chapter 8-11 FIN 3010

What is the net present value of a project with the following cash flows if the discount rate is 15 percent? Year Cash Flow 0 -$39,400 1 $12,800 2 $21,700 3 $18,100

A. $39.80

Portfolio diversification eliminates which one of the following?

Unsystematic risk

If the financial markets are semistrong form efficient, then:

only individuals with private information have a marketplace advantage.

Over the period of 1926-2011:

the risk premium on stocks exceeded the risk premium on bonds

Services United is considering a new project that requires an initial cash investment of $78,000. The project will generate cash inflows of $29,500, $32,700, $18,500, and $10,000 over each of the next four years, respectively. How long will it take to recover the initial investment?

B. 2.85 years Payback = 2 + ($78,000 - $29,500 - $32,700)/$18,500 = 2.85 years

Which one of the following is the primary advantage of payback analysis?

B. Ease of use

The Flour Baker is considering a project with the following cash flows. Should this project be accepted based on its internal rate of return if the required return is 11 percent? Year Cash Flow 0 -$59,000 1 $12,000 2 $24,000 3 $22,000 4 $13,000

C. No, because the project's rate of return is 7.78 percent The IRR is the interest rate that causes the NPV to equal zero.

You are considering the following two mutually exclusive projects. The crossover point is _____ and Project _____ should be accepted if the discount rate is 14 percent. Year Project A Project B A-B 0 -$21,000 -$21,000 0 0 $7,000 $15,000 -8,000 2 $7,000 $5,000 2,000 3 $15,000 $7,000 8,000

C. 13.28 percent; B The crossover point is 13.28 percent. Project B should be accepted at 14 percent because it has the higher net present value.

Which one of the following statements is correct?

C. The payback period ignores the time value of money.

Which one of the following is the best example of systematic risk?

Decrease in gross domestic product

The expected return on a security depends on which of the following? I. Risk-free rate of return II. Amount of the security's unique risk III Market rate of return IV. Standard deviation of returns

I and III only

The average compound return earned per year over a multi-year period is called the _____ average return.

geometric

A $36,000 portfolio is invested in a risk-free security and two stocks. The beta of Stock A is 1.29 while the beta of Stock B is 0.90. One-half of the portfolio is invested in the risk-free security. How much is invested in Stock A if the beta of the portfolio is 0.58?

$12,000

A portfolio has an expected return of 12.3 percent. This portfolio contains two stocks and one risk-free security. The expected return on Stock X is 9.7 percent and on Stock Y it is 17.7 percent. The risk-free rate is 3.8 percent. The portfolio value is $78,000 of which $18,000 is the risk-free security. How much is invested in Stock X?

$21,375

One year ago, you purchased a 6 percent coupon bond with a face value of $1,000 when it was selling for 98.6 percent of par. Today, you sold this bond for 101.2 percent of par. What is your total dollar return on this investment?

$86 SOLUTION: Dollar Return = coupon + selling price - buying price Buying Price = .986*1000 = $986 Selling Price = 1.012 * 1000 = $1012 Coupon = .06 * 1000 = $60 Dollar Return = $60 + $1012 - $986 = $86

Given the following information, what is the variance of the returns on this stock? B, .18, N, .77, R, .05

0.021449

You currently own a portfolio valued at $56,000 that has a beta of 1.28. You have another $10,000 to invest and would like to invest it in a manner such that the portfolio beta decreases to 1.20. What does the beta of the new investment have to be?

0.75

What is the beta of the following portfolio? B, (S, .97. T, 1.26, U, .79, V, 1.48)

1.02

BJB, Inc. stock has an expected return of 15.15 percent. The risk-free rate is 3.8 percent and the market risk premium is 8.6 percent. What is the stock's beta?

1.32

A stock has an expected return of 15.0 percent, the risk-free rate is 3.2 percent, and the market risk premium is 8.1 percent. What must the beta of this stock be?

1.46

Currently, the risk-free rate is 4.0 percent. Stock A has an expected return of 9.6 percent and a beta of 1.08. Stock B has an expected return of 13.5 percent. The stocks have equal reward-to-risk ratios. What is the beta of Stock B?

1.83

You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.12 and the total portfolio is equally as risky as the market, what must the beta be for the other stock in your portfolio?

1.88

You own a portfolio of two stocks, A and B. Stock A is valued at $6,500 and has an expected return of 11.2 percent. Stock B has an expected return of 8.1 percent. What is the expected return on the portfolio if the portfolio value is $9,500?

10.22 percent

Given the following information, what is the standard deviation of the returns on a portfolio that is invested 40 percent in Stock A, 35 percent in Stock B, and the remainder in Stock C? RoR, (A, 14.3, B, 16.7, C, 18.2)

11.86 percent

Given the following information, what is the expected return on a portfolio that is invested 30 percent in both Stocks A and C, and 40 percent in Stock B? RoR, (A, 7.8, B, 23.6, C, 18.4)

11.97 percent

You own a portfolio that has $1,900 invested in Stock A and $2,700 invested in Stock B. If the expected returns on these stocks are 9 percent and 15 percent, respectively, what is the expected return on the portfolio?

12.52 percent

What was the average annual risk premium on small-company stocks for the period 1926-2011?

12.9 percent

You own a portfolio consisting of the securities listed below. The expected return for each security is as shown. What is the expected return on the portfolio? ER, (W, 8.9, X, 11.6. Y, 28.4, 12.7)

14.20 percent

You want to create a $48,000 portfolio that consists of three stocks and has an expected return of 14.5 percent. Currently, you own $16,700 of Stock A and $24,200 of Stock B. The expected return for Stock A is 18.7 percent, and for Stock B it is 11.2 percent. What is the expected rate of return for Stock C?

15.87 percent

Stock J has a beta of 1.47 and an expected return of 15.8 percent. Stock K has a beta of 1.05 and an expected return of 11.9 percent. What is the risk-free rate if these securities both plot on the security market line?

2.15 percent

Stock Y has a beta of 1.28 and an expected return of 13.7 percent. Stock Z has a beta of 1.02 and an expected return of 11.4 percent. What would the risk-free rate have to be for the two stocks to be correctly priced relative to each other?

2.38 percent

Given the following information, what is the standard deviation of the returns on this stock? B, .04, N, .74, R, .22

25.52 percent

Noah's Landing stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

4.05 percent

Consider the following information on a portfolio of three stocks: The portfolio is invested 35 percent in each Stock A and Stock B and 30 percent in Stock C. If the expected T-bill rate is 3.90 percent, what is the expected risk premium on the portfolio? Boom, (.15, .05, .21, .18)

6.19 percent

A stock has a beta of 1.47 and an expected return of 16.6 percent. The risk-free rate is 4.8 percent. What is the slope of the security market line?

8.03 percent

A risky security has less risk than the overall market. What must the beta of this security be?

> 0 but < 1

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

A decrease in the probability of an economic boom

Which one of the following statements related to the security market line is correct?

A security with a beta of 1.54 will plot on the security market line if it is correctly priced.

Which one of the following is the best example of unsystematic risk?

A warehouse fire

What is the net present value of the following cash flows if the relevant discount rate is 9.0 percent? Year Cash Flow 0 -$21,260 1 $11,215 2 $14,678 3 -$9,807 4 $13,500

A. $3,374.11

Molly is considering a project with cash inflows of $918, $867, $528, and $310 over the next four years, respectively. The relevant discount rate is 10 percent. What is the net present value of this project if it the start-up cost is $2,100?

A. $59.50

Professional Properties is considering remodeling the office building it leases to Heartland Insurance. The remodeling costs are estimated at $3.4 million. If the building is remodeled, Heartland Insurance has agreed to pay an additional $820,000 a year in rent for the next five years. The discount rate is 15 percent. What is the benefit of the remodeling project to Professional Properties?

A. -$651,233

The average accounting return:

A. measures profitability rather than cash flow.

What is the net present value of the following cash flows if the relevant discount rate is 8.0 percent? Year Cash Flow 0 -$68,000 1 $51,000 2 -$39,000 3 $74,000

B. $4,529.59

Chasteen, Inc. is considering an investment with an initial cost of $185,000 that would be depreciated straight-line to a zero book value over the life of the project. The cash inflows generated by the project are estimated at $76,000 for the first two years and $30,000 for the following two years. What is the internal rate of return?

B. 6.94 percent The IRR is defined as the interest rate that makes the NPV equal zero.

Which one of the following defines the internal rate of return for a project?

B. Discount rate that results in a zero net present value for the project

The modified internal rate of return is specifically designed to address the problems associated with which one of the following?

B. Unconventional cash flows

The Tool Box needs to purchase a new machine costing $1.46 million. Management is estimating the machine will generate cash inflows of $223,000 the first year and $600,000 for the following three years. If management requires a minimum 12 percent rate of return, should the firm purchase this particular machine? Why or why not?

B. Yes, because the IRR is 12.74 percent The IRR is defined as the interest rate that makes the NPV equal zero. The project should be accepted because the IRR is greater than the required rate.

Empire Industries is considering adding a new product to its lineup. This product is expected to generate sales for four years after which time the product will be discontinued. What is the project's net present value if the firm wants to earn a 13 percent rate of return? Year Cash Flow 0 -$62,000 1 $16,500 2 $23,800 3 $27,100 4 $23,300

C. $4,312.65

A project has the following cash flows. What is the payback period? Year Cash Flow 0 -$31,000 1 $15,600 2 $10,200 3 $8,700 4 $7,100

C. 2.60 years Payback = 2 + ($31,000 - $15,600 - $10,200)/$8,700 = 2.60 years

Based on the most recent survey information presented in your textbook, CFOs tend to use which two methods of investment analysis the most frequently?

C. Internal rate of return and net present value

Jefferson International is trying to choose between the following two mutually exclusive design projects: Year Cash Flow (A) Cash Flow (B) 0 -$75,000 -$38,000 1 $32,400 $17,800 2 $30,200 $14,200 3 $36,600 $19,800 The required return is 12 percent. If the company applies the profitability index (PI) decision rule, which project should the firm accept? If the company applies the NPV decision rule, which project should it take? Given your first two answers, which project should the firm actually accept?

C. Project B; Project A; Project A The firm should select Project A because the PI rule should not be applied to mutually exclusive projects.

An investment has conventional cash flows and a profitability index of 1.0. Given this, which one of the following must be true?

C. The net present value is equal to zero.

An investment has an initial cost of $300,000 and a life of four years. This investment will be depreciated by $60,000 a year and will generate the net income shown below. Should this project be accepted based on the average accounting rate of return (AAR) if the required rate is 9.5 percent? Why or why not? Year Net Income 1 $14,500 2 $16,900 3 $19,600 4 $23,700

C. Yes, because the AAR is greater than 9.5 percent Average net income = ($14,500 + $16,900 + $19,600 + $23,700)/4 = $18,675 Average book value = ($300,000 + $240,000 + $180,000 + $120,000 + $60,000)/5 = $180,000 AAR = $18,675/$180,000 = 10.38 percent The project should be accepted because the AAR is greater than the required return.

The net present value of a project's cash inflows is $8,216 at a 14 percent discount rate. The profitability index is 1.03 and the firm's tax rate is 34 percent. What is the initial cost of the project?

D. $7,976.70 Initial cost = $8,216/1.03 = $7,976.70

A firm is reviewing a project that has an initial cost of $71,000. The project will produce annual cash inflows, starting with year 1, of $8,000, $13,400, $18,600, $33,100, and finally in year 5, $37,900. What is the profitability index if the discount rate is 11 percent?

D. 1.07

A project has the following cash flows. What is the internal rate of return? Year Cash Flow 0 -$92,000 1 $36,100 2 $59,900 3 $21,300

D. 14.09 percent The IRR is defined as the interest rate that makes the NPV equal zero.

You are considering an equipment purchase costing $187,000. This equipment will be depreciated straight-line to zero over its three-year life. What is the average accounting return if this equipment produces the following net income? Year Net Income 1 $16,300 2 $17,800 3 $12,200

D. 16.51 percent AAR = [($16,300 + $17,800 + $12,200)/3]/[($187,000 + $0)/2] = 16.51 percent

You're trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $26 million, which will be depreciated straight-line to zero over its three-year life. If the plant has projected net income of $2,348,000, $2,680,000, and $1,920,000 over these three years, what is the project's average accounting return (AAR)?

D. 17.82 percent AAR = [($2,348,000 + $2,680,000 + $1,920,000)/3] + [($26,000,000 + $0)/2] = 17.82 percent

Diamond Enterprises is considering a project that will produce cash inflows of $238,000 a year for three years followed by $149,000 in year 4. What is the internal rate of return if the initial cost of the project is $749,000?

D. 6.32 percent The IRR is defined as the interest rate that makes the NPV equal zero.

Joe and Rich are both considering investing in a project with the following cash flows. Joe is content earning a 9 percent return, but Rich desires a return of 16 percent. Who, if either, should accept this project? Year Cash Flow 0 -$25,000 1 $13,700 2 $18,400

D. Both Joe and Rich Both Joe and Rich should accept the project as the NPV is positive at 9 and 16 percent.

You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and wants to know only what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests?

D. Profitability index

You are using a net present value profile to compare Project A and B, which are mutually exclusive. Which one of the following statements correctly applies to the crossover point between these two?

D. The net present value of Project A equals that of Project B, but generally does not equal zero.

The Nifty Fifty is considering opening a new store at a start-up cost of $720,000. The initial investment will be depreciated straight-line to zero over the 15-year life of the project. What is the average accounting rate of return? Years Net Income 1-5 $62,000 6-10 $54,000 11-15 $39,000

E. 14.35 percent AAR = {[($62,000 × 5) + ($54,000 × 5) + ($39,000 × 5)]/15}/[($720,000 + $0)/2] = 14.35 percent

The Golden Goose is considering a project with an initial cost of $46,700. The project will produce cash inflows of $10,000 a year for the first two years and $12,000 a year for the following three years. What is the payback period?

E. 4.23 years Payback = 4 + ($46,700 - $10,000 - $10,000 - $12,000 - $12,000)/$12,000 = 4.23 years

Which one of the following is specifically designed to compute the rate of return on a project that has unconventional cash flows?

E. Modified internal rate of return

The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:

E. recoup its initial cost.

Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that stock. Which one of the following best describes the 16.5 percent rate?

Expected return

The security market line is a linear function that is graphed by plotting data points based on the relationship between which two of the following variables?

Expected return and beta

You earned 26.3 percent on your investments for a time period when the risk-free rate was 3.8 percent and the inflation rate was 4.0 percent. What was your real rate of return for the period?

Real return (1+earned/1+inflation) - 1 = (1.263/1.040) - 1 = 21.44 percent

The risk premium for an individual security is based on which one of the following types of risk?

Systematic

Consider a portfolio comprised of four risky securities. Assume the economy has three states with varying probabilities of occurrence. Which one of the following will guarantee that the portfolio variance will equal zero?

The portfolio expected rate of return must be the same for each economic state.

Which one of the following statements is true regarding the period 1926-2011?

U.S. Treasury bills had a positive average real rate of return

The period 1926-2011 illustrates that U.S. Treasury bills:

can either outperform or underperform inflation on an annual basis

Systematic risk is:

measured by beta.

Which one of the following is the positive square root of the variance?

standard deviation

If the financial markets are efficient then:

stock prices should respond only to unexpected news and events

Assume the securities markets are strong form efficient. Given this assumption, you should expect which one of the following to occur?

the prices of each security in the market will frequently fluctuate

Which one of the following is the computation of the risk premium for an individual security? E(R) is the expected return on the security, Rf is the risk-free rate, β is the security's beta, and E(RM) is the expected rate of return on the market.

β[E(RM) - Rf]