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.
B.
C.
D.
low-risk projects.
high-risk projects.
average-risk projects.
risk-free projects.
2. The cost of capital is the same as the cost of equity for firms that are financed:
A.
B.
C.
D.
entirely by debt.
by both debt and equity.
entirely by equity.
by 50% equity and 50% debt.
3. The cost of capital for a project depends on:
A.
B.
C.
D.
the company's cost of capital.

the use of the capital (the project).
the industry cost of capital.
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.
B.
C.
D.
I only
II only
III only
I and III only
9-1
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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.
B.
C.
D.
I only
I and II only
I, II, and III
II only
6. If a firm uses a project-specific cost of capital for evaluating all projects, which
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.
B.
C.
D.
I only
II only
III only
I, II, and III
7. Which of the following types of projects generally have the highest total risk?
A.
B.
C.
D.
speculative ventures
new products
expansions of existing business
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)
A.
B.
C.
D.
III only
I, II, and III only
II and IV only
I, II, III, and IV
9-2
9. Which of the following types of projects has the lowest unique risk?
A.
B.
C.
D.
new products
cost improvements
10. Which of the following types of projects has average total risk?
A.
B.
C.
D.
new products
cost improvements
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.
B.
C.
D.
20%
17%
14%
11%
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.
B.
C.
D.
15%
10%
11%
9%
13. The hurdle rate for capital budgeting decisions is:
A.
B.
C.
D.
the cost of capital.

the cost of debt.
the cost of equity.
the risk-free rate.
9-3
14. The company cost of capital, when the firm has both debt and equity financing, is
called the:
A.
B.
C.
D.
cost of debt.
cost of equity.
the weighted average cost of capital (WACC).
the return on equity (ROE).
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.
B.
C.
D.
15%
14.6%
13%
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.
B.
C.
D.
9.2%
14.0%
8.1%
10.8%
9-4
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.
B.
C.
D.
I and II
I & III
II & III
I, II & III
19. A firm's cost of equity can be estimated using the:
A.
B.
C.
D.
Fama-French three-factor model.

capital asset pricing model (CAPM).
arbitrage pricing theory (APT).
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.
B.
C.
D.
1.75
1.0
0.57
0.75
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 riskfree 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.
B.
C.
D.
18%
14%
12%
10%
9-5
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.
B.
C.
D.
4%
8%
12%
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.
B.
C.
D.
overpriced.
underpriced.
correctly priced.
need more information.
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.
B.
C.
D.
Stock B 16%, market portfolio: 14%

observed variance of the market portfolio returns.
A.
B.
C.
D.
192.0
128.0
28.0
18.7
observed covariance of returns between Stock B and the market portfolio.
A.
B.
C.
D.
24
28
36
292
9-6
beta for Stock B.
A.
B.
C.
D.
0.86
1.00
1.13
1.17
portfolio are: Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. If the riskfree rate is 4%, calculate the expected market risk premium.
A.
B.
C.
D.
18.1%
14%
10%
6%
29. On a graph with common stock returns on the Y-axis and market returns on the Xaxis, the slope of the regression line represents:
A.
B.
C.
D.
alpha
beta
R-squared
standard error
required rate of return (cost of equity) for Stock B using the CAPM. (The risk-free rate
of return = 4%.)
A.
B.
C.
D.
8.6%
12.6%
14.3%
16.0%
9-7
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.
B.
C.
D.
0.86
0.50
1.50
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.
B.
C.
D.
5%
10%
15%
13%
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.
B.
C.
D.
1.1 - 2.3
1.4 - 2.0
1.7 - 2.0
1.4 - 1.7
34. Generally, for CAPM calculations, the value to use for the risk-free interest rate is
the:
A.
B.
C.
D.
short-term U.S. Treasury bill rate.

long-term corporate bond rate.
medium-term corporate bond rate.
medium-term average rate on common stocks.
9-8
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.
B.
C.
D.
$175.21
$165.29
$228.30
$182.76
A.
B.
C.
D.
$622.04
$164.29
$401.90
$416.13
A.
B.
C.
D.
$622.04
$360.33
$401.90
$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.
B.
C.
D.
$228.35
$197.25
$300
$270.02
9-9
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.
B.
C.
D.
deep discount.
haircut for risk.
arbitrage profit.
speculative gain.
41. An example of diversifiable risk that a financial manager should ignore when
analyzing a project's risk would include:
A.
B.
C.
D.
commodity price changes

labor costs
overall stock price fluctuations
risks of government nonapproval of the project
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.
9-10
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
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
53. Firms with cyclical revenues tend to have lower asset betas.
True
False
9-11
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
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
9-12
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
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.
69. Briefly explain how the use of a single company cost of capital to evaluate all projects
might lead to erroneous decisions.
9-13
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).
72. Briefly explain, when using the CAPM, which value should be used for the risk-free
interest rate.
9-14
73. Briefly describe the factors that determine asset betas.
74. Briefly discuss the certainty equivalent approach to estimating the NPV of a project.
75. Briefly discuss the risk-adjusted discount rate approach to estimating the NPV of a
project.
9-15
76. Why do firms with large cash-flow betas also have high asset betas?
9-16
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.
B.
C.
D.
low-risk projects.
high-risk projects.
average-risk projects.
risk-free projects.
Type: Medium
2.
The cost of capital is the same as the cost of equity for firms that are financed:
A.
B.
C.
D.
entirely by debt.
by both debt and equity.
entirely by equity.
by 50% equity and 50% debt.
Type: Easy
3.
The cost of capital for a project depends on:
A.
B.
C.
D.
the company's cost of capital.

the use of the capital (the project).
the industry cost of capital.
the company's level of debt financing.
Type: Easy
9-17
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.
B.
C.
D.
I only
II only
III only
I and III only
Type: Easy
5.
If a firm uses the same company cost of capital for evaluating all projects, which
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.
B.
C.
D.
I only
I and II only
I, II, and III
II only
Type: Medium
6.
If a firm uses a project-specific cost of capital for evaluating all projects, which
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.
B.
C.
D.
I only
II only
III only
I, II, and III
Type: Difficult
9-18
7.
Which of the following types of projects generally have the highest total risk?
A.
B.
C.
D.
new products
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.
B.
C.
D.
III only
I, II, and III only
II and IV only
I, II, III, and IV
Type: Easy
9.
Which of the following types of projects has the lowest unique risk?
A.
B.
C.
D.
new products
cost improvements
Type: Easy
10.
Which of the following types of projects has average total risk?
A.
B.
C.
D.
new products
cost improvements
Type: Easy
9-19
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.
B.
C.
D.
20%
17%
14%
11%
Company cost of capital = (5/20)(8%) + (15/20)(20%) = 17%.
Type: Medium
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.
B.
C.
D.
15%
10%
11%
9%
Company cost of capital = (40/100)(5%) + (60/100)(15%) = 11%.
Type: Medium
13.
The hurdle rate for capital budgeting decisions is:
A.
B.
C.
D.
the cost of capital.

the cost of debt.
the cost of equity.
the risk-free rate.
Type: Medium
9-20
14.
The company cost of capital, when the firm has both debt and equity financing, is
called the:
A.
B.
C.
D.
cost of debt.
cost of equity.
the weighted average cost of capital (WACC).
the return on equity (ROE).
Type: Medium
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.
B.
C.
D.
15%
14.6%
13%
7%
rE = 5 + 1.25(8) = 15; rD = 5%.

Company cost of capital = 5% (5/25) + 15% (20/25) = 1 + 12 = 13%.
Type: Difficult
9-21
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.
B.
C.
D.
9.2%
14.0%
8.1%
10.8%
rE = 6 + 0.8(10) = 14%; rD = 5%; cost of capital = (60/100)(6%) + (40/100) (14%)

= 9.2%.
Type: Difficult
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.
B.
C.
D.
I and II
I & III
II & III
I, II & III
Type: Medium
19.
A firm's cost of equity can be estimated using the:
A.
B.
C.
D.
Fama-French three-factor model.

capital asset pricing model (CAPM).
arbitrage pricing theory (APT).
all of the options.
Type: Medium
9-22
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.
B.
C.
D.
1.75
1.0
0.57
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
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.
B.
C.
D.
18%
14%
12%
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.
B.
C.
D.
4%
8%
12%
16%
rM = (10 + 10 + 16)/3 = 12%; RPM = (12 - 4) = 8%.
Type: Medium
9-23
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.
B.
C.
D.
overpriced.
underpriced.
correctly priced.
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.
B.
C.
D.
Stock
Stock
Stock
Stock
B
B
B
B
16%,
14%,
24%,
12%,
market
market
market
market
portfolio:
portfolio:
portfolio:
portfolio:
14%
16%
12%
16%
RB = (24 + 0 + 24)/3 = 16%; RM = (10 + 12 + 20)/3 = 14%.
Type: Easy
25.
the observed variance of the market portfolio returns.
A.
B.
C.
D.
192.0
128.0
28.0
18.7
Variance = [(10 - 14)^2 + (12 - 14)^2 + (20 - 14)^2]/(3 - 1) = 28.
Type: Difficult
9-24
26.
the observed covariance of returns between Stock B and the market portfolio.
A.
B.
C.
D.
24
28
36
292
Cov(RB, RM) = [(24 - 16)(10 - 14) + (0 - 16)(12 - 14) + (24 - 16)(20 - 14)]/(3 - 1) =
24.
Type: Difficult
27.
the beta for Stock B.
A.
B.
C.
D.
0.86
1.00
1.13
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
28.
portfolio are: Stock B: 24%, 0%, 24%; Market portfolio: 10%, 12%, 20%. If the riskfree rate is 4%, calculate the expected market risk premium.
A.
B.
C.
D.
18.1%
14%
10%
6%
rM = (10 + 12 + 20)/3 = 14%; Expected market risk premium = 14 - 4 = 10%.
Type: Easy
9-25
29.
On a graph with common stock returns on the Y-axis and market returns on the Xaxis, the slope of the regression line represents:
A.
B.
C.
D.
alpha
beta
R-squared
standard error
Type: Medium
30.
the required rate of return (cost of equity) for Stock B using the CAPM. (The riskfree rate of return = 4%.)
A.
B.
C.
D.
8.6%
12.6%
14.3%
16.0%
E(RB) = 4 + 0.86(14 - 4) = 12.6%.
Type: Medium
31.
The historical returns for the past four years for Stock C and the stock market
Calculate the beta of Stock C:
A.
B.
C.
D.
0.86
0.50
1.50
0.38
Type: Medium
9-26
32.
The historical returns for the past four years for Stock C and the stock market
If the risk-free rate of return is 5%, calculate the required rate of return on Stock C
using the CAPM.
A.
B.
C.
D.
5%
10%
15%
13%
RM = (5 + 15 + 25 + 15)/4 = 15%; RC = 5 + (0.50)(15 - 5) = 10%.
Type: Medium
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.
B.
C.
D.
1.1
1.4
1.7
1.4
2.3
2.0
2.0
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.
B.
C.
D.
short-term U.S. Treasury bill rate.

long-term corporate bond rate.
medium-term corporate bond rate.
medium-term average rate on common stocks.
Type: Easy
9-27
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.
B.
C.
D.
$175.21
$165.29
$228.30
$182.76
r = 6% + 1.50 (16% - 6%) = 21%; CEQ1 = (200/1.21) 1.06 = 175.21.
Type: Medium
36.
A.
B.
C.
D.
$622.04
$164.29
$401.90
$416.13
r = 4% + 1.20 (14% - 4%) = 16%; CEQ2 = (500/1.16^2) 1.04^2 = 401.90.
Type: Medium
37.
A.
B.
C.
D.
$622.04
$360.33
$401.90
$693.82
r = 4% + 1.20 (14% - 4%) = 16%; CEQ3 = (500/1.16^3) 1.04^3 = 360.33.
Type: Medium
9-28
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.
B.
C.
D.
$228.35
$197.25
$300
$270.02
r = 5% + (1.25 8) = 15%; CEQ3 = (300/1.15^3) (1.05)^3 = 228.35.
Type: Medium
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.
B.
C.
D.
deep discount.
haircut for risk.
arbitrage profit.
speculative gain.
Type: Medium
9-29
41.
An example of diversifiable risk that a financial manager should ignore when

analyzing a project's risk would include:
A.
B.
C.
D.
commodity price changes

labor costs
overall stock price fluctuations
risks of government nonapproval of the project
Type: Difficult
42.
Which of the following projects most likely has the lowest cost of capital?
A.
B.
C.
D.
Construction of a new steel factory

Investment in latest-technology, high-end television production
Construction of a luxury resort
Investment in a gold-mining operation
Type: Difficult
43.
An analyst computes a beta coefficient with a low standard error. This implies
that:
A.
B.
C.
D.
this particular beta is more reliable than most.

this particular beta has little meaning.
too few observations were used to compute this particular beta.
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
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
9-30
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
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
9-31
54.
Risky projects can be evaluated by discounting expected cash flows at a riskadjusted discount rate.
TRUE
Type: Medium
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
9-32
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
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
9-33
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
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
9-34
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
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
9-35
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
9-36

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Chapter 09

Risk and the Cost of Capital

Multiple Choice Questions

3. The cost of capital for a project depends on:

the company's cost of capital.

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

8. A firm might categorize its projects into:

13. The hurdle rate for capital budgeting decisions is:

the cost of capital.

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

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

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

Fama-French three-factor model.

Stock B 16%, market portfolio: 14%

short-term U.S. Treasury bill rate.

commodity price changes

A. this particular beta is more reliable than most.

True / False Questions

51. Cyclical firms tend to have high betas.

63. A pure play is a comparable firm that specializes in one activity.

73. Briefly describe the factors that determine asset betas.

Chapter 09 Risk and the Cost of Capital Answer Key

Multiple Choice Questions

The cost of capital for a project depends on:

the company's cost of capital.

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

A firm might categorize its projects into:

Which of the following types of projects has average total risk?

Company cost of capital = (5/20)(8%) + (15/20)(20%) = 17%.

Company cost of capital = (40/100)(5%) + (60/100)(15%) = 11%.

The hurdle rate for capital budgeting decisions is:

the cost of capital.

rE = 5 + 1.25(8) = 15; rD = 5%.

rE = 6 + 0.8(10) = 14%; rD = 5%; cost of capital = (60/100)(6%) + (40/100) (14%)

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

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

Fama-French three-factor model.

Beta = Cov(RA, RM)/Var(RM) = 0.75;

Beta: = Cov(RA, RM)/Var(RM) = 0.75;

rM = (10 + 10 + 16)/3 = 12%; RPM = (12 - 4) = 8%.

RB = (24 + 0 + 24)/3 = 16%; RM = (10 + 12 + 20)/3 = 14%.

Variance = [(10 - 14)^2 + (12 - 14)^2 + (20 - 14)^2]/(3 - 1) = 28.

Beta(b) = Cov(RB, RM)/Var(RM) = 24/28 = 0.86.

rM = (10 + 12 + 20)/3 = 14%; Expected market risk premium = 14 - 4 = 10%.

E(RB) = 4 + 0.86(14 - 4) = 12.6%.

RM = (5 + 15 + 25 + 15)/4 = 15%; RC = 5 + (0.50)(15 - 5) = 10%.

Range = 1.7 +/-2 (0.3) or (1.1 - 2.3).

short-term U.S. Treasury bill rate.

r = 6% + 1.50 (16% - 6%) = 21%; CEQ1 = (200/1.21) 1.06 = 175.21.

r = 4% + 1.20 (14% - 4%) = 16%; CEQ2 = (500/1.16^2) 1.04^2 = 401.90.

r = 4% + 1.20 (14% - 4%) = 16%; CEQ3 = (500/1.16^3) 1.04^3 = 360.33.

r = 5% + (1.25 8) = 15%; CEQ3 = (300/1.15^3) (1.05)^3 = 228.35.

Which of the following informational updates would prompt a financial manager to

An example of diversifiable risk that a financial manager should ignore when

commodity price changes

Construction of a new steel factory

this particular beta is more reliable than most.

True / False Questions

The company cost of capital is the cost of debt of the firm.

Generally, an industry beta, calculated from a portfolio of companies in the same

Cyclical firms tend to have high betas.

Firms with cyclical revenues tend to have lower asset betas.

Risky projects can be evaluated by discounting certainty equivalent cash flows at