Q1. (20 marks total) True/False/Uncertain.
Read the statement carefully. Decide whether the statement is true, false or uncertain and explain
the arguments for your answer. Answers without an explanation will not receive credit. If the
answer you give is based on any assumptions, be sure to state them clearly. Otherwise, you may
not receive full marks for your answer.
Notice that answers without an explanation will not receive credit, even if the answer is
a) (5 marks) (Non-mutually exclusive) projects that are accepted when using the NPV rule
maybe rejected when applying the Internal Rate of Return criterion.
False. For an independent project, if the NPV of the project is positive, the internal rate of
return will be greater than the required rate of return of the project (assuming no multiple
IRRs), which means that applying the NPV rule or the IRR rule will lead to the same
b) (5 marks) Suppose a firm decreases its fixed costs and increases its variable costs, leaving the
EBIT unchanged. At the same time, it also raises debt to buy back shares. Then the firm's
required rate of return on equity remains constant.
False. The required rate of return on equity can go up or down. :s;
The operating leverage of the firm declines when the fixed costs decrease and the variable
costs increase. As a result, the firm’s beta decreases, so does the required rate of return on
equity.:t; However, rising debt to equity ratio increases the risk of equity, which
increases the required rate of return on equity. :t;
c) (5 marks) The liquidity of stocks refers to the cost of buying and selling stocks. To increase
the liquidity of equity, firms might want to increase the bid-ask spread to lower the cost of
False. Bid-ask spread is the difference between the bid price (the price a buyer is willing to
pay for a stock) and the ask price (the price a seller is willing to sell). The larger bid-ask
spread, the bigger transaction cost.
So firms have incentive to reduce the bid-ask spread to increase liquidity and hence to lower
the cost of capital.
d) (5 marks) If a firm uses a simple uniform hurdle rate for all investment project returns, then
over time on average, the firm's non-diversifiable risk will increase.
True. A firm should use different discount rates to evaluate different investment projects
according to the risk characteristics of projects. Using a simple uniform hurdle rate might