Question

The Drill Cafe has a cost of equity of 14.7 percent and a pretax cost of debt of 7.5 percent. The debt-equity ratio is .6 and the tax rate is 21 percent. What is the unlevered cost of capital?

	A.	11.60 percent
	B.	12.38 percent
	C.	12.85 percent
	D.	11.15 percent

The Green Florist has 45,000 shares of stock outstanding with a par value of $0.50 per share and a market value of $12.60 a share. The company just announced a 2-for-3 reverse stock split. Currently, you own 1,200 shares of this stock. How many shares will you own after the reverse stock split?

	A.	3,250 shares
	B.	1,800 shares
	C.	800 shares
	D.	640 shares

All other things held constant, if the exercise price of an option decreases, then the value of the put option _____ and the value of the call option _____.

	A.	increases; increases
	B.	decreases; increases
	C.	decreases; decreases
	D.	increases; decreases

Answer 1

Drill Cafe: Using MM Proposition,
Re = R_UL + (R_UL - Rd) x (D/E) x (1 - Tc)
14.7 = R_UL + (R_UL - 7.5) x 0.6 x (0.79)
14.7 = 1.474R_UL - 3.555
Hence, R_UL = 12.38%

Green Florist: With the reverse stock split, the firm is reducing its no. of shares outstanding.
New Shares = Shares Previously x (m/n) = 1200 x 2/3 = 800

Options: Out of the money call options are cheap, while in the money call options are expensive. As the exercise price reduces, the option moves in the money therefore, value of call increases.
On the other hand, the value of the put option decreases.