# Diversification, CAPM, NPV, IRR, MIRR, Risk, WACC, equity

True/False questions:

T F 1. Diversification eliminates unsystematic risk. (According to portfolio the theory and CAPM.)

T F 2. With as little as 10 or less securities, we can eliminate a significant portion of diversifiable risk or unsystematic risk. (According to portfolio the theory and CAPM.)

T F 3. The greater the risk of expected cash inflows, the lower the discount rate we should use to determine the net present value (NPV).

T F 4. The Modified Internal Rate of Return (MIRR) assumes that a project's cash inflows will be reinvested at the project's internal rate of return.

T F 5. Using the CAPM to estimate the cost of equity capital assumes only systematic risk is relevant in the pricing of risky assets.

T F 6. The greater the beta of a company, the higher its cost of equity capital, if everything else holds equal. (According to portfolio the theory and CAPM.)

T F 7. An increase in perceived risk (i.e. market risk) will cause the price of a risky asset to decline.

T F 8. Earning an economic rate of return that is greater than the cost of capital will create a value.

T F 9. The greater the default risk premium, the greater the required rate of return on debt.

T F 10. The risk (and after-tax cost) to holders or owners of preferred stock is higher or greater than the risk to owners of debt in the same company.

T F 11. An increase in economic or political risk in a country would increase the cost of capital to companies in that country.

T F 12. The weighted average cost of capital falls as the firm increases the debt/equity ratio toward its optimal capital structure because investors value the tax deductibility of interest.

T F 13. The greater the uncertainty about a company's net operating income or EBIT, the greater the variability of its free cash flows.

T F 14. According to maturity-matching principle long-term (permanent) assets should be financed with long-term sources of capital.

T F 15. In ranking good independent projects, we should rank projects from highest to lowest internal rate of return.

T F 16. Equity represented by retained earnings has a lower cost that equity from newly issued stock.

T F 17. An increase in the financial risk of a company would cause its optimal debt/equity ratio to decrease.

T F 18. Equity or stockholders have greater risk than creditors of the same company.

T F 19. An increase in the variable cost per unit will increase the (accounting) break-even point for the company.

T F 20. Speeding up the cash inflows (i.e. getting the cash flows earlier in time) that we receive from a project will increase the project's NPV.

T F 21. The greater the debt/equity ratio, the greater the cost of levered equity, if everything else holds equal (according to the MM theory).

T F 22. An increase in liquidity (i.e., a reduction in trading costs) lowers a firm's cost of capital.

T F 23. The relationship between fixed and variable costs in production results in operating leverage.

T F 24. Retained earnings have a cost that represents an opportunity cost if earnings are reinvested

T F 25. Interest paid by corporation is a tax deduction for the paying corporation, but dividends paid are not deductible.

T F 26. Retained earnings are the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends.

T F 27. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

T F 28. Since capital gains can be deferred, the tax rate on dividends is greater than the effective tax rate on capital gains.

T F 29. On its 1999 balance sheet, Sherman Books showed a balance of retained earnings equal to $510 million. On its 2000 balance sheet, the balance of retained earnings was also equal to $510 million. If the company's net income was $200 million, the dividend paid must have also equaled $200 million.

T F 30. The stand-along risk is the project's risk if it were the firm's only asset.

T F 31. Free cash flow is the amount of cash flow available for distribution to all investors after making all necessary investments (in fixed assets and working capital) to support operations.

T F 32. Net operating working capital (NOWC) is equal to the operating current assets minus the operating current liabilities.

T F 33. Net operating profit after taxes (NOPAT) is the amount of profit a company would have from its operations if it had no interest income or interest expenses.

T F 34. The higher the assets to sales ratio (i.e. the capital intensity ratio) the more additional funds needed to support a growth in sales.

T F 35. An equal percentage increase or decrease in the required market return on a bond will have an unequal dollar change in the market price of the bond.

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#### Solution Preview

True/False questions:

T F 1. Diversification eliminates unsystematic risk. (According to portfolio the theory and CAPM.)

True

( Due to different stocks in portfolio)

T F 2. With as little as 10 or less securities, we can eliminate a significant portion of diversifiable risk or unsystematic risk. (According to portfolio the theory and CAPM.)

True.

T F 3. The greater the risk of expected cash inflows, the lower the discount rate we should use to determine the net present value (NPV).

False.

Higher risk will lead to higher cost of capital.

T F 4. The Modified Internal Rate of Return (MIRR) assumes that a project's cash inflows will be reinvested at the project's internal rate of return.

False.

There is a difference between financing and reinvestment rate.

T F 5. Using the CAPM to estimate the cost of equity capital assumes only systematic risk is relevant in the pricing of risky assets.

True

T F 6. The greater the beta of a company, the higher its cost of equity capital, if everything else holds equal. (According to portfolio the theory and CAPM.)

True

( as there is increase in risk)

T F 7. An increase in perceived risk (i.e. market risk) will cause the price of a risky asset to decline.

True

T F 8. Earning an economic rate of return that is greater than the cost of capital will create a value

True as it will provide positive value to the project

T F 9. The greater the default ...

#### Solution Summary

Diversification, CAPM, NPV, IRR, MIRR, Risk, WACC, equity

Finance: unlevered beta, WACC, project NPV, MIRR, market risk premium

1) Morgan Entertainment has a levered beta of 1.20. The firm's capital structure consists of 40% debt and 60% equity and it has a corporate tax rate of 40%. What is Morgan's unlevered beta?

2) Rhino Inc. hired you as a consultant to help them estimate their cost of capital. You have been provided with the following data: D1  $1.30; P0  $40.00; and g  7% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

3) Edison Electric Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC  10%

Year: 0 1 2 3

Cash flows: -$1,000 $450 $460 $470

4) A company is considering a project with the following cash flows:

Project

Year Cash Flow

0 -$100,000

1 50,000

2 50,000

3 50,000

4 -10,000

The project's WACC is estimated to be 10%. What is the MIRR?

5) The Jones Company plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20%, what should be the stock's market value?

6) The real risk-free rate is 2.50%, investors expect a 3.50% future inflation rate, the market risk premium is 5.50%, and Krogh Enterprises has a beta of 1.40. What is the required rate of return on Krogh's stock? (Hint: First find the market risk premium.)

7) Blumberg Inc. has an unlevered beta of 1.10. The firm currently has no debt, but is considering changing its capital structure to be 40% debt and 60% equity. Its corporate tax rate is 40%, rRF = 5% and the market risk premium is 4%. What is Blumberg's cost of equity?

8) Which of the following statements is CORRECT?

In general, a firm with low operating leverage has a small proportion of its total costs in the form of fixed costs.

An increase in the personal tax rate would not affect firms' capital structure decisions.

A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.

If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.

Increasing the amount of debt in a firm's capital structure, so that it reaches its optimal capital structure, will decrease the costs of both debt and equity financing.

9) Which of the following statements best describes what would be expected to happen as you randomly select stocks and add them to your portfolio?

Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.

Adding more such stocks will reduce the portfolio's beta.

Adding more such stocks will increase the portfolio's expected return.

Adding more such stocks will reduce the portfolio's market risk.

Adding more such stocks will have no effect on the portfolio's risk.

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