## 50 terms

### False

A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at par. These bonds provide compensation to investors in the form of capital appreciation.

### False

A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)

### True

The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.

### True

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

### True

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the lower standard deviation.

### True

Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.

### False

We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio.

### True

The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.

### True

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the firm's total corporate value.

### False

Preferred stock is a hybrid--a sort of cross between a common stock and a bond--in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond.

### False

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

### True

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

### The 15-year bond is more sensitive to interest rate changes, and hence has more price risk.

Does a 1-year or 15-year bond have more price risk if both have the same coupon rate and the same probability of default.

### low coupon bond will have more price risk

What has more price risk, a low coupon payment of a high coupon payment?

### B/H requires another minimum acceptable return to hold the bond that is different from the coupon rate

What would happened if market interest rates (rd) changed? Or coupon rate changed?

### Risk averse investor

An investor that dislikes risks and requires higher rates of return as an inducement to buy riskier securities.

### Market risk premium

Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk.

### risk premium

Risk-averse investors require a higher _______ as a compensation for additional risk assumed for holding any risky security over a riskless one.

### The bond's expected capital gains yield is zero.

A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT?

### c. All else equal, if a bond's yield to maturity increases, its price will fall.

Which of the following statements is CORRECT?

a. A zero coupon bond's current yield is equal to its yield to maturity.

b. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par.

c. All else equal, if a bond's yield to maturity increases, its price will fall.

d. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par.

e. All else equal, if a bond's yield to maturity increases, its current yield will fall.

### b. A 10-year, $1,000 face value, zero coupon bond.

Which of the following bonds has the greatest price risk?

a. A 10-year $100 annuity.

b. A 10-year, $1,000 face value, zero coupon bond.

c. A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.

d. All 10-year bonds have the same price risk since they have the same maturity.

e. A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.

### a. If a coupon bond is selling at par, its current yield equals its yield to maturity.

Which of the following statements is CORRECT?

a. If a coupon bond is selling at par, its current yield equals its yield to maturity.

b. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity.

c. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.

d. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium.

e. If a coupon bond is selling at a premium, its current yield equals its yield to maturity.

### a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.

Which of the following statements is CORRECT?

a. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.

b. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond.

c. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used.

d. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate.

e. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.

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

Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?

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

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

c. Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.

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

e. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.

### b. The portfolio's expected return is 15%.

Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is CORRECT?

a. The portfolio's beta is less than 1.2.

b. The portfolio's expected return is 15%.

c. The portfolio's standard deviation is greater than 20%.

d. The portfolio's beta is greater than 1.2.

e. The portfolio's standard deviation is 20%.

### c. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?

### e. In equilibrium, the expected return on Stock A will be greater than that on B.

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

a. Stock A would be a more desirable addition to a portfolio then Stock B.

b. In equilibrium, the expected return on Stock B will be greater than that on Stock A.

c. When held in isolation, Stock A has more risk than Stock B.

d. Stock B would be a more desirable addition to a portfolio than A.

e. In equilibrium, the expected return on Stock A will be greater than that on B.

### b. The corporate valuation model discounts free cash flows by the required return on equity.

Which of the following statements is NOT CORRECT?

a. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends.

b. The corporate valuation model discounts free cash flows by the required return on equity.

c. The corporate valuation model can be used to find the value of a division.

d. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements.

e. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value.

### a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.

Which of the following statements is CORRECT?

a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.

b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital.

c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital.

d. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital.

e. The corporate valuation model requires the assumption of a constant growth rate in all years.

### b. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock.

Which of the following statements is CORRECT?

a. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation.

b. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock.

c. Corporations cannot buy the preferred stocks of other corporations.

d. Preferred dividends are not generally cumulative.

e. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation.

### c. the stock is a good buy.

If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks..

### c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

Which of the following statements is CORRECT?

a. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

b. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.

c. The stock valuation model, P0 = D1/(rs - g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

e. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time.

### a. The market risk premium declines.

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

### If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.

Which of the following statements is CORRECT?

a. A change in a company's target capital structure cannot affect its WACC.

b. WACC calculations should be based on the before-tax costs of all the individual capital components.

c. Flotation costs associated with issuing new common stock normally reduce the WACC.

d. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.

e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

### e. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

Which of the following statements is CORRECT?

a. The WACC is calculated using before-tax costs for all components.

b. The after-tax cost of debt usually exceeds the after-tax cost of equity.

c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.

d. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.

e. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

### c. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

Which of the following statements is CORRECT?

a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

c. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.

e. Higher flotation costs tend to reduce the cost of equity capital.

### c. A Division A project with an 11% return.

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

### d. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

b. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.

c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

d. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.

e. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.