Question 1

The standard deviation of returns on Wildcat Oil Drilling is very high.Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios?
 Explain why or why not.

Accepted Answer

The answer of The standard deviation of returns on Wildcat...

Question 2

Investments A and B both cost $100,000 and each promises a single payoff in one year.The distribution of payoffs for each investment appears below.
  Ignoring possible differences in nondiversifiable risk,which investment would a risk-averse investor prefer,and why?

Accepted Answer

The answer of Investments A and B both cost $100,000...

Question 3

What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2 percent per year forever?
 Assume the appropriate discount rate is 12 percent.

Accepted Answer

The answer of What is the present value of a...

Question 4

Suppose that your company's weighted-average cost of capital is 9 percent.Your company is planning to undertake a project with an internal rate of return of 12%,but you believe that this project is not a good investment for the firm.What logical arguments might you use to convince your boss to forego the project despite its high rate of return?
 Is it possible that making investments with expected returns higher than your company's cost of capital will destroy value?
 If so,how?

Accepted Answer

The answer of Suppose that your company's weighted-average cost of...

Question 5

The discount rate assigned to an individual project should be based on:
A) the firm's weighted average cost of capital.
B) the actual sources of funding used for the project.
C) an average of the firm's overall cost of capital for the past five years.
D) the current risk level of the overall firm.
E) the risks associated with the use of the funds required by the project.
F) None of the above.

Accepted Answer

The discount rate for a project should reflect the specific risks associated with that project, not just the firm's overall cost of capital or past averages.

Question 6

Key facts and assumptions concerning Costco Company, at December 31, 2011, appear below.
 
-Use the above information to answer the following questions.
a.Estimate Costco's cost of equity capital.
b.Estimate Costco's weighted-average cost of capital.

Accepted Answer

The answer of Key facts and assumptions concerning Costco Company,...

Question 7

Honest Abe's is a chain of furniture retail stores.Integral Designs is a furniture maker and a supplier to Honest Abe's.Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12.Both firms carry no debt,i.e.,are 100% equity-financed.The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent.What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture?
A) 12.46 percent
B) 12.92 percent
C) 13.50 percent
D) 14.08 percent
E) 14.54 percent
F) None of the above.

Accepted Answer

Since the project involves manufacturing furniture, Honest Abe's should use Integral Designs' beta of 1.12. The discount rate is calculated using the Capital Asset Pricing Model (CAPM): Risk-free rate + (Beta * Market risk premium) = 3.5% + (1.12 * 8%) = 12.46%.

Question 8

Explain the difference between systematic and unsystematic risk,and why one of these types of risks is rewarded with a risk premium while the other type is not.

Accepted Answer

The answer of Explain the difference between systematic and unsystematic...

Question 9

The weighted average cost of capital for a firm is the:
A) discount rate which the firm should apply to all of the projects it undertakes.
B) rate of return a firm must earn on its existing assets to maintain the current value of its stock.
C) coupon rate the firm should expect to pay on its next bond issue.
D) minimum discount rate the firm should require on any new project.
E) rate of return shareholders should expect to earn on their investment in this firm.
F) None of the above.

Accepted Answer

The weighted average cost of capital (WACC) is the rate of return a firm must earn on its existing assets to maintain the current value of its stock. It reflects the average rate of return required by all of the firm's investors, including equity and debt holders.

Question 10

Blue Diamond Equipment has 80,000 bonds outstanding that are selling at par.Bonds with similar characteristics are yielding 6.75 percent.The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding.The preferred stock sells for $53 a share.The common stock has a beta of 1.34 and sells for $42 a share.The U.S.Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent.The corporate tax rate is 38 percent.What is the firm's weighted average cost of capital?
A) 10.39 percent
B) 10.64 percent
C) 11.18 percent
D) 11.30 percent
E) 11.56 percent
F) None of the above.

Accepted Answer

The correct answer is A because the weighted average cost of capital (WACC) is 10.39 percent. The WACC is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) + (P/V) * Rpwhere:E = market value of equityV = total value of the firmRe = cost of equityD = market value of debtRd = cost of debtTc = corporate tax rateP = market value of preferred stockRp = cost of preferred stockIn this case, the market value of equity is $105 million ($42 * 2.5 million), the total value of the firm is $180 million ($80 million + $105 million), the cost of equity is 11.56 percent, the market value of debt is $80 million, the cost of debt is 6.75 percent, the corporate tax rate is 38 percent, the market value of preferred stock is $39.75 million ($53 * 750,000), and the cost of preferred stock is 7 percent.Plugging these values into the WACC formula, we get:WACC = (105/180) * 11.56% + (80/180) * 6.75% * (1 - 0.38) + (39.75/180) * 7%WACC = 10.39%

Quiz 8: Risk Analysis in Investment Decisions

The standard deviation of returns on Wildcat Oil Drilling is very high.Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

Investments A and B both cost $100,000 and each promises a single payoff in one year.The distribution of payoffs for each investment appears below. Ignoring possible differences in nondiversifiable risk,which investment would a risk-averse investor prefer,and why?

What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2 percent per year forever? Assume the appropriate discount rate is 12 percent.

The discount rate assigned to an individual project should be based on:

Key facts and assumptions concerning Costco Company, at December 31, 2011, appear below. -Use the above information to answer the following questions. a.Estimate Costco's cost of equity capital. b.Estimate Costco's weighted-average cost of capital.

Explain the difference between systematic and unsystematic risk,and why one of these types of risks is rewarded with a risk premium while the other type is not.

The weighted average cost of capital for a firm is the: