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Chapter 08 - Risk Analysis in Investment Decisions




Question;Multiple Choice Questions;1. Total risk is measured by _____ and systematic risk;is measured by ____.;A. beta, alpha;B. beta, standard deviation;C. WACC, beta;D. standard deviation, beta;E. standard deviation, variance;F. None of the above.;2. When investment returns are less than perfectly;positively correlated, the resulting diversification effect means that;A. making an investment in two or three large stocks will eliminate all of;the unsystematic risk.;B. making an investment in three companies all within the same industry;will greatly reduce the systematic risk.;C. spreading an investment across five diverse companies will not lower;the total risk.;D. spreading an investment across many diverse assets will eliminate all;of the systematic risk.;E. spreading an investment across many diverse assets will eliminate some;of the total risk.;F. None of the above.;3. Unsystematic risk;A. can be effectively eliminated by portfolio diversification.;B. is compensated for by the risk premium.;C. is measured by beta.;D. is measured by standard deviation.;E. is related to the overall economy.;F. None of the above.;4. 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.;A. I and III only;B. II and IV only;C. II and III only;D. I and IV only;E. I, III, and IV only;F. None of the above.;5. Which of the following statements are correct;concerning diversifiable, or unsystematic, risks?;I. Diversifiable risks can be largely eliminated by investing in thirty;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.;A. I and III only;B. II and IV only;C. I and IV only;D. I, II, and III only;E. I, II, III, and IV;F. None of the above.;6. 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.;A. I and III only;B. II and IV only;C. I and II only;D. III and IV only;E. I, II, and III only;F. None of the above.;7. Which one of the following is an example of;systematic risk?;A. The Federal Reserve unexpectedly announces an increase in target;interest rates.;B. A flood washes away a firm's warehouse.;C. A city imposes an additional one percent sales tax on all products.;D. A toymaker has to recall its top-selling toy.;E. Corn prices increase due to increased demand for alternative fuels.;F. None of the above.;8. 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;A. market risk premium.;B. risk premium.;C. systematic return.;D. total return.;E. real rate of return.;F. None of the above.;9. 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;A. I and II only;B. I and IV only;C. II and III only;D. I, II, and III only;E. I, III, and IV only;F. None of the above.;10. The cost of equity for a firm;A. tends to remain static for firms with increasing levels of risk.;B. increases as the unsystematic risk of the firm increases.;C. ignores the firm's risks when that cost is based on the dividend growth;model.;D. equals the risk-free rate plus the market risk premium.;E. equals the firm's pretax weighted average cost of capital.;F. None of the above.;11. The pre-tax cost of debt;A. is based on the current yield to maturity of the firm's outstanding;bonds.;B. is equal to the coupon rate on the latest bonds issued by a firm.;C. is equivalent to the average current yield on all of a firm's;outstanding bonds.;D. is based on the original yield to maturity on the latest bonds issued;by a firm.;E. has to be estimated as it cannot be directly observed in the market.;F. None of the above.;12. The after-tax cost of debt generally increases;when;I. a firm's bond rating increases.;II. the market-required rate of interest for the company's bonds increases.;III. tax rates decrease.;IV. bond prices rise.;A. I and III only;B. II and III only;C. I, II, and III only;D. II, III, and IV only;E. I, II, III, and IV;F. None of the above.;Key facts and assumptions concerning FM Foods, Inc.;at December 31, 2011, appear below.;13. Estimate FM's after-tax cost of equity;capital.;A. 4.50%;B. 6.92%;C. 7.93%;D. 12.20%;E. 17.48%;F. None of the above.;14. Estimate FM's after-tax cost of debt capital.;A. 2.21%;B. 4.10%;C. 4.55%;D. 6.30%;E. 7.00%;F. None of the above.;15. Estimate the appropriate weight of equity to be;used when calculating FM's weighted average cost of capital.;A. 11.5%;B. 19.3%;C. 80.7%;D. 88.5%;E. 100.0%;F. None of the above.;16. Estimate the appropriate weight of debt to be used;when calculating FM's weighted average cost of capital.;A. 11.5%;B. 19.3%;C. 80.7%;D. 88.5%;E. 100.0%;F. None of the above.;17. Estimate FM's weighted-average cost of;capital.;A. 6.46%;B. 6.58%;C. 11.27%;D. 11.32%;E. 11.52%;F. None of the above.;18. FM is contemplating an average-risk investment;costing $100 million and promising an annual after-tax cash flow of $15 million;in perpetuity. Which of the following statements is/are correct?;I. FM should reject the project because the IRR is greater than the firm's;WACC.;II. FM should accept the project because the IRR is greater than the firm's;WACC.;III. FM should accept the project because the NPV is greater than zero.;IV. FM should reject the project because the NPV is less than zero.;A. I only;B. II only;C. IV only;D. I and IV only;E. II and III only;F. None of the above.;19. Which of the following statements are correct?;I. Using the same risk-adjusted discount rate to discount all future cash flows;adjusts for the fact that the more distant cash flows are often more risky than;cash flows occurring sooner.;II. If you can borrow all of the money you need for a project at 5%, the cost;of capital for this project is 5%.;III. The best way to obtain the cost of debt capital for a firm is to use the;coupon rates on its bonds.;IV. The cost of capital, or WACC, is not the correct discount rate to;use for all projects undertaken by a firm.;A. I and III only;B. II and IV only;C. I and II only;D. I and IV only;E. I, II, and III only;F. None of the above;20. The capital structure weights used in computing;the weighted average cost of capital;A. are based on the book values of total debt and total equity.;B. are based on the market value of the firm's debt and equity securities.;C. are computed using the book value of the long-term debt and the book;value of equity.;D. remain constant over time unless the firm issues new securities.;E. are restricted to the firm's debt and common stock.;F. None of the above.;21. The discount rate assigned to an individual;project should be based on;A. the firm's weighted average cost of capital.;B. the actual sources of funding used for the project.;C. an average of the firm's overall cost of capital for the past five;years.;D. the current risk level of the overall firm.;E. the risks associated with the use of the funds required by the project.;F. None of the above.;22. The weighted average cost of capital for a firm is;the;A. discount rate which the firm should apply to all of the projects it;undertakes.;B. rate of return a firm must earn on its existing assets to maintain the;current value of its stock.;C. coupon rate the firm should expect to pay on its next bond issue.;D. minimum discount rate the firm should require on any new project.;E. rate of return shareholders should expect to earn on their investment;in this firm.;F. None of the above.;23. Blue Diamond Equipment has 80,000 bonds;outstanding that are selling at par. Bonds with similar characteristics are;yielding 6.75 percent. The company also has 750,000 shares of 7 percent;preferred stock and 2.5 million shares of common stock outstanding. The;preferred stock sells for $53 a share. The common stock has a beta of 1.34 and;sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the;return on the market is 11.2 percent. The corporate tax rate is 38 percent.;What is the firm's weighted average cost of capital?;A. 10.39 percent;B. 10.64 percent;C. 11.18 percent;D. 11.30 percent;E. 11.56 percent;F. None of the above.;24. Honest Abe's is a chain of furniture retail;stores. Integral Designs is a furniture maker and a supplier to Honest Abe's.;Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12.;Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of;return is 3.5 percent and the market risk premium is 8 percent. What discount;rate should Honest Abe's use if it considers a project that involves the;manufacturing of furniture?;A. 12.46 percent;B. 12.92 percent;C. 13.50 percent;D. 14.08 percent;E. 14.54 percent;F. None of the above.;Short Answer Questions;Key facts and assumptions concerning Costco Company;at December 31, 2011, appear below.;25. Use the above information to answer the following;questions.;a. Estimate Costco's cost of equity capital.;b. Estimate Costco's weighted-average cost of capital.;26. Explain the difference between systematic and;unsystematic risk, and why one of these types of risks is rewarded with a risk;premium while the other type is not.;27. Suppose that your company's weighted-average cost;of capital is 9 percent. Your company is planning to undertake a project with;an internal rate of return of 12%, but you believe that this project is not a;good investment for the firm. What logical arguments might you use to convince;your boss to forego the project despite its high rate of return? Is it possible;that making investments with expected returns higher than your company's cost of;capital will destroy value? If so, how?;28. The standard deviation of returns on Wildcat Oil;Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is;a high-risk investment when investors hold diversified portfolios? Explain why;or why not.;29. Investments A and B both cost $100,000 and each;promises a single payoff in one year. The distribution of payoffs for each;investment appears below.;Ignoring possible differences in nondiversifiable risk, which investment would;a risk-averse investor prefer, and why?;30. What is the present value of a cash flow stream of;$10,000 per year annually for 11 years that then grows at 2 percent per year;forever? Assume the appropriate discount rate is 12 percent.


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