Chapter 3 Flashcards
Which of the following statements regarding the valuing of costs and benefits is not correct?
A) The first step in evaluating a project is to identify its costs and benefits.
B) In the absence of competitive markets, we can use one-sided prices to determine exact cash values.
C) Competitive market prices allow us to calculate the value of a decision without worrying about the tastes or opinions of the decision maker.
D) Because competitive markets exist for most commodities and financial assets, we can use them to determine cash values and evaluate decisions in most situations.
B
By evaluating cost and benefits using competitive market prices, we can determine whether a decision will make the firm and its investors wealthier. This central concept is called A) the Law of One Price. B) the Present Value. C) the Valuation Principle. D) the Internal Rate of Return.
C
Which of the following statements is incorrect?
A) In general, money today is worth more than money in one year.
B) We define the risk-free interest rate, rf for a given period as the interest rate at which money can be
borrowed or lent without risk over that period.
C) We refer to (1 - rf) as the interest rate factor for risk-free cash flows.
D) For most financial decisions, costs and benefits occur at different points in time.
C
Which of the following formulas regarding NPV is incorrect? A) NPV + PV(benefits) = PV(Cost) B) NPV + PV(costs) = PV(benefits) C) NPV = PV(All project cash flows) D) All of the above
A
Which of the following statements regarding the Law of One Price is incorrect?
A) At any point in time, the price of two equivalent goods trading in different competitive markets will be the same.
B) One useful consequence of the Law of One Price is that when evaluating costs and benefits to compute a net present value, we can use any competitive price to determine a cash value, without checking the price in all possible markets.
C) If equivalent goods or securities trade simultaneously in different competitive markets, then they will trade for the same price in both markets.
D) An important property of the Law of One Price is that it holds even in markets where arbitrage is not possible
D
Which of the following statements regarding arbitrage and security prices is incorrect?
A) We call the price of a security in a normal market the no-arbitrage price for the security.
B) In financial markets it is possible to sell a security you do not own by doing a short sale.
C) When a bond is underpriced, the arbitrage strategy involves selling the bond and investing some of the proceeds.
D) The general formula for the no-arbitrage price of a security is Price(security) = PV(All cash flows paid by the security).
C
Which one of the following statements is false?
A) When we compute the return of a security based on the average payoff we expect to receive, we call it the expected return.
B) The notion that investors prefer to have a safe income rather than a risky one of the same average amount is call risk aversion.
C) Because investors are risk averse, the risk-free interest rate is not the right rate to use when converting risky cash flows across time.
D) The more risk averse investors are, the higher the current price of a risky asset will be compared to a risk- free bond
D
Which of the following statements is false?
A) No arbitrage opportunities will exist until the underlying prices diverge by more than the amount of the transaction costs.
B) Because you will generally pay a slightly lower price when you buy a security (the ask price) than you receive when you sell (the bid price) you will pay the bid-ask spread.
C) The price of a security should equal the present value of its cash flows, up to the transaction costs of trading the security and the cash flows.
D) In most markets, you must pay transactions costs to trade securities
B
