Test 3 Review

CHAPTERS 13-16
Chapter 13
RETURN, RISK, SML
Conceptual Questions Warm up
1. What are advantages and disadvantages of the dividend growth
model approach?
2. What are the advantages and disadvantages of the CAPM/SML
approach?
Conceptual Answer
1. 2.

Advantages: Advantages:
simple (easy to understand and use) 1. Explicitly adjusts for systematic risk
2. Applicable to all firms, as long as we can
Disadvantages: compute beta
-applicable only to companies who pay dividends
-assumes dividends grow at constant rate Disadvantages:
-estimate cost of equity is very sensitive to 1. Have to estimate the expected market risk
estimated growth rate premium and beta
-no direct adjustment for the riskiness of the 2. relying on the past to predict the future
investment
-rely on the past to predict the future
 Question 2
1. Find the Expected return and
Probability Stock A Stock B standard deviation of each stock

Recession .19 .08 − .19

Normal .56 .11 .10

Boom .25 .16 .27

Answer 2
The expected return of an asset is the sum σA^2 =.19(.08 − .1168)2 + .56(.11 − .1168)2 + .25(.16 −
of each return times the probability of that .1168)2
return occurring. So, the expected return of
each stock asset is: σA^2 = .00075

σA = (.00075)^(1/2)
E(RA) = .19(.08) + .56(.11) + .25(.16) σA = .0274, or 2.74%
E(RA) = 11.68%
σB^2 =.19(−.19 − .0874)2 + .56(.10 − .0874)2 + .25(.27 −
.0874)2
E(RB) = .19(−.19) + .56(.10) + .25(.27) σB^2 = .02305
E(RB) = 8.74%

σB = (.02305)^(1/2)
σB = .1518, or 15.18%
Answer 3
a. This portfolio does not have an equal weight in each asset. b. To calculate the standard deviation, we first need to calculate
We first need to find the return of the portfolio in each state of the variance. To find the variance, we find the squared deviations
the economy. To do this, we will multiply the return of each from the expected return. We then multiply each possible squared
asset by its portfolio weight and then sum the products to get the deviation by its probability, then add all of these up. The result is
portfolio return in each state of the economy. Doing so, we get: the variance. So, the variance and standard deviation of the
Boom: RP = .30(.35) + .40(.40) + .30(.27) = or 34.60%
portfolio are:

Good: RP = .30(.16) + .40(.17) + .30(.08) = 14.00% P2 = .10(.3460 – .1051)2 + .60(.1400 – .1051)2 + .25(–
.0270 – .1051)2 + .05(–.1350 – .1051)2
Poor: RP = .30(–.01) + .40(–.03) + .30(–.04) = –2.70%
P2 = .01378
Bust: RP = .30(–.12) + .40(–.18) + .30(–.09) = – 13.50%
P = .013781/2
And the expected return of the portfolio is: P = .1174, or 11.74%
E(RP) = .10(.3460) + .60(.1400) + .25(–.0270) + .05(–
.1350)
E(RP) = .1051, or 10.51%
Chapter 14
COST OF CAPITAL
Conceptual Questions Warm up
1. How do you determine the appropriate cost of debt for a company?
Does it make a difference if the company's debt is privately placed as
opposed to being publicly traded? How would you estimate the cost of
debt for a firm whose only debt issues are privately held by
institutional investors?
Conceptual Answer

1. The appropriate aftertax cost of debt to the company is the interest rate it
would have to pay if it were to issue new debt today. Hence, if the YTM on
outstanding bonds of the company is observed, the company has an accurate
estimate of its cost of debt. If the debt is privately placed, the firm could still
estimate its cost of debt by (a) looking at the cost of debt for similar firms in
similar risk classes, (b) looking at the average debt cost for firms with the
same credit rating (assuming the firm’s private debt is rated), or (c) consulting
analysts and investment bankers. Even if the debt is publicly traded, an
additional complication occurs when the firm has more than one issue
outstanding; these issues rarely have the same yield because no two issues
are ever completely homogeneous.
Question 5
Jiminy's Cricket Farm issued a 30-year, 6 percent semiannual bond three
years ago. The bond currently sells for 93 percent of its face value. The
company's tax rate is 22 percent.

a. What is the pretax cost of debt?

b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the aftertax cost of debt? Why?
Answer 5
a. The pretax cost of debt is the YTM of the company’s bonds, so:

P0 = $930 = $30(PVIFAR%,54) + $1,000(PVIFR%,54)

R = 3.278%
YTM = 2 × 3.278%
YTM = 6.56%

b. The aftertax cost of debt is:

RD = .0656(1 – .22)
RD = .0511, or 5.11%

c. The aftertax rate is more relevant because that is the actual cost to the company.
Question 6
Mcdonalds has 7 million shares of common stock outstanding. The current share price is $68, and
the book value per share is $8. The company also has two bond issues outstanding. The first bond
issue has a face value of $70 million, a coupon rate of 6 percent, and sells for 97 percent of par.
The second issue has a face value of $40 million, a coupon rate of 6.5 percent, and sells for 108
percent of par. The first issue matures in 21 years, the second in 6 years. Both bonds make
semiannual coupon payments.

a. What are the company's capital structure weights on a book value basis?
b. What are the company's capital structure weights on a market value basis?
c. Which are more relevant, the book or market value weights? Why?
Answer 6 a & b
The book value of equity is the book value per share times The market value of equity is the share price times the number of
the number of shares, and the book value of debt is the shares, so:
face value of the company’s debt, so:
MVE = 7,000,000($68)
MVE = $476,000,000
BVE = 7,000,000($8)
BVE = $56,000,000 Using the relationship that the total market value of debt is the price
quote times the par value of the bond, we find the market value of debt
BVD = $70,000,000 + 40,000,000 is:
BVD = $110,000,000
MVD = .97($70,000,000) + 1.08($40,000,000)
So, the total value of the company is: MVD = $111,100,000

V = $56,000,000 + 110,000,000 This makes the total market value of the company:
V = $166,000,000
V = $476,000,000 + 111,100,000
V = $587,100,000
And the book value weights of equity and debt are:
And the market value weights of equity and debt are:
E/V = $56,000,000/$166,000,000
E/V = .3373 E/V = $476,000,000/$587,100,000
E/V = .8108
D/V = 1 – E/V
D/V = .6627 D/V = 1 – E/V
D/V = .1892
Answer 6 part c
The market value weights are more relevant because they represent a more current
valuation of the debt and equity.
Chapter 15
RAISING CAPITAL
Conceptual Questions Warm up
1. The following material represents the cover page and summary of the prospectus for the
initial public offering of the Pest Investigation Control Corporation (PICC), which is going
public tomorrow with a firm commitment initial public offering managed by the investment
banking firm of Erlanger and Ritter. Answer the following questions:

a. Assume you know nothing about PICC other than the information contained in the prospectus.
Based on your knowledge of finance, what is your prediction for the price of PICC tomorrow?
Provide a short explanation of why you think this will occur.

b. b. Assume you have several thousand dollars to invest. When you get home from class
tonight, you find that your stockbroker, whom you have not talked to for weeks, has called. She
has left a message that PICC is going public tomorrow and that she can get you several
hundred shares at the offering price if you call her back first thing in the morning. Discuss the
merits of this opportunity.
Conceptual Answer
a. The price will probably go up because IPOs are generally underpriced. This is especially
true for smaller issues such as this one

b. It is probably safe to assume that they are having trouble moving the issue, and it is
likely that the issue is not substantially underpriced.
Question 7
The Whistling Straits Corporation needs to raise $60 million to finance its
expansion into new markets. The company will sell new shares of equity
via a general cash offering to raise the needed funds. If the offer price is
$21 per share and the company's underwriters charge a spread of 7
percent, how many shares need to he sold?
Answer 7
Using X to stand for the required sale proceeds, the equation to calculate the total
sale proceeds, including flotation costs is:

X(1 – .07) = $60,000,000

X = $64,516,129 required total proceeds from sale.

So the number of shares offered is the total amount raised divided by the offer
price, which is:

Number of shares offered = $64,516,129/$21

Number of shares offered = 3,072,197
Question 8
The Raven Co. has just gone public. Under a firm commitment
agreement, Raven received $21.39 for each of the 20 million shares sold.
The initial offering price was $23 per share, and the stock rose to $28.41
per share in the first few minutes of trading. Raven paid $950,000 in direct
legal and other costs and $320,000 in indirect costs. What was the
flotation cost as a percentage of funds raised?
 Answer 8
We need to calculate the net amount raised and the costs associated with the offer. The net amount raised
is the number of shares offered times the price received by the company, minus the costs associated with
the offer, so:

Net amount raised = (20,000,000 shares)($21.39) – 950,000 – 320,000

Net amount raised = $426,530,000

The company received $426,530,000 from the stock offering. Now we can calculate the direct costs. Part
of the direct costs are given in the problem, but the company also had to pay the underwriters. The stock
was offered at $23 per share, and the company received $21.39 per share. The difference, which is the
underwriters spread, is also a direct cost. The total direct costs were:

Total direct costs = $950,000 + ($23 – 21.39)(20,000,000 shares)

Total direct costs = $33,150,000
Answer 8 cont
We are given part of the indirect costs in the problem. Another indirect cost is the immediate price
appreciation. The total indirect costs were:

Total indirect costs = $320,000 + ($28.41 – 23)(20,000,000 shares)

Total indirect costs = $108,520,000

This makes the total costs:

Total costs = $33,150,000 + 108,520,000

Total costs = $141,670,000

The flotation costs as a percentage of the amount raised is the total cost divided by the amount raised, so:

Flotation costs = $141,670,000/$426,530,000

Flotation costs = .3321, or 33.21%
 Chapter 16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
Conceptual Questions Warm up
1. Are certain types of industries more likely to be highly leveraged than
others? What are some possible reasons for this observed
segmentation? Do the operating results and tax history of the firms
play a role? How about their future earnings prospects? Explain.
Conceptual Answer
1. The more capital-intensive industries, such as airlines, cable television, and
electric utilities, tend to use greater financial leverage. Also, industries with
less predictable future earnings, such as computers or drugs, tend to use less
financial leverage. Such industries also have a higher concentration of growth
and startup firms. Overall, the general tendency is for firms with identifiable,
tangible assets and relatively more predictable future earnings to use more
debt financing. These are typically the firms with the greatest need for
external financing and the greatest likelihood of benefiting from the interest
tax shelter.
Question 8
a. Meyer & Co. expects its EBIT to be $97,000 every year forever. The
firm can borrow at 8 percent. The company currently has no debt, and
its cost of equity is 13 percent. If the tax rate is 24 percent, what is the
value of the firm? What will the value be if the company borrows
$195,000 and uses the proceeds to repurchase shares?
b. What is the cost of equity after recapitalization? What is the WACC?
What are the implications for the firm's capital structure decision?
Answer 8 a & b
The value of the unlevered firm is: We can find the cost of equity using M&M Proposition II with
taxes. Doing so, we find:

VU = EBIT(1 – TC)/RU RE = RU + (RU – RD)(D/E)(1 – TC)

RE = .13 + (.13 – .08)($195,000/[($613,877 – 195,000)](1 –
VU = $97,000(1 – .24)/.13 .24)
VU = $567,076.92 RE = .1477, or 14.77%

Using this cost of equity, the WACC for the firm after
The value of the levered firm is: recapitalization is:

WACC = (E/V)RE + (D/V)RD(1 – TC)

VL = VU + TCD WACC = .1477[($613,877 – 195,000)/$613,877] + .08(1 –
VL = $567,076.92 + .24($195,000) .24)($195,000/$613,877)
VL = $613,876.92 WACC = .1201, or 12.01%

When there are corporate taxes, the overall cost of capital for the
firm declines the more highly leveraged is the firm’s capital
structure. This is M&M Proposition I with taxes.
Question 9
Citee Corp. has no debt but can borrow at 6.1 percent. The firm's WACC
is currently 9.4 percent, and the tax rate is 21 percent.
a. What is the company's cost of equity?
b. If the firm converts to 25 percent debt, what will its cost of equity be?
c. If the firm converts to 50 percent debt, what will its cost of equity be?
d. What is the company's WACC in part (b)? In part (c)?
Answer 9 a & b
a. For an all-equity financed company:

WACC = RU = RE = .0940 or 9.40%

b. To find the cost of equity for the company with leverage we need to use M&M
Proposition II with taxes, so:

RE = RU + (RU – RD)(D/E)(1 – TC)

RE = .094 + (.094 – .061)(.25/.75)(1 – .21)
RE = .1027, or 10.27%
 Answer 9 c & d
Using M&M Proposition II with taxes again, The WACC with 25 percent debt is:
we get:
WACC = (E/V)RE + (D/V)RD(1 – TC)
RE = RU + (RU – RD)(D/E)(1 – TC) WACC = .75(.1027) + .25(.061)(1 – .21)
RE = .094 + (.094 – .061)(.50/.50)(1 – .21) WACC = .0891, or 8.91%
RE = .1201, or 12.01%
And the WACC with 50 percent debt is:

WACC = (E/V)RE + (D/V)RD(1 – TC)

WACC = .50(.1201) + .50(.061)(1 – .21)
WACC = .0841, or 8.41%