Question 1

Assume the overall market has a risk premium of 7.1 percent,and the risk-free rate is 2.9 percent.What is the risk premium for a stock that has a beta of 0.94 and a standard deviation of 12.7 percent?

Accepted Answer

RP_S = 0.94(0.071)= 0.0667,or 6.67%

Question 2

Assume the S&P 500 has a dividend yield of 3.2 percent.Analysts expect overall dividends to grow at 5.4 percent annually.Treasury bills yield 2.1 percent.The expected market rate of return is ________ percent,and the market risk premium is ________ percent.

Accepted Answer

R_M = 3.2% + 5.4% = 8.6% R_M − R_F = 8.6% - 2.1% = 6.5%

Question 3

A stock portfolio consists of 27 percent Stock A,38 percent Stock B,and the remainder is invested in Stock C.The security betas are 1.09,0.84,and 1.33 for Stocks A,B,and C,respectively.What is the portfolio beta?

Accepted Answer

β_P = 0.27(1.09)+ 0.38(0.84)+ (1 - 0.27 - 0.38)(1.33)= 1.079

Question 4

A project has an internal rate of return of 11.76 percent.The company beta is 1.22,and the pure play beta is 1.14.The market rate of return is 11.8 percent,the tax rate is 35 percent,and the risk-free rate is 3.3 percent.Should this project be accepted according to the CAPM if the firm is all-equity financed? Why or why not?

Accepted Answer

The pure play beta best represents the risks of the project,so: R_s = 0.033 + 1.14(0.118 - 0.033)= 0.1299,or 12.99% The project should be rejected because the IRR < CAPM.

Question 5

Whitehall Camps recently paid its annual dividend of $1.42 a share.These dividends have been increasing by 2.2 percent each year and are expected to continue this trend.What is the cost of equity if the stock sells for $22.89 a share?

Accepted Answer

R = {[$1.42(1 + 0.022)] / $22.89} + 0.022
R = 0.0854,or 8.54%

Question 6

A levered firm has a debt-to-equity ratio of 0.38 and an equity beta of 1.42.What would be the beta of the firm if it switched to an all-equity financial structure?

Accepted Answer

β_Asset = [1 / (0.38 + 1)] × 1.42 = 1.029

Question 7

The Lumber Shack just paid an annual dividend of $1.23 a share.The dividend growth rate is 4 percent,the tax rate is 34 percent,and the common stock sells for $38 a share.What is the cost of equity?

Accepted Answer

R_S = ($1.23 × 1.04)/ $38 + 0.04 = 0.0737,or 7.37%

Question 8

ABC stock has a beta that is 13 percent higher than the overall market beta.The risk-free rate is 3.1 percent,and the market rate of return is 10.6 percent.What is the company's cost of equity?

Accepted Answer

R_s = 0.031 + 1.13(0.106 − 0.031)= 0.1158,or 11.58%

Question 9

The Template Corporation has an equity beta of 1.16 and a market value debt-to-equity ratio of 0.52.What is the asset beta?

Accepted Answer

β_Asset = [1 / (0.52 + 1)](1.16)= 0.763

Question 10

Upper Roads is an all-equity financed firm.The beta is 0.89,the market risk premium is 7.2 percent,and the tax rate is 34 percent.The firm just issued its annual dividend of $1.04 per share and announced that future dividends will increase by 3 percent annually.The stock sells for $22 a share.What is the cost of equity?

Accepted Answer

R_S = ($1.04 × 1.03)/ $22 + 0.03 = 0.0787,or 7.87%

Question 11

What value should you assign as the flotation cost of internally generated equity financing?

Accepted Answer

The flotation cost for internally generated equity financing is zero because there are no costs associated with issuing new shares or securities. This is because the company is simply reinvesting profits back into the business rather than issuing new shares to raise capital.

Question 12

Tanner's Leather is an all-equity financed firm with a beta of 1.07.The market risk premium is 7.08 percent,the market rate of return is 9.84 percent,and the tax rate is 34 percent.The company announced that the next annual dividend will be $0.72 per share and future dividends will increase by 2.8 percent annually.The stock sells for $11 a share.What is the average cost of equity?

Accepted Answer

R_S = $0.72 / $11 + 0.028 = 0.0935,or 9.35% R_RF = 9.84% - 7.08% = 2.76% R_S = 2.76% + 1.07(7.08%)= 10.34% Average R_S = (9.35% + 10.34%)/ 2 = 9.84%

Question 13

The cost of equity for Ryan Corporation is 17 percent.The expected return on the market is 12.94 percent,the risk-free rate is 3.5 percent,and the tax rate is 34 percent.What is the company's equity beta?

Accepted Answer

0.17 = 0.035 + β(0.1294 − 0.035)
β = 1.43

Question 14

Delta Foods is an unlevered firm that is equally as risky as the market.U.S.Treasury bills are yielding 2.4 percent,and the market rate of return is 8.1 percent.What discount rate should be assigned to a project that has the same risks as Delta Foods?

Accepted Answer

R<sub>S</sub> = 8.1%

Question 15

An all-equity firm has a beta of 0.94.Assume the beta of debt is equal to the risk-free beta.If the firm changes to a debt-equity ratio of 0.35,its equity beta would be ________,and if it changes its debt-equity ratio to 0.40,its equity beta would be ________.

Accepted Answer

β_B = β_RF = 0 β_Equity = 0.94(1 + 0.35)= 1.269 β_Equity = 0.94(1 + 0.40)= 1.316

Question 16

The weights used in the computation of a project's flotation costs should be based on the

Accepted Answer

The weights used in the computation of a project's flotation costs should be based on the company's target debt-to-equity ratio. The target debt-to-equity ratio reflects the optimal capital structure for the company and should be used as a guideline for determining the proportions of debt and equity that should be used to finance a project.

Question 17

An all-equity firm has a beta of 1.03.The firm is evaluating a project that will increase the output of the firm's existing products.The market risk premium is 6.9 percent,and the risk-free rate is 3.4 percent.What discount rate should be assigned to this expansion project?

Accepted Answer

The project beta is the same as the company beta since this is an expansion of the firm's current operations. R_S = 0.034 + 1.03(0.069)= 0.1051,or 10.51%

Question 18

A portfolio is invested 40 percent each in Stock L with a beta of 1.48 and Stock K with a beta of 1.05.The remainder of the portfolio is invested in secured debt.What is the portfolio beta?

Accepted Answer

The beta of debt is assumed to be zero. β_P = 0.4(1.48)+ 0.4(1.05)+ (1 - 0.4 - 0.4)(0)= 1.012

Question 19

Metal Roofs has an equity beta of 1.47,a capital structure with three parts of debt for every five parts of equity,and a zero tax rate.What is its asset beta?

Accepted Answer

β_Asset = [5 / (3 + 5)](1.47)= 0.919

Question 20

An all-equity firm has a beta of 1.27.What will be the equity beta if the firm adopts a debt-to-equity ratio of 0.42?

Accepted Answer

β_Equity = 1.27[1 + (0.42 / 1)] = 1.803

Quiz 12: Risk, cost of Capital, AMCQ Valuation