# Finance chap 9, 12, 13

The company cost of capital is the appropriate discount rate for a firm’s
average-risk projects
Cost of capital is the same as cost of equity for firms
financed entirely by equity
The cost of capital for a project depends on:
The use to which the capital is put, i.e. the project
Using the company cost of capital to evaluate a project is:
Correct for projects that are about as risky as the average of the firms other assets
If a firm uses the same company cost of capital for evaluating all projects, which of the following is likely?
I) Rejecting good low risk projects
II) Accepting poor high risk projects
III) Correctly accept projects with average risk
If firms use the company cost of capital for evaluating all of their projects, which of the following is likely?
Correctly accept projects with average risk
Which of the following types of projects have the highest risk?
Speculation ventures
A firm might categorize its projects into:
I) Cost improvement projects
III) New products projects
IV) Speculative ventures
Which of the following type of projects has the lowest risk?
Cost improvement
Which of the following type of projects has average risk?
The hurdle rate for capital budgeting decisions is:
The cost of capital
The company cost of capital when debt as well as equity is used for financing is
the weighted average cost of capital (WACC)
The after-tax weighted average cost of capital (WACC) is calculated using the formula
WACC = (rD) (1 – TC ) (D/V) + (rE) (E/V) where: V = D + E
Cost of equity can be estimated using:
A. Discounted cash flow (DCF) approach
B. Capital Asset Pricing Model (CAPM)
C. Arbitrage Pricing theory (APT
D. The Fama-French three-factor model
The historical returns data for the past three years for Company A’s stock is -6.0%, 15%, 15%and that of the market portfolio is 10%, 10% and 16%. According to the security market line (SML), the Stock A is:
Over priced
On a graph with common stock returns on the Y- axis and market returns on the X-axis, the slope of the regression line represents the
Beta
Generally, the value to use for the risk-free interest rate is:
Short-term Treasury bill rate
Financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent is a
Haircut for risk
An example of diversifiable risk that should be ignored when analyzing project risk would include
Stock price fluctuations
A fudge factor might include
Risk of government non-approval
What does a low standard error mean relative to beta?
Beta is a reliable measurement of risk
In the principal-agent framework, the ultimate principal is:
Shareholders
The following are agency problems in capital budgeting except
Accepting all the positive NPV projects
The following are agency problems associated with capital budgeting:
A. Reduced effort
C. Empire building
D. Perks
The following capital expenditure(s) are (is) included in the capital budget
Investment in a new office building
Which of the following capital expenditure may not appear in capital budget?
Investment in training employees
The following actions by the managers may result in over-investment problem
I) entrenching investments
II) empire building
III) investing beyond the point where NPV falls zero
Managers on a fixed salary are subjected to following temptations all the time
I) reduced effort
II) perks or private benefits
III) empire building
IV) entrenching investments
V) avoiding risks
Agency costs can be thought of as the loss in the value of a firm resulting from the following actions by managers
I) reduced effort
II) perks or private benefits
III) empire building
IV) entrenching iinvestments
V) avoiding risks
Monitoring is done by:
I) Shareholders
II) Board of Directors
III) Independent accountants
IV) Lenders
The ultimate responsibility for monitoring a firm rests with
Shareholders
In large public companies monitoring is delegated to
Shareholders
Agency costs can be reduced by monitoring
I) managers efforts
II) managers actions
III) by intervening when managers veer off course
Free-rider problem in the case of monitoring results in
I) ineffective monitoring by the shareholders
II) monitoring being delegated
III) no monitoring by a large number of small individual investors
Because monitoring is not perfect, managers compensation plans must be designed provide them incentives to
maximize the value of the firm to the shareholders
Generally, mangers compensation is based on
verifiable results
CEO compensation is the highest in
USA
When stock options are given to managers as incentives, typically the exercise price of these options is set equal to the firms
stock price on the day the options are granted.
Stern-Stewart
Economic Value Added (EVA) is calculated as follows
EVA = Income Earned – (cost of capital) * (investment)
Economic profit (EP) is calculated as follows
EP = (ROI – r) * (capital invested) where r = cost of capital
The following are disadvantages of using EVA as a measure of performance except
EVA reduces explicit monitoring by top management
The following are advantages of using EVA as a measure of performance except
EVA does not measure present value
EVA is used for
I) Measuring performance within the firm
II) Rewarding performance within the firm
III) Improving performance within the firm
The following firms have positive EVAs
A. Microsoft
C. Wal-Mart Stores
D. Intel Corp.
The following firms have negative EVAs
A. Time Warner
B. Pfizer
C. IBM
The plant manager can improve EVA by
I) increasing earnings
IV) reducing capital employed
Generally, firms with high levels of intangible assets tend to report
Higher than actual ROI
Economic rate of return is defined as:
[(C1 + PV1 – PV0 )]/(PV0)
According to the survey of senior managers by Graham, Harvey and Rajgopal, the senior managers admitted to the following
I) adjusting their firms operations and investments in order to manage earnings.
II) they were willing to decrease discretionary spending in R&D, advertising or maintenance if necessary to meet earnings target.
III) many of them would, if necessary, also defer or reject investment projects with positive NPVs
If the capital markets are efficient, then the sale or purchase of any security at the prevailing market price is
Generally a zero NPV transaction
Financing decisions differ from investment decisions for which of the following reasons?
The market for financial assets is more active
Financing decisions differ from investment decisions because:
I) it is easy to reverse a financing decision
II) the market for financial assets is very competitive
III) generally, financing decisions have zero NPV
Generally, a firm is able to find positive NPV opportunities with
Capital investment decisions
The statement that stock prices follow a random walk implies that:
Successive price changes are independent of each other
The statement that stock prices follow a random walk implies that:
The correlation coefficient between successive price changes (auto correlation) is not significantly different from zero.
Stock price cycles or patterns self-destruct as soon as investors recognize them through
Which of the following is a statement of weak form efficiency?
If markets are efficient in the weak form, then it is impossible to make consistently superior profits by using trading rules based on past returns
Different forms of market efficiency are:
I) Weak form
II) Semi-strong form
III) Strong form
Which of the following statement(s) is/are true if the efficient market hypothesis holds
it implies that prices reflect all available information
Strong form market efficiency states that the market incorporates all information in the stock price. Strong form efficiency implies that
An insider or corporate officer can not outperform the market by trading on the inside information
If the weak form of market efficiency holds then
I) Technical analysis is useless
II) Stock prices reflect information contained in past prices
III) Stock price changes follow a random walk
Which of the following is a statement of semi-strong form efficiency??
If the markets are efficient in the semi-strong form then prices will adjust immediately to public information
If the efficient market hypothesis holds, investors should expect
I) to receive a fair price for their security
II) to earn a normal rate of return on their investments
Predictable cycles in stock price movements
self destruct as soon as investors recognize them
Informational efficiency in financial markets result in stock prices being
fairer
Weak form efficiency implies that past stock price(s)
do not matter
If the markets are efficient, none of the following investors should have above normal return on assets over time
A. Those who choose their stocks by throwing darts at a list of stocks found in the financial pages of a newspaper.
B. Analysts who spend considerable time evaluating the best stocks to buy.
C. Mutual fund managers who manage other peoples money for a living
One important implication of the efficient markets hypothesis is that
investors should hold a diversified portfolio and avoid active trading.
The semi-strong form of efficiency deals with the following type of information
publiicly available information
The semi-strong form of has been tested by measuring how rapidly security prices react various news items like
I) earnings announcements
II) dividend announcements
III) news of takeovers
IV) macroeconomic information
Adjusted stock return is calculated as
return on stock-return on market
In order to test the efficient-market hypothesis in the weak form, researchers have used the following methods except:
Measurement of how rapidly security prices adjust to different news items
Abnormal stock return is calculated as:
actual stock return-expected stock return
n order to test the efficient-market hypothesis in the semi-strong form, researchers have used(the):
Measurement of how rapidly security prices adjust to different news items
The event study methodology is used in the test of:
semi-strong form efficiency
In order to test the strong form of market efficiency, researchers have
I) examined the recommendations of professional security analysts
II) performance of mutual funds
III) performance of pension funds
Which of the following observations would provide evidence against the strong form of efficient market theory
Managers who trade in their own firms stocks make superior returns
A lawyer works for a firm that advises corporate firms planning to sue other corporations for antitrust damages. He finds that he can beat the market by short selling the stock of the firm that will be sued. This finding is in violation of the:
Strong form market efficiency
Strong-form efficiency implies that mutual fund managers:
Buy the index that maximizes diversification and minimizes cost of managing portfolios
The following are anomalies associated with market efficiency except:
The various lessons of market efficiency are
I) Markets have no memory
II) Trust market prices
IV) There are no financial illusions
V) The do-it yourself alternative
VI) Seen one stock, seen them all
Studies on behavioral finance have been developed using
psychological evidence
Investors are particularly averse to the possibility of even a very small loss and need a high return to compensate for it. Such a concept is related to what theory
Prospect theory
Which theory offers an explanation for the crash of a stock market one day and its rebound the next
Random walk theory

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