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 equityvalue 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