Equity Cost of Capital and

Efficiency of Market (Portfolio)

Tutorial 5
1. 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. difference between the return on the market and the risk-free rate.
C. beta times the market risk premium.
D. beta times the risk-free rate.
E. market rate of return.

2. The best fit line of a pairwise plot of the returns of the security against
the market index returns is called the:
A. Security Market Line.
B. Capital Market Line.
C. Beta Line.
D. risk line.
E. None of the above.

3. Using the CAPM to calculate the cost of capital for a risky project
assumes that:
A. using the firm's beta is the same measure of risk as the project.
B. the firm is all-equity financed.
C. the financial risk is equal to business risk.
D. Both A and B.
E. Both A and C.

4. If the risk of an investment project is different than the firm's risk then:
A. you must adjust the discount rate for the project based on the firm's risk.
B. you must adjust the discount rate for the project based on the project
risk.
C. you must exercise risk aversion and use the market rate.
D. an average rate across prior projects is acceptable because estimates
contain errors.
E. one must have the actual data to determine any differences in the
calculations.

5. The beta of a security provides an:

A. estimate of the slope of the Capital Market Line.
B. estimate of the slope of the Security Market Line.
C. estimate of the market risk premium.
D. estimate of the systematic risk of the security.
E. None of the above.

6. Regression analysis can be used to estimate:

A. beta.
B. the risk-free rate.
C. standard deviation.
D. variance.
E. expected return.

7. Beta measures depend highly on the:

A. direction of the market variance.
B. overall cycle of the market.
C. variance of the market and asset, but not their co-movement.
D. covariance of the security with the market and how they are correlated.
E. All of the above.

8. The formula for calculating beta is given by dividing the ___________ of

the stock with the market portfolio by the ___________ of the market
portfolio.
A. variance; covariance
B. covariance; variance
C. standard deviation; variance
D. expected return; variance
E. expected return; covariance

9. Companies that have highly cyclical sales will have a:

A. low beta if sales are highly dependent on the market cycle.
B. high beta if sales are highly dependent on the market cycle.
C. high beta if sales are independent of the market cycle.
D. All of the above.
E. None of the above.

10. Betas may vary substantially across an industry. The decision to use
the industry or firm beta to estimate the cost of capital depends on:
A. whether the company is a leader or follower.
B. how similar the firm's operations are to the operations of all other firms
in the industry.
C. how small the estimation errors are of all betas across industries.
D. the size of the company's public float.
E. None of the above.
11. Beta is useful in the calculation of the:
A. company's variance.
B. systematic risk.
C. company's standard deviation.
D. unsystematic risk.
E. company's market rate.
12. The hypothesis that market prices reflect all public available
information is called:
A) Public Form of Efficiency
B) Strong Form Efficiency
C) Semi-Strong Form Efficiency
D) Semi-Weak Form Efficiency
E) Weak Form Efficiency
13. In Arbitrage Pricing Theory, a Factor is a variable that:
A. affects the returns of risky assets in a systematic fashion.
B. affects the returns of risky assets in an unsystematic fashion.
C. correlates with risky asset returns in a unsystematic fashion.
D. does not correlate with the returns of risky assets in a systematic
fashion.
E. None of the above.
14. What would not be true about a GNP beta?
A. If a stock's GDP = 1.5, the stock will experience a 1.5% increase for
every 1% surprise increase in GDP.
B. If a stock's GDP = -1.5, the stock will experience a 1.5% decrease for
every 1% surprise increase in GDP.
C. It is a measure of risk.
D. It measures the impact of systematic risk associated with GDP.
E. None of the above.

15. If the expected rate of inflation was 3% and the actual rate was 6.2%;
the systematic response coefficient from inflation, I, would result in a
change in any security return of ___ I.
A. 9.2
B. 3.2
C. -3.2
D. 3.0
E. 6.2
16. In a portfolio of risky assets, the response to a factor, Fi, can be
determined by:
A. summing the weighted i s and multiplying by the factor Fi.
B. summing the Fi s.
C. adding the average weighted expected returns.
D. summing the weighted random errors.
E. All of the above.

17. In a one factor (APT) model, the characteristic line to estimate i

passes through the origin, unlike the estimate used in the CAPM because:
A. the relationship is between the actual return on a security and the
market index.
B. the relationship measures the change in the security return over time
versus the change in the market return.
C. the relationship measures the change in excess return on a security
versus GNP.
D. the relationship measures the change in excess return on a security
versus the return on the factor about its mean of zero.
E. Cannot be determined without actual data.
18. The betas along with the factors in the APT adjust the expected return
for:
A. calculation errors.
B. unsystematic risks.
C. spurious correlations of factors.
D. differences between actual and expected levels of factors.
E. All of the above.

19. The single factor APT model that resembles the market model uses
_________ as the single factor.
A. arbitrage fees
B. GNP
C. the inflation rate
D. the market return
E. the risk-free return
20. For a diversified portfolio including a large number of stocks, the:
A. weighted average expected return goes to zero.
B. weighted average of the betas goes to zero.
C. weighted average of the unsystematic risk goes to zero.
D. return of the portfolio goes to zero.
E. return on the portfolio equals the risk-free rate.

Part 2

Use the following information to answer the question(s) below.

Asset
Division
Beta
Oil Exploration 1.4
Oil Refining 1.1
Gas & Convenience
Stores 0.8

Next Period's Expected Free

Cash
Flow ($mm)
450
525

Expected
Growth
Rate
4.0%
2.5%

600

3.0%

The risk-free rate of interest is 3% and the market risk premium is 5%.
1. What is the cost of capital for the oil exploration division?
13. What is the cost of capital for the oil refining division?
Expected Return
Oil Exploration
Oil Refining
Riskfree Rate

40.50%
20%
3%

Standard
Deviation
50%
25%
0%

Market

8%

7%

Beta

3.0
1.5
0

Base
Lending 3%
Rate (BLR) of a
Bank

0.1

The returns of Oil Exploration and Oil Refining are perfectly negatively
correlated. The correlation between the projects is -1.
3. If you want a zero risk portfolio, what proportions of Oil Exploration and
Oil Refining should you allocate your capital to?
4. Using Capital Asset Pricing Model, calculate the return of your zero-risk
portfolio?

5) Draw the risk return of Oil Exploration and Oil Refining on a chart.

Below are a simplified balance sheet for Firma A Ltd and the share
information for its FIRMA, at year end 2013.
Petrobus Balance Sheet (as of 31st December 2013, in $ millions)
2014
(in $ million)
ASSETS
Current Assets

2648

Fixed Asset

11.212

Total Assets

13,860

LIABILITIES AND STOCKHOLDER'S EQUITY

Total Current Liabilities

50

Noncurrent Liabilities
Long Term Debt

8,345

Total Liabilities

8,395

Shareholder's Equity

Shareholders Equity (in $Million)

Retained earnings

4,814
0

Total Stockholder's Equity

4,814

Total Liabilities and Stockholder's Equity

13,860

FIRMA Shares Information as at 31st December 2013

Bilangan saham biasa ( dalam juta)
Number of ordinary shares outstanding (in Millions)

263.4

Par Value of Share

$1.00

Harga saham
Price of the share

$44

The riskfree rate is 5.3% and the market return is 13.7%

The Beta of Stock A, Firm As stock is 0.72.
6. Calculate the market capitalization of Firma A.
7. Using CAPM, what is the equity cost of capital?