Multiple Choice Questions
1. Total risk is measured by _____ and systematic risk
is measured by ____.
A. beta; alpha
B. beta; standard deviation
C. WACC; beta
D. standard deviation; beta
E. standard deviation; variance
F. None of the above.
2. When investment returns are less than perfectly
positively correlated, the resulting diversification effect means that:
A. making an investment in two or three large stocks will eliminate all of
the unsystematic risk.
B. making an investment in three companies all within the same industry
will greatly reduce the systematic risk.
C. spreading an investment across five diverse companies will not lower
the total risk.
D. spreading an investment across many diverse assets will eliminate all
of the systematic risk.
E. spreading an investment across many diverse assets will eliminate some
of the total risk.
F. None of the above.
3. Unsystematic risk:
A. can be effectively eliminated by portfolio diversification.
B. is compensated for by the risk premium.
C. is measured by beta.
D. is measured by standard deviation.
E. is related to the overall economy.
F. None of the above.
4. Which of the following are examples of
diversifiable risk?
I. An earthquake damages Oakland, California.
II. The federal government imposes an additional $1,000 fee on all business
entities.
III. Employment taxes increase nationally.
IV. Toymakers are required to improve their safety standards.
A. I and III only
B. II and IV only
C. II and III only
D. I and IV only
E. I, III, and IV only
F. None of the above.
5. Which of the following statements are correct
concerning diversifiable, or unsystematic, risks?
I. Diversifiable risks can be largely eliminated by investing in thirty
unrelated securities.
II. There is no reward for accepting diversifiable risks.
III. Diversifiable risks are generally associated with an individual firm or
industry.
IV. Beta measures diversifiable risk.
A. I and III only
B. II and IV only
C. I and IV only
D. I, II, and III only
E. I, II, III, and IV
F. None of the above.
6. Which of the following statements concerning risk
are correct?
I. Systematic risk is measured by beta.
II. The risk premium increases as unsystematic risk increases.
III. Systematic risk is the only part of total risk that should affect asset
prices and returns.
IV. Diversifiable risks are market risks you cannot avoid.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I, II, and III only
F. None of the above.
7. Which one of the following is an example of
systematic risk?
A. The Federal Reserve unexpectedly announces an increase in target
interest rates.
B. A flood washes away a firm’s warehouse.
C. A city imposes an additional one percent sales tax on all products.
D. A toymaker has to recall its top-selling toy.
E. Corn prices increase due to increased demand for alternative fuels.
F. None of the above.
8. The excess return earned by a risky asset, for
example with a beta of 1.4, over that earned by a risk-free asset is referred
to as a:
A. market risk premium.
B. risk premium.
C. systematic return.
D. total return.
E. real rate of return.
F. None of the above.
9. The dividend growth model can be used to compute
the cost of equity for a firm in which of the following situations?
I. Firms that have a 100 percent retention ratio
II. Firms that pay an unchanging dividend
III. Firms that pay a constantly increasing dividend
IV. Firms that pay an erratically growing dividend
A. I and II only
B. I and IV only
C. II and III only
D. I, II, and III only
E. I, III, and IV only
F. None of the above.
10. The cost of equity for a firm:
A. tends to remain static for firms with increasing levels of risk.
B. increases as the unsystematic risk of the firm increases.
C. ignores the firm’s risks when that cost is based on the dividend growth
model.
D. equals the risk-free rate plus the market risk premium.
E. equals the firm’s pretax weighted average cost of capital.
F. None of the above.
11. The pre-tax cost of debt:
A. is based on the current yield to maturity of the firm’s outstanding
bonds.
B. is equal to the coupon rate on the latest bonds issued by a firm.
C. is equivalent to the average current yield on all of a firm’s
outstanding bonds.
D. is based on the original yield to maturity on the latest bonds issued
by a firm.
E. has to be estimated as it cannot be directly observed in the market.
F. None of the above.
12. The after-tax cost of debt generally increases
when:
I. a firm’s bond rating increases.
II. the market-required rate of interest for the company’s bonds increases.
III. tax rates decrease.
IV. bond prices rise.
A. I and III only
B. II and III only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.
Key facts and assumptions concerning FM Foods, Inc.
at December 31, 2011, appear below.
13. Estimate FM’s after-tax cost of equity
capital.
A. 4.50%
B. 6.92%
C. 7.93%
D. 12.20%
E. 17.48%
F. None of the above.
14. Estimate FM’s after-tax cost of debt capital.
A. 2.21%
B. 4.10%
C. 4.55%
D. 6.30%
E. 7.00%
F. None of the above.
15. Estimate the appropriate weight of equity to be
used when calculating FM’s weighted average cost of capital.
A. 11.5%
B. 19.3%
C. 80.7%
D. 88.5%
E. 100.0%
F. None of the above.
16. Estimate the appropriate weight of debt to be used
when calculating FM’s weighted average cost of capital.
A. 11.5%
B. 19.3%
C. 80.7%
D. 88.5%
E. 100.0%
F. None of the above.
17. Estimate FM’s weighted-average cost of
capital.
A. 6.46%
B. 6.58%
C. 11.27%
D. 11.32%
E. 11.52%
F. None of the above.
18. FM is contemplating an average-risk investment
costing $100 million and promising an annual after-tax cash flow of $15 million
in perpetuity. Which of the following statements is/are correct?
I. FM should reject the project because the IRR is greater than the firm’s
WACC.
II. FM should accept the project because the IRR is greater than the firm’s
WACC.
III. FM should accept the project because the NPV is greater than zero.
IV. FM should reject the project because the NPV is less than zero.
A. I only
B. II only
C. IV only
D. I and IV only
E. II and III only
F. None of the above.
19. Which of the following statements are correct?
I. Using the same risk-adjusted discount rate to discount all future cash flows
adjusts for the fact that the more distant cash flows are often more risky than
cash flows occurring sooner.
II. If you can borrow all of the money you need for a project at 5%, the cost
of capital for this project is 5%.
III. The best way to obtain the cost of debt capital for a firm is to use the
coupon rates on its bonds.
IV. The cost of capital, or WACC, is not the correct discount rate to
use for all projects undertaken by a firm.
A. I and III only
B. II and IV only
C. I and II only
D. I and IV only
E. I, II, and III only
F. None of the above
20. The capital structure weights used in computing
the weighted average cost of capital:
A. are based on the book values of total debt and total equity.
B. are based on the market value of the firm’s debt and equity securities.
C. are computed using the book value of the long-term debt and the book
value of equity.
D. remain constant over time unless the firm issues new securities.
E. are restricted to the firm’s debt and common stock.
F. None of the above.
21. The discount rate assigned to an individual
project should be based on:
A. the firm’s weighted average cost of capital.
B. the actual sources of funding used for the project.
C. an average of the firm’s overall cost of capital for the past five
years.
D. the current risk level of the overall firm.
E. the risks associated with the use of the funds required by the project.
F. None of the above.
22. The weighted average cost of capital for a firm is
the:
A. discount rate which the firm should apply to all of the projects it
undertakes.
B. rate of return a firm must earn on its existing assets to maintain the
current value of its stock.
C. coupon rate the firm should expect to pay on its next bond issue.
D. minimum discount rate the firm should require on any new project.
E. rate of return shareholders should expect to earn on their investment
in this firm.
F. None of the above.
23. Blue Diamond Equipment has 80,000 bonds
outstanding that are selling at par. Bonds with similar characteristics are
yielding 6.75 percent. The company also has 750,000 shares of 7 percent
preferred stock and 2.5 million shares of common stock outstanding. The
preferred stock sells for $53 a share. The common stock has a beta of 1.34 and
sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the
return on the market is 11.2 percent. The corporate tax rate is 38 percent.
What is the firm’s weighted average cost of capital?
A. 10.39 percent
B. 10.64 percent
C. 11.18 percent
D. 11.30 percent
E. 11.56 percent
F. None of the above.
24. Honest Abe’s is a chain of furniture retail
stores. Integral Designs is a furniture maker and a supplier to Honest Abe’s.
Honest Abe’s has a beta of 1.38 as compared to Integral Designs’ beta of 1.12.
Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of
return is 3.5 percent and the market risk premium is 8 percent. What discount
rate should Honest Abe’s use if it considers a project that involves the
manufacturing of furniture?
A. 12.46 percent
B. 12.92 percent
C. 13.50 percent
D. 14.08 percent
E. 14.54 percent
F. None of the above.
Short Answer Questions
Key facts and assumptions concerning Costco Company,
at December 31, 2011, appear below.
25. Use the above information to answer the following
questions.
a. Estimate Costco’s cost of equity capital.
b. Estimate Costco’s weighted-average cost of capital.
26. Explain the difference between systematic and
unsystematic risk, and why one of these types of risks is rewarded with a risk
premium while the other type is not.
27. Suppose that your company’s weighted-average cost
of capital is 9 percent. Your company is planning to undertake a project with
an internal rate of return of 12%, but you believe that this project is not a
good investment for the firm. What logical arguments might you use to convince
your boss to forego the project despite its high rate of return? Is it possible
that making investments with expected returns higher than your company’s cost of
capital will destroy value? If so, how?
28. The standard deviation of returns on Wildcat Oil
Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is
a high-risk investment when investors hold diversified portfolios? Explain why
or why not.
29. Investments A and B both cost $100,000 and each
promises a single payoff in one year. The distribution of payoffs for each
investment appears below.
Ignoring possible differences in nondiversifiable risk, which investment would
a risk-averse investor prefer, and why?
30. What is the present value of a cash flow stream of
$10,000 per year annually for 11 years that then grows at 2 percent per year
forever? Assume the appropriate discount rate is 12 percent.
