Risks, Returns and Capital Structure

FAR EASTERN UNIVERSITY

Institute of Accounts Business and Finance
FINANCIAL MARKETS
QUIZ NO. 1 – RISKS, RETURNS AND CAPITAL STRUCTURE

GENERAL INSTRUCTIONS:
▪ All answers should be placed on the answer sheet provided.
▪ Direct all your questions during the duration of your examination to your proctor.
▪ You are only allowed to use basic calculators for the examination.
▪ You may write anything on the questionnaire. This is yours.
▪ For the theory questions, write CAPITAL LETTERS ONLY for your answers.
▪ If there is a need to compute for the present value factors, round off your factors into four decimal places and
your final answer into two decimal places.
▪ Write legibly your answers.
▪ CHEATING is never allowed.
▪ Do not forget to write your name and your section on the questionnaire and on the answer sheet.
▪ You have three hours to finish this test. Good luck!

QUESTIONNAIRE

1. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital
budget would be so large that it would have to issue new common stock. Since new stock has a higher cost
than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would
reduce its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.

2. The expected risk premium on a stock is equal to the expected return on the stock minus the:
a. expected market rate of return.
b. risk-free rate.
c. inflation rate.
d. standard deviation.

3. The common stock of Ruby Janes pays a constant annual dividend. Thus, the market price of Ruby Janes
stock will:
a. also remain constant.
b. increase over time.
c. decrease over time.
d. decrease when the market rate of return increases.

4. Over the past 84 years, we have observed that investments with the highest average annual returns also
tend to have the highest standard deviations of annual returns. This observation supports the notion that
there is a positive correlation between risk and return. Which of the following answers correctly ranks
investments from highest to lowest risk (and return), where the security with the highest risk is shown first,
the one with the lowest risk last?
a. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds,
U.S. Treasury bills.
b. Large-company stocks, small-company stocks, long-term corporate bonds, Treasury bills, long-term
government bonds.
c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds,
Treasury bills.
d. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large
company stocks.
e. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds,
Treasury bills.

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5. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium,
rM − rRF, is positive. Which of the following statements is correct?
a. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will
increase by more than Stock B's.
b. Stock B's required rate of return is twice that of Stock A.
c. If Stock A's required return is 11%, then the market risk premium is 5%.
d. If Stock B's required return is 11%, then the market risk premium is 5%.

6. Stocks that have high financial rewards are generally accompanied by:
a. high dividend payments
b. low dividend payments because of internally generated growth
c. high risk
d. all of the above

7. Risk aversion implies that an investor

a. will accept no risk.
b. places the same value on all risky investments.
c. demands a premium for accepting risk.
d. assigns a negative value to all risky investments.

8. The minimum return that will make an investment acceptable to an investor is called
a. the required rate of return.
b. the risk premium.
c. the risk-free interest rate.
d. beta.

9. An intuitively pleasing and prudent investment strategy is to hold:

a. high beta stocks in a rising market and low beta stocks in a declining market
b. high beta stocks in both rising and declining markets
c. low beta stocks in both rising and declining markets
d. high beta stocks in a declining market and low beta stocks in a rising market

10. Supernormal growth refers to a firm that increases its dividend by:
a. three or more percent per year.
b. a rate which is most likely not sustainable over an extended period of time.
c. a constant rate of 2 or more percent per year.
d. P0.10 or more per year.

11. A stock is expected to pay a dividend of P0.75 at the end of the year. The required rate of return is 10.5%,
and the expected constant growth rate is 6.4%. What is the stock's current price?
ANS: P18.29

12. If D1 = P1.25, g (which is constant) = 4.7%, and P0 = P26.00, what is the stock’s expected dividend yield for
the coming year?
ANS: 4.81% or 4.8.%

13. If D0 = P1.75, g (which is constant) = 3.6%, and P0 = P32.00, what is the stock’s expected total return for
the coming year?
ANS: 9.27% or 9.26%

14. Diverse Corporation just paid a dividend of P0.75 per share, and that dividend is expected to grow at a
constant rate of 6.50% per year in the future. The company's beta is 1.25, the required return on the
market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price?
ANS: P14.52 or P14.55

15. Norhan Industries just paid a dividend of P1.32. Analysts expect the company's dividend to grow by 30%
this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on
this low-risk stock is 9.00%. What is the best estimate of the stock’s current market value?

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ANS: P44.83 or P44.93

16. HBS, Inc. has a growth rate of 6 percent and is equally as risky as the market. The stock is currently selling
for P15 a share. The overall stock market has a 12 percent rate of return and a risk premium of 9 percent.
What is the expected rate of return on HBS's stock?
ANS: 12%

17. Assume that you wish to purchase a 20-year bond that has a maturity value of P1,000 and makes
semiannual interest payments of P40. If you require a 10 percent yield to maturity on this investment, what
is the maximum price you should be willing to pay for the bond?
ANS: P828.36

18. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent
common equity. The firm expects to earn P600 in after-tax income during the coming year, and it will retain
40 percent of those earnings. The current market price of the firm's stock is P 0 = P28; its last dividend was D0
= P2.20, and its expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15
percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a
capital budget requiring P600 in total new capital?
ANS: 15.80% or 15.79%

19. If a stock has a beta coefficient equal to 1.20, the risk premium associated with the market is 9 percent, and
the risk-free rate is 5 percent, application of the capital asset pricing model indicates the appropriate return
should be.
ANS: 15.8%

20. Berg Inc. has just paid a dividend of P2.00. Its stock is now selling for P48 per share. The firm is half as risky
as the market. The expected return on the market is 14 percent, and the yield on Treasury bills is 11 percent.
If the market is in equilibrium, what rate of growth is expected?
ANS: 8%

21. Company X is interested in calculating it weighted-average cost of capital. Company X has a current financial
structure that is composed of 50% debt, 40% common stock, and 10% preferred stock. Ignore the effects of
cost of retained earnings. The beta of Company X stock is 0.7, and the current risk-free rate of return is 4%.
The market risk premium is 6%. The preferred dividend on Company X preferred stock is set at P2.25, and
the net issuance price per share (which happens to be the same as the current price per share) of preferred
stock is P30. Debt issued by Company X yields an 11% stated interest rate to investors. The marginal tax
rate for Company X is 40%. What is the weighted-average cost of capital for Company X?
ANS: 7.33%

22. Super Sounds is expecting a period of intense growth and has decided to retain more of their earnings to help
finance that growth. As a result, they are going to reduce the annual dividend by 20 percent a year for the
next three years. After that they will maintain a constant dividend of P1 a share. Last year, the company paid
P2.25 as the annual dividend per share. What is the market value of this stock if the required rate of return is
16 percent?
ANS: P7.36

23. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for P25.00 per share. Goode's
dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D 0?
ANS: P1.05 or P1.06

24. A 12-year bond pays an annual coupon of 8.5 percent. The bond has a yield to maturity of 9.5 percent and a
par value of P1,000. What is the bond’s current yield?
ANS: 9.14%

25. Palmer Products has outstanding bonds with an annual 8 percent coupon. The bonds have a par value of
P1,000 and a price of P865. The bonds will mature in 11 years. What is the yield to maturity on the bonds?
ANS: 10.04% or 10.09%

26. Simplicity is a relatively new firm that appears to be on the road to great success. The company paid their
first annual dividend yesterday in the amount of P0.15 a share. The company plans to double each annual

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dividend payment for the next four years. After that time, they are planning on paying a constant dividend of
P2.50 per share indefinitely. What is one share of this stock worth today if the market rate of return on
similar securities is 13.45 percent?
ANS: P14.22

27. Su Lee's Cookware pays a constant dividend of P0.75 a share. The company announced today that they will
continue to pay this for another 3 years after which time they will discontinue operations. What is one share
of this stock worth today if the required rate of return is 18 percent?
ANS: P1.64 or P1.63

28. The Nunal Corporation finds that it is necessary to determine its marginal cost of capital. Nunal’s current
capital structure calls for 45% debt, 15% preferred stock and 40% common equity. The costs of the various
sources of financing are as follows: debt, after-tax 5.6%; preferred stock, 9%; retained earnings, 12%; and
new common stock, 13.2%. If the firm has P12 million retained earnings, and Nunal has an opportunity to
invest in an attractive project that costs P45 million, what is the marginal cost of capital of Nunal
Corporation?
ANS: 8.83%

29. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%, and its debt
ratio is 60%. Gravy uses no preferred stock. At what amount of financing will there be a break point in
Gravy’s marginal cost of capital?
ANS: 45,000,000

30. A firm has common stock with a market price of P55 per share and an expected dividend of P2.81 per share
at the end of the coming year. The dividends paid on the outstanding stock over the past five years are as
follows:
Year Dividend

1 P 2.00
2 2.14
3 2.29
4 2.45
5 2.62

The cost of the firm's common stock equity is

ANS: 12.11%

31. Gardner Company’s stock is currently selling for P120 a share. The firm is expected to earn P10.80 per share
and to pay a year-end dividend of P7.20. Investors require a 9% return. If Gardner reinvests retained
earnings in projects whose aggregate return is equal to the stock’s expected rate of return and it will continue
the constant dividend growth rate, how much is the year-end dividend next year?
ANS: P7.42 or P7.416

32. Assume that the risk-free rate is 5 percent and that the market risk premium is 7 percent. If a stock has a
required rate of return of 13.75 percent, what is its beta?
ANS: 1.25

33. A company has P1 million in shareholders' equity and P2 million in debt equity (8% bonds). Its after-tax
weighted-average cost of capital is 12%, but it uses 15% as the hurdle rate in capital budgeting decisions.
During the past year, its operating income before tax and interest was P500,000. Its tax rate is 40%. What is
the company's cost of equity capital?
ANS: 26.40%

34. KCG, Inc. has the following mix of funds and costs
Type Amount Cost
Debt P 150,000 18%
Preferred stock 500,000 15%
Common equity 700,000 12%

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Total funds P1,350,000

What is KCG’s weighted average cost of capital?
ANS: 13.78%

35. Dobson Dairies has a capital structure that consists of 60 percent long-term debt and 40 percent common
stock. The company’s CFO has obtained the following information:
• The before-tax yield to maturity on the company’s bonds is 8 percent.
• The company’s common stock is expected to pay a P3.00 dividend at year end (D 1 = P3.00), and the
dividend is expected to grow at a constant rate of 7 percent a year. The common stock currently sells for
P60 a share.
• Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget.
• The company’s tax rate is 40 percent.
What is the company’s weighted average cost of capital (WACC)?
ANS: 7.68%

36. An investor was expecting a 15% return on his portfolio with beta of 1.25 before the market risk premium
increased from 6% to 9%. Based on this change, what return will now be expected on the portfolio?
ANS: 18.75%

37. Calculate the market price today of a P1,000 bond which has 10 years until maturity and pays quarterly
interest
at an annual coupon rate of 12 percent. The required return on similar-risk bonds is 20 percent.
ANS: P656.77

38. The Spade Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a
P1,000, face value; and the coupon interest rate is 9%. What is the estimated yield to maturity of the bonds
at their current market price of P829?
ANS: 14.79%

39. What is the yield to maturity on Fox Inc.'s bonds if its after-tax cost of debt is 9% and its tax rate is 34%?
ANS: 13.64%

40. Mars Company plans to issue some P100 preferred stock with an 11% dividend. The stock is selling on the
market for P97, and Mars must pay flotation costs of 5% of the market price. The company is under the 40%
corporate tax rate. The cost of preferred stock for Mars Company is
ANS: 11.94%

“Some succeed because they are destined to, but most succeed because they are determined to.” - Anonymous

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