Business Finance Final: Conceptual
The formula for the required return from the SML is:
RE = Rf + B(RM − Rf)
The ____ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.
beta
Flotation costs are costs incurred to ____.
bring new security issues to the market
Which of the following is a conclusion that can be drawn regarding market efficiency from capital market history?
future market prices are hard to predict based on publicly available information
The _____ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.
systematic
Most financial securities have some level of ________ risk.
systematic
The percentage of a portfolio's total value that is invested in a particular asset is the portfolio _____.
weight
The___ is the squared standard deviation
variance
Finding a firm's overall cost of equity is difficult because _____.
there is no way of directly observing the return that the firm's equity investors require on their investment
The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?
-10.9% -12.9%
Studying market history can reward us by demonstrating that _____.
-on average, investors will earn a reward for bearing risk -the greater the potential reward is, the greater the risk
The Treasury bills used in the Ibbotson-Sinquefield studies had maturities of ___.
1 month
The majority of the diversifiable risk in a portfolio can be eliminated by owning as few as ________ stocks.
10
A projected IRR on a risky investment in the _____ percent range is not unusual.
10-20
Suppose you buy a share for $100. At the end of one year the share price is $114 and a $1 dividend is paid. If you do not sell the share, your total annual return is ____.
15%
Based on average historical returns shown in the text, small-company stocks increased in value by _____ percent in a typical year.
16
Which of the following statements regarding unsystematic risk is accurate?
It can be effectively eliminated by portfolio diversification.
What does the security market line depict?
It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.
What is unsystematic risk?
It is a risk that affects a single asset or a small group of assets.
________ measures total risk, and ________ measures systematic risk.
Standard deviation; beta
Which one of the following is true?
Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.
If you wish to create a portfolio of stocks, what is the required minimum number of stocks?
You must invest in stocks of more than one corporation.
The WACC is the weighted average of the cost of equity and the _____.
aftertax cost of debt
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when ___.
all projects have the same risk as the current firm
The ______ is the excess return an asset earns based on the level of risk taken.
alpha
The two potential ways to make money as a stockholder are through ______ and capital appreciation.
dividends
To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.
dividends
The most well-known approach to company performance evaluation is the _____ method.
economic value added
The return an investor in a security receives is ______ the cost of the security to the company that issued it.
equal to
The ____ return is the return that an investor will probably earn on a risky asset in the future.
expected
True or false: Systematic risk will impact all securities in every portfolio equally.
false
The ____(greater/lower) the risk, the greater the required return.
greater
Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n):
portfolio.
The ________ is a positively sloped linear function that plots securities' expected returns against their betas.
security market line
Kate Corporation has discovered a very secret new product, but hasn't yet announced the discovery to the public. If the stock price reacts before the announcement (assuming no corporate "leaks"), the market is _____ form efficient.
strong
Capital____ weights can be interpreted just like portfolio weights.
structure
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?
$2/$20
Including preferred stock in the WACC adds the term:
(P/V) × RP
To estimate the growth rate of a particular stock, we can ___.
-use the historical dividend growth rate. -use security analysts' forecasts
A firm has a target debt-equity ratio of .5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?
.5
The risk-free asset has a beta of _____.
0.00
Of the options listed below, which is the best measure of systematic risk?
Beta
Which of the following are tax-deductible to the firm?
Coupon interest paid on bonds
What is the equation for the capital asset pricing model?
Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)
True or false: The smaller the variance or standard deviation is, the more spread out the returns will be.
False
Which type of risk does not change as we add more securities to a portfolio?
Systematic, or market, risk
Which of the following variables is not required to calculate the expected return on a risky asset?
The rate of inflation
Using the SML approach, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
What is the intercept of the security market line (SML)?
The risk-free rate
What does WACC stand for?
Weighted average cost of capital
The calculation of a portfolio beta is similar to the calculation of _____.
a portfolio's expected return
The best way to include flotation costs is to ___.
add them to the initial investment
The dividend yield for a 1-year period is equal to the annual dividend amount divided by the ______.
beginning stock price
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes
cannot
The cost of ____ is the minimum required return on a new investment.
capital
The____gains yield can be found by taking the difference between the ending stock price and the initial stock price and dividing it by the initial stock price.
capital
Average returns can be calculated using____ or arithmetic average.
geometric
The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.
grows at a constant rate
The Sharpe ratio measures ___.
reward to risk
Projects that have the same risk are said to be in the same _____
risk class
The standard deviation is the ______ of the variance.
square root
When an investor is diversified only ________ risk matters.
systematic
Which type of risk is unaffected by adding securities to a portfolio?
systematic
The systematic risk principle argues that the market does not reward risks _____.
that are borne unnecessarily
If a security's expected return is equal to the expected return on the market, its beta must be ____.
1
The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.
increases; increases
Dividends are the ______ component of the total return from investing in a stock.
income
What is systematic risk?
It is a risk that pertains to a large number of assets.
The expected return of a stock, based on the likelihood of various economic outcomes, equals the:
weighted average of the returns for each economic state.
The Ibbotson-Sinquefield data show that over the long-term, ___.
-small-company stocks had the highest risk level -T-bills, which had the lowest risk, generated the lowest return -small-company stocks generated the highest average return
Which of the following is true?
A company can deduct interest paid on debt when computing taxable income.
If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?
An efficient market reaction
If you are forecasting a few decades in the future (as you might do for retirement planning) you should calculate the expected return using:
Blume's formula
Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?
Division B
Economic value added (EVA) is a means of evaluating corporate performance.
True
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably _____.
better than no risk adjustment
A firm's overall cost of capital will include both its cost of _____capital and equity capital.
debt
The SML is very important because it tells us the "going rate" for bearing ____ in the economy.
risk
The second lesson from capital market history is that there is a direct link between___ and reward.
risk
The geometric average rate of return is approximately equal to ___.
the arithmetic mean minus half of the variance
An investor who owns a well-diversified portfolio would consider ________ to be irrelevant.
unsystematic risk
The cost of capital depends primarily on the ___(use/source) of funds.
use
The cost of capital depends on the _____ of funds, not the _____ of funds.
use source
According to the CAPM, which of the following events would affect the return on a risky asset?
-A change in the yield on T-bills -A strengthening of the country's currency -Federal reserve actions that affect the economy
Which of the following are components used in the construction of the WACC?
-Cost of preferred stock -Cost of debt -Cost of common stock
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
-It is likely to decrease. -It may eventually be almost totally eliminated.
Which of the following are examples of information that may impact the risky return of a stock?
-The Fed's decision on interest rates at their meeting next week -The outcome of an application currently pending with the Food and Drug Administration.
What are the two components of the market risk premium?
-The risk-free rate -The expected return on the market
Preferred stock ___.
-pays a constant dividend -pays dividends in perpetuity
Arrange the following investments in ascending order from lowest historical risk premium at the top to highest historical risk premium at the bottom.
1. US Treasury Bill 2. Long-term corporate bonds 3. Large-companys stocks 4. small-company stocks
Bonds used in Ibbotson-Sinquefield's long-term U.S. government bond portfolio had maturities of ____ years.
20
_____formula is the equation that combines the arithmetic average return and the geometric average return
Blumes
True or false: A well-diversified portfolio will eliminate all risks.
False
True or false: Based on capital market history, market efficiency shows us that it is relatively simple to identify stocks that are incorrectly priced
False
True or false: Systematic risk can be eliminated by diversification
False
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
What is the definition of expected return?
It is the return that an investor expects to earn on a risky asset in the future.
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
An investor wants to reduce the unsystematic risk in her portfolio. Which of the following actions is least likely to do so?
Reducing the number of stocks held in her stock portfolio
In the Ibbotson study, the large-company common stock portfolio is based on the ____.
S&P 500 Index
B = the market value of a firm's debt S = the market value of that same firm's equity RB = the before-tax yield on the firm's debt TC = the corporate tax rate RS = the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:
[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market _____.
already knew about most of the news item
The ________ explains the relationship between the expected return on a security and the level of that security's systematic risk.
capital asset pricing model
If you buy a stock for $10 and later sell it for $16, you will have a ____.
capital gain of $6
WACC is used to discount ______.
cash flows
The geometric rate of return takes ______ into account.
compounding
Finding a firm's overall cost of equity is___ (straightforward/difficult)
difficult
When we _____ an announcement or a news item, we say that it has less of an impact on price because the market already factored it in.
discount
The ______ rate of return is the difference between risky returns and risk-free returns.
excess
In an efficient market, firms should expect to receive ______ value for securities they sell.
fair
True or false: Projects should always be discounted at the firm's overall cost of capital.
false
The issuance costs of bonds and stocks are referred to as ______ costs.
flotation
An important advantage to a firm raising equity internally is not having to pay ___.
flotation costs
In general, the arithmetic average return is probably too _____ (low/high) for longer periods and the geometric average is probably too _____ (low/high) for shorter periods.
high; low
When discounting the cash flows of a project at the WACC to estimate NPV, we need to find an alternative in the financial markets that is _____ as the given project.
in the same risk class
The CPI is the most commonly used measure of____
inflation
Based on the historical returns shown in the text, the average___ was 2.9 percent per year over the 94-year span depicted.
inflation rate
An efficient market is one that fully reflects all available ______.
information
Stock prices fluctuate from day to day because of _____.
information flow
In reality, most firms cover the equity portion of their capital spending with ___.
internally generated cash flow
The most appropriate weights to use in the WACC are the ______ weights.
market value
The____ ____ approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.
pure play
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
To calculate the expected risk premium on a stock, one must subtract the ________ from the stock's expected return.
risk-free rate
The market value cost of debt is often Blank______ the book value cost of debt.
similar to
With the use of the approach to estimating WACC, the firm's WACC may change through time as economic conditions change
subjective
A normal distribution has a ______ shape.
symmetrical
The portfolio weight is _____.
the percentage of the total value that is invested in an asset
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?
the risk-free rate of return
To determine whether an investment has a positive NPV, you can compare the expected return on that new investment to what the financial market offers on an investment with _____.
the same beta
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.
too many high-risk
True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it
true
The true risk of any investment is the _____ portion.
unanticipated
An unexpected post on social media caused the prices of 22 different companies' stocks to immediately increase by 10 to 15 percent. This occurrence is best described as an example of ________ risk.
unsystematic
One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future _____.
when economic conditions change quickly
A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?
-An increase in the Federal funds rate -An increase in the corporate tax rate
If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclude about the value of the security's beta based on CAPM?
It is equal to 0.
If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?
The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected
When a company declares a dividend, shareholders generally receive ______.
cash
True or false: The cost of debt on the market value basis is typically much higher than the cost of debt on the book value basis.
False
A ________ is the market's measure of systematic risk.
beta of 1
There is ______ correlation between the unsystematic risk of two companies from different industries.
no
If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be _____.
rejected, when it should be accepted
A distribution tends to have a smooth shape when the number of observations is ___.
very large
The efficient markets hypothesis contends that _____ capital markets such as the NASDAQ are efficient.
well-organized
In the Ibbotson-Sinquefield study, the U.S. small-company common stock portfolio corresponds to the bottom fifth, in terms of market value, of stocks traded on ____.
the New York Stock Exchange
If a firm has multiple projects, each project should be discounted using:
a discount rate that commensurates with the project's risk.
Which of the following methods for calculating the cost of equity ignores risk?
The dividend growth model
Which of the following are ways to make money by investing in stocks? (Select all that apply.)
-Capital gains -Dividends
Some important characteristics of the normal distribution are that it is:
-bell-shaped -symmetrical
During the financial crisis of 2008, the S&P 500 Index fell by _____ percent.
37
Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose?
Asset A
If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.
is highly risky
The variance of a portfolio_____ (is/isn't) generally a simple combination of the variances of the assets in the portfolio.
isn't
More volatility in returns produces ______ difference between the arithmetic and geometric averages.
larger
Which of the following are true?
-Common stocks may experience negative returns. -T-bills sometimes outperform common stocks.
What can we say about the dividends paid to common and preferred stockholders?
-Dividends to common stockholders are not fixed. -Dividends to preferred stockholders are fixed.
Which of the following are examples of a portfolio?
-Holding $100,000 investment in a combination of stocks and bonds -Investing $100,000 in a combination of U.S. and Asian stocks -Investing $100,000 in the stocks of 50 publicly traded corporations
Which of the following are true?
-Ideally, we should use market values in the WACC. -Book values are often similar to market values for debt.
The Ibbotson-Sinquefield data shows that ___.
-long-term corporate bonds had less risk or variability than stocks -U.S. T-bills had the lowest risk or variability
The SML approach requires estimates of the _____.
-market risk premium -beta coefficient
A firm's cost of debt can be ___
-obtained by talking to investment bankers -obtained by checking yields on publicly traded bonds -estimated easier than its cost of equity
To estimate the expected return on a risky asset, we need to know the ___.
-stock's beta -risk-free rate -market risk premium
An efficient market is one in which any change in available information will be reflected in the company's stock price ___.
immediately
The slope of the security market line is the:
market risk premium.
The risk of owning an asset comes from:
-surprises -unanticipated events
Which is true of flotation costs in calculating WACC?
They are relevant cash flows.
The cost of can be observed because it is the interest rate the firm must pay on new loans.
debt
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.
decrease