FINAN 4040 Practice
Hanover Tech is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity? - $2.209 million - $2.005 million - $2.312 million - $2.012 million - $2.108 million
$2.005 million
Jiminy's Cricket Farm issued a 20-year, 7 percent, semiannual bond four years ago. The bond currently sells for 108 percent of its face value. What is the aftertax cost of debt if the company's combined tax rate is 23 percent? - 4.96 percent - 4.78 percent - 4.15 percent - 4.12 percent - 3.86 percent
B) 4.78 percent
Which one of the following is the equity risk related to capital structure policy? - Market risk - Systematic risk - Static risk - Business risk - Financial risk
Financial risk
It is believed by some individuals that, in an efficient market, the actions of traders who constantly buy and sell on any perceived market mispricing will in effect cause market prices to correctly reflect asset values. A person who believes that the actions of these traders will not result in correctly valued prices are most apt to believe in which one of the following? - Gambler's fallacy - Limits to arbitrage - Availability bias - False consensus - Clustering illusion
Limits to arbitrage
Which one of the following statements is true? - Market crashes tend to be accompanied by low market volume. - The Asian market crash was followed by a quick recovery. - The market crashes of 1929 and 1987 are very similar in both the percentage decline in market value and in the ensuing market recovery. - Market crashes tend to follow market bubbles. - Market bubbles and crashes prove that financial markets are inefficient.
Market crashes tend to follow market bubbles.
Jeremy believes he excels at picking stock winners and thus trades frequently. Which characteristic does he most likely represent? A) Confirmation bias B) Frame dependence C) Overconfidence D) Representativeness heuristic E) Break-even effect
Overconfidence
Which one of the following involves a payment in shares that increases the number of shares a shareholder owns but also decreases the value per share? - Cash dividend - Stock dividend - Stock repurchase - Stock split - Reverse stock split
Stock dividend
HJ Corporation has excess cash and has opted to buy some of its outstanding shares. What is this process of buying called? - Stock dividend - Stock split - Stock repurchase - Reverse stock split - Stock repeal
Stock repurchase
Historical returns support which one of the following statements? - Financial markets are highly inefficient as suggested by behavioral finance. - Professional money managers tend to outperform the Vanguard 500 index fund about 60 percent of the time on average. - The longer the time span, the more likely a professional money manager will outperform an index fund, such as the S&P 500. - Historical data supports the statement that arbitrage results in a 100 percent totally efficient market. - The financial markets appear to be highly efficient because, on average, they outperform professional money managers.
The financial markets appear to be highly efficient because, on average, they outperform professional money managers.
An investor is more likely to prefer a high dividend payout if that investor: - has a high marginal tax rate on dividends. - is a corporation. - pays a higher tax rate than the dividend payer. - does not require additional cash flows. - pays taxes on dividends but not on capital gains.
is a corporation.
Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 a share. The common stock has a beta of 1.32 and sells for $41 a share. The preferred stock has a stated value of $100. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital? - 8.09 percent - 8.64 percent - 10.18 percent - 9.30 percent - 10.56 percent
A) 8.09 percent
The dividend growth model: - is only as reliable as the estimated rate of growth. - can only be used if historical dividend information is available. - considers the risk that future dividends may vary from their estimated values. - applies only when a company is currently paying dividends. - is based solely on historical dividend information.
A) is only as reliable as the estimated rate of growth.
Which one of these statements is correct? - Capital structure has no effect on shareholder value. - The optimal capital structure occurs when the cost of equity is minimized. - The optimal capital structure maximizes shareholder value. - Shareholder value is maximized when WACC is also maximized. - Unlevered firms have more value than levered firms when firms are profitable.
C) The optimal capital structure maximizes shareholder value.
Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the: - compound rate. - current yield. - cost of debt. - capital gains yield. - cost of capital.
C) cost of debt.
A company's weighted average cost of capital: - is equivalent to the aftertax cost of the outstanding liabilities. - should be used as the required return when analyzing any new project. - is the return investors require on the total assets of the firm. - remains constant when the debt-equity ratio changes. - is unaffected by changes in corporate tax rates.
C) is the return investors require on the total assets of the firm.
The tendency for a decision maker to search for reassurance that a recent decision he or she made was a good decision represents which one of the following characteristics? - Overconfidence - Overoptimism - Affect heuristic - Confirmation bias - Representativeness heuristic
Confirmation bias
Central Systems desires a weighted average cost of capital of 12.7 percent. The firm has an aftertax cost of debt of 4.8 percent and a cost of equity of 15.4 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? - .37 - .42 - .56 - .34 - .44
D) .34
The business risk of a company: - depends on the company's level of unsystematic risk. - is inversely related to the required return on the company's assets. - is dependent upon the relative weights of the debt and equity used to finance the company. - has a positive relationship with the company's cost of equity. - has no relationship with the required return on a company's assets according to M&M theory.
D) has a positive relationship with the company's cost of equity.
Which one of the following makes the capital structure of a company irrelevant? - Taxes - Interest tax shield - 100 percent dividend payout ratio - Debt-equity ratio that is greater than 0 but less than 1 - Homemade leverage
E) Homemade leverage
Which one of the following is the primary determinant of a firm's cost of capital? - Debt-equity ratio of any new funds raised - Marginal tax rate - Pretax cost of equity - Aftertax cost of equity - Use of the funds raised
E) Use of the funds raised
Why do we use an aftertax figure for cost of debt but not for cost of equity?
Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.
If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money.
Tool Inc. has expected free cash flows of $47,450 in perpetuity and a tax rate of 35%. The firm has $145,000 in outstanding debt at an interest rate of 7.25%, and its unlevered cost of capital is 11 percent. What is the value of the firm according to M&M Proposition I with taxes, but no bankruptcy costs? Should the firm change its debt-equity ratio if the goal is to maximize the value of the firm? Explain.
To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value of the unlevered firm is: VU = FCF/RU VU =47,450/.11 VU = $431,363.64 Now we can find the value of the levered firm as: VL = VU + TD VL = $431,363.64 + .35($145,000) VL = $482,113.64 Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should continue to increase its debt/equity ratio to maximize the value of the firm.
United Foods declared a dividend of $.62 a share on Thursday, October 16. The dividend will be paid on Monday, November 10, to shareholders of record on Friday, October 31. Which one of the following is the ex-dividend date? - Tuesday, October 28 - Wednesday, October 30 - Thursday, October 30 - Wednesday, November 5 - Thursday, November 6
Wednesday, October 30
JC Corp. issued a 30-year, 8% semi-annual bond 3 years ago. The bond currently sells for 93% of its face value. The company's tax rate is 35%. a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which is more relevant, the pretax or the aftertax cost of debt? Why?
a. The pretax cost of debt is the YTMof the company's bonds, so: R = 4.338% YTM = 2 × 4.338% = 8.68% b The aftertax cost of debt is:RD = .0868(1 - .35) = .0564, or 5.64% c The aftertax rate is more relevant because that is the actual cost to the company.
of $0.40 and the dividends are expected to grow at 5%. The expected return on the market is 12%, and Treasury bills are yielding 5.5%. The most recent stock price for Berta is $72. a. Calculate the cost of equity using the DGM method. b. Calculate the cost of equity using the SML-CAPM method. c. Why do you think your estimates in (a) and (b) are so different?
a. Using the dividend discount model, the cost of equity is: RE = [(0.40)(1.05)/$72] + .05RE = .0558, or 5.58% b. Using the CAPM, the cost of equity is: RE = .055 + 1.25(.12 - .0550) RE = .1363, or 13.63% c. When using the dividend growth model or the CAPM, you must remember that both are estimates for the cost of equity. Additionally, and perhaps more importantly, each method of estimating the cost of equity depends upon different assumptions.
Paget Inc. has a target debt-equity ratio of 1.25. Its WACC is 9.2% and the tax rate is 35%. a. If the company's cost of equity is 14%, what is its pretax cost of debt? b. If instead you know that the aftertax cost of debt is 6.8%, what is the cost of equity?
a. Using the equation to calculate WACC, we find: WACC = .092 = (1/2.25)(.14) + (1.25/2.25)(1 - .35)RD RD = .0825, or 8.25% b. Using the equation to calculate WACC, we find: WACC = .092 = (1/2.25)RE + (1.25/2.25)(.068) RE = .1220, or 12.20%
Cost of capital and capital structure: a. A project has aftertax cash flow -$50,000, $30,000, $30,000 , $30,000 at time 0, 1, 2, and 3. It has net present value of $24,605.56. What is the cost of capital for this project? b. The project in part (a) is fully financed by equity. The risk-free rate is 2%. Market premium is 8%. What is the beta of the project?
a. 10% b. Apply CAPM:10% = 2% + 𝛽 × 8%⇒𝛽 = 1
Project A generates $10,000 EBIT forever. It is funded partly by debt. The cost of debt is 3%. The debt-equity ratio is 0.5. Tax rate is 34%. A similar project, project B is fully financed by equity and has a required rate of return of 10%. a. What is the NPV of project A if it were 100% equity financed? b. What is the present value of the tax shield and levered NPV? c. What is the cost of equity for project A? d. What is the WACC for project A?
a. Use the project B required rate of return as 𝑅𝑈 𝑉𝑈 = 10000 × ((1 ― 0.34)/0.1) = $66,000 b. Since the interest payment is a perpetuity 𝑃𝑉(𝑇𝑆) = 𝑡𝐷 = 0.35 × 𝐷 𝐷/𝐸 = 0.5⇒𝐷/𝑉 = 1/3 𝐷 = 66,000 × 1/3 = $22,000 𝑃𝑆(𝑇𝑆) = 0.35 × 22000 = 7700 𝑉𝐿 = 𝑉𝑈 + 𝑃𝑉(𝑇𝑆) = 66000 + 7700 = $73,700 c. Apply M&M proposition II formula: 𝑅𝐸 = 𝑅𝑈 + (𝑅𝑈 ― 𝑅𝐷)𝐷/𝐸 (1 ― 𝑡) 𝑅𝐸 = 10% + (10% ― 3%)0.5 × (1 ― 0.34) = 12.31% d. Apply WACC formula 𝑊𝐴𝐶𝐶 = (𝐸/𝑉)𝑅𝐸 + (𝐷/𝑉)𝑅𝐷(1 ― 𝑡) = 2/3 × 12.31% + 1/3 × 3% × 0.66 = 8.87%
Based on M&M Proposition I with taxes, the weighted average cost of capital: - is equal to the aftertax cost of debt. - has a linear relationship with the cost of equity capital. - is unaffected by the tax rate. - decreases as the debt-equity ratio increases. - is equal to RU(1 − TC).
decreases as the debt-equity ratio increases.
The tendency to sell winners and hold losers is known as the: - representativeness heuristic. - disposition effect. - house money effect. - self-attribution bias. - affect heuristic.
disposition effect.
All else equal, the market value of a stock will tend to decrease by roughly the aftertax value of the dividend on the: - dividend declaration date. - ex-dividend date. - date of record. - date of payment. - day after the date of payment.
ex-dividend date.
All of the following create limits to arbitrage except: - firm-specific risk. - noise traders. - thinly traded securities. - rational traders. - implementation costs.
rational traders.
