Course Packet P2

Question 1

Investment A

0 1 2 3 4
-$50 25 20 20 15
Investment B

0 1 2 3 4
-$100 20 40 50 60

IRR(A) =24% and IRR(B) =21%. Assume the opportunity cost of capital is 5%. Then: NPV(A) = $21.57 and NPV(B) = $47.88.
Which has the higher IRR? Higher NPV?

Which investment is more attractive?

Answer 1

A has the higher irr; B has the higher NPV

B is the more attractive option -> higher NPV

Question 2

Increases in Current Assets will __________ NWC which is a ___________of cash.

Answer 2

increase; use

Question 3

Increases in Current Liabilities will ___________ NWC which is a ____________of cash.

Answer 3

decrease; source

Question 4

You have the following partial balance sheet data:
2020 2019
Accounts receivable $20,000 Accounts receivable $18,000
Inventory $300,000 Inventory $320,000
Machinery $1,200,000 Machinery $1,100,000
Accounts Payable $40,000 Accounts Payable $35,000

What is the change in NWC from 2019 to 2020 and is it a source or use of cash?

Answer 4

-23000 Decrease in NWC as a source of case

Question 5

You own a prime piece of retail zoned real estate that you bought 2 years ago for $110,000 and you believe you could sell the land today for $135,000. You are considering building your own ski shop on the land instead of selling it. To build the store, it will cost you $120,000 and you plan to depreciate this cost straight-line over four years to zero. US Bank offered to loan you the money to build the store at a 5% interest rate, to be repaid over three years. You expect to generate $65,000 in revenues each year from sales and repairs of skis. You estimate that you will incur costs of $30,000 each year in your daily operations. There will be an initial requirement for working capital of $7,000, this level of working capital will remain the same for the life of the project and be recovered in the last year. 10% is your estimated cost of capital. The cash tax rate in Multnomah County is 30%. Should you build your ski shop?

Answer 5

-151028 Reject the Project

Question 6

Wood Furnishings is considering purchasing a new thickness sander which has a $100,000 initial cost, to be depreciated straight-line over five-years to zero. The company’s tax rate is 35%.

From the increased production of furniture, $45,000 in additional revenue is expected annually, as well as $15,000 in additional annual expenses. There will be an increased requirement for working capital of $8,000 for the life of the project which will be recovered at the end of the project. 11% is the company’s cost of capital.

Answer 6

-5,311

Question 7

Suppose you are deciding whether to invest in a new manufacturing plant. You own the land and buildings that will be used, but existing buildings must be demolished. Which of the following are incremental cash flows? (Ask yourself “Is this project causing this change in future cash flows?”)

Costs of demolition and clearing the land so that the new plant may be built.

Market value of the land and existing buildings which could be sold if you did not use it for the manufacturing plant.

Cost of a new access road that was put in last year.

Lost earnings from other products due to managers’ time spent on the new plant. Initial investment on inventories and raw materials for the new plant.
Payments already made for the engineering design of the new plant.

Answer 7

Costs of Demolition and Clearing the Land:

Yes, incremental. These costs occur because of the decision to build the new plant.
Market Value of the Land and Existing Buildings:

Yes, incremental. This is an opportunity cost. If the land and buildings could be sold for a certain amount, but instead are used for the project, this foregone cash is a relevant cash flow for the project.
Cost of a New Access Road That Was Put in Last Year:

No, not incremental. This cost is a sunk cost, as it was incurred in the past and cannot be recovered or changed by the decision to proceed with or abandon the new plant.
Lost Earnings from Other Products Due to Managers’ Time Spent on the New Plant:

Yes, incremental. This is an indirect cost but is still a result of the project. The time managers spend on this project is time not spent on other potentially profitable activities.
Initial Investment on Inventories and Raw Materials for the New Plant:

Yes, incremental. These are direct costs required to start up the new plant.
Payments Already Made for the Engineering Design of the New Plant:

No, not incremental. This is another example of a sunk cost. These expenses have already been incurred regardless of whether the project goes forward or not.

Question 8

Find the NPV for a project with a $250,000 initial cost that will have cash inflows of $60,000 for five years. The required return on the project is 12%.

Answer 8

-33,713.43

Question 9

What is the operating cash flow for the following project? Sales are $200,000, operating costs are $50,000, depreciation is $20,000 and the tax rate is 30%.

Answer 9

111,000

Question 10

Your company is considering expanding its retail outlet. Currently, inventory levels are $5,000. With the expansion, it is expected that inventory levels will need to be $9,500. It is expected that accounts receivable will increase by $4,000 and accounts payable will decrease by $10,000. The expansion of the building will cost $120,000. What change in net working capital is this expansion causing? Is this is a source or a use of cash?

Answer 10

18,500

Question 11

Bloom Industries is considering a new project which will impact their net working capital. For each item listed on the table below, label it as either a source or use of cash, or not part of net working capital. Also, report the total change in net working capital resulting from the project and note if it is a source or use of cash.

Answer 11

3,800

Question 12

You own a prime piece of retail zoned real estate that you bought 2 years ago for $120,000 and you believe you could sell the land today for $135,000. You are considering building your own bike shop on the land instead of selling it. To build the store, it will cost you $120,000 and you plan to depreciate this cost straight-line over four years to zero. US Bank offered to loan you the money to build the store at a 5% interest rate, to be repaid over three years. You expect to generate $65,000 in revenues each year from sales and repairs of bikes. You estimate that you will incur costs of $30,000 each year in your daily operations. There will be an initial requirement for working capital of $7,000, this level of working capital will remain the same for the life of the project and be recovered in the last year. 10% is your estimated cost of capital. The tax rate in Lane County is 30%. Should you build your bike shop?

Answer 12

151,028

Question 13

You purchased land 3 years ago for $50,000 and believe its market value is now $60,000. You are considering building a hotel on this land instead of selling it. To build the hotel, it will initially cost you $75,000, an expense that you plan to depreciate straight line to zero over the next three years. (We will assume an unrealistically short depreciation schedule for Simplicity in class.) Wells Fargo offered you a loan for $60,000 at an 8% interest rate to be repaid over the next 4 years. You anticipate that the hotel will earn revenues of $140,000 each year while expenses will be a mere $30,000 each year. The initial working capital requirement will be $7,000, which will be recovered at the end of the project. The tax rate is 35%. Your estimated cost of capital is 11%. Assume, for the sake of simplicity the project terminates after year 3. Is the hotel a good investment? Why or why not?

Answer 13

59.23(Thousands)

Question 14

You buy 100 shares of Adidas AG currently selling for $215 each. The stock will provide a rate of return of 30% if their latest golf shoe is a success, and –10% if it is not. You believe the likelihood of success is 40%. What is Adidas’s expected return?

Using the same Adidas example, what is the standard deviation of the stock?

Answer 14

6% ; 19.59%

Question 15

If we have a portfolio of 30 stocks, why can’t we just take the average of the 30 standard deviations to get the portfolio standard deviation?

Answer 15

Because diversification reduces some of the risk

Question 16

How much risk is eliminated through diversification?

Answer 16

We need a measure that tells us how the asset prices move relative to each other.
The risk of a portfolio depends not only on the risk of each asset in the portfolio, but also on the relation between the returns from the two assets.

Question 17

Suppose the risk-free rate is 5%, the return on the market is 15% and you have researched the  of Six Flags Entertainment Corporation (SIX) and found it to be 1.8. What is the required return on Six Flags according to the CAPM? Graph the SML and show the risk free asset, the market portfolio and SIX.

Answer 17

23%

Question 18

You own a portfolio that is 50% invested in stock X, 30% in stock Y, and 20% in stock Z. The expected returns on these three stocks are 11%, 17%, and 14%, respectively. What is the expected return on the portfolio?

Answer 18

134.4%

Question 19

You are considering a new investment. The rate on T-bills is 3.3% and the return on the S&P 500 is 8.5%. You have measured the non-diversifiable risk of the investment you are considering to be .7. What rate of return will you require on the investment?

Answer 19

6.94%

Question 20

If you were told the risk free rate was 4%, the market return was 14% and the beta of a stock was .2, what is the expected (required) return on that stock?

Answer 20

6%

Question 21

Give one example of systematic risk and one example of unsystematic risk.

b. Which type of risk can a portfolio help you avoid? How?
c. Which type of risk are you rewarded for bearing? Why?

Answer 21

a. Examples of Systematic and Unsystematic Risk:

Systematic Risk: An example of systematic risk is a significant change in interest rates. This type of risk affects the entire market or a broad range of asset classes. For instance, if the central bank of a country raises interest rates significantly, it may cause stock prices to fall broadly, as higher interest rates can lead to lower corporate profits and reduced economic activity.

Unsystematic Risk: An example of unsystematic risk is a sudden drop in the stock price of a specific company due to an internal scandal or a failed product launch. This type of risk is unique to a particular company or industry and does not impact the broader market.

b. Type of Risk Avoided by Portfolio Diversification:

Unsystematic Risk: A well-diversified portfolio can help investors avoid unsystematic risk. Diversification involves investing in a variety of assets across different industries, geographic locations, and asset classes. By spreading investments across a wide range of assets, the negative impact of any single asset’s poor performance is minimized. This is because the poor performance of one asset or a few assets can be offset by the better performance of others in the portfolio.
c. Type of Risk Rewarded for Bearing and Why:

Systematic Risk: Investors are typically rewarded for bearing systematic risk. This is because systematic risk, also known as market risk, cannot be diversified away. It is inherent to the entire market or a broad range of assets. Since investors cannot eliminate this risk through diversification, they expect and usually receive a higher return for taking on this risk. The concept is that investors need to be compensated for the extra risk they take on when investing in the market as a whole, as opposed to risk-free investments such as government bonds.

Question 22

The risk free rate is 8% and the expected return on the market portfolio is 16%. A firm considers a project that is expected to have a beta of 1.3.

A. What is the required rate of return on the project?
B. If the expected IRR of the project is 19%, should it be accepted?

Answer 22

18.4%

Yes.

Question 23

What is the beta of a portfolio with E(Rp) = 18%, if rf = 6% and E(Rm) = 14%?

Answer 23

1.5%

Question 24

Within the context of the CAPM, assume:

• Expected return on the market = 15%
• Risk free rate = 8%
• Expected rate of return on XYZ security = 17%
• Beta of XYZ security = 1.25

What is the required return on XYZ security according to the CAPM? Is XYZ fairly, over or under priced? If over or under priced, by how much? Graph the SML and show the risk free asset, the market portfolio, and XYZ.

Answer 24

16.75%

Question 25

Stock XYZ has an expected return of 12% and beta = 1. ABC has expected return of 13% and beta =
1.5. The market’s expected return is 11% and rf = .05.

A. According to CAPM, which stock is a better buy?

B. What is the alpha of each stock?

C. Plot the SML and each stock’s risk-return point on one graph. Graphically show the alphas.

Answer 25

Alpha XYZ = 1%

Alpha ABC = -1%

Question 26

Executive Foods, Inc. has issued debt, preferred stock and common stock. The market values of these securities are $4M, $2M, and $6M, respectively. The required returns are 6%, 12%, and 18%, respectively. The tax rate is 35%.

Q: Determine the WACC for Executive Foods, Inc.

Answer 26

12.29%

Question 27

What is a firm’s weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket.

Answer 27

14.39%

Question 28

What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate?

Answer 28

13.6%

Question 29

Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5%, and the return on the market is 10%.

Answer 29

11.5%

Question 30

What is the weighted-average cost of capital for a firm with the following sources of funds and corresponding required rates of return: $5 million common stock at 16%, $500,000 preferred stock at 10%, and $3 million debt at 9%? All amounts are listed at market values and the firm’s tax rate is 35%.

Answer 30

12%

Question 31

What is the after tax cost of debt for a $2,000,000 loan that has an 8% interest rate if the firm is in the 30% tax bracket?

Answer 31

5.6%

Question 32

What is the present value of the interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket?

Answer 32

The present value of the interest tax shield for a firm with $3 million in debt, paying 12% interest and in the 35% tax bracket, is approximately $126,000. ​​

Question 33

Which types of issuances are underwritten? What does this mean about the risk the issuing firm faces and therefore the costs of issuance?

Answer 33

Underwriting involves investment banks committing to buy and sell an entire issuance of securities (like IPOs and bonds) from the issuer. This process mitigates the risk for the issuing firm of not selling all the securities at the desired price, ensuring capital is raised. However, underwriting introduces costs:

Underwriters’ Fees: These are charges for the service of underwriting and can be a significant expense for the issuer.
Risk Transfer: The risk of selling the securities at the market price is transferred from the issuer to the underwriters.
Pricing and Marketing Support: Underwriters assist in setting the initial offering price and marketing the securities, which can influence the success of the issuance.
In essence, underwriting reduces the issuer’s risk of capital raising but at the expense of underwriting fees.

Question 34

Why does taking on debt increase a company’s value (in the presence of taxes)?

Answer 34

Taking on debt can increase a company’s value in the presence of taxes due to the tax deductibility of interest payments, known as the interest tax shield. This concept is a key component of the Modigliani-Miller theorem on capital structure in a world with taxes.

Interest Tax Shield: Interest payments on debt reduce taxable income, leading to lower tax payments. This tax saving increases the net income available to shareholders.

Cost of Capital: Debt typically has a lower cost than equity because it poses less risk to investors (being prioritized in case of liquidation) and due to the tax shield benefit. Incorporating cheaper debt financing can lower the company’s overall cost of capital.

Value Enhancement: The reduction in taxes paid (thanks to the interest tax shield) and the lowering of the overall cost of capital increase the firm’s net cash flows and therefore its value.

Optimal Capital Structure: There’s an optimal mix of debt and equity that maximizes a company’s value by balancing the benefits of debt (like the tax shield) with the increasing risks of financial distress and bankruptcy associated with high levels of debt.

In summary, the tax benefits associated with debt (interest tax shield) and the impact on the cost of capital play crucial roles in enhancing a company’s value when it takes on debt.

Question 35

Why is the M&M Proposition important?

Answer 35

The Modigliani-Miller (M&M) Propositions are foundational in corporate finance theory for understanding the impact of capital structure on a firm’s value. They are important for several reasons:

Capital Structure Irrelevance (in a Perfect Market): The original M&M Proposition I states that, in a perfect market (no taxes, bankruptcy costs, agency costs, or asymmetric information), a firm’s value is unaffected by its capital structure. This idea was revolutionary, suggesting that the mix of debt and equity financing doesn’t influence the total value of a firm.

Introduction of Real World Factors: Later, M&M Proposition II introduced the concept of taxes. It showed that in a world with corporate taxes, debt financing can increase a company’s value due to the interest tax shield. This helped to understand the benefits of leverage in a more realistic setting.

Influence on Corporate Finance Practices: These propositions have had a significant impact on how companies approach financing decisions. They provide a theoretical framework for understanding the trade-offs between debt and equity financing.

Basis for Further Research: The M&M Propositions laid the groundwork for further research in areas like capital structure, dividend policy, and corporate governance. They challenged the existing norms and led to a deeper understanding of financial leverage and risk.

Practical Decision-Making Tool: While the real world deviates from the perfect market conditions assumed in M&M’s original proposition, their framework still guides financial managers in making more informed decisions about debt and equity financing.

In essence, the M&M Propositions provide a fundamental theoretical framework for understanding how capital structure affects a firm’s value and have significantly influenced both academic research and practical corporate finance decision-making.

Question 36

What is often the market reaction to a company’s announcement of stock sales?

A) Increase in stock prices
B) Decrease in stock prices
C) No change in stock prices
D) Fluctuation in stock prices

Answer 36

B) Decrease in stock prices

Question 37

How does the announcement of a debt issue typically affect a company’s equity prices?

A) Causes a significant increase
B) Leads to a significant decrease
C) Has little or no effect
D) Results in high volatility

Answer 37

C) Has little or no effect

Question 38

What does the pecking order theory suggest about a company’s preference for funding investments?

A) Preference for external equity over debt
B) Preference for debt over external equity
C) Preference for equal use of debt and equity
D) Preference for internal over external financing

Answer 38

D) Preference for internal over external financing

Question 39

Under the pecking order theory, what type of funding do businesses rely on if internally generated cash flow is insufficient?

A) External equity
B) Debt
C) Additional stock sales
D) Venture capital

Answer 39

B) Debt

Question 40

According to the pecking order theory, how do profitable firms typically finance their high NPV (Net Present Value) investments?

A) Primarily through debt
B) Mostly through external equity
C) Through a mix of debt and equity
D) Using internally generated capital

Answer 40

D) Using internally generated capital

Question 41

In the context of the pecking order theory, why do less profitable firms tend to issue more debt?

A) Preference for leveraging
B) High returns on debt
C) Quick exhaustion of internally generated funds
D) Market demand for company debt

Answer 41

C) Quick exhaustion of internally generated funds

Question 42

What is the new value (VL) of a firm valued at $120 million with no debt (VU) that decides to take on $10 million in debt, considering a corporate tax rate of 35%?

A) $123.5 million
B) $130 million
C) $120 million
D) $133.5 million

Answer 42

A) $123.5 million

Question 43

What does the Trade-Off Theory in capital structure suggest?

A) Optimum debt/equity ratio does not affect market value
B) There is no benefit in tax shield from debt
C) An optimum debt/equity ratio maximizes market value
D) Financial distress costs are negligible

Answer 43

C) An optimum debt/equity ratio maximizes market value

Question 44

What is a characteristic trend among utilities and retailers in terms of borrowing according to the Trade-Off Theory?

A) They tend to issue more equity than debt
B) They typically do not prefer borrowing
C) They tend to borrow heavily
D) They avoid both debt and equity

Answer 44

C) They tend to borrow heavily

Question 45

According to the Trade-Off Theory, how do debt/equity ratios vary?

A) They are similar across all industries
B) They vary widely across industries and companies
C) They are always low regardless of the industry
D) They are always high in high-profit industries

Answer 45

B) They vary widely across industries and companies

Question 46

Why do highly profitable companies like Merck often forgo the tax shield advantage of debt?

A) Preference for higher financial risk
B) Lack of tangible assets for collateral
C) High taxable profits make debt less attractive
D) Preference for maintaining a high debt/equity ratio

Answer 46

C) High taxable profits make debt less attractive

Question 47

What is a critical argument of the Modigliani and Miller (M&M) Theorems regarding financing policy?

A) Financing policy greatly affects firm value
B) Financing policy has no effect on firm value
C) Only equity financing affects firm value
D) Only debt financing affects firm value

Answer 47

B) Financing policy has no effect on firm value

Question 48

According to M&M, if financing policy affects firm value, which factor is not a contributing reason?

A) Taxes
B) Information or Transaction costs
C) Investment Policy influenced by Financing Policy
D) Market speculation

Answer 48

D) Market speculation

Question 49

What effect does issuing debt have on a firm’s taxable income and tax payments?

A) Increases both taxable income and tax payments
B) Reduces both taxable income and tax payments
C) Increases taxable income but reduces tax payments
D) Reduces taxable income but increases tax payments

Answer 49

B) Reduces both taxable income and tax payments

Question 50

What does the PV of the tax shield depend on, according to M&M?

A) Only the riskiness of the tax shield
B) The perpetuity of the debt and the riskiness of the tax shield
C) Only the amount of debt
D) The market speculation of debt

Answer 50

B) The perpetuity of the debt and the riskiness of the tax shield

Question 51

Under what circumstances will the value of the tax shield be smaller?

A) When the debt is a perpetuity
B) When the debt is not permanent and there is risk of not utilizing tax shields
C) When the company’s stock price is volatile
D) When the firm’s investment policy changes frequently

Answer 51

B) When the debt is not permanent and there is risk of not utilizing tax shields

Question 52

Which formula represents the value of a leveraged firm (VL) according to M&M?

A) VL = VU - (PV Tax Shield)
B) VL = VU + (PV Tax Shield)
C) VL = VU / (PV Tax Shield)
D) VL = VU × (PV Tax Shield)

Answer 52

B) VL = VU + (PV Tax Shield)

Question 53

According to M&M, what happens to the value of a firm when it manages to reduce the government’s claim through actions such as issuing debt?

A) Decreases significantly
B) Remains unchanged
C) Increases
D) Fluctuates unpredictably

Answer 53

C) Increases

Question 54

In the context of M&M’s theory, what role does the government (Uncle Sam) play in a firm’s financial structure?

A) Investor
B) Creditor
C) Tax collector
D) Regulatory authority

Answer 54

C) Tax collector

Question 55

What is the primary reason for the Modigliani and Miller Theorems being considered significant in financial theory?

A) They confirm the importance of financing policy
B) They pinpoint specific areas where financing policy matters
C) They demonstrate the direct impact of stock prices on firm value
D) They establish the non-importance of debt in capital structure

Answer 55

B) They pinpoint specific areas where financing policy matters

Question 56

Which of the following is not a key area affected by a firm’s financing policy according to M&M?

A) Market demand
B) Taxes
C) Information or Transaction Costs
D) Investment Policy

Answer 56

A) Market demand

Question 57

What does M&M Proposition 1 assume regarding taxes and transaction costs?

A) They are significant in financing decisions
B) They are variable based on investment size
C) They are absent or negligible
D) They are the main factors in financing decisions

Answer 57

C) They are absent or negligible

Question 58

According to M&M Proposition 1, how does a company’s market value relate to its capital structure?

A) Directly dependent on the capital structure
B) Inversely proportional to the equity portion
C) Not dependent on the capital structure
D) Only dependent on the debt portion

Answer 58

C) Not dependent on the capital structure

Question 59

What does a “Fixed Real Investment Policy” imply in the context of M&M Proposition 1?

A) Changing investment strategies frequently
B) Commitment to using NPV rule consistently
C) Investing only in fixed assets
D) Varying the investment based on market conditions

Answer 59

B) Commitment to using NPV rule consistently

Question 60

In M&M’s simplified example of a coffee stand, if the expected profit is $34,500 and the cost of setup is $24,000, what does Proposition 1 suggest about financing the setup cost?

A) Financing through debt increases the value of the opportunity
B) Financing through equity decreases the value of the opportunity
C) Choice of financing (debt or savings) does not affect the value of the opportunity
D) The value is maximized if financed through external investors

Answer 60

C) Choice of financing (debt or savings) does not affect the value of the opportunity

Question 61

What is a key concept demonstrated by M&M Proposition 1 in the context of investment policy?

A) The size of the investment determines its value
B) Investment value is influenced by market perceptions
C) The structure of financing affects the potential cash flows
D) The form of financing does not affect the value of generated cash flows

Answer 61

D) The form of financing does not affect the value of generated cash flows

Question 62

What does a ‘Negotiated Purchase’ in the context of securities issuance mean?

A) The issuing firm allows the public to bid for its securities.
B) The issuing firm selects an investment banker to underwrite the issue and negotiates the terms of the offer.
C) The issuing firm sells the securities directly to the investing public without involving an investment banker.
D) Investment bankers compete to offer the best price to the issuing firm.

Answer 62

B) The issuing firm selects an investment banker to underwrite the issue and negotiates the terms of the offer.

Question 63

In a ‘Competitive Bid’ issuance, how is the underwriting investment banker selected?

A) By direct sale to the investing public.
B) Through negotiation between the issuing firm and a single investment banker.
C) Multiple investment bankers bid, and the firm selects the one offering the highest price.
D) The firm uses a best efforts approach and does not underwrite the issue.

Answer 63

C) Multiple investment bankers bid, and the firm selects the one offering the highest price.

Question 64

What characterizes a ‘Best Efforts’ issuance method?

A) The issue is fully underwritten by an investment banker.
B) The investment bank attempts to sell the issue for a commission without underwriting it.
C) The issue is directly sold to a select group of investors like employees or customers.
D) Investment bankers compete in bidding for the issue.

Answer 64

B) The investment bank attempts to sell the issue for a commission without underwriting it.

Question 65

What is a ‘Privileged Subscription’ in securities issuance?

A) Securities are sold directly to the public without an investment banker.
B) Investment banker underwrites and sells the issue in an open market.
C) Securities are offered to current stockholders, employees, or customers, typically through an investment banker.
D) The issuing firm engages in competitive bidding to select an investment banker.

Answer 65

C) Securities are offered to current stockholders, employees, or customers, typically through an investment banker.

Question 66

In the context of capital structure, what fundamental question does a financial manager need to address?

A) How to maximize the company’s stock price.
B) The proportion of equity or debt to use for financing projects.
C) Choosing the right investment banker for issuing securities.
D) Determining the dividend policy of the firm.

Answer 66

B) The proportion of equity or debt to use for financing projects.

Question 67

What is a ‘Direct Sale’ in the context of securities issuance?

A) Securities are sold directly to the public without the involvement of an investment banker.
B) The issuing firm negotiates exclusively with one investment banker for the sale of securities.
C) Securities are offered to a select group of investors like employees or customers.
D) Investment bankers compete to bid for the right to underwrite the firm’s issue.

Answer 67

A) Securities are sold directly to the public without the involvement of an investment banker.

Question 68

Why do firms in the same industry sometimes have different capital structures?

A) Due to differences in market conditions only.
B) Because of the varying investment opportunities available to them.
C) Solely based on the preferences of the firm’s management.
D) Due to differences in their financial strategies and needs.

Answer 68

D) Due to differences in their financial strategies and needs.

Question 69

What does the financing policy of a firm primarily concern itself with?

A) Choosing the right investment opportunities only.
B) Deciding where to get the cash for necessary investments.
C) Selecting the best investment banker for securities issuance.
D) Maximizing the company’s dividend payouts.

Answer 69

B) Deciding where to get the cash for necessary investments.

Question 70

In financing decisions, what is a fundamental question related to capital structure?

A) How to minimize tax liabilities.
B) How much total debt should the firm issue.
C) The best strategy for diversifying investments.
D) Determining the ideal number of employees.

Answer 70

B) How much total debt should the firm issue.

Question 71

What does ‘Capital Structure’ in finance refer to?

A) The structure of the firm’s investment portfolio.
B) The mix of long-term debt and equity financing in a firm.
C) The organization of a firm’s top management team.
D) The layout of a firm’s physical capital assets.

Answer 71

B) The mix of long-term debt and equity financing in a firm.

Question 72

What is the first step in the IPO process?

A) Hiring an investment banker
B) Deciding to go public
C) Filing a registration statement with the SEC
D) Conducting a road show

Answer 72

B) Deciding to go public

Question 73

What role does an investment banker play in an IPO?

A) Provides legal advice
B) Advises on pricing and timing, sells shares, and ensures analyst coverage
C) Decides the type of deal for the IPO
D) Finalizes the share price

Answer 73

B) Advises on pricing and timing, sells shares, and ensures analyst coverage

Question 74

What is the ‘quiet period’ in the context of an IPO?

A) The time before hiring an investment banker
B) The period when the share price is decided
C) The 25 days after the initial sale of stock when no new information can be discussed
D) The time taken for book-building

Answer 74

C) The 25 days after the initial sale of stock when no new information can be discussed

Question 75

What is the purpose of the road show in an IPO process?

A) To finalize the share price
B) To sell shares to retail investors
C) To sell shares to institutional investors and record interest
D) To file the registration statement

Answer 75

C) To sell shares to institutional investors and record interest

Question 76

When is the price for IPO shares typically finalized?

A) After the road show
B) Before the quiet period
C) At the start of the quiet period
D) The market close before the actual sale

Answer 76

D) The market close before the actual sale

Question 77

What is a common reason for underpricing in IPOs?

A) To increase the likelihood of oversubscription
B) To comply with SEC regulations
C) To decrease the company’s market value
D) To prolong the quiet period

Answer 77

A) To increase the likelihood of oversubscription

Question 78

Why might companies not complain about IPO underpricing?

A) It simplifies the registration process
B) It creates excitement and future capital raising prospects
C) It reduces the need for road shows
D) It reduces the workload of investment bankers

Answer 78

B) It creates excitement and future capital raising prospects

Question 79

What is the impact of underpricing on the capital raised by companies in an IPO?

A) Increases the capital raised
B) Reduces the capital raised
C) No impact on the capital raised
D) Variable impact depending on the company

Answer 79

B) Reduces the capital raised

Question 80

What role does book-building play in an IPO process?

A) It is used to record the interest of retail investors
B) It determines the final price of the IPO
C) It records institutional investors’ interest in purchasing shares
D) It is a strategy to avoid underpricing

Answer 80

C) It records institutional investors’ interest in purchasing shares

Question 81

What is the main incentive for investment bankers to underprice IPO issues?

A) To comply with government regulations
B) To ensure a successful future stock offering
C) To maintain relationships with their best customers
D) To simplify the IPO process

Answer 81

C) To maintain relationships with their best customers

Question 82

What are common sources of new venture capital?

A) Self, Friends, and Family
B) Business Angels and Venture Capital Investors
C) Small Business Investment Companies and Trade Credit
D) All of the above

Answer 82

D) All of the above

Question 83

What is the primary purpose of Venture Capital?

A) To provide long-term loans to established firms
B) To finance new and rapidly growing firms
C) To invest in government securities
D) To provide ongoing operational funding

Answer 83

B) To finance new and rapidly growing firms

Question 84

What is a key consideration when choosing a Venture Capitalist?

A) Investment return rates
B) Global presence
C) Management Style
D) Product portfolio

Answer 84

C) Management Style

Question 85

In the context of financial market components, what is a Public Offering?

A) Securities sold exclusively to institutional investors
B) Securities offered only to a select group of investors
C) Securities made available to both individual and institutional investors
D) A private event for select shareholders

Answer 85

C) Securities made available to both individual and institutional investors

Question 86

What is a primary role of investment bankers in the context of issuing securities?

A) Legal consulting
B) Underwriting the issue
C) Direct selling to the public
D) Managing company operations

Answer 86

B) Underwriting the issue

Question 87

What does ‘Private Placement’ in financial markets refer to?

A) Publicly advertising securities for all investors
B) Offering securities to government entities only
C) Selling securities to a limited number of investors
D) Placement of private equity in public firms

Answer 87

C) Selling securities to a limited number of investors

Question 88

Which of the following is a key consideration for a firm when selecting a venture capitalist?

A) The geographic location of the venture capitalist
B) The ability to provide additional resources (Financial Strength)
C) The number of employees in the venture capital firm
D) The age of the venture capital firm

Answer 88

B) The ability to provide additional resources (Financial Strength)

Question 89

What role do ‘Business Angels’ play in new venture capital?

A) They provide legal and accounting services
B) They are primarily government-funded entities
C) They are individual investors who provide capital for startups
D) They focus only on large-scale industrial investments

Answer 89

C) They are individual investors who provide capital for startups

Question 90

What is an ‘Exit Strategy’ in the context of venture capital?

A) A plan for scaling up the business
B) A method for resolving internal disputes
C) A plan for the venture capitalist to ‘cash out’
D) Strategy for acquiring competitors

Answer 90

C) A plan for the venture capitalist to ‘cash out’

Question 91

How is the market value of bonds determined?

A) Current interest rate divided by the par value
B) Present value of all coupons and par value discounted at the current interest rate
C) Sum of all future interest payments
D) Market price per bond times number of bonds issued

Answer 91

B) Present value of all coupons and par value discounted at the current interest rate

Question 92

How can you calculate the market value of equity?

A) Total assets minus total liabilities
B) Par value of stock multiplied by outstanding shares
C) Market price per share multiplied by the number of outstanding shares
D) Dividend per share multiplied by the number of shares

Answer 92

C) Market price per share multiplied by the number of outstanding shares

Question 93

What does the yield to maturity (YTM) represent for bonds?

A) The final return expected from a bond at maturity
B) The required rate of return for bonds
C) The annual interest rate of the bond
D) The total interest income from the bond

Answer 93

B) The required rate of return for bonds

Question 94

What is the formula for calculating the required return on common stock using CAPM?

A) rE = Div1/P0 + g
B) rE = rf + β (rm-rf)
C) rE = YTM
D) rE = Div1 - g

Answer 94

B) rE = rf + β (rm-rf)

Question 95

In the constant growth Dividend Discount Model (DDM), how do you calculate the required return on equity?

A) rE = Div1 + g
B) rE = Div1/P0 + g
C) rE = P0 * (Div1 + g)
D) rE = rf + (Div1/P0) - g

Answer 95

B) rE = Div1/P0 + g

Question 96

How is the required return on preferred stock calculated using the no growth DDM?

A) rp = Div1
B) rp = Div1/P0
C) rp = P0/Div1
D) rp = rf + (Div1/P0)

Answer 96

B) rp = Div1/P0

Question 97

What is the first step in calculating the WACC?

A) Determine the market value of assets
B) Calculate the value of each security as a proportion of the firm’s market value
C) Determine the required rate of return for each security
D) Calculate the after-tax cost of debt

Answer 97

B) Calculate the value of each security as a proportion of the firm’s market value

Question 98

How do you calculate the proportion of debt in Geothermal Inc.’s capital structure?

A) Debt / Total Equity
B) Debt / Total Assets
C) Debt / Market Value of Assets
D) Total Equity / Total Debt

Answer 98

C) Debt / Market Value of Assets

Question 99

How is the after-tax cost of debt calculated for WACC?

A) Pretax cost x (1 + tax rate)
B) Pretax cost x tax rate
C) Pretax cost x (1 - tax rate)
D) Pretax cost + tax rate

Answer 99

C) Pretax cost x (1 - tax rate)

Question 100

Why are interest payments on debt considered in calculating the WACC?

A) They are not tax deductible
B) They increase the firm’s market value
C) They are tax deductible, reducing the firm’s taxable income
D) They represent a fixed cost of capital

Answer 100

C) They are tax deductible, reducing the firm’s taxable income

Question 101

What is the significance of the Capital Asset Pricing Model (CAPM) for financial managers?

A) It helps determine the market value of the firm
B) It estimates the required return on a stock, reflecting the cost of equity
C) It calculates the firm’s total assets
D) It determines the company’s credit rating

Answer 101

B) It estimates the required return on a stock, reflecting the cost of equity

Question 102

Besides common stock, which other sources of funding contribute to a firm’s capital structure?

A) Bonds and dividends
B) Preferred stock and debt
C) Retained earnings and debentures
D) Government grants and loans

Answer 102

B) Preferred stock and debt

Question 103

What does the firm’s Weighted Average Cost of Capital (WACC) represent?

A) The average interest rate on the firm’s loans
B) The weighted average of costs of equity, debt, and preferred stock
C) The average market return expected by investors
D) The total asset value of the firm

Answer 103

B) The weighted average of costs of equity, debt, and preferred stock

Question 104

Why is understanding the cost of capital important for financial managers?

A) It helps in setting the product pricing strategy
B) It aids in budgeting and financial forecasting
C) It is a measure of the cost of raising funds needed to operate the firm
D) It determines the firm’s investment in research and development

Answer 104

C) It is a measure of the cost of raising funds needed to operate the firm

Question 105

What is the definition of ‘Cost of Capital’?

A) The interest paid on the firm’s debts
B) The return investors could expect to earn from securities with similar risk
C) The operational expenses of the firm
D) The cost of issuing new shares

Answer 105

B) The return investors could expect to earn from securities with similar risk

Question 106

What does ‘Capital Structure’ refer to in a firm?

A) The organization’s operational and managerial hierarchy
B) The mix of long-term debt financing and equity financing
C) The firm’s investment in capital assets
D) The distribution of dividends to shareholders

Answer 106

B) The mix of long-term debt financing and equity financing

Question 107

What is the goal of an Active Investment Strategy?

A) To replicate market indices
B) To achieve returns that match the risk profile
C) To achieve returns greater than what the associated risk would predict
D) To hold a diversified portfolio without frequent trading

Answer 107

C) To achieve returns greater than what the associated risk would predict

Question 108

What characterizes a Passive Investment Strategy?

A) Frequent trading to capitalize on market trends
B) Focusing on short-term investments for quick returns
C) Maintaining a well-diversified portfolio and minimizing trading
D) Actively searching for undervalued stocks

Answer 108

C) Maintaining a well-diversified portfolio and minimizing trading

Question 109

In the context of the efficient market hypothesis, which investment strategy aligns best?

A) Active Investment Strategy
B) Passive Investment Strategy
C) Sector-specific Investment Strategy
D) High-risk Investment Strategy

Answer 109

B) Passive Investment Strategy

Question 110

What is the primary focus of Money Market Funds?

A) Long-term capital appreciation
B) Investing in a mix of stocks and bonds
C) Short-term, liquid investments
D) High-risk, high-return investments

Answer 110

C) Short-term, liquid investments

Question 111

What type of investments do Fixed Income Funds primarily make?

A) In stocks for maximum capital gain
B) In short-term liquid assets
C) In fixed income investments like corporate bonds and T-bonds
D) In diversified sectors for balanced growth

Answer 111

C) In fixed income investments like corporate bonds and T-bonds

Question 112

What is the investment objective of Index Funds?

A) To actively trade for quick profits
B) To replicate the performance of a broad-based index like the S&P 500
C) To focus on a specific sector like biotechnology
D) To mix stocks and bonds for balanced growth

Answer 112

B) To replicate the performance of a broad-based index like the S&P 500

Question 113

Which fund type would be a good candidate for an entire investment portfolio due to its mix of equities and fixed income?

A) Money Market Funds
B) Equity Funds
C) Balanced and Income Funds
D) Specialized Sector Funds

Answer 113

C) Balanced and Income Funds

Question 114

What is the primary purpose of mutual funds?

A) To provide high-risk investment opportunities
B) To allow individual investors to buy shares in a diversified portfolio
C) To invest solely in bonds and fixed income assets
D) To enable trading in international markets only

Answer 114

B) To allow individual investors to buy shares in a diversified portfolio

Question 115

What distinguishes closed-end funds from open-end funds in mutual funds?

A) Closed-end funds continually add shareholders; open-end funds do not
B) Closed-end funds require higher minimum investments
C) Closed-end funds issue a fixed number of shares; open-end funds do not
D) Closed-end funds only invest in bonds; open-end funds only in stocks

Answer 115

C) Closed-end funds issue a fixed number of shares; open-end funds do not

Question 116

What are load fees in the context of mutual funds?

A) Yearly maintenance fees
B) Fees charged for managing the fund’s assets
C) Up-front fees charged to purchase shares in a mutual fund
D) Fees charged for withdrawing from the fund

Answer 116

C) Up-front fees charged to purchase shares in a mutual fund

Question 117

How do Index Funds typically operate?

A) By frequently trading to beat the market
B) By buying and holding securities, with minimal trading
C) By investing only in high-risk assets
D) By focusing only on international markets

Answer 117

B) By buying and holding securities, with minimal trading

Question 118

Why is it suggested to diversify internationally with index funds?

A) To take advantage of varying tax laws
B) Because international funds are less risky
C) Because index funds from different countries are not perfectly correlated
D) To focus solely on emerging markets

Answer 118

C) Because index funds from different countries are not perfectly correlated

Question 119

According to Mutual Fund Performance Studies, how do mutual fund managers typically perform relative to the market?

A) They consistently outperform the market
B) They do not usually ‘Beat the Market’
C) They focus on short-term gains only
D) Their performance is not measurable

Answer 119

B) They do not usually ‘Beat the Market’

Question 120

Which type of mutual funds continually adds to the number of shareholders?

A) Closed-end funds
B) Open-end funds
C) Index funds
D) Equity funds

Answer 120

B) Open-end funds

Question 121

What is the primary benefit of diversifying a portfolio by holding a number of assets?

A) Guaranteeing higher returns
B) Reducing unsystematic risk
C) Eliminating market risk
D) Ensuring fixed income

Answer 121

B) Reducing unsystematic risk

Question 122

What is the minimum investment typically required for an Individual Retirement Account (IRA) in mutual funds?

A) $100
B) $250
C) $500
D) $1000

Answer 122

C) $500

Question 123

What is the primary purpose of mutual funds for individual investors?

A) To provide high-risk investment options
B) To offer shares in a diversified portfolio
C) To guarantee returns on investment
D) To focus solely on equity investments

Answer 123

B) To offer shares in a diversified portfolio

Question 124

What is the focus of a passive investment strategy in mutual funds?

A) Speculative trading for quick gains
B) Actively managing assets to beat the market
C) Establishing a diversified portfolio without trying to find mispriced securities
D) Focusing solely on bonds for income

Answer 124

C) Establishing a diversified portfolio without trying to find mispriced securities

Question 125

What does the Security Market Line (SML) in the CAPM represent?

A) The relationship between the beta of an asset and its expected return
B) The variance of returns for different securities
C) The correlation between different assets in the market
D) The historical returns of a security

Answer 125

A) The relationship between the beta of an asset and its expected return

Question 126

On the SML graph, what does the y-intercept represent?

A) Market return
B) Beta of the market portfolio
C) Risk-free rate
D) Expected return of the asset

Answer 126

C) Risk-free rate

Question 127

What is the beta of a risk-free asset in the context of SML?

A) 0
B) 1
C) Equal to the market beta
D) Variable depending on the asset

Answer 127

A) 0

Question 128

According to CAPM, what would be the required return for Six Flags Entertainment Corporation (SIX) with a beta of 1.8, given a risk-free rate of 5% and a market return of 15%?

A) 18%
B) 23%
C) 13%
D) 10%

Answer 128

B) 23%

Question 129

How would you interpret an asset that plots below the SML?

A) It is underpriced with positive NPV and should be accepted.
B) It is overpriced with negative NPV and should be rejected.
C) It has a zero NPV and is priced correctly.
D) It indicates high market volatility.

Answer 129

B) It is overpriced with negative NPV and should be rejected.

Question 130

What does a negative alpha indicate in the context of SML and CAPM?

A) The asset is yielding exactly the required return.
B) The asset is underpriced and a good investment opportunity.
C) The asset is overpriced and not an appealing investment.
D) The asset has no relation to market risk.

Answer 130

C) The asset is overpriced and not an appealing investment.

Question 131

What does Beta in the CAPM equation represent?

A) The total risk of an asset
B) The market’s average return
C) The non-diversifiable risk of an asset
D) The risk-free rate of return

Answer 131

C) The non-diversifiable risk of an asset

Question 132

What is the Beta of the market portfolio in CAPM?

A) 0
B) 0.5
C) 1
D) 1.5

Answer 132

C) 1

Question 133

According to CAPM, how is the risk premium of an asset calculated?

A) Risk premium per unit of nondiversifiable risk times the Beta of the asset
B) The difference between the asset’s return and the risk-free rate
C) The sum of the asset’s standard deviation and market portfolio deviation
D) The asset’s correlation with the market portfolio

Answer 133

A) Risk premium per unit of nondiversifiable risk times the Beta of the asset

Question 134

If the risk-free rate is 5%, the market return is 15%, and an asset’s Beta is 1.8, what is the required return on the asset according to CAPM?

A) 10%
B) 23%
C) 18%
D) 13%

Answer 134

B) 23%

Question 135

What does a Beta of 0 represent in the context of CAPM?

A) High-risk asset
B) Risk-free asset
C) Average market risk
D) Inefficient asset

Answer 135

B) Risk-free asset

Question 136

What does the portfolio standard deviation depend on when considering assets like Amazon and 3M?

A) The average of the individual standard deviations
B) The weighted average of the individual standard deviations
C) The correlation coefficient between the assets
D) The highest standard deviation among the assets

Answer 136

C) The correlation coefficient between the assets

Question 137

What is the portfolio standard deviation for Amazon and 3M if their correlation coefficient (ρ) is 0.5?

A) 26.67%
B) 23.09%
C) 18.9%
D) 13.33%

Answer 137

B) 23.09%

Question 138

How does diversification impact the risk of a portfolio?

A) Increases non-diversifiable risk
B) Reduces diversifiable risk
C) Eliminates market risk
D) Increases systematic risk

Answer 138

B) Reduces diversifiable risk

Question 139

What type of risk is likely to be compensated with a higher expected return?

A) Non-diversifiable risk
B) Diversifiable risk
C) Idiosyncratic risk
D) Firm-specific risk

Answer 139

A) Non-diversifiable risk

Question 140

If a portfolio contains 50 stocks from 20 different industries, what can be said about its diversification?

A) It is not diversified
B) It is only diversified in terms of asset numbers
C) It is diversified across different sectors
D) It focuses on one specific industry

Answer 140

C) It is diversified across different sectors

Question 141

What does the term σ_p represent in portfolio risk calculation?

A) The total return of the portfolio
B) The standard deviation of the portfolio’s returns
C) The correlation between two assets in the portfolio
D) The weighted average return of the portfolio

Answer 141

B) The standard deviation of the portfolio’s returns

Question 142

what does ρ_ab stand for?

A) The difference in returns between assets A and B
B) The combined weight of assets A and B
C) The correlation coefficient between the returns of assets A and B
D) The sum of the standard deviations of assets A and B

Answer 142

C) The correlation coefficient between the returns of assets A and B

Question 143

When calculating the expected return of a portfolio, what is the first step?

A) Determine the total investment in the portfolio
B) Calculate the weights of the individual assets
C) Identify the standard deviation of each asset
D) Assess the correlation between each pair of assets

Answer 143

B) Calculate the weights of the individual assets

Question 144

If you invest $30,000 in Alphabet (Goog) and $20,000 in Apple (Appl), what is the weight of Alphabet in your portfolio?

A) 40%
B) 50%
C) 60%
D) 66.67%

Answer 144

D) 66.67%

Question 145

Why is it recommended to use a spreadsheet for calculating the variance and standard deviation in larger portfolios?

A) To avoid manual calculation errors
B) Because the formulas are too simple for manual calculation
C) Due to the increasing complexity and number of terms in the formula
D) It’s not recommended; manual calculation is always preferred

Answer 145

C) Due to the increasing complexity and number of terms in the formula

Question 146

What does the correlation coefficient (ρ) between two assets indicate in portfolio management?

A) The total risk of the portfolio
B) The linear relationship between the returns of the two assets
C) The sum of the standard deviations of the two assets
D) The combined weight of the two assets in the portfolio

Answer 146

B) The linear relationship between the returns of the two assets

Question 147

What is the range of the correlation coefficient (ρ) between two assets?

A) 0 to 1
B) -1 to 1
C) -0.5 to 0.5
D) 0 to 0.5

Answer 147

B) -1 to 1

Question 148

If the correlation coefficient (ρ) between two assets is -1, what does this imply about their returns?

A) They have no correlation.
B) They move in the same direction.
C) They move in opposite directions.
D) One asset’s return is double the other’s.

Answer 148

C) They move in opposite directions.

Question 149

What impact does diversification have on a portfolio if the assets are less than perfectly positively correlated?

A) Increases overall risk
B) Reduces diversifiable risk
C) Does not affect risk
D) Increases the expected return

Answer 149

B) Reduces diversifiable risk

Question 150

In terms of correlation, when is an individual asset’s risk most significant to a portfolio’s overall risk?

A) When the asset is strongly correlated with other assets
B) When the asset is weakly correlated with other assets
C) When the asset has a moderate correlation with other assets
D) The individual asset’s risk is always significant regardless of correlation

Answer 150

A) When the asset is strongly correlated with other assets

Question 151

Why can’t the portfolio standard deviation be simply the average of the standard deviations of individual assets?

A) Because individual assets’ returns are not correlated
B) Diversification impacts the risk by reducing some of it
C) The weights of assets are not considered in averages
D) Individual asset risk is always higher than portfolio risk

Answer 151

B) Diversification impacts the risk by reducing some of it

Question 152

In portfolio theory, what does the symbol ‘ρ’ (rho) represent?

A) The rate of return of the portfolio
B) The risk-free rate
C) The correlation coefficient between two assets
D) The variance of the portfolio

Answer 152

C) The correlation coefficient between two assets

Question 153

How does the correlation between assets in a portfolio affect its overall risk?

A) No effect on the overall risk
B) Increases the risk irrespective of correlation
C) Can either increase or decrease the risk, depending on the degree of correlation
D) Always decreases the risk

Answer 153

C) Can either increase or decrease the risk, depending on the degree of correlation

Question 154

What is the primary benefit of diversification in a portfolio?

A) Guarantees higher returns
B) Reduces the total risk, particularly diversifiable risk
C) Increases the correlation between assets
D) Ensures fixed returns

Answer 154

B) Reduces the total risk, particularly diversifiable risk

Question 155

Calculate the expected return and standard deviation for the following single stock:

State of economy Probability of state of economy
Return if state of the economy occurs
Recession .15 .04
Normal .25 .08
Boom .60 .12

Answer 155

The expected return for the single stock is approximately 9.8%, and its standard deviation, which measures the volatility of the returns, is about 2.96%.

Question 156

You are told the following information about 3 stock investments:

Expected return	Standard deviation Stock A	8%	10% Stock B	2%	25% Stock C	6%	15% Which stock investment will you choose (A, B or C) and why?

Answer 156

Given these considerations, Stock A appears to be the most attractive option. It offers a higher return than Stock C for a lower level of risk, and a significantly higher return than Stock B with much lower risk. This makes it a more balanced choice in terms of risk and reward.

Question 157

Given the following historical data, calculate the mean return and standard deviation.

Year Annual returns
1 10%
2 -5%
3 3%
4 15%

Answer 157

8.694%

R = 5.75%

Question 158

What does the Mean-Standard Deviation Rule in investment analysis imply?

A) Higher risk is always preferable
B) Investors prefer more return to less and less risk to more
C) Return and risk are unrelated
D) Standard deviation is irrelevant in investment decisions

Answer 158

B) Investors prefer more return to less and less risk to more

Question 159

What are the two key attributes investors care about in their portfolios, according to a portfolio perspective?

A) Return and liquidity
B) Return and risk
C) Risk and market trends
D) Liquidity and market trends

Answer 159

B) Return and risk

Question 160

What is the fundamental premise behind risk and investment analysis?

A) Security market participants are indifferent to risk
B) High-risk investments are typically accompanied by low expected returns
C) High-risk investments must be accompanied by high expected returns
D) Risk-free investments offer the highest returns

Answer 160

C) High-risk investments must be accompanied by high expected returns

Question 161

How do investors typically estimate the mean value and volatility of an asset’s value?

A) Through theoretical modeling
B) Using time-series means and standard deviations
C) By predicting future market trends
D) Based solely on past performance

Answer 161

B) Using time-series means and standard deviations

Question 162

In risk and return analysis, what is the first step in evaluating an investment opportunity?

A) Estimating the expected level and timing of incremental free cash flow
B) Calculating the net present value
C) Determining the riskiness of the asset
D) Comparing with the market’s average return

Answer 162

A) Estimating the expected level and timing of incremental free cash flow

Question 163

What is the essence of risk in financial markets?

A) The probability of receiving dividends
B) The dispersion of possible outcomes from the expected return
C) The total amount invested
D) The duration of investment

Answer 163

B) The dispersion of possible outcomes from the expected return

Question 164

How is the expected return (E[R]) of an investment calculated?

A) By adding all possible returns
B) By multiplying the probability of each return by the return and summing them up
C) By taking the average of past returns
D) By considering the highest possible return

Answer 164

B) By multiplying the probability of each return by the return and summing them up

Question 165

What does the standard deviation in investment analysis measure?

A) The average return of an investment
B) The total risk of an investment
C) The dispersion of returns around the mean
D) The probability of achieving the expected return

Answer 165

C) The dispersion of returns around the mean

Question 166

Why might investors demand a higher return on a Ford Motor bond compared to a Treasury bond?

A) Because the Ford Motor bond has a higher expected return
B) Due to the higher risk associated with the Ford Motor bond
C) Because corporate bonds always offer higher returns
D) Treasury bonds are less liquid than corporate bonds

Answer 166

B) Due to the higher risk associated with the Ford Motor bond.

Question 167

What is the primary objective in identifying and undertaking investment opportunities in financial markets?

A) To achieve the highest possible return irrespective of risk
B) To add value to a firm’s assets or to stockholders’ wealth
C) To consistently beat the market’s average return
D) To focus solely on high-risk, high-return investments

Answer 167

B) To add value to a firm’s assets or to stockholders’ wealth.

Question 168

When assessing investment opportunities, what does adjusting cash flows for differences in risk involve?

A) Changing the cash flow amounts based on market trends
B) Estimating the return of cash flows based on their risk profile
C) Ignoring the timing of cash flows
D) Keeping cash flows constant regardless of the investment’s risk

Answer 168

B) Estimating the return of cash flows based on their risk profile.

Question 169

What is indicated by a higher discount rate applied to riskier cash flows or payoffs in investment decision-making?

A) A preference for lower-risk investments
B) An indifference to the risk associated with the investment
C) A preference for higher-risk investments
D) A focus on short-term rather than long-term investments

Answer 169

A) A preference for lower-risk investments.

Question 170

What are the two key elements that matter when thinking about gambles or investments, according to risk and return analysis?

A) The amount of investment and the duration of investment
B) The expected return and the dispersion of possible returns
C) The type of assets involved and market conditions
D) The age of the investment and its liquidity

Answer 170

B) The expected return and the dispersion of possible returns

Question 171

In the context of financial markets, what does the standard deviation measure about an investment?

A) The average profitability of the investment
B) The likelihood of achieving the expected return
C) The variability or dispersion of returns around the expected return
D) The total amount of returns over a given period

Answer 171

C) The variability or dispersion of returns around the expected return

Question 172

How is the terminal value (TV) calculated for a project or firm in perpetuity using the Gordon Growth Model?

A) TV = CF0 * (1 + g) / (r – g)
B) TV = CF1 / (r – g)
C) TV = CF1 * (1 + g)1 / (r + g)
D) TV = CFn / (r + g)

Answer 172

B) TV = CF1 / (r – g)

Question 173

What does the term ‘perpetuity’ imply in the context of terminal value calculation?

A) The project will end after a fixed number of years
B) The project will continue indefinitely with a constant growth rate
C) The project has no initial cash flows
D) The project’s cash flows decrease over time

Answer 173

B) The project will continue indefinitely with a constant growth rate

Question 174

In the Gordon Growth Model, what does the ‘g’ represent?

A) The cost of capital
B) The growth rate of cash flows
C) The discount rate
D) The net present value

Answer 174

B) The growth rate of cash flows

Question 175

When calculating the Net Present Value (NPV), what factor is crucial to consider for future cash flows?

A) The total amount invested initially
B) The projected increase in market value
C) The expected rate of return
D) The discount rate applied to future cash flows

Answer 175

D) The discount rate applied to future cash flows

Question 176

In the context of NPV calculation with terminal value, why is it important to consider the terminal growth rate of operating cash flow?

A) It affects the initial investment amount
B) It influences the calculation of future cash flows beyond a certain year
C) It determines the total number of years for the project
D) It adjusts the initial cash flows for inflation

Answer 176

B) It influences the calculation of future cash flows beyond a certain year

Question 177

What typically happens to the working capital at the end of a project’s life?

A) It is reinvested into another project
B) It is typically written off as a loss
C) It is recovered by selling off inventory and collecting receivables
D) It remains as an asset on the company’s balance sheet

Answer 177

C) It is recovered by selling off inventory and collecting receivables

Question 178

How is the after-tax proceeds from the sale of an asset at the end of a project calculated?

A) Sale price minus purchase price
B) Sale price minus book value
C) Sale price minus capital gains tax
D) Sale price only

Answer 178

C) Sale price minus capital gains tax

Question 179

When calculating terminal cash flows, what happens to the machines and equipment used during the project?

A) They are kept for future projects
B) They are donated
C) They are typically sold off, generating after-tax cash flow
D) They are depreciated to zero and written off

Answer 179

C) They are typically sold off, generating after-tax cash flow

Question 180

In the context of terminal cash flows, what are ‘clean up costs’?

A) Costs associated with marketing the project’s final product
B) Expenses related to the final year’s operations
C) Costs to physically clean the project site
D) Costs associated with concluding the project, including environmental or dismantling expenses

Answer 180

D) Costs associated with concluding the project, including environmental or dismantling expenses

Question 181

How is the book value of an asset determined at the time of sale?

A) Original purchase price minus any depreciation expensed over its life
B) Current market value of the asset
C) Original purchase price only
D) Depreciation value over the life of the asset

Answer 181

A) Original purchase price minus any depreciation expensed over its life

Question 182

PDX Custom Ski’s LLC currently has no working capital. It is considering introducing a new line of skate skis which will require the following changes in NWC in year zero: $200,000 increase in inventory, a $60,000 increase in accounts receivable, a $100,000 increase in machinery, and an $80,000 decrease in accounts payable in another unit caused by this project. By year 1, NWC is expected to be $210,000.

What are the levels of working capital for years 0 and 1?
What are the net change s in working capital that would appear in your free cash flow statement for years 0 and 1?
Which belongs in your cash flow analysis, levels or changes? Are the changes sources or uses of cash?

Answer 182

Levels of Working Capital for Years 0 and 1:

Year 0:
Increase in Inventory: $200,000
Increase in Accounts Receivable: $60,000
Increase in Machinery: $100,000 (Note: Machinery is not typically part of NWC)
Decrease in Accounts Payable: -$80,000
Working Capital (NWC) = (Inventory + Accounts Receivable - Accounts Payable)
NWC in Year 0 = ($200,000 + $60,000 - (-$80,000)) = $340,000
Year 1:
NWC is given as $210,000.
Net Changes in Working Capital (for Free Cash Flow Statement):

Change from Year 0 to Year 1 = NWC in Year 1 - NWC in Year 0
Change = $210,000 - $340,000 = -$130,000
Cash Flow Analysis:

In cash flow analysis, the changes in NWC are used, not the levels.
The changes are sources or uses of cash:
A positive change (increase in NWC) is a use of cash (cash outflow).
A negative change (decrease in NWC) is a source of cash (cash inflow).
Thus, the -$130,000 change from Year 0 to Year 1 is a source of cash.

Question 183

You have the following partial balance sheet data:
2020 2019
Accounts receivable $20,000 $18,000
Inventory $300,000 $320,000
Machinery $1,200,000 $1,100,000
Accounts Payable $40,000 $35,000

What is the change in NWC from 2019 to 2020 and is it a source or use of cash?

Answer 183

The Net Working Capital (NWC) for the years 2019 and 2020 are as follows:

NWC in 2019: $303,000
NWC in 2020: $280,000
The change in NWC from 2019 to 2020 is -$23,000. This decrease in NWC indicates it is a source of cash. A decrease in NWC means that the firm has either increased its short-term liabilities more than its short-term assets or reduced its short-term assets more than its short-term liabilities, leading to a net cash inflow.

Question 184

You are in charge of considering the following two projects. Your firm can only invest in one of them and you have to decide which one. The projects have 4-year lives and their cash flows (in $millions) are given in the table.

0	1	2	3	4 Project A	-5,000	2,500	2,000	500	3,300 Project B	-4,000	1,000	3,000	2,000	700

The IRR of Project A is 24% and the IRR of Project B is 25%. The NPV of Project A is $1,555 million and the NPV of Project B is $1,369 million.
a. What are the payback periods of the two projects?
b. Your underling suggests taking project B because it has the higher Internal Rate of Return. What do you think? Explain your reasoning.

Answer 184

Choose Project A despite its longer payback period and slightly lower IRR. Although Project B has a higher IRR and a shorter payback period, Project A’s significantly higher NPV ($1,555M compared to $1,369M for Project B) suggests it will add more value. NPV is a more comprehensive indicator than IRR, especially when there’s a notable difference, as it accounts for the time value of money and total value addition.

Question 185

What is the formula for calculating annual depreciation expense using straight-line depreciation?

A) Cost of asset / # of years of useful life
B) (Cost of asset - Salvage value) / # of years
C) Cost of asset * Depreciation rate
D) (Cost of asset - Salvage value) * Depreciation rate

Answer 185

A) Cost of asset / # of years of useful life

Question 186

In straight-line depreciation, if a machine costs $75,000 and is depreciated over three years, what is the annual depreciation expense?

A) $25,000
B) $24,000
C) $20,000
D) $15,000

Answer 186

A) $25,000

Question 187

What does an increase in Net Working Capital (NWC) indicate?

A) A source of cash
B) A use of cash
C) No change in cash flow
D) Reduction in liabilities

Answer 187

B) A use of cash

Question 188

Which of the following is included in the calculation of Net Working Capital (NWC)?

A) Machinery and equipment
B) Sales and purchases on credit
C) Depreciation expense
D) Interest expenses

Answer 188

B) Sales and purchases on credit

Question 189

What happens to cash when Accounts Receivable (A/R) increases?

A) Increases
B) Decreases
C) Remains constant
D) Becomes negative

Answer 189

B) Decreases

Question 190

What does it mean for cash flow when accounts payable (A/P) increase?

A) Cash flow increases
B) Cash flow decreases
C) Cash flow remains unchanged
D) Cash flow becomes unpredictable

Answer 190

A) Cash flow increases

Question 191

How should you treat sunk costs and pre-committed expenditures in capital budgeting?

A) Include them in project costs
B) Consider them for future benefits
C) Ignore them, as they are not incremental
D) Add them to the salvage value

Answer 191

C) Ignore them, as they are not incremental

Question 192

What is included in the components of Free Cash Flow related to capital spending?

A) Depreciation and amortization expenses
B) Purchase or sale of long-term assets
C) Interest expenses and dividends
D) Operating costs and revenues

Answer 192

B) Purchase or sale of long-term assets

Question 193

In terminal cash flow calculations, how should clean-up costs be accounted for?

A) As part of the initial investment
B) They should be ignored
C) Added to the final year’s operational costs
D) Considered in the terminal year

Answer 193

D) Considered in the terminal year

Question 194

When calculating terminal cash flows, how is the after-tax proceeds from the sale of an asset determined?

A) Sale price minus book value
B) Sale price minus capital gains tax
C) Sale price only
D) Book value minus depreciation

Answer 194

B) Sale price minus capital gains tax

Question 195

What is capital budgeting?

A) The process of managing a company’s long-term investments
B) The process of analyzing capital investment projects and deciding which to undertake
C) The process of budgeting for a company’s operational expenses
D) The process of evaluating a company’s financial performance

Answer 195

B) The process of analyzing capital investment projects and deciding which to undertake

Question 196

What are the two primary tasks in evaluating investment proposals in capital budgeting?

A) Analyzing market trends and forecasting sales
B) Determining project feasibility and sourcing funds
C) Measuring incremental free cash flows and determining the appropriate discount rate
D) Calculating net income and assessing risk management

Answer 196

C) Measuring incremental free cash flows and determining the appropriate discount rate

Question 197

In capital budgeting, what are incremental cash flows?

A) Regular operating cash flows of a business
B) Changes in free cash flows caused by an investment
C) Total cash flows from all of a company’s investments
D) Cash flows that occur regardless of undertaking a project

Answer 197

B) Changes in free cash flows caused by an investment

Question 198

What components are included in the calculation of Free Cash Flow (FCF)?

A) Net profit, dividends, and tax payments
B) Operating cash flow, changes in net working capital, and capital spending
C) Sales revenue, interest income, and capital gains
D) Earnings before interest and taxes, depreciation, and amortization

Answer 198

B) Operating cash flow, changes in net working capital, and capital spending

Question 199

What is the impact of depreciation on a firm’s taxable income?

A) Increases taxable income by reducing net income
B) Has no impact on taxable income
C) Reduces taxable income as it’s a non-cash expense
D) Increases taxable income by increasing expenses

Answer 199

C) Reduces taxable income as it’s a non-cash expense

Question 200

What is typically included in the initial outlay (CF0) of a capital budgeting project?

A) Dividends and interest expenses
B) Purchasing and installing new plants and equipment, and working capital
C) Depreciation and amortization expenses
D) Marketing and distribution costs

Answer 200

B) Purchasing and installing new plants and equipment, and working capital

Question 201

What does not get included in the after-tax incremental cash flows (CF1 to CFN) in capital budgeting?

A) Changes in revenue minus expenses
B) Depreciation tax shields
C) Interest expenses
D) Changes in working capital

Answer 201

C) Interest expenses

Question 202

What are terminal cash flows in capital budgeting typically comprised of?

A) Initial investment and interest expenses
B) Salvage value, recovery of working capital, and clean-up costs
C) Dividends and capital gains
D) Operating income and depreciation expense

Answer 202

B) Salvage value, recovery of working capital, and clean-up costs

Question 203

When considering a new project, why must a firm include the effects on revenues and operating costs in other parts of the company?

A) To account for incidental effects
B) To calculate the project’s net income
C) To determine the market value of the firm
D) To estimate the project’s return on investment

Answer 203

A) To account for incidental effects

Question 204

How is depreciation treated in the calculation of Free Cash Flow?

A) Added back to net income because it’s a non-cash expense
B) Ignored as it doesn’t affect cash flow
C) Deducted from operating income
D) Treated as a capital expenditure

Answer 204

A) Added back to net income because it’s a non-cash expense

Question 205

What does IRR (Internal Rate of Return) measure in capital budgeting?

A) The rate of return at which the NPV of an investment equals zero
B) The time it takes to recover the initial investment
C) The annual growth rate of the firm’s dividends
D) The rate at which an investment’s capital cost is recovered

Answer 205

A) The rate of return at which the NPV of an investment equals zero

Question 206

What is a major drawback of using the payback period as a decision rule in capital budgeting?

A) It is difficult to calculate
B) It does not correspond to the value of a firm
C) It always gives a negative result
D) It overestimates the value of distant cash flows

Answer 206

B) It does not correspond to the value of a firm

Question 207

What limitation does the payback period have in terms of cash flow analysis?

A) It overemphasizes early cash flows
B) It considers the time value of money
C) It always requires a benchmark for comparison
D) It considers all cash flows over the life of the project

Answer 207

A) It overemphasizes early cash flows

Question 208

In mutually exclusive projects, how should the decision be made when there is a conflict between NPV and IRR?

A) Choose the project with the higher IRR
B) Choose the project with the higher NPV
C) Select the project with the shorter payback period
D) Reject both projects

Answer 208

B) Choose the project with the higher NPV

Question 209

Why might a firm prefer a project with a lower IRR over one with a higher IRR?

A) The project with the lower IRR has a shorter payback period
B) The project with the lower IRR has a higher NPV
C) The project with the lower IRR is less risky
D) The project with the lower IRR requires less initial investment

Answer 209

B) The project with the lower IRR has a higher NPV

Question 210

When comparing mutually exclusive projects with different scales, what factor should be considered in addition to NPV and IRR?

A) The total investment amount
B) The payback period
C) The risk of the projects
D) The duration of the projects

Answer 210

A) The total investment amount

Question 211

What is the Internal Rate of Return (IRR)?

A) The discount rate at which the Net Present Value (NPV) of a project is zero
B) The average annual return over the life of an investment
C) The rate of return required by equity investors
D) The interest rate charged for a loan

Answer 211

A) The discount rate at which the Net Present Value (NPV) of a project is zero

Question 212

How is IRR useful in evaluating investment projects?

A) It determines the exact amount of profit an investment will generate
B) It shows the annual rate of return expected from the investment
C) It compares the profitability of different projects regardless of their scale
D) It indicates the time it takes to recoup the initial investment

Answer 212

B) It shows the annual rate of return expected from the investment

Question 213

Why might IRR be inappropriate for comparing two projects with different initial investments?

A) It does not consider the scale of investment
B) It always gives a higher value for larger projects
C) It is based solely on the project’s duration
D) It assumes reinvestment at the project’s IRR

Answer 213

A) It does not consider the scale of investment

Question 214

What is a limitation of using IRR when a project has multiple sign changes in its cash flow stream?

A) It can yield multiple IRR values
B) It always leads to a negative IRR
C) It underestimates the project’s risk
D) It overestimates the project’s duration

Answer 214

A) It can yield multiple IRR values

Question 215

When should a project be accepted based on its IRR?

A) When the IRR is greater than the project’s discount rate
B) When the IRR is lower than the project’s discount rate
C) When the IRR is equal to the project’s NPV
D) When the IRR equals the market rate of return

Answer 215

A) When the IRR is greater than the project’s discount rate

Question 216

What issue arises with the Internal Rate of Return (IRR) when the term structure of interest rates is not flat?

A) IRR becomes irrelevant for short-term projects
B) IRR can provide misleading results due to varying discount rates
C) IRR overestimates the risk of long-term projects
D) IRR becomes equal to the Net Present Value (NPV)

Answer 216

B) IRR can provide misleading results due to varying discount rates

Question 217

In capital budgeting, how is the Payback Period defined?

A) Time taken for an investment’s cash inflows to equal its initial cost
B) Duration required to double the investment
C) Time taken to achieve the project’s break-even point in sales
D) Period after which a project’s NPV becomes positive

Answer 217

A) Time taken for an investment’s cash inflows to equal its initial cost

Question 218

Why might the Payback Period method be criticized when evaluating investment projects?

A) It considers the time value of money
B) It ignores cash flows occurring after the payback period
C) It is always longer than the project’s actual duration
D) It overemphasizes the project’s initial costs

Answer 218

B) It ignores cash flows occurring after the payback period

Question 219

What is the primary disadvantage of using Payback Period as the sole method of evaluating investments?

A) It does not provide any information on a project’s profitability
B) It requires complex financial modeling
C) It is only applicable to projects with regular cash flows
D) It always leads to a conservative investment strategy

Answer 219

A) It does not provide any information on a project’s profitability

Question 220

What is the Net Present Value (NPV) method in capital budgeting?

A) A technique that calculates the total value of a project by discounting future cash flows to their present value
B) A method to determine the duration needed to recover the initial investment
C) A way to calculate the average annual return of a project
D) A process to find the interest rate that equates a project’s inflows and outflows

Answer 220

A) A technique that calculates the total value of a project by discounting future cash flows to their present value

Question 221

What happens to NPV when a project’s cash flows are an annuity and the discount rate decreases?

A) NPV remains unchanged
B) NPV decreases
C) NPV increases
D) NPV becomes negative

Answer 221

C) NPV increases

Question 222

In the NPV profile graph, what does the point where the NPV equals zero represent?

A) Break-even point
B) Maximum possible loss
C) Internal Rate of Return (IRR)
D) Optimal discount rate

Answer 222

C) Internal Rate of Return (IRR)

Question 223

What limitation does NPV have in capital budgeting analysis?

A) It cannot be used for comparing projects of different sizes
B) It is too complex to calculate for large projects
C) It overlooks the value of managerial flexibility in future decisions
D) It only considers the initial cost of the project

Answer 223

C) It overlooks the value of managerial flexibility in future decisions

Question 224

Which factor is NOT considered while calculating NPV?
A) The source of project financing
B) Incremental free cash flows
C) Discount rate reflecting the risk of investment
D) Managerial flexibility in future decision

Answer 224

A) The source of project financing

Question 225

How does the discount rate affect the Net Present Value (NPV) of a project?

A) An increase in the discount rate increases the NPV
B) The discount rate has no effect on NPV
C) An increase in the discount rate decreases the NPV
D) The discount rate only affects the initial investment

Answer 225

C) An increase in the discount rate decreases the NPV

Question 226

What does the NPV method primarily evaluate?

A) The initial cost of a project
B) The present value of all future free cash flows of an investment
C) The time it takes for a project to recover its initial investment
D) The annual rate of return on the investment

Answer 226

B) The present value of all future free cash flows of an investment

Question 227

What is the primary objective of Net Present Value (NPV) in capital budgeting?
A) To determine the break-even point of a project
B) To assess the profitability of short-term investments
C) To measure the dollar impact of an investment on a company’s assets
D) To calculate the internal rate of return for a project

Answer 227

C) To measure the dollar impact of an investment on a company’s assets

Question 228

Would you demand a higher return on a $1,000 par Treasury bond, or a $1,000 par Ford Motor bond?

Answer 228

Ford

Question 229

Would you buy a stock in GE if you thought it would only retun as much as t-bond?

Answer 229

No