Fin3403 Conceptuals

[Stock Valuation] Which statement is NOT (or least) correct?

A) The constant growth model can be used to evaluate zero growth stocks, such as preferred stock.

B) Free cash flows and the firm's cost of capital can be used to find enterprise value; subtracting debt and other liabilities gives equity value, which divided by shares outstanding gives price per share.

C) Expected return on common stock = expected dividend yield + expected capital gains yield; the capital gains yield is the expected price growth rate and, for a constant growth stock, also the dividend growth rate.

D) If markets are semi-strong-form efficient, there is no value to either technical or fundamental analysis.

E) To use the constant growth model, we must assume the investor's required rate of return is less than the long-run constant growth rate.

E. To use the constant growth model, we must assume the investor's required rate of return is less than the long-run constant growth rate.

(This is backwards: required return must be GREATER than g.)

[Stock Valuation] Select the statement that is most correct.

A) Retention rate plus dividend payout rate must always sum to zero.

B) Stockholders have the first claim on earnings and assets in default, so they provide the least risk.

C) Most academic research clearly shows markets are weak, semi-strong, and strong form efficient.

D) If a firm increases the growth rate of dividends, the stock price will automatically increase.

E) Markets are in equilibrium when supply equals demand, which is also where investors' required rates of return equal expected rates of return.

E. Markets are in equilibrium when supply equals demand, which is also where required rates of return equal expected rates of return.

[Stock Valuation] Select the statement that is most correct.

A) Markets are weak, semi-strong, and strong-form efficient if no one except insiders can consistently earn abnormal returns.

B) If two constant growth stocks have the same required return and Stock A's price is greater than Stock B's, Stock A must have a lower dividend yield.

C) To price a supernormal growth stock, value both the dividends during the supernormal period and the price at the end of the supernormal period (the value of the remaining dividends to infinity), both discounted to the present.

D) Firm value equals expected future free cash flows discounted at the pre-tax cost of debt, and increases as long as BEP exceeds the cost of debt.

E) If stock prices are in equilibrium, the expected return will be greater than the required return (like a positive NPV project).

C. To price a supernormal growth stock, value both the dividends during the supernormal period and the price at the end of that period (the remaining dividend stream to infinity), both discounted to the present.

[Stock Valuation] If two constant growth stocks have the same required rate of return and the same price, which statement is most correct?

A) They must have the same per-share dividend.

B) The stock with the higher dividend yield will have a higher dividend growth rate.

C) They must have the same dividend growth rate.

D) The stock with the higher dividend yield will have a lower dividend growth rate.

E) They must have the same dividend yield.

D. The stock with the higher dividend yield will have a lower dividend growth rate.

[Stock Valuation] Select the statement that is most correct.

A) Risk aversion implies that some securities will go unpurchased even if a large risk premium is paid.

B) The constant growth model for common stock may also be used to find the price of perpetual preferred stock or any other perpetuity.

C) Because of diversification, a 100-security portfolio will have a lower beta than a one-security portfolio.

D) Under the basic stock valuation model, the value an investor assigns to a share depends on how long the investor plans to hold it.

E) If two securities are perfectly positively correlated, combining them in the correct unequal proportions can produce a portfolio with less risk than either security alone.

B. The constant growth model for common stock may also be used to find the price of perpetual preferred stock or any other perpetuity.

[Stock Valuation] Stocks A and B have the same required rate of return and the same expected year-end dividend (D1). Stock A's dividend grows at a constant 10% per year; Stock B's at a constant 5% per year. Which statement is most correct?

A) The two stocks should sell at the same price.

B) Stock A has a higher dividend yield than Stock B.

C) Currently Stock B has a higher price, but over time Stock A will eventually have a higher price.

D) Statements B and C are correct.

E) None of the statements above is correct.

E. None of the statements above is correct.

[Stock Valuation] Select the statement that is most correct.

A) Risk is the chance an unfavorable event occurs, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.

B) Portfolio diversification reduces the variability of returns on an individual stock.

C) When company-specific risk has been diversified, the remaining market risk is constant for all securities.

D) A stock with a beta of -1.0 has zero market risk.

E) The SML relates required returns to firms' market risk; its slope and intercept cannot be controlled by the financial manager.

E. The SML relates required returns to firms' market risk; its slope and intercept cannot be controlled by the financial manager.

[Stock Valuation] Which statement is incorrect (least correct)?

A) The price of a share will theoretically decline by the present value of the dividend given up when the stock goes ex dividend.

B) For a constant growth stock, dividend growth = price growth, and in equilibrium this growth rate = required return minus expected dividend yield.

C) The price sensitivity of a share of common stock increases with the time remaining until it matures.

D) The preemptive right protects existing shareholders against dilution of their ownership interests.

E) To evaluate dividend policy changes, we assume investing and financing decisions are already made, so increasing a dividend is accomplished by issuing new equity and decreasing it by repurchasing equity.

C. The price sensitivity of a share of common stock increases with the time remaining until it matures.

(Incorrect: common stock has no maturity; this describes bonds.)

[Cost of Capital] Which statement is NOT (or least) correct?

A) Because of the tax shelter created by preferred stock dividends (70% of dividends are excluded from taxes), the firm's after-tax cost of preferred stock may be significantly less than its before-tax cost.

B) The weighted average cost of embedded/historical capital will have little significance when the firm looks at new projects that require additional capital.

C) If a firm with two divisions of significantly different risk evaluates all investments using a single corporate WACC rather than divisional screening rates, it is likely to become more risky (taking on more high-risk projects) and less valuable (taking on projects that earn less than their risk requires).

D) Flotation costs may not be significant for bonds, since many bond issues are privately placed with minimal administrative expense.

E) Flotation costs may be significant for new common sto

A. Because of the tax shelter created by preferred stock dividends, the firm's after-tax cost of preferred stock may be significantly less than its before-tax cost.

(Incorrect: the 70% exclusion benefits the corporate investor, not the issuer, so no tax adjustment to the cost of preferred stock.)

[Cost of Capital] If a U.S. company with two divisions, one very risky and the other significantly less risky, uses the same corporate discount rate to evaluate all projects, the most likely outcome is that the firm will become:

A) Riskier over time, and its value will decline.

B) Riskier over time, and its value will rise.

C) Less risky over time, and its value will rise.

D) Less risky over time, and its value will decline.

E) No change in risk or value is expected.

A. Riskier over time, and its value will decline.

[Cost of Capital] A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm. In evaluating this asset, the decision maker should:

A) Increase the IRR of the asset to reflect the greater risk.

B) Increase the NPV of the asset to reflect the greater risk.

C) Reject the asset, since its acceptance would increase the risk of the firm.

D) Ignore the risk differential if the asset is only a small fraction of the firm's total assets.

E) Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

E. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project.

[Cost of Capital] Select the statement that is most correct.

A) Since most stock is privately placed, a firm's required return on a new issue of common stock equals the investors' required return.

B) The WACC represents the historical cost of capital and is usually calculated on a before-tax basis.

C) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible.

D) Since the money is readily available, the cost of retained earnings is usually much cheaper than the cost of debt.

E) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred dividends are tax deductible.

C. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible.

[Cost of Capital] Select the statement that is most correct.

A) When a bond's coupon rate is greater than its YTM, the coupon rate should be used as the before-tax cost of debt.

B) All other things equal (including component costs), a higher tax rate will lower a firm's WACC only if the firm uses debt financing.

C) While higher-than-average risk projects require discounting at a rate above WACC, it is usually not appropriate to discount lower-than-average risk projects at a rate below WACC.

D) Even if project risks vary widely within a firm, a project's cash flows should always be discounted at the corporate WACC.

E) Because of their size, it is more difficult to use the CAPM to estimate the cost of equity for large public firms than for small private firms.

B. All other things equal (including component costs), a higher tax rate will lower a firm's WACC only if the firm uses debt financing.

[Cost of Capital] Which statement is most correct?

A) An increase in the corporate tax rate, all else constant, should increase a firm's WACC.

B) A firm can lower its component cost of debt simply by issuing debt with a lower coupon rate.

C) The "enterprise" value of the firm can be found by taking the free cash flow available to all investors and discounting it at the firm's WACC.

D) Since most equity is privately placed for public corporations, flotation costs are negligible and the cost of new common stock is essentially the investor's required return.

E) Since market values change constantly and book values are more stable, the firm should use book value weights to define its optimal capital structure.

C. The "enterprise" value of the firm can be found by taking the free cash flow available to all investors and discounting it at the firm's WACC.

[Cost of Capital] Which statement is most correct?

A) If a company's tax rate increases but the YTM of its noncallable bonds stays the same, then, all else constant, the firm's WACC should decrease.

B) If the beta of a company's equity decreases, then even after flotation costs it is possible to achieve a lower WACC by issuing new common stock rather than relying on retained earnings.

C) Typically, the before-tax cost of debt exceeds the after-tax cost of equity.

D) Since the firm retains earnings not paid out as dividends, the cost of retained earnings is usually much cheaper than the cost of debt.

E) All of the statements above are incorrect.

A. If a company's tax rate increases but the YTM of its noncallable bonds stays the same, then, all else constant, the firm's WACC should decrease.

[Cost of Capital] Which statement is most correct?

A) Since there are no flotation costs, the cost of retained earnings will always be less than the after-tax cost of debt.

B) When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred dividends are tax deductible for the issuer.

C) If a company's tax rate increases, all else equal, its WACC will also increase.

D) A decrease in the risk-free rate, all else equal, will likely increase the marginal costs of both debt and equity.

E) A company's targeted capital structure will affect its cost of capital. Changes from the target may cause the WACC to either increase or decrease.

E. A company's targeted capital structure will affect its cost of capital. Changes from the target may cause the WACC to either increase or decrease.

[Cost of Capital] Select the statement that is most correct.

A) The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt in WACC.

B) The total return on a share of stock is the dividend yield less any commissions paid.

C) The cost of issuing preferred stock must be adjusted to an after-tax figure because of the 70% dividend exclusion for corporations holding other corporations' preferred stock.

D) The cost of retained earnings can be less than, equal to, or greater than the cost of external equity, depending on tax rates, flotation costs, investor attitudes, and other factors.

E) The component costs of capital are market-determined variables, in as much as they are based on investors' required returns.

E. The component costs of capital are market-determined variables, in as much as they are based on investors' required returns.

[Financial Statement Analysis] A company issued new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. This had no effect on total assets or operating income. Which effect occurred?

A) The current ratio decreased.

B) The basic earning power ratio increased.

C) The times interest earned ratio decreased.

D) The debt ratio increased.

E) The equity multiplier decreased.

E. The equity multiplier decreased.

(Less debt and more equity lowers total assets / equity.)

[Financial Statement Analysis] Companies C and D have the same total assets, the same EBIT, and the same tax rate. Company C has a higher debt ratio and interest expense than D, and a lower profit margin than D. Which statement is most correct?

A) Company C must have a higher level of sales.

B) Company C must have a lower ROE.

C) Company C must have a higher TIE ratio.

D) Company C must have a lower ROA.

E) Company C must have a higher BEP ratio.

D. Company C must have a lower ROA.

(Same assets and EBIT, but higher interest means lower net income.)

[Financial Statement Analysis] Company A's current ratio is 0.5 and Company B's is 1.5. Each firm doubles its current liabilities by adding short-term debt and puts the funds in cash. Which statement best describes the results?

A) No effect on the current ratios.

B) Only Company A's current ratio will increase.

C) Both current ratios will increase.

D) Only Company B's current ratio will increase.

E) Both current ratios will decrease.

B. Only Company A's current ratio will increase.

(A: $50/$100 = 0.50 becomes $150/$200 = 0.75. B: $150/$100 = 1.50 becomes $250/$200 = 1.25.)

[Financial Statement Analysis] Company A and Company B have the same tax rate, total assets, and basic earning power. Both have positive net incomes. Company A has a higher debt ratio and higher interest expense than B. Which statement is most correct?

A) Company A has a higher ROA.

B) Company A has a higher TIE ratio.

C) Company A has a higher net income.

D) Company A pays less in taxes than Company B.

E) Company A has a lower equity multiplier.

D. Company A pays less in taxes than Company B.

(Higher interest expense lowers taxable income.)

[Financial Statement Analysis] Which statement is least correct (most incorrect)?

A) In an inflationary environment, using FIFO rather than LIFO can lead to higher reported earnings, higher taxes, and lower cash flows. Likewise, basing depreciation on historical rather than replacement costs may lead to lower reported earnings, lower taxes, and higher cash flows.

B) Ratio analysis is used by managers, equity investors, long-term creditors, and short-term creditors, who may care about different aspects (equity investors: income statement; long-term creditors: balance sheet).

C) Seasonal factors matter when comparing firms; year-end balance sheets of two toy companies with different fiscal year ends may not be directly comparable.

D) A firm facing pure competition may be constrained to increasing asset turnover rather than profit margin, but can raise ROE by increasing financial leverage.

E) Ratio analysis is more us

A.

(Incorrect: historical-cost depreciation in inflation leads to HIGHER reported earnings, higher taxes, and lower cash flows, not lower earnings and taxes.)

[Financial Statement Analysis] Which statement is most incorrect?

A) If a firm's P/E has decreased for three years and finally drops below its industry P/E, it will clearly be undervalued and a good buy.

B) If two firms have the same total assets and BEP but one is all-equity and the other has debt, the firm with debt will have a lower ROA.

C) Firm A (uses debt) has a lower profit margin than Firm B (all equity) because of interest expense, but this does not mean A necessarily has a lower ROA.

D) If an industry's ROE exceeds a firm's ROE but both meet shareholders' required return, the firm may have less debt and a smaller equity multiplier, implying less financial risk and a lower required return.

E) To adjust for income statements being "flows over time" and balance sheets being "snapshots in time," take an average of beginning and ending balance sheet accounts when a ratio uses both.

A.

(Incorrect: a falling P/E that drops below the industry P/E does not clearly mean the stock is undervalued.)

[Financial Statement Analysis] Which statement is most correct?

A) In an inflationary environment, using FIFO instead of LIFO leads to a lower cost of goods sold and a higher cash flow.

B) In an inflationary environment, historical rather than actual costs for straight-line depreciation lead to both lower reported income and taxes.

C) In an inflationary environment, a firm is better off as a net debtor (owes more than is owed to it) than as a net creditor.

D) In an inflationary environment, using LIFO instead of FIFO leads to higher reported earnings.

E) In an inflationary environment, a firm should use LIFO instead of FIFO to maximize inventory value for collateral.

C. In an inflationary environment, a firm is better off as a net debtor (owes more than is owed to it) than as a net creditor.

[Financial Statement Analysis] Which statement is most incorrect?

A) Firms A and B have the same equity multiplier and ROA. If A raises its profit margin relative to B, A's ROE should rise relative to B's.

B) Du Pont analysis disaggregates ROA and ROE into component parts, helping explain changes over time or differences from the industry or peers.

C) Firms A and B have the same equity multiplier and ROA. If B raises its total asset turnover relative to A, B's ROE should rise relative to A's.

D) An increase in debt and interest expense will lead to a higher ROA, all else constant, but the added leverage may lower ROE.

E) One theory of why ROA differs across firms is a risk/return trade-off: the riskier the assets, the higher the return they should earn.

D.

(Incorrect: more debt and interest expense lowers ROA, and leverage may raise ROE.)

[Financial Statement Analysis] A profitable firm (positive net income) increases its short-term debt (notes payable) and invests the proceeds in assets earning more than its WACC. Which would you most expect to observe?

A) An increase in its current ratio.

B) A decrease in market value added (MVA).

C) No change in NOPAT.

D) An increase in economic value added (EVA).

D. An increase in economic value added (EVA).

[Financial Statement Analysis] Disaggregation of ROA and ROE allows us to do all of the following EXCEPT:

A) Determine whether the firm has effectively traded off its current ratio against its debt ratio to maximize ROE.

B) Determine how the firm's ROA and ROE compare with itself over time.

C) Determine how the firm's ROA and ROE compare with other firms or the industry.

D) Determine the underlying reasons why a firm's ROA is less or greater than another firm's or the industry's.

E) Determine whether the firm's use of debt has increased or decreased ROE relative to ROA.

A. Determine whether the firm has effectively traded off its current ratio against its debt ratio to maximize ROE.

[Financial Statement Analysis] Which statement about LIFO versus FIFO is most correct if a firm has been operating in an inflationary environment?

A) Firms that use FIFO will report lower earnings than if they used LIFO.

B) Firms that use FIFO will appear to have a stronger balance sheet (at least in inventory) than if they used LIFO, which may be best when arranging loans from creditors who look at inventory as collateral.

C) Since LIFO vs. FIFO is simply an accounting convention, sophisticated investors will realize there is no "real" effect on the firm.

D) Firms that use LIFO will report a lower cost of goods sold than if they used FIFO.

E) Firms that use LIFO will have a higher tax expense than if they used FIFO.

B. Firms that use FIFO will appear to have a stronger balance sheet (at least in inventory) than if they used LIFO, which may be best when arranging loans from creditors who look at inventory as collateral.

[Financial Statement Analysis] Company A and Company B have the same total assets, the same total assets turnover, and the same ROE. Company A has a higher ROA than Company B. Which statement is most correct?

A) Company A has a higher profit margin and a higher debt ratio.

B) Company A has a lower profit margin and a lower debt ratio.

C) Company A has a higher profit margin and a lower debt ratio.

D) Company A has lower net income but more common equity.

E) Company A has a lower P/E ratio.

C. Company A has a higher profit margin and a lower debt ratio than Company B.

[Financial Statements, Cash Flow, Taxes] A firm completed 2002 (its second year), depreciating fixed assets on a 20-year straight-line basis. It is profitable, makes no new fixed asset investment in 2003, and everything else is constant. If the firm changes its depreciable life from 20 years to 10 years for 2003, what would you most expect to observe (2002 vs. 2003)?

A) NOWC would decrease.

B) NOPAT would increase.

C) Total operating capital (TOC) would decrease.

D) Operating cash flow (OCF) would decrease.

E) Net income (NI) would increase.

C. Total operating capital (TOC) would decrease.

(More depreciation lowers net fixed assets.)

[Financial Statements, Cash Flow, Taxes] Info: retained earnings were $700,000 at year-end 2001 and $320,000 at year-end 2002; no dividends; depreciation is the only non-cash expense; no non-cash revenues; 2002 net cash flow was $150,000. Which statement is most correct?

A) The company had negative net income in 2002.

B) The company had positive net income in 2002, but less than in 2001.

C) 2002 depreciation expense was less than $150,000.

D) Year-end 2002 cash must be lower than year-end 2001 cash.

E) 2002 net cash flow must be higher than 2001 net cash flow.

A. The company had negative net income in 2002.

(Retained earnings fell by $380,000 with no dividends.)

[Financial Statements, Cash Flow, Taxes] Last year, a firm had positive net cash flow, yet cash on the balance sheet decreased. Which could explain this?

A) The company issued new common stock.

B) The company issued new long-term debt.

C) The company sold off some assets.

D) The company eliminated its dividend.

E) The company purchased a lot of new fixed assets.

E. The company purchased a lot of new fixed assets.

[Financial Statements, Cash Flow, Taxes] Which statement is least correct (most incorrect)?

A) The balance sheet is a snapshot at a point in time while the income statement covers a period, so some people use average beginning and ending balance sheet items for ratios mixing both.

B) Discounting free cash flows at WACC gives enterprise value; subtracting the market value of debt and other liabilities leaves the value of equity.

C) In the United States tax rates are regressive: wealthy taxpayers face a higher marginal rate, but their average tax rate is lower.

D) A firm can be financially healthy with negative free cash flows for several years, especially in start-up years (low NOPAT, large investments in NOWC and fixed assets).

E) If a firm has no interest expense, NI equals NOPAT and NCF equals OCF, regardless of fixed assets and depreciation.

C.

(Incorrect: U.S. personal tax rates are progressive, not regressive.)

[Financial Statements, Cash Flow, Taxes] Which is likely to INCREASE the additional funds needed (AFN) in a given year?

A) The company reduces its dividend payout ratio.

B) The company's profit margin increases.

C) The company decides to reduce its reliance on accounts payable as a form of financing.

D) The company is operating well below full capacity.

E) All of the statements above are correct.

C. The company decides to reduce its reliance on accounts payable as a form of financing.

[Financial Statements, Cash Flow, Taxes] Which statement is most incorrect?

A) One way to find the value of a firm's equity is to discount free cash flows available to equity shareholders at their required rate of return.

B) If price per share is above book value per share, MVA will be positive and market-to-book will be greater than 1.0.

C) One way to find the value of equity is to discount free cash flows to all investors at WACC, then subtract the market value of debt.

D) If a firm has interest-paying debt, NOPAT will always be more than net income, since NOPAT subtracts total tax on operations and ignores the interest tax shelter.

E) The firm's OCF for the past year can be calculated as the change in total operating capital, which equals the change in working capital (total current assets plus total current liabilities) plus the change in net fixed assets.

E.

(Incorrect: OCF is not calculated as the change in total operating capital, and working capital is current assets minus current liabilities, not plus.)

[Financial Statements, Cash Flow, Taxes] Which variable is NOT needed to determine a firm's free cash flow?

A) Net fixed assets

B) Net income

C) Current operating assets

D) Earnings before interest and taxes

E) Tax rate

B. Net income

[Financial Statements, Cash Flow, Taxes] Which statement is most correct?

A) Personal taxes are regressive: the lower your income, the more you pay as a percentage of taxable income.

B) Individuals may deduct 70% of dividend income before calculating taxes.

C) The "marriage penalty" reflects that married couples can be taxed up to 43% while individuals max out at 39.6%.

D) Since corporations can deduct interest before calculating taxable income, interest is paid with before-tax dollars.

E) Corporations may deduct 70% of any dividend they pay, creating a tax shelter like interest.

D. Since corporations are allowed to deduct interest before calculating taxable income, interest is paid with before-tax dollars.

[Financial Statements, Cash Flow, Taxes] Which statement concerning valuation is most correct?

A) A firm that takes on a risky project will increase its value as long as the project increases expected future cash flows.

B) Investors will not purchase the stock of a firm if they expect its cash flow to continually decrease.

C) One way to determine the value of equity is to first determine the value of the entire firm (free cash flows and WACC) and then subtract the value of the firm's debt.

D) One way to determine the value of equity is to find the present value of the firm's OCF using WACC.

E) Any firm whose equity has a value greater than zero will also have positive MVA and positive EVA.

C. One way to determine the value of a firm's equity is to first determine the value of the entire firm (free cash flows and WACC) and then subtract the value of the firm's debt.

[Financial Statements, Cash Flow, Taxes] Companies A and B have the same total assets. A has higher total assets turnover and higher profit margin than B. B has higher inventory turnover and a higher current ratio than A. Which statement is most correct?

A) Company A must have a higher net income.

B) Company A must have a higher ROE.

C) Company B must have a higher ROA.

D) Statements A and B are correct.

E) Statements A and C are correct.

A. Company A must have a higher net income.

(Same assets, higher TAT means higher sales, and higher margin on higher sales means higher NI.)

[Financial Statements, Cash Flow, Taxes] The CFO estimates the company's EVA for the past year was zero. Cost of equity is 10%, cost of debt is 6%, and debt ratio is 40%. Which statement is most correct?

A) Net income was zero.

B) Net income was negative.

C) ROA was 10%.

D) ROE was 10%.

E) After-tax operating income was less than the total dollar cost of capital.

D. The company's ROE was 10 percent.

(Zero EVA means ROE equals the cost of equity.)

[Financial Statements, Cash Flow, Taxes] Company A vs. Company B: profit margin 4% vs. 3%; ROA 9% vs. 8%; total assets $2.0B vs. $1.5B; BEP 20% vs. 20%; ROE 18% vs. 24%. Which statement is most correct?

A) A has a higher total assets turnover than B.

B) A has a higher debt ratio than B.

C) A has higher net income than B.

D) Statements A and B are correct.

E) All of the statements above are correct.

C. Company A has higher net income than Company B.

(A: ROA 9% x $2.0B = $180M. B: ROA 8% x $1.5B = $120M. B has higher TAT (2.667x vs. 1.350x) and higher debt ratio (0.667 vs. 0.505).)

[Financial Statements, Cash Flow, Taxes] Select the statement that is most correct.

A) Any forecast of financial requirements is obtained by adding increases in assets and spontaneous liabilities and subtracting operating income.

B) The percent of sales method requires only a forecast of the balance sheet; a forecasted income statement is not essential.

C) Because dividends are paid after taxes from retained earnings, they are not included in the percent of sales method.

D) Financing feedbacks describe the fact that interest must be paid on the debt used to finance AFN and dividends must be paid on the shares issued to raise the equity part of AFN; these payments lower the net income and retained earnings in the projected statements.

E) None of the statements above is correct.

D. Financing feedbacks: interest must be paid on the debt financing AFN and dividends on the shares issued for the equity part of AFN, lowering net income and retained earnings in the projected statements.

[Risk and Returns] Which statement is NOT (or least) correct?

A) The coefficient of variation is a measure of a distribution's dispersion per unit of expected value.

B) Although the beta of a diversified portfolio represents risk that cannot be diversified away, the beta of a single security is a measure of its total or stand-alone risk.

C) Beta can be defined as [COV(J,M) / Var(M)] or as [COR(J,M) x SD(J) / SD(M)], so a security with a higher correlation with the market does not necessarily have the higher beta.

D) The beta of a 100-stock portfolio will not necessarily be less than the beta of a 50-stock portfolio.

E) The standard deviation of a 100-stock portfolio will not necessarily be less than that of a 50-stock portfolio.

B.

(Incorrect: a single security's beta measures its market (non-diversifiable) risk, not its total or stand-alone risk.)

[Risk and Returns] Select the statement that is most correct.

A) Assuming everyone can lend and borrow at the same risk-free rate, rational investors will hold a portfolio on the capital market line (a ray from the risk-free rate tangent to the efficient frontier of risky securities).

B) The CAPM says a stock's required return equals the risk-free rate plus a risk premium compensating for diversifiable risk.

C) An investor can eliminate company-specific risk simply by increasing a security's correlation with the market.

D) The slope of the SML measures a security's beta, and beta can change whenever there is a change in expected inflation and/or risk aversion.

E) A portfolio of two perfectly positively correlated stocks will be exactly as risky as either stock.

A. Assuming everyone can lend and borrow at the same risk-free rate, rational investors will hold a portfolio on the capital market line.

[Risk and Returns] Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which statement is most correct?

A) Stock Y's actual return this year will be higher than Stock X's.

B) Stock Y's actual return has a higher standard deviation than Stock X.

C) If expected inflation increases (market risk premium unchanged), the required returns on the two stocks will increase by the same amount.

D) If the market risk premium declines (risk-free rate unchanged), Stock X will have a larger decline in required return than Stock Y.

E) A $50,000/$50,000 portfolio of X and Y will have a beta less than 1.0 provided the returns are not perfectly correlated.

C. If expected inflation increases (market risk premium unchanged), the required returns on the two stocks will increase by the same amount.

[Risk and Returns] Which statement is most correct?

A) Portfolio diversification reduces the variability of returns on the individual stocks held in the portfolio.

B) With enough stocks, an investor can eliminate virtually all company-specific risk; a portfolio of all publicly traded stocks would be riskless.

C) The required return on a firm's stock is determined by its systematic risk; if known and constant, no other information, including market information, is required to specify the required return.

D) A security's beta measures its non-diversifiable (systematic, or market) risk relative to that of the market or an "average stock."

E) A stock's beta is less relevant as a measure of risk to a well-diversified investor than to an investor who holds only that one stock.

D. A security's beta measures its non-diversifiable (systematic, or market) risk relative to that of the market or an "average stock."

[Risk and Returns] Which statement is most correct?

A) Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure stand-alone risk.

B) If the calculated beta underestimates the firm's true investment risk, the CAPM method will overestimate ks.

C) The DCF method of estimating the cost of equity can't be used unless g is constant during the analysis period.

D) An advantage shared by DCF and CAPM is that they yield precise estimates and require little or no judgment.

E) All of the statements above are false.

A. Beta measures market risk, but if a firm's stockholders are not well diversified, beta may not accurately measure stand-alone risk.