Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
expand_more
expand_more
format_list_bulleted
Question
Chapter 21, Problem 2MC
1.
Summary Introduction
Case summary: The Person DL is the CEO of the Company LST has debt financing concerns. The Company LST uses temporary debt rather than permanent or long-term debt. The person wonders the reason of using debt sources for financing and its impact on the value of stocks. Due to this, the person raised some question to the assistant which was hired recently.
To determine: The value of V, s, r and WACC for firm U and L.
b.
Summary Introduction
To draw: A graph showing relationship between capital cost and leverage and also relationship between value of the firm and debt.
Expert Solution & Answer
Trending nowThis is a popular solution!
Students have asked these similar questions
Suppose the Capital Asset Pricing Model (CAPM) is valid in a market. Use CAPM to ex-
plain and answer following questions. Note: There is no relationship between each situation.
(a) Can security A exist in the market? (Hint: Security market line) If yes, compute risk
premium on security A. If not, is this security underpriced or overpriced?
Expected return
5%
Asset
Beta
Risk-free
Market
12%
1
A
15%
1.3
(b) Can security B exist in the market? (Hint: Security market line) If yes, compute risk
premium on security B. If not, is this security underpriced or overpriced?
Expected return
6%
Asset
Beta
Risk-free
Market
13%
16.5%
1
1.5
Suppose the expected cash flow can be collected from investment in security B is $1000
at time 1. And an investor thinks the beta of security B is 1.8. But the actual beta is given
in the above table. Then how much more/less (you also need to select "more" or "less") will
he offer for the firm than it is truly worth at time 0? Hint: the present value of the cash…
Instructions:
Assume the following data for two firms (U = unlevered firm) and (L = levered firm). Assume the two firms are in the same risk class when it comes to business risk. Both firms have EBIT = €1000 000. Firm U has zero debt and its required rate of return (KsU = 12%). Firm L has €2000 000 debt and pays 10% interest rate.
Based on the data provided, answer the following questions and show all your computations and interpret your results.
Find the value of unlevered (U) and levered (L) firms under zero corporate tax assumption.
Find the market value of the firm’s L’s debt and equity.
Do 1 and 2 under the assumption of corporate tax = 60%
Show your work for the following
A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)
Multiple Choice
A) 0.7
B) 0
C) 1.0
D) 1.2
Chapter 21 Solutions
Financial Management: Theory & Practice
Ch. 21 - Prob. 1QCh. 21 - Modigliani and Miller assumed that firms do not...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 - Prob. 3PCh. 21 - Prob. 4PCh. 21 - A company’s most recent free cash flow to equity...Ch. 21 - Air Tampa has just been incorporated, and its...Ch. 21 - Companies U and L are identical in every respect...Ch. 21 - Schwarzentraub Corporation’s expected free cash...
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- Assume the Capital Asset Pricing Model is true and that all securities should lie along the line created by the equation (the Security Market Line). Greg Noronha has been told the expected return on Merchants Bank is 9.75%, He knows the risk-free rate is 1.9%, the market risk premium is 6.75%, and Merchants' beta is 1.15. Based on the Capital Asset Pricing Model, Merchants Bank is: A. fairly valued. B. undervalued. C. overvalued.arrow_forward1. Assume the risk free interest rate is 3%, the market rate of return is 7% and beta for company X is 2. Given this information, the non-diversifiable risk for this company is a) 8% b) 4% c) 2 d) 6% 2. Referring to question 1, the required rate of return for the company is a) 2% b) 9% c) 8% d) 11% 3. Referring to question 1, this company has a risk that is a) Equal to the market risk b) We cannot tell c) More than the market risk d) Less than the market risk 4. Assume that you have a portfolio of two stocks, X and Y. If the risk of stock X is 1.2 and the risk of stock Y is 4, then the return on stock Y should be a) Greater than the return on Stock X b) We cannot tell c) Less than the return on stock X d) Equal to the return on stock S 5. If the portfolio in the previous question is well diversified and stocks are strongly negatively related, then the risk for the portfolio will be a) Greater than the risk of stock X (i.e. greater than 1.2) but less than the risk on stock Y(i.e less…arrow_forwardConsider the following financial market with two risky assets x and y as well as a risk-free asset f: E[r]. x (10%, 8%) •z (6.6%, 6.3%) y (8%, 5%) (0%, 3%) f Is it possible to construct portfolio z with existing assets? Explain.arrow_forward
- Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of Ls operations is 4 million (the value of its debt plus equity). Assume also that its debt consists of 1-year, zero coupon bonds with a face value of 2 million. Finally, assume that Ls volatility, , is 0.60 and that the risk-free rate rRF is 6%.arrow_forwardWithin the context of the capital asset pricing model (CAPM), assume:∙ Expected return on the market = 15%∙ Risk-free rate = 8%∙ Expected rate of return on XYZ security = 17%∙ Beta of XYZ security = 1.25Which one of the following is correct?a. XYZ is overpriced.b. XYZ is fairly priced.c. XYZ’s alpha is −.25%.d. XYZ’s alpha is .25%. Please explain in detail the calculationarrow_forwardAnswer the following a) When will the different DCF methods use the same discount rate? b) The cost of debt (ka) will change as the capital structure of a firm changes. Why or why not? c) Why does the cost of equity (k.) increase as the amount of debt in the capital structure of a firm increases? Why? d) Freebie Inc.'s common stock has a beta of 1.3. If the risk-free rate is 4.5% and the expected return on the market is 12%, what is its cost of equity capital? e) Why do branded food companies command the highest EBIT multiple (about 8) and transportation companies the lowest (about 3)? f) Should a firm use its cost of capital as a hurdle/discount rate to value all internal divisions? Why or why not? g) An option can have more than one source of value. Consider a mining company. The company can mine for ores today or wait another year (or more) to mine. What real options can you identify here? h) Do you consider dividend payments by the firm in calculating cash flows? Why or why not? i)…arrow_forward
- A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)arrow_forwardAssume that security returns are generated by the single-index model, Ri = αi + βiRM + ei where Ri is the excess return for security i and RM is the market’s excess return. The risk-free rate is 3%. Suppose also that there are three securities A, B, and C, characterized by the following data: Security βi E(Ri) σ(ei) A 1.4 14 % 23 % B 1.6 16 14 C 1.8 18 17 a. If σM = 22%, calculate the variance of returns of securities A, B, and C. b. Now assume that there are an infinite number of assets with return characteristics identical to those of A, B, and C, respectively. What will be the mean and variance of excess returns for securities A, B, and C? (Enter the variance answers as a percent squared and mean as a percentage. Do not round intermediate calculations. Round your answers to the nearest whole number.)arrow_forwardSuppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD = .03X1+ .02X2 - .05X3+ error, where X1 is the borrower's debt/equity ratio, X2is the volatility of borrower earnings, and X3= 0.10 is the borrower’s profit ratio. For a particular loan applicant, X1= 0.75, X2= 0.25, and X3= 0.10. Required: What is the projected probability of default for the borrower? What is the projected probability of repayment if the debt/equity ratio is 2.5?arrow_forward
- The beta of Company’s X equity is equal to 1. Assuming that the company's debt is risk-free, that X's debt to equity ratio is equal to 1, and that there are no taxes, the beta of company X’s assets is 1 1/2 2 2/3arrow_forwardCalculate the union’s cost of equity from the CAPM using its own beta (0.90) estimate and the industry beta (1.25) estimate. How different are your answers? Assume a risk-free rate of 2% and a market risk premium of 7%. Can you be confident that Union Pacific’s true beta is not the industry average?arrow_forwardAssume that there are two factors that price assets. Risk free rate is 4%. Factor 1 has anexpected return of 8% and factor 2 has an expected return of 10%. Calculate the expectedreturn for each asset with the following sensitivities using the Arbitrage Pricing Theory (APT). (a) β1 = 1.2, β2 = 0.9; (b) β1 = 1.5, β2 = −0.60;arrow_forward
arrow_back_ios
SEE MORE QUESTIONS
arrow_forward_ios
Recommended textbooks for you
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning
Intermediate Financial Management (MindTap Course...
Finance
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Cengage Learning
Financial leverage explained; Author: The Finance story teller;https://www.youtube.com/watch?v=GESzfA9odgE;License: Standard YouTube License, CC-BY