Chapter 08 Test Bank

Chapter 08Test Bank

 

1. An average-risk project that has an NPV of zero when its cash flows are discounted at the weighted-average cost of capital will provide sufficient returns to satisfy both stockholders and bondholders.

 

TRUE

 

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2. All else equal, if two competing firms in industry X are valuing the same plant in industry Y for a potential acquisition, the firm with the more volatile stock should arrive at a lower valuation for the plant.

 

FALSE

 

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3. A beta greater than 1 is indicative of an above-average level of diversifiable (unsystematic) risk.

 

FALSE

 

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4. Failing to include real options in a project valuation could cause the NPV of the project to be overestimated.

 

FALSE

 

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5. The adjusted present value (APV) method of valuation is superior to the standard WACC method of valuation because the WACC method makes no adjustment for interest tax shields.

 

FALSE

 

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6. In reality, the cost of equity is always less than the cost of debt because firms are not obligated to pay out cash to shareholders.

 

FALSE

 

 

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7. Asset betas measure financial risk and business risk.

 

FALSE

 

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8. When projected cash flows are in nominal dollars, they should be discounted with a nominal discount rate.

 

TRUE

 

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9. A firm’s WACC is the appropriate discount rate to value a project undertaken by the firm only if the project has the same risk as the firm’s existing assets.

 

TRUE

 

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10. If a firm’s cost of debt is lower than its cost of equity, shifting the firm’s financing toward more debt will always reduce the firm’s WACC.

 

FALSE

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11. Total risk is measured by _____, and systematic risk is measured by ____.

 

1. beta; alpha
2. beta; standard deviation
3. WACC; beta
4. standard deviation; beta
5. standard deviation; variance
6. None of the options are correct.

 

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12. When investment returns are less than perfectly positively correlated, the resulting diversification effect means that

 

1. making an investment in two or three large stocks will eliminate all of the unsystematic risk.
2. making an investment in three companies all within the same industry will greatly reduce the systematic risk.
3. spreading an investment across five diverse companies will not lower the total risk.
4. spreading an investment across many diverse assets will eliminate all of the systematic risk.
5. spreading an investment across many diverse assets will eliminate some of the total risk.
6. None of the options are correct.

 

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13. Unsystematic risk

 

1. can be effectively eliminated by portfolio diversification.
2. is compensated for by the risk premium.
3. is measured by beta.
4. is measured by standard deviation.
5. is related to the overall economy.
6. None of the options are correct.

 

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14. Which of the following are examples of diversifiable risk?
15. An earthquake damages Oakland, California.
16. The federal government imposes an additional $1,000 fee on all business entities.

III. Employment taxes increase nationally.

1. Toymakers are required to improve their safety standards.

 

1. I and III only
2. II and IV only
3. II and III only
4. I and IV only
5. I, III, and IV only
6. None of the options are correct.

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15. Which of the following statements are correct concerning diversifiable, or unsystematic, risks?
16. Diversifiable risks can be largely eliminated by investing in 50 unrelated securities.
17. There is no reward for accepting diversifiable risks.

III. Diversifiable risks are generally associated with an individual firm or industry.

1. Beta measures diversifiable risk.

 

1. I and III only
2. II and IV only
3. I and IV only
4. I, II, and III only
5. I, II, III, and IV
6. None of the options are correct.

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16. Which of the following statements concerning risk are correct?
17. Systematic risk is measured by beta.
18. 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.

1. Diversifiable risks are market risks you cannot avoid.

 

1. I and III only
2. II and IV only
3. I and II only
4. III and IV only
5. I, II, and III only
6. None of the options are correct.

 

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17. Which one of the following is an example of systematic risk?

 

1. The Federal Reserve unexpectedly announces an increase in target interest rates.
2. A flood washes away a firm’s warehouse.
3. A city imposes an additional one-percent sales tax on all products.
4. A toymaker has to recall its top-selling toy.
5. Corn prices increase due to increased demand for alternative fuels.
6. None of the options are correct.

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18. The excess return earned by a risky asset, for example, with a beta of 1.4, over that earned by a risk-free asset is referred to as a

 

1. market risk premium.
2. risk premium.
3. systematic return.
4. total return.
5. real rate of return.
6. None of the options are correct.

 

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19. The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
20. Firms that have a 100-percent retention ratio
21. Firms that pay an unchanging dividend

III. Firms that pay a constantly increasing dividend IV. Firms that pay an erratically growing dividend

 

1. I and II only
2. I and IV only
3. II and III only
4. I, II, and III only
5. I, III, and IV only
6. None of the options are correct.

 

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20. The cost of equity for a firm

 

1. tends to remain static for firms with increasing levels of risk.
2. increases as the unsystematic risk of the firm increases.
3. can be estimated from the capital asset pricing model or the dividend growth model.
4. equals the risk-free rate plus the market risk premium.
5. equals the firm’s pre-tax weighted-average cost of capital.
6. None of the options are correct.

 

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21. The pre-tax cost of debt

 

1. is based on the current yield to maturity of the firm’s outstanding bonds.
2. is equal to the coupon rate on the latest bonds issued by a firm.
3. is equivalent to the average current yield on all of a firm’s outstanding bonds.
4. is based on the original yield to maturity on the latest bonds issued by a firm.
5. has to be estimated as it cannot be directly observed in the market.
6. None of the options are correct.

 

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22. The after-tax cost of debt generally increases when
23. a firm’s bond rating improves.
24. the market-required rate of interest for the company’s bonds increases.

III. tax rates decrease.

1. bond prices rise.

 

1. I and III only
2. II and III only
3. I, II, and III only
4. II, III, and IV only
5. I, II, III, and IV
6. None of the options are correct.

 

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[The following information applies to the questions displayed below.]
FM Foods, Inc.
Facts and assumptions as of Dec. 31, 2017	4.4%
Yield to maturity on long-term government bonds
Yield to maturity on company long-term bonds	6.3%
Coupon rate on company long-term bonds	7.0%
Historical excess return on common stocks	6.5%
Company equity beta	1.20
Stock price	$40.00
Number of shares outstanding (millions)	240
Book value of equity (millions)	$5,240
Book value of interest-bearing debt (millions)	$1,250
Tax rate	35.0%

 

23. Please refer to the information for FM Foods above. Estimate FM’s after-tax cost of equity capital.

 

4. 4.50%
5. 6.92%
6. 7.93%
7. 12.20%
8. 17.48%
9. None of the options are correct.

 

^KE = gov’t borrowing rate + equity beta × market risk premium = 0.044 + 1.2 × 0.065 = 0.122

 

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24. Please refer to the information for FM Foods above. Estimate FM’s after-tax cost of debt capital.

 

2. 2.21%
3. 4.10%
4. 4.55%
5. 6.30%
6. 7.00%
7. None of the options are correct.

 

The correct approach is to use the YTM on the firm’s bonds for the before-tax cost. Thus, after-tax cost = 6.3% × (1 − 0.35) = 4.10%.

 

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25. Please refer to the information for FM Foods above. Estimate the appropriate weight of equity to be used when calculating FM’s weighted-average cost of capital.

 

11. 11.5%
12. 19.3%
13. 80.7%
14. 88.5%
15. 100.0%
16. None of the options are correct.

 

Market value of equity = $40 × 240 million = $9,600 million. Weight of equity = 9,600/(9,600 + 1,250) = 0.8848 or 88.5%.

 

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26. Please refer to the information for FM Foods above. Estimate the appropriate weight of debt to be used when calculating FM’s weighted-average cost of capital.

 

11. 11.5%
12. 19.3%
13. 80.7%
14. 88.5%
15. 100.0%
16. None of the options are correct.

 

Market value of equity = $40 × 240 million = $9,600 million. Weight of debt = 1,250/(9,600 + 1,250) = 0.1152 or 11.5%.

 

 

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27. Please refer to the information for FM Foods above. Estimate FM’s weighted-average cost of capital.

 

6. 6.46%
7. 6.58%
8. 11.27%
9. 11.32%
10. 11.52%
11. None of the options are correct.

 

KW =	(1 − t)KD	D	+ KE	E
		D + E		D + E

 

KW  = (1−0.35) 0.063 (0.115) + 0.122 (0.885)

KW = 0.1127

 

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28. Please refer to the information for FM Foods above. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity. Which of the following statements is/are correct?

 

1. FM should reject the project because the IRR is greater than the firm’s WACC.
2. 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.

1. FM should reject the project because the NPV is less than zero.

 

1. I only
2. II only
3. IV only
4. I and IV only
5. II and III only
6. None of the options are correct.

 

The IRR of the investment is 15/100 = 15%. FM’s WACC of 11.27% is shown in the calculations below. The NPV of the investment at the WACC = −100 + 15/0.1127 = $33.1 million.

 

KW=  (1− t)KD	D	+ KE	E
	D + E		D + E

 

KW = (1−0.35) 0.063 (0.115) + 0.122 (0.885)

KW= 0.1127

 

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29.	Celebrity Auto Parts, Inc.
	Facts and assumptions as of Dec. 31, 2017
	EBIT for 2017 (millions)	$	420
	Company equity beta		1.20
	Stock price	$	30
	Number of shares outstanding (millions)		200
	Book value of equity (millions)	$	3,500
	Book value of interest-bearing debt (millions)	$	1,500
	WACC		9%
	Tax rate		25%

 

Please refer to the information for Celebrity Auto Parts above. What was Celebrity’s EVA in 2017?

 

1. −$360 million
2. −$135 million
3. −$30 million
4. $765 million
5. None of the options are correct.

 

EVA = EBIT(1 − t) − KWC = 420(1 − 25%) − 9%(3,500 + 1,500) = −$135

 

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30. Which of the following statements are correct?
31. 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.
32. 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 best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds.

1. A firm’s weighted-average cost of capital is NOT the correct discount rate to use for all projects undertaken by the firm.

 

1. I and III only
2. II and IV only
3. I and II only
4. I and IV only
5. I, II, and III only
6. None of the options are correct.

 

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31. The capital structure weights used in computing the weighted-average cost of capital

 

1. are based on the book values of total debt and total equity.
2. are based on the market value of the firm’s debt and equity securities.
3. are computed using the book value of the long-term debt and the book value of equity.
4. remain constant over time unless the firm issues new securities.
5. are restricted to the firm’s debt and common stock.
6. None of the options are correct.

 

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32. The discount rate assigned to an individual project should be based on

 

1. the firm’s weighted-average cost of capital.
2. the actual sources of funding used for the project.
3. an average of the firm’s overall cost of capital for the past five years.
4. the current risk level of the overall firm.
5. the risks associated with the use of the funds required by the project.
6. None of the options are correct.

 

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33. The weighted-average cost of capital for a firm is the

 

1. discount rate which the firm should apply to all of the projects it undertakes.
2. rate of return a firm must earn on its existing assets to maintain the current value of its stock.
3. coupon rate the firm should expect to pay on its next bond issue.
4. minimum discount rate the firm should require on any new project.
5. rate of return shareholders should expect to earn on their investment in this firm.
6. None of the options are correct.

 

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34. 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 as compared to Integral Designs’ beta of 1.12. Both firms carry 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?

 

12. 12.46%
13. 12.92%
14. 13.50%
15. 14.08%
16. 14.54%
17. None of the options are correct.

 

KE= gov’t borrowing rate + equity beta × market risk premium = 0.035 + 1.12(0.08) = 0.1246 or 12.46%

 

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35. A firm is considering an average-risk project with an IRR of 6%. The firm’s cost of debt (KD) is 5%, its cost of equity (KE) is 12%, and its tax rate (t) is 20%. The target debt ratio (D/(D+E)) for the project, in market values, is 0.5. The firm should

 

1. accept the project only if it can be completely financed with equity.
2. accept the project only if it can be completely financed with debt.
3. accept the project regardless of the financing method.
4. reject the project regardless of the financing method.

KW =(1− t)KD	D	+ KE	E
	D + E		D + E

 

KW = (1−0.2)0.05(0.5) + 0.12(0.5)

KW  = 0.08 = 8%

The project should be rejected because the IRR of 6% does not meet the hurdle of 8%.

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36. Unitron Corp. is considering project Z, which costs $50 million and offers an annual after-tax cash flow of $7.5 million in perpetuity. The project is in an industry that has greater market risk than Unitron’s typical projects. Unitron’s company weighted-average cost of capital, based on its typical projects, is 15%. Should Unitron Corp. accept project Z?

 

1. Yes, because the NPV of the project is positive.
2. Yes, because a zero-NPV project is marginally acceptable.
3. No, because a zero-NPV project is a waste of resources.
4. No, because the NPV of the project is negative.

 

Use the equation for a perpetuity to solve for the IRR:

7.5/IRR = 50 IRR = 15%

Since the IRR is 15%, it would have an NPV of zero at a WACC of 15%. However, this project is riskier than the firm’s average projects, so the WACC would be higher than 15%, which would make the NPV negative.

 

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37. Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the appropriate debt ratio (D/(D+E)) to use for calculating Company X’s weighted-average cost of capital?

 

23. 23.1%
24. 25.0%
25. 31.0%
26. 33.3%

 

D = 0.9 × $2 million = $1.8 million E = $3 ×2 million = $6 million D/(D+E) = 1.8/(1.8 + 6) = 0.231

 

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38. JKL Corporation, a company devoted primarily to paper products, is estimating the cost of equity appropriate for a vegetable processing plant it is planning to build. JKL Corp. has an equity beta of 1.0 and a debt ratio (D/(D+E)) of 0.3. A comparable (vegetable processing) firm has an equity beta of 0.8 and a debt ratio of 0.2. Assume a risk-free rate of 5% and a market risk premium of 8%. What cost of equity should JKL use in this situation?

 

7. 7.7%
8. 11.4%
9. 12.3%
10. 13.0%

 

Unlever the comparable firm’s beta: βA = (E/V)βE = (0.8)0.8 = 0.64

Then relever at JKL’s debt ratio: βE = βA/(E/V) = 0.64/(0.7) = 0.91

Cost of Equity: KE = 5% + 0.91(8%) = 12.3%

 

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39. Florida Corp. is calculating the appropriate rate for discounting cash flows on a project valued using the APV method. Florida’s target debt ratio (D/(D+E)) in market value terms is 50%, and the yield-to-maturity on its outstanding debt is 6%. A comparable firm has an equity beta of 1.4 and a debt ratio (D/(D+E)) of 40%. Assume a risk-free rate of 5% and a market risk premium of 8%. Florida’s tax rate is 40%. What discount rate should Florida use?

 

7. 7.66%
8. 11.02%
9. 11.72%
10. 18.44%

 

βA= (E/V)βE = (0.6)1.4 = 0.84 KE = 5% + 0.84(8%) = 11.72%

 

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40. Key facts and assumptions concerning Costco Company, at December 31, 2011, appear below.

 

Facts and Assumptions
Yield to maturity on long-term government bonds		3.28%
Yield to maturity on company long-term bonds		4.62%
Coupon rate on company long-term bonds		5.50%
Historical excess return on common stocks		6.10%
Company equity beta		0.80
Stock price	$	75.08
Number of shares outstanding (millions)		449.5
Book value of equity (millions)	$11,585
Book value of interest-bearing debt (millions)	$	2,524
Tax rate		35.00%

 

Use the above information to answer the following questions.

1. Estimate Costco’s cost of equity capital.
2. Estimate Costco’s weighted-average cost of capital.

 

3. KE = gov’t borrowing rate + equity beta × market risk premium KE = 3.28 + 0.80 × 6.10 = 8.16%

 

449. Market value of equity = 449.5 × 75.08 = $33,748

Weight for debt = 2,524/(2,524 + 33,748) = 0.070

 

KW =  (1− t)KD	D	+ KE	E
	D + E		D + E

 

KW = (1−0.35)0.0462(0.07) + 0.0816(0.93)

KW = 0.078 = 7.8%

 

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41. Explain the difference between systematic and unsystematic risk and why one of these types of risks is rewarded with a risk premium while the other type is not.

 

Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded because it can be eliminated by investors. Systematic risk is risk that affects most, or all, securities and cannot be diversified away. Since systematic risk cannot be eliminated by investors it is rewarded with a risk premium. Systematic risk is measured by beta.

 

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42. Suppose that your company’s weighted-average cost of capital is 9 percent. Your company is planning to undertake a project with an internal rate of return of 12%, but you believe that this project is not a good investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company’s cost of capital will destroy value? If so, how?

 

If the investment is above the company’s average risk, the company’s cost of capital is not an appropriate benchmark. Equivalently, you might argue that the high risk of the investment places it below the security market line. Such investments destroy value because they promise returns that, while greater than the company’s WACC, are still below those available on similar-risk investments available. Other possible arguments include that the investment is not consistent with the strategic plan or that the cash flow estimates are too optimistic.

 

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43. The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

 

The equation for beta in Chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio. Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. In other words, if investors can diversify away most of Wildcat’s risk, then it is not truly a high-risk investment.

 

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44. What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2 percent per year forever? Assume the appropriate discount rate is 12 percent.

 

Divide the cash flows into two periods: An 11-year annuity of $10,000, and a growing perpetuity beginning in the 11^th year. The value of the 11-year annuity is $59,377, as shown below:

 

Input:	11	12	?	10,000	0
	n	i	PV	PMT	FV
Output:			−59,377

 

In Excel:

=              PV(0.12,11,10000)

=              −59,377

The value of the growing perpetuity (using the formula provided in Chapter 8 for a growing dividend into perpetuity) at

time 11 is $10,000(1 + 0.02)/(0.12 − 0.02) = $102,000. Its value at time zero is $102,000/(1.12)¹¹ = $29,323. Adding these values, 29,323 + 59,377 = $88,700.

 

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45. Kilborn Corporation’s balance sheet is shown below. The current rate on treasury bonds is 7%. The yield to maturity on Kilborn’s bonds is 10%. Assume a market risk premium of 8%. Kilborn’s tax rate is 40%. Kilborn’s stock price is $45, and it has 2 million shares outstanding. Kilborn’s beta is unknown because it only recently went public, but it is known that a comparable firm’s stock has a beta of 1.2 and that the comparable firm’s debt ratio (D/(D+E)) is 0.4. What is the weighted-average cost of capital for Kilborn Corporation?

 

	Kilborn Corporation
	Balance Sheet ($ millions)
Assets			Liabilities and Equity
Cash and securities	10		Bonds	20
Accounts receivable	50		Common stock	50
Inventory	50		Retained earnings	80
Net fixed assets		40
Total assets	150		Total liab. and equity	150

 

Note that for Kilborn:

 

D = 20; E = 45 ×2 = 90; V = D + E = 110

Unlever the comparable firm’s beta: βA = (E/V)βE = (0.6)1.2 = 0.72

Then relever at Kilborn’s debt ratio: βE = βA/(E/V) = 0.72/(90/110) = 0.88

Cost of Equity: KE = 7% + 0.88(8%) = 14.04%

Cost of Debt: KD = 10%

KW =	(1 − t)KD	D	+ KE	E
		D + E		D + E

 

KW = (1−0.4) 0.1 (20/110) + 0.1404 (90/110)

KW = 0.126 = 12.6%

 

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Chapter 08 Test Bank Summary

Category	# of Questions
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Difficulty:  1 Easy	26
Difficulty:  2 Medium	17
Difficulty:  3 Hard	2
Gradable: automatic	39
Gradable: manual	6