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FINA3313-005 Homework 3 Fall 2015 Chapter 08 Net Present Value and Other Investment Criteria True / False Questions (True A, False B) 1. As the opportunity cost of capital decreases, the net present value of a project increases. 2. The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of capital. 3. Unlike using IRR, selecting projects according to their NPV will always lead to a correct acceptreject decision. 4. For mutually exclusive projects, the project with the higher IRR is the correct selection. 5. When using a profitability index to select projects, a value of .63 is preferred over a value of 0.21. 6. The payback period considers all project cash flows. 7. If a project has multiple IRRs, the highest one is assumed to be correct. 8. When choosing among mutually exclusive projects, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. 9. For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. 10. For most managers, discounted cash-flow analysis is in fact the dominant tool for project evaluation. Multiple Choice Questions 11. If the net present value of a project that costs $20,000 is $5,000 when the discount rate is 10%, then the: A. project's IRR equals 10%. B. project's rate of return is greater than 10%. C. net present value of the cash inflows is $4,500. D. project's cash inflows total $25,000. 12. What is the NPV of a project that costs $100,000 and returns $50,000 annually for 3 years if the opportunity cost of capital is 14%? A. $13,397.57 B. $14,473.44 C. $16,081.60 D. $33,748.58 13. What should occur when a project's net present value is determined to be negative? A. The discount rate should be decreased. B. The profitability index should be calculated. C. The present value of the project cost should be determined. D. The project should be rejected. 14. What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for 3 years, and the cost of capital is 9%? A. $101,251.79 B. $109,200.00 C. $126,564.73 D. $130,800.00 1 FINA3313-005 Homework 3 Fall 2015 15. Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. A. "A" has a small, but negative, NPV. B. "B" has a positive NPV when discounted at 10%. C. "C's" cost of capital exceeds its rate of return. D. "D" has a zero NPV when discounted at 14%. 16. If the opportunity cost of capital for a lending project exceeds the project's IRR, then the project has a(n): A. positive NPV. B. negative NPV. C. acceptable payback period. D. positive profitability index. 17. What is the IRR for a project that costs $100,000 and provides annual cash inflows of $30,000 for 6 years starting one year from today? A. 19.91% B. 16.67% C. 15.84% D. 22.09% 18. What is the minimum number of years in which an investment costing $210,000 must return $65,000 per year at a discount rate of 13% in order to be an acceptable investment? A. 8.69 years B. 5.37 years C. 7.51 years D. 4.46 years 19. If the IRR for a project is 15%, then the project's NPV would be: A. negative at a discount rate of 10%. B. positive at a discount rate of 20%. C. negative at a discount rate of 20%. D. positive at a discount rate of 15%. 20. Given a particular set of project cash flows, which one of the following statements must be correct? A. There can be only one NPV for the project, even with multiple discount rates. B. There can be only one IRR for the project. C. There can be more than one IRR for the project. D. There can be only one profitability index for the project, even with multiple discount rates. Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital True / False Questions(True A, False B) 21. For investment horizons greater than 20 years, long-term corporate bonds traditionally have outperformed common stocks. 22. The S&P 500 accounts for nearly 75% of the total market value of stocks traded in the United States. 2 FINA3313-005 Homework 3 Fall 2015 23. The expected return on an investment includes compensation for both the time value of money and the risks assumed. 24. If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio. 25. Historically speaking, the market risk premium in Italy has been higher than that of the United States. 26. Market risk can be eliminated in a stock portfolio through diversification. 27. The risk that remains in a stock portfolio after efforts to diversify is known as unique risk. 28. Every additional stock added to a portfolio reduces the portfolio's level of risk by an equal amount. 29. The expected return on an investment provides compensation to investors both for waiting and for worrying. 30. All financial managers and economists believe that long-run historical returns are the best available measure of future returns. Multiple Choice Questions 31. A share of stock currently sells for $60, pays an annual dividend of $4.00, and earned a rate of return of 20% over the past year. What did this stock sell for one year ago? A. $42.00 B. $46.15 C. $48.46 D. $53.33 32. An investor receives a 15% total return by purchasing a stock for $40 and selling it after one year with a 5% capital gain. How much was received in dividend income during the year? A. $2.00 B. $2.20 C. $4.00 D. $4.40 33. Which one of the following statements seems most appropriate when the Dow Jones Industrial Average increases by 2%? A. All stocks on the exchange increased by 2%. B. All 30 DJIA stocks increased by 2%. C. One market indicator was up by 2%. D. The S&P 500 index increased by 2%. 34. Which one of these is considered to be the safest investment? A. U.S. Treasury bonds B. Common stock C. U.S. Treasury bill D. Preferred stock 35. The idea that investors in a common stock may expect a lower total return if they purchase a stock with limited price volatility rather than one with high price volatility suggests that: A. investors are irrational. B. there is a relationship between risk and return. 3 FINA3313-005 Homework 3 Fall 2015 C. real rates of return will be lower during periods of price stability. D. stocks should be avoided when inflation is low. 36. The wider the dispersion of returns on a stock, the: A. lower the expected rate of return. B. higher the standard deviation. C. lower the real rate of return. D. lower the variance. 37. In a year in which common stocks offered an average return of 18%, Treasury bonds offered 10%, and Treasury bills offered 7%. The risk premium for common stocks was: A. 1%. B. 3%. C. 8%. D. 11%. 38. A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. The economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? A. 11.98% B. 12.06% C. 11.10% D. 11.23% 39. What is the approximate variance of returns if over the past 3 years an investment returned 8%, -12%, and 15%? A. 31 B. 131 C. 182 D. 961 40. In general, which stocks should be combined into a portfolio if the goal is the greatest reduction possible in overall portfolio risk? A. Stocks with returns that are positively correlated B. Stocks with returns that are negatively correlated C. Stocks with returns that are not correlated D. Stocks that have the highest expected returns 41. The major benefit of diversification is the: A. increased expected return. B. removal of all negative risk assets from the portfolio. C. reduction in the portfolio's systematic risk. D. reduction in the portfolio's total risk. 42. What is the standard deviation of returns of a 4-stock portfolio (each stock being equally weighted) that produced returns of 20%, 20%, 25%, and 30%? A. 2.15% B. 3.15% 4 FINA3313-005 Homework 3 Fall 2015 C. D. 4.15% 5.15% Chapter 12 Risk, Return, and Capital Budgeting True / False Questions(True A, False B) 43. The capital asset pricing model (CAPM) assumes that the stock market is dominated by welldiversified investors who are concerned only with market risk. 44. The CAPM states that the expected risk premium on any security equals its beta times the market risk premium. 45. The security market line sets a standard for other investmentsinvestors will be willing to hold other investments only if they offer equally good prospects as shown by the points on the line. 46. There is little doubt that the CAPM captures everything that is going on in the market. 47. If a low-risk company invests in a high-risk project, those cash flows should be discounted at a high cost of capital. 48. Beta measures a stock's sensitivity to market risks. 49. Diversification decreases the variability of both unique and market risk. 50. As a project's beta increases, the project's opportunity cost of capital increases. Multiple Choice Questions 51. If a security plots below the security market line, it is: A. ignoring all of the security's unique risk. B. underpriced, a situation that should be temporary. C. offering too little return to justify its risk. D. a defensive security, which expects to offer lower returns. 52. In theory, the "market portfolio" should contain: A. the securities of the S&P 500. B. the securities of the Dow. C. the securities of the S&P 500 and Treasury bills. D. all risky assets. 53. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2%, then its beta equals: A. 1.04. B. 1.24. C. 1.33. D. 1.40. 54. What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73? A. 1.0 B. 1.17 C. 1.22 D. 1.25 55. What is the beta of a U.S. Treasury bill? A. 1.0 5 FINA3313-005 Homework 3 Fall 2015 B. -1.0 C. 0 D. Unknown 56. A project has an assigned beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%. What is the project's expected rate of return? A. 15.21% B. 11.41% C. 10.50% D. 14.61% 57. Which one of the following statements is correct when Treasury bills yield 7.5% and the market risk premium is 9.5%? A. The S&P 500 would be expected to yield about 8.50%. B. The S&P 500 would be expected to yield about 9.50%. C. The S&P 500 would be expected to yield about 12.68%. D. The S&P 500 would be expected to yield about 17.00%. 58. What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a stock with a beta of 1.4 is expected to yield 18%? A. 8.67% B. 10.84% C. 12.02% D. 14.57% 59. An investor was expecting a return of 14.7% on her portfolio with a beta of 1.13 before the market risk premium decreased from 8 to 7%. Based on this change, what return should she now expect on the portfolio? A. 13.57% B. 13.89% C. 14.67% D. 15.87% 60. Why do stock market investors seem to ignore unique risks when calculating expected rates of return? A. There is no method for quantifying unique risks. B. Unique risks are assumed to be diversified away. C. Unique risks are compensated by the risk-free rate. D. Beta includes a component to compensate for unique risk. 61. A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return? A. 8.39% B. 7.76% C. 10.80% D. 9.02% 6 FINA3313-005 Homework 3 Fall 2015 62. A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%? A. 2.825% B. 3.250% C. 3.275% D. 3.415% 63. Which one of these statements is correct? A. Betas are exact measurements. B. If a stock has a very low beta, it is most apt to maintain that beta in the future. C. The expected future risk premium is easy to accurately determine. D. CAPM is widely used as a means of valuing stock. 64. A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable. A. company cost of capital B. risk-free rate C. market risk premium D. project cost of capital 65. A project with higher than average risk offers an expected return of 14%. Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%? A. Project NPV is positive; it should be accepted. B. Project NPV is negative; it should be rejected. C. Project NPV is positive but it should be rejected. D. Project NPV is negative but it should be accepted. 66. If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would: A. determine where the project plots in relation to the security market line. B. make the project look more attractive than it should be. C. be correct from a theoretical perspective. D. be incorrect and could cause the project to be erroneously rejected. Chapter 13 The Weighted-Average Cost of Capital and Company True / False Questions(True A, False B) 67. Capital structure refers to a firm's mix of long-term debt and equity financing. 68. The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. 69. Weighted-average cost of capital is the expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings related to interest payments. 60. If a project has a zero NPV when the expected cash flows are discounted at the weightedaverage cost of capital, then the project's cash flows are just sufficient to give debtholders and shareholders the return they require. 7 FINA3313-005 Homework 3 Fall 2015 71. The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders. 72. A firm's cost of capital will generally increase if the firm lowers its debt-equity ratio. 73. The cost of equity will generally increase for risky firms when the risk-free rate of return increases. 74. Interest tax shields are available to the firm on debt and preferred stock but not on common equity. 75. Assuming a project has the same risk and financing as the firm, it will have a positive NPV if its rate of return is greater than the firm's WACC. Multiple Choice Questions 76. What appears to be the targeted debt ratio of a firm that issues $15 million in bonds and $35 million in equity to finance its new capital projects? A. 15% B. 30% C. 35% D. 43% 77. To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's: A. weighted-average cost of capital. B. pre-tax cost of debt. C. aftertax cost of debt. D. cost of equity. 78. The weighted-average cost of capital for a firm with a 65/35 debt/equity split, 8% pre-tax cost of debt, 15% cost of equity, and a 35% tax rate would be: A. 8.63%. B. 9.12%. C. 10.45%. D. 13.80%. 79. The weighted-average cost of capital for a firm with a 40/60 debt/equity split, 8% cost of debt, 15% cost of equity, and a 34% tax rate would be: A. 12.20%. B. 8.63%. C. 11.11%. D. 13.80%. 80. What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% aftertax cost of debt? A. 5.85% B. 12.15% C. 15.38% D. 25.71% 8 FINA3313-005 Homework 3 Fall 2015 81. Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the weight of debt for WACC purposes? A. 13.91% B. 23.08% C. 31.03% D. 27.67% 82. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds requiring an 8% return? A. $1,392,000 B. $1,488,000 C. $2,480,000 D. $2,800,000 83. Which one of the following statements is incorrect concerning the equity component of the WACC? A. The value of retained earnings is excluded. B. Market values should be used in the calculations. C. Preferred equity is a separate component of WACC. D. There is a tax shield on the dividends paid. 84. A firm has 12,000 shares of common stock outstanding with a book value of $20 per share and a market value of $39. There are 5,000 shares of preferred stock with a book value of $10 and a market value of $26. There is a $400,000 face value bond issue outstanding that is selling at 87% of par. What weight should be placed on the preferred stock when computing the firm's WACC? A. 7.25% B. 13.74% C. 11.48% D. 15.09% 85. If a firm earns the WACC as an average return on its average-risk assets, then: A. equityholders will be satisfied, but bondholders will not. B. bondholders will be satisfied, but equityholders will not. C. all investors will earn their minimum required rate of return. D. the firm is investing in only positive NPV projects. 86. A firm's WACC: A. is the proper discount rate for every project the firm undertakes. B. is used to value all of the firm's existing projects. C. is a benchmark discount rate that is adjusted for the riskiness of each project. D. is an informational value only and should never be used as a discount rate. 87. An increase in which one of the following is most apt to decrease the WACC of a firm that has both debt and equity in its capital structure? A. Firm's beta B. Market rate of return 9 FINA3313-005 Homework 3 Fall 2015 C. Tax rate D. Yield on preferred stock 88. A company's CFO wants to maintain a target debt-to-equity ratio of 1/4. If the WACC is 18.6%, and the pretax cost of debt is 9.4%, what is the cost of common equity assuming a tax rate of 34%? A. 19.90% B. 20.90% C. 21.70% D. 22.73% 89. The yield-to-maturity of a firm's bond is 8.5%. The firm has a beta of 1.3 and a tax rate of 34%. The market risk premium is 8.4% and the risk-free rate is 3.8%. What is the firm's WACC if the firm has a capital structure that is 40% debt financed? A. 10.74% B. 11.08% C. 11.61% D. 11.38% 90. If a company's cost of capital is less than the required return on equity, then the firm: A. is financed with more than 50% debt. B. is perceived to be safe. C. has debt in its capital structure. D. is all equity financed. 10