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 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)7%

Answer 2

13%

Question 3

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% equity and 50% debt.

Answer 3

entirely by equity.

Question 4

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 5

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%.If the Treasury bill rate is 6%,what is the firm's cost of capital? (Assume no taxes.)

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

Question 6

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 +
B)WACC = (r_D)(1 - T_C)(D/V)+ (r_E)(1 - T_C)(E/V),where: V = D +
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 7

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)the weighted average cost of capital (WACC).
D)the return on equity (ROE).

Question 8

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 9

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 10

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.

Question 11

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

A)1.75
B)1.0
C)0.57
D)0.75

Question 12

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.

Question 13

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 14

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% and that on its debt is 5%,calculate the company's cost of capital.(Assume no taxes.)

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

Question 15

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 (APT)

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

Question 16

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% and that on its debt is 8%,calculate the company's cost of capital.(Assume no taxes.)

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

Question 17

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 18

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 19

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 20

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 21

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 22

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 23

The historical returns for the past four years for Stock C and the stock market portfolio 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 Stock C using the CAPM.

A)5%
B)10%
C)15%
D)13%

Question 24

A project has an expected risky cash flow of $200 in year 1.The risk-free rate is 6%,the expected market rate of return is 16%,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 25

A project has an expected risky cash flow of $500 in year 2.The risk-free rate is 4%,the expected market rate of return is 14%,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 26

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% 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 27

A project has an expected cash flow of $300 in year 3.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,CEQ₃.

A)$228.35
B)$197.25
C)$300
D)$270.02

Question 28

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

A)18.1%
B)14%
C)10%
D)6%

Question 29

The historical returns for the past three years for Stock B and the stock market portfolio are: Stock B: 24%,0%,24%; Market portfolio: 10%,12%,20%.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%
B)12.6%
C)14.3%
D)16.0%

Question 30

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

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

Question 31

The historical returns for the past three years for Stock B and the stock market portfolio are: Stock B: 24%,0%,24%; Market portfolio: 10%,12%,20%.Calculate the average 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)Stock B 12%,market portfolio: 16%

Question 32

Company A's historical returns for the past three years were: 6%,15%,and 15%.Similarly,the market portfolio's returns were: 10%,10%,and 16%.According to the security market line (SML),Stock A was:A.However,one needs to know the risk-free rate to construct the SML.

A)overpriced.
B)underpriced.
C)correctly priced.
D)need more information.The given numbers enable the calculation of beta for Company

Question 33

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

A)24
B)28
C)36
D)292

Question 34

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 35

Company A's historical returns for the past three years are: 6.0%,15%,and 15%.Similarly,the market portfolio's returns were: 10%,10%,and 16%.Suppose 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),computed with the CAPM?

A)18%
B)14%
C)12%
D)10%

Question 36

A project has an expected risky cash flow of $500 in year 3.The risk-free rate is 4%,the expected market rate of return is 14%,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 37

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

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

Question 38

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

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

Question 39

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

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

Question 40

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 41

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

Question 42

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

Question 43

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

Question 44

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 45

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

Question 46

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

Question 47

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 48

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 49

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

Question 50

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 51

Cyclical firms tend to have high betas.

Question 52

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 53

Firms with cyclical revenues tend to have lower asset betas.

Question 54

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 55

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

Question 56

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

Question 57

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

Question 58

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

Question 59

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 60

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

Question 61

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

Question 62

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

Question 63

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

Question 64

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

Question 65

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

Question 66

Briefly describe the factors that determine asset betas.

Question 67

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

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

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

Question 70

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

Question 71

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

Question 72

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

Question 73

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

Question 74

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 75

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