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08/02/2018 Basic Finance Flashcards | Quizlet

Basic Finance 69 terms rjd210

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A market index is used True


to measure
performance of a
broad-based portfolio
of stocks.

For investment False - Stocks, due to their greater risk, have had higher
horizons greater than returns than long-term corporate bonds.
20 years, long-term
corporate bonds
traditionally have
outperformed
common stocks.

If one portfolio's True


variance exceeds that
of another portfolio, its
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standard deviation will


also be greater than
that of the other
portfolio.
Market risk can be False - Diversification does not eliminate market risk.
eliminated in a stock
portfolio through
diversification.

The risk that remains in False - It is known as systematic, market, risk.


a stock portfolio after
efforts to diversify is
known as unique risk.

The tighter the False - The tighter, more peaked, the probability
probability distribution distribution is the more likely you are going to earn the
of its expected future expected return. So, a tighter probability distribution
returns, the greater the indicates less risk, a smaller standard deviation.
risk of a given
investment as
measured by its
standard deviation.

Risk-averse investors True - Risk-averse means investors do not like to take


require higher rates of risk, but they will be willing to take risk if they expect to
return on investments earn a higher return.
whose returns are
highly uncertain, and
most investors are risk
averse.

An individual stock's True - Adding more stocks to a portfolio will reduce the
diversifiable risk can diversifiable risk.
be lowered by adding
more stocks to the
portfolio in which the
stock is held.

Bad managerial True


judgments or
unforeseen negative
events that happen to
a firm are defined as
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"company-specific," or
"unsystematic," events,
and their effects on
investment risk can in
theory be diversified
away.

The fact that historical common stocks should offer a higher return than
returns on Treasury Treasury bills.
bills are less volatile
than common stock
returns indicates that:

The risk premium that excess of expected return over a risk-free return
is offered on common
stock is equal to the:

Treasury bonds have greater price risk due to longer maturities.


provided a higher
historical return than
Treasury bills, which
can be attributed to:

An individual stock's False - Beta measures systematic risk, the risk that cannot
diversifiable risk, which be diversified away, not diversifiable risk.
is measured by its
beta, can be lowered
by adding more stocks
to the portfolio in
which the stock is held.

According to the True


Capital Asset Pricing
Model, investors are
primarily concerned
with portfolio risk, not
the risks of individual
stocks held in isolation.
Thus, the relevant risk
of a stock is the stock's
contribution to the
riskiness of a well-
diversified portfolio.
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Bad managerial True - Investors' degree of risk aversion determines the


judgments or market risk premium, which will ultimately determine the
unforeseen negative slope of the SML
events that happen to
a firm are defined as
"company-specific," or
"unsystematic," events,
and their effects on
investment risk can in
theory be diversified
away.

The capital asset True


pricing model (CAPM)
assumes that the stock
market is dominated
by well-diversified
investors who are
concerned only with
market risk.

Which of the following b. Lower beta stocks have higher required returns.
statements is
CORRECT?

a. The slope of the


security market line is
equal to the market
risk premium.
b. Lower beta stocks
have higher required
returns.
c. A stock's beta
indicates its
diversifiable risk.
d. Diversifiable risk
cannot be completely
diversified away.
e. Two securities with
the same stand-alone

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risk must have the


same betas.

Assume that investors a. The required rate of return for an average stock will
have recently become increase by an amount equal to the increase in the
more risk averse, so market risk premium.
the market risk
premium has - An average risk stock has a beta of one. So, the
increased. Also, required rate of return of an average stock will increase
assume that the risk- directly in proportion with the market risk premium.
free rate and expected
inflation have not
changed. Which of the
following is most likely
to occur?

a. The required rate of


return for an average
stock will increase by
an amount equal to the
increase in the market
risk premium.
b. The required rate of
return will decline for
stocks whose betas
are less than 1.0.
c. The required rate of
return on the market,
rM, will not change as
a result of these
changes.
d. The required rate of
return for each
individual stock in the
market will increase by
an amount equal to the
increase in the market
risk premium.
e. The required rate of

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return on a riskless
bond will decline.

Why do stock market Unique risks are assumed to be diversified away.


investors appear not to
be concerned with
unique risks when
calculating expected
rates of return?

If a security plots offering too little return to justify its risk. - If a security's
below the security return plots below the security market line, it means is it
market line, it is: expected to provide less return than is "fair." So, it is
providing too little return, given its risk.

The company cost of the proposal has a different degree of risk. - Remember,
capital may be an the required return, the cost of capital, needs to be
inappropriate discount adjusted for the risk of the cash flows being discounted.
rate for a capital So, if the project has a different degree of risk than the
budgeting proposal if: overall firm, the cost of capital should be adjusted to
a. it calculates a reflect this risk.
negative NPV for the
proposal.

The cost of debt is False - We estimate the cost of debt by calculating the
equal to one minus the yield to maturity, not by using the coupon rate. So, it
marginal tax rate should be the yield to maturity times one minus the
multiplied by the marginal tax rate.
average coupon rate
on all outstanding
debt.

If a firm's marginal tax True - An increase in the marginal tax rate will reduce the
rate is increased, this after-tax cost of debt.
would, other things
held constant, lower
the cost of debt used
to calculate its WACC.

When using the WACC True


as a discount rate, it is
often adjusted upward
for riskier projects and

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downward for safer


projects.

5. For a company d. The cost of equity is always greater than the cost of
whose target capital debt.
structure calls for 50% - Since equity holders take more risk, there cost should
debt and 50% always be greater than the cost of debt.
common equity, which
of the following
statements is
CORRECT?

a. The interest rate


used to calculate the
WACC is the average
after-tax cost of all the
company's outstanding
debt as shown on its
balance sheet.
b. The WACC is
calculated on a
before-tax basis.
c. The WACC exceeds
the cost of equity.
d. The cost of equity is
always greater than
the cost of debt.
e. The cost of retained
earnings typically
exceeds the cost of
new common stock.

Other things held False - You compare the cost of capital to the internal
constant, an increase rate of return. So, a change in the cost of capital will not
in the cost of capital impact the calculated internal rate of return. The internal
will result in a rate of return is independent of the cost of capital.
decrease in a project's
IRR.

Under certain True - Yes, if you have non-normal cash flows, more than
conditions, a project one change in sign, you can have a multiple IRR

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may have more than problem.


one IRR. One such
condition is when, in
addition to the initial
investment at time = 0,
a negative cash flow
(or cost) occurs at the
end of the project's
life.

Unlike using IRR, True


selecting projects
according to their NPV
will always lead to a
correct accept-reject
decision.

The NPV method's True - Reinvestment at the cost of capital is a more


assumption that cash realistic assumption than reinvestment at the project's
inflows are reinvested internal rate of return since there is no guarantee the
at the cost of capital is firm will be able to reinvest the cash flows in another
generally more project that provides the same rate of return.
reasonable than the
IRR's assumption that
cash flows are
reinvested at the IRR.
This is an important
reason why the NPV
method is generally
preferred over the IRR
method.

The regular payback False - Both the payback and discounted payback
method is deficient in methods fail to account for the cash flows beyond the
that it does not take payback period.
account of cash flows
beyond the payback
period. The discounted
payback method
corrects this fault.

Which of the following e. One defect of the IRR method versus the NPV is that

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statements is the IRR does not take proper account of differences in


CORRECT? the sizes of projects.

a. One defect of the - There is a potential scale problem when comparing


IRR method versus the mutually exclusive projects using the internal rate of
NPV is that the IRR return method.
does not take account
of cash flows over a
project's full life.
b. One defect of the
IRR method versus the
NPV is that the IRR
does not take account
of the time value of
money.
c. One defect of the
IRR method versus the
NPV is that the IRR
does not take account
of the cost of capital.
d. One defect of the
IRR method versus the
NPV is that the IRR
values a dollar
received today the
same as a dollar that
will not be received
until sometime in the
future.
e. One defect of the
IRR method versus the
NPV is that the IRR
does not take proper
account of differences
in the sizes of projects.

Which of the following b. One drawback of the payback criterion for evaluating
statements is projects is that this method does not properly account
CORRECT? Assume for the time value of money. - The payback method does
that the project being not account the time value money.

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considered has normal


cash flows, with one
outflow followed by a
series of inflows.

a. The longer a
project's payback
period, the more
desirable the project is
normally considered
to be by this criterion.
b. One drawback of
the payback criterion
for evaluating projects
is that this method
does not properly
account for the time
value of money.
c. If a project's
payback is positive,
then the project
should be rejected
because it must have a
negative NPV.
d. The regular payback
ignores cash flows
beyond the payback
period, but the
discounted payback
method overcomes
this problem.
e. If a company uses
the same payback
requirement to
evaluate all projects,
say it requires a
payback of 4 years or
less, then the company
will tend to reject
projects with relatively
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short lives and accept


long-lived projects,
and this will cause its
risk to increase over
time.

Assume a project has b. A project's NPV increases as the WACC declines.


normal cash flows. All - As you reduce the discount rate, the WACC, the
else equal, which of project's NPV will increase.
the following
statements is
CORRECT?

a. A project's IRR
increases as the WACC
declines.
b. A project's NPV
increases as the WACC
declines.
c. A project's MIRR is
unaffected by changes
in the WACC.
d. A project's regular
payback increases as
the WACC declines.
e. A project's
discounted payback
increases as the WACC
declines.

Which of the following a. The NPV method assumes that cash flows will be
statements is reinvested at the WACC, while the IRR method assumes
CORRECT? reinvestment at the IRR.

a. The NPV method


assumes that cash
flows will be
reinvested at the
WACC, while the IRR
method assumes
reinvestment at the
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IRR.
b. The NPV method
assumes that cash
flows will be
reinvested at the risk-
free rate, while the IRR
method assumes
reinvestment at the
IRR.
c. The NPV method
assumes that cash
flows will be
reinvested at the
WACC, while the IRR
method assumes
reinvestment at the
risk-free rate.
d. The NPV method
does not consider all
relevant cash flows,
particularly cash flows
beyond the payback
period.
e. The IRR method
does not consider all
relevant cash flows,
particularly cash flows
beyond the payback
period.

Which of the following c. One reason some people prefer the MIRR to the
statements is regular IRR is that the MIRR is based on a generally more
CORRECT? reasonable reinvestment rate assumption. - The MIRR
assumes reinvestment at the WACC, which is more
a. The MIRR and NPV reasonable than assuming reinvestment at the IRR, which
decision criteria can is what the IRR method assumes.
never conflict.
b. The IRR method can
never be subject to the
multiple IRR problem,

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while the MIRR


method can be.
c. One reason some
people prefer the
MIRR to the regular
IRR is that the MIRR is
based on a generally
more reasonable
reinvestment rate
assumption.
d. The higher the
WACC, the shorter the
discounted payback
period.

If an investment True - You are giving up the opportunity to sell the land.
project would make So, there's an opportunity cost
use of land which the
firm currently owns,
the project should be
charged with the
opportunity cost of the
land.

If debt is to be used to False - Financing costs are accounted for in the WACC.
finance a project, then So, if you were to account for them in the cash flows,
when cash flows for a you would be double counting them.
project are estimated,
interest payments
should be included in
the analysis.

If a project permits a True - A reduction in net working capital is a positive


reduction in the level cash flow, whereas an increase in net working capital is a
of net working capital, negative cash flow.
this reduction is
assumed to increase
cash flows.

When funds must be True - Unless indicated otherwise, we always assume


committed to net recovery of net working capital at the end of the
working capital, those project's life.

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funds are assumed to


be recovered at the
end of the project's
life.

Upon the sale of False - If the book value of the equipment exceeds the
equipment at the end sales price, the equipment is being sold at a loss. So,
of its useful life, tax rather than a tax liability, we would expect a tax asset
liability will be incurred (tax savings from selling the equipment at a loss).
whenever the book
value of the equipment
exceeds the sales
price.

In cash flow True - Any side effects, externalities, should be


estimation, the accounted for in the analysis.
existence of
externalities should be
taken into account if
those externalities
have any effects on
the firm's long-run
cash flows.

Which of the following e. Sunk costs that have been expensed for tax purposes.
is NOT a relevant cash - Sunk costs are ignored since they are not incremental.
flow and thus should
NOT be reflected in
the analysis of a capital
budgeting project?

a. Changes in net
operating working
capital.
b. Shipping and
installation costs for
machinery acquired.
c. Cannibalization
effects.
d. Opportunity costs.
e. Sunk costs that have

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been expensed for tax


purposes.

Which of the following b. An example of an externality is a situation where a


statements is bank opens a new office, and that new office causes
CORRECT? deposits in the bank's other offices to decline. - This
would be an example of a negative externality since it
a. An externality is a hurts another area of the business.
situation where a
project would have an
adverse effect on
some other part of the
firm's overall
operations. If the
project would have a
favorable effect on
other operations, then
this is not an
externality.
b. An example of an
externality is a situation
where a bank opens a
new office, and that
new office causes
deposits in the bank's
other offices to
decline.
c. The NPV method
automatically deals
correctly with
externalities, even if
the externalities are
not specifically
identified, but the IRR
method does not. This
is another reason to
favor the NPV.
d. Both the NPV and
IRR methods deal
correctly with

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externalities, even if
the externalities are
not specifically
identified. However,
the payback method
does not.
e. Identifying an
externality can never
lead to an increase in
the calculated NPV.

Rowell Company spent If the building could be sold, then the after-tax proceeds
$3 million two years that would be generated by any such sale should be
ago to build a plant for charged as a cost to any new project that would use it. -
a new product. It then We must account for the opportunity cost.
decided not to go
forward with the
project, so the building
is available for sale or
for a new product.
Rowell owns the
building free and
clear--there is no
mortgage on it. Which
of the following
statements is
CORRECT?

A company is a. In calculating the project's operating cash flows, the


considering a firm should not deduct financing costs such as interest
proposed new plant expense, because financing costs are accounted for by
that would increase discounting at the WACC. If interest were deducted
productive capacity. when estimating cash flows, this would, in effect, "double
Which of the following count" it.
statements is
CORRECT?

a. In calculating the
project's operating
cash flows, the firm
should not deduct
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financing costs such as


interest expense,
because financing
costs are accounted
for by discounting at
the WACC. If interest
were deducted when
estimating cash flows,
this would, in effect,
"double count" it.
b. Since depreciation is
a non-cash expense,
the firm does not need
to deal with
depreciation when
calculating the
operating cash flows.
c. When estimating the
project's operating
cash flows, it is
important to include
both opportunity costs
and sunk costs, but the
firm should ignore the
cash flow effects of
externalities since they
are accounted for in
the discounting
process.
d. Capital budgeting
decisions should be
based on before-tax
cash flows because
WACC is calculated on
a before-tax basis.
e. The WACC used to
discount cash flows in
a capital budgeting
analysis should be
calculated on a
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before-tax basis. To do
otherwise would bias
the NPV upward.

The extra risk resulting False - The extra risk brought on by the use of debt is
from a firm's use of called financial risk.
debt is called business
risk.

The trade-off theory True - We trade-off the tax shield benefit from the debt
states that capital versus the additional financial risk (costs) brought on by
structure decisions the debt.
involve a tradeoff
between the costs and
benefits of debt
financing

Other things held True - Firms with more stable and predictable operating
constant, firms with income, have lower business risk, which means they will
more stable and likely take on more financial risk.
predictable operating
income tend to use
more debt than firms
with less stable sales.

Other things held False - A lower tax rate reduces the interest tax shield,
constant, the lower a making debt less attractive.
firm's tax rate, the
more logical it is for
the firm to use debt.

Under MM, when taxes unlevered firm plus the present value of the tax shield. -
are considered, the Remember, Modigliani and Miller are making the
value of a levered firm assumption that there are no distress or bankruptcy cost.
equals the value of So, if you only account for taxes, the value of the levered
the: firm is equal to the value of the unlevered firm plus the
present value of the debt tax shield.

The "trade-off theory" firms with higher risk should use less debt. - A firm that
of capital structure has higher risk to begin with will find that the benefit of
suggests that: the tax shield from the debt is more quickly offset by the
increasing financial risk as more debt is used.

Debt may be the equity issuance is considered by investors to be a


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preferred form of negative sign. - The direct and indirect costs of issuing
external financing for equity (the flotation costs) are quite high. One of the
many firms because: indirect costs of issuing equity is the negative signal that
it conveys to the market. The flotation costs of issuing
debt are much lower than equity.

According to the tax savings and financial distress and bankruptcy costs.
trade-off theory, the
capital structure is a
trade-off between:

Which of the following d. Increasing a company's debt ratio will typically


statements is increase the marginal costs of both debt and equity
CORRECT? financing. However, this action still may lower the
company's WACC. - Even though the costs of both debt
a. Since debt financing and equity increase as you use more debt financing, the
raises the firm's weighted average cost of capital might not necessarily
financial risk, increase since the weightings used to calculate the
increasing the target weighted average cost of capital are also changing while
debt ratio will always at the same time the cost of debt is lower than the cost
increase the WACC. of equity.
b. Since debt financing
is cheaper than equity
financing, raising a
company's debt ratio
will always reduce its
WACC.
c. Increasing a
company's debt ratio
will typically reduce
the marginal costs of
both debt and equity
financing. However,
this action still may
raise the company's
WACC.
d. Increasing a
company's debt ratio
will typically increase
the marginal costs of
both debt and equity
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financing. However,
this action still may
lower the company's
WACC.
e. Since a firm's beta
coefficient is not
affected by its use of
financial leverage,
leverage does not
affect the cost of
equity.

Based on the c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price =
information below, $31.20. - Our goal is to choose the capital structure with
what is the firm's the highest expected stock price.
optimal capital
structure?

a. Debt = 40%; Equity =


60%; EPS = $2.95;
Stock price = $26.50.
b. Debt = 50%; Equity =
50%; EPS = $3.05;
Stock price = $28.90.
c. Debt = 60%; Equity =
40%; EPS = $3.18; Stock
price = $31.20.
d. Debt = 80%; Equity =
20%; EPS = $3.42;
Stock price = $30.40.
e. Debt = 70%; Equity =
30%; EPS = $3.31; Stock
price = $30.00.

Which of the following c. The debt ratio that maximizes expected EPS generally
statements is exceeds the debt ratio that maximizes share price. - If
CORRECT? you focus on maximizing return, expected EPS, you will
likely take on too high of a level of risk. The share price
a. Increasing its use of considers both risk and return.
financial leverage is
one way to increase a
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firm's return on
investors' capital
(ROIC).
b. If a firm lowered its
fixed costs but
increased its variable
costs by just enough
to hold total costs at
the present level of
sales constant, this
would increase its
operating leverage.
c. The debt ratio that
maximizes expected
EPS generally exceeds
the debt ratio that
maximizes share price.
d. If a company were
to issue debt and use
the money to
repurchase common
stock, this would
reduce its return on
investors' capital
(ROIC). (Assume that
the repurchase has no
impact on the
company's operating
income.)
e. If a change in the
bankruptcy code
made bankruptcy less
costly to corporations,
this would tend to
reduce corporations'
debt ratios.

A dividend does not True - The ex-dividend date is the first date that the stock
accompany stocks that trades without dividend.

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are purchased on the


ex-dividend date.

Companies can pay True


out cash to their
shareholders in two
ways. They can pay a
dividend or they can
buy back some of their
outstanding shares.

According to the MM True


dividend-irrelevance
proposition, since
investors do not need
dividends to convert
their shares to cash,
they will not pay
higher prices for firms
with higher dividend
payouts.

The "information True


content of dividends"
says that dividend
increases send good
news about cash flow
and earnings, while
dividend cuts send
bad news.

Other things held False - A higher payout ratio means a lower retention
constant, the higher a ratio and a lower retention ratio means lower expected
firm's target payout growth.
ratio, the higher its
expected growth rate
should be.

A 100% stock dividend True - A 100% stock dividend will double the number of
and a 2:1 stock split shares outstanding, which is the same thing a two-for-
should, at least one split would do. Remember, a stock split is just a
conceptually, have the large stock dividend.

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same effect on the


firm's stock price.

A "reverse split" False - A reverse stock split, such as a 1 for 2, would


reduces the number of reduce the number shares outstanding.
shares outstanding.

If the information True - If dividends convey signals, changing dividends


content, or signaling, will likely impact the firm's stock price.
hypothesis is correct,
then a change in a
firm's dividend policy
can have an important
effect on its stock
price.

If a firm uses the True - More investments will mean more retention and
residual dividend less payout.
model to set dividend
policy, then dividends
are determined as a
residual after providing
for the equity required
to fund the capital
budget. Under this
model, the better the
firm's investment
opportunities, the
lower its payout ratio
will be, other things
held constant.

When a firm declares a dividend is not likely to be repeated.


special cash dividend
of $1 per share,
shareholders realize
that the:

Your firm adheres The firm's net income increases. - An increase in net
strictly to the residual income, holding everything else constant, will lead to a
dividend model. All larger payout under the residual dividend model.
else equal, which of
the following factors
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would be most likely


to lead to an increase
in the firm's dividend
per share?

Which of the following e. Stock repurchases make the most sense at times when
statements is a company believes its stock is undervalued. - If the firm
CORRECT? repurchases undervalued stock, it is a good investment.

a. Firms with a lot of


good investment
opportunities and a
relatively small amount
of cash tend to have
above-average
dividend payout ratios.
b. One advantage of
the residual dividend
model is that it leads to
a stable dividend
payout, which
investors like.
c. An increase in the
stock price when a
company cuts its
dividend is consistent
with signaling theory
as postulated by MM.
d. If the "clientele
effect" is correct, then
for a company whose
earnings fluctuate, a
policy of paying a
constant percentage
of net income will
probably maximize its
stock price.
e. Stock repurchases
make the most sense
at times when a

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company believes its


stock is undervalued.

ABC Corp. stock is 10 shares of ABC Corp.


selling for $30 per
share when a 10%
stock dividend is
declared. If you own
100 shares of ABC
Corp. then you will
receive:

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