TEST BANK management advisory services by tan t04 risks cost of capital

MANAGEMENT ADVISORY SERVICES RISKS INVESTMENT RISK Catherine & Co has extra cash at the end of the year and is analyzing the best way to invest the funds The company should invest in a project only if A The expected return on the project exceeds the return on investments of comparable risk B The return on investments of comparable risk exceeds the expected return on the project C The expected return on the project is equal to the return on investments of comparable risk Gleim D The return on investments of comparable risk equals the expected return on the project Interest-rate Risk Which of the following are components of interest-rate risk? Gleim A Purchasing-power risk and default risk C Portfolio risk and reinvestment-rate risk B Price risk and market risk D Price risk and reinvestment-rate risk Long-term government bonds have: A Interest rate risk B Default risk C Market risk D None of the above 26 The portion of the risk that can be eliminated by diversification is called: A Unique risk C Interest rate risk B Market risk D Default risk B&M Market Risk The type of risk that is not diversifiable and even affects the value of a portfolio is (E) A Purchasing-power risk C Nonmarket risk B Market risk D Interest-rate risk Gleim C Firm specific risk D All of the above RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS B&M In capital market analysis, the nonsystematic risk a Is correlated with qualitative aspects of the underlying entity b Is correlated with quantitative aspects of the underlying entity c Cannot easily be overcome by individual investors d Is considered random B&M Gleim Which of the following statements is correct? (E) a Well diversified stockholders not consider corporate risk when determining required rates of return b Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk c Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices d Market risk is important but does not have a direct effect on stock price because it only affects beta e All of the statements above are correct Brigham In theory, the decision maker should view market risk as being of primary importance However, within-firm, or corporate, risk is relevant to a firm’s(M) a Well-diversified stockholders, because it may affect debt capacity and operating income b Management, because it affects job stability c Creditors, because it affects the firm’s credit worthiness d Statements a and c are correct e All of the statements above are correct Brigham B&M Purchasing-power Risk Default Risk The marketable securities with the least amount of default risk are (E) a Federal government agency securities c Repurchase agreements b U.S Treasury securities d Commercial paper CMA 0691 1-11 Nonmarket Risk or Company-specific Risk 27 The unique risk is also called the: A Unsystematic risk B Diversifiable risk 29 As the number of stocks in a portfolio is increased: A Unique risk decreases and approaches to zero B Market risk decrease C Unique risk decreases and becomes equal to market risk Portfolio Risk Total Risk The risk of a single asset is A Nonmarket risk B Total risk An asset with high risk will have a(n) A Low expected return C Portfolio risk D Market risk Gleim C Increasing expected return Page of 52 MANAGEMENT ADVISORY SERVICES B Lower price than an asset with low risk RISKS D High standard deviation of returns Gleim b c d e 10 Risk to a company is affected by both project variability and how project returns correlate with those of the company’s prevailing business Overall company risk will be lowest when a project’s returns exhibit CIA 1186 IV-39 a Low variability and negative correlation c High variability and positive correlation b Low variability and positive correlation d High variability and no correlation Liquidity Risk 11 The risk that securities cannot be sold at a reasonable price on short notice is called A Default risk C Purchasing-power risk B Interest-rate risk D Liquidity risk CIA 1190 IV-51 12 When purchasing temporary investments, which one of the following best describes the risk associated with the ability to sell the investment in a short period of time without significant price concessions? (E) A Interest rate risk C Financial risk B Purchasing power risk D Liquidity risk CMA 0697 1-11 Business Risk 13 Business risk is the risk inherent in a firm's operations that excludes financial risk It depends on all of the following factors except (E) A Amount of financial leverage C Demand variability B Sales price variability D Input price variability Gleim 14 Business risk excludes such factors as A Financial risk B Amount of operating leverage C Demand variability D Fluctuations in suppliers' prices Gleim A decrease in the debt ratio will generally have no effect on (E) a Financial risk b Total risk c Business risk d Market risk Brigham Business risk is concerned with the operations of the firm Which of the following is not associated with (or not a part of) business risk? (E) a Demand variability RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS Sales price variability The extent to which operating costs are fixed Changes in required returns due to financing decisions The ability to change prices as costs change Brigham 15 Which of the following affects a firm’s business risk? (E) a The level of uncertainty about future sales b The degree of operating leverage c The degree of financial leverage d Statements a and b are correct e All of the statements above are correct Financial Risk * Which of the following would increase risk? (M) a Increase the level of working capital b Change the composition of working capital to include more liquid assets c Increase the amount of short-term borrowing d Increase the amount of equity financing Brigham RPCPA 1091 16 A firm’s financial risk is a function of how it manages and maintains its debt Which one of the following sets of ratios characterizes the firm with the greatest amount of financial risk? A High debt-to-equity ratio, high interest coverage ratio, stable return on equity B Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity C High debt-to-equity ratio, low interest coverage ratio, volatile return on equity D Low debt-to-equity ratio, high interest coverage ratio, stable return on equity CMA 1291 14 Business and financial risk Which of the following statements is most correct? (E) a A firm’s business risk is solely determined by the financial characteristics of its industry b The factors that affect a firm’s business risk are determined partly by industry characteristics and partly by economic conditions Unfortunately, these and other factors that affect a firm’s business risk are not subject to any degree of managerial control c One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much less important d The firm’s financial risk may have both market risk and diversifiable risk components Brigham Page of 52 MANAGEMENT ADVISORY SERVICES Exchange-rate Risk 17 The risk of loss because of fluctuations in the relative value of foreign currencies is called A Expropriation risk C Multinational beta B Sovereign risk D Exchange rate risk CIA 1191 IV-60 RISKS 18 O & B Company, a U.S corporation, is in possession of accounts receivable denominated in German deutsche marks To what type of risk are they exposed? (E) A Liquidity risk C Exchange-rate risk B Business risk D Price risk Gleim 19 Bonner Electronics has subsidiaries in several international locations and is concerned about its exposure to foreign exchange risk In countries where currency values are likely to fall, Bonner should encourage all of the following policies except A Granting trade credit whenever possible B Investing excess cash in inventory or other real assets C Purchasing materials and supplies on a trade credit basis CFM Sample Q D Borrowing local currency funds if an appropriate interest rate can be obtained 20 A firm may seek to avoid exchange-rate risk by A Maintaining a net monetary debtor position in countries with strengthening currencies B Maintaining a net monetary creditor position in countries with weakening currencies C Avoiding diversification of foreign-currency transactions Gleim D Buying forward exchange contracts to cover liabilities denominated in a foreign currency Cultural Risk 56 A U.S manufacturer of which of the following goods would be likely to face the most cultural risks in operating globally? a Furniture c Clothing b Automobiles d Food Barfields 57 A U.S manufacturer of which of the following goods would be likely to face the fewest cultural risks in operating globally? a Toys c Clothing b Food d Furniture Barfields Political Risk 58 Which of the following would be considered a political risk in doing business globally? a Asset expropriation c Workplace diversity b Inflation d All of the above Barfields 21 Political risk may be reduced by A Entering into a joint venture with another foreign company RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS Page of 52 MANAGEMENT ADVISORY SERVICES B Making foreign operations dependent on the domestic parent for technology, markets, and supplies C Refusing to pay higher wages and higher taxes D Financing with capital from a foreign country Gleim Comprehensive * All of the following statements are correct except: a The matching of asset and liability maturities is considered desirable because this strategy minimizes interest rate risk b Default risk refers to the inability of the firm to pay off its maturing obligations c The matching of assets and liability maturities lowers default risk d An increase in the payables deferral period will lead to a reduction in the need to nonspontaneous funding RPCPA 1095 RISKS RISK MANAGEMENT METHODS Portfolio Theory Portfolio Theory was first developed by: A Merton Miller B Franco Modigliani C Harry Markowitz D Richard Breadey B&M 12 A portfolio will a usually contain: A One riskless asset B Two or more assets C One risky asset D None of the above B&M Portfolio Management Efficient Portfolio 25 Efficient portfolios are those which offer: A Highest expected return for a given level of risk B Highest risk for a given level of expected return C The maximum risk and expected return D All of the above B&M 33 Efficient portfolios are portfolios that: A Offer the highest rate of return for a given level of risk B Offer the lowest rate of return for a given level of risk C Offer the lowest level of risk for a given rate of return D A and C B&M Feasible Portfolio 22 A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given expected return is a(n) A Optimal portfolio C Efficient portfolio B Desirable portfolio D Effective portfolio Gleim Optimal Portfolio 23 An optimal portfolio of investments is (E) A Efficient because it offers the highest expected return B Any portfolio chosen from the efficient set of portfolios C Any portfolio chosen from the feasible set of portfolios D Tangent to the investor's highest indifference curve RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS Gleim Page of 52 MANAGEMENT ADVISORY SERVICES RISKS 24 A company uses portfolio theory to develop its investment portfolio If the company wishes to obtain optimal risk reduction through the portfolio effect, it should make its next investment in A An investment that correlates negatively to the current portfolio holdings B An investment that is uncorrelated to the current portfolio holdings C An investment that is highly correlated to the current portfolio holdings D An investment that is perfectly correlated to the current portfolio holdings CIA 0591 IV-48 Minimum Variance Portfolio 24 Florida Company (FC) and Minnesota Company (MC) are both service companies Their historical return for the past three years are: FC: -10%,15%, 25%; MC: 10%, 6%, 32% Which portfolio is better? A Portfolio with 50% in FC and 50% in MC C Investment in FC B Minimum variance portfolio D None of the above B&M 26 Is the minimum variance portfolio an efficient portfolio? A Yes C Not necessarily B No B&M Well-Diversified Portfolio 30 In a well diversified portfolio, the type of risk remaining is: A Individual security risk C Total risk B Zero risk D Market risk B&M 31 A well-diversified portfolio has negligible: A Systematic risk B Unique risk C Market risk D None of the above B&M Portfolio Matrix Analysis 25 Which one of the following planning techniques is most likely to be used to determine which business units will receive additional capital and which will be divested? (D) A Competitive strategies model C Scenario development B Portfolio matrix analysis D Situational analysis CMA Samp Q3-9 Unsystematic Risk 26 In a well diversified portfolio (M) a market risk is negligible b systematic risk is negligible Bodie c unsystematic risk is negligible d nondiversifiable risk is negligible RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS Systematic Risk 27 Capital Asset Pricing Theory asserts that portfolio returns are best explained by: (E) a economic factors c systematic risk b specific risk d diversification Bodie Standard Deviation vs Beta Coefficient 23 Standard deviation and beta both measure risk, but they are different in that (E) a beta measures both systematic and unsystematic risk b beta measures only systematic risk while standard deviation is a measure of total isk c beta measures only unsystematic risk while standard deviation is a easure of total risk d beta measures both systematic and unsystematic risk while standard deviation measures only systematic risk Bodie e beta measures total risk while standard deviation measures only nonsystematic risk Market Price of Risk 28 The market price of risk (M) a is the risk premium divided by the standard deviation of the market returns b has a reward-to-risk ratio of [E(rM ) - rf]/σ2M c is the price of a U S T-bill d a and b e a and c Bodie Risk Level of Securities 29 Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for return? (E) A U.S Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock B Corporate income bonds; corporate mortgage bonds; convertible preferred stock; subordinated debentures C Common stock; corporate first mortgage bonds; corporate second mortgage bonds; corporate income bonds CIA 0589 IV-49 D Preferred stock; common stock; corporate mortgage bonds; corporate debentures Which of the following portfolios have the least risk? A A portfolio of treasury bills B A portfolio of long term United States Government bonds C Standard and Poor's composite index D Portfolio of common stocks of small firms B&M Page of 52 MANAGEMENT ADVISORY SERVICES RISKS B Pure play risk (beta) C The weighted average of project risk (betas) D Accounting risk (beta) 30 From the viewpoint of the investor, which of the following securities provides the least risk? a Mortgage bond c Income bond b Subordinated debenture d Debentures CIA 1191 IV-50 CIA 0592 IV-49 36 31 The expected rate of return for the stock of Corn Enterprises is 20%, with a standard deviation of 15% The expected rate of return for the stock of Must Associates is 10%, with a standard deviation of 9% The riskier stock is A Corn because its return is higher B Corn because its standard deviation is higher C Must because its standard deviation is higher D Must because its coefficient of variation is higher CMA 0692 1-6 Risky Investment vs Riskless Investment 32 The difference between the required rate of return on a given risky investment and that on a riskless investment with the same expected return is the A Risk premium C Standard deviation B Coefficient of variation D Beta coefficient CIA 1192 IV-48 Capital Asset Pricing Model 33 The capital asset pricing model deals with risk and rates of return of a A Single security B Group of securities in a portfolio which follows a buy and hold strategy C Portfolio and how a new security affects that portfolio D Single fixed asset 34 CIA 0585 IV-28 According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of (E) a market risk c unique risk b unsystematic risk d reinvestment risk Bodie Beta Coefficient 37 The "beta" is a measure of: A Unique risk B Market risk C Total risk D None of the above 35 The level of risk that concerns investors who supply capital to a diversified company is A Project risk (beta) RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS B&M A company's beta value has decreased because of a change in its marketing strategy Consequently, the discount rate applied to expected cash flows of potential projects will be A Reduced C Unchanged B Increased D Zero CIA 1185 IV-26 Portfolio Beta 39 The beta of market portfolio is: A B +0.5 C +1.0 D –1.0 B&M 40 The beta of a risk-free portfolio is: A B +0.5 C +1.0 D –1.0 B&M 34 Beta of Treasury bills portfolio is: A Zero B +0.5 C –1.0 D +1.0 B&M 44 A stock with a beta of zero would be expected to: A Have a rate of return equal to the risk-free rate B Have a rate of return equal to the market risk premium C Have a rate of return equal to zero D Have a rate of return equal to the market rate of return B&M Equity Beta 37 If beta of debt is zero, then the beta of equity is equal to: A (1 + Debt-equity ratio)(beta of assets) C (Beta of assets)/(debt-equity ratio) B (Debt-equity ratio)(beta of assets) D None of the above B&M 37 In many situations debt beta can be safely assumed to be zero Under this assumption, equity beta can be expressed as: [E = market value of equity and D = market value of debt] A equity beta = (1-(D/E.) (asset beta) C equity beta = (asset beta)/(1+(D/E.) B equity beta = (1+(D/E.) (asset beta) D None of the above B&M Page of 52 MANAGEMENT ADVISORY SERVICES RISKS Asset Beta, Debt Beta & Equity Beta 32 Which of the following is true? A bD > bA > bE B bE > bA > bD C bA > bE > bD D None of the above are true 34 Which of the following is true? A bD < bA < bE B bE < bA < bD C bA < bE < bD D None of the above are true Standard Deviation 38 The variance or standard deviation is a measure of: A Total risk C Market risk B Unique risk D None of the above B&M B&M 28 In the formula for calculating the variance of an N-asset portfolio, how many are variance terms? A [N(N-1)]/2 C N B N^2 D None of the above B&M B&M 32 The variance formula for a four stock portfolio contains: A individual variance terms and unique covariance terms B individual variance terms and unique covariance terms C individual variance terms and unique covariance terms D individual variance terms and unique covariance terms Investments A and B both offer an expected rate of return of 12% If the standard deviation of A is 20% and that of B is 30%, then investors would: A Prefer A to B B Prefer B to A C Prefer a portfolio of A and B D Cannot answer without knowing investor's risk preferences B&M Coefficient of Variation 24 Which of the following can be computed and compared for each alternative to determine the relative riskiness of investments that have different levels of expected return? A coefficient of variation C standard deviation B variance D expected value Carter & Usry 37 The expected rate of return for the stock of Cornhusker Enterprises is 20%, with a standard deviation of 15% The expected rate of return for the stock of Mustang Associates is 10% with a standard deviation of 9% The riskier stock is (M) a Cornhusker because the return is higher b Cornhusker because the standard deviation is higher c Mustang because the standard deviation is higher d Mustang because the return is lower e Mustang because the coefficient of variation is higher CMA 0692 1-6 RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS Variance 27 In the formula for calculating the variance of an asset portfolio, how many are covariance terms? A [N(N-1)]/2 C N B N^2 D None of the above B&M B&M Covariance 38 Which of the following specifically measures the volatility of returns together with their correlation with the returns of other securities? (M) A Variance C Coefficient of variation B Standard deviation D Covariance Gleim 39 If the covariance of stock A with stock B is -.0076, then what is the covariance of stock B with stock A? A +.0076 C Greater than 0076 B -.0076 D Less than -.0076 Gleim Indifference Curve 40 An indifference curve represents combinations of portfolios having equal utility to the investor Given that risk and returns are plotted on the horizontal and vertical axes, respectively, and that the investor is risk averse, the curve has A An increasingly steeper slope if the investor is less risk averse B A decreasingly negative slope if the investor's utility increases C An increasingly positive slope D A decreasingly positive slope Gleim Page of 52 MANAGEMENT ADVISORY SERVICES Expected Rate of Return When stocks with the same expected return are combined into a portfolio, the expected return of the portfolio is: A Less than the average expected return value of the stocks B Greater than the average expected return of the stocks C Equal to the average expected return of the stocks D Impossible to predict B&M 41 An investor uses the capital asset pricing model (CAPM) to evaluate the risk-return relationship on a portfolio of stocks held as an investment Which of the following would not be used to estimate the portfolio's expected rate of return? (D) A Expected risk premium on the portfolio of stocks B Interest rate for the safest possible investment C Expected rate of return on the market portfolio D Standard deviation of the market returns CIA 1193 IV-47 RISKS A +1 B C –0.5 D –1 B&M 11 Maximum diversification is obtained by combining two stocks with a correlation coefficient equal to: A +1.0 C –1.0 B 0.0 D +0.5 B&M Correlation The correlation measures the: A Rate of movements of the return of individual stocks B Direction of movement of the return of individual stocks C Direction of movement between the returns of two stocks D Stock market volatility B&M 42 Expected Return – Beta Relationship 25 The expected return-beta relationship (M) a is the most familiar expression of the CAPM to practitioners b refers to the way in which the covariance between the returns on a stock and returns on the market measures the contribution of the stock to the variance of the market portfolio, which is beta c assumes that investors hold well-diversified portfolios d all of the above are true Bodie Comprehensive 12 According to the Capital Asset Pricing Model (CAPM), which one of the following statements is false? (M) a The expected rate of return on a security decreases in direct proportion to a decrease n the risk-free rate b The expected rate of return on a security increases directly with its beta c A fairly priced security has an alpha of zero d In equilibrium, all securities lie on the security market line Bodie Two-Stocks Portfolio Correlation Coefficient 36 For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks is: RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS The returns on two stocks can be correlated in values except those that are A Positive C Neutral B Negative D Skewed Gleim Variance 29 If the correlation between two stocks is +1, then a portfolio combining these two stocks will have variance that is: A Less than the weighted average of the two individual variances B More than the weighted average of the two individual variances C Equal to the weighted average of the two individual variances D None of the above B&M Expected Return Stock A has an expected return of 20%, and stock B has an expected return of 12% The risk of Stock A as measured by the variance of the returns is twice that of stock B If the two stocks are combined equally in a portfolio, what would be the expected return of the portfolio? A 16% C 20% B 12% D Need more information to answer B & M Hedging 43 When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying Page of 52 MANAGEMENT ADVISORY SERVICES A Working capital management B Return maximization RISKS C Financial leverage D A hedging approach C A commitment today to purchase a product on a specific future date at a price determined today D A commitment today to purchase a product only when its price increases above its current exercise price Gleim CMA 1291 1-13 44 Contracts to hedge risk by exchanging cash flows include (E) Gleim A B Interest-Rate Swaps Yes Yes Currency Swaps Yes No C No Yes D No No 45 The use of derivatives to either hedge or speculate results in A Increased risk regardless of motive B Decreased risk regardless of motive C Offset risk when hedging and increased risk when speculating D Offset risk when speculating and increased risk when hedging Gleim 46 A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor However, it is somewhat concerned that the market price of this stock could decrease over the short run The company could hedge against the possible decline in the stock's market price by CIA 0590 IV-57 A Purchasing a call option on that stock C Selling a put option on that stock B Purchasing a put option on that stock D Obtaining a warrant option on that stock Duration Hedging 47 Duration hedging involves hedging interest-rate risk by matching the duration of assets with the duration of liabilities Which of the following is a true statement about duration hedging? (M) A If duration increases, the volatility of the price of a debt instrument decreases B The goal of duration hedging is to equate the duration of assets with the duration of liabilities C The firm is immunized against interest-rate risk when the total price change for assets equals the total price change for liabilities D Duration is higher if the nominal rate on a debt instrument is higher Gleim Forward Contract 48 A forward contract involves (E) A A commitment today to purchase a product on a specific future date at a price to be determined some time in the future B A commitment today to purchase a product some time during the current day at its present price RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS 49 If a corporation holds a forward contract for the delivery of U.S Treasury bonds in months and, during those months, interest rates decline, at the end of the months the value of the forward contract will have A Decreased B Increased C Remained constant D Any of the answers may be correct, depending on the extent of the decline in interest rates Gleim Futures Contract 50 A distinguishing feature of a futures contract is that A Performance is delayed C Delivery is to be on a specific day Gleim B It is a hedge, not a speculation D The price is marked to market each day 51 An automobile company that uses the futures market to set the price of steel to protect a profit against price increases is an example of A A short hedge B A long hedge C Selling futures to protect the company from loss D Selling futures to protect against price declines Gleim Interest rate futures contract Interest rate Swap 52 In an interest rate swap, the first company A Sells its right to low interest rate financing at a financial institution to the second company that is seeking to borrow funds B Agrees to service the debt of the second company by making interest payments directly to the bank of the second company, while the second company agrees in exchange to make interest payments to the bank of the first company C Buys the outstanding public debt of the second company and swaps the interest payments it receives on that debt for the interest payments it must make on its own debt Page of 52 MANAGEMENT ADVISORY SERVICES RISKS D Agrees to exchange with the second company the difference between the interest charges on its own borrowings and the interest charges on the borrowings of the second company CIA 0596 IV-29 Interest Rate & Currency Swap 53 Contracts to hedge risk by exchanging cash flows include Gleim A B Interest-Rate Swaps Yes Yes Currency Swaps Yes No C No Yes D No No METHODS OF ANALYZING RISK Sensitivity Analysis 54 Which of the following approaches would best analyze the risk of increasing the price of a table by $50? (E) A Sensitivity analysis C Informal method B Simulation analysis D Certainty equivalent adjustments Gleim Simulation Analysis 55 Which method for measuring risk considers both the sensitivity of changing NPVs and the range of values of the variables that are changed? A Simulation analysis C Sensitivity analysis B The Capital Asset Pricing Model D Certainty equivalent adjustments Gleim Analysis of Pricing Technique 50 The acronym APT stands for: A Arbitrage Pricing Model B Asset Pricing Tool C Analysis of Pricing Technique D Analysis Pricing Theory 51 A "factor" in APT is a variable that: A Affects the return of risky assets in a systematic manner B Correlates with risky asset returns in an unsystematic manner C Is purely "noise" D Affects the return of a risky asset in a random manner Three-factor Model 55 The three factors in the Three-Factor Model are: A Market factor C Book-to-market factor B Size factor D All of the above RPCPA, AICPA CMA & CIA EXAMINATION QUESTIONS B&M B&M RISK-ADJUSTED DISCOUNT RATE 56 Mega Inc., a large conglomerate with operating divisions in many industries, uses risk-adjusted discount rates in evaluating capital investment decisions Consider the following statements concerning Mega's use of risk-adjusted discount rates I Mega may accept some investments with internal rates of return less than Mega's overall average cost of capital II Discount rates vary depending on the type of investment III Mega may reject some investments with internal rates of return greater than the cost of capital IV Discount rates may vary depending on the division Which of the above statements are correct? (D) A I and III only C II, III, and IV only B II and IV only D I, II, III, and IV CMA Samp Q4-5 57 Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5 The financial manager is evaluating a project with an expected return of 21 percent, before any risk adjustment The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent The project being evaluated is riskier than Boe’s average project, in terms of both beta risk and total risk Which of the following statements is most correct? (E) a The project should be accepted since its expected return (before risk adjustment) is greater than its required return b The project should be rejected since its expected return (before risk adjustment) is less than its required return c The accept/reject decision depends on the risk-adjustment policy of the firm If the firm’s policy were to reduce a riskier-than-average project’s expected return by percentage point, then the project should be accepted d Riskier-than-average projects should have their expected returns increased to reflect their added riskiness Clearly, this would make the project acceptable regardless of the amount of the adjustment e Projects should be evaluated on the basis of their total risk alone Thus, there is insufficient information in the problem to make an accept/reject decision Brigham 58 B&M Assume you are the director of capital budgeting for an all-equity firm The firm’s current cost of equity is 16 percent; the risk-free rate is 10 percent; and the market risk premium is percent You are considering a new project that has 50 percent more beta risk than your firm’s assets currently have, that is, its beta is 50 percent larger than the firm’s existing beta The Page 10 of 52 47 Answer (C) is correct The goal of duration hedging is not to equate the duration of assets and the duration of liabilities but for the following relationship to apply: (Value of assets) X (Duration of assets)(Value of liabilities) X (Duration of liabilities)The firm is immunized against interest-rate risk when the total price change for assets equals the total price change for liabilities Answer (A) is incorrect because if duration increases, the volatility of the price of a debt instrument Answer (B) is incorrect because the goal is to equate the total price change for assets and the total price change for liabilities Answer (D) is incorrect because duration is lower if the nominal rate on a debt instrument is higher 48 Answer (C) is correct A forward contract is an executory contract in which the parties involved agree to the terms of a purchase and a sale, but performance is deferred Accordingly, a forward contract involves a commitment today to purchase a product on a specific future date at a price determined today Answer (A) is incorrect because the price of a future contract is determined on the day of commitment, not some time in the future Answer (B) is incorrect because performance is deferred in a future contract, and the price of the product is not necessarily its present price The price can be any price determined on the day of commitment Answer (D) is incorrect because a forward contract is a firm commitment to purchase a product It is not based on a contingency Also, a forward contract does not involve an exercise price (exercise price is in an option contract) 49 Answer (B) is correct Interest rate futures contracts involve risk-free bonds, such as U.S Treasury bonds When interest rates decrease over the period of a forward contract, the value of the bonds and the forward contract increase Answer (A) is incorrect because the value of the forward contract will increase when interest rates decrease Answer (C) is incorrect because the value of the forward contract will increase when interest rates decrease Answer (D) is incorrect because any decline in interest rates increases the value of the bonds 50 Answer (D) is correct A distinguishing feature of futures contracts is that their prices are marked to market every day at the close of the day Thus, the market price is posted at the close of business each day A mark-tomarket provision minimizes a futures contract's chance of default because profits and losses on the contracts must be received or paid each day through a clearinghouse Answer (A) is incorrect because both a forward contract and a futures contract are executory Answer (B) is incorrect because a futures contract may be speculative Answer (C) is incorrect because a futures contract is for delivery during a given month 51 Answer (B) is correct A change in prices can be minimized or avoided by hedging Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements The automobile company desires to stabilize the price of steel so that its cost to the company will not rise and cut into profits Accordingly, the automobile company uses the futures market to create a long hedge, which is a futures contract that is purchased to protect against price increases Answer (A) is incorrect because a short hedge is a futures contract that is sold to protect against price declines The automobile company wishes to protect itself against price increases Answer (C) is incorrect because the automobile company needs to purchase futures in order to protect itself from loss, not sell futures Selling futures protects against price declines Answer (D) is incorrect because it is the definition of a short hedge, which is used for avoiding price declines The automobile company wants to protect itself against price increases 52 Answer (D) is correct In an interest rate swap, two companies exchange their debt servicing obligations Such a transaction arises because the companies (called the counter parties) wish to limit interest rate risk If a company with a variable-rate loan desires the certainty of a fixed-rate loan, it may swap with a company that prefers the floating rate The actual exchange of funds during the agreement is in the form of a net payment from the party owing the greater amount for the period Interest rate swaps are a form of off-balance-sheet financing because only the original borrowing, not the swap agreement, appears on the balance sheet Answer (A) is incorrect because an interest rate swap is not a sale of a right to borrow at a preferential rate Answer (B) is incorrect because the parties to an interest rate swap deal only with each other Answer (C) is incorrect because an interest rate swap is an exchange of interest obligations, not an offsetting of interest income and interest expense 53 Answer (A) is correct Swaps are contracts to hedge risk by exchanging cash flows In an interest-rate swap, one firm exchanges its fixed interest and principal payments for a series of payments based on a floating rate If a firm has debt with fixed charges, but its revenues fluctuate with interest rates, it may prefer to swap for cash outflows based on a floating rate The advantage is that revenues and the amounts of debt service will then move in the same direction, and interest-rate risk will be reduced A currency swap is an exchange of an obligation to pay out cash flows denominated in one currency for an obligation to pay in another For example, a U.S firm with revenues in francs has to pay suppliers and workers in dollars, not francs To minimize exchange-rate risk, it might agree to exchange francs for dollars held by a firm that needs francs The exchange rate will be an average of the rates expected over the life of the agreement Answer (B) is incorrect because contracts to hedge risk by exchanging cash flows include interest-rate swaps and currency swaps Answer (C) is incorrect because contracts to hedge risk by exchanging cash flows include interestrate swaps and currency swaps Answer (D) is incorrect because contracts to hedge risk by exchanging cash flows include interest-rate swaps and currency swaps 54 Answer (A) is correct Under sensitivity analysis, forecasts of many calculated NPVs under various assumptions are compared to see how sensitive the NPV of a possible project is to the change of a single input variable In this instance, the single unit variable being changed is the price of a table Answer (B) is incorrect because simulation analysis requires the use of a computer to generate many examples of results based upon various assumptions Answer (C) is incorrect because the informal method calculates NPVs at the firm's discount rate (k) and individually reviews the possible projects Answer (D) is incorrect because certainty equivalent adjustments are not frequently used since decision makers are not familiar with its concept It forces the decision maker to specify at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum 55 Answer (A) is correct Simulation analysis considers both the sensitivity of the NPV when variables are changed and the range of values of the variables that are changed Answer (B) is incorrect because The Capital Asset Pricing Model is derived from the use of portfolio theory Answer (C) is incorrect because sensitivity analysis only considers the sensitivity of the NPV when variables are changed, not the range of values of the variables that are changed Answer (D) is incorrect because certainty equivalent adjustments does not involve calculating NPVs 56 Answer (D) is correct Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate This technique adjusts the interest rate used for discounting upward as an investment becomes riskier The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR In this case, the investment presumably has very little risk Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits Answer (A) is incorrect because discount rates may vary with the project or with the subunit of the organization Answer (B) is incorrect because the company may accept some projects with IRRs less than the cost of capital, or reject some project with IRRs greater than the cost of capital Answer (C) is incorrect because the company may accept some projects with IRRs less than the cost of capital, or reject some project with IRRs greater than the cost of capital 57 ks = 10% + (16% - 10%)1.5 = 10% + 9% = 19% Expected return = 21% 21% - Risk adjustment 1% = 20% Risk-adjusted return = 20% > ks = 19% 58 Calculate the beta of the firm, and use to calculate project beta: ks = 0.16 = 0.10 + (0.05)bFirm bFirm = 1.2 bProject = (bFirm)1.5 (bProject is 50% greater than current bFirm) bProject = (1.2)1.5 = 1.8 Calculate required return on project, kProject, and compare to expected return: Project: kProject = 0.10 + (0.05)1.8 = 0.19 = 19% Expected return = 0.18 = 18% Since the required return is one percentage point greater than the expected return, the firm should not accept the new project 59 Calculate the beta of the firm, and use to calculate project beta: ks = 0.16 = 0.10 + (0.05)bFirm bFirm = 1.2 bProject = (bFirm)1.5 (bProject is 50% greater than current bFirm) bProject = (1.2)1.5 = 1.8 Calculate required return on project, kProject, and compare to IRR Project: kProject = 0.10 + (0.05)1.8 = 0.19 = 19% IRR = 0.18 = 18% Since the required return is one percentage point greater than the expected IRR, the firm should not accept the new project 60 Answer (C) is correct The theory underlying the cost of capital is based primarily on the cost of long-term funds and the acquisition of new funds The reason is that long-term funds are used to finance long-term investments For an investment alternative to be viable, the return on the investment must be greater than the cost of the funds used The objective in short-term borrowing is different Short-term loans are used for working capital, not to finance longterm investments Answer (A) is incorrect because the concern is with the cost of new funds; the cost of old funds is a sunk cost and of no relevance for decision-making purposes Answer (B) is incorrect because the cost of short-term funds is not usually a concern for investment purposes Answer (D) is incorrect because there is less concern with the cost of old funds or short-term funds 61 Answer (C) is correct The cost of capital is the minimum, not maximum, rate of return that must be earned on new investments so as not to dilute shareholder interest If new investments have a rate of return less than the cost of capital, a loss will be incurred on those investments Thus, the cost of capital must be the minimum rate of return See SMA 4A, Cost of Capital Answer (A) is incorrect because cost of capital is used to make capital investment decisions so that each investment returns more than the cost of capital Answer (B) is incorrect because the cost of maintaining working capital is based on the cost of capital Answer (D) is incorrect because the performance of individual investments, investment managers, and others can be related to the cost of capital 62 Answer (D) is correct The U-shaped curve indicates that the cost of capital is quite high when the debt-toequity ratio is quite low As debt increases, the cost of capital declines as long as the cost of debt is less than that of equity Eventually, the decline in the cost of capital levels off because the cost of debt ultimately rises as more debt is used Additional increases in debt (relative to equity) will then increase the cost of capital The implication is that some debt is present in the optimal capital structure because the cost of capital initially declines when debt is added However, a point is reached at which debt becomes excessive and the cost of capital begins to rise Answer (A) is incorrect because the composition of the capital structure affects the cost of capital since the components have different costs Answer (B) is incorrect because the cost of debt does not remain constant as financial leverage increases Eventually, that cost also increases Answer (C) is incorrect because the initial decline in the U-shaped graph indicates that the financial markets reward moderate levels of debt 63 Answer (A) is correct The overall cost of capital is the rate of return on a firm's assets that exactly covers the costs associated with the funds employed It is the weighted average of the various debt and equity components Answer (B) is incorrect because the cost of capital is based on what a company pays for its capital, not the return earned on the capital employed Answer (C) is incorrect because the overall cost of capital is the minimum rate a firm must earn on all investments to cover capital costs Answer (D) is incorrect because the overall cost of capital is based on both debt and equity components 64 Answer (A) is correct An imputed cost is one that has to be estimated It is a cost that exists but is not specifically stated and is the result of a process designed to recognize economic reality An imputed cost may not require a dollar outlay formally recognized by the accounting system, but it is relevant to the decision-making process For example, the stated interest on a bank loan is not an imputed cost because it is specifically stated and requires a dollar outlay But the cost of using retained earnings as a source of capital is unstated and has to be imputed Answer (B) is incorrect because the cost of obsolete assets should be written off Answer (C) is incorrect because understated depreciation results in unstated costs Answer (D) is incorrect because the lower-than-market return on a loan is an imputed cost of the products 65 REQUIRED: The implicit cost of financing DISCUSSION: (B) Debt capital often appears to have a lower cost than equity because the implicit costs are not obvious The implicit costs are attributable to the increased risk created by the additional debt burden Thus, as the debt-to-equity ratio increases, the cost of both debt and equity will increase given the increased risk to both shareholders and creditors from a higher degree of leverage An explanation based on the marginal cost of capital and the marginal efficiency of investment leads to the same conclusion Lower cost capital sources are used first Additional projects must then be undertaken with funds from higher cost sources Similarly, risk is increased because the most profitable investments are made initially, leaving the less profitable investments for the future Answer (A) is incorrect because both debt and equity sources increase in cost as leverage increases Answer (C) is incorrect because equity costs decline as leverage decreases Answer (D) is incorrect because the weightedaverage cost of capital will increase with increased leverage 66 Retained earnings are just another form of equity When the company has retained earnings, they can one of two things reinvest them or pay them out as dividends If they reinvest the earnings, they need to earn a return that is at least as high as the k s of the stock Otherwise, investors would be happier getting the dividends and investing them in something that will get them k s Therefore, statement a is false Some of the preferred stock dividends are excluded from taxation when another company owns them It makes no tax difference to the company that pays the dividends, since dividends come out of after-tax dollars Therefore, statement b is false Interest payments are tax deductible Therefore, statement c is true 67 Answer (B) is correct The cost of debt capital is simply the debt interest rate times (1 - the firm's tax rate) Thus, if the tax rate is 40%, the effective cost of debt capital is 60% times the interest rate because the interest is tax deductible See SMA 4A, Cost of Capital Answer (A) is incorrect because it ignores the tax deductibility of interest payments Answer (C) is incorrect because it ignores the tax deductibility of interest payments Answer (D) is incorrect because the capital asset pricing model is one means of determining the cost of common equity 68 Answer (D) is correct The after-tax cost of debt is the cost of debt times the quantity one minus the tax rate For example, the after-tax cost of a 10% bond is 7% [10% x (1 - 30%)] if the tax rate is 30% Answer (A) is incorrect because the after-tax cost of debt is the cost of debt times the quantity one minus the tax rate Answer (B) is incorrect because the after-tax cost of debt is the cost of debt times the quantity one minus the tax rate Answer (C) is incorrect because the cost of debt times the marginal tax rate equals the tax savings from issuing debt 69 Answer (D) is correct Because interest is deductible for tax purposes, the actual cost of debt capital is the net effect of the interest payment and the offsetting tax deduction The actual cost of debt equals the interest rate times one minus the marginal tax rate Thus, if a firm with an 8% market rate is in a 40% tax bracket, the net cost of the debt capital is 4.8% [8% x (1 - 4)] Answer (A) is incorrect because the tax deduction always causes the market yield rate to be higher than the cost of debt capital Answer (B) is incorrect because additional debt may or may not be issued more cheaply than earlier debt, depending upon the interest rates in the market place Answer (C) is incorrect because the cost of debt is less than the yield rate given that bond interest is tax deductible 70 Answer (C) is correct As a larger proportion of an entity's capital is provided by debt, the debt becomes riskier and more expensive, i.e., requires a higher interest rate Answer (A) is incorrect because the diversity decreases, not increases, risk Answer (B) is incorrect because $50 million is minuscule in the debt markets Answer (D) is incorrect because the combination alternative maintains the same debt/equity mixture, which would not warrant a rate increase in the cost of debt or equity 71 Answer (C) is correct The excess of the price over the face value is a premium A premium is paid because the coupon rate on the bond is greater than the market rate of interest In other words, because the bond is paying a higher rate than other similar bonds, its price is bid up by investors Answer (A) is incorrect because, if a bond sells at a premium, the market rate of interest is less than the coupon rate Answer (B) is incorrect because a bond sells at a discount when the price is less than the face amount Answer (D) is incorrect because a bond sells at a discount when the price is less than the face amount 72 REQUIRED: The definition of the marginal cost of debt DISCUSSION: (C) The marginal cost of debt is calculated as the cost of new debt times one minus the marginal tax rate, or Kd (1 - T) This d expression equals Kd - KdT Answer (A) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm's marginal tax rate multiplied by the interest rate Answer (B) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm's marginal tax rate multiplied by the interest rate Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt Answer (D) is incorrect because the marginal cost of debt financing is the interest rate on new debt minus the firm's marginal tax rate multiplied by the interest rate Moreover, the marginal or incremental cost of debt to the firm is based on the cost of newly issued debt, not on the cost of outstanding debt 73 The debt cost used to calculate a firm’s WACC is kd(1 - T) If kd remains constant but T increases, then the term (1 - T) decreases and the value of the entire equation, kd(1 - T), decreases Statement b is false; if a company’s stock price increases, and all else remains constant, then the dividend yield decreases and ks decreases This can be seen from the equation ks = D1/P0 + g Statement c is false for the same reason The cost of issuing new common stock is ke = D1/[P0(1 - F)] + g If P0 increases but there’s no change in the flotation cost, ke will decrease 74 Answer (B) is correct Providers of equity capital are exposed to more risk than are lenders because the firm is not obligated to pay them a return Also, in case of liquidation, creditors are paid before equity investors Thus, equity financing is more expensive than debt because equity investors require a higher return to compensate for the greater risk assumed Answer (A) is incorrect because the obligation to repay at a specific maturity date reduces the risk to investors and thus the required return Answer (C) is incorrect because the demand for equity capital is directly related to its greater cost to the issuer Answer (D) is incorrect because dividends are based on managerial discretion and may rarely change; interest rates, however, fluctuate daily based upon market conditions 75 Statement a is correct Most preferred stock is owned by corporations which receive a 70 percent exclusion of dividends Consequently, the before-tax coupons on preferred stock are often lower than the before-tax coupons on debt, despite the fact that preferred stock is riskier than debt All the other statements are false 76 Answer (B) is correct The dividend growth model is used to calculate the price of stock Po = D1 R-G If: PO = current price D1 = next dividend R = required rate of return G = EPS growth rate Assuming that D1 and G remain constant, an increase in R resulting from an increase in the nominal interest rate will cause PO to decrease Answer (A) is incorrect because a higher interest rate raises the required return of investors, which results in a lower stock price Answer (C) is incorrect because a higher interest rate raises the required return of investors, which results in a lower stock price Answer (D) is incorrect because a higher interest rate raises the required return of investors, which results in a lower stock price 77 REQUIRED: The item resulting in a higher market value for common shares DISCUSSION: (A) The dividend growth model is used to calculate the cost of equity The simplified formula is R= D +G P R is the required rate of return, D is the next dividend, P is the stock’s price, and G is the growth rate in earnings per share The equation is also used to determine the stock price P= D R-G Thus, when investors have a lower required return on equity, the denominator is smaller, which translates in to a higher market value Answer (B) is incorrect because, if investors expect lower dividend growth, the market value of common shares will decrease Answers (C) and (D) are incorrect because the expected holding periods of investors are not related to the market value of the common shares 78 Answer (B) is correct Newly issued or external common equity is more costly than retained earnings The company incurs issuance costs when raising new, outside funds Answer (A) is incorrect because the cost of retained earnings is the rate of return stockholders require on equity capital the firm obtains by retaining earnings The opportunity cost of retained funds will be positive Answer (C) is incorrect because retained earnings will always be less costly than external equity financing Earnings retention does not require the payment of issuance costs Answer (D) is incorrect because retained earnings will always be less costly than external equity financing Earnings retention does not require the payment of issuance costs 79 Statement a is correct; the other statements are false Preferred stock dividends are not tax deductible; therefore, the cost of preferred stock is only kp The risk premium in the bond-yield-plus-risk premium approach would be added to the firm’s cost of debt, not the risk-free rate Preferred stock also has flotation costs 80 REQUIRED: The effect of a higher dividend-payout ratio DISCUSSION: (A) the higher the dividend-payout ratio, the sooner retained earnings are exhausted and the company must seek external financing Assuming the same investments are undertaken, the result is a higher marginal cost of capital because lower-cost capital sources will be used up earlier Answer (B) is incorrect because the marginal cost of capital is higher Answers (C) and (D) are incorrect because the existence of investment opportunities is unrelated to the dividend payout 81 Answer (D) is correct The marginal cost of capital is the cost of the next dollar of capital The marginal cost continually increases because the lower cost sources of funds are used first The marginal cost represents a weighted average of both debt and equity capital Answer (A) is incorrect because, if the cost of capital were the same as the rate of return on equity (which is usually higher than that of debt capital), there would be no incentive to invest Answer (B) is incorrect because the marginal cost of capital is affected by the degree of debt in the firm's capital structure Financial risk plays a role in the returns desired by investors Answer (C) is incorrect because the rate of return used for capital budgeting purposes should be at least as high as the marginal cost of capital 82 Answer (B) is correct The measure of the value of an individual stock is dependent entirely upon the stream of future cash flows that it will produce To determine the stock's current value, these cash flows should be discounted to time zero (now) to obtain the stream's present value Stocks primarily provide cash flows to investors via dividends (including share repurchases and liquidating dividends) and capital gain (loss) at the time of sale Once the stream of cash flows has been discounted over a significant number of periods, it is easy to see that the dividend stream, not the capital gain (loss) in the final period, drives the value of the stock in question Of course, all firms not pay a dividend Common financial theory, however, states that it is the intention of every firm to pay a dividend to shareholders at some time in the future, once the firm feels it is strong enough to so and still support future operations After all, it is the primary goal of a firm's management to maximize shareholder wealth Although many factors should be considered when purchasing a security, the primary consideration for a value-seeking investor is the future cash flow stream Answer (A) is incorrect because book value is a measure of the stock's worth on a company's accounting records Answer (C) is incorrect because the beta coefficient is a measure of how volatile the price movements of a stock are relative to the market as a benchmark Answer (D) is incorrect because standard deviation is a measure of risk While risk is a consideration for the investor, one of the fundamental concepts in finance is that there is (should be) a trade-off between risk and return, and as long as risk is compensated for, it is not a primary consideration 83 is Answer (D) is correct The dividend growth model is used to calculate the cost of equity The simplified formula R= D1 +G PO R is the required rate of return, D is the next dividend, PO is the stock's price, and G is the growth rate in earnings per share The equation is also used to determine the stock price Po = D1 R-G Answer (A) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return Answer (B) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return Answer (C) is incorrect because the model uses the growth rate in dividends and the investor's required rate of return 84 Answer (D) is correct The Gordon (dividend) growth model requires three elements to estimate the cost of equity capital These are the dividends per share, the expected growth rate in dividends per share, and the market price of the stock Basically, the cost of equity capital can be computed as the dividend yield (dividends ÷ price) plus the growth rate Answer (A) is incorrect because book value per share is not a consideration in computing the cost of equity capital Answer (B) is incorrect because current dividends, not current earnings, per share are a requirement for the formula Answer (C) is incorrect because book value per share is not a consideration in computing the cost of equity capital Also, current dividends, not current earnings, per share are a requirement for the formula 85 The CAPM assumes that investors are price-takers with the same single holding period and that there are no taxes or transaction costs 86 87 The SML is a measure of expected return-beta (the CML is a measure of expected return-standard deviation of market returns) The SML provides the expected return-beta relationship for "fairly priced" securities; thus if a portfolio manager selects securities that are underpriced and produces a portfolio with a positive alpha, this portfolio manager would receive a positive evaluation 88 Both the Capital Market Line and the Security Market Line depict risk/return relationships However, the risk measure for the CML is standard deviation and the risk measure for the SML is beta (thus c is not true; the other statements are true) 89 In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price of risk for the market If not, investors will buy or sell the security until they are equal 90 An underpriced security will have a higher expected return than the SML would predict; therefore it will plot above the SML 91 Answer (A) is correct The capital asset pricing model adds the risk-free rate to the product of the market risk premium and the beta coefficient The market risk premium is the amount above the risk-free rate (approximated by the U.S treasury bond yield) that must be paid to induce investment in the market The beta coefficient of an individual stock is the correlation between the price volatility of the stock market as a whole and the price volatility of the individual stock Answer (B) is incorrect because the price-earnings ratio is not a component of the model Answer (C) is incorrect because the price-earnings ratio is not a component of the model Answer (D) is incorrect because the dividend payout ratio is not a component of the model 92 The expected rate of return on any security is equal to the risk free rate plus the systematic risk of the security (beta) times the market risk premium, E(rM - Rf) 93 The tangency point between the capital market line and the indifference curve is the optimal portfolio for a particular investor The SML is a measure of expected return per unit of risk, where risk is defined as beta (systematic risk) 94 95 A security with a positive alpha is one that is expected to yield an abnormal rate of return, based on the perceived risk of the security, and thus is underpriced 96 Answer (B) is correct The required rate of return on equity capital in the Capital Asset Pricing Model is the riskfree rate (determined by government securities), plus the product of the market risk premium times the beta coefficient (beta measures the firm's risk) The market risk premium is the amount above the risk-free rate that will induce investment in the market The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock market and that of the price of the individual stock For example, if an individual stock goes up 15% and the market only 10%, beta is 1.5 Answer (A) is incorrect because the coefficient of variation compares risk with expected return (standard deviation ÷ expected return) Answer (C) is incorrect because standard deviation measures dispersion (risk) of project returns Answer (D) is incorrect because expected return does not describe risk 97 Answer (A) is correct The word beta is derived from the regression equation for regressing the return of an individual security (the dependent variable) to the overall market return The beta coefficient is the slope of the regression line The beta for a security may also be calculated by dividing the covariance of the return on the market and the return on the security by the variance of the return on the market Answer (B) is incorrect because beta equals the covariance of the returns on the market and on the security divided by the variance of the return on the market Answer (C) is incorrect because beta equals the covariance of the returns on the market and on the security divided by the variance of the return on the market Answer (D) is incorrect because beta equals the covariance of the returns on the market and on the security divided by the variance of the return on the market 98 Answer (C) is correct The relevant risk of a security is its contribution to the portfolio's risk It is the risk that cannot be eliminated through diversification and is synonymous with market risk and systematic risk The relevant risk results from factors, such as inflation, recession, and high interest rates, that affect all stocks Answer (A) is incorrect because company-specific risk can be eliminated through portfolio diversification Answer (B) is incorrect because diversifiable risk can be eliminated through portfolio diversification Answer (D) is incorrect because only the systematic component of total risk is relevant to security valuation 99 Beta is a measure of how a security's return covaries with the market returns, normalized by the market variance 100 By definition, the beta of the market portfolio is 101 Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by beta 102 E(RS) = rf + 0(RM - rf) = rf 103 The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a stock or portfolio varies directly with beta 104 The risk premium on the market portfolio is proportional to the average degree of risk aversion of the investor population and the risk of the market portfolio measured by its variance 105 A zero alpha results when the security is in equilibrium (fairly priced for the level of risk) Calculate the required return, ks, and use to calculate the WACC: ks = 10% + 1.38(5%) = 16.9% WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05% ˆ Compare expected project return, k Project , to WACC: 106 ˆ But k Project = IRR = 13.0% Accept the project since IRRProject > WACC: 13.0% > 12.05% Answer (B) is correct To estimate the required rate of return on equity, the capital asset pricing model (CAPM) adds the risk-free rate (determined by government securities) to the product of the beta coefficient (a measure of the firm's risk) and the difference between the market return and the risk-free rate Below is the basic equilibrium equation for the CAPM R = RF + ß (RM - RF ) Thus, given a beta of 1.2, R is 11% [5% + 1.2 (10% - 5%)] At a beta of 1.5, R is 12.5% [5% + 1.5 (10% - 5%)] Answer (A) is incorrect because 3% equals the market return times the increase in the beta Answer (C) is incorrect because the company's required rate of return is affected by a change in the company's beta coefficient Answer (D) is incorrect because the change results in an increase of the company's required rate of return, not a decrease 107 11% = 5% + 1.5(9% - 5%) = 11.0%; therefore, the security is fairly priced 108 12% < 7% + 1.3(15% - 7%) = 17.40%; therefore, stock is overpriced and should be shorted 109 A:12% - [5% + 1.2(9% - 5%)] = 2.2% 110 111 Answer (B) is correct The cost of capital of a firm is the current, weighted average, after-tax cost of the firm's various financing components Historical costs are irrelevant Answer (A) is incorrect because the cost of capital is a weighted average for all sources of capital Answer (C) is incorrect because costs are considered after taxes For example, the deductibility of interest must be considered Answer (D) is incorrect because the time value of money should be incorporated into the calculations 112 Answer (D) is correct A weighted average of the costs of all financing sources should be used, with the weights determined by the usual financing proportions The terms of any financing raised at the time of initiating a particular project not represent the cost of capital for the firm When a firm achieves its optimal capital structure, the weighted-average cost of capital is minimized Answer (A) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions The cost of capital should also be calculated on an after-tax basis Answer (B) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions The cost of capital should also be calculated on an after-tax basis Answer (C) is incorrect because the cost of capital is a composite, or weighted average, of all financing sources in their usual proportions The cost of capital should also be calculated on an after-tax basis 113 Answer (A) is correct The cost of capital of a firm is the current, weighted-average, after-tax cost of the firm's various financing components Historical costs are irrelevant Answer (B) is incorrect because costs are considered after taxes For example, the deductibility of interest must be considered Answer (C) is incorrect because the time value of money should be incorporated into the calculations Answer (D) is incorrect because the cost of capital is a weighted average for all sources of capital 114 If a firm paid no income taxes, its cost of debt would not be adjusted downward, hence the component cost of debt would be higher than if T were greater than With a higher component cost of debt, the WACC would be increased Of course, the company would have higher earnings, and its cash flows from a given project would be high, so the higher WACC would not impede its investments, that is, its capital budget would be larger than if it were taxed 115 Statements a and c are both correct; therefore, statement d is the correct choice Statement a recites the definition of the weighted average cost of capital Statement c is correct because kd = kRF + LP + MRP + DRP while ks = kRF + (kM - kRF)b If kRF increases then the values for kd and ks will increase 116 Statement a is correct; the other statements are false Statement b is incorrect; WACC is an average of debt and equity financing Since debt financing is cheaper and is adjusted downward for taxes, it should, when averaged with equity, cause the WACC to be less than the cost of equity financing Statement c is incorrect; WACC is calculated on an after-tax basis Statement d is incorrect; the WACC is based on marginal, not embedded, costs Statement e is incorrect; the cost of issuing new common stock is greater than the cost of retained earnings Because corporations can exclude dividends for tax purposes, preferred stock often has a before-tax market return that is less than the issuing company’s before-tax cost of debt Then, if the issuer’s tax rate is zero, its component cost of preferred would be less than its after-tax cost of debt 117 WACC measures the marginal after-tax cost of capital; therefore, statement a is false The after-tax cost of debt financing is less than the after-tax cost of equity financing; therefore, statement b is false The correct choice is statement c 118 The preferred stock dividend is not tax deductible like the interest payment on debt Therefore, there is no tax benefit from preferred stock Statement a is true Retained earnings are equity, and equity will have a higher cost than debt Therefore, statement b is false If the beta increases, investors will require a higher rate of return to hold or buy the stock Therefore, the cost of equity will go up, and statement c is true Because statements a and c are true, the correct choice is statement e 119 Statements a and b are true Statement c is false The cost of new stock is higher than the cost of retained earnings because there are flotation costs associated with issuing new stock Since statements a and b are true the correct choice is statement d 120 Statement c is the correct choice A tax rate increase would lead to a decrease in the after-tax cost of debt and, consequently, the firm’s WACC would decrease 121 Statement a is correct; the other statements are false If RPM decreases, the cost of equity will be reduced Answers b through e will all increase the company’s WACC 122 123 Calculate the required return, ks, and compare to the expected return, k s k s = 7% ks = kRF + (kM - kRF)b = 0.07 + (0.10 - 0.07)0.5 = 0.085 = 8.5% ks > k s ; 8.5% > 7.0%; reject the investment Calculate the required return, ks, and use to calculate the WACC: ks = 10% + 1.38(5%) = 16.9% WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05% Compare expected project return, kˆproject , to WACC: But kˆproject = 13.0% Accept the project since kˆproject > WACC: 13.0% > 12.05% 124 Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7% If the company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then it will retain earnings of $50,000 The retained earnings breakpoint is $50,000/0.4 = $125,000 Since it will require financing in excess of $125,000 to undertake any of the alternatives, we can conclude the firm must issue new equity Therefore, the pertinent component cost of equity is the cost of new equity Calculate the expected dividend per share (note this is D1) as $50,000/10,000 = $5 Thus, the cost of new equity is $5/[($35(1 - 0.12)] + 6% = 22.23% Jackson’s WACC is 7%(0.6) + 22.23%(0.4) = 13.09% Only the return on Project A exceeds the WACC, so only Project A will be undertaken 125 Answer (C) is correct The degree of operating leverage is the percentage change in EBIT resulting from a given percentage change in sales Thus, it causes EBIT to be more sensitive to changes in sales Answer (A) is incorrect because the term credit is not applicable to leverage Answer (B) is incorrect because financial leverage refers to the sensitivity of EPS to EBIT Answer (D) is incorrect because the term intrinsic is not applicable to leverage 126 Answer (A) is correct Operating leverage is based on the degree to which fixed costs are used in production Firms may increase fixed costs, such as by automation, to reduce variable costs The result is a greater degree of operating leverage (DOL), which is the percentage change in earnings before interest and taxes (net operating profit) divided by the percentage change in unit sales It can also be determined from the following formula, given that Q is quantity of units sold, P is unit price, V is unit variable cost, and F is fixed cost: Q(P - V) Q(P - V) - F Answer (B) is incorrect because the degree of financial leverage equals the percentage change in EPS divided by the percentage change in net operating profit Answer (C) is incorrect because the breakeven point is the sales volume at which total revenue equals total costs Answer (D) is incorrect because the degree of total (combined) leverage equals the percentage change in EPS divided by the percentage change in sales 127 Answer (C) is correct The degree of operating leverage (DOL) is a measure of the change in earnings available to common stockholders associated with a given change in operating earnings It is calculated, for a particular level of sales, as: sales revenue - variable costs sales revenue - variable costs - fixed operating costs Answer (A) is incorrect because DOL varies with the sales level Answer (B) is incorrect because the degree of financial leverage is a measure of the change in earnings available to common stockholders associated with a given change in operating earnings Answer (D) is incorrect because the degree of total leverage is the multiple of the degree of operating leverage and the degree of financial leverage Other things being equal, DOL is higher if the degree of total leverage is higher 128 Answer (A) is correct The degree of operating leverage (DOL) is equal to the percentage change in net operating income, that is, earnings before interest and taxes (EBIT) divided by the percentage change in sales Because interest expenses are not included in EBIT, the DOL is not affected by a change in interest expense Answer (B) is incorrect because variable cost per unit affects EBIT and therefore the DOL Answer (C) is incorrect because quantity of units sold affects EBIT and therefore the DOL Answer (D) is incorrect because fixed costs affect EBIT and therefore the DOL 129 Answer (B) is correct Operating leverage is a measure of the degree to which fixed costs are used in the production process A company with a higher percentage of fixed costs (higher operating leverage) has greater risk than one in the same industry that relies more heavily on variable costs The DOL equals the percentage change in net operating income divided by the percentage change in sales Thus, profits became more sensitive to changes in sales volume as the DOL increases Answer (A) is incorrect because a firm with higher operating leverage has higher fixed costs and lower variable costs Answer (C) is incorrect because a firm with higher leverage will be relatively more profitable than a firm with lower leverage when sales are high The opposite is true when sales are low Answer (D) is incorrect because a firm with higher leverage is more risky Its reliance on fixed costs is greater 130 Answer (B) is correct A purchase of treasury stock involves a decrease in assets (usually cash) and a corresponding decrease in shareholders' equity Thus, equity is reduced and the debt-to-equity ratio and financial leverage increase Answer (A) is incorrect because assets decrease when treasury stock is purchased Answer (C) is incorrect because a firm's interest coverage ratio is unaffected Earnings, interest expense, and taxes will all be the same regardless of the transaction Answer (D) is incorrect because the purchase of treasury stock is antidilutive; the same earnings will be spread over fewer shares Some firms purchase treasury stock for this reason 131 REQUIRED: The effect of increasing the DFL DISCUSSION: (D) The DFL equals the percentage change in earnings available to common shareholders divided by the percentage change in net operating income When the DFL rises, fixed interest charges and the riskiness of the firm rise As a result, the variability of the returns to equity holders will increase In other words, the standard deviation of returns on the equity of the company rises Answer (A) is incorrect because an increase in the DFL increases the riskiness of the firm’s stock Thus, beta rises Beta is a measure of the volatility of a firm’s stock price relative to the average stock Answers (B) and (C) are incorrect because systematic risk, also known as market risk, is unrelated to the DFL Systematic risk is not specific to a company It is the risk associated with a company’s stock that cannot be diversified because it arises from factors that affect all stocks 132 Answer (C) is correct Financial leverage is the use of borrowed money to earn money for the benefit of shareholders The expectation is that investment earnings will be greater than the interest paid on the borrowed funds Increasing debt (such as bonds) increases financial leverage Answer (A) is incorrect because the issuance of common stock does not increase financial leverage No increase in borrowed capital and fixed interest charges occurs when equity is issued Answer (B) is incorrect because a decrease in the dividend payout ratio would result in increased owners' equity (retained earnings), and would not increase debt capital and financial leverage Answer (D) is incorrect because using debt, not equity, funds to finance new investments increases financial leverage 133 Answer (C) is correct Earnings per share is less volatile in less highly leveraged firms Lower fixed costs result in less variable earnings when sales fluctuate Answer (A) is incorrect because higher leverage is associated with higher, not lower, EPS when sales exceed the breakeven point Answer (B) is incorrect because earnings per share is more volatile in more highly leveraged firms Answer (D) is incorrect because less leverage is associated with lower, not higher, EPS when sales exceed the breakeven point 134 Answer (B) is correct Financial leverage is the amount of the fixed cost of capital, principally debt, in a firm's capital structure relative to its operating profit Leverage creates financial risk and is directly related to the cost of capital Because the company is retiring bonds, the total debt is decreased Given that the amount of debt and leverage are directly related, a decrease in the amount of debt results in a decrease in financial leverage Answer (A) is incorrect because the bond retirement decreases the debt-equity ratio Answer (C) is incorrect because the total assets will decrease (assets will be used to retire the debt, resulting in an increased asset turnover ratio (net sales ÷ average total assets) Answer (D) is incorrect because the interest expense avoided will increase net profit and the return on shareholders' equity 135 Statement a is true; a higher EPS does not always mean that the stock price will increase Statement b is false; a lower WACC will mean a higher stock price Statement c is false; EPS can increase just because shares outstanding decline 136 Statement a is incorrect because BEP = EBIT/Total assets The extent to which the firm uses debt financing does not effect EBIT or total assets Statement b is incorrect because firms with a high percentage of fixed costs have a high degree of operating leverage by definition 137 BEP = EBIT/TA Since they both have the same total assets and the same BEP, then EBIT must be the same for both companies If A has a higher debt ratio and higher interest expense than B, and they both have the same EBIT and tax rate, then A must have a lower NI than B Therefore, statement a is true If A has a lower NI than B but both have the same total assets, then A’s ROA (NI/TA) must be lower than B’s ROA Therefore, statement b is true If both companies have the same total assets but A’s debt ratio is higher than B’s, then A’s equity must be lower (since Total assets = Total debt + Total equity) If A has less equity, and a lower NI than B, it is not possible to judge which company’s ROE (NI/EQ) is higher 138 BEP = EBIT/TA If both firms have the same BEP ratio and same total assets, then they must have the same EBIT Since Firm U has no debt in its capital structure, Firm U will have higher net income than Firm L because U has no interest expense and L does The TIE ratio is EBIT/Int If the two companies have the same EBIT, the one with the lower interest expense (Firm U), will have a higher TIE Therefore, statement a is false Firms L and U have the same EBIT, but Firm L has a higher interest expense, so its net income will be lower than Firm U Since ROA is equal to NI/TA, and the two firms have the same total assets, Firm L will have a lower ROA than Firm U Therefore, statement b is true Leverage will increase ROE if BEP > k d Since BEP is 20 percent and k d is percent, leverage will increase Firm L’s ROE Therefore, statement c is false 139 Statement a is false; A’s net income is lower than B’s due to higher interest expense, but its assets are equal to B’s, so A’s ROA must be lower than B’s ROA Statement b is false; A has the same EBIT as B, but higher interest payments than B; therefore, A’s TIE is lower than B’s Statement c is correct 140 Answer (B) is correct Leverage is the amount of the fixed cost of capital, principally debt, in a firm's capital structure relative to its operating income It is also defined as the ratio of debt to total assets or debt to capital Leverage, by definition, creates financial risk, which relates directly to the question of the cost of capital The more leverage, the higher the financial risk, and the higher the cost of debt capital The degree of financial leverage (DFL) is the percentage change in earnings available to common stockholders that is associated with a given percentage change in net operating income (earnings before interest and taxes) The more financial leverage employed, the greater the DFL, and the riskier the firm Whenever the return on assets is greater than the cost of debt, additional leverage is favorable An increase in the equity component of the capital structure, however, decreases financial leverage Operating leverage is a related concept based on the degree that fixed costs are used in the production process A company with a high percentage of fixed costs is riskier than a firm in the same industry that relies more on variable costs to produce The degree of operating leverage (DOL) is the percentage change in net operating income that is associated with a given percentage change in sales When fixed assets increase, operating leverage also increases Answer (A) is incorrect because financial leverage would decrease and operating leverage would increase Answer (C) is incorrect because financial leverage would decrease and operating leverage would increase Answer (D) is incorrect because financial leverage would decrease and operating leverage would increase 141 Answer (D) is correct Insurance is a method of spreading losses that arise from risks to which many persons are subject Loss is an unanticipated diminution in economic value as opposed to normal depreciation Risk is uncertainty about the occurrence or the amount of loss For example, buildings are subject to the risk of loss by fire If the owners all pay small fees (premiums) for insurance coverage, every participant bears part of the loss instead of a few bearing all the loss Answer (A) is incorrect because risk avoidance and loss control not transfer risk of loss Answer (B) is incorrect because an insurable interest is merely a potential for economic loss if an event occurs Answer (C) is incorrect because there must be an insurable interest, which is basically potential for loss if an event occurs Gambling occurs when only a bet is at risk 142 Answer (A) is correct An insurance contract (a policy) must satisfy the usual requirements: offer and acceptance, consideration, legality, and capacity of the parties The insured must have an insurable interest in the subject matter of the contract Also, the subject matter generally must exist at the time of contracting In the contract, the insurer makes a promise to pay a stated amount for loss or injury incurred as a result of a contingent event Answer (B) is incorrect because the payee may be a stranger to the contract A person who insures his/her own life names a third party as a beneficiary Moreover, not every insurer is an insurance company, and the contingent event insured against must involve a risk Answer (C) is incorrect because there is no general requirement that an insurance contract be written Answer (D) is incorrect because the contract may often be oral, and, if the risk is not already in existence, the transaction is in essence a wager, not insurance 143 Answer (A) is correct An insurance contract is very similar to any other contract However, an additional requirement is that the insured must have an insurable interest Answer (B) is incorrect because there is no general requirement that an insurance contract be written Oral binders are given every day in the insurance business Answer (C) is incorrect because consideration is needed for the initial formation of an insurance contract The premium may be paid immediately, or a promise to pay is required Answer (D) is incorrect because the insurance company can also commit a breach by refusing to pay the proceeds of the policy upon the occurrence of the event 144 Answer (A) is correct Life insurance is usually purchased to protect against the cessation of income needed for support of the family and to shield them from the decedent's debts Answer (B) is incorrect because life insurance is customarily long-term, if not for life Answer (C) is incorrect because, unlike other forms of insurance, life insurance does not attempt to reimburse for the actual amount of a loss since loss of life is not measurable Life insurance is intended to replace economic benefits lost by a person's death Answer (D) is incorrect because, except for term policies, life insurance differs from other kinds of coverage in providing cash value 145 Answer (D) is correct Term life insurance provides protection for a specified period Premiums are level throughout the period When the term ends, the insured receives no payment Term insurance may be renewable (possibly at higher premiums) or convertible to another form It is the cheapest kind of life insurance Answer (A) is incorrect because whole life furnishes lifetime insurance protection with a cash surrender value Answer (B) is incorrect because an endowment policy provides life insurance protection for its duration A cash payment is made (the policy endows) at the end of the term Premiums for endowment policies are higher than for whole life insurance Answer (C) is incorrect because a straight life or ordinary policy is whole life insurance with level premiums payable for life 146 Answer (B) is correct When one person insures the life of another, the policyholder must have an insurable interest in the insured That interest is found among persons who have a close family relationship or expect to suffer substantial economic loss from the death Business entities are thus permitted to insure key people in their organizations whose death might have an adverse effect on profits Answer (A) is incorrect because a corporation has an insurable interest only in its key employees, i.e., those whose death would cause loss to the firm Answer (C) is incorrect because the required loss need not be so great as to cause cessation of business Answer (D) because one need not be an owner or an officer to be insurable as a key person 147 Answer (A) is correct Fire insurance is the most standardized kind of insurance Following the lead of New York, almost all states have enacted a standard policy either by legislative or administrative action Answer (B) is incorrect because, given that fire insurance is usually written for a 1- to 3-year period, an incontestability clause is not necessary Such a clause bars insurer defenses after a period specified by law or the policy Answer (C) is incorrect because a policy may state a definite value of the insured property or simply a maximum amount of coverage that is not conclusive as to valuation when loss occurs A policy may thus be valued or open (unvalued) A pro rata clause is often included (but not required) which requires the loss to be shared pro rata when there is more than one insurer Answer (D) is incorrect because the insurable interest merely requires the person, e.g., mortgagee, bailee, etc., to suffer a loss if the event insured against occurs 148 Answer (D) is correct If a premium is not received by the due date, the policyholder has a grace period under state law, usually a month or 31 days, in which to pay After the grace period, the cash surrender value is not forfeited but can be withdrawn or used to buy a paid-up policy Answer (A) is incorrect because life insurance policies often not cover death while the insured is in the military Answer (B) is incorrect because life insurance policies often not cover death as a result of a noncommercial air flight Answer (C) is incorrect because a lapsed policy may often be reinstated by payment of overdue premiums plus interest 149 Answer (B) is correct Ordinarily, smoke, water, or other damage caused by hostile, but not friendly, fires will be indemnified under a fire insurance policy Hostile fires are those ignited in places where they are not meant to be A friendly fire is one that burns where it is intended to burn, such as a fireplace or furnace For example, if a friendly fire is kept within its usual container, damage caused by smoke from it will not be reimbursed Answer (A) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires Answer (C) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires Answer (D) is incorrect because fire insurance usually indemnifies for loss caused by hostile, but not friendly, fires 150 Answer (C) is correct Arson, fraud, or another intentional act of the insured calculated to cause the damage insured against will preclude recovery The parties to an insurance contract have an implied duty not to bring about the very event that is the subject matter of the policy Answer (A) is incorrect because agency rules not apply; i.e., the intentional act of an agent will not be imputed to the insured under the doctrine of respondeat superior Arson by an agent without the actual knowledge or conspiracy of the insured will not preclude recovery Answer (B) is incorrect because arson is compensable unless intended by the insured Answer (D) is incorrect because negligence without fraud will not prevent recovery by an insured who has acted in good faith 151 Answer (D) is correct Fire insurance generally protects the insured from damage to the insured property as a result of fire It does not cover the insured for causing a fire on someone else's property Answer (A) is incorrect because malpractice insurance is a special form of liability insurance protecting professionals from lawsuits by third parties for negligence Answer (B) is incorrect because homeowners insurance generally contains a liability section in the event guests are injured on the premises Answer (C) is incorrect because a primary purpose of automobile insurance is to protect the owner or driver from liability in the event (s)he is responsible for damage to another person or property 152 Answer (C) is correct Co-insurance is a method of sharing risk between the insurer and the insured A coinsurance clause typically provides that, if the policyholder insures his/her property for at least a stated percentage (usually 80%) of its actual cash value, any loss will be paid in full up to the face amount of the policy Thus, a co- insurance clause is used by many property and casualty insurers to encourage policyholders to insure commercial property for an amount that is near to its full replacement cost Answer (A) is incorrect because, if a policyholder does not insure the property for an amount close enough to its full replacement cost, the policyholder must bear a proportionate part of any partial loss Answer (B) is incorrect because the co-insurance requirement applies only to partial losses Total losses result in recovery of the face amount of the policy Answer (D) is incorrect because a co-insurance clause encourages policyholders to insure commercial property for an amount that is near to its full replacement cost 153 Answer (A) is correct Conditions precedent, called warranties, are part of the property insurance policy Breach of a warranty precludes recovery and results in a forfeiture Since the law disfavors forfeitures, courts construe questions of interpretation favorably to the insured and against the insurer that drafted the policy However, if the parties expressly agree that certain statements are warranties, then a court would recognize them as warranties Since Jewelry warranted never to display more than $10,000 of jewelry, the breach of warranty prevents recovery Answer (B) is incorrect because Jewelry will recover nothing; it is not entitled to $2,000 Answer (C) is incorrect because the warranty will not be construed as a mere representation; the intention of the parties clearly was to make it a warranty Answer (D) is incorrect because attachment of the application to the policy is usually sufficient to make it a part thereof It may also be incorporated into the policy by reference to it ... Structure Cost of Capital Debt Capital vs Equity Capital Imputed Costs vs Explicit Costs Cost of Debt Capital Marginal Cost of Debt Cost of Equity Capital Marginal Cost of Capital Optimal Cost of Capital. .. The cost of equity financing D The weighted-average cost of capital CIA 0597 IV-42 113 Which of the following is true regarding the calculation of a firm's cost of capital? (E) A The cost of capital. .. cost of capital, all of the following are true except that (E) A The cost of capital of a firm is the weighted average cost of its various financing components B The calculation of the cost of