Principles of Finance

Principles of Finance Week 4 Quiz An

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1. Beta is estimated as the slope of a regression line fit to pairs of periodic returns, (r_x, r_y), where: (Points : 1)       r_x is the return for a market index such as the S&P 500 Index.

      r_xis the return for the stock being analyzed—for example, IBM’s return if we are estimating IBM’s beta.

      the slope measures the average return for the market portfolio for each percentage change in the value of the security of interest.

      r_yis the return for the market index such as the S&P 500 Index.

Question 2. 2. One reason why we are not concerned with idiosyncratic risk (also called firm-specific risk) is that: (Points : 1)       most risk is not firm-specific, so we can ignore it.       through hedging and insurance, investors may now invest in stocks with almost no risk exposure of any kind.       it is easy and almost costless to diversify one’s portfolio and eliminate idiosyncratic risk.       investing in bonds can offset the idiosyncratic risks of shares of stock.

Question 3. 3. In the Capital Asset Pricing Model, the market risk premium is best approximated by: (Points : 1)       the most recent one-year return on the S&P 500 Index (or another market index).       the long-term historic return on a stock market index such as the S&P 500 (or another market index).       the long-term average spread of the S&P 500 (or another market index) over the yield of long-term government bonds.       the return of the S&P 500 (or another market index) over the current yield of long-term government bonds.

Question 4. 4. Which of the following statements regarding business risk, financial risk, and investors’ risk, is true? (Points : 1)       Business risk is very similar to the risk of bankruptcy and is closely linked to the amount of debt in a firm’s financing mix.       Financial risk is associated with the returns earned by equity investors.       Business risk is often measured by the variability of earnings before depreciation and taxes and is closely associated with the risk inherent in the goods and services a business is selling.       Investment risk is the uncertainty associated with a firm’s investment projects. It can be thought of as the likelihood that the expected IRR or NPV from an investment project will not materialize.

Question 5. 5. Which of the following statements regarding the cost of debt is true? (Points : 1)       The cost of debt for bonds equals the coupon rate of outstanding bonds.       The cost of debt for bonds is found by dividing the price by the annual coupon.       The cost of debt for bonds is found by calculating their yield to maturity.       The cost of debt equals the flotation costs charged by investment bankers who advise the firm.

Question 6. 6. A bond pays semiannual coupon payments of $30 each. It matures in 20 years and is selling for $1,200. What is the firm’s cost of debt if the bond’s par value is $1,000? (Don’t forget this is a semiannual coupon.) (Points : 1)       2.23%       4.48%       1.80%       3.60%

Question 7. 7. The discount rate used in project evaluation should: (Points : 1)       be based on the firm’s overall risk.       be based on each project’s risk.       be estimated using the WACC for all projects.       All of the above are correct.

Question 8. 8. In the Capital Asset Pricing Model, the market risk premium can be thought of as: (Points : 1)       the return investors expect to earn for each unit of risk as measured by beta.       the risk premium that any asset must pay above the risk-free rate.       the expected return on the market portfolio (or a broad market index).       a measure of risk of an asset.

Question 9. 9. We assume investors are risk averse, and therefore they: (Points : 1)       are equally concerned with upside potential and downside risk.       expect a higher return for bearing more risk.       will pay more for an investment with higher risk.       have very high required rates of return.

Question 10. 10. Chapter 9 discusses three different types of returns. Identify the item in the list below that is NOT one of those three types of returns. (Points : 1)       the actual rate of return       the expected rate of return       the risk-free rate of return       the required rate of return

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