Question

Use the following information for questions 1-7. A corporation has 9,000,000 shares of stock outstanding at a price of $40 per share. They just paid a dividend of $2 and the dividend is expected to grow by 5% per year forever. The stock has a beta of .9, the current risk free rate is 4%, and the market risk premium is 6%. The corporation also has 300,000 bonds outstanding with a price of $1,100 per bond. The bond has a coupon rate of 8% with semiannual interest payments, a face value of $1,000, and 13 years to go until maturity. The company plans on adding debt until they reach their target debt ratio of 70%. They expect their cost of debt to be 9% and their cost of equity to be 14% under this new capital structure. The tax rate is 25%

1. What is the required return on the corporation’s stock?

a) 9.4%          b) 10.25%      c) 11.3%         d) 12.2%       

2. What is the expected return on the corporation’s stock?

a) 9.4%           b) 10.25%      c) 11.3%         d) 12.2%       

3. What is the yield to maturity on the company’s debt?

a) 6.2%          b) 6.5%           c) 6.8%            d) 7.1%

4. What percent of their current market value capital structure is made up of debt?

a) 33%           b) 48%            c) 58%             d) 69%

5. What is their WACC using their target capital structure and expected costs of debt and equity?

a) 7.7%          b) 8.9%           c) 9.4%            d) 10.2%

6. Given the new cost of debt, what should be the new price of the bond?

a) $925          b) $960            c) $1,025         d) $1,175

7. Given the new cost of equity, what should be the new price of the stock?

a) $23.33       b) $27.25         c) $33.50         d) $36.67

8. Which of the following does NOT affect the business risk of a firm?

a)Variability in Sales (Price and/or Volume)

b)Degree of Operating Leverage      

c)Product Diversification

d)Level of Debt

9. According to the tradeoff model of capital structure, which is true at the optimal capital structure?

a)Earnings per share is maximized

b)WACC is minimized

c)The total value of equity is maximized

d)Return on Equity is Maximized

10. Which is NOT a reason why the costs of debt and equity might increase at an increasing rate as the level of debt rises?

a)The firm’s best employees begin to leave

b)The firm must pay higher legal and accounting costs

c)Managers start accepting positive NPV projects

d)Assets may be sold at below market prices during liquidation

                                                      

11.       The Price Co. can make widgets for $5 and sell them for $8. If fixed costs are $200,000, then how many widgets must they sell in order to have an EBIT of $100,000?

a) 30,000            b) 50,000              c) 100,000            d) 150,000

Answer 1

Part1:- Price of equity = D1(1+g)/(1+i)+D1(1+g)^2/(1+i)^2+.....

This means

40= 2(1.05)/(1+i)+2(1.05)^2/(1+i)^2+.....

i= 10.25%

Part2:- CAPM= Risk free rate+ beta* risk premium

=0.04+0.9*0.06= 9.4%

Part 3:- Current market price of bond = 81.6PVAF_@i,13 +1000PVF_@i,13

This gives

At i=10%

RHS= 81.6*7.1034+1000*0.28966= 869.297

At i= 3%

RHS= 1548.766

Now current price of bond =1100

Using interpolation

(1100-869.297)/(1548.766-869.297)=(i-0.10)/(0.03-0.10)

i= 7.623%

Part 4:- (300000*1100)/(9000000*40+300000*1100)= 47.826%

Part 5:- WACC= proportion of equity * cost of equity + proportion of, debt* cost of debt(1- tax rate) = 0.30*0.14+0.70*0.09(1-0.25)= 8.925%

Part 6:- New price = 81.6* PVAF_@9%,13+1000*PVF_@9%,13

=81.6*7.4869+1000*0.32618= 937.111

Part 7:- new price = 2(1.05)/(0.14-0.05)= 23.33

Part 9:- option b is the correct option because optimal capital structure is the one at which the firm value is maximized. Therefore minimum WACC will maximise the value of the firm.