Practice Questions

1. Answer the following questions

(a) A company has issued bonds that have a 10% coupon rate, payable semi-annually. The
bonds mature in 8 years, have a face value of INR 1,000, and a yield to maturity of
8.5%. What is the price of the bonds?

(b) A bond trader purchased each of the following bonds at a yield to maturity of 8%.
Immediately after she purchased the bonds, the interest rates fell to 7%. What is the
percentage change in the price of each bond after the decline in interest rates?
i. 10-year, 10% annual coupon bond
ii. 10-year zero coupon bond
iii. INR 100 annual coupon, perpetual bond

(c) A bond that matures in 7 years sells for INR 1,020. The bond has a face value of INR
1,000, and a yield to maturity of 10.5883%. The bond pays coupon semi-annually. What
is the bond’s current yield?

2. Assume a company has the following capital structure, which it considers to be optimal:
Long Term Debt = 25%, Preferred Stock = 15%, Common Stock = 60%. The company
has marginal tax rate of 40%, and investors expect earnings and dividends to grow at a
constant rate of 6% in the future. The company paid a dividend of INR 5.00 per common
share last year (DPS0).
Ten-year Treasury bonds yield 6%, the market risk premium is 5%, and the stock beta
is 1.3. The following terms would apply to new security offerings:
Preferred Stock: Preferred stock is trading at a price of INR 100 per share, with a fixed
preferred dividend of INR 10 per share.
Long Term Debt: Long Term Debt has an interest rate of 9% per annum.
Common Stock: All new common equity will be raised internally by reinvesting
earnings.

Based on the above information, answer the following questions

(a) What is the cost of common equity of the firm?

(b) What is the cost of preferred equity of the firm?
(c) What is the Weighted Average Cost of Capital (WACC) of the firm?
(d) What is the intrinsic value of common share price of the firm?

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3. You run a regression of stock returns of Thakurpukur Chemicals Ltd. (TCL) against
market returns and arrive at the following estimated regression model:
R(i) = 0.15% + 1.50*R(mkt)
The company has, in market value terms, INR 500 million of debt and INR 500 million
of equity. The company currently has two divisions. Division A, whose assets have a
market value of INR 600 million, produces only inorganic chemicals. You have found
five listed companies on the exchange which make only inorganic chemicals which
have an average levered beta of 1.31 and an average debt equity ratio of 20%. Division
B produces only organic chemicals and you could not find any comparable companies.
Assume that all companies face a tax rate of 50%.
Based on the information above, answer the following questions

(a) What is the asset beta for division B?

(b) If the company divests itself of Division A and reduces its debt-equity ratio to 0.5,
what would the company’s levered beta be?
(c) If the company divests itself of Division B and increases its debt-equity ratio to 2,
what would the company's levered beta be?

4. You have been asked to analyze the capital structure of a company, which have the
following details:
There are 100 million shares outstanding, trading at INR 10 per share. The firm has debt
outstanding of INR 500 million, in market value terms. The levered beta for the firm
currently is 1.04. The risk-free rate is 5% and the market risk premium is 5.50%. The
firm’s current bond rating is A, and the default spread for A rated bonds is 1.5%.
Marginal tax rate of the firm is 40%.
Based on the above information, answer the following questions

(a) Estimate the current cost of capital of the firm

(b) Assume that you have computed the optimal debt to value ratio to be 60%. The average
pretax cost of debt will rise by 50 basis points, if the company moves to the optimal
capital structure. Then, estimate the new cost of equity of the company at its optimal
capital structure.

(c) Estimate the new cost of capital of the firm at its optimal capital structure.

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5. Pailan Financial Services Ltd. (PFSL) is a publicly traded financial services company
that has INR 200 million in debt outstanding, in both book value and market value
terms. The book value of equity in the company is INR 400 million and there are 40
million shares outstanding, trading at INR 20 per share. The company currently has an
Earnings before Interest and Tax (EBIT) of 100 million. The current levered beta for
the company is 1.15, and the company’s pre-tax cost of borrowing is 5%. The current
risk-free rate is 3%, the equity risk premium is 5% and the tax rate is 40%.
The company has plans to triple its debt to capital ratio through buyback of its
outstanding shares. The shares will be bought back at its current traded price, and the
entire buyback will be funded by issuance of new debt. This will raise the average pre-
tax cost of debt to 8%. (Assume no change in market value of firm due to this
restructuring).
Based on the above information, answer the following questions

(a) Cost of equity under existing capital structure

(b) Cost of capital under existing capital structure
(c) Earnings Per Share (EPS) under existing capital structure
(d) Cost of equity under proposed capital structure
(e) Cost of capital under proposed capital structure
(f) Earnings Per Share (EPS) under proposed capital structure

6. You have run a regression of annual stock returns of Joka Corporation against the
annual market portfolio returns, and arrived at the following estimated regression
model:

R(stock) = – 0.1% + 1.43 * R(market), R-Square = 0.3383

The following information are also available:

Market Portfolio Joka Corporation Pailan

Corporation
Annual expected
return as per * 15.15% 11.00%
CAPM
Standard Deviation
20.0% * 25.8%
(annual)
Correlation with
* 0.465
Market Portfolio
Stock Beta * *

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Based on above information, answer the following questions

(a) Stock Beta of Joka Corporation?

(b) Stock Beta of Pailan Corporation?

(c) Correlation coefficient of Joka Corporation stock return with Market return

(d) Proportion of variance of Joka Corporation stock return which is not explained by
the variance of market portfolio return

(e) Standard deviation of annual stock returns of Joka Corporation?

(f) Annual risk-free rate of return?

(g) Annual expected return from market portfolio?

(h) Expected annual return from a portfolio which is 50% invested in Joka Corporation
and 50% invested in Pailan Corporation?

7. Assume that you manage a portfolio of 4 crores and your portfolio consists of
four stocks
Stock Amount (INR) Beta
A 40 Lakhs 1.50
B 60 Lakhs -0.50
C 1 Crore 1.25
D 2 Crores 0.75

If the market is expected to deliver 14% and the risk-free rate is 6%, what is the
expected return on your portfolio?

8. Suppose you have INR 2 million worth of portfolio consisting of INR 100,000
investment in each of the 20 different stocks. The portfolio has a beta of 1.1. You are
planning to selling 100,000 worth of stock with a beta of 0.9 and use the proceeds to
buy another stock with a beta of 1.4. What will be the new portfolio beta?

9. Stock A has a beta of 1.5 and stock B has as beta of 0.75. The expected return
of a 50-50 portfolio of stock A and B is 13% and the risk-free rate is 7%. What is the
difference between the required return of stock A and stock B?

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 10. Assume that two securities A and B form the market portfolio. Their proportion and
variances are given below:
Stock Weight Variance
A 0.39 160
B 0.61 340

The covariance between the two securities is 190. Calculate the beta of the two
securities and the market beta.

11. You are given following information

Stock Mean SD
A 20% 30%
B 10% 20%
The correlation between the returns of A and B is 0.5. You can borrow and lend at the
risk-free rate of 3%.
a) Which stock provides a better risk-return trade off when combined with the risk-
free asset?
b) Find the portfolio weights of a risk-free asset and stock A that gives an expected
return of 25%
c) What is the standard deviation of the portfolio above?

12. A company has a weighted average cost of capital of 8%. Its debt-to-equity
ratio is 1:2, and its beta equity is 1.5 and the equity risk premium is 6%. It raised its
debt at a cost of 3% per annum. There is an opportunity raise additional debt to bring
the debt-to-equity ratio to 1:1. If everything else is the same, then what would be the
updated WACC? Should the company consider it? Assume zero tax rate. What would
be the answer, if tax rate is 35%

13. A firm has a debt-to-equity ratio of 2:1. Its cost of debt is 5%. The variance of
the equity returns of the company is 300%. The expected return on the market is 8%
and the variance of the market returns is 200%. The correlation between a return of
the company and the market is 0.4. The risk-free rate is 5% and the corporate tax rate
is 30%. What is the weighted average cost of capital of the company at the present
leverage ratio. If the debt-to-equity ratio increases to 4:1, what would be the cost of
capital of the firm?

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 14. A firm has 10 million of notes payable and one million shares outstanding
with a price of 60. The firm has also issued 30,000 bonds with a face value of 1000.
The bonds carry coupon rate of 6% and the yield to maturity on the bonds is 10%.
Compute the market-based weights of the different sources of financing of the firm.

15. You are given the following information about the book value of the capital raised
through Bonds, Preferred shares and Common shares of a company.
Instrument Book Value in Millions
Bonds 30
Preferred Shares 5
Common Equity 40

In addition, you know the following:

• The face value of the bond is 100 and pays a semi-annual coupon of 8%. The bond
will mature in 20 years and its present yield is 12%
• Preferred shares have a par value of 100 and pays an annual dividend of 8. The
expected return on the preferred shares by the market is 12%
• There are 4 million common shares outstanding, and the present market value is
20
Compute the following:
a) Weights of Bonds, Preferred shares and Common shares in market value terms
b) If the flotation cost associated with preferred shares is 5%. What is the return
demanded by investors while investing in the preferred shares of the company?