Chapter 13
1: Which one of these statements is true?
Stock prices appear to behave as though successive values differ by a
random number.
2:“There are three forms of the efficient-market hypothesis. Tests of
randomness in stock returns provide evidence for the weak form of the
hypothesis. Tests of stock price reaction to well-publicized news provide
evidence for the semistrong form, and tests of the performance of
professionally managed funds provide evidence for the strong 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 strong 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 weak form.”
3: Indicate whether the following statements are true or false.
a. Financing decisions are less easily reversed than investment decisions.
False. Financing decisions do not have the same degree of finality as
investment decisions and are therefore more easily reversed
b. Tests have shown that there is almost perfect negative correlation
between successive price changes.
False. Tests have shown that there is essentially no correlation between
stock price changes.
c. The semistrong form of the efficient-market hypothesis states that
prices reflect all publicly available information.
True
d. In efficient markets, the expected return on each stock is the same.
False. An individual stock’s return is dependent on the stock’s market
risk as measured by beta.
4: Analysis of 60 monthly rates of return on United Futon common stock
indicates a beta of 1.45 and an alpha of −0.2% per month. A month later,
the market is up by 5%, and United Futon is up by 6%. What is Futon’s
abnormal rate of return?
Explanation
Abnormal stock return = Actual stock return − Expected stock return
Abnormal stock return = Actual stock return − (α + β × Return on market
index)
Abnormal stock return = 0.06 − (−0.002 + 1.45 × 0.05)
Abnormal stock return = −0.0105, or −1.05%
5: a.
Most managers tend to be overconfident.
True. Overconfidence is a systematic bias.
b. Psychologists have found that once people have suffered a loss, they
are more relaxed about the possibility of incurring further losses.
False. Once investors have incurred a loss, they are often even more
concerned about future losses.
c. Psychologists have observed that people tend to put too much weight
on recent events when forecasting.
True
d. Behavioral biases open up the opportunity for easy arbitrage profits.
False. There are limits on the ability of the rational investors to exploit
market inefficiencies. These limits include things such as trading costs
and the availability of shares to borrow.
6: If capital markets are efficient, then the sale or purchase of any security
at the prevailing market price is generally a zero-NPV transaction.
7: Generally, a firm is able to find positive-NPV opportunities among its
I) financing decisions;
II) capital investment decisions;
III) short-term borrowing decisions
8: The statement that stock prices follow a random walk implies that
I) successive price changes are independent of each other;
II) successive price changes are positively related;
III) successive price changes are negatively related;
IV) the autocorrelation coefficient is either +1.0 or −1.0
9: A random walk process for a single stock consists of the toss of a fair
coin at the end of each day. If the outcome is heads, the stock price
increases by 1.25 percent. If the outcome is tails, the stock price decreases
by 0.75 percent. What is the drift of such a process?
Drift = (0.5)(1.25%) + (0.5)(−0.75%) = +0.25%.
10: Stock price cycles or patterns tend to self-destruct as soon as investors
recognize them through
trading by investors.
11: Which of the following is a statement of weak-form efficiency?
I) If markets are efficient in the weak form, then it is impossible to make
consistently superior profits by using trading rules based on past returns.
II) If markets are efficient in the weak form, then prices will adjust
immediately to public information.
III) If markets are efficient in the weak form, then prices reflect all
information.
12: Strong-form market efficiency states that the market incorporates all
information into stock prices. Strong-form efficiency implies that
I) an investor can only earn risk-free rates of return;
II) an investor can always rely on technical analysis;
III) professional investors cannot consistently outperform the market;
13: In order to test the weak form of the efficient-market hypothesis,
researchers have used the following methods except
measurement of how rapidly security prices adjust to different news
items.
14: For most stocks, a scatter plot chart of stock returns versus past stock
returns will appear as
a shotgun pattern centered close to the origin.
15: The study of behavioral finance has best helped explain which of the
following investor behaviors?
Investors are generally too slow to update their beliefs in the face of new
evidence.
16: In an efficient market, information is costless.
False
17: Behavioral finance deals with the idea that individual investors have
built-in biases and misconceptions that can drive prices away from fair
values.
True
Chapter 9
1: Quark Productions (“Give your loved one a quark today.”) uses its
company cost of capital to evaluate all projects. Will it underestimate or
overestimate the value of high-risk projects?
Overestimate
2:
a. The expected return on debt; if the debt has very low default risk, this
is close to its yield to maturity.
Cost of debt
b. The expected return on equity.
Cost of equity
c. A weighted average of the cost of equity and the after-tax cost of debt,
where the weights are the relative market values of the firm's debt and
equity.
After-tax WACC
d. The change in the return of the stock for each additional one percent
change in the market return.
Equity beta
e. The change in the return on a portfolio of all the firm's securities (debt
and equity) for each additional one percent change in the market return.
Asset beta
f. A company specializing in one activity that is similar to that of a
division of a more diversified company.
Pure-play comparable
g. A certain cash flow occurring at time t with the same present value as
an uncertain cash flow at time
Certainty equivalent
3: EZCUBE Corp. is 50% financed with long-term bonds and 50% with
common equity. The debt securities have a beta of 0.15. The company’s
equity beta is 1.25. What is EZCUBE’s asset beta?
Asset β = 0.5 × 0.15 + 0.5 × 1.25
Asset β = 0.7
4: Which of these projects is likely to have the higher asset beta, other
things equal?
The sales force for project A is paid a fixed annual salary. Project B’s
sales force is paid by commissions only.
Project A: a project with higher fixed costs generally has higher operating
leverage, which leads to a higher beta
Project C is a first-class-only airline. Project D is a well-established line
of breakfast cereals.
Project C: airline revenue is more cyclical than cereal revenue.
5:
A: The company cost of capital is the correct discount rate for all projects
because the high risks of some projects are offset by the low risk of other
projects.
False. The company cost of capital is the correct discount rate for new
projects only if the new projects have the same risk level as the existing
business. If a new project is riskier, a higher cost of capital should be
used. If the new project is less risky, a lower cost of capital should be
used.
B: Distant cash flows are riskier than near-term cash flows. Therefore
long-term projects require higher risk-adjusted discount rates.
False. In order to account for the riskiness inherent in distant cash flows,
it is necessary to account for several possible outcomes in cash flows and
calculate the probability-weighted cash flow for each scenario. The
discount rates should not be adjusted based on uncertainty in cash flows.
C: Adding fudge factors to discount rates undervalues long-lived projects
compared with quick-payoff projects.
True. A fudge factor applied to a discount rate would compound over
time thereby undervaluing a project.
6: Nero Violins has the following capital structure:
Security
Debt
Preferred stock
Common stock
Beta
0
0.20
1.20
Total Market
Value
($ millions)
$ 100
40
299
a. What is the firm's asset beta? (Hint: What is the beta of a portfolio
of all the firm's securities?)
b. Assume that the CAPM is correct. What discount rate should Nero
set for investments that expand the scale of its operations without
changing its asset beta? Assume a risk-free interest rate of 5% and a
market risk premium of 6%. Ignore taxes.
Explanation
a.
Total market value = $100m + 40m + 299m
Total market value = $439m
βAsset = $100m / $439m × 0 + $40m / $439m × 0.20 + $299m / $439m ×
1.20
βAsset = 0.836
b.
r = rf + β(rm − rf)
r = 0.05 + 0.836(0.06)
r = 0.1001, or 10.01%
7: The following table shows estimates of the risk of two well-known
Canadian stocks:
Sun Life Financial
Loblaw
Standard
Deviation (%)
18.7
19.5
R2
0.12
0.06
Standard
Beta Error of Beta
0.86
0.30
0.63
0.33
a. What proportion of each stock’s risk was market risk, and what
proportion was specific risk?
b. What is the variance of the returns for Sun Life Financial stock? What
is the specific variance?
c. What is the confidence interval on Loblaw's beta?
d. If the CAPM is correct, what is the expected return on Sun Life?
Assume a risk-free interest rate of 5% and an expected market return
of 12%.
e. Suppose that next year, the market provides a 20% return. Knowing
this, what return would you expect from Sun Life?
Explanation
a.
The R2 value for Sun Life Financial was 0.12, which means that 12 percent of total risk
comes from movements in the market, i.e., market risk. Therefore, (1 − 0.12) = 0.88, or
88 percent of total risk is unique risk.
The R2 value for Loblaw’s was 0.06, which means that 6 percent of total risk comes from
movements in the market and 94 percent is unique risk.
b.
The variance of Sun Life Financial is: (18.7)2 = 349.7
Variance due to the market = 0.12 × 349.7 = 42
Variance of diversifiable returns = (1 − 0.12) × 349.7 = 307.7
c.
95% confidence interval
95% confidence interval
95% confidence interval
Loblaw’s
Loblaw’s
Loblaw’s
= β ± 2(Std error of β)
= 0.63 ± 2(0.33)
= −0.03 to 1.29
d.
rSLF = rf + βSLF × (rm − rf)
rSLF = 0.05 + 0.86(0.12 − 0.05)
rSLF = 0.1102, or 11.02%
e.
rSLF = rf + βSLF × (rm − rf)
rSLF = 0.05 + 0.86(20 − 0.05)
rSLF = 0.1790, or 17.9%
8: You are given the following information for Golden Fleece
Financial:
Long-term debt outstanding:
Current yield to maturity (rdebt):
Number of shares of common stock:
Price per share:
Book value per share:
Expected rate of return on stock (requity):
$300,000
8%
10,000
$
50
$
25
15%
Calculate Golden Fleece's company cost of capital. Ignore taxes.
Explanation
Market values:
Debt = $300,000
Equity = 10,000 × $50 = $500,000
Total = $300,000 + 500,000 = $800,000
rassets = $300,000 / $800,000 × 0.08 + $500,000 / $800,000 × 0.15
rassets = 0.1238, or 12.38%
9: Binomial Tree Farm’s financing includes $5 million of bank loans.
Its common equity is shown in Binomial’s Annual Report at $6.67
million. It has 500,000 shares of common stock outstanding, which
trade on the Wichita Stock Exchange at $18 per share. What debt
ratio should Binomial use to calculate its WACC or asset beta?
Debt ratio = Market value of debt / Total market value of debt
and equity
Debt ratio = $5 million / [$5 million + (500,000 × $18)]
Debt ratio = 0.3571, or 35.71%
10: An oil company is drilling a series of new wells on the perimeter
of a producing oil field. About 20% of the new wells will be dry holes.
Even if a new well strikes oil, there is still uncertainty about the
amount of oil produced: 40% of new wells that strike oil produce only
1,000 barrels a day; 60% produce 5,000 barrels per day.
a. Forecast the annual cash revenues from a new perimeter well. Use
a future oil price of $100 per barrel. (Assume 365 days in a year.
Round your answer to the nearest whole dollar amount.)
a.
Daily production = (0.2 × 0) + 0.8 × [(0.4 × 1,000) + (0.6 × 5,000)]
Daily production = 2,720 barrels
Annual cash revenues = 2,720 × 365 × $100
Annual cash revenues = $99,280,000
11: The figures below show plots of monthly rates of return on three
stocks versus those of the market index. The beta and standard
deviation of each stock is given beside the plot.
a. Which stock is safest for a diversified investor?
b. Which stock is safest for an undiversified investor who puts all her
money in one of these stocks?
c. Consider a portfolio with equal investments in each stock. What
would be this portfolio’s beta?
d. Consider a well-diversified portfolio composed of stocks with the
same beta and standard deviation as Ford. What are the beta and
standard deviation of this portfolio’s return? The standard deviation
of the market portfolio’s return is 20%.
e. Use the capital asset pricing model to estimate the expected return on
each stock. The risk-free rate is 4%, and the market risk premium is
8%.
Explanation
a.
According the analysis of the three securities, a diversified investor would be safest to
invest in the lowest market risk stock of Newmont, with β=0.10.
b.
For the undiversified investor, the least risky option is IBM with a standard deviation of
returns of 17.5%.
c.
With equal weightings of each stock, the portfolio would contain the average beta:
Portfolio beta = (1/3) × 0.94 + (1/3) × 0.10 + (1/3) × 1.26 =
0.77
d.
Since all the stocks have equivalent market risk to Ford, the portfolio would also have a
beta of 1.26. However, since the idiosyncratic risk in the portfolio will be eliminated
through diversification (assuming here low correlations given that the portfolio is “well”
diversified) the portfolio would have a standard deviation of 25.20% or 1.26 times the
market of standard deviation of 20%.
e.
IBM = 4% + 0.94 × (8%) = 11.52%
Newmont = 4% + 0.10 × (8%) = 4.80%
Ford = 4% + 1.26 × (8%) = 14.08%
Indicate whether the following statements are true or false.
a. Financing decisions are less easily reversed than investment decisions.
b. Tests have shown that there is almost perfect negative correlation
between successive price changes.
c. The semistrong form of the efficient-market hypothesis states that prices
reflect all publicly available information.
d. In efficient markets, the expected return on each stock is the same.
Explanation
a.
False. Financing decisions do not have the same degree of finality as investment decisions and are
therefore more easily reversed.
b.
False. Tests have shown that there is essentially no correlation between stock price changes.
c.
True.
d.
False. An individual stock’s return is dependent on the stock’s market risk as measured by beta.
Analysis of 60 monthly rates of return on United Futon common stock
indicates a beta of 1.45 and an alpha of −0.2% per month. A month later, the
market is up by 5%, and United Futon is up by 6%. What is Futon’s
abnormal rate of return?
Abnormal stock return = Actual stock return − Expected stock return
Abnormal stock return = Actual stock return − (α + β × Return on market index)
Abnormal stock return = 0.06 − (−0.002 + 1.45 × 0.05)
Abnormal stock return = −0.0105, or −1.05%
Indicate whether the following statements are true or false.
Explanation
a.
True. Overconfidence is a systematic bias.
b.
False. Once investors have incurred a loss, they are often even more concerned about future
losses.
c.
True.
d.
False. There are limits on the ability of the rational investors to exploit market inefficiencies.
These limits include things such as trading costs and the availability of shares to borrow.
A random walk process for a single stock consists of the toss of a fair coin at
the end of each day. If the outcome is heads, the stock price increases by
1.25 percent. If the outcome is tails, the stock price decreases by 0.75
percent. What is the drift of such a process?
Explanation
Drift = (0.5)(1.25%) + (0.5)(−0.75%) = +0.25%.
Stock price cycles or patterns tend to self-destruct as soon as investors
recognize them through
trading by investors.
Correct

Which of the following is a statement of weak-form efficiency?
1. I) If markets are efficient in the weak form, then it is impossible to
make consistently superior profits by using trading rules based on
past returns.
Strong-form market efficiency states that the market incorporates all information into
stock prices. Strong-form efficiency implies that
1. III) professional investors cannot consistently outperform the market;
In order to test the weak form of the efficient-market hypothesis, researchers
have used the following methods except
Multiple Choice

estimation of the serial correlation (autocorrelation) for securities and markets.

measurement of the profitability of trading rules used by technical analysts.

measurement of how rapidly security prices adjust to different news items.
Correct

All of the options are methods used for testing weak-form market efficiency.
For most stocks, a scatter plot chart of stock returns versus past stock returns
will appear as
Multiple Choice
a shotgun pattern centered close to the origin.
Behavioral finance deals with the idea that individual investors have built-in
biases and misconceptions that can drive prices away from fair values.
True
Chapter 17
1: Spam Corp. is financed entirely by common stock and has a beta of 1.0.
The firm is expected to generate a level, perpetual stream of earnings and
dividends. The stock has a price–earnings ratio of 8 and a cost of equity of
12.5%. The company’s stock is selling for $50. Now the firm decides to
repurchase half of its shares and substitute an equal value of debt. The debt
is risk-free, with an interest rate of 5%. The company is exempt from
corporate income taxes. Assume MM are correct.
a. Calculate the cost of equity after the refinancing.
b. Calculate the overall cost of capital (WACC) after the
refinancing. (Enter your answer as a percent rounded to 1 decimal
place.)
c. Calculate the price–earnings ratio after the refinancing.
d. Calculate the stock price after the refinancing.
e. Calculate the stock’s beta after the refinancing.
Explanation
a.
Given a 12.5 percent cost of equity before debt we find the expected return on equity:
rA = rD(D / V) + rE(E / V)
0.125 = 0.05(0.50) + rE(0.50)
rE = 0.20, or 20%
b.
The overall cost of capital will remain unchanged at 12.5 percent.
c.
Maintaining the perpetual stream of earnings and dividends, the E/P must now be 20 percent,
which implies a P/E ratio of 5.
d.
Assuming MM are correct, the stock price remains at $50.
e.
Since the debt is risk free, its beta is zero; the beta of the stock is found as:
βA = βD(D / V) + βE(E / V)
1.0 = 0(0.50) + βE(0.50)
βE = 2.0
2: Macbeth Spot Removers is entirely equity financed with values as shown
below:
Data
Number of shares
Price per share
Market value of shares
1,000
10
10,000
$
$
Although it expects to have an income of $1,500 a year in perpetuity, this
income is not certain. This table shows the return to stockholders under
different assumptions about operating income. We assume no taxes.
Operating income ($)
500
Outcomes
1,000
1,500
2,000
Suppose that Macbeth Spot Removers issues only $2,500 of debt and uses
the proceeds to repurchase 250 shares. The interest rate on the debt is 10%.
a. Calculate the equity earnings, earnings per share, and return on shares for
each operating income assumption.
Outcomes
Operating
income ($)
500
1,000selected answer 1,500selected answer 2,000selected answer
correct
correct
correct
Interest
250
Equity earnings
($)
Earnings per
share ($)
Return on
shares (%)
250selected answer
250selected answer
correct
correct
correct
750selected answer 1,250selected answer 1,750selected answer
250
0.33
3.33
250selected answer
correct
correct
correct
1.00selected answer
1.67selected answer
2.33selected answer
correct
correct
correct
10.00selected answer 16.67selected answer
correct
correct
23.33
b. If the beta of Macbeth's assets is 0.8 and its debt is risk-free, what would
be the beta of the equity after the debt issue?
All-equity beta0.80 Debt beta0.00 D/E ratio0.33 Equity beta1.07
Explanation
a.
Share price = $10; Shares outstanding = 750
b.
New capital structure:
Debt = $2,500
Equity = $10,000 – 2,500
Equity = $7,500
D / E = 0.33
βA = βD(D / V) + βE(E / V)
0.8 = 0.0($2,500 / $10,000) + βE($7,500 / $10,000)
βE = 1.07
3: Indicate whether the following statements are true or false.
a. MM’s propositions assume perfect financial markets, with no distorting
taxes or other imperfections.
True

b. MM’s proposition 1 says that corporate borrowing increases earnings per
share but reduces the price–earnings ratio. Assume the return earned by the
company exceeds the interest payment.

True
c. MM’s proposition 2 says that the cost of equity increases with borrowing
and that the increase is proportional to D/V, the ratio of debt to firm value.
False
d. MM’s proposition 2 assumes that increased borrowing does not affect the
interest rate on the firm's debt.
False
e. Borrowing does not increase financial risk and the cost of equity if there
is no risk of bankruptcy.
False
f. Borrowing always increases firm value if there is a clientele of investors
with a reason to prefer debt.
False
4: Macbeth Spot Removers is entirely equity financed. Use the following
information.
Data
Number of shares
Price per share
Market value of shares
Expected operating income
Return on assets
1,000
$
10
$10,000
$ 1,500
15%
Macbeth now decides to issue $5,000 of debt and to use the proceeds to
repurchase stock. Suppose that Ms. Macbeth's investment bankers have
informed her that since the new issue of debt is risky, debtholders will
demand a return of 12.5%, which is 2.5% above the risk-free interest rate.
a. What are rA and rE after the debt issue?
b. Suppose that the beta of the unlevered stock was 0.6. What will βA, βE ,
and βD be after the change to the capital structure?
Explanation
a.
Debt = $5,000
Equity = $10,000 – 5,000
Equity = $5,000
Total = $10,000
The return on assets will remain constant at 15 percent.
rA = rD(D / V) + rE(E / V)
0.15 = 0.125(0.50) + rE (0.50)
rE = 0.1750, or 17.50%
b.
The beta of the assets is unchanged; βA = 0.6
βA = βD(D / V) + βE(E / V)
0.6 = 0.50βD + 0.50βE
To solve for two unknowns, you need two formulas:
The second formula requires the risk-free rate, which is:
Risk-free rate = 12.5% – 2.5
Risk-free rate = 10%
We know the risk premium per unit of beta must be constant, therefore:
Risk premiumD / βD = Risk premiumE / βE
(0.125 – 0.100) / βD = (0.175 – 0.100) / βE
βE = 3βD
Substituting back into our original formula we have:
0.6 = 0.50βD + 0.50(3βD)
βD = 0.3
Given the value of βD:
βE = 3βD
βE = 3(0.3)
βE = 0.9
5: Gaucho Services starts life with all-equity financing and a cost of equity
of 14%. Suppose it refinances to the following market-value capital
structure:
Debt (D)
Equity (E)
45%
55%
at rD = 9.5%
Use MM’s proposition 2 to calculate the new cost of equity. Gaucho pays
taxes at a marginal rate of Tc = 40%. Calculate Gaucho’s after-tax weightedaverage cost of capital. (Do not round intermediate calculations. Enter
your answer as a percent rounded to 2 decimal places.)
Explanation
rE = rA + (rA − rD)(D / E)
rE = 0.14 + (0.14 − 0.095) × (45 / 55)
rE = 0.1768, or 17.68%
After-tax WACC = rD(1 − Tc)(D / V) + rE(E / V)
After-tax WACC = 0.095 × (1 − 0.40) × 0.45 + 0.1768 × 0.55
After-tax WACC = 0.1229, or 12.29%
6: Archimedes Levers is financed by a mixture of debt and equity. Complete
the following: (Enter your rE and rA answers as a percent rounded to 2
decimal places. Round your beta answers to 2 decimal places.)
Explanation
We begin with rE and the capital asset pricing model:
rE = rf + βE(rm – rf)
rE = 0.10 + 1.5(0.18 – 0.10)
rE = 0.2200, or 22.00%
Similarly for debt:
rD = rf + βD(rm – rf)
0.12 = 0.10 + βD(0.18 – 0.10)
βD = 0.25
Also, we know that:
rA = rD(D / V) + rE(E / V)
rA = 0.12(0.50) + 0.22(0.50)
rA = 0.1700, or 17.00%
Lastly, solving for βA:
βA = βD(D / V) + βE(E / V)
βA = 0.25(0.50) + 1.5(0.50)
βA = 0.88
7: If an investor buys a portion (X) of both the debt and equity of a levered
firm, then his/her payoff is
Multiple Choice

(X) × (profits).
8: If an investor buys a portion (X) of the equity of a levered firm, then his/her payoff
is
(X) × (profits − interest).
9: If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is
(X) × (profits).
10: Capital structure is irrelevant if
1. I) capital markets are efficient;
2. II) each investor can borrow/lend on the same terms as the firm;
3. III) there are no tax benefits to debt
I, II, and III
11: An EPS-operating income graph, such as Figure 17.1, shows the
1. I) greater risk associated with debt financing, which is evidenced by a
greater slope;
2. II) the break-even point where EPS of two different debt ratios are
equal;
3. III) the minimum operating income needed to pay the interest for a
given level of debt
I, II, and III
12: According to an EPS-operating income graph, such as Figure 17.1, EPS
is higher when expected operating income is
greater than the break-even income.
13: A firm has zero debt in its capital structure. Its overall cost of capital is
10 percent. The firm is considering a new capital structure with 60 percent
debt. The interest rate on the debt would be 8 percent. Assuming there are
no taxes, its cost of equity capital with the new capital structure would be
Explanation
rE = 10 + (60/40)(10 − 8) = 10 + 3 = 13.
14: A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of
equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of
equity if there are no taxes?
Explanation
rE = 12 + 1.0(12 − 9) = 15%.
15: For a levered firm where bA = beta of assets and bD = beta of debt, the
equity beta (bE) equals:
bE = bA + (D/E) × [bA - bD]
16: The beta of an all-equity firm is 1.2. Suppose the firm changes its capital
structure to 50 percent debt and 50 percent equity using 8 percent debt
financing. What is the equity beta of the levered firm? The beta of debt is
0.2. (Assume no taxes.)
Explanation
βE = 1.2 + (0.5/0.5)(1.2 − 0.2) = 2.2.
17: Generally, which of the following is true?
rE > rA > rD
18: If MM’s Proposition I holds, minimizing the weighted average cost of
capital (WACC) is the same as maximizing the:
market value of the firm.
19: Assume the following data for U&P Company: Debt (D) = $100 million;
Equity (E) = $300 million; rD = 6%; rE = 12%; and TC = 30%. Calculate the
after-tax weighted average cost of capital (WACC):
WACC=E/V*Re+D/V*Rd(1-t)
After-tax WACC = (1/4)(1 − 0.3)(6) + (3/4)(12) = 10.05%.
20: The firm's debt beta is usually approximately 1.0.
F
CHAPTER18
Here are book and market value balance sheets of the United Frypan
Company (UF):
Net working capital
Long-term assets
Book Value Balance Sheet
$ 20 $ 40 Debt
80
60 Equity
$100
$100
Market Value Balance Sheet
Net working capital
$ 20 $ 40 Debt
Long-term assets
140
120 Equity
$160
$160
Assume that MM's theory holds with taxes. There is no growth, and the $40
of debt is expected to be permanent. Assume a 40% corporate tax rate.
a. How much of the firm’s value in dollar terms is accounted for by the
debt-generated tax shield?
b. How much better off will UF's shareholders be if the firm borrows $20
more and uses it to repurchase stock?
Explanation
a.
PV tax shield = TcD
PV tax shield = 0.40 × $40
PV tax shield = $16
b.
Increase in equity = Tc × increase in debt
Increase in equity = 0.40 × $20
Increase in equity = $8
Compute the present value of interest tax shields generated by these three
debt issues. Consider corporate taxes only. Assume that the marginal tax
rate is Tc = 0.30.
a. A $1,000, one-year loan at 8%.
b. A five-year loan of $1,000 at 8%. Assume no principal is repaid until
maturity.
c. A $1,000 perpetuity at 7%.
Explanation
a.
PV tax shield = Tc(rdD) / (1 + rD)
PV tax shield = [0.30 (0.08 × $1,000)] / (1 + 0.08)
PV tax shield = $22.22
b.
PV tax shield =Σt=15=[0.30(0.08×$1,000)]/(1+0.08)tPV tax shield =Σt=15=[0.30(0.08×$1,0
00)]/(1+0.08)t
PV tax shield = $95.83
c.
PV tax shield = TcD
PV tax shield = 0.30 × $1,000
PV tax shield = $300
Which of the following entities likely has the highest cost of financial
distress?
Multiple Choice

A pharmaceuticals development company
The trade-off theory of capital structure predicts that

safe firms should borrow more than risky ones.
The pecking order theory of capital structure predicts that
Multiple Choice
if two firms are equally profitable, the more rapidly growing firm will end up borrowing
more, other things
Financial slack includes:
1. I) cash;
2. II) marketable securities;
3. III) readily salable real assets;
4. IV) ready access to debt markets or bank loans
What signal is sent to the market when a firm decides to issue new stock to raise capital?
Stock price is too high.
Risk shifting, refusing to contribute equity, and playing for time are some of
the consequences of firms facing bankruptcy.
The following are sensible reasons for mergers:
1. I) economies of scale;
2. II) economics of vertical integration;
3. III) complementary resources;
4. IV) prevent target firm from wasting surplus funds;
5. V) eliminate target firm inefficiencies;
6. VI) industry consolidation
Valeant and its ally, Pershing Square, lost the battle to acquire Allergan.
Sometimes, the losers in a takeover battle can also win if they own a toehold
stake in the target’s stock. Between April and June 2014, Pershing acquired
a 9.7% stake in Allergan at an estimated average price of $128 a share. In
November, Actavis offered $219 per share for each of Allergan’s 299
million shares.
What was Pershing’s profit on its holding?
Explanation
Investment = [0.097 × 299 million shares × $128/share] = $3,712.4 million
Return = [0.097 × 299 million shares × $219/share] = $6,351.7 million
Profit = $6,351.7 − $3,712.4 = $2,639.3 million