Your brother Joe is a surgeon who suffers badly from the overconfidence bias. He loves to trade stocks and believes his predictions with 100% confidence. In fact, he is uninformed like most investors. Rumors are that Vital Signs (a startup that makes warning labels in the medical industry) will receive a takeover offer at $20 per share. Absent the takeover offer, the stock will trade at $15 per share. The uncertainty will be resolved in the next few hours. Your brother believes that the takeover will occur with certainty and has instructed his broker to buy the stock at any price less than $20. In fact, the true probability of a takeover is 50%, but a few people are informed and know whether the takeover will actually occur. They also have submitted orders. Nobody else is trading in the stock. a. Describe what will happen to the market price once these orders are submitted if in fact the takeover will occur in a few hours. What will your brother’s profits be: positive, negative, or zero? b. What range of possible prices could result once these orders are submitted if the takeover does not occur? What will your brother’s profits be: positive, negative, or zero? c. What are your brother’s expected profits?
> On May 14, 2008, General Motors paid a dividend of $0.25 per share. During the same quarter GM lost a staggering $15.5 billion or $27.33 per share. Seven months later the company asked for billions of dollars of government aid and ultimately declared ban
> Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the trade-off theory.
> Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt: Suppose the firm has a beta of zero, so that the appropri
> Facebook, Inc. has no debt. As Problem 21 in Chapter 15 makes clear, by issuing debt Facebook can generate a very large tax shield potentially worth nearly $2 billion. Given Facebook’s success, one would be hard pressed to argue that Facebook’s managemen
> You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, “If we go bankrupt, we don’t have t
> Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of four values next year: $150 million, $135 million, $95 million, or $80 million. These outcomes are all equally likely, and this
> Safeco Inc. has no debt, and maintains a policy of holding $10 million in excess cash reserves, invested in risk-free Treasury securities. If Safeco pays a corporate tax rate of 35%, what is the cost of permanently maintaining this $10 million reserve?
> Bay Transport Systems (BTS) currently has $30 million in debt outstanding. In addition to 6.5% interest, it plans to repay 5% of the remaining balance each year. If BTS has a marginal corporate tax rate of 40%, and if the interest tax shields have the sa
> Ten years have passed since Arnell issued $10 million in perpetual interest only debt with a 6% annual coupon, as in Problem 6. Tax rates have remained the same at 35% but interest rates have dropped, so Arnell’s current cost of debt capital is 4%. a. Wh
> Arnell Industries has just issued $10 million in debt (at par). The firm will pay interest only on this debt. Arnell’s marginal tax rate is expected to be 35% for the foreseeable future. a. Suppose Arnell pays interest of 6% per year on its debt. What is
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. Compute Mydeco’s ROE each year from 2012 to 2016. b. Compute Mydeco’s ROA each year from 2012 to 2016. c. Which return is more vol
> Braxton Enterprises currently has debt outstanding of $35 million and an interest rate of 8%. Braxton plans to reduce its debt by repaying $7 million in principal at the end of each year for the next five years. If Braxton’s marginal corporate tax rate i
> PMF, Inc., is equally likely to have EBIT this coming year of $10 million, $15 million, or $20 million. Its corporate tax rate is 35%, and investors pay a 15% tax rate on income from equity and a 35% tax rate on interest income. a. What is the effective
> Colt Systems will have EBIT this coming year of $15 million. It will also spend $6 million on total capital expenditures and increases in net working capital, and have $3 million in depreciation expenses. Colt is currently an all-equity firm with a corpo
> With its current leverage, Impi Corporation will have net income next year of $4.5 million. If Impi’s corporate tax rate is 35% and it pays 8% interest on its debt, how much additional debt can Impi issue this year and still receive the benefit of the in
> Suppose the tax rate on interest income is 35%, and the average tax rate on capital gains and dividend income is 10%. How high must the marginal corporate tax rate be for debt to offer a tax advantage?
> Garnet Corporation is considering issuing risk-free debt or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 15%. However, the dividends on preferred stock are not d
> Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markum’s corporate tax rate is 35%. a. Absent personal taxes, what is the value of the interest tax shield from the new debt? b. If investors pay a tax ra
> Facebook, Inc. had no debt on its balance sheet in 2014, but paid $2 billion in taxes. Suppose Facebook were to issue sufficient debt to reduce its taxes by $250 million per year permanently. Assume Facebook’s marginal corporate tax rate is 35% and its b
> Suppose the corporate tax rate is 40%, and investors pay a tax rate of 15% on income from dividends or capital gains and a tax rate of 33.3% on interest income. Your firm decides to add debt so it will pay an additional $15 million in interest each year.
> Rally, Inc., is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding. Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 35%, and Rally plans to keep its outstanding
> In early-2015, United Airlines (UAL) had a market capitalization of $24.8 billion, debt of $12.8 billion, and cash of $5.5 billion. United also had annual revenues of $38.9 billion. Southwest Airlines (LUV) had a market capitalization of $28.8 billion, d
> Suppose Microsoft has 8.75 billion shares outstanding and pays a marginal corporate tax rate of 35%. If Microsoft announces that it will pay out $50 billion in cash to investors through a combination of a special dividend and a share repurchase, and if i
> Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate is 35%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05 million, and it expects to maintain this level of debt permanentl
> Acme Storage has a market capitalization of $100 million and debt outstanding of $40 million. Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate of 7.5% on its debt and has a corporate tax rate of 35%. a. If
> Restex maintains a debt-equity ratio of 0.85, and has an equity cost of capital of 12% and a debt cost of capital of 7%. Restex’s corporate tax rate is 40%, and its market capitalization is $220 million. a. If Restex’s free cash flow is expected to be $1
> Rogot Instruments makes fine violins and cellos. It has $1 million in debt outstanding, equity valued at $2 million, and pays corporate income tax at rate of 35%. Its cost of equity is 12% and its cost of debt is 7%. a. What is Rogot’s pretax WACC? b. Wh
> Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has interest expenses of $125 million and a corporate tax rate of 40%. a. What is Pelamed’s 2006 net income? b. What is the total of Pelamed’s 2006 net income and interest pay
> Zetatron is an all-equity firm with 100 million shares outstanding, which are currently trading for $7.50 per share. A month ago, Zetatron announced it will change its capital structure by borrowing $100 million in short-term debt, borrowing $100 million
> Schwartz Industry is an industrial company with 100 million shares outstanding and a market capitalization (equity value) of $4 billion. It has $2 billion of debt outstanding. Management have decided to deliver the firm by issuing new equity to repay all
> Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. Currently, Cisoft is an all-equity firm
> Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade for a price of $22 per share. Omega Technology has 20 million sh
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. Compute Mydeco’s PE ratio each year from 2012 to 2016. In which year was it the highest? b. What was Mydeco’s Enterprise Value to
> Wolfrum Technology (WT) has no debt. Its assets will be worth $450 million in one year if the economy is strong, but only $200 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $250 millio
> Suppose Levered Bank is funded with 2% equity and 98% debt. Its current market capitalization is $10 billion, and its market to book ratio is 1. Levered Bank earns a 4.22% expected return on its assets (the loans it makes), and pays 4% on its debt. New c
> Zelnor, Inc., is an all-equity firm with 100 million shares outstanding currently trading for $8.50 per share. Suppose Zelnor decides to grant a total of 10 million new shares to employees as part of a new compensation plan. The firm argues that this new
> You are CEO of a high-growth technology firm. You plan to raise $180 million to fund an expansion by issuing either new shares or new debt. With the expansion, you expect earnings next year of $24 million. The firm currently has 10 million shares outstan
> Yerba Industries is an all-equity firm whose stock has a beta of 1.2 and an expected return of 12.5%. Suppose it issues new risk-free debt with a 5% yield and repurchases 40% of its stock. Assume perfect capital markets. a. What is the beta of Yerba stoc
> Jim Campbell is founder and CEO of Open Start, an innovative software company. The company is all equity financed, with 100 million shares outstanding. The shares are trading at a price of $1. Campbell currently owns 20 million shares. There are two poss
> Indell stock has a current market value of $120 million and a beta of 1.50. Indell currently has risk-free debt as well. The firm decides to change its capital structure by issuing $30 million in additional risk-free debt, and then using this $30 million
> In mid-2015 Qualcomm Inc. had $11 billion in debt, total equity capitalization of $89 billion, and an equity beta of 1.43 (as reported on Yahoo! Finance). Included in Qualcomm’s assets was $21 billion in cash and risk-free securities. Assume that the ris
> Mercer Corp. has 10 million shares outstanding and $100 million worth of debt outstanding. Its current share price is $75. Mercer’s equity cost of capital is 8.5%. Mercer has just announced that it will issue $350 million worth of debt. It will use the p
> Hartford Mining has 50 million shares that are currently trading for $4 per share and $200 million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the p
> You are analyzing the leverage of two firms and you note the following (all values in millions of dollars): a. What is the market debt-to-equity ratio of each firm? b. What is the book debt-to-equity ratio of each firm? c. What is the EBIT/interest cov
> Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.60. Due to the increased risk, shareholders now expect
> Global Pistons (GP) has common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets. a. Suppose GP issues $100 million of n
> Suppose Visa Inc. (V) has no debt and an equity cost of capital of 9.2%. The average debt-to value ratio for the credit services industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt
> Consider the entrepreneur described in Section 14.1 (and referenced in Tables 14.1–14.3). Suppose she funds the project by borrowing $750 rather than $500. a. According to MM Proposition I, what is the value of the equity? What are its
> Explain what is wrong with the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low
> Why does the CAPM imply that investors should trade very rarely?
> You are trading in a market in which you know there are a few highly skilled traders who are better informed than you are. There are no transaction costs. Each day you randomly choose five stocks to buy and five stocks to sell (by, perhaps, throwing dart
> Explain what the following sentence means: The market portfolio is a fence that protects the sheep from the wolves, but nothing can protect the sheep from themselves.
> What are the only conditions under which the market portfolio might not be an efficient portfolio?
> Use the data in Problem 8 to determine the change, from 2012 to 2015, in GE’s a. book debt-equity ratio. b. market debt-equity ratio. Data from Problem 8: In early 2012, General Electric (GE) had a book value of equity of $116 billion, 10.6 billion sha
> You know that there are informed traders in the stock market, but you are uninformed. Describe an investment strategy that guarantees you will not lose money to the informed traders and explain why it works.
> Suppose the CAPM equilibrium holds perfectly. Then the risk-free interest rate increases, and nothing else changes. a. Is the market portfolio still efficient? b. If your answer to part a is yes, explain why. If not, describe which stocks would be buying
> You work for Microsoft Corporation (ticker: MSFT), and you are considering whether to develop a new software product. The risk of the investment is the same as the risk of the company. a. Using the data in Table 13.1 and in the table above, calculate the
> You are currently considering an investment in a project in the energy sector. The investment has the same riskiness as Exxon Mobil stock (ticker: XOM). Using the data in Table 13.1 and the table above, calculate the cost of capital using the FFC factor
> Using the factor beta estimates in the table shown here and the monthly expected return estimates in Table 13.1, calculate the risk premium of General Electric stock (ticker: GE) using the FFC factor specification. (Annualize your result by multiplying b
> Explain why an employee who cares only about expected return and volatility will likely underweight the amount of money he invests in his own company’s stock relative to an investor who does not work for his company.
> Explain why if some investors are subject to systematic behavioral biases, while others pick efficient portfolios, the market portfolio will not be efficient.
> Explain why you might expect stocks to have nonzero alphas if the market proxy portfolio is not highly correlated with the true market portfolio, even if the true market portfolio is efficient.
> If you can use past returns to construct a trading strategy that makes money (has a positive alpha), it is evidence that market portfolio is not efficient. Explain why.
> Explain how to construct a positive-alpha trading strategy if stocks that have had relatively high returns in the past tend to have positive alphas and stocks that have had relatively low returns in the past tend to have negative alphas.
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. How did Mydeco’s book debt-equity ratio change from 2012 to 2016? b. How did Mydeco’s market debt-equity ratio change from 2012 to
> In Problem 20, assume the risk-free rate is 3% and the market risk premium is 7%. a. What does the CAPM predict the expected return for each stock should be? b. Clearly, the CAPM predictions are not equal to the actual expected returns, so the CAPM does
> Consider the following stocks, all of which will pay a liquidating dividend in a year and nothing in the interim: a. Calculate the expected return of each stock. b. What is the sign of correlation between the expected return and market capitalization o
> Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the
> Each of the six firms in the table below is expected to pay the listed dividend payment every year in perpetuity. a. Using the cost of capital in the table, calculate the market value of each firm. b. Rank the three S firms by their market values and l
> Assume all firms have the same expected dividends. If they have different expected returns, how will their market values and expected returns be related? What about the relation between their dividend yields and expected returns?
> Explain what the size effect is.
> Assume the economy consisted of three types of people. 50% are fad followers, 45% are passive investors (they have read this book and so hold the market portfolio), and 5% are informed traders. The portfolio consisting of all the informed traders has a b
> Allison and Bill are both mutual fund managers, although Allison is more skilled than Bill. Both have $100 million in assets under management and charge a fee of 1%/year. Allison is able to generate a 2% alpha before fees and Bill is able to generate a 1
> Davita Spencer is a manager at Half Dome Asset Management. She can generate an alpha of 2% a year up to $100 million. After that her skills are spread too thin, so cannot add value and her alpha is zero. Half Dome charges a fee of 1% per year on the tota
> Suppose that all investors have the disposition effect. A new stock has just been issued at a price of $50, so all investors in this stock purchased the stock today. A year from now the stock will be taken over, for a price of $60 or $40 depending on the
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. By how much did Mydeco increase its debt from 2012 to 2016? b. What was Mydeco’s EBITDA/Interest coverage ratio in 2012 and 2016? Did its coverage ratio ever fall bel
> Consider the price paths of the following two stocks over six time periods: Neither stock pays dividends. Assume you are an investor with the disposition effect and you bought at time 1 and right now it is time 3. Assume throughout this question that y
> How does the disposition effect impact investors’ tax obligations?
> To put the turnover of Figure 13.3 into perspective, let’s do a back of the envelope calculation of what an investor’s average turnover per stock would be were he to follow a policy of investing in the S&P 500 port
> Assume that all investors have the same information and care only about expected return and volatility. If new information arrives about one stock, can this information affect the price and return of other stocks? If so, explain why?
> From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean the market risk premium we should have used in the CAPM was negative?
> Suppose that in place of the S&P 500, you wanted to use a broader market portfolio of all U.S. stocks and bonds as the market proxy. Could you use the same estimate for the market risk premium when applying the CAPM? If not, how would you estimate the co
> Standard and Poor’s also publishes the S&P Equal Weight Index, which is an equally weighted version of the S&P 500. a. To maintain a portfolio that tracks this index, what trades would need to be made in response to daily price changes? b. Is this index
> Suppose Best Buy stock is trading for $30 per share for a total market cap of $9 billion, and Walt Disney has 1.65 billion shares outstanding. If you hold the market portfolio, and as part of it hold 100 shares of Best Buy, how many shares of Walt Disney
> Aluminum maker Alcoa has a beta of about 2.0, whereas Hormel Foods has a beta of 0.45. If the expected excess return of the marker portfolio is 5%, which of these firms has a higher equity cost of capital, and how much higher is it?
> You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 9%. However, the new business will be 25% debt financed,
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. Compare Mydeco’s accounts payable days in 2012 and 2016. b. Did this change in accounts payable days improve or worsen Mydeco’s ca
> Unida Systems has 40 million shares outstanding trading for $10 per share. In addition, Unida has $100 million in outstanding debt. Suppose Unida’s equity cost of capital is 15%, its debt cost of capital is 8%, and the corporate tax rate is 40%. a. What
> Your company operates a steel plant. On average, revenues from the plant are $30 million per year. All of the plants costs are variable costs and are consistently 80% of revenues, including energy costs associated with powering the plant, which represent
> Harrison Holdings, Inc. (HHI) is publicly traded, with a current share price of $32 per share. HHI has 20 million shares outstanding, as well as $64 million in debt. The founder of HHI, Harry Harrison, made his fortune in the fast food business. He sold
> Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.60, expects to generate free cash flow of $50 million this year, and anticipates a 3% perpetual growth rate. The industrial chemicals division has
> Consider the following airline industry data from mid-2009: a. Use the estimates in Table 12.3 to estimate the debt beta for each firm (use an average if multiple ratings are listed). b. Estimate the asset beta for each firm. c. What is the average ass
> In mid-2015, Cisco Systems had a market capitalization of $130 billion. It had A-rated debt of $25 billion as well as cash and short-term investments of $60 billion, and its estimated equity beta at the time was 1.11. a. What is Cisco’s enterprise value?
> IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly t
> Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft’s stock has a volatility of 30%. a. Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is higher than 10%? b.
> Consider the setting of Problem 18. You decided to look for other comparables to reduce estimation error in your cost of capital estimate. You find a second firm, Thurbinar Design, which is also engaged in a similar line of business. Thurbinar has a stoc
> Your firm is planning to invest in an automated packaging plant. Harburtin Industries is an all-equity firm that specializes in this business. Suppose Harburtin’s equity beta is 0.85, the risk free rate is 4%, and the market risk premium is 5%. If your f
> See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. a. How did Mydeco’s accounts receivable days change over this period? b. How did Mydeco’s inventory days change over this period? c.
> The Dunley Corp. plans to issue 5-year bonds. It believes the bonds will have a BBB rating. Suppose AAA bonds with the same maturity have a 4% yield. Assume the market risk premium is 5% and use the data in Table 12.2 and Table 12.3. a. Estimate the yiel
> During the recession in mid-2009, homebuilder KB Home had outstanding 6-year bonds with a yield to maturity of 8.5% and a BB rating. If corresponding risk-free rates were 3%, and the market risk premium was 5%, estimate the expected return of KB Home’s d
