Q: Galt Industries has a market capitalization of $$50 billion, 30 $$billion in debt, and $8 billion in cash. If Galt's equity beta is 1.15 and the debt beta is 0.10, what is the formula for calculating the asset beta, and what is Galt's asset beta closest to?

Asset beta is calculated as $$\frac{E}{E+D} \times \beta_{equity} + \frac{D}{E+D} \times \beta_{debt}$$, and Galt's asset beta is closest to 0.92.

Q: Using the Capital Asset Pricing Model (CAPM), what is the formula for the equity cost of capital, and what is the equity cost of capital for 'Miney' (beta = 1.05, risk-free rate = 3%, market return = 9%)?

The formula is $$r_e = r_f + \beta \times (r_m - r_f)$$, and Miney's equity cost of capital is 9.30%.

Q: A corporate bond with a B rating has an average default rate of 5.2%. If the yield to maturity is 8.6%, the risk-free rate is 3%, and the market risk premium is 6%, what is the expected return on the bond in a normal economy?

Expected return is $$8.6\% - 5.2\% \times 8.6\% = 4.6\%.$$

Q: A project requires an $$80,000 initial investment and will generate 90$$,000 in a weak economy or $$117,000 in a strong economy, each equally likely. If the firm borrows 80$$,000 at the risk-free rate (5%), what is the cash flow to equity holders in a strong economy after repaying the loan?

Cash flow to equity holders is $$117,000 - 80,000 \times 1.05 = 33$$,000.

Q: Rosewood Industries has EBIT of $$450 million, interest expense of 175 $$million, and a corporate tax rate of 35%. What is the formula for net income, and what is the total of Rosewood's net income and interest payments?

Net income is $$(EBIT - Interest) \times (1 - Tax Rate)$$, so total is $$[(450M$$ - $$175M) \times 0.65] + 175M$$ = $355M.

Q: Wyatt Oil issued $100 million in perpetual debt with an annual coupon of 7%. If Wyatt's marginal tax rate is 40%, what is the formula for the annual interest tax shield, and what is its value?

Annual interest tax shield is $$\text{Interest} \times \text{Tax Rate} = 7\% \times 100M \times 0.40 = 2.8M.$$

Question 1

Galt Industries has a market capitalization of $$50 billion, 30 $$billion in debt, and $8 billion in cash. If Galt's equity beta is 1.15 and the debt beta is 0.10, what is the formula for calculating the asset beta, and what is Galt's asset beta closest to?

Accepted Answer

Asset beta is calculated as $$\frac{E}{E+D} 	imes \beta_{equity} + \frac{D}{E+D} 	imes \beta_{debt}$$, and Galt's asset beta is closest to 0.92.

Question 2

Given the following firm volatilities and betas: Eenie (0.45, 20%), Meenie (0.75, 18%), Miney (1.05, 35%), Moe (1.20, 25%), which firm has the most total risk, and what is the difference between total risk and market risk?

Accepted Answer

Miney has the most total risk. Total risk is measured by volatility, while market risk is measured by beta.

Question 3

Using the Capital Asset Pricing Model (CAPM), what is the formula for the equity cost of capital, and what is the equity cost of capital for 'Miney' (beta = 1.05, risk-free rate = 3%, market return = 9%)?

Accepted Answer

The formula is $$r_e = r_f + \beta 	imes (r_m - r_f)$$, and Miney's equity cost of capital is 9.30%.

Question 4

A corporate bond with a B rating has an average default rate of 5.2%. If the yield to maturity is 8.6%, the risk-free rate is 3%, and the market risk premium is 6%, what is the expected return on the bond in a normal economy?

Accepted Answer

Expected return is $$8.6\% - 5.2\% 	imes 8.6\% = 4.6\%.$$

Question 5

Nielson Motors has a BB debt rating. Based on the provided table, what is the estimated debt beta for Nielson Motors?

Accepted Answer

Debt beta is closest to 0.17.

Question 6

A project requires an $$80,000 initial investment and will generate 90$$,000 in a weak economy or $$117,000 in a strong economy, each equally likely. If the firm borrows 80$$,000 at the risk-free rate (5%), what is the cash flow to equity holders in a strong economy after repaying the loan?

Accepted Answer

Cash flow to equity holders is $$117,000 - 80,000 	imes 1.05 = 33$$,000.

Question 7

Which of the following statements about capital structure is FALSE?

Accepted Answer

The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.

Question 8

Rosewood Industries has EBIT of $$450 million, interest expense of 175 $$million, and a corporate tax rate of 35%. What is the formula for net income, and what is the total of Rosewood's net income and interest payments?

Accepted Answer

Net income is $$(EBIT - Interest) 	imes (1 - Tax Rate)$$, so total is $$[(450M$$ - $$175M) 	imes 0.65] + 175M$$ = $355M.

Question 9

Wyatt Oil issued $100 million in perpetual debt with an annual coupon of 7%. If Wyatt's marginal tax rate is 40%, what is the formula for the annual interest tax shield, and what is its value?

Accepted Answer

Annual interest tax shield is $$	ext{Interest} 	imes 	ext{Tax Rate} = 7\% 	imes 100M 	imes 0.40 = 2.8M.$$

Question 10

Rearden Metal currently has no debt and an equity cost of capital of 14%. If it increases leverage to maintain a market debt-to-value ratio of 1/2, with a debt cost of capital of 8% and a corporate tax rate of 40%, what is the formula for after-tax WACC and what is its value?

Accepted Answer

After-tax WACC is $$\frac{E}{V} r_e + \frac{D}{V} r_d (1 - T_c)$$, so $$\frac{1}{2} 	imes 14\% + \frac{1}{2} 	imes 8\% 	imes 0.6 = 10.8\%.$$

Question 11

Monsters Incorporated (MI) will have a value of $$100M, 150M$$, or $$191M next year, each equally likely. If MI has zero-coupon debt with a 125M $$face value due next year and 20% of asset value is lost in bankruptcy, what is the formula for yield to maturity, and what is the yield to maturity of MI's debt?

Accepted Answer

Yield to maturity is $$\frac{FV}{P} - 1$$, and MI's yield to maturity is closest to 13.75%.

Question 12

Wyatt Oil has assets of $$600M (70M $$cash), debt of $$250M, and 20M shares outstanding. If Wyatt Oil distributes 70M as a $$share repurchase, what is the formula for the number of shares repurchased, and how many shares will remain outstanding?

Accepted Answer

Shares repurchased = $$\frac{70M}{\frac{600M - 70M - 250M}{20M}}$$, so shares outstanding after repurchase is closest to 16.5M.

Question 13

In which years were dividends NOT tax disadvantaged, based on the historical capital gains and dividend tax rates provided?

Accepted Answer

1988 - 1990, 2003 - 2009

Question 14

Which of the following statements about agency costs and debt covenants is FALSE?

Accepted Answer

Agency costs are smallest for long-term debt.

Question 15

According to the managerial entrenchment theory of payout policy, which statement is FALSE?

Accepted Answer

Managers pay out cash only when pressured to do so by the firm's investors.

Question 16

If a firm with positive earnings faces uncertainty regarding EBIT, what is the impact of higher interest expense on the risk of exceeding EBIT, and how does growth affect optimal leverage?

Accepted Answer

Higher interest expense increases the risk that interest will exceed EBIT, and growth affects the optimal leverage ratio even for firms with positive earnings.

Question 17

Which of the following statements about financial distress and bankruptcy is FALSE?

Accepted Answer

Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy.

Question 18

Which of the following statements about leverage and managerial entrenchment is FALSE?

Accepted Answer

According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

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