ARE 171 Final MC Review UC DAVIS

You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?

The discount rate increases

Market Risk is

Caused by things that affect all stocks

Agency Costs refer to:

the costs of any conflicts of interest between stockholders and management

The relationship between nominal interest rates on default-free, pure discount securities and the time to maturity is called the

Term structure of interest rates

The time value of money concept can be defined as

The relationship between a dollar to be received in the future and a dollar today

Your bank account pays a 6% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is correct?

The periodic rate of interest is 1.5% and the effective rate of interest is greater than 6%

Which of the following bank accounts has the highest effective annual return?

a)An account that pays 8% nominal interest with monthly compounding. b)An account that pays 8% nominal interest with annual compounding. c)An account that pays 7% nominal interest with daily (365-day) compounding. d)An account that pays 7% nominal interest with monthly compounding. e)An account that pays 8% nominal interest with daily (365-day) compounding.

e) An account that pays 8% nominal interest with daily (365-day) compounding.

The functions of the finance department include all of the following activities except:

a)paying employees and vendors b)selling products to customers c)selling stock d)receiving payments from customers e)paying dividends

receiving payments from customers

An agreement giving the bond issuer the option to repurchase the bond at a specified price prior to maturity is the _____ provision.

call

Which of the following constitute the interest rate model?

r = r* + inflation adjustment + default risk premium + liquidity risk premium + maturity risk premium

The increased volatility of longer term bonds in response to interest rate movements is reflected in the

Maturity Risk Premium

Your aunt is about to retire, and she wants to sell some of her stock and buy an annuity that will provide her with income of $12,500 per month for 30 years, beginning a year from today. The current annual rate on such annuities is 6.00%. How much would it cost her to buy such an annuity today?

2,084,895.18

Which of the following statements is correct?

a)The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

b)The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

c)The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.

d)If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.

e)The real risk-free rate should increase if people expect inflation to increase.

The yield on a 2-year corporate bond should always exceed the yield on a 2-Year Treasury Bond

Which of the following risks do debt ratings specifically measure?

Default Risk

The risks associated with owning a single stock are called

Stand-alone risk because the stock stands alone outside of any portfolio

A 20 Year Treasury Bond and Corporate Bond have the following rates and ratings: T-Bond: 7.72%, AAA= 8.72%, A=9.64%, BBB= 10.18%

The differences in these rates were probably caused primarily by:

Default and liquidity risk differences

If its yield to maturity is less than its coupon rate, a bond will sell at a _____, and increases in market interest rates will _____.

premium, decrease this premium

The primary goal of financial management is to:

Maximize the current value per share of the existing stock

If its YTM declined by 1%, which of the following bonds would have the largest percentage increase in value?

a)A 1-year zero coupon bond.

b)A 1-year bond with an 8% coupon.

c)A 10-year bond with an 8% coupon.

d)A 10-year bond with a 12% coupon.

e)A 10-year zero coupon bond.

A 10-year, zero coupon bond

The practice generally known as double taxation is due to

a)shareholders' dividends being taxed at both the federal and state levels.

b)corporate income being taxed at both the federal and state levels.

c)both A and B above.

d)corporate incomes being taxed at the corporate level, then again at the shareholder level when corporate profits are paid out as dividends.

d)corporate incomes being taxed at the corporate level, then again at the shareholder level when corporate profits are paid out as dividends.

t/f

A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to personal liabilities in the event of bankruptcy than are investors in a typical partnership.

false

t/f

If a bank compounds savings accounts quarterly, the nominal rate (r) will exceed the effective annual rate (APY)

false

t/f

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

false

t/f

If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*

true

t/f

Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond. False.

false

Tom O'Brien has a 2-stock portfolio with a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio's beta?

1.17

Which of the following arises because long-term bond prices change more with interest rate movements than short-term bond prices?

Maturity Risk

Which of the following statements is correct?a)Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.

b)If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

c)If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

d)If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

D) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Coupon Rate Formula

Annual Coupon/Par Value

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.)

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

The interest rates we observe in the economy differ from the risk-free rate because of

Risk Premiums

7)Which of the following statements is correct?

a)If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.

b)Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

c)The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.

d)Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.

e)Higher flotation costs tend to reduce the cost of equity capital.

A) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject

Discounted Payback?

(#Years prior to full recovery) + (Cumulative Discounted -CF (Year prior) / Discounted CF)

Payback

(# Years prior to full recovery) + (Unrecovered cost at start of year/ Cash flow during full recovery year)

What is the cost of equity raised by selling new common stock? (Formula)

r^e= [(D1)/(P1)(1-F)] + g

If current interest rates are higher than a bond's coupon rate, owners can:

a)hold the bond until maturity, at which point its market value will equal its face value

b)sell the bond at a premium, because investors are sensitive to price changes in bonds caused by increased interest rates

c)sell the bond at a discount, because investors recognize that the lower the bond's price the higher is its yield

d)a and c

D) A and C

-Hold the bons until maturity, at which point its market value will equal its face value

-Sell the bond at a discount, because investors recognize that the lower the bond's price, the higher is its yield

Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and Bond Z has a 12% annual coupon. Each of the bonds is noncallable, has a maturity of 10 years, and has a yield to maturity of 10%. Which of the following statements is correct?

a)Bond X has the greatest reinvestment rate risk.

b)If market interest rates decline, the prices of all three bonds will increase, but Z's price will have the largest percentage increase.

c)If the bonds' market interest rate remains at 10%, Bond Z's price will be lower one year from now than it is today.

d)If market interest rates remain at 10%, Bond Z's price will be 10% higher one year from today.

e)If market interest rates increase, Bond X's price will increase, Bond Z's price will decline, and Bond Y's price will remain the same.

If the bonds'market interest rate remains at 10%, Bond Z's price will be lower one year from now than it is today.

Acompany is considering a new project. The CFO (chief financial officer) plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to include in the cash flows when estimating the relevant cash flows?

a)all sunk costs that have been incurred relating to the project.

b)all interest expenses on debt used to help finance the project.

c)sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.

d)the investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

e)effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

d)the investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

Which of the following rules is correct for capital budgeting analysis

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.

Which of the following statements is correct?

a)The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.

b)For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.

c)Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.

d)If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.

e)The percentage difference between the MIRR and the IRR is equal to the project's WACC.

Multiple IRRs can exist, but not multiple MIRRS. This is one reason why some people favor the MIRR over the regular IRR.

The payback rule states that you should accept projects:

If the payback period is less than some pre-specified period of time

which of the possible answers best describes the historical betas for A and B, given the following rates

Market: .03, -.05, .01, 0.1, .06

Stock A: .16, .20, .18, .25, .14

Stock B: .05,.05,.05,.05,.05

bA< 0; bB= 0.

Turnips and Parsley common stock sells for $39.86 a share at a market rate of return of 9.5%. The company just paid their annual dividend of $1.20. What is the rate of growth of their dividend? Hint: Use the dividend pricing model

P0= D1(1+g)/(r-g)

.063

Which one of the following is the best example of two mutually exclusive projects?

a)planning to build a warehouse and a retail outlet side by side

b)buying sufficient equipment to manufacture both desks and chairs simultaneously

c)using an empty warehouse for storage or renting it entirely out to another firm

d)using the company sales force to promote sales of both shoes and socks

e)buying both inventory and fixed assets using funds from the same bond issue

C) Using an empty warehouse for storage or renting it entirely out to another firm.

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

a)If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

b)If Project A has a higher IRR than Project B, then Project A must have the lower NPV.

c)If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

d)The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC.

e)The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.

a) If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

Which of the following statements is correct?a)The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.b)The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.c)The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.d)If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.e)a, b, and c are all true.

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Once a bond has been issued, if the holder of the bond retains it until maturity:

the market value of the bond may change, but the cash flows will not.

The characteristic line is graphically depicted as

the plot of the security returns against the market index returns.

The definition of agency problem is

the difficulties that arise when a principle hires an agent and cannot fully monitor the agent's actions.

Which of the following statements is correct?

a)One of the advantages of the corporate form of organization is that it avoids double taxation.

b)It is easier to transfer one's ownership interest in a partnership than in a corporation.

c)One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote."

d)Corporations of all types are subject to the corporate income tax.

e)One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability.

e)One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability.

Which of the following statements is correct?

a)The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.

b)The most likely explanation for an inverted yield curve is that investors expect inflation to increase.

c)The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.

d)If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.

e)Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

c)The most likely explanation for an inverted yield curve is that investors expect inflation to decrease

The relationship between nominal rates, real rates, and inflation is known as the:

Fisher Effect

You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would increase the calculated value of the investment?

The discount rate decreases

The security market line depicts the graphical relationship between which two things?

Required Return and Systematic Risk

t/f

The preferred stock of a given firm is generally less risky to investors than the same firm's common stock

true

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, what must be true?

(Stock A: beta 1.1, constant growth rate of 7%)

(Stock B: beta .9, constant growth rate of 7%)

Stock A must have a higher dividend yield than stock B

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?

a)If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

b)Stock Y's realized return during the coming year will be higher than Stock X's return.

c)If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.

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

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

C) If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.

Define the CAPM formula and stock price formula for solving for a company's stock price

CAPM: Rs=Rrf + (Rm-Rrf) * bs

P0=[D1(1+g)]/(r-g)

The_____premium is that portion of a nominal interest rate or bond yield that represents compensation for the possibility of nonpayment by the bond issuer.

default risk

Which one of the following statements is correct concerning bond classifications?

a)A debenture is a long-term bond secured by the fixed assets of a firm.

b)A note is a bond which has an original maturity date longer than 10 years.

c)A subordinated bond receives preferential treatment over all other bonds in a bankruptcy.

d)A callable bond can be repurchased by the issuer prior to the initial maturity date.

e)All of the above are true.

d) A callable bond can be repurchased by the issuer prior to the initial maturity date

The more frequent the compounding the

greater the effective interest rate (APY)

The distinguishing feature of a corporation is that:

It is a legally defined, artificial being, separate from its owners

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

a)The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium.

b)It is impossible to tell without knowing the coupon rates of the bonds.

c)The yields on the two securities would be equal.

d)It is impossible to tell without knowing the relative risks of the two securities.

e)The yield on a 10-year bond would be less than that on a 1-year bill.

e) The yield on a 10-year bond would be less than that on a 1-year bond

The _____ premium is that portion of a nominal interest rate or bond yield that represents compensation for expected future overall price appreciation.

Inflation

The rate of return by investors in the market for owning a bond is called the

Yield to Maturity

Semi-annual coupon payment formula

(i*PAR)/2

A portfolio of securities has a beta of 1.14. Given this, you know that

The expected return on the portfolio is greater than the expected market return

These individuals examine a firm's financial strength for its debt holders

Credit Analysts

Systematic Risk is measured by

beta

Dirty bond price formula

Market Price + (Days since last coupon payment/ days in coupon period)

The written, legally binding agreement between the corporate borrower and the lender detailing the terms of a bond issue is called the:

indenture

More frequent compounding results in future values and present values than less frequent compounding at the same nominal interest rate.

higher, lower

An account managed by the bond trustee for early bond redemption payments is called a:

Sinking fund

Which of the following is not an advantage of sole proprietorship?

Single Taxation, Ease of setup, limited liability, no separation of ownership and control

Limited Liability

Where will a security plot in relation to the security market line (SML) if it is considered to be a good purchase because it is underpriced?

Above the SML

t/f

The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the greater the present value of a given lump sum to be received at some future date.

false

t/f

A perpetuity, a special form of annuity, pays cashflows and is not affected by interest rate changes.

False.

t/f

The higher the rate of interest the smaller the present value of a future sum of money.

True

The definition of agency problem is

The difficulties that arise when a principle hires an agent and cannot fully monitor the agent's actions

As individual legal entities, corporations assume liability for their own debts, so the shareholders hold

only limited liability

t/f

The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month.

true

Bond Price Formula

i*PAR/2[(1/r/m)-(1/(1/r/m)(1+/r/m)^mt] + PAR/(1+r/m)^mt

Nominal Dollar Value for coupon payments made during t amount of years?

iPARt

PV of a coupon payment made at the end of 6.5 years?

coupon payment/ (1+r)^mt

The WACC is used to _______ the expected cash flows when the firm has ____________ .

discount; debt and equity in the capital structure

The dividend discount model assumes that

At least one dividend will be paid in the future

Stock Price formula?

P0=D1(1+g)/(r-g)

WACC formula using bonds and common equity

(Weight for debt)(Bond yield)(1-Tax rate) + (Weight of common equity)*(Rate to bring stock into market)

You are trying to determine whether to accept project A or project B. These projects are mutually exclusive. As part of

your analysis, you should compute the incremented IRR by determining:

the internal rate of return for the differences in the cash flows of the two projects.

The beta of a security provides an

estimate of the systematic risk of the security.

The WACC is used to _______ the expected cash flows when the firm has ____________ .

discount; debt and equity in the capital structure

The stated interest payment, in dollars, made on a bond each period is called the bond's:

coupon

The mixture of debt and equity used by a firm to finance its operations is called:

capital structure

standard deviations measure_______ risk

total

A stock with an actual return that lies above the security market line

has yielded a higher return than expected for the level of risk assumed

Which of the following issues should be considered with respect to the accuracy of stock pricing models.

a) assumptions regarding growth rates are imprecise

b) assumptions regarding market returns are difficult to make accurately

c) the dividend discount model is only an approximation of the present value of an infinite stream of future cash flows.

d) both (a) and (b) above have to be considered.

e) all of the above have to be considered.

d) both (a) and (b) above have to be considered.

The market price of _____ maturity bonds fluctuates _____ compared with _____ maturity bonds as interest rates

change

shorter, less, longer

The internal rate of return (IRR):

Is the rate generated solely by the cash flows of an investment and is the rate that causes the NPV of a project to exactly equal 0.

The slope of the characteristic line is the estimated

beta

The cost of equity from selling new stock is greater than the cost of retained earnings because

of flotation costs