*Multiple Choice Questions*

___ 1.Which of the following assumptions of an ideal (or perfect) capital market most closely relates to the assumed *symmetry* of information set shared by all firms and all investors?

a.Capital Markets are frictionless

b.Homogeneous expectations

c.Atomistic competition

d.The firm has a fixed investment program

e.Once chosen, the firm’s financing is fixed

___ 2.Until now, Delaware East, Inc. has been an all-equity firm; its most recent market equity value was $100 mn., and its cost of equity (and cost of assets) is 15%. Now, the firm decides to increase its leverage by issuing $40 mn. in debt, with the proceeds being used to pay a dividend to shareholders. The cost of the debt is r_{D}=7%. What is the firm’s new cost of equity capital, according to Modigliani and Miller’s Proposition II?

a.15.33%

b.18.20%

c20.33%

d.22.50%

___ 3.Until now, Delaware East, Inc. has been an all-equity firm; its most recent market equity value was $80 mn., and its cost of equity (and cost of assets) is 15%. Now, the firm decides to increase its leverage by issuing $40 mn. in debt, with the proceeds being used to pay a dividend to shareholders. The cost of the debt is r_{D}=7%. What is the firm’s new cost of equity capital, according to Modigliani and Miller’s Proposition II?

a.15.33%

b.18.20%

c20.33%

d.23.00%

___ 4.Firm XYZ is currently financed entirely with equity. The market value of the firm’s assets and equity is V_{U}=E_{U}=500, and the expected return on the firm’s assets and equity is r_{A}=r_{E}=12.5%. Suppose the firm issues debt with a value of D_{L}= 200, and uses the proceeds to retire equity. The market value of the firm remains the same, V_{L}=E_{L}+D_{L}=500. If the expected return on the debt is r_{D}=7%, what is the expected return on the firm’s levered equity?

a.15.33%

b.18.20%

c20.33%

d.23.00%

___ 5.For the equity of Delaware East, ?=1.25. If the expected return on the market is 15% and the risk-free rate is 5%, what is the expected return on the firm’s equity?

a.12.50%

b.15.00%

c.17.50%

d.18.75%

___ 6.The market value of Delaware East’s assets is $100 mn. The firm has one issue of pure-discount debt outstanding which promises to pay $60 mn. in 5 years. If the standard deviation of the firm’s assets is 22% and the risk-free rate is 5%, what are the values of the firm’s equity and debt, based on the Black-Scholes model?

__value of equity____value of debt__

a.$54 mn.$46 mn.

b.$46 mn.$54 mn.

c.$38 mn.$62 mn.

d.$30 mn.$70 mn.

___ 7.Suppose you develop a mutual fund that includes 500 NYSE stocks, all with equal weights in the fund’s portfolio. The average standard deviation of the stocks is 36%, and the average pair-wise correlation among the stocks is 0.40. What is your estimate of the standard deviation of the fund’s portfolio?

a.19.9%

b.22.8%

c.26.2%

d.32.1%

___ 8.Suppose you develop a mutual fund that includes 78 stocks, all with equal weights in the fund’s portfolio. The average standard deviation of the stocks is 44%, and the average pair-wise correlation among the stocks is 0.30. What is your estimate of the standard deviation of the fund’s portfolio?

a.19.5%

b.24.5%

c.29.5%

d.34.5%

___ 9.Using the Binomial Model, find the value of a firm’s levered equity (E_{L}) given the following values: V=100, u=1.3, d=1/u, p=0.7, r_{f}=5%, X=100, and T=3.

__ E___{L}__ __

a.32.34

b.27.34

c.23.96

d.18.96

___ 10.Using the Binomial Model, find the values of a firm’s levered equity (E_{L}), and the expected return on the equity, r_{LE}, given the following values: V=100, u=1.3, d=1/u, p=0.7, r_{f}=5%, X=100, and T=3.

__ E___{L}__ __ __ r___{LE}__ __

a.32.34 6.92%

b.32.3410.74%

c.18.96 6.92%

d.18.9610.74%

___ 11.The expected returns on the debt and equity of a levered firm are r_{E}=15% and r_{D}=7%, and the current market value of the debt and equity are E=66 and D=44, respectively. What is the firm’s weighted average cost of capital (WACC)?

a.7.8%

b.9.8%

c.11.8%

d.13.8%

___ 12.The expected returns and standard deviations for stocks A and B are r_{A}=14% and r_{B}=19%, respectively, and ?_{A}=23% and ?_{B}=34%, respectively. The correlation of the returns on the two stocks is ?_{AB}=0.3. What is the expected return, r_{P}, and standard deviation, ?_{P}, of a portfolio with weights of w_{A}=0.60 and w_{B}=0.40 in stocks A and B, respectively?

r_{P}?_{P}

a.16%22.1%

b.16%24.8%

c.17%22.1%

d.17%24.8%

___ 13.For your retirement fund, you have decided to place 40% of your contributions into a riskfree asset that pays 4% interest per annum, and the remaining 60% of your contributions will be placed in an available stock mutual fund that approximates the holdings of the mythical *market ** ** ** **portfolio*. You expect this fund to provide an average return of r_{P}=9%, but will expose you to risk, measured in terms of an estimated standard deviation of ?_{P}=20%. What is your estimate of the expected return and standard deviation of your complete portfolio, r_{C} and ?_{C}, respectively?

r_{P}?_{P}

a.6% 5.9%

b.6%20.0%

c.7%12.0%

d.7%20.0%

___ 14.Suppose the beta of the stock of Microsoft, Inc. is ?_{msft}=1.45. If r_{f}=4% and r_{M}=9%, what is the equilibrium expected return on Microsoft stock, r_{msft}, according to the CAPM? As an analyst of the firms in the high-technology industry, you expect Microsoft to provide a return of 10% over the next year. Comparing your estimate with equilibrium expected return on Microsoft that you just calculated, would you recommend to your investors that they buy Microsoft stock?

a.Yes: Microsoft is underpriced

b.No: Microsoft is overpriced

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