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FINA Ch.8 Risk Analysis in Investment Decisions
Exam 100% Verified
Total risk is measured by _____ and systematic risk is measured by ____. - ANSWER D. standard deviation; beta
When investment returns are less than perfectly positively correlated, the resulting diversification effect means that: - ANSWER E. spreading an investment across many diverse assets will eliminate some of the total risk.
Unsystematic risk: - ANSWER A. can be effectively eliminated by portfolio diversification.
Which of the following are examples of diversifiable risk?
I. An earthquake destroys Oakland, California.
II. The federal government levies an added $1,000 tax on all business entities.
III. Taxes on employment rise across the United States.
IV. Toymakers must make their toys substantially safer. - ANSWER D. I and IV only
Which of the following statements are correct concerning diversifiable, or unsystematic, risks?
I. Diversifiable risks can be effectively diversified away if an investor holds a portfolio containing thirty unrelated securities.
II. There is no reward for bearing diversifiable risks.
III. Diversifiable risks are usually related to a particular firm or industry.
IV. Beta measures diversifiable risk - ANSWER D. I, II, and III only
Which of the following statements concerning risk are correct?
I. Systematic risk is measured by beta.
II. The risk premium increases as unsystematic risk increases.
III. Systematic risk is the only part of total risk that should affect asset prices and returns.
IV. Diversifiable risks are market risks you cannot avoid. - ANSWER A. I and III only
Which one of the following is an example of systematic risk? - ANSWER A. The Federal Reserve unexpectedly announces an increase in target interest rates.
The extra return earned by a risky asset, for example with a beta of 1.4, over that earned by a risk-free asset is called a: - ANSWER B. risk premium.
The dividend growth model can be used to calculate the cost of equity for a firm in which of the following situations?
I. Firms that have a 100 percent retention ratio
II. Firms that pay an unchanging dividend
III. Firms that pay a constantly increasing dividend
IV. Firms that pay an erratically growing dividend - ANSWER C. II and III only
The cost of equity for a firm: - ANSWER C. ignores the firm's risks when that cost is based on the dividend growth model.
The pre-tax cost of debt - ANSWER A. is based on the current yield to maturity of the firm's outstanding bonds.
look at actual test - ANSWER C. 11.27%
FM is considering an average-risk investment with a cost of $100 million and an after-tax cash flow of $15 million per year in perpetuity. Which of the following statements is/are correct?
I. FM should reject the project because the IRR is greater than the firm's WACC.
II. FM should accept the project because the IRR is greater than the firm's WACC.
III. FM should accept the project because the NPV is greater than zero.
IV. FM should reject the project because the NPV is less than zero. - ANSWER E. II and III only
The IRR of the investment is 15/100 = 15%. FM's WACC of 11.27% is given in the table below. The NPV of the investment at the WACC = -100 + 15/.1127 = $33.1 million.
Which of the following statements are correct?
I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner.
II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%.
III. The cost of debt capital for a firm is most appropriately estimated using the coupon rates on its bonds.
IV. WACC or cost of capital is not the appropriate discount rate for all projects that a firm undertakes. - ANSWER D. I and IV only
Weighting method
The capital structure weights used in computing the weighted average cost of capital: - ANSWER B. are based on the market value of the firm's debt and equity securities.
Discount Rate Selection
The discount rate assigned to an individual project should be based on: - ANSWER E. the risks associated with the use of the funds required by the project.
Weighted average cost of capital for a firm is the - ANSWER B. rate of return a firm must earn on its existing assets to maintain the current value of its stock.
Blue Diamond Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750, shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the company's weighted average cost of capital? - ANSWER A. 10.39 percent
Re = 0.028 + 1.34 (0.112 - 0.028) = 0.14056; Rp = (0.07 $100)/$53 = 0.
Market values of: debt = 80,000$1,000 = $80.00M; preferred = 750,000$53 = $39.75M; and common = 2.5M * $42 = $105.00M. These sum to $224.75M. Thus, the WACC = ($105M/$224.75M) (0.14056) + ($39.75M/$224.75M) (0.13208) + ($80M/$224.75M) (0.0675) (1 - 0.38) = 10.39 percent
Honest Abe's is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe's. Honest Abe's has a beta of 1.38 relative to Integral Designs' beta of 1.12. Both firms have no debt, i.e., are 100% equity-financed. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture? - ANSWER A. 12.46 percent
KE = gov't borrowing rate + equity beta*market risk premium = 0.035 + 1.12(0.08) = 0.1246 or 12.46 percent
