EBF 401 EBF401 Midterm 3 with Answers
EBF 401 EBF401 Midterm 3 Answers (Version 2)
Multiple-choice questions (2 points each).
1. The beta of a firm is more likely to be high under what two conditions?
a. High cyclical business activity and low operating leverage;
b. High cyclical business activity and high operating leverage;
c. Low cyclical business activity and high financial leverage;
d. Low cyclical business activity and low financial leverage;
e. Low cyclical business activity and low operating leverage.
2. When using the cost of debt, the relevant number is the:
a. Pre-tax cost of debt, since most corporations pay taxes at the same tax rate;
b. Pre-tax cost of debt, since it is the actual rate the firm is paying to bondholders;
c. Post-tax cost of debt, since dividends are tax deductible;
d. Post-tax cost of debt, since interest is tax deductible;
e. None of these.
3. Suppose that Simmons’ common stock has a beta of 1.6. If the risk-free rate is 5% and the market risk premium is 4%, the expected return on the stock is:
4. The U.S. Securities and Exchange Commission periodically charges individuals for insider trading and claims those individuals have made unfair profits. Based on this fact, you would tend to argue that the financial markets are at best ____ form efficient.
5. Uptown Interior Designs is an all-equity firm that has 40,000 shares of stock outstanding. The company has decided to borrow $1 million to buy out the shares of a deceased shareholder who owns 2,500 shares. What is the total value of the levered firm, after the buy out, if you ignore taxes?
a. $15.5 million;
b. $15.6 million;
c. $16 million;
d. $16.8 million;
e. $17.2 million.
6. A manager should attempt to maximize the value of the firm by:
a. Changing the capital structure if and only if the value of the firm increases;
b. Changing the capital structure if and only if the value of the firm increases to the benefit of the inside management;
c. Changing the capital structure if and only if the value of the firm increases only to the benefits of the debtholders;
d. Changing the capital structure if and only if the value of the firm increases although it decreases the stockholders’ value;
e. Changing the capital structure if and only if the value of the firm increases and stockholder wealth is constant.
7. The proposition that the cost of equity is a positive linear function of capital structure is called:
a. The capital asset pricing model;
b. M&M Proposition I;
c. M&M Proposition II;
d. The law of one price;
e. The efficient market hypothesis.
8. Individuals that continually monitor the financial markets seeking mispriced securities:
a. Tend to make substantial profits on a daily basis;
b. Tend to make the markets more efficient;
c. Are never able to find a security that is temporarily mispriced;
d. Are always quite successful using only well-known public information as their basis of evaluation;
e. Are always quite successful using only historical price information as their basis of evaluation.
9. The hypothesis that market prices reflect all available information of every kind is called ____ form efficiency:
10. For the levered firm the equity beta is _____ the asset beta:
a. Greater than;
b. Less than;
c. Equal to;
d. Sometimes greater than and sometimes less than;
e. None of these.
Please answer 2 questions worth 5 points.
11. When is the asset beta equal to the equity beta? When is it different (and how)? Explain.
12. Define an arbitrage.
13. What are the implications of the efficient market hypothesis for firms who issue securities and sell them on capital markets?
14. Define a perfect capital market and an efficient capital market. If a market is perfect, is it also efficient? If a market is efficient, is it also perfect?
15. What does Proposition I of Modigliani and Miller state (in a world without taxes)? What is the key assumption that lies behind the theory, and what does this assumption imply?
16. Why should financial managers care about market efficiency? State and discuss the three implications of efficiency for managers.
Please answer 1 question worth 20 points.
17. Filer Manufacturing has 8.3 million shares of common stock outstanding. The current share price is $53, and the book value per share is $4. Filer Manufacturing has two bond issues outstanding. The first bond issue has a face value of $70 million and a coupon rate of 7%, and sells for 108.3% of par. The second issue has a face value of $60 million and a coupon rate of 7.5%, and sells for 108.9% of par. The first issue matures in 8 years, the second in 27 years.
18. Titan Mining Corp. has 9.3 million shares of common stock outstanding and 260,000 6.8% semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $34 per share and has a beta of 1.20, while the bonds have 20 years to maturity and sell for 104 percent at par. The market risk premium is 7%, T-bills are yielding 3.5% and Titan Mining’s tax rate is 35%.
Please answer 3 questions worth 10 points.
19. Bose, Inc. has a target debt-equity ratio (D/E) of 0.45. Its WACC is 11.2% and the tax rate is 35%. If the company’s aftertax cost of debt is 6.4%, what is the cost of equity?
20. Longmont Inc. has a cost of equity of 12% and a pre-tax cost of debt of 6%. The required return on the assets is 10%. What is the firm’s debt-equity ratio, based on M&M Proposition II with no taxes?
21. Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.
22. Slippery Slope Roof’s Free Cash Flows for years 1, 2 and 3 are $70,000, $60,000 and $96,000, respectively. After year 3, cash flows grow at a constant rate of 3% with a WACC of 9%. What is the value of the firm?
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