Question No: 41 ( Marks: 5 )
What
are the real markets effects of leverage on WAAC? (Answer the question in
bulleted form only).
Answer:
Real Markets Effects of leverage on WACC:
- Increase in
leverage causes a a large increase in cost of equity
- Increase in
leverage causes relatively small increase in cost of debt as compared to
cost of equity
- As leverage
increases WACC 1st falls because of tax saving shield.
- With further
increase in leverage WACC fall to its minimum point which is the optimal
point for capital structure
- Further increase
in leverage causes increase in WACC because of bankruptcy risk
Question No: 42 ( Marks: 5 )
Suppose a Firm ABC has Total Assets of
Rs.1000 and is 100% Equity based (i.e. Un-levered). There were 10 equal Owners
and 5 of them want to leave. So the Firm takes a Bank Loan of Rs.500 (at 10%pa
Mark-up) and pays back the Equity Capital to the 5 Owners who are leaving. Now,
half of the Equity Capital has been replaced with a Loan from a Bank (i.e.
Debt). What impact does this have on ROE?
Answer:
As the firm replaces equity with debt it is increasing financial leverage which
is a cause of financial risk. The impact of debt on ROE is that ROE will
increase but with the greater uncertainty hence greater will be the risk.
Question No: 43 ( Marks: 10 )
Stock
X has a beta of 0.5, stock Y has a beta of 1.0, and stock Z has a beta of 1.25.
The risk free rate is 10% and the expected market return is 18%.
a.
Find the
expected return on stock X
b.
Find the
expected return on stock Y
c.
Find the
expected return on stock Z
d.
Suppose that
you construct a portfolio consisting of 40% X, 20% Y and 40% Z. What is the
beta of the portfolio?
Answer:
a. rM
= 18%
rRF = 10%
β = 0.5
r = rRF + ( rM + rRF ) β
= 10% + (18%-10%) 0.5
= 10% + 4%
= 14%
b.
rM = 18%
rRF = 10%
β = 1.00
r = rRF + ( rM + rRF )
β
= 10% + (18%-10%) 1.00
= 10% + 8%
= 18%
- rM
= 18%
rRF = 10%
β = 1.25
r = rRF + ( rM + rRF )
β
= 10% + (18%-10%) 1.25
= 10% + 10%
= 20%
d.
Beta of portfolio = βP = X βX + Y βY + Z
βZ
=
(40/100)0.5 + (20/100)1.0 + (40/100)1.25
= 0.4x0.5 + 0.2x1.0 + 0.4x1.25
= 0.2 + 0.2 + 0.5
= 0.9
Question No: 44 ( Marks: 10 )
The ABC company is in the 35% marginal
tax bracket. The current market value of the firm is Rs. 12 million. If there
are no costs to bankruptcy:
a.
What will be ABC’ annual tax savings from interest deductions be if it
issues Rs. 2 million of five years bonds at 12 % interest rate? What will be
the value of the firm?
ANSWER:
Annual Coupon payment
each yr = 12% of 2,000,000
= 2000000 x 12/100
= 24000
Tax
saving for 5 yrs = 5(35 % of 24000)
= 5(24000 x 35/100)
= 5x8400
= 42000
b.
What will ABC’ annual tax savings from interest deductions be if it issues
Rs. 2 million of seven years bonds at 12 % interest rate? What will be the
value of the firm?
Answer:
Annual Coupon
payment each yr = 12% of 2,000,000
= 2000000 x 12/100
= 24000
Tax
saving for 7 yrs = 7(35 % of 24000)
= 7(24000 x 35/100)
= 7x8400
= 58800
Question No:
45 ( Marks: 10 )
Using the Capital Asset Pricing Model
(CAPM), determine the required return on equity for the following situations:
|
Situations
|
Expected
return on market portfolio
|
Risk-
free rate
|
Beta
|
|
1
|
16%
|
12%
|
1.00
|
|
2
|
18
|
8
|
0.80
|
|
3
|
15
|
14
|
0.70
|
|
4
|
17
|
13
|
1.20
|
|
5
|
20
|
15
|
1.60
|
What
generalization can you make?
ANSWER:
Required return= r = rRF + ( rM + rRF
) β
Where
rRF = risk free return
rM = expected return on market
β = beta of stock
1.
rM = 16%
rRF = 12%
β = 1.00
r = rRF + ( rM + rRF )
β
= 12% + (16%-12%)1.00
= 12% + 4%
= 16%
2.
rM = 18%
rRF = 8%
β = 0.80
r = rRF + ( rM + rRF )
β
= 8% + (18%-8%)0.80
= 8% + 8%
= 16%
3.
rM = 15%
rRF = 14%
β = 0.70
r = rRF + ( rM + rRF )
β
= 14% + (15%-14%)0.70
= 14% + 0.70
= 14.7%
4.
rM = 17%
rRF = 13%
β = 1.20
r = rRF + ( rM + rRF )
β
= 13% + (17%-13%)1.20
= 13% + 4.8%
= 17.8%
5.
rM = 20%
rRF = 15%
β = 1.60
r = rRF + ( rM + rRF ) β
= 15% + (20%-15%) 1.60
= 15% + 8%
= 23%
GENERALIZATION: As beta of stock rises the return on stock also rises.
Question
No: 1 ( Marks: 1 ) - Please choose one
Why companies invest in projects with
negative NPV?
►
Because there is hidden value in each project (repeated)
► Because they have chance of rapid growth
► Because they have invested a lot
► All of the given options
Question No: 2 ( Marks: 1 ) - Please
choose one
Mutually exclusive means that you can
invest in _________ project(s) and having chosen ______ you cannot choose
another.
► One; one (repeated)
► Two; two
► Two; one
► Three; one
Question No: 3 ( Marks: 1 ) - Please
choose one
The weighted average of possible
returns, with the weights being the probabilities of occurrence is referred to
as __________.
► A probability distribution
► The expected return
► The standard deviation
► Coefficient of variation
Question No: 4 ( Marks: 1 ) - Please
choose one
A set of possible values that a random
variable can assume and their associated probabilities of occurrence are
referred to as __________.
► Probability distribution
► The expected return
► The standard deviation
► Coefficient of variation
Question No: 5 ( Marks: 1 ) - Please
choose one
The present value of growth
opportunities (PVGO) is equal to
I)
The difference between a stock's price and its no-growth value per share
II)
The stock's price
III) Zero if its
return on equity equals the discount rate
IV)
The net present value of
favorable investment opportunities
► I and IV
► II and IV
► I, III, and IV
► II, III, and IV
Question No: 6 ( Marks: 1 ) - Please
choose one
Which of the following is CORRECT,
if a firm has a required rate of return equal to the ROE?
The
firm can increase market price ► and P/E by retaining more earnings
The
firm can increase market price ► and P/E by increasing the growth rate
The
amount of earnings retained by ► the firm does not affect market price or the
P/E
None
of the given options ►
Question No: 7 ( Marks: 1 ) - Please
choose one
Which of the following would tend to
reduce a firm's P/E ratio?
The
firm significantly decreases financial ► leverage
The
firm increases return on equity for the ► long term
The
level of inflation is expected to increase ► to double-digit levels
The
rate of return on Treasury bills decreases ►
Question
No: 8 ( Marks: 1 ) - Please choose one
A company whose stock is selling at a
P/E ratio greater than the P/E ratio of a market index, most likely has
_________.
An
anticipated earnings growth rate which is ► less than that of the average firm
A
dividend yield which is less than that of ► the average firm
Less
predictable earnings growth than that of ► the average firm
Greater
cyclicality of earnings ► growth than that of the average firm
Question No: 9 ( Marks: 1 ) - Please
choose one
In the dividend discount model, which
of the following is (are) NOT incorporated into the discount rate?
Real
risk-free rate ►
Risk
premium for stocks ►
Return on assets ► (doubted)
Expected
inflation rate ►
Question No: 10 ( Marks: 1 ) - Please
choose one
The market capitalization rate on the
stock of Steel Company is 12%. The expected ROE is 13% and the expected
EPS are Rs. 3.60. If the firm's plowback ratio is 50%, what will be the
P/E ratio?
7.69 ►
8.33 ►
9.09 ►
11.11 ►
Question No: 11 ( Marks: 1 ) - Please
choose one
How dividend yield on a stock is
similar to the current yield on a bond?
Both
represent how much each ► security’s price will increase in a year
Both
represent the security’s ► annual income divided by its price (repeated)
Both
are an accurate representation ► of the total annual return an investor can
expect to earn by owning the security
Both
incorporate the par value in ► their calculation
Question
No: 12 ( Marks: 1 ) - Please choose one
Low Tech Company has an expected ROE
of 10%. The dividend growth rate will be ________ if the firm follows a
policy of paying 40% of earnings in the form of dividends.
6.0% ► (repeated)
4.8% ►
7.2% ►
3.0% ►
Growth = ROE * plow back ratio
Plowback ratio ratio that measures the
amount of earnings retained after dividends have been paid out
(100%-40% = 60%)
Let us plug in the value into above formula
10% * .60 = 6%
Question
No: 13 ( Marks: 1 ) - Please choose one
The value of direct claim security is
derived from which of the following?
► Fundamental analysis
► Underlying real asset (P # 63)
► Supply and demand of securities in the market
► All of the given options
Question No: 14 ( Marks: 1 ) - Please
choose one
Which of the following value of the
shares changes with investor’s perception about the company’s future and supply
and demand situation?
► Par value
► Market value (repeated)
► Intrinsic value
► Face value
Question No: 15 ( Marks: 1 ) - Please
choose one
How efficient portfolios of
"N" risky securities are formed?
►
These are formed with the securities that have the highest rates of return
regardless of their standard deviations
►
They have the highest risk and rates of return and the highest standard
deviations
►
They are selected from those securities with the lowest standard deviations
regardless of their returns
►
They have the highest rates of return for a given level of risk
Question No: 16 ( Marks: 1 ) - Please
choose one
When a bond will sell at a discount?
► The coupon rate is greater than the current yield and the current yield is
greater than yield to maturity
►
The coupon rate is greater than yield to maturity
►
The coupon rate is less than the current yield and the current yield is greater
than the yield to maturity
► The coupon rate is less than the current yield and the current yield is less
than yield to maturity
Question No: 17 ( Marks: 1 ) - Please
choose one
Which of the following is a
characteristic of a coupon bond?
► Pays interest on a regular basis (typically every six months)
► Does not pay interest on a regular basis but pays a lump sum at maturity
► Can always be converted into a specific number of shares of common stock in
the issuing company
► Always sells at par
Question No: 18 ( Marks: 1 ) - Please
choose one
A coupon bond pays annual interest,
has a par value of Rs.1,000, matures in 4 years, has a coupon rate of 10%, and
has a yield to maturity of 12%. What is the current yield on this bond?
► 10.65%
► 10.45%
► 10.95%
► 10.52%
In this we have to first calculate the price of bond first
=100*(1 + 0.12)^-1+100*(1 + 0.12)^-2+100*(1 +
0.12)^-3+1100*(1.12)^-4 = 939.25
Current yield = coupon amount /Price of bond
100/939.25 =
So coupon payment for 4 year @ 10% = 100*4 = 400
Plug the values in Current yield formula = 400/1000 = .1064 =
10.64%
Question No: 19 ( Marks: 1 ) - Please
choose one
If a 7% coupon bond is trading for Rs.
975 it has a current yield of _________ percent.
► 7.00
► 6.53
► 8.53
► 7.18
Current yield = annual interest payment/market price
(7%*1000)/975 = 70/975 = 0.0719*100 = 7.18
Question No: 20 ( Marks: 1 ) - Please
choose one
Interest rate risk for long term bonds
is more than the interest rate risk for short term bonds provided the _________
for the bonds is similar.
► Interest rate risk
► Market rate
► Coupon rate (P # 68)
► Inflation rate
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