Practical Returns, CAPM, WACC Extra Problems

Your portfolio is comprised of 36 percent of Stock X, 18 percent of Stock Y, and 46 percent of Stock Z. Stock X has a beta of 1.19, Stock Y has a beta of .87, and Stock Z has a beta of 1.26. What is the beta of your portfolio? A) 1.16 B) 1.09 C) 1.13 D) 1.18 E) 1.11

A) 1.16

EXCEL CAN BE HELPFUL: What is the variance of the returns on a portfolio that is invested 40 percent in Stock S and 60 percent in Stock T? Probability of State of Economy: Boom .06; Good .92; Bust .02 Stock S: Rate of Return if State Occurs: Boom .22; Good .15; Bust .26 Stock R: Rate of Return if State Occurs: Boom .18; Good .14; Bust .09 A) .00107 B) .00091 C) .00118 D) .00136 E) .00083

B) .00091

EASY: A stock has an expected return of 13.24 percent, the risk-free rate is 4.4 percent, and the market risk premium is 8.98 percent. What is the stock's beta? A) 1.03 B) .98 C) 1.09 D) 1.11 E) 1.06

B) .98

The Market Outlet is an all-equity financed firm with a beta of 1.08 and a cost of equity of 12.58 percent. The risk-free rate of return is 3.6 percent. What discount rate should the firm assign to a new project that has a beta of 1.22? A) 13.33 percent B) 13.58 percent C) 13.74 percent D) 14.14 percent E) 14.36 percent

C) 13.74 percent

Central Systems desires a weighted average cost of capital of 12.7 percent. The firm has an aftertax cost of debt of 4.8 percent and a cost of equity of 15.4 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? A) .37 B) .42 C) .56 D) .34 E) .44

D) .34

Chelsea Fashions is expected to pay an annual dividend of $1.26 a share next year. The market price of the stock is $24.09 and the growth rate is 2.6 percent. What is the cost of equity? A) 9.77 percent B) 7.91 percent C) 9.24 percent D) 7.83 percent E) 7.54 percent

D) 7.83 percent

The common stock of Jensen Shipping has an expected return of 15.4 percent. The return on the market is 11.2 percent and the risk-free rate of return is 3.6 percent. What is the beta of this stock? A) 1.46 B) 1.23 C) 1.33 D) 1.41 E) 1.55

E) 1.55

Your portfolio has a beta of 1.28. The portfolio consists of 35 percent U.S. Treasury bills, 31 percent Stock A, and 34 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) 2.04 D) 1.84 E) 2.85

E) 2.85

Cookie Dough Manufacturing has a target debt-equity ratio of .76. Its cost of equity is 15.3 percent, and its pretax cost of debt is 9 percent. What is the WACC given a tax rate of 21 percent? A) 11.76 percent B) 12.78 percent C) 13.11 percent D) 11.48 percent E) 12.53 percent

A) 11.76 percent

EASY, EXCEL CAN BE HELPFUL: You own the following portfolio of stocks. What is the portfolio weight of Stock C? Stock A Number of shares 650; per share price $15.82 Stock B Number of shares 320; per share price $11.09 Stock C Number of shares 400; per share price $39.80 Stock D Number of shares 100; per share price $7.60 A) 52.18 percent B) 53.86 percent C) 53.41 percent D) 51.09 percent E) 52.65 percent

A) 52.18 percent

TIME CONSUMING, EXCEL CAN BE HELPFUL: Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 a share. The common stock has a beta of 1.32 and sells for $41 a share. The preferred stock has a stated value of $100 per share. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital? A) 8.09 percent B) 8.64 percent C) 10.18 percent D) 9.30 percent E) 10.56 percent

A) 8.09 percent

Which of the following statements concerning risk are correct? I. Non-diversifiable risk exposure is measured by beta. II. The risk premium increases as diversifiable risk increases. III. Systematic risk is another name for non-diversifiable risk. IV. Diversifiable risks are market risks you cannot avoid. A) I and III only B) II and IV only C) I and II only D) III and IV only E) I, II, and III only

A) I and III only

Which one of the following is least apt to reduce the unsystematic risk of a portfolio? A) Reducing the number of stocks held in a portfolio B) Adding bonds to a stock portfolio C) Adding international securities into a portfolio of U.S. stocks D) Adding U.S. Treasury bills to a risky portfolio E) Adding technology stocks to a portfolio of industrial stocks

A) Reducing the number of stocks held in a portfolio

Which one of the following statements related to WACC is correct for a company that uses debt in its capital structure? A) The WACC would most likely decrease if the firm replaced its preferred stock with debt. B) The weight assigned to preferred stock decreases as the market value of the preferred stock increases. C) The WACC will decrease as the corporate tax rate decreases. D) The weight of equity is based on the number of shares outstanding and the book value per share. E) The WACC will remain constant unless a company retires some of its debt.

A) The WACC would most likely decrease if the firm replaced its preferred stock with debt.

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.

A) can be effectively eliminated by portfolio diversification

The cost of preferred stock: A) is equal to the dividend yield. B) is equal to the yield to maturity. C) is highly dependent on the dividend growth rate. D) is independent of the stock's price. E) decreases when tax rates increase.

A) is equal to the dividend yield.

The intercept point of the security market line is the rate of return which corresponds to: A) the risk-free rate. B) the market rate. C) a return of zero. D) a return of 1.0 percent. E) the market risk premium

A) the risk-free rate.

Tidewater Fishing has a current beta of 1.16. The market risk premium is 6.8 percent and the risk-free rate of return is 2.9 percent. By how much will the cost of equity increase if the company expands its operations such that the company beta rises to 1.18? A) .28 percent B) .14 percent C) .26 percent D) .12 percent E) .43 percent

B) .14 percent

MEDIUM or TIME CONSUMING, EXCEL CAN BE HELPFUL: What is the expected return on this portfolio? Stock A Expected Return .11; Number of shares 200; per share price $18.60 Stock B Expected Return .06; Number of shares 400; per share price $43.90 Stock C Expected Return .17; Number of shares 300; per share price $43.90 A) 11.48 percent B) 13.42 percent C) 12.03 percent D) 11.56 percent E) 13.97 percent

B) 13.42 percent

Miller Stores has an overall beta of 1.38 and a cost of equity of 12.7 percent for the company overall. The firm is all-equity financed. Division A within the firm has an estimated beta of 1.52 and is the riskiest of all of the company's operations. What is an appropriate cost of capital for Division A if the market risk premium is 7.4 percent? A) 13.12 percent B) 13.74 percent C) 12.63 percent D) 12.77 percent E) 13.01 percent

B) 13.74 percent

Theresa's Flower Garden has 650 bonds outstanding that are selling for $1,007 each, 2,100 shares of preferred stock with a market price of $68 a share, and 42,000 shares of common stock valued at $44 a share. What weight should be assigned to the preferred stock when computing the weighted average cost of capital? A) 6.08 percent B) 5.40 percent C) 6.67 percent D) 5.00 percent E) 5.75 percent

B) 5.40 percent

TIME CONSUMING, EXCEL CAN BE HELPFUL: AZ Products has 140,000 shares of common stock outstanding at a market price of $27 a share. Next year's annual dividend is expected to be $1.43 a share and the dividend growth rate is 2 percent. The company also has 2,500 bonds outstanding with a face value of $1,000 per bond. The bonds have a pretax yield of 7.35 percent and sell at 98.2 percent of face value. The company's tax rate is 21 percent. What is the weighted average cost of capital? A) 8.41 percent B) 6.71 percent C) 7.52 percent D) 6.58 percent E) 6.59 percent

B) 6.71 percent

Which one of these will increase a company's aftertax cost of debt? A) A decrease in the company's debt-equity ratio B) A decrease in the company's tax rate C) An increase in the credit rating of the company's bonds D) An increase in the company's beta E) A decrease in the market rate of interest

B) A decrease in the company's tax rate

Which one of the following statements is correct concerning a portfolio beta? A) Portfolio betas range between −1.0 and +1.0. B) A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio. C) A portfolio beta cannot be computed from the betas of the individual securities comprising the portfolio because some risk is eliminated via diversification. D) A portfolio of U.S. Treasury bills will have a beta of +1.0. E) The beta of a market portfolio is equal to zero.

B) A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio.

At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset? I. Asset's standard deviation II. Asset's beta III. Risk-free rate of return IV. Market risk premium A) I and III only B) II and IV only C) III and IV only D) I, III, and IV only E) I, II, III, and IV

B) II and IV only

Southern Bakeries just paid its annual dividend of $.48 a share. The stock has a market price of $17.23 and a beta of .93. The return on the U.S. Treasury bill is 3.1 percent and the market risk premium is 7.6 percent. What is the cost of equity? A) 9.98 percent B) 10.04 percent C) 10.17 percent D) 10.30 percent E) 10.45 percent

C) 10.17 percent

Suppose you observe the following situation: Security A Beta 1.16; Expected Return .1137 Security B Beta .92; Expected Return .0984 Assume these securities are correctly priced. Based on the CAPM, what is the return on the market? A) 9.99 percent B) 11.42 percent C) 10.35 percent D) 9.78 percent E) 11.01 percent

C) 10.35 percent

Dee's Fashions has a growth rate of 3.2 percent and is equally as risky as the market while its stock is currently selling for $32 a share. The overall stock market has a return of 10.9 percent and a risk premium of 6.8 percent. What is the expected rate of return on this stock? A) 10.0 percent B) 9.2 percent C) 10.9 percent D) 11.3 percent E) 11.7 percent

C) 10.9 percent

You own a portfolio that has $2,800 invested in Stock A and $3,250 invested in Stock B. The expected returns on these stocks are 14.7 percent and 9.3 percent, respectively. What is the expected return on the portfolio? A) 12.06 percent B) 12.36 percent C) 11.80 percent D) 11.13 percent E) 11.41 percent

C) 11.80 percent

The expected return on a portfolio: I. can never exceed the expected return of the best performing security in the portfolio. II. must be equal to or greater than the expected return of the worst performing security in the portfolio. III. is independent of the unsystematic risks of the individual securities held in the portfolio. IV. is independent of the systematic risks of the individual securities held in the portfolio. A) I and III only B) II and IV only C) I and II only D) I, II, and III only E) I, II, III, and IV

C) I and II only

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) I, III, and IV only

Which one of the following statements related to risk is correct? A) The beta of a portfolio must increase when a stock with a high standard deviation is added to the portfolio. B) Every portfolio that contains 25 or more securities is free of unsystematic risk. C) The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio. D) Adding five additional stocks to a diversified portfolio will lower the portfolio's beta. E) Stocks that move in tandem with the overall market have zero betas.

C) The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio.

A stock with an actual return that lies above the security market line has: A) more systematic risk than the overall market. B) more risk than that warranted by CAPM. C) a higher return than expected for the level of risk assumed. D) less systematic risk than the overall market. E) a return equivalent to the level of risk assumed.

C) a higher return than expected for the level of risk assumed.

Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the: A) compound rate. B) current yield. C) cost of debt. D) capital gains yield. E) cost of capital.

C) cost of debt.

A company's overall cost of equity is: A) generally less than its WACC given a debt-equity ratio of .5. B) unaffected by changes in the market risk premium. C) directly related to the risk level of the firm. D) generally less than the firm's aftertax cost of debt. E) inversely related to changes in the level of inflation.

C) directly related to the risk level of the firm.

The primary purpose of portfolio diversification is to: A) increase returns and risks. B) eliminate all risks. C) eliminate asset-specific risk. D) eliminate systematic risk. E) lower both returns and risks.

C) eliminate asset-specific risk.

A company's weighted average cost of capital: A) is equivalent to the aftertax cost of the outstanding liabilities. B) should be used as the required return when analyzing any new project. C) is the return investors require on the total assets of the firm. D) remains constant when the debt-equity ratio changes. E) is unaffected by changes in corporate tax rates.

C) is the return investors require on the total assets of the firm.

You have $21,600 to invest in a stock portfolio. Your choices are Stock X with an expected return of 14.3 percent and Stock Y with an expected return of 8.1 percent. Your goal is to create a portfolio with an expected return of 12.5 percent. All money must be invested. How much will you invest in Stock X? A) $15,800 B) $18,273 C) $14,600 D) $15,329 E) $19,208

D) $15,329

You have a $15,000 portfolio which is invested in Stocks A and B, and a risk-free asset. $6,000 is invested in Stock A. Stock A has a beta of 1.63 and Stock B has a beta of .95. How much needs to be invested in Stock B if you want a portfolio beta of 1.10? A) $8,998.90 B) $8,333.33 C) $7,706.20 D) $7,073.68 E) $9,419.27

D) $7,073.68

EXCEL CAN BE HELPFUL: What is the standard deviation of the returns on a portfolio that is invested in Stocks A, B, and C? Twenty percent of the portfolio is invested in Stock A and 35 percent is invested in Stock C. Probability of State of Economy: Boom .04; Good .81; Recession .15 Stock A: Rate of Return if State Occurs: Boom .17; Good .08; Recession .24 Stock B: Rate of Return if State Occurs: Boom .09; Good .06; Recession .02 A) 6.31 percent B) 6.49 percent C) 7.38 percent D) 5.65 percent E) 7.72 percent

D) 5.65 percent

You would like to combine a risky stock with a beta of 1.76 with U.S. Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market. What percentage of the portfolio should be invested in the risky stock? A) 63.3 percent B) 49.6 percent C) 47.2 percent D) 56.8 percent E) 52.0 percent

D) 56.8 percent

Sweet Treats common stock is currently priced at $36.72 a share. The company just paid $2.18 per share as its annual dividend. The dividends have been increasing by 2.2 percent annually and are expected to continue doing the same. What is the cost of equity? A) 9.41 percent B) 9.51 percent C) 8.47 percent D) 8.27 percent E) 8.82 percent

D) 8.27 percent

Which one of the following is the best example of a diversifiable risk? A) Interest rates increase B) Energy costs increase C) Core inflation increases D) A firm's sales decrease E) Taxes decrease

D) A firm's sales decrease

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 65 percent of the company's overall sales. Division A is also the riskier of the two divisions. 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 larger 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 company's weighted average cost of capital. D) assign appropriate, but different, 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 65 percent of the funds to Division A and 35 percent of the funds to Division B.

D) assign appropriate, but different, discount rates to each project and then select the projects with the highest net present values.

A company's current cost of capital is based on: A) only the return required by the company's current shareholders. B) the current market rate of return on equity shares. C) the weighted costs of all future funding sources. D) both the returns currently required by its debtholders and stockholders. E) the company's original debt-equity ratio.

D) both the returns currently required by its debtholders and stockholders

The reward-to-risk ratio for Stock A is less than the reward-to-risk ratio of Stock B. Stock A has a beta of .82 and Stock B has a beta of 1.29. This information implies that: A) Stock A is riskier than Stock B and both stocks are fairly priced. B) Stock A is less risky than Stock B and both stocks are fairly priced. C) either Stock A is underpriced or Stock B is overpriced or both. D) either Stock A is overpriced or Stock B is underpriced or both. E) both Stock A and Stock B are correctly priced since Stock A is less risky than Stock B.

D) either Stock A is overpriced or Stock B is underpriced or both.

HARD or TIME CONSUMING, EXCEL CAN BE HELPFUL: Your portfolio is invested 25 percent each in Stocks A and C, and 50 percent in Stock B. What is the standard deviation of your portfolio given the following information? Probability of State of Economy: Boom .07; Good .55, Poor .36; Bust .02 Stock A: Rate of Return if State Occurs: Boom .28; Good .19, Poor .21; Bust .65 Stock B: Rate of Return if State Occurs: Boom .14; Good .12, Poor .07; Bust .03 Stock C: Rate of Return if State Occurs: Boom .11; Good .09, Poor .06; Bust .03 A) 6.52 percent B) 9.64 percent C) 12.72 percent D) 10.89 percent E) 7.39 percent

E) 7.39 percent

EXCEL CAN BE HELPFUL: Suppose you observe the following situation: Probability of State of Economy: Boom .21; Good .74; Recession .05 Stock A: Rate of Return if State Occurs: Boom .189; Good .158; Recession .246 Stock B: Rate of Return if State Occurs: Boom .097; Good .076; Recession .042 Assume the capital asset pricing model holds, both stocks are correctly priced, and Stock A's beta is greater than Stock B's beta by .84. What is the expected market risk premium? A) 8.28 percent B) 9.05 percent C) 10.06 percent D) 7.94 percent E) 7.81 percent

E) 7.81 percent

HARD or TIME CONSUMING, EXCEL CAN BE HELPFUL: Consider the following information on three stocks: State of Economy Probability of State of Economy Rate of Return if State Occurs Probability of State of Economy: Boom .25; Normal .65, Bust .10 Stock A: Rate of Return if State Occurs: Boom .27; Normal .14; Bust −.19 Stock B: Rate of Return if State Occurs: Boom .15; Normal .11; Bust −.04 Stock C: Rate of Return if State Occurs: Boom .11; Normal .09; Bust .05 A portfolio is invested 45 percent each in Stock A and Stock B and 10 percent in Stock C. What is the expected risk premium on the portfolio if the expected T-bill rate is 3.2 percent? A) 11.47 percent B) 12.38 percent C) 1.67 percent D) 4.29 percent E) 8.71 percent

E) 8.71 percent

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) I, II, III, and IV

Which one of the following is represented by the slope of the security market line? A) Return on a risky security B) Market standard deviation C) Beta coefficient D) Risk-free interest rate E) Market risk premium

E) Market risk premium

The common stock of Alpha Manufacturers has a beta of 1.24 and an actual expected return of 13.25 percent. The risk-free rate of return is 3.7 percent and the market rate of return is 11.78 percent. Which one of the following statements is true given this information? A) The actual expected stock return will graph above the security market line. B) The stock is currently underpriced. C) To be correctly priced according to CAPM, the stock should have an expected return of 13.56 percent. D) The stock has less systematic risk than the overall market. E) The actual expected stock return indicates the stock is currently overpriced.

E) The actual expected stock return indicates the stock is currently overpriced.

The capital asset pricing model approach to equity valuation: A) is dependent upon the unsystematic risk of a security. B) assumes the reward-to-risk ratio increases as beta increases. C) can only be applied to dividend-paying firms. D) assumes a firm's future risks will be higher than its current risks. E) assumes the reward-to-risk ratio is constant.

E) assumes the reward-to-risk ratio is constant.

The weighted average cost of capital for a company is least dependent upon the: A) company's beta. B) coupon rate of the company's outstanding bonds. C) growth rate of the company's dividends. D) company's marginal tax rate. E) standard deviation of the company's common stock.

E) standard deviation of the company's common stock.

The discount rate assigned to an individual project should be based on: A) the company's overall weighted average cost of capital. B) the actual sources of funding used for the project. C) an average of the company's overall cost of capital for the past five years. D) the current risk level of the overall firm. E) the risks associated with the use of the funds required by the project.

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

The primary advantage of using the dividend growth model to estimate a company's cost of equity is: A) the ability to apply either current or future tax rates. B) the model's applicability to all corporations. C) is the model's consideration of risk. D) the stability of the computed cost of equity over time. E) the simplicity of the model.

E) the simplicity of the model.