RISK & COST OF CAPITAL
WC Inc. has a $10 million (face value), 10-year bond issue selling for 99 percent of par that pays an annual coupon of 9 percent. What would be WC's before-tax component cost of debt?
9.16%
Which of these statements is true?
When people purchase a stock, they do not know what their return is going to be—either short term or in the long run.
Which one of these is the most effective means of lowering the beta of a portfolio?
Replace the highest beta security with a risk-free asset
How is the capital gain or loss on a stock investment computed?
Ending stock value - Beginning stock value
Stock investors cannot avoid which type of risk?
Market risk
What is firm-specific risk?
Risk that affects only one firm or one industry
What is the relationship between risk and return?
The higher the risk, the higher the expected return.
The dollar return on a stock investment includes which of these?
Dividend income and capital gains or losses
What does standard deviation measure?
total risk
A firm has a capital structure of 40 percent common stock, 10 percent preferred stock, and 50 percent debt. A new project is being funded with $40,000 of debt and $30,000 of common stock. What weight should be used for equity in the project WACC?
$30,000/($30,000 + $40,000), or 43 percent
FedEx Corp. stock ended the previous year at $113.39 per share. It paid a $0.40 per share dividend last year. It ended last year at $126.69. If you owned 300 shares of FedEx, what was your dollar return and percent return?
$4,110, 12.08 percent
FedEx Corp. stock ended the previous year at $113.39 per share. It paid a $0.40 per share dividend last year. It ended last year at $126.69. If you owned 300 shares of FedEx, what was your dollar return and percent return?
$4110, 12.08% Buying price = $113.39 Selling price = $126.69 Dividend = $0.4 % Profit = (Selling price + dividend - buying price)/ buying price = ( $126.69 + $0.4 + $113.39)/ $113.39= 12.08% Dollar profit = 300 shares * ($126.69 + $0.4 + $113.39) = $4110
How is the capital gain or loss on a stock investment computed?
(Ending stock value - Beginning stock value) + Dividend income
How is the total dollar return on a stock investment calculated?
(Ending stock value - Beginning stock value) + Dividend income
Paper Exchange has 10 million shares of common stock outstanding, 5 million shares of preferred stock outstanding, and 100 thousand bonds. If the common shares are selling for $25 per share, the preferred shares are selling for $10 per share, and the bonds are selling for 98 percent of par, what would be the weight used for preferred stock in the computation of Paper's WACC?
12.56 percent
A company's current stock price is $84.50 and it is likely to pay a $3.50 dividend next year. Since analysts estimate the company will have a 10 percent growth rate, what is its expected return?
14.14 percent
A company's current stock price is $84.50 and it is likely to pay a $3.50 dividend next year. Since analysts estimate the company will have a 10 percent growth rate, what is its expected return?
14.14%
WayCo stock was $75 per share at the end of last year. Since then, it paid a $3 per share dividend last year. The stock price is currently $70. If you owned 200 shares of WayCo, what was your percent return?
14000+600-15000/15000-400/15000= -0.0266666Percentage= -2.27*100 =-2.67%
If you invested $1,000 in Disney and $5,000 in Oracle and the two companies returned 15 percent and 18 percent respectively, what was your portfolio's return?
17.5 percent
The S&P 500 had the highest decade average return for which period?
1950s
OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of preferred stock outstanding, and 50 thousand bonds. If the common shares are selling for $21 per share, the preferred shares are selling for $10 per share, and the bonds are selling for 111 percent of par ($1,000), what weight should you use for debt in the computation of OMG's WACC?
32.74 percent
Which one of these best illustrates a probability distribution at it relates to next year's economy?
40 percent chance of recession; 60 percent chance of a normal economy
A firm has a capital structure of 40% common stock, 10% preferred stock, and 50% debt. A new project is being internally funded. What weight should be used for equity in the project WACC?
40%
The yield to maturity on a firm's bonds is 8.8 percent. What is the component cost of debt if the tax rate is 35 percent?
5.72 percent Reason: Interest is tax deductible so the component cost is the after-tax cost of debt. Cost of debt = 0.088 × (1 - 0.35) = 0.0572 = 5.72%
Carrie D's has 6 million shares of common stock outstanding, 2 million shares of preferred stock outstanding, and 10 thousand bonds. If the common shares are selling for $15 per share, the preferred shares are selling for $28 per share, and the bonds are selling for 109 percent of par, what would be the weight used for common stock in the computation of Carrie D's WACC?
57.36%
Year-to-date, Oracle had earned a 15.0 percent return. During the same time period, Valero Energy earned −12.96 percent and McDonald's earned 1.80 percent. If you have a portfolio made up of 50 percent Oracle, 10 percent Valero Energy, and 40 percent McDonald's, what is your portfolio return?
6.92 percent
Economic State Probability Return Fast Growth 0.2 23% Slow Growth 0.6 14% Recession 0.2 −30%
7%
A company's current stock price is $50.00 and its most recent dividend was $1.00 per share. Since analysts estimate the company will have a 5 percent growth rate, what is its expected return?
7.10 percent
A company has a beta of 0.50. If the market return is expected to be 12 percent and the risk-free rate is 5 percent, what is the company's required return?
8.5 percent
Apple's 9 percent annual coupon bond has 10 years until maturity and the bonds are selling in the market for $890. The firm's tax rate is 21 percent. What is the firm's after-tax cost of debt?
8.58%
Economic State Probability Return Fast Growth 0.40 25 % Slow Growth 0.55 12 % Recession 0.05 − 50 %
= (0.40 × 25%) + (0.55 × 12%) + (0.05 × -50%) = 10% + 6.6% + -2.5% = 14.1% The expected return from a security is calculated by multiplying forecasted returns of security by the probabilities of those returns. Expected return = Sum (Probability × Return)Probability = estimated probability of occurrence of each scenario Return = forecasted return in each scenario Expected return
What does a firm-wide WACC represent?
A firm's overall cost of financing
Which one of these defines the efficient market hypothesis (EMH)?
A theory that describes what types of information are reflected in current market prices
How is the term "dollar return" defined?
Amount of profit or loss from an investment expressed in dollars
Which of the following will decrease the risk level of a firm?
Acquiring a less risky firm Accepting a low-risk project Reason: This will decrease the firm's risk level. Reason: This will lower the firm's risk level.
Which of the following will increase the risk level of a firm?
Acquiring a riskier firm Accepting riskier projects Selling the lowest-risk division Reason: This will increase the firm's risk level. Reason: This will increase the firm's risk level as will selling the lowest risk-division or acquiring a riskier firm. Reason: This will increase the firm's risk level as will accepting riskier projects or acquiring a riskier firm.
Why must the cost of debt be adjusted for taxes?
Because interest on debt is tax deductible which lowers the firm's total cost of debt financing
Which one of these variables is used to measure compensable risk in the capital asset pricing model (CAPM)?
Beta, β Reason: Beta, β, is used in CAPM to measure compensable, or market, risk.
Which of these statements apply to business risk?
Business risk is the risk of a project arising from the line of business the project is in. A change in the level of business risk can affect stockholders' required rate of return. Business risk is related to a firm's mix of new and existing product lines. REASON: This is a definition of business risk. Business risk refers to the lines of business a firm is in. As business risk changes, stockholders will adjust their required return to reflect the new risk level. This is correct as business risk relates to the lines of business a firm is in.
The adjustments used in the subjective approach are generally based on which of these?
Management's opinion of both a division's level of risk and the risk-reward premium
Which of these statements related to the capital asset pricing theory (CAPM) is (are) correct?
CAPM provides higher expected returns than those found on the efficient frontier. The key difference between CAPM returns and efficient frontier returns is the inclusion of a risk-free rate. The CAPM is derived from modern portfolio theory. Reason: CAPM begins with modern portfolio theory and the efficient frontier and adds in a risk-free rate, which yields higher rates of return. Reason: CAPM begins with modern portfolio theory and the efficient frontier and adds in a risk-free rate, which yields higher rates of return. Reason: CAPM begins with modern portfolio theory and the efficient frontier and adds in a risk-free rate, which yields higher rates of return.
What are the three sources of external capital for a firm?
Common stock, preferred stock, bonds
Assume a firm takes on a new project that is much riskier than the firm's existing projects. Which party disproportionately bears this new risk?
Common stockholders
Which variable most needs adjusting when revising a firmwide WACC into a divisional WACC?
Cost of equity, iE
A company's current stock price is $65.40 and it is likely to pay a $2.25 dividend next year. Since analysts estimate the company will have an 11.25 percent growth rate, what is its expected return?
Current stock price = D1 / (k -g) Current stock price = $65.40 D1 = Next year dividend = $2.25 k = rate of return = ? g = growth rate = 11.25% $65.40 = $2.25 / (k - 0.1125) 65.40(k - 0.1125) = 2.25 65.40k - 7.3575 = 2.25 65.40k = 9.6075 k = 0.146904 = 14.69%
Which of these includes any capital gain (or loss) that occurred as well as any income that you received from a specific investment?
dollar return
Which of these are pros of using divisional WACCs as compared to applying the firmwide WACC to all projects?
Divisional WACCs increase the accuracy of accept/reject decisions. Divisional WACCs adjust for the average risks of the projects in each division.
Sprint Nextel Corp. stock ended the previous year at $25.00 per share. It paid a $2.57 per share dividend last year. It ended last year at $18.89. If you owned 650 shares of Sprint, what was your dollar return and percent return?
Dollar return = ( Ending price - Beginning price + Dividends )*Number of shares = ( $18.89 - $25 + $2.57 )*650 = -$3.54*650= -$2,301 Percent return = Dollar return / Beginning price = -$2,301 / $25*650 = -$2,301 / $16,250= -0.1416*100= -14.16%.
The risk-free rate is 3.2 percent while the market risk premium is 8.9 percent. How is the expected return for a stock with a beta of 0.98 computed?
E(R) = 0.032 + 0.98(0.089)
A stock has a beta of 1.2, the market rate of return is 11.3 percent, and the risk-free rate is 4.2 percent. How is the expected return on the stock computed?
E(R) = 0.042 + 1.2(0.113 - 0.042)
When computing a divisional WACC, a proxy value is needed for which one of these?
Equity risk
Louis Enterprises stock is selling for $48 a share. Flotation cost on new equity issues is 15 percent. How is the value of F computed for use in the flotation-adjusted cost of equity formula?
F = 0.15 × $48
A European option may be exercised anytime up to and including the expiration date.
FALSE REASON: A European option may be exercised only on the expiration date.
What are flotation costs?
Fees paid to investment banks for issuing new securities
Which of the following is a true statement?
Firms can quite possibly change their stocks' risk level by substantially changing their business.
Rank the following three stocks by their total risk level, highest to lowest. Night Ryder has an average return of 14 percent and standard deviation of 30 percent. The average return and standard deviation of WholeMart are 12 percent and 25 percent; and of Fruit Fly are 25 percent and 40 percent.
Fruit Fly, Night Ryder, WholeMart
Which of the following is correct?
Hedge funds often sell stock they don't even own. Hedge funds maintain secrecy about their holdings, trading, and strategies. Hedge funds are limited to sophisticated investors. All of these choices are correct.
Modern portfolio theory (MPT) is designed to achieve which one of these?
Highest return for a given level of risk
Which of these are characteristics associated with a stock market bubble?
Investor enthusiasm Inflated bull market Reason: Investor enthusiasm causes an inflated bull market that drives prices too high, ending in a dramatic collapse in prices. Investor enthusiasm causes an inflated bull market that drives prices too high, ending in a dramatic collapse in prices.
Which of these activities will involve flotation costs?
Issuing bonds to finance a new project Issuing new shares of stock to fund a firm's expansion
Why do managers need to understand shareholder's required returns?
Managers must include shareholder returns in new project analysis. Managers must understand that increasing the risk level of a firm will increase the returns required by investors. Managers must ensure firms adequately reward their investors. Reason: There is no requirement that managers be shareholders, although it is commonly recommended. Managers must ensure a firm earns sufficient income to adequately reward investors for the risks assumed. Managers must ensure a firm earns sufficient income to adequately reward investors for the risks assumed.
The security market line (SML) graphs required return against which risk measure?
Market risk Reason: The SML graphs required return against market risk as measured by beta.
What type of risk exists in a fully-diversified portfolio?
Market risk only
What determines the weights to be used in computing a portfolio rate of return? Select an answer that applies to both equal and unequal portfolio allocations.
Market value of each security expressed as a percentage of the total portfolio value
How is standard deviation defined in relation to investments?
Measure of past return volatility, or risk
How is correlation defined?
Measure of the co-movement between the returns on two variables
What is the definition of the coefficient of variation?
Measure of total risk to reward
What is the primary focus of modern portfolio theory (MPT)?
Minimizing portfolio risk for a given level of return
The market portfolio has which of these characteristics?
No firm-specific risk Is part of the efficient frontier Lies on the capital market line Reason: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio. Reason: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio. Reason: The market portfolio has only market risk, lies on the capital market line, and is an efficient portfolio.
What type of relationship exists between risk and expected return?
POSITIVE
Which of these are characteristics of the security market line (SML)?
Passes through the market rate of return Upward-sloping function
How is a stock market bubble defined?
Period of overinflated prices followed by a dramatic collapse in prices
Year-to-date, Oracle had earned a 15.0 percent return. During the same time period, Valero Energy earned −12.96 percent and McDonald's earned 1.80 percent. If you have a portfolio made up of 50 percent Oracle, 10 percent Valero Energy, and 40 percent McDonald's, what is your portfolio return?
Portfolio Return = Weight of oracle * Return of oracle + Weight of valero energy * Return of valero energy + weight of mc donald's * Return of mc donald's = (0.50*15%)+(-12.96*0.10)+(1.80*0.40) =7.5%-1.296%+0.72= 6.92%
Asset pricing can be described as which type of process?
Process of directly specifying an equation that relates a stock's required return to an appropriate risk premium
Rank the following three stocks by their risk-return relationship, best to worst. Rail Haul has an average return of 8 percent and standard deviation of 10 percent. The average return and standard deviation of Idol Staff are 10 percent and 20 percent; and of Poker-R-Us are 6 percent and 15 percent.
Rail Haul, Idol Staff, Poker-R-Us
If the risk-free rate is 10 percent and the market risk premium is 4 percent, what is the required return for the market?
Required Return = Risk free rate + Market risk premium = 10 + 4 = 14%
A company has a beta of 0.25. If the market return is expected to be 8 percent and the risk-free rate is 2 percent, what is the company's required return?
Risk free rate = 2% Expected Market return = 8% And β of company =0.25 Putting all the values in the equation we can get Required rate of Return of company = 2% + 0.25 * (8% - 2%) = 2% + 0.25 *6% = 3.50%
How can firm-specific risk be defined?
Risk that can be reduced by diversification
The required return on a security is equal to which of these?
Risk-free rate + Security's risk premium Real interest rate + Expected inflation premium + Security's risk premium Reason: The risk-free rate consists of the real interest rate plus an expected inflation premium.
Which one of these is the correct formula for computing the return on a portfolio comprised of unequal amounts of stocks A, B, and C?
Rp = (wA × RA) + (wB × RB) + (wC × RC)
Which of the following is an index that tracks 500 companies, which allows for a great deal of diversification?
S&P 500
Which one of these is commonly used as a proxy for the market portfolio?
S&P 500 Index Reason: The DJIA only covers 30 stocks. The S&P 500 Index is commonly used as a proxy for the market portfolio since it includes 500 stocks. Reason: The S&P 500 Index is commonly used as a proxy for the market portfolio. Reason: The S&P 500 Index is commonly used as a proxy for the market portfolio since in includes 500 stocks in a variety of industries.
Based on annual returns for the years 2000-2012, which one of the following exhibited the greatest risk and why?
S&P 500 because the highest annual return was 28.7 percent and the lowest annual return was -35.5 percent.
What is the definition of an efficient market?
Securities market in which prices fully reflect available information on each security
Which one of these can be used as a definition of an efficient market?
Securities market where prices accurately value the risk-return relationship of each security given all available information
Which one of these statements applies to the efficient market hypothesis (EMH)?
Security prices fully reflect all available information.
Which of these defines correlation?
Statistical value ranging from -1 to +1
The annual return on the S&P 500 Index was 18.1 percent. The annual T-bill yield during the same period was 6.2 percent. What was the market risk premium during that year?
T-bill yield = Risk free rate = 6.2% S&P 500 return = Market return = 18.1% Market risk premium = Market return - Risk free rate = 18.1% - 6.2% = 11.9%
Based on actual performance for the period 1950-2017, which one of the following displayed the least amount of risk and why?
T-bills as their returns were less volatile.
Based on actual performance for the period 1950-2017, which one of the following displayed the least amount of risk and why? Select the best answer. Multiple choice question.
T-bills as their returns were less volatile.
What is the subjective approach to divisional WACCs?
The assignment of an adjustment factor to the firmwide WACC for each division
A stock has an expected return of 15 percent and a standard deviation of 20 percent. Long-term Treasury bonds have an expected return of 9 percent and a standard deviation of 11 percent. Given this data, which of the following statements is correct?
The bond investment has a better risk-return trade-off. CoV for the stock investment: 20/15 = 1.33; CoV for the bond: 11/9 = 1.22
How is the range of beta values defined for a portfolio of risky assets?
The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio. The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio.
How is the range of beta values defined for a portfolio of risky assets?
The lowest possible portfolio beta is defined as the lowest beta of any security held in the portfolio. The highest possible portfolio beta is defined as the highest beta of any security held in the portfolio. Reason: Since the portfolio beta is a weighed average of the security betas, it cannot be lower than the lowest security beta. Reason: Since the portfolio beta is a weighted average of the security betas, it cannot be higher than the highest security beta.
What condition must a new project meet if the project is to qualify to use the firm's WACC as the project's WACC?
The new project must be very similar to the firm's existing projects.
Applying a firmwide WACC to projects of varying levels of risk implies which assumption?
The rate of return is unaffected by the level of risk.
Which of these best summarizes market performance for the period 1950-2012?
The returns on the S&P 500 were more volatile than long-term Treasury bond returns but produced a higher average return in the long-run.
Which of these illustrates the definition of a probability distribution?
There is a 60 percent chance of rain and a 40 percent chance of pure sunshine.
How are flotation costs incorporated into the constant-growth formula for computing the cost of equity?
They are subtracted from the stock price.
How is required return defined?
Total return investors demand as compensation for the risk taken
Asset pricing can be defined as mathematically relating a security's required return to the security's level of risk.
True Reason: Asset pricing is the process of directly specifying, via a formula, the relationship between required return and risk.
For firms to be able to sell shares of stock, their managers must understand the returns required by shareholders.
True Reason: Shareholders will only buy shares when they expect to be adequately compensated. Managers try to ensure that happens.
How can business risk be defined?
Variability of a firm's cash flows
Risk, as it is used in the coefficient of variation (CoV), is best defined as a measure of which one of these?
Volatility of returns Reason: Risk, as used in CoV, is a measure of the volatility of returns.
Which one of these applies to the weighted-average cost of capital (WACC)?
WACC is an after-tax cost.
Which of these questions need to be answered when determining a project's WACC?
Which inputs should be project-specific and which should be firmwide values? How does the risk level of the project compare to the overall risk level of the firm?
Which of these values represents the pretax cost of debt?
Which of these values represents the pretax cost of debt?
Which of the following will impact the cost of equity component in the weighted average cost of capital?
all of these choices are correct.
Which of the following is a model that includes an equation that relates a stock's required return to an appropriate risk premium?
asset pricing
Which of these is a measure summarizing the overall past performance of an investment?
average return
We commonly measure the risk-return relationship using which of the following?
coefficient of variation
To find the percentage return of an investment
divide the dollar return by the investment's value at the beginning of the period.
Which of the following is the use of debt to increase an investment position?
financial leverage
Which one of these formulas correctly computes the return required by an investor?
i = (D1/P0) + g
A stock just paid an annual dividend of $1.34 which increases by 2 percent per year. How do you compute the required return if the stock is selling for $43 a share?
i = [($1.34 × 1.02)/$43] + 0.02
When calculating the weighted average cost of capital, weights are based on
market values
Which of the following is another term for market risk?
nondiversifiable risk
The total risk of the S&P 500 Index is equal to
nondiversifiable risk.
The reason that we do not use an after-tax cost of preferred stock is
none of these choices are correct. because preferred dividends are paid out of before-tax income. because most of the investors in preferred stock do not pay tax on the dividends. because we can only estimate the marginal tax rate of the preferred stockholders.
Which of the following is typically considered the return on U.S. government bonds and bills and equals the real interest plus the expected inflation premium?
risk-free rate
Whenever a set of stock prices go unnaturally high and subsequently crash down, the market experiences what we call
stock market bubble.
Which of the following will directly impact the cost of equity?
stock price
Which statement makes this a false statement? When a firm pays commissions to underwriting firms that float the issuance of new stock
the component cost will need to be integrated to figure project WACCs.
The optimal portfolio for you will be
the one that reflects the amount of risk that you are willing to take.
Any debt and preferred stock components of capital should
use firmwide, not project-specific, WACC figures
