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essentials corporate finance
Corporate Finance With Connect Access Card 10th Edition Stephen Ross ,Randolph Westerfield ,Jeffrey Jaffe - Solutions
Efficient Market Hypothesis Define the three forms of market efficiency.
Efficient Market Hypothesis A stock market analyst is able to identify mispriced stocks by comparing the average price for the last 10 days to the average price for the last 60 days. If this is true, what do you know about the market?
Efficient Market Hypothesis Several celebrated investors and stock pickers frequently mentioned in the financial press have recorded huge returns on their investments over the past two decades. Does the success of these particular investors invalidate the EMH? Explain.
Efficient Market Hypothesis For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is
Technical Analysis What would a technical analyst say about market efficiency?
Investor Sentiment A technical analysis tool that is sometimes used to predict market movements is an investor sentiment index. AAII, the American Association of Individual Investors, publishes an investor sentiment index based on a survey of its members. In the following table you will find the
Performance of the Pros In the middle to late 1990s, the performance of the pros was unusually poor—on the order of 90 percent of all equity mutual funds underperformed a passively managed index fund. How does this bear on the issue of market efficiency?
Efficient Markets A hundred years ago or so, companies did not compile annual reports. Even if you owned stock in a particular company, you were unlikely to be allowed to see the balance sheet and income statement for the company. Assuming the market is semistrong form efficient, what does this say
Efficient Market Hypothesis Aerotech, an aerospace technology research firm, announced this morning that it has hired the world’s most knowledgeable and prolific space researchers. Before today Aerotech’s stock had been selling for $100.Assume that no other information is received over the next
Efficient Market Hypothesis When the 56-year-old founder of Gulf & Western, Inc., died of a heart attack, the stock price immediately jumped from $18.00 a share to $20.25, a 12.5 percent increase. This is evidence of market inefficiency because an efficient stock market would have anticipated his
Efficient Market Hypothesis Today, the following announcement was made:“Early today the Justice Department reached a decision in the Universal Product Care (UPC) case. UPC has been found guilty of discriminatory practices in hiring.For the next five years, UPC must pay $2 million each year to a
Efficient Market Hypothesis Newtech Corp. 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 firm’s stock before the news release on the device? After reading the announcement in The Wall
Efficient Market Hypothesis TransTrust Corp. has changed how it accounts for inventory. Taxes are unaffected, although the resulting earnings report released this quarter is 20 percent higher than what it would have been under the old accounting system. There is no other surprise in the earnings
Efficient Market 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 subscribers. Those subscribers beat the market consistently, earning substantially higher returns after
Efficient Market 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 manufacturing firms that eight years earlier had been listed in an industry magazine as the best-managed small
Efficient Market Hypothesis A famous economist just announced in The Wall Street Journal his findings that the recession is over and the economy is again entering an expansion. Assume market efficiency. Can you profit from investing in the stock market after you read this announcement?
Efficient Market Hypothesis Suppose the market is semistrong form efficient. Can you expect to earn excess returns if you make trades based on:a. Your broker’s information about record earnings for a stock?b. Rumors about a merger of a firm?c. Yesterday’s announcement of a successful new
Efficient Market Hypothesis Imagine that a particular macroeconomic variable that influences your firm’s net earnings is positively serially correlated. Assume market efficiency. Would you expect price changes in your stock to be serially correlated? Why or why not?
Efficient Market Hypothesis Assume that markets are efficient. During a trading day American Golf Inc. announces that it has lost a contract for a large golfing project that, prior to the news, it was widely believed to have secured. If the market is efficient, how should the stock price react to
Efficient Market Hypothesis Prospectors, Inc., is a publicly traded gold prospecting company in Alaska. Although the firm’s searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors’ cumulative abnormal returns
Evidence on Market Efficiency Some people argue that the efficient market hypothesis cannot explain the 1987 market crash or the high price-to-earnings ratios of Internet stocks during the late 1990s. What alternative hypothesis is currently used for these two phenomena?
Cumulative Abnormal Returns Delta, United, and American Airlines announced purchases of planes on July 18 (7/18), February 12 (2/12), and October 7 (10/7), respectively. Given the following information, calculate the cumulative abnormal return (CAR) for these stocks as a group. Graph the result and
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 diagram is the announcement month. Assume that no other information is received and the stock market as a
Cumulative Abnormal Returns A study analyzed the behavior of the stock prices of firms that had lost antitrust cases. Included in the diagram are all firms that lost the initial court decision, even if the decision was later overturned on appeal. The event at Time 0 is the initial, pre-appeal court
Is the diagram consistent with market efficiency? Why or why not? CAR 10%- 0% -10% -20% -30%- -40% -12 -6 0 6 Time in months relative to event month
What implications do you draw from the graph for mutual fund investors?You have been at your job for East Coast Yachts for a week now and have decided you need to sign up for the company’s 401(k) plan. Even after your discussion with Sarah Brown, the Bledsoe Financial Services representative, you
Is the graph consistent or inconsistent with market efficiency? Explain carefully.You have been at your job for East Coast Yachts for a week now and have decided you need to sign up for the company’s 401(k) plan. Even after your discussion with Sarah Brown, the Bledsoe Financial Services
What investment decision would you make for the equity portion of your 401(k)account? Why?You have been at your job for East Coast Yachts for a week now and have decided you need to sign up for the company’s 401(k) plan. Even after your discussion with Sarah Brown, the Bledsoe Financial Services
If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and
Construct Stephenson’s market value balance sheet before it announces the purchase.Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has
Suppose Stephenson decides to issue equity to finance the purchase.a. What is the net present value of the project?b. Construct Stephenson’s market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm’s
Suppose Stephenson decides to issue debt to finance the purchase.a. What will the market value of the Stephenson company be if the purchase is financed with debt?b. Construct Stephenson’s market value balance sheet after both the debt issue and the land purchase. What is the price per share of
Which method of financing maximizes the per-share stock price of Stephenson’s equity?Stephenson Real Estate Company was founded 25 years ago by the current CEO, Robert Stephenson. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has
MM Assumptions List the three assumptions that lie behind the Modigliani–Miller theory in a world without taxes. Are these assumptions reasonable in the real world?Explain.
MM Propositions In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? If a firm issues equity to repurchase some of its debt, the price per share of the firm’s stock will rise because the shares are less risky.
MM Propositions In a world with no taxes, no transaction costs, and no costs of financial distress, is the following statement true, false, or uncertain? Moderate borrowing will not increase the required return on a firm’s equity. Explain.
MM Propositions What is the quirk in the tax code that makes a levered firm more valuable than an otherwise identical unlevered firm?
Business Risk versus Financial Risk Explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.
EBIT and Leverage Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a
EBIT, Taxes, and Leverage Repeat parts (a) and (b) in Problem 1 assuming Money has a tax rate of 35 percent.
Break-Even EBIT Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outstanding and $2.8 million in
Break-Even EBIT and Leverage Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent.a. Ignoring taxes, compare both of
Homemade Leverage Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000 shares outstanding and the price per share is $58.EBIT is expected to remain at $33,000 per year
Homemade Leverage and WACC ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 8 percent. Both firms
Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is 11 percent, and its cost of debt is 7 percent. The corporate tax rate is 35 percent.a. What is Weston’s cost of equity capital?b. What is Weston’s unlevered cost of equity capital?c. What would the cost of equity
Calculating WACC Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is currently 11 percent, and the tax rate is 35 percent.a. What is Shadow’s cost of equity?b. If the firm converts to 25 percent debt, what will its cost of equity be?c. If the firm converts to 50 percent
MM and Taxes Bruce & Co. expects its EBIT to be $185,000 every year forever.The firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if Bruce borrows $135,000 and uses
MM Proposition I Levered, Inc., and Unlevered, Inc., are identical in every way except their capital structures. Each company expects to earn $29 million before interest per year in perpetuity, with each company distributing all its earnings as dividends. Levered’s perpetual debt has a market
MM Proposition I with Taxes The Maxwell Company is financed entirely with equity. The company is considering a loan of $1.8 million. The loan will be repaid in equal installments over the next two years, and it has an interest rate of 8 percent.The company’s tax rate is 35 percent. According to
MM Proposition I without Taxes Alpha Corporation and Beta Corporation are identical in every way except their capital structures. Alpha Corporation, an allequity firm, has 15,000 shares of stock outstanding, currently worth $30 per share.Beta Corporation uses leverage in its capital structure. The
Cost of Capital Acetate, Inc., has equity with a market value of $23 million and debt with a market value of $7 million. Treasury bills that mature in one year yield 5 percent per year, and the expected return on the market portfolio is 12 percent. The beta of Acetate’s equity is 1.15. The firm
Homemade Leverage The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Company’s 6 percent bonds is $1.4 million. Financial information for the two firms appears here. All earnings streams are perpetuities. Neither
MM Propositions Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate debt. As a result, the firm’s debt–equity ratio is expected to rise from 35 percent to 50 percent. The firm currently has $3.6 million worth of debt outstanding. The cost of this debt
MM with Taxes Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent.Williamson is subject to a corporate tax rate of 35 percent.a. What is Williamson’s cost of equity capital?b. What is
Weighted Average Cost of Capital In a world of corporate taxes only, show that the R WACC can be written as R WACC 5 R 0 3 [1 2 t C ( B y V )].
Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of debt equals the risk-free rate, R f . Define b A as the firm’s asset beta—that is, the systematic risk of the firm’s assets. Define b S to be the beta of the firm’s equity. Use the capital asset pricing
Stockholder Risk Suppose a firm’s business operations mirror movements in the economy as a whole very closely—that is, the firm’s asset beta is 1.0. Use the result of previous problem to find the equity beta for this firm for debt–equity ratios of 0, 1, 5, and 20. What does this tell you
APV How is the APV of a project calculated?
WACC and APV What is the main difference between the WACC and APV methods?
FTE What is the main difference between the FTE approach and the other two approaches?
Capital Budgeting You are determining whether your company should undertake a new project and have calculated the NPV of the project using the WACC method when the CFO, a former accountant, notices that you did not use the interest payments in calculating the cash flows of the project. What should
Beta and Leverage What are the two types of risk that are measured by a levered beta?
Beta and Leverage North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.10 if both were all equity financed. The market value information for each company is shown here:North Pole South Pole Debt $2,900,000 $3,800,000 Equity
NPV of Loans Daniel Kaffe, CFO of Kendrick Enterprises, is evaluating a 10-year, 8 percent loan with gross proceeds of $5,850,000. The interest payments on the loan will be made annually. Flotation costs are estimated to be 2.5 percent of gross proceeds and will be amortized using a straight-line
NPV for an All-Equity Company Shattered Glass, Inc., is an all-equity firm. The cost of the company’s equity is currently 11 percent, and the risk-free rate is 3.5 percent.The company is currently considering a project that will cost $11.4 million and last six years. The project will generate
WACC Bolero, Inc., has compiled the following information on its financing costs:Type of Financing Book Value Market Value Cost Short-term debt $10,000,000 $11,000,000 4.1%Long-term debt 3,000,000 3,000,000 7.2 Common stock 6,000,000 26,000,000 13.8 Total $19,000,000 $40,000,000 The company is in
Beta and Leverage Stackhouse Industries has a new project available that requires an initial investment of $4.5 million. The project will provide unlevered cash flows of $675,000 per year for the next 20 years. The company will finance the project with a debt-to-value ratio of .40. The company’s
APV, FTE, and WACC Lone Star Industries just issued $235,000 of perpetual 8 percent debt and used the proceeds to repurchase stock. The company expects to generate $118,000 of earnings before interest and taxes in perpetuity. The company distributes all its earnings as dividends at the end of each
Projects That Are Not Scale Enhancing Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt–equity ratio of .40, but the industry target debt–equity ratio is .35. The industry average beta is 1.2. The market risk
Cheek Products, Inc. (CPI) was founded 53 years ago by Joe Cheek and originally sold snack foods such as potato chips and pretzels. Through acquisitions, the company has grown into a conglomerate with major divisions in the snack food industry, home security systems, cosmetics, and plastics.
Time Value On subsidized Stafford loans, a common source of financial aid for college students, interest does not begin to accrue until repayment begins. Who receives a bigger subsidy, a freshman or a senior? Explain.Use the following information to answer the next five questions:Toyota Motor
Time Value of Money Why would TMCC be willing to accept such a small amount today ($24,099) in exchange for a promise to repay about four times that amount($100,000) in the future?
Time Value of Money Would you be willing to pay $24,099 today in exchange for$100,000 in 30 years? What would be the key considerations in answering yes or no?Would your answer depend on who is making the promise to repay?
Investment Comparison Suppose that when TMCC offered the security for $24,099 the U.S. Treasury had offered an essentially identical security. Do you think it would have had a higher or lower price? Why?
Length of Investment The TMCC security is bought and sold on the New York Stock Exchange. If you looked at the price today, do you think the price would exceed the $24,099 original price? Why? If you looked in the year 2019, do you think the price would be higher or lower than today’s price? Why?
Calculating Future Values Compute the future value of $1,000 compounded annually fora. 10 years at 5 percent.b. 10 years at 10 percent.c. 20 years at 5 percent.d. Why is the interest earned in part (c) not twice the amount earned in part (a)?
Calculating Present Values For each of the following, compute the present value:Present Value Years Interest Rate Future Value 6 7% $ 13,827 9 15 43,852 18 11 725,380 23 18 590,710
Calculating Interest Rates Solve for the unknown interest rate in each of the following:Present Value Years Interest Rate Future Value$ 242 4 $ 307 410 8 896 51,700 16 162,181 18,750 27 483,500
Calculating the Number of Periods Solve for the unknown number of years in each of the following:Present Value Years Interest Rate Future Value$ 625 9% $ 1,284 810 11 4,341 18,400 17 402,662 21,500 8 173,439
Calculating the Number of Periods At 8 percent interest, how long does it take to double your money? To quadruple it?
Calculating Present Values Imprudential, Inc., has an unfunded pension liability of $630 million that must be paid in 20 years. To assess the value of the firm’s stock, financial analysts want to discount this liability back to the present. If the relevant discount rate is 7.1 percent, what is
Calculating Rates of Return Although appealing to more refined tastes, art as a collectible has not always performed so profitably. During 2010, Deutscher-Menzies sold Arkies under the Shower , a painting by renowned Australian painter Brett Whiteley, at auction for a price of $1,100,000.
Perpetuities An investor purchasing a British consol is entitled to receive annual payments from the British government forever. What is the price of a consol that pays $150 annually if the next payment occurs one year from today? The market interest rate is 4.6 percent.
Continuous Compounding Compute the future value of $1,900 continuously compounded fora. 7 years at a stated annual interest rate of 12 percent.b. 5 years at a stated annual interest rate of 10 percent.c. 12 years at a stated annual interest rate of 5 percent.d. 10 years at a stated annual interest
Present Value and Multiple Cash Flows Conoly Co. has identified an investment project with the following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows? What is the present value at 18 percent? At 24 percent?Year Cash Flow 1 $ 960 2 840 3 935 4 1,350
Present Value and Multiple Cash Flows Investment X offers to pay you $4,500 per year for nine years, whereas Investment Y offers to pay you $7,000 per year for five years. Which of these cash flow streams has the higher present value if the discount rate is 5 percent? If the discount rate is 22
Calculating Perpetuity Values The Perpetual Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $15,000 per year forever. If the required return on this investment is 5.2 percent, how much will you pay for the policy? Suppose the Perpetual Life Insurance
Calculating EAR Find the EAR in each of the following cases:Stated Rate (APR) Number of Times Compounded Effective Rate (EAR)7% Quarterly 16 Monthly 11 Daily 12 Infinite
Calculating APR Find the APR, or stated rate, in each of the following cases:Stated Rate (APR) Number of Times Compounded Effective Rate (EAR)Semiannually 9.8%Monthly 19.6 Weekly 8.3 Infinite 14.2
Calculating EAR First National Bank charges 11.2 percent compounded monthly on its business loans. First United Bank charges 11.4 percent compounded semiannually. As a potential borrower, to which bank would you go for a new loan?
Interest Rates Well-known financial writer Andrew Tobias argues that he can earn 177 percent per year buying wine by the case. Specifically, he assumes that he will consume one $10 bottle of fine Bordeaux per week for the next 12 weeks. He can either pay $10 per week or buy a case of 12 bottles
Calculating Number of Periods One of your customers is delinquent on his accounts payable balance. You’ve mutually agreed to a repayment schedule of $700 per month. You will charge 1.3 percent per month interest on the overdue balance. If the current balance is $21,500, how long will it take for
Future Value What is the future value in six years of $1,000 invested in an account with a stated annual interest rate of 9 percent,a. Compounded annually?b. Compounded semiannually?c. Compounded monthly?d. Compounded continuously?e. Why does the future value increase as the compounding period
Calculating Annuities You are planning to save for retirement over the next 30 years.To do this, you will invest $800 a month in a stock account and $350 a month in a bond account. The return of the stock account is expected to be 11 percent, and the bond account will pay 6 percent. When you
Calculating Rates of Return You’re trying to choose between two different investments, both of which have up-front costs of $65,000. Investment G returns$125,000 in six years. Investment H returns $185,000 in 10 years. Which of these investments has the higher return?
Growing Perpetuities Mark Weinstein has been working on an advanced technology in laser eye surgery. His technology will be available in the near term. He anticipates his first annual cash flow from the technology to be $175,000, received two years from today. Subsequent annual cash flows will grow
Perpetuities A prestigious investment bank designed a new security that pays a quarterly dividend of $4.50 in perpetuity. The first dividend occurs one quarter from today. What is the price of the security if the stated annual interest rate is 6.5 percent, compounded quarterly?
Annuity Present Values What is the present value of an annuity of $6,500 per year, with the first cash flow received three years from today and the last one received 25 years from today? Use a discount rate of 7 percent.
Calculating Interest Expense You receive a credit card application from Shady Banks Savings and Loan offering an introductory rate of 2.40 percent per year, compounded monthly for the first six months, increasing thereafter to 18 percent compounded monthly. Assuming you transfer the $7,500 balance
Perpetuities Barrett Pharmaceuticals is considering a drug project that costs$2.5 million today and is expected to generate end-of-year annual cash flows of$227,000, forever. At what discount rate would Barrett be indifferent between accepting or rejecting the project?
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