16. The covariance between Van Gough’s common stock returns and the return on th
ID: 2765295 • Letter: 1
Question
16. The covariance between Van Gough’s common stock returns and the return on the market portfolio is 0.008. The variance of the market 0.02. Which of the following comes closest to the beta of Van Gough’s common stock?
A. 0.6
B. 0.4
C. 0.1
D. 0.2
17. According to the M&M tax model, the value of a levered firm is equal to the value of an unlevered firm plus the tax shield from debt. What does this model imply about the firm’s optimal capital structure?
0 % debt
25% debt
100% debt
50% debt
18. Northern Wood Products is currently an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000. Management is considering raising additional $88,000 either by issuing additional 1000 common stocks at $88 each, or by issuing 88 bonds with a 6 percent coupon rate and $1000 face value. If the firm is expected to have EBIT of $26,000,
what will the earnings per share be if they issue additional stock? Assume tax rate of 50%.
0.76
0.36
0.65
0.48
PLEASE ANSWER ALL QUESTIONS
A.0 % debt
B.25% debt
C.100% debt
D.50% debt
Explanation / Answer
16. Beta = Covariance between stock and market / variance of mrket
= 0.008 / 0.02
= 0.4
So, the right answer is B 0.4
17. C. 100% Debt
M&M tx model provides that debt financing is advantageous, and at the extreme, a firm's optimal capital structure is 100 percent debt. It also means a firm's WACC decreases as firm relies more heavily on debt financing.
18. If additional stock is issued, then the number of shares would become 17000 (16000 +1000)
EBIT = $26000
Earnings for shareholders = 26000 - 50% taxes = $13000
Earnings per share = 13000 / 17000 = 0.76
So, A $0.76 is the correct answer
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