FIN 300 Lecture Notes - Lecture 10: Bmo Nesbitt Burns, Dividend Yield, Efficient-Market Hypothesis
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Which of the following risks cannot be diversified away?
| A. | risk of a local natural disaster affecting company production | |
| B. | risk created by world political happenings | |
| C. | risk of losing a major contract | |
| E. | risk of a failed marketing campaign |
Magee Company's stock has a beta of 1.20, the risk-free rate is 4.50%, and the market risk premium is 5.00%. What is Magee's required return?
| A. | 10.25% | |
| B. | 10.50% | |
| D. | 11.00% | |
| E. | 11.25% |
Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)
| A. | When held in isolation, Stock A has more risk than Stock B. | |
| C. | Stock A would be a more desirable addition to a portfolio than Stock B. | |
| D. | The required return on Stock A will be greater than that on Stock B. | |
| E. | The required return on Stock B will be greater than that on Stock A. |
Which of the following statements is CORRECT?
| B. | Portfolio diversification reduces the variability of returns on an individual stock. | |
| C. | The smaller standard deviation is, the less likely that actual returns will be closer to expected returns, the lower the investment risk. | |
| D. | A stock with a beta of 1 is more risky than an average stock on the market. | |
| E. | A well-diversified investor will require to earn higher return on stocks with higher beta. |
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? (WACC is the weighted average cost of capital, the financing rate, or discount rate)
| A. | The projectâs IRR increases as the WACC declines. | |
| B. | The projectâs NPV increases as the WACC declines. | |
| D. | The projectâs IRR decreases as the WACC declines. | |
| E. | none of the above is correct. |
Burlees Inc.âs CFO has collected the following information to calculate its WACC:
⢠The companyâs capital structure consists of 60% debt and 40% common stock.
The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.
The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.
The companyâs tax rate is 40%.
What is the companyâs cost of common equity?
| A. | 9.65% | |
| B. | 13.00% | |
| D. | 17.60% | |
| E. | 18.91% |
Burlees Inc.âs CFO has collected the following information to calculate its WACC:
⢠The companyâs capital structure consists of 60% debt and 40% common stock.
The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.
The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.
The companyâs tax rate is 40%.
What is the companyâs weighted average cost of capital (WACC)?
| A. | 8.69% | |
| B. | 9.21% | |
| D. | 11.04% | |
| E. | 12.51% | |
Which of the following statement is correct?
| A. | Higher flotation costs tend to reduce the cost of equity capital. | |
| C. | The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest. | |
| D. | A higher risk projectâs WACC should be adjusted higher. | |
| E. | Retained earnings bear no capital cost at all. |
You recently graduated from Suffolk University, and your job search led you to J&J Bagel, Inc. As you are finishing your employment paperwork, Jerry Chen, one of the co-owners of J&J Bagel, informs you about the companyâs new 401(k) plan. A 401(k) is a type of retirement plan, offered by many companies.
A 401(k) is tax deferred, which means that any deposits you make into the plan are deducted from your current income, so no current taxes are paid on these deposits. For example, if your annual salary is $30,000 and you contribute $1,500 to the 401(k) plan, you will pay taxes only on the $28,500 in income. No taxes will be due on any capital gains or plan income while you are invested in the plan, but you will pay taxes when you withdraw the money at retirement. You can contribute up to 15 percent of your salary to the plan. As is common, J&J Bagel has a 5 percent match program. This means that the company will match your contribution dollar-for-dollar up to 5 percent of your salary, but you must contribute to get the match. In other words, if you contribute 5 percent of your $30,000 salary (which is $1,500) towards the 401(k) plan, J&J Bagel will match your contribution by adding another $1,500 to your plan, so that $3,000 in total will be contributed to your 401(k) plan.
The 401(k) plan has several options for investments, most of which are mutual funds. As you know, a mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fundâs assets, similar to purchasing shares of stock in a company. The return of the fund is the weighted average of the return of the assets owned by the fund, minus expenses. The largest expense is typically the management fee paid to the fund managers, who make all of the investment decisions for the fund. J&J Bagel uses Imperium Financial Services as its 401(k) plan administrator.
Jerry Chen then explains the following retirement investment options available for employees:
Company Stock. One option is stock in J&J Bagel. The company is currently privately held. The price you would pay for the stock is based on an annual appraisal, less a 20 percent discount. When you are interviewed by the owners, John Benson and Jerry Chen, they informed you that the company stock was expected to be publically sold in three to five years. If you needed to sell the stock before it became publicly traded, the company would buy it back at the then-current appraised value.
Imperium S&P 500 Index Fund. This mutual fund tracks the S&P 500 Index. Stocks in the fund are weighted exactly the same as they are in the S&P 500 Index. This means that the fundâs return is approximately the return of the S&P 500 Index, minus expenses. With an index fund, the manager is not required to research stocks and make investment decisions, so fund expenses are usually low. The Imperium S&P 500 Index Fund charges expenses of 0.20 percent of assets per year.1
Imperium Small-Cap Fund. This fund primarily invests in small capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside of the U.S. This fund charges 1.7 percent of assets in expenses per year.
Imperium Large-Cap Fund. This fund invests primarily in large capitalization stocks of companies based in the U.S. The fund is managed by Jenna King and has outperformed the market in six out of the last eight years. The fund charges 1.5 percent in expenses.
Imperium Bond Fund. This fund invests in long-term corporate bonds issued by U.S. companies. The fund is restricted to investments in bonds with investment grade credit rating. This fund charges 1.4 percent in expenses.
Imperium Money Market Fund. This fund invests in short-term, high credit quality debt instruments, which include Treasury Bills. As such, the return on money market funds is only slightly higher than the return on Treasury Bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges 0.60 percent in expenses.
*1 The return on a mutual fund after accounting for management expenses is calculated as follows. If a fund charges 2 percent in expenses and it is expected to yield a 10 percent return before expenses, then the return on this fund after expenses will be (1 + 0.10)Ã(1 â 0.02) â 1 = 0.078 or 7.8 percent*
QUESTIONS
1. advantages/disadvantages do the mutual funds offer compared to company stock for your retirement investing?
2. One can assess investment risk by looking forward to how assets are expected to react to a particular set of circumstances or âstates of economyâ. Use the following set of assumptions for the coming year to compute the expected rates of return (before expenses) and the standard deviations for the mutual funds described above.
| Probability | S&P 500 index fund | Small-cap fund | large-cap fund | Bondfund | moneymarketfund | |
|---|---|---|---|---|---|---|
| Recession | 20% | -12% | -30% | -10% | 18% | 2% |
| Near Recession | 10% | -8% | -20% | -6% | 14% | 3% |
| Normal | 30% | 12% | 22% | 12% | 8% | 4% |
| Near Boom | 20% | 22% | 38% | 15% | -1% | 5% |
| Boom | 20% | 26% | 54% | 20% | -6% | 6% |
3. Given the expected returns calculated for each of the mutual funds above, estimate the betas of these funds. Assume a risk-free rate of 4 percent and the expected market return equal to the expected return on the S&P 500 Index.
4. If you decide to invest your money equally in the Small-Cap and Bond funds, what would your portfolioâs expected return and risk level (standard deviation and beta) be? (Hint: Adjust mutual fund returns for management expenses as explained in footnote 1.
5. What would happen if you were to put 70 percent of your portfolio in the Small-Cap fund and 30 percent in the S&P 500 Index fund? Would this combination be better for you?
6. The returns of the Imperium Small-Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund?
