IFM Conceptual Questions

Domestic Bonds

Domestic bonds are issued by a local body, available in a local market, and priced in the local currency. These bonds are intended for foreign investors.

syndicated bank loan.

If a single loan is funded by a group of banks rather than just a single bank

Determine which of the following statements about weighted average cost of capital (WACC) is TRUE. A) The WACC provides a good evaluation measure for a specific capital budgeting project that is safer than other projects of the firm. B) One purpose of the WACC is to adjust the cost of equity by the appropriate tax rate. C) The WACC provides correct discount rate only for projects with business risks that are similar to those of the average existing assets of the firm. D) Only before-tax costs should be considered. E) If a company issues additional debts, the increased leverage causes the WACC to rise.

C

You are given the following probability density function of a normal random variable XX. Which is statement is false: A The mean of XX can be greater than the variance of XX. B The downside semi-variance of XX is half the variance of XX. C The value-at-risk of XX is not coherent. D The tail-value-at-risk of XX is coherent. E The tail-value-at-risk of XX for 0<α<10<α<1 is always less than or greater than the median of XX.

C - most of time it's not VaR is not coherent, but it can be shown to be for a normal distribution

Determine which of the following is NOT a reason why the market portfolio might not be efficient. A) We cannot include most of the traded investment wealth in the economy in the market proxy because competitive price data is not available. B) Some investors may be subject to systematic behavioral biases. C) Some investors may be attracted to investments with skewed distributions that have a small probability of an extremely high payoff. D) Some investors are exposed to other significant risks outside their portfolio that are not tradable, the most important of which is due to their human capital. E) Some investors fail to diversify their portfolios adequately.

E is not a reason. Underdiversifiaction does not affect the efficiency of the market portfolio

Eurobonds

Eurobonds are international bonds that are not priced in the country of origin's currency. They can be traded anywhere, and the entity which issues them may be local or foreign.

You purchase a shout put option on an index. Let StSt denote the value at time tt of the index on which the option is written, let KK denote the strike price of the option, and let TT denote the time of option expiry. You are given: ST>KST>K. The minimum value of StSt over the life of the option is less than KK. You shout to the writer at a time that maximizes your payoff at expiration. Determine which of the following options will produce the same payoff at expiration as the shout put option. Assume all of the options​ have the same strike price, same time to expiration, and same underlying asset as the shout put option.

Extrema lookback put

Which of the following demonstrates evidence for the semi-strong form of the efficient market hypothesis? I) A fund manager is reliably able to make abnormal profits by trading based on historical patterns in stock prices. II) A talented analyst routinely earns excess returns through analysis of corporate financial statements. III) There is an instantaneous increase in stock price when a company announces unexpectedly good earnings but not significant abnormal returns afterwards.

III only

pari passu

Seniority. Investors in later rounds might demand higher seniority than investors in earlier rounds; when instead those investors are given equal priority, they are deemed pari passu, which is Latin for "on equal footing."

Angel Investors

Since it is difficult to value a business in its early stages, angel investors usually hold convertible notes rather than equity. These convertible notes allow angel investors to convert the note into equity, at discounted prices to what new investors pay when the company raises finances with equity for the first time.

Determine which of the following statement regarding diversification in stock portfolios is FALSE. A Another name of undiversifable risk is unique risk. B Another name of firm-specific risk is idiosyncratic risk. C When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. D The risk premium for diversifiable risk is zero. E The risk premium of a security is determined by its systematic risk.

A

Down round

A "down round" is said to have occurred when a company raises funds at a lower price than in the previous funding round. Anti-dilution protection allows the preferred stockholder to convert their shares to a common stock at a cheaper price. This helps to increase their ownership percentage in a down round.

Shareholders can gain by making negative-NPV investments or decisions that sufficiently increase the firm's risk. Which of the following best describes the agency cost above? A Asset substitution B Debt overhang C Cashing out D Managerial entrenchment E Asymmetric information

A - asset substitution

alpha versus risk free rate

A risk-averse investor requires a higher return for accepting the riskiness of a stock, thus α>r

Which of the following statements about efficient markets is/are true? 1) In the strong form of the efficient market theory, prices reflect all public information. 2) In an efficient market, a portfolio manager is not expected to consistently outperform the market. 3) In the weak form of the efficient market theory, prices reflect all information contained in the record of

All three are true

Determine which of the following statements regarding project risk analysis is TRUE. A When break-even analysis is used, we calculate the value of each parameter so that the project has an IRR of zero. B The IRR is the rate at which NPV is zero. C Scenario analysis involves changing the input variables one at a time to see how NPV changes. D Sensitivity analysis explores how IRR changes when various desired subsets of the complete set of model variables are changed simultaneously E In a Monte Carlo simulation, input variables are assumed to be independent with each other.

B

Which of the following statements about Arbitrage Pricing Theory (APT) is FALSE? A The CAPM yields an equation equivalent to the one-factor APT with the factor being the stock market index. B The factors in the APT must be based on market capitalization, book-to-market ratios, and momentum. C A portfolio with no exposure to any APT risk factors should earn the risk-free rate on average. D The APT can be used to estimate the cost of equity capital for a firm. E None of (A), (B), (C), or (D)

B

Determine which of the following statements about the leverage ratchet effect is FALSE. A) When an unlevered firm issues new debt, equity holders will bear any anticipated agency or bankruptcy costs via a discount in the price they receive for that new debt. B) Once a firm has debt already in place, some of the agency or bankruptcy costs that result from taking on additional leverage will fall on new debt holders. C) Debt overhang will inhibit firms from reducing leverage once it is in place. D) Once existing debt is in place, shareholders may have an incentive to increase leverage even if it decreases the value of the firm. E) Once existing debt is in place, shareholders will not have an incentive to decrease leverage by buying back debt, even if it will increase the value of the firm.

B is false. Once a firm has debt already in place, some of the bankruptcy or agency costs from taking on additional debt can fall on existing debt holders.

Determine which of the following statements regarding option strategies is false. A The payoff diagram of a covered put is the mirror image as that of a floor reflected about the horizontal axis. B The profit diagram of a collared stock is identical to the payoff diagram of a bull spread. C The profit diagram of a short box spread and a long box spread are identical. D The payoff diagram of a cap is the mirror image as that of a covered call reflected about the horizontal axis. E A short straddle can be combined with a long strangle to create a butterfly spread.

B) is false. The payoff diagram of a collared stock and a bull spread differ by a long bond. Because the profit of a long zero-coupon is 0, the profit diagrams of both a collared stock and a bull spread are identical.

Determine which of the following statements is FALSE. A A market order is a buy or sell order to be executed immediately at the best price currently available. B A limit order is an order to buy a security at no more than a specific price, or to sell a security at no less than a specific price. C A stop-loss order specifies that the stock is sold if the price increases to the specified amount. D A limit order and a stop-loss order might never be filled if the price does not move past the cutoff point. E If a stop-loss order is executed, it is possible that the sale price could be less than the cutoff point.

C

Which of the following statements regarding reasons to early exercise an American option is TRUE? A For an American call, the advantage of early exercising is receiving the strike price sooner rather than later. B For an American call, the advantage of early exercising is receiving the implicit insurance protection against the possibility that the stock price will move below the strike price. C For an American put, the advantage of early exercising is receiving the strike price sooner rather than later. D For an American put, the advantage of early exercising is receiving the implicit insurance protection against the possibility that the stock price will move above the strike price. E The correct answer is not given by (A), (B), (C), or (D).

C For an American call: The advantage of early exercising is receiving the stock sooner rather than later, thus becoming eligible to receive future dividends. The disadvantages of early exercising include giving up the interest on the strike price as well as losing the insurance implicit in the call. By holding the call instead of exercising, the option holder is protected against the possibility that the stock price will be less than the strike price at expiration. Once the option is exercised, this protection no longer exists. For an American put: The advantage of early exercising is receiving the strike price sooner rather than later. The disadvantages of early exercising include the dividends lost by giving up the stock as well as losing the insurance implicit in the put. By holding the put instead of exercising, the option holder is protected against the possibility that the stock price will be greater than the strike price at expiration. Once the option is exercised, this protection no longer exists.

Assume the Black-Scholes framework. Which of the following statements regarding a long position in a put option is true? A All else being equal, if the volatility of the underlying asset decreases, the value of the option increases. B All else being equal, if the risk-free rate increases, the value of the option increases. C All else being equal, if the dividend yield decreases, the value of the option decreases. D All else being equal, if the stock price increases, the value of the option increases. E All else being equal, if the time to expiration decreases, the value of the option usually increases.

C is true Vega is positive. As the volatility decreases, the option value will decrease. Rho is negative. As the risk-free rate increases, the option value will decrease. Psi is positive. As the dividend yield decreases, the option value will decrease. Delta is negative. As the stock price increases, the option value will decrease. Theta is usually negative. As the time advances (i.e. time to expiration decreases), the option value will usually decrease.

Determine which of the following statements regarding equity financing for private companies is TRUE. A) Angel financing often occurs at such an early stage in the business that it is difficult to assess a value for the firm. Angel investors often circumvent this problem by holding equity. B) A venture capital firm is a general partnership that specializes in raising money to invest in the private equity of young firms. C) A venture capital firm is run by the limited partners. D) Private equity firms often initiate their investment by finding a publicly traded firm and purchasing the outstanding equity, thereby taking the company private in a transaction called a leveraged buyout. E) Corporate investors will only invest ​in companies for the financial return that they will earn on their investments.

D

Determine which of the following statements regarding futures contracts is FALSE. A Futures contracts are essentially exchange-traded forward contracts. B Frequent marking-to-market and settlement of a futures contract can lead to pricing differences between a futures contract and an otherwise identical forward. C For a futures contract, it is possible to offset an obligation on a given date by entering into the opposite position. D Over-the-counter futures contracts can be customized to suit the buyer or seller. E Futures contracts are structured so as to minimize the effects of credit risk.

D. Futures contracts can't be customized

Determine which of the following statements is TRUE. A The value of a European call can never exceed the strike price. B The value of a European put can never exceed the stock price. C The value of a European call on a stock with dividends (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European call (with time-to-maturity T1T1), where T1≤T2T1≤T2. D The value of a European call on a nondividend-paying stock (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European call (with time-to-maturity T1T1), where T1≤T2T1≤T2. E The value of a European put option (with time-to-maturity T2T2) is always at least as great as the value of an otherwise equivalent European put option (with time-to-maturity T1T1), where T1≤T2T1≤T2.

D. While C is generally true, it is not always true

Determine which of the following statements is TRUE. A Beta measures market risk whereas volatility measures firm-specific risk. B In a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk. C A portfolio's beta is the arithmetic average of all the betas for the individual stocks in the portfolio. D A stock's beta is the ratio of the covariance between the stock returns and the market returns to the standard deviation of market returns. E The average beta of a stock in the market is greater than 1.

Diversification reduces a portfolio's total risk by averaging out non-systematic fluctuations. Non-systematic risks (also known as firm-specific, independent, idiosyncratic, unique, or diversifiable risks) can be reduced through diversification, whereas systematic risks (also known as common, market, or undiversifiable risks) cannot be avoided through diversification. Thus, when we combine many firms' stocks into a portfolio, only non-systematic risks (firm-specific risks) will be removed. The portfolio volatility will decline until only the systematic risk (market risk) remains. As a result, in a well-diversified portfolio, market risk accounts for a considerably greater proportion of total risk than firm-specific risk.

Determine which one of the following statements regarding project risk characteristics and financing is FALSE: A Asset betas for firms represent the market risk of an average project for the firm. B For projects that may be more or less risky than average, beta should be estimated based on asset betas of firms that are concentrated in a similar line of business. C If a firm has multiple divisions, one should use different asset betas for each division. D The higher the degree of operating leverage, the higher the project's beta. E Projects with an above-average proportion of fixed costs should be assigned with a lower cost of capital.

E! Operating leverage, which is the relative proportion of fixed costs to total costs (where total costs equal fixed costs plus variable costs), can also affect beta estimates. The higher the degree of operating leverage (i.e., the higher the proportion of fixed costs), the higher the sensitivity of the project's cash flows to market risk, and the higher the project's beta. From the CAPM, a higher beta leads to a higher cost of capital. The discounting rate for costs lowers from the cost of capital to risk-free rate. A lower discounting rate leads to a higher present value of the costs. A higher present value of the costs leads to a lower project value. A lower project value means a higher project cost of capital. A higher project cost of capital means a higher project beta.

A company uses derivatives to manage its financial risk. Determine in which of the following scenarios the company is MOST LIKELY to use a derivative security. A) To comply with generally accepted accounting principles. B) To minimize its tax deductions. C) To hedge against the increase of an asset the company already owns. D) To guarantee that an asset it will be purchasing can be bought at higher price. E) To adequately fund a guarantee it has sold to its customers.

E) To adequately fund a guarantee it has sold to its customers.

Determine which of the following statements regarding international bonds is FALSE: A Domestic bonds are bonds issued by a local entity and traded in a local market, but purchased by foreigners, and are denominated in the local currency. B Foreign bonds are bonds issued by a foreign company in a local market and are intended for local investors, and are denominated in the foreign currency. C Foreign bonds in the United States are known as Yankee bonds. D Eurobonds are international bonds that are not denominated in the local currency of the country in which they are issued. E Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously.

Foreign bonds are denominated in LOCAL currency

Foreign Bonds

Foreign bonds are issued by a foreign entity but traded in a local market and priced in the local currency. These bonds are intended for local investors.

Global Bonds

Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously.

Which of the following statements regarding the valuation in a traditional IPO process is/are true? I) The only way to set the initial price range for the offer price is by estimating the present value of future cash flows. II) Once an initial price range is set, the underwriters try to determine what the market thinks of the valuation by using a greenshoe provision. III) The underwriters undergo a process called book building where they adjust the share price to customer demand so that the IPO is most likely to succeed.

I - FALSE. Can estimate future CF OR compare to similar companies II - FALSE - this is not what a greenshoe is (see FC above) III- TRUE

Which of the following are evidence against the efficient market hypothesis? I) Lesser-known firms yield abnormally high returns. II) New issues have high returns on the first day but underperform over the 3-5 year period after issue. III) There was a one-time increase in the stock price at the time of takeover announcement but no significant abnormal returns afterwards.

I and II

Which of the following statements regarding SEC filings is/are true? I) The SEC requires companies to prepare a registration statement that provides its financial and other information to investors prior to an IPO. II) The red herring circulates to investors before the stock is offered. III) The red herring contains all the details of the IPO, including the number of shares offered and the offer price.

I and II. III is false because the # of shares and price dont come until the final prospectus

Which of the following statements regarding the lognormal distribution is/are TRUE? I) Products of independent lognormal random variables are lognormally distributed. II) Any number could occur when you draw from the distribution. III) Its median is always less than or equal to its mean. IV) In the binomial model, the continuously compounded stock return approaches normality as the number of steps increases.

I,III,IV

Under the Capital Asset Pricing Model, which of the following statements is/are TRUE? All traded securities should lie on the capital market line. All traded securities should lie on the security market line. All traded securities have risk premiums that are scaled according to their systematic risks.

II and III

You are given the following scenarios regarding investor behavior: I) A significant number of uninformed investors hold an inefficient portfolio because they are overconfident in their ability to manage a portfolio. II) Investors hold inefficient portfolios because they care about other factors other than expected return and volatility. II)) Investors do not have rational expectations, thus misinterpret information to believe they are earning a positive alpha when they are actually holding a negative alpha. Determine which of the scenarios above would cause the market portfolio to become inefficient.

II and III

Consider the following 5 asset classes: I) International stocks II) Small-cap stocks III) Large-cap stocks IV) Treasury bills V) AAA-rated corporate bonds Looking at a very long time period (at least several decades), rank the asset classes above from highest to lowest volatility, assuming the future is consistent with the past.

II,III,I,V,IV

Which of the following statements regarding the normal distribution is FALSE? A It is symmetric. B Any number could occur when you draw from the distribution. C Its single hump occurs at the mean. D Sums of independent normal random variables are normally distributed. E In the binomial model, the stock's annual effective return approaches normality as the number of steps becomes large.

In the binomial model, the continuously compounded return approaches normality as the number of steps becomes large.

A binomial tree is used to model stock prices. As the number of periods in the tree increases, which distribution of stock price will the binomial tree approximate?

Lognormal

Research proves that the capital asset pricing model does not depend on homogeneous expectations of investors. However, it does require rational expectations and everyone to hold the market portfolio in aggregate. Determine the bias or effect that will NOT cause inefficiency in the market portfolio. A Overconfidence bias B Disposition effect C Information cascade effect D Herd behavior E Size effect

Of the answer choices, overconfidence bias is the only nonsystematic bias. Thus, the effects of this bias will be "diversified out" and will not have an impact on market prices. Every other bias or effect is systematic, where all investors act irrationally in the same manner, thus causing a stock price to deviate from its fundamental value.

Determine which of the following is least likely a transaction cost associated with short-selling stocks. Collateral Dividends Bid-ask spreads Commission fees Opportunity costs

Opportunity Costs: This is an implicit cost, not a transactional cost

Determine which of the following statements regarding sovereign debt is TRUE. A Sovereign debt is issued by state and local governments. B Treasury securities that do not pay any coupons and have an original maturity of 26 weeks are called STRIPS. C Treasury securities that pay semiannual coupons and have an original maturity of 7 years are called Treasury bonds. D Treasury securities that pay semiannual coupons and have an original maturity of 15 years are called Treasury bonds. E The dollar coupon of TIPS is fixed.

Solution Statement A is false. Sovereign debt is issued by national governments. Municipal bonds are issued by state and local governments. Statement B is false. Treasury securities that do not pay any coupons and have an original maturity of 26 weeks are called Treasury bills. Treasury bills are zero-coupon bonds with maturities shorter than 1 year, whereas STRIPS are zero-coupon bonds with maturities longer than 1 year. Statement C is false. Treasury securities that pay semiannual coupons and have an original maturity of 7 years are called Treasury notes. Treasury notes are semiannual coupon bonds with maturities ranging from 1 to 10 years. Statement D is true. Treasury bonds are semiannual coupon bonds with maturities longer than 10 years. Statement E is false. Treasury inflation-protected securities (TIPS) are semiannual coupon bonds where the principal is adjusted for inflation. Although the coupon rate is fixed, the dollar coupon payment varies because the semiannual coupon payments are a fixed rate of the inflation-adjusted principal.

Determine which of the following statements about the capital structure in a perfect capital market is FALSE. A Even with perfect capital markets, leverage would affect a firm's value. B Leverage increases the risk of the equity of a firm. C Leverage increases the risk of equity even when there is no risk that the firm will default. D A risk-free debt has a risk premium of zero. E Promised payments to debt holders must be made before any payments to equity holders are distributed.

Statement A is false. In a perfect capital market, financing and investment decisions are independent of each other. A firm's financing decisions do not change the cash flows generated by its investments. Thus, the firm's capital structure is irrelevant. Changing a firm's capital structure merely changes how the value of its assets is divided between debt and equity, but not the firm's total value. Statements B and C are true. Modigliani-Miller Proposition II states that the cost of capital of levered equity increases with the firm's debt-to-equity ratio. This is true even when there is no risk that the firm will default. Statement D is true. A risk-free debt has a beta of zero: Statement E is true. Debt holders have a priority claim on assets and income above equity holders. Debt holders must be paid first before any payments to equity holders are distributed.

Determine which of the following statements regarding public debt is FALSE: A Corporate bonds always pay coupons semiannually. B Bearer bonds are like currency. C Almost all bonds that are issued today are registered bonds. D Debentures and notes are unsecured debt. E For asset-backed bonds and mortgage bonds, specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy.

Statement A is false. Most corporate bonds in the United States pay semiannual coupons. However, some companies (e.g., Coca-Cola) issue zero-coupon bonds. Statements B and C are true. Bearer bonds are like currency: Whoever physically holds the bond certificate owns the bond. Historically, most corporate bonds were bearer bonds, where the owner of the bearer bond physically held the bond certificate. The holder must provide explicit proof of ownership in order to receive coupon payments. However, most bonds now are registered bonds, where the owner does not physically hold the bond certificate. The issuer just maintains a list of all holders of its bonds and pays coupons automatically to the holders in the list on the coupon payment dates. Statements D and E are true. There are four common types of corporate debt: notes, debentures, mortgage bonds, and asset-backed bonds. Notes and debentures are unsecured. In case of bankruptcy, bondholders can only claim assets which are not already being used as collateral to other debt. Also, notes have shorter maturities than debentures. Mortgage bonds and asset-backed bonds are secured. Thus, in case of bankruptcy, bondholders can claim specific assets which have been designated as collateral. Mortgage bonds are secured with real property, while asset-backed bonds are secured with any kind of asset.

A multi-factor model is sometimes used as an alternative to the Capital Asset Pricing Model. Determine which of the following statements must be TRUE regarding the multi-factor model. a) Investors incur taxes and/or transaction costs in trading securities. b) Investors have varying expectations regarding the volatilities, correlations, and expected returns of securities. c) The market portfolio of securities is efficient. d) It is necessary to identify the efficient portfolio to calculate the expected return of a security. e) A collection of well-diversified portfolios can be used to calculate the expected return of a security.

Statement A is false. The Berk/DeMarzo text does not mention anything about taxes and/or transaction costs when discussing the multi-factor model. Statement B is false. The Berk/DeMarzo text does not mention anything about investor's expectations regarding the volatilities, correlations, and expected returns of securities when discussing the multi-factor model. Statement C is false. According to the Berk/DeMarzo text, the reason why the multi-factor model is used as an alternative to the CAPM is because the market portfolio may not be efficient. Statement D is false and Statement E is true. It is extremely difficult to identify efficient portfolios because we cannot measure the expected return and the standard deviation of a portfolio with great accuracy. Fortunately, we can construct an efficient portfolio from other well-diversified portfolios. It is not necessary to identify the efficient portfolio itself; as long as we can identify a collection of well-diversified portfolios from which an efficient portfolio can be constructed, we can use the collection itself to calculate the expected return of a security.

Determine which of the following statements regarding investor behavior and capital market efficiency is FALSE: a) If an investor can use past returns to construct a trading strategy that makes consistent profit, it is evidence that market portfolio is not efficient. b) Investors might expect stocks to have non-zero alphas if the market proxy portfolio is not highly correlated with the true market portfolio, even if the true market portfolio is efficient. c) If some investors are subject to systematic behavioral biases while others select efficient portfolios, then the market portfolio will not be efficient. d) An employee who cares about the risk due to human capital will likely underweight the amount of money he invests in his own company's stock relative to an investor who does not work for his company. e) The disposition effect reduces investor's tax obligations.

Statement A is true. If the market portfolio is efficient, then all stocks will plot on the SML and have an alpha of zero. Investors cannot construct any strategy that has a positive alpha. Statement B is true. If the proxy portfolio is not highly correlated with the market portfolio, then it will not capture some components of systematic risk. The alphas reflect the risk components that the proxy portfolio is not capturing. The true market portfolio includes every type of tradable assets in the economy, such as bonds, real estate, and art. However, due to the lack of competitive price data, the market proxy cannot include most of these investments. So, even if the true market portfolio is efficient, the proxy may be inaccurate. Statement C is true. The market portfolio consists of the combination of all investors' portfolios. If some investors hold inefficient portfolios that depart from being efficient in systematic ways while the rest of investors hold efficient portfolios, the sum of all these investors' portfolios will not be efficient. Statement D is true. Since employees are already partially invested in their company due to their work (human capital), their optimal diversification strategy should take this into account, and thus should underweight their own company's stock. Statement E is false. The disposition effect has negative tax consequences. The disposition effect causes investors to sell stocks that have appreciated and hold onto stocks that have depreciated. Thus, investors are paying capital gains taxes that they could defer and deferring tax deductions they could take immediately. As a result, these investors are increasing their required tax obligations (due to the time value of money).

Determine which of the following statements regarding private debt is FALSE: A Private debt is cheaper to issue than public debt. B The private debt market is larger than the public debt market. C The private debt market is more liquid than the public debt market. D A private placement is a bond issue that is sold privately to a small group of investors. E A revolving line of credit is a credit commitment for a specific time period up to some limit.

Statement A is true. It is cheaper to issue private debts because there is no registration cost. Statement B is true. The private debt market is indeed larger than the public debt market. Statement C is false. Note however, that the private debt market, although larger than the public debt market, is illiquid. Thus, the advantage of private debt is you avoid the cost of registration, but the disadvantage is illiquidity. Statement D is true. A private placement is a bond issue that is sold privately to a small group of investors. It is cheaper to issue since, in addition to the absence of any registration cost, a simple promissory note is used instead of an indenture, and the standards that apply are not as restrictive as for public debt. Statement E is true. A revolving line of credit is a credit commitment for a specific time period up to some limit, which a company can use as necessary. The line of credit is backed by specific assets, so it is more secure than the term loan. A term loan is a bank loan that lasts for a period of time.

Determine which of the following statements regarding the direct costs of bankruptcy is FALSE. A When a corporation becomes financially distressed, outside professionals, such as legal and accounting experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are generally hired. B The direct costs of bankruptcy are likely to be higher for firms with more complicated business operations and for firms with larger numbers of creditors. C The direct costs of bankruptcy are typically lower, in percentage terms, for smaller firms. D When a financially distressed firm is successful at reorganizing outside of bankruptcy, it is called a workout. E With a prepackaged bankruptcy, a firm will first develop a reorganization plan with the agreement of its main creditors, and then file Chapter 11 to implement the plan.

Statement A is true. When a corporation becomes financially distressed, it generally incurs direct costs of bankruptcy. Direct costs include fees to outside professionals like legal and accounting experts, consultants, appraisers, auctioneers, and investment bankers. Statement B is true. This is true because​ it may be more difficult to reach agreement among many creditors regarding the final disposition of the firm's assets. Statement C is false. As many aspects of the bankruptcy process are independent of the size of the firm, the costs are typically higher, in percentage terms, for smaller firms. Statements D and E are true. Alternatives to bankruptcy, designed to save the direct costs, are: Workout. The company negotiates directly with creditors and works out an agreement. Prepackaged bankruptcy (or "prepack"). The company will first create a reorganization plan with the agreement of its primary creditors, and then file Chapter 11 reorganization to implement the plan.

Which of the following would not support the weak form of the efficient market hypothesis? A Stock prices behave more like a random walk. B Stock returns exhibit positive serial correlation. C Prior to the takeover announcement, there was a gradual increase in the target's stock price. At the time of the announcement, there was a one-time instantaneous price increase. After the announcement, there was no significant further price drift. D The top performing fund managers in one year only have a 50% chance to beat their reference index the following year. E (A), (B), (C), and (D) support the weak form of the efficient market hypothesis.

Statement B does not support the weak form. It illustrates the momentum effect, which asserts that there is a positive serial correlation in stock prices, meaning rising stock prices continue to rise and falling prices continue to fall. This is against the weak form EMH, which asserts that stock prices are purely random or unrelated to past data.

Determine which one of the following statements regarding diversification is FALSE: A It is possible for the covariance of returns between two stocks to be negative. B Stocks in the same industry tend to have less highly correlated returns than stocks in different industries. C Almost all pairs of randomly selected stocks will have positive correlation coefficients. D The lower the correlation coefficients among pairs of stocks in a portfolio, the lower the variability of the portfolio. E The diversification benefit is least valuable when adding a second stock to a one-stock portfolio when the correlation coefficient is 11.

Statement B is false. Stocks in the same industry tend to have more highly correlated returns than stocks in different industries. The returns for the stocks in the same industry tend to go up and down together than stocks in different industries.

Determine which of the following statements regarding multi-factor models is NOT true. A If we use multiple portfolios as factors, then together these factors may capture all systematic risk, with each factor capturing different components of the systematic risk. B The model is also referred to as the Arbitrage Pricing Theory (APT). C A self-financing portfolio is any portfolio with portfolio weights that sum to zero. D A self-financing portfolio is constructed​ by going long some stocks, and going short other stocks with equal book value. E Multifactor models rely on the weaker condition that we can construct an efficient portfolio from a collection of well-diversified portfolios or factors.

Statement D is false. A self-financing portfolio is constructed​ by going long some stocks, and going short other stocks with equal market value.

Determine which of the following is NOT an assumption that underlies the Capital Asset Pricing Model. A Investors hold only efficient portfolios of traded securities. B Investors can borrow and lend at the risk-free rate of return. C Investors can buy and sell all securities at competitive market prices without incurring taxes or transaction costs. D Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities. E A collection of well-diversified portfolios can be used to calculate the expected return of a security.

Statement E is an assumption that underlies the multi-factor factor (APT) model. It is not an assumption that underlies the CAPM.

Determine which one of the following statements about the agency costs of leverage is FALSE: A When a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm. B When an unlevered firm issues new debt, equity holders will bear any agency or bankruptcy costs via a discount in the price they receive for the new debt. C When a levered firm issues new debt, existing debt holders will bear agency or bankruptcy costs. D Equity holders may have an incentive to increase financial leverage, even if doing so would decrease the value of the firm. E Agency costs are larger for short-term debt than for long-term debt.

Statement E is false. Agency costs are smallest for short-term debt.

Determine which of the following statements regarding the average behavior of individual investors is FALSE. A Investors fail to diversify their portfolios adequately. B Investors favor investments in companies they are familiar with. C Investors care most about the performance of their portfolio relative to that of their peers. D Investors tend to trade very actively. E Investors tend to hang on to winners and sell losers.

Statement E is related to disposition effect. Investors tend to hold on to investments that have lost value (losers) and sell investments that have increased in value (winners).

Determine which of the following statements is TRUE. A Diversification would reduce risk even if the stocks were perfectly positively correlated. B Diversification over a large number of assets completely eliminates risk. C Diversification only works when assets are uncorrelated. D A stock with a low volatility always contributes less to portfolio risk than a stock with a higher volatility. E The contribution of a stock to the risk of a well-diversified portfolio depends on its market risk.

Statement E is true. For a well-diversified portfolio, all diversifiable (a.k.a. non-systematic, firm-specific, unique, independent) risks are eliminated. As a result, the only risk that matters for a well-diversified portfolio is nondiversifiable (a.k.a. systematic, market) risk.

Determine which of the following statements regarding project risk analysis is TRUE: A Break-even analysis does not consider the time value of money. B Sensitivity analysis and scenario analysis are useful tools for estimating the impact on a project's NPV of changing the value of one capital budgeting input variable at a time. C Sensitivity analysis accounts for the fact that the underlying variables are interrelated. D Scenario analysis is designed to identify the variables that are most influential on the success or failure of a project. E Monte Carlo simulation allows for combining the risk of various sources of uncertainty.

Statement E is true. Monte Carlo simulation allows for combining the risk of various sources of uncertainty. It is the most thorough method for project analysis because allows us to consider all possible combinations of model variables in an aggregate framework. The more complex an insurance product, or an investment portfolio, the more beneficial simulation methods will be. For example, if the insurance product's cash flows depend either on interest rates or the stock market, or if the investment portfolio contains a combination of stocks, bonds, and options.

According to Corporate Finance by Berk and DeMarzo, which of the following statements regarding a financially distressed airline is TRUE? The direct cost of bankruptcy is often much larger than the indirect costs of financial distress. Customers will still be willing to buy plane tickets in advance. An airline may sell their aircraft at prices that are lower than the prices received by healthier rivals in an effort to avoid bankruptcy and its associated costs.

Statement I is false. The indirect costs of financial distress are often much larger than the direct costs of bankruptcy. Statement II is false. Customers may be unwilling to buy products from firms in financial distress, especially if the products depend on future support or service from the firm. For example, customers will be reluctant to buy plane tickets in advance from a distressed airline that may cease to operate. Statement III is true. Distressed firms may attempt to sell assets quickly to raise cash. They may accept a lower price than would be optimal if it were financially healthy. This is known as fire sales of assets. A study of airlines shows that distressed companies sell their aircraft at prices that are 15% to 40% below the prices received by healthier rivals.

Which of the following statements about the optimal debt level is/are TRUE? The optimal level of debt is the same for all firms. Firms with high R&D costs and future growth opportunities typically maintain low debt levels. Mature, low-growth firms with stable cash flows and tangible assets often maintain low debt levels.

Statement I is false. The relative magnitudes of the different costs and benefits of debt vary with the characteristics of the firm. Likewise, the optimal level of debt varies. Statement II is true. According to the Berk/DeMarzo text, firms with high R&D costs and future growth opportunities typically maintain low debt levels. These firms tend to have low current free cash flows, so they need little debt to provide a tax shield or to control managerial spending. In addition, they tend to have high human capital, so there will be large costs as a result of financial distress. Also, these firms may find it easy to increase the risk of their business strategy (by pursuing a riskier technology) and often need to raise additional capital to fund new investment opportunities. Thus, their agency costs of debt are also high. Biotechnology and technology firms often maintain less than 10% leverage. (Berk, Jonathan. Corporate Finance) Statement III is false. According to the Berk/DeMarzo text, mature, low-growth firms with stable cash flows and tangible assets often fall into the high-debt category. These firms tend to have high free cash flows with few good investment opportunities. Thus, the tax shield and incentive benefits of leverage are likely to be high. With tangible assets, the financial distress costs of leverage are likely to be low, as the assets can be liquidated for close to their full value. Examples of low-growth industries in which firms typically maintain greater than 20% leverage include real estate, utilities, and supermarket chains. (Berk, Jonathan. Corporate Finance) REPORT

Determine which of the following statements about Modigliani and Miller propositions in a perfect capital market is FALSE. A If investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result. B As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm. C With perfect capital markets, because different choices of capital structure offer no benefit to investors, they do not affect the value of the firm. D A firm's WACC increases with the firm's market value debt-equity ratio. E With perfect capital markets, a firm's WACC is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.

Statements A and B are true. Since MM assumes investors can borrow and lend without any cost, investors can borrow or lend on their own to achieve a capital structure different from what the firm has chosen. For example, if an investor wants more leverage than the firm has chosen, he or she can borrow and add leverage to his or her portfolio. This is known as homemade leverage. As long as the investors can borrow or lend at the interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm. Statement C is true. According to MM Proposition I, the total value of a firm's securities is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. Changing a firm's capital structure merely changes how the value of its assets is divided between debt and equity, but not the firm's total value. Statement D is false. The cost of capital of levered equity increases with the firm's market value debt-equity ratio, while the WACC remains constant. Statement E is true. Based on MM Proposition I, in a perfect capital market, the value of an unlevered firm is equal to the value of a levered firm. Thus, the market value of the assets in an unlevered firm is equal to that of a levered firm. Note that: Since an unlevered firm is 100% equity and no debt, the market value of the assets in an unlevered firm is simply equal to the market value of unlevered equity (U)(U). The market value of the assets in a levered firm is the sum of the market value of levered equity (E)(E) and the market value of debt (D)(D): VU⇒U=VL=E+DVU=VL⇒U=E+D The return on the assets of an unlevered firm must be the same as that for a levered firm. Thus, we can establish the following relationship between the cost of capital for unlevered equity (rU)(rU), levered equity (rE),(rE), and debt (rD)(rD): rU=rWACC=EE+D⋅rE+DE+D⋅rDrU=rWACC=EE+D⋅rE+DE+D⋅rD Thus, with perfect capital markets, a firm's WACC is independent of its capital structure and is equal to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets.

Assume a perfect capital market. Determine which of the following statements regarding Modigliani-Miller I is FALSE. A In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets. B By the Law of One Price, the firm's securities and its assets must have the same total market value. C As long as the firm's choice of securities does not change the cash flows generated by its assets, this decision will not change the total value of the firm or the amount of capital it can raise. D Using leverage may result in net gain or loss. E The value of the firm is determined by the present value of the cash flows from its current and future investments.

Statements I, II, and III are true. In a perfect capital market, the total value of a firm's securities is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. If the firm's securities and its assets are fairly priced (i.e., they abide by the law of one price), then there is no arbitrage, and the total market value of the firm should equal the market value of its asset. Statement IV is false but statement V is true. If securities are fairly priced, then buying or selling securities has an NPV of zero, and thus should not change the value of a firm. The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives upfront. Therefore, there is no net gain or loss from using leverage. The value of the firm is determined by the present value of the cash flows from its current and future investments.

Determine which of following is an example of a behavioral bias that might cause the market portfolio not to be efficient. A Investors are attracted to large growth stocks that receive greater news coverage. B Investors are attracted to investments with skewed distributions that have a small probability of an extremely high payoff. C The true market portfolio may be efficient, but the proxy an investor uses to mimic the market portfolio may be inaccurate. D Investors are exposed to significant non-tradeable risks outside their portfolio, such as human capital. E Investors systematically ignore positive-NPV investment opportunities.

There are several reasons why the market portfolio might not be efficient: Proxy Error. Even though the true market portfolio may be efficient, the market proxy that the investors used may be inaccurate. The true market portfolio consists of all traded wealth, which includes bonds, real estate, art, and so on. Unfortunately, it is not possible to include most of these investments in the market proxy because not all price data is available. As a result, standard proxies such as the S&P 500 may be inefficient compared with the true market. Behavioral Biases. While some sophisticated investors hold efficient portfolios, some other investors may be subject to behavioral biases. For example, some investors may be attracted to large growth stocks that receive greater news coverage, or sell winners and hang on to losers, following a contrarian strategy. As a result, they hold inefficient portfolios. Since the market portfolio is the combined holdings of the biased and sophisticated investors, the resulting market portfolio might not be efficient. Alternative risk preferences. Some investors focus on risk characteristics other than the volatility of their portfolio. As a result, they may choose inefficient portfolios. For example, some investors may choose investments with skewed distributions that have a small probability of an extremely high payoff. Non-tradable Wealth. Investors are exposed to other significant non-tradable risks outside their portfolio. For example, an investment banker is exposed to financial sector risk, while a computer programmer is exposed to tech sector risk. These risks are due to their work (human capital) and are not tradable. As the banker and the programmer select their portfolios, they may choose to invest more or less in these sectors. They deviate from the market portfolio to offset the inherent exposures. Thus, A is correct.

Venture capital firms

Venture Capital Firms. When a company requires more capital than angel investors can provide, it can seek funds from venture capital firms. A venture capital firm is a limited partnership specializing in raising money to invest in early-stage companies (often investing in many for diversification). Venture capital firms consist of (i) general partners (also called "venture capitalists") who run the firm, and (ii) limited partners consisting mainly of institutional investors (such as pension funds). A venture capital firm usually demands a great deal of control in exchange for capital. Once funding has been provided, the general partners become actively involved in running the company, often sitting on the board of directors and assuming key management roles. In addition to an annual management fee of about 1.5%-2.5% of the fund's committed capital, general partners also take a share of any profit generated by the fund in a fee referred to as carried interest. Most firms charge 20%, but some take up to 30%, of any profits as carried interest.

Yankee Bonds

Yankee bonds are foreign bonds in the United States. In other countries, foreign bonds also have special names. For example, in Japan they are called Samurai bonds; in the United Kingdom, they are known as Bulldogs.

Determine which of the following statements regarding behavioral biases is FALSE: a) Uninformed investors are more likely to purchase stocks that have advertised a lot or have experienced unusually high recent trading volume or returns. b) Investors who follow the herd do not consistently outperform those who take more contrarian (i.e., anti-herd) views. c) The information cascade effect occurs when traders ignore their own information and act on information from others that they trust more. d) If fund managers are going to fail, they would much rather have done something different than their peers than to demonstrate herd behavior. e) Studies have indicated that men, on average, earn lower returns than women do.

d: One of the explanations for herd behavior is that investment managers may risk damaging their reputations if their actions are far different from those of their peers. This means that if they feel they are going to fail, then they would rather fail with most of their peers than fail while most succeed.

Carried interest

general partners of venture capital firms also take a share of any profit generated by the fund in a fee referred to as carried interest. Most firms charge 20%, but some take up to 30%, of any profits as carried interest.

leverage ratchet effect

once existing debt is in place, shareholders may have an incentive to increase leverage even if it decreases the value of the firm, and shareholders may prefer not to decrease leverage by buying back debt even when it will increase the value of the firm

Market order

pays the market price (the ask price) to buy the stock immediately, or sells at the market price (the bid price) immediately. As long as there are willing sellers and buyers, market orders are executed. Market orders are used when certainty of execution is a priority over price of execution.

cost of carry

r-delta

stop-loss order

specifies that the stock is sold if the price decreases to the specified amount. As with all limit orders, a stop-limit order doesn't get filled if the security's price never reaches the specified limit price. Since the stock is sold at the market price, the actual sales price may be less than the cutoff point.

limit order

specifies the maximum buying price or the minimum selling price. This gives the trader control over the price at which the trade is executed; however, the order may never be executed. Limit orders are used when the trader wishes to control price rather than certainty of execution.

Determine which of the following statements about issuing equity and adverse selection is FALSE. A The stock price declines on the announcement of an equity issue. B Managers issuing equity have an incentive to delay the issue until any news that might positively affect the stock price becomes public. C The stock price tends to rise prior to the announcement of an equity issue. D Firms tend to issue equity immediately before earnings announcements. E Managers who perceive the firm's equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity.

tatements A, B, C, and E are true. Statement D is false. Adverse selection has a number of important implications for equity issuance: Stock prices decline when an equity issue is announced. When a firm issues equity, it signals to investors that the firm's equity may be overvalued. As a result, investors are not willing to pay the pre-annoucement price of the equity, and consequently the stock price declines. Stock prices tend to rise prior to the announcement of an equity issue. This is because managers issuing equity delay releasing bad news before an equity issue but release any good news. Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements. Negative price reaction is smallest immediately following an earnings annoucement. This leads to the pecking order hypothesis, which asserts that managers prefer to make financing choices that send positive rather than negative signals to outside investors. As a result, the pecking order (from most favored to least favored financing option) is: Internally generated equity (i.e., retained earnings) Debt External equity (i.e., newly issued shares)