ASSIGNMENT

1. Use the following information to answer the questions.

Security	Beta	Standard deviation	Expected return
Market Risk-free Firm A Firm B Firm C	1.0 0.0 1.5 (     ) 2.0	10% 2% 30% 20% 25%	6.0% 3.0% (     )% 4.5% (     )%

• Figure out the expected returnfor Firm A. (20points)
• Figure out the betafor Firm B (20points)

 

• Compare Firm A with Firm C.

1. Which firm hashigher total risk? Firm A or C? (20points)
2. Which firm will have higher expected return? Firm A or C? Why? (20points)

 

• There are three kinds of risk: total risk, systematic risk, and unsystematic risk. Which risk can you remove by forming a diversified portfolio? (20points)

2. Answer the questions

• The current stock price for Firm D is $100 while the next dividend is $4. Suppose that the dividend is expected to grow at 6% every year. Figure out the cost of equity for Firm D based on Dividend growth model. (25points

 

• Figure out thecost of debt if the bond price for Firm D is $920 for the 5-year bond with a par value of $1,000 and a coupon rate of 6% paid semiannually. (25points)

 

• Firm Dhas a Debt-to-Equity ratio (D/E) of 200%. Figure out the debt-to-firm value (D/V) using the Debt-to-Equity ratio (D/E). (25points)

 

• Figure out the weighted average cost of capital of Firm D (WACC) when the tax rate is 50%. (25points)

 

3. Use the following information to answer the questions

Case I: Capital structure (no corporate tax)	Case II: Capital structure (corporate tax)
Debt-to-firm value (D/V): 0% Cost of equity: 10% Cost of debt: 6%	Debt: $ 0 million EBIT: $40 million Tax rate: 50% Unlevered cost of capital: 10%

• In Case I,when the debt-to-firm value (D/V) increases from 0% to 50%,

1. Figure out the newcost of equity. (25points).

 

 

1. Figure out the old WACC with zero debt.Figure out the new WACC with debt of 50%.  (25points).

 

 

• In Case II, when the debt increasesfrom $0 to $60mil.,

1. Figure out the leveredfirm’s value. (25points)

 

1. Figure out the optimal capital structure. In other words, does the capital structure affect the WACC?(25points)

 

 

4. Answer the questions.

 

• The average returnis usually proportional to a level of risk. (15points)

1. True       b. False

 

• Stock risk premiumis usually greater than bond risk premium. (15points)

1. True       b. False

 

• As we increasea number of securities for a portfolio, the portfolio volatility always continues to decrease. (15points)

1. True       b. False

 

• Expected returnof a security contains a component for the pure time value of money. (15points)

1. True       b. False

 

• Cost of capitalis the required return for capital budgeting, while cost of capital is not affected by capital structure. (15points)

1. True       b. False

 

• A higher WACCleads to a higher NPV of a project. (15points)

1. True       b. False

 

• As firms increasethe leverage, the cost of asset (WACC) can go up or down, while the cost of equity will increase. (15points)

1. True       b. False

 

• Capital structure theorywith corporate tax says that there is no optimal capital structure. (15points)
  1. True       b. False

 

• Capital structure theorywith bankruptcy costs argues that as firms increase debt, the additional value of interest tax shield will be offset by the expected bankruptcy cost (15points)

1. True       b. False

 

• Pecking Order theory argues that to finance corporate investment, firms follow a specific order:1. retained earnings, 2. equity, and 3. debt.(15points)
  1. True       b. False