Chapter 9.pdf

Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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% D. None of the above

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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

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Chapter 09 - Risk and the Cost of Capital

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 riskfree 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

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Chapter 09 - Risk and the Cost of Capital

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).

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Chapter 09 - Risk and the Cost of Capital

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.

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Chapter 09 - Risk and the Cost of Capital

66. Why do firms with large cash flow betas also have high asset betas?

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Chapter 09 - Risk and the Cost of Capital

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

Type: Easy

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Chapter 09 - Risk and the Cost of Capital

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

Type: Difficult

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Chapter 09 - Risk and the Cost of Capital

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

Type: Easy

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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%

Type: Difficult

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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%

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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

Type: Difficult

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Chapter 09 - Risk and the Cost of Capital

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%

Type: Easy

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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

Type: Easy

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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

Type: Easy

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Chapter 09 - Risk and the Cost of Capital

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 riskfree interest rate. TRUE

Type: Medium

56. The relative accuracy of a beta estimate for risk can be determined by the standard error. TRUE

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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 lowrisk projects and accept high-risk projects. In reality low - risk projects should be discounted at a lower rate and high-risk projects at a higher discount rate to account for differing risks.

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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.

Type: Medium

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Chapter 09 - Risk and the Cost of Capital

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.

Type: Medium

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