QUESTIONS

1.West intends to adjust Taylor's beta estimates slightly downward in view of the fact that the firm's degree of operating leverage is decreasing. Does such an adjustment seem appropriate? Explain.

2.The required return on equity (cost of equity), K_e, can be estimated in a number of ways.

(a)Estimate K using a risk premium approach.

(b)Use the dividend valuation model to estimate K_e.

(c)In your view, what is K_e? Justify your choice.

3.Estimate Taylor's cost of capital or required rate of return. (You may use book values in your calculations. Assume the existing capital structure is optimal and ignore preferred stock. The relevant tax rate is 40 percent.)

4.Preferred stock is a riskier investment than a bond. Yet companies have been known to issue preferred stock at a lower yield than they issue bonds. How can this be, assuming investors are rational?

5.(a) Estimate the cost of preferred stock (required return of preferred

stock).

(b) Redo question 3 including preferred stock as a financing source, and

assume the target weights are as follows: notes, 5 percent; bonds, 40

percent; preferred, 5 percent; equity, 50 percent.

6.What additional information would you like in order to make more informed estimates about the cost of equity and the cost of preferred stock?

7.(a) What would you guess is the market value of the firm's notes payable?

Explain.

(b) Taylor has onc long-terin debt security outstanding with a coupon rate

of 7 percent. It is a debenture issue maturing in 10 years, and interest

is paid semiannually. Determine the debenture's current market value

assuming that all principal will be paid in 10 years. Assume also that

the bond's semiannual required return is 4 percent.

(c)The MV/BV ratio is 1.15. Calculate the market value of Taylor's stock.

(d)Estimate Taylor's cost of capital or required return assuming that these market values are consistent with the financing weights desired by management. You may ignore preferred stock.)

8.(a) Argue for using market values to determine a firm's required return

(cost of capital).

(b) Argue for using book values.

9.(a) Apparently the 30 percent hurdle rate used by Taylor exceeds its

actual cost of capital or required rate of return. Let us suppose a

company errs inthe other direction and chooses a hurdle rate considerably less

than its actual cost of capital. What difficulties could this cause?

(b) West believes that Taylor's high cost of capital encourages managers to

develop overly optimistic cash flow forecasts. Is a more accurate cost- of

capital estimate likely to reduce this bias, as he apparently thinks?

Explainyour answer.

10. (a) Suppose that West will present a summary of his findings to senior

management. Would you recommend that he present his estimate of

Taylor's required return (cost of capital) as XX percent, XX.X percent,

orXX.XX percent? That is, how-if at allwould you suggest the

estimate be rounded off? (Keep in mind that he is likely to be

questioned thoroughly by Unruh, who appears skeptical of West's

efforts.)

(b) Would you recommend that West use market or book values in his

presentation? Defend your recommendation.

Help me to get the answer for question 5,6,10