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essentials corporate finance
Financial Markets And Corporate Strategy Irwin/McGraw Hill Seri 1st Edition Sheridan Titman, Mark Grinblatt - Solutions
Explain how inflation affects the capital structure decision. Does inflation affect the capital structure choice differently for different firms?
As owner of 1 0 percent of ABC Industries, you have control of its capital structure decision. The current corporate tax rate is 34 percent and your personal tax rate is 31 percent. Assume that the returns to stockholders accrue as nontaxable capital gains. ABC currently has no debt and can finance
Assume that the real riskless interest rate is zero and the corporate tax rate is 33 percent. IGWT Industries can borrow at the riskless interest rate.It will have an inflation-adjusted £6/7 next?
Suppose the firm in exercise 13,2 unexpectedly announces that it will issue additional debt, with the same seniority as existing debt and a face value of $50. The firm will use the entire proceeds to repurchase some of the outstanding shares.a. What is the market price of the new debt?b. Just after
Consider a single period binomial setting where the riskless interest rate is zero, and there are no taxes. A firm consists of a machine that will produce cash flows of $210 if the economy is good and $80 if the economy is bad. The good and bad states occur with equal risk-neutral probability.
Suppose /•„ = 12%, fE = 10%, 7, = 33%, T„ = 20%.a. What is the marginal tax rate on stock income T^ which would make an investor indifferent in terms of after-tax returns between holding stock or bonds? Assume all betas are zero.b. What is the probability that a firm will not utilize its tax
Use the risk-neutral valuation method to directly show that the risk-neutral discounted value of the existing debt of Unitron is $636,000 higher if the project in Example 12.18 is adopted.
Compute tlie nel present value of the mold in Example 12.5, assuming that the debt capacity of the project is zero.
Compute the value of the debt tax shield for Acme Industries in Example 12.6.
The HTT Company is considering a new product. The new product has a five-year life. Sales and net income after taxes for the new product are estimated in the following table The equipment to produce the new product costs$500,0(JO. The $500,000 would be borrowed at an interest rate of 14 percent.
GT Associates have plans to start a widget company financed with 60 percent debt and 40 percent equity. Other widget companies are financed with 25 percent debt and 75 percent equity and have equity betas of 1 .5. GT's borrowing costs will be 14 percent, the risk-free rate is 8 percent, and the
Compute the WACC of Marriott's restaurant division in Example 12.16 by doing the following:a. Compute the /?£ of Marriott's restaurant division using equation ( 12.6).b. Apply the CAPM's risk e.xpected return equation to obtain the restaurant /-£, assuming a risk-free rate of 4 percent and a
Apply the APV method. First, compute the value of the operating assets of the Hughes acquisition.Next, compute the present value of the tax shield. Finally, add the two numbers.
Compute the value of Hughes if the WACC of GM at its existing leverage ratio is used instead of the WACC computed from the comparison firms(see exercise 12.4).
Compute the value of Hughes with the WACC from exercise 12.4.
Compute the WACC for the Hughes acquisition.
Compute the fi^ for the Hughes acquisition at the target debt level.
Compute ^q^, the beta of the operating assets of the Hughes acquisition by taking the average of the betas of the operating assets of Lockheed and Northrop.
Analyze the Hughes acquisition (which never took place) by first computing the betas of the comparison firms, Lockheed and Northrop, as if they were all equity financed. Hi>it: Use equation(12.7) to obtain ySy^ from (if .
Solve for the unlevered price/earnings ratio, A/X.by rearranging equation (11.1).
Porter and Spence ( 1982) pointed out that firms may want to overinvest in production capacity to show a commitment to maintain their market share to competitors. In their model, excess plant capacity would not be a positive net present value project if the cash flows were calculated taking the
Although there is no empirical evidence to strongly support this hypothesis, some financial journalists have claimed that American managers are shortsighted and overly risk averse, preferring to take on relatively safe projects that pay off quickly instead of taking on longer-term projects with
Compute the risk-neutral probabilities attached to the two states—high demand and low demand in Example 1 1.2. Show that applying these probabilities to value the mine provides the same answer for scenarios 1 and 2 as given in Example 1 1 .2.
The futures closing prices on the New York Mercantile Exchange from The Wall Street Journal published on August 28, 1996 (for August 27 closing prices) specify that futures prices per barrel for light sweet crude oil delivered monthly from mid-October 1996 through mid-December 1998 are,
Widget production and sales take place over a one-year cycle. For simplicity, assume that all
A silver mine has reserves of 25,000 troy ounces of silver. For simplicity, assume the following schedule for extraction, ore purification, and sale of the silver ore:
Vacant land has been zoned for either one 10,000-square-foot five-unit condominium or two single-family homes, each with 3,000 square feet. The cost of constructing the single-family homes is $100 per square foot and the cost of constructing the condominium is $120 per square foot. If the real
The XYZ firm can invest in a new DRAM chip factory for $500 million. The factory, which must be invested in today, has cash flows two years from now that depend on the state of the economy. The cash flows when the factory is running at full capacity are described by the following tree diagram:
Maytag merges with Whirlpool. Assume that Maytag's price/earnings ratio is 20 and Whirlpool's is 15. If Maytag accounts for 60 percent of the earnings of the merged firm, and if there are no synergies between the two merged firms, what is the price/earnings ratio of the merged firm?
Risk-free rates at horizons of one year, two years, and three years are 6.00 percent per year, 6.25 percent per year, and 6.75 percent per year, respectively. The manager of the space shuttle at Rockwell International forecasts respective cash flows of $200 million, $250 million, and $300 million
In a two-factor APT model, Dell Computer has a factor beta of 1.15 on the first factor portfolio, which is highly correlated with the change in GDP, and a factor beta of —.3 on the second factor portfolio, which is highly correlated with interest rate changes. If the risk-free rate is 5 percent
Compute the value of Hughes if GM's cost of capital is used as a discount rate instead of the cost of capital computed from the comparison firms.
Compute the value of Hughes with the cost of capital estimated in exercise 10.12.
Compute the cost of capital for the Hughes acquisition, assuming no taxes.
Compute the beta of the assets of the Hughes acquisition, assuming no taxes, by taking the average of the asset betas of Lockheed and Northrop.
Analyze the Hughes acquisition (which never took place) by first computing the betas of the comparison firms, Lockheed and Northrop, as if they were all equity financed. Assume no taxes.
Explain intuitively why the certainty equivalent of a cash flow with a negative beta exceeds the cash flow's expected value.
In Section 10. 3"s illustration, asset values increased 10 percent from 1995 to 1996. from$100 million to $1 10 million.a. Compute the percentage increase in the value of equity if the firm is financed with $50 million in debt.h. Compute the leverage ratio of this firm in 1996.
Start with the risk-adjusted discount rate formula. Derive the certainty equivalent formula by rearranging terms and noting that the/, = /3 X PV.
Explain why the answer to exercise 10.5 differs from the answer in Example 10.2.
Discount your answer in exercise 10.4 at a risk- free rate of 4 percent per year to obtain the present value.
Assuming that historical data suggests that the market risk premium is 8.4 percent per year and the market standard deviation is 40 percent per year, find the certainty equivalent of the year 1 cash flow. What are the advantages and disadvantages of using such historical data for market inputs as
Find the covariance of the cash flow with the market return and its cash flow beta.
Compute the expected year 1 restaurant cash flow for Marriott.
A project has an expected cash flow of $1 million one year from now. The standard deviation of this cash flow is $250,000. If the expected return of the market portfolio is 10 percent, the risk-free rate is 5 percent, the standard deviation of the market return is 5 percent, and the correlation
Compute spot yields and annuity yields for years 1, 2, 3, and 4 if par yields for years 1, 2, 3, and 4 are, respectively, 4.5 percent, 5 percent, 5.25 percent, and 5.25 percent. Assume annual compounding for all rates and annual payments for all bonds.
Compute annuity yields and par yields for years 1 , 2, and 3 if spot yields for years 1 , 2, and 3 are respectively 4.5 percent, 5 percent, and 5.25 percent. Assume annual compounding for all rates and annual payments for all bonds.
A zero-coupon bond maturing two years from now has a yield to maturity of 8 percent (annual compounding). Another zero-coupon bond with the same maturity date has a yield to maturity of 10 percent (annual compounding). Both bonds have a face value of $100. a . What are the prices of the zero-coupon
Investco, a West Coast research company, must decide on the level of computer technology it will buy for its analysis department. Package A, a midlevel technology, would cost $2.5 million for firmwide installation, while package B, a higherlevel technology, would cost $3.5 million. Equipped with
ABC Metalworks wants to determine which model sheetcutter to purchase. Three choices are available.( 1) machine 1 costs the least but must be replaced the most frequently, (2) machine 2 has average cost and average lifespan, and (3) machine 3 costs the most but needs only infrequent
As a regional managing director of Finco, a U.S.- based investment company, your mandate is to scour the Midwest in .search of promising investment opportunities and to recommend one project to corporate headquarters in Los Angeles. Your analysts have screened thousands of prospective ventures and
Consider the cash flows as.sociated with undertaking Project X.a. Is this an early or later cash flow stream?h. Based on the rates in exercise 9.5, what is the hurdle rate? What does such a rate represent?( . Calculate the IRR for Project X.d. Based on the hurdle rate calculated and a comparison
What is the cost or revenue associated with such a portfolio at date 0?r. What is the NPV of Project X?d. How are your answers to parts b and c related?
Let B, = price per $100 of face value of a zero- coupon bond maturing at year /. Then, if S, = $94.00,^2 = $88.20,^3 = $81.50, B4 = $76.00, and = $73.00:(7. Determine zero-coupon rates for years 1 through 5 to the nearest .01 percent.b. Consider the tracking portfolio in exercise
Describe the equivalent tracking portfolio for project X, giving long and short positions and amounts, under a flat term structure of 8 percent, compounded annually. Conceptually, why are we interested in tracking project X's cash flows with a portfolio of marketable securities?
Respond to parts a through il.a. What are the incremental cash flows associated with Small Corp.'s undertaking project X? Are these inflows or outflows, costs or revenue?b. What is the PI ' of project X under a flat term structure of 8 percent, compounded annually, irrespective of maturity.c. Under
The Wheatena Company is considering the purchase of a new milling machine. What purchase price makes the NPV of the project zero? Base your analysis on the following facts:• The new milling machine will reduce operating expen.ses by exactly $20,000 per year for 10 years. Each of the.se cash flow
Your firm has recently reached an expansion phase and is seeking possible new geographic regions to market the newly patented chemical compound Glupto. The five regional projections are as follows:
Callable bonds appear to have market values that are determined as if the issuing corporation optimally exercises the call option implicit in the bond. You know, however, that these options tend to get exercised past the optimal point. Write up a nontechnical presentation for your boss, the
Describe what happens to the amount of stock held in the tracking portfolio for a call (put) as the stock price goes up (down). Hint: Prove this by looking at delta.
In the chapter's opening vignette, Chrysler Corporation argued that there was little risk in the government guarantee of Chrysler's debt because Chrysler also was offering a senior claim of Chrysler's assets to the government. In light of this, Chrysler's warrants appear to have been a free gift to
PSA is a privately held firm. As an analyst trying to determine the value of PSA's common stock and bonds, you have estimated the market value of the firm's assets to be $1 million and the standard deviation of the asset return to be .3. The debt of PSA, which consists of zero-coupon bank loans,
Steady Corp. has a share value of $50. At-the- money American call options on Steady Corp. with nine months to expiration are trading at $3. Sure Corp. also has a share value of $50. At-the-money American call options on Sure Corp. with nine months to expiration are trading at $3. Suddenly, a
The present price of an equity share of Strategy Inc. is $50. The stock follows a binomial process where each period the stock either goes up 10 percent or down 10 percent. Compute the fair market value of an American put option on Strategy Inc. stock with a strike price of $50 and two periods to
Suppose you observe a European call option on a stock that is priced at less than the value of 5n - PV{K) - PV(div). What type of transaction should you execute to achieve arbitrage? (Be specific with respect to amounts and avoid using puts in this arbitrage.) 8.8 Consider a position of two
If PV{K) = r- take the partial derivative of(1 + i-ff the Black-Scholes value of a call option with respect to the interest rate r,. Show that this derivative is positive and equal to TX PV(K)N{d\ - aVf)/{\ + r^).
Take the partial derivative of the Black-Scholes value of a call option with respect to the volatility parameter cr. Show that this derivative is positive and equal to SqV 77V'(
Take the partial derivative of the Black-Scholes value of a call option with respect to the underlying security's price, S(y Show that this derivative is positive and equal to N{d^). Hint: First showthatS(yV'(J,) - PV(K)N'{d^ - aVf) equals zero by using the fact that the derivative of A' with 1
Intel stock has a volatility of cr = .25 and a price of $60 a share. A European call option on Intel stock with a strike price of $65 and an expiration time of one year has a price of $10. Using the BlackScholes Model, describe how you would construct an arbitrage portfolio, assuming that the
Combine the Black-Scholes formula with the putcall parity formula to derive the Black-Scholes formula for European puts.
You hold an American call option with a $30 strike price on a stock that sells at $35. The option sells for $5 one year before expiration. Compare the cash flows at expiration from ( 1 ) exercising the option now and putting the $5 proceeds in a bank account until the expiration date and (2)
Assume that futures prices for Hewlett-Packard (HP) can appreciate by 15 percent or depreciate by 10 percent and that the risk-free rate is 10 percent over the next period. Price a derivative security on HP that has payoffs of $25 in the up state and -$5 in the down state in the next period, where
Assume the Eurodollar rate (nine-month LIBOR) is 9 percent and the Eurosterling rate (nine-month LIBOR for the U.K. currency) is 1 1 percent. What is the nine -month forward $/£ exchange rate if the current spot exchange rate is $1.58/£? (Assume that nine months from now is 274 days.)
Assume that forward contracts to purchase one share of Sony and Digital Equipment ( DEC) at $100 and $40, respectively, in one year are currently selling for $3.00 and $2.20. Assume that neither stock pays a dividend over the coming year, and that one-year zero-coupon bonds are selling for $93 per
Consider a forward contract on IBM requiring purchase of a share of IBM stock for $150 in six months. The stock currently sells for $140 a share. Assume that it pays no dividends over the coming six months. Six-month zero-coupon bonds are selling for $98 per $100 of face value.a. If the forward is
Consider a stock that can appreciate by 50 percent or depreciate by 50 percent per period. Three periods from now, a stock with an initial value of $32 per share can be worth ( 1 ) $108—three up moves; (2) $36—two up moves, one down move;(3) $12—one up move, two down moves; or(4) $4—3 down
In many instances, whether a cash flow occurs early or not is a decision of the issuer or holder of the derivative. One example of this is a callable bond, which is a bond that the issuing firm can buy back at a prespecified call price. Valuing a callable bond is complicated because the early call
Value a risky corporate bond, assuming that the risk-free interest rate is 4 percent per period, where a period is defined as six months. The corporate bond has a face value of $100 payable two periods from now and pays a 5 percent coupon per period;that is, interest payments of $5 at the end of
A convertible bond can be converted into a specified number of shares of stock at the option of the bondholder. Assume that a convertible bond can be converted to 1 .5 shares of stock. A single share of this stock has a price that follows the binomial process:Date 0 Date I
Using risk-neutral valuation, derive a formula for a derivative that pays cash flows over the next two periods. Assume the risk-free rate is 4 percent per period.The underlying asset, which pays no cash flows, has a market value that is modeled by the following tree diagram.
Compute the firm-specihc variance and tirmspecific standard deviation of a portfolio that minimizes the firm-specific variance of a portfolio of 20 stocks. The first 10 stocks have firm-specific variances of .10. The second 10 stocks have firmspecific variances of .05.
Prove thata, = ( 1 — /3,)/'| in equation (6.3), assuming the CAPM holds. To do this, take expected values of both sides of this equation and match up the values with those of the equation for the CAPM's securities market line.
Describe how you might design a portfolio of the 40 largest stocks that mimic the S&P 500. Why might you prefer to do this instead of investing in allSOO of the S&P 500 stocks?
Two stocks, Uni and Due. ha\e returns tliat tullovv the one factor model: = .11 + 2F + e;,„,''due = .17 + 5F + ej„e How much should be invested in each of the two securities to design a portfolio that has a factor beta of —3. What is the expected return of this portfolio, assuming that the
How much should be invested in each of the stocks in exercise 6.3 to design two portfolios?The first portfolio has the following attributes:factor 1 beta factor 2 beta 0 The second portfolio has the attributes:factor 1 beta = 0 factor 2 beta = 1 Compute the expected returns and risk premiums of
Write out the factor betas, factor equations, and expected returns of the following portfolios:( 1 ) A portfolio of the three stocks in exercise 6.3 with $20,000 invested in stock A,-$20,000 invested in stock B, and $10,000 invested in stock C.(2) A portfolio consisting of the portfolio formed in
What are the expected returns of the three stocks in exercise 6.3?
Consider the following two-factor model for the returns of three stocks. Assume that the factors and epsiJons have means of zero. Also, assume the factors have variances of .01 and are uncorrelated with each other.i\ = .13 + 6F, -I- 4F2 +i-Q = .15 + 2F| -I- 2F2 + eg i~c = -07 + 5F, - \F2 + ic If
What is the minimum number of factors needed to explain the expected returns of a group of 10 securities if the securities returns have no firmspecific risk? Why?
Prove that the portfolio-weighted average of a stock'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 of the factor if the factors are uncorrelated with each other. Do this with the following steps: (1)
What value must ACYOU Corporation's expected return be in Example 5.4 to prevent us from forming a combination of Henry's portfolio, ACME, ACYOU, and the risk-free asset that is mean-variance superior to Henry's portfolio?
The following are the returns for Exxon and the corresponding returns of the S&P 500 market index for each month in 1994.Using a spreadsheet, compute Exxon's beta. Then apply the Bloomberg adjustment to derive the adjusted beta.
The Alumina Corporation has the following simplified balance sheet (based on market values)Assets Liabilities and Equity Debt $10 billion $6 billion Common Stock $4 billion a . The debt of Alumina, being risk-free, earns the risk-free return of 6 percent per year. The equity of Alumina has a mean
Using a spreadsheet, compute the minimum variance and tangency portfolios for the universe of three stocks described below. Assume the risk- free return is 5 percent. Hypothetical data necessary for this calculation are provided in the table below. See exercise 5.6 for detailed instructions.
What is the covariance of the return of the tangency portfolio from exercise 5.2 with the return of all portfolios that have the same expected return as Netscape?
Using the fact that the hyperbolic boundary of the feasible set of the three stocks is generated by any two portfolios:a. Find the boundary portfolio that is uncorrelated with the langency portfolio in exercise 5.2.h. What is the covariance with the tangency portfolio of all inefficient portfolios
a. Compute the betas of Netscape, Microsoft, and Novell with respect to the tangency portfolio found in exercise 5,2.h. Then compute the beta of an equally weighted portfolio of the three stocks.
Repeat exercises 5,2 and 5.3, but use a spreadsheet to solve for the tangency portfolio weights of Netscape, Microsoft, and Novell in the three cases. The solution of the system of equations requires you to invert the matrix of covariances above, then post multiply the inverted covariance matrix by
Show that an equally weighted portfolio of Netscape, Microsoft, and Novell can be improved upon with marginal variance-marginal mean analysis.
Draw a mean-standard deviation diagram and plot Netscape, Microsoft, and Novell on this diagram as well as the three tangency portfolios found in exercises 5.2 and 5.3.
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