Deck 9: Risk and the Cost of Capital

Question 1

Using a company's cost of capital to evaluate a project is
I.always correct;
II.always incorrect;
III.correct for projects that have average risk compared to the firm's other assets

A)I only
B)II only
C)III only
D)I and III only

Answer 1

III only

Question 2

The market value of XYZ Corporation's common stock is $40 million and the market value of its risk-free debt is $60 million. The beta of the company's common stock is 0.8 and the expected market risk premium is 10 percent. If the Treasury bill rate is 6 percent, what is the firm's cost of capital? (Assume no taxes.)

A)9.2 percent
B)14.0 percent
C)8.1 percent
D)10.8 percent

Answer 2

9.2 percent

Question 3

The cost of capital for a project depends on

A)the company's cost of capital.
B)the use of the capital (the project).
C)the industry cost of capital.
D)the company's level of debt financing.

Answer 3

the use of the capital (the project).

Question 4

The company cost of capital is the appropriate discount rate for a firm's

A)low-risk projects.
B)high-risk projects.
C)average-risk projects.
D)risk-free projects.

Question 5

If a firm uses the same company cost of capital for evaluating all projects, which situation(s)will likely occur?
I.The firm will reject good low-risk projects;
II.The firm will accept poor high-risk projects;
III.The firm will correctly accept projects with average risk

A)I only
B)I and II only
C)I,II, and III
D)II only

Question 6

Company A's historical returns for the past three years are 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. Calculate the beta for Stock A.

A)1.75
B)1.00
C)0.57
D)0.75

Question 7

If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s)will likely occur?
I.The firm will accept poor low-risk projects.
II.The firm will reject good high-risk projects.
III.The firm will correctly accept projects with average risk.

A)I only
B)II only
C)III only
D)I, II, and III

Question 8

A firm's cost of equity can be estimated using the
I.discounted cash-flow (DCF)approach;
II.capital asset pricing model (CAPM);
III.arbitrage pricing theory

A)I and II
B)I and III
C)II and III
D)I, II, and III

Question 9

The market value of Charter Cruise Company's equity is $15 million and the market value of its debt is $5 million. If the required rate of return on the equity is 20 percent and that on its debt is 8 percent, calculate the company's cost of capital. (Assume no taxes.)

A)20 percent
B)17 percent
C)14 percent
D)11 percent

Question 10

The market value of Cable Company's equity is $60 million and the market value of its debt is $40 million. If the required rate of return on the equity is 15 percent and that on its debt is 5 percent, calculate the company's cost of capital. (Assume no taxes.)

A)15 percent
B)10 percent
C)11 percent
D)9 percent

Question 11

One calculates the after-tax weighted average cost of capital (WACC)using which of the following formulas?

A)WACC = (r_D)(D/V)+ (r_E)(E/V), where V = D + E.
B)WACC = (r_D)(1 − T_C)(D/V)+ (r_E)(1 − T_C)(E/V), where V = D + E.
C)WACC = (r_D)(D/E)+ (r_E)(E/D).
D)WACC = (r_D)(1 − T_C)(D/V)+ (r_E)(E/V), where V = D + E.

Question 12

The market value of Charcoal Corporation's common stock is $20 million, and the market value of its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and the market risk premium is 8 percent. If the Treasury bill rate is 5 percent, what is the company's cost of capital? (Assume no taxes.)

A)15.0 percent
B)14.6 percent
C)13.0 percent
D)7.0 percent

Question 13

Which of the following types of projects has the lowest unique risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements

Question 14

Which of the following types of projects generally have the highest total risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements using known technology

Question 15

A firm might categorize its projects into
I.cost improvements;
II.expansion projects (existing business);
III.new products;
IV.speculative ventures

A)III only
B)I, II, and III only.
C)II and IV only
D)I, II, III, and IV

Question 16

Which of the following types of projects has average total risk?

A)Speculative ventures
B)New products
C)Expansions of existing business
D)Cost improvements

Question 17

The hurdle rate for capital budgeting decisions is

A)the cost of capital.
B)the cost of debt.
C)the cost of equity.
D)the risk-free rate.

Question 18

The cost of capital is the same as the cost of equity for firms that are financed

A)entirely by debt.
B)by both debt and equity.
C)entirely by equity.
D)by 50 percent equity and 50 percent debt.

Question 19

A firm's cost of equity can be estimated using the

A)Fama-French three-factor model.
B)capital asset pricing model (CAPM).
C)arbitrage pricing theory (APT).
D)All of the options are correct.

Question 20

The company cost of capital, when the firm has both debt and equity financing, is called the

A)cost of debt.
B)cost of equity.
C)weighted average cost of capital (WACC).
D)return on equity (ROE).

Question 21

A project has an expected risky cash flow of $500 in year 3. The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20. Calculate the certainty equivalent cash flow for year 3, CEQ₃.

A)$622.04
B)$360.33
C)$401.90
D)$693.82

Question 22

Which of the following informational updates would prompt a financial manager to use a higher cost of capital to analyze a project?

A)Sales estimates from the marketing department have been less accurate of late.
B)The treasurer has recently indicated that the firm will increase its use of debt financing.
C)The treasurer has recently indicated that the firm will decrease its use of debt financing.
D)Recent estimates indicate the project has a greater percentage of fixed costs than previously thought.

Question 23

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the observed variance of the market portfolio returns. (Ignore the correction for the loss of a degree of freedom set out in the text.)

A)192.0
B)128.0
C)28.0
D)18.7

Question 24

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the average return for Stock B and the market portfolio.

A)Stock B: 16 percent; market portfolio: 14 percent
B)Stock B: 14 percent; market portfolio: 16 percent
C)Stock B: 24 percent; market portfolio: 12 percent
D)Stock B: 12 percent; market portfolio: 16 percent

Question 25

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the observed covariance of returns between Stock B and the market portfolio. (Ignore the correction for the loss of a degree of freedom set out in the text.)

A)16
B)28
C)36
D)292

Question 26

Company A's historical returns for the past three years are 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. Suppose the risk-free rate of return is 4 percent and that investors expect the market to return 10 percent. What is the cost of equity capital (required rate of return of company A's common stock), computed with the CAPM?

A)8.5 percent
B)14.0 percent
C)12.0 percent
D)10.0 percent

Question 27

The market portfolio's historical returns for the past three years were 10 percent, 10 percent, and 16 percent. Suppose the risk-free rate of return is 4 percent. Estimate the market risk premium.

A)4 percent
B)8 percent
C)12 percent
D)16 percent

Question 28

Financial slang referring to the reduction of cash flows from a project's forecasted value to its certainty equivalent is a(n)

A)deep discount.
B)haircut for risk.
C)arbitrage profit.
D)speculative gain.

Question 29

Generally, for CAPM calculations, the value to use for the risk-free interest rate is the

A)short-term U.S. Treasury bill rate.
B)long-term corporate bond rate.
C)medium-term corporate bond rate.
D)medium-term average rate on common stocks.

Question 30

An analyst computes the beta of the computer company WinDoze as 1.7 and the standard error of the estimate as 0.3. What is the 95 percent confidence interval for the calculated beta?

A)1.1 - 2.3
B)1.4 - 2.0
C)1.7 - 2.0
D)1.4 - 1.7

Question 31

The historical returns for the past four years for Stock C and the stock market portfolio are Stock C: 10 percent, 30 percent, 20 percent, 20 percent; market portfolio: 5 percent, 15 percent, 25 percent, 15 percent. Calculate the beta of Stock C.

A)0.86
B)0.50
C)1.50
D)0.38

Question 32

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the beta for Stock B.

A)0.86
B)1.00
C)1.13
D)1.17

Question 33

Company A's historical returns for the past three years were 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. According to the security market line (SML), Stock A was

A)overpriced.
B)underpriced.
C)correctly priced.
D)More information is needed.

Question 34

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. The expected market return is 12 percent. Calculate the required rate of return (cost of equity)for Stock B using the CAPM. (The risk-free rate of return = 4%.)

A)8.6 percent
B)12.6 percent
C)10.9 percent
D)16.0 percent

Question 35

On a graph with common stock returns on the y-axis and market returns on the x-axis, the slope of the regression line represents

A)alpha.
B)beta.
C)R-squared.
D)standard error.

Question 36

A project has an expected risky cash flow of $200 in year 1. The risk-free rate is 6 percent, the expected market rate of return is 16 percent, and the project's beta is 1.50. Calculate the certainty equivalent cash flow for year 1, CEQ₁.

A)$175.21
B)$165.29
C)$228.30
D)$182.76

Question 37

A project has an expected risky cash flow of $500 in year 2. The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20. Calculate the certainty equivalent cash flow for year 2, CEQ₂.

A)$622.04
B)$164.29
C)$401.90
D)$416.13

Question 38

The historical returns for the past four years for Stock C and the stock market portfolio are Stock C: 10 percent, 30 percent, 20 percent, 20 percent; market portfolio: 5 percent, 15 percent, 25 percent, 15 percent. If the risk-free rate of return is 5 percent and the expected market return is 12 percent, calculate the required rate of return on Stock C using the CAPM.

A)5.0 percent
B)10.0 percent
C)8.5 percent
D)13.0 percent

Question 39

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. If the risk-free rate is 4 percent, calculate the market risk premium.

A)18.1 percent
B)14.0 percent
C)10.0 percent
D)6.0 percent

Question 40

A project has an expected cash flow of $300 in year 3. The risk-free rate is 5 percent, the market risk premium is 8 percent, and the project's beta is 1.25. Calculate the certainty equivalent cash flow for year 3, CEQ₃.

A)$228.35
B)$197.25
C)$300.00
D)$270.02

Question 41

An analyst should evaluate each project at its own opportunity cost of capital. The true cost of capital depends on the particular use of that capital.

Question 42

An example of diversifiable risk that a financial manager should ignore when analyzing a project's risk would include

A)commodity price changes.
B)labor costs.
C)overall stock price fluctuations.
D)risks of government nonapproval of the project.

Question 43

A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger confidence interval.

Question 44

Firms with high operating leverage tend to have higher asset betas.

Question 45

Portfolio betas for an industry are usually higher than the average betas of individual stocks in that same industry.

Question 46

The company cost of capital is the cost of debt of the firm.

Question 47

Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount rate.

Question 48

For firms with relatively high levels of debt, the company cost of capital is the cost of equity of the firm.

Question 49

An analyst computes a beta coefficient with a low standard error. This implies that

A)this particular beta is more reliable than most.
B)this particular beta has little meaning.
C)too few observations were used to compute this particular beta.
D)this stock responds less to market changes than most stocks.

Question 50

Firms with cyclical revenues tend to have lower asset betas.

Question 51

Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity instead of market values. The resulting WACC estimates will generally be too high.

Question 52

The company cost of capital is the correct discount rate for any project undertaken by the company.

Question 53

Generally, an industry beta, calculated from a portfolio of companies in the same industry, is more accurate than a beta estimate for a single company.

Question 54

The company cost of capital is the correct discount rate only for investments that have the same risk as the company's overall business.

Question 55

Projects with great amounts of diversifiable risk should generally have higher company costs of capital.

Question 56

One calculates the weighted average cost of capital (WACC), on an after-tax basis, as WACC = (r_D)(1 − T_C )(D/V)+ (r_E)(E/V), where V = D + E.

Question 57

Generally, one should use the short-term Treasury bill rate for the risk-free rate.

Question 58

Which of the following projects most likely has the lowest cost of capital?

A)Construction of a new steel factory
B)Investment in latest-technology, high-end television production
C)Construction of a luxury resort
D)Investment in a gold-mining operation

Question 59

Cyclical firms tend to have high betas.

Question 60

Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.

Question 61

Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a project.

Question 62

The cost of capital is always less than or equal to the cost of equity.

Question 63

Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM).

Question 64

Briefly explain how the use of a single company cost of capital to evaluate all projects might lead to erroneous decisions.

Question 65

In general, one should use higher discount rates for longer-term projects.

Question 66

Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate.

Question 67

Why do firms with large cash-flow betas also have high asset betas?

Question 68

If one uses a long-term risk-free rate for the CAPM instead of a short-term risk-free rate, then one will generate a flatter security market line.

Question 69

A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the discount rate.

Question 70

A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-term projects as opposed to long-term projects.

Question 71

Briefly explain the difference between company and project cost of capital.

Question 72

Companies with high ratios of fixed costs to project values tend to have high betas.

Question 73

A pure play is a comparable firm that specializes in one activity.

Question 74

Discuss why one might use an industry beta to estimate a company's cost of capital.

Question 75

Briefly describe the factors that determine asset betas.

Question 76

Briefly discuss the certainty equivalent approach to estimating the NPV of a project.