Question

8. Stella has three investment options: Stock A, Stock B and Stock C. Stock A has an expected return of 14%, Stock B has an expected return of 18% and Stock C has an expected return of 8%.

The expected market return is 12%. Which stock should Stella purchase to maximize her systematic risk?

Group of answer choices

Stock B

Stock A

Stock C

Assume the current corporate income tax rate is 0%. If the rate were increased to 15%, how would this impact the after-tax cost of debt? All else equal, would firms be more or less likely to issue debt as opposed to equity?

Group of answer choices

After-tax cost of debt increases; firms are more likely to issue debt

After-tax cost of debt decreases; firms are less likely to issue debt

After-tax cost of debt increases; firms are more likely to issue debt

After-tax cost of debt decreases; firms are more likely to issue debt

Answer 1

8)

Expected Return on Stock = Risk Free Rate+Stock's Beta(Expected Return on Market-Risk Free Rate)

Therefore, Expected Return on each stock is based on its Beta.

Higher the Beta, Higher the Expected Return and HIGHER THE SYSTEMATIC RISK.

Therefore, TO maximize Systematic Risk, one should invest in the Stock with Highest Expected Return i.e. Stock B

After Tax Cost of Debt = Before Tax Cost of Debt*(1-Tax Rate)

Therefore, Higher the Tax Rate, Lower the After Tax Cost of Debt.

Lower the After Tax Cost of Debt, more likely the firm will be to issue debt.

Therefore, After Tax Cost of Debt DECREASES; firms are MORE likely to issue debt.