Finance Midterm 2

Question 1

Volatility is measured by:

Answer 1

• Variance
• Standard Deviation

Question 2

Volatility of returns is what is considered as

Answer 2

Risk

Question 3

Diversification:

Answer 3

Strategy designed to reduce risk by spreading the portfolio across many investments. This is possible because assets possess two kinds of risk.

Question 4

Unique risk:

Answer 4

Risk factors affecting only that firm. Also called specific, diversifiable or non-systematic risk

Question 5

Market risk:

Answer 5

Economy-wide (macroeconomic) source of risk that affects the overall stock market. Also called systematic or non-diversifiable risk

Question 6

Portfolio Risk:

Answer 6

Portfolio standard deviation depends on the individuals stocks’ standard deviation and also on their correlation to one another

Question 7

You cannot eliminate all risk from a portfolio by adding

Answer 7

Securities

Question 8

Typically, once you get beyond 15 stocks, adding more stocks does

Answer 8

Very little to reduce the risk of the portfolio

Question 9

The risk that cannot be diversified away is called:

Answer 9

Market risk (or systematic or non-diversifiable risk)

Question 10

For reasonably well diversified portfolio

Answer 10

Only market risk matter

Question 11

Capital Asset Pricing Model (CAPM)

Answer 11

A Model to analyze the risk and required rates of return on assets when held in portfolios

Question 12

7 assumptions of CAPM:

Answer 12

1. Investors choose among portfolios on the basis of means and standard deviation
2. Individuals can borrow and lend at the risk-free rate
3. Investors have homogeneous expectations
4. Assets are perfectly divisible and liquid
5. Not transactions costs or taxes
6. Investors are price takers
7. Quantities of all assets are given and fixed

Question 13

The Market Portfolio:

Answer 13

Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P/TSX or S&P Composite Index, is used to represent the market

Question 14

The market portfolio is used as a

Answer 14

Benchmark to measure the risk of individual stock

Question 15

Beta

Answer 15

Sensitivity of a stock’s return on the market portfolio and a measure of market risk

Question 16

Portfolio Beta

Answer 16

The weighted average of the betas of the individual assets; with the weight being equal to the proportion of wealth invested in each asset

Question 17

Market Risk Premium

Answer 17

The difference between the expected return on the market portfolio and the interest rate on Treasury bills (risk free asset)

Question 18

Since the return on the t-bill is fixed and unaffected by what happens in the market;

Answer 18

The beta of the risk-free asset is zero

Question 19

By definition, the beta of the market portfolio is

Answer 19

1

Question 20

Security Market Line

Answer 20

The relationship between the market risk of the security (beta) and its expected return

Question 21

According to the CAPM, what lies on the SML?

Answer 21

Expected rates of return for all securities and all portfolios

Question 22

Company Cost of Capital

Answer 22

Is the expected rate of return demanded by investors in a company, determined by the average risk of the company’s assets and operations

Question 23

Project Cost of Capital

Answer 23

Is the minimum acceptable expected rate of return on a project given its risk

Question 24

Weighted Average Cost of Capital

Answer 24

Is the expected rate of return on a portfolio of all the firm’s securities, adjusted for tax saving due to interest payments

Question 25

The cost of capital must be based on

Answer 25

What investors are actually willing to pay for the company’s outstanding securities

Question 26

The interest payments on the debt are

Answer 26

Deducted from income before tax is calculated

Question 27

Issues with using WACC

Answer 27

1. Changing the capital structure
2. Changing the capital structure might affect beta

Question 28

[Changing the capital structure] If leverage increases

Answer 28

The debt is riskier so debtholders are likely to demand a higher return

Question 29

[Changing the capital structure] As shareholders are paid only after debtholders

Answer 29

Increasing debt may also increase the shareholders’ required rate of return

Question 30

[Changing the capital structure] There are actually two costs of debt finance

Answer 30

• The explicit cost of debt
• The implicit cost of debt

Question 31

Explicit Cost of Debt

Answer 31

The rate of interest that bondholders demand

Question 32

With increased debt there is

Answer 32

More financial risk to shareholders as they are paid only after debt holders receive their promised interest and principal

Question 33

Increasing leverage raises the debt-equity ratio and

Answer 33

Increases the financial risk to shareholders resulting in higher beta

Question 34

A company’s WACC is the right

Answer 34

Discount rate for average risk project

Question 35

The WACC is the return the company needs to

Answer 35

Earn on its investments, after tax, to satisfy all its security holders

Question 36

If the firm increases its debt ratio

Answer 36

Both the debt and equity will become riskier

Question 37

3 Pitfalls of the IRR Rule

Answer 37

1. Lending or Borrowing?
2. Mutually exclusive projects involving different outlays
3. Multiple rates of return

Question 38

Incremental Cash Flows Cash Flows

Answer 38

A project’s PV depends on the extra (or incremental) cash flow it produces

Question 39

Incremental Cash Flow =

Answer 39

Cash flow with project - cash flow without project

Question 40

Identifying Cash Flows, things to look out for

Answer 40

1. Include all indirect effects
2. Forget sunk costs
3. Include opportunity costs
4. Recognize the working capital investment
5. Remember shutdown cash flows
6. Beware of allocated overhead costs
7. Separate investment and financing decisions

Question 41

Half-year rule:

Answer 41

Only one-half of the purchase cost of the asset is added to the asset class and used to compute CCA in the year of purchase

Question 42

Project cash flows do not equal

Answer 42

Profit. Allow for changes in working capital and depreciation

Question 43

CCA reduces

Answer 43

Taxable income and tax

Question 44

Most asset classes use what to calculate CCA

Answer 44

Declining balance

Question 45

Most assets generate CCA tax shields over

Answer 45

An infinite time frame

Question 46

Calculate PV of operating cash flows separately from the

Answer 46

PV of the CCA tax sheilds