Exam 9: Risk and the Cost of Capital

The company cost of capital is the appropriate discount rate for a firm's

Why do firms with large cash-flow betas also have high asset betas?

An analyst should evaluate each project at its own opportunity cost of capital. The true cost of capital depends on the particular use of that capital.

An example of diversifiable risk that a financial manager should ignore when analyzing a project's risk would include

Firms with high operating leverage tend to have higher asset betas.

The company cost of capital is the correct discount rate for any project undertaken by the company.

Briefly explain the difference between company and project cost of capital.

Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount rate.

A firm's cost of equity can be estimated using the I.discounted cash-flow (DCF)approach; II.capital asset pricing model (CAPM); III.arbitrage pricing theory

Cyclical firms tend to have high betas.

Company A's historical returns for the past three years were 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. According to the security market line (SML), Stock A was

Briefly explain how the use of a single company cost of capital to evaluate all projects might lead to erroneous decisions.

Company A's historical returns for the past three years are 6 percent, 15 percent, and 15 percent. Similarly, the market portfolio's returns were 10 percent, 10 percent, and 16 percent. Suppose the risk-free rate of return is 4 percent and that investors expect the market to return 10 percent. What is the cost of equity capital (required rate of return of company A's common stock), computed with the CAPM?

A project has an expected risky cash flow of $500 in year 2. The risk-free rate is 4 percent, the expected market rate of return is 14 percent, and the project's beta is 1.20. Calculate the certainty equivalent cash flow for year 2, CEQ₂.

If a firm uses the same company cost of capital for evaluating all projects, which situation(s)will likely occur? I.The firm will reject good low-risk projects; II.The firm will accept poor high-risk projects; III.The firm will correctly accept projects with average risk

The historical returns for the past four years for Stock C and the stock market portfolio are Stock C: 10 percent, 30 percent, 20 percent, 20 percent; market portfolio: 5 percent, 15 percent, 25 percent, 15 percent. If the risk-free rate of return is 5 percent and the expected market return is 12 percent, calculate the required rate of return on Stock C using the CAPM.

Which of the following types of projects has average total risk?

The company cost of capital is the cost of debt of the firm.

A firm's cost of equity can be estimated using the

The historical returns for the past three years for Stock B and the stock market portfolio were Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the observed variance of the market portfolio returns. (Ignore the correction for the loss of a degree of freedom set out in the text.)