Question 1

An average-risk project that has an NPV of zero when its cash flows are discounted at the weighted-average cost of capital will provide sufficient returns to satisfy both stockholders and bondholders.

Accepted Answer

If a project has an NPV of zero when its cash flows are discounted at the weighted-average cost of capital, it means that the project will earn a return equal to the cost of capital. This return is sufficient to satisfy both stockholders and bondholders because it covers the cost of funding the project and provides a return to shareholders. However, it is important to note that this only applies to an average-risk project. If the project is high-risk, stockholders may require a higher return to compensate for the additional risk, which could result in a negative NPV.

Question 2

The cost of equity for a firm:

Accepted Answer

The cost of equity for a firm can be estimated from the capital asset pricing model or the dividend growth model. Option A is incorrect because the cost of equity increases with increasing levels of risk. Option B is incorrect because the cost of equity is affected by systematic risk instead of unsystematic risk. Option D is partially correct, but it only provides a basic formula for calculating the cost of equity, whereas the CAPM and dividend growth model provide more detailed calculations. Option E is incorrect because the cost of equity is only one component of the firm's WACC, which includes both debt and equity.

Question 3

Total risk is measured by _____ and systematic risk is measured by ____.

Accepted Answer

Total risk, also known as the variability of returns or volatility, is measured by standard deviation. Systematic risk, which is the risk that cannot be diversified away and is related to overall market movements, is measured by beta. Therefore, the best choice is D, as it correctly matches each type of risk with its corresponding measurement.

Question 4

The after-tax cost of debt generally increases when:
i.a firm's bond rating improves.II.the market-required rate of interest for the company's bonds increases.III.tax rates decrease.IV.bond prices rise.

Accepted Answer

When the market-required rate of interest for the company's bonds increases, the after-tax cost of debt generally increases. Also, when tax rates decrease, the after-tax cost of debt generally increases. However, when a firm's bond rating improves, the after-tax cost of debt generally decreases. Bond prices rising generally do not affect the after-tax cost of debt. Therefore, the correct choice is II and III only, which are options (B).

Question 5

The excess return earned by a risky asset,for example with a beta of 1.4,over that earned by a risk-free asset is referred to as a:

Accepted Answer

The excess return earned by a risky asset over that earned by a risk-free asset is referred to as a risk premium. The market risk premium refers to the excess return earned by the market as a whole over the risk-free rate. Systematic return is the portion of the total return that is related to the overall market or systematic risk factors, and not company-specific factors. Total return includes both the risk premium and the risk-free rate. The real rate of return is the return earned after accounting for inflation.

Question 6

Unsystematic risk:

Accepted Answer

Unsystematic risk refers to the risk that is specific to a particular company or industry, and can be effectively eliminated by portfolio diversification. Therefore, option A is the best choice. Option B refers to the compensation for all types of risk, not just unsystematic risk. Option C refers to the measurement of systematic risk, not unsystematic risk. Option D refers to the measurement of total risk, not just unsystematic risk. Option E refers to the macroeconomic factors that affect the overall market, not just unsystematic risk.

Question 7

Which one of the following is an example of systematic risk?

Accepted Answer

Systematic risk refers to the risk that is inherent in the entire market or economy and affects all similar types of investments. The announcement of an interest rate hike by the Federal Reserve would affect the entire market, not just an individual firm or industry. This is an example of systematic risk. The other options are examples of unsystematic or diversifiable risks, which are risks specific to an individual firm or industry.

Question 8

A beta greater than 1 is indicative of an above-average level of diversifiable (unsystematic)risk.

Accepted Answer

A beta greater than 1 is indicative of an above-average level of market risk (systematic risk), not diversifiable (unsystematic) risk.

Question 9

Which of the following statements concerning risk are correct?
i.Systematic risk is measured by beta.II.The risk premium increases as unsystematic risk increases.III.Systematic risk is the only part of total risk that should affect asset prices and returns.IV.Diversifiable risks are market risks you cannot avoid.

Accepted Answer

i. Systematic risk, which affects the entire market or a large segment of the market, is indeed measured by beta. It represents the sensitivity of a security's returns to market movements. iii. Systematic risk, also known as non-diversifiable risk, is the part of total risk that affects all securities and cannot be eliminated through diversification. It is this risk that should affect asset prices and returns, as investors are not rewarded for bearing risks that could be diversified away.

Question 10

In reality,the cost of equity is always less than the cost of debt because firms are not obligated to pay out cash to shareholders.

Accepted Answer

The statement is false. Generally, the cost of equity is higher than the cost of debt because equity investors are not guaranteed a fixed rate of return and their investment is considered riskier than debt. Shareholders may also require a higher return on their investment to compensate for the lack of guaranteed payments.

Question 11

Which of the following are examples of diversifiable risk?
i.An earthquake damages Oakland,California.II.The federal government imposes an additional $1,000 fee on all business entities.III.Employment taxes increase nationally.IV.Toymakers are required to improve their safety standards.

Accepted Answer

Diversifiable risk is the risk that can be eliminated by diversifying investments. Examples of diversifiable risk are risks that are specific to a company or industry and can be reduced by investing in a variety of companies and industries. Option I is an example of non-diversifiable risk as it affects only the Oakland region and cannot be diversified away. Options II and III are not diversifiable risks as they affect all businesses or employees nationally. Option IV is a diversifiable risk as it affects only the toymakers and can be reduced by diversifying investments into other industries. Thus, the correct answer is D.

Question 12

The pre-tax cost of debt:

Accepted Answer

The pre-tax cost of debt is based on the current yield to maturity of the firm's outstanding bonds, as this reflects the return required by investors for holding the bonds. The coupon rate on a bond represents the annual interest payment as a percentage of the bond's face value, but does not necessarily reflect the return required by investors in the market. The average current yield on all of a firm's outstanding bonds may provide an estimate of the cost of debt, but may not accurately reflect the return investors would require on a new bond issuance. The original yield to maturity on the latest bonds issued by a firm would not reflect changes in market conditions since the bonds were issued. Although the pre-tax cost of debt cannot be directly observed in the market, it can be estimated based on observable market data.

Question 13

All else equal,if two competing firms in industry X are valuing the same plant in industry Y for a potential acquisition,the firm with the more volatile stock should arrive at a lower valuation for the plant.

Accepted Answer

The volatility of a firm's stock does not directly affect the valuation of a plant they are looking to acquire. Valuation is typically based on the plant's financial performance, future cash flow projections, and synergies with the acquiring firm, not the acquiring firm's stock volatility.

Question 14

Asset betas measure financial risk and business risk.

Accepted Answer

Asset betas measure only business risk, isolating it from financial risk by assuming the company is financed entirely by equity.

Question 15

When investment returns are less than perfectly positively correlated,the resulting diversification effect means that:

Accepted Answer

Diversification across many diverse assets will not eliminate all of the systematic risk, but it will reduce some of the total risk. By investing in assets with less than perfectly positively correlated returns, the diversification effect means that losses in one asset may be offset by gains in another, reducing the overall risk of the investment portfolio. Spreading the investment across five diverse companies may also lower the total risk, but diversifying across many assets is typically more effective. A, B, and D are incorrect statements.

Question 16

Failing to include real options in a project valuation could cause the NPV of the project to be overestimated.

Accepted Answer

Failing to include real options in a project valuation typically leads to underestimation of the project's NPV, as it does not account for the potential additional value that could be realized from future opportunities or flexibility within the project.

Question 17

Which of the following statements are correct concerning diversifiable,or unsystematic,risks?
i.Diversifiable risks can be largely eliminated by investing in 50 unrelated securities.II.There is no reward for accepting diversifiable risks.III.Diversifiable risks are generally associated with an individual firm or industry.IV.Beta measures diversifiable risk.

Accepted Answer

I. Diversifiable risks can indeed be largely eliminated through diversification, such as by investing in a broad portfolio of unrelated securities. II. There is no additional expected reward for taking on diversifiable risk because it can be eliminated through diversification. III. Diversifiable risks are specific to an individual firm or industry, such as risks related to management decisions or industry-specific factors. IV. Beta measures systematic risk, not diversifiable risk, so this statement is incorrect.

Question 18

The adjusted present value (APV)method of valuation is superior to the standard WACC method of valuation because the WACC method makes no adjustment for interest tax shields.

Accepted Answer

The statement is incorrect. The WACC method does take into account the interest tax shields by incorporating the tax rate in calculating the cost of debt. The APV method, on the other hand, calculates the value of the unlevered firm and then adds the value of tax shields separately. Therefore, the APV method is more suitable when there are significant tax shield benefits from debt financing.

Question 19

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I.Firms that have a 100 percent retention ratio
II.Firms that pay an unchanging dividend
III.Firms that pay a constantly increasing dividend
IV.Firms that pay an erratically growing dividend

Accepted Answer

The dividend growth model assumes that the dividend paid by a company grows at a constant rate. Therefore, it can be used to compute the cost of equity for firms that pay a constantly increasing dividend (III) and firms that pay an unchanging dividend (II). However, it cannot be used for firms that have a 100 percent retention ratio (I) because they do not pay any dividends. It also cannot be used for firms that pay an erratically growing dividend (IV) because the model assumes constant growth. Therefore, the best choice is II and III only, which is option C.

Question 20

When projected cash flows are in nominal dollars,they should be discounted with a nominal discount rate.

Accepted Answer

When projecting cash flows in nominal dollars, the discount rate should also be nominal in order to maintain consistency and account for inflation. Using a real discount rate could lead to incorrect calculations of the present value.

Quiz 8: Risk Analysis in Investment Decisions