21
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4) The Market’s average historical excess return is closest to:
A) -2.50%
B) -3.33%
C) -4.33%
D) -5.17%
5) Wyatt Oil’s excess return for 2009 is closest to:
A) 18.6%
B) 19.6%
C) 20.0%
D) 21.5%
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6) The Market’s excess return for 2008 is closest to:
A) -40.0%
B) -38.5%
C) -37.0%
D) -34.1%
7) Using the average historical excess returns for both Wyatt Oil and the Market portfolio, your
estimate of Wyatt Oil’s Beta is closest to:
A) 0.75
B) 0.84
C) 1.00
D) 1.19
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8) Using the average historical excess returns for both Wyatt Oil and the Market portfolio
estimate of Wyatt Oil’s Beta. When using this beta, the alpha for Wyatt oil in 2007 is closest to:
A) -0.5000%
B) -0.0250%
C) -0.0125%
D) +0.0250%
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9) Using just the return data for 2009, your estimate of Wyatt Oil’s Beta is closest to:
A) 0.84
B) 0.87
C) 1.00
D) 1.16
10) Using just the return data for 2008, your estimate of Wyatt Oil’s Beta is closest to:
A) 0.85
B) 0.87
C) 1.00
D) 1.17
28
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11) Which of the following statements is FALSE?
A) Beta is the expected percent change in the excess return of the security for a 1% change in the
excess return of the market portfolio.
B) Beta represents the amount by which risks that affect the overall market are amplified for a
given stock or investment.
C) It is common practice to estimate beta based on the historical correlation and volatilities.
D) Beta measures the diversifiable risk of a security, as opposed to its market risk, and is the
appropriate measure of the risk of a security for an investor holding the market portfolio.
12) Which of the following statements is FALSE?
A) One difficulty when trying to estimate beta for a security is that beta depends on the
correlation and volatilities of the security’s and market’s returns in the future.
B) It is common practice to estimate beta based on the expectations of future correlations and
volatilities.
C) One difficulty when trying to estimate beta for a security is that beta depends on investors
expectations of the correlation and volatilities of the security’s and market’s returns.
D) Securities that tend to move less than the market have betas below 1.
13) Which of the following statements is FALSE?
A) Securities that tend to move more than the market have betas higher than 0.
B) Securities whose returns tend to move in tandem with the market on average have a beta of 1.
C) Beta corresponds to the slope of the best fitting line in the plot of the securities excess returns
versus the market excess return.
D) The statistical technique that identifies the bets-fitting line through a set of points is called
linear regression.
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Use the equation for the question(s) below.
Consider the following linear regression model:
(Ri – rf) = ai + bi(RMkt – rf) + ei
14) The bi in the regression
A) measures the sensitivity of the security to market risk.
B) measures the historical performance of the security relative to the expected return predicted
by the SML.
C) measures the deviation from the best fitting line and is zero on average.
D) measures the diversifiable risk in returns.
15) The ai in the regression
A) measures the sensitivity of the security to market risk.
B) measures the deviation from the best fitting line and is zero on average.
C) measures the diversifiable risk in returns.
D) measures the historical performance of the security relative to the expected return predicted
by the SML.
16) The ei in the regression
A) measures the market risk in returns.
B) measures the deviation from the best fitting line and is zero on average.
C) measures the sensitivity of the security to market risk.
D) measures the historical performance of the security relative to the expected return predicted
by the SML.
12.4 The Debt Cost of Capital
Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating AAA AA A BBB BB B CCC
Average Default Rate 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2%
Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%
Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31
1) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The corresponding risk-free rate is 3% and the market risk premium is
5%. Assuming a normal economy, the expected return on Wyatt Oil’s debt is closest to:
A) 3.0%
B) 3.5%
C) 4.9%
D) 5.5%
2) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The bondholders’ expected loss rate in the event of default is 70%.
Assuming a normal economy the expected return on Wyatt Oil’s debt is closest to:
A) 3.0%
B) 3.5%
C) 4.9%
D) 6.7%
3) Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of
7.0%, and a BBB rating. The bondholders’ expected loss rate in the event of default is 70%.
Assuming the economy is in recession, then the expected return on Wyatt Oil’s debt is closest to:
A) 3.5%
B) 4.9%
C) 5.5%
D) 7.0%
4) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The corresponding risk-free rate is 3% and the market risk premium is 6%.
Assuming a normal economy, the expected return on Rearden Metal’s debt is closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
5) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming a normal economy the expected return on Rearden Metal’s debt is closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
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6) Rearden Metal has a bond issue outstanding with ten years to maturity, a yield to maturity of
8.6%, and a B rating. The bondholders expected loss rate in the event of default is 50%.
Assuming the economy is in recession, then the expected return on Rearden Metal’s debt is
closest to:
A) 0.6%
B) 1.6%
C) 4.6%
D) 6.0%
7) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.
Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk
premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield
that these bonds will have to pay during average economic times is closest to:
A) 3.50%
B) 3.75%
C) 4.00%
D) 5.50%
8) Nielson Motors plans to issue 10-year bonds that it believes will have an BBB rating.
Suppose AAA bonds with the same maturity have a 3.5% yield. Assume that the market risk
premium is 5% and the expected loss rate in the event of default on the bonds is 60%. The yield
that these bonds will have to pay during a recession is closest to:
A) 3.50%
B) 3.75%
C) 4.00%
D) 5.50%
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12.5 A Project’s Cost of Capital
Use the following information to answer the question(s) below.
Consider the following information regarding corporate bonds:
Rating AAA AA A BBB BB B CCC
Average Default Rate 0.0% 0.1% 0.2% 0.45% 2.2% 5.5% 12.2%
Recession Default Rate 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0%
Average Beta 0.05 0.05 0.05 0.10 0.17 0.26 0.31
Company Market
Capitalization
($mm) Total
Enterprise
Value ($mm) Equity
Beta Debt
Rating
Taggart Transcontinental $4,500 8,000 1.1 BBB
Rearden Metal $3,800 7,200 1.3 AAA
Wyatt Oil $2,400 3,800 0.9 A
Nielson Motors $1,500 4,400 1.75 BB
1) Your estimate of the debt beta for Taggart Transcontinental would be:
A) 0.05
B) 0.10
C) 0.17
D) 1.00
2) Your estimate of the debt beta for Nielson Motors would be:
A) 0.10
B) 0.17
C) 1.00
D) 1.68
3) Your estimate of the asset beta for Taggart Transcontinental is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.71
4) Your estimate of the asset beta for Rearden Metal is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.71
5) Your estimate of the asset beta for Wyatt Oil is closest to:
A) 0.59
B) 0.66
C) 0.71
D) 0.90
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6) Your estimate of the asset beta for Nielson Motors is closest to:
A) 0.59
B) 0.66
C) 0.71
D) 1.75
7) Suppose that because of the large need for steel in building railroad infrastructure, Taggart
Transcontinental and Rearden Metal decide to form into one large conglomerate. Your estimate
of the asset beta for this new conglomerate is closest to:
A) 0.42
B) 0.59
C) 0.66
D) 0.68