DOTHAN INC.'S STOCK HAS A 25% CHANCE OF PRODUCING A 28% RETURN, A 50% CHANCE OF PRODUCING A 12% RETURN.

Dothan Inc.’s stock has a 25% chance of producing a 28% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm’s expected rate of return?

Mikkelson Corporation’s stock had a required return of 12.25% last year, when the risk-free rate was 3% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm’s beta remain unchanged. What is the company’s new required rate of return? (Hint: First calculate the beta, then find the required return.)

Jill Angel holds a $200,000 portfolio consisting of the following stocks. The portfolio’s beta is 0.88.

Stock Investment Beta

A $50,000 0.50

B $50,000 0.80

C $50,000 1.00

D $50,000 1.20

Total $200,000

If Jill replaces Stock A with another stock, E, which has a beta of 1.25, what will the portfolio’s new beta be?

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose?

WACC: 11.50%

0 1 2 3 4

CFS -$1,025 $380 $380 $380 $380

CFL -$2,150 $765 $765 $765 $765

Simms Corp. is considering a project that has the following cash flow data. What is the project’s IRR? Note that a project’s projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Year 0 1 2 3

Cash flows -$1,300 $425 $425 $425

Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

WACC: 8.00%

0 1 2 3 4

CFS -$1,050 $675 $650

CFL -$1,050 $360 $360 $360 $360

Kedia Inc. forecasts a negative free cash flow for the coming year, FCF = -$10 million, but it expects positive numbers thereafter, with FCF = $13 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14.0%, what is the firm’s total corporate value, in millions?

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

A B

Required return 10% 12%

Market price $25 $40

Expected growth 7% 9%

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $47.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings?

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $45.00; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 22.5% and a beta of 1.00. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock?

Tom O’Brien has a 2-stock portfolio with a total value of $100,000. $55,000 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio’s beta?

Kebt Corporation’s Class Semi bonds have a 12-year maturity and an 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their $1,000 par value. The firm’s Class Ann bonds have the same risk, maturity, nominal interest rate, and par value, but these bonds pay interest annually. Neither bond is callable. At what price should the annual payment bond sell?

McCue Inc.’s bonds currently sell for $1,350. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond’s YTM and its YTC? (Subtract the YTC from the YTM; it is possible to get a negative answer.)

Which of the following statements is CORRECT?

a. The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond’s price at the beginning of the year.

b. 10-year, zero coupon bonds have more reinvestment risk than 10-year, 10% coupon bonds.

c. A 10-year, 10% coupon bond has less reinvestment risk than a 10-year, 5% coupon bond (assuming all else equal).

d. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond.

e. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%.

An investor is considering buying one of two 10-year, $1,000 face value, noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, and the YTM is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?

a. Bond A’s current yield is greater than 8%.

b. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.

c. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

d. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.

e. One year from now, Bond A’s price will be higher than it is today.

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Mikkelson Corporation’s stock had a required return of 12.25% last year, when the risk-free rate was 3% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm’s beta remain unchanged. What is the company’s new required rate of return? (Hint: First calculate the beta, then find the required return.)

Jill Angel holds a $200,000 portfolio consisting of the following stocks. The portfolio’s beta is 0.88.

Stock Investment Beta

A $50,000 0.50

B $50,000 0.80

C $50,000 1.00

D $50,000 1.20

Total $200,000

If Jill replaces Stock A with another stock, E, which has a beta of 1.25, what will the portfolio’s new beta be?

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose?

WACC: 11.50%

0 1 2 3 4

CFS -$1,025 $380 $380 $380 $380

CFL -$2,150 $765 $765 $765 $765

Simms Corp. is considering a project that has the following cash flow data. What is the project’s IRR? Note that a project’s projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Year 0 1 2 3

Cash flows -$1,300 $425 $425 $425

Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

WACC: 8.00%

0 1 2 3 4

CFS -$1,050 $675 $650

CFL -$1,050 $360 $360 $360 $360

Kedia Inc. forecasts a negative free cash flow for the coming year, FCF = -$10 million, but it expects positive numbers thereafter, with FCF = $13 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14.0%, what is the firm’s total corporate value, in millions?

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

A B

Required return 10% 12%

Market price $25 $40

Expected growth 7% 9%

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $47.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings?

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $45.00; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 22.5% and a beta of 1.00. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock?

Tom O’Brien has a 2-stock portfolio with a total value of $100,000. $55,000 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio’s beta?

Kebt Corporation’s Class Semi bonds have a 12-year maturity and an 5.75% coupon paid semiannually (2.875% each 6 months), and those bonds sell at their $1,000 par value. The firm’s Class Ann bonds have the same risk, maturity, nominal interest rate, and par value, but these bonds pay interest annually. Neither bond is callable. At what price should the annual payment bond sell?

McCue Inc.’s bonds currently sell for $1,350. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond’s YTM and its YTC? (Subtract the YTC from the YTM; it is possible to get a negative answer.)

Which of the following statements is CORRECT?

a. The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond’s price at the beginning of the year.

b. 10-year, zero coupon bonds have more reinvestment risk than 10-year, 10% coupon bonds.

c. A 10-year, 10% coupon bond has less reinvestment risk than a 10-year, 5% coupon bond (assuming all else equal).

d. The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond.

e. A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11%.

An investor is considering buying one of two 10-year, $1,000 face value, noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, and the YTM is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?

a. Bond A’s current yield is greater than 8%.

b. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.

c. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

d. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.

e. One year from now, Bond A’s price will be higher than it is today.

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