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BFIN3321 FINAL EXAM FALL I 2016 MULTIPLE CHOICE 1. The volatility of an investment, including firm specific risk as well as market risk, is defined as A. standard deviation B. diversifiable risk C. market risk D. total risk 2. This is a comparison of market yields on securities, assuming all characteristics except maturity are the same. A. market risk B. liquidity risk C. maturity risk D. term structure of interest rates 3. This is the portion of total risk that is attributable to overall economic factors. A. modern portfolio risk B. firm specific risk C. market risk D. total risk 4. This is the risk that a security issuer will miss an interest or principal payment or continue to miss such payments. A. price risk B. default risk C. liquidity risk D. maturity risk 5. This is defined as the portion of total risk that is attributable to firm or industry factors and can be reduced through diversification. A. modern portfolio risk B. firm specific risk C. market risk D. total risk 6. This is defined as a combination of investment assets held by an investor. A. bundle B. portfolio C. market basket D. All of these 7. This is the investor's combination of securities that achieves the highest expected return for a given risk level. A. efficient portfolio B. modern portfolio C. optimal portfolio D. total portfolio 8. This is the term for portfolios with the highest return possible for each risk level. A. efficient portfolios B. modern portfolios C. optimal portfolios D. total portfolios 9. Dominant Portfolios Determine which one of these three portfolios dominates another. Name the dominated portfolio and the portfolio that dominates it. Portfolio Blue has an expected return of 14 percent and risk of 19 percent. The expected return and risk of portfolio Yellow are 15 percent and 18 percent, and for the Purple portfolio are 16 percent and 21 percent. A. Portfolio Purple dominates Portfolio Blue B. Portfolio Blue dominates Portfolio Yellow C. Portfolio Yellow dominates Portfolio Blue D. Portfolio Purple dominates Portfolio Yellow 10. This is a measurement of the co-movement between two variables that ranges between -1 and +1. A. coefficient of variation B. standard deviation C. correlation D. total risk 11. This is the ease with which an asset can be converted into cash. A. liquidity B. direct transfer C. primary market D. secondary market 12. A security formalizing an agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future is A. liquidity asset B. trading volume C. derivative security D. initial public offering 13. Once firms issue financial instruments in primary markets, these same stocks and bonds are then traded in which of these? A. direct transfers B. secondary markets C. initial public offerings D. over-the-counter stocks 14. Which of the following is NOT a capital market instrument? A. U.S. Treasury bills B. Corporate stocks and bonds C. U.S. Treasury notes and bonds D. U.S. government agency bonds 15. These provide a forum in which demanders of funds raise funds by issuing new financial instruments, such as stocks and bonds. A. money markets B. primary markets C. investment banks D. secondary markets 16. Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on stock market for the first time. We usually refer to these first-time issues as which of the following? A. direct transfers B. initial public offerings C. money market transfers D. over-the-counter stocks 17. This is the interest rate that is actually observed in financial markets. A. nominal interest rates B. real interest rates C. real risk free rate D. market premium 18. This theory argues that individual investors and financial institutions have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred requires a higher interest rate. A. Unbiased Expectations Theory B. Liquidity Premium Hypothesis C. Market Segmentation Theory D. Supply and Demand Theory 19. According to this theory of term structure of interest rates, at any given point in time, the yield curve reflects the market's current expectations of future short-term rates. A. Expectations Theory B. Unbiased Expectations Theory C. Future Short-term Rates Theory D. Term Structure of Interest Rates Theory 20. This is the average of the possible returns weighted by the likelihood of those returns occurring. A. market return B. efficient return C. required return D. expected return 21. This is the interest rate that would exist on a default free security if no inflation were expected. A. nominal interest rate B. real risk free rate C. real interest rate D. market premium 22. This is typically considered the return on U.S. government bonds and bills and equals the real interest and the expected inflation premium. A. market risk premium B. required return C. risk-free rate D. risk premium 23. In theory, this is a combination of securities that places the portfolio on the efficient frontier and on a line tangent from the riskfree rate. A. efficient market B. market portfolio C. stock market bubble D. probability distribution 24. A measure of the sensitivity of a stock or portfolio to market risk. A. behavioral finance B. efficient market C. hedge D. beta 25. This is the reward investors require for taking risk. A. market risk premium B. required return C. risk premium D. risk-free rate 26. Which of these is the measurement of risk for a collection of stocks for an investor? A. beta B. portfolio beta C. efficient market D. expected return 27. The use of debt to increase an investment position. A. stock market bubble B. behavioral finance C. financial leverage D. probability 28. Which of the following is NOT a necessary condition for an efficient market? A. Many buyers and sellers. B. No trading or transaction costs. C. No prohibitively high barriers to entry. D. Free and readily available information available to all participants. 29. The constant growth model assumes which of the following? A. That there are executive stock options available to managers. B. That there is privately held information. C. That the stock is efficiently priced. D. That there is no restricted stock. 30. A theory that describes the types of information that are reflected in current stock prices. A. asset pricing B. behavioral finance C. public information D. efficient market hypothesis 31. Accelerated depreciation allows firms to A. receive less of the dollars of depreciation earlier in the asset's life. B. receive more of the dollars of depreciation earlier in the asset's life. C. not pay any taxes during an asset's life. D. receive more of the dollars of depreciation later in the asset's life. 32. Section 179 allows a business, with certain restrictions, to do which of the following? A. Offset the tax liability with the cost of the asset in the year of purchase. B. Expense the asset immediately in the year of purchase. C. Expense the asset using double declining balance depreciation during the life of the asset. D. Get a government grant to purchase the asset. 33. For which situation below would one need to "smooth out" the variation in each set of cash flows so that each become a perpetuity? A. choosing between projects with differing risks B. choosing between independent project C. choosing between alternative assets with differing lives D. choosing between alternative assets with equal lives 34. The approach to convert an infinite series of asset purchases into a perpetuity is known as the A. Net working capital approach B. Net present value approach C. Equivalent annual cost approach D. Equivalent annual cash flow approach 35. With regard to depreciation, the time value of money concept tells us that A. delaying the depreciation expense is always better. B. taking the depreciation expense sooner is always better. C. delaying the depreciation expense is sometimes better. D. taking the depreciation expense sooner is sometimes better. 36. When looking at these types of projects, one must consider any cash flows that arise from surrendering old equipment before the end of its useful life. A. incremental B. replacement C. cost-cutting D. new 37. Of the capital budgeting techniques discussed, which works equally well with normal and non- normal cash flows and with independent and mutually exclusive project? A. payback period B. discounted payback period C. modified internal rate of return D. net present value 38. The Net Present Value decision technique may not be the only pertinent unit of measure if the firm is facing A. time or resource constraints. B. a labor union. C. the election of a new board of directors. D. a major investment. 39. Neither payback period nor discounted payback period techniques for evaluating capital projects accounts for A. time value of money. B. market rates of return. C. cash flows that occur after payback. D. cash flows that occur during payback. 40. Which rate-based decision statistic measures the excess return - the amount above and beyond the cost of capital for a project, rather than the gross return? A. Internal Rate of Return, IRR B. Modified Internal Rate of Return, MIRR C. Profitability Index, PI D. Net Present Value, NPV 41. When calculating the weighted average cost of capital, weights are based on A. book values. B. book weights. C. market values. D. market betas. 42. A true statement regarding the appropriate tax rate to be used in the WACC is A. One would use the marginal tax rate that the firm paid the prior year. B. One would use the average tax rate that the firm paid the prior year. C. One would use the weighted average of the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction. D. One would use the marginal tax rates that would have been paid on the taxable income shielded by the interest deduction. 43. Which of these is the basic intuition behind calculating the cost of capital? A. Firms need to know what the cost of all their current sources of capital cost them. B. When firms use multiple sources of capital, they need to calculate the current expenditures in a dollar amount format. C. When firms use multiple sources of capital, they need to calculate the appropriate interest rate for valuing their firm's cash flows as a weighted average of the capital components. D. When firms use multiple sources of capital, they need to calculate the appropriate interest rate after taxes for estimating current cash outflows. 44. These are fees paid by firms to investment bankers for issuing new securities. A. floatation costs B. interest expense C. seller financing charges D. user fees 45. This is a principle of capital budgeting which states that the calculations of cash flows should remain independent of financing. A. generally accepted accounting principle B. financing principle C. separation principle D. WACC principle 46. This is the process of estimating expected future cash flows of a project using only the relevant parts of the balance sheet and income statements. A. incremental cash flows B. cash flow analysis C. pro forma analysis D. substitutionary analysis 47. Concerning incremental project cash flow, this is a cost one would never count as an expense of the project. A. initial investment B. taxes paid C. operating expenses of the project D. financing costs 48. This is used as a measure of the total amount of available cash flow from a project. A. free cash flow B. operating cash flow C. investment in operating capital D. sunk cash flow 49. When calculating operating cash flow for a project, one would calculate it as being mathematically equal to which of the following? A. EBIT - Interest - Taxes + Depreciation B. EBIT - Taxes C. EBIT + Depreciation D. EBIT - Taxes + Depreciation 50. A decrease in net working capital (NWC) is treated as a A. cash inflow B. cash outflow C. sunk cost D. historical cost 51. These are groups or pairs of projects where you can accept one but not all. A. dependent B. independent C. mutually exclusive D. mutually dependent 52. A capital budgeting technique that converts a project's cash flows using a more consistent reinvestment rate prior to applying the Internal Rate of Return, IRR, decision rule. A. discounted payback B. net present value C. modified internal rate of return D. profitability index 53. Investing in stocks is like gambling when: A. Both have a short time horizon B. Both involve risk C. Both involve an initial outflow of cash D. Both result in long-term loses. 54. Which of the following is false? A. Incremental costs can be Opportunity costs. B. Opportunity costs can be Incremental cost. C. Of the three categories of Opportunity costs, only one is usually an Incremental cost. D. Opportunity costs and Incremental costs are the same thing. E. Some Opportunity costs are not incremental costs. 55. If the risk of an investment project is different than the firm's risk then: A. you must adjust the discount rate for the project based on the firm's risk. B. you must adjust the discount rate for the project based on the project risk. C. you must exercise risk aversion and use the market rate. D. an average rate across prior projects is acceptable because estimates contain errors. E. one must have the actual data to determine any differences in the calculations. 56. Insider trading does not offer any advantages if the financial markets are: A. strong form efficient. B. semi-strong form efficient. C. semi-weak form efficient. D. weak form efficient. E. inefficient. PROBLEMS - SHOW YOUR WORK! 1. (4 points) A particular security's default risk premium is 1 percent. For all securities, the inflation risk premium is 2 percent and the real interest rate is 3 percent. The security's liquidity risk premium is 5 percent and maturity risk premium is 4 percent. The security has no special covenants. What is the security's equilibrium rate of return? % 2. (4 points) Suppose that the current one-year rate (one-year spot rate) and expected one-year T- bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows: 1R1 = 4.0%, E(2R1) = 2.5%, E(3R1) = 10.0%, E(4R1) = 12.0%, Using the unbiased expectations theory, what is the current (longterm) rate for four-year-maturity Treasury securities (1R4)? % 3. (4 points) HydroTech Corp stock was $40 per share a year ago when it was purchased. Since then, it paid a $5 per share dividend. The stock price is currently $36. If you owned 1,000 shares of HydroTech, what was your percent return for the past year? % 4. (4 points) Portfolio Return Year-to-date, Company X had earned a - 4 percent return. During the same time period, Company Y earned + 10 percent and Company Z earned + 5 percent. If you have a portfolio made up of 50 percent Company X, 30 percent Company Y, and 20 percent Company Z, what is your portfolio return? % 5. (8 points) You hold the positions in the table below. COMPANY Goodmonth Icestone Bridgerock PRICE $20.00 $60.00 $40.00 # SHARES 100 50 125 BETA + 1.5 - 2.0 - 1.2 A. What is the beta of your portfolio? B. If you expect the market to earn 14 percent and the risk-free rate is 4 percent, what is the required return of the portfolio? 6. (4 points) TAB Inc. has a $1,000 (face value), 20 year bond issue selling for $829.73 that pays an annual coupon of 8.0 percent. What would be TAB's current before-tax component cost of debt? 7. (4 points) Team Sports has 10 million shares of common stock outstanding, 5 million shares of preferred stock outstanding, and 200 thousand bonds ($1,000 par). If the common shares are selling for $50.00 per share, the preferred share are selling for $20 per share, and the bonds are selling at par, what would be the weight used for common stock in the computation of Team's WACC? 8. (4 points) Suppose that TipsNToes, Inc.'s capital structure features 60 percent equity, 40 percent debt, and its cost of equity is 10 percent, while its before-tax cost of debt is 9 percent. If the appropriate weighted average tax rate is 25 percent, what will be TipsNToes's aftertax WACC? 9. (4 points) Suppose you sell a fixed asset for $10,000 when its book value is $7,500. If your company's marginal tax rate is 40%, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)? 10. (7 points) The firm is planning to spend $20,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $1,000. The machine has an expected life of 3 years, a $2,000 estimated resale value, and falls under the MACRS 3-Year class life. Revenue from the new game is expected to be $50,000 per year, with costs of $30,000 per year (excluding depreciation). The firm has a tax rate of 20 percent, an opportunity cost of capital of 10 percent, and it expects net working capital to increase by $5,000 at the beginning of the project. What will be the net cash flow for year one of this project? 11. (5 points) Compute the Payback statistic for Project X and recommend whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent and the maximum allowable payback is 5 years. TIME: 012345 CASH FLOW: - 300 50 150 200 100 50 12. (4 points) Compute the NPV for Project Y and accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent. TIME: 012345 CASH FLOW: - 300 50 150 200 100 50 13. (4 points) Compute the IRR statistic for Project X and note whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent. TIME: 012345 CASH FLOW: - 300 50 150 200 100 50 14. (8 points) Suppose your firm is considering two mutually exclusive, required projects with the cash flows shown below. The required rate of return of both projects for their risk class is 8 percent. TIME: 0 1 2 3 Project A CF: $ - 10,000 $ 30,000 $ 40,000 $ 10,000 Project B CF: $ - 40,000 $ 50,000 $ 80,000 $ 56,850 Use the Profitability Index (PI) decision rule to evaluate these projects; what is the PI for each project, and which one(s) should it be accepted or rejected