Deck 9: Risk and the Cost of Capital

Question 1

Cost of equity can be estimated using:

A) The Fama-French three-factor model
B) Capital Asset Pricing Model (CAPM)
C) Arbitrage Pricing theory (APT)
D) All of the above

Answer 1

All of the above

Question 2

If a firm uses the same company cost of capital for evaluating all projects, which of the following is likely?
I. Rejecting good low risk projects
II. Accepting poor high risk projects
III. Correctly accept projects with average risk

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

Answer 2

I, II, and III

Question 3

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

A) 15%
B) 10%
C) 11%
D) None of the above

Answer 3

11%

Question 4

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%. If the Treasury bill rate is 5%, what is the company's cost of capital? (Assume no taxes.)

A) 15%
B) 14.6%
C) 13%
D) None of the above

Question 5

The company cost of capital when debt as well as equity is used for financing is:

A) cost of debt
B) cost of equity
C) the weighted average cost of capital (WACC)
D) none of the above

Question 6

The historical returns data for the past three years for Company A's stock is -6.0%, 15%,
15% and that of the market portfolio is 10%, 10% and 16%. If the risk-free rate of return is
4%, what is the cost of equity capital (required rate of return of company A's common stock)
Using CAPM?

A) 18%
B) 14%
C) 12%
D) None of the above

Question 7

A firm might categorize its projects into:
I. Cost improvement projects
II. Expansion projects (existing business)
III. New products projects
IV. Speculative ventures

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

Question 8

The cost of capital for a project depends on:

A) The company's cost of capital
B) The use to which the capital is put, i.e. the project
C) The industry cost of capital
D) All of the above

Question 9

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) all of the above

Question 10

Cost of equity can be estimated using:

A) Discounted cash flow (DCF) approach
B) Capital Asset Pricing Model (CAPM)
C) Arbitrage Pricing theory (APT)
D) All of the above

Question 11

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

A) Speculation ventures
B) New products
C) Expansion of existing business
D) Cost improvement, (known technology)

Question 12

The after-tax weighted average cost of capital (WACC) is calculated using the formula:

A) WACC = (r_D) (D/V) + (r_E) (E/V) where: V = D + E
B) WACC = (r_D) (1 - TC ) (D/V) + (r_E) (E/V) where: V = D + E
C) WACC = (r_D) (D/E) + (r_E) (E/D)
D) none of the above

Question 13

Which of the following type of projects has the lowest risk?

A) Speculation ventures
B) New products
C) Expansion of existing business
D) Cost improvement

Question 14

If firms use the company cost of capital for evaluating all of their projects, which of the following is likely?
I. Accepting poor low risk projects.
II. Rejecting good high risk projects.
III. Correctly accept projects with average risk.

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

Question 15

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

A) 20%
B) 17%
C) 14%
D) None of the above

Question 16

Cost of capital is the same as cost of equity for firms:

A) financed entirely by debt
B) financed by both debt and equity
C) financed entirely by equity
D) none of the above

Question 17

Which of the following type of projects has average risk?

A) Speculation ventures
B) New products
C) Expansion of existing business
D) Cost improvement

Question 18

The market value of XYZ Corporation's common stock is 40 million and the market value of the 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%. If the Treasury bill rate is 6%, what is the firm's cost of capital? (Assume no taxes.)

A) 9.2%
B) 14%
C) 8.1%
D) None of the above

Question 19

Using the company cost of capital to evaluate a project is:
I. Always correct
II. Always incorrect
III. Correct for projects that are about as risky as the average of the firm's other assets

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

Question 20

The hurdle rate for capital budgeting decisions is:

A) The cost of capital
B) The cost of debt
C) The cost of equity
D) All of the above

Question 21

The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the expected return for Stock B and the market portfolio.

A) Stock B 16%, Market Portfolio: 14%
B) Stock B 14%, Market Portfolio: 16%
C) Stock B 24%, Market Portfolio: 12%
D) None of the above

Question 22

The country beta for Egypt is:

A) 1.0
B) 0.14
C) 1.35
D) 0.93

Question 23

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

A) 0.86
B) 0.5
C) 1.5
D) none of the above

Question 24

An example of diversifiable risk that should be ignored when analyzing project risk would include

A) Commodity price changes
B) Labor costs
C) Stock price fluctuations
D) Risk of government non-approval

Question 25

The beta of the computer company is 1.7 and the standard error of the estimate is 0.3. What is the range of values for beta, that has 95% chance of being right?

A) 1.1 - 2.3
B) 1.4 - 2.0
C) 1.5 - 2.0
D) None of the above

Question 26

The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the variance of the market portfolio returns.

A) 192
B) 128
C) 28
D) None of the above

Question 27

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

A) Short-term Treasury bill rate
B) Long-term Corporate bond rate
C) Medium-term Corporate bond rate
D) none of the above

Question 28

A project has an expected risky cash flow of $200, in year-1. The risk-free rate is 6%, the market rate of return is 16%, and the project's beta is 1.5. Calculate the certainty equivalent cash flow for year-1.

A) $175.21
B) $164.29
C) $228.30
D) None of the above

Question 29

The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the covariance of returns between Stock B and the market portfolio.

A) 24
B) 28
C) 292
D) None of the above

Question 30

The risk-free rate is 5%, the market risk premium is 8% and the project's beta is 1.25. Calculate the certainty equivalent cash flow for
Year-3.

A) $228.35
B) $197.25
C) $300
D) None of the above

Question 31

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

A) 8.6%
B) 12.6%
C) 14.3%
D) None of the above

Question 32

A project has an expected risky cash flow of $500, in year-2. The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-2.

A) $622.04
B) $164.29
C) $401.90
D) None of the above

Question 33

Financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent is a

A) Deep discount
B) Haircut for risk
C) Arbitrage profit
D) Speculative gain

Question 34

The historical data for the past three years for the market portfolio are 10%, 10% and
16%) If the risk-free rate of return is 4%, what is the market risk premium?

A) 4%
B) 8%
C) 16%
D) None of the above

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 the:

A) Alpha
B) Beta
C) R-squared
D) Adjusted beta

Question 36

A fudge factor might include:

A) Commodity price changes
B) Labor costs
C) Stock price fluctuations
D) Risk of government non-approval

Question 37

The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-3.

A) $622.04
B) $360.33
C) $401.90
D) None of the above

Question 38

The historical returns data for the past three years for Company A's stock is -6.0%, 15%,
15% and that of the market portfolio is 10%, 10% and 16%. According to the security market line (SML), the Stock A is:

A) Over priced
B) Under priced
C) Correctly priced
D) Need more information

Question 39

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

A) 5%
B) 10%
C) 15%
D) none of the above

Question 40

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

A) 18.1%
B) 14%
C) 10%
D) None of the above

Question 41

It is generally more accurate to estimate an "industry beta" for a portfolio of companies in the same industry than to estimate beta for a single company.

Question 42

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

Question 43

The weighted average cost of capital (WACC) on an after-tax basis is calculated as: WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V) where: V = D + E

Question 44

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

Question 45

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

Question 46

What does a low standard error mean relative to beta?

A) Beta is a reliable measurement of risk
B) Beta has very little meaning
C) There is tremendous benefit to be gained from diversification
D) Nothing

Question 47

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

Question 48

Company cost of capital is the cost of equity of the firm.

Question 49

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

Question 50

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

Question 51

Briefly explain what value should be used for the risk-free interest rate.

Question 52

Cyclical firms tend to have high betas.

Question 53

Generally, the value to use for the risk-free rate is the short-term Treasury bill rate.

Question 54

The relative accuracy of a beta estimate for risk can be determined by the standard error.

Question 55

Each project should be evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which the capital is put.

Question 56

Company cost of capital is the cost of debt of the firm.

Question 57

Firms with cyclical revenues tend to have lower asset betas.

Question 58

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

Question 59

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

Question 60

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

Question 61

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

Question 62

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

Question 63

Briefly describe the factors that determine asset betas.

Question 64

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