Corporate Finance Exam 1
One would expect a stock with a beta of 1.25 to increase returns
25% more than the market in up markets
Suppose a firm sets aside assets to protect particular investors. These assets are called
collateral
Which portfolio has had the highest average risk premium during the period 1900-2017?
common stocks
A corporate bond that can be exchanged for a fixed number of shares of stock is called a
convertible bond
A "factor" in APT is a variable that
correlates with the returns of a risky assets in a systematic manner
the required return of preferred stock is equal to the _______ on the preferred stock
dividend yield
Weak-form efficiency implies that past stock returns
do not help predict future returns
The cost of capital is the same as the cost of equity for firms that are financed
entirely by equity
By combining lending and borrowing at the risk-free rate with efficient portfolios, we can
extend the range of investment possibilities, change the set of efficient portfolios from being curvilinear to a straight line, and provide a higher expected return for any level of risk, except for the tangential portfolio and the risk-free asset
An efficient portfolio is one that:
gives the highest return for a given level of risk and provides the least risk for a given level of expected return
The features of Municipal bonds make them attractive to high income, _________ bracket investors
high-tax
Preferred stock
is issued with a set dividend that will be paid each period forever
Different classes of stock are usually issued in order to
maintain ownership control, by holding the class of stock with greater voting rights
Beta is a measure of
market risk
If a bond is junior (or subordinated), it
must give preference to senior creditos in the event of default
If the expected rate of return =15% and the required rate of return found with the CAPM equation = 16% then the stock is:
overpriced the price must fall to make the required 16% return realistic
The rare event in which a firm's existing directors and management compete with outsiders for the effective control of the corporation is called a
proxy contest
A grant of authority allowing someone else to vote shares of stock that you own is called
proxy voting
A common criticism of the CAPM is that it
requires only a single measure of systematic risk
CAPM (or SML equation)
rf+B(rm-rf)
Preference in position among creditors when it comes to repayment is called
seniority
Generally, the CAPM calculations, the value to use for the risk-free interest rate is the
short-term US Treasury bill rate
As a provider of funds to a corporation, owning which of the following corporate securities will give you the strongest rights to cash flow?
short-term bank loan
One important implication of the EMH is that most investors
should avoid active trading
Suppose that a lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can "beat the market" by short selling the stock of firms that will be sued. This hypothetical finding would violate the
strong-form hypothesis of market efficiency
Market risk is also called:
systematic risk and undiversifiable risk
The stock return's beta measures
the change in the stock's return for a given change in the market return
the hurdle rate for capital budgeting decisions is
the cost of capital
A set of efficient portfolios is called
the efficient frontier
The type of risk that can be eliminated by diversification is called
unique risk
The number of stocks in a portfolio is increase:
unique risk decreases and approaches zero
Which of the following instruments gives the owner the right to purchase securities directly from the firm at a fixed price during a specified period of time?
warrant
Primary market
when a firm issues debt or equity, it is sold in this market -the firm receives the proceeds from the sale
For each additional 1% change in the market return, the return on a stock having a beta of 2.2 changes, on average, by
2.20%
The market value of equity equals
(Market price) * (# of shares outstanding)
The Sharpe ratio is
(rp-rf)/σp
For a two stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks equals:
-1.0
Alternative theories to CAPM
-Arbitrage Pricing Theory -Factor Model -Fama-French Three-Factor Model -Four Factor Model
Suppose that in year 2030, investors become much more willing than before to bear risk. As a result, they require a return of 9.9% to invest in common stocks rather than the 11.9% that they had required in the past. This shift in risk aversion causes a 16.9% change in the value of the market portfolio.
-Rise by 16.9% Investors require less expected return to offset the lower risk, so they are willing to pay more for the same level of future dividends.
secondary market
-after issuance, any further trading of debt/equity takes place here -one investor sells to another investor - no cash goes to the firm -this is a large majority of all trades that occur
Types of financial institutions
-banks -savings & loan companies -insurance companies -mutual funds -brokerages -investment banks
types of equity
-common stock -preferred stock
In order to test the weak form of the efficient-market hypothesis, researchers have used the following methods:
-estimation of the serial correlation (autocorrelation) for securities and markets -measurement of the profitability of trading rules used by technical analysts
types of debt
-loans -bonds -notes
functions of financial institutions
-payment mechanism -facilitate borrowing and lending -pooling risk
The correlation coefficient between the efficient portfolio and the risk free asset is
0.0
If the covariance between Stock A and Stock B is 100, the standard deviation of Stock A is 10% and that of Stock B is 20%, calculate the correlation coefficient between the two securities
0.5 Corr(a,b) = 100/(10*20) = +0.5
For any individual stock, there are two sources of risk:
1. the risk based on factors 2. the risk based on noise
If a standard deviation of returns on the market is 20% and the beta of a well-diversified portfolio is 1.5, calculate the standard deviation of this portfolio
30% All unique risk has been eliminated through diversification. Beat will measure the remaining market risk. Standard deviation of the portfolio = (1.5) * 20 = 30%
If the average annual rate of return for common stocks is 11.7% and 4% for US Treasury bills, what is the average market risk premium?
7.7% treasury bill yield rate is usually considered the risk free rate MRP= (E(rm)-rf)
A firm's target capital structure represents:
A fixed debt-equity ratio that the company attempts to maintain
Which of the following portfolios has the least risk?
A portfolio of treasury bills
The semistrong form of the efficient markets hypothesis has been tested by measuring how rapidly security prices react to various news items like I) earnings announcements; II) dividend announcements; III) news of takeovers; IV) macroeconomic information
All of them
When completing a large debt issue, financial managers of large firms will usually consider the following questions: I) Should the firm borrow short term or long term? II) Should the firm issue fixed- or floating-rate debt? III) Should the firm borrow in foreign currency
All of them
As a provider of funds to a corporation, owning which of the following corporate securities will give you the most control rights?
Common stock
Treasury issues are:
Exempt from state income taxes but, not federal income taxes
The statement that stock prices follow a random walk implies that I) successive price changes are independent of each other; II) successive price changes are positively related; III) successive price changes are negatively related; IV) the autocorrelation coefficient is either +1.0 or −1.0
I only
Which of the following is a statement of semistrong form efficiency? I) Stock prices will adjust immediately to public information. II) Stock prices reflect all information. III) Stock prices will adjust to newly published information after a long time delay.
I only
Which of the following is a statement of weak-form efficiency? I) If markets are efficient in the weak form, then it is impossible to make consistently superior profits by using trading rules based on past returns. II) If markets are efficient in the weak form, then prices will adjust immediately to public information. III) If markets are efficient in the weak form, then prices reflect all information.
I only
Financing decisions differ from investment decisions because I) financing decisions are easier to reverse; II) markets for financial assets are generally more competitive than real asset markets; III) generally, financing decisions have NPVs very close to zero
I, II and III
Generally, managers of corporations prefer internally generated cash to finance their capital expenditures because I) they can avoid the discipline of financial markets; II) the costs of issuing new securities are high; III) the announcement of a new equity issue is usually bad news for investors
I, II and III
If the weak form of market efficiency holds, then I) technical analysis is useless; II) stock prices reflect all information contained in past prices; III) stock price returns follow a random walk
I, II and III
The following functions, provided by financial intermediaries, enable the smooth functioning of the economy: I) processing of payments; II) borrowing and lending; III) pooling risks
I, II and III
If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur? I). the firm will reject good, low-risk projects II). the firm will accept poor, high-risk projects III). the firm will correctly accept projects with average risk
I,II and III
Financing decisions differ from investment decisions for which of the following reasons? I) you cannot use NPV to evaluate financing decisions; II) markets for financial assets are more active than for real assets; III) it is easier to find financing decisions with positive NPV than to find investment decisions with positive NPV
II only
Generally, a firm is able to find positive-NPV opportunities among its I) financing decisions; II) capital investment decisions; III) short-term borrowing decisions
II only
Predictable cycles in stock price movements I) tend to persist for a long time; II) tend to self-destruct as soon as investors recognize them; III) never appear, since stock returns change randomly
II only
If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely occur? I). The firm will accept poor low-risk projects II). The firm will reject good high-risk projects III). The firm will correctly accept projects with average risk
III only
Strong-form market efficiency states that the market incorporates all information into stock prices. Strong-form efficiency implies that I) an investor can only earn risk-free rates of return; II) an investor can always rely on technical analysis; III) professional investors cannot consistently outperform the market;
III only
The following are characteristics of preferred stock except it I) pays fixed dividends; II) can demand payments of cumulative dividends; III) has voting rights
III only
Using a company's cost of capital to evaluate a project is I). always correct II). always incorrect III). correct for projects that have average risk compared to the firms other assets
III only
Which of the following observations would provide evidence against the strong form of efficient market theory? I) Mutual fund managers do not on average make superior returns. II) In any year approximately 50% of all pension funds outperform the market. III) Managers who trade in their own firm's stocks make superior returns.
III only
Which of the following statements is true of strong-form EMH holds? I). Analysts can easily forecast stock price changes II). Financial markets are irrational III). Stock returns follow a particular pattern IV). stock prices reflect all available information
IV only
Which of the following is included in the Fama-French 3 factor model?
Market factor, book-to-market factor, and size factor
When in equilibrium, where should stocks lie?
On the SML
the graphical representation of the CAPM model is called the
Security Market Line
Consider the aggregate balance sheet for manufacturing corporations in the United States. Which of the following sources of financing plays the largest role?
Stockholder's equity
If capital markets are efficient, then the sale or purchase of any security at the prevailing market price is generally
a zero-NPV transaction
If a stock were underpriced, it would plot
above the security market line
Generally, a bond can be valued as a package of
annuity and single payment only
The company cost of capital is the appropriate discount rate for a firm's
average-risk projects
if a stock were overpriced it would plot
below the security market line
On a graph with common stock returns on the y-axis, and market returns on the x-axis, the slope of the regression line represents
beta
The SML is a positively sloped straight line that displays the relationship between expected return and
beta
How can an investor earn more than the return generated by the tangency portfolio and still stay on the SML
borrow at the risk-free rate and invest in the tangency portfolio
Strong-form efficiency implies that mutual fund managers should
buy the index that maximizes diversification and minimizes the cost of managing portfolios