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business
principles corporate finance

Corporate Finance 6th Edition Jonathan Berk, Peter DeMarzo - Solutions

You know that there are informed traders in the stock market, but you are uninformed. Describe an investment strategy that guarantees you will not lose money to the informed traders and explain why it works.Appendix
What are the only conditions under which the market portfolio might not be an efficient portfolio?Appendix
Explain what the following sentence means: The market portfolio is a fence that protects the sheep from the wolves, but nothing can protect the sheep from themselves.Appendix
Why does the CAPM imply that investors should trade very rarely?Appendix
Your cousin Jess is a surgeon who suffers badly from the overconfidence bias. Jess loves to trade stocks and makes predictions with 100% confidence. In fact, Jess is uninformed like most investors. Rumors are that Vital Signs (a start-up that makes warning labels in the medical industry)will
To put the turnover of Figure 13.3 into perspective, let’s do a back of the envelope calculation of what an individual investor’s average turnover (per dollar invested) would be were he or she to follow a policy of investing in the S&P 500 portfolio. Because the portfolio is value weighted,
How does the disposition effect impact investors’ tax obligations?Appendix
Suppose that all investors have the disposition effect. A new stock has just been issued at a price of $50, so all investors in this stock purchased the stock today. A year from now the stock will be taken over, for a price of $60 or $40 depending on the news that comes out over the year.The stock
Davita Spencer is a manager at El Cap Asset Management. She can generate an alpha of 2%a year up to $100 million. After that her skills are spread too thin, so cannot add value and her alpha is zero. El Cap charges a fee of 1% per year on the total amount of money under management(at the beginning
Allison and Bill are both mutual fund managers, although Allison is more skilled than Bill. Both have $100 million in assets under management and charge a fee of 1%/year. Allison is able to generate a 2% alpha before fees and Bill is able to generate a 1% alpha before fees.a. What is the net alpha
Explain what the size effect is.Appendix
Assume all firms have the same expected dividends. If they have different expected returns, how will their market values and expected returns be related? What about the relation between their dividend yields and expected returns?Appendix
Consider the following stocks, all of which will pay a liquidating dividend in a year and nothing in the interim:a. Calculate the expected return of each stock.b. What is the sign of correlation between the expected return and market capitalization of the stocks?Appendix Stock A Market
Explain how to construct a positive-alpha trading strategy if stocks that have had relatively high returns in the past tend to have positive alphas and stocks that have had relatively low returns in the past tend to have negative alphas.Appendix
If you can use past returns to construct a trading strategy that makes money (has a positive alpha), it is evidence that market portfolio is not efficient. Explain why.Appendix
Explain why you might expect stocks to have nonzero alphas if the market proxy portfolio is not highly correlated with the true market portfolio, even if the true market portfolio is efficient.Appendix
Explain why if some investors are subject to systematic behavioral biases, while others pick efficient portfolios, the market portfolio will not be efficient.Appendix
Explain why an employee who cares only about expected return and volatility will likely underweight the amount of money he invests in his own company’s stock relative to an investor who does not work for his company.Appendix
Using the factor beta estimates in the table shown here and the monthly expected return estimates in Table 13.1, calculate the risk premium of General Electric stock (ticker: GE) using the FFC factor specification. (Annualize your result by multiplying by 12.) GE’s CAPM beta over the same time
You are currently considering an investment in a project in the energy sector. The investment has the same riskiness as Exxon Mobil stock (ticker: XOM). Using the data in Table 13.1 and the table above, calculate the cost of capital using the FFC factor specification if the current risk-free rate
You work for Microsoft Corporation (ticker: MSFT), and you are considering whether to develop a new software product. The risk of the investment is the same as the risk of the company.a. Using the data in Table 13.1 and in the table above, calculate the cost of capital using the FFC factor
Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of $5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of $800 or $1000 each year. After paying any interest on debt, both companies use all remaining free cash
Explain what is wrong with the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising
Suppose PayPal (PYPL) has no debt and an equity cost of capital of 9.2%. The average debt-tovalue ratio for the credit services industry is 15%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%?Appendix
Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.60. Due to the increased risk, shareholders now expect a return of 13%. Assuming there are no taxes
Hartford Mining has 50 million shares that are currently trading for $4 per share and $200 million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to fall 25% to $3 per
In early 2022 Meta Platforms had $14.5 billion in debt, total equity capitalization of $600 billion, and an equity beta of 1.38 (as reported on Yahoo! Finance). Included in Meta’s assets was $48 billion in cash and risk-free securities. Assume Meta’s debt beta is close to zero, the risk-free
Indell stock has a current market value of $120 million and a beta of 1.50. Indell currently has risk-free debt as well. The firm decides to change its capital structure by issuing $30 million in additional risk-free debt, and then using this $30 million plus another $10 million in cash to
Pelamed Pharmaceuticals has EBIT of $325 million in 2006. In addition, Pelamed has interest expenses of $125 million and a corporate tax rate of 25%.a. What is Pelamed’s 2006 net income?b. What is the total of Pelamed’s 2006 net income and interest payments?c. If Pelamed had no interest
Grommit Engineering expects to have net income next year of $20.75 million and free cash flow of $22.15 million. Grommit’s marginal corporate tax rate is 20%.a. If Grommit increases leverage so that its interest expense rises by $1 million, how will its net income change?b. For the same increase
Suppose the corporate tax rate is 25%. Consider a firm that earns $1000 before interest and taxes each year with no risk. The firm’s capital expenditures equal its depreciation expenses each year, and it will have no changes to its net working capital. The risk-free interest rate is 5%.a. Suppose
Braxton Enterprises currently has debt outstanding of $35 million and an interest rate of 8%.Braxton plans to reduce its debt by repaying $7 million in principal at the end of each year for the next five years. If Braxton’s marginal corporate tax rate is 25%, what is the interest tax shield from
Your firm currently has $100 million in debt outstanding with a 10% interest rate. The terms of the loan require the firm to repay $25 million of the balance each year. Suppose that the marginal corporate tax rate is 25%, and that the interest tax shields have the same risk as the loan.What is the
Arnell Industries has just issued $10 million in debt (at par). The firm will pay interest only on this debt. Arnell’s marginal tax rate is expected to be 21% for the foreseeable future.a. Suppose Arnell pays interest of 6% per year on its debt. What is its annual interest tax shield?b. What is
Ten years have passed since Arnell issued $10 million in perpetual interest only debt with a 6%annual coupon, as in Problem 6. Tax rates have remained the same at 21% but interest rates have dropped, so Arnell’s current cost of debt capital is 4%.a. What is Arnell’s annual interest tax
Bay Transport Systems (BTS) currently has $30 million in debt outstanding. In addition to 6.5%interest, it plans to repay 5% of the remaining balance each year. If BTS has a marginal corporate tax rate of 25%, and if the interest tax shields have the same risk as the loan, what is the present value
Safeco Inc. has no debt, and maintains a policy of holding $10 million in excess cash reserves, invested in risk-free Treasury securities. If Safeco pays a corporate tax rate of 21%, what is the cost of permanently maintaining this $10 million reserve? (Hint : What is the present value of the
Rogot Instruments makes fine violins and cellos. It has $1 million in debt outstanding, equity valued at $2 million, and pays corporate income tax at rate of 21%. Its cost of equity is 12%and its cost of debt is 7%.a. What is Rogot’s pretax WACC?b. What is Rogot’s (effective after-tax)
Rumolt Motors has 30 million shares outstanding with a price of $15 per share. In addition, Rumolt has issued bonds with a total current market value of $150 million. Suppose Rumolt’s equity cost of capital is 10%, and its debt cost of capital is 5%.a. What is Rumolt’s pretax weighted average
Summit Builders has a market debt-equity ratio of 0.65 and a corporate tax rate of 25%, and it pays 7% interest on its debt. The interest tax shield from its debt lowers Summit’s WACC by what amount?Appendix
NatNah, a builder of acoustic accessories, has no debt and an equity cost of capital of 15%.Suppose NatNah decides to increase its leverage and maintain a market debt-to-value ratio of 0.5. Suppose its debt cost of capital is 9% and its corporate tax rate is 21%. If NatNah’s pretax WACC remains
Restex maintains a debt-equity ratio of 0.85, and has an equity cost of capital of 12% and a debt cost of capital of 7%. Restex’s corporate tax rate is 25%, and its market capitalization is$220 million.a. If Restex’s free cash flow is expected to be $10 million in one year, what constant
Acme Storage has a market capitalization of $100 million and debt outstanding of $40 million.Acme plans to maintain this same debt-equity ratio in the future. The firm pays an interest rate of 7.5% on its debt and has a corporate tax rate of 21%.a. If Acme’s free cash flow is expected to be $7
Milton Industries expects free cash flow of $5 million each year. Milton’s corporate tax rate is 21%, and its unlevered cost of capital is 15%. The firm also has outstanding debt of $19.05 million, and it expects to maintain this level of debt permanently.a. What is the value of Milton Industries
Suppose Microsoft has 8.75 billion shares outstanding and pays a marginal corporate tax rate of 21%. If Microsoft announces that it will pay out $50 billion in cash to investors through a combination of a special dividend and a share repurchase, and if investors had previously assumed Microsoft
Rally, Inc., is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding.Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 21%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.a.
Suppose the corporate tax rate is 25%, and investors pay a tax rate of 20% on income from dividends or capital gains and a tax rate of 33% on interest income. Your firm decides to add debt so it will pay an additional $15 million in interest each year. It will pay this interest expense by cutting
Facebook, Inc. had no debt on its balance sheet in 2014, but paid $2 billion in taxes. Suppose Facebook were to issue sufficient debt to reduce its taxes by $250 million per year permanently.Assume Facebook’s marginal corporate tax rate is 35% and its borrowing cost is 5%.a. How much debt would
Markum Enterprises is considering permanently adding $100 million of debt to its capital structure. Markum’s corporate tax rate is 25%.a. Absent personal taxes, what is the value of the interest tax shield from the new debt?b. If investors pay a tax rate of 37% on interest income, and a tax rate
Suppose the tax rate on interest income is 35%, and the average tax rate on capital gains and dividend income is 10%. How high must the marginal corporate tax rate be for debt to offer a tax advantage?Appendix
Without leverage, Impi Corporation will have net income next year of $4.5 million. If Impi’s corporate tax rate is 21% and it pays 8% interest on its debt, how much additional debt can Impi issue this year and still receive the benefit of the interest tax shield next year? (Note:Assume Impi’s
Baruk Industries has no cash and a debt obligation of $36 million that is now due. The market value of Baruk’s assets is $81 million, and the firm has no other liabilities. Assume perfect capital markets.a. Suppose Baruk has 10 million shares outstanding. What is Baruk’s current share price?b.
When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive a cost of bankruptcy?Appendix
Which type of firm is more likely to experience a loss of customers in the event of financial distress:a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)?b. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports
Which type of asset is more likely to be liquidated for close to its full market value in the event of financial distress:a. An office building or a brand name?b. Product inventory or raw materials?c. Patent rights or engineering “know-how”?Appendix
You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties.To quote your manager, “If we go bankrupt, we don’t have to service the warranties. We therefore
Historically, Meta Platforms (parent company of Facebook) has had more cash than debt. As Problem 21 in Chapter 15 makes clear, by issuing more debt Meta could generate a very large tax shield worth billions. Given Meta’s success, one would be hard pressed to argue that Meta’s management are
Hawar International is a shipping firm with a current share price of $5.50 and 10 million shares outstanding. Suppose Hawar announces plans to lower its corporate taxes by borrowing $20 million and repurchasing shares.a. With perfect capital markets, what will the share price be after this
Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs
Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.Appendix
Sarvon Systems has a debt-equity ratio of 1.2, an equity beta of 2.0, and a debt beta of 0.30. It currently is evaluating the following projects, none of which would change the firm’s volatility(amounts in $ million):a. Which project will equity holders agree to fund?b. What is the cost to the
Empire Industries forecasts net income this coming year as shown below (in thousands of dollars):Approximately $200,000 of Empire’s earnings will be needed to make new, positive-NPV investments. Unfortunately, Empire’s managers are expected to waste 10% of its net income on needless perks, pet
Although the major benefit of debt financing is easy to observe—the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.Appendix
Which of the following industries have low optimal debt levels according to the tradeoff theory?Which have high optimal levels of debt?a. Tobacco firmsb. Accounting firmsc. Mature restaurant chainsd. Lumber companiese. Cell phone manufacturers Appendix
According to the managerial entrenchment theory, managers choose capital structure so as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of default. On the other hand, if they do not take advantage of the tax shield
During the Internet boom of the late 1990s, the stock prices of many Internet firms soared to extreme heights. As CEO of such a firm, if you believed your stock was significantly overvalued, would using your stock to acquire non-Internet stocks be a wise idea, even if you had to pay a small premium
What options does a firm have to spend its free cash flow (after it has satisfied all interest obligations)?appendix
ABC Corporation announced that it will pay a dividend to all shareholders of record as of Monday, April 2, 2012. It takes three business days of a purchase for the new owners of a share of stock to be registered.a. When is the last day an investor can purchase ABC stock and still get the dividend
Describe the different mechanisms available to a firm to use to repurchase shares.appendix
RFC Corp. has announced a $1 dividend. If RFC’s price last price cum-dividend is $50, what should its first ex-dividend price be (assuming perfect capital markets)?appendix
EJH Company has a market capitalization of $1 billion and 20 million shares outstanding. It plans to distribute $100 million through an open market repurchase. Assuming perfect capital markets:a. What will the price per share of EJH be right before the repurchase?b. How many shares will be
Suppose the board of Natsam Corporation decided to do the share repurchase in Problem 7 part ( b), but you, as an investor, would have preferred to receive a dividend payment. How can you leave yourself in the same position as if the board had elected to make the dividend payment instead?appendix
Suppose you work for Oracle Corporation, and part of your compensation takes the form of stock options. The value of the stock option is equal to the difference between Oracle’s stock price and an exercise price of $10 per share at the time that you exercise the option. As an option holder, would
The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity.Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose that other investments with equivalent risk to HNH stock offer an after-tax return of 12%.a. What is the price of
Using Table 17.2, for each of the following years, state whether dividends were tax disadvantaged or not for individual investors with a one-year investment horizon:a. 1985b. 1989c. 1995d. 1999e. 2005f. 2018 appendix
What was the effective dividend tax rate for a U.S. investor in the highest tax bracket who planned to hold a stock for one year in 1981? How did the effective dividend tax rate change in 1982 when the Reagan tax cuts took effect? (Ignore state taxes.)appendix
The dividend tax cut passed in 2003 lowered the effective dividend tax rate for a U.S. investor in the highest tax bracket to a historic low. During which other periods in the last 35 years was the effective dividend tax rate as low?appendix
You purchased CSH stock for $40 one year ago and it is now selling for $50. The company has announced that it plans a $10 special dividend. You are considering whether to sell the stock now, or wait to receive the dividend and then sell.a. Assuming 2008 tax rates, what ex-dividend price of CSH will
At current tax rates, which of the following investors are most likely to hold a stock that has a high dividend yield:a. individual investors,b. pension funds,c. mutual funds,d. corporations appendix
Que Corporation pays a regular dividend of $1 per share. Typically, the stock price drops by$0.80 per share when the stock goes ex-dividend. Suppose the capital gains tax rate is 20%, but investors pay different tax rates on dividends. Absent transactions costs, what is the highest dividend tax
A stock that you know is held by long-term individual investors paid a large one-time dividend.You notice that the price drop on the ex-dividend date is about the size of the dividend payment.You find this relationship puzzling given the tax disadvantage of dividends. Explain how the
Assume capital markets are perfect. Kay Industries currently has $100 million invested in shortterm Treasury securities paying 7%, and it pays out the interest payments on these securities each year as a dividend. The board is considering selling the Treasury securities and paying out the proceeds
Redo Problem 22, but assume that Kay must pay a corporate tax rate of 35%, and investors pay no taxes.appendix
Harris Corporation has $250 million in cash, and 100 million shares outstanding. Suppose the corporate tax rate is 35%, and investors pay no taxes on dividends, capital gains, or interest income. Investors had expected Harris to pay out the $250 million through a share repurchase.Suppose instead
Redo Problem 22, but assume the following:a. Investors pay a 15% tax on dividends but no capital gains taxes or taxes on interest income, and Kay does not pay corporate taxes.b. Investors pay a 15% tax on dividends and capital gains, and a 35% tax on interest income, while Kay pays a 35% corporate
Use the data in Table 15.3 to calculate the tax disadvantage of retained cash in the following:a. 1998b. 1976 appendix
Explain under which conditions an increase in the dividend payment can be interpreted as a signal of the following:a. Good newsb. Bad news appendix
Berkshire Hathaway’s A shares are trading at $120,000. What split ratio would it need to bring its stock price down to $50?appendix
Suppose the stock of Host Hotels & Resorts is currently trading for $20 per share.a. If Host issued a 20% stock dividend, what will its new share price be?b. If Host does a 3:2 stock split, what will its new share price be?c. If Host does a 1:3 reverse split, what will its new share price
Explain why most companies choose to pay stock dividends (split their stock).appendix
When might it be advantageous to undertake a reverse stock split?appendix
After the market close on May 11, 2001, Adaptec, Inc., distributed a dividend of shares of the stock of its software division, Roxio, Inc. Each Adaptec shareholder received 0.1646 share of Roxio stock per share of Adaptec stock owned. At the time, Adaptec stock was trading at a price of $10.55 per
Explain whether each of the following projects is likely to have risk similar to the average risk of the firm.a. The Clorox Company considers launching a new version of Armor All designed to clean and protect notebook computers.b. Alphabet, Inc., plans to purchase real estate to expand its
Suppose Caterpillar, Inc., has 530 million shares outstanding with a share price of $218.75, and $38 billion in debt. If in three years, Caterpillar has 650 million shares outstanding trading for $230 per share, how much debt will Caterpillar have if it maintains a constant debt-equity
In 2022, Costco Wholesale Corporation had a market capitalization of $238 billion, debt of$6.5 billion, cash of $12 billion, and EBIT of about $8 billion. If Costco were to increase its debt by $1 billion and use the cash for a share repurchase, which market imperfections would be most relevant for
Acort Industries has 10 million shares outstanding and a current share price of $40 per share.It also has long-term debt outstanding. This debt is risk free, is four years away from maturity, has annual coupons with a coupon rate of 10%, and has a $100 million face value. The first of the remaining
Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 25%, and a debt-equity ratio of 2.6. Suppose Goodyear maintains a constant debt-equity ratio.a. What is Goodyear’s WACC?b. What is Goodyear’s unlevered
You are a consultant who was hired to evaluate a new product line for Markum Enterprises. The up-front investment required to launch the product line is $10 million. The product will generate free cash flow of $750,000 the first year, and this free cash flow is expected to grow at a rate of 4% per
Consider Alcatel-Lucent’s project in Problem 6.a. What is Alcatel-Lucent’s unlevered cost of capital?b. What is the unlevered value of the project?c. What are the interest tax shields from the project? What is their present value?d. Show that the APV of Alcatel-Lucent’s project matches the
Consider Alcatel-Lucent’s project in Problem 6.a. What is the free cash flow to equity for this project?b. What is its NPV computed using the FTE method? How does it compare with the NPV based on the WACC method?Appendix

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