Personal Finance Quiz 9

You recently purchased a stock that is expected to earn 12% in a booming economy, 8% in a normal economy and lose 5% in a recessionary economy. There is a 15% probability of a boom, a 75% chance of a normal economy, and a 10% chance of a recession. What is your expected rate of return on this stock?

11. What is the Cost of Equity? ke = Risk Free Rate + (Beta X Risk Premium of 7.5% points). .03 + (.99 x .075) = 10.43%.

E. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2010. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2010. Estimate the market value-based weighted average cost of capital for Castillo Products.

9. You want to purchase a business with the following cash flows. How much would you pay for this business today assuming you needed a 14% return to make this deal?

-Martin Industries just paid an annual dividend of $1.30 a share. The market price of the stock is $36.80 and the growth rate is 6.0 percent. What is the firm's cost of equity?

a. What risk-free rate and risk premium did you use to calculate the cost of equity?

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

Comments from teacher: In question 1, why do we use these equitation’s, explain and show then, i.e. ROE can go up with more leverage. More on comparables. In Q1 assumptions explained, that are then used in DCF. Max for question 1 and 2, two pages. Must power to put in Q3. Deduct tax in table 3. In DCF, show more how calculated and assumption missing about other income and corporate expenses. Table 6 to be fixed (already been done). Skip in DCF advantage and disadvantage. Do table 4 different, use Exhibit 11, value range, use median value and calculate enterprise value with multiples en deduct net debt 318,5 and get equity value. Explain better in main text footnote 12. . Use

1. Which of the following statements about finance, accounting, and financial management is most correct?

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated

• Step 6: You will now want to consider the impact of each form of financing on the firm. How does the form of financing impact the company’s debt ratios, EPS, ROE, etc.?

3. The expected return for each firm was calculated: Expected Return = Alpha + (Beta x BSE 500 actual return).

3. Calculate the cost of equity capital using the CAPM, assuming a market risk premium of 5%.

6. Yes, we think that it is better for the society if companies use debt. This allows people who have extra funds and need to invest it to earn interest revenue on their funds. Debt is generally less risky than equity investing because as we know debt has certain maturity date and

The company earns 5 percent on current assets and 15 percent on fixed assets. The firm's current liabilities cost 7 percent to maintain and the average annual cost of long-term funds is 20 percent. a) The firm's initial net working capital is ________. [Numerical Answer] b) The firm's initial annual profits on total assets are ________. [Numerical Answer] c) If the firm was to shift $3,000 of current assets to fixed assets, the firm's net working capital would ________, the annual profits on total assets would ________, and the risk of technical insolvency would ________, respectively. [Choose either the word increase or decrease for each blank] d) If the firm was to shift $7,000 of fixed assets to current assets, the