Intermediate Finance Chapters 7-9

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

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

Which of the following statements are true about correlation?

-Correlation measures the interrelationship between the returns of two securities. -Correlation is related to covariance.

As more securities are added to a portfolio, what will happen to the portfolio's total specific risk?

-It is likely to decrease. -It may eventually be eliminated.

Which of the following are examples of specific risk?

-Labor strikes -Changes in management

Which two of these are the best examples of cyclical firms?

-Luxury retailers -Automakers

Which of the following are needed in order to compute the variance of a portfolio consisting of two stocks, A and B?

-The covariance between stocks A and B -The variances of stocks A and B -The market value, in dollars, of the investments in stock A and B

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

-The death of the CFO -A hostile takeover attempt by a competitor

Which of the following are true about expected returns?

-The expected return can be calculated as the average of the returns in previous periods. -The expected return reflects an estimate that can be based on sophisticated forecasts of future outcomes. -The actual return can be higher or lower than the expected return.

Which of the following are true?

-Variable costs change with changes in quantity. -Fixed costs do not change as quantity changes.

Which of the following statements are true about variance?

-Variance is a measure of the squared deviations of a security's return from its expected return. -Standard deviation is the square root of variance.

Which two of the following are the best examples of non-cyclical goods?

-milk -diapers

To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.

-risk-free rate -stock's beta -market risk premium

Which of the following are components used in the construction of the WACC?

-the cost of debt -the cost of equity

What is the beta for stock A if the covariance between stock A and the market is 1.5 and the variance of the market is 2.5?

.6 (1.5/2.5)

What is the beta of the average asset equal to?

1

Rank the following in order from the lowest variance to the highest variance over the time period from 1900-2014.

1. Treasury bills 2. Government bonds 3. Common stocks

Arrange the following investments from lowest historical risk premium to highest historical risk premium

1. U.S. Treasury Bills 2. Government Bonds 3. Common stocks

Standard deviation of American stocks from 1900-2014:

19.9%

If the variance of a portfolio is .0025, what is the standard deviation?

5% (.0025^.5)

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

6.2%

What is the arithmetic average return for a stock that had annual returns of 8%, 2%,and 11% for the past 3 years?

7%

From 1900 to 2014, the U.S. had the world's ___ highest market risk premium.

8th

Which of the following are true?

A company can deduct interest paid on debt when computing taxable income.

Why can an investor holding a well-diversified portfolio of securities ignore the specific risk of individual securities?

Because specific risk should be eliminated or reduced through diversification

Which of the following are true about the historical equity risk premiums of the countries studied by Dimson, Marsh, and Staunton?

Denmark had the lowest equity risk premium.

True or false: A high beta always goes along with a high standard deviation.

False

True or false: Market risk will impact all securities in a portfolio equally.

False

True or false: Investors will pay extra for firms that diversify.

False.

What is a specific risk?

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

What does beta measure?

It measures the risk of a security in relation to the overall market.

What type or risk does not change as we add more securities to a portfolio?

Market risk

What happens to the expected returns of the existing securities in your portfolio if new securities are added to your portfolio?

The expected returns of existing securities will not change.

What is expected return?

The return that an individual expects to earn over the next period

What is likely to happen to the total specific risk of a portfolio when we add new securities to a portfolio?

The total specific risk of the portfolio will decrease.

What is the impact on the variance of a two-asset portfolio if the covariance between the two securities is negative?

The variance will decrease.

What is the main purpose of holding a diversified portfolio?

To reduce total risk by spreading investment dollars across various assets

True or false: It is possible for the specific risk of a portfolio to be reduced to close to zero.

True

The ___ mean is the best estimate of next year's return.

arithmetic

What is the appropriate measure of risk for an individual security if an investor holds a diversified portfolio?

beta

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

compare stock returns with the returns on other securities

A firm should only undertake a project if its expected return is ___ that of a financial asset of a comparable risk.

equal to or greater than

On what type of returns does the CAPM focus?

expected returns

Arithmetic average returns are ___ the compound annual returns over a period of time.

higher than

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

increase

If the operations of a firm are similar to its industry, the ___ beta should be used to estimate the firm's cost of equity capital.

industry's

The sales of cyclical firms are ___ sensitive to the business cycle than are the sales of non-cyclical firms.

more

The company cost of capital is the ___ cost of capital for investment in all of the firm's assets.

opportunity

Companies that specialize in one line of business or activity are called ___.

pure plays

The ___ is the difference between risky returns and risk-free returns.

risk premium

Risky projects can be evaluated by discounting expected cash flows at a ___ rate.

risk-adjusted discount

Compound annual averages are usually ___ arithmetic averages.

smaller than

The standard deviation is the ___ of the variance.

square root

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

the risk-free rate

In a firm with no outstanding debt, the company cost of capital is ___ the expected rate of return to the shareholders.

the same as

If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ____ projects.

too many high-risk

The concept that present values can be added because the firm value is just the sum of its parts is called ___.

value additivity