FINA Ch.8 Risk Analysis in Investment Decisions

Which of the following statements concerning risk are correct? I. Systematic risk is measured by beta. II. The risk premium increases as unsystematic risk increases. III. Systematic risk is the only part of total risk that should affect asset prices and returns. IV. Diversifiable risks are market risks you cannot avoid.

A. I and III only

Unsystematic risk:

A. can be effectively eliminated by portfolio diversification.

The pre-tax cost of debt

A. is based on the current yield to maturity of the firm's outstanding bonds.

Which of the following are examples of diversifiable risk? I. An earthquake damages Oakland, California. II. The federal government imposes an additional $1,000 fee on all business entities. III. Employment taxes increase nationally. IV. Toymakers are required to improve their safety standards.

D. I and IV only

Which of the following statements are correct? I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner. II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%. III. The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds. IV. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm.

D. I and IV only

Which of the following statements are correct concerning diversifiable, or unsystematic, risks? I. Diversifiable risks can be largely eliminated by investing in thirty unrelated securities. II. There is no reward for accepting diversifiable risks. III. Diversifiable risks are generally associated with an individual firm or industry. IV. Beta measures diversifiable risk

D. I, II, and III only

Blue Diamond Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital?

A. 10.39 percent Re = 0.028 + 1.34 (0.112 - 0.028) = 0.14056; Rp = (0.07 $100)/$53 = 0.13208 Market values of: debt = 80,000*$1,000 = $80.00M; preferred = 750,000*$53 = $39.75M; and common = 2.5M * $42 = $105.00M. These sum to $224.75M. Thus, the WACC = ($105M/$224.75M) (0.14056) + ($39.75M/$224.75M) (0.13208) + ($80M/$224.75M) (0.0675) (1 - 0.38) = 10.39 percent

Estimate the appropriate weight of debt to be used when calculating FM's weighted average cost of capital.

A. 11.5% Market value of equity = $40 * 240 million = $9,600 million. Weight of debt = 1,250/(9,600 + 1,250) = .1152 or 11.5%.

Honest Abe's is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe's. Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12. Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture?

A. 12.46 percent KE = gov't borrowing rate + equity beta*market risk premium = 0.035 + 1.12(0.08) = 0.1246 or 12.46 percent

Which one of the following is an example of systematic risk?

A. The Federal Reserve unexpectedly announces an increase in target interest rates.

Estimate FM's after-tax cost of debt capital.

B. 4.10% The correct approach is to use the YTM on the firm's bonds for the before-tax cost. Thus, after-tax cost = 6.3% (1 - .35) = 4.10%.

The after-tax cost of debt generally increases when: I. a firm's bond rating increases. II. the market-required rate of interest for the company's bonds increases. III. tax rates decrease. IV. bond prices rise.

B. II and III only

The capital structure weights used in computing the weighted average cost of capital:

B. are based on the market value of the firm's debt and equity securities.

The weighted average cost of capital for a firm is the

B. rate of return a firm must earn on its existing assets to maintain the current value of its stock.

The excess return earned by a risky asset, for example with a beta of 1.4, over that earned by a risk-free asset is referred to as a:

B. risk premium.

.** Estimate FM's weighted-average cost of capital *look at actual test*

C. 11.27%

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. Firms that have a 100 percent retention ratio II. Firms that pay an unchanging dividend III. Firms that pay a constantly increasing dividend IV. Firms that pay an erratically growing dividend

C. II and III only

The cost of equity for a firm:

C. ignores the firm's risks when that cost is based on the dividend growth model.

Estimate FM's after-tax cost of equity capital.

D. 12.20% KE = gov't borrowing rate + equity beta * market risk premium = .044 + 1.2(.065) = 0.122

. Estimate the appropriate weight of equity to be used when calculating FM's weighted average cost of capital.

D. 88.5% Market value of equity = $40 * 240 million = $9,600 million. Weight of equity = 9,600/(9,600 + 1,250) = .8848 or 88.5%.

Total risk is measured by _____ and systematic risk is measured by ____.

D. standard deviation; beta

. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity. Which of the following statements is/are correct? I. FM should reject the project because the IRR is greater than the firm's WACC. II. FM should accept the project because the IRR is greater than the firm's WACC. III. FM should accept the project because the NPV is greater than zero. IV. FM should reject the project because the NPV is less than zero.

E. II and III only The IRR of the investment is 15/100 = 15%. FM's WACC of 11.27% is shown in the table below. The NPV of the investment at the WACC = -100 + 15/.1127 = $33.1 million.

When investment returns are less than perfectly positively correlated, the resulting diversification effect means that:

E. spreading an investment across many diverse assets will eliminate some of the total risk.

The discount rate assigned to an individual project should be based on:

E. the risks associated with the use of the funds required by the project.