es the project with new debt or new equity. (b) _____ You are thinking about investing in either stock A or stock B. Both stocks have an expected return of 12%, but stock A has a standard deviation of 25% annually and stock B has a standard deviation of 35% an
. True or false? Briefly explain.
(a) _____ Your firm has the opportunity to invest $20 million in a new project. The interest rate on the
firm’s debt is 7% and the
whether the firm finances the project with new debt or new equity.
(b) _____ You are thinking about investing in either stock A or stock B. Both stocks have an expected
return of 12%, but stock A has a standard deviation of 25% annually and stock B has a
standard deviation of 35% annually. You should invest in stock A since it is less risky.
(c) _____ Your firm currently has a debt-to-equity ratio of 10%: debt = $50 million and equity = $500
million (market values). The interest rate on the firm’s debt (rD) is 8% and the cost of equity
(rE) is 13%. Since the cost of debt rD is lower than the cost of equity rE, the firm can lower its
overall cost of capital by borrowing more. Ignore taxes.
(d) _____ Your firm had a terrific year. You will soon announce that annual EPS is $0.10 above your
earlier
reaction, you have gathered data on all firms with positive earnings surprises last year: Cumulative return
10%
8%
6%
4%
2%
0%
-2%
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50
Day 0 = announcement
This plot is consistent with an
1
60
2. Your firm currently supplies audio equipment to car manufacturers. You are thinking about
expanding into the home retail market, selling high-quality stereo components directly to consumers.
Describe how you would estimate the cost of capital for this expansion. Specifically, what
information do you need and how you would estimate it?
3. You work for Microsoft. Your boss, Steve Ballmer, asks you to evaluate the firm’s capital structure.
Microsoft currently has a market value of $200 billion and no long-term debt outstanding. You
forecast that the firm will earn $10 billion next year and will generate cashflows of $8 billion after all
investments have been made. The forecasts are accurate to within +/– $1.2 billion. The firm’s
marginal tax rate is 40%.
(a) Microsoft is thinking about issuing $30 billion in public bonds. It will use the proceeds from the
sale to repurchase equity. How will this transaction affect the riskiness of the firm’s equity?
Why?
(b) If Microsoft is similar to other firms that have a leverage recapitalization, how will the stock
market react to this transaction? Why does the market react this way?
(c) The interest rate on the new debt is 7% and Microsoft plans to roll-over this debt in perpetuity
(sell new debt when the old debt matures). How much does the debt add to Microsoft’s value?
Be precise.
(d) Microsoft currently has a 14% cost of capital. After the leverage recapitalization, will Microsoft’s
cost of capital be higher, lower, or the same? Why?
2
4. Your firm, Cambridge Entertainment (CE), has two distinct operating divisions. The first division,
which represents 60% of market value, is a traditional publishing company (magazines, books, etc.).
The second division, which represents 40% of market value, owns a large collection of TV and radio
stations broadly dispersed around the U.S. Your boss asks you to evaluate the firm’s cost of capital.
You have collected the following information about the firm and its main competitors:
Firm Debt / (Debt + Equity) rD Equity β
CE 0.25 0.08 1.3
Publishing firms 0.25 0.08 1.1
Broadcasting firms 0.25 0.08 1.6
The tax rate is 40%, the Tbill rate is 6%, and the market risk premium is 5%.
(a) If the
(b) CE has the opportunity to buy a small publishing company. The acquisition is expected to
generate cashflows of $12 million in the first year, with annual growth of 4%. CE will finance the
acquisition entirely with equity, but the deal will have a negligible effect on the firm’s overall
capital structure (D/V will remain at 25%). How much should CE be willing to pay for the
acquisition?
5. Suppose the stock and bond markets are efficient.
(a) What implication does market efficiency have for your personal investment decisions?
(b) What implication does market efficiency have for your firm’s financing decisions
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