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Practice Problems – Hedging

Multiple Choice Questions

Question 1
The cost of capital is

(a) the minimum rate of return an investment project must generate in order to pay its
financing costs.
(b) the minimum rate of return an investment project must generate in order to pay its
financing costs plus a reasonable profit.
(c) the maximum rate of return an investment project must generate in order to pay its
financing costs.
(d) the maximum rate of return an investment project must generate in order to pay its
financing costs plus a reasonable profit.

Answer: A

Question 2
In the notation from the slides the weighted average cost of capital (WACC) is expressed as 𝐾 =
(1 − 𝜆)𝐾𝑒 + 𝜆(1 − 𝜏)𝑖. Which of these is correct?

A) The debt-to-equity ratio is λ


B) The tax rate is τ
C) The after-tax cost of debt capital is i
D) all of the options

Answer: B

Question 3
In the notation from the slides the weighted average cost of capital (WACC) is expressed as 𝐾 =
(1 − 𝜆)𝐾𝑒 + 𝜆(1 − 𝜏)𝑖. Which of these is correct?

A) The debt-to-total market value ratio is λ


B) The pre-tax cost of debt is (1 − 𝜏)𝑖
C) The after-tax cost of debt capital is i
D) all of the options

Answer: A

Question 4
Solve for the weighted average cost of capital. 𝐾𝑒 = 10.6% (cost of equity for the leveraged
1
firm). 𝜆 = 3. 𝑖 = 8.0%. 𝜏 = 40.0%.

(a) 8.67 percent


(b) 8.00 percent
(c) 7.60 percent
(d) 7.33 percent

Answer: A

Explanation: 𝐾 = (1 − 0.33)(0.106) + 0.33(1 − 0.4)(0.08) = 0.0867

Question 5
Solve for the weighted average cost of capital. 𝐾𝑒 = 11.2% (cost of equity for the leveraged
1
firm). 𝜆 = 2. 𝑖 = 8.0%. 𝜏 = 40.0%.

11.20% = K1 = cost of equity capital for a leveraged firm


1/2 = Λ = debt-to-total-market-value ratio
8.0% = i = before-tax borrowing cost
40.0% = Τ = marginal corporate income tax rate

(a) 8.67 percent


(b) 8.00 percent
(c) 7.60 percent
(d) 7.33 percent

Answer: B

Explanation: 𝐾 = (1 − 0.5)(0.112) + 0.5(1 − 0.4)(0.08) = 0.08

Question 6
Norev Corp. has a weighted average cost of capital 7.6%. It has a cost of equity of 11.8% and an
after tax cost of debt of 4.8%. What does the capital structure of Norev look like?

(a) 30% debt, 70% equity


(b) 40% debt, 60% equity
(c) 60% debt, 40% equity
(d) 70% debt, 30% equity
(e) More information is needed to answer this question

Answer: C

Explanation: Use the WACC equation to solve for 𝜆 (debt to total market value).Note that
(1 − 𝜏)𝑖 = 0.048.

0.076 = (1 − 𝜆)(0.118) + 𝜆(0.048)

3
𝜆= 𝑜𝑟 0.6
5
Question 7
The cost of equity capital is

(a) the expected return on the firm's stock that investors require.
(b) frequently estimated by using the Capital Asset Pricing Model (CAPM).
(c) generally considered to be a linear function of the systematic risk inherent in the
security.
(d) all of the options

Answer: D

Question 8
A reduced cost of equity capital increases the firm's value

(a) through revaluation of the firm's existing cash flows from existing projects.
(b) through increased investment as more projects become positive NPVs.
(c) both of the options
(d) none of the options

Answer: C

Question 9
Suppose that the firm's cost of capital can be reduced from Kl under the local capital structure to
Kg under an internationalized capital structure. The take-away lesson from the graph is that,
(a) the firm can then increase its profitable investment outlay from 𝐼𝑙𝑜𝑐𝑎𝑙 to 𝐼𝑔𝑙𝑜𝑏𝑎𝑙
contributing to the firm's value.
(b) a reduced cost of capital increases the firm's value not only through increased
investments in new projects but also through revaluation of the cash flows from existing
projects.
(c) K local and K global represent, respectively, the cost of capital under local and
international capital structures; IRR represents the internal rate of return on investment
projects; 𝐼𝑙𝑜𝑐𝑎𝑙 and 𝐼𝑔𝑙𝑜𝑏𝑎𝑙 represent the optimal investment outlays under the alternative
capital structures.
(d) all of the options

Answer: A

Explanation: (b) and (c) are also correct statements; however, they are not the main takeaway
from the graph.

Question 9
The domestic country beta

(a) is always lower than its world beta.


(b) is normally smaller than the world beta.
(c) is normally higher than the world beta.
(d) is exactly equal to the world beta.

Answer: C

Explanation: (a) is incorrect as there are counterexamples (e.g., Petrobras as discussed in


class). However, for most countries and most firms the world beta tends to be lower than the
domestic beta.

Question 10
For a firm confronted with a fixed schedule of possible new investments, any policy that lowers
the firm's cost of capital will increase the profitable capital expenditures the firm takes on and
increase the wealth of the firm's shareholders. One such policy is

(a) internationalizing the firm's capital budgeting opportunities.


(b) internationalizing the firm's cost of capital.
(c) investing in riskier projects financed with debt.
(d) none of the options

Answer: B
This information is relevant for Questions 11, 12 and 13 below.

Correlation Coefficients
Stansfield England World 𝜎 𝐸(𝑟𝑖 )
Stansfield (S) 1.00 0.90 0.60 20% ?
England (E) 1.00 0.80 18% 14%
World (W) 1.00 15% 12%

Question 11
Compute the domestic country beta of Stansfield Bicycles as well as its world beta.

(a) 1.00 and 0.80 respectively


(b) 0.80 and 0.00 respectively
(c) 4.50 and 4.00 respectively
(d) none of the options
Answer: A
Explanation:
From the slides,
𝑐𝑜𝑣(𝑟𝑖 , 𝑟𝑚 )
𝛽𝑖 = 2
𝜎𝑚
We will use this formula to compute the beta domestic and world beta of Stansfield (S). The
domestic beta is a how sensitivity the returns on Stansfield are to movements in the returns on
the England market portfolio (E).

𝑐𝑜𝑣(𝑟𝐸 , 𝑟𝑆 )
𝑐𝑜𝑟𝑟(𝑟𝐸 , 𝑟𝑆 ) = ⇒ 𝑐𝑜𝑣(𝑟𝐸 , 𝑟𝑆 ) = 𝑐𝑜𝑟𝑟(𝑟𝐸 , 𝑟𝑆 )𝜎𝐸 𝜎𝑆 = 0.9(0.2)(0.18) = 0.0324
𝜎𝐸 𝜎𝑆

𝑐𝑜𝑣(𝑟𝑆 , 𝑟𝐸 ) 0.0324
𝛽𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 = = =1
𝜎𝐸2 (0.18)2

The world beta is a how sensitivity the returns on Stansfield are to movements in the returns on
the world market portfolio (W).

𝑐𝑜𝑣(𝑟𝑊 , 𝑟𝑆 )
𝑐𝑜𝑟𝑟(𝑟𝑊 , 𝑟𝑆 ) = ⇒ 𝑐𝑜𝑣(𝑟𝑊 , 𝑟𝑆 ) = 𝑐𝑜𝑟𝑟(𝑟𝑊 , 𝑟𝑆 )𝜎𝑊 𝜎𝑆 = 0.6(0.2)(0.15) = 0.018
𝜎𝑊 𝜎𝑆

𝑐𝑜𝑣(𝑟𝑆 , 𝑟𝑊 ) 0.018
𝛽𝑊𝑜𝑟𝑙𝑑 = 2 = = 0.8
𝜎𝑊 (0.15)2

Question 12
Suppose that the British stock market is segmented from the rest of the world. Using the CAPM
and a risk-free rate of 5 percent, estimate the equity cost of capital for Stansfield.
(a) 14 percent
(b) 12 percent
(c) 9 percent
(d) none of the options

Answer: A

Explanation: From Q11 we know that 𝛽𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 = 1.

𝐾𝑒 = 𝐸(𝑟𝑠 ) = 𝑟𝑓 + 𝛽𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 [𝐸(𝑟𝑒 ) − 𝑟𝑓 ] = 0.05 + 1.0[0.14 − 0.05] = 0.14 𝑜𝑟 14%

Question 13
Suppose that the British stock market is integrated with the rest of the world and Stansfield
Company has made its shares tradable internationally via cross-listing on the NYSE. Using the
CAPM and a risk-free rate of 5 percent, estimate the equity cost of capital for Stansfield.

(a) 12 percent
(b) 10.60 percent
(c) 6.60 percent
(d) None of the options

Answer: B

Explanation: It seems likely that Stansfield’s investors are globally diversified (as the British
market is integrated with the world economy and the cross-listing likely means Stansfield has
many foreign shareholders). Therefore, it seems appropriate to use the global CAPM to estimate
the cost of equity capital of Stansfield.

From Q11 we know that 𝛽𝑔𝑙𝑜𝑏𝑎𝑙 = 0.8,

𝐾𝑒 = 𝐸(𝑟𝑠 ) = 𝑟𝑓 + 𝛽𝑊𝑜𝑟𝑙𝑑 [𝐸(𝑟𝑊 ) − 𝑟𝑓 ] = 0.05 + 0.8[0.12 − 0.05] = 0.104 𝑜𝑟 10.6%

Question 14
The following is an outline of certain potential benefits as well as costs associated with the cross-
border listings of stocks:

(i) the company can expand its potential investor base


(ii) the company has to meet the exchange disclosure and listing requirements
(iii) creates a secondary market for the company's shares
(iv) volatility spillover from the overseas markets
(v) increased liquidity
(vi) control of the company by foreigners
(vii) enhances the visibility of the company's name and its products in foreign marketplaces

Which of the following represent all the potential benefits of the cross-border listings of stocks?

(a) (i), (ii), and (iii)


(b) (ii), (iv), and (vi)
(c) (i), (iii), (v), and (vii)
(d) (iv), (v), (vi), and (vii)
(e) (i), (ii) and (viii)

Answer: C

Question 15
A firm may cross-list its share to

(a) establish a broader investor base for its stock.


(b) establish name recognition in foreign capital markets, thus paving the way for the
firm to source new equity and debt capital from investors in different markets.
(c) expose the firm's name to a broader investor and consumer groups.
(d) all of the options

Answer: D

Question 16
Nestle has two classes of common stock:

1. Registered stock
2. Bearer stock

Until 1989, foreigners were not allowed to buy registered stocks. In the case of Nestlé this had
the effect of

(a) distorting the prices of registered stock downward.


(b) distorting the prices of registered stock upward.
(c) this had no effect on prices.
(d) none of the options

Answer: A

Question 17
If a firm lies within a country with ________ or ________ domestic capital markets, it can
achieve lower global cost and greater availability of capital with a properly designed and
implemented strategy to participate in international capital markets.

(a) liquid; segmented


(b) liquid; large
(c) illiquid; segmented
(d) large; illiquid

Answer: C

Question 17
Which of the following is NOT a key variable in the equation for the capital asset pricing model?

(a) the risk-free rate of interest


(b) the expected rate of return on the market portfolio
(c) the marginal tax rate
(d) All are important components of the CAPM.

Answer: C

Question 18
The difference between the expected (or required) return for the market portfolio and the risk-
free rate of return is referred to as:

(a) beta.
(b) the geometric mean.
(c) the market risk premium.
(d) the arithmetic mean.

Answer: C

Question 19
If a company fails to accurately predict it's cost of equity, then:

(a) the firm's WACC will also be inaccurate.


(b) the firm may not be using the proper interest rate to estimate NPV.
(c) the firm may incorrectly accept or reject projects based on decisions made using the
cost of capital computed with an incorrect cost of equity.
(d) All of the above are true.
(e) None of the above

Answer: D

Question 20
Which of the following will NOT affect a firm's beta?

(a) the choice of the market portfolio against which to compare the variability of a firm's
returns
(b) the choice of the risk-free security
(c) the choice of the time period used to calculate the firm's beta
(d) None of the above, because each of them affects the calculation of a firm's beta.

Answer: B

Question 21
Unsystematic risk:

(a) is the remaining risk in a well-diversified portfolio.


(b) is measured with beta.
(c) can be diversified away.
(d) all of the above

Answer: C

Question 22
Capital market segmentation is a financial market imperfection caused mainly by:

(a) government constraints.


(b) institutional practices.
(c) investor perceptions.
(d) all of the above

Answer: D
Short Answer Questions

Question 1
Suppose the domestic US beta of IBM is 1.0 (i.e.,βUS
IBM = 1). In addition, assume that the
̅ US = 0.12) and the risk-free rate,
expected return on the US market portfolio is 12 percent (R
which is proxied by the US T-Bill return, is 6%.

(a) If the US markets are segmented from the rest of the world, what is the expected return on
IBM stock?

Use the CAPM,

𝑅̅𝐼𝐵𝑀 = 𝑅𝑓 + 𝛽𝐼𝐵𝑀
𝑈𝑆
(𝑅̅𝑈𝑆 − 𝑅𝑓 ) = 6 + 1(12 − 6) = 12%

That is considering the domestic beta of IBM, investors would require a 12 percent return on
their investment in IBM stock.

(b) Suppose now that that US capital markets are integrated with the rest of the world and that
the world beta of IBM is 0.8 (βWIBM = 0.8). Further assume that the expected return on the world
equity portfolio is 12 percent. What is the expected return on IBM if capital markets are
integrated?

𝑅̅𝐼𝐵𝑀 = 𝑅𝑓 + 𝛽𝐼𝐵𝑀
𝑊
(𝑅̅𝑊 − 𝑅𝑓 ) = 6 + 0.8(12 − 6) = 10.8%

(c) Given your answers to (a) and (b) above, explain why it may be beneficial for firms to
internationalize their ownership structure.

In integrated capital markets (i.e., if the firm has an international ownership structure), investors
have diversified away some country specific risk which results in a lower cost of capital. A lower
cost of capital will enable the firm to (i) take on more value-enhancing projects and (ii) make
higher profits on existing projects. Both (i) and (ii) will increase shareholder value.

Question 2
Suppose that your firm is operating in a segmented capital market.

(a) What actions would you as the CEO of the firm recommend to mitigate the negative effects
of this?

A potential solution for this problem is to cross-list your firm’s stock in overseas markets like
London and New York that are not segmented. But you should be aware of the associated costs
such as the cost of adjusting financial statements, fees charged by the listing exchanges, etc.

(b) Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-
listed on foreign stock exchanges.
If a stock becomes internationally tradable upon overseas listing, the required return on the
stock is likely to go down because the shareholder base tends to be expanded across countries
and the stock will be priced according to the international systematic risk rather than the local
systematic risk. It is well known that for a typical stock, the international systematic risk is lower
than the local systematic risk.

(c) Discuss how the cost of capital is determined in segmented vs. integrated capital markets.

In segmented capital markets, the cost of capital will be determined essentially by the securities’
domestic systematic risks. In integrated capital markets, on the other hand, the cost of capital
will be determined by the securities’ world systematic risk, regardless of nationality.

(d) Discuss foreign equity ownership restrictions. Why do you think countries impose these
restrictions?

Many countries restrict the maximum fractional ownership of local firms by foreigners. Mostly,
these restrictions are imposed to ensure domestic control of local firms.

Question 3
Find the debt-to-value ratio for a firm with a debt-to-equity ratio of 1/2.

Value of the firm = Assets = Equity + Debt

We know that,

𝐷𝑒𝑏𝑡 1
=
𝐸𝑞𝑢𝑖𝑡𝑦 2

That is, for every one dollar of debt the firm has two dollars of equity. Thus,

𝐷𝑒𝑏𝑡 1
=
𝑉𝑎𝑙𝑢𝑒 3

Question 4
The firm's tax rate is 34 percent. The firm's pre-tax cost of debt is 8 percent; the firm's debt-to-
equity ratio is 4; the risk-free rate is 3 percent; the beta of the firm's common stock is 1.5; the
market risk premium is 9 percent. Calculate the weighted average cost of capital.

Use the CAPM to find the cost of equity,

𝐾𝑙 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅̅𝑓𝑖𝑟𝑚 = 𝑅𝑓 + 𝛽𝑓𝑖𝑟𝑚 (𝑅̅𝑀 − 𝑅𝑓 ) = 3 + 1.5(9) = 16.5%

𝐷𝑒𝑏𝑡 4
=
𝐸𝑞𝑢𝑖𝑡𝑦 1
Therefore,

𝐷𝑒𝑏𝑡 4
𝜆= = = 0.8
𝑉𝑎𝑙𝑢𝑒 5

𝑊𝐴𝐶𝐶 = (1 − 𝜆)𝐾𝑙 + 𝜆(1 − 𝜏)𝑖 = (1 − 0.8)(0.165) + (0.8)(1 − 0.34)(0.08) = 0.075

The firm’s cost of capital is 7.5%.

Question 5
Briefly explain the graph below,

𝐾𝑙𝑜𝑐𝑎𝑙 and 𝐾𝑔𝑙𝑜𝑏𝑎𝑙 represent, respectively, the cost of capital under local and international
capital structures respectively; IRR represents the internal rate of return on investment projects;
𝐼𝑙𝑜𝑐𝑎𝑙 and 𝐼𝑔𝑙𝑜𝑏𝑎𝑙 represent, respectively, the optimal investment outlays under local and
international capital structures. The figures implies that as the global cost of capital is lower, it
lowers the hurdle rate which leads to the firm accept more project and investing more.