FIN505
CHAP 6 QUIZ: Risk, Return & the Capital Asset Pricing Model
Standard deviation measures:
systematic risk.
unsystematic risk.
total risk.
beta risk.
The CAPM (capital asset pricing model) assumes that:
all assets can be traded
investors are risk-averse
investors have homogeneous expectations
all of the above
Suppose that over the last 20 years, company XYZ has averaged a return of 13%. Over the same period, the
Treasury bond rate has averaged 4%. The current estimate of the Treasury bond rate is 6.5%. Using the historical
approach, what is the estimate of XYZ's expected return.
13.0%
16.5%
15.5%
19.5%
The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 0, what is its
expected return?
0%
5%
13%
none of the above
A particular stock has an expected return of 18%. If the expected return on the market portfolio is 13%, and the
risk-free rate is 5%, what's the stock's CAPM beta?
1.000
1.625
2.250
1.385
According to the CAPM (capital asset pricing model), what is the single factor that explains differences in returns
across securities?
the risk-free rate
the expected risk premium on the market portfolio
the beta of a security
the expected return on the market portfolio
the volatility of a security
An investor put 40% of her money in Stock A and 60% in Stock B. Stock A has a beta of 1.2 and Stock B has a beta
of 1.6. If the risk-free rate is 5% and the expected return on the market is 12%, what's the investor's expected return?
22.28%
14.80%
15.08%
21.80%
The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 1.5, what is its
expected return?
17%
12%
19.5%
24.5%
According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of this
line should be equal to
zero
the expected risk premium on the market portfolio
the risk-free rate
the expected return on the market portfolio
The stock of Alpha Company has an expected return of 15.5% and a beta of 1.5, and Gamma Company stock has an
expected return of 13.4% and a beta of 1.2. Assume the CAPM holds. What’s the expected return on the market?
12%
Investors can eliminate what type of risk by diversifying?
systematic risk
unsystematic risk
beta risk
total risk
Expected returns are:
always positive.
always greater than the risk-free rate.
inherently unobservable.
usually equal to actual returns.
A particular asset has a beta of 1.2 and an expected return of 10%. The expected return on the market portfolio is
13% and the risk-free is 5%. The stock is
overpriced
underpriced
appropriately priced
Cannot tell from the given information
Suppose David can borrow and lend at the risk-free rate of 5%. Which of the following three risky portfolios should he
hold in combination with a position in the risk-free asset?
portfolio with a standard deviation of 16% and an expected return of 12%
portfolio with a standard deviation of 20% and an expected return of 16%
portfolio with a standard deviation of 30% and an expected return of 20%
he should be indifferent in holding any of the three portfolios
The stock of Alpha Company has an expected return of 18% and a beta of 1.5, and Gamma Company stock has an
expected return of 15.6% and a beta of 1.2. Assume the CAPM holds. What's the risk-free rate?
8.0%
6.0%
0%
4.7%
A stock that pays no dividends is currently priced at $40 and is expected to increase in price to $45 by year end. The
expected risk premium on the market portfolio is 6% and the risk-free is 5%. If the stock has a beta of 0.6, the stock is
overpriced
underpriced
appropriately priced
Cannot tell from the given information
The stock of Alpha Company has an expected return of 0.10 and a standard deviation of 0.25. The stock of Gamma
Company has an expected return of 0.16 and a standard deviation of 0.40. The correlation coefficient between the two
stock's return is 0.2. If a portfolio consists of 40% of Alpha Company and 60% of Gamma Company, what's the
expected return of the portfolio?
0.126
0.136
0.160
0.130
If the market portfolio has an expected return of 0.12 and a standard deviation of 0.40, and the risk-free rate is 0.04,
what is the slope of the security market line?
0.08
0.20
0.04
0.12
A particular asset has a beta of 1.2 and an expected return of 10%. The expected return on the market portfolio is
13% and the risk-free is 5%. Which of the following statement is correct?
This asset lies on the security market line.
This asset lies above the security market line.
This asset lies below the security market line.
Cannot tell from the given information.
Chap 7 Capital Budgeting Process & Decision Criterion
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old equipment.
Assume the new machine will generate after-tax savings of $250,000 per year over the next four years.
If Gamma Electronics has a 15% cost of capital, what's the IRR of the investment?
23.4%
15.0%
34.9%
100.0%
Kelley Industries has 100 million shares of common stock outstanding with a current market price of $50. The firm is
contemplating undertaking an investment project which requires an initial cash outflow of $100 million. The IRR of the
project is equal to the firm's cost of capital. What will be the firm's stock price if capital markets fully reflect the value of
undertaking the project?
$50
$49
$51
Cannot tell from the given information
You are provided with the following data on two mutually exclusive projects. The cost of capital is 15%.
Initial cash outflow
Project 1
-$5,000
Project 2
-$1,000
Year 1 cash inflow
$5,000
$1,000
Year 2 cash inflow
$2,500
$ 850
NPV
$1,238
$ 512
PI
1.25
1.51
Which project should you accept? What is the problem that you should be concerned with in making this decision?
Project 1; the timing of cash flows
Project 2; the timing of cash flows
Project 1; project scale
Project 2; project scale
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old equipment.
Assume the new machine will generate after-tax savings of $250,000 per year over the next four years.
If the firm has a 15% cost of capital, what's the discount payback period of the investment?
1.5 years
2.0 years
2.4 years
2.6 years
A firm has 10 million shares outstanding with a current market price of $20 per share. There is one investment project
available to the firm. The initial investment of the project is $20 million, and the NPV of the project is $10 million. What
will be the firm's stock price if capital markets fully reflect the value of undertaking the project?
$19
$20
$21
$22
Consider a project with the following cash flows.
Year Cash Flow
0
-$16,000
1
$42,000
2
-$27,000
What's the IRR of the project? If a firm's cost of capital is 15%, should the firm accept the project?
50%; accept the project
12.5%; reject the project
12.5% and 50%; accept the project
12.5%, and 50%; reject the project
You must know all the cash flows of an investment project to compute its
NPV, IRR, PI, and discount payback period
NPV, IRR, PI, payback period, and discount payback period,
NPV, PI, IRR
NPV, accounting rate of return, IRR, PI
The preferred technique for evaluating most capital investments is
payback period
discount payback period
internal rate of return
net present value
You must know the discount rate of an investment project to compute its
NPV, IRR, PI, and discount payback period
NPV, PI, discount payback period
NPV, PI, IRR
NPV, accounting rate of return, PI, discount payback period
Elite corp. is considering the purchase of testing equipment that will cost $500,000 to replace old equipment. Assume
the new machine will generate after-tax savings of $250,000 per year over the next four years. What's the payback
period for the investment?
1.8 years
2.0 years
2.5 years
2.8 years
Flaws of the accounting rate of return method include:
the choice of accounting g hurdle return rate is essentially arbitrary
depreciation method has a large impact on the accounting rate of return
this method makes no adjustment for project risk or for the time value of money
all of the above
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old equipment.
Assume the new machine will generate after-tax savings of $250,000 per year over the next four years.
If Gamma Electronics has a 15% cost of capital, what's the profitability index of the investment?
1.4
0.4
2.0
1.0
Delta Pharmaceuticals has 200 million shares outstanding with a current market price of $30 per share. Its stock rose
to $32 on the news that Delta Pharmaceuticals' long-awaited new drug Zentac is to hit the market next month. What's
the market's consensus of the NPV that the new drug will generate for Delta Pharmaceuticals?
$400 million
$6,400 million
$6,000 million
None of the above
Suppose a particular investment project will generate an immediate cash inflow of $1,000,000 followed by cash
outflows of $500,000 in each of the next three years. What is the project's IRR? Suppose a company's hurdle rate is
15%, should it accept the project?
23%; reject the project
23%; accept the project
15%; reject the project
15%; accept the project
Should a firm invest in projects with NPV = $0?
Yes
No
The firm is indifferent between accepting or rejecting projects with zero NPVs
The firm should look at the PI and IRR of the projects
You have a $1 million capital budget and must make the decision about which investments your firm should undertake
for the coming year. There are three projects available and the cash flows of each project appear below. Assume a
cost of capital of 12%. Which project or projects do you select?
Project 1
Project 2
Project 3
Cash flow
Year 0
-$400,000
-$500,000
-$1,000,000
Year 1
200,000
300,000
500,000
Year 2
Year 3
Project 1
300,000
300,000
350,000
350,000
700,000
700,000
Project 2
Project 3
Project 1 & Project 2
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old equipment.
Assume the new machine will generate after-tax savings of $250,000 per year over the next four years.
If Gamma Electronics has a 15% cost of capital, what's the NPV of the investment?
$213,745
$185,865
$713,745
$500,000
A project may have multiple IRRs when
the project generates an alternating series of net cash inflows and outflows
the project generates an immediate cash inflow followed by cash outflow
the project has a negative NPV
the project is of considerably large scale
Suppose a particular investment project will require an initial cash outlay of $1,000,000 and will generate a cash inflow
of $500,000 in each of the next three years. What is the project's IRR? Suppose a company's hurdle rate is 15%,
should it accept the project?
23%; reject the project
23%; accept the project
15%; reject the project
15%; accept the project
CHAP 8 Cashflow and Capital Budgeting
Sam's Insurance must choose between two types of printers. Both printers meet the firm's quality standard. Printer A
costs $3,500 and is expected to last 3 years with operating costs of $380 per year. Printer B costs $2,500 and is
expected to last 2 years with operating costs of $400 per year. Assume a discount rate of 10%. Which printer should
Sam's Insurance purchase? What is the equivalent annual cost of this machine?
Printer B; $3,194
Printer A; $1,625
Printer B; $2,904
Printer A; $1,787
Financial analysts focus on ____ when evaluating potential investments.
cash
profit
accruals
expenses
Alpha Car Rental purchased 5 cars for a total of $100,000 three years ago. Now it is replacing the cars with newer
vehicles. The company has depreciated 92.59% of the old cars, and sold these cars for a total of $ 25,000. Assume a
tax rate of 40%. What is the cash inflow from the sale of these vehicles?
$25,000
$15,000
$17,964
$16,500
The relevant tax rate for capital budgeting purposes is the:
average tax rate.
maximum tax rate.
minimum tax rate.
marginal tax rate.
Roger is considering the expansion of his business into a property he purchased two years ago. Which of the
following items should not be included in the analysis of this expansion?
Roger can lease the property to another company for $12,000 per year.
Costs of hiring additional staff
The property was extensively renovated last year at a cost of $15,000.
The expansion will result in a slight increase of inventory carried.
You are given the following information. What is the initial cash outflow?
Purchase and installation of new equipment$12,000
Sale price of replaced equipment$ 4,000
Book value of replaced equipment$ 3,000
When the new equipment is installed:
Inventory increase$ 2,000
Accounts payable increase$ 1,000
Tax rate40%
$9,400
$9,000
$13,000
$10,600
Capital budgeting must be placed on an incremental basis. This means that ____ must be ignored and ____ must be
considered.
sunk cost; opportunity cost
sunk cost; financing cost
cannibalization; opportunity cost
opportunity cost; net working capital
An increase in net working capital represents:
a cash inflow.
a cash outflow.
an increase in fixed assets.
a decrease in fixed assets.
A machine costs $3 million and has zero salvage value. Assume a discount rate of 10% and a 40% tax rate. The
machine is depreciated straight-line over 3 years for tax purpose. What is the present value of depreciation tax
savings associated with this machine?
$1,200,000
$994,741
$1,090,900
$400,000
Future Semiconductor is considering the purchase of photolithography equipment that will cost $3 million. The
equipment requires maintenance of $5,000 at the end of each of the next five years. After five years it will be sold for
$500,000. Assume a cost of capital of 15% and no taxes. What is the present value of the cost of the equipment?
What is the equivalent annual cost of the equipment?
$3,016,761; $899,947
$2,516,760; $750,789
$2,407,106; $718,077
$2,768,172; $825,789
Fox Entertainment is evaluating the NPV of launching a new iPet product. Fox paid a market research firm $120,000
last year to test the market viability of iPet. Fox Entertainment should treat this $120,000 as a ____ for the capital
budgeting decision now confronting the firm.
fixed cost
opportunity cost
sunk cost
cannibalization cost
Georgia Food is exploring the possibility of bringing a new frozen pasta to the market. Which of the following items are
not relevant for the project's analysis?
Cost of increasing shelf space at grocery stores
fir
Lost revenue from its frozen pizza sales since some customers will switch to purchase the new frozen pasta
Cost of advertising the new product
Market research funds the company has spent on testing the viability of the new product
A firm is evaluating two machines. Both machines meet the firm's quality standard. Machine A costs $40,000 initially
and $1,000 per year to maintain. Machine B costs $24,000 initially and $2,000 per year to maintain. Machine A has a
6-year useful life and machine B has a 3-year useful life. Both machines have zero salvage value. Assume the firm will
continue to replace worn-out machines with similar machines, and the discount rate is 7%. Which machine should the
firm purchase?
Machine A
Machine B
The firm is indifferent to the two machines
Can't tell from the given information
A project requires an initial investment in equipment and machinery of $10 million. The equipment is expected to
have a 5-year lifetime with no salvage value and will be depreciated on a straight-line basis. The project is expected to
generate revenues of $5.1 million each year for the 5 years and have operating expenses (not including depreciation)
amounting to 1/3 of revenues.
Assume the tax rate is 40%, and the cost of capital is 10%. What is the present value of cash inflows from year 1 to
year 5? What percentage of this present value is attributed to the tax benefits accruing from depreciation?
$12.89m; 24%
$10.77m; 28%
3.18m; 95%
7.73m; 39%
$10.77m; 24%
The cash flows associated with an investment project are as follows:
Cash Flows
Initial Outflow
-$7,000,000
Year 1
$100,000
Year 2
$200,000
Year 3
$540,000
In year 4 and beyond, cash flows would continue to grow at 4 percent per year. Assume a discount rate of 10%. What
is the NPV of this investment?
$385,220
$423,742
$631,104
$694,215
Thompson Manufacturing must choose between two types of furnaces to install. Model A has a 6-year life, and an
NPV of $5,000. Model B has a 5-year life, and an NPV of $4,200. The relevant discount rate is 12%. Which model
should be chosen? What's the annual cash flow from that model?
Model B; $1,165
Model B; $840
Model A; $833
Model A; $1,216
Gamma Electronics is considering the purchase of testing equipment that will cost $500,000. The equipment has a 5year lifetime with no salvage value. Assume the new machine will generate after-tax savings of $100,000 per year for
the five years.
If the firm has a 15% cost of capital, what is the equivalent annual cost of the equipment?
$32,924
$42,746
$49,158
$37,863
A project requires an initial investment in equipment and machinery of $10 million. The equipment is expected to have
a 5-year lifetime with no salvage value and will be depreciated on a straight-line basis. The project is expected to
generate revenues of $5.1 million each year for the 5 years and have operating expenses (not including depreciation)
amounting to 1/3 of revenues.
Assume the tax rate is 40%, and the cost of capital is 10%. What is the net present value of the project?
$2.89m
$0.77m
-$6.82m
-$2.27m
Arizona Truck Company (ATC) is considering the replacement of an old truck. The old truck can be sold for $7,800
now. If it is sold in one year, the resale price will be $5,500, but ATC will spend $2,500 just before selling the truck to
make it attractive to a buyer. Assume a cost of capital of 12%. What is the total cost of keeping the old truck for one
more year? Express the cash flow in terms of its future value one year from now.
5,121
$5,736
$4,800
$5,376
None of the above