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retaker
10-22-2002, 05:37 PM
The present values of the following three annuities are equal:

(i) perpetuity-immediate paying 1 each year, calculated at an annual effective interest rate of 7.25%.

(ii) 50-year annuity-immediate paying 1 each year, calculated at an annual effective interest rate of j%

(iii) n-year annuity-immediate paying 1 each year, calculated at an annual effective interest rate of j - 1%

Calculate n.

(A) 30 (B) 33 (C) 36 (D) 39 (E) 42

They say the answer to this is E. I disagree.

The market value of a company’s liabilities consists of 40 of debt and 80 of equity, for total liabilities of 120.
The Beta for the company’s debt and equity are 0.3 and 1.65, respectively. The expected return on the company’s debt is 9%. The company has a weighted average cost of capital of 14%.

Which of the following statements are true, ignoring the effect of taxes?

I. If the proceeds from issuing additional equity of 10 are used to retire
10 of debt, the company’s cost of capital will increase to 14.6%.

II. If a proposed new project has a Beta of 1.05, the project is riskier

III. If the risk-free rate is 8%, then the expected risk premium on the
market is 5% .

(A) I only
(B) II only
(C) III only
(D) I and II only
(E) I and III only

They say A is the correct answer.

shluffer
10-22-2002, 07:21 PM
The answer to the second question is C not A. for C all you have to do is use the capm: .14=.08+1.2*X where X is the expected risk remium, .05. II is false because the B for the company is 1.2. Statement one is false because Brealy Myers prescribes to the M&M theory that return on asset will not change in a no tax world when you change either the required return on equity or debt changes. Rather, the oother one compensates.

c3 taker
10-22-2002, 07:47 PM
I get 30.17 for the the first one. So a.) I guess

Eeyore
10-22-2002, 07:50 PM
The answer to the first question is A
Let me know if you need to see my solution

retaker
10-23-2002, 09:04 AM
Thanks guys, I thought they were incorrect but wanted to make sure.

For the Finance one I tried to verify the 3rd statement using not the company's cost of capital and the asset beta, but with r_d and beta debt. (because r_d was given)

.09 =? .08 + .3(r_m - r_d)

I believe you should be able to do this this way too, but it doesn't work.

Avi
10-23-2002, 02:09 PM
Thanks guys, I thought they were incorrect but wanted to make sure.

For the Finance one I tried to verify the 3rd statement using not the company's cost of capital and the asset beta, but with r_d and beta debt. (because r_d was given)

.09 =? .08 + .3(r_m - r_d)

I believe you should be able to do this this way too, but it doesn't work.

.09 is the cost of debt.
The WACC is .14 and thus:

.14 = .08 + 1.2(.05)