BF for Test 3

If the arithmetic average return is 10% and the variance of returns is 0.05, find the approximate geometric mean.

0.10 - 0.05/2 = 0.075 or 7.5%

If a firm's sales estimate used in its base case analysis is 1,000 units per year and they anticipate the upper and lower bounds to be +/- 15%, What is the "best case" for units sold per year?

1,150 Reason: 1.15 × 1,000 = 1,150

The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step. Instructions

1. Calculating the expected return. 2. Calculate the deviation of each return from the expected return. 3. Square each deviation. 4. Calculate the average squared deviation.

Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2014 has revealed as shown in Table 10.3: Instructions

1. Small company common stock. 2. Large company common stock. 3. Long-term corporate bonds. 4. Long term government bonds. 5. U.S. Treasury bills.

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

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

Which of the following are considered relevant cash flows?

1. cash flows from erosion effects 2. cash flows from external costs 3. cash flows from beneficial spillover effects

Investment in net working capital arises when ___.

1. cash is kept for unexpected expenditures 2. credit sales are made 3. inventory is purchased

If a firm's variable cost per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper and lower bounds to be +/- 10%, What is the "worst case" for variable cost per unit?

1.10 × $50 = $55; The worst case for costs is the higher value.

A dividend yield of 10% says that, for each dollar we invest, we get ____ cents in dividends.

10 cents

If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be

100% reversed.

The rules for depreciating assets for tax purposes are based upon provisions in the:

1986 Tax Reform Act

If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?

An efficient market reaction

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

Capital gains Dividends

Which of the following are components of project cash flow?

Change in net working capital Operating cash flow Capital spending

______ risk is reduced as more securities are added to the portfolio

Diversifiable Company-specific Unsystematic

Operating cash flow is a function of:

Earnings Before Interest and Taxes Taxes Depreciation

The number of positive NPV projects is unlimited for any given firm.

False

True or false: A well-diversified portfolio will eliminate all risks.

False

True or false: Arithmetic and geometric averages are useful because they are not influenced by volatility.

False

True or false: Calculating the expected return is the last step in the computation of variance.

False

True or false: Discounting a news item is the same as taking the present value of that item.

False

True or false: Expected return and inflation are the two components of risky return in the total return equation.

False

True or false: Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio increases.

False

True or false: Percentage returns are difficult to use for comparisons because they depend on the dollar amount invested.

False

True or false: Portfolio weights can be defined as the dollars invested in each asset.

False

True or false: The average return of a given period is typically not a good estimate of the returns over that same period.

False

True or false: The calculation of the portfolio beta is similar to the calculation of the portfolio weights.

False

True or false: The capital gains yield = (Pt+1 - Pt)/Dt

False

True or false: The expected return of a portfolio is a combination of the weights of each asset in a portfolio.

False

True or false: The geometric average rate of return measures the return in an average year over a given period.

False

True or false: The smaller the variance or standard deviation is, the more spread out the returns will be.

False

True or false: The surprise part of any announcement is the information the market uses to form the expectation of the return on the stock.

False

True or false: To get the average return, the yearly returns are summed and then multiplied by the number of returns.

False

Which of the following are examples of systematic risk?

Future rates of inflation Regulatory changes in tax rates

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

IRR NPV payback period

Which of the following are examples of a portfolio?

Investing $100,000 in the stocks of 50 publicly traded corporations Investing $100,000 in a combination of stocks and bonds Investing $100,000 in a combination of US and Asian stocks

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

It considers all the cash flows. It considers time value of money. It properly chooses among mutually exclusive projects It considers the riskiness of the project.

In the context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

What is unsystematic risk?

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

What is systematic risk?

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

What is a risk premium?

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

What is an uncertain or risky return?

It is the portion of return that depends on information that is currently unknown.

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

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

It may eventually be almost totally eliminated. It is likely to decrease.

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

Market risk Unsystematic risk U = m + ε

A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish?

Market value

Which of the following techniques will provide the most consistently correct result?

Net Present Value

The Tax Shield Approach

OCF = (Sales - Costs) x (1-TC) + Depreciation x TC

Which of the following is the equation for estimating operating cash flows using the tax shield approach?

OCF = (Sales - Costs) × (1 - Tax rate) + Depreciation × Tax rate

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

One

Which type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock?

Overreaction and correction

Which of the following is an example of a sunk cost?

Project consultation fee

Which of the following is an example of an opportunity cost?

Rental income likely to be lost by using a vacant building for an upcoming project

What is the difference between scenario analysis and sensitivity analysis?

Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time.

What is scenario analysis?

Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

Which of the following types of risk is not reduced by diversification?

Systematic, or market risk

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

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

The CAPM shows that the expected return for an asset depends on which three things?

The amount of systematic risk The reward for bearing systematic risk The pure time value of money

What is the slope of the security market line (SML)?

The market-risk premium

Which of the following are needed to describe the distribution of stock returns?

The mean return The standard deviation of returns

Which of the following qualify as "managerial options"?

The option to expand The option to abandon The option to wait

A manager has estimated a positive NPV for a project. What could drive this result?

The project is a good investment. The cash flow estimations are inaccurate. Overly optimistic management

What is the intercept of the security market line (SML)?

The risk-free rate

According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?

The risk-free rate of return

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

There is no relationship.

The total dollar return is the sum of dividends and __________.

Total dollar return = dividend income + capital gain or loss

What is the equation for total return?

Total return = Expected return + Unexpected return

The dividend yield = Dt+1/Pt

True

True or false: A capital gain on a stock is counted as part of the total return whether or not the gain is realized from selling the stock.

True

True or false: A capital loss is the same thing as a negative capital gain.

True

True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero.

True

True or false: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.

True

True or false: Investment in net working capital may arise from the need to cover credit sales.

True

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

True

True or false: Labor strikes are an example of unsystematic risk.

True

True or false: Net working capital will be recovered at the end of a project.

True

True or false: The expected return is the return that an investor expects to earn on a risky asset in the future.

True

True or false: The risk premium can be interpreted as a reward for bearing risk

True

True or false: Unsystematic risk is specific only to a single company or industry.

True

What two factors determine a stock's total return?

Unexpected return Expected return

Which of the following statements is (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.

What will the dividend income be on W number of shares of XYZ stock if XYZ distributes a $Y per share dividend?

W x $Y

If you wish to create a portfolio of stocks, what is the required minimum number of stocks?

You must invest in stocks of more than one corporation.

What is the Reward-to-Risk Ratio?

[E(RA) - Rf]/βA

More volatility in returns produces ______ difference between the arithmetic and geometric averages.

a larger

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

a portfolio's expected return

Unsystematic risk will affect

a specific firm firms in a single industry

Cash flows should always be considered on a(n) ___________ basis.

after-tax

Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices. Instructions

all information > strong form efficiencyall public information > semi-strong form efficiencyhistorical stock prices > weak form efficiency

In an efficient market ______ investments have a _____ NPV.

all; zero

Percentage returns are more convenient than dollar returns because they:

allow comparison against other investments apply to any amount invested

When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market:

already knew about most of the news item

A positive capital gain on a stock results from ___.

an increase in price

When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:

asking what-if questions scenario analysis

The goals of risk analysis in capital budgeting include:

assessing the degree of financing risk identifying critical components

The dividend yield for a one-year period is equal to the annual dividend amount divided by the ____.

beginning stock price

Opportunity costs are ____.

benefits lost due to taking on a particular project

The capital asset pricing model is the equation of the security market line showing the relationship between expected return and ______

beta

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

cannot be observed

The percentage change in the price of a stock over a period of time is called its ___________.

capital gain yield

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

cash

Cash flows used in project estimation should always reflect:

cash flows when they occur after-tax cash flows

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

compare stock returns with the returns on other securities

The geometric average _____ return is the average return earned per year over a multiyear period. Listen to the complete question

compound

The geometric rate of return takes ______ into account.

compounding

Managerial options are taken into consideration in ____ planning.

contingency

The appropriate discount rate to use to evaluate a new project is the _____.

cost of capital

The minimum required return on a new project is known as the:

cost of capital

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio:

declines

Historically, there is a(n) ______ relationship between risk and expected return in the financial markets.

direct

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.

direct

The total dollar return on a stock is the sum of the ____ and the _____.

dividends; capital gains

Side effects from investing in a project refer to cash flows from:

erosion effects beneficial spillover effects

The possibility that errors in projected cash flows will lead to incorrect decisions is known as:

estimation risk forecasting risk

The ______ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.

excess

We underestimate NPV because of the option(s) to ______.

expand abandon

The _____ return on a portfolio is a combination of the expected returns on the assets in the portfolio.

expected

In an efficient market, firms should expect to receive ______ value for securities they sell.

fair

True or false: In calculating cash flows, you should consider all financing costs.

false

True or false: Labor strikes are an example of systematic risk.

false

True or false: Operating cash flow is based on the salvage value of equipment.

false

Sunk costs are costs that ____.

have already occurred and are not affected by accepting or rejecting a project

The risk-return relationship states that a riskier investment should demand a ____________ return.

higher

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

ignored

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

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

income

Synergy will _____ the sales of existing products.

increase

The stand-alone principle assumes that evaluation of a project may be based on the project's ________________ cash flows.

incremental

The difference between a firm's cash flows with a project versus without the project is called ________________.

incremental cash flows

An efficient market is one that fully reflects all available ______.

information

Stock prices fluctuate from day to day because of:

information flow

The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the:

initial stock price

If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.

is highly risky

Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:

it affects a firm's annual tax liability it determines taxes owed on fixed assets when they are sold it determines the book value of assets which affects net salvage value

Which of the following are examples of unsystematic risk?

labor strikes changes in management

An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.

less than

The primary risk in estimation errors is the potential to __________.

make incorrect capital budgeting decisions

An option on a real asset rather than a financial asset is known as a:

managerial option real option

Systematic risk is also called ______________ risk.

market

To get the average, or _____ return, the yearly returns are summed and then divided by the number of returns.

mean

The project cash flow equals the project operating cash flow _____ project change in NWC minus project capital spending.

minus

Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.

net working capital

The difference between a firm's current assets and its current liabilities is known as the _____.

net working capital

Systematic risk will ____ when securities are added to a portfolio.

not change

The most valuable alternative that is given up if an investment is undertaken is called what?

opportunity cost

If you use an arithmetic average to project long-run wealth levels, your results will most likely be _______.

optimistic

If you use a geometric average to project short-run wealth levels, your results will most likely be _______ .

pessimistic

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

positive

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive

The risk ______ can be interpreted as the reward for bearing risk

premium

Given a level of investment in net working capital, that same investment must be ____ at some time in the future.

recovered

Erosion will ______ the sales of existing products.

reduce

One of the most important steps in estimating cash flow is to determine the _________ cash flows.

relevant

Opportunity costs are classified as ____ costs in project analysis.

relevant

The first step in estimating cash flow is to determine the _________ cash flows.

relevant

An unrealized gain is treated the same as a realized gain when computing the total ____

return

The arithmetic average rate of return measures the ____.

return in an average year over a given period

If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.

risk premium; systematic risk

Scenario analysis considers a combination of factors for each scenario while ____ analysis focuses on only one variable at a time.

sensitivity

To investigate the impact on NPV of a change in one variable, you would employ ________.

sensitivity analysis

The depreciation tax _____ is the tax savings that results from the depreciation deduction

shield

Using capital market history as a guide, it would appear the greatest reward would come from investing in _______.x

small-company common stock

Geometric averages are usually ______ arithmetic averages.

smaller than

The standard deviation is the ______ of the variance.

square root

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

stand-alone

The variance and its square root, the ______ ________, are the most commonly used measures of volatility.

standard deviation

The _____ is the news that influences the unanticipated return on the stock.

surprise

The true risk of any investment comes from _______________ .

surprises

The true risk of any investment comes from:

surprises unanticipated events

Even if the portfolio is well diversified, the investor is still exposed to _____ risk.

systematic

The return expected on an investment depends only on the asset's _____ risk.

systematic

Beta tells us the amount of ________ risk of an asset or portfolio relative to ______.

systematic; an average risky asset

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

that are borne unnecessarily that are diversifiable

To determine the appropriate required return for an investment, we can use _____________________.

the Security Market Line

Two ways of calculating average returns are _______ and _______.

the geometric average the arithmetic average

A portfolio can be described by its portfolio weights which are defined as _____________________.

the percentage of dollars invested in each asset

If the standard deviation of a portfolio is __________?

the square root of the variance

The standard deviation is ___.the square root of the variance

the square root of the variance

Studying market history can reward us by demonstrating that:

there is a reward for bearing risk the greater the potential reward is, the greater the risk

Average returns can be calculated:

two different ways

In a competitive market, positive NPV projects are:

uncommon

In order to analyze the risk of a project's NPV estimate, we should establish ___________ for each important estimate variable.

upper and lower bounds

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

variance

If a study of past stock prices and volume to find mis-priced securities will not lead to gains in the market, then the market must be at least _____ efficient.

weak-form

The efficient markets hypothesis contends that _____________ capital markets such as the NYSE are efficient.

well-organized

The basic approach to evaluating cash flow and NPV estimates involves asking:

what-if questions

If you receive a $2 dividend per share on your 100 shares, your total dividend income is ____.

$2 x 100

Broadband, Inc., has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.

$400,000