Question 1

If an asset's beta is high, its:

Accepted Answer

Beta measures an asset's nondiversifiable risk, so a high beta means that the asset's nondiversifiable risk is high. This is why the correct answer is option B. A high beta does not necessarily indicate that the expected return is high.

Question 2

The asset beta in the Capital Asset Pricing Model is a moderate number that measures:

Accepted Answer

The asset beta measures how sensitive the asset's return is to market movements. It is a measure of systematic risk, or the risk that cannot be diversified away.

Question 3

Which is the best example of a nondiversifiable risk for Stalwart Shoes?

Accepted Answer

The state of the U.S. economy would affect Stalwart Shoes along with the entire market as a whole, making it a nondiversifiable risk that cannot be hedged against through diversification within the company's specific industry.

Question 4

The "Capital Asset Pricing Model" measures the risk premium for a capital investment by comparing the expected return on that investment with the:

Accepted Answer

The Capital Asset Pricing Model (CAPM) measures the risk premium for a capital investment by comparing the expected return on that investment with the expected return on the entire stock market. This model helps in understanding the relationship between the risk of an investment and its expected return, using the market's return as a benchmark.

Question 5

The beta for General Motors (GM) is 0.5, the risk-free rate is 4%, and the market return is 9%. What is GM's risk-adjusted discount rate?

Accepted Answer

The formula for the risk-adjusted discount rate is:

Risk-adjusted discount rate = Risk-free rate + Beta x (Market return - Risk-free rate)

Substituting the given values, we get:

Risk-adjusted discount rate = 4% + 0.5 x (9% - 4%) = 4% + 0.5 x 5% = 6.5%

Therefore, the correct answer is C) 6.5%.

Question 6

Of the following endeavors of Happy Home Insurance Company of California, which involves the most nondiversifiable risk?

Accepted Answer

Earthquake insurance involves the most nondiversifiable risk, as earthquakes are natural disasters and can affect a large area, making it difficult to spread the risk. This type of insurance is also more expensive due to the high potential loss from an earthquake.

Question 7

If a project's only risk is diversifiable,

Accepted Answer

Diversifiable risk, also known as unsystematic risk, can be eliminated through diversification. Therefore, it is not priced into the market and does not affect the discount rate used for evaluating projects in the context of the Capital Asset Pricing Model (CAPM) or similar models. Only non-diversifiable (systematic) risk affects the discount rate.

Question 8

The Ampex Corp. manufactures brass fittings for the plumbing industry. It has an opportunity to produce and sell brass components for residential electric fixtures. If it does produce components for electrical fixtures, it will have to spend $500,000 initially. It expects to get a nominal net cash flow of $200,000 in each of the five years life of the project. If the real interest rate is 8 percent per year and the inflation rate is 4 percent per year, what will the NPV of the project be?

Accepted Answer

The answer of The Ampex Corp. manufactures brass fittings for...

Question 9

You have been given an opportunity to invest in a stock. Recent trends suggest that a one percent rise in the stock market leads to approximately a two and one-half percent rise in the price of this stock. The real risk-free rate currently stands at 6% and stocks on average have provided 12% returns. Using the capital asset pricing model, determine the appropriate discount rate for the stock in question.

Accepted Answer

The answer of You have been given an opportunity to...

Question 10

The decision firms make about new capital projects is most like the decision consumers make when they decide:

Accepted Answer

The decision firms make about new capital projects involves considering the potential costs and benefits of the project over a long period of time, similar to the decision consumers make when deciding whether to buy a new house. Both decisions involve a significant investment of resources and a long-term commitment. The other options listed involve shorter-term decisions or less significant investments.

Question 11

A "risky" asset will earn a rate of return close to that of "riskless" assets if its risk is:

Accepted Answer

Diversifiable risk refers to the specific risk associated with individual assets that can be mitigated through diversification. When an asset's risk is diversifiable, it means that by combining it with other assets in a well-diversified portfolio, the overall risk can be reduced to the point where the portfolio's return could approach that of riskless assets, assuming the diversifiable risks are effectively managed.

Question 12

Some universities now offer "tuition bonds." Parents can purchase a bond at the time their child is born. The bond is redeemable in 18 years for an amount of money equal to the cost of the university's tuition at that time. Which of the following would reduce the market price of these bonds?

Accepted Answer

An increase in the rate of interest would make alternative investments more attractive compared to the tuition bonds, reducing their market price. Legislation limiting tuition increases to the rate of inflation could make the bonds less valuable if tuition costs were expected to increase at a rate higher than inflation, also reducing their market price.

Question 13

Suppose a firm's stock valuation is worth three times its outstanding debt. The firm's stock earns an annual return of 6 percent and pays 8 percent on the outstanding debt. What is the firm's company cost of capital?

Accepted Answer

The first step is to find the weights of debt and equity. Since the stock valuation is worth three times the outstanding debt, we can assume that the firm has one unit of debt and three units of equity.

Weight of debt = 1 / (1 + 3) = 0.25
Weight of equity = 3 / (1 + 3) = 0.75

Next, we need to calculate the cost of equity using the capital asset pricing model (CAPM):

Cost of equity = risk-free rate + beta * market risk premium
Assuming the risk-free rate is 2 percent and the equity's beta is 1 (which is average), we can use the market risk premium as the difference between the equity return and the risk-free rate:

Market risk premium = 6% - 2% = 4%

Cost of equity = 2% + 1 * 4% = 6%

Finally, we can calculate the weighted average cost of capital (WACC) using the weights and costs of debt and equity:

WACC = (0.25 * 8%) + (0.75 * 6%) = 6.5%

Question 14

The higher the beta,

Accepted Answer

Beta is a measure of systematic risk, which is nondiversifiable risk. Therefore, as beta increases, so does nondiversifiable risk (D). The diversifiable risk is company-specific risk, which is not affected by changes in beta (A and C are incorrect).

Question 15

Use the following statements to answer this question: I. The company cost of capital is identical to the risk-adjusted rate of return.
II) The company cost of capital does not depend on beta but does depend on the firm's interest rate on debt obligations.

Accepted Answer

I is false because the company cost of capital is not always identical to the risk-adjusted rate of return; it is a broader concept that includes the weighted average cost of capital (WACC), which accounts for the cost of equity and the cost of debt. II is false because the company cost of capital does depend on beta, which affects the cost of equity as part of the Capital Asset Pricing Model (CAPM). The firm's interest rate on debt obligations is only part of the cost of capital, not the sole determinant.

Question 16

If the rate of return on the stock market is r_m and the rate of return on a risk-free asset is r_f, then:

Accepted Answer

The difference between the rate of return on the stock market and the risk-free rate of return represents the additional return an investor can earn by taking on the risk of investing in the stock market. This risk includes both diversifiable (company-specific) and non-diversifiable (market-wide) components, but since the question specifies "all of it nondiversifiable," we can conclude that the difference in returns measures the non-diversifiable risk an investor must accept in order to earn the higher return from the stock market.

Question 17

Which kind of risk affects the opportunity cost of capital?

Accepted Answer

Nondiversifiable risk, also known as systematic or market risk, affects the overall market and cannot be eliminated through diversification. This type of risk affects the opportunity cost of capital because investors will require a higher return to compensate for taking on this risk.

Question 18

The weighted average of a firm's expected return on its stock and the interest rate that it pays for debt is known as the:

Accepted Answer

The weighted average of a firm's expected return on its stock and the interest rate that it pays for debt is known as the company cost of capital. This is the minimum rate of return that a company must earn on its investments in order to satisfy its investors and creditors. It is used in evaluating potential investment opportunities, as any project or investment must generate returns that exceed the company cost of capital in order to be considered worthwhile.

Question 19

Another name for diversifiable risk is:

Accepted Answer

Diversifiable risk is also known as unsystematic or nonsystematic risk, which is the risk that comes from specific company or industry factors and can be reduced through diversification of investments.

Question 20

An asset's beta can be used to compute its discount rate for an NPV calculation because the discount rate is equal to:

Accepted Answer

The discount rate is equal to the risk-free rate plus the asset's beta multiplied by the market risk premium, which is the difference between the market return and the risk-free rate. This can be expressed as r = r_f + b(r_m - r_f). Rearranging the equation yields r = r_f + b(r_m - r_f) = r_f + br_m - br_f. This is the same equation as choice D, where r__f represents the risk-free rate, r__m represents the market return, and r__f - r__m represents the risk premium.

Quiz 15: Investment, Time, and Capital Markets