FINC 680 – Fall 2013 – Final Exam
Problems – You must show all your work to receive any credit (5pts each)
1. Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a
market price of $15 a share. The firm's management has decided to issue $30,000 worth
of debt and use the funds to repurchase shares of the outstanding stock. The interest rate
on the debt will be 10 percent. What are the earnings per share at the break-even level of
earnings before interest and taxes? Assume a tax rate of 35%.
2. Phillips Equipment has 80,000 bonds outstanding that are selling at a quote of 97.6.
Bonds with similar characteristics are yielding 7.5 percent. The company has 2.5 million
shares of common stock outstanding, and recently paid a dividend of $1.77. The
common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is
yielding 2.8 percent and the market risk premium is 6.3 percent. The corporate tax rate is
38 percent. What is the firm's weighted average cost of capital, if this company has
clearly communicated that it is open to changing its capital structure?
3. What is the expected return on this portfolio?
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4. What is the standard deviation of the returns on a $30,000 portfolio which consists of
stocks S and T? Stock S is valued at $21,000.
5. Delta Lighting has 30,000 shares of common stock outstanding at a market price of
$15.00 a share. This stock was originally issued at $31 per share. The firm also has a
bond issue outstanding with a total face value of $280,000 (the company has stated it will
not change its capital structure) which is selling at a quote of 86 and will mature in 5.5
years. The cost of equity is 13 percent while the aftertax cost of debt is 6.9 percent. The
firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of
capital?
6. Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent,
and expected earnings before interest and taxes of $15,700. The company has $12,000 in
bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are
selling at par value. What is the cost of equity, if this company might issue new debt in
the future?
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7. The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent
coupon, pay interest semiannually, and have a current market price equal to 98.6 percent
of face value. The tax rate is 39 percent. What is the amount of the annual interest tax
shield?
8. The City Street Corporation's common stock has a beta of 1.2. The risk-free rate is 3.5
percent and the expected return on the market is 13 percent. What is the firm's cost of
equity?
9. You would like to combine a risky stock with a beta of 1.68 with U.S. Treasury bills in
such a way that the risk level of the portfolio is equivalent to the risk level of the overall
market. What percentage of the portfolio should be invested in the risky stock?
10. Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of
capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and
a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What
is the firm's weighted average cost of capital?
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Multiple Choice Questions (2pts each)
1. In a world with taxes, but no bankruptcy, the weighted average cost of capital…
a. Is equal to the after-tax cost of debt
b. Has a linear relationship with the cost of equity
c. Is unaffected by the tax rate
d. Has an inverse relationship with the debt-equity ratio
e. Is equal to Ru x (1-T)
2. Scholastic Toys is considering developing and distributing a new board game for
children. The project is similar in risk to the firm's current operations. The firm maintains
a debt-equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How
should the firm determine its cost of equity?
a.
b.
c.
d.
e.
By adding the market risk premium to the after-tax cost of debt
By multiplying the market risk premium by (1-0.40)
By using the dividend growth model
By using the capital asset pricing model
By averaging the costs from the dividend growth model and the capital asset pricing
model
3. Total risk is measured by _____ and systematic risk is measured by _____.
a. Standard deviation; beta
b. Beta; alpha
c. Alpha; beta
d. Standard deviation; variance
e. Beta; standard deviation
4. Bankruptcy…
a. Creates value for the firm
b. Transfers wealth from the shareholders to the bondholders
c. Technically occurs when total equity equals total debt
d. Costs are limited to legal and administrative fees
e. Is an inexpensive means of reorganizing a firm
5. According to CAPM, the amount of reward an investor receives for bearing the risk of an
individual security depends upon the:
a. Amount of total risk assumed and the market risk premium
b. Market risk premium and the security’s response to the systematic risk in the market
c. Risk-free rate, the market return, and the standard deviation of the security
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d. Beta of the security and the market return
e. Standard deviation of the security and the risk-free rate
True/False (2pts each)
1. Beyond the optimal point of capital structure, the benefits from the tax shield exceed the costs of
potential financial distress
2. Systematic risk can be reduced in a well-diversified portfolio
3. Ceteris paribus, decreasing the WACC would yield an increase in the NPV of the firm’s projects
4. The beta of a stock that is as risky as the overall stock market should be 1.0
5. You’ve already asked Santa for more speech topics under the tree
Short Essays – Remember to be complete in your responses (10pts each)
In a world with taxes, but no potential for bankruptcy, what would you tell a financial manager who is
searching for the optimal point of capital structure?
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Why do you suppose that the WACC is the appropriate discount rate for companies to use for their
projects?
For a well-diversified investor, which measure is a more appropriate measure of risk: standard deviation
or beta?
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