Exam 9: Risk and the Cost of Capital

Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity instead of market values. The resulting WACC estimates will generally be too high.

On a graph with common stock returns on the y-axis and market returns on the x-axis, the slope of the regression line represents

Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate.

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the average return for Stock B and the market portfolio.

A project has an expected cash flow of $300 in year 3. The risk-free rate is 5 percent, the market risk premium is 8 percent, and the project's beta is 1.25. Calculate the certainty equivalent cash flow for year 3, CEQ₃.

Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free interest rate.

The cost of capital is the same as the cost of equity for firms that are financed

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. Calculate the beta for Stock B.

The market value of XYZ Corporation's common stock is $40 million and the market value of its risk-free debt is $60 million. The beta of the company's common stock is 0.8 and the expected market risk premium is 10 percent. If the Treasury bill rate is 6 percent, what is the firm's cost of capital? (Assume no taxes.)

A pure play is a comparable firm that specializes in one activity.

The company cost of capital, when the firm has both debt and equity financing, is called the

A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger confidence interval.

Which of the following informational updates would prompt a financial manager to use a higher cost of capital to analyze a project?

The historical returns for the past three years for Stock B and the stock market portfolio are Stock B: 24 percent, 0 percent, 24 percent; market portfolio: 10 percent, 12 percent, 20 percent. The expected market return is 12 percent. Calculate the required rate of return (cost of equity)for Stock B using the CAPM. (The risk-free rate of return = 4%.)

Projects with great amounts of diversifiable risk should generally have higher company costs of capital.

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. Calculate the beta of Stock C.

A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-term projects as opposed to long-term projects.

An analyst computes the beta of the computer company WinDoze as 1.7 and the standard error of the estimate as 0.3. What is the 95 percent confidence interval for the calculated beta?

Briefly describe the factors that determine asset betas.

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. Calculate the beta for Stock A.