Question: Rate of return The level of the

> John Barleycorn estimates his firm’s after-tax WACC at only 8%. Nevertheless, he sets a 15% companywide discount rate to offset the optimistic biases of project sponsors and to impose “discipline” on the capital budgeting process. Suppose Mr. Barleycorn

> Many investment projects are exposed to diversifiable risks. What does “diversifiable” mean in this context? How should diversifiable risks be accounted for in project valuation? Should they be ignored completely?

> You run a perpetual encabulator machine, which generates revenues averaging $20 million per year. Raw material costs are 50% of revenues. These costs are variable—they are always proportional to revenues. There are no other operating costs. The cost of c

> What types of firms need to estimate industry asset betas? How would such a firm make the estimate? Describe the process step by step.

> EZCUBE Corp. is 50% financed with long-term bonds and 50% with common equity. The debt securities have a beta of .15. The company’s equity beta is 1.25. What is EZCUBE’s asset beta?

> Which of these projects is likely to have the higher asset beta, other things equal? Why? a. The sales force for project A is paid a fixed annual salary. Project B’s sales force is paid by commissions only. b. Project C is a first-class-only airline. Pro

> Look again at Table 9.1. This time we will concentrate on Union Pacific. a. Calculate Union Pacific’s cost of equity from the CAPM using its own beta estimate and the industry beta estimate. How different are your answers? Assume a risk-free rate of 2% a

> The following table shows estimates of the risk of two well-known Canadian stocks: a. What proportion of each stock’s risk was market risk, and what proportion was specific risk? b. What is the variance of the returns for Sun Life Finan

> Figure 9.4 shows plots of monthly rates of return on three stocks versus those of the market index. The beta and standard deviation of each stock is given beside the plot. a. Which stock is safest for a diversified investor? b. Which stock is safest for

> The second column in Table 13.1 shows the monthly return on the British FTSE 100 index from January 2015 through July 2017. The remaining columns show returns on the stocks of two firms—Executive Cheese and Paddington Beer. Both firms a

> Most managers have no difficulty avoiding blatantly dishonest actions. But sometimes there are gray areas, where it is debatable whether an action is unethical and unacceptable. Suggest an important ethical dilemma that companies may face. What principle

> Define the following terms: a. Cost of debt. b. Cost of equity. c. After-tax WACC. d. Equity beta. e. Asset beta. f. Pure-play comparable. g. Certainty equivalent.

> Use the long-term data on security returns in Sections 7-1 and 7-2 to calculate the historical level of the Sharpe ratio for the market portfolio.

> Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolio’s expected annual rate of return is 9%, and the annual standard deviation is 10%. Amanda Reckonwith, Percival’s financial adviser, recommends that Percival consid

> Here are returns and standard deviations for four investments. Calculate the standard deviations of the following portfolios. a. 50% in Treasury bills, 50% in stock P. b. 50% each in Q and R, assuming the shares have 1. Perfect positive correlation. 2. P

> Ebenezer Scrooge has invested 60% of his money in share A and the remainder in share B. He assesses their prospects as follows: a. What are the expected return and standard deviation of returns on his portfolio? b. How would your answer change if the cor

> Mark Harrywitz proposes to invest in two shares, X and Y. He expects a return of 12% from X and 8% from Y. The standard deviation of returns is 8% for X and 5% for Y. The correlation coefficient between the returns is .2. a. Compute the expected return a

> Look back at the calculation for Southwest Airlines and Amazon in Section 8-1. a. Recalculate the expected portfolio return and standard deviation for different values of x1 and x2, assuming the correlation coefficient ρ12 = 0. Plot the range of possible

> a. Plot the following risky portfolios on a graph: b. Five of these portfolios are efficient, and three are not. Which are inefficient ones? c. Suppose you can also borrow and lend at an interest rate of 12%. Which of the portfolios has the highest Sharp

> The following question illustrates the APT. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two factors: We assume that the expected risk premium is 4% on factor 1 and 8%

> Look again at the set of the three efficient portfolios that we calculated in Section 8-1. a. If the interest rate is 5%, which of the three efficient portfolios should you hold? b. How would your answer to part (a) change if the interest rate were 2%?

> Analysis of 60 monthly rates of return on United Futon common stock indicates a beta of 1.45 and an alpha of –.2% per month. A month later, the market is up by 5%, and United Futon is up by 6%. What is Futon’s abnormal rate of return?

> In footnote 4, we noted that the minimum-risk portfolio contained an investment of 53% in Amazon and 47% in Southwest Airlines. Prove it. (Hint: You need a little calculus to do so.)

> Between 2008 and 2017, the returns on Microfund averaged 10% a year. In his 2017 discussion of performance, the fund president noted that this was 2.5% a year better than the return on the U.S. market, a result that he attributed to the fundâ€

> The following table shows the sensitivity of four stocks to the three Fama–French factors. Estimate the expected return on each stock assuming that the interest rate is 2%, the expected risk premium on the market is 7%, the expected ris

> APT Look again at Problem 19. Consider a portfolio with equal investments in stocks P, P2, and P3. a. What are the factor risk exposures for the portfolio? b. What is the portfolio’s expected return?

> Figure 8.11 purports to show the range of attainable combinations of expected return and standard deviation. a. Which diagram is incorrectly drawn and why? b. Which is the efficient set of portfolios? c. If rf is the rate of interest, mark with an X the

> Consider the following simplified APT model: Calculate the expected return for the following stocks. Assume rf = 5%.

> Some true or false questions about the APT: a. The APT factors cannot reflect diversifiable risks. b. The market rate of return cannot be an APT factor. c. There is no theory that specifically identifies the APT factors. d. The APT model could be true bu

> APT Consider a three-factor APT model. The factors and associated risk premiums are Calculate expected rates of return on the following stocks. The risk-free interest rate is 7%. a. A stock whose return is uncorrelated with all three factors. b. A stock

> Epsilon Corp. is evaluating an expansion of its business. The cash-flow forecasts for the project are as follows: The firm’s existing assets have a beta of 1.4. The risk-free interest rate is 4% and the expected return on the market por

> The Treasury bill rate is 4%, and the expected return on the market portfolio is 12%. Using the capital asset pricing model: a. Draw a graph similar to Figure 8.6 showing how the expected return varies with beta. b. What is the risk premium on the market

> True or false? a. If markets are efficient, shareholders should expect to receive only the risk-free interest rate on their investment. b. If markets are efficient, investment in the stock market is a mug’s game. c. If markets are efficient, investors sh

> Suppose that the Treasury bill rate is 6% rather than 2%. Assume that the expected return on the market stays at 9%. Use the betas in Table 8.2. a. Calculate the expected return from Johnson & Johnson. b. Find the highest expected return that is offered

> True or false? a. The CAPM implies that if you could find an investment with a negative beta, its expected return would be less than the interest rate. b. The expected return on an investment with a beta of 2.0 is twice as high as the expected return on

> True or false? Explain or qualify as necessary. a. Investors demand higher expected rates of return on stocks with more variable rates of return. b. The CAPM predicts that a security with a beta of 0 will offer a zero expected return. c. An investor who

> Portfolio beta Refer to Table 7.5. a. What is the beta of a portfolio that has 40% invested in ExxonMobil and 60% in Newmont? b. Would you invest in this portfolio if you had no superior information about the prospects for these stocks? Devise an alterna

> Look back at Problem 9 in Chapter 7. The risk-free interest rate in each of these years was as follows: a. Calculate the average return and standard deviation of returns for Ms. Sauros’s portfolio and for the market. Use these figures t

> For each of the following pairs of investments, state which would always be preferred by a rational investor (assuming that these are the only investments available to the investor): a. Portfolio A, r = 18% σ = 20%; portfolio B, r = 14% σ = 20%. b. Portf

> What is the beta of each of the stocks shown in Table 7.9?

> Portfolio risk Suppose that the standard deviation of returns from a typical share is about .40 (or 40%) a year. The correlation between the returns of each pair of shares is about .3. a. Calculate the variance and standard deviation of the returns on a

> True or false? a. Investors prefer diversified companies because they are less risky. b. If stocks were perfectly positively correlated, diversification would not reduce risk. c. Diversification over a large number of assets completely eliminates risk. d

> Here are the percentage returns on two stocks. a. Calculate the monthly variance and standard deviation of each stock. Which stock is the riskier if held on its own? b. Now calculate the variance and standard deviation of the returns on a portfolio that

> What does the efficient-market hypothesis have to say about these two statements? a. “I notice that short-term interest rates are about 1% below long-term rates. We should borrow short-term.” b. “I notice that interest rates in Japan are lower than rates

> Risk Premium Suppose that in year 2030, investors become much more willing than before to bear risk. As a result, they require a return of 8% to invest in common stocks rather than the 10% that they had required in the past. This shift in risk aversion c

> Here are inflation rates and U.S. stock market and Treasury bill returns between 1929 and 1933: a. What was the real return on the stock market in each year? b. What was the average real return? c. What was the risk premium in each year? d. What was the

> Arithmetic average and compound returns* Integrated Potato Chips (IPC) does not pay a dividend. Its current stock price is $150 and there is an equal probability that the return over the coming year will be –10%, +20%, or +50%. a. What is the expected pr

> Real versus nominal returns The Costaguana stock market provided a rate of return of 95%. The inflation rate in Costaguana during the year was 80%. In Ruritania the stock market return was 12%, but the inflation rate was only 2%. Which country’s stock ma

> Here are some historical data on the risk characteristics of Ford and Harley Davidson: Assume the standard deviation of the return on the market was 9.5%. a. The correlation coefficient of Ford’s return versus Harley Davidson is 0.30. W

> Go to the Excel spreadsheet versions of Table 6.2 and answer the following questions. a. New engineering estimates raise the possibility that capital investment will be more than $12 million, perhaps as much as $15 million. On the other hand, you believe

> Project NPV and IRR A project requires an initial investment of $100,000 and is expected to produce a cash inflow before tax of $26,000 per year for five years. Company A has substantial accumulated tax losses and is unlikely to pay taxes in the foreseea

> Project NPV Imperial Motors is considering producing its popular Rooster model in China. This will involve an initial investment of RMB 4 billion. The plant will start production after one year. It is expected to last for five years and have a salvage va

> Project NPV Marsha Jones has bought a used Mercedes horse transporter for her Connecticut estate. It cost $35,000. The object is to save on horse transporter rentals. Marsha had been renting a transporter every other week for $200 per day plus $1.00 per

> Two financial managers, Alpha and Beta, are contemplating a chart showing the actual performance of the Standard and Poor’s Composite Index over a five-year period. Each manager’s company needs to issue new shares of common stock sometime in the next yea

> Better Mousetrap’s research laboratories have developed a new trap. The project requires an initial investment in plant and equipment of $6 million. This investment will be depreciated straight-line over five years to a value of zero, b

> The following table tracks the main components of working capital over the life of a four-year project. Calculate net working capital and the cash inflows and outflows due to investment in working capital.

> Real and nominal flows Guandong Machinery are evaluating a new project to produce encapsulators. The initial investment in plant and equipment is RMB 500,000.15 Sales of encapsulators in year 1 are forecasted at RMB 200,000 and costs at RMB 100,000. Both

> Restate the net cash flows in Table 6.2 in real terms. Discount the restated cash flows at a real discount rate. Assume a 20% nominal rate and 10% expected inflation. NPV should be unchanged at +3,806, or $3,806,000.

> A forklift will last for only two more years. It costs $5,000 a year to maintain. For $20,000 you can buy a new forklift that can last for 10 years and should require maintenance costs of only $2,000 a year. a. If the discount rate is 4% per year, should

> You are operating an old machine that is expected to produce a cash inflow of $5,000 in each of the next three years before it fails. You can replace it now with a new machine that costs $20,000 but is much more efficient and will provide a cash flow of

> Hayden Inc. has a number of copiers that were bought four years ago for $20,000. Currently maintenance costs $2,000 a year, but the maintenance agreement expires at the end of two years, and thereafter, the annual maintenance charge will rise to $8,000.

> Economy-Cool air conditioners cost $300 to purchase, result in electricity bills of $150 per year, and last for five years. Luxury Air models cost $500, result in electricity bills of $100 per year, and last for eight years. The discount rate is 21%. a.

> You can purchase an optical scanner today for $400. The scanner provides benefits worth $60 a year. The expected life of the scanner is 10 years. Scanners are expected to decrease in price by 20% per year. Suppose the discount rate is 10%. 1. Should you

> Deutsche Transport can lease a truck for four years at a cost of €30,000 annually. It can instead buy a truck at a cost of €80,000, with annual maintenance expenses of €10,000. The truck will be sold at the end of four years for €20,000. Ignore taxes. a.

> Here again are the five lessons of market efficiency. For each lesson give an example showing the lesson’s relevance to financial managers. a. Markets have no memory. b. Trust market prices. c. Read the entrails. d. The do-it-yourself alternative. e. See

> In 2022, the California Air Resources Board (CARB) started planning its “Phase 3” requirements for reformulated gasoline (RFG). RFG is gasoline blended to tight specifications designed to reduce pollution from motor vehicles. CARB consulted with refiners

> Suppose that Sudbury Mechanical Drifters is proposing to invest $10 million in a new factory. It can depreciate this investment straight-line over 10 years. The tax rate is 40%, and the discount rate is 10%. a. What is the present value of Sudbury’s depr

> In the International Mulch and Compost example (Section 6-3), we assumed that early losses on the project could be used to offset taxable profits elsewhere in the corporation. Suppose that the losses had to be carried forward and offset against future ta

> Consider the following two projects: a. If the opportunity cost of capital is 11%, which of these two projects would you accept (A, B, or both)? b. Suppose that you can choose only one of these two projects. Which would you choose? The discount rate is s

> Plot the NPVs for the following projects for discount rates from 0% to 30%: a. Which one of these projects has no IRR? b. One of the projects has two IRRs. Which is this project and what are the IRRs? c. What are the IRRs of the other two projects? d. Su

> Consider the following two mutually exclusive projects: a. Calculate the NPV of each project for discount rates of 0%, 10%, and 20%. Plot these on a graph with NPV on the vertical axis and discount rate on the horizontal axis. b. What is the approximate

> Respond to the following comments: a. “I like the IRR rule. I can use it to rank projects without having to specify a discount rate.” b. “I like the payback rule. As long as the minimum payback period is short, the rule makes sure that the company takes

> Look up Intel (INTC), Oracle (ORCL), and HP (HPQ) on finance.yahoo.com. Rank the companies’ forward P/E ratios from highest to lowest. What are the possible reasons for the different ratios? Which of these companies appears to have the most valuable grow

> Look up General Mills (GIS), Kellogg (K), Campbell Soup (CPB), and Seneca Foods (SENEA). a. What are the current P/E and P/B ratios for these food companies? What are the dividend and dividend yield for each company? b. What are the growth rates of EPS a

> Here are forecasts for next year for two stocks: a. What are the dividend payout ratios for each firm? b. What are the expected dividend growth rates for each stock? c. If investors require a return of 15% on each stock, what are their values?

> Give two or three examples of research results or events that raise doubts about market efficiency. Briefly explain why.

> True or false? a. All stocks in an equivalent-risk class are priced to offer the same expected rate of return. b. The value of a share equals the PV of future dividends per share. c. The value of a share equals the PV of earnings per share assuming the f

> Look up P/E and P/B ratios for Entergy (ticker symbol ETR), using Yahoo! Finance or another Internet source. Calculate the same ratios for the following potential comparables: American Electric Power (AEP), CenterPoint Energy (CNP), and Southern Company

> Stock quotes Go to finance.yahoo.com and get trading quotes for IBM. a. What is the latest IBM stock price and market cap? b. What is IBM’s dividend payment and dividend yield? c. What is IBM’s trailing P/E ratio? d. Calculate IBM’s forward P/E ratio usi

> Here is a small part of the order book for Mesquite Foods: a. Georgina Sloberg submits a market order to sell 100 shares. What price will she receive? b. Norman Pilbarra submits a market order to buy 400 shares. What is the maximum price that he will pay

> a. “I would like to sell 1000 shares of Walmart at best.” b. “I would like to buy 500 shares of Hattersley at $50 or better.” Which of these is a limit order and which is a market order? If the price of Walmart is $50 and the price of Hattersley is $60,

> Phoenix Corp. faltered in the recent recession but is recovering. Free cash flow has grown rapidly. Forecasts made in 2019 are as follows: Phoenix’s recovery will be complete by 2024, and there will be no further growth in net income or

> Permian Partners (PP) produces from aging oil fields in west Texas. Production is 1.8 million barrels per year in 2018, but production is declining at 7% per year for the foreseeable future. Costs of production, transportation, and administration add up

> True or false? a. The bid price is always greater than the ask price. b. An investor who wants to sell his stock immediately should enter a limit order. c. The sale of shares by a large investor usually takes place in the primary market. d. Electronic Co

> Write a spreadsheet program to construct a series of bond tables that show the present value of a bond given the coupon rate, maturity, and yield to maturity. Assume that coupon payments are semiannual and yields are compounded semiannually.

> A bond’s credit rating provides a guide to its price. In the fall of 2017 Aaa bonds yielded 3.6% and Baa bonds yielded 4.3%. If some bad news causes a 10% five-year bond to be unexpectedly downrated from Aaa to Baa, what would be the effect on the bond

> True or false? The efficient-market hypothesis assumes that: a. There are no taxes. b. There is perfect foresight. c. Successive price changes are independent. d. Investors are irrational. e. There are no transaction costs. f. Forecasts are unbiased.

> The following table shows the prices of a sample of Narnian Treasury strips in December 2018. Each strip makes a single payment of $1,000 at maturity. a. Calculate the annually compounded, spot interest rate for each year. b. Is the term structure upward

> Look again at the bonds in part (b) of Problem 24. a. Explain intuitively why the yield to maturity on the 10% bond is less than that on the 5% bond. b. What should be the yield to maturity on a five-year zero-coupon bond? c. Show that the correct yield

> Choose 10 U.S. Treasury bonds with different coupons and different maturities. Calculate how their prices would change if their yields to maturity increased by 1 percentage point. Are long- or short-term bonds most affected by the change in yields? Are h

> Bond prices and yields In November 2017, Treasury 4¾s of 2041 offered a semiannually compounded yield to maturity of 2.6%. Recognizing that coupons are paid semiannually, calculate the bond’s price.

> The following statements are true. Explain why. a. If a bond’s coupon rate is higher than its yield to maturity, then the bond will sell for more than face value. b. If a bond’s coupon rate is lower than its yield to maturity, then the bond’s price will

> A 10-year bond is issued with a face value of $1,000, paying interest of $60 a year. If interest rates increase shortly after the bond is issued, what happens to the bonds: a. Coupon rate? b. Price? c. Yield to maturity?

> A bank loan requires you to pay $70,000 at the end of each of the next eight years. The interest rate is 8%. a. What is the present value of these payments? b. Calculate for each year the loan balance that remains outstanding, the interest payment on the

> Annuities due A store offer two payment plans. Under the installment plan, you pay 25% down and 25% of the purchase price in each of the next 3 years. If you pay the entire bill immediately, you can take a 10% discount from the purchase price. a. Which i

> The $40 million lottery prize that you have just won actually pays out $2 million a year for 20 years. The interest rate is 8%. a. If the first payment comes after 1 year, what is the present value of your winnings? b. What is the present value if the fi

> Lofting Snodbury is considering investing in a new boring machine. It costs $380,000 and is expected to produce the following cash flows: If the cost of capital is 12%, what is the machine’s NPV?

> Some extreme bubbles are obvious with hindsight, after they burst. But how would you define a bubble? There are many examples of good news and rising stock prices, followed by bad news and falling stock prices. Can you set out rules and procedures to dis

> a. If the present value of $139 is $125, what is the discount factor? b. If that $139 is received in year 5, what is the interest rate?

> In the five years preceding the end of 2016, the price of Amazon shares rose by 34% a year. If you had invested $100 in Amazon at the beginning of this period, how much would you have by the end of the period?