CH8

When choosing among mutually exclusive projects, the choice is easy using the NPV rule. As long as at least one project has positive NPV, simply choose the project with the highest NPV. 1. True False For many firms the limits on capital funds are "soft." By this we mean that the capital rationing is not imposed by investors. 2. True False A project's opportunity cost of capital is: the forgone return from investing in the project. the return earned by investing in the project. equal to the average return on all company projects. designed to be less than the project's IRR. What should occur when a project's net present value is determined to be negative? The discount rate should be decreased. The profitability index should be calculated. The present value of the project cost should be determined. The project should be rejected.

(1)

(1)

3.

(1)

4.

What is the maximum that should be invested in a project at time zero if the inflows are estimated at $50,000 annually for three years, and the cost of capital is 9%? $101,251.79 $109,200.00 $126,565.00 $130,800.00
(1)

5.

(1)

Which of the following projects would you feel safest in accepting? Assume the opportunity cost of capital to be 12% for each project. "A" has a small, but negative, NPV. "B" has a positive NPV when discounted at 10%. 6. "C's" cost of capital exceeds its rate of return. "D" has a zero NPV when discounted at 14%. 7. What is the minimum number of years that an investment costing $500,000 must return

(1)

$65,000 per year at a discount rate of 13% in order to be an acceptable investment? 8.69 years 14.00 years 27.51 years An infinite number of years. NPV = (65,000/.13) - $500,000 NPV = 500,000 - 500,000 NPV = 0 Which of the following statements is most likely correct for a project costing $50,000 and returning $14,000 per year for five years? NPV = $3,071.01. NPV = $20,000. IRR = 2.8%. IRR is greater than 10%.

(1)

8.

What is the NPV for the following project cash flows at a discount rate of 15%? CF 0 = ($1,000), CF1 = $700, CF2 = $700. ($308.70) ($138.00) $138.00 $308.70
(1)

9.

(1)

A project costing $20,000 generates cash inflows of $9,000 annually for the first three years, followed by cash outflows of $1,000 annually for two years. At most, this project has ______ different IRR(s). one 10. two three five

(1)

How many IRRs are possible for the following set of cash flows? CF0 = -1,000, CF1 = +500, CF2 = -300, CF3 = +1,000, CF4 = +200. 1 2 11. 3 4 Given a particular set of project cash flows, which of the following statements is correct? There can be only one NPV for the project. There can be only one IRR for the project. 12. There can be more than one NPV for the project. There can be only one profitability index for the project. When managers cannot determine whether to invest now or wait until costs decrease later, the rule should be to: postpone until costs reach their lowest. invest now to maximize the NPV. 13. postpone until the opportunity cost reaches its lowest. invest at the date that gives the highest NPV today. Use of a profitability index to select projects in the absence of capital rationing: will provide the same rankings as an NPV criterion. will maximize NPV, but not IRR. 14. can result in misguided selections. is technically impossible. Which of the following statements is true for a project with $20,000 initial cost, cash inflows of $5,800 per year for six years, and a discount rate of 15%? Its payback period is roughly 3 1/2 years. Its NPV is $2,194. 15. Its IRR is 1.85%. Its profitability index is 0.109. The "gold standard" of investment criteria refers to: net present value. internal rate of return. payback period. profitability index.

(1)

(1)

(1)

(1)

(1)

16.

(1)

17. Which of the following investment decision rules tends to improperly reject long-lived projects? net present value. internal rate of return. payback period.

profitability index. If a project's IRR is 13% and the project provides annual cash flows of $15,000 for four years, how much did the project cost? $44,617 $52,200 $60,000 $72,747
(1)

18.

(1)

A project has a payback period of five years and the firm employs a 10% cost of capital. Which of the following statements is correct concerning this project's discounted payback? Discounted payback will exceed five years. Discounted payback will be less than five years. 19. Discounted payback will decrease if the project's IRR exceeds 10%. Discounted payback will increase if the project's IRR is less than 10%. You can continue to use your less efficient machine at a cost of $8,000 annually for the next five years. Alternatively, you can purchase a more efficient machine for $12,000 plus $5,000 annual maintenance. At a cost of capital of 15%, you should: Buy the new machine and save $600 in equivalent annual costs. Buy the new machine and save $388 in equivalent annual costs. Keep the old machine and save $388 in equivalent annual costs. Keep the old machine and save $580 in equivalent annual costs.

(1)

20.

$12,000 + $16,760.78 = $28,760.78 Total PV of cost, which represents an EAC of $8,579.79, which is $579.79 more annually. A firm uses the profitability index to select between two mutually exclusive investments. If no capital rationing has been imposed, which project should be selected? Select the project with the higher profitability index. 21. Select the project with the lower profitability index. Without capital rationing, both projects can be selected. Without capital rationing, select by NPV method.

(1)

CH 9
15.What is the present value at a 10% discount rate of the depreciation tax shield for a firm in the 35% tax bracket that purchases a $50,000 asset being depreciated straight-line over a five-year life to a zero salvage value? $10,866 $13,268 $17,500 $37,908

CH11
For investment horizons greater than 20 years, long-term corporate bonds traditionally have 1. outperformed common stocks. True False When inflation is expected to be low, the risk premium on common stocks is expected to be low. True False

(1)

2.

(1)

The historical record fails to show that investors have received a risk premium for holding risky assets. True 3. False What is the percentage return on a stock that was purchased for $50.00, paid a $3.00 dividend after one year and was then sold for $49.00? (2.50%) 2.50% 4. 4.00% 7.50%

(1)

(1)

How is it possible for real rates of return to increase during times when the rate of inflation increases? Inflation increased more than the real return. Nominal returns actually decreased. 5. Nominal returns increased more than inflation. Nominal returns increased less than inflation. What nominal return was received by an investor when inflation averaged 8.0% and the real rate of return was a negative 2.5%? 5.30% 5.36% 6.50% 10.77%

(1)

6.

(1)

7. What real rate of return is earned by a one-year investor in a bond that was purchased for $1,000, has an 8% coupon, and was sold for $960 when the inflation rate was 6%? -1.89% 1.92% 5.66% 11.47%

(1)

The Dow Jones Industrial Average is: the most representative of stock market indexes. an index of America's 500 major corporations. 8. an index of 30 major industrial stocks. an equally weighted index of all stocks traded on the New York Stock Exchange. Although Standard and Poor's Composite Index contains a small portion of U.S. publicly traded stocks, the Index represents: all stocks that prefer to be equally-weighted. all stocks that prefer to be value-weighted. 9. approximately 50% of U.S. stocks traded, in value. approximately 75% of U.S. stocks traded, in value. Market interest rates have risen substantially in the five years since an investor purchased Treasury bonds that were offering a 7% return. If the investor sells now she is likely to receive: greater than a 7% total return. 10. less than a 7% total return. a 7% total rate of return. a 7% nominal return but less than a 7% real return. The risk premium that is offered on common stock is equal to the: expected return on the stock. real rate of return on the stock. excess of expected return over a risk-free return. expected return on the S&P 500 index.

(1)

(1)

(1)

11.

(1)

An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the rate of return on: Treasury bills. the market portfolio. 12. the market portfolio minus the rate of return on Treasury bills. Treasury bonds plus a maturity premium.

What is the variance of return of a three-stock portfolio (with unequal weights 25%, 50% and 25%) that produced returns of 20%, 25% and 30%, respectively? 10.00 12.50 15.00 20.00
(1)

13.

(1)

What is the standard deviation of a portfolio's returns if the mean return is 15%, the variance of returns is 184, and there are three stocks in the portfolio? 7.83% 13.56% 41.00% 14. 225.00%

(1)

The standard deviations of individual stocks are generally higher than the standard deviation of the market portfolio because individual stocks: offer higher returns. have more systematic risk. 15. have no diversification of risk. do not have unique risk. The benefits of portfolio diversification are highest when the individual securities have returns that: vary directly with the rest of the portfolio. vary indirectly with the rest of the portfolio. 16. are less than perfectly correlated with the rest of the portfolio. are countercyclical. A stock investor owns a diversified portfolio of 15 stocks. What will be the likely effect on portfolio standard deviation from adding one more stock? A slight increase will occur. A large increase will occur. 17. A slight decrease will occur. A large decrease will occur.

(1)

(1)

(1)

Most of the beneficial effects of diversification will have been received by the time a portfolio of common stocks contains _____ stocks. 2 5 18. 20 50 Risk factors that are expected to affect only a specific firm are referred to as: market risk. diversifiable risk. 19. systematic risk. risk premiums. Although unique risk is present in differing amounts, individual stocks are: exposed to the same amount of market risk. exposed to differing amounts of market risk also. 20. not exposed to market risk; only the general economy is subject to market risk. able to diversify away their market risk. In stock market parlance, Black Monday refers to: the observation that most stocks post positive returns on Mondays. a blackout of information concerning stock prices on Monday mornings. 21. the tendency for most stocks to decline in value on Mondays. a major stock market crash during 1987.

(1)

(1)

(1)

(1)

If when a coin is tossed the observance of a head rewards you with a dollar and the observance of a tail costs you fifty cents, how much would you expect to gain after twenty tosses? $5.00 $7.50 22. $10.00 $15.00 Expected return = 20 x [($1.00 x .5) - (.50 x .5)] = 20 x ($.25) = $5.00 If a project's expected return is 15%, which represents a 35% return in a booming economy and a 5% return in a stagnant economy, what is the probability of a booming economy? 18.33% 25.00% 23. 33.33% 50.00% 15% = 35%(X) + 5%(1 - X) 10% = 30%X 33.33% = X

(1)

CH 12
Capital asset pricing model states that the expected risk premium on any security equals its beta times the market risk premium. True False There is little doubt that the CAPM is too simple to capture everything that is going on in the market. 2. True False According to the CAPM, a stock's expected return is positively related to its beta. True False

(1)

(1)

3.

(1)

CAPM, Capital Asset Pricing Model, is a theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium. 4. True False Project cost of capital and company cost of capital are synonymous terms. True False The cost of capital for a project depends on the risk of the company. True False In practice, the market portfolio is often represented by: a portfolio of U.S. Treasury securities. a diversified stock market index. an investor's mutual fund portfolio. the historic record of stock market returns.

(1)

5.

(1)

6.

(1)

7.

(1)

What should be the beta of a replacement stock if an investor wishes to achieve a portfolio beta of 1.0 by replacing Stock C in the following equally weighted portfolio: Stock A = .9 beta; Stock B = 1.1 beta; Stock C = 1.35 beta? .93 beta 1.00 beta 1.08 beta 8. 1.15 beta New Portfolio Beta = (.333 x .9) + (.333 x 1.1) + (.333 x Beta C) 1.0 = .3 + .366 +.333 x Beta C .334 = .333 x Beta C 1.00 = Beta C

(1)

9.

The beta of an investment in U.S. Treasury bills is: 0.0 0.5 1.0 meaningless; only common stocks have betas.

(1)

An investor was expecting a 18% return on his portfolio with beta of 1.25 before the market risk premium decreased from 8% to 6%. Based on this change, what return will now be expected on the portfolio? 15.5% 20.5% 22.5% 10. 26.0% Old: 18% = rf + 1.25(8%) = rf + 10.0% 8.0% = rf New: Expected return = 8.0% + 1.25(6%) = 8.0% + 7.5% = 15.5% What rate of return should an investor expect for a stock that has a beta of 1.25 when the market is expected to yield 14% and Treasury bills offer 6%? 9.2% 11.2% 12.4% 16.0% 11. r = rf + B(rm - rf) = 6% + 1.25(14% - 6%) = 6% + 10% = 16% What return should be expected from investing in the market portfolio which is expected to yield 18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at the risk-free rate of 6%? 18.6% 19.6% 21.6% 12. 30.0% Beta = (2.0 x Bmarket) + (-1 x Bloan) = (2.0 x 1) + 0 = 2.0 Expected return = 6% + 2.0(18% - 6%) = 6% + 24% = 30%

(1)

(1)

(1)

13. Which of the following statements is more likely to be correct concerning the statement, "Stock A has a higher expected return than Stock B"? Stock A has more unique risk. Stock B plots below the security market line. Stock B is a cyclical stock.

Stock A has a higher beta. A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable. company cost of capital risk-free rate 14. market risk premium project cost of capital The project cost of capital is: equal to the company cost of capital. less than the company cost of capital. greater than the company cost of capital. not necessarily related to the company cost of capital.

(1)

(1)

15.

(1)

Which of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index? The portfolio contains fairly aggressive stocks. The portfolio's stock plot below the security market line. 16. The portfolio's beta is less than 1.0. The portfolio contains a significant amount of unique risk. A project is determined to have equal probability of generating $1 million annually or $500,000 annually for four years. The initial outlay is $2 million. The expected return on Treasury bills is 6% and the market risk premium is 10%. What is the highest project beta that will justify acceptance of the project? 0.00 1.00 1.245 2.31

(1)

17 .

This suggests a risk premium of 12.45% on the project, which corresponds to a beta of 1.245.
(1)

18. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive: the risk-free rate plus 75% of the expected return on the market. the risk-free rate plus 75% of the expected market risk premium. 75% of the expected return on the market. 25% of the risk-free rate plus 75% of the expected return on the market.

(1)

How is it possible to invest only in the market portfolio yet have a portfolio beta of 1.5? Don't diversify away the unique risks. 19. Purchase only aggressive stocks for the portfolio. Purchase only stocks with high levels of systematic risk. Borrow funds to increase your investment.