Finance Exam #3

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:

of each security must equal the slope of the security market line.

Farmer's Supply, Inc. is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that should be used to evaluate this proposed expansion. Which one of the following terms is used to describe the approach Farmer's Supply is taking to establish an appropriate discount rate for the project?

pure play approach

Which one of the following is the vertical intercept of the security market line?

risk-free rate

Steve is fairly cautious when analyzing a new project and thus he projects the most optimistic, the most realistic, and the most pessimistic outcome that can reasonably be expected. Which type of analysis is Steve using?

scenario analysis

According to the capital asset pricing model, the expected return on a security will be affected by all of the following except the:

security's standard deviation.

An analysis of the change in a project's NPV when a single variable is changed is called _____ analysis.

sensitivity

Which type of analysis identifies the variable, or variables, that are most critical to the success of a particular project?

sensitivity

Mark is analyzing a proposed project to determine how changes in the variable costs per unit would affect the project's net present value. What type of analysis is Mark conducting?

sensitivity analysis

An analysis which combines scenario analysis with sensitivity analysis is called _____ analysis

simulation

Which one of the following types of analysis is the most complex to conduct

simulation

The procedure of allocating a fixed amount of funds for capital spending to each business unit is called

soft rationing

If the financial markets are efficient then:

stock prices should respond only to unexpected news and events.

The stock of Southern United is priced at $41 a share and has a dividend yield of 2.1 percent. The firm pays constant annual dividends. What is the amount of the next dividend per share?

$0.861

A project has sales of $462,000, costs of $274,000, depreciation of $31,000, interest expense of $3,400, and a tax rate of 35 percent. What is the value of the depreciation tax shield?

$10,850

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

Zero

The security market line is defined as a positively sloped straight line that displays the relationship between the:

expected return and beta of either a security or a portfolio.

As the degree of sensitivity of a project to a single variable rises, the:

greater the importance of accurately predicting the value of that variable.

PC Enterprises wants to commence a new project but is unable to obtain the financing under any circumstances. This firm is facing:

hard rationing

Scenario analysis is best suited to accomplishing which one of the following when analyzing a project?

identifying the potential range of reasonable outcomes

Forecasting risk is defined as the possibility that:

incorrect decisions will be made due to erroneous cash flow projections.

. Which one of the following will decrease the aftertax cost of debt for a firm?

increase in tax rates

. Which one of the following will increase the cost of equity, all else held constant?

increase in the dividend growth rate

In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market fine?

increases in direct relation to the stock's systematic risk

The cost of preferred stock:

is equal to the stock's dividend yield.

If a security plots to the left and above the security market line, then the security has ____ systematic risk than the market and is ____.

less; underpriced

Which one of the following is the primary determinant of an investments cost of capital?

level of risk

The base case values used in scenario analysis are the ones considered the most:

likely to occur

You are considering a project that you believe is quite risky. To reduce any potentially harmful results from accepting this project, you could:

lower the degree of operating leverage.

The lower the standard deviation of returns on a security, the _____ the expected rate of return and the _____ the risk.

lower; lower

The slope of the security market line represents the

market risk premium

Systematic risk is:

measured by beta.

The base case in scenario analysis is best described as:

most likely outcome for a project

. Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent upon which one of the following?

nature of the investment

Kate is the CFO of a major firm and has the job of assigning discount rates to each project that..consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk lecel of the project increases over that of the current firm. Likewise, she assigns rate as the risk level decreases. Which one of the following approaches is Kate using?

subjective approach

Variance measures _____ risk while beta measures _____ risk.

total; systematic

Over the period of 1926-2011, which one of the following investment classes had the lowest volatility of returns?

treasury bills

Portfolio diversification eliminates:

unsystematic risk.

The standard deviation measures the _____ of a security's returns over time.

volatility

Simulation analysis is based on assigning a _____ and analyzing the results.

wide range of values to multiple variables simultaneously

All else constant, an increase in a firm's cost of debt:

will result in an increase in the firm's cost of capital.

When you assign the lowest anticipated sales price and the highest anticipated costs to a project, you are analyzing the project under the condition known as

worst case scenario analysis.

Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive?

Cost of capital

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

Cost of equity

Which one of these is the best example of systematic risk?

Decrease in gross domestic product

Which one of the following combinations will always result in an increased dividend yield?

Decrease in the stock price combined with a higher dividend amount

Which one of the following is the hypothesis that securities markets are efficient?

Efficient markets hypothesis

The security market line is a linear function which is graphed by plotting data points based on the relationship between which two of the following variables?

Expected return and beta

Which one of the following is defined as the average compound return earned per year over a multiyear period?

Geometric average return

Which one of the following best describes a portfolio?

Group of assets held by an investor

Which one of the following is the slope of the security market line?

Market risk premium

Assume that large-company stocks had an average return of 11.4 percent and a standard deviation of 19.7 percent for a 40-year period. What range of returns would you expect to see on these stocks 68 percent of the time?

-8.3 percent to 31.1 percent

Jody's Boutique just paid an annual dividend of $1.65 on its common stock. The firm increases its dividend by 2.5% annually. What is the rate of return on this stock if the current stock price is $38.20 a share?

6.93

Which one of the following is the best example of unsystematic risk?

A warehouse fire

The variance is the average squared difference between which of the following?

Actual return and average return

Which statement is correct?

An underpriced security will plot above the security market line.

Which one of the following describes unsystematic risk?

Asset specific risk

An efficient capital market is best defined as a market in which security prices reflect which one of the following?

Available information

Which one of the following is an example of systematic risk?

Increase in consumption created by a reduction in personal tax rates

Which one of the following combinations will always result in an decreased dividend yield?

Increase in the stock price combined with a lower dividend amount

Trendsetters has a cost of equity of 18.1%. The market risk premium is 10.2 % and the risk-free rate is 4.4%. The company is acquiring a competitor, which will increase the company's beta to 1.6. What effect, if any, will the acquisition have on the firm's cost of equity capital?

Increase of 2.62%

Which one of the following will affect the capital structure weights used to compute a firm's weighted average cost of capital?

Increases in the market value of the firm's common stock

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, and an aftertax cost of debt of 6 percent. Given this, which one of the following will increase the firm's

Increasing the firm's beta

The systematic risk principle states that the expected return on a risky asset depends only on which one of the following?

Market risk

When, if ever, will the geometric average return exceed the arithmetic average return for a given set of returns?

Never

Which one of the following is defined as a bell-shaped frequency distribution that is defined by its average and its standard deviation?

Normal Distribution

Stock A comprises 28 percent of Susan's portfolio. Which one of the following terms applies to the 28 percent?

Portfolio weight

Which one of the following best describes an arithmetic average return?

Return earned in an average year over a multiyear period

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision?

Risk level of the project

On a particular risky investment, investors require an excess return of 7 percent in addition to the risk-free rate of 4 percent. What is this excess return called?

Risk premium

Which one of the following describes systemic risk?

Risk that affects a large number of assets

Which one of the following statements concerning scenario analysis is correct

Scenario analysis helps managers analyze various outcomes that are possible given reasonable ranges for each of the assumptions.

The risk premium for an individual security is based on which one of the following types of risk?

Systematic

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's WACC?

The arithmetic average of 12.4 percent and 18.7 percent

Which one of the following statements is correct?

The cost of preferred stock is unaffected by the issuer's tax rate

Which one of the following statements is correct?

The higher the expected rate of return, the wider the distribution of returns.

Which one of the following statements is correct concerning capital structure weights?

The repurchase of preferred stock will increase the weight of debt.

The rate of return on which one of the following is used as the risk-free rate?

U.S. Treasury bill

Which one of the following best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

Portfolio diversification eliminates which one of the following?

Unsystematic risk

Which of the following represents the rate of return a firm must earn on its assest's if it is to maintain its' current value of its securities?

Weighted average cost of capital

Which of the following is the pretax of debt?

Weighted average yield to maturity on the firm's outstanding debt

Which one of the following is the pretax cost of debt?

Weighted average yield to maturity on the firm's outstanding debt

According to the efficient markets hypothesis, professional investors will earn:

a dollar return equal to the value paid for an investment.

Forecasting risk emphasizes the point that the correctness of any decision to accept or reject a project is highly dependent upon the

accuracy of the projected cash flows.

Semistrong form market efficiency states that the value of a security is based on:

all publicly available information

Bell Weather Goods has several proposed independent projects that have positive NPVs. However, the firm cannot initiate any of the projects due to a lack of financing. This situation is referred to as:

capital rationing.

The capital asset pricing model:

considers the relationship between the fluctuations in a security's returns versus the market's returns.

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

cost of debt

The weighted average cost of capital is defined as the weighted average of a firm's

cost of equity and its aftertax cost of debt

Which one of the following is the relationship between the percentage change in operating cash flow and the percentage change in quantity sold?

degree of operating leverage

Sensitivity analysis determines the:

degree to which the net present value reacts to changes in a single variable.

Scenario analysis is defined as the:

determination of changes in NPV estimates when what-if questions are posed.

Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

diversification

Ted is analyzing a project using simulation. His focus is limited to the short-term. To ease the simulation process, he is combining expenses into various categories. Which one of the following should he include in the fixed cost category?

equipment insurance

Weston Steel purchased a new coal furnace six years ago at a cost of $2.2 million. Last year, the government changed the emission requirements and this furnace cannot meet those standards. Thus, Weston can no longer use the furnace, nor has it been able to locate anyone willing to purchase the furnace. Given the current situation, the furnace is best described as which type of cost?

sunk cost

A project has a payback period that exactly equals the project's life. The project is operating at:

the accounting break-even point.

Which of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

the annual dividend used in the computation must be for 1 year if you are using today's stock price to compute the return

The beta of a risky portfolio (assuming no borrowing or shortselling) cannot be less than _____ nor greater than _____.

the lowest individual beta in the portfolio; the highest individual beta in the portfolio

Which one of the following will be used in the computation of the best-case analysis of a proposed project?

the lowest variable cost per unit that can reasonably be expected