## B.A. 130 Fall 1996 Midterm 1

Part A (30 minutes): Identifications. Write two sentences on each.

1. What is "economic depreciation"? How is it different from "accounting depreciation"?

2. What is "decision tree analysis"?

3. What is "Monte Carlo analysis"?

4. What is a"stock split"?

5. What is a "rights issue"?

6. What is meant when a security is called "subordinated"?

7. What is a "discount bond"? How is it different from a "coupon bond"?

8. What is meant by the "separation of ownership from control"?

Part B (25 minutes): Values. Show your work.

1. Suppose the risk-free rate r*f is 4% per year and the market portfolio expected return r*m is 8% per year. Suppose the standard deviation of the market portfolio's annual return is 20%, and the covariance of the annual return of security i with the market portfolio's annual return is 0.04. Suppose, further, that the expected cash flow from security i is \$1,250,000 each year forever. What is the current market price of security i?

2. Consider an asset with the following cash flows:

 Year Zero Year One Year Two Year Three Cash Flows: -\$60 +\$32 +\$28 +\$24

The discount rate is 20% per year. Calculate economic depreciation. Calculate the true profitability of the asset in each year.

3. Suppose the covariance of the Betatron Company's annual return with the market is .04, and the standard deviation of the market return is 20% per year. Suppose, further, that half of the market value of the Betatron Company is in the form of bonds; half is held in the form of common stocks; and that the Betatron Company's bonds have a beta of 1.1.

What is the beta of the Betatron Company's common stock?

4. In 1996, Megacorp makes a rights issue, at \$5 per share, of one new share for every two shares held. Before the issue there were 50 million shares outstanding, and the share price was \$12. What is the value of a right? What is the prospective post-rights issue price of the stock?

Part C (25 minutes): Capital Structure. Show your work.

1. What is the present value of the interest tax shield generated by:

• A \$1,000,000, one-year loan at 8% per year?
• A \$10,000,000, five-year loan at 8% per year?
• A \$10,000,000 perpetual loan at 7% per year?

Consider corporate income taxes only, and assume that the marginal tax rate is 35%.

2. What is the tax advantage of corporate debt if the corporate tax rate is 35% and the personal tax rate is 31%, and if all equity income is ultimately received by investors as capital gains and escapes personal income tax entirely?

3. Atlas Industries and Bering Enterprises are identical except for their capital structures. Atlas is financed 30% by debt and 70% by equity. Bering is financed 10% by debt and 90% by equity. The debt of both companies is risk-free.

• What investment package--made up of borrowing, lending, and purchasing stock in Bering--would produce the same cash flows as a 1% equity stake in Atlas?
• What investment package--made up of borrowing, lending, and purchasing stock in Atlas--would produce the same cash flows as a 2% equity stake in Bering?

4. Consider a firm expected to produce a constant, level stream of operating profit. Describe, qualitatively, what happens to the equity earnings-price ratio as leverage is increased. ÿ