Managerial Finance Final Test Review

A probability distribution is:

A summary of the different values that a random variable can take, along with their relative likelihoods.

A firms assets beta can be measured by

All of the above.

Which of these statements is true?

An empirical returns distribution is more useful to describe the past, while a theoretical return distribution is more useful to predict the future.

If transactions cost are zero, there is no information asymmetry or personal taxes and bankruptcy is costless, but corporate taxes exist and interest payments are tax-deductible, what is the optimal amount of debt to have?

As much debt as possible

Issuing equity is bad for existing shareholders because it dilutes earning. Suppose the numbers of shares outstanding is 100K, and earnings per share is $2. 100K new shares are issued at a price of $20/share, raising new equity of $200K, which are invested in a project expected to yield annual earnings of $105K. New EPS would be than one answer may be correct, if so, indicate all that you think are correct)

Can't tell; need more information on whether the new project is of higher or lower risk than than exiting projects or of equal risk. Can't tell; we need to know whether the stock market is overvaluing or undervaluing the stock.

According to CAPM, the risk premium for a security with high diversifiable risk and high systematic risk is greater than the risk premium for a security with a low diversifiable risk and high systematic risk.

False

According to the Modigliani-Miler Hypothesis, choosing the right capital structure can increase the value of the firm.

False

According to the Modligliani-Miller Hypothesis, if a firm does an equity-for-debt swap, but does not change the operation of the firms, the value of the firm's equity will not change.

False

An investor should not concern herself with firm-specific uncertainty even if she holds only equity of one particular firm.

False

Bondholders do not have to worry about opportunistic managerial actions because they can always use bond covenants to specify what a manager can or cannot do.

False

If the MM hypothesis holds, the firm's cost of capital depends on how close is to the firm's optimal leverage

False

If the MM hypothesis holds, the firm's cost of capital depends on how close is to the firm's optimal leverage.

False

If the MM hypothesis holds, the risk of equity does not change as we increase the leverage of the firm.

False

Insurance policies are useful primarily because they transfer risk from one party to another

False

Managers acting on behalf of shareholders be less likely to pay excessive dividends when a firm is in trouble because the firms needs to keep all the financial resources it has.

False

Standard deviation is a good measure of risk for somebody who is primarily worried about loss of capital

False

The following is idiosyncratic risk: The risk that the economy slows, decreasing demand for Firms X's products.

False

The following is idiosyncratic risk: the risk that the Fed will increase interest rates, thus decreasing demand for real state company X's products.

False

The geometric mean is greater than the arithmetic mean

False

The standard error of the estimate of the expected return is higher than the standard deviation of returns.

False

The theoretical probability distribution can be described using more parameters than an empirical frequency distribution.

False

There is a lot of cross-sectional variation in debt equity ratios, but they do not vary systematically across industries

False

There is a lot of-sectional variation in debt-equity ratios, but they do not vary systematically across industries.

False

Under MM, the value of the firm is independent of its capital structure, but the weighted average, cost of capital still depends on the capital structure.

False

The following firms are likely to have high asset beta

Firms with niche appeal Firms that sell luxury and Goods.

Firms with the highest equity betas have

High operating leverage and high financial leverage.

Which of the following is true?

Idiosyncratic risk is less important for diversified investors than market risk.

Bankruptcy is bad for the following reason:

In bankruptcy, claims are often restructured and the new claims have to be valued, which involves negotiating costs. This reduces firms' value. In bankruptcy, assets either have to be sold off, generating transactions cost. Those that are not sold off have to be value and this generates negotiating cost. This reduces firm value. Illiquid assets often have to be sold off in a rush at lower than intrinsic value. This reduces firm value.

Market wide risk is more relevant for assets pricing than idiosyncratic-risk because

Investors generally hold diversified portfolios.

An Asset with a beta less than 1

Is less risky than the market portfolio.

An asset's Beta

Is the covariance between the return on the asset and the return on the market portfolio divided by the variance of returns on the market portfolio. A measure of an asset's exposure to system-wide risk

The NY Times in its recent report on the sale of Starwood Hotels reported (article) We do not believe Marriott is willing to incur earnings dilution to facilitate the transactions, "analysts at Wells Fargo wrote in a research note on Monday." If earnings dilution is irrelevant, why do managers worry about it?

Managers are evaluated and compensated on earnings per share; this is why they worry about earnings dilution even though it is unrelated to the market value per se.

If corporate and personal taxes exist, and interest payments are tax-deductible for corporations, would firms take on as much debt as possible?

No. even though interest payments are tax-deductible to the corporation, there are personal taxes on interest income that must be paid. Investors would therefore require a higher rate of return on corporate bonds than otherwise. No. The effect personal tax rate on equity is usually lower than the effective personal tax rate on interest income because capital gains are only taxed on realization. This makes investors prefer equity to debt.

Suppose we had created portfolios of investment in different asset categories in 1925, with an initial investment of $100, and dividends and interest reinvested in that same asset category, period-after-period. Which of the following is an ordering of annual portfolio return volatility, starting with the most volatile portfolio to the least volatile portfolio.

Portfolio of small US stocks, portfolio of large US stocks, portfolio of US corporate bonds, one-month treasury bills.

Firms in the following sectors tend to have high betas

Technology Services

If bankruptcy were cost less and there were no information asymmetry, but interest payment are tax-deductible, what is the weighted average cost of capital?

The WACC is the weighted average of the cost of equity and the after-tax cost of debt.

According to the MM hyphothesis, the value of the firm is determined by its operations, not by its financial structure

True

Firms selling durable goods are more affected by financial distress than selling nondurable goods

True

The following idiosyncratic risk: The risk that your firm X's employees will be hired away by competitors

True

The following is ideosyncratic risk: The risk that the main production plant of Company X is shut down due to a tornado.

True

The following is idiosyncratic risk: the risk that the new product Firms X's manager experts his R&D division to produce will not materialize.

True

The market risk premium is always positive

True

Which of the following is true

We should be interested in historical return data because return distributions are relatively stable across the time.

Which of the following is true?

We should be interested in historical return data because return distributions are relatively stable across time.

Managers of highly leveraged firms tend to take more risk than those of less leveraged firms.

Yes.

The variance of Asset returns is measured in the following units

percent-squared