Financial Management
Which of the following statements is most correct?
Market participants are able to eliminate virtually all company-specific risk if they hold a large diversified portfolio of stocks. It is possible to have a situation where the market risk of a single stock is less than that of a well diversified portfolio.
Inflation, recession, and high interest rates are economic events that are characterized as
Market risk
Assume that interest rates on the following Treasury bonds with different maturities, all of which are noncallable, are as follows: 5 year T-bond = 7.72%, 10-year T-bond = 9.64%, 30-year T-bond = 10.18%. The differences in rates among these issues were most probably caused primarily by:
Maturity risk premium differences.
The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to
Maximize shareholder wealth, which is equivalent to maximizing the firm's stock price per share.
The primary goal of a publicly-owned firm interested in serving its stockholders should be to
Maximize the stock price per share.
A capital investment's internal rate of return
Must exceed the cost of capital in order for the firm to accept the investment. Is similar to the yield to maturity on a bond.
Assume that the expectations theory describes the term structure of interest rates. Which of the following statements is most correct?
The maturity risk premium is zero.
Which of the following statements is CORRECT?
The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
Which of the following statements is CORRECT?
The percentage flotation costs associated with issuing new common equity are typically larger than the flotation costs for new debt.
Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?
The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%.
Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary (or deferred) annuity, the other is an annuity due. Which of the following statements is most correct?
The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.
Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary annuity, the other is an annuity due. Which of the following statements is most correct?
The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.
Frank Lewis has a 30-year, $100,000 mortgage with a nominal interest rate of 10% and monthly compounding. Which of the following statements regarding his mortgage is most correct?
The proportion of the monthly payment that represents interest will be lower for the last payment than for the first payment on the loan. The total dollar amount of principal being paid off each month gets larger as the loan approaches maturity.
Under normal conditions, which of the following would be most likely to decrease the coupon rate required for a bond to be issued at par?
The rating agencies change the bond's rating from Baa to Aaa.
Which of the following statements is most correct?
The slope of the security market line is the market risk premium, (rm-rRF).
Which of the following statements is most correct?
The stock valuation model, P0 = D1/(ks - g), can be used for firms which have negative growth rates.
For the foreseeable future, the real risk-free rate of interst, k*, is expected to remain at 3 percent. Inflation is expected to steadily increase over time. The maturity risk premium equals 0.1(t-1)%, where t represents the bond's maturity. On the basis of this information, which of the following statements is most correct?
The yield on 10-year Treasury securities must exceed the yield on 2-year Treasury securities. The yield on 10-year corporate bonds must exceed the yield on 8-year Treasury securities.
The New York Stock Exchange is primarily
a secondary market. a physical location auction market.
Which of the following statements is most correct?
Bond covenants are designed to reduce potential conflicts between stockholders and bondholders.
Which of the following actions are likely to reduce the agency problem between stockholders and managers?
A manager receives a lower salary but receives additional shares of the company's stock. The board of directors has become more vigilant in its oversight of the company's management
Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company's capital structure consists of common stock, preferred stock, and debt. Which of the following events will reduce the company's WACC?
A reduction in the market risk premium.
Which of the following statements is CORRECT, assuming stocks are in equilibrium?
A required condition for one to use the constant growth model is that the stock's required rate of return exceeds the expected growth rate.
Which of the following statements is CORRECT?
A zero coupon bond's current yield is equal to its yield to maturity.
Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital (WACC) as it applies to capital budgeting?
Accounts payable and accruals.
Which of the following statements best describes what would be expected to happen as you randomly add stocks to your portfolio?
Adding more stocks to your portfolio reduces the portfolio's company-specific risk.
Which of the following statements is most correct?
Agency problems exist between stockholders and managers, and between stockholders and creditors.
Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?
All else equal, a project's NPV increases as the cost of capital declines.
Which of the following statements is most correct?
All else equal, long-term bonds have more interet rate risk than short-term bonds. All else equal, high-coupon bonds have more reinvestment rate risk than low-coupon bonds. All else equal, short-term bonds have more reinvestment rate risk than do long-term bonds.
Which of the following statements would most people in business agree with?
Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
You are interested in investing your money in a bank account. Which of the following banks provide you with the highest effective rate of interest?
Bank 4; 8 percent with daily (365 - day) compounding.
Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)
Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant.
Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return?
Because of the call premium, the required rate of return would increase.
Which of the following statements is most correct?
Bond covenants are designed to reduce potential conflicts between stockholders and bondholders
A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the yield to maturity of both bonds decreases by the same amount, which of the following statements would be CORRECT?
Both bonds would increase in price, but the 10-year bond would have the greater percentage increase in price.
Until this year, Cheers Inc. was organized as a partnership. This year, the partners have decided to organize the business as a corporation. As a result of this change in organizational form, which of the following statements is most correct?
Cheers' shareholders (the ex-partners) will now have limited liability.
Which of the following factors are likely to lead to an increase in nominal interest rates?
Companies see an increase in their production opportunities that leads to an increase in the demand for funds. There is an increase in expected inflation.
Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?
Corporations generally find it easier to raise large amounts of capital.
Which of the following is CORRECT?
Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.
Which of the following is likely to encourage a firm's managers to make decisions that are in the best interest of shareholders?
Executive compensation comes primarily in the form of stock options. Institutional investors such as mutual funds and pension funds hold large amounts of the firm's stock.
Suppose Randy Jones plans to invest $1,000. He can earn an effective annual rate of 5% on Security A, while Security B has an effective annual rate of 12%. After 11 years, the compounded value of Security B should be somewhat less than twice the compounded value of Security A. (Ignore risk, and assume that compounding occurs annually.)
False
The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal.
False
Assume that the expectations theory holds. Which of the following statements about Treasury bill rates is most correct? (2-year rates apply to bonds that will mature in two years, 3-year rates apply to bonds that will mature in 3 years, and so on).
If 2-year rates exceed 1-year rates, then the market expects interest rates to rise.
Which of the following statements is most correct?
If a project's internal rate of return (IRR) exceeds the cost of capital, then the project's net present value (NPV) must be positive.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
If a project's payback is positive, then the project should be accepted because it must have a positive NPV.
Assume that the risk-free rate is 5%. Which of the following statements is correct?
If a stock has a negative beta, its required return would be less than 5%.
Which of the following statements is CORRECT?
If expected inflation increases, interest rates are likely to increase.
Assume that a 10-year Treasury bond has a 12 percent annual coupon, while a 15-year Treasury bond has an 8 percent annual coupon. The yield curve is flat; all Treasury securities have a 10 percent yield to maturity. Which of the following statements is most correct?
If interest rates decline, the price of both bonds will increase, but the 15-year bond will have a larger percentage increase in price.
Which of the following statements is most correct? (Assume that the risk-free rate remains constant.)
If the market risk premium increase by 1 percentage point, then the required return will increase by 1 percentage point for a stock that has a beta equal to 1.0.
Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
If the market risk premium increases by 1%, then the required return will increase for stocks that have a positive beta, but it will decrease for stocks that have a negative beta.
Which of the following statements is CORRECT?
If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future.
You are considering two Treasury bonds. Bond A had a 9% annual coupon, and Bond B has a 6% annual coupon. Both bonds have a yield to maturity of 7%. Assume that the yield to maturity is expect to remain at 7%. Which of the following statements is most correct?
If the yield to maturity remains at 7%, the price of Bond A will decrease over time, but the price of Bond B will increase over time.
A major disadvantage of the payback period is that it
Ignores cash flows beyond the payback period.
Which of the following statements is most correct?
In part due to limited liability and ease of ownership transfer, corporations have less trouble raising money in financial markets than other organizational forms.
Which of the following works to reduce agency conflicts between stockholders and bondholders?
Including restrictive covenants in the company's bond contract.
Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?
Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.
If the stock market is semistrong-form efficent, which of the following statements is most correct?
Investors can outperform the market if they have access to information that has not yet been publicly revealed.
Which of the following statements is most correct?
One advantage of forming a corporation is that you have limited liability
Which of the following statements is CORRECT?
One disadvantage of operating a business as a corporation is that the firm is subject to double taxation, because taxes are levied at both the firm level and the individual shareholder level.
Which of the following statements is most correct?
One of the disadvantages of the sole proprietorship form of organization is that there is unlimited liability.
An investor is considering buying one of two bonds issued by Carson City Airlines. Bond A has a 7 percent annual coupon, whereas Bond B has a 9 percent annual coupon. Both bonds have 10 years to maturity, face values of $1,000, and yields to maturity of 8 percent. Assume that the yield to maturity for both of the bonds will remain constant over the next 10 years. Which of the following statements is most correct?
One year from now, Bond A's price will be higher than it is today.
Stock A and Stock B both have an expected return of 10 percent and a standard deviation of 25 percent. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a portfolio with 50 percent invested in Stock A and 50 percent invested in Stock B. Which of the following statements is most correct?
Portfolio P has more market risk than Stock A but less market risk than Stock B.
Stock A and Stock B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a portfolio with 50% invested in Stock A and 50% invested in Stock B. Which of the following statements is CORRECT?
Portfolio P has more market risk than Stock A but less market risk than Stock B.
Wagner Inc estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Project B is of below-average risk and has a return of 8.5%.
Which of the following statements is most correct?
Relative to coupon-bearing bonds, zero coupon bonds have more interest rate risk but less reinvestment rate risk.
Which of the following statements is CORRECT?
Relative to sole proprietorships, corporations generally face fewer regulations, and they also find it easier to raise capital.
Which of the following statements is most correct?
Sinking fund provisions sometimes work to the detriment of bondholders--particularly if interest rates have declined over time. If interest rates have increased since the time a company issues bonds with a sinking fund provision, the company is more likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.
Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)
Stock B would be a more desirable addition to a portfolio than Stock A.
Which of the following statements is most correct?
The IRR method is appealing to some managers because it produces a rate of return upon which to base decisions rather than a dollar amount like the NPV method. For independent projects, the decission to accept or reject will always be the same using either the IRR method or the NPV method.
Which of the following statements is most correct?
The WACC measures the after-tax cost of capital. The WACC measures the marginal cost of capital.
Which of the following statements is correct?
The WACC should include only after-tax component costs. Therefore, the required rates of return (or "market rates") on debt, preferred, and common equity (rd, rp, and rs) must be adjusted to an after-tax basis before they are used in the WACC equation.
A 10-year bond has a 10 percent annual coupon and a yield to maturity of 12 percent. The bond can be called in 5 years at a call price of $1,050 and the bond's face value is $1,000. Which of the following statements is most correct?
The bond's current yield is greater than 10 percent. The bond is selling at a price below par.
Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8 percent, and a standard deviation of 25 percent. Becky has a $50,000 portfolio with a beta of 0.8, an expected return of 9.2 percent, and a standard deviation of 25 percent. The correlation coefficient, r, between Bob's and Becky's portfolios is 0. Bob and Becky are engaged to be married. Which of the following best describes their combined $100,000 portfolio?
The combined portfolio's expected return is a simple average of the expected returns of the two individual portfolios (10%). The combined portfolio's beta is a simple average of the betas of the two individual portfolios (1.0). The combined portfolio's standard deviation is less than a simple average of the two portfolios' standard deviations (25%), even though there is no correlation between the returns of the two portfolios.
Maese Sisters Inc has been paying out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reduce the WACC?
The company's beta decreases.
Which of the following statements is most correct?
The constant growth model takes into consideration the capital gains earned on a stock.
Which of the following statements is most correct?
The cost of retained earnings is the rate of return stockholders require on a firm's common stock.
You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?
The discount rate increases.
Which of the following statements is most correct?
The dividend yield on a stock is equal to the expected return less the expected capital gain
The future value of a lump sum at the end of five years is $1,000. The nominal interest rate is 10% and interest is compounded semiannually. Which of the following statements is most correct?
The effective annual rate is greater than 10%. The periodic interest rate is 5%.
The preemptive right is important to shareholders because it
protects the current shareholders against dilution of ownership interests.
Stocks A and B have the following data: Stock A has a required return of 10%, its stock has a market price of $25, and Stock A has an expected growth rate of 9%. Stock B has a required return of 12%, its stock has a market price of $40, and Stock B has an expected growth rate of 9%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
These two stocks must have the same expected capital gains yield.
You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?
This is an example of a direct transfer of capital.
Managers do not always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. Thus, conflicts between stockholders and managers can exist. Additionally, there can be conflicts between stockholders and bondholders.
True
Which of the following statements is most correct?
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible.
Which of the following statements is CORRECT?
When calculating the cost of preferred stock, a company does not need to adjust for taxes, because preferred stock dividends are not tax deductible.
All of the following may serve to reduce the coupon rate that would otherwise be required on a bond issued at par except a,
call provision.
One of the basic relationships in interest rate theory is that, other things held constant, for a given change in the required rate of return, the ____ the time to maturity, the ___ the change in price.
longer; greater shorter; smaller
One reason the preemptive right is important to shareholders is because it
prevents managers from issuing and purchasing a large number of additional shares