Multiple-Choice
1) Which of the following statements is CORRECT?
A. Beta of a portfolio of stocks is always smaller than betas of any of the individual stocks.
B. If you found a stock with the zero historical beta and held it as the only stock in your portfolio, you will by definition have a riskless portfolio.
C. The beta coefficient of a stock is usually found by regressing past returns on a stock against past market returns. One can also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. Though, this historical beta may differ from the beta which exists in the future.
D. The beta of a portfolio of stocks is always larger than betas of any of the individual stocks.
E. It is theoretically possible for the stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return will be equal to the risk-free (default-free) rate of return, rRF.
2) Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements should be true, assuming the CAPM is correct.
A. Stock A will be a more desirable addition to a portfolio then Stock B.
B. In equilibrium, the expected return on Stock B would be greater than that on Stock A.
C. When held in isolation, Stock A has more risk than Stock B.
D. Stock B will be a more desirable addition to a portfolio than A.
E. In equilibrium, the expected return on Stock A would be greater than that on B.
3) Which of the following statements is CORRECT?
A. An investor could eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.
B. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
C. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
D. Once a portfolio has about 40 stocks, adding additional stocks would not reduce its risk by even a small amount.
E. An investor could remove virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.
4) Inflation, recession, and high interest rates are economic events which are best characterized as being
A. Systematic risk factors which could be diversified away.
B. Company-specific risk factors which can be diversified away.
C. Among the factors which are responsible for market risk.
D. Risks which are beyond the control of investors and therefore must not be considered by security analysts or portfolio managers.
E. Irrelevant except to governmental authorities like the Federal Reserve.
5) Which of the following statements is CORRECT?
A. A two-stock portfolio would always have a lower standard deviation than a one-stock portfolio.
B. A portfolio which consists of 40 stocks which are not highly correlated with "the market" would probably be less risky than a portfolio of 40 stocks which are highly correlated with the market, supposing the stocks all have same standard deviations.
C. A two-stock portfolio would always have a lower beta than a one-stock portfolio.
D. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio would always have a lower beta than a one-stock portfolio.
E. A stock with the above-average standard deviation should also have an above-average beta.
6) Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?
A. Your portfolio has a standard deviation of 30%, and its expected return is 15%.
B. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
C. Your portfolio has a beta equal to 1.6, and its expected return is 15%.
D. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
E. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.
7) Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?
A. Portfolio P has a beta that is greater than 1.2.
B. Portfolio P has a standard deviation that is greater than 25%.
C. Portfolio P has an expected return that is less than 12%.
D. Portfolio P has a standard deviation that is less than 25%.
E. Portfolio P has a beta that is less than 1.2.
8) Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
A. Stock B's required return is double that of Stock A's.
B. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
C. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
D. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
E. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.
9) In a year in which common stocks offered an average return of 18%, Treasury bonds offered 10% and Treasury bills offered 7%, the risk premium for common stocks was:
A. 1%
B. 3%
C. 8%
D. 11%
10) What is the approximate standard deviation of returns if over the past four years an investment returned 8.0%, -12.0%, -12% and 15.0%?
A. 9.26%
B. 10.26%
C. 11.26%
D. 12.01%
11) What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks?
A. Individual stock's standard deviation will be lower.
B. Individual stock's standard deviation will be higher.
C. The standard deviations should be equal.
D. There is no way to predict this relationship.
12) What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase by 16% in normal times, and will increase by 23% during boom times if each scenario has equal likelihood?
A. 8.67%
B. 13.00%
C. 13.43%
D. 17.33%
13) Which of the following risk types can be diversified by adding stocks to a portfolio?
A. Systematic risk
B. Unique risk
C. Default risk
D. Market risk
14) A stock's beta measures the:
A. Average return on the stock.
B. Variability in the stock's returns compared to that of the market portfolio.
C. Difference between the return on the stock and return on the market portfolio.
D. Market risk premium on the stock.
15) When the overall market is up by 10%, an investor with a portfolio of defensive stocks will probably have:
A. Negative portfolio returns less than 10%.
B. Negative portfolio returns greater than 10%.
C. Positive portfolio returns less than 10%.
D. Positive portfolio returns greater than 10%.
16) If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2% then its beta:
A. Equals 1.04.
B. Equals 1.24.
C. Equals 1.33.
D. Equals 1.40.
17) What is the beta of a three-stock portfolio including 25% of Stock A with a beta of .90, 40% Stock B with a beta of 1.05, and 35% Stock C with a beta of 1.73?
A. 1.05
B. 1.17
C. 1.22
D. 1.25
18) What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a stock with a beta of 1.4 is expected to yield 18%?
A. 8.6%
B. 10.8%
C. 12.0%
D. 14.6%
19) Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?
A. If the WACC is 10%, both projects will have positive NPVs.
B. If the WACC is 6%, Project S will have the higher NPV.
C. If the WACC is 13%, Project S will have the lower NPV.
D. If the WACC is 10%, both projects will have a negative NPV.
E. Project S’s NPV is more sensitive to changes in WACC than Project L's.
20) Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?
A. If the WACC is 13%, Project A’s NPV will be higher than Project B’s.
B. If the WACC is 9%, Project A’s NPV will be higher than Project B’s.
C. If the WACC is 6%, Project B’s NPV will be higher than Project A’s.
D. If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s.
E. If the WACC is 9%, Project B’s NPV will be higher than Project A’s.
21) An investment today of $25,000 promises to return $10,000 annually for the next three years. What is the approximate real rate of return on this investment if inflation averages 6% annually during the period?
A. 3.5%
B. 9.7%
C. 14.0%
D. 20.0%
22) Anderson Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's expected NPV is negative, it should be rejected.
WACC: 9.00%
Year 0 1 2 3
Cash flows -$1,000 $500 $500 $500
A. $265.65
B. $278.93
C. $292.88
D. $307.52
E. $322.90
23) Warr Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC or negative, in both cases it will be rejected.
Year 0 1 2 3 4
Cash flows -$1,050 $400 $400 $400 $400
A. 14.05%
B. 15.61%
C. 17.34%
D. 19.27%
E. 21.20%
24) Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback?
Year 0 1 2 3
Cash flows -$1,150 $500 $500 $500
A. 1.86 years
B. 2.07 years
C. 2.30 years
D. 2.53 years
E. 2.78 years
25) Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's expected NPV can be negative, in which case it will be rejected.
WACC: 12.00%
Year 0 1 2 3 4 5
Cash flows -$1,100 $400 $390 $380 $370 $360
A. $250.15
B. $277.94
C. $305.73
D. $336.31
E. $369.94
26) Simkins Renovations Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's IRR can be less than the WACC (and even negative), in which case it will be rejected.
Year 0 1 2 3 4
Cash flows -$850 $300 $290 $280 $270
A. 13.13%
B. 14.44%
C. 15.89%
D. 17.48%
E. 19.22%
27) Lasik Vision Inc. recently analyzed the project whose cash flows are shown below. However, before Lasik decided to accept or reject the project, the Federal Reserve changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's expected NPV can be negative, in which case it should be rejected.
Old WACC: 8.00% New WACC: 11.25%
Year 0 1 2 3
Cash flows -$1,000 $410 $410 $410
A. -$59.03
B. -$56.08
C. -$53.27
D. -$50.61
E. -$48.08
28) Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?
WACC: 10.00%
Year 0 1 2 3
Cash flows -$900 $500 $500 $500
A. 1.88 years
B. 2.09 years
C. 2.29 years
D. 2.52 years
E. 2.78 years
29) Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
A. Long-term debt.
B. Accounts payable.
C. Retained earnings.
D. Common stock.
E. Preferred stock.
30) Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
A. Increase the dividend payout ratio for the upcoming year.
B. Increase the percentage of debt in the target capital structure.
C. Increase the proposed capital budget.
D. Reduce the amount of short-term bank debt in order to increase the current ratio.
E. Reduce the percentage of debt in the target capital structure.
31) For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.
A. rs > re > rd > WACC.
B. re > rs > WACC > rd.
C. WACC > re > rs > rd.
D. rd > re > rs > WACC.
E. WACC > rd > rs > re.
32) When working with the CAPM, which of the following factors can be determined with the most precision?
A. The market risk premium (RPM).
B. The beta coefficient, bi, of a relatively safe stock.
C. The most appropriate risk-free rate, rRF.
D. The expected rate of return on the market, rM.
E. The beta coefficient of “the market,” which is the same as the beta of an average stock.
33) Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects must the firm accept?
A. A Division B project with a 13% return.
B. A Division B project with a 12% return.
C. A Division A project with an 11% return.
D. A Division A project with a 9% return.
E. A Division B project with an 11% return.
34) Daves Inc. recently hired you as the consultant to estimate the company’s WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?
A. 7.16%
B. 7.54%
C. 7.93%
D. 8.35%
E. 8.79%
35) Bo Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it will incur a flotation cost of 4.00% of the price paid by investors. Find out the company's cost of preferred stock for use in calculating the WACC?
A. 8.72%
B. 9.08%
C. 9.44%
D. 9.82%
E. 10.22%
36) Suppose that you are the consultant to Broske Inc., and you have been provided with following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from retained earnings based on the DCF approach?
A. 9.42%
B. 9.91%
C. 10.44%
D. 10.96%
E. 11.51%
37) To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
A. 4.35%
B. 4.58%
C. 4.83%
D. 5.08%
E. 5.33%
38) Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and common stock presently sells for $52.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained earnings?
A. 7.07%
B. 7.36%
C. 7.67%
D. 7.98%
E. 8.29%
Part II Essay Questions
1) Magee Inc.'s manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns would have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.)
Economic
Conditions Prob. Return
Strong 25% 32.0%
Normal 35% 10.0%
Weak 40% -16.0%
2) Suppose that you have been hired as the consultant by CGT, a major producer of chemicals and plastics, the company has long term debt $50,000,000 and shareholders’ equity $100,000,000.
The stock is presently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
i) What is the best estimate of the after-tax cost of debt?
ii) Based on the CAPM, what is the firm's cost of common stock?
iii) Which of the following is the best estimate for the weight of debt for use in computingthe firm’s WACC?
iv) What is the best estimate of the firm's WACC?