Homework Problems: FIN 6406 Corporate Finance

CHAPTER 2Present Value, The Objective of the Firm, and Corporate Governance

1. C0 is the initial cash flow on an investment, and C1 is the cash flow at the end of one year. The symbol r is the discount rate.a. Is C0 usually positive or negative?b. What is the formula for the present value of the investment?c. What is the formula for the net present value?d. The symbol r is often termed the opportunity cost of capital. Why?e. If the investment is risk-free, what is the appropriate measure of r?

2. If the present value of $150 paid at the end of one year is $130, what is the one-year discount factor? What is the discount rate?

3. Calculate the one-year discount factor DF1 for discount rates of (a) 10 percent, (b) 20 percent, and (c) 30 percent.

4. A merchant pays $100,000 for a load of grain and is certain that it can be resold at the end of one year for $132,000.a. What is the return on this investment?b. If this return is lower than the rate of interest, does the investment have a

positive or a negative NPV?c. If the rate of interest is 10 percent, what is the PV of the investment?d. What is the NPV?

5. What is the net present value rule? What is the rate of return rule? Do the two rules give the same answer?

6. Write down the formulas for an investment’s NPV and rate of return. Prove thatNPV is positive only if the rate of return exceeds the opportunity cost of capital.

7. A parcel of land costs $500,000. For and additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year.Suppose that common stocks with the same risk as this investment offer a 10 Percent expected return. Would you construct the motel? Why or why not?

8. Calculate the NPV and rate of return for each of the following investments. The opportunity cost of capital is 20 percent for all four investments.

Investment Initial Cash Flow, C0 Cash Flow in Year 1, C1

1 -10,000 +18,0002 -5,000 +9,0003 -5,000 +5,7004 -2,000 +4,000

a. Which investment is most valuable?b. Suppose each investment would require use of the same parcel of land.

Therefore you can take only one. Which one? Hint: What is the firm’s objective: to earn a high rate of return or to increase firm value?

CHAPTER 3How to Calculate Present Values

1. At an interest rate of 12 percent, the six-year discount factor is .507. How many dollars is $.507 worth in six years if invested at 12 percent?

2. If the PV of $139 is $125, what is the discount factor?

3. If the eight-year discount factor is .285, what is the PV of $596 received in eight years?

4. If the cost of capital is 9 percent, what is the PV of $374 paid in year 9?

5. A project produces the following cash flows:

If the cost of capital is 15 percent, what is the project’s PV?

6. If you invest $100 at an interest rate of 15 percent, how much will you have at the end of eight years?

7. An investment costs $1, 5438 and pays $138 in perpetuity. If the interest rate is 9Percent, what is the NPV?

8. A common stock will pay a cash dividend of $4 next year. After that, the dividends are expected to increase indefinitely at 4 percent per year. If the discount rate is 14 percent, what is the PV of the stream of dividend payments?

9. You win a lottery with a prize of $1.5 million. Unfortunately the prize is paid in10 annual installments. The first payment is next year. How much is the prize really worth? The discount rate is 8 percent.

10. Do not use the Appendix tables for these questions. The interest rate is 10 percent.a. What is the PV of an asset that pays $1 a year in perpetuity?b. The value of an asset that appreciates at 10 percent per annum approximately

doubles in seven years. What is the approximate PV of an asset that pays $1 a year in perpetuity beginning in year 8?

c. What is the approximate PV of an asset that pays $1 a year for each of the next seven years?

d. A piece of land produces an income that grows by 5 percent per annum. If the First year’s flow is $10,000, what is the value of the land?

Year Flow1 4322 1373 797

11. Use the Appendix tables at the end of the book for each of the following calculations:a. The cost of a new automobile is $10,000. If the interest rate is 5 percent, how

much would you have to set aside now to provide this sum in five years?b. You have to pay $12,000 a year in school fees at the end of each of the next

six years. If the interest rate is 8 percent, how much do you need to set aside today to cover these bills?

c. You have invested $60,476 at 8 percent. After paying the above school fees, how much would remain at the end of the six years?

12. You have the opportunity to invest the Belgravian Republic at 25 percent interest.The inflation rate is 21 percent. What is the real rate of interest?

13. You are quoted an interested of 6 percent on an investment of $10 million. What Is the value of your investment after four years if the interest rate is compounded:a. Annually, b. monthly, or c. continuously?

14. What is meant by a bond’s yield to maturity and how is it calculated?

15. Use the discount factors shown in Appendix Table 1 at the end of the book to Calculate the PV of $100 received in:a. Year 10 (at a discount rate of 1 percent).b. Year 10 (at a discount rate of 13 percent).c. Year 15(at a discount rate of 25 percent).d. Each of years 1 through 3 (at a discount rate of 12 percent).

16. Use the annuity factors shown in Appendix Table 3 to calculate the PV of $100 in each of:a. Years 1 through 20 (at a discount rate of 23 percent).b. Years 1 through 5 (at a discount rate of 3 percent).c. Years 3 through 12 (at a discount rate of 9 percent).

17. a. If the one-year discount factor is .88, what is the one-year interest rate?b. If the two-year interest rate is 10.5 percent, what is the two-year discount

factor?c. Given these one and two-year discount factors, calculate the two-year annuity

factor.d. If the PV of $10 a year for three years is $24.49, what is the three-year

annuity factor?e. From your answers to (c) and (d), calculate the three-year factor.

18. A factory costs $800,000. You reckon that it will produce an inflow after

operating costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14 percent, what is the net present value of the factory? What will the factory be worth at the end of five years?

19. Harold Filbert is 30 years of age and his salary next will be $20,000. Harold Forecasts that his salary will increase at a steady rate of 5 percent per annum until his retirement at age 60.a. If the discount rate is 8 percent, what is the PV of these future salary

payments?b. If Harold saves 5 percent of his salary each year and invests these savings at

an interest rate of 8 percent, how much will he have saved by age 60?c. If Harold plans to spend these savings in even amounts over the subsequent

20 years, how much can he spend each year?

20. A factory costs $400,000. You reckon that it will produce an inflow after operating costs of $100,000 in year 1, $200,000 in year 2, and $300,000 in year 3. The opportunity cost of capital is 12 percent. Draw up a worksheet likethat shown in Table 3.1 and use tables to calculate the NPV.

21. As winner of a breakfast cereal competition, you can choose one of the following prizes:a. $100,000 nowb. $180,000 at the end of five yearsc. $11,400 a year foreverd. $19,000 for each of 10 yearse. $6,500 next year and increasing thereafter by percent a year forever.If the interest rate is 12 percent, which is the most valuable prize?

22. Siegfried Basset is 65 years of age and has a life expectancy of 12 more years.He wishes to invest $20,000 in an annuity that will make a level payment at the end of each year until his death. If the interest rate is 8 percent, what income canMr. Basset expect to receive each year?

23. James and Helen Turnip are saving to buy a boat at the end of five years. If the boat costs $20,000 and they can earn 10 percent a year on their savings, how much do they need to put aside at the end of years 1 through 5?

24. Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and then $300 a month for the next 30 months. Turtle Motors next door does not offer free credit but will give you $1,000 off the list price. If the rate of interest is 10 percent a year, which company is offering the better deal?

25.

a. How much will an investment of $100 be worth at the end of 10 years if invested at 15 percent a year simple interest?

b. How much will it be worth if invested at 15 percent a year compound interest?c. How long will it take your investment to double its value at 15 percent

compound interest?

26. Which would you prefer?a. An investment paying interest of 12 percent compounded annually.b. An investment paying interest of 11.7 percent compounded semiannually.c. An investment paying 11.5 percent compounded continuously.Work out the value of each of these investments after1, 5, and 20 years.

27. Fill in the blanks in the following table:

Nominal Interest Rate (%) Inflation Rate (%) Real Interest Rate (%)6 1 -- 10 129 - 3

28. A famous quarterback just signed a $15 million contract providing $3 million a year for five years. A less famous receiver signed a $14 million five-year contract providing $4 million now and $2 million a year for five years. Who is better paid? The interest rate is 10 percent.

Chapter 4The Value of Bonds and Common Stock

1. Company X is expected to pay an end-of-year dividend of $10 a share. After the dividend its stock is expected to sell at $110. If the market capitalization rate is 10 percent, what is the current stock price?

2. Company Y does not plow back any earnings and is expected to produce a level dividend stream of $5 a share. If the current stock is $40, what is the market capitalization rate?

3. Company Z’s earnings and dividends per share are expected to grow indefinitely by 5 percent a year. If next year’s dividend is $10 and the market capitalization rate is 8 percent, what is the current stock price?

4. Company Z-prime is like Z in all respects save one: Its growth will stop after year 4. In year 5 and afterward, it will pay out all earnings as dividends. What is Z-prime’s stock price? Assume next year’s EPS is $15.

5. If company Z (see question 5) were to distribute all its earnings, it could maintain a level dividend stream of $15 a share. How much is the market actually paying per share for growth opportunities?

6. In March 2001, Fly Paper’s stock sold for about $73. Security analysts were forecasting a long-term earnings growth rate of 8.5 percent. The company was paying dividends of $1.68 per share.a. Assume dividends are expected to grow along with earnings at g = 8.5 percent

per year in perpetuity. What rate of return r were investors expecting?b. Fly Paper was expected to earn about 12 percent on book equity and to pay

out about 50 percent of earning as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.

7. You believe that next year the Superannuation Company will pay a dividend of $2 on its common stock. Thereafter you expect dividends to grow at a rate of 4 percent a year in perpetuity. If you require a return of 12 percent on your investment, how much should you be prepared to pay for the stock?

8. Consider the following three stocks:a. Stock A is expected to provide a dividend of $10 a share forever.b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend

growth is expected to be 4 percent a year forever.c. Stock C is expected to pay a divided of $5 next year. Thereafter, dividend

growth is expected to be 20 percent a year for 5 years (i.e., until year 6) and zero thereafter.

CHAPTER 5Why Net Present Value Leads to Better Investment Decisions Than Other Criteria

1. What is the opportunity cost of capital supposed to represent? Give a concise definition.

2. a. What is the payback period on each of the following projects?

Cash Flows ($)Project C0 C1 C2 C3 C4

A -5,000 +1,000 +1,000 +3,000 0B -1,000 0 +1,000 +2,000 +3,000C -5,000 +1,000 +1,000 +3,000 +5,000

b. Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept?

c. If you use a cutoff period of three years, which projects would you accept?d. If the opportunity cost of capital is 10 percent, which projects have positive

NPVs?e. “Payback gives too much weight to cash flows that occur after the cutoff

date.” True of false?f. “If a firm uses a single cutoff period for all projects, it is likely to accept too

many short-lived projects.” True or false?g. If the firm uses the discounted-payback rule, will it accept any negative-NPV

projects? Will it turn down positive-NPV projects? Explain.

3. What is the book rate of return? Why is it not an accurate measure of the value of a capital investment project?

4. Write down the equation defining a project’s internal rate of return (IRR). In practice how is IRR calculated?

5. a. Calculate the net present value of the following project for discount rates of 0, 50 and 100 percent:

Cash Flows ($)C0 C1 C2

-6,750 +4,500 +18,000

b. What is the IRR of the project?

6. You have the chance to participate in a project that produces the following cash flows:

Cash Flows ($)C0 C1 C2

+5,000 +4,000 -11,000

a. What is the internal rate of return?

b. If the opportunity cost of capital is 10%, would you accept the offer?

7. Suppose you have the following investment opportunities, but only $90,000 available for investment. Which projects should you take?

Project NPV Investment1 5,000 10,0002 5,000 5,0003 10,000 90,0004 15,000 60,0005 15,000 75,0006 3,000 15,000

8. What is the difference between hard and soft capital rationing? Does softrationing mean the manager should stop trying to maximize NPV? How about hard rationing?

9. Consider the following projects:

Cash flows ($)Project C0 C1 C2 C3 C4 C5

A -1,000 +1,000 0 0 0 0B -2,000 +1,000 +1,000 +4,000 +1,000 +1,000C -3,000 +1,000 +1,000 0 +1,000 +1,000

10. Respond to the following comments:

a. “I like the IRR rule. I can use it to rank projects without having to specify a discount rate.”

b. “I like the payback rule. As long as the minimum payback period is short, the rule makes sure that the company takes no borderline projects. That reduces risk.”

CHAPTER 6

Making Investment Decisions with the Net Present Value Rule

1. Which of the following should be treated as incremental cash flows when deciding whether to invest in a new manufacturing plant? The site is already owned by the company, but existing buildings would need to be demolished.a. The market value of the site and existing buildings.b. Demolition costs and site clearance.c. The cost of a new access road put in the last year.d. Lost earnings on other products due to executive time spent on the new facility.e. A proportion of the cost of leasing the president’s jet airplane.f. Future depreciation of the new plant.g. The reduction in the corporation’s tax bill resulting from tax depreciation of the new plant.h. The initial investment in inventories of raw materials.i. Money already spent on engineering design of the new plant.

2. M. Loup Garou will be paid 100,000 euros one year hence. This is the nominal flow, which he discounts at an 8 percent nominal discount rate:

PV=100,000= €92,593 1.08

The inflation rate is 4 percent. Calculate the PV of M. Garou’s payment using the equivalent real cash flow and real discount rate. You should get exactly the same answer as he did.

3. How does PV of depreciation tax shields vary across the recovery-period classes shown in the table 6.4? Give the general answer; then check it by calculating the PVs of depreciation tax shields in the five year and seven year classes. The tax rate is 35 percent. Use any reasonable discount rate.

4. The following table tracks the main components of working capital over life of a four year project.

2001 2002 2003 2004Accounts receivable 0 150,000 225,000 190,000Inventory 75,000 130,000 130,000 95,000Account payable 25,000 50,000 50,000 35,000

Calculate net working capital and the cash inflows and outflows due to investment in working capital.

5. When appraising mutually exclusive investments in plant and equipment, many companies calculate the investments’ equivalent annual costs and rank the investments on this basis. Why is this necessary? Why not just compare the investments’ NPVs? Explain briefly.

6. Air conditioning for a college dormitory will cost 1.5 million to install and $200,000 per year to operate. The system should last 25 years. The real cost of

the capital is 5 percent, and the college pays no taxes. What is the equivalent annual cost?

7. Machines A and B are mutually exclusive and are expected to produce the following cash flows:

Cash flows ($ thousands)Machine C0 C1 C2 C3

A -100 +110 +121B -120 +110 +121 +133

The real opportunity cost of capital is 10 percent.a. Calculate the NPV of each machine.b. Calculate the equivalent annual cash flow from each machine.c. Which machine should you buy?

8. Restate the net cash flows in Table 6.6 in real terms. Discount the restated cash flows at a real discount rate. Assume a 20 percent nominal rate 10 percent expected inflation. NPV should be unchanged at +3,802, or $3,802,000.

9. Each of the following statements is true. Explain why they are consistent.a. When a company introduces new product, or expands production of an

existing product, investment in the net working capital is usually an important cash outflow.

b. Forecasting changes in the net working capital is not necessary if the timing of all cash inflows and outflows is carefully specified.

10. A widget manufacturer currently produces 200,000 units a year. It buys widget lids from an outside supplier at a price of $2 a lid. The plant manager believes that it would be cheaper to make these lids rather than buy them. Direct production costs are estimated to be only $1.50 a lid. The necessary machinery would cost $150,000. This investment could be written off for tax purposes using the seven year tax depreciation schedule. The plant manager estimates that the operation would require additional working capital $30,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. If the company pays tax at a rate of 35 percent and the opportunity cost of capital is 15 percent, would you support the plant manager’s proposal? State clearly any additional assumptions that you need to make.

11. Hayden Inc. has a number of copiers that were bought four years ago for $20,000. Currently maintenance costs $2,000, a year, but the maintenance agreement expires at the end of the two years and thereafter the annual maintenance charge will rise to $8,000. The machines have a current resale value of $8,000, but at the end of year 2 their value will have fallen to $3,500. By the end of year 6 the machines will be valueless and would be scrapped.

12. The Borstal Company has to choose between two machines that do the same job but have different lives. The two machines have the following costs:

Year Machine A Machine B0 $40,000 $50,0001 10,000 8,0002 10,000 8,0003 10,000 + replace 8,0004 8,000 + replace

These costs are expressed in real terms.a. Suppose you are Borstal’s financial manager. If you had to buy one or the

other machine and rent it to the production manager for that machine’s economic life, what annual rental payment would you have to charge? Assume a 6 percent real discount rate and ignore taxes.

b. Which machine should Borstal buy?c. Usually rental payments you derived in part (a) are just hypothetical –a way of

calculating and interpreting equivalent annual cost. Suppose you actually do buy one of the machines and rent it to the production manager. How much would you actually have to charge in each future year if there is steady 8 percent per year inflation? (Note: The rental payments calculated in part (a) are real cash flows. You would have to mark up those payments to cover inflation.)

CHAPTER 7Introduction to Risk, Return, and the Opportunity Cost of Capital

1. a. What was the average annual return on United States common stocks from 1926 to 2000 (approximately)?b. What was the average difference between this return and the return on the Treasury bills?c. What was the average return on Treasury bills in real terms?d. What was the standard deviation of returns on the market index?e. Was this standard deviation more or less than most individual stocks?

2. A game of chance offers the following odds and payoffs. Each play of the game costs $100, so the net profit per play is the payoff less $100.

Probability Payoff Net Profit.10 $500 $400.50 100 0.40 0 -100

What are the expected cash payoff and expected rate of return? Calculate the variance and standard deviation of this rate of return.

3. The following table shows the nominal returns on the Mexican stock market and the Mexican rate of inflation.a. What was the standard deviation of the market returns?b. Calculate the average real return.

Year Nominal Return Inflation (%)1995 16.5 52.01996 21.9 27.71997 53.4 15.71998 -20.8 18.61999 84.3 12.3

4. Fill in the missing words: Risk is usually measured by the variance of returns or the____________, which is simply the square root of the variance. As long as the stock price changes are not perfectly___________, the risk of a diversified portfolio is __________than the average risk of the individual stocks. The risk that can be eliminated by diversification if known as ___________risk. But diversification cannot remove all risk; the risk that it cannot eliminate is known as _________risk.

5. Lawrence Interchange, ace mutual fund manager, produced the following percentage rates of return from 1996 to 2000. Rates of return on the S& P 500 are given for comparison.

1996 1997 1998 1999 2000Mr. Interchange +16.1 +28.4 +25.1 +14.3 -6.0S & P 5000 +23.1 +33.4 +28.6 +21.0 -9.1

Calculate the average return and standard deviation of Mr. Interchange’s mutual fund. Did he do better or worse than the S & P by these measures?

6. True or False?a. Investors prefer diversified companies because they are less risky.b. If stocks were perfectly positively correlated, diversification would not reduce

risk.c. The contribution of a stock to the risk of a well diversified portfolio depends

on its market risk.d. A well diversified portfolio with a beta of 2.0 is twice as risky as the market

portfolio.e. An undiversified portfolio with a beta 2.0 is less than twice as risky as the

market portfolio.

7. In which of the following situations would you get the largest reduction in risk by spreading your investment across two stocks?a. The two shares are perfectly correlated.b. There is no correlation.c. There is modest negative correlation.d. There is perfect negative correlation.

8. To calculate the variance of a three-stock portfolio, you need to add nine boxes.

Use the same symbols that we used in this chapter; for example, X1= proportion invested in stock 1 and S12 = covariance between stocks 1 and 2. Now complete the nine boxes.

9. Suppose the standard deviation of the market return in 20 percent.a. What is the standard deviation of returns on a well diversified portfolio with a

beta of 1.3?b. What id the standard deviation of returns on a well diversified portfolio with a

beta of 0?c. A well-diversified portfolio has a standard deviation of 15 percent. What is its

beta?d. A poorly diversified portfolio has a standard deviation of 20 percent. What

can you say about its beta?

10. A portfolio contains equal investment in 10 stocks. Five have a beta of 1.2; the remainder have a beta of 1.4. What is the portfolio beta?a. 1.3.b. Greater than 1.3 because the portfolio is not completely diversified.c. Less than 1.3 because diversification reduces beta.

11. What is the beta of each of the stocks shown in Table 7.7?

Table 7.7 Expected Stock

Return if MarketReturn is:

Stock -10% +10%A 0 +20B -20 +20C -30 0D +15 +15E +10 -10

12. True or False? Why? “Diversification reduces risk. Therefore corporations ought to favor capital investments with low correlations with their existing lines of business.”

13. Here are inflation rates and stock market and Treasury bill returns between 1996 and 2000.

Year Inflation S & P 500 Return

T-Bill Return

1996 3.3 23.1 5.21997 1.7 33.4 5.31998 1.6 28.6 4.91999 2.7 21.0 4.72000 3.4 -9.1 5.9

a. What was the real return on the S & P 500 in each year?b. What was the average real return?c. What was the risk premium in each year?d. What the average risk premium?e. What was the standard deviation of the risk premium?

14. Each of the following statements is dangerous or misleading. Explain why.a. A long-term United States government bond is always absolutely safe.b. All investors should prefer stocks to bonds because stocks offer higher long-

run rates of return.c. The best practical forecast of future rates of return on the stock market is a 5-

or 10-year average of historical returns.

15. Lonesome Gulch Mines has a standard deviation of 42 percent per year and a beta of +.10. Amalgamated Copper has a standard deviation of 31 percent a year and a beta of +.66. Explain why Lonesome Gulch is the safer investment for a diversified investor.

16. Lambeth Walk invests 60 percent of his funds in stock I and the balance in stock J. The standard deviation of returns on I is 10 percent, and on J it is 20 percent. Calculate the variance of portfolio returns, assuminga. The correlation between the returns is 1.0.b. The correlation is .5.c. The correlation is 0.

17. There are few, real companies with negative betas. But suppose you found one with β = -.25.a. How would you expect this stock’s rate of return to change if the overall

market rose by an extra 5 percent? What if the market by an extra 5 percent?b. You have $1 million invested in a well-diversified portfolio of stocks. Now

you receive an additional $20,000 bequest. Which of the following actions will yield the safest overall portfolio return?i. Invest $20,000 in Treasury bills (which have β = 0).

ii. Invest $20,000 in stocks with β = -.25.iii. Invest $20,000 in the stock with β = -.25.Explain your answer.

CHAPTER 8Risk and Return

1. Here are returns and standard deviations for four investments.

Return Standard DeviationTreasury Bills 6% 0%Stock P 10 14Stock Q 14.5 28Stock R 21.0 26

Calculate the standard deviations of the following portfolios.a. 50 percent in Treasury bills, 50 percent in stock P.b. 50 percent each in Q and R, assuming the shares have

Perfect positive correlation Perfect negative correlation No correlation

c. Plot the figure like Figure 8.4 for Q and R, assuming a correlation coefficient of .5.

d. Stock Q has a lower return than R but a higher standard deviation. Does that mean that Q’s price is too high or that R’s price is too low?

2. For each the following pairs of investments, state which would always be preferred by a rational investor (assuming that these are the only investments available to the investor):a. Portfolio A r = 18 percent s20percent Portfolio B r = 14 percent s20 percentb. Portfolio C r = 15 percent s18 percent Portfolio D r = 13 percent s8 percentc. Portfolio E r = 14 percent s16 percent Portfolio F r = 14 percent s= 10 percent

3. Figures 8.13a and 8.13b purport to show the range of attainable combinations of expected return and standard deviation.a. Which diagram is incorrectly drawn and why?b. Which is the efficient set of portfolios?c. If rf is the rate of interest, mark with an X the optimal stock portfolio.

4. a. Plot the following risky portfolios on a graph:

PortfolioA B C D E F G H

Expected return (r), % 10 12.5 15 16 17 18 18 20Standard deviation (s), % 23 21 25 29 29 32 35 45

b. Five of these portfolios are efficient, and three are not. Which are inefficient ones?c. Suppose you can also borrow and lend an interest rate of 12 percent. Which of the above portfolios is best?d. Suppose you are prepared to tolerate a standard deviation of 25 percent. What

is the maximum expected return that you can achieve if you cannot borrow or lend?

e. What your optimal strategy if you can borrow or lend at 12 percent and are prepared to tolerate a standard deviation of 25 percent? What is the maximum expected return that you can achieve?

5. How could an investor identity the best of a set of efficient portfolios of common stocks? What does “best” mean? Assume the investor can borrow or lend at the risk-free interest rate.

6. Suppose that the Treasury bill rate is 4 percent and the expected return on the market is 10 percent. Use the betas in the following Table:

Stock BetaAmazon.Com 3.25Boeing .56Coca-Cola .74Dell Computer 2.21Exxon Mobil .40General Electric 1.18General Motors .91McDonalds .68Pfizer .71Reebok .69

a. Calculate the expected return from McDonald’s.b. Find the highest expected return that is offered by one of these stocks.c. Find the lowest expected return that is offered by one these stocks.d. Would Dell offer higher or lower expected return of the interest rate was 6

rather than 4 percent? Assume that the expected market return stays at 10 percent.

e. Would Exxon Mobil offer a higher or lower expected return if the interest rate was 6 percent?

7. True or False?a. The CAMP implies that if you could find an investment with a negative beta, its expected return would be less than the interest rate.b. The expected return on an investment with a beta of 2.0 is twice as high as the

expected return on the market.c. If a stock lies below the security market line, it is undervalued.

8. True or False? Explain or qualify as necessary.a. Investors demand higher expected rates of return on stocks with more variable

rates of return.b. The CAPM predicts that a security with a beta of 0 will offer a zero expected

return.c. An investor who puts $10,000 in Treasury bills and $20,000 in the market

portfolio will have a beta of 2.0.d. Investors demand higher expected rates of return from stocks with returns that

are highly exposed to macroeconomic changes.e. Investors demand higher expected rates of return from stocks with returns that

are sensitive to fluctuations in the stock market.

9. Mark Harrywitz proposes to invest in two shares, X and Y. He expects a return of 12 percent from X and Y and 8 percent from Y. The standard deviation of returns is 8 percent for X and 5 percent from Y. The correlation coefficient between the returns is .2.a. Compute the expected return and standard deviation of the following

portfolios:

Portfolio Percentage in X Percentage in Y1 50 502 25 753 75 25

b. Sketch the set of portfolios composed of X and Y.c. Suppose that Mr. Harrywitz can also borrow or lend at an interest rate of 5

percent. Show on your sketch how this alters his opportunities. Given that he can borrow or lend, what proportions of the common stock portfolios should be invested in X and Y?

10. M.Grandet has invested 60 percent of his money in share A and the remainder in share B. He assesses their prospects as follows:

A B

Expected return (%) 15 20

Standard Deviation 20 22

Correlation between the returns

.5

a. What are the expected return and standard deviation of returns on his portfolio?

b. How could your answer change if the correlation coefficient was 0 or -.5?

c. Is M.Grandet’s portfolio better or worse than one invested entirely in share A, or is it not possible to say?

11. The Treasury bill rate is 4 percent, and the expected return on the market portfolio is 12 percent. On the basis of the capital asset pricing model:a. Draw a graph similar to figure 8.7 showing how the expected return varies

with beta.b. What is the risk premium on the market?c. What is the required return on an investment with a beta of 1.5?d. If an investment with a beta of .8 offers an expected return of 9.8 percent,

does it have a positive NPV?e. If the market expects a return of 11.2 percent from stock X, what is its beta?

12. Percival Hygiene has $10 million invested in long-term corporate bonds. This bon portfolio’s expected annual rate of return is 9 percent, and the annual standard deviation is 10 percent.Amanda Reckonwith, Percival’s financial adviser, recommends that Percival consider investing in an index fund which closely tracks the Standard and Poor’s 500 index. The index has an expected return of 14 percent, and its standard deviation is 16 percent.

a. Suppose Percival puts all money in a combination of the index fund and Treasury bills. Can he thereby improve his expected rate of return without changing the risk of his portfolio? The Treasury bill yield is 6 percent.

b. Could Percival do even better by investing equal amounts in the corporate bond portfolio and the index fund? The correlation between the bond portfolio and the index fund is +1.

CHAPTER 9Capital Budgeting and Risk

1. Suppose a firm uses its company cost of capital to evaluate all projects. Will it underestimated or overestimate the value of high-risk projects?

2. A company is financed 40 percent by risk-free debt. The interest rate is 10 percent, the expected market return is 18 percent, and the stock’s beta is .5. What is the company cost of capital?

3. The total market value of the common stock of the Okenfenokee Real Estate Company is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 9 percent. The Treasury bill rate is 8 percent. Assume for simplicity that Okenfenokee debt is risk-free.a. What is the required return on Okenfenokee stock?b. What is the beta of the company’s existing portfolio of assets?c. Estimate the company cost of capital.d. Estimate the discount rate for an expansion of the company’s present business.e. Suppose the company wants to diversify into the manufacture of rose-colored

spectacles. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on Okenfenokee’s new venture.

4. Nero Violins has the following capital structure”Security Beta Total Market Value,

$millionsDebt 0 100Preferred stock .20 40Common stock 1.20 200

a. What is the firm’s asset beta (i.e., the beta of a portfolio of all the firm’s securities)?

b. How would the asset beta change if Nero issued an additional $140 million of common stock and used the cash to repurchase all the debt and preferred stock?

c. Assume that expand the scale of its operations without changing its asset beta? Assume a risk-free interest rate of 5 percent and a market risk premium of 6 percent.

5. Which of these companies is likely to have the higher cost of capital?a. A’s sales force is paid a fixed annual rate; B’s is paid on a commission basis.b. C produces machine tools; D produces breakfast cereal.

6. “The cost of capital always depends on the risk of the project being evaluated. Therefore the company cost of capital is useless.” Do you agree?

7. Amalgamated Products has three operating divisions:

Division Percentage of Firm ValueFood 50Electronics 30Chemicals 20

To estimate the cost of capital for each division, Amalgamated has identified the following three principal competitors.

Estimated Equity Beta Debt/ (Debt + Equity)United Foods .8 .3General Electronics 1.6 .2Associated Chemicals 1.2 .4

Assume these betas are accurate estimates and that he CAPM is correct.a. Assuming that the debt of these firms is risk-free, estimate the asset beta for

each of the Amalgamated’s divisions.b. Amalgamated’s ratio of debt to debt plus equity is .4. If your estimates of

divisional betas are right, what is Amalgamated’s equity beta?c. Assume that the risk-free interest rate is 7 percent and that the expected return

on the market index is 15 percent. Estimate the cost of capital for each of Amalgamated’s divisions.

d. How much would your estimates of each divisions cost of capital change if you assumed that debt has a beta of .2?

CHAPTER 29Financial Analysis and Planning

1. There are no universally accepted definitions of financial ratios, but five of the following ratios to make no sense at all. Substitute the correct definitions.a. Debt—equality ratio = (long-term debt + value of leases) / long-term debt +

value of leases + equity)b. Return on equity = (EBIT – tax) / average equityc. Payout ratio = dividend / stock priced. Profit margin = (EBIT – tax) /salese. Inventory turnover = sales / average inventoryf. Current ratio = current liabilities / current assetsg. Sales-to-net-working-capital = average sales / average net working capitalh. Average collection period = sales / average receivables ÷ 365)i. Quick ratio = (current assets – inventories ) / current liabilities

2. True or False?a. A company’s debt—equity ratio is always less than 1.b. The quick ratio is always less than the current ratio.c. The return on equity is always less than the return on assets.d. If a project is slow to reach full profitability, straight-line depreciation is

likely to produce an overstatement of profits in the early years.e. A substantial new advertising campaign by a cosmetics company will tend to

depress earnings and cause the stock to sell at a low price—earnings multiple.

3. In each of the following cases, explain briefly which of the two companies is likely to be characterized by the higher ratio:a. Debt-equity ratio: a shipping company or computer software company.b. Payout ratio: United Foods Inc. or Computer Graphics Inc.c. Sales-to-assets ratio: an integrated pulp and paper manufacturer or a paper

mill.d. Average collection period: a supermarket chain or a mail-order company.e. Price-earnings multiple: Basic Sludge Company or Fledging Electronics.

4. Magic Flutes has total receivables of $3,000, which represent 20 days sales. Average total assets are $75,000. The firm’s profit margin is 5 percent. Find the firm’s return on assets and sales-to-assets ratio.

5. Consider this simplified balance sheet for Geomorph Trading:

Current Assets 100 60 Current liabilities280 Long-term debt

Long-term assets 500 70 Other liabilities190 Equity

600 600

a. Calculate the ratio of debt to equity.b. What are Geomorph’s net working capital and total long term capital? Calculate

the ratio of debt to total long term capital.

6. Airlux Antartica has current liabilities of $200 million and crash—sorry—cash ratio of .05. How much cash and marketable securities does it hold?

7. On average, it takes Microlimp’s customers 60 days to pay their bills. If Microlimp has annual sales of $500 million, what is the average value of unpaid bills?

8. Executive Paper’s return on equity is higher than its return on assets. Is this always the case? Explain.

9. True or False?

a. Financial planning should attempt to minimize risk.b. The primary aim of financial planning is to obtain better forecasts of future

cash flows and earnings.c. Financial planning is necessary because financing and investment decisions

interact and should not be made independently.d. Firm’s planning horizons rarely exceed three years.e. Financial planning requires accurate forecasting.f. Financial planning models should include as much detail as possible.

10. Abbreviated financial statements for Archimedes Levers are shown in 29.11. If sales increase by 10 percent in 2002 and all other items, including debt, increase correspondingly, what must be balancing item? What will be its value?

CHAPTER 13Corporate Financing and the Six Lessons of Market Efficiency

1. Which (if any) of these statements are true? Stock prices appear to behave as though successive values (a) are random numbers, (b) follow regular cycles, (c) differ by a random number.

2. Supply the missing words: “There are three forms of efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the ___________ form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the ___________ form. Market efficiency results from competition between investors. Many investors search for new information about the company’s business that would help them to value the stock more accurately. Such research helps to ensure that prices reflect all available information; in other words, it helps to keep the market efficient in the __________________ form. Other investors study past stock prices for recurrent patterns that would allow them to make superior profits. Such research helps to ensure that prices reflect all the information contained in past stock prices; in other words, it helps to keep the market efficient in the __________ form.”

3. True or False? The efficient-market hypothesis assumes that a. There are no taxes.b. There is perfect foresight.c. Successive price changes are independent.d. Investors are irrational.e. There are no transaction costs.f. Forecasts are unbiased.

4. The stock of United Boot is priced at $400 and offers a dividend yield of 2 percent. The company has a 2-for-1 stock split.a. Other things equal, what would you expect to happen to the stock price?b. In practice would you expect to happen to the stock price?c. Suppose that a few months later United Boot announces a rise in dividends

that is exactly in line with that of other companies. Would you expect the announcements to lead to a sight abnormal rise in the stock price, a slight abnormal fall, or change?

5. How would you respond to the following comments?a. “Efficient market, my eye! I know lots of investors who do crazy things.”b. “Efficient market? Balderdash! I know at least a dozen people who have made

a bundle in the stock market.”c. “The trouble with the efficient-market theory is that it ignores investors’

psychology.”d. “Despite all the limitations, the best guide to a company’s value is its written-

down book value. It is much more stable than market value, which depends on temporary fashions.”

6. Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semistrong, or strong form of the inefficient-market hypothesis.a. Tax exempt municipal bonds to offer pretax returns than taxable government

bonds.b. Managers make superior returns on their purchases of their company’s stock.c. There is a positive relationship between the return on the market in one

quarter and the change in aggregate profits in the next quarter.d. There is disputed evidence that stocks which have appreciated unusually in

the recent past continue to do so in the future.e. The stock of an acquired firm tends to appreciate in the period before the

merger announcement.f. Stocks of companies with unexpectedly high earnings appear to offer high

returns for several months after the earnings announcement.g. Very risky stocks on average give higher returns than safe stocks.

7. Stock splits are important because they convey information. Can you suggest some other financial decisions that do so?

8. Here are alphas and betas for Intel and Conagra for the 60 months ending October 2001. Alpha is expressed as a percent per month.

Alpha BetaIntel .77 1.61Conagra .17 .47

Explain how these estimates would be used to calculate an abnormal return.

CHAPTER 17Does Debt Policy Matter

1. Assume a perfectly competitive market with no corporate or personal taxes. Companies A and B each earn gross profits of P and differ only in their capital structure—A is wholly equity-financed and B has debt outstanding on which it pays a certain $100 of interest each year. Investor X purchases 10 percent of the equity of A.a. What profit does X obtain?b. What alternative strategy would provide the same result?c. Suppose investor Y purchases 10 percent of the equity of B. What profits

does Y obtain?d. What alternative strategy would provide the same result?

2. Ms. Kraft owns 50,000 shares of the common stock of Copperhead Corporation with a market value of $2 per share, or $100,000 overall. The company is currently financed as follows:

Book ValueCommon stock(8 million shares) $2 million

Short-term loans $2 million

Copperhead now announces that it is replacing $1 million of short-term debt with an issue of common stock. What action can Ms. Kraft take to ensure that she entitled to exactly the same proportion of profits as before? (Ignore taxes.)

3. The common stock and debt of Northern Sludge are valued at $50 million and $30 million and an 8 percent return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and there are no taxes. If the risk of the debit did increase, would your answer underestimate or overestimate the expected return on the stock?

4. True or False? Explain briefly.a. Stockholders always benefit from an increase in company value.b. MM’s proposition I assumes that actions which maximize firm value also

maximize shareholder wealth.c. The reason that borrowing increases equity risk is because it increases the

probability of bankruptcy.d. If firms did not have limited liability, the risk of their assets would be

increased.e. If firms did not have limited liability, the risk of their equity would be

increased.

f. Borrowing does not affect the return on equity if the return on the firm’s assets is equal to the interest rate.

g. As long as the firm is certain that the return on assets will be higher than the interest rate, an issue of debt makes the shareholders better off.

h. MM’s proposition I implies that an issue of debt increases expected earnings per share and leads to an offsetting fall in the price—earnings ratio.

i. MM’s proposition II assumes increase borrowing does not affect the interest rate on the firm’s debt.

j. Borrowing increase firm value if there is a clientele of investors with a reason to prefer debt.

5. “MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest.” Explain carefully whether that is valid objection.

6. Indicate what’s wrong with the following arguments:a. “As the firm borrows more and debt becomes risky, both stockholders and

bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

b. “Moderate borrowing doesn’t significantly affect the probability of financial distress or bankruptcy. Consequently moderate borrowing won’t increase the expected rate of return demanded by stockholders.”

7. It has been suggested that one disadvantage of common stock financing is that share prices tend to decline in recessions, there by increasing the cost of capital and deterring investment. Discuss this view. Is it an argument for greater use of debt financing?

CHAPTER 16The Dividend Controversy

1. In the 1st quarter of 2001 Merck paid a regular quarterly dividend of $.34 a share.a. Match each of the following sets of dates:

(A1) 27 February 2001 (B1) Record date(A2) 6 March 2001 (B2) Payment date(A3) 7 March 2001 (B3) Ex-dividend date(A4) 9 March 2001 (B4) Last with-dividend date(A5) 2 April 2001 (B5) Declaration date

b. One of these dates of the stock price is likely to fall by about the value of the dividend. Which date? Why?

c. Merck’s stock price at the end of February was $80.20. What was the dividend yield?

d. If earnings per share for 2001 are $3.20, what is the percentage payout rate?e. Suppose that in 2001 the company paid a 10 percent stock dividend. What

would be the expected fall in price?

2. Here are several “facts” about typical corporate dividend policies. Which are true and which false?a. Companies decide each year’s dividend by looking at their capital expenditure

requirements and then distributing whatever crash is left over.b. Most companies have the same notion of a target payout ratio.c. They set each year’s dividend equal to the target payout ratio times that year’s

earnings.d. Managers and investors seem more concerned with dividend changes than

with dividend levels.e. Managers often increase dividends temporarily when earnings are

unexpectedly high for a year or two.f. Companies undertaking substantial share repurchases usually finance them wit

an offsetting reduction in cash dividends.

3. a. The London Match Company has 1 million shares outstanding, on which it currently pays an annual dividend of £5.00 a share. The chairman has proposed that the dividend should be increased to £7.00 a share. If investment policy and capital structure are not be affected, what must the company do to offset the

dividend increase?b. Patriot Games has 5 million shares outstanding. The president has proposed

that, given the firm’s large cash holdings, the annual dividend should be increased from $6.00 a share to $8.00. If you agree with the president’s plans for investment and capital structure, what else must the company do as a consequence of the dividend increase?

4. “Risky companies tend to have lower target payout ratios and more gradual adjustment rate.” Explain what is meant by this statement. Why do you think it is so?

5. An article on stock repurchase in Los Angeles Times noted: “An increasing number of companies are finding that the best investment they can make the days in themselves.” Discuss this view. How is the desirability of repurchase affected by company prospects and the price of its stock?