Finance 300 Exam 3

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.

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

The discounted payback period has which of these weaknesses?

Loss of simplicity as compared to the payback method Arbitrary cutoff date Exclusion of some cash flows

If a project has multiple internal rates of return, which of the following methods should be used?

NPR MIRR

Mona Corporation has a variance of returns of 343, while Scott Corporation has a variance of returns of 898. Which company's actual returns vary more from their mean return?

Scott corporation

Using the payback period rule will bias toward accepting which type of investment?

Short term

The systematic risk principle argues that the market does not reward risks _____.

That are borne unnecessarily

Which of the following are examples of information that may impact the risky return of a stock?

The Fed's decision on interest rates at their meeting next week The outcome of an application currently pending with the Food and Drug Administration.

A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?

The death of the CEO A hostile takeover attempt by a competitor

What is the expected return on a security with beta of 1?

The expected return on the market.

What is the slope of the security market line (SML)?

The market-risk premium

What are the two components of unexpected return (U) in the total return equation?

The systematic portion The unsystematic portion

How are the unsystematic risks of two different companies in two different industries related?

There is no relationship

True or false: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

True

True or false: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

True

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.

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:

Zero

The calculation of a portfolio beta is similar to the calculation of _____.

a portfolio's expected return

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

A project should be __________ if its NPV is greater than zero.

accepted

Payback period tells the time it takes to break even in an ____ sense. Discounted payback period tells the time it takes to break even in an ______ or financial sense.

accounting, economic

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 item

Percentage returns are more convenient than dollar returns because they ____.

apply to any amount invested

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitary

The dividend yield for a 1-year period is equal to the annual dividend amount divided by the ______.

beginning stock price

Some important characteristics of the normal distribution are that it is:

bell-shaped symmetrical

The AAR is calculated by taking the average net income and dividing it by the average

book value

Capital

budgeting is the decision-making process for accepting and rejecting projects.

gains yield can be found by taking the difference between the ending stock price and the initial stock price and dividing it by the initial stock price.

capital

If you buy a stock for $10 and later sell it for $16, you will have a ____.

capital gain of $6

The total dollar return is the sum of dividends and __________.

capital gains or losses

When a company declares a dividend, shareholders generally receive ______.

cash

The geometric rate of return takes ______ into account.

compounding

When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.

decrease

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

discount payback period

NPV ______ cash flows properly.

discounts

The two potential ways to make money as a stockholder are through ______ and capital appreciation.

dividends

The total dollar return on a stock is the sum of the ____ and the _____.

dividends; capital gains

If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclude about the value of the security's beta based on CAPM?

equal to 0

The payback period method allows lower management to make smaller

everyday financial decisions effectively.

he variance of a portfolio is not

generally a simple combination of the variances of the assets in the portfolio.

In terms of investments, the greater the potential risk, the

greater should be the expected return.

One of the main disadvantages of the discounted payback period rule is that the cutoff is arbitrarily set and cash flows beyond that point are:

ignored

he increase in the number of stocks in a portfolio results in a(n) decrease

in the average standard deviation of annual portfolio returns.

Dividends are the ______ component of the total return from investing in a stock.

income

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.

increase, increase

Based on the historical returns shown in the text, the average was 2.9 percent per year over the 94-year span depicted.

inflation

The present value of all cash flows (after the initial investment) is divided by the ______ to calculate the profitability index.

initial investment

The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the ______.

initial stock price

The point at which the NPV profile crosses the horizontal axis is the:

internal rate of return

Net Present Value

is a measure of how much value is created or added today by undertaking an investment.

beta coefficient

is the amount of systematic risk present in a particular risky asset relative to that in an average asset.

Based on the discounted payback rule, an investment is acceptable if

its discounted payback is less than some prespecified number of years.

Greater return volatility produces a (smaller/larger) difference between the arithmetic and geometric averages.

larger

More volatility in returns produces ______ difference between the arithmetic and geometric averages.

larger

A situation in which taking one investment prevents the taking of another is called a

mutually exclusive investment decision

By ignoring time value, the payback period rule may incorrectly accept projects with a

negative NPV

There is ______ correlation between the unsystematic risk of two companies from different industries.

no

Systematic risk will ____ when securities are added to a portfolio.

not change

The IRR rule can lead to bad decisions when cash flows are _____ or projects are mutually exclusive.

not conventional

Studying market history can reward us by demonstrating that _____.

on average, investors will earn a reward for bearing risk the greater the potential reward is, the greater the risk

Average returns can be calculated using geometric or

or arithmetic average.

The discounted payback is the time it takes to break even in an economic

or financial sense

The ____________ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

payback

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

payback method

The amount of time needed for the cash flows from an investment to pay for its initial cost is the

payback period

Historically, there is a(n) ______ relationship between risk and expected return in the stock market.

positive

If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be _____.

positive

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive

For a project with conventional cash flows, the NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

positive, negative

In capital budgeting, the net ______ determines the value of a project to the company.

present value

The IRR rule can lead to bad decisions when _____ or _____.

projects are mutually exclusive cash flows are not conventional

Historically, the real return on Treasury bills has been _____.

quite low

The sharpe

ratio is calculated as the risk premium of the asset divided by the standard deviation.

The ______ rate of return is the difference between risky returns and risk-free returns.

real

The basic NPV investment rule is:

reject a project if its NPV is less than zero. accept a project if the NPV is greater than zero. if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference

According to the basic IRR rule, we should _____.

reject a project if the IRR is less than the required return

If the IRR is greater than the _______ ________, we should accept the project.

required rate

The arithmetic average rate of return measures the ____.

return in an average year over a given period

The expected

return is the return that an investor will probably earn on a risky asset in the future.

percent

returns tell how much was received for each dollar invested, so they can be applied to any initial investment amount.

The Sharpe ratio measures ___.

reward to risk

The excess return on a risky asset is the difference between the risky return and the ____ rate.

risk free

The systematic

risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

When dealing with the history of capital market returns, an average stock market return is useful because it ___.

simplifies detailed market data is the best estimate of any one year's stock market return during the specified period

The standard deviation is the ______ of the variance.

square root

The first step to calculate the variances of the returns on two stocks is to determine the

squared deviations from the expected return.

A capital gain on a stock results from an increase in ______.

stock price

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggest accepting

The point at which the NPV profile crosses the vertical axis is the:

sum of the cash flows of the project

The risk of owning an asset comes from:

surprises unanticipated events

The principle of diversification tells us that, to a diversified investor, the only type of risk that matters is

systematic

When an investor is diversified only ________ risk matters. Multiple choice question. diversifiable unsystematic unnatural systematic

systematic

Which type of risk is unaffected by adding securities to a portfolio?

systematic

Which one of the following types of risk is not reduced by diversification?

systematic or market

The geometric average rate of return is approximately equal to ___.

the arithmetic mean minus half of the variance

the lower the risk

the greater the required return.

The standard deviation is ___.

the square root of the variance

The true risk of any investment is the _____ portion.

unanticipated

The risk that affects a single asset or a small group of assets is ______ risk.

unsystematic

For a well-diversified portfolio, the Blank______ risk is negligible. Multiple select question.

unsystematic unique diversifiable

The three attributes of NPV are that it:

uses all the cash flows of a project. uses cash flows. discounts the cash flows properly.

The is the squared standard deviation.

variance

A distribution tends to have a smooth shape when the number of observations is ___.

very large

When we discount an announcement

we say that it has less of an impact on price because the market already factored it in.

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio

weight

The dividend is defined as the annual dividend amount divided by the beginning stock price.

yeild

The IRR is the discount rate that makes the NPV of a project equal to ______.

zero

By definition, what is the beta of the average asset equal to?

1

Advantages of Payback period rule

1. Easy to understand 2. Adjusts for uncertainty of later cash flows 3. Biased toward liquidity

Disadvantages of Payback period rule

1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects

The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?

12.9% 10.9%

Based on average historical returns shown in the text, small-company stocks increased in value by _____ percent in a typical year.

16

Which of the following are mutually exclusive investments?

A restaurant or a gas station on the same piece of land. Two different choices for the assembly lines that will make the same product.

According to the CAPM, which of the following events would affect the return on a risky asset?

A strengthening of the country's currency A change in the yield on T-bills Federal reserve actions that affect the economy

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

An increase in the corporate tax rate An increase in the Federal funds rate

Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose?

Asset A

How can a positive relationship between the expected return on a security and its beta be justified?

Because the difference between the return on the market and the risk-free rate is likely to be positive

Which of the following are examples of unsystematic risk?

Changes in management Labor strikes

Arrange the steps involved in the discounted payback period in order starting with the first step.

Discount the cash flows using the discount rate Add the discounted cash flows Accept if the discounted payback period is less than some prespecified number of years

Which of the following are ways to make money by investing in stocks? (Select all that apply.)

Dividends Capital gains

True or false: Systematic risk can be eliminated by diversification

False

True or false: The MIRR function eliminates multiple IRRs and should replace NPV.

False

The profitability index is calculated by dividing the PV of the _________ cash flows by the initial investment.

Future

Which of the following are examples of systematic risk?

Future rates of inflation Regulatory changes in tax rates

Which of the following are examples of a portfolio?

Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in a combination of U.S. and Asian stocks Investing $100,000 in the stocks of 50 publicly traded corporations

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.

What is unsystematic risk?

It is a risk that affects a single asset or a small group of assets.

The risk-free asset has a beta of _____.

0