

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? $17.39 $17.84 $18.29 $18.75 $19.22

$18.29 P0 = D1/(rs - g)= .75/(.105 - .064) = $18.29

Acme Corporation just paid a dividend of D1 = $1.72. Analysts expect the company's dividend to grow by 10% between year 1 and 2, and at a constant rate of 5% from year 2 to 3 and continue with the 5% thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value? $41.59 $42.65 $43.75 $44.97 $45.99

$44.97 Because g > r (10% > 9%) and also because g is non-constant, you can't use V0 = D1/r-g. But after t = 1 we can use it as V1 = D2/r-g because after t = 2 g < r (5% < 9%) and constant. You could also use the same equation at t = 2 but it will then require an extra discount calculation. D2 = 1.72 x 1.1 = 1.892 P1 = V1 = 1.892/(.09 - .05) = 47.30 and now, all you need to do is add the dividend to the selling price of the stock at t =1 and discount back to t = 0: (47.30 +1.72) /1.09 = $44.97

If you buy a share of stock for $100, sell it for $103 one year later, and receive a $3 dividend during this time period, your total rate of return on holding the share for the year will be: 0.02 0.04 0.06 0.08 0.03

(103 - 100 + 3)/100 = 6/100 = .06 or 6%

Assume that you are a consultant to XYZ 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? 9.42% 9.91% 10.44% 10.96% 11.51%

10.44% Using the relationship developed above where total return can be rewritten as dividend yield and growth: r = D1/P0+ g = .67/27.50 + .08 = 0.10436

ABC Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; Market Risk Premium is 5.25% (Expected Return on the Market is 9.35%); and β = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings? 9.67% 9.97% 10.28% 10.60% 10.93%

10.93% E(ri) = rRF + beta[E(rm) - rRF] = 4.1 + 1.3(5.25) = 10.925%

What is the price of a zero coupon (1,000 face value) bond with FOUR years to maturity when the required rate of return is 5%? $822.70 $836.53 $898.35 $932.55 $1006.12

1000(1.05)-4 = 1000(.82270) = 822.70

What is the price of a zero coupon (1,000 face value) bond with FIVE years to maturity when the required rate of return is 5%? $677.20 $783.53 $813.35 $923.36 $1120.35

1000(1.05)-5 = 1000(.78353) = 783.53

Suppose that a ten-year maturity bond with $1,000 face value and 10% coupon is available for $800. You should buy this bond if your required rate for this type of bond is 13%? Hint: Do the math and price the bond! True False

100[{1-(1.13)-10}/.13] + 1000(1.13)-10 = 100(5.42624) + 1000(.294588) = 837.21 True. Since the value of the bond is greater than the market price of the bond, buy it!

Suppose that a ten-year maturity bond with $1,000 face value and 10% coupon is available for $800. You should buy this bond if your required rate for this type of bond is 14%? Hint: Do the math and price the bond! True False

100[{1-(1.14)-10}/.14] + 1000(1.14)-10 = 100(5.21611) + 1000(.26974) = 791.36 False. Since the value of the bond is less than the market price of the bond, don't buy it!

Several years ago the Weir Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? Hint: Use a spreadsheet as I did in the notes. 4.28% 4.46% 4.65% 4.83% 5.03%

4.65% You need to solve for the YTM (same as IRR) for this bond. One way is to set it up in a spreadsheet or use a financial calculator to solve for IRR using cash flow of -$925 at t = 0, followed by 39 cash flows of $35 and a final cash flow of $1070 at t = 40. This yields an IRR of 3.87% but that is for six months, so the nominal rate for a whole year is twice that or 7.74. The after-tax rate for the bond is 7.74(1 - .4) = 4.65%.

If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the coming year? 6.50% 6.83% 7.17% 7.52% 7.90%

6.50%

ABC Company's bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 8.2% on these bonds. What is the bond's price? $903.04 $925.62 $948.76 $972.48 $996.79

65[{1-(1.082)-8}/.082] + 1000(1.082)-8 = 65(5.703278) + 1000(.532331) =903.04 (see page 1)

ABC Corporation issued 20-year, 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 NINETEEN YEARS TO MATURITY? $1,113.48 $1,142.03 $1,171.32 $1,201.35 $1,232.15

75[{1-(1.055)-19}/.055] + 1000(1.055)-19 = 75(11.6076535) + 1000(.3615790) = 1,232.15 See page 2

Weir 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? Hint: See textbook on how to adjust a stock price for floatation costs; they show it for common shares if not for preferred. 8.72% 9.08% 9.44% 9.82% 10.22%

9.08%

You were hired as a consultant to ABC Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC? 8.98% 9.26% 9.54% 9.83% 10.12%

9.26% WACC = wdrd(1 - T) + wprp + wsrs = (.40)(6) + (.15)(7.5) + (.45)(12.75) = 9.2625%

Suppose that a firm wants to issue bonds at par. Which of the following would cause the firm to increase the coupon rate?

Adding a call provision

Which of the following statements is most true? An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

You are considering two bonds. Bond A has a 8% annual coupon while Bond B has a 6% annual coupon. Both bonds are valued at the prevailing discount rate of 7% which is expected to remain constant for the life of the bond. Which of the following statements is CORRECT? Both bonds are premium bonds. Both bonds are priced at par. Bond B is a premium bond and bond A is a discount bond. Bond A is a premium bond and bond B is a discount bond. Both bonds are discount bonds.

Bond A is a premium bond and bond B is a discount bond.

The XYZ Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. 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. If the CEO's position is accepted, what is likely to happen over time?

Correct The company will take on too many high-risk projects and reject too many low-risk projects.

A stock's return has the following range of outcomes and probabilities: Outcomes Probability of the Outcome .03 .20 .08 .40 .13 .40 Calculate the expected value of this stock. Hint: convert rates of return into percentages for easier math. When done convert back to rates of return. 0.06 0.07 0.08 0.09 0.10

E(r) = sum RsPs = 3(.20) + 8(.40) + 13(.40) = 9% or 0.09

Firm ABC's stock has a 50% chance of producing a 20% return, a 30% chance of producing a 15% return, and a 20% chance of producing a -25% return. What is the firm's expected rate of return? 9.41% 9.65% 9.90% 9.50% 10.40%

E(r) = sum RsPs blank = 20(.50) + 15(.30) − 25(.20) = 10 + 4.5 - 5 = 9.5%

You believe the following probability distribution exists for stock ABC. What is the coefficient of variation on ABC's stock? Hint: You need to do several intermediate calculations such as the mean, the variance, and the standard deviation. Probability Stock's State of of State Expected the Economy Occurring Return Boom 0.45 25% Normal 0.50 15% Recession 0.05 5% Selected Answer: 0.2839 0.3069 0.3299 0.3547 0.3813

E(r) = sum subscript blank superscript blank rsps = 25(.45) + 15(.50) + 5(.05) = 19% Var(r) = sum subscript blank superscript blank [ rs - E(s)]2 ps = (25-19)2(.45) + (15-19)2(.20) + (5-19)2(.05) = 34 Std. Dev (r) = square root of blank end root Var(r) = square root of blank end root 34 = 3.7416% = 5.83% CV = std. dev./ exp. return = 5.83/19 = 0.30689

ABC Corporation's stock had an expected return of 11.75% last year, when the risk-free rate was 5.50% and the MARKET RISK PREMIUM was 4.75%. Then an increase in investor risk aversion caused the MARKET RISK PREMIUM to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is ABC stock's new expected rate of return? (Hint: First calculate beta, and then find the expected return.) 14.38% 14.74% 15.11% 15.49% 15.87%

E(ri) = rRF + betai[E(rm) - rRF] The market risk premium is the quantity in the brackets in the CAPM: the excess return of the market portfolio over the risk-free rate. Solving for the beta: 11.75 = 5.5 + beta(4.75) therefore beta = (11.75 - 5.5)/4.75 = 1.3157894 The new expected return after the risk premium increases would be: 5.5 + 1.3157894(6.75) = 14.38%

ABC's stock has a beta of 1.60, the risk-free rate is 4.25%, and the expected return on the market portfolio is 8.00%. What is the expected return on ABC's stock? 10.25% 11.65% 11.95% 12.25% 12.55%

E(ri) = rRF + betai[E(rm) - rRF] = 4.25 + 1.6(8.00 - 4.25) = 10.25

A bond that has a sinking fund has both advantages and disadvantages to the bondholder, but on balance the advantages outweigh the disadvantages, resulting in a higher coupon rate for such bonds. True False

False

A firm that has callable bonds is more likely to invoke the call provision and redeem the bonds if market interest rates go up. True False

False

A mortgage bond is a bond that is secured by specific assets and therefore would provide a return higher than unsecured bonds. True False

False

A zero coupon bond offers no coupon payments and therefore can never provide as much return to bondholders as a coupon bond. True False

False

Junk bonds are bonds of firms that are in the middle of a financial crisis, therefore they should be avoided by prudent investors. True False

False

Which of the following statements is CORRECT? Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. Higher flotation costs tend to reduce the cost of equity capital.

If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

Which of the following statements is CORRECT? A change in a company's target capital structure cannot affect its WACC. WACC calculations should be based on the before-tax costs of all the individual capital components. Flotation costs associated with issuing new common stock normally reduce the WACC. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.

When might a company call their callable bonds?

If the general interest rate goes down from when they initially issued the bonds

Stock A's beta is 1.4 and Stock B's beta is 1.5. If we assume that the Capital Asset Pricing Model holds: Stock A would be a more desirable addition to a portfolio then Stock B. In equilibrium, the expected return of Stock B will be greater than that of Stock A. When held in isolation, Stock A has more risk than Stock B. Stock B would be a more desirable addition to a portfolio than A. In equilibrium, the expected return of Stock A will be greater than that of B.

In equilibrium, the expected return of Stock B will be greater than that of Stock A.

ABC Corp. 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. Since new stock has a higher cost than retained earnings, ABC would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? Increase the dividend payout ratio for the upcoming year. Increase the percentage of debt in the target capital structure. Increase the proposed capital budget. Reduce the amount of short-term bank debt in order to increase the current ratio. Reduce the percentage of debt in the target capital structure.

Increase the percentage of debt in the target capital structure.

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is correct? The classes are: common shares, founders shares, and preferred shares. All common stocks, regardless of class, must have the same voting rights. All firms have several classes of common stock. All common stock, regardless of class, must pay the same dividend. Some class or classes of common stock are entitled to more votes per share than other classes.

Some class or classes of common stock are entitled to more votes per share than other classes.

A 6% coupon bond, an 8% coupon bond, and a 10% coupon bond, all with the same maturity, bond covenants and other provisions, are issued by the same firm under equal market conditions; therefore investors use the same discount rate to determine the bond values. Further suppose interest rates will stay the same until the bonds mature and the 8% coupon is priced at par. Which of the following statement is most likely?

The 6% bond will see its price increase over the coming year

Which of the following statements is NOT CORRECT? The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. The corporate valuation model discounts free cash flows by the required return on equity. The objective of a corporate valuation model is identical to the dividend discount model: to estimate the intrinsic value of the firm's stock. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value.

The corporate valuation model discounts free cash flows by the required return on equity.

Suppose you see the following rates in the marketplace: 10-year T-bond with a 4.56% yield, 10-year corporate bond with S&P rating of AAA with a 6.67% yield, and a 10-year corporate bond with S&P rating of BBB with an 8.32% yield. The rate differences are most likely the result of

The differences in the likelihood of default

If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock's expected dividend yield for the coming year? 4.12% 4.34% 4.57% 4.81% 5.05%

The dividend yield, D1/ P0 = 1.25/26 = 0.0481 or 4.81%

Which of the following statements is CORRECT? If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms that have negative growth rates. The stock valuation model, P0 = D1/(rs - g), can be used only for firms whose growth rates exceed their required return.

The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.

Suppose you are investing in only 2 stocks with a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.25. What is your portfolio's beta to the nearest hundredth? 1.06 1.17 1.29 1.35 1.42

The proportions in the two stocks are 37500/100000 = .375 and 1 - .375 = .625 Using the weighted average of the betas, and the weights are the proportions invested in each stock: .75(0.375) + 1.25(0.625) = 1.0625

If a stock has a beta of 1.5 and the market portfolio has an expected return of 9% when the risk-free rate is 5%, what is the risk premium of the stock? 5% 6% 7.5% 11% 21%

The risk premium of the stock is the amount of the expected return above the risk-free rate, so using the CAPM: E(ri) = rRF + betai[E(rm) - rRF] the risk premium would be the second term of the above equation: betai[E(rm) - rRF] =1.5(9 - 5) = 6%

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? These two stocks should have the same price. These two stocks must have the same dividend yield. These two stocks should have the same expected return. These two stocks must have the same expected capital gains yield. These two stocks must have the same expected year-end dividend.

These two stocks must have the same dividend yield.

Generally, new bond issues are issued close to par, therefore the coupon rate is set to be similar to discount rate used by market participants looking at bonds of similar default risk, maturity, and other characteristics listed in the bond indenture. True False

True

A stock's return has the following range of outcomes and probabilities: Outcomes Probability of the Outcome .03 .20 .08 .40 .13 .40 Calculate the standard deviation (not the variance!) of the above return. Hint: Use the results from 13 above! Keep working in percentages instead of rates! 0.00072 0.00140 0.03742 0.02683 0.01788

Using the 9% expected return from the previous question, Var(r) = sum subscript blank superscript blank [ rs - E(s)]2 ps = (3-9)2(.20) + (8-9)2(.4) + (13-9)2(.4) = 36(.2) + 1(.4) + 16(.4) = 14 Std. Dev (r) = square root of blank end root Var(r) = square root of blank end root 14 = 3.7416% = 0.03742

The coupon payment is the total compensation for interest for:

bonds priced at par.

The beta of a portfolio of stocks is: always smaller than the betas of any of the individual stocks. always larger than the betas of any of the individual stocks. can never be equal to zero. is equal to the arithmetic average of the individual stocks' beta. is equal to the weighted average of the individual stocks' beta.

is equal to the weighted average of the individual stocks' beta.

The correlation coefficient between two stocks: measures the amount of risk associated with the securities at a given moment in time. measures the expected values of the securities at a specified moment in time. measures the joint movement between two stocks. measures the joint movement between the stocks and the market. measures the movement of the stocks with respect to the risk-free rate.

measures the joint movement between two stocks.

Consider two stocks. If all their characteristics remain the same except for the correlation coefficient with each other, which value of the correlation would make a portfolio of these two stocks the least risky: negative infinity negative one zero positive one plus infinity

negative one It is a negative one because the negative correlation would result in the least portfolio standard deviation, which is still our measure of risk of the total combined assets that we are considering.

The preemptive right is important to shareholders because it allows managers to buy additional shares below the current market price. will result in higher dividends per share. is included in every corporate charter. protects the current shareholders against a dilution of their ownership interests. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.

protects the current shareholders against a dilution of their ownership interests

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. rs > re > rd > WACC. re > rs > WACC > rd. WACC > re > rs > rd. rd > re > rs > WACC. WACC > rd > rs > re.

re > rs > WACC > rd.

One way to calculate a stock's beta is to: calculate the stock's coefficient of variation. calculate both the stock's mean return and the std. dev. of the returns. regress the stock's past returns against the risk-free rate. regress the stock's past returns against past market returns. draw a trend line using past measures of the stock's beta.

regress the stock's past returns against past market returns.

Which of the following had the greatest ex-post returns based on historic sample measures? Treasury bills Treasury bonds corporate bonds rated AAA small company stocks large company stocks

small company stocks The assets with the greatest variability using actual sample data is usually the returns of smaller companies, which is why we think that investing in these firms is the greatest risk. But according to our theory they should also result in greater expected return.

The following entities are planning to sell bonds; indicate the one with the least default risk?

the US treasury

Identify the best measure of risk for a stock held in a diversified portfolio? the correlation coefficient the standard deviation the beta the coefficient of variation the range

the beta This is our measure of risk as stated in both the notes and the text. The reason it is not the standard deviation because part of that risk can be dissipated in a well-diversified portfolio, therefore the marketplace will not compensate you for holding that risk. The undiversifiable risk will best captured by beta, which is why it plays such an important role in the CAPM.

If a stock's beta is equal to one, then: the stock's expected rate of return would be equal to the risk-free rate. the stock's expected rate of return would be equal to the expected rate of the market the stock's expected rate would also equal one. the stock's expected rate would equal zero. it is impossible for the stock's beta to equal one.

the stock's expected rate of return would be equal to the expected rate of the market This can be seen from the CAPM. Substitute 1 for beta: E(ri) = rRF + betai[E(rm) - rRF] = rRF + E(rm) - rRF = E(rm)

The best measure to use for measuring the risk of a random variable would be: the expected value of the distribution the weighted average of the distribution using probability as weights the expected deviation from the mean the variance of the distribution the range of the distribution

the variance of the distribution

Suppose that stock A and B and the market (as measured by the S&P 500 Index) produce the following returns over the last five years. Years Market Stock A Stock B 1 0.06 0.16 0.03 2 -0.06 0.20 0.03 3 0.01 0.18 0.03 4 -0.12 0.22 0.03 5 0.08 0.15 0.03 Which of the following statements regarding the beta of these stocks would be true? Hint: No calculations are needed here just a good observation of the numbers. βA < 0; βB = 0. βA > +1; βB = 0. βA = 0; βB = -1. βA > 0; βB = 1. βA < -1; βB = 1.

βA < 0; βB = 0.