1. Preferred stock is less risky than common stock, but more risky than debt.

True
2. According to the CAPM, for each unit of Beta an asset’s required rate of return increases
by the market’s risk premium. True
3. The market risk premium remains constant over time because the risk free rate of
return moves inversely with beta. False
4. The benefits of diversification occur as long as the investments in a portfolio are
perfectly positively correlated. False
5. Floatation costs cause a corporation’s cost of capital to be lower than its investors’
required returns. False
6. The firm’s best financial structure is determined by finding the capital structure that
minimizes the firm’s cost of capital. True
7. The cost of internal common equity is already on anafter-tax basis since dividends paid
to common stockholders are not tax deductible. True
8. Vaughn Corporation common stock a required return of 17.5% and a beta of 1.75. If the
expected risk-free return is 3%, what is the expected return for the market based on the
CAPM? 11.29%

9. The category of securities with the highest historical risk premium is small company
stocks.
10. Portfolio risk is typically measured by Beta while the of a single investment is measured
by standard deviation.
11. If the risk-free rate of return is 2% and the market-risk premium is &%, then the
required return on the portfolio is 15.93%.

12. Stock @’s expected rate of return is 12.68%.

13. What is the Stock W’s standard deviation of returns? 36.96%
14. Preferred stock valuation usually treats preferred stock as a perpepuity.
15. Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta
of 1.8 and a standard deviation of returns of 18%. If the arket risk premium increase,
then (according to the CAPM) the required return on stock B will increases more than
the required return on stock A.
16. If you expect NoDiv Corporation to sell for $75 per share in one year while paying no
dividends along the way, and if your required rate of return is 16%, how much is the
stock worth today (rounded to the nearest cent)? $64.66

17. What is the value of a preferred stock with a 5% stated dividend percentage and $100
par value if your required rate of return is 6% per year? $83.33
18. You are considering the purchase of a common stock that paid a dividend of $2
yesterday. You expect this stock to have a growth rate of 20 percent for the next 3 yers,
resulting in dividends of D1=$2.40, D2=$2.88, D3=$3456. The long-run normal growth
rate after year 3 is expected to be 11 percent (that is, a constant growth rate after year
3 of 11% per year forever). If you require a 14 percent rate of return, how much should
you be willing to pay for this stock? $92.96

19. Purchase a variety of securities through diversification to your investment portfolio

without having to accept a lower expected return.
20. Beginning with an investment in one company’s securities, as we add securities of other
companies to our portfolio, which type of risk declines? Unsystematic risk
21. Longhorn Corporation paid a $4 dividend recejtly and the market price of the stock is
$55. If the required rate of return for investors is 9%, what growth rate would the
company have to provide the investors? 1.61%

22. Most stocks have betas between .6 and 1.6

23. Beta is a statistical measure of the relationship between an investment’s returns and the
market’s returns.
24. Assume that you have $100,000 invested in a stock with a Beta of.85, $200,000 invested
in a stock with a Beta of 1.05, and $300,000 invested in a stock with a Beta of 1.25.
What is the beta of your portfolio (rounded to the nearest hundredth)? 1.12
25. The investor is worried that the Beta of his portfolio is too high, so he wants to sell some
stock and add stock D, which has a Beta of 1.0, to his portfolio. If the investor wants his
portfolio to have a Beta of 1.72, how much stock C must be replace with stock D?
$56,000

26. A company has preferred stock that can be sold for $22 per share. The preferred stock
pays an annual dividend of 4.5% based on a par value of $100. Flotation costs associated
with the sale of preferred stock equal $1.25 per share. The company’s marginal tax rate
is 35%. Therefore, the cost of preferred stock is 21.69%

27. Peabody Manufacturing paid a dividend yesterday of $5 pershare. The dividend is

expected to grow at a constant rate of 8% per ykear. The price of Peabody stock today is
$29 per share. If Peabody decides to issue new common stock, flotation costs will equal
$2.5 per share. Peabody marginal tax rate is 35%. Based on the above information, the
cost of retained earnings is 26.62%
28. Peabody Manufacturing paid a dividend yesterday of $5 pershare. The dividend is
expected to grow at a constant rate of 8% per ykear. The price of Peabody stock today is
$29 per share. If Peabody decides to issue new common stock, flotation costs will equal
$2.5 per share. Peabody marginal tax rate is 35%. Based on the above information, the
cost of new common stock is 28.38%

29. Crandal Dockworks is undergoing a major expansion. The expansion will financed by
issuing new 15-year, $1000 par, 9% annual coupon bonds. The market price of the
bonds is $1070 each. Crandal’s flotation expense on the new bonds wil be $50 per bond.
Crandal’s marginal tax rate is 35%. What is the yield to maturity on the newly-issued
bonds? 8.17%

30. Crandal Dockworks is undergoing a major expansion. The expansion will financed by
issuing new 15-year, $1000 par, 9% annual coupon bonds. The market price of the
bonds is $1070 each. Crandal’s flotation expense on the new bonds wil be $50 per bond.
Crandal’s marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued
bonds? 8.76%
31. Crandal Dockworks is undergoing a major expansion. The expansion will financed by
issuing new 15-year, $1000 par, 9% annual coupon bonds. The market price of the
bonds is $1070 each. Crandal’s flotation expense on the new bonds wil be $50 per bond.
Crandal’s marginal tax rate is 35%. What is the after tax cost of debt for the newly-
issued bonds? 5.7%

32. Lindsay Inc. has a target capital structure of $40 million debt, $10 million preferred
stock, and $50 million common equity. The company’s after-tax cost of debt is 8%, its
cost of preferred stock is 11%, its cost of retained earnings is 14%, and its cost of new
common stock is 16%. The company stock has a beta of 1.5 and the company’s marginal
tax rate is35%. What is Lindsay Inc.’s weighted average cost of capital if retained
earnings are used to fund the common equity portion? 11.3%
33. Ford is considering expanding one of its production facilities to build a new line of
sewing kits. The project would require a $12,000,000 capital investment and will be fully
depreciated (straight-line) over its 3-yearlife. They believe they can salvage $400,000 for
the equipment at that time.

Incremental sales are expected to be $11,000,000 annually with costs (excluding

depreciation) of 52%. The company would also have to commit intial working capital to
the project of $1,200,000. The company has a 20% tax rate. Ford has a WACC of 10%
and the propsed project has the same of risk as the overall.

33 Project cash flow for Year 0 is: -$13,200,00

34 Project cash flow for Year 1 is: $4,896,000
35 Project cash flow for Year 2 is: $4,896,000
36 Project cash flow for Year 3 is: $6,376,000
37. Using a 10% discount rate, what is this project’s net present value (rounded to the
nearest dollar)? $87,573
38 What is the projects’s internal rate of return? 10.36%
39 Should Ford undertake this project?
Yes, the project has positive NPV and an IRR greater than 10%.