Question 383 Merton model of corporate debt, real option, option
In the Merton model of corporate debt, buying a levered company's debt is equivalent to buying the company's assets and:
A one year European-style put option has a strike price of $4.
The option's underlying stock currently trades at $5, pays no dividends and its standard deviation of continuously compounded returns is 47% pa.
The risk-free interest rate is 10% pa continuously compounded.
Use the Black-Scholes-Merton formula to calculate the option price. The put option price now is:
An old company's Firm Free Cash Flow (FFCF, same as CFFA) is forecast in the graph below.
To value the firm's assets, the terminal value needs to be calculated using the perpetuity with growth formula:
###V_{\text{terminal, }t-1} = \dfrac{FFCF_{\text{terminal, }t}}{r-g}###
Which point corresponds to the best time to calculate the terminal value?
Question 370 capital budgeting, NPV, interest tax shield, WACC, CFFA
| Project Data | ||
| Project life | 2 yrs | |
| Initial investment in equipment | $600k | |
| Depreciation of equipment per year | $250k | |
| Expected sale price of equipment at end of project | $200k | |
| Revenue per job | $12k | |
| Variable cost per job | $4k | |
| Quantity of jobs per year | 120 | |
| Fixed costs per year, paid at the end of each year | $100k | |
| Interest expense in first year (at t=1) | $16.091k | |
| Interest expense in second year (at t=2) | $9.711k | |
| Tax rate | 30% | |
| Government treasury bond yield | 5% | |
| Bank loan debt yield | 6% | |
| Levered cost of equity | 12.5% | |
| Market portfolio return | 10% | |
| Beta of assets | 1.24 | |
| Beta of levered equity | 1.5 | |
| Firm's and project's debt-to-equity ratio | 25% | |
Notes
- The project will require an immediate purchase of $50k of inventory, which will all be sold at cost when the project ends. Current liabilities are negligible so they can be ignored.
Assumptions
- The debt-to-equity ratio will be kept constant throughout the life of the project. The amount of interest expense at the end of each period has been correctly calculated to maintain this constant debt-to-equity ratio. Note that interest expense is different in each year.
- Thousands are represented by 'k' (kilo).
- All cash flows occur at the start or end of the year as appropriate, not in the middle or throughout the year.
- All rates and cash flows are nominal. The inflation rate is 2% pa.
- All rates are given as effective annual rates.
- The 50% capital gains tax discount is not available since the project is undertaken by a firm, not an individual.
What is the net present value (NPV) of the project?
Question 625 dividend re-investment plan, capital raising
Which of the following statements about dividend re-investment plans (DRP's) is NOT correct?
A firm wishes to raise $100 million now. The firm's current market value of equity is $300m and the market price per share is $5. They estimate that they'll be able to issue shares in a rights issue at a subscription price of $4. All answers are rounded to 6 decimal places. Ignore the time value of money and assume that all shareholders exercise their rights. Which of the following statements is NOT correct?
Question 1018 RBA cash rate, monetary policy, foreign exchange rate
RBA Governor Phil Lowe says that when the RBA raises the cash rate (by surprise), the Australian dollar (AUD) tends to:
Question 523 income and capital returns, real and nominal returns and cash flows, inflation
A low-growth mature stock has an expected nominal total return of 6% pa and nominal capital return of 2% pa. Inflation is expected to be 3% pa.
All of the above are effective nominal rates and investors believe that they will stay the same in perpetuity.
What are the stock's expected real total, capital and income returns?
The answer choices below are given in the same order.
Question 525 income and capital returns, real and nominal returns and cash flows, inflation
Which of the following statements about cash in the form of notes and coins is NOT correct? Assume that inflation is positive.
Notes and coins:
Question 575 inflation, real and nominal returns and cash flows
You expect a nominal payment of $100 in 5 years. The real discount rate is 10% pa and the inflation rate is 3% pa. Which of the following statements is NOT correct?
Question 740 real and nominal returns and cash flows, DDM, inflation
Taking inflation into account when using the DDM can be hard. Which of the following formulas will NOT give a company's current stock price ##(P_0)##? Assume that the annual dividend was just paid ##(C_0)##, and the next dividend will be paid in one year ##(C_1)##.
Question 578 inflation, real and nominal returns and cash flows
Which of the following statements about inflation is NOT correct?
Which of the following investable assets are NOT suitable for valuation using PE multiples techniques?
Question 749 Multiples valuation, PE ratio, price to revenue ratio, price to book ratio, NPV
A real estate agent says that the price of a house in Sydney Australia is approximately equal to the gross weekly rent times 1000.
What type of valuation method is the real estate agent using?
A stock has a beta of 1.2. Its next dividend is expected to be $20, paid one year from now.
Dividends are expected to be paid annually and grow by 1.5% pa forever.
Treasury bonds yield 3% pa and the market portfolio's expected return is 7% pa. All returns are effective annual rates.
What is the price of the stock now?
Question 800 leverage, portfolio return, risk, portfolio risk, capital structure, no explanation
Which of the following assets would you expect to have the highest required rate of return? All values are current market values.
Question 241 Miller and Modigliani, leverage, payout policy, diversification, NPV
One of Miller and Modigliani's (M&M's) important insights is that a firm's managers should not try to achieve a particular level of leverage in a world with zero taxes and perfect information since investors can make their own leverage. Therefore corporate capital structure policy is irrelevant since investors can achieve their own desired leverage at the personal level by borrowing or lending on their own.
This principal of 'home-made' or 'do-it-yourself' leverage can also be applied to other topics. Read the following statements to decide which are true:
(I) Payout policy: a firm's managers should not try to achieve a particular pattern of equity payout.
(II) Agency costs: a firm's managers should not try to minimise agency costs.
(III) Diversification: a firm's managers should not try to diversify across industries.
(IV) Shareholder wealth: a firm's managers should not try to maximise shareholders' wealth.
Which of the above statement(s) are true?
Question 337 capital structure, interest tax shield, leverage, real and nominal returns and cash flows, multi stage growth model
A fast-growing firm is suitable for valuation using a multi-stage growth model.
It's nominal unlevered cash flow from assets (##CFFA_U##) at the end of this year (t=1) is expected to be $1 million. After that it is expected to grow at a rate of:
- 12% pa for the next two years (from t=1 to 3),
- 5% over the fourth year (from t=3 to 4), and
- -1% forever after that (from t=4 onwards). Note that this is a negative one percent growth rate.
Assume that:
- The nominal WACC after tax is 9.5% pa and is not expected to change.
- The nominal WACC before tax is 10% pa and is not expected to change.
- The firm has a target debt-to-equity ratio that it plans to maintain.
- The inflation rate is 3% pa.
- All rates are given as nominal effective annual rates.
What is the levered value of this fast growing firm's assets?
An analyst is valuing a levered company whose owners insist on keeping a constant market debt to assets ratio into the future.
The analyst is wondering how asset values and other things in her model will change when she changes the forecast sales growth rate.
Which of the below values will increase as the forecast growth rate of sales increases, with the debt to assets ratio remaining constant?
Assume that the cost of debt (yield) remains constant and the company’s asset beta will also remain constant since any expansion (or downsize) will involve buying (or selling) more of the same assets.
The analyst should expect which value or ratio to increase when the forecast growth rate of sales increases and the debt to assets ratio remains unchanged? In other words, which of the following values will NOT remain constant?
Question 1029 Buffett ratio
Tesla CEO Elon Musk asked a question to ARK Invest CEO Cathie Wood on 6 April 2021: "What do you think of the unusually high ratio of the S&P market cap to GDP?", to which Cathie Wood replied.
What are the units of this S&P500 market cap to GDP ratio, commonly known as the Buffett ratio?
Question 1032 inflation, percent of sales forecasting, no explanation
Investment bank Canaccord's Think Childcare (TNK) initiation of coverage states: "Building lease costs – Rent expense is the second largest cost and TNK reported rent/sales of 12.1%, within the industry range that we typically see as 12-14% of sales. TNK lease all their properties and do not intend to own property. Leases are generally long term with 10-15 year terms and additional options. Although terms vary across properties and landlords, rental increases are generally tied to the consumer price index (CPI)" (Canaccord, 2016).
Assuming that sales grow faster than the CPI, when Canaccord forecast TNK's building lease costs using the 'percent of sales' method, that proportion should:
A stock has a beta of 0.5. Its next dividend is expected to be $3, paid one year from now. Dividends are expected to be paid annually and grow by 2% pa forever. Treasury bonds yield 3% pa and the market risk premium (MRP) is 6% pa. All returns are effective annual rates.
Which of the following statements is NOT correct?
Question 850 gross domestic product, gross domestic product per capita
Below is a table showing some countries’ GDP, population and GDP per capita.
| Countries' GDP and Population | |||
| GDP | Population | GDP per capita | |
| USD million | millions of people | USD | |
| United States | 18,036,648 | 325 | 55,492 |
| China | 11,158,457 | 1,383 | 8,066 |
| Japan | 4,383,076 | 127 | 34,586 |
| Germany | 3,363,600 | 83 | 40,623 |
| Norway | 500,519 | 5 | 95,027 |
Source: "GDP and its breakdown at current prices in US Dollars" United Nations Statistics Division. December 2016.
Using this data only, which one of these countries’ citizens have the highest living standards?
Which form of production is included in the Gross Domestic Product (GDP) reported by the government statistics agency?
Question 1053 bond pricing, monetary policy, supply and demand
In his 31 August 2021 article 'The rich get richer and rates get lower', Robert Armstrong states that: "Savings chase returns, so when there are more savings and the same number of places to put them, rates of return must fall" (Armstrong, 2021).
Another way of saying that "rates of return must fall" when there are more savings (loanable funds) invested into fixed coupon government and corporate bonds, is that increased:
What effect is being referred to in the following quote from the MARTIN model description?
Economy-wide models also account for feedback between economic variables. For example, an increase in aggregate demand will encourage firms to hire more workers, which raises employment and lowers the unemployment rate. The tightening of the labour market is likely to lead to an increase in wages growth. The resulting increase in household incomes is likely to lead to an increase in consumption, further raising aggregate demand. (Ballantyne et al, 2019)
The name of the effect being referred to is:
Question 1052 monetary policy, equilibrium real interest rate, marginal propensity to consume, gross domestic product, bond pricing
In the below chart by Rachel and Summers (2019), the red dotted line depicts the decline in advanced economies’ (AE) equilibrium real interest rate (R*) in percentage points since the 1970’s. The authors attribute this to the factors represented by columns above and below the x-axis. The sum of these columns is given by the black line labelled 'Total response of R* in the GE (general equilibrium) models'.
Which of the below statements about this graph is NOT correct?