1. The Hamada Equation allows the firm to:
- solve for a company's total risk.
- adjust the beta of a pure-play firm for its use of debt financing.
- estimate its asset beta.
- Both b and c are correct.
2. In order to find the cost of equity using the firm's cost of debt, the rule of thumb is to:
- multiply Kd by one plus the tax rate.
- multiply Kd by one minus the tax rate.
- add 3% to 6% to Kd.
- multiply Kd by the firm's beta.
3. We assume investors are risk averse, and therefore they:
- are equally concerned with upside potential and downside risk.
- expect a higher return for bearing more risk.
- will pay more for an investment with higher risk.
- have very high required rates of return.
4. The financing mix reflected in the WACC should:
- reflect the desired mix and not necessarily the mix being used to finance a specific project.
- vary from project to project, depending on how they are financed.
- always reflect the firm's current capital structure.
- None of these answers is correct.
5. If a firm just paid a dividend equal to $4.00 a share, then for the WACC, in order to find the cost of equity, $4 should be:
- divided by the current price of the stock, and the quotient should be added to the dividend growth rate.
- divided by the current price of the stock.
- multiplied by one minus the tax rate, and the difference divided by the current price of the stock.
- multiplied by the sum of one plus the growth rate, and then divided by the current price of the stock; this quotient should be added to the dividend growth rate.
6. In the Capital Asset Pricing Model, the market risk premium is best approximated by:
- the most recent one-year return on the S&P 500 Index (or another market index).
- the long-term historic return on a stock market index such as the S&P 500 (or another market index).
- the long-term average spread of the S&P 500 (or another market index) over the yield of long-term government bonds.
- the return of the S&P 500 (or another market index) over the current yield of long-term government bonds.
7. Beta is estimated as the slope of a regression line fit to pairs of periodic returns, (rx, ry), where:
- rx is the return for a market index such as the S&P 500 Index.
- rx is the return for the stock being analyzed-for example, IBM's return if we are estimating IBM's beta.
- the slope measures the average return for the market portfolio for each percentage change in the value of the security of interest.
- ry is the return for the market index such as the S&P 500 Index.
8. In the Capital Asset Pricing Model, the market risk premium is estimated over a long period of time because:
- more data is always better than less.
- a longer holding period gives a more reliable estimate because it is, in effect, a larger sample size.
- almost all investors hold stocks for many years, so it matches their investment horizon.
- historical returns are the best indicators of future returns.
Question 9. 9. Which of the following statements regarding business risk, financial risk, and investors' risk, is true?
- Business risk is very similar to the risk of bankruptcy and is closely linked to the amount of debt in a firm's financing mix.
- Financial risk is associated with the returns earned by equity investors.
- Business risk is often measured by the variability of earnings before depreciation and taxes and is closely associated with the risk inherent in the goods and services a business is selling.
- Investment risk is the uncertainty associated with a firm's investment projects. It can be thought of as the likelihood that the expected IRR or NPV from an investment project will not materialize.
10. Which of the following is beta is used for?
- estimating a regression line
- estimating a firm's total risk to be used in the WACC
- estimating a firm's market risk and used with the CAPM
- estimating the amount of leverage used by the firm