Diddy Corp. stock has a beta of 1.2, the current risk-free rate is 5 percent, and the expected return on the market is 13.5 percent. What is Diddy’s cost of equity?
> In 2000, the S&P 500 Index earned −9.1 percent while the T-bill yield was 5.9 percent. Does this mean the market risk premium was negative? Explain.
> Why expected return is considered “forward-looking”? What are the challenges for practitioners to utilize expected return?
> Consider an asset that provides the same return no matter what economic state occurs. What would be the standard deviation (or risk) of this asset? Explain.
> Compare and contrast the assumptions that need to be made to compute a required return using CAPM and the constant growth rate model.
> As discussed in the text, beta estimates for one firm will vary depending on various factors like such as the time over which the estimation is conducted, the market portfolio proxy, and the return intervals. You will demonstrate this variation using ret
> Build a spreadsheet that automatically computes the expected market return and risk for different assumptions about the state of the economy. a. First, create the following spreadsheet and compute the expected return and standard deviation. b. Compute t
> When you go on the Web to find a firm’s beta, you do not know how recently it was computed, what index was used as a proxy for the market portfolio, or which time series of returns the calculations used. Earlier in this chapter, it was
> No Nuns Cos. has a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, let’s assume that the firm
> For the same economic state probability distribution in Problem 10-1, determine the standard deviation of the expected return. Economic Probability Return State Fast growth Slow growth 0.3 40% 0.4 10% Recession 0.3 -25%
> A manager believes his firm will earn a 14 percent return next year. His firm has a beta of 1.2, the expected return on the market is 11 percent, and the risk-free rate is 5 percent. Compute the return the firm should earn given its level of risk and d
> A manager believes his firm will earn a 14 percent return next year. His firm has a beta of 1.5, the expected return on the market is 12 percent, and the risk-free rate is 4 percent. Compute the return the firm should earn given its level of risk and
> For the same economic state probability distribution in Problem 10-2, determine the standard deviation of the expected return. Economic Probability Return State Fast growth Slow growth 0.2 35% 0.6 10% Recession 0.2 -30%
> You own $10,000 of Olympic Steel stock that has a beta of 2.2. You also own $7,000 of Rent-a-Center (beta = 1.5) and $8,000 of Lincoln Educational (beta = 0.5). What is the beta of your portfolio?
> You own $7,000 of Human Genome stock that has a beta of 3.5. You also own $8,000 of Frozen Food Express (beta = 1.6) and $10,000 of Molecular Devices (beta = 0.4). What is the beta of your portfolio?
> Compute the expected return given these three economic states, their likelihoods, and the potential returns: Economic Probability Return State Fast growth Slow growth 0.3 40% 0.4 0.3 10 Recession -25
> Universal Forest’s current stock price is $57.50 and it is likely to pay a $0.26 dividend next year. Since analysts estimate Universal Forest will have a 9.5 percent growth rate, what is its required return?
> Paccar’s current stock price is $48.20 and it is likely to pay a $0.80 dividend next year. Since analysts estimate Paccar will have an 8.8% growth rate, what is its required return?
> The Japanese stock market bubble peaked at 38,916 in 1989. Two and a half years later it had fallen to 15,900. What was the percentage decline?
> Would you expect a utility company to have high or low debt levels? Why?
> The Nasdaq stock market bubble peaked at 4,816 in 2000. Two and a half years later it had fallen to 1,000. What was the percentage decline?
> You have a portfolio with a beta of 1.1. What will be the new portfolio beta if you keep 85 percent of your money in the old portfolio and 15 percent in a stock with a beta of 0.5?
> You have a portfolio with a beta of 1.35. What will be the new portfolio beta if you keep 85 percent of your money in the old portfolio and 5 percent in a stock with a beta of 0.78?
> Paycheck, Inc. has a beta of 0.94. If the market return is expected to be 11 percent and the risk-free rate is 3 percent, what is Paycheck’s risk premium?
> Netflix, Inc. has a beta of 3.61. If the market return is expected to be 13 percent and the risk-free rate is 3 percent, what is Netflix’ risk premium?
> Nanometrics, Inc. has a beta of 3.15. If the market return is expected to be 10 percent and the risk-free rate is 3.5 percent, what is Nanometrics’ required return?
> Hastings Entertainment has a beta of 0.65. If the market return is expected to be 11 percent and the risk-free rate is 4 percent, what is Hastings’ required return?
> The average annual return on the S&P 500 Index from 1996 to 2005 was 10.8 percent. The average annual T-bill yield during the same period was 3.6 percent. What was the market risk premium during these ten years?
> Could you calculate the component cost of equity for a stock with nonconstant expected growth rates in dividends if you didn’t have the information necessary to compute the component cost using the CAPM? Why or why not?
> Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The constant-growth model?
> If the U.S. government completely eliminated taxation at the corporate level, how would this influence the capital structures of firms in a world with bankruptcy?
> Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the WACC?
> Why don’t we multiply the cost of preferred stock by one minus the tax rate, as we do for debt?
> How would you handle calculating the cost of capital if a firm were planning to issue two different classes of common stock?
> Suppose a new project was going to be financed partially with retained earnings. What flotation costs should you use for retained earnings?
> When will the subjective approach to forming divisional WACCs be better than using the firmwide WACC to evaluate all projects?
> Suppose your firm wanted to expand into a new line of business quickly, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years. If the expansion was going to be financed
> Why do we use market-based weights instead of book-value-based weights when computing the WACC?
> LilyMac Studios, a national chain of photography studios, is considering opening up a chain of coffee shop/art galleries. While the existing operations of the firm have a beta of 1.17, the new chain is expected to have a beta of 0.8. LilyMac currently ha
> LilyMac Studios, a national chain of photography studios, is considering opening up a chain of coffee shop/art galleries. While the existing operations of the firm have a beta of 1.17, the new chain is expected to have a beta of 0.8. LilyMac currently ha
> Suppose that B2B, Inc. has a capital structure of 37 percent equity, 17 percent preferred stock, and 46 percent debt. If the before-tax component costs of equity, preferred stock and debt are 14.5 percent, 11 percent, and 9.5 percent, respectively, what
> Explain why, in a world with both corporate taxes and the chance of bankruptcy, a small firm with volatile EBIT is unlikely to have much debt.
> Suppose that JB Cos. has a capital structure of 78 percent equity, 22 percent debt, and that its before-tax cost of debt is 11 percent while its cost of equity is 15 percent. If the appropriate weighted average tax rate is 25 percent, what will be JB’s W
> Suppose that TapDance, Inc.’s capital structure features 65 percent equity, 35 percent debt, and that its before-tax cost of debt is 8 percent, while its cost of equity is 13 percent. If the appropriate weighted average tax rate is 34 percent, what will
> Suppose that Brown-Murphies’ common shares sell for $19.50 per share, that the firm is expected to set their next annual dividend at $0.57 per share, and that all future dividends are expected to grow by 4 percent per year, indefinitely. If Brown- Murphi
> Suppose that MNINK Industries’ capital structure features 63 percent equity, 7 percent preferred stock, and 30 percent debt. If the before-tax component costs of equity, preferred stock and debt are 11.60 percent, 9.5 percent, and 9 percent, respectively
> BetterPie Industries has three million shares of common stock outstanding, two million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $47 per share, the preferred shares are selling for $24.50 per share, and
> Johnny Cake Ltd. has ten million shares of stock outstanding selling at $23 per share and an issue of $50 million in 9 percent, annual coupon bonds with a maturity of 17 years, selling at 93.5 percent of par. If Johnny Cake’s weighted average tax rate is
> TAFKAP Industries has three million shares of stock outstanding selling at $17 per share and an issue of $20 million in 7.5 percent, annual coupon bonds with a maturity of 15 years, selling at 106 percent of par. If TAFKAP’s weighted average tax rate is
> WhackAmOle has two million shares of common stock outstanding, 1.5 million shares of preferred stock outstanding, and 50,000 bonds. If the common shares are selling for $63 per share, the preferred shares are selling for $52 per share, and the bonds are
> OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the common shares sell for $17 per share, the preferred shares sell for $16 per share, and the bonds sell for 108 perce
> Suppose you were the financial manager for a firm and were considering a proposed increase in the amount of debt in the firm’s capital structure. If you thought the firm was going to consistently earn a level of EBIT above its break-even level of EBIT (b
> FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares sell for $27 per share, the preferred shares sell fo
> OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the common shares are selling for $27 per share, the preferred shares are selling for $26 per share, and the bonds are
> FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $27 per share, the preferred shares
> OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the common shares are selling for $17 per share, the preferred shares are selling for $26 per share, and the bonds are
> FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $27 per share, the preferred shares
> Marme, Inc. has preferred stock selling for 96 percent of par that pays an 11 percent annual coupon. What would be Marme’s component cost of preferred stock?
> ILK has preferred stock selling for 97 percent of par that pays an 8 percent annual coupon. What would be ILK’s component cost of preferred stock?
> Oberon, Inc. has a $20 million (face value) 10-year bond issue selling for 97 percent of par that pays an annual coupon of 8.25 percent. What would be Oberon’s before-tax component cost of debt?
> JaiLai Cos. stock has a beta of 0.9, the current risk-free rate is 6.2 percent, and the expected return on the market is 12 percent. What is JaiLai’s cost of equity?
> Suppose that LilyMac Photography expects EBIT to be approximately $200,000 per year for the foreseeable future, and that they have 1,000 10-years, 9 percent annual coupon bonds outstanding. What would the appropriate tax rate be for use in the calculatio
> If an investor wanted to reduce the risk of a levered stock in their portfolio, how could they go about doing so while still retaining shares in the company?
> KatyDid Clothes has a $150 million (face value) 30-year bond issue selling for 104 percent of par that carries a coupon rate of 11 percent, paid semiannually. What would be Katydid’s before-tax component cost of debt?
> PDQ, Inc. expects EBIT to be approximately $11 million per year for the foreseeable future, and that they have 25,000 20-years, 8 percent annual coupon bonds outstanding. What would the appropriate tax rate be for use in the calculation of the debt compo
> A firm is considering a project that will generate perpetual after-tax cash flows of $15,000 per year beginning next year. The project has the same risk as the firm's overall operations and must be financed externally. Equity flotation costs 14 percent a
> Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.6, 1.0, 1.3, and 1.6, respectively. If all current and future projects will
> An all-equity firm is considering the projects shown as follows. The T-bill rate is 4 percent and the market risk premium is 7 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrec
> An all-equity firm is considering the projects shown as follows. The T-bill rate is 4 percent and the market risk premium is 7 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrec
> Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.9, 1.1, 1.3, and 1.5, respectively. If all current and future projects will
> Suppose a new project was going to be financed partially with retained earnings. What flotation costs should you use for retained earnings?
> When will the subjective approach to forming divisional WACCs be better than using the firmwide WACC to evaluate all projects?
> Suppose your firm wanted to expand into a new line of business quickly, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years. If the expansion was going to be financed
> If a firm increased the amount of debt in its capital structure, but a shareholder wanted to switch back to the mixture of expected return and risk she had before the switch, how would she go about doing so?
> Why do we use market-based weights instead of book-value-based weights when computing the WACC?
> Could you calculate the component cost of equity for a stock with nonconstant expected growth rates in dividends if you didn’t have the information necessary to compute the component cost using the CAPM? Why or why not?
> Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The constant-growth model?
> Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the WACC?
> Why don’t we multiply the cost of preferred stock by one minus the tax rate, as we do for debt?
> How would you handle calculating the cost of capital if a firm were planning to issue two different classes of common stock?
> Explain why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division.
> Will an increase in flotation costs increase or decrease the initial cash flow for a project?
> How many TVM formulas do you use every time you calculate EAC for a project?
> In a cost-cutting proposal, what might cause you to sometimes have negative EBIT?
> Why does allowing for the existence of corporate taxation cause firms to prefer the maximum amount of debt possible?
> Would it be possible for a firm to announce a “reverse stock dividend”?
> In a replacement problem, will incremental net depreciation always be less than the gross depreciation on the new piece of equipment?
> In a replacement problem, would we ever see changes in NWC?
> Everything else held constant, would you rather depreciate a project with DDB depreciation or deduct it under a Section 179 deduction?
> Everything else held constant, would you rather depreciate a project with straight-line depreciation or with DDB?
> Why does a decrease in NWC result in a cash inflow to the firm?
> Suppose you paid your old college finance professor to evaluate a project for you. If you would pay him regardless of your decision concerning whether to proceed with the project, should his fee for evaluating the project be included in the project’s inc
> How is the pro forma statement we used in this chapter for computing OCF different from an accountant’s income statement?
> Your company, Dawgs “R” Us, is evaluating a new project involving the purchase of a new oven to bake your hotdog buns. If purchased, the new oven will replace your existing oven, which was purchased seven years ago for a total, installed price of $1,000
> KADS, Inc. has spent $400,000 on research to develop a new computer game. The firm is planning to spend $200,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $50,000.
> You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck for $60,000. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck wil
> In M&M’s perfect world, will the debt holders ever bear any of the risk of the firm?
> If the lathe in the previous problem can be sold for $5,000 at the end of year 3, what is the after-tax salvage value?
> Your firm needs a computerized machine tool lathe which costs $50,000, and requires $12,000 in maintenance for each year of its three-year life.
> Suppose you sell a fixed asset for $109,000 when its book value is $129,000. If your company’s marginal tax rate is 39 percent, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)?
> You are evaluating two different cookie-baking ovens. The Pillsbury 707 costs $57,000, has a five-year life, and has an annual OCF (after tax) of -$10,000 per year. The Keebler CookieMunster costs $90,000, has a seven-year life, and has an annual OCF (af
