Practice%20quesions%20(final)

# Practice%20quesions%20(final) - Practice questions Final...

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Practice questions – Final (Answers are in capital letters) 1 1. You are considering a risky project. This risk of the project is evenly split between unsystematic and systematic risk. What is the appropriate cost of capital for this project? a. r m b. r m -r f c. r f D Not enough information e. β *(r m -r f ) 2. Suppose that returns on Durham Co. have a variance of 0.36 and a correlation of 0.6 with the market. The variance of the market return is 0.04. If the market risk premium is 9.4% and the expected return on Treasury bills is 4.9%, what is the required return of Durham Co.? a. 10.54% b. 5.58% c. 19.00% D 21.82% e. 15.00% covariance = .6*.2*.6 = .072 beta = covariance/variance(market) = 0.072/0.04 = 1.8 return = risk free + beta*market risk premium = 0.049 + (1.8)*(.094) = 21.82% 3. Brandywine Co. has two divisions of equal market value. Its asset beta is 1.12 and the debt to equity ratio (D/E) is 3/7. Korbell Brandy Co., which is purely in brandy business, has an asset beta of 1.16 and a debt to equity ratio of 2/3. The current risk free rate is 4% and the expected return on the market portfolio is 12%. What can we say about the investment performance for the wine division if Brandywine uses Korbell Brandy Co.’s discount rate? a. invest efficiently B underinvest c. not enough information d. overinvest e. invest optimally Brandywine: beta_asset = w_brandy * beta_brandy + w_wine * beta_wine 1.12 = (0.5)*(1.16) + (0.5)*beta_wine beta_wine = 1.08 discount rate for the wine division: r = r_f + beta_wine*(r_m - r_f) = .04 + 1.08*(.12-.04) = .1264 discount rate for the brandy division: r = r_f + beta_wine*(r_m - r_f) = .04 + 1.16*(.12- .04) = .1328 r_brandy > r_wine = > underinvest 4. You are considering a project that involves deploying a satellite this year (t=0). The cost for the project is \$100 million (for sure) by the end of current period. If the deployment fails (30% chance) the costs will be lost (i.e., the project will not create any cash flows). If the deployment succeeds (70% chance), the satellite will produce a revenue stream with a beta of 2, starting at year 1. The expected cash flows will be \$22 million forever. Assume that the risk free rate is 3% per year and the market equity premium is 4%. What is the expected NPV of this project today (t=0)? a. \$100.00 B \$ 40.00 c. \$ 50.00 d. \$ 48.54 e. \$ 38.83 r=0.03+(2)(0.04)=0.11 NPV if the project succeeds: -100=100/.11=100 NPV if the project fails: -100 Expected NPV = (.3)(-100)+(.7)(100) = 40 5. If markets are efficient, is there any incentive to collect information (i.e., to trade)? a. No; the prices already contain all relevant information b. Irrelevant; trading will take place under any circumstances c. No; if investors collect information the market will become inefficient D Yes; if we fail to collect information the prices will no longer contain all relevant information e. Yes; investors are inherently interested in collecting information

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2 6. Martha Stewart’s actions that created her some legal trouble prove that
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## This note was uploaded on 05/06/2008 for the course ACCT 2000 taught by Professor Holmes during the Spring '08 term at LSU.

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Practice%20quesions%20(final) - Practice questions Final...

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