Test 2

Assume the marginal corporate tax rate is 30. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 million in perpetual debt and repurchased the same amount of equity?

$115 million Vu = 100; (Tc)(B) = 0.3(50) = 15; Vl = Vu + TcB = 100+15 = $115

If the covariance between Stock A and Stock B is 100, the standard deviation of Stock A is 10% and that of stock B is 20%, calculate the correlation coefficient between the two securities.

+.05 Corr(Ra, Rb) = 100/(10*20) = +.05

Florida company (FC) and Minnesota Company (MC) are both service companies. Their stock returns for the past three years were: FC: -5%, 15%, 20%: MC: 8%,8%, 20%. Calculate the correlation coefficient between the returns of FC and MC.

+0.655 Correlation coefficient = covariance /[S.D.(FC))*(S.D.(MC))] =60/(13.22*6.93) = +0.655

The beta of the market portfolio is:

+1.0

If the correlation coefficient between the returns on stock C and stock D is +1.0, the standard deviation of return for stock C is 15% and that for stock D is 30%, calculate the covariance between stock C and stock D.

+450 Cov(Rc, Rd) = (+1)(30)(15)=+450

What range of values can correlation coefficients take?

-1 to +1

The beta of Treasury bills is:

0.0

The correlation coefficient between the efficient portfolio and the risk-free asset is:

0.0

Suppose the beta of Microsoft is 1.13, the risk-free rate is 3%, and the market risk premium is 8%. Calculate the expected return for Microsoft.

12.04% E(R) = 3+1.13(8) = 12.04%

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes)

2.2 Equity Beta = 1.2 + (0.5/0.5)(1.2 - 0.2) = 2.2

What has been the approximate standard deviation of returns of U.S. common stocks during the period between 1900 and 2011?

20.0%

One would expect a stock with a beta of 1.25 to increase in returns:

25% more than the market in up markets.

If the average annual rate of return for common stocks is 11.7% and 4.0% for U.S Treasury bills, what is the average market risk premium?

7.7 Average risk premium: 11.7-4.0=7.7

The M&M company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes)

8% WACC = (4/10)(5) + (6/10)(10) = 2 + 6 = 8%

Spill Drink Company's stocks had -8%, 11%, and 24% rates of return during the last three years respectively; calculate the (arithmetic) average rate of return for the stock.

9% per year Average rate of return=(-8+11+24)/3 = 9%

Which of the following entities likely has the highest cost of financial distress? A) a pharmaceuticals development company B) a downtown bayfront hotel C) a yacht leasing company D) a real estate investment trust

A pharmaceuticals development company. *The more tangible the assets available to liquidate, the lower the cost to exercise bankruptcy.

Which of the following portfolios has the least risk?

A portfolio of Treasury bills

Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; Rd = 6%, Re=12%, Tc=30%. Calculate the after-tax weighted average cost of capital (WACC):

After-tax WACC = (1/4)(1-0.3)(6)+(3/4)(12) = 10.05%

Generally, which of the following is true? A) rD>rA>rE B) rE>rD>rA C) rE>rA>rD D) rA>rE>rD

C) rE>rA>rD

Which of the following is NOT a potential result from Financial distress? A) Suppliers refuse to extend terms to the firm B) Key employees leave the firm, fearing the firm won't last. C) The firm has difficulty issuing additional bonds D) Due to the interest tax shields, the firm's effective tax rate is very low.

D) Due to the interest tax shields, the firm's effective tax rate is very low.

Florida company (FC) and Minnesota Company (MC) are both service companies. Their stock returns for the past three years were: FC: -5%, 15%, 20%; MC: 8%, 8%, 20%. Calculate the mean return for each company.

FC: 10%, MC: 12% R(FC) = (-5+15+20)/3 = 10% R(MC) = (8+8+20)/3 = 12%

Almost all tests of the CAPM have confirmed that it explains stock returns, especially for high-beta stocks.

False

In theory, the CAPM requires the market portfolio consist of only common stocks.

False

What has been the average annual nominal rate of return on a portfolio of U.S. common stocks over the past 111 years (from 1900 to 2011)?

Greater than 11%

What has been the average annual rate of return in real terms for a portfolio of U.S. common stocks between 1900 and 2011?

Greater than 8%

Who first developed portfolio theory?

Harry Markowitz

When a firm has no debt, then such a firm is known as: I) an unlevered firm II) a levered firm III) an all-equity firm

I & III only

MM Proposition II states that: I) the expected return on equity is positively related to leverage II) the required return on equity is a linear function of the firm's debt to equity ratio III) the risk to equity increases with leverage

I, II, and III

The pecking order theory of capital structure implies that: I) high-risk firms will end up borrowing more II) firms prefer internal finance III) firms prefer debt to equity when external financing is required.

II and III only

The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issues. II) interest expenses are tax deductible III) unlettered firm have higher value than levered firms

II only

For long-term U.S. government bonds, which risk concerns investors the most?

Interest rate risk

If a firm permanently borrows $100 million attain interest rate of 8%, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 30%)

PV of interest shield = (0.3)(100) = $30 million

What signal is sent to the market when a firm decides to issue new stock to raise capital?

Stock price is too high.

A statistical measure of the degree to which securities' returns move together is called a:

correlation coefficient

The correlation coefficient measures the:

degree to which the returns of two stocks move together.

If the market risk premium is 8%, then according to the CAPM, the risk premium of a stock with beta value of 1.7 must be:

greater than 12%

Inclusion of restrictions in a bond contract leads to:

higher agency costs

An efficient portfolio:

ii) provides the highest expected return for a given level of risk iii) provides the least risk for a given level of expected return.

If an individual wants to borrow with limited liability, he/she should:

invest in the equity of a levered firm.

According to the trade-off theory of capital structure:

optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.

Health and Wealth Company is financed entirely by common stock that is priced to offer a 15% expected return. If the company repurchases 25% of the common stocking substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Ignore taxes.)

rE = rA + (D/E)(rA - rD) = 15 + (0.25/0.75) (15 - 6) = 18%

The graphical representation of the CAPM (capital asset pricing model)is called the:

security market line

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt:

stay fixed, leaving more income to be distributed over fewer shares.

Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the:

stockholders of the firm

Modigliani and MIller's Proposition I states that:

the market value of any firm is independent of its capital structure

One would expect a stock with a beta of zero to have a rate of return equal to:

the risk-free rate

The law of conservation of value implies that:

the value of any asset is preserved regardless of the nature of the claims against it.

The type of risk that can be eliminated by diversification is called:

unique risk

As the number of stocks in a portfolio is increased:

unique risk decreases and approaches zero

If the expected return of stock A is 12% and that of stock B is 14%, and both have the same variance, then non diversified investors would prefer stock B to stock A.

True

Most investors dislike uncertainty.

True

On an expected return versus standard deviation diagram, most investors prefer portfolios that appear more towards the top and the left.

True

The firm's mix of securities used to finance its assets is called the firm's capital structure.

True

Underpriced stocks will plot above the security market line.

True

The total market value (V) of the securities of a firm that has both debt (D) and equity (E) is:

V=D+E

For a levered firm:

as EBIT increases, EPS increases by a larger percentage.

Which of the following is true?

bE>bA>bD or bD<bA<bE

If a stock were overpriced, it would plot:

below the security market line.