Corporate Finance Exam 1

One would expect a stock with a beta of 1.25 to increase returns

25% more than the market in up markets

Suppose a firm sets aside assets to protect particular investors. These assets are called

collateral

Which portfolio has had the highest average risk premium during the period 1900-2017?

common stocks

A corporate bond that can be exchanged for a fixed number of shares of stock is called a

convertible bond

A "factor" in APT is a variable that

correlates with the returns of a risky assets in a systematic manner

the required return of preferred stock is equal to the _______ on the preferred stock

dividend yield

Weak-form efficiency implies that past stock returns

do not help predict future returns

The cost of capital is the same as the cost of equity for firms that are financed

entirely by equity

By combining lending and borrowing at the risk-free rate with efficient portfolios, we can

extend the range of investment possibilities, change the set of efficient portfolios from being curvilinear to a straight line, and provide a higher expected return for any level of risk, except for the tangential portfolio and the risk-free asset

An efficient portfolio is one that:

gives the highest return for a given level of risk and provides the least risk for a given level of expected return

The features of Municipal bonds make them attractive to high income, _________ bracket investors

high-tax

Preferred stock

is issued with a set dividend that will be paid each period forever

Different classes of stock are usually issued in order to

maintain ownership control, by holding the class of stock with greater voting rights

Beta is a measure of

market risk

If a bond is junior (or subordinated), it

must give preference to senior creditos in the event of default

If the expected rate of return =15% and the required rate of return found with the CAPM equation = 16% then the stock is:

overpriced the price must fall to make the required 16% return realistic

The rare event in which a firm's existing directors and management compete with outsiders for the effective control of the corporation is called a

proxy contest

A grant of authority allowing someone else to vote shares of stock that you own is called

proxy voting

A common criticism of the CAPM is that it

requires only a single measure of systematic risk

CAPM (or SML equation)

rf+B(rm-rf)

Preference in position among creditors when it comes to repayment is called

seniority

Generally, the CAPM calculations, the value to use for the risk-free interest rate is the

short-term US Treasury bill rate

As a provider of funds to a corporation, owning which of the following corporate securities will give you the strongest rights to cash flow?

short-term bank loan

One important implication of the EMH is that most investors

should avoid active trading

Suppose that a lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can "beat the market" by short selling the stock of firms that will be sued. This hypothetical finding would violate the

strong-form hypothesis of market efficiency

Market risk is also called:

systematic risk and undiversifiable risk

The stock return's beta measures

the change in the stock's return for a given change in the market return

the hurdle rate for capital budgeting decisions is

the cost of capital

A set of efficient portfolios is called

the efficient frontier

The type of risk that can be eliminated by diversification is called

unique risk

The number of stocks in a portfolio is increase:

unique risk decreases and approaches zero

Which of the following instruments gives the owner the right to purchase securities directly from the firm at a fixed price during a specified period of time?

warrant

Primary market

when a firm issues debt or equity, it is sold in this market -the firm receives the proceeds from the sale

For each additional 1% change in the market return, the return on a stock having a beta of 2.2 changes, on average, by

2.20%

The market value of equity equals

(Market price) * (# of shares outstanding)

The Sharpe ratio is

(rp-rf)/σp

For a two stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals:

-1.0

Alternative theories to CAPM

-Arbitrage Pricing Theory -Factor Model -Fama-French Three-Factor Model -Four Factor Model

Suppose that in year 2030, investors become much more willing than before to bear risk. As a result, they require a return of 9.9% to invest in common stocks rather than the 11.9% that they had required in the past. This shift in risk aversion causes a 16.9% change in the value of the market portfolio.

-Rise by 16.9% Investors require less expected return to offset the lower risk, so they are willing to pay more for the same level of future dividends.

secondary market

-after issuance, any further trading of debt/equity takes place here -one investor sells to another investor - no cash goes to the firm -this is a large majority of all trades that occur

Types of financial institutions

-banks -savings & loan companies -insurance companies -mutual funds -brokerages -investment banks

types of equity

-common stock -preferred stock

In order to test the weak form of the efficient-market hypothesis, researchers have used the following methods:

-estimation of the serial correlation (autocorrelation) for securities and markets -measurement of the profitability of trading rules used by technical analysts

types of debt

-loans -bonds -notes

functions of financial institutions

-payment mechanism -facilitate borrowing and lending -pooling risk

The correlation coefficient between the efficient portfolio and the risk free asset is

0.0

If the covariance between Stock A and Stock B is 100, the standard deviation of Stock A is 10% and that of Stock B is 20%, calculate the correlation coefficient between the two securities

0.5 Corr(a,b) = 100/(10*20) = +0.5

For any individual stock, there are two sources of risk:

1. the risk based on factors 2. the risk based on noise

If a standard deviation of returns on the market is 20% and the beta of a well-diversified portfolio is 1.5, calculate the standard deviation of this portfolio

30% All unique risk has been eliminated through diversification. Beat will measure the remaining market risk. Standard deviation of the portfolio = (1.5) * 20 = 30%

If the average annual rate of return for common stocks is 11.7% and 4% for US Treasury bills, what is the average market risk premium?

7.7% treasury bill yield rate is usually considered the risk free rate MRP= (E(rm)-rf)

A firm's target capital structure represents:

A fixed debt-equity ratio that the company attempts to maintain

Which of the following portfolios has the least risk?

A portfolio of treasury bills

The semistrong form of the efficient markets hypothesis has been tested by measuring how rapidly security prices react to various news items like I) earnings announcements; II) dividend announcements; III) news of takeovers; IV) macroeconomic information

All of them

When completing a large debt issue, financial managers of large firms will usually consider the following questions: I) Should the firm borrow short term or long term? II) Should the firm issue fixed- or floating-rate debt? III) Should the firm borrow in foreign currency

All of them

As a provider of funds to a corporation, owning which of the following corporate securities will give you the most control rights?

Common stock

Treasury issues are:

Exempt from state income taxes but, not federal income taxes

The statement that stock prices follow a random walk implies that I) successive price changes are independent of each other; II) successive price changes are positively related; III) successive price changes are negatively related; IV) the autocorrelation coefficient is either +1.0 or −1.0

I only

Which of the following is a statement of semistrong form efficiency? I) Stock prices will adjust immediately to public information. II) Stock prices reflect all information. III) Stock prices will adjust to newly published information after a long time delay.

I only

Which of the following is a statement of weak-form efficiency? I) If markets are efficient in the weak form, then it is impossible to make consistently superior profits by using trading rules based on past returns. II) If markets are efficient in the weak form, then prices will adjust immediately to public information. III) If markets are efficient in the weak form, then prices reflect all information.

I only

Financing decisions differ from investment decisions because I) financing decisions are easier to reverse; II) markets for financial assets are generally more competitive than real asset markets; III) generally, financing decisions have NPVs very close to zero

I, II and III

Generally, managers of corporations prefer internally generated cash to finance their capital expenditures because I) they can avoid the discipline of financial markets; II) the costs of issuing new securities are high; III) the announcement of a new equity issue is usually bad news for investors

I, II and III

If the weak form of market efficiency holds, then I) technical analysis is useless; II) stock prices reflect all information contained in past prices; III) stock price returns follow a random walk

I, II and III

The following functions, provided by financial intermediaries, enable the smooth functioning of the economy: I) processing of payments; II) borrowing and lending; III) pooling risks

I, II and III

If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur? I). the firm will reject good, low-risk projects II). the firm will accept poor, high-risk projects III). the firm will correctly accept projects with average risk

I,II and III

Financing decisions differ from investment decisions for which of the following reasons? I) you cannot use NPV to evaluate financing decisions; II) markets for financial assets are more active than for real assets; III) it is easier to find financing decisions with positive NPV than to find investment decisions with positive NPV

II only

Generally, a firm is able to find positive-NPV opportunities among its I) financing decisions; II) capital investment decisions; III) short-term borrowing decisions

II only

Predictable cycles in stock price movements I) tend to persist for a long time; II) tend to self-destruct as soon as investors recognize them; III) never appear, since stock returns change randomly

II only

If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely occur? I). The firm will accept poor low-risk projects II). The firm will reject good high-risk projects III). The firm will correctly accept projects with average risk

III only

Strong-form market efficiency states that the market incorporates all information into stock prices. Strong-form efficiency implies that I) an investor can only earn risk-free rates of return; II) an investor can always rely on technical analysis; III) professional investors cannot consistently outperform the market;

III only

The following are characteristics of preferred stock except it I) pays fixed dividends; II) can demand payments of cumulative dividends; III) has voting rights

III only

Using a company's cost of capital to evaluate a project is I). always correct II). always incorrect III). correct for projects that have average risk compared to the firms other assets

III only

Which of the following observations would provide evidence against the strong form of efficient market theory? I) Mutual fund managers do not on average make superior returns. II) In any year approximately 50% of all pension funds outperform the market. III) Managers who trade in their own firm's stocks make superior returns.

III only

Which of the following statements is true of strong-form EMH holds? I). Analysts can easily forecast stock price changes II). Financial markets are irrational III). Stock returns follow a particular pattern IV). stock prices reflect all available information

IV only

Which of the following is included in the Fama-French 3 factor model?

Market factor, book-to-market factor, and size factor

When in equilibrium, where should stocks lie?

On the SML

the graphical representation of the CAPM model is called the

Security Market Line

Consider the aggregate balance sheet for manufacturing corporations in the United States. Which of the following sources of financing plays the largest role?

Stockholder's equity

If capital markets are efficient, then the sale or purchase of any security at the prevailing market price is generally

a zero-NPV transaction

If a stock were underpriced, it would plot

above the security market line

Generally, a bond can be valued as a package of

annuity and single payment only

The company cost of capital is the appropriate discount rate for a firm's

average-risk projects

if a stock were overpriced it would plot

below the security market line

On a graph with common stock returns on the y-axis, and market returns on the x-axis, the slope of the regression line represents

beta

The SML is a positively sloped straight line that displays the relationship between expected return and

beta

How can an investor earn more than the return generated by the tangency portfolio and still stay on the SML

borrow at the risk-free rate and invest in the tangency portfolio

Strong-form efficiency implies that mutual fund managers should

buy the index that maximizes diversification and minimizes the cost of managing portfolios