Chapter012(2)

CHAPTER 12 Risk, Cost of Capital, and Capital Budgeting Multiple Choice Questions: I.

DEFINITIONS

WACC e 1.

a. b. b. c. d. e.

The The wei weigh ghte ted d aver averag agee of of the the firm firm’s ’s cost costss of of equi equity ty,, prefe preferr rred ed sto stock ck,, and and aft after er tax tax debt debt is the: rewa reward rd to to ris risk k rat ratio io for for the the firm firm.. expe expect cted ed cap capit ital al gai gains ns yie yield ld for for the the sto stock ck.. expe expect cted ed capi capita tall gain gainss yie yield ld for for the the firm firm.. port portfo foli lio o beta beta for for the the firm firm.. weig weight hted ed ave avera rage ge cos costt of capi capita tall (WAC (WACC) C)..

Difficulty level: Easy CAPM

b

2. a. b. c. d. e.

If the the CAPM CAPM is is use used d to to est estim imat atee the the cost cost of equ equit ity y cap capit ital al,, the the exp expec ecte ted d exc exces esss mar marke kett ret retur urn n is is equal to the: retu return rn on the the sto stock ck minu minuss the the risk risk-f -free ree rate rate.. differ differenc encee betwee between n the return return on the the marke markett and the risk-f risk-free ree rate rate.. beta beta time timess the the mark market et risk risk prem premiu ium. m. beta beta time timess the the risk risk-f -fre reee rate rate.. market rat rate of ret return. rn.

Difficulty level: Easy CHARACTERISTIC LINE

c

3. a. b. c. d. e.

The The bes bestt fit fit line line of a pai pairw rwis isee plot plot of the the ret retur urns ns of the the sec secur urit ity y aga again inst st the the mark market et inde index x returns is called the: Security Market Line. Capital Market Line. characteris ristic line. risk line. None of the above.

Difficulty level: Medium USE OF DEBT

c

4. a. b. c. d. e.

The use of debt is called: operating le leverage. production lev leveerage. financial le leverage. total otal asse assett tu turnov rnover er risk risk.. business risk.

Difficulty level: Medium

12-1

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WEIGHTED AVERAGE COST OF CAPITAL b 5. The The wei weigh ghte ted d av averag eragee co cost of cap capiital tal fo for a firm firm is the the: a. discount discount rate which which the the firm firm should should apply to all all of of the the projects projects it undert undertakes akes.. b. overall overall rate rate which which the the firm firm must must earn on its its existin existing g assets assets to to maintain maintain the value value of its stock. c. rate rate the the firm firm shoul should d expec expectt to pay on its its next next bon bond d issue issue.. d. maximu maximum m rate rate which which the firm firm should should requ require ire on on any proje projects cts it it undert undertake akes. s. e. rate of of return return that that the firm’s firm’s preferred preferred stockhold stockholders ers should should expect expect to earn over the the long long term. Difficulty level: Medium II.

CONCEPTS

WACC

a

6. a. b. c. d. e.

The The WAC WACC C is is use used d to to ___ _____ ____ __ the the exp expec ecte ted d cas cash h flo flows ws when when the the fir firm m has has ____ ______ ____ ____ ____ __ . disc discou ount nt;; debt debt and and equ equit ity y in the the cap capit ital al str struc uctu ture re discou discount; nt; short short term term fin financ ancing ing on the balanc balancee shee sheett incr increa ease se;; debt debt and and equ equit ity y in the the capi capita tall stru struct ctur uree decr decrea ease se;; shor shortt term term fin finan anci cing ng on on the the bala balanc ncee shee sheett None of the above.

Difficulty level: Medium CAPM

d

7. a. b. c. d. e.

Usin Using g the the CAPM CAPM to to cal calcu cula late te the the cos costt of of capi capita tall for for a risk risky y proj projec ectt assu assume mess tha that: t: using using the firm's firm's beta beta is the same same measu measure re of of risk risk as as the the proje project. ct. the the fir firm m is is all all-e -equ quit ity y fin finan ance ced. d. the the fin finan anci cial al risk risk is equa equall to to bus busin ines esss ris risk. k. Both A and B. Both A and C.

Difficulty level: Medium WACC

c

8. a. b. c. d. e.

The use of WAC WACC C to to sel selec ectt inv inves estm tmen ents ts is acce accep ptabl tablee whe when n th the: corr correl elat atio ion n of of all all new new pro proje ject ctss are are equa equal. l. NPV NPV is posi positi tive ve whe when n disc discou ount nted ed by by the the WACC WACC.. risk risk of of the the proj projec ects ts are are equ equal al to to the the risk risk of of the the firm firm.. firm firm is well well divers diversifi ified ed and and the the unsyst unsystema ematic tic risk risk is negl negligi igible ble.. None of the above.

Difficulty level: Easy





















DISCOUNT RATE

b

9. a. b. c. d. e.

If the the ris risk k of of an an inv inves estm tmen entt pro proje ject ct is diff differ eren entt tha than n the the firm firm's 's risk risk then then:: you must must adjust adjust the the discou discount nt rate rate for for the the projec projectt based based on the the firm' firm'ss risk. risk. you must must adjust adjust the the disco discount unt rate rate for for the the projec projectt based based on the the proje project ct risk. risk. you must must exerc exercise ise risk risk aver aversio sion n and and use use the the market market rate. rate. an average average rate rate across across prior prior project projectss is is accepta acceptable ble because because estima estimates tes contain contain errors. errors. one must must have have the the actua actuall data data to deter determin minee any diff differe erence ncess in the the calcul calculati ations ons..

Difficulty level: Easy SECURITY MARKET LINE

a

10. 10. a. b. c. d. e.

If the the pro proje ject ct bet betaa and and IRR IRR coor coordi dina nate tess plot plot abov abovee the the SML SML the the proj project ect shou should ld be: be: accepted. rejected. It is is im impossible to to te tell. It wil willl depen epend d on the NPV NPV.. None of the above.

Difficulty level: Medium BETA

d

11. a. b. c. d. e.

The be beta of of a security pr provides an an: esti estima mate te of the the mar marke kett ris risk k pre premi mium um.. esti estima mate te of of the the slop slopee of the the Cap Capit ital al Mar Marke kett Line Line.. esti estima mate te of of the the slo slope pe of of the the Secu Securi rity ty Mar Marke kett Lin Line. e. esti estima mate te of of the the syst system emat atic ic ris risk k of the the secu securi rity ty.. None of the above.

Difficulty level: Easy BETA ESTIMATION

a

12. 12. a. b. c. d. e.

Reg Regress ressiion anal analy ysis sis ca can be used sed to esti estima matte: beta. the ri risk-free ra rate. standard deviation. variance. expected return.

Difficulty level: Easy BETA

d

13. a.

Beta measures depe epend highly on the: dire direct ctio ion n of of the the mark market et vari varian ance ce..
























BETA

b

14. a. b. c. d. e.

The formul formulaa for for calc calcula ulatin ting g beta beta is given given by the dividi dividing ng the ______ _________ _____ __ of the stock stock with with the market portfolio by the ___________ of the market portfolio. variance; covariance covaria riance; variance stan standa dard rd devi deviat atio ion; n; vari varian ance ce expec xpecte ted d ret retur urn; n; var varianc iancee expec xpecte ted d ret retur urn; n; cov covaria arianc ncee

Difficulty level: Medium BETA AND CHARACTERISTIC LINE

b

15. 15. a. b. c. d. e.

The The slo slope pe of the the cha chara ract cter eris isti ticc lin linee is is the the esti estima mate ted: d: intercept. beta. unsystematic ri risk. market va variance. market ri risk pr premium.

Difficulty level: Medium CYCLICAL BUSINESS AND BETA

b

16. 16. a. b. c. d. e.

Compan Comp anie iess tha thatt hav havee hig highl hly y cyc cycli lica call sal sales es will will have have a: low beta beta if sales sales are highl highly y depe depende ndent nt on the the mark market et cycl cycle. e. high high beta beta if if sales sales are highl highly y depen dependen dentt on the market market cycle. cycle. high high bet betaa if sal sales es are are ind indep epen ende dent nt on on the the mark market et cyc cycle le.. All of the above. None of the above.

Difficulty level: Medium INDUSTRY OR FIRM BETA

b

17.

Betas Betas may vary vary subs substan tantia tially lly across across an indust industry. ry. The decisi decision on to use the indust industry ry or firm firm beta beta:: to estimate the cost of capital depends on











e.

company's mar market rat rate.

Difficulty level: Medium PROJECT AND FIRM BETA

c

19. a. b. c. d. e.

For a mult multi-p i-prod roduct uct firm, firm, if a proj project ect's 's beta beta is is diff differe erent nt from from that that of the overal overalll firm firm,, then then the: the: CAPM CAPM can can no longe ongerr be used sed. projec projectt shoul should d be discou discounte nted d using using the overal overalll firm' firm'ss beta. beta. projec projectt should should be disc discoun ounted ted at at a rate rate commen commensur surate ate with with its own own beta. beta. proj projec ectt shou should ld be be disc discou ount nted ed at at the the mark market et rat rate. e. proj projec ectt shou should ld be be disc discou ount nted ed at at the the T-bi T-bill ll rat rate. e.

Difficulty level: Medium FIRM’S BETA

e

20. a. b. c. d. e.

The proble problem m of of usin using g the the overal overalll firm firm's 's beta beta in in disc discoun ountin ting g proj project ectss of of diffe differen rentt risk risk is the: the: firm firm wou would ld accep acceptt too too many many high high-r -ris isk k pro proje ject cts. s. firm firm wou would ld rejec rejectt too too many many low low risk risk pro proje ject cts. s. firm firm wou would ld rejec rejectt too too many many high high-r -ris isk k proj project ects. s. firm firm wou would ld accep acceptt too too many many low low ris risk k proj projec ects ts.. Both A and B.

Difficulty level: Medium ASSET BETA

e

21. 21. a. b. c. d. e.

The ass asset beta eta of a lever evered ed firm irm is is gen general erally ly:: equal to to th the eq equity be beta. diff differ eren entt fro from m the the equi equity ty beta beta.. diff ifferen erentt fro from m the the debt ebt bet beta. a. the the simp simple le ave avera rage ge of of the the equi equity ty bet betaa and and debt debt bet beta. a. Both B and C.












b. c. d. e.

Operating le leverage Financial leverage All of the above. None of the above.












FACTORS AFFECTING BETA

b

24. 24. a. b. c. d. e.

The The bet betaa of of a firm firm is more more like likely ly to be high high unde underr wha whatt two two cond condit itio ions ns?? High High cycl cyclica icall busi busines nesss acti activit vity y and and low low oper operati ating ng levera leverage ge High High cycli cyclical cal busine business ss acti activit vity y and and high high oper operati ating ng leve leverag ragee Low cyclic cyclical al busine business ss activi activity ty and low financ financial ial levera leverage ge Low cyclic cyclical al bus busine iness ss acti activit vity y and and low low operat operating ing levera leverage ge None of the above.

Difficulty level: Medium CYCLICAL EARNINGS

a

25. 25. a. b. c. d. e.

A fir firm m wit with h cy cycli clical cal ear earn nings ings is char charac acte teri rize zed d by by: reve revenu nuee patt patter erns ns tha thatt vary vary wit with h the the busi busine ness ss cyc cycle le.. high high leve levels ls of of debt debt in its its capi capita tall str struc uctu ture re.. high fixed costs. high pr price pe per un unit. low cont contri rib butio ution n mar margi gins ns..

Difficulty level: Medium OPERATING LEVERAGE

c

26. a. b. c. d. e.

A fi firm wi with hi high op operating le leverage ha has: low low fix fixed ed cost costss in in its its prod produc ucti tion on proc proces ess. s. high high var varia iabl blee cost costss in its its prod produc ucti tion on pro proce cess ss.. high high fixe fixed d cos costs ts in its its pro produ duct ctio ion n pro proce cess ss.. high pr price pe per un unit. low price per unit.

Difficulty level: Medium OPERATING LEVERAGE

a

27.

If a firm firm has low fixed fixed costs costs relati relative ve to all other other firms firms in the same same indu industr stry, y, a large large change change in sales volume (either up or down) would have: all han in EBIT EBIT for the fir us the the oth other er firm firm























OPERATING AND FINANCIAL LEVERAGE

c

28. 28. a. b. c. d. e.

A firm firm wit with h high high ope opera rati ting ng lev lever erag agee is cha chara ract cter eriz ized ed by by ____ ______ ____ ____ __ whi while le one one wit with h high high financial leverage is characterized by __________. low fixed fixed cost cost of produc productio tion; n; low fixed fixed financ financial ial costs costs high high varia variable ble cos costt of prod product uction ion;; high high vari variabl ablee financ financial ial cost costss high high fixed fixed costs costs of prod product uction ion;; high high fixed fixed financ financial ial costs costs low costs costs of produc productio tion; n; high high fixe fixed d fina financi ncial al costs costs high high fixed fixed costs costs of prod product uction ion;; low low variab variable le fin financ ancial ial costs costs

Difficulty level: Medium DETERMINANTS OF BETA

b

29. a. b. c. d. e.

Firms Firms whose whose reve revenue nuess are are strong strongly ly cyclic cyclical al and whose whose operat operating ing levera leverage ge is high high are are like likely ly to have: low betas. high betas. zero betas. negative betas. None of the above.

Difficulty level: Medium DETERMINANTS OF BETA

e

30. 30.

An ind indu ustry stry is lik likel ely y to to ha have a low low beta beta if the the::











e.

Both A and C.

Difficulty Level: Challenge LIQUIDITY

d

33. 33. a. b. c. d. e.

Two Two stoc stock k mark market et bas based ed cos costs ts of of liqu liquid idit ity y that that aff affec ects ts the the cos costt of capi capita tall are are the: the: bidbid-as ask k spr sprea ead d and and the the spe speci cial alis istt spr sprea ead. d. mark market et imp impac actt cost cost and and the the bro broke kera rage ge cos costs ts.. invest investor or opport opportuni unity ty cost cost and and the broker brokerage age costs. costs. bidbid-as ask k sprea spread d and and the the mark market et imp impac actt cost costs. s. None of the above.

Difficulty Level: Medium ADVERSE SELECTION

b

34. 34. Wh When en a spe speci cial alis istt is cau caugh ghtt in the the mid middl dlee of a tra trade de bet betwe ween en an an info inform rmed ed and and an an unif unifor orme med d traders which effectively eliminates the spread or causes a loss is subject to: a. marke rket impact costs. b. adverse selection. c. brok roker's er's quot quotat atio ion n bi bias. as. d. incr increa easi sing ng the the num numbe berr of uni uninf nfor orme med d trad trader ers. s. e. None of the above.

Difficulty Level: Challenge





















WEIGHTED AVERAGE COST OF CAPITAL d 36. Peter’ Peter’ss Audi Audio o Shop Shop has a cost cost of of debt debt of 7%, 7%, a cost cost of equity equity of 11%, 11%, and a cost cost of pref preferr erred ed stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter’s Audio Shop? a. 6.14% b. 6.54% c. 8.60% d. 9.14% e. 9.45% Difficulty level: Medium WEIGHTED AVERAGE COST OF CAPITAL c 37. Phil’s Phil’s Carvin Carvings gs,, Inc. Inc. want wantss to have have a weig weighte hted d avera average ge cost cost of capita capitall of of 9%. 9%. The The firm firm has an after-tax cost of debt of 5 %and a cost of equity of 11%. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? a. .33 b. .40 c. .50 d. .60 e. .67 Difficulty level: Medium











Difficulty level: Easy CAPM

a

40. 40.

a. b. c. d. e.

Assu Assumi ming ng the the CAPM CAPM or or one-f one-fac acto torr mode modell hold holds, s, wha whatt is the the cost cost of of equi equity ty for for a fir firm m if the the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the market is 9%, and the return to the company's debt is 7%? 10.4% 10.8% 12.8% 14.4% None of the above.

Difficulty level: Medium EQUITY BETA

b

41. 41. a. b. c. d. e.

The The cost cost of of equi equity ty for for Rya Ryan n Corp Corpor orat atio ion n is 8.4% 8.4%.. If the the exp expec ecte ted d retu return rn on on the the mark market et is is 10% 10% and the risk-free rate is 5%, then the equity beta is ___. 0.48 0.68 1.25 1.68 Impo Imposs ssib ible le to to calc calcul ulat atee with with inf infor ormat matio ion n give given. n.
























ASSET BETA

a

44. a. b. c. d. e.

Slippe Slippery ry Slope Slope Roof Roof Cont Contrac ractin ting g has has an an equi equity ty beta beta of of 1.2, 1.2, capita capitall stru structu cture re with with 2/3 2/3 debt, debt, and and a zero tax rate. What is its asset beta? 0.40 0.72 1.20 1.80 None of the above

Difficulty level: Medium ASSET BETA

e

45. 45.

The The Temp Templa late te Cor Corpo pora rati tion on has has an an equi equity ty bet betaa of 1.2 1.2 and and a debt debt bet betaa of .8. .8. The The fir firm' m'ss mark market et value debt to equity ratio is .6. Template has a zero tax rate. What is the asset beta?





















IV.

ESSAYS

BETA AND COVARIANCE

47. Given Given the sample sample of returns returns of the Top Black Black Asphalt Asphalt Company Company and and the S&P 500 index, index, calcula calculate te Top Black's covariance and beta. Rs(Top Black) +15% + 6% -10% 0% 4%

Rm(Market) +8% +2% -7% 3% 2%























BETA

49. Eyes of the World World Corporatio Corporation n has traditional traditionally ly employed employed a firm wide discount discount rate rate for capital capital budgeting purposes. However, its two divisions – publishing and entertainment - have different degrees of risk given by ßP = 1.0, ßE = 2.0, and the beta f or the overall firm is 1.3. The firm is considering the following capital expenditures:





















BETA

51. Explain Explain the factors factors that that determine determine beta beta and how an asset asset beta can differ differ from from equity equity betas. betas. Operating leverage Cyclicality of revenues











SOLUTIONS TO TEST BANK PROBLEMS Chapter 12

Chapter012(2)

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