Deck 9: Risk and the Cost of Capital

Question 1

A firm's cost of equity can be estimated using the

A)discounted cash-flow (DCF) approach and capital asset pricing model (CAPM).
B)discounted cash-flow (DCF) approach and arbitrage pricing theory (APT).
C)capital asset pricing model (CAPM) and arbitrage pricing theory (APT).
D)discounted cash-flow (DCF) approach, capital asset pricing model (CAPM), and arbitrage pricing theory (APT).

Answer 1

discounted cash-flow (DCF) approach, capital asset pricing model (CAPM), and arbitrage pricing theory (APT).

Question 2

The company cost of capital, when the firm has both debt and equity financing, is called the

A)cost of debt.
B)cost of equity.
C)weighted average cost of capital (WACC).
D)return on equity (ROE).

Answer 2

weighted average cost of capital (WACC).

Question 3

The market value of XYZ Corporation's common stock is $40 million and the market value of its risk-free debt is $60 million.The beta of the company's common stock is 0.8 and the expected market risk premium is 10 percent.If the Treasury bill rate is 6 percent, what is the firm's cost of capital? (Assume no taxes.)

A)9.2 percent
B)14.0 percent
C)8.1 percent
D)10.8 percent

Answer 3

9.2 percent

Question 4

The market value of Charter Cruise Company's equity is $15 million and the market value of its debt is $5 million.If the required rate of return on the equity is 20 percent and that on its debt is 8 percent, calculate the company's cost of capital.(Assume no taxes.)

A)20 percent
B)17 percent
C)14 percent
D)11 percent

Question 5

Which of the following types of projects have average total risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements

Question 6

Company A's historical returns for the past three years were 6 percent, 15 percent, and 15 percent.Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent.Suppose the risk-free rate of return is 4 percent and that investors expect the market to return 10 percent.What is the cost of equity capital (required rate of return of company A's common stock), computed with the CAPM?

A)8.5 percent
B)14.0 percent
C)12.0 percent
D)10.0 percent

Question 7

The hurdle rate for capital budgeting decisions is

A)the cost of capital.
B)the cost of debt.
C)the cost of equity.
D)the risk-free rate.

Question 8

Which of the following types of projects generally have the highest total risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements using known technology

Question 9

Which of the following types of projects have the lowest unique risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements

Question 10

Using a company's cost of capital to evaluate a project is

A)always correct.
B)always incorrect.
C)correct for projects that have average risk compared to the firm's other assets.
D)always correct and correct for projects that have average risk compared to the firm's other assets.

Question 11

A firm's cost of equity can be estimated using the

A)Fama-French three-factor model.
B)capital asset pricing model (CAPM).
C)arbitrage pricing theory (APT).
D)All of the options are correct.

Question 12

The market value of Cable Company's equity is $60 million and the market value of its debt is $40 million.If the required rate of return on the equity is 15 percent and that on its debt is 5 percent, calculate the company's cost of capital.(Assume no taxes.)

A)15 percent
B)10 percent
C)11 percent
D)9 percent

Question 13

Company A's historical returns for the past three years were 6 percent, 15 percent, and 15 percent.Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent.Calculate the beta for Stock

A)1.75
B)1.00
C)0.57
D)0.75

Question 14

The cost of capital is the same as the cost of equity for firms that are financed

A)entirely by debt.
B)by both debt and equity.
C)entirely by equity.
D)by 50 percent equity and 50 percent debt.

Question 15

If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur?

A)The firm will reject good low-risk projects only.
B)The firm will reject good low-risk projects and will accept poor high-risk projects.
C)The firm will reject good low-risk projects, accept poor high-risk projects, and accept poor high-risk projects.
D)The firm will accept poor high-risk projects only.

Question 16

The cost of capital for a project depends on the

A)company's cost of capital.
B)use of the capital (the project).
C)industry cost of capital.
D)company's level of debt financing.

Question 17

If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely occur?

A)The firm will accept poor low-risk projects only.
B)The firm will reject good high-risk projects only.
C)The firm will correctly accept projects with average risk only.
D)The firm will accept poor low-risk projects, reject good high-risk projects, and correctly accept projects with average risk.

Question 18

A firm might categorize its projects into

A)new products only.
B)cost improvements, expansion projects (existing business), and new products only.
C)expansion projects (existing business) and speculative ventures only.
D)cost improvements, expansion projects (existing business), new products, and speculative ventures.

Question 19

The market value of Charcoal Corporation's common stock is $20 million, and the market value of its risk-free debt is $5 million.The beta of the company's common stock is 1.25, and the market risk premium is 8 percent.If the Treasury bill rate is 5 percent, what is the company's cost of capital? (Assume no taxes.)

A)15.0 percent
B)14.6 percent
C)13.0 percent
D)7.0 percent

Question 20

The company cost of capital is the appropriate discount rate for a firm's

A)low-risk projects.
B)high-risk projects.
C)average-risk projects.
D)risk-free projects.

Question 21

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.Calculate the beta for Stock B.

A)0.86
B)1.00
C)1.13
D)1.17

Question 22

Generally, for CAPM calculations, the value to use for the risk-free interest rate is the

A)short-term U.S.Treasury bill rate.
B)long-term corporate bond rate.
C)medium-term corporate bond rate.
D)medium-term average rate on common stocks.

Question 23

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.If the risk-free rate is 4 percent, calculate the market risk premium.

A)18.1 percent
B)14.0 percent
C)10.0 percent
D)6.0 percent

Question 24

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.Calculate the observed covariance of returns between Stock B and the market portfolio.(Ignore the correction for the loss of a degree of freedom set out in the text.)

A)16
B)28
C)36
D)292

Question 25

Financial slang referring to the reduction of cash flows from a project's forecasted value to its certainty equivalent is a(n)

A)deep discount.
B)haircut for risk.
C)arbitrage profit.
D)speculative gain.

Question 26

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.Calculate the average return for Stock B and the market portfolio.

A)Stock B: 16 percent; market portfolio: 14 percent
B)Stock B: 14 percent; market portfolio: 16 percent
C)Stock B: 24 percent; market portfolio: 12 percent
D)Stock B: 12 percent; market portfolio: 16 percent

Question 27

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.The expected market return is 12 percent.Calculate the required rate of return (cost of equity) for Stock B using the CAPM.(The risk-free rate of return = 4%.)

A)8.6 percent
B)12.6 percent
C)10.9 percent
D)16.0 percent

Question 28

The market portfolio's historical returns for the past three years were 10 percent, 10 percent, and 16 percent.Suppose the risk-free rate of return is 4 percent.Estimate the market risk premium.

A)4 percent
B)8 percent
C)12 percent
D)16 percent

Question 29

A project has an expected risky cash flow of $200 in year 1.The risk-free rate is 6 percent, the expected market rate of return is 16 percent, and the project's beta is 1.50.Calculate the certainty equivalent cash flow for year 1, CEQ₁.

A)$175.21
B)$165.29
C)$228.30
D)$182.76

Question 30

The historical returns for the past four years for Stock C and the stock market portfolio were Stock C: 10 percent, 30 percent, 20 percent, 20 percent; market portfolio: 5 percent, 15 percent, 25 percent, 15 percent.Calculate the beta of Stock C.

A)0.86
B)0.50
C)1.50
D)0.38

Question 31

A project has an expected risky cash flow of $500 in year 2.The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20.Calculate the certainty equivalent cash flow for year 2, CEQ₂.

A)$622.04
B)$164.29
C)$401.90
D)$416.13

Question 32

Which of the following informational updates would prompt a financial manager to use a higher cost of capital to analyze a project?

A)Sales estimates from the marketing department have been less accurate of late.
B)The treasurer has recently indicated that the firm will increase its use of debt financing.
C)The treasurer has recently indicated that the firm will decrease its use of debt financing.
D)Recent estimates indicate the project has a greater percentage of fixed costs than previously thought.

Question 33

The historical returns for the past four years for Stock C and the stock market portfolio were Stock C: 10 percent, 30 percent, 20 percent, 20 percent; market portfolio: 5 percent, 15 percent, 25 percent, 15 percent.If the risk-free rate of return is 5 percent and the expected market return is 12 percent, calculate the required rate of return on Stock C using the CAPM.

A)5.0 percent
B)10.0 percent
C)8.5 percent
D)13.0 percent

Question 34

An analyst computes the beta of the computer company WinDoze as 1.7 and the standard error of the estimate as 0.3.What is the 95 percent confidence interval for the calculated beta?

A)1.1-2.3
B)1.4-2.0
C)1.7-2.0
D)1.4-1.7

Question 35

A project has an expected risky cash flow of $500 in year 3.The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20.Calculate the certainty equivalent cash flow for year 3, CEQ₃.

A)$622.04
B)$360.33
C)$401.90
D)$693.82

Question 36

Company A's historical returns for the past three years were 6 percent, 15 percent, and 15 percent.Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent.According to the security market line (SML), Stock A was

A)overpriced.
B)underpriced.
C)correctly priced.
D)More information is needed.

Question 37

On a graph with common stock returns on the y-axis and market returns on the x-axis, the slope of the regression line represents

A)alpha.
B)beta.
C)R-squared.
D)standard error.

Question 38

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent.Calculate the observed variance of the market portfolio returns.(Ignore the correction for the loss of a degree of freedom set out in the text.)

A)192.0
B)128.0
C)28.0
D)18.7

Question 39

A project has an expected cash flow of $300 in year 3.The risk-free rate is 5 percent, the market risk premium is 8 percent, and the project's beta is 1.25.Calculate the certainty equivalent cash flow for year 3, CEQ₃.

A)$228.35
B)$197.25
C)$300.00
D)$270.02

Question 40

An example of diversifiable risk that a financial manager should ignore when analyzing a project's risk would include

A)commodity price changes.
B)labor costs.
C)overall stock price fluctuations.
D)risks of government nonapproval of the project.

Question 41

One calculates the weighted average cost of capital (WACC), on an after-tax basis, as WACC = (r_D) (1 - T_C )
(D/V) + (r_E) (E/V), where V = D +
E.

Question 42

Generally, one should use the short-term Treasury bill rate for the risk-free rate.

Question 43

Portfolio betas for an industry are usually higher than the average betas of individual stocks in that same industry.

Question 44

Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount rate.

Question 45

An analyst computes a beta coefficient with a low standard error.This implies that

A)this particular beta is more reliable than most.
B)this particular beta has little meaning.
C)too few observations were used to compute this particular beta.
D)this stock responds less to market changes than most stocks.

Question 46

Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity instead of market values.The resulting WACC estimates will generally be too high.
Book value of equity is generally lower than market value, while the book value of debt is generally nearer to the market value.Using book values will therefore underweight the cost of equity.The resulting WACC estimates will generally be too low.

Question 47

Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.

Question 48

Generally, an industry beta, calculated from a portfolio of companies in the same industry, is more accurate than a beta estimate for a single company.

Question 49

A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger confidence interval.

Question 50

If one uses a long-term risk-free rate for the CAPM instead of a short-term risk-free rate, then one will generate a flatter security market line.

Question 51

An analyst should evaluate each project at its own opportunity cost of capital.The true cost of capital depends on the particular use of that capital.

Question 52

Firms with cyclical revenues tend to have lower asset betas.

Question 53

Projects with great amounts of diversifiable risk should generally have higher company costs of capital.

Question 54

The company cost of capital is the cost of debt of the firm.

Question 55

Which of the following projects most likely has the lowest cost of capital?

A)Construction of a new steel factory
B)Investment in latest-technology, high-end television production
C)Construction of a luxury resort
D)Investment in a gold-mining operation

Question 56

Cyclical firms tend to have high betas.

Question 57

Firms with high operating leverage tend to have higher asset betas.

Question 58

The company cost of capital is the correct discount rate only for investments that have the same risk as the company's overall business.

Question 59

The company cost of capital is the correct discount rate for any project undertaken by the company.

Question 60

For firms with relatively high levels of debt, the company cost of capital is the cost of equity of the firm.

Question 61

A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-term projects as opposed to long-term projects.

Question 62

Briefly explain the difference between company cost of capital and project cost of capital.

Question 63

Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate.

Question 64

A pure play is a comparable firm that specializes in one activity.

Question 65

Why do firms with large cash-flow betas also have high asset betas?

Question 66

Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a project.

Question 67

Companies with high ratios of fixed costs to project values tend to have high betas.

Question 68

The cost of capital is always less than or equal to the cost of equity.

Question 69

Briefly discuss the certainty equivalent approach to estimating the NPV of a project.

Question 70

In general, one should use higher discount rates for longer-term projects.

Question 71

A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the discount rate.

Question 72

Discuss why one might use an industry beta to estimate a company's cost of capital.

Question 73

Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM).

Question 74

Briefly explain how the use of a single company cost of capital to evaluate all projects might lead to erroneous decisions.