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Question No: 42 ( Marks: 5 )

Suppose a Firm ABC has Total Assets of Rs.1000 and is 100% Equity based (i.e. Un-levered). There were 10 equal Owners and 5 of them want to leave. So the Firm takes a Bank Loan of Rs.500 (at 10%pa Mark-up) and pays back the Equity Capital to the 5 Owners who are leaving. Now, half of the Equity Capital has been replaced with a Loan from a Bank (i.e. Debt). What impact does this have on ROE?

Answer: As the firm replaces equity with debt it is increasing financial leverage which is a cause of financial risk. The impact of debt on ROE is that ROE will increase but with the greater uncertainty hence greater will be the risk.

Question No: 43 ( Marks: 10 )

Stock X has a beta of 0.5, stock Y has a beta of 1.0, and stock Z has a beta of 1.25. The risk free rate is 10% and the expected market return is 18%.

a. Find the expected return on stock X

b. Find the expected return on stock Y

c. Find the expected return on stock Z

d. Suppose that you construct a portfolio consisting of 40% X, 20% Y and 40% Z. What is the beta of the portfolio?

Answer:

a. rM = 18%

rRF = 10%

β = 0.5

r = rRF + ( rM + rRF ) β

= 10% + (18%-10%) 0.5

= 10% + 4%

= 14%

b. rM = 18%

rRF = 10%

β = 1.00

r = rRF + ( rM + rRF ) β

= 10% + (18%-10%) 1.00

= 10% + 8%

= 18%

c. rM = 18%

rRF = 10%

β = 1.25

r = rRF + ( rM + rRF ) β

= 10% + (18%-10%) 1.25

= 10% + 10%

= 20%

d. Beta of portfolio = βP = X βX + Y βY + Z βZ

= (40/100)0.5 + (20/100)1.0 + (40/100)1.25

= 0.4x0.5 + 0.2x1.0 + 0.4x1.25

= 0.2 + 0.2 + 0.5

= 0.9

Question No: 44 ( Marks: 10 )

The ABC company is in the 35% marginal tax bracket. The current market value of the firm is Rs. 12 million. If there are no costs to bankruptcy:

a. What will be ABC’ annual tax savings from interest deductions be if it issues Rs. 2 million of five years bonds at 12 % interest rate? What will be the value of the firm?

ANSWER: Annual Coupon payment each yr = 12% of 2,000,000

= 2000000 x 12/100

= 24000

Tax saving for 5 yrs = 5(35 % of 24000)

= 5(24000 x 35/100)

= 5x8400

= 42000

b. What will ABC’ annual tax savings from interest deductions be if it issues Rs. 2 million of seven years bonds at 12 % interest rate? What will be the value of the firm?

Answer: Annual Coupon payment each yr = 12% of 2,000,000

= 2000000 x 12/100

= 24000

Tax saving for 7 yrs = 7(35 % of 24000)

= 7(24000 x 35/100)

= 7x8400

= 58800

Question No: 45 ( Marks: 10 )

Using the Capital Asset Pricing Model (CAPM), determine the required return on equity for the following situations:

Situations Expected return on market portfolio Risk- free rate Beta

1 16% 12% 1.00

2 18 8 0.80

3 15 14 0.70

4 17 13 1.20

5 20 15 1.60

What generalization can you make?

ANSWER: Required return= r = rRF + ( rM + rRF ) β

Where rRF = risk free return

rM = expected return on market

β = beta of stock

1. rM = 16%

rRF = 12%

β = 1.00

r = rRF + ( rM + rRF ) β

= 12% + (16%-12%)1.00

= 12% + 4%

= 16%

2. rM = 18%

rRF = 8%

β = 0.80

r = rRF + ( rM + rRF ) β

= 8% + (18%-8%)0.80

= 8% + 8%

= 16%

3. rM = 15%

rRF = 14%

β = 0.70

r = rRF + ( rM + rRF ) β

= 14% + (15%-14%)0.70

= 14% + 0.70

= 14.7%

4. rM = 17%

rRF = 13%

β = 1.20

r = rRF + ( rM + rRF ) β

= 13% + (17%-13%)1.20

= 13% + 4.8%

= 17.8%

5. rM = 20%

rRF = 15%

β = 1.60

r = rRF + ( rM + rRF ) β

= 15% + (20%-15%) 1.60

= 15% + 8%

= 23%

GENERALIZATION: As beta of stock rises the return on stock also rises.

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