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Chapter 13 Risk, Cost of Capital, and Capital Budgeting Answer Key

Multiple Choice Questions

1. The weighted average of the firm's costs of equity, preferred stock, and after tax debt is the:

A. reward to risk ratio for the firm.

B. expected capital gains yield for the stock.

C. expected capital gains yield for the firm.

D. portfolio beta for the firm.

E. weighted average cost of capital (WACC).

Difficulty level: Easy

Topic: WACC

Type: DEFINITIONS

2. If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the:

A. return on the stock minus the risk-free rate.

B. difference between the return on the market and the risk-free rate.

C. beta times the market risk premium.

D. beta times the risk-free rate.

E. market rate of return.

Difficulty level: Easy

Topic: CAPM

Type: DEFINITIONS

3. The best fit line of a pairwise plot of the returns of the security against the market index returns is called the:

A. Security Market Line.

B. Capital Market Line.

C. characteristic line.

D. risk line.

E. None of the above.

Difficulty level: Medium

Topic: CHARACTERISTIC LINE

Type: DEFINITIONS

4. The use of debt is called:

A. operating leverage.

B. production leverage.

C. financial leverage.

D. total asset turnover risk.

E. business risk.

Difficulty level: Medium

Topic: USE OF DEBT

Type: DEFINITIONS

5. The weighted average cost of capital for a firm is the:

A. discount rate which the firm should apply to all of the projects it undertakes.

B. overall rate which the firm must earn on its existing assets to maintain the value of its stock.

C. rate the firm should expect to pay on its next bond issue.

D. maximum rate which the firm should require on any projects it undertakes.

E. rate of return that the firm's preferred stockholders should expect to earn over the long term. Difficulty level: Medium

Topic: WEIGHTED AVERAGE COST OF CAPITAL

Type: DEFINITIONS

6. The WACC is used to _______ the expected cash flows when the firm has ____________.

A. discount; debt and equity in the capital structure

B. discount; short term financing on the balance sheet

C. increase; debt and equity in the capital structure

D. decrease; short term financing on the balance sheet

E. None of the above.

Difficulty level: Medium

Topic: WACC

Type: CONCEPTS

7. Using the CAPM to calculate the cost of capital for a risky project assumes that:

A. using the firm's beta is the same measure of risk as the project.

B. the firm is all-equity financed.

C. the financial risk is equal to business risk.

D. Both A and B.

E. Both A and C.

Difficulty level: Medium

Topic: CAPM

Type: CONCEPTS

8. The use of WACC to select investments is acceptable when the:

A. correlation of all new projects are equal.

B. NPV is positive when discounted by the WAC

C.

C. risk of the projects are equal to the risk of the firm.

D. firm is well diversified and the unsystematic risk is negligible.

E. None of the above.

Difficulty level: Easy

Topic: WACC

Type: CONCEPTS

9. If the risk of an investment project is different than the firm's risk then:

A. you must adjust the discount rate for the project based on the firm's risk.

B. you must adjust the discount rate for the project based on the project risk.

C. you must exercise risk aversion and use the market rate.

D. an average rate across prior projects is acceptable because estimates contain errors.

E. one must have the actual data to determine any differences in the calculations. Difficulty level: Easy

Topic: DISCOUNT RATE

Type: CONCEPTS

10. If the project beta and IRR coordinates plot above the SML the project should be:

A. accepted.

B. rejected.

C. It is impossible to tell.

D. It will depend on the NPV.

E. None of the above.

Difficulty level: Medium

Topic: SECURITY MARKET LINE

Type: CONCEPTS

11. The beta of a security provides an:

A. estimate of the market risk premium.

B. estimate of the slope of the Capital Market Line.

C. estimate of the slope of the Security Market Line.

D. estimate of the systematic risk of the security.

E. None of the above.

Difficulty level: Easy

Topic: BETA

Type: CONCEPTS

12. Regression analysis can be used to estimate:

A. beta.

B. the risk-free rate.

C. standard deviation.

D. variance.

E. expected return.

Difficulty level: Easy

Topic: BETA ESTIMATION

Type: CONCEPTS

13. Beta measures depend highly on the:

A. direction of the market variance.

B. overall cycle of the market.

C. variance of the market and asset, but not their co-movement.

D. covariance of the security with the market and how they are correlated.

E. All of the above.

Difficulty level: Medium

Topic: BETA

Type: CONCEPTS

14. The formula for calculating beta is given by the dividing the ___________ of the stock with the market portfolio by the ___________ of the market portfolio.

A. variance; covariance

B. covariance; variance

C. standard deviation; variance

D. expected return; variance

E. expected return; covariance

Difficulty level: Medium

Topic: BETA

Type: CONCEPTS

15. The slope of the characteristic line is the estimated:

A. intercept.

B. beta.

C. unsystematic risk.

D. market variance.

E. market risk premium.

Difficulty level: Medium

Topic: BETA AND CHARACTERISTIC LINE

Type: CONCEPTS

16. Companies that have highly cyclical sales will have a:

A. low beta if sales are highly dependent on the market cycle.

B. high beta if sales are highly dependent on the market cycle.

C. high beta if sales are independent of the market cycle.

D. All of the above.

E. None of the above.

Difficulty level: Medium

Topic: CYCLICAL BUSINESS AND BETA

Type: CONCEPTS

17. Betas may vary substantially across an industry. The decision to use the industry or firm beta to estimate the cost of capital depends on:

A. how small the estimation errors are of all betas across industries.

B. how similar the firm's operations are to the operations of all other firms in the industry.

C. whether the company is a leader or follower.

D. the size of the company's public float.

E. None of the above.

Difficulty level: Medium

Topic: INDUSTRY OR FIRM BETA

Type: CONCEPTS

18. Beta is useful in the calculation of the:

A. company's variance.

B. company's discount rate.

C. company's standard deviation.

D. unsystematic risk.

E. company's market rate.

Difficulty level: Medium

Topic: BETA

Type: CONCEPTS

19. For a multi-product firm, if a project's beta is different from that of the overall firm, then the:

A. CAPM can no longer be used.

B. project should be discounted using the overall firm's beta.

C. project should be discounted at a rate commensurate with its own beta.

D. project should be discounted at the market rate.

E. project should be discounted at the T-bill rate.

Difficulty level: Medium

Topic: PROJECT AND FIRM BETA

Type: CONCEPTS

20. The problem of using the overall firm's beta in discounting projects of different risk is the:

A. firm would accept too many high-risk projects.

B. firm would reject too many low risk projects.

C. firm would reject too many high-risk projects.

D. firm would accept too many low risk projects.

E. Both A and B.

Difficulty level: Medium

Topic: FIRM'S BETA

Type: CONCEPTS

21. The asset beta of a levered firm is generally:

A. equal to the equity beta.

B. different from the equity beta.

C. different from the debt beta.

D. the simple average of the equity beta and debt beta.

E. Both B and C.

Difficulty level: Medium

Topic: ASSET BETA

Type: CONCEPTS

22. Comparing two otherwise equal firms, the beta of the common stock of a levered firm is ____________ than the beta of the common stock of an unlevered firm.

A. equal to

B. significantly less

C. slightly less

D. greater

E. None of the above.

Difficulty level: Medium

Topic: LEVERED VS. UNLEVERED BETA

Type: CONCEPTS

23. The beta of a firm is determined by which of the following firm characteristics?

A. Cycles in revenues

B. Operating leverage

C. Financial leverage

D. All of the above.

E. None of the above.

Difficulty level: Medium

Topic: DETERMINANTS OF BETA

Type: CONCEPTS