DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to ... Accounting MCQs | Accounting MCQs

DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.
? Issue $15 million of 20-year bonds at a price of $101, with a coupon rate of 8%, and flotation costs of 2% of par.
? Use $35 million of funds generated from earnings.
? The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.
The capital asset pricing model (CAPM) computes the expected return on a security by adding the risk-free rate of return to the incremental yield of the expected market return, which is adjusted by the company’s beta. Compute DQZ’s expected rate of return.

9.20%7.20%7.20%12.00%Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (A) is correct. The market return (RM), given as 12%, minus the risk-free rate (RF), given as 5%, is the market risk premium. It is the rate at which investors must be compensated to induce them to invest in the market. The beta coefficient (?) of an individual stock, given as 60%, is the correlation between volatility (price variation) of the stock market and the volatility of the price of the individual stock. Consequently, the expected rate of return is 9.20% [RF + ? (RM – RF) = .05 + .6(.12 – 0.05)].