Brealey and Myers' Fundamentals of Corporate Finance, 11th Edition — Solutions Manual

3ee841f2-d0c1-4c4f-8971-169e1d58e270.pdf Est time: 01–05 Financial Statements a. Cash and marketable securities b. Accounts receivable c. Inventories d. Total current assets e. Net fixed assets f. Debt due for repayment g. Accounts payable h. Total current liabilities i. Long-term debt j. Equity Est time: 01–05 Balance Sheet Balance Sheet a. If the firm paid income taxes of $2,000, and the average tax rate was 20%, then taxable income must have been: $2,000/0.20 = $10,000. b. c. Est time: 06–10 Income Statement Est time: 01–05 Financial Statements Shareholders’ equity = total assets  total liabilities Shareholders’ equity = total assets  total liabilities Net working capital = current assets  current liabilities h. Current liabilities increased by $10. Therefore, current liabilities other than accounts payable must have increased by $45. Financial statement analysis Est time: 11–15 Financial Statement Analysis Est time: 11–15 Financial Statements a. Book value equals the $200,000 the founder of the firm has contributed in tangible assets. b. Market value equals the value of his patent plus the value of the production plant: $50,000,000 + $200,000 = $50,200,000. c. Book value per share = $200,000/2 million shares = $0.10 d. Price per share = $50.2 million/2 million shares = $25.10 Est time: 01–05 Balance Sheet Est time: 01–05 Market and Book Values a. In late 2020, investors saw the value of assets on the books of Citigroup as worth less than the value recorded, which may be historical value. Loans are the primary assets for Citigroup, and investors perceived a high likelihood that the loans it made would default. If so, it would need to write down its values, reducing income available to shareholders. b. In contrast to the banks, investors perceived the assets of this company to be worth more than the historical value presented on the company’s book. Consistent with the analysis in Part (a), shareholders in this company are expecting to have higher income in future periods, and the value of the company’s assets are expected to grow. Market and Book Values Est time: 01–05 Noncash Items a. Cash will increase as one current asset (inventory) is exchanged for another (cash). b. Cash will increase. The machine will bring in cash when it is sold, but the lease payments will be made over several years. c. The firm will use cash to buy back the shares from existing shareholders. Cash balance will decrease. Est time: 01–05 Cash Flows Cash Flows Est time: 01–05 Change in Net Working Capital Est time: 06–10 Income Statement a. The fact that start-up firms typically have negative net cash flows for several years does not mean they are failing. Start-up firms invest in inventories and other assets designed to produce income in later periods. Growth is costly, and particularly fast growing firms consume capital in hopes of future gains. b. Accounting profits for start-up businesses are also commonly negative because these firms incur costs, such as advertising, that cannot be recorded on the balance sheet. These costs are selling and general administrative expenses the firm incurs in each period, not investments like those in inventories that are built up for future sales. Est time: 06–10 Cash Flows Est time: 01–05 Operating Cash Flow Est time: 01–05 Operating Cash Flow Candy Canes, Inc. Sales COGS Δ ↑A/R Δ↑ Inventory Cash flow* Net income** Est time: 06–10 Operating Cash Flow Quarter 1 Quarter 2 Quarter 3 Quarter 4 Est time: 11–15 Operating Cash Flow Value Added Inc. (in 000s) January February March April Est time: 11–15 Operating Cash Flow Est time: 11–15 Operating Cash Flow b. Tax increase due to $517 million more in taxable income: $108.57 = ($517 × .21) Est time: 11–15 Operating Cash Flow Est time: 06–10 Taxes Est time: 06–10 Taxes Est time: 06–10 Taxes Est time: 01–05 Taxes Taxes Est time: 06–10 Taxes Assets Liabilities and Shareholders’ Equity Est time: 06–10 Financial Statements Est time: 01–05 Net Working Capital Est time: 06–10 Income Statement Est time: 01–05 Income Statement Est time: 01–05 Financial Statements Assets Liabilities & Market and Book Values Cash provided by operations Cash flows from investments (from Question #35) Cash provided by (used for) financing activities Est time: 06–10 Operating Cash Flow Est time: 01–05 Taxes 660fa14a-021c-4205-a7d8-0631b7f88a04.pdf a. Market value = 657 million × $83 = $54,531 million b. Market / book = 54,531/17,532 = 3.11 c. The company has increased the value of equity investment by $36,999 million, which is 211% of shareholders’ equity on the balance sheet. Est time: 06–10 Market Value Ratios Est time: 06–10 Market Value Ratios a. EVA = after-tax interest + net income − (cost of capital × total capitalization) b. c. d. Yes. The EVA indicates the firm is producing value in excess of the cost of capital. Thus, it is producing value. The ROC and ROE are also consistent with this conclusion. Est time: 06–10 Market Value Ratios Est time: 06–10 Market Value Ratios Est time: 06–10 Profitability Ratios Est time: 01–05 Profitability Ratios a. Return on equity b. Return on assets c. Return on capital d. Days sales in inventory e. Inventory turnover f. Average collection period g. Operating profit margin h. Long-term debt ratio i. Total debt ratio j. Times interest earned k. Cash coverage ratio l. Current ratio m. Quick ratio Profitability Ratios a. Debt/equity = ($60 + 280 + 70)/$190 = 2.58 b. Total long-term debt/total long-term capital = $280/($280 + 190) = 0.60 c. Net working capital = $100 – 60 = $40 d. Current ratio = $100/$60 = 1.67 Est time: 01–05 Profitability Ratios Est time: 01–05 Short-Term Solvency Ratios Est time: 01–05 Short-Term Solvency Ratios Est time: 01–05 Profitability Ratios a. Interest expense = 0.08  $10 million = $800,000 Times interest earned = $1,000,000/$800,000 = 1.25 b. Cash coverage ratio Est time: 01–05 Liquidity Short-Term Solvency Ratios Est time: 06–10 Short-Term Solvency Ratios Asset Management Ratios Long-Term Solvency Ratios Market and Book Values Short-Term olvency Ratios a. No change: Inventory is a current asset as is the proceeds from a sale of inventory. b. Increase: A new bank loan is an increase in a long-term liability. In this case, it is being used to reduce a current liability. c. No change: Unless used, the existence of a line of credit does not impact the balance sheet. d. No change: An overdue accounts receivable, unless already written off, is a current asset. The payment of a receivable is trading one current asset for another. e. No change: Cash and inventory are both current assets. Thus, trading one for the other has no impact. Short-Term Solvency Ratios a. False: A number below 1 implies debt is less than equity and that may not always be the case. b. False: For example, if a firm only has cash, marketable securities, and receivables in its current assets, then the quick ratio will equal the current ratio. While many firms carry inventory, others do not. Est time: 01–05 Profitability Ratios Est time: 06–10 Asset Management Ratios This Year Last Year Financial Statement Analysis Financial Statement Analysis Est time: 01–05 DuPont Identity Est time: 01–05 DuPont Identity DuPont Identity DuPont Identity Est time: 06–10 DuPont Identity 9c5dbe8a-5118-4823-9007-b2ee11b16cb4.pdf Est time: 01–05 Interest Rates Est time: 01–05 Simple and Compound Interest Est time: 01–05 Future Value—Single Period a. $100  (1.08)10 = $215.89 b. $100  (1.08)20 = $466.10 c. $100  (1.04)10 = $148.02 d. $100  (1.04)20 = $219.11 Est time: 01–05 Future Value—Single Period a. With simple interest, you earn 4% of $1,000, or $40 each year. There is no interest on interest. After 10 years, you earn total interest of $400, and your account accumulates to $1,400. b. FV = PV × (1 + r)t Est time: 01–05 Simple and Compound Interest Number of Time Periods Future Value—Single Period = 0.9163/0.1484 = 6.17 years Number of Time Periods a. The present value of the future payoff is PV = FV/(1 + r)t = $2,000/(1.06)10 = $1,116.79. This is a good deal: Present value exceeds the initial investment. b. The present value is now equal to PV = FV/(1 + r)t = $2,000/(1.10)10 = $771.09. Present Value—Single Period Future Value—Single Period Annuities Annuities Present Value—Single Period Est time: 01–05 Present Value—Multiple Cash Flows Present Value Years Future Value Interest Rate Present Value—Single Period Est time: 06–10 Future Value—Single Period Interest Rates a. PV = C1/(1 + r)1 + C2/(1 + r)2 + C3/(1 + r)3 b. The PV exceeds the cost of the factory, so the investment is attractive. Present Value—Multiple Cash Flows Future Value—Single Period Annuities Annuities Perpetuities Perpetuities Perpetuities Perpetuities Annuities Annuities Annuities Annuities Annuities Future Value—Annuity Annuities Annuities Present Value—Annuity a. If we assume cash flows come at the end of each period (ordinary annuity) when in fact they actually come at the beginning (annuity due), we discount each cash flow by one period too many. Therefore, we can obtain the PV of an annuity due by multiplying the PV of an ordinary annuity by (1 + r). b. Similarly, the FV of an annuity due equals the FV of an ordinary annuity multiplied by (1 + r). Because each cash flow comes at the beginning of the period, it has an extra period to earn interest compared to an ordinary annuity. Annuities Annuities Annuities Annuities Future Value—Annuity Future Value—Annuity Present Value—Annuity Future Value—Annuity Time Value of Money Future Value—Annuity Future Value—Annuity Perpetuities Nominal and Real Returns Est time: 06–10 Interest Rates Interest Rates Interest Rates Interest Rates Interest Rates Interest Rates Interest Rates Interest Rates Interest Rates Annuities Continuous Compounding Simple and Compound Interest Simple and Compound Interest Interest Rates Simple and Compound Interest Interest Rates Rule of 72 Time Value of Money Nominal and Real Returns Nominal and Real Returns Nominal and Real Returns Nominal and Real Returns Annuities Interest Rates Nominal and Real Returns Nominal and Real Returns Nominal and Real Returns Est time: 16–20 Present Value—Multiple Cash Flows b855d4ef-878a-445f-b15a-0f22f7fbf1c1.pdf Bond Yields and Returns Bond Yields and Returns a. Coupon payment = 0.08  $1,000 = $80 Bond Yields and Returns Bond Valuation Bond Yields and Returns Bond Yields and Returns Bond Valuation Bond Yields and Returns Bond Valuation Bond Valuation Bond Valuation Bond Valuation Bond Valuation Bond Coupons Bond Yields and Returns Nominal and Real Returns Bond Yields and Returns Bond Yields and Returns Bond Yields and Returns Bond Yields and Returns Nominal and Real Returns Nominal and Real Returns Nominal and Real Returns Interest Rate Risk Interest Rate Risk Interest Rate Risk Interest rate risk Est time: 01–05 Treasury Yield Curve Est time: 01–05 Treasury Yield Curve Est time: 06–10 Bond Ratings and Credit Risk Est time: 06–10 Bond Ratings and Credit Risk a. True. Ignoring reinvestment risk, the promised yield on a treasury will materialize, provided the bond is held to maturity. This bond is assumed to be risk free. b. True. Since corporate bonds have default risk, the actual return has the possibility of being below the promised yield. c. True. If interest rates fall, the price of the bonds will rise and the realized return could increase. Est time: 06–10 Bond Ratings and Credit Risk Bond Ratings and Credit Risk Est time: 01–05 Bond Ratings and Credit Risk Est time: 01–05 Interest Rate Risk f27d259a-f470-4492-8668-3d4044359549.pdf Est time: 01–05 Net Present Value Est time: 01–05 Net Present Value Net Present Value Est time: 01–05 Internal Rate of Return Est time: 01–05 Internal Rate of Return Est time: 01–05 Profitability Index Est time: 01–05 Profitability Index Est time: 01–05 Payback Est time: 01–05 Payback Est time: 01–05 Internal Rate of Return Est time: 01–05 Net Present Value Est time: 06–10 Net Present Value Est time: 01–05 Net Present Value Est time: 06–10 Internal Rate of Return Est time: 06–10 Internal Rate of Return Est time: 01–05 Internal Rate of Return Est time: 11–15 Internal Rate of Return Est time: 01–05 Internal Rate of Return Est time: 01–05 Internal Rate of Return Est time: 01–05 Internal Rate of Return NPV NPV Est time: 11–15 Net Present Value Est time: 01–05 Profitability Index Est time: 06–10 Profitability Index Est time: 06–10 Profitability Index Est time: 06–10 Mutually Exclusive Projects Est time: 01–05 Net Present Value Est time: 06–10 Payback Est time: 01–05 Payback Mutually Exclusive Projects Est time: 16–20 Capital Budgeting Est time: 06–10 Mutually Exclusive Projects Est time: 06–10 Equivalent Annual Costs Est time: 11–15 Equivalent Annual Costs Est time: 11–15 Equivalent Annual Costs Est time: 06–10 Capital Budgeting Est time: 06–10 Capital Budgeting Est time: 06–10 Capital Budgeting Est time: 11–15 Capital Budgeting ecd58ff4-7398-47f0-a8de-cc89074c2cc9.pdf Est time: 01–05 Cash Flows Cash Flows a. If the office space would have remained unused in the absence of the proposed project, then the incremental cash outflow from allocating the space to the project is effectively zero. The incremental cost of the space used should be based on the cash flow given up by allocating the space to this project rather than some other use. b. One reasonable approach would be to assess a cost to the space equal to the rental income that the firm could earn if it allowed another firm to use the space. This is the opportunity cost of the space. Cash Flows Cash Flows Cash Flows b. False. Regardless of the actual financing, you should view the project as if it were all-equity financed, treating all cash outflows required for the project as coming from stockholders and all cash inflows as going to them. Cash Flows Est time: 01–05 Income Statement c. The cash flows: Income Statement Cash Flows b. If the R&D costs have been spent, then they fall into the category of a sunk costs and should be ignored. c. The increase in working capital, exhibited here as an investment in inventories, is an appropriate cash flow. A financial manager may want to consider the recovered working capital investment at the end of the project when the company is able to reduce inventories. d. This note specifies that cash flows are in real terms, instead of nominal, and therefore we should discount the project using a real rate of return. e. The indirect costs should be scrutinized in two ways. First, they should be strictly incremental costs contingent on accepting the new project—if not, then the costs would be incurred anyway and should be excluded from the analysis. Second, by tying the indirect costs to direct labor costs per unit, we want to make sure that the indirect costs are truly variable—if fixed, then they should be held fixed throughout the project life rather than fluctuating with sales volume. f. The marketing and administrative costs should be strictly incremental costs contingent on accepting the new project—if not, then the costs would be incurred anyway and should be excluded from the analysis. g. Depreciation expense in a noncash expense and therefore should not reduce project cash flows. They will reduce taxable income and therefore would actually provide project cash flows. h. Financing decisions should be separate from the investment decision. The project cash flow analysis should assume all-equity financing. i. Income should be adjusted for all items mentioned above. j. The tax loss carry forwards may not be realized if the firm has other profitable business segments. In this case, the loss recorded in Year 2022 should reduce the tax bill in that year. k. The net cash flow calculation should be adjusted for all items aforementioned. l. The net present value calculation should reflect correctly calculated cash flows. Also, since the cash flows are stated in real terms, the 15% discount rate must be a real cost of capital. Est time: 05–10 Operating Cash Flow Est time: 01–05 Operating Cash Flow Est time: 06–10 Equivalent Annual Costs Est time: 11–15 Net Present Value d. To find the internal rate of return, find the interest rate “r” that makes the present value of the inflows equal and opposite to the initial outflow. To do this set the PV of the 3-year annuity to $71.50 and solve for the discount rate (r): Est time: 11–15 Project Analysis and Evaluation Est time: 11–15 Project Evaluation Est time: 06–10 Project Evaluation c. Since the operating costs are the same, then Do-It-Right is preferred because it has the lower EAC. Est time: 11–15 Project Evaluation Est time: 06–10 Project Evaluation Est time: 16-20 Project Analysis and Evaluation Est time: 16-20 Est time: 01–05 Cash Flows Est time: 01–05 Cash Flow From Assets Est time: 01–05 Cash Flow From Assets Est time: 11–15 Depreciation b. If the company depreciates the installation costs, the present value of the tax shields will be less than if they can shield income immediately and thus the present value of the kiln cost will be greater. To calculate the tax shields in this scenario, we can schedule depreciation tax shields as follows: Est time: 06–10 Operating Cash Flow Est time: 01–05 Change in Net Working Capital Est time: 01–05 Change in Net Working Capital Est time: 01–05 Change in Net Working Capital Cash Flows Est time: 01–05 Change in Net Working Capital Est time: 06–10 Net Present Value Project Analysis and Evaluation Est time: 11–15 Project Analysis and Evaluation All figures in thousands Est time: 11–15 Project Analysis and Evaluation 1586508d-b693-40a3-8d2a-dd0f56a47518.pdf Project Analysis and Evaluation Project Analysis and Evaluation Project Analysis and Evaluation The extra 2 million burgers increase total costs by $1.0 million. a. Fixed costs = $2.5 million b. Variable costs = $0.50 per burger c. Total cost = (1 million burgers × $0.50) + $2.5 million = $3.0 million d. Total cost = (2 million burgers × $0.50) + $2.5 million = $3.5 million e. The fixed costs are spread across more burgers—thus the average cost falls. Operating Leverage Est time: 06–10 Sensitivity analysis a. Initial investment = $225  NPV = −$44.94 b. Initial investment = $150  NPV = $18.70 c. Initial investment = $113  NPV = $50.52 d. Revenues = $128  NPV = −$21.10 e. Revenues = $150  NPV = $18.70 f. Revenues = $180  NPV = $71.77 g. Variable costs, % of Revenues = 44%  NPV = −$0.40 h. Variable costs, % of Revenues = 40%  NPV = $18.70 i. Variable costs, % of Revenues = 36%  NPV = $37.80 j. Fixed costs = 60  NPV = −$44.97 k. Fixed costs = 40  NPV = $18.70 l. Fixed costs = 28  NPV = $56.90 m. Receivables and inventory, % of Exp. value = 25.00%, 22.50%  NPV = $9.88 n. Receivables and inventory, % of Exp. value = 16.67%, 15.00%  NPV = $18.70 o. Receivables and inventory, % of Exp. value = 8.33%, 7.50%  NPV = $27.52 Est time: 06–10 Sensitivity Analysis Est time: 06–10 Sensitivity Analysis Sensitivity Analysis Scenario Analysis Break-Even Analysis a. Each dollar of sales generates $0.60 of pretax profit. Depreciation expense is $100,000 per year, and fixed costs are $200,000. Therefore: b. Let Q = the number of diamonds sold. Break-Even Analysis Break-Even Analysis a. Cash flow = Net income + Depreciation b. If cash flow = 0 for the entire life of the project, then the present value of cash flows = 0, and project NPV will be negative in the amount of the required investment. Break-Even Analysis Break-Even Analysis a. The accounting break-even level of sales would INCREASE if the depreciation were pushed earlier. This is counterintuitive, but looking at the equation above, if the depreciation of 600 increases, then M increases in our equation to keep up. The reason is that under accounting rules, depreciation counts as a cost, and hence more cost earlier drives UP the number of units we must sell to break even. b. NPV break-even level of sales decreases. The accelerated depreciation increases the PV of the tax shield and thus reduces the level of sales necessary to achieve zero NPV. c. Accelerated depreciation makes the project more attractive. The PV of the tax shield is higher, so the NPV of the project at any given level of sales is higher. Break-Even Analysis Break-Even Analysis Operating Leverage Operating Leverage Operating Leverage Operating Leverage a. The option to delay expansion is a Timing Option because the decision to expand is not a “now or never” decision. b. While the initial NPV is negative, the existence of the production capability gives the company the Option to Expand when the market demand rises. c. By delaying installation of a fully integrated production line, the company retains its Option to Abandon and can upgrade to newer technology if it emerges. d. The ability to switch the use of the plane gives the company a Production Flexibility Option. Est time: 06–10 Real Options Real Options Real Options Real Options Real Options Real Options c7d0f7ff-83f9-4d3e-8bfa-467931e0d2a0.pdf a. For the period 1900–2019, average rate of return = 11.46% (see Table 11-1). b. For the period 1900–2019, average risk premium = 7.73% (see Table 11-1). c. For the period 1900–2019, standard deviation of returns = 19.61% (see Table 11-4). Historical Performance Risk Premium Risk Premium Est time: 01–05 Risk Premium Risk Premium Est time: 11–15 Standard Deviation and Variance a. b. Dividend yield = Dividend/Initial share price = $2/$40 = 0.05 = 5% Capital gains yield = Capital gain/Initial share price = $4/$40 = 0.10 = 10% c. Dividend yield = $2/$40 = 0.05 = 5% Dollar and Percentage Returns Est time: 06–10 Nominal and Real Returns Nominal and Real Returns Nominal and Real Returns Stock Market Prices and Reporting Stock Market Prices and Reporting Standard Deviation and Variance Standard Deviation and Variance Standard Deviation and Variance Standard Deviation and Variance Standard Deviation and Variance Standard Deviation and Variance Est time: 01–05 Diversification Concepts and Measures Diversification Concepts and Measures Systematic and Unsystematic Risk 16749e95-7672-4fbb-8b3d-e76c30fc2af1.pdf Diversification Concepts and Measures Systematic and Unsystematic Risk Systematic and Unsystematic Risk Risks and Returns Beta a. Call the weight in the S&P 500 w and the weight in T-bills (1 − w). Then w must satisfy the equation: b. To form a portfolio with  = 0.4, use a weight of 0.40 in the S&P 500 and a weight of 0.60 in T-bills. Then the portfolio  is: c. Both portfolios have the same ratio of risk premium to : Beta Beta Risks and Returns Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model c. If the market return remained at 8% and the risk-free rate increased to 6%  the market risk premium must fall to 2% (from 7%). The new expected returns are: d. Comparing the higher risk-free rate with Table 12.2 yields the following: e. As shown in Part (d), Walmart, with its low beta, benefits from a higher risk-free rate, increasing expected returns from 3.48% to 6.71%. Capital Asset Pricing Model Expected Return Capital Asset Pricing Model a. If investors believe the year-end stock price will be $52, then the expected return on the stock is: b. Alternatively, the “fair” price of the stock (i.e., the present value of the investor’s expected cash flows) is: Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model a. False. Investors require higher expected rates of return on investments with high market risk, not high total risk. Variability of returns is a measure of total risk. b. False. If  = 0, then the asset’s expected return should equal the risk-free rate, not zero. c. False. The portfolio is invested one third in Treasury bills and two thirds in the market. Its  will be: d. True. The asset’s beta is a function of its sensitivity to macroeconomic risks, among other factors. e. True. This is exactly what beta measures. Risks and Returns Capital Asset Pricing Model Risk Analysis and Profile Capital Asset Pricing Model a. False. The stock’s risk premium, not its expected rate of return, is twice as high as the risk premium of the market portfolio. b. True. The stock’s specific risk does not affect its contribution to portfolio risk. c. False. A stock plotting below the SML offers too low an expected return relative to the expected return indicated by the CAPM. The stock is overpriced. d. True. If the portfolio is diversified to such an extent that it has negligible unique risk, then the only source of volatility is its market exposure. A  of 2 then implies twice the volatility of the market portfolio. e. False. An undiversified portfolio has more than twice the volatility of the market. In addition to the fact that it has double the sensitivity to market risk, it also has volatility due to specific risk. Risks and Returns Capital Asset Pricing Model Required Return Required Return Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model Capital Asset Pricing Model Required Return 32ecbc71-3c20-48f7-a7f2-1afc274871cf.pdf Weighted-Average Cost of Capital Est time: 01–05 Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital Est time: 06–10 Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital a. The risk of the project determines the discount rate, and in this case Geothermal’s WACC is more reflective of the risk of the project in question. The proper discount rate, therefore, is not 12.3%. b. Executive Fruit should use the WACC of Geothermal, not its own WACC, when evaluating an investment in geothermal power production. It is more likely to be 11.7%. Weighted-Average Cost of Capital a. r = rf +  × (rm − rf) = 4% + (1.2  10%) = 16% c. If the company plans to expand its present business, then the WACC is a reasonable estimate of the discount rate since the risk of the proposed project is similar to the risk of the existing projects. Use a discount rate of 10.864%. d. The WACC of optical projects should be based on the risk of those projects. Using a  of 1.4, the discount rate for the new venture is: Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital Est time: 01–05 Weighted-Average Cost of Capital a. b. c. Market value is the proper measure, as it is determined by cash flows and forecasts, rather than accounting rules. Capital Structure Est time: 01–05 Capital Structure Est time: 01–05 Capital Structure Cost of Debt Cost of Equity Cost of Debt Est time: 01–05 Cost of Preferred Stock Cost of Equity Est time: 01–05 Weighted-Average Cost of Capital Weighted-Average Cost of Capital Weighted-Average Cost of Capital 71c6b8e1-687e-4e9c-838c-48791bed90eb.pdf a. False. Because of efficient markets, it is difficult to find undervalued securities or issue overvalued securities. Thus, good investment decisions are more valuable to owners. b. False. Competition is an important component in creating efficient markets. With sufficient competition between investors, securities will be properly valued. Est time: 01–05 Capital Market Efficiency b. True. c. False. Debt ratios in the United States increased until about 1990, but since then they have generally declined. Est time: 01–05 Capital Market Efficiency Est time: 01–05 Equity Securities Equity Securities Equity Securities a. Par value of common shares will increase by: Est time: 06–10 Equity Securities a. A company’s equity includes both common and preferred stock. True. b. The sum of common equity and preferred stock is known as net worth. False. c. As its name implies, preferred stock is a more important source of financing than common equity. False. d. A corporation pays tax on only 50% of the common or preferred dividends it receives from other corporations. True. e. Because of the tax advantage, a large fraction of preferred shares is held by corporations. True. Est time: 01–05 Preferred Stock Features Preferred Stock Features Est time: 01–05 Capital Structure and Taxes a. Yes. The company has the option to buy back the notes. The redemption price is the greater of $1,000 or a price that is determined by the value of an equivalent Treasury bond. b. The annual coupon is $58.05, paid in two installments of $29.03 each. c. No. While these notes are not secured, they are senior debt, and if Boeing sets aside assets to protect any other bondholders, the notes will also be secured by these assets. This is called a negative pledge clause. d. No. Moody’s bond rating is Baa, the fourth highest quality rating. It is characterized by “adequate payment capacity” and is the lowest investment grade rating. e. The bonds are repaid in one lump sum at maturity, in 2050. f. Since the debt is due in 2050 and is longer than 1 year, it is considered funded debt. Est time: 01–05 Bond Features Bond Types a. Debt maturing in more than 1 year is often called funded debt. b. An issue of bonds that is sold simultaneously in several countries is traditionally called a Eurobond. c. If a lender ranks behind the firm’s general creditors in the event of default, the loan is said to be junior. d. In many cases a firm is obliged to make regular contributions to a sinking fund, which is then used to repurchase bonds. e. Some bonds give the firm the right to repurchase or call the bonds at specified prices. f. The benchmark interest rate that banks charge to their customers with good credit is generally termed the prime rate. g. The interest rate on bank loans is often tied to short‐term interest rates. These loans are usually called floating rate loans. h. Where there is a private placement, securities are sold directly to a small group of institutional investors. These securities cannot be resold to individual investors. i. In the case of a public issue, debt can be freely boug