1. Texas Electric recently declared a 15 percent stock dividend. On the date of the stock
dividend Texas Electric had 16 million shares outstanding priced at $46 per share in
the market. An accounting entry was required on the balance sheet transferring some
retained earnings to the common stock account. If retained earnings were $280
million prior to the transaction, what was the dollar amount of retained earnings after
the transfer? (5 points)
16,000,000*$46= $736,000,000 value of the equity
.15*736,000,000= $110,400,000 value of the dividend
2. The capital budgeting director of Spencer Corporation is evaluating a project that
costs $200,000, is expected to last for 10 years and produce after-tax cash flows,
including depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent
and its tax rate is 40 percent, what is the project's IRR? (5 points)
PV=-200,000; n=10; PMT=44,503; IRR=18%
3. You are holding a stock that has a beta of 2.0 and is currently in equilibrium. The
required return on the stock is 15 percent, and the return on the market is 10 percent.
What would be the percentage change in the return on the stock if the return on the
market increased by 30 percent while the risk-free rate remained unchanged? (5
15=Rf+2(10-Rf) and R= Rf+2(13-Rf). Subtract the first equation from the second and
get R=21%; Percentage increase= (21-15)/15 = 40%
4. If the subscription price for a new equity issue is $12, and the ex-rights price of the
stock is $16, and the number of rights required to buy one share of new stock is 2,
what is the value of a right? (5 points)
Cost to buy one share = $12+2 rights = $16; implies each right is worth $2.
5. For each of the following pairs of investments, state which would always be preferred
by a rational investor (assuming that these are the only investments available to the
investor): (10 points)
a. Portfolio A r=18% =20% same risk and more return.
Portfolio B r=14% =20%
b. Portfolio C r=15% =18%
Portfolio D r=13% =8% less risk per unit of reward.
c. Portfolio E r=14% =16%
Portfolio F r=14% =10% same return and less risk.
6. You have just purchased a life insurance policy that requires you to make 40
semiannual payments of $350 each, where the first payment is due in 6 months. The
insurance company has guaranteed that these payments will be invested to earn you
an effective annual rate of 8.16 percent, although interest is to be compounded
semiannually. At the end of 20 years (40 payments), the policy will mature. The
insurance company will pay out the proceeds of this policy to you in 10 equal annual
payments, with the first payment to be made one year after the policy matures. If the
effective interest rate remains at 8.16 percent, how much will you receive during each
of the 10 years? (10 points)
n=40; PMT=350; i=4%; FV=33,259.
PV=33,259, i=8.16, n=10, PMT = $4,992.40
7. The MJM Corporation has two different bonds currently outstanding. Bond A has a
face value of $10,000 and matures in 10 years. The bond makes no payments for the
first four years, then pays $500 every six months over the next three years and then
pays $750 every six months over the last three years. Bond B also has a face value of
$10,000 and a maturity of 10 years; it makes no coupon payments over the life of the
bond. If the required rate of return on both bonds is 14 percent compounded
semiannually, what is the current price of bond A? Of bond B? (10 points)
8. Stanton Inc. is considering the purchase of a new machine which will reduce
manufacturing costs by $5,000 annually and increase earnings before depreciation
and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the
machine. It expects to sell the machine at the end of its 5-year operating life for
$10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent
cost of capital to evaluate projects of this type. The machine costs $40,000. (15
a. What is the operating cash flow in year 2?
OCF=(6000+5000)(1-.4) + D(.4) = 11,720
I also gave credit if you assumed that the reduction in expenses was included in the 6000.
This gave a cash flow of 8720 and a NPV of (9377.64)
b. What is the non-operating cash flow in year 5?
c. What is the NPV of the project?
Year 5-Year Macrs Depreciation OCF
1 20% 8,000 9,800
2 32% 12,800 11,720
3 19.2% 7,680 9,672
4 11.52% 4,608 8,443
5 11.52% 4,608 8,443
6 5.76% 2,304
9. The Smith-Walters Corporation is a zero growth firm with an expected EBIT of
$100,000 and a corporate tax rate of 30 percent. S-W uses $500,000 of 12 percent
debt financing, and the cost of equity to an unlevered firm in the same risk class is 16
percent. (15 points)
a. What is the value of the firm according to MM with corporate taxes?
VU = 100,000(1-.3)/.16 =437,500; VL = VU+500,000(.3)=587,500
b. What is the firm's cost of equity?
rS=.16+(500,000/87,500)(.16-.12)(1-.3) = 32%
c. If the personal tax rate on debt income is 25 percent and on stock income is 20
percent, what is the firm value according to the Miller Model.
10. Raiford Corporation has a target capital structure of 20 percent debt, 20 percent
preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon,
paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could
sell at par, $100 preferred stock which pays a 12 percent annual dividend. Raiford's
beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent.
Raiford is a constant growth firm that just paid a dividend of $2.00, sells for $27.00
per share, and has a growth rate of 8 percent. The firm's marginal tax rate is 40
percent. (20 points)
a. What is Raiford's cost of debt?
12% before tax or 7.2% after tax. Use the YTM on outstanding bonds. Since the bond is
selling at par value YTM=Coupon rate. More correctly use the EAR of 12.36%.
b. What is Raiford's cost of preferred stock?
c. What is Raiford's cost of equity?
d. What is Raiford's WACC?
WACC=.2(7.2)+.2(12)+.6(16) = 13.44%