Deck 11: Investing in Risky Projects

Question 1

Which of the following algebraic expressions is the ploughback ratio? (b is the fraction of earnings retained in the firm and g is the growth rate.)

A)g = (1 - b) $\times$ ROE
B)g = ROE $\div$ b
C)g = b $\times$ ROE
D)g = (1 + b) $\times$ ROE

Answer 1

g = b $\times$ ROE

Question 2

"There is no theoretical reason to select a short-term risk-free rate over a long-term risk-free rate,or vice versa in the CAPM or APT risk-expected return relation." Explain the statement.

Answer 2

In general,the use of the long-term versus the short-term risk-free rate in the CAPM or APT risk-expected return relation depends on practical considerations,not on the horizon of the cash flow.As an illustration,consider the valuation of a long-horizon certain cash flow.It is very clear that the yield of a default-free zero-coupon bond of matched horizon provides the appropriate rate for discounting the certain cash flow.This discounting is equivalent to finding a tracking portfolio which perfectly tracks the certain cash flow.For practical reasons,valuation with perfect tracking is generally more accurate than valuation using the market portfolio or factor portfolios.Thus,for a long horizon,the beta of the certain cash flow,measured over long horizons,is zero,and the risk-free rate is the long-term riskless rate.However,if one believes the CAPM is correct,it is also appropriate to track a long-horizon certain cash flow with short-horizon riskless bonds and the market portfolio.

Question 3

The risk-adjusted discount rate method discounts the expected future cash flows of a project at:

A)the risk-free rate.
B)the project's cost of capital.
C)the market risk premium.
D)a rate which is the difference of risk-free rate and the cost of debt.

Answer 3

B

Question 4

The estimated cost of capital for Zeta Corporation is 10.44%.The company is expected to produce €35 million in cash flows at the end of this year,and that this number will grow by 5% per year for ever.Find the value of Zeta Corporation.

A)€443.25
B)€700
C)€335.25
D)€643.38

Question 5

Which of the following is true of tracking error and the present value of the cash flows of a project?

A)If a tracking portfolio for the future cash flows of a project generates tracking error with zero systematic risk and zero expected value,the market value of the tracking portfolio is the undiscounted cash flows of the project.
B)If a tracking portfolio for the future cash flows of a project generates tracking error with zero systematic risk and zero expected value,the market value of the tracking portfolio is equal to the project?s future cash outflows.
C)If a tracking portfolio for the future cash flows of a project generates tracking error with zero systematic risk and zero expected value,the market value of the tracking portfolio is equal to the project?s future cash inflows.
D)If a tracking portfolio for the future cash flows of a project generates tracking error with zero systematic risk and zero expected value,the market value of the tracking portfolio is the present value of the project?s future cash flows.

Question 6

Which of the following is true of leverage on risk of a project?

A)Increasing the firm's debt decreases the beta per unit of equity investment.
B)Risk per unit of equity investment will increase non-linearly in the D/E ratio if the debt is risk free.
C)Risk per unit of equity investment will decrease non-linearly in the D/E ratio if the debt is risk free.
D)Reducing equity increases the risk per unit of equity investment.

Question 7

The betas of the actual returns of projects equal the:

A)project's profitability index times the appropriate beta needed to compute the true present value of the project.
B)project's payback period times the appropriate beta needed to compute the true present value of the project.
C)project's IRR times the appropriate beta needed to compute the true present value of the project.
D)project's NPV times the appropriate beta needed to compute the true present value of the project divided by the initial cash outflow.

Question 8

As per the risk-free scenario method,

A)the certainty equivalent cash flow is assumed to be the expected cash flow in situations where the tangency portfolio return equals the risk-free rate plus the market risk premium.
B)the certainty equivalent cash flow is assumed to be the expected cash flow in situations where the tangency portfolio return equals the risk-free rate.
C)the certainty equivalent cash flow is assumed to be the expected cash flow in situations where the optimal portfolio return equals the risk-free rate.
D)the certainty equivalent cash flow is assumed to be the expected cash flow in situations where the tangency portfolio return equals the market risk premium.

Question 9

Retailclique is a British company and operates in the retail industry.A comparable firm from the same industry,Zeta Corporation,has an equity beta of 0.63,a market capitalization of equity equal to £1.44 billion,and a book value of debt equal to £0.13 billion.Find the asset beta of Zeta Corporation if its debt is risk-free.

A)0.917
B)0.577
C)0.082
D)0.052

Question 10

Which of the following is the correct algebraic expression of the levered beta of a project?

A)
B)
C)
D)

Question 11

Define the certainty equivalent method.

Question 12

Which of the following is the correct algebraic expression of the risk-adjusted discount rate method?

A)
B)
C)
D)

Question 13

Which of the following is an implicit assumption of the dividend discount model?s estimate of the cost of capital?

A)The firm can borrow and lend at a risk-free rate.
B)The firm's earning growth rate will be equal to the dividend growth rate.
C)The earnings growth forecasts are unbiased.
D)The firm's earnings and dividends grow at the different constant rate,forever.

Question 14

Operating leverage is defined as the:

A)ratio of operating cash flow to investing cash flow.
B)ratio of fixed costs to variable costs.
C)ratio of fixed assets to current assets.
D)ratio of operating income to net income.

Question 15

The cash flow beta is the:

A)covariance of the future cash flow with the return of the tangency portfolio,divided by the standard deviation of the return of the tangency portfolio.
B)covariance of the future cash flow with the return of the tangency portfolio,multiplied by the standard deviation of the return of the tangency portfolio.
C)covariance of the future cash flow with the return of the tangency portfolio,divided by the variance of the return of the tangency portfolio.
D)covariance of the future cash flow with the return of the tangency portfolio,multiplied by the variance of the return of the tangency portfolio.

Question 16

The certainty equivalent of an uncertain future cash flow is obtained by:

A)adding the tangency portfolio risk premium to the expected cash flow.
B)subtracting the tangency portfolio risk premium from the expected cash flow.
C)adding the product of the cash flow beta and the tangency portfolio risk premium to the expected cash flow.
D)subtracting the product of the cash flow beta and the tangency portfolio risk premium from the expected cash flow.

Question 17

Tracking error is the:

A)difference between the cash flows of the tracking portfolio and the cash flows of the project.
B)difference between the cash flows of the tracking portfolio and the initial investment of the project.
C)sum of the cash flows of the tracking portfolio multiplied by the difference in the risk-free rate and the discounting rate.
D)difference between the NPV of the tracking portfolio and the initial investment of the project.