FIN CH 10, 12, 13, 14 Smartbook
If you were forecasting a few decades in the future, as you might do for retirement planning, you should calculate the expected return using
Blume's formula
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.
The formula for the required return from the SML is:
RE = Rf + B(RM − Rf)
strong form efficiency
Implies that all information of every kind is reflected in stock prices
The first step in estimating cash flow is to determine the __ cash flow.
Relevant
The dividend __ is defined as the annual dividend amount divided by the beginning stock price.
yield
More volatility in returns produces ______ difference between the arithmetic and geometric averages.
larger
What is the slope of the security market line?
market risk premium
How are the unsystematic risks of two different companies in two different industries related?
there is no relationship
A projected IRR on a risky investment in the __ percentage range is not unusual
10 to 20
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
When analyzing a project, sunk costs __ incremental cash flows.
Are not
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
Asset A has an expected return of 17% in standard deviation of 5%. Asset B has an expected return of 15% and standard deviation of 5%. Which asset would a rational investor choose.
Asset A, has higher rate of return, therefore, higher risk, but same deviation
How can a positive positive relationship between the expected return on a security and its beta be justified?
Because the difference between the return on the market, and the risk free rate is likely to be positive
oppurtunity costs are
Benefits lost due to taking on a particular project
An efficient market is one in which any change in available information will be reflected in the company stock price __.
Immediately
As appreciation expense __ net, income and taxes will decrease, what cash flows will __.
Increases Increases
Cash flows from sunk costs are
Irrelevant
If the dispersion of returns on a particular security is very spread out from the security's mean return, the security
Is highly risky
What is unsystematic risk?
It is a risk that affects a single asset or a small group of assets
What is systematic risk?
It is a risk that pertains to a large number of assets.
What is a risk premium?
It is additional compensation for taking risk, over and above the risk-free rate
Opportunity cost are classified as __ costs in project analysis.
Relevant
In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.
SML
Which of the following are needed to describe the distribution of stock returns?
The mean return The standard deviation of returns
The variance of a portfolio __ generally a simple combination of the variances of the assets in the portfolio.
isn't
The most appropriate weights to use in the WACC are the __ weights.
market value
Accounts, receivable and accounts payable are not an issue with project cash flow estimation unless changes in the __ are overlooked.
net working capital
By definition, what is the beta of the average asset equal to?
one
The tax saving that results from the depreciation deduction is called the depreciation tax
shield
A calculated NPV of $15,000 means that the project is expected to create a positive value for the firm and __.
should be accepted if there is no capital rationing constraint
Capital _____ weights can be interpreted just like portfolio weights.
structure
The __ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.
systematic
When an investor is diversified only __ risk matters
systematic
Which type of risk does not change as we add more securities to a portfolio?
systematic or market risk
The portfolio weight is
the percentage of a portfolio's total value that is invested in a particular asset
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
Average returns can be calculated
two different ways: arithmetic & geometric
The true risk of any investment is the _____ portion.
unanticipated
The cost of capital depends primarily on the ______ of funds, not the _____.
use; source
The __ is the squared standard deviation.
variance
The square of the standard deviation is equal to the
variance
What does WACC stand for?
weighted average cost of capital
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.
Including preferred stock in the WACC adds the term:
(P/V) × RP
To estimate the growth rate of a particular stock, we can
- Use security analysts forecasts - Use the historical dividend growth rate
Which of the following are components used in the construction of the WACC?
- cost of debt - cost of preferred stock - cost of common stock
The SML approach requires estimates of:
- market risk premium - beta coefficient
The growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
The risk free asset has a beta of
0
If a securities expected, return is equal to the expected return on the market, the beta must be
1
The steps for calculating variance
1. Calculate the expected return. 2. Determine the square deviation from the expected Return. 3. Multiply each square deviation by its probability. 4. The result is the variance.
The ibbotson-sinquefield data shows that
1. Long-term corporate bonds had less risk or variability than stocks. 2. U.S. T-bills had the lowest risk or variability
Investment in net working capital arises when ___.
1. cash is kept for unexpected expenditures 2. credit sales are made 3. inventory is purchased
Arrange the investments from highest to lowest return, based on what our study of capital market history has revealed about risk premiums
1. Small company common stock 2. Long-term corporate bonds 3. US treasury bills.
Arrange investments and ascending order from Lois historical risk premium at the top to highest historical risk premium at the bottom.
1. US treasury bills. 2. Long-term corporate bonds. 3. Large company stocks. 4. Small company stocks.
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% The standard deviation of a portfolio is less than or equal to the weighted average of the standard deviations of the assets in the portfolio.
According to the 2017 Tax Cuts and Job Act, bonus depreciation is phased out after __.
2026
In 2008 long-term treasuries in the United States gained __ percent, well short-term treasury bonds were up to 13%.
40%
The probability of an outcome being within (+/-) one standard deviation of the mean in a nominal distribution is approximately __ percent
68%
Which of the following is true?
A company can deduct interest paid on debt when computing, taxable income.
A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?
A hostile takeover attempt by a competitor The death of the CEO
The WACC is the weighted average of the cost of equity and the __.
After tax cost of debt
What is the term for the excess return and asset earns based on the level of risk taken?
Alpha
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 new item is discounted, it means that the market
Already knew about most of the news item
If the market changes and stock prices instantly, and fully reflect new information, which time path is such change exhibit?
An efficient market reaction
Which of the following are considered relevant cash flows?
Cash flows from beneficial spillover effects Cash flows from erosion effects Cash flows from external costs
Which of the following are examples of unsystematic risk?
Changes in management Labor strikes
Which of the following are true of common stock and t-bills?
Common stocks may experience negative returns T bill sometimes outperform common stocks
Which of the following is commonly used to measure inflation?
Consumer Price Index (CPI)
Which of the following are fixed cost? Net working capital Cost of equipment Inventory costs Rent on a production facility
Cost of equipment Rent on a production facility
Which of following are tax-deductible to the firm?
Coupon interest paid on bonds
For a well-diversified portfolio, the __ risk is negligible.
Diversifiable Unsystematic Unique
The return and investor in a security receives is __ the cost of the security to the company that issued it.
Equal
The cash flows of a new project that come at the expense of a firm's existing projects is called __
Erosion
What two factors determine a stock's total return?
Expected return and unexpected return
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: systematic risk, will impact all securities in every portfolio equally
FALSE (While it is possible, it is highly unlikely that systematic risk such as changes in interest rates will affect all firms equally.)
True or False: the smaller, the variance or standard deviation is, the more spread out the returns will be.
False The larger the variance of standard deviation is, the more spread out the returns will be.
True or false: the process to calculate a portfolio's beta is opposite of the process to calculate a portfolio expected Return
False the processes are similar
A pro ___ financial statement projects future years' operations.
Forma
Which of the following are examples of systematic risk?
Future rates of inflation Regulatory changes in tax rates
While making capital, budgeting decisions, which of the following sentences is true, regarding the initial investment of net working capital?
It is expected to be recovered by the end of the project's life.
semi-strong form efficiency
It is the most controversial, and all public information is reflected in the stock price
What is the definition of expected return?
It is the return that an investor expects to earn on a risky asset in the future.
Weak form efficiency
It suggests that at a minimum the current price of a stock reflects the stocks own pass prices
If a securities 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's equal to zero
The probability of an outcome being more than three standard deviations away from the mean in a normal distribution is approximately
Less than 1% (0.3%)
Once cash flows have an estimated, which of the following investment criteria can be applied to them?
NPV IRR Payback period
Preferred stock __
Pays a constant dividend Pays dividends in perpetuity
_______ returns tell how much was received for each dollar invested, so they can be applied to any initial investment amount.
Percentage
Too much
Pic
The percentage of a portfolio's total value invested in a particular asset is called that asset's:
Portfolio weight
The security market line shows that the relationship between a securities expected return and its beta is
Positive
The __ ratio is calculated as the risk premium of the asset divided by standard deviation
Sharpe
The principle of diversification tells us that spreading an investment and cross a number of assets will eliminate __ of the risk.
Some
The __ -alone principle is the assumption that evaluation of a project may be based on the project's incremental cash flows.
Stand
According to the __ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."
Stand-alone
A capital gain on a stock results from an increase in
Stock price
The rules for depreciating assets for tax purposes are based upon provisions in the
Tax Reform Act of 1986
Which approach to estimating the operating cash flows uses the following equation? OCF=(Sales-Costs) x (1-Tax Rate) + Depreciation x Tax Rate
Tax Shield Approach
Which of the following statements regarding the relationship between book value, sales, price, and taxes are true, when a firm sells a fixed asset?
Taxes are based on the difference between the book value and the sales price; Book value represents the purchase price minus the accumulated depreciation; There will be a tax savings if the book value exceeds the sales price.
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.
Blume's Formula combines __
The arithmetic average return and geometric average return
What are the two components of the market risk premium?
The risk-free rate The expected return on the market
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
What is the equation for total return as a function of expected and unexpected returns
Total return = Expected return + Unexpected return
True or False: Cash flows should always be considered on an aftertax basis.
True
A distribution tends to have a smooth shape when the numbers of observations is
Very large
What is the top-down approach?
We start at the top of the income statement with sales and work our way down to net cash flow by subtracting cost, taxes, and other expenses. Along the way, we leave out any strictly non-cash items such as depreciation.
What is the bottom up approach?
We start with the accountants, bottom line net income, and add back any non-cash deductions, such as depreciation.
When analyzing a proposed investment, we (will/won't) include interest paid or any other financing costs.
Won't
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 calculation of a portfolio beta is similar to the calculation of
a portfolio's expected return
The __ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset
beta
_______ were a bright spot for U.S. investors during 2008.
bonds
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 payers taxable income for tax purposes.
cannot
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
The cost of _____ is the minimum required return on a new investment.
capital
Which of the following are ways to make money by investing in stocks?
capital gains and dividends
WACC is used to discount
cash flows
The geometric rate of return takes __ into account.
compounding
What is net working capital?
current assets - current liabilities
The standard deviation is
the square root of the variance
The cost of _____ can be observed because it is the interest rate the firm must pay on new loans.
debt
Historical return, data indicates that, as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio __
declines
When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.
decrease
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
To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.
dividend
Which of the following methods for calculating the cost of equity ignores risk?
dividend growth model
When developing cash flows for capital budgeting, it is __ to overlook the important items.
easy
Side effects from investing in a project refer to cash flows from __.
erosion effects beneficial spillover effects
What is the expected return on a security with a beta of 1?
expected return on market
The __ step is to determine whether cash flows are relevant.
first
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 underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.
grows at a constant rate
Interest expenses incurred on debt financing are __ when computing cash flows from a project.
ignored
An increase in depreciation expense will ____ cash flows from operations.
increase
The expected return on the market will increase if the risk-free rate __ or if the market risk premium __
increases, increases
____ cash flows come about as a direct consequence of taking a project under consideration.
incremental
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:
positive
Historically, the real return on Treasury bills has been:
quite low
Which of the following variables is not required to calculate the expected return on a risky asset?
rate of inflation
The accelerated cost __ system is a depreciation method under US tax law, allowing for the accelerated write off of property under various classifications
recovery
The rate used to discount project cash flows is known as the
required return discount rate cost of capital
The arithmetic average rate of return measures the
return in an average year over a given period
The Sharpe ratio measures
reward to risk
The SML is very important because it tells us the "going rate" for bearing _____ in the economy.
risk
Using the SML approach, what is the expected return on a stock if its beta is equal to zero?
risk free rate
What is the intercept of the security market line?
risk free rate
The excess return on a risky asset is the difference between the risky return and the __ rate
risk-free
To estimate the expected return on a risky asset, we need to know the ___.
risk-free rate stock's beta market risk premium
In an efficient market:
security prices react quickly to new information, security prices are seldom far above or below their justified levels, and security analysis will not enable investors to realize superior returns consistently. All investments are zero NPV investments, assets are priced at the present value of their future cash flows.
