FINANCE 634 Exam III
Fall 1998
You need to determine the appropriate discount rate to use to evaluate an average-risk capital project. Your company is financed with debt and common stock, with a market capitalization of $15M in short-term liabilities, $45M in long-term debt, and $75M in common equity. This capital structure has been determined to be optimal for this company. The marginal tax rate is 34%.
Your company currently has an issue of long-term bonds outstanding with 2 years remaining to maturity, a 10.5% coupon rate (semi-annual payments) and a $1,000 par value. The next coupon payment is due in exactly six months. These bonds are currently selling for $1,017.83 in the market. Your investment banker feels that new 20-year bonds could be sold at par at the same yield to maturity as the existing bonds. Your company also currently has a short-term bank loan for $15 million (8.0% rate) that is used to carry the company through the peak selling season, after which it is paid off within a few months.
Your common stock is not publicly traded, so you don't know your company's Beta. However, you have located a company that is very similar in terms of operations, and their publicly traded stock reflects a Beta of 1.25. The other company has a debt/assets ratio of .25 and it has no short-term debt. It's marginal tax rate is also 34%. You believe that the appropriate risk-free rate and market risk premium to use in the CAPM are 4.5% and 5.6%, respectively.
Given this information, answer the following THREE questions.
1. In the computation for the company's weighted average cost of capital (WACC), the correct proportional weight for common equity is:
a. 75.0%
b. 60.0%
c. 37.5%
d. 62.5%
e. None of the above.
2. The after-tax non-weighted cost of debt that would be used in the WACC computation is:
a. 6.93%b. 4.75%
c. 6.02%
d. 6.27%
e. 3.13%
3. What is the best estimate of the company's after-tax non-weighted cost of common equity that can be derived from the given information?
a. 12.50%
b. 15.87%
c. 10.21%
d. 10.10%
e. 8.32%
4. Which of the following statements is(are) true?
a. In estimating a company's weighted average cost of capital, you should use the book values of the company's debt and equity to determine the appropriate weights.
b. If a company's stock is not publicly traded it is impossible to determine its cost of capital.
c. A company's cost of capital is the appropriate rate to use for discounting cash flows in projects that have the same risk as the company's current operations.
d. Two of the above.
e. All of the above.
5. Which of the following statements is(are) true?
a. The weighted average cost of capital for a particular company is not affected by the risk associated with the company since risk can be diversified away by investors.
b. Internally generated funds have a very low cost of capital since these funds were created out of the profits generated by the company and thus require no payments to investors.
c. An increase in financial leverage will always reduce the average cost of capital for a company.
d. More than one of the above.
e. None of the above.
6. An increase in the marginal tax rate for a company
a. will cause its weighted average cost of capital to increase, other things equal.
b. will cause its weighted average cost of capital to decrease, other things equal.
c. will not affect its weighted average cost of capital, other things equal.
d. More than one of the above.
e. None of the above.
7. The required rate of return on a particular project is determined by
a. The risk-free rate, the project beta, and the firm's cost of debt.
b. The project beta, the firm's cost of equity, and the expected market return.
c. The risk-free rate, the project beta, and the expected market return.
d. The risk-free rate, the project beta, and the firm's WACC.
e. None of the above.
8. If a firm uses its weighted average cost of capital to evaluate all investments, what will be probable result over time?
a. The firm will reject some value-creating low-risk projects and accept some value-reducing high-risk projects.
b. The firm will reject some value-creating high-risk projects and accept some value-reducing low-risk projects.
c. The overall risk of the company's portfolio of projects will decrease.
d. a and c.
e. b and c.
Suppose a company has one product that sells for $15.00 per unit and costs $9.50 per unit (variable cost) to produce. The company has fixed operating costs of $240,000.00 per year. Use this information to answer the next TWO questions.
9. At 60,000 units of sales, the company's break even point and before-tax operating profit (EBIT) are closest to:
a. 16,000 units and $90,000, respectively.
b. 16,000 units and $330,000, respectively.
c. 25,264 units and $90,000, respectively.
d. 43,634 units and $330,000, respectively.
e. 43,634 units and $90,000, respectively.
10. At 60,000 units of sales, the company's degrees of operating leverage (DOL) is closest to:
a. 0.00
b. 0.28
c. 1.00
d. 2.38
e. 3.67
11. Which of the following statements is(are) true?
a. In a perfect capital market, the WACC is constant regardless of the proportion of debt in the capital structure.
b. In a perfect capital market, the use of debt increases the value of a company.
c. In a perfect capital market, the cost of equity is constant regardless of the proportion of debt in the capital structure.
d. More than one of the above.
e. None of the above.
12. Which of the following statements is(are) true?
a. Other things equal, the expected value of bankruptcy costs is positively related to the amount of debt a company uses.
b. In the pecking order view of capital structure, companies with large proportions of equity are preferred by investors to those with smaller proportions of equity.
c. In the absence of perfect capital markets, the way to maximize a company's value is to minimize its risk - thus implying a capital structure with no debt.
d. Two of the above.
e. All of the above.
13. Debt creates risk for the firm by
a. increasing the probability of bankruptcy.
b. increasing the variability of cash flows to shareholders.
c. increasing the risk of financial distress.
d. Two of the above.
e. All of the above.
14. An increase in the level of debt in the capital structure will the firm's beta
and the firm's cost of capital, other things equal.
a. increase, decrease
b. increase, increase
c. increase, not change
d. decrease, increase
e. not enough information
15. If the firm issues debt but writes protective and restrictive covenants into the loan contract, then the debt may be issued at a ___________interest rate compared with otherwise similar debt.
a. significantly higher
b. slightly higher
c. equal
d. lower
e. either a or b
Consider a company with expected EBIT of $160 million per year, no debt, and a current cost of common equity of 12.5%. The company has 8 million shares of common stock outstanding with a Beta coefficient of .90. Suppose the company can borrow perpetual debt at the riskless rate of 6.3%. The company is non-taxable. Other standard MM assumptions apply. If the company borrows $700 mllion and uses the proceeds to repurchase common shares, compute the information requested in the next THREE questions.
16. The market value of one common share following the restructuring will be:
a. $247.50
b. $160.00
c. $72.50
d. $20.00
e. None of the above.
17. The cost of common equity following the restructuring will be closest to:
a. 13.71%
b. 15.89%
c. 17.43%
d. 13.05%
e. 19.98%
18. Now assume that the company is taxable and has a marginal tax rate of 34%. The company's total market value following the restructuring will be closest to:
a. $1,280,000,000
b. $844,800,000
c. $1,895,160,000
d. $844,800,000
e. $1,082,800,000
19. In determining the firm's target cash balance, trading costs (transactions costs):
a. tend to rise when cash balances are large.
b. tend to fall when cash balances are large.
c. are not affected by cash balances.
d. More than one of the above.
e. None of the above.
20. Concerning the Baumol model, which of the following is not correct (all other things equal)?
a. The optimum cash balance rises as fixed order costs rise.
b. The optimum cash balance rises as interest rates rise.
c. The optimum cash balance rises as the firm's total cash requirement rises.
d. More than one of the above.
e. None of the above.
21. Which of the following statements is (are) true?
a. Zero balance accounts insure that firms never drop below a comfortable level of cash in the cash account.
b. The fastest but most expensive way to transfer surplus funds from the local deposit bank to the concentration bank is by wire transfer.
c. The cash cycle equals the inventory period plus the accounts receivable period.
d. More than one of the above.
e. None of the above.
22. Net working capital is defined as:
a. the present value of short term cashflows.
b. the difference between current assets and current liabilities.
c. the total amount of current assets in a business.
d. the difference between all assets and liabilities.
e. none of the above.
23. Which of the following statements concerning the cash balance is not true?
a. Firms with seasonal sales are more likely to experience both cash deficits and cash surpluses throughout the year than companies with steady sales.
b. Cash shortfalls are almost always indicative of financial distress.
c. Delayed collection on sales will usually lead to lower net working capital.
d. Two of the above.
e. All of the above are true.
24. A manager who felt that interest rates were going to decline and who wanted to gamble on the direction of interest rates would follow the
a. maturity matching approach
b. the conservative approach
c. the liberal approach
d. the aggressive approach
e. None of the above.
25. A firm with an inventory conversion period of 25 days, a receivables conversion period of 50 days, and a payables deferral period of 30 days would have a cash conversion cycle of
a. 75 days
b. 45 days
c. 55 days
d. 105 days
e. None of the above.
26. Which of the following statements is(are) true?
a. The three basic motives for holding cash are transactions demand, precautionary demand, and liquidity demand.
b. For businesses in general, the greatest source of short-term funds is trade credit.
c. Compensating balance requirements increase the effective cost of bank loans.
d. Two of the above.
e. All of the above.
27. When the credit terms are 3/15 Net 60, the annualized (assume 365 days in a year) cost of not taking the discount and paying for the purchases on the 60th day is closest to:
a. 11.28%
b. 18.25%
c. 25.08%
d. 24.33%
e. 18.81%
28. The effective annual interest rate (APY) on a $125,000 discount-interest bank loan with a 3-month life, a 15% compensating balance requirement, and a 12% stated annual interest rate is closest to:
a. 13.62%
b. 15.45%
c. 14.33%
d. 14.12%
e. 12.87%
29. Concerning the article "Thirsting for Credit", which of the following statements is(are) true?
a. Mead was denied credit by 2 of the 12 banks with which it had previously had a line of credit because the company's financial condition had deteriorated.
b. RAROC stands for Risk Adjusted Rate of Collection.
c. Some banks are now setting a lower limit on the amount of a line of credit or revolving loan that can remain undrawn to improve the profitability of the loan.
d. More than one of the above.
e. None of the above.
Extra credit: 5 Points maximum, partial credit is possible.
Describe what you think has happened to the cost of capital for a moderately-sized manufacturing company over the past three months. Justify your answer in words, explaining as many factors as you can. Write your answer in the space below.
Answers:
1=D, 2=D, 3=A, 4=C, 5=E, 6=B, 7=C, 8=A, 9=E, 10=E, 11=A, 12=B, 13=E, 14=E, 15=D, 16=B, 17=E, 18=E, 19=B, 20=B, 21=B, 22=B, 23=A, 24=D, 25=B, 26=C, 27=C, 28=B, 29=C