Question

 

1) Which of the following statements is correct?

a. If a project has an IRR greater than the required return, the NPV of the project should be positive.

b. Major strengths of the traditional payback method include the fact that it accounts for time-value-of money and for cash flows subsequent to the payback period.

c. The typical payback for the cost of a student’s education at WWU is at least 20 years.

d. Of all the capital budgeting methods, the profitability index method is used the most by executives.

e. None of the above statements is correct.

-

2) The data in regards to two stocks is shown below:

-----------------------------------------------------------------Returns for---------

State of Economy - Probability --------------- Stock A --- Stock B -----

Boom ------------------- 30% -------------------------100% -------20%

Normal ------------------40% --------------------------15% ---------15%

Recession --------------30%-------------------------( -70%)------- 10%

Which of the following statements regarding Stocks A and B is true? [Note: you do not need to calculate standard deviation; you merely need to look at the figures to see which stock has a higher deviation.]

a. Stock A has a higher expected return than Stock B, but Stock A is more risky because it has a lower standard deviation.

b. Stock A has the same expected return as Stock B, but Stock A is more risky because it has a higher standard deviation.

c. Stock B has the same expected return as Stock A, but Stock B is more risky because it has a higher standard deviation.

d. Stock B has a higher expected return than Stock A, but Stock B is less risky because it has a lower standard deviation.

e. Both stocks have the same expected returns and the same standard deviations.

-

3) Which of the following is NOT true regarding beta (the beta coefficient)?

a. It is a measure of systematic risk, which cannot be diversified away.

b. A stock with a beta of .5 generally is considered to be less risky than a stock with beta of 2.

c. A stock with a beta of 3 historically moves three times as far as the overall market.

d. A beta of one indicates an investment is totally risk free.

e. A negative beta means that a stock price has reacted in an opposite direction to the overall market.

-

4) Assume the following information is available: Return on ABC, 30-year, corporate bonds is 8%. The bonds are regularly traded and very liquid. The current and expected inflation rate is 3% Return on U.S. Treasury Bill is 4% Return on 30-year U.S. Treasury Bond is 6% Which of the following statements is correct?

a. The real risk-free rate is approximately 2%

b. The return on the U.S. Treasury bond includes an interest-rate risk premium of 4%

c. The return on the corporate bond includes a default risk premium of 3%

d. The return on the corporate bond includes a liquidity risk premium of 2%

e. The return on the corporate bond includes a default risk premium of 2%

-

5) Fort his question, let's assume that Treasury Bills currently yield 4.5% and the market risk premium is 4% (i.e. expected market return is 8.5%). If the common stock of Hughley Corp. has a beta of 1.42, which of the following statements is true?

a. Hughley’s cost of equity financing (from common stock) is 4.8%

b. Hughley’s after-tax cost of equity financing (from common stock) is 6.6%.

c. Hughley’s stock is not as volatile as the overall market.

d. Hughley’s cost of equity financing (from common stock) is 10.2%

e. None of the above statements is true

Answer 1

Solution:-

(1)

Option (a):

NPV is calculated using required rate of return as the discount rate. A positive NPV means that the expected rate of return is higher than the required rate of return and vice-versa.

IRR is the actual rate of return expected from the project. Therefore, if the IRR of a project is higher than the required rate of return, it means that the NPV of the project would be positive.

Therefore, the correct option is option (a)

Other options:

Traditional payback method is based on actual cash flows and not dicounted cash flows, therefore it doesn't take into account the time value of money.

Payback period of a student's education at WWU can't be commented without data

Out of all methods, NPV is most widely used by executives and not profitability index.

Therefore, all the other options are incorrect.

.

(2)

Expected Return (A)= 100%*0.3 + 15%*0.4 + (-70%*0.3) = 15%

Expected Return (B)= 20%*0.3 + 15%*0.4 + 10%*0.3 = 15%

As we can see the expected returns of the two stocks are same, i.e. 15%. Now, clearly the returns of stock A are more volatile than than those of stock B which means stock A has a higher standard deviation than stock B. Based on this, the correct option is option b.

(3)

Beta is a measure of risk of a stock but not absolute risk. It is a measure of systematic risk of a stock relative to the risk of the overall market. A beta of 1 means that stock is as risky as the overall market. A beta of higher than 1 means that the stock is more risky than the market and vice-versa.

Option d:

A beta of 1 doesn't mean that stock is risk free. It means that the stock's risk is equal to the risk of the overall market. Therefore, the given statement is incorrect and hence option d is the correct option.

Other options:

Beta is a measure of the systematic risk relative to the market and it can't be diversified away

Lower the betas lower the risk relative to the market. So, a beta of 0.5 is considered lower than 2.

A beta of 3 means that the stock is three times as risk as the market as therefore, moves 3 times faster.

A negative beta does mean that the stock behaves opposite to the market.

Therefore, all these are valid statements and hence the options are incorrect.

(4)

The 30-year corporate bond has 8% return while a 30-year treasury bond has a return of 6%. We are told that the corporate bond has enough liquidity and therefore, there is no need of any liquidity premium in its returns.

Based on above, it is clear that the extra 2% return of corporate bond as compared to the treasury bond is due to the default risk that corporate bond carries.

Based on above, the return of corporate bond includes a default risk premium of 2% and the correct option is option e.

(5)

Hughley's cost of equity using CAPM is as follows:

Cost of equity= Risk free rate + beta*market risk premium= 4.5% + 1.42*4% = 10.2%

Therefore, the correct option is option d.