FIN6406 Exam 2

True or false: Throwing darts at the financial pages to construct a portfolio is not be a good strategy because professional security analysts always outperform dart portfolios.

False

True or false: Other companies that specialize only in projects similar to the project your firm is considering are called pure plays.

True

Which of the following variables do we need to compute the beta for a company's stock (Select all that apply)? a: the variance of the market index's returns. b: the covariance between the stock and the market index's returns. c: the correlation between the stock's returns and the CPI index. d: the covariance between the stock and the industry index's returns.

Which of the following variables do we need to compute the beta for a company's stock (Select all that apply)? a: the variance of the market index's returns. b: the covariance between the stock and the market index's returns.

The weighted average cost of capital (WACC) formula, for a firm with no debt or preferred stock, will have a WACC of ______. a: 1 × Cost of equity b: 1 + Cost of equity c: Cost of equity/Cost of debt d: Cost of debt/Cost of equity

a: 1 × Cost of equity

Which of the following is true? a: A company can deduct interest paid on debt up to 30 percent of EBIT when computing taxable income. b: A company cannot deduct interest paid on debt when computing taxable income. c: A company can deduct dividends paid to shareholders when computing taxable income.

a: A company can deduct interest paid on debt up to 30 percent of EBIT when computing taxable income.

For both academics and practitioners, the pendulum has swung over to the ______ for estimating the cost of equity capital. a: CAPM b: DDM c: LMN d: retention ratio

a: CAPM

Which of the following does the efficient markets hypothesis tell us (select all that apply)? a: Financial managers cannot time bond and stock sales. b: Prices correctly reflect value. c: Investors are foolish. d: There is no upward trend in stock prices.

a: Financial managers cannot time bond and stock sales. b: Prices correctly reflect value.

Which of the following are true (Select all that apply)? a: Ideally, we should use market values in the WACC. b: Book values are often similar to market values for debt. c: Ideally, we should use book values in the WACC. d: Book values are often similar to market values for equity.

a: Ideally, we should use market values in the WACC. b: Book values are often similar to market values for debt.

Which of the following assumptions is necessary for MM Proposition I to hold? a: Individuals can borrow on their own at an interest rate equal to that of the firm. b: Personal taxes must be lower than corporate taxes. c: Interest rates must be low. d: Managers must be acting to maximize the value of the firm.

a: Individuals can borrow on their own at an interest rate equal to that of the firm.

What is the impact of fraud on security prices (select all that apply)? a: Security prices will likely revert to equilibrium once the fraud is discovered. b: Security prices are not affected by fraudulent data. c: Security prices will never be restored to equilibrium level. d: It will distort prices in the short-run.

a: Security prices will likely revert to equilibrium once the fraud is discovered. d: It will distort prices in the short-run.

A corporation gains no value from an interest tax shield if which of the following are true (select all that apply)? a: The corporation has no debt. b: The debt-equity ratio is 1. c: Corporate tax rates are zero. d: The corporation is an all-equity firm.

a: The corporation has no debt. c: Corporate tax rates are zero. d: The corporation is an all-equity firm.

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI) (select all that apply)? a: The rate of return on assets is unaffected by leverage. b: Below the indifference or break-even point in EBIT, an unlevered capital structure is best. c: Financial leverage increases the slope of the EPS line. d: Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.

a: The rate of return on assets is unaffected by leverage. b: Below the indifference or break-even point in EBIT, an unlevered capital structure is best. c: Financial leverage increases the slope of the EPS line.

Under MM with no taxes, as debt is ______ to capital structure, the cost of equity ______ (select all that apply). a: added; increases b: removed; increases c: removed; decreases d: added; decreases

a: added; increases c: removed; decreases

Flotation costs are costs incurred to ______. a: bring new security issues to the market b: obtain a bank loan c: insure the payment due to bondholders d: keep a firm in business

a: bring new security issues to the market

Which of the following can cause a firm's beta to change over time (Select all that apply)? a: changes in product line b: changes in the betas of other companies c: changes in technology d: changes in leverage

a: changes in product line c: changes in technology d: changes in leverage

An increase in ______ will increase beta (Select all that apply). a: financial leverage b: revenues c: dividend payments d: operating leverage

a: financial leverage d: operating leverage

The types of equity and debt to sell is an example of a(n) ______. a: financing decision b: cost decision c: net present value d: operating decision

a: financing decision

Levered equity has ______ risk than unlevered equity. a: greater b: less c: the same

a: greater

Managers should choose the capital structure that will have the ______ firm value. a: highest b: lowest

a: highest

A key assumption of MM Proposition I is that ______. a: individuals can borrow as cheaply as corporations b: corporations can borrow at a cheaper rate than individuals c: individuals can only borrow at a higher rate than corporations

a: individuals can borrow as cheaply as corporations

An efficient market is one that fully reflects all available ______. a: information b: investments c: redundancies d: inefficiencies

a: information

It is not uncommon for IPOs to ______ experience large gains. a: initially b: never c: eventually

a: initially

In reality, most firms cover the equity portion of their capital spending with ______. a: internally generated cash flow b: a new bond issue c: a new preferred stock issue d: a new common stock issue

a: internally generated cash flow

A company should select the capital structure that ______. a: maximizes the company's value b: results in the lowest debt c: has the lowest leverage d: results in the lowest taxes

a: maximizes the company's value

To estimate the dividend yield of a particular stock, we can ______ (Select all that apply). a: multiply last year's dividend by (1 + g) b: use the average bank's annual CD rate c: use the average market dividend yield d: use security analysts' forecasts

a: multiply last year's dividend by (1 + g) d: use security analysts' forecasts

Which of the following are factors that affect beta (Select all that apply)? a: operating leverage b: changes in the market risk premium c: the cyclical nature of revenues d: financial leverage

a: operating leverage c: the cyclical nature of revenues d: financial leverage

The expected return on equity is ______ to leverage. a: positively related b: unrelated c: negatively related

a: positively related

What types of information affect the rates at which stock prices adjust to new information (Select all that apply)? a: publicly available information b: past information c: all information d: no information

a: publicly available information b: past information c: all information

The ______ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk (Select all that apply). a: slope b: length c: width d: beta

a: slope d: beta

What do we know about the stability of a firm's beta (Select all that apply)? a: Betas are more likely to change if the firm remains in the same industry. b: Betas can change over time. c: Betas are more likely to be stable if the firm remains in the same industry. d: Betas do not change over time.

b: Betas can change over time. c: Betas are more likely to be stable if the firm remains in the same industry.

What can we say about the dividends paid to common and preferred stockholders (Select all that apply)? a: Preferred stock dividends change every year based on the earnings of the firm. b: Dividends to preferred stockholders are fixed. c: Dividends to common stockholders are not fixed. d: Dividends are guaranteed for both preferred and common stockholders.

b: Dividends to preferred stockholders are fixed. c: Dividends to common stockholders are not fix

Which of the following are true (Select all that apply)? a: Fixed costs never change. b: Fixed costs do not change as quantity changes. c: Variable costs change with changes in quantity. d: Variable costs never change.

b: Fixed costs do not change as quantity changes. c: Variable costs change with changes in quantity.

Which of the following is true about the IPO market? a: Usually no changes in price occur with IPOs. b: Large initial gains in stock prices often occur. c: Large initial losses in stock prices often occur.

b: Large initial gains in stock prices often occur.

______ companies prefer the CAPM to the DDM. a: An equal amount of b: More c: Less

b: More

If the expected return of a project is below that of a financial asset of comparable risk, the firm should ______ the project. a: Accept b: Reject

b: Reject

Which of these statements is true regarding corporate capital structures? a: The best capital structure is always the all-equity option. b: The capital structure that maximizes the value of the firm provides the most benefit for its stockholders. c: The optimal capital structure results in a lower stock price and a higher cost of capital.

b: The capital structure that maximizes the value of the firm provides the most benefit for its stockholders.

Which one of the following is true? a: Under U.S. tax law, all company interest payments are taxable to the company. b: Under U.S. tax law, a corporation's interest payments up to 30 percent of EBIT are tax-deductible. c: Under international tax law, all company interest payments are taxable to the company. d: Under international tax law, all company interest payments are tax deductible.

b: Under U.S. tax law, a corporation's interest payments up to 30 percent of EBIT are tax-deductible.

The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered. a: cost of debt b: WACC c: cost of equity

b: WACC

U.S. Treasury securities are considered to be risk-free because they have minimal, if any, ______ risk. a: price b: default c: inflation d: interest rate

b: default

Different types of information will affect stock prices ______. a: equally b: differently

b: differently

A firm should only undertake a project if its expected return is ______ that of a financial asset of comparable risk. a: equal to or less than b: equal to or greater than

b: equal to or greater than

An unlevered firm ______. a: has more risk than a levered firm b: has an all-equity capital structure c: is always superior to a levered firm d: has more volatility than a levered firm

b: has an all-equity capital structure

When valuing a complete business enterprise, the same process that is used for individual projects can be used. However, the analysis is complicated because a ______ must be used, and a terminal firm value must be determined. a: duration b: horizon c: population d: mutation

b: horizon

If company managers believe interest rates will rise, they have a(n) ______ to borrow long term. a: disinclination b: incentive c: disincentive d: obligation

b: incentive

If a firm issues no debt, its average cost of capital will equal ______. a: half the sum of the cost of debt and equity b: its cost of equity c: its cost of debt d: its dividend yield

b: its cost of equity

The sales of cyclical firms are ______ sensitive to the business cycle than are the sales of non-cyclical firms. a: less b: more

b: more

Weak form efficiency considers trading strategies that use information based solely on ______ stock prices. a: future b: past c: current

b: past

Preferred stock ______ (Select all that apply). a: has a fixed maturity b: pays a constant dividend c: pays dividends in perpetuity d: does not pay dividends

b: pays a constant dividend c: pays dividends in perpetuity

A market is said to be semistrong efficient if prices incorporate which type of information? a: insider information b: publicly available information c: all information, both public and private

b: publicly available information

Volatility or ______ increases for equity holders when leverage increases. a: certainty b: risk c: yield-to-maturity d: inevitability

b: risk

For debt, book values and market values are typically ______. a: different b: similar

b: similar

When valuing a firm with the weighted average cost of capital, the ______ value of the firm can be estimated by assuming a constant perpetual growth rate for cash flows beyond the horizon. a: substantial b: terminal c: fundamental d: retroactive

b: terminal

Throwing darts at the financial pages to construct a portfolio may not be a good strategy because ______. a: dart throwing assumes that the markets are semistrong form efficient b: the darts cannot consider the overall risk of the portfolio c: professional security analysts always outperform dart portfolios

b: the darts cannot consider the overall risk of the portfolio

A firm's capital structure refers to ______. a: how the firm invests its capital b: the firm's mix of debt and equity c: the amount of capital in the firm d: the amount of cash in a firm

b: the firm's mix of debt and equity

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because ______ (select all that apply). a: capital structures are fixed b: the overall cost of capital cannot be reduced c: debt is not cheaper than equity d: as debt is added, the equity becomes more risky

b: the overall cost of capital cannot be reduced d: as debt is added, the equity becomes more risky

Not everyone believes in efficient markets because ______, a: of corporate greed b: there are anomalies c: investors suffer illusions d: the SEC does a poor job

b: there are anomalies c: investors suffer illusions

Which of the following are true about U.S. Treasury instruments (Select all that apply)? a: They are completely free of the risk of default. b: T-bills are perfectly risk free, but T-bonds are not. c: They have never defaulted. d: They are not expected to default at this time.

c: They have never defaulted. d: They are not expected to default at this time.

What does WACC stand for? a: Working amount of corporate cash b: Weighted average company cost c: Weighted average cost of capital d: Working amount of corporate costs

c: Weighted average cost of capital

If you can beat the market by ______, then you are violating weak form efficiency. a: using your intuition b: utilizing insider information c: analyzing historical price patterns d: analyzing balance sheets

c: analyzing historical price patterns

Today, the majority of financial economists ______. a: believe in efficient markets b: take the behavioral position that markets are inefficient c: are not convinced one way or the other about market efficiency

c: are not convinced one way or the other about market efficiency

The slope of the characteristic line of a firm's returns versus those of the market is the ______. a: gamma b: delta c: beta d: alpha

c: beta

Beating the market ______ would illustrate a violation of semistrong form efficiency. a: with insider information b: with intuition c: by analyzing financial statements

c: by analyzing financial statements

When calculating the cash flow for a levered firm, you must consider ______. a: dividends paid to stockholders only b: interest paid to bondholders only c: cash flows to both bondholders and stockholders d: cash flows to both bondholders and all stakeholders

c: cash flows to both bondholders and stockholders

The issuance costs of bonds and stocks are referred to as ______ costs. a: reparation b: sunk c: flotation d: market

c: flotation

If company managers believe interest rates will rise, they will ______ borrowing now. a: decrease b: not change c: increase

c: increase

Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ______. a: is unaffected by leverage b: decreases with leverage c: increases with leverage

c: increases with leverage

The effect of financial leverage ______ for all earning levels. a: is advantageous b: is disadvantageous c: is variable

c: is variable

According to the efficient markets hypothesis, the timing of a new equity issue is ______ important. a: somewhat b: very c: not

c: not

Other companies that specialize only in projects similar to the project your firm is considering are called ______. a: conglomerates b: knock-offs c: pure plays d: matched pairs

c: pure plays

The proponents of efficient markets question whether the psychological traits of ______ will dominate in any given situation. a: attachment or separateness b: representativeness or democracy c: representativeness or conservatism d: conservatism or liberalism

c: representativeness or conservatism

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because ______. a: debt reduces the cost of equity b: debt has the same cost as equity c: shareholders capture the interest tax shield d: shareholders prefer levered firms

c: shareholders capture the interest tax shield

If a firm has multiple projects, each project should be discounted using ______. a: the firm's overall cost of capital b: the marginal cost of capital for the latest project c: the average cost of capital d: a discount rate commensurate with the project's risk

d: a discount rate commensurate with the project's risk

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ______. a: guaranteed dividends b: collateral assets c: stock options d: a higher expected return

d: a higher expected return

If a firm increases its level of debt, its beta will ______. a: fall b: remain the same c: become unstable d: also increase

d: also increase

The WACC is the weighted average cost of ______ plus the weighted average cost of ______. a: capital; funds b: common stock; equity c: long-term debt; short-term debt d: debt; equity

d: debt; equity

A cyclical firm is one in which revenues go ______ in the contraction phase of the business cycle. a: all over b: up c: sideways d: down

d: down

An important advantage to a firm raising equity internally is not having to pay ______. a: capital gains b: dividends c: coupons d: flotation costs

d: flotation costs

An efficient market is one in which any change in available information will be reflected in the company's stock price ______. a: in a day b: in 2 days c: at least within a week d: immediately

d: immediately

If managers who want to issue equity believe the company's stock is overpriced, they are likely to ______. a: issue debt immediately b: wait until the stock is underpriced to issue equity c: do nothing at all d: issue equity immediately

d: issue equity immediately

True or false: If a firm stays in the same industry, its beta will never change. True false question.

False

True or false: Projects should always be discounted at the firm's overall cost of capital.

False

The difference between the expected return on the market portfolio and the risk-free rate is the market risk __________.

Premium

Typical financing decisions include ______ (select all that apply). a: the types of equity and debt to sell b: choosing between operating cash flow and financing cash flow c: when to sell equity and debt d: how much equity and debt to sell e: choosing between NPV and IRR

a: the types of equity and debt to sell c: when to sell equity and debt d: how much equity and debt to sell

One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future ______. a: when economic conditions change quickly b: when economic conditions are relatively stable

a: when economic conditions change quickly

The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its ______. a: reputation b: value c: market share d: capital structure

b: value

The covariance between the stock and the market index's returns divided by the variance of the market index's returns represents the _______ for a company's stock.

beta

A short sale occurs if the seller initially _____ the asset and then sells it.

borrows

A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio? a: 0.5 b: 1.5 c: 1 d: 2

c: 1

Which of the following is true about the WACC (Select all that apply)? a: The WACC will always increase if the level of debt in the capital structure increases. b: The WACC does not change over time. c: It represents the marginal cost of capital. d: It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems.

c: It represents the marginal cost of capital. d: It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems.

If you beat the market with inside information, you have violated the concept of ______ form efficiency. a: regressive b: semistrong c: strong d: weak

c: strong

The manager of a firm should change the capital structure if and only if ______. a: it benefits management b: the value of the debt exceeds the value of the equity c: the change will increase the value of the firm d: the change will decrease the value of the firm

c: the change will increase the value of the firm

The risk-free measure for the risk-free rate should be ______ the risk-free rate used for the market risk premium. a: greater than b: less than c: the same as

c: the same as

Financial leverage affects the performance of a firm because the range of possible values for ______. a: operating income is wider b: earnings per share is smaller c: operating income is smaller d: earnings per share is wider

d: earnings per share is wider

The use of fraudulent accounting methods can cause a company's stock price to ______. a: remain unchanged for decades b: invert along the cotangent c: be fairly priced d: exceed its fair value

d: exceed its fair value

Changes in _______ leverage and _______ leverage will affect beta.

financial, operating

_______ costs do not change as the quantity sold changes, while _______ costs do change as the quantity sold changes.

fixed, variable

A _____ sale occurs if the seller borrows the asset and then sells it.

short