Finance 221 Fall 2005 Exam 3

 

Multiple Choice

Identify the letter of the choice that best completes the statement or answers the question.

 

           1.           Which of the following is a problem with the Internal Rate of Return?

A)

appropriate adjustment for the time value of money

B)

focus on cash flows

C)

multiple IRRs

D)

all of the above are problems with the Internal Rate of Return

 

 

           2.           An asset has a beta of 2.0 and an expected return of 20%. The expected risk premium on the market portfolio is 5% and the risk-free is 7%. The stock is

A)

overpriced

B)

underpriced

C)

appropriately priced

D)

Cannot tell from the given information

 

 

           3.           The slope of the security market line is:

A)

the return on the market.

B)

beta.

C)

the market risk premium.

D)

the risk-free rate.

 

 

           4.           A company just paid a $2.00 per share dividend on its common stock (D0 = $2.00). The dividend is expected to grow at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If the company issues additional stock, it must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, ke?

A)

11.76%

B)

11.88%

C)

11.98%

D)

12.22%

E)

12.30%

 

 

           5.           Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting?

A)

Long-term debt.

B)

Common stock.

C)

Accounts payable and accruals.

D)

Preferred stock.

 

 

           6.           You have the following data on the securities of three firms:

 

 

Return last year

Beta

Firm A

10%

0.8

Firm B

11%

1.0

Firm C

12%

1.2

 

If the risk-free rate last year was 3%, and the return on the market was 11%, which firm had the best performance on a risk-adjusted basis?

A)

Firm A

B)

Firm B

C)

Firm C

D)

There is no difference in performance on a risk-adjusted basis

 

 

           7.           Hudson Hotels is considering two mutually exclusive projects, Project A and Project B. The cash flows from the projects are summarized below:

 

Year

Project A Cash Flow

Project B Cash Flow

0

-$100,000   

-$200,000   

1

25,000

50,000

2

25,000

50,000

3

50,000

80,000

4

50,000

100,000 

 

The two projects have the same risk. At what cost of capital would the two projects have the same net present value (NPV)?

A)

   2.86%

B)

 13.04%

C)

 15.90%

D)

 10.03%

E)

-24.45%

 

 

           8.           Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?

A)

A reduction in the market risk premium.

B)

An increase in the flotation costs associated with issuing new common stock.

C)

An increase in the company's beta.

D)

An increase in expected inflation.

E)

An increase in the flotation costs associated with issuing preferred stock.

 

 

           9.           A particular stock has a beta of 1.4 and an expected return of 13%. If the expected risk premium on the market portfolio is 6%, what’s the expected return on the market portfolio?

A)

10.6%

B)

4.6%

C)

8.4%

D)

9.3%

 

 

           10.         Thames Inc.'s most recent dividend was $2.40 per share (D0 = $2.40). The dividend is expected to grow at a rate of 6 percent per year. The risk-free rate is 5 percent and the return on the market is 9 percent. If the company's beta is 1.3, what is the price of the stock today?

A)

$72.14

B)

$57.14

C)

$40.00

D)

$68.06

E)

$60.57

 

 

           11.         The managers of Kenforest Grocers are trying to determine the company's optimal capital budget for the upcoming year. Kenforest is considering the following projects:

 

Project

Size

Rate of Return

Risk

A

$200,000 

16%

High

B

500,000

14 

Average

C

400,000

12 

Low

D

300,000

11 

High

E

100,000

10 

Average

F

200,000

10 

Low

G

400,000

7

Low

 

The company estimates that its WACC is 11 percent. All projects are independent. The company adjusts for risk by adding 2 percentage points to the WACC for high-risk projects and subtracting 2 percentage points from the WACC for low-risk projects. Which of the projects will the company accept?

A)

A, B, C, E, F

B)

B, D, F, G

C)

A, B, C, E

D)

A, B, C, D, E

E)

A, B, C, F

 

 

           12.         Clark Communications has a capital structure that consists of 70 percent common stock and 30 percent long-term debt. In order to calculate Clark's weighted average cost of capital (WACC), an analyst has accumulated the following information:

 

·

The company currently has 15-year bonds outstanding with annual coupon payments of 8 percent. The bonds have a face value of $1,000 and sell for $1,075.

·

The risk-free rate is 5 percent.

·

The market risk premium is 4 percent.

·

The beta on Clark's common stock is 1.1.

·

The company's retained earnings are sufficient so that they do not have to issue any new common stock to fund capital projects.

·

The company's tax rate is 38 percent.

 

Given this information, what is Clark's WACC?

A)

5.93%

B)

7.40%

C)

7.91%

D)

8.07%

E)

8.73%

 

 

           13.         What is one of the most important lessons from capital market history?

A)

Risk does not matter.

B)

There is a positive relationship between risk and return.

C)

You are always better off investing in stock.

D)

T-bills are the highest yielding investment.

 

 

           14.         Shannon Industries is considering a project that has the following cash flows:

 

Year

Project Cash Flow

0

?

1

$2,000 

2

3,000

3

3,000

4

1,500

 

The project has a payback of 2.5 years. The firm's cost of capital is 12 percent. What is the project's net present value (NPV)?

A)

$   577.68

B)

$   765.91

C)

$1,049.80

D)

$2,761.32

E)

$3,765.91

 

 

           15.         Martin Manufacturers is considering a five-year investment that costs $100,000. The investment will produce cash flows of $25,000 each year for the first two years (t = 1 and t = 2), $50,000 a year for each of the remaining three years (t = 3, t = 4, and t = 5). The company has a weighted average cost of capital of 12 percent. What is the MIRR of the investment?

A)

12.10%

B)

14.33%

C)

16.00%

D)

18.25%

E)

19.45%

 

 

           16.         Project A and Project B are mutually exclusive projects with equal risk. Project A has an internal rate of return of 12 percent, while Project B has an internal rate of return of 15 percent. The two projects have the same net present value when the cost of capital is 7 percent. (In other words, the crossover rate is 7 percent.) Assume each project has an initial cash outflow followed by a series of inflows. Which of the following statements is most correct?

A)

If the cost of capital is 10 percent, each project will have a positive net present value.

B)

If the cost of capital is 6 percent, Project B has a higher net present value than Project A.

C)

If the cost of capital is 13 percent, Project B has a higher net present value than Project A.

D)

Statements a and b are correct.

E)

Statements a and c are correct.

 

 

           17.         A capital investment's internal rate of return

A)

Changes when the cost of capital changes.

B)

Is equal to the annual net cash flows divided by one half of the project's cost when the cash flows are an annuity.

C)

Must exceed the cost of capital in order for the firm to accept the investment.

D)

Is similar to the yield to maturity on a bond.

E)

Statements c and d are correct.

 

 

           18.         A portfolio has 40% invested in Asset 1, 50% invested in Asset 2 and 10% invested in Asset 3. Asset 1 has a beta of 1.2, Asset 2 has a beta of 0.8 and Asset 3 has a beta of 1.8,  what’s the beta of the portfolio?

A)

1.27

B)

0.80

C)

1.06

D)

1.20

E)

Cannot tell from given information

 

 

           19.         If a company uses the same cost of capital for evaluating all projects, which of the following results is likely?

A)

Accepting poor, high-risk projects.

B)

Rejecting good, low-risk projects.

C)

Accepting only good, low-risk projects.

D)

Accepting no projects.

E)

Answers a and b are correct.

 

 

Exhibit 7-2

 

Outcome

Probability

Return

Recession

40%

-25%

Expansion

25%

20%

Boom

35%

45%

 

 

           20.         Given Exhibit 7-2, what is the expected standard deviation?

A)

957.38%

B)

1058.69%

C)

30.71%

D)

32.54%

 

 

           21.         A major disadvantage of the payback period is that it

A)

Is useless as a risk indicator.

B)

Ignores cash flows beyond the payback period.

C)

Does not directly account for the time value of money.

D)

Statements b and c are correct.

E)

All of the statements above are correct.

 

 

           22.         Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The company's long-term bonds have a before-tax yield to maturity of 8.4 percent. The company uses the DCF approach to determine the cost of equity. Flaherty's common stock currently trades at $45 per share. The year-end dividend (D1) is expected to be $2.50 per share, and the dividend is expected to grow forever at a constant rate of 7 percent a year. The company estimates that it will have to issue new common stock to help fund this year's projects. The flotation cost on new common stock issued is 10 percent, and the company's tax rate is 40 percent. What is the company's weighted average cost of capital, WACC?

A)

10.73%

B)

10.30%

C)

11.31%

D)

  7.48%

E)

  9.89%

 

 

           23.         Project A has a 10 percent cost of capital and the following cash flows:

 

Year

Project A Cash Flow

0

-$300  

1

100

2

150

3

200

4

 50

 

What is Project A's discounted payback?

A)

2.25 years

B)

2.36 years

C)

2.43 years

D)

2.50 years

E)

2.57 years

 

 

           24.         According to the CAPM (capital asset pricing model), what is the single factor that explains differences in returns across securities?

A)

the risk-free rate

B)

the expected risk premium on the market portfolio

C)

the beta of a security

D)

the expected return on the market portfolio

E)

the volatility of a security

 

 

           25.         If we are able to eliminate all of the unsystematic risk in a portfolio then, what is the result?

A)

a risk-free portfolio

B)

a portfolio that contains only systematic risk

C)

a portfolio that has an expected return of zero

D)

such a portfolio cannot be constructed since there will always be unsystematic risk in any portfolio

 


Finance 221 Fall 2005 Exam 3

Answer Section

 

MULTIPLE CHOICE

 

           1.                   C

 

           2.                   B

 

           3.                   C

 

           4.                   D

 

           5.                   C

 

           6.                   A

 

           7.                   D

 

           8.                   A

 

           9.                   A

 

           10.                 E

 

           11.                 E

 

           12.                 C

 

           13.                 B

 

           14.                 B

 

           15.                 E

 

           16.                 E

 

           17.                 E

 

           18.                 C

 

           19.                 E

 

           20.                 C

 

           21.                 D

 

           22.                 A

 

           23.                 E

 

           24.                 C

 

           25.                 B