Deck 13: Risk and Capital Budgeting

Question 1

A common stock with a beta of 1.0 is said to be of equal risk with the market.

Answer 1

True

Question 2

A basic assumption in financial theory is that most investors and managers are risk seekers.

Answer 2

False

Question 3

The investor's portfolio should always be on the efficient frontier.

Answer 3

True

Question 4

In order to reduce risk, one should diversify into areas that are positively correlated with current areas of involvement.

Question 5

When choosing portfolios of assets, management should try to achieve the highest possible return at a given level of risk.

Question 6

The coefficient of correlation represents the standard deviation divided by the expected value.

Question 7

The highest possible value for positive correlation is +1.

Question 8

Projects that are totally uncorrelated provide some overall reduction in portfolio risk.

Question 9

If we are risk-averse, a risky investment with an 8% return will be preferred over a 10% risk-free investment.

Question 10

Generally, because of the unpredictability of earnings, cyclical stocks are given higher price-earnings multiples than growth stocks.

Question 11

In considering the share price effect on risk-return trade-offs, our goal should always be to earn the highest return possible.

Question 12

The cost of capital is assumed to contain no risk for the firm.

Question 13

The expected value is a weighted average of the outcomes multiplied by their probabilities.

Question 14

Projects with high positive correlation are sometimes valuable because they allow us to smooth out the overall performance of the firm during a business cycle.

Question 15

Investment A may have a higher standard deviation than investment B and still have less risk.

Question 16

Generally, the higher the coefficient of variation a project has, the higher the discount rate it should be assigned.

Question 17

Risk is not only measured in terms of losses, but also in terms of variability.

Question 18

The efficient frontier is always along the left-most portion of the risk-return tradeoff diagram.

Question 19

Combining assets with highly correlated returns will reduce portfolio risk.

Question 20

A firm might be willing to accept high risk in a given investment if the portfolio effect (for the whole firm) were beneficial.

Question 21

Simulation models allow the analyst to test possible changes in the variables used in the model.

Question 22

The capital budgeting decisions of a firm will have no effect on the share price of the common stock.

Question 23

Risk may be integrated into capital budgeting decisions by

A) adjusting the standard deviation of possible outcomes.
B) determining the expected value.
C) adjusting the discount rate.
D) adjusting the time horizon.

Question 24

If three investment alternatives all have some degree of risk and different expected returns, which of the following measures could best be used to rank the risk levels of the projects?

A) coefficient of correlation
B) coefficient of variation
C) standard deviation of returns
D) net present value

Question 25

To account for risk an alternative to adjusting the discount rate is the certainty equivalent which adjusts the cash flows.

Question 26

The "efficient frontier" indicates

A) alternatives with neutral combinations of risk and return.
B) alternatives with the highest returns.
C) alternatives with the best combination of risk and return.
D) alternatives with no risk.

Question 27

Sensitivity analysis helps the financial planner to determine how sensitive shareholders will be to changes in investment strategy.

Question 28

Computers are helpful for "what if" simulations, but so far they are not able to assess project risk.

Question 29

The term "risk averse" means that

A) an individual refuses to take risks.
B) most investors and businesspersons seek risk.
C) an individual will seek to avoid risk or be compensated with a higher return.
D) only investment proposals with no risk should be accepted.

Question 30

The firm's highest risk-adjusted discount should be applied to

A) the repair of old machinery.
B) a new product in a related field.
C) a new product in a foreign market.
D) the purchase of new equipment.

Question 31

As the time horizon becomes shorter, more uncertainty enters the forecast.

Question 32

If one project has a higher standard deviation than another

A) it has a greater risk.
B) it has a higher expected value.
C) it has more possible outcomes.
D) it may be riskier, but this can only be determined by the coefficient of variation.

Question 33

As the time horizon increases, the standard deviation for each forecast of cash flow usually increases.

Question 34

Risk is usually measured as the

A) potential loss.
B) variability of outcomes around some expected value.
C) probability of expected values.
D) potential expected loss.

Question 35

Which of the following is a false statement?

A) risky investments may produce large losses
B) risky investments may produce large gains
C) the coefficient of variation is a risk measure
D) risk-averse investors cannot be induced to invest in risky assets

Question 36

In order to reduce risk in a firm, the firm would seek to enter a business that

A) has high positive correlation with its present business.
B) has zero correlation with its present business.
C) has high negative correlation with its present business.
D) has high negative variation with its present business.

Question 37

Choosing projects with returns equal to the company norm but having a higher level of risk will most likely lower the company's share price.

Question 38

Decision trees present a tabular or graphical comparison of projected decision outcomes.

Question 39

Projects which are totally uncorrelated provide more overall risk reduction than negatively correlated projects.

Question 40

Selection of portfolio combinations from the efficient frontier will depend upon our willingness to assume risk.

Question 41

Which investment has the least amount of risk?

A) standard deviation = $500, expected return = $5,000
B) standard deviation = $700, expected return = $ 500
C) standard deviation = $900, expected return = $ 800
D) standard deviation = $400, expected return = $ 350

Question 42

Firm X is considering a project and its analysts have projected the following outcomes and their probabilities. $\begin{array}{lcc}\text { OUTCOME }&\text { PROBABILITY OF OUTCOME, }&\text { ASSUMPTIONS }\\\$ 5,250 & 25 \% & \text { pessimistic } \\\$ 7,800 & 45 \% & \text { moderately successful } \\\$ 13,500 & 30 \% & \text { optimistic }\end{array}$ What is the expected value of the outcomes?

A) $3,123
B) $8,460
C) $8,873
D) cannot be determined/depends upon which prediction is correct

Question 43

An analytical tool which helps to organize the decision process by presenting a graphical comparison of investment choices is called a (an)

A) module hierarchy diagram.
B) "what if" simulation.
C) decision tree.
D) none of the other answers are correct

Question 44

Which of the following is a characteristic of beta?

A) Beta measures only the volatility of returns on an individual bond relative to a bond market index.
B) A beta of 1.0 is of equal risk with the market.
C) A beta of greater than 1.0 has less risk than the market.
D) two of the above are true

Question 45

A correlation coefficient of zero indicates

A) the projects have the same expected value.
B) there is no correlation and no risk reduction between combined projects.
C) there is no correlation, but some risk reduction when the projects are combined.
D) the projects have the same standard deviation.

Question 46

The standard deviation can be defined as the

A) square root of the sum (D - $\overline { \mathrm { D } }$ )² P
B) square root of the sum (D - $\overline { \mathrm { D } }$ )P
C) square root of (D - $\overline { \mathrm { D } }$ )²P
D) square root of (D - $\overline { \mathrm { D } }$ )P

Question 47

Which of the following is a common approach in dealing with uncertainty?

A) Monte Carlo simulation
B) internal rate of return
C) net present value
D) beta analysis

Question 48

The portfolio effect in capital budgeting refers to

A) the relationship of stocks to bonds.
B) the degree of correlation between various investments.
C) the coefficient of variation.
D) the risk-adjusted discount rate.

Question 49

The concept of being risk averse means

A) for a given situation investors would prefer relative certainty to uncertainty.
B) investors would prefer investments with high standard deviations and greater opportunity for gain.
C) that the greater the risk the higher the expected return must be.
D) two of the other answers are correct

Question 50

In a portfolio, risk is evaluated in a different way than with an individual project. In evaluating portfolio risk we

A) need to consider the impact of a given project on the overall risk of the firm.
B) recognize that a risky investment may create a portfolio with less risk.
C) need to consider how the returns of the projects in the portfolio are correlated.
D) all of the other answers are correct.

Question 51

In determining the appropriate discount rate for an individual project, the financial manager will be most influenced by the

A) expected value.
B) internal rate of return.
C) standard deviation.
D) coefficient of variation.

Question 52

Projects that are negatively correlated

A) cut down the maximum profit potential for the firm.
B) increase the possible losses of the firm.
C) are generally in the same industry.
D) none of the other answers are correct.

Question 53

The lower the coefficient of correlation the greater the

A) risk when projects are combined.
B) risk reduction when projects are combined.
C) return when projects are combined.
D) standard deviation when projects are combined.

Question 54

The coefficient of correlation

A) takes on values anywhere from 0 to +1.
B) takes on values anywhere from -1 to 0.
C) takes on values anywhere from -1 to +1.
D) takes on values of 0 or larger.

Question 55

A "what if" simulation using a computer helps to:

A) reduce the risk associated with a particular investment.
B) determine the effects of changes in certain variables.
C) increase the accuracy of the inputs.
D) more than one of the above are true

Question 56

The coefficient of variation (V) can be defined as the

A) expected value multiplied by the standard deviation.
B) standard deviation divided by the mean (expected value).
C) mean (expected value) divided by the standard deviation.
D) standard deviation squared, divided by the expected value.

Question 57

An example of negative correlation may exist between the

A) forest products and housing industries.
B) jewellery and discount furniture industries.
C) steel and aluminum industries.
D) oil and auto industries.

Question 58

Simulation models allow the planner to

A) reduce the standard deviations of projects.
B) test possible changes in each variable.
C) deal with the uncertainty in forecasting outcomes.
D) two of the other answers are correct

Question 59

A project has the following projected outcomes in dollars: $250, $350, and $500. The probabilities of their outcomes are 25%, 50%, and 25% respectively. What is the standard deviation of these outcomes?

A) $363
B) $89
C) $94
D) $178

Question 60

In order to evaluate risk, management may also set qualitative risk classes. Rank these four projects from the least to the most risky. 1. completely new market in Canada
2) completely new market in South America
3) addition to normal product line
4) repair to old machinery

A) 4, 3, 1, 2
B) 1, 2, 3, 4
C) 3, 4, 1, 2
D) 2, 3, 4, 1

Question 61

In a portfolio, risk is evaluated in a different way than with an individual project. In evaluating portfolio risk we

A) need to consider the impact of a given project on the overall risk of the firm.
B) recognize that a risky investment always creates a portfolio with less risk.
C) need to ensure all the projects in the portfolio are positively correlated.
D) all of the other answers are correct.

Question 62

Using the risk-adjusted discount rate approach, the cost of capital is applied to projects with

A) normal risk.
B) high risk.
C) no risk.
D) low risk.

Question 63

A project's coefficient of variation is 0.40. The project has a positive coefficient of correlation of 0.20. The expected value is $2,000. What is one standard deviation?

A) $400.00
B) $500.00
C) $800.00
D) $1,000.00

Question 64

The concept of being risk averse means

A) for a given situation investors would prefer relative certainty to uncertainty.
B) investors would prefer investments with low standard deviations and greater opportunity for gain.
C) that the lower the risk the lower the expected return must be.
D) all of the other answers are correct

Question 65

The "efficient frontier" indicates

A) alternatives with neutral combinations of risk and return.
B) alternatives with the highest returns.
C) alternatives with no risk.
D) none of the other answers are correct

Question 66

Golden Corporation is considering the purchase of new equipment costing $200,000. The expected life of the equipment is 10 years. It is expected that the new equipment can generate an increase in net income of $35,000 per year for the next 10 years. The probabilities for the increase in net income depend on the state of the economy. $\begin{array}{lcr}\text { Aftertax }&\text { Aftertax Probabilities}&\text { Net Income}\\\text { Recession } & .3 & (\$ 15,000) \\\text { Normal } & .5 & 25,000 \\\text { Boom } & .2 & 35,000\end{array}$ The equipment can be amortized using straight-line amortization for tax purposes. Golden's cost of capital is 14%. What is the expected NPV? Should they purchase the new equipment?

Question 67

Projects that are totally uncorrelated provide

A) no risk reduction.
B) some risk reduction.
C) extreme risk reduction.
D) need more information

Question 68

A Monte Carlo simulation model uses

A) random variables as inputs.
B) a point estimate.
C) the cost of capital.
D) portfolio risk.

Question 69

The certainty equivalent approach

A) is only appropriate for analyzing cash flows with risk similar government securities.
B) adjusts each cash flow based on a probability distribution.
C) adjusts the discount to suit the risk of each cash flow.
D) models the sequence of decisions required over time.

Question 70

A coefficient of _____ provides the greatest risk reduction.

A) 0
B) -1
C) + 1
D) +.5

Question 71

Simulation models allow the planner to

A) reduce the standard deviations of projects.
B) test possible changes in each variable.
C) deal with all uncertainty in forecasting outcomes.
D) increase the standard deviations of projects.

Question 72

A coefficient correlation of _____ provides no risk reduction.

A) 0
B) -1
C) + 1
D) +.5

Question 73

Projects that are negatively correlated

A) increase the maximum profit potential for the firm.
B) increase the possible losses of the firm.
C) are generally in the same industry.
D) none of the other answers are correct

Question 74

In order to reduce risk in a firm, the firm would seek to enter a business that

A) has high positive correlation with its present business.
B) has zero correlation with its present business.
C) has high negative correlation with its present business.
D) none of the other answers are correct

Question 75

Using progressively higher discount rates

A) tends to penalize late flows more than early flows.
B) tends to penalize early flows more than late flows.
C) tends to lower net present value.
D) two of the other answers are correct

Question 76

Which investment has the least amount of risk?

A) standard deviation = $800, expected return = $400
B) standard deviation = $700, expected return = $ 3,000
C) standard deviation = $1000, expected return = $8,000
D) standard deviation = $1000, expected return = $7,000

Question 77

Using the risk-adjusted discount rate approach, projects with high coefficients of variation will have ______ net present values than projects with low coefficients of variation.

A) somewhat higher
B) substantially higher
C) lower
D) none of the other answers are correct

Question 78

Beta is a better risk measure than standard deviation when the firm

A) is effectively diversified.
B) focused on total risk.
C) uses the CAPM in its cost of capital calculation.
D) has a beta that is close to 1.0.

Question 79

Cooper Construction is considering purchasing new, technologically advanced equipment. The equipment will cost $625,000 with a salvage value of $50,000 at the end of its useful life of 10 years. The equipment is expected to generate additional annual cash inflows with the following probabilities for the next 10 years: $\begin{array}{cc}\text { Probability }&\text { Cash Flow }\\.15 & \$ 60,000 \\.25 & 85,000 \\.45 & 110,000 \\.15 & 130.000\end{array}$ A) What is the expected cash flow?
B) Cooper's cost of capital is 10%. What is the expected net present value?
C) Should Cooper buy the equipment?

Question 80

Which of the following is a true statement?

A) risky investments may produce large losses
B) risky investments may produce large gains
C) the coefficient of variation is a risk measure
D) all of the other statements are true