Finance 2000 exam 3 concept questions

Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as:

incremental cash flows

Which one of the following principles refers to the assumption that a project will be evaluated based on its incremental cash flows?

Stand-alone principle

The variance is the average squared difference between which of the following?

A) Actual return and average return

B) Actual return and (average return ÷ N − 1)

C) Actual return and the real return

D) Average return and the standard deviation

E) Actual return and the risk-free rate

Actual return and average return

Which one of the following is the positive square root of the variance?

A) Standard deviation

B) Mean

C) Risk-free rate

D) Average return

E) Real return

Standard deviation

Which one of the following is defined as a bell-shaped frequency distribution that is defined

by its average and its standard deviation?

A) Arithmetic average return

B) Variance

C) Standard deviation

D) Probability curve

E) Normal distribution

Normal distribution

An efficient capital market is best defined as a market in which security prices reflect which

one of the following?

A) Current inflation

B) A risk premium

C) All available information

D) The historical arithmetic rate of return

E) The historical geometric rate of return

All available information

Which one of the following is the hypothesis that securities markets are efficient?

A) Geometric market hypothesis

B) Standard deviation hypothesis

C) Efficient markets hypothesis

D) Capital market hypothesis

E) Financial markets hypothesis

Efficient markets hypothesis

Over the period of 1926-2023, which one of the following investment classes had the highest volatility of returns?

A) Large-company stocks

B) U.S. Treasury bills

C) Small-company stocks

D) Long-term corporate bonds

E) Long-term government bonds

Small-company stocks

Which one of the following had a zero standard deviation of returns for the period of 1926-

2023?

A) All of the listed security types had a standard deviation of returns in excess of zero percent.

B) U.S. Treasury bills

C) Long-term corporate bonds

D) Large-company stocks

E) Long-term government bonds

All of the listed security types had a standard deviation of returns in excess of zero percent.

Which one of the following categories has the widest frequency distribution of returns for the period 1926-2023?

A) Small-company stocks

B) U.S. Treasury bills

C) Long-term government bonds

D) Inflation

E) Large-company stock

Small-company stocks

What was the average annual risk premium on small-company stocks for the period 1926-

2023?

12.7%

For the period 1926-2023, which one of the following had the smallest risk premium?

A) Large-company stocks

B) Small-company stocks

C) Long-term corporate bonds

D) U.S. Treasury bills

E) Long-term government bonds

U.S. Treasury bills

The lower the standard deviation of returns on a security, the __________ the expected rate of return and the __________ the risk.

lower; lower

The standard deviation measures the __________ of a security's returns over time.

Volatility

Which one of the following has the narrowest distribution of returns for the period 1926-2023?

A) Long-term corporate bonds

B) Long-term government bonds

C) Intermediate-term government bonds

D) Large-company stocks

E) Small-company stocks

Intermediate-term government bonds

What is the probability associated with a return that lies in the upper tail when the mean plus two standard deviations is graphed?

2.5%

New Labs just announced that it has received a patent for a product that will eliminate all flu viruses. This news is totally unexpected and viewed as a major medical advancement. Which one of the following reactions to this announcement indicates the market for New Labs stock is efficient?

A) The price of New Labs stock remains unchanged.

B) The price of New Labs stock increases rapidly and then settles back to its pre-

announcement level.

C) The price of New Labs stock increases rapidly to a higher price and then remains at

that price.

D) All stocks quickly increase in value and then all but New Labs stock fall back to their

original values.

E) The value of all stocks suddenly increase and then level off at their higher values.

The price of New Labs stock increases rapidly to a higher price and then remains at

If the financial markets are efficient then:

A) stock prices should remain constant.

B) stock prices should increase or decrease slowly as new events are analyzed and the

information is absorbed by the markets.

C) an increase in the value of one security should be offset by a decrease in the value of

another security.

D) stock prices will change only when an event actually occurs, not at the time the event

is anticipated.

E) stock prices should respond only to unexpected news and events.

stock prices should respond only to unexpected news and events.

According to the efficient markets hypothesis, professional investors will earn:

A) excess profits over the long term.

B) excess profits, but only on short-term investments.

C) a dollar return equal to the value paid for an investment.

D) a return that cannot be accurately predicted because investments are subject to the

random movements of the markets.

E) a return that "beats the market."

a dollar return equal to the value paid for an investment

Semistrong form market efficiency states that the value of a security is based on:

all publicly available information

Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are:

A) weak form efficient.

B) strong form efficient.

C) semistrong form efficient.

D) efficient at any level.

E) aware that the trader is an insider.

strong form efficient

If the financial markets are semistrong form efficient, then:

only individuals with private information have a marketplace advantage

Mary owns a risky stock and anticipates earning 16.5 percent on her investment in that

stock. Which one of the following best describes the 16.5 percent rate?

Expected return

Which term best refers to the practice of investing in a variety of diverse assets as a

means of reducing risk?

A) Systematic

B) Unsystematic

C) Diversification

D) Security market line

E) Capital asset pricing model

Diversification

Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive?

A) Risk-free rate

B) Market risk premium

C) Expected return minus the risk-free rate

D) Market rate of return

E) Cost of capital

Cost of capital

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

A) An increase in the rate of return in a recessionary economy

B) An increase in the probability of an economic boom

C) A decrease in the probability of a recession occurring

D) A decrease in the probability of an economic boom

E) An increase in the rate of return for a normal economy

A decrease in the probability of an economic boom

Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

A) Security beta multiplied by the market rate of return

B) Market risk premium

C) Security beta multiplied by the market risk premium

D) Risk-free rate of return

E) Zero

Zero

Portfolio diversification eliminates:

unsystematic risk.

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do which one of the following?

A) Increase the expected risk premium

B) Reduce the beta of the portfolio to one

C) Increase the security's risk premium

D) Reduce the portfolio's systematic risk level

E) Reduce the portfolio's unique risks

Reduce the portfolio's unique risks

Assume you own a portfolio of diverse securities which are each correctly priced. Given this, the reward-to-risk ratio:

A) for the portfolio must equal 1.0.

B) for the portfolio must be less than the market risk premium.

C) for each security must equal zero.

D) of each security is equal to the risk-free rate.

E) of each security must equal the slope of the security market line.

of each security must equal the slope of the security market line.

According to the capital asset pricing model, the expected return on a security will be affected by all of the following except the:

security’s standard deviation

The capital asset pricing model:

considers the relationship between the fluctuations in a security’s returns versus the market’s returns

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

A) Weighted average cost of capital

B) Pure play cost

C) Cost of equity

D) Subjective cost

E) Cost of debt

Cost of equity

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

A) The rate of growth must exceed the required rate of return.

B) The rate of return must be adjusted for taxes.

C) The annual dividend used in the computation must be for Year 1 if you use Time 0’s stock price to compute the return.

D) The cost of equity is equal to the return on the stock plus the risk-free rate.

E) The cost of equity is equal to the return on the stock multiplied by the stock's beta.

The annual dividend used in the computation must be for Year 1 if you use Time 0’s stock price to compute the return.

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

A) 12.4 percent because it is lower than 18.7 percent

B) 18.7 percent because it is higher than 12.4 percent

C) The arithmetic average of 12.4 percent and 18.7 percent

D) The arithmetic average of 12.4 percent, 13.5 percent, and 18.7 percent

E) 13.5 percent

The arithmetic average of 12.4 percent and 18.7 percent

When evaluating a project, the dividend growth model:

is relatively simple to use

The results of the dividend growth model:

are sensitive to the rate of dividend growth

In an efficient market, the cost of equity for a highly risky firm:

increases in direct relation to the stock's systematic risk.

Which one of the following will increase the cost of equity, all else held constant?

A) Increase in the dividend growth rate

B) Decrease in beta

C) Decrease in future dividends

D) Increase in stock price

E) Decrease in market risk premium

Increase in the dividend growth rate

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the:

cost of debt.

An increase in a levered firm’s tax rate will:

decrease the firm’s cost of capital.

Which one of the following is used as the pretax cost of debt?

A) Average coupon rate on the firm's outstanding bonds

B) Coupon rate on the firm's latest bond issue

C) Weighted average yield to maturity on the firm's outstanding debt

D) Average current yield on the firm's outstanding debt

E) Annual interest divided by the market price per bond for the latest bond issue

Weighted average yield to maturity on the firm's outstanding debt

Which one of the following will decrease the after-tax cost of debt for a firm?

A) Decrease in the firm's beta

B) Increase in tax rates

C) Increase in the risk-free rate of return

D) Decrease in the market price of the debt

E) Increase in a bond's yield to maturity

Increase in tax rates

Which one of the following statements is accurate for a levered firm?

A) WACC should be used as the required return for all proposed investments.

B) A firm's WACC will decrease whenever the firm's tax rate decreases.

C) An increase in the market risk premium will decrease a firm's WACC.

D) The subjective approach totally ignores a firm's own WACC.

E) A reduction in the risk level of a firm will tend to decrease the firm's WACC.

A reduction in the risk level of a firm will tend to decrease the firm's WACC

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an aftertax cost of debt of 5.2 percent, and a tax rate of 25 percent. Given this, which one of the following will increase the firm's weighted average cost of capital?

A) Increasing the firm's tax rate

B) Issuing new bonds at par

C) Redeeming shares of common stock

D) Increasing the firm's beta

E) Increasing the debt-equity ratio

Increasing the firm's beta

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if:

the firm's bonds start selling at a premium rather than at a discount.