Bonds, Bond Valuation, and Interest Rates T-1. Many think that owning bonds is not risky. List and briefly explain two specific reasons why owning bonds is risky. T-2. Explain how an investor’s risk aversion is reflected in a bond’s maturity risk premium. T-3. Would an increase in the volatility of long-term interest rates cause a bond investor to pay more or less for a non-callable bond that had high convexity? Briefly explain your answer. T-4. When computing a bond’s ex ante yield to maturity two assumptions are made. List and briefly explain these two assumptions (assume the bond is non- callable). T-5. Say you purchase a callable bond for $X. Explain how you are simultaneously selling a call option. T-6. With words only explain how reinvestment rate risk on a long-term non- callable bond might cause the bond’s ex ante YTM to differ from its actual YTM. (This question is focusing on the bond’s interest payment cash flows, not reinvestment of principal.) T-7. Explain how a long-term bond’s price is impacted in opposite directions when the required rate of return on the bond rises. Risk, Return, and the Capital Asset Pricing Model T-1. Let’s say you face the following two gambles: Gamble 1: .50 x ($10,000) + .50 x ($20,000) Gamble 2: .60 x ($ 8,000) + .40 x($40,000) If both gambles offer you the same expected utility (i.e., the same expected satisfaction), what is the dollar amount of your risk premium? T-2. Explain why a common stock should be evaluated in a portfolio context as opposed to being evaluated in isolation. T-3. Assume you have a two-stock portfolio. How does the correlation coefficient, ρ, between the two stocks’ returns impact the standard deviation of this portfolio? Explain your answer. (Hint: The two variables under discussion are ρ and σP.) T-4. When would the coefficient of variation be preferred over the standard deviation for comparing two risky stocks in isolation? Fully explain your answer. T-5. Common stock mutual fund manager, Mr. Jim, forms expectations about the cyclical phase of the stock market when actively managing his fund portfolio. In what situation might Mr. Jim want to lower the average beta of the fund that he manages? Explain Mr. Jim’s reasoning. (Note that a mutual fund portfolio is simply a portfolio of various stocks.) T-6. What does the capital asset pricing model (CAPM) claim it can do for the investor? (Hint: The answer is not related to the “basic proposition.”) Stocks, Stock Valuation, and Stock Market Equilibrium T-1. Distinguish between the intrinsic price of a share of common stock and its current market price. Why might they differ? How does the concept of market efficiency fit into this distinction? (This question is related to question 7-4 above. Note that there are three questions here. Separate paragraphs needed for each question part.) T-2. Mr. Jim owns 1,500 shares of stock in Company X. Company X’s 18,750 shares outstanding are publicly traded and come with a pre-emptive right. They are currently trading at $27 per share. Company X is considering issuing 10,500 new shares to help finance the purchase of additional plant and equipment. If Mr. Jim wishes to maintain his proportionate ownership in the company, what is the additional dollar amount he will be required to make assuming he can purchase the new shares from the company at a 5% discount? T-3. The last observed dividend for Company Z before today was $2.15. Dividends are growing at a constant rate of 8.5% annually. If the required rate of return on the stock is 12.5%, what will be the total expected dollar capital gain per share on the stock three years from today? Assume dividends are paid annually. T-4. Based on rational investor behavior, why is it reasonable to assume that the denominator in the constant growth rate model will be positive? (“Because the stock price would be negative” is not the answer. Use an economic, not a mathematical argument. ) T-5. Using the constant growth rate model (and data from Bloomberg) shows that the present value of expected dividends for the next five years for McDonald’s is only about $1.98. Thus, over a forward-looking five-year horizon the value of the stock is $1.98. Yet on this same date McDonald’s stock is selling among investors in the secondary market for $24.83 per share. How can such a large discrepancy in the two dollar values on the same date be explained? T-6. List and briefly explain two reasons why the free cash flow model of stock price determination is superior to conventional dividend discount models of stock price determination. The Cost of Capital T-1. Why is the firm’s weighted average cost of capital (WACC) considered a “hurdle rate”? T-2. Explain the distinction between the firm’s weighted average cost of capital (WACC) and its weighted marginal cost of capital (WMCC)? Are the calculations of the WACC and the WMCC different? Explain. (Two questions here.) T-3. Explain how the use of book value weights taken from the balance sheet might render the calculation of a firm’s WACC unreliable. T-4. Briefly explain the following statement: Models that attempt to estimate the firm’s cost of retained earnings are simultaneously measuring the opportunity cost borne by equity investors in the firm (i.e., those that own stock in the firm). T-5. Regarding the firm’s WACC estimate, list and explain two real-world problems encountered in estimating the firm’s cost of equity capital. Be specific. T-6. In terms of using the accept/reject criteria in capital budgeting decisions, what might be two outcomes of using the firm’s WACC instead of its risk- adjusted WACC (assuming a risk-adjusted WACC is appropriate)? T-7. Under typical circumstances the cost of debt is lower than the cost of equity. List two reason why. Do not use flotation costs and taxes on dividends as reasons. T-8. Firm X’s stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60. Show your work. A) If investors require a 9% return, what rate of growth must be expected for Firm X? B) If Firm X reinvests earnings in projects with average returns equal to the stock’s expected rate of return, then what will be next year’s EPS? (Recall that g = ROE x Retention ratio.) The Basics of Capital Budgeting: Evaluating the Cash Flows T-1. In a capital budgeting context, explain how a positive NPV is evidence of an “abnormal” rate of return on a project. T-2. Briefly explain the following statement: For the most part the market for financial securities is efficient while the market for capital budgeting ideas is not. T-3. Explain the following statement: “When the NPV of a project = $0, the discount rate being used will equal the project’s IRR.” Use math to explain your answer. Hint: Equations 10-1 and 10-2 may help with the math. T-4. Compare the reinvestment rate assumptions made by the NPV, IRR, and MIRR methods. Which method, NPV or IRR, makes a more reasonable reinvestment rate assumption? Explain why? T-5. Do the NPV and IRR methods always agree with respect to capital budgeting accept-reject decisions? Answer and explain. (Hint: See Figure 10-7) T-6. In what sense is a project’s IRR similar to the YTM on a bond? Cash Flow Estimation and Risk Analysis T-1. Why are incremental cash flows the relevant cash flows for capital budgeting analysis? Why not just analyze the levels of cash flow and be done with it? Fully explain. T-2. Should cannibalization effects be considered sunk costs or opportunity costs in a capital budgeting context? Explain. T-3. What problem would arise if in projecting cash flows for a capital budgeting decision on a project interest expense was not excluded? T-4. Why do firms typically choose to use MACRS depreciation methods to compute depreciation expense for tax purposes yet report depreciation expense to stockholders using straight line depreciation? T-5. Carrying out NPV analysis using computer simulation methods tends to lead to a more ambiguous capital budgeting accept/reject situation than conventional NPV analysis (which concludes with either an “accept” or “reject” decision). Why then use simulation analysis if the technique clouds the accept/reject decision? T-6. In a capital budgeting context what is an “embedded option”? Briefly explain how an embedded option can affect the value of a conventionally- calculated project NPV. Capital Valuation, Value-Based Management, and Corporate Governance T-1. In a free cash flow model of firm value explain the term “horizon value.” How is the computation of horizon value similar to the computations involved in the Constant Growth Rate model studied Chapter 7? (Two questions here—separate paragraphs needed.) T-2. Value-based management concentrates on the (present) value of operations. Why? T-3. How might the excessive cash needs of a young, rapidly-growing firm lead to an incorrect value of the firm’s stock using the free cash flow approach? T-4. List two of the so-called “value drivers” and briefly explain how each impacts cash flow and the value of operations. Number each explanation separately. T-5. Sales growth alone is not enough to insure an increase in the firm’s value of operations. Why not? Distributions to Shareholders: Dividends & Repurchases T-1. List and briefly discuss two motivations that would lead a firm to engage in a stock repurchase versus a straight cash dividend. T-2. Briefly describe the implications of the tradeoff between dividends and free cash flow retention. T-3. Explain this statement: “Even though both the Constant Dividend Payout theory of dividends and the residual theory of dividends result in erratic dividends over time, both theories arrive at the same conclusion differently.” (State the conclusion first, then in a new paragraph follow with the answer.) T-4. In what way is the Modigliani/Miller dividend irrelevance theory similar to the residual dividend theory? (Think before you write.) T-5. A. What is the “signaling hypothesis” as it regards a firm’s dividend policy? B. How might the signaling hypothesis be used to justify the observed practice of “dividend smoothing” in the real world? T-6. Why would the effect of “signaling” be absent if information about the firm was symmetric (not asymmetric) regarding changes in a firm’s dividend payout? T-7. Using words only provide a plausible explanation why a firm’s stock price will be maximized when its dividend policy accommodates its growth opportunities. T-8. Using words only explain why the intrinsic value of equity stays the same for either a cash dividend or a stock repurchase when the cash paid out is the same?
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