FIN 310 Test 2 Review
Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:
of each security must equal the slope of the security market line.
If the financial markets are semi-strong form efficient, then:
only individuals with private information have a marketplace advantage.
Profitability Index (PI)
(NPV + Initial Investment) / Initial Investment
Potential to increase the NPV of investment
- the ability to immediately shut down a project, should the project become unprofitable - the ability to wait until the economy improves before making the investment - the option to increase production beyond that which was initially projected
Which of the following statements is FALSE? The cost to a firm for capital funding equals the expected return to the providers of those funds A firm's cost of capital depends primarily on the source of the funds, not the use WACC is affected by market conditions including interest rates, tax rates, and the market risk premium A firm's WACC reflects the average risk of the existing projects undertaken by the firm
A firm's cost of capital depends primarily on the source of the funds, not the use
Which of the following statements is TRUE? The Gordon Growth Model assumes constant dividend growth but implies that stock prices grow at a different rate. A stock's price is the present value of its future cash flows, namely, its expected capital gains and dividends. Brokers buy and sell securities from their own inventory, while dealers bring buyers and sellers together to complete transactions. Holders of common stock have greater voting rights in corporate decisions than holders of preferred stock, but they have less voting rights than creditors of the corporation.
A stock's price is the present value of its future cash flows, namely, its expected capital gains and dividends.
If any, which of the following does NOT have the potential to increase the net present value of a proposed investment? The ability to immediately shut down a project should the project become unprofitable The ability to wait until the economy improves before making the investment The option to increase production beyond that initially projected All of the above have the potential to increase the NPV of a proposed investment
All of the above have the potential to increase the NPV of a proposed investment
Dealer
An agent who buys and sells securities from inventory
Which of the following statements is FALSE? Asset-specific risks can be easily diversified with highly correlated assets in a portfolio Asset-specific risks can be easily diversified with numerous assets in a portfolio Bearing risk is rewarded with higher expected returns Only market-wide risks, not asset-specific risks, should earn rewards
Asset-specific risks can be easily diversified with highly correlated assets in a portfolio
A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm: Automatically gives preferential treatment in the allocation of funds to its riskiest division Encourages the division managers to only recommend their most conservative projects Maintains the current risk level and capital structure of the firm Automatically maximizes the total value created for its shareholders
Automatically gives preferential treatment in the allocation of funds to its riskiest division
An efficient capital market is best defined as a market in which security prices reflect which one of the following? Current inflation A risk premium Available information The historical arithmetic rate of return The historical geometric rate of return
Available information
Which one of the following methods of analysis ignores cash flows? Profitability index Net present value Average accounting return Modified internal rate of return Internal rate of return
Average accounting return
Which one of the following methods of analysis is most similar to computing the return on assets (ROA)? Average accounting return Payback Internal rate of return Profitability index
Average accounting return
Which one of the following methods of analysis is most similar to computing the return on assets (ROA)? Profitability index Net present value Average accounting return Modified internal rate of return Internal rate of return
Average accounting return
A broker is an agent who: Trades on the floor of an exchange for himself or herself. Buys and sells from inventory. Offers new securities for sale to dealers only. Brings buyers and sellers together.
Brings buyers and sellers together.
Which of the following statements is TRUE? By investing in varied and numerous assets, an investor is able to virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply. It is possible, but not very easy, for an investor to control market-wide risks in his portfolio, and increases in these market-wide risks are costly because they reduce expected returns. The most important characteristic in determining the expected return of a well-diversified portfolio is the total variance risks of the individual assets in the portfolio. When a portfolio has a positive investment in every one of its assets, its standard deviation cannot be less than that on every asset in the portfolio.
By investing in varied and numerous assets, an investor is able to virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply.
Which one of the following types of securities has no priority in a bankruptcy proceeding?
Common Stock
What type of security has no priority in a bankruptcy proceeding?
Common stock
What generally pays a fixed dividend, receives first priority in dividend payment, and maintains the right to a dividend payment, even if that payment is deferred?
Cumulative preferred
The managers of H.R Construction are considering remodeling plans for an old building the firm currently owns. The building was purchased 8 years ago for $689,000. Over the past 8 years, the firm rented out the building and used the rent to pay off the mortgage. The building is now owned free and clear and has a current market value of $898,000. The firm is considering remodeling the building into a conference centre and sandwich bar at an estimated cost of $1.7 million. The estimated present value of the future income from this centre is $2.9 million. Which one of the following defines the opportunity cost of the remodeling project?
Current market value of the building
An agent who buys and sells securities from inventory is called a: Specialist Dealer Broker Floor Trader
Dealer
Which one of the following defines the internal rate of return for a project? Discount rate that creates a zero cash flow from assets Discount rate which results in a zero net present value for the project Discount rate which results in a net present value equal to the project's initial cost Rate of return required by the project's investors The project's current market rate of return
Discount rate which results in a zero net present value for the project
Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk? Systematic Unsystematic Diversification Security market line Capital asset pricing model
Diversification
Which of the following statements is FALSE? The cost of debt for bonds is the same as the yield implied by their market quoted prices, except when that promised yield is too high due, for example, to the high default probabilities for junk bonds. The cost of preferred stock equals its dividend yield as a percent of the current price, rather than the preferred dividend as a percent of its stated liquidating value, which is usually $100. Judgment is typically required when estimating the cost of equity, particularly when a company pays no dividends and when its beta estimate is imprecise. Due to its lower priority and greater risk, a firm's cost of equity can sometimes be, and often is, less that its after-tax cost of debt.
Due to its lower priority and greater risk, a firm's cost of equity can sometimes be, and often is, less that its after-tax cost of debt.
Which of the following statements is TRUE? Efficient markets will protect investors from wrong choices if they do not diversify. Consistent with efficient markets, stock prices reach equilibrium several times per week. Efficient markets react to new information by instantly adjusting the price of a stock to its new fair market value without any delay or overreaction. Weak form efficiency implies that all information is reflected in stock prices.
Efficient markets react to new information by instantly adjusting the price of a stock to its new fair market value without any delay or overreaction.
Which one of the following terms is most commonly used to describe the cash flows of a new project that are simply an offset of reduced cash flows for a current project? Opportunity cost Sunk cost Erosion Replicated flows Pirated flows
Erosion
The security market line is a linear function which is graphed by plotting data points based on the relationship between which two of the following variables? Risk-free rate and beta Market rate of return and beta Market rate of return and the risk-free rate Risk-free rate and the market rate of return Expected return and beta
Expected return and beta
The Blackwell Group is unable to obtain financing for any new projects under any circumstances. Which term best applies to this situation? Contingency planning Soft rationing Hard rationing Sensitivity analysis Scenario analysis
Hard rationing
Which of the following statements is FALSE? The Gordon Growth Model assumes constant dividend growth and implies that stock prices grow at the same rate. A stock's price is the present value of the expected dividends and capital gains. Dealers buy and sell securities from their own inventory, while brokers bring buyers and sellers together to complete transactions. Holders of preferred stock have greater voting rights in corporate decisions than holders of common stock.
Holders of preferred stock have greater voting rights in corporate decisions than holders of common stock.
Which of the following have the potential to increase the net present value of a proposed investment? I. ability to immediately shut down a project should the project become unprofitable II. ability to wait until the economy improves before making the investment III. option to place the investment on hold until a more favorable discount rate becomes available IV. option to increase production beyond that initially projected
I, II, III, and IV
Which of the following should be included in the analysis of a proposed investment? I. erosion effects II. opportunity costs III. sunk costs IV. side effects
I, II, and IV only
Based on the capital asset pricing model, investors are compensated based on which of the following? I. market risk premium II. portfolio standard deviation III. portfolio beta IV. risk-free rate
I, III, and IV only
Which of the following statements is TRUE? If a portfolio has a positive investment in every asset, the standard deviation on the portfolio can be less than that on every asset in the portfolio. Labor strikes and part shortages are examples of market-wide systematic risks. Market-wide systematic risks can be significantly reduced by diversification. Asset-specific unsystematic risks can be substantially reduced with less numerous and less correlated assets in a portfolio.
If a portfolio has a positive investment in every asset, the standard deviation on the portfolio can be less than that on every asset in the portfolio.
Which of the following statements is FALSE? The bid price is the price that a dealer is willing to pay for a security and is lower than the ask price. Bonds trade less frequently than stocks. In the stock market, the secondary market is the market where new securities are originally sold to investors by the issuing company. Dividends received by corporations have a 70% to 100% exclusion from taxable income.
In the stock market, the secondary market is the market where new securities are originally sold to investors by the issuing company.
Which one of the following is an example of systematic risk? Major layoff by a regional manufacturer of powerboats Increase in consumption created by a reduction in personal tax rates Surprise firing of a firm's chief financial officer Closure of a major retail chain of stores Product recall by one manufacturer
Increase in consumption created by a reduction in personal tax rates
Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as which one of the following? Eroded cash flows Deviated projections Incremental cash flows Directly impacted flows Assumed flows
Incremental cash flows
The profitability index reflects the value created per dollar:
Invested
The average accounting return method of analyzing projects: Incorporates cash flows. Is similar to calculating the Return on Assets. Is difficult to estimate using information from accounting statements. Should accept all projects with positive AAR.
Is similar to calculating the Return on Assets.
Which of the following statements is TRUE? It is better to use Geometric Return than Average Return to forecast what the stock market over the next 50 years The return earned in an average year over a multiyear period is known as the geometric return The compound return earned per year over a multiyear period is known as the arithmetic average return The average return is always smaller than the geometric return
It is better to use Geometric Return than Average Return to forecast what the stock market over the next 50 years
Which of the following statements is FALSE? Unlike equity holders, debt holders are not owners Lenders can exert control over a company's managers by voting for its board of directors. A corporation cannot deduct its payments to preferred shareholders before it pays taxes Holders of convertible bonds can force bankruptcy if their coupons are not paid
Lenders can exert control over a company's managers by voting for its board of directors.
Which of the following statements is FALSE? Over the long run, investments in small-company stocks have had the largest return but also the most risk, when compared with large-company stocks, bonds, and T-Bills. The average return is always greater than the geometric return. Investors who hold bonds instead of stocks over long horizons can be rational and relatively averse to risk. Like the dividend yield, the capital gains yield can never be negative.
Like the dividend yield, the capital gains yield can never be negative.
Which of the following statements is TRUE? Opportunity costs are those values that have already been incurred, cannot be recouped, and should not be considered in an investment decision. Under hard capital rationing, a business enforces limits on investment budgets because it prefers not to raise financing from the capital markets. Managerial real options can be very valuable but difficult to measure, and ignoring them will underestimate a project's true Net Present Value. Forecasting risk is more troublesome when NPV estimates are particularly large.
Managerial real options can be very valuable but difficult to measure, and ignoring them will underestimate a project's true Net Present Value.
The systematic risk principle states that the expected return on a risky asset depends only on?
Market risk
Which one of the following is the slope of the security market line? Risk-free rate Market risk premium Beta coefficient Risk premium on an individual asset Market rate of return
Market risk premium
Valley Forge and Metal purchased a truck five years ago for local deliveries. Which one of the following costs related to this truck is the best example of a sunk cost? Assume the truck has a usable life of eight years. New tires that will be purchased this winter Costs of repairs needed so the truck can pass inspection next month Money spent last month repairing a damaged front fender Engine tune-up that is scheduled for this afternoon Cost for a truck driver for the remainder of the truck's useful life
Money spent last month repairing a damaged front fender
If any, which of the following statements is FALSE? NPV measures the value created by taking on an investment NPV indicates how much a project will improve owner wealth NPV is the discounted present value of a project's expected future accounting net income at the required return, subtracting the initial investment None of the above statements is false
NPV is the discounted present value of a project's expected future accounting net income at the required return, subtracting the initial investment
A specialist is a(n): employee who executes orders to buy and sell for clients of his or her brokerage firm. individual who trades on the floor of an exchange for his or her personal account. NYSE member who functions as a dealer for a limited number of securities. broker who buys and sells securities from a market maker. trader who only deals with primary offerings.
NYSE member who functions as a dealer for a limited number of securities.
Which one of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities? Payback Profitability index Accounting rate of return Internal rate of return Net present value
Net present value
Which of the following statements is FALSE? One reason why the Average Accounting Return is a flawed measure in making business decisions is that it is based on cash flows. IRR measures the dollar-weighted return on an investment. In order to use the Payback Rule as a tool to determine if an investment is acceptable, a manager needs to provide a pre-specified limit of time for recouping investment costs. The Profitability Index measures the value created per dollar invested, based on the time value of money.
One reason why the Average Accounting Return is a flawed measure in making business decisions is that it is based on cash flows.
Which one of the following terms refers to the best option that was foregone when a particular investment is selected? Side effect Erosion Sunk cost Opportunity cost Marginal cost
Opportunity cost
Turner Industries started a new project three months ago. Sales arising from this project are exceeding all expectations. Given this, which one of the following is management most apt to implement?
Option to expand
Which one of the following indicates that a project is expected to create value for its owners? Profitability index less than 1.0 Payback period greater than the requirement Positive net present value Positive average accounting rate of return Internal rate of return that is less than the requirement
Positive net present value
Newly issued securities are sold to investors in which one of the following markets? Proxy Inside Secondary Primary
Primary
Newly issued securities are sold to investors in which one of the following markets? Proxy Stated value Inside Secondary Primary
Primary
Arithmetic average return
Return earned in an average year over a multiyear period
Which one of the following describes systemic risk? Risk that affects a large number of assets An individual security's total risk Diversifiable risk Asset specific risk Risk unique to a firm's management
Risk that affects a large number of assets
Mark is analyzing a proposed project to determine how changes in the variable costs per unit would affect the project's net present value. What type of analysis is Mark conducting?
Sensitivity analysis
Which of the following statements is FALSE? Sensitivity analysis helps determine the reasonable range of expectations for a project's outcome. The impacts of estimation errors and forecasting risks are small when NPVs are large and negative. Under intense competition, positive NPV projects are rare. The error of commission, or Type 1 error NPV estimation, is the risk that a project will be accepted when its true NPV is negative.
Sensitivity analysis helps determine the reasonable range of expectations for a project's outcome.
Which one of the following categories has the widest frequency distribution of returns for the period 1926-2008?Small-company stocks U.S. Treasury bills Long-term government bonds Inflation Large-company stock
Small-company stocks
Which one of the following is the most apt to have the largest risk premium in the future based on the historical record for 1926-2008? U.S. Treasury bills Large-company stocks Long-term government debt Small-company stocks Long-term corporate debt
Small-company stocks
Marcos Enterprises has three separate divisions. The firm allocates each division $1.5 million per year for capital purchases. Which one of the following terms applies to this allocation process? Soft rationing Hard rationing Opportunity cost Sunk cost Strategic planning
Soft rationing
Which one of the following refers to the option to expand into related businesses in the future? Strategic option Contingency option Soft rationing Hard rationing Capital rationing option
Strategic option
A cost that should be ignored when evaluating a project because that cost has already been incurred and cannot be recouped is referred to as which type of cost?
Sunk Cost
The risk premium for an individual security is based on which type of risk?
Systematic
Which of the following should not be included in the analysis of a proposed investment? The current market value of an existing building to be used in the project. The amount paid 4 years ago for an existing building to be used in the project. The expected after-tax salvage value at the end of a project of an existing building to be used in the project. The net working capital balance remaining at the end of the project.
The amount paid 4 years ago for an existing building to be used in the project.
Geometric average return
The average compound return earned per year over a multiyear period
Which of the following statements is FALSE? Over the long run, investments in small-company stocks have had the largest return but also the most risk, when compared with large-company stocks, bonds, and T-Bills. The average return is always less than the geometric return. Investors who hold bonds instead of stocks over long horizons can be rational and relatively averse to risk. Unlike the capital gains yield, the dividend yield can never be negative.
The average return is always less than the geometric return.
Which of the following statements is FALSE? The cost of capital is the minimum required return to compensate financial investors. The cost of capital for a project depends primarily on the source of funds. The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. A firm's WACC reflects the average risk of the existing projects undertaken by the firm.
The cost of capital for a project depends primarily on the source of funds.
Which one of the following statements is TRUE? The risk-free rate of return has a risk premium of 1.0. The reward for bearing risk is called the standard deviation. Risks and expected return are inversely related. The higher the expected rate of return, the wider the distribution of returns.
The higher the expected rate of return, the wider the distribution of returns.
Which one of the following statements is correct? The risk-free rate of return has a risk premium of 1.0. The reward for bearing risk is called the standard deviation. Risks and expected return are inversely related. The higher the expected rate of return, the wider the distribution of returns. Risk premiums are inversely related to the standard deviation of returns.
The higher the expected rate of return, the wider the distribution of returns.
An investment has conventional cash flows and a profitability index of 1.0. Given this, which one of the following must be true? The internal rate of return exceeds the required rate of return. The investment never pays back. The net present value is equal to zero. The average accounting return is 1.0. The net present value is greater than 1.0.
The net present value is equal to zero.
Which one of the following statements is correct? The internal rate of return is the most reliable method of analysis for any type of investment decision. The payback method is biased towards short-term projects. The modified internal rate of return is most useful when projects are mutually exclusive. The average accounting return is the most difficult method of analysis to compute. The net present value method is only applicable if a project has conventional cash flows.
The payback method is biased towards short-term projects.
New Labs just announced that it has received a patent for a product that will eliminate all flu viruses. This news is totally unexpected and viewed as a major medical advancement. Which one of the following reactions to this announcement indicates the market for New Labs stock is efficient?
The price of New Labs stock increases rapidly to a higher price and then remains at that price.
Under Munich, a footwear manufacturer, recently announced that they have just designed a new footwear product which includes the latest technology. This news is totally unexpected and viewed as a major advancement in the footwear industry. Which one of the following reactions to this announcement indicates the market for New Labs stock is efficient? The price of Under Munich doesn't change, but then it increases one week after the announcement. The price of all stocks quickly increase in value and then all but Under Munich stock fall back to their original values. The price of Under Munich's stock suddenly increases, and then remains at that price. The price of Under Munich's stock increases rapidly, and then settles back to its pre-announcement level.
The price of Under Munich's stock suddenly increases, and then remains at that price.
Which of the following statements is FALSE? The internal rate of return is defined as the discount rate which results in a zero net present value for the project. The primary advantage to payback analysis is that it biases companies to invest in long-term projects that require large current expenditures on research and development. The average accounting return ignores cash flows is most similar to computing the return on assets (ROA). The profitability index reflects the value created per dollar invested.
The primary advantage to payback analysis is that it biases companies to invest in long-term projects that require large current expenditures on research and development.
Fill in the blanks: Standard deviation measures ______ risk, while beta measures ______ risk. Asset-specific; market-wide Market-wide; total Total; market-wide Total; asset-specific
Total; market-wide
Which of the following statements is FALSE? Since errors of commission are often readily apparent, managers have a tendency to be cautious when evaluating new projects Errors of omission can result in lost potential value as much as errors of commission can destroy value. Type 1 errors occur when managers reject projects whose true NPVs are positive Errors in projected cash flows create large forecasting risks when their net present values are particularly small in magnitude.
Type 1 errors occur when managers reject projects whose true NPVs are positive
Which of the following statements is FALSE?? The impacts of estimation errors and forecasting risks are small when NPVs are large and positive. Under intense competition, positive NPV projects are as common as negative NPV projects. Scenario analysis helps determine the reasonable range of expectations for a project's outcome. Sensitivity analysis helps identify the variable within a project that presents the greatest forecasting risk.
Under intense competition, positive NPV projects are as common as negative NPV projects.
Which one of the following best exemplifies unsystematic risk? Unexpected economic collapse Unexpected increase in interest rates Unexpected increase in the variable costs for a firm Sudden decrease in inflation Expected increase in tax rates Response Feedback:Refer to section 11.6.
Unexpected increase in the variable costs for a firm
Portfolio diversification eliminates which of the following? Total investment risk Reward for bearing risk Market-wide risk Unsystematic risk
Unsystematic risk
Portfolio diversification eliminates which one of the following? Total investment risk Portfolio risk premium Market risk Unsystematic risk Reward for bearing risk
Unsystematic risk
Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic firm-specific risk associated with an individual security? Security beta multiplied by the market rate of return Market risk premium Risk-free rate of return Zero
Zero
Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security? Security beta multiplied by the market rate of return Market risk premium Security beta multiplied by the market risk premium Risk-free rate of return Zero
Zero
Average accounting return (AAR) purpose
accounting return
Semi-strong form market efficiency states that the value of a security is based on:
all publicly available information.
Broker
an agent who brings buyers and sellers together.
Internal rate of return (IRR) purpose
expected return
Beta
exposure to market risk - positive: w/ market - negative: against market - 1: same as market (in sync) - 1<: more sensitive than market - 1>: less sensitive than market
Scenario analysis
helps determine the reasonable range of expectations for a project's anticipated outcome.
Sensitivity analysis
helps identify the variable within a project that presents the greatest forecasting risk.
Sensitivity analysis: looks at the most reasonably optimistic and pessimistic results for a project. helps identify the variable within a project that presents the greatest forecasting risk. is generally conducted prior to scenario analysis just to determine if the range of potential outcomes is acceptable. illustrates how an increase in operating cash flow caused by changing both the revenue and the costs simultaneously will change the net present value for a project.
helps identify the variable within a project that presents the greatest forecasting risk.
Payback purpose
liquidity
Fill in the blanks: Stock prices fall if investors either expect _________ growth rates or require _________ returns. higher, higher higher, lower lower, higher lower, lower
lower, higher
Inside quotes are defined as the:
lowest asked and highest bid offers.
Ignoring the option to wait...
may underestimate the net present value of a project.
If the financial markets are semi-strong form efficient, then: only the most talented analysts can determine the true value of a security. only individuals with private information have a marketplace advantage. technical analysis provides the best tool to use to gain a marketplace advantage. no one individual has an advantage in the marketplace.
only individuals with private information have a marketplace advantage.
PI purpose
rationing rank
If you own shares what are 2 ways you can make cash from it?
sell or dividends
If the financial markets are efficient then...
stock prices should only respond to unexpected news and events.
Total risk =
systematic risk + unsystematic risk
The beta of a risky portfolio (assuming no borrowing or short-selling) cannot be less than _____ nor greater than _____.
the lowest individual beta in the portfolio; the highest individual beta in the portfolio
Over the period of 1926-2008:
the risk premium on stocks exceeded the risk premium on bonds.
Standard deviation measures _____ risk while beta measures _____ risk.
total; systematic
Risk
uncertainty of returns, investors are rewarded for certain types of risks they take on
NPV purpose
value credited
