FIN701 Spring 2020: Quiz 5, Practice Exam 1 & 2 Solutions

This document provides detailed solutions to a FIN701 quiz and practice exams, covering key concepts in corporate finance. The solutions include calculations for the dividend discount model to determine stock valuation, analysis of expected return and standard deviation for stock portfolios, and explanations of stock dividends and their impact. The document also addresses the relationship between debt and the cost of equity, the effects of stock splits, and the interpretation of dividend signals. Furthermore, the solutions encompass asset beta calculation, the impact of tax rate changes on WACC, the cost of unlevered equity, and the pecking order theory. Additionally, the document explores the benefits of debt financing, the application of the security market line, the impact of dividend payments on retained earnings, and the valuation of a firm. Finally, it includes the holding period return for bonds under various economic scenarios.

Exam PDF 2

Exam pdf 2
Part 1: e: Using the formula of dividend discount model which is given by
Stock Price = Dividend /(1+Required Return)^N
= 2.1/(1+0.145)^1 + 36.5/(1+0.145)^2
=1.834 + 27.84 = $29.67
Part 2: e
The expected return for each of the stock would be calculated,
Expected Return Q = 0.25*18% + 0.75* 9% = 4.5%+6.75% = 11.25%
Expected Return R= 0.25*9% + 0.75* 5% = 2.25%+3.75% = 6%
The Standard deviation of each stock would be calculated by
Expected Return ^2 * Probability Q= 18^2*0.25 + 9^2*0.75 = 0.0081+0.0060275 = 0.014175
Expected Return ^2 * Probability R= 9^2*0.25 + 5^2*0.75 = 0.002025+0.001875 = 0.0039
Standard deviation of Q = (0.014175-0.1125^2)^0.5 = (0.001525)^0.5 = 3.9%
Standard deviation of R = (0.0039-0.06^2)^0.5 = (0.0003)^0.5 = 1.73%
Standard deviation of the portfolio = 3.9%*0.4 + 1.73%*0.6 = 2.6%
Part 3: d:
The value of shares in the stock account = 5000. The Stock dividend which is announced by
the company is 50%
Hence the value of stock dividend announced = 5000*0.5 = 2500.
The value of the Stock account after stock dividend = 5000+2500 =7500

Part 4: d: This is because the as the level of debt increases in the company, the cost of equity
increases as the risk for the equity share holder increases.
Part 5: a:
The earnings for the company is $5, while the corporate tax rate for the company is 34%.
Hence income available for shareholders is = 5*(1-0.34) = $3.3
The payout ratio of the company is 40% while the tax on dividend is 10%. Hence the
dividend income of the shareholders is = 3.3*0.4*(1-0.1) = $1.188
Part 6: a: The asset specific risk is also known as unsystematic risk which is reduced by the
diversification of the portfolio.
Part 7: a:
Part 8: a: The shareholders would receive 1 share for every 5 shares which is held by the
investor. Thus the number of shares for the company would become = 125000/5 = 25000
shares. Also the par value of the share would increase by the splitting ratio, hence the par
value of each share would be $1*5 = $5
Part 9: b: An increase in dividend implies that the company is expected to maintain the new
dividend amount in the future. It signals the investor and provides expectations of increase in
future cash flow.
Part 10: e: The asset beta of the company is calculated by the formula,
Asset Beta = Levered Beta/(1+Debt/Equity Ratio) = 1.2/ 1+0.47 = 0.816
Part 11: a: The decrease in the tax rate would reduce the interest rate tax shield for the debt
financing. This would increase the cost of debt and hence the WACC of the firm.
Part 12: e: The cost of unlevered equity is provided by the following formula,

Value of levered equity = Value of unlevered +(Debt /Equity)*(Value of unlevered –Value of
debt)
13.04% = VU + 0.64*(VU-8%)= 13.04 = VU+0.64VU-5.12%
13.04% + 5.12% = 1.64VU = 18.16% = 1.64VU =VU = 18.16/1.64 = 11.56%
Part 13: b: As the dividend of the company are indicator of the future growth of the company
and the policy makers need to have consistent dividend policy. If the dividend of the
company is unstable it creates uncertainty among investors which decreases the value of the
company.
Part 14: e: The pecking order theory is the manner in which the firm raises its capital for its
projects. The 1st layer is financing through the retained earnings which is followed by debt
financing and then equity financing.
Part 15: c: As it provides tax shield on the interest expense of debt which is paid by the
company and hence reduces the overall cost of debt for the company.
Part 16: e:
The holding period return for both the bonds is calculated in both the situation using the
following formula,
( Selling Price - Purchase Price)/Purchase Price
Doing well = 35-25.5/25.5 = 37.2%
Poor = 20-25.5/25.5 = -21.5%
The probability being 50% the return which is promised to the bond holders is
= 37.2%*0.5 + (-21.5% * 0.5) = 7.84%

Part 17: e: The tax on dividend reduces the earnings for the shareholders when they are taxed
as ordinary income. In such a situation the company should use other methods of creating
value for the shareholders.
Part 18: b: Any security which lies above the security market line is undervalued and should
be used for investment purpose. As the level of return would be higher as per the level of risk.
Part 19: d: The dividend is paid out of the earnings which is retained by the company. Hence
the dividend which is paid is $0.82 per share and the number of share is 120000. The retained
earnings of the company would reduce by 120000*0.82 = $98400.
Part 20: b: The price of each share is calculated which is debt / no of shares = 74000/2100 =
$35.23.
This value is multiplied with the total number of shares outstanding = (40000-2100)*35.23 =
$1335217
Value of the firm = Value of equity + value of debt = 1335217 +74000 = 1409524.