Centre for Innovation & Enterprise B320 Business Finance

B320 Business Finance

UT3 EXTRA PRACTICE QUESTION SET

Question 1

Patrick has a portfolio of the following stocks as shown in the table below.

Investment Allocation Beta

Stock A 10% 1.3
Stock B 20% 1.4
Stock C 70% 0.7

a) What is the portfolio beta?

Answer:

Portfolio beta = (W1*B1) + (W2*B2) + (W3*B3)

= (10%*1.3) + (20%*1.4) + (70%*0.7)
= 0.9

b) Do you think Patrick’s portfolio is more risky than the market portfolio?

Answer:

No. Patrick’s portfolio beta is less than 1, thus it is less risky than the market
portfolio.

© 2009 RP/CIE/AF/Sem 2 Page 1

Centre for Innovation & Enterprise B320 Business Finance

Question 2

Vertical Bank has $3m of long term debt and equity of $7m. The current corporate
tax rate is 17% and the bank’s beta is 1.25.

a) Given that the interest rate of the long term debt is 5%, what is the after tax cost of
debt?

Answer:

Cost of debt after tax = Cost of debt before tax * (1 – Tax Rate)
= 5% * (1 – 17%)
= 4.15%

b) Given the following information, what is the bank’s cost of equity?

Annual Market Return: 10%

One year government bond: 3%

Answer:

Cost of equity = Rf + (Rm – Rf)(B)

= 3% + (10% - 3%)(1.25)
= 11.75%

c) What is the weighted average cost of capital (WACC) of the bank?

Answer:

WACC = (Long Term debt/Total Debt & Equity)(Cost of debt after tax) +
(Equity/Total Debt & Equity)(Cost of Equity)
= (3/10)(4.15%) + (7/10)(11.75%)
= 9.47%

d) Vertical Bank is considering making an investment with expected return of 12%.

Do you think they should make the investment?

Answer:

Yes, the expected return is 12% which is higher than the WACC which is 9.47%.
They would still make a profit of 2.53% from this investment.

© 2009 RP/CIE/AF/Sem 2 Page 2

Centre for Innovation & Enterprise B320 Business Finance

Question 3

Dector Design is contemplating a suitable capital structure for its company. In

addition to the following information below, the tax rate is 20% and earnings before
interest and tax (EBIT) is $2m.

a) Fill in the blanks with the respective values of the bank.

Proportion of debt in WACC Value of the bank

capital structure
20% 7.8% EBIT * (1 – Tax Rate) / WACC
= 2 * (1-20%) / 7.8%
= 20.51m
50% 6.6% EBIT * (1 – Tax Rate) / WACC
= 2 * (1-20%) / 6.6%
= 24.24m
80% 7.1% EBIT * (1 – Tax Rate) / WACC
= 2 * (1-20%) / 7.1%
= 22.53m

b) What is the desirable capital structure for Dector Design?

Answer:

50% Porportion of debt in capital structure because to optimal capital structure, when
WACC is Minimized, the value of firm is maximized.

© 2009 RP/CIE/AF/Sem 2 Page 3

Centre for Innovation & Enterprise B320 Business Finance

Question 4

Complete the table with its respective theory/hypothesis for the following
descriptions.

Description Theory/ Hypothesis

• Distribution of dividends has no Dividend Irrelevance Theory
effect on either its value or its cost of
capital in a perfect capital market.
• Investors regard dividend changes Signaling Hypothesis
as signals of management’s earning
forecast.
• An increase in dividends is viewed
as positive signal and investors bid up
the share price.
• People in the high income bracket Tax Preference Theory
prefer capital gains to dividends when
capital gains tax rate is less than
dividend income tax rate.

© 2009 RP/CIE/AF/Sem 2 Page 4