HW5 and HW6

According to the tradeoff theory of capital structure (with taxes and bankruptcy costs), higher debt always corresponds to higher firm value. A) True B) False

A

The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market.

A

What is the amount of the risk premium on a U.S. Treasury bill if the risk-free rate is 2.8 percent and the market rate of return is 8.35 percent? A. 0.00 percent B. 2.80 percent C. 5.55 percent D. 8.35 percent E. 11.15 percent

A

Which one of the following correctly describes the dividend yield? A. next year's annual dividend divided by today's stock price B. this year's annual dividend divided by today's stock price C. this year's annual dividend divided by next year's expected stock price D. next year's annual dividend divided by this year's annual dividend E. the increase in next year's dividend over this year's dividend divided by this year's dividend

A

Which one of the following is the formula that explains the relationship between the expected return on a security and the level of that security's systematic risk? A. capital asset pricing model B. time value of money equation C. unsystematic risk equation D. market performance equation E. expected risk formula

A

Which one of the following measures the amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset? A. beta B. reward-to-risk ratio C. risk ratio D. standard deviation E. price-earnings ratio

A

Which one of the following statements is correct? A. The greater the volatility of returns, the greater the risk premium. B. The lower the volatility of returns, the greater the risk premium. C. The lower the average return, the greater the risk premium. D. The risk premium is unrelated to the average rate of return. E. The risk premium is not affected by the volatility of returns.

A

A stock has annual returns of 6 percent, 14 percent, -3 percent, and 2 percent for the past four years. The arithmetic average of these returns is _____ percent while the geometric average return for the period is _____ percent. A. 4.57; 4.75 B. 4.75; 4.57 C. 6.33; 6.19 D. 6.19; 6.33 E. 6.33; 6.33

B

Delta Lighting has 30,000 shares of common stock outstanding at a market price of $15.00 a shar This stock was originally issued at $31 per shar The firm also has a bond issue outstanding with a total face value of $280,000 which is selling for 86 percent of par. The cost of equity is 13 percent while the aftertax cost of debt is 6.9 percent. The firm has a beta of 1.48 and a tax rate of 30 percent. What is the weighted average cost of capital? A. 10.07 percent B. 10.87 percent C. 12.36 percent D. 13.29 percent E. 13.47 percent

B

Estimates of the rate of return on a security based on a historical arithmetic average will probably tend to _____ the expected return for the long-term and estimates using the historical geometric average will probably tend to _____ the expected return for the short-term. A. overestimate; overestimate B. overestimate; underestimate C. underestimate; overestimate D. underestimate; underestimate E. accurately; accurately

B

Miller Sisters has an overall beta of 0.79 and a cost of equity of 11.2 percent for the firm overall. The firm is 100 percent financed with common stock. Division A within the firm has an estimated beta of 1.08 and is the riskiest of all of the firm's operations. What is an appropriate cost of capital for division A if the market risk premium is 9.5 percent? A. 13.12 percent B. 13.96 percent C. 14.63 percent D. 15.77 percent E. 16.01 percent

B

The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over the last four years, respectively. The stock is currently selling for $26 a shar What is this firm's cost of equity? A. 7.56 percent B. 7.93 percent C. 10.38 percent D. 10.53 percent E. 11.79 percent

B

The aftertax cost of debt generally increases when: I. a firm's bond rating increases. II. the market rate of interest increases. III. tax rates decrease. IV. bond prices rises A. I and III only B. II and III only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV

B

The market has an expected rate of return of 11.2 percent. The long-term government bond is expected to yield 5.8 percent and the U.S. Treasury bill is expected to yield 3.9 percent. The inflation rate is 3.6 percent. What is the market risk premium? A. 6.0 percent B. 7.3 percent C. 7.6 percent D. 8.5 percent E. 9.3 percent

B

Tidewater Fishing has a current beta of 1.21. The market risk premium is 8.9 percent and the risk-free rate of return is 3.2 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.50? A. 1.88 percent B. 2.58 percent C. 2.60 percent D. 3.10 percent E. 3.26 percent

B

Unsystematic risk: A. can be effectively eliminated by portfolio diversification. B. is compensated for by the risk premium. C. is measured by beta. D. is measured by standard deviation. E. is related to the overall economy.

B

Today, you sold 200 shares of Indian River Produce stock. Your total return on these shares is 6.2 percent. You purchased the shares one year ago at a price of $31.10 a share. You have received a total of $100 in dividends over the course of the year. What is your capital gains yield on this investment? A. 3.68 percent B. 4.59 percent C. 5.67 percent D. 7.26 percent E. 7.41 percent

B: Capital gains yield = .062 - [($100/$200)/$31.10] = 4.59 percent

A firm's overall cost of equity is: A. is generally less that the firm's WACC given a leveraged firm. B. unaffected by changes in the market risk premium. C. highly dependent upon the growth rate and risk level of the firm. D. generally less than the firm's aftertax cost of debt. E. inversely related to changes in the firm's tax rat

C

Boulder Furniture has bonds outstanding that mature in 15 years, have a 6 percent coupon, and pay interest annually. These bonds have a face value of $1,000 and a current market price of $1,075. What is the company's aftertax cost of debt if its tax rate is 32 percent? A. 2.97 percent B. 3.24 percent C. 3.58 percent D. 5.21 percent E. 5.53 percent

C

Southern Home Cookin' just paid its annual dividend of $0.65 a shar The stock has a market price of $13 and a beta of 1.12. The return on the U.S. Treasury bill is 2.5 percent and the market risk premium is 6.8 percent. What is the cost of equity? A. 9.98 percent B. 10.04 percent C. 10.12 percent D. 10.37 percent E. 10.45 percent

C

Suppose you observe the following situation: Assume the capital asset pricing model holds and stock A's beta is greater than stock B's beta by 0.21. What is the expected market risk premium? A. 8.8 percent B. 9.5 percent C. 12.6 percent D. 17.9 percent E. 20.0 percent

C

The Market Outlet has a beta of 1.38 and a cost of equity of 14.945 percent. The risk-free rate of return is 4.25 percent. What discount rate should the firm assign to a new project that has a beta of 1.25? A. 13.54 percent. B. 13.72 percent. C. 13.94 percent. D. 14.14 percent. E. 14.36 percent.

C

The capital asset pricing model (CAPM) assumes which of the following? I. a risk-free asset has no systematic risk. II. beta is a reliable estimate of total risk. III. the reward-to-risk ratio is constant. IV. the market rate of return can be approximated. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, III, and IV

C

The cost of equity for a firm: A. tends to remain static for firms with increasing levels of risk. B. increases as the unsystematic risk of the firm increases. C. ignores the firm's risks when that cost is based on the dividend growth model. D. equals the risk-free rate plus the market risk premium. E. equals the firm's pretax weighted average cost of capital.

C

Which of the following statements is correct in relation to a stock investment? I. The capital gains yield can be positive, negative, or zero. II. The dividend yield can be positive, negative, or zero. III. The total return can be positive, negative, or zero. IV. Neither the dividend yield nor the total return can be negative. A. I only B. I and II only C. I and III only D. I and IV only E. IV only

C

Which one of the following is a risk that applies to most securities? A. unsystematic B. diversifiable C. systematic D. asset-specific E. total

C

Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure A. This model considers a firm's rate of growth. B. The model applies only to non-dividend paying firms. C. The model is dependent upon a reliable estimate of the market risk premium. D. The model generally produces the same cost of equity as the dividend growth model. E. This approach generally produces a cost of equity that equals the firm's overall cost of capital.

C

Which one of the following will be constant for all securities if the market is efficient and securities are priced fairly? A. variance B. standard deviation C. reward-to-risk ratio D. beta E. risk premium

C

You are evaluating a project which requires $230,000 in external financing. The flotation cost of equity is 11.6 percent and the flotation cost of debt is 5.4 percent. What is the initial cost of the project including the flotation costs if you maintain a debt-equity ratio of 0.45? A. $248,494 B. $249,021 C. $254,638 D. $255,551 E. $255,646

C

You recently purchased a stock that is expected to earn 30 percent in a booming economy, 9 percent in a normal economy, and lose 33 percent in a recessionary economy. There is a 5 percent probability of a boom and a 75 percent chance of a normal economy. What is your expected rate of return on this stock? A. -3.40 percent B. -2.25 percent C. 1.65 percent D. 2.60 percent E. 3.50 percent

C

Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a shar The company also has 40,000 bonds outstanding that are quoted at 106 percent of face valu What weight should be given to the debt when the firm computes its weighted average cost of capital? A. 42 percent B. 46 percent C. 50 percent D. 54 percent E. 58 percent

D

Flotation costs for a levered firm should: A. be ignored when analyzing a project because they are not an actual project cost. B. be spread over the life of a project thereby reducing the cash flows for each year of the project. C. only be considered when two projects are mutually exclusive. D. be weighted and included in the initial cash flow. E. be totally ignored when internal equity funding is utilized.

D

Inside information has the least value when financial markets are: A. weak form efficient. B. semiweak form efficient. C. semistrong form efficient. D. strong form efficient. E. inefficient.

D

Justice, Inc has a capital structure which is based on 30 percent debt, 5 percent preferred stock, and 65 percent common stock. The flotation costs are 11 percent for common stock, 10 percent for preferred stock, and 7 percent for debt. The corporate tax rate is 37 percent. What is the weighted average flotation cost? A. 8.97 percent B. 9.48 percent C. 9.62 percent D. 9.75 percent E. 10.00 percent

D

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should: A. allocate more funds to Division A since it is the largest of the two divisions. B. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. C. allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. D. assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values. E. fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.

D

Stacy purchased a stock last year and sold it today for $3 a share more than her purchase price. She received a total of $0.75 in dividends. Which one of the following statements is correct in relation to this investment? A. The dividend yield is expressed as a percentage of the selling price. B. The capital gain would have been less had Stacy not received the dividends. C. The total dollar return per share is $3. D. The capital gains yield is positive. E. The dividend yield is greater than the capital gains yield.

D

The expected return on a stock given various states of the economy is equal to the: A. highest expected return given any economic state. B. arithmetic average of the returns for each economic state. C. summation of the individual expected rates of return. D. weighted average of the returns for each economic state. E. return for the economic state with the highest probability of occurrence.

D

What is the beta of the following portfolio? A. .95 B. 1.01 C. 1.05 D. 1.09 E. 1.23

D

Suppose you observe the following situation: Assume these securities are correctly priced. Based on the CAPM, what is the return on the market? A. 13.99 percent B. 14.42 percent C. 14.67 percent D. 14.78 percent E. 15.01 percent

E

The principle of diversification tells us that: A. concentrating an investment in two or three large stocks will eliminate all of the unsystematic risk. B. concentrating an investment in three companies all within the same industry will greatly reduce the systematic risk. C. spreading an investment across five diverse companies will not lower the total risk. D. spreading an investment across many diverse assets will eliminate all of the systematic risk. E. spreading an investment across many diverse assets will eliminate some of the total risk.

E

Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company's tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash inflows of $87,000, $279,000, and $116,000 over the next three years, respectively. What is the projected net present value of this project? A. $68,211.04 B. $68,879.97 C. $69,361.08 D. $74,208.18 E. $76,011.23

E

Treynor Industries is investing in a new project. The minimum rate of return the firm requires on this project is referred to as the: A. average arithmetic return. B. expected return. C. market rate of return. D. internal rate of return. E. cost of capital

E

Which form of financing do firms prefer to use first according to the pecking-order theory? A. regular debt B. convertible debt C. common stock D. preferred stock E. internal funds

E

Which one of the following is represented by the slope of the security market line? A. reward-to-risk ratio B. market standard deviation C. beta coefficient D. risk-free interest rate E. market risk premium

E

Your portfolio has a beta of 1.12. The portfolio consists of 40 percent U.S. Treasury bills, 30 percent stock A, and 30 percent stock B. Stock A has a risk-level equivalent to that of the overall market. What is the beta of stock B? A. 1.47 B. 1.52 C. 1.69 D. 1.84 E. 2.73

E

One year ago, you purchased a stock at a price of $47.50 a share. Today, you sold the stock and realized a total loss of 22.11 percent. Your capital gain was -$12.70 a share. What was your dividend yield? A. 4.63 percent B. 4.88 percent C. 5.02 percent D. 12.67 percent E. 14.38 percent

a

What is the standard deviation of the returns on a portfolio that is invested 52 percent in stock Q and 48 percent in stock R? A. 1.66 percent B. 2.47 percent C. 2.63 percent D. 3.28 percent E. 3.41 percent

a

Which one of the following statements is correct for a firm that uses debt in its capital structure? A. The WACC should decrease as the firm's debt-equity ratio increases. B. When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate multiplied by the par value of the preferred. C. The firm's WACC will decrease as the corporate tax rate decreases. D. The weight of the common stock used in the computation of the WACC is based on the number of shares outstanding multiplied by the book value per share. E. The WACC will remain constant unless a firm retires some of its debt

a

You own the following portfolio of stocks. What is the portfolio weight of stock C? A. 39.85 percent B. 42.86 percent C. 44.41 percent D. 48.09 percent E. 52.65 percent

a

Efficient financial markets fluctuate continuously because: A. the markets are continually reacting to old information as that information is absorbed. B. the markets are continually reacting to new information. C. arbitrage trading is limited. D. current trading systems require human intervention. E. investments produce varying levels of net present values.

b

If the economy is normal, Charleston Freight stock is expected to return 16.5 percent. If the economy falls into a recession, the stock's return is projected at a negative 11.6 percent. The probability of a normal economy is 80 percent while the probability of a recession is 20 percent. What is the variance of the returns on this stock? A. 0.010346 B. 0.012634 C. 0.013420 D. 0.013927 E. 0.014315

b

Standard deviation is a measure of which one of the following? A. average rate of return B. volatility C. probability D. risk premium E. real returns

b

Steve has invested in twelve different stocks that have a combined value today of $121,300. Fifteen percent of that total is invested in Wise Man Foods. The 15 percent is a measure of which one of the following? A. portfolio return B. portfolio weight C. degree of risk D. price-earnings ratio E. index value

b

The excess return is computed as the: A. return on a security minus the inflation rate. B. return on a risky security minus the risk-free rate. C. risk premium on a risky security minus the risk-free rate. D. the risk-free rate plus the inflation rate. E. risk-free rate minus the inflation rate

b

What is the standard deviation of the returns on a stock given the following information? A. 1.57 percent B. 2.03 percent C. 2.89 percent D. 3.42 percent E. 4.01 percent

b

You are comparing stock A to stock B. Given the following information, what is the difference in the expected returns of these two securities? A. -0.85 percent B. 2.70 percent C. 3.05 percent D. 13.45 percent E. 13.55 percent

b

You own 400 shares of Western Feed Mills stock valued at $51.20 per share. What is the dividend yield if your annual dividend income is $352? A. 1.68 percent B. 1.72 percent C. 1.83 percent D. 1.13 percent E. 1.21 percent

b

Last year, you purchased 500 shares of Analog Devices, Inc. stock for $11.16 a share. You have received a total of $120 in dividends and $7,190 from selling the shares. What is your capital gains yield on this stock? A. 26.70 percent B. 26.73 percent C. 28.85 percent D. 29.13 percent E. 31.02 percent

c

A stock had annual returns of 3.6 percent, -8.7 percent, 5.6 percent, and 12.5 percent over the past four years. Which one of the following best describes the probability that this stock will produce a return of 22 percent or more in a single year? A. less than 0.1 percent B. less than 0.5 percent but greater than 0.1 percent C. less than 1.0 percent but greater the 0.5 percent D. less than 2.5 percent but greater than 0.5 percent E. less than 5 percent but greater than 2.5 percent

d

The common stock of Air United, Inc., had annual returns of 15.6 percent, 2.4 percent, -11.8 percent, and 32.9 percent over the last four years, respectively. What is the standard deviation of these returns? A. 13.29 percent B. 14.14 percent C. 16.50 percent D. 17.78 percent E. 19.05 percent

e

The common stock of Jensen Shipping has an expected return of 14.7 percent. The return on the market is 10.8 percent and the risk-free rate of return is 3.8 percent. What is the beta of this stock? A. .92 B. 1.23 C. 1.33 D. 1.41 E. 1.56

e

The expected return on a portfolio considers which of the following factors? I. percentage of the portfolio invested in each individual security II. projected states of the economy III. the performance of each security given various economic states IV. probability of occurrence for each state of the economy A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, III, and IV

e

Which one of the following best defines the variance of an investment's annual returns over a number of years? A. The average squared difference between the arithmetic and the geometric average annual returns. B. The squared summation of the differences between the actual returns and the average geometric return. C. The average difference between the annual returns and the average return for the period. D. The difference between the arithmetic average and the geometric average return for the period. E. The average squared difference between the actual returns and the arithmetic average return.

e

One year ago, you purchased 500 shares of Best Wings, Inc. stock at a price of $9.75 a share. The company pays an annual dividend of $0.10 per share. Today, you sold all of your shares for $15.60 a share. What is your total percentage return on this investment? A. 38.46 percent B. 39.10 percent C. 39.72 percent D. 62.50 percent E. 61.03 percent

e: Total percentage return = ($15.60 - $9.75 + $0.10)/$9.75 = 61.03 percent