Questions and Answers of Theory Of Corporate Finance

Your borrowing rate is 15% per year. Your lending rate is 10% per year. The project costs$5,000 and has a rate of return of 12%.(a) Should you take the project if you have$2,000 to invest?(b) If you
What are the perfect market assumptions?
Evaluate whether supermarkets operate in perfect markets.
Uncle Sam would benefit from an increase in inflation, because he taxes nominal rates of return, not real rates of return. In the real world, interest rates would also have to rise to compensate
Instead of 10%, you earn only 98% . 10% + 2% . (−100%) = 7.8%. Translated into a formula, this is (1 −d) . rnominal, before tax+ d . (−100%) = rnominal, before tax− d . (1 + rnominal, before
First, a simple version of the answer: Your one real apple becomes eight nominal pseudoapples (at 700%), which is four real apples after 100% inflation. One goes bad, so you are left with three
What is your after-tax rate of return on taxable bonds? $100 will grow to $110 at a 10% interest rate before tax, minus the 20% that Uncle Sam collects. Uncle Sam takes 1.1 . $100 = $110, subtracts
From Altman’s evidence: The default premium seems more important than the other non-time premiums.From de Jong’s evidence, ranking the remaining premiums: For investment-grade bonds, the
Entrepreneurs pay interest rates as high as 1,000 basis points for one of two reasons: First, default rates are high. (This is not necessarily a difference in expected rates of return.) Second,
For comparing the zero- and coupon bonds, assume you start with $1,000 of money:(a) The 10% zero-bond would have a single before-tax payout of $1,000 . 1.1010 ≈ $2,593.74, for which the IRS would
The $1 is paid from after-tax income, so leave it as is. The $10 million is taxed, so you will only receive $7 million.With a 1 in 9 million chance of winning, the expected payoff is $7,000,000 .
Your opportunity cost of capital is determined by the tax-exempt bond, because 66.67% . 20% < 15%.Your project’s $2,000 will turn into 66.67% . $2,000 ≈ $1,334 after-tax earnings, or $13,334
First, you need to compute your best opportunity cost of capital if you do not take your project.The Treasury will pay $108 before tax. You could therefore earn $108 − 0.375 . $8 = $105 after
On March 28, 2008, 5-year AAA munis were offering 3.04%/4.14% ≈ 73.43% of the 5-year corporate AAA yields. Therefore, (1 − τ) ≈ 0.7343, which means that the marginal investor’s tax rate was
If the marginal investor’s tax rate is 30% and taxable bonds offer a rate of return of 6%, then munis should offer r = 70% . 6% = 4.2% to earn the marginal investor the same after-tax income.
For every $100, you receive $6. Uncle Sam takes 20% of $6, or $1.20. Your after-tax rate of return is$4.80/$100 = 4.8%. You could have also computed (1 − 20%) . 6% = 4.8% directly.
The marginal tax rate is usually not lower but higher. The average tax rate is usually lower, because the first few dollars of income are taxed at lower tax rates.
The first preference of taxpayers is to receive income in the form of capital gains (especially as long-term capital gains, which is usually under the control of the taxpayer). Their second
A taxpayer prefers to have a before-tax expense, because it reduces the amount that Uncle Sam considers as income, which Uncle Sam would then want to tax.
A liquidity premium is an up front lower price to compensate you for transaction costs later on. This can allow you to earn a higher expected rate of return on the investment.
For this house transaction cost question, you first need to assume a proper discount rate for the$4,000/month rent. At a 7%effective interest rate per year, your true monthly rate is 1.071/12 − 1
Direct transaction cost components: broker costs, market maker or exchange costs (bid-ask spread), and other cash expenses (e.g., advertising costs and postage). Indirect transaction cost components:
Dell is a large stock, just like PepsiCo. Therefore, a round-trip transaction would probably cost a bid-ask spread of between 0.1% and 0.3%. On a $10,000 investment, the bid-ask cost would be around
Covenants, collateral, and credit ratings are all common mechanisms to aid the lender in determining the probability of default. Even if disclosure is not required, good borrowers would still want to
(a) The expected payoff is $99. The discounted expected payoff is $99/1.05 ≈ $94.286. The promised yield is therefore $100/$94.286 − 1 ≈ 6.06%.(b) This borrower would believe the value to be
True. In a perfect and risk-neutral market, the default rates may be quite different, but the expected rates of return on all investments should be the same.
Yes, banks can quote different borrowing and lending rates even in a perfect market! Stated interest rates include a default premium. A perfect market is about equality of expected rates, not about
False. A perfect market is still socially valuable, because sellers and buyers receive surpluses. The buyer surplus is the difference between the value that the good has to a particular buyer and the
For the $1,000 cost project:(a) You would have to borrow $100 at an interest rate of 10% in order to take the project. If you take the project, you will therefore have $1,000 . 1.08 − $110 = $970
The perfect market assumptions are: (a) no differences in information, (b) no market power, (c) no transaction costs, and (d) no taxes.
There is no perfect capital market in this world. However, the concept of a perfect market helps you evaluate what departures from a perfect market really mean—and even what kind of departures you
A competitive market is only one of the four conditions of a perfect market.
In a perfect market, borrowing and lending rates are identical. An important implication of equal borrowing and lending rates is that there is a unique price for which a product would be selling
If the private sector is a net saver (e.g., leaving the public sector as a net borrower), does Uncle Sam have an incentive to reduce or increase inflation?
REALLY ADVANCED: Assume there is a 10% nominal rate of return, a tax rate of 40%, and an inflation rate of 5%. (In the taxes-and-inflation example from Formula 10.1 we worked out that the
ADVANCED: Assume the inflation rate is 100% per year and the nominal rate of interest is 700% per year. (This was also our apples example from Section 5.2.) Now, assume that there is also a 25%
Assume you have both taxes and inflation. You are in the 20% tax bracket, and the inflation rate is 5% per year. A 1-year project offers you $3,000 return for a $20,000 investment. Taxable bonds
How important are the various premiums for investment-grade bonds and junk bonds? (Omit the time premium.)
Assume your marginal tax rate is 25%. Assume that the IRS would tax payments only when made. (Sorry, in real life, the IRS nowadays does tax zero-bonds even when they do not yet pay out anything.)(a)
It is not uncommon for individuals to forget about taxes, especially when investments are small and payoffs are large but rare. Say you are in the 30% tax bracket. Is the NPV of a $1 lottery ticket
You are in the 33.3% tax bracket. A project will return $14,000 in 1 year for a $12,000 investment—a $2,000 net return. The equivalent taxexempt bond yields 15%, and the equivalent taxable bond
You have a project that costs $50,000 and will return $80,000 in 3 years.Your marginal capital gains tax rate on the $30,000 gain will be 37.5%.Treasuries pay a rate of return of 8%per year; munis
On March 28, 2008, tax-exempt AAA-rated 5-year muni bonds traded at a yield of 3.04%. Corporate 5-year AAA bonds traded at 4.14%.What was the marginal investor’s tax rate?
If the marginal investor’s tax rate is 30% and taxable bonds offer a rate of return of 6%, what rate of return do equivalent muni bonds offer?
If your tax rate is 20%, what interest rate do you earn in after-tax terms if the before-tax interest rate is 6%?
Why is the marginal tax rate usually lower than the average tax rate?
What types of income do taxpayers prefer?Why?
Is it better for the taxpayer to have a before-tax or an after-tax expense?Why?
What is the difference between a liquidity premium and a transaction cost?
Compute your after-transaction-costs rate of return on purchasing a house for $1,000,000 if you have to pay 0.5% transaction fees up front and pay a 6%broker’s commission (plus 2% in waiting costs)
List important transaction cost components, both direct and indirect.
What would you guess the transaction costs to be for a round-trip transaction of $10,000 worth of shares in Dell Computer? Describe in percentage and in absolute terms.
What mechanisms can borrowers use to assure lenders? If providing this information is not legally required, will they still volunteer to do so?
A bond will pay off $100 with probability 99%, and nothing with probability 1% next year. The equivalent appropriate expected rate of return for risk-free bonds is 5%.(a) What is an appropriate
“If the world is risk neutral and the market is perfect, then the promised and expected rates of return may be different, but the expected rate of return on all loans should be equal.” Evaluate.
Can there be a difference in the borrowing and lending rates quoted by the bank in perfect markets?
Evaluate the following statement: “In a perfect market, no one is getting a good deal. Thus, it would not matter from a social perspective if this market were not available.”
Your borrowing rate is 10% per year. Your lending rate is 4% per year.Your project costs $1,000 and will have a rate of return of 8%. Assume you have $900 to invest.(a) Should you take the
Without looking back, what are the perfect market assumptions?
Does a perfect capital market exist in the real world? What is the use of the perfect markets concept?
What is the difference between a perfect market and a competitive market?
What does the assumption of a perfect market buy you that would not be satisfied in an imperfect market?
Assume that you ran a time-series regression with your project on the Fama-French factors and found the following:E(˜ri) − rF= (12%) + (0.3) . XMKT + (0.3). UMD + (−0.5) . HML + (−0.5) . SMB
What are the Fama-French-Momentum factors?
What are the APT factors?
Outline the logic that leads to the CAPM.What is mathematics?What is economics?
Confirm that the portfolio L that invests 50%in H and 50% in I is not mean-variance efficient. If the risk-free rate of return is 4%, confirm that the CAPM relationship does not hold for L.
Your corporate division had the following net cash flows:Year: 1999 2000 2001 2002 S&P 500 +21.4% −5.7% −12.8% −21.9%Cash Flows +$2,000 $0 $0 $0 Year: 2003 2004 2005 S&P 500 +26.4% +9.0%
Although you are a millionaire, keeping all your money in the market, you have managed to secure a great deal: If you give your even richer Uncle Vinny $20,000 today, he will help you buy a house,
The Fama-French-Momentum model suggestsThis is a rate quoted above the risk-free rate. Thus, your appropriate cost of capital (hurdle rate) would be 3% + 7% = 10%. - E(7) = (1.3) E(XMKT) + (0.1)
The APT is almost like a multifactor version of the CAPM. Whereas in the CAPM, everything depends on one factor (that is, the rate of return on the stock market), in the APT there can be multiple
Recall the data from Table 9.2:♣ ♦ ♥ ♠ Mean Var I −6% +12% 0% 18% 6% 90%%H −12% +18% +24% +6% 9% 189%%Now compute the beta of H and I with respect to portfolio H. The beta of H with
Working off Table 9.2:(a) The covariance between H and N is 78.75%%.(b) The covariance between I and N is 81%%.(c) The variance of N is 79.31%%. Actually, this number was in the table itself.(d) The
First, compute the de-meaned cash flows:Year 1999 2000 2001 2002 2003 2004 Average Variance S&P 500 +21.4% −5.7% −12.8% −21.9% +26.4% +9.0% +2.7% 373.4%%∗Cash Flows +$2,864 +$1,666
This is a certainty equivalence question. Although it is not a gift per se, you cannot assume that $10,000 is a fair market value, so that you can compute a rate of return of 1,900%—after all, it
Assume that you ran a time-series regression with your project on the Fama-French factors and found the following:E(˜ri) − rF= (−2%) + (1.3) . XMKT + (0.1) . UMD + (−1) . HML+ (−0.1) . SMB
Explain how the APT model is similar to, but more general than, the CAPM.
Confirm that the portfolio H is not mean-variance efficient if the riskfree rate of return is 4%.
This question asks you to confirm the beta computations. Work with the data from Table 9.2.(a) Compute the covariance between H and N.(b) Compute the covariance between I and N.(c) Compute the
A firm reported the following cash flows:Year: 1999 2000 2001 2002 2003 2004 Average S&P 500 +21.4% −5.7% −12.8% −21.9% +26.4% +9.0% +2.7%Cash Flows +$2,864 +$1,666 −$1,040 +$52 +$1,478
Although you are a millionaire, keeping all your money in the market, you have managed to secure a great deal: If you promise to go to school (which costs you a net disutility worth $10,000 today),
Explain the kinds of projects for which it is important to get accurate equity premium estimates.
Under what circumstances is the CAPM a good model to use?What are the main arguments in favor of using it?When is it not a good model?
Why do you need to understand the CAPM?
Does the empirical evidence suggest that the CAPM is correct?
Draw some possible security markets relations that would not be consistent with the CAPM.
Apply the CAPM. Assume the risk-free rate of return is the current yield on 5-year bonds.Assume that the market’s expected rate of return is 3% per year above this. Download 5 years of daily rate
The prevailing risk-free rate is 5% per annum.A competitor to your own firm, though publicly traded, has been using an overall project cost of capital of 12% per annum. The competitor is financed by
A Fortune 100 firm is financed with $15 billion in debt and $5 billion in equity. Its historical levered equity beta has been 2. If the firm were to increase its leverage from $15 billion to $18
A comparable firm (in a comparable business)has an equity beta of 2.5 and a debt/equity ratio of 2. The debt is almost risk free. Estimate the beta for your equity if projects have constant betas,
Look up betas on Yahoo! Finance today, and compare them to those in Table 8.2 on page 218.(a) How does the beta of Intel today compare to its earlier estimate from May 2008? Was its beta stable (over
Consider the following historical rate of return series:Year S&P 500 IBM Year S&P 500 IBM 1991 +0.2631 −0.2124 2000 −0.1014 −0.2120 1992 +0.0446 −0.4336 2001 −0.1304 +0.4231 Year S&P 500
An unlevered firm has an asset market beta of 1.5. The risk-free rate is 3%. The equity premium is 4%.(a) What is the firm’s cost of capital?(b) The firm refinances itself. It repurchases half of
Should a negative-beta asset offer a higher or a lower expected rate of return than the risk-free asset? Does this make sense?
Should you use the same risk-free rate of return both as the CAPM formula intercept and in the equity premium calculation, or should you assume an equity premium that is independent of investment
Explain in 200 words or less: What are reasonable guesstimates for the market risk premium and why?
If you do not want to estimate the equity premium, what are your alternatives to finding a cost-of-capital estimate?
Explain the basic schools of thought when it comes to equity premium estimation.
A corporate zero-bond promises 7% in 1 year.Its market beta is 0.3. The equity premium is 4%; the equivalent Treasury rate is 3%. What is the appropriate bond price today?
What would it take for a bond to have a larger risk premium than default premium?

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