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FIN 6301 Financial Management

Task:

Multiple Choice: Select the best response. You may add comments to explain your reasoning.

1.Financial risk arises from

A.Debt use

B.Fixed operating costs

C.Cyclical revenues.

2.The ____ theory states that managers have a preference for certain types of funds (retained earnings, then debt, then common stock) based on cost and convenience.

A.Pecking order

B.Tradeoff theory

C.Signaling theory

3.Which of the following statements about financial distress is true?

A.Stock covenants encourage game playing by managers for firms in financial distress.

B.Bankruptcy costs are higher for firms with intangible assets than for one with tangible assets.

C.Debt holders pay for their monitoring costs through lower returns on debt.

4.If the correlation coefficient is 0,

A.You eliminate risk by short selling the riskier asset and investing the proceeds in the less risky one.

B.You can eliminate risk by investing positive amounts in each security.

C.You cannot eliminate the risk.

5.Uses several macroeconomic factors to examine the impact of market surprises on returns

A.Arbitrage pricing theory.

B.Capital asset pricing model

C.Security market line

6.Ajax Inc. has 2 divisions and a cost of capital of 14%. The Safe Division has a cost of capital of 10% while the Risky Division has a cost of capital of 18%. The Risky Division has a new project that is guaranteed with no risk. The risk-free rate is 4%. What rate (required return) should they use in evaluating the guaranteed project?

A.18%

B.14%

C.10%

D. 4%

7.If an investor is well-diversified, then they are concerned with

A.Market risk only

B.Unique risk only

C.Both market and unique risk

8.The degree to which two variables move together

A.Variance

B.Covariance

C.Return

9.In a perfect world with no corporate taxes, firm value is maximized by

A.All equity financing

B.All debt financing

C.A weighted average of debt and equity financing

D.Capital structure is irrelevant in this case

10.An investor is attempting to select one of the investment opportunities selected below. Given the information supplied, can you eliminate any of the choices?

Opportunity Expected Return Standard Deviation

A 25% .15

B 30% .05

A.Eliminate A

B.Eliminate B

C.Cannot be determined

Risk

1.(5) Define unique risk and give one example.

2.(10) Stock X has an expected return of 36%, a variance of .08 and a beta of .70. Stock Y has an expected return of 48%, a variance of .18 and a beta of 1.2. Stocks X and Y have a correlation coefficient of .40. For a portfolio consisting of $120,000 invested in stock X and $40,000 invested in stock Y, calculate the return on the portfolio (in %), the standard deviation of the portfolio (in %) and the beta of the portfolio (carry the work to 2 decimals).

Cost of Capital

3.(15) Crow Corporation is planning a $200 million expansion to be financed with debt, preferred stock, and common stock. Their target capital structure includes 20% debt and 5% preferred stock. They will raise the rest of the funds by retained earnings. The tax rate is 25%.

Bonds: Crow Corporation has bonds with 6 years to maturity and a face value of $1000. The coupon rate is 7.8% and coupons are paid semiannually. The bonds trade at $990 per bond. The (before-tax) cost on any new debt will be the same as the yield to maturity on the current bonds.

Preferred Stock: Crow issues preferred stock with a $2.85 dividend per year. They are sold to the market at $27 per share, but issue costs are $2 per share.

Retained Earnings: Crow has a just paid a dividend of $2.40. The retention rate is 40% and return on equity (ROE) is 20%. The price of the common stock is $36 per share.

a.Calculate the weighted average cost of capital (WACC).

b.The expansion is expected to produce cash flows of $48,000,000 every year for the next 6 years. Use the WACC to find the net present value (NPV). Should they expand? Explain.

Financing

4.(10) This is a world with NO TAXES (perfect capital markets). The firm is a no growth firm and pays out all of its earnings as dividends. It is originally all equity financed (unlevered). The firm decides to issue $500,000 in debt to repurchase stock. The cost of debt is 4%. Fill in ALL the missing values in the table.

Unlevered Levered

EBIT 200,000 200,000

INTEREST

Earnings (Net Income)

#Shares 20,000

Ru 8% 8%

RE

EPS

Price

Value of the Firm

5.BONUS (10): RLS has 30% debt in its capital structure. Currently, the levered equity beta is 1 and the debt beta is 0. The T-bill rate is 4% and the expected return on the market is 14%. The firm plans to issue additional debt. The debt moves the firm to its target debt level of 40%. What is the new return on equity?

Forecasting and Firm Valuation

6.(10) Rand is considering a new project that requires an investment of $60 million in machinery. This is expected to produce sales of $94 million per year for 4 years and operating expenses of $71 million per year for 4 years. The machinery will be fully depreciated to a zero book value over 4 years using straight-line depreciation. They can sell it for $5 million at the end of 4 years. Working capital costs are negligible. The tax rate is 30%. The unlevered cost of capital is 12%.

a.Calculate the base-case NPV.

b.BONUS (5): The project will be financed with $20,000,000 in bonds. The bonds have a 4-year life, a coupon rate of 6% and a yield of 6%. Find the adjusted present value (APV).

7.(15) Cook Wares has a target debt ratio (debt/value) of 60%. The 10-year bonds have a coupon rate of 8.3% (paid annually) and a yield to maturity of 7.2%. Tax rate is 25%. The cost of equity is 14.8%.

a.Calculate the weighted average cost of capital.

b.The firm has a 3-year planning period. The firm expects cash flows of $6M next year, and the cash flows will initially grow at 10%. After year 3, they estimate that the cash flows will grow at 2% indefinitely. Find the value of the operations.

c.The firm has $8M in cash, $2M in debt and 5M shares outstanding. Find the share price.