Question

1. Assume investment X has a standard deviation of 20%, investment Y has a standard deviation of 20%, and X and Y have a correlation of 0.5. If 50% is invested in X and 50% is invested in Y then which is following is true?

a. The portfolio standard deviation will be greater than 20%

b. The portfolio standard deviation will be less than 20%

2. Which of the following is true?

a. Total risk decreases as the number of stocks in a portfolio increases

b. Diversifiable risk increases as the number of stocks in a portfolio increases

c. Firm specific risk increases as the number of stocks in a portfolio increases

3. Which of the following is true?

a. As the marginal tax rate increases the WACC increases

b. As the marginal tax rate increases the after tax cost of debt decreases

c. As floatation costs increase the WACC decreases

d. As floatation costs increase cost of a new stock issue decreases

4. Which of the following is true?

a. As beta increases the cost of equity increases

b. As the growth rate increases the cost of equity decreases

c. As the dividend on preferred stock increases the cost of preferred stock decreases

d. As the market price of preferred stock increases the cost of preferred stock increases

5. Which of the following is true?

a. WACC is calculated by adding the component costs together and dividing by 3

b. WACC is higher when retained earnings are used compared to issuing new stock

c. When calculating the WACC, the appropriate weights are the target market value weights

d. Corporate tax rates always favor the use of common equity as a source of financing

Answer 1

Q1. Answer is b.

You can check it by using the mathematical relation for standard deviation of a 2 stock portfolio which is:

Hence, std deviation = 17.32% (less than 20%)

Q2. Answer is a.

As the number of stocks in portfolio increase, the amount of total risk in the portfolio decreases. This is because it decreases the diversifiable risk component of the inidividual stocks.

Q3. Answer is b

After tax cost of debt = Pretax Cost of debt * (1 - Tax Rate). This implies higher the tax, lower would be the after tax cost of debt

Q4. Answer is a

Based on CAPM, Cost of Equity = Risk free rate + Beta * Market Risk Premium. As Beta of a stock would increase, so would the cost of equity as both are positively related in the relation.

Q5. Answer is c

WACC is calculated by using weights based on the target market value of capital components. They are not based on the book value weights of the component.