Unit 3 Chapter 9

If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely occur? I) The firm will accept poor low-risk projects II) The firm will reject good high-risk projects. III) The firm will correctly accept projects with average risk.

3 only

Using a company's cost of capital to evaluate a project is: I) always correct II) always incorrect III) correct for projects that have average risk compared to the firm's other assets

3 only

Pure-play comparable

A company specializing in one activity that is similar to that of a division of a more diversified company

Many investment projects are exposed to diversifiable risks. What does "diversifiable" mean in this context? How should diversifiable risks be accounted for in project valuation? Should they be ignored completely?

A diversifiable risk has no affect on the risk of a well-diversified portfolio and therefore no affect on the project's beta. If a risk is diversifiable, it does not change the cost of capital for the project. However, any possibility of bad outcomes does need to be factored in when calculating expected cash flows

Many investment projects are exposed to diversifiable risks. What does "diversifiable" mean in this context? How should diversifiable risks be accounted for in project valuation? Should they be ignored completely?

A diversifiable risk has no affect on the risk of a well-diversified portfolio and therefore no affect on the project's beta. If a risk is diversifiable, it does not change the cost of capital for the project. However, any possibility of bad outcomes does need to be factored in when calculating expected cash flows.

After-tax WACC

A weighted average of the cost of equity and the after-tax cost of debt, where the weights are the relative market values of the firm's debt and equity.

A firm might categorize its projects into: I) cost improvements II) expansion projects (existing business) III) new products IV) speculative ventures

All are correct

A firm's cost of equity can be estimated using the: I) discounted cash-flow (DCF) approach; II) capital asset pricing model (CAPM); III) arbitrage pricing theory (APT)

All are correct

T/F The company cost of capital is the correct discount rate for any project undertaken by the company.

False

T/F A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the discount rate.

False

T/F Firms with cyclical revenues tend to have lower asset betas.

False

T/F For firms with relatively high levels of debt, the company cost of capital is the cost of equity of the firm.

False

T/F Portfolio betas for an industry are usually higher than the average betas of individual stocks in that same industry.

False

T/F Projects with great amounts of diversifiable risk should generally have higher company costs of capital.

False

T/F The company cost of capital is the cost of debt of the firm.

False

T/F Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity instead of market values. The resulting WACC estimates will generally be too high.

False Book value of equity is generally lower than market value, while the book value of debt is generally nearer to the market value. Using book values will therefore underweight the cost of equity. The resulting WACC estimates will generally be too low.

T/F In general, one should use higher discount rates for longer-term projects.

False This answer is addressing the misperception that the discount rate needs to be increased for longer-term cash flows because of their higher risk. The higher risk associated with longer-term cash flows is accounted for through the compounding effect of the discount rate

T/F A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-term projects as opposed to long-term projects.

False A fudge factor is an addition to the discount rate to reflect nonsystematic risk. This addition (through the compounding effect) penalizes long-term cash flows more than short-term cash flows, ceteris paribus.

T/F The company cost of capital is the correct discount rate for all projects, because the high risks of some projects are offset by the low risk of other projects

False. In order to account for the riskiness in distant cash flows, it is necessary to account for several possible outcomes in cash flows and calculate the probability weighted cash flow for each scenario. The discount rates should not be adjusted based on uncertainty in cash flows.

T/F Distant cash flows are riskier than near-term cash flows. Therefore long-term projects require higher risk-adjusted discount rates.

False. The company cost of capital is the correct discount rate for new projects only if the new projects have the same risk level as the existing business. If a new project is riskier, a higher cost of capital should be used. If the new project is less risky, a lower cost of capital should be used.

What happens to the operating leverage and business risk of a company if you agree to fixed-price contract, over a variable cost contract?

If you agree to the fixed price contract, you have now incurred a fixed cost and your operating leverage increases. Changes in revenue result will result in greater than proportional changes in profit. Business risk, measured by βa, increases as a result.

Which of the following projects most likely has the lowest cost of capital?

Investment in a gold-mining operation Changes in gold prices tend to vary inversely with the market and so the covariance of the returns to gold mining operations with the market returns tends to be low (if not negative). With such a low covariance, the beta (i.e., systematic risk) of gold mining operations tends to be low and so the cost of capital tends to be low.

Under what circumstances might you advise Norfolk Southern to calculate its cost of equity based on its own beta estimate?

Norfolk Southern's beta might be different from the industry beta for a variety of reasons. For example, Norfolk Southern's business might be more cyclical than is the case for the typical firm in the industry. Or, Norfolk Southern might have more fixed operating costs so that operating leverage is higher. Another possibility is that Norfolk Southern has more debt than is typical for the industry so that it has higher financial leverage.

Suppose a firm uses its company cost of capital to evaluate all projects (regardless of the riskiness of each project). Will it underestimate or overestimate the value of high-risk projects?

Overestimate. High-risk projects should have a higher cost of capital relative to the company's existing securities. Therefore, the value of a high-risk project would be overestimated if the company cost of capital is used.

Which of the following informational updates would prompt a financial manager to use a higher cost of capital to analyze a project?

Recent estimates indicate the project has a greater percentage of fixed costs than previously thought. Higher fixed costs are associated with higher business risk much like higher debt (and therefore higher interest payments) is associated with higher financial risk.

Equity beta

The change in the return of the stock for each additional 1% change in the market return.

Asset beta

The change in the return on a portfolio of all the firm's securities (debt and equity) for each additional 1% change in the market return.

What is the discount rate for an expansion of the company's present business?

The cost of capital depends on the riskiness of the project (i.e., expansion) being evaluated. If the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital. Assuming that is case with the proposed expansion, the appropriate discount rate would be the firm's present cost of capital: 9.4%.

Cost of debt

The expected return on debt 'cost of debt' and 'expected return on debt' are two terms for the same thing, depending on one's perspective of the transaction When viewed from the investor's perspective, interest payments on debt are part of the investor's return. But from the borrower's perspective, interest payments are a cost of borrowing.

Cost of equity

The expected return on equity

T/F The company cost of capital is the correct discount rate only for investments that have the same risk as the company's overall business.

True

T/F A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger confidence interval.

True

T/F A pure play is a comparable firm that specializes in one activity.

True

T/F An analyst should evaluate each project at its own opportunity cost of capital. The true cost of capital depends on the particular use of that capital.

True

T/F Companies with high ratios of fixed costs to project values tend to have high betas.

True

T/F Cyclical firms tend to have high betas.

True

T/F Firms with high operating leverage tend to have higher asset betas.

True

T/F Generally, an industry beta, calculated from a portfolio of companies in the same industry, is more accurate that a beta estimate for a single company.

True

T/F Generally, one should use the short-term Treasury bill rate for the risk-free rate.

True

T/F One calculates the weighted average cost of capital (WACC), on an after-tax basis, as:WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V), where: V = D + E.

True

T/F Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.

True

T/F Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount rate.

True

The cost of capital is always less than or equal to the cost of equity.

True This is true as long as the firm's asset beta is positive (which is almost always true; gold mining stock might be an exception as they can be countercyclical stocks).

T/F If one uses a long-term risk-free rate for the CAPM, instead of a short-term risk-free rate, then one will normally generate a flatter security market line.

True With a normal (i.e., upward-sloping) yield curve, long-term rates are higher than short-term rates. With a higher risk-free rate the market risk premium (i.e., the slope of the security market line) will be flatter.

T/F Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff projects

True.

If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur? I) The firm will reject good low-risk projects; II) The firm will accept poor high-risk projects; III) The firm will correctly accept projects with average risk

all are correct

The company cost of capital is the appropriate discount rate for a firm's:

average-risk projects.

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:

beta

Which types of projects has the lowest unique risk?

cost improvements

The cost of capital is the same as the cost of equity for firms that are financed:

entirely by equity.

Which type of projects has average total risk?

expansions of existing business

Generally, for CAPM calculations, the value to use for the risk-free interest rate is the:

short-term U.S. Treasury bill rate.

Which of the following types of projects generally have the highest total risk?

speculative ventures

The hurdle rate for capital budgeting decisions is:

the cost of capital.

The company cost of capital, when the firm has both debt and equity financing, is called the:

the weighted average cost of capital (WACC)

An analyst computes a beta coefficient with a low standard error. This implies that:

this particular beta is more reliable than most. A low standard error implies a tight confidence interval and this is associated with higher "reliability." In other words, we can be more confidence that our point estimate of the beta is equal to the true beta.