Fin 534 final exam

Question 1

Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

Variance; correlation coefficient.

Standard deviation; correlation coefficient.

Beta; variance.

Coefficient of variation; beta.

Beta; beta

Question 2

Which of the following statements about pension plans if any, is incorrect?

A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee’s final salary.

A portable pension plan is one that an employee can carry from one employer to another.

An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.

If assets exceed the present value of benefits, the pension plan is fully funded.
Question 3

You have the following data on three stocks:

Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

As a risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

A; A.

A; B.

B; C.

C; A.

C; B.

Question 4

Which of the following statements concerning capital structure theory is NOT
CORRECT?

The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

Under MM with zero taxes, financial leverage has no effect on a firm’s value.

Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.

Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.

Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.

Question 5

Which of the following would cause average inventory holdings to decrease, other things held constant?

Fixed order costs double.

The purchase price of inventory items decreases by 50 percent.

The carrying price of an item decreases (as a percent of purchase price).

The sales forecast is revised downward by 10 percent.

Interest rates fall.

8 points

Question 6

Which of the following is NOT a real option?

The option to expand production if the product is successful.

The option to buy shares of stock if its price goes up.

The option to expand into a new geographic region.

The option to abandon a project.

The option to switch the type of fuel used in an industrial furnace.

Question 7

Which of the following statements is CORRECT?

The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.

The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.

The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.

The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

Question 8

Which of the following will NOT increase the value of a real option?

Lengthening the time in which a real option must be exercised.

An increase in the volatility of the underlying source of risk.

An increase in the risk-free rate.

An increase in the cost of obtaining the real option.

A decrease in the probability that a competitor will enter the market of the project in question.

Question 9

Which of the following statements is most CORRECT?

One advantage of forward contracts is that they are default free.

Futures contracts generally trade on an organized exchange and are marked to market daily.

Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.

There are futures contracts for currencies but no forward contracts for currencies.

Futures contracts don’t have any margin requirements but forward contracts do.

Question 10

Which of the following statements concerning the MM extension with growth is NOT
CORRECT?

The tax shields should be discounted at the cost of debt.

The value of a growing tax shield is greater than the value of a constant tax shield.

For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.

For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.

The total value of the firm increases with the amount of debt.

Question 11

In a portfolio of three different stocks, which of the following could NOT be true?

The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.

The beta of the portfolio is less than the betas of each of the individual stocks.

The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.

The beta of the portfolio can not be equal to 1.

Question 12

Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

When held in isolation, Stock A has greater risk than Stock B.

Stock B must be a more desirable addition to a portfolio than Stock A.

Stock A must be a more desirable addition to a portfolio than Stock B.

The expected return on Stock A should be greater than that on Stock B.

The expected return on Stock B should be greater than that on Stock A.

Question 13

Which of the following are the factors for the Fama-French model?

The excess market return, a size factor, and a book-to-market factor.

The excess market return, a debt factor, and a book-to-market factor.

The excess market return, a size factor, and a debt.

A debt factor, a size factor, and a book-to-market factor.

The excess market return, an industrial production factor, and a book-to-market factor.

Question 14

Which of the following statements is CORRECT?

The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

The slope of the CML is (M – rRF)/bM.

All portfolios that lie on the CML to the right of sM are inefficient.

All portfolios that lie on the CML to the left of sM are inefficient.

The slope of the CML is (M – rRF)/sM..

Question 15

For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),

The expected rate of return must be equal to the required rate of return; that is, .

The past realized rate of return must be equal to the expected rate of return; that is,

The required rate of return must equal the realized rate of return; that is, ..

all companies must pay dividends.

no companies can be in danger of declaring bankruptcy.

Question 16

Which of the following statements about defined contribution plans is incorrect?

A defined contribution plan places the risk of poor pension portfolio performance on the employee.

In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.

In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.

Defined benefit plans are used more often by large corporations than by small companies.

The PBGC insures a portion of pension benefits.

Question 17

The major contribution of the Miller model is that it demonstrates that

personal taxes increase the value of using corporate debt.

personal taxes decrease the value of using corporate debt.

financial distress and agency costs reduce the value of using corporate debt.

equity costs increase with financial leverage.

debt costs increase with financial leverage

Question 18

Which of the following statements about pension plan portfolio performance is incorrect?

Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.

Peer comparison examines the relative performance of portfolio managers with similar investment objectives.

A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.

In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.

Question 19

A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?

A swap involves the exchange of cash payment obligations.

The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.

Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.

A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.

A company can swap fixed interest payments for floating interest payments.

Question 20

Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank?

Convenience of location.

Competitive cost of services provided.

Size of the bank's deposits.

Experience of personnel.

Loyalty and willingness to assume lending risks.

Question 21

Which one of the following is an example of a “flexibility” option?

A company has an option to invest in a project today or to wait a year.

A company has an option to close down an operation if it turns out to be unprofitable.

A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.

A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.

A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial.

Question 22

Which of the following statements about project risk analysis in not-for-profit firms is incorrect?

The market risk of a project is not relevant to not-for-profit firms.

A project’s corporate beta measures the contribution of the project to the overall corporate risk of the firm.

A project’s corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio.

A project’s corporate beta is defined as (σP/σF)rPF, where σP
is the standard deviation of the project’s returns, σF
is the standard deviation of the firm’s returns, and rPF is the correlation among the two sets of returns.

In practice, it is usually difficult, if not impossible, to directly measure a project’s corporate risk, so project risk analysis typically focuses on stand-alone risk.

Question 23

Which of the following statements concerning the MM extension with growth is NOT
CORRECT?

The tax shields should be discounted at the unlevered cost of equity.

The value of a growing tax shield is greater than the value of a constant tax shield.

For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.

For a given D/S, the WACC is less than the WACC under MM’s original (with tax) assumptions.

The total value of the firm increases with the amount of debt.

Question 24

A firm’s credit policy consists of which of the following items?

Credit period, cash discounts, credit standards, receivables monitoring.

Credit period, cash discounts, credit standards, collection policy.

Credit period, cash discounts, receivables monitoring, collection policy.

Cash discounts, credit standards, receivables monitoring, collection policy.

Credit period, receivables monitoring, credit standards, collection policy.
Question 25

Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.

If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.

If the average inventory increases by 20%, then the total carrying costs will increase by 20%.

If the average inventory increases by 20% the total order costs will increase by 20%.

The EOC is the same for all comppanies.

Question 26

Which of the following statements concerning the MM extension with growth is NOT
CORRECT?

The tax shields should be discounted at the unlevered cost of equity.

The value of a growing tax shield is greater than the value of a constant tax shield.

For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.

For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.

The total value of the firm is independent of the amount of debt it uses.

Question 27

Which of the following statements is CORRECT?

Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

Richard Roll has argued that it is possible to test the CAPM to see if it is correct.

Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.

Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.

The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.

Question 28

Which of the following is NOT a potential problem with beta and its estimation?

Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta.

The beta of “the market,” can change over time, sometimes drastically.

Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

There is a wide confidence interval around a typical stock’s estimated beta.

Question 29

Which of the following are NOT ways risk management can be used to increase the value of a firm?

Risk management can increase debt capacity.

Risk management can help a firm maintain its optimal capital budget.

Risk management can reduce the expected costs of financial distress.

Risk management can help firms minimize taxes.

Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

Question 30

Which of the following is not correct?

Collection policy is how a firm goes about collecting past-due accounts.

A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales.

Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased.

Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account.

A lax collection policy will frequently lead to an increase in accounts receivable.

Question 31

The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
What is the firm's cost of equity?

21.0%

23.3%

25.9%

28.8%

32.0%

Question 32

Calculate the required rate of return for Mercury, Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Mercury has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.

10.29%

10.83%

11.40%

12.00%

12.60%

Question 33

XYZ Company needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan?

16.22%

17.97%

17.48%

18.67%

18.00%

Question 34

Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and harvest its fruit crop. Picard borrows on a discount interest basis at a nominal annual rate of 11 percent. If Picard must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note?

$111,000

$100,000

$112,360

$ 89,000

$108,840

Question 35

Oklahoma Instruments (OI) is considering a project called F-200 that has an up-front cost of $250,000. The project’s subsequent cash flows are critically dependent on whether another of its products, F-100, becomes an industry standard. There is a 50% chance that the F-100 will become the industry standard, in which case the F-200’s expected cash flows will be $110,000 at the end of each of the next 5 years. There is a 50% chance that the F-100 will not become the industry standard, in which case the F-200’s expected cash flows will be $25,000 at the end of each of the next 5 years. Assume that the cost of capital is 12%.
Based on the above information, what is the F-200’s expected net present value?

-$6,678

-$3,251

$15,303

$20,004

$45,965