Tan , Ma. Cecilia A.

WARM-UP’S EXERCISE

CHAPTER 6

E6-1 The risk-free rate on T-bills recently was 1.23%. If the real rate of interest is estimated to be

0.80%, what was the expected level of inflation?

Answer : Finding the real rate of interest

r*= Rf – IP

0.8% = 1.23% - IP

IP = 1.23 – 0.08 = 0.43%

E6–2 The yields for Treasuries with differing maturities on a recent day were as shown in the table on

Maturity Yield page 253.

3 months 1.41%
A . Use the information to plot a yield curve for this date.

6 months 1.71

2 years 2.68

3 years 3.01

5 years 3.70

10 years 4.51

30 years 5.25

B . If the expectations hypothesis is true, approximately what rate of return do investors expect a 5-year

Treasury note to pay 5 years from now?

Tan , Ma. Cecilia A.

{ ( 4.51% ×10 )− (3.7 % ×5 ) } ÷ 5

= { 45.1 %−18.5 % } ÷ 5

= 26.6% ÷ 5=5.32 %

C . If the expectations hypothesis is true, approximately (ignoring compounding) what rate of return do

investors expect a 1-year Treasury security to pay starting 2 years from now?

( 3.01 % ×3 )−( 2.68 % × 2 )=9.03 %−5.36 %=3.67 %

D. Is it possible that even though the yield curve slopes up in this problem, investors do not expect rising

interest rates? Explain.

Yield curves may slope up for many reasons beyond expectations of rising interest rate .

According to liquidity preference theory , long – term interest rate tend to be higher than short-

term rates , because longer-term debt has lower liquidity , higher responsiveness to general

interest rate movements , and borrower willingness to pay a higher interest rate to lock in money

for a longer period of time . In addition to expectation theory and liquidity preference theory ,

market segmentation theory allows for additional interest rate increase arising from either limited

availability of funds or greater demand for funds at longer maturities.

Real rate of
Maturity Yield
interest
3 months 1.41% 0.80%
6 months 1.71 0.80 E6–3 The yields for Treasuries with differing maturities,
2 years 2.68 0.80
3 years 3.01 0.80 including an estimate of the real rate of interest, on a
5 years 3.7 0.80
recent day were as shown in the following table:
10 years 4.51 0.80
30 years 5.25 0.80
Tan , Ma. Cecilia A.
Use the information in the preceding table to calculate the inflation expectation for each maturity.

Answer : Calculating inflation expectation

The inflation expectation for a specific maturity in the difference between the yield and the real

interest rate at that maturity .

Real Rate of Inflation

Maturity Yields Interest Expectation

3 months 1.14% 0.80% 0.61%
6 months 1.71% 0.80% 0.91%
2 years 2.68% 0.80% 1.88%
3 years 3.01% 0.80% 2.21%
5 years 3.70% 0.80% 2.90%
10 years 4.51% 0.80% 3.71%
30 years 5.25% 0.80% 4.45%

E6–4 Recently, the annual inflation rate measured by the Consumer Price Index (CPI) was forecast to

be 3.3%. How could a T-bill have had a negative real rate of return over the same period? How

could it have had a zero real rate of return? What minimum rate of return must the T-bill have

earned to meet your requirement of a 2% real rate of return?

ANSWER : A treasury bill can experience a negative real rate of return if its interest rate is less than

the inflation rate as measured by the CPI. The real rate of return would be 0 if the treasury

bill rate was 3.3% that matching the CPI rate. To get a 2% real return, the reate of treasury

bill have to be at least 5.3%.

Tan , Ma. Cecilia A.
E6–5 Calculate the risk premium for each of the following rating classes of long-term securities,

Rating Nominal Interest assuming that the yield to maturity (YTM) for comparable

class Rate Treasuries is 4.51%.

AAA 5.12%
BBB 5.78
B 7.82 ANSWER : Risk premium calculation:

To calculate other securities risk premium, subtract 4.51% risk

free rate from each nominal interest rate:

Security Nominal Interest Rate Risk Premium

AAA 5.12% 5.12% - 4.51% = 0.61%

BBB 5.78 5.78% - 4.51% = 1.27%

B 7.82 7.82% - 4.51% = 3.31%

E6–6 You have two assets and must calculate their values today based on their different payment

streams and appropriate required returns. Asset 1 has a required return of 15% and will produce

a stream of $500 at the end of each year indefinitely. Asset 2 has a required return of 10% and

will produce an end-of-year cash flow of $1,200 in the first year, $1,500 in the second year, and

$850 in its third and final year.

ANSWER : Values of two assets:

Finding the cash flow stream PV for the assets by discounting the expected cash flows

with respective required return:

Asset 1: PV = $500 / 0.15 = $3,333.33

Asset 2: [($1,200 / 1.10) + ($1,500 / (1.10)²) + ($850 / (1.10)³) = $2,969.20

Tan , Ma. Cecilia A.
E6–7 A bond with 5 years to maturity and a coupon rate of 6% has a par, or face, value of $20,000.

Interest is paid annually. If you required a return of 8% on this bond, what is the value of this bond

to you?

ANSWER : A bond PV is the PV of its future cash flows. In the 5 – year treasury bond case, the

expected cash flows are $1,200 for 5 years at the end of each year, plus the bond face value that

will be received at the bond maturity. With the help of financial calculator, the solution is as

follows:

PV of interest: PV of the bond’s face value:

PMT = -1,200 FV = $20,000

I = 8%/year N = 5 periods

N = 5 periods I = 8%/year

Solve for PV = $4,791.25 Solve for PV = $13,61

Bond PV = $4,791.25 + $13,611.66 = $18,402.91

The answer is consistent with the knowledge that when interest rate increase, the values of bonds

that are issue previously fall. The present value is a cash outflow, or cost of investor.

E6–8 Assume a 5-year Treasury bond has a coupon rate of 4.5%.

A. Give examples of required rates of return that would make the bond sell at a discount, at a

premium, and at par.

B. If this bond’s par value is $10,000, calculate the differing values for this bond given the

required rates you chose in part a.

ANSWER :
Tan , Ma. Cecilia A.
A. Student answers will vary but any required rate of return above the coupon rate will cause the

bond to sell at a discount , while at a required return of 4.5% the bond will sell at par. Any

required rate of below the coupon rate will cause the bond to sell at a premium .

B. Student answers will vary but should be consistent with their answers to part a.

Chapter 7

E7–1 A balance sheet balances assets with their sources of debt and equity financing. If a corporation

has assets equal to $5.2 million and a debt ratio of 75.0%, how much debt does the corporation

have on its books?

ANSWER : Using debt ratio to calculate a firm’s total liabilities

Debt ratio total = liabilities÷total assets

Total liabilities¿debt ratio× total assets

= 0.75× $5,200,000 = $3,900,000

E7–2 Angina, Inc., has 5 million shares outstanding. The firm is considering issuing an additional 1

million shares. After selling these shares at their $20 per share offering price and netting 95% of

the sale proceeds, the firm is obligated by an earlier agreement to sell an additional 250,000

shares at 90% of the offering price. In total, how much cash will the firm net from these stock

sales?

Answer : Determining net proceeds from the sale of stockNet proceeds

= (1,000,000$200.95)  (250,000$20×0.90)

 $19,000,000$4,500,000$23,500,000
Tan , Ma. Cecilia A.
E7–3 Figurate Industries has 750,000 shares of cumulative preferred stock outstanding. It has passed

the last three quarterly dividends of $2.50 per share and now (at the end of the current quarter)

wishes to distribute a total of $12 million to its shareholders. If Figurate has 3 million shares of

common stock outstanding, how large a per-share common stock dividend will it be able to pay?

Answer : Preferred and common stock dividends

Common stock dividend  (Cash available  preferred dividends)  number of common shares

 [$12,000,000  (3  $2.50  750,000)]  3,000,000

 $2.125 per share

E7–4 Today the common stock of Gresham Technology closed at $24.60 per share, down $0.35 from

yesterday. If the company has 4.6 million shares outstanding and annual earnings of $11.2

million, what is its P/E ratio today? What was its P/E ratio yesterday?

Answer : Price/earning ratios

Earnings per share (EPS)  $11,200,000  4,600,000

  $2.43 per share Today’s P/E ratio 

 $24.60  $2.43

 10.12Yesterday’s P/E ratio 

 $24.95  $2.43  10.27

E7–5 Stacker Weight Loss currently pays an annual year-end dividend of $1.20 per share. It plans to

increase this dividend by 5% next year and maintain it at the new level for the foreseeable future.

If the required return on this firm’s stock is 8%, what is the value of Stacker’s stock?
Tan , Ma. Cecilia A.
Answer : Using the zero- growth model to value stock

P0 [$1.20 (1.05)] 0.08 

 $1.26  0.08 

 $15.75 per share

E7–6 Brash Corporation initiated a new corporate strategy that fixes its annual dividend at $2.25 per

share forever. If the risk-free rate is 4.5% and the risk premium on Brash’s stock is 10.8%, what is

the value of Brash’s stock?

Answer : Capital asset pricing model

Step 1: Calculate the required rate of return.

rs  4.5%  1.8(10.5%  4.5%)  15.3%

Step 2: Calculate the value of the stock using the zero-growth model.

P0  $2.25  0.153  $14.71 per share

Chapter 9

E9–1 A firm raises capital by selling $20,000 worth of debt with flotation costs equal to 2% of its par

value. If the debt matures in 10 years and has a coupon interest rate of 8%, what is the bond’s

YTM? Weighted average cost of capital

Answer: Weighted average cost of capital

N = 10,

PV = $20,000 (1−¿0.02) ¿$19,600,

Tan , Ma. Cecilia A.
PMT= −¿0.08 ×$20,000 ¿−¿$1,600,

FV = −¿$20,000

Solve for I 8.30%

E9–2 Your firm, People’s Consulting Group, has been asked to consult on a potential preferred stock

offering by Brave New World. This 15% preferred stock issue would be sold at its par value of $35

per share. Flotation costs would total $3 per share. Calculate the cost of this preferred stock.

Answer: Cost of preferred stock

  The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds

from the sale of the preferred stock.

r  p = Dp+ N  p

r  p = (0.15 ×$35)÷ ($35−¿ $3)

¿ $5.25 ÷ $32 ¿16.4%

E9–3 Duke Energy has been paying dividends steadily for 20 years. During that time, dividends have

grown at a compound annual rate of 7%. If Duke Energy’s current stock price is $78 and the firm

plans to pay a dividend of $6.50 next year, what is Duke’s cost of common stock equity?

Answer: Cost of common stock equity

The cost of common stock equity can be found by dividing the dividend expected at the

end ofyear 1 by the current price of the stock and adding the expected growth rate.

r s(D1÷P0) +g 

r  s = ($6.50÷ $78) +¿7% = 15.33%

Tan , Ma. Cecilia A.

E9–4 Weekend Warriors, Inc., has 35% debt and 65% equity in its capital structure. The firm’s

estimated after-tax cost of debt is 8% and its estimated cost of equity is 13%. Determine the firm’s

weighted average cost of capital (WACC).

ANSWER : Weighted average cost of capital

Ra=(0.35 × 0.08¿+ ( 0.65× 0.13 )

¿ 0.0280+0.0845

¿ 11.25

E9–5 Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The firm’s capital

structure targets the following proportions: debt, 55%; preferred stock, 10%; and common stock,

35%. If the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%,

what is Oxy’s weighted average cost of capital (WACC)?

Answer: Weighted average cost of capital

ra¿(0.55× 0.067) + (0.10 ×0.092) + (0.35 × 0.106)

= 0.0832

= 8.32%

Chapter 14

E14–1 Stephanie’s Cafes, Inc., has declared a dividend of $1.30 per share for shareholders of

record on Tuesday, May 2. The firm has 200,000 shares outstanding and will pay the dividend on

May 24. How much cash will be needed to pay the dividend? When will the stock begin selling ex

dividend?
Tan , Ma. Cecilia A.
Answer: Relevant dividend dates

The firm will need $260,000 of cash to pay the dividend. Because a weekend intervenes,

the stock will begin selling ex-dividend on Friday, April 28, which is 4 days before the date of

record .

E14–2 Chancellor Industries has retained earnings available of $1.2 million. The firm plans to

make two investments that require financing of $950,000 and $1.75 million, respectively.

Chancellor uses a target capital structure with 60% debt and 40% equity. Apply the residual

theory to determine what dividends, if any, can be paid out, and calculate the resulting dividend

pay out ratio.

Answer: Residual theory of dividend pay out

  1. New investments  $2,700,000

2. Retained earnings available  1,200,000

3. Equity needed (40% of 1)  1,080,000

4. Dividends [(2) – (3)]  120,000

5. Dividend pay out ratio [(4) – (2)]  10%

E14–3 Ashkenazi Companies has the following stockholders’ equity account:

Common stock (350,000 shares at $3 par) $1,050,000

Paid-in capital in excess of par 2,500,000

Retained earnings 750,000

Total stockholders’ equity 4,300,000

Tan , Ma. Cecilia A.
Assuming that state laws define legal capital solely as the par value of common stock, how much of a

per-share dividend can Ashkenazi pay? If legal capital were more broadly defined to include all paid-in

capital, how much of a per-share dividend could Ashkenazi pay?

Answer: Legal constraints on dividend pay out

 If legal capital is defined solely as the par value of common stock, Ashkenazi will be able

to pay out paid-in capital in excess of par plus all retained earnings.

Paid-in capital in excess of par  2,500,000

Retained earnings  750,000

Total available for dividends  $3,250,000

Potential dividend per share (divide total available by 350,000 shares) = $9.29

If legal capital is defined as both the par value of common stock and paid-in capital in excess of par ,

Ashkenazi will only be able to pay out the retained earnings.

Total available for dividends  $750,000

Potential dividend per share (divide total available by 350,000 shares) = $2.14

E14–4 The board of Kopi Industries is considering a new dividend policy that would set dividends at

60% of earnings. The recent past has witnessed earnings per share (EPS) and dividends paid per

share as follows:
Tan , Ma. Cecilia A.
Year EPS Dividend/Share Based on Kopi’s historical dividend pay out ratio, discuss whether a
2009 1.75 0.95
2010 1.95 1.2 constant pay out ratio of 60% would benefit shareholders.
2011 2.05 1.25
2012 2.25 1.3
Answer : Constant dividend pay out ratio

The first step in analysing the Kopi scenario is to determine the historical pay out ratio.

Year EPS Dividend/Share Dividend Pay out Ratio

2009 $1.75 $0.95 54.29%

2010 1.95 1.20 61.54

2011 2.05 1.25 60.98

2012 2.25 1.30 57.78

Discussion: Kopi Companies’ historical dividend pay out ratio has been fairly consistent

and near the 60% constant pay out ratio that the board is considering. So in terms of dollar

amounts, the new policy would not significantly change the dividend pay out to the shareholders

in the future.

Once the dividend is tied to a constant percentage, the dividends will be tied to Kopi’s

future earnings and could fluctuate from year to year.

However, the evidence from the past 4 years shows that Kopi’s earnings have increased

from 5% to 11% per year with no down years.

E14–5 The current stockholders’ equity account for Hilo Farms is as follows: Common stock

(50,000 shares at $3 par) $150,000 Paid-in capital in excess of par 250,000 Retained earnings

Total stockholders’ equity . Hilo has announced plans to issue an additional 5,000 shares of

common stock as part of its stock dividend plan. The current market price of Hilo’s common stock
Tan , Ma. Cecilia A.
is $20 per share. Show how the proposed stock dividend would affect the stockholder’s equity

account.

Answer: Stock dividend

After the 10% stock dividend, Hilo’s stockholder’s equity account is as follows:

Common stock (55,000 shares at $3 par) $165,000

Paid-in capital in excess of par 335,000

Retained earnings 350,000

Total stockholders’ equity $850,000

Chapter 18

E18–1 Toni’s Typesetters is analyzing a possible merger with Pete’s Print Shop. Toni’s has a tax

loss carry forward of $200,000, which it could apply to Pete’s expected earnings before taxes of

$100,000 per year for the next 5 years. Using a 34% tax rate, compare the earnings after taxes

for Pete’s over the next 5 years both without and with the merger.

Answer: Tax loss carry forward

After-Tax Earnings without a Merger

Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $100,00 $100,00 $100,00 $100,0 $100,00

0 0 0 0 0

0
Taxes     34,00     34,00     34,00     34,0     34,00

0 0 0 0 0
Tan , Ma. Cecilia A.
0
AT earnings $  66,00 $  66,00 $  66,00 $ 66,00 $  66,00

0 0 0 0 0

Earnings with a Merger

Year 1 Year 2 Year 3 Year 4 Year 5
Earnings before $100,000 $100,000 $100,00 $100,000 $100,000

losses 0
Tax loss carry   100,000 100,000             0                           

forward 0 0
Earnings before $           0 $           0 $100,00 $100,000 $100,000

taxes 0
Taxes              0              0     34,00     34,00     34,000

0 0
AT earnings $100,000 $100,000 $  66,00 $  66,00 $  66,000

0 0

E18–2 Cautionary Tales, Inc., is considering the acquisition of Danger Corp. at its asking price of

$150,000. Cautionary would immediately sell some of Danger’s assets for $15,000 if it makes the

acquisition. Danger has a cash balance of $1,500 at the time of the acquisition. If Cautionary

believes it can generate after-tax cash inflows of $25,000 per year for the next 7 years from the

Danger acquisition, should the firm make the acquisition? Base your recommendation on the net

present value of the outlay using Cautionary’s 10% cost of capital.

Answer: Evaluation of a proposed merger

You may use a financial calculator to determine present values (PV):

Find the PV of cash outflows: −¿$150,000

Find the PV of one-time cash inflows: $15,000 +¿$1,500 = $16,500

Tan , Ma. Cecilia A.
Find the PV of annual cash inflows:

N = 7, I = 10%, PMT = −¿25,000

Solve for PV = $121,710

Net present value (NPV) = −¿$150,000 +¿ $121,710 +¿ 16,500 = −¿$11,790

Based on net present value analysis, Cautionary Tales should not make the acquisition.

E18–3 Willow Enterprises is considering the acquisition of Steadfast Corp. in a stock swap

transaction. Currently, Willow’s stock is selling for $45 per share. Although Stead fast’s shares

are currently trading at $30 per share, the firm’s asking price is $60 per share. a. If Willow accepts

Stead fast’s terms, what is the ratio of exchange? b. If Steadfast has 15,000 shares outstanding,

how many new shares must Willow issue to consummate the transaction? c. If Willow has

110,000 shares outstanding before the acquisition, and earnings for the merged company are

estimated to be $450,000, what is the EPS for the merged company?

Answer : Stock swap

a. The ratio of exchange is $60 ÷ $45 = 1.333333

b. Total number of new shares ¿−¿ 15,000 × 1.33333 = 20,000 shares

c. Total number of shares after the merger = 110,000 + 20,000 = 130,000

EPS = $450,000 −¿ 130,000 = $3.46 per share

E18–4 Phylum Plants’ stock is currently trading at a price of $55 per share. The company is

considering the acquisition of Taxonomy Central, whose stock is currently trading at $20 per

share. The transaction would require Phylum to swap its shares for those of Taxonomy, which

would be paid $60 per share. Calculate the ratio of exchange and the ratio of exchange in market

price for this transaction.

Tan , Ma. Cecilia A.
Answer : Ratio of exchange in market price

Ratio of exchange ¿ $ 60 ÷ $ 55=1.091

MPR=( $ 55 × 1.091 ) ÷ $ 20=$ 3.00

of the market price of Phylum∈exchange for $ 1.00 of themarket price of Taxonomy Central .

E18–5 All-Stores, Inc., is a holding company that has voting control over both General Stores and

Star Stores. All-Stores owns General Stores and Star Stores common stock valued at $15,000

and $12,000, respectively. General’s balance sheet lists $130,000 of total assets; Star has total

assets of $110,000. All-Stores has total common stock equity of $20,000.

A . What percentage of the total assets controlled by All-Stores does its common stock

equity represent?

B . If a stockholder holds $5,000 worth of All-Stores common stock equity, and this amount

gives this stockholder voting control, what percentage of the total assets controlled does

this stockholder’s equity investment represent?

Answer: Percentage of the total assets controlled

a. Total assets controlled by All-Stores=$ 130,000+ $ 110,000=$ 240,000.

All-Stores equity as a percentage of total assets ¿ $ 20,000÷ $ 240,000 ¿=8.33 % .

b. Percentage of the total assets controlled ¿( $ 5,000 ÷ $ 240,000)=2.08 % .

Chapter 19

E19–1 Santana Music is a U.S.-based MNC whose foreign subsidiary had pretax income of $55,000; all

after-tax income is available in the form of dividends to the parent company. The local tax rate is

40%, the foreign dividend withholding tax rate is 5%, and the U.S. tax rate is 34%. Compare the
Tan , Ma. Cecilia A.
net funds available to the parent corporation (a) if foreign taxes can be applied against the U.S.

tax liability and (b) if they cannot.

Answer : Taxation of income of a foreign subsidiary

Subsidiary income before local taxes $55,000

Foreign income tax at 40% −22,000

Dividend available to be declared $33,000

Foreign dividend withholding tax at 5% −1,650

Santana’s receipt of dividends $31,350

a. Santana’s receipt of dividends $31,350

U.S. tax liability at 34% $10,659

Foreign taxes available to be used as a credit −23,650 −23,650

U.S. taxes due (i.e., credit exceeds U.S. tax) 0

Net funds available to Santana $31,350

b. Foreign taxes cannot be applied against the U.S. tax liability

Santana’s receipt of dividends $31,350

U.S. tax liability at 34% −10,659

Net funds available to Santana $20,691

E19–2 Assume that the Mexican peso currently trades at 12 pesos to the U.S. dollar. During the

year U.S. inflation is expected to average 3%, while Mexican inflation is expected to average 5%.
Tan , Ma. Cecilia A.
What is the current value of one peso in terms of U.S. dollars? Given the relative inflation rates,

what will the exchange rates be 1 year from now? Which currency is expected to appreciate and

which currency is expected to depreciate over the next year?

Answer : Currency valuation

a. Dollar price for the Mexican peso = US $0.083333

b. Calculate the exchange rates 1 year from now Assume a basket of goods costs $100 in the

United States and 1,200 pesos in Mexico. One year from now the expected cost of the same

basket of goods will be:

United States $100 × 1.03 = $103

Mexico 1,200 pesos × 1.05 = 1,260 pesos

Dollar price of the Mexican peso 1 year from now = $103 ÷ 1,260 pesos = US$0.081746

Peso price of the U.S dollar 1 year from now = $1,260 peso ÷ $103 = 12.233010 pesos Based on

expected inflation rates, the dollar is expected to appreciate in value against the peso and the

peso is expected to depreciate in value against the U.S. dollar over the next year.

E19–3 If Like A Lot Corp. borrows yen at a nominal annual interest rate of 2% and during the

year the yen appreciates by 10%, what will the effective annual interest rate be for the loan?

Answer : Effective interest rate of a foreign currency loan

E = N + F + (N × F) = 0.02 + 0.10 + (0.02 × 0.10) = 0.1220 = 12.20%

E19–4 Carry Trade, Inc., borrows yen when the yen is trading at ¥110/US$. If the nominal annual

interest rate of the loan is 3% and at the end of the year the yen trades at ¥120/US$, what is the

effective annual interest rate of the loan?

Tan , Ma. Cecilia A.
Answer : Effective interest rate of a foreign loan

F = Forecast percentage change of the yen

= 9.09% E = N + F + (N × F) = 0.03 + 0.0909 + (0.03 × 0.0909) = 0.1236 = 12.36%

E19–5 Denim Industries can borrow its needed financing for expansion using one of two foreign

lending facilities. It can borrow at a nominal annual interest rate of 8% in Mexican pesos or at 3%

in Canadian dollars. If the peso is expected to depreciate by 10% and the Canadian dollar is

expected to appreciate by 3%, which loan has the lower effective annual interest rate?

Answer : Comparing effective interest rates of two loans

EMP = N + F + (N × F) = 0.08 − 0.10 + (0.08 × −0.10) = −0.0280 = −2.80%

ECD = N + F + (N × F) = 0.03 + 0.03 + (0.03 × 0.03) = 0.0609 = 6.09%

The loan in Mexican pesos has the lower effective annual interest rate.