EPGP15FM2

Q1.

ABC corp. pays an annual dividend of ₹3.80 on its preferred stock. What is the cost of preferred
stock if the share currently sells for ₹42.70 a share and the tax rate is 21 percent?

Q1. Cost of Preferred Stock

 Dividend = ₹3.80

 Price = ₹42.70

Formula:
Kp=D/Net proceeds*100=3.8/42.7*100

Answer: 8.9%

Q2.

Radiocity has issued an 8% preference share at ₹100 face value and has 8 years to mature. The share
currently trades at ₹90 per share on the NSE. Radiocity currently pays a tax rate of 25%. Estimate the
cost of this preference share.

 Face = ₹100, Coupon = 8%, Market Price = ₹90

=Dp promised is = 8%100= 8

Face value= 100, Net proceeds= 90 tax rate Kp= 8/90*100=8.88

Answer: 8.89% , no tax saving on preference share on all equity firm

Q3.

Migsetra Inc. is an all-equity financed firm. The beta is 0.75, the market risk premium is 7.78 percent,
and the risk-free rate is 3.84 percent. What is the expected rate of return on this stock?

Q3. Expected Return (CAPM), all equity firm has no tax saving

 Beta = 0.75, Market Premium = 7.78%, Risk-Free = 3.84%

Formula:
R = Rf + beta(Rm - R_f) = 3.84 + 0.75 *7.78 = 9.675

Answer: 9.68%

Q4.

A firm has 80 bonds outstanding that are selling at their par value of ₹1,000 each. Bonds with similar
characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of equity stock
outstanding. The stock has a beta of 1.1 and sells for ₹40 a share. The RBI 10-year T-bill is yielding 4
percent, the market risk premium is 8 percent, and the firm's tax rate is 21 percent. What is the
firm's weighted average cost of capital, assuming its earnings are sufficient to classify all interest as a
tax-deductible expense?

Q4. WACC Calculation, total debt=1000*80, D=8.6, B=1.1, Equity value= 4000*40, Kd2= 4%, Km-kf=
8%,

WACC= Kd1+Kd2+Ke=(0.086*80000)/80000+4+ 4+1.1*0.08

=80000/Net proceed*100+4%+40

 Debt = ₹80,000, Equity = ₹160,000

 Cost of Debt = 8.6%, Tax = 21%

 Cost of Equity (CAPM):

R_e = 4 + 1.1 * 8 = 12.8

Weighted average for debt=80000/(80000+160000)=0.33

Weighted average for equity=160/240=0.666

Risk free premium=4%, market premium=8%, Re= Rf+Beta*market premium=4+1.1*8=12.8

WACC=(160 ÷ 240) × 12.8 + (80 ÷ 240) × 8.6 × (1-0.21)=10.79

Answer: 10.79%

Q5.

ABC Stores has debt with a market value of ₹319,000. The firm's equity has a market value of
₹684,000. The tax rate is 21 percent and the cost of capital is 11.2 percent. What is the market value
of this firm based on MM Proposition I without taxes?

Q5. MM Proposition I

 Debt = ₹319,000, Equity = ₹684,000

Total Value:
V = D + E = ₹1,003,000

Answer: ₹1,003,000

Q6.

Assume an unlevered firm has total assets of $6,000, earnings before interest and taxes of $600, and
500 shares of stock outstanding. Further assume the firm decides to change 40 percent of its capital
structure to debt with an interest rate of 8 percent. Ignore taxes. What will be the amount of the
change in the earnings per share as a result of this change in the capital structure?
 Levered Unlevered

Total assets 6000 6000

Debt (8%) 2400 0

Shares
outstanding 40%debt ie 60% equity=60%500=300 500

Equity 3600 6000

EBIT 600 (it will be same, revenue will be same) 600

Interest 192 0

EBT 600-192=408 600

=EBT/shares=600/500=1.2
EPS =EBT/300=1.36 ……..delta is 0.16

Q7.A firm has a debt-equity ratio of 0.64, a pretax cost of debt of 8.5 percent, and a required return
on assets of 12.6 percent. What is the cost of equity if you ignore taxes?

Rate of return on Asset= rate of return on unlevered firm

Q7. Cost of Equity (MM Prop II)

Rs=Re+D/E(Re-Rb)= 12.6+0.64*(12.6-8.5)= 15.224

 D/E = 0.64, Rd = 8.5%, Ra = 12.6%

Answer: 15.22%

Q8.The beta of ABC and XYZ is 0.85 and 1.25, whereas their expected returns are 15 and 21%,
respectively. Find Rm and Rf.

Return of stock1, R1= risk free+B1*(market risk-risk free)

Return of stock2, R2= risk free+B2*(market risk-risk free)

 ABC: β = 0.85, R = 15%

 XYZ: β = 1.25, R = 21%

Solve CAPM equations:

1. 15 = Rf + 0.85(Rm - R_f) )

2. 21 = Rf + 1.25(Rm - R_f) )

Answer: Rm ≈ 9.6%, Rf ≈ 3.6%

Q9. For a given risk-free rate of 6% and Rm of 14%, find the beta and return of the equally weighted
portfolio from the following table:

Stock Beta

A 0.85

B 1.15

C 1.25

D 1.65

E 0.95

F 1.45

Q9. Portfolio Beta and Return

 Rf = 6%, Rm = 14%

 Equally weighted portfolio of stocks A–F with given betas

Average Beta of portfolio---- B1+B2----Bn/n

Beta = {0.85 + 1.15 + 1.25 + 1.65 + 0.95 + 1.45}/{6} = 1.2167
Return of portfolio, Rp= Rf+Bavg(Rf-Rm)
R = 6 + 1.2167 * (14 - 6) = 15.73

Answer: Beta ≈ 1.22, Return ≈ 15.73%

Q10.The market price of Indian Ltd is ₹200. Last year it paid a dividend of ₹8.50. Based on its long-
term growth in dividend, the market is expecting this year’s dividend to be ₹9.50. What is the
implied cost of equity? Also, calculate the cost of equity if dividend payout increases to ₹9.70.

Implied cost of equity=return on investment=EBT/Equity value

Q10. Implied Cost of Equity

 Price = ₹200, Dividend = ₹9.50

Formula:
R=D/Net proceed = 9.5/200 = 4.75 , return on investment= dividend is the return to shareholder/his
investement
If dividend = ₹9.70:
cost of equity=9.7/200 = 4.85

Answer: 4.75% and 4.85%

Q11.
Firm A has the following capital structure:

 Equity: 100 (Market value: ₹820, Beta: 1.2, Rf: 3%, Market risk premium: 12%)

 Reserves: ₹400

 Debt: 200 (Market value: ₹180, Maturity 5 years, coupon 9%)

Calculate the cost of capital for this firm based on market and book weights.

Q11. Cost of Capital (Market & Book Weights)

Debt to equity, 2:1

Re= 3+1.2*12= 17.4%

Rd 9%

WACC= 1*17.4+9*2=35.4

Market Weights:

Equity weight= 820/(820+180)=0.82,Debt WeighT=1-0.82

 Equity = ₹820, Debt = ₹180

 Cost of Equity = ( 3 + 1.2 *12 = 17.4% )

 WACC = ( 0.82 * 17.4 + 0.18 * 9 = 15.89% )

Book Weights:

 Equity = ₹500(EQUITY +RESEARVES), Debt = ₹200

 WACC = ( 0.714 * 17.4 + 0.286 * 9 = 15.0% )

Answer: Market WACC ≈ 15.89%, Book WACC ≈ 15.0%

Q12.Suppose you are evaluating a firm’s capital structure policy. The firm has a zero-debt policy
currently. Running the CAPM model yielded a return of 15%. This firm has decided to borrow so that
the debt-to-equity ratio is 1:2.5. Cost of debt is 10%. Tax rate is 25%. On further examination, you
found that this firm’s bankruptcy cost exactly matches the interest tax shield every year. Estimate
the firm’s weighted average cost of capital after the restructure.

Ro= 15%, D/B=1/2.5, Rd=10, Tax=0.25 kd=rd, Ro= unlevered firm= 15%

Ks=equity return of levered firm is= Ro+D/E(Rd-Ro)=17%

WACC=1/(1+2.5)*Kd(1-t)+2.5/(1+2.5)*Ks=1/3.5*10*0.75+2.5/3.5*17=14.28

Answer: 14.28%

Q13. A firm currently has a WACC of 12%. 35% of its assets are funded by debt. The post-tax cost of
debt is 6%. If this firm chooses to borrow an additional sum so that its debt makes up 40% of its
assets, estimate the new WACC.

Q13. New WACC

  Old WACC = 12%, Debt = 35%, New Debt = 40%, Cost of debt = 6%

Assume cost of equity = 15.23% (from earlier)

New WACC:
$ 0.6 * 15.23 + 0.4 * 6 = 11.54% $

Answer: 11.54%

Q14.For a firm with debt-to-value ratio of 0.4, what is the rate of return for its equity holder if post-
tax cost of debt is 6%, unlevered beta is 1.2, market return is 9%, risk-free rate is 5%, and tax rate is
35%?

D/V=0.4 D/D+E=0.4 WACC= D/V*0.06(1-0.35)+E/V*Ke

Unlevered beta=1.2, Rm=9%, Rf=5%, Ro=return on unlevered equity= Rf+Beta*(Rm-Rf)=5+1.2*(9-

5)=9.8, Klevered=Ke=Ro+D/B(Ro-Rb)=11.32

D/D+E=0.4==(D+E)*0.4=D==D(1-0.4)= E*0.4== D/E=0.4/0.6

Q14. Return on Equity

 D/V = 0.4, Cost of debt = 6%, β_U = 1.2, Rm = 9%, Rf = 5%

Levered Beta: beta levered, βL = βU + βU* (1 - Tax Rate) * (D/E)]

=1.2+1.2*(1-0.35)*0.4/0.6=1.4

beta_L = 1.2 * (1 + 0.4/0.6*(1-t)) = 1.72

Return:
Rs = 5 + 1.72 * (9 - 5) = 11.88%

Answer: 11.88%

Q15.The Backwoods Lumber Co. has a debt-equity ratio of 0.80. The firm's return on assets is 12%
and its levered cost of equity is 15.68%. What is unlevered cost of equity assuming no taxes? Also,
What is the pretax cost of debt based on MM Proposition II with no taxes?

Ans unlevered cost of equity = 12%(in no equity firm),

Rl=Rul+D/E(Rul-Rd), 15.68=12+0.8(12-Rd)

Rd= 7.4%

Q16.
You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in
this closely held, all-equity firm. The other shareholders have agreed to have the firm borrow $1.5
million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore
taxes?

Total shares in company is 4000, Equity shares 3000

 Firm value = Debt+Equity

 =1.5million@1000+1.5*3@1000= 6 million

Answer: ₹6 million

Q17. The Telescoping Tube Company is planning to raise $2,500,000 in perpetual debt at 11% to
finance part of their expansion. They have just received an offer from the Albanic County Board of
Commissioners to raise the financing for them at 8% if they build in Albanic County. What is the total
added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic raises it for
them?

Q17. Value of Debt Financing

 Debt = ₹2.5 million, Tax = 34%

 Interest difference = 11% - 8% = 3%

Value Added:
$ 2.5 * 0.34 * 0.03 = ₹25,500 $

Answer: ₹25,500

Q18. Wincorp Manufacturing is currently all equity financed, has an EBIT of ₹2 million, and is in the
34% tax bracket. Peter, the company's founder, is the lone shareholder. If the firm were to convert
₹4 million of equity into debt at a cost of 10%, what would be the total cash flow to Peter if he holds
all the debt? How much more is this when compared with the case when the firm was unlevered?

Q18. Cash Flow to Peter

 EBIT = ₹2 million, Tax = 34%, Debt = ₹4 million @ 10%

Unlevered:
$ 2m * 0.66 = ₹1.32m $
Levered:
Interest = ₹400,000
Tax shield = ₹136,000
Cash flow = ₹1.32m + ₹136,000 = ₹1.456m

Answer: ₹1.456m, gain of ₹136,000

Q19.

The risk-free rate is 5%, and market on average returns 7%. You have two fund managers who report
to you. Tom manages a portfolio with a beta of 1.4, and Jerry manages a portfolio with a beta of
0.95. Both their portfolios yielded returns of 7.5%, and 7.1% respectively. Between Tom and Jerry,
who are you giving a greater bonus?

Q19. Bonus Comparison

 Tom: β = 1.4, Return = 7.5%

 Jerry: β = 0.95, Return = 7.1%

 Rf = 5%, Rm = 7%

CAPM:

 Tom: ( 5 + 1.4 * 2 = 7.8% ), Actual = 7.5% → Underperformed

 Jerry: ( 5 + 0.95 * 2 = 6.9% ), Actual = 7.1% → Outperformed

Answer: Jerry gets higher bonus

Q20. Stock A has an average return of 18%. Stock B has a return of 14%. A has a variance of 0.25, B’s
variance is 0.1225. The covariance of A and B is 0.075. If you desire 16% returns from A and B, how
much do you invest in A and how much do you invest in B?

Q20. Portfolio Allocation

 A: 18%, B: 14%, Desired = 16%

Let weight of A = w

$ 18w + 14(1 - w) = 16 \Rightarrow w = 0.5 $

Answer: 50% in A, 50% in B

Answer: 0.3614

Q21. In the previous problem, what is your portfolio’s standard deviation?

Q21. Portfolio Std Dev

 Var(A) = 0.25, Var(B) = 0.1225, Cov = 0.075

$ \sigma_p = \sqrt{0.25 * 0.25 + 0.25 * 0.1225 + 2 * 0.5 * 0.5 * 0.075} = \sqrt{0.0625 + 0.030625 +
0.0375} = \sqrt{0.130625} \approx 0.3614 $