ANSWERS TO THE END-OF-UNIT TESTS
UNIT 2
1.B 2.D 3.A 4.C 5.B 6.D 7.D 8.E 9.E 10.E
Notes:
5.
I applied the formula (4.16) for PV of annuity but adapted for a frequency different than once a year, quarterly instead: r = 0,055 C = 500 m = 4 T = 25

The result is approx. 27090 pounds which doesn’t appear as a possible answer. I chose the value nearest to that, therefore answer B. 6.
I calculated the future values of the cash flows as not annuity and as annuity. I really don’t think these cash flows should be understood as annuities therefore the right way to calculate the future values is using table A.3. By means of that table the result is 18957,11 which doesn’t appear as a possible result so I chose the nearest one, that’s D. Future value

End of year| Cash flow| Future value factor| Future value of cash flow| 1| 5180| 1,06| 5490,8|
2| 9600| 1,1236| 10786,56|
3| 2250| 1,1910| 2679,75|
| | TOTAL| 18957,11|

Just in case the calculation should be done as annuity:
Future value of an annuity
End of year| Cash flow| Future value factor| Future value of cash flow| 1| 5180| 1| 5180|
2| 9600| 2,06| 19776|
3| 2250| 3,2149| 7233,525|
| | TOTAL| 32189,525|

----
Just in case the assignment question was wrong, I calculated present values: Present value
End of year| Cash flow| Present value factor| Present value of cash flow| 1| 5180| 0,9434| 4886,812|
2| 9600| 0,89| 8544|
3| 2250| 0,8396| 1889,1|
| | TOTAL| 15319,912|

Present value of an annuity
End of year| Cash flow| Present value factor| Present value of cash flow| 1| 5180| 0,9434| 4886,812|
2| 9600| 1,8334| 17600,64|
3| 2250| 2,6730| 6014,25|
| | TOTAL| 28501,702|

...increased the risk. The unexpected increase in the financial risk caused the value of the bonds to decline. An argument for the bondholders is their rights were violated that are supposed to be protected under the bond covenants. An argument against the bondholders is they accepted the default risk by becoming a creditor.
8. Under pressure from outside investors including corporate raider Carl Icahn, USX Corporation, the parent corporation for U.S. Steel and Marathon Oil, announced a plan to split its stock into separate steel and energy issues. The market response to this action was immediately positive, with the stock price of USX increasing $2.37 to close at $31.25 on the day of the announcement. Why do you think this action by USX was so well received by the stock market?
The company is doing well and the stock price is expensive for investors to acquire ownership. By splitting the number of shares and the price now being half of what it was the liquidity is increased. This promotes trade which in turn promotes an increase in price.
9. How can the adherence to high standards of ethical business practice contribute to the goal of shareholder wealth maximization?
This would increase the company’s reputation and make it more valuable. If a business is found to be doing unethical business we can conclude that most people and other companies wouldn’t want to be associated with that making the company less valuable and reducing the stock price....

...1. Calculate TRUST’s company after-tax WACC. The risk-free rate was 4.21%, the market risk premium was 6% and the company tax rate was 30%. The WACC should be rounded to four decimal places.
After-tax WACC = rD (1-Tc) D/V + rE E/V
rE = rf + βequity(rm – rf)
rE = 0.0421 + 0.81(0.06)
rE = 0.0907
E = number of outstanding shares x current share price
E = 60 million x $3.43
E = $205.8 million
D = $44 million bank loans + $1.2 million short-term hire purchase commitments
D = $45.2 million
V = $205.8 million + $45.2 million
V = $251 million
After-tax WACC = (1-0.3)(0.0348 x 44/251 + 0.0618 x 1.2/251) + 0.0907 x 205.8/251
After-tax WACC = 0.0789
Calculate the RV Division WACC using Stephens’s method in paragraph 20.
rE = rf + βequity(rm – rf)
rE = 0.0421 + 2.1(0.06)
rE = 0.1681
Using TRUST’s debt-to-equity mix of 21%:
Pre-tax divisional WACC = 0.1442 = (rD x 0.21) + (0.1681 x 0.79)
From above:
rD = 0.0543
After-tax divisional WACC = (1-0.3)(0.0543 x 0.21) + (0.1681 x 0.79)
After-tax divisional WACC = 0.1408
What could be deduced about the relative business risk of the RV Division compared to its industry competitors if the industry equity beta was 2.10?
Using industry equity beta to determine the cost of equity suggests that the RV Division’s equity risk is the same as that of the industry. This indicates that the difference in business risk between the RV Division and its industry competitors will stem from TRUST’s choice of...

...Chapter 06
Discounted Cash Flow Valuation
Multiple Choice Questions
1. An ordinary annuity is best defined by which one of the following?
A. increasing payments paid for a definitive period of time
B. increasing payments paid forever
C. equal payments paid at regular intervals over a stated time period
D. equal payments paid at regular intervals of time on an ongoing basis
E. unequal payments that occur at set intervals for a limited period of time
2. Which one of the following accurately defines a perpetuity?
A. a limited number of equal payments paid in even time increments
B. payments of equal amounts that are paid irregularly but indefinitely
C. varying amounts that are paid at even intervals forever
D. unending equal payments paid at equal time intervals
E. unending equal payments paid at either equal or unequal time intervals
3. Which one of the following terms is used to identify a British perpetuity?
A. ordinary annuity
B. amortized cash flow
C. annuity due
D. discounted loan
E. consol
4. The interest rate that is quoted by a lender is referred to as which one of the following?
A. stated interest rate
B. compound rate
C. effective annual rate
D. simple rate
E. common rate
5. A monthly interest rate expressed as an annual rate would be an example of which one of the following rates?
A. stated rate
B. discounted annual rate
C. effective annual rate
D. periodic monthly rate
E. consolidated...

...CONCEPT QUESTIONS - CHAPTER 1
1.1 ( What are the three basic questions of corporatefinance?
a. Investment decision (capital budgeting): What long-term investment strategy should a firm adopt?
b. Financing decision (capital structure): How much cash must be raised for the
required investments?
c. Short-term finance decision (working capital): How much short-term cash flow does company need to pay its bills.
( Describe capital structure.
Capital structure is the mix of different securities used to finance a firm's investments.
( How is value created?
( List three reasons why value creation is difficult.
Value creation is difficult because it is not easy to observe cash flows directly. The reasons are:
a. Cash flows are sometimes difficult to identify.
b. The timing of cash flows is difficult to determine.
c. Cash flows are uncertain and therefore risky.
1.2 ( What is a contingent claim?
A contingent claim is a claim whose payoffs are dependent on the value of the firm at the end of the year. In more general terms, contingent claims depend on the value of an underlying asset.
( Describe equity and debt as contingent claims.
Both debt and equity depend on the value of the firm. If the value of the firm is greater than the amount owed to debt holders, they...

...1. Refer to the following information:
Stock | E(r) | | Correlation Coefficients |
1 | 0.06 | 0.20 | 1 with 2: -0.10 |
2 | 0.08 | 0.10 | 1 with 3: +0.60 |
3 | 0.15 | 0.15 | 2 with 3: +0.05 |
A portfolio is formed as follows: sell short $1,000 of Stock 1; buy $1,500 of Stock 2; buy $1,500 of Stock 3. The investor uses $1,000 of his own equity, with the remaining amount borrowed at a risk-free interest rate of 4% (with continuous compounding).
(a) Assuming that there are no restrictions on the use of short-sale proceeds, what is this investors expected rate of return?
(b) What are some of the issues associated with short-selling, and what impact could these issues have on the expected return calculated in part (a).
ANSWER
(a) w1 = -1; w2 = 1.5; w3 = 1.5; wr = -1
E(r) = -1*0.06 + 1.5*0.08 + 1.5*0.15 + (-1)*0.04 = 24.5%
(b) short selling is restricted; unable to use proceeds from the short sale; fee for short selling reduces return. All of these restrictions could fundamentally change the return to the portfolio.
2. Consider a European call option on a stock. The stock price is $70, the time to maturity is 12 months, the risk free rate of interest is 10% per annum (with continuous compounding), the exercise price is $65, and the volatility is 32%. A dividend of $1 is expected in six months time. Determine the price of the option using the binomial method with 6-month steps.
ANSWER
3. The current price of silver is $9 per...

...Final Exam Practice Problems
1. Firm ABC’s only outstanding debt is $100,000 worth of coupon bond (market value). Its yield to maturity is 8%. Given that its tax rate is 40%, what is its effective cost of debt?
Effective cost of debt = cost of debt * (1-tax rate) =8%*(1-40%)=4.8%
2. Firm ABC has a stock currently traded at $20. The next year’s dividend will be $0.20. The dividend growth rate is forecasted to be 6% forever. Risk-free rate is 3%, and market risk premium is 4%. Assume that Constant Dividend Growth Model and CAPM give you the same estimate of the cost of capital for equity, what is the beta of its stock?
By the Constant Dividend Growth Model:
Cost of Equity = D/P+g = 0.2/20+6%=7%
By CAPM, cost of equity = R(f)+ beta * market risk premium = 3% + beta* 4%,
Set this to be equal to 7%, solve for beta: beta=1
3. Firm ABC has a cost of equity of 8%, a cost of debt of 5%. It stock is traded at $10/share, and has 10 million shares outstanding. Its debt value is $20 million. Tax rate is 40%. What is its after-tax WACC?
Equity Value = 10*10=$100 million, Debt Value=$20 million
So, equity weight = 100/120=83.3%, debt weight=20/120=16.7%
After-tax WACC= equity weight * cost of equity + debt weight * effective cost of debt
=83.3%*8%+16.7%*5%*(1-40%) = 7.2%
4. Suppose you are the founder of a private company ABC. Initially you raised $500,000 from an angel investor from the first-round financing. As a result, both you and...

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