FIN 4504 Lecture Notes - Lecture 14: Value Investing, Efficient-Market Hypothesis, Only Time
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Instructions: Use the formula below to compute the problems: âPlease Read the question carefully.â
Kd = Yield (1 â T)
1. Telecom Systems can issue debt yielding 8 percent. The company is in a 35 percent bracket. What is its after-tax cost of debt?
2. After-tax cost of debt: Royal Jewelers Inc., has an aftertax cost of debt of 6 percent. With a tax rate of 40 percent, what can you assume the yield on the debt is?
3.
Cash flow: Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below.
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
4.
Cost of preferred stock: Medco Corporation can sell preferred stock for $80 with an estimated flotation cost of $3. It is anticipated the preferred stock will pay $6 per share in dividends.
a. Compute the cost of preferred stock for Medco Corp.
b. Do we need to make a tax adjustment for the issuing firm?
5. Cost of preferred stock: The Meredith Corporation issued $100 par value preferred stock 10 years ago. The stock provided an 8 percent yield at the time of issue. The preferred stock is now selling for $75. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)
6. Costs of retained earnings and new common stock: Barton Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D1) of $1.20 per share, and the current price of its common stock is $30 per share. The expected growth rate is 9 percent.
a. Compute the cost of retained earnings (Ke). Use Formula 11-6.
b. If a $2 flotation cost is involved, compute the cost of new common stock (Kn). Use Formula 11-7.
7. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (Kp= D/Po+ g).
8. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.
a. True
b. False
9. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.
a. True
b. False
10. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.
a. True
b. False
11. You have the following data on three stocks:
| Stock | Standard Deviation | Beta |
| A | 20% | 0.59 |
| B | 10% | 0.61 |
| C | 12% | 1.29 |
If you are a strict risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.
a. A; A.
b. A; B.
c. B; A.
d. C; A.
e. C; B.
12. A portfolioâs risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
a. True
b. False
13. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?
a. The price of Bond B will decrease over time, but the price of Bond A will increase over time.
b. The prices of both bonds will remain unchanged.
c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.
d. The prices of both bonds will increase by 7% per year.
e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
14. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
a. If market interest rates decline, the price of the bond will also decline.
b. The bond is currently selling at a price below its par value.
c. If market interest rates remain unchanged, the bondâs price one year from now will be lower than it is today.
d. The bond should currently be selling at its par value.
e. If market interest rates remain unchanged, the bondâs price one year from now will be higher than it is today.
15. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
e. 6.28%
16. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%
17. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
18. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?
a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.
b. The discount rate increases.
c. The riskiness of the investmentâs cash flows decreases.
d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.
e. The discount rate decreases.
19. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk premium.
e. The expectations theory cannot hold if inflation is decreasing.
20. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.
a. True
b. False