Kaplan Mock 5 - Part 2

Question 1

`Starlight, Inc., has a degree of operating leverage of 1.2 and degree of financial leverage of 1.8. Starlight’s earnings last year were $1 million on sales of $20 million. If sales increase to $23 million, Starlight’s estimated earnings based on these measures of leverage will be closest to:

A)
$1,216,000.
Incorrect Answer
B)
$1,324,000.
Correct Answer
C)
$1,454,000.
Incorrect Answer
Explanation
Degree of total leverage = 1.2 × 1.8 = 2.16

Percent change in sales = $23 / $20 − 1 = 15%

Percent change in earnings = 15% × 2.16 = 32.4%

Expected earnings = $1 million × 1.324 = $1,324,000

(Module 35.1, LOS 35.c)

Answer 1

Make sure that the formula has change

When we talk about earning, it will be EPS.

Question 2

An investor bought a stock on margin one year ago when its price was $50. The margin requirement was 60%. The current price of the stock is $75. The interest rate on the margin loan was 10%. Ignoring transactions costs, the investor’s net return on this transaction is closest to:

Answer 2

margin = 0.60 × $50 = $30 (equity)

interest on loan = 0.10 × $20 (debt) = $2

(75 − 50 − 2) / 30 = 76.67%

(Module 36.2, LOS 36.f)

Question 3

An investor purchases a newly issued 15-year bond at a YTM of 8% when the bond’s Macaulay duration is 10 years. Shortly after purchase, the market yield on the bonds increases to 9% and remains there until maturity. Assuming the bond does not default, the investor can expect to earn an annual rate of return greater than 8%:

A)
if the bond is sold after 7 years.
Incorrect Answer
B)
if the bond is sold after 12 years.
Correct Answer
C)
at no point during the bond’s life.
Incorrect Answer

Answer 3

If an investor holds the bond for more than 10 years (its Macaulay duration), the added reinvestment income will more than offset the price decrease that results from the yield increase. (Module 46.3, LOS 46.k)

Question 4

Given the following assumptions about a company’s financial estimates:

Earnings retention rate at 40%.
Required rate of return, ke, of 12.5%.
Return on equity (ROE) of 11%, expected to remain constant.
Estimated earnings per share (EPS) for next year of $2.75.
The company’s estimated leading P/E ratio and share value are closest to:

P/E ratio Share value

Answer 4

P/E ratio = dividend payout / (ke − g)

dividend payout = (1 − retention rate) = 1 − 0.40 = 0.60

g = retention rate × ROE = 0.40 × 0.11 = 0.044, or 4.4%

P/E = 0.60 / (0.125 − 0.044) = 7.41

P0 = P/E × EPS = 7.41 × $2.75 = $20.38

(Module 41.3, LOS 41.k)

D1 / E1 = Dividend payout ratio = (1 - RR)
P / E1 * EPS = Price per share (share value)