Question 1

If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the:

Accepted Answer

If changing the discount rate from the company cost of capital to the project cost of capital changes the NPV from negative to positive, it means that the project's cash flows are not being discounted appropriately using the company cost of capital. Using the project cost of capital will provide a more accurate discount rate for the project's cash flows and will result in a positive NPV. Therefore, the project should use the project cost of capital and be accepted.

Question 2

The slope of the security market line equals:

Accepted Answer

The slope of the security market line (SML) is the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate.

Question 3

A project with a higher than average risk offers an expected return of 18%.Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%?

Accepted Answer

The project's expected return of 18% is higher than the company's opportunity cost of capital of 12%, indicating that the project is generating excess returns. However, the project's opportunity cost of capital at 15% is also higher than the company's cost of capital, indicating that the project carries some additional risk. Despite the higher risk, the project's expected return remains higher than the company's cost of capital, so it should be accepted as it is expected to generate positive NPV. Therefore, choice A is correct.

Question 4

What would you recommend to an investor who is considering an investment that, according to its Beta, plots below the security market line (SML)?

Accepted Answer

A security plotting below the SML indicates that it offers a lower return for its level of risk compared to the market, suggesting it is not a good investment.

Question 5

What will happen to a stock that offers a lower risk premium than predicted by the CAPM?

Accepted Answer

If a stock offers a lower risk premium than predicted by the CAPM, it is considered overvalued, leading to a decrease in its price until the yield aligns with the expected risk premium.

Question 6

Which of the following statements best explains the fact that cyclical firms tend to have high Betas?

Accepted Answer

Cyclical firms tend to have high Betas because their earnings are not stable and are highly dependent on the fluctuations in the overall economy. This makes their stocks more sensitive to market movements, resulting in a higher Beta coefficient.

Question 7

A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable.

Accepted Answer

The answer of A proposed investment must earn at least...

Question 8

The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if:

Accepted Answer

The company cost of capital is appropriate only if the project has the same risk as the company's average project. If the proposal has a different degree of risk, a different discount rate should be used to reflect that risk.

Question 9

The project cost of capital is:

Accepted Answer

The project cost of capital can differ from the company cost of capital, as it will depend on the risk and return associated with the specific project being evaluated. Factors such as market conditions, the nature of the project, and other project-specific factors can impact the project cost of capital. Therefore, the project cost of capital is not necessarily related to the company cost of capital.

Question 10

What return should be expected from investing in the market portfolio that is expected to yield 18% if the investment includes all of the investor's funds plus 30% of additional funds borrowed at the risk-free rate of 6%?

Accepted Answer

The expected return is calculated using the formula: Expected return = Risk-free rate + Beta * (Market return - Risk-free rate). Here, Beta is 1.3, the market return is 18%, and the risk-free rate is 6%. Thus, the expected return is 6% + 1.3 * (18% - 6%) = 21.6%.

Question 11

Investment projects that plot above the security market line would be considered to have:

Accepted Answer

Investment projects that plot above the security market line have a higher return than the risk-free rate and the level of risk associated with the investment. Therefore, they would have a positive NPV.

Question 12

Which of the following statements is more likely to be correct concerning the statement, "Stock A has a higher expected return than Stock B"?

Accepted Answer

A higher expected return is typically associated with higher systematic risk, as measured by beta. Therefore, Stock A is more likely to have a higher beta than Stock B.

Question 13

A stock's risk premium is equal to the:

Accepted Answer

The risk premium of a stock is calculated as the expected market risk premium times the stock's Beta, which measures its sensitivity to market movements.

Question 14

What return should be expected from investing in the market portfolio which is expected to yield 18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at the risk-free rate of 6%?

Accepted Answer

The answer of What return should be expected from investing...

Question 15

Investing borrowed funds in a stock portfolio will:

Accepted Answer

Investing borrowed funds will increase the Beta of the portfolio. Beta measures the volatility of a stock or a portfolio compared to the overall market, and borrowed funds have the effect of amplifying the portfolio's volatility, making it a riskier investment with a higher Beta.

Question 16

The minimum acceptable expected rate of return on a project of a specific risk is the:

Accepted Answer

The minimum acceptable expected rate of return on a project of a specific risk is the project cost of capital, which is the minimum return required by the investors to undertake the project. It should be equal to or higher than the cost of capital of the company, which reflects the overall risk of the company. The risk-free rate of return is used to calculate the cost of equity, while the project Beta times market risk premium is used to calculate the cost of equity in the capital asset pricing model. However, the project cost of capital considers the specific risk factors of the project, such as market conditions, competition, and other variables that affect the potential returns.

Question 17

What type of risk is properly reflected in a project's discount rate?

Accepted Answer

Market risk is properly reflected in a project's discount rate because it represents the risk that affects all companies in the market. Unique, total, and diversifiable risks are specific to a company or can be mitigated through diversification, and thus are not typically reflected in the discount rate.

Question 18

What happens to expected portfolio return if the portfolio Beta increases from 1.0 to 1.5, the risk-free rate decreases from 5% to 4%, and the market risk premium increases from 8% to 9%?

Accepted Answer

The expected portfolio return can be calculated using the Capital Asset Pricing Model (CAPM). With an increase in portfolio beta from 1.0 to 1.5, and an increase in the market risk premium from 8% to 9%, the expected portfolio return increases. However, with a decrease in the risk-free rate from 5% to 4%, the expected portfolio return decreases. Using the CAPM formula, the new expected portfolio return can be calculated as: R_p = 4% + 1.5(9) = 17.5%. Therefore, the answer is option B.

Question 19

Decreases in the risk-free rate will reduce:

Accepted Answer

Decreases in the risk-free rate will lead to a decrease in the cost of borrowing funds, which in turn will lower the expected return on investments. As a result, the expected return on the stock will reduce  since investors require less compensation for investing in risk-free securities. Therefore, D is the correct answer.  A, B, and C are incorrect as they are not related to the risk-free rate.

Question 20

Given the CAPM's noted difficulties, which of the following statements may be correct concerning a low price-earnings ratio stock?

Accepted Answer

A low price-earnings ratio stock may plot above the security market line, indicating it is undervalued and offers a higher expected return for its level of systematic risk.

Quiz 12: Risk, Return, and Capital Budgeting