Problem 1. A firm wants to expand its business and to do so it must issue new capital (debt, common stock, or preferred stock) since its internal cash flow is not sufficient to pay for the expansion. The firm wants to issue the cheapest type of capital. Given the following information, what type of capital will the firm prefer to issue first, second, and third?
11% Before-tax cost of debt
20% Tax rate
0.8 Beta of common stock
5% Risk free rate
10% Expected return of the stock (common) market
$100 Preferred stock price
$80 Par value of preferred stock
$10 Preferred stock dividend
5% Floatation cost for new preferred stock
a) 1st common stock, 2nd preferred stock, 3rd debt
b) 1st common stock, 2nd debt, 3rd preferred stock
c) 1st preferred stock, 2nd debt, 3rd, common stock
d) 1st preferred stock, 2nd common stock, 3rd debt
e) 1st debt, 2nd, common stock, 3rd preferred stock
f) 1st debt, 2nd preferred stock, 3rd common stock
Problem 2. Management of a firm is trying to determine an optimal capital structure – the one that yields the lowest WACC. Management realizes that, in general, debt is a cheaper source of capital than equity; however, it also knows that as it raises the amount of debt in its capital structure that the cost of debt and equity will rise. Which of the capital structures below yields the lowest WACC?
Capital Structure A: 10% debt; 40% tax rate; 4% before tax cost of debt, 8% cost of equity
Capital Structure B: 25% debt; 40% tax rate; 5% before tax cost of debt, 9% cost of equity
Capital Structure C: 40% debt; 40% tax rate; 6% before tax cost of debt, 10% cost of equity
Capital Structure D: 55% debt; 40% tax rate; 7% before tax cost of debt, 11% cost of equity
Capital Structure E: 70% debt; 40% tax rate; 8% before tax cost of debt, 12% cost of equity
Note: assume that there is only debt and equity in the capital structure.
a) A
b) B
c) C
d) D
e) E
Problem 3. Oftentimes, firms use the same or a very similar WACC to value all projects for a firm. This is convenient, but it may not be appropriate if different projects have different risk profiles. What will result if the company uses one WACC - the WACC for the overall firm - as the minimum rate of return that all projects must make in order to be accepted?
a) Risk of the overall firm will rise
b) Risk of the overall firm will fall
c) Risk of the overall firm will probably not be impacted
d) Projects that are accepted will all have returns less than the firm-level WACC
Problem 4. An analyst has determined that the required rate of return, using the Fama and French three factor model, for a stock is 11.0%. The analyst used the following information to make this determination:
rrf = 5%
rm = 10%
rSMB = 4%
rHML = 5%
beta to market factor = 1.2
beta to size factor = -2.0
beta to valuation factor = 1.6
Fill in the blank. The stock is most likely a _____ company and a (an) _____ priced stock, and a stock that is overall ____ risky than the market.
(Hint: For the last blank, recall that risk and return should be positively related. You will need to consider the return of the market and the required return on the stock.)
a) Large, Expensively, More
b) Large, Expensively, Less
c) Large, Cheaply, More
d) Small, Expensively, More
e) Small, Cheaply, More
f) Small, Cheaply, Less
Problem 5. You are analyzing four companies. Right now, each company makes $0 in profit; however, the companies have different sensitivity of profit to change in units.
Here is the data:
Firm Units VC/Unit Fixed Costs Price/Unit Profit Today
A 10 1 40 5 0.0
B 15 15 0 15 0.0
C 5 25 15 28 0.0
D 20 20 40 22 0.0
If units rise by 1 for each firm, which firm would you expect to have the largest profits?
a) Firm A
b) Firm B
c) Firm C
d) Firm D
Problem 6. You are a financial advisor and you have a client that is considering whether to take a lump sum payment at retirement (the client retires today) or a 20 year series of semiannual payments. The semiannual payments are a healthy $15,000 starting six months from today, and the lump sum is worth $200,000 and would be paid immediately. You are a great investor, so you determine that you can make 12% on your client’s assets each year.
Which of the following statements is TRUE?
Hint: The series of semiannual payments is like a series of semiannual coupons on a 20 year bond. You will need to calculate the present value of the series of semiannual payments and the present value of the lump sum payment at time zero to answer the question.
Note: This is an example of a situation that impacts many people at retirement who have pension plans through their place of employment.
a) You should recommend to your client to take the lump sum payment
b) You should recommend to your client to take the series of semiannual payments
c) Using the above assumptions, the series of semiannual payments is worth (in present value terms) $245,522 more than the lump sum payment
d) If your client only believes that you can make 10% on his or her investments, then the lump sum payment becomes even more attractive relative to the series of semiannual payments
Problem 7. Which one of the following is FALSE?
(Notes: Yield to maturity is sometimes denoted rd; a discount and premium imply that the price of a bond is < and > par value, respectively, and par value is also referred to as face value and maturity value.)
a) If the yield to maturity is < coupon rate, then the bond price will rise as time to maturity nears (assuming all other factors are unchanged)
b) As the yield to maturity of a bond falls, the price of the bond rises
c) If the coupon rate of a bond is 6%, the yield to maturity is 8%, and the par value is $1,000, then the price of the bond is < $1000
d) If a bond is priced at a premium, then the bond price will fall as time to maturity nears (assuming all other factors are unchanged).
e) If a bond is priced at $800, its par value is $1000, then its yield to maturity is > the bond’s coupon rate
Problem 8. This is a question you may have to consider if you invest in bonds in your current or future portfolio. You should care about the coupon interest payments you earn and how the bond price rises and falls over time (also called capital appreciation and depreciation). The total of these two amounts is the total return on a bond.
Total return = coupon payment + capital appreciation (or – capital depreciation)
Over the last year, bond yields on bonds of different time to maturities have changed by different amounts (see slide 21 of the Bond Valuation slides). Long-term and short-term rates have come down; however, long-term rates have fallen less than short-term rates.
• In general, a drop in interest rates impacts long-term bonds more than short-term bonds because the drop in rates impacts more cash flows and cash flows further out in time for long-term bonds than short-term bonds.
What is the total return of the short-term and long-term bonds below over a period of one year?
Hints: To determine the answer, you have to calculate each bond’s total return. To do so, you have to calculate the value of each bond at the beginning and end of the year to determine each bond’s capital appreciation (or depreciation), and add to this amount the coupon collected from each bond.
Short-term bond Type of bond Long-term bond
2 # of years to maturity at beginning of year 10
5.0% Coupon rate 4.9%
5.0% YTM beginning of year 4.9%
0.5% YTM end of year 4.0%
1 # coupon payments per year 1
a) Short-term bond = $139.33; Long-term bond = $122.00
b) Short-term bond = $94.78; Long-term bond =$115.92
c) Short-term bond = $50.00; Long-term bond = $49.00
d) Short-term bond = $49.78; Long-term bond = $106.92
Problem 9. Nominal risk free rate 2.5%
Inflation rate over last year 1.00%
(Note: The level of the real risk-free interest rate indicates whether the Federal Reserve is following an expansionary or restrictive monetary policy. The data provided reflects the situation right now.)
a) -1.5%
b) 0.5%
c) 1.5%
d) 2.5%
e) 3.5%
Problem 10. Which of the following bonds has a higher liquidity premium?
(Recall: We discussed a similar example during class. Assume the interest rates of the bonds are determined only by liquidity and default risk premiums. Assume that bond ratings accurately reflect the risk of default.)
a) A rated bond
b) BBB rated bond
Problem 11. The Federal Reserve is currently engaged in QE2 (Quantitative Easing 2). QE2 involves the Federal Reserve buying government bonds ($600 billion worth of bonds). The act of buying bonds will likely push up bond prices. Why is the Federal Reserve doing this?
a) Move interest rates down
b) Move interest rates up
c) Pushing up bond prices has no impact on interest rates
d) To slow the economy
Problem 12. Please see slide 10 in the Stock Valuation I slides. The investor (aka investor 1) expects dividends to be $2.00 at the end of year 1, $2.10 at the end of year 2, and $2.205 at the end of year 3, and the price to be $15.435 at the end of year 3. Investor 1 also requires 20% return on investments of this risk. Given these assumptions, the investor values the stock (today) at $13.33.
Let’s also assume that the price of the stock is actually $10.00. The price of the stock should reflect the average expectation of all investors, which may not be the same as the investor who values the stock at $13.33.
Which of may explain why the stock is priced at $10.00?
Note: if there is more than one possible correct answer, then you must select both correct answers to receive credit for this question.
a) Assuming all else equal to investor 1 assumptions, the average investor differs by requiring a return of 34%
b) Assuming all else equal to investor 1 assumptions, the average investor differs by expecting the stock price to be $12.10 at the end of year 3
c) Assuming all else equal to investor 1 assumptions, the average investor differs by requiring a return of 15.25%
d) Assuming all else equal to investor 1 assumptions, the average investor differs by expecting no dividends over the next three years
e) A and D
f) A and B
g) B and D
h) A, B, and D
Problem 13. Use the following information to answer to value the stock.
$1.00 Dividends today
$1.50 Dividends in one year
5% Growth rate of dividends in years 2 through infinity
10% Cost of equity capital
a) $9.95
b) $15.64
c) $28.64
d) $30.00
e) $31.50
f) $32.86
Problem 14. True or false: A problem of the DDM (dividend discount model) for stock valuation is that small changes in the estimated growth rate and cost of equity capital have a large impact on the value calculated.
a) True
b) False
Problem 15. Assume a company does not pay dividends, but you have information on its earnings. You also know that its competitors trade at a 15 P/E (the price paid for each dollar of earnings). If you believe the company should trade at a similar P/E as the competitors and you forecast earnings for the firm to be $2.15 in one year, what is the value you place on the stock today if your required rate of return on equity for a firm of this risk is 10%?
a) $12.75
b) $17.15
c) $29.32
d) $30.00
e) $32.25