EBK FINANCIAL MANAGEMENT: THEORY & PRAC
15th Edition
ISBN: 9781305886902
Author: EHRHARDT
Publisher: CENGAGE LEARNING - CONSIGNMENT
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Chapter 21, Problem 2MC
1.
Summary Introduction
Case summary: The Person DL is the CEO of the Company LST has debt financing concerns. The Company LST uses temporary debt rather than permanent or long-term debt. The person wonders the reason of using debt sources for financing and its impact on the value of stocks. Due to this, the person raised some question to the assistant which was hired recently.
To determine: The value of V, s, r and WACC for firm U and L.
b.
Summary Introduction
To draw: A graph showing relationship between capital cost and leverage and also relationship between value of the firm and debt.
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Assume that Firms U and L are in the same risk class and that both have EBIT=$500,000. Firm U uses no debt financing, and its cost of equity is rsU=14%. Firm L has $1 million of debt outstanding at a cost of rd=8%. There are no taxes. Assume that the MM assumptions hold.
Find V, S, rs, and WACC for Firms U
Suppose the Capital Asset Pricing Model (CAPM) is valid in a market. Use CAPM to ex-
plain and answer following questions. Note: There is no relationship between each situation.
(a) Can security A exist in the market? (Hint: Security market line) If yes, compute risk
premium on security A. If not, is this security underpriced or overpriced?
Expected return
5%
Asset
Beta
Risk-free
Market
12%
1
A
15%
1.3
(b) Can security B exist in the market? (Hint: Security market line) If yes, compute risk
premium on security B. If not, is this security underpriced or overpriced?
Expected return
6%
Asset
Beta
Risk-free
Market
13%
16.5%
1
1.5
Suppose the expected cash flow can be collected from investment in security B is $1000
at time 1. And an investor thinks the beta of security B is 1.8. But the actual beta is given
in the above table. Then how much more/less (you also need to select "more" or "less") will
he offer for the firm than it is truly worth at time 0? Hint: the present value of the cash…
Instructions:
Assume the following data for two firms (U = unlevered firm) and (L = levered firm). Assume the two firms are in the same risk class when it comes to business risk. Both firms have EBIT = €1000 000. Firm U has zero debt and its required rate of return (KsU = 12%). Firm L has €2000 000 debt and pays 10% interest rate.
Based on the data provided, answer the following questions and show all your computations and interpret your results.
Find the value of unlevered (U) and levered (L) firms under zero corporate tax assumption.
Find the market value of the firm’s L’s debt and equity.
Do 1 and 2 under the assumption of corporate tax = 60%
Chapter 21 Solutions
EBK FINANCIAL MANAGEMENT: THEORY & PRAC
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- Show your work for the following A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.) Multiple Choice A) 0.7 B) 0 C) 1.0 D) 1.2arrow_forwardHow would each of the following scenarios affect a firm’s cost of debt, kd(1 – T); its cost of equity ke and its WACC? Indicate with a plus sign (+), a minus (-) or a zero if the factor would raise, would lower or would have indeterminate effect on the item in question. Assume for each answer that other things are held constant even though in some instances this would probably not be true. Be prepared to justify your answer but recognize that several of the parts have no single correct answer.arrow_forwardNote:- • Do not provide handwritten solution. Maintain accuracy and quality in your answer. Take care of plagiarism. • Answer completely. • You will get up vote for sure.arrow_forward
- 1. Assume the risk free interest rate is 3%, the market rate of return is 7% and beta for company X is 2. Given this information, the non-diversifiable risk for this company is a) 8% b) 4% c) 2 d) 6% 2. Referring to question 1, the required rate of return for the company is a) 2% b) 9% c) 8% d) 11% 3. Referring to question 1, this company has a risk that is a) Equal to the market risk b) We cannot tell c) More than the market risk d) Less than the market risk 4. Assume that you have a portfolio of two stocks, X and Y. If the risk of stock X is 1.2 and the risk of stock Y is 4, then the return on stock Y should be a) Greater than the return on Stock X b) We cannot tell c) Less than the return on stock X d) Equal to the return on stock S 5. If the portfolio in the previous question is well diversified and stocks are strongly negatively related, then the risk for the portfolio will be a) Greater than the risk of stock X (i.e. greater than 1.2) but less than the risk on stock Y(i.e less…arrow_forwardthis is actually one question with three parts, could you answer it pleasearrow_forwardThe asset of company X have a beta equal to 1. Assume that company’s debt has a beta to 0.5 and that X’s equity has a Beta equal to 2, consider an investor who holds 10% of company’s debt and 10% of the company’s equity, the beta of the investor’s portfolio is equal to? A. 0.25 B. 1 C. 1.25 D. 0.1arrow_forward
- 2. Denote by Cn and P calls and puts with strike price K 240 and exercise date N = 1. Let the bank account be Bn = e", with r = 0.05 and let the underlying cost So = 250. Assume that Co 75 and Po = 70. Check whether NA holds. If NA does not hold, propose an %3D arbitrage strategy.arrow_forwardAnswer the following a) When will the different DCF methods use the same discount rate? b) The cost of debt (ka) will change as the capital structure of a firm changes. Why or why not? c) Why does the cost of equity (k.) increase as the amount of debt in the capital structure of a firm increases? Why? d) Freebie Inc.'s common stock has a beta of 1.3. If the risk-free rate is 4.5% and the expected return on the market is 12%, what is its cost of equity capital? e) Why do branded food companies command the highest EBIT multiple (about 8) and transportation companies the lowest (about 3)? f) Should a firm use its cost of capital as a hurdle/discount rate to value all internal divisions? Why or why not? g) An option can have more than one source of value. Consider a mining company. The company can mine for ores today or wait another year (or more) to mine. What real options can you identify here? h) Do you consider dividend payments by the firm in calculating cash flows? Why or why not? i)…arrow_forwardA firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)arrow_forward
- Which of the following are assumptions of the Capital Asset Pricing Model (CAPM)? Check all that apply. Consider the equation for the Capital Asset Pricing Model (CAPM): All assets are perfectly divisible and liquid. Investors assume that their investment activities won't affect the price of a stack. 7 = TRF + (TM - TRF) X bi -0.50 There are no transaction costs. 0.30 Assets have unique liquidity. In this equation, the term (M - TRF) represents the 1.00 Suppose that the market's average excess return on stocks is 12.00% and that the risk-free rate is 1.00%. Complete the following table expected returns to stocks for each beta coefficient using the Capital Asset Pricing Model (CAPM): 3.00 Cov(ri, TM) 02 M Expected Return to Stocks (%) Based on the CAPM and your calculations for the return to stocks, what does it mean when the coefficient b; > 1? O The stock's return correlates with the stock market as a whole. The stock is more volatile than the market.arrow_forwardThe beta of Company’s X equity is equal to 1. Assuming that the company's debt is risk-free, that X's debt to equity ratio is equal to 1, and that there are no taxes, the beta of company X’s assets is 1 1/2 2 2/3arrow_forwardCan you show how this is donearrow_forward
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