Corporate Finance Ch 9 (Just Short Answers)
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1. 58. Briefly explain If a firm is considering projects that have the same risk as
the difference be- the firm, then the company cost of
tween company capital is the same as the project cost of capital. But if the
and project cost firm is considering projects which
of capital. have risks different from the company then the project cost
of capital becomes relevant.
2. 59. Briefly explain If the firm is considering projects with differing risk charac-
how the use of teristics, the firm will reject lowrisk
single company projects and accept high-risk projects. In reality low - risk
cost of capital to projects should be discounted
evaluate projects at a lower rate and high-risk projects at a higher discount
might rate to account for differing risks.
lead to erroneous
decisions.
3. 60. Discuss why Generally, an industry beta can be estimated more precise-
one might use an ly than a company's beta. This is
industry beta to similar to the estimate of the beta of a portfolio is more
estimate a com- precise than the estimate of the beta of
pany's cost of a single stock. The estimated industry cost of capital must
capital. be suitably adjusted before using
for company's cost of capital. For example, differences in
the capital structure of the firm and
the industry.
4. 61. Briefly explain The first step is to estimate the beta of the firm's common
how a firm's cost stock by regressing the returns on
of equity is esti- the stock on the market returns using historical data. Ex-
mated using the pected stock return is estimated using
capital asset pric- CAPM [E(R) = rf + (beta)( rm - rf)]. Expected return is the
ing estimate of the firm's cost of equity.
model (CAPM).
5. 62. Briefly ex- Generally, the value used for the risk-free rate is the
plain what value short-term Treasury bill rate.
should be used
for the risk-free
interest rate.
1/2
, Corporate Finance Ch 9 (Just Short Answers)
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6. 63. Briefly de- Asset betas are determined by the cyclical nature of the
scribe the fac- cash flows. Generally, cyclical firms
tors that deter- have higher betas. Operating leverage also affects the
mine asset betas. asset beta of a firm. Firms with high
fixed costs tend to have higher asset betas.
7. 64. Briefly dis- In the certainty equivalent approach, certainty equivalent
cuss the certain- cash flows are discounted at the
ty equivalent ap- risk-free rate to calculate the NPV of a project. First risky
proach to esti- cash flows have to be converted to
mating the NPV certainty equivalent cash flows by using individual risk
of a project. factors. One advantage of this method
is that the risk adjustment is separated from the time value
of money. Conceptually this is a
more sensible method than the risk adjusted discount rate
method. But estimating certainty
equivalent cash flows could be cumbersome.
8. 65. Briefly dis- The risk adjusted discount rate approach uses the discount
cuss the risk ad- rate to adjust for both risk and the
justed discount time value of money. The main advantage of this approach
rate approach to is simplicity. Risky project cash
estimating the flows are discounted using risk adjusted discount rates
NPV of a (higher rates) to calculate the NPV of a
project. project.
9. 66. Why do firms There is a strong correlation between the risk of the assets
with large cash of a firm and the risk of the firm's
flow betas also earnings. As such high asset betas lead to high cash flow
have high asset betas.
betas?
2/2
, Investments Test 2
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1. Briefly explain whether investors should expect a Because system-
higher return from holding portfolio A versus portfolio atic risk (mea-
B under the CAPM. Assume that both portfolios are sured by beta) is
fully diversified. equal to 1.2 for
both portfolios, an
Portfolio A: Systematic risk (Beta) 1.2 , Specific risk investor would ex-
for each individual security high pect the SAME
RATE OF RE-
Portfolio B: Systematic risk (Beta)1.2, Specific risk for TURN from both
each individual security Very Low portfolios A and
B. Moreover, since
both portfolios are
well-diversified, it
doesn't matter if
the specific risk
of individual secu-
rities is high or low.
The firm-specific
risk has been di-
versified away for
both.
2. Liquidity is a risk factor that __________. A. Has yet to be
accurately mea-
sured and incorpo-
rated into portfolio
management
3. The CAPM applies to.... all portfolios and
individual securi-
ties
4. According to CAPM, fairly priced securities... have zero alphas
a. have positive betas
b. have zero alphas
c. have negative betas
d. have positive alphas
, Investments Test 2
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5. Capital Asset Pricing Theory asserts that portfolio re- b. systematic risk
turns are best explained by...
a. economic factors
b. systematic risk
c. specific risk
d. diversification
6. Liquidity is a factor that ________________. has yet to be ac-
curately measured
and incorporated
into portfolio man-
agement
7. Standard deviation and beta both measure risk, but beta measures
they are different in that... only systematic
risk while standard
deviation is a mea-
sure of total risk
8. Which of the following is not an example of common d. real options pric-
CAPM applications? ing
a. capital budgeting
b. portfolio evaluation
c. risk management
d. real options pricing
9. The stock market follows a... b. submartingale
a. nonrandom walk
b. submartingale
c. predictable pattern that can be exploited
d. nonrandom walk and predictable pattern that can
be exploited
10. In an efficient market the correlation coefficient be- c. zero
tween stock returns for two non-overlapping time pe-
riods should be...
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1. 58. Briefly explain If a firm is considering projects that have the same risk as
the difference be- the firm, then the company cost of
tween company capital is the same as the project cost of capital. But if the
and project cost firm is considering projects which
of capital. have risks different from the company then the project cost
of capital becomes relevant.
2. 59. Briefly explain If the firm is considering projects with differing risk charac-
how the use of teristics, the firm will reject lowrisk
single company projects and accept high-risk projects. In reality low - risk
cost of capital to projects should be discounted
evaluate projects at a lower rate and high-risk projects at a higher discount
might rate to account for differing risks.
lead to erroneous
decisions.
3. 60. Discuss why Generally, an industry beta can be estimated more precise-
one might use an ly than a company's beta. This is
industry beta to similar to the estimate of the beta of a portfolio is more
estimate a com- precise than the estimate of the beta of
pany's cost of a single stock. The estimated industry cost of capital must
capital. be suitably adjusted before using
for company's cost of capital. For example, differences in
the capital structure of the firm and
the industry.
4. 61. Briefly explain The first step is to estimate the beta of the firm's common
how a firm's cost stock by regressing the returns on
of equity is esti- the stock on the market returns using historical data. Ex-
mated using the pected stock return is estimated using
capital asset pric- CAPM [E(R) = rf + (beta)( rm - rf)]. Expected return is the
ing estimate of the firm's cost of equity.
model (CAPM).
5. 62. Briefly ex- Generally, the value used for the risk-free rate is the
plain what value short-term Treasury bill rate.
should be used
for the risk-free
interest rate.
1/2
, Corporate Finance Ch 9 (Just Short Answers)
Studia online su https://quizlet.com/_4x6dwj
6. 63. Briefly de- Asset betas are determined by the cyclical nature of the
scribe the fac- cash flows. Generally, cyclical firms
tors that deter- have higher betas. Operating leverage also affects the
mine asset betas. asset beta of a firm. Firms with high
fixed costs tend to have higher asset betas.
7. 64. Briefly dis- In the certainty equivalent approach, certainty equivalent
cuss the certain- cash flows are discounted at the
ty equivalent ap- risk-free rate to calculate the NPV of a project. First risky
proach to esti- cash flows have to be converted to
mating the NPV certainty equivalent cash flows by using individual risk
of a project. factors. One advantage of this method
is that the risk adjustment is separated from the time value
of money. Conceptually this is a
more sensible method than the risk adjusted discount rate
method. But estimating certainty
equivalent cash flows could be cumbersome.
8. 65. Briefly dis- The risk adjusted discount rate approach uses the discount
cuss the risk ad- rate to adjust for both risk and the
justed discount time value of money. The main advantage of this approach
rate approach to is simplicity. Risky project cash
estimating the flows are discounted using risk adjusted discount rates
NPV of a (higher rates) to calculate the NPV of a
project. project.
9. 66. Why do firms There is a strong correlation between the risk of the assets
with large cash of a firm and the risk of the firm's
flow betas also earnings. As such high asset betas lead to high cash flow
have high asset betas.
betas?
2/2
, Investments Test 2
Studia online su https://quizlet.com/_83ci22
1. Briefly explain whether investors should expect a Because system-
higher return from holding portfolio A versus portfolio atic risk (mea-
B under the CAPM. Assume that both portfolios are sured by beta) is
fully diversified. equal to 1.2 for
both portfolios, an
Portfolio A: Systematic risk (Beta) 1.2 , Specific risk investor would ex-
for each individual security high pect the SAME
RATE OF RE-
Portfolio B: Systematic risk (Beta)1.2, Specific risk for TURN from both
each individual security Very Low portfolios A and
B. Moreover, since
both portfolios are
well-diversified, it
doesn't matter if
the specific risk
of individual secu-
rities is high or low.
The firm-specific
risk has been di-
versified away for
both.
2. Liquidity is a risk factor that __________. A. Has yet to be
accurately mea-
sured and incorpo-
rated into portfolio
management
3. The CAPM applies to.... all portfolios and
individual securi-
ties
4. According to CAPM, fairly priced securities... have zero alphas
a. have positive betas
b. have zero alphas
c. have negative betas
d. have positive alphas
, Investments Test 2
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5. Capital Asset Pricing Theory asserts that portfolio re- b. systematic risk
turns are best explained by...
a. economic factors
b. systematic risk
c. specific risk
d. diversification
6. Liquidity is a factor that ________________. has yet to be ac-
curately measured
and incorporated
into portfolio man-
agement
7. Standard deviation and beta both measure risk, but beta measures
they are different in that... only systematic
risk while standard
deviation is a mea-
sure of total risk
8. Which of the following is not an example of common d. real options pric-
CAPM applications? ing
a. capital budgeting
b. portfolio evaluation
c. risk management
d. real options pricing
9. The stock market follows a... b. submartingale
a. nonrandom walk
b. submartingale
c. predictable pattern that can be exploited
d. nonrandom walk and predictable pattern that can
be exploited
10. In an efficient market the correlation coefficient be- c. zero
tween stock returns for two non-overlapping time pe-
riods should be...
