# EBF 401 EBF401 Midterm 3 with Answers (Penn State University)

EBF 401 EBF401 Midterm 3 Answers (Penn State University)

**Multiple-choice questions (2 points each).**

1. Companies that have highly cyclical sales will have a:

a. Low beta if sales are highly dependent on the market cycle;

b. High beta if sales are highly dependent on the market cycle;

c. High beta if sales are independent of the market cycle;

d. All of these;

e. None of these.

2. Comparing two otherwise equal firms, the beta of the common stock of a levered firm is ____ than the beta of the common stock of an unlevered firm.

a. Equal to;

b. Significantly less;

c. Slightly less;

d. Greater;

e. Lower.

3. The cost of equity for Ryan Corporation is 8.4%. If the expected return on the market is 10% and the risk-free rate is 5%, then the equity beta is ____:

a. 0.48;

b. 0.68;

c. 1.25;

d. 1.68;

e. Impossible to calculate with information given.

4. The hypothesis that market prices reflect all publicly available information is called ____ form efficiency.

a. Open;

b. Strong;

c. Semistrong;

d. Weak;

e. Stable.

5. Thomson and Thomson is an all-equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of the levered firm, after shares have been repurchased, if you ignore taxes?

a. $20 million;

b. $20.8 million;

c. $21 million;

d. $21.2 million;

e. $21.3 million.

6. Which of the following statements are correct in relation to M&M Proposition II with no taxes?

I. The required return on assets is equal to the weighted average cost of capital;

II. Financial risk is determined by the debt-equity ratio;

III. The cost of equity is the same regardless of the firmâ€™s amount of leverage;

IIII. The cost of equity declines when the amount of leverage used by a firm rises.

a. I and III only;

b. II and IV;

c. I and II;

d. III and IV;

e. I and IV.

7. If the efficient market hypothesis holds, investors should expect:

a. To earn only a normal return;

b. To receive a fair price for their securities;

c. To always be able to pick stocks that will outperform the market averages;

d. Both to earn only a normal return and to receive a fair price for their securities;

e. Both to receive a fair price for their securities and to always be able to pick stocks that will outperform the market averages.

8. Insider trading does not offer any advantages if the financial markets are:

a. Weak form efficient;

b. Semiweak form efficient;

c. Semistrong form efficient;

d. Strong form efficient;

e. Inefficient.

9. The proposition that the value of the firm is independent of its capital structure is called: Â

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.

10. According to the efficient market hypothesis, financial markets fluctuate daily because they: Â

a. Are inefficient;

b. Slowly react to new information;

c. Are continually reacting to new information;

d. Offer many arbitrage opportunities;

e. Only reflect historical information.

**Short questions**

**Please answer 2 questions worth 5 points.**

11. Define the three forms of market efficiency.

12. What are the implications of the efficient market hypothesis for investors who buy and sell stocks in an attempt to â€śbeat the marketâ€ť?

13. State the law of one price. Does this result always hold in a perfect market? Do we expect it to hold in an efficient market?

**Please answer 2 questions worth 10 points.**

14. Define the three main factors that determine beta and explain how they affect betas.

(10 points)

15. How can firms create value through financing opportunities? Describe the three methods discussed in class.

16. 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?

**Problems**

**Please answer 1 question worth 20 points.**

17. Online Text Co. has four new text publishing products that it must decide on publishing to expand its services. The firmâ€™s WACC has been 17%. The projects are of equal risk, and all of their Î˛ are equal to 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects are expected to earn as follows:

Project |
Â |

W |
14% |

X |
18% |

Y |
17% |

Z |
15% |

18. Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $29 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Leveredâ€™s perpetual debt has a market value of $91 million and costs 8% per year. Levered has 2.3 million shares outstanding, currently worth $105 per share. Unlevered has no debt and 4.5 million shares outstanding, currently worth $80 per share. Neither firm pays taxes. Is Leveredâ€™s stock a better buy than Unleveredâ€™s stock?

**Please answer 3 questions worth 10 points.**

19. You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this all-equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of the all-equity firm today, if you ignore taxes?Â

Â

20. Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on the assets is 11%. What is the firmâ€™s debt-equity ratio, based on M&M Proposition II with no taxes?

21. The Free Cash Flows of your firm for years 1, 2 and 3 are $42,000, $49,000 and $64,000, respectively. After year 3, the growth rate in cash flow is a constant 2% with a WACC of 8%. What is the present value of the terminal value?

22. 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 companyâ€™s cost of equity is 15%, what is its pretax cost of debt?