FIN-3403 Lecture Notes - Lecture 12: United States Treasury Security, Risk Premium, Systematic Risk
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Instructions: Use the formula below to compute the problems: “Please Read the question carefully.”
Kd = Yield (1 – T)
1. Telecom Systems can issue debt yielding 8 percent. The company is in a 35 percent bracket. What is its after-tax cost of debt?
2. After-tax cost of debt: Royal Jewelers Inc., has an aftertax cost of debt of 6 percent. With a tax rate of 40 percent, what can you assume the yield on the debt is?
3.
Cash flow: Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below.
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
4.
Cost of preferred stock: Medco Corporation can sell preferred stock for $80 with an estimated flotation cost of $3. It is anticipated the preferred stock will pay $6 per share in dividends.
a. Compute the cost of preferred stock for Medco Corp.
b. Do we need to make a tax adjustment for the issuing firm?
5. Cost of preferred stock: The Meredith Corporation issued $100 par value preferred stock 10 years ago. The stock provided an 8 percent yield at the time of issue. The preferred stock is now selling for $75. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)
6. Costs of retained earnings and new common stock: Barton Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D1) of $1.20 per share, and the current price of its common stock is $30 per share. The expected growth rate is 9 percent.
a. Compute the cost of retained earnings (Ke). Use Formula 11-6.
b. If a $2 flotation cost is involved, compute the cost of new common stock (Kn). Use Formula 11-7.
7. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (Kp= D/Po+ g).
8. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.
a. True
b. False
9. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.
a. True
b. False
10. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.
a. True
b. False
11. You have the following data on three stocks:
| Stock | Standard Deviation | Beta |
| A | 20% | 0.59 |
| B | 10% | 0.61 |
| C | 12% | 1.29 |
If you are a strict risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.
a. A; A.
b. A; B.
c. B; A.
d. C; A.
e. C; B.
12. A portfolio’s risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
a. True
b. False
13. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?
a. The price of Bond B will decrease over time, but the price of Bond A will increase over time.
b. The prices of both bonds will remain unchanged.
c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.
d. The prices of both bonds will increase by 7% per year.
e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
14. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
a. If market interest rates decline, the price of the bond will also decline.
b. The bond is currently selling at a price below its par value.
c. If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.
d. The bond should currently be selling at its par value.
e. If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.
15. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
e. 6.28%
16. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%
17. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
18. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?
a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.
b. The discount rate increases.
c. The riskiness of the investment’s cash flows decreases.
d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.
e. The discount rate decreases.
19. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk premium.
e. The expectations theory cannot hold if inflation is decreasing.
20. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.
a. True
b. False
Question 5
The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly.
| True |
| False |
Question 6.
In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.
| True |
| False |
Question 7
Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage bonds are backed by assets while debentures are unsecured.
| True |
| False |
Question 8
If two firms have the same current dividend and the same expected growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium.
| True |
| False |
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Question 9
Which of the following is the best measure of the wealth of a firm's stockholders?
| The firm's Net Income during the past year |
| Expected Earnings per Share during the coming year |
| Book Value (or Net Worth) as recorded on the balance sheet |
| The price of the firm's stock on the open market |
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Question 10
Consider the following firms:
| Net Income | Stock Price at | Stock Price at | |
| this year | Beg of Year | End of Year | |
| Firm A: | $10,000,000 | $20 | $10 |
| Firm B: | $(10,000,000) | $10 | $20 |
| The manager of Firm A is doing a better job than B |
| The manager of Firm B is doing a better job than A |
| Neither manager is doing a good job |
| Both managers are doing a good job |
Question 11
A company has the following income statement. What is its net operating profit after taxes (NOPAT)?
Sales $1,000
Costs 700
Depreciation 100
EBIT $ 200
Interest expense 50
EBT $ 150
Taxes (40%) 60
Net income $ 90
| $ 90 |
| $120 |
| $150 |
| $180 |
| $200 |
Question 12
Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6 percent, and Carter's marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would make Carter's treasurer indifferent between the two?
| 2.40% |
| 3.60% |
| 4.50% |
| 5.25% |
| 6.00% |
Question 13
If a firm's current ratio is less than 1.0, it indicates that:
| The firm had negative net income for the year |
| The firm will be unable to pay its shortterm loans which come due this year |
| Current Assets are less than Current Liabilities |
| The firm is insolvent |
Question 14
A firm which has a relatively large amount of cash and receivables in its current assets accounts and a relatively small amount of current liabilities would be considered:
| liquid |
| profitable |
| risky |
| nuts |
Question 15
In November 2011 you bought 100 shares of Microsoft stock for $35.375 a share. In November 2013 you sold your stock for $92.5625 a share. What was your average annual rate of return on your Microsoft investment? (disregard dividends and commissions)
| 262% |
| 62% |
| 585% |
| 1.6% |
Question 16
You deposit $2,000 in a savings account that pays 10 percent interest, compounded annually. How much will your account be worth in 15 years?
| $2,030.21 |
| $5,000.00 |
| $8,091.12 |
| $8,354.50 |
| $9,020.10 |
Question 17
You can earn 8 percent interest, compounded annually. How much must you deposit today to withdraw $10,000 in 6 years?
| $5,402.69 |
| $6,301.70 |
| $6,756.76 |
| $8,432.10 |
| $9,259.26 |
Question 18
Calculate the required rate of return for Mercury, Inc., assuming that the real rate of interest is 3 percent, investors expect a 5 percent rate of inflation in the future, and they expect the rate of return on the overall stock market to be 13 percent. Mercury has a beta of 2.0.
| 15% |
| 16% |
| 17% |
| 18% |
| None of the above |
Question 19
Which is the best measure of risk for an asset held in isolation? Which is the best measure for an asset held in a diversified portfolio?
| Variance; correlation coefficient |
| Standard deviation; correlation coefficient |
| Beta; variance |
| Coefficient of variation; beta |
| Beta; beta |
Question 20
You have three stocks in your portfolio. $10,000 is invested in a stock with a beta of 1.50 and $15,000 is invested in a stock with a beta of 1.00, and $25,000 is invested in a stock with a beta of 0.50. What is the beta of your portfolio?
| 0.28 |
| 0.85 |
| 1.00 |
| 3.00 |
Question 21
A corporate bond with a $1,000 face value pays a $50 coupon every six months. The bond will mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the bond?
| $ 634.86 |
| $1,064.18 |
| $1,065.04 |
| $1,078.23 |
| $1,094.56 |
Question 22
The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20 percent, what should be the stock's market value?
| $150 |
| $100 |
| $ 50 |
| $ 25 |
| $ 10 |
Question 23
A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15 percent, and if investors require a 19 percent rate of return, what is the price of the stock?
| $57.50 |
| $62.25 |
| $71.86 |
| $64.00 |
| $44.92 |
Question 24
A stock is not expected to pay a dividend over the next four years. Five years from now, the company anticipates that it will establish a dividend of $1.00 per share (i.e., D5 = $1.00). Once the dividend is established, the market expects that the dividend will grow at a constant rate of 5 percent per year forever. The risk-free rate is 5 percent, the company's beta is 1.2, and the market risk premium is 5 percent. The required rate of return on the company’s stock is expected to remain constant. What is the current stock price?
| $ 7.36 |
| $ 8.62 |
| $ 9.89 |
| $10.98 |
| $11.53 |
