Reference no: EM133272601

Question 1

Sensitivity analysis is unnecessary for projects whose asset betas are zero.

True

False

Question 2

The greatest benefit of diversification can be attributed to the inclusion of the second randomly selected stock in the portfolio.

True

False

Question 3

Option prices only consider the systematic (i.e. market-based) component of a stocks volatility as an input to the Black-Scholes formula.

True

False

Question 4

A firm faces two alternatives. The first is to proceed with an investment today. The second is to conduct additional R&D that will delay the project by a year and cost $100,000. Since the costs are related to R&D, the firm can exclude them from their cash flow analysis in determining whether to proceed today or postpone the project for one year.

True

False

Question 5

Owning a stock and selling a put option on that stock will double your losses relative to owning the stock by itself when stock prices are less than the exercise price on the expiration date.

True

False

Question 6

Which of the following alternative offers you the same expected return as a stock with a beta of 1.5?

Invest one-third of your money in T-bills and two-thirds in the market portfolio.

Invest one-half of your money in T-bills and one-half in the market portfolio.

Borrow an amount equal to one-third of your original resources and invest 100% of your original resources in addition to what you borrow in the market portfolio.

Borrow an amount equal to one-half of your original resources and invest 100% of your original resources in addition to what you borrow in the market portfolio.

You cannot attain a beta of 1.5 without investing in a stock with a beta of 1.5.

Question 7

An investment project is most likely to be accepted by the payback rule with a payback of 3 years but rejected by the NPV rule if the project has

most of the cash flows near the beginning of the project.

a large initial investment with significantly smaller cash inflows over a very long period of time.

a very large cash inflow after year 3.

There is no relation between payback and NPV.

None of the above statements are correct.

Question 8

Which of the following statements is true? Indicate only one answer.

Bondholders and stockholders share the risk of the firm's assets once the debt becomes risky.

Stock prices are more susceptible to large changes if the growth rate exceeds the opportunity cost when estimated using a growing perpetuity formula and the two rates are close to one another.

The Dow Jones Industrial Average is calculated by summing of the prices of the 30 stocks in the index.

Investors earn additional returns above the current market rate when they invest in a bond whose coupon rate on a bond exceeds the current market rate for assets of similar risk.

More than one of these statements are correct.

Question 9

Investors can achieve some diversification benefits by

(a) buying stocks with a high (but not perfect) correlation among returns.

(b) buying stocks whose returns often move in opposite directions.

(c) buying stocks with a low correlation among returns

(d) randomly selecting 10 stocks from the population of NYSE stocks.

(e) randomly selecting 10 stocks from within the same industry.

Two of the answers (a) through (e) are correct.

Three of the answers (a) through (e) are correct.

All of the statements (a) through (e) are correct.

Question 10

You have been asked to value the assets of a privately-held company. You used the Capital Asset Pricing Model to estimate the equity betas for every firm in the industry and then computed the average equity beta. You noticed that firms in the industry have significantly different capital structures. You told your boss that this average beta is the appropriate beta to use for valuing the firms assets. Should your boss agree with you? Why or why not? If not, what alternative approach would you recommend? Explain.

Question 11

One of the ideas to fund the Owen School is to purchase a 50% stake in a joint venture to drill for oil on 21st Avenue. Owen will receive a payoff only if the venture strikes oil. Since the outcome of this investment is very uncertain, the opportunity cost of capital will need to be high (beta > 1) to compensate investors for this risk. Do you agree or disagree? Why or why not? Explain.

Question 12

Standard finance theory predicts that management should maximize the value of the firm by selecting investment projects whose NPV is positive and rejecting projects whose NPV is negative. Consider an all-equity firm. Under what conditions might management incorrectly apply the CAPM such that they accept negative NPV investments or reject positive NPV investments? Explain.

Question 13

We determined that the price of a call option depends on five variables; (a) stock price, (b) exercise price, (c) time to expiration, (d) volatility of the stock, and (e) the risk-free rate. Now consider the price of a put option. How would you expect the price of a put option to change with an increase in each of the following factors? Complete the following table.

Variable

Increase in the variable has a +, - or no impact on price of the put option

Stock Price

Exercise Price

Time to Expiration

Volatility of the Stock

Question 14

A project has perpetual cash flows of $C per year beginning next year, an initial investment of $Inv, and an IRR or r%. What is the relation between the projects payback and its IRR? Demonstrate algebraically. What implications does your answer have for long-lived projects with relatively constant cash flows? (Hint: Recall the definition of the IRR for an investment, and let t=payback number of years.)

Question 15

(1) A firm is considering an investment that will produce annual revenues of $1,250,000, require variable costs of $500,000 per year, and will have relevant fixed costs of $200,000 per year (these fixed costs do not include depreciation.) All receipts and payments begin one year from today and end five years from today. The production equipment purchased at date 0 is depreciated to a zero book value with no hope of selling the equipment at end of the project.

Assume that the total present value of the after-tax cash flows from operations is $1,762,716. If the opportunity cost is 10% and the corporate tax rate is 35%, what is the annual depreciation charge and the original cost of the equipment? Show your work for partial credit.

Question 16

(2) A project will have annual sales of $100 beginning in one year. Sales will remain constant forever. Costs will be $54 in one year and will increase by 8% every year thereafter. Ignoring taxes, what is the maximum possible total NPV of the project if the discount rate is 10%. Assume that management has the discretion to discontinue the project at any time.

Question 17

(3) You own equity in a firm whose asset beta is 0.50, and whose assets are partially funded with risk-free debt. The market value of the equity is $15 million and the market value of the debt is $10 million. If the equity beta of the firm's stock is equal to the beta of a portfolio comprised of one-third Treasury Bills and two-thirds of the market, what is the firm's debt-equity ratio? Show your work.

Question 18

(4) You have been hired as a consultant by Vogus Corporation and have been asked to evaluate their capital budgeting procedures. They provide you with a list of recently accepted projects, and you learn that the firm accepts investments whose payback period is 5 years or less. You read that one of the accepted projects had an initial cost of $1,200. All cash flows except the initial investment are non-negative cash inflows. If the appropriate discount rate is 20% per year, what is the worst-case NPV for this project? Show your work.

Question 19

(5) Recall our in-class example of a call option with an exercise price of $100, current stock price of $100 and a risk-less rate of 5%. Next period, the stock would be worth either $110 or $90. Under these conditions, we found that the option value was $7.143. What is the price of the option if the distribution of the stock prices next period is $80 and $120 when all other inputs are equal to their original values? What is the relation between option prices and changes in the volatility of the underlying stock price?

Question 20

(6) Suppose that the current price of a stock is $60. The expected dividend at date one is $20 and the expected dividend at date two is $10. If the opportunity cost of capital is 10% per year, can you estimate the expected stock price at date two? If so, what is the expected price at date 2? If not, what other information would you require to estimate the price at date two?