JR Industries has a $20 million loan due at the end of the year and under its current
business strategy its assets will have a market value of only $15 million when the loan
comes due. JR is considering a new much riskier business strategy. While this new
riskier strategy can be implemented using JR’s existing assets without any additional
investment, the new strategy has only a 40% probability of succeeding. If the new
strategy is a success, the market value of JR’s assets will be $30, but if the strategy fails
the assets will be worth only $5 million.
What is the expected payoff to equity holders under JR’s new riskier business strategy?
A) $15 million
B) $11 million
C) $20 million
D) $4 million
Suppose that Gold Digger’s beta is -0.8. If the market risk premium is 8% and the
risk-free interest rate is 4%, then the expected return for Gold Digger’s stock is?
A) -2.4%
B) 4.8%
C) 2.4%
D) 10.4%
An independent film maker is considering producing a new movie. The initial cost for
making this movie will be $20 million today. Once the movie is completed, in one year,
the movie will be sold to a major studio for $25 million. Rather than paying for the $20
million investment entirely using its own cash, the film maker is considering raising
additional funds by issuing a security that will pay investors $11 million in one year.
Suppose the risk-free rate of interest is 10%.
What is the NPV of this project if the film maker invests his own money and does not
issue the new security? What is the NPV if the film maker issues the new security?
A) $1.7 million; $1.7 million
B) $1.7 million; $2.7 million
C) $2.7 million; $1.7 million
D) $2.7 million; $2.7 million
Consider the following information regarding corporate bonds:
Your estimate of the asset beta for Wyatt Oil is closest to:
A) 0.59
B) 0.66
C) 0.71
D) 0.90
Which of the following statements is FALSE?
A) The levered equity return equals the unlevered return, plus an extra “kick” due to
leverage.
B) By holding a portfolio of the firm’s equity and its debt, we can replicate the cash
flows from holding its levered equity.
C) The cost of capital of levered equity is equal to the cost of capital of unlevered
equity plus a premium that is proportional to the market value debt-equity ratio.
D) If a firm is unlevered, all of the free cash flows generated by its assets are available
to be paid out to its equity holders.
If the risk-free rate of interest is 7.5%, then the value of security “B” is closest to:
A) $91.00
B) $92.50
C) $93.00
D) $100.00
In practice which market index would best be used as a proxy for the market portfolio
in the CAPM?
A) S&P 500
B) Dow Jones Industrial Average
C) U.S. Treasury Bill
D) Wilshire 5000
If it is managed efficiently, Luther industries will have assets with market value of $100
million, $300, million, or $500 million next year, with each outcome being equally
likely. Managers may, however, engage in wasteful empire building which will reduce
the firm’s market value by $20 million in all cases. Managers may also increase the risk
of the firm, changing the probability of each outcome to 50%, 20%, and 30%
respectively.
Assume that EGI decides to wait until after the release of the new video game before
they raise the $100 million through the issuance of new shares. EGI’s share price
following the release of the new video game will be closest to:
A) $18.00
B) $20.00
C) $16.00
D) $19.00
Consider an equally weighted portfolio that contains 100 stocks. If the average
volatility of these stocks is 50% and the average correlation between the stocks is .7,
then the volatility of this equally weighted portfolio is closest to:
A) .72
B) .63
C) .40
D) .50
Consider a corporate bond with a $1000 face value, 8% coupon with semiannual
coupon payments, 7 years until maturity, and a YTM of 9%. It has been 57 days since
the last coupon payment was made and there are 182 days in the current coupon period.
The dirty (cash) price for this bond is closest to:
A) $949.70
B) $961.40
C) $936.40
D) $948.90
Which of the following statements is FALSE?
A) The value of a firm is equal to the amount of money the firm can raise by issuing
securities.
B) By reducing a firm’s corporate tax liability, debt allows the firm to pay more of its
cash flows to investors.
C) Equity investors must pay taxes on dividends but not capital gains.
D) For individuals, interest payments received from debt are taxed as income.
Ford Motor Company is considering launching a new line of Plug-in Electric SUVs.
The heavy advertising expenses associated with the new SUV launch would generate
operating losses of $35 million next year. Without the new SUV, Ford expects to earn
pre-tax income of $80 million from operations next year. Ford pays a 30% tax rate on
its pre-tax income.
The amount that Ford Motor Company owe in taxes next year with the launch of the
new SUV is closest to:
A) $13.5 million
B) $31.5 million
C) $56.0 million
D) $24.0 million
Which of the following statements is false regarding profitable and unprofitable
growth?
A) If a firm wants to increase its share price, it must cut its dividend and invest more.
B) If the firm retains more earnings, it will be able to pay out less of those earnings,
which means that the firm will have to reduce its dividend.
C) A firm can increase its growth rate by retaining more of its earnings.
D) Cutting the firm’s dividend to increase investment will raise the stock price if, and
only if, the new investments have a positive NPV.
Consider the following formula:
Ï„* =
The term Ï„i is:
A) the effective personal tax rate on interest income.
B) the effective personal tax rate on equity.
C) the effective corporate tax rate on income.
D) the effective tax advantage of debt.
Which stock has the highest systematic risk?
A) Merck since it has a higher Beta
B) Exxon-Mobil since it has a lower beta
C) Exxon-Mobil since it has a higher volatility
D) Merck since it has a lower volatility
Consider two firms, With and Without, that have identical assets that generate identical
cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade
for a price of $24 per share. With has 2 million shares outstanding and $12 million
dollars in debt at an interest rate of 5%.
Assume that MM’s perfect capital markets conditions are met and that you can borrow
and lend at the same 5% rate as with. You have $5000 of your own money to invest and
you plan on buying With stock. Using homemade (un)leverage you invest enough at the
risk-free rate so that the payoff of your account will be the same as a $5000 investment
in Without stock? The number of shares of With stock you purchased is closest to:
A) 100
B) 425
C) 1650
D) 825
Consider the following four corporate bonds that have semiannual compounding:
Consider a bond that pays annually an 8% coupon with 20 years to maturity. The
percentage change in the price of the bond if its yield to maturity increases from 5% to
7% is closest to:
A) 22%
B) 24%
C) -22%
D) -24%
Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future and
that all earnings are paid out as dividends. RC is currently an all equity firm. It expects
to generate earnings before interest and taxes (EBIT) of $6 million over the next year.
Currently RC has 5 million shares outstanding and its stock is trading for a price of
$12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the
proceeds to repurchase shares at the current price of $12.00.
Following the borrowing of $12 and subsequent share repurchase, the expected
earnings per share for RC is closest to:
A) $1.32
B) $1.44
C) $1.40
D) $1.20