Deck 13: Risk, Return, and Capital Budgeting

Question 1

If the risk of an investment project is different than the firm's risk then:

A) you must calculate the discount rate for the project based on the firm's risk.
B) you must calculate the discount rate for the project based on the project risk.
C) you must exercise risk aversion and use the market rate.
D) an average rate across prior projects is acceptable because estimates contain errors.

Answer 1

you must calculate the discount rate for the project based on the project risk.

Question 2

The beta of a security provides:

A) an estimate of the market risk premium.
B) an estimate of the slope of the CML.
C) an estimate of the slope of the SML.
D) an estimate of the systematic risk of the security.

Answer 2

an estimate of the systematic risk of the security.

Question 3

The use of WACC to select investments is theoretically acceptable when:

A) the correlation of all new projects are equal.
B) the NPV is positive when discounted by the WACC.
C) the systematic risk of the projects are equal to the systematic risk of the firm.
D) the firm is well diversified and the unsystematic risk is negligible.

Answer 3

the systematic risk of the projects are equal to the systematic risk of the firm.

Question 4

Two stock market based costs of liquidity that affects the cost of capital are the:

A) bid-ask spread and the specialist spread.
B) market impact cost and the brokerage costs.
C) investor opportunity cost and the brokerage costs.
D) bid-ask spread and the market impact costs.

Question 5

The formula for calculating beta is given by the dividing the ___________ of the stock with the market portfolio by the ___________ of the market portfolio.

A) variance; covariance
B) covariance; variance
C) standard deviation; variance
D) expected return; variance
E) expected return; covariance

Question 6

Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the return to the company's debt is 7%?

A) 10.8%.
B) 12.8%.
C) 10.4%.
D) 14.4%.

Question 7

When using the cost of debt, the relevant number is the:

A) pre-tax cost of debt since most corporations pay taxes at the same tax rate.
B) pre-tax cost of debt since it is the actual rate the firm is paying bondholders.
C) post-tax cost of debt since dividends are tax deductible.
D) post-tax cost of debt since interest is tax deductible.

Question 8

The Consolidated Transfer Co. is an all-equity financed firm. The beta is.75, the market risk premium is 8% and the risk-free rate is 4%. What is the expected return of Consolidated?

A) 10%.
B) 7%.
C) 13%.
D) 9%.
E) 8%.

Question 9

Betas may vary substantially across an industry. The decision to use the industry or company beta to estimate the cost of capital depends on:

A) how small the estimation errors are of all betas.
B) how similar the firm's operations are to the operations of all other firms in the industry.
C) whether your company is a leader or follower.
D) the size of your company's public float.

Question 10

Beta measures depend highly on the:

A) direction of the market variance.
B) the overall cycle of the market.
C) the variance of the market and asset, but not their co-movement.
D) the standard deviation of the security and the market and how they are correlated.

Question 11

The NPV formula for risky projects evaluates __________ using the __________.

A) riskless discount rate; expected incremental cashflows.
B) certain cashflows; risk-free discount rate.
C) expected incremental cashflows; risk-free discount rate.
D) certain cashflows; risky discount rate.
E) expected incremental cashflows; risky discount rate.

Question 12

The constant growth dividend valuation model can also be used to estimate the cost of equity capital as:

A) D₁/[r_s - g].
B) D₁/P_o - g.
C) D₁/P_o + g.
D) P_o(r_s - g).
E) (D₁/P_o)(1 + r_s).

Question 13

Regression analysis can be used to:

A) estimate beta.
B) estimate the risk-free rate.
C) estimate standard deviations.
D) estimate variances.
E) estimate expected returns.

Question 14

The slope of the characteristic line is the estimated:

A) intercept.
B) beta.
C) unsystematic risk.
D) market variance.
E) market risk premium.

Question 15

The best fit line of pairwise plot of the returns of the security against the market index returns is called :

A) the SML.
B) the CML.
C) the characteristic line.
D) the risk line.

Question 16

If the project beta, IRR co-ordinates plot above the SML the project should be:

A) accepted because it is overvalued.
B) accepted because it is undervalued.
C) rejected because it is overvalued.
D) rejected because it is undervalued.

Question 17

The WACC is used to _______ the expected cash flows when the firm has ___________.

A) discount; debt and equity in the capital structure.
B) capitalize; short term financing on the balance sheet.
C) increase; debt and equity in the capital structure.
D) decrease; short term financing on the balance sheet.

Question 18

In terms of the decision of what to do with extra cash, the firm's managers should undertake projects only if:

A) the firm never pays a dividend.
B) the expected return on the project is greater than that of an asset of similar risk.
C) the expected return on the project is less than that of an asset of similar risk.
D) the expected return on the project is equal to that of an asset of similar risk.

Question 19

If the CAPM is used to estimate the cost of equity capital the expected excess market return is equal to:

A) the return on the stock minus the risk-free rate.
B) the difference between the return on the market and the risk-free rate.
C) the beta times the market risk premium.
D) the beta times the risk-free rate.
E) the market rate of return.

Question 20

The cost of equity for Gruwom Corp. is 8.4%. If the return to the market is 10% and the risk-free rate is 5%, then the equity beta is:

A) 0.48.
B) 1.25.
C) 0.68.
D) 1.68.

Question 21

Slippery Slope Roof Contracting has an equity beta of 1.2, capital structure with 2/3 debt, and a zero tax rate. What is their asset beta?

A) 1.8.
B) 0.40.
C) 0.72.
D) 1.2.

Question 22

A firm with high operating leverage is characterized by _________ while one with high financial leverage is characterized by _____________.

A) low fixed cost of production; low fixed financial costs
B) high variable cost of production; high variable financial costs
C) high fixed costs of production; high fixed financial costs
D) low costs of production; high fixed financial costs
E) high fixed costs of production; low variable financial costs

Question 23

A firm with high operating leverage has:

A) low amounts of fixed cost in their production process.
B) high amounts of variable cost in their production process.
C) high amounts of fixed cost in their production process.
D) high price per unit.
E) low price per unit.

Question 24

Comparing two otherwise equal firms, the beta of the common stock of a levered firm is ____________ than the beta of the common stock of an unlevered firm.

A) equal to
B) significantly less
C) slightly less
D) greater

Question 25

For a multi-product firm, if a project's beta is different from that of the overall firm, then:

A) the CAPM can no longer be used.
B) the project should be discounted using the overall firm's beta.
C) the project should be discounted at a rate commensurate with its own beta.
D) the project should be discounted at the market rate in all cases.
E) the project should be discounted at the T-bill rate in all cases.

Question 26

If a stock's monthly return is consistently positive when the market's monthly return is negative, and vice-versa, then the beta of the company's stock will likely be:

A) zero.
B) negative.
C) positive.
D) very high.

Question 27

Suppose that the Simmons Corporation's common stock has a beta of 1.6. If the risk-free rate is 5% and the market risk premium is 4%, the expected return for Simmons' common is:

A) 4.0%.
B) 5.0%.
C) 5.6%.
D) 10.6%.
E) 11.4%.

Question 28

Companies that have highly cyclical sales will have a:

A) low beta if sales are highly dependent on the market cycle.
B) high beta if sales are highly dependent on the market cycle.
C) high beta if sales are independent of the market cycle.
D) low beta if sales are independent of the market cycle.

Question 29

RKKL is considering buying a company that has no leverage but an asset beta of.7. The market risk premium is 6% and the risk-free rate is 2%. If they plan to use 75% debt, what will the required rate of return be?

A) 18.8%
B) 6.2%
C) 8.0%
D) 14.6%

Question 30

The beta of a portfolio of the firm's debt and equity:

A) is equal to the sum of all the betas.
B) is equal to the sum of all the betas weighted by their market value weight.
C) is greater than the beta of each component.
D) is always less than zero.

Question 31

Two firms have the same operating structure and the same operating systematic risk, ß = .8. Firm 1 has 20% debt in their capital structure while Firm 2 has four units of debt for every 7 units of equity. If the tax rate faced by both firms is 0.4 which has the riskier equity?

A) Firm 1 because it has a higher ratio of debt to equity.
B) Neither because they both have the same ß = .8.
C) Firm 2 because it has a higher ratio of debt to equity.
D) Neither firm because systematic risk is unaffected by the financing.

Question 32

The $\beta$ of all equity firm versus the $\beta$ of the same firm with leverage is different:

A) by the impact of business risk.
B) by the $\beta$ of the assets.
C) because the $\beta$ of the assets are not exposed to financial leverage.
D) because the $\beta$ of the assets are exposed to financial leverage.

Question 33

An industry is likely to have a low beta if the:

A) stream of revenues is unstable than the market.
B) economy is in an expansion.
C) market for its goods is affected by the market cycle.
D) stream of revenues is more volatile than the market.
E) stream of revenues is stable and less volatile than the market.

Question 34

A firm with cyclical earnings is characterized by:

A) revenue patterns that vary with the business cycle.
B) high levels of debt in their capital structures.
C) high fixed costs.
D) high price per unit.
E) low contribution margins.

Question 35

Suppose the Barges Corporation's common stock has an expected return of 12%. Assume that the risk-free rate is 5%, and the market risk premium is 6%. If no unsystematic influence affected Barges' return, the beta for Barges is:

A) 1.00.
B) 1.17.
C) 1.20.
D) 2.50.

Question 36

The beta of a firm is more likely to be high under what two conditions?

A) High cyclical business activity and low operating leverage.
B) High cyclical business activity and high operating leverage.
C) Low cyclical business activity and low financial leverage.
D) Low cyclical business activity and low operating leverage.

Question 37

If a firm has low fixed costs relative to all other firms in the same industry, a large change in volume (either up or down) would have:

A) a smaller change in EBIT for the firm versus the other firms.
B) no effect in any way on the firms as volume does not affect fixed costs.
C) a decreasing effect on the cyclical nature of the business.
D) a large change in EBIT for the firm versus the other firms.

Question 38

Two firms have the same operating structure and the same operating systematic risk, ß = .8. firm 1 has 20% debt in their capital structure while Firm 2 has four units of debt for every 7 units of equity. The tax rate faced by both firms is.4. The debt beta is assumed to zero. What is the difference in systematic risk between the riskier firm and the less risky firm?

A) 0.26 Firm 2 beta greater than Firm 1 beta.
B) 0.15 Firm 2 beta greater than Firm 1 beta.
C) 0.30 Firm 2 beta greater than Firm 1 beta.
D) 0.10 firm 2 beta greater than Firm 1 beta.

Question 39

Firms whose revenues are strongly cyclical and whose operating leverage is high are likely to have:

A) low betas.
B) high betas.
C) zero betas.
D) negative betas.

Question 40

Beta is useful in the calculation of:

A) the company's variance.
B) the companies discount rate.
C) the company's standard deviation.
D) unsystematic risk.
E) the risk free-rate or the market rate.

Question 41

XYZ INC has several divisions and the one managed by Dr. Donaldson has asset base of $4 million and earnings after taxes is $2 million. A new project would earn $2 million per year on an investment of $3 million. If the new project is on, Mr. Donaldson's bonus should not be based on:

A) EVA.
B) ROA.
C) Sales.
D) Accounting profits.
E) Cash flows.

Question 42

The Tenplen Corporation has an asset beta of 1.05 and a debt beta of.8. The debt portion of the capital structure in market terms is.375. Tenplen has a zero tax rate. What is the equity beta?

A) 0.80.
B) 0.90.
C) 1.05.
D) 1.20.
E) 0.40.

Question 43

On-line Text Co. has four new text publishing products that it is considering. The projects are of equal risk with a beta of 1.6. The risk-free rate is 4.2 percent and the market rate is expected to be 12.3 percent. The projects and their expected internal rates of return are: W = 14.4 percent; X = 18 percent, Y = 16.4 percent; and Z = 17.2 percent. Which projects should be accepted? Justify your acceptance decision.

Question 44

The Neptune Company offers network communications systems to computer users. The company is planning a major investment expansion but is unsure of the correct measure of equity capital as it has no traded equity. Your job is to determine the basis of the equity cost. List and explain the steps you will need to take.

Question 45

The use of debt is called:

A) operating leverage.
B) production leverage.
C) financial leverage.
D) total asset turnover risk.
E) business risk.

Question 46

XYZ INC has several divisions and the one managed by Dr. Donaldson has asset base of $4 million and earnings after taxes is $2 million. A new project would earn $2 million per year on an investment of $5 million. As a result, ROA of the division changed from:

A) 50% to 44%.
B) 55% to 40%.
C) 44% to 50%.
D) 50% to 70%.

Question 47

Phil's Carvings, Inc. wants to have a weighted average cost of capital of 9%. The firm has an after-tax cost of debt of 5% and a cost of equity of 11%. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?

A) 0.33
B) 0.40
C) 0.50
D) 0.60
E) 0.67

Question 48

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The b of the equity is 1.4 and the tax rate if 30%. What is the firm's market value of debt and equity respectively?

A) 22,500,000; 6,750,000
B) 2,020,000; 22,500,000
C) 4,750,000; 15,750,000
D) 9,642,857; 15,750,000
E) 9,642,857; 22,500,000

Question 49

Explain the factors that determine beta and how an asset beta can differ from equity betas.

Question 50

The Upper Tier has a current debt-equity ratio of.52 and a target debt-equity ratio of.45. The cost of floating equity is 9.5 percent and the floatation cost of debt is 6.6 percent. What should the firm use as their weighted average floatation cost?

A) 8.01%
B) 8.52%
C) 8.33%
D) 7.76%
E) 8.60%

Question 51

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The b of the equity is 1.4 and the tax rate if 30%. What is the firm's WACC?

A) 10.44%
B) 13.16%
C) 14.24%
D) 19.04%
E) 14.28%

Question 52

The NuPress Valet Co. has an improved version of its' hotel stand. The investment cost is expected to be 72 million dollars and will return 13.50 million dollars for 5 years in net cash flows. The ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate is 34%. What is the NPV of the project?

A) - 4,500,000
B) -24,517,378
C) -19,489,708
D) -20,123,870

Question 53

Peter's Audio Shop has a cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop?

A) 6.14%
B) 6.54%
C) 8.60%
D) 9.14%
E) 9.45%

Question 54

One Caveat of using EVA as a measure of performance measurement is, managers:

A) may not have incentive to work hard.
B) may overstate earnings.
C) may cut back production.
D) none of these.

Question 55

Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's weighted average cost of capital?

A) 7.10%
B) 7.39%
C) 10.38%
D) 10.65%
E) 11.37%

Question 56

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The b of the equity is 1.4 and the tax rate if 30%. What is the market value of firm and the debt respectively?

A) 22,500,000; 6,750,000
B) 32,142,857; 9,642,857
C) 32,142,857; 22,500,000
D) 15,750,000; 9,642,857
E) 9,642,857; 22,500,000

Question 57

Jake's Sound Systems has 210,000 shares of common stock outstanding at a market price of $36 a share. Last month, Jake's paid an annual dividend in the amount of $1.593 per share. The dividend growth rate is 4%. Jake's also has 6,000 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7% coupon, pay interest annually, and mature in 4.89 years. The bonds are selling at 99% of face value. The company's tax rate is 34%. What is Jake's weighted average cost of capital?

A) 5.3%
B) 5.8%
C) 6.3%
D) 6.9%
E) 7.2%

Question 58

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The b of the equity is 1.4 and the tax rate if 30%. What is the required rate of return on equity?

A) 9.6%
B) 14.4%
C) 15.2%
D) 18.56%

Question 59

The Tenplen Corporation has an equity beta of 1.2 and a debt beta of.8. The firm's market value debt to equity ratio is.6. Tenplen has a zero tax rate. What is the asset beta?

A) 0.70.
B) 1.04.
C) 1.05.
D) 0.96.
E) 0.72.

Question 60

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The b of the equity is 1.4 and the tax rate if 30%. What is the market value of debt and its' net cost to the firm?

A) 9,642,857; 8.4%.
B) 9,642,857; 12%.
C) 6,750,000; 8.4%.
D) 6,750,000; 12%.
E) 4,725,000; 12%.

Question 61

Given the sample of returns of the Top Black Asphalt Company and the S&P 500 index, calculate Top Black's covariance and beta.

Question 62

On-line Text Co. has four new text publishing products that they must decide on publishing to expand their services. The firm's WACC has been 17%. The projects are of equal risk, ßs of 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects are expected to earn as follows:
$\bullet$ Project W: 14%
$\bullet$ Project X: 18%
$\bullet$ Project Y: 17%
$\bullet$ Project Z: 15%
What projects should be selected and why?

Question 63

Eyes of the World Corporation has traditionally employed a firm wide discount rate for capital budgeting purposes. However, its two divisions - publishing and entertainment - have different degrees of risk given by $\beta$ P = 1.0, $\beta$ E = 2.0, and the beta for the overall firm is 1.3. The firm is considering the following capital expenditures:
Which projects would the firm accept if it uses the opportunity cost of capital for the entire company? Which projects would it accept if it estimates cost of capital separately for each division? Use 6% as the risk-free rate, and 12% as the expected return on the market.