FINC 680 – Spring 2014 – Final Exam
Problems (5pts each) – You must show all your work on the problems to receive any credit
What is the standard deviation on a portfolio which is invested 25 percent in stock A, 55 percent in stock
B, and the remainder in stock C?
Smith’s Entertainment has $80 million in face value of bonds outstanding that are selling at a quote of
102.4. Bonds with similar characteristics are providing investors with a total return of 7.5%. The
company also has 1.7 million shares of common stock outstanding selling for $38.50 a share. The U.S.
Treasury bill is yielding 2.2 percent and the return on the market is 9.3 percent. The corporate tax rate is
35 percent and the beta on the stock is 0.84. What is the firm's weighted average cost of capital?
Assume this firm might issue new debt in the future.
The market has an expected rate of return of 11.2 percent. The U.S. Treasury bill is expected to yield 3.9
percent and the inflation rate is 3.6 percent. What is the market risk premium?
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Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the
process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding
stock. What is the value of this firm if you ignore taxes?
Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $45
a share. The firm has decided to leverage its operations by issuing $120,000 of debt at a cost of 9.5%.
This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected
to increase the earnings per share. What is the minimum level of earnings before interest and taxes that
the firm is expecting? Ignore taxes.
Bango’s Mangoes has 45,000 shares of common stock outstanding at a market price of $18.00 a share.
Last year, this stock was selling for $14.75. The firm also has 28,000 bonds outstanding, which are selling
for 95 percent of par. The firm’s dividends are expected to grow at 3.5%, and it just paid a dividend of
$0.35. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of
capital if the aftertax cost of debt is 7.1%? Assume this company will not change its capital structure
anytime soon.
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Johnson Tire Distributors has debt with a face value of $12,000 that is selling for 103.3 percent of par
value. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before
interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital for this firm
would be 11.7 percent. What is the firm's cost of equity if you assume this firm will not be altering its
capital structure?
What is the expected return on a portfolio that is equally weighted between stocks K and L given the
following information?
The outstanding bonds of Tech Express are priced at $989 and mature in 10 years. These bonds have a 6
percent coupon and pay interest annually. The firm's tax rate is 35 percent. What is the firm's aftertax
cost of debt?
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You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected return of 9.8
percent. Stock A has an expected return of 11.4 percent while stock B is expected to return 6.4 percent.
What is the portfolio weight of stock A?
Multiple Choice Questions (1pt each)
1. You have computed the break-even EBIT point between a levered and an unlevered capital
structure. Assume there are no taxes. At the break-even level, which of the following is certain:
a. firm is just earning enough to pay for the cost of the debt.
b. firm's earnings before interest and taxes are equal to zero.
c. earnings per share for the levered option are exactly double those of the unlevered
option.
d. advantages of leverage exceed the disadvantages of leverage.
e. firm has a debt-equity ratio of .50.
2. Which one of the following statements is correct for a firm that uses debt in its capital
structure? Assume taxes, but no potential bankruptcy.
a. The WACC should decrease as the firm's debt-equity ratio increases.
b. The firm's WACC will decrease as the corporate tax rate decreases.
c. The weight of the common stock used in the computation of the WACC is based on the
number of shares outstanding multiplied by the book value per share.
d. The WACC will remain constant unless a firm retires some of its debt.
e. The WACC will increase as the cost of equity increases.
3. Which one of the following risks is still relevant to a well-diversified investor?
a. Unsystematic risk.
b. Standard deviation.
c. Unsystematic portion of a surprise.
d. Systematic risk.
e. All of the above are all relevant to a well-diversified investor.
4. Assuming taxes and bankruptcy, the capital structure that maximizes the value of a firm also:
a. Minimizes financial distress costs.
b. Minimizes the cost of capital.
c. Maximizes the present value of the tax shield.
d. Maximizes the value of debt.
e. Maximizes the value of the unlevered firm.
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5. Ceteris paribus, companies would prefer which of the following…?
a. WACC = 13%.
b. WACC = 10%.
c. WACC = 7%.
d. WACC = 5%.
e. Companies do not care about their WACC.
True/False (1pt each)
1. The idea behind “homemade leverage” makes capital structure irrelevant
2. An investor with about 5 individual stocks in her portfolio could still achieve maximum
diversification
3. If your WACC is equal to the IRR of a project, then you’d be financially indifferent towards taking
that project
4. With taxes and bankruptcy, it is possible that the optimal point of capital structure is at 0% debt
5. With the final celebration now almost complete, you’re actually sad because you realize you’ll
never have this much fun in your other MBA classes
Short Essays (10pts each) – Remember to be compete in your responses
Please graphically show the relationship between the cost of capital and the debt level of a firm in a
world with taxes, but no bankruptcy. Where is the optimal point of capital structure? Is there anything
unique about this point?
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In an ex ante world, would you expect the market risk premium to be positive or negative? Could either
of the two make sense?
Why does it make sense for a company to discount its projects at its WACC?
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Comprehensive Questions (1pt each)
1. Generally, which of the following would usually have the highest value for a levered firm?
a. Cost of equity
b. Cost of debt
c. WACC
d. Impossible to determine
e. I don’t know
2. The time value of money basically tells us that…
a. A dollar today has the same value as a dollar tomorrow in a positive inflationary
environment
b. A dollar today is more valuable than a dollar tomorrow if inflation were zero
c. A dollar today is less valuable than a dollar tomorrow in a positive inflationary
environment
d. A dollar today is more valuable than a dollar tomorrow in a positive inflationary
environment
e. I don’t know
3. A bond investor in today’s interest rate environment would be best served to focus on which of
the following bond investments?
a. Long-term (over 5 years)
b. Short-term (2 year or less)
c. Medium-term (2-5 years)
d. Any of the above
e. I don’t know
4. Which of the following risks is the same, regardless of the number of stocks in your portfolio?
a. Unsystematic
b. Systematic
c. Firm-specific
d. Standard deviation
e. I don’t know
5. In a world with taxes, but no bankruptcy, which of the following firms would have the highest
value?
a. D = 30%; E = 70%
b. D = 75%; E = 25%
c. D = 45%; E = 55%
d. D = 0%; E = 100%
e. I don’t know
6. For a par bond, which of the following will be true for the upcoming year (remember, CY is the
current yield)?
a. CY > YTM
b. CY = YTM
c. CY < YTM
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7.
8.
9.
10.
11.
d. No relationship between CY and YTM
e. I don’t know
For most dividend paying companies, what do we typically observe regarding their dividend
payments over time?
a. g is constantly increasing
b. g is sporadic
c. g is zero
d. g is constantly decreasing
e. I don’t know
Most investors would prefer their portfolio standard deviations to go in which direction?
a. Up
b. Down
c. Flat (no change)
d. They wouldn’t care
e. I don’t know
As a firm takes on more debt, its cost of equity will…?
a. Rise because its business risk is rising
b. Rise because its financial risk is rising
c. Fall because its business risk is falling
d. Fall because its financial risk is falling
e. I don’t know
Which of the following projects would yield the highest NPV?
a. IRR = 15%; WACC = 13%
b. IRR = 20%; WACC = 17%
c. IRR = 12%; WACC = 8%
d. IRR = 14%; WACC = 9%
e. I don’t know
Suppose that the current risk-free rate is 2.5% and the return on the stock market is expected to
be 11.2%. If the company’s beta is 1.35 and it just paid a dividend of $3.03, then what is this
company’s cost of equity?
a. 10.85%
b. 13.74%
c. 11.20%
d. 14.25%
e. I don’t know
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12. Suppose that you plan to save $375 at the end of each month for the next 35 years, as you build
for your retirement that begins in 35 years. You will be investing this money into the stock
market, and you expect to earn an 11% return on your investment. If you need $12,500 per
month during your retirement, then how long (in years) will it be until you run out of money?
Assume that you earn a 6% return during your retirement.
a. 20.96 years
b. 22.46 years
c. 23.87 years
d. 24.02 years
e. I don’t know
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