- Use the following information to answer the questions.
Security | Beta | Standard deviation | Expected return |
Market
Risk-free Firm A Firm B Firm C |
1.0
0.0 1.5 ( ) 2.0 |
10%
2% 30% 20% 25% |
6.0%
3.0% ( )% 4.5% ( )% |
- Figure out the expected return for Firm A. (20points)
- Figure out the beta for Firm B (20points)
- Compare Firm A with Firm C.
- Which firm has higher total risk? Firm A or C? (20points)
- Which firm will have higher expected return? Firm A or C? Why? (20points)
- There are three kinds of risk: total risk, systematic risk, and unsystematic risk. Which risk can you remove by forming a diversified portfolio? (20points)
- Answer the questions
- The current stock price for Firm D is $100 while the next dividend is $4. Suppose that the dividend is expected to grow at 6% every year. Figure out the cost of equity for Firm D based on Dividend growth model. (25points)
- Figure out the cost of debt if the bond price for Firm D is $920 for the 5-year bond with a par value of $1,000 and a coupon rate of 6% paid semiannually. (25points)
- Firm D has a Debt-to-Equity ratio (D/E) of 200%. Figure out the debt-to-firm value (D/V) using the Debt-to-Equity ratio (D/E). (25points)
- Figure out the weighted average cost of capital of Firm D (WACC) when the tax rate is 50%. (25points)
- Use the following information to answer the questions
Case I: Capital structure (no corporate tax) | Case II: Capital structure (corporate tax) |
Debt-to-firm value (D/V): 0%
Cost of equity: 10% Cost of debt: 6% |
Debt: $ 0 million
EBIT: $40 million Tax rate: 50% Unlevered cost of capital: 10% |
- In Case I, when the debt-to-firm value (D/V) increases from 0% to 50%,
- Figure out the new cost of equity. (25points).
- Figure out the old WACC with zero debt. Figure out the new WACC with debt of 50%. (25points).
- In Case II, when the debt increases from $0 to $60mil.,
- Figure out the levered firm’s value. (25points)
- Figure out the optimal capital structure. In other words, does the capital structure affect the WACC? (25points)
- Answer the questions.
- The average return is usually proportional to a level of risk. (15points)
- True b. False
- Stock risk premium is usually greater than bond risk premium. (15points)
- True False
- As we increase a number of securities for a portfolio, the portfolio volatility always continues to decrease. (15points)
- True b. False
- Expected return of a security contains a component for the pure time value of money. (15points)
- True b. False
- Cost of capital is the required return for capital budgeting, while cost of capital is not affected by capital structure. (15points)
- True False
- A higher WACC leads to a higher NPV of a project. (15points)
- True b. False
- As firms increase the leverage, the cost of asset (WACC) can go up or down, while the cost of equity will increase. (15points)
- True False
- Capital structure theory with corporate tax says that there is no optimal capital structure. (15points)
- True False
- Capital structure theory with bankruptcy costs argues that as firms increase debt, the additional value of interest tax shield will be offset by the expected bankruptcy cost (15points)
- True False
- Pecking Order theory argues that to finance corporate investment, firms follow a specific order:1. retained earnings, 2. equity, and 3. debt. (15points)
- True False