Question: Company cost of capital Quark Productions (“Give

> Fama and French show that average stock returns on firms with small market capitalizations have been significantly higher than average returns for “large-cap” firms. What are the possible explanations for this result? Does the result disprove market effi

> Reliable Electric, a major Ruritanian producer of electrical products, is considering a proposal to manufacture a new type of industrial electric motor that would replace most of its existing product line. A research breakthrough has given Reliable a two

> “If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin.” Explain why this is not so.

> Explain why setting a higher discount rate is not a cure for upward-biased cash-flow forecasts.

> Draw up an outline or flowchart tracing the capital budgeting process from the initial idea for a new investment project to the completion of the project and the start of operations. Assume the idea for a new obfuscator machine comes from a plant manager

> Explain how each of the following actions or problems can distort or disrupt the capital budgeting process. a. Overoptimism by project sponsors. b. Inconsistent forecasts of industry and macroeconomic variables. c. Capital budgeting organized solely as a

> True or false? a. The approval of a firm’s capital budget allows managers to go ahead with any project included in the budget. b. Capital budgets and project authorizations are mostly developed “bottom up.” Strategic planning is a “top-down” process. c.

> You are considering a proposal to produce and market a new sluffing machine. The most likely outcomes for the project are as follows: Expected sales: 30,000 units per year Unit price: $50 Variable cost: $30 Fixed cost: $300,000 The project will last for

> What is the NPV of the electric scooter project under the following scenario? Unit sales are 20% below expectations. Unit price is 10% below expectations. Unit variable cost remains at 50% of revenue. Fixed costs increase by 5%. Investment in plant and e

> A project currently generates sales of $10 million, variable costs equal 50% of sales, and fixed costs are $2 million. The firm’s tax rate is 21%. What are the effects of the following changes on cash flow? a. Sales increase from $10 million to $11 milli

> Emperor’s Clothes Fashions can invest $5 million in a new plant for producing invisible makeup. The plant has an expected life of five years, and expected sales are 6 million jars of makeup a year. Fixed costs are $2 million a year, and variable costs ar

> Use the spreadsheet for the guano project in Chapter 6 to undertake a sensitivity analysis of the project. Make whatever assumptions seem reasonable to you. What are the critical variables? What should the company’s response be to your analysis?

> The Rustic Welt Company is proposing to replace its old welt-making machinery with more modern equipment. The new equipment costs $9 million (the existing equipment has zero salvage value). The attraction of the new machinery is that it is expected to cu

> Respond to the following comments: a. “The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets.” b. “If everyone believes you can make money by charting stock prices,

> Decision trees Magna Charter is a new corporation formed by Agnes Magna to provide an executive flying service for the southeastern United States. The founder thinks there will be a ready demand from businesses that cannot justify a full-time company pla

> Monte Carlo simulation Look back at the guano project in Section 6-3. Use the Crystal Ball™ software to simulate how uncertainty about inflation could affect the project’s cash flows.

> Project analysis New Energy is evaluating a new bio fuel facility. The plant would cost $4,000 million to build and has the potential to produce up to 40 million barrels of synthetic oil a year. The product is a close substitute for conventional oil and

> Otobai’s staff (see Section 10-1) has come up with the following revised estimates for the electric scooter project: Conduct a sensitivity analysis using the spreadsheets (available in Connect). What are the principal uncertainties in t

> Decision trees look again at the example in Figure 10.4. The R&D team has put forward a proposal to invest an extra $20 million in expanded phase II trials. The object is to prove that the drug can be administered by a simple inhaler rather than as a liq

> Decision trees Look again at the decision tree in Figure 10.4. Expand the possible outcomes as follows: 1. Blockbuster: PV = $1.5 billion with 5% probability. 2. Above average: PV = $700 million with 20% probability. 3. Average: PV = $300 million with 40

> Decision trees* Your midrange guess as to the amount of oil in a prospective field is 10 million barrels, but there is a 50% chance that the amount of oil is 15 million barrels and a 50% chance of 5 million barrels. If the actual amount of oil is 15 mill

> Decision trees Look back at the Vegetron electric mop project in Section 9-4. Assume that if tests fail and Vegetron continues to go ahead with the project, the $1 million investment would generate only $75,000 a year. Display Vegetron’s problem as a dec

> Real options An auto plant that costs $100 million to build can produce a line of flex-fuel cars. The investment will produce cash flows with a present value of $140 million if the line is successful but only $50 million if it is unsuccessful. You believ

> A silver mine can yield 10,000 ounces of silver at a variable cost of $32 per ounce. The fixed costs of owning the mine are $40,000 per year regardless of whether the mine is open or closed. In half the years, silver can be sold for $48 per ounce; in the

> How would you respond to the following comments? a. “Efficient market, my eye! I know lots of investors who do crazy things.” b. “Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market.” c. “The trouble wi

> Real options True or false? a. Decision trees can help identify and describe real options. b. The option to expand increases PV. c. High abandonment value decreases PV. d. If a project has positive NPV, the firm should always invest immediately.

> Real options describe the real option in each of the following cases: a. Moda di Milano postpones a major investment. The expansion has positive NPV on a discounted cash-flow basis, but top management wants to get a better fix on product demand before pr

> Real options Explain why options to expand or contract production are most valuable when forecasts about future business conditions are most uncertain.

> Monte Carlo simulation Suppose a manager has already estimated a project’s cash flows, calculated its NPV, and done a sensitivity analysis like the one shown in Table 10.2. List the additional steps required to carry out a Monte Carlo simulation of proje

> True or false? a. Sensitivity analysis is unnecessary for projects with asset betas that are equal to zero. b. Sensitivity analysis can be used to identify the variables most crucial to a project’s success. c. If only one variable is uncertain, sensitivi

> A project has fixed costs of $1,000 per year, depreciation charges of $500 a year, annual revenue of $6,000, and variable costs equal to two-thirds of revenues. a. If sales increase by 10%, what will be the increase in pretax profits? b. What is the degr

> Operating leverage What is the lowest possible value for the degree of operating leverage for a profitable firm? Show with a numerical example that if Modern Artifacts (see Problem 12) has zero fixed costs and zero depreciation, then DOL = 1 and, in fact

> Operating leverage Look again at Modern Artifacts in Problem 12. a. What is the degree of operating leverage of Modern Artifacts when sales are $7,000? b. What is the degree of operating leverage when sales are $12,000? c. Why is operating leverage diffe

> Operating leverage You estimate that your cattle farm will generate $1 million of profits on sales of $4 million under normal economic conditions and that the degree of operating leverage is 8. a. What will profits be if sales turn out to be $3.5 million

> Fixed and variable costs In a slow year, Deutsche Burgers will produce 2 million hamburgers at a total cost of $3.5 million. In a good year, it can produce 4 million hamburgers at a total cost of $4.5 million. a. What are the fixed costs of hamburger pro

> Supply the missing words: “There are three forms of the efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the form

> Break-even analysis A financial analyst has computed both accounting and NPV breakeven sales levels for a project using straight-line depreciation over a six-year period. The project manager wants to know what will happen to these estimates if the firm c

> Break-even analysis Define the cash-flow break-even point as the sales volume (in dollars) at which cash flow equals zero. a. Is the cash-flow break-even level of sales higher or lower than the zero-profit (accounting) break-even point? b. If a project o

> Modern Artifacts can produce keepsakes that will be sold for $80 each. Non depreciation fixed costs are $1,000 per year, and variable costs are $60 per unit. The initial investment of $3,000 will be depreciated straight-line over its useful life of five

> Dime a Dozen Diamonds makes synthetic diamonds by treating carbon. Each diamond can be sold for $100. The materials cost for a synthetic diamond is $40. The fixed costs incurred each year for factory upkeep and administrative expenses are $200,000. The m

> Break-even analysis Break-even calculations are most often concerned with the effect of a Short fall in sales, but they could equally well focus on any other component of cash flow. Dog Days is considering a proposal to produce and market a caviar-flavor

> Match each of the following terms to one of the definitions or descriptions listed below: sensitivity analysis, scenario analysis, break-even analysis, operating leverage, Monte Carlo simulation, decision tree, real option, tornado diagram. a. Recalculat

> Refer to the top-right panel of Figure 9.2. What proportion of U.S. Steel’s returns was explained by market movements? What proportion of risk was diversifiable? How does the diversifiable risk show up in the plot? What is the range of possible errors in

> Binomial Tree Farm’s financing includes $5 million of bank loans. Its common equity is shown in Binomial’s Annual Report at $6.67 million. It has 500,000 shares of common stock outstanding, which trade on the Wichita Stock Exchange at $18 per share. What

> A company is 40% financed by risk-free debt. The interest rate is 10%, the expected market risk premium is 8%, and the beta of the company’s common stock is .5. What is the after-tax WACC, assuming that the company pays tax at a 20% rate?

> Company cost of capital Nero Violins has the following capital structure: a. What is the firm’s asset beta? (Hint: What is the beta of a portfolio of all the firm’s securities?) b. Assume that the CAPM is correct. What

> Which (if any) of these statements are true? Stock prices appear to behave as though successive values (a) Are random numbers. (b) Follow regular cycles. (c) Differ by a random number.

> You are given the following information for Golden Fleece Financial: Calculate Golden Fleece’s company cost of capital. Ignore taxes.

> The total market value of the common stock of the Okefenokee Real Estate Company is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the m

> An oil company executive is considering investing $10 million in one or both of two wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is expected to produce $2 million for 15 years. These are real (inflation-adjusted)

> Suppose that you are valuing a future stream of high-risk (high-beta) cash outflows. High risk means a high discount rate. But the higher the discount rate, the less the present value. This seems to say that the higher the risk of cash outflows, the less

> The McGregor Whisky Company is proposing to market diet scotch. The product will first be test-marketed for two years in southern California at an initial cost of $500,000. This test launch is not expected to produce any profits but should reveal consume

> A project has the following forecasted cash flows: The estimated project beta is 1.5. The market return rm is 16%, and the risk-free rate rf is 7%. a. Estimate the opportunity cost of capital and the project’s PV (using the same rate to

> A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. The interest rate is 5%, the estimated risk premium on the market is 10%, and the project has a beta of .5. If you use a constant risk-adjusted discount rate, what is, a. The PV

> An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20% of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40% of new wells that s

> True or false? a. The company cost of capital is the correct discount rate for all projects because the high risks of some projects are offset by the low risk of other projects. b. Distant cash flows are riskier than near-term cash flows. Therefore, long

> True or false? a. Financing decisions are less easily reversed than investment decisions. b. Tests have shown that there is almost perfect negative correlation between successive price changes. c. The semistrong form of the efficient-market hypothesis st

> Fudge factors Mom and Pop Groceries has just dispatched a year’s supply of groceries to the government of the Central Antarctic Republic. Payment of $250,000 will be made one year hence after the shipment arrives by snow train. Unfortunately, there is a

> John Barleycorn estimates his firm’s after-tax WACC at only 8%. Nevertheless, he sets a 15% companywide discount rate to offset the optimistic biases of project sponsors and to impose “discipline” on the capital budgeting process. Suppose Mr. Barleycorn

> Many investment projects are exposed to diversifiable risks. What does “diversifiable” mean in this context? How should diversifiable risks be accounted for in project valuation? Should they be ignored completely?

> You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues. These costs are variable—they are always proportional to revenues. There are no other operating costs. The cost of c

> What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step.

> EZCUBE Corp. is 50% financed with long-term bonds and 50% with common equity. The debt securities have a beta of .15. The company’s equity beta is 1.25. What is EZCUBE’s asset beta?

> Which of these projects is likely to have the higher asset beta, other things equal? Why? a. The sales force for project A is paid a fixed annual salary. Project B’s sales force is paid by commissions only. b. Project C is a first-class-only airline. Pro

> Look again at Table 9.1. This time we will concentrate on Union Pacific. a. Calculate Union Pacific’s cost of equity from the CAPM using its own beta estimate and the industry beta estimate. How different are your answers? Assume a risk-free rate of 2% a

> The following table shows estimates of the risk of two well-known Canadian stocks: a. What proportion of each stock’s risk was market risk, and what proportion was specific risk? b. What is the variance of the returns for Sun Life Finan

> Figure 9.4 shows plots of monthly rates of return on three stocks versus those of the market index. The beta and standard deviation of each stock is given beside the plot. a. Which stock is safest for a diversified investor? b. Which stock is safest for

> The second column in Table 13.1 shows the monthly return on the British FTSE 100 index from January 2015 through July 2017. The remaining columns show returns on the stocks of two firms—Executive Cheese and Paddington Beer. Both firms a

> Most managers have no difficulty avoiding blatantly dishonest actions. But sometimes there are gray areas, where it is debatable whether an action is unethical and unacceptable. Suggest an important ethical dilemma that companies may face. What principle

> Define the following terms: a. Cost of debt. b. Cost of equity. c. After-tax WACC. d. Equity beta. e. Asset beta. f. Pure-play comparable. g. Certainty equivalent.

> Use the long-term data on security returns in Sections 7-1 and 7-2 to calculate the historical level of the Sharpe ratio for the market portfolio.

> Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolio’s expected annual rate of return is 9%, and the annual standard deviation is 10%. Amanda Reckonwith, Percival’s financial adviser, recommends that Percival consid

> Here are returns and standard deviations for four investments. Calculate the standard deviations of the following portfolios. a. 50% in Treasury bills, 50% in stock P. b. 50% each in Q and R, assuming the shares have 1. Perfect positive correlation. 2. P

> Ebenezer Scrooge has invested 60% of his money in share A and the remainder in share B. He assesses their prospects as follows: a. What are the expected return and standard deviation of returns on his portfolio? b. How would your answer change if the cor

> Mark Harrywitz proposes to invest in two shares, X and Y. He expects a return of 12% from X and 8% from Y. The standard deviation of returns is 8% for X and 5% for Y. The correlation coefficient between the returns is .2. a. Compute the expected return a

> Look back at the calculation for Southwest Airlines and Amazon in Section 8-1. a. Recalculate the expected portfolio return and standard deviation for different values of x1 and x2, assuming the correlation coefficient ρ12 = 0. Plot the range of possible

> a. Plot the following risky portfolios on a graph: b. Five of these portfolios are efficient, and three are not. Which are inefficient ones? c. Suppose you can also borrow and lend at an interest rate of 12%. Which of the portfolios has the highest Sharp

> The following question illustrates the APT. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two factors: We assume that the expected risk premium is 4% on factor 1 and 8%

> Look again at the set of the three efficient portfolios that we calculated in Section 8-1. a. If the interest rate is 5%, which of the three efficient portfolios should you hold? b. How would your answer to part (a) change if the interest rate were 2%?

> Analysis of 60 monthly rates of return on United Futon common stock indicates a beta of 1.45 and an alpha of –.2% per month. A month later, the market is up by 5%, and United Futon is up by 6%. What is Futon’s abnormal rate of return?

> In footnote 4, we noted that the minimum-risk portfolio contained an investment of 53% in Amazon and 47% in Southwest Airlines. Prove it. (Hint: You need a little calculus to do so.)

> Between 2008 and 2017, the returns on Microfund averaged 10% a year. In his 2017 discussion of performance, the fund president noted that this was 2.5% a year better than the return on the U.S. market, a result that he attributed to the fundâ€

> The following table shows the sensitivity of four stocks to the three Fama–French factors. Estimate the expected return on each stock assuming that the interest rate is 2%, the expected risk premium on the market is 7%, the expected ris

> APT Look again at Problem 19. Consider a portfolio with equal investments in stocks P, P2, and P3. a. What are the factor risk exposures for the portfolio? b. What is the portfolio’s expected return?

> Figure 8.11 purports to show the range of attainable combinations of expected return and standard deviation. a. Which diagram is incorrectly drawn and why? b. Which is the efficient set of portfolios? c. If rf is the rate of interest, mark with an X the

> Consider the following simplified APT model: Calculate the expected return for the following stocks. Assume rf = 5%.

> Some true or false questions about the APT: a. The APT factors cannot reflect diversifiable risks. b. The market rate of return cannot be an APT factor. c. There is no theory that specifically identifies the APT factors. d. The APT model could be true bu

> APT Consider a three-factor APT model. The factors and associated risk premiums are Calculate expected rates of return on the following stocks. The risk-free interest rate is 7%. a. A stock whose return is uncorrelated with all three factors. b. A stock

> Epsilon Corp. is evaluating an expansion of its business. The cash-flow forecasts for the project are as follows: The firm’s existing assets have a beta of 1.4. The risk-free interest rate is 4% and the expected return on the market por

> The Treasury bill rate is 4%, and the expected return on the market portfolio is 12%. Using the capital asset pricing model: a. Draw a graph similar to Figure 8.6 showing how the expected return varies with beta. b. What is the risk premium on the market

> True or false? a. If markets are efficient, shareholders should expect to receive only the risk-free interest rate on their investment. b. If markets are efficient, investment in the stock market is a mug’s game. c. If markets are efficient, investors sh

> Suppose that the Treasury bill rate is 6% rather than 2%. Assume that the expected return on the market stays at 9%. Use the betas in Table 8.2. a. Calculate the expected return from Johnson & Johnson. b. Find the highest expected return that is offered

> True or false? a. The CAPM implies that if you could find an investment with a negative beta, its expected return would be less than the interest rate. b. The expected return on an investment with a beta of 2.0 is twice as high as the expected return on

> True or false? Explain or qualify as necessary. a. Investors demand higher expected rates of return on stocks with more variable rates of return. b. The CAPM predicts that a security with a beta of 0 will offer a zero expected return. c. An investor who

> Portfolio beta Refer to Table 7.5. a. What is the beta of a portfolio that has 40% invested in ExxonMobil and 60% in Newmont? b. Would you invest in this portfolio if you had no superior information about the prospects for these stocks? Devise an alterna

> Look back at Problem 9 in Chapter 7. The risk-free interest rate in each of these years was as follows: a. Calculate the average return and standard deviation of returns for Ms. Sauros’s portfolio and for the market. Use these figures t

> For each of the following pairs of investments, state which would always be preferred by a rational investor (assuming that these are the only investments available to the investor): a. Portfolio A, r = 18% σ = 20%; portfolio B, r = 14% σ = 20%. b. Portf

> What is the beta of each of the stocks shown in Table 7.9?

> Portfolio risk Suppose that the standard deviation of returns from a typical share is about .40 (or 40%) a year. The correlation between the returns of each pair of shares is about .3. a. Calculate the variance and standard deviation of the returns on a

> True or false? a. Investors prefer diversified companies because they are less risky. b. If stocks were perfectly positively correlated, diversification would not reduce risk. c. Diversification over a large number of assets completely eliminates risk. d