Question

13.Which of the following statements is FALSE concerning the Absolute Priority Rule?

a.  Common Stockholders are the last to be paid in a bankruptcy.

b.  Secured Creditors do not appear on the list at all.

c.  Consumer claims are paid after government claims.

d.  Bondholders are included in Unsecured Creditors.

e.  Lawyers generally get their money first.

14.  Keep Going, Inc. has 30% common stock, 10% preferred stock, and 60% debt.  Its cost of equity is 12%, cost of preferred stock is 8% and cost of debt is 11%.  The tax rate is 35%.  What is Keep’s WACC?

1. 8.72%
2. 9.58%
3. 9.66%
4. 8.83%
5. None of the above

15. An investor with a portfolio beta of .95 is thinking of adding one of the three following stocks to his portfolio:

Dell (Beta 1.15), Apple  (Beta 1.2) and IBM (Beta .75). Which one would increase the risk of the overall portfolio?

1. Either Dell or Apple
2. Either IBM or Apple
3. Dell
4. Apple
5. IBM

Answer 1

Solution to 13

b and e are false.

Secured creditors appear on the list and have priority over unsecured claims. Lawyers claims would form part of unsecured claims. Government claims such as taxes would be given priority among unsecured creditors

Solution to 14

e. None of the above

The WACC works out to 8.69%

Formula for WACC is:

(Weight of common stock x cost of equity) + (Weight of preferred stock x cost of preferred stock) + (Weight of debt x cost of debt x (1 - tax rate))

since cost of debt is tax deductible

= (0.30 x 0.12) + (0.10 x 0.08) + (0.60 x 0.11 x (1 - 0.35))

= 0.036 + 0.008 + 0.0429

= 0.0869 or 8.69%

Solution to 15

a. Either Dell or Apple

Beta of a portfolio is the weighted average of the individual stock betas that make up the portfolio. On adding either Dell or Apple to the portfolio the weighted portfolio beta would increase since Dell and Apple have betas higher (greater than 1) than the beta of the portfolio (less than 1). Addition of IBM would lower the portfolio beta since its beta is lower than portfolio beta.