I. TRUE or FALSE

1. The returns that firms have to pay their investors represent the firms' cost of capital.

2. An asset's risk can be analyzed in 2 ways: on a stand-alone basis, and on a portfolio basis.

3. An investment can be undertaken if its expected return isn't enough to compensate for its perceived risk.

4. The risk of an asset is the same when the asset is held by itself and when it is held as a part of a group of assets.

5. The tighter the probability distribution of expected future returns, the higher the risk of a given investment.

6. Using standard deviation, the smaller the standard deviation, the tighter the probability distribution and, the lower the risk.

7. The standard deviation is a measure of how far the actual return is likely to deviate from the expected return.

8. Portfolio risk is the weighted average of the individual stocks' standard deviations.

9. If returns of stocks in a portfolio are not related to one another, they are said to be negatively correlated.

10. The returns of 2 perfectly positively correlated stocks with the same expected return would move up and down together, and a portfolio consisting of these stocks would not be as risky as the individual stocks.

11. Diversifying stocks in a portfolio that are perfectly positively correlated are useful in reducing risk.

12. Beta measure a given stock's volatility relative to the market.

13. The market risk of a stock is measured by its beta coefficient.

14. Risk-free rate of return is the same as market risk premium.

15. For capital structure purposes, no distinction is made between common equity raised by issuing stock versus retaining earnings.

16. Business risk is the riskiness of the firm's assets if debt is used.

17. When a firm is said to have a high degree of operating leverage, a low percentage of total costs are fixed.

18. Mutually exclusive projects that involve alternative production methods for a given product often have different degrees of operating leverage and thus different break-even points but similar degrees of risk.

19. Financial risk is the additional risk placed on common stockholders as a result of the decision to finance debt.

20. Typically, using financial leverage decreases the expected rate of return for an investment.

21. The optimal capital structure calls for a Debt-to-Capital ratio that is higher than the one that maximizes expected EPS.

22. The capital structure that maximize the WACC is also the capital structure that minimizes the firm's stock price.

23. Firms with greater business risk should limit their use of more equity.

24. Typically, the sequence in which firms prefer to raise capital is first spontaneous credit, next is retained earnings, then new common stock, and lastly, other debt.

25. Other things held constant, a firm with less operating leverage is better able to employ financial leverage.

26. The times-interest-earned ratio gives an indication of how vulnerable the firm is to financial distress.

27. The optimal dividend policy strikes the balance between current dividends and future growth that maximizes the stock price.

28. Under Dividend Irrelevance Theory, dividend policy does affect either the price of a firm's stock or its cost of capital.

29. Dividends increase transactions cost for investors who are looking for steady income.

30. A dividend cut generally leads to increase in the stock price.

31. Firms with many good investment opportunities generally distribute little or no cash dividends, thus attracting investors who prefer capital gains.

32. As long as a firm finances with the optimal mix of debt and equity and uses only retained earnings, the marginal cost of new amount of capital will be maximized.

33. If firms have high flotation costs, they tend to set low payout ratios.

34. Stock dividends and stock splits are similar in purpose.

35. One reason that stock splits and stock dividends may lead to lower prices is that investors often take stock splits and dividends as having no effect on higher future earnings.

36. One situation for stock repurchases is when the firm has issued options to employees, and it uses open market repurchases to obtain stock even if options are not exercised.

37. In calculating weighted average cost of capital (WACC), only investor-supplied capital is considered.

38. In calculating WACC, the before-tax cost of debt is used.

39. Equity raised by issuing stock has a lower cost than equity from retained earnings.

40. Stocks have no comparable stated cost rate.

41. If a stock is in equilibrium, its required rate of return is lower than its expected rate of return.

42. A firm can't directly affect its cost of capital by changing its capital structure.

43. An increase in the use of debt will increase the riskiness of both the debt and the equity, and these increases in component costs have no effect on the WACC.

44. The higher the dividend payout ratio, the smaller the addition to retained earnings, the higher the cost of equity, and the higher the firm's WACC will be.

45. The firm's capital budgeting decisions don't affect its cost of capital.

46. In capital budgeting analysis, all cash flows are relevant.

47. For replacement projects in capital budgeting, the difference in the free cash flows on the continued use of the old asset versus the new asset is computed, and if the NPV of the differential flows is zero, the replacement should be made.

48. Market risk is least relevant of the 3 types of risks considered in capital budgeting.

49. Stand-alone risk in capital budgeting can be analyzed using scenario analysis, sensitivity analysis, and simulation.

50. When comparing projects with unequal lives, the one with the lower equivalent annual annuity should be chosen.

II. Computation (With solution)

1. If the risk-free rate is 3% and the market risk premium is 6%, what is the required rate of return on a stock with a beta of 1.5?

2. If the risk-free rate is 4% and the market risk premium is 8%, what is the required return for the overall stock market?

3. If a stock has a 16% expected rate of return, a 12% required rate of return on the market, and a 4% risk-free rate of return, what is its beta coefficient?

4. If a firm's tax rate is 35% and its interest rate on debt is 10%, what is it's after-tax cost of debt?

5. A firm's preferred stock currently trades at P100 per share and pays a P10 annual dividend per share. Ignoring flotation costs, what is the firm's cost of preferred stock?

6. A firm plans to retain 63 million of earnings for the year. Using a target capital structure of 53% debt, 2% preferred, and 45% equity, what's its retained earnings breakpoint?

7. What is this project's NPV if it costs P52,125; its expected cash inflows are P12,000 each year for 8 years, and its WACC is 12%?

8. Referring to the given in #8, instead of NPV, compute its IRR.

9. Referring to the given in #8, instead of NPV, compute its payback period.

10. Referring to the given in #7, instead of NPV, compute its discounted payback period.