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Both bonds make annual payments, have a YTM of 9 percent, and have five years to maturity. The current yield for Bonds P and D is percent and percent, respectively. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16)) If interest rates remain unchanged, the expected capital gains yield over the next year for Bonds P and D is percent and percent, respectively. (Do not include the percent signs (%). Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16))

Explanation:

-1.75 ± 1.0% 2.21 ± 1.0%

10.75 ± 1.0% 6.79 ± 1.0%

To find the capital gains yield and the current yield, we need to find the price of the bond. The current price of Bond P and the price of Bond P in one year is: P: P0 = $120(PVIFA9%,5) + $1,000(PVIF9%,5) = $1,116.69 P1 = $120(PVIFA9%,4) + $1,000(PVIF9%,4) = $1,097.19 Current yield = $120 / $1,116.69 = .1075 or 10.75% The capital gains yield is: Capital gains yield = (New price – Original price) / Original price Capital gains yield = ($1,097.19 – 1,111.69) / $1,116.69 = –.0175 or –1.75% The current price of Bond D and the price of Bond D in one year is: D: P0 = $60(PVIFA9%,5) + $1,000(PVIF9%,5) = $883.31 P1 = $60(PVIFA9%,4) + $1,000(PVIF9%,4) = $902.81 Current yield = $60 / $883.81 = .0679 or 6.79% Capital gains yield = ($902.81 – 883.31) / $883.31 = +.0221 or +2.21% All else held constant, premium bonds pay high current income while having price depreciation as maturity nears; discount bonds do not pay high current income but have price appreciation as maturity nears. For either bond, the total return is still 9%, but this return is distributed differently between current income and capital gains

One More Time Software has 9.2 percent coupon bonds on the market with nine years to maturity. The bonds make semiannual payments and currently sell for 106.8 percent of par. The current yield on the bonds is percent, the YTM is percent, and the effective annual yield is percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16.))

Explanation:

8.12 ± 1% 8.29 ± 1% 8.61 ± 1%

percent. (Do not include the

The bond price equation for this bond is: P0 = $1,068 = $46(PVIFAR%,18) + $1,000(PVIFR%,18) Using a spreadsheet, financial calculator, or trial and error we find: R = 4.06% This is the semiannual interest rate, so the YTM is: YTM = 2 × 4.06% = 8.12% The current yield is: Current yield = Annual coupon payment / Price = $92 / $1,068 = .0861 or 8.61% The effective annual yield is the same as the EAR, so using the EAR equation: Effective annual yield = (1 + 0.0406)2– 1 = .0829 or 8.29%

Grohl Co. issued 11-year bonds a year ago at a coupon rate of 6.9 percent. The bonds make semiannual payments. If the YTM on these bonds is 7.4 percent, the current bond price is $ ($). Round your answer to 2 decimal places. (e.g., 32.16))

Explanation:

965.1 ± 1%

. (Do not include the dollar sign

To find the price of this bond, we need to realize that the maturity of the bond is 10 years. The bond was issued one year ago, with 11 years to maturity, so there are 10 years left on the bond. Also, the coupons are semiannual, so we need to use the semiannual interest rate and the number of semiannual periods. The price of the bond is: P = $34.50(PVIFA3.7%,20) + $1,000(PVIF3.7%,20) = $965.10

Kiss the Sky Enterprises has bonds on the market making annual payments, with 13 years to maturity, and selling for $1,045. At this price, the bonds yield 7.5 percent. The coupon rate on the bonds is include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16))

Explanation:

8.05 ± 1%

percent. (Do not

Here we need to find the coupon rate of the bond. All we need to do is to set up the bond pricing equation and solve for the coupon payment as follows:

P = $1,045 = C(PVIFA7.5%,13) + $1,000(PVIF7.5%,13) Solving for the coupon payment, we get: C = $80.54 The coupon payment is the coupon rate times par value. Using this relationship, we get: Coupon rate = $80.54 / $1,000 = .0805 or 8.05%

Ackerman Co. has 9 percent coupon bonds on the market with nine years left to maturity. The bonds make annual payments. If the bond currently sells for $934, the YTM is (%). Round your answer to 2 decimal places. (e.g., 32.16))

Explanation:

10.15 ± 1%

percent. (Do not include the percent sign

Here we need to find the YTM of a bond. The equation for the bond price is: P = $934 = $90(PVIFAR%,9) + $1,000(PVIFR%,9) Notice the equation cannot be solved directly for R. Using a spreadsheet, a financial calculator, or trial and error, we find: R = YTM = 10.15%

Suppose you buy a 7 percent coupon, 20-year bond today when it's first issued. If interest rates suddenly rise to 15 percent, the value of your bond will decrease .

Explanation:

Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when interest rates rise—hence, the price of the bond decreases.

Metroplex Corporation will pay a $3.04 per share dividend next year. The company pledges to increase its dividend by 3.8 percent per year indefinitely. If you require an 11 percent return on your investment, you will pay $

42.22 ± 1.0%

for the company's stock today. (Do not include the dollar sign ($). Round your answer to 2

055 = $2. so: Dividend yield = 1/2(. we find the price per share of the preferred stock is: . (e.decimal places.038) = $42.16)) Explanation: 2.45 Resnor. Round your answer to 2 decimal We know the stock has a required return of 11 percent.45 ± 1. (Do not include the percent The price a share of preferred stock is the dividend divided by the required return. most preferred stock pays a fixed dividend. and the dividend and capital gains yield are equal. This is the same equation as the constant growth model.g.11) = . with a dividend growth rate of zero percent.0% per share. If it's the company's policy to always maintain a constant growth rate in its dividends.59 / 1. we find the price of the stock today is: P0 = D1 / (R– g) = $3.055($47) = $2. so the growth rate is zero. 32. (Do not include the dollar sign ($).0% percent. so: D1 = .055 = Capital gains yield Now we know both the dividend yield and capital gains yield. the current dividend is $ places.g.16)) Explanation: 5. 32. Inc.22 Suppose you know a company's stock currently sells for $47 per share and the required return on the stock is 11 percent. The question asks for the dividend this year... the required return is sign (%).055) D0 = $2.. Round your answer to 2 decimal places.16)) Explanation: Using the constant growth model. Remember.59 This is the dividend next year.59 = D0(1 + . Using the relationship between the dividend this year and the dividend next year: D1 = D0(1 + g) We can solve for the dividend that was just paid: $2.11 – .g.09 ± 1. Using this equation.. has an issue of preferred stock outstanding that pays a $5. You also know that the total return on the stock is evenly divided between a capital gains yield and a dividend yield.50 dividend every year in perpetuity. The dividend is simply the stock price times the dividend yield. (e. (e. If this issue currently sells for $108 per share. 32.04 / (.

0% . The price of the stock in Year 3 is the PV of the dividends in Years 4. To find the value of the stock today.50/$108 = . a 12 percent return for the next three years. The current share price for GPF stock is $ (e.0% .50 (1. and a 10 percent return thereafter.09% Great Pumpkin Farms (GPF) just paid a dividend of $3. 32. 5..14 + $3.47 Far Side Corporation is expected to pay the following dividends over the next four years: $11. 2.50 / 1. Round your answer to 2 decimal places. and 6.05) 2 / (1.05)6 / 1. The price of the stock in Year 3 is: P3 = $3.50(1.05) = $98.g) = $3.. plus the PV of the stock price in Year 6.0509 or 5.123 P3 = $80.50 on its stock. and $2.. Investors require a 14 percent return on the stock for the first three years.81 / (1. we can find the price of the stock today.16)) 40. plus the PV of the stock in Year 3.10 . (Do not include the dollar sign ($).05)4 / 1.R = D/P0 = $5. the current share price is $ Round your answer to 2 decimal places.05)3 / (1. 32. (Do not include the dollar sign ($). The price of the stock today is: P0 = $3. If the required return on the stock is 12 percent. Explanation: This stock has a constant growth rate of dividends.50(1. but the required return changes twice. The price of the stock in Year 6 will be the dividend in Year 7.14)2 + $3.14)3 P0 = $63.g) = D0 (1 + g)7 / (R . Explanation: .122 + $3. The growth rate in dividends is expected to be a constant 5 percent per year indefinitely. So: P6 = D6 (1 + g) / (R .12 + $3.50 Now we can find the price of the stock in Year 3. We need to find the price here since the required return changes at that time. Afterward. we will begin by finding the price of the stock at Year 6.g.05)7/ (. divided by the required return minus the growth rate in dividends.81 Finally.50(1.05)5 / 1.14)3 + $80. $5.50(1.50(1.123 + $98. (e.16)) 63.05) / 1.47 ± 1.50(1.g. the company pledges to maintain a constant 5 percent growth rate in dividends forever.09 ± 1. when both the dividend growth rate and the required return are stable forever. and 3. $8. The price today will be the PV of the dividends in Years 1.

16)) Explanation: We are asked to find the dividend yield and capital gains yield for each of the stocks. 0 percent.0% percent. at the beginning of the constant dividend growth.0% percent.19 . The stock begins constant growth in Year 4.19 . plus the PV of the Year 4 stock price. as: P4 = D4(1 + g) / (R .09 Consider four different stocks.12 + $8.05)/(.19 .68 Dividend yield = D1/P0 = $4.g) = $4.. X. we find the price of the stock when the dividends level off at a constant growth rate.81 Dividend yield = D1/P0 = $4.50/$23. percent. 19 ± 1.50(0.With supernormal dividends. The capital gains yield for the stock will be the total return (required return) minus the dividend yield.00 / 1. and Y are expected to maintain constant growth rates in dividends for the foreseeable future of 10 percent. To find the components of the total return.19 + .4% X: Y: Z: .50(1 .122 + $5.00(1. All of the stocks have a 19 percent required return. and then find the PV of the future stock price.24 = -. 24 ± 1.00 / 1. Stock Z is a growth stock that will increase its dividend by 20 percent for the next two years and then maintain a constant 12 percent growth rate thereafter.0% percent.10)/(.68 / (1. and 10 ± 1..g.00 Dividend yield = D1/P0 = $4. respectively.50(1.19) + $4. 32.6 ± 1.19 .0% percent.066 or 6.12)/(.g2) = D0(1 + g1)2(1 + g2)/(R .81 = .50(1. The expected capital gains yield for the respective stocks are -5 12.10) = $55....19 ..10 or 10% P0 = D0(1 + g) / (R .0) = $23.. we need to find the stock price for each stock.0% 0 9 ± 1.19 = 0% P0 = D0(1 + g) / (R . plus the PV of all dividends during the supernormal growth period. Using this stock price and the dividend.05 or -5% P2 = D2(1 + g2) / (R . and -5 percent per year. and Z is 6.09 or 9% Capital gains yield = . we can calculate the dividend yield.g) = $4.. percent. So. and percent. (e.00 The price of the stock today is the PV of the first four dividends.50(1.g) = $4. Round your answers to 2 decimal places.0% percent. which is the sum of the dividend yield and the capital gains yield.19 or 19% Capital gains yield = .95)/$17. X.066 = .6% Capital gains yield = .05) = $17.10)/$55..124 = $40.00 / 1.33 = .50 per share.50 (1. Stocks W. respectively.09 = .50/(.05) / (.124 or 12. the price of the stock today will be: P0 = $11.20) / (1. Negative amount should be indicated by a minus sign.00 / 1.12 .19 .4 ± 1.20)/$82. (Do not include the percent signs (%).12) = $103.33 Dividend yield = D1/P0 = $4. Y.68 P0 = $4.124 + $30.68 = . W: P0 = D0(1 + g) / (R .19)2 + $103.50 (1.20) 2 / (1. so we can find the price of the stock in Year 4.24 or 24% Capital gains yield = .20)2(1.50(1.19)2 = $82.05) = $30. The dividend yield for Stocks W.00 = .123 + $2.g) = $2.g2) = $4.19 .00 / 1. all of which have a required return of 19 percent and a most recent dividend of $4.

the quarterly dividend will be one-fourth of annual dividend. the price of the stock paying annual dividends will be: P0 = D0(1 + g) / (R .53 ± 1. b.) Explanation: 59. the current share price is $ 56. Using the constant growth model.. Suppose a company currently pays a $3.g) = $3. (Do not include the dollar signs ($).06)/(. This would assume the dividends increased each quarter.02 ± 1. Most corporations pay quarterly dividends on their common stock rather than annual dividends.In all cases. or maintains the current dividend once a year and then pays this dividend out in equal quarterly installments to its shareholders. mature.12.06) = $56. but the return is distributed differently between current income and capital gains.87%. lowers.20 annual dividend on its common stock in a single annual installment.0287 The effective annual dividend will be the FVA of the quarterly dividend payments at the effective quarterly required return. just paid a dividend of $2. or: Quarterly dividend: $3.02 Note that we can not simply find the quarterly effective required return and growth rate to find the value of the stock. (e.16)) a. Now suppose the company in (a) actually pays its annual dividend in equal quarterly installments. If the required return .54/(.848 To find the equivalent annual dividend. and management plans on raising this dividend by 6 percent per year indefinitely. Round your answers to 2 decimal places.g. Barring any unusual circumstances during the year. we must assume that the quarterly dividends are reinvested at the required return. this company has just paid a $. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth. (Hint: Find the equivalent annual end-of-year dividend for each a.0% . High growth stocks have an appreciable capital gains component but a relatively small current income yield.12 .4) = $3.0% .If the company pays quarterly dividends instead of annual dividends. thus. In other words.12 .45 per share. the effective quarterly rate is: Effective quarterly rate: 1. the effective annual dividend will be: Effective D1 = $0. If the required return on this stock is 12 percent. In this case. We can then use this interest rate to find the equivalent annual dividend. we can use the constant growth model to find the current stock price as: P0 = $3.54 Now.1 = . negative-growth stocks provide a high current income but also price depreciation over time. the required return is 19%..06)/4 = $0. 32.20(1.53 b. we reinvest it at the required return on the stock.06) = $59.. conversely.80 dividend per share. when we receive the quarterly dividend. the board raises.20(1. as it has for the previous three quarters. after which the company will keep a constant growth rate forever. not each year.25 .848(FVIFA2. The value for the current share price is now $ year. So. Storico Co.

11 3 + $65. 32. just paid a dividend of $2.45(1. Round your answer to 2 decimal places.000 face value.040.10)/(1 + R)3 + [$2.45(1.24 ± 1. a share of stock will sell for $ ($).10)/1.11) + $2.15)/1.20)(1.82 We need to find the roots of this equation.05) / (. and use trial and error to find the unknown rate of return.0% today. what was your total dollar return on this investment over the past year? (Do not include the dollar sign ($).82 today.10)(1. Required: (a) Assuming a $1.15)(1. If a share of Storico stock sells for $63..15)(1. plus the PV of the stock price in Year 3.08/1.g. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth.g. (Do not include the dollar sign Here we have a stock with supernormal growth.11 .15)/(1 + R)2 + $2.7 ± 1. (e..05)/(R Â– . We can find the price of the stock in Year 3 since the dividend growth rate is constant after the third dividend. (Do not include the percent sign (%).20)/(1. Using spreadsheet. or a calculator with a root solving function.10)(1. Round your answer to 2 decimal places. 32.20)(1. The bond sells for $1.) Explanation: 10.45(1. divided by the required return minus the constant dividend growth rate. So. The equation for the stock price is: P = $2.20)(1.05)]/(1 + R)3 = $63. we find that: R = 10.20)(1.20)(1.113 P0 = $55.16)) Explanation: 55.) . trial and error.45(1. The price of the stock in Year 3 will be the dividend in Year 4.24% Suppose you bought a 7 percent coupon bond one year ago for $1.08 The price of the stock today will be the PV of the first three dividends.45 per share.15)(1.15)(1.45(1.on Storico stock is 11 percent.20)(1. after which the company will keep a constant growth rate.11 2 + $2.70 Storico Co. forever. (e.45(1. the required return on Storico stock is percent.45(1.0% Here we want to find the required return that makes the PV of the dividends equal to the current stock price.16)) (Hint: Set up the valuation formula with all the relevant cash flows. so: P0 = $2.. the price in Year 3 will be: P3 = $2.070 today.45(1.05) = $65. but the dividend growth changes every year for the first four years.20)/(1 + R) + $2.

g.16) and for variance round your answers to 6 decimal places.16)) Nominal rate of return 9.62 ± 1% percent (c) If the inflation rate last year was 4 percent.g. the variances. 32. For average return and standard deviation round your answers to 2 decimal places.g.040 = .0962 / 1.070 – 1.Total dollar return $ 100 ± 1% (b) What was your total nominal rate of return on this investment over the past year? (Do not include the percent sign (%)...16)) Real rate of return 5.040) + 70] / $1. Round your answer to 2 decimal places.62% Notice here that we could have simply used the total dollar return of $100 in the numerator of this equation (c) Using the Fisher equation.6 ± 1% % . what was your total real rate of return on this investment? (Do not include the percent sign (%). and the standard deviations for X and Y. (e. (e. 32.161616)) Returns Year 1 2 3 4 5 X 8% 21 17 –16 9 Y 16% 38 14 –21 26 X Average Return 7. 32.. Round your answer to 2 decimal places.8 ± 1% Y % 14. (e.070 – 1.0540 or 5. the real return was: (1 + R) = (1 + r)(1 + h) r = (1.40% Using the following returns.040 + 70 = $100 (b) The total percentage return of the bond is: R = [($1. 32.0962 or 9.. so: Total dollar return = $1. (e.4 ± 1% percent Explanation: (a) The total dollar return is the increase in price plus the coupon payment.04) – 1 = . (Do not include the percent signs (%). calculate the arithmetic average returns.g.

38 + .0780 or 7.36 4. we calculate the variance of each stock as: / (N – 1) σx2 = 1 5–1 1 5–1 =.38% σY = (.16 + .1460 or 14.048680 ± 1% 22.21 + .99 -14.50% 4.23 7.020670 ± 1% 14.S.99 5.06% Consider the following table for the period from 1970 through 1975.29 7.38 ± 1% . Returns LargeCompany Stocks 3.09] /N= 5 = .048680)1/2 = .30 18.048680 The standard deviation is the square root of the variance.21 + .87 Years 1970 1971 1972 1973 1974 1975 .2206 or 22. divided by the number of returns.60% Remembering back to statistics.47 37.80% [.Variance Standard Deviation .020670 σy2 = =.16 + .14 – .26] /N= 5 = . The average return for each stock was: [.69 -26.17 – .94% 14.1438 or 14.08 + .020670)1/2 = .06 ± 1% % % Explanation: The average return is the sum of the returns. Treasury Bills 6. so the standard deviation of each stock is: σX = (.23 U.

23 ± 1% 1.76 -21.4 ± 1% -0.0555)2] Variance = 0.0555)2 + (.1469 – . we find the variance for large company stocks over this period was: Variance = 1/5[(.0555)2 + (.2647 – .0604)2 + (.99 -14.36 -2.1899 – .69 -26. Round your answers to 2 decimal places.36 4.Required: a. stock return 3.0799 – .16)) c.053967 And the standard deviation for large company stocks over this period was: Standard deviation = (0.55 ± 1% percent and percent. 32.53 ± 1% The average risk premium over this period was 24. Using the equation for variance.23 33..24 The average return for large company stocks over this period was: Large company stocks average return = 33. 32. Round your answers to 2 decimal places.94% 14.0436 – .. (Do not include the percent signs (%).23 7.1430 – .053967)1/2 = 0.47 37.0650 – .g. Doing so. The standard deviation of the returns for large-company stocks and T-bills over this time period was percent and percent.98 -34.04 ± 1% 5.87 36. Do not include the percent signs (%).0604)2 + (.g. (Do not include the percent signs (%).16)) b. Round your answers to 2 decimal places.3723 – .0604)2 + (. We will calculate the sum of the returns for each asset and the observed risk premium first.0729 – .0587 – . we get: Large co.50% 4. (Negative amount should be indicated by a minus sign.0394 – . 23.0604)2] . respectively.24% / 6 = 6. 32.94 14.55% And the average return for T-bills over this period was: T-bills average return = 36. respectively.16)) Explanation: a.0604)2 + (.0423 – . we find the variance for T-bills over this period was: Variance = 1/5[(.0604)2 + (. (e.23% Using the equation for variance.0555)2 + (–. The arithmetic average returns for large-company stocks and T-bills over this time period was 6.g.30 18.99 5.04% b.29 7.94 Year 1970 1971 1972 1973 1974 1975 T-bill return 6.2323 or 23.49 ± 1% percent and the standard deviation was percent.30% / 6 = 5.56% 9.46 31.30 Risk premium -2..0555)2 + (. (e.0555)2 + (–. (e.

32. Your choices are Stock X with an expected return of 14 percent and Stock Y with an expected return of 10. respectively.66 = .0049))2 + (–.64) / $73.g. The return for each year is: R1 = ($73.574..16)) Explanation: 11.2340 or 23.1126)(1 + . (e.57 ± 0.428.059517)1/2 = 0. The average observed risk premium over this period was: Average observed risk premium = –2.58 ± 1% To calculate the arithmetic and geometric average returns.20) / $78. we must first calculate the return for each year.53% c.Variance = 0. 32.000 to invest in a stock portfolio.60) / $60.49 – 89.0436)(1 + . (e.059517 And the standard deviation of the observed risk premium was: Standard deviation = (0.0049))2 + (.18 – 73.94% / 6 = –0. Round your answer to 2 decimal places.1183 or 11.2873)(1 – .g.0049))2] Variance = 0.80)/ $89.0256 – (–.18 = .49 = .20 Required: The arithmetic and geometric returns for the stock are percent and percent.2340)(1 + . you will invest $ in Stock X and $ the dollar signs ($).4 percent.40% A stock has had the following year-end prices and dividends: Year 1 2 3 4 5 6 Price $60.49 + 1.64 .26% R5 = ($95.35 + 0.0994 – (–.73% R3 = ($89.49 95.0049))2 + (.66 94.49% The variance of the observed risk premium was: Variance = 1/5[(–.83 ± 1% 10..000234 And the standard deviation for T-bills over this period was: Standard deviation = (0.18 + 0.2340 + 0.66 + 0.2873 – 0.0436 or –4.40% R2 = ($94.35 – 94.0049))2 + (.80 1.36% R4 = ($78.2440 or 24.16)) Explanation: 5.35 78.18 73.83% And the geometric average return was: RG = [(1 + .2263 or 22. (Do not include .5 percent.1126 or 11.72 . Round your answers to 2 decimal places.1476 – (–.63% The arithmetic average return was: RA = (0.0436 + 0.35 = –.0049))2 + (–.58% You have $10.000234)1/2 = 0.05 – 78.0153 or 1.18 = –.60 .1% 4.18 89.72) / $94.2198 – (–.18 + 0.43 ± 0.2263)]1/5 – 1 = 0.1058 or 10.66 – 60.3446 – (–.2263)/5 = 0. If your goal is to create a portfolio with an expected return of 12.05 Dividend — $.3136 – (–.1% in Stock Y. (Do not include the percent signs (%).2873 or 28.1126 + 0.

or: Investment in X = 0.124 = . 32. 15 percent in Stock S.105wX .84) + .)) 10.14wX + .16. Required: (a) The expected return on a portfolio that is equally invested in the two assets is include the percent sign (%). We can use the equation for the expected return of a portfolio to solve this problem.124 = . So. The betas for these four stocks are .95. respectively.36. The portfolio beta is 1.84. and 1.11.105(1 – wX) We can now solve this equation for the weight of Stock X as: .g.11) + .57 And the dollar amount invested in Stock Y is: Investment in Y = (1 – 0. 20 percent in Stock R.15 ± 1.105 – . Round your answer to 2 decimal places.428. and 40 percent in Stock T.43 You own a stock portfolio invested 25 percent in Stock Q. the weight of the stock is 70.0% percent.4 ± 1. 1.0% percent and the weight . the weight of Stock Y must be one minus the weight of Stock X..16..000) = $4.15 A stock has a beta of 1. this means: E(Rp) = .8 percent.14wX + . 32. the beta of the portfolio is: βp = .)) Explanation: The beta of a portfolio is the sum of the weight of each asset times the beta of each asset.574.542857)($10.000) = $5.Here we are given the expected return of the portfolio and the expected return of each asset in the portfolio.019 = .542857($10.17. (e.g. 1. (Round your answer to 2 decimal places.17) + . (e.40(1. (Do not (b) If a portfolio of the two assets has a beta of .36) = 1.35 and an expected return of 16 percent.0% . and are asked to find the weight of each asset.15(1.20(1.035wX So.25(. Since the total weight of a portfolio must equal 1 (100%). the dollar amount invested in Stock X is the weight of Stock X times the total portfolio value. A risk-free asset currently earns 4.37 ± 1. Mathematically speaking.

. The expected return of the portfolio is: E(Rp) = (. 32.08 = . Explanation: (a) Again we have a special case where the portfolio is equally weighted.of the risk-free is decimal places.16wS + .048(1 – wS) .16.95 = wS(1.35wS + 0 – 0wS wS = 0.35 wS = .2963 (c) We need to find the portfolio weights that result in a portfolio with an expected return of 8 percent.35 = 2 wRf = 1 – 2 = –1 The portfolio is invested 200% in the stock and –100% in the risk-free asset.0% percent and the weight of the risk-free is percent (Negative amount should be indicated by a minus sign.35) + (1 – . we find: βp = 2. 32. or 100 percent.)) (c) 29.048)/2 = . (e. the b of the portfolio will be: bp = . (Do not include the percent signs (%).35) + (1 – wS)(0) wS = 2. the weight of the stock is -100 ± 1.16 + .1040 or 10.70 = wS(1. (Round your (d) If a portfolio of the two assets has a beta of 2.95.g. We also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio weights must sum to one.g.16wS + . So: E(Rp) = .70/1. We also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio weights must sum to one.95/1.70..2857)(0) = 0. So: bp = 0. the weight of the risk-free asset is: wRf = 1 – . Round your answers to 2 If a portfolio of the two assets has an expected return of 8 percent. so we can sum the returns of each asset and divide by the number of assets.40% (b) We need to find the portfolio weights that result in a portfolio with a b of 0.08 = .161)) 0.0% 200 ± 1.2857(1.63 ± 1.95 = 1..35) + (1 – wS)(0) 0. or 100 percent.2857 So.048 – .386 ± 1. We know the b of the risk-free asset is zero. This represents borrowing at the riskfree rate to buy more of the stock.0% percent.0% .048wS wS = .7037 = . Do not include the percent signs (%)).386 (d) Solving for the β of the portfolio as we did in part b. its beta is answer to 3 decimal places. (e.7037 And.

16. Round your answer to 2 decimal places.12% To calculate the standard deviation.15(–.28) + .09) = . 0. we get: Boom: E(Rp) = . the variance and standard deviation of the portfolio is: σ2p = . The approximate and exact expected real risk 11. Round your answer to 2 decimal If the expected T-bill rate is 3. we will multiply the return of each asset by its portfolio weight and then sum the products to get the portfolio return in each state of the economy.202 – . (Do not include the percent signs (%).55) = . 32.28 –.138) + .4(–.80% Bust: E(Rp) = .g.g..) The variance is deviation is places.1804 or 18. we first need to calculate the variance.00 –.16.62 ± 1% percent and 12.35(.17 .16.1612)2 + .1612 or 16..03253 σp = (.4(.1380 or 13.)) (b) 18..16.4(. we find the squared deviations from the expected return. (e.16125. The result is the variance.50 percent.202) = . (Do not include the percent sign (%).32 ± 1% We need to find the return of the portfolio in each state of the economy.19 ± 1% percent.4(. (Do not include the percent sign (%).) and standard percent.g.2020 or –20.35 .00) + .04 ± 1% (Round your answer to 5 decimal places.45 State of Economy Boom Normal Bust Probability of State of Economy . respectively.32 ± 1% percent.2(.13) + .9 ± 1% premiums on the portfolio are percent and percent.45) = –. the approximate and exact expected real returns on the portfolio are 12. minus the risk-free rate..4(. So.03253 ± 1% 32.4(. so: .2(.09 .1612)2 + .24) + . Round your answer to 2 decimal places.g.50(.55 .35(.17) + .00% Normal: E(Rp) = .15(–.)) 12.50 . We then multiply each possible squared deviation by its probability.2(–.24 .50(. (c) If the expected inflation rate is 3. respectively. (e. (e. T-bills are often used as the risk-free rate. (e. (e. To find the variance.35 – .35) + .g.36) + .13 .15 Required: (a) If your portfolio is invested 40 percent each in A and B and 20 percent in C.138 – . the portfolio expected return is 16. 32.1612)2 σ2p = .3500 or 35.Consider the following information on three stocks: Rate of Return if State Occurs Stock A Stock B Stock C .. the expected risk premium on the portfolio is (Do not include the percent sign (%). than add all of these up.80 percent. 32.36 .)) Explanation: (a) 12. Round your answers to 2 decimal places.12 ± 1% percent.03253)1/2 = . 32.04% (b) The risk premium is the return of a risky asset.20% And the expected return of the portfolio is: E(Rp) = . Doing so. To do this.

000) = $324.0350)[1 + e(ri)] e(ri) = (1. 32)) Asset Stock A Stock B Stock C Risk-free asset $ $ Investment $210. Doing so.85 1. or: 1 = wA + wB + wC + wRf = 1 – .0380 = .62% To find the exact real return.1190 or 11.000. we will use the Fisher equation. the dollar investment in the risk-free asset must be: Invest in risk-free asset = .926 . Doing so.324074 = wRf wRf = .1262 or 12.be certain to enter "0" wherever required.000.000/$1.210 wB = $320.g. The weights of Stock A and Stock B are: wA = $210.000 324.1232 or 12.000) = $145. so the weight of the risk-free asset must be one minus the asset weight we know. Leave no cells blank .000. We also know the β of the risk-free asset is zero. divided by one plus the inflation rate.035) – 1 = .1612 – .320 We also know the total portfolio weight must be one.1612 – . so: Approximate expected real risk premium = . (e. so we can find the weight of these two stocks.320 – . Round your answers to the nearest whole dollar amount. so: Approximate expected real return = .0 = wA(.85) + wB(1.145926($1.926 ± 1% Beta .035 = .074 We know the total portfolio value and the investment of two stocks in the portfolio.20 1.324074($1.000 to invest. (Do not include the dollar signs ($).35 0 ± 1% Explanation: Since the portfolio is as risky as the market. We can use the equation for the β of a portfolio to find the weight of the third stock.324074 So.000 $320.000.145926 So. the dollar investment in Stock C must be: Invest in Stock C = . we find: wC = .074 ± 1% 145.19% The approximate real risk premium is the expected return minus the risk-free rate.1612 – .000 = . and you have $1. Given this information.90% You want to create a portfolio equally as risky as the market.1612/1.000. the β of the portfolio must be equal to one. fill in the rest of the following table.1219 or 12..1232/1.35) + wRf(0) Solving for the weight of Stock C.000 / $1. we find: βp = 1.32% (c) The approximate expected real return is the expected nominal return minus the inflation rate.20) + wC(1. we get: 1 + E(Ri) = (1 + h)[1 + e(ri)] 1.RPi = E(Rp) – Rf = .1232 or 12.1612 = (1.038 = .000 = . so: Exact expected real risk premium = .035 = .32% The exact expected real risk premium is the approximate expected real risk premium.210 – .

23% Suppose you observe the following situation: Return if State Occurs Stock A Stock B –..35(RM – .03075 Rf = .0559) .1 ± 1% 13.59% Now using CAPM to find the expected return on the market with both stocks.132 – Rf)/1.132 – Rf) = 1.35 .)) Expected return Stock A Stock B 15. the expected return on the market is percent.Suppose you observe the following situation: Security Pete Corp. Based on the CAPM. Round Here we have the expected return and beta for two assets.35(. Setting the risk premiums of the assets equal to each other and solving for the risk-free rate. The risk-free rate is your answers to 2 decimal places.80 . Round your answers to 2 decimal places.g.15 Required: (a) Calculate the expected return on each stock. (e. we find: .16. (e.4 ± 1% percent percent . If the CAPM is true.80(. which means all assets have the same risk premium.0559 + .0559 + 1. 32. (Do not include the percent signs (%).80 Expected Return .101 – Rf) .23 ± 1% 5.13 .08 –.70 .35 = (.0559) RM = . we find: (..101 Assume these securities are correctly priced.23% RM = . 32.29 State of Economy Bust Normal Boom Probability of State .101 = . Beta 1.80(RM – .05 .101 – Rf)/.132 = . then the security market line holds as well.132 .13635 – 1.55Rf = .59 ± 1% percent.8Rf = .0559 or 5.1056 – . Repete Co. We can express the returns of the two assets using CAPM.)) Explanation: 11.14 .1123 or 11.g.35Rf .15 .16. (Do not include the percent signs (%).48 .1123 or 11.

If we remember the historical return on large capitalization stocks.25 SlopeSML = .g..(b) Assuming the capital asset pricing model holds and stock A's beta is greater than stock B's beta by . (Do not include the percent sign (%).15(–.70(.16)) Explanation: 11.1510 – . so we cannot definitively say one of the estimates is incorrect. The slope of the security market line (SML) equals: SlopeSML = Rise / Run SlopeSML = Increase in expected return / Increase in beta SlopeSML = (. what is the expected market risk premium? (Do not include the percent sign (%).80% And using the dividend growth model. We have the information available to calculate the cost of equity using the CAPM and the dividend growth model.25. and dividends are expected to grow at a 6 percent annual rate indefinitely.05) + .1340). So. the expected market risk premium must be 6. So.1510 or 15. the cost of equity is RE = [$1.10% E(RB) = .15(.017 (= . If the stock sells for $37 per share.70(. and T-bills are currently yielding 5 percent.48) = .08) + .80% Since the market's beta is 1 and the risk-free rate has a beta of zero.1340 or 13.15(–.g.06)/$37] + .15(. your best estimate of Country Road's cost of equity is (e. so: RE = (. Round your answer to 2 decimal places. The company's most recent dividend was $1. the slope of the Security Market Line equals the expected market risk premium. Therefore.1119 or 11.25.1510 – . (e.60(1.19% .25 greater than the beta of Stock B.85. 32.1180 or 11.1180 + .29) = .08) = .14) + .. the estimate from the CAPM model is about two percent higher than average. and the estimate from the dividend growth model is about one percent higher than the historical average.8 percent.60 per share. 32.13) + . we will use the average of the two. we find: RE = . the expected return on a security increases by . the expected return of each stock is: E(RA) = . Round your answer to 2 decimal places.8 ± 1% percent Explanation: (a) The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. Given this.19 ± 1.05 + 0.06 = .40% (b) We can use the expected returns we calculated to find the slope of the Security Market Line.85(.0% percent.58% Both estimates of the cost of equity seem reasonable.1340) / .0680 or 6. The market risk premium is 8 percent. as beta increases by .1058 or 10.1058)/2 = . We know that the beta of Stock A is .16)) Expected market risk premium 6. Using the CAPM. Stock in Country Road Industries has a beta of .

05(1 + g)4 g = 0.43 = $1..16)) (a) Mullineaux's WACC is 10.1146 or 11.43 – 1.0% percent.30 per share in the last four years. we find: $1.12 – 1.0625 + .1000 or 10.43(1.g.46% Mullineaux Corporation has a target capital structure of 60 percent common stock. $1..0625 or 6. (e.19.0804 or 8. and 35 percent debt.05 = .0677 + .0667 or 6.12.12)/$1. (Do not include the percent sign (%).03% The cost of equity using the geometric dividend growth rate is: RE = [$1.00] + .00] + . Its cost of equity is 14 percent.04% Using this growth rate in the dividend growth model.16)) rev: 10_18_2011 11.05)/$1.05. your best estimate is (Do not include the percent signs (%).1000)/4 = . (b) Which of the following statement is true? .0% percent. 5 percent preferred stock.43 per share on its common stock. $1.0803 or 8. 32. the cost of preferred stock is 6 percent. Round your answer to 2 decimal places.12 = .47 ± 1. the increase in dividends each year was: g1 = ($1. and the cost of debt is 8 percent. Round your answers to 2 decimal places.52 ± 1.0924 + .46 ± 1.30 = .0804)/$45.0924 or 9.Suppose In a Found Ltd. (e.0% 11.47% Calculating the geometric growth rate in dividends. 32.25% g3 = ($1.43(1. your best estimate of the company's cost of equity capital using the arithmetic average growth rate in dividends is percent.0803)/$45. If the stock currently sells for $45. we find the cost of equity is: RE = [$1. Explanation: To use the dividend growth model.19)/$1. and $1.30)/$1. So.g. we first need to find the growth rate in dividends. The relevant tax rate is 35 percent.24% g4 = ($1. The company paid dividends of $1.19 – 1.19 = .00% So. just issued a dividend of $1.67% g2 = ($1. If you use the geometric average growth rate. the average arithmetic growth rate in dividends was: g = (.0804 = .30 – 1.0803 = .1147 or 11.

(Do not include the Here we need to use the debt–equity ratio to calculate the WACC. The current share price is $68.42) + $1.40% Filer Manufacturing has 11 million shares of common stock outstanding. and sells for 93 percent of par. Both bonds make semiannual payments.16)) Explanation: 11.(Do not include the percent sign (%).0% percent. Its cost of equity is 15 percent.20% Hence. 32.. so: RE = [$4.10 and the dividend growth rate is 6 percent. The first bond issue has a face value of $70 million.14) + .33 ± 1. The company's WACC is Round your answer to 2 decimal places. If the tax rate is 35 percent. debt is cheaper than the preferred stock. The tax rate is 35 percent.1140 or 11. and the book value per share is $6. (e.06) + .000(PVIFR%.08(1 – . we find: P1 = $930 = $35(PVIFAR%. debt is cheaper than the preferred stock. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues.35(.On an aftertax basis. Sixx AM Manufacturing has a target debt–equity ratio of 0.42) .35) = .09(.06)/$68] + .15(1/1. The most recent dividend was $4. Filer Manufacturing also has two bond issues outstanding. (e. First.65) + . Doing so. the second in 6 years. 32.0% percent.0520 or 5.35) = . has an 8 percent coupon.52% b: Since interest is tax deductible and dividends are not. we find: WACC = . Explanation: a: Using the equation to calculate the WACC. the company's WACC is percent sign (%). The first issue matures in 21 years. we find: WACC = .g. Doing so.05(.35) = .. and sells for 104 percent of par.1052 or 10.65)(1 – .65. and its cost of debt is 9 percent.16)) Explanation: 11. we need to find the YTM on both bond issues. Round your answer to 2 decimal places.40 ± 1.g. on an aftertax basis. The information provided allows us to solve for the cost of equity using the dividend growth model.10(1.06 = . The second issue has a face value of $55 million.39% Next. we must look at the aftertax cost of debt. we will find the cost of equity for the company.65/1. has a 7 percent coupon.1239 or 12.60(. which is: .08)(1 – .

35)[(.000.000)/$122.g.000 = .000 And the market value weights of equity and debt are: E/V = $748. 32. Inc..1239) + .000.4677)(.000)/$122.1133 or 11.0484 or 4.33% Jungle.000/$870.8595 D/V = 1– E/V = .000) = $122. so: MVE = 11. we find the market value of debt is: MVD = .000) + 1.68% P2 = $1.1405 Using these costs we have found and the weight of debt we calculated earlier.0484) = .584% × 2 = 7. Its WACC is 9.000 To find the weighted average aftertax cost of debt.000(PVIFR%.000($68) = $748.300.300.17% Using the relationship that the total market value of debt is the price quote times the par value of the bond.000.300.R = 3.84% The market value of equity is the share price times the number of shares.. (Do not include the percent signs (%).05.8595(.0768) + (.000. Round your answers to 2 decimal places.93($70. This gives us: RD = (1– .0717)] = .93($70.000 + 122.000 = .000 This makes the total market value of the company: V = $748.16)) Required: .300.4677 Now we can multiply the weighted average cost of debt times one minus the tax rate to find the weighted average aftertax cost of debt.838% × 2 = 7.4 percent.5323 wD2 = 1.04($55.000.5323)(. and the tax rate is 35 percent.04($55.000. We find: wD1 = .300.1405(. (e. the WACC is: WACC = .838% YTM = 3.300.000 = $870.12) + $1.040 = $40(PVIFAR%. has a target debt–equity ratio of 1.000.12) R = 3. we need the weight of each bond as a percentage of the total debt.000.584% YTM = 3.000 = .

094 = (1/2.000 shares outstanding. we can find the cost of equity using the CAPM.05. 15.000)(0.0% Debt: Common stock: Preferred stock: Market: 8..000 par value.5 percent coupon bonds outstanding.005.5 percent risk-free rate. we find: WACC = .000 MVE = 250.05)(. Round your answer to 2 decimal places.000 Now. the bonds make semiannual payments.1213 or 12.000 = $23.16)) 9.360.000 MVP = 15.05)(. the WACC is percent.000($1. the cost of equity is 12.35)RD RD = .05)RE + (1. $1. its pretax cost of debt is 7. The cost of equity is: .72% Req b: Using the equation to calculate WACC.395.250.094 = (1/2. (e.000 6.0% percent.05)(1 – . 250. We find: MVD = 8. we find: WACC = .360. 32.0% percent. selling for 92 percent of par.8 percent. currently selling for $93 per share. Explanation: Req a: Using the equation to calculate WACC.000 + 1. selling for $57 per share.250.83 ± 1.000 shares of 5 percent preferred stock outstanding.14) + (1.000 And the total market value of the firm is: V = $7.000 + 14.000($57) = $14..0772 or 7.000($93) = $1.13 ± 1.92) = $7.(a) If Jungle's cost of equity is 14 percent.g.05/2. Assume the company's tax rate is 35 percent.72 ± 1. (Do not include the percent sign (%). the beta is 1. 8 percent market risk premium and 4. (b) If instead you know the aftertax cost of debt is 6.13% Given the following information for Evenflow Power Co. 20 years to maturity.05/2. Explanation: We will begin by finding the market value of each type of financing.395.068) RE = .

32)) 21.632% × 2 = 7.0% Your company's weighted average flotation cost is percent.000(PVIFR%.0671 or 6.439.0538 or 5..40) R = 3.83% Notice that we didn't include the (1– tC) term in the WACC equation. so: fT = . (e.005) = .38% Now we have all of the components to calculate the WACC.75/1.632% YTM = 3.72% The cost of preferred stock is: RP = $5/$93 = .005) + .75) = ..0983 or 9.35)(. We used the aftertax cost of debt in the equation. 32.08) = .50(PVIFAR%.395/23.RE = .16)) (b) The true cost of building the new assembly line after taking flotation costs into account is $ (Do not include the dollar sign ($). so: P0 = $920 = $32.0472 or 4. Your target debt-equity ratio is .1290 or 12.75.510 ± 0. The WACC is: WACC = .40) + $1. (Do not include the percent sign (%).36/23.01% .26% And the aftertax cost of debt is: RD = (1– . so the term is not needed here Suppose your company needs $20 million to build a new assembly line. Required: (a) 6.75) + .g.045 + 1.g.1290(14. but the flotation cost for debt is only 5 percent. Round your answer to the nearest whole dollar amount. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.0472(7.05(.0726) = .90% The cost of debt is the YTM of the bonds.08(1/1.05(.005) + . The flotation cost for new equity is 8 percent. Explanation: Req a: The weighted average floatation cost is the weighted average of the floatation costs for debt and equity. (e.0538(1. Round your answer to 2 decimal places.71 ± 1.71% .25/23.

. Round your answer to the nearest whole dollar amount.510 Even if the specific funds are actually being raised completely from debt. The interest payment is the amount of debt times the interest rate.16)) 3. net income is the same as EBIT with no corporate tax.16)) 2.000. (b) Under Plan I. Under Plan I.8 million in debt outstanding. The EPS under this capitalization will be: EPS = $350.000 shares .000/160.000 shares EPS = $1.000.. (Do not include the (c) The break-even EBIT is $ . so: NI = $350. 32. the net income is $500. there would be 80. Round your answers to 2 decimal places.000 – .g. (Do not include the dollar sign ($). Round your answers to 2 decimal places.000/160.000 ± 0. the levered company.000 shares of stock outstanding and $2. the unlevered company. James Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). The interest rate on the debt is 8 percent.g.19 Under Plan II.g. should be valued as if the firm’s target capital structure is used. Plan I's EPS is $ while Plan II's EPS is $ dollar signs ($). and there are no taxes.000 Amount raised = $20.000/(1 – .000 And the EPS will be: EPS = $126.58 ± 1% .000 and the EPS is: EPS = $500.000 shares EPS = $2. the company would have 160.800..0671) = $20. 32.439. (e.000) NI = $126. Under Plan II.)) 448.Req b: The total cost of the equipment including floatation costs is: Amount raised(1 – .08($2. EBIT will be reduced by the interest payment.000. Plan I's EPS is $ and Plan II's EPS is $ dollar signs ($). and hence true investment cost.19 ± 1% 1.000/80.1% Explanation: (a) Under Plan I.0671) = $21.000.13 ± 1% 3. (Do not include the (b) If EBIT is $500. (e. (e. the flotation costs.000 shares of stock outstanding.58 Plan I has the higher EPS when EBIT is $350. Required: (a) If EBIT is $350. 32.45 ± 1% .000.

we simply set the equations for EPS equal to each other and solve for EBIT.000 – .g. Round your answers to the nearest whole dollar amount.000 shares EPS = $3.000 in debt. (e. Round your answers to 2 decimal places.. 32. is comparing two different capital structures.g. respectively. The allequity plan would result in 11.000 EBIT = $448. (a) Ignoring taxes.45 Plan II has the higher EPS when EBIT is $500..000.1% 44. (e.000 = [EBIT – .1% (d) Repeat parts (a). (Do not include the dollar sign ($).000 shares of stock and $240. (b).000)]/80.000 in debt. the break-even levels of EBIT for Plans I and II are $ and $ .08($2. and (c) assuming that the corporate tax rate is 40 percent.8 ± 1% 2. Plan II would result in 5. 32)) 44. (Do not include the dollar signs ($).97 ± 1% 1. II and all-equity are $ .55 ± 1% 3. Round your answers to 2 decimal places.29 ± 1% .1% .000 ± 0.$ . 32)) 44. (I) EPSs for Plans I. Plan II has ... (e. (c) To find the breakeven EBIT for two different capital structures.000 shares of stock outstanding.000) NI = $276.000.1% 44. respectively.13 ± 1% (ii) Break-even EBITs for Plans I and II compared to an all-equity plan are $ and $ .000 Keenan Corp.08($2.000/80. as compared to that for an all-equity plan.000 ± 0.. compare both of these plans to an all-equity plan assuming that EBIT will be $39. Round your answer to the nearest whole dollar amount.000 ± 0. The interest rate on the debt is 10 percent.16)) 3 ± 1% 3.g. the net income is: NI = $500.000 And the EPS is: EPS = $276. (e.000 ± 0.EPS = $3. (Do not include the dollar signs ($).000 ± 0. (Do not include the dollar signs (b) In part (a). 32)) 44. and the All-Equity Plan has an EPS of $ ($). 32.g. EPS will be identical for Plans I and II when their EBITs are each $ . and $ .000 shares of stock and $160.13 Under Plan II. (e. Plan I would result in 7. Plan I has an EPS of $ an EPS of $ .16)) 1.800.1% (c) Ignoring taxes.800.g. Round your answers to the nearest whole dollar amount. The breakeven EBIT is: EBIT/160. (Do not include the dollar signs ($). respectively.

000)]/7.10($240.000 ± 0. (c) Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT.55 EBIT Interest NI EPS The all-equity plan has the highest EPS. For the all-equity capital structure. (d) . Plan II has the lowest EPS.000 0 $39.000 The break-even levels of EBIT are the same because of M&M Proposition I.000 = [EBIT – .000 $3.000 = [EBIT – .(iii) Break-even EBIT for Plan I versus Plan II: $ answer to the nearest whole dollar amount.000 $3. The breakeven EBIT between the all-equity capital structure and Plan I is: EBIT/11.000 24. (Do not include the dollar sign ($). we get: [EBIT – .000 This break-even level of EBIT is the same as in part b again because of M&M Proposition I.29 II $39. Dividing by the shares outstanding gives us the EPS.10($240. The EPS is calculated as: EPS = (EBIT – RDD)/Shares outstanding This equation calculates the interest payment (RDD) and subtracts it from the EBIT.000)]/5.000 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT/11.000 EBIT = $44. To find the breakeven EBIT for two different capital structures.000 $23.000 $3.10($160. (e.10($160. which results in the net income.000)]/5.1% .g.000 $15. Round your Explanation: (a) The income statement for each capitalization plan is: I $39. the interest term is zero. 32)) 44. (b) The breakeven level of EBIT occurs when the capitalization plans result in the same EPS.00 All-equity $39.000 EBIT = $44.000 EBIT = $44.000)]/7.000 = [EBIT – . we simply set the equations equal to each other and solve for EBIT.000 16..

. uses no debt. the interest expense term is zero in the all-equity capital structure.000 The break-even levels of EBIT do not change because the addition of taxes reduces the income of all three plans by the same percentage.000 0 $15. So.000 9.10($240.10($240.600 $23.97 II $39. EBIT is $ Input your answer in dollars. We can calculate the EPS as: EPS = [(EBIT – RDD)(1 – tC)]/Shares outstanding This is similar to the equation we used before.000 = [EBIT – .070.000)](1 – .000 $9.567)) Explanation: 2.000 And the breakeven between Plan I and Plan II is: [EBIT – .13 EBIT Interest Taxes NI EPS The all-equity plan still has the highest EPS.000 EBIT = $44.40)/11. so: .g.10($160. Wood Corp.000)](1 – . (Do not include the dollar sign ($).000 = [EBIT – . they do not change relative to one another.40)/11.000 ± 0.000 = [EBIT – .40)/5.000 $1.The income statement for each capitalization plan with corporate income taxes is: I $39.000 16.000 $6.40)/7. the value of an unlevered firm is equal to EBIT divided by the unlevered cost of equity.40)/7.10($160. (e. The weighted average cost of capital is 9 percent.000 EBIT = $44.000)](1 – .000)](1 – .80 All-equity $39.000 24. therefore.01% . With no taxes. Plan II still has the lowest EPS.000 The breakeven EBIT between the all-equity plan and Plan II is: EBIT(1 – .40)/5. 1.234. Again.400 $2.000 EBIT = $44. the breakeven EBIT between the all-equity plan and Plan I is: EBIT(1 – . not in millions.800 $1. If the current market value of the equity is $23 million and there are no taxes.200 $13. except now we need to account for taxes.

V = EBIT/WACC $23.5)RE + (1. If the current market value of the equity is $23 million and the corporate tax rate is 35 percent.000. With the information provided. uses no debt. 16.09($23.184. we can use the equation for calculating WACC to find the cost of equity.615 ± 0.615 Due to taxes. Round your answers to 2 decimal places.01 ± 1% percent if the debt-equity ratio were 2. Its WACC is 10 percent.35) .16)) Required: a.09 EBIT = $3. 32. and 20. EBIT is $ 9 ± 1% 3.5. 12. Maxwell's unlevered cost of equity capital is c. EBIT for an all-equity firm would have to be higher than it would if there were no taxes for the firm to still be worth $23 million Maxwell Industries has a debt-equity ratio of 1. 32)) Explanation: If there are corporate taxes. the value of an unlevered firm is: VU = EBIT(1 – tC)/RU Using this relationship.5.070. (Do not include the dollar ("$") and percent sign (%). we can find EBIT as: $23.5)(.000. and its cost of debt is 7 percent.66 ± 1% percent. (e. and the weight of equity is 1/2.34 ± 1% percent if the 12. Explanation: a.5.10 = (1/2.01% and the WACC is percent.18 ± 1% percent.000 Wood Corp.g.5. The equation for WACC is: WACC = (E/V)RE + (D/V)RD(1 – tC) The company has a debt-equity ratio of 1. Round your answers to the nearest whole number.66 ± 1% percent if the debt-equity ratio were zero.000 = EBIT(1 – ..35)/. (Do not include the percent signs (%).g.09 EBIT = . The weighted average cost of capital is 9 percent..5/2.0.5/2. Maxwell's cost of equity capital is 18. The cost of equity would be debt-equity ratio were 1.000) EBIT = $2.184.000 = EBIT/.07)(1 – . so WACC = .000. The corporate tax rate is 35 percent. (e. b. which implies the weight of debt is 1.

35) RE = . the cost of equity is: RE = .1266 + (.11 + (.65) RE = . we can again use M&M Proposition II with taxes.1634 or 16.g.1266 – . For an all-equity financed company: WACC = RU = RE = .11 – .1266 or 12.16)) a. the cost of equity is: RE = RU + (RU – RD)(D/E)(1 – tC) RE = . its cost of equity will be c.50/. Round your answers to 2 decimal places. percent.35) RE = RU = .07)(1. has no debt but can borrow at 8.1266 or 12. (Do not include the percent signs (%).08 ± 1% b.2001 or 20.61 ± 1% 12. To find the cost of equity for the company with leverage we need to use M&M Proposition II with taxes.04 ± 1% percent. Empress' WACC in parts (b) and (c) is Explanation: 10. To find the unlevered cost of equity we need to use M&M Proposition II with taxes.1266 + (. we get: RE = RU + (RU – RD)(D/E)(1 – tC) RE = . If the firm converts to 25 percent debt.35) RE = .1266 – .35) RE = .01% With a debt-equity ratio of 1. The firm's WACC is currently 11 percent. percent. its cost of equity will be d.2 percent.07)(0)(1 – . The WACC with 25 percent debt is: .082)(.18% b.11 or 11% b.1161 or 11. To find the cost of equity under different capital structures. Empress' cost of equity is 11 ± 1% percent.1818 = RU + (RU – . the cost of equity is: RE = .82% d. and the tax rate is 35 percent. percent and a.66% c.5)(1 – . (e. so: RE = RU + (RU – RD)(D/E)(1 – tC) ..1266 – .50)(1 – .66% Empress Corp. If the firm converts to 50 percent debt. respectively.07)(2)(1 – .11 – .07)(1)(1 – .25/. With a debt-equity ratio of 2.082)(.1266 + (.1818 or 18. 32. so: RE = RU + (RU – RD)(D/E)(1 – tC) RE = . 11.35) RU = .RE = .11 + (.82 ± 1% 9.0.61% c.34% And with a debt-equity ratio of 0. Using M&M Proposition II with taxes again.75)(.1282 or 12.

it can be shown from the capital asset pricing model.666. so that the cost of debt equals the risk-free rate. that is.666. .0. 1.35($60.0908 or 9.35) WACC = . The value will be $ if Frederick borrows $60. along with M&M Proposition II that .67 Assume a firm's debt is risk-free. the value of the unlevered firm is: VU = EBIT(1 – tC)/RU VU = $92.25(.75(. Suppose a firm's business operations are such that they mirror movements in the economy as a whole very closely.50(.04% And the WACC with 50 percent debt is: WACC = (E/V)RE + (D/V)RD(1 – tC) WACC = .67 ± 0.082)(1 – . Assuming the tax rate is zero. 32. the value of the firm is $ . where D/E is the debt−equity ratio. and 20. the systematic risk of the firm's assets. (e.67 + .666.1% If the tax rate is 35%. 5..35) WACC = .15 VU = $398.000) VU = $419.082)(1 – . (Do not include the dollar signs ($).67 If Frederick borrows $60.666. If the tax rate is 35 percent. .50(. expects its EBIT to be $92.16)) Explanation: 398. The firm can borrow at 9 percent.35)/. Debt-equity ratio 0 1 5 20 Equity beta 1 ± 1% 2 ± 1% 6 ± 1% 21 ± 1% Explanation: Using the equation βE = βA(1 + D/E). (CAPM).1282) + . Round your answers to 2 decimal places.g. Frederick currently has no debt. By using the above result find the equity beta for this firm for debt−equity ratios of 0.WACC = (E/V)RE + (D/V)RD(1 – tC) WACC = .666.000(1 – .000 every year forever. the value of the levered firm is: VU = VU + tCD VU = $398.67 ± 0.1161) + .1% 419.1004 or 10. the firm's asset beta is 1.000.08% Frederick & Co. Define as the firm's asset beta—that is. and its cost of equity is 15 percent. Define to be the beta of the firm's equity.000 and uses the proceeds to repurchase shares.

The equity beta for the respective asset betas is: Debt-equity ratio 0 1 5 20 Equity beta 1(1 + 0) = 1 1(1 + 1) = 2 1(1 + 5) = 6 1(1 + 20) = 21 .

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