ch7

1. The valuation models that use the weighted-average cost of capital as a discount rate are the:

a.   free cash flow and the adjusted present value models

b.   residual income and flows to equity models

c.   dividend discount and adjusted present value models

d.   free cash flow and residual income models

1. The valuation models that use the cost of common equity as a discount rate are the:

a.   dividend discount and flows to equity models

b.   dividend discount and free cash flow models

c.   free cash flows and flows to equity models

d.   free cash flows and dividend discount models

1. Using the capital asset pricing model (CAPM), the variable known as the risk-free interest rate best approximates the interest rate on the:

a.   30-year Treasury bond

b.   average 5-year bank certificate of deposit

c.   average systematic risk computed for the general domestic bond market over the last 30 months

d.   prime interest rate as established by the Federal Reserve Bank

1. In the capital asset pricing model formula, the additional expected return above the risk-free rate that an investor requires to hold an average-price stock is known as:

a.   historical equity premium earned

b.   equity risk premium

c.   beta

d.   risk-free rate of interest

1. Beta represents the firm’s sensitivity to market performance when using CAPM. If a firm has a beta that is greater than 1 on a particular day, then we can conclude that the firm’s expected return:

1. is greater than market movement in both directions on that day
2. is less than market movement in both directions on that day
3. is whatever the market’s return was on that day
4. It is impossible for a firm to have a beta greater than 1.

The cost of equity can be expressed as k_e = r_f + m · β when using the CAPM. In the formula, m represents:

1. the cost of equity
2. the risk free interest rate
3. the equity risk premium
4. systematic risk

A fact that is critically important to an investor who holds a diversified portfolio is:

1. systematic risk can be eliminated by holding a diversified portfolio
2. unsystematic risk can be eliminated by holding a diversified portfolio
3. all risk can be eliminated by holding a diversified portfolio
4. the risk factors for diversified portfolios are approximately the same as risk factors for nondiversified portfolios

To understand what beta means we must formalize the distinction between correlation with the market and volatility. R_t = β · R_mt + E_t  is the formula that expresses this relationship.  The variable R_mt stands for the:

a.   market return on date t

b.   firm’s return on date t

c.   additional volatility unrelated to the market

d.   measure of correlation with the market

In a situation in which a firm’s economic balance sheet consists of only core operations, debt, and common equity, the weighted-average cost of capital (WACC) is defined as the weighted average of the after-tax cost of debt and cost of equity. The weightings in this case are based on __________, not __________.

a.   historical costs; fair market values

b.   the proportion of debt to equity; debt to total capital

c.   appraisals and industry guidelines; historical costs

d.   fair values of debt and equity; book values of debt and equity

A characteristic of the WACC is that:

a.   it is the discount rate used for the adjusted present value model

b.   the only capital supplier considered in the WACC are debtholders

c.   it is the discount rate used in the flows to equity valuation model

d.   it blends the costs of equity and other sources of financing

28.       In a situation in which a firm’s economic balance sheet consists of only core operations, debt, and common equity, the combined risk of __________ and of __________ must equal the risk of __________.

a.   the firm’s debt; the firm’s equity; the firm’s core operations

b.   the firm’s core operations; the firm’s equity; the marketplace

c.   the firm’s core operations; its nonoperating assets; the firm’s total debt

d.   the firm’s investors; the marketplace; the firm’s diversified portfolio

In the WACC model, the effect of the firm holding other assets such as Treasury Bonds:

a.   does not affect the nature of the firm’s equity

b.   does affect the nature of its core operations

c.   does not affect the nature of its core operations

d.   does affect the nature of the firm’s debt

Using the WACC model, Treasury Bonds that the firm holds is treated as a nonoperating asset. The Treasury Bonds in this situation would be treated in the WACC model as:

a.   positive debt

b.   negative debt

c.   a hedge against an inflationary spiral

d.   a hedge against the discount rate applied to the firm’s core operations

To estimate the firm’s unlevered cost of equity, the analyst must first find the unlevered beta. Formulas are employed to convert levered betas to unlevered betas. There are different formulas used to perform this task, because the relationship between levered and unlevered betas depends on:

a.   the pattern of the free cash flow stream

b.   whether the debt will remain as a fixed dollar amount, a fixed percentage of capital, or follow some other pattern

c.   the beta on the firm’s debt

d.   All of the answers are correct.

The adjusted present value model uses the unlevered cost of equity as:

a.   a way to compute the levered betas required for the formula

b.   a way to estimate the unlevered beta directly from stock returns

c.   its discount rate

d.         None of the above answers are correct

Estimating a discount rate for privately held companies adds complications not faced with public companies. The degree of accuracy of the various estimated betas identified by the analyst is commonly known as:

a.   direct beta estimation

b.   the standard average beta formula

c.   precision

d.   beta appraisal

An analyst must adjust the beta estimates of comparable private companies for the difference in their capital structures. The analyst can approach this task by:

a.   choosing a firm with a comparable capital structure similar to the one being valued, if possible

b.   choosing an estimated average beta based on public firm industry standards

c.   estimating the cost of capital for the comparable firm.

d.   Answers a and c are both correct.

Most companies operate a number of different businesses. Each of these businesses faces different risks and therefore suitable discount rates will vary among divisions, product lines, or subsidiaries based on the risk profile of the particular business. To determine the cost of capital, an analyst should:

a.   use a single discount rate for the entire firm

b.   estimate the beta separately for each division, and then obtain a weighted average of all divisions to compute the firm’s cost of capital

c.   consult industry standards for publicly held firms in a similar industry

d.   None of the above answers are correct.