FINN 3120 Exam 4: Reading Questions

Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?

(P/V) × RP

The Combination MIRR method is used by the Excel MIRR function and uses which of the following?

-A financing rate for discounting -Discounting all cash outflows to time 0 -A reinvestment rate for compounding -Compounding cash inflows to the end of the project

Which of the following are components used in the construction of the WACC?

-Cost of preferred stock -Cost of common stock -Cost of debt

______ risk is reduced as more securities are added to the portfolio

-Diversifiable -Unsystematic -Company-specific

Which of the following are examples of a portfolio?

-Investing $100,000 in the stocks of 50 publicly traded corporations -Investing $100,000 in a combination of stocks and bonds -Investing $100,000 in a combination of US and Asian stocks

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

-It is likely to decrease. -It may eventually be almost totally eliminated.

Which of the following are reasons why IRR continues to be used in practice?

-The IRR of a proposal can be calculated without knowing the appropriate discount rate. -Businesspeople prefer to talk about rates of return. -It is easier to communicate information about a proposal with an IRR.

Which of the following are methods of calculating the MIRR of a project?

-The Reinvestment Approach -The Combination Approach -The Discounting Approach

Which of the following are weaknesses of the payback method?

-The cutoff date is arbitrary. -Cash flows received after the payback period are ignored. -Time value of money principles are ignored.

The CAPM shows that the expected return for an asset depends on which three things?

-The pure time value of money -The amount of systematic risk -The reward for bearing systematic risk

Specifying variables in the Excel NPV function differs from the manner in which they are entered in a financial calculator in which of the following ways?

-The range of cash flows specified in Excel begins with Cashflow 1, not Cashflow 0. -The discount rate in Excel is entered as a decimal, or as a percentage with a percent sign. -With the Excel NPV function, Cashflow 0 must be handled outside the NPV function. -The Excel NPV function is actually a PV function.

Which of the following statements is (are) 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.

Which of the following is true about a firm's cost of debt?

-Yields can be calculated from observable data -It is easier to estimate than the cost of equity.

Unsystematic risk will affect

-a specific firm -firms in a single industry

The basic NPV investment rule is:

-accept a project if the NPV is greater than zero. -if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference -reject a project if its NPV is less than zero.

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

-it will accept projects that it should have rejected -the firm overall will become riskier -It will reject projects that it should have accepted

Which of the following present problems when using the IRR method?

-mutually exclusive projects -non-conventional cash flows

In general, NPV is ___.

-negative for discount rates above the IRR -equal to zero when the discount rate equals the IRR -positive for discount rates below the IRR

The rate used to discount project cash flows is known as the ___.

-required return -cost of capital -discount rate

To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.

-stock's beta -risk-free rate -market risk premium

The systematic risk principle argues that the market does not reward risks:

-that are diversifiable -that are borne unnecessarily

By definition, what is the beta of the average asset equal to?

1

What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4 percent and the expected return on the market is 12 percent?

4% + 1.2(12% - 4%) = 13.6% 13.6%

The spreadsheet function for calculating net present value is ______.

=NPV(rate,CF1, ..., CFn) + CF0

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

Which of the following is tax-deductible to the firm?

Coupon interest paid on bonds

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: A well-diversified portfolio will eliminate all risks.

False

True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.

False

True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.

False

True or false: Expected return and inflation are the two components of risky return in the total return equation.

False

True or false: Finding the cost of equity is fairly straightforward.

False

True or false: Portfolio weights can be defined as the dollars invested in each asset.

False

True or false: Projects should always be discounted at the firm's overall cost of capital.

False

True or false: The IRR is easy to use because you only need to know the appropriate discount rate.

False

True or false: The calculation of the portfolio beta is similar to the calculation of the portfolio weights.

False

True or false: The discount rate is also known as the expected return.

False

True or false: The expected return of a portfolio is a combination of the weights of each asset in a portfolio.

False

True or false: The payback period takes into consideration the time value of money.

False

True or false: The primary disadvantage of the dividend growth model approach is its simplicity.

False

True or false: The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its future cost.

False

True or false: The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be smaller than the initial investment.

False

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

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 the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

What are the two components of risky return (U) in the total return equation?

Market risk Unsystematic risk

_______ is a measure of how much value is created or added by undertaking an investment.

Net Present Value

What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?

RE = D1/P0

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The formula of the SML is:

RE = Rf + Beta x (RM- Rf)

What is the equation for finding the cost of preferred stock?

RP=D/P0

Which of the following is a disadvantage of the payback period rule?

Requires an arbitrary cutoff point

____________ risk is the only risk important to the well diversified investor.

Systematic

Which of the following types of risk is not reduced by diversification?

Systematic, or market risk

What is the slope of the security market line (SML)?

The market-risk premium

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

The risk-free rate

What is the intercept of the security market line (SML)?

The risk-free rate

True or false: A project with non-conventional cash flows will produce two or more IRRs.

True

True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero.

True

True or false: It is possible for the unsystematic risk of a portfolio to be reduced almost to zero.

True

True or false: RP=D/P0

True

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

True or false: When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the discount rate raised to the nth power.

True

Given V = E + D, if we divide both V and D by _____________ , we can calculate the capital structure weights.

V

What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?

WACC

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.

If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E+D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is:

[E/V] × RE + [D/V] × RD ×(1 - T c)

If a firm has multiple projects, each project should be discounted using ___.

a discount rate commensurate with the project's risk

The calculation of a portfolio beta is similar to the calculation of:

a portfolio's expected return

The internal rate of return is a function of ____.

a project's cash flows

A project should be __________ if its NPV is greater than zero.

accepted

The discount rate for the firm's projects equals the cost of capital for the firm as a whole when:

all projects have the same risk as that of the firm overall

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

arbitrary

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:

better than no risk adjustment

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

The appropriate discount rate to use to evaluate a new project is the _____.

cost of capital

The minimum required return on a new project is known as the:

cost of capital

The Profitability Index is also called the __________ ratio.

cost-benefit

The dividend growth model is applicable to companies that pay __________

dividends

The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.

equal to

The ________ return on a portfolio is a combination of the expected returns on the assets in the portfolio.

expected

The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.

future

A(n) ______ project does not rely on the acceptance or rejection of another project.

independent

The profitability index (PI) is calculated by dividing the present value of an investment's future cash flows by its _____ _____.

initial cost

The present value of the future cash inflows are divided by the ______ to calculate the profitability index.

initial investment

Components of the WACC include funds that come from ______ .

investors

Finding a firm's overall cost of equity is difficult because:

it cannot be observed directly

An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.

less than

Systematic risk is also called ______________ risk.

market

The most appropriate weights to use in the WACC are the ______ weights.

market value

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered _______________.

mutually exclusive

In capital budgeting, ______ determines the dollar value of a project to the company.

net present value

One of the flaws of the payback period method is that cash flows after the cutoff date are ___.

not considered in the analysis

The ______ method evaluates a project by determining the time needed to recoup the initial investment.

payback

The __________ is best suited for decisions on relatively small, minor projects while ______ is more appropriate for large complex projects.

payback period; NPV

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive

Other companies that specialize only in projects similar to the project your firm is considering are called ___.

pure plays

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:

rejected, when it should be accepted

Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.

required return

The WACC of a firm reflects the _____ and the target capital structure of the firm's existing assets as a whole.

risk

If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.

risk premium; systematic risk

It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making ______________ adjustments to the overall WACC.

subjective

The true risk of any investment comes from _______________ .

surprises

The return expected on an investment depends only on the asset's _____ risk.

systematic

Beta tells us the amount of ________ risk of an asset or portfolio relative to ______.

systematic; an average risky asset

To determine the appropriate required return for an investment, we can use _____________________.

the Security Market Line

SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?

the beta for software companies that collect and store data

When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus ______ rate raised to the nth power.

the discount

The standard deviation is ___.

the square root of the variance

If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects.

too many

For a firm with outstanding debt, the cost of debt will be the ________ on that debt..

yield to maturity

The IRR is the discount rate that makes NPV equal to ______.

zero