Finance Exam 3
The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio? (A) 10.9% (B) 12.9% (C) 14.9%
(A) 10.9% (B) 12.9% The standard deviation of a portfolio is less than or equal to the weighted average of the standard deviations of the assets in the portfolio
In an efficient market (select all that apply): (A) All investments have NPV = 0 (B) Assets are priced at the present value of their future cash flows (C) It is easy to find stocks that are under- or over-valued
(A) All investments have NPV = 0 (B) Assets are priced at the present value of their future cash flows
The cost of capital (select all that apply): (A) Is an opportunity cost that depends on the use of the funds, not the source (B) Is the same thing as the required rate of return (C) Is the same as the WACC for projects with the same risk as the firm as a whole (D) Is different than the appropriate discount rate
(A) Is an opportunity cost that depends on the use of the funds, not the source (B) Is the same thing as the required rate of return (C) Is the same as the WACC for projects with the same risk as the firm as a whole
The Ibbotson-Sinquefield data shows that _______ (select all that apply): (A) Long-term corporate bonds had less risk of variability than stocks (B) Large-company stocks had higher returns than small-company stocks (C) Inflation was always higher than the U.S. T-bill yield (D) U.S. T-bills had the lowest risk or variability
(A) Long-term corporate bonds had less risk of variability than stocks (D) U.S. T-bills had the lowest risk or variability
A firm's cost of debt can be _____ (select all that apply) (A) Obtained by checking yields on publicly traded bonds (B) Calculated using the dividend growth model (C) Estimated easier than its cost of equity (D) Obtained by talking to investment bankers
(A) Obtained by checking yields on publicly traded bonds (C) Estimated easier than its cost of equity (D) Obtained by talking to investment bankers
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be: (A) Positive (B) Unimaginably large (C) Zero (D) Negative
(A) Positive
The growth rate of dividends can be found using (select all that apply): (A) Security analysts' forecasts (B) Historical dividend growth rates (C) The capital asset pricing model (CAPM) (D) The perpetuity model
(A) Security analysts' forecasts (B) Historical dividend growth rates
The rates of return in the Ibbotson-Sinquefield studies are not adjusted for which of the following? (A) Taxes (B) Inflation (C) Bond coupons (D) Dividends
(A) Taxes (B) Inflation
Ignoring taxes, if a firm issues debt at par, then (select all that apply): (A) The cost of debt is equal to its coupon rate (B) The cost of debt is equal to its yield-to-maturity (C) The cost of the debt differs from its current yield
(A) The cost of debt is equal to its coupon rate (B) The cost of debt is equal to its yield-to-maturity
Which of the following are potential problems associated with the use of the dividend growth model to compute the cost of equity? (A) The estimated cost of equity is sensitive to the estimated dividend growth rate (B) Everything needed for the model is directly observable except the current dividend (C) The approach explicitly considers risk
(A) The estimated cost of equity is sensitive to the estimated dividend growth rate
Which of the following are examples of information that may impact the risky return of a stock? (A) The outcome of an application currently pending with the FDA (B) The trend in sales growth over the last 10 years (C) The Fed's decision on interest rates at their meeting next week (D) Last year's net income as a percentage of sales and gross fixed assets
(A) The outcome of an application currently pending with the FDA (C) The Fed's decision on interest rates at their meeting next week Risky return is affected by information that will be revealed in the near future, not historical information
Which of the following is considered an advantage of using the SML approach to calculate the cost of equity? (A) This approach explicitly accounts for risk (B) This approach applies only to companies that pay dividends (C) This approach is not sensitive to estimates used as inputs in the model
(A) This approach explicitly accounts for risk
If a firm uses its overall cost of capital to discount cash flows from the higher risk projects, it will accept _____ projects. (A) too many high-risk (B) the optimal number of (C) only profitable
(A) too many high-risk
You need to compute the cost of equity capital for a firm that is traded on the NYSE. Which of the following would be least helpful to you? (A) The rate of return on stocks of similar risk (B) A copy of the Wall Street Journal from six months ago (C) An investment publication that provides an estimate of the firm's beta (D) An investment survey that projects future dividend growth rates for the firm (E) A data set containing dividends paid for the past ten years
(B) A copy of the Wall Street Journal from six months ago (this is stale info)
Which of the following are true (select all that apply)? (A) Book values are often similar to market values for equity (B) Book values are often similar to market values for debt (C) Ideally, we should use market values in the WACC (D) Ideally, we should use book values in the WACC
(B) Book values are often similar to market values for debt (C) Ideally, we should use market values in the WACC
Which of the following are ways to make money by investing in stocks (select all that apply): (A) Amortization (B) Capital gains (C) Interest (D) Dividends
(B) Capital gains (D) Dividends
According to the CAPM, which of the following events would affect the return on a risky asset? (A) A fire in the company's plant (B) Federal reserve actions that affect the economy (C) A change in the yield on T-bills (D) A change in the company's leadership (E) A strengthening of the country's currency
(B) Federal reserve actions that affect the economy (C) A change in the yield on T-bills (E) A strengthening of the country's currency
Kate Corp. has discovered a very secret new product, but hasn't yet announced the discovery to the public. If the stock price reacts before the announcement (assuming no corporate "leaks"), the market is: (A) Semi-strong form efficient (B) Strong form efficient (C) Weak form efficient
(B) Strong form efficient
A firm that uses its WACC as a cutoff without considering the risk involved in a project will (select all that apply): (A) Tend to become less risky over time (B) Tend to accept negative NPV projects over time (C) Likely see its WACC rise over time
(B) Tend to accept negative NPV projects over time (C) Likely see its WACC rise over time not (A) because companies get more risky after repeated wrong decisions on investments
Which of the following is true? (A) Under international tax law, all company interest payments are tax deductible to the company (B) Under U.S. tax law, a corporation's interest payments are tax deductible (C) Under international tax law, all company interest payments are tax deductible (D) Under U.S. tax law, all company interest payments are tax deductible to the company
(B) Under U.S. tax law, a corporation's interest payments are tax deductible
Advantages of using the SML approach as opposed to the dividend growth approach to estimate the cost of equity include (select all that apply): (A) We must estimate the firm's equity beta (B) We can adjust for differences in risk (C) A firm need not maintain a constant growth rate in dividends
(B) We can adjust for differences in risk (C) A firm need not maintain a constant growth rate in dividends (A) is a disadvantage
The best way to include flotation costs is to ____. (A) decrease the WACC and add them to the initial investment (B) add them to the initial investment (C) adjust the WACC upward
(B) add them to the initial investment
Preferred stock ______ (select all that apply) (A) does not pay dividends (B) pays a constant dividend (C) has a fixed maturity (D) pays dividends in perpetuity
(B) pays a constant dividend (D) pays dividends in perpetuity
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 are guaranteed for both preferred and common stockholders (C) Dividends to preferred stockholders are fixed (D) Dividends to common stockholders are not fixed
(C) Dividends to preferred stockholders are fixed (D) Dividends to common stockholders are not fixed
Which of the following is accurate regarding the dividend growth model approach to estimating the cost of equity capital? (A) A key disadvantage to this model is its low degree of complexity (B) The results from this model are not sensitive to changes in the dividend growth rate (C) One method of estimating future growth rates is the use of historical growth rates (D) The model works particularly well for companies who maintain a mostly unsteady growth in dividends (E) The model explicitly considers risk
(C) One method of estimating future growth rates is the use of historical growth rates
Aziz Equipment Co. invests in a group of risky projects that increase the unsystematic risk of the firm, but does not change the systematic risk of the firm. All else equal, the expected risk premium on its common stock will most likely: (A) Increase, because the gap between the expected return on the firm's stock and the risk-free rate widens (B) Decrease, because the gap between the expected return on the firm's stock and the risk-free rate narrows (C) Remain unchanged, because the expected return will not change since the level of systematic risk is unchanged
(C) Remain unchanged, because the expected return will not change since the level of systematic risk is unchanged
What does the variance measure (select all that apply)? (A) The square root of the standard deviation (B) The average of the sample of returns (C) The dispersion of the sample of returns (D) The riskiness of a security's returns
(C) The dispersion of the sample of returns (D) The riskiness of a security's returns
Your firm's common stock has a beta of 1.5. Which of the following is/are implied by this? (A) Your firm's common stock has a 50% higher expected return than the average stock (B) Given a market risk premium of 10%, the expected return on your firm's stock would be 15% (C) Your firm's common stock has 50% more systematic risk than the average stock
(C) Your firm's common stock has 50% more systematic risk than the average stock For A: your firm's common stock has a 50% higher RISK PREMIUM than the average stock For B: given a market risk premium of 10%, the RISK PREMIUM on your firm's stock would be 15%
Flotation costs are incurred to ______. (A) keep a firm in business (B) insure the payment due to bondholders (C) bring new security issues to the market (D) obtain a bank loan
(C) bring new security issues to the market
Suppose a firm uses a constant WACC in determining the value of capital budgeting projects, rather than using the SML. The firm will tend to _______. (A) Accept profitable, low risk projects and reject unprofitable, high risk projects (B) Accept profitable, low risk projects and accept unprofitable, high risk projects (C) Reject unprofitable, high risk projects (D) Become more risky over time (E) Accept profitable, low risk projects
(D) Become more risky over time it would reject profitable, low risk projects and accept unprofitable, high risk projects
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: (A) Accepted, as it should be (B) Accepted, when it should be rejected (C) Rejected, as it should be (D) Rejected, when it should be accepted
(D) Rejected, when it should be accepted if the project's beta is less than the firm's overall beta, its cost of capital will be less than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, leading to the possible rejection of a value creating project
The stock in Scoundrel Inc. shows a historical return of 13.5% with a standard deviation of 20%. The projected return on Scoundrel, based on 5 possible states of the economy, is 15.5% with a standard deviation of 22%. Which of the following is true about the stock? (A) The projected returns of Scoundrel must be positive in all possible states of the economy (B) Projected returns vary less widely from the expected return than historical returns did from historical average return (C) Investors who prefer investments with high returns and relatively low risk will likely now be more interested in the stock than in the past (D) The risk premium for the stock has likely increased (E) Investors who choose this stock should expect, on average, to lose money
(D) The risk premium for the stock has likely increased
If a firm has multiple projects, each project should be discounted using ___. (A) the marginal cost of capital for the latest project (B) the average cost of capital (C) the firm's overall cost of capital (D) a discount rate that commensurates with the project's risk
(D) a discount rate that commensurates with the project's risk
You are considering an investment project. You know that the cost of capital associated with the project depends on ______. (A) the total risk of the firm's equity (B) the type of security to be issued to finance the project (C) the type of assets needed for the project, that is, whether they are long-term or short-term assets (D) the risk associated with the project (E) the coupon rate on the firm's existing long-term bonds
(D) the risk associated with the project (A) would be right if it said SYSTEMATIC risk not TOTAL risk
Which of the following is NOT correct about the use of the dividend growth model to compute the cost of equity? (A) The estimated cost of equity is sensitive to the estimated dividend growth rate (B) The approach does not explicitly consider risk (C) The approach requires one to assume that the dividend growth rate will remain constant (D) The approach requires dividend growth become a constant rate at some point in the future (E) The approach works particularly well for firms that currently pay no dividends
(E) The approach works particularly well for firms that currently pay no dividends
You are looking at two different stocks. IBMOB has a beta of 1.25 and Microsquish has a beta of 1.95. Which statement is true about these investments? (A) IBMOB is a better addition to your portfolio (B) Microsquish is a better addition to your portfolio (C) The expected return on IBMOB will be the higher of the two (D) You cannot tell which of the two will have the higher expected return without further information (E) The stock in IBMOB should have the same reward to risk ratio as Microsquish
(E) The stock in IBMOB should have the same reward to risk ratio as Microsquish
Which of the following is true about trying to estimate a firm's cost of equity capital? (A) We have no model that will provide reasonable estimates (B) It is relatively easy to compute the firm's cost of debt and then back the cost of equity out of it (C) The cost of equity is equal to the weighted average cost of capital (D) The cost of equity depends on the total risk of the firm's equity (E) There is no way to directly observe the return required by the firm's equity investors
(E) There is no way to directly observe the return required by the firm's equity investors
What does a beta of 1, >1, and <1 imply in regards to the systematic risk of an asset?
- A beta of 1 implies the asset has the same systematic risk as the overall market - A beta < 1 implies the asset has less systematic risk (safer) than the overall market - A beta > 1 implies the asset has more systematic risk than the overall market
What are some examples of unexpected information that might contribute to uncertain return?
- News about the company's research - Government figures released on GDP - The results from the latest arms control talks - The news that the company's sales figures are higher than expected - A sudden, unexpected drop in interest rates
What are some examples of unsystematic risk?
- The discovery of positive NPV projects such as successful new products and innovative cost savings --> increase value of the stock - Unanticipated lawsuits, industrial accidents, strikes, and similar events --> decrease future cash flows and reduce share values
When might problems arise when using the WACC to evaluate investments?
- When the investments have risks that are substantially different from those of the overall firm - In a corporation with more than one line of business (having different levels of risk)
What is the risk-free asset's beta?
0
A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's floatation costs?
0.5
What is the beta of the market portfolio?
1
According to the WACC formula, a firm with no debt or preferred stock will have a WACC of what?
1 x cost of equity
Assuming all weights are positive... 1) Can the return on the portfolio ever be lower than the lowest return on an individual security in the portfolio? 2) Can the variance of the portfolio ever be less than the lowest variance of an individual security in the portfolio?
1) No 2) Yes
The return on investment will usually have two components. What are they?
1. Income component: you may receive some cash directly while you own the investment 2. The capital gain (or loss) component: the value of the asset you purchase will often change
What are the advantages of the SML approach for cost of equity?
1. It explicitly adjusts for risk 2. It is applicable to companies other than just those with steady dividend growth
What are the disadvantages of the SML approach for cost of equity?
1. It requires that two things be estimated: the market risk premium and the beta coefficient - To the extent that our estimates are poor, the resulting cost of equity will be inaccurate 2. We essentially rely on the past to predict the future - Economic conditions can change quickly; so as always, the past may not be a good guide to the future
What are the disadvantages of the dividend growth model approach for cost of equity?
1. Only applicable to companies that pay dividends - Even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate (this will never exactly be the case) 2. The estimated cost of equity is very sensitive to the estimated growth rate - For a given stock price, an upward revision of g by just one percentage point increases the estimated cost of equity by at least a full percentage point - Because D1 will probably be revised upward as well, the increase will actually be somewhat larger than that 3. The approach really does not explicitly consider risk - There is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends
What does capital market history say about market efficiency?
1. Prices appear to respond rapidly to new information, and the response is at least not grossly different from what we would expect in an efficient market 2. The future of market prices, particularly in the short run, is difficult to predict based on publicly available information 3. If mispriced stocks exist, then there is no obvious means to identifying them -- simpleminded schemes based on public info will probably not be successful
The return on any stock traded in a financial market is composed of two parts. What are they?
1. The normal (expected) return from the stock that depends on the information shareholders have that bears on the stock 2. The uncertain (risky) return that comes from unexpected information revealed within the year
What are the three things the CAPM depends on?
1. The pure time value of money 2. The reward for bearing systematic risk 3. The amount of systematic risk
What are the three things that the required (or expected) return on a risky investment depends on?
1. The risk-free rate 2. The market risk premium 3. The beta coefficient
What are the three parts of the systematic risk principle?
1. There is a reward for bearing systematic risk 2. There is not a reward for bearing risk unnecessarily 3. The expected return on a risky asset depends only on that asset's systematic risk since unsystematic risk can be diversified away
What are the two ways to estimate g, the growth rate?
1. Use historical growth rates 2. Use analysts' forecasts of future growth rates
What is an average asset's beta?
1.0
Long-term corporate or government bonds are based on high-quality bonds with _____ years to maturity?
20
What is a pure play firm?
A company that focuses on a single line of business
What is the capital asset pricing model (CAPM)?
A model of the relationship between expected risk and expected return
What is a market portfolio?
A portfolio made up of all the assets in the market
What is a strong form efficient market?
All information of every kind is reflected in stock prices; there is no such thing as inside information
What is a semi-strong form efficient market? What does it imply?
All public information is reflected in the stock price Implies that a security analyst who tries to identify mispriced stocks using, for example, financial statement information, is wasting time because that information is already reflected in the current price
What is a weak form efficient market? What does it imply?
At minimum, the current price of a stock reflects the stock's own past prices It implies that searching for patterns in historical prices that will be useful in identifying mispriced stocks will not work
Why is the cost of issuing debt often cheaper than the cost of issuing equity?
Because bondholders tend to be more concentrated
How can a positive relationship between the expected return on a security and its beta be justified?
Because the difference between the return on the market and the risk-free rate is likely to be positive
If you are forecasting a few decades into the future, you should use what?
Blume's formula
Does the CAPM only work for individual assets or does it also work for portfolios of assets?
Both
How do you determine whether an investment has a positive NPV?
Compare the expected return on that new investment to what the financial market offers on an investment with the same beta
The dividend growth model for the cost of equity capital can be estimated using three pieces of information: D0, P0, and g. Which of these can be observed directly from a publicly traded company?
D0 and P0
What can substantially reduce the variability of returns without an equivalent reduction in expected returns?
Diversification
In situations where using the firm's WACC inappropriately leads to problems, how can we come up with appropriate discount rates?
Examine other investments outside the firm that are in the same risk class as the one we are considering and use the market required return on these investments as the discount rate Or, if we are considering a new line of business, we would try to develop the appropriate cost of capital by looking at the market-required returns on companies already in that business
True or False: If the standard deviation of return on the stocks of the Dow Jones Industrial Average has been approximately 24% per year over the last decade, it must be true that half of the firms in the DJIA have a standard deviation of return below 24% over the same period.
False
True or False: If the total risk of firm X is greater than that of firm Y, then the beta of firm X must be greater than that of firm Y
False
True or False: Variance of a portfolio is generally a simple combination of the variances of the assets in the portfolio
False
True or False: efficient markets imply that investors cannot earn a positive return in the stock market
False
True or False: For a well-designed portfolio, all the risk is essentially unsystematic risk
False - the unsystematic risk is negligible; all the risk is essentially systematic risk
True or False: Systematic risk will impact all securities in every portfolio equally
False - while it is possible, it is highly unlikely that systematic risk (such as changes in interest rates) will affect all firms equally
True or False: Suppose that new information regarding future inflation in the U.S. causes investors to become less risk averse. The SML approach indicates that, all else equal, most firms will see their cost of capital increase.
False -- decrease
True or False: If you invest in stocks with higher-than-average betas, you are certain to earn higher-than-average returns over the next year
False -- expected return does not equal realized return
True or False: the best way to adjust for the existence of flotation costs is to add their percentage costs to the WACC
False -- it is to adjust the initial investment cost and then add to the WACC??
True or False: It is NOT possible to construct a portfolio with zero variance of expected returns from assets whose expected returns have positive variance individually
False -- it's possible because the variance can be negative
True or False: No matter how much total risk an asset has, only the unsystematic portion is relevant in determining the expected return on that asset
False -- only the systematic portion is relevant
True or False: The effect of flotation costs is to increase the computed NPV of any given project.
False -- the effect is to decrease the computed NPV
True or false: the market cannot be efficient because stock prices fluctuate from day to day
False. Price movements are in no way inconsistent with efficiency. The fact that prices fluctuate is a reflection of the constant flow of information.
True or False: To a diversified investor, only unsystematic risk matters
False: only systematic risk matters
When we look at an entire company, we will often see an interest deduction because the company has borrowed money. Is this a financing cost or an operating cost? Does this affect the company's tax bill?
Financing cost Yes - the tax bill is lower because interest paid is tax deductible
What is the only way to benefit the shareholders when making investments as a firm? Why?
Finding investments with expected returns that are superior to what the financial markets offer for the same risk Such investments will have a positive NPV This is because shareholders can always invest for themselves in the financial markets
When is the difference between geometric average returns and arithmetic average returns largest?
For more volatile investments
Which will always be smaller than the other: geometric average returns or arithmetic average returns?
Geometric average returns
What does volatility of a return measure?
How much the actual return deviates from the average return in a typical year
Why must the reward-to-risk ratio be the same for all the assets in the market?
If one asset has a higher reward-to-risk ratio than another, investors will be attracted to that asset, and its price would rise while the other's price will fall. Therefore, buying and selling would continue until the two assets plotted on exactly the same line, meaning they offer the same reward for bearing risk.
In an efficient market, why is NPV zero for investments?
If prices are neither too low nor too high, then the difference between the market value of an investment and its cost is zero. As a result, investors get exactly what they pay for when they buy securities, and firms receive exactly what their stocks and bonds are worth when they sell them.
What is the WACC decision rule?
If the project has a negative NPV using the firm's WACC, reject the project because the financial markets offer superior projects in the same risk class If the project has a positive NPV using the firm's WACC, accept the project
What does the risk-appropriate WACC indicate?
If you have a riskier project, it will have a higher required return If you have a less risky project, it will have a lower required return
The probability of a recession is 50% and the probability of a boom is 50%. Stock L has a rate of return of -20% in a recession and 70% in a boom. What does this mean?
If you hold Stock L for a number of years, you'll lose 20% half of the time and earn 70% the other half.
Which average (geometric or arithmetic) do you use when forecasting future wealth levels?
If you know the true arithmetic average return, then this is what you should use in your forecast We usually have only estimates of the returns (which have errors), so the arithmetic average is probably too high for longer periods and the geometric average is probably too low for shorter periods So, use Blume's formula (a combination of the two averages)
What does it mean for information to be "priced out"?
In an efficient market, the price of a stock is "fair" because it reflects the value of the stock given the information available to the firm
Which of the following are deductible for tax purposes? (A) Interest paid by a corporation (B) Payments to stockholders (such as dividends)
Interest paid by a corporation is tax deductible Since dividends are not, this means that the government pays some of the interest
How does a firm fund a project?
Issues (sells) debt, equity, preferred stock, or a combination of the three
If an asset has a beta of 0.5, what is its systematic risk compared to an average asset?
It has half as much systematic risk as an average asset
How can you estimate the cost of preferred stock?
It is equal to the dividend yield on the preferred stock Or, you can observe the required returns on other, similarly rated shares of preferred stock
If a security's expected return is equal to the risk-free rate of return, and the market-risk premium is greater than zero, what can you conclude about the value of the security's beta based on CAPM?
It is equal to zero E(Ri) = Rf + betai (Rm - Rf) --> betai = 0
In CAPM, what is the amount of systematic risk? What is measured by?
It is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset It is measured by beta
In CAPM, what is the pure time value of money? What is it measured by?
It is the reward for merely waiting for your money, without taking any risk It is measured by the risk-free rate
In CAPM, what is the reward for bearing systematic risk? What is it measured by?
It is the reward the market offers for bearing an average amount of systematic risk in addition to waiting It is measured by the market risk premium
When dealing with the history of capital market returns, why is an average stock market return is useful?
It simplified detailed market data and is the best estimate of any one year's stock market return during the specified period
What are the advantages of the dividend growth model approach for cost of equity?
Its simplicity -- it is easy to understand and use
An investment will have a negative NPV when its expected return is (equal to; greater than; less than) what the financial markets offer for the same risk
Less than
How do you determine the required return on a risk-free project?
Look at the capital markets and observe the current rate offered by risk-free investments --> use this rate to discount the project's cash flows
What are other names for systematic risk?
Market risk; nondiversifiable risk
What is the logical consequence of a lot of information gathering and analysis in an efficient market?
Mispriced stocks will become fewer and fewer
Is it desirable to hold on to a security that has a negative beta?
Negative beta stocks are considered insurance stocks If disaster hits, the market crumbles, but your stock will be okay If nothing happens in the market, you will be at a negative beta (kinda like being at negative cash outflow because of insurance payments)
The standard deviation of the annual return on a portfolio of 500 large common stocks has historically been about 20%. Does this mean that the standard deviation of the annual return on a typical stock in that group of 500 is about 20%?
No
Can systematic risk be eliminated by diversification?
No, because a systematic risk affects almost all assets to some degree
Are all betas created equal?
No, different providers use somewhat different methods for estimating betas, and significant differences sometimes occur
Are the following portfolios adjusted for inflation or taxes? Large-company stocks Small-company stocks Long-term corporate bonds Long-term U.S. government bonds U.S. Treasury bills
No, they are nominal, pre-tax returns
In any given year, the unexpected return will be _______. Through time, the average value of U will be ______.
Positive or negative; zero
What does the Sharpe ratio measure?
Reward per unit of Risk
In 2008, what happened to stocks and bonds?
Stock prices were highly volatile; many of them tanked Long-term treasuries and corporate bonds went up The rate of inflation was essentially zero
The average return on the stock market can be used to compare what?
Stock returns with the returns on other securities
What is preferred stock?
Stock that gets paid dividends first It has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity
Describe an example of the pure play approach
Suppose McDonald's decides to enter the cell phone and tablet business with a line of electronics called McPhones. The risks involved are quite different from those in the fast-food business. As a result, McDonald's would need to look at companies already in the consumer electronics business to compute a cost of capital for the new division. An obvious pure play candidate is Apple. Samsung would not be a good choice because it sells more product lines.
What is the difference between systematic and unsystematic risk?
Systematic risk affects almost all assets in the economy, at least to some degree while unsystematic risk affects at most a small number of assets
Why is the coupon rate on the firm's outstanding debt irrelevant in determining cost of debt?
That rate tells us roughly what the firm's cost of debt was back when the bonds were issued, not what the cost of debt is today
Why is it more convenient to summarize information about returns in percentage terms, rather than dollar terms?
That way your return doesn't depend on how much you actually invest
What is risk premium?
The "extra" return earned for taking on risk; the return over and above the risk-free rate; the reward for bearing risk
What is commonly used to measure inflation?
The Consumer Price Index (CPI)
Which Act placed limitations on the amount of interest that can be deducted in certain situations?
The Tax Cuts and Jobs Act of 2017
If we were evaluating the cash flows from a proposed expansion of our existing operations, which discount rate would we use?
The WACC
What does it mean if the market has "discounted" an announcement?
The announcement isn't news; it has less of an impact on the price because the market already knew much of it
Say we have two stocks, L and U. Stock L is expected to have a return of 25% and Stock U is expected to have a return of 20% in the coming year. Why would anyone want to hold Stock U?
The answer depends on the risk of the two investments. The return on Stock L, although it is expected to be 25%, could actually turn out to be higher or lower.
Unlike a firm's cost of equity, its cost of debt can normally be observed either directly or indirectly. How would you observe it indirectly?
The cost of debt is the interest rate the firm must pay on new borrowing, so we can observe interest rates in financial markets If the firm has bonds outstanding, then the yield to maturity on those bonds is the market-required rate on the firm's debt
What is the expected return on a security with a beta of 1?
The expected return on the market
Suppose shareholders have predicted the GDP increase to be 0.5%, but the government announces that the actual GDP increase has been 1.5%. What do you call this difference between the actual result and the forecast?
The innovation or the surprise
What does it mean when we say that the required return on an investment is 10%?
The investment will have a positive NPV only if its return exceeds 10%. 10% is the cost of capital associated with the investment
What is the appropriate discount rate on a new project?
The minimum expected rate of return an investment must offer to be attractive -- also called the cost of capital
What is nondiversifiable risk?
The minimum level of risk that cannot be eliminated by diversifying
The CAPM assumes that T-bills are risk-free. In reality, they're not quite risk-free. Why?
The model holds true for "future beta"; to the extent that "historic beta" is not a good estimator The model assumes that investors can borrow and lend at the same rate, and that there are no limitations on short-selling The market portfolio is unobservable -- we have to use proxies, such as the S&P 500
What is capital structure?
The particular mixture of debt and equity a firm chooses to employ
What are capital structure weights?
The percentages of the total capital represented by the debt and equity E/V, P/V, and D/V
What is an overreaction in the market?
The price overadjusts to the new information; it overshoots the new price and subsequently corrects
What is a delayed market reaction?
The price partially adjusts to the new information; there is an elapse before the price completely reflects the new information
What is the Security Market Line (SML) used to describe?
The relationship between systematic risk and expected return in financial markets
Why is the minimum required return called the cost of capital?
The required return is what the firm must earn on its capital investment in a project just to break even It can be interpreted as the opportunity cost associated with the firm's capital investment
What is the systematic risk principle?
The reward for bearing risk depends only on the systematic risk of an investment Because unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it
What are the two components of the expected return on the market (Rm)?
The risk premium and the risk-free rate Since the market's beta is 1, it really doesn't affect the expected return on the market
What is the cost of capital for a risk-free investment?
The risk-free rate
According to the CAPM, what is the expected return on a security with a beta of zero?
The risk-free rate of return E(R) = Rf + 0 x market risk premium
If two divisions in one firm were competing for resources, and the firm used a single WACC as a cutoff, which division would tend to be awarded greater funds for investment?
The riskier division because they have greater returns
Does the cost of capital depend primarily on the use of funds or the source of the funds?
The use of funds
What is an asset's "alpha" in regards to the Security Market Line?
The vertical distance between an asset's expected return and the SML
Of all the government bonds, which have the shortest time to maturity?
Treasury bills
True or False: Divisions often require separate discount rates
True
True or False: The cost of capital associated with an investment depends on the risk of that investment
True
True or False: highly diversified portfolios will tend to have almost no unsystematic risk
True
True or False: relevant information known today is reflected in the expected return?
True
True or False: the expected return (and risk premium) on an asset depends only on that asset's systematic risk
True
True or False: the reward-to-risk ratio should be the same for every asset as it is for the market because they all fall along the SML
True
True or False: The market value of a firm that invests only in projects equally as risky as the firm as it exists and providing a return equal to its WACC will not change over time
True IRR = WACC --> NPV = 0
True or False: An example of systematic risk would be if the stock of airlines dropped after two airplanes crashed on the same day making many passengers too nervous to fly
True -- possibly the airlines, hotels, and other related industries would be affected, so it is systematic risk
If Stock L has a higher expected return, but Stock U has less risk, which should you buy?
We can't really say; it depends on your personal preferences
When will the use of firm WACC as the discount rate be appropriate for evaluating projects?
When the new projects has similar risk characteristics to those already in the firm
Why does diversification result in a reduction in risk for a portfolio?
Worse than expected returns from one asset are offset by better than expected returns from another
Is it possible for the percentage invested in an asset to exceed 100%?
Yes - this can happen if the investor borrows at the risk-free rate
Can you have a beta that is negative?
Yes -- it just means that you are borrowing money A -1 beta means that you are borrowing 100% this is a short position
Does the CAPM work in real life?
Yes, returns are strongly related with beta of pre-1982 data and returns are not related to firm-specific risk But... this relationship is much weaker on post-1982 data. Other variables (size, book-to-market, etc.) yield better explanatory power
How do you measure cost of equity?
You can't directly observe it, so you have to estimate it by either using the dividend growth model approach or the security market line approach
What will be the cost of incorrectly using firm WACC to evaluate new projects?
You run into the risk of incorrectly accepting/rejecting a project
What is the 40/60 rule?
You should invest 60% of wealth in the stock market portfolio and 40% of your wealth in a bond market portfolio. As you approach retirement age, you want to invest more assets in the risky stock market than the long-term but safe bond market
If we are determining the discount rate appropriate to cash flows, is the discount rate expressed on a pre-tax or after-tax basis?
after-tax
Blume's formula says that if you are forecasting up to a decade or so into the future, then you should use what?
arithmetic average
What do you need to calculate to answer this question: "What was your return in an average year over a particular period?"
arithmetic average return
Why is the debt represented by T-bills have risk-free return?
because the government can always raise taxes to pay its bills
Based on standard economic models, it has been argued that the historical risk premium is too (big/small) and is an (overestimate/underestimate) of what is likely to happen in the future
big; overestimate
Dividends paid to commons stockholders (can/cannot) be deducted from the payer's taxable income for tax purposes
cannot
WACC is used to discount what?
cash flows
What makes a market efficient?
competition among investors
The standard deviation (increases/declines) as the number of securities in a portfolio increases
declines
If the new projects are significantly less risky than those already in the firm, which way do you adjust the firm WACC?
downward
The return an investor in a security receives is (equal to/less than/greater than) the cost of the security to the company that issued it
equal to
The difference between the return on T-bills and the return on common stocks can be interpreted as a measure of the _________ on the average risky asset
excess return
If Stock B is overvalued relative to Stock A, you would expect to see its price (rise/fall) relative to Stock A's price.
fall
An important advantage to a firm raising equity internally is not having to pay ______.
flotation costs
What are some examples of systematic risk?
general economic conditions such as GDP, interest rates, or inflation
Blume's formula says that if you are forecasting many decades into the future, then you should use what?
geometric average
What do you need to calculate to answer this question: "What was your average compound return per year over a particular period?"
geometric average return
The higher the beta, the (less/greater) the risk premium should be
greater
Assets with larger betas have (greater/less) systematic risks and (greater/less) expected returns
greater; greater
If a project is risky, assuming that all the other information is unchanged, the required return is (higher/lower). The cost of capital is (greater/less) than the risk-free rate. The appropriate discount rate is (greater/less) than the risk-free rate.
higher; greater; greater
An asset is said to be overvalued when?
if its price is too high given its expected return and risk
Does the absence of price movements suggests inefficiency or efficiency?
inefficiency
More volatility in returns produces a (larger/smaller) difference between the arithmetic and geometric averages.
larger
Is the geometric average growth rate usually higher or lower than the arithmetic average growth rate?
lower
The portfolio return is (higher/lower) than the individual best performer.
lower it is also higher than the individual worst performer
Do companies use book values or market values for debt in WACC calculations?
market values if book values are used, it is because they are similar to market values, but this can lead to trouble
The bigger the variance is, the (more/less) the actual returns tend to differ from the average return
more
U.S. Treasury bills have ______ maturity
one-month maturity
Projects that sit below the SML are (overvalued/undervalued) with a (positive/negative) NPV, so we should (reject/accept)
overvalued; negative; reject
Variance is measured in _________, while standard deviation is measured in _________.
percent squared; percent
Based on the CAPM, there is generally a (positive/negative) relationship between beta and the expected return on a security
positive
Expected returns are based on the probabilities of what?
possible outcomes
The CAPM can be used to estimate the ______.
required return on equity
How does the government borrow money?
selling bonds
Blume's formula says that if you are forecasting a few decades into the future (ex: retirement planning), then you should use what?
split the difference between the arithmetic and geometric average
the larger the variance or standard deviation is, the more _________ the returns will be
spread out
What is the principle of diversification?
spreading an investment across a number of assets will eliminate some, but not all, of the risk
To apply the dividend growth model to a particular stock, what do you have to assume?
that the firm's dividend will grow at a constant rate
What stock portfolio are large-company stocks based on?
the S&P 500 index (contains 500 of the largest U.S. companies in terms of total market value of outstanding stock)
What is the beta coefficient?
the amount of systematic risk present in a particular risky asset relative to that in an average asset
What is variance?
the average squared difference between the actual returns and the average return
How do we measure systematic risk?
the beta coefficient
The return an investor in a security receives is the cost of that security to whom?
the company that issued it
What is the slope of the security market line (SML)?
the market risk premium
What is the cost of capital?
the minimum required return on a new investment
What is the weighted average cost of capital (WACC)?
the minimum return a company needs to earn to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders, to maintain the value of its stock It is also the required return on any investments by the firm that have essentially the same risks as existing operations
What is an efficient market reaction?
the price instantaneously adjusts to and fully reflects new information; there is no tendency for subsequent increases and decreases to occur
What is diversification?
the process of spreading an investment across assets (and thereby forming a portfolio)
What is the security market line (SML)?
the relationship between risk and return it tells us the "going rate" for bearing risk in the economy
What is risk-free return?
the return on debt that is essentially free of any default risk over its life
What is cost of equity?
the return required by equity investors given the risk of the cash flows from the firm
What is the cost of debt?
the return the firm's creditors demand on new borrowing
What is the intercept of the security market line (SML)?
the risk-free rate
What stock portfolio are small-company stocks based on?
the smallest 20% of the companies listed on the NY Stock Exchange (as measured by market value of outstanding stock)
How do you measure total risk?
the standard deviation of returns
What is a firm's total capitalization?
the sum of its long-term debt and equity
The total risk for a diversified portfolio is essentially equivalent to what?
the systematic risk
What are flotation costs?
the transaction cost incurred when a firm raises funds by issuing a particular type of security
True or False: Risky assets, on average, earn a risky premium
true
In reality, is equity generated internally or externally?
typically, it is generated internally (cash flows are sufficient to cover the equity portion of their capital spending)
The greater the volatility of an asset, the greater the ________ of its returns?
uncertainty
Projects that sit above the SML are (overvalued/undervalued) with a (positive/negative) NPV, so we should (reject/accept)
undervalued; positive; accept
What are some other names for unsystematic risk?
unique risk; asset-specific risk; diversifiable risk
Which type of risk can you diversify away?
unsystematic risk
If the new projects are significantly more risky than those already in the firm, which way do you adjust the firm WACC?
upward
What are the most commonly used measures of volatility?
variance and standard deviation
What does the efficient markets hypothesis (EMH) state?
well-organized capital markets, such as the NYSE, are efficient markets -- although inefficiencies may exist, they are relatively small and uncommon
A new project will have a positive NPV only if its returns exceed what?
what the financial markets offer on investments of similar risk
If you are investing more and more in safe (bond) assets, you move (up/down) the SML and your beta (increases/decreases)
you move down toward the risk-free asset beta decreases
What is a risk-free asset's beta?
zero
