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 riskfree 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
riskfree rate. 
4. A company just paid a $2.00 per share dividend on its
common stock (D_{0} = $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, k_{e}?
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) 
Longterm 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 riskfree rate last year was 3%,
and the return on the market was 11%, which firm had the best performance on a
riskadjusted basis?
A) 
Firm A 
B) 
Firm B 
C) 
Firm C 
D) 
There is no difference in performance on
a riskadjusted 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 (D_{0}
= $2.40). The dividend is expected to grow at a rate of 6 percent per year. The
riskfree 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 highrisk projects and subtracting 2
percentage points from the WACC for lowrisk 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 longterm debt. In order to calculate
Clark's weighted average cost of capital (WACC), an analyst has accumulated the
following information:
· 
The company currently has 15year bonds
outstanding with annual coupon payments of 8 percent. The bonds have a face
value of $1,000 and sell for $1,075. 
· 
The riskfree 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) 
Tbills
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 fiveyear 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, highrisk projects. 
B) 
Rejecting good, lowrisk projects. 
C) 
Accepting only good, lowrisk projects. 
D) 
Accepting no projects. 
E) 
Answers a and b are correct. 
Exhibit 72
Outcome 
Probability 
Return 
Recession 
40% 
25% 
Expansion 
25% 
20% 
Boom 
35% 
45% 
20. Given Exhibit 72, 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 longterm bonds have a
beforetax 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 yearend dividend (D_{1}) 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
riskfree 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 riskfree 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