Final Exam Study Guide

It is well known that the stock market efficiently incorporates information. Which of the following statements is incorrect (does not make sense) assuming that the stock market is efficient.

(a) "The reported earnings of Caterpillar was much higher than investors' expectations. Therefore, the Caterpillar stock price increased sharply following the release of the earnings news." (b) "It is expected that the oil price increase will boost profits of Exxon Mobil during the next quarter. Therefore, Exxon Mobil's stock price should appreciate during the next quarter." (c) "Everyone expects the Federal Reserve to announce an increase of the interest rate tomorrow. Therefore, the announcement may not affect stock prices tomorrow." (d) "When the stock prices incorporate information efficiently, stock prices behave like random walks, i.e., their price changes (or returns) are difficult to predict." (e) None of the above statements are incorrect. All of the above statements are reasonable. (b) "It is expected that the oil price increase will boost profits of Exxon Mobil during the next quarter. Therefore, Exxon Mobil's stock price should appreciate during the next quarter."

Which one of the following statements is incorrect?

(a) Based on our cost of capital of 10%, Project A has a NPV of $10,000 and Project B has a NPV of $5,000. We should take Project A and reject Project B. (b) Project A has an IRR of 14% and Project B has an IRR of 12%. Therefore, we should prefer Project A to Project B. (c) Project A has an IRR of 14% and Project B has an IRR of 12%. Given that our cost of capital is 10%, we should take both Project A and Project B. (d) None of the above. (i.e., All of the above statements are correct.) (b) Project A has an IRR of 14% and Project B has an IRR of 12%. Therefore, we should prefer Project A to Project B.

Examine the validity of the following two statements. Statement A: If you are using the NPV rule to evaluate investment projects, you will accept projects only if their NPV is greater than the initial cost of investment. Statement B: Assume that you are comparing 3 prospective, mutually exclusive projects (i.e. you can only select one project). The Net Present Value (NPV) rule and Internal Rate of Return Rule (IRR) rule will always rank the projects in the same order.

(a) Statement A is incorrect. Statement B is correct. (b) Statement A is correct. Statement B is incorrect. (c) Both statements are correct. (d) Both statements are incorrect.

Which statement about the internal rate of return (IRR) is correct?

(a) The goal of a firm should be to use its budget to generate the highest possible IRR for its cash inflows. (b) Comparing the NPV and the IRR will always result in the same ranking of projects. (c) If the Net Present Value (NPV) of a project is zero, the IRR of that project will always be less than the firm's cost of capital (required rate of return). (d) When the NPV of a project is positive, the project's IRR exceeds the firm's required rate of return (the cost of capital). (d) When the NPV of a project is positive, the project's IRR exceeds the firm's required rate of return (the cost of capital).

The following two figures summarize important results of the CAPM. Which one of the following statements is incorrect?

(a) The horizontal axis in Figure A (Axis A) represents the standard deviation (volatility), and the horizontal axis in Figure B (Axis B) represents the Beta. (b) The risk-free rate corresponds to the point C in both figures. (c) According to the CAPM, expected return of the market portfolio corresponds to the point D in both Ögures. (d) According to the CAPM, the market portfolio coincides with the tangency portfolio in Figure A. (e) According to the CAPM, all stocks have to be on or below the Security Market Line (SML) in Figure B. (e) According to the CAPM, all stocks have to be on or below the Security Market Line (SML) in Figure B.

If your portfolio has a beta of one, what rate of return would you expect from the portfolio?

(a) The risk free rate. (b) A rate lower than the risk free rate. (c) Expected return of the market portfolio. (d) Expected return of the market portfolio in excess of the risk free rate (Market risk premium). (e) A rate between the risk free rate and the expected return on the market portfolio. (c) Expected return of the market portfolio.

Which statement about the CAPM is correct?

(a) When two stocks have the same Beta, they must have the same standard deviation. (b) When two stocks have the same Beta, they must have the same systematic risk. (c) Betas are not informative about the risk of stocks. (d) Stocks with high Betas are always preferred to stocks with lower Betas, because they offer higher expected returns. (b) When two stocks have the same Beta, they must have the same systematic risk.

The expected return on the market portfolio is 10% and the risk-free rate is 3%. Chardonnet Inc. has a beta of 1.6. Assume that the CAPM is the correct theory of expected/required returns. If the future return on the Chardonnet is projected to be 13 percent, would you buy the Chardonnet stock?

(a) Yes, Chardonnet stock is a good buy, because its projected return is higher than its theoretical expected/required return. (b) Yes, Chardonnet stock is a good buy, because its projected return is lower than its theoretical expected/required return. (c) No, Chardonnet stock is not a good buy, because its projected return is higher than its theoretical expected/required return. (d) No, Chardonnet stock is not a good buy, because its projected return is lower than its theoretical expected/required return. (e) Indifferent, because Chardonnetís projected return is equal to its theoretical expected/ required return. (d) No, Chardonnet stock is not a good buy, because its projected return is lower than its theoretical expected/required return.

The slope of the security market line (SML) is

(a) equal to one. (b) beta. (c) the market risk premium. (d) the risk free rate. (c) the market risk premium.

Assume that your firm's marginal tax rate is 35% and that your firm has the following capital structure: Debt: (Long term bonds) coupon rate = 6% yield-to-maturity = 8% Market value of bonds = $20 million Book value of bonds = $25 million Common stock: Book value of common shares = $25 million Market value of common shares = $30 million Required rate of return = 12% Your firm's WACC is:

*do NOT use coupon rate or book values* WACC = [20/50 * 8% * (1-0.35)] + (30/50 * 12% = 9.28%

Your firm has a marginal tax rate of 35%. Your firm has the following capital structure: Debt: (Long term bonds) Total face value: $75 million Total market value: $65 million Coupon Rate: 9% Yield to Maturity: 10% Common Equity: Total book value: $80 million Total market value: $120 million dividend yield: 4% Required rate of return (according to CAPM): 18% Your firm's Weighted Average Cost of Capital is:

*do NOT use face value, coupon rate, book value, dividend yield* WACC = [65/185 * 10% * (1-0.35)] + (120/185 *18%) = 13.96%

The market risk premium is 5%. The risk-free rate is 6%. Stock A has a standard deviation of 30%, and the market has a standard deviation of 20%. The correlation coefficient between stock A and the market is 0.8. What is the required return for stock A?

12% Beta = (30% / 20%) *0.8 = 1.2 Required Return = 6 + (1.2*5) = 12%

The stock of Columbia Environment has a beta of 1.2. If the current risk-free rate is 5% and the market risk premium is 6%, then according to the Capital Asset Pricing Model, the required rate of return for this stock should be:

12.2% 5 + (1.2*6) = 12.2%

Suppose that the return on Petit-Syrah's common stock has a standard deviation of 50%, and the return on the market portfolio has a standard deviation of 15%. The expected return of the market portfolio is 12%, and the risk-free rate is 4%. Assume that the Petit-Syrah stock has an expected return of 24% under the CAPM theory. What is the correlation between the Petit-Syrah stock and the Market portfolio?

2.5 * (.15/.50) = 0.75 24 = 4 + Beta * (12-4) so Beta = 2.5 Beta = .50 / .15 = 2.5

A project has a cost of $400 million, and its expected net cash inflows are $100 million per year for 5 years. What is the NPV of this project when the WACC is 10%?

NPV = -20.92 < 0 Reject it. N = 5 I = 10 PMT = 100 FV = 0 ?PV = 379.08 - Initial Investment ($400m)

You are presented a proposal for a project. The project costs $5 million and will produce after-tax cash inflows of $1 million at the end of year 1, $2 million at the end of year 2, and $3million at the end of year 3. What is the NPV of this project if your WACC is 5%?

NPV = 0.358 > 0 Accept it = 1/1.05 + 2/1.05^2 + 1/1.05^3 = 5.358 = 5.358 - 5 = 0.358 *will not be on exam*

Assume a project has the following cash flows (Yr 0 is the initial investment): Yr 0 = 224 Yr 1 = +110 Yr 2 = +110 Yr 3 = +110 If the WACC is 15%, what is the Net Present Value (NPV) of this project?

NPV = 27.15>0 Accept it. N = 3 I = 15 FV = 0 PMT = 110 ?PV = 251.15 - Initial Investment (224)

The expected return on the market portfolio is 10 percent and a risk free interest rate is 2 percent. HoneyBear Inc. has a beta of 1.25. What return must HoneyBear provide investors to compensate them for the systematic risk of the stock? (In other words, what should the expected return of HoneyBear be according to the CAPM?) If the future return on the HoneyBear stock is predcited to be 11 percent, would you buy the HoneyBear stock? Why?

No, because the expected return is lower than the required return. Required Return = 2 + 1.25(10-2) = 12%

Assume that your firm has a cost of equity of 13% and a pre-tax cost debt of 4%. The current tax rate for your firm is 25%. Your firm has never issued, and will not issue preferred stocks. Suppose that the target debt-to-equity ratio of your firm is 0.25. What is the Weighted Average Cost of Capital (WACC) of your firm? Note: The debt-to-equity ratio is: debt/equity = wd/we

Wd = 0.25We Wd + We = 1 so, 0.25We + We = 1.25We = 1 1/1.25 = 0.8 [0.2 * 4 * (1-0.25)] + (0.8 * 13) = 11%