A firm is considering a new project whose risk is greater than the risk of the f
ID: 2672557 • Letter: A
Question
A firm is considering a new project whose risk is greater than the risk of the firms average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?____
Increase the estimated IRR of the project to reflect its greater risk
Reject the project, since its acceptance would increase the firms risk
Ignore the risk differential if the project would amount to only a small fraction of the firms total assets
Increase the cost of capital used to evaluate the project to reflect the projects higher-than-average risk
Currently, DEF Ltd. Has a beta of 1 and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the companys average projects. Also, the new projects sales would be counter-cyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following is true?
____
The proposed new project would have more stand-alone risk than the firms typical project
The proposed new project would increase the firms corporate risk
The proposed new project would not affect the firms risk at all
The proposed new project would have less stand-alone risk than the firms typical project
If a firm is losing money, then the after-tax cost of debt is
____
Equal to kd(1-T)
Found by trial and error
Equal to the pre-tax cost of debt
Equal to the yield-to-maturity
Both (C) and (D)
Determine the weighted average cost of capital for the ABC Co. that will finance its optimal capital budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (ks = 16%). ABCs current capital structure is considered optimal. The companys tax rate is 40%.
____
14.3%
12.6%
14.6%
None of the above
Hint:
What is the cost of a preferred share with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years.
____
9.6%
9.9%
10.0%
Undetermined
Hint:
DEF Ltd. has a beta of 1.15. If 3-month Treasury bills currently yield 7.9% and the market risk premium is estimated to be 8.3%, what is DEFs cost of equity capital?
____
17.45%
8.36%
9.55%
Undetermined
Hint:
ABC Co. has a current dividend of $1.80. Dividends are expected to grow at a rate of 7% a year into the foreseeable future. What is ABCs cost of external equity if its shares can be sold to net $46 a share?
____
10.9%
11.2%
7.2%
None of the above
Hint:
If a firm sells asset to generate cash flows, the cost of these funds is
____
The firms cost of equity
The firms cost of cash flows
The firms weight cost of capital
Zero
Infinite
Retained earnings are a cheaper source of funds than the sale of new equity because
____
Retention defers the payment of taxable dividends to shareholders
There are no flotation costs
New shares are usually priced below current market price
All of the above
None of the above
The CAPM assumes that the only risk of concern to the investor is ____, which is measured by ___.
____
Nonsystematic risk; beta
Systematic risk; the return to the market portfolio
Systematic risk; beta
Nonsystematic risk; the return to the market portfolio
If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects
____
Its cost of capital will rise
The average risk premium for the firm will decline
The risk-free rate will increase as more risk is added
None of the above
Explanation / Answer
A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
____
Increase the estimated IRR of the project to reflect its greater risk
Reject the project, since its acceptance would increase the firm’s risk
Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets
Increase the cost of capital used to evaluate the project to reflect the project’s higher-than-average risk
Currently, DEF Ltd. Has a beta of 1 and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than one of the company’s average projects. Also, the new project’s sales would be counter-cyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following is true?
____
The proposed new project would have more stand-alone risk than the firm’s typical project
The proposed new project would increase the firm’s corporate risk
The proposed new project would not affect the firm’s risk at all
The proposed new project would have less stand-alone risk than the firm’s typical project
If a firm is losing money, then the after-tax cost of debt is
____
Equal to kd(1-T)
Found by trial and error
Equal to the pre-tax cost of debt
Equal to the yield-to-maturity
Both (C) and (D)
What is the cost of a preferred share with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years.
____
9.6%
9.9%
10.0%
Undetermined
Hint:
DEF Ltd. has a beta of 1.15. If 3-month Treasury bills currently yield 7.9% and the market risk premium is estimated to be 8.3%, what is DEF’s cost of equity capital?
____
17.45%
8.36%
9.55%
Undetermined
Hint:
If a firm sells asset to generate cash flows, the cost of these funds is
____
The firm’s cost of equity
The firm’s cost of cash flows
The firm’s weight cost of capital
Zero
Infinite
Retained earnings are a cheaper source of funds than the sale of new equity because
____
Retention defers the payment of taxable dividends to shareholders
There are no flotation costs
New shares are usually priced below current market price
All of the above
None of the above
The CAPM assumes that the only risk of concern to the investor is ____, which is measured by ___.
____
Nonsystematic risk; beta
Systematic risk; the return to the market portfolio
Systematic risk; beta
Nonsystematic risk; the return to the market portfolio
If a firm adopts a large proportion of above-average-risk investment projects that are not offset by below-average-risk investment projects
____
Its cost of capital will rise
The average risk premium for the firm will decline
The risk-free rate will increase as more risk is added
None of the above
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