TBChap 009

Chapter 09
Risk and the Cost of Capital
Multiple Choice Questions
1. The company cost of capital is the appropriate discount rate for a firm's:
A. low-risk projects.
B. high-risk projects.
C. average-risk projects.
D. risk-free projects.
2. The cost of capital is the same as the cost of equity for firms that are financed:
A. entirely by debt.
B. by both debt and equity.
C. entirely by equity.
D. by 50% equity and 50% debt.
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3. The cost of capital for a project depends on:
A. the company's cost of capital.
B. the use of the capital (the project).
C. the industry cost of capital.
D. the company's level of debt financing.
4. Using a company's cost of capital to evaluate a project is:
I) always correct;
II) always incorrect;

III) correct for projects that have average risk compared to the firm's other assets
A. I only
B. II only
C. III only
D. I and III only
5. If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will
likely occur?
I) The firm will reject good low-risk projects;
II) The firm will accept poor high-risk projects;

III) The firm will correctly accept projects with average risk
A. I only
B. I and II only
C. I, II, and III
D. II only
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6. If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely
occur?
I) The firm will accept poor low-risk projects.

II) The firm will reject good high-risk projects.
III) The firm will correctly accept projects with average risk.
A. I only
B. II only
C. III only
D. I, II, and III
7. Which of the following types of projects generally have the highest total risk?
A. speculative ventures
B. new products
C. expansions of existing business
D. cost improvements using known technology
8. A firm might categorize its projects into:

I) cost improvements; II) expansion projects (existing business); III) new products; IV) speculative
ventures
A. III only
B. I, II, and III only
C. II and IV only
D. I, II, III, and IV
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9. Which of the following types of projects has the lowest unique risk?
B. new products
D. cost improvements
10. Which of the following types of projects has average total risk?
B. new products
11. The market value of Charter Cruise Company's equity is $15 million and the market value of its
debt is $5 million. If the required rate of return on the equity is 20% and that on its debt is 8%,
calculate the company's cost of capital. (Assume no taxes.)
A. 20%
B. 17%
C. 14%
D. 11%
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12. The market value of Cable Company's equity is $60 million and the market value of its debt is $40
million. If the required rate of return on the equity is 15% and that on its debt is 5%, calculate the
company's cost of capital. (Assume no taxes.)
A. 15%
B. 10%
C. 11%
D. 9%
13. The hurdle rate for capital budgeting decisions is:
A. the cost of capital.
B. the cost of debt.
C. the cost of equity.
D. the risk-free rate.
14. The company cost of capital, when the firm has both debt and equity financing, is called the:
A. cost of debt.
B. cost of equity.
C. the weighted average cost of capital (WACC).
D. the return on equity (ROE).
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15. One calculates the after-tax weighted average cost of capital (WACC) using which of the following
formulas:
A. WACC = (rD) (D/V) + (rE) (E/V), where: V = D + E.
B. WACC = (rD) (1 - TC) (D/V) + (rE) (1 - TC) (E/V), where: V = D + E.
C. WACC = (rD) (D/E) + (rE) (E/D).
D. WACC = (rD) (1 - TC) (D/V) + (rE) (E/V), where: V = D + E.
16. The market value of Charcoal Corporation's common stock is $20 million, and the market value of
its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and the market
risk premium is 8%. If the Treasury bill rate is 5%, what is the company's cost of capital? (Assume
no taxes.)
A. 15%
B. 14.6%
C. 13%
D. 7%
17. The market value of XYZ Corporation's common stock is $40 million and the market value of its
risk-free debt is $60 million. The beta of the company's common stock is 0.8, and the expected
market risk premium is 10%. If the Treasury bill rate is 6%, what is the firm's cost of capital?
(Assume no taxes.)
A. 9.2%
B. 14.0%
C. 8.1%
D. 10.8%
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18. A firm's cost of equity can be estimated using the:
I) discounted cash-flow (DCF) approach;
II) capital asset pricing model (CAPM);

III) arbitrage pricing theory (APT)
A. I and II
B. I & III
C. II & III
D. I, II & III
A. Fama-French three-factor model.
B. capital asset pricing model (CAPM).
C. arbitrage pricing theory (APT).
D. all of the options.
20. Company A's historical returns for the past three years are: 6%, 15%, and 15%. Similarly, the market
portfolio's returns were: 10%, 10%, and 16%. Calculate the beta for Stock A.
A. 1.75
B. 1.0
C. 0.57
D. 0.75
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21. Company A's historical returns for the past three years are: 6.0%, 15%, and 15%. Similarly, the
market portfolio's returns were: 10%, 10%, and 16%. Suppose the risk-free rate of return is 4%.
What is the cost of equity capital (required rate of return of company A's common stock),
computed with the CAPM?
A. 18%
B. 14%
C. 12%
D. 10%
22. The market portfolio's historical returns for the past three years were 10%, 10%, and 16%. Suppose
the risk-free rate of return is 4%. Estimate the market risk premium?
A. 4%
B. 8%
C. 12%
D. 16%
23. Company A's historical returns for the past three years were: 6%, 15%, and 15%. Similarly, the
market portfolio's returns were: 10%, 10%, and 16%. According to the security market line (SML),
Stock A was:
A. overpriced.
B. underpriced.
C. correctly priced.
D. need more information.
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24. The historical returns for the past three years for Stock B and the stock market portfolio are: Stock
B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the average return for Stock B and
the market portfolio.
A. Stock B 16%, market portfolio: 14%
B. Stock B 14%, market portfolio: 16%
C. Stock B 24%, market portfolio: 12%
D. Stock B 12%, market portfolio: 16%
B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the observed variance of the market
portfolio returns.
A. 192.0
B. 128.0
C. 28.0
D. 18.7
B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the observed covariance of returns
between Stock B and the market portfolio.
A. 24
B. 28
C. 36
D. 292
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B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the beta for Stock B.
A. 0.86
B. 1.00
C. 1.13
D. 1.17
B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. If the risk-free rate is 4%, calculate the expected
market risk premium.
A. 18.1%
B. 14%
C. 10%
D. 6%
29. On a graph with common stock returns on the Y-axis and market returns on the X-axis, the slope
of the regression line represents:
A. alpha
B. beta
C. R-squared
D. standard error
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B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the required rate of return (cost of
equity) for Stock B using the CAPM. (The risk-free rate of return = 4%.)
A. 8.6%
B. 12.6%
C. 14.3%
D. 16.0%
31. The historical returns for the past four years for Stock C and the stock market portfolio are: Stock
C: 10%, 30%, 20%, 20%; Market portfolio: 5%, 15%, 25%, 15%. Calculate the beta of Stock C:
A. 0.86
B. 0.50
C. 1.50
D. 0.38
32. The historical returns for the past four years for Stock C and the stock market portfolio are: Stock
C: 10%, 30%, 20%, 20%; Market portfolio: 5%, 15%, 25%, 15%. If the risk-free rate of return is 5%,
calculate the required rate of return on Stock C using the CAPM.
A. 5%
B. 10%
C. 15%
D. 13%
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33. An analyst computes the beta of the computer company WinDoze as 1.7 and the standard error of
the estimate as 0.3. What is the 95% confidence interval for the calculated beta?
A. 1.1 - 2.3
B. 1.4 - 2.0
C. 1.7 - 2.0
D. 1.4 - 1.7
34. Generally, for CAPM calculations, the value to use for the risk-free interest rate is the:
A. short-term U.S. Treasury bill rate.
B. long-term corporate bond rate.
C. medium-term corporate bond rate.
D. medium-term average rate on common stocks.
35. A project has an expected risky cash flow of $200 in year 1. The risk-free rate is 6%, the expected
market rate of return is 16%, and the project's beta is 1.50. Calculate the certainty equivalent cash
flow for year 1, CEQ1.
A. $175.21
B. $165.29
C. $228.30
D. $182.76
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A. $622.04
B. $164.29
C. $401.90
D. $416.13
A. $622.04
B. $360.33
C. $401.90
D. $693.82
38. A project has an expected cash flow of $300 in year 3. The risk-free rate is 5%, the market risk
premium is 8%, and the project's beta is 1.25. Calculate the certainty equivalent cash flow for year
3, CEQ3.
A. $228.35
B. $197.25
C. $300
D. $270.02
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39. Which of the following informational updates would prompt a financial manager to use a higher
cost of capital to analyze a project?
A. Sales estimates from the marketing department have been less accurate of late.
B. The treasurer has recently indicated that the firm will increase its use of debt financing.
C. The treasurer has recently indicated that the firm will decrease its use of debt financing.
D. Recent estimates indicate the project has a greater percentage of fixed costs than previously
thought.
40. Financial slang referring to the reduction of cash flows from a project's forecasted value to its
certainty equivalent is a(n):
A. deep discount.
B. haircut for risk.
C. arbitrage profit.
D. speculative gain.
41. An example of diversifiable risk that a financial manager should ignore when analyzing a project's
risk would include:
A. commodity price changes
B. labor costs
C. overall stock price fluctuations
D. risks of government nonapproval of the project
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42. Which of the following projects most likely has the lowest cost of capital?
A. Construction of a new steel factory
B. Investment in latest-technology, high-end television production
C. Construction of a luxury resort
D. Investment in a gold-mining operation
43. An analyst computes a beta coefficient with a low standard error. This implies that:
A. this particular beta is more reliable than most.
B. this particular beta has little meaning.
C. too few observations were used to compute this particular beta.
D. this stock responds less to market changes than most stocks.
True / False Questions
44. The company cost of capital is the correct discount rate for any project undertaken by the
company.
True False
45. An analyst should evaluate each project at its own opportunity cost of capital. The true cost of
capital depends on the particular use of that capital.
True False
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46. One calculates the weighted average cost of capital (WACC), on an after-tax basis, as:
WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V), where: V = D + E.
True False
47. The company cost of capital is the cost of debt of the firm.
True False
48. For firms with relatively high levels of debt, the company cost of capital is the cost of equity of the
firm.
True False
49. Generally, an industry beta, calculated from a portfolio of companies in the same industry, is more
accurate that a beta estimate for a single company.
True False
50. Generally, one should use the short-term Treasury bill rate for the risk-free rate.
True False
51. Cyclical firms tend to have high betas.
True False
52. Firms with high operating leverage tend to have higher asset betas.
True False
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53. Firms with cyclical revenues tend to have lower asset betas.
True False
54. Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount
rate.
True False
55. Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free
interest rate.
True False
56. A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger
confidence interval.
True False
57. Portfolio betas for an industry are usually higher than the average betas of individual stocks in that
same industry.
True False
58. The company cost of capital is the correct discount rate only for investments that have the same
risk as the company's overall business.
True False
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59. Projects with great amounts of diversifiable risk should generally have higher company costs of
capital.
True False
60. Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity
instead of market values. The resulting WACC estimates will generally be too high.
True False
61. If one uses a long-term risk-free rate for the CAPM, instead of a short-term risk-free rate, then one
will generate a flatter security market line.
True False
62. The cost of capital is always less than or equal to the cost of equity.
True False
63. A pure play is a comparable firm that specializes in one activity.
True False
64. Companies with high ratios of fixed costs to project values tend to have high betas.
True False
65. A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the
discount rate.
True False
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66. A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-
term projects as opposed to long-term projects.
True False
67. In general, one should use higher discount rates for longer-term projects.
True False
Essay Questions
68. Briefly explain the difference between company and project cost of capital.
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69. Briefly explain how the use of a single company cost of capital to evaluate all projects might lead
to erroneous decisions.
70. Discuss why one might use an industry beta to estimate a company's cost of capital.
71. Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model
(CAPM).
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72. Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate.
73. Briefly describe the factors that determine asset betas.
74. Briefly discuss the certainty equivalent approach to estimating the NPV of a project.
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75. Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a project.
76. Why do firms with large cash-flow betas also have high asset betas?
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Chapter 09 Risk and the Cost of Capital Answer Key
Multiple Choice Questions
1. The company cost of capital is the appropriate discount rate for a firm's:
A. low-risk projects.
B. high-risk projects.
C. average-risk projects.
D. risk-free projects.
Type: Medium
2. The cost of capital is the same as the cost of equity for firms that are financed:
A. entirely by debt.
B. by both debt and equity.
C. entirely by equity.
D. by 50% equity and 50% debt.
Type: Easy
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3. The cost of capital for a project depends on:
A. the company's cost of capital.
B. the use of the capital (the project).
C. the industry cost of capital.
D. the company's level of debt financing.
Type: Easy
4. Using a company's cost of capital to evaluate a project is:
I) always correct;
II) always incorrect;

III) correct for projects that have average risk compared to the firm's other assets
A. I only
B. II only
C. III only
D. I and III only
Type: Easy
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5. If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will
likely occur?
I) The firm will reject good low-risk projects;

II) The firm will accept poor high-risk projects;
III) The firm will correctly accept projects with average risk
A. I only
B. I and II only
C. I, II, and III
D. II only
Type: Medium
6. If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will
likely occur?
I) The firm will accept poor low-risk projects.
II) The firm will reject good high-risk projects.

III) The firm will correctly accept projects with average risk.
A. I only
B. II only
C. III only
D. I, II, and III
Type: Difficult
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7. Which of the following types of projects generally have the highest total risk?
B. new products
D. cost improvements using known technology
Type: Easy
8. A firm might categorize its projects into:

I) cost improvements; II) expansion projects (existing business); III) new products; IV) speculative
ventures
A. III only
B. I, II, and III only
C. II and IV only
D. I, II, III, and IV
Type: Easy
9. Which of the following types of projects has the lowest unique risk?
B. new products
Type: Easy
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10. Which of the following types of projects has average total risk?
B. new products
Type: Easy
11. The market value of Charter Cruise Company's equity is $15 million and the market value of its
debt is $5 million. If the required rate of return on the equity is 20% and that on its debt is 8%,
A. 20%
B. 17%
C. 14%
D. 11%
Company cost of capital = (5/20)(8%) + (15/20)(20%) = 17%.
Type: Medium
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12. The market value of Cable Company's equity is $60 million and the market value of its debt is
$40 million. If the required rate of return on the equity is 15% and that on its debt is 5%,
A. 15%
B. 10%
C. 11%
D. 9%
Company cost of capital = (40/100)(5%) + (60/100)(15%) = 11%.
Type: Medium
13. The hurdle rate for capital budgeting decisions is:
A. the cost of capital.
B. the cost of debt.
C. the cost of equity.
D. the risk-free rate.
Type: Medium
14. The company cost of capital, when the firm has both debt and equity financing, is called the:
A. cost of debt.
B. cost of equity.
C. the weighted average cost of capital (WACC).
D. the return on equity (ROE).
Type: Medium
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15. One calculates the after-tax weighted average cost of capital (WACC) using which of the
following formulas:
A. WACC = (rD) (D/V) + (rE) (E/V), where: V = D + E.
B. WACC = (rD) (1 - TC) (D/V) + (rE) (1 - TC) (E/V), where: V = D + E.
C. WACC = (rD) (D/E) + (rE) (E/D).
D. WACC = (rD) (1 - TC) (D/V) + (rE) (E/V), where: V = D + E.
Type: Difficult
16. The market value of Charcoal Corporation's common stock is $20 million, and the market value
of its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and the
market risk premium is 8%. If the Treasury bill rate is 5%, what is the company's cost of capital?
(Assume no taxes.)
A. 15%
B. 14.6%
C. 13%
D. 7%
rE = 5 + 1.25(8) = 15; rD = 5%.

Company cost of capital = 5% (5/25) + 15% (20/25) = 1 + 12 = 13%.
Type: Difficult
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17. The market value of XYZ Corporation's common stock is $40 million and the market value of its
risk-free debt is $60 million. The beta of the company's common stock is 0.8, and the expected
market risk premium is 10%. If the Treasury bill rate is 6%, what is the firm's cost of capital?
(Assume no taxes.)
A. 9.2%
B. 14.0%
C. 8.1%
D. 10.8%
rE = 6 + 0.8(10) = 14%; rD = 5%; cost of capital = (60/100)(6%) + (40/100) (14%) = 9.2%.
Type: Difficult
I) discounted cash-flow (DCF) approach;

II) capital asset pricing model (CAPM);
III) arbitrage pricing theory (APT)
A. I and II
B. I & III
C. II & III
D. I, II & III
Type: Medium
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A. Fama-French three-factor model.
B. capital asset pricing model (CAPM).
C. arbitrage pricing theory (APT).
D. all of the options.
Type: Medium
20. Company A's historical returns for the past three years are: 6%, 15%, and 15%. Similarly, the
market portfolio's returns were: 10%, 10%, and 16%. Calculate the beta for Stock A.
A. 1.75
B. 1.0
C. 0.57
D. 0.75
Beta = Cov(RA, RM)/Var(RM) = 0.75;
Cov(RB, RM) = [(6 - 12)(10 - 12) + (15 - 12)(10 - 12) + (15 - 12)(16 - 12)]/(3 - 1) = 9;
Var(RM) = [(10 - 12)^2 + (10 - 12)^2 + (16 - 12)^2]/(3 - 1) = 12.
Type: Difficult
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21. Company A's historical returns for the past three years are: 6.0%, 15%, and 15%. Similarly, the
market portfolio's returns were: 10%, 10%, and 16%. Suppose the risk-free rate of return is 4%.
What is the cost of equity capital (required rate of return of company A's common stock),
computed with the CAPM?
A. 18%
B. 14%
C. 12%
D. 10%
Beta: = Cov(RA, RM)/Var(RM) = 0.75;

rM = (10 + 10 + 16)/3 = 12%; rA = 4 + 0.75 (12 - 4) = 10%.
Type: Difficult
22. The market portfolio's historical returns for the past three years were 10%, 10%, and 16%.
Suppose the risk-free rate of return is 4%. Estimate the market risk premium?
A. 4%
B. 8%
C. 12%
D. 16%
rM = (10 + 10 + 16)/3 = 12%; RPM = (12 - 4) = 8%.
Type: Medium
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23. Company A's historical returns for the past three years were: 6%, 15%, and 15%. Similarly, the
market portfolio's returns were: 10%, 10%, and 16%. According to the security market line (SML),
Stock A was:
A. overpriced.
B. underpriced.
C. correctly priced.
D. need more information.
The given numbers enable the calculation of beta for Company A. However, one needs to know
the risk-free rate to construct the SML.
Type: Difficult
24. The historical returns for the past three years for Stock B and the stock market portfolio are:
Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the average return for Stock
B and the market portfolio.
A. Stock B 16%, market portfolio: 14%
B. Stock B 14%, market portfolio: 16%
C. Stock B 24%, market portfolio: 12%
D. Stock B 12%, market portfolio: 16%
RB = (24 + 0 + 24)/3 = 16%; RM = (10 + 12 + 20)/3 = 14%.
Type: Easy
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Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the observed variance of the
market portfolio returns.
A. 192.0
B. 128.0
C. 28.0
D. 18.7
Variance = [(10 - 14)^2 + (12 - 14)^2 + (20 - 14)^2]/(3 - 1) = 28.
Type: Difficult
Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the observed covariance of
returns between Stock B and the market portfolio.
A. 24
B. 28
C. 36
D. 292
Cov(RB, RM) = [(24 - 16)(10 - 14) + (0 - 16)(12 - 14) + (24 - 16)(20 - 14)]/(3 - 1) = 24.
Type: Difficult
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Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the beta for Stock B.
A. 0.86
B. 1.00
C. 1.13
D. 1.17
Beta(b) = Cov(RB, RM)/Var(RM) = 24/28 = 0.86.

[Statistical functions in a calculator may be used for this estimation.]
Type: Difficult
Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. If the risk-free rate is 4%, calculate the
expected market risk premium.
A. 18.1%
B. 14%
C. 10%
D. 6%
rM = (10 + 12 + 20)/3 = 14%; Expected market risk premium = 14 - 4 = 10%.
Type: Easy
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29. On a graph with common stock returns on the Y-axis and market returns on the X-axis, the
slope of the regression line represents:
A. alpha
B. beta
C. R-squared
D. standard error
Type: Medium
Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. Calculate the required rate of return
(cost of equity) for Stock B using the CAPM. (The risk-free rate of return = 4%.)
A. 8.6%
B. 12.6%
C. 14.3%
D. 16.0%
E(RB) = 4 + 0.86(14 - 4) = 12.6%.
Type: Medium
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31. The historical returns for the past four years for Stock C and the stock market portfolio are:
Stock C: 10%, 30%, 20%, 20%; Market portfolio: 5%, 15%, 25%, 15%. Calculate the beta of Stock
C:
A. 0.86
B. 0.50
C. 1.50
D. 0.38
Type: Medium
32. The historical returns for the past four years for Stock C and the stock market portfolio are:
Stock C: 10%, 30%, 20%, 20%; Market portfolio: 5%, 15%, 25%, 15%. If the risk-free rate of return
is 5%, calculate the required rate of return on Stock C using the CAPM.
A. 5%
B. 10%
C. 15%
D. 13%
RM = (5 + 15 + 25 + 15)/4 = 15%; RC = 5 + (0.50)(15 - 5) = 10%.
Type: Medium
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33. An analyst computes the beta of the computer company WinDoze as 1.7 and the standard error
of the estimate as 0.3. What is the 95% confidence interval for the calculated beta?
A. 1.1 - 2.3
B. 1.4 - 2.0
C. 1.7 - 2.0
D. 1.4 - 1.7
Range = 1.7 +/-2 (0.3) or (1.1 - 2.3).
Type: Medium
34. Generally, for CAPM calculations, the value to use for the risk-free interest rate is the:
A. short-term U.S. Treasury bill rate.
B. long-term corporate bond rate.
C. medium-term corporate bond rate.
D. medium-term average rate on common stocks.
Type: Easy
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35. A project has an expected risky cash flow of $200 in year 1. The risk-free rate is 6%, the
expected market rate of return is 16%, and the project's beta is 1.50. Calculate the certainty
equivalent cash flow for year 1, CEQ 1.
A. $175.21
B. $165.29
C. $228.30
D. $182.76
r = 6% + 1.50 (16% - 6%) = 21%; CEQ1 = (200/1.21) 1.06 = 175.21.
Type: Medium
A. $622.04
B. $164.29
C. $401.90
D. $416.13
r = 4% + 1.20 (14% - 4%) = 16%; CEQ2 = (500/1.16^2) 1.04^2 = 401.90.
Type: Medium
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A. $622.04
B. $360.33
C. $401.90
D. $693.82
r = 4% + 1.20 (14% - 4%) = 16%; CEQ3 = (500/1.16^3) 1.04^3 = 360.33.
Type: Medium
38. A project has an expected cash flow of $300 in year 3. The risk-free rate is 5%, the market risk
premium is 8%, and the project's beta is 1.25. Calculate the certainty equivalent cash flow for
year 3, CEQ3.
A. $228.35
B. $197.25
C. $300
D. $270.02
r = 5% + (1.25 8) = 15%; CEQ3 = (300/1.15^3) (1.05)^3 = 228.35.
Type: Medium
9-40
39. Which of the following informational updates would prompt a financial manager to use a
higher cost of capital to analyze a project?
A. Sales estimates from the marketing department have been less accurate of late.
B. The treasurer has recently indicated that the firm will increase its use of debt financing.
C. The treasurer has recently indicated that the firm will decrease its use of debt financing.
D. Recent estimates indicate the project has a greater percentage of fixed costs than previously
thought.
Type: Difficult
40. Financial slang referring to the reduction of cash flows from a project's forecasted value to its
certainty equivalent is a(n):
A. deep discount.
B. haircut for risk.
C. arbitrage profit.
D. speculative gain.
Type: Medium
41. An example of diversifiable risk that a financial manager should ignore when analyzing a
project's risk would include:
A. commodity price changes
B. labor costs
C. overall stock price fluctuations
D. risks of government nonapproval of the project
Type: Difficult
9-41
42. Which of the following projects most likely has the lowest cost of capital?
A. Construction of a new steel factory
B. Investment in latest-technology, high-end television production
C. Construction of a luxury resort
D. Investment in a gold-mining operation
Type: Difficult
43. An analyst computes a beta coefficient with a low standard error. This implies that:
A. this particular beta is more reliable than most.
B. this particular beta has little meaning.
C. too few observations were used to compute this particular beta.
D. this stock responds less to market changes than most stocks.
Type: Difficult
True / False Questions
44. The company cost of capital is the correct discount rate for any project undertaken by the
company.
FALSE
Type: Medium
9-42
45. An analyst should evaluate each project at its own opportunity cost of capital. The true cost of
capital depends on the particular use of that capital.
TRUE
Type: Medium
46. One calculates the weighted average cost of capital (WACC), on an after-tax basis, as:
WACC = (rD) (1 - TC ) (D/V) + (rE) (E/V), where: V = D + E.
TRUE
Type: Medium
47. The company cost of capital is the cost of debt of the firm.
FALSE
Type: Medium
48. For firms with relatively high levels of debt, the company cost of capital is the cost of equity of
the firm.
FALSE
Type: Difficult
49. Generally, an industry beta, calculated from a portfolio of companies in the same industry, is
more accurate that a beta estimate for a single company.
TRUE
Type: Medium
9-43
50. Generally, one should use the short-term Treasury bill rate for the risk-free rate.
TRUE
Type: Easy
51. Cyclical firms tend to have high betas.
TRUE
Type: Medium
52. Firms with high operating leverage tend to have higher asset betas.
TRUE
Type: Medium
53. Firms with cyclical revenues tend to have lower asset betas.
FALSE
Type: Medium
54. Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount
rate.
TRUE
Type: Medium
9-44
55. Risky projects can be evaluated by discounting certainty equivalent cash flows at the risk-free
interest rate.
TRUE
Type: Medium
56. A higher standard error of a beta estimate indicates both a less-reliable estimate and a larger
confidence interval.
TRUE
Type: Medium
57. Portfolio betas for an industry are usually higher than the average betas of individual stocks in
that same industry.
FALSE
Type: Medium
58. The company cost of capital is the correct discount rate only for investments that have the
same risk as the company's overall business.
TRUE
Type: Easy
59. Projects with great amounts of diversifiable risk should generally have higher company costs of
capital.
FALSE
Type: Medium
9-45
60. Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity
instead of market values. The resulting WACC estimates will generally be too high.
FALSE
Book value of equity is generally lower than market value, while the book value of debt is
generally nearer to the market value. Using book values will therefore underweight the cost of
equity. The resulting WACC estimates will generally be too low.
Type: Difficult
61. If one uses a long-term risk-free rate for the CAPM, instead of a short-term risk-free rate, then
one will generate a flatter security market line.
TRUE
Type: Difficult
62. The cost of capital is always less than or equal to the cost of equity.
TRUE
Type: Medium
63. A pure play is a comparable firm that specializes in one activity.
TRUE
Type: Easy
9-46
64. Companies with high ratios of fixed costs to project values tend to have high betas.
TRUE
Type: Medium
65. A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the
discount rate.
FALSE
Type: Medium
66. A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short-
term projects as opposed to long-term projects.
FALSE
Type: Difficult
67. In general, one should use higher discount rates for longer-term projects.
FALSE
Type: Difficult
Essay Questions
9-47
68. Briefly explain the difference between company and project cost of capital.
If a firm is considering projects that have the same risk as the firm, then the company cost of
capital is the same as the project cost of capital. However, if the firm is considering projects that
have risks different from the company, then the project cost of capital is a better risk estimate
than the company cost of capital.
Type: Medium
69. Briefly explain how the use of a single company cost of capital to evaluate all projects might
lead to erroneous decisions.
If the firm is considering projects with differing risk characteristics, the firm will reject low-risk
projects and accept high-risk projects. Low-risk projects should be discounted at a lower rate
and high-risk projects at a higher discount rate to account for differing risks.
Type: Medium
70. Discuss why one might use an industry beta to estimate a company's cost of capital.
Generally, an industry beta can be estimated more precisely than a company's beta. This is
similar to the estimate of the beta of a portfolio being more precise than the estimate of the
beta of a single stock. The estimated industry cost of capital must be suitably adjusted before
using it as the company's cost of capital. For example, one must account for differences in the
capital structure of the firm versus the industry.
Type: Medium
9-48
71. Briefly explain how a firm's cost of equity is estimated using the capital asset pricing model
(CAPM).
The first step estimates the beta of the firm's common stock by regressing the returns on the
stock on the market returns using historical data. The expected stock return is estimated using
CAPM [E(R) = rf + (beta)(rm - rf)]. Expected return is the estimate of the firm's cost of equity.
Type: Medium
72. Briefly explain, when using the CAPM, which value should be used for the risk-free interest rate.
Generally, the value used for the risk-free rate is the short-term U.S. Treasury bill rate.
Type: Easy
73. Briefly describe the factors that determine asset betas.
Asset betas are determined by the cyclical nature of the cash flows. Generally, cyclical firms
have higher betas. Operating leverage also affects the asset beta of a firm. Firms with high fixed
costs tend to have higher asset betas.
Type: Medium
9-49
74. Briefly discuss the certainty equivalent approach to estimating the NPV of a project.
In the certainty equivalent approach, certainty equivalent cash flows are discounted at the risk-
free rate to calculate the NPV of a project. First, risky cash flows have to be converted to
certainty-equivalent cash flows by using individual risk factors. One advantage of this method is
that the risk adjustment is separated from the time value of money. Conceptually this is a more
sensible method than the risk-adjusted discount rate method. However, estimating certainty
equivalent cash flows could be cumbersome.
Type: Medium
75. Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a project.
The risk-adjusted discount rate approach uses the discount rate to adjust for both risk and the
time value of money. The main advantage of this approach is simplicity. Risky project cash flows
are discounted using risk adjusted discount rates (higher rates) to calculate the NPV of a
project.
Type: Medium
76. Why do firms with large cash-flow betas also have high asset betas?
There is a strong correlation between the risk of the assets of a firm and the risk of the firm's
cash flows. As such, high cash-flow betas lead to high asset betas.
Type: Medium
9-50

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Chapter 09

Risk and the Cost of Capital

Multiple Choice Questions

B. by both debt and equity.

D. by 50% equity and 50% debt.

A. the company's cost of capital.

B. the use of the capital (the project).

C. the industry cost of capital.

D. the company's level of debt financing.

4. Using a company's cost of capital to evaluate a project is:

II) always incorrect;

D. I and III only

I) The firm will reject good low-risk projects;

II) The firm will accept poor high-risk projects;

C. I, II, and III

I) The firm will accept poor low-risk projects.

D. I, II, and III

C. expansions of existing business

D. cost improvements using known technology

8. A firm might categorize its projects into:

B. I, II, and III only

D. I, II, III, and IV

C. expansions of existing business

C. expansions of existing business

13. The hurdle rate for capital budgeting decisions is:

A. the cost of capital.

B. the cost of debt.

C. the cost of equity.

D. the risk-free rate.

C. the weighted average cost of capital (WACC).

D. the return on equity (ROE).

A. WACC = (rD) (D/V) + (rE) (E/V), where: V = D + E.

B. WACC = (rD) (1 - TC) (D/V) + (rE) (1 - TC) (E/V), where: V = D + E.

C. WACC = (rD) (D/E) + (rE) (E/D).

D. WACC = (rD) (1 - TC) (D/V) + (rE) (E/V), where: V = D + E.

I) discounted cash-flow (DCF) approach;

II) capital asset pricing model (CAPM);

19. A firm's cost of equity can be estimated using the:

A. Fama-French three-factor model.

B. capital asset pricing model (CAPM).

C. arbitrage pricing theory (APT).

D. all of the options.

D. need more information.

A. Stock B 16%, market portfolio: 14%

B. Stock B 14%, market portfolio: 16%

C. Stock B 24%, market portfolio: 12%

D. Stock B 12%, market portfolio: 16%

market risk premium.

of the regression line represents:

A. short-term U.S. Treasury bill rate.

B. long-term corporate bond rate.

C. medium-term corporate bond rate.

D. medium-term average rate on common stocks.

flow for year 1, CEQ1.

cost of capital to analyze a project?

certainty equivalent is a(n):

B. haircut for risk.

risk would include:

A. commodity price changes

C. overall stock price fluctuations

D. risks of government nonapproval of the project

A. Construction of a new steel factory

B. Investment in latest-technology, high-end television production