FINANCE 340 Chapter 11, 12, 13

Which one of the following statements about portfolio diversification and negatively correlated assets is true?

Adding a negatively correlated asset will initially reduce volatility of portfolio returns

The standard deviation of returns is a useful measure of risk for individual assets in isolation, but is a misleading risk measure for assets in a portfolio due to the ___ effect caused by ___

Diversification, imperfect correlation of portfolio asset returns

CAPM formula

Expected return = Rf + beta x (Rm - Rp)

Best describes the firm's capital structure?

Firm's mix of debt and equity financing

The WACC is the appropriate discount rate for use with ____ projects but should be adjusted _____ for higher risk ones or ____ for lowr risk ones

average, upward, downward

Free cash flow is often _____ in the beginning years of a firm due to heavy initial investing

negative

If a firm uses the book value of debt instead of the market value of debt to calculate its WACC, then its WACC will likely be

only slightly off

For well diversified investors, the only relevant measure of investment risk is their

portfolio beta

The total risk of a well-diversified portfolio of stocks can be calculated as the product of the ___ times the ___

portfolio beta; standard deviation of the market portfolio

Minimum acceptable expected rate of return for a project is called the

project cost of capital

The ______ is usually accepted as a firm's cost of debt capital for WACC calculations

promised yield to maturity on the firm's existing bonds

If the corporate tax rate is zero, then increasing the proportion of debt in a firm's capital structure causes the WACC to

remain unchanged

The return on US treasury bills is often referred to as the

risk-free rate

The square root of variance is called

standard deviation

To estimate the future risk of a stock investment, analysts will calculate the ______ and assume it is a reasonable estimate of future risk

standard deviation of historical returns for that stock

The market risk premium is the additional return that investors require to invest in _____ rather than ____

the market portfolio, treasury bills

The market value of a firm is equal to

the market value of debt + the market value of equity

A firm's after-tax cost of debt is equal to

(1-tax rate) x pretax cost

The average beta for all stocks (the beta of the market portfolio) is

+1

Two assets whose returns move up and down in perfect tandem have a correlation of

+1

Why is it not reasonable to use the past average stock market return to forecast the expected future stock market return?

-The market return can be expressed as the sum of the treasury bill return plus a market risk premium. The treasury bill return varies over time. -Investors are not likely to demand the same return each year on their stock investment.

A firm can have high total risk but a low beta if its ____ is high

-firm specific risk -diversifiable risk

What statements regarding the company cost of capital are true?

-it is the minimum rate of return that the firm must earn on its average risk investments -it is an opportunity cost -it is used to value new assets that have the same risk as the existing ones

The total risk of a security investment consists of ____ plus _____

-market risk, firm specific risk -market risk, diversifiable risk

The total risk of a diversified portfolio of stocks is determined by the ____ since all ____ has been diversified away

-portfolio beta, firm specific risk - portfolio beta, diversifiable risk

Contrary to the predictions of the CAPM, empirical evidence has shown that ____ stocks provide consistently higher returns than ____ stocks

-small firm, large firm -value, growth

Terms that are related to the riskiness of an asset investment

-standard deviation of returns -variability of returns -volatility of returns

Which of the following statements are true regarding the risks undertaken by investors in common stock?

-the investors can lose all or part of the principal invested -risk and return are almost always higher than for Treasury bills and bonds -Returns on stock consist of dividends and capital gains

U.S. Treasury Bills are nearly a risk-free investment because

-they are issued by the U.S. government - they have short-term maturities

What is true about variance?

-variance is a measure of the squared deviations of a security's return from its expected return -standard deviation is the square root of variance

What are some of the limitations of using an historical market risk premium to forecast future market returns?

-we cannot be sure that investors demand the same risk premium today as in the past -it is very difficult to measure the market risk premium exactly -some financial managers and economists believe that the historical risk premium is too large

Rank the following countries in order from the country with the lowest market risk premium to the highest market risk premium

1) Denmark 2) canada 3) UK 4) US 5) Japan 6) Germany

Rank the following in order of risk, from least risky to most risky

1) Treasury bills 2) Long-term treasury bonds 3) common stock

Rank stocks from lowest to highest risk

1) beta .2 2) beta .9 3) beta 1.2 4) beta 2

Rank the following investments in terms of historical returns, lowest to highest

1)Treasury bills 2) treasury bonds 3) common stock

Once you have added about _____ or more diversified stocks to your portfolio, you have removed about as much specific risk as you possibly can

30

The annual market risk premium average over the past century is approximately

7.6%

The equation for the expected return of a stock according to the Capital Asset Pricing Model is

=risk free rate + beta x (market portfolio return - risk free rate) = risk free rate + beta x market risk premium

Variance

A measure of the squared deviations of a security's return from its expected return

The firm's cost of equity is usually calculated using the _____ equation

CAPM

Which industries have less than average exposure to macro and market risk

Grocery stores, electric utilities

If there is a chance that a firm may be unable to repay its debt, then the yield to maturity on the firm's bonds will be _____ the expected return

Higher than

According to the CAPM, what is the expected return on a stock its beta is equal to zero?

Risk free rate

The Standard and Poor's Composite Index is also referred to as the

S&P 500 Index

What stock index includes the stocks of 500 major companies in proportion to the number of their shares that have been issued to investors?

Standard and Poor's Composite Index

Which of the following is the relevant risk to investors of a single stock held in a diversified portfolio?

The sensitivity of its returns to fluctuations in the overall stock market

Which of the following statements is true regarding the risks undertaken by investors in US Treasury Bonds?

Their principal is guaranteed, but their market price may fall with rising interest rates

True or false? The market value and book value of debt are often very similar, so many financial managers use book value in WACC calculations

True

The Weighted average cost of capital is the expected rate of return investors would demand on a portfolio of

all of the firm's outstanding securities

The CAPM predicts that the difference in return between stock A and stock B should be due only to the difference in the ____ of the two stocks

beta

To determine the equity value of an entire business, discount the firm's _____ using the ____ as the discount rate, then subtract the value of the firm's _____

cash flows, WACC, debt

If the corporate tax rate is not zero, increasing the proportion of debt in the capital structure causes the WACC to

change

Another name for the WACC is

company cost of capital

Firms may use a _____ to discount the cash flows of their average risk projects

company cost of capital

The opportunity cost of capital for investment in the firm as a whole is called the

company cost of capital

The rate of return that shareholders could expect to earn if they invested in equally risky securities is called the

cost of capital

The company cost of capital is calculated as a weighted average of the firm's ___ and ____

debt; equity

Preferred stock is valued like a perpetuity. The price of a preferred stock is therefor equal to:

dividend/ r (preferred)

Dividend yield =

dividend/initial share price

The increase in the rate that bondholders demand as the amount of debt borrowed increases is called the ____ cost of debt

explicit

There are two costs of debt finance, the _____ cost and the _____ cost

explicit, implicit

The cash flow available to distribute to investors after paying for new investments or additions to working capital is a firm's

free cash flow

For projects of higher than average risk, firms may use a discount rate that is ____ the company cost of capital

greater than

The standard deviation of the returns of an individual security measure

how risky that security would be if held in isolation

The _____ value of equity should always be used when calculating a firm's capital structure weight of equity

market

The cost of capital used by firms should be based on _____ values of the firm's securities

market

The market value of equity can be calculated by multiplying the _____ times ____

market price per share; number of shares outstanding

For a well-diversified investor, the only type of risk that matters is

market-risk

The appropriate cost of capital to be used to discount risk-free projects is

the Treasury bill rate of return