FINA 307 - Final Exam Study Set

What nominal return was received by an investor when inflation averaged 3.46% and the real rate of return was 2.5%? 0.96% 5.96% 6.05% 5.47%

(1+Normal Rate)=(1+Real Rate)(1+Inflation rate) (1+Normal Rate)=(1+0.025)(1+0.0346) Normal rate =6.05%

The following table shows betas for several companies. Calculate each stock's expected rate of return using the CAPM. Assume the risk-free rate of interest is 6%. Use a 8% risk premium for the market portfolio. Company..............................Beta...............Cost of Capital Caterpillar.............................1.75........................? Apple......................................1.39........................? Johnson & Johnson...........0.58.......................? Consolidated Edison.......0.30......................?

.06 + 1.75 x 0.08 = 20% .06 + 1.39 x 0.08 = 17.12% .06 + 0.58 x 0.08 = 10.64% .06 + 0.30 x 0.08 = 8.4%

What is the beta of a U.S. Treasury bill? 1.0 −1.0 0 Unknown

0

In a year in which common stocks offered an average return of 12% and Treasury bills offered 3%. The risk premium for common stocks was: 1%. 3%. 12%. 9%.

12%-3% = 9%

Pangbourne Whitchurch has preferred stock outstanding. The stock pays a dividend of $9 per share, and sells for $60. The corporate tax rate is 21%. What is the percentage cost of the preferred stock?

9/60 = 15%

What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? 1.0 1.17 1.22 1.25

= (0.25 × 0.9) + (0.4 × 1.05) + (0.35 × 1.73) = 1.25

Binomial Tree Farm's financing includes $6.40 million of bank loans and $7.40 million book (face) value of 10-year bonds, which are selling at 90% of par value. Its common equity is shown in Binomial's Annual Report at $8.07. It has 640,000 shares of common stock outstanding which trade on the Wichita Stock Exchange at $29 per share. What debt ratio should Binomial use to calculate its WACC?

= (Bank loans + par value x face val) / (Bank loans + par value x face val + shares x per share) = (6.40 mill + 90% x 7.40 mill) / (6.40 mill + 90% x 7.40 mill + 640,000 shares x $29) = $ 13.06 million / $ 31.62 million = 0.41 Approximately

What is the percentage return on a stock that was purchased for $48.40, paid a $1.67 dividend, and was then sold after one year for $46.20? −2.50% −1.10% 0.23% −0.33%

=(46.20-48.40+1.67)/48.40 =-1.10% R = ($46.20 + 1.67 − 48.40) / $48.40 = −0.0110, or −1.10% % return = (capital gain + dividend)/initial share price

Suppose that the S&P 500, with a beta of 1.0, has an expected return of 11% and T-bills provide a risk-free return of 4%. a. What would be the expected return and beta of portfolios constructed from these two assets with weights in the S&P 500 of (i) 0; (ii) 0.25; (iii) 0.50; (iv) 0.75; (v) 1.0? b. How does expected return vary with beta?

CH 11&12 part 2 #5

Volatility is likely to be highest in which of the following investments? Common stocks Preferred stock Corporate bonds Treasury bonds

Common stocks

Which one of the following security classes has the highest standard deviation of returns? Common stocks Long-term Treasury bonds Treasury bills Corporate bonds

Common stocks

The total book value of WTC's equity is $7 million, and book value per share is $14. The stock has a market-to-book ratio of 1.5, and the cost of equity is 12%. The firm's bonds have a face value of $4 million and sell at a price of 110% of face value. The yield to maturity on the bonds is 9%, and the firm's tax rate is 21%. What is the company's WACC?

D = 1.10 × $4m = $4.4m E = 1.5 × $7m = $10.5m V = D + E = $4.4m + $10.5m = $14.9m WACC = (D / V) × (1 − Tc)rDebt + (E / V) × rEquity = ($4.4m / $14.9m) × (1 − 0.21)(0.09) + ($10.5m / $14.9m) × 0.12 = 0.1056, or 10.56%

Which one of the following risks would be classified as a specific risk for an auto manufacturer? Interest rates Delays in launching a new model Business cycles Foreign exchange rates

Delays in launching a new model

An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year? $2.00 $2.20 $4.00 $4.40

Dividend income = Total return − Capital gains yield = 15−5=10% The dividend income percent is 10% The income will be calculated as follows: Dividend = Price x Dividend rate =40×10%=4 The dividend will be $4

What would you recommend to an investor who is considering an investment that plots below the security market line? Invest; The expected return is high relative to the risk. Don't invest; The risk is high relative to the expected return. Invest; All stocks revert to the SML over time. Don't invest; All stocks below the SML are low-growth stocks.

Don't invest; The risk is high relative to the expected return.

A mutual fund manager expects her portfolio to earn a rate of return of 10% this year. The beta of her portfolio is 0.5. The rate of return available on risk-free assets is 3% and you expect the rate of return on the market portfolio to be 13%. What expected rate of return would you demand before you would be willing to invest in this mutual fund? Is this fund attractive to you?

E(R) = Rf + beta x (Rm - Rf) E(R) = 0.03+ 0.5 x (0.13- 0.03)= 0.08 = 8.00% b. Yes. As the fund is expected to provide return of 10% which is more than required return of 8% calculated above we should invest in this mutual fund.

Which one of the following risks is most important to a well-diversified investor in common stocks? Market risk Specific risk Unsystematic risk Diversifiable risk

Market risk

A stock with a beta of 1.2 has an expected rate of return of 14%. If the market return this year turns out to be 8 percentage points below expectations, what is your best guess as to the rate of return on the stock?

New Stock return = 14% - (8% × 1.20) = 14% - 9.60% = 4.40% New Stock return after market return this year turns out to be 8 percentage points below expectations is 4.40%.

Which one of the following guarantees is offered to common stock investors? Guarantee to receive dividends Guarantee to receive capital gains Guarantee only to receive a refund of principal No guarantees of any form

No guarantees of any form

Stock A has an expected return of 15%; stock B has an expected return of 8%. What is the expected return on a portfolio is comprised of 60% of Stock A and 40% of Stock B? 12.2% 10.8% 9.1% 14.4%

Portfolio Rate of Return (RoR) = (fraction of portfolio in 1st asset x RoR on 1st asset) + fraction of portfolio in 2nd asset x RoR on 2nd asset) (0.6x0.15)+(0.4x0.08) = 12.2%

A share of stock with a beta of 0.68 now sells for $43. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 3%, and the market risk premium is 6%. If the stock is perceived to be fairly priced today, what must be investors' expectation of the price of the stock at the end of the year?

Required Return=risk free rate+Beta*market risk premium =.03+(0.68*.06)=.0708 Required return=(D1/Current price)+Growth rate 0.0708=(2/43)+Growth rate Growth rate=0.0708-(2/43) =0.0242883721 Hence price expected=Current price*(1+Growth rate) =43*(1+0.0242883721) =$44.04

Stock A has a beta of 0.5, and investors expect it to return 6%. Stock B has a beta of 1.5, and investors expect it to return 16%. Use the CAPM to calculate the market risk premium and the expected rate of return on the market.

Some values below may show as rounded for display purposes, though unrounded numbers should be used for actual calculations. r = rf + b(rm − rf) Using the CAPM relationship, we can see that a change in beta will change the rate of return by the change in beta × market risk premium. So, solving for the market risk premium: MRP = (16% - 6%) / (1.5 - 0.5) = 10% Given the market risk premium, we can now solve for the risk-free rate using Stock A (It doesn't matter which stock you use.):0.05 = rf + 0.5(0.10) rf = 0.01, or 1% We know the beta of the market is 1, so the market rate of return is: Market return = 1% + 1(10%) = 11%

Why should stock market investors ignore specific risks when calculating required rates of return? There is no method for quantifying specific risks. Specific can be diversified away. Specific risks are compensated by the risk-free rate. Beta includes a component to compensate for specific risk.

Specific can be diversified away.

What is the standard deviation of a portfolio's returns if the mean return is 15%, and the variance of returns is 184? 7.83% 13.56% 41.00% 225.00%

Square root of 184 = 13.56%

Why is debt financing said to include a tax shield for the company? Taxes are reduced by the amount of the debt. Taxes are reduced by the amount of the interest. Taxable income is reduced by the amount of the debt. Taxable income is reduced by the amount of the interest.

Taxable income is reduced by the amount of the interest.

What is the typical relationship between the standard deviation of an individual common stock and the standard deviation of a diversified portfolio of common stocks? The individual stock's standard deviation will be lower. The individual stock's standard deviation will be higher. The standard deviations should be equal. There is no relationship.

The individual stock's standard deviation will be higher.

Which one of the following statements is incorrect? The equity component of WACC reflects the return expected by the company's shareholders. Market values should be used in calculating WACC. Preferred equity is a separate component of WACC. There is a tax shield on the equity dividends paid.

There is a tax shield on the equity dividends paid.

Which combination of companies is likely to provide the best diversification benefit? Ford, Toyota, Nissan, GM Facebook, Twitter, Google, Amazon Tyson, Sony, Apple, Delta Walmart, Target, Home Depot, Lowes

Tyson, Sony, Apple, Delta

Which one of these is the safest investment? Corporate bonds Common stock U.S. Treasury bills Preferred stock

U.S. Treasury bills

What decision should be made on a project with above-average market risk? Accept if the cash flows discounted at the WACC have a positive NPV. Discount the cash flows at the IRR and accept if NPV is positive. Accept if the IRR is greater than the WACC. Use a higher discount rate than the WACC to reflect the project's risk and accept if NPV is positive at this higher discount rate.

Use a higher discount rate than the WACC to reflect the project's risk and accept if NPV is positive at this higher discount rate.

If the expected rate of return on the market portfolio is 14% and T-bills yield 5%, what must be the beta of a stock that investors expect to return 10%?

Using CAPM, Expected Return, E(R) = Rf + beta x (Rm - Rf) Here, Rf - Risk free rate = 5%, Rm - Market Return = 14%, E(R) = 10% 10% = 5% + beta x (14% - 5%) beta = 0.5556

Reactive Power Generation has the following capital structure. Its corporate tax rate is 21%. Security.......................Market Value..........Required Rate of Return Debt...............................20 million..................2% Preferred Stock........30 million..................4% Common Stock.........50 million..................8% What is its WACC?

WACC = (D / V) × Rd × (1 − Tc) + (P / V) × Rp + (E / V) × Re = ($20m / $100m) × (0.02)(1 − 0.21) + ($50m / $100m) × 0.08 + ($30m / $100m) × 0.04 =$0.0552, or 5.52%

In practice, the market portfolio is often represented by: a portfolio of U.S. Treasury securities. a diversified stock market index. an investor's mutual fund portfolio. the historic record of stock market returns.

a diversified stock market index.

A project under consideration has an internal rate of return of 15% and a beta of 0.8. The risk-free rate is 5%, and the expected rate of return on the market portfolio is 15%. a. What is the required rate of return on the project? b. Should the project be accepted? c. What is the required rate of return on the project if its beta is 1.80? d. If project's beta is 1.80, should the project be accepted?

a. Required return =rf+ β (rm−rf) = 5% + [0.8 × (15% − 5%)] = 13% b. With an IRR of 15%, the project should be accepted. c. 5% + [1.8 × (15% − 5%)] = 23% d. Required rate of return is greater than the project IRR. You should now reject the project.

Universal Foods has a debt-to-value ratio of 41%, its debt is currently selling on a yield of 7%, and its cost of equity is 11%. The corporate tax rate is 40%. The company is now evaluating a new venture into home computer systems. The internal rate of return on this venture is estimated at 13.4%. WACCs of firms in the personal computer industry tend to average around 14%. a. What is Universal's WACC? b. Will Universal make the correct decision if it discounts cash flows on the proposed venture at the firm's WACC? c. Should the new project be pursued?

a. WACC = (D / V) × (1 - Tc)rDebt + (E / V) × rEquity = 0.41 × (1 - 0.40)(0.07) + (1 - 0.41) × 0.11 =0.0821, or 8.21% b. No. The IRR is above the company WACC, so the project appears attractive. In fact, the project is not attractive since the proper discount rate is 14%. c. No. Since the IRR is below the required discount rate of 14%, it produces a negative NPV.

The common stock of Buildwell Conservation & Construction Inc. (BCCI) has a beta of 0.9. The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. BCCI's capital structure is 22% debt, paying an interest rate of 5%, and 78% equity. The debt sells at par. Buildwell pays tax at 21%. a. What is BCCI's cost of equity capital? b.What is its WACC? c. If BCCI is presented with a normal project with an internal rate of return of 12%, should it accept the project if it has the same level of risk as the current firm?

a. rEquity=rf + β(rm - rf) =0.04 + 0.9(0.08) =0.112, or 11.2% b. WACC=(D / V) × Rd(1 - Tc) + (E / V) × rE = 0.22 × .05(1 - 0.21) + 0.78 × 0.112 = 0.0961, or 9.61% c. The internal rate of return, which is 12%, exceeds the cost of capital. Therefore, BCCI should accept the project.

The Costaguanan stock market provided a rate of return of 97%. The inflation rate in Costaguana during the year was 82%. In Ruritania, in contrast, the stock market return was only 14%, but the inflation rate was only 3%. a. Calculate the real rate of return for both the Costaguana and the Ruritania stock markets. b. Which country's stock market provided the higher real rate of return?

a. (1 + Nominal rate) = (1 + Real rate) * (1 + Inflation) For Costaguanan Stock, (1 + 97%) = (1 + Real rate) * (1 + 82%) (1 + Real Rate) = 1.0824 Real Rate = 0.0824 = 8.24% For Ruritania Stock, (1 + 14%) = (1 + Real rate) * (1 + 3%) (1 + Real Rate) = 1.1068 Real Rate = 0.1068 = 10.68% b. Ruritania CH 11&12 part 1 #29

We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It prospers in recessions when other firms are struggling. Consequently, its beta is negative, −0.3. a. If the interest rate on Treasury bills is 7% and the expected return on the market portfolio is 17%, what is the expected return on the shares of the law firm according to the CAPM? b. Suppose you invested 70% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio?

a. 0.07-0.03(0.17-0.07) = 4% b. 0.7(1)+0.3(-0.3) = 0.61

Top hedge fund manager Sally Buffit believes that a stock with the same market risk as the S&P 500 will sell at year-end at a price of $51. The stock will pay a dividend at year-end of $3.00. Assume that risk-free Treasury securities currently offer an interest rate of 2.1%. Average rates of return on Treasury bills, government bonds, and common stocks, 1900-2017 (figures in percent per year) are as follows. Portfolio.........Av Annual RoR..........Av Premium Treas bills.................3.8% Treas bons...............5.3%..............................1.5% Comm stocks.........11.5%..............................7.7% a. What is the discount rate on the stock? b. What price should she be willing to pay for the stock today?

a. 7.7%+2.1% = 9.8% b. (51+3)/(1+0.098) = $49.18

The Treasury bill rate is 5%, and the expected return on the market portfolio is 10%. According to the capital asset pricing model: a. What is the risk premium on the market? b. What is the required return on an investment with a beta of 1.5? c. If an investment with a beta of 0.7 offers an expected return of 8.0%, does it have a positive or negative NPV? d. If the market expects a return of 11.5% from stock X, what is its beta?

a. Market risk premium = expected return on market-rf rate Market risk premium = 10% - 5% = 5% b. CAPM = rf + β(MRP) = 5% + 1.5 × (5%) = 12.5% c. CAPM = 5% + 0.7 × (5%) = 8.50% > 8.00% As per CAPM, stock should return more (8.50%) than what is expected (8.0%), so this is a negative NPV investment. d. CAPM = rf + β(MRP) = 5% + β × (5%) = 11.5% Solving for β, we derive the stock should have a beta of 1.30.

Geothermal's WACC is 10.7%. Executive Fruit's WACC is 11.6%. Now Executive Fruit is considering an investment in geothermal power production. a. Should it discount project cash flows at 11.6%? b. What would be a better discount rate for this investment?

a. No b. 10.7%

The risk-free rate is 6% and the expected rate of return on the market portfolio is 10%. a. Calculate the required rate of return on a security with a beta of 1.24. b. If the security is expected to return 16%, is it overpriced or underpriced?

a. Required Return = Risk free Return + (Market Return - Risk free return)* Beta Required Return = 6% + (10% - 6%)*1.24 Required Return = 10.96% Expected Return = 16.00% b. It is Underpriced

A stock is selling today for $75 per share. At the end of the year, it pays a dividend of $6 per share and sells for $87. a. What is the total rate of return on the stock? b.What are the dividend yield and percentage capital gain? c. Now suppose the year-end stock price after the dividend is paid is $72. What are the dividend yield and percentage capital gain in this case?

a. total return = (end price+dividend-beginning price)/beginning price =(87+6-75)/75 = 24% b. dividend yield = dividend/beginning price =6/75 = 8% capital gain yield = (end price-beginning price)/beginning price =(87-75)/75 = 16% c. dividend yield = dividend/beginning price =6/75 = 8% capital gain yield = (end price-beginning price)/beginning price = -3/75 = -4%

If a firm earns the WACC on its assets, then: equityholders will be satisfied, but bondholders will not. bondholders will be satisfied, but equityholders will not. all investors will earn their minimum required rate of return. the firm is investing in only positive NPV projects.

all investors will earn their minimum required rate of return.

A stock with a beta greater than 1.0 would be termed: an aggressive stock, expected to increase more than the market increases. a defensive stock, expected to decrease more than the market increases. an aggressive stock, expected to decrease more than the market increases. a defensive stock, expected to increase more than the market decreases.

an aggressive stock, expected to increase more than the market increases.

Risks that are peculiar to a single firm: are called market risks cannot be diversified away are called specific risks tend to cause stocks to move together

are called specific risks

The benefits of portfolio diversification are highest when the individual securities within the portfolio have returns that: vary directly with the rest of the portfolio. vary proportionally with the rest of the portfolio. are largely uncorrelated with the rest of the portfolio. are perfectly correlated with the market portfolio.

are largely uncorrelated with the rest of the portfolio.

The variance of a stock's returns can be calculated as the: average value of deviations from the mean. average value of squared deviations from the mean. square root of the average value of deviations from the mean. sum of the deviations from the mean.

average value of squared deviations from the mean.

The slope of the line fitted to a plot of a stock's returns versus the market's returns measures the: security market line. beta of the stock. market risk premium. capital asset pricing model.

beta of the stock.

A stock's total risk depends on the stock's ________ and ________. beta; specific risk beta; market risk specific risk; firm-specific risk aggressive risk; defensive risk

beta; specific risk

The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because the market portfolio: offers lower returns. has less systematic risk. diversifies risk. has specific risk.

diversifies risk.

The average of the betas for all stocks is: greater than 1.0; most stocks are aggressive. less than 1.0; most stocks are defensive. unknown; betas are continually changing. exactly 1.0; these stocks represent the market.

exactly 1.0; these stocks represent the market.

A stock's risk premium is equal to the: expected market return times beta. Treasury bill yield plus the expected market return. risk-free rate plus the expected market risk premium. expected market risk premium times beta.

expected market risk premium times beta.

Individual stocks are: exposed to the same amount of market risk. exposed to differing amounts of market risk. not exposed to market risk; only the general economy is subject to market risk. exposed to differing amounts of market risk but the same amount of specific risk.

exposed to differing amounts of market risk.

If the slope of the line measuring a stock's returns against the market's returns is positive, then the stock: has a beta greater than 1.0. has no specific risk. has a positive beta. plots above the security market line.

has a positive beta.

If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be more profitable to invest in: high beta stocks. low beta stocks. stocks with large amounts of specific risk. stocks that plot above the security market line.

high beta stocks.

The wider the dispersion of returns on a stock, the: lower the expected rate of return. higher the standard deviation. lower the real rate of return. lower the variance.

higher the standard deviation.

A firm's WACC: is the proper discount rate for every project the firm undertakes. is used to value all of the firm's existing projects. is a benchmark discount rate that may be adjusted for the riskiness of each project. is for informational value only and should never be used as a discount rate.

is a benchmark discount rate that may be adjusted for the riskiness of each project.

If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori, we could expect this individual stock to: lose more than 10%. lose, but less than 10%. gain more than 10%. gain, but less than 10%.

lose, but less than 10%.

If a security plots below the security market line, it is: ignoring all of the security's specific risk. underpriced, a situation that should be temporary. offering too little return to justify its risk. a defensive security, which expects to offer lower returns.

offering too little return to justify its risk.

When the overall market is up by 10%, investors with portfolios of defensive stocks will probably have: negative portfolio returns less than 10%. negative portfolio returns greater than 10%. positive portfolio returns less than 10%. positive portfolio returns greater than 10%.

positive portfolio returns less than 10%.

You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecasts (in millions of dollars) for the project are as follows: Years..........Cash Flow 0......................(-100) 1-10.................(+18) On the basis of the behavior of the firm's stock, you believe that the beta of the firm is 1.31. Assuming that the rate of return available on risk-free investments is 4% and that the expected rate of return on the market portfolio is 14%, what is the net present value of the project?

r = rf + β(rm - rf) = 4% + 1.31 × (14% - 4%) = 17.10% Calculator: npv(17.1, -100, {18}, {10}) = -16.45 million dollars

Here is some information about Stokenchurch Inc.: Beta of common stock = 1.7 Treasury bill rate = 4% Market risk premium = 8.0% Yield to maturity on long-term debt = 9% Book value of equity = $490 million Market value of equity = $980 million Long-term debt outstanding = $980 million Corporate tax rate = 21% What is the company's WACC?

rEquity = rf + β(rm − rf) =0.04 + 1.7(0.080) =0.1760, or 17.60% rDebt = 0.09 WACC = (D / V) × (1 − Tc)rDebt + (E / V) × rEquity = [$980 / ($980 + 980)] × (1 − 0.21)(0.09) + [$980 / ($980 + 980)] × 0.176 =0.1236, or 12.36%

The major benefit of diversification is the: increased expected return. removal of all negative risk assets from the portfolio. reduction in the portfolio's market risk. reduction in the portfolio's total risk.

reduction in the portfolio's total risk.

A stock's beta measures the: average return on the stock. sensitivity of the stock's returns to those of the market portfolio. difference between the return on the stock and the return on the market portfolio. market risk premium on the stock.

sensitivity of the stock's returns to those of the market portfolio.

As you add more stocks to a portfolio: specific risk at first falls, then rises. market risk is increasingly diversified away. specific risk is increasingly diversified away. market risk declines but specific risk rises.

specific risk is increasingly diversified away.

Risks that affect only a single firm are called: market risks. specific risks. systematic risks. risk premiums.

specific risks.

Macro events only are reflected in the performance of the market portfolio because: the market portfolio contains only risk-free securities. only macro events are tracked by economists. the specific risks have been diversified away. the firm-specific events would be too numerous to quantify.

the specific risks have been diversified away.

The idea that investors on average have earned a higher return from common stocks than from Treasury bills supports the view that: investors are irrational. there is a relationship between risk and return. real rates of return will be lower during periods of price stability. stocks should be avoided when inflation is low.

there is a relationship between risk and return.

total return = ? dividend yield = ? capital gain yield = ?

total return = (end price + dividend - beg price)/beg price dividend yield = dividend/beginning price capital gain yield = (end price - beg price)/beg price

The variance of an investment's returns is a measure of the: volatility of the rates of return. probability of a negative return. historic return over long time periods. average value of the investment.

volatility of the rates of return.

To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's: weighted-average cost of capital. pre-tax cost of debt. after-tax cost of debt. cost of equity.

weighted-average cost of capital.

The higher the standard deviation of a stock's returns, the: lower the level of specific risk. lower the expected rate of return. higher the accuracy of predictions of the stock's return for any given year. wider the dispersion of those returns over time.

wider the dispersion of those returns over time.