Topic 1.

RISK AND RETURN

1. Calculating Returns and Variability Using the following returns, calculate the
average returns, the variances, and the standard deviations for X and Y:

2. Portfolio Expected Return You own a portfolio that is 20 percent invested in

Stock X, 45 percent in Stock Y, and 35 percent in Stock Z. The expected returns on
these three stocks are 11 percent, 17 percent, and 14 percent, respectively. What is
the expected return on the portfolio?

3. Calculating Returns and Standard Deviations Based on the following

information, calculate the expected return and standard deviation for the two
stocks:

4. Covariance and Correlation Based on the following information, calculate the

expected return and standard deviation for each of the following stocks. What
are the covariance and correlation between the returns of the two stocks?

5. You have been provided the following data about the securities of three firms, the
market portfolio, and the risk-free asset:

*With the market portfolio.

a. Fill in the missing values in the table.

b. Is the stock of Firm A correctly priced according to the capital asset pricing model
(CAPM)? What about the stock of Firm B? Firm C? If these securities are not correctly
priced, what is your investment recommendation for someone with a well diversified
portfolio?

Topic 2. COST OF CAPITAL

1. Finding the WACC Titan Mining Corporation has 8.7 million shares of common
stock outstanding and 230,000 6.4 percent semiannual bonds outstanding, par value
$1,000 each. The common stock currently sells for $37 per share and has a beta of
1.20, and the bonds have 20 years to maturity and sell for 104 percent of par. The
market risk premium is 7 percent, T-bills are yielding 3.5 percent, and the company’s
tax rate is 35 percent.

a. What is the firm’s market value capital structure?

b. If the company is evaluating a new investment project that has the same risk as
the firm’s typical project, what rate should the firm use to discount the project’s cash
flows?

2. WACC and NPV Och, Inc., is considering a project that will result in initial after tax
cash savings of $2.9 million at the end of the first year, and these savings will grow at
a rate of 4 percent per year indefinitely. The company has a target debt–equity ratio
of .65, a cost of equity of 13 percent, and an after tax cost of debt of 5.5 percent. The
cost-saving proposal is somewhat riskier than the usual projects the firm undertakes;
management uses the subjective approach and applies an adjustment factor of +2
percent to the cost of capital for such risky projects. Under what circumstances should
the company take on the project?

3. Preferred Stock and WACC The Saunders Investment Bank has the following
financing outstanding. What is the WACC for the company?

Debt: 50,000 bonds with a coupon rate of 5.7 percent and a current price quote of
106.5; the bonds have 20 years to maturity. 200,000 zero coupon bonds with a price
quote of 17.5 and 30 years until maturity.

Preferred stock: 125,000 shares of 4 percent preferred stock with a current price of
$79, and a par value of $100.

Common stock: 2,300,000 shares of common stock; the current price is $65, and the
beta of the stock is 1.20.

Market: The corporate tax rate is 40 percent, the market risk premium is 7 percent,
and the risk-free rate is 4 percent.

4. Firm Valuation Schultz Industries is considering the purchase of Arras

Manufacturing. Arras is currently a supplier for Schultz, and the acquisition would
allow Schultz to better control its material supply. The current cash flow from assets
for Arras is $6.8 million. The cash flows are expected to grow at 8 percent for the next
five years before leveling off to 4 percent for the indefinite future. The cost of capital
for Schultz and Arras is 12 percent and 10 percent, respectively. Arras currently has
2.5 million shares of stock outstanding and $30 million in debt outstanding. What is
the maximum price per share Schultz should pay for Arras?

5. Flotation Costs and NPV Photochronograph Corporation (PC) manufactures time

series photographic equipment. It is currently at its target debt–equity ratio of .55. It’s
considering building a new $50 million manufacturing facility. This new plant is
expected to generate after tax cash flows of $6.7 million a year in perpetuity. The
company raises all equity from outside financing. There are three financing options:

a. A new issue of common stock: The flotation costs of the new common stock would
be 8 percent of the amount raised. The required return on the company’s new equity
is 14 percent.

b. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4
percent of the proceeds. If the company issues these new bonds at an annual coupon
rate of 8 percent, they will sell at par.

c. Increased use of accounts payable financing: Because this financing is part of the
company’s ongoing daily business, it has no flotation costs, and the company assigns
it a cost that is the same as the overall firm WACC. Management has a target ratio of
accounts payable to long-term debt of .20. (Assume there is no difference between
the pretax and aftertax accounts payable cost.)

What is the NPV of the new plant? Assume that PC has a 35 percent tax rate.

Topic 3. CAPITAL STRUCTURE

1. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC
is10.5 percent, and its cost of debt is 6 percent. The corporate tax rate is 35 percent.

a. What is the company’s cost of equity capital?

b. What is the company’s unlevered cost of equity capital?

c. What would the cost of equity be if the debt–equity ratio were 2? What if it were
1.0? What if it were zero?

2. Firm Value Janetta Corp. has EBIT of $850,000 per year that is expected to
continue in perpetuity. The unlevered cost of equity for the company is 14 percent,
and the corporate tax rate is 35 percent. The company also has a perpetual bond
issue outstanding with a market value of $1.9 million.

a. What is the value of the company?

b. The CFO of the company informs the company president that the value of the
company is $4.3 million. Is the CFO correct?

a. What is the value today of Steinberg’s debt and equity? What about that for
Dietrich’s?

b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than
Dietrich’s because the firm has less debt and therefore less bankruptcy risk. Do you
agree or disagree with this statement?

3. Firm Value Cavo Corporation expects an EBIT of $26,850 every year forever. The
company currently has no debt, and its cost of equity is 14 percent. The tax rate is35
percent.

a. What is the current value of the company?

b. Suppose the company can borrow at 8 percent. What will the value of the company
be if it takes on debt equal to 50 percent of its unlevered value? What if it takes on
debt equal to 100 percent of its unlevered value?
c. What will the value of the company be if it takes on debt equal to 50 percent of its
levered value? What if the company takes on debt equal to 100 percent of its levered
value?

4. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are

identical in every way except their capital structures. Alpha Corporation, an all-equity
firm, has 18,000 shares of stock outstanding, currently worth $35 per share. Beta
Corporation uses leverage in its capital structure. The market value of Beta’s debt is
$85,000, and its cost of debt is 9 percent. Each firm is expected to have earnings
before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every
investor can borrow at 9 percent per year.

a. What is the value of Alpha Corporation?

b. What is the value of Beta Corporation?

c. What is the market value of Beta Corporation’s equity?

d. How much will it cost to purchase 20 percent of each firm’s equity?

e. Assuming each firm meets its earnings estimates, what will be the dollar return to
each position in part (d) over the next year?

f. Construct an investment strategy in which an investor purchases 20 percent of

Alpha’s equity and replicates both the cost and dollar return of purchasing 20 percent
of Beta’s equity.

g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.

5. Stock Value and Leverage Green Manufacturing, Inc., plans to announce that it
will issue $1.8 million of perpetual debt and use the proceeds to repurchase common
stock. The bonds will sell at par with a coupon rate of 6 percent. Green is currently an
all-equity company worth $5.9 million with 350,000 shares of common stock
outstanding. After the sale of the bonds, the company will maintain the new capital
structure indefinitely. The company currently generates annual pretax earnings of
$1.35 million. This level of earnings is expected to remain constant in perpetuity. The
tax rate is 40 percent.

a. What is the expected return on the company’s equity before the announcement of
the debt issue?

b. Construct the company’s market value balance sheet before the announcement of
the debt issue. What is the price per share of the firm’s equity?

c. Construct the company’s market value balance sheet immediately after the
announcement of the debt issue.

d. What is the company’s stock price per share immediately after the repurchase
announcement?
e. How many shares will the company repurchase as a result of the debt issue? How
many shares of common stock will remain after the repurchase?

f. Construct the market value balance sheet after the restructuring.

g. What is the required return on the company’s equity after the restructuring?
Topic 4. CAPITAL BUDGETING
1. NPV and APV Zoso is a rental car company that is trying to determine whether to
add 25 cars to its fleet. The company fully depreciates all its rental cars over five
years using the straight-line method. The new cars are expected to generate
$215,000 per year in earnings before taxes and depreciation for five years. The
company is entirely financed by equity and has a 35 percent tax rate. The required
return on the company’s unlevered equity is 13 percent, and the new fleet will not
change the risk of the company.

a. What is the maximum price that the company should be willing to pay for the new
fleet of cars if it remains an all-equity company?

b. Suppose the company can purchase the fleet of cars for $650,000. Additionally,
assume the company can issue $430,000 of five-year debt to finance the project at
the risk-free rate of 8 percent. All principal will be repaid in one balloon payment at
the end of the fifth year. What is the adjusted present value (APV) of the project?

2. FTE Milano Pizza Club owns three identical restaurants popular for their specialty
pizzas. Each restaurant has a debt–equity ratio of 40 percent and makes interest
payments of $41,000 at the end of each year. The cost of the firm’s levered equity is
19 percent. Each store estimates that annual sales will be $1.45 million; annual cost
of goods sold will be $785,000; and annual general and administrative costs will be
$435,000. These cash flows are expected to remain the same forever. The corporate
tax rate is 40 percent.

a. Use the flow to equity approach to determine the value of the company’s equity.

b. What is the total value of the company?

3. APV Triad Corporation has established a joint venture with Tobacco Road
Construction, Inc., to build a toll road in North Carolina. The initial investment in
paving equipment is $93 million. The equipment will be fully depreciated using the
straight-line method over its economic life of five years. Earnings before interest,
taxes, and depreciation collected from the toll road are projected to be $12.9 million
per annum for 20 years starting from the end of the first year. The corporate tax rate
is 35 percent. The required rate of return for the project under all-equity financing is
13 percent. The pretax cost of debt for the joint partnership is 8.5 percent. To
encourage investment in the country’s infrastructure, the U.S. government will
subsidize the project with a $30 million, 15-year loan at an interest rate of 5 percent
per year. All principal will be repaid in one balloon payment at the end of Year 15.
What is the adjusted present value of this project?

4. WACC Neon Corporation’s stock returns have a covariance with the market
portfolio of .0415. The standard deviation of the returns on the market portfolio is 20
percent, and the expected market risk premium is 7.5 percent. The company has
bonds outstanding with a total market value of $45 million and a yield to maturity of
6.5 percent. The company also has 4.2 million shares of common stock outstanding,
each selling for $30. The company’s CEO considers the firm’s current debt–equity
ratio optimal. The corporate tax rate is 35 percent, and Treasury bills currently yield
3.4 percent. The company is considering the purchase of additional equipment that
would cost $47 million. The expected unlevered cash flows from the equipment are
$13.5 million per year for five years. Purchasing the equipment will not change the
risk level of the firm.

a. Use the weighted average cost of capital approach to determine whether Neon
should purchase the equipment.
b. Suppose the company decides to fund the purchase of the equipment entirely with
debt. What is the cost of capital for the project now? Explain.

5. APV, FTE, and WACC Newkirk, Inc., is an unlevered firm with expected annual
earnings before taxes of $21 million in perpetuity. The current required return on the
firm’s equity is 16 percent, and the firm distributes all of its earnings as dividends at
the end of each year. The company has 1.3 million shares of common stock
outstanding and is subject to a corporate tax rate of 35 percent. The firm is planning a
recapitalization under which it will issue $30 million of perpetual 9 percent debt and
use the proceeds to buy back shares.

a. Calculate the value of the company before the recapitalization plan is announced.
What is the value of equity before the announcement? What is the price per share?

b. Use the APV method to calculate the company value after the recapitalization plan
is announced. What is the value of equity after the announcement? What is the price
per share?

c. How many shares will be repurchased? What is the value of equity after the
repurchase has been completed? What is the price per share?

d. Use the flow to equity method to calculate the value of the company’s equity after
the recapitalization.

Topic 5. DIVIDENDS AND OTHER PAYOUTS

1. Stock Dividends The owners’ equity accounts for Hexagon International are
shown here:

a. If the company’s stock currently sells for $39 per share and a 10 percent stock
dividend is declared, how many new shares will be distributed? Show how the equity
accounts would change.

b. If the company declared a 25 percent stock dividend, how would the accounts
change?

c. Show how the equity accounts will change if the company declares a four-for-one
stock split. How many shares are outstanding now? What is the new par value per
share?

2. Dividends and Stock Price The Mann Company belongs to a risk class for which
the appropriate discount rate is 10 percent. Mann currently has 240,000 outstanding
shares selling at $105 each. The firm is contemplating the declaration of a $4
dividend at the end of the fiscal year that just began. Assume there are no taxes on
dividends. Answer the following questions based on the Miller and Modigliani model,
which is discussed in the text.

a. What will be the price of the stock on the ex-dividend date if the dividend is
declared?
b. What will be the price of the stock at the end of the year if the dividend is not
declared?

c. If Mann makes $4.3 million of new investments at the beginning of the period,
earns net income of $1.9 million, and pays the dividend at the end of the year, how
many shares of new stock must the firm issue to meet its funding needs?

d. Is it realistic to use the MM model in the real world to value stock? Why or why not?

3. Stock Repurchase Flychucker Corporation is evaluating an extra dividend versus

a share repurchase. In either case $6,300 would be spent. Current earnings are $2.60
per share, and the stock currently sells for $51 per share. There are 1,500 shares
outstanding. Ignore taxes and other imperfections in answering parts (a) and (b).

a. Evaluate the two alternatives in terms of the effect on the price per share of the
stock and shareholder wealth.

b. What will be the effect on the company’s EPS and PE ratio under the two different
scenarios?

4. Dividend Policy Gibson Co. has a current period cash flow of $1.3 million and
pays no dividends. The present value of the company’s future cash flows is $18
million. The company is entirely financed with equity and has 550,000 shares
outstanding. Assume the dividend tax rate is zero.

a. What is the share price of the company’s stock?

b. Suppose the board of directors of the company announces its plan to pay out 50
percent of its current cash flow as cash dividends to its shareholders. How can Jeff
Miller, who owns 1,000 shares of the company’s stock, achieve a zero payout policy
on his own?

5. Dividends versus Reinvestment After completing its capital spending for the
year, Carlson Manufacturing has $1,000 extra cash. Carlson’s managers must choose
between investing the cash in Treasury bonds that yield 8 percent or paying the cash
out to investors who would invest in the bonds themselves.
a. If the corporate tax rate is 35 percent, what personal tax rate would make the
investors equally willing to receive the dividend or to let Carlson invest the money?

b. Is the answer to (a) reasonable? Why or why not?

c. Suppose the only investment choice is a preferred stock that yields 12 percent. The
corporate dividend exclusion of 70 percent applies. What personal tax rate will make
the stockholders indifferent to the outcome of Carlson’s dividend decision?