FRL 301 FINAL REVIEW

You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected return of 9.8 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?

0.098 = [0.114 ×] + [0.064 (1 - ×)]; × = 68 percent

Which one of the following is the equity risk related to a firm's capital structure policy?

Financial

Which one of the following best describes pro forma financial statements?

Financial statements showing projected values for future time periods.

International bonds issued in a single country and denominated in that country's currency are called:

Foreign bonds

Mr. Black has agreed to a currency exchange with Mr. White. The parties have agreed to exchange C$12,500 for $10,000 with the exchange occurring four months from now. This agreed-upon exchange rate is called the:

Forward rate

The dividend growth model cannot be used to compute the cost of equity for a firm that:

Has a retention ratio of 100 percent

The reward-to-risk ratio for stock A is less than the reward-to-risk ratio of stock B. Stock A has a beta of 0.82 and stock B has a beta of 1.29. This information implies that:

Either stock A is overpriced or stock B is underpriced or both.

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Indirect bankruptcy

All of the following are related to a proposed project. Which one of these should be included in the cash flow at Time 0?

Initial investment in inventory to support the project

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Low probability of financial distress.

The concept of homemade leverage is most associated with:

M&M Proposition I with no tax.

According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the:

Market risk premium and the amount of systematic risk inherent in the security.

Grill Works has 7 percent preferred stock outstanding that is currently selling for $49 a share. The market rate of return is 14 percent and the firm's tax rate is 37 percent. What is the firm's cost of preferred stock?

RP = (.07 × $100) / $49 = .1429, or 14.29 percent

Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering investing in new web sites that will enhance online reservations. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project?

Both Wilderness Adventures and Travel Excitement.

G & L Plastic Molders spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost?

Sunk

The current book value of a fixed asset that was purchased two years ago is used in the computation of which one of the following?

Tax due on the salvage value of that asset.

Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?

VU = [$6,200 × (1 - .34)] / .14 = $29,228.57 VL = $29,228.57 + (.34 × $2,500) = $30,078.57 VE = $30,078.57 - 2,500 = $27,578.57 RE = .14 + (.14 - .09) × ($2,500 / $27,578.57) × (1 - .34) = .142991 WACC = [($27,578.57 / $30,078.57) × .142991] + [($2,500 / $30,078.57) × .09 × (1 - .34)] = .1360, or 13.60 percent

Lester's has expected earnings before interest and taxes of $69,750, an unlevered cost of capital of 12.6 percent, and debt with both a book and face value of $78,000. The debt has a coupon rate of 5.75 percent. The tax rate is 34 percent. What is the value of the firm?

VU = [$69,750 × (1 - .34)] / .126 = $365,357.14 VL = $365,357.14 + (.34 × $78,000) = $391,877.14

What is the beta of the following portfolio? Stick Amount Invested Security Beta A $6,700 1.41 B 3,000 1.23 C 8,500 0.79

ValuePortfolio = $6,700 + 3,000 + 8,500 = $18,200 BetaPortfolio = ($6,700/$18,200)(1.41) + ($4,900/$18,200)(1.23) + ($8,500/$18,200)(0.79) = 1.09

The value of a firm is maximized when the:

Weighted average cost of capital is minimized.

The outstanding bonds of Tech Express are priced at $989 and mature in 10 years. These bonds have a face value of $1,000, a coupon rate of 6 percent, and pay interest annually. The firm's tax rate is 35 percent. What is the firm's aftertax cost of debt?

$989 = (.06 × $1,000) × ({1 - [1 / (1 + r)10]} / r) + $1,000 / (1 + r)10 Using trial-and-error, a financial calculator, or a computer, r = 6.15 percent Aftertax cost of debt = 6.15 percent × (1 - .35) = 4.00 percent

Assume the spot rate for the British pound currently is £.6369 per $1. Also assume the one-year forward rate is £.6421 per $1. A risk-free asset in the U.S. is currently earning 3.2 percent. If interest rate parity holds, what rate can you earn on a one-year risk-free British security?

(£.6421 / £.6369) = [(1 + RFC) / 1.032] RFC = .0404, or 4.04 percent

You own some equipment that you purchased four years ago at a cost of $287,000. The equipment is five- year property for MACRS. The MACRS rates are .2, .32, .192, .1152, .1152, .0576, for years 1 to 6, respectively. You are considering selling the equipment today for $99,000. Which one of the following statements is correct if your tax rate is 35 percent?

Accumulated depreciation4 = $287,000 ×(.20 + .32 + .192 + .1152) = $237,406.40 Book value4 = $287,000 - 237,406.40 = $49,593.60 Taxable gain on sale = $99,000 - 49,593.60 = $49,406.40 Tax due = $49,406.40 ×.35 = $17,292.24 Aftertax salvage value = $99,000 - 17,292.24 = $81,707.76

You are evaluating a project that requires $460,000 in external financing. The flotation cost of equity is 10.4 percent and the flotation cost of debt is 5.7 percent. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of .40?

Average flotation cost = (1 / 1.40)(.104) + (.40 / 1.40)(.057) = .090571 Initial cost = $460,000 / (1 - .090571) = $505,812

Unsystematic risk:

Can be effectively eliminated by portfolio diversification.

Assume $1 is currently equal to A$1.1024 in the spot market. Also assume the expected inflation rate in Australia is 2.8 percent as compared to 3.4 percent in the U.S. What is the expected exchange rate one year from now if relative purchasing power parity exists?

E(S1) = A$1.1024 [1 + (.028 - .034)] = A$1.0958

What is the standard deviation of the returns on a stock given the following information? State of Economy Probability of State of Economy Rate of Return if State Occurs Boom 30% 15% Normal 65 12 Recession 5 6

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 = .000414 Std dev = √.000414= 2.03 percent

The expected return on JK stock is 15.78 percent while the expected return on the market is 11.34 percent. The stock's beta is 1.51. What is the risk-free rate of return?

E(r) = 0.1578 = rf + 1.51 (0.1134 - rf); rf = 2.63 percent

The LIBOR is primarily used as the basis for the rate charged on:

Eurodollar loans in the London market.

Which of the following statements are correct concerning diversifiable risks? I. Diversifiable risks can be essentially eliminated by investing in 30 unrelated securities. II. There is no reward for accepting diversifiable risks. III. Diversifiable risks are generally associated with an individual firm or industry. IV. Beta measures diversifiable risk.

I, II and III only

Home Furnishings is expanding its product offerings to reach a wider range of customers. The expansion project includes increasing floor inventory by $656,000 and increasing its debt to suppliers by 85 percent of that amount. The company will also spend $1,110,000 for a building contractor to expand the size of its showroom. As part of the expansion plan, the company will be offering credit to its customers and thus expects accounts receivable to rise by $275,000. For the project analysis, what amount should be used as the initial cash flow for net working capital?

NWC0 = -$656,000 + (.85 × $656,000) - $275,000 = -$373,400

PGH, Inc. is considering a new six-year expansion project that requires an initial fixed asset investment of $3.102 million. The fixed asset will be depreciated straight-line to zero over its six-year tax life, after which time it will be worthless. The project is estimated to generate $1,987,000 in annual sales, with costs of $1,102,200. The tax rate is 35 percent and the required return on the project is 16 percent. What is the net present value for this project?

OCF = ($1,987,000 - 1,102,200)(1 - .35) + ($3,102,000 / 6)(.35) = $756,070 NPV = -$3,102,000 + $756,070({1 - [1 / (1.16)6]} / .16) = -$316,081.72

A project will require $498,000 for fixed assets and $58,000 for net working capital. The fixed assets will be depreciated straight-line to a zero book value over the five-year life of the project. At the end of the project, the fixed assets will be worthless. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $875,000 and costs of $640,000. The tax rate is 35 percent and the required rate of return is 15 percent. What is the amount of the annual operating cash flow?

OCF = ($875,000 - 640,000)(1 - .35) + ($498,000 / 5)(.35) = $187,610

Mason Farms purchased a building for $689,000 eight years ago. Six years ago, repairs costing $136,000 were made to the building. The annual taxes on the property are $11,000. The building has a current market value of $840,000 and a current book value of $494,000. The building is totally paid for and solely owned by the firm. If the company decides to use this building for a new project, what value, if any, should be included in the initial cash flow of the project for this building?

Opportunity cost = $840,000

AZ Products has 375,000 shares of common stock outstanding at a market price of $32 a share. Next year's annual dividend is expected to be $1.50 a share and the dividend growth rate is 2 percent. The firm also has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds have a pre-tax yield of 7.65 percent and sell at 98.6 percent of face value. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital?

RE = $1.50 / $32 + .02 = .066875 D = 7,500 × .986 × $1,000 = $7,395,000 E = 375,000 × $32= $12,000,000 V = $7,395,000 + 12,000,000 = $19,395,000 WACC = ($12,000,000 / $19,395,000)(.066875) + ($7,395,000 / $19,395,000)(.0765)(1 - .34) = .0606, or 6.06 percent

Southern Home Cooking just paid its annual dividend of $.75 a share. The stock has a market price of $16.80 and a beta of 1.14. The return on the U.S. Treasury bill is 2.7 percent and the market risk premium is 7.1 percent. What is the cost of equity?

RE = .027 + 1.14(.071) = .1079, or 10.79 percent

Roy & Daughter has a cost of equity of 13.9 percent and a pretax cost of debt of 6.8 percent. The required return on the assets is 12.9 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

RE = .139 = .129 + (.129 - .068) × D/E D/E = .164

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?

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

Assume €1 = $1.2762 and $1 = S$1.2522. A new coat costs S$187 in Singapore. How much will the identical coat cost in euros if absolute purchasing power parity exists?

S$187 ($1 / S$1.2522) (€1 / $1.2762) = €117.02

Standard deviation measures which type of risk?

Total