Finance 300 Exam 3 Study Guide

The risk-free asset has a beta of:

0.00

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

1. The unsystematic portion. 2. The systematic portion.

Which of the following are mutually exclusive investments?

1. Two different choices for the assembly lines that will make the same product. 2. A restaurant or a gas station on the same piece of land.

The risk of owning an asset comes from:

1. Unanticipated events 2. Surprises

The calculation of a portfolio beta is similar to the calculation of:

A portfolio's expected return

Based on the capital asset pricing model (CAPM) there is generally ____ relationship between beta and the expected return on a security.

A positive

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

Accept

The increase in the number of stocks in a portfolio results in a(n) ________________ in the average standard deviation of annual portfolio returns.

Decline

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

Income

If the variance of a portfolio increases, then the portfolio standard deviation will _________

Increase

The most important alternative to NPV is the ______ method.

Internal rate of return

IRR continues to be very popular in practice, partly because:

It gives a rate of return rather than a dollar value.

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.

A security has a beta of 1, the market risk premium is 8%, and the risk-free rate is 3 %. What will happen to the expected return if the beta doubles?

The expected return will increase to 19% from 11%

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%?

NPV = -95 + (107/1.06) = 5.94

True or False: The crossover rate is the rate at which the NPVs of two projects are equal.

True

By ignoring time value, the payback period rule may accept projects with a _________________ (positive/negative) NPV

Negative

Which of the following projects is acceptable if the average accounting return is required to be at least 20%.

1. Restaurant: average income = $450,000, average book value = $2,180,000 2. Book store: Average Income = $140,000, average book value = $1,200,000

_________ risk is reduced as more securities are added to the portfolio.

1. Unique 2. Unsystematic 3. Diversifiable

If you buy 40 Shares of BP stock at $35 per Share, your total investment in BP is ______.

40 shares x $35 = $1,400

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

Future

The second lesson from studying capital market history is that risk is:

Handsomely rewarded

A(n) _________ project does not rely on the acceptance or rejection of another project.

Independent

What is a risk premium?

It is additional compensation for taking risk, over and above the risk-free rate

True or False: Some projects, such as mines, have cash outflows following by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

True

What will your capital gain be if you hold 40 shares of BP stock and the stock price rises from $27 to $40 a share?

(40-27) x 40 = 520

What is the PL for a project with an initial cash outflow of $30 and subsequent cash inflows of $80 in year 1 and $20 in year 2 if the discount rate is 12%

(80/1.12 + 20/1.12^2)/30 = 2.91

Consider the following two assets: Asset X Y Expected Return 5.8% 14.2% Beta 0.8 1.8 If the risk free rate is 1%, what is the reward-to-risk ratio for Asset X?

(E(R_A) -R_1)/Beta_A =(5.8%-1%)/0.8 = 6%

Which is the return on a portfolio that consists of: $50,000 in an index fund, $30,000 in a bond fund, and $20,000 in a foreign stock fund? The expected returns are 7% -3%, and 18%, respectively.

.5 x 7% + .3% + .2 x 18% = 6.2%

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.

0.5 x 10% + 0.5 x 15% = 12.5%

Marks Company believes that there is a sixty percent chance of a recession and a forty percent chance of a boom. In the case of recession, the company expects to earn a 2% return. In the case of boom, the company expects to earn 22%. What is Marks Company's expected return?

0.6&0.02+0.4&0.22 = 0.10

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

1

Look at the frequency distribution in Figure 12.9 and rank the following ranges of stock returns in order from highest to lowest frequency.

1. 10% - 20% 2. 20% - 30% 3. 0 - 10% 4. -10% - 0

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?

1. 12.9% 2. 10.9%

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

1. A change in the yield on T-bills 2. A strengthening of the country's currency 3. Federal reserve actions that affect the economy

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

1. A hostile takeover attempt by a competitor. 2. The death of the CEO. 3. Changes in management 4. Labor strikes

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

1. An Increase in the Federal funds rate 2. An increase in the corporate tax rate.

Place the steps in the computation of variance in the correct order from the first step to the last step.

1. Calculate the expected return 2. Determine the squared deviation from the expected return 3. Multiply each squared deviation by its probability 4. The result is the variance

Which of the following are ways to make money by investing in stocks?

1. Capital gain 2. Dividends

Which of the following are weaknesses of the payback method?

1. Cash Flows received after the payback period are ignores 2. Time value of money principles are ignored. 3. The cutoff date is arbitrary.

The IRR rule can lead to bad decision when _______ or _______.

1. Cash flow are not conventional 2. Projects are mutually exclusive

When cash flows are conventional, NPV is ___________

1. Equal to zero when the discount rate equals the IRR 2. Positive for discount rates below the IRR 3. Negative for discount rates above the IRR.

The basic NPV investment rule is:

1. If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. 2. Reject a project if its NPV is less than zero. 3. Accept a project if the NPV is greater than zero.

According to Graham and Harvey's 1999survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?

1. Internal rate of return 2. Net present value

Which of the following are examples of a portfolio?

1. Investing $100,000 in a combination of US and Asian stocks. 2. Holding $100,000 investment in a combination of stocks and bonds. 3. Investing $100,000 in the stocks of 50 publicly traded corporations.

Which of the following are advantage(s) of AAR

1. Is easy to compute. 2. Needed information is usually available.

What does variance measure?

1. It measures the riskiness of a security's returns. 2. It measures the spread of the sample of returns

Arrange the following investments from highest to lowest return based on what our study of capital market history has revealed has revealed about risk premiums.

1. Small-company common stock 2. Long-term corporate bonds 3. U.S. Treasury bills

The Ibbotson-Sinquefield data show that over the long-term, _______.

1. Small-company stocks had the highest risk level. 2. Small-company stocks generated the highest average return. 3. T-bills, which had the lowest risk, generated the lowest return.

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

1. Symmetrical 2. Bell-shaped

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

1. Symmetrical 2. Bell-shaped

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

1. The Fed's decision on interest rates at their meeting next week. 2. The outcome of an application currently pending with the Food and Drug Administration.

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

1. The outcome of an application currently pending with the Food and Drug Admiration. 2. The Fed's decision on interest rates at their meeting nest week.

What are the advantages of the payback period method for management?

1. The payback period method is easy to use. 2. The payback period method is ideal for short project. 3. It allows lower level managers to make small decisions effectively.

What are two components of the expected return on the market (R_M)?

1. The risk premium 2. The risk-free rate (R_F)

Arrange the following investments in ascending order from lowest historical risk premium at the top to highest historical risk premium at the bottom.

1. U.S. Treasury Bills 2. Long-term corporate bonds 3. Large-company stocks 4. Small-company stocks

The Three attributes NPV are

1. Uses all the cash flows of a project. 2. Uses cash flow 3. Discounts the cash flow properly.

Which of the following are true?

1. common stocks may experience negative returns. 2. Treasury-bills sometimes outperform common stocks.

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

What will the dividend income be on 1,000 shares of XYZ stock if XYZ distributes a $.20 per share dividend?

1000x .20 = 200

If you invested $100 and made a total dollar return of %10 over the course of the year, your year-end total cash if the stock is sold would be ________.

110

If the annual stock market returns for Berry Company were 19%, 13%, and -8% percent, what was the arithmetic mean for those 3 years?

19+13-8/3 = 8%

Saxon Company is considering a project that will generate net income of $50,000 in Year 1, $75,000 in Year 2, and $90,000 in Year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in the three years of the investment. What is their average accounting return?

20.48

If the risk premium of stock JKL is 5% while the standard deviation is 10%, then the Sharpe ratio equals. _________.

5%/10% = 0.05

John's portfolio consists of $1,200 worth of Chi Corporation common stock and $400 worth of Lambda Corporation common stock. Lambda's portfolio weight is 25%, and Chi's portfolio weight is:

75.00%

The spreadsheet function for calculating net present value is ________.

=NPV()

What is variance?

A measure of the squared deviations of a security's return from its expected return.

The PI rule for an independent project is to ________ the project if the PI is greater than 1.

Accept

Arithmetic average return

Arithmetic Average Return = (Sum of total Return percent)/Number of years

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

Budgeting

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

Capital gain of $6

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

Cash

The average return on the stock market can be used to ________.

Compare stock returns with the returns on other security

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

Decrease

A share of common stock currently sells for $100 and will pay a dividend of $2 at the end of the year. If the price is expected to increase to $113 at the end of one year, what is the stock's current dividend yield?

Dividend Yield = Dividend Price /Common Stock $2/$100 = 2%

True or False: Investing more money in a project will always lead to greater profits.

False

True or False: The MIRR function eliminates multiple IRR and should replace NPV.

False

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 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

What is unsystematic risk?

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

What is systematic risk?

It is a risk that pertains to a large number of assets.

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.

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

Positive

Normally, the excess rate of return on risky assets is ________.

Positive

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

Present value

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If Projects Alpha and Beta have conventional cash flows, are mutually exclusive and the NPV profiles cross at 15% (where the NPVs are positive), which of the projects has a higher internal rate of return?

Project Beta

Historically, the real return on Treasury bills has been:

Quite low

According to the basis IRR rule, we should:

Reject a project if the IRR is Less than the required return.

The arithmetic average rate of return measures the ________.

Return in an average year over a given period

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

Risk-free

It would be useful to understand how the _________ of the risk premium on a risky asset is determined

Size

Geometric averages are ______arithmetic averages.

Smaller than

In Which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: 1000 Ending cash flow: -2000 Whenever cash inflows exceed cash outflows, the NPV profile is upward sloping; the IRR will give the wrong decision.

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

Suggests accepting

Which type of risk does not change as we add more securities to a portfolio?

Systematic, or market, risk

The systematic risk principle argues that market does not reward risks:

That are borne unnecessarily

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

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

There is no relationship.

What is the IRR for a project with an initial investment of $250 and subsequently cash inflows of $100 per year for 3 years?

Using the TI-83 Plus IRR = (-250,{100,100,100}) = 9.70

The square of the standard deviation is equal to the __________.

Variance

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

Very large

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

Zero

if a stock has a returns of 10% and 20% over 2 years, the geometric average rate of return can be calculated by _______.

[(1.10)(1.20)]^.5 - 1

The year 2008 was:

one of the worst years for stock market investors in U.S. history

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________.

($114-100)/100 = 14%

You buy a stock for $50. Its price rises to $55, and it pays a $2 dividend in a year. You do not sell the stock. Your dividend yield is _____%.

($55-50)/50 = 10%

Palmer Company had the following returns: 2009 12% 2010 10% 2011 -8% 2012 4% 2013 22% What is the variance of Palmer's returns?

((0.12-0.08)^2 + (0.1-0.08)^2 + (-0.08-0.08)^2 + (0.04-0.08)^2 + (0.22-0.08)^2)/(5-1) = 0.0122

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

Asset A

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?

B_p = (2.5 + 1.5)/2 = 22%

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

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

Beginning stock price

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

Variance is measured in _______, while standard deviation is measure in ________.

Percent squared; Percent

Negative

When cash flows are conventional, NPV is ___________ if the discount rate is above the IRR.

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 Ibbotson- Sinquefield data presents rates of return from 1925 recent times for:

1. Large-company stocks 2. Long-term U.S. government bonds

Which of the following are true about the historical risk premium of the countries studies by Dimson, Marsh,

1. Italy had the highest equity risk premium 2. Denmark had the lowest equity risk premium.

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

1. NPV 2. MIRR

The price of XYZ stock rises from $10 to $15. If you own 100 shares your capital gain is ________.

(15-10) x 100 = $500

What two factors determine a stock's total return?

1. Expected return. 2. Unexpected return.