Deck 21: Capital Budgeting and Risk Analysis

Question 1

Assume you are the director of capital budgeting for an all-equity firm.The firm's current cost of equity is 17.50%;the risk-free rate is 0.25%;and the market risk premium is 7%.You are considering a new project that has 50% more beta risk than your firm's assets currently have,that is,its beta is 50% larger than the firm's existing beta.The expected return on the new project is 18%.Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement.

A) No;a 50% increase in beta risk gives a risk-adjusted required return of 24%.
B) Yes;its expected return is greater than the firm's WACC.
C) No;the project's risk-adjusted required return is 8.13% above its expected return.
D) Yes;the project's risk-adjusted required return is less than its expected return.
E) No;the project's risk-adjusted required return is 9.13% above its expected return.

Answer 1

C

Question 2

Louisiana Enterprises,an all-equity firm,is considering a new capital investment.Analysis has indicated that the proposed investment has a beta of 0.55 and will generate an expected return of 5%.The firm currently has a required return of 10.75% and a beta of 1.25.The investment,if undertaken,will double the firm's total assets.If r_RF is 7% and the market risk premium is 5%,should the firm undertake the investment?

A) Yes;the beta of the asset will reduce the risk of the firm.
B) No;the expected return of the asset is less than the firm's required return,which is 10.75%.
C) No;the expected return of the asset (5%)is less than the required return (9.64%).
D) No;the risk of the asset (beta)will increase the firm's beta.
E) Yes;the expected return of the asset (5%)exceeds the required return (4.5%).

Answer 2

C

Question 3

If the firm is being operated so as to maximize shareholder wealth,and if our basic assumptions concerning the relationship between risk and return are true,then which of the following should be true?

A) If an asset's beta is larger than the firm's beta,then the required return on the asset is less than the required return on the firm.
B) If the beta of the asset is smaller than the firm's beta,then the required return on the asset is greater than the required return on the firm.
C) If the beta of the asset is greater than the firm's beta prior to the addition of that asset,then the firm's beta after the purchase of the asset will be smaller than the original firm's beta.
D) If the beta of an asset is larger than the firm's beta prior to the addition of that asset,then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
E) None of the statements is true.

Answer 3

D

Question 4

Using the Security Market Line concept in capital budgeting,which of the following statements is CORRECT?

A) If the expected rate of return on a given capital project lies above the SML,the project should be accepted even if its beta is greater than the beta of the firm's average project.
B) If a project's return lies below the SML,it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.
C) If two mutually exclusive projects' expected returns are both above the SML,the project with the lower risk should be accepted.
D) If a project's expected rate of return is greater than the expected rate of return on an average project,it should be accepted.
E) None of the statements is correct.

Question 5

Sunshine Inc.has two equally-sized divisions.Division A has a beta of 0.8 and Division B has a beta of 1.2.The company is 100% equity financed.The risk-free rate is 6% and the market risk premium is 5%.Sunshine assigns different hurdle rates to each division based on each division's market risk.Which of the following statements is CORRECT?

A) Sunshine's composite WACC is 10%.
B) Division B has a lower WACC than Division A.
C) If the same WACC is used for each division,the firm would select too many Division A projects and reject too many Division B projects.
D) If the same WACC is used for each division,the firm would select too many Division B projects and reject too many Division A projects.
E) Sunshine's composite WACC is 12%.