SECTION A: Multiple Choice
SECTION B: Short Answer (8 Questions)
(Answer all questions in this section, each question is worth 5 marks)
1. How is it possible that dividends are so important but, at the same time, dividend policy is irrelevant ?
Signalling theory shows that dividends are important since they convey inside information to investors hence affect shares price. Under the MM assumptions, dividend policy is irrelevant because it only defines the form in which shareholders’ returns are received. Funds paid out as ...view middle of the document...
4. Why do agency problems exist between managers and shareholders? Explain four methods to reduce the agency problem.
Although shareholders own the company, managers have more information and run the business. When mangers and shareholders have conflict of interests, agency problem exists.
Get the sack - threat
Company Takeover – threat
Role of auditor
Remuneration package (share options) – significant debate at present (legislation in US).
5. You are considering three investments. The first is a bond that is selling in the market at $1,100. The bond has a $1,000 par value, pays interest at 13 percent, and is scheduled to mature in 15 years. For bonds of this risk class you believe that a 14 percent rate of return should be required. The second investment that you are analysing is a preferred stock ($100 par value) that sells for $90 and pays an annual dividend of $ 13. Your required rate of return for this stock is 15 percent. The last investment is a common stock ($25 par value) that recently paid a $2 dividend. The firm's earnings per share have increased from $3 to $6 in 10 years, which also reflects the expected growth in dividends per share for the indefinite future. The stock is selling for $20, and you think a reasonable required rate of return for the stock is 20 percent.
a) Calculate the value of each security based on your required rate of return.
b) Which investment(s) should you accept? Why?
c) If your anticipated growth rate in dividends per share changed to 12 percent, would your answer change?
Bond : P = 130/0.14*(1-1/(1.14^15)) + 1000/(1.14)^15 = $938.58 (Market price :$1100)
Preferred Stock: P = 13/0.15 = $86.67 (Market price :$90)
Common Stock :
g = ((6/3)^(1/10 ))-1 = 7.18%
P = (2*(1+ 0.0718))/(0.2-0.0718)= $16.72 (Market price :$20)
b) All investments are overvalued (the market prices are higher than the fundamental values), hence they should not be accepted.
c) P = (2*(1+ 0.12))/(0.2-0.12)= $28
Increase in growth increases the value of the stock. Since the new value is higher than the market value, should invest in common stock.
6. Stewart Inc. has $4,000,000 in total assets. The company’s current capital structure consists of 25 percent debt and 75 percent common equity. Currently, the company’s before-tax cost of debt is 8 percent. The risk-free rate (kRF) is 5 percent and the market risk premium (kM – kRF) is also 5 percent. At the firm’s current capital structure, the company’s beta is 1.15. Stewart’s operating income (EBIT) is $300,000, its interest expense is $80,000, and its tax rate is 40 percent. The company has 80,000 outstanding shares of common stock. The company’s net income is currently $132,000, and its earnings per share (EPS) is $1.65.
What is the company’s WACC?
wd = 25%; ws = 75%; kd = 8%; T = 40%.
WACC = 0.75*10.75% +0.25*(8.0% ( (1 - 0.40)) =...