Chapter 09
Risk and the Cost of Capital
Multiple Choice Questions
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. all of the above
2. Cost of capital is the same as cost of equity for firms: A. financed entirely by debt
B. financed by both debt and equity C. financed entirely by equity D. none of the above
3. The cost of capital for a project depends on: A. The company's cost of capital
B. The use to which the capital is put, i.e. the project C. The industry cost of capital
D. All of the above
4. Using the company cost of capital to evaluate a project is: I) Always correct
II) Always incorrect
III) Correct for projects that are about as risky as the average of 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 of the following is likely?
I) Rejecting good low risk projects II) Accepting poor high risk projects
III) Correctly accept projects with average risk A. I only
B. I and II only C. I, II, and III D. II only
6. If firms use the company cost of capital for evaluating all of their projects, which of the following is likely?
I) Accepting poor low risk projects. II) Rejecting good high risk projects.
III) 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 have the highest risk? A. Speculation ventures
B. New products
C. Expansion of existing business
D. Cost improvement, (known technology)
8. A firm might categorize its projects into: I) Cost improvement projects
II) Expansion projects (existing business) III) New products projects
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 type of projects has the lowest risk? A. Speculation ventures
B. New products
C. Expansion of existing business D. Cost improvement
10. Which of the following type of projects has average risk? A. Speculation ventures
B. New products
C. Expansion of existing business D. Cost improvement
11. The market value of Charter Cruise Company's equity is $15 million, and the market value of its risk-free debt is $5 million. If the required rate of return on the equity is 20% and that on the debt is 8%, calculate the company's cost of capital. (Assume no taxes.)
A. 20% B. 17% C. 14%
D. None of the above
12. The market value of Cable Company's equity is $60 million, and the market value of its risk-free debt is $40 million. If the required rate of return on the equity is 15% and that on the debt is 5%, calculate the company's cost of capital. (Assume no taxes.)
A. 15% B. 10% C. 11%
D. None of the above
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. All of the above
14. The company cost of capital when debt as well as equity is used for financing is: A. cost of debt
B. cost of equity
C. the weighted average cost of capital (WACC) D. none of the above
15. The after-tax weighted average cost of capital (WACC) is calculated using the formula: A. WACC = (rD) (D/V) + (rE) (E/V) where: V = D + E
B. WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V) where: V = D + E C. WACC = (rD) (D/E) + (rE) (E/D)
D. none of the above
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%. If the Treasury bill rate is 5%, what is the company's cost of capital? (Assume no taxes.)
A. 15% B. 14.6% C. 13%
D. None of the above
17. The market value of XYZ Corporation's common stock is 40 million and the market value of the 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%. If the Treasury bill rate is 6%, what is the firm's cost of capital? (Assume no taxes.)
A. 9.2% B. 14% C. 8.1%
D. None of the above
18. Cost of equity can be estimated using: A. Discounted cash flow (DCF) approach B. Capital Asset Pricing Model (CAPM) C. Arbitrage Pricing theory (APT) D. All of the above
19. Cost of equity can be estimated using: A. The Fama-French three-factor model B. Capital Asset Pricing Model (CAPM) C. Arbitrage Pricing theory (APT) D. All of the above
20. The historical returns data for the past three years for Company A's stock is -6%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. Calculate the beta for Stock A. A. 1.75
B. 1.0 C. 0.57
D. None of the above
21. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. If the risk-free rate of return is 4%, what is the cost of equity capital (required rate of return of company A's common stock) using CAPM?
A. 18% B. 14% C. 12%
D. None of the above
22. The historical data for the past three years for the market portfolio are 10%, 10% and 16%. If the risk-free rate of return is 4%, what is the market risk premium?
A. 4% B. 8% C. 16%
23. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. According to the security market line (SML), the Stock A is:
A. Over priced B. Under priced C. Correctly priced
D. Need more information
24. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the expected return for Stock B and the market portfolio.
A. Stock B 16%, Market Portfolio: 14% B. Stock B 14%, Market Portfolio: 16% C. Stock B 24%, Market Portfolio: 12% D. None of the above
25. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the variance of the market portfolio returns.
A. 192 B. 128 C. 28
D. None of the above
26. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the covariance of returns between Stock B and the market portfolio.
A. 24 B. 28 C. 292
D. None of the above
27. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the beta for Stock B.
A. 0.86 B. 1.0 C. 0.125
D. None of the above
28. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. If the risk-free rate is 4%, calculate the market risk premium.
A. 18.1% B. 14% C. 10%
D. None of the above
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 the:
A. Alpha B. Beta C. R-squared D. Adjusted beta
30. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the required rate of return (cost of equity) for Stock B using CAPM. (The risk-free rate of return = 4%)
A. 8.6% B. 12.6% C. 14.3%
D. None of the above
31. The historical returns data for the past four years for Stock C and the stock market portfolio returns are: Stock C: 10%, 30%, 20%,20%; Market Portfolio: 5%, 15%, 25%, 15%. Calculate the beta for the stock:
A. 0.86 B. 0.5 C. 1.5
D. none of the above
32. The historical returns data for the past four years for Stock C and the stock market
portfolio returns are: Stock C: 10%, 30%, 20%, 20%; Market Portfolio: 5%, 15%, 25%, 15%. If the risk-free rate of return is 5%, calculate the required rate of return on the Stock C using CAPM.
A. 5% B. 10% C. 15%
D. none of the above
33. The beta of the computer company is 1.7 and the standard error of the estimate is 0.3. What is the range of values for beta, that has 95% chance of being right?
A. 1.1 - 2.3 B. 1.4 - 2.0 C. 1.5 - 2.0
D. None of the above
34. Generally, the value to use for the risk-free interest rate is: A. Short-term Treasury bill rate
B. Long-term Corporate bond rate C. Medium-term Corporate bond rate D. none of the above
35. A project has an expected risky cash flow of $200, in year-1. The risk-free rate is 6%, the market rate of return is 16%, and the project's beta is 1.5. Calculate the certainty equivalent cash flow for year-1.
A. $175.21 B. $164.29 C. $228.30
D. None of the above
36. A project has an expected risky cash flow of $500, in year-2. The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-2.
A. $622.04 B. $164.29 C. $401.90
D. None of the above
37. The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-3.
A. $622.04 B. $360.33 C. $401.90
D. None of the above
38. The risk-free rate is 5%, the market risk premium is 8% and the project's beta is 1.25. Calculate the certainty equivalent cash flow for
year-3. A. $228.35 B. $197.25 C. $300
D. None of the above
39. The country beta for Egypt is: A. 1.0 B. 0.14 C. 1.35 D. 0.93
40. Financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent is a
A. Deep discount B. Haircut for risk C. Arbitrage profit D. Speculative gain
41. An example of diversifiable risk that should be ignored when analyzing project risk would include
A. Commodity price changes B. Labor costs
C. Stock price fluctuations
D. Risk of government non-approval
42. A fudge factor might include: A. Commodity price changes B. Labor costs
C. Stock price fluctuations
D. Risk of government non-approval
43. What does a low standard error mean relative to beta? A. Beta is a reliable measurement of risk
B. Beta has very little meaning
C. There is tremendous benefit to be gained from diversification D. Nothing
True / False Questions
44. The company cost of capital is the correct discount rate for any project undertaken by the company.
True False
45. Each project should be evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which the capital is put.
True False
46. The weighted average cost of capital (WACC) on an after-tax basis is calculated as: WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V) where: V = D + E
True False
47. Company cost of capital is the cost of debt of the firm. True False
48. Company cost of capital is the cost of equity of the firm. True False
49. It is generally more accurate to estimate an "industry beta" for a portfolio of companies in the same industry than to estimate beta for a single company.
True False
50. Generally, the value to use for the risk-free rate is the short-term Treasury bill rate. True False
51. Cyclical firms tend to have high betas. True False
52. Firms with high operating leverage tend to have higher asset betas. True False
53. Firms with cyclical revenues tend to have lower asset betas. True False
54. Risky projects can be evaluated by discounting the expected cash flows at a risk-adjusted discount rate.
True False
55. Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.
True False
56. The relative accuracy of a beta estimate for risk can be determined by the standard error. True False
57. Portfolio betas for an industry are usually higher than the beta of individual stocks in that same industry. True False Essay Questions
58. Briefly explain the difference between company and project cost of capital.
59. Briefly explain how the use of single company cost of capital to evaluate projects might lead to erroneous decisions.
60. Discuss why one might use an industry beta to estimate a company's cost of capital.
61. Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM).
62. Briefly explain what value should be used for the risk-free interest rate.
63. Briefly describe the factors that determine asset betas.
64. Briefly discuss the certainty equivalent approach to estimating the NPV of a project.
65. Briefly discuss the risk adjusted discount rate approach to estimating the NPV of a project.
66. Why do firms with large cash flow betas also have high asset betas?
Chapter 09 Risk and the Cost of Capital
Answer Key
Multiple Choice Questions
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. all of the above
Type: Medium
2. Cost of capital is the same as cost of equity for firms:
A. financed entirely by debt
B. financed by both debt and equity
C. financed entirely by equity
D. none of the above
Type: Easy
3. The cost of capital for a project depends on:
A. The company's cost of capital
B. The use to which the capital is put, i.e. the project
C. The industry cost of capital
D. All of the above
4. Using the company cost of capital to evaluate a project is: I) Always correct
II) Always incorrect
III) Correct for projects that are about as risky as the average of the firm's other assets
A. I only
B. II only
C. III only
D. I and III only
Type: Easy
5. If a firm uses the same company cost of capital for evaluating all projects, which of the following is likely?
I) Rejecting good low risk projects II) Accepting poor high risk projects
III) Correctly accept projects with average risk
A. I only
B. I and II only
C. I, II, and III
D. II only
Type: Medium
6. If firms use the company cost of capital for evaluating all of their projects, which of the following is likely?
I) Accepting poor low risk projects. II) Rejecting good high risk projects.
III) 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 have the highest risk?
A. Speculation ventures
B. New products
C. Expansion of existing business
D. Cost improvement, (known technology)
Type: Easy
8. A firm might categorize its projects into: I) Cost improvement projects
II) Expansion projects (existing business) III) New products projects
IV) Speculative ventures
A. III only
B. I, II and III only
C. II and IV only
D. I,II,III, and IV
Type: Easy
9. Which of the following type of projects has the lowest risk?
A. Speculation ventures
B. New products
C. Expansion of existing business
D. Cost improvement
Type: Easy
10. Which of the following type of projects has average risk?
A. Speculation ventures
B. New products
C. Expansion of existing business
D. Cost improvement
11. The market value of Charter Cruise Company's equity is $15 million, and the market value of its risk-free debt is $5 million. If the required rate of return on the equity is 20% and that on the debt is 8%, calculate the company's cost of capital. (Assume no taxes.)
A. 20%
B. 17%
C. 14%
D. None of the above
Company cost of capital = (5/20)(8) + (15/20)(20) = 17%
Type: Medium
12. The market value of Cable Company's equity is $60 million, and the market value of its risk-free debt is $40 million. If the required rate of return on the equity is 15% and that on the debt is 5%, calculate the company's cost of capital. (Assume no taxes.)
A. 15%
B. 10%
C. 11%
D. None of the above
Company cost of capital = (40/100)(5) + (60/100)(15) = 11%
Type: Medium
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. All of the above
14. The company cost of capital when debt as well as equity is used for financing is:
A. cost of debt
B. cost of equity
C. the weighted average cost of capital (WACC)
D. none of the above
Type: Medium
15. The after-tax weighted average cost of capital (WACC) is calculated using the formula:
A. WACC = (rD) (D/V) + (rE) (E/V) where: V = D + E
B. WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V) where: V = D + E
C. WACC = (rD) (D/E) + (rE) (E/D)
D. none of the above
Type: Difficult
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%. If the Treasury bill rate is 5%, what is the company's cost of capital? (Assume no taxes.)
A. 15%
B. 14.6%
C. 13%
D. None of the above
rE = 5 + 1.25(8) = 15 ; rD = 5%
Company Cost of capital = 5 (5/25) + 15(20/25) = 1 + 12 = 13%
17. The market value of XYZ Corporation's common stock is 40 million and the market value of the 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%. If the Treasury bill rate is 6%, what is the firm's cost of capital? (Assume no taxes.)
A. 9.2%
B. 14%
C. 8.1%
D. None of the above
rE = 6 + 0.8(10) = 14%; rD = 5%; Cost of capital = (0.6)(6) + (0.4) (14) = 9.2%
Type: Difficult
18. Cost of equity can be estimated using:
A. Discounted cash flow (DCF) approach
B. Capital Asset Pricing Model (CAPM)
C. Arbitrage Pricing theory (APT)
D. All of the above
Type: Medium
19. Cost of equity can be estimated using:
A. The Fama-French three-factor model
B. Capital Asset Pricing Model (CAPM)
C. Arbitrage Pricing theory (APT)
D. All of the above
20. The historical returns data for the past three years for Company A's stock is -6%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. Calculate the beta for Stock A.
A. 1.75
B. 1.0
C. 0.57
D. None of the above
Beta: = Cov(RA, RM)/Var(RM) = 21/12 = 1.75
Type: Difficult
21. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. If the risk-free rate of return is 4%, what is the cost of equity capital (required rate of return of company A's common stock) using CAPM?
A. 18%
B. 14%
C. 12%
D. None of the above
rM = (10 + 10 + 16)/3 12% ; r = 4 + 1.75 (12 - 4) = 18%
Type: Medium
22. The historical data for the past three years for the market portfolio are 10%, 10% and 16%. If the risk-free rate of return is 4%, what is the market risk premium?
A. 4%
B. 8%
C. 16%
D. None of the above
rM = (10 + 10 + 16)/3 = 12%; RPM = (12 - 4)= 8%
23. The historical returns data for the past three years for Company A's stock is -6.0%, 15%, 15% and that of the market portfolio is 10%, 10% and 16%. According to the security market line (SML), the Stock A is:
A. Over priced
B. Under priced
C. Correctly priced
D. Need more information
(-6 + 15 + 15)/3 = 8%; (8% < 18%)
Type: Easy
24. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the expected return for Stock B and the market portfolio.
A. Stock B 16%, Market Portfolio: 14%
B. Stock B 14%, Market Portfolio: 16%
C. Stock B 24%, Market Portfolio: 12%
D. None of the above
RB = (24 + 0 + 24)/3 = 16%; RM = (10 + 12 + 20)/3 = 14%
Type: Medium
25. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the variance of the market portfolio returns.
A. 192
B. 128
C. 28
D. None of the above
Variance = [(10 - 14)^2 + (12 - 14)^2 + (20 - 14)^2]/2 = 28
26. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the covariance of returns between Stock B and the market portfolio.
A. 24
B. 28
C. 292
D. None of the above
Cov(RB, RM) = (24 - 16)(10 - 14) + (0 - 16)(12 - 14) + (24 - 16)(20 - 14)]/2 = 24
Type: Difficult
27. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the beta for Stock B.
A. 0.86
B. 1.0
C. 0.125
D. None of the above beta(b) = 24/28 = 0.86
[Statistical functions in a calculator may be used for this estimation]
Type: Difficult
28. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. If the risk-free rate is 4%, calculate the market risk premium.
A. 18.1%
B. 14%
C. 10%
D. None of the above
rM = (10 + 12 + 20)/3 = 8%; Market risk premium = 14 - 4 = 10%
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 the:
A. Alpha B. Beta C. R-squared D. Adjusted beta Type: Medium
30. The historical returns data for the past three years for Stock B and the stock market portfolio are: Stock B: 24%, 0%, 24%, Market Portfolios: 10%, 12%, 20%. Calculate the required rate of return (cost of equity) for Stock B using CAPM. (The risk-free rate of return = 4%)
A. 8.6%
B. 12.6%
C. 14.3%
D. None of the above
E(RB) = 4 + 0.86(14 - 4) = 12.6%
Type: Medium
31. The historical returns data for the past four years for Stock C and the stock market portfolio returns are: Stock C: 10%, 30%, 20%,20%; Market Portfolio: 5%, 15%, 25%, 15%. Calculate the beta for the stock:
A. 0.86
B. 0.5
C. 1.5
D. none of the above
32. The historical returns data for the past four years for Stock C and the stock market
portfolio returns are: Stock C: 10%, 30%, 20%, 20%; Market Portfolio: 5%, 15%, 25%, 15%. If the risk-free rate of return is 5%, calculate the required rate of return on the Stock C using CAPM.
A. 5%
B. 10%
C. 15%
D. none of the above
RM = (5 + 15 + 25 + 15)/4 = 15%; RC = 5 + (0.5)(15 - 5) = 10%
Type: Medium
33. The beta of the computer company is 1.7 and the standard error of the estimate is 0.3. What is the range of values for beta, that has 95% chance of being right?
A. 1.1 - 2.3
B. 1.4 - 2.0
C. 1.5 - 2.0
D. None of the above
Range = 1.7 +/- 2(0.3) i.e. (1.1 - 2.3)
Type: Medium
34. Generally, the value to use for the risk-free interest rate is:
A. Short-term Treasury bill rate
B. Long-term Corporate bond rate
C. Medium-term Corporate bond rate
D. none of the above
35. A project has an expected risky cash flow of $200, in year-1. The risk-free rate is 6%, the market rate of return is 16%, and the project's beta is 1.5. Calculate the certainty equivalent cash flow for year-1.
A. $175.21
B. $164.29
C. $228.30
D. None of the above
rw = 6 + 1.5(10) = 21%; CEQ = (200 * 1.06)/1.21 = 175.21
Type: Medium
36. A project has an expected risky cash flow of $500, in year-2. The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-2.
A. $622.04
B. $164.29
C. $401.90
D. None of the above
rw = 4 + 1.2(10) = 16%; CEQ = (500 * 1.04^2)/ (1.16^2) = 401.90
Type: Medium
37. The risk-free rate is 4%, the market rate of return is 14%, and the project's beta is 1.2. Calculate the certainty equivalent cash flow for year-3.
A. $622.04
B. $360.33
C. $401.90
D. None of the above
rw = 4 + 1.2(10) = 16%; CEQ = (500 * 1.04^3)/ (1.16^3) = 360.33
38. The risk-free rate is 5%, the market risk premium is 8% and the project's beta is 1.25. Calculate the certainty equivalent cash flow for
year-3.
A. $228.35
B. $197.25
C. $300
D. None of the above
rw = 5 + (1.25 * 8) = 15% CF = 300(1.05)^3/(1.15^3) = 228.35
Type: Medium
39. The country beta for Egypt is:
A. 1.0 B. 0.14 C. 1.35 D. 0.93 Type: Easy
40. Financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent is a
A. Deep discount
B. Haircut for risk
C. Arbitrage profit
D. Speculative gain
41. An example of diversifiable risk that should be ignored when analyzing project risk would include
A. Commodity price changes
B. Labor costs
C. Stock price fluctuations
D. Risk of government non-approval
Type: Difficult
42. A fudge factor might include:
A. Commodity price changes
B. Labor costs
C. Stock price fluctuations
D. Risk of government non-approval
Type: Difficult
43. What does a low standard error mean relative to beta?
A. Beta is a reliable measurement of risk
B. Beta has very little meaning
C. There is tremendous benefit to be gained from diversification
D. Nothing
Type: Difficult
True / False Questions
44. The company cost of capital is the correct discount rate for any project undertaken by the company.
FALSE
45. Each project should be evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which the capital is put.
TRUE
Type: Medium
46. The weighted average cost of capital (WACC) on an after-tax basis is calculated as: WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V) where: V = D + E
TRUE
Type: Medium
47. Company cost of capital is the cost of debt of the firm.
FALSE
Type: Medium
48. Company cost of capital is the cost of equity of the firm.
FALSE
Type: Difficult
49. It is generally more accurate to estimate an "industry beta" for a portfolio of companies in the same industry than to estimate beta for a single company.
TRUE
Type: Medium
50. Generally, the value to use for the risk-free rate is the short-term Treasury bill rate.
TRUE
51. Cyclical firms tend to have high betas.
TRUE
Type: Medium
52. Firms with high operating leverage tend to have higher asset betas.
TRUE
Type: Medium
53. Firms with cyclical revenues tend to have lower asset betas.
FALSE
Type: Medium
54. Risky projects can be evaluated by discounting the expected cash flows at a risk-adjusted discount rate.
TRUE
Type: Medium
55. Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.
TRUE
Type: Medium
56. The relative accuracy of a beta estimate for risk can be determined by the standard error.
TRUE
57. Portfolio betas for an industry are usually higher than the beta of individual stocks in that same industry. FALSE Type: Medium Essay Questions
58. Briefly explain the difference between company and project cost of capital.
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. But if the firm is considering projects which have risks different from the company then the project cost of capital becomes relevant.
Type: Medium
59. Briefly explain how the use of single company cost of capital to evaluate projects might lead to erroneous decisions.
If the firm is considering projects with differing risk characteristics, the firm will reject low-risk projects and accept high-low-risk projects. In reality low - low-risk projects should be discounted at a lower rate and high-risk projects at a higher discount rate to account for differing risks.
60. Discuss why one might use an industry beta to estimate a company's cost of capital. 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 is more precise than the estimate of the beta of a single stock. The estimated industry cost of capital must be suitably adjusted before using for company's cost of capital. For example, differences in the capital structure of the firm and the industry.
Type: Medium
61. Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model (CAPM).
The first step is to estimate the beta of the firm's common stock by regressing the returns on the stock on the market returns using historical data. 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.
Type: Medium
62. Briefly explain what value should be used for the risk-free interest rate. Generally, the value used for the risk-free rate is the short-term Treasury bill rate.
Type: Easy
63. Briefly describe the factors that determine asset betas.
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.
64. Briefly discuss the certainty equivalent approach to estimating the NPV of a project. 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. But estimating certainty equivalent cash flows could be cumbersome.
Type: Medium
65. Briefly discuss the risk adjusted discount rate approach to estimating the NPV of a project.
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.
Type: Medium
66. Why do firms with large cash flow betas also have high asset betas?
There is a strong correlation between the risk of the assets of a firm and the risk of the firm's earnings. As such high asset betas lead to high cash flow betas.
