MBA 611 Exam 3

Generally, a less risky portfolio would have_____ rate of return.

a lower

Which type of real option allows a firm to shut down a project if its cash flows are lower than expected?

abandonment option

Using the __________ depreciation method will result in the highest NPV for the project

accelerated

Suppose a company bought equipment with a 10-year life. If it took a 30-year debt to finance the equipment, then it would have to pay off its debt with the cash flows generated from

assets other than the equipment bought

If the amount of financing required is relatively small, the company is likely to

get a term loan or a private placement

What kind of company is most likely to follow a strict residual distribution policy?

A firm with stable, predictable earnings and investment

________ dividend reinvestment program invests the dividends in newly issued stock. This type of plan raises new capital for the firm.

A new stock

A rental car company bought a new fleet of midsize cars and sold off its old midsize cars because they had too many miles on them. Which type of project would this be considered?

A replacement project

If the firm wants to influence the hostile bidder to leave it alone, which of the following methods could be an effective way of doing so?

A targeted stock repurchase

Which type of real option allows the inputs in the production process to be altered if market conditions change during a project's life?

An input flexibility option

Based on your understanding of the constraints on dividend payments, identify the type of constraint this condition represents. Assume that all other factors are held constant.

Availability of cash

The CAPM is one of the most extensively tested models in finance. The following statements describe the assumptions, methods, and findings of several of these studies. Based on your understanding of these issues, which of the following statements are true? Check all that apply.

Based on Levy's 1971 examination of the stability of the betas of both individual securities and portfolios of 10 or more randomly selected stocks, it is logical to conclude that the CAPM is a better concept for structuring investment portfolios than for estimating the required return of individual securities. Most tests of the CAPM have used portfolios of securities rather than individual stocks, due to the instability of the betas of individual securities. Two important hypotheses addressed in tests of the CAPM and SML are that (1) the intercept on the vertical axis should equal the risk-free rate (rRFRF) and (2) the required return on a stock or portfolio exhibiting a beta of 1.0 should equal the required market return (rMM).

According to signalling theory, a firm with a very positive outlook might tend to use debt financing ???? the normal target capital structure.

Beyond

____________ is measured by the project's impact on uncertainty regarding the firm's future returns.

Corporate, or within-firm, risk

According to Miller's theory on the impact of personal taxes, which of the following statements is true?

Debt financing has an advantage over equity financing because it provides an interest tax shield.

Which of the following is a reason cash flows may differ from accounting income?

Depreciation is a tax-deductible expense but is not a cash outlay.

If you were to graph a firm's earnings, cash flows, and dividends over the past 20 years, which would you expect to be the most stable over time?

Dividends

Decision tree analysis is more commonly used in valuing securities than real assets. True or False: The preceding statement is correct.

False

True or False: A real option embedded in a capital project gives the investing firm the right and the obligation to buy, sell, or transfer an asset at a set price during a specified period of time.

False

True or False: Repurchases are more dependable than dividends because the investor wealth does not decrease after a repurchase, whereas the stock price decreases when dividends are distributed.

False

Based on the factor described, identify whether corporate investors, in general, will tend to favor high or low payout ratios.

Favor a high payout

Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage?

Firms with a higher proportion of variable-versus-fixed costs

On the preceding graph, the green and blue lines represent the indifference curves of two investors, investor Green and investor Blue. Which investor requires a lower risk premium?

Investor Blue requires a lower risk premium.

Another firm, called Robbem Power & Water, an established public utility company, has been paying dividends for the past 20 years. This year Robbem also announced that it will increase its dividends by 10%. Which class of investors is more likely to be pleased by Robbem's dividend announcement?

Investors with low tax rates who depend on current dividend income for living expenses

Which of the following is a characteristic of a firm's optimal dividend policy?

It maximizes the firm's intrinsic value.

______ levels of participation in a dividend reinvestment program suggest that stockholders are content with the amount of cash dividends that the firm is paying out.

Low

Real option analysis adds value to a project when it is used for which of the following? Check all that apply.

Making managers aware of the consequences of their decisions and actions on the creation or destruction of value for a capital project Modifying the way that decision makers perceive flexibility in capital budgeting activities Expanding the way that managers view risk and uncertainty, seeing them as phenomena to be appreciated and exploited rather than feared and avoided

___________ is a risk analysis technique that uses sophisticated software to analyze a large number of scenarios and generate estimated rates of return and risk indexes

Monte Carlo Simulation

In a taxless world with no brokerage costs, repurchases and dividends have the same effect on shareholder wealth. In the real world, however, repurchases provide more preferable tax treatment than dividends to ordinary investors. Does this mean that firms should always use share repurchases so that investors can gain from this tax benefit?

No

Is it reasonable to expect that the beta value estimated via the regression of stock A's returns against the market returns will equal the true value of stock A's beta?

No

Identify which of the two theories is described by the statement.

Pecking-order hypothesis

Purple Hedgehog Forestry is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firm's annual dividend, assuming that all other factors are held constant?

Purple Hedgehog Forestry will pay a smaller annual dividend if it goes forward with this decision.

A leveraged buyout (LBO) helps the firm ???? both its excess cash flows and managers' temptation to incur wasteful expenses.

Reduce

Which of the following uses is considered to be a good use of free cash flow? Select the better answer.

Repurchase stock

Which of the following measures the average return earned by a portfolio, over and above the risk-free rate of return, divided by the standard deviation of the portfolio's average returns?

Sharpe's reward-to-variability ratio

Evaluating risk is an important part of the capital budgeting process. Which of the following is measured by the variability of the project's expected returns?

Stand-alone risk

How do managers typically deal with within-firm risk and beta risk when they are evaluating a potential project?

Subjectively

Which of the following statements is true?

Taxes on dividend income are paid in the year that they are received.

Which of the following statements about the Arbitrage Pricing Theory (APT) are correct? Check all that apply.

The APT requires fewer assumptions than the Capital Asset Pricing Model (CAPM). The APT allows the required return be a function of two, three, four, or more factors.

A successful sushi chain in Hong Kong spent $500,000 to conduct a study on whether to open a location in the United States. The study showed that the best place for the company to open their first location would be in Chicago. When conducting its capital budgeting analysis, how should the company account for the cost of the study when estimating the amount of the initial investment that the new store will require?

The company should ignore it.

Garcia Real Estate is involved in commercial real estate ventures throughout the United States. Some of these ventures are much riskier than other ventures because of market conditions in different regions of the country. If Garcia does not risk-adjust its discount rate for specific ventures properly, which of the following is likely to occur over time?

The firm's overall risk level will increase The firm could potentially reject projects that provide a higher rate of return than the company should require

If an investor wants to hold an efficient portfolio that offers an expected return of 10%, should the investor select portfolio A that exhibits a standard deviation of 3% or portfolio C that has a standard deviation of 8%? (Assume that both the portfolios offer an expected return of 10%.)

The investor should select portfolio A.

Which of the following factors affects management's decisions regarding a firm's distribution policy? Check all that apply.

The level of retained earnings to maintain The level of payout to shareholders that is sustainable in the future The method of payment to shareholders—cash or stocks

Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes. Review the list and identify which items are correct.

The pre-tax cost of debt increases as a firm's risk of bankruptcy increases. An increase in debt financing beyond a certain point is likely to increase the firm's cost of equity. An increase in the risk of bankruptcy is likely to reduce a firm's free cash flows in the future.

Suppose that the correlation between stocks A and B is ρABρAB = 1, instead of zero. Which of the following statements correctly reflects the new data?

The risk associated with the portfolio is higher.

Based on the CAPM and your calculations for the return to stocks, what does it mean when the coefficient bibi = 1?

The stock's return correlates with the stock market as a whole.

In terms of the investment, the highest level of satisfaction the investor can attain is represented by which part of the graph?

The tangency between the investor's indifference curve and the efficient frontier.

If you were to look at a firm's cash distributions to its shareholders over time, which method of cash distribution is more likely to be used if the firm experiences volatile business cycles?

The use of stock repurchases

Which of the following are assumptions of the Capital Asset Pricing Model (CAPM)? Check all that apply.

There are no taxes. Investors assume that their investment activities won't affect the price of a stock. Investors can borrow an unlimited amount at a risk-free rate.

The value of operations depends on whether a firm decides to make distributions in the form of dividends or stock repurchases.

This statement is false because ignoring possible tax effects and signals, the value of a firm's operations does not depend on how the firm distributes its residual earnings.

Dividends provide signals about a firm's future prospects, whereas some investors might misinterpret why a firm is repurchasing stock.

True

Is the statement true or false?

True

Under the pecking-order hypothesis, a firm will raise capital by using its net income, selling its marketable securities, issuing debt, and then issuing stock as the last resort. This statement is ????.

True

Based on the information given, determine which of the statements is correct.

When the CFO adjusts the cost per ton of processing the cardboard, the project's NPV will decrease.

Which of the following statements about inflation's effect on net present value (NPV) is correct?

When the selling price and cost per unit are expected to increase at the same rate, forgetting to take inflation into account in a capital budgeting analysis will typically cause the estimated NPV to be lower than the true NPV.

Is this information accurate?

Yes

As a result, the U.S. tax code encourages many individual investors to prefer to receive

capital gains

When a firm is performing a sensitivity analysis on a project, an increase in variable costs or fixed costs will generally cause the project's net present value (NPV) to ________

decrease

If its risk management strategy is successful and Carlson Co. can reduce its volatility, the value of Carlson Co.'s stock will ______, and the value of its debt will ______

decrease ..... increase

Ideally, capital budgeting analysis should take cash flows into account ....

exactly when they occur

This example describes a real option to

expand

When other things are held constant, the higher a firm's operating leverage, the ______ will be its business risk.

higher

Typically, using financial leverage will ________ a project's expected ROE.

increase

In this equation, the term riri represents

individual stock's required return

Assuming that the black line represents the efficient frontier, which of the following best describes portfolios that lie to the right of this line?

inefficient

If a firm expects earnings to decline in the future, it will likely use

long-term debt

When a firm has a large number of profitable investment opportunities, it will usually have a ____ target payout ratio.

low

As with all financial decisions, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also the debt-equity mix that:

minimizes the firm's weighted average cost of capital.

If management is concerned with keeping control of the company, it will be likely to retain _____ earnings than it otherwise would to avoid diluting control by issuing new stock to raise capital.

more

Companies decide to start, continue, or terminate their dividend reinvestment plans for their stockholders based on the firms' need for equity capital. A firm is likely to start using new stock DRIPs if it ______ additional equity capital.

needs

This statement is false because if the firm uses its FCF to pay off all of its debt, it would have __________ and no deductible

no interest payment

A firm's ________ dividend policy determines its current clientele of investors.

past

A cell phone company recently gave customers the ability to buy applications that they can download to their cell phones. Allowing customers to use these applications increased cell phone sales. This is an example of a __________ externality.

positive within-firm

Repurchase transactions allow a firm to buy back stock that may be needed to fulfill obligations when employees exercise their stock options. This ______ the costs associated with issuing new shares.

saves

The procedure in which a set of key elements affecting the expected value are changed to study the effect on the expected value is called __________ analysis.

scenario

Repurchases give stockholders a choice to _______ their stock and realize their capital gains or keep their stock and receive future dividends.

sell

True or False: An investor who is slightly risk averse will exhibit shallow indifference curves.

true