Finance final word problems
66. Real options in projects generally: A) Increase the value of the project to investor B) Decrease the value of the project to the investor C) Do not impact the value of the project
A) Increase the value of the project to investor
1. Which of the following best describes the Net Present Value rule? A) Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative. B) Take any investment opportunity where the net present value (NPV) exceeds the opportunity cost of capital; turn down any opportunity where the cost of capital exceeds the net present value (NPV) C) When choosing among any list of investment opportunities where resources are limited, always choose those projects with the highest net present value (NPV). D) If the payback period of the project is below a cut-off value, accept it. Otherwise, reject it.
A) Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.
134. An article in today's Wall Street Journal reports that Microsoft reported profits were larger than expected. If markets follow the efficient market hypothesis: A) The stock price will have already adjusted to incorporate this new information. B) The stock price will adjust gradually and profitable trading opportunities are available. C) This analysis of Efficient Markets has nothing to do with information. D) None of the above.
A) The stock price will have already adjusted to incorporate this new information.
33. Which of the following statements is FALSE? A) To estimate a firm's enterprise value, we compute the present value (PV) of the free cash flows (FCF) that the firm has available to pay equity holders. B) The net present value (NPV) of any individual project represents its contribution to the firm's enterprise value. C) When using the total payout model, we discount total dividends and share repurchases, and use the growth rate in earnings when forecasting the growth of the firm's payout. D) In the total payout model, we first value the firm's equity, rather than just a single share
A) To estimate a firm's enterprise value, we compute the present value (PV) of the free cash flows (FCF) that the firm has available to pay equity holders. Explanation: FCF is available to pay both debt and equity holders.
151. To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear. A) True B) False
A) True
159. The cash flow from a change in Net Working Capital is always equal in size and opposite in sign to the changes in Net Working Capital. A) True B) False
A) True
72. When different investment rules give conflicting answers, then decisions should be based on the Net Present Value rule, as it is the most reliable and accurate decision rule. A) True B) False
A) True
119. You expect General Motors (GM) to have a beta of 1.5 over the next year and the beta of Exxon Mobil (XOM) to be 1.9 over the next year. Also, you expect the volatility of General Motors to be 50% and that of Exxon Mobil to be 35% over the next year. Which stock has more systematic risk? Which stock has more total risk? A) XOM, GM B) GM, XOM C) GM, GM D) XOM, XOM
A) XOM, GM
93. For each 1% change in the market portfolio's excess return, the investment's excess return is expected to change by __________ percent due to risks that it has in common with the market. A) beta B) alpha C) zero D) cannot say for sure
A) beta
106. Because investors can eliminate unsystematic risk "for free" by diversifying their portfolios, they ________ a risk premium for bearing it. A) do not require B) require C) are indifferent about D) none of the above
A) do not require
84. A portfolio of stocks can achieve diversification benefits if the stocks that comprise the portfolio are A) not perfectly correlated. B) perfectly correlated. C) susceptible to common risks only. D) both B and C
A) not perfectly correlated.
89. Diversification reduces the risk of a portfolio because __________ and some of the risks are averaged out of the portfolio. A) stocks do not move identically B) stocks have common risks C) stocks are unpredictable D) stocks are always effected by the market
A) stocks do not move identically
31. If you want to value the equity of a firm but do not want to explicitly forecast its dividends, share repurchases, or its use of debt, what is the simplest model for you to use? A) the discounted free cash flow model B) the dividend-discount model C) the enterprise value model D) the total payout model
A) the discounted free cash flow model
79. Which of the following is NOT a diversifiable risk? A) the risk that the economy slows, reducing demand for your firm's products B) the risk that the CEO is killed in a plane crash C) the risk of a key employee being hired away by a competitor D) the risk of a product liability lawsuit
A) the risk that the economy slows, reducing demand for your firm's products
107. Many former employees at Enron, an energy trading and supply company, had a large part of their portfolio invested in Enron stock. These employees were bearing a high degree of ________ risk. A) unsystematic B) systematic C) market specific D) non-diversifiable
A) unsystematic
147. In general, it is possible to eliminate ________ risk by holding a large portfolio of assets. A) unsystematic B) systematic C) unsystematic and systematic D) market
A) unsystematic
83. Many former employees at Enron had a large part of their portfolio invested in Enron stock. These employees were bearing a high degree of __________ risk. A) unsystematic B) systematic C) market specific D) non-diversifiable
A) unsystematic
96. The S&P 500 index traditionally is a __________ portfolio of the 500 largest U.S. stocks. A) value weighted B) equally weighted C) chain weighted D) price weighted
A) value weighted
82. While __________ seems to be a reasonable measure of risk when evaluating a large portfolio, the __________ of an individual security does not explain the size of its average return. A) volatility, volatility B) the mean return, standard deviation C) mode, volatility D) none of the above
A) volatility, volatility
80. Because investors can eliminate unsystematic risk "for free" by diversifying their portfolios, they __________ a risk premium for bearing it. A) won't earn B) require C) are indifferent about D) none of the above
A) won't earn
136. You are playing a simple gambling game with your friend with $100 at stake. The outcome is that you win double your bet if it is heads and lose the amount betted if it turns out to be tails. Will a rational investor prefer 1 play with a bet for $100 or 100 plays with each bet for $1 each? A) 1 play for $100. B) 100 plays for $1 each. C) A rational investor is indifferent between these two choices. D) None of the above.
B) 100 plays for $1 each.
146. A portfolio's Beta captures the: A) Change in the value of a portfolio as the risk free rate changes. B) Change in the value of a portfolio as the value of the market portfolio changes. C) Change in the unsystematic risk of a portfolio. D) None of the above
B) Change in the value of a portfolio as the value of the market portfolio changes.
156. The WACC does not depend on the risk of a company's line of business. A) True B) False
B) False
34. Which of the following statements is FALSE? A) The more cash the firm uses to repurchase shares, the less it has available to pay dividends. B) Free cash flow measures the cash generated by the firm after payments to debt or equity holders are considered. C) We estimate a firm's current enterprise value by computing the present value (PV) of the firm's free cash flow. D) We can interpret the enterprise value as the net cost of acquiring the firm's equity, taking its cash, and paying off all debts.
B) Free cash flow measures the cash generated by the firm after payments to debt or equity holders are considered. Explanation: FCF is cash generated by the firm before payments to debt and equity holders, not after.
3. Which of the following is NOT a limitation of the payback period rule? A) It does not account for time value of money. B) It is difficult to calculate. C) It ignores cash flows after payback. D) The cut-off payback period is determined arbitrarily.
B) It is difficult to calculate.
117. A linear regression was done to estimate the relation between Sprint's stock returns and the market's return. The intercept of the line was found to be 0.23 and the slope was 1.47. Which of the following statements is true regarding Sprint's stock? A) Sprint's beta is 0.23 B) Sprint's beta is 1.47 C) The risk-free rate is 1.47%D) The standard deviation of Sprint's excess returns is 23%
B) Sprint's beta is 1.47
77. Which of the following would you NOT consider when making a capital budgeting decision? A) The additional taxes a firm would have to pay in the next year B) The cost of marketing study completed last year C) The change in direct labor expense due to the purchase of a new machine D) The opportunity to lease out a warehouse instead of using it to house a new production line
B) The cost of marketing study completed last year Sunk costs are not incremental.
32. Which of the following statements is FALSE? A) In a share repurchase, the firm uses excess cash to buy back its own stock. B) The discounted free cash flow model begins by determining the value of the firm's equity. C) The discounted free cash flow model focuses on the cash flows to all of the firm's investors, both debt and equity holders, and allows us to avoid estimating the impact of the firm's borrowing decisions on earnings. D) In recent years, an increasing number of firms have replaced dividend payouts with share repurchases.
B) The discounted free cash flow model begins by determining the value of the firm's equity. Explanation: The discounted free cash flow model begins by determining the value of the entire firm (the enterprise value) first. Only in the second step, it subtracts the value of the firm's net debt from the enterprise value of the firm to finally find the value of the firm's equity.
65. A real option in a project refers to: A) The option to discount cash flows at a higher rate B) The right but not the obligation to make a certain business decision C) The obligation to delay a project D) The right to rescind all future cash flows
B) The right but not the obligation to make a certain business decision
157. Anheuser Busch, a manufacturer of beverages, is planning to purchase Six Flags theme parks. Anheuser Busch should use the ___________ to evaluate the business of Six Flags. A) WACC of Anheuser Busch B) WACC of Six Flags C) Average market return D) Divisional cost of capital
B) WACC of Six Flags
138. The risk premium for diversifiable risk is: A) Negative B) Zero C) Positive D) None of the above
B) Zero
114. Stocks tend to move together if they are affected by A) company specific events. B) common economic events. C) unrelated to the economy. D) idiosyncratic shocks.
B) common economic events.
97. The Capital Asset Pricing Model asserts that the __________ return is equal to the risk-free rate plus a risk premium for systematic risk. A) realized return B) expected return C) holding period return D) ex-post return
B) expected return
91. The volatility of Home Depot Share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio and the stocks returns have zero correlation, the overall volatility of returns of the portfolio is A) unchanged at 30%. B) less than 30%. C) more than 30%. D) cannot say for sure
B) less than 30%.
85. Companies that sell household products and food have very little relation to the state of the economy because such basic needs do not go away. These stocks tend to have __________ betas. A) high B) low C) negative D) cannot say for sure
B) low
15. Which of the following costs would you consider when making a capital budgeting decision? A) sunk cost B) opportunity cost C) interest expense D) fixed overhead cost
B) opportunity cost
150. If the Federal Reserve were to change from an expansionary to a contractionary monetary policy, this would be an example of ________. A) unsystematic risk B) systematic risk C) independent risk D) diversification risk
B) systematic risk
81. The risk premium of a security is determined by its __________ risk and does not depend on its __________ risk. A) systematic, undiversifiable B) systematic, unsystematic C) diversifiable, diversifiable D) all of the above
B) systematic, unsystematic
11. Which of the following best defines incremental earnings? A) cash flows arising from a particular investment decision B) the amount by which a firm's earnings are expected to change as the result of an investment decision C) the earnings arising from all projects that a company plans to undertake in a fixed timespan D) the net present value (NPV) of earnings that a firm is expected to receive as the result of an investment decision
B) the amount by which a firm's earnings are expected to change as the result of an investment decision
148. A company's stock price jumped when it announced that its revenue had decreased because of the quality issues of its products. This is an example of ________. A) market risk B) unsystematic risk C) systematic risk D) undiversifiable risk
B) unsystematic risk
104. Apple's stock price jumped when it announced that its revenue had increased because of the successful launch of iPad and the increased sales of Macbook computers. This is an example of A) market risk. B) unsystematic risk. C) systematic risk. D) both A and C
B) unsystematic risk.
116. If you build a large enough portfolio, you can diversify away all ________ risk, but you will be left with ________ risk. A) diversifiable, unsystematic B) unsystematic, systematic C) systematic, undiversifiable D) diversifiable, diversifiable
B) unsystematic, systematic
92. Which of the following statements is FALSE? A) Stock returns will tend to move together if they are affect similarly by economic events. B) Stocks in the same industry tend to have more highly correlated returns than stocks in different industries. C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together. D) With a positive amount invest in each stock, the more the stocks move together and the higher their covariance or correlation, the more variable the portfolio will be.
C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together. Explanation: Almost all of the correlations between stocks are positive, illustrating the general tendency of stocks to move together.
109. Which of the following statements is FALSE? A) The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk. B) When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. C) Fluctuations of a stock's returns that are due to firm-specific news are common risks. D) The volatility in a large portfolio will decline until only the systematic risk remains.
C) Fluctuations of a stock's returns that are due to firm-specific news are common risks.
37. Which of the following models can be used to value a firm without explicitly forecasting that firm's dividends, share repurchases, or its use of debt?I. Dividend-discount modelII. Total payout model III. Discounted free cash flow model A) I only B) II only C) III only D) II and III
C) III only
36. Which of the following statements is FALSE? A) The long-run growth rate of free cash flows, gFCF, is typically based on the expected long-run growth rate of the firm's revenues. B) Because the firm's free cash flow is equal to the sum of the free cash flows from the firm's current and future investments, we can interpret the firm's enterprise value as the total net present value (NPV) that the firm will earn from continuing its existing projects and initiating new ones. C) If the firm has no debt, then rwacc equals the risk-free rate of return. D) When using the discounted free cash flow model, we forecast the firm's free cash flow up to some horizon, together with some terminal (continuation) value of the enterprise.
C) If the firm has no debt, then rwacc equals the risk-free rate of return. Explanation: If the firm has no debt then rwacc = the cost of equity.
105. As we increase the number of stocks in a portfolio, the standard deviation of returns of the portfolio A) increases. B) remains unchanged. C) decreases. D) none of the above
C) decreases.
29. If you want to value the equity of a firm's equity that consistently pays out its earnings as dividends, the simplest model for you to use is the A) enterprise value model. B) total payout model. C) dividend-discount model. D) discounted free cash flow model.
C) dividend-discount model.
90. We can reduce the volatility of stock portfolios without sacrificing expected returns by investing in less than perfectly correlated assets through diversification because the expected return of a portfolio is the weighted average of the expected returns of its stocks, but the volatility of a portfolio A) is higher than the weighted average volatility. B) is independent of weights in the stocks. C) is less than the weighted average volatility. D) depends on the expected return.
C) is less than the weighted average volatility.
12. Cameron Industries is purchasing a new chemical vapor depositor in order to make silicon chips. It will cost $6 million to buy the machine and $10,000 to have it delivered and installed. Building a clean room in the plant for the machine will cost an additional $3 million. The machine is expected to have a working life of six years. Which of these activities will be reported as an operating expense? A) the delivery and install cost only B) the cost of the depositor only C) the redesign of the plant only D) the delivery and install cost and the cost of the depositor
C) the redesign of the plant only
108. Which of the following is NOT a systematic risk? A) the risk that the global price of oil rises, increasing production costs B) the risk that the economy slows, reducing demand for your firm's products C) the risk that your new product will not receive regulatory approval D) the risk that the Federal Reserve raises interest rates
C) the risk that your new product will not receive regulatory approval
30. If you want to value the equity of a firm that has consistent earnings growth, but varies how it pays out these earnings to shareholders between dividends and repurchases, the simplest model for you to use is the A) enterprise value model. B) dividend-discount model. C) total payout model. D) discounted free cash flow model.
C) total payout model.
112. The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio and the stocks returns have a correlation of +1, the overall volatility of returns of the portfolio is A) more than 30%. B) less than 30%. C) unchanged at 30%. D) cannot say for sure
C) unchanged at 30%.
113. The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio with an equal amount in each, and the stocks returns have a correlation of -1, the overall volatility of returns of the portfolio is A) more than 30%. B) unchanged at 30%. C) zero. D) cannot say for sure
C) zero.
94. The beta of the market portfolio is: A) 0 B) -1 C) 2 D) 1
D) 1
44. Which of the following situations can lead to IRR giving a different decision than NPV? A) Delayed investment B) Multiple IRRs C) Differences in project scale D) All of the above can lead to IRR giving a different decision than NPV
D) All of the above can lead to IRR giving a different decision than NPV
137. The risk of interest rates changing in an economy is an example of: A) Diversifiable risk B) Systematic Risk C) Non-diversifiable risk D) Both B) and C)
D) Both B) and C)
139. The volatility of returns for the stock of IBM is 35% and that for Ford is also 35% per year. This means that they have the same: A) Diversifiable risk B) Systematic Risk C) Non-diversifiable risk D) None of the above
D) None of the above
55. Which of the following best explains why is it sensible for a firm to use an accelerated depreciation schedule such as MACRS rather than straight-line depreciation? A) The firm will substantially decrease its depreciation tax shield across all of the depreciation timeline. B) The firm can decide over how many years an item may be depreciated, thus allowing it full control of its depreciation expenses. C) The firm will have substantially fewer depreciation expenses later in the depreciation timeline. D) The firm will receive greater benefits to its cash flow earlier in the depreciation timeline and thus increase net present value (NPV).
D) The firm will receive greater benefits to its cash flow earlier in the depreciation timeline and thus increase net present value (NPV). The faster a firm can depreciate its assets, the higher will be the depreciation expenses and the associated deprecation tax shields (tax savings) during the earlier years of the project's lifetime. The earlier the firm realizes its depreciation tax savings, the greater is their present value due to the time value of money. This increases the project's NPV.
115. Which of the following statements is FALSE? A) A stock's return is perfectly positively correlated with itself. B) When the covariance equals 0, the stocks have no tendency to move either together or in opposition of one another. C) The closer the correlation is to -1, the more the returns tend to move in opposite directions. D) The variance of a portfolio depends only on the variance of the individual stocks.
D) The variance of a portfolio depends only on the variance of the individual stocks. Explanation: The variance of a portfolio depends on the variance and correlations of the individual stocks.
102b. The excess return is the difference between the average return on a security and the average return for A) Corporate bonds. B) a portfolio of securities with similar risk. C) a broad-based market portfolio like the S&P 500 index. D) Treasury bills.
D) Treasury bills.
35. Which of the following statements is FALSE? A) The firm's weighted average cost of capital, denoted rwacc, is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm's equity and debt. B) Intuitively, the difference between the discounted free cash flow model and the dividend-discount model is that in the divided-discount model the firm's cash and debt are included indirectly through the effect of interest income and expenses on earnings in the dividend-discount model. C) We interpret rwacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm's debt and equity together. D) When using the discounted free cash flow model we should use the firm's equity cost of capital.
D) When using the discounted free cash flow model we should use the firm's equity cost of capital. Explanation: You would use the firm's weighted average cost of capital to discount its free cash flows, not its equity cost of capital.
2. Which of the following investment decision measures is best defined as the amount of time it takes to pay back the initial investment? A) internal rate of return (IRR) B) profitability index C) net present value (NPV) D) payback period
D) payback period
16. Which of the following adjustments should NOT be made when computing free cash flow from incremental earnings? A) adding back depreciation expenses B) subtracting capital expenditures C) subtracting increases in Net Working Capital D) subtracting depreciation expenses
D) subtracting depreciation expenses
149. The risk premium of a stock is not affected by its ________. A) undiversifiable risk B) market risk C) systematic risk D) unsystematic risk
D) unsystematic risk
