Jenna Kiragis

5/11/2014
FIN 534 Homework Chapter 9


Directions: Answer the following five questions on a separate document. Explain how you
reached the answer or show your work if a mathematical calculation is needed, or both. Submit
your assignment using the assignment link in the course shell. Each question is worth five points
apiece for a total of 25 points for this homework assignment.


1. When working with the CAPM, which of the following factors can be determined with the most
precision?
a. The beta coefficient, bi, of a relatively safe stock.
b. The most appropriate risk-free rate, rRF.
c. The expected rate of return on the market, rM.
d. The beta coefficient of "the market," which is the same as the beta of an average
stock.
e. The market risk premium (RPM).

Explanation:
For this question, we turn to section 9-6 of our textbook Using the CAPM to Estimate
the Cost of Common Stock. In this section, I see that in order to estimate a beta, you
have to look at the beta of other stock. I concluded that Answer D would be the most
appropriate and could give me the most precision (Brigham & Ehrhardt, 2014).



2. Bloom and Co. has no debt or preferred stockit uses only equity capital, and has two
equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the
corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of
Division Y's projects. However, the projects of Division X are less risky than those of Division Y.
Which of the following projects should the firm accept?
a. A Division Y project with a 12% return.
b. A Division X project with an 11% return.
c. A Division X project with a 9% return.
d. A Division Y project with an 11% return.
e. A Division Y project with a 13% return.

Explanation:
For this question, I turned to Section 9-11b Adjusting the Cost of Capital for Risk:
Division and Projects to find this answer. I am looking for a slight increase (11%) which
is more than the WACC of 10%. I am also seeing that Division X projects are less risky
than Division Y. Therefore I chose B a Division X project with an 11% return
(Brigham & Ehrhardt, 2014).



3. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average
risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%.
Which of the following projects (A, B, and C) should the company accept?
a. Project C, which is of above-average risk and has a return of 11%.
b. Project A, which is of average risk and has a return of 9%.
c. None of the projects should be accepted.
d. All of the projects should be accepted.
e. Project B, which is of below-average risk and has a return of 8.5%.


Explanation:
After looking at the question and reading the answers, E really fit the model of below-
average risk and a return greater than 8%.



4. Weatherall Enterprises has no debt or preferred stockit is an all-equity firmand has a beta
of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before
any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project
being evaluated is riskier than an average project, in terms of both its beta risk and its total risk.
Which of the following statements is CORRECT?
a. The project should definitely be rejected because its expected return (before risk
adjustment) is less than its required return.
b. Riskier-than-average projects should have their expected returns increased to
reflect their higher risk. Clearly, this would make the project acceptable
regardless of the amount of the adjustment.
c. The accept/reject decision depends on the firm's risk-adjustment policy. If
Weatherall's policy is to increase the required return on a riskier-than-average
project to 3% over rS, then it should reject the project.
d. Capital budgeting projects should be evaluated solely on the basis of their total
risk. Thus, insufficient information has been provided to make the accept/reject
decision.
e. The project should definitely be accepted because its expected return (before
any risk adjustments) is greater than its required return.

Explanation:
The answer comes from the question. CFO is evaluating therefore the answer needs
to circle around the firms risk-adjustment policy. After carefully reading the answer, I
chose C because if the firm increases the required return then the project is not worth
doing.



5. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects.
The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the
company's average-risk projects, but that a lower rate should be used for lower-risk projects and
a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though
projects have different risks, the WACC used to evaluate each project should be the same
because the company obtains capital for all projects from the same sources. If the CEO's position
is accepted, what is likely to happen over time?
a. The company will take on too many low-risk projects and reject too many high-
risk projects.
b. Things will generally even out over time, and, therefore, the firm's risk should
remain constant over time.
c. The company's overall WACC should decrease over time because its stock price
should be increasing.
d. The CEO's recommendation would maximize the firm's intrinsic value.
e. The company will take on too many high-risk projects and reject too many low-
risk projects.


Explanation:
This question circle around section 9-13 Adjusting the cost of capital for risk. From
reading chapter 9 from our textbook and carefully analyzing this question, I feel that
answer E made the most sense. If the firm standardizes the 12% for WACC then it will
be looking for high-risk projects (Brigham & Ehrhardt, 2014).


Brigham, E., & Ehrhardt, M. (2014). Financial management. (14th ed.). Mason, Ohio: Cengage Learning.