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Question: Cavo Corporation expects an EBIT of $19,


Cavo Corporation expects an EBIT of $19,750 every year forever. The company currently has no debt, and its cost of equity is 15 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 10 percent. If the corporate tax rate is 35 percent, what will the value of the firm be if the company takes on debt equal to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent of its unlevered value?
c. What will the value of the firm be if the company takes on debt equal to 50 percent of its levered value? What if the company takes on debt equal to 100 percent of its levered value?



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> The market portfolio has an expected return of 12 percent and a standard deviation of 22 percent. The risk-free rate is 5 percent. a. What is the expected return on a well-diversified portfolio with a standard deviation of 9 percent? b. What is the stand

> Suppose a stock had an initial price of $75 per share, paid a dividend of $1.20 per share during the year, and had an ending share price of $86. Assuming the ending share price is $67. Compute the percentage total return. What was the dividend yield? Th

> The following figures present the results of four cumulative abnormal returns (CAR) studies. Indicate whether the results of each study support, reject, or are inconclusive about the semi-strong form of the efficient market hypothesis. In each figure, Ti

> Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be negative after the fact? Explain.

> Assume that the returns on individual securities are generated by the following two-factor model: R it = E ( R it ) + β ij F 1 t + β i 2 F 2 t Here: Rit is the return on Security i at Time t. F1t and F2tare market factors with zer

> Which of the following statements are true about the efficient market hypothesis? a. It implies perfect forecasting ability. b. It implies that prices reflect all available information. c. It implies an irrational market. d. It implies that prices do not

> Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company’s tax rate is 35 percent. a. What is the pretax cost of debt? b. What is the aftertax cost of debt? c. Which

> Suppose a factor model is appropriate to describe the returns on a stock. The current expected return on the stock is 10.5 percent. Information about those factors is presented in the following chart: a. What is the systematic risk of the stock return?

> David McClemore, the CFO of Ultra Bread, has decided to use an APT model to estimate the required return on the company’s stock. The risk factors he plans to use are the risk premium on the stock market, the inflation rate, and the price of wheat. Becaus

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> Suppose the expected returns and standard deviations of Stocks A and B are E( R A ) = .09, E( RB ) = .15, αA = .36, and αB 5 .62. a. Calculate the expected return and standard deviation of a portfolio that is composed of 35 percent A and 65 percent B whe

> Suppose the returns on large-company stocks are normally distributed. Based on the historical record, use the NORMDIST function in Excel ® to determine the probability that in any given year you will lose money by investing in common stock.

> Prospectors, Inc., is a publicly traded gold prospecting company in Alaska. Although the firm’s searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors’ cumulative abn

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> Suppose Tom O’Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm’s cost of debt and cost of equity capital. a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It

> For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3)

> In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

> Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent

> In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? If a firm issues equity to repurchase some of its debt, the price per share of the firm’s stock will rise because th

> Beginning with the cost of capital equation—that is: show that the cost of equity capital for a levered firm can be written as follows: В RWACC =B+SRs+ B+S R, = R, + (R, - R)

> Suppose a firm’s business operations mirror movements in the economy as a whole very closely—that is, the firm’s asset beta is 1.0. Use the result of previous problem to find the equity beta for this firm for debt–equity ratios of 0, 1, 5, and 20. What d

> Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, R f . Define βA as the firm’s asset beta—that is, the systematic risk of the firm’s assets. Define βS to be the beta of the firm’s equity. Use the capital asset pricin

> Assuming a world of corporate taxes only, show that the cost of equity, R S, is as given in the chapter by MM Proposition II with corporate taxes.

> In a world of corporate taxes only, show that the R WACC can be written as R WACC = R0 × [1 – tC ( B/V )].

> Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent. Williamson is subject to a corporate tax rate of 35 percent. a. What is Williamson’s cost of equity cap

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> What are the main features of a corporate bond that would be listed in the indenture?

> Do you agree or disagree with the following statement: In an efficient market, callable and noncallable bonds will be priced in such a way that there will be no advantage or disadvantage to the call provision. Why?

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> Continental Airlines once filed for bankruptcy, at least in part, as a means of reducing labor costs. Whether this move was ethical or proper was hotly debated. Give both sides of the argument.

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> When personal taxes on interest income and bankruptcy costs are considered, the general expression for the value of a levered firm in a world in which the tax rate on equity distributions equals zero is: VL = VU + {1 – [(1 – tC) / (1 – tB)}] × B – C ( B

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> An outstanding issue of Public Express Airlines debentures has a call provision attached. The total principal value of the bonds is $250 million, and the bonds have an annual coupon rate of 9 percent. The company is considering refunding the bond issue.

> Do you think preferred stock is more like debt or equity? Why?

> Good Time Company is a regional chain department store. It will remain in business for one more year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It is projected that the company will generate a total ca

> As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this a proper use of the bankruptcy process?

> Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is expected to remain

> Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 7 percent, payable annually. The one-year interest rate is 7 percent. Next year, there is a 35 percent probability that interest rates will increase to 9 per

> Bowdeen Manufacturing intends to issue callable, perpetual bonds with annual coupon payments. The bonds are callable at $1,175. One-year interest rates are 9 percent. There is a 60 percent probability that long-term interest rates one year from today wil

> What are the direct and indirect costs of bankruptcy? Briefly explain each.

> Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that

> Refer to the observed capital structures given in Table 17.3 of the text. What do you notice about the types of industries with respect to their average debt–equity ratios? Are certain types of industries more likely to be highly levera

> Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. Ignoring taxes, wha

> Is there an easily identifiable debt–equity ratio that will maximize the value of a firm? Why or why not?

> A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?

> Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of the continuation of the current exp

> What are the sources of agency costs of equity?

> Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. a. Ignoring taxes,

> How would you answer in the following debate? Q : Isn’t it true that the riskiness of a firm’s equity will rise if the firm increases its use of debt financing? A : Yes, that’s the essence of MM Proposition II. Q : And isn’t it true that, as a firm incre

> New Business Ventures, Inc., has an outstanding perpetual bond with a 10 percent coupon rate that can be called in one year. The bond makes annual coupon payments. The call premium is set at $150 over par value. There is a 60 percent chance that the inte

> Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent

> What are the main differences between corporate debt and equity? Why do some firms try to issue equity in the guise of debt?

> Edwards Construction currently has debt outstanding with a market value of $85,000 and a cost of 9 percent. The company has EBIT of $7,650 that is expected to continue in perpetuity. Assume there are no taxes. a. What is the value of the company’s equity

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> Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outst

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> KIC, Inc., plans to issue $5 million of bonds with a coupon rate of 8 percent and 30 years to maturity. The current market interest rates on these bonds are 7 percent. In one year, the interest rate on the bonds will be either 10 percent or 6 percent wit

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> Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were entirely financed by equity would be $17.85 million. The company also has 350,000 shares of stock outstanding that sell at a price of $38 per share. The c

> What steps can stockholders take to reduce the costs of debt?

> Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outst

> List the three assumptions that lie behind the Modigliani–Miller theory in a world without taxes. Are these assumptions reasonable in the real world? Explain.

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