Finance Final Exam

systematic risk

market risk that affects all firms (ex. tax rates, wars,)

Investor's Required Rate of Return

minimum rate of return necessary to attract an investor to purchase or hold a security

a stock with a beta greater than one has

more systematic risk

a stock with beta of 0 has ______

no systematic risk

risk

potential variability in future cash flows

drawbacks of NPV

requires long term forecast of cash flows

Cash flows are used to measure ______ and not accounting profits.

returns

investors required rate of return formula

risk free rate of return + risk premiums

If the beta for stock A equals zero, then__________

stock A's required return is equal to the risk-free rate of return

a stock with a beta of 1 has ___

systematic risk equal to the typical stock in the market

What is the internal rate of return's assumption about how cash flows are reinvested?

the are reinvested at the projects internal rate of return

a portfolio can be less risky than ____________

the average risk of its individual investments.

Internal Rate of Return

the discount rate at which the net present value of an investment project is zero; the rate of return of a project over its useful life

diversification only prevents against ___________ risk

unsystematic

A firm's optimal capital structure occurs where?

where WACC is minimizes, and stock price is maximized

Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The net present value for Project B is

$66.363

Lithium, Inc. is considering a projects B. Project B costs $100,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The net present value for Project B is_______________

$86,363

Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the market risk premium is 7.5%, the risk-free rate of return is

1.5%

Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the risk-free rate of return is 4.2%, the expected return on the market portfolio is_________

10.2%

The rate on T-bills is currently 2%. Environment Help Company stock has a beta of 1.5 and a required rate of return of 17%. According to CAPM, determine the return on the market portfolio.

12.0%

Green Company stock has a beta of 2 and a required return of 23%, while Gold Company stock has a beta of 1.0 and a required return of 14%. The standard deviation of returns for Green Company is 10% more than the standard deviation for Gold Company. The expected return on the market portfolio according to the CAPM is ________

14%

Sonderson Corporation is undertaking a capital budgeting analysis. The firm's beta is 1.5. The rate on six-month T-bills is 5%, and the return on the S&P 500 index is 12%. What is the appropriate cost of common equity in determining the firm's cost of capital?

15.5%

The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of common equity if the long-term growth in dividends is projected to be 8%?

18%

14) You are considering investing in Ford Motor Company. Which of the following are examples of diversifiable risk? I. Risk resulting from possibility of a stock market crash. II. Risk resulting from uncertainty regarding a possible strike against Ford. III. Risk resulting from an expensive recall of a Ford product. IV. Risk resulting from interest rates decreasing

2 and 3

Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is

35.27%

Lithium, Inc. is considering a projects B. Project B costs $100,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is_________

48.37%

J & B, Inc. has $5 million of debt outstanding with a coupon rate of 12%. Currently, the yield to maturity on these bonds is 14%. If the firm's tax rate is 40%, what is the after-tax cost of debt to J & B?

8.4%

You are considering investing in a project with the following possible outcomes: State 1: Economic boom of 18% 20% probability State 2: Economic growth of 42% 16% probability State 3: Economic decline 30% 3% probability State 4: Depression 10% -25% Calculate the expected rate of return on this investment

8.72%

Kokapeli, Inc. has a target capital structure of 50% debt and 50% common equity, and has a 40% marginal tax rate. If the firm's yield to maturity on bonds is 7.5% and investors require a 15% return on the firm's common stock, what is the firm's weighted average cost of capital?

9.75%

How can investors reduce the risk associated with an investment portfolio without having to accept a lower expected return?

A) Purchase a variety of securities; i.e., diversify

Synergisitc

Although some projects may take sales away from a firm's existing projects (such as a new flavor of ice cream), in other cases new projects may add sales to the existing line (such as adding a coffee store to an existing retail store).

Which of the following statements is MOST correct? A) A project with a NPV = 0 is not acceptable. B) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. C) The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR. D) If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative.

C

Which of the statements below describes the IRR decision criterion? A) The decision criterion is to reject a project if the IRR exceeds the desired or required return rate. B) The decision criterion is to accept a project if the NPV is positive. C) The decision criterion is to accept a project if the IRR falls below the desired or required return rate. D) The decision criterion is to accept a project if the IRR exceeds the desired or required return rate

D

A company's cost of capital is equal to a weighted average of its investors' required returns TRUE OR FALSE

FALSE

A rational investor will always prefer an investment with a lower standard deviation of returns, because such investments are less risky TRUE OR FALSE

FALSE

According to the moderate view of capital structure theory, the cost of common equity is constant regardless of the debt financing level. TRUE OR FALSE

FALSE

Accounting profits are used to make capital budgeting decisions because generally accepted accounting principles ensure that profits are the best measure of a company's economic activity. TRUE OR FALSE

FALSE

Adding gourmet coffee stations to my convenience store is expected to increase sales of my breakfast sandwiches; however, the sales of breakfast sandwiches should not be included in the evaluation of the gourmet coffee project because only relevant, incremental cash flows should be considered. TRUE OR FALSE

FALSE

An increase in a corporation's marginal tax rate will cause the corporation's after-tax cost of debt to increase, other things remaining the same. TRUE OR FALSE

FALSE

If a firm's tax rate increases, then its weighted average cost of capital increases TRUE OR FALSE

FALSE

If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after-tax cost of debt is 2.8%. TRUE OR FALSE

FALSE

If we ignore bankruptcy and agency costs then the optimal capital structure for a firm under the independent view would be 100% debt. TRUE OR FALSE

FALSE

Proper diversification generally results in the elimination of risk TRUE OR FALSE

FALSE

The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on common stock. TRUE OR FALSE

FALSE

The characteristic line for any well-diversified portfolio is horizontal TRUE OR FALSE

FALSE

The characteristic line for any well-diversified portfolio is horizontal. TRUE OR FALSE

FALSE

The independence hypothesis suggests that the cost of equity decreases as financial leverage increases. TRUE OR FALSE

FALSE

The moderation hypothesis suggests that the total market value of the firm's outstanding securities is unaffected by its capital structure. TRUE OR FALSE

FALSE

The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases. TRUE OR FALSE

FALSE

Two projects that have the same cost and the same expected cash flows will have the same net present value. TRUE OR FALSE

FALSE

A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bills are greater than zero TRUE OR FALSE

False

Actual returns are always less than expected returns because actual returns are determined at the end of the period and must be discounted back to present value. TRUE OR FALSE

False

if NPV is positive, _______

I R R will be greater than the required rate of return

If NPV is negative then

I R R will be less than required rate of return

If NPV = 0

IRR is the required rate of return

Two main Capital Budgeting Decision Criteria

NPV and IRR

) Whenever the IRR on a project equals that project's required rate of return,_________

NPV will equal 0

A grocery store decides to offer beer for sale and this decision results in more potato chip sales. This is an example of a synergistic effect. TRUE OR FALSE

TRUE

A project's IRR is analogous to the concept of the yield to maturity for bonds. TRUE OR FALSE

TRUE

A security with a beta of one has a required rate of return equal to the overall market rate of return TRUE OR FALSE

TRUE

A stock with a beta of 1.4 has 40% more variability in returns than the average stock TRUE OR FALSE

TRUE

An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt, but have no impact on its cost of common equity. TRUE OR FALSE

TRUE

Beta is a measurement of the relationship between a security's returns and the general market's returns. TRUE OR FALSE

TRUE

Beta represents the average movement of a company's stock returns in response to a movement in the market's returns TRUE OR FALSE

TRUE

Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20 securities TRUE OR FALSE

TRUE

If the before-tax cost of debt is 7% and the firm has a 40% marginal tax rate, the after-tax cost of debt is 4.2% TRUE OR FALSE

TRUE

In order to create value, a corporation must earn a rate of return on its invested capital that is higher than the market's required rate of return on that invested capital. TRUE OR FALSE

TRUE

Stocks that plot above the security market line are underpriced because their expected returns exceed their risk-adjusted required returns TRUE OR FALSE

TRUE

Stocks that plot above the security market line are underpriced because their expected returns exceed their risk-adjusted required returns. TRUE OR FALSE

TRUE

Sunk costs are cash outflows that will occur regardless of the current accept/reject decision, and therefore should be excluded from the analysis. TRUE OR FALSE

TRUE

The benefits of diversification occur as long as the investments in a portfolio are not perfectly positively correlated. TRUE OR FALSE

TRUE

The beta of a T-bill is zero. TRUE OR FALSE

TRUE

The capital asset pricing model uses three variables to evaluate required returns on common equity: the risk-free rate, the beta coefficient, and the market risk premium. TRUE OR FALSE

TRUE

The independence hypothesis suggests that the total market value of the firm's outstanding securities is unaffected by its capital structure. TRUE OR FALSE

TRUE

The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay. TRUE OR FALSE

TRUE

The required rate of return reflects the costs of funds needed to finance a project TRUE OR FALSE

TRUE

The required rate of return represents the cost of capital for a project. TRUE OR FALSE

TRUE

Total risk equals systematic risk plus unsystematic risk TRUE OR FALSE

TRUE

Unique security risk can be eliminated from an investor's portfolio through diversification TRUE OR FALSE

TRUE

Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero. TRUE OR FALSE

TRUE

Which of the following statements is MOST correct concerning a corporation's optimal capital structure?

The optimal capital structure occurs at the point where the market value of the levered firm is maximized

Capital Asset Pricing Model (CAPM)

a model that relates the required rate of return on a security to its systematic risk as measured by beta

If IRR >= required rate of return then ________

accept

Portfolio risk is typically measured by ________ while the risk of a single investment is measured by ______

beta, standard deviation

Portfolio risk is typically measured by ________ while the risk of a single investment is measured by ________.

beta, standard deviation

Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent. Both projects have a required return of 12 percent. Which of the following statements is MOST correct?

both projects have a positive NPV

they key to reducing risk through diversification to ___________

combine investments whose returns are not perfectly positively correlated

unsystematic risk

company unique risk (strikes, lawsuits, CEO change)

Benefits of NPV

considers all cash flows recognizes time value of money

If two stocks are perfectly positively correlated, _________

diversification has no effect on risk

Holding Period Rate of Return formula

dollar gain __________________ Beginning investment

characteristic line

the line of "best fit" through a series of returns for a firm's stock relative to the market's returns. The slope of the line, frequently called beta, represents the average movement of the firm's stock returns in response to a movement in the market's returns

Optimal capital structure is____________

the mix of permanent sources of funds used by the firm in a manner that will maximize the company's common stock price.

If two stocks are perfectly negatively correlated, _____________

the portfolio is perfectly diversified

The net present value of an investment is ________.

the present value of all benefits (cash inflows) minus the present value of all costs (cash outflows) of the project

Net Present Value

the present value of current and future benefits minus the present value of current and future costs

Capital Budgeting

the process of planning and managing a firm's long-term investments

standard deviation

the square root of the average squared deviations from the mean of scores in a distribution; a measure of variability

free cash flow accurate reflects the ____________

timing of benefits and costs better then accounting profits