Week 6 Assignment (ch. 12 & 13) FIN600

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Week 6 Assignment (ch. 12 & 13) FIN600 Chapter 12 1) If a stock tends to rise in value in response to news that inflation is exceeding expectations, the stock has a: A) zero inflation beta. B) positive inflation beta. C) beta that exactly matches the market beta. D) negative inflation beta. E) beta equal to the risk-free beta. Answer: 2) Assume a security has a GNP beta of 1.3. Accordingly, the security's total rate of return will: A) increase by 1.3 percent for every 1 percent decrease in GNP. B) increase by 1.3 percent every time the GNP increases by 1.3 percent. C) change by 1.3 times the percentage amount of any unexpected change in GNP. D) change by the unexpected percentage change in GNP divided by 1.3. E) increase by 1.3 percent whenever the GNP increases by 1.3 percent. Answer: 3) If the expected rate of GNP growth was 4 percent and the actual rate was .3 percent higher than the expectation, the total return on a stock would change by ____ based on a multifactor model. A) 4.3β GNP B) .3β GNP C) −.3β GNP D) −4.3β GNP E) 4β GNP Answer: 4) A three-factor model of a security’s return would most likely include factors such as: A) tax rates, inflation, and profit margin. B) PE ratio, price-to-book ratio, and firm size. C) firm size, inflation, and GNP. D) inflation, GNP, and interest rates. E) GNP, interest rates, and PE ratios. Answer: 5) A beta coefficient reflects the response of a security's return to: A) the risk-free rate. B) an unsystematic risk. C) a systematic risk. D) the market rate of return. E) idiosyncratic risk. Answer:

6) Which one of the following statements is true? A) A well-diversified portfolio has negligible systematic risk. B) A well-diversified portfolio has negligible unsystematic risk. C) An individual security has negligible systematic risk. D) An individual security has negligible unsystematic risk. E) Both a well-diversified portfolio and an individual security have negligible unsystematic risk. Answer: 7) The single-factor model generally uses ___ as the single factor. A) arbitrage fees B) GNP C) the inflation rate D) the market risk premium E) the risk-free return Answer: 8) A growth-stock portfolio is probably best characterized as having a: A) high PE ratio relative to the overall market. B) lower risk premium than the overall market. C) low level of systematic risk and a high level of unsystematic risk. D) low PE ratio relative to the overall market. E) lower beta than the overall market. Answer: 9) Assume a one-factor model where the factor is associated with the overall market. Suppose McTavish common stock has a factor beta of .8, the risk-free rate is 3.2 percent, and the expected market rate of return is 11.2 percent. What is the expected return for the stock? A) 10.25% B) 6.40% C) 7.20% D) 9.60% E) 12.16% Answer: 10) Which type of risk is unaffected by portfolio diversification? A) Unsystematic risk B) Idiosyncratic risk C) Total risk D) Systematic risk E) All types of risk are affected by portfolio diversification. Answer:

Chapter 13 11) If a firm issues new stock to fund a project, the firm should expect the issuance to: A) have no effect on the previous shareholders. B) create costless benefits for the firm. C) cause any potential gains to the firm from the project to be lost. D) affect future dividends but not the appreciation realized by previous shareholders. E) dilute the capital gains that would have been earned by the previous shareholders. Answer: 12) An all-equity firm is evaluating a capital project that has the same level of risk as the firm. The project should be accepted if its: A) internal rate of return exceeds the firm’s cost of equity capital. B) expected rate of return exceeds the market rate of return. C) anticipated rate of return exceeds the firm’s return on assets. D) internal rate of return is positive given this level of risk. E) expected rate of return exceeds the risk-free rate. Answer: 13) With respect to the CAPM, which one of the following statements is correct? A) The CAPM is the only available method for determining an appropriate discount rate for a proposed project. B) The market rate of return is most commonly based on the forecasted return on the market for the next 5-year period. C) CAPM is used quite frequently by firms in their capital budgeting processes. D) The expected return on the 30-year U.S. Treasury bond is the most commonly used as the risk-free rate of return. E) An increase in the risk-free rate combined with a beta greater than 1.0 increases the discount rate computed using the CAPM. Answer: 14) When estimating the cost of equity using the DDM, the factor that is the most apt to add error to this estimate is the: A) value of the last dividend. B) firm’s tax rate. C) historical beta. D) dividend growth rate. E) current stock price. Answer: 15) With respect to beta, which one of the following statements is correct? A) Firm betas have less error than industry betas. B) Firms should always rely on their own beta rather than their industry’s beta. C) Beta is unaffected by a firm’s capital structure.

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D) The sample size used to compute beta may be too small to yield a reliable result. E) Firm betas rarely vary over time. Answer: 16) Assume you plotted the monthly returns for both a stock and the S&P 500. Using regression analysis, the straight line through these points that is developed by the analysis is referred to as the ______ which has a slope of _____ and an intercept of ______. A) security market line; alpha; gamma B) characteristic line; beta; alpha C) characteristic line; alpha; beta D) security market line; beta; gamma E) characteristic line; gamma; alpha Answer: 17) If two firms are equivalent in all other respects, an analyst should expect the beta of the levered firm’s common stock to be _____ the beta of the unlevered firm’s the common stock. A) roughly equivalent to B) significantly less than C) slightly less than D) greater than E) equal to Answer: 18) The beta of a firm is most likely to be high under which of the following conditions? A) High cyclical business activity and low operating leverage B) High cyclical business activity and high operating leverage C) Low cyclical business activity and low financial leverage D) Low cyclical business activity and low operating leverage E) Low financial leverage and low operating leverage Answer: 19) A firm with cyclical earnings is characterized by: A) revenue patterns that vary with the business cycle. B) high levels of debt in its capital structure. C) high fixed costs. D) high costs per unit. E) low contribution margins. Answer: 20) Wyatt Materials is equivalent to other firms in its industry in all ways but one: Wyatt has much lower fixed costs than its peers. Accordingly, an analyst should expect Wyatt to have: A) a lower beta than its industry. B) the same beta as the industry but a lower beta than the other firms in the industry. C) a higher beta than its industry. D) a higher beta than the industry and all the firms within that industry. E) the same beta as the industry but a higher beta than the other firms in the industry.

Answer: 21) An industry is likely to have a low beta if the: A) stream of revenues within that industry is less volatile than the market. B) economy is in a recessionary period. C) market for its goods is highly affected by the market cycle. D) number of firms within the industry is fairly constant. E) industry tends to use a lot of debt financing. Answer: 22) For a levered firm the equity beta is _____ the asset beta. A) greater than B) less than C) equal to D) sometimes greater than and sometimes less than E) unrelated to Answer: 23) The CAPM has an advantage over the DDM because the CAPM: A) explicitly adjusts for risk. B) applies to firms that pay dividends. C) has no measurement risk. D) specifically considers a firm’s rate of growth. E) ignores changes in the overall market over time. Answer: 24) Yu and De Leon is evaluating a project that has a different level of risk than the overall firm. This project should be evaluated: A) using the market beta. B) using the overall firm’s beta. C) using a beta commensurate with the project’s risks. D) at the market rate of return. E) at the T-bill rate of return. Answer: 25) The discount rate applied to an individual project should be based on the: A) sources of funding for that project. B) risks associated with the project’s cash flows. C) sponsoring firm’s average level of risk. D) expertise of the project’s managers. E) size and duration of the project’s life. Answer:

26) If a firm applies its overall firm beta to projects with varying levels of risk, the firm will tend to: A) reject the riskiest projects. B) accept all low-risk projects. C) accept only projects of equal risk to its current operations. D) remain at its current level of overall risk. E) become riskier over time. Answer: 27) Tedjo, Incorporated, is considering a project that is markedly different from its current operations. An analyst at Tedjo has located the beta of a firm that is a good example of a pure play for this new project. Although it is a good fit, why might Tedjo assign a higher beta to the project than the beta of the pure play? A) Tedjo should assign a project beta that is based on the average of Tedjo and the pure play firm’s betas. B) The expected project revenues may be less cyclical than those of the pure play firm. C) Tedjo may use less debt in its operations than does the pure play firm. D) The pure play firm has more experience in the new area than Tedjo does. E) The project may incur flotation costs so a higher beta is warranted to offset the additional cost. Answer: 28) The cost of preferred stock: A) should be adjusted for taxes when computing WACC. B) is ignored by all firms when computing WACC. C) is generally calculated using the overall firm’s beta. D) is equal to the stock’s dividend yield. E) is set equal to the pretax cost of debt since it is a fixed income security. Answer: 29) Baumgartner’s already has debt outstanding but will issue new debt in order to expand. The best estimate of the pretax cost of the new debt is the _____ of the already outstanding debt. A) original yield to maturity B) current yield to maturity C) embedded cost D) current yield E) coupon rate Answer: 30) When computing WACC, an analyst should use the: A) pretax cost of debt because most corporations pay taxes at the same tax rate. B) pretax cost of debt because it is the actual rate the firm is paying its bondholders. C) current yield because it is based on the current market price of debt. D) aftertax cost of debt because interest is partially, if not fully, tax deductible. E) pretax yield to maturity because it considers the current market price of debt. Answer:

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31) All else held constant, which one of the following actions is most likely to increase the WACC of a levered firm? A) An increase in the weight of debt B) A decrease in a firm’s equity beta C) A decrease in the dividend growth rate D) A decrease in the tax rate E) An increase in the risk-free rate when the equity beta exceeds 1.0 Answer: 32) What is the cost of equity for a firm that has a beta of 1.22 if the risk-free rate of return is 1.4 percent and the expected market return is 6.6 percent? A) 6.60% B) 7.74% C) 8.27% D) 7.60% E) 2.03% Answer: 33) Lancaster recently paid its annual dividend of $4.20 per share. At that time, the firm announced that all future dividends will be increased by 5.5 percent annually. What is the firm’s cost of equity if the stock is currently selling for $51.75 per share? A) 13.62% B) 8.11% C) 8.55% D) 14.06% E) 4.95% Answer: 34) The cost of equity for Chang Corporation is 8.4 percent and the debt-equity ratio is .6. The expected return on the market is 10.4 percent and the risk-free rate is 3.8 percent. Using the common assumption for the debt beta, what is the asset beta? A) .70 B) .44 C) .62 D) .67 E) .59 Answer: 35) Alpha, Incorporated, has an overall cost of capital of 11.6 percent and a beta of 1.31. The firm is contemplating a new project that is unrelated to the firm’s current operations. Omega Corporation is a firm that operates similarly to the new project and Omega has a cost of capital of 10.7 percent. Alpha knows that it will be less efficient than Omega and thus feels

that an adjustment of +1 percentage point should be added to the project’s discount rate to allow for this inefficiency. What discount rate should be assigned to the new project? Answer: 36) Counterweight Company has debt outstanding with a coupon rate of 4.5 percent and a yield to maturity of 7.5 percent. What is the aftertax cost of debt if the tax rate is 22 percent? Assume all interest is tax deductible. Answer: 37) Tiara Events has an aftertax cost of debt of 5.1 percent at its current tax rate of 34 percent. What will its aftertax cost of debt be if the tax rate drops to 21 percent? Assume all interest is tax deductible. A) 6.10% B) 5.92% C) 6.17% D) 4.03% E) 4.47% Answer: 38) Harvey Machinery has 80 bonds outstanding that are selling at their par value of $1,000 each. Bonds with similar characteristics are yielding a pretax 8.6 percent. The firm also has 4,000 shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 per share. The U.S. T-bill is yielding 4 percent, the market risk premium is 8 percent, and the firm’s tax rate is 21 percent. What is the firm’s weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense? Answer: 39) Zachary Confections has a yield to maturity on its debt of 7.8 percent, a cost of equity of 12.4 percent, and a cost of preferred stock of 8 percent. The firm has 105 shares of common stock outstanding at a market price of $22 per share. There are 25 shares of preferred stock outstanding at a market price of $45 per share. The bond issue has a total face value of $1,500 and sells at 98 percent of face value. If the tax rate is 21 percent, what is the weighted average cost of capital assuming all interest is tax deductible? Answer: 40) Jahzeel’s wants to have a weighted average cost of capital of 9.5 percent. The firm has an aftertax cost of debt of 6.5 percent and a cost of equity of 12.75 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? Answer:

41) Brick and Mortar has 200 shares of common stock outstanding at a market price of $37 per share. The firm recently paid an annual dividend in the amount of $1.20 per share and has a dividend growth rate of 4 percent. The firm also has 5 bonds outstanding with a face value of $1,000 per bond that are selling at 99 percent of par. The bonds have a coupon rate of 6 percent and a yield to maturity of 6.7 percent. All interest is tax deductible. If the tax rate is 21 percent, what is the weighted average cost of capital? Answer: 42) The common stock of Plank Communications has a beta of 1.37, the risk-free rate is 3.4 percent, and the market risk premium is 8.2 percent. The yield to maturity on the firm’s bonds is 7.6 percent and the debt-equity ratio is .45. What is the WACC if the tax rate is 23 percent and all interest is tax deductible? Answer: 43) Edelman’s net cash flows for the next three years are projected at $72,000, $78,000, and $84,000, respectively. After that, the cash flows are expected to increase by 3.2 percent annually. The aftertax cost of debt is 6.2 percent and the cost of equity is 11.4 percent. What is the value of the firm if it is financed with 40 percent debt and 60 percent equity? Answer: 44) Skyler Audio has developed an improved version of its most popular product. To get this improvement to the market will cost $48 million but the project will return an additional $13.5 million for 5 years in net cash flows. The firm’s debt-equity ratio is .25, the cost of equity is 13 percent, the pretax cost of debt is 9 percent, and the tax rate is 21 percent. All interest is tax deductible. What is the net present value of this proposed project? Answer: 45) Zander Systems has 25,000 shares of common stock outstanding with a beta of 1.4, a market price of $32 per share, and a dividend yield of 5.7 percent. Dividends increase by 4.2 percent annually. The firm also has $450,000 of debt outstanding that is selling at 102 percent of par that has a yield to maturity of 6.8 percent. The tax rate is 21 percent and all interest is tax deductible. The firm is considering a project that has the same risk level as the firm’s current operations, an initial cost of $328,000, and cash inflows of $52,500, $155,000, and $225,000 for Years 1 to 3, respectively. What is the NPV of the project? Answer:

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46) Alpha Corporation is considering acquiring Omega, Incorporated, and has compiled the following information about Omega: Year 1 2 3 EBIT $ 318,000 $ 364,000 $ 392,000 Capital spending 46,500 28,000 36,200 Increases in net working capital 5,500 6,500 1,200 Depreciation 34,000 32,100 28,700 The applicable tax rate is 21 percent and the terminal value of Omega as of Year 3 is $2.5 million. What is the NPV of this acquisition if the discount rate is 7.1 percent and the acquisition cost is $2.25 million? Answer: 47) Andrews has a current debt-equity ratio of .52 and a target debt-equity ratio of .45. The cost of floating equity is 9.5 percent and the flotation cost of debt is 6.6 percent. What should the firm use as its weighted average flotation cost? Answer: 48) Jillian Retail can issue equity at a flotation cost of 8.76 percent and debt at 5.93 percent. The firm currently has a debt-equity ratio of .37 but prefers a ratio of .35. What should this firm use as its weighted average flotation cost? Answer:

Week 6 Assignment (ch. 12 & 13) FIN600

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