Finance 316 practice problems for final exam 1. True or False: According to the CAPM, a stock's expected return is positively related to its beta. >> True 2. In practice, the market portfolio is often represented by: A. a portfolio of U.S. Treasury securities. B. a diversified stock market index. C. an investor's mutual fund portfolio. D. the historic record of stock market returns. 3. A stock's beta measures the: A. average return on the stock. B. variability in the stock's returns compared to that of the market portfolio. C. difference between the return on the stock and return on the market portfolio. D. market risk premium on the stock. 4. If the slope of the line measuring a stock's historic returns against the market's historic returns is positive, then the stock: A. has a beta greater than 1.0. B. has no unique risk. C. has a positive beta. D. plots above the security market line. 5. One of the easiest methods of diversifying away firm-specific risks is to: A. buy stocks with a beta of 1.0. B. build a portfolio with 20-25 individual stocks. C. purchase the shares of a mutual fund. D. purchase stocks that plot above the security market line. 6. An investor was expecting a 18% return on his portfolio with beta of 1.25 before the market risk premium increased from 8% to 10%. Based on this change, what return will now be expected on the portfolio? A. 20.0% B. 20.5% C. 22.5% D. 26.0% Old: 18% = rf + 1.25(8%) = rf + 10.0%, therefore, 8.0% = rf New: Expected return = 8.0% + 1.25(10%) = 8.0% + 12.5% = 20.5% 7. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is: A. 0.70. B. 1.05. C. 1.40. D. 2.10. Portfolio beta = (W1 x B1) + (W2 x B2) = (.5 x 1.4) + (.5 x .70) = 1.05 1
Finance 316 practice problems for final exam 8. According to CAPM estimates, what is the cost of equity for a firm with beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%? Expected return on stock = 6% + 1.5(15% - 6%) = 6 + 13.5 = 19.5%
9. A firm’s dividend is expected to be $7 next year, and then $9 in the following year. After that, its dividends are expected to grow at an annual rate of 4%. If the firm’s required return on equity is 11%, then what must be its current stock price?
10. Consider two savings accounts that have the same effective annual rate. Account #1 pays 8.8% APR compounded quarterly. Account #2 is compounded monthly. What is Account #2’s APR?
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Therefore, account #2 has an APR of 8.74%.
11. Your firm is thinking about purchasing a coal mining company. Suppose that the mining company’s cash flows are expected to be -$50 million this year, $0 next year, +$20 million per year for the following 15 years, and then nothing after that. You may assume that the expected rate of return on the market portfolio is 15%, the risk-free rate is 4%, and the corporate tax rate is 35%. (a) What is the mining company’s current weighted average cost of capital if it is financed with 25% debt and 75% equity, its equity has a beta of 0.75, and its debt has a beta of 0.1? ( ( ) )
Finance 316 practice problems for final exam (b) Using your answer from part (a), what is the value of the mining company’s equity?
12. Campbell soup currently has a capital structure that consists of 70% equity and 30% debt. Its equity has a beta of 0.5, and its debt has a beta of 0.1. You may assume that the risk-free rate is 5%, the expected return on the market is 12%, and that the corporate tax rate is 40%. Use this information in your answers to questions (a) and (b) below. (a) What is Campbell Soup’s weighted average cost of capital (WACC)? ( ( ) )
(b) You expect Campbell Soup to generate operating cash flows of $750 million per year for three years (starting next year), and then $500 million per year in perpetuity thereafter. Using your answer to (a) above, what is the most you should be willing to pay to...
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