Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a U.S.-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable "pure-play" companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the U.S. NASDAQ. The debt ratio of the industry has risen slightly in recent years.

 

Company	Sales (in millions)	Market Value Equity (in millions)	Market Value Debt (in millions)	Equity Beta	Tax Rate	Share Price
Relevant   Ltd.	$752	$3,800	$0.0	1.702	23%	$42
ABJ,   Inc.	$843	$2,150	$6.5	2.800	23%	$24
Opus   Software Pvt.   Ltd.	$211	$972	$13.0	3.400	23%	$13

 

Duarte uses the information from the preliminary prospectus for TagOn's initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12.  The current capital structure of TagOn consists of a $2.4 million five-year non-callable bond issue and 1 million common shares.  The $2.4 million face value non-callable bond issue has a coupon rate of 12.5 percent, and a current market value of $2.156 million.  The risk-free rate is assumed to be 5.25% and the estimated equity risk premium is 7%.  The tax rate for TagOn is 23%.

 

16. The asset betas for Relevant, ABJ, and Opus, respectively, are: 

a. 1.70, 2.52, and 2.73. 

b. 1.70, 2.79, and 3.37. 

c. 1.70, 2.81, and 3.44. 

 

17. The average asset beta for the pure players in this industry, Relevant, ABJ, and Opus, weighted by market value of equity is closest to: 

 

a. 1.67. 

b. 1.97. 

c. 2.27. 

 

 

18. Using the capital asset pricing model, the cost of equity capital for a company in this industry with a debt-to-equity ratio of 0.01, asset beta of 2.27, and a marginal tax rate of 23% is closest to: 

 

a. 17%. 

b. 21%. 

c. 24%. 

 

 

 

 

 

19. The marginal cost of capital for TagOn, based on an average asset beta of 2.27 for the industry and assuming that new stock can be issued at $8 per share, is closest to: 

 

a. 20.5%. 

b. 21.0%. 

c. 21.5%. 

 

 

20. Two years ago, a company issued $20 million in long-term bonds at par value with a coupon rate of 9%. The company has decided to issue an additional $20 million in bonds and expects the new issue to be priced at par value with a coupon rate of 7%. The company has no other debt outstanding and has a tax rate of 40%. To compute the company's weighted average cost of capital, the appropriate after-tax cost of debt is closest to: 

 

a. 4.2%. 

b. 4.8%. 

c. 5.4%. 

 

 

21. An analyst gathered the following information about a company and the market:

 The current market price per share of common stock is $28.00
 The most recent dividend per share paid on common stock (D₀) was $2.00 per share
 The expected dividend payout rate is 40%
 The expected return on equity (ROE) is 15%
 The beta for the common stock is 1.3
 The expected rate of return on the market portfolio is 13%
 The risk-free rate of return is 4%

 Using the capital asset pricing model (CAPM) approach, the cost of retained earnings for the company is closest to: 

 

a. 13.6%. 

b. 15.7%. 

c. 16.1%. 

 

 

 

 

22. An analyst gathered the following information about a private company and its publicly traded competitor:

Comparable   Companies	Tax Rate	Debt/Equity	Equity Beta
Private   Company	30%	1.00	N.A.
Public   Company	35%	0.90	1.75

 Using the pure-play method, the estimated equity beta for the private company is closest to: 

 

a. 1.029. 

b. 1.104. 

c. 1.877. 

 

 

23. If investors have homogeneous expectations, the market is efficient, and there are no taxes, no transactions costs, and no bankruptcy costs, the Modigliani and Miller Proposition I states that: 

 

a. bankruptcy risk rises with more leverage. 

b. managers cannot change the value of the company by using more or less debt. 

c. managers cannot increase the value of the company by employing tax saving strategies. 

 

 

24. According to Modigliani and Miller's Proposition II without taxes: 

 

a. the capital structure decision has no effect on the cost of equity. 

b. investment and the capital structure decisions are interdependent. 

c. the cost of equity increases as the use of debt in the capital structure increases. 

 

 

25. Suppose the weighted average cost of capital of the Gadget Company is 10%. If Gadget has a capital structure of 50% debt and 50% equity, a before-tax cost of debt of 5%, and a marginal tax rate of 20%, then its cost of equity capital is closest to: 

 

a. 12%. 

b. 14%. 

c. 16%. 

 

26. The current weighted average cost of capital (WACC) for Van der Welde is 10%. The company announced a debt offering that raises the WACC to 13%. The most likely conclusion is that for Van der Welde: 

 

a. the company's prospects are improving. 

b. equity financing is cheaper than debt financing. 

c. the company's debt/equity ratio has moved beyond the optimal range. 

 

 

27. According to the static trade-off theory: 

 

a. debt should be used only as a last resort. 

b. companies have an optimal level of debt. 

c. the capital structure decision is irrelevant. 

Answer rating: 100% (QA)

16 b 170 279 and 344 The asset betas for Relevant ABJ and Opus are 170 279 and 344 respectively This can be determined by looking at the data provided 17 c 227 The average asset beta for the pure play... View the full answer