FIN 311 Final Exam Terms/Questions

Cost of equity

return required by equity investors given the risk of the cash flows from the firm

Cash flows included in calculations

-Income statement effects due to project after taxes -Opportunity costs -Side effects (ONLY if stated in the problem) -Balance sheet effects (purchase/sale of equipment, working capital effects) NOT INCLUDED are financing costs and sunk costs

Factors that affect expected returns

1. Time value of money 2. Reward per unit of systematic risk (market risk premium) 3. Asset's systematic risk

Pure play firm

A firm whose projects are homogeneous (and for which the WACC is the required return for all of its capital budgeting projects)

Systematic risk

Affects all firms/a large number of firms in the market Macroeconomic factors (government policies, etc) Impossible to diversify away Quantified by the beta value

Unsystematic risk

Affects only one/ a small number of firms Microeconomic factors (CEO quits, etc) Can be diversified away

The required return to common stockholders is equal to the cost to the firm of having common stock

Also called the cost of equity

Swanson & Sons has two separate divisions. Each division is in a separate line of business. Division A is larger and represents 65% of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When mgmt is deciding which of the various divisional projects should be accepted, the managers should: a. allocate more funds to Division A since it is the largest of the two divisions. b. fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. c. allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. d. assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values. e. fund the highest net present value projects from each division based on an allocation of 65 percent of the funds to Division A and 35 percent of the funds to Division B.

Assign appropriate, but differing, discount rates to each project and then select the projects with the highest NPVs. **Assign different discount rates because riskier projects need a higher required return. The required returns in division A will be higher than those in division B because division A is riskier.

A security that has a rate of return that exceeds the US Treasury Bill rate but is less than the market rate of return must: a. be a risk-free asset. b. have a beta that is greater than 1.0 but less than 2.0. c. be a risk-free asset with a beta less than 0.99. d. be a risky asset with a standard deviation less than 1.0. e. be a risky asset with a beta less than 1.0.

Be a risky asset with a beta of less than 1.0 **Rate of return is between market rate and risk free rate, therefore the beta of the asset must be in between the risk free beta (0) and the market beta (1).

A firm is a result of its _____

Capital budgeting decisions

Incremental cash flows

Cash flows that come into or out of being because the project is undertaken

Stand-alone principle

Evaluating the project on its own, not as a part of the entire firm

Cost of capital

the minimum return needed to compensate investors for the use of capital needed to finance a project

An increase in the number of stocks in a portfolio ____ risk.

Decreases

What would you recommend to an investor who is considering an investment which, according to its beta, plots below the security market line (SML)? A. Invest, return is high relative to risk. B. Don't invest, risk is high relative to return. C. Invest, stock reverts to the SML over time. D. Don't invest, stocks that plot below the SML have too much unique risk. E. Invest, NPV > 0.

Don't invest, risk is high relative to return

The market rewards risk, but not easily avoidable risks

Expected returns only depend on the level of systematic risk in the asset

The return to an investor is the same as the cost to the company

For common stock, cost of equity For bonds, cost of debt For assets, cost of capital

The more unrelated the assets are (the more negative the covariance), the ____ the benefits of diversification

Greater

Does higher standard deviation mean higher or lower risk?

Higher risk. The range of possible returns is wider when the standard deviation is higher

All of the following are anticipated effects of a proposed project. Which of these should be included in the initial project cash flow? I. Decrease in inventory of $5,000,000 II. Increase in fixed assets of $7,600,000 III. Decrease in accounts payable of $2,525,000 IV. Increase in fixed costs of $3,110,000 A. I, II, and III only B. I and III only C. I and II only D. I, II and IV only E. II, III and IV only

I, II, and III only **I and III are changes in NWC (invested in year 0), and II is a change in capital spending at time t = 0. IV is a part of OCF which is not counted until year 1

If the firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to: I. reject some positive net present value projects. II. accept some negative net present value projects. III. favor low risk projects over high risk projects. IV. become riskier over time. A) I, II, III and IV B) I and III only C) I, II, and IV only D) III and IV only E) I and II only

I, II, and IV only

Which of the following statements are correct concerning the security market line (SML) approach to determining the cost of equity for a firm? I. The SML approach considers the amount of unsystematic risk associated with a firm. II. The SML approach can be applied to more firms than the dividend growth model can. III. The SML approach considers only future information. IV. The SML approach assumes the reward-to-risk ratio is constant. A. I and III only B. II and IV only C. III and IV only D. I, II, and III only E. I, II, III, and IV

II and IV only

Due to rapid growth, a computer superstore is contemplating expanding by adding another location. Which of the following items should the financial officer not include in estimating the cash flows associated with this expansion? I. The company owns the land of the future site of the new location. II. The new location is expected to take sales away from the existing location. III. The company spent $100,000 six months ago in a major advertising campaign which will help get the new store become profitable sooner. IV. The company will need to borrow money to finance this project at a rate of 2.8%, compounded monthly A. I, II and III only B. II and III only C. III and IV only D. I, III and IV only E. I, II, III and IV

III and IV only **I is an opportunity cost (included), II is a part of OCF (included), III is a sunk cost (not included), IV is a capital structure decision (not included)

As the cost of capital is increased, the A. NPV of all projects increase B. firm needs to raise more capital C. IRR of all projects remain the same D. overall risk of the firm has decreased E. all of the above are correct

IRR of all projects remain the same

Pure play approach

If a firm is evaluating a project where it can find a publicly traded pure play company that specializes in that project, the WACC for the pure play company is the appropriate required return for that project

Under which of the following conditions will a change in accounting procedures be most likely to increase the value of the firm's shares? A) increases reported earnings. B) increases cash flows. C) increases the risk of the firm. D) increases the number of outstanding shares.

Increased cash flows

What is the typical relationship between the standard deviation of an individual common stock and the st dev of a diversified portfolio of common stocks? A) Individual stock's standard deviation will be lower. B) Individual stock's standard deviation will be higher. C) The standard deviations should be equal. D) There is no way to predict this relationship.

Individual stock's st dev will be higher **Higher st dev = more risk. Portfolio of diversified assets significantly decreases risk

Which of the following is generally true about a firm's cost of debt? A) It is equal to the yield to maturity on the firm's outstanding bonds. B) It is greater than the cost of equity. C) It normally cannot be observed, directly or indirectly, in the marketplace. D) It is greater than the average coupon payments on outstanding debt. E) It is equal to the coupon rate on the firm's outstanding bonds.

It is equal to the yield to maturity on the firm's outstanding bonds

Portfolios of unrelated assets have ______ risk than the individual assets

Less UNSYSTEMATIC risk

Working capital will affect incremental cash flows if: A) current liabilities change more than current assets. B) current assets change more than current liabilities. C) inventory changes from previous levels. D) net working capital changes from previous levels.

Net working capital changes from previous levels

If a security plots below the security market line, it is: A) not rewarding the investor for its unique risk. B) underpriced, a situation that should be temporary. C) Overpriced, which will increase the demand for the stock. D) offering too little return to justify its risk. E) It is not possible that a security will plot below the security market line.

Offering too little return to justify its risk

If a stock lies below the SML, it is

Overvalued

The overall cost of capital for a retail store: A. is equivalent to the aftertax cost of the firm's liabilities. B. should be used as the required return when analyzing a potential acquisition of a wholesale distributor. C. reflects the return investors require on the total assets of the firm. D. remains constant when the debt-equity ratio changes. E. is unaffected by changes in corporate tax rates.

Reflects the return investors require on the total assets of the firm

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to: a. reject profitable, low-risk projects and accept unprofitable, high-risk projects. b. reject profitable, low-risk projects and reject profitable, high-risk projects. c. accept profitable, low-risk projects and accept unprofitable, high-risk projects. d. accept profitable, low-risk projects and reject unprofitable, high-risk projects. e. There is not enough information given to answer this question.

Reject profitable, low-risk projects and accept unprofitable, high-risk projects. **This is because they will only select projects with returns above the WACC. Projects with higher returns have more risk. They may have negative NPVs.

Subjective approach

Required return is subjectively greater than the WACC for riskier projects and subjectively lower for less risky projects

If the market is at equilibrium, all assets must have the same ___

Reward to risk ratio

If the markets are efficient and securities are prices fairly then the ______ will be constant for all securities A. systematic risk B. standard deviation C. reward-to-risk ratio D. beta E. required return

Reward to risk ratio

The slope of the SML is called the

Reward to risk ratio

The principle of diversification tells us that: a. Concentrating an investment in two or three large stocks will eliminate all of your risk. b. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk. c. spreading an investment across five diverse companies will not lower your overall risk at all. d. spreading an investment across many diverse assets will eliminate all of the risk e. spreading an investment across many diverse assets will eliminate some of the risk.

Spreading an investment across many diverse assets will eliminate some of the risk

Which one of the following is an example of diversifiable risk? A. The price of electricity just increased. B. The employees of Textile, Inc. just voted to go on strike. C. The government just imposed new safety standards for all employees. D. The government just lowered corporate tax rates. E. The cost of group health insurance just increased nationwide

The employees of Textile, Inc. just voted to go on strike **Unsystematic risk

When calculating the weighted average cost of capital, an adjustment is made for taxes because a. equity earns a higher return than debt. b. equity is risky. c. the interest on debt is tax deductible. d. dividends paid are tax deductible. e. taxes do not affect the weighted average cost of capital

The interest on debt is tax deductible

Total risk

The standard deviation (includes both systematic and unsystematic risk)

If a stock lies above the SML, it is

Undervalued

Which risk type can be be diversified by adding stocks to a portfolio? a. Systematic risk b. Unique risk c. Default risk d. Market risk e. Capital market risk

Unique risk

The firm's cost of debt is also known as the bond's

Yield to maturity