Financial Management Exam 3
A stock has an expected return of 13.24 percent, the risk-free rate is 4.4 percent, and the market risk premium is 8.98 percent. What is the stock's beta?
.98 E(Ri) = .1324 = .044 + βi(.0898)βi = .98
Rossdale Co. stock currently sells for $70.45 per share and has a beta of 1.11. The market risk premium is 7.80 percent and the risk-free rate is 3.24 percent annually. The company just paid a dividend of $3.85 per share, which it has pledged to increase at an annual rate of 3.60 percent indefinitely. What is your best estimate of the company's cost of equity using both CAPM and the Dividend Growth Model?
10.58% RE = .0324 + 1.11(.0780) RE = .1190, or 11.90% RE = $3.85(1.0360)/$70.45 + .0360RE = .0926, or 9.26% RE = (11.90% + 9.26)/2RE = 10.58%
Judy's Boutique just paid an annual dividend of $2.83 on its common stock. The firm increases its dividend by 3.55 percent annually. What is the company's cost of equity if the current stock price is $40.36 per share?
10.81% RE = [($2.83(1.0355)/$40.36] + .0355RE = .1081, or 10.81%
The stock in Bowie Enterprises has a beta of 1.13. The expected return on the market is 12.30 percent and the risk-free rate is 3.30 percent. What is the required return on the company's stock?
13.47% RE = .0330 + 1.13(.1230 − .0330)RE = .1347, or 13.47%
Thayer Farms stock has a beta of 1.38. The risk-free rate of return is 3.87 percent, the inflation rate is 3.93 percent, and the market risk premium is 9.03 percent. What is the expected rate of return on this stock?
16.33 percent E(r) = .0387 + 1.38(.0903)E(r) = .1633, or 16.33%
Bethesda Water has an issue of preferred stock outstanding with a coupon rate of 4.80 percent that sells for $92.78 per share. If the par value is $100, what is the cost of the company's preferred stock?
5.17% RP = $4.80/$92.78RP = .0517, or 5.17%
Take It All Away has a cost of equity of 10.75 percent, a pretax cost of debt of 5.41 percent, and a tax rate of 39 percent. The company's capital structure consists of 75 percent debt on a book value basis, but debt is 35 percent of the company's value on a market value basis. What is the company's WACC?
8.14% WACC = .65(10.75%) + .35(5.41%)(1 − .39) WACC = 8.14%
The Two Dollar Store has a cost of equity of 10.7 percent, the YTM on the company's bonds is 5.3 percent, and the tax rate is 40 percent. If the company's debt-equity ratio is .42, what is the weighted average cost of capital?
8.48% WACC = (1/1.42)(10.7%) + (.42/1.42)(5.3%)(1 − .40) WACC = 8.48%
Suppose the common stock of United Industries has a beta of 1.28 and an expected return of 15.47 percent. The risk-free rate of return is 3.7 percent while the inflation rate is 4.2 percent. What is the expected market risk premium?
9.20 percent E(r) = .1547 = .037 + 1.28MrpMrp = .0920, or 9.20%
Expected Rate of Return Equation
= (Probability of Outcome 1 x Rate of Return of Outcome 1) + (Probability of Outcome 2 x Rate of Return of Outcome 2) . . .
Portfolio Return Equation
= (Weight of Security 1 x Rate of Return of Security 1) + (Weight of Security 2 x Rate of Return of Security 2)
Rate of Return Equation
= Return on Investment / Amount Invested
Portfolio
A collection of financial assets
Which one of the following indicates a portfolio is being effectively diversified?
A decrease in the portfolio standard deviation
Risk Neutral
An entity who is ambivalent between choices with different levels of risk, all else being equal
Risk Seeking
An entity who prefers a more risky alternative to a less risky one, all else being equal
Administrative Costs
Any additional Costs such as legal, accounting or printing
Rd =
Component Cost of Debt
A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith Inc. What is the return that these individuals require on this investment called?
Cost of equity
Flotation Costs
Cost of issuing and selling a security
Returns
For an investment, the amount of money we end with, less our invested money
Diversification
Holding a portfolio of different assets so as not to concentrate exposure on one particular asset
Debt + Risk Premium
If our stock has traded at a particular premium to our cost of debt, then we use the relationship to estimate our cost of equity. If our stock isn't publicly traded, we can estimate it based on competitors or industry averages
Which one of the following is an example of systematic risk?
Investors panic causing security prices around the globe to fall precipitously
Market Risk
Minimum amount of risk that must be borne by those investing in stocks due to factors that affect the entire market. Also called systematic risk or non-diversifiable risk
Underwriting Costs
Payments to the investment banker for issuing the security
Suzie owns five different bonds and twelve different stocks. Which one of the following terms most applies to her investments?
Portfolio
Steve has invested in twelve different stocks that have a combined value today of $121,300. Fifteen percent of that total is invested in Wise Man Foods. The 15 percent is a measure of which one of the following?
Portfolio weight
Standard Deviation does not...
Present all aspects of risk
The common stock of Alpha Manufacturers has a beta of 1.24 and an actual expected return of 13.25 percent. The risk-free rate of return is 3.7 percent and the market rate of return is 11.78 percent. Which one of the following statements is true given this information?
The actual expected stock return indicates the stock is currently overpriced.
Firm-specific Risk
The additional risk that any stock has above its market risk, the encompasses all factors that would affect the company's stock price, but not the market in general. Also called unsystematic, diversifiable, or unique risk
Weighted Average Cost of Capital (WACC):
The average of the returns required by equity holders and debt holders, weighted by the company's relative usage of each
Strong Form of the EMH
The belief that all public and non-public information has been accounted for by the market. Those with insider in sider knowledge (this is, material non-public financial information) about companies cannot profitably trade on the information if the market is strongly efficient.
Semi-strong form of the EMH
The belief that all public information has been accounted by the market (including financial analysis of released statements and analysis' forecasts) If the semi-strong form is true, than investments based upon fundamentals of a company shouldn't be able to earn excess profits.
Risk Premium
The expected return in excess of the risk free rate
Price Discovery
The process by which investors sell or buy an asset based upon their valuation of the asset. This will cause the price to shift until the equilibrium price is reached.
Cost of Capital
The rate of return a firm must supply to investors
Beta
The ratio of a company's risk premium versus the market's risk premium
Rate of Return
The ratio of our return to our investment
Risk Aversion
The tendency for most people to prefer less risk to more risk, all else being equal
Efficient Market Hypothesis (EMH)
The theory that the market, in aggregate, has more information than any one investor could possibly have. The market price will be reached by this information, so an investor should not be able to abnormally profit from his or her private information.
Expected Rate of Return
The weighted mean of the possible investment outcomes; that is, each possible outcome weighted by the profitability of that outcome.
Dividend Discount Model
This model states that the cost of stock equals the dividend expected at the end of year one dividend by the current price (dividend yield) plus the growth rate of the dividend (capital gains yield)
Risk
Uncertainty in outcome of knowing events
Which one of the following is the primary determinant of a firm's cost of capital?
Use of the funds raised
The expected return on a stock computed using economic probabilities is:
a mathematical expectation based on a weighted average and not an actual anticipated outcome.
The capital structure weights used in computing a company's weighted average cost of capital:
are based on the market values of the outstanding securities.
Systematic risk is measured by:
beta
Unsystematic risk:
can be effectively eliminated by portfolio diversification.
Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the:
cost of debt.
The cost of capital for a new project:
depends upon how the funds raised for that project are going to be spent.
A company's overall cost of equity is:
directly related to the risk level of the firm.
Capital Asset Pricing Model (CAPM)
is a relationship between the return for a given stock and the non-diversification risk for that stock using be
Capital Asset Pricing Model (CAPM):
is a relationship between the return for a given stock and the non-diversification risk for that stock using be
A company's weighted average cost of capital:
is the return investors require on the total assets of the firm.
The expected risk premium on a stock is equal to the expected return on the stock minus the:
risk-free rate.
The principle of diversification tells us that:
spreading an investment across many diverse assets will eliminate some of the total risk.
The primary advantage of using the dividend growth model to estimate a company's cost of equity is:
the simplicity of the model.
Standard deviation of a portfolio is not....
the weighted average of the standard deviations of the components. It must be computed from the portfolio return
