Test Bank Answers Chapter.9 Risk And The Cost Of Capital

Principles of Corporate Finance, 13e (Brealey)

Chapter 9 Risk and the Cost of Capital

1) 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.

2) 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.

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.

4) 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

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

6) 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

7) 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

8) 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

9) 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

10) 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

11) 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

12) 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

13) 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.

14) 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).

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

A) WACC = (rD) (D/V) + (rE) (E/V), where V = D + E.

B) WACC = (rD) (1 − TC) (D/V) + (rE) (1 − TC) (E/V), where V = D + E.

C) WACC = (rD) (D/E) + (rE) (E/D).

D) WACC = (rD) (1 − TC) (D/V) + (rE) (E/V), where V = D + E.

16) 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

17) 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

18) 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

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.

20) 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

21) 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

22) 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

23) 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.

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

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 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

26) 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

27) 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

28) 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

29) 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.

30) 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

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

32) 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

33) 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

34) 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.

35) 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

36) 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

37) 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

38) 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

39) 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.

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.

41) 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.

42) 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

43) 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.

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

45) 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.

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

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

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

49) 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.

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

51) Cyclical firms tend to have high betas.

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

53) Firms with cyclical revenues tend to have lower asset betas.

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

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

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

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

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

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

60) 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.

61) 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.

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

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

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

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

66) 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.

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

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

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

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

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

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

73) Briefly describe the factors that determine asset betas.

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

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

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