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business
theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

What is the difference between a perfect market and a competitive market?
What does the assumption of a perfect market buy you that would not be satisfied in an imperfect market?
Assume that you ran a time-series regression with your project on the Fama-French factors and found the following:E(˜ri) − rF= (12%) + (0.3) . XMKT + (0.3). UMD + (−0.5) . HML + (−0.5) . SMB
What are the Fama-French-Momentum factors?
What are the APT factors?
Outline the logic that leads to the CAPM.What is mathematics?What is economics?
Confirm that the portfolio L that invests 50%in H and 50% in I is not mean-variance efficient. If the risk-free rate of return is 4%, confirm that the CAPM relationship does not hold for L.
Your corporate division had the following net cash flows:Year: 1999 2000 2001 2002 S&P 500 +21.4% −5.7% −12.8% −21.9%Cash Flows +$2,000 $0 $0 $0 Year: 2003 2004 2005 S&P 500 +26.4% +9.0%
Although you are a millionaire, keeping all your money in the market, you have managed to secure a great deal: If you give your even richer Uncle Vinny $20,000 today, he will help you buy a house,
The Fama-French-Momentum model suggestsThis is a rate quoted above the risk-free rate. Thus, your appropriate cost of capital (hurdle rate) would be 3% + 7% = 10%. - E(7) = (1.3) E(XMKT) + (0.1)
The APT is almost like a multifactor version of the CAPM. Whereas in the CAPM, everything depends on one factor (that is, the rate of return on the stock market), in the APT there can be multiple
Recall the data from Table 9.2:♣ ♦ ♥ ♠ Mean Var I −6% +12% 0% 18% 6% 90%%H −12% +18% +24% +6% 9% 189%%Now compute the beta of H and I with respect to portfolio H. The beta of H with
Working off Table 9.2:(a) The covariance between H and N is 78.75%%.(b) The covariance between I and N is 81%%.(c) The variance of N is 79.31%%. Actually, this number was in the table itself.(d) The
First, compute the de-meaned cash flows:Year 1999 2000 2001 2002 2003 2004 Average Variance S&P 500 +21.4% −5.7% −12.8% −21.9% +26.4% +9.0% +2.7% 373.4%%∗Cash Flows +$2,864 +$1,666
This is a certainty equivalence question. Although it is not a gift per se, you cannot assume that $10,000 is a fair market value, so that you can compute a rate of return of 1,900%—after all, it
Assume that you ran a time-series regression with your project on the Fama-French factors and found the following:E(˜ri) − rF= (−2%) + (1.3) . XMKT + (0.1) . UMD + (−1) . HML+ (−0.1) . SMB
Explain how the APT model is similar to, but more general than, the CAPM.
Confirm that the portfolio H is not mean-variance efficient if the riskfree rate of return is 4%.
This question asks you to confirm the beta computations. Work with the data from Table 9.2.(a) Compute the covariance between H and N.(b) Compute the covariance between I and N.(c) Compute the
A firm reported the following cash flows:Year: 1999 2000 2001 2002 2003 2004 Average S&P 500 +21.4% −5.7% −12.8% −21.9% +26.4% +9.0% +2.7%Cash Flows +$2,864 +$1,666 −$1,040 +$52 +$1,478
Although you are a millionaire, keeping all your money in the market, you have managed to secure a great deal: If you promise to go to school (which costs you a net disutility worth $10,000 today),
Explain the kinds of projects for which it is important to get accurate equity premium estimates.
Under what circumstances is the CAPM a good model to use?What are the main arguments in favor of using it?When is it not a good model?
Why do you need to understand the CAPM?
Does the empirical evidence suggest that the CAPM is correct?
Draw some possible security markets relations that would not be consistent with the CAPM.
Apply the CAPM. Assume the risk-free rate of return is the current yield on 5-year bonds.Assume that the market’s expected rate of return is 3% per year above this. Download 5 years of daily rate
The prevailing risk-free rate is 5% per annum.A competitor to your own firm, though publicly traded, has been using an overall project cost of capital of 12% per annum. The competitor is financed by
A Fortune 100 firm is financed with $15 billion in debt and $5 billion in equity. Its historical levered equity beta has been 2. If the firm were to increase its leverage from $15 billion to $18
A comparable firm (in a comparable business)has an equity beta of 2.5 and a debt/equity ratio of 2. The debt is almost risk free. Estimate the beta for your equity if projects have constant betas,
Look up betas on Yahoo! Finance today, and compare them to those in Table 8.2 on page 218.(a) How does the beta of Intel today compare to its earlier estimate from May 2008? Was its beta stable (over
Consider the following historical rate of return series:Year S&P 500 IBM Year S&P 500 IBM 1991 +0.2631 −0.2124 2000 −0.1014 −0.2120 1992 +0.0446 −0.4336 2001 −0.1304 +0.4231 Year S&P 500
An unlevered firm has an asset market beta of 1.5. The risk-free rate is 3%. The equity premium is 4%.(a) What is the firm’s cost of capital?(b) The firm refinances itself. It repurchases half of
Should a negative-beta asset offer a higher or a lower expected rate of return than the risk-free asset? Does this make sense?
Should you use the same risk-free rate of return both as the CAPM formula intercept and in the equity premium calculation, or should you assume an equity premium that is independent of investment
Explain in 200 words or less: What are reasonable guesstimates for the market risk premium and why?
If you do not want to estimate the equity premium, what are your alternatives to finding a cost-of-capital estimate?
Explain the basic schools of thought when it comes to equity premium estimation.
A corporate zero-bond promises 7% in 1 year.Its market beta is 0.3. The equity premium is 4%; the equivalent Treasury rate is 3%. What is the appropriate bond price today?
What would it take for a bond to have a larger risk premium than default premium?
A junk bond with a beta of 0.4 will default with 20% probability. If it does, investors receive only 60% of what is due to them. The risk-free rate is 3% per annum and the risk premium is 5% per
Draw the SML if the true expected rate of return on the market is 6% per annum and the risk-free rate is 2% per annum. How would the figure look if you were not sure about the expected rate of return
The risk-free rate is 6%. The expected rate of return on the stock market is 10%.What is the appropriate cost of capital for a project that has a beta of −2? Does this make economic sense?
The risk-free rate is 6%. The expected rate of return on the stock market is 8%. What is the appropriate cost of capital for a project that has a beta of 2?
Write down the CAPM formula. Which are economy-wide inputs, and which are projectspecific inputs?
In a perfect world and in the absence of externalities, should you take only the projects with the highest NPV?
If the CAPM holds, then what should you do as the manager if you cannot find projects that meet the hurdle rate suggested by the CAPM?
What are the assumptions underlying the CAPM? Are the perfect market assumptions among them? Are there more?
For short-term investments, the expected cash flows are most critical to estimate well (see Section 4.1A on page 70). In this case, the trouble spot (d) is really all that matters. For long-term
The CAPM should work very well if beta is about 0. The reason is that you do not even need to guess the equity premium if this is so.
Even though the CAPM is empirically rejected, it remains the benchmark model that everyone uses in the real world. Moreover, even if you do not trust the CAPM itself, at the very least it suggests
No, the empirical evidence suggests that the CAPM does not hold. The most important violation seems to be that value firms had market betas that were low, yet average returns that were high. The
Your combined happy-marriage beta would be βCombined= (3/4) . 2.4 + (1/4) . 0.4 = 1.9.
This is an asset beta versus equity beta question. Because the debt is almost risk free, we can use βDebt≈ 0.(a) First compute an unlevered asset beta for your comparable with its debt-to-asset
Yes, a zero-beta asset can still have its own idiosyncratic risk. And, yes, it is perfectly kosher for a zerobeta asset to offer the same expected rate of return as the risk-free asset. The reason is
The duration of this cash flow is around, or a little under, 5 years. Thus, a 5-year zero Treasury would be a reasonably good guess. You should not be using a 30-day, a 30-year, or even a 10-year
Use the 1-year Treasury rate for the 1-year project, especially if the 1-year project produces most of its cash flows at the end of the year. If it produces constant cash flows throughout the year, a
An estimate between 1% and 8% per year is reasonable. Anything below 0% and above 10% would seem unreasonable to me. For reasoning, please see the different methods in the chapter.
The cost needs to be discounted with the current interest rate. Since payment is up front, this cost is $30,000 now! The appropriate expected rate of return for cash flows (of your earnings) is 3% +
It does not matter what you choose as the per-unit payoff of the bond. If you choose $100, you expect it to return $99.(a) Thus, the price of the bond is PV = $99/(1 + [3% + 5% . 0.2]) ≈ $95.19.(b)
The equity premium, E(˜rM) − rF, is the premium that the stock market expects to offer on the risky market above and beyond what it offers on Treasuries.
A firm reported the following cash flows: Exp. rate of return (in %) 15 10- S Risk-free Treasury F Market M -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 True market beta
Write down the CAPM formula and solve E(˜ri) = rF+ [E(˜rM) − rF] . βi= 4% + (7% − 4%) . βi= 5%.Therefore, βi= 1/3. Note that we are ignoring the promised rate of return.
No—the real-world SML is based on historical data and not true expectations. It would be a scatterplot of historical risk and reward points. If the CAPM holds, a straight, upward-sloping line would
With rF= 4% and E(˜rM) = 12%, the cost of capital for a project with a beta of −3 is E(˜r) = rF+ [E(˜rM) −rF] . βi= 4% + (12% − 4%) . (−3) = −20%. Yes, it does make sense that a project
With rF= 4% and E(˜rM) = 12%, the cost of capital for a project with a beta of 3 is E(˜r) = rF+ [E(˜rM) −rF] . βi= 4% + (12% − 4%) . 3 = 28%.
With rF= 4% and E(˜rM) = 7%, the cost of capital for a project with a beta of 3 is E(˜r) = rF+ [E(˜rM) −rF] . βi= 4% + (7% − 4%) . 3 = 13%.
Yes, the perfect market is an assumption underlying the CAPM. In addition,(a) Investors are rational utility maximizers.(b) Investors care only about overall portfolio mean rate of return and risk at
To value an ordinarily risky project, that is, a project with a beta in the vicinity of about 1, what is the relative contribution of your personal uncertainty (lack of knowledge) in (a) the
Is the CAPM likely to be more accurate for a project where the beta is very high, one where it is very low, or one where it is zero?
If the CAPM is wrong, why do you need to learn it?
Does the empirical evidence suggest that the CAPM is correct?
You own a stock market portfolio that has a market beta of 2.4, but you are getting married to someone who has a portfolio with a market beta of0.4. You are three times as wealthy as your future
A comparable firm(with comparable size and in a comparable business)has a Yahoo! Finance–listed equity beta of 2.5 and a debt/asset ratio of 2/3. Assume the debt is risk free.(a) Estimate the beta
According to the CAPM formula, a zero-beta asset should have the same expected rate of return as the risk-free rate. Can a zero-beta asset still have a positive standard deviation? Does it make sense
If you can use only one Treasury, which risk-free rate should you use for a project that will yield $5 million each year for 10 years?.
What is today’s risk-free rate for a 1-year project? For a 10-year project?
What are appropriate equity premium estimates? What are not? What kind of reasoning are you relying on?
Going to your school has total additional and opportunity costs of$30,000 this year and up front. With 90% probability, you are likely to graduate fromyour school. If you do not graduate, you have
A corporate bond with a beta of 0.2 will pay off next year with 99%probability. The risk-free rate is 3% per annum, and the equity premium is 5% per annum.(a) What is the price of this bond?(b)What
What is the equity premium, both mathematically and intuitively?
Draw the security market line if the risk-free rate is 5% and the equity premium is 10%.
The risk-free rate is 4%. The expected rate of return on the stock market is 7%. A corporation intends to issue publicly traded bonds that promise a rate of return of 6% and offer an expected rate of
Is the real-world security market line a line?
The risk-free rate is 4%. The expected rate of return on the stock market is 12%. What is the appropriate cost of capital for a project that has a beta of −3? Does this make economic sense?
The risk-free rate is 4%. The expected rate of return on the stock market is 12%. What is the appropriate cost of capital for a project that has a beta of 3?
The risk-free rate is 4%. The expected rate of return on the stock market is 7%.What is the appropriate cost of capital for a project that has a beta of 3?
What are the assumptions underlying the CAPM? Are the perfect market assumptions among them? Are there more?
Return to the example with a risk-free asset in Formula 8.14 on page 240. What are the risk and reward of a portfolio that invests wH= 150%? (This means that if you have$100, you would borrow $50 at
The Vanguard European stock fund, Pacific stock fund, and Exxon Mobil reported the following historical dividend-adjusted prices:Year 1991 1992 1993 1994 1995 1996 VEURX 6.53 7.15 6.91 9.34 9.03
In the absence of a risk-free asset, would anyone buy the portfolio wH= 110%, wI=−10%?
Mathematically and based on Figure 8.6 on page 238, the risk and reward of the portfolio wH= −0.2, wI= −1.2.
An asset has an annual mean of 12% and standard deviation of 30% per year. What would you expect its monthly mean and standard deviation to be?
Recompute the portfolio variance if you invest in a portfolio O with wH= 90% and wI=10% in Table 8.4.(a) Compute the rates of return on the portfolio in each scenario, and then treat the resulting
If the risk-free rate were lower, then the tangency line would become steeper. The tangency portfolio would shift from around K to around L. Therefore, it would involve more H.
This question asks you to show howmuch better off you are with this particular risk-free asset for a particular risk choice.(a) In Formula 8.12 on page 237, we showed that this no-risk-free
Because the net-of-mean F is always 0, so is its coproduct with anything else. This means that the covariance of the risk-free asset with any risky asset is zero, too.
Portfolios to the right of H on the line have a negative weight in F and a weight above 1 in H. (The portfolio weights must add to 100%!) This means that they would borrow money at a 4% annual
The covariance between H and Z is 85.5%%, which is much higher than the 45%% covariance between H and I from Formula 8.9 on page 233. This means that the correlation between H and Z shoots up to
If the correlation was higher, diversification would help less, so the risk would be higher. Therefore, the efficient frontier would not bend as far toward the west (a risk of 0). An easy way to

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