Chapter 10

Question 0

What is the breakeven point of EBIT between the choices of debt and equity financing?

Capital to be raised: 4 mil
Cost of debt: 10%
Current shares outstanding: 200k
Additional shares to be sold: 100k

Answer 0

EBIT = (300,000 x 400,000)/ 100,000 = $1.2 mil

Question 1

Formula to determine breakeven EBIT

Answer 1

EBIT = (total shares of outstanding if stock is sold x cost of debt) / additional shares to be sold If EBIT is lower than breakeven point, equity financing would make sense.

Question 2

What are the limitations of financial leverage ?

Answer 2

Interest rates go up as amount borrowed increases

Less available cash

Increased risk of default (cost of financial distress)

Question 3

Why is the cost of insurance leverage fixed?

Answer 3

It is the interest expense on bonds issued.

Question 4

Which ratio is used to measure insurance leverage?

Answer 4

Reserves-to-surplus

Question 5

This ratio measures an insurer’s relative exposure to underwriting risks.

Answer 5

Premium-to-surplus

Question 6

Which ratio can be used to estimate the cost of operations?

Answer 6

Underwriting results to reserves

Question 7

What is the formula for underwriting results to reserves ratio?

Answer 7

[loss * (1 - tax rate)] / reserves

Question 8

What are the limitations on an insurer’s ability to expand?

Answer 8

• SAP requires immediate recognition of policy acquisition costs and deferral of revenues
• states require minimum surplus
• cost of insurer debt must be less than the expected return
• as new business is written, there is increased chance of underwriting losses.

Question 9

What does the cost of capital depend on?

Answer 9

The type of capital.

Question 10

What is used to determine the cost of capital when there are multiple sources of capital?

Answer 10

WACC

Question 11

What can the discounted cash flow model only be used for?

Answer 11

To determine the cost of equity. Only used on companies that pay dividends.

Question 12

What is the discounted cash flow formula to determine the cost of equity for a company paying a dividend?

Answer 12

(Dividend * (1 + dividend growth rate) / price + dividend growth rate

Question 13

What is the formula got the capital asset pricing model of pricing an asset? (CAPM)

Answer 13

Cost = risk-free rate + beta * (expected market return - risk free rate)

Question 14

Which types of risk does the CAPM take into account?

Answer 14

Systematic and unsystematic risk. I’m

Question 15

How is the cost of preferred stock determined?

Answer 15

Like a perpetuity unless it is callable. Then it would be valued like a bond.

Formula: dividend / price

Question 16

How is the cost of new debt determined?

Answer 16

It is the interest expense.

Risk free rate + risk premium) * (1 - tax rate

Question 17

When is the WACC used?

Answer 17

Used to determine cost of capital when there are different types of capital.

Question 18

How is WACC calculated?

Answer 18

Cost of capital = (cost of equity * %) + (cost of debt * %)

Question 19

What is WACC especially important for?

Answer 19

Budgeting purposes. When looking at projects if return is less than WACC them they have to be avoided so they don’t reduce value to shareholders.

Question 20

Use dividend growth model. Which of the following equals the cost of equity capital. 
Capital to be raised $1.5MM
Current dividend per share $3
Present cost of stock per share $60
Dividend growth 6%

6. 9
7. 8
8. 3
9. 2

Answer 20

?

Question 21

Which types of risk does RBC look at?

Answer 21

Asset, credit, underwriting

Question 22

Calculate the cost of insurer debt using the underwriting results to reserves ratio.

$4 million loss
30% tax rate
$100M reserves

Answer 22

-4,000,000 * (1-.30) / $100,000,000 = 2.8%

Question 23

safety has 4 to 1 premium written to ph surplus ratio and a .6 to 1 reserves to premium written ratio. What is the insurance leverage?

Answer 23

Multiply both to get 2.4

Question 24

DCF Model

Stock has 10% dividend rate and price is $50. What is the cost of issuing equity?

Answer 24

Dividend = 5

(5 * 1.10) (5.50) / 50 + .10 (50.1$

5.5 / 50.1 = 11%

Question 25

CAPM model

Risk free rate 3%
Expected market return 15%
Beta of asset 1.2

Calculate cost of equity

Answer 25

(.03 + 1.2) * (15 + 3)

1.23 * .18 = .22

Question 26

This preferred stock pays a dividend of 10%. Shares are $50. What is the cost?

Answer 26

$5/$50