Financial Risk Management and Capital Budgeting

Question 1

The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium.

Answer 1

Equity risk premium

Question 2

Investors that prefer investments with higher returns whether or not they have risk; risk is a nonfactor

Answer 2

Risk-neutral investors

Question 3

Investorst hat prefer totake risks and would invest in a higher-risk investment despite the fact that a lower-risk investment might have the same return

Answer 3

Risk-seeking investors

Question 4

The sum of the historical returns for anumber of periods and dividing by the number of periods *recommended for assets with shorter holding periods

Answer 4

Arithmetic average return

Question 5

A computation that depicts the compound annual return earned by an investor who bought hte asset and held it for hte number of historical periods examined *recommended for assets with longer holding periods

Answer 5

Geometric average return

Question 6

A financial measure that captures the degree to which the asset returns move together over time in a portfolio

Answer 6

covariance

Question 7

the risk that exist for one particular investment or a group of like investments –can be eliminted by diversification

Answer 7

unsystematic risk

Question 8

Rsik that relates to market factors that cannot be diversified away (ex. fluctuations in GDP, inflation, interest rates, etc.)

Answer 8

Systematic risk

Question 9

A standardized measure that has been developed to estimate an investemnt’s systematic risk

Answer 9

Beta

Question 10

Describe an investor’s trade-off between risk and return

Answer 10

Risk preference function

Question 11

An investment portfolio that falls on the line described by an investor’s risk preference function

Answer 11

Efficient portfolio

Question 12

The risk that the firm will default on payment of interest or principal of hte loan or bond; can be divided into a firm’s creditworthiness and sector risk

Answer 12

Credit or default risk

Question 13

The risk related to economic conditions in the firm’s economic sector; an unsystematic risk

Answer 13

Sector risk

Question 14

The riskthat the value of hte loan or bond will decline due to an increase in interest rates; a systematic risk

Answer 14

Interest rate risk

Question 15

The risk that hte value of hte loan or bond iwll decline due to a decline in hte aggregate value of all the assets in the economy; a systematic risk

Answer 15

Market risk

Question 16

The contractual rate charged by the lendor

Answer 16

stated interest rate

Question 17

The interest rate that reflects the true annual return to the lender

Answer 17

effective annual interest rate

Question 18

An upward sloping interest rate curve in which short-term rates are less than intermediate-term rates which are less than long-term rates

Answer 18

Normal yield curve

Question 19

A downward-sloping curve in which short-term rates are greater than intermediate-term rates twhich are greater than long-term rates

Answer 19

Inverted (abnormal) yield curve

Question 20

A yield curve in which short-term, intermediate, and long-term rates are all about the same

Answer 20

Flat yield curve

Question 21

A yield curve in wich intermediate-term rates are higher than both short-term and long-term rates

Answer 21

Humped yield curve

Question 22

A theory that stattes that long term interest rates should be higher than short-term rates because investors have to be offered a premium to entice them to hold less liquid and more price-sensitive securities

Answer 22

Liquidity preference theory

Question 23

A theory that states that treasury securities are divided into market segments by the various financial institutions investing in the market, and hte demand for various term securities is dependent on the deamnds of these segmented groups investors

Answer 23

Market segmentation theory

Question 24

A theory that explains yields on long-term securties as a function of short-term rates; long-term rates reflect hte average of short-term expected rates over the time perido that hte long-term security will be outstanding

Answer 24

Expectations theroy

Question 25

a measure the describes the risk of an investment project relative to other investments in general

Answer 25

beta coefficient

Question 26

A financial instrument or contract whose value is derived from some other financial measure and includes payment provisions (ex. options, forwards, futures, etc.)

Answer 26

Derivative

Question 27

An option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap (have characteristics of both options and interest rate swaps)

Answer 27

Swaption

Question 28

The risk of loss from ineffective hedging activities

Answer 28

Basis risk

Question 29

The risk of loss from a legal or regultaory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement

Answer 29

Legal risk

Question 30

The method is used to determine the fair value of interest rate swaps—net settlements from the swap are estimated and discountedback to their current value and used for financial reporting purposes

Answer 30

zero-coupon method

Question 31

A position in which a firm is committed to sell something it does not own

Answer 31

short position

Question 32

a technique used to evaluate and control long-term investments; 6 stages

Answer 32

capital budgeting

Question 33

Stage of capital budgeting where management determines the type of capital projects that are necessary to achieve management’s objectives and strategies

Answer 33

Identification stage

Question 34

Stage of capibal budgeting where managment attempts to identify alternative capital investments that will achieve management’s objectives

Answer 34

Search stage

Question 35

Stage of capital budgeting where management attempts to revaluate the various investments in terms of their costs and benefits

Answer 35

Information-acquisition stage

Question 36

Capitabl budgeting stage where management chooses the projects that best meet the criteria established

Answer 36

Selection stage

Question 37

The capital budgeting stage where management decides on the best source of funding for hte project

Answer 37

Financing stage

Question 38

Capital budgeting stage wehre management undertakes the project and monitors hte performance of the investment

Answer 38

Implementation and control stage

Question 39

Costs that will not continue ot be incurred if a department or product is terminated

Answer 39

Avoidable costs

Question 40

Costs that arise from a company’s basic commitment ot open its doors and engage in business (depr, property taxes, salaries, etc.)

Answer 40

committed costs

Question 41

Fixed costs whose level is set by current managment decisions

Answer 41

Discretionary costs

Question 42

future costs that will change as a result of a specific decision

Answer 42

Relevant costs

Question 43

The difference in costs between two alternatives

Answer 43

Differential (incremental) cost

Question 44

The maximum income or savings foregone by rejecting an alternative

Answer 44

Opportunity cost

Question 45

cash disbursement associated with a specific project

Answer 45

Outlay (out-of-pocket) costs

Question 46

Investment decision method that evaluates investments based on the legnth of time until recapture (return) of the investment

Answer 46

Payback method

Question 47

Payback method except the payback period is calculated by first discounted cash flows to their present value

Answer 47

Discounted payback method

Question 48

Investment decision method that computes an approximate rate of return which ignores the time value of money; often used to evaluate mangement

Answer 48

Adjusted Rate of Return (ARR) method

Question 49

Investment decision method that uses a discountedcash flow method that calculates the present value of the future cash flows of a project and compares this with the investment outlay required to implement hte project

Answer 49

Net Present Value (NPV) method

Question 50

Discounted cash flow method that determines the rate of discount at which the present valueof hte future cash flows will exactly equal the investment outlay

Answer 50

Internal Rate of Return (IRR) method

Question 51

The firm’s minimum acceptable rate of return for a project; determined based on the market rate of return for projects with similar risk levels

Answer 51

Hurdle rate

Question 52

(standard deviation)/ (expected value of hte investment)

Answer 52

coefficient of variation

Question 53

Exploring “what-if” situations ot determine the variables to which the outcomes are particularly sensitive

Answer 53

Sensitivity analysis

Question 54

A more complex version of sensitivity analysis where managmenet develops scenarios that might happen if a number of related variables change

Answer 54

Senario analysis

Question 55

An investment decision technique that asssumes that once managmeent makes an initial investment, it has an option to take a number of future actions that will change the value of the investment, so the initial decision can be viwed as purchasing an option

Answer 55

Real options

Question 56

A real option for managment to expand the investment

Answer 56

Expansion option

Question 57

A real option for management to abandon a project

Answer 57

Abandonment option

Question 58

A real option in which management may receive other investment opportunities when investing in the project

Answer 58

Follow-up investment options

Question 59

A real option in which managment may be provided with the ability to take advntages of changes in economic circumstances

Answer 59

Flexibility options