Finance 401-Chapter 10, 11, 13 Homework #3
Suppose a firm has a target debt-equity ratio of 2.5. What is the firm's target capital structure weight for common stock?
1/3.5 = .2857
A company recently paid a dividend of $2 per share. You estimate dividend growth to be 6 percent. What do you expect next year's dividend to be?
2*(1+.06) = 2.12
A long-term corporate bond is a portfolio of high-quality corporate bonds with -year maturities.
20
Suppose a firm faces a risk-free rate of 2 percent, a beta of 1, and a market risk premium of 4 percent. What is its cost of capital if it is an all-equity firm?
6% correct answer.
Sound Systems (SS) has 200,000 shares of common stock outstanding at a market price of $37 a share. SS recently paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 4 percent. SS also has 4,500 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a 6 percent coupon and a 6.7 percent yield to maturity. If the tax rate is 34 percent, what is the weighted average cost of capital?
6.26%
From 1900 to 2010, the United States equity premium was ---- percent.
7.2%
(Accept or reject) the project if internal rate of return is greater than the cost of equity capital
Accept
--- the project if expected return above required return.
Accept
When computing WACC, you should use the:
After tax cost of debt because interest is tax deductible.
Which of the following will be true in a world with homogeneous expectations?
All investors will hold the market portfolio.
What does normal return depend upon.
All relevant information available to shareholders.
How do we measure stock's risk or expected return.
Beta
The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the for a company's stock.
Beta
The slope of the characteristic line of a firm's returns versus those of the market is the Blank______.
Beta
The average return on the stock market can be used to Blank______.
Can be used to compare with the returns on other securities.
The slope of the characteristic line is the --- on the market return, and it gives us the estimate of beta.
Coefficient on the market return.
Another name for discount rate
Cost of capital
The variance of the return on a portfolio with many securities is more dependent on the Blank______ between the individual securities than on the Blank______ of the individual securities.
Covariances, variances
What two factors determine the beta
Cyclical nature of revenues and operating leverage
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to Blank______.
Decrease
Historically, there is a(n) Blank______ relationship between risk and expected return in the financial markets.
Direct
BPJ stock is expected to earn 14.8 percent in a recession, 6.3 percent in a normal economy, and lose 4.7 percent in a booming economy. The probability of a boom is 20 percent while the probability of a normal economy is 55 percent. What is the expected rate of return on this stock?
E(r) Boom = Prob(0.20 *-0.047) = -0.0094 Normal = (0.55*0.063) = 0.03465 Recession = (0.25 * 0.148) = 0.037 Add all = 0.06225 or 6.23%
The asset beta is the beta of common stock had the firm been all ---
Equity
If a point plotted above the security market line (SML) represents a project being considered by an all-equity firm, the project's IRR must be greater than the cost of Blank______.
Equity and capital
A security has a beta of 1, the market risk premium is 8 percent, and the risk-free rate is 3 percent. What will happen to the expected return if the beta doubles?
Expected return = .03 +2*(.08). Expected return = .19 19%. The expected return will increase to 19 percent from 11 percent. E(Rm) = Rf + Risk premium
T/F. The diversification effect applies as long as there is a perfect correlation
False
U.S. treasury instruments has no danger of ---
Future default
What is efficient frontier or efficient set.
Graph that shows maximum expected return at each level of portfolio.
A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project:
Has the same level of risk as the firm's current operations.
During the period from 1926 through 2020, U.S. Treasury bills produced annual rates of return that:
Have always been positive
A world where all investors possess the same estimates of expected returns, variances, and covariances is Blank______.
Imaginary
If a firm increases its level of debt, its beta will Blank______.
Increase
Increase in a firm's leverage (increase in debt) will --- the firm's beta.
Increase
If you wish to create a portfolio of stocks, what is the required minimum number of stocks?
Invest in more than once corporation
What is the principle of diversification.
Investing in different assets will eliminate some, but not all of the risks. Systematic risk still remains.
What does the security market line depict?
It is a graphical depiction of the capital asset pricing model.
What is systematic risk.
It is a risk that pertains to a large number of assets. Examples, natural disasters, weather, interest rates.
What is a normal return.
It is the return that shareholders predict or expect.
What is WACC
It represent the marginal cost of capital and it is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems.
If a firm issues no debt, its average cost of capital will equal Blank______.
Its cost of equity
A firm with debt in its capital structure is said to be Blank_____
Levered
What is the slope of the security market line (SML)
Market risk premium Rm-Rf
The goal of a rational, wealth maximizing investor in developing a portfolio is to be maximizing the - and minimizing the ---
Maximize the expected returns, minimize standard deviation
What is WACC
Minimum return a company needs to earn to satisfy investors
The sales of cyclical firms are Blank______ sensitive to the business cycle than are the sales of non-cyclical firms.
More
The variance of the return on a portfolio with many securities is Blank______ dependent on the covariances between the individual securities than on the variances of the individual securities
More
The Ibbotson SBBI small-company stock portfolio includes the bottom 20 percent of Blank______-listed stocks.
NYSE
U.S. Treasury instruments are /have--
Never defaulted and are not expected to default at this time.
A firm's cost of debt can be Blank______.
Obtained by checking yields on publicly traded bonds. Cost of debt can be estimated easier than its cost of equity. Obtained by talking to investment bankers.
An increase in Blank______ will increase beta.
Operating and financial leverage
Firms with high fixed costs and low variable costs are generally said to have high ---
Operating leverage.
Changes in - leverage and --- leverage will affect beta.
Operating, financial
What is dividend discount model to calculate market risk premium
P0 = D1/Rs-g. D1 dividend per share for next year, Rs discount rate , g is the constant annual rate of growth.
Preferred stocks ---
Pays dividend in perpetuity and pays a constant dividend
A point above the SML line represents a project with a Blank______ NPV for an all-equity firm.
Positive
Based on the capital asset pricing model (CAPM), there is generally Blank______ relationship between beta and the expected return on a security.
Positive
Normally, the excess rate of return is Blank______.
Positive
The difference between the expected return on the market portfolio and the risk-free rate is the market risk ---
Premium
For a multi-product firm, if a project's level of risk differs from that of the overall firm, then the:
Project should be discounted using a beta commensurate with a project's risks.
Other companies that specialize only in projects similar to the project your firm is considering are called Blank______.
Pure plays
What is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7 percent, −3 percent, and 18 percent, respectively
R =? Index fund = 50,000/1000 * Expected returns = 7%. Bond = 30,000/1000 *Expected returns = -3% Stock = 20,000/1000 * Expected returns = 18%. Find the sum of all = 6.2%
What is the CAPM formula?
RS = RF + β × (RM- RF).
If the expected return of a project is below that of a financial asset of comparable risk, the firm should Blank______ the project.
Reject
The CAPM can be used to estimate the Blank______.
Required return on equity
A firm with cyclical earnings is characterized by:
Revenue patterns that vary with the business cycle.
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
Risk free rate
The excess return on a risky asset is the difference between the risky return and the Blank______ rate.
Risk-free
Formula for market risk premium
Rm - Rf
A company recently paid a dividend of $2 per share. You estimate dividend growth to be 6 percent. What do you expect next year's dividend to be?
Rs discount rate = Next year's dividend per share/Current price + g Correct answer 2.12
If the risk-free rate is 4 percent, an all-equity firm's beta is 2, and the market risk premium is 6 percent, what is the firm's cost of capital?
Rve = Rf + beta * (RM-RF). 0.04+2+.06 = .16
In the Ibbotson study, the large-company common stock portfolio is based on the Blank______.
S&P composite index
The risk-free measure for the risk-free rate should be Blank______ the risk-free rate used for the market risk premium.
Same
The rates of return in the Ibbotson SBBI yearbook are not adjusted for which of the following?
Taxes and transaction costs
What is another name of feasible set.
The best possible expected return-standard deviation pair that can be constructed from a set of assets. Also called opportunity set.
If a firm has multiple projects, each project should be discounted using Blank______.
The discount rate commensurate with the project's risk
What is expected return on a portfolio
The expected return on a portfolio is a weighted average of the expected returns on the individual securities.
The expected return ---
The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. The expected return can be calculated as the average of the returns in previous periods. The actual return can be higher or lower than the expected return.
What is expected return.
The return an individual expects to earn over the next period.
What is expected return.
The return that an individual expects to earn over the next period
Which statements are possibly true if we look at the returns of two stocks in the same industry, such as Pfizer and Merck
The returns will move in the same direction (i.e. positive) but not by the same magnitude.
What are the two components of the expected return on the market (RM)?
The risk premium, Rm-Rf
The firm's cost of equity capital is Blank______ the required rate of return to the shareholders.
The same as
How can a positive relationship between expected return on a security and its beta be justified?
because the difference between the return on the market and the risk-free rate is likely to be positive
In the Ibbotson and Sinquefield study, the large-company common stock portfolio consists of 500 companies with the largest --- Value
market
What factors affect the beta
operating leverage. financial leverage. the cyclical nature of revenues.
To estimate the dividend yield of a particular stock, we can Blank______.
use security analysts' forecasts. multiply last year's dividend by (1 + g)
Stock A is expected to return 14 percent in a normal economy and lose 21 percent in a recession. Stock B is expected to return 11 percent in a normal economy and 5 percent in a recession. The probability of the economy being normal is 75 percent with a 25 percent probability of a recession. What is the covariance of these two securities?
.00394
What is the expected return of a security with a beta of 1.2, if the risk-free rate is 4 percent and the expected return on the market is 12 percent?
.04+1.2*(.12-.04) Expected return = 13.6
Suppose a firm faces a risk-free rate of 2 percent, a beta of 1, and a market risk premium of 4 percent. What is its cost of capital if it is an all-equity firm?
0.02+1*(0.04) = 0.06
A portfolio consists of Stocks A and B and has an expected return of 11.6 percent. Stock A has an expected return of 17.8 percent while Stock B is expected to return 8.4 percent. What is the portfolio weight of Stock A?
0.116 = x*0.178 +(1-x) * 0.084 0.116 = x*0.178 +0.084 - 0.084+x 0.032 =0.094x x = 0.34 or 34%
The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock, will have a WACC of Blank______.
1* Cost of equity
Tin Roof's net cash flows for the next three years are projected at $72,000, $78,000, and $84,000, respectively. After that the cash flows are expected to increase by 3.2 percent annually. The after-tax cost of debt is 6.2 percent, and the cost of equity is 11.4 percent. What is the value of the firm if it is financed with 40 percent debt and 60 percent equity?
1,279,622.65
What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?
1.5/2.5 = 0.6
How many variance and covariance terms will be needed in order to calculate the variance of a portfolio consisting of 100 stocks?
100 variances and 9,900 covariances terms.
A portfolio has 38 percent of its funds invested in Security C and 62 percent invested in Security D. Security C has an expected return of 8.47 percent and a standard deviation of 7.12 percent. Security D has an expected return of 13.45 percent and a standard deviation of 16.22 percent. The securities have a coefficient of correlation of .89. What are the portfolio rate of return and variance values?
11.56%, .015688
Kali's Ski Resort, Inc. stock is quite cyclical. In a boom economy, the stock is expected to return 30 percent in comparison to 12 percent in a normal economy and a negative 20 percent in a recessionary period. The probability of a recession is 15 percent while there is a 30 percent chance of a boom economy. The remainder of the time, the economy will be at normal levels. What is the standard deviation of the returns?
15.83%
In the Ibbotson study, a long-term corporate bond is a portfolio of high-quality corporate bonds with a maturity of Blank______.
20 years
Which one of the following is generally thought of as risk-free security?
3-month treasury bill
RTF stock is expected to return 10.6 percent if the economy booms and only 4.2 percent if the economy goes into a recessionary period. The probability of a boom is 55 percent while the probability of a recession is 45 percent. What is the standard deviation of the returns on RTF stock
3.18%
From 1900 to 2010, the United States ranked Blank______ out of 17 countries in terms of having the highest equity risk premium.
7th
What is true about company's deduct interest paid.
A company can deduct interest paid on debt up to 30 percent of EBIT when computing taxable income.
What is characteristic line for the security
A straight line through the data points.
What is the appropriate measure of risk for individual security if an investor holds a diversified portfolio?
Beta
Estimating beta formula
Beta = covariance (Ri,Rm)/ Variance (Rm)
What is stock B's beta if the covariance between stock B and the market is 3.75, and the variance of the market is 2.5?
Beta = covariance/ variance or (covar)^2. Beta = 3.75/2.5 = 1.5
What do we know about the stability of a firm's beta?
Betas are more likely to be stable if the firm remains in the same industry. Betas can change over time.
When computing the weighted average cost of capital, which of these are adjusted for taxes?
Cost of debt
Bond has --- risk
Default
U.S. Treasury securities are considered to be risk-free because they have minimal, if any, Blank______ risk.
Default
The Blank______ effect applies as long as there is less than perfect correlation.
Diversification
The ---- discount model for a stock can be generalized to the market as a whole.
Dividend
How do we calculate historical data approach to calculate market risk premium
Estimate the market risk premium using historical average difference between the return on the market portfolio and a risk free security.
What is the expected return for security if the risk-free rate is 5 percent, the expected return on the market is 9 percent, and the security's beta is 1.5?
Expected return = Risk free rate + Beta *(Market rate -Risk free rate) 0.05+1.5*(0.09-0.05) = .11 or 11%. Also known as Capital Asset Pricing Model
True or false: If a firm stays in the same industry, its beta will never change.
False
The range of risk-return combinations possible with a portfolio of securities is captured by the opportunity set, which is also known as the Blank______ set
Feasible
--- cost do not change as the quantity sold change, while --- costs do change as the quantity sold changes.
Fixed, variable
-cost do not change as the quantity sold changes, while --- costs do change as the quantity sold changes.
Fixed, variable
Companies will generally have a ---
High beta if their sales are highly dependent on the market cycle.
What is homogenous expectations.
Idea that all individuals have the same beliefs concerning future expected returns, variances, and covariances.
The expected return on the market will increase if the risk-free rate Blank______ or if the market risk premium Blank______.
Increase, increase
The linear relation between an asset's expected return and its beta coefficient defines the:
Security market line
The correct discount rate on a project Blank______ the expected return on a financial asset of comparable risk.
Should be
An industry is likely to have a low beta if the:
Stream of revenues within that industry is less volatile than the market.
Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
Systematic
Which one of the following types of risk is not reduced by diversification?
Systematic or market risk.
Beta measures ---
Systematic risk of security
The Ibbotson SBBI data shows that ---
T-bills had the lowest risk or variability, and long-term government bonds had less risk or variability than stocks.
A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?
Target D/E = 0.5/0.5 = 1
When valuing a firm with the weighted average cost of capital, the Blank______ value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon.
Terminal
Why is the determination of the efficient set for 50 securities more complex than the determination of the efficient set for two securities?
The number of variance, return, and correlation calculations increases dramatically.
Which of the following are true about optimal portfolios?
They offer the highest return for a given level of risk. They offer the lowest risk for a given level of return. They provide the best risk-return trade-off.
Why are the deviations of returns squared when computing variance?
This ensure that the sum of the deviation is a positive number.
Standard deviation measure --- risk, while beta measures --- risk.
Total , systematic.
Standard deviation measures _____ risk while beta measures ____ risk.
Total, systematic
True or false. Common stocks frequently experience negative returns.
True
T/f. T-bills sometimes outperforms common stocks.
True.
What is true about tax law.
Under U.S. tax law, a corporation's interest payments up to 30 percent of EBIT are tax-deductible.
--- risk is reduced as more securities are added to the portfolio.
Unique, idiosyncratic, unsystematic.
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
Unsystematic risk will decrease and eventually be almost totally eliminated.
The SML will be Blank______ if the expected return on the market is higher than the risk-free rate.
Upward sloping.
The beta of the portfolio is a Blank______ average of the betas of the individual items in the portfolio.
Weighted
A stock with an actual return that lies above the security market line has:
Yielded a higher return than expected for the level of risk assumed.
Which of the following are reasons why an investor cannot attain a portfolio above the feasible or opportunity set?
an investor cannot decrease the standard deviation of individual securities. an investor cannot increase the return on individual securities. An investor cannot decrease the correlation between the two securities
A firm should only undertake a project if its expected return is Blank______ that of a financial asset of comparable risk.
equal to or greater than
Investors cannot attain a portfolio below the feasible set or opportunity set because they cannot Blank______.
increase the standard deviation of the securities. increase the correlation between two securities. lower the return on individual securities
In the context of a portfolio of two securities, the opportunity set Blank______.
shows the range of risk-return combinations, based on various weights for the two securities
The Ibbotson SBBI data shows that over the long-term, Blank______.
small-company stocks generated the highest average return T-bills, which had the lowest risk, generated the lowest return. small-company stocks had the highest risk level
Using the Ibbotson SBBI yearbook, year-by-year real returns can be calculated by Blank______.
subtracting the annual inflation rate from the annual historical rate of return
What does WACC stand for?
weighted average cost of capital
Cost of capital for projects. What is comparable method or twins' method to estimate a project-specific discount rate?
1) Find one or more comparable firms that specialize in projects. Otherwise use firms in the same industry 2). Calculate the equity beta of each firm.
The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.
1)Calculate the expected return. 2) Calculate the deviation of each return from the expected return. 3) Square each deviation. 4)Calculate the average squared deviation.
The Ibbotson SBBI small-company stock portfolio includes the bottom Blank______ of NYSE-listed stocks.
20%
Peter's Audio has a yield to maturity on its debt of 7.8 percent, a cost of equity of 12.4 percent, and a cost of preferred stock of 8 percent. The firm has 105,000 shares of common stock outstanding at a market price of $22 a share. There are 25,000 shares of preferred stock outstanding at a market price of $45 a share. The bond issue has a total face value of $1.5 million and sells at 98 percent of face value. If the tax rate is 34 percent, what is the weighted average cost of capital?
9.22%
What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks.
=(10+15)/2 = 12.5%
For a diversified investor, what is the best way to measure the systematic risk of an individual security?
Beta = Cov/sigma square
Stock A has an expected return of 12 percent and a variance of .0203. The market has an expected return of 11 percent and a variance of .0093. What is the beta of Stock A if the covariance of Stock A with the market is .0137.
Beta = Covar Stock /Market Var
If a firm has $15 million of debt with a debt beta of 0.2 and $40 million of equity with equity beta of 2.2, then the firm's asset beta is Blank______.
Beta Asset = Beta equity * S/B+S. 2.2*15/15+40 2.2*15/55 = 0.65 +1 = 1.65
If a firm has $10 million of debt with a debt beta of 0.4 and $30 million of equity with equity beta of 2, then the firm's asset beta is Blank______.
Beta Asset = S/B+S * Beta Equity. 1.6
You would like to combine a risky stock with a beta of 1.87 with U.S. Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market. What percentage of the portfolio should be invested in the risky stock?
Beta Treasury bill = 0 Beta Market = 1 1= (wt*beta)+ (1-wt)*beta of treasury bill 1= (x*1.87) +(1-1.187)*0 1=1.87*x X = 1/1.87 = 53.48%
The Blank______ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk.
Beta and slope
The amount of systematic risk present in a particular risky asset, relative to the systematic risk present in an average risky asset, is called the particular asset's:
Beta coefficient
What variables are required when using CAPM to compute the cost of equity capital.
Beta, market risk premium, risk free rate
For both academics and practitioners, the pendulum has swung over to the Blank______ for estimating the cost of equity capital.
CAPM
The --- can be used to estimate the required return on equity.
CAPM
What we can use to estimate the required return.
CAPM model Return on stock = Rf +Beta*(Rm -Rf)
What can we say about the dividends paid to common and preferred stockholders?
Dividends to preferred stockholders are fixed. Dividends to common stockholders are not fixed.
A cyclical firm is one in which revenues go Blank______ in the contraction phase of the business cycle.
Down
What is the expected return of a security with a beta of 1.2, if the risk-free rate is 4 percent and the expected return on the market is 12 percent?
Expected return = Rf + Beta*(Rm-Rf). Expected return = .04+1.2(.12-.04). Expected return = .136
True or false: Projects should always be discounted at the firm's overall cost of capital.
False
True or false: Systematic risk will impact all securities in every portfolio equally.
False
True or false: The average return on the stock market can be used to find ways to beat the market.
False
An increase in a firm' s level of debt is an example of Blank______.
Financial leverage
The beta of a firm is more likely to be high under which two conditions?
High cyclical business activity and high operating leverage.
A firm with high operating leverage has ---
High fixed cost in its production process.
The return per unit of risk of the optimal portfolio will be Blank______ compared to that of any other portfolio.
Higher
The ---- period rate of return is the rate of return over some arbitrary investment period.
Holding
When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a Blank______ must be used, and a terminal firm value must be determined.
Horizon
Hu's has 25,000 shares of common stock outstanding with a beta of 1.4, a market price of $32 a share, and a dividend yield of 5.7 percent. Dividends increase by 4.2 percent annually. The firm also has $450,000 of debt outstanding that is selling at 102 percent of par that has a yield to maturity of 6.8 percent. The tax rate is 35 percent. The firm is considering a project that has the same risk level as the firm's current operations, an initial cost of $328,000 and cash inflows of $52,500, $155,000, and $225,000 for Years 1 to 3, respectively. What is the NPV of the project?
NPV = 32,882.62
Based on the period from 1926 through 2020, _____ have tended to outperform other securities over the long-term.
Small-company stocks.
Which of the following statements are true about the expected return?
The actual return can be higher or lower than the expected return. The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. The expected return can be calculated as the average of the returns in previous periods.
True or false: According to CAPM, if the historical market risk premium is negative, we cannot justify a positive relationship between a security's expected return and its beta.
True
True or false: The correct discount rate on a project should be the expected return on a financial asset of comparable risk.
True
True or false: The dividend discount model for a stock can be generalized to the market as a whole.
True
True or false: The rate of return required by shareholders is the same as the firm's cost of equity capital.
True
The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its Blank______.
Value
What is true about fixed cost and variable cost.
Variable costs change with changes in quantity. Fixed costs do not change as quantity changes.
The Blank______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.
WACC
The expected return on a portfolio is best described as ____ average of the expected returns on the individual securities held in the portfolio.
Weighted
What is formula for WACC
Wt*Market value *cost of capital (after taxes, 1-Tax rate) = WACC
Which of the following variables do we need to compute the beta for a company's stock?
the variance of the market index's returns. the covariance between the stock and the market index's returns.