finance test 3 concepts

The beta of the risk-free asset is:

0.0

Portfolio weights must sum to ____.

1

Refer to NPV Profile. What's the IRR for project 1?

14%

Refer to NPV Profile. What's the IRR for project 2?

18%

Refer to Gamma Electronics. What's the payback period for the investment?

2.0 years

An asset that falls into the 3-year MACRS asset class is fully depreciated over:

4 years.

Which type of firm would most likely have the greatest systematic risk?

A vibrating chair manufacturer

Financial leverage:

All of the above (results when a firm finances a portion of its assets with debt; can enhance a firm's earnings if sales increase; can impact the beta of the firm's stock)

Which of the following is not a "con" of the Accounting Rate of Return method?

All of the above are cons of the Accounting Rate of Return method. (The method makes no adjustment for the time value of money or project risk.; The depreciation method used impacts both the numerator and denominator.; It focuses on net income rather than a company's ability to generate cash.; The choice of the hurdle rate is arbitrary)

Which of the following is a reason why firms do not tend to issue new shares of common stock to fund new projects?

All of the above are reasons. (Raising new capital via equity may send a unintended negative signal to the market. b. Issuing new equity dilutes a manager's ownership stake in the firm (unless they purchase at least an equal proportion of the new shares as they currently own). c. By rationing capital senior managers hope to weed out investments with an optimistic bias built into the cash flow projections.)

Which of the following statements is true?

All of the above are true. (To help combat optimistic bias when estimating a project's cash flows, companies place responsibility for analyzing an investment proposal under an independent authority from the group proposing the project. b. Financial experts need to have a sense of what is reasonable when forecasting a potential project's profit margin and growth potential. c. Financial analysts need to be prepared to defend their assumptions for a potential project and explain why their estimates do not agree with those offered by the project's advocates.)

Which of the following statements is true?

All of the above statements are false. (Using the same WACC to discount all a firm's potential investments is a sound financial practice.; When a firm has debt in its capital structure, the cost of equity is the appropriate discount rate to use in NPV calculations.; If an investment being evaluated has higher risk than the firm's current set of projects, the firm's WACC is the appropriate discount rate to use.; Statements (a) and (b) are true)

They should be included in the cash flow calculations.

All of the above statements are true. (Depreciation is a noncash expense and reduces taxable income thereby reducing the cash outflow associated with tax payments.; Depreciation's impact upon cash flows can be accounted for by adding depreciation back to net income before interest and after taxes.; Depreciation's impact upon cash flows can be accounted for by adding the tax savings associated with the depreciation to net income before interest and after taxes.)

A fund based on the efficient market hypothesis is most likely

An Index portfolio

A fund that attempts to researches and finds undervalued and overvalued stocks

An active portfolio

A fund that attempts to mimic the S&P 500

An index portfolio

Asset 1 has a beta of 1.2 and Asset 2 has a beta of 0.6. Which of the following statements is correct?

Asset 1 has a higher expected return than Asset 2.

Which of the following statements is true?

Because expected returns on stocks exceeds expected returns on bonds, it is more reasonable to expect that stocks will outperform bonds in any given year.

The discount rate used to evaluate a firm's projects should:

Both (a) and (b) are true

When a firm operates at less than full capacity

Both (a) and (c) are true. (managers should charge the cost of accelerating new capacity development against the current proposal for using excess capacity.; treating that excess capacity as a free asset may accelerate the need for more capacity in the future.)

Refer to NPV Profile. If Gamma Company has a hurdle rate of 11%, and the two projects are independent, which project should Gamma Company invest?

Both project 1 and project 2.

The formula for the Capital Asset Pricing Model is:

E(Ri) = Rf + bi(E(Rm) - Rf)

The slope of the security market line is:

E(Rm) - Rf

operating leverage describes the relationship between

EBIT and sales

If the risk-free rate last year was 3%, and the return on the market was 11%, which firm had the best performance on a risk-adjusted basis?

Firm A

Which of the following approaches to estimating an asset's expected return assumes that the future and the past share much in common?

Historical

The compound annual return on a project is known as its:

IRR

Which of the following would fall under the definition of cannibalism as it applies to capital budgeting?

If a firm offered a 'low-fat' version of a current product and sales of that new product were expected to reduce sales of the current version.

Which of the following statements is true?

Incremental cash flows effectively represent the marginal costs and marginal benefits expected to result from undertaking a proposed investment.

Taxes impact the WACC calculation because:

Interest paid on debt is tax deductible.

While the NPV approach offers many advantages over some other capital budgeting techniques, several cons exist with respect to the approach. Which of the following is (are) cons of the NPV method?

It seems less intuitive to many users than other methods

The system in the U.S. which defines the allowable annual depreciation deductions for various classes of assets is known as:

MACRS

Georgia Food is exploring the possibility of bringing a new frozen pasta to the market. Which of the following items are not relevant for the project's analysis?

Market research funds the company has spent on testing the viability of the new product

Which of the following statements is true?

More risk leads to higher option values

Which of the following statements is true?

Multiple IRRs can result for some projects which can lead to a difficulty for the IRR method.

Which method directly estimates the change in shareholder wealth?

NPV

You must know all the cash flows of an investment project to compute its

NPV, PI, IRR

You must know the discount rate of an investment project to compute its

NPV, PI, discount payback period

Refer to NPV Profile. If the hurdle rate is 19%, and the two projects are independent, which project should be accepted?

Neither project

When evaluating a potential capital budgeting decision, fixed asset expenditures

Only (b) and (c) are true. (b. often appear as the initial cash outflow for a project. c. can be significantly increased due to the costs of installing the equipment.)

If a firm is subject to capital rationing, when choosing a set of potential investments the firm should rank the projects by:

PI and choose the best ones until funding is exhausted.

Refer to NPV Profile. If the hurdle rate is 11%, and the two projects are mutually exclusive, which project should be accepted

Project 1

Refer to NPV Profile. The NPV of which project is more sensitive to the discount rate?

Project 1

Which project should you accept? What is the problem that you should be concerned with in making this decision?

Project 1; project scale

Refer to NPV Profile. If the hurdle rate is 13%, and the two projects are mutually exclusive, which project should be accepted?

Project 2

Refer to NPV Profile. Suppose the two projects require about the same initial investment. Which project generates more cash flows in the early years

Project 2

Refer to Tompson Manufacturing. Suppose the hurdle rate of the firm is 10%. If the two projects are mutually exclusive, which project should be chosen? What is the problem that the firm should be concerned with in making this decision?

Quality improvement project; the timing of cash flows

Which of the following items will lead to a rise in net working capital?

Raw materials are purchased prior to the sale of finished goods

The intercept of the security market line is:

Rf

The country with the highest level of systematic risk is:

Russia

Which of the following describes a visual representation of the sequential choices that managers face over time with regard to a particular investment?

Scenario analysis

Should a firm invest in projects with NPV = $0?

The firm is indifferent between accepting or rejecting projects with zero NPVs

Which of the following statements is false?

The general rule of thumb is that a project will have as many IRRs are there are negative cash flows.

Which of the following statements is false?

The payback method considers all cash flows for a project, even those occurring after the payback period.

Roger is considering the expansion of his business into a property he purchased two years ago. Which of the following items should not be included in the analysis of this expansion?

The property was extensively renovated last year at a cost of $15,000.

A particular asset has a beta of 1.2 and an expected return of 10%. The expected return on the market portfolio is 13% and the risk-free is 5%. Which of the following statement is correct?

This asset lies below the security market line. (Equilibrium return = 5% + 1.2 (13%-5%) = 14.6%)

A firm prefers to assume a probability distribution concerning each of the major inputs for the net present value of a project and then randomly draw those inputs over and over again until a distribution is generated for the net present value of an entire project. The firm is performing

a Monte Carlo analysis on its projects.

The IRR is analogous to:

a bond's yield-to-maturity

An increase in net working capital represents:

a cash outflow.

The right but not the obligation to produce oil from one of your existing oil wells can be described as

a real option

If a company decides to change one input at a time in its net present value analysis, in order to measure the NPV impact of such a change then the firm is performing

a sensitivity analysis.

The option to withdraw resources from projects that fail to live up to shortrun expectations is know as a(n):

abandonment option

What type of mutual fund managers do extensive analysis to identify mispriced stocks?

active

Financial managers prefer a capital budgeting technique with which of the following characteristics?

all of the above (Easily-applied and considers cash flows; Recognizes the time value of money and accounts for risk and return; When applied leads to higher stock prices)

The CAPM (capital asset pricing model) assumes that:

all of the above (all assets can be traded; investors are risk-averse; investors have homogeneous expectations)

Modern financial markets are:

all of the above (competitive.; transparent.; efficient)

which of the following is considered a type of real optons

all of the above (expansion option, abandonment option, flexibility option)

The capital budgeting process involves

all of the above (identifying potential investments and estimating the incremental cash inflows and outflows of cash associated with each investment; analyzing and prioritizing the investments utilizing various decision criteria; implementing and monitoring the selected investment projects; estimating a fair rate of return on each investment given its risk)

Which of the following statements is true?

all of the above are true (When conducting sensitivity analysis all variables except one are held constant.; When conducting sensitivity analysis a 'base-case' set of assumptions must be established.; Scenario analysis is a more complex form of sensitivity analysis.; both (a) and (b) are true)

Which of the following statements is false?

all of the above statements are false. (Ideas for investment projects stem mainly from the firm's finance department.; Capital projects by their nature are easily reversible.; Once a capital project is)

Capital budgeting techniques should:

all of the above. (fully account for expected risk and return.; recognize the time value of money.; lead to higher stock prices when applied.

The NPV method is most likely to be used in:

all of the above. (large firms.; publicly traded firms.; firms run by CFOs with MBAs.)

Accountants measure inflows and outflows of business operations on:

an accrual basis.

A mutual fund that adopts a passive management style is called:

an index fund

Sunk costs:

are irrelevant

The payback method is more likely to be used by:

b. and c. (older CFOs.; CFOs without an MBA)

You are an aerospace defense contractor and you routinely work projects for the U.S. Department of Defense that generate cash flows that by themselves, do not cover the cost of capital for the firm. One reason for this may be

because the projects have an implicit option to work on nondefense related projects at a lower direct research cost than projects without defense related work.

A standardized measure of risk is:

beta

A firm may be unable to accept all projects that are expected to have positive NPVs due to:

both (a) and (b) are true (the lack of funds b. the lack of trained and reliable personnel )

Refer to Exhibit 8-3. If the two projects are independent, which project should the firm choose based on the IRR rule?

both projects

a manager who wants to find out at which point a project's profits and costs are equal will conduct a

breakeven anaylsis

When a firm introduces a new product and some of the new product's sales come at the expense of the firm's existing products, this is known as:

cannibalization.

The process of identifying which long-lived investment projects a firm should undertake is known as:

capital budgeting.

The idea that a company may be unable to accept all projects that are expected to have positive NPVs due to the lack of funds is known as:

capital rationing

When a firm cannot invest in every positive NPV project because of limited funds, this is known as:

capital rationing.

Capital investment is also known as:

capital spending

Financial analysts focus on ____ when evaluating potential investments.

cash

The IRR method focuses on:

cash flows.

The NPV method focuses on:

cash flows.

A decrease in accounts receivable will ____ net working capital.

decrease

As the discount rate increases, the NPV of a project:

decreases.

The first step in the risk-based approach to estimating a security's expected return is to:

define what is meant by "risk" and to measure it.

The accounting rate of return

does not take into account the time value of money

The hypothesis that states that it is nearly impossible to predict exactly when stocks will do well relative to bonds is known as the:

efficient market hypothesis.

The idea that asset prices fully reflect all available information is known as the

efficient market hypothesis.

Which of the following industries would you expect to have the highest degree of operating leverage?

electrical utility

When the IRR is equal to the discount rate, the NPV is:

equal to zero.

Which of the following is not a method used by analysts to estimate an asset's expected return?

estimation approach

The right to invest additional resources in investments that enjoy early success is known as a:

expansion option

The payback method:

fails to explicitly consider the time value of money.

When investors take a short position in one asset to invest more in another asset, they are using:

financial leverage

The option to make additional investments should earlier investments prove to be successful is known as a(n):

follow-on investment option

Options that offer a firm the ability to adapt to changes in inputs, outputs and maintaining excess production capacity are known as:

follow-on investment options

The ____ makes capital budgeting ____ complicated.

human element, more

The profitability index is most useful

in capital rationing situations

An increase in inventory will ____ net working capital

increase

Cash Flows that occur if and only if a project is accepted are:

incremental cash flows

Expected returns are:

inherently unobservable.

As the discount rate increases, the IRR of a project:

is unaffected.

A problem with the payback method is:

it assigns a 0 percent discount rate to cash flows that occur before the cutoff point.

An advantage of the probabilistic approach to estimating an asset's returns is:

it does not require one to assume that the future will look like the past.

The relevant tax rate for capital budgeting purposes is the:

marginal tax rate.

The difference between the return on the market portfolio and the risk-free rate is known as the:

market risk premium

which approach estimates NPV by taking a distribution of values for each of the model's assumptions?

monte carlo simmulation

Which of the following is a problem with the Internal Rate of Return?

multiple IRRs

a project's discount rate

must be high enough to compensate investors for the project's risk

The accounting rate of return is calculated as:

net income/book value of assets

The preferred technique for evaluating most capital investments is

net present value

The difference between current assets and current liabilities is known as:

net working capital

Paul earns $60,000 as an engineer, and he is considering quitting his job and going to graduate school. This $60,000 should be treated as a ____ if Paul runs an NPV analysis of his graduate degree.

opportunity cost

Cash flows on an alternative investment that a firm decides not to make are a(n):

opportunity cost.

A particular asset has a beta of 1.2 and an expected return of 10%. The expected return on the market portfolio is 13% and the risk-free is 5%. The stock is

overpriced (Equilibrium return = 5% + 1.2 (13%-5%) = 14.6%)

Suppose Sarah can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios should she hold in combination with a position in the riskfree asset?

portfolio with a standard deviation of 19% and an expected return of 15%

Suppose David can borrow and lend at the risk-free rate of 5%. Which of the following three risky portfolios should he hold in combination with a position in the risk-free asset?

portfolio with a standard deviation of 20% and an expected return of 16%

To help rank projects in a capital rationing environment, managers often use the:

profitability index

If the two projects are mutually exclusive, and the firm's hurdle rate is 18%, which project should the firm choose?

project 1

Refer to Exhibit 8-3. If the two projects are mutually exclusive, which project should the firm choose? What is the problem that the firm should be concerned with in making this decision?

project 1; project scale

Which approach estimates NPV by changing the value of several assumptions at once to represent possible outcomes of the project?

scenaria analysis

which answer describes an analysis of what happens to NPV estimates when we chance the values of one variable at a time?

sensitivity analysis

If any project is to have a positive NPV, advocates of that project:

should be able to articulate a project's competitive advantage prior to crunching the numbers.

Opportunity costs

should be considered when determining an investment's relevant cash flows

The main virtue of the payback method is its:

simplicity

A high degree of operating leverage suggests that

small percentage increase in sales leads to a large percentage increase in earnings before interest and taxes.

When evaluating different capital budgeting techniques such as payback, net present value, internal rate of return, profitability index and accounting rate of return,

some techniques have advantages over others.

Fox Entertainment is evaluating the NPV of launching a new iPet product. Fox paid a market research firm $120,000 last year to test the market viability of iPet. Fox Entertainment should treat this $120,000 as a ____ for the capital budgeting decision now confronting the firm.

sunk cost

A cash outlay that has already been committed whether a project is accepted or not is known as a:

sunk cost.

Capital budgeting must be placed on an incremental basis. This means that ____ must be ignored and ____ must be considered.

sunk cost; opportunity cost

Which type of risk affects many different securities

systematic risk

You are a gold producer and have noticed that the value of your business may increase even though the price of gold falls. Your explanation for this phenomenon is

that increased risk may increase the real option value of the firm.

A disadvantage of the probabilistic approach to estimating an asset's returns

that the range of possible outcomes is often broader than the scenarios used.

The IRR method assumes that the reinvestment rate of cash flows is

the IRR

Which statement is true about a firm that earns ZERO economic profit?

the NPV of projects the firm considers equals zero

Which statement is FALSE regarding WACC and its components?

the WACC should be used as the discount rate for all projects that the firm considers

Flaws of the accounting rate of return method include:

the choice of accounting g hurdle return rate is essentially arbitrary

The hurdle rate used in IRR analysis should be:

the discount rate used in NPV analysis

operating leverage meausres

the effect of fixed operating costs on the responsiveness of the firm's earnings before interest and taxes to changes in the level of sales.

According to the CAPM (capital asset pricing model), the security market line is a straight line. The slope of this line should be equal to

the expected risk premium on the market portfolio

According to the CAPM (capital asset pricing model), what is the single factor that explains differences in returns across securities?

the expected risk premium on the market portfolio

Which of the following is not required for a firm to utilize its current weighted average cost of capital to evaluate a future project?

the future project has an expected life that is similar to its existing project lives

The percentage of taxes owed on an incremental dollar of income is called:

the marginal tax rate.

The slope of the security market line is:

the market risk premium

A project may have multiple IRRs when

the project generates an alternating series of net cash inflows and outflows

the appropriate cost of capital for a project depends on

the risk associated with the project

One major flaw in decision trees is that:

the risk of many investments changes as one moves from one point in the decision tree to another

A drawback to the historical approach of estimating an asset's expected return is:

the risk of the firm may have changed over time.

According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of this line should be equal to

the risk-free rate

NPV and IRR may give conflicting decisions for mutually exclusive projects because:

the scale of the projects may differ.

Potential problems in using the IRR as a capital budgeting technique include:

the scale problem

A firm's weighted average cost of capital is

the simple weighted average of the current required rates of return on debt and equity.

The value of a project at a given future point in time is known as:

the terminal value.

Standard deviation measures

total risk.

Active managers:

trade more frequently than passive managers

A buy-and-hold strategy:

typically earns higher returns, after expenses, than an active stock picking strategy.

An asset has a beta of 2.0 and an expected return of 20%. The expected risk premium on the market portfolio is 5% and the risk-free is 7%. The stock is

underpriced (Equilibrium return = 7% + 2.0 (5%) = 17%)

A stock that pays no dividends is currently priced at $40 and is expected to increase in price to $45 by year end. The expected risk premium on the market portfolio is 6% and the risk-free is 5%. If the stock has a beta of 0.6, the stock is

underpriced (Equilibrium return = 5% + 0.6 (6%) = 8.6%)

Investors can eliminate what type of risk by diversifying?

unsystematic risk

Which type of risk affects just a few securities at a time?

unsystematic risk

everything else being equal a higher corporate tax rate

will decrease the WACC of a firm with some debt in its capital structure