Exam 22: Financial Management and Stock Equilibrium

Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16%; the risk-free rate is 10%; and the market risk premium is 5%. You are considering a new project that has 50% more beta risk than your firm's assets currently have, that is, its beta is 50% larger than the firm's existing beta. The expected return on the new project is 18%. Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement.

McGwire Company's pension fund projects that most of its employees will take advantage of an early retirement program the company plans to offer in 5 years. Anticipating the need to fund these pensions, the firm bought zero coupon U.S. Treasury Trust Certificates maturing in 5 years. When these instruments were originally issued, they were 12% coupon, 30 year U.S. Treasury bonds. The stripped Treasuries are currently priced to yield 10%. Their total maturity value is $6,000,000. What is their total cost (price) to McGwire today?

How much should you be willing to pay for an account today that will have a value of $1,000 in 10 years under continuous compounding if the nominal rate is 10%?

You have $5,436.60 in an account that pays 10% interest, compounded continuously. If you deposited some funds 10 years ago, how much was your original deposit?

If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

Given the following returns on Stock Q and "the market" during the last three years, what is the difference in the calculated beta coefficient of Stock Q when Year 1 and Year 2 data are used as compared to Year 2 and Year 3 data? (Hint: Think rise over run.)

Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7%. The firm currently has a required return of 10.75% and a beta of 1.25. The investment, if undertaken, will double the firm's total assets. If rRF is 7% and the market risk premium is 3%, should the firm undertake the investment?

Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

Using the Security Market Line concept in capital budgeting, which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is most correct?

(The following information applies to the next two problems.) You have been asked to use a CAPM analysis to choose between Stocks R and S, with your choice being the one whose expected rate of return exceeds its required return by the widest margin. The risk-free rate is 6%, and the required return on an average stock (or the "market") is 10%. Your security analyst tells you that Stock S's expected rate of return is equal to 11%, while Stock R's expected rate of return is equal to 12%. The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock. The following past rates of return are to be used to calculate the two stocks' beta coefficients, which are then to be used to determine the stocks' required rates of return: Note: The averages of the historical returns are not needed, and they are generally not equal to the expected future returns. -Calculate both stocks' betas. What is the difference between the betas? That is, what is the value of betaR - betaS? (Hint: The graphical method of calculating the rise over run, or (Y2 - Y1) divided by (X2 - X1) may aid you.)

If you receive $15,000 today and can invest it at a 5% annual rate compounded continuously, what will be your ending value after 20 years?

Which of the following statements is CORRECT?

Consider each of the following bonds: Bond A: 8-year maturity with a 7% annual coupon. Bond B: 10-year maturity with a 9% annual coupon. Bond C: 12-year maturity with a zero coupon. Each bond has a face value of $1,000 and a yield to maturity of 8%. Which of the following statements is NOT correct?

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Interstate Transport has a target capital structure of 50% debt and 50% common equity. The firm is considering a new independent project that has a return of 13% and is not related to transportation. However, a pure-play proxy firm has been identified that has a beta of 1.38. Both firms have a marginal tax rate of 40%, and Interstate's before-tax cost of debt is 12%. The risk-free rate is 10% and the market risk premium is 5%. The firm should:

Other things held constant, which of the following would increase the NPV of a project being considered?

Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pure-play firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0.8 and Division B has a beta of 1.5. The two divisions are the same size. The risk-free rate is 5% and the market risk premium is 6%. Assume that Northern is 100% equity financed. What is the overall composite WACC for Northern Conglomerate?

Which of the following statements about listing on a stock exchange is most CORRECT?