Questions and Answers of Corporate Finance 5th Edition

Your manager tells you that for the APT to be useful, the number of systematic risk factors must be small. Is your manager right? Explain.
As financial director of Renault SA, you have been tasked with estimating the required return on the company’s equity. What risk factors should you use? Explain your choice.
What are the differences between the Carhart (1997) model and the market model?
What is the relationship between the one-factor model and the CAPM? In contrast to the CAPM, the APT does not indicate which factors are expected to determine the risk premium of an asset. How can we
You plan to purchase a company and wish to estimate the expected return on the company’s equity using a three-factor model. You believe the appropriate factors are the market return, the percentage
Suppose a factor model is appropriate to describe stock returns for a company, with information about these factors set out in the table below. The expected return on the stock is 10.5 per cent.(a)
Suppose the Fama–French three-factor model is appropriate to describe the returns of an equity. Information about those three factors is presented in the following table:(a) What is the systematic
Suppose the Carhart (1997) factor model is appropriate to describe the returns on an equity. The current expected return on the equity is 10.5 per cent. Information about the factors is presented in
Suppose equity returns can be explained by the Fama–French three-factor model:Assume there is no firm-specific risk. The information for each equity is presented here:The risk premiums for the
Suppose equity returns can be explained by the Fama–French three factor model. The firm-specific risks for all equities are independent. The following table shows the information for three
Assume that the market model is given by:In this equation, Ri, t represents the return on asset i at time t; RM,t represents the return on a portfolio containing all risky assets in the same
You are forming an equally weighted portfolio of equities. Many equities have the same beta of 0.84 for factor 1 and the same beta of 1.69 for factor 2. They also have the same expected return of 11
The returns on three equities, A, B and C, are given by the following:(a) Are the returns correlated? Explain.(b) Assume that you have another equity, D. This equity’s returns are generated as:If
The UK is found to have two factors, GDP growth and the inflation rate, that generate the returns of all equities. The expected GDP growth rate in the next year is 2 per cent and the expected
The returns on Ericsson, Electrolux and Swedbank are generated as follows:How would you determine the return on an equally weighted portfolio of all three equities? Name Ericsson Electrolux Swedbank
Prove that the portfolio-weighted average of a security’s sensitivity to a particular factor is the same as the covariance between the return of the portfolio and the factor divided by the variance
How can the return on a portfolio be expressed in terms of a factor model?What is the minimum number of factors needed to explain the expected returns of a group of five securities if the
Consider the following two-factor model for the returns of three securities.Assume that the factors and epsilons have means of zero. Also, assume the factors have variances of 0.1 and are
A portfolio manager wants to create a simple portfolio from only two stocks, A and B. The returns for stocks A and B are given by the following equations:The manager forms a portfolio with market
Assume a two-factor APT model is appropriate for asset returns, and there are an infinite number of assets in the economy. Two factors drive expected return: the percentage change in GDP and interest
Dawn Browne, an investment broker, has been approached by client Jack Thomas about the risk of his investments. Dawn has recently read several articles concerning the risk factors that can
Explain what is meant by the cost of equity capital. How is the cost of equity capital linked to the risk of the assets of a firm? How would you use cost of equity in a capital budget analysis?
What factors determine the beta of a security?Define and describe each. Explain why an equity’s beta is important in capital budgeting.How do you calculate beta and what are the pitfalls you may
What are the six major steps involved in the capital budget process?
How would you estimate the cost of capital for a project if its risk is different from the rest of the company? Similarly, how would you estimate the cost of capital for a project when the company
What are the main issues you need to consider when estimating the cost of capital of a project in practice? State any potential problems or challenges you may face.
Why would a firm wish to reduce its cost of capital?Review different ways in which this can be done. Which way do you think is the most effective? Explain.
Corporations use many methods to estimate the cost of capital. Why do you think there is no consensus on the best method? If you were estimating the cost of capital in an emerging market, what method
Explain what is meant by Economic Value Added and show how it can be used to evaluate the performance of a firm.
‘My company can borrow at 5 per cent so it means that its cost of capital for all new projects is 5 per cent.’ Do you agree with this statement? Explain.
The beta of Ericsson, the Swedish communications technology firm, is 0.70.What do you think is the main determinant of Ericsson’s beta and why?
WACC and Taxes ‘If I use the after-tax cost of debt for my project analysis then I should use the after-tax cost of equity as well.’ Do you agree with this statement? Explain.
If you use the equity beta and the security market line to compute the discount rate for a project, what assumptions are you implicitly making? What are the advantages of using the SML approach to
What are the benefits of using an industry beta instead of a company beta when undertaking a capital budgeting analysis? Explain, using an example.
How would a manager of a new stock exchange-listed company reduce its cost of equity capital?
As financial manager of Cosco Pacific Limited, you have been tasked with determining your firm’s cost of debt and cost of equity capital.(a) The shares currently sell for HK$10.40, and the dividend
Both AstraZeneca plc, a large pharmaceutical firm, and Shire plc, a major prescription medicine manufacturer, are thinking of investing in an Indian generic drugs company. Assume that both
An all-equity firm is considering the following projects:The expected return on the market is 12 per cent, and the current rate on UK gilts is 5 per cent.(a) Which projects have a higher expected
The Dybvig Corporation’s equity has a beta of 1.3. If the riskfree rate is 4.5 per cent and the expected return on the market is 12 per cent, what is Dybvig’s cost of equity capital?
Advance plc is trying to determine its cost of debt. The firm has a debt issue outstanding with 7 years to maturity that is quoted at 92 per cent of face value.The issue makes semi-annual payments
Shanken NV issued a 30-year, 10 per cent semi-annual bond 7 years ago. The bond currently sells for 108 per cent of its face value. The company’s tax rate is 35 per cent.(a) What is the pre-tax
Mullineaux Corporation has a target capital structure of 55 per cent equity and 45 per cent debt. Its cost of equity is 16 per cent, and the cost of debt is 9 per cent.The relevant tax rate is 35 per
The returns of Siracha plc have a standard deviation of 40 per cent per annum and have a correlation with the FTSE 100 of 0.65. The standard deviation of the FTSE 100 is 20 per cent. What is
Miller Manufacturing has a target debt–equity ratio of 0.60. Its cost of equity is 18 per cent, and its cost of debt is 10 per cent. If the tax rate is 35 per cent, what is Miller’s WACC?
Fama’s Llamas has a weighted average cost of capital of 11.5 per cent. The company’s cost of equity is 16 per cent, and its cost of debt is 8.5 per cent.The tax rate is 35 per cent. What is
Filer Manufacturing has 9.5 million shares of equity outstanding. The current share price is £53, and the book value per share is £5.Filer Manufacturing also has two bond issues outstanding. The
In the previous problem, suppose the company’s equity has a beta of 1.2. The risk-free rate is 5.2 per cent, and the market risk premium is 9 per cent. Assume that the overall cost of debt is the
Kose SA has a target debt–equity ratio of 0.80. Its WACC is 10.5 per cent, and the tax rate is 35 per cent.(a) If Kose’s cost of equity is 15 per cent, what is its pre-tax cost of debt?(b) If
Given the following information for Huntington Power, find the WACC.Assume the company’s tax rate is 28 per cent. Debt: Equity: Market: 40,000 7 per cent coupon bonds outstanding, 100 par value, 20
The power systems firm, Raging Volts, has a market value of equity of £15.77 billion and total debt of £1.21 billion. The cost of equity capital is 19.96 per cent and the cost of debt is 5 per
Titan Mining Corporation has 9 million shares of equity outstanding and 1,200,000 8.5 per cent semi-annual bonds outstanding, par value £100 each. The equity currently sells for £34 per share and
An all-equity firm is considering the following projects:The T-bill rate is 3 per cent, and the expected return on the market is 7.5 per cent.(a) Which projects have a higher expected return than the
Och SpA is considering a project that will result in initial after-tax cash savings of €3.5 million at the end of the first year, and these savings will grow at a rate of 5 per cent per year
Bottled Water is a listed European company which has a corporate finance structure as shown below. What is the company’s WACC? Debt: Preferred stock: Common stock: Market: 50,000 bonds with a
Photochronograph Corporation (PC) manufactures time series photographic equipment. It is currently at its target debt–equity ratio of 1.3. It is considering building a new £45 million
This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Defence
1. Fresnillo plc explores and mines gold and silver in Mexico. The gold production accounts for 55 per cent of the activities of the firm, with the rest of the effort involved in silver mining. Other
You have recently been hired by Martyn Airlines (MA), a budget airline based in and around the Eurozone region. MA was founded 8 years ago by John Martyn and currently operates 74 flights in the
Financing Decisions and Firm Value What rule should a firm follow when making financing decisions? How can firms create valuable financing opportunities?
Efficient Capital Markets What are the three conditions under which Fama (1970) argues markets may be efficient? Describe these in detail and provide a practical example illustrating each condition
Efficient Market Hypothesis Explain what is meant by the efficient market hypothesis.Define the three forms of market efficiency and explain why a characteristic of an efficient market is that
Efficient Market Hypothesis: The Evidence Suppose XYZ plc announced this morning that its profit from last quarter has dropped 15 per cent compared to the previous quarter, and that its closing price
Behavioural Finance In recent years, a new interpretation of market behaviour has emerged. Explain this theory and review what it says about Shleifer’s three conditions of market efficiency.
Empirical Challenges to Market Efficiency Discuss some of the anomalies to market efficiency that have been detected in academic research. Taken together, do these anomalies provide concrete evidence
Efficient Market Theory versus Behavioural Finance The efficient market hypothesis implies that abnormal returns are expected to be zero. Yet in order for markets to be efficient, arbitrageurs must
Implications for Corporate Finance What does efficient market theory and behavioural finance imply for corporate decision making? Provide three examples of how each theory may affect managerial
Efficient Market Hypothesis Which of the following statements are true about the efficient market hypothesis?(a) It implies perfect forecasting ability.(b) It implies that prices reflect all
Technical Trading ‘Every day I check the price patterns from the day before to identify the shares I wish to trade that day.’ What do the efficient markets hypothesis and behavioural finance
Investment Gurus Warren Buffett and several other investors earned significantly positive returns during the financial crisis, 2008–2009. How can you explain this using the efficient markets
Competitive Product Markets Assume that markets are efficient, and that investment firms have decided to retire all portfolio managers and financial analysts, letting random choice via a computer
Investor Sentiment Some people believe that following the European Consumer Confidence Index (see chart below) allows you to predict future market movements. What is the Consumer Confidence Index
Efficient Markets Since 2005, all publicly listed European companies follow International Accounting Standards. This means that financial statements are based largely on market values instead of
Efficient Markets Hypothesis Kasetsart Agriculture, a Thai agricultural technology research firm, announced this morning that it has hired the world’s most knowledgeable and prolific agriculture
Behavioural Finance Do you think emerging markets will be more or less efficient?Do you think they will be more or less sensitive to market sentiment? Explain.
Efficient Markets Hypothesis When the 56-year-old founder of the Turkish firm, Gulf Oil and Minerals, died of a heart attack, the share price immediately jumped from 18.00 Lira a share to 20.25 Lira,
Efficient Markets Hypothesis Newtech GmbH is going to adopt a new chip-testing device that can greatly improve its production efficiency. Do you think the lead engineer can profit from purchasing the
Efficient Markets Hypothesis In 2005, all companies in the European Union adopted IFRS, International Financial Reporting Standards. TransTrust NV changed how it accounts for inventory. Taxes are
Efficient Markets Hypothesis The Durkin Investing Agency has been the best stock picker in the country for the past two years. Before this rise to fame occurred, the Durkin newsletter had 200
Efficient Markets Hypothesis Your broker commented that well-managed firms are better investments than poorly managed firms. As evidence your broker cited a recent study examining 100 small
Efficient Markets Hypothesis A famous economist just announced in the Financial Times his findings that the recession is over and the economy is again entering an expansion.Assume market efficiency.
Efficient Markets Hypothesis Suppose the market is strong form efficient. Can you expect to earn excess returns if you make trades based on:(a) An analyst’s forecasts about future company
Efficient Markets Hypothesis Imagine that a particular macroeconomic variable that influences your firm’s net earnings is positively serially correlated. Assume market efficiency. Would you expect
Efficient Markets Hypothesis The efficient market hypothesis implies that all mutual funds should obtain the same expected risk-adjusted returns. Therefore, we can simply pick mutual funds at random.
Efficient Markets Hypothesis Assume that markets are efficient. During a trading day, British Golf plc announces that it has lost a contract for a large golfing project that, prior to the news, it
Efficient Markets Hypothesis Prospectors plc is a publicly traded gold prospecting company with operations in Northern Tanzania. Although the firm’s searches for gold usually fail, the prospectors
Evidence on Market Efficiency Some people argue that the efficient market hypothesis cannot explain the 2010 US flash market crash or the high price-to-earnings ratio of European shares in 2005 and
Shareholder Activism Many financial institutions use the media to drive shareholder activism strategies so that pressure is maximized on the target firm managers. Is this evidence that institutional
Initial Public Offerings Research has shown that managers of newly listed firms rein in their capital expenditure plans if the market share price performance is not particularly strong around the IPO
Insider Trading When corporate executives trade the shares of their own company, the share price normally responds in a correlated way (i.e. share price increases after buy transactions and share
Cumulative Abnormal Returns National Airlines Group, Air France-KLM and Lufthansa announced purchases of planes on 18 July (18/7), 12 February (12/2), and 7 October (7/10), respectively. Given the
Cumulative Abnormal Returns The following diagram shows the cumulative abnormal returns (CAR) for 386 oil exploration companies announcing oil discoveries between 1950 and 1980. Month 0 in the
Cumulative Abnormal Returns The following figures present the results of four cumulative abnormal returns (CAR) studies. Indicate whether the results of each study support, reject or are inconclusive
Cumulative Abnormal Returns A study analysed the behaviour of the equity prices of firms that had lost monopoly cases. Included in the diagram are all firms that lost the initial court decision, even
1. Explain what is meant by efficient market theory and discuss some of its implications for corporate financial management. (25 marks)2. ‘Even in an efficient market it is still valid to seek out
You have been at your job for West Coast Yachts for a week now and have decided you need to sign up for the company’s retirement plan. Even after your discussion with Sarah Brown, the Skandla
In many countries, regulators have moved to ban an activity called equity short-selling. In order to sell equity short, a trader would open an account with a broker, borrow shares from existing
What is a proxy? What is the difference between voting rights and cash flow rights? Do you think this will have an impact on share values?
Why do you think companies have issued bonds in different currencies, maturities and coupon rates? Shouldn’t the coupon be the same on every bond?Explain.
Preference shares do not offer a corporate tax shield on the dividends paid. Why do we still observe some firms issuing preference shares?
Why do you think companies in certain countries prefer different forms of financing? Carry out your own research and comment on capital structure choice among firms in the G7 countries.

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