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Corporate Finance, 12e (Ross)
1) The cost of capital used to compute the present value of a project should be the rate that can
be earned on:
A) the overall market portfolio.
B) the sponsoring firm's return on assets.
C) a financial asset of comparable risk.
D) a riskless asset with a similar life span.
E) the sponsoring firm's return on equity.
2) If the CAPM is used to estimate the cost of equity capital, the expected excess market return is
equal to the:
A) return on the stock minus the risk-free rate.
B) return on the market minus the risk-free rate.
C) beta times the market risk premium.
D) beta times the risk-free rate.
E) market rate of return.
3) The issuance of stock to fund a project tends to:
A) have no effect on the previous shareholders.
B) create costless benefits for the firm.
C) cause any potential gains to the firm from the project to be lost.
D) affect future dividends but not the appreciation realized by previous shareholders.
E) dilute the capital gains that would have been earned by the previous shareholders.
4) A project with the same level of risk as an all-equity firm should be accepted if the project's:
A) internal rate of return exceeds the firm's cost of equity capital.
B) expected rate of return exceeds the market rate of return.
C) anticipated rate of return exceeds the firm's return on assets.
D) internal rate of return is positive given this level of risk.
E) expected rate of return exceeds the risk-free rate.
5) Which one of these statements is correct concerning the CAPM?
A) The CAPM is the only available method for determining an appropriate discount rate for a
proposed project.
B) The market rate of return is most commonly based on the forecasted return on the market for
the next 5-year period.
C) CAPM is used quite frequently by firms in their capital budgeting process.
D) The expected return on the 30-year U.S. Treasury bond is the most commonly used as the
risk-free rate of return.
E) An increase in the risk-free rate combined with a beta greater than 1.0 increases the discount
rate computed using the CAPM.
6) When estimating the cost of equity using the DDM, the factor that is the most apt to add error
to this estimate is the:
A) value of the last dividend.
B) firm's tax rate.
C) historical beta.
D) dividend growth rate.
E) current stock price.
7) Which one of these statements related to beta is correct?
A) Firm betas have less error than industry betas.
B) Firms should always rely on their own beta rather than their industry's beta.
C) Beta is unaffected by a firm's capital structure.
D) The sample size used to compute beta may be too small to yield a reliable result.
E) Firm betas rarely vary over time.
8) The beta of a security is calculated as: (________ of a security's return with the return on the
market portfolio/________).
A) Variance; Covariance of the market return
B) Covariance; Variance of the market return
C) Covariance; Standard deviation of the market return
D) Variance; Covariance of the security return
E) Covariance; Variance of the security return
9) Assume you plot the monthly returns for a stock and also for the S&P 500. Using regression
analysis, the straight line through these points that is developed by the analysis is referred to as
the ________ which has a slope of ________ and an intercept of ________.
A) security market line; alpha; gamma
B) characteristic line; beta; alpha
C) characteristic line; alpha; beta
D) security market line; beta; gamma
E) characteristic line; gamma; alpha
10) Companies will generally have a ________ beta if their:
A) low; stock price is relatively low.
B) high; sales are highly dependent on the market cycle.
C) high; sales are growing at a steady rate of increase.
D) high; sales are high compared to other firms in their industry.
E) low; production costs are primarily fixed in nature.
11) If a firm increases its use of both operating and financial leverage, then you should expect
the firm's:
A) asset beta to exceed its equity beta.
B) beta of debt to exceed 1.0.
C) beta to remain constant as the increased operating leverage will offset the increased financial
leverage.
D) equity beta to increase.
E) debt beta to exceed its equity beta.
12) The beta of debt is commonly considered to be:
A) equal to the market beta.
B) one-half of the equity beta.
C) equal to the asset beta.
D) zero.
E) one.
13) Comparing two otherwise equivalent firms, the beta of the common stock of the levered firm
is ________ the beta of the common stock of the unlevered firm.
A) roughly equivalent to
B) significantly less than
C) slightly less than
D) greater than
E) equal to
14) The beta of a firm is more likely to be high under which two conditions?
A) High cyclical business activity and low operating leverage
B) High cyclical business activity and high operating leverage
C) Low cyclical business activity and low financial leverage
D) Low cyclical business activity and low operating leverage
E) Low financial leverage and low operating leverage
15) A firm with cyclical earnings is characterized by:
A) revenue patterns that vary with the business cycle.
B) high levels of debt in its capital structure.
C) high fixed costs.
D) high costs per unit.
E) low contribution margins.
16) A firm with high operating leverage has:
A) low fixed costs in its production process.
B) high variable costs in its production process.
C) high fixed costs in its production process.
D) high total costs per unit.
E) low total costs per unit.
17) Assume LK Metals is similar to its industry with one exception; it has low fixed costs
relative to all other firms in that industry. Given this, you should expect LK Metals to have:
A) a lower beta than its industry.
B) the same beta as the industry but a lower beta than the other firms in the industry.
C) a higher beta than its industry.
D) a higher beta than the industry and all the firms within that industry.
E) the same beta as the industry but a higher beta than the other firms in the industry.
18) The use of leverage:
A) increases both the asset and the equity betas.
B) decreases both the asset and the equity betas.
C) decreases the equity beta and increases the asset beta.
D) increases the equity beta but does not affect the asset beta.
E) decreases the equity beta but does not affect the asset beta.
19) An industry is likely to have a low beta if the:
A) stream of revenues within that industry is less volatile than the market.
B) economy is in a recessionary period.
C) market for its goods is highly affected by the market cycle.
D) number of firms within the industry is fairly constant.
E) industry tends to use a lot of debt financing.
20) For a levered firm the equity beta is ________ the asset beta.
A) greater than
B) less than
C) equal to
D) sometimes greater than and sometimes less than
E) unrelated to
21) The CAPM has an advantage over DDM because the CAPM:
A) explicitly adjusts for risk.
B) applies to firms that pay dividends.
C) has no measurement risk.
D) specifically considers a firm's rate of growth.
E) ignores changes in the overall market over time.
22) Which one of these is a correct means of calculating an expected rate of growth?
A) ROA × Dividend payout ratio
B) ROE × Profit margin
C) ROA × Retention ratio
D) ROA × Profit margin
E) ROE × Retention ratio
23) Lesco's is evaluating a project that has a different level of risk than the overall firm. This
project should be evaluated:
A) using the market beta.
B) using the overall firm's beta.
C) using a beta commensurate with the project's risks.
D) at the market rate of return.
E) at the T-bill rate of return.
24) The discount rate applied to an individual project should be based on the:
A) sources of funding for that project.
B) risks associated with the project's cash flows.
C) sponsoring firm's average level of risk.
D) expertise of the project's managers.
E) size and duration of the project's life.
25) If a firm applies its overall firm's beta to projects with varying levels of risk, the firm will
tend to:
A) reject the riskiest projects.
B) accept all low-risk projects.
C) accept only projects of equal risk to its current operations.
D) remain at its current level of overall risk.
E) become riskier over time.
26) JR's is preparing to start a new project in an industry that differs significantly from its current
operations. JR's has searched and found the beta of a firm that is a good fit as a pure play for this
new project. Given this good fit, why might JR's assign a higher beta to the project than the beta
of the pure play?
A) JR's should assign a project beta that is based on the average of JR's and the pure play firm's
betas.
B) The expected project revenues may be less cyclical than those of the pure play firm.
C) JR's may use less debt in its operations than does the pure play firm.
D) The pure play firm has more experience in the new area than JR's does.
E) The project may incur flotation costs so a higher beta is warranted to offset the additional
cost.
27) The cost of preferred stock:
A) should be adjusted for taxes when computing WACC.
B) is ignored by all firms when computing WACC.
C) is generally calculated using the overall firm's beta.
D) is equal to the stock's dividend yield.
E) is set equal to the pretax cost of debt since it is a fixed income security.
28) Lewis Bros. currently has outstanding debt but has decided to issue additional debt for
expansion purposes. The pretax cost of the new debt is best estimated at the ________ of the
currently outstanding debt.
A) original yield to maturity
B) current yield to maturity
C) embedded cost
D) current yield
E) coupon rate
29) As of 2018, U.S. tax law limits the tax deduction for interest payments to 30 percent of:
A) EBIT.
B) EBT.
C) net income.
D) net revenue.
E) the total interest paid.
30) When computing WACC, you should use the:
A) pretax cost of debt because most corporations pay taxes at the same tax rate.
B) pretax cost of debt because it is the actual rate the firm is paying its bondholders.
C) current yield because it is based on the current market price of debt.
D) aftertax cost of debt because interest is partially, if not fully, tax deductible.
E) pretax yield to maturity because it considers the current market price of debt.
31) When computing the weighted average cost of capital, which of these are adjusted for taxes?
A) Cost of equity
B) Cost of preferred stock
C) Both the cost of equity and the cost of preferred stock
D) The costs of debt and preferred stock
E) Cost of debt
32) All else held constant, which one of these is most apt to increase the WACC of a levered
firm?
A) An increase in the weight of debt
B) A decrease in a firm's equity beta
C) A decrease in the dividend growth rate
D) A decrease in the tax rate
E) An increase in the risk-free rate when the equity beta exceeds 1.0
33) The weighted average cost of capital for a firm is the:
A) discount rate which the firm should apply to all the projects it undertakes.
B) overall rate which the firm must earn on its existing assets to maintain the value of its stock.
C) rate the firm should expect to pay on its next bond issue.
D) maximum rate which the firm should require on any projects it undertakes.
E) rate of return that the firm's preferred stockholders should expect to earn over the long term.
34) A firm's WACC can be correctly used to discount the expected cash flows of a new project
when that project will:
A) have the same level of risk as the firm's current operations.
B) be financed solely with new debt and internal equity.
C) be managed by the firm's current managers.
D) be financed based on the firm's current debt-equity ratio.
E) be financed solely with internal equity.
35) When valuing a firm financed with debt and equity, the individual cash flows should be
discounted using:
A) the market rate of return.
B) the average of the DDM and CAPM costs of equity.
C) (1 + WACC)T.
D) (1 + CAPM)T.
E) (r − g).
36) The terminal value of a firm is also commonly referred to as the:
A) final value.
B) cash value.
C) non-constant value.
D) estimated value.
E) horizon value.
37) A firm's net cash flow is calculated as:
A) EBIT − Taxes + Depreciation − Capital spending − Increases in net working capital.
B) EBIT + Taxes + Depreciation − Capital spending − Increases in net working capital.
C) EBIT − Taxes − Depreciation − Capital spending + Increases in net working capital.
D) EBIT − Taxes + Depreciation + Capital spending − Increases in net working capital.
E) EBIT + Taxes + Depreciation − Capital spending + Increases in net working capital.
38) Assume a levered firm plans to raise new capital to finance a project. To properly account for
the flotation costs, the firm should:
A) subtract the pretax flotation cost from the project's NPV.
B) deduct the amount of the flotation cost from the cash flows for Year 1 of the project.
C) add the percentage of the flotation cost to the WACC when discounting the cash flows.
D) divide the amount of project capital needed by (1 − Weighted average flotation cost).
E) increase the target weights of both debt and equity to account for the flotation percentage.
39) When calculating the weighted average flotation cost, the weights should be based on the:
A) mix of debt and equity that will be used to finance the specific project.
B) firm's target capital structure.
C) percentages of internal and external financing that will be used for the project.
D) firm's current mix of debt and equity.
E) average amounts of external capital raised during the past twelve months.
40) The flotation cost of internal equity is:
A) assumed to be zero.
B) assumed to be the same as the cost of external equity.
C) assigned a cost equal to the aftertax cost of equity.
D) assumed to be the same as the firm's return on equity.
E) assigned a cost equal to the risk-free rate.
41) Consolidated Transfer is an all-equity financed firm. The beta is .75, the market risk
premium is 7.78 percent, and the risk-free rate is 3.84 percent. What is the expected rate of return
on this stock?
A) 6.80 percent
B) 8.22 percent
C) 9.54 percent
D) 9.68 percent
E) 8.46 percent
42) What is the cost of equity for a firm that has a beta of 1.2 if the risk-free rate of return is 2.9
percent and the expected market return is 11.4 percent?
A) 13.1 percent
B) 10.8 percent
C) 12.8 percent
D) 14.4 percent
E) 13.6 percent
43) Albert's recently paid its annual dividend of $1.98 per share. At that time, the firm
announced that all future dividends will be increased by 2.2 percent annually. What is the firm's
cost of equity if the stock is currently selling for $28.40 a share?
A) 9.33 percent
B) 11.32 percent
C) 10.47 percent
D) 11.08 percent
E) 10.06 percent
44) Winslow and Sons is expected to pay an annual dividend of $1.35 per share one year from
now with future increases of 2.5 percent annually. The stock currently sells for $14.70 a share.
What is the cost of equity?
A) 13.48 percent
B) 12.29 percent
C) 12.60 percent
D) 11.68 percent
E) 13.23 percent
