Exam 3 Prep

Question 1

Which of the following is the best example of systematic risk?

Answer 1

The Federal Reserve tightens the money supply to fight inflation which causes the interest rates to rise.

Question 2

The risk-return tradeoff principle in finance is:

Answer 2

the expectation of receiving higher returns for higher risk investments.

Question 3

Which of the following is the best description of systematic risk?

Answer 3

Any risk that will impact the value of all assets simultaneously.

Question 4

Asset; Expected return; beta
A: 16%; 1.2
B: 14%; 1.0
C: 21%; 1.6

What is the beta of a portfolio consisting of 25% invested in Asset A, 45% invested in asset B, and 30% in asset C?

Answer 4

1.23

Question 5

You purchased Hobo Hats stock last year for $60 a share. Today, you received $2 a share dividend and immediately sold the stock for $63. Your realized return, or holding period return, was

Answer 5

8.33%

Question 6

An asset with a beta of 1.6 will have an expected return of ________ when the risk-free rate is 4% and the expected return on the market is 12%.

Answer 6

16.8%

Question 7

The beta for a portfolio is determined by calculating

Answer 7

a weighted average of individual stock betas where the weight equals the percentage invested in each stock.

Question 8

the correlation coefficient is a measure of

Answer 8

the degree of variation between asset returns.

Question 9

Under the capital asset pricing model, the relevant risk is

Answer 9

systematic risk

Question 10

the equity market risk premium is the

Answer 10

return of equities over T-bills

Question 11

Which of the following correlation coefficients would generate the most benefit in terms of risk reduction for a 2-asset portfolio that consists of 40% in Asset A and 60% in Asset B?

Answer 11

-0.65

Question 12

What is a percentage return of stock that was purchased at $45 and sold one year later for $55 if the stock also paid $3 in dividends over that time period?

Answer 12

28.9%

Question 13

A stock’s holding period return represents

Answer 13

the total return over a specific period through buying and selling an asset.

Question 14

____ risk is the only risk that matters to investors with broadly diversified portfolios.

Answer 14

systematic

Question 15

According to the security market line, a security with a beta of 1.5 should provide a risk premium that is ______ times the risk premium existing for the market as a whole.

Answer 15

1.5

Question 16

the correlation coefficient is a measure of

Answer 16

the degree of variation between asset returns.

Question 17

if the required return for a security is 15% and the risk-free rate is 6%, the risk premium is

Answer 17

9%

Question 18

You are considering two securities. Security A has a historical average annual return of 7% and a standard deviation of 3%. Security B has a historical average annual return of 7% and a standard deviation of 9%. From this information you can conclude that:

Answer 18

Security B is more risky than Security A

Question 19

firm-specific risk is the

Answer 19

diversifiable risk of an asset.

Question 20

The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock.

Answer 20

cost of capital

Question 21

The cost of retained earnings is equivalent to the cost of __________.

Answer 21

common stock

Question 22

The WACC represents the average __________ for the firm.

Answer 22

cost of financing

Question 23

The firm’s optimal mix of debt and equity is called its:

Answer 23

target capital structure

Question 24

The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.

Answer 24

9.57%

Question 25

Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?

Answer 25

current stock price

Question 26

A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm’s marginal tax rate is 40%. The cost of the preferred stock is;

Answer 26

8.25%

Question 27

The specific cost of each source of long-term financing is based on __________ costs.

Answer 27

after-tax and current

Question 28

A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources; Long-term debt = 45%, after-tax cost = 7% Preferred stock = 15%, after-tax cost = 10% Common stock equity = 40%, after-tax cost = 14% The weighted average cost of capital for this firm is;

Answer 28

10.25%

Question 29

The cost of debt used in the WACC is adjusted lower __________.

Answer 29

since there is a tax shield associated with paying interest

Question 30

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CAPM, what is the company’s cost of equity?

Answer 30

10.5%

Question 31

The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction’s effective cost of debt is:

Answer 31

4.65%

Question 32

A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________.

Answer 32

11.2%

Question 33

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CDGM, what is the company’s cost of equity?

Answer 33

7.3%

Question 34

A tax adjustment must be made in determining the cost of:

Answer 34

long-term debt

Question 35

the effective cost of debt is

Answer 35

less than the return paid to debt holders due to tax benefits of interest paid

Question 36

Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?

Answer 36

current stock price

Question 37

The cost of new preferred stock in the WACC is computed as the preferred dividend divided by the __________.

Answer 37

net proceeds from the sale of the preferred.