TEST BANK management advisory services by tan t04 risks cost of capital

The firm’s current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5percent.. The firm’s current cost of equity is 16 percent; the risk-fre

INVESTMENT RISK

1 Catherine & Co has extra cash at the end of the year and is analyzing the best way to invest

the funds The company should invest in a project only if

A The expected return on the project exceeds the return on investments of comparable risk

B The return on investments of comparable risk exceeds the expected return on the project

C The expected return on the project is equal to the return on investments of comparable

D The return on investments of comparable risk equals the expected return on the project

Interest-rate Risk

2 Which of the following are components of interest-rate risk? Gleim

A Purchasing-power risk and default risk C Portfolio risk and reinvestment-rate risk

B Price risk and market risk D Price risk and reinvestment-rate risk

4 Long-term government bonds have:

Purchasing-power Risk

Default Risk

3 The marketable securities with the least amount of default risk are (E)

a Federal government agency securities c Repurchase agreements

b U.S Treasury securities d Commercial paper CMA 0691 1-11

26 The portion of the risk that can be eliminated by diversification is called:

Market Risk

4 The type of risk that is not diversifiable and even affects the value of a portfolio is (E)

A Purchasing-power risk C Nonmarket risk

Nonmarket Risk or Company-specific Risk

27 The unique risk is also called the:

29 As the number of stocks in a portfolio is increased:

A Unique risk decreases and approaches to zero

B Market risk decrease

C Unique risk decreases and becomes equal to market risk B & M

5 In capital market analysis, the nonsystematic risk

a Is correlated with qualitative aspects of the underlying entity

b Is correlated with quantitative aspects of the underlying entity

c Cannot easily be overcome by individual investors

6 Which of the following statements is correct? (E)

a Well diversified stockholders do not consider corporate risk when determining requiredrates of return

b Undiversified stockholders, including the owners of small businesses, are more concernedabout corporate risk than market risk

c Empirical studies of the determinants of required rates of return (k) have found that onlymarket risk affects stock prices

d Market risk is important but does not have a direct effect on stock price because it onlyaffects beta

7 In theory, the decision maker should view market risk as being of primary importance.However, within-firm, or corporate, risk is relevant to a firm’s(M)

a Well-diversified stockholders, because it may affect debt capacity and operating income

b Management, because it affects job stability

c Creditors, because it affects the firm’s credit worthiness

d Statements a and c are correct

Portfolio Risk Total Risk

8 The risk of a single asset is

9 An asset with high risk will have a(n)

A Low expected return C Increasing expected return

B Lower price than an asset with low risk D High standard deviation of returns Gleim

10 Risk to a company is affected by both project variability and how project returns correlate with

those of the company’s prevailing business Overall company risk will be lowest when a

a Low variability and negative correlation c High variability and positive correlation

b Low variability and positive correlation d High variability and no correlation

Liquidity Risk

11 The risk that securities cannot be sold at a reasonable price on short notice is called

12 When purchasing temporary investments, which one of the following best describes the risk

associated with the ability to sell the investment in a short period of time without significant

price concessions? (E)

A Interest rate risk C Financial risk

B Purchasing power risk D Liquidity risk CMA 0697 1-11

Business Risk

13 Business risk is the risk inherent in a firm's operations that excludes financial risk It depends

on all of the following factors except (E)

A Amount of financial leverage C Demand variability

B Sales price variability D Input price variability Gleim

14 Business risk excludes such factors as

B Amount of operating leverage D Fluctuations in suppliers' prices Gleim

1 A decrease in the debt ratio will generally have no effect on (E)

a Financial risk

b Total risk

c Business risk

2 Business risk is concerned with the operations of the firm Which of the following is not

associated with (or not a part of) business risk? (E)

a Demand variability

b Sales price variability

c The extent to which operating costs are fixed

d Changes in required returns due to financing decisions

15 Which of the following affects a firm’s business risk? (E)

a The level of uncertainty about future sales

b The degree of operating leverage

c The degree of financial leverage

d Statements a and b are correct

Financial Risk

* Which of the following would increase risk? (M)

a Increase the level of working capital

b Change the composition of working capital to include more liquid assets

c Increase the amount of short-term borrowing

16 A firm’s financial risk is a function of how it manages and maintains its debt Which one of thefollowing sets of ratios characterizes the firm with the greatest amount of financial risk?

A High debt-to-equity ratio, high interest coverage ratio, stable return on equity

B Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity

C High debt-to-equity ratio, low interest coverage ratio, volatile return on equity

D Low debt-to-equity ratio, high interest coverage ratio, stable return on equity CMA 1291 4

1-Business and financial risk

3 Which of the following statements is most correct? (E)

a A firm’s business risk is solely determined by the financial characteristics of its industry

b The factors that affect a firm’s business risk are determined partly by industrycharacteristics and partly by economic conditions Unfortunately, these and other factorsthat affect a firm’s business risk are not subject to any degree of managerial control

c One of the benefits to a firm of being at or near its target capital structure is that financialflexibility becomes much less important

d The firm’s financial risk may have both market risk and diversifiable risk components

Brigham

Exchange-rate Risk

17 The risk of loss because of fluctuations in the relative value of foreign currencies is called

A Expropriation risk C Multinational beta

18 O & B Company, a U.S corporation, is in possession of accounts receivable denominated inGerman deutsche marks To what type of risk are they exposed? (E)

19 Bonner Electronics has subsidiaries in several international locations and is concerned aboutits exposure to foreign exchange risk In countries where currency values are likely to fall,Bonner should encourage all of the following policies except

A Granting trade credit whenever possible

B Investing excess cash in inventory or other real assets

C Purchasing materials and supplies on a trade credit basis CFM Sample Q 5

D Borrowing local currency funds if an appropriate interest rate can be obtained

20 A firm may seek to avoid exchange-rate risk by

A Maintaining a net monetary debtor position in countries with strengthening currencies

B Maintaining a net monetary creditor position in countries with weakening currencies

C Avoiding diversification of foreign-currency transactions Gleim

D Buying forward exchange contracts to cover liabilities denominated in a foreign currency

Cultural Risk

56 A U.S manufacturer of which of the following goods would be likely to face the most cultural

risks in operating globally?

57 A U.S manufacturer of which of the following goods would be likely to face the fewest cultural

risks in operating globally?

Political Risk

58 Which of the following would be considered a political risk in doing business globally?

21 Political risk may be reduced by

A Entering into a joint venture with another foreign company

B Making foreign operations dependent on the domestic parent for technology, markets, and

supplies

C Refusing to pay higher wages and higher taxes

Comprehensive

* All of the following statements are correct except:

a The matching of asset and liability maturities is considered desirable because this strategy

minimizes interest rate risk

b Default risk refers to the inability of the firm to pay off its maturing obligations

c The matching of assets and liability maturities lowers default risk

d An increase in the payables deferral period will lead to a reduction in the need to

RISK MANAGEMENT METHODS Portfolio Theory

1 Portfolio Theory was first developed by:

12 A portfolio will a usually contain:

Portfolio Management

Efficient Portfolio

25 Efficient portfolios are those which offer:

A Highest expected return for a given level of risk

B Highest risk for a given level of expected return

C The maximum risk and expected return

33 Efficient portfolios are portfolios that:

A Offer the highest rate of return for a given level of risk

B Offer the lowest rate of return for a given level of risk

C Offer the lowest level of risk for a given rate of return

Feasible Portfolio

22 A feasible portfolio that offers the highest expected return for a given risk or the least risk for agiven expected return is a(n)

A Optimal portfolio C Efficient portfolio

Optimal Portfolio

23 An optimal portfolio of investments is (E)

A Efficient because it offers the highest expected return

B Any portfolio chosen from the efficient set of portfolios

C Any portfolio chosen from the feasible set of portfolios

D Tangent to the investor's highest indifference curve Gleim

24 A company uses portfolio theory to develop its investment portfolio If the company wishes to

obtain optimal risk reduction through the portfolio effect, it should make its next investment in

A An investment that correlates negatively to the current portfolio holdings

B An investment that is uncorrelated to the current portfolio holdings

C An investment that is highly correlated to the current portfolio holdings

D An investment that is perfectly correlated to the current portfolio holdings CIA 0591 IV-48

Minimum Variance Portfolio

24 Florida Company (FC) and Minnesota Company (MC) are both service companies Their

historical return for the past three years are: FC: -10%,15%, 25%; MC: 10%, 6%, 32% Which

portfolio is better?

A Portfolio with 50% in FC and 50% in MC C Investment in FC

B Minimum variance portfolio D None of the above B & M

26 Is the minimum variance portfolio an efficient portfolio?

Well-Diversified Portfolio

30 In a well diversified portfolio, the type of risk remaining is:

A Individual security risk C Total risk

31 A well-diversified portfolio has negligible:

Portfolio Matrix Analysis

25 Which one of the following planning techniques is most likely to be used to determine which

business units will receive additional capital and which will be divested? (D)

A Competitive strategies model C Scenario development

B Portfolio matrix analysis D Situational analysis CMA Samp Q3-9

Unsystematic Risk

a market risk is negligible c unsystematic risk is negligible

b systematic risk is negligible d nondiversifiable risk is negligible

Systematic Risk

27 Capital Asset Pricing Theory asserts that portfolio returns are best explained by: (E)

Standard Deviation vs Beta Coefficient

23 Standard deviation and beta both measure risk, but they are different in that (E)

a beta measures both systematic and unsystematic risk

b beta measures only systematic risk while standard deviation is a measure of total isk

c beta measures only unsystematic risk while standard deviation is a easure of total risk

d beta measures both systematic and unsystematic risk while standard deviation measures

e beta measures total risk while standard deviation measures only nonsystematic risk

Market Price of Risk

28 The market price of risk (M)

a is the risk premium divided by the standard deviation of the market returns

b has a reward-to-risk ratio of [E(rM ) - rf]/2

M

c is the price of a U S T-bill

d a and b.

Risk Level of Securities

29 Which of the following classes of securities are listed in order from lowest risk/opportunity forreturn to highest risk/opportunity for return? (E)

A U.S Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferredstock

B Corporate income bonds; corporate mortgage bonds; convertible preferred stock;subordinated debentures

C Common stock; corporate first mortgage bonds; corporate second mortgage bonds;

D Preferred stock; common stock; corporate mortgage bonds; corporate debentures

1 Which of the following portfolios have the least risk?

A A portfolio of treasury bills

B A portfolio of long term United States Government bonds

C Standard and Poor's composite index

30 From the viewpoint of the investor, which of the following securities provides the least risk?

31 The expected rate of return for the stock of Corn Enterprises is 20%, with a standard deviation

of 15% The expected rate of return for the stock of Must Associates is 10%, with a standard

deviation of 9% The riskier stock is

A Corn because its return is higher

B Corn because its standard deviation is higher

C Must because its standard deviation is higher

D Must because its coefficient of variation is higher CMA 0692 1-6

Risky Investment vs Riskless Investment

32 The difference between the required rate of return on a given risky investment and that on a

riskless investment with the same expected return is the

B Coefficient of variation D Beta coefficient CIA 1192 IV-48

Capital Asset Pricing Model

33 The capital asset pricing model deals with risk and rates of return of a

A Single security

B Group of securities in a portfolio which follows a buy and hold strategy

C Portfolio and how a new security affects that portfolio

34 According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return

is a function of (E)

Beta Coefficient

37 The "beta" is a measure of:

35 The level of risk that concerns investors who supply capital to a diversified company is

A Project risk (beta)

B Pure play risk (beta)

C The weighted average of project risk (betas)

36 A company's beta value has decreased because of a change in its marketing strategy.Consequently, the discount rate applied to expected cash flows of potential projects will be

44 A stock with a beta of zero would be expected to:

A Have a rate of return equal to the risk-free rate

B Have a rate of return equal to the market risk premium

C Have a rate of return equal to zero

D Have a rate of return equal to the market rate of return B & MEquity Beta

37 If beta of debt is zero, then the beta of equity is equal to:

A (1 + Debt-equity ratio)(beta of assets) C (Beta of assets)/(debt-equity ratio)

B (Debt-equity ratio)(beta of assets) D None of the above B & M

37 In many situations debt beta can be safely assumed to be zero Under this assumption, equitybeta can be expressed as: [E = market value of equity and D = market value of debt]

A equity beta = (1-(D/E.) (asset beta) C equity beta = (asset beta)/(1+(D/E.)

B equity beta = (1+(D/E.) (asset beta) D None of the above B & M

Asset Beta, Debt Beta & Equity Beta

32 Which of the following is true?

A bD > bA > bE C bA > bE > bD

B bE > bA > bD D None of the above are true B & M

34 Which of the following is true?

A bD < bA < bE C bA < bE < bD

B bE < bA < bD D None of the above are true B & M

Standard Deviation

38 The variance or standard deviation is a measure of:

2 Investments A and B both offer an expected rate of return of 12% If the standard deviation of

A is 20% and that of B is 30%, then investors would:

A Prefer A to B

B Prefer B to A

C Prefer a portfolio of A and B

D Cannot answer without knowing investor's risk preferences B & M

Coefficient of Variation

24 Which of the following can be computed and compared for each alternative to determine the

relative riskiness of investments that have different levels of expected return?

A coefficient of variation C standard deviation

37 The expected rate of return for the stock of Cornhusker Enterprises is 20%, with a standard

deviation of 15% The expected rate of return for the stock of Mustang Associates is 10% with

a standard deviation of 9% The riskier stock is (M)

a Cornhusker because the return is higher

b Cornhusker because the standard deviation is higher

c Mustang because the standard deviation is higher

d Mustang because the return is lower

e Mustang because the coefficient of variation is higher CMA 0692 1-6

Variance

27 In the formula for calculating the variance of an asset portfolio, how many are covarianceterms?

28 In the formula for calculating the variance of an N-asset portfolio, how many are varianceterms?

32 The variance formula for a four stock portfolio contains:

A 4 individual variance terms and 6 unique covariance terms

B 3 individual variance terms and 6 unique covariance terms

C 6 individual variance terms and 9 unique covariance terms

D 6 individual variance terms and 6 unique covariance terms B & MCovariance

38 Which of the following specifically measures the volatility of returns together with theircorrelation with the returns of other securities? (M)

39 If the covariance of stock A with stock B is -.0076, then what is the covariance of stock B withstock A?

A An increasingly steeper slope if the investor is less risk averse

B A decreasingly negative slope if the investor's utility increases

C An increasingly positive slope

Expected Rate of Return

3 When stocks with the same expected return are combined into a portfolio, the expected return

of the portfolio is:

A Less than the average expected return value of the stocks

B Greater than the average expected return of the stocks

C Equal to the average expected return of the stocks

41 An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return

relationship on a portfolio of stocks held as an investment Which of the following would not be

used to estimate the portfolio's expected rate of return? (D)

A Expected risk premium on the portfolio of stocks

B Interest rate for the safest possible investment

C Expected rate of return on the market portfolio

D Standard deviation of the market returns CIA 1193 IV-47

Expected Return – Beta Relationship

25 The expected return-beta relationship (M)

a is the most familiar expression of the CAPM to practitioners

b refers to the way in which the covariance between the returns on a stock and returns on the

market measures the contribution of the stock to the variance of the market portfolio, which is

beta

c assumes that investors hold well-diversified portfolios

b The expected rate of return on a security increases directly with its beta

c A fairly priced security has an alpha of zero

d In equilibrium, all securities lie on the security market line Bodie

Two-Stocks Portfolio

Correlation Coefficient

36 For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient

between the two stocks is:

9 The correlation measures the:

A Rate of movements of the return of individual stocks

B Direction of movement of the return of individual stocks

C Direction of movement between the returns of two stocks

42 The returns on two stocks can be correlated in values except those that are

A Less than the weighted average of the two individual variances

B More than the weighted average of the two individual variances

C Equal to the weighted average of the two individual variances

Expected Return

4 Stock A has an expected return of 20%, and stock B has an expected return of 12% The risk

of Stock A as measured by the variance of the returns is twice that of stock B If the twostocks are combined equally in a portfolio, what would be the expected return of the portfolio?

Hedging

43 When a firm finances each asset with a financial instrument of the same approximate maturity

as the life of the asset, it is applying

A Working capital management C Financial leverage.

B Return maximization D A hedging approach CMA 1291 1-13

45 The use of derivatives to either hedge or speculate results in

A Increased risk regardless of motive

B Decreased risk regardless of motive

C Offset risk when hedging and increased risk when speculating

D Offset risk when speculating and increased risk when hedging Gleim

46 A company has recently purchased some stock of a competitor as part of a long-term plan to

acquire the competitor However, it is somewhat concerned that the market price of this stock

could decrease over the short run The company could hedge against the possible decline in

A Purchasing a call option on that stock C Selling a put option on that stock

B Purchasing a put option on that stock D Obtaining a warrant option on that stock

Duration Hedging

47 Duration hedging involves hedging interest-rate risk by matching the duration of assets with

the duration of liabilities Which of the following is a true statement about duration hedging?

(M)

A If duration increases, the volatility of the price of a debt instrument decreases

B The goal of duration hedging is to equate the duration of assets with the duration of

liabilities

C The firm is immunized against interest-rate risk when the total price change for assets

equals the total price change for liabilities

D Duration is higher if the nominal rate on a debt instrument is higher Gleim

Forward Contract

48 A forward contract involves (E)

A A commitment today to purchase a product on a specific future date at a price to be

determined some time in the future

B A commitment today to purchase a product some time during the current day at its

present price

C A commitment today to purchase a product on a specific future date at a price determinedtoday

D A commitment today to purchase a product only when its price increases above its current

49 If a corporation holds a forward contract for the delivery of U.S Treasury bonds in 6 monthsand, during those 6 months, interest rates decline, at the end of the 6 months the value of theforward contract will have

50 A distinguishing feature of a futures contract is that

A Performance is delayed C Delivery is to be on a specific day Gleim

B It is a hedge, not a speculation D The price is marked to market each day

51 An automobile company that uses the futures market to set the price of steel to protect a profitagainst price increases is an example of

A A short hedge

B A long hedge

C Selling futures to protect the company from loss

D Selling futures to protect against price declines Gleim

Interest rate futures contract Interest rate Swap

52 In an interest rate swap, the first company

A Sells its right to low interest rate financing at a financial institution to the second companythat is seeking to borrow funds

B Agrees to service the debt of the second company by making interest payments directly tothe bank of the second company, while the second company agrees in exchange to makeinterest payments to the bank of the first company

C Buys the outstanding public debt of the second company and swaps the interestpayments it receives on that debt for the interest payments it must make on its own debt

D Agrees to exchange with the second company the difference between the interest charges

on its own borrowings and the interest charges on the borrowings of the second company

CIA 0596 IV-29

Interest Rate & Currency Swap

METHODS OF ANALYZING RISK

Sensitivity Analysis

54 Which of the following approaches would best analyze the risk of increasing the price of a

table by $50? (E)

A Sensitivity analysis C Informal method

B Simulation analysis D Certainty equivalent adjustments Gleim

Simulation Analysis

55 Which method for measuring risk considers both the sensitivity of changing NPVs and the

range of values of the variables that are changed?

A Simulation analysis C Sensitivity analysis

B The Capital Asset Pricing Model D Certainty equivalent adjustments Gleim

Analysis of Pricing Technique

50 The acronym APT stands for:

A Arbitrage Pricing Model C Analysis of Pricing Technique

51 A "factor" in APT is a variable that:

A Affects the return of risky assets in a systematic manner

B Correlates with risky asset returns in an unsystematic manner

C Is purely "noise"

D Affects the return of a risky asset in a random manner B & M

Three-factor Model

55 The three factors in the Three-Factor Model are:

RISK-ADJUSTED DISCOUNT RATE

56 Mega Inc., a large conglomerate with operating divisions in many industries, uses risk-adjusteddiscount rates in evaluating capital investment decisions Consider the following statementsconcerning Mega's use of risk-adjusted discount rates

I Mega may accept some investments with internal rates of return less than Mega's overallaverage cost of capital

II Discount rates vary depending on the type of investment

III Mega may reject some investments with internal rates of return greater than the cost ofcapital

IV Discount rates may vary depending on the division

Which of the above statements are correct? (D)

A I and III only C II, III, and IV only

B II and IV only D I, II, III, and IV

CMA Samp Q4-5

57 Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5 The financialmanager is evaluating a project with an expected return of 21 percent, before any riskadjustment The risk-free rate is 10 percent, and the required rate of return on the market is 16percent The project being evaluated is riskier than Boe’s average project, in terms of bothbeta risk and total risk Which of the following statements is most correct? (E)

a The project should be accepted since its expected return (before risk adjustment) isgreater than its required return

b The project should be rejected since its expected return (before risk adjustment) is lessthan its required return

c The accept/reject decision depends on the risk-adjustment policy of the firm If the firm’spolicy were to reduce a riskier-than-average project’s expected return by 1 percentagepoint, then the project should be accepted

d Riskier-than-average projects should have their expected returns increased toreflect their added riskiness Clearly, this would make the project acceptable regardless ofthe amount of the adjustment

e Projects should be evaluated on the basis of their total risk alone Thus, there is cient information in the problem to make an accept/reject decision Brigham

insuffi-58 Assume you are the director of capital budgeting for an all-equity firm The firm’s current cost

of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5percent You are considering a new project that has 50 percent more beta risk than your firm’sassets currently have, that is, its beta is 50 percent larger than the firm’s existing beta The

expected return on the new project is 18 percent Should the project be accepted if beta risk is

the appropriate risk measure? Choose the correct statement (M)

a Yes; its expected return is greater than the firm’s cost of capital

b Yes; the project’s risk-adjusted required return is less than its expected return

c No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent

d No; the project’s risk-adjusted required return is 2 percentage points above its expected

return

e No; the project’s risk-adjusted required return is 1 percentage point above its expected

59 Assume you are the director of capital budgeting for an all-equity firm The firm’s current cost

of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5

percent You are considering a new project that has 50 percent more beta risk than your firm’s

assets currently have, that is, its beta is 50 percent larger than the firm’s existing beta The

expected return on the new project is 18 percent Should the project be accepted if beta risk is

the appropriate risk measure? Choose the correct statement (M)

a Yes; its expected return is greater than the firm’s cost of capital

b Yes; the project’s risk-adjusted required return is less than its expected return

c No; a 50 percent increase in beta risk gives a risk-adjusted required return of 24 percent

d No; the project’s risk-adjusted required return is 2 percentage points above its expected

return

e No; the project’s risk-adjusted required return is 1 percentage point above its expected

COST OF CAPITAL

42 Cost of capital is (E)

a The interest rate an entity must pay to borrow money

b The return an entity’s stockholders expect on their investment

c The rate of return the entity can earn from investing available cash

d A concept of managerial finance incorporating all of the above L & H

13 Cost of capital is

a The amount the company must pay for its plant assets

b The dividends a company must pay on its equity securities

c The cost the company must incur to obtain its capital resources

d The cost the company is charged by investment bankers who handle the issuance of

26 A dollar now is worth more than a dollar to be received in the future because of

60 The theory underlying the cost of capital is primarily concerned with the cost of

A Long-term funds and old funds

B Short-term funds and new funds

C Long-term funds and new funds

D Any combination of old or new, short-term or long-term funds CMA 0692 1-13

61 Management knowledge of the cost of capital is useful for each of the following except (D)

a Making capital investment decisions

b Managing working capital

c Setting the maximum rate of return on new investments

62 In referring to the graph of a firm's cost of capital, if e is the current position, which one of thefollowing statements best explains the saucer or U-shaped curve?

Cost ofCapital(percent)

e

Debt-to-Equity Ratio

A The composition of debt and equity does not affect the firm's cost of capital

B The cost of capital is almost always favorably influenced by increases in financialleverage

C The financial markets will penalize firms that borrow even in moderate amounts

D Use of at least some debt financing will enhance the value of the firm CMA 1288 1-5

26 The pre-tax cost of capital is higher than the after-tax cost of capital because (E)

a interest expense is deductible for tax purposes

b principal payments on debt are deductible for tax purposes

c the cost of capital is a deductible expense for tax purposes

d dividend payments to stockholders are deductible for tax purposes Barfield

63 The overall cost of capital is the

A Rate of return on assets that covers the costs associated with the funds employed

B Average rate of return a firm earns on its assets

C Minimum rate a firm must earn on high-risk projects

D Cost of the firm's equity capital at which the market value of the firm will remain

* Which of these statements are pertinent to cost of capital? (D)

1 It is the expected return that investors demand for a given level of risk

2 It may be employed as a benchmark for the evaluation of performance

3 For investment decisions, it must be based on the current or prospective cost of the

various capital components rather than on their historical costs

4 It may also be used in acquisition analysis, liquidation studies and source of financing

decisions

5 It may differ from the hurdle rate used to reflect relative risk attributed to a specific project,

a All five statements c Statements 1, 2, 3, and 4 only

b Statements 1, 2 and 3 only d Statements 1, 2, 4 and 5 only

24 Which of the following is true?

a Companies can raise common equity only by issuing new shares of common stock

b There is no opportunity cost associated with use of retained earnings as a source of

common equity

c Most large mature firms issue new shares of common stock on a regular basis

d Companies can raise common equity by issuing new shares of common stock and

25 Which of the following is incorrect?

a The after-tax cost of debt for a firm with losses is equal to the interest rate on the debt

b Most debt is placed privately and thus there is no flotation cost

c Flotation costs for preferred stock are higher than for debt

d Firms always pay dividends on their common stock issues because of the ease with which

common shareholders can assume control of the firm S, S & S

Imputed Costs vs Explicit Costs

64 All of the following are examples of imputed costs except (M)

a The stated interest paid on a bank loan

b Assets that are considered obsolete that maintain a net book value

c Decelerated depreciation

d Lending funds to a supplier at a lower-than-market rate in exchange for receiving the

65 The explicit cost of debt financing is the interest expense The implicit cost(s) of debt financing

is (are) the (D)

a Increase in the cost of debt as the debt-to-equity ratio increases

b Increases in the cost of debt and equity as the debt-to-equity ratio increases

c Increase in the cost of equity as the debt-to-equity ratio decreases CMA 1291 1-2

d Decrease in the weighted-average cost of capital as the debt-to-equity ratio increases

Cost of Debt Capital

66 Which of the following statements is most correct? (E)

a Since the money is readily available, the cost of retained earnings is usually a lot cheaper

than the cost of debt financing

b When calculating the cost of preferred stock, a company needs to adjust for taxes,

because preferred stock dividends are tax deductible

c When calculating the cost of debt, a company needs to adjust for taxes, because interest

payments are tax deductible

d Statements a and b are correct

67 In computing the cost of capital, the cost of debt capital is determined by (E)

a Annual interest payment divided by the proceeds from debt issuance

b Interest rate times (1 – the firm’s tax rate)

c Annual interest payment divided by the book value of the debt

68 If k is the cost of debt and t is the marginal tax rate, the after-tax cost of debt k, is best

represented by the formula

69 If Brewer Corporation's bonds are currently yielding 8% in the marketplace, why is the firm's

cost of debt lower? (E)

A Market interest rates have increased

B Additional debt can be issued more cheaply than the original debt

C There should be no difference; cost of debt is the same as the bonds' market yield

70 The interest rate on the bonds is greater for the second alternative consisting of pure debt than

it is for the first alternative consisting of both debt and equity because

A The diversity of the combination alternative creates greater risk for the investor

B The pure debt alternative would flood the market and be more difficult to sell

C The pure debt alternative carries the risk of increasing the probability of default

D The combination alternative carries the risk of increasing dividend payments

71 If a $1,000 bond sells for $1,125, which of the following statements are correct?

I The market rate of interest is greater than the coupon rate on the bond

II The coupon rate on the bond is greater than the market rate of interest

III The coupon rate and the market rate are equal

IV The bond sells at a premium

V The bond sells at a discount

* If the return on total assets is 10% and if the return on common stockholders’ equity is 12%then (D)

a The after-tax cost of long-term debt is probably greater than 10%

b The after-tax cost of long-term debt is 12%

b The component cost of preferred stock is expressed as kp(1 - T), because preferred stockdividends are treated as fixed charges, similar to the treatment of debt interest

c The reason that a cost is assigned to retained earnings is because these funds arealready earning a return in the business; the reason does not involve the opportunity cost

d The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equityinvolves adding a subjectively determined risk-premium to the market risk-free bond rate

Marginal Cost of Debt

72 The marginal cost of debt for a firm is defined as the interest rate on <List A> debt minus the

<List B> (M)

D Outstanding Interest rate times the firm's marginal tax rate

73 Which of the following statements is most correct? (E)

a If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains

the same, the company’s marginal cost of debt capital used to calculate its weighted

average cost of capital will fall

b All else equal, an increase in a company’s stock price will increase the marginal cost of

retained earnings, ks

c All else equal, an increase in a company’s stock price will increase the marginal cost of

issuing new common equity, ke

d Statements a and b are correct

Cost of Debt & Cost of Preferred Stock

17 The basis for measuring the cost of capital derived from bonds and preferred stock,

respectively, is the (M)

A after-tax rate of interest for bonds and stated annual dividend rate for preferred stock

B pretax rate of interest for bonds and stated annual dividend rate less the expected

earnings per share for preferred stock

C pretax rate of interest for bonds and stated annual dividend rate for preferred stock

D after-tax rate of interest for bonds and stated annual dividend rate less the expected

Cost of Debt vs Cost of Equity Capital

74 In general, it is more expensive for a company to finance with equity capital than with debt

capital because (E)

A Long-term bonds have a maturity date and must therefore be repaid in the future

B Investors are exposed to greater risk with equity capital

C Equity capital is in greater demand than debt capital

D Dividends fluctuate to a greater extent than interest rates CMA 0690 1-15

Cost of Equity Capital

Cost of Preferred Stock

75 Which of the following statements is most correct? (M)

a The before-tax cost of preferred stock may be lower than the before-tax cost of debt, even

though preferred stock is riskier than debt

b If a company’s stock price increases, this increases its cost of common equity

c If the cost of equity capital is low enough, it may be cheaper to issue common stock than it

is to finance projects with retained earnings

Cost of Common Equity Which of the following factors in the discounted cash flow (DCF) approach to estimating thecost of common equity is the least difficult to estimate? (E)

a Expected growth rate, g c Required return, ks

b Dividend yield, D1/P0 d Expected rate of return, ks Brigham

76 Assume that nominal interest rates just increased substantially but that the expected futuredividends for a company over the long run were not affected As a result of the increase innominal interest rates, the company's stock price should

77 The market value of a firm’s outstanding common shares will be higher, everything else equal,

if (M)

a Investors have a lower required return on equity

b Investors expect lower dividend growth

c Investors have longer expected holding periods

d Investors have shorter expected holding periods CIA 1196 IV-25Cost of Retained Earnings

78 When calculating the cost of capital, the cost assigned to retained earnings should be (E)

A Zero

B Lower than the cost of external common equity

C Equal to the cost of external common equity

D Higher than the cost of external common equity CIA 1195 IV-43

79 Which of the following statements is most correct? (M)

a The cost of retained earnings is the rate of return stockholders require on a firm’s commonstock

b The component cost of preferred stock is expressed as kp(1 - T), because preferred stockdividends are treated as fixed charges, similar to the treatment of debt interest

c The bond-yield-plus-risk-premium approach to estimating a firm’s cost of common equityinvolves adding a subjectively determined risk-premium to the market risk-free bond rate

d The higher the firm’s flotation cost for new common stock, the more likely the firm is to use

Marginal Cost of Capital

80 If a company has a higher dividend-payout ratio, then, if all else if equal, it will have

a A higher marginal cost of capital.

b A lower marginal cost of capital

c A higher investment opportunity schedule

81 The firm’s marginal cost of capital (E)

a Should be the same as the firm’s rate of return on equity

b Is unaffected by the firm’s capital structure CMA 1291 1-8

c In inversely related to the firm’s required rate of return used in capital budgeting

d Is a weighted-average of the investors’ required returns on debt and equity

Dividend Growth Model

82 Which of the following criteria theoretically should be used to determine the valuation of

common stock? (E)

83 Which of the following is directly applied in determining the value of a stock when using the

dividend growth model?

A The firm's capital structure

B The firm's cash flows

C The firm's liquidity

D The investor's required rate of return on the firm's stock CIA 1190 IV-53

84 The three elements needed to estimate the cost of equity capital for use in determining a firm's

weighted-average cost of capital are (E)

A Current dividends per share, expected growth rate in dividends per share, and current

book value per share of common stock

B Current earnings per share, expected growth rate in dividends per share, and current

market price per share of common stock

C Current earnings pers share, expected growth rate in earnings per share, and current

book value per share of common stock

D Current dividends per share, expected growth rate in dividends per share, and current

25 The value of the stock:

A Increases as the dividend growth rate increases

B Increases as the required rate of return decreases

C Increases as the required rate of return increases

Dividend Growth Rate

14 Dividend growth rate for a stable firm can be estimated as:

A Plow back rate * the return on equity (ROE)

B Plow back rate / the return on equity (ROE)

C Plow back rate +the return on equity (ROE)

24 The growth rate in dividends can be thought of as a sum of two parts They are:

A ROE and the Retention Ratio

B Dividend yield and growth rate in dividends

C ROA and ROE

Dividend Growth Model Formula

12 The required rate of return on the market capitalization rate is estimated as follows:

A Dividend yield + expected rate of growth in dividends

B Dividend yield - expected rate of growth in dividends

C Dividend yield / expected rate of growth in dividends

D (Dividend yielD * (expected rate of growth in dividends) B & M

Capital Asset Pricing Model (CAPM)

49 The acronym CAPM stands for:

A Capital Asset Pricing Model C Current Arbitrage Pricing Method B & M

B Certainty Asset Pricing Method D Cumulative Arbitrage Pricing Model

85 The capital asset pricing model assumes (E)

a all investors are price takers

b all investors have the same holding period

c investors pay taxes on capital gains

d both a and b are true.

33 If investors do not know their investment horizons for certain (M)

a the CAPM is no longer valid

b the CAPM underlying assumptions are not violated

c the implications of the CAPM are not violated as long as investors’ liquidity needs re not

priced

37 The capital asset pricing model (CAPM) states that:

A The expected risk premium on an investment is proportional to its beta

B The expected rate of return on an investment is proportional to its beta

C The expected rate of return on an investment depends on the risk-free rate and the

D The expected rate of return on an investment is dependent on the risk-free rate

56 The drawback of the CAPM is that it:

A Ignores the return on the market portfolio

B Required a single measure of systematic risk

C Ignores risk-free return

Security Market Line

46 The security market line (SML) shows the relationship between

A Expected return and standard deviation

B Expected return and beta

C Standard deviation and risk

D Variance and beta

38 The security market line (SML) is the graph of:

A Expected rate on investment (Y-axis) vs variance of return

B Expected return on investment vs standard deviation of return

C Expected rate of return on investment vs beta

86 The Security Market Line (SML) is (M)

a the line that describes the expected return-beta relationship for well-diversified portfolios only

b also called the Capital Allocation Line

c the line that is tangent to the efficient frontier of all risky assets

d the line that represents the expected return-beta relationship

e the line that represents the relationship between an individual security’s return and the

87 The security market line (SML) (M)

a can be portrayed graphically as the expected return-beta relationship

b can be portrayed graphically as the expected return-standard deviation of market returnsrelationship

c provides a benchmark for evaluation of investment performance

d a and c.

88 Which statement is not true regarding the Capital Market Line (CML)? (M)

a The CML is the line from the risk-free rate through the market portfolio

b The CML is the best attainable capital allocation line

c The CML is also called the security market line

89 In equilibrium, the marginal price of risk for a risky security must be (M)

a equal to the marginal price of risk for the market portfolio

b greater than the marginal price of risk for the market portfolio

c less than the marginal price of risk for the market portfolio

90 An underpriced security will plot (E)

a on the Security Market Line

b below the Security Market Line

d either above or below the Security Market Line depending on its covariance with the arket

e either above or below the Security Market Line depending on its standard deviation

47 If a stock is overpriced it would plot:

A Above the security market line C Below the security market line

Variables

91 An analysis of a company’s planned equity financing using the capital asset pricing model (orsecurity market line) would incorporate only the

a Expected market earnings, the current U.S Treasury bond yield, and the beta coefficient

b Expected market earnings and the price-earnings ratio

c Current U.S Treasury bond yield, the price-earnings ratio, and the beta coefficient

d Current U.S Treasury bond yield and the dividend payout ratio CMA 1291 1-16

93 Which statement is not true regarding the market portfolio? (M)

a It includes all assets of the universe

c All securities in the market portfolio are held in proportion to their market values

d It is the tangency point between the capital market line and the indifference curve

Alpha Coefficient

94 According to the Capital Asset Pricing Model (CAPM), fairly priced securities (M)

a have positive betas c have negative betas

95 According to the Capital Asset Pricing Model (CAPM), (M)

a a security with a positive alpha is considered overpriced

b a security with a zero alpha is considered to be a good buy

c a security with a negative alpha is considered to be a good buy

d a security with a positive alpha is consider to be underpriced Bodie

Beta Coefficient

96 A measure that describes the risk of an investment project relative to other investments in

general is the (E)

A Coefficient of variation C Standard deviation

97 What is the formula for the beta coefficient of a security?

A Covariance of the returns on the market and on the security ÷ Variance of the return on

the market

B Covariance of the returns on the market and on the security x Variance of the return on

the market

C Variance of the return on the market ÷ Variance of the return on the security

D Variance of the return on the market x Variance of the return on the security ÷ Covariance

98 According to the capital asset pricing model (CAPM), the relevant risk of a security is its

A Company-specific risk C Systematic risk

39 Beta measures:

A The ability to diversify risk

B The change in the rate of return of an investment for a given change in the market rate ofreturn

C The actual return on an asset

40 Beta measure indicates:

A The ability to diversify risk

B The change in the rate of return on an investment for a given change in the market return

C The actual return on an asset

99 The market risk, beta, of a security is equal to (M)

a the covariance between the security’s return and the market return divided by the variance ofthe market's returns

b the covariance between the security and market returns divided by the standard deviation ofthe market's returns

c the variance of the security's returns divided by the covariance between the security and

d the variance of the security's returns divided by the variance of the market's returns

100 The market portfolio has a beta of (E)

If the firm is being operated so as to maximize shareholder wealth, and if our basicassumptions concerning the relationship between risk and return are true, then which of thefollowing should be true? (M)

a If the beta of the asset is larger than the firm’s beta, then the required return on the asset

is less than the required return on the firm

b If the beta of the asset is smaller than the firm’s beta, then the required return on the asset

is greater than the required return on the firm

c If the beta of the asset is greater than the firm’s beta prior to the addition of that asset,

then the firm’s beta after the purchase of the asset will be smaller than the original firm’s

beta

d If the beta of an asset is larger than the firm’s beta prior to the addition of that asset, then

the required return on the firm will be greater after the purchase of that asset than prior to

Which of the following statements is most correct? (M)

a Beta measures market risk, but if a firm’s stockholders are not well diversified, beta may

not accurately measure stand-alone risk

b If the calculated beta underestimates the firm’s true investment risk, then the CAPM

method will overestimate ks

c The discounted cash flow method of estimating the cost of equity can’t be used unless the

growth component, g, is constant during the analysis period Brigham

d An advantage shared by both the DCF and CAPM methods of estimating the cost of

equity capital, is that they yield precise estimates and require little or no judgement

Which of the following statements is correct? (M)

a The cost of capital used to evaluate a project should be the cost of the specific type of

financing used to fund that project

b The cost of debt used to calculate the weighted average cost of capital is based on an

average of the cost of debt already issued by the firm and the cost of new debt

c One problem with the CAPM approach to estimating the cost of equity capital is that if a

firm’s stockholders are, in fact, not well diversified, beta may be a poor measure of the

firm’s true investment risk

d The bond-yield-plus-risk-premium approach is the most sophisticated and objective

method of estimating a firm’s cost of equity capital

e The cost of equity capital is generally easier to measure than the cost of debt, which

varies daily with interest rates, or the cost of preferred stock since preferred stock is

101 In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is (E)

45 A stock with a beta of 1.2 would be expected to:

A Increase 20% faster than the market in up markets

B Increase 20% faster than the market in down markets

C Increase 120% faster than the market in up markets

D Increase 120% faster than the market in down markets B & MRisk-free Rate

102 What is the expected return of a zero-beta security? (M)

a The market rate of return c A negative rate of return

Risk Premium

103 According to the CAPM, the risk premium an investor expects to receive on any stock or portfolioincreases: (E)

a directly with alpha d inversely with beta

b inversely with alpha e in proportion to its standard deviation

104 The risk premium on the market portfolio will be proportional to (M)

a the average degree of risk aversion of the investor population

b the risk of the market portfolio as measured by its variance

c the risk of the market portfolio as measured by its beta

d both a and b are true.

36 The market risk premium is:

A The difference between the rate of return on an asset and the risk-free rate

B The difference between the rate of return on the market portfolio and the risk-free rate

C The risk-free rate

Pure Play Method Which of the following methods involves calculating an average beta for firms in a similarbusiness and then applying that beta to determine a project’s beta? (M)

a Risk premium method c Accounting beta method

105 Interstate Transport has a target capital structure of 50 percent debt and 50 percent commonequity The firm is considering a new independent project that has an expected return of 13

percent and is not related to transportation However, a pure play proxy firm has been

identified that is exclusively engaged in the new line of business The proxy firm has a beta of

1.38 Both firms have a marginal tax rate of 40 percent, and Interstate’s before-tax cost of debt

is 12 percent The risk-free rate is 10 percent and the market risk premium is 5 percent The

firm should(M)

a Reject the project; its expected return is less than the firm’s required rate of return on the

project of 16.9 percent

b Accept the project; its expected return is greater than the firm’s required rate of return on

the project of 12.05 percent

c Reject the project; its expected return is only 13 percent

d Accept the project; its expected return exceeds the risk-free rate and the before-tax cost

of debt

e Be indifferent between accepting or rejecting; the firm’s required rate of return on the

Required Rate of Return

106 If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on a

company's required rate of return on its stock of an increase in the beta coefficient from 1.2 to

1.5?

Expected Rate of Return vs Required Rate of Return

107 Security X has an expected rate of return of 0.11 and a beta of 1.5 The risk-free rate is 0.05 and

the market expected rate of return is 0.09 According to the Capital Asset Pricing Model, this

security is (M)

a underpriced

b overpriced

c fairly priced

108 The risk-free rate is 7 percent The expected market rate of return is 15 percent If you expect

stock X with a beta of 1.3 to offer a rate of return of 12 percent, you should (M)

a buy stock X because it is overpriced

b sell short stock X because it is overpriced

c sell stock short X because it is underpriced

109 Given the following two stocks A and B

If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would

be considered the better buy and why? (M)

a A because it offers an expected excess return of 1.2%

b B because it offers an expected excess return of 1.8%

c A because it offers an expected excess return of 2.2%

d B because it offers an expected return of 14%

Weighted-Average Cost of Capital (WACC)

1 The cost of capital is defined as (E)

a the simple average of the interest rates of all debt outstanding

b the simple average of the cost of debt and equity

c the weighted average of the interest rates of all debt outstanding

d the weighted average of the cost of debt and equity S, S & S Which of the following is not considered a capital component for the purpose of calculating theweighted average cost of capital as it applies to capital budgeting? (E)

28 The combined weighted average interest rate that a firm incurs on its long-term debt, preferredstock, and common stock is the

108.The weighted average cost of capital represents the

a cost of bonds, preferred stock, and common stock divided by the three sources

b equivalent units of capital used by the organization

c overall cost of capital from all organization financing sources

d overall cost of dividends plus interest paid by the organization Barfield

29 The weighted average cost of capital that is used to evaluate a specific project should bebased on the

a mix of capital components that was used to finance a project from last year

b overall capital structure of the corporation.

c cost of capital for other corporations with similar investments

d mix of capital components for all capital acquired in the most recent fiscal year Barfield

110 Which of the following statements is correct? (M)

a Because we often need to make comparisons among firms that are in different income tax

brackets, it is best to calculate the WACC on a before-tax basis

b If a firm has been suffering accounting losses and is expected to continue suffering such

losses, and therefore its tax rate is zero, it is possible that its after-tax component cost of

preferred stock as used to calculate the WACC will be less than its after-tax component

cost of debt

c Normally, the cost of external equity raised by issuing new common stock is above the

cost of retained earnings Moreover, the higher the growth rate is relative to the dividend

yield, the more the cost of external equity will exceed the cost of retained earnings

d The lower a company’s tax rate, the greater the advantage of using debt in terms of

111 When calculating a firm's cost of capital, all of the following are true except that (E)

A The cost of capital of a firm is the weighted average cost of its various financing

components

B The calculation of the cost of capital should focus on the historical costs of alternative

forms of financing rather than market or current costs

C All costs should be expressed as after-tax costs

D The time value of money should be incorporated into the calculations CMA 1288 1-2

112 A company has made the decision to finance next year's capital projects through debt rather

than additional equity The benchmark cost of capital for these projects should be (M)

A The before-tax cost of new-debt financing

B The after-tax cost of new-debt financing

C The cost of equity financing

113 Which of the following is true regarding the calculation of a firm's cost of capital? (E)

A The cost of capital of a firm is the weighted-average cost of its various financing

components

B All costs should be expressed as pre-tax costs

C The time value of money should be excluded from the calculations

18 The weighted-average cost of capital approach to decision making is not directly affected bythe: (E)

A proposed mix of debt, equity, and existing funds used to implement the project

B value of the common stock

C cost of debt outstanding

30 Debt in the capital structure could be treated as if it were common equity in computing theweighted average cost of capital if the debt were

For a typical firm with a given capital structure, which of the following is correct? (Note: Allrates are after taxes.) (E)

a kd > ke > ks > WACC c WACC > ke > ks > kd

b ks > ke > kd > WACC d ke > ks > WACC > kd Brigham

33 Which of the following is true?

A rD < rA < rE C rE < rA < rD

B rE < rD < rA D None of the above are true B & M

31 Generally, which of the following is true?

A rD > rA > rE C rE > rA > rD

B rE > rD > rA D None of the above are true B & M

114 Which of the following statements is correct? (M)

a The WACC should include only after-tax component costs Therefore, the required rates

of return (or “market rates”) on debt, preferred, and common equity (kd, kp, and ks) must beadjusted to an after-tax basis before they are used in the WACC equation Brigham

b The cost of retained earnings is generally higher than the cost of new common stock

c Preferred stock is riskier to investors than is debt Therefore, if someone told you that themarket rates showed kd >kp for a given company, that person must have made a mistake

d If a company with a debt ratio of 50 percent were suddenly exempted from all futureincome taxes, then, all other things held constant, this would cause its WACC to increase

115 Which of the following statements is most correct? (M)

a The weighted average cost of capital for a given capital budget level is a weighted

average of the marginal cost of each relevant capital component that makes up the firm’s

target capital structure

b The weighted average cost of capital is calculated on a before-tax basis

c An increase in the risk-free rate is likely to increase the marginal costs of both debt and

equity financing

116 A company has a capital structure that consists of 50 percent debt and 50 percent equity

Which of the following statements is most correct? (E)

a The cost of equity financing is greater than or equal to the cost of debt financing

b The WACC exceeds the cost of equity financing

c The WACC is calculated on a before-tax basis

d The WACC represents the cost of capital based on historical averages In that sense, it

does not represent the marginal cost of capital

e The cost of retained earnings exceeds the cost of issuing new common stock Brigham

117 Which of the following statements is most correct? (E)

a The WACC is a measure of the before-tax cost of capital

b Typically the after-tax cost of debt financing exceeds the after-tax cost of equity financing

c The WACC measures the marginal after-tax cost of capital

d Statements a and b are correct

118 Campbell Co is trying to estimate its weighted average cost of capital (WACC) Which of the

following statements is most correct? (E)

a The after-tax cost of debt is generally cheaper than the after-tax cost of preferred stock

b Since retained earnings are readily available, the cost of retained earnings is generally

lower than the cost of debt

c If the company’s beta increases, this will increase the cost of equity financing, even if the

company is able to rely on only retained earnings for its equity financing

d Statements a and b are correct

119 Which of the following statements is most correct? (E)

a The WACC represents the after-tax cost of capital

b The WACC represents the marginal cost of capital

c The cost of retained earnings is generally more expensive than the cost of issuing newcommon stock, because it includes an opportunity cost

d Statements a and b are correct

120 Which of the following statements about the cost of capital is incorrect? (E)

a A company’s target capital structure affects its weighted average cost of capital

b Weighted average cost of capital calculations should be based on the after-tax costs of allthe individual capital components

c If a company’s tax rate increases, then, all else equal, its weighted average cost of capitalwill increase

d Flotation costs can increase the weighted average cost of capital

e An increase in the risk-free rate is likely to increase the marginal costs of both debt and

A company estimates that an average-risk project has a WACC of 10 percent, a average risk project has a WACC of 8 percent, and an above-average risk project has aWACC of 12 percent Which of the following independent projects should the companyaccept? (E)

below-a Project A has average risk and a return of 9 percent

b Project B has below-average risk and a return of 8.5 percent

c Project C has above-average risk and a return of 11 percent

d All of the projects above should be accepted

22 Which of the following regarding the weighted-average cost of capital is true?

a The tax effect of preferred stock dividends should be included in the calculation ofweighted-average cost of capital

b The tax effect of common stock dividends should be included in the calculation ofweighted-average cost of capital

c The tax effect of debt should be included in the calculation of the weighted-average cost

of capital

d Taxes do not affect the weighted-average cost of capital S, S & S

23 Which of the following is true regarding the weighted-average cost of capital?

a A company may have two weighted-average costs of capital if the firm's capital structure

is so large that new common stock must be sold

b The book value of the components of capital should always be used to calculate the

weighted-average cost of capital

c The cost of common equity is lower than the cost of retained earnings

d The cost of preferred stock is adjusted for the tax deduction associated with preferred

WACC in a Tax-Free Environment

21 The cost of capital for a firm, rWACC, in a tax free environment is:

A Equal to the expected EBIT divided by market value of the unlevered firm

B Equal to rA, the rate of return for that business risk class

C Equal to the overall rate of return required on the levered firm

Capital Asset Pricing Model

121 Wyden Brothers has no retained earnings The company uses the CAPM to calculate the cost

of equity capital The company’s capital structure consists of common stock, preferred stock,

and debt Which of the following events will reduce the company’s WACC? (M)

a A reduction in the market risk premium

b An increase in the flotation costs associated with issuing new common stock

c An increase in the company’s beta

d An increase in expected inflation

e An increase in the flotation costs associated with issuing preferred stock Brigham

Required Rate of Return

122 Louisiana Enterprises, an all-equity firm, is considering a new capital investment Analysis has

indicated that the proposed investment has a beta of 0.5 and will generate an expected return

of 7 percent The firm currently has a required return of 10.75 percent and a beta of 1.25 The

investment, if undertaken, will double the firm’s total assets If kRF is 7 percent and the market

return is 10 percent, should the firm undertake the investment? (Choose the best answer.) (D)

a Yes; the expected return of the asset (7%) exceeds the required return (6.5%)

b Yes; the beta of the asset will reduce the risk of the firm

c No; the expected return of the asset (7%) is less than the required return (8.5%)

d No; the risk of the asset (beta) will increase the firm’s beta

e No; the expected return of the asset is less than the firm’s required return, which is

123 Interstate Transport has a target capital structure of 50 percent debt and 50 percent common

equity The firm is considering a new independent project that has a return of 13 percent and

is not related to transportation However, a pure play proxy firm has been identified that isexclusively engaged in the new line of business The proxy firm has a beta of 1.38 Both firmshave a marginal tax rate of 40 percent, and Interstate’s before-tax cost of debt is 12 percent.The risk-free rate is 10 percent and the market risk premium is 5 percent The firm should(M)

a Reject the project; its return is less than the firm’s required rate of return on the project of16.9 percent

b Accept the project; its return is greater than the firm’s required rate of return on the project

of 12.05 percent

c Reject the project; its return is only 13 percent

d Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt

e Be indifferent between accepting or rejecting; the firm’s required rate of return on the

Optimal Project Selection

no retained earnings If the company’s tax rate is 30 percent, then which of the projects will beaccepted? (M)

b Projects A and C d All of the investment projects will be taken

Sensitivity Analysis

Risk, Required Return and project betas If the firm is being operated so as to maximize shareholder wealth, and if our basicassumptions concerning the relationship between risk and return are true, then which of thefollowing should be true? (M)

a If the beta of the asset is larger than the firm’s beta, then the required return on the asset

is less than the required return on the firm

b If the beta of the asset is smaller than the firm’s beta, then the required return on the asset

is greater than the required return on the firm

c If the beta of the asset is greater than the corporate beta prior to the addition of that asset,

then the corporate beta after the purchase of the asset will be smaller than the original

corporate beta

d If the beta of an asset is larger than the corporate beta prior to the addition of that asset,

then the required return on the firm will be greater after the purchase of that asset than

Beta and project risk

Which of the following statements is correct? (D)

a A relatively risky future cash outflow should be evaluated using a relatively low discount

rate

b If a firm’s managers want to maximize the value of the stock, they should concentrate

exclusively on projects’ market, or beta, risk

c If a firm evaluates all projects using the same cost of capital, then the riskiness of the firm

as measured by its beta will probably decline over time

d If a firm has a beta that is less than 1.0, say 0.9, this would suggest that its assets’ returns

are negatively correlated with the returns of most other firms’ assets Brigham

Comprehensive

Which of the following statements is correct? (M)

a Although some methods of estimating the cost of equity capital encounter severe

difficulties, the CAPM is a simple and reliable model that provides great accuracy and

consistency in estimating the cost of equity capital

b The DCF model is preferred over other models to estimate the cost of equity because of

the ease with which a firm’s growth rate is obtained

c The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always

accurate but its advantages are that it is a standardized and objective model

d Depreciation-generated funds are an additional source of capital and, in fact, represent

the largest single source of funds for some firms Brigham

LEVERAGE

Limits of leverage

21 Which of the following are practical difficulties associated with capital structure and degree of

leverage analyses? (M)

a It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (ks

values) are affected by different degrees of financial leverage

b Managers’ attitudes toward risk differ and some managers may set a target capitalstructure other than the one that would maximize stock price

c Managers often have a responsibility to provide continuous service; they must preservethe long-run viability of the enterprise Thus, the goal of employing leverage to maximizeshort-run stock price and minimize capital cost may conflict with long-run viability

d All of the statements above are correct

e None of the statements above represents a serious impediment to the practicalapplication of leverage analysis in capital structure determination Brigham

126 The percentage change in earnings before interest and taxes associated with the percentage

change in sales volume represents the degree of (E)

A Operating leverage C Breakeven leverage

B Financial leverage D Combined leverage CIA 1189 IV-54

127 The degree of operating leverage (DOL) is

A Constant at all levels of sales

B A measure of the change in earnings available to common stockholders associated with a

given change in operating earnings

C A measure of the change in operating income resulting from a given change in sales

D Lower if the degree of total leverage is higher, other things held constant CIA 0594 IV-52

128 Companies experience changes in interest expenses, variable cost per unit, quantity of units

sold, and fixed costs Their degree of operating leverage is not affected by the change in

A Interest expenses C Quantity of units sold

B Variable cost per unit D Fixed costs CIA 1193 IV-53

129 A firm with a higher degree of operating leverage when compared to the industry average

implies that the

A Firm has higher variable costs

B Firm's profits are more sensitive to changes in sales volume

C Firm is more profitable

Financial Leverage

* Securing the funds for investment at a fixed rate of return to fund suppliers, to enhance the

well-being of the common stockholders is known as

* It refers to the practice of financing assets with borrowed capital Its extensive use may impact

on the return on common stockholders’ equity to be above or below the rate of return on total

assets

* “Trading on equity” pertains to the practice of (E) RPCPA 1077, 0588

a Trading in the stock of other companies c Using funds provided by creditors

b Retiring bonds before maturity d Purchasing and selling treasury stocks

* This accounting terminology has reference to long-term debt and means that you borrow

somebody’s money at an interest rate which is lower than the rate which you can earn on that

money

b Leverage or trading on equity d None of the above RPCPA 1084

* The use of borrowed capital by business firms is referred to as leverage or trading on equity.This leverage is likely to be a sound financial strategy for stockholders of companies having

a Cyclical high and low amounts of reported earnings

b Steady amounts of reported earnings

c Volatile fluctuation in reported earnings over short periods of time

d Steadily declining amounts of reported earnings RPCPA 1079

130 The purchase of treasury stock with a firm's surplus cash CMA 1291 1-5

A Increases a firm's assets C Increases a firm's interest coverage ratio

B Increases a firm's financial leverage D Dilutes a firm's earnings per share

131 When a company increases its degree of financial leverage (DFL)

a The equity beta of the company falls

b The systematic risk of the company falls

c The systematic risk of the company rises

d The standard deviation of returns on the equity of the company rises CIA 0597 IV-50

132 Sylvan Corporation has the following capital structure

The financial leverage of Sylvan Corporation would increase as a result of (M)

A Issuing common stock and using the proceeds to retire preferred stock

B Maintaining the same dollar level of cash dividends as the prior year, even thoughearnings have increased by 7%

C Financing its future investments with a higher percentage of bonds

D Financing its future investments with a higher percentage of equity funds CMA 0690 1-9

133 Everything else being equal, a <List A> highly leveraged firm will have <List B> earnings per share (D)

134 A company is considering the early retirement of its 10%, 10-year bonds payable Beforeretiring the bonds, the company's capital structure was

A Debt-equity ratio will increase C Asset turnover ratio will decrease.

B Financial leverage will decrease D Return on owner's equity will decrease

Financial leverage and EPS

135 Volga Publishing is considering a proposed increase in its debt ratio, which will also increase

the company’s interest expense The plan would involve the company issuing new bonds and

using the proceeds to buy back shares of its common stock The company’s CFO expects that

the plan will not change the company’s total assets or operating income However, the

company’s CFO does estimate that it will increase the company’s earnings per share (EPS)

Assuming the CFO’s estimates are correct, which of the following statements is most correct?

(E)

a Since the proposed plan increases Volga’s financial risk, the company’s stock price still

might fall even though its EPS is expected to increase

b If the plan reduces the company’s WACC, the company’s stock price is also likely to

decline

c Since the plan is expected to increase EPS, this implies that net income is also expected

to increase

d Statements a and b are correct

136 Which of the following statements is most correct? (E)

a Increasing financial leverage is one way to increase a firm’s basic earning power (BEP)

b Firms with lower fixed costs tend to have greater operating leverage

c The debt ratio that maximizes EPS generally exceeds the debt ratio which maximizes

share price

d Statements a and b are correct

Financial leverage and ratios

137 Company A and Company B have the same tax rate, the same total assets, and the samebasic earning power Both companies have a basic earning power that exceeds their before-tax costs of debt, kd However, Company A has a higher debt ratio and higher interest expensethan Company B Which of the following statements is most correct? (E)

a Company A has a lower net income than B

b Company A has a lower ROA than B

c Company A has a lower ROE than B

138 Firm U and Firm L each have the same total assets Both firms also have a basic earningpower of 20 percent Firm U is 100 percent equity financed, while Firm L is financed with 50percent debt and 50 percent equity Firm L’s debt has a before-tax cost of 8 percent Bothfirms have positive net income Which of the following statements is most correct? (E)

a The two companies have the same times interest earned (TIE) ratio

b Firm L has a lower ROA

c Firm L has a lower ROE

d Statements a and b are correct

Financial leverage and ratios

139 Company A and Company B have the same total assets, operating income (EBIT), tax rate,and business risk Company A, however, has a much higher debt ratio than Company B.Company A’s basic earning power (BEP) exceeds its cost of debt financing (kd) Which of thefollowing statements is most correct? (M)

a Company A has a higher return on assets (ROA) than Company B

b Company A has a higher times interest earned (TIE) ratio than Company B

c Company A has a higher return on equity (ROE) than Company B, and its risk, asmeasured by the standard deviation of ROE, is also higher than Company B’s

Operating and Financial Leverage

20 Which of the following statements is most correct? (M)

a Firms whose sales are very sensitive to changes in the business cycle are more likely torely on debt financing

b Firms with large tax loss carry forwards are more likely to rely on debt financing

c Firms with a high operating leverage are more likely to rely on debt financing

d Statements a and c are correct