Question 1

The β of all equity firm versus the β of the same firm with leverage is different
A) by the impact of business risk.
B) by the β of the assets.
C) because the β of the assets are not exposed to financial leverage.
D) because the β of the assets are exposed to financial leverage.

Accepted Answer

The β of the assets are not exposed to financial leverage. Business risk only affects the β of equity, whereas financial risk triggered by leverage only affects the equity portion of the firm's capital structure. The beta of the assets remains constant in both cases. Therefore, leverage does not affect the beta of the assets, and the answer is C.

Question 2

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) .26 Firm 2 beta greater than Firm 1 beta.
B) .15 Firm 2 beta greater than Firm 1 beta.
C) .30 Firm 2 beta greater than Firm 1 beta.
D) .10 firm 2 beta greater than Firm 1 beta.

Accepted Answer

The equity beta can be calculated using the formula: β_equity = β_asset * (1 + (1 - tax rate) * (D/E)). For Firm 1, D/E = 0.2/0.8 = 0.25. For Firm 2, D/E = 4/7. Calculating both, Firm 1's equity beta is 0.8 * (1 + 0.6 * 0.25) = 0.92, and Firm 2's equity beta is 0.8 * (1 + 0.6 * (4/7)) = 1.07. The difference is 1.07 - 0.92 = 0.15.

Question 3

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.

Accepted Answer

The formula to calculate the expected return of a stock is:

Expected Return = Risk-free rate + Beta*(Market risk premium)

Using the given information, we can rearrange the formula to solve for the beta of Barges:

Beta = (Expected Return - Risk-free rate) / Market risk premium
Beta = (0.12 - 0.05) / 0.06
Beta = 1.17

Therefore, the correct answer is B.

Question 4

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

Accepted Answer

The beta of the common stock of a levered firm is generally greater than the beta of an unlevered firm because debt adds financial risk, which amplifies the effects of market movements on equity returns. Therefore, with all other factors being equal, the levered firm's beta will be higher.

Question 5

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 .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.

Accepted Answer

The riskiness of equity is determined by the amount of financial leverage employed by the firm. Firm 1 has a 20% debt-to-equity ratio while Firm 2 has a 4:7 debt-to-equity ratio, which translates to a 1.75 debt-to-equity ratio (4/7 = 0.57, inverse of 0.57 = 1.75). Therefore, Firm 2 has a higher amount of financial leverage, which makes its equity riskier. The systematic risk, ß = 0.8, is the same for both firms and thus does not impact the riskiness of equity.

Question 6

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.

Accepted Answer

Operating leverage refers to the extent to which fixed costs are used in production, while financial leverage refers to the extent to which debt or other fixed-cost financing is used to fund operations. Therefore, a firm with high operating leverage has high fixed costs of production, and a firm with high financial leverage has high fixed financial costs. Choice C reflects both of these characteristics.

Question 7

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.

Accepted Answer

A negative beta indicates that the company's stock moves in the opposite direction of the market. If the stock consistently performs well when the market is performing poorly, and vice versa, this suggests it has a negative correlation to the market, and therefore a negative beta.

Question 8

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.

Accepted Answer

The beta of a portfolio of debt and equity is equal to the sum of all the betas weighted by their market value weight. This is because the beta of each component reflects the riskiness of that particular security relative to the market, but the overall riskiness of the portfolio will depend on the proportion of each component in the portfolio. Therefore, using market value weightings to calculate the portfolio beta is more accurate than simply summing the individual betas. Option A is incorrect because simply adding the betas does not account for the proportion of each component. Option C is incorrect because the portfolio beta could be less than the beta of each component if the portfolio has a lower overall level of risk than any individual security. Option D is incorrect because betas cannot be negative, as they represent the positive correlation between a security and the market.

Question 9

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.

Accepted Answer

Beta measures the volatility of a stock or portfolio compared to the overall market. A high beta means that the stock is more volatile than the market, while a low beta means that the stock is less volatile than the market. High cyclical business activity and high operating leverage both contribute to higher beta. High cyclical business activity means that the firm's revenues and earnings are more sensitive to changes in the economy, while high operating leverage means that the firm has high fixed costs relative to variable costs. This combination can result in large swings in earnings and stock prices, which increase beta.

Question 10

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.

Accepted Answer

A firm with high operating leverage has a high proportion of fixed costs in its production process. This means that a small change in sales volume can cause a significant change in profits, as the fixed costs remain constant while the variable costs increase with higher levels of production. Therefore, a firm with high operating leverage is more sensitive to changes in sales volume, and may have difficulty adapting to changes in demand.

Question 11

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%.

Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return for Simmons' common stock is:

Expected Return = Risk-free rate + Beta * Market Risk Premium

= 5% + 1.6 * 4%

= 11.4%

Therefore, the expected return for Simmons' common stock is 11.4%, which is option E.

Question 12

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.

Accepted Answer

Beta is a measure of systematic risk, which is the risk that cannot be diversified away. It is used in the calculation of the company's discount rate, which is a required rate of return that investors demand for investing in the company's stock. Therefore, choice B is the best choice as it directly relates to the use of beta.

Question 13

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.

Accepted Answer

The project should be discounted at a rate commensurate with its own beta. This is because an individual project's risk and return should be evaluated independently of the overall company's risk and return. Using the overall firm's beta would not adequately capture the unique risk factors of the project. Therefore, the appropriate discount rate is one that reflects the project's specific level of risk.

Question 14

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.

Accepted Answer

Firms with strongly cyclical revenues and high operating leverage are likely to be more sensitive to economic fluctuations and market movements, resulting in high betas. Beta measures the volatility or the systematic risk of a stock or a portfolio in relation to the overall market, so a high beta indicates that the stock/portfolio is likely to have large price swings in response to changes in the market.

Question 15

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.

Accepted Answer

A firm with cyclical earnings is characterized by revenue patterns that vary with the business cycle, meaning their earnings may be higher in boom periods and lower in recessionary periods. The other options listed do not necessarily apply to all firms with cyclical earnings.

Question 16

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) .70.
B) 1.04.
C) 1.05.
D) .96.
E) .72.

Accepted Answer

The answer of The Tenplen Corporation has an equity beta...

Question 17

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%
D) 14.6%

Accepted Answer

The correct answer is A because the required rate of return is equal to the risk-free rate plus the market risk premium times the asset beta times the debt-to-equity ratio. In this case, the required rate of return is 2% + 6% * 0.7 * 0.75 = 18.8%.

Question 18

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) .80.
B) .90.
C) 1.05.
D) 1.20.
E) .40.

Accepted Answer

The correct answer is A because the equity beta is calculated as the asset beta multiplied by the equity portion of the capital structure, which is 1 - the debt portion. In this case, the equity portion is 1 - .375 = .625, so the equity beta is 1.05 * .625 = .80.

Question 19

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 effect 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.

Accepted Answer

When a firm has low fixed costs relative to other firms in the industry, a large change in volume (either up or down) will have a smaller proportional effect on the firm's EBIT compared to other firms with higher fixed costs. This is because the firm with low fixed costs has a higher proportion of variable costs, which will change proportionally with changes in output or sales. Therefore, the answer is A.

Question 20

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) .40
C) .72
D) 1.2

Accepted Answer

The answer of Slippery Slope Roof Contracting has an equity...

Quiz 13: Risk, Return, and Capital Budgeting

The β of all equity firm versus the β of the same firm with leverage is different

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:

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.

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 .4 which has the riskier equity?

A firm with high operating leverage is characterized by _ while one with high financial leverage is characterized by _____.

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:

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

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

A firm with high operating leverage has:

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:

Beta is useful in the calculation of:

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

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

A firm with cyclical earnings is characterized by:

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?

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?

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?

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:

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?