Which firm will have higher expected return? Firm A or C? Why?

Finance by Geoffrey
  1. 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.
  1. Which firm has higher total risk? Firm A or C? (20points)

 

  1. 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)

 

 

  1. 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)

 

 

 

  1. 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%,
  1. Figure out the new cost of equity. (25points).

 

 

  1. 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.,
  1. Figure out the levered firm’s value. (25points)

 

  1. Figure out the optimal capital structure. In other words, does the capital structure affect the WACC? (25points)

 

 

  1. Answer the questions.

 

  • The average return is usually proportional to a level of risk. (15points)
  1. True b. False

 

  • Stock risk premium is usually greater than bond risk premium. (15points)
  1. True False

 

  • As we increase a number of securities for a portfolio, the portfolio volatility always continues to decrease. (15points)
  1. True b. False

 

  • Expected return of a security contains a component for the pure time value of money. (15points)
  1. True b. False

 

  • Cost of capital is the required return for capital budgeting, while cost of capital is not affected by capital structure. (15points)
  1. True False

 

  • A higher WACC leads to a higher NPV of a project. (15points)
  1. 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)
  1. True False

 

  • Capital structure theory with corporate tax says that there is no optimal capital structure. (15points)
    1. 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)
  1. 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)
    1. True False