Deck 13: Risk and Capital Budgeting

Question 1

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.

Answer 1

D

Question 2

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.

Answer 2

D

Question 3

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.

Answer 3

C

Question 4

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 5

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 6

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 7

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) have an equal amount of risk.

Question 8

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 9

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 10

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 11

The standard deviation can be defined as the:

A) square root of the sum (D- )2P.
B) square root of the sum (D-)P.
C) square root of (D- )2P.
D) square root of (D- )P.

Question 12

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 13

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 14

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 15

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 16

The concept of being risk averse means:

A) for a given situation investors would prefer relative uncertainty to certainty.
B) investors would prefer investments with high standard deviations and greater opportunity for gain.
C) that the lower the volatility the higher the standard deviation must be.
D) that the greater the risk the higher the expected return must be.

Question 17

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 18

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 19

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 20

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 21

Simulation models allow the planner to:

A) consider unknown risks of mutually exclusive projects.
B) test possible changes in each variable.
C) generate a unique value for consideration.
D) determine the risk in a Government of Canada Treasury Bill.

Question 22

A coefficient of _____ provides the greatest risk reduction.

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

Question 23

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 24

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) random simulation.

Question 25

Projects that are totally uncorrelated provide:

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

Question 26

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) Beta measures the correlation between the risk free rate and the market rate of risk.

Question 27

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 28

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 29

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

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

Question 30

Firm X is considering a project and its analysts have projected the following outcomes and their probabilities. 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 31

Using progressively higher discount rates:

A) tends to reduce early and late cash flows equally.
B) tends to penalize early flows more than late flows.
C) tends to lower net present value.
D) reflects the decreasing nature of risk in the discount rate.

Question 32

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) the best risk return line for a firm.

Question 33

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) none of these answer options are true.

Question 34

A Monte Carlo simulation model uses:

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

Question 35

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 36

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) no change on

Question 37

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

A) don't need to consider the impact of a given project on the overall risk of the firm.
B) recognize that a risky investment will not create a portfolio with less risk.
C) consider the risk of the project with the highest beta only.
D) need to consider how the returns of the projects in the portfolio are correlated.

Question 38

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 39

A coefficient correlation of _____ provides no risk reduction.

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

Question 40

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 41

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

Question 42

-What is the expected value of the outcomes?

A) $8,200
B) $6,400
C) $8,500
D) Cannot be determined until we know the actual outcome.

Question 43

A project has the following projected outcomes: $100, $500, and $800. The probabilities of their outcomes are 10%, 50%, and 40% respectively. What is the standard deviation of these outcomes?

A) $124
B) $214
C) $546
D) $580

Question 44

The concept of being risk averse means:

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

Question 45

Which of the following is a true statement?

A) Risky investments may produce large losses.
B) Risky investments will not produce large gains.
C) The coefficient of variation is not a risk measure.
D) All risky investments have a high probability of succeeding.

Question 46

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 = $1,000, expected return = $8,000
D) Standard deviation = $1,000, expected return = $7,000

Question 47

-This project's coefficient of variation is ______.

A) 0.80
B) 0.90
C) 1.67
D) 2.30

Question 48

-This project's expected profit is ________.

A) $5,000
B) $5,499
C) $8,250
D) $12,890

Question 49

-What is the standard deviation of the outcomes?

A) $2,850
B) $4,200
C) $1,536
D) Cannot be determined with the information given.

Question 50

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 51

-A project's total risk is measured by _________________________.

A) Beta
B) Sharpe Ratio
C) Chi Square
D) coefficient of variation

Question 52

The W Equity portfolio has a standard deviation of returns of 8. The R Bond portfolio has a standard deviation of returns of 6. If the Covariance of these portfolio is 5 what is this portfolio's coefficient of correlation?

A) 0.1042
B) 0.889
C) 0.43
D) -0.1042

Question 53

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) only consider the average beta.

Question 54

A project's coefficient of variation is 0.50. The project has a positive coefficient of correlation of 0.20. The expected value is $3,000. What is the standard deviation?

A) $600
B) $300
C) $1,200
D) $1,500

Question 55

-This project's standard deviation is ___________.

A) $5,626
B) $8,254
C) $7,462
D) $2,597

Question 56

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

Question 57

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 increase net present value.
D) is not reflective of risk expectations.

Question 58

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) provide a degree of risk reduction.

Question 59

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

Question 60

-What is the coefficient of variation of the outcomes?

A) 1.29
B) 0.19
C) 0.44
D) Cannot be determined with the information given

Question 61

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

Question 62

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

Question 63

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

Question 64

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 65

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

Question 66

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

Question 67

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

Question 68

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

Question 69

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

Question 70

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

Question 71

Combining assets with highly correlated returns will reduce portfolio risk.

Question 72

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 73

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

Question 74

The highest possible value for positive correlation is +1.

Question 75

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

Question 76

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

Question 77

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

Question 78

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

Question 79

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

Question 80

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