Financial Management Final
According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio. T or F
True
Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division A project with an 11% return. b. A Division B project with a 13% return. c. A Division A project with a 9% return. d. A Division B project with a 12% return. e. A Division B project with an 11% return.
a
If a typical U.S. company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. b. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. c. become less risky over time, and this will maximize its intrinsic value. d. become riskier over time, but its intrinsic value will be maximized. e. accept too many low-risk projects and too few high-risk projects
a
McCall Manufacturing has a WACC of 10%. The firm is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT? a. If the crossover rate is 8%, Project B will have the higher NPV. b. Only one project has a positive NPV. c. Each project must have a negative NPV. d. If the crossover rate is 8%, Project A will have the higher NPV. e. Since the projects are mutually exclusive, the firm should always select Project B.
a
The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higherrisk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many high-risk projects and reject too many low-risk projects. b. The CEO's recommendation would maximize the firm's intrinsic value. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. e. The company will take on too many low-risk projects and reject too many high-risk projects.
a
Which of the following statements is CORRECT? a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. b. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. c. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected. d. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. e. 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.
a
Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR. b. The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life. c. If a project has "normal" cash flows, then its MIRR must be positive. d. If a project has "normal" cash flows, then its IRR must be positive. e. If a project has "normal" cash flows, then it will have exactly two real IRRs.
a
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows a. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. b. If a project's IRR is positive, then its NPV must also be positive. c. If a project's IRR is smaller than the WACC, then its NPV will be positive. d. A project's regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC. e. A project's regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR
a
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. b. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. c. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes. d. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.
b
An increase in a firm's expected growth rate would cause its required rate of return to a. increase. b. fluctuate less than before. c. possibly increase, possibly decrease, or possibly remain constant. d. decrease. e. fluctuate more than before.
c
The expected return on Natter Corporation's stock is 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The current dividend per share is $4.00. b. The stock's dividend yield is 7%. c. The stock price is expected to be $54 a share one year from now. d. The stock price is expected to be $57 a share one year from now. e. The stock's dividend yield is 8%.
c
Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. A stock's dividend yield can never exceed its expected growth rate. b. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, then its expected dividend yield is 5% as well. c. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. d. A required condition for one to use the constant growth model is that the stock's expected growth rate exceed its required rate of return. e. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return.
c
Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. d. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself. e. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.
d
A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? a. When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. b. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward. c. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. d. Since depreciation is a non-cash expense, it has no impact on a project's calculated NPV. e. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.
e
Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC? a. Project S. b. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. c. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs. d. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. e. Project L.
e
Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If both expected inflation and the market risk premium (r - r ) increase, the required returns of both stocks will increase by the same amount. b. If expected inflation remains constant but the market risk premium (r - r ) declines, the required return of Stock LB will decline but the required return of Stock HB will increase. c. Since the market is in equilibrium, the required returns of the two stocks should be the same. d. If expected inflation remains constant but the market risk premium (r - r ) declines, the required return of Stock HB will decline but the required return of Stock LB will increase. e. If both expected inflation and the market risk premium (r - r ) increase, the required return on Stock HB will increase by more than that on Stock LB.
e
Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM? a. Stock Y's return has a higher standard deviation than Stock X. b. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y. c. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated. d. Stock Y's realized return during the coming year will be higher than Stock X's return. e. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
e
Which of the following statements is CORRECT? a. If two projects are mutually exclusive, then they are likely to have multiple IRRs. b. For a project to have more than one IRR, then both IRRs must be greater than the WACC. c. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon. d. If a project is independent, then it cannot have multiple IRRs. e. Multiple IRRs can occur only if the signs of the cash flows change more than once.
e
Which of the following statements is CORRECT? a. The MIRR method assumes that cash flows are reinvested at the crossover rate. b. The MIRR and NPV decision criteria can never conflict. c. The higher the WACC, the shorter the discounted payback period. d. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. e. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.
e
A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. t or f
false
According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. t or f
false
Preferred stock is a hybrid—a cross between a common stock and a bond—in the sense that it pays dividends that normally increase annually (like a stock), but its payments are contractually guaranteed (like interest on a bond). t or f
false
Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another. t or f
false
Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision - estimates of its effect would really just be guesses. In this case, the externality should be ignored - i.e., not considered at all - because if it were considered it would make the analysis appear more precise than it really is. t or f
false
The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. t or f
false
The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. t or f
false
The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly t or f
false
We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis t or f
false
A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it immediately expenses depreciation than if it uses straight-line depreciation, other things being equal. t or f
true
If the returns of two firms are negatively correlated, then one of them must have a negative beta t or f
true
One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk. t or f
true
Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. t or f
true
Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. t or f
true
Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the firm's total corporate value. t or f
true
Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms. t or f
true
Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk. t or f
true
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. t or f
true
The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. t or f
true
