ECO 359 Practice Problems 2
(Some questions are from your textbook)
1. Consider the example from the lecture slides on “Alternative Rules of Investment”, slide 9
(“The timing problem”).
(a) Which project are you supposed to choose when using the IRR ranking rule?
(b) Assume that the required rate of return is 10%. Show that when using the NPV rule to
rank the projects, the ranking that you found in (a) is reversed (that is, you would choose a
(c) What implicit assumption did you make in (a) when ranking the projects? How about (b)?
2. Furniture Depot, Inc. is an all-equity firm with a beta of 0.95. The market risk premium is 9%
and the risk-free rate is 5%. The company is considering a project that will generate annual
after-tax flows of $340,000 at year-end for five years. The project requires an immediate
investment of $1.2 million. If the project has the same risk as the firm as a whole, should
Furniture Depot undertake the project?
3. Consider a levered firm's projects that have similar risks to the firm as a whole. Is the discount
rate for the projects the same as, higher, or lower than the rate computed using the security
market line? Why?
4. What are the main factors that determine the beta of a stock? Define and describe each.
5. A stock has an expected return of 17%, a beta of 1.9, and the expected return on the market is
11 percent. What must the risk free rate be?
6. True or False: “A risky security cannot have an expected return that is less than the risk-free
7. If you use the stock beta and the security market line to compute the discount rate for a
particular project, which assumption are you implicitly making?
8. Lang Cosmetics is evaluating a project to produce a perfume line. Lang currently produces no
body-scent products and is an all-equity firm.
(a) Should Lang Cosmetics use its stock beta to evaluate the project?
(b) How should Lang Cosmetics compute the appropriate beta to evaluate the
9. The Dybvig Corporation's common stock has a beta of 1.3. If the risk-free rate is 4.5% and the
expected return on the market is 12%, what is Dybvig's cost of equity capital?