Corporate Finance Final Exam Review

Foreign exchange with euros and yen

$1 = 112 yen 1 euro = $1.11

Indirect quote

1 euro

To find yen

1/112

Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio? A. Adding more such stocks will reduce the portfolio's unsystematic/diversifiable risk. B. Adding more such stocks will increase the portfolio's expected return C. Adding more will reduce the portfolio's beta coefficient and thus its systematic risk D. It will have no effect on the risk

A

Which of the following is correct? A. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the SD of a portfolio with fewer stocks, regardless of how those are selected. B. Diversifiable risk can be reduced by forming a large portfolio, but normally even high-diversified portfolios are subject to market/systematic risk. C. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. D. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk.

B

Which of the following statements is correct? A. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. B. If you formed a portfolio that consisted of all stocks with the betas less than 1.0, which is about half of all stocks, the portfolio would it self have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. C. Market risk can be eliminated by forming a large portfolio, and if some treasury bonds are held in the portfolio, the portfolio can be made to be completely risk less. D. A portfolio that consists of all stocks in the market would have a required return that is equal to the risk less rate.

B

Assume that inflation and market risk premium have declined and all stocks have positive betas. Which will most likely occur? A. Required return on all stocks have fallen, but the decline has been greater for stocks with lower betas. B. Required return on all stocks have fallen, but the fall has been greater for stocks with higher betas. C. Average required return on the market has remained constant D. Required returns have increased for stocks with betas greater than 1.0, but have declined for stocks with betas less than 1.0 E. Required returns have fallen by the same amount.

B Market Risk Premium = (rM - rRF)

During the coming year, the market risk premium (rM- rRF) is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given the forecast, which of the following statements is correct? A. The required return will increase for stocks with a beta less than 1.0 and decrease for stocks with a beta greater than 1.0 B. The required return with remain unchanged C. The required return will fall for all stocks, but it will fall more for stocks with higher betas D. The required return will fall for all stocks by the same amount E. The required return will fall for all stocks, but it will fall less for stocks with higher betas

C

Inflation, recession, and high interest rates are economic events that are best characterized as being A. Systematic risk factors that can be diversified away B. Company specific risk factors that can be diversified away C. Among the factors that are responsible for market risk D. Risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers E. Irrelevant except to government authorities like the Federal Reserve

C

Which of the following correctly ranks investments from HIGHEST to LOWEST risk and return? A. small-company stocks, long-term corporate bonds, large - company stocks, long-term govt bonds, US T-bills B. large-company stocks, small-company stocks, long-term corporate bonds, US T-bills, long term govt bonds. C. small-company stocks, large-company stocks, long-term corporate bonds, long-term govt bonds, US T-bills D. US T-bills, long-term govt bonds, long-term corporate bonds, small-company stocks, large company stocks

C

Which of the following statements is correct? A. A stocks beta is less relevant as a measure of risk to an investor with a well diversified portfolio than to an investor who holds only one stock B. If an investor buys enough stocks, he can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially risk less C. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return D. A securities beta measures it's non-diversifiable, or market, risk relative to that of an average stock.

D

Which of the following statements is correct? A. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks. B. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. C. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. D. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

D. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

Stock A's beta is 1.5, and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct. A. Stock A would be more desirable B. In equilibrium, the expected return on Stock B will be greater than that on Stock A. C. Stock B would be more desirable D. In equilibrium, the expected return on Stock A will be greater than that on B.

D. In equilibrium, the expected return on Stock A will be greater than that on B.

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. True False

False

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule, it will not be possible to eliminate all diversifiable risk. True False

False cannot eliminate market risk through diversification

Payback Method

How long does it take to get your money back?? decision rule: select project w lowest payback period

NPV

If NPV is greater than 0, accept the project NPV changes when k changes best method doesn't give % return

What happens if US interest rate goes up?

If US interest rates rise, the currency value goes up the dollar appreciates

WILL PAY

K = (D1 / Po) + g

Calculate rate of return for PREFERRED stock

K = D/P

Common stock w flotation cost

K = D1 / (Po(1-F)) + g

Systematic Risk

Market Risk affects every security/stock recession, interest rate, war cannot reduce through diversification - only way to reduce is to leave stock market

4 methods of Capital Budgeting

NPV IRR PI Payback

The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. True False

True

The slope of the SML is determined by investors' aversion to risk. The grater the average investor's aversion, the steeper the SML. True False

True

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. True False

True

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. True False

True b > 1 = high beta and more risky beta measures systematic risk

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific" or "unsystematic" events, and their effects on investment risk can in theory be diversified away. True Flase

True unsystematic - company specific systematic - market

Risk

Uncertainty, how much returns vary from the mean Measure risk by standard deviation

Cost of preferred stock equation

V = D/K V= value of stock D = dividend K = rate of return

Cost of COMMON stock equation

V = Do(1+g) / k-g K = (Do(1+g) / Po) + g

Weighted Average Cost of Capital (WACC)

WACC = WcsRcs + WpsRps + WdRd (1-T)

fixed currencies

determined by govt Chinese currency

freely floating currency

determined by the market interaction between supply and demand

Unsystematic Risk

diversifiable risk company-specific diversify to reduce the risk occurs when product lines fail, medicines have bad side effects, lawsuits

Dividends Tax Shield

dividends do not have a tax shield paying more in dividends does not have any tax benefits since taxes are paid out prior to dividends

What happens if US interest rate goes down?

if interest rates decrease, the dollar value depreciates

What affects value of currency?

interest and inflation rates

Interest Tax Shield

interest has a tax shield the more you pay in interest, the less you pay in taxes

IRR -Internal Rate of Return

is the k for which NPV = 0 when IRR is greater than or equal to k (cost of capital), accept the project! IRR stays the same when k changes as long as cash flows stay the same

Companies raise money by

issuing bonds (debt) issuing common stock (equity) issuing preferred stock

rF = 4%, rM = 10%, B = 2%, what is rA?

rA = rF + (rM - rF)B rA = 4% (10% - 4%) 2% = 4% + (6%) 2% = 16%

Capital Asset Pricing Model

rA = rF + (rM - rF)B rA = expected return of stock (asset) rF = risk free rate rM = expected return of market B = beta

Risk premium

rM - rF

Profitability Index

rationing of funds PI = 1 + (NPV/Initial Outlay) (use absolute value of initial investment) When PI is greater than or equal to one, accept the project!

Security Market Line (SML)

risk - return trade off for the investor risk averse investors will have a steeper SML (they want a lower beta with less return)

B (beta)

systematic risk how individual stock varies from market high beta - greater than one: more risky low beta - less than one: less risky based on historical measures

How to calculate after-tax

take before tax rate (I/Y) and multiply by (1-T) T is tax rate (which will be provided)

Yesterday you could buy 112 yen with $1, today you can buy 114

the dollar appreciated the yen depreciated

Yesterday one euro could buy $1.11, today one euro can buy $1.12

the euro has appreciated the dollar depreciated

what does a strong dollar mean?

the value went up you can buy more foreign goods hurts exports

Direct Quote

written in our currency $1