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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

NOTE: 1. The question pool is extracted from a different textbook (Corporate Finance, 3rd Edition, by Berk and DeMarzo) with slightly different coverage. 2. Not all questions are relevant. 3. If the answer does not make sense to you, please post your question on “Discussion Boards > Forum 05: Questions Related to Final Exam” on LMS.

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Chapter 7 Investment Decision Rules 7.1 NPV and Stand-Alone Projects 1) Which of the following statements is FALSE? A) About 75% of firms surveyed used the NPV rule for making investment decisions. B) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. C) To decide whether to invest using the NPV rule, we need to know the cost of capital. D) NPV is positive only for discount rates greater than the internal rate of return. Answer: D Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Conceptual Use the following information to answer the question(s) below. Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear on TV news as a political commentator. Given her popularity, assume that she could have earned $8 million over the year (paid at the end of the year) she spent writing the book. Assume that she was unable to fulfill her media commitments of appearing on TV news as a political commentator or give speeches.while she was writing the book. 2) Assume that once her book is finished, it is expected to generate royalties of $5 million in the first year (paid at the end of the year) and these royalties are expected to decrease by 40% per year in perpetuity. Assuming that Palin's cost of capital is 10% and given these royalties payments, the NPV of Palin's book deal is closest to: A) $3.75 million B) $12.20 million C) $13.00 million D) $13.75 million Answer: D Explanation: D) NPV = $11 - $8/(1.10)1 + $5/(.10 - -0.40) = $ 13.72727 Diff: 3 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

3) Which of the following statements is FALSE? A) In general, the difference between the cost of capital and the IRR is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision. B) The IRR can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) If the cost of capital estimate is more than the IRR, the NPV will be positive. Answer: D Explanation: D) If the cost of capital estimate is more than the IRR, the NPV will be negative. Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Conceptual Use the following information to answer the question(s) below. You are considering investing in a start up project at a cost of $100,000. You expect the project to return $500,000 to you in seven years. Given the risk of this project, your cost of capital is 20%. 4) The NPV for this project is closest to: A) $29,200 B) $39,500 C) $129,200 D) $139,500 Answer: B Explanation: B) NPV = -100,000 + 500,000/(1.020)7 = 39,540.82 Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical 5) The IRR for this project is closest to: A) 15.60% B) 18.95% C) 20.00% D) 25.85% Answer: D Explanation: D) IRR =

- 1 = .25849895

Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

6) The decision you should take regarding this project is A) reject the project since the NPV is negative. B) reject the project since the NPV is positive. C) accept the project since the IRR < 20%. D) accept the project since the IRR > 20%. Answer: D Explanation: D) IRR =

- 1 = .25849895

NPV = -100,000 + 500,000/(1.020)7 = 39,540.82 Therefore we should accept because NPV > 0 and because IRR > 20%. Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical Use the following information to answer the question(s) below. Sarah Palin reportedly was paid a $11 million advance to write her book Going Rogue. The book took one year to write. In the time she spent writing, Palin could have been paid to give speeches and appear on TV news as a political commentator. Given her popularity, assume that she could have earned $8 million over the year (paid at the end of the year) she spent writing the book. Assume that she was unable to fulfill her media commitments of appearing on TV news as a political commentator or give speeches.while she was writing the book. 7) Assuming that Palin's cost of capital is 10%, then the NPV of her book deal is closest to: A) $2.00 million B) $2.20 million C) $3.00 million D) $3.75 million Answer: D Explanation: D) NPV = $11 - $8/(1.10)1 = $ 3.72727 Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical 8) The IRR of Palin's book deal is closest to: A) -27.25% B) -37.50% C) 27.25% D) 37.50% Answer: A Explanation: A) IRR =

- 1 = -0.27272727

Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider a project with the following cash flows: Year 0 1 2 3 4

Cash Flow -10,000 4,000 4,000 4,000 4,000

9) If the appropriate discount rate for this project is 15%, then the NPV is closest to: A) $6,000 B) -$867 C) $1,420 D) $867 Answer: C Explanation: C) NPV = -10,000 + 4000/(1.15)1 + 4000/(1.15)2 + 4000/(1.15)3 + 4000/(1.15)4 = 1419.91 Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical Use the table for the question(s) below. Consider the following two projects: Project A B

Year 0 Year 1 Year 2 Year 3 Year 4 Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow -100 40 50 60 N/A -73 30 30 30 30

Discount Rate .15 .15

10) The NPV of project A is closest to: A) 12.0 B) 12.6 C) 15.0 D) 42.9 Answer: A Explanation: A) NPV = -100 + 40/(1.15)1 + 50/(1.15)2 + 60/(1.15)3 = 12.04 Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) The NPV of project B is closest to: A) 12.6 B) 23.3 C) 12.0 D) 15.0 Answer: A Explanation: A) NPV = -73+ 30/(1.15)1 + 30/(1.15)2 + 30/(1.15)3 + 30/(1.15)4 = 12.6494 Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical Use the information for the question(s) below. The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project as detailed below: Year One $200,000

Year Two $225,000

Year Three $275,000

Year Four $200,000

The appropriate discount rate for this project is 16%. 12) The NPV for this project is closest to: A) $176,270 B) $123,420 C) $450,000 D) $179,590 Answer: A Explanation: A) NPV = -450000+ 200,000/(1.16)1 + 225000/(1.15)2 + 275000/(1.15)3 + 200,000/(1.15)4 = 176,265 Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount Project C/F C/F C/F C/F C/F C/F C/F C/F Rate Alpha -79 20 25 30 35 40 N/A N/A 15% Beta -80 25 25 25 25 25 25 25 16% 13) The NPV for project alpha is closest to: A) $20.96 B) $16.92 C) $24.01 D) $14.41 Answer: B Explanation: B) NPV = -79+ 20/(1.15)1 + 25/(1.15)2 + 30/(1.15)3 + 35/(1.15)4 + 40/(1.15)5 = 16.92 Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical 14) The NPV for project beta is closest to: A) $24.01 B) $16.92 C) $20.96 D) $14.41 Answer: C Explanation: C) NPV = -80 + 25/(1.16)1 + 25/(1.16)2 + 25/(1.16)3 + 25/(1.16)4 + 25/(1.16)5 + 50/(1.16)6 + 25/(1.16)7= 20.96 Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that would pay him $5 million at the end of each of the next three years. Assume Larry's personal cost of capital is 10% per year. 15) The NPV of Larry's three movie Larry Boy offer is closest to: A) 3.5 million B) -1.6 million C) 1.6 million D) -1.0 million Answer: C Explanation: C) NPV = 14 + -5/(1.10)1 + -5/(1.10)2 + -5/(1.10)3 = 1.57 Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Boulderado has come up with a new composite snowboard. Development will take Boulderado four years and cost $250,000 per year, with the first of the four equal investments payable today upon acceptance of the project. Once in production the snowboard is expected to produce annual cash flows of $200,000 each year for 10 years. Boulderado's discount rate is 10%. 16) The NPV for Boulderado's snowboard project is closest to: A) $228,900 B) $46,900 C) $51,600 D) $23,800 Answer: C Explanation: C) CF0 = -250,000 CF1 = -250,000 CF2 = -250,000 CF3 = -250,000 CF4 = +200,000 CF5 = +200,000 CF6 = +200,000 CF7 = +200,000 CF8 = +200,000 CF9 = +200,000 CF10 = +200,000 CF11 = +200,000 CF12 = +200,000 CF13 = +200,000 I = 10 Compute NPV = 51,588 Diff: 2 Section: 7.1 NPV and Stand-Alone Projects Skill: Analytical 17) The NPV profile graphs: A) the project's NPV over a range of discount rates. B) the project's IRR over a range of discount rates. C) the project's cash flows over a range of NPVs. D) the project's IRR over a range of NPVs. Answer: A Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Definition

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

18) The NPV profile A) shows the payback period - the point at which NPV is positive. B) shows the internal rate of return - the point at which NPV is zero. C) shows the NPV over a range of discount rates. D) B and C are correct. Answer: D Diff: 1 Section: 7.1 NPV and Stand-Alone Projects Skill: Definition

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7.2 The Internal Rate of Return Rule Use the following information to answer the question(s) below. Frank Dewey Esquire from the firm of Dewey, Cheatum, and Howe, has been offered an upfront retainer of $30,000 to provide legal services over the next 12 months to Taggart Transcontinental. In return for this upfront payment, Taggart Transcontinental would have access to 8 hours of legal services from Frank for each of the next 12 months. Frank's normal billable rate is $250 per hour for legal services. 1) Assuming that Dewey's cost of capital is 12% EAR, then the NPV of his retainer offer is closest to: A) -$7,500 B) -$7,400 C) $6,000 D) $7,400 Answer: D Explanation: D) Step #1 Monthly Interest Rate - 1 = .009488793 Step #2 Monthly Opportunity Cost = 8 × $250 = $2,000 Step #3 NPV = $30,000 - 2,000

-

= $7,416.97

Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

2) Assuming that Dewey's cost of capital is 12% EAR, then the IRR of his retainer offer is closest to: A) -39.3% B) -3.3% C) 20.0% D) 39.3% Answer: A Explanation: A) Step #1 Monthly Opportunity Cost = 8 × $250 = $2,000 Step #2 PV = 30000, N = 12, PMT = -2000, FV = 0, Compute I = -3.276502% × 12 = -39.3180% Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 3) Assuming that Dewey's cost of capital is 12% EAR, then the number of potential IRRs that exist for this problem is equal to: A) 0 B) 1 C) 2 D) 12 Answer: B Explanation: B) This problem begins with a positive cash flow that is followed by 12 negative (opportunity) cash flows, giving one change in the signs of the cash flows. This indicates that there will be one IRR for this problem. Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the following information to answer the question(s) below. Rearden Metals is considering opening a strip mining operation to provide some of the raw materials needed in producing Rearden metal. The initial purchase of the land and the associated costs of opening up mining operations will cost $100 million today. The mine is expected to generate $16 million worth of ore per year for the next 12 years. At the end of the 12th year Rearden will need to spend $20 million to restore the land to its original pristine nature appearance. 4) The number of potential IRRs that exist for Rearden's mining operation is equal to: A) 0 B) 1 C) 2 D) 12 Answer: C Explanation: C) This problem begins with a negative cash flow that is followed by 11 positive cash flows and finally by one last negative cash flow, giving two changes in the signs of the cash flows. This indicates that there will be two IRRs for this problem. Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 5) One of the IRR for Rearden's mining operation is closest to: A) 0% B) 10.6% C) 12.4% D) 72.0% Answer: B Explanation: B) CF0 = -100, CFj = 16, Nj = 11, CFj = -4, Nj = 1, Compute IRR = 10.58%. The TI Calculator does not alert to the second IRR, while the HP Calculator gives an error because of multiple IRRs. Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 6) Which of the following statements is FALSE? A) The IRR investment rule will identify the correct decision in many, but not all, situations. B) By setting the NPV equal to zero and solving for r, we find the IRR. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) The simplest investment rule is the NPV investment rule. Answer: D Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7) Which of the following statements is FALSE? A) The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital. B) The IRR investment rule states that you should take any investment opportunity where the IRR exceeds the opportunity cost of capital. C) Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV decision rule, the IRR decision rule will always identify the correct investment decisions. D) There are situations in which multiple IRRs exist. Answer: C Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Conceptual Use the table for the question(s) below. Consider a project with the following cash flows: Year 0 1 2 3 4

Cash Flow -10,000 4,000 4,000 4,000 4,000

8) Assume the appropriate discount rate for this project is 15%. The IRR for this project is closest to: A) 21% B) 22% C) 15% D) 60% Answer: B Explanation: B) CF0 = -10000 CF1 = 4000 CF2 = 4000 CF3 = 4000 CF4 = 4000 Compute IRR = 21.86% Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Project A B

Year 0 Year 1 Year 2 Year 3 Year 4 Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow -100 40 50 60 N/A -73 30 30 30 30

Discount Rate .15 .15

9) The internal rate of return (IRR) for project A is closest to: A) 7.7% B) 21.6% C) 23.3% D) 42.9% Answer: B Explanation: B) CF0 = -100 CF1 = 40 CF2 = 50 CF3 = 60 Compute IRR = 21.64% Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 10) The internal rate of return (IRR) for project B is closest to: A) 21.6% B) 23.3% C) 42.9% D) 7.7% Answer: B Explanation: B) CF0 = -73 CF1 = 30 CF2 = 30 CF3 = 30 CF4 = 30 Compute IRR = 23.34% Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) Which of the following statements is correct? A) You should accept project A since its IRR > 15%. B) You should reject project B since its NPV > 0. C) Your should accept project A since its NPV < 0. D) You should accept project B since its IRR < 15%. Answer: A Explanation: A) NPVA = -100 + 40/(1.15)1 + 50/(1.15)2 + 60/(1.15)3 = 12.04 NPVB = -73+ 30/(1.15)1 + 30/(1.15)2 + 30/(1.15)3 + 30/(1.15)4 = 12.65 IRR A CF0 = -100 CF1 = 40 CF2 = 50 CF3 = 60 Compute IRR = 21.64% IRR B CF0 = -73 CF1 = 30 CF2 = 30 CF3 = 30 CF4 = 30 Compute IRR = 23.34% Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 12) The maximum number of IRRs that could exist for project B is: A) 3 B) 1 C) 2 D) 0 Answer: B Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects:

Project Alpha Beta

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount C/F C/F C/F C/F C/F C/F C/F C/F Rate -79 20 25 30 35 40 N/A N/A 15% -80 25 25 25 25 25 25 25 16%

13) The internal rate of return (IRR) for project Alpha is closest to: A) 25.0% B) 22.2% C) 24.5% D) 22.7% Answer: D Explanation: D) CF0 = -79 CF1 = 20 CF2 = 25 CF3 = 30 CF4 = 35 CF5 = 40 Compute IRR = 22.68 Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 14) The internal rate of return (IRR) for project Beta is closest to: A) 25.0% B) 22.7% C) 24.5% D) 22.2% Answer: C Explanation: C) PV = -80 PMT = 25 FV = 0 N=7 Compute I = 24.52 Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 15) Which of the following statements is correct? A) You should invest in project Beta since NPVBeta > 0. B) You should invest in project Alpha since IRRAlpha > IRRBeta. C) Your should invest in project Alpha since NPVAlpha < 0. D) You should invest in project Beta since IRRBeta > 0. Answer: A Explanation: A) NPV Alpha 17

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

NPV = -79 + 20/(1.15)1 + 25/(1.15)2 + 30/(1.15)3 + 35/(1.15)4 + 40/(1.15)5 = 16.92 NPV Beta NPV = -80 + 25/(1.16)1 + 25/(1.16)2 + 25/(1.16)3 + 25/(1.16)4 + 25/(1.16)5 + 25/(1.16)6 + 25/(1.16)7= 20.96 IRR Alpha CF0 = -79 CF1 = 20 CF2 = 25 CF3 = 30 CF4 = 35 CF5 = 40 Compute IRR = 22.68 IRR Beta PV = -80 PMT = 25 FV = 0 N=7 Compute I = 24.52 Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project as detailed below: Year One $200,000

Year Two $225,000

Year Three $275,000

Year Four $200,000

The appropriate discount rate for this project is 16%. 16) The IRR for this project is closest to: A) 18.9% B) 22.7% C) 34.1% D) 39.1% Answer: C Explanation: C) CF0 = -450000 CF1 = 200000 CF2 = 225000 CF3 = 275000 CF4 = 200000 Compute IRR = 34.12% Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that would pay him $5 million at the end of each of the next three years. Assume Larry's personal cost of capital is 10% per year. 17) The IRR for Larry's three movie deal offer is closest to: A) 3.5% B) 1.6% C) -3.5% D) -1.6% Answer: A Explanation: A) CF0 = +14 CF1 = -5 CF2 = -5 CF3 = -5 Compute IRR = 3.53% Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 18) Larry should: A) reject the offer because the NPV < 0. B) accept the offer even though the IRR < 10%, because the NPV > 0. C) reject the offer because the IRR < 10%. D) accept the offer because the IRR > 0%. Answer: B Explanation: B) NPV = 14 + -5/(1.10)1 + -5/(1.10)2 + -5/(1.10)3 = 1.57 CF0 = +14 CF1 = -5 CF2 = -5 CF3 = -5 Compute IRR = 3.53% Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Boulderado has come up with a new composite snowboard. Development will take Boulderado four years and cost $250,000 per year, with the first of the four equal investments payable today upon acceptance of the project. Once in production the snowboard is expected to produce annual cash flows of $200,000 each year for 10 years. Boulderado's discount rate is 10%. 19) The IRR for Boulderado's snowboard project is closest to: A) 10.4% B) 10.0% C) 11.0% D) 15.1% Answer: C Explanation: C) CF0 = -250,000 CF1 = -250,000 CF2 = -250,000 CF3 = -250,000 CF4 = +200,000 CF5 = +200,000 CF6 = +200,000 CF7 = +200,000 CF8 = +200,000 CF9 = +200,000 CF10 = +200,000 CF11 = +200,000 CF12 = +200,000 CF13 = +200,000 Compute IRR = 11.01% Diff: 2 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

20) Calculate the IRR for the snow board project and use it to determine he maximum deviation allowable in the cost of capital estimate that leaves the investment decision unchanged. The maximum deviation allowable is closest to: A) 11.0% B) 0.0% C) 2.5% D) 1.0% Answer: D Explanation: D) CF0 = -250,000 CF1 = -250,000 CF2 = -250,000 CF3 = -250,000 CF4 = +200,000 CF5 = +200,000 CF6 = +200,000 CF7 = +200,000 CF8 = +200,000 CF9 = +200,000 CF10 = +200,000 CF11 = +200,000 CF12 = +200,000 CF13 = +200,000 Compute IRR = 11.01% Maximum deviation = IRR - Cost of Capital = 11.0% - 10.0% = 1.0% Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Analytical 21) When using the internal rate of return (IRR) investment rule, we compare: A) the average return on the investment opportunity to returns on all other investment opportunities in the market. B) the average return on the investment opportunity to returns on other alternatives in the market with equivalent risk and maturity. C) the NPV of the investment opportunity to the average return on the investment opportunity. D) the average return on the investment opportunity to the risk-free rate of return. Answer: B Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Definition

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

22) The internal rate of return rule can result in the wrong decision if the projects being compared have: A) differences in scale. B) differences in timing. C) differences in NPV. D) A and B are correct. Answer: D Diff: 1 Section: 7.2 The Internal Rate of Return Rule Skill: Definition Use the information for the question(s) below. Larry the Cucumber has been offered $14 million to star in the lead role of the next three Larry Boy adventure movies. If Larry takes this offer, he will have to forgo acting in other Veggie movies that would pay him $5 million at the end of each of the next three years. Assume Larry's personal cost of capital is 10% per year. 23) Explain why the NPV decision rule might provide Larry with a different decision outcome than the IRR rule when evaluating Larry's three movie deal offer. Answer: The NPV rule will always give the right decision. In this problem, Larry starts with the cash up front, a positive cash flow, then followed by three negative cash flows. This is the exact opposite as what we want with the IRR. The IRR assumes that we start with a negative outflow followed by Inflow(s). Since we start with a positive cash inflow, the IRR rule cannot be trusted to give the correct answer. Diff: 3 Section: 7.2 The Internal Rate of Return Rule Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7.3 The Payback Rule Use the following information to answer the question(s) below. Rearden Metals is considering opening a strip mining operation to provide some of the raw materials needed in producing Rearden metal. The initial purchase of the land and the associated costs of opening up mining operations will cost $100 million today. The mine is expected to generate $16 million worth of ore per year for the next 12 years. At the end of the 12th year Rearden will need to spend $20 million to restore the land to its original pristine nature appearance. 1) The payback period for Rearden's mining operation is closest to: A) 5.00 years B) 6.00 years C) 6.25 years D) 6.50 years Answer: C Explanation: C) Payback = 100/16 = 6.25 years Diff: 1 Section: 7.3 The Payback Rule Skill: Analytical 2) Which of the following statements is FALSE? A) It is possible that an IRR does not exist for an investment opportunity. B) If the payback period is less than a pre-specified length of time you accept the project. C) The internal rate of return (IRR) investment rule is based upon the notion that if the return on other alternatives is greater than the return on the investment opportunity you should undertake the investment opportunity. D) It is possible that there is no discount rate that will set the NPV equal to zero. Answer: C Diff: 2 Section: 7.3 The Payback Rule Skill: Conceptual 3) Which of the following statements is FALSE? A) The payback investment rule is based on the notion that an opportunity that pays back its initial investments quickly is a good idea. B) An IRR will always exist for an investment opportunity. C) A NPV will always exist for an investment opportunity. D) In general, there can be as many IRRs as the number of times the project's cash flows change sign over time. Answer: B Diff: 2 Section: 7.3 The Payback Rule Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) Which of the following statements is FALSE? A) In general, the IRR rule works for a stand-alone project if all of the project's positive cash flows precede its negative cash flows. B) There is no easy fix for the IRR rule when there are multiple IRRs. C) The payback rule is primarily used because of its simplicity. D) No investment rule that ignores the set of alternative investment alternatives can be optimal. Answer: A Diff: 2 Section: 7.3 The Payback Rule Skill: Conceptual 5) Which of the following statements is FALSE? A) The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the NPV. B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital. C) For most investment opportunities expenses occur initially and cash is received later. D) Fifty percent of firms surveyed reported using the payback rule for making decisions. Answer: B Diff: 2 Section: 7.3 The Payback Rule Skill: Conceptual Use the table for the question(s) below. Consider a project with the following cash flows: Year 0 1 2 3 4

Cash Flow -10,000 4,000 4,000 4,000 4,000

6) Assume the appropriate discount rate for this project is 15%. The payback period for this project is closest to: A) 3.0 B) 2.5 C) 2.0 D) 4.0 Answer: B Explanation: B) Payback = 10000/4000 = 2.5 Diff: 1 Section: 7.3 The Payback Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Project A B

Year 0 Year 1 Year 2 Year 3 Year 4 Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow -100 40 50 60 N/A -73 30 30 30 30

Discount Rate .15 .15

7) The payback period for project A is closest to: A) 2.0 years B) 2.4 years C) 2.5 years D) 2.2 years Answer: D Explanation: D) Payback period. It is clear that the project is not paid off after two years since we have only received 90 toward the 100 investment. To calculate the fraction of the third year, we take the $10 yet to be repaid ($100 investment - $40 (year 1) - $50 (year 2))/$60 (cashflow in year 3) = .166667 so the payback is 2.166667 years. Diff: 2 Section: 7.3 The Payback Rule Skill: Analytical 8) The payback period for project B is closest to: A) 2.5 years B) 2.0 years C) 2.2 years D) 2.4 years Answer: D Explanation: D) Payback = 73/30 = 2.43 years Diff: 1 Section: 7.3 The Payback Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount Project C/F C/F C/F C/F C/F C/F C/F C/F Rate Alpha -79 20 25 30 35 40 N/A N/A 15% Beta -80 25 25 25 25 25 25 25 16% 9) The payback period for project Alpha is closest to: A) 3.2 years B) 2.9 years C) 3.1 years D) 2.6 years Answer: C Explanation: C) It is clear that the project will not be paid off until sometime after year 3. After the cashflow in year three there will still be $4 remaining to be paid back in year four (79 - 20 - 25 - 30) = 4 To find the fractional year take 4/35 = .1143 so payback is 3.11 years Diff: 2 Section: 7.3 The Payback Rule Skill: Analytical 10) The payback period for project beta is closest to: A) 2.9 years B) 3.1 years C) 2.6 years D) 3.2 years Answer: D Explanation: D) Payback = 80/25 = 3.2 Diff: 1 Section: 7.3 The Payback Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project as detailed below: Year One $200,000

Year Two $225,000

Year Three $275,000

Year Four $200,000

The appropriate discount rate for this project is 16%. 11) The payback period for this project is closest to: A) 2.1 years B) 3.0 years C) 2.0 years D) 2.2 years Answer: A Explanation: A) It is clear that the project will not be paid off after 2 years. The balance due after the second year is equal to 450000 - 200000 - 225000 = $25,000, so to find the fractional year we take 25000/275000 = .0909 so the payback period = 2.09 years Diff: 1 Section: 7.3 The Payback Rule Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7.4 Choosing Between Projects 1) Which of the following statements is FALSE? A) Problems can arise using the IRR method when the mutually exclusive investments have different cash flow patterns. B) The IRR is affected by the scale of the investment opportunity. C) Multiple incremental IRRs might exist. D) The incremental IRR rule assumes that the riskiness of the two projects is the same. Answer: B Diff: 2 Section: 7.4 Choosing Between Projects Skill: Conceptual 2) Which of the following statements is FALSE? A) The incremental IRR investment rule applies the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives. B) When a manager must choose among mutually exclusive investments, the NPV rule provides a straightforward answer. C) The likelihood of multiple IRRs is greater with the regular IRR rule than with the incremental IRR rule. D) Problems can arise using the IRR method when the mutually exclusive investments have differences in scale. Answer: C Diff: 2 Section: 7.4 Choosing Between Projects Skill: Conceptual 3) Which of the following statements is FALSE? A) When using the incremental IRR rule, you must keep track of which project is the incremental project and ensure that the incremental cash flows are initially positive and then become negative. B) Picking one project over another simply because it has a larger IRR can lead to mistakes. C) Problems arise using the IRR method when the mutually exclusive investments have differences in scale. D) When the risks of two projects are different, only the NPV rule will give a reliable answer. Answer: A Diff: 2 Section: 7.4 Choosing Between Projects Skill: Conceptual 4) Which of the following statements is FALSE? A) The incremental IRR need not exist. B) If a change in the timing of the cash flows does not affect the NPV, then the change in timing will not impact the IRR. C) Although the incremental IRR rule can provide a reliable method for choosing among projects, it can be difficult to apply correctly. D) When projects are mutually exclusive, it is not enough to determine which projects have positive NPVs. Answer: B Diff: 2 29

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Section: 7.4 Choosing Between Projects Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

5) Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should: A) take opportunity A if the regular IRR exceeds the cost of capital. B) take opportunity A if the incremental IRR exceeds the cost of capital. C) take opportunity B if the regular IRR exceeds the cost of capital. D) take opportunity B if the incremental IRR exceeds the cost of capital. Answer: B Diff: 1 Section: 7.4 Choosing Between Projects Skill: Conceptual 6) You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is: A) NPV. B) profitability index. C) IRR. D) incremental IRR. Answer: A Diff: 1 Section: 7.4 Choosing Between Projects Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Project A B

Year 0 Year 1 Year 2 Year 3 Year 4 Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow -100 40 50 60 N/A -73 30 30 30 30

Discount Rate .15 .15

7) Assume that projects A and B are mutually exclusive. The correct investment decision and the best rational for that decision is to A) invest in project A since NPVB < NPVA. B) invest in project B since IRRB > IRRA. C) invest in project B since NPVB > NPVA. D) invest in project A since NPVA > 0. Answer: C Explanation: C) NPVA = -100 + 40/(1.15)1 + 50/(1.15)2 + 60/(1.15)3 = 12.04 NPVB = -73+ 30/(1.15)1 + 30/(1.15)2 + 30/(1.15)3 + 30/(1.15)4 = 12.64 IRR A CF0 = -100 CF1 = 40 CF2 = 50 CF3 = 60 Compute IRR = 21.65% IRR B CF0 = -73 CF1 = 30 CF2 = 30 CF3 = 30 CF4 = 30 Compute IRR = 23.34% Diff: 3 Section: 7.4 Choosing Between Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8) An incremental IRR of Project B over Project A is closest to: A) 12.6% B) 23.3% C) 1.7% D) 17.3% Answer: A Explanation: A) First we need to find the incremental cash flows by taking cashflows of A cashflows of B. IRR A - B CF0 = (-100 - -73) = -27 CF1 = (40 - 30) = 10 CF2 = (50 - 30) = 20 CF3 = (60 - 30) = 30 CF4 = (0 - 30) = -30 Compute IRR = 12.63% Diff: 3 Section: 7.4 Choosing Between Projects Skill: Analytical 9) The maximum number of incremental IRRs that could exist for project B over project A is: A) 1 B) 2 C) 0 D) 3 Answer: B Diff: 3 Section: 7.4 Choosing Between Projects Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount Project C/F C/F C/F C/F C/F C/F C/F C/F Rate Alpha -79 20 25 30 35 40 N/A N/A 15% Beta -80 25 25 25 25 25 25 25 16% 10) Assume that projects Alpha and Beta are mutually exclusive. The correct investment decision and the best rational for that decision is to A) invest in project Beta since NPVBeta > 0. B) invest in project Alpha since NPVBeta < NPVAlpha. C) invest in project Beta since IRRB > IRRA. D) invest in project Beta since NPVBeta > NPVAlpha > 0. Answer: D Explanation: D) NPV Alpha NPV = -79 + 20/(1.15)1 + 25/(1.15)2 + 30/(1.15)3 + 35/(1.15)4 + 40/(1.15)5 = 16.92 NPV Beta NPV = -80 + 25/(1.16)1 + 25/(1.16)2 + 25/(1.16)3 + 25/(1.16)4 + 25/(1.16)5 + 50/(1.16)6 + 25/(1.16)7 = 20.96 IRR Alpha CF0 = -79 CF1 = 20 CF2 = 25 CF3 = 30 CF4 = 35 CF5 = 40 Compute IRR = 22.68 IRR Beta PV = -80 PMT = 25 FV = 0 N=7 Compute I = 24.52 Diff: 3 Section: 7.4 Choosing Between Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) Assume that projects Alpha and Beta are mutually exclusive. Which of the following statements is true regarding the investment decision tools' suitability for deciding between projects Alpha & Beta? A) The incremental IRR should not be used since the projects have different lives. B) The incremental IRR should not be used since the projects have different discount rates C) The incremental IRR should not be used since the projects have different cash flow patterns. D) Both the NPV and incremental IRR approaches are appropriate to solve this problem. Answer: B Diff: 2 Section: 7.4 Choosing Between Projects Skill: Conceptual 12) When choosing between projects, an alternative to comparing their IRRs is: A) to compute the incremental IRR, which tells us the discount rate at which it becomes profitable to switch from one project to the other. B) to compute the incremental payback period, which tells us the number of years during which it becomes profitable to switch from one project to the other. C) to compute the incremental NPV, which tells us the discount rate at which it becomes profitable to switch from one project to the other. D) There is no alternative selection criterion to comparing IRRs. Answer: A Diff: 1 Section: 7.4 Choosing Between Projects Skill: Definition

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider two mutually exclusive projects with the following cash flows: Project A B

C/F0 C/F1 $(41,215) $12,500 $(46,775) $15,000

C/F2 $14,000 $15,000

C/F3 $16,500 $15,000

C/F4 $18,000 $15,000

C/F5 $20,000 $15,000

C/F6 N/A $15,000

13) You are considering using the incremental IRR approach to decide between the two mutually exclusive projects A & B. How many potential incremental IRRs could there be? A) 3 B) 0 C) 2 D) 1 Answer: A Explanation: A) C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6 Project A ($41,215) $12,500 $14,000 $16,500 $18,000 20,000 0 B ($46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 B-A

($5,560)

$2,500

$1,000 ($1,500) ($3,000) ($5,000) $15,000

Note that there are three sign changes hence there potential IRRs. Diff: 2 Section: 7.4 Choosing Between Projects Skill: Analytical 14) If the discount rate for project A is 16%, then what is the NPV for project A? Answer: NPV A CF0 = -41,215 CF1 = 12,500 CF2 = 14,000 CF3 = 16,500 CF4 = 18,000 CF5 = 20,000 I = 16 Compute NPV = $9,999.50 Diff: 2 Section: 7.4 Choosing Between Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

15) If the discount rate for project B is 15%, then what is the NPV for project B? Answer: NPV B CF0 = -46,775 CF1 = 15,000 CF2 = 15,000 CF3 = 15,000 CF4 = 15,000 CF5 = 15,000 CF6 = 15,000 Compute NPV = $9,992.24 Diff: 2 Section: 7.4 Choosing Between Projects Skill: Analytical 16) What is one of the incremental IRRs for project B over project A? Would you feel comfortable basing your decision on the incremental IRR? Answer: C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6 Project A ($41,215) $12,500 $14,000 $16,500 $18,000 20,000 0 B ($46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 B-A

($5,560)

$2,500

$1,000

($1,500) ($3,000) ($5,000) $15,000

Compute IRR = 8.95%, no since there are multiple sign changes in the incremental cash flows. Diff: 2 Section: 7.4 Choosing Between Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

17) Assuming that the discount rate for project A is 16% and the discount rate for B is 15%, then given that these are mutually exclusive projects, which project would you take and why? Answer: NPV A CF0 = -41,215 CF1 = 12,500 CF2 = 14,000 CF3 = 16,500 CF4 = 18,000 CF5 = 20,000 I = 16 Compute NPV = $9,999.50 NPV B CF0 = -46,775 CF1 = 15,000 CF2 = 15,000 CF3 = 15,000 CF4 = 15,000 CF5 = 15,000 CF6 = 15,000 Compute NPV = $9,992.24 Take A, since NPV of A > NPV of B and NPV of A is positive. Diff: 3 Section: 7.4 Choosing Between Projects Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7.5 Project Selection with Resource Restraints 1) Which of the following statements is FALSE? A) If there is a fixed supply of resource available, you should rank projects by the profitability index, selecting the project with the lowest profitability index first and working your way down the list until the resource is consumed. B) Practitioners often use the profitability index to identify the optimal combination of projects when there is a fixed supply of resources. C) If there is a fixed supply of resources available, so that you cannot undertake all possible opportunities, then simply picking the highest NPV opportunity might not lead to the best decision. D) The profitability index is calculated as the NPV divided by the resources consumed by the project. Answer: A Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Conceptual 2) Which of the following statements is FALSE? A) The profitability index measures the value created in terms of NPV per unit of resource consumed. B) The profitability index is the ratio of value created to resources consumed. C) The profitability index can can be easily adapted for determining the correct investment decisions when multiple resource constraints exist. D) The profitability index measures the "bang for your buck." Answer: C Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Conceptual 3) You are opening up a brand new retail strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space? A) IRR B) Payback period C) NPV D) Profitability index Answer: D Diff: 1 Section: 7.5 Project Selection with Resource Constraints Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider a project with the following cash flows: Year 0 1 2 3 4

Cash Flow -10,000 4,000 4,000 4,000 4,000

4) Assume the appropriate discount rate for this project is 15%. The profitability index for this project is closest to: A) .14 B) .22 C) .60 D) .15 Answer: A Explanation: A) NPV = -10,000 +

+

+

+

= $1420

PI = NPV/investment = 1420/10000 = .1420 Diff: 1 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical Use the table for the question(s) below. Consider the following two projects: Project A B

Year 0 Year 1 Year 2 Year 3 Year 4 Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow -100 40 50 60 N/A -73 30 30 30 30

Discount Rate .15 .15

5) The profitability index for project A is closest to: A) 0.12 B) 21.65 C) 0.17 D) 12.04 Answer: A Explanation: A) PI = NPV/Investment (or resources consumed) NPV = -100 + 40/(1.15)1 + 50/(1.15)2 + 60/(1.15)3 = 12.04 So, PI = 12.04/100 = .1204 Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical 6) The profitability index for project B is closest to: 40

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

A) 23.34 B) 12.64 C) 0.17 D) 0.12 Answer: C Explanation: C) PI = NPV/Investment (or resources consumed) NPV = -73 + 30/(1.15)1 + 30/(1.15)2 + 30/(1.15)3 + 30/(1.15)4 = 12.64 So, PI = 12.64/73 = .1732 Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical Use the table for the question(s) below. Consider the following list of projects: Project A B C D E F G H I

Investment 135,000 200,000 125,000 150,000 175,000 75,000 80,000 200,000 50,000

NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

7) Assuming that your capital is constrained, which investment tool should you use to determine the correct investment decisions? A) Profitability Index B) Incremental IRR C) NPV D) IRR Answer: A Diff: 1 Section: 7.5 Project Selection with Resource Constraints Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8) Assuming that your capital is constrained, which project should you invest in first? A) Project C B) Project G C) Project B D) Project F Answer: A Explanation: A) Profitability Project Investment NPV Index Rank A 135,000 6,000 0.0444 8 B 200,000 30,000 0.1500 2 C 125,000 20,000 0.1600 1 D 150,000 2,000 0.0133 9 E 175,000 10,000 0.0571 7 F 75,000 10,000 0.1333 3 G 80,000 9,000 0.1125 4 H 200,000 20,000 0.1000 5 I 50,000 4,000 0.8000 6 Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical 9) Assuming that your capital is constrained, what is the fifth project that you should invest in? A) Project H B) Project I C) Project B D) Project A Answer: A Explanation: A) Profitability Project Investment NPV Index Rank A 135,000 6,000 0.0444 8 B 200,000 30,000 0.1500 2 C 125,000 20,000 0.1600 1 D 150,000 2,000 0.0133 9 E 175,000 10,000 0.0571 7 F 75,000 10,000 0.1333 3 G 80,000 9,000 0.1125 4 H 200,000 20,000 0.1000 5 I 50,000 4,000 0.8000 6 Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10) Assuming that your capital is constrained, which project should you invest in last? A) Project A B) Project I C) Project D D) Project C Answer: C Explanation: C) Profitability Project Investment NPV Index Rank A 135,000 6,000 0.0444 8 B 200,000 30,000 0.1500 2 C 125,000 20,000 0.1600 1 D 150,000 2,000 0.0133 9 E 175,000 10,000 0.0571 7 F 75,000 10,000 0.1333 3 G 80,000 9,000 0.1125 4 H 200,000 20,000 0.1000 5 I 50,000 4,000 0.8000 6 Diff: 2 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) Assuming that your capital is constrained, so that you only have $600,000 available to invest in projects, which projects should you invest in and in what order? A) CBFH B) CBGF C) BCFG D) CBFG Answer: A Explanation: A) Project Investment A 135,000 B 200,000 C 125,000 D 150,000 E 175,000 F 75,000 G 80,000 H 200,000 I 50,000

NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Profitability Index 0.0444 0.1500 0.1600 0.0133 0.0571 0.1333 0.1125 0.1000 0.8000

Rank 8 2 1 9 7 3 4 5 6

This is a tricky problem in that by the rankings CBFG seem optimal, but this combination leaves $120,000 on the table uninvested. By replacing G with H the full $600,000 is invested and the NPV of the combination of projects is increased by $11,000. Therefore you should invest in projects CBFH. Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

12) Assume that your capital is constrained, so that you only have $600,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total NPV for all the projects you invest in will be closest to: A) $65,000 B) $80,000 C) $69,000 D) $111,000 Answer: B Explanation: B) Project Investment A 135,000 B 200,000 C 125,000 D 150,000 E 175,000 F 75,000 G 80,000 H 200,000 I 50,000

NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Profitability Index 0.0444 0.1500 0.1600 0.0133 0.0571 0.1333 0.1125 0.1000 0.8000

Rank 8 2 1 9 7 3 4 5 6

This is a tricky problem in that by the rankings CBFG seem optimal, but this combination leaves $120,000 on the table uninvested. By replacing G with H the full $600,000 is invested and the NPV of the combination of projects is increased by $11,000. Therefore you should invest in projects CBFH. The NPV = NPVC + NPVB + NPVF + NPVH = 20000 + 30000 + 10000 + 20000 = $80,000. Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

13) Assume that your capital is constrained, so that you only have $500,000 available to invest in projects. If you invest in the optimal combination of projects given your capital constraint, then the total NPV for all the projects you invest in will be closest to: A) $111,000 B) $69,000 C) $80,000 D) $58.000 Answer: B Explanation: B) Project Investment A 135,000 B 200,000 C 125,000 D 150,000 E 175,000 F 75,000 G 80,000 H 200,000 I 50,000

NPV 6,000 30,000 20,000 2,000 10,000 10,000 9,000 20,000 4,000

Profitability Index 0.0444 0.1500 0.1600 0.0133 0.0571 0.1333 0.1125 0.1000 0.8000

Rank 8 2 1 9 7 3 4 5 6

The optimal combination based upon PI rankings is CBFG, so the total NPV = 20000 + 30000 + 10000 + 9000 = $69,000 Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

46

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. The Sisyphean Company is planning on investing in a new project. This will involve the purchase of some new machinery costing $450,000. The Sisyphean Company expects cash inflows from this project as detailed below: Year One $200,000

Year Two $225,000

Year Three $275,000

Year Four $200,000

The appropriate discount rate for this project is 16%. 14) The profitability index for this project is closest to: A) .44 B) .26 C) 0.39 D) .34 Answer: C Explanation: C) PI = NPV/Investment NPV = -450000 + 200000/(1.16)1 + 225000/(1.16)2 + 275000/(1.16)3 + 2000000/(1.16)4 = 176,265 So, PI = 176265/450000 = 0.39 Diff: 1 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Your firm is preparing to open a new retail strip mall and you have multiple businesses that would like lease space in it. Each business will pay a fixed amount of rent each month plus a percentage of the gross sales generated each month. The cash flows from each of the businesses has approximately the same amount of risk. The business names, square footage requirements, and monthly expected cash flows for each of the businesses that would like to lease space in your strip mall are provided below: Business Name Videos Now Gords Gym Pizza Warehouse Super Clips 30 1/2 Flavors S-Mart WalVerde Drugs Multigular Wireless

Square Feet Expected Monthly Required Cash Flow 4,000 70,000 3,500 52,500 2,500 52,500 1,500 25,500 1,500 28,500 12,000 180,000 6,000 147,000 1,000 22,250

15) If your new strip mall will have 15,000 square feet of retail space available to be leased, to which businesses should you lease and why? Answer: Square Feet Expected Monthly C/F per Project Business Name Required Cash Flow S.F. Rank Videos Now 4,000 70,000 17.5 5 Gords Gym 3,500 52,500 15 7 Pizza Warehouse 2,500 52,500 21 3 Super Clips 1,500 25,500 17 6 30 1/2 Flavors 1,500 28,500 19 4 S-Mart 12,000 180,000 15 8 WalVerde Drugs 6,000 147,000 24.5 1 Multigular Wireless 1,000 22,250 22.25 2 So we select projects based upon their ranking until we run out of space. The optimal combination is shown below: WalVerde Drugs 6,000 147,000 Multigular Wireless 1,000 22,250 Pizza Warehouse 2,500 52,500 30 1/2 Flavors 1,500 28,500 Videos Now 4,000 70,000 Total 15,000 $320,250 Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

24.5 22.25 21 19 17.5

1 2 3 4 5

16) If your new strip mall will have 16,000 square feet of retail space available to be leased, to which businesses should you lease and why? 48

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Answer: Business Name Videos Now Gords Gym Pizza Warehouse Super Clips 30 1/2 Flavors S-Mart WalVerde Drugs Multigular Wireless

Square Feet Required 4,000 3,500 2,500 1,500 1,500 12,000 6,000 1,000

Expected Monthly Cash Flow 70,000 52,500 52,500 25,500 28,500 180,000 147,000 22,250

C/F per S.F. 17.5 15 21 17 19 15 24.5 22.25

Project Rank 5 7 3 6 4 8 1 2

So we select projects based upon their ranking until we run out of space. This combination is shown below: WalVerde Drugs Multigular Wireless Pizza Warehouse 30 1/2 Flavors Videos Now Total

6,000 1,000 2,500 1,500 4,000 15,000

147,000 22,250 52,500 28,500 70,000 $320,250

24.5 22.25 21 19 17.5

1 2 3 4 5

But notice that this combination leaves 1,000 square feet unleased. We therefore should look to see if there is a combination that leases more space and offers a higher monthly cash flow. If we forgo renting to Videos Now and instead rent to both Super Clips and Gords Gym we will obtain a higher monthly cash flow. The optimal combination is shown below: WalVerde Drugs 6,000 147,000 Multigular Wireless 1,000 22,250 Pizza Warehouse 2,500 52,500 30 1/2 Flavors 1,500 28,500 Super Clips 1,500 25,500 Gords Gym 3,500 52,500 Total 16,000 $328,250 Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

24.5 22.25 21 19 17 15

1 2 3 4 6 7

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

17) Consider the following list of projects: Project A B C D E F G H I J

Investment 405,000 600,000 375,000 450,000 525,000 225,000 240,000 600,000 150,000 270,000

NPV 18,000 90,000 60,000 6,000 30,000 30,000 27,000 60,000 12,000 30,000

You are given a budget of only $1,800,000 to invest in projects. Which projects will you select, in what order will you select them, and why? Answer: Project Investment NPV PI Rank A 405,000 18,000 0.0444 9 B 600,000 90,000 0.15 2 C 375,000 60,000 0.16 1 D 450,000 6,000 0.0133 10 E 525,000 30,000 0.0571 8 F 225,000 30,000 0.1333 3 G 240,000 27,000 0.1125 4 H 600,000 60,000 0.1 6 I 150,000 12,000 0.08 7 J 270,000 30,000 0.1111 5 Beginning Project Cost Ending $1,800,000 C $375,000 $1,425,000 $1,425,000 B $600,000 $825,000 $825,000 F $225,000 $600,000 $600,000 G $240,000 $360,000 $360,000 J $270,000 $90,000 Diff: 3 Section: 7.5 Project Selection with Resource Constraints Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Chapter 8 Fundamentals of Capital Budgeting 8.1 Forecasting Earnings 1) Which of the following statements is FALSE? A) A capital budget lists the projects and investments that a company plans to undertake during the coming year. B) Income Tax = EBIT × (1 - τc). C) When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalization. D) Overhead expenses are often allocated to the different business activities for accounting purposes. Answer: B Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual 2) Which of the following statements is FALSE? A) Sales will ultimately decline as the product nears obsolescence or faces increased competition. B) Managers sometimes continue to invest in a project that has a negative NPV because they have already invested a large amount in the project and feel that by not continuing it, the prior investment will wasted. C) With straight-line depreciation the asset's cost is divided equally over its life. D) A projects unlevered net income is equal to its incremental revenues less costs and depreciation, evaluated on an pre-tax basis. Answer: D Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual 3) Which of the following statements is FALSE? A) We begin the capital budgeting process by determining the incremental earnings of a project. B) The marginal corporate tax rate is the tax rate the firm will pay on an incremental dollar of pre-tax income. C) Investments in plant, property, and equipment are directly listed as expense when calculating earnings. D) The opportunity cost of using a resource is the value it could have provided in its best alternative use. Answer: C Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) Which of the following statements is FALSE? A) When evaluating a capital budgeting decision, the correct tax rate to use is the firm's average corporate tax rate. B) To determine the capital budget, firms analyze alternative projects and decide which ones to accept through a process called capital budgeting. C) A new product typically has lower sales initially, as customers gradually become aware of the product. D) Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Answer: A Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual 5) Which of the following statements is FALSE? A) Because value is lost when a resource is used by another project, we should include the opportunity cost as an incremental cost of the project. B) Sunk costs are incremental with respect to the current decision regarding the project and should be included in its analysis. C) Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation. D) When computing the incremental earnings of an investment decision, we should include all changes between the firm's earnings with the project versus without the project. Answer: B Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual 6) Which of the following statements is FALSE? A) The firm deducts a fraction of the investments in plant, property, and equipment each year as depreciation. B) If securities are fairly priced, the net present value of a fixed set of cash flows is independent of how those cash flows are financed. C) Sunk cost fallacy is a term used to describe the tendency of people to ignore sunk costs in capital budgeting analysis. D) A good rule to remember is that if our decision does not affect a cash flow then the cash flow should not affect our decision. Answer: C Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7) Which of the following statements is FALSE? A) The ultimate goal in capital budgeting is to determine the effect of the decision to take a particular project on the firm's cash flows. B) To the extent that overhead costs are fixed and will be incurred in any case, they are incremental to the project and should be included in the capital budgeting analysis. C) Unlevered Net Income = (Revenue - Costs - Depreciation) × (1 - τc). D) Earnings are not cash flows. Answer: B Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual 8) Which of the following statements is FALSE? A) Project externalities are direct effects of the project that may increase of decrease the profits of other business activities of the firm. B) Incremental earnings are the amount by which the firm's earnings are expected to change as a result of the investment decision. C) The average selling price of a product and its cost of production will generally change over time. D) Any money that has already been spent is a sunk cost and therefore irrelevant in the capital budgeting process. Answer: A Diff: 3 Section: 8.1 Forecasting Earnings Skill: Conceptual 9) Which of the following statements is FALSE? A) Many projects use a resource that the company already owns. B) When evaluating a capital budgeting decision, we generally include interest expense. C) Only include as incremental expenses in your capital budgeting analysis the additional overhead expenses that arise because of the decision to take on the project. D) As a practical matter, to derive the forecasted cash flows of a project, financial managers often begin by forecasting earnings. Answer: B Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10) Which of the following statements is FALSE? A) The simplest method used to calculate depreciation is the straight-line method. B) A sunk cost is any unrecoverable cost for which the firm is already liable. C) Unlevered Net Income = EBIT × τc. D) The decision to continue or abandon should be based only on the incremental costs and benefits of the project going forward. Answer: C Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual 11) Which of the following costs would you consider when making a capital budgeting decision? A) Sunk cost B) Opportunity cost C) Interest expense D) Fixed overhead cost Answer: B Diff: 1 Section: 8.1 Forecasting Earnings Skill: Conceptual 12) A decrease in the sales of a current project because of the launching of a new project is: A) cannibalization. B) a sunk cost. C) an overhead expense. D) irrelevant to the investment decision. Answer: A Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition 13) Money that has been or will be paid regardless of the decision whether or not to proceed with the project is: A) cannibalization. B) considered as part of the initial investment in the project. C) an opportunity cost. D) a sunk cost. Answer: D Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

14) The value of currently unused warehouse space that will be used as part of a new capital budgeting project is: A) an opportunity cost. B) irrelevant to the investment decision. C) an overhead expense. D) a sunk cost. Answer: A Diff: 1 Section: 8.1 Forecasting Earnings Skill: Definition Use the information for the question(s) below. Ford Motor Company is considering launching a new line of Plug-in Electric SUVs. The heavy advertising expenses associated with the new SUV launch would generate operating losses of $35 million next year. Without the new SUV, Ford expects to earn pre-tax income of $80 million from operations next year. Ford pays a 30% tax rate on its pre-tax income. 15) The amount that Ford Motor Company owe in taxes next year without the launch of the new SUV is closest to: A) $24.0 million B) $56.0 million C) $31.5 million D) $13.5 million Answer: A Explanation: A) = $80 × .30 = $24 million Diff: 1 Section: 8.1 Forecasting Earnings Skill: Analytical 16) The amount that Ford Motor Company owe in taxes next year with the launch of the new SUV is closest to: A) $13.5 million B) $31.5 million C) $56.0 million D) $24.0 million Answer: A Explanation: A) = (80 - 35) × .30 = 13.5 million Diff: 1 Section: 8.1 Forecasting Earnings Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their store. The firm expects that sales from the new one hour machine will be $150,000 per year. FFL currently offers overnight film processing with annual sales of $100,000. While many of the one hour photo sales will be to new customers, FFL estimates that 60% of their current overnight photo customers will switch and use the one hour service. 17) The level of incremental sales associated with introducing the new one hour photo service is closest to: A) $90,000 B) $150,000 C) $60,000 D) $120,000 Answer: A Explanation: A) = $150,000 - (cannibalized sales) = 150000 - .60 × 100,000 = $90,000 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical 18) Suppose that of the 60% of FFL's current overnight photo customers, half would start taking their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour service. The level of incremental sales in this case is closest to: A) $60,000 B) $150,000 C) $90,000 D) $120,000 Answer: D Explanation: D) = $150,000 - (cannibalized sales) = 150000 - (.60 × .50) × 100,000 = $120,000 Note that the rate of cannibalization is only 30% (.60 × .50) since the other 30% would have taken their film elsewhere. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Glucose Scan Incorporated (GSI) currently sells its latest glucose monitor, the Glucoscan 3000, to diabetic patients for $129. GSI plans on lowering their price next year to $99 per unit. The cost of goods sold for each Glucoscan unit is $50, and GSI expects to sell 100,000 units over the next year. 19) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. The incremental impact of this price drop on the firms EBIT is closest to: A) a decline of 1.5 million. B) an increase of 1.5 million. C) a decline of 2.4 million. D) an increase of 2.4 million. Answer: A Explanation: A) Without price cut = 100,000 units × ($129 - 50) = $7,900,000 With price cut = 130,000 units × ($99 - 50) = $6,370,000 So, incremental = 6,370,000 - 7,900,000 = -1,530,000 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical 20) Suppose that if GSI drops the price on the Glucoscan 3000 immediately, it can increase sales over the next year by 30% to 130,000 units. Also suppose that for each Glucoscan monitor sold, GSI expects additional sales of $100 per year on glucose testing strips and these strips have a gross profit margin of 75%. Considering the increase in the sale of testing strips, the incremental impact of this price drop on the firms EBIT is closest to: A) a decline of 1.5 million. B) a decline of 0.7 million. C) an increase of 0.7 million. D) an increase of 1.5 million. Answer: C Explanation: C) Without Price Cut Monitor sales = 100,000 × ($129 - $50) = $7,900,000 Strip sales = 100,000 × ($100 - $25) = $7,500,000 Total EBIT = 7,900,000 + 7,500,000 = 15,400,000 With Price Cut Monitor sales = 130,000 × ($99 - $50) = $6,370.000 Strip sales = 130,000 × ($100 - $25) = $9,750,000 Total EBIT = 6,370,000 + 9,750,000 = 16,120,000 Incremental = 16,120,000 - 15,400,000 = 720,000 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical Use the information for the question(s) below. 57

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 21) The incremental EBIT in the first year for the Sisyphean Corporation's project is closest to: A) $18,000 B) $8,000 C) $11,700 D) $5,200 Answer: B Explanation: B) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000/3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

22) The incremental unlevered net income in the first year for the Sisyphean Corporation's project is closest to: A) $8,000 B) $18,000 C) $5,200 D) $11,700 Answer: C Explanation: C) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000/3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical 23) The depreciation tax shield for the Sisyphean Corporation's project in the first year is closest to: A) $8,000 B) $3,500 C) $2,800 D) $5,200 Answer: B Explanation: B) Depreciation tax shield = depreciation × τc = (30000/3) × .35 = $3,500 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

24) The amount of incremental income taxes that the Sisyphean Company will pay in the first year on this new project is closest to: A) $6,300 B) $5,200 C) $3,500 D) $2,800 Answer: D Explanation: D) Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000/3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 2 Section: 8.1 Forecasting Earnings Skill: Analytical 25) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: A sunk cost is any unrecoverable cost for which the firm is already liable. Sunk costs will have to be paid regardless of the decision whether or not to proceed with the project. Therefore, sunk costs are not incremental with respect to the current decision regarding the project and should not be included in its analysis. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual 26) What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not? Answer: Many projects use resources that the company already owns. An opportunity cost is the cost of using a resource that otherwise could have provided value to the firm. The opportunity cost of using a resource is the value it could have provided in its best alternative use. Because this value is lost when a resource is used by another project, we should always include the opportunity cost as an incremental cost of the project. Diff: 2 Section: 8.1 Forecasting Earnings Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 27) Construct a simple income statement showing the incremental EBIT and the incremental unlevered net income for all three years of the Sisyphean Companies project. Answer: Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000/3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Diff: 3 Section: 8.1 Forecasting Earnings Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8.2 Determining Free Cash Flow and NPV 1) Which of the following statements is FALSE? A) Depreciation is not a cash expense paid by the firm. B) Net Working Capital = Cash + Inventory + Payables - Receivables. C) Since 1997, companies can "carry back" losses for two years and "carry forward" losses for 20 years. D) Earnings do not represent real profits. Answer: B Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 2) Which of the following questions is FALSE? A) Net Working Capital = Current Assets - Current Liabilities. B) Because depreciation is not a cash flow, we do not include it in the cash flow forecast. C) Tax loss carry backs allow corporations to take losses during the current year and use them to offset income in future years. D) Earnings are an accounting measure of firm performance. Answer: C Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 3) Which of the following statements is FALSE? A) Depreciation is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. B) Sometimes the firm explicitly forecast free cash flow over a shorter horizon than the full horizon of the project or investment. C) Earnings include the cost of capital investments, but do not include non-cash charges, such as depreciation. D) Firms often report a different depreciation expense for accounting and for tax purposes. Answer: C Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 4) Which of the following statements is FALSE? A) Most projects will require the firm to invest in net working capital. B) The main components of net working capital are cash, inventory, receivables, and property, plant and equipment. C) ΔNWCt = NWCt - NWCt - 1. D) In the final year of a project, the firm ultimately recovers the investment in net working capital. Answer: B Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

5) Which of the following statements is FALSE? A) Depreciation expenses have a positive impact on free cash flow. B) Free Cash Flow = (Revenues - Costs - Depreciation) × (1 - τc) - Capital Expenditures ΔNWC + τc × Depreciation. C) The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. D) The depreciation tax shield is the tax savings that results from the ability to deduct depreciation. Answer: B Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 6) Which of the following statements is FALSE? A) Because only the tax consequences of depreciation are relevant for free cash flow, we should use the depreciation expense that the firm will use for tax purposed in our free cash flow forecasts. B) A firm generally identifies its marginal tax rate by determining the tax bracket that it falls into based on its overall level of pre-tax income. C) Free Cash Flow = (Revenues - Costs) × (1 - τc) - Capital Expenditures - ΔNWC + τc × Depreciation. D) Net working capital is the difference between current liabilities and current assets. Answer: D Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 7) Which of the following statements is FALSE? A) The terminal of continuation value of the project represents the market value (as of the last forecast period) of the free cash flow from the project at all future dates. B) The incremental effect of a project on the firm's available cash is the project's free cash flow. C) (1 - τc) × Depreciation is called the depreciation tax shield. D) To evaluate a capital budgeting decision, we must determine its consequences for the firm's available cash. Answer: C Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8) Which of the following cash flows are relevant incremental cash flows for a project that you are currently considering investing in? A) The tax savings brought about by the project's depreciation expense B) The cost of a marketing survey you conducted to determine demand for the proposed project C) Interest payments on debt used to finance the project D) Research and Development expenditures you have made Answer: A Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Conceptual 9) Your firm is considering building a new office complex. Your firm already owns land suitable for the new complex. The current book value of the land is $100,000, however a commercial real estate again has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is: A) $650,000 B) $0 C) $100,000 D) $750,000 Answer: A Explanation: A) It is appropriate to use the market value. If taxes are include, the value would be the after-tax value of the land. Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Definition 10) You are considering adding a microbrewery on to one of your firm's existing restaurants. This will entail an increase in inventory of $8,000, an increase in Accounts payable of $2,500, and an increase in property, plant, and equipment of $40,000. All other accounts will remain unchanged. The change in net working capital resulting from the addition of the microbrewery is: A) $45,500 B) $10,500 C) $6,500 D) $5,500 Answer: D Explanation: D) NWC = CA - CL = $8000 - $2500 = $5500 Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) You are considering adding a microbrewery on to one of your firm's existing restaurants. This will entail an investment of $40,000 in new equipment. This equipment will be depreciated straight line over five years. If your firm's marginal corporate tax rate is 35%, then what is the value of the microbrewery's depreciation tax shield in the first year of operation? A) $2,800 B) $14,000 C) $5,200 D) $26,000 Answer: A Explanation: A) First figure out the straight line depreciation. $40,000/5 years = $8000 depreciation per year. Then .35 × $8000 = $2,800 depreciation tax shield per year. Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 12) The Sisyphean Company is considering a new project that will have an annual depreciation expense of $2.5 million. If Sisyphean's marginal corporate tax rate is 40% and their average corporate tax rate is 30%, then what is the value of the depreciation tax shield on their new project? A) $750,000 B) $1,000,000 C) $1,500,000 D) $1,750,000 Answer: B Explanation: B) Here we need to use the marginal tax rate. So depreciation tax shield = $2,500,000 × .40 = $1 million Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%. 13) The required net working capital in the first year for the Sisyphean Corporation's project is closest to: A) $3,600 B) $3,960 C) $2,880 D) $5,400 Answer: A Explanation: A) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

14) The required net working capital in the second year for the Sisyphean Corporation's project is closest to: A) $3,960 B) $4,360 C) $3.190 D) $5,940 Answer: A Explanation: A) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 15) The change in Net working capital from year one to year two is closest to: A) A decrease of $360 B) An increase of $360 C) An increase of $396 D) A decrease of $396 Answer: B Explanation: B) Networking Capital Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cash (2% of sales) 720 792 871.2 Accounts Receivable (4% of sales) 1440 1584 1742.4 Inventory (9% of sales) 3240 3564 3920.4 Accounts Payable (5% of sales) 1800 1980 2178 NWC (Cash + Inventory+ AR - AP) 3600 3960 4356 Change = 3960 - 3600 = 360 Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

16) Bubba Ho-Tep Company reported net income of $300 million for the most recent fiscal year. The firm had depreciation expenses of $125 million and capital expenditures of $150 million. Although they had no interest expense, the firm did have an increase in net working capital of $20 million. What is Bubba Ho-Tep's free cash flow? A) $170 million B) $255 million C) $150 million D) $5 million Answer: B Explanation: B) FCF = NI + Dep - Capital Ex - chg NWC = 300 + 125 - 150 - 20 = 255 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical Use the information for the question(s) below. Temporary Housing Services Incorporated (THSI) is considering a project that involves setting up a temporary housing facility in an area recently damaged by a hurricane. THSI will lease space in this facility to various agencies and groups providing relief services to the area. THSI estimates that this project will initially cost $5 million to setup and will generate $20 million in revenues during its first and only year in operation (paid in one year). Operating expenses are expected to total $12 million during this year and depreciation expense will be another $3 million. THSI will require no working capital for this investment. THSI's marginal tax rate is 35%. 17) Ignoring the original investment of $5 million, what is THSI's free cash flow for the first and only year of operation? A) $5.0 million B) $3.75 million C) $8.0 million D) $6.25 million Answer: D Explanation: D) FCF = (revenues - expenses - depreciation) × (1 - tax rate) + depreciation FCF = (20 - 12 - 3) × (1 - .35) + 3 =6.25 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

18) Assume that THSI's cost of capital for this project is 15%. The NPV of this temporary housing project is closest to: A) $435,000 B) -$650,000 C) $1,960,000 D) -$435,000 Answer: A Explanation: A) FCF = (20 - 12 - 3) × (1 - .35) + 3 = 6.25 So, NPV = -5.0 + 6.25/1.15 = .434782 or $434,782 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical Use the information for the question(s) below. Shepard Industries is evaluating a proposal to expand its current distribution facilities. Management has projected the project will produce the following cash flows for the first two years (in millions). Year Revenues Operating Expense Depreciation Increase in working capital Capital expenditures Marginal corporate tax rate

1 1200 450 240 60 300 30%

2 1400 525 280 70 350 30%

19) The incremental EBIT for Shepard Industries in year one is closest to: A) $360 B) $750 C) $595 D) $510 Answer: D Explanation: D) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

20) The incremental EBIT for Shepard Industries in year two is closest to: A) $415 B) $875 C) $595 D) $510 Answer: C Explanation: C) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 21) The incremental unlevered net income Shepard Industries in year one is closest to: A) $510 B) $415 C) $600 D) $355 Answer: D Explanation: D) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

22) The incremental unlevered net income Shepard Industries in year two is closest to: A) $355 B) $415 C) $600 D) $510 Answer: B Explanation: B) Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 23) The depreciation tax shield for Shepard Industries project in year one is closest to: A) $84 B) $168 C) $96 D) $72 Answer: D Explanation: D) $240 × .30 = $72 Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 24) The depreciation tax shield for Shepard Industries project in year two is closest to: A) $84 B) $196 C) $72 D) $96 Answer: A Explanation: A) $280 × .30 = $84 Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

25) The free cash flow from Shepard Industries project in year one is closest to: A) $240 B) $300 C) -$5 D) $390 Answer: A Explanation: A) Free Cash Flow Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 + Depreciation 240 280 - Capital expenditures 300 350 - Change in NWC 60 70 Free Cash Flow 237 276.5 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 26) The free cash flow from Shepard Industries project in year two is closest to: A) $345 B) $455 C) $275 D) -$5 Answer: C Explanation: C) Free Cash Flow Revenues 1200 1400 - Expenses 450 525 - Depreciation 240 280 = EBIT 510 595 - Taxes (30%) 153 178.5 Incremental Net Income 357 416.5 + Depreciation 240 280 - Capital expenditures 300 350 - Change in NWC 60 70 Free Cash Flow 237 276.5 Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year Sales (Revenues) - Cost of Goods Sold (50% of Sales) - Depreciation = EBIT - Taxes (35%) = unlevered net income + Depreciation + changes to working capital - capital expenditures

0

1 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

2 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

3 100,000 50,000 30,000 20,000 7000 13,000 30,000 10,000

-90,000

27) The free cash flow for the first year of Epiphany's project is closest to: A) $43,000 B) $25,000 C) $38,000 D) $45,000 Answer: C Explanation: C) Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 -90,000 33,929 PV of FCF (FCF/(1 + I)n discount rate 0.12 NPV = 11,946 IRR = 19.14% Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

30,293

37,724

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

28) The free cash flow for the last year of Epiphany's project is closest to: A) $53,000 B) $38,000 C) $35,000 D) $43,000 Answer: A Explanation: A) Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 -90,000 33,929 PV of FCF (FCF/(1 + I)n discount rate 0.12 NPV = 11,946 IRR = 19.14% Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

30,293

37,724

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

29) The NPV for Epiphany's Project is closest to: A) $4,825 B) $39,000 C) $11,946 D) $20,400 Answer: C Explanation: C) Year 0 1 Sales (Revenues) 100,000 - Cost of Goods Sold (50% of Sales) 50,000 - Depreciation 30,000 = EBIT 20,000 - Taxes (35%) 7000 = unlevered net income 13,000 + Depreciation 30,000 + changes to working capital -5,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 PV of FCF (FCF/(1 + I)n discount rate NPV = 11,946 IRR = 19.14%

-90,000 0.12

33,929

2 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

3 100,000 50,000 30,000 20,000 7000 13,000 30,000 10,000

38,000

53,000

30,293

37,724

Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 30) Luther Industries has outstanding tax loss carryforwards of $70 million from losses over the past four years. If Luther earns $15 million per year in pre-tax income from now on, Luther first pays taxes in: A) 7 years B) 2 years C) 4 years D) 5 years Answer: D Explanation: D) The number of years the tax loss carryforwards will last ban be calculated as the tax loss carry forward dividend by the annual pre-tax income or: Years with no tax =

= 4.67 years, so Luther won't have to pay taxes for the next

four years, but will have to start paying some taxes 5 years from now. Diff: 1 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

31) You are considering investing $600,000 in a new automated inventory system that will provide after-tax cost savings of $50,000 next year. These cost savings are expected to grow at the same rate as sales. If sales are expected to grow at 5% per year and your cost of capital is 10%, then what is the NPV of the automated inventory system? A) $400,000 B) $500,000 C) -$100,000 D) $1,000,000 Answer: A Explanation: A) NPV =

- $600,000 = $400,000

Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical Use the information for the question(s) below. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0. The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are estimated to grow by 10% per year each year through year three. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each. Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 6% of its annual sales in accounts payable. The firm is in the 35% tax bracket, and has a cost of capital of 10%.

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32) Calculate the total Free Cash Flows for each of the three years for the Sisyphean Corporation's new project. Answer: Incremental Earnings Forecast Year 1 2 3 Units 2,000 2,200 2,420 Sales (units × $18) 36,000 39,600 43,560 Cost of Good Sold (units × $9) 18,000 19,800 21,780 Gross Profit 18,000 19,800 21,780 Depreciation ($30,000/3) 10,000 10,000 10,000 EBIT 8,000 9,800 11,780 Income tax at 35% 2,800 3,430 4,123 Unlevered net income 5,200 6,370 7,657 Add back Depreciation 10,000 10,000 10,000 Cash Flows from Operations 15,200 16,370 17,657 Networking Capital Forecast Year Sales (units × $18) Cash (2% of sales) Accounts Receivable (4% of sales) Inventory (9% of sales) Accounts Payable (5% of sales) NWC (Cash + Inventory + AR AP) Change (investment) in NWC -3600

1 36,000 720 1440 3240 1800

2 39,600 792 1584 3564 1980

3 43,560 871.2 1742.4 3920.4 2178

3600 -360

3960 -396

4356 4356

15,974

22,013

Investment in machine -30,000 Total Free Cash Flows -33,600 14,840 Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Kinston Industries is considering investing in a machine that will cost $125,000 and will last for three years. The machine will generate revenues of $120,000 each year and the cost of goods sold will be 50% of sales. At the end of year three the machine will be sold for $15,000. The appropriate cost of capital is 10% and Kinston is in the 35% tax bracket. 33) Assume that Kinston's new machine will be depreciated straight line to a salvage value of $5,000 at the end of year three. What is the after-tax salvage value of this project? Answer: If the machine is depreciated straight line to a book value of $5,000. So $15,000 $5,000 = $10,000 gain on the sale which is taxable. So the after tax salvage value = $15,000 - $10,000 × .35 (tax rate) = $11,500. Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical 34) Assume that Kinston's new machine will be depreciated straight line to a salvage value of $5,000 at the end of year three. What is the NPV for this project? Answer: Year 0 1 2 3 Sales (revenues) 120,000 120,000 120,000 Cost of Goods Sold 60,000 60,000 60,000 - Depreciation 40,000 40,000 40,000 EBIT 20,000 20,000 20,000 -Taxes (35%) 7,000 7,000 7,000 = unlevered net income 13,000 13,000 13,000 + Depreciation 40,000 40,000 40,000 + capital expenditures -125,000 + Liquidation cash flows 11,500 Free Cash Flow -125,000 53,000 53,000 64,500 PV of FCF (I = 10%) -125,000 48,182 43,802 48,46 NPV = 15,443 Liquidation/Salvage Value Calculation: If the machine is depreciated straight line to a book value of $5,000. So $15,000 - $5,000 = $10,000 gain on the sale which is taxable. So, the after tax salvage value = $15,000 $10,000 × .35 (tax rate) = $11,500. Diff: 3 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

35) Assume that Kinston's new machine will be depreciated using MACRS according to the following schedule: Year 1 2 3 4

3 Years 33.33% 44.45% 14.81% 7.41%

What is the NPV of this project? Answer: Year 0 1 2 3 Sales (revenues) 120,000 120,000 120,000 Cost of Goods Sold 60,000 60,000 60,000 - Depreciation 41,663 55,563 18,513 EBIT 18,338 4,438 41,488 -Taxes (35%) 6,418 1,553 14,521 = unlevered net income 11,919 2,884 26,967 + Depreciation 41,663 55,563 18,513 + capital expenditures -125,000 + Liquidation cash flows 12,992 Free Cash Flow -125,000 53,582 PV of FCF (I = 10%) -125,000 48,711 NPV = 15,944 Liquidation/Salvage Value Calculation:

58,447 48,303

58,471 43,930

If the machine is depreciated straight line to a book value of 7.41% × 125,000 = $9,263. So $15,000 - $9,263 = $5,737 gain on the sale which is taxable. So the after tax salvage value = $15,000 - $7,737 × .35 (tax rate) = $12,992. Diff: 2 Section: 8.2 Determining Free Cash Flow and NPV Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8.3 Choosing Among Alternatives Use the following information to answer the question(s) below. Galt Motors currently produces 500,000 electric motors a year and expects output levels to remain steady in the future. It buys armatures from an outside supplier at a price of $2.50 each. The plant manager believes that it would be cheaper to make these armatures rather than buy them. Direct in-house production costs are estimated to be only $1.80 per armature. The necessary machinery would cost $700,000 and would be obsolete in 10 years. This investment would be depreciated to zero for tax purposes using a 10-year straight line depreciation. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the ten years. The expected proceeds from scrapping the machinery after 10 years are estimated to be $10,000. Galt Motors pays tax at a rate of 35% and has an opportunity cost of capital of 14%. 1) The incremental cash flow that Galt Motors will incur today (Year 0) if they elect to manufacture armatures in house is closest to: A) -740,000 B) -700,000 C) -660,000 D) 740,000 Answer: A Explanation: A) CF0 = -700,000 + - 40,000 = -740,000 Diff: 1 Section: 8.3 Choosing Among Alternatives Skill: Analytical 2) The incremental cash flow that Galt Motors will incur in year 4 if they elect to manufacture armatures in house is closest to: A) 25,000 B) 350,000 C) 375,000 D) 1,250,000 Answer: C Explanation: C) Incremental cash flow = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 = 374,500 Diff: 1 Section: 8.3 Choosing Among Alternatives Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

3) The incremental cash flow that Galt Motors will incur in year 10 if they elect to manufacture armatures in house is closest to: A) 40,000 B) 335,000 C) 375,000 D) 415,000 Answer: D Explanation: D) Incremental cash flow = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 + 40,000 = 414,500 Diff: 2 Section: 8.3 Choosing Among Alternatives Skill: Analytical 4) The NPV for Galt Motors of manufacturing the armatures in house is closest to: A) 1,095,000 B) 1,215,000 C) 1,225,000 D) 1,250,000 Answer: C Explanation: C) CF0 = -700,000 + - 40,000 = -740,000 CF(1 - 9) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 = 374,500 CF(10) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 + 40,000 = 414,500 CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute NPV = 1,224,225 Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical 5) The IRR for Galt Motors of manufacturing the armatures in house is closest to: A) 48% B) 49% C) 50% D) 53% Answer: C Explanation: C) CF0 = -700,000 + - 40,000 = -740,000 CF(1 - 9) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 = 374,500 CF(10) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 + 40,000 = 414,500 CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute IRR = 49.7639% Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

6) What decision should Galt Motors take regarding manufacturing the armatures in house? A) Proceed with in house manufacture since NPV is negative B) Proceed with in house manufacture since NPV is positive C) Reject in-house manufacture since NPV is negative D) Reject in-house manufacture since IRR is greater than 14% Answer: B Explanation: B) CF0 = -700,000 + - 40,000 = -740,000 CF(1 - 9) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 = 374,500 CF(10) = 500,000 units × ($2.50 - $1.80) + .35 × 700,000/10 + 40,000 = 414,500 CF0 = -740000, CFj = 374500. nj = 9, CFj = 414500, Nj = 1, I = 14, compute NPV = 1,224,225 Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical Use the following information to answer the question(s) below. Two years ago the Krusty Krab Restaurant purchased a grill for $50,000. The owner, Eugene Krabs, has learned that a new grill is available that will cook Krabby Patties twice as fast as the existing grill. This new grill can be purchased for $80,000 and would be depreciated straight line over 8 years, after which it would have no salvage value. Eugene Krab expects that the new grill will produce EBITDA of $50,000 per year for the next eight years while the existing grill produces EBITDA of only $35,000 per year. The current grill is being depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. The Krusty Krab's tax rate is 35%. 7) The incremental cash flow that the Krusty Krab will incur today (Year 0) if they elect to upgrade to the new grill is closest to: A) -80,000 B) -50,000 C) -46,500 D) +30,000 Answer: C Explanation: C) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] = -46,500 Diff: 2 Section: 8.3 Choosing Among Alternatives Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8) The incremental cash flow that the Krusty Krab will incur in year 1 if they elect to upgrade to the new grill is closest to: A) 6,500 B) 7,800 C) 10,800 D) 11,500 Answer: D Explanation: D) Incremental EBITDA = 50,000 - 35,000 = 15,000 Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000 Incremental cash flow = (15,000 - 5,000) × (1 - .35) + 5,000 = 11,500 Diff: 2 Section: 8.3 Choosing Among Alternatives Skill: Analytical 9) The incremental after tax cash flow that the Krusty Krab will receive from selling the existing grill is closest to: A) 19,500 B) 30,000 C) 33,500 D) 50,000 Answer: C Explanation: C) 30,000 [sale price] + .35(40,000 - 30,000) [tax write off old grill sold at loss] = 33,500 Diff: 2 Section: 8.3 Choosing Among Alternatives Skill: Analytical 10) If the Krusty Krab's opportunity cost of capital is 12%, then the NPV for upgrading to the new grill is closest to: A) -22,875 B) -15,025 C) 7,130 D) 10,630 Answer: D Explanation: D) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] = -46,500 Incremental EBITDA = 50,000 - 35,000 = 15,000 Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000 Incremental cash flow (years 1 - 8) = (15,000 - 5,000) × (1 - .35) + 5,000 = 11,500 CF0 = -46,500, CFj = 11,500. nj = 8, I = 12, compute NPV = 10,627.86 Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) If the Krusty Krab's opportunity cost of capital is 12%, then the IRR for upgrading to the new grill is closest to: A) 3.25% B) 16.00% C) 18.25% D) 21.00% Answer: C Explanation: C) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] = -46,500 Incremental EBITDA = 50,000 - 35,000 = 15,000 Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000 Incremental cash flow (years 1 - 8) = (15,000 - 5,000) × (1 - .35) + 5,000 = 11,500 CF0 = -46,500, CFj = 11,500. nj = 8, compute IRR = 18.27% Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical 12) If the Krusty Krab's opportunity cost of capital is 12%, what decision should the Krusty Krab take regarding the new grill? A) Do not install the new grill since NPV is approximately = - $10,630 B) Install the new grill since NPV is approximately = + $10,630 C) Install the new grill since IRR is approximately = 15% D) Don't install the new grill since IRR is less than 12% Answer: B Explanation: B) CF0 = -80,000 + 30,000 + .35(40,000 - 30,000) [tax write off old grill sold at loss] = -46,500 Incremental EBITDA = 50,000 - 35,000 = 15,000 Incremental Depreciation = 80,000/8 - 50,000/10 = 5,000 Incremental cash flow (years 1 - 8) = (15,000 - 5,000) × (1 - .35) + 5,000 = 11,500 CF0 = -46,500, CFj = 11,500. nj = 8, I = 12, compute NPV = 10,627.86; compute IRR = 18.27% Diff: 3 Section: 8.3 Choosing Among Alternatives Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8.4 Further Adjustments to Free Cash Flow Use the following information to answer the question(s) below. (Include the MACRS Table from the Appendix.) Casa Grande Farms is considering purchasing multiple tractors for a total purchase price of $540,000. These tractors are expected to generate EBITDA of $250,000 for each of the next three years. Casa Grande Farms has a 35% tax rate and has a cost of capital of 10%. 1) Assuming that Casa Grande Farms depreciates these tractors straight line over the three year life, then the annual depreciation tax shield in year 2 is closest to: A) 63,000 B) 80,000 C) 84,000 D) 117,000 Answer: A Explanation: A) Depreciation Tax Shield = (540,000/3) × .35 = 63,000 Diff: 1 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical 2) Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation method for three-year property starting immediately, then the annual depreciation tax shield in year 2 is closest to: A) 20,785 B) 27,991 C) 84,000 D) 180,000 Answer: B Explanation: B) Depreciation Tax Shield = 540,000 × .1481 × .35 = 27,991 Diff: 2 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

3) Assuming that Casa Grande Farms depreciates these tractors straight line over the three year life, then the NPV of buying the tractors is closest to: A) 20,785 B) 36,225 C) 81,715 D) 513,235 Answer: A Explanation: A) Cash Flows (1 - 3) = (250,000 - 540,000 × 1/3) × (1 - .35) + 540,000 × 1/3 = 225,500 CF0 = - 540000, CFj = 225,500, Nj = 3, I = 10, Compute NPV = 20,785.12 Diff: 2 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical 4) Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation method for three-year property starting immediately, then the NPV of buying the tractors is closest to: A) 20,785 B) 36,225 C) 81,715 D) 513,235 E) 560,785 Answer: B Explanation: B) CF0 = -540,000 + 540,000 × .3333 × .35 = -477,006.30 CF1 = (250,000 - 540,000 × .4445) × (1 - .35) + 540,000 × .4445 = 246,510.50 CF2 = (250,000 - 540,000 × .1481) × (1 - .35) + 540,000 × .1481 = 190,490.90 CF3 = (250,000 - 540,000 × .0741) × (1 - .35) + 540,000 × .0741 = 176,504.90 I = 10 Compute NPV = 36,226.30 Diff: 3 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the following information to answer the question(s) below. Taggart Transcontinental is considering adding a trucking division to expand the coverage of its existing rail lines. The trucking division will cost $1,000,000 and is expected to generate free cash flows of $100,000 for each of the next five years. Taggart Transcontinental forecasts that future free cash flows after year 5 will grow at 2% per year, forever. Taggart Transcontinental's cost of capital is 10%. 5) The continuation value for the trucking division in year five is closest to: A) 1,000,000 B) 1,250,000 C) 1,275,000 D) 1,375,000 Answer: C Explanation: C) Continuation value (year 5) = PMT(1 + g)/(i - g) = 100,000(1.02)/(.10 - .02) = 1,275,000 Diff: 2 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical 6) The NPV for the trucking division is closest to: A) 170,750 B) 200,000 C) 212,550 D) 250,000 E) 312,500 Answer: A Explanation: A) Continuation value (year 5) = PMT(1 + g)/(i - g) = 100,000(1.02)/(.10 - .02) = 1,275,000 PMT = 100,000, FV = 1,275,000, N = 5, I = 10, Compute PV = 1,170,753.36 - 1,000,000 = 170,753.36 Diff: 2 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the following information to answer the question(s) below. Really Big Conglomerate (RBC) is considering acquiring POP, Inc. a smaller unsuccessful Internet firm. POP has outstanding tax loss carry forwards of $320 million from losses over the past six years. RBC has pre-tax income of $100 million per year, a cost of capital of 10%, and pays 35% in taxes. 7) If RBC acquires POP, in what year will RBC be required to pay corporate taxes again? A) 2 years B) 3 years C) 4 years D) 5 years Answer: C Explanation: C) The tax shield will last for 320/100 = 3.2 years, so in the fourth year RBC will have (100 - 20) = 80 million in taxable income. Diff: 1 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical 8) If RBC acquires POP, then the NPV of POP tax loss carry forwards to RBC is closest to: A) $92 million B) $236 million C) $262 million D) $320 million Answer: A Explanation: A) The total of 320 in tax loss carry forwards will offset income of $100 million in years 1 - 3 and $20 million in year 4. The tax savings will be 35% of these amounts, so the NPV of the tax loss carry forwards in millions is 35/(1.10)1 + 35/(1.10)2 + 35 (1.10)3 + 7/(1.10)4 = $91.82 million Diff: 2 Section: 8.4 Further Adjustments to Free Cash Flow Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

8.5 Analyzing the Project 1) Which of the following statements is FALSE? A) The break-even level of an input is the level for which the investment has an IRR of zero. B) The most difficult part of capital budgeting is deciding how to estimate the cash flows and the cost of capital. C) When evaluating a capital budgeting project, financial managers should make the decision that maximizes NPV. D) Sensitivity analysis reveals which aspects of the project are most critical when we are actually managing the project. Answer: A Diff: 1 Section: 8.5 Analyzing the Project Skill: Conceptual 2) Which of the following statements is FALSE? A) Sensitivity analysis allows us to explore the effects of errors in our estimated inputs in our NPV analysis for the project. B) To compute the NPV for a project, you need to estimate the incremental cash flows and choose a discount rate. C) Estimates of the cash flows and cost of capital are often subject to significant uncertainty. D) When we are certain regarding the input to a capital budgeting decision, it is often useful to determine the break-even level of that input. Answer: D Diff: 2 Section: 8.5 Analyzing the Project Skill: Conceptual 3) Which of the following statements is FALSE? A) We can use scenario analysis to evaluate alternative pricing strategies for our project. B) Scenario analysis considers the effect on NPV of changing multiple project parameters. C) The difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. D) Scenario analysis breaks the NPV calculation into its component assumptions and show how the NPV varies as each one of the underlying assumptions change. Answer: D Diff: 2 Section: 8.5 Analyzing the Project Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) The difference between scenario analysis and sensitivity analysis is that: A) scenario analysis is based upon the IRR and sensitivity analysis is based upon NPV. B) only sensitivity analysis allows us to change our estimated inputs of our NPV analysis. C) scenario analysis considers the effect on NPV of changing multiple project parameters. D) only scenario analysis breaks the NPV calculation into its component assumptions. Answer: C Diff: 2 Section: 8.5 Analyzing the Project Skill: Definition 5) An exploration of the effect on NPV of changing multiple project parameters is called: A) scenario analysis. B) IRR analysis. C) accounting break-even analysis. D) sensitivity analysis. Answer: A Diff: 1 Section: 8.5 Analyzing the Project Skill: Definition 6) An analysis that breaks the NPV calculation into its component assumptions and shows how the NPV varies as one of the underlying assumptions is changed is called: A) scenario analysis. B) IRR analysis. C) accounting break-even analysis. D) sensitivity analysis. Answer: D Diff: 1 Section: 8.5 Analyzing the Project Skill: Definition 7) What is sensitivity analysis? Answer: Sensitivity analysis breaks the NPV calculation into its component assumptions and shows how the NPV varies as each of the underlying assumptions change. Sensitivity analysis allows us to explore the effects of errors in your estimated inputs to our NPV calculations and reveals which aspects of the project are most critical when we are actually managing the project. Diff: 2 Section: 8.5 Analyzing the Project Skill: Conceptual 8) How does scenario analysis differ from sensitivity analysis? Answer: Where sensitivity analysis considers the change in NPV for individual parameter changes, scenario analysis considers the effect on NPV of change multiple project parameters simultaneously. Diff: 2 Section: 8.5 Analyzing the Project Skill: Conceptual Use the information for the question(s) below. 90

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projects: Year Sales (Revenues) - Cost of Goods Sold (50% of Sales) - Depreciation = EBIT - Taxes (35%) = unlevered net income + Depreciation + changes to working capital - capital expenditures

0

2 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

3 100,000 50,000 30,000 20,000 7000 13,000 30,000 10,000

1 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

2 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

3 100,000 50,000 30,000 20,000 7000 13,000 30,000 10,000

38,000

38,000

53,000

33,929

30,293

37,724

-90,000

9) What is the NPV of the Epiphany's project? Answer: Year 0 Sales (Revenues) - Cost of Goods Sold (50% of Sales) - Depreciation = EBIT - Taxes (35%) = unlevered net income + Depreciation + changes to working capital - capital expenditures -90,000 = Free Cash Flow -90,000 PV of FCF (FCF/(1 + I)n) discount rate NPV = Diff: 2 Section: 8.5 Analyzing the Project Skill: Analytical

1 100,000 50,000 30,000 20,000 7000 13,000 30,000 -5,000

-90,000 0.12 11,946

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10) Epiphany would like to know how sensitive the project's NPV is to changes in the discount rate. How much can the discount rate vary before the NPV reaches zero? Answer: Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 -90,000 33,929 PV of FCF (FCF/(1 + I)n) discount rate 0.12 NPV = 11,946 IRR = 19.14% So the discount rate can vary by 12% - 19.14% = 7.14% Diff: 3 Section: 8.5 Analyzing the Project Skill: Analytical

30,293

37,724

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) Epiphany is worried about the reliability of the sales forecast. How sensitive is the project's NPV to a 10% change in sales. Answer: Base Case Year 0 1 2 3 Sales (Revenues) 100,000 100,000 100,000 - Cost of Goods Sold (50% of Sales) 50,000 50,000 50,000 - Depreciation 30,000 30,000 30,000 = EBIT 20,000 20,000 20,000 - Taxes (35%) 7000 7000 7000 = unlevered net income 13,000 13,000 13,000 + Depreciation 30,000 30,000 30,000 + changes to working capital -5,000 -5,000 10,000 - capital expenditures -90,000 = Free Cash Flow -90,000 38,000 38,000 53,000 PV of FCF (FCF/(1 + I)n) discount rate NPV = IRR =

-90,000 0.12 11,946 19

33,929

30,293

37,724

0

1 90,000 45,000 30,000 15,000 5250 9,750 30,000 -5,000

2 90,000 45,000 30,000 15,000 5250 9,750 30,000 -5,000

3 90,000 45,000 30,000 15,000 5250 9,750 30,000 10,000

34,750

34,750

49,750

31,027

27,702

35,411

10% Decrease in Sales Year Sales (Revenues) - Cost of Goods Sold (50% of Sales) - Depreciation = EBIT - Taxes (35%) = unlevered net income + Depreciation + changes to working capital - capital expenditures = Free Cash Flow

-90,000 -90,000

PV of FCF (FCF/(1 + I)n) discount rate NPV =

-90,000 0.12 4,140

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10% Increase in Sales Year Sales (Revenues) - Cost of Goods Sold (50% of Sales) - Depreciation = EBIT - Taxes (35%) = unlevered net income + Depreciation + changes to working capital - capital expenditures = Free Cash Flow

0

-90,000 -90,000

1 110,000 55,000 30,000 25,000 8750 16,250 30,000 -5,000

2 110,000 55,000 30,000 25,000 8750 16,250 30,000 -5,000

3 110,000 55,000 30,000 25,000 8750 16,250 30,000 10,000

41,250

41,250

56,250

-90,000 36,830 32,884 40,038 PV of FCF (FCF/(1+I)n) discount rate 0.12 NPV = 19,752 So a + or - 10% change in sales will cause the NPV to vary between 4,140 and 19,752. Diff: 3 Section: 8.5 Analyzing the Project Skill: Analytical

94

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Chapter 9 Valuing Stocks 9.1 The Dividend-Discount Model 1) Which of the following is NOT a way that a firm can increase its dividend? A) By increasing its retention rate B) By decreasing its shares outstanding C) By increasing its earnings (net income) D) By increasing its dividend payout rate Answer: A Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 2) Which of the following statements is false regarding profitable and unprofitable growth? A) If a firm wants to increase its share price, it must cut its dividend and invest more. B) If the firm retains more earnings, it will be able to pay out less of those earnings, which means that the firm will have to reduce its dividend. C) A firm can increase its growth rate by retaining more of its earnings. D) Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments have a positive NPV. Answer: A Explanation: A) This will only increase the share price if the reinvested money is invested in positive NPV projects. Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 3) Which of the following statements is FALSE? A) Estimating dividends, especially for the distant future, is difficult. B) A firm can only pay out its earnings to investors or reinvest their earnings. C) Successful young firms often have high initial earnings growth rates. D) According to the constant dividend growth model, the value of the firm depends on the current dividend level, divided by the equity cost of capital plus the growth rate. Answer: D Explanation: D) According to the constant dividend growth model, the value of the firm depends on the current dividend level, divided by the equity cost of capital adjusted by the growth rate. Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) Which of the following statements is FALSE? A) We should use the general dividend discount model to value the stock of a firm with rapid or changing growth. B) As firms mature, their growth slows to rates more typical of established companies. C) The dividend discount model values the stock based on a forecast of the future dividends paid to shareholders. D) The simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever. Answer: A Explanation: A) A multistage model should be used. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 5) Which of the following statements is FALSE? A) A common approximation is to assume that in the long run, dividends will grow at a constant rate. B) The dividend each year is the firm’s earnings per share (EPS) multiplied by its dividend payout rate. C) There is a tremendous amount of uncertainty associated with any forecast of a firm’s future dividends. D) During periods of high growth, it is not unusual for firms to pay out 100% of their earnings to shareholders in the form of dividends. Answer: D Explanation: D) During periods of high growth, it is not unusual for these firms to retain 100% of their earnings to exploit profitable investment opportunities. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 6) Which of the following statements is FALSE? A) As firms mature, their earnings exceed their investment needs and they begin to pay dividends. B) Total return equals earnings multiplied by the dividend payout rate. C) Cutting the firm’s dividend to increase investment will raise the stock price if, and only if, the new investments have a positive NPV. D) We cannot use the constant dividend growth model to value the stock of a firm with rapid or changing growth. Answer: B Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7) Which of the following formulas is INCORRECT? A) g = retention rate × return on new investment B) Divt = EPSt × Dividend Payout Rate C) P0 = D) rE =

-g

Answer: D Explanation: D) rE =

+g

Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 8) Which of the following formulas is INCORRECT? A) Divt =

× Dividend Payout Rate

B) PN = C) earnings growth rate = retention rate × return on new investment D) P0 =

+

+ ... +

+

×

Answer: B Explanation: B) PN = Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual Use the following information to answer the question(s) below. Rearden Metals has a current stock price of $30 share, is expected to pay a dividend of $1.20 in one year, and its expected price right after paying that dividend is $33. 9) Rearden's expected dividend yield is closest to: A) 3.40% B) 3.65% C) 4.00% D) 4.20% Answer: C Explanation: C) Div yield = 1.20/30 = .04 or 4% Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 10) Rearden's expected capital gains yield is closest to: A) 4.0% 97

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

B) 6.4% C) 8.2% D) 10.0% Answer: D Explanation: D) Div yield = (33 - 30)/30 = .10 or 10% Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 11) Rearden's equity cost of capital is closest to: A) 4.0% B) 6.4% C) 8.2% D) 14.0% Answer: D Explanation: D) Equity cost of capital = 1.20/30.00 + (33 - 30)/30 = .04 + .10 = .14 Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 12) Nielson Motors has a share price of $25 today. If Nielson Motors is expected to pay a dividend of $0.75 this year, and its stock price is expected to grow to $26.75 at the end of the year, then Nielson's dividend yield and equity cost of capital are: A) 3.0% and 7.0% respectively. B) 3.0% and 10.0% respectively. C) 4.0% and 6.0% respectively. D) 4.0% and 10.0% respectively. Answer: B Explanation: B) Dividend Yield = $0.75/$25 = .03 or 3% Equity cost of capital = 0.75/25.00 + (26.75 - 25.00)/25.00 = .03 + .07 = .10 or 10% Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

13) NoGrowth industries presently pays an annual dividend of $1.50 per share and it is expected that these dividend payments will continue indefinitely. If NoGrowth's equity cost of capital is 12%, then the value of a share of NoGrowth's stock is closest to: A) $10.00 B) $15.00 C) $14.00 D) $12.50 Answer: D Explanation: D) P0 = Div1/(rE - g) = $1.50/(.12 - 0) = $12.50 Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 14) Von Bora Corporation (VBC) is expected to pay a $2.00 dividend at the end of this year. If you expect VBC's dividend to grow by 5% per year forever and VBC's equity cost of capital is 13%, then the value of a share of VBS stock is closest to: A) $25.00 B) $40.00 C) $15.40 D) $11.10 Answer: A Explanation: A) P0 = Div1/(rE - g) = 2.00/(.13 - .05) = $25.00 Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 15) Luther Industries has a dividend yield of 4.5% and and a cost of equity capital of 12%. Luther Industries dividends are expected to grow at a constant rate indefinitely. The grow rate of Luther's dividends are closest to: A) 7.5% B) 5.5% C) 16.5% D) 12% Answer: A Explanation: A) rE = Div1/P0 + g .12 = .045 + g so g = .075 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

16) The Sisyphean Company's common stock is currently trading for $25.00 per share. The stock is expected to pay a $2.50 dividend at the end of the year and the Sisyphean Company's equity cost of capital is 14%. If the dividend payout rate is expected to remain constant, then the expected growth rate in the Sisyphean Company's earnings is closest to: A) 8% B) 6% C) 4% D) 2% Answer: C Explanation: C) P0 = Div1/(rE - g) = 25.00 = 2.50/(.14 - g) so g = .04 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical 17) You expect KT Industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity cost of capital is 12%. The expected growth rate for KTI's dividends is closest to: A) 6.0% B) 7.5% C) 4.5% D) 3.0% Answer: B Explanation: B) g = retention rate × return on new investment = (3.00 - 1.50)/3.00 × .15 = .075 or 7.5% Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 18) You expect KT Industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity cost of capital is 12%. The value of a share of KTI's stock is closest to: A) $39.25 B) $20.00 C) $33.35 D) $12.50 Answer: C Explanation: C) g = retention rate × return on new investment = (3.00 - 1.50)/3.00 × .15 = .075 or 7.5% P0 = Div1/(rE - g) = 1.50/(.12 - .075) = 33.33 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

19) JRN Enterprises just announced that it plans to cut its dividend from $2.50 to $1.50 per share and use the extra funds to expand its operations. Prior to this announcement, JRN's dividends were expected to grow at 4% per year and JRN's stock was trading at $25.00 per share. With the new expansion, JRN's dividends are expected to grow at 8% per year indefinitely. Assuming that JRN's risk is unchanged by the expansion, the value of a share of JRN after the announcement is closest to: A) $25.00 B) $15.00 C) $31.25 D) $27.50 Answer: A Explanation: A) Two steps. Step #1 solve for rE, rE = Div1/P0 + g = 2.50/25.00 + .04 = .14 or 14% Step #2 solve for new stock price: P0 = Div1/(rE - g) = 1.50/(.14 - .08) = 25.00 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

20) You expect that Bean Enterprises will have earnings per share of $2 for the coming year. Bean plans to retain all of its earnings for the next three years. For the subsequent two years, the firm plans on retaining 50% of its earnings. It will then retain only 25% of its earnings from that point forward. Retained earnings will be invested in projects with an expected return of 20% per year. If Bean's equity cost of capital is 12%, then the price of a share of Bean's stock is closest to: A) $17.00 B) $10.75 C) $27.75 D) $43.50 Answer: C Explanation: C) Year Earnings Dividends g 1 $2.00 $0.00 20% 2 $2.40 $0.00 20% 3 $2.88 $0.00 20% 4 $3.46 $1.73 10% 5 $3.80 $1.90 10% 6 $4.18 $3.14 5% P0 = 1.73/(1.12)4 + 1.90/1.125 + (3.14/(.12 - .05))/1.125 = 27.63 Each g is calculated as the 20% return on the projects × the retention ratio. Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical 21) Monsters Inc. is a utility company that recently paid a common stock dividend of $2.35 per share. Determine the current price of a share of Monsters' common stock if its divided growth rate is expected to remain at 7 percent per year indefinitely and its equity cost of capital is 12 percent. Answer: Using the constant growth dividend valuation model VC = D1/(kc - g) = D0 × (1 + g)/(kc - g) = $2.35 × (1.07)/(0.12 - 0.07) = $ 50.29 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

22) MJ LTD is expected to grow at various rates over the next five years. The company just paid a $1.00 dividend. The company expects to grow at 20% for the next two years (effecting D1 and D2), then the company expects to grow at 10% for three additional years (D3, D4, D5) after which the company expects to grow at a constant rate of 5% per year indefinitely. If the required rate of return on MJ's common stock is 12%, then what is a share of MJ's stock worth? Answer: Time Period Dividend Present Value 1 $1.00(1.20) $1.00(1.20)/(1.12) = 1.071 2 2 $1.00(1.20) $1.00(1.20)2/(1.12)2 = 1.148 3 $1.00(1.20)2(1.10)1 $1.00(1.20)2(1.10)/(1.12)3 = 1.127 4 $1.00(1.20)2(1.10)2 $1.00(1.20)2(1.10)2/(1.12)4 = 1.107 5 $1.00(1.20)2(1.10)3 $1.00(1.20)2(1.10)3/(1.12)5 = 1.088 6 $1.00(1.20)2(1.10)3(1.05) $1.00(1.20)2(1.10)3(1.05)/[(.12-.05)(1.12)5] = 16.313 Current Value of Share = 1.071 + 1.148 + 1.127 + 1.107 + 1.088 + 16.313 = $21.85 Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical 23) Growing Real Fast Company (GRF) is expected to have a 25 percent growth rate for the next four years (effecting D1, D2, D3, and D4). Beginning in year five, the growth rate is expected to drop to 7 percent per year and last indefinitely. If GRF just paid a $2.00 dividend and the appropriate discount rate is 15 percent, then what is the value of a share of GRE? Answer: Time Period Dividend Present Value 1 1 $2.00(1.25)/(1.15) = 2.174 $2.50(1.25) 2 2 $2.00(1.25) $2.00(1.25)2/(1.15)2 = 2.363 3 $2.00(1.25)3 $2.00(1.25)3/(1.15)3 = 2.568 4 $2.00(1.25)4 $2.00(1.25)4/(1.15)4 = 2.792 5 $2.00(1.25)4(1.07) $2.00(1.25)4(1.07)/[(.15-.07)(1.15)4 ] = 37.34 Current Value of Share = 2.174 + 2.363 + 2.568 + 2.792 + 37.34 = $47.24 Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

24) Which of the following statements is FALSE? A) There are two potential sources of cash flows from owning a stock. B) An investor will be willing to pay a price today for a share of stock up to the point that this transaction has a zero NPV. C) An investor might generate cash by choosing to sell the shares at some future date. D) Because the cash flows from stock are known with certainty, we can discount them using the risk-free interest rate. Answer: D Explanation: D) Because these cash flows are risky, we cannot discount them using the riskfree interest rate. Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 25) When discounting dividends you should use: A) the weighted average cost of capital. B) the after tax weighted average cost of capital. C) the equity cost of capital. D) the before tax cost of debt. Answer: C Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 26) Which of the following statements is FALSE? A) The equity cost of capital for a stock is the expected return of other investments available in the market with equivalent risk to the firm’s shares. B) The price of a share of stock is equal to the present value of the expected future dividends it will pay. C) If the current stock price were less than P0 =

, it would be a negative NPV

investment, and we would expect investors to rush in and sell it, driving down the stocks price. D) The law of one price implies that to value any security, we must determine the expected cash flows an investor will receive from owning it. Answer: C Explanation: C) In this case the stock would be undervalued and we would expect investors to buy it. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

27) Which of the following statements is FALSE? A) We must discount the cash flows from stock based on the equity cost of capital for the stock. B) The divided yield is the percentage return the investor expects to earn from the dividend paid by the stock. C) The firm might pay out cash to its shareholders in the form of a dividend. D) The dividend yield is the expected annual dividend of a stock, divided by its expected future sale price. Answer: D Explanation: D) The dividend yield is the annual dividend divided by the current price. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 28) Which of the following statements is FALSE? A) Future dividend payments and stock prices are not known with certainty; rather these values are based on the investor’s expectations at the time the stock is purchased. B) The capital gain is the difference between the expected sale price and the purchase price of the stock. C) The sum of the dividend yield and the capital gain rate is called the total return of the stock. D) We divide the capital gain by the expected future stock price to calculate the capital gain rate. Answer: D Explanation: D) The capital gains rate is the capital gain divided by the current stock price. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 29) Which of the following statements is FALSE? A) An investor will be willing to pay up to the point at which the current price of a share of stock equals the present value of the expected future dividends an expected future sale price. B) The expected total return of a stock should equal the expected return of other investments available in the market with equivalent risk. C) The total amount received in dividends and from selling the stock will depend on the investor’s investment horizon. D) If the current stock price were greater than P0 =

, it would be a positive NPV

investment, and we would expect investors to rush in and buy it, driving up the stocks price. Answer: D Explanation: D) It would be a negative NPV investment. Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

30) Which of the following formulas is INCORRECT? A) Capital Gains Rate = B) Dividend Yield = C) P0 =

+

D) rE = Capital Gains Rate + Dividend Yield Answer: A Explanation: A) Capital Gains Rate = Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual 31) Which of the following formulas is INCORRECT? A) P0 =

+

+ ... +

B) P0 = C) rE = D) P0 = Answer: C Explanation: C) rE = Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Conceptual

106

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. Von Bora Corporation is expected pay a dividend of $1.40 per share at the end of this year and a $1.50 per share at the end of the second year. You expect Von Bora's stock price to be $25.00 at the end of two years. Von Bora's equity cost of capital is 10%. 32) The price you would be willing to pay today for a share of Von Bora stock, if you plan to hold the stock for two years is closest to: A) $23.15 B) $20.65 C) $21.95 D) $21.90 Answer: A Explanation: A) P0 =

+

=

+

= $23.17

Diff: 1 Section: 9.1 The Dividend-Discount Model Skill: Analytical 33) Suppose you plan to hold Von Bora stock for one year. The price one would expect to be able to sell a share of Von Bora stock for in one year is closest to: A) $26.50 B) $22.70 C) $23.15 D) $24.10 Answer: D Explanation: D) P1 =

=

= $24.10

Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

34) Suppose you plan to hold Von Bora stock for only one year. Your capital gain from holding Von Bora stock for the first year is closest to: A) $0.95 B) $1.40 C) $1.85 D) $1.25 Answer: A Explanation: A) P1 = P0 =

+

= =

= $24.10

+

= $23.17

Capital Gain = P1 - P0 = 24.10 - 23.17 = $0.93 Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical 35) Suppose you plan to hold Von Bora stock for only one year. Your capital gain rate from holding Von Bora stock for the first year is closest to: A) 3.5% B) 4.0% C) 6.0% D) 4.5% Answer: B Explanation: B) P1 = P0 =

+

= =

+

= $24.10 = $23.17

Capital Gain = P1 - P0 = 24.10 - 23.17 = $0.93 Capital Gain rate = capital gain/P0 = 0.93/23.17 = .0401 or 4.0% Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical

108

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

36) Suppose you plan to hold Von Bora stock for only one year. Your dividend yield from holding Von Bora stock for the first year is closest to: A) 6.0% B) 4.0% C) 6.5% D) 5.5% Answer: A Explanation: A) P0 =

+

=

+

= $23.17

Dividend yield = Div1/P0 = $1.40/23.17 = .0604 or 6.0% Diff: 2 Section: 9.1 The Dividend-Discount Model Skill: Analytical 37) Suppose you plan on purchasing Von Bora stock in one year, right after the $1.40 dividend is paid. You then plan on selling your stock at the end of year two, right after the $1.50 dividend is paid. The capital gain rate that you will receive on your investment is closest to: A) 4.00% B) 3.75% C) 6.25% D) 3.50% Answer: B Explanation: B) P1 =

=

= $24.10

So capital gain rate = (P2 - P1)/P1 = ($25.00 - $24.10)/$24.10 = .03734 or 3.73% Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical 38) Suppose you plan on purchasing Von Bora stock in one year, right after the $1.40 dividend is paid. You then plan on selling your stock at the end of year two, right after the $1.50 dividend is paid. The dividend yield that you will receive on your investment is closest to: A) 5.75% B) 6.50% C) 6.25% D) 4.00% Answer: C Explanation: C) P1 =

=

= $24.10

So dividend yield = $1.50/$24.10 = .0622 or 6.22% Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical 109

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

39) Suppose you plan on purchasing Von Bora stock in one year, right after the $1.40 dividend is paid. You then plan on selling your stock at the end of year two, right after the $1.50 dividend is paid. The total return that you will receive on your investment is closest to: A) 9.50% B) 10.75% C) 10.25% D) 10.00% Answer: D Explanation: D) P1 =

=

= $24.10

So dividend yield = $1.50/$24.10 = .0622 or 6.22% So capital gain rate = (P2 - P1)/P1 = ($25.00 - $24.10)/$24.10 = .03734 or 3.73% Total return = capital gains rate + dividend yield = 3.73% + 6.22% = 9.95% Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical 40) Suppose you plan to hold Von Bora stock for only one year. Calculate your total return from holding Von Bora stock for the first year. Answer: P1 = P0 =

+

= =

= $24.10 +

= $23.17

Capital Gain = P1 - P0 = 24.10 - 23.17 = $0.93 Capital Gain rate = capital gain/P0 = 0.93/23.17 = .0401 or 4.0% Dividend yield = Div1/P0 = $1.40/23.17 = .0604 or 6.0% Total return = capital gain rate + dividend yield = 4.0% + 6.0% = 10% Diff: 3 Section: 9.1 The Dividend-Discount Model Skill: Analytical

110

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9.2 Applying the Dividend-Discount Model 1) Taggart Transcontinental has a divided yield of 2.5%. Taggart's equity cost of capital is 10%, and its dividends are expected to grow at a constant rate. Based on this information, Taggart's constant growth rate in dividends is closest to: A) 2.5% B) 5.0% C) 10.0% D) 7.5% Answer: D Explanation: D) P0 =

→ re - g =

= .10 - g = .025 = g = .075 or 7.5%

Diff: 2 Section: 9.2 Applying the Dividend-Discount Model Skill: Analytical 2) Wyatt oil presently pays no dividend. You anticipate Wyatt Oil will pay an annual dividend of $0.56 per share two years from today and you expect dividends to grow by 4% per year thereafter. In Wyatt Oil's equity cost of capital is 12%, then the value of a share of Wyatt oil today is: A) $4.67 B) $5.00 C) $6.25 D) $7.00 Answer: C Explanation: C) P0 =

+

= $6.25

Diff: 2 Section: 9.2 Applying the Dividend-Discount Model Skill: Analytical

111

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3) Kinston Industries just announced that it will cut its dividend from $3.00 to $2.00 per share and use the extra funds to expand its operations. Kinston's dividends were expected to grow at a 2% rate, and its share price was $37.50. With the new expansion, Kinston dividends are expected to grow at a 5% rate. Kinston's share price following this announcement should be: A) $20.00 B) $30.00 C) $37.50 D) $40.00 Answer: D Explanation: D) Step #1 Step #2 P0 =

re =

+ .02 = .10

= 40.00

Diff: 2 Section: 9.2 Applying the Dividend-Discount Model Skill: Analytical 4) Rearden Metals expects to have earnings this coming year of $2.50 per share. Rearden plans to retain all of its earnings for the next year. For the subsequent three years, the firm will retain 50% of its earnings. It will ten retain 25% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 20% per year. Any earnings that are not retained will be paid out as dividends. Assume Rearden's shares outstanding remains constant and all earnings growth comes from the investment of retained earnings. If Rearden's equity cost of capital is 10%, then Rearden's stock price is closest to: A) $40.80 B) $44.60 C) $59.80 D) $63.50 Answer: B Explanation: B) Growth in Earnings Retained (.20 × Year EPS Earnings R.E.) Dividends 1 $2.50 $2.50 $0.50 0 2 $3.00 $1.50 $0.30 $1.50 3 $3.30 $1.65 $0.33 $1.65 4 $3.63 $1.82 $0.36 $1.82 5 $3.99 $1.00 $0.20 $2.99 growthyear 5 = P0 =

+

= .050125 or 5% +

+

= 44.57

Diff: 3 Section: 9.2 Applying the Dividend-Discount Model Skill: Analytical

112

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9.3 Total Payout and Free Cash Flow Valuation Models 1) Which of the following statements is FALSE? A) The total payout model allows us to ignore the firm’s choice between dividends and share repurchases. B) By repurchasing shares, the firm increases its share count, which decreases its earning and dividends on a per-share basis. C) The total payout model discounts the total payouts that the firm makes to shareholders, which is the total amount spent on both dividends and share repurchases. D) In the dividend discount model we implicitly assume that any cash paid out to the shareholders takes the form of a dividend. Answer: B Explanation: B) By repurchasing shares, the firm decreases its share count, which increases its earning and dividends on a per-share basis. Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 2) If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for you to use is the: A) enterprise value model. B) total payout model. C) dividend discount model. D) discounted free cash flow model. Answer: C Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 3) If you want to value a firm that has consistent earnings grow, but varies how it pays out these earnings to shareholders between dividends and repurchases, the simplest model for you to use is the: A) enterprise value model. B) dividend discount model. C) total payout model. D) discounted free cash flow model. Answer: C Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual

113

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4) If you want to value a firm but don't want to explicitly forecast its dividends, share repurchases, or its use of debt, what is the simplest model for you to use? A) Discounted free cash flow model B) Dividend discount model C) Enterprise value model D) Total payout model Answer: A Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 5) Which of the following statements is FALSE? A) In a share repurchase, the firm uses excess cash to buy back its own stock. B) The discounted free cash flow model begins by determining the value of the firm's equity. C) The discounted free cash flow model focuses on the cash flows to all of the firm’s investors, both debt and equity holders, and allows us to avoid estimating the impact of the firm’s borrowing decisions on earnings. D) In recent years an increasing number of firms have replaced dividend payouts with share repurchases. Answer: B Explanation: B) The discounted free cash flow model is used to find the value of the firm. Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 6) Which of the following statements is FALSE? A) To estimate a firm’s enterprise value, we compute the present value of the free cash flows (FCF) that the firm has available to pay equity holders. B) The NPV of any individual project represents its contribution to the firm’s enterprise value. C) When using the total payout model, we discount total dividends and share repurchases, and use the growth rate in earnings when forecasting the growth of the firm’s payout. D) In the total payout model, we first value the firm’s equity, rather than just a single share. Answer: A Explanation: A) FCF is available to pay both debt and equity holders. Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual

114

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

7) Which of the following statements is FALSE? A) The more cash the firm uses to repurchase shares, the less it has available to pay dividends. B) Free cash flow measures the cash generated by the firm after payments to debt or equity holders are considered. C) We estimate a firm's current enterprise value by computing the present value of the firm's free cash flow. D) We can interpret the enterprise value as the net cost of acquiring the firm's equity, taking its cash and paying off all debts. Answer: B Explanation: B) FCF is cash generated by the firm before payments to debt and equity holders. Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 8) Which of the following statements is FALSE? A) The firm’s weighted average cost of capital (WACC) denoted rwacc is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm’s equity and debt. B) Intuitively, the difference between the discounted free cash flow model and the dividenddiscount model is that in the divided-discount model the firm’s cash and debt are included indirectly through the effect of interest income and expenses on earnings in the dividenddiscount model. C) We interpret rwacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm's debt and equity together. D) When using the discounted free cash flow model we should use the firm's equity cost of capital. Answer: D Explanation: D) You would use the firm's weighted average cost of capital. Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual 9) Which of the following statements is FALSE? A) The long-run growth rate gFCF is typically based on the expected long-run growth rate of the firm's revenues. B) Because the firm's free cash flow is equal to the sum of the free cash flows from the firm's current and future investments, we can interpret the firm's enterprise value as the total NPV that the firm will earn from continuing its existing projects and initiating new ones. C) If the firm has no debt then rwacc = the risk-free rate of return. D) When using the discounted free cash flow model, we forecast the firm's free cash flow up to some horizon, together with some terminal (continuation) value of the enterprise. Answer: C Explanation: C) If the firm has no debt then rwacc = the cost of equity. Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual

115

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10) Which of the following equations is INCORRECT? A) P0 = B) V0 =

+

+ ... +

+

C) Free Cash Flow = EBIT × (1 - τc) + Depreciation - Capital Expenditures - DNWC D) Enterprise Value = Market Value of Equity + Debt - Cash Answer: A Explanation: A) P0 = Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Conceptual Use the following information to answer the question(s) below. Taggart Transcontinental pays no dividends, but spent $4 billion on share repurchases last year. Taggart's equity cost of capital is 13% and if the amount spent on repurchases is expected to grow by 5% per year. Taggart currently has 2 billion shares outstanding. 11) Taggart's market capitalization is closest to: A) $25 billion B) $31 billion C) $40 billion D) $50 billion Answer: D Explanation: D) Market Capitalization =

= $50 billion

Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 12) Taggart's stock price is closest to: A) $12.50 B) $15.40 C) $20.00 D) $25.00 Answer: D Explanation: D) Market Capitalization =

= $50 billion/2 billion shares = $25.00 per

share Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

116

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the following information to answer the question(s) below. Wyatt Oil, an all-equity financed firm, has just reported EPS of $4.00 per share. Despite an economic downturn, Wyatt is confident regarding its current investment opportunities, but due to the current financial crisis, Wyatt does not wish to fund these investments externally. Wyatt's board has therefore decided to suspend its stock repurchase plan and cut its dividend to $1 per share (from its current level of $2 per share) and retain these funds instead. The firm just paid its current dividend of $1.00 per share and expects to keep its dividend at $1 per share next year as well. In subsequent years, it expects its growth opportunities to slow, and it will still be able to fund its growth internally with a target 40% dividend payout ratio, and reinitiating its stock repurchase plan for a total payout rate of 60%. All dividends and repurchases occur at the end of each year. Wyatt's existing operations are expected to generate the current level of earnings per share in the future. Assume that the return on new investments is 16% and that reinvestments will account for all future earnings growth. Wyatt's current equity cost of capital is 12%. 13) Wyatt's expected EPS in two years is closest to: A) $4.48 B) $4.64 C) $5.04 D) $5.38 Answer: C Explanation: C) Retention ratioYear 1 =

= .75 × 16% return = 12% growth rate

EPSYear 1 = $4.00 (1.12) = $4.48 Retention ratioYear 2 =

= .776786 × 16% return = 12.4286% growth rate

EPSYear 2 = $4.48 (1.124286) = $5.0368 Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

14) Wyatt's current stock price is closest to: A) $51.23 B) $54.00 C) $49.11 D) $61.38 Answer: C Explanation: C) Retention ratioYear 1 =

= .75 × 16% return = 12% growth rate

EPSYear 1 = $4.00 (1.12) = $4.48 Retention ratioYear 2 =

= .776786 × 16% return = 12.4286% growth rate

EPSYear 2 = $4.48 (1.124286) = $5.0368 Retention ratioYear 3 = .40% × 16% return = 6.4% growth rate P0 =

+

=

Diff: 3 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 15) The Rufus Corporation has 125 million shares outstanding and analysts expect Rufus to have earnings of $500 million this year. Rufus plans to pay out 40% of its earnings in dividends and they expect to use another 20% of their earnings to repurchase shares. If Rufus' equity cost of capital is 15% and Rufus' earnings are expected to grow at a rate of 3% per year, then the value of a share of Rufus stock is closest to: A) $13.35 B) $33.50 C) $20.00 D) $16.00 Answer: C Explanation: C) Dividends = $500 × .40 = $200 million Repurchases = $500 × .20 = $100 million PV(Future Total Dividends and Repurchases) = ($200 + $100)/(.15 - .03) = $2,500 million P0 = $2,500 million/125 million shares = $20 per share Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

118

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. You expect CCM Corporation to generate the following free cash flows over the next five years: Year FCF ($ millions)

1 25

2 28

3 32

4 37

5 40

Following year five, you estimate that CCM's free cash flows will grow at 5% per year and that CCM's weighted average cost of capital is 13%. 16) The enterprise value of CCM corporation is closest to: A) $396 million B) $290 million C) $382 million D) $350 million Answer: A Explanation: A) V0 =

V0 =

+

+

+

+ ... +

+

+

+

= 395.58 million

Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 17) If CCM has $200 million of debt and 8 million shares of stock outstanding, then the share price for CCM is closest to: A) $49.50 B) $12.50 C) $19.35 D) $24.50 Answer: D Explanation: D) V0 =

V0 =

+

+

+

+ ... +

+

+

+

= 395.58 million or 396 million.

Equity value = $396 - $200 (debt) = $196 million/8 million shares = $24.50 Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

119

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

18) If CCM has $150 million of debt and 12 million shares of stock outstanding, then the share price for CCM is closest to: A) $49.50 B) $11.25 C) $20.50 D) $22.75 Answer: C Explanation: C) V0 =

V0 =

+

+

+

+ ... +

+

+

+

= 395.58 million or 396 million.

Equity value = $396 - $150 (debt) = $246 million/12 million shares = $20.50 Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical Use the information for the question(s) below. Defenestration Industries plans to pay a $4.00 dividend this year and you expect that the firm's earnings are on track to grow at 5% per year for the foreseeable future. Defenestration's equity cost of capital is 13%. 19) Assuming that Defenestration's dividend payout rate and expected growth rate remain constant, and Defenestration does not issue or repurchase shares, then Defenestration's stock price is closest to: A) $50.00 B) $32.30 C) $22.25 D) $30.75 Answer: A Explanation: A) P0 =

=

= $50

Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

20) Suppose that Defenestration decides to pay a dividend of only $2 per share this year and use the remaining $2 per share to repurchase stock. If Defenestration's payout rate remains constant, then Defenestration's stock price is closest to: A) $50.00 B) $22.25 C) $32.30 D) $30.75 Answer: A Explanation: A) P0 =

=

= $50

Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 21) Suppose that Defenestration decides to pay a dividend of only $2 per share this year and use the remaining $2 per share to repurchase stock. If Defenestration maintains this dividend and total payout rate, then the rate at which Defenestration's dividends and earnings per share are expected to grow is closest to: A) 7% B) 13% C) 9% D) 5% Answer: C Explanation: C) P0 =

=

= $50

g = rE - Div1/P0 = .13 - $2/$50 = .09 or 9% Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 22) A firm's net investment is: A) its capital expenditures in excess of depreciation. B) its free cash flow net of increases in working capital. C) its enterprise value in excess of debt owed. D) the market value of equity plus debt. Answer: A Diff: 1 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Definition

121

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the information for the question(s) below. You expect DM Corporation to generate the following free cash flows over the next five years: Year FCF ($ millions)

1 75

2 84

3 96

4 111

5 120

Beginning with year six, you estimate that DM's free cash flows will grow at 6% per year and that DM's weighted average cost of capital is 15%. 23) Calculate the enterprise value for DM Corporation. Answer: V0 =

+

V0 =

+

+

+ ... +

+

+

+

+

= 1017.66 million

Diff: 2 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical 24) If DM has $500 million of debt and 14 million shares of stock outstanding, then what is the price per share for DM Corporation? Answer: V0 =

+

V0 =

+

+

+ ... +

+

+

+

+

= 1017.66 million or

$1018 million Equity value = $1018 - $500 (debt) = $518 million/14 million shares = $37.00 Diff: 3 Section: 9.3 Total Payout and Free Cash Flow Valuation Models Skill: Analytical

122

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9.4 Valuation Based on Comparable Firms 1) Which of the following statements is FALSE? A) Even two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of different size or scale. B) In the method of comparables we estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future. C) Consider the case of a new firm that is identical to an existing publicly traded company. If these firms will generate identical cash flows, the Law of One Price implies that we can use the value of the existing company to determine the value of the new firm. D) A valuation multiple is a ratio of some measure of the firm’s scale to the value of the firm. Answer: D Explanation: D) A valuation multiple is a ratio of the value of the firm to some measure of the firm’s scale. Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual 2) Which of the following statements is FALSE? A) The most common valuation multiple is the price-earnings (P/E) ratio. B) You should be willing to pay proportionally more for a stock with lower current earnings. C) A firm’s P/E ratio is equal to the share price divided by its earnings per share. D) The intuition behind the use of the P/E ratio is that when you buy a stock, you are in sense buying the rights to the firm’s future earnings and differences in the scale of firms’ earnings are likely to persist. Answer: B Explanation: B) You should be willing to pay proportionally more for a stock with higher current earnings. Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual 3) Which of the following statements is FALSE? A) We can estimate the value of a firm’s shares by multiplying its current earnings per share by the average P/E ratio of comparable firms. B) For valuation purposes, the trailing P/E ratio is generally preferred, since it is based on actual not expected earnings. C) Forward earnings are the expected earnings over the coming 12 months. D) Trailing earnings are the earnings over the previous 12 months. Answer: B Explanation: B) For valuation purposes, the leading P/E ratio is generally preferred, since it is based on the expected earnings. Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) Which of the following statements is FALSE? A) Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are made. B) We can compute a firm's P/E ratio by using either trailing earnings or forward earnings with the resulting ratio called the trailing P/E or forward P/E. C) It is common practice to use valuation multiples based on the firm’s enterprise value. D) Using a valuation multiple based on comparables is best viewed as a "shortcut" to the discounted cash flow method of valuation. Answer: A Explanation: A) Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows before interest payments are made. Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual 5) Which of the following statements is FALSE? A) The fact that a firm has an exceptional management team, has developed an efficient manufacturing process, or has just secured a patient on a new technology is ignored when we apply a valuation multiple. B) Valuation multiples have the advantage that they allow us to incorporate specific information about the firm’s cost of capital or future growth. C) For firms with substantial tangible assets, the ratio of price to book value of equity per share is sometimes used. D) Using multiples will not help us determine if an entire industry is overvalued. Answer: B Explanation: B) Discounted cash flows methods have the advantage that they allow us to incorporate specific information about the firm's cost of capital or future growth. Diff: 3 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual

124

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

6) Which of the following statements is FALSE? A) Because capital expenditures can vary substantially from period to period, most practitioners rely on enterprise value to free cash flow multiples. B) Common multiples to consider are enterprise value to EBIT, EBITDA, and free cash flow. C) If two stocks have the same payout and EPS growth rates as well as equivalent risk, then they should have the same P/E ratio. D) Looking at enterprise value as a multiple of sales can be useful if it is reasonable to assume that the firms will maintain similar margins in the future. Answer: A Explanation: A) Because capital expenditures can vary substantially from period to period (e.g., a firm may need to add capacity and build a new plant one year, but then not need to expand further for many years), most practitioners rely on enterprise value to EBITDA multiples. Diff: 3 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual 7) Which of the following formulas is INCORRECT? A) Forward

=

B) Forward

=

C) D) Forward

= =

Answer: B Explanation: B) Forward

=

Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical

125

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the following information to answer the question(s) below. Company Ticker Abbott Labs ABT Bristol-Myers-Squibb BMY GlaxoSmithKline GSK Johnson & Johnson JNJ Merck MRK PfizerPFE

Price per Share 54.35 25.45 41.3 62.6 36.25 $18.30

Earnings per Share 3.69 1.93 3.15 4.58 3.81 $1.20

Book Value per Share 13.79 7.33 6.03 18.27 10.86 8.19

8) Assuming that Novartis AG (NVS) has an EPS of $3.35, based upon the average P/E ratio for its competitors, Novartis' stock price is closest to: A) $13.00 B) $31.86 C) $43.47 D) $44.35 Answer: D Explanation: D) Price Earnings Book Value Price/ Price/ Company Ticker per Share per Share per Share Earnings Book Abbott Labs ABT 54.35 3.69 13.79 14.73 3.94 Bristol-Myers-Squibb BMY 25.45 1.93 7.33 13.19 3.47 GlaxoSmithKline GSK 41.3 3.15 6.03 13.11 6.85 Johnson & Johnson JNJ 62.6 4.58 18.27 13.67 3.43 Merck MRK 36.25 3.81 10.86 9.51 3.34 Pfizer PFE $18.30 $1.20 8.19 15.25 2.23 Average 13.24 3.88 Novartis' stock price = 3.35 × 13.24 = $44.35 Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical

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9) Assuming that Novartis AG (NVS) has an EPS of $3.35, based upon the average price-tobook ratio for its competitors, Novartis' stock price is closest to: A) $13.00 B) $22.95 C) $39.70 D) $44.35 Answer: A Explanation: A) Price Earnings Book Value Price/ Price/ Company Ticker per Share per Share per Share Earnings Book Abbott Labs ABT 54.35 3.69 13.79 14.73 3.94 Bristol-Myers-Squibb BMY 25.45 1.93 7.33 13.19 3.47 GlaxoSmithKline GSK 41.3 3.15 6.03 13.11 6.85 Johnson & Johnson JNJ 62.6 4.58 18.27 13.67 3.43 Merck MRK 36.25 3.81 10.86 9.51 3.34 Pfizer PFE $18.30 $1.20 8.19 15.25 2.23 Average 13.24 3.88 Novartis' stock price = 3.35 × 3.88 = $12.998 or $13.00 Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical 10) Assuming that Novartis AG (NVS) has an EPS of $3.35, based upon the P/E ratios for its competitors, the highest expected stock price for Novartis is closest to: A) $31.86 B) $44.35 C) $51.09 D) $62.60 Answer: C Explanation: C) Price Earnings Book Value Price/ Price/ Company Ticker per Share per Share per Share Earnings Book Abbott Labs ABT 54.35 3.69 13.79 14.73 3.94 Bristol-Myers-Squibb BMY 25.45 1.93 7.33 13.19 3.47 GlaxoSmithKline GSK 41.3 3.15 6.03 13.11 6.85 Johnson & Johnson JNJ 62.6 4.58 18.27 13.67 3.43 Merck MRK 36.25 3.81 10.86 9.51 3.34 Pfizer PFE $18.30 $1.20 8.19 15.25 2.23 Average 13.24 3.88 Novartis' stock price = 3.35 × 15.25 = $51.09 Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical

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11) Assuming that Novartis AG (NVS) has an EPS of $3.35, based upon the price-to-book ratios for its competitors, the lowest expected stock price for Novartis is closest to: A) $7.47 B) $13.00 C) $22.95 D) $31.86 Answer: A Explanation: A) Price Earnings Book Value Price/ Price/ Company Ticker per Share per Share per Share Earnings Book Abbott Labs ABT 54.35 3.69 13.79 14.73 3.94 Bristol-Myers-Squibb BMY 25.45 1.93 7.33 13.19 3.47 GlaxoSmithKline GSK 41.3 3.15 6.03 13.11 6.85 Johnson & Johnson JNJ 62.6 4.58 18.27 13.67 3.43 Merck MRK 36.25 3.81 10.86 9.51 3.34 Pfizer PFE $18.30 $1.20 8.19 15.25 2.23 Average 13.24 3.88 Novartis' stock price = 3.35 × 2.23 = $7.47 Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical 12) You expect Whirlpool Corporation (WHR)to have earnings per share of $6.10 over the coming year. If the average P/E ratio for the appliance industry sector is 17.0, the value of a share of Whirlpool stock based upon the comparables approach is closest to: A) $103.70 B) $27.90 C) $35.90 D) $23.10 Answer: A Explanation: A) Price = Forward earnings × P/E = $6.10 × 17 = $103.70 Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical

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13) You expect Whirlpool Corporation (WHR)to have earnings per share of $6.10 over the coming year. If Whirlpool stock is currently trading at $87.00 per share, then Whirlpool's P/E ratio is closest to: A) 17.00 B) 13.50 C) 14.25 D) 7.00 Answer: C Explanation: C) P/E = price/forward earnings = $87/$6.10 = 14.262 Diff: 1 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical Use the information for the question(s) below. Suppose that Texas Trucking (TT) has earnings per share of $3.45 and EBITDA of $45 million. TT also has 5 million shares outstanding and debt o $150 million (net of cash). You believe that Oklahoma Logistics and Transport (OLT) is comparable to TT in terms of its underlying business, but OLT has no debt. OLT has a P/E of 12.5 and an enterprise value to EBITDA multiple of 7. 14) Based upon the price earnings multiple, the value of a share of Texas Trucking is closest to: A) $49.30 B) $43.10 C) $24.15 D) $27.60 Answer: B Explanation: B) Price = forward earnings × P/E = 3.45 × 12.5 = 43.12 Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical 15) Based upon the enterprise value to EBITDA ratio, the value of a share of Texas Trucking is closest to: A) $33.00 B) $82.50 C) $43.10 D) $21.25 Answer: A Explanation: A) Enterprise value = EBITDA × multiple = $45 × 7 = $315 - $150 debt = $165 equity value/5 million shares = $33.00 per share Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Analytical

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16) What are some common multiples used to value stocks? Answer: Price to Earnings Enterprise value to sales Enterprise value to free cash flow Enterprise value to EBITDA Enterprise value to EBIT Price to book value per share Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual 17) What are some implicit assumptions that are made when valuing a firm using multiples based on comparable firms? Answer: Comparable firms have similar future prospects. No fundamental differences between firms. Same growth rates. Same costs of capital. Industry is correctly valued. Diff: 2 Section: 9.4 Valuation Based on Comparable Firms Skill: Conceptual

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9.5 Information, Competition, and Stock Prices 1) Which of the following is NOT a situation where a trader is able to identify positive NPV trading opportunities in the securities markets? A) An investor who has access to information known only to a few investors B) An investor who has lower trading costs than other market participants C) An investor who gets up really early in the morning so he can be the first to read and act upon the information contained in that day's Wall Street Journal D) An investor who has expertise in a highly complicated area for which a company has just released information Answer: C Diff: 1 Section: 9.5 Information, Competition, and Stock Prices Skill: Conceptual 2) Which of the following statements is FALSE? A) Many managers make the mistake of focusing on accounting earnings as opposed to free cash flows. B) Given accurate information about any two of these variables (a firm’s future cash flows, its cost of capital, and its share price) a valuation model allows use to make inferences about the third variable. C) A valuation model will tell us the most about the variable for which our prior information is the least reliable. D) The idea that investors are able to identify positive NPV trading opportunities is referred to as the efficient markets hypothesis. Answer: D Diff: 1 Section: 9.5 Information, Competition, and Stock Prices Skill: Conceptual 3) Which of the following statements is FALSE? A) Stock markets aggregate the information and view of many different investors. B) Only in the relatively rare case in which we have some superior information that other investors lack regarding the firm's cash flows and cost of capital would it make sense to second-guess the market stock price. C) In most situations, a valuation model is best applied to tell us something about the value of the firm's stock. D) The efficient market hypothesis implies that securities will be fairly priced, based on their future cash flows, given all information that is available to investors. Answer: C Diff: 1 Section: 9.5 Information, Competition, and Stock Prices Skill: Conceptual 4) Which of the following statements is FALSE? A) If the profit opportunities from having private information are large, other individuals will attempt to gain the expertise and devote the resources needed to acquire it. B) When private information is relegated to the hands of a relatively small number of investors, these investors may be able to profit by trading on their information. C) When a buyer seeks to buy a stock, the willingness of other parties to sell the same stock 131

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

suggests that they value the stock differently. D) Since stock markets aggregate the information and view of many different investors, we expect the stock price to react slowly to new publicly available information as the investors continue to trade until a consensus is reached as to the new value of the stock. Answer: D Explanation: D) Since stock markets aggregate the information and view of many different investors, we expect the stock price to react quickly to new publicly available information as the investors continue to trade until a consensus is reached as to the new value of the stock. Diff: 2 Section: 9.5 Information, Competition, and Stock Prices Skill: Conceptual

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Use the following information to answer the question(s) below. Nielson Motors has a share price of $50.00. Its dividend was $2.50, and you expect Nielson Motors to raise its dividend by approximately 6% per year in perpetuity. 5) If Nielson's equity cost of capital is 13%, then Nielson's expected share price is closest to: A) $19.23 B) $37.86 C) $35.71 D) $50.00 Answer: B Explanation: B) P = $2.50(1.06)/(.13 - .06) = 37.86 Diff: 1 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical 6) Given Nielson's current share price, if Nielson's equity cost of capital is 13%, then Nielson's expected growth rate is closest to: A) 5% B) 6% C) 7% D) 8% Answer: D Explanation: D) G = .13 - 2.50/50.00 = .08 or 8% Diff: 2 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical 7) Wyatt Oil just reported that a major fire destroyed one of its oil production facilities in Colorado. While the facility was fully insured, the loss of oil production will decrease Wyatt's free cash flow by $120 million at the end of this year and by $80 million at the end of next year. Wyatt has 50 million shares outstanding and has a weighted average cost of capital of 9%. Assuming the value of Wyatt's debt is not affected by this event, the expected decrease in Wyatt's stock price is closest to: A) $2.00 B) $3.55 C) $3.87 D) $4.00 Answer: B Explanation: B) Decline =

= $3.5485 per share

Diff: 2 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical

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8) Vacinox is a biotechnology firm that is about to announce the results of its clinical trials of a potential new vaccine. If the trials are successful, Vacinox stock will be worth $80 per share. However, if the trials are not successful, then Vacinox stock will only be worth $12 per share. If on the morning that the announcement is schedule, Vacinox stock is trading for $60.96, then the probability that investors place on the trials being successful are closest to: A) 48% B) 50% C) 60% D) 72% Answer: D Explanation: D) price = (p)success + (1 - p)fail = 60.96 = p(80) + (1 - p)12 → 68p = 48.96 → p = .72 Diff: 2 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical 9) Because of a catastrophic plane crash, the FAA announced that it is withdrawing its air worthiness certification for Fly by Night Aviation's (FBNA) new four seat private plane. As a result FBNA’s future expected free cash flows will decline by $40 million a year for the next eight years. FBNA has 20 million shares outstanding, no debt, and an equity cost of capital of 12%. If this news is a complete surprise to investors, then the amount that FBNA’s stock price should fall upon the announcement is closest to: A) $2.00 B) $16.00 C) $16.70 D) $9.90 Answer: D Explanation: D) FV = 0 PMT = 40 I = 12 N=8 Compute PV = 198.71/20 shares = $9.94 Diff: 2 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical

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Use the information for the question(s) below. In a surprise announcement, NASA released details of a major contract with LockheedMartin (LMT) that would increase LMT's market value by $7.5 billion. It was widely expected by the market that this contract would be awarded to LMT's major competitor Boeing (BA). Assume that Boeing has 800 million shares outstanding and Lockheed Martin has 425 million shares outstanding. Prior to this announcement, the market felt that the probability of Boeing winning the contract was 90% and that Lockheed-Martin's chance was only about 10%. 10) What do you anticipate will happen to Lockheed-Martin and Boeing's stock prices are a result of this surprise announcement? Answer: Lockheed-Martin Price increase = $7500 million × .90 (probability not already incorporated in price) = 6750/425 shares = 15.88 increase Boeing Price decrease = $7500 million × .90 (probability already incorporated in price) = 6750/800 shares = 8.44 decrease Diff: 3 Section: 9.5 Information, Competition, and Stock Prices Skill: Analytical 11) What are the implications of the efficient market hypothesis for corporate managers? Answer: A manager seeking to boost the price of her firm's stock should make investments that increase the present value of the firm’s free cash flows. Many managers make the mistake of focusing on accounting earnings as opposed to free cash flows. With efficient markets, the accounting consequences of a decision do not directly affect the value of the firm and should not drive decision making. With efficient markets, the firm can sell its shares at a fair price to new investors. Thus, the firm should not be constrained from raising capital to fund positive NPV investment opportunities. Diff: 3 Section: 9.5 Information, Competition, and Stock Prices Skill: Conceptual

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Chapter 10 Capital Markets and the Pricing of Risk 10.1 Risk and Return: Insights from Years of Investor History 1) Which of the following investments offered the lowest overall return over the past eighty years? A) Small stocks B) Treasury Bills C) S&P 500 D) Corporate bonds Answer: B Diff: 1 Section: 10.1 A First Look at Risk and Return Skill: Definition 2) Which of the following investments offered the highest overall return over the past eighty years? A) Treasury Bills B) S&P 500 C) Small stocks D) Corporate bonds Answer: C Diff: 1 Section: 10.1 A First Look at Risk and Return Skill: Definition 3) Which of the following investments had the largest fluctuations overall return over the past eighty years? A) Small stocks B) S&P 500 C) Corporate bonds D) Treasury Bills Answer: A Diff: 1 Section: 10.1 A First Look at Risk and Return Skill: Definition

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10.2 Common Measures of Risk and Return 1) Which of the following statements is FALSE? A) The variance increases with the magnitude of the deviations from the mean. B) The variance is the expected squared deviation from the mean. C) Two common measures of the risk of a probability distribution are its variance and standard deviation. D) If the return is riskless and never deviates from its mean, the variance is equal to one. Answer: D Explanation: D) If the return is riskless and never deviates from its mean, the variance is equal to zero. Diff: 1 Section: 10.2 Common Measures of Risk and Return Skill: Conceptual 2) Which of the following statements is FALSE? A) When an investment is risky, there are different returns it may earn. B) In finance, the variance of a return is also referred to as its volatility. C) The expected or mean return is calculated as a weighted average of the possible returns, where the weights correspond to the probabilities. D) The variance is a measure of how "spread out" the distribution of the return is. Answer: B Explanation: B) In finance, the standard deviation of a return is also referred to as its volatility. Diff: 1 Section: 10.2 Common Measures of Risk and Return Skill: Conceptual 3) Which of the following statements is FALSE? A) The standard deviation is the square root of the variance. B) Because investors dislike only negative resolutions of uncertainty, alternative measures that focus solely on downside risk have been developed, such as the semi-variance and the expected tail loss. C) While the variance and the standard deviation are the most common measures of risk, they do not differentiate between upside and downside risk. D) While the variance and the standard deviation both measure the variability of the returns, the variance is easier to interpret because it is in the same units as the returns themselves. Answer: D Explanation: D) While the variance and the standard deviation both measure the variability of the returns, the standard deviation is easier to interpret because it is in the same units as the returns themselves. Diff: 2 Section: 10.2 Common Measures of Risk and Return Skill: Conceptual

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4) Which of the following equations is INCORRECT? A) Var(R) = B) SD(R) = C) Var(R) =

PR × (R - E[R])2

D) E[R] = PR × R Answer: A Explanation: A) SD(R) = Diff: 2 Section: 10.2 Common Measures of Risk and Return Skill: Conceptual Use the table for the question(s) below. Consider the following probability distribution of returns for Alpha Corporation: Current Stock Price ($) $25

Stock Price in One Year ($) $35 $25 $20

Return R 40% 0% -20%

Probability PR 25% 50% 25%

5) The expected return for Alpha Corporation is closest to: A) 6.67% B) 5.00% C) 10% D) 0.00% Answer: B Explanation: B) E[R] = PR × R = .25(40%) + .50(0%) + .25(-20%) = 5% Diff: 1 Section: 10.2 Common Measures of Risk and Return Skill: Analytical 6) The variance of the return on Alpha Corporation is closest to: A) 5.00% B) 4.75% C) 3.625% D) 3.75% Answer: B Explanation: B) E[R] = PR × R = .25(40%) + .50(0%) + .25(-20%) = 5% Var(R) = PR × (R - E[R])2 = .25(.40 - .05)2 + .50(.00 - .05)2 + .25(-20 - .05)2 = .0475 or 4.75% Diff: 2 Section: 10.2 Common Measures of Risk and Return Skill: Analytical 7) The standard deviation of the return on Alpha Corporation is closest to: 138

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A) 22.4% B) 19.0% C) 21.8% D) 19.4% Answer: C Explanation: C) E[R] = PR × R = .25(40%) + .50(0%) + .25(-20%) = 5% Var(R) = PR × (R - E[R])2 = .25(.40 - .05)2 + .50(.00 - .05)2 + .25(-20 - .05)2 = .0475 or 4.75% SD(R) = = = .2179 or 21.79% Diff: 3 Section: 10.2 Common Measures of Risk and Return Skill: Analytical 8) Suppose an investment is equally likely to have a 35% return or a - 20% return. The expected return for this investment is closest to: A) 7.5% B) 15% C) 5% D) 10% Answer: A Explanation: A) E[R] = PR × R = .50(35%) + .50(-20%) = 7.5% Diff: 1 Section: 10.2 Common Measures of Risk and Return Skill: Analytical 9) Suppose an investment is equally likely to have a 35% return or a - 20% return. The variance on the return for this investment is closest to: A) .151 B) .0378 C) 0 D) .075 Answer: D Explanation: D) E[R] = PR × R = .50(35%) + .50(-20%) = 7.5% Var(R) = PR × (R - E[R])2 = .50(.35 - .075)2 + .50(-.20 - .075)2 = .07563 Diff: 2 Section: 10.2 Common Measures of Risk and Return Skill: Analytical

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10) Suppose an investment is equally likely to have a 35% return or a -20% return. The standard deviation on the return for this investment is closest to: A) 38.9% B) 0% C) 19.4% D) 27.5% Answer: D Explanation: D) E[R] = PR × R = .50(35%) + .50(-20%) = 7.5% Var(R) = PR × (R - E[R])2 = .50(.35 - .075)2 + .50(-.20 - .075)2 = .07563 Sdev = .07563(1/2) = .2750 Diff: 2 Section: 10.2 Common Measures of Risk and Return Skill: Analytical

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10.3 Historical Returns of Stocks and Bonds 1) Which of the following statements is FALSE? A) The expected return is the return is the return that actually occurs over a particular time period. B) If you hold the stock beyond the date of the first dividend, then to compute you return you must specify how you invest any dividends you receive in the interim. C) The average annual return of an investment during some historical period is simply the average of the realized returns for each year. D) The realized return is the total return we earn from dividends and capital gains, expressed as a percentage of the initial stock price. Answer: A Diff: 1 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Definition 2) Which of the following statements is FALSE? A) We measure the degree of estimation error statistically through the standard error of the estimate. B) When focusing on the returns of a single security, its common practice to assume that all dividends are immediately invested at the risk-free rate. C) We estimate the standard deviation or volatility as the square root of the variance. D) We estimate the variance by computing the average squared deviation from the average realized return. Answer: B Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Conceptual

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3) Which of the following statements is FALSE? A) The standard error provides an indication of how far the sample average might deviate from the expected return. B) The 95% confidence interval for the expected return is defined as the Historical Average Return plus or minus three standard errors. C) We can use a security's historical average return to estimate its actual expected return. D) The standard error is the standard deviation of the average return. Answer: B Explanation: B) The 95% confidence interval for the expected return is defined as the Historical Average Return plus or minus two standard errors. Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Conceptual 4) Which of the following statements is FALSE? A) The compounded geometric average return is most often used for comparative purposes. B) We should use the arithmetic average return when we are trying to estimate an investment's expected return over a future horizon based on its past performance. C) The geometric average return will always be above the arithmetic average return and the difference grows with the volatility of the annual returns. D) The geometric average return is a better description of the long-run historical performance of an investment. Answer: C Explanation: C) The geometric average return will always be below the arithmetic average return and the difference grows with the volatility of the annual returns. Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Conceptual 5) If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each quarter, then the annual realized return is calculated as: A) Rannual = B) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) C) Rannual = (1 + R1)(1 + R2)(1 + R3)(1 + R4) - 1 D) Rannual = R1 + R2 + R3 + R4 Answer: C Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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Use the table for the question(s) below. Consider the following Price and Dividend data for General Electric Company: Date December 31, 2008 January 26, 2009 April 28, 2009 July 29, 2009 October 28, 2009 December 30, 2009

Price ($) Dividend ($) $14.64 $13.35 $0.10 $9.14 $0.10 $10.74 $0.10 $8.02 $0.10 $7.72

6) Assume that you purchased General Electric Company stock at the closing price on December 31, 2008 and sold it after the dividend had been paid at the closing price on January 26, 2009. Your dividend yield for this period is closest to: A) -8.15% B) 0.75% C) 0.70% D) -8.80% Answer: C Explanation: C) = div/P0 = .10/14.64 = .0068 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 7) Assume that you purchased General Electric Company stock at the closing price on December 31, 2008 and sold it after the dividend had been paid at the closing price on January 26, 2009. Your capital gains rate (yield) for this period is closest to: A) 0.75% B) 0.70% C) -8.80% D) -8.15% Answer: C Explanation: C) = (P1 - P0)/P0 = (13.35 - 14.64)/14.64 = -.088115 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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8) Assume that you purchased General Electric Company stock at the closing price on December 31, 2008 and sold it after the dividend had been paid at the closing price on January 26, 2009. Your total return rate (yield) for this period is closest to: A) 0.75% B) -8.80% C) 0.70% D) -8.15% Answer: D Explanation: D) = (P1 + D1 - P0)/P0 = (13.35 + .10 - 14.64)/14.64 = -.08128 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 9) Assume that you purchased Ford Motor Company stock at the closing price on December 31, 2008 and sold it at the closing price on December 30, 2009. Your realized annual return for the year 2009 is closest to: A) -45.1% B) -44.5% C) -48.5% D) -47.3% Answer: A Explanation: A) Date Price ($) Dividend ($) Return (1 + return) December 31, 2008 $14.64 1 1 January 26, 2009 $13.35 $0.10 -8.13% 0.918716 0.918716 April 28, 2009 $9.14 $0.10 -30.79% 0.692135 0.635875 July 29, 2009 $10.74 $0.10 18.60% 1.185996 0.754145 October 28, 2009 $8.02 $0.10 -24.39% 0.756052 0.570173 December 30, 2009 $7.72 -3.74% 0.962594 0.548845 The Product of (1 + returns) - 1 = -0.45116 The last column in the table contains the cumulative product of (1 + returns) Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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Use the table for the question(s) below. Consider the following realized annual returns: Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index Realized Stock A Realized Return Return 23.6% 46.3% 24.7% 26.7% 30.5% 86.9% 9.0% 23.1% -2.0% 0.2% -17.3% -3.2% -24.3% -27.0% 32.2% 27.9% 4.4% -5.1% 7.4% -11.3%

10) The average annual return on the Index from 2000 to 2009 is closest to: A) 7.10% B) 4.00% C) 9.75% D) 8.75% Answer: D Explanation: D) Rannual =

=

=

= 8.82%

Diff: 1 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 11) The average annual return on Stock A from 2000 to 2009 is closest to: A) 29.9% B) 16.40% C) 18.2% D) 18.7% Answer: B Explanation: B) Rannual =

=

=

= 16.45%

Diff: 1 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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12) The variance of the returns on the Index from 2000 to 2009 is closest to: A) .0450 B) .3400 C) .1935 D) .0375 Answer: D Explanation: D) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index Realized Return 23.6% 24.7% 30.5% 9.0% -2.0% -17.3% -24.3% 32.2% 4.4% 7.4%

(R - R) 14.78% 15.88% 21.68% 0.18% -10.82% -26.12% -33.12% 23.38% -4.42% -1.42%

=

=

= 8.8%

(R - R)2 0.0218448 0.0252174 0.0470022 3.24E-06 0.0117072 0.0682254 0.1096934 0.0546624 0.0019536 0.0002016

Variance = SUM of (R - R)2/T - 1 = 0.3405116/9 = 0.0378346 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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13) The variance of the returns on Stock A from 2000 to 2009 is closest to: A) .3145 B) .0990 C) .1100 D) .9890 Answer: C Explanation: C) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Stock A Realized Return 46.3% 26.7% 86.9% 23.1% 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

=

(R - R) 29.85% 10.25% 70.45% 6.65% -16.25% -19.65% -43.45% 11.45% -21.55% -27.75%

= 16.45%

(R - R)2 0.0891023 0.0105063 0.4963203 0.0044223 0.0264063 0.0386123 0.1887903 0.0131103 0.0464403 0.0770063

Variance = SUM of (R - R)2/T - 1 = 0.9907165/9 = 0.1100796 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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14) The standard deviation of the returns on the Index from 2000 to 2009 is closest to: A) 19.5% B) 20.5% C) 3.8% D) 8.8% Answer: A Explanation: A) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index Realized Return 23.6% 24.7% 30.5% 9.0% -2.0% -17.3% -24.3% 32.2% 4.4% 7.4%

=

(R - R) 14.78% 15.88% 21.68% 0.18% -10.82% -26.12% -33.12% 23.38% -4.42% -1.42%

=

= 8.8%

(R - R)2 0.0218448 0.0252174 0.0470022 3.24E-06 0.0117072 0.0682254 0.1096934 0.0546624 0.0019536 0.0002016

Variance = SUM of (R - R)2/T - 1 = 0.3405116/9 = 0.0378346 Standard deviation = = = 0.1945112 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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15) The standard deviation of the returns on Stock A from 2000 to 2009 is closest to: A) 33.2% B) 16.4% C) 31.5% D) 11.0% Answer: A Explanation: A) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Stock A Realized Return 46.3% 26.7% 86.9% 23.1% 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

=

(R - R) 29.85% 10.25% 70.45% 6.65% -16.25% -19.65% -43.45% 11.45% -21.55% -27.75%

= 16.45%

(R - R)2 0.0891023 0.0105063 0.4963203 0.0044223 0.0264063 0.0386123 0.1887903 0.0131103 0.0464403 0.0770063

Variance = SUM of( R - R)2/T - 1 = 0.9907165/9 = 0.1100796 Standard deviation = = = 0.3317825 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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16) Suppose that you want to use the 10 year historical average return on the Index to forecast the expected future return on the Index. The standard error of your estimate of the expected return is closest to: A) 19.4% B) 3.8% C) 6.2% D) 1.95% Answer: C Explanation: D) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index Realized Return 23.6% 24.7% 30.5% 9.0% -2.0% -17.3% -24.3% 32.2% 4.4% 7.4%

=

(R - R) 14.78% 15.88% 21.68% 0.18% -10.82% -26.12% -33.12% 23.38% -4.42% -1.42%

=

= 8.8%

(R - R)2 0.0218448 0.0252174 0.0470022 3.24E-06 0.0117072 0.0682254 0.1096934 0.0546624 0.0019536 0.0002016

Variance = SUM of (R - R)2/T - 1 = 0.3405116/9 = 0.0378346 Standard deviation = = = 0.1945112 Standard error = Standard Deviation/ = 0.1945112/ = 0.0615 or 6.15% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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17) Suppose that you want to use the 10 year historical average return on Stock A to forecast the expected future return on Stock A. The standard error of your estimate of the expected return is closest to: A) 16.4% B) 3.32% C) 10.49% D) 33.20% Answer: C Explanation: B) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Stock A Realized Return 46.3% 26.7% 86.9% 23.1% 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

=

(R - R) 29.85% 10.25% 70.45% 6.65% -16.25% -19.65% -43.45% 11.45% -21.55% -27.75%

= 16.45%

(R - R)2 0.0891023 0.0105063 0.4963203 0.0044223 0.0264063 0.0386123 0.1887903 0.0131103 0.0464403 0.0770063

Variance = SUM of (R - R)2/T - 1 = 0.9907165/9 = 0.1100796 Standard deviation = = = 0.3317825 Standard error = Standard Deviation/ = 0.3317825/ = 0.1049 or 10.49% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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18) Suppose that you want to use the 10 year historical average return on the Index to forecast the expected future return on the Index. The 95% confidence interval for your estimate of the expect return is closest to: A) -9.6% to 27.3% B) 6.8% to 10.7% C) -3.5% to 21.1% D) 4.9% to 12.7% Answer: C Explanation: D) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Index Realized Return 23.6% 24.7% 30.5% 9.0% -2.0% -17.3% -24.3% 32.2% 4.4% 7.4%

=

(R - R) 14.78% 15.88% 21.68% 0.18% -10.82% -26.12% -33.12% 23.38% -4.42% -1.42%

= 8.8%

(R - R)2 0.0218448 0.0252174 0.0470022 3.24E-06 0.0117072 0.0682254 0.1096934 0.0546624 0.0019536 0.0002016

Variance = SUM of (R - R)2/T - 1 = 0.3405116/9 = 0.0378346 Standard deviation =

=

Standard error = Standard Deviation/

= 0.1945112 = 0.1945112/

= 0.0615 or 6.15%

95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .0878 - 2 × 0.0615 = -3.5% upper bound = .0878 + 2 × 0.0615 = 21.1% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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19) Suppose that you want to use the 10 year historical average return on Stock A to forecast the expected future return on Stock A. The 95% confidence interval for your estimate of the expect return is closest to: A) 13.2% to 19.5% B) -4.5% to 37.4% C) 6.5% to 26.3% D) -15.0% to 47.9% Answer: B Explanation: B) Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Stock A Realized Return 46.3% 26.7% 86.9% 23.1% 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

=

(R - R) 29.85% 10.25% 70.45% 6.65% -16.25% -19.65% -43.45% 11.45% -21.55% -27.75%

= 16.45%

(R - R)2 0.0891023 0.0105063 0.4963203 0.0044223 0.0264063 0.0386123 0.1887903 0.0131103 0.0464403 0.0770063

Variance = SUM of (R - R)2/T - 1 = 0.9907165/9 = 0.1100796 Standard deviation = = = 0.3317825 Standard error = Standard Deviation/ = 0.3317825/ = 0.1049 or 10.49% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .1638 - 2 × 0.1049= -4.5% upper bound = .1638 + 2 × 0.1049 = 37.4% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 20) The geometric average annual return on the Index from 2000 to 2009 is closest to: A) 9.75% B) 8.75% C) 7.10% D) 8.35% Answer: C Explanation: C) Geometric Average =

-1

= - 1 = 1.071067 - 1 = 0.071067 Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 21) The geometric average annual return on Stock A from 2000 to 2009 is closest to: A) 12.4% 153

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B) 16.7% C) 13.2% D) 17.8% Answer: A Explanation: A) Geometric Average =

-1

= - 1 = 1.124476 - 1 = 0.124476 Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical Use the table for the question(s) below. Consider the following Price and Dividend data for J. P. Morgan Chase: Date December 31, 2008 February 9, 2009 May 7, 2009 August 10, 2009 November 8, 2009 December 30, 2009

Price ($) $40.06 $36.80 $30.41 $34.86 $25.86 $18.86

Dividend ($) $0.50 $0.50 $0.50 $0.50

22) Assume that you purchased J. P. Morgan Chase stock at the closing price on December 31, 2008 and sold it at the closing price on December 30, 2009. Calculate your realized annual return is for the year 2005. Answer: Date Price ($) Dividend ($) Return (1 + return) December 31, 2008 $40.06 0.00% 1 1 January 26, 2009 $36.80 $0.50 -6.89% 0.931103 0.931103 April 28, 2009 $30.41 $0.50 -16.01% 0.839946 0.782076 July 29, 2009 $34.86 $0.50 16.28% 1.162775 0.909379 October 28, 2009 $25.86 $0.50 -24.38% 0.756168 0.687643 December 30, 2009 $18.86 -27.07% 0.729312 0.501506 The Product of (1 + returns) - 1 = -0.49849 The last column in the table contains the cumulative product of (1 + returns) Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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Use the table for the question(s) below. Consider the following realized annual returns: Market Realized Return 21.2% 30.3% 22.3% 25.3% -11.0% -11.3% -20.8% 33.1% 13.0% 7.3%

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Stock B Realized Return 88.3% 56.4% 114.6% 68.4% -62.8% 52.7% -22.0% 6.9% 9.2% -0.9%

23) Suppose that you want to use the 10 year historical average return on the Market to forecast the expected future return on the Market. Calculate the 95% confidence interval for your estimate of the expect return. Answer: Rannual =

Year End 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Market Realized Return 21.2% 30.3% 22.3% 25.3% -11.0% -11.3% -20.8% 33.1% 13.0% 7.3%

=

(R - R) 10.23% 19.40% 11.35% 14.32% -21.98% -22.20% -31.78% 22.21% 2.07% -3.63%

= 10.93%

(R - R)2 0.0104625 0.03763 0.0128899 0.0205182 0.0483043 0.0492984 0.1009717 0.0493349 0.0004274 0.0013148

Variance = SUM of (R - R)2/(T - 1) = 0.3311521/9 = 0.0367947 Standard deviation = = = 0.1916972 Standard error = Standard Deviation/ = .1916972/ = 0.06062 or 6.062% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = 0.1093-2*0.060 = -0.012 or -1.2% upper bound = .1093 + 2 × 0.060 = 0.231 or 23.1% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical 24) Suppose that you want to use the 10 year historical average return on Stock B to forecast the expected future return on Stock B. Calculate the 95% confidence interval for your 155

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estimate of the expect return. Answer: Rannual = Stock B Realized Year End Return 2000 88.3% 2001 56.4% 2002 114.6% 2003 68.4% 2004 -62.8% 2005 52.7% 2006 -22.0% 2007 6.9% 2008 9.2% 2009 -0.9%

=

(R - R) 57.24% 25.36% 83.53% 37.29% -93.92% 21.66% -53.04% -24.19% -21.92% -32.02%

= 31.1%

(R - R)2 0.3276925 0.0642878 0.6977065 0.1390502 0.8821468 0.0469291 0.281292 0.058501 0.0480275 0.1025221

Variance = SUM of (R - R)2/T - 1 = 2.6481554/9 = 0.29409 Standard deviation = = = 0.542301 Standard error = Standard Deviation/ = 0.542301/ = 0.17149 or 17.149% 95% Confidence Interval = mean return + or - 2 standard errors, so lower bound = .311 - 2 × 0.17149 = -0.204 or -20.4% upper bound = .311 + 2 × 0.17149 = 0.825 or 82.5% Diff: 3 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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25) Using the data provided in the table, calculate the average annual return, the variance of the annual returns, and the standard deviation of the average returns for the market from 2000 to 2009. Answer: Rannual = Market Realized Year End Return 2000 21.2% 2001 30.3% 2002 22.3% 2003 25.3% 2004 -11.0% 2005 -11.3% 2006 -20.8% 2007 33.1% 2008 13.0% 2009 7.3%

=

(R - R) 10.23% 19.40% 11.35% 14.32% -21.98% -22.20% -31.78% 22.21% 2.07% -3.63%

= 10.93%

(R - R)2 0.0104625 0.03763 0.0128899 0.0205182 0.0483043 0.0492984 0.1009717 0.0493349 0.0004274 0.0013148

Variance = SUM of (R - R)2/T - 1 = 0.3311521/9 = 0.0367947 Standard deviation = = = 0.1918194 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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26) Using the data provided in the table, calculate the average annual return, the variance of the annual returns, and the standard deviation of the average returns for Stock B from 2000 to 2009. Answer: Rannual = Stock B Realized Year End Return 2000 88.3% 2001 56.4% 2002 114.6% 2003 68.4% 2004 -62.8% 2005 52.7% 2006 -22.0% 2007 6.9% 2008 9.2% 2009 -0.9%

=

(R - R) 57.24% 25.36% 83.53% 37.29% -93.92% 21.66% -53.04% -24.19% -21.92% -32.02%

= 31.1%

(R - R)2 0.3276925 0.0642878 0.6977065 0.1390502 0.8821468 0.0469291 0.281292 0.058501 0.0480275 0.1025221

Variance = SUM of (R - R)2/T -1 = 2.6481554/9 = 0.2942395 Standard deviation = = = 0.5424385 Diff: 2 Section: 10.3 Historical Returns of Stocks and Bonds Skill: Analytical

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10.4 The Historical Tradeoff Between Risk and Return 1) The excess return if the difference between the average return on a security and the average return for: A) Treasury Bonds. B) a portfolio of securities with similar risk. C) a broad based market portfolio like the S&P 500 index. D) Treasury Bills. Answer: D Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Definition

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2) Which of the following statements is FALSE? A) Expected return should rise proportionately with volatility. B) Investors would not choose to hold a portfolio that is more volatile unless they expected to earn a higher return. C) Smaller stocks have lower volatility than larger stocks. D) The largest stocks are typically more volatile than a portfolio of large stocks. Answer: C Explanation: C) Smaller stocks have higher volatility than larger stocks. Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Conceptual 3) Which of the following statements is FALSE? A) Investments with higher volatility have rewarded investors with higher average returns. B) Investments with higher volatility should have a higher risk premium and therefore higher returns. C) Volatility seems to be a reasonable measure of risk when evaluating returns on large portfolios and the returns of individual securities. D) Riskier investments must offer investors higher average returns to compensate them for the extra risk they are taking on. Answer: C Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Conceptual

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Use the table for the question(s) below. Consider the following average annual returns: Investment Small Stocks S&P 500 Corporate Bonds Treasury Bonds Treasury Bills

Average Return 23.2% 13.2% 7.5% 6.2% 4.8%

4) What is the excess return for the portfolio of small stocks? A) 10.0% B) 15.7% C) 18.4% D) 17.0% Answer: C Explanation: C) Average Average Return - Tbill Investment Return Return Small Stocks 23.2% 18.40% S&P 500 13.2% 8.40% Corporate Bonds 7.5% 2.70% Treasury Bonds 6.2% 1.40% Treasury Bills 4.8% 0.0% Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Analytical 5) What is the excess return for the S&P 500? A) 5.7% B) 7.0% C) 0% D) 8.4% Answer: D Explanation: D) Average Average Return - Tbill Investment Return Return Small Stocks 23.2% 18.40% S&P 500 13.2% 8.40% Corporate Bonds 7.5% 2.70% Treasury Bonds 6.2% 1.40% Treasury Bills 4.8% Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Analytical 6) What is the excess return for corporate bonds? A) 2.7% 161

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B) 1.3% C) -5.7% D) 0% Answer: A Explanation: A) Average Average Return - Tbill Investment Return Return Small Stocks 23.2% 18.40% S&P 500 13.2% 8.40% Corporate Bonds 7.5% 2.70% Treasury Bonds 6.2% 1.40% Treasury Bills 4.8% Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Analytical 7) What is the excess return for Treasury Bills? A) 0% B) -8.4% C) -2.7% D) -1.4% Answer: A Explanation: A) Average Average Return - Tbill Investment Return Return Small Stocks 23.2% 18.40% S&P 500 13.2% 8.40% Corporate Bonds 7.5% 2.70% Treasury Bonds 6.2% 1.40% Treasury Bills 4.8% 0.00% Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Analytical 8) Do expected returns for individual stocks increase proportionately with volatility? Answer: No, although there is a proportional relationship with large portfolios of stocks, this relationship doesn't hold for individual securities. Diff: 1 Section: 10.4 The Historical Tradeoff Between Risk and Return Skill: Conceptual

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10.5 Common Versus Independent Risk 1) Common risk is also called: A) diversifiable risk. B) correlated risk. C) uncorrelated risk. D) independent risk. Answer: B Diff: 1 Section: 10.5 Common Versus Independent Risk Skill: Definition Use the following information to answer the problems below. Consider two banks. Bank A has 1000 loans outstanding each for $100,000, that it expects to be fully repaid today. Each of Bank A's loans have a 6% probability of default, in which case the bank will receive $0 for each of the defaulting loans. Bank B has 100 loans of $1 million outstanding, which it also expects to be fully repaid today. Each of Bank B's loans have a 5% probability of default, in which case the bank will receive $0 for each of the defaulting loans. The chance of default is independent across all the loans. 2) The expected overall payoff to Bank A is: A) $5,000,000 B) $6,000,000 C) $94,000,000 D) $95,000,000 Answer: C Explanation: C) E[payoff] = (.06)(1000)($0) + (1 - .06)(1000)($100,000) = $94,000,000 Diff: 1 Section: 10.5 Common Versus Independent Risk Skill: Analytical 3) The expected overall payoff to Bank B is: A) $5,000,000 B) $6,000,000 C) $94,000,000 D) $95,000,000 Answer: D Explanation: D) E[payoff] = (.05)(100)($0) + (1 - .05)(100)($1,000,000,000) = $95,000,000 Diff: 1 Section: 10.5 Common Versus Independent Risk Skill: Analytical

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4) The standard deviation of the overall payoff to Bank A is closest to: A) $689,000 B) $751,000 C) $2,179,000 D) $2,375,000 Answer: B Explanation: B) E[payoff] = (.06)(1000)($0) + (1 - .06)(1000)($100,000) = $94,000,000 SD(Payoff) = = 23.748684 million SD(Overall Payoff) =

= $750,999.33

Diff: 2 Section: 10.5 Common Versus Independent Risk Skill: Analytical 5) The standard deviation of the overall payoff to Bank B is closest to: A) $751,000 B) $2,179,000 C) $2,375,000 D) $21,794,000 Answer: B Explanation: B) E[payoff] = (.05)(100)($0) + (1 - .05)(100)($1,000,000) = $95,000,000 SD(Payoff) = = 21.794495 million SD(Overall Payoff) =

= $2,179,450

Diff: 2 Section: 10.5 Common Versus Independent Risk Skill: Analytical

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Use the information for the question(s) below. Big Cure and Little Cure are both pharmaceutical companies. Big Cure presently has a potential "blockbuster" drug before the Food and Drug Administration (FDA) waiting for approval. If approved, Big Cure's blockbuster drug will produce $1 billion in net income for Big Cure. Little Cure has 10 separate less important drugs before the FDA waiting for approval. If approved, each of Little Cure's drugs would produce $100 million in net income for Little Cure. The probability of the FDA approving a drug is 50%. 6) What is the expected payoff for Big Cure's Blockbuster drug? A) $100 million B) $0 C) $1 billion D) $500 million Answer: D Explanation: D) expected payoff = prob of payoff × amount if successful = .5 × $1 billion = $500 million Diff: 1 Section: 10.5 Common Versus Independent Risk Skill: Analytical 7) What is the expected payoff for Little Cure's ten drugs? A) $500 million B) $100 million C) $1 billion D) $0 Answer: A Explanation: A) expected payoff = prob of payoff × amount if successful = .5 × $100 = $50 million for each drug $50 million × 10 drugs = $500 million Diff: 1 Section: 10.5 Common Versus Independent Risk Skill: Analytical 8) What is the standard deviation of Big Cure's average net income for their new blockbuster drug? A) $0 B) $1 billion C) $100 million D) $500 million Answer: D Explanation: D) expected payoff = prob of payoff × amount if successful = .5 × $1 billion = $500 million Standard deviation = = 500 million Diff: 2 Section: 10.5 Common Versus Independent Risk Skill: Analytical 9) The standard deviation of Little Cure's average net income for their ten new drugs is closest to: 165

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

A) $50 million B) $25 million C) $16 million D) $500 million Answer: C Explanation: C) expected payoff = prob of payoff × amount if successful = .5 × $1 billion = $500 million Standard deviation for one drug= = 50 million Standard deviation(all drugs) = SD(one drug)/ = 50/ = 15.81 million Diff: 2 Section: 10.5 Common Versus Independent Risk Skill: Analytical 10) Which pharmaceutical company faces less risk? Answer: Little Cure, because it has a lower standard deviation of expected net income. Big Cure expected payoff = prob of payoff × amount if successful = .5 × $1 billion = $500 million Standard deviation = = 500 million Little Cure expected payoff = prob of payoff × amount if successful = .5 × $1 billion = $500 million Standard deviation for one drug= Standard deviation(all drugs) = SD(one drug)/ Diff: 2 Section: 10.5 Common Versus Independent Risk Skill: Analytical

= 50 million = 50/

= 15.81 million

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10.6 Diversification in Stock Portfolios 1) Which of the following is NOT a diversifiable risk? A) The risk that oil prices rise, increasing production costs B) The risk of a product liability lawsuit C) The risk that the CEO is killed in a plane crash D) The risk of a key employee being hired away by a competitor Answer: A Diff: 1 Section: 10.6 Diversification in Stock Portfolios Skill: Conceptual

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2) Which of the following is NOT a systematic risk? A) The risk that oil prices rise, increasing production costs B) The risk that the Federal Reserve raises interest rates C) The risk that the economy slows, reducing demand for your firm's products D) The risk that your new product will not receive regulatory approval Answer: D Diff: 1 Section: 10.6 Diversification in Stock Portfolios Skill: Conceptual 3) Which of the following types of risk doesn't belong? A) Market risk B) Unique risk C) Idiosyncratic risk D) Unsystematic risk Answer: A Diff: 1 Section: 10.6 Diversification in Stock Portfolios Skill: Definition 4) Which of the following types of risk doesn't belong? A) Idiosyncratic risk B) Undiversifiable risk C) Market risk D) Systematic risk Answer: A Diff: 1 Section: 10.6 Diversification in Stock Portfolios Skill: Definition 5) Which of the following statements is FALSE? A) Firm specific news is good or bad news about the company itself. B) Firms are affected by both systematic and firm-specific risk. C) When firms carry both types of risk, only the firm-specific risk will be diversified when we combine many firms' stocks into a portfolio. D) The risk premium for a stock is affected by its idiosyncratic risk. Answer: D Explanation: D) The risk premium for a stock is affected by its systematic risk. Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Conceptual

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6) Which of the following statements is FALSE? A) Because investors are risk averse, they will demand a risk premium to hold unsystematic risk. B) Over any given period, the risk of holding a stock is that the dividends plus the final stock price will be higher or lower than expected, which makes the realized return risky. C) The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk. D) Because investors can eliminate firm-specific risk "for free" by diversifying their portfolios, they will not require a reward or risk premium for holding it. Answer: A Explanation: A) Because investors are risk averse, they will demand a risk premium to hold systematic risk. Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Conceptual 7) Which of the following statements is FALSE? A) Fluctuations of a stock's returns that are due to firm-specific news are common risks. B) The volatility in a large portfolio will decline until only the systematic risk remains. C) When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. D) The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk. Answer: A Explanation: A) Fluctuations of a stock's returns that are due to firm-specific news are not common risks. Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Conceptual 8) Consider a portfolio that consists of an equal investment in 20 firms. For each of these firms, there is a 70% probability that the firms will have a 16% return and a 30% that they will have a - 8% return. Each of these firms' returns is independent of all others. The standard deviation of this portfolio is closest to: A) 2.5% B) 4.2% C) 8.8% D) 11.0% Answer: A Explanation: A) E[return] = (.70)(16%) + (.30)(-8%) = 8.8% SD(Rt) = = 10.9982% SD(Rportfolio) =

= 2.459268%

Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Analytical

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Use the information for the question(s) below. Consider an economy with two types of firms, S and I. S firms always move together, but I firms move independently of each other. For both types of firm there is a 70% probability that the firm will have a 20% return and a 30% probability that the firm will have a -30% return. 9) What is the expected return for an individual firm? A) 14% B) 3% C) 5% D) -5% Answer: C Explanation: C) expected return = .7(20%) + .3(-30%) = 5% Diff: 1 Section: 10.6 Diversification in Stock Portfolios Skill: Analytical 10) The standard deviation for the return on an individual firm is closest to: A) 23.0% B) 5.25% C) 15.0% D) 10.0% Answer: A Explanation: A) expected return = .7(20%) + .3(-30%) = 5% standard deviation = = .2291 Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Analytical 11) The standard deviation for the return on a portfolio of 20 type S firms is closest to: A) 5.10% B) 23.0% C) 15.0% D) 5.25% Answer: B Explanation: B) expected return = .7(20%) + .3(-30%) = 5% standard deviation = = .2291 Since all these firms move the same, there is no adjustment to the standard deviation. Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Analytical

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12) The standard deviation for the return on an portfolio of 20 type I firms is closest to: A) 5.25% B) 5.10% C) 15.0% D) 23.0% Answer: B Explanation: B) expected return = .7(20%) + .3(-30%) = 5% standard deviation = = .2291 Since all these firms move independently stdev = stdev(single firm)/ = .2291/ = .0512 Diff: 2 Section: 10.6 Diversification in Stock Portfolios Skill: Analytical

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10.7 Measuring Systematic Risk Use the following information to answer the question(s) below. Suppose that the market portfolio is equally likely to increase by 24% or decrease by 8%. Security "X" goes up on average by 29% when the market goes up and goes down by 11% when the market goes down. Security "Y" goes down on average by 16% when the market goes up and goes up by 16% when the market goes down. Security "Z" goes up on average by 4% when the market goes up and goes up by 4% when the market goes down. 1) The beta for security "X" is closest to: A) 0 B) 0.80 C) 1.00 D) 1.25 Answer: D Explanation: D) Change in Market = 24% - (-8%) = 32%, change in security = 29% - (-11%) = 40%, Beta = 40%/32% = 1.25 Diff: 1 Section: 10.7 Measuring Systematic Risk Skill: Analytical 2) The beta for security "Y" is closest to: A) -1.00 B) -0.25 C) 0.00 D) 0.25 Answer: A Explanation: A) Change in Market = 24% - (-8%) = 32%, change in security = -16% - (16%) = -32%, Beta = -32%/32% = -1.00 Diff: 1 Section: 10.7 Measuring Systematic Risk Skill: Analytical 3) The beta for security "Z" is closest to: A) -1.00 B) -0.25 C) 0.00 D) 0.25 Answer: C Explanation: C) Change in Market = 24% - (-8%) = 32%, change in security = 4% - (4%) = 0%, Beta = 0%/32% = 0 Diff: 1 Section: 10.7 Measuring Systematic Risk Skill: Analytical 4) The risk-free rate is closest to: A) 0% B) 4% 172

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C) 8% D) 16% Answer: B Explanation: B) Security "Z" is the risk-free asset since its return is constant regardless of the market. Therefore the risk-free rate is the return on security Z which is 4%. Diff: 1 Section: 10.7 Measuring Systematic Risk Skill: Analytical 5) The expected return on the market portfolio is closest to: A) 0% B) 4% C) 8% D) 16% Answer: C Explanation: C) .50(24%) + .50(-8%) = 8% Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical 6) The expected return on security "Y" is closest to: A) 0% B) 4% C) 10% D) 15% Answer: A Explanation: A) .50(-16%) + .50(.16%) = 0% Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical 7) The expected return on security with a beta of 0.8 is closest to: A) 0.0% B) 3.2% C) 6.4% D) 7.2% Answer: D Explanation: D) Security "Z" is the risk-free asset since its return is constant regardless of the market. Therefore the risk-free rate is the return on security Z which is 4%. The expected return on the market rate is .50(24%) + .50(-8%) = 8%. Using the CAPM, the return on this security is .04 + 0.8(.08 -.04) = 7.2% Diff: 3 Section: 10.7 Measuring Systematic Risk Skill: Analytical 8) The expected return on security with a beta of 1.2 is closest to: A) 4.8% B) 8.0% C) 8.8% D) 9.6% 173

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Answer: C Explanation: C) Security "Z" is the risk-free asset since its return is constant regardless of the market. Therefore the risk-free rate is the return on security Z which is 4%. The expected return on the market rate is .50(24%) + .50(-8%) = 8%. Using the CAPM, the return on this security is .04 + 1.2(.08 -.04) = 8.8% Diff: 3 Section: 10.7 Measuring Systematic Risk Skill: Analytical 9) The expected return on security with a beta of 0 is closest to: A) -4.0% B) 0.0% C) 3.2% D) 4.0% Answer: D Explanation: D) Security "Z" is the risk-free asset since its return is constant regardless of the market. Therefore the risk-free rate is the return on security Z which is 4%. The expected return on the market rate is .50(24%) + .50(-8%) = 8%. Using the CAPM, the return on this security is .04 + 0(.08 -.04) = 4.0% Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical

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10) The expected return on security with a beta of 1 is closest to: A) -4.0% B) 3.2% C) 4.0% D) 8.0% Answer: D Explanation: D) Security "Z" is the risk-free asset since its return is constant regardless of the market. Therefore the risk-free rate is the return on security Z which is 4%. The expected return on the market rate is .50(24%) + .50(-8%) = 8%. Using the CAPM, the return on this security is .04 + 1(.08 -.04) = 8.0% Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical 11) Which of the following statements is FALSE? A) In exchange for bearing systematic risk, investors want to be compensated by earning a higher return. B) A key step to measuring systematic risk is finding a portfolio that contains only unsystematic risk. C) When evaluating the risk of an investment, an investor will care about its systematic risk, which cannot be eliminated through diversification. D) To measure the systematic risk of a stock, we must determine how much of the variability of its return is due to systematic, market-wide risks versus diversifiable, firm specific risks. Answer: B Explanation: B) A key step to measuring systematic risk is finding a portfolio that contains only systematic risk (the market portfolio). Diff: 1 Section: 10.7 Measuring Systematic Risk Skill: Conceptual 12) Which of the following statements is FALSE? A) Beta differs from volatility. B) The risk premium investors can earn by holding the market portfolio is the difference between the market portfolio's expected return and the risk-free interest rate. C) Stocks in cyclical industries, in which revenues tend to vary greatly over the business cycle, are likely to be more sensitive to systematic risk and have higher betas than stocks in less sensitive industries. D) If we assume that the market portfolio (or the S&P 500) is efficient, then changes in the value of the market portfolio represent unsystematic shocks to the economy. Answer: D Explanation: D) If we assume that the market portfolio (or the S&P 500) is efficient, then changes in the value of the market portfolio represent systematic shocks to the economy. Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Conceptual

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13) Which of the following statements is FALSE? A) Beta measures the sensitivity of a security to market wide risk factors. B) Volatility measures total risk, while beta measures only systematic risk. C) The beta is the expected percentage change in the excess return of the market portfolio for a 1% change in the excess return of a security. D) Utilities tend to be stable and highly regulated, and thus are insensitive to fluctuations in the overall market. Answer: C Explanation: C) The beta is the expected percentage change in the excess return of a security for a 1% change in the excess return of the market portfolio. Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Conceptual 14) Which of the following statements is FALSE? A) Because diversification improves with the number of stocks held in a portfolio an efficient portfolio should be a large portfolio containing many different stocks. B) The beta of a security is the sensitivity of the security's return to the return of the overall market. C) An efficient portfolio cannot be diversified further, that is there is no way to reduce the risk of the portfolio without lowering its expected return. D) We call a portfolio that contains only unsystematic risk an efficient portfolio. Answer: D Explanation: D) We call a portfolio that contains only systematic risk an efficient portfolio. Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Conceptual

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Use the information for the question(s) below. Suppose the market portfolio's excess return tends to increase by 30% when the economy is strong and decline by 20% when the economy is weak. A type S firm has excess returns that increase by 45% when the economy is strong and decrease by 30% when the economy is weak. A type I firm will also have excess returns of either 45% or -30%, but the type I firm's excess returns will depend only upon firm-specific events and will be completely independent of the state of the economy. 15) What is the Beta for a type I firm? A) 1.0 B) 0.75 C) 0.0 D) 1.5 Answer: C Explanation: C) The systematic risk of the strength of the economy produces at 30% - -20% = 50% change in return for the market portfolio. The type I firm's return is independent of the economy as a whole so its change = 0% Beta = 0%/50% = 0 Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical 16) What is the Beta for a type S firm? A) 1.5 B) 0.0 C) 1.0 D) 0.75 Answer: A Explanation: A) The systematic risk of the strength of the economy produces at 30% - -20% = 50% change in return for the market portfolio. The type S firm's return changes by 45% - -30% = 75%, so Beta = 75%/50% = 1.5 Diff: 2 Section: 10.7 Measuring Systematic Risk Skill: Analytical

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10.8 Beta and the Cost of Capital Use the following information to answer the question(s) below. Company Ford Motor Company International Business Machines Merck

Ticker F IBM MRK

Beta 2.77 0.73 0.90

1) If the market risk premium is 6% and the risk-free rate is 4%, then the expected return of investing in Ford Motor Company is closest to: A) 10.0% B) 16.2% C) 17.1% D) 20.6% Answer: D Explanation: D) Return = .04 + 2.77(.06) = .2062 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 2) If the market risk premium is 6% and the risk-free rate is 4%, then the expected return of investing in Merck is closest to: A) 5.4% B) 9.4% C) 10.0% D) 10.4% Answer: B Explanation: B) Return = .04 + 0.9(.06) = .094 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 3) If the expected return on the market is 11% and the risk-free rate is 4%, then the expected return of investing in IBM is closest to: A) 9.1% B) 10.3% C) 11.0% D) 12.0% Answer: A Explanation: A) Return = .04 + 0.73 (.11 - .04) = .0911 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical

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4) If the expected return on the market is 11% and the expected return of investing in Merck is 10.35%, then the risk-free rate must be: A) 3.0% B) 4.0% C) 4.5% D) 5.0% Answer: C Explanation: C) Return → .1035 = X + 0.9(.11 - X) → .1X = .1035 - .9(.11) → X = .045 Diff: 2 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 5) If the risk-free rate is 5% and the expected return of investing in Merck is 11.3%, then the expected return on the market must be: A) 8.0% B) 10.0% C) 10.4% D) 12.0% Answer: D Explanation: D) Return → .113 = .05 + 0.9(X - .05) → .9X = .113 - .05 + .045 → X = .12 Diff: 2 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 6) Suppose that Luther's beta is 0.9. If the market risk premium is 8% and the risk-free interest rate is 4%, then then expected return for Luther stock is? A) 7.6% B) 11.6% C) 11.2% D) 12.9% Answer: C Explanation: C) E[R] = Rf + Beta × Risk Premium = .04 + .9 × .08 = .112 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 7) Suppose that KAN's beta is 1.5. If the market risk premium is 8% and the risk-free interest rate is 4%, then then expected return for KAN stock is? A) 8.0% B) 16.0% C) 13.5% D) 10.0% Answer: B Explanation: B) E[R] = Rf + Beta × Risk Premium = .04 + 1.5 × .08 = .16 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 8) Suppose that Gold Digger's beta is -0.8. If the market risk premium is 8% and the risk-free interest rate is 4%, then the expected return for Gold Digger's stock is? 179

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A) -2.4% B) 4.8% C) 2.4% D) 10.4% Answer: A Explanation: A) E[R] = Rf + Beta × Risk Premium = .04 + -0.8 × .08 = -0.024 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 9) Which of the following statements is FALSE? A) The Capital Asset Pricing Model is the most important method for estimating the cost of capital that is used in practice. B) Because the risk that determines expected returns is unsystematic risk, which is measured by beta, the cost of capital for an investment is the expected return available on securities with the same beta. C) A common assumption is that the project has the same risk as the firm. D) To determine a project's cost of capital we need to estimate its beta. Answer: B Explanation: B) Because the risk that determines expected returns is systematic risk, which is measured by beta, the cost of capital for an investment is the expected return available on securities with the same beta. Diff: 2 Section: 10.8 Beta and the Cost of Capital Skill: Conceptual Use the information for the question(s) below. Suppose that in the coming year, you expect Exxon-Mobil stick to have a volatility of 42% and a beta of 0.9, and Merck's stock to have a volatility of 24% and a beta of 1.1. The risk free interest rate is 4% and the market's expected return is 12%. 10) Which stock has the highest total risk? A) Merck since it has a lower volatility B) Merck since it has a higher Beta C) Exxon-Mobil since it has a higher volatility D) Exxon-Mobil since it has a lower beta Answer: C Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Conceptual

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11) Which stock has the highest systematic risk? A) Merck since it has a higher Beta B) Exxon-Mobil since it has a lower beta C) Exxon-Mobil since it has a higher volatility D) Merck since it has a lower volatility Answer: A Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Conceptual 12) The cost of capital for a project with the same beta as Exxon Mobil's stock is closest to: A) 11.6% B) 11.2% C) 12.8% D) 7.6% Answer: B Explanation: B) E[R] = Rf + Beta × Risk Premium = .04 + .9 × (.12 - .04) = .112 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 13) The cost of capital for a project with the same beta as Merck's stock is closest to: A) 11.2% B) 12.8% C) 12.4% D) 11.6% Answer: B Explanation: B) E[R] = Rf + Beta × Risk Premium = .04 + 1.1 × (.12 - .04) = .128 Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Analytical 14) Which of the following is consistent with the CAPM and efficient capital markets? A) A security with a beta of 1 has a return last year of 8% when the market has a return of 12%. B) Small stocks with a beta of 1.5 tend to have higher returns on average than large stocks with a beta of 1.5. C) A security with only diversifiable risk has an expected return that exceeds the risk-free interest rate. D) A security with only systematic risk has an expected return that exceeds the risk-free interest rate. Answer: D Diff: 2 Section: 10.8 Beta and the Cost of Capital Skill: Conceptual

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15) Which of the following statements is FALSE? A) If the market portfolio were not efficient, investors could find strategies that would "beat the market" with higher average returns and lower risk. B) The CAPM states that the cost of capital depends only on systematic risk. C) Efficient capital markets is a much stronger hypothesis than the CAPM. D) The market portfolio is an efficient portfolio. Answer: C Diff: 2 Section: 10.8 Beta and the Cost of Capital Skill: Conceptual 16) What is the market portfolio? Answer: The portfolio that contains all shares of all stocks and securities in the market is called the market portfolio. Diff: 1 Section: 10.8 Beta and the Cost of Capital Skill: Definition

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Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 11.1 The Expected Return of a Portfolio 1) Which of the following statements is FALSE? A) Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return. B) The expected return of a portfolio is simply the weighted average of the expected returns of the investments within the portfolio. C) Portfolio weights add up to 1 so that they represent the way we have divided our money between the different individual investments in the portfolio. D) A portfolio weight is the fraction of the total investment in the portfolio held in an individual investment in the portfolio. Answer: A Explanation: A) Without trading, the portfolio weights will increase for the stocks in the portfolio whose returns are above the overall portfolio return. Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Conceptual 2) Which of the following equations is INCORRECT? A) xi = B) Rp = Σi xiRi C) Rp = x1R1 + x2R2 + ... + xnRn D) E[Rp] = E[Σi xiRi] Answer: A Explanation: A) xi = Diff: 2 Section: 11.1 The Expected Return of a Portfolio Skill: Conceptual

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Use the information for the question(s) below. Suppose you invest $20,000 by purchasing 200 shares of Abbott Labs (ABT) at $50 per share, 200 shares of Lowes (LOW) at $30 per share, and 100 shares of Ball Corporation (BLL) at $40 per share. 3) The weight on Abbott Labs in your portfolio is: A) 50% B) 40% C) 30% D) 20% Answer: A Explanation: A) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000 xi = value of security/value of portfolio = (200 × $50)/$20000 = .50 or 50% Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 4) The weight on Lowes in your portfolio is: A) 40% B) 20% C) 50% D) 30% Answer: D Explanation: D) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000 xi = value of security/value of portfolio = (200 × $30)/$20000 = .30 or 30% Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 5) The weight on Ball Corporation in your portfolio is: A) 50% B) 40% C) 20% D) 30% Answer: C Explanation: C) Value of portfolio = 200 × $50 + 200 × $30 + 100 × $40 = $20,000 xi = value of security/value of portfolio = (100 × $40)/$20000 = .20 or 20% Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical

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6) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The return on your portfolio over the year is: A) 0% B) 7.5% C) 3.5% D) 5.0% Answer: C Explanation: C) Stock Weight Return W × R ABT 0.5 -0.1 -0.05 LOW 0.3 0.2 0.06 BLL 0.2 0.125 0.025 Rp = 0.035 Diff: 2 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 7) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The value of your portfolio over the year is: A) $21,000 B) $20,000 C) $20,700 D) $21,500 Answer: C Explanation: C) Stock Weight Return W × R ABT 0.5 -0.1 -0.05 LOW 0.3 0.2 0.06 BLL 0.2 0.125 0.025 Rp = 0.035 Value of portfolio = 20000(1 + .035) = 20700 Diff: 2 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical

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8) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The weight on Ball Corporation in your portfolio after one year is closest to: A) 20.0% B) 12.5% C) 20.7% D) 21.7% Answer: D Explanation: D) Stock Weight Return W × R ABT 0.5 -0.1 -0.05 LOW 0.3 0.2 0.06 BLL 0.2 0.125 0.025 Rp = 0.035 Value of portfolio = 20000(1 + .035) = 20700 Value of BLL = $4000(1 + .125) = $4500 Weight for BLL = 4500/20700 = 0.217391 Diff: 3 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 9) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The weight on Abbott Labs in your portfolio after one year is closest to: A) -10.0% B) 43.5% C) 45.0% D) 50.0% Answer: B Explanation: B) Stock Weight Return W × R ABT 0.5 -0.1 -0.05 LOW 0.3 0.2 0.06 BLL 0.2 0.125 0.025 Rp = 0.035 Value of portfolio = 20000(1 + .035) = 20700 Value of ABT = $10000(1 + -.10) = $9000 Weight for ABT = 9000/20700 = 0.434783 Diff: 3 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical

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10) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The weight on Lowes in your portfolio after one year is closest to: A) 20.0% B) 34.8% C) 30.0% D) 36.0% Answer: B Explanation: B) Stock Weight Return W × R ABT 0.5 -0.1 -0.05 LOW 0.3 0.2 0.06 BLL 0.2 0.125 0.025 Rp = 0.035 Value of portfolio = 20000(1 + .035) = 20700 Value of LOW = $6000(1 + .20) = $7200 Weight for LOW = 7200/20700 = 0.347826 Diff: 3 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 11) Suppose you invest $15,000 in Merck stock and $25,000 in Home Depot stock. You expect a return of 16% for Merck and 12% for Home Depot. What is the expected return on your portfolio? A) 13.50% B) 14.00% C) 13.75% D) 14.50% Answer: A Explanation: A) = (15,000/40,000)(.16) + (25,000/40,000)(.12) = .135 Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical 12) Suppose you invest $15,000 in Merck stock and $25,000 in Home Depot stock. You receive an actual return of -8% for Merck and 12% for Home Depot. What is the actual return on your portfolio? A) 4.50% B) 4.00% C) 10.00% D) 2.00% Answer: A Explanation: A) = (15,000/40,000)(-0.08) + (25,000/40,000)(.12) = .045 Diff: 1 Section: 11.1 The Expected Return of a Portfolio Skill: Analytical

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11.2 The Volatility of a Two-Stock Portfolio 1) Which of the following statements is FALSE? A) The covariance and correlation allow us to measure the co-movement of returns. B) Correlation is the expected product of the deviations of two returns. C) Because the prices of the stocks do not move identically, some of the risk is averaged out in a portfolio. D) The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together. Answer: B Diff: 1 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual 2) Which of the following statements is FALSE? A) While the sign of the correlation is easy to interpret, its magnitude is not. B) Independent risks are uncorrelated. C) When the covariance equals 0, the returns are uncorrelated. D) To find the risk of a portfolio, we need to know more than the risk and return of the component stocks; we need to know the degree to which the stocks' returns move together. Answer: A Diff: 1 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual 3) Which of the following statements is FALSE? A) Dividing the covariance by the volatilities ensures that correlation is always between -1 and +1. B) Volatility is the square root of variance. C) The closer the correlation is to 0, the more the returns tend to move together as a result of common risk. D) If two stocks move together, their returns will tend to be above or below average at the same time, and the covariance will be positive. Answer: C Explanation: C) The closer the correlation is to 1, the more the returns tend to move together as a result of common risk. Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual

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4) Which of the following statements is FALSE? A) Stock returns will tend to move together if they are affect similarly by economic events. B) Stocks in the same industry tend to have more highly correlated returns than stocks in different industries. C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together. D) With a positive amount invest in each stock, the more the stocks move together and the higher their covariance or correlation, the more variable the portfolio will be. Answer: C Explanation: C) Almost all of the correlations between stocks are positive, illustrating the general tendency of stocks to move together. Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual 5) Which of the following statements is FALSE? A) A stock's return is perfectly positively correlated with itself. B) When the covariance equals 0, the stocks have no tendency to move either together or in opposition of one another. C) The closer the correlation is to -1, the more the returns tend to move in opposite directions. D) The variance of a portfolio depends only on the variance of the individual stocks. Answer: D Explanation: D) The variance of a portfolio depends on the variance and correlations of the individual stocks. Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual 6) Which of the following statements is FALSE? A) If two stocks move in opposite directions, one will tend to be above average when to other is below average, and the covariance will be negative. B) The correlation between two stocks has the same sign as their covariance, so it has a similar interpretation. C) The covariance of a stock with itself is simply its variance. D) The covariance allows us to gauge the strength of the relationship between stocks. Answer: D Explanation: D) The correlation allows us to gauge the strength of the relationship between stocks. Diff: 1 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Conceptual

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7) Which of the following equations is INCORRECT? A) Cov(Ri,Rj) =

Σ(Ri - Ri)(Rj - Rj)

B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) C) Corr(Ri,Rj) = D) Cov(Ri,Rj) = E[(Ri - E[Ri])(Rj - E[Rj])] Answer: C Explanation: C) Corr(Ri,Rj) = Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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Use the table for the question(s) below. Consider the following returns:

Year End 2004 2005 2006 2007 2008 2009

Stock X Realized Return 20.1% 72.7% -25.7% 56.9% 6.7% 17.9%

Stock Y Realized Return -14.6% 4.3% -58.1% 71.1% 17.3% 0.9%

Stock Z Realized Return 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

8) The covariance between Stock X's and Stock Y's returns is closest to: A) 0.10 B) 0.29 C) 0.12 D) 0.69 Answer: A Explanation: A) (RL - RL) Stock X Stock Y Stock X Stock Y Deviation Deviation × Realized Realized (R R ) (R R ) (R Year End Return Return L L H H H - RH) 2004 20.1% -14.6% -4.7% -18.1% 0.00843889 2005 72.7% 4.3% 47.9% 0.8% 0.00391456 2006 -25.7% -58.1% -50.5% -61.6% 0.31079056 2007 56.9% 71.1% 32.1% 67.6% 0.21727489 2008 6.7% 17.3% -18.1% 13.8% -0.02496211 2009 17.9% 0.9% -6.9% -2.6% 0.00177389 average = 24.8% 3.5% Variance = 0.125447467 0.177795367 Stdev = 0.354185639 0.421657879 Covariance = 0.103446133 Correlation = 0.692664763 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9) The Volatility on Stock X's returns is closest to: A) 35% B) 10% C) 13% D) 42% Answer: A Explanation: A) Stock X Stock X Stock Y Deviation Realized Realized (RL - RL) Year End Return Return 2004 20.1% -14.6% -4.7% 2005 72.7% 4.3% 47.9% 2006 -25.7% -58.1% -50.5% 2007 56.9% 71.1% 32.1% 2008 6.7% 17.3% -18.1% 2009 17.9% 0.9% -6.9% average = 24.8% 3.5%

Stock Y Deviation (RH - RH) -18.1% 0.8% -61.6% 67.6% 13.8% -2.6%

(RL - RL) × (RH - RH) 0.00843889 0.00391456 0.31079056 0.21727489 -0.02496211 0.00177389

Variance = 0.125447467 0.177795367 Stdev = 0.354185639 0.421657879 Covariance = 0.103446133 Correlation = 0.692664763 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

10) The Volatility on Stock Y's returns is closest to: A) 35% B) 31% C) 42% D) 18% Answer: C Explanation: C) Stock X Stock X Stock Y Deviation Realized Realized (RL - RL) Year End Return Return 2004 20.1% -14.6% -4.7% 2005 72.7% 4.3% 47.9% 2006 -25.7% -58.1% -50.5% 2007 56.9% 71.1% 32.1% 2008 6.7% 17.3% -18.1% 2009 17.9% 0.9% -6.9% average = 24.8% 3.5%

Stock Y Deviation (RH - RH) -18.1% 0.8% -61.6% 67.6% 13.8% -2.6%

(RL - RL) × (RH - RH) 0.00843889 0.00391456 0.31079056 0.21727489 -0.02496211 0.00177389

Variance = 0.125447467 0.177795367 Stdev = 0.354185639 0.421657879 Covariance = 0.103446133 Correlation = 0.692664763 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11) The Correlation between Stock X's and Stock Y's returns is closest to: A) 0.58 B) 0.29 C) 0.69 D) 0.10 Answer: C Explanation: C) (RL - RL) Stock X Stock Y Stock X Stock Y Deviation Deviation × Realized Realized (RL - RL) (RH - RH) (RH - RH) Year End Return Return 2004 20.1% -14.6% -4.7% -18.1% 0.00843889 2005 72.7% 4.3% 47.9% 0.8% 0.00391456 2006 -25.7% -58.1% -50.5% -61.6% 0.31079056 2007 56.9% 71.1% 32.1% 67.6% 0.21727489 2008 6.7% 17.3% -18.1% 13.8% -0.02496211 2009 17.9% 0.9% -6.9% -2.6% 0.00177389 average = 24.8% 3.5% Variance = 0.125447467 0.177795367 Stdev = 0.354185639 0.421657879 Covariance = 0.103446133 Correlation = 0.692664763 Diff: 3 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

12) The variance on a portfolio that is made up of equal investments in Stock X and Stock Y stock is closest to: A) 0.12 B) 0.10 C) 0.69 D) 0.29 Answer: A Explanation: A) (RL - RL) Stock X Stock Y Stock X Stock Y Deviation Deviation × Realized Realized (R R ) (R R ) (R Year End Return Return L L H H H - RH) 2004 20.1% -14.6% -4.7% -18.1% 0.00843889 2005 72.7% 4.3% 47.9% 0.8% 0.00391456 2006 -25.7% -58.1% -50.5% -61.6% 0.31079056 2007 56.9% 71.1% 32.1% 67.6% 0.21727489 2008 6.7% 17.3% -18.1% 13.8% -0.02496211 2009 17.9% 0.9% -6.9% -2.6% 0.00177389 average = 24.8% 3.5% Variance = 0.125447467 0.177795367 Stdev = 0.354185639 0.421657879 Covariance = 0.103446133 Correlation = 0.692664763 Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.50)2(0.125447467) + (.50)2(0.177795367) + 2(.5)(.5)(0.103446133) = 0.118913264 Diff: 3 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

13) The covariance between Stock X's and Stock Z's returns is closest to: A) 0.05 B) 0.06 C) 0.10 D) 0.71 Answer: A Explanation: A) (RL - RL) Stock X Stock Z Stock X Stock Z Deviation Deviation × Realized Realized (RL - RL) (RI - RI) (RI - RI) Year End Return Return 2004 20.1% 0.2% -4.7% 3.3% -0.00155542 2005 72.7% -3.2% 47.9% -0.1% -0.00048871 2006 -25.7% -27.0% -50.5% -23.9% 0.12061406 2007 56.9% 27.9% 32.1% 30.9% 0.09943858 2008 6.7% -5.1% -18.1% -2.0% 0.00367960 2009 17.9% -11.3% -6.9% -8.2% 0.00565832 average = 24.8% -3.1% Variance = 0.125447467 0.032239975 Stdev = 0.354185639 0.179554936 Covariance = 0.045469287 Correlation = 0.714973344 Var(Port) =

0.062156504

Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

14) The Correlation between Stock X's and Stock Z's returns is closest to: A) 0.71 B) 0.60 C) 0.62 D) 0.05 Answer: A Explanation: A) (RL - RL) Stock X Stock Z Stock X Stock Z Deviation Deviation × Realized Realized (RL - RL) (RI - RI) (RI - RI) Year End Return Return 2004 20.1% 0.2% -4.7% 3.3% -0.00155542 2005 72.7% -3.2% 47.9% -0.1% -0.00048871 2006 -25.7% -27.0% -50.5% -23.9% 0.12061406 2007 56.9% 27.9% 32.1% 30.9% 0.09943858 2008 6.7% -5.1% -18.1% -2.0% 0.00367960 2009 17.9% -11.3% -6.9% -8.2% 0.00565832 average = 24.8% -3.1% Variance = 0.125447467 0.032239975 Stdev = 0.354185639 0.179554936 Covariance = 0.045469287 Correlation = 0.714973344 Var(Port) =

0.062156504

Diff: 3 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

15) The variance on a portfolio that is made up of equal investments in Stock X and Stock Z stock is closest to: A) 0.62 B) 0.05 C) 0.12 D) 0.06 Answer: D Explanation: D) (RL - RL) Stock X Stock Z Stock X Stock Z Deviation Deviation × Realized Realized (R R ) (R R ) (R Year End Return Return L L I I I - RI) 2004 20.1% 0.2% -4.7% 3.3% -0.00155542 2005 72.7% -3.2% 47.9% -0.1% -0.00048871 2006 -25.7% -27.0% -50.5% -23.9% 0.12061406 2007 56.9% 27.9% 32.1% 30.9% 0.09943858 2008 6.7% -5.1% -18.1% -2.0% 0.00367960 2009 17.9% -11.3% -6.9% -8.2% 0.00565832 average = 24.8% -3.1% Variance = 0.125447467 0.032239975 Stdev = 0.354185639 0.179554936 Covariance = 0.045469287 Correlation = 0.714973344 Var(Port) =

0.062156504

Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.50)2(0.125447467) + (.50)2(0.032239975 + 2(.5)(.5)(0.045469287) = 0.062156504 Diff: 3 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

16) The Volatility on Stock Z's returns is closest to: A) 3% B) 13% C) 16% D) 18% Answer: D Explanation: D) Stock X Stock X Stock Z Deviation Realized Realized (RL - RL) Year End Return Return 2004 20.1% 0.2% -4.7% 2005 72.7% -3.2% 47.9% 2006 -25.7% -27.0% -50.5% 2007 56.9% 27.9% 32.1% 2008 6.7% -5.1% -18.1% 2009 17.9% -11.3% -6.9% average= 24.8% -3.1%

Stock Z Deviation (RI - RI) 3.3% -0.1% -23.9% 30.9% -2.0% -8.2%

(RL - RL) × (RI - RI) -0.00155542 -0.00048871 0.12061406 0.09943858 0.00367960 0.00565832

Variance = 0.125447467 0.032239975 Stdev = 0.354185639 0.179554936 Covariance = 0.045469287 Correlation = 0.714973344 Var(Port) =

0.062156504

Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

199

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following covariances between securities: Duke Microsoft Wal-Mart

Duke 0.0568 -0.0193 0.0037

Microsoft -0.0193 0.2420 0.1277

Wal-Mart 0.0037 0.1277 0.1413

17) The variance on a portfolio that is made up of equal investments in Duke Energy and Microsoft stock is closest to: A) .065 B) 0.090 C) .149 D) -0.020 Answer: A Explanation: A) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.50)2(0.0568) + (.50)2(0.2420) + 2(.5)(.5)(-0.0193) = 0.0651 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical 18) The variance on a portfolio that is made up of a $6000 investments in Duke Energy and a $4000 investment in Wal-Mart stock is closest to: A) .050 B) .045 C) .051 D) -0.020 Answer: B Explanation: B) Total invested = $6000 + $4000 = $10,000 XDuke = XWal-Mart =

= .60 = .40

Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.60)2(0.0568) + (.40)2(0.1413) + 2(.6)(.4)(0.0037) = 0.0449 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

200

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following returns:

Year End 2004 2005 2006 2007 2008 2009

Stock X Realized Return 20.1% 72.7% -25.7% 56.9% 6.7% 17.9%

Stock Y Realized Return -14.6% 4.3% -58.1% 71.1% 17.3% 0.9%

Stock Z Realized Return 0.2% -3.2% -27.0% 27.9% -5.1% -11.3%

19) Calculate the covariance between Stock Y's and Stock Z's returns . Answer: (RL - RL) Stock Y Stock Z Stock Y Stock Z Deviation × Realized Realized Deviation (R R ) (R R ) (R Year End Return Return H H I I H - RI) 2004 -14.6% 0.2% -18.1% 3.3% -0.00602724 2005 4.3% -3.2% 0.8% -0.1% -0.00000833 2006 -58.1% -27.0% -61.6% -23.9% 0.14718262 2007 71.1% 27.9% 67.6% 30.9% 0.20924394 2008 17.3% -5.1% 13.8% -2.0% -0.00281401 2009 0.9% -11.3% -2.6% -8.2% 0.00212874 average = 3.5% -3.1% Variance = 0.177795367 0.032239975 Stdev = 0.421657879 0.179554936 Covariance = 0.069941142 Correlation = 0.923794031 Var(Port) =

0.087479407

Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

20) Calculate the correlation between Stock Y's and Stock Z's returns . Answer: (RL - RL) Stock Y Stock Z Stock Y Stock Z Deviation × Realized Realized Deviation (RH - RH) (RI - RI) (RH - RI) Year End Return Return 2004 -14.6% 0.2% -18.1% 3.3% -0.00602724 2005 4.3% -3.2% 0.8% -0.1% -0.00000833 2006 -58.1% -27.0% -61.6% -23.9% 0.14718262 2007 71.1% 27.9% 67.6% 30.9% 0.20924394 2008 17.3% -5.1% 13.8% -2.0% -0.00281401 2009 0.9% -11.3% -2.6% -8.2% 0.00212874 average = 3.5% -3.1% Variance = 0.177795367 0.032239975 Stdev = 0.421657879 0.179554936 Covariance = 0.069941142 Correlation = 0.923794031 Var(Port) =

0.087479407

Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

21) Calculate the variance on a portfolio that is made up of equal investments in Stock Y and Stock Z stock . Answer: (RL - RL) Stock Y Stock Z Stock Y Stock Z Deviation × Realized Realized Deviation (R R ) (R R ) (R Year End Return Return H H I I H - RI) 2004 -14.6% 0.2% -18.1% 3.3% -0.00602724 2005 4.3% -3.2% 0.8% -0.1% -0.00000833 2006 -58.1% -27.0% -61.6% -23.9% 0.14718262 2007 71.1% 27.9% 67.6% 30.9% 0.20924394 2008 17.3% -5.1% 13.8% -2.0% -0.00281401 2009 0.9% -11.3% -2.6% -8.2% 0.00212874 average = 3.5% -3.1% Variance = 0.177795367 0.032239975 Stdev = 0.421657879 0.179554936 Covariance = 0.069941142 Correlation = 0.923794031 Var(Port) =

0.087479407

Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.50)2(0.177795367) + (.50)2(0.032239975 + 2(.5)(.5)(00.069941142 = 0.087479407 Diff: 3 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

203

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following covariances between securities: Duke Microsoft Wal-Mart Duke 0.0568 -0.0193 0.0037 Microsoft -0.0193 0.2420 0.1277 Wal-Mart 0.0037 0.1277 0.1413 22) The variance on a portfolio that is made up of a $6000 investments in Microsoft and a $4000 investment in Wal-Mart stock is closest to: Answer: Total invested = $6000 + $4000 = $10,000 XMicrosoft =

= .60

XWal-Mart =

= .40

Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) = (.60)2(0.2420) + (.40)2(0.1413) + 2(.6)(.4)(0.1277) = 0.1710 Diff: 2 Section: 11.2 The Volatility of a Two-Stock Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11.3 The Volatility of a Large Portfolio 1) Which of the following statements is FALSE? A) The variance of a portfolio is equal to the weighted average correlation of each stock within the portfolio. B) The variance of a portfolio is equal to the sum of the covariances of the returns of all pairs of stocks in the portfolio multiplied by each of their portfolio weights. C) The variance of a portfolio is equal to the weighted average covariances of each stock within the portfolio. D) The volatility declines as the number of stocks in a portfolio grows. Answer: A Diff: 1 Section: 11.3 The Volatility of a Large Portfolio Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

2) Which of the following statements is FALSE? A) The volatility declines as the number of stocks in a portfolio grows. B) An equally weighted portfolio is a portfolio in which the same amount is invested in each stock. C) As the number of stocks in a portfolio grows large, the variance of the portfolio is determined primarily by the average covariance among the stocks. D) When combining stocks into a portfolio that puts positive weight on each stock, unless all of the stocks are uncorrelated with the portfolio, the risk of the portfolio will be lower than the weighted average volatility of the individual stocks. Answer: D Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Conceptual 3) Which of the following statements is FALSE? A) The expected return of a portfolio is equal to the weighted average expected return, but the volatility of a portfolio is less than the weighted average volatility. B) Each security contributes to the volatility of the portfolio according to its volatility, scaled by its covariance with the portfolio, which adjusts for the fraction of the total risk that is common to the portfolio. C) Nearly half of the volatility of individual stocks can be eliminated in a large portfolio as a result of diversification. D) The overall variability of the portfolio depends on the total co-movement of the stocks within it. Answer: B Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

4) Which of the following formulas is INCORRECT? A) Variance of an equally Weighted Portfolio = (1 - )(Average Variance of Individual Stocks) + (Average covariance between the stocks) B) Variance of a portfolio = C) Variance of a portfolio = D) Variance of a portfolio = Answer: A Explanation: A) Variance of an equally Weighted Portfolio =

(Average Variance of

Individual Stocks) + (1 - )(Average covariance between the stocks) Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Conceptual 5) Consider an equally weighted portfolio that contains five stocks. If the average volatility of these stocks is 40% and the average correlation between the stocks is .5, then the volatility of this equally weighted portfolio is closest to: A) .17 B) ..03 C) .41 D) .19 Answer: B Explanation: B) Variance of an equally Weighted Portfolio =

(Average Variance of

Individual Stocks) + (1 - )(Average covariance between the stocks) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Cov(R1,R2) Var = (1/5)(.40)2 + (1 - 1/5)(.5)(.40)(.40) Var = 0.032 + .064 = .096 stdev = = .0309 Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

6) Consider an equally weighted portfolio that contains 20 stocks. If the average volatility of these stocks is 35% and the average correlation between the stocks is .4, then the volatility of this equally weighted portfolio is closest to: A) .17 B) .41 C) .14 D) .37 Answer: D Explanation: D) Variance of an equally Weighted Portfolio =

(Average Variance of

Individual Stocks) + (1 - )(Average covariance between the stocks) Var = (1/20)(.35)2 + (1 - 1/20)(.4)( ( Var = .05(.1225) + .95(.4)(.35) = .139125

)

stdev = = .372995 Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Analytical 7) Consider an equally weighted portfolio that contains 100 stocks. If the average volatility of these stocks is 50% and the average correlation between the stocks is .7, then the volatility of this equally weighted portfolio is closest to: A) .72 B) .63 C) .40 D) .50 Answer: B Explanation: B) Variance of an equally Weighted Portfolio =

(Average Variance of

Individual Stocks) + (1 - )(Average covariance between the stocks) Var = (1/100)(.50)2 + (1 - 1/100)(.7)( Var = .01(.25) + .99(.8)(.50) = .3985

(

)

stdev = = .6312 Diff: 2 Section: 11.3 The Volatility of a Large Portfolio Skill: Analytical

208

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following covariances between securities: Duke Microsoft Wal-Mart

Duke 0.0568 -0.0193 0.0037

Microsoft -0.0193 0.2420 0.1277

Wal-Mart 0.0037 0.1277 0.1413

8) What is the variance on a portfolio that has $2000 invested in Duke Energy, $3000 invested in Microsoft, and $5000 invested in Wal-Mart stock? Answer: COV Duke Microsoft Wal-Mart Duke 0.0568 -0.0193 0.0037 Microsoft -0.0193 0.2420 0.1277 Wal-Mart 0.0037 0.1277 0.1413 Weights X iX j XDuke XMicrosoft XWal-Mart

0.2 XDuke 0.04 0.06 0.1

0.3

XMicrosoft XWal-Mart 0.06 0.1 0.09 0.15 0.15 0.25

XiXjCOV(I,j) Duke Duke 0.002272 Microsoft -0.00116 Wal-Mart 0.000367 Var(P) =

0.5

Microsoft -0.00116 0.021776 0.019153

Wal-Mart 0.000367 0.019153 0.035318

0.096086

Variance of a portfolio = Diff: 3 Section: 11.3 The Volatility of a Large Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9) What is the variance on a portfolio that has $3000 invested in Duke Energy, $4000 invested in Microsoft, and $3000 invested in Wal-Mart stock? Answer: Variance of a portfolio = COV Duke Microsoft Wal-Mart

Duke 0.0568 -0.0193 0.0037

Weights

Microsoft -0.0193 0.2420 0.1277

0.3

X iX j XDuke XDuke 0.09 XMicrosoft 0.12 XWal-Mart 0.09

0.4

0.3

XMicrosoft

XWal-Mart

0.12 0.16 0.12

0.09 0.12 0.09

XiXjCOV(I,j) Duke Duke 0.005112 Microsoft -0.00232 Wal-Mart 0.00033 Var(P) =

Wal-Mart 0.0037 0.1277 0.1413

Microsoft -0.00232 0.038714 0.015322

Wal-Mart 0.00033 0.015322 0.012715

0.083205

Diff: 3 Section: 11.3 The Volatility of a Large Portfolio Skill: Analytical

210

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

11.4 Risk Versus Return: Choosing an Efficient Portfolio 1) Which of the following statements is FALSE? A) We say a portfolio is an efficient portfolio whenever it is possible to find another portfolio that is better in terms of both expected return and volatility. B) We can rule out inefficient portfolios because they represent inferior investment choices. C) The volatility of the portfolio will differ, depending on the correlation between the securities in the portfolio. D) Correlation has no effect on the expected return on a portfolio. Answer: A Explanation: A) We say a portfolio is an efficient portfolio whenever it is not possible to find another portfolio that is better in terms of both expected return and volatility. Diff: 1 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

2) Which of the following statements is FALSE? A) When stocks are perfectly positively correlated, the set of portfolios is identified graphically by a straight line between them. B) An investor seeking high returns and low volatility should only invest in an efficient portfolio. C) When the correlation between securities is less than 1, the volatility of the portfolio is reduced due to diversification. D) Efficient portfolios can be easily ranked, because investors will choose from among them those with the highest expected returns. Answer: D Diff: 1 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual 3) Which of the following statements is FALSE? A) We say a portfolio is long those stocks that have negative portfolio weights. B) The efficient portfolios are those portfolios offering the highest possible expected return for a given level of volatility. C) When two stocks are perfectly negatively correlated, it becomes possible to hold a portfolio that bears absolutely no risk. D) The lower the correlation of the securities in a portfolio the lower the volatility we can obtain. Answer: A Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual 4) Which of the following statements is FALSE? A) A short sale is a transaction in which you buy a stock that you do not own and then agree to sell that stock back in the future. B) The efficient portfolios are those portfolios offering the lowest possible level of volatility for a given level of expected return. C) A positive investment in a security can be referred to as a long position in the security. D) It is possible to invest a negative amount in a stock or security call a short position. Answer: A Explanation: A) A short sale is a transaction in which you sell a stock that you do not own and then agree to buy that stock back in the future. Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

5) Which of the following statements is FALSE? A) Graphically, the efficient portfolios are those on the northeast edge of the set of possible portfolios, an area which we call the efficient frontier. B) To arrive at the best possible set of risk and return opportunities, we should keep adding stocks until all investment opportunities are represented. C) We say a portfolio is short those stocks that have negative portfolio weights. D) Adding new investment opportunities allows for greater diversification and improves the efficient frontier. Answer: A Diff: 3 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual 6) Suppose you have $10,000 in cash to invest. You decide to sell short $5,000 worth of Kinston stock and invest the proceeds from your short sale, plus your $10,000 into one-year U.S. treasury bills earning 5%. At the end of the year, you decide to liquidate your portfolio. Kinston Industries has the following realized returns:

Kinston

P0

Div1

P1

$25.00

$1.00

$29.00

The return on your portfolio is closest to: A) -0.5% B) 13.5% C) -2.5% D) 14.5% Answer: C Explanation: C) You short sold $5000/$25 = 200 shares of Kinston and invested the $5,000 + $10,000 in T-notes. In one year you will have (15,000)(1.05) = $15,750 - 200 × ($29 + $1) = $9,750. So, your total return is equal to

= -0.025 or -2.5%

Diff: 3 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical

213

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following expected returns, volatilities, and correlations:

Stock Duke Energy Microsoft Wal-Mart

Expected Standard Return Deviation 14% 6% 44% 24% 23% 14%

Correlation with Duke Energy 1.0 -1.0 0.0

Correlation Correlation with Microsoft with Wal-Mart -1.0 0.0 1.0 0.7 0.7 1.0

7) Consider a portfolio consisting of only Duke Energy and Microsoft. The percentage of your investment (portfolio weight) that you would place in Duke Energy stock to achieve a risk-free investment would be closest to: A) 15% B) 40% C) 23% D) 10% Answer: B Explanation: B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2 x1 = .40 Diff: 3 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical 8) The expected return of a portfolio that is equally invested in Duke Energy and Microsoft is closest to: A) 28% B) 29% C) 24% D) 23% Answer: B Explanation: B) .5(14%) + .5(44%) = 29% Diff: 1 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

9) The volatility of a portfolio that is equally invested in Duke Energy and Microsoft is closest to: A) 8% B) 9% C) 11% D) 6% Answer: B Explanation: B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2 = .52(.06)2 + .52(.24)2 + 2(.5)(.5)(-1)(.06)(.24) = .0081 stdev = = .09 Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical 10) The expected return of a portfolio that is consists of a long position of $10000 in WalMart and a short position of $2000 in Microsoft is closest to: A) 21% B) 12% C) 27% D) 18% Answer: D Explanation: D) = (10,000/8,000)(.23) + (-2000/8,8000)(.44) = (1.25)(.23) + (-.25)(.44) = .1775 Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical 11) The volatility of a portfolio that is consists of a long position of $10000 in Wal-Mart and a short position of $2000 in Microsoft is closest to: A) 9% B) 14% C) 11% D) 12% Answer: B Explanation: B) Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2 = 1.252(.14)2 + (- 25)2(.24)2 + 2(1.25)(-.25)(0.7)(.14)(.24) = .019525 stdev = = .139732 Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical

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12) Consider a portfolio consisting of only Microsoft and Wal-Mart stock. Calculate the expected return on such a portfolio when the weight on Microsoft stock is 0%, 25%, 50%, 75%, and 100% Answer: Rp = x1R1 + x2R2 + ... + xnRn Weight on Weight on Portfolio Microsoft Wal-Mart Return 0% 100% 23% 25% 75% 28% 50% 50% 34% 75% 25% 39% 100% 0% 44% Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical 13) Consider a portfolio consisting of only Microsoft and Wal-Mart stock. Calculate the volatility of such a portfolio when the weight on Microsoft stock is 0%, 25%, 50%, 75%, and 100% Answer: Var(Rp) = x12Var(R1) + x22Var(R2) + 2X1X2Corr(R1,R2)SD1SD2 Weight on Weight on Portfolio Portfolio Portfolio Microsoft Wal-Mart Return Variance Volatility 0% 100% 23% 0.0196 0.140 25% 75% 28% 0.023445 0.153 50% 50% 34% 0.03106 0.176 75% 25% 39% 0.042445 0.206 100% 0% 44% 0.0576 0.240 Diff: 3 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Analytical

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14) What is the efficient frontier and how does it change when more stocks are used to construct portfolios? Answer: The efficient portfolios are those portfolios offering the highest possible expected return for a given level of volatility. The efficient portfolios are those portfolios offering the lowest possible level of volatility for a given level of expected return. Graphically, the efficient portfolios are those on the northwest edge of the set of possible portfolios, an area which we call the efficient frontier. Adding new investment opportunities allows for greater diversification and improves the efficient frontier (moves it to the northwest, thereby providing better risk/return opportunities). To arrive at the best possible set of risk and return opportunities, we should keep adding stocks until all investment opportunities are represented. Diff: 2 Section: 11.4 Risk Versus Return: Choosing an Efficient Portfolio Skill: Conceptual

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11.5 Risk-Free Saving and Borrowing 1) Which of the following statements is FALSE? A) A portfolio that consists of a long position in the risk-free investment is known as a levered portfolio. B) The optimal portfolio will not depend on the investor's personal tradeoff between risk and return. C) The volatility of the risk-free investment is zero. D) Our total volatility is only a fraction of the volatility of the efficient portfolio, based on the amount we invest in the risk free asset. Answer: A Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual 2) Which of the following statements is FALSE? A) Margin investing is a risky investment strategy. B) Because our return on the risk-free investments is fixed and does not move with (or against) our portfolio, the correlation between the risk-free investment and the portfolio is always equal to one. C) Short selling the risk free investment is equivalent to borrowing money at the risk-free interest rate through a standard loan. D) Margin investing can provide higher expected returns than investing in the efficient portfolio using only the funds we have available. Answer: B Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual

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3) Which of the following statements is FALSE? A) The Sharpe ratio measures the ratio of volatility-to-reward provided by a portfolio. B) Borrowing money to invest in stocks is referred to as buying stocks on margin. C) The Sharpe ratio is the number of stand deviations the portfolio's return would have to fall to under-perform the risk-free investment. D) The slope of the line through a given portfolio is often referred to as the Sharpe ratio of the portfolio. Answer: A Explanation: A) The Sharpe ratio measures the ratio of reward-to-volatility provided by a portfolio. Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual 4) Which of the following statements is FALSE? A) The tangent portfolio is efficient and that, once we include the risk-free investment, all efficient portfolios are combinations of the risk-free investment and the tangent portfolio. B) The optimal portfolio of risky investments depends on how conservative or aggressive the investor is. C) By combining the efficient portfolio with the risk-free investment, an investor will earn the highest possible expected return for any level of volatility her or she is willing to bear. D) The efficient portfolio is the tangent portfolio, the portfolio with the highest Sharpe ratio in the economy. Answer: B Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual 5) Which of the following statements is FALSE? A) If we increase the fraction invested in the efficient portfolio beyond 100%m we are short selling the risk-free investment. B) As we increase the fraction invested in the efficient portfolio, we increase our risk premium but not our risk proportionately. C) To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free investment. D) Every investor should invest in the tangent portfolio independent of his or her taste for risk. Answer: B Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual

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6) Which of the following statements is FALSE? A) An investor's preferences will determine only how much to invest in the tangent or efficient portfolio versus the risk-free investment. B) Conservative investors will invest a small amount in the tangent or efficient portfolio, choosing a portfolio on the line near the risk-free investment C) Only aggressive investors will choose to hold the portfolio of risky assets, the tangent or efficient portfolio. D) Aggressive investors will invest more in the tangent portfolio choosing a portfolio that is near the tangent portfolio or even beyond it by buying stocks on margin. Answer: C Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual 7) Which of the following equations is INCORRECT? A) E[Rxp] = rf + x(E[Rp] - rf) B) E[Rxp] = (1 - x)rf + xE[Rp] C) Sharpe ratio = D) SD( Rxp) = xSD(Rp) Answer: C Explanation: C) Sharpe ratio = Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Conceptual Use the information for the question(s) below. Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a 6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange traded fund (ETF) with a 12% expected return and a 20% volatility. 8) The expected return on your of your investment is closest to: A) 18% B) 20% C) 12% D) 24% Answer: A Explanation: A) E[Rxp] = rf + x(E[Rp] - rf) = .06 + 2(.12 - .06) = .18 or 18% Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical

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9) The volatility of your of your investment is closest to: A) 40% B) 20% C) 30% D) 24% Answer: A Explanation: A) SD( Rxp) = xSD(Rp) = 2(.20) = .40 Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical 10) Assume that the EFT you invested in returns -10%, then the realized return on your investment is closest to: A) -20% B) -10% C) -24% D) -26% Answer: D Explanation: D) Value of portfolio = $20,000( 1 + -.10) = $18,000 - $10,600 loan & interest = 7,400 So, return = (7400 - 10000)/10000 = -26% Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical Use the information for the question(s) below. Suppose that you currently have $250,000 invested in a portfolio with an expected return of 12% and a volatility of 10%. The efficient (tangent) portfolio has an expected return of 17% and a volatility of 12%. The risk-free rate of interest is 5%. 11) The Sharpe ratio for your portfolio is closest to: A) 1.2 B) 0.6 C) 1.0 D) 0.7 Answer: D Explanation: D) Sharpe ratio =

=

= .7

Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical

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12) The Sharpe ratio for the efficient portfolio is closest to: A) 0.7 B) 1.0 C) 1.4 D) 1.2 Answer: B Explanation: B) Sharpe ratio =

=

= 1.0

Diff: 1 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical 13) You want to maximize your expected return without increasing your risk. Without increasing your volatility beyond its current 10%, the maximum expected return you could earn is closest to: A) .12.0% B) 12.5% C) 13.4% D) 15.0% Answer: D Explanation: D) SD( Rxp) = xSD(Rp) .10 = x(.12) x = .10/.12 x = .833333 So, E[Rxp] = rf + x(E[Rp] - rf) = .05 + .8333(.17 -.05) = .15 or 15% Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical

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14) Suppose that you want to maximize your expected return without increasing your risk. How can you achieve this goal? Without increasing your risk, what is the maximum expected return you can expect? Answer: By investing in a combination of the risk-free asset and the efficient portfolio. We find the weights and expected returns as follows: SD( Rxp) = xSD(Rp) .10 = x(.12) x = .10/.12 x = .833333 invested in the efficient portfolio So, E[Rxp] = rf + x(E[Rp] - rf) = .05 + .8333(.17 - .05) = .15 or 15% Diff: 2 Section: 11.5 Risk-Free Saving and Borrowing Skill: Analytical

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11.6 The Efficient Portfolio and Required Returns 1) Which of the following statements is FALSE? A) A portfolio is efficient if it has the highest possible Sharpe ratio; that is it is efficient if it provides the largest increase in expected return possible for a given increase in volatility. B) The required return for an investment is equal to a risk premium that is equal to the risk premium of the investor's current portfolio scaled by

.

C) Increasing the investment in investment I will increase the Sharpe ratio of portfolio P if its expected return E[Ri] exceeds the required return ri, which is given by ri = rf +

× (E[Rp]

- rf). D) If a security i's expected return is less than the required return ri, we should reduce our holding of security i. Answer: B Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Conceptual

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2) Which of the following statements is FALSE? A) The Sharpe ratio if the portfolio tells us how much our expected return will increase for a given increase in volatility. B) We should continue to trade securities until the expected return of each security equals its required return. C) The required return is the expected return that is necessary to compensate for the risk that an investment will contribute to the portfolio. D) If security i’s required return exceeds its expected return, then adding more of it will improve the performance of the portfolio. Answer: D Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Conceptual 3) Which of the following statements is FALSE? A) Because all other risk is diversifiable, it is an investment’s beta with respect to the efficient portfolio that measures its sensitivity to systematic risk, and therefore determines its cost of capital. B) If a security's expected return exceeds its required return given our current portfolio, then we can improve the performance of our portfolio by adding more of the security. C) The appropriate risk premium for an investment can be determined from its beta with the efficient portfolio. D) As we buy shares of a security i, its correlation with our portfolio P will increase, ultimately raising its required return until E[Ri] = Rp. Answer: D Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Conceptual

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Use the following information to answer the question(s) below. Firm Taggart Transcontinental Wyatt Oil Rearden Metal

Portfolio Weight 0.25 0.35 0.40

Volatility 14% 18% 15%

Correlation w/ Market Portfolio 0.7 0.6 0.5

The volatility of the market portfolio is 10%, the expected return on the market is 12%, and the risk-free rate of interest is 4%. 4) The Sharpe Ratio for the market portfolio is closest to: A) 0.40 B) 0.48 C) 0.56 D) 0.80 Answer: D Explanation: D) Sharpe Ratio =

=

= 0.80

Diff: 1 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical Use the information for the question(s) below. You are presently invested in the Luther Fund, a broad based mutual fund that invest in stocks and other securities. The Luther Fund has an expected return of 14% and a volatility of 20%. Risk-free Treasury bills are currently offering returns of 4%. You are considering adding a precious metals fund to your current portfolio. The metals fund has an expected return of 10%, a volatility of 30%, and a correlation of -.20 with the Luther Fund. 5) The beta of the precious metals fund with the Luther Fund

is closest to:

A) -0.3 B) -0.6 C) 0.3 D) 0.6 Answer: A Explanation: A)

=

=

= -0.3

Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical

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6) The expected return on the precious metals fund is closest to: A) -3% B) 4% C) 1% D) 10% Answer: C Explanation: C) ri = rf +

=

=

= -0.3

× (E[Rp] - rf) = .04 + (-0.3)(.14 - .04) = .01

Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical Use the information for the question(s) below. Sisyphean industries is seeking to raise capital from a large group of investors to fund a new project. Suppose that the efficient portfolio has an expected return of 14% and a volatility of 20%. Sisyphean's new project is expected to have a volatility of 40% and a 70% correlation with the efficient portfolio. The risk-free rate is 4%. 7) The beta for Sisyphean's new project is closest to: A) 1.25 B) 1.40 C) 0.70 D) 1.75 Answer: B Explanation: B)

=

=

= 1.4

Diff: 1 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical 8) The required return for Sisyphean's new project is closest to: A) 24% B) 14% C) 18% D) 10% Answer: C Explanation: C) ri = rf +

=

=

= 1.4

× (E[Rp] - rf) = .04 + (1.4)(.14 - .04) = .18

Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical Use the information for the question(s) below. 227

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You are presently invested in the Luther Fund, a broad based mutual fund that invest in stocks and other securities. The Luther Fund has an expected return of 14% and a volatility of 20%. Risk-free Treasury bills are currently offering returns of 4%. You are considering adding a precious metals fund to your current portfolio. The metals fund has an expected return of 10%, a volatility of 30%, and a correlation of -.20 with the Luther Fund. 9) Will adding the precious metals fund improve your portfolio? Answer: Yes = ri = rf +

=

= -0.3

× (E[Rp] - rf) = .04 + (-0.3)(.14 - .04) = .01 < .10 (the expected return on metals

fund) Since the required return is less than the expected return, you can benefit from adding the precious metals fund to your portfolio. Diff: 2 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical Use the following information to answer the question(s) below. Suppose that all stocks can be grouped into two mutually exclusive portfolios (with each stock appearing in only one portfolio): growth stocks and value stocks. Assume that these two portfolios are equal in size (market value), the correlation of their returns is equal to 0.6, and the portfolios have the following characteristics:

Value Stocks Growth Stocks

Expected Return 0.12 0.15

Volatility 14% 24%

The risk free rate is 3.5%. 10) The Sharpe ratio for the value stock portfolio is closest to: A) .53 B) .58 C) .61 D) .79 Answer: C Explanation: C) Sharpe Ratio =

=

= 0.607143

Diff: 1 Section: 11.6 The Efficient Portfolio and Required Returns Skill: Analytical

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11.7 The Capital Asset Pricing Model Use the following information to answer the question(s) below. Your investment portfolio consists of $10,000 worth of Google stock. Suppose that the riskfree rate is 4%, Google stock has an expected return of 14% and a volatility of 35%, and the market portfolio has an expected return of 12% and a volatility of 18%. Assume that the CAPM assumptions hold. 1) What alternative investment has the lowest possible volatility while having the same expected return as Google? A) -25% in the risk-free asset and +125% in the market portfolio B) -20% in the risk-free asset and +120% in the market portfolio C) 0% in the risk-free asset and +100% in the market portfolio D) 20% in the risk-free asset and +80% in the market portfolio Answer: A Explanation: A) r = wm(rm) + 1 - wm)(rf) → .14 = wm(.12) + (1 - wm)(.04) → .08wm = .10 → wm = 1.25 → wrf = -.25 Diff: 1 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical 2) The volatility of the alternative investment that has the lowest possible volatility while having the same expected return as Google is closest to: A) 18.0% B) 22.5% C) 23.4% D) 35.0% Answer: B Explanation: B) r = wm(rm) + (1 - wm)(rf) → .14 = wm(.12) + (1 - wm)(.04) → .08wm = .10 → wm = 1.25 → wrf = -.25 SD(rxp) = x SD(rp) = 1.25(.18) = .225 Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical

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3) What alternative investment has the highest possible expected return while having the same volatility as Google? A) -25% in the risk-free asset and +125% in the market portfolio B) -20% in the risk-free asset and +120% in the market portfolio C) -94% in the risk-free asset and +194% in the market portfolio D) 6% in the risk-free asset and +94% in the market portfolio Answer: C Explanation: C) SD(rxp) = x SD(rp) = x(.18) = .35 → x = 1.944444 Diff: 1 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical 4) The expected return on the alternative investment having the highest possible expected return while having the same volatility as Google is closest to? A) 21.6% B) 19.6% C) 23.4% D) 35.0% Answer: B Explanation: B) SD(rxp) = x SD(rp) = x(.18) = .35 → x = 1.944444 r = wm(rm) + (1 - wm)(rf) = 1.944444 (.12) + (-0.944444)(.04) = .1956 Diff: 1 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical

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Use the following information to answer the question(s) below. Suppose that all stocks can be grouped into two mutually exclusive portfolios (with each stock appearing in only one portfolio): growth stocks and value stocks. Assume that these two portfolios are equal in size (market value), the correlation of their returns is equal to 0.6, and the portfolios have the following characteristics:

Value Stocks Growth Stocks

Expected Return 0.12 0.15

Volatility 14% 24%

The risk free rate is 3.5%. 5) The expected return on the market portfolio (which is a 50-50 combination of the value and growth portfolios) is closest to: A) 12.0% B) 13.5% C) 15.0% D) 19.0% Answer: B Explanation: B) expected return = .50(12%) + .50(15%) = 13.5% Diff: 1 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical 6) The volatility on the market portfolio (which is a 50-50 combination of the value and growth portfolios) is closest to: A) 13.5% B) 15.2% C) 17.1% D) 19.0% Answer: C Explanation: C) σp2 = x12 [(SD(R1))]2 + x22 [(SD(R2))]2 + 2x1x2 Corr(R1, R2)SD(R1)SD(R2) = [(.5)]2 [(.14)]2 + [(.5)]2 [(.24)]2 + 2(.5)(.5)(.6) ... Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Analytical

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7) Which of the following statements is FALSE? A) Because all investors should hold the risky securities in the same proportions as the efficient portfolio, their combined portfolio will also reflect the same proportions as the efficient portfolio. B) When the CAPM assumptions hold, choosing an optimal portfolio is relatively straightforward: it is the combination of the risk-free investment and the market portfolio. C) Graphically, when the tangent line goes through the market portfolio, it is called the security market line (SML). D) A portfolio's risk premium and volatility are determined by the fraction that is invested in the market. Answer: C Explanation: C) Graphically, when the tangent line goes through the market portfolio, it is called the capital market line (CML). Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Conceptual 8) Which of the following is NOT an assumption used in deriving the Capital Asset Pricing Model (CAPM)? A) Investors have homogeneous expectations regarding the volatilities, correlation, and expected returns of securities. B) Investors have homogeneous risk adverse preferences toward taking on risk. C) Investors hold only efficient portfolios of traded securities, that is portfolios that yield the maximum expected return for the given level of volatility. D) Investors can buy and sell all securities at competitive market prices without incurring taxes or transactions cost and can borrow and lend at the risk-free interest rate. Answer: B Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Conceptual 9) Which of the following statements is FALSE? A) Short-term margin loans from a broker are often 1% to 2% lower than the rates paid on short-term Treasury securities. B) In the real world investors have different information and expectations regarding securities. C) The SML is still valid when interest rates differ. D) When borrowing and lending occur at different rates there are different tangent portfolios identified. Answer: A Diff: 1 Section: 11.7 The Capital Asset Pricing Model Skill: Conceptual

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10) Which of the following statements is FALSE? A) A combination of portfolios on the efficient frontier of risky investments is also on the efficient frontier of risky investments. B) The conclusion of the CAPM that investors should hold the market portfolio combined with the risk-free investment depends on the quality of an investor's information. C) The SML holds with some rate r* between rs and rb in place of rf, where r* depends on the proportion of savers and borrowers in the economy. D) In reality, investors have different information and spend varying amounts of effort on research for assorted stocks. Answer: B Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Conceptual 11) Which of the following statements is FALSE? A) When an investor chooses her optimal portfolio, she will do so by finding the tangent line using the risk-free rate that corresponds to her investment horizon. B) If the market portfolio is not efficient, savvy investors who recognize that the market portfolio is not optimal will push prices and expected returns back into balance. C) Even though different investors may research different stocks, their information will not impact the market portfolio since there is no way to share this information with other investors. D) In the real world borrowers pay higher interest rates than savers receive. Answer: C Diff: 2 Section: 11.7 The Capital Asset Pricing Model Skill: Conceptual

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11.8 Determining the Risk Premium Use the following information to answer the question(s) below. Firm Taggart Transcontinental Wyatt Oil Rearden Metal

Portfolio Weight 0.25 0.35 0.40

Volatility 14% 18% 15%

Correlation w/ Market Portfolio 0.7 0.6 0.5

The volatility of the market portfolio is 10%, the expected return on the market is 12%, and the risk-free rate of interest is 4%. 1) The beta for Taggart Transcontinental is closest to: A) 0.75 B) 0.80 C) 1.00 D) 1.10 Answer: C Explanation: C) βTT =

=

= 0.98

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical 2) The beta for Wyatt Oil is closest to: A) 0.75 B) 0.80 C) 1.00 D) 1.10 Answer: D Explanation: D) βWO =

=

= 1.08

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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3) The expected return for Wyatt Oil is closest to: A) 11.4% B) 11.8% C) 12.0% D) 12.6% Answer: D Explanation: D) βWO =

=

= 1.08

ri = rf + βi(Rm - rf) = .04 + 1.08(.12 - .04) = .1264 or 12.64% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 4) The expected return for Rearden Metal is closest to: A) 10.0% B) 11.4% C) 11.8% D) 12.0% Answer: A Explanation: A) βRM =

=

= 0.75

ri = rf + βi(Rm - rf) = .04 + 0.75(.12 - .04) = .10 or 10.00% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 5) The beta for the market is closest to: A) 0.80 B) 1.00 C) 1.10 D) 1.25 Answer: B Explanation: B) βWO =

=

= 1.00

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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6) The beta for the portfolio of the three stocks is closest to: A) 0.92 B) 0.94 C) 1.00 D) 1.02 Answer: A Explanation: A) βTT =

=

βWO =

=

= 1.08

βRM =

=

= 0.75

= 0.98

βport = = (.25)0.98 + (.35)1.08 + (.40)0.75 = .9230 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 7) The expected return on the portfolio of the three stocks is closest to: A) 10.0% B) 11.4% C) 11.8% D) 12.0% Answer: B Explanation: B) βTT =

=

βWO =

=

= 1.08

βRM =

=

= 0.75

= 0.98

βport = = (.25)0.98 + (.35)1.08 + (.40)0.75 = .9230 ri = rf + βi(Rm - rf) = .04 + 0.9230(.12 - .04) = .113840 or 11.38% Diff: 3 Section: 11.8 Determining the Risk Premium Skill: Analytical

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8) The Sharpe Ratio for Rearden Metal is closest to: A) 0.40 B) 0.56 C) 0.80 D) 1.00 Answer: A Explanation: A) βRM =

=

= 0.75

ri = rf + βi(Rm - rf) = .04 + 0.75(.12 - .04) = .10 or 10.00% Sharpe Ratio =

=

= 0.40

Diff: 3 Section: 11.8 Determining the Risk Premium Skill: Analytical 9) The Sharpe Ratio for Wyatt Oil is closest to: A) 0.40 B) 0.48 C) 0.56 D) 0.80 Answer: B Explanation: B) βWO =

=

= 1.08

ri = rf + βi(Rm - rf) = .04 + 1.08(.12 - .04) = .1264 or 12.64% Sharpe Ratio =

=

= 0.48

Diff: 3 Section: 11.8 Determining the Risk Premium Skill: Analytical 10) Suppose that Google Stock has a beta of 1.06 and Boeing stock has a beta of 1.31. The beta on a portfolio that consists of 30% Google stock and 70% Boeing stock is closest to: A) 1.06 B) 1.14 C) 1.19 D) 1.24 Answer: D Explanation: D) βport = = (.30)1.06 + (.70)1.31 = 1.2350 Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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11) Suppose that Google Stock has a beta of 1.06 and Boeing stock has a beta of 1.31. If the risk-free interest rate is 4% and the expected return from the market portfolio is 12%, then the expected return on a portfolio that consists of 30% Google stock and 70% Boeing stock is closest to: A) 12.5% B) 13.1% C) 13.5% D) 13.9% Answer: D Explanation: D) βport = = (.30)1.06 + (.70)1.31 = 1.2350 ri = rf + βi(Rm - rf) = .04 + 1.235(.12 - .04) = .1388 or 13.88% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical Use the following information to answer the question(s) below. Suppose that all stocks can be grouped into two mutually exclusive portfolios (with each stock appearing in only one portfolio): growth stocks and value stocks. Assume that these two portfolios are equal in size (market value), the correlation of their returns is equal to 0.6, and the portfolios have the following characteristics:

Value Stocks Growth Stocks

Expected Return 0.12 0.15

Volatility 14% 24%

The risk free rate is 3.5%. 12) The Sharpe ratio for the market (which is a 50-50 combination of the value and growth portfolios) portfolio is closest to: A) .53 B) .58 C) .61 D) .79 Answer: B Explanation: B) expected return = .50(12%) + .50(15%) = 13.5% σp2 = x12 [(SD(R1))]2 + x22 [(SD(R2))]2 + 2x1x2 Corr(R1, R2)SD(R1)SD(R2) = [(.5)]2 [(.14)]2 + [(.5)]2 [(.24)]2 + 2(.5)(.5)(.6) ... Sharpe Ratio =

=

= 0.583410

Diff: 3 Section: 11.8 Determining the Risk Premium Skill: Analytical 13) Which of the following equations is INCORRECT? A) E[RxCML] = rf + x(E[RMkt] + rf) 238

FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

B) ri = rf + b(E[RMkt] - rf) C) SD(RxCML) = xSD(RMkt) D) E[RxCML] = (1 - x)rf + xE[RMkt] Answer: A Explanation: A) E[RxCML] = rf + x(E[RMkt] - rf) Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical Use the information for the question(s) below. Tom's portfolio consists solely of an investment in Merck stock. Merck has an expected return of 13% and a volatility of 25%. The market portfolio has an expected return of 12% and a volatility of 18%. The risk-free rate is 4%. Assume that the CAPM assumptions hold in the market. 14) Assuming that Tom wants to maintain the current volatility of his portfolio, then the amount that Tom should invest in the market portfolio to maximize his expected return is closest to: A) 72% B) 92% C) 110% D) 140% Answer: D Explanation: D) SD(RxCML) = xSD(RMkt) .25 = x(.18) → x = .25/.18 = 1.39 Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

15) Assuming that Tom wants to maintain the current volatility of his portfolio, then the maximum expected return that Tom could achieve by investing in the market portfolio and risk-free investment is closest to: A) 13% B) 15% C) 16% D) 12% Answer: B Explanation: B) SD(RxCML) = xSD(RMkt) .25 = x(.18) → x = .25/.18 = 1.39 E[RxCML] = rf + x(E[RMkt] - rf) E[RxCML] = .04 + 1.39(.12 - .04) = .1512 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 16) Assuming that Tom wants to maintain the current expected return on his portfolio, then the amount that Tom should invest in the market portfolio to minimize his volatility is closest to: A) 100% B) 90% C) 125% D) 110% Answer: D Explanation: D) E[RxCML] = rf + x(E[RMkt] - rf) .13 = .04 + x(.12 - .04) x = .09/.08 = 1.125 Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

17) Assuming that Tom wants to maintain the current expected return on his portfolio, then the minimum volatility that Tom could achieve by investing in the market portfolio and riskfree investment is closest to: A) 20% B) 25% C) 22% D) 18% Answer: A Explanation: A) E[RxCML] = rf + x(E[RMkt] - rf) .13 = .04 + x(.12 - .04) x = .09/.08 = 1.125 SD(RxCML) = xSD(RMkt) 1.125(.18) = .2025 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 18) You currently own $100,000 worth of Wal-Mart stock. Suppose that Wal-Mart has an expected return of 14% and a volatility of 23%. The market portfolio has an expected return of 12% and a volatility of 16%. The risk-free rate is 5%. Assuming the CAPM assumptions hold, what alternative investment has the lowest possible volatility while having the same expected return as Wal-Mart? What is the volatility of this portfolio? Answer: E[RxCML] = rf + x(E[RMkt] - rf) .14 = .05 + x(.12 - .05) x = .09/.07 = 1.286. So the portfolio is long 129% market and short 29% risk-free asset SD(RxCML) = xSD(RMkt) 1.286(.16) = .2057 = 20.6% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

19) You currently own $100,000 worth of Wal-Mart stock. Suppose that Wal-Mart has an expected return of 14% and a volatility of 23%. The market portfolio has an expected return of 12% and a volatility of 16%. The risk-free rate is 5%. Assuming the CAPM assumptions hold, what alternative investment has the highest possible expected return while having the same volatility as Wal-Mart? What is the expected return of this portfolio? Answer: SD(RxCML) = xSD(RMkt) .23 = x(.16) → x = .23/.16 = 1.4375, so long 144% market and short 44% risk-free E[RxCML] = rf + x(E[RMkt] - rf) E[RxCML] = .05 +1.4375(.12 - .05) = .2081 or 20.8% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 20) Which of the following statements is FALSE? A) The risk premium of a security is equal to the market risk premium (the amount by which the market's expected return exceeds the risk-free rate), divided by the amount of market risk present in the security's returns measured by its beta with the market. B) We refer to the beta of a security with the market portfolio simply as the securities beta. C) There is a linear relationship between a stock's beta and its expected return. D) A security with a negative beta has a negative correlation with the market, which means that this security tend to perform will when the rest of the market is doing poorly. Answer: A Explanation: A) The risk premium of a security is equal to the market risk premium (the amount by which the market’s expected return exceeds the risk-free rate), multiplied by the amount of market risk present in the security’s returns measured by its beta with the market. Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual 21) Which of the following statements is FALSE? A) The expected return of a portfolio should correspond to the portfolio's beta. B) Graphically the line through the risk-free investment and the market portfolio is called the capital market line (CML). C) The beta of a portfolio is the weighted average beta of the securities in the portfolio. D) By holding a negative beta security, an investor can reduce the overall market risk of her portfolio. Answer: B Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

22) Which of the following statements is FALSE? A) To improve the performance of their portfolios, investors who are holding the market portfolio will compare the expected return of each security with its required return from the security market line. B) The Sharpe ratio of a portfolio will increase if we sell stocks with positive alphas. C) When a stock's alpha is not zero, investors can improve upon the performance of the market portfolio. D) When the market portfolio is efficient, all stocks are on the security market line and have an alpha of zero. Answer: B Explanation: B) The Sharpe ratio of a portfolio will decrease if we sell stocks with positive alphas. Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual 23) Which of the following statements is FALSE? A) We can improve the performance of our portfolio by selling stocks with negative alphas. B) The market portfolio is on the SML, and according to the CAPM, since all other portfolios are inefficient they will not fall on the SML. C) The difference between a stock's expected return and its required return according to the security market line is called the stock's alpha. D) The risk premium for any security is proportional to its beta with the market. Answer: B Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual 24) Which of the following statements is FALSE? A) The market portfolio is the efficient portfolio. B) Many practitioners believe it is sensible to use the CAPM and the security market line as a practical means to estimate a stock's required return and therefore a firm's equity cost of capital. C) If we plot individual securities according to their expected return and beta, the CAPM implies that they should all fall along the CML. D) As savvy investors attempt to trade to improve their portfolios, they raise the price and lower the expected return of the positive alpha stocks, and they depress the price and raise the expected return of negative alpha stocks, until the stocks are once again on the security market line and the market portfolio is efficient. Answer: C Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

25) The beta for the market portfolio is closest to: A) 1 B) 0 C) Unable to answer this question without knowing the markets expected return D) Unable to answer this question without knowing the markets volatility Answer: A Explanation: A) Beta of the Market Portfolio = bmkt =

=

Corr(Rmkt,Rmkt) = 1 (since the market is perfectly correlated with itself.) Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical 26) The beta for the risk free investment is closest to: A) 1 B) 0 C) Unable to answer this question without knowing the risk free rate D) Unable to answer this question without knowing the markets volatility Answer: B Explanation: B) Beta of the Market Portfolio = brf =

=

since the risk free investment has zero volatility, the Beta must equal zero. Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical Use the information for the question(s) below. Suppose that the risk-free rate is 5% and the market portfolio has an expected return of 13% with a volatility of 18%. Monsters Inc. has a 24% volatility and a correlation with the market of .60, while California Gold Mining has a 32% volatility and a correlation with the market of -.7. Assume the CAPM assumptions hold. 27) Monsters' beta with the market is closest to: A) 1.3 B) 1.0 C) 0.6 D) 0.8 Answer: D Explanation: D) bMonsters =

=

= .80

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

28) Monsters' required return is closest to: A) 10.0% B) 13.0% C) 11.5% D) 15.5% Answer: C Explanation: C) bMonsters =

=

= .80

ri = rf + b(E[RMkt] - rf) = .05 + .8(.13 - .05) = .114 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 29) Suppose that Monsters' expected return is 12%. Then Monsters' alpha is closest to: A) -2.0% B) -1.0% C) 1.0% D) 0.5% Answer: D Explanation: D) bMonsters =

=

= .80

ri = rf + b(E[RMkt] - rf) = .05 + .8(.13 - .05) = .114 so alpha = .12 - 11.4 = 0.6% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 30) California Gold Mining's beta with the market is closest to: A) 0.9 B) 1.25 C) -0.9 D) -1.25 Answer: D Explanation: D) bCGM =

=

= -1.24

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

31) California Gold Mining's required return is closest to: A) -5% B) 13% C) 15% D) 5% Answer: A Explanation: A) bCGM =

=

= -1.24

ri = rf + b(E[RMkt] - rf) = .05 + -1.24(.13 - .05) = -.05 or -5% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 32) Suppose that California Gold Mining's expected return is 2%. Then California Gold Mining's alpha is closest to: A) -3% B) -13% C) 7% D) -11% Answer: C Explanation: C) bCGM =

=

= -1.24

ri = rf + b(E[RMkt] - rf) = .05 + -1.24(.13 - .05) = -.05 or -5% Alpha = .02 - -.05 = 7% Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

Use the table for the question(s) below. Consider the following three individuals portfolios consisting of investments in four stocks: Stock Eenie Meenie Minie Moe

Beta 1.3 1.0 0.8 -0.5

Peter's Investment 2500 2500 2500 2500

Paul's Investment 5000 5000 5000 -5000

Mary's Investment 10000 10000 -5000 -5000

33) The beta on Peter's Portfolio is closest to: A) 0.7 B) 0.8 C) 1.8 D) 1.0 Answer: A Explanation: A) bportfolio = Σxibi Stock Eenie Meenie Minie Moe

Beta 1.3 1.0 0.8 -0.5

Peter's Paul's Mary's Peter's Investment Investment Investment Weights 2500 5000 10000 25% 2500 5000 10000 25% 2500 5000 -5000 25% 2500 -5000 -5000 25% Port Beta= 0.65

Paul's Weights 50% 50% 50% -50% 1.80

Mary's Weights 100% 100% -50% -50% 2.15

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

34) Assuming that the risk-free rate is 4% and the expected return on the market is 12%, then required return on Peter's Portfolio is closest to: A) 10% B) 12% C) 9% D) 8% Answer: C Explanation: C) bportfolio = Σxibi ri = rf + b(E[RMkt] - rf) = .04 + .65(.12 - .04) = .092 Stock Eenie Meenie Minie Moe

Beta 1.3 1.0 0.8 -0.5

Peter's Paul's Mary's Peter's Investment Investment Investment Weights 2500 5000 10000 25% 2500 5000 10000 25% 2500 5000 -5000 25% 2500 -5000 -5000 25% Port Beta= 0.65

Paul's Weights 50% 50% 50% -50% 1.80

Mary's Weights 100% 100% -50% -50% 2.15

Paul's Weights 50% 50% 50% -50% 1.80

Mary's Weights 100% 100% -50% -50% 2.15

Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 35) The beta on Paul's Portfolio is closest to: A) 1.5 B) 1.8 C) 1.3 D) 1.0 Answer: B Explanation: B) bportfolio = Σxibi Stock Eenie Meenie Minie Moe

Beta 1.3 1.0 0.8 -0.5

Peter's Paul's Mary's Peter's Investment Investment Investment Weights 2500 5000 10000 25% 2500 5000 10000 25% 2500 5000 -5000 25% 2500 -5000 -5000 25% Port Beta= 0.65

Diff: 1 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

36) Assuming that the risk-free rate is 4% and the expected return on the market is 12%, then required return on Peter's portfolio is closest to: A) 20% B) 22% C) 18% D) 16% Answer: C Explanation: C) bportfolio = Σxibi ri = rf + b(E[RMkt] - rf) = .04 + 1.8(.12 - .04) = .184 Stock Eenie Meenie Minie Moe

Beta 1.3 1.0 0.8 -0.5

Peter's Paul's Mary's Peter's Investment Investment Investment Weights 2500 5000 10000 25% 2500 5000 10000 25% 2500 5000 -5000 25% 2500 -5000 -5000 25% Port Beta= 0.65

Paul's Weights 50% 50% 50% -50% 1.80

Mary's Weights 100% 100% -50% -50% 2.15

Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 37) Assuming that the risk-free rate is 4% and the expected return on the market is 12%, then calculate the required return on Mary's portfolio. Answer: bportfolio = Σxibi ri = rf + b(E[RMkt] - rf) = .04 + 2.15(.12 - .04) = .212 Peter's Paul's Mary's Peter's Paul's Mary's Stock Beta Investment Investment Investment Weights Weights Weights Eenie 1.3 2500 5000 10000 25% 50% 100% Meenie 1.0 2500 5000 10000 25% 50% 100% Minie 0.8 2500 5000 -5000 25% 50% -50% Moe -0.5 2500 -5000 -5000 25% -50% -50% Port Beta= 0.65 1.80 2.15 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

38) Suppose that the risk-free rate is 5% and the market portfolio has an expected return of 13% with a volatility of 18%. Luther Industries has a volatility of 24% and a correlation with the market of .5. If you assume that the CAPM assumptions hold, then what is the expected return on Luther stock? Answer: bMonsters =

=

= .66667

ri = rf + b(E[RMkt] - rf) = .05 + .66667(.13 - .05) = .103333 Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Analytical 39) Which of the following statements is FALSE? A) Investors may have different information regarding expected returns, correlations, and volatilities, but they correctly interpret that information and the information contained in market prices and they adjust their estimates of expected returns in a rational way. B) Investors may learn different information through their own research and observations, but as long as they understand the differences in information and learn from other investors by observing prices, the CAPM conclusions still stand. C) Every investor, regardless of how much information he has access to, can guarantee himself an alpha of zero by holding the market portfolio. D) The CAPM requires making the strong assumption of homogeneous expectations. Answer: D Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual 40) Which of the following statements is FALSE? A) Because of the higher and uncompensated risk involved, no investor should choose a portfolio with a negative alpha. B) Because the average portfolio of all investors is the market portfolio, the average alpha for all investors is zero. C) The market portfolio can be inefficient if a significant number of investors misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha. D) If no investor earns a positive alpha, then no investor can earn a negative alpha, and the market portfolio must be efficient. Answer: A Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual

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FINA1221 2018 Sem 1 Final Exam Multiple-Choice Question Revision Pool

41) Explain how having different interest rates for borrowing and lending affects the CAPM and the SML. Answer: The basic conclusions of the CAPM will still hold. However, investors will now be faced with a group of efficient portfolios of risky assets along the efficient frontier. An individual investors optimal efficient portfolio will be the one identified by the line tangent to the efficient frontier that intersects at their appropriate interest rate. The market portfolio will become the average of all the individual efficient portfolios, and an average interest rate can be used to generalize the CAPM and SML to all investors using the market portfolio. Diff: 2 Section: 11.8 Determining the Risk Premium Skill: Conceptual

Good luck with all your exams and future studies! 251