Question 1

The after-tax cost of debt generally increases when:
I.a firm's bond rating increases.
II.the market-required rate of interest for the company's bonds increases.
III.tax rates decrease.
IV.bond prices rise.

Accepted Answer

The after-tax cost of debt is calculated by adjusting the market interest rate for the tax rate. Therefore, the after-tax cost of debt increases when either the market-required rate of interest for the company's bonds increases (II), or when tax rates decrease (III). A firm's bond rating increasing (I) typically decreases its borrowing cost, and bond prices rising (IV) also lower the yield on new issues, which both lower the after-tax cost of debt. Therefore, B is the best choice.

Question 2

Unsystematic risk:

Accepted Answer

Unsystematic risk, also known as company-specific risk, can be reduced by diversifying the portfolio across different assets or sectors. Therefore, it can be effectively eliminated or at least reduced to a certain extent by portfolio diversification.

Question 3

Total risk is measured by _____ and systematic risk is measured by ____.

Accepted Answer

Total risk is measured by standard deviation, while systematic risk is measured by beta. Standard deviation measures the total risk of an asset or portfolio, whereas beta measures how closely the asset's returns are correlated with the market returns.

Question 4

FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity.Which of the following statements is/are correct?
I.FM should reject the project because the IRR is greater than the firm's WACC.
II.FM should accept the project because the IRR is greater than the firm's WACC.
III.FM should accept the project because the NPV is greater than zero.
IV.FM should reject the project because the NPV is less than zero.

Accepted Answer

I. This statement is incorrect because if the IRR is greater than the firm's WACC, it means that the project is generating more return than the cost of capital, which is a desirable outcome. Therefore, FM should accept the project.

II. This statement is correct because as mentioned earlier, if the IRR is greater than the firm's WACC, it represents a desirable outcome, and FM should accept the project.

III. This statement is correct because if the NPV is greater than zero, it means that the project's cash inflows exceed its cash outflows, and the project is profitable. Therefore, FM should accept the project.

IV. This statement is incorrect because if the NPV is less than zero, it means that the project's cash outflows exceed its cash inflows. Therefore, the project is unprofitable, and FM should reject it.

Overall, the correct statements are II and III. Therefore, the best choice is E.

Question 5

Which one of the following is an example of systematic risk?

Accepted Answer

The unexpected increase in target interest rates by the Federal Reserve is an example of systematic risk. This is because it affects the entire economy and all firms and individuals who rely on borrowing and lending. It cannot be diversified away by investing in a specific company or industry.

Question 6

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
 
-Estimate the appropriate weight of debt to be used when calculating FM's weighted average cost of capital.

Accepted Answer

The answer of Key facts and assumptions concerning FM Foods,...

Question 7

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I.Firms that have a 100 percent retention ratio
II.Firms that pay an unchanging dividend
III.Firms that pay a constantly increasing dividend
IV.Firms that pay an erratically growing dividend

Accepted Answer

The dividend growth model can only be used for firms that pay a constantly increasing dividend (III) or firms that pay an unchanging dividend (II), which are the assumptions of the model. Therefore, choices I and IV are not applicable. Thus, choice C, which includes II and III, is the correct answer.

Question 8

The pre-tax cost of debt:

Accepted Answer

The pre-tax cost of debt is based on the current yield to maturity of the firm's outstanding bonds. This reflects the current market conditions and the perceived risk of the firm's debt. The coupon rate and original yield to maturity may be historical values that do not reflect current market conditions. The average current yield may also not reflect the current market conditions for each individual bond. Therefore, option A is the best choice.

Question 9

Which of the following statements are correct?
I.Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner.
II.If you can borrow all of the money you need for a project at 5%,the cost of capital for this project is 5%.
III.The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds.
IV.The cost of capital,or WACC,is not the correct discount rate to use for all projects undertaken by a firm.

Accepted Answer

I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner. This statement is incorrect because using the same discount rate for all cash flows does not adjust for the different levels of risk associated with each cash flow.IV. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm. This statement is correct because the WACC is a weighted average of the costs of debt and equity, and it may not be appropriate to use this rate to discount all projects.

Question 10

The capital structure weights used in computing the weighted average cost of capital:

Accepted Answer

The capital structure weights used in computing the weighted average cost of capital are based on the market value of the firm's debt and equity securities. This is because market value reflects the true economic value of the securities and represents the amount that investors are willing to pay for them. The book value, on the other hand, simply represents the historical cost of the securities and may not reflect their current market value. Therefore, using market value weights provides a more accurate measure of the firm's cost of capital.

Question 11

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
 
-Estimate FM's after-tax cost of equity capital.

Accepted Answer

The answer of Key facts and assumptions concerning FM Foods,...

Question 12

The cost of equity for a firm:

Accepted Answer

The answer of The cost of equity for a firm:
...

Question 13

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
 
-Estimate FM's weighted-average cost of capital.

Accepted Answer

The answer of Key facts and assumptions concerning FM Foods,...

Question 14

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
 
-Estimate FM's after-tax cost of debt capital.

Accepted Answer

The after-tax cost of debt is calculated by multiplying the pre-tax cost of debt by (1 - tax rate). Assuming a typical tax rate and given the options, 4.10% is a reasonable estimate for the after-tax cost of debt.

Question 15

When investment returns are less than perfectly positively correlated,the resulting diversification effect means that:

Accepted Answer

When investment returns are less than perfectly positively correlated, spreading an investment across many diverse assets will eliminate some of the total risk. This is because diversification helps to reduce unsystematic risk. However, it does not eliminate all risk as there may still be systematic risk that cannot be diversified away. Option A is incorrect because investing in two or three large stocks will not necessarily eliminate all unsystematic risk. Option B is incorrect because investing in companies within the same industry does not reduce systematic risk. Option C is incorrect because spreading an investment across five diverse companies will lower the total risk through diversification. Option D is incorrect because diversification cannot eliminate all systematic risk.

Question 16

Which of the following statements concerning risk are correct?
I.Systematic risk is measured by beta.
II.The risk premium increases as unsystematic risk increases.
III.Systematic risk is the only part of total risk that should affect asset prices and returns.
IV.Diversifiable risks are market risks you cannot avoid.

Accepted Answer

Statement I is correct as systematic risk, also known as market risk, is measured by beta. Beta measures how sensitive an asset's returns are to the overall market movement.
Statement III is also correct as systematic risk is the only risk that should affect asset prices and returns since it is beyond an investor's control and affects the entire market.
Statement II is incorrect as the risk premium actually decreases as unsystematic risk increases since investors can diversify and reduce the impact of unsystematic risk on their portfolio. 
Statement IV is incorrect as diversifiable risks are risks that can be avoided by diversification, such as company-specific risks or industry risks. They are also known as unsystematic risks, while market risks are known as systematic risks.

Question 17

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
 
-Estimate the appropriate weight of equity to be used when calculating FM's weighted average cost of capital.

Accepted Answer

The answer of Key facts and assumptions concerning FM Foods,...

Question 18

The excess return earned by a risky asset,for example with a beta of 1.4,over that earned by a risk-free asset is referred to as a:

Accepted Answer

The excess return earned by a risky asset over that earned by a risk-free asset is called risk premium. The market risk premium, on the other hand, is the return in excess of the risk-free rate that investors require to invest in the overall stock market. Systematic return refers to the portion of an investment's return that is related to general market movement and cannot be diversified away, while total return is the overall return earned by an investment, including both capital appreciation and income. The real rate of return is the return adjusted for inflation.

Question 19

Which of the following statements are correct concerning diversifiable,or unsystematic,risks?
I.Diversifiable risks can be largely eliminated by investing in thirty unrelated securities.
II.There is no reward for accepting diversifiable risks.
III.Diversifiable risks are generally associated with an individual firm or industry.
IV.Beta measures diversifiable risk.

Accepted Answer

Diversifiable risks can be reduced by diversification (I) and are specific to a firm or industry (III). There is no reward for taking on diversifiable risks (II). Beta measures systematic risk, not diversifiable risk, so IV is incorrect.

Question 20

Which of the following are examples of diversifiable risk?
I.An earthquake damages Oakland,California.
II.The federal government imposes an additional $1,000 fee on all business entities.
III.Employment taxes increase nationally.
IV.Toymakers are required to improve their safety standards.

Accepted Answer

I is an example of an undiversifiable risk because it is a natural disaster that affects all businesses and individuals in Oakland, CA. 
II is an example of an undiversifiable risk because it affects all business entities. 
III is an example of a diversifiable risk because it only affects businesses in a specific country, and investors could mitigate this risk by diversifying across different countries. 
IV is an example of a diversifiable risk because it only affects toymakers, and investors could mitigate this risk by diversifying across different industries.

Quiz 8: Risk Analysis in Investment Decisions

The after-tax cost of debt generally increases when: I.a firm's bond rating increases. II.the market-required rate of interest for the company's bonds increases. III.tax rates decrease. IV.bond prices rise.

Unsystematic risk:

Total risk is measured by _ and systematic risk is measured by .

Which one of the following is an example of systematic risk?

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below. -Estimate the appropriate weight of debt to be used when calculating FM's weighted average cost of capital.

The pre-tax cost of debt:

The capital structure weights used in computing the weighted average cost of capital:

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below. -Estimate FM's after-tax cost of equity capital.

The cost of equity for a firm:

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below. -Estimate FM's weighted-average cost of capital.

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below. -Estimate FM's after-tax cost of debt capital.

When investment returns are less than perfectly positively correlated,the resulting diversification effect means that:

Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below. -Estimate the appropriate weight of equity to be used when calculating FM's weighted average cost of capital.

The excess return earned by a risky asset,for example with a beta of 1.4,over that earned by a risk-free asset is referred to as a:

Which of the following are examples of diversifiable risk? I.An earthquake damages Oakland,California. II.The federal government imposes an additional $1,000 fee on all business entities. III.Employment taxes increase nationally. IV.Toymakers are required to improve their safety standards.