Answer ot question #1: Not provided as we agreed to check it by yourself.
Answer to question #2: B
Explanation: Expected return and mean return are completely two different concepts. Expected return is the weighted average of the possible returns, where the weights correspond to probabilities. In contrast, mean return is the average of all of the historical returns over a particular time period. So the statement B is not correct.
Answer to question #3: A
Answer to question #4: B
Explanation: Dividend yield is the return on investment in the form of dividend. It measures the dividend income earned for each dollar invested. Here General Electric Company stock was purchased at the price of S14.64 on December 31, 2008 and the dividend income as of January 26, 2009 was $0.10. So dividend yield for the period is closet to
Answer to question #5: B
Explanation: The excess return also known as alpha is the difference between the average return on a security and the average return on a benchmark or index with the similar level of risk. Return on a portfolio of securities with similar risk can be a benchmark in measuring alpha generated on the security investment.
Answer to question # 6: D
Explanation: S&P 500 is a stock market index. It better represents the risks underlying security investments. The excess return for the portfolio of small stocks is .
Answer to question # 7: B
Explanation: Treasury securities are considered risk free assets as they are backed by government guarantee. So in the calculation of excess return for Treasury Bills, we can consider the return on Treasury Bonds as benchmark. So the excess return for Treasury Bills is .
Answer to question # 8: D
Explanation: Total risk is the combination of systematic and unsystematic risk which is measured by volatility. Miney has the most total risk as it exhibits highest volatility.
Answer to question # 9: A
Explanation: Risk premium
Answer to question #10: C
Explanation: Market Capitalization is the total market value of all of the outstanding shares of a public limited company. Merck’s market capitalization is closest to
Answer to question #11: A
Explanation: The market capitalization for Wal-Mart is closest to
Answer to question #12: A
Explanation: There is no straight answer to the question in the available options. However, Option A best suits the answer to the question. Cost of capital is the weighted average cost of all available capital sources. Unlevered firm has no debt. Unlevered cost of capital does not give any weight to debt capital.
Answer to question #13: C
Explanation: Asset betas are expected to be invariable within firms in the same industry. Businesses that are less sensitive to market and economic conditions usually have lower asset betas than more cyclical industries.
Answer to question #14: B
Explanation: According to MM proposition, capital structure decision does not affect the value of company. So the value of Nielson remains the same whether the company is all equity financed or has $150 million of debt.
Expected value of all equity firm
Expected Value of the firm after dividend payment
Value of new debt after one year
Remaining equity Value
Ex-dividend market value of equity
Expected return after dividend payment
Answer to question 15: B
Explanation: Equity holder receives residual cash flow.
Free cash flow in weak economy
Interest expense
Residual cash flow after interest and debt payment in a weak economy
Answer to question # 16: C
Explanation: Interest tax shield is the deduction in taxes for the allowable tax deductibility of interest expense.
Interest tax shield in 2006
Answer to question # 17: D
Explanation: Interest tax shield in 2006
Answer to question # 18: A
Explanation: In this case, the company would not incur interest expense.
Income available to equity holders of the unlevered firm
Answer to question #19: B
Explanation: Annual interest expense
Annual interest tax shield
Answer to question #20:
Essay:
The capital structure of a company is the mix of debt and equity (the combination of common and preferred shares) that the company uses to finance its business. An effective capital structure maximizes the value of a company by employing the optimum level of financial leverage. According to the modified MM propositions, in the absence of the costs of financial distress and bankruptcy, the use of debt provides a tax shield that enhances the value of company. In addition, rising cost of equity with increasing levels of debt does not fully offset the benefit of the lower cost of debt. As a result, the weighted average cost of capital for the levered company falls as debt increases and overall company value increases. Based on the rationales, MM propositions assert that debt financing is beneficial for a company and in the extreme; a company’s optimal capital structure is all debt.
Considering the case of KAHR, free cash flow to firm stands at $45(1-0.35) million + $9 million - $18 million = $20.25 million.
If we assume that the free cash flow will continue in perpetuity, then the value of unlevered KAHR is:
We assume that the company had $50 million debt at the interest rate of 8% or annual interest expense of $4 million. According to MM Proposition I, when there are corporate taxes, the value of KAHR is $202.5 million + 0.35($50 million) = $220.0 million. Here the levered KAHR gets the benefit of interest tax shield. MM propositions say that KAHR will continue to get the benefit of interest tax shield with the additional levels of debt and it should be fully leveraged to maximize its interest tax shield.
The cost of levered equity is
The value of the firm (
= $50 million + $170 million
= $220 million
In this scenario, the cost of equity increases from 10% to 10.38% as KAHR incurs debt. But the increasing cost of equity does not nullify the benefit of the lower cost of debt. As a result, levered company value increases by $17.5 million.
In practice, there are many issues surrounding the use of debt which affect the value of a levered company. The profitability of KAHR may deteriorate during economic slowdown putting company under financial distress. This financial distress has both implicit and explicit costs. The weighted average cost of capital curve of KAHR should be U shaped as the cost of financial distress reduce or even negate the cost savings due to the greater use of debt. According to the static trade off theory of capital distress, optimal debt usage is found at the point where the cost of financial distress for any additional debt would be greater than the benefit of the additional tax shield. So KAHR should take leverage up to the point where the marginal tax benefits of additional debt equals the marginal cost of financial distress and bankruptcy. KAHR should adopt the optimum capital structure as its target capital structure in order to maximize company value.
