Bxam 2
(175 pts)
FIN 4303/5970
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Fall2009 S. Linn
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Instructions: This is a closed noteslclosed book exam. You must show your work to receive credit. The
exam is worth a total of 175 points. Present value factor tables are attached to the quiz. Some useful
equations appear on the last page of the exam. Good luck!
1. Assume the Capital Asset Pricing Model is the correct model for computing expected returns
on a stock. The risk-free rate of return is 4% and the market risk premium is 8%. What is the
expected rate of retum on a stockfrIth-iEEiftf t.2g?
A. 9.12%
B. 10.24%
c. 13.12%
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2. Assume the Capital Asset Pricing Model is the correct model for computing the expected
return on a stock. The common stock of Flavorful Teas has an expected return of 14.42oh.The
return on the market is l0% and the risk-free rate of return is 3.5%. What is the beta of this
stock? Round off to the second decimal place.
A. .65
B. 1.09
c.
1.32
D.
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Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value (meaning
Yachbond has a market value of $1,000). The yield-to-maturity on the bonds is 8.5%. The
company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and
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sells for $40 a share. The U.S. Treasury bill is yielding 4Y, and the market risk premium is 8%.
Jack's tax rate is 35%. What is Jack's weighted average cost of capital?
A. 6.669 %
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expects its operations will produce a perpetuity of $2,100 in
earnings before interest and taxes. Investors also hold these same beliefs. The comp'any has an
unlevered cost of capital of 74o/o and a tax rate of 34o/o. The company also has $2,800 of
perpetual debt that carries a 7o/o cotpon. The debt is selling at par value, meaning each bond sells
for its par value of $1,000. What is the value of this firm? Assume there are no costs of
4. The Winter Wear Company
bankruptcy or financial distress or costs associated with managerial or equity holder incentive
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I 5. Anderson's Furniture Outlet has an unlevered cost of capital of 10o/o, a tax rate of 34oh, and
\grfected eamings before interest and taxes of $1,600. EBIT is a perpetuity. The company has
$3,000 in perpetual bonds outstanding (face value) that have anSo/o coupon and pay interest
annually. The bonds are selling at par value (meaning the market value of the bonds is equal to
the face value). What is the cost of equity for this firm? Assume there are no costs of bankruptcy
or financial distress or costs associated with managerial or equityholder incentive problems (that
is, none of the costs described in Chapter l6 are not present). Round off your answer.
A. 8.670/,
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6. Margerit is reviewing a project with projected sales of 1,500 units a year, an after-tax cash
flow of $40 a unit and a three-year project life. The initial6st olthe project is $95,000. The
relevant discount rate is 75o/o.Margerit has the option to abandon the project after one year at
which time she feels she could sell the project for $60,000. If sales in units drop to 1000 per year
in years 2 and 3 should Margerit abandon the project. For purposes of computing your answer
assume that irrespective of the year in which they are produced each unit sold will generate an
after-tax cash flow of $40 per unit. Show your work.
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has a new electronic answering machine ready to market. If the firm
producl.
the
for
the market now with the product, there is a 40 percent chance of high demand
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However, the firm can conduct a market research study, which will take ayear and cost $
customers
potential
million. By completing the market research, ANS will be able to better target
to 60 percent. If
and will increase the piobability of high demand for the answering machine
goes
to the market
there is high demand for the product (irrespective of whether the company
the investment
now or *uitr;, the answering machine will bring a net present value (at the time
be
low the net
to
out
turns
in the project is made) of $ io rnillion. If on the other hand demand
pr"r"ri rulu. will be only $ 2 million (at the time the investment in the project is made). Should
in" n.,, conduct the mar-ket researgb-stu{y or go directly to market with the answering machine? .
7. ANS Inc.
rhe approp"ut. ai..orni;;,;
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8. Assume the world conforms to the Modigliani and Miller conditions unde
personal taxes (MM proposition II, No Taxes). Graph the relationship between the w-tphtEd-ur"rug" cost of capital and leverage (in this case the debt/equity ratio), the relationship between
the coit of debt and leverage (the debt/equity ratio) and the relationship between the cost of
equity and leverage (the debtlequity ratio). Use the graph provided below. Label your lines
appropriately. What does this proposition say about how the weighted average cost of capital
changes as the debt/equity ratio changes?
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