Basic Finance Avanced
The risk that remains in a stock portfolio after efforts to diversify is known as unique risk.
False - It is known as systematic, market, risk.
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
False - We estimate the cost of debt by calculating the yield to maturity, not by using the coupon rate. So, it should be the yield to maturity times one minus the marginal tax rate.
A market index is used to measure performance of a broad-based portfolio of stocks.
True
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.
True
A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's stock price.
True - A 100% stock dividend will double the number of shares outstanding, which is the same thing a two-for-one split would do. Remember, a stock split is just a large stock dividend.
When a firm declares a special cash dividend of $1 per share, shareholders realize that the:
dividend is not likely to be repeated.
Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project? a. Changes in net operating working capital. b. Shipping and installation costs for machinery acquired. c. Cannibalization effects. d. Opportunity costs. e. Sunk costs that have been expensed for tax purposes.
e. Sunk costs that have been expensed for tax purposes. - Sunk costs are ignored since they are not incremental.
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's IRR increases as the WACC declines. b. A project's NPV increases as the WACC declines. c. A project's MIRR is unaffected by changes in the WACC. d. A project's regular payback increases as the WACC declines. e. A project's discounted payback increases as the WACC declines.
b. A project's NPV increases as the WACC declines. - As you reduce the discount rate, the WACC, the project's NPV will increase.
According to the trade-off theory, the capital structure is a trade-off between:
tax savings and financial distress and bankruptcy costs.
ABC Corp. stock is selling for $30 per share when a 10% stock dividend is declared. If you own 100 shares of ABC Corp. then you will receive:
10 shares of ABC Corp.
Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be.
False - A higher payout ratio means a lower retention ratio and a lower retention ratio means lower expected growth.
Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.
False - A lower tax rate reduces the interest tax shield, making debt less attractive.
A "reverse split" reduces the number of shares outstanding.
False - A reverse stock split, such as a 1 for 2, would reduce the number shares outstanding.
An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.
False - Beta measures systematic risk, the risk that cannot be diversified away, not diversifiable risk.
The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.
False - Both the payback and discounted payback methods fail to account for the cash flows beyond the payback period.
Market risk can be eliminated in a stock portfolio through diversification.
False - Diversification does not eliminate market risk.
If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.
False - Financing costs are accounted for in the WACC. So, if you were to account for them in the cash flows, you would be double counting them.
Upon the sale of equipment at the end of its useful life, tax liability will be incurred whenever the book value of the equipment exceeds the sales price.
False - If the book value of the equipment exceeds the sales price, the equipment is being sold at a loss. So, rather than a tax liability, we would expect a tax asset (tax savings from selling the equipment at a loss).
For investment horizons greater than 20 years, long-term corporate bonds traditionally have outperformed common stocks.
False - Stocks, due to their greater risk, have had higher returns than long-term corporate bonds.
The extra risk resulting from a firm's use of debt is called business risk.
False - The extra risk brought on by the use of debt is called financial risk.
The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.
False - The tighter, more peaked, the probability distribution is the more likely you are going to earn the expected return. So, a tighter probability distribution indicates less risk, a smaller standard deviation.
Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.
False - You compare the cost of capital to the internal rate of return. So, a change in the cost of capital will not impact the calculated internal rate of return. The internal rate of return is independent of the cost of capital.
Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?
If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. - We must account for the opportunity cost.
Your firm adheres strictly to the residual dividend model. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share?
The firm's net income increases. - An increase in net income, holding everything else constant, will lead to a larger payout under the residual dividend model.
According to the MM dividend-irrelevance proposition, since investors do not need dividends to convert their shares to cash, they will not pay higher prices for firms with higher dividend payouts.
True
Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.
True
Companies can pay out cash to their shareholders in two ways. They can pay a dividend or they can buy back some of their outstanding shares.
True
If one portfolio's variance exceeds that of another portfolio, its standard deviation will also be greater than that of the other portfolio.
True
The "information content of dividends" says that dividend increases send good news about cash flow and earnings, while dividend cuts send bad news.
True
The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-diversified investors who are concerned only with market risk.
True
Unlike using IRR, selecting projects according to their NPV will always lead to a correct accept-reject decision.
True
When using the WACC as a discount rate, it is often adjusted upward for riskier projects and downward for safer projects.
True
If a project permits a reduction in the level of net working capital, this reduction is assumed to increase cash flows.
True - A reduction in net working capital is a positive cash flow, whereas an increase in net working capital is a negative cash flow.
An individual stock's diversifiable risk can be lowered by adding more stocks to the portfolio in which the stock is held.
True - Adding more stocks to a portfolio will reduce the diversifiable risk.
If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.
True - An increase in the marginal tax rate will reduce the after-tax cost of debt.
In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows.
True - Any side effects, externalities, should be accounted for in the analysis.
Other things held constant, firms with more stable and predictable operating income tend to use more debt than firms with less stable sales.
True - Firms with more stable and predictable operating income, have lower business risk, which means they will likely take on more financial risk.
If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can have an important effect on its stock price.
True - If dividends convey signals, changing dividends will likely impact the firm's stock price.
Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.
True - Investors' degree of risk aversion determines the market risk premium, which will ultimately determine the slope of the SML
If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm's investment opportunities, the lower its payout ratio will be, other things held constant.
True - More investments will mean more retention and less payout.
The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method.
True - Reinvestment at the cost of capital is a more realistic assumption than reinvestment at the project's internal rate of return since there is no guarantee the firm will be able to reinvest the cash flows in another project that provides the same rate of return.
Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.
True - Risk-averse means investors do not like to take risk, but they will be willing to take risk if they expect to earn a higher return.
A dividend does not accompany stocks that are purchased on the ex-dividend date.
True - The ex-dividend date is the first date that the stock trades without dividend.
When funds must be committed to net working capital, those funds are assumed to be recovered at the end of the project's life.
True - Unless indicated otherwise, we always assume recovery of net working capital at the end of the project's life.
The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing
True - We trade-off the tax shield benefit from the debt versus the additional financial risk (costs) brought on by the debt.
Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.
True - Yes, if you have non-normal cash flows, more than one change in sign, you can have a multiple IRR problem.
If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.
True - You are giving up the opportunity to sell the land. So, there's an opportunity cost
Why do stock market investors appear not to be concerned with unique risks when calculating expected rates of return?
Unique risks are assumed to be diversified away.
A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? a. 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. b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. c. 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. d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. e. 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.
a. 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.
Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. b. The required rate of return will decline for stocks whose betas are less than 1.0. c. The required rate of return on the market, rM, will not change as a result of these changes. d. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium. e. The required rate of return on a riskless bond will decline.
a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. - An average risk stock has a beta of one. So, the required rate of return of an average stock will increase directly in proportion with the market risk premium.
Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. - This would be an example of a negative externality since it hurts another area of the business.
Which of the following statements is CORRECT? a. The slope of the security market line is equal to the market risk premium. b. Lower beta stocks have higher required returns. c. A stock's beta indicates its diversifiable risk. d. Diversifiable risk cannot be completely diversified away. e. Two securities with the same stand-alone risk must have the same betas.
b. Lower beta stocks have higher required returns.
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. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. c. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. - The payback method does not account the time value money.
If a security plots below the security market line, it is:
offering too little return to justify its risk. - If a security's return plots below the security market line, it means is it expected to provide less return than is "fair." So, it is providing too little return, given its risk.
Based on the information below, what is the firm's optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. - Our goal is to choose the capital structure with the highest expected stock price.
Which of the following statements is CORRECT? a. The MIRR and NPV decision criteria can never conflict. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. 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. d. The higher the WACC, the shorter the discounted payback period.
c. 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. - The MIRR assumes reinvestment at the WACC, which is more reasonable than assuming reinvestment at the IRR, which is what the IRR method assumes.
Which of the following statements is CORRECT? a. Increasing its use of financial leverage is one way to increase a firm's return on investors' capital (ROIC). b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage. c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price. d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors' capital (ROIC). (Assume that the repurchase has no impact on the company's operating income.) e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.
c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price. - If you focus on maximizing return, expected EPS, you will likely take on too high of a level of risk. The share price considers both risk and return.
The fact that historical returns on Treasury bills are less volatile than common stock returns indicates that:
common stocks should offer a higher return than Treasury bills.
Which of the following statements is CORRECT? a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC. d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.
d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. - Even though the costs of both debt and equity increase as you use more debt financing, the weighted average cost of capital might not necessarily increase since the weightings used to calculate the weighted average cost of capital are also changing while at the same time the cost of debt is lower than the cost of equity.
5. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of equity is always greater than the cost of debt. e. The cost of retained earnings typically exceeds the cost of new common stock.
d. The cost of equity is always greater than the cost of debt. - Since equity holders take more risk, there cost should always be greater than the cost of debt.
Which of the following statements is CORRECT? a. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. c. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. d. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects. - There is a potential scale problem when comparing mutually exclusive projects using the internal rate of return method.
Which of the following statements is CORRECT? a. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above-average dividend payout ratios. b. One advantage of the residual dividend model is that it leads to a stable dividend payout, which investors like. c. An increase in the stock price when a company cuts its dividend is consistent with signaling theory as postulated by MM. d. If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize its stock price. e. Stock repurchases make the most sense at times when a company believes its stock is undervalued.
e. Stock repurchases make the most sense at times when a company believes its stock is undervalued. - If the firm repurchases undervalued stock, it is a good investment.
Debt may be the preferred form of external financing for many firms because:
equity issuance is considered by investors to be a negative sign. - The direct and indirect costs of issuing equity (the flotation costs) are quite high. One of the indirect costs of issuing equity is the negative signal that it conveys to the market. The flotation costs of issuing debt are much lower than equity.
The risk premium that is offered on common stock is equal to the:
excess of expected return over a risk-free return
The "trade-off theory" of capital structure suggests that:
firms with higher risk should use less debt. - A firm that has higher risk to begin with will find that the benefit of the tax shield from the debt is more quickly offset by the increasing financial risk as more debt is used.
Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to:
greater price risk due to longer maturities.
The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if: a. it calculates a negative NPV for the proposal.
the proposal has a different degree of risk. - Remember, the required return, the cost of capital, needs to be adjusted for the risk of the cash flows being discounted. So, if the project has a different degree of risk than the overall firm, the cost of capital should be adjusted to reflect this risk.
Under MM, when taxes are considered, the value of a levered firm equals the value of the:
unlevered firm plus the present value of the tax shield. - Remember, Modigliani and Miller are making the assumption that there are no distress or bankruptcy cost. So, if you only account for taxes, the value of the levered firm is equal to the value of the unlevered firm plus the present value of the debt tax shield.