Chapter 9 Problem Set PDF

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Chapter 9 Problem Set

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

1) 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) $416.13

B) $622.04

C) $401.90

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D) $164.29

2) 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) 17 percent B) 11 percent C) 14 percent D) 20 percent

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3) Which of the following types of projects have average total risk? A) Speculative ventures B) New products C) Cost improvements D) Expansions of existing business

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4) If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur? A) The firm will reject good low-risk projects, accept poor high-risk projects, and accept poor high-risk projects. B) The firm will reject good low-risk projects and will accept poor high-risk projects. C) The firm will accept poor high-risk projects only. D) The firm will reject good low-risk projects only.

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5) 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. 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) 14.0 percent B) 10.0 percent C) 8.5 percent D) 12.0 percent

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6) The cost of capital is the same as the cost of equity for firms that are financed A) by 50 percent equity and 50 percent debt. B) entirely by debt. C) entirely by equity. D) by both debt and equity.

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7) 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) 12 percent B) 8 percent C) 16 percent D) 4 percent

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8) An example of diversifiable risk that a financial manager should ignore when analyzing a project's risk would include A) commodity price changes. B) risks of government nonapproval of the project. C) overall stock price fluctuations. D) labor costs.

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9) 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) 28.0 B) 18.7 C) 192.0 D) 128.0

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10) The cost of capital for a project depends on the A) industry cost of capital. B) use of the capital (the project). C) company's cost of capital. D) company's level of debt financing.

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11) The company cost of capital, when the firm has both debt and equity financing, is called 11) the A) return on equity (ROE). B) cost of equity. C) weighted average cost of capital (WACC). D) cost of debt. 12) Using a company's cost of capital to evaluate a project is A) always correct and correct for projects that have average risk compared to the firm's other assets. B) always incorrect. C) always correct. D) correct for projects that have average risk compared to the firm's other assets.

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13) Financial slang referring to the reduction of cash flows from a project's forecasted value to its certainty equivalent is a(n) A) speculative gain. B) deep discount. C) haircut for risk. D) arbitrage profit.

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14) The historical returns for the past four years for Stock C and the stock market portfolio 14) were 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) 10.0 percent B) 8.5 percent C) 13.0 percent D) 5.0 percent

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15) A firm's cost of equity can be estimated using the A) capital asset pricing model (CAPM) and arbitrage pricing theory (APT). B) discounted cash-flow (DCF) approach and capital asset pricing model (CAPM). C) discounted cash-flow (DCF) approach and arbitrage pricing theory (APT). D) discounted cash-flow (DCF) approach, capital asset pricing model (CAPM), and arbitrage pricing theory (APT).

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16) 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) $197.25 B) $270.02 C) $228.35 D) $300.00

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

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18) 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) 1.7–2.0 B) 1.4–1.7 C) 1.1–2.3 D) 1.4–2.0

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19) 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) 14.0 percent B) 8.1 percent C) 10.8 percent D) 9.2 percent

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20) 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 beta for Stock B. A) 1.17 B) 1.00 C) 1.13 D) 0.86

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TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 21) 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.

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22) Cyclical firms tend to have high betas.

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

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

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

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

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

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

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29) 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.

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

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ESSAY. Write your answer in the space provided or on a separate sheet of paper. 31) Briefly explain how the use of a single company cost of capital to evaluate all projects might lead to erroneous decisions. 32) Briefly discuss the certainty equivalent approach to estimating the NPV of a project. 33) Why do firms with large cash-flow betas also have high asset betas? 34) Discuss why one might use an industry beta to estimate a company's cost of capital. 35) Briefly describe the factors that determine asset betas. 36) Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM). 37) Briefly explain the difference between company cost of capital and project cost of capital. 38) Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate. 39) Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a project.

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Answer Key Testname: CHAPTER 9 PROBLEM SET

1) C 2) A 3) D 4) A 5) C 6) C 7) B 8) B 9) B 10) B 11) C 12) D 13) C 14) B 15) D 16) C 17) C 18) C 19) D 20) D 21) TRUE 22) TRUE 23) FALSE 24) FALSE 25) TRUE 26) FALSE 27) FALSE 28) TRUE 29) TRUE 30) FALSE 31) If the firm is considering projects with differing risk characteristics, the firm will reject low-risk projects and accept high-risk projects. Low-risk projects should be discounted at a lower rate and high-risk projects at a higher discount rate to account for differing risks. 32) In the certainty equivalent approach, certainty equivalent cash flows are discounted at the risk-free rate to calculate the NPV of a project. First, risky cash flows have to be converted to certainty-equivalent cash flows by using individual risk factors. One advantage of this method is that the risk adjustment is separated from the time value of money. Conceptually, this is a more sensible method than the risk-adjusted discount rate method. However, estimating certainty equivalent cash flows could be cumbersome. 33) There is a strong correlation between the risk of the assets of a firm and the risk of the firm's cash flows. As such, high cash-flow betas lead to high asset betas. 5

Answer Key Testname: CHAPTER 9 PROBLEM SET

34) Generally, an industry beta can be estimated more precisely than a company's beta. This is similar to the estimate of the beta of a portfolio being more precise than the estimate of the beta of a single stock. The estimated industry cost of capital must be suitably adjusted before using it as the company's cost of capital. For example, one must account for differences in the capital structure of the firm versus the industry. 35) Asset betas are determined by the cyclical nature of the cash flows. Generally, cyclical firms have higher betas. Operating leverage also affects the asset beta of a firm. Firms with high fixed costs tend to have higher asset betas. 36) The first step estimates the beta of the firm's common stock by regressing the returns on the stock on the market returns using historical data. The expected stock return is estimated using CAPM [E(R) = rf + (beta)(rm - rf)]. Expected return is the estimate of the firm's cost of equity. 37) If a firm is considering projects that have the same risk as the firm, then the company cost of capital is the same as the project cost of capital. However, if the firm is considering projects that have risks different from the company, then the project cost of capital is a better risk estimate than the company cost of capital. 38) Generally, the value used for the risk-free rate is the short-term U.S. Treasury bill rate. 39) The risk-adjusted discount rate approach uses the discount rate to adjust for both risk and the time value of money. The main advantage of this approach is simplicity. Risky project cash flows are discounted using risk-adjusted discount rates (higher rates) to calculate the NPV of a project.

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