Finance Exam 3
________ is the process of evaluating and selecting long−term investments that are consistent with a firm's goal of maximizing owners' wealth.
Capital budgeting
Mutually Exclusive Projects
Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function
Independent Projects
Projects whose cash flows are unrelated to (or independent of) one another; accepting or rejecting one project does not change the desirability of other projects
Which of the following is true of risk?
Risk is a measure of the uncertainty surrounding the return that an investment will earn.
According to the CAPM, what is the only reason that some stocks have higher expected returns than others?
Stocks differ in the extent to which they are sensitive to market risk.
Projects A and B both require an initial investment of $100,000. Project A produces $200,000 in cash flows in the subsequent 5 years. Project B produces cash flow of $400,000 next year, $300,000 in year 2, $200,000 in year 3, and$50,000 in years 4 and 5. Which of the following is true?
The NPV of project A will be more sensitive to changes in the cost of capital compared to the NPV of project B.
Which of the following statements is correct for a given company?
The cost of equity is greater than the cost of debt.
Accept-Reject Approach
The evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion
Capital Rationing
The financial situation in which a firm has only a fixed number of dollars available for capital expenditures and numerous projects compete for these dollars
- Unlimited Funds
The financial situation in which a firm is able to accept all independent projects that provide an acceptable return
Capital Budgeting
The process of evaluating and selecting long-term investments that contribute to the firm's goal of maximizing owners' wealth/benefit
Ranking Approach
The ranking of capital expenditure projects on the basis of some predetermined measure, such as how much value the project creates for shareholders
corporate governance
The system of controls, regulations, and incentives designed to minimize agency costs between managers and investors and prevent corporate fraud
Foreign Direct Investment
The transfer of capital, managerial, and technical assets to a foreign country
beta coefficient
a measure of nondiversifiable risk. -index of the degree of movement of an asset's return in response to a change in the market return
. Capital rationing prevents the company from _____.
funding all positive NPV projects
The lower the correlation between asset returns, the ________.
greater the potential diversification of risk
A beta coefficient of +1 represents an asset that ________.
has the same expected return as the market portfolio
Sunk costs are costs that _____.
have been incurred in the past and cannot be recouped fully
When capital is limited, we should generally accept the project with a profitability index that is _____.
highest
the board of directors does what?
hires the executive team, sets its compensation, approves major investments and acquisitions, and dismisses executives if necessary.
A corporation that uses both debt and equity in its capital structure has concluded that the risk premium it must pay on its common stock is too high. To decrease this, the firm can ________.
increase the proportion of common stock equity to decrease financial risk
Recently the corporate tax law in the U.S. changed so that firms that previously faced a marginal tax rate of close to40% now pay tax at a flat rate of 21%. Holding everything else constant, this reduction in the tax rate faced by corporations
increased the after−tax cost of debt
Financial leverage _____.
increases gains and losses
An increase in the Treasury Bill rate ________.
increases the required rate of return of a common stock
The ________ is the compound annual rate of return that a firm will earn if it invests in the project and receives the given cash inflows.
internal rate of return (IRR)
IRR-Rule:
invest when the IRR of a project exceeds the cost of capital
The beta associated with a risk−free asset ________.
is equal to zero
The yield to maturity is a good estimate of the before−tax cost of debt for a firm that ________,
issues investment−grade bonds
Thinking in terms of the goal of wealth maximization, a project breaks even for shareholders, meaning that it neither creates nor destroys value, if ________.
its NPV equals 0
Thinking in terms of the goal of wealth maximization, a project breaks even for shareholders, meaning that it neither creates nor destroys value, if ________.
its NPV equals 0
For a firm without long-term debt or preferred stock, its weighted average cost of capital will be equal to _____.
its cost of equity
When discussing weighing schemes for calculating the weighted average cost of capital, ________.
market value weights are preferred over book value weights
Comparing net present value and internal rate of return ________.
may give different accept−reject decisions
The optimal capital structure maximizes the value of the firm, which is the same as _____.
minimizing the cost of capital
The term capital structure refers to the company's
mix of debt and equity
Which capital budgeting method is most useful for evaluating a project that has an initial after−tax cost of $5,000,000 and is expected to provide after−tax operating cash flows of $1,800,000 in year 1, ($2,900,000) in year 2, $2,700,000 in year 3, and $2,300,000 in year 4?
net present value
Systematic risk is also referred to as ________.
nondiversifiable risk
War, inflation, and the condition of the foreign markets are all examples of ________.
nondiversifiable risk
capital asset pricing model (CAPM) links
nondiversifiable risk to expected returns
Cash flows that could be realized from the best alternative use of an owned asset are called ________.
opportunity costs
Which of the following capital budgeting techniques ignores the time value of money?
payback period approach
The ________ of a given outcome is its chance of occurring.
probability
The purpose of adding an asset with a negative or low positive beta to a portfolio is to ________.
reduce risk
If an investor prefers investments with greater risk even if they have lower expected returns, then he could be called a________ investor.
risk-seeking
If an investor prefers an investment with a higher expected return regardless of its risk, then he could be called a________ investor.
risk−neutral
The graphical representation of the CAPM is called the _____.
security market line
Which of the types of investments below has the highest standard deviation based on historical data in the U.S?
stocks issued by smaller companies
Cash outlays that had been previously made and have no effect on the cash flows relevant to a current decision are called ________.
sunk costs
. Beta measures the _____.
systematic or market risk of a stock
When the market values of a firm's securities have been changing dramatically, the firm may want to calculate its WACC based on ________
target weights
When the market values of a firm's securities have been changing dramatically, the firm may want to calculate its WACC based on ________.
target weights
When a company takes on more and more debt, _____.
the benefits of debt will eventually be offset by the cost of bankruptcy
In calculating the cost of common stock equity, the model which describes the relationship between the required return and the nondiversifiable risk of the firm is ________.
the capital asset pricing modelthe capital asset pricing model
You are thinking about going to graduate school to earn a masters degree, which you hope will allow you to earn more money. Which of the following is NOT an incremental cash flow associated with your decision to extend your schooling versus going into the workforce when you finish your undergraduate degree?
the cost of living expenses, such as rent and food, while you are in graduate school
When evaluating a capital budgeting project, installation costs of a new machine must be considered as part of________.
the initial cash flow
The analysis of an investment project is most likely to include a terminal value calculation when ________.
the project has an unlimited life
The cost of common stock equity is ________.The cost of common stock equity is ________.
the rate at which investors discount the expected dividends of the firm to determine its share valuev
In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment.
the weighted average cost of all financing sources
In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment.
the weighted average cost of all financing sources
Two assets have a correlation coefficient of −1.0. If you combine these two assets in a portfolio ________.
there will be some combination of the two assets that produces a portfolio with no risk at all
A certain firm originally had capital structure weights of 50% debt and 50% common equity. Since establishing thoseweights, the firm's stock price has risen dramatically. The firm has done no additional borrowing. Assume that nothing else in the economy has changed (e.g., interest rates, tax rates, and other macroeconomic factors remain constant). Because the firm's stock price has increased a great deal, ________.
the firm's cost of equity has decreased
In U.S., during the past 120 years, on average the return on common stocks has exceeded the average return on Treasury bonds.
true
In order to recognize the interrelationship between financing and investments, a firm should use ________ when evaluating an investment
yield to maturity
Capital Budgeting Process
- Consists of five distinct but interrelated steps: proposal generation, review and analysis, decision making, implementation, and follow-up
Why is there dispersed ownership?
- Diversification - Wealth of individuals is low compared to investment size of projects - Liquidity: a larger stake is harder to sell
Capital Budgeting Techniques
- To ensure that the investment projects a firm selects have the best chance of increasing the value of the firm, financial managers need tools to help them evaluate the merits of individual projects and to rank competing investments - A number of techniques are available for performing such analyses - The best techniques take into account the time value of money as well as the tradeoff between risk and return - Project evaluation methods that fail to account for money's time value or for risk may not lead to shareholder value maximization
Using the internal rate of return approach to ranking projects, which project(s) should the firm accept? (See Table 10.4)
1, 2, 3, and 5
Nicole holds three stocks in her portfolio: A, B, and C. The portfolio beta is 1.40. Stock A comprises 15 percent of the dollar value of her holdings and has a beta of 1.0. If Nicole sells all of her investment in A and invests the proceeds in the risk−free asset, her new portfolio beta will be ________.
1.25
Investment A guarantees its holder $100 return. Investment B earns $0 or $200 with equal chances (i.e., an average of$100) over the same period. Both investments have equal risk.
False
Which of the following statements is true of payback period?
If the payback period is less than the maximum acceptable payback period, accept the project.
Which of the following is true regarding an NPV profile?
It charts the net present value of a project as a function of the cost of capital.
What is a disadvantage of using NPV analysis for capital budgeting?
It ignores real options
Which decision criterion leads most consistently to the correct decision?
NPV
The IRR is the discount rate that _____.
NPV to 0
A firm is evaluating two projects that are mutually exclusive with initial investments and cash flows as follows: If the firm in Table 10.3 has a required payback of two years, it should ________.
accept Project A and Project B
We use the _____ cost of debt in the calculation of the weighted average cost of capital since interest payments _____.
after-tax; are tax deductible
Scenario Analysis
an approach that uses several possible alternative outcomes (scenarios) to obtain a sense of the variability of returns, measured here by NPV -getting a feel for the variability of return in response to changes in a key outcome
Risk aversion is the behavior exhibited by investors who require ________.
an increase in return, for a given increase in risk
An increase in the beta of a corporation, all else being the same, indicates ________.
an increase in risk, a higher required rate of return, and hence a lower share price
all else being the same, what effect does increasing risk have on the value of the stock?
by increasing risk of cash flows received from an asset, the required rate of return increases, which reduces the value of the asset
Unsystematic risk ________.
can be eliminated through diversification
The ________ describes the relationship between nondiversifiable risk and the required rate of return.
capital asset pricing model
A $60,000 outlay for a new machine with a usable life of 15 years is called ________.
capital expenditure
An increase in nondiversifiable risk would ________.
cause an increase in the beta and would increase the required return
________ is a statistical measure of the relationship between any two series of numbers.
correlation
The ________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.
cost of capital
Debt is generally the least expensive source of capital. This is primarily due to ________.
debt being less risky than equity and interest payments being tax deductible
A firm finances its activities with both debt (that costs 8%) and equity (that costs 14%). The firm can borrow additional funds at 8% if it so desires. A financial analyst at this firm argues that the firm should undertake only those investments that earn a return of at least 14% because only those investments will increase shareholder value If a firm decides to make investments based on this logic it will ________.
decline to make investments that it should undertake
Strikes, lawsuits, regulatory actions, or the loss of a key account are all examples of ________.
diversifiable risk
The CAPM says that only nondiversifiable risk affects expected returns because ________.
diversifiable risk is easy (and costless) to eliminate through diversification
Combining two less than perfectly positively correlated assets to reduce risk is known as ________.
diversification
A(n) ________ portfolio maximizes return for a given level of risk.
efficent
If accounts receivable increase by $1,000,000, inventory decreases by $500,000, and accounts payable increase by$500,000, net working capital would ________.
experience no change
________ projects do not compete with each other; the acceptance of one ________ the others from consideration.
Independent; does not eliminate
Which of the following is a strength of payback period?
It's simple to calculate and understand.
Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project Y also costs $600, and generates cash flows of $500 and $275 for the next 2years, respectively. Which investment should the firm choose if the cost of capital is 25 percent?
neither, since both the projects have negative NPV
Perfectly ________ correlated series move exactly together and have a correlation coefficient of ________, while perfectly ________ correlated series move exactly in opposite directions and have a correlation coefficient of ________.
positively; +1; negatively; −1
