1. Suppose that your company is expected to pay a dividend of $1.70/share next y

Question

1. Suppose that your company is expected to pay a dividend of $1.70/share next year. There has been a steady growth in dividends of 5.1%/year and the market expects that to continue. The current price is $35. What is the cost of equity? a) 0.100 b) 0.200 c) 0.015 d) 0.001 2. W hich one of the following is best classified as unsystematic risk? a) An unexpected recessionary period b) An unexpected increase in interest rates c) An unexpected decline in the sales of a firm d) A sudden increase in the inflation rate 3. The goal of diversification is to eliminate: a) Total risk. b) The market risk premium. c) Systematic risk d) Unsystematic risk. 4. Which one of the following has a rate of return that is used as a proxy for the risk-free rate? a) Treasury notes (short-term government securities) b) Large-company stocks c) Long-term corporate bonds d) Inflation, as measured by the consumer price index 5. A risk premium is defined as a) The expected market return b) The premium you have to pay for investing in risky assets c) The premium you have to pay for investing in assets that have high returns with low risk. d) The extra return received on an asset above the risk free rate 6. What is the Beta of the market? a) d) Depends on the systematic risk in the market risk in the market 7. The cost of capital for a project should

Explanation / Answer

1.

Correct option is > a) 0.10

Cost of equity = (Expected dividend / Current stock price) + Growth Rate

Cost of equity = (1.7/35) + 5.1%

Cost of equity = 0.10

2.

Correct option is > c) An unexpected decline in sales of a firm

The firm specific risk can be classified as unsystematic risk and decline in sales of a firm is firm specific.

3.

Correct option is > d) Unsystematic risk

Diversification can theoretically eliminate the unsystematic risk. By investing in many securities, we can diversify the portfolio to eliminate unsystematic risk.

4.

Correct option is > a) Treasury notes (short-term government securities)

Government securities represent risk free rate.

5.

Correct option is > d) The extra return received on an asset above the risk-free rate

6.

Correct option is > b) 1

Beta of Market is always 1. Individual security can have market beta less than, more than or equal to one.

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