Capital Structure Part 1

Question 1

A bond will sell at a ______________ when the stated coupon rate on the bond is greater than the market interest rate on the bond at a given date.

Answer 1

premium

Question 2

Which of the following types of bonds is most likely to maintain a constant market value?

Answer 2

Floating-rate bond

Question 3

What bonds would automatically adjust the return on a financial instrument to produce a constant market value for that instrument. No premium or discount would be required since market changes would be accounted for through the interest rate?

Answer 3

Floating-rate

Question 4

What bonds have, in effect, a fixed stated rate of return that would require assignment of a premium or discount to the underlying security to produce a market rate of interest if that market yield is different from the stated rate?

Answer 4

Zero-coupon

Question 5

What financial product typically does NOT have an active secondary market?

Answer 5

Commercial Paper

Question 6

Generally, what is the time frame for maturity on commercial paper?

Answer 6

Less than 270 days

Question 7

The following are characteristics/advantages of which market?

-Avoids the expense of maintaining a compensating balance with a commercial
bank.

-Provides a broad distribution for borrowing.

-Accrues a benefit to the borrower because its name becomes more widely
known

Answer 7

The commercial paper market

Question 8

What is a risk reward ratio, assuming standard deviation is a good measure of risk?

Answer 8

Mean return / Standard Deviation

Note: the higher the number, the better.

Question 9

What is the formula for market capitalization?

Answer 9

number of common shares outstanding X fair market value per share

Note: Bonds are NOT part of this calculation!!!!

Question 10

Which of the rate is most commonly compared to the internal rate of return to evaluate whether to make an investment?

Answer 10

The weighted-average cost of capital (WACC)

NOTE: The weighted-average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.

Question 11

What is the rate of return required to cover the cost of resources employed?

Answer 11

“The overall cost of capital” a.k.a. “hurdle rate”

Question 12

What can be used as a measure of the overall cost of capital, because it factors the company’s proportion of its cost of debt and its cost of equity?

Answer 12

The weighted-average cost of capital (WACC)

Question 13

The optimal capitalization for an organization is usually determined by?

Answer 13

The lowest weighted-average cost of capital (WACC)

Question 14

_________________ does not require any payment, it does not mature and, because it increases equity while having no effect on debt, it decreases the debt equity ratio and increases the credit-worthiness of the firm.

Answer 14

Common stock

Question 15

What is the after tax WACC formula?

Answer 15

Calculate investment structure percentage.
Using: debt/total = debt percentage & equity/total = equity percentage (common and preferred separately if needed)

Multiply each times their respective cost of investment.
For debt only, account for tax effect and use the after tax #.

Add the two percentages together to derive the Weighted-average cost of capital (WACC).

Question 16

Which portion of the WACC formula needs to be accounted for by the marginal tax rate (multiplied by 1 - tax rate)

Answer 16

DEBT

note. common and preferred stock are not subject to “tax effect” in the WACC calculation.

Question 17

Cost of debt is measured as?

Answer 17

Cost of debt minus tax savings

Question 18

What is typically the cheapest source of new capital (after tax)?

Answer 18

Bonds aka Debt

NOTE: Preferred stock does NOT have any tax advantage

Question 19

When calculating net cost of debt, does the calculation use the “coupon rate” or “effective interest rate”?

Answer 19

Effective interest rate

Question 20

When calculating annual/semi-annual disbursements of bonds/debentures, does the calculation use the “coupon rate” or “effective interest rate”?

Answer 20

Coupon rate

Question 21

What is the formula for calculating the cost of preferred stock?

Answer 21

Dividend paid / Net Proceeds = Cost of preferred shares

Dividend paid = (par value x dividend %)

Net proceeds = pref stk sold price - flotation cost
Note: Flotation cost is the cost of issuing the stock, and therefore is subtracted from the sale price of the preferred stock.

Question 22

What is the formula by which BETA measures inherent volatility/risk?

Answer 22

% change in stock price divided by % change in overall market price.

Question 23

What does beta measure in the CAPM?

Answer 23

The volatility of a stock relative to the market

Question 24

What is the CAPM formula?

Answer 24

R = RF + B (RM - RF)

R = Required rate of return on equity
RF = Risk-free rate earned on US treasury Bonds
B = Beta coefficient
RM = Expected Market Return

Cost of retained earnings = Risk Free Rate + [Beta x (Market return - Risk Free Rate)]

Question 25

A capital investment whose rate of return is ______________ than the rate of return associated with the firm’s beta factor will increase the value of the firm.

Answer 25

Greater

Note: If the cap investment return is less than the beta factor return, the value of the firm will decrease.

Question 26

Which of the following assumptions applies to the basic theory underlying the capital asset pricing model?

Answer 26

A single risk-free rate exists.

Question 27

The market rate of interest on a one year US treasury bill is comprised of which two rates added together?

Answer 27

Risk Free Rate of Return + Inflation Premium = market rate of interest in a one year US treasury bill rate

Question 28

Which of the following factors would not be relevant when determining the risk premium on a specific security?

A. Length of maturity.
B. Relative liquidity.
C. Relative seniority.
D. Earnings per share.

Answer 28

Choice “D” is correct. The risk premium on a security in essence compensates an
investor for the risk associated with the security’s cash flows. Earnings per share (EPS) is calculated by taking net income and dividing it by the number of common shares of stock outstanding. There is no additional risk component factored into the risk premium as a result of the EPS calculation.

Question 29

______________________ is a factor in the risk premium, as the longer
the time period is until the security matures, the higher the risk associated with the investor receiving his/her cash flows.

Answer 29

Length of maturity

Question 30

____________________ is a key component of the risk premium as the investor must be compensated for the extent to which a security can be sold without risking loss of principal.

Answer 30

Liquidity

Note: Higher (lower) liquidity will cause the risk premium to decrease (increase).

Question 31

__________________ is an important factor with respect to risk premium, because the more senior the security is, the less risk associated with future cash flows for the investor

Answer 31

Relative Seniority

Question 32

The three elements needed to estimate the cost of equity capital are:

Answer 32

1. Current dividends per share (D)
2. Expected growth rate in dividends (g)
3. Current market price per share of common stock (P)

Cost of equity capital formula
R = (D1 / P0 ) + g

Question 33

What is the cost of equity capital formula?

Answer 33

R = (D1 / P0 ) + g

Important step:
To obtain D1, Multiply D0 x (1+g)

Variable definitions:
D = current dividends per share
P = Current market price per share
g = expected growth rate in dividends

Question 34

Using the discounted cash flow method, estimate the cost of retained earnings for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10 percent.

Answer 34

K = D/P + G

$3 dividend next period / $30 stock price + 10% growth

10% + 10% = 20% cost of retained earnings

Question 35

What is the CAPM formula?

Answer 35

E = R + B * (M-R)

E = expected return on an asset
R = Risk-free rate (treasury bond)
B = Beta Coefficient
M = Market Rate of Return