ACFM Final Multiple Choice
14) Which of the following statements is FALSE? A. Overhead expenses are often allocated to the different business activities for accounting purposes. B. When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalization. C. A capital budget lists the projects and investments that a company plans to undertake during the coming year. D. Income Tax = EBIT × (1 − τc).
D
Which of the following investments offered the highest overall return over the past ninety −six years? Small stocks S&P 500 Treasury Bills Corporate bonds
small stocks
24) You are considering adding a microbrewery on to one of your firm's existing restaurants. This will entail an increase in inventory of $8000, an increase in accounts payable of $2500, and an increase in property, plant, and equipment of $40,000. All other accounts will remain unchanged. The change in net working capital resulting from the addition of the microbrewery is: $10,500. $6500. $45,500. $5500.
$5500
12) Which of the following statements is FALSE? A. It is common practice to estimate beta based on the historical correlation and volatilities. B. Beta measures the diversifiable risk of a security, as opposed to its market risk, and is the appropriate measure of the risk of a security for an investor holding the market portfolio. C. Beta is the expected percent change in the excess return of the security for a 1% change in the excess return of the market portfolio. D. Beta represents the amount by which risks that affect the overall market are amplified for a given stock or investment.
B
13) What does the beta of a stock measure? A. Beta measures the amount of uncertainty in a stock. B. Beta measures the amount of systematic risk in a stock. C. Beta measures the use of debt. D. Beta measures interest rate risk.
B
13) Which of the following statements is FALSE? A. Beta corresponds to the slope of the best −fitting line in the plot of the securities excess returns versus the market excess return. B. Securities that tend to move more than the market have betas lower than 0. C. Securities whose returns tend to move in tandem with the market on average have a beta of 1. D. The statistical technique that identifies the best −fitting line through a set of points is called linear regression.
B
14) Assume all investors want to hold a portfolio that, for a given level of volatility, has the maximum possible expected return. Explain why, when a risk-free asset exists, all investors will choose to hold the same portfolio of risky stocks. A. All investors will do the same thing —that is, they will maximize their expected returns —so they will all hold the same portfolio. B. Investors who want to maximize their expected return for a given level of volatility will pick portfolios that maximize their Sharpe ratio. The set of portfolios that does this is a combination of a risk-free asset and a single portfolio of risky assets —the tangential portfolio. C. When a risk-free asset exists, it provides a safe investment opportunity. Given this safe investment opportunity, investors who maximize their expected returns for a given level of volatility will pick the same expected return
B
15) Which of the following types of risk doesn't belong? Unique risk Market risk Firm −specific risk Idiosyncratic risk
B
16) Which of the following statements is FALSE? A. The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre−tax income. B. Investments in plant, property, and equipment are directly listed as expenses when calculating earnings. C. We begin the capital budgeting process by determining the incremental earnings of a project. D. The opportunity cost of using a resource is the value it could have provided in its best alternative use.
B
17) Which of the following statements is FALSE? A. When firms carry both types of risk, only the firm −specific risk will be diversified when we combine many firms' stocks into a portfolio. B. The risk premium for a stock is affected by its idiosyncratic risk. C. Firms are affected by both systematic and firm −specific risk. D. Firm −specific news is good or bad news about the company itself.
B
18) Which of the following statements is FALSE? A. The beta of a portfolio is the weighted average beta of the securities in the portfolio. B. The capital market line (CML) shows the expected return for each security as a function of its beta with the market. C. By holding a negative beta security, an investor can reduce the overall market risk of her portfolio. D. The expected return of a portfolio should correspond to the portfolio's beta.
B
22) Which of the following cash flows are relevant incremental cash flows for a project that you are currently considering investing in? A. The cost of a marketing survey you conducted to determine demand for the proposed project B. The tax savings brought about by the project's depreciation expense C. Interest payments on debt used to finance the project D. Research and Development expenditures you have made
B
22) Which of the following statements is FALSE? A. The risk −free interest rate is generally determined using the yields of U.S. Treasury securities, which are free from default risk. B. Most financial analysts report using the yields of Treasury Bills to determine the risk−free rate when valuing a long−term investment with an indefinite horizon. C. The CAPM states that we should use the risk−free interest rate corresponding to the investment horizon of the firm's investors. D. To determine the risk premium for a stock using the security market line, we need an estimate of the market risk premium.
B
6) Which of the following statements is TRUE? A. Individual stocks with higher volatility have consistently rewarded investors with higher average returns. B. Volatility seems to be a reasonable measure of risk when evaluating returns on large portfolios. C. Portfolios with lower volatility have historically rewarded investors with higher average returns. D. Volatility seems to be a reasonable measure of risk when evaluating returns on individual stocks.
B
7) How does the relationship between the average return and the historical volatility of individual stocks differ from the relationship between the average return and the historical volatility of large, well-diversified portfolios? A. Higher returns are always associated with large volatilities. B. Large portfolios with higher returns have higher volatilities. For individual stocks comma no clear relationship exists. C. Individual stocks with higher returns have higher volatilities. For large portfolios comma no clear relationship exists. D. For large stocks and large portfolios comma there is a clear relationship. Higher returns are associated with higher volatilities. However comma for small stocks and small portfolios comma there is no relationship between returns and volatilities. E. There is no clear relationship between returns and volatilities for individual stocks or large portfolios.
B
10) Consider two investment projects, both of which require an upfront investment of $11 million and pay a constant positive amount each year for the next 9 years. Under what conditions can you rank these projects by comparing their IRRs? A. Ranking by IRR will work in this case so long as the projects' cash flows do not decrease from year to year. B. There are no conditions under which you can use the IRR to rank projects. C. Ranking by IRR will work in this case so long as the projects' cash flows do not increase from year to year. D. Ranking by IRR will work in this case so long as the projects have the same risk.
D
10) Consider two local banks. Bank A has 80 loans outstanding, each for $1.0 million, that it expects will be repaid today. Each loan has a 3% probability of default, in which case the bank is not repaid anything. The chance of default is independent across all the loans. Bank B has only one loan of $80 million outstanding, which it also expects will be repaid today. It also has a 3% probability of not being repaid. Which bank faces less risk? Why? A. The expected payoffs are the same, but Bank A is riskier. I prefer Bank B. B. The expected payoff is higher for Bank A, but is riskier. I prefer Bank B. C. In both cases, the expected loan payoff is the same: $80 million×0.97=$77.6 million. Consequently, I don't care which bank I own. D. The expected payoffs are the same, but Bank A is less risky. I prefer Bank A.
D
11) Consider the following two, completely separate, economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move together —in good times all prices go up together and in bad times they all fall together. In the second economy, stock returns are independent —one stock increasing in price has no effect on the prices of other stocks. Assuming you are risk-averse and you could choose one of the two economies in which to invest, which one would you choose? Explain. A. A risk-averse investor would prefer the economy in which stock returns are independent because by combining the stocks into a portfolio he or she can get a higher expected return than in the economy in which all stocks move together. B. A risk-averse investor would choose the economy in which stocks move together because the uncertainty is much more predict
D
11) From the start of 1999 to the start of 2009, the S&P 500 had a negative return. Does this mean the market risk premium we should use in the CAPM is negative? A. Yes, during this time period the risk premium is negative. B. Yes, the data shows that the risk premium on the market proxy is negative. C. No, negative risk premiums are impossible, there is clearly an error in the estimation. D. No, to get a reliable estimate of an expected return we need much more data.
D
12) Which of the following statements is FALSE? A. If there is a fixed supply of resources available, so that you cannot undertake all possible opportunities, then simply picking the highest NPV opportunity might not lead to the best decision. B. Practitioners often use the profitability index to identify the optimal combination of projects when there is a fixed supply of resources. C. The profitability index is calculated as the NPV divided by the resources consumed by the project. D. If there is a fixed supply of a resource available, you should rank projects by the profitability index, selecting the project with the lowest profitability index first and working your way down the list until the resource is consumed.
D
7) Which of the following statements is FALSE? A. The volatility of the portfolio will differ, depending on the correlation between the securities in the portfolio. B. We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility. C. Correlation has no effect on the expected return of a portfolio. D. We can rule out inefficient portfolios because they represent inferior investment choices.
B
2) Suppose an investment is equally likely to have a 35% return or a −20% return. The expected return for this investment is closest to: 10%. 7.5%. 15%. 5%.
7.5%
23) Your firm is considering building a new office complex. Your firm already owns land suitable for the new complex. The current book value of the land is $100,000. However, a commercial real estate agent has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is: $650,000. $100,000. $750,000. $0.
$650,000
Your estimate of the asset beta for Taggart Transcontinental is closest to: 0.66. 0.71. 0.42. 0.59.
0.66
4) Use the following information to answer the question(s) below. Frank Dewey Esquire from the firm of Dewey, Cheatum, and Howe, has been offered an upfront retainer of $30,000 to provide legal services over the next 12 months to Taggart Transcontinental. In return for this upfront payment, Taggart Transcontinental would have access to 8 hours of legal services from Frank for each of the next 12 months. Frank's normal billable rate is $250 per hour for legal services. Assuming that Dewey's cost of capital is 12% EAR, then the number of potential IRRs that exist for this problem is equal to: 12. 1. 0. 2.
1
3) The figure in the popup window, shows the one-year return distribution for RCS stock. The table below shows the one-year return distribution of Startup, Inc: Probability 40% 20% 20% 10% 10% Return −100% −75% −40% −30% 1000% Characterize the difference between the two stocks. What trade-offs would you face in choosing one to hold? 1. RCS has lower expected return. 2. RCS has lower volatility 3. All investors will prefer to hold the stock with the higher return. 4. All investors will prefer to hold the stock with the lower volatility. 5. It is impossible to know which stock investors will prefer to hold, without knowing more about their preferences for risk-taking and the other investments they may be holding.
1, 2, 5
19) Use the following information to answer the question(s) below. Suppose that the market portfolio is equally likely to increase by 24% or decrease by 8%. Security "X" goes up on average by 29% when the market goes up and goes down by 11% when the market goes down. Security "Y" goes down on average by 16% when the market goes up and goes up by 16% when the market goes down. Security "Z" goes up on average by 4% when the market goes up and goes up by 4% when the market goes down. The beta for security "X" is closest to: 1.25. 1.00. 0. 0.80.
1.25
21) Use the following information to answer the question(s) below. Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Luther has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost of capital is 7%, and the corporate tax rate is 21%. Luther's weighted average cost of capital is closest to: 11.1%. 13.0%. 9.8%. 10.8%.
11.1%
5) Use the following information to answer the question(s) below. Rearden Metals is considering opening a strip−mining operation to provide some of the raw materials needed in producing Rearden metal. The initial purchase of the land and the associated costs of opening up mining operations will cost $100 million today. The mine is expected to generate $16 million worth of ore per year for the next 12 years. At the end of the 12th year Rearden will need to spend $20 million to restore the land to its original pristine nature appearance. The number of potential IRRs that exist for Rearden's mining operation is equal to: 1. 2. 12. 0.
2
Wyatt Oil has a bond issue outstanding with seven years to maturity, a yield to maturity of 7.0%, and a BBB rating. The corresponding risk −free rate is 3% and the market risk premium is 5%. Assuming a normal economy, the expected return on Wyatt Oil's debt is closest to: 3.5%. 4.9%. 5.5%. 3.0%.
3.5%
Use the following information to answer the question(s) below. Suppose that the market portfolio is equally likely to increase by 24% or decrease by 8%. Security "X" goes up on average by 29% when the market goes up and goes down by 11% when the market goes down. Security "Y" goes down on average by 16% when the market goes up and goes up by 16% when the market goes down. Security "Z" goes up on average by 4% when the market goes up and goes up by 4% when the market goes down. The risk −free rate is closest to: 16%. 4%. 8%. 0%.
4%
15) When the CAPM correctly prices risk, the market portfolio is an efficient portfolio. Explain why. A. All investors will want to maximize their Sharpe ratios by picking efficient portfolios. When a riskless asset exists, this means that all investors will pick the same efficient portfolio, and because the sum of all investors' portfolios is the market portfolio, this efficient portfolio must be the market portfolio. B. When the CAPM holds, the market portfolio is on the security market line, hence it is efficient. C. The beta of the market portfolio is one. Furthermore, every investor holds the market portfolio. This means that in aggregate, every investor's portfolio has a beta of one, which implies that the market is efficient. D. When the CAPM holds, the market portfolio is on the capital market line, hence it is efficient.
A
16) Which of the following types of risk doesn't belong? A. Idiosyncratic risk B. Market risk C. Undiversifiable risk D. Systematic risk
A
8) Which of the following statements is FALSE? A. A short sale is a transaction in which you buy a stock that you do not own and then agree to sell that stock back in the future. B. It is possible to invest a negative amount in a stock or security, which is called a short position. C. A positive investment in a security can be referred to as a long position in the security. D. The efficient portfolios are those portfolios offering the lowest possible level of volatility for a given level of expected return.
A
9) In practice which market index is most widely used as a proxy for the market portfolio in the CAPM? A. S&P 500 B. Wilshire 5000 C. Dow Jones Industrial Average D. U.S. Treasury Bill
A
7) Which of the following statements is FALSE? A. It is possible that an IRR does not exist for an investment opportunity. B. The internal rate of return (IRR) investment rule is based upon the notion that if the return on other alternatives is greater than the return on the investment opportunity, you should undertake the investment opportunity. C. It is possible that there is no discount rate that will set the NPV equal to zero. D. If the payback period is less than a pre−specified length of time, you accept the project.
B
12) A hedge fund has created a portfolio using just two stocks. It has shorted $36,000,000 worth of Oracle stock and has purchased $96,000,000 of Intel stock. The correlation between Oracle's and Intel's returns is 0.67. The expected returns and standard deviations of the two stocks are given in the following table: Suppose the correlation between Intel and Oracle's stock increases, but nothing else changes. Would the portfolio be more or less risky with this change? A. More risky. B. Cannot say without knowing how investors trade off expected return and volatility. C. Less risky. D. Riskiness of the portfolio stays the same.
C
17) Which of the following statements is FALSE? A. Because value is lost when a resource is used by another project, we should include the opportunity cost as an incremental cost of the project. B. Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation. C. Sunk costs are incremental with respect to the current decision regarding the project and should be included in its analysis. D. When computing the incremental earnings of an investment decision, we should include all changes between the firm's earnings with the project versus without the project.
C
4) Which of the following statements is FALSE? A. If two stocks move together, their returns will tend to be above or below average at the same time, and the covariance will be positive. B. Dividing the covariance by the volatilities ensures that correlation is always between −1 and +1. C. The closer the correlation is to 0, the more the returns tend to move together as a result of common risk. D. Volatility is the square root of variance.
C
6) Which of the following statements is FALSE? A. By setting the NPV equal to zero and solving for r, we find the IRR. B. The IRR investment rule will identify the correct decision in many, but not all, situations. C. The simplest, though least accurate, investment rule is the NPV investment rule. D. If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate.
C
Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions? A. NPV B. Incremental IRR C. Profitability Index D. IRR
C
Which of the following statements is FALSE? A. A portfolio weight is the fraction of the total investment in the portfolio held in an individual investment in the portfolio. B. The expected return of a portfolio is simply the weighted average of the expected returns of the investments within the portfolio. C. Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return. D. Portfolio weights add up to 1 so that they represent the way we have divided our money between the different individual investments in the portfolio.
C
10) Suppose Johnson & Johnson and Walgreen Boots Alliance have expected returns and volatilities shown here, with a correlation of 24%. Assume the portfolio is equally invested in these two stocks. If the correlation between Johnson & Johnson's and Walgreens' stock were to increase, a. Would the expected return of the portfolio rise or fall? b. Would the volatility of the portfolio rise or fall? a. Would the expected return of the portfolio rise or fall? (Select the best choice below.) A. Cannot tell from the information provided. B. Rise. C. Remain the same. D. Fall. b. Would the volatility of the portfolio rise or fall? (Select the best choice below.) A. Fall. B. Remain the same. C. Rise. D. Cannot tell from the information provided.
C, C
15) Which of the following statements is FALSE? A. Sales will ultimately decline as the product nears obsolescence or faces increased competition. B. With straight−line depreciation the asset's cost is divided equally over its life. C. Managers sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will be wasted. D. A project's unlevered net income is equal to its incremental revenues less costs and depreciation, evaluated on a pre−tax basis.
D
16) Which of the following is NOT an assumption used in deriving the Capital Asset Pricing Model (CAPM)? A. Investors have homogeneous expectations regarding the volatilities, correlation, and expected returns of securities. B. Investors can buy and sell all securities at competitive market prices without incurring taxes or transactions cost and can borrow and lend at the risk −free interest rate. C. Investors hold only efficient portfolios of traded securities, that is portfolios that yield the maximum expected return for the given level of volatility. D. Investors have homogeneous risk −averse preferences toward taking on risk.
D
17) Which of the following statements is FALSE? A. We refer to the beta of a security with the market portfolio simply as the security's beta. B. A security with a negative beta has a negative correlation with the market, which means that this security tends to perform well when the rest of the market is doing poorly. C. There is a linear relationship between a stock's beta and its expected return. D. The risk premium of a security is equal to the market risk premium (the amount by which the market's expected return exceeds the risk −free rate), divided by the amount of market risk present in the security's returns measured by its beta with the market.
D
18) Which of the following statements is FALSE? A. Because investors can eliminate firm −specific risk "for free" by diversifying their portfolios, they will not require a reward or risk premium for holding it. B. Over any given period, the risk of holding a stock is that the dividends plus the final stock price will be higher or lower than expected, which makes the realized return risky. C. The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm −specific risk. D. Because investors are risk averse, they will demand a risk premium to hold unsystematic risk.
D
18) Which of the following statements is FALSE? A. Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. B. Many projects use a resource that the company already owns. C. As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings. D. When evaluating a capital budgeting decision, we generally include interest expense.
D
20) In a world with taxes, which of the following is the rate we should use to evaluate a project with the same risk and the same financing as the firm itself? A. The cost of debt B. The pre−tax WACC C. The cost of equity D. The weighted−average cost of capital
D
25) Which of the following statements is FALSE? A. Estimates of the cash flows and cost of capital are often subject to significant uncertainty. B. Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our NPV analysis for the project. C. To compute the NPV for a project, you need to estimate the incremental cash flows and choose a discount rate. D. When we are certain regarding the input to a capital budgeting decision, it is often useful to determine the break−even level of that input.
D
3) There are two ways to calculate the expected return of a portfolio: either calculate the expected return using the value and dividend stream of the portfolio as a whole, or calculate the weighted average of the expected returns of the individual stocks that make up the portfolio. Which return is higher? A. Impossible to tell, it depends on the portfolio. B. The weighted average expected return of the individual stocks is higher because returns are convex. C. The weighted average expected return of the individual stocks is higher because returns are concave. D. Neither —both calculations give the same answer.
D
8) Which of the following statements is FALSE? A. No investment rule that ignores the set of alternative investment opportunities can be optimal. B. There is no easy fix for the IRR rule when there are multiple IRRs. C. The payback rule is primarily used because of its simplicity. D. In general, the IRR rule works for a stand−alone project if all of the project's positive cash flows precede its negative cash flows.
D
4) If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each quarter, then the annual realized return is calculated as: Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4). Rannual = R1 + R2 + R3 + R4 / 4 Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) − 1. Rannual = R1 + R2 + R3 + R4.
Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) − 1.
9) Common risk is also called: independent risk. Firm −specific risk. market risk. diversifiable risk.
market risk
