Name:_______________________ BUS 320 Spring 2011 Section 5 FINANCIAL MANAGEMENT EXAM 2

1. (8-3) Portfolio risk

i.

FN

Answer: a

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

a. True b. False

2.(8-3) Market risk

ii.

FN

Answer: a

An individual stock's idiosyncratic risk can be lowered by adding more stocks to the portfolio in which the stock is held.

a. True b. False

3. (8-2) CV vs. SD
iii.

FN

Answer: b

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

a. True

b. False

4.(8-3) Beta coefficients

iv.

CN

Answer: e

Stock A's beta is 2.3 and Stock B's beta is 1.2. Which of the following statements must be true about these securities? (Assume market equilibrium.)

a. Stock A must be a more desirable addition to a portfolio than B. b. When held in isolation, Stock A has more risk than Stock B. c. Stock B must be a more desirable addition to a portfolio than A. d. The expected return on Stock B should be greater than that on A. e. The expected return on Stock A should be greater than that on B.

5.(8-3) Market risk

v.

CN

Answer: b

Inflation, recession, and high interest rates are economic events that are best characterized as being

a. systematic risk factors that can be diversified away. b. among the factors that are responsible for market risk. c. company-specific risk factors that can be diversified away. d. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. e. irrelevant except to governmental authorities like the Federal Reserve.

6. (8-2) Coefficient of variation

vi.

CN

Answer: a

Bae Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation?

a. 0.67 b. 0.73 c. 0.81 d. 0.89 e. 0.98

7.(8-3) Portfolio beta

vii.

CN

Answer: e

Bill Dukes has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Ys beta is 0.70. What is the portfolio's beta?

a. 0.65 b. 0.72 c. 0.80 d. 0.89 e. 0.98

8.(8-4) CAPM: required rate of return

CN

Answer: c

viii. Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk

premium is 5.50%. What is the firm's required rate of return?

a. 11.36% b. 11.65% c. 11.95% d. 12.25%

e. 12.55%

9.(8-4) Market risk premium

ix.

CN

Answer: a

Porter Inc's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?

a. 5.80% b. 5.95% c. 6.09% d. 6.25% e. 6.40%

10.(8-4) CAPM: req. rate of return

x.

CN

Answer: c

Google has a beta of 1.04, the real risk-free rate is 4.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 3.50%. What is Google's required rate of return?

a. 9.43% b. 9.67% c. 10.64% d. 10.77% e. 10.83%

11. (9-1) Preemptive right

xi.

FG

Answer: b

If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.

a. True b. False

12.(9-2) Founders' shares

xii.

FG

Answer: b

Preferred stock is a type of stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock.

a. True b. False

13. (9-7) Corporate valuation model

FG

Answer: a

xiii. The corporate valuation model can be used if a company doesn't pay dividends.

a. True b. False

14. (9-4) Total stock returns

xiv.

FG

Answer: b

The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

a. True b. False

15. 8(9-5) Required return

CG

Answer: c

xv.

A decrease in a firms expected growth rate would cause its required rate of return to

a. increase. b. decrease. c. possibly increase, possibly decrease, or possibly remain constant. d. fluctuate less than before. e. fluctuate more than before.

16. (9-5) Required return

xvi.

CG

Answer: c

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

A Price Expected growth Expected return $50 4% 9%

B $30 6% 11%

a. The two stocks should have the same expected dividend. b. The two stocks could not be in equilibrium with the numbers given in the question. c. A's expected dividend is $2.50. d. B's expected dividend is $1.75. e. A's expected dividend is $2.95 and B's expected dividend is $1.50.

17. (9-5) Dividend yield and g

CG

Answer: b

xvii. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required

rate of return. Which of the following statements is CORRECT? (Hint: rs

D1 g) P0

a. Stock B must have a higher dividend yield than Stock A. b. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock Bs. c. Stock A must have a higher dividend yield than Stock B. d. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock Bs. e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.

18. (9-5) Constant growth valuation

CG

Answer: e

xviii. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the

constant growth rate is g = 4.0%. What is the current stock price?

a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57

19. (9-5) Expected dividend yield

xix.

CG

Answer: b

If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stocks expected dividend yield for the coming year?

a. 4.42%

b. 4.66% c. 4.89% d. 5.13% e. 5.39%

20. (9-7) Corporate valuation model

xx.

CG

Answer: d

Suppose Boyson Corporations projected free cash flow for next year is FCF1 = $150,000, and FCF is expected to grow at a constant rate of 6.5%. If the companys weighted average cost of capital is 11.5%, what is the value of its operations?

a. $2,572,125 b. $2,707,500 c. $2,850,000 d. $3,000,000 e. $3,150,000

21. (10-1) Cost of capital

xxi.

FI

Answer: a

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

a. True b. False

22. (Comp.) Capital components

CI

Answer: b

xxii. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and

assume that the firm operates at its target capital structure.

a. rs > re > rd > WACC. b. re > rs > WACC > rd. c. WACC > re > rs > rd. d. rd > re > rs > WACC. e. WACC > rd > rs > re.

23. (10-3) Cost of debt

FI

Answer: a

xxiii. The after-tax cost of debt, which is lower than the before-tax cost, is used as the component

cost of debt for purposes of developing the firm's WACC.

a. True b. False

24. (10-5) Cost of RE: CAPM

CI

Answer: e

xxiv. Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have

been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?

a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93%

25. (10-7) WACC and target cap. struc.

xxv.

CI

Answer: a

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

a. 8.15% b. 8.48% c. 8.82% d. 9.17% e. 9.54%

4.i.
ii.

(8-3) Portfolio risk (8-3) Market risk

FN FN FN CN CN CN

Answer: a Answer: b Answer: b Answer: d Answer: c Answer: a

2.iii. (8-2) CV vs. SD

iv.

(8-3) Beta coefficients (8-3) Market risk (8-2) Coefficient of variation

v.

vi.

Expected return Standard deviation

15.0% 10.0%

Coefficient of variation = std dev/expected return = 0.67

vii.

(8-3) Portfolio beta

CN Weight

Answer: e

Company X Y

Investment $35,000 $65,000 $100,000

Weight 0.35 0.65 1.00 CN 1.40 4.25% 5.50% 11.95%

Beta 1.50 0.70

beta 0.53 0.46 0.98 = Portfolio beta Answer: c

viii. (8-4) CAPM: req. rate of return

Beta Risk-free rate Market risk premium Required return

ix.

(8-4) Market risk premium

CN

Answer: a

Use the SML to determine the market risk premium with the given data.

rs = rRF + bStock RPM 12.25% = 5.00% + 1.25 RPM 7.25% = RPM 1.25 5.80% = RPM 20.x. (8-4) CAPM: req. rate of return CN Answer: d

Real risk-free rate, r* Expected inflation, IP Market risk premium, RPM Beta, b Risk-free rate = r* + IP =

2.00% 3.00% 4.70% 1.10 5.00%

Kollo's required return = rRF + b(RPM) = 10.17%

xi.

(9-1) Preemptive right (9-2) Founders' shares

FG FG FG FG CG CG

Answer: b Answer: a Answer: b Answer: b Answer: e Answer: e

xii.

xiii. (9-7) Corporate valuation model

xiv.

(9-4) Total stock returns (9-5) Required return (9-5) Required return

xv.

xvi.

The following calculations show that answer e is correct. The others are all wrong.

A Price Expected growth Expected return $25 7% 10%

B $40 9% 12%

A = P0 = D1/(r g) = D1=P0(r) P0(g) = $0.75 B = P0 = D1/(r g) = D1=P0(r) P0(g) = $1.20

xvii. (9-5) Dividend yield and g

CG

Answer: a

Statement a is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock Bs, the growth rate for Stock A must be higher to offset this.
xviii. (9-5) Constant growth valuation

CG

Answer: e

D0 rs g D1 = D0(1 + g) = P0 = D1/(rs g)
xix.

$1.50 10.1% 4.0% $1.56 $25.57 CG Answer: b

(9-5) Expected dividend yield D0 g P0 D1 = D0(1 + g) = $2.25 3.5% $50.00 $2.329

Dividend yield = D1/P0 = 4.66%

xx.

(9-7) Corporate valuation model FCF1 g WACC Value ops = FCF1/(WACC g) =

CG $150,000 6.50% 11.50% $3,000,000

Answer: d

xxi.

(10-1) Cost of capital

FI

Answer: a

xxii. (Comp.) Capital components

CI FI CI 4.10% 5.25% 1.30 10.925% CI

Answer: b Answer: b Answer: e

xxiii. (10-3) Cost of debt

xxiv. (10-5) Cost of RE: CAPM

rRF RPM b rs = rRF + (RPM b)

xxv.

(10-7) WACC and target cap. struc. Tax rate = 40% Weights Debt Preferred Common WACC 35% 10% 55% 100% rd 6.50%

Answer: a

AT Costs 3.90% 6.00% 11.25% 8.15%