Final- Finance
you bought one share of stock for $100 and received $2 dividend. If the price of the stock rose to $103, then your total sollar would be
$5 $2 divid+ (103-100)= $5
-If a stock has returns of 10 percent and 20 percent over 2 years, the geometric average rate of return can be calculated by _____.
((1.10)(1.20))^5-1
One year ago, Ernie purchased shares of RTF common stock for $100 a share. Today the stock paid a dividend of $1 per share. If the stock currently sells for $114 per share, what is Ernie's total return?
(114-100+1)/100 = 15%
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and Rp is the cost of preferred?
(P/V) * Rp
what can we say about the dividends paid to common and preferred stockholders?
* dividends to preferred stockholders are fixed *dividends to common stockholders are NOT fixed
unsystematic risk will affect
* firms in a single industry *a specific firm
The Ibbotson-Sinquefield data shows that
*long-term corporate bonds had less risk or variability than stocks *U.S. T-bills had the lowest risk or variability
the following are disadvantages of the SML approach
*requires estimation of beta * requires estimation of the market risk premium
the growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
what are some reasons why IRR continues to be sed in practice
-business people prefer rates of return -the IRR of a proposal can be calculated without knowing the appropriate discount rate -It is easier to communicate information about a proposal with an IRR
which of the following is true relative to capital rationing
-hard rationing implies the firm is unable to raise funds for projects **necessary financing -soft rationing is typically internal in that the firm allocates funds to divisions for capital projects
thought depreciation is a non-cash expense, it is important to capital budgeting for these reasons
-it affects a firms annual tax liability -it determines taxes owed on fixed assets when they are sold -it determines the book value of assets which affects net salvage value
What is the beta of the risk-free asset?
0
If the arithmetic average return is 10% and the variance of returns is 0.05, find the approximate geometric mean
0.10 -1/2 * 0.05 = 7.5% 7.5%
If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?
1.25
In 2008, the S&P 500 plunged ________%
37%
what is scenario analysis?
Determines the impact on NPV of a set of events ( usually worst case, most likely case, and best case.) relating to a specific scenario ..
True or false: an advantage of the ARR is that it is based on book values not market values
False
An efficient market is one in which any change in available information will be reflected in the company's stock price _____.
Immediately
the present value of the future cash inflows are divided by the _____ to calculate the profitability index
Initial investment
what are the advantages of the payback period method for management?
Its ideal for minor projects its easy to use it allows lower level managers to make small decisions effectively
what is the required return on a stock (Re) according to the constant dividend growth model, if the growth rate (g) is Zero?
Re=D1/Po
the formula of the SML is:
Re=Rf+Beta * (Rm-Rf)
what is systematic risk?
Risk that pertains to a large number of assets
When calculating NVP the present value of the nth cash flow is found by diving the nth cash flow by 1 plus _____ rate raised to the nth power.
The discount rate
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
Discounting Approach (MIRR)
With the discounting approach, the idea is to discount all negative cash flows back to the present at the required return and add them to the initial cost. Then, calculate the IRR.
Reinvestment Approach (MIRR)
With the reinvestment approach, we compound all cash flows (positive and negative) except the first out to the end of the project's life and then calculate the IRR. In a sense, we are "reinvesting" the cash flows and not taking them out of the project until the very end
If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E+D), Rd the yield on the firm's debt, Tc is the corporate tax rate, and Re the cost of equity, the weighted average cost of capital is:
[E/V]*Re+[D/V]*Rd *(1-Tc)
a portfolio can be descries by its portfolio weights which are defined as _________.
a % of dollars invested in each asset.
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk
The calculation of a portfolio beta is similar to the calculation of:
a portfolios expected return
the internal rate of return is a function of
a project's cash flows
in an efficient market ____ investments have a _____ NPV
all;zero
% returns are more convenient than dollar returns because they
allow comparison against other investments apply to any amount invested
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market:
already knew about most of the news items
A positive capital gain on a stock results from _____.
an increase in price
the possibility that errors in projected cash flows will lead to incorrect decisions is know as:
forecasting risk estimation risk
the true risk of any investment comes from__________.
surprises
cash flows used in projects estimation should always reflect
after tax cash flows cash flows when they occur
Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices.
all info-strong form efficiency all public info- semi-strong form efficiency historical stock price- weak form efficiency
which of the following is an example of a sunk cost
project consultation fee
the arithmetic average rate of return measure the _____.
rate of return in an average year over a given period. it does not account for compounding
erosion will _______ the sale of existing products.
reduce
which of the following are examples of systematic risk
regulatory changes in tax rates future rates of inflation
which of the following are examples of systematic risk?
regulatory changes in tax rates future rates of inflation
which of the following are examples of unsystematic risk?
* labor strikes *changes in management
what are examples of info that may impact the risky return of a stock?
* the outcomes of an application currently pending with the food and drug administration *the Fed's decision on interest rates at their meeting next week
the following are advantages of the SML approach
*Adjusts for risk *Does not require the company to pay a dividend
Some of the important characteristics for good leadership are
*bell-shaped *symmetrical
which of the following are true based on the year to year returns from 1926-2014?
*common stocks frequently experience negative returns *T-bills sometimes outperform common stock
To estimate the dividend yield of a particular stock, we need:
*current stock price *forecasts of the dividend growth rate, G *the last dividend paid,D0
which of the following are ways to make money by investing in stocks?
*dividends *capital gains
which of the following is true about a firms cost of debt?
*easier to estimate than the cost of equity *yield can be calculated from observable data
what two factors determine a stock's total return?
*expected return *unexpected return
which of the following are examples of a portfolio?
*investing $100,000 in a combo of stocks and bonds *investing 100 in stock of 50 publicly traded corps *investing $100,000 in a combination of US and Asian stocks
which of the following is true about a firms cost of debt?
*is its easier to estimate than the cost of equity *yields can be calculated from observable data
what are some true statements about variance?
*it is a measure of the squared deviations of a security's return from its expected return. *standard deviation is the square root of variance
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
*it may eventually be totally eliminated *it is likely to decrease
If an asset has a Reward-to-Risk Ratio of 60%, that means it has a _________ of 6.0% per unit of ________.
*risk premium;systematic risk
arrange investments starting from highest to lowest risk(standard deviation) based on what our study of capital market history from 1926-2014 has revealed as shown in table 10.3
*small comp. common stock *large comp common stock *long term corporate bonds *long term gov. bonds *US treasury bills
the WACC is the minimum required return for ______.
*stockholders and bond holders *the overall firm
the Ibbotson SBBI data show that over the long-term, _______.
*t-bills, which had the lowest risk, generated the lowest return *small-company stocks had the highest risk-level *small-company stocks generate the highest average return
the systematic risk principle argues that the market does not reward risks:
*that are diversifiable *that are bone unnecessarily
what will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
*the firms overall will become riskier *it will reject projects that it should have accepted *It will accept projects that it should have rejected
which of the following are needed to describe the distribution of stock returns
*the standard deviation of returns *the mean return
the normal distribution is completely described by the _____ and _____.
*variance or standard deviation *mean
If stock ABC has a mean return of 10% with a standard deviation of 5%, then the probability of earning a return greater than 15% is about ____________%.
0% is 2 SDs below the mean (0.10-(2 & *0.05) Probability of R being more than two standard deviations from the mean is (1- 0.95), but that means either two standard deviations above or below the mean. The probability of it being 2 standard deviations below the mean, divide by w (half are above and half are below in a normal distribution) 0.05/2 == 2.5% 2.5%
treasury bills yield a nominal average return over 86 years of 3.5% versus an average inflation rate of 3.0% over the same period. this makes the real return on T-bills approximately equal to_________>
0.5% 3.5%-3.0%=.5%
what is the total number of inputs that change while doing sensitivity analysis
1
If stock GHI had returns 6% and -2% over 2 years, the geometric average rate of return is ______.
1.92 [(1.06)(0.98)]^5-1=1.92%
The computation of variance requires 4 steps. What are the first step to the last step.
1.calculate the expected return 2.calculate the deviation of each return from the expected return 3.square each deviation 4. calculate the average squared deviation
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 40%, the after-tax rate of return on its preferred stock is:
10%
if a preferred stock pays a dividend of $2 per year an is selling for $20, its yield is
10% $2/$20=10%
a firms capital structure consists of 40% debt and 60% equity. the aftertac yield on debt is 2.5% and the cost of equity is 15%. The project is about as risky as the overall firm. what discount rate should be used to estimate the projects net present value?
10% WACC= .4*2.5%+.6*15%=10%
a company has a borrowing rate of 15% and a tax rate of 30%. Wha t is its aftertax cost of debt
10.5% 15%*(1-.3)=10.5%
supposed a firms capital structure consists of 30% debt, 10% preferred stock and 60% equity. The firm's bonds yield 10% on average before taxes, the cost of preferred stock is 8% and the cost of equity is 16%. Calculate the firms WACC assuming a tax rate pf 40%
12.20% 0.6 x 16% +.3 x 10% x (1-.4) +.1 x 8% = 12.20
what is the expected return of a portfolio consisting of stocks a and b if the expected return is 10% for A and 15% for B? Assume you are equally invested in both the stocks
12.5%
what is the expected return of a security with a beta of 1.2 if the risk-free rate is 4% and the expected return on the market is 12%
13.6% 4%+1.2(12%-4%)=13.6%
What is the IRR for a project with an initial investment of $500 and subsequent cash inflows of $145 per year for 5 years?
13.82
the rules for depreciating assets for tax purposes are based upon provisions in the:
1986 tax reform act
ABC has a beta of 2.5 and XYZ has a beta of 1.5. The Risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?
22% =(2.5+1.5)/2=2 expected return=4%+2(9%)=22%
if a stocks returns for years 1 to 4 were 3%,5%,8% and -2%, what is the SD of the returns?
4.203%
If the variance of a portfolio is .0025, what is the standard deviation?
5% =.0025^.5=.05 or 5%
what is the standard deviation of the following portfolio: probability Port return .25 10% .50 4% .25 -6%
5.74% mean return= .25*.1+.5*.04+.25*(-.06)=.03 standard deviation =(.25*(.1-.03)^2+.5*[.04-.03)^2+.25*(-.06-.03)^2]^.8 =.0574
If a firm is funded with $400 in debt and $1200 in equity, the weight of equity in the capital structure is ____ %and the weight of debt is __%.
75;25
what is the profitability index for a project with an initial cash outflow of $30 and subsequent cash inflows of $80 in year one and $20 in year two if the discount rate is 12%?
=((80/1.12)+(20/1.12^2))/30=2.91
The spreadsheet function for calculating net present value is:
=NVP(rate, CF1,....,CFn)+CF0
what is the reward-to-risk ratio?
A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. Slope = (E(Ra) - Rf) / (βA - 0)
A project should be ____ if the NVP is greater than zero
Accepted
the payback period rule ____ a project if it has a payback period that is less than or equal to a particular cutoff date
Accepts
when a company declares a dividend, shareholders generally receive ______.
Cash
the ___ rate of return is the difference between the rate of return on a risky asset and the risk free rate of return
Excess
capital budgeting is probably the most important of the three key ares of concerns to the financial manager because
It defines the business of the firm
What is a risk premium?
It is additional compensation for taking risk, over and above the risk-free rate
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
higher cash flows earlier in a projects life are _________ valuable than higher cash flows later on
MORE
Which of the following present problems when using the IRR method
Mutually-exclusive projects non-conventional cash flows
If a project has multiple internal rates of return, which of the following methods should be used?
NPV MIRR
Combination Approach (MIRR)
Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.
______ is a measure of how much value is created or added by undertaking an investment
Net present value
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are widely used by firms in the US and Canada
Net present value Internal rate of return
which of the following is the equation for estimating operating cash flows using the tax shield approach
OCF=(sales-Costs) * (1- Tax rate) + Deprc. * Tax rate
the _____ method evaluates a project by determining the time needed to recoup the initial investment
Payback method
which of the following are weaknesses of the payback method?
Time value of money principles are ignored cash flows received after the payback period are ignored the cut off date is arbitrary
what is the equation for total return?
Total Return = Expected Return + Unexpected Return
True or false: Payback period ignores time value of money
True
true or false: a project with non-conventional cash flows will produce two or more IRRs
True
True or false: some projects., such as mines, have cash outflows followed by cash inflows and cash outflows again giving the project multiple internal rates of return
True **whenever subsequent cash flows are both negative and positive, multiple internal rates of return may occur
arrange investments starting from lower historical risk premium to highest historical risk premium
US treasury bills long term corporate bonds large company stocks small-company stocks
the internal rate of return is a function of _____
a project's cash flows
According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:
a target average accounting return
according to the average rate of return rule, a project is acceptable is its average accounting return exceeds
a target average accounting return
the PI rule for an independent project is to ________ the project if the PI is greater than 1
accept (if the PI is <1, the present value of the cash flows generated by a project exceed the projects initial cost)
Cash flows should always be considered on a(n) _______________ basis.
after tax basis
Percentage returns are more convenient than dollar returns because they:
apply to any amount invested allow comparison against other investments
what is the arithmetic average return for a stock that had annaual returns of 8%,2% and 11% for the past 3 years?
arithmetic average=(8%+2%+11%)/3=7%
When we estimate the best-case, worst-case, base-case flows and calculate the corresponding NPVs, we are engaging in:
asking what if questions scenario analysis
the average accounting return is defined as
average net income/average book value
the dividend yield for a one- year period is equal to the annual dividend amount divided by the _____.
beginning stock price
-_____ were a bright spot for U.S. investors during 2008.
bonds
A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:
cant be observed
the total dollar return is the sum of dividends and _______.
capital gains or losses
You buy a stock for $100. In one year its price rises to $114, and it pays a $1 dividend. Your capital gains yield is _____
capital gains yield= (Pt+1 - Pt)/Pt (114-100)/100= 14%
A manager has estimated a positive NPV for a project. What could drive this result?
cash flow estimations are not correct the project is a good investment overly optimistic management
which of the following are considered relevant cash flows?
cash flows from... erosion effects beneficial spillover effects external costs
Cash flows used in project estimation should always reflect:
cash flows when they occur after tax cash flows
which of the following are components of project cash flow?
change in net working capital capital spending operating cash flow
the appropriate discount rate to use to evaluate a new project is the ______
cost of capital
the minimum required return on a new project is known as the:
cost of capital
which of the following are components used in the construction of the WACC?
cost of preferred stock cost of common stock cost of debt
historical return data indicated that as number of securities in a portfolio increase, the standard deviation of returns for the portfolio:
declines
operating cash flows is a function of
depreciation taxes earnings before interest and taxes
The Combination MIRR method is used by the Excel MIRR function and uses which of the following?
discounting all cashflows to time 0 compounding cash inflows to the end of the project a reinvestment rate for compounding a financing rate for discounting
_____ risk is reduced as more securities are added to the portfolio
diversifiable unsystematic company-specific
-The two potential ways to make money as a stockholder are through _____ and capital appreciation.
dividends
the dividend growth model is applicable to companies that pay ______.
dividends
the total dollar return on a stock is the sum of the ______ and the ___.
dividends; capital gains
the return an investor in a security receives is _____ _____ the cost of the security to the company that issues it
equal to
side effects from investing in a project refer to cash flows from:
erosion effect beneficial spillover effects
In the cotext of capital budgeting, what does sensitivity analysis do?
examines how sensitivity a particular NPV calculation is to change in underlying assumptions
what two factors determine a stocks total return?
expected return and unexpected return
what is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security beta is 1.5?
expected return for a security= 5+1.5 *(9-5)=11%
what is the equation for the capital asset pricing model?
expected return on security=Risk-free rates + beta * (return on market -risk free rates)
in an efficient market, firms should expect t receive________ value for securities they sell.
fair
the second lesson from studying capital market history states that ______ the potential reward, the ________ the risk.
greater;greater lower;lower
the second lesson from studying capital market history is that risk is:
handsomely rewarded
the goals of risk analysis in capital budgeting include?
identifying critical components assessing the degree of financial risk
The difference between a firms cash flows with a project versus without the project is called
incremental cash flows
stock prices fluctuate from day to day because of
information flow
the capital gain field can be found by finding the difference between the ending stock price and the initial stock price are dividing it by the:
initial stock price
Components of the WACC include funds that come from ____________
investors
which of the following is a disadvantage of the profitability index?
it cannot rank mutually exclusive projects
the payback period can lean to foolish decisions of it is used too literally because
it ignores cash flows after the cut off date
If a firm issues no debt, its average cost of capital will equal ____.
its cost of equity
More Volatility in returns produces _____ difference between the arithmetic and geometric averages
larger
an investment will have a negative NPV when its expected return is ________ ________ what the financial markets offer for the same risk.
less than
The primary risk in estimation errors is the potential to ________
make incorrect capital budgeting decisions
the most appropriate weights to use in the WACC are the _____ weights
market value
If a firm is evaluating two possible projects, both of which require the use of the same production facilities, these projects would be considered ___.
mutually exclusive
in General NVP is
negative for discount rates above the IRR Positive for discount rates below the IRR equal to zero when the discount rate is equals the IRR
Identify the three main sources of cash flows over the life of a typical project
net cash flows from sales and expenses over the life of the project net cash flows from salvage value at the end of the project cash outflows from investment in plant and equipment at the inception of the project
which of the following techniques will provide the most consistently correct result?
net present value
systematic risk will _____ when securities are added to a portfolio
not change
One of the flaws of the payback period method is that cash flows after the cutoff date are ____.
not considered in the analysis
in the Ibbotson- sinquefield studies, U.S treasury bill data is based on t-bills with a maturity of _____ month(s)
one
The year 2008 was:
one of the worst years for stock market investors in US history
if you use an arithmetic average to project long-run wealth levels your results will most likely be _______.
optimistic
preferred stock _______.
pays a constant dividend pays dividends in perpetuity
If you use a geometric average to project short-run wealth levels, your results will most likely be ___.
pessimistic
The NVP is ____ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR
positive, negative
the security market line (SML) shows that the relationship between a security's expected return and its beta is ________.
positive; the higher the risk, the higher the expected return
Historically, the real return on treasury bills has been
quite low
which of the following are methods of calculating the MIRR of a project?
reinvestment approach discounting approach combination approach
according to the basic IRR rule, we should:
reject a project if the IRR is less than the required return
the first step in estimating cash flows is to determine the ______ cash flows
relevant
which of the following are fixed costs
rent on a production facility cost of equipment
if the IRR> ___ ____, we should accept the project
required return
to investigate the impact of NPV of a change in one variable, you would employ ___
sensitivity analysis
Using capital market history as a guide, it would appear the greatest reward would come from investing in ___.
small-company common stock
geometric average are usually ______ arithmetic averages
smaller than (they are smaller because of the effect of the compounding)
which of the following are needed to describe the distribution of stock returns?
standard deviation of returns mean returns
To estimate a firms equity cost of Capital using CAPM we need to know
stock's beta market risk premium risk-free rate
which of the following types of risk is not reduced by diversification?
systematic risk cannot be diversified away
What is the intercept of the security market line (SML)?
the _____-risk premium
Two ways of calculating average returns are ___ and ___.
the arithmetic average the geometric average
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?
the beta for software companies that collect and store data
what is the slope of the security market line (SML)?
the market rise premium (expected return on the market minus the risk free rate of return)
which of the following qualify as "managerial options"?
the option to.. wait abandon expand
what is the definition of expected return?
the return that an investor expects to earn on a risky asset in the future
according to the capital assets pricing model (CAPM), what is the expected return on a security with a beta of zero?
the risk-free rate of return
to determine the appropriate required return for an investment, we can use _________.
the security market line
to determine the appropriate required return for an investment,we can use _________.
the security market line
Studying market history can reward us by demonstrating that:
there is a reward for bearing risk the greater the potential reward is, the greater the risk
how are the unsystematic risks of the two different companies in two different industries relates?
there is no relationship
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ____ projects.
too many
the total dollar return on a stock is sum of the ____ and the ______.
total dollar return= dividend income + capital gain
average returns can be calculated:
two ways: geometric average method arithmetic average method
the true risk of any investment comes from:
unanticipated events surprises
_____ risk is reduces as more securities are added to the portfolio
unsystematic diversifiable company-specific
what are two components of risky return (U) in the total return equation?
unsystematic risk market risk
the WACC is the overall rate of return the firm must earn on its existing assets to maintain the _______ lf its stock
value
The square of the standard deviation is equal to the _____.
variance
What does WACC stand for?
weighted average cost of capital
the efficient markets hypothesis contends that ______ capital markets such as the NYSE are efficient.
well organized
erosion
when a new products sales will reduce the sales of existing products
For a firm with outstanding debt, the cost of debt will be the ____________ on that debt.
yield to maturity
If you wish to create a portfolio of stocks, what is the required minimum number of stocks?
you must invest in stocks of more than one corporation
the IRR is the discount rate that makes NPV equal to
zero
