FIN 301 – Porter Exam 4 Review

  1. The model that reflects a stocks risk after diversification is the
  2. CAPM (Capital Asset Pricing Model)
  3. SML (Security Market Line. This is the graph of the CAPM)
  4. Beta (This measures a stock’s market risk and shows how risky it is in a well diversified portfolio. Beta is part of the CAPM)
  5. Market Risk Premium (This is part of the CAPM. It is the additional return over the risk free rate; (rM – rRF))
  6. A risky stock will normally have a beta
  7. >1 (Riskier then the average stock)
  8. =1 (Average riskiness of a stock)
  9. <1 (Less risk then the average stock)
  10. -1 (Can only happen if the correlation between the stock and the market is negative. This situation is unlikely, but can happen. Refer to the insurance example)
  11. Which of the following statements is correct?
  12. To plot the SML, the expected return on many stocks is needed (The expected return of only two stocks is needed. These two returns are usually the return on the market (beta = 1) and the return on the risk free asset (beta = 0))
  13. A stock above the SML has a low expected return (A stock above the SML has a high expected return)
  14. The distance a stock is above or below the SML is measured by 
  15. A stock below the SML has a high expected return
  16. The market is currently returning 9% while the risk free asset is returning 4%. What is the return on a stock with a beta of .8?
  17. 7.2%
  18. 13%
  19. 8%: CAPM: rs = rRF + b ( rM – rRF) => .04 + .8(.09-.04)
  20. 11.2%
  21. The market risk premium and the risk free rate of return are both currently returning 6%. If a stock has a beta of 1.25, what is its required rate of return?
  22. 13.5%: CAPM: rs = rRF + b ( rM – rRF) => .06 + 1.25(.06)
  23. 6%
  24. 9.75%
  25. 11.25%
  26. The required rate of return on stock XYZ is 14%. The S&P 500 is currently yielding 11% and 30-day T-bills are yielding 5%. What is the beta for this stock? Compared to the average stock, this stock has a ______risk.
  27. 1.5; more CAPM: rs = rRF + b ( rM – rRF) => .14 = .05 + b(.11-.05) => .09 = b(.06) => divide both sides by .06 so beat = 1.5. If a stock has a beat greater then 1, it has more risk then the average stock.
  28. .5; more
  29. 1.5; less
  30. .5; less
  31. An investor has a portfolio containing 30% of stock W (b = .8), 22% of stock X (b = 1.3), 27% stock Y (b = 1.5), and 21% of stock Z (b = .5). What is the beta of this portfolio?
  32. 1.025
  33. 1.25
  34. 1.36
  35. 1.036: bp = ∑wb => .3(.8) + .22(1.3) + .27(1.5) + .21(.5)
  36. An investor invested $45,000 in stock A, $25,000 in stock B, and $37,000 in stock C. These stocks betas are 1.75, 1.2, and .4, respectfully. What is the beta of the portfolio?
  37. 1.236
  38. 1.155: First sum the amount of money invested to get a total of $107,000. Then, follow bp = ∑wb => (45,000/107,000)(1.75) + (25,000/107,000)(1.2) + (37,000/107,000)(.4)
  39. 1.177
  40. 1.847

Chapter 9:

  1. Which of the following statements regarding preferred stock is incorrect?
  2. Preferred stock is a hybrid between stocks and bonds (It is sold like stock but pays set dividends like a bond)
  3. Preferred stocks pay dividends
  4. The growth rate of preferred stock is zero (There is not growth, the dividends are set at a given rate)
  5. Paying common stock dividends comes before paying preferred stock dividends (Dividends must be paid to preferred shareholders before they are paid to common stock holders.)
  6. The management of a publicly traded company
  7. Is the same as the companies board of directors (The board of directors hires the management)
  8. Aims to maximize shareholder wealth
  9. Is elected by the shareholders (The board of directors is elected by shareholders)
  10. Is only concerned with their own wealth(This should not be the main concern for management, however it sometimes is)
  11. All of the following are correct except
  12. A stock whose future dividends are not expected to grow is also known as a zero coupon bond (This is called a zero growth stock and has the same equation as a perpetuity)
  13. When in equilibrium, a stock’s price equals its intrinsic value
  14. A stock below its intrinsic value is undervalued
  15. There are three different methods that can be used to find the intrinsic value of a stock (refer to the next question for the three methods)
  16. All of the following are formulas to determine the intrinsic value of a stock except
  17. P/E = ((1-b)(1+g)) / (r-g) (This method is called the multiples of comparable firms. The P/E ratio is the most commonly used equation to compare similar firms, but the P/sale and P/CF can also be used.)
  18. FCF = NOPAT – Net Capital Investment (This method is called the corporate value model. It takes the after-tax operating income and subtracts what you have to pay to debt holders, and the rest can be distributed to shareholders)
  19. ri = rRF + b ( rM – rRF ) (This is the equation for the CAPM. This equation can be used to find the return, r, in the dividend growth model, but it is not directly used to find the intrinsic value of a firm.
  20. P0 = D1 / ( r - g ) (This is the dividend growth model. It is used to find the present value of the future cash flows and is only valid if r>g)
  1. Nation Corp. just paid a dividend of $.95, is expected to grow at 4% per year and is expected to return 12% per year. What is the current price of this stock?
  2. $11.88
  3. $12.35: Pt = Dt+1/(r-g) and Dt = D0 (1+g)t .

First find D1 = D0 (1+g)1 =>.95(1+.04)1 = .988

Then, plug D1 into the equation to find P0

P0 = D1/(r-g) => .988/(.12-.04)

  1. $7.92
  2. $9.76
  1. If a company just paid a dividend of $1.55 and is expected to grow at 3.5% per year and return 10%, what will the price of the stock be five years from now (P5)?
  2. $23.85
  3. $31.17
  4. $27.36
  5. $29.38: Pt = Dt+1/(r-g) and Dt = D0 (1+g)t .

First find D6 = D0 (1+g)6 =>1.55(1+.035)6 = 1.91

Then, plug D6 into the equation to find P5

P5 = D6/(r-g) => 1.91/(.10-.035)

  1. Nadir Motion Pictures is expected to pay a dividend of $1.35 next year, and earnings have been growing at a constant rate of 4% per year. If Nadir has a beta of .85, the market expected return is 15%, and the risk-free return is 5%, what is your estimate of the current value of a share of Nadir stock?
  2. $14.21: P0 = D1/(r-g) and rs = rRF + b ( rM – rRF)

First find r using the CAPM to use it in the Dividend growth model

rs = rRF + b ( rM – rRF) => .05 + .85(.15-.05) = .1350

Then, plug this r into the P0 equation

P0 = D1/(r-g) => 1.35/(.1350 - .04)

  1. $16.63
  2. $18.72
  3. $21.84
  1. What is the dividend yield of a stock that is selling for $65 and just paid a dividend of $1.25 and is expected to grow at 4.5% per year?
  2. 1.92%
  3. 5.2%
  4. 4.9%
  5. 2.02%: Dividend Yield = D1/P0 andDt = D0 (1+g)t

First find D1

D1 = 1.25(1+.045)1 = 1.31

Now plug this number into the DY equation

D1/P0 => 1.31/65

  1. Last year a stock sold for $90 and this year it is selling for $112. What is the capital gains yield for this stock?
  2. 19.64%
  3. 20.56%
  4. 23.41%
  5. 24.44%: CGY = (P1 – P0) / P0 => (112-90)/90
  1. If a stock sold for $35 last year, $42 this year, and is expected to pay a $1.10 dividend, what is the total return of this stock?
  2. 16.86%
  3. 19.81%
  4. 23.14%: Total Return = Dividend Yield + Capital Gains Yield

Dividend Yield = D1/P0 and CGY = (P1 – P0) / P0

Dividend Yield = 1.10/35 = .0314 or 3.14%

CGY = (42-35)/35 = .2 or 20%

Total Return = 3.14% + 20%

  1. 22.62%
  1. If a stock is expected to make a dividend payment of $2.60 and is expected to return 14% but has a growth rate of zero, what is the current price of the stock?
  2. $2.60
  3. $18.57: P0 = PMT/r => 2.60/.14 ***This is the same equation to find the value of preferred stock and is also the equation for a perpetuity.
  4. $36.40
  5. Not enough information to tell
  6. Alpik Ltd. stock just paid a dividend of $1.50 and has a required rate or return of 10%. Due to a new patent Alpik created, they are expected rapid growth of 27% for the next four years and continual growth of 7% thereafter. What is the current price of Alpik stock?
  7. $103.88

  1. $136.94
  2. $8.71
  3. $10.28

Chapter 10:

  1. Which of the following statements regarding corporate finance is correct?
  2. Focusing on past capital is the best way to decided how to raise new capital (What happened in the past is a sunk cost, so look forward not in the past)
  3. Using the company’s actual book numbers is the best way to determine weight values for the WACC (use target weights because they are forward looking)
  4. In finance, we worry about after tax costs of capital
  5. The return on preferred stock is the only value of the WACC that must be adjusted for tax (The cost of debt must be adjusted for taxes because
  6. Which of the following is used to calculate the common cost of equity rs?
  7. CAPM: rs= rrf + (rm-rrf)b
  8. DCF: rs= (D1/P0) + g
  9. Own Bond Yield Plus Risk Premium: rs= rd + RP
  10. All of the above can be used.
  11. A 12-year, 15% semi annual coupon bond sells for $1,586.54. What is the cost of rd?
  12. 3.75%
  13. 7.44%
  14. 7.5%: N = 24, PV = -1586.54, PMT = 75, FV = 1000, solve for I/Y
  15. 8.34%
  16. A company’s current outstanding bonds have 10% coupon and 12% YTM. Their marginal tax rate is 35%. What is the after tax cost of debt?
  17. 7.8%: rd (1-T) => .12(1-.35)
  18. 3.5%
  19. 4.2%
  20. 6.5%
  21. If a company’s preferred stock sells at a price of $45.00 a share and pays a dividend of $6.50, what is the cost of preferred stock?
  22. 6.92%
  23. 8.31%
  24. 14.44% => rp = Dp/Pp => 6.50/45.00
  25. 8.04%
  26. The risk free rate is 6%, the market risk premium is 9% and the beta is 1.45. What is the common cost of equity using the CAPM?
  27. 10.35%
  28. 19.05%: CAPM: rs = rRF + b ( rM – rRF) => .06 + 1.45(.09-.06)
  29. 1.65%
  30. 13.35%
  31. A company just paid a dividend of 3.50, and their stock is currently selling at $35.50 per share. It is expected to have a constant growth rate of 5%. What is the common cost of equity using the DCF approach?
  32. 14.86%
  33. 9.86%
  34. 15.35%

D1= D0(1+g) => 3.5(1.05)

DCF: rs= (D1/P0) + g => (3.675/35.50) + 0.05

  1. 10.35%
  1. Find rs using the DCF approach when a company retains 40% of its earnings, has a return on equity of 18%, just paid a dividend of $2.35, and the common stock is selling for $55.
  2. 5.81%
  3. 15.07%
  4. 11.47%
  5. 11.78%

g = (1-payout)(ROE)

g = (1 - .60)(.18) = 7.2%

D1= D0(1+g) => 2.35(1.072) = 2.52

rs= (D1/P0) + g => (2.52/55) + 0.072

  1. A corporation’s is currently selling 5-year bonds for $970 and paying a semi-annual coupon of $40. If the risk premium is 5%, what is the cost of retained earnings using the bond-yield-plus-risk-premium approach?
  2. 9.69%
  3. 11.25%
  4. 13.75%

rs = rd + RP => Use the 5 buttons to solve for rd => N=10; PV=-970; PMT=40; FV=1000; CPT I/Y = 4.3768 semi-annual so take it times 2 to get annual of 8.7537%

rs = 8.7537 + 5

  1. 14.75%
  1. FINAL Corp found that their rs, using the CAPM method, was 8.8%. They also know that their cost of debt is 3.95% and their risk premium is 4.55%. They have an expect growth rate of 6.5% and their stock is selling for $32 and just paid a dividend of $.75. What is the average rs for FINAL Corp?
  2. 8.77%

BY = rd + RP = 3.95 + 4.55 = 8.5%

DCF = rs= (D1/P0) + g => ((.75(1.065))/32) + .065 = 9%

AVG rs = (8.5 + 9 + 8.8)/3 = 8.77%

  1. 8.34%
  2. 7.26%
  3. 11%
  1. A company’s common stock is currently trading for $50 per share and it is expected to pay a dividend of $4.55 at the end of the year. The constant growth rate is 5.75%. If they wanted to issue new stock, and would have flotation cost of 10%, what would the cost of equity of the new stock be?
  2. 3.1%
  3. 15.86%

rs= (D1/[P0(1-F)] + g)

= (4.55/ [50(1-0.10)] + 0.0575)

  1. 14.85%
  2. 20.11%
  1. A company has a target capital structure of 35% debt, and 65% common equity, with no preferred stock. Its before tax cost of debt is 10% and its marginal tax rate is 35%. The current stock price is $32.50 and they just paid a dividend of $3.00. It is expected to grow at a constant rate of 6.5%. What is the cost of common equity and the WACC?
  2. 15.73%; 12.50%
  3. 16.33%; 11.84%
  4. 15.73%; 11.45%
  5. 16.33%; 12.89%

D1= D0(1 + g) = 3(1.065) = 3.195

rs= (D1/P0) + g = (3.195/32.50) + .065 = 16.33%

WACC= wdrd(1-T) + wprp + wcrs

= (0.35)(10%)(1-.35) + 0 + (0.65)(16.33%)

= 2.275 + 0 + 10.6145

Chapter 11:

  1. Which of the following steps for capital budgeting is out of order?
  2. Estimate Cash Flows
  3. Assess Riskiness of Cash Flows
  4. Determine Appropriate Cost of Capital
  5. Accept if NPV>0 and or IRR > WACC
  6. Find NPV and or IRR (PB, DPB, MIRR, etc) (Should go between letters c and d)
  7. Which of the following are types of projects that have cash flows that are unaffected by each other and therefore, more than one can be accepted at a time?
  1. Mutually exclusive projects
  2. Independent projects
  3. Dependent projects
  4. Accepted projects
  1. If a series of cash flows changes from negative to positive and remains positive, this is an example of a
  2. Nonnormal Cash Flow
  3. Mutually Exclusive Cash Flow
  4. Normal Cash Flow
  5. Independent Cash Flow

Use the following information for the next five questions

  1. Project W costs $35,000 and has expected cash inflows of $12,000 a year for 5 years. It has a weighted average cost of capital of 10%. What is the projects NPV? Should you accept or reject the project based on NPV?
  2. $10,489.44; accept

CF0= -35,000

CF1= 12,000

F= 5

NPV

I= 10

Enter, down

NPV CPT= $10,489.44 You should accept the project b/c the NPV is > 0

  1. $80,489.44; accept
  2. $10,489.44; reject
  3. $80,489.44; reject
  1. What is the IRR for project W? Should you accept or reject the project based on IRR?
  1. 21.15%; accept

Keep the info in your calculator from the previous problem

IRR CPT= 21.15%

Accept because the IRR > WACC

  1. 65.71%; accept
  2. 21.15%; reject
  3. 65.71%; reject
  1. What is the MIRR for project W? Should you accept or reject the project based on MIRR?
  1. 15.92%; accept

Professional: Keep the info in your calculator from the previous problem

Press the down arrow. Enter 10 in for the RI, down arrow, CTP MOD

Student:

  1. -65.71%; accept
  2. 15.92%; reject
  3. -65.71%; reject
  1. What is the payback period for project W?
  1. 2.92 years

Professional:

NPV, down, down, down

PB CPT= 2.92 years

Student:

  1. 3.92 years
  2. 2.083 years
  3. 3.083 years
  1. What is the discounted payback for project W?
  1. 0.53 years
  2. 3.43 years
  3. 2.63 years
  4. 3.63 years

Professional:

NPV, down, down, down, down

DPB CPT= 3.63 years

Student:

Chapter 12: No conceptual questions are covered for Chapter 12 in this review. Don’t forget to review these concepts and terms on your own.

Use the following information for the next two questions:

A company has the following information about a project

Sales Revenue / $12 Million
Operating Costs (excluding dep’r) / $6 Million
Depreciation / $2 Million
Interest Expense / $1.5 Million

The company has a 35% tax rate and the WACC is 10%.

  1. What is the projects operating cash flow for year one? (t=1)

Sales12,000,000

-Operating Costs6,000,000

-Depreciation2,000,000

= Operating income before taxes 4,000,000

-Tax Expense (35%)1,400,000

= Operating income after taxes2,600,000

+ Depreciation2,000,000

= Operating Cash Flow4,600,000

  1. $1,400,000
  2. $2,600,000
  3. $3,400,000
  4. $4,600,000
  1. If this project would cannibalize other parts of the company by $2 million of cash flow before taxes per year, how would this change your answer?

OCF – (Cannibalizing Cost (1 – T))

4,600,000- (2,000,000(1-0.35))= 3,300,000 is the new operating cash flow.

  1. $2,600,000
  2. $3,300,000
  3. $3,600,000
  4. $3,900,000
  1. A company is in the final year of a project. The equipment originally cost $45,000,000, but 75% of it has depreciated. They used equipment can be sold today for $12,000,000, and its tax rate is 35%. What is the equipments after tax net salvage value?

Equipment’s original cost $45,000,000

Depreciation (75) 33,750,000

Book Value 11,250,000

Gain on Sale: Sell Today – Book Value => 12,000,000 – 11,250,000= 750,000

Tax on Gain: Gain on Sale (Tax Rate) => 750,000(0.35)= 262,500

After Tax Net Salvage Value: Sell Today – Tax on Sale => 12,000,000-262,500= $11,737,500

  1. $750,000
  2. $11,250,000
  3. $11,737,500
  4. $12,262,500

Chapter 13:Review the Chapter 13 content covered in class on Thursday, April 30 on your own before the final.