Intermediate Finance 092403

Name:______________________________________ 09/24/03

Multiple Choice
Identify the letter of the choice that best completes the statement or answers the question. Note: all questions
are worth 5 points, except questions 10, 11, and 17, which are worth 10 points.)

____ 1. Even if the correlation between the returns on two different securities is perfectly positive, if the securities are
combined in the correct unequal proportions, the resulting portfolio can have less risk than either security
held alone.
a. True
b. False
____ 2. Which of the following statements is most correct?
a. The slope of the security market line is beta.
b. A stock with a negative beta must have a negative required rate of return.
c. If a stock's beta doubles its required rate of return must double.
d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes
in the market risk premium.
e. None of the above statements is correct.
____ 3. Which of the following statements is most correct?
a. Portfolio diversification reduces the variability of the returns on the individual stocks held
in the portfolio.
b. If an investor buys enough stocks, he or she can, through diversification, eliminate
virtually all of the nonmarket (or company-specific) risk inherent in owning stocks.
Indeed, if the portfolio contained all publicly traded stocks, it would be riskless.
c. The required return on a firm's common stock is determined by its systematic (or market)
risk. If the systematic risk is known, and if that risk is expected to remain constant, then no
other information is required to specify the firm's required return.
d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that
of an average stock.
e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified
portfolio than to an investor who holds only that one stock.
____ 4. Which of the following statements is most correct?
a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate
all the market risk from the portfolio.
b. If you form a large portfolio of stocks each with a beta greater than 1.0, this portfolio will
have more market risk than a single stock with a beta = 0.8.
c. Company-specific (or unsystematic) risk can be reduced by forming a large portfolio, but
normally even highly diversified portfolios are subject to market (or systematic) risk.
d. Answers a, b, and c are correct.
e. Answers b and c are correct.
____ 5. HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10 percent, and the
required rate of return on an average stock is 15 percent. Now the expected rate of inflation built into rRF falls
by 3 percentage points, the real risk-free rate remains constant, the required return on the market falls to 11
percent, and the betas remain constant. When all of these changes are made, what will be the difference in the
required returns on HR's and LR's stocks?
a. 1.0%
b. 2.5%
c. 4.5%
d. 5.4%
e. 6.0%

____ 6. Assume that you wish to purchase a bond with a 30-year maturity, an annual coupon rate of 10 percent, a face
value of $1,000, and semiannual interest payments. If you require a 9 percent nominal yield to maturity on
this investment, what is the maximum price you should be willing to pay for the bond?
a. $905.35
b. $1,102.74
c. $1,103.19
d. $1,106.76
e. $1,149.63
____ 7. In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures
to a market value basis. KJM Corporation's balance sheet as of today, January 1, 2003, is as follows:

Long-term debt (bonds, at par) $10,000,000

Preferred stock 2,000,000
Common stock ($10 par) 10,000,000
Retained earnings 4,000,000
Total debt and equity $26,000,000

The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They mature on
January 1, 2013. The yield to maturity is 12 percent, so the bonds now sell below par. What is the current
market value of the firm's debt?
a. $5,412,000
b. $5,480,000
c. $2,531,000
d. $7,706,000
e. $7,056,000
____ 8. A corporate bond matures in 14 years. The bond has an 8 percent semiannual coupon and a par value of
$1,000. The bond is callable in five years at a call price of $1,050. The price of the bond today is $1,075.
What are the bond's yield to maturity and yield to call?
a. YTM = 14.29%; YTC = 14.09%
b. YTM = 3.57%; YTC = 3.52%
c. YTM = 7.14%; YTC = 7.34%
d. YTM = 6.64%; YTC = 4.78%
e. YTM = 7.14%; YTC = 7.05%
____ 9. A share of common stock has just paid a dividend of $3.00. If the expected long-run growth rate for this stock
is 5 percent, and if investors require an 11 percent rate of return, what is the price of the stock?
a. $50.00
b. $50.50
c. $52.50
d. $53.00
e. $63.00

____ 10. ABC Company has been growing at a 10 percent rate, and it just paid a dividend of D0 = $3.00. Due to a new
product, ABC expects to achieve a dramatic increase in its short-run growth rate, to 20 percent annually for
the next 2 years. After this time, growth is expected to return to the long-run constant rate of 10 percent. The
company's beta is 2.0, the required return on an average stock is 11 percent, and the risk-free rate is 7 percent.
What should the dividend yield (D1/P0) be today?
a. 3.93%
b. 4.60%
c. 10.00%
d. 7.54%
e. 2.33%
____ 11. Hard Hat Construction's stock is currently selling at an equilibrium price of $30 per share. The firm has been
experiencing a 6 percent annual growth rate. Last year's earnings per share, E0, were $4.00, and the dividend
payout ratio is 40 percent. The risk-free rate is 8 percent, and the market risk premium is 5 percent. If market
risk (beta) increases by 50 percent, and all other factors remain constant, by how much will the stock price
change? (Hint: Use four decimal places in your calculations.)
a. -$ 7.33
b. +$ 7.14
c. -$15.00
d. -$15.22
e. +$22.63

____ 12. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.
a. True
b. False
____ 13. Wyden Brothers uses the CAPM to calculate the cost of equity capital. The company's capital structure
consists of common stock, preferred stock, and debt. Which of the following events will reduce the
company's WACC?
a. A reduction in the market risk premium.
b. An increase in the risk-free rate.
c. An increase in the company's beta.
d. An increase in expected inflation.
e. An increase in the flotation costs associated with issuing preferred stock.
____ 14. Which of the following statements is most correct?
a. The weighted average cost of capital for a given capital budget level is a weighted average
of the marginal cost of each relevant capital component which makes up the firm's target
capital structure.
b. The weighted average cost of capital is calculated on a before-tax basis.
c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and
equity financing.
d. Answers a and c are correct.
e. All of the answers above are correct.
____ 15. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent and the market risk
premium (rM - rRF) is 6 percent. What is the company's cost of common stock, rs?
a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4%

Rollins Corporation
This information applies to the following problems.

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent
preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a
current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays
a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-
free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just
paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to
use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs.
The firm's marginal tax rate is 40 percent.

____ 16. Refer to Rollins Corporation. What is Rollins' WACC?

a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
 Essay

17. Assume that the following returns were earned on Stock Y and the market during the last eight years:

Year rY rM Year rY rM
2003 14% 20% 1999 6 10
2002 9 10 1998 -1 -5
2001 1 -5 1997 11 20
2000 11 15 1996 9 15
Average return 7.5% 10%
Standard deviation 5.18% 10%

a. What is Stock Y's beta coefficient? (Hint: Use a calculator with statistical functions to
determine the least squares line.)
b. If the expected value of rM is 10 percent and rRF is 6 percent, what is the required rate of return
on Stock Y?
c. Suppose that in January, 2004, investors learn that Firm Y will, in the future, face much
greater competition, and investors conclude that Stock Y will, in the future, be exposed to
much higher nondiversifiable risk. Expected future profits and dividends, however, are
unchanged (although the uncertainty about profits and dividends does increase). What effect is
this knowledge likely to have on Stock Y's market price, on the realized rate of return on Stock
Y during 2004, on the required rate of return on the stock, and on the expected rate of return
on the stock in the future?
d. Suppose that during 2004 Stock Y had a return of minus 5 percent, while the market return
was 20 percent. What would this do to the calculated beta coefficient for Stock Y? (Hint: Add
the new data point and recalculate beta.)
e. Use the CAPM to calculate the required rate of return for Stock Y. Assume rM = 10 percent
and rRF = 6 percent.
f. How does this new estimate of rY compare with the estimate based on data through 2003?
Does this seem reasonable?
 Intermediate Finance 092403
Answer Section

MULTIPLE CHOICE

1. ANS: B
2. ANS: E
Statement e is correct; the others are false. The market risk premium is the slope of the SML. If a stock has a
negative beta, this does not mean its required return is negative. A doubling of a stock's beta doesn't mean that
its required return will double. The required return is a function of rRF, rM, and beta. The required return is
affected by the market risk premium.
3. ANS: D
A security's beta does indeed measure market risk relative to that of an average stock. Diversification reduces
the variability of the portfolio's return. An investor, through diversification, can eliminate company-specific
risk; however, a portfolio containing all publicly-traded stocks would still be exposed to market risk. The
CAPM specifies a stock's required return as: rs = rRF + (rM - rRF)b. Thus, the risk-free rate and the market risk
premium are needed along with a stock's beta to determine its required return. A stock's beta is more relevant
as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that
one stock.
4. ANS: E
5. ANS: E
bHR = 2.0; bLR = 0.5. No changes occur.
rRF = 10%. Decreases by 3% to 7%.
rM = 15%. Falls to 11%.
Now SML: ri = rRF + (rM - rRF)bi.
rHR = 7% + (11% - 7%)2 = 7% + 4%(2) = 15%
rLR = 7% + (11% - 7%)0.5 = 7% + 4%(0.5) = 9
Difference 6%
6. ANS: C

Numerical solution:
VB = $50((1- 1/1.04560)/0.045) + $1,000(1/1.04560)
= $50(20.6380) + $1,000(0.071289) = $1,103.19≈ $1,103.

Financial calculator solution:

Inputs: N = 60; I = 4.5; PMT = 50; FV = 1,000.
Output: PV = -$1,103.19; VB ≈ $1,103.
7. ANS: A
 Numerical solution:
VB = $20(PVIFA6%,20) + $1,000(PVIF6%,20)
= $20((1- 1/1.0620)/0.06) + $1,000(1/1.0620)
= $20(11.4699) + $1,000(0.3118) = $541.20 per bond.

Since there are 10,000 bonds outstanding the total value of debt is $541.20(10,000) = $5.412 million.

Financial calculator solution:

Inputs: N = 20; I = 6; PMT = 20; FV = 1,000.
Output: PV = -$541.20; VB = $541.20.
8. ANS: E
To calculate YTM: N = 28, PV = -1075, PMT = 40, and FV = 1000. Solve for I/YR = 3.57% × 2 = 7.14%.

To calculate YTC: N = 10, PV = -1075, PMT = 40, and FV = 1050. Solve for I/YR = 3.52% × 2 = 7.05%.
9. ANS: C

P0 = = $52.50.
10. ANS: B

rs = 0.07 + (0.11 - 0.07)2.0 = 0.15 = 15%.

Dividend yield = $3.60/$78.26 = 4.60%.

Financial calculator solution:

Inputs: CF0 = 0; CF1 = 3.60; CF2 = 99.36; I = 15.
Output: NPV = $78.26.
Dividend yield = $3.60/$78.26 = 0.0460 = 4.60%.
11. ANS: A
Calculate the required rate of return
D0 = E0(Payout ratio) = $4.00(0.40) = $1.60.

+g= + 0.06 = 11.65%.

Calculate beta
11.65% = 8% + (5%)b; b = 0.73.
Calculate the new beta
 bNew = 0.73(1.5) = 1.095.
Calculate the new required rate of return
rs = 8% + (5%)1.095 = 13.475% ≈ 13.48%.
Calculate the new expected equilibrium stock price

0
= = $22.67
Change in stock price = $22.67 - $30.00 = -$7.33.
12. ANS: B
13. ANS: A
Statement a is correct; the other statements are false. If RPM decreases, the cost of equity will be reduced.
Answers b through e will all increase the company's WACC.
14. ANS: D
Statements a and c are both correct; therefore, statement d is the correct choice. Statement a recites the
definition of the weighted average cost of capital. Statement c is correct because rd = rRF + LP + MRP + DRP
while rs = rRF + (rM - rRF)b. If rRF increases then the values for rd and rs will increase.
15. ANS: D
The cost of common equity as calculated from the CAPM is

rs
= rRF + (rM - rRF)b
= 5% + (6%)1.2
= 12.2%.
16. ANS: A
WACC = wdrd(1 - T) + wpsrps + wcers
= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56% ≈ 13.6%.

ESSAY

17. ANS:

a. The least squares procedure yields the following equation for predicting the rate of return on
Stock Y: rY = a + brM = 2.5 + 0.5rM. Therefore, the beta for Stock Y is 0.50. The regression line
is plotted in the graph.
b. rY = rRF + (rM - rRF)bY = 6% + (4%)0.5 = 8%.

c. The stock is now riskier. With greater risk and the same expected earnings and dividends, the
price of the stock would fall. Thus, capital losses would be incurred, and they would offset if
not overwhelm the dividend return, with the net result being a low or even negative realized
rate of return during 2004. The required rate of return would rise. With the same expected
dividends and dividend growth rate, but a lower market price, the expected rate of return on
the now lower priced stock would rise to equal the now higher required rate of return.

d. Adding the point -5, 20 for 2004 to the data set produces this regression equation:

rY = 2.75 + 0.3rM. beta = 0.3.

Thus, the historical beta declines when the 2004 data is added.

e. rY = 6% + (4%)0.3 = 7.2%

f. This is down from 8% in 2003. Since we know that investors regard Stock Y as being riskier,
the true required rate of return must be higher than 8%, not lower. This demonstrates one of
the problems with using the CAPM. In this case, rising risk caused a decline in the price of the
stock, which caused a low rate of return, which in turn caused the calculated beta to decline. In
this example, historical betas do not reflect risk well at all.