Heleveton Industries is 100% equity financed. Its current beta is 1.1.

The expected market risk premium

is 8.5%, and the risk-free rate is 4.2%. If Heleveton changes its capital structure to 25% debt, it estimates
its beta will increase to 1.2. If the after-tax cost of debt will be 6%, should Heleveton make the capital
structure change?
a. No, stock price would decrease due to increased risk
b. No, cost of capital increases by 0.85%
c. Yes, cost of capital decreases 1.67%
d. Yes, cost of capital decreases by 2.52%

Ans : c

In considering the SML concept, the required returns for any individual security are dependent on certain
values. List and discuss those values.
For the toolbar, press ALT+F10 (PC) or ALT+FN+F10 (Mac).

A beta value of 0.5 for a security indicates that the security has __.

a.no unsystematic risk

b.below-average systematic risk

c.above-average systematic risk

d.average systematic risk

ans: B

Security A offers an expected return of 14%, with a standard deviation of 8%. Security B offers an
expected return of 11%, with a standard deviation of 6%. If you wish to construct a portfolio with a
12.8% expected return, what percentage of the portfolio will consist of security A?

a. 45%

b. 55%

c. 65%

d. 60%
ans: 60%

Question 5

The expectations, liquidity premium, and market segmentation theories all attempt to __.
 a. predict the values of effective interest rates

b. account for the differences between systematic and unsystematic risks in the securities
market

c. explain the shape of the yield curve

d. define investors' required rates of return

ans: a

The cost of external common equity is represented in financial formulas as __.

a. kd

b. ke

c. ki

d. k'e

ans: b

In general, when the correlation coefficient between the returns on two securities is _, the risk of a
portfolio is ___ the weighted average of the total risk of the two individual securities.

a. equal to +1.0; equal to

b. less than +1.0; greater than

c. greater than –1.0; less than

d. None of these are correct

ans : c

The cost of common stock equity may be estimated by using which of the following?

a. Capital asset pricing model

b. Price/Earnings ratio

c. Dupont analysis

d. Earnings curve

ans a
The most relevant risk that must be considered for any widely traded individual security is its ____.
a. systematic risk
b. covariance risk
c. standard deviation
d. unsystematic risk

Ans: a

Determine the beta of a portfolio consisting of the following common stocks:

ans: 1.11

If a preferred stock is callable, then the calculation of the cost of preferred stock financing is ____.
a. similar to that for bonds
b. equal to Dp less flotation costs
c. equal to Dp/Pn
d. less than Dp/Pn

An:a
The real rate of interest is expected to be 3%, and the expected rate of inflation for next year is expected
to be 5.5%. If the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4
percentage points, what is the required return on a 1-year U.S. Treasury security?

a. 9.6%

b. 8.5%

c. 10.0%

d. 8.9%
ans: 10

If Alliant can issue a $110 million 20-year refunding bond at 7.45% and call an older $110 million issue
with 20 years to maturity that had a coupon of 8.80%, what is the present value of the interest savings?
Assume a 40% tax rate.
a. $17,820,000
b. $11,620,259
c. $ 9,117,935
d. $29,561,100
ans c

During the 1980s, the cost of capital for U.S. firms averaged about 3.3 percentage points higher than
Japanese firms. During 1990 this disadvantage may have disappeared due to ____.
a. higher exports to the United States
b. higher Japanese stock market
c. higher real interest rates in Japan
d. larger shareholder interest

Ans: c

For a company that is not planning to change its target capital structure, the proportions of debt and equity
used in calculating the weighted cost of capital should be based on the current ____ value weights of the
individual components.
a. market
b. accounting
c. book
d. replacement

Ans : a

Twin City Knitting (TCK) pays a current dividend of $2.20, and dividends are expected to grow at a rate of
7% annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2% and the market
risk premium is 6%, at what price would you expect TCK's common stock to sell?

a. $14.35

b. $23.40

c. $33.63

d. $25.04
ans : d

HDTV has planned on diversifying into the VR field. As a result, HDTV's beta would rise to 1.6 from 1.2
and the expected future long-term growth rate in the firm's earnings would increase from 12% to 16%.
The expected market return, k m, is 14%; the risk-free rate, r f, is 7%; and the current dividend, D o, is
$0.50. Should HDTV go into the VR field?
a. Yes, stock price increases $3.81.
b. No, stock price decreases $7.82.
c. Yes, stock price increases $9.89.
d. No, stock price decreases $3.78.
ans: c

Question 17
The real rate of interest is expected to be 3%, and the expected rate of inflation for next year is expected
to be 5.5%. If the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4
percentage points, what is the required return on a 1-year U.S. Treasury security?
a. 9.6%
b. 8.5%
c. 10.0%
d. 8.9%

Question 18
Gates Industries' current common stock dividend (year 0) is $2.50 per share and is expected to continue
growing at a rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the
estimated market risk premium (i.e., k m - r f) is 8.3%. Value Line has estimated Gates Industries' beta to
be 1.10. Determine the expected price for Gates Industries, common stock.
a. $15.78
b. $15.03
c. $21.50
d. $22.57

Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury
bills was 9.17%. Over the same time period, the average annual inflation rate was 6.39%. Therefore, the
____.
a. realized real rate of return was 2.78 percentage points
b. required rate of return was 6.39 percentage points
c. real expected rate of return was 9.17 percentage points
d. inflation premium was 2.78 percentage points

Ans: a

For firms subject to the 40% marginal tax rate, the after-tax cost of __ is roughly three-fifths the cost of
preferred stock.

a. retained earnings

b. new common stock

c. long-term debt

d. None of these are correct

ans c
The ability of an investor to buy and sell a company's securities quickly and without a significant loss of
value is known as the ____ risk.
a. marketability
b. financial
c. business
d. security

Ans: b

uestion 20
Total risk of a security can be viewed as consisting of two parts. Which of the following apply?
 I.  verifiable risk
II. non-verifiable risk
a. Both statements I and II are correct.
b. Only statement I is correct.
c. Only statement II is correct.
d. Neither statement I nor II is correct.

ans: d

The business risk of a firm refers to the ____.

a. results from using fixed-cost sources of funds
b variability in the price of a firm's securities
.
c. variability in the firm's operating earnings over time
d influence of government regulations on business earnings
.
Ans: d

Easy Slider Inc. sold a 15-year $1,000 face value bond with a 10% coupon rate. Interest is paid annually.
After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these
bonds if the firm's marginal tax rate is 40%.
a. 6.0%
b. 6.6%
c. 7.8%
d. 7.2%

Ans: a

Gates Industries' current common stock dividend (year 0) is $2.50 per share and is expected to continue
growing at a rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the
estimated market risk premium (i.e., k m - r f) is 8.3%. Value Line has estimated Gates Industries' beta to
be 1.10. Determine the expected price for Gates Industries, common stock.
 a. $15.78
b. $15.03
c. $21.50
d. $22.57

Ans: d

American Dental Laser is selling a 10-year $1,000 face value bond with an 8% coupon rate. Interest is
paid annually. The price to the public is $820, and the issue costs per bond are $10 each. Compute the
pretax cost of debt for these bonds.
a. 11.5%
b. 11.8%
c. 11.1%
d. 11.3%

Ans: d
Rank in ascending order (lowest to highest) the relative riskiness of the various types of corporate and
government securities.
a. common stock, preferred stock, corporate debt, long-term government debt
b. corporate debt, long-term government debt, preferred stock, common stock
c. corporate debt, preferred stock, long-term government debt, common stock
d. long-term government debt, corporate debt, preferred stock, common stock
Ans: d

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