Chapter 11 & 12 corporate finance
Which of the following statements is (are) true about variance? (Select all that apply) -Variance is a measure of the squared deviations of a security's return from its expected return. -Variance measures a security's expected return over many periods. -Standard deviation is the square root of variance. -Computation of variance requires the use of a computer.
--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.
The following are disadvantages of the SML approach -Adjusts for risk -Does not require the company to pay a dividend -Requires estimation of beta -Requires estimation of the market risk premium
-Adjusts for risk -Does not require the company to pay a dividend
he following are advantages of the SML approach -Requires estimation of the market risk premium -Adjusts for risk -Requires estimation of beta -Does not require the company to pay a dividend
-Adjusts for risk -Does not require the company to pay a dividend
What is systematic risk? -It is a risk that increases in a systematic, gradual fashion. -It is a risk that pertains to a large number of assets. -It is a risk that affects only one or a few assets. -It is a risk that is caused by failure of the internal control system of a corporation.
-It is a risk that pertains to a large number of assets.
What is the definition of expected return? -It is the expected variation in return on a risky asset. -It is the return that an investor expects to earn on a risky asset in the future. -It is the return that was earned in the past on a risky asset. -It is the variation in return during the last period.
-It is the return that an investor expects to earn on a risky asset in the future.
The growth rate of dividends can be found using: -historical dividend growth rates -the perpetuity model -the capital asset pricing model -security analysts' forecasts
-historical dividend growth rates -security analysts' forecasts
Which of the following are examples of unsystematic risk? (Select all that apply) -Labor strikes -The expected rate of inflation next year -Changes in management -Changes in the federal tax code
-labor strikes -changes in management
A well-diversified portfolio will eliminate all risks.
False
What is unsystematic risk? -It is a risk that is always caused by external factors. -It is a risk that affects a single asset or a small group of assets. -It is a risk that is unavoidable. -It is a risk that affects all the assets in a diversified portfolio.
It is a risk that affects a single asset or a small group of assets.
What is a risk premium? -It is a fee charged to investors by the SEC that allows them to invest in risky securities. -It is the return on risk-free securities. -It is a numerical estimate of beta. -It is additional compensation for taking risk, over and above the risk-free rate.
It is additional compensation for taking risk, over and above the risk-free rate.
The most appropriate weights to use in the WACC are the ______ weights. -book value -government mandated -market value -salvage value
Market value
The _____ is the news that influences the unanticipated return on the stock. -known item -surprise -joint concern -false information
Surprise
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero? -The risk-free rate of return -The market risk premium -The return on market -Zero
The risk-free rate of return
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
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ________ of its stock.
Value or price
For a firm with outstanding debt, the cost of debt will be the ________ on that debt.. -coupon rate -yield to maturity -current yield -average yield
YTM
The CAPM can also be used for a portfolio by first determining the portfolio's ________.
beta
The capital asset pricing model is the equation of the security market line showing the relationship between expected return and ________.
beta
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes. -can -should -may -cannot
cannot
Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio: -declines -fluctuates randomly -increases -does not change
declines
If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital. -debt -derivative -government -equity
equity
The ________ return on a portfolio is a combination of the expected returns on the assets in the portfolio.
expected
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
In the WACC calculation, V = E - D
false
Labor strikes are an example of systematic risk
false
Projects should always be discounted at the firm's overall cost of capital.
false
Reason: The slope of the SML is the market-risk premium (expected return on the market minus the risk-free rate of return).
false
Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.
false
The SML approach is advantageous because all it requires is estimation of beta.
false
The cost of capital depends on the source of the funds
false
The cost of equity is D1/P0 minus the analysts' estimates of growth.
false
The discount rate is also known as the expected return.
false
The expected return of a portfolio is a combination of the weights of each asset in a portfolio.
false
The growth rate of dividends can be found using the CAPM
false
The primary disadvantage of the dividend growth model approach is its simplicity.
false
The standard deviation is the variance squared.
false
The surprise part of any announcement is the information the market uses to form the expectation of the return on the stock.
false
Portfolio weights can be defined as the dollars invested in each asset
falsee
Which of the following are true? -Ideally, we should use book values in the WACC. -Ideally, we should use market values in the WACC. -The market value of debt and equity are not reliable in case of privately owned company. -Book values are often similar to market values for equity.
ideally, we should use market values in the WACC
If a firm issues no debt, its average cost of capital will equal ___. -its cost of equity -its dividend yield -its cost of debt -half the sum of the cost of debt and equity
its cost of equity
An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk. -equal to -less than -greater than
less than
In the WACC calculation, D represents the ________ value of the firm's debt.
market
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: -accepted, as it should be -accepted, when it should be rejected -rejected, as it should be -rejected, when it should be accepted
rejected, when it should be accepted
The WACC of a firm reflects the ________ and the target capital structure of the firm's existing assets as a whole.
risk
According to the CAPM, what is the expected return on a stock if its beta is equal to zero? -Multiple choice question. -The market-risk premium The risk-free rate -Zero -The return on the market minus -the risk-free rate
risk free rate
The true risk of any investment comes from _______________ . -anticipated events -surprises -expected return -errors
surprises
Even if the portfolio is well diversified, the investor is still exposed to _____ risk. -unknown -multiplied -mean -systematic
systematic
Beta tells us the amount of ________ risk of an asset or portfolio relative to ______. -systematic; an average risky asset -systematic; the risk-free asset -unsystematic; the risk-free asset -unsystematic; an average risky asset
systematic; an average risky asset
A portfolio can be described by its portfolio weights which are defined as _____________________. -the dollars invested in each asset -the dollars invested in each asset class. -the percentage of dollars invested in each asset class -the percentage of dollars invested in each asset
the percentage of dollars invested in each asset
f a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects. -too many -the optimal number of- too few
too many
RP=D/P0
true
T/F: The expected return is the return that an investor expects to earn on a risky asset in the future.
true
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/(E+D)] × RP -(V/P) × RP -(P/V) × RP
(P/V) × RP
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level? -the firm overall will become riskier -it will accept projects that it should have rejected -It will reject projects that it should have accepted -the firm's risk will not change over time -using the firm's WACC to evaluate all projects is appropriate
-the firm overall will become riskier -it will accept projects that it should have rejected -It will reject projects that it should have accepted
The formula of the SML is: -RE = Rf + Beta x (RM- Rf) -RE = Rf + Beta/(RM+ Rf) -RE = Rf - Beta + RM- Rf
RE = Rf + Beta x (RM- Rf)
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities? -Percentage of completion -RD -TC -WACC
WACC
The minimum required return on a new project is known as the: -cost of capital -payback period -internal rate of return -capital of cost
cost of capital
Which of the following is tax-deductible to the firm? -Dividends paid on preferred stock -Principal amounts paid on debt -Dividends paid on common stock -Coupon interest paid on bonds
coupon interest paid on bonds
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. less than greater than unrelated to equal to
equal to
Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
false
Discounting a news item is the same as taking the present value of that item.
false
Finding the cost of equity is fairly straightforward.
false
For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
false
T/F: Calculating the expected return is the last step in the computation of variance.
false
The return expected on an investment depends only on the asset's _____ risk. -unsystematic -diversifiable -unnatural -systematic
systematic
Which of the following are components used in the construction of the WACC? -Cost of accounts payable -Cost of common stock -Cost of debt -Cost of preferred stock
-Cost of common stock -Cost of debt -Cost of preferred stock
What can we say about the dividends paid to common and preferred stockholders? -Dividends to preferred stockholders are fixed. -Dividends are guaranteed for both preferred and common stockholders. -Dividends to common stockholders are not fixed. -Dividends to preferred stockholders are fixed.
-Dividends to preferred stockholders are fixed. -Dividends to common stockholders are not fixed.
By definition, what is the beta of the average asset equal to?
1
Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.
true
The return an investor in a security receives is equal to the cost of the security to the company that issued it.
true
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___. -risk-free rate -annual dividend amount -stock's beta -market risk premium
-risk-free rate -stock's beta -market risk premium
To determine the appropriate required return for an investment, we can use ____. --the risk free rate -the lowest going rate -the Security Market Line -the average return on the market
-the Security Market Line
What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5? -6.5% -11% -13.5% 4%
11%
What is an uncertain or risky return? -It is the portion of return that is unaffected by present or future information. -It is the portion of return that depends on information that is currently unknown. -It is the return that is classified as risky by bond rating agencies. It is the portion of return that depends on information that is currently known
It is the portion of return that depends on information that is currently unknown.
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 -RE = D0 - P1 -RE = D0 + P1 -RE = D0/P1
RE=D1/P0
What is the equation for total return? -total return = Expected return - Unexpected return -Total return = Expected return + Unexpected return -Total return = Risk-free rate + Normal return -Total return = Risk-free rate + Normal return + Risky return
Total return = Expected return + Unexpected return
What is the Reward-to-Risk Ratio? -[Rf - E(RA)]/βA [E(RA) - Rf]/βA [E(RA) - βA]/Rf [E(RA) + Rf]/βA
[E(RA) - Rf]/βA
The cost of capital depends primarily on the ______ of funds, not the _____. -use; cost -use; source -source; use -source; cost
use; source
Which of the following are examples of a portfolio? (Select all that apply) -Investing $100,000 in a combination of US and Asian stocks -Investing $100,000 to buy 100 shares of the best performing stock on the NYSE -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 -Investing $100,000 to buy 100 shares of the best performing stock on the NYSE -Investing $100,000 in the stocks of 50 publicly traded corporations -Investing $100,000 in a combination of stocks and bonds
What does the security market line depict? -It depicts the relationship between systematic risk and unsystematic risk. -It depicts the relationship between the return on the S&P 500 and an individual security's return. -It depicts the relationship between expected return and the standard deviation of returns. -It is a graphical depiction of the capital asset pricing model.
-It is a graphical depiction of the capital asset pricing model.
Which of the following are examples of information that may impact the risky return of a stock? (Select all that apply) -Last year's net income as a percentage of sales and gross fixed assets. -The outcome of an application currently pending with the Food and Drug Administration. -The Fed's decision on interest rates at their meeting next week -The trend in sales growth over the last 10 years.
-The outcome of an application currently pending with the Food and Drug Administration. -The Fed's decision on interest rates at their meeting next week
What are the two components of risky return (U) in the total return equation? (Select all that apply) -Unsystematic risk -Expected risk -Market risk -Expected return
-Unsystematic risk -Market risk
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. -You must invest in stocks of at least 10 corporations. -You must invest in at least 2 stocks of 1 corporation. -You must invest in the stocks of at least 30 corporations.
-You must invest in stocks of more than one corporation.
If a firm has multiple projects, each project should be discounted using ___. -the firm's overall cost of capital -the average cost of capital -the marginal cost of capital for the latest project -a discount rate commensurate with the project's risk
-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 -a portfolio's standard deviation the value of a put option -a portfolio's variance
-a portfolio's expected return
Unsystematic risk will affect (Select all that apply) -a specific firm -all manufacturing firms -the market as a whole -firms in a single industry
-a specific firm -firms in a single industry
Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by: -multiplying the components by the inflation rate -multiplying these two components. -adding these two components. -subtracting the first from the second.
-adding these two components.
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market: -reversed its position based on the news -doesn't pay attention to news items -already knew about most of the news item
-already knew about most of the news item
The rate used to discount project cash flows is known as the ___. -cost of capital -market rate -discount rate -required return
-cost of capital -discount rate -required return
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) -[E/D] × RE + [D/E] × RD × (1 - Tc) -[(E+D)/E] × RE + [(E+D)/D] × RD × (1 - Tc)
[E/V] × RE + [D/V] × RD ×(1 - T c)
Components of the WACC include funds that come from ______ -investors -accruals -non-cash expenses
investors
Finding a firm's overall cost of equity is difficult because: -it cannot be observed directly -it requires the use of differential equations -the federal government refuses to disclose equity costs -it can only be guessed at
it cannot be observed directly
Systematic risk is also called ______________ risk. -diversifiable -market -world-wide -industry-specific
market
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be: -unimaginably large -positive -negative -zero
positive
The security market line (SML) shows that the relationship between a security's expected return and its beta is ______. -Positive -Insignificant -negative -Overrated
positive
Other companies that specialize only in projects similar to the project your firm is considering are called ___. -conglomerates -matched pairs -pure plays -knock-offs
pure plays
If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______. -return; risk -risk premium; systematic risk -return; systematic risk -systematic risk; risk premium
risk premium; systematic risk
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 as a whole -the beta for SmartKids -the beta for software companies that collect and store data -the beta for the textbook industry as a whole
the beta for software companies that collect and store data