STUDY GUIDE 1. What is the beta of a firm whose equity has an expected return of 21.30%, the risk-free rate is 7%, and the expected return on the stock market is 18%? 2. Two reasons for the agency problem in modern corporations is: A. Dispersion of ownership, B. Managers know how to manage the firm better than stockholders, C. Separation of ownership and control of the firm, D. [A] and [C]. 3. Capital budgeting includes the evaluation of which of the following? A. Size of future cash flows only B. Size and timing of future cash flows C. Timing and risk of future cash flows D. Risk and size of future cash flows only E. Size, timing, and risk of future cash flows 4. According to corporate finance, the financial manager is responsible for: A. Capital budgeting, B. The Financing decision, C. Dividend policy, D. All of the above. 5. The primary goal of a corporate finance manager is to maximize: A. Current profits B. Market share C. Number of shares outstanding D. Value of the firm E. Revenue growth 6. Which of the following direct incentives may align management goals with shareholder interests? I. Employee stock options II. Threat of a takeover III. Management bonuses tied to performance goals IV. Threat of a proxy fight A. I and III only B. II and IV only C. I, II, and III only D. I, III, and IV only E. I, II, III, and IV 7. The group of stakeholders of a firm includes: A. Anyone with a direct or indirect interest in the firm as an ongoing business concern. B. Anyone with control of the firm. 8. The net present value of any investment represents the difference between the investments: A. cash inflows and outflows. B. cost and its net profit. C. cost and its market value. D. cash flows and its profits. E. assets and liabilities. 9. The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to: A. produce a positive annual cash flow. B. produce a positive cash flow from assets. C. offset its fixed expenses. D. offset its total expenses. E. recoup its initial cost. 10. Which one of the following defines the internal rate of return for a project? A. Discount rate that creates a zero cash flow from assets B. Discount rate that results in a zero net present value for the project C. Discount rate that results in a net present value equal to the project’s initial cost D. Rate of return required by the project’s investors E. The project’s current market rate of return 11. Both Projects A and B are acceptable as independent projects. However, the selection of either one of these projects eliminates the option of selecting the other project. Which one of the following terms best describes the relationship between Project A and Project B? A. Mutually exclusive B. Conventional C. Multiple choice D. Dual return E. Crosswise 12. Which one of the following indicates that a project is expected to create value for its owners? A. Profitability index less than 1.0 B. Payback period greater than the required period of time C. Positive net present value D. Positive average accounting rate of return E. Internal rate of return that is less than the project’s opportunity cost 13. The net present value: A. decreases as the required or hurdle rate of return increases. B. is equal to the initial investment when the internal rate of return is equal to the required return. C. method of analysis cannot be applied to mutually exclusive projects. D. is directly related to the discount rate. E. is unaffected by the timing of an investment’s cash flows. 14. If an investment is producing a return that is equal to the required cost of capital, the project’s net present value will be: A. positive. B. greater than the project’s initial investment. C. zero. D. equal to the project’s net profit. E. less than, or equal to, zero. 15. If the initial investment of project X is -$400 million dollar, the cash flow at the end of year 1 is +$ 960 million and at the end of year 2 is $-572 million. Is the IRR the right tool to make the investment decision? (No need for calculations, just answer yes, no, or maybe). 16. One implicit managerial incentive is: A. The firm’s probability of bankruptcy, B. Stock-options, C. A bonus, D. [B] and [C]. 17. Which one of the following methods of analysis is most appropriate to use when two investments are mutually exclusive? A. Internal rate of return B. Profitability index C. Net present value D. Equivalent annuities E. B and D 18. The net present value of project A is $442 with a maturity of 5 years. The net present value of project B is $478 with a maturity of 10 years. If the WACC is 12% and both projects are mutually exclusive which one you will pick? 19. Any changes to a firm’s projected future cash flows that are caused by adding a new project are referred to as which one of the following? A. Eroded cash flows B. Deviated projections C. Incremental cash flows D. Directly impacted flows E. Assumed flows 20. Jamie is analyzing the estimated net present value of a project under various what if scenarios. The type of analysis that Jamie is doing is best described as: A. sensitivity analysis. B. erosion planning. C. scenario analysis. D. benefit planning. E. opportunity evaluation 21. If financial markets are not efficient, then: A. Expected returns are not needed, B. The need for a discount rate to analyze project cash flows is not needed, C. Estimates of expected returns based on security prices are not reliable, D. None of the above. 22. Scenario analysis: A. determines the impact a $1 change in sales has on the internal rate of return. B. determines which variable has the greatest impact on a project’s net present value. C. helps determine the reasonable range of expectations for a project’s anticipated outcome. D. evaluates a project’s net present value while sensitivity analysis evaluates a project’s internal rate of return. E. determines the absolute worst and absolute best outcome that could ever occur. 23. Turner Industries started a new project three months ago. Sales arising from this project are exceeding all expectations. Given this, which one of the following is management most apt to implement? A. Option to wait B. Soft rationing C. Strategic option D. Option to abandon E. Option to expand 24. Ignoring the option to wait: A. may overestimate the internal rate of return on a project. B. may underestimate the net present value of a project. C. ignores the ability of a manager to increase output after a project has been implemented. D. is the same as ignoring all strategic options. E. ignores the value of discontinuing a project early. 25. The ability to delay an investment: A. is commonly referred to as the best-case scenario. B. is valuable provided there are conditions under which the investment will have a positive net present value in the future. C. ensures that the investment will have an expected net present value that is positive. D. offsets the need to conduct sensitivity analysis. E. is referred to as the option to abandon. 26. Explain the concept of incremental cash flow analysis and its purpose. 27. Identify three managerial options that relate to project analysis and explain how those options affect the net present value of a project. 28. Which one of the following describes systemic risk? A. Economic-driven risk that affects a large number of assets B. An individual security’s total risk C. Diversifiable risk D. Asset specific risk E. Risk unique to a firm’s management 29. Which of the following terms can be used to describe unsystematic risk? I. Asset-specific risk II. Diversifiable risk III. Market risk IV. Unique risk A. I and IV only B. II and III only C. I, II, and IV only D. II, III, and IV only E. I, II, III, and IV 30. Which one of the following statistics measures the amount of systematic risk present in a particular risky asset relative to that in an average risky asset? A. Squared deviation B. Beta coefficient C. Standard deviation D. Mean E. Variance 31. From the financial point of view the asset side of the balance sheet of a corporation includes: A. Fixed assets, B. Growth assets, C. Assets in place, D. [B] and [C]. 32. Which one of the following is the slope of the security market line? A. Risk-free rate B. Market risk premium C. Beta coefficient D. Risk premium on an individual asset E. Market rate of return 33. Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive to any potential investor? A. Risk-free rate B. Market risk premium C. Expected return minus the risk-free rate D. Market rate of return E. Cost of capital 34. Which one of the following is the computation of the risk premium for an individual security? E(R) is the expected return on the security, Rf is the risk-free rate, β is the security’s beta, and E(RM) is the expected rate of return on the market. A. E(RM) – Rf B. E(R) – E(RM) C. E(R) – [E(RM) + Rf] D. β[E(RM) – Rf] E. β[E(R) – Rf] 35. Which one of the following is the best example of unsystematic risk? A. Inflation exceeding market expectations B. A warehouse fire C. Decrease in corporate tax rates D. Decrease in the value of the dollar E. Increase in private personal consumer spending 36. Which one of the following is the best example of systematic risk? A. Discovery of a major gas field B. Decrease in textile imports C. Increase in agricultural exports D. Decrease in gross domestic product E. Decrease in management bonuses for banking executives 37. Standard deviation measures _____ risk while beta measures _____ risk. A. systematic; unsystematic B. unsystematic; systematic C. total; unsystematic D. total; systematic E. asset-specific; market 38. Which one of the following portfolios will have a beta of zero? A. A portfolio that is equally as risky as the overall market B. A portfolio that consists of a single stock C. A portfolio comprised solely of U. S. Treasury bills D. A portfolio with a zero variance of returns E. No portfolio can have a beta of zero. 39. A risky security has less risk than the overall market. What must the beta of this security be? A. 0 B. > 0 but < 1 C. 1 D. > 1 E. The beta cannot be determined based on the information provided. 40. The addition of a risky security to a fully diversified portfolio: A. must decrease the portfolio’s expected return. B. must increase the portfolio beta. C. may or may not affect the portfolio beta. D. will increase the unsystematic risk of the portfolio. E. will have no effect on the portfolio beta or its expected return. 41. Which one of the following is the vertical intercept of the security market line? A. Market rate of return B. Individual security rate of return C. Market risk premium D. Individual security beta multiplied by the market risk premium E. Risk-free rate 42. Based on the capital asset pricing model, investors are compensated based on which of the following? I. Market risk premium II. Portfolio standard deviation III. Portfolio beta IV. Risk-free rate A. I and III only B. II and IV only C. I, II, and III only D. I, III, and IV only E. I, II, III, and IV 43. Ben & Terry’s has an expected return of 12.9 percent and a beta of 1.25. The expected return on the market is 11.7 percent. What is the risk-free rate? A. 3.87 percent B. 4.24 percent C. 4.61 percent D. 6.29 percent E. 6.92 percent 44. Under the narrow definition of corporate governance, the financial manager is responsible for making decisions that are in the best interest of the firm’s owners. A. True, B. False 45. The weighted average cost of capital is defined as the weighted average of a firm’s: A. return on its investments. B. cost of equity and its after-tax cost of debt. C. pretax cost of debt and equity securities. D. bond coupon rates. E. dividend and capital gains yields. 46. Which of the following will increase the cost of equity for a firm with a beta of 1.1? I. Decrease in the security’s beta II. Decrease in the market risk premium III. Decrease in the risk-free rate IV. Increase in the risk-free rate A. II only B. III only C. I and II only D. II and III only E. I and IV only 47. All else constant, which of the following will increase the after-tax cost of debt for a firm? I. Increase in the yield to maturity of the firm’s outstanding debt II. Decrease in the yield to maturity of the firm’s outstanding debt III. Increase in the firm’s tax rate IV. Decrease in the firm’s tax rate A. I only B. I and III only C. I and IV only D. II and III only E. II and IV only 48. Which one of the following will affect the capital structure weights used to compute a firm’s weighted average cost of capital? A. Decrease in the book value of a firm’s equity B. Decrease in a firm’s tax rate C. Increase in the market value of the firm’s common stock D. Increase in the market risk premium E. Increase in the firm’s beta 49. A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, and an after-tax cost of debt of 6 percent. Given this, which one of the following will increase the firm’s weighted average cost of capital? A. Increasing the firm’s tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm’s beta E. Increasing the debt-equity ratio 50. Bermuda Cruises issues only common stock and coupon bonds. The firm has a debt-equity ratio of 0.65. The cost of equity is 18.3 percent and the pretax cost of debt is 9.9 percent. What is the capital structure weight of the firm’s equity if the firm’s tax rate is 34 percent? A. 46.75 percent B. 49.97 percent C. 52.93 percent D. 59.08 percent E. 60.61 percent 51. M & M proposition I states that the capital structure problem is irrelevant A. True, B. False. 52. The WACC of the firm is 13%. You know that the firm’s cost of debt is 10% and the cost of equity 20%. What proportion of the firm is financed with debt? 53. Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship? A. Static theory of interest rates B. M&M Proposition I C. Financial risk D. Interest tax shield E. Homemade leverage 54. No separation in the capital markets: A. Provides support to the pecking order theory of Myers and Majluf, B. Means that there is only one big global market, C. Builds from Akerlof’s lemons problem, D. [A] and [C]. 55. Which one of the following is a direct bankruptcy cost? A. Loss of customer goodwill resulting from a bankruptcy filing B. Legal and accounting fees related to a bankruptcy proceeding C. Management time spent on a bankruptcy proceeding D. Any financial distress cost E. Costs a firm spends trying to avoid bankruptcy 56. Given the lemons problem: A. One can observe a market breakdown, B. Information asymmetries are crucial to explain the efficiency of the markets, C. Cross-subsidization may happen, D. All of the above. 57. Two determinants of the optimal debt ratio are: A. Depreciation, B. Operating risk, C. Marginal tax rate, D. [B] and [C]. 58. Which one of the following statements is the core principle of M&M Proposition I (without taxes)? A. A firm’s cost of equity is directly related to the firm’s debt-equity ratio. B. A firm’s WACC is directly related to the firm’s debt-equity ratio. C. The interest tax shield increases the value of a firm. D. The capital structure of a firm is totally irrelevant. E. Levered firms have greater value than unlevered firms. 59. Which one of the following is an implication of M&M Proposition II (with taxes)? A. A firm’s optimal capital structure is 100 percent debt. B. WACC is unaffected by the capital structure of a firm. C. WACC decreases as the debt-equity ratio increases. D. A firm’s capital structure is irrelevant. E. The risk of equity depends on financial leverage and the riskiness of the firm’s operations. 60. Which one of the following represents the present value of the interest tax shield? A. D × (1 – Tc) B. D/(1 – Tc) C. D/Tc D. D – D(Tc) E. Tc × D 61. Which one of the following factors favors a high-dividend payout? A. Low transaction costs on stock trades B. Lower taxes on capital gains than on dividends C. Tax deferment on capital gains, but not on dividend income D. Flotation costs E. Corporate shareholders 62. Cash dividends send which two of the following signals to the market? I. Agency costs will be lowered since less cash will be held by the firm. II. The firm is planning on downsizing. III. The firm is currently, and expects to continue to be, profitable. IV. The firm will no longer conduct stock repurchases. A. I and II only B. II and III only C. III and IV only D. II and IV only E. I and III only 63. The winners’ curse in IPOs refers to: A. The negative price reaction after going public because of overvaluation. B. The negative price reaction after going public because of colluding between the syndicate of underwriters and the issuer. 64. The beta of the stock is 1.25, the marginal tax rate of the firm is 36%, and the debt equity ratio is 0.30. What is the value of the unlevered beta? 65. Explain briefly the pecking order theory of funds developed by Myers and Majluf (1984)? What is Ross (1977) argument for separation in the capital markets?