2. Which of the following is NOT a capital market instrument?
A. U.S. Treasury bills
B. Corporate stocks and bonds
C. Ll.S, Treasury notes and bonds
D. U.S. government agency bonds
8. According to this theory of term structure of interest rates, at any given point in time, the yield
curve reflects the market’s current expectations of future short-term rates.
A. Expectations Theory
B. Unbiased Expectations Theory
C. Future Short-term Rates Theory
D. Term Structure of Interest Rates Theory
MULTIPLE CHOICE
7. This is the interest rate that is actually observed in financial markets.
A. nominal interest rates
B. real interest rates
C. real risk free rate
1. Once firms issue financial instruments in primary markets, these same stocks and bonds are then D. market premium
traded in which of these?
A direct transfers
/.B) secondary markets
C. initial public offerings
D. over-the-counter stocks
3. These provide a forum in which demanders of funds raise funds by issuing new financial
instruments, such as stocks and bonds.
A. money markets
B. primary markets
C. investment banks
D. secondary markets
9. This theory argues that individual investors and financial institutions have specific maturity
preferences, and to encourage buyers to hold securities with maturities other than their most
preferred requires a higher interest rate.
A. Unbiased Expectations Theory
B. Liquidity Premium Hypothesis
C. Market Segmentation Theory
D. Supply and Demand Theory
4. Primary market financial instruments include stock issues from firms allowing their equity shares to
be publicly traded on stock market for the first time. We usually refer to these first-time issues as
which of the following?
A. direct transfers
B. initial public offerings
C. money market transfers
D. over-the-counter stocks
10. This is the interest rate that would exist on a default free security if no inflation were expected.
A. nominal interest rate
B. real risk free rate
C. real interest rate
D. market premium
5. This is a security formalizing an agreement between two parties to exchange a standard quantity
of an asset at a predetermined price on a specified date in the future.
A. liquidity asset
B. trading volume
C. derivative security
D. initial public offering
11. This is the risk that a security issuer will miss an interest or principal payment or continue to miss
such payments.
A. price risk
B. default risk
C. liquidity risk
D. maturity risk
6. This is the ease with which an asset can be converted into cash.
A. liquidity
B. direct transfer
c. primary market
D. secondary market
12. This is a comparison of market yields on securities, assuming all characteristics except maturity
are the same.
A. market risk
B. liquidity risk
C. maturity risk
D. term structure of interest rates
13. This is defined as the volatility of an investment, which includes firm specific risk as well as
market risk.
C. standard deviation
A. diversifiable risk
B. market risk
D. total risk
17. This is the investor’s combination of securities that achieves the highest expected return for a
given risk level.
A. efficient portfolio
B. modem portfolio
C. opti mal portfolio
D. total portfolio
23. In theory, this is a combination of securities that places the portfolio on the efficient frontier and
on a line tangent from the risk-free rate.
A. efficient market
B. market portfolio
C. stock market bubble
D. probability distribution
14. This is defined as the portion of total risk that is attributable to firm or industry factors and can
be reduced through diversification.
A. modern portfolio risk
B. firm specific risk
C. market risk
D. total risk
21. This is the average of the possible returns weighted by the likelihood of those returns occurring.
A. market return
B. efficient return
C. required return
D. expected return
15. This is defined as a combination-ofinvestment-assets-held-by-an1nvest~r. 22 This is…t¥picall’l-consid..er:ed1he~etum..o.n…U…S.-glMilllrn.bon entds and bills and equals the real
A. bundle interest and the expected inflation premium.
B. portfolio A. market risk premium
C. market basket B. required return
D. All of these c. risk-free rate
D. risk premium
16. This is the portion of total risk that is attributable to overall economic factors.
A. modern portfolio risk
B. firm specific risk
C. market risk
D. total risk
18. This is the term for portfolios with the highest return possible for each risk level.
A. efficient portfolios
B. modern portfolios
C. opti mal portfolios
D. total portfolios
24. The use of debt to increase an investment position.
A. stock market bubble
B. behavioral finance
C. financial leverage
D. probability
19. This is a measurement of the co-movement between two variables that ranges between -1 and
+1.
A. coefficient of variation
B. standard deviation
C. correlation
D. total risk
25. A measure of the sensitivity of a stock or portfolio to market risk.
A. behavioral finance
B. efficient market
C. hedge
D. beta
20. Dominant Portfolios Determine which one of these three portfolios dominates another. Name the
dominated portfolio and the portfolio that dominates it Portfolio Blue has an expected retum of 14
percent and risk of 19 percent. The expected return and risk of portfolio Yellow are 15 percent and
18 percent, and for the Purple portfolio are 16 percent and 21 percent.
A. Portfolio Purple dominates Portfolio Blue
B. Portfolio Blue dominates Portfolio Yellow
C. Portfolio Yellow dominates Portfolio Blue
D. Portfolio Purple dominates Portfolio Yellow
26. This is the reward investors require for taking risk.
A. market risk premium
B. required return
C. risk premium
D. risk-free rate
Portfolio Yellow dannete: PatfDlio Blue becease it hiJS both ” highEr expected return l¥1d” /ower risk level.
27. Which of these is the measurement of risk for a collection of stocks for an investor?
A. beta
B. portfolio beta
C. efficient market
D. expected return
28. Which of the following is NOT a necessary condition for an efficient market?
A. Many buyers and sellers.
B. No trading or transaction costs.
e. No prohibitively high barriers to entry.
D. Free and readily available information available to all participants.
34. These are fees paid by firms to investment bankers for issuing new securities.
A. floatation costs
B. interest expense
C. seller financing charges
D. user fees
29. The constant growth model assumes which of the following?
A. That there are executive stock options available to managers.
B. That there is privately held information.
e. That the stock is efficiently priced.
D. That there is no restricted stock.
35. This is a principle of capital budgeting which states that the calculations of cash flows should
remain independent of financing.
A. generally accepted accounting principle
B. financing principle
C. separation principle
D. WACCprinciple
30. A theory that describes the types of information that are reflected in current stock prices.
A. asset pricing
B. behavioral finance
e. public information
D. efficient market hypothesis
36. This is the process of estimating expected future cash flows of a project using only the relevant
parts of the balance sheet and income statements.
A. incremental cash flows
B. cash flow analysis
e. pro forma analysis
D. substitutionary analysis
37. Conceming incremental project cash flow, this is a cost one would never count as an expense of
the project.
A. initial investment
B. taxes paid
e. operating expenses of the project
D. financing costs
31. When calculating the weighted average cost of capital, weights are based on
A. book values.
B. book weights.
e. market values.
D. market betas.
32. Which of the following is a true statement regarding the appropriate tax rate to be used in the
WACC?
A. One would use the marginal tax rate that the firm paid the prior year.
B. One would use the average tax rate that the firm paid the prior year.
C. One would use the weighted average of the marginal tax rates that would have been paid on the
taxable income shielded by the interest deduction.
D. One would use the marginal tax rates that would have been paid on the taxable income shielded
by the interest deduction.
38. This is used as a measure of the total amount of available cash flow from a project.
A. free cash flow
B. operating cash flow
e. investment in operating capital
D. sunk cash flow
39. When calculating operating cash flow for a project, one would calculate it as being
mathematically equal to which of the following?
A. EBIT – Interest – Taxes + Depreciation
B. EBIT – Taxes
C. EBIT + Depreciation
D. EBlT – Taxes + Depreciation
33. Which of these is the basic intuition behind calculating the cost of capital?
A. Firms need to know what the cost of all their current sources of capital cost them.
B. When firms use multiple sources of capital, they need to calculate the current expenditures in a
dollar amount format.
e. When firms use multiple sources of capital, they need to calculate the appropriate interest rate for
valuing their firm’s cash flows as a weighted average of the capital components.
D. When firms use multiple sources of capital, they need to calculate the appropriate interest rate
after taxes for estimating current cash outflows.
40. A decrease in net working capital (NWC) is treated as a
A. cash inflow
B. cash outflow
e. sunk cost
D. historical cost
48. The Net PresentValue decision technique may not be the onl
firm is facing
A. time or resource constraints.
B. a labor union.
e. the election of a new board of directors.
D. a major investment.
flows
49. Neither payback period nor discounted payback period techn
accounts for
A. time value of money.
B. market rates of return.
C. cash flows that occur after payback.
D. cash flows that occur during payback.
n as
50. Which rate-based decision statistic measures the excess reti
the cost of capital for a project, rather than the gross return?
A. Internal Rate of Retum, IRR
B. Modified Internal Rate of Return, MIRR
e. Profitability Index, PI
D. Net Present Value, NPV
on-
51. These are groups or pairs of projects where you can accept
A. dependent
B. independent
C. mutually exclusive
D. mutually dependent
52. A capital budgeting technique that converts a project’s cast
reinvestment rate prior to applying the Internal Rate of Return,
A. discounted payback
B. net present value
C. modified internal rate of return
D. profitability index
53. Investing in stocks can be like gambling when:
A. Both have a short time horizon
B. Both involve risk
C. Both involve an initial outflow of cash
D. Both have a positive expected return
E. Both result in long-term loses.
54. Which of the following is false?
A. Incremental costs can be Opportunity costs.
B. Opportunity costs can be Incremental cost.
e. Of the three categories of Opportunity costs, only one is us
D. Opportunity costs and Incremental cost may be discounted
E. Some Opportunity costs are not Incremental costs.
IRI = 5.0%, E(2RI) = 5.5%, E(3RI) = 6.5%, E(4RI) = 7.0%,
55. If the risk of an investment project is different than the firm’s risk then:
A. you must adjust the discount rate for the project based on the firm’s risk.
B. you must adjust the discount rate for the project based on the project risk.
C. you must exercise risk aversion and use the market rate.
D. an average rate across prior projects is acceptable because estimates contain errors.
E. one must have the actual data to determine any differences in the calculations.
PROBLEMS
1. (3 points) A particular security’s default risk premium is 5 percent. For all securities, the inflation
risk premium is 4 percent and the real interest rate is 3 percent. The security’s liquidity risk premium
is 1 percent and maturity risk premium is 2 percent. The security has no special covenants. What is
the security’s equilibrium rate of return?
56. Insider trading does not offer any advantages if the financial markets are:
A. strong form efficient.
B. semi-strong fomn efficient.
C. semi-weak form efficient.
D. weak form efficient.
E. inefficient.
2. (3 points) Supposethat the current one-year rate (one-year spot rate) and expected one-year Tbill
rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
Using the unbiased expectations theory, what is the current (long-term) rate for four-year-maturity
Treasury securities?
3. (3 points) One-year Treasury bills currently earn 5.50 percent. You expect that one year from
now, one-year Treasury bill rates will increase to 5.75 percent. The liquidity premium on two-year
securities is 0.75 percent. If the liquidity premium theory is correct, what should the current rate be
on two-year Treasury securities?
4. (5 points) HydroTech Corp stock was $32 per share at the end of last year. Sincethen, it paid a
$1 per share dividend. The stock price is currently $45. If you owned 500 shares of MedTech, what
was your percent return?
5. (3 points) Year-to-date, Company X had earned a -2 percent return. During the same time
period, Company Yearned 8 percent and Company Z earned 6 percent. If you have a portfolio made
up of 40 percent Company X, 30 percent Company Y, and 30 percent Company Z, what is your
portfolio return?
6. (3 points) If the annual return on the S&P 500 Index was 15 percent. The annual T-bill yield
during the same period was 6 percent. What was the market risk premium during that year?
7. (7 points) You hold the positions in the table below.
—- ~=-:’–=-~IP’:;~~SI;aIr;··” 1- -Bcl,;-l
Website.corn $20.50 100 3.2 I
Budaet Stores I $36.20 I L50 I 1.5 I
Manufacturing Corp I $60.70 I 75 I 2.4 l
Pharmacy Corp I $28.40 I 200 I 0.75 I
A. What is the beta of your portfolio?
B. If you expect the market to earn 14 percent and the risk-free rate is 5 percent, what is the
required return of the portfolio?
8. (3 points) TAB Inc. has a $100 million (face value), 10 year bond issue selling for 95 percent of
par that pays an annual coupon of 8.5 percent. What would be TAB’s before-tax component cost of
debt?
9. (4 points) Team Sports has 4 million shares of common stock outstanding, 2 million shares of
preferred stock outstanding, and 20 thousand bonds ($1,000 par). If the oommon shares are selling
for $5 per share, the preferred share are selling for $20 per share, and the bonds are selling for 99
percent of par, what would be the weight used for equity in the oomputation of Team’s WACC?
10. (6 points) An all-equity firm is considering the projects shown below. The T-bill rate is 3 percent
and the market risk premium is 6 percent .
. P•.oject Expected Return Beta
A 10.0% 0.9
n 17.0% 1.1
C 12.0% 1.4
D .15.0%. 2.2
A. If the firm uses its current WACCof 12 percent to evaluate these projects, which project(s), if
any, will be incorrectly rejected?
B. If the firm uses its current WACCof 12 percent to evaluate these projects, which project(s), if
any, will be inoorrectly accepted?
11. (3 points) Suppose that TipsNToes, Inc.’s capital structure features 40 percent equity, 60 percent
debt, and that its before-tax cost of debt is 9 percent, while its cost of equity is 15 percent. If the
appropriate weighted average tax rate is 34 percent, what will be TipsNToes’s WACC?
r the firm should
of capital is 10
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