Financial Management Test 4
A firm needs to raise $950,00 but will incur flotation costs of 5 percent. How much will it pay in flotation costs?
$1,000,000-$950,000=$50,000
Including preferred stock in the WACC adds the term:
(P/V)*Rp
Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM
0.05+(2*(0.1-0.05))=0.15
What is the expected return for a 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?
11% {.05+1.5(.09-.05)}
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.
12.5%
What is variance?
A measure of the squared deviations of a security's return from its expected return.
A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?
An increase in the Federal funds rate. An increase in the corporate tax rate.
Asset A has an expected return of 17% and standard deviation of 5%. Asset B has an expected return of 15% and standard deviation of 5%. Which asset would a rational investor choose?
Asset A
Which of the following are tax-deductible to the firm?
Coupon Interest paid on bonds
One method for estimating the cost of equity is based on the _ model.
Dividend discount
On what type of returns does the CAPM focus?
Expected returns
To apply the dividend growth model to a particular stock, you need to estimate the _.
Growth rate, dividend yield
What is systematic risk?
It is a risk that pertains to a large number of assets.
What does variance measure?
It measure the riskiness of a security's returns. It measures the dispersion of the sample of returns.
Which of the following are examples of unsystematic risk?
Labor strikes. Changes in management.
A project should only be accepted if its return is above what is _.
Required by investors
What is the slope of the security market line (SML)?
The market-risk premium (expected return on the market minus the risk-free rate of return)
What does WACC stand for?
Weighted average cost of capital
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV
$950,000
A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percet, and the tax rate is 40 percent. What is its WACC?
(0.7*0.16)+(0.3*0.1*(1-0.4))=0.13
What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 30%, and pays $20 in interest on its bonds.
(200-90-20)*(1-0.3)=$63
The risk-free asset has a beta of:
0
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?
0.04+(2*0.06)= 0.16
A company has a borrowing rate of 15 percent and a tax rate of 30 percent. What is its aftertax cost of debt?
0.15*(1-0.6)=0.105
By definition, what is the beta of the average asset equal to?
1
If an analyst's forecast for a firm's earnings growth is 7 percent, and its dividend yield is 3 percent, its cost of equity will be _.
10%
If the variance of a portfolio is .0025, what is the standard deviation?
5%
Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is its capital if it is an all-equity firm?
6%
John's portfolio consists of $1,200 worth of Chi Corporation common stock and $400 worth of Lambda Corporation common stock. Lambda's portfolio weight is 25%, and Chi's portfolio weight is:
75%
WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C =-$10, Project D =$40. Which projects should the firm accept?
A and D
The calculation of a portfolio beta is similar to the calculation of:
A portfolio's expected return
Based on the capital asset pricing model (CAPM) there is generally _ relationship between beta and the expected return on a security.
A positive
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when _.
All projects have the same risk as the current firm
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market:
Already knew about most of the news item
How can a positive relationship between the 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
Economic Value Added (EVA) uses the weighted average cost of capital to determine if value is:
Being created or destroyed
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
Better than no risk adjustment
Which of the following are true?
Book values are often similar to market values for debt, ideally we should use market values in the WACC
Flotation costs are costs incurred to _.
Bring new security issues to the market
The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.
Calculate the expected return, calculate the deviation of each return from the expected return, square each deviation, calculate the average squared deviation.
WACC is used to discount _ _
Cash flows
If a firm issues no debt, its average cost of capital will equal _.
Cost of equity
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.
If the firm is all-equity, the discount rate is equal to the firm's cost of _ capital.
Equity
True or false: Projects should always be discounted at the firm's overall cost of capital.
False
The issuance costs of bonds and stocks are referred to as _ costs.
Flotation
An important advantage to a firm raising equity internally is not having to pay _.
Flotation costs
Finding a firm's overall cost of equity is difficult because:
It cannot be observed directly
What is unsystematic risk?
It is a risk that affects a single asset or a small group of assets.
What is a risk premium?
It is additional compensation for taking risk, over and above the risk-free rate.
The WACC is the minimum return a company needs to earn to satisfy _.
Its bondholders, its stockholders
If the firm issued so much debt that its equity was valueless, its average cost of capital wold equal _.
Its cost of debt
The most appropriate weights to use in the WACC are the _ weights.
Market value
The systematic risk principle argues that the market does not reward risks:
That are borne unnecessarily.
What is the expected return on a security with beta of 1?
The expected return on the market.
What happens to the expected returns of the existing securities in your portfolio if new securities are added to your portfolio?
The expected returns of existing securities will not change.
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
What is the intercept of the security market line (SML)?
The risk-free rate
What are two components of the expected return on the market?
The risk-free rate, the risk premium.
The standard deviation is _.
The square root of the variance.
Why are the deviations of returns squared when computing variance?
This ensure that the sum of the deviations is a positive number.
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30 percent, ULC's aftertax earnings are _, which is _ than LEV's aftertax earnings.
UCL=$110*(1-.3)=$77 LEV= $90*(1-.3)=$63
The weighted average cost of capital formula can be written as:
[S/(S+B)]*Rs + [B/(S+B)]*Rb*(1-Tc)
Dividends paid to common stockholders _ be deducted from the payer's taxable income for tax purposes.
cannot
A firm has 20 percent debt, debt flotation costs of 5 percent, equity flotation costs of 10 percent, and wants to raise $9,100. What are the flotation costs?
f0=0.2*0.05+0.8*0.1=0.09 $9,100/(1-0.09)-$9,100=$900
An investment will have a negative NPV when its expected return is _ _ what the financial markets offer for the same risk.
less than
If a firm has multiple projects, each project should be discounted using _.
A discount rate commensurate with the project's risk
A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?
A hostile takeover attempt by a competitor. The death of the CEO.
The minimum required return on a new project when its risk is similar to that of projects the firm currently owns is known as the:
Cost of capital
What is the equation for the capital asset pricing model?
Expected return on security = Risk-free rate + Beta x (Return on market - Risk-free rate)
In reality, most firms cover the equity portion of their capital spending with _.
Internally generate cash flow
Other companies that specialize only in projects similar to the project your firm is considering are called _.
Pure plays
Which of following are examples of systematic risk?
Regulatory changes in tax rates. Future rates of inflation.
If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:
Rejected, when it should be accepted.
The CAPM can be used to estimate the _.
Required return on equity
To estimate a firm's equity cost of capital using the CAPM, we need to know the_.
Stock's beta, risk-free rate, and market risk premium.
The cost of capital is an appropriate name since a project must earn enough to pay those who _ the capital.
Supply
When an investor is diversified only _ risk matters.
Systematic
Which type of risk does not change as we add more securities to a portfolio?
Systematic, or market, risk
True or false: Dividend payments on preferred stock are not tax deductible.
True
True or false: It is possible for unsystematic risk of a portfolio to be reduced to practically zero.
True
The SML will be _ if the expected return on the market is higher than the risk-free rate.
Upward sloping
If you wish to create a portfolio of stocks, what is the required minimum number of stocks.
You must invest in stocks of at least 2 corporations.
If an all-equity firm's beta is 2, the risk-free rate is 3%, and the historical market risk premium is 7%, what is the firm's cost of capital?
0.03+2*0.07=0.17
The best way to include flotation costs is to _.
Add them to the initial investment.
Which of the following are components used in the construction of the WACC?
Cost of common stock, cost of preferred stock, cost of debt
Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio:
Declines
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _.
Decrease
Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?
Division B
The return an investor in a security receives is _ _ the cost of the security to the company that issued it.
Equal to
A firm's cost of debt can be _.
Estimated easier than its cost of equity, obtained by checking yields on publicly traded bonds, obtained by talking to investment bankers.
True or false: A well-diversified portfolio will eliminate all risks.
False
Which of the following are examples of a portfolio?
Investing $100,000 in a combination of stocks and bonds. Investing $100,000 in the stocks of 50 publicly traded corporations. Investing $100,000 in a combination of US and Asian stocks.
The market risk premium is defined as:
Rm-Rf
The CAPM formula is:
Rt+B(E(Rm)-Rf)
If a security's expected return is equal to the expected return on the market, its beta must be _.
1
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
10%
True or false: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.
False
True or false: Systematic risk will impact all securities in every portfolio equally.
False
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
It is likely to decrease. It may eventually be almost totally eliminated.
In the total return equation, which of the following does epsilon (E) refer to?
Unsystematic risk. Part of risky return.
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept _ projects.
too many high-risk
A firm's capital structure consists of 40 percent debt and 60 percent equity. The aftertax yield on debt is 2.5 percent and the cost of equity is 15 percent. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
0.4*0.025+0.6*0.15=0.1
A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?
0.5
If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?
1.25
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?
13.6%
Which of the following is true?
A company can deduct interest paid on debt when computing taxable income
The rate used to discount project cash flows is known as the _.
Cost of capital, required return, discount rate
The growth rate of dividends can be found using:
Historical dividend growth rates, security analysts' forecasts.
_ risk is reduced as more securities are added to the portfolio
Idiosyncratic, Unique, Unsystematic
If a security's return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclue about the value of the security's beta based on CAPM.
It is equal to 0.
As more securities are added to a portfolio, that will happen to the portfolio's total unsystematic risk?
It is likely to decrease. It may eventually be almost totally eliminated.
What is the definition of expected return?
It is the return that an investor expects to earn on a risky asset in the future.
There is _ correlation between the unsystematic risk of two companies from different industries.
No
A firm's cost of debt can be_.
Obtained by checking yields on publicly traded bonds, obtained by talking to investment bankers, estimated easier than its cost of equity.
Preferred stock _.
Pays dividends in perpetuity, pays a constant dividend
The security market line (SML) shows that the relationship between a security's expected return and its beta is _.
Positive
What is the required return on a stock, according to the constant dividend growth model, if the growth rate is zero?
Re=D1/P0
It would be useful to understand how the _ of the risk premium on a risky asset is determined.
Size
Which type of risk is unaffected by adding securities to a portfolio?
Systematic risk
Which one of the following types of risk is not reduced by diversification?
Systematic, or market risk
Which of the following are examples of information that may impact the risky return of stock?
The Fed's decision on interest rates at their meeting next week. The outcomes of an application currently pending with the Food and Drug Administration.
What are the two components of unexpected return (U) in the total return equation?
The systematic portion. The unsystematic portion.
What is the equation for total return?
Total return = Expected return + Unexpected return
The risk of owning an asset comes from:
Unanticipated events. Surprises.
Which one of the following is true?
Under U.S. tax law, a corporation's interest payments are tax deductible.
What two factors determin a stock's total return?
Unexpected return. Expected return.
To estimate the growth rate of a particular stock, we can _.
Use the historical dividend growth rate, use security analysts' forecasts
Which of the following statements are true about variance?
Variance is a measure of the squared deviations of a security's return from its expected return. Standard deviation is the square root of variance.
A good website to find WACC estimates is:
www.valuepro.net