Quiz #6: Module 4, Chapters 13-15
FIN 5405
J. Houston
Calculating unlevered beta
1.
Morgan Entertainment has a levered beta of 1.20. The firm's capital structure consists of
40% debt and 60% equity and it has a corporate tax rate of 40%. What is Morgan's
unlevered beta?
a.
b.
c.
d.
e.
0.7534
0.7811
0.8043
0.8249
0.8571
1.20 = bu (1 + 0.6 * 4/6)
1.20 = 1.4 * bu
bu = 1.2/1.4 = 0.8571
Answer: e
Abandonment option – NPV
2.
Nelson Manufacturing is considering a project which would require a $6.2 million
investment today (t = 0). The after-tax cash flows the factory generates will depend on
whether the state imposes a new property tax. There is a 50-50 chance that the tax will
pass. If the tax passes, the factory will produce after-tax cash flows of $1,000,000 at the
end of each of the next 5 years. If the tax does not pass, the factory will produce after-tax
cash flows of $2,000,000 for the next 5 years. The project has a WACC of 12%. If the
factory is unsuccessful, the firm will have the option to abandon the project 1 year from
now if the tax passes. If the factory project is abandoned, the firm will receive the expected
$1 million cash flow at t = 1, and the property will be sold netting $6 million (after taxes
are considered) at t = 1. Once the project is abandoned, the company would no longer
receive any cash inflows from it. What is the project’s expected NPV if it can be
abandoned?
a.
b.
c.
d.
e.
$486,524
$509,831
$529,776
$537,098
$541,234
1
Year
No Tax CF
Tax CF
Abandonment CF
0
-6,200
-6,200
-6,200
1
2,000
1,000
7,000
2
2,000
1,000
3
2,000
1,000
4
2,000
1,000
5
2,000
1,000
NPV
1,009.55
2,595.22
Final NPV = 1,009.55 + 50 / 2 = 529.7750
Answer: c
2
50
Real options
3.
Which of the following statements is CORRECT?
a. In general, the more uncertainty there is about market conditions, the more attractive
it may be to wait before making an investment. True
b. In general, the greater the strategic advantages of being the first competitor to enter a
given market, the more attractive it may be to wait before making an investment.
False
c. In general, the higher the discount rate, the more attractive it may be to wait before
making an investment.
d. It is not possible for abandonment options to decrease a project’s risk as measured by
the project’s coefficient of variation. False
e. Very few projects actually have real options. Real options are theoretically
interesting but of little practical importance. False
Answer: a
Financial leverage and EPS
4.
Which of the following statements is CORRECT?
a. Increasing financial leverage is one way to increase a firm’s basic earning power
(BEP).
b. Firms with lower fixed costs tend to have greater operating leverage. False
c. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes
share price.
d. If a company were to issue debt and use the money to repurchase common stock, this
action would have no impact on the company’s return on assets. (Assume that the
repurchase has no impact on the company’s operating income.)
e. If changes in the bankruptcy code make bankruptcy less costly to corporations, then
this would likely reduce the debt ratio of the average corporation. False
Residual dividend model - NI and payout ratio
5.
Scholes Motors has a capital budget of $1,100,000, but it wants to maintain a target capital
structure of 50% debt and 50% equity. The company expects to pay a dividend of $250,000.
If the company follows a residual dividend policy, what is its forecasted dividend payout
ratio?
a.
b.
c.
d.
e.
31.25%
33.00%
34.75%
36.50%
38.25%
Answer: a
3
Dividends = Net Income – [(Target Equity Ratio) * (Total Capital Budget)]
250,000 = Net Income – 0.5 * 1,100,000
Net Income = 800,000
Dividend Payout ratio = 250,000 / 800,000 = 31.25%
Dividend theory
6.
Which of the following statements is CORRECT?
a. Firms with a large number of investment opportunities and a relatively small amount of
cash tend to have above average dividend payout ratios. False
b. One advantage of the residual dividend policy is that it leads to a stable dividend payout,
which investors like. False
c. An increase in the stock price when a company decreases its dividend is consistent with
signaling theory. False
d. If the “clientele effect” is correct, then for a company whose earnings fluctuate, a policy
of paying a constant percentage of net income will probably maximize the stock price.
False
e. Stock repurchases make the most sense at times when a company believes that its stock is
undervalued. True
Answer: e
Residual dividend model - debt ratio
7.
Carroll Co. is forecasting EPS of $3.00 this year on its 500,000 shares of stock outstanding.
Its capital budget for the upcoming year will be $800,000. The company is also committed
to maintaining its $2.00 dividend per share (DPS), and it wants to avoid issuing new common
stock. The company’s capital structure consists of debt and common stock. Given the above
constraints, what portion of the capital budget will be funded with debt?
a.
b.
c.
d.
e.
27.50%
30.00%
32.50%
35.00%
37.50%
Investment timing option - NPV
8.
Damon Corp. is considering a new product that would require an investment of $20
million at t = 0. If the new product is well received, then the project would produce aftertax cash flows of $10 million at the end of each of the next 3 years (t = 1, 2, 3), but if the
market did not like the product, then the cash flows would be only $4 million per year.
There is a 50% probability that the market will be good. Damon could delay the project
for a year while it could conduct a test to determine if demand would be strong or weak.
4
The project’s cost and expected annual cash flows are the same whether the project is
delayed or not. The project's WACC is 11%. What is the value of the project after
considering the investment timing option?
a.
b.
c.
d.
e.
$1,353,892
$1,489,453
$1,545,376
$1,767,031
$1,998,715
5
Cost of equity - unlevering/relevering betas
9.
OMS Inc. is trying to establish its optimal capital structure. Its current capital structure
consists of 20% debt and 80% equity; however, the CEO believes the firm should use
more debt. The risk-free rate, rRF, is 4%, the market risk premium, RPM, is 5%, and the
firm’s tax rate is 40%. Currently, the firm’s cost of equity is 11%, which is determined by
the CAPM. What would be the firm’s estimated cost of equity if it changed its capital
structure to 40% debt and 60% equity?
a.
b.
c.
d.
e.
10.85%
11.66%
12.52%
13.03%
13.89%
Answer: c
Step I: Calculate the current levered beta:
rS = rRF + RPM (bL)
11 = 4 + 5 (bL)
bL = 1.40
Step II: Use Hamada’s equation to find the unlevered beta:
1.40 = bU (1 + 0.6 * 2/8)
bU = 1.2174
Step III: Find levered beta for the current capital structure
bL = 1.2174 (1 + 0.6 * 4/6)
bL = 1.7044
Step IV: Use CAPM to find rs
rS = rRF + RPM (bL)
= 4 + 5 * 1.7044)
= 12.5220
Recapitalization
10.
McKean Inc. is an all-equity firm with 200,000 shares outstanding. The company’s EBIT
is $2,000,000, and EBIT is expected to remain constant over time. The company pays
out all of its earnings each year, so its earnings per share (EPS) equals its dividends per
shares (DPS). The company’s tax rate is 40%.
The company is considering issuing $2 million worth of bonds (at par) and using the
proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of
10%. The risk-free rate is 6.5%, and the market risk premium is 5.0%. The company’s
beta is currently 0.90, but investment bankers say the beta will rise to 1.10 if the
recapitalization occurs.
6
Assume that the shares are repurchased at a price equal to the stock market price prior
to the recapitalization. What would be the company’s stock price following the
recapitalization?
a.
b.
c.
d.
e.
$54.00
$55.10
$56.20
$57.30
$58.40
7