BFI Exam 2 Conceptuals

Which of the following statements is most correct? A. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. B. If an investor buys enough stocks, they can, through diversification, eliminate virtually all of the non-market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. C. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known and expected to remain constant, then no additional information, including market information, is required to specify the firm's 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" within the market. E. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio 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" within the market.

If Stocks J and K are constant growth stocks, and have the same required rate of return, but the price of Stock J is lower than the price of Stock K, then Stock J must have a lower expected dividend yield. A. True B. False

B. False

Select the statement that is most correct. A. Long-run sustainable growth is a function of the firm's retention rate and its return on equity. The firm's retention rate, when added to its dividend payout rate, must always sum to zero. B. The stockholders have the first claim on the firm's earnings and on specific assets in the event of the firm's default on their commitments. Therefore, these securities provide the least risk to investors. C. Most academic research clearly shows that markets are weak, semi-strong, and strong form efficient. D. Investors like dividends that grow over time. If a firm can take actions that will increase the growth rate of dividends, then the price of the stock will automatically increase. E. Markets are in equilibrium when supply is equal to demand. This is also where investors' required rates of return are equal to expected rates of return.

E. Markets are in equilibrium when supply is equal to demand. This is also where investors' required rates of return are equal to expected rates of return.

A firm is considering the purchase of an asset whose risk exceeds the current risk of the firm, based on any method for assessing risk. 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, as its acceptance would increase the firm's risk. D. Ignore the risk differential if the asset to be accepted would comprise only a small portion of the firm's total assets. E. Increase the cost of capital used to evaluate the project to reflect the higher risk associated with it.

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

Increasing a company's debt will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company's WACC. A. True B. False

B. False

Your company recently issued new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. This action had no effect on the company's total assets or operating income. Determine which of the following effects did occur as a result of this action. A. The company's current ratio decreased. B. The company's basic earning power ratio increased. C. The company's time interest earned ratio decreased. D. The company's debt ratio increased. E. The company's equity multiplier decreased.

E. The company's equity multiplier decreased.

You have collected the following information regarding Companies C and D: The two companies have the same total assets. The two companies have the same operating income (EBIT). The two companies have the same tax rate. Company C has a higher debt ratio and interest expense than Company D. Company C has a lower profit margin than Company D. On the basis of this information, select the statement that 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 times interest earned (TIE) ratio. D. Company C must have a lower ROA. E. Company C must have a higher basic earning power (BEP) ratio.

D. Company C must have a lower ROA.

Which of the following statements is most correct? A. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. B. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the non-market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. C. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information, including market information, is required to specify the firm's 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" within the market. E. A stock's beta is less relevant as a measure of risk to an investor with a well- diversified portfolio 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" within the market.

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements is most correct? A. Stock Y's actual return this year will be higher than Stock X's return. B. Stock Y's actual return has a higher standard deviation than Stock X. C. If expected inflation increases (but the market risk premium is unchanged), the required returns on the two stocks will increase by the same amount. D. If the market risk premium declines (leaving the risk-free rate unchanged), Stock X will have a larger decline in its required return than will Stock Y. E. If you invest $50,000 in Stock X and $50,000 in Stock Y, your portfolio will have a beta less than 1.0, provided the stock returns on the two stocks are not perfectly correlated.

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

The variance of a portfolio consisting of Securities 1 through 5, with weights W1 through W5, can be written as: σP² = W1²σ1² + W2²σ2² + W3²σ3² + W4²σ4² + W5²σ5² + 2W1W2COV12 + 2W1W3COV13 + 2W1W4COV14 + 2W1W5COV15 + 2W2W3COV23 + 2W2W4COV24 + 2W2W5COV25 + 2W3W4COV34 + 2W3W5COV35 + 2W4W5COV45 A. True B. False

A. True

The Efficient Frontier can be defined as consisting of those portfolios that offer the highest return for a given level of risk, or the least risk for a given level of return. A. True B. False

A. True

A covariance matrix involving N securities will have [ (N)(N) ] cells, [ N ] variance terms, [ (N)(N-1) / 2 ] covariance terms, and [ (N)*(N-1) / (N-1) ] pairs of covariance terms. A. True B. False

B. False

Assume that Securities A and B are expected to pay exactly the same dividend stream over time. However, Security A has a beta of -1.50, while Security B has a beta of +1.50. Because Security A has less risk than Security B (in fact, because of the negative beta it has less risk than a risk-free security), its required rate of return will be less and its price will be more than for Security B. A. True B. False

A. True

Fannie Mae uses duration to manage its interest rate risk. To do so, it attempts to maximize the difference between the duration of its assets and the duration of its liabilities. This help to maximize profits while immunizing or minimizing their exposure to interest rate risk. A. True B. False

B. False

Prices of debt (fixed income) securities are directly related to the required rate of return. As market interest rates (required rates of return) go up, the price of the security also goes up. A. True B. False

B. False

If you constructed a variance/covariance matrix for the S&P 500, you would need to calculate 500 variances and 124,750 pairs of covariances. A. True B. False

A. True

The variance of a 4-security portfolio can be calculated as follows: σP² = W1²σ1² + W2²σ2² + W3²σ3² + W4²σ4² + W1W2σ1σ2COR12 + W1W3σ1σ3COR13 + W1W4σ1σ4COR14 + W2W3σ2σ3COR23 + W2W4σ2σ4COR24 + W3W4σ3σ4COR34 A. True B. False

B. False

Given a risk-free rate of 5 percent and an expected return on the market of 12 percent (a market risk premium of 7 percent), a security with a beta of +2.0 will have a required rate of return of 19 percent, while a security with a beta of -2.0 will have a required rate of return of -9 percent. A. True B. False

A. True

The sinking of the PetroBras oil-drilling platform in March of 2001 is an example of company, or idiosyncratic risk, since the risk was specifically related to PetroBras, and not the market as a whole. And, as such, it could have been diversified away. A. True B. False

A. True

Because of flotation costs, the cost to the firm of debt financing, preferred stock, retained earnings, newly issued equity, etc., will always be greater than the investors' comparable required rates of return. A. True B. False

B. False

One common way of selecting a risk-adjusted discount rate for a project is simply to make a subjective adjustment to the firms overall cost of capital: increase the rate for higher-risk projects and decrease the rate for lower-risk projects. A. True B. False

A. True

Which of the following statements is not (or least) correct? A. The coefficient of variation is a measure of a distribution's degree of dispersion per unit of expected value. B. Although the beta of a diversified portfolio represents that risk which cannot be diversified away, the beta of a single security, since it is not diversified, is a measure of its total or stand-alone risk. C. Beta can be defined either as [(COVJM) / (σ²M)] or as [(CORJM)(σJ) / (σM)]. This indicates that when comparing securities, a security that has a higher correlation with the market may not necessarily also have the higher beta. D. The beta of a portfolio comprised of 100 stocks will not necessarily be less than the beta of a portfolio comprised of only 50 stocks. E. The standard deviation (or stand-alone risk) of a portfolio comprised of 100 stocks will not necessarily be less than the standard deviation of a portfolio comprised of only 50 stocks.

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

Select the statement that is most correct. A. Assuming that everyone can lend and borrow at the same risk-free rate, rational investors will hold a portfolio on the capital market line (i.e., a ray from the risk-free rate that is tangent to the efficient frontier of risky securities). B. The Capital Asset Pricing Model is based on the proposition that any stock's required rate of return is equal to the risk-free rate plus a risk premium that compensates investors 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 security market line measures a security's beta (non-diversifiable risk) and beta can change whenever there is a change in investors' expectations of inflation and/or their degree of risk aversion. E. A portfolio consisting of two stocks that are perfectly positively correlated will be exactly as risky (using either standard deviation or beta) as either of the stocks comprising the portfolio.

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

Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements is most correct? A. Stock Y's actual return this year will be higher than Stock X's return. B. Stock Y's actual return has a higher standard deviation than Stock X. C. If expected inflation increases (but the market risk premium is unchanged), the required returns on the two stocks will increase by the same amount. D. If the market risk premium declines (leaving the risk-free rate unchanged), Stock X will have a larger decline in its required return than will Stock Y. E. If you invest $50,000 in Stock X and $50,000 in Stock Y, your portfolio will have a beta less than 1.0, provided the stock returns on the two stocks are not perfectly correlated.

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

Which of the following statements is most correct? A. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. B. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the non-market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless. C. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information, including market information, is required to specify the firm's 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" within the market. E. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio 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" within the market.

Which of the following statements 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, then the CAPM method will overestimate ks. C. The discounted cash flow method of estimating the cost of equity can't be used unless the growth component, g, is constant during the analysis period. D. An advantage shared by both the DCF and CAPM methods of estimating the cost of equity capital, 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.

The Gordon Growth Model, for evaluating the price of a share of common stock, may also be used to find the price of preferred stock or any other perpetuity. A. True B. False

A. True

Because of diversification, a completely diversified portfolio of stocks has no market risk. A. True B. False

B. False

In the CAPM, the risk-free rate is multiplied by the stock's beta coefficient to determine the additional risk premium that is required by investors for the risk inherent in the stock. A. True B. False

B. False

Dell Corporation would be involved in a spot market transaction if it were to agree today to sell 500 computers, seven months from now at a price of $500 each, to Best Buy. A. True B. False

B. False

The degree of investors' risk aversion will have no effect on the security market line. A. True B. False

B. False

All other factors held constant, the higher a security's market risk, the higher its required rate of return, and the lower its price. A. True B. False

A. True

The Gordon Dividend Growth Model can be defined as [ D1 / Ks - g ]. However, for this model to work, the growth rate (g) must be positive and less than the required rate of return (Ks). A. True B. False

B. False

We can define the long-run sustainable growth rate of a firm as a function of the firm's retention rate and the firm's return on equity. A. True B. False

A. True

The retention rate of the firm is equivalent to the dividend payout rate of the firm. A. True B. False

B. False

In general, we can say that undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk. A. True B. False

A. True

To use the Gordon, constant growth model to evaluate the price of a firm's stock, based on the present value of the dividends to be paid on the stock, we must assume that the long-run sustainable growth rate of dividends is less than the investors' required rate of return. If we do not, we may easily get nonsensical results. A. True B. False

A. True

No rational investor should be willing to pay for a share of stock where the dividend is expected to decrease constantly over time. A. True B. False

B. False

If Stocks J and K are constant growth stocks, and have the same required rate of return, but the price of Stock J is lower than the price of Stock K, then Stock J must have a higher expected dividend yield. A. True B. False

B. False

If Stocks J and K are constant growth stocks, and have the same required rate of return, but the price of Stock J is lower than the price of Stock K, then Stock J must have a lower expected dividend yield. A. True B. False

B. False

If a stock is in constant growth, then the growth rate of its price (price appreciation or capital gain) is exactly the same as the growth rate of its dividends. A. True B. False

A. True

If a stock is in constant growth, then the growth rate of its dividends will be exactly the same as its expected dividend yield. A. True B. False

B. False

Which of the following statements is not (or least) correct? A. The constant growth model can be used to evaluate zero growth stocks, such as preferred stock. B. An alternative method of finding the price per share is to use free cash flows and the firm's cost of capital to determine an "enterprise" or firm value. Subtracting the value of the debt and other liabilities will leave us with the value of the firm's equity. If we then divide this value by the number of shares outstanding, this should give us the appropriate price per share. C. The investors' expected rate of return on common stock is equal to an expected dividend yield plus an expected capital gains yield. The expected capital gains yield is also the expected growth rate of the stock's price and, if the stock is a constant growth stock, it is also the expected growth rate of the firm's dividend. D. If markets were shown to be semi-strong-form efficient, then this would indicate that there is no value to either technical or fundamental analysis of stocks. E. In order to use the constant growth model to evaluate the price of a share of common stock, we must assume that the investor's required rate of return will be less than the long-run constant growth rate.

E. In order to use the constant growth model to evaluate the price of a share of common stock, we must assume that the investor's required rate of return will be less than the long-run constant growth rate.

Select the statement that is most correct. A. Long-run sustainable growth is a function of the firm's retention rate and its return on equity. The firm's retention rate, when added to its dividend payout rate, must always sum to zero. B. The stockholders have the first claim on the firm's earnings and on specific assets in the event of the firm's default on their commitments. Therefore, these securities provide the least risk to investors. C. Most academic research clearly shows that markets are weak, semi-strong, and strong form efficient. D. Investors like dividends that grow over time. If a firm can take actions that will increase the growth rate of dividends, then the price of the stock will automatically increase. E. Markets are in equilibrium when supply is equal to demand. This is also where investors' required rates of return are equal to expected rates of return.

E. Markets are in equilibrium when supply is equal to demand. This is also where investors' required rates of return are equal to expected rates of return.

Select the statement that is most correct. A. Markets are said to be weak, semi-strong, and strong form efficient if no one, except insiders, is able to earn abnormal returns (that is, beat the market) on a consistent basis. B. If two, constant growth stocks have the same required rate of return, but where the price of Stock A is greater than the price of Stock B, then Stock A must have a lower dividend yield. C. To find the current price of a supernormal growth stock, we must value both the dividends during the supernormal period as well as the price at the end of the supernormal period (equivalent to the value of the remaining dividend stream out to infinity), where both have been discounted to the present. D. Not only is the market value of a company equal to the expected future free cash flows discounted at the pre-tax cost of debt, but the value of the firm will increase as long as the firm's basic earnings power (BEP) is greater than the cost of the firm's debt. E. If stock prices are in equilibrium, then investing in the stock is the same as investing in a positive NPV project. That is, the expected return on the stock will be greater than the required rate of return on the stock.

C. To find the current price of a supernormal growth stock, we must value both the dividends during the supernormal period as well as the price at the end of the supernormal period (equivalent to the value of the remaining dividend stream out to infinity), where both have been discounted to the present.

If two constant growth stocks have the same required rate of return and the same price, which of the following statements is most correct? A. The two stocks must have the same per-share dividend. B. The stock with the higher dividend yield will have a higher dividend growth rate. C. The two stocks must have the same dividend growth rate. D. The stock with the higher dividend yield will have a lower dividend growth rate. E. The two stocks must have the same dividend yield.

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

Select the statement that is most correct. A. Risk aversion implies that some securities will go unpurchased in the market even if a large risk premium is paid to investors. B. The constant growth model used for evaluating the price of a share of common stock may also be used to find the price of perpetual preferred stock or any other perpetuity. C. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we know that Portfolio B will have the lower market risk; that is, Portfolio B will have the lower beta. D. According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock. E. Even if the correlation between the returns on two different securities is perfectly positively correlated, if the securities are combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held alone.

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

Stocks A and B have the same required rate of return and the same expected year-end dividend (D1). Stock A's dividend is expected to grow at a constant rate of 10 percent per year, while Stock B's dividend is expected to grow at a constant rate of 5 percent per year. Which of the following statements 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.

Select the statement that is most correct. A. Risk refers to the chance that some unfavorable event will occur, 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 inherent risk that remains is market risk, which is constant for all securities in the market. D. A stock with a beta of -1.0 has zero market risk. E. The SML relates required returns to the firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.

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

Which of the following statements is incorrect (least correct)? A. Theoretically, the price of a share of stock will decline by the present value of the dividend given up when the stock goes ex dividend. B. If a share of stock is growing at a constant rate, then the growth rate of dividends should be equal to the growth rate of price (capital appreciation). In addition, if the stock price is in a state of equilibrium, then this growth rate should also be equal to the investors' required rate of return minus the 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 is important because it protects existing shareholders against dilution of their ownership interests. E. To evaluate theoretical changes in dividend policy we assume that capital budgeting (investing) and capital structure (financing) decisions have already been made. Thus, increasing a dividend is accomplished by issuing new equity and decreasing a dividend is accomplished by repurchasing existing equity.

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

If a U.S. company with two divisions, one very risky and the other with significantly less risky, uses the same corporate discount rate to evaluate all projects, the most likely outcome, as discussed in class, 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. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.

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

When calculating a WACC for a company with preferred stock, there is no need to adjust the cost of the preferred stock to reflect the tax exclusion of 70% of the preferred stock dividend. A. True B. False

A. True

A firm can only have one break point in its marginal cost of capital curve, which will occur when they deplete their additions to retained earnings and must switch over to new issues of equity. A. True B. False

B. False

Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge a higher rate of interest to compensate for the present value of bankruptcy costs. A. True B. False

A. True

Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company's WACC. A. True B. False

B. False

Although quite rare, the mathematics is such that the after-tax component cost of debt financing can be greater than the after-tax component cost of equity financing. A. True B. False

B. False

The cost to the firm of retained earnings is zero, since they are generated from the current earnings of the firm and there are no flotation costs associated with their retention. A. True B. False

B. False

If we assume that the stock market is efficient, and if we assume that Stock A has a beta of 1.20, while Stock B has a beta of 1.40 (that is, B has higher risk than A), then we must also assume that the required rate of return on Stock B exceeds the required rate of return on Stock A. A. True B. False

A. True

If a firm must pay flotation expense when issuing a security, then the firm's required rate of return on that security will be greater than the investor's required rate of return for that security. A. True B. False

A. True

The easiest way to correctly calculate the firm's cost of debt is simply to multiply the coupon rate on the debt times one minus the firm's tax rate. A. True B. False

B. False

The cost of equity capital from the sale of new common stock (re) is generally equal to the cost of equity capital from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 - F). A. True B. False

B. False

If expectations for long-term inflation rose, but the slope of the SML remained constant, this, for most firms, would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd. In other words, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. (Hint: play with some numbers and see what happens.) A. True B. False

B. False

If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant. A. True B. False

B. False

Which of the following statements is not (or least) correct? A. Because of the tax shelter created by issuing preferred stock dividends (remember that 70 percent 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 (capital already raised by the firm) will have little significance when the firm looks at taking on new projects that will require them to issue additional capital. C. Assume that a firm is comprised of two divisions that differ significantly in risk and, therefore, in terms of their divisional screening rates. If the firm evaluates all investments by using a weighted average corporate cost of capital (rather than using divisional screening rates), the firm is likely to become more risky by taking on more of the higher-risk projects and become less valuable by taking on projects that earn a rate of return that is less than what they should be earned based on the actual risk of the project. D. Flotation costs may not be a significant factor for a firm's bonds, since many bond issues are privately placed (sold to institutional investors) with minimal administrative expense. That is, the firm essentially nets what the institutional investor pays. E. Flotation costs may be a significant factor when a firm issues new shares of common stock. If so, the firm's cost of equity (new issues of common stock) will be higher than the firm's cost of retained earnings, but the firm's cost of retained earnings will still be equal to the investors' required rate of return on the firm's common stock.

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

If a U.S. company with two divisions, one very risky and the other with significantly less risky, uses the same corporate discount rate to evaluate all projects, the most likely outcome, as discussed in class, 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. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.

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

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. 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 to be accepted would comprise only a small fraction of the total assets of the firm. 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.

Select the statement that is most correct. A. Since most stock is privately placed, a firm's required rate of return for a new issue of common stock will be equal to the investors' required rate of return for that same issue. 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 a lot cheaper than the cost of debt financing. E. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible.

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

Select the statement that is most correct. A. When a bond's coupon rate is greater than its yield to maturity, the coupon rate should be used as the firm's 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 cash flows at a rate above the firm's WACC, it is usually not appropriate to discount lower-than-average risk projects at a rate below the firm's WACC. D. Even if project risks vary widely within a firm, a project's cash flows should always be discounted at the corporate cost of capital (WACC). E. Because of the sheer size of large, publicly traded firms, it is more difficult to use the CAPM to estimate their cost of equity than to estimate it for small, privately held 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.

Which of the following statements is most correct? A. An increase in the corporate tax rate, all other factors held constant, should lead to an increase in a firm's weighted average cost of capital. 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 investor's and discounting it at the firm's weighted average cost of capital. D. Since most equity is privately placed for publicly traded corporations, flotation costs are negligible, and the firm's cost of a new issue of common stock will be, therefore, essentially the same as the investor's required rate of return. E. Since the market value of the firm's debt and equity will continuously change throughout the day, and since the firm's book value of debt and equity is much more stable over time, the firm should use book value weight 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 investor's and discounting it at the firm's weighted average cost of capital.

Which of the following statements is most correct? A. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same, then, all other factors held constant, the firm's WACC should decrease. B. If the beta of a company's equity decreases, then, even when flotation costs have been accounted for, it is possible for a company to achieve a lower WACC by issuing new shares of common stock to meet its equity needs, rather than relying upon retained earnings to meet those needs. C. Typically, the before-tax cost of debt financing exceeds the after-tax cost of equity financing. D. Since the firm retains any earnings that are not needed to be paid out as dividends, the cost of retained earnings is usually much cheaper that the cost of debt financing. E. All of the statements above are incorrect.

A. If a company's tax rate increases but the yield to maturity of its noncallable bonds remains the same, then, all other factors held constant, the firm's WACC should decrease.

Which of the following statements is correct (most correct)? A. Since there are no flotation costs associated with it, the cost of retained earnings will always be less than the after-tax cost of debt financing. B. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible for the issuing firm. C. If a company's tax rate increases then, all else equal, the company's weighted average cost of capital 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 securities. E. A company's targeted capital structure will affect its cost of capital. Changes from the target may cause the weighted average cost of capital 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 weighted average cost of capital to either increase or decrease.

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 for purposes of developing the firm's WACC. B. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. C. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. D. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, 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.

A firm with financial leverage will have a larger equity multiplier than an otherwise identical firm with no debt in its capital structure. A. True B. False

A. True

If a company were to issue debt and use the proceeds to increase assets, and if the company's return on assets (ROA) remained the same, then the return on equity (ROE) would increase. A. True B. False

A. True

If certain ratios for a firm's assets, such as accounts receivable turnover, inventory turnover, total asset turnover, etc., are generally constant over time, then the level (amount) of these assets can also be expressed as a percentage of sales. A. True B. False

A. True

Since ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same net income must have the same ROA. A. True B. False

B. False

Retained earnings is the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and thus, these cash accounts, when added together, will always be equal to the total retained earnings of the firm. A. True B. False

B. False

In accounting, emphasis is placed on determining net income. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary consideration is cash flow because that's what is used to run the business. A. True B. False

B. False

Since ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. A. True B. False

B. False

Suppose a firm wants to maintain a specific TIE ratio. If the firm knows the level of its debt, the interest rate it will pay on that debt, and the applicable tax rate, the firm can then calculate the earnings level required to maintain its target TIE ratio. A. True B. False

A. True

One of the problems of ratio analysis is that account relationships can be manipulated. For example, we know that if we use some of our cash to pay off some of our current liabilities, the current ratio will always increase, especially if the current ratio is low initially, for example, below 1.0. A. True B. False

B. False

Your company recently issued new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. This action had no effect on the company's total assets or operating income. Determine which of the following effects did occur as a result of this action. A. The company's current ratio decreased. B. The company's basic earning power ratio increased. C. The company's time interest earned ratio decreased. D. The company's debt ratio increased. E. The company's equity multiplier decreased.

E. The company's equity multiplier decreased.

You have collected the following information regarding Companies C and D: The two companies have the same total assets. The two companies have the same operating income (EBIT). The two companies have the same tax rate. Company C has a higher debt ratio and interest expense than Company D. Company C has a lower profit margin than Company D. On the basis of this information, select the statement that 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 times interest earned (TIE) ratio. D. Company C must have a lower ROA. E. Company C must have a higher basic earning power (BEP) ratio.

D. Company C must have a lower ROA.

Company A's current ratio is 0.5, while Company B's current ratio is 1.5. Both firms want to "window dress" their coming end-of-year financial statements. As part of its window dressing strategy, each firm will double its current liabilities by adding short-term debt and placing the funds obtained in the cash account. Which of the statements below best describes the actual results of these transactions? (Hint: you may wish to construct some simple numerical examples.) A. The transactions will have no effect on the current ratios. B. Only Company A's current ratio will be increased. C. The current ratios of both firms will be increased. D. Only Company B's current ratio will be increased. E. The current ratios of both firms will be decreased.

B. Only Company A's current ratio will be increased.

Company A and Company B have the same tax rate, total assets, and basic earning power. Both companies have positive net incomes. Company A has a higher debt ratio, and therefore, higher interest expense than Company B. Which of the following statements is most correct? A. Company A has a higher ROA than Company B. B. Company A has a higher times interest earned (TIE) ratio than Company B. C. Company A has a higher net income than Company B. D. Company A pays less in taxes than Company B. E. Company A has a lower equity multiplier than Company B.

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

Your company recently issued new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. This action had no effect on the company's total assets or operating income. Which of the following effects did occur as a result of this action? A. The company's equity multiplier decreased. B. The company's current ratio decreased. C. The company's basic earning power ratio increased. D. The company's time interest earned ratio decreased. E. The company's debt ratio increased.

A. The company's equity multiplier decreased.

Which of the following statements is least correct (most incorrect)? A. In an inflationary environment, a firm's use of FIFO rather than LIFO can lead to higher reported earnings, higher taxes, and lower cash flows. In the same manner, basing depreciation expense on historical costs rather than actual replacement values in an inflationary environment may lead to lower reported earnings, lower taxes, and higher cash flows. B. Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. However, it is not unusual for them to be concerned about different aspects of the firm. For instance, equity investors may be more concerned about the strength of the firm's income statement, while long-term creditors may be more concerned about the strength of the firm's balance sheet. C. We must be concerned about seasonal factors when comparing two firms or a firm against the industry average. For instance, it may be inappropriate to directly compare the year-end balance sheets of two toy companies if they have differing fiscal year ends. D. A firm that faces pure competition might wish to increase its ROA by increasing its profit margin, but may find itself constrained to increasing its asset turnover. In any event, the firm may be able to increase its ROE by increasing its degree of debt financing (that is, financial leverage). E. Ratio analysis becomes more useful when we: (1) look at how the ratios for a firm have changed over time, (2) look at how the ratios for a firm compare to the firm's peers or an industry average, and (3) understand how a "bad" ratio may be offset by a "good" ratio.

A. In an inflationary environment, a firm's use of FIFO rather than LIFO can lead to higher reported earnings, higher taxes, and lower cash flows. In the same manner, basing depreciation expense on historical costs rather than actual replacement values in an inflationary environment may lead to lower reported earnings, lower taxes, and higher cash flows.

Which of the following statements is most incorrect? A. Assume that a firm has had a decreasing P/E ratio for the last three years. When its P/E finally drops below the P/E for its industry, it will clearly be undervalued and a good buy for your investment portfolio. B. If two firms have the same total assets and the same basic earnings power (BEP), but one is all equity financed while the other has debt in its capital structure, then the firm with debt in its capital structure will have a lower ROA. C. Assume that Firm A uses debt while Firm B is an all-equity firm. Also assume that Firm A has a lower profit margin than Firm B because its use of debt results in interest expense. This does not mean that A will necessarily have a lower ROA than Firm B. D. Assume that the ROE for an industry is greater than the ROE for one of the firm's within the industry, but that both adequately meet their shareholders' required rate of return. One possibility is that the firm has less debt and a smaller equity multiplier that the industry as a whole, which could also imply that the firm's equity shareholders face less financial risk and thus require a smaller rate of return. E. One way to adjust for the fact that income statements are "flows over time" while balance sheets are "snapshots in time" is to take an average of the beginning and ending balance sheet accounts whenever you must calculate a ratio using data from both the income statement and the balance sheet.

A. Assume that a firm has had a decreasing P/E ratio for the last three years. When its P/E finally drops below the P/E for its industry, it will clearly be undervalued and a good buy for your investment portfolio.

Which of the following statements is most correct? A. In an inflationary environment, a firm's use of FIFO instead of LIFO will lead to a lower cost of goods sold and a higher cash flow. B. In an inflationary environment, the use of historical versus actual costs to record straight-line depreciation expense will lead to both lower reported income and taxes. C. In an inflationary environment, a firm is better off if it is a net debtor (owes more money than is owed to it) rather than a net creditor (owes less money than is owed to it). D. In an inflationary environment, a firm's use of LIFO instead of FIFO will lead to higher reported earnings. E. In an inflationary environment, a firm should use LIFO instead of FIFO if they are trying to maximize the possible value of their inventory for collateral purposes.

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

Which of the following statements is most incorrect? A. Assume that firm's A and B have the same equity multiplier and the same ROA. If firm A is able to increase its profit margin relative to firm B, all other factors held constant, then its ROE should increase relative to the ROE for firm B. B. Du Pont analysis allows us to disaggregate ROA and ROE into their component parts. This allows us to better understand why the ROA and ROE for a firm has changed over time, or why it differs from the industry or its peers. C. Assume that firm's A and B have the same equity multiplier and the same ROA. If firm B is able to increase its total asset turnover relative to firm A, all other factors held constant, then its ROE should increase relative to the ROE for firm A. D. An increase in debt and interest expense will lead to a higher ROA for a firm, all other factors held constant, but this increase in leverage may lower the firm's ROE. E. One theory of why we observe firms with differing levels of ROA is that there is a risk/return trade-off. That is, the more risky the assets, the higher the return the assets should earn.

D. An increase in debt and interest expense will lead to a higher ROA for a firm, all other factors held constant, but this increase in leverage may lower the firm's ROE.

Assume that a firm is profitable (positive net income) and that it increases its use of short-term debt (notes payable) and invests the proceeds in assets that earn a return greater than the firm's weighted average cost of capital. Which of the following would you most expect to observe? A. An increase in its current ratio (CR). B. A decrease in market value added (MVA). C. No change in its net operating profit after taxes (NOPAT). D. A decrease in market value added (MVA) E. An increase in economic value added (EVA)

E. An increase in economic value added (EVA)

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 its ROE. B. Determine how the firm's ROA and ROE compares with itself over time. C. Determine how the firm's ROA and ROE compares with other firms or the industry. D. Determine the underlying reasons why a firm may have an ROA that is less than or greater than another firm or the industry. E. Determine whether the firm's use of debt has increased or decreased the firm's ROE relative to its ROA.

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

Which of the following statements concerning 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 terms of inventory) than if they used LIFO: this may be best when trying to arrange loans from creditors, such as banks, that look at the value of inventory as collateral. C. Since the firm's use of LIFO versus FIFO is simply an accounting convention, financially sophisticated investors will realize that 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 terms of inventory) than if they used LIFO: this may be best when trying to arrange loans from creditors, such as banks, that look at the value of inventory as collateral.

Company A and Company B have the same total assets, the same total assets turnover, and the same return on equity. However, Company A has a higher return on assets than Company B. Given this information, determine which of the following statements is most correct. A. Company A has a higher profit margin and a higher debt ratio than Company B. B. Company A has a lower profit margin and a lower debt ratio than Company B. C. Company A has a higher profit margin and a lower debt ratio than Company B. D. Company A has lower net income but more common equity than Company B. E. Company A has a lower price earnings ratio than Company B.

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

An increase in a firm's debt ratio, with no changes in its sales and operating costs, could be expected to lower its profit margin on sales. A. True B. False

A. True

An increase in the DSO, other things held constant, would generally lead to an increase in the total assets turnover ratio. A. True B. False

B. False

One drawback of economic value added (EVA) as a performance measure is that it mistakenly assumes that equity capital is free. A. True B. False

B. False

If you look at two firms that are identical from an operational perspective (assets, costs, sales, etc.), except for their use of debt financing, then the firm with the higher debt ratio will also have the lower basic earnings power ratio. A. True B. False

B. False

One way to increase economic value added (EVA) is to maintain the same operating income with less capital. A. True B. False

A. True

Given recent changes in the tax laws, the marriage penalty (for a married couple, filing jointly) no longer exists. A. True B. False

B. False