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fundamentals of corporate finance

Questions and Answers of Fundamentals Of Corporate Finance

16. Operating leverage (S10.2) You estimate that your cattle farm will generate $1 million of profits on sales of $4 million under normal economic conditions and that the degree of operating leverage
15. Operating leverage (S10.2) In a slow year, Deutsche Burgers will produce 2 million hamburgers at a total cost of $3.5 million. In a good year, it can produce 4 million hamburgers at a total cost
14. Break-even analysis (S10.2) A financial analyst has computed both accounting and NPV break-even sales levels for a project using straight-line depreciation over a six-year period.The project
13. Break-even analysis (S10.2) Define the cash-flow break-even point as the sales volume (in dollars) at which cash flow equals zero.a. Is the cash-flow break-even level of sales higher or lower
12. Break-even analysis (S10.2) Modern Artifacts can produce keepsakes that will be sold for$80 each. Non-depreciation fixed costs are $1,000 per year, and variable costs are $60 per unit. The
11. Break-even analysis (S10.2) Dime-a-Dozen Diamonds makes synthetic diamonds by treating carbon. Each diamond can be sold for $100. The materials cost for a synthetic diamond is$40. The fixed costs
10. Break-even analysis (S10.2) Break-even calculations are most often concerned with the effect of a shortfall in sales, but they could equally well focus on any other component of cash flow. Dog
9. Scenario analysis (S10.1) You are considering a proposal to produce and market a new sluffing machine. The most likely outcomes for the project are as follows:a. Expected sales: 30,000 units per
8. Scenario analysis (S10.1) Recalculate the NPV of the electric scooter project in a scenario where the outcome is as follows:a. Unit sales are 20% below expectations, andb. Unit price is 10% below
7. Sensitivity analysis (S10.1) A project currently generates sales of $10 million, variable costs equal 50% of sales, and fixed costs are $2 million. The firm’s tax rate is 21%. What are the
6. Sensitivity analysis (S10.1) Emperor’s Clothes Fashions can invest $5 million in a new plant for producing invisible makeup. The plant has an expected life of five years, and expected sales are
5. Sensitivity analysis (S10.1) Use the spreadsheet for the guano project in Chapter 6 to undertake a sensitivity analysis of the project. Make whatever assumptions seem reasonable to you.What are
4. Sensitivity analysis (S10.1) The Rustic Welt Company is proposing to replace its old weltmaking machinery with more modern equipment. The new equipment costs $9 million (the existing equipment has
3. Sensitivity analysis (S10.1) Otobai’s staff (see Section 10-1) has come up with the following revised estimates for the electric scooter project:● ● ● ● ●PROBLEM SETS ®Chapter 10
2. Project analysis (S10.1–10.2) True or false?a. Sensitivity analysis is unnecessary for projects with asset betas that are equal to zero.b. Sensitivity analysis can be used to identify the
1. Terminology (S10.1–10.3) Match each of the following terms to one of the definitions or descriptions listed below: sensitivity analysis, scenario analysis, break-even analysis, operating
2. Now consider operating leverage. How should the shipping costs be valued, assuming that output is known and the costs are fixed? How would your answer change if the shipping costs were
1. Calculate the NPV of the wildcat oil well, taking account of the probability of a dry hole, the shipping costs, the decline in production, and the forecasted increase in oil prices. How long does
b. Average the returns for each month to give the return on an equally weighted portfolio of the stocks. Then calculate the industry beta using these portfolio returns. How does the R2 of this
2. Identify a sample of food companies. For example, you could try Campbell Soup (CPB), General Mills (GIS), Kellogg (K), Mondelez International (MDLZ), and Tyson Foods (TSN).a. Estimate beta and R2
1. Look at the companies listed in Table 8.4. Calculate monthly rates of return for two successive five-year periods. Calculate betas for each subperiod using the Excel SLOPE function.How stable was
d. Is there any single fudge factor that could be added to the discount rate for developed wells that would yield the correct NPV for both wells? Explain.
c. What do you say the true NPVs of the two wells are?
b. The oil company executive proposes to add 20 percentage points to the real discount rate to offset the risk of a dry hole. Calculate the NPV of each well with this adjusted discount rate.
24. Fudge factors (S9.3) An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is
23. Beta of costs (S9.2) Suppose that you are valuing a future stream of high-risk (high-beta)cash outflows. High risk means a high discount rate. But the higher the discount rate, the less the
22. Certainty equivalents (S9.4) A project has the following forecasted cash flows:Cash Flows ($ thousands)C0 C1 C2 C3–100 +40 +60 +50 The estimated beta is 1.5. The market return is 16%, and the
21. Certainty equivalents (S9.4) A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. The interest rate is 5%, the estimated risk premium on the market is 10%, and the project
20. Fudge factors (S9.3) An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes 272 Part
b. How much is the $250,000 payment really worth if the odds of a coup d’état are 25%?
19. Fudge factors (S9.3) Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Central Antarctic Republic. Payment of $250,000 will be made one year hence
18. Fudge factors (S9.3) Mario Barleycorn estimates his firm’s company cost of capital at only 8%. Nevertheless, he sets a 15% companywide discount rate to offset the optimistic biases of project
17. Diversifiable risk (S9.3) Many investment projects are exposed to diversifiable risks. What does “diversifiable” mean in this context? How should diversifiable risks be accounted for in
16. Betas and operating leverage (S9.3) You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues.These costs are
15. Asset betas (S9.3) What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step.
14. Asset betas (S9.3) Which of these projects is likely to have the higher asset beta, other things equal? Why?a. The sales force for project A is paid a fixed annual salary. Project B’s sales
13. Asset betas (S9.2) EZCUBE Corp. is 50% financed with long-term bonds and 50% with common equity. The debt securities have a beta of .15. The company’s equity beta is 1.25.What is EZCUBE’s
12. Measuring risk (S9.1) Look again at Table 9.1. This time we will concentrate on Union Pacific.a. Calculate Union Pacific’s cost of equity from the CAPM using its own beta estimate and the
e. Suppose that next year, the market provides a 20% return. Knowing this, what return would you expect from Sun Life?Chapter 9 Risk and the Cost of Capital 271
d. If the CAPM is correct, what is the expected return on Sun Life? Assume a risk-free interest rate of 5% and an expected market return of 12%.
c. What is the confidence interval on Suncor’s beta? (See Section 9-2 on Estimating Beta for a definition of “confidence interval.”)
b. What is the variance of the returns for Sun Life Financial stock? What is the specific variance?
11. Measuring risk (S9.2) The following table shows estimates of the risk of two well-known Canadian stocks:Standard Deviation (%) R 2 Beta Standard Error of Beta Sun Life Financial 18.3 0.34 0.89
d. Consider a well-diversified portfolio composed of stocks with the same beta and standard deviation as Tesla. What are the beta and standard deviation of this portfolio’s return?The standard
c. Consider a portfolio with equal investments in each stock. What would be this portfolio’s beta?
b. Which stock is safest for an undiversified investor who puts all her money in one of these stocks?
10. Measuring risk (S9.2) Figure 9.4 shows plots of monthly rates of return on three stocks versus those of the market index. The beta and standard deviation of each stock is given beside the plot.a.
9. Measuring risk (S9.2) Refer to the top-right panel of Figure 9.2. What proportion of U.S.Steel’s returns was explained by market movements? What proportion of risk was diversifiable?How does the
8. Company cost of capital (S9.2) Binomial Tree Farm’s financing includes $5 million of bank loans. Its common equity is shown in Binomial’s Annual Report at $6.67 million. It has 500,000 shares
7. Company cost of capital (S9.2) A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is 8%, and the beta of the company’s common stock is 0.5.
b. Assume that the CAPM is correct. What discount rate should Nero set for investments that expand the scale of its operations without changing its asset beta? Assume a risk-free interest rate of 5%
6. Company cost of capital (S9.2) Nero Violins has the following capital structure:Security Beta Total Market Value($ millions)Debt 0 $100 Preferred stock 0.20 40 Common stock 1.20 299a. What is the
5. Company cost of capital (S9.2) You are given the following information for Golden Fleece Financial:Long-term debt outstanding: $300,000 Current yield to maturity (rdebt): 8%Number of shares of
d. Suppose the company wants to diversify into the manufacture of rose-colored spectacles.The beta of optical manufacturers that have no debt is 1.2. Estimate the required return on Okefenokee’s
c. What is the discount rate for an expansion of the company’s present business?
b. Estimate the company cost of capital.
4. Company cost of capital (S9.2) The total market value of the common stock of the Okefenokee Real Estate Company is $6 million, and the total value of its debt is $4 million. The treasurer
3. Company cost of capital (S9.1) Quark Productions (“Give your loved one a quark today.”)uses its company cost of capital to evaluate all projects. Will it underestimate or overestimate the
2. True/false (S9.1–S9.3) True or false?a. The company cost of capital is the correct discount rate for all projects because the high risks of some projects are offset by the low risk of other
1. Definitions (S9.1–S9.3) Define the following terms:a. Cost of debt.b. Cost of equity.c. Company cost of capital.d. Equity beta.e. Asset beta.f. Pure-play comparable.
2. Recalculate the betas for the stocks in Table 8.1 using the latest 60 monthly returns.Recalculate expected rates of return from the CAPM formula, using a current risk-free rate and a market risk
d. Find a high-risk stock and redo parts (a) and (b).
c. Suppose that you forecasted a return on the stock that is 5 percentage points higher than the CAPM return used in part (b). Redo parts (a) and (b) with the higher forecasted return.
b. Suppose that you can borrow or lend at 5%. Would you invest in some combination of your low-risk stock and the market, or would you simply invest in the market? Explain.
1. Find a low-risk stock—Walmart or Kellogg would be a good candidate. Use monthly returns for the most recent three years to confirm that the beta is less than 1.0. Now estimate the annual
f. Suppose that the APT did not hold and that X offered a risk premium of 8%, Y offered a premium of 14%, and Z offered a premium of 16%. Devise an investment that has zero sensitivity to each factor
e. Suggest two possible ways that you could construct a fund that has a sensitivity of 0.5 to factor 1 only. (Hint: One portfolio contains an investment in Treasury bills.) Now compare the risk
d. Finally, suppose you buy $160 of X and $20 of Y and sell $80 of Z. What is your portfolio’s sensitivity now to each of the two factors? And what is the expected risk premium?
c. Suppose you buy $80 of X and $60 of Y and sell $40 of Z. What is the sensitivity of your portfolio to each of the two factors? What is the expected risk premium?
b. Suppose you buy $200 of X and $50 of Y and sell $150 of Z. What is the sensitivity of your portfolio to each of the two factors? What is the expected risk premium?
18. APT (S8.4) The following question illustrates the APT. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two
17. Evaluating investment performance (S8.4) Between 2008 and 2017, the returns on Microfund averaged 10% a year. In his 2017 discussion of performance, the fund president noted that this was 2.5% a
16. Three-factor model (S8.4) The following table shows the sensitivity of four stocks to the three Fama–French factors. Estimate the expected return on each stock assuming that the interest rate
15. APT (S8.4) Look again at Problem 14. Consider a portfolio with equal investments in stocks P, P2, and P3.a. What are the factor risk exposures for the portfolio?b. What is the portfolio’s
14. APT (S8.4) Consider the following simplified APT model:Factor Expected Risk Premium (%)Market 6.4 Interest rate −0.6 Yield spread 5.1 Calculate the expected return for the following stocks.
13. APT (S8.4) Some true or false questions about the APT:a. The APT factors cannot reflect diversifiable risks.b. The market rate of return cannot be an APT factor.c. There is no theory that
12. APT (S8.4) Consider a three-factor APT model. The factors and associated risk premiums are Factor Risk Premium (%)Change in gross national product (GNP) +5 Change in energy prices −1 Change in
11. Evidence for or against the CAPM (S8.3) True or false?a. Long-run average rates of return have been higher for high-beta stocks than for low-beta stocks.b. Low-beta stocks have earned lower rates
10. Security market line (S8.2) Briefly explain the difference between the security market line and the capital market line. Hint: One applies to efficient portfolios only.
9. CAPM (S8.2) The Treasury bill rate is 4%, and the expected return on the market portfolio is 12%. Using the CAPM:a. Draw a graph similar to Figure 8.3 showing how the expected return varies with
c. Find the lowest expected return that is offered by one of these stocks.d. Would U.S. Steel offer a higher or lower expected return if the interest rate were 6% rather than 2%? Assume that the
b. Find the highest expected return that is offered by one of these stocks.
8. CAPM (S8.2) Suppose that the Treasury bill rate is 6% rather than the 2% assumed in earlier examples. Assume that the expected return on the market stays at 9%. Use the betas in Table 8.1.a.
b. The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market.c. If a stock lies below the security market line, it is undervalued.
7. CAPM (S8.2) True or false?a. The CAPM implies that if you could find an investment with a negative beta, its expected return would be less than the interest rate.
d. The CAPM predicts that investors demand higher expected rates of return from stocks with returns that are highly exposed to business-cycle risk.e. Investors demand higher expected rates of return
c. An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will have a beta of 2.0.
6. CAPM (S8.2) True or false? Explain or qualify as necessary.a. Investors demand higher expected rates of return on stocks with more variable rates of return.b. The CAPM predicts that a security
c. Now repeat parts (a) and (b) with a portfolio that has 40% invested in Coca-Cola and 60%in Amazon.
b. Would you invest in this portfolio if you had no superior information about the prospects for these stocks? Devise an alternative portfolio with the same expected return and less risk.
5. Portfolio betas (S8.1) Refer to Table 8.1.a. What is the beta of a portfolio that has 40% invested in ExxonMobil and 60% in Newmont?
d. A poorly diversified portfolio has a standard deviation of 20%. What can you say about its beta?
c. A well-diversified portfolio has a standard deviation of 15%. What is its beta?
b. What is the standard deviation of returns on a well-diversified portfolio with a beta of 0?
4. Portfolio betas (S8.1) Suppose the standard deviation of the market return is 20%.a. What is the standard deviation of returns on a well-diversified portfolio with a beta of 1.3?
3. Portfolio betas (S8.1) A portfolio contains equal investments in 10 stocks. Five have a beta of 1.2; the remainder have a beta of 1.4. What is the portfolio beta?a. 1.3.b. Greater than 1.3 because
2. Stock betas (S8.1) There are few, if any, real companies with negative betas. But suppose you found one with β = –0.25.a. How would you expect this stock’s rate of return to change if the
1. Stock betas (S8.1) What is the beta of each of the stocks shown in Table 8.6?● ● ● ● ●PROBLEM SETS ®Stock Return if Market Return Is:Stock −10% +10%A − 5 + 5 B −20 +20 C −8 +8 D
2. A large mutual fund group such as Fidelity offers a variety of funds. They include sector funds that specialize in particular industries and index funds that simply invest in the market index. Log
d. Calculate the standard deviation of returns for a portfolio with equal investments in the three stocks.

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