Chapter 4 The Value of Common Stocks

Multiple Choice Questions

1. If the Vol. 100s is reported as 10,233 in the Wall Street Journal quotation, then the trading volume
for that day of trading is
!" 10,233 shares
#" 102,330 shares
$" 1,023,300 shares
%" 10,233,000 shares
!ns&er $
'ype (edium
)age *0
+esponse 'rading volume , 10,233 - 100 , 1,023,300
2. 'he dividend yield reported as .ld. / in 'he Wall Street Journal quotation is 0al0ulated as
follo&s
!" 1dividends 2 hi"
#" 1dividends 2 lo"
$" 1dividends 2 0lose"
%" 3one of the a4ove
!ns&er $
'ype (edium
)age *0
3. 'he Wall Street Journal quotation for a 0ompany has the follo&ing values %iv 2.25, )6 17,
$lose 89.30. $al0ulate the dividend pay out ratio for the 0ompany.
!" 95/
#" 12/
$" 89/
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age *0
+esponse 6)S , 189.30"217 , 3.7*31 dividend payout , 2.2523.7*31 , 0.9893, 95/
90
:. If the Wall Street Journal ;uotation for a 0ompany has the follo&ing values 0lose 2*.00< 3et
0hg ,=1.00< then the 0losing pri0e for the sto0> for the previous trading day &as?
!" @2*
#" @29
$" @28
%" 3one of the a4ove.
!ns&er #
'ype (edium
)age *0
+esponse )revious 0losing , todayAs 0losing net 0hg. , 2*.00B1.00, @29.00
9. 'he value of a 0ommon sto0> today depends on
!" 3um4er of shares outstanding and the num4er of shareholders
#" 'he Wall Street analysts
$" 'he eCpe0ted future dividends and the dis0ount rate
%" )resent value of the future earnings per share
!ns&er $
'ype 6asy
)age *2
*. Super $omputer $ompanyAs sto0> is selling for @100 per share today. It is eCpe0ted that this
sto0> &ill pay a dividend of 9 dollars per share, and then 4e sold for @120 per share at the end of
one year. $al0ulate the eCpe0ted rate of return for the shareholders.
!" 20/
#" 29/
$" 10/
%" 19/
!ns&er #
'ype 6asy
)age *2
+esponse r , 1120=9B100"2100 , 29/
8. )$ $ompany sto0>holders eCpe0t to re0eive a yearBend dividend of @10 per share and then 4e
sold for @122 dollars per share. If the required rate of return for the sto0> is 20/, &hat is the
0urrent value of the sto0>?
!" @100
#" @122
$" @132
%" @110
!ns&er %
'ype (edium
)age *2
+esponse ) , 1122=10"21.2 , 110
91
5. (a0rohard $ompany eCpe0ts to pay a dividend of @* per share at the end of year one, @5 per
share at the end of year t&o and then 4e sold for @13* per share. If the required rate on the sto0>
is 20/, &hat is the 0urrent value of the sto0>?
!" @100
#" @109
$" @110
%" @120
!ns&er #
'ype (edium
)age *2
+esponse ) , 1*21.2"=15=13*"211.2D2" , 109
7. 'he 0onstant dividend gro&th formula )
0
, %
1
21rBg" assumes
!" 'he dividends are gro&ing at a 0onstant rate g forever.
#" r E g
$" g is never negative.
%" #oth ! and #
!ns&er %
'ype (edium
)age *:
10. $asino $o. is eCpe0ted to pay a dividend of @* per share at the end of year one and these
dividends are eCpe0ted to gro& at a 0onstant rate of 5/ per year forever. If the required rate of
return on the sto0> is 20/, &hat is 0urrent value of the sto0> today?
!" @30
#" @90
$" @100
%" @9:
!ns&er #
'ype (edium
)age *:
+esponse ) , 1*210.2B0.05" , 90
92
11. World'our $o. has Fust no& paid a dividend of @* per share 1%
o
", the dividends are eCpe0ted to
gro& at a 0onstant rate of 9/ per year forever. If the required rate of return on the sto0> is 19/,
&hat is the 0urrent value on sto0>, after paying the dividend?
!" @*3
#" @9*
$" @:0
%" @:5
!ns&er !
'ype (edium
)age *:
+esponse ) , 1*-1.09"210.19 0.09" , *3
12. 'he required rate of return or the mar>et 0apitaliGation rate is estimated as follo&s
!" %ividend yield = eCpe0ted rate of gro&th in dividends
#" %ividend yield B eCpe0ted rate of gro&th in dividends
$" %ividend yield 2 eCpe0ted rate of gro&th in dividends
%" 1%ividend yield" - 1eCpe0ted rate of gro&th in dividends"
!ns&er !
'ype %iffi0ult
)age *9
13. (0om $o. is eCpe0ted to pay a dividend of @: per share at the end of year one and the dividends
are eCpe0ted to gro& at a 0onstant rate of :/ forever. If the 0urrent pri0e of the sto0> is @29 per
share 0al0ulated the required rate of return or the mar>et 0apitaliGation rate for the firmsA sto0>.
!" :/
#" 1*/
$" 20/
%" 3one of the a4ove.
!ns&er $
'ype (edium
)age *9
+esponse r , 1:229" = 0.0: , 20/
1:. %ividend gro&th rate for a sta4le firm 0an 4e estimated as
!" )lo& 4a0> rate - the return on equity 1+H6"
#" )lo& 4a0> rate 2 the return on equity 1+H6"
$" )lo& 4a0> rate =the return on equity 1+H6"
%" )lo& 4a0> rate B the return on equity 1+H6"
!ns&er !
'ype %iffi0ult
)age **
93
19. (J $o. pays out *0/ of its earnings as dividends. Its return on equity is 20/. What is the sta4le
dividend gro&th rate for the firm?
!" 3/
#" 9/
$" 5/
%" 12/
!ns&er $
'ype %iffi0ult
)age **
+esponse g , 11 B 0.*"-20 , 5/
1*. (i0higan (otor $ompany is 0urrently paying a dividend of @1.90 per year. 'he dividends are
eCpe0ted to gro& at a rate of 20/ for the neCt three years and then a 0onstant rate of * /
thereafter. What is the eCpe0ted dividend per share in year 9?
!" @2.97
#" @2.00
$" @2.71
%" @1.90
!ns&er $
'ype (edium
)age *7
+esponse %9 , 11.9" - 11.2D3" - 11.0*D2" , 2.71
18. Ireat Ja>es $o. is 0urrently paying a dividend of @2.20 per share. 'he dividends are eCpe0ted to
gro& at 29/ per year for the neCt four years and then gro& 9/ per year thereafter. $al0ulate the
eCpe0ted dividend in year *.
!" @9.38
#" @2.79
$" @9.72
%" @5.37
!ns&er !
'ype (edium
)age *7
+esponse %iv*,2.2 - 11.29D:" - 11.09D2" , 9.72
9:
15. .2K 'e0hnology $orporation has Fust paid a dividend of @0.:0 per share. 'he dividends are
eCpe0ted to gro& at 30/ per year for the neCt t&o years and at 9/ per year thereafter. If the
required rate of return in the sto0> is 19/ 1!)+", 0al0ulate the 0urrent value of the sto0>.
!" @1.:20
#" @*.33
$" @9.*3
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age *7
+esponse )o , L10.: -1.3"21.19M = L10.: - 1.3D2"211.19D2"M = L10.: - 1.3D2-1.0*"2111.19D2 - 10.19
0.09""M , @*.33
17. 'he 3et'e0h $o. has Fust paid a dividend of @1 per share. 'he dividends are eCpe0ted to gro& at
20/ per year for the neCt three years and at the rate of 9/ per year thereafter. If the required
rate of return on the sto0> is 19/1!)+", &hat is the 0urrent value of the sto0>?
!" @15.1:
#" @19.20
$" @12.91
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age *7
+esponse ) , 11.221.19" = 11.::21.19D2" = 11.82521.19D3" = 11.51::2111.19D3" - 10.19 0.09"" ,
19.20
20. Ja>e $o. has paid a dividend @2 per share out of earnings of @: per share. If the 4oo> value per
share is @29, &hat is the eCpe0ted gro&th rate in dividends 1g"?
!" 1*/
#" 12/
$" 5/
%" :/
!ns&er $
'ype %iffi0ult
)age 82
+esponse g , 11 0.9" 1:229" , 0.05 or 5/
99
21. Ja>e $o. has paid a dividend @2 per share out of earnings of @: per share. If the 4oo> value per
share is @29 and is 0urrently selling for @30 per share, 0al0ulate the required rate of return on the
sto0>. 1Nse the 0al0ulated g from the previous pro4lem to ans&er this question."
!" 8.2/
#" 19.2/
$" 1:.8/
%" 1*.*/
!ns&er #
'ype %iffi0ult
)age 82
+esponse g , 11 0.9"1:229" , 0.05 or 5/< L12-1.05"230M = 0.05 , 19.2 /.
22. Ja>e $o. has paid a dividend @3 per share out of earnings of @9 per share. If the 4oo> value per
share is @:0, &hat is the eCpe0ted gro&th rate in dividends?
!" 12.9/
#" 5/
$" 9/
%" 3/
!ns&er $
'ype %iffi0ult
)age 82
+esponse g , 11 192:0" , .09 or 9/<
23. Ja>e $o. has paid a dividend @3 per share out of earnings of @9 per share. If the 4oo> value per
share is @:0 and the share value is 92.90 per share, 0al0ulate the required rate of return on the
sto0>. 1Nse the 0al0ulated AgA from the previous pro4lem to ans&er this question"
!" 11/
#" 12/
$" 9/
%" */
!ns&er !
'ype %iffi0ult
)age 82
+esponse g , 11 0.*" 192:0" , .09 or 9/< L13-1.09"292.90M = 0.09 , 0.11 , 11/.
2:. 'he gro&th rate in dividends 0an 4e thought of as a sum of t&o parts. 'hey are
!" +H6 and the +etention +atio.
#" %ividend yield and gro&th rate in dividends
$" +H! and +H6
%" #oo> value per share and 6)S
!ns&er !
'ype (edium
)age 82
9*
29. 'he value of the sto0>
!" In0reases as the dividend gro&th rate in0reases
#" In0reases as the required rate of return de0reases
$" In0reases as the required rate of return in0reases
%" #oth ! and #
!ns&er %
'ype %iffi0ult
)age 82
2*. $ompany O has a )26 ratio of 10 and a sto0> pri0e of @90 per share. $al0ulate earnings per share
of the 0ompany.
!" @9 per share
#" @10 per share
$" @0.20 per share
%" @* per share
!ns&er !
'ype (edium
)age 8:
+esponse 6)S , 90210 , @9
28. $ompanies &ith higher eCpe0ted gro&th opportunities usually sell for
!" Jo&er )26 ratio
#" Pigher )26 ratio
$" ! pri0e that is independent of )26 ratio
%" ! pri0e that the dependent upon the payment ratio
!ns&er #
'ype (edium
)age 8:
25. Whi0h of the follo&ing formulas regarding earnings to pri0e ratio is true
!" 6)S2)o , rL1=1)VIH2)oM
#" 6)S2)o , rL1 B 1)VIH2)o"M
$" 6)S2)o , Lr=1)VIH2)o"M
%" 6)S2)o ,Lr11=1)VIH2)o"M2r
!ns&er #
'ype %iffi0ult
)age 8:
98
27. Woe $o. is eCpe0ted to pay a dividend or @:.00 per share out of earnings of @8.90 per share. If
the required rate of return on the sto0> is 19/ and dividends are gro&ing at a 0urrent rate of 10/
per year, 0al0ulate the per0ent value of the gro&th opportunity for the sto0> 1)VIH".
!" @50
#" @90
$" @30
%" @2*
!ns&er $
'ype %iffi0ult
)age 8:
+esponse 3o gro&th value , 8.920.19 , 90< )o , :2 10.19B0.1" , 50< )VIH , 50B90 , 30
30. )ar0el $orporation is eCpe0ted to pay a dividend of @9 per share neCt year, and the dividends pay
out ratio is 90/. If the dividends are eCpe0ted to gro& at a 0onstant rate of 5/ forever and the
required rate of return on the sto0> is 13/, 0al0ulate the present value of the gro&th opportunity.
!" @23.05
#" @*:.10
$" @100
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 8:
+esponse 6)S, 1920.9",@10< 3o Iro&th Value , 1020.13 , 8*.72< Iro&th Value , 9210.13B0.05"
, 100< )VIH , 100B8*.72 , 23.05
31. ! high proportion of the value a gro&th sto0> 0omes from
!" )ast dividend payments
#" )ast earnings
$" )VIH 1)resent Value of the Iro&th Hpportunities"
%" #oth ! and #
!ns&er $
'ype (edium
)age 8:
32. Ienerally high gro&th sto0>s pay
!" Pigh dividends
#" Jo& or no dividends
$" 6rrati0 dividends
%" #oth ! and $
!ns&er #
'ype (edium
)age 8:
95
33. 'he follo&ing sto0>s are eCamples of gro&th sto0>s eC0ept
!" WalB(art
#" %ell $omputer
$" (i0rosoft
%" $hu44
!ns&er %
'ype (edium
)age 8:
3:. 'he follo&ing sto0>s are eCamples of in0ome sto0>s eC0ept
!" 6CCon (o4il
#" WalB(art
$" $hu44
%" Kellogg
6" !ll of the a4ove
!ns&er #
'ype 6asy
)age 8:
39. Whi0h of the follo&ing sto0>s are gro&th sto0>s?
!" %ell $omputer
#" !'Q'
$" %u>e )o&er
%" 6CCon
6" 3one of the a4ove
!ns&er !
'ype 6asy
)age 8:
3*. Whi0h of the follo&ing sto0>s are in0ome sto0>s?
!" %u>e )o&er
#" %ell $omputer
$" (i0rosoft
%" WalB(art
6" 3one of the a4ove
!ns&er !
'ype 6asy
)age 8:
97
38. 'he relationship 4et&een )26 ratio and mar>et 0apitaliGation rate 0an 4e des0ri4ed 4y the
follo&ing statements
!" 6)S2)o measures r, only if )VIH , 0
#" Pigh )26 ratios indi0ate lo& r
$" 'here is no relia4le asso0iation 4et&een the )26 ratio and r
%" ! and $ a4ove
!ns&er %
'ype 6asy
)age 89
35. Nniversal !ir is a no gro&th firm and has t&o million shares outstanding. It is eCpe0ted to earn a
0onstant 20 million per year on its assets. If all earnings are paid out as dividends and the 0ost of
0apital is 10/, 0al0ulate the 0urrent pri0e per share for the sto0>.
!" @200
#" @100
$" @190
%" @90
!ns&er #
'ype (edium
)age 88
+esponse 6)S , %)S , 2022 , @10 per share , )o , 1020.1 , 100
37. Whi0h of the follo&ing statements regarding free 0ash flo& is true?
!" Rree 0ash flo& is al&ays positive
#" Rree 0ash flo& is al&ays negative
$" Rree 0ash flo& is the net 0ash flo& to the shareholders after paying for future investments
%" 3one of the a4ove
!ns&er $
'ype (edium
)age 88
:0. %is0ounted 0ash flo& formulas &or> for the valuation of
!" Sto0>s &ith 0onstant dividend gro&th
#" #usinesses
$" Sto0>s &ith super normal dividend gro&th
%" !ll of the a4ove
!ns&er %
'ype (edium
)age 88
*0
:1. 'he value of a 4usiness is given 4y
!" )V , )V1free 0ash flo&s"
#" )V , )V1free 0ash flo&s" = )V 1horiGon value"
$" )V1free 0ash flo&s" S )V1horiGon value"
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 88
:2. 'he present value of free 0ash flo& is @9 million and the present value of the horiGon value is @10
million. $al0ulate the present value of the 4usiness.
!" @9 million
#" @10 million
$" @19 million
%" 3one of the a4ove
!ns&er $
'ype (edium
)age 88
+esponse )V14usiness" , 9 = 10 , 19
True/False Questions
' R :3. 'he 3e& .or> Sto0> 6C0hange is the only sto0> mar>et in the NS.
!ns&er Ralse
'ype 6asy
)age *0
' R ::. Shareholders re0eive 0ash from the firm in the form of dividends and 0apital gains.
!ns&er Ralse
'ype %iffi0ult
)age *1
' R :9. 'he return that is eCpe0ted 4y investors from a 0ommon sto0> is often 0alled its mar>et
0apitaliGation rate.
!ns&er 'rue
'ype (edium
)age *1
*1
' R :*. !t ea0h point in time, all se0urities in an equivalentBris> 0lass are pri0ed to offer the same
eCpe0ted return.
!ns&er 'rue
'ype %iffi0ult
)age *2
' R :8. 'he 0onstant gro&th formula for sto0> valuation does not &or> for firms &ith negative
gro&th 1de0lining" rates in dividends.
!ns&er Ralse
'ype %iffi0ult
)age *:
' R :5. 'he mar>et 0apitaliGation equals the dividend yield plus the gro&th rate in dividends for a
0onstant dividend gro&th sto0>.
!ns&er 'rue
'ype (edium
)age *9
' R :7. 'he value of a share of 0ommon sto0> is equal to the dis0ounted stream of free 0ash flo&
per share.
!ns&er 'rue
'ype %iffi0ult
)age *7
' R 90. 'he value of a share of 0ommon sto0> is equal to the dis0ounted stream of earnings per
share.
!ns&er Ralse
'ype (edium
)age *7
' R 91. 'here is a strong relationship 4et&een a sto0>As pri0eBearnings 1)26" ratio and its
0apitaliGation rate.
!ns&er Ralse
'ype (edium
)age 80
*2
' R 92. %is0ounted 0ash flo& approa0h 0an 4e used to value ongoing 4usinesses.
!ns&er 'rue
'ype (edium
)age 8*
Essay Questions
93. 6Cplain the term Tprimary mar>et.T
'ype 6asy
)age 97
!ns&er
When ne& shares of 0ommon sto0>s are sold in the mar>et to raise 0apital, it is 0alled a primary
mar>et transa0tion. ! good eCample of a primary mar>et transa0tion is the I)H 1Initial )u4li0
Hffering".
9:. 6Cplain the term Tse0ondary mar>et.T
'ype 6asy
)age 97
!ns&er
When already issued sto0>s are traded in the mar>et, it is 0alled a se0ondary mar>et transa0tion.
(ost transa0tions in the sto0> mar>et are se0ondary mar>et transa0tions.
99. #riefly eCplain the term Tmar>et 0apitaliGation rate.T
'ype (edium
)age *1
!ns&er
'he rate of return eCpe0ted 4y the investors in 0ommon sto0>s is 0alled the mar>et 0apitaliGation
rate. Ror a 0onstant gro&th sto0> it is the dividend yield plus the gro&th rate in dividends.
9*. %is0uss the general prin0iple in the valuation of a 0ommon sto0>.
'ype (edium
)age *2
!ns&er
'he value of a 0ommon sto0> is the present value of all the dividends re0eived 4y o&ning the
sto0> dis0ounted at the mar>et 0apitaliGation rate. 'his is 0alled the dis0ounted 0ash flo& 1%$R"
method.
*3
98. %is0uss the term Tpri0eBearnings 1)26" ratio.T
'ype (edium
)age 80
!ns&er
'he )26 ratio is a &idely used finan0ial indi0ator, 4ut is also quite am4iguous. Ienerally, a high
)26 ratio indi0ates that the investors thin> a firm has good gro&th potential. 'he )26 ratio is
helpful in evaluating sho0>s. It is the ratio of 0urrent mar>et pri0e and earnings of a sto0>.
95. %is0uss the pro4lems inherent in the valuation of a 4usiness.
'ype %iffi0ult
)age 89
!ns&er
'he main pro4lems are estimating future 0ash flo&s for the neCt several years, and estimating the
horiGon value. 'he latter is quite diffi0ult and is a signifi0ant proportion of the total estimated
value of the firm. Ienerally, the dis0ounted 0ash flo& approa0h is applied for the valuation.
'here are other methods li>e using the mar>et to 4oo> ratio and the )26 ratio.
Chapter 5 Why Net resent Value !ea"s to #etter $n%estment &ecisions than 'ther Criteria
Multiple Choice Questions
1. 'he follo&ing measures are used 4y firms &hen ma>ing 0apital 4udgeting de0isions eC0ept
!" )ay4a0> period
#" Internal rate of return
$" 3et present value
%" )26 ratio
!ns&er %
'ype 6asy
)age 71
2. Whi0h of the follo&ing investment rules does not use the time value of the money 0on0ept?
!" 'he pay4a0> period
#" Internal rate of return
$" 3et present value
%" !ll of the a4ove use the time value 0on0ept
!ns&er !
'ype 6asy
)age 73
3. Suppose a firm has a @900 million in eC0ess 0ash. It 0ould
!" Invest the funds in proFe0ts &ith positive 3)Vs
#" )ay high dividends to the shareholders
*:
$" #uy another firm
%" !ll of the a4ove
!ns&er %
'ype 6asy
)age 73
:. Whi0h of the follo&ing investment rules has value additivity property?
!" 'he pay4a0> period method
#" 'he internal rate of return method
$" 'he 4oo> rate of return method
%" 3et present value method
6" !ll of the a4ove have value additivity property
!ns&er %
'ype %iffi0ult
)age 73
*9
9. If the net present value of proFe0t ! is =@50, and of proFe0t # is =@*0, then the net present value
of the 0om4ined proFe0t is
!" =@50
#" =@*0
$" =@1:0
%" 3one of the a4ove
!ns&er $
'ype 6asy
)age 73
+esponse 3)V1! =#" , 50 = *0 , 1:0
*. If the 3)V of proFe0t ! is =@100, and that of proFe0t # is B@90 and that of proFe0t $ is =@20, &hat
is the 3)V of the 0om4ined proFe0t?
!" @100
#" B@90
$" @120
%" @80
!ns&er %
'ype 6asy
)age 73
+esponse 3)V1!=#=$" , 100 = 20 , 80
8. .ou are given a Fo4 to ma>e a de0ision on proFe0t O, &hi0h is 0omposed of three independent
proFe0ts !, #, and $ &hi0h have 3)Vs of =@90, B@20 and =@100, respe0tively. Po& &ould you
go a4out ma>ing the de0ision a4out &hether to a00ept or reFe0t the proFe0t?
!" !00ept the firmAs Foint proFe0t as it has a positive 3)V
#" +eFe0t the Foint proFe0t
$" #rea> up the proFe0t into its 0omponents a00ept ! and $ and reFe0t #
%" 3one of the a4ove
!ns&er $
'ype %iffi0ult
)age 73
5. If the 3)V of proFe0t ! is =@90 and that of proFe0t # is B@*0, than the 3)V of the 0om4ined
proFe0t is
!" =@90
#" =@*0
$" B@10
%" 3one of the a4ove.
!ns&er $
'ype 6asy
)age 73
+esponse 3)V1!=#" , 90 B *0 , 10
**
7. 'he net present value of a proFe0t depends upon
!" fore0asted 0ash flo&s and opportunity 0ost of 0apital
#" managerAs tastes and preferen0es
$" 0ompanyAs 0hoi0e of a00ounting method
%" all of the a4ove
!ns&er !
'ype (edium
)age 73
10. 'he pay4a0> period rule
!" Varies the 0utBoff point &ith the interest rate
#" %etermines a 0utBoff point so that all proFe0ts a00epted 4y the 3)V rule &ill 4e a00epted 4y
the pay4a0> period rule.
$" +equires an ar4itrary 0hoi0e of a 0utBoff point
%" #oth ! and $
!ns&er $
'ype (edium
)age 7:
11. 'he pay4a0> period rule a00epts all proFe0ts for &hi0h the pay4a0> period is
!" Ireater than the 0utBoff value
#" Jess than the 0utBoff value
$" Is positive
%" !n integer
!ns&er #
'ype 6asy
)age 7:
12. Whi0h of the follo&ing investment rules may not use all possi4le 0ash flo&s in its 0al0ulations?
!" )ay4a0> period.
#" 3)V
$" I++
%" !ll of the a4ove
!ns&er !
'ype (edium
)age 79
*8
13. Iiven the follo&ing 0ash flo&s for proFe0t ! $
0
, B2000, $
1
, =900 , $
2
, =1900 and $
3
,
=9000, 0al0ulate the pay4a0> period.
!" Hne year
#" 2 years
$" 3 years
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 79
+esponse 2000 , .ear one 0ash flo& = year 2 0ash flo&< )ay4a0> period , 2 years
1:. 'he main advantage of the pay4a0> rule is
!" !dFustment for un0ertainty of early 0ash flo&s
#" It is simple to use
$" %oes not dis0ount 0ash flo&s
%" #oth ! and $
!ns&er #
'ype (edium
)age 7:
19. Whi0h of the follo&ing statements regarding the dis0ounted pay4a0> period rule is true?
!" 'he dis0ounted pay4a0> rule uses the time value of money 0on0ept.
#" 'he dis0ounted pay4a0> rule is 4etter than the 3)V rule
$" 'he dis0ounted pay4a0> rule 0onsiders all 0ash flo&s
%" 'he dis0ounted pay4a0> rule eChi4its the value additive property
!ns&er !
'ype 6asy
)age 79
1*. 'he follo&ing are disadvantages of using the pay4a0> rule eC0ept
!" 'he pay4a0> rule ignores all 0ash flo& after the 0utoff date
#" 'he pay4a0> rule does not use the time value of money
$" 'he pay4a0> period is easy to 0al0ulate and use
%" 'he pay4a0> rule does not have the value additive property
!ns&er $
'ype (edium
)age 79
*5
18. Iiven the follo&ing 0ash flo&s for proFe0t U $
0
, B2,000, $
1
, *00, $
2
, 21*0 and $
3
, *000,
0al0ulate the dis0ounted pay4a0> period for the proFe0t at a dis0ount rate of 20/.
!" Hne year
#" 2 years
$" 3 years
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age 7*
+esponse 2000 , 1*0021.2" = 121*021.2D2"< 'he dis0ounted pay4a0> , 2 years
15. Iiven the follo&ing 0ash flo&s for )roFe0t ( $
0
, B2,000, $
1
, =900, $
2
, =1,900, $
3
, =1:99,
0al0ulate the I++ for the proFe0t.
!" 10/
#" 15/
$" 25/
%" 3one of the a4ove
!ns&er $
'ype %iffi0ult
)age 7*
+esponse B2000 = L900211=I++"M = L1900211=I++"D2M = L1:99211 = I++"D3M , 0< I++ , 25/
17. 'he qui0>est &ay to 0al0ulate the I++ of a proFe0t is 4y
!" 'rial and error method
#" Nsing the graphi0al method
$" Nsing a finan0ial 0al0ulator
%" Iuessing the I++
!ns&er $
'ype 6asy
)age 78
20. If an investment proFe0t 1normal proFe0t" has an I++ equal to the 0ost of 0apital , the 3)V for that
proFe0t is
!" )ositive
#" 3egative
$" Uero
%" Nna4le to 4e determined
!ns&er $
'ype 6asy
)age 78
*7
21. )roFe0t .BRile has the follo&ing 0ash flo&s $
0
, =2000, $
1
, B1,200, and $
2
, B1,900. If the
I++ of the proFe0t is 21.*9/ and if the 0ost of 0apital is 19/, you &ould
!" !00ept the proFe0t
#" +eFe0t the proFe0t
!ns&er #
'ype %iffi0ult
)age 75
+esponse 'his is a loan proFe0t therefore reFe0t
22. )roFe0t .BRile has the follo&ing 0ash flo&s $
0
, =2000, $
1
, B1,200, and $
2
, B1,200. If the
I++ of the proFe0t is 13.1/ and if the 0ost of 0apital is 19/, you &ould
!" !00ept the proFe0t
#" +eFe0t the proFe0t
!ns&er #
'ype %iffi0ult
)age 75
+esponse 'his is a loan proFe0t therefore a00ept
23. 'he I++ is defined as
!" 'he dis0ount rate that ma>es the 3)V equal to Gero
#" 'he differen0e 4et&een the 0ost of 0apital and the present value of the 0ash flo&s
$" 'he dis0ount rate used in the 3)V method
%" 'he dis0ount rate used in the dis0ounted pay4a0> period method
!ns&er !
'ype 6asy
)age 75
2:. 'he follo&ing are some of the short0omings of the I++ method eC0ept
!" I++ is 0on0eptually easy to 0ommuni0ate
#" )roFe0ts 0an have multiple I++s
$" I++ method 0annot distinguish 4et&een a 4orro&ing proFe0t and a lending proFe0t
%" It is very 0um4ersome to evaluate mutually eC0lusive proFe0ts using the I++ method
!ns&er !
'ype %iffi0ult
)age 77
80
29. Valentine $ompany is 0onsidering investing in a ne& proFe0t. 'he proFe0t &ill need an initial
investment of @1,200,000 and &ill generate @*00,000 1afterBtaC" 0ash flo&s for three years.
$al0ulate the I++ for the proFe0t.
!" 1:.9/
#" 15.*/
$" 23.:/
%" 20.2/
!ns&er $
'ype %iffi0ult
)age 77
+esponse B1,200,000 = L*00,000211=I++"M = L*00,000211=I++"D2M = L*00,000211=I++"D3M , 0<
I++ , 23.:/.
2*. Valentine $ompany is 0onsidering investing in a ne& proFe0t. 'he proFe0t &ill need an initial
investment of @1,200,000 and &ill generate @*00,000 1afterBtaC" 0ash flo&s for three years.
$al0ulate the (I++ 1modified internal rate of return" for the proFe0t if the 0ost of 0apital is 19/.
!" 1:.9/
#" 15.*/
$" 23.:/
%" 20.2/
!ns&er %
'ype %iffi0ult
)age 101
+esponse B1,200,000 = L1*00,00011.19"D2"= 1*00,00011.19"" = *00,000M2L11=(I++"D3M , 0<
(I++ , 20.2/.
28. Valentine $ompany is 0onsidering investing in a ne& proFe0t. 'he proFe0t &ill need an initial
investment of @1,200,000 and &ill generate @*00,000 1afterBtaC" 0ash flo&s for three years.
$al0ulate the 3)V for the proFe0t if the 0ost of 0apital is 19/.
!" @1*7,739
#" @127,211
$" @*00,000
%" @129,5:*
!ns&er !
'ype (edium
)age 102
+esponse 3)V , B1,200,000 = L1*00,000"211.19"M = L1*00,000211.19"D2M = L*00,000211.19"D3M ,
1*7,739
81
25. ! proFe0t &ill have only one internal rate of return if
!" 'he net present value is positive
#" 'he net present value is negative
$" 'here is a one fifth 0hange in the 0ash flo&s
%" 'he 0ash flo&s de0line over the life of the proFe0t
!ns&er $
'ype (edium
)age 102
27. 6lephant 0ompany is investing in a giant 0rane. It is eCpe0ted to 0ost 2.2 million in initial
investment and it is eCpe0ted to generate an end of year 0ash flo& of 1.0 million ea0h year for
three years. $al0ulate the I++ approCimately.
!" 1:.*
#" 1*.:
$" 22.1
%" 18.3
!ns&er %
'ype (edium
)age 101
+esponse 0 , B2.2 = 111211=I++" = 112111=I++"D2"" = 112111=I++"D3"""< I++ , 18.3 14y trial Q
error"
30. 6lephant 0ompany is investing in a giant 0rane. It is eCpe0ted to 0ost 2.2 million in initial
investment and it is eCpe0ted to generate an end of year 0ash flo& of 1.0 million ea0h year for
three years. $al0ulate the (I++ for the proFe0t if the 0ost of 0apital is 12/ !)+.
!" 19.3/
#" 18.3/
$" 23.5/
%" 22.1/
!ns&er !
'ype %iffi0ult
)age 102
+esponse .ear 0 , B2.2, .ear 3 , 3.38::< 1 = (I++ , 13.38::22.2"D0.3333 , 19.3/
82
31. 6lephant 0ompany is investing in a giant 0rane. It is eCpe0ted to 0ost 2.2 million in initial
investment and it is eCpe0ted to generate an end of year 0ash flo& of 1.0 million ea0h year for
three years. $al0ulate the 3)V at 12/ 1approCimately".
!" 2.: million
#" 0.20 million
$" 0.50 million
%" 0.:0 million
!ns&er #
'ype (edium
)age 102
+esponse 3)V , B2.2 = 121.12 = 1211.12D2" = 1211.12D3" , 0.2
32. Iiven the follo&ing 0ash flo& for proFe0t ! $
0
, B2000, $
1
, =900, $
2
, =1900 and $
3
,
=9000, 0al0ulate the 3)V of the proFe0t using a 19/ dis0ount rate.
!" @9000
#" @2598
$" @3201
%" @2392
!ns&er #
'ype (edium
)age 102
+esponse 3)V , B2000 = 190021.19" = 11900 2 1.19D2" = 1900021.19D3" , 2598
33. )rofita4ility indeC is the ratio of
!" )resent value of 0ash flo& to initial investment
#" 3et present value 0ash flo& to initial investment
$" 3et present value of 0ash flo& to I++
%" )resent value of 0ash flo& to I++
!ns&er #
'ype (edium
)age 10*
3:. #enefitB0ost ratio is defined as the ratio of
!" )resent value of 0ash flo& to initial investment
#" 3et present value 0ash flo& to initial investment
$" 3et present value of 0ash flo& to I++
%" )resent value of 0ash flo& to I++
!ns&er !
'ype (edium
)age 10*
83
39. )rofita4ility indeC is useful under
!" $apital rationing
#" (utually eC0lusive proFe0ts
$" 3onBnormal proFe0ts
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 10*
3*. 'he follo&ing ta4le gives the availa4le proFe0ts for a firm.
! # $ % 6 R I
7 0 2 0 * 0 9 0 1 9 0 : 0 2 0 I n i t i a l i n v e s t m e n t
1 : 0 8 0 * 9 B 1 0 3 0 3 2 1 0 3 ) V
If the firm has a limit of 210 million to invest, &hat is the maCimum 3)V the 0ompany 0an
o4tain?
!" 200
#" 308
$" 253
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age 10*
+esponse ! = # = $ = R , 1:0 = 80 = *9 = 32 , 308
38.
! # $ % 6 R I
9 . 0 : . 0 9 . 0 1 . 0 2 . 0 8 . 0 5 . 0 I n i t i a l i n v e s t m e n t
1 . 9 B 0 . 9 1 . 0 0 . 9 0 . 9 1 . 0 1 . 0 3 ) V
'he firm has only t&enty million to invest. What is the maCimum 3)V that the 0ompany 0an
o4tain?
!" 3.9
#" :.9
$" :.0
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age 10*
+esponse ! = $ = % = 6 = R , :.9
8:
35. 'he profita4ility indeC 0an 4e used for ran>ing proFe0ts under
!" Soft 0apital rationing
#" Pard 0apital rationing
$" $apital rationing at t , 0
%" #oth ! and #
!ns&er $
'ype %iffi0ult
)age 105
True/False Questions
' R 37. )resent values have value additivity property.
!ns&er 'rue
'ype %iffi0ult
)age 73
' R :0. 'he pay4a0> rule gives equal &eight to all 0ash flo&s 4efore the pay4a0> date and Gero
&eight to su4sequent 0ash flo&s.
!ns&er 'rue
'ype (edium
)age 79
' R :1. 'he dis0ounted pay4a0> rule 0al0ulates the pay4a0> period and then dis0ounts it at the
opportunity 0ost of 0apital.
!ns&er Ralse
'ype (edium
)age 7*
' R :2. 'he internal rate of return is the dis0ount rate that ma>es the )V of a proFe0t equal to
Gero.
!ns&er Ralse
'ype %iffi0ult
)age 7*
89
' R :3. 'he I++ rule states that firms should a00ept any proFe0t offering an internal rate of return
in eC0ess of the 0ost of 0apital.
!ns&er 'rue
'ype (edium
)age 78
' R ::. In 0ase of a loan proFe0t, one should a00ept the proFe0t if the I++ is less than the 0ost of
0apital.
!ns&er 'rue
'ype %iffi0ult
)age 75
' R :9. (I++s have the value additivity property and I++s do not.
!ns&er Ralse
'ype %iffi0ult
)age 101
' R :*. Soft rationing may 4e used to 0ontrol managerial 4ehavior.
!ns&er 'rue
'ype 6asy
)age 105
Essay Questions
:8. #riefly eCplain the value additivity property.
'ype (edium
)age 73
!ns&er
Ror eCample, the net present value 13)V" of the 0om4ined proFe0t say ! and # is equal to the
3)V1!" and 3)V1#". 'his property holds good for the present values also. 'his property is not
shared 4y I++. I++ of the 0om4ined proFe0t is not the sum of the individual I++s. 'he value
additivity property is very useful &hen ma>ing de0isions a4out numerous proFe0ts.
8*
:5. %is0uss some of the advantages of using the pay4a0> method.
'ype 6asy
)age 79
!ns&er
It tells you ho& qui0>ly you 0an re0over your investment. 'he main advantage is that it is easy to
0al0ulate and use.
:7. %is0uss some of the disadvantages of the pay4a0> rule.
'ype 6asy
)age 79
!ns&er
'he disadvantages are that it does not ta>e the time value of money into a00ount and also does
not use all the 0ash flo&. It has limited appli0ations su0h as small proFe0ts.
90. What are some of the advantages of using the I++ method?
'ype (edium
)age 78
!ns&er
'he main advantage of I++ is that it is easy to 0ommuni0ate.
91. What are some of the disadvantages of using the I++ method?
'ype %iffi0ult
)age 75
!ns&er
'here are several disadvantages to I++ method. It is diffi0ult to intuitively eCplain the 0on0ept of
internal rate of return. It is not useful in evaluating 0ompleC proFe0ts, mutually eC0lusive proFe0ts
and dependent proFe0ts. Ror proFe0ts &ith high I++s, reinvestment rate assumption impli0it in the
method may 4e unrealisti0. It is also more 0ompli0ated to 0al0ulate. .ou 0an also get multiple
rates of return in 0ase of 0ompleC proFe0ts. Hne &ay to eliminate this pro4lem is 4y using the
modified internal rate of return method. !lso, I++ 0annot distinguish 4et&een 4orro&ing and
lending proFe0ts
92. In &hat &ay is the modified internal rate of return 1(I++" method 4etter than the I++ method?
'ype (edium
)age 101
!ns&er
With the modified internal rate of return method, 0ash flo&s form the proFe0t are eCpli0itly
reinvested at the 0ost of 0apital, thus eliminating the reinvestment rate assumption pro4lem. 'his
eliminates the multiple I++ pro4lems inherent in 0ompleC proFe0ts. !lso reinvesting the 0ash
flo&s from the proFe0t at the 0ost of 0apital is more realisti0.
88
85
93. #riefly dis0uss 0apital rationing.
'ype (edium
)age 10*
!ns&er
'here are t&o types of 0apital rationing< soft rationing imposed 4y the 0ompany and hard
rationing imposed 4y the 0apital mar>ets. $apital rationing results in the firm foregoing some
positive 3)V proFe0ts there4y redu0ing a firmAs value.
9:. #riefly eCplain ho& linear programming is useful for solving 0apital rationing pro4lems.
'ype %iffi0ult
)age 108
!ns&er
Jinear programming 0an 4e used for solving 0ompleC 0apital rationing pro4lems. In this method
3)V fun0tion, &hi0h is a linear fun0tion of all feasi4le proFe0ts, is maCimiGed su4Fe0t to
0onstraints of availa4le 0apital. (any times linear programming solutions tell us to ta>e
Tfra0tionalT proFe0ts to maCimiGe 3)V. 'his might 4e possi4le for 0ertain proFe0ts only. !
modified form of linear programming 0alled Tinteger programmingT 0an 4e used if only &hole
proFe0ts are to 4e a00epted.
99. #riefly eCplain the term Tsoft rationingT
'ype (edium
)age 105
!ns&er
Soft rationing is used 4y management to help in finan0ial 0ontrol. Soft rationing is imposed 4y
the management on a temporary 4asis and not 4y 0apital mar>ets.
Chapter ( Makin) $n%estment &ecisions *ith the Net resent Value +ule
Multiple Choice Questions
1. )refera4ly, 0ash flo&s for a proFe0t are estimated as
!" $ash flo&s 4efore taCes
#" $ash flo&s after taCes
$" 6arnings 4efore taCes
%" 6arnings after taCes
!ns&er #
'ype (edium
)age 117
2. Important points to remem4er &hile estimating 0ash flo&s of proFe0ts are
87
!" only 0ash flo& is relevant
#" al&ays estimate 0ash flo&s on an in0remental 4asis
$" 4e 0onsistent in the treatment of inflation
%" all of the a4ove
6" none of the a4ove
!ns&er %
'ype 6asy
)age 120
3. 3et Wor>ing $apital is the
!" %ifferen0e 4et&een shortBterm assets and short term lia4ilities
#" %ifferen0e 4et&een longBterm assets and long term lia4ilities
$" %ifferen0e 4et&een longBterm assets and short term lia4ilities
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 121
:. 3et Wor>ing $apital should 4e 0onsidered in proFe0t 0ash flo&s 4e0ause
!" 'hey are sun> 0osts
#" Rirms must invest 0ash in shortBterm assets to produ0e finished goods
$" Rirms need positive 3)V proFe0ts for investment
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 121
9. Investment in net &or>ing 0apital is not depre0iated 4e0ause
!" it is not a 0ash flo&
#" it is a sun> 0ost
$" it is re0overed during or at the end of the proFe0t and is not a depre0iating asset
%" all of the a4ove
!ns&er $
'ype (edium
)age 121
*. 'he prin0ipal shortBterm assets are
!" $ash
#" !00ounts re0eiva4le
$" Inventories
%" !ll of the a4ove
50
!ns&er %
'ype 6asy
)age 121
8. Investment in inventories in0ludes investment in
!" +a& material
#" Wor>BinBprogress
$" Rinished goods
%" !ll of the a4ove
!ns&er %
'ype 6asy
)age 121
5. 'he 0ost of a resour0e that may 4e relevant to an investment de0ision even &hen no 0ash 0hanges
hand is 0alled a 1an"
!" sun> 0ost
#" &or>ing 0apital
$" opportunity 0ost
%" none of the a4ove
!ns&er $
'ype (edium
)age 121
51
7. 'he follo&ing 0ash flo&s should 4e treated as in0remental flo&s &hen de0iding &hether to go
ahead &ith an ele0tri0 0ar eC0ept
!" 'he 0onsequent dedu0tion in sales of the 0ompanyAs eCisting gasoline models
#" 'he eCpenditure on ne& plants and equipment
$" 'he value of tools that 0an 4e transferred from the 0ompanyAs eCisting plants
%" Interest payment on de4t
!ns&er %
'ype (edium
)age 121
10. Whi0h of the follo&ing 0ash flo&s should 4e treated as in0remental flo&s &hen de0iding &hether
to go ahead &ith an ele0tri0 0ar?
!" 'he 0ost of resear0h and development underta>en for developing the ele0tri0 0ar in the past
three years
#" 'he annual depre0iation 0harge
$" 'he redu0tion in taCes resulting from the depre0iation 0harges
%" %ividend payments
!ns&er $
'ype %iffi0ult
)age 121
11. (oney that a firm has already spent or 0ommitted to spend regardless of &hether a proFe0t is
ta>en is 0alled
!" Sun> 0ost
#" Hpportunity 0ost
$" RiCed 0ost
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 121
12. 'he value of a previously pur0hased ma0hine eCpe0ted to 4e used 4y a proposed proFe0t is an
eCample of
!" Sun> 0ost
#" Hpportunity 0ost
$" RiCed 0ost
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 121
52
13. ! firm o&ns a 4uilding &ith a 4oo> value of @190,000 and a mar>et value of @290,000. If the
4uilding is utiliGed for a proFe0t, then the opportunity 0ost ignoring taCes is
!" @100,000
#" @190,000
$" @290,000
%" 3one of the a4ove
!ns&er $
'ype (edium
)age 121
1:. ! firm has a general purpose ma0hine &hi0h has a 4oo> value of @:00,000 and is sold for
@*00,000 in the mar>et. If the taC rate is 30/, &hat is the opportunity 0ost of using the ma0hine
in a proFe0t?
!" @900,000
#" @*00,000
$" @9:0,000
%" 3one of the a4ove
!ns&er $
'ype %iffi0ult
)age 121
+esponse *00,000 1*00,000 :00,000" - 0.30 , 9:0,000
19. ! redu0tion in the sales of eCisting produ0ts 0aused 4y the introdu0tion of a ne& produ0t is an
eCample of
!" sun> 0ost
#" opportunity 0ost
$" in0idental effe0ts
%" none of the a4ove
!ns&er $
'ype 6asy
)age 121
1*. 'he real rate of interest is 2/ and the inflation is 9/. What is the nominal rate of interest?
!" 3/
#" :/
$" 8.1/
%" 1/
!ns&er $
'ype 6asy
)age 123
+esponse 1 = nominal rate , 1.02- 1.09 , 1.081< nominal rate , 8.1/
53
18. ! 0ash flo& re0eived in t&o years is eCpe0ted to 4e @11,23*. If the real rate of interest is :/ and
the inflation rate is */, &hat is the real 0ash flo& for yearB2?
!" @11,23*
#" @10,355
$" @10,000
%" @7,2:*
!ns&er $
'ype (edium
)age 123
+esponse +eal 0ash flo& , 1123*211.0*D2" , 10,000
15. 'he real interest rate is 2/ and the inflation rate is :/. What is the nominal interest rate?
!" 3/
#" :/
$" *.05/
%" 2/
!ns&er $
'ype 6asy
)age 123
+esponse 1 = nominal rate , 11 = real rate" 11 = inflation rate" , 11.02"11.0:" ,11.0*05" , *.05/
17. If the nominal interest rate is *.9/ and the inflation rate is 3/, &hat is the real interest rate?
!" 3.:/
#" 7.9/
$" :/
%" 3one of the a4ove
!ns&er !
'ype 6asy
)age 123
+esponse 1 = real rate , 11 = nominal rate" 2 11 = inflation rate" , 1.0*921.03 ,1.03:< real rate ,
3.:/
20. )roper treatment of inflation in the 3)V 0al0ulation involves
!" %is0ounting nominal 0ash flo&s using the nominal dis0ount rate
#" %is0ounting real 0ash flo&s using the real dis0ount rate
$" %is0ounting nominal 0ash flo&s using the real dis0ount rates
%" ! and #
!ns&er %
'ype (edium
)age 123
5:
21. +eal 0ash flo& o00urring in yearB2 is 90,000. If the inflation rate is 10/ per year, 0al0ulate
nominal 0ash flo& for yearB2.
!" *0,900
#" 90,000
$" 99,000
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 123
+esponse 3ominal 0ash flo& , 190,000"11.1"D2 , *0,900
22. 'he 3)V value o4tained 4y dis0ounting nominal 0ash flo&s using the nominal dis0ount rate is
!" 'he same as the 3)V value o4tained 4y dis0ounting real 0ash flo&s using the real dis0ount
rate
#" 'he same as the 3)V value o4tained 4y dis0ounting real 0ash flo&s using the nominal
dis0ount rate
$" 'he same as the 3)V value o4tained 4y dis0ounting nominal 0ash flo&s using the real
dis0ount rate
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 123
23. ! 0apital equipment 0osting @100,000 today has no 1Gero" salvage value at the end of 9 years. If
straightBline depre0iation is used, &hat is the 4oo> value of the equipment at the end of three
years?
!" @110,000
#" @50,000
$" @*0,000
%" @:0,000
!ns&er %
'ype (edium
)age 12:
+esponse
!nnual depre0iation , @100,00029 , 20,000
%epre0iation for 3 years , *0,000
#oo> value , 100,000 *0,000 , :0,000
59
2:. $apital equipment 0osting @200,000 today has 90,000 salvage value at the end of 9 years. If the
straight line depre0iation method is used, &hat is the 4oo> value of the equipment at the end of
t&o years?
!" @200,000
#" @180,000
$" @1:0,000
%" @90,000
!ns&er $
'ype (edium
)age 12:
+esponse
!nnual depre0iation , 1200,000 90,000"29 , 30,000
#oo> value at the end of t&o years , 200,000 *0,000 , 1:0,000
29. Ror proFe0t ! in year B 2, inventories in0rease 4y @10,000 and a00ounts paya4le 4y @:,000.
$al0ulate the in0rease or de0rease in net &or>ing 0apital for yearB2.
!" In0reases 4y @1:,000
#" %e0reases 4y @1:,000
$" In0reases 4y @*,000
%" %e0reases 4y @*,000
6" 3one of the a4ove
!ns&er $
'ype (edium
)age 12:
+esponse Wor>ing 0apital , 10,000 :000 , *,000
2*. Ror proFe0t O, year B 9 inventories in0rease 4y @9,000, a00ounts re0eiva4les 4y @3,000 and
a00ounts paya4les 4y @2,000. $al0ulate the in0rease or de0rease in &or>ing 0apital for yearB9.
!" In0reases 4y @*,000
#" %e0reases 4y @*,000
$" In0reases 4y @5,000
%" %e0reases 4y @8,000
!ns&er !
'ype (edium
)age 12:
+esponse Wor>ing 0apital 9000 = 3000 2000 , *,000
5*
28. If the depre0iation amount is @100,000 and the marginal taC rate is 30/, then the taC shield due to
depre0iation is
!" @333,333
#" @100,000
$" @30,000
%" 3one of the a4ove
!ns&er $
'ype 6asy
)age 128
+esponse 'aC shield effe0t , 1100,000"1.3" , 30,000
25. If the depre0iation amount is *00,000 and the marginal taC rate is 30/, then the taC shield due to
depre0iation is
!" @150,000
#" @*00,000
$" @210,000
%" 3one of the a4ove
!ns&er !
'ype 6asy
)age 128
+esponse 'aC shield effe0t , 1*00,000"10.30" , 150,000
Nse the follo&ing to ans&er questions 27B30
.ou o&n 100 a0res of tim4erland, &ith young tim4er &orth @20,000 if logged today. 'his represents 900
0ords of &ood at @:0 per 0ord. !fter logging, the land 0an 4e sold today for @10,000 1@100 per a0re".
'he opportunity 0ost of 0apital is 10/. .ou have made the follo&ing estimates
1i" 'he pri0e of a 0ord of &ood &ill in0rease 4y 9/ per year.
1ii" 'he pri0e of land &ill in0rease 4y 3/ per year.
1iii" 'he yearly gro&th rate of the 0ords of &ood on your land are years 1B2 19/< years 3B: 10/< years
9B5 9/< years thereafter 2/.
27. 'he present value of the optimal de0ision is approCimately
!" @30,000
#" @32,500
$" @3:,290
%" @33,530
!ns&er $
'ype %iffi0ult
)age 127
+esponse )V , L90011.19D2"11.1D2"1:0"11.09D:" = 110,000"11.03D:"M211.1D:" , 3:,290
58
30. 'he optimal de0ision is to sell after
!" 5 years
#" 9 years
$" : years
%" 3 years
!ns&er $
'ype %iffi0ult
)age 127
31. .ou have 4een as>ed to evaluate a proFe0t &ith infinite life. Sales and 0osts are proFe0ted to 4e
@1000 and @900 respe0tively. 'here is no depre0iation and the taC rate is 30/. 'he real required
rate of return is 10/. 'he inflation rate is :/ and is eCpe0ted to 4e :/ forever. Sales and 0osts
&ill in0rease at the rate of inflation. If the proFe0t 0osts @3000, &hat is the 3)V?
!" @3*9.35
#" @1*27.*2
$" @900.00
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 127
+esponse L11100021.0:" 190021.0:"" 10.8"M 2 0.1 B 3000 , @3*9.35
32. ! proFe0t 0osts @100 today. It has sales of @100 per year forever. $osts &ill 4e @90 the first year
and in0rease 4y 17/ per year. Ignoring taCes 0al0ulate the 3)V of the proFe0t at the dis0ount rate
of 10/.
!" @11.*2
#" @*9.00
$" @100.00
%" $annot 4e 0al0ulated as g E r
!ns&er !
'ype %iffi0ult
)age 127
+esponse 3)V , B100 = 1100B90"21.1 = 1100 190 - 1.17""211.1D2" = 1100 90 11.17D2""211.1"D3 =
1100 90 11.17D3""211.1D:" , B100=111.*2 , @11.*2
55
33. ! proFe0t requires an initial investment of @200,000 and is eCpe0ted to produ0e a 0ash flo& 4efore
taCes of 120,000 per year for t&o years. Li.e. 0ash flo&s &ill o00ur at t , 1 and t , 2M. 'he
0orporate taC rate is 30/. 'he assets &ill 4e depre0iated using (!$+S S 3 year s0hedule t,1,
33.33/< t , 2 ::.:9/< t , 3 1:.51/< t , : 8.:/. 'he 0ompanyAs taC situation is su0h that it 0an
ma>e use of all appli0a4le taC shields. 'he opportunity 0ost of 0apital is 12/. !ssume that the
asset 0an 4e sold for 4oo> value. $al0ulate the 3)V of the proFe0t at the end of t&o years.
1approCimately"
!" @1*,910
#" @17,981
$" @:8,039
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 127
+esponse B200,000 = 110:,00021.12" = 11110,*80=::,::0"211.12D2"" , @1*,910
3:. 'he I++ for the proFe0t in the previous question is 1approCimately"
!" 12/
#" 10/
$" 18.5/
%" 3one of the a4ove
!ns&er %
'ype %iffi0ult
)age 127
+esponse 0 , B200,000 = 110:,000211=I++"" = 1199,0002111=I++"D2"" , 18.5/
39. H( $onstru0tion $ompany must 0hoose 4et&een t&o types of 0ranes. $rane ! 0osts @*00,000,
&ill last for 9 years, and &ill require @*0,000 in maintenan0e ea0h year. $rane # 0osts @890,000
and &ill last for seven years and &ill require @30,000 in maintenan0e ea0h year. (aintenan0e
0osts for 0ranes ! and # are in0urred at the end of ea0h year. 'he appropriate dis0ount rate is
12/ per year. Whi0h ma0hine should H( $onstru0tion pur0hase?
!" $rane ! as 6!$ is @22*,:::
#" $rane # as 6!$ is @17:,33*
$" $rane ! as the )V is @51*,25*
%" $annot 4e 0al0ulated as the revenues for the proFe0t are not given
!ns&er #
'ype %iffi0ult
)age 131
+esponse
)V 1!" , *00000 = *0000 13.*0:5" , 51*,25*
6!$ , @ 22*,:::
)V1#" , 890000 = 30000 1:.9*35" , 55*,713
6!$ , 17:,33*.:9
57
3*. 'he proFe0ts have the follo&ing 3)Vs and proFe0t lives.
Project NPV Life
)roFe0t ! @9,000 : years
)roFe0t # @8,000 8 years
If the 0ost of 0apital is 12/, &hi0h proFe0t &ould you a00ept?
!" !
#" #
$" #oth ! and #
%" +eFe0t 4oth ! and #
!ns&er #
'ype %iffi0ult
)age 133
+esponse
6!$1!" , 900023.0383:7 , 1*:*.18
6!$1#" , 80002:.9*3890 , 1933.52
38. '&o ma0hines, ! and #, &hi0h perform the same fun0tions, have the follo&ing 0osts and lives.
' y p e ) V $ o s t s J i f e
( a 0 h i n e ! @ * 0 0 0 9
( a 0 h i n e # @ 5 0 0 0 8
Whi0h ma0hine &ould you 0hoose? 'he t&o ma0hines are mutually eC0lusive and the 0ost of
0apital is 19/.
!" (a0hine ! as the 6!$ is @1857.57
#" (a0hine # as the 6!$ is @1722.55
$" %onAt 4uy either ma0hine
!ns&er !
'ype %iffi0ult
)age 133
+esponse
6!$1!" , *,00023.39219 , 1857.57
6!$1#" , 50002:.1*0: , 1722.55
True/False Questions
' R 35. When 0al0ulating 0ash flo&s, it is important to 0onsider all in0idental effe0ts.
!ns&er 'rue
'ype 6asy
)age 120
70
' R 37. Sun> 0osts are unaffe0ted 4y the de0ision to a00ept or reFe0t and should 4e ignored.
!ns&er 'rue
'ype 6asy
)age 121
' R :0. Hpportunity 0osts should not 4e in0luded as they are missed opportunities.
!ns&er Ralse
'ype (edium
)age 121
' R :1. #y underta>ing the analysis in real terms, the finan0ial manager avoids having to fore0ast
inflation.
!ns&er Ralse
'ype (edium
)age 122
' R :2. %o not forget to in0lude interest and dividend payments &hen 0al0ulating the proFe0tAs
0ash flo&.
!ns&er Ralse
'ype (edium
)age 122
' R :3. %epre0iation a0ts as a taC shield in redu0ing the taCes.
!ns&er 'rue
'ype (edium
)age 125
' R ::. !n investment should 4e postponed as long as the opportunity 0ost of 0apital is less than
the gro&th rate of the value of the proFe0t.
!ns&er 'rue
'ype (edium
)age 130
71
' R :9. 'he rule for 0omparing ma0hines &ith different lines is to sele0t the ma0hine &ith the
lo&est equivalent annual 0ost 16!$".
!ns&er 'rue
'ype (edium
)age 132
' R :*. .ou should repla0e a ma0hine &hen the 6!$ of 0ontinuing to operate it eC0eeds the 6!$
of the neCt ma0hine.
!ns&er 'rue
'ype %iffi0ult
)age 133
' R :8. .ou should al&ays repla0e all old ma0hines &ith ne& ones.
!ns&er Ralse
'ype (edium
)age 13*
Short ,ns*er Questions
:5. %efine the term 0ash flo& for a proFe0t.
!ns&er $ash flo& for a proFe0t is the net in0ome plus depre0iation.
'ype 6asy
)age 120
:7. What are some of the important points to remem4er &hile estimating the 0ash flo&s of a proFe0t?
!ns&er
6stimate afterBtaC 0ash flo&s on an in0remental 4asis.
In0lude all in0idental effe0ts.
In0lude &or>ing 0apital requirements
In0lude opportunity 0osts.
%o not in0lude sun> 0osts
'a>e inflation into 0onsideration in a 0onsistent manner
'ype (edium
)age 123
72
90. #riefly dis0uss ho& taCes are ta>en into 0onsideration in other 0ountries li>e Japan.
!ns&er In Japan and all of the 6uropean $ommunity 0ountries, it is not possi4le to separate taC
a00ounts reported to the government and those reported to shareholders. 'hey must 4e the same.
'ype (edium
)age 127
91. What are some of the additional fa0tors that have to 4e 0onsidered &hile estimating 0ash flo&s in
other 0ountries and 0urren0ies
!ns&er
$urren0y of the 0ash flo& should 4e relevant to the proFe0t
Nse an appropriate inflation rate for the proFe0t
Nse the relevant taC rate for the proFe0t
Nse the appropriate dis0ount rate for the proFe0t
'ype (edium
)age 130
92. Po& do you 0ompare proFe0ts &ith different lives?
!ns&er )roFe0ts &ith different lives are 0ompared assuming that the proFe0ts are repeated to
infinity, 0alled repla0ement 0hains. 'he repla0ement 0hains are analyGed using equivalent annual
0osts 16!$" or adFusted 3)Vs 1adFusted for differen0es in proFe0t lives"
'ype (edium
)age 139
93. #riefly eCplain ho& the de0ision to repla0e an eCisting ma0hine is made?
!ns&er 'he de0ision to repla0e an eCisting ma0hine is done for e0onomi0 or te0hnologi0al
reasons or for 4oth. Ror this equivalent annuity approa0h is used. !s long as the 4enefits eC0eed
equivalent annual 0osts repla0ing old ma0hine &ith a ne& one &ill 4e a sound de0ision.
'ype %iffi0ult
)age 139
9:. #riefly eCplain the term T proFe0t intera0tionsT
!ns&er )roFe0t intera0tions 0an happen in many &ays. (utually eC0lusive proFe0ts and
dependent proFe0ts are simple eCamples. )roFe0t intera0tions o00ur &hen ta>ing a proFe0t affe0ts
the 0ash flo&s of other proFe0ts.
'ype (edium
)age 138
73
99. 6Cplain the idea 4ehind the optimal timing of investment.
!ns&er In many situations a proFe0t may 4e more valua4le if underta>en in the future. 'hus
&aiting may 4e an option in many situations. 'hese have to 4e analyGed 4efore underta>ing a
proFe0t.
'ype (edium
)age 138
9*. #riefly eCplain ho& pea> demand 0an 4e met e0onomi0ally.
!ns&er (any proFe0ts involve dealing &ith flu0tuating demand. Keeping inventory of finished
goods is one &ay of handling this pro4lem. (any times it is e0onomi0al to use old 1less effi0ient"
ma0hines to ta>e 0are of pea> demand if it o00urs for a short period of time. Investing in ne&
equipment to meet pea> loads may not 4e e0onomi0al. In some instan0es, the option of not
repla0ing all the old ma0hines &ith ne& ma0hines should also 4e 0onsidered.
'ype (edium
)age 135
Chapter - $ntro"uction to +isk. +eturn. an" the 'pportunity Cost of Capital
Multiple Choice Questions
1. Whi0h of the follo&ing portfolios have the least ris>?
!" ! portfolio of 'reasury 4ills
#" ! portfolio of long term Nnited States Iovernment 4onds
$" Standard and )oorAs 0omposite indeC
%" )ortfolio of 0ommon sto0>s of small firms
!ns&er !
'ype 6asy
)age 193
2. What has 4een the average nominal rate of interest on 'reasury 4ills over the past seventyBfive
years?
!" Jess than 1/
#" #et&een 1/ and 2/
$" #et&een 2/ and 3/
%" #et&een 3/ and :/
!ns&er %
'ype 6asy
)age 199
3. What has 4een the average real rate of interest on 'reasury 4ills over the past seventyBfive years?
7:
!" Jess than 1/
#" #et&een 1/ and 2/
$" #et&een 2/ and 3/
%" #et&een 3/ and :/
!ns&er !
'ype 6asy
)age 199
:. Standard and )oorAs 900 IndeC is a
!" )ortfolio of 0ommon sto0>s
#" )ortfolio of 0orporate 4onds
$" )ortfolio of government 4onds
%" ! and # a4ove
!ns&er !
'ype (edium
)age 199
79
9. JongBterm government 4onds have
!" Interest rate ris>
#" %efault ris>
$" (ar>et ris>
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 199
*. Hne dollar invested in the SQ) indeC in 172* &ould have gro&n in nominal value 4y the end of
year 2000 to
!" @*:02.2
#" @295*.9
$" @*:.1
%" @1*.*
!ns&er #
'ype (edium
)age 199
8. Hne dollar invested in the SQ) indeC in 172* &ould have gro&n in real value 4y the end of year
2000 to
!" @*97.*
#" @2**.9
$" @*.*
%" @9.0
!ns&er #
'ype (edium
)age 199
5. What has 4een the average ris> premium on 0ommon sto0>s 4et&een 172* and 2000?
!" 13.:/
#" 7.1/
$" 2.2/
%" 1.7/
!ns&er #
'ype (edium
)age 199
7*
7. What has 4een the average annual rate of return 1normal value" for small 0ommon sto0>s 4et&een
172* and 2000?
!" 18.3/
#" 13.0/
$" *.0/
%" 3.7/
!ns&er !
'ype (edium
)age 199
10. Whi0h portfolio had the highest average annual 1real" return 4et&een 172* and 2000?
!" Small firm 0ommon sto0>s
#" $ommon sto0>s
$" Iovernment 4onds
%" 'reasury 4ills
!ns&er !
'ype (edium
)age 199
11. Whi0h portfolio has had the lo&est average annual nominal rate of return during the 172*B2000
period?
!" Small firm 0ommon sto0>s
#" $ommon sto0>s
$" Iovernment 4onds
%" 'reasury 4ills
!ns&er %
'ype (edium
)age 199
12. What has 4een the average ris> premium on smallBfirm 0ommon sto0>s 4et&een 172* and 2000?
!" (ore than 10/
#" #et&een 5/ and 10/
$" #et&een 2/ and 9/
%" Jess than 2/
!ns&er !
'ype (edium
)age 199
78
13. Whi0h portfolio has had the highest average ris> premium during the period 172*B2000?
!" Small firm 0ommon sto0>s
#" $ommon sto0>s
$" Iovernment 4onds
%" 'reasury 4ills
!ns&er !
'ype (edium
)age 199
1:. Standard error measures
!" 3ominal annual rate of return on a portfolio
#" +is> of a portfolio
$" +elia4ility of an estimate
%" +eal annual rate of return on a portfolio
!ns&er $
'ype %iffi0ult
)age 19*
19. Standard error is estimated as
!" !verage annual rate of return divided 4y the square root of the num4er of o4servations
#" Standard deviation of returns divided 4y the square root of the num4er of o4servations
$" Varian0e divided 4y the num4er of o4servations
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 19*
1*. If the standard deviation is 13.:/ and the num4er of o4servations is 10, &hat is the standard
error?
!" :.23 /
#" 2.:/
$" 0.:8/
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 19*
+esponse Standard error , 13.:v10 , :.23/
75
18. Spill Hil $ompanyAs sto0>s had B5/, 12/ and 2*/ rates of return during the last three years
respe0tively< 0al0ulate the average rate of return for the sto0>.
!" 10/ per year
#" 5/ per year
$" 12/ per year
%" 3one of the a4ove
!ns&er !
'ype 6asy
)age 19*
+esponse !verage rate of return , 1B5 = 12 = 2*" 2 3 , 10/
15. If the average annual rate of return for 0ommon sto0>s is 13/, and treasury 4ills is 3.5/, &hat is
the average mar>et ris> premium?
!" 13/
#" 3.5/
$" 7.2/
%" 3one of the a4ove
!ns&er $
'ype 6asy
)age 19*
+esponse !verage ris> premium 13 3.5 , 7.2/
17. 'he dis0ount rate for safe proFe0ts is the
!" (ar>et rate of return
#" +is>Bfree rate
$" (ar>et ris> premium
%" 3one of the a4ove
!ns&er #
'ype 6asy
)age 198
20. 'he dis0ount rate for a proFe0t &ith a ris> the same as the mar>et ris> is the
!" (ar>et rate of return
#" +is>Bfree rate
$" (ar>et ris> premium
%" 3one of the a4ove
!ns&er !
'ype 6asy
)age 198
77
21. (ega $orporation has the follo&ing returns for the past three years 5/, 1*/ and 2:/.
$al0ulate the varian0e of the return and the standard deviation of the returns.
!" *: and 5/
#" 125 and 11.3/
$" :3 and *.9/
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 1*1
+esponse (ean , 15=*=2:"23 , 1*/< Varian0e , L15B1*"D2 = 11*B1*"D2 = 12:B1*"D2M213B1" , *:<
Standard deviation , *:D1122" , 5/
22. (a0ro $orporation has had the follo&ing returns for the past three years, B20/, 10/, :0/.
$al0ulate the standard deviation of the returns.
!" 10/
#" 30/
$" *0/
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age 1*1
+esponse (ean , 1B20=10=:0"23 , 10/< Varian0e , L1B20B10"D2 = 110B10"D2 = 1:0B10"D2M 22 ,
700<
Standard deviation , 30/
23. (i0ro $orporation has had returns of S9/, 19/ and 20/ for the past three years. $al0ulate the
standard deviation of the returns.
!" 10/
#" 22.7/
$" 30/
%" 3one of the a4ove
!ns&er #
'ype %iffi0ult
)age 1*1
+esponse 1B9 =19=20"23 , 10/< Varian0e , L1B9B10"D2 = 119B10"D2 = 120B10"D2M213B1" , 929<
Standard deviation , 929D1122" , 22.7/
100
2:. What has 4een the standard deviation of returns of 0ommon sto0>s during the period 4et&een
172* and 2000?
!" 20.2/
#" 33.:/
$" 5.8/
%" 7.:/
!ns&er !
'ype (edium
)age 1*:
29. Whi0h portfolio had the highest standard deviation during the period 4et&een 172* and 2000?
!" Small firm 0ommon sto0>s
#" $ommon sto0>s
$" Iovernment 4onds
%" 'reasury 4ills
!ns&er !
'ype 6asy
)age 1*:
2*. 'he standard deviation of the NK mar>et during the period from 177* through 2001 &as
!" 2:.1/
#" 20.8/
$" 1:.9/
%" 3one of the a4ove
!ns&er $
'ype (edium
)age 1**
28. 'he portion of the ris> that 0an 4e eliminated 4y diversifi0ation is 0alled
!" Nnique ris>
#" (ar>et ris>
$" Interest rate ris>
%" %efault ris>
!ns&er !
'ype (edium
)age 1*5
101
25. 'he unique ris> is also 0alled the
!" Nnsystemati0 ris>
#" %iversifia4le ris>
$" Rirm spe0ifi0 ris>
%" +esidual ris>
6" !ll of the a4ove
!ns&er 6
'ype 6asy
)age 1*5
27. Sto0> ! has an eCpe0ted return of 10/ per year and sto0> # has an eCpe0ted return of 20/. If
99/ of the funds are invested in sto0> #, &hat is the eCpe0ted return on the portfolio of sto0> !
and sto0> #?
!" 10/
#" 20/
$" 19.9/
%" 3one of the a4ove
!ns&er $
'ype 6asy
)age 1*7
+esponse 0.99110" = 0.:9120" , 19.9/
30. !s the num4er of sto0>s in a portfolio is in0reased
!" Nnique ris> de0reases and approa0hes to Gero
#" (ar>et ris> de0rease
$" Nnique ris> de0reases and 4e0omes equal to mar>et ris>
%" total ris> approa0hes to Gero
!ns&er !
'ype (edium
)age 1*7
102
31. Sto0> O has a standard deviation of return of 10/. Sto0> . has a standard deviation of return of
20/. 'he 0orrelation 0oeffi0ient 4et&een sto0>s is 0.9. If you invest *0/ of the funds in sto0> O
and :0/ in sto0> ., &hat is the standard deviation of a portfolio?
!" 10/
#" 20/
$" 12.2/
%" 22/
6" 3one of the a4ove
!ns&er $
'ype %iffi0ult
)age 181
+esponse 10.*D2"110D2" = 10.:D2" 120D2" = 12"10.*"10.:"10.9"110"120" , 1:5 < Standard deviation
, 11:5D0.9" , 12.2/
32. Sto0> ( and Sto0> 3 have had returns for the past three years of S12/. 10/, 32/ and */, 19/,
2:/ respe0tively. $al0ulate the 0ovarian0e 4et&een the t&o se0urities.
!" =175
#" S175
$" =132
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 181
+esponse
1B12 =10 = 32"23 , 10/
1*=19=2:"23 , 19/
$ov1+(, +3" , L1B12B10"1*B19" = 110B10"119B19"=132B10"12:B19"M213B1" , 175
33. Sto0> ) and sto0> ; have had annual returns of B10/, 12/, 25/ and 5/, 13/, 2:/ respe0tively.
$al0ulate the 0ovarian0e of return 4et&een the se0urities.
!" 1:7
#" S1:7
$" 100
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 181
+esponse
(ean 1)" , 1B10 = 12 = 25"23 , 10/ (ean 1;" , 15=13=2:"23 , 19/
$ov1),;" , L1B10B10"15B19"= 112B10" 113B19" = 125B10"12:B19"M22 , 1:7
103
3:. If the 0ovarian0e 4et&een sto0> ! and sto0> # is 100, the standard deviation of sto0> ! is 10/
and that of sto0> # is 20/, 0al0ulate the 0orrelation 0oeffi0ient 4et&een the t&o se0urities.
!" =0.9
#" =1.0
$" S0.9
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 181
+esponse $orr1+!, +#" , 1002110 - 20" , =0.9
39. If the 0orrelation 0oeffi0ient 4et&een sto0> $ and sto0> % is =1.0/ and the standard deviation of
return for sto0> $ is 19/ and that for sto0> % is 30/, 0al0ulate the 0ovarian0e 4et&een sto0> $
and sto0> %.
!" =:9
#" =:90
$" S:9
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 181
+esponse $ov1+$, +%" , 1=1"130"119" , =:90
3*. 'he range of values that 0orrelation 0oeffi0ients 0an ta>e 0an 4e
!" S1 to =1
#" Gero to =1
$" Sinfinity to =infinity
%" Gero to =infinity
!ns&er !
'ype (edium
)age 181
38. Ror a t&oBsto0> portfolio, the maCimum redu0tion in ris> o00urs &hen the 0orrelation 0oeffi0ient
4et&een the t&o sto0>s is
!" =1
#" 0
$" S0.9
%" S1
!ns&er %
'ype (edium
)age 181
10:
35. 'he T4etaT is a measure of
!" Nnique ris>
#" (ar>et ris>
$" 'otal ris>
%" 3one of the a4ove
!ns&er #
'ype (edium
)age 183
37. 'he varian0e or standard deviation is a measure of
!" 'otal ris>
#" Nnique ris>
$" (ar>et ris>
%" 3one of the a4ove
!ns&er !
'ype (edium
)age 183
:0. 'he 4eta of mar>et portfolio is
!" 0
#" =0.9
$" =1.0
%" S1.0
!ns&er $
'ype 6asy
)age 188
:1. 'he 4eta of a ris>Bfree portfolio is
!" 0
#" =0.9
$" =1.0
%" S1.0
!ns&er !
'ype 6asy
)age 188
109
:2. If the standard deviation of returns of the mar>et is 20/ and the 4eta of a &ellBdiversified
portfolio is 1.9, 0al0ulate the standard deviation of the portfolio
!" 10/
#" 20/
$" 30/
%" :0/
6" none of the a4ove
!ns&er $
'ype (edium
)age 188
+esponse Standard deviation of the portfolio , 11.9"-120" , 30/
:3. 'he 0orrelation 0oeffi0ient 4et&een sto0> ! and the mar>et portfolio is =0.*. 'he standard
deviation of return of the sto0> is 30/ and that of the mar>et portfolio is 20/. $al0ulate the 4eta
of the sto0>.
!" 0.7
#" 1.0
$" 1.1
%" 0.*
!ns&er !
'ype %iffi0ult
)age 188
+esponse
$ov 1+s, +m" , 10.*"120"130" , 3*0 var1+m", 20D2 , :00
#eta , 1$ov1+s, +m"" 2 var1+m", 3*02:00 , 0.7
::. 'he 0orrelation 0oeffi0ient 4et&een sto0> # and the mar>et portfolio is 0.5. 'he standard
deviation of the sto0> # is 39/ and that of the mar>et is 20/. $al0ulate the 4eta of the sto0>.
!" 1.0
#" 1.:
$" 0.5
%" 0.8
!ns&er #
'ype %iffi0ult
)age 188
+esponse $ov1+4 +m", 10.5"120"139" , 9*0 #eta , 9*02:00 , 1.:
10*
:9. Pistori0al nominal return for sto0> ! is S5/, =10/ and =22/. 'he nominal return for the
mar>et portfolio is =*/, =15/ and 2:/. $al0ulate the 4eta for sto0> !.
!" 1.*:
#" 0.*1
$" 1.0
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 188
+esponse (ean ! , 5/, (ean (,1*/, $ov1+a, +m" , 135 Var 1+m" , 5: #eta,13525:,1.*:
:*. 'he three year annual return for sto0> # 0omes out to 4e 0/, 10/ and 2*/. 'hree year annual
returns for the mar>et portfolios are =*/, 15/, 2:/. $al0ulate the 4eta for the sto0>.
!" 1.3*
#" 0.8:
$" 0
%" 3one of the a4ove
!ns&er !
'ype %iffi0ult
)age 188
+esponse (ean # , 12/, (ean (,1*/, $ov1+a, +m" , 11: Var 1+m" , 5: #eta,11:25:,1.3*
True/False Questions
' R :8. 'reasury 4ills have provided the lo&est average return 4et&een 172*B1778.
!ns&er 'rue
'ype 6asy
)age 199
' R :5. +is> premium is the differen0e 4et&een the se0urity return and the 'reasury 4ill return.
!ns&er 'rue
'ype 6asy
)age 199
' R :7. 'he standard statisti0al measures of spread are varian0e and standard deviation.
!ns&er 'rue
'ype 6asy
)age 1*0
108
105
' R 90. %iversifi0ation redu0es ris> 4e0ause pri0es of different se0urities do not move eCa0tly
together.
!ns&er 'rue
'ype 6asy
)age 1*8
' R 91. 'he ris> that 0annot 4e eliminated 4y diversifi0ation is 0alled mar>et ris>.
!ns&er 'rue
'ype (edium
)age 1*5
' R 92. 'he ris> that 0annot 4e eliminated 4y diversifi0ation is 0alled unique ris>.
!ns&er Ralse
'ype (edium
)age 1*5
' R 93. 'he average 4eta of all sto0>s is Gero.
!ns&er Ralse
'ype (edium
)age 189
' R 9:. ! portfolio &ith a 4eta of Gero offers an eCpe0ted return of Gero.
!ns&er Ralse
'ype (edium
)age 188
' R 99. #eta of a &ellBdiversified portfolio is equal to the value &eighted average 4eta of the
se0urities in0luded in the portfolio.
!ns&er 'rue
'ype (edium
)age 188
107
Short ,ns*er Questions
9*. %efine the term ris> premium.
!ns&er 'he differen0e 4et&een the se0urity return and the ris> free rate, su0h as a 'reasury 4ill
return, is 0alled the ris> premium. 'his denotes the additional return on the se0urity 4e0ause of
additional ris>.
'ype (edium
)age 199
98. #riefly eCplain the term Tvarian0eT of the returns.
!ns&er Varian0e is a standard statisti0al measure of spread. 'he varian0e is the eCpe0ted
squared deviation from the eCpe0ted return. Rrom a finan0e point of vie& this measures the total
ris> of a se0urity higher the varian0e, higher the ris>. 'his is also 0alled the measure of total ris>.
'ype (edium
)age 1*1
95. #riefly eCplain ho& diversifi0ation redu0es ris>.
!ns&er %iversifi0ation redu0es ris> 4e0ause pri0es of different se0urities do not move eCa0tly
together. When you form portfolios using a large num4er of sta0>s the varia4ility of the portfolio
is mu0h less than average varia4ility of individual sto0>s.
'ype (edium
)age 1*5
97. In the formula for 0al0ulating the varian0e of 3B asset portfolio, ho& many 0ovarian0e and
varian0e terms are there?
!ns&er In the formula for 0al0ulating the varian0e of 3Basset portfolio, there are L313B1"M22
0ovarian0e terms and 3 varian0e terms
'ype 6asy
)age 185
*0. %is0uss the importan0e of T4etaT as a measure of ris>.
!ns&er T#etaT is a measure of mar>et ris>. It is also 0alled relative measure of ris> as it
measures ris> relative to the mar>et ris>. #eta is useful as a measure of ris> in the 0onteCt of
&ellBdiversified portfolios. It measures the ris> 0ontri4ution of a single se0urity to the portfolio
ris>.
'ype (edium
)age 183
110
*1. #riefly eCplain ho& T4etaT of a sto0> is estimated.
!ns&er T#etaT of a sto0> 0an 4e estimated graphi0ally 4y plotting the mar>et returns on the CB
aCis and the 0orresponding sto0> returns on the yBaCis. 'he slope of the resulting linear graph is
the T4etaT estimate for the sto0>. L
i
, $ov1+
i
, +
m
"2Var1+
m
"M
'ype (edium
)age 183
*2. What is the statisti0al definition of T4etaT?
!ns&er Statisti0ally, 4eta is defined as the ratio of 0ovarian0e 4et&een sto0> returns and the
mar>et returns, and the varian0e of the mar>et returns. LL
i
, $ov1+
i
, +
m
"2Var1+
m
"M
'ype (edium
)age 189
*3. #riefly eCplain the differen0e 4et&een 4eta as a measure of ris> and varian0e as a measure of ris>.
!ns&er Varian0e measures the total ris> of a se0urity and is a measure of standBalone ris>. 'otal
ris> has 4oth unique ris> and mar>et ris>. In a &ellBdiversified portfolio, unique ris>s tend to
0an0el ea0h other out and only the mar>et ris> is remaining. #eta is a measure of mar>et ris> and
is useful in the 0onteCt of a &ellBdiversified portfolio. #eta measures the sensitivity of the
se0urity returns to 0hanges in mar>et returns. (ar>et portfolio has a 4eta of one and is
0onsidered the average ris>.
'ype (edium
)age 18*
*:. #riefly eCplain ho& individual se0urities affe0t portfolio ris>.
!ns&er 'he ris> of a &ellBdiversified portfolio depends on the mar>et ris> of the se0urities
in0luded in the portfolio. )ortfolio 4eta is the &eighted average of individual se0urity 4etas
in0luded in the portfolio.
'ype (edium
)age 18*
111
*9. What is the 4eta of a portfolio &ith a large num4er of randomly sele0ted sto0>s?
!ns&er 'he 4eta of a portfolio &ith a large num4er of randomly sele0ted sto0>s is equal to one.
'he standard deviation of su0h a portfolio is equal to the standard deviation of the mar>et.
'ype (edium
)age 188
**. Po& 0an individual investors diversify?
!ns&er Hne of the simplest &ays for individual investor to diversify is to 4uy shares in a mutual
fund that holds a diversified portfolio.
'ype (edium
)age 185
112