Question 1

1. The risk premium for an individual security is computed by:

A. multiplying the securitys beta by the market risk premium.
B. multiplying the securitys beta by the risk-free rate of return.
C. adding the risk-free rate to the securitys expected return.
D. dividing the market risk premium by the quantity (1 beta).
E. dividing the market risk premium by the beta of the security.
6 points
Question 2
1. The primary purpose of portfolio diversification is to:
A.

increase returns and risks.

B.

eliminate all risks.

C.

eliminate or minimize asset-specific risk.

D.

eliminate or minimize systematic risk.

E.

lower both returns and risks.

6 points
Question 3
1. Beta measures:
A.

the ability to diversify risk.

B.

how an asset covaries with the market.

C.

the actual return on an asset.

D.

the standard of the assets' returns.

E.

All of the above.

6 points
Question 4
1. According to the CAPM, which one of the following stocks is correctly priced if
the risk-free rate of return is 2.5%, the market risk premium is 8%, and the
stocks have the expected returns given below at their current price?
Stoc
Expected
Beta
k
Return
A

.68 8.2%

1.42 13.9%

1.23 11.8%

2.
A.

B.

C.

D.

Both B & C

E.

Both A & C

6 points
Question 5
1. According to the CAPM, the beta of a security provides an:
A.

estimate of the market risk premium.

B.

estimate of the slope of the Capital Market Line.

C.

estimate of the slope of the Security Market Line.

D. estimate of the systematic risk of the security.

E.

None of the above.

6 points
Question 6
1. Comparing two otherwise equal firms, the beta of the common stock of a
levered firm is ____________ than the beta of the common stock of an
unlevered firm.
A.

equal to

B.

significantly less

C.

slightly less

D.

greater

E.

None of the above.

6 points
Question 7
1. According to the efficient market hypothesis, financial markets fluctuate daily
because they:

6 points
Question 8

A.

are inefficient.

B.

slowly react to new information.

C.

are continually reacting to new information.

D.

offer tremendous arbitrage opportunities.

E.

only reflect historical information.

1. Which of the following tend to reinforce the argument that the financial
markets are efficient?
I. Information spreads rapidly in todays world.
II. There is tremendous competition in the financial markets.
III. Market prices continually fluctuate.
IV. Market prices react suddenly to unexpected news announcements.
A.

I and III only

B.

II and IV only

C.

I, II, and III only

D.

II, III, and IV only

E.

I, II, III, and IV

6 points
Question 9
1. In an efficient market when a firm makes an announcement of a new product
or product enhancement with superior technology providing positive NPV, the
price of the stock will:
A.

rise gradually over the next few days.

B.

decline gradually over the next few days.

C.

rise on the same day to the new price.

D.

stay at the same price, with no net effect.

E.

drop on the same day to the new price.

6 points
Question 10
1. The interest tax shield has no value for a firm when:
I. the tax rate is equal to zero.
II. the debt-equity ratio is exactly equal to 1.

III. the firm is unlevered.

IV. a firm elects 100% equity as its capital structure.
A.

I and III only

B.

II and IV only

C.

I, III, and IV only

D.

II, III, and IV only

E.

I, II, and IV only

6 points
Question 11
1. The Modigliani-Miller Proposition I without taxes states:
A. a firm cannot change the total value of its outstanding securities by
changing its capital structure proportions.
B. when new projects are added to the firm the firm value is the sum of the old
value plus the new.
C. managers can make correct corporate decisions that will satisfy all
shareholders if they select projects that maximize value.
D. the determination of value must consider the timing and risk of the cash
flows.
E. None of the above.
6 points
Question 12
1. MM Proposition I with corporate taxes states that:
A. capital structure can affect firm value.
B. by increasing the debt ratio, the firm can increase its total value.
C. the tax deductibility of interest payments can increase shareholder wealth.

D. All of the above.

E. None of the above.
6 points
Question 13
1. Your firm has a $250,000 bond issue outstanding. These bonds have a 7%
coupon, pay interest annually, and have a current market price equal to
103% of face value. What is the amount of the annual interest tax shield
given a tax rate of 35%?
A.

$6,125

B.

$6,309

C.

$9,500

D.

$17,500

E.

$18,025

6 points
Question 14
1. One of the indirect costs to bankruptcy is the incentive toward
underinvestment. Following this strategy may result in:
A. the firm always choosing projects with the positive NPVs.
B. the firm turning down positive NPV projects that it would clearly accept in an
all equity firm.
C. bondholders contributing the full amount of the investment, but only
stockholders reaping the benefits of the project.
D. Both A and C.
E. None of the above.
6 points
Question 15

1. When shareholders pursue selfish strategies such as taking large risks or

paying excessive dividends, these will result in:
A. no action by debtholders since these are equity holder concerns.
B. positive agency costs, which will diminish firm value.
C. investments of the same risk class that the firm is in.
D. undertaking scale enhancing projects.
E. lower agency costs, as shareholders have more control over the firm's
assets.
6 points
Question 16
1. Jacks Construction Co. (JCC) has 80,000 bonds outstanding that are currently
selling at par (face) value. Bonds with similar characteristics are currently
yielding 8.5%. The company also has 4 million shares of common stock
outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S.
Treasury bill is currently yielding 4% and the market risk premium is 8%. The
corporate tax rate is 35%.
Use this information to answer sections (a) - (e).
a. What is JCC's after-tax cost of debt? (6 points)
b. What is JCC's cost of equity? (6 points)
c. What is the proportion (weight) of debt in JCC's capital structure? (6 points)
d. What is the proportion (weight) of equity in JCC's capital structure? (6 points)
e. What is JCC's WACC? (6 points)

30 points
Question 17
1. Folgers Air Transport (FAT) is currently an unlevered firm. It is considering a
capital restructuring to allow $200 in perpetual debt. The company expects to
generate perpetual EBIT of $151.52. (Assume that depreciation equals capital
expenditures and there are no additions to working capital.) The corporate

tax rate is 34% and the pre-tax cost of debt will be 10%. Unlevered firms in
the same industry have a cost of equity capital of 20%. Compute the value of
FAT after the restructuring. Ignore any costs of financial distress and assume
that interest tax shields are discounted at the pre-tax cost of debt. (30 points)