Deck 13: Risk and Capital Budgeting

Question 1

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

Answer 1

True
Explanation: A higher coefficient of variation denotes greater risk, so investors will require a higher rate of return-thus (all else being equal), a "risk-adjusted" rate.

Question 2

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

Answer 2

False
Explanation: The level of uncertainty increases with time.

Question 3

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

Answer 3

True

Question 4

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

Question 5

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

Question 6

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

Question 7

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

Question 8

Regardless of risk, no projects should be accepted unless they earn more than the firm's weighted average cost of capital.

Question 9

The standard deviation is the measure of dispersion or variability around the expected value.

Question 10

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

Question 11

The equation for the coefficient of variation is (V) =
$\frac { \sigma } { D }$

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 of occurrence.

Question 14

Expected value is defined as ΣDP where the outcomes are D and probabilities are P.

Question 15

Beta is another measurement of risk and measures the stability of returns on an individual stock relative to the stock market index of returns.

Question 16

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

Question 17

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

Question 18

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

Question 19

If possible outcomes are D and probabilities are P, the standard deviation is defined as
? =
$\sqrt { \sum ( D - D ) ^ { 2 } P }$

Question 20

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

Question 21

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

Question 22

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

Question 23

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

Question 24

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 25

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

Question 26

The highest possible value for positive correlation is +1.

Question 27

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

Question 28

Assume that Widget Repair Corporation provides services to 100 customers whose decision to change suppliers is uncorrelated. The portfolio effect suggests that the entrepreneur/owner of Widget, who is compensated on the basis of the firm's profits, may have lower cash-flow risk than a clerk who works full-time for Widget on a fixed salary.

Question 29

Insurance companies take advantage of the portfolio effect by insuring many different homeowners against loss. However, the risks of loss for individual homes in hurricane-prone or earthquake-prone areas such as Florida and California are highly correlated. This suggests that insurance companies should avoid writing (or consider canceling) some customers' policies in Florida and California, even when the policies are both needed by homeowners and expected to be highly profitable to the insurer.

Question 30

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

Question 31

Cyclical businesses are likely to have higher costs of capital than firms with less variability in earnings. Therefore, more cyclical firms should typically use a higher discount rate in project evaluation.

Question 32

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

Question 33

The coefficient of variation considers how an investment impacts the total risk of the firm, while the coefficient of correlation considers the specific risk of an investment.

Question 34

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

Question 35

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

Question 36

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

Question 37

The coefficient of variation is calculated to help correlate the standard deviation and the relative expected value of an investment, which makes it easier to compare different sized investments.

Question 38

The efficient frontier is always along the left-most portion of the risk-return trade-off diagram in which risk is measured on the X-axis and return is measured on the Y-axis.

Question 39

Combining assets with highly correlated returns will greatly reduce portfolio risk.

Question 40

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

Question 41

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 42

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

Question 43

The standard deviation can be defined as

A) $\sqrt { \sum ( D - D ) ^ { 2 } P }$
B) $\sqrt { \sum ( D - D ) P }$
C) $\sqrt { ( D - D ) ^ { 2 } P }$
D) $\sqrt { ( D - D ) P }$

Question 44

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 expected value of these outcomes?

A) $362.5
B) $89.4
C) $94.5
D) $178.3

Question 45

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 has zero risk.
C) A beta of less than 1.0 has less risk than the market.
D) A beta is always equal to 1.0.

Question 46

If one project has a higher standard deviation than another,

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

Question 47

A project's cash flows have a beta of 1.2, a standard deviation of $340, and a coefficient of variation of 0.40. What is the expected cash flow?

A) $850
B) $167
C) $2,400
D) $500

Question 48

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 49

Buchanan Corp. forecasts the following payoffs from a project:
$$\begin{array}{l}\begin{array} { c c l l } &\text { Probability of }\\\text { Outcome } & \text { Outcome } & & \text { Assumption } \\\$2,000 & 40 \% & \text { pessirnistic } \\\$4,000 & 60 \% & \text { moderately successful } \\\$6,000 & 30 \% & \text { optimistic }\end{array}\end{array}$$
What is the expected value of the outcomes?

A) $5,000
B) $4,000
C) $5,300
D) The forecast is incorrect and must be modified before finding the expected value.

Question 50

A project's coefficient of variation is 0.55. The project has a positive coefficient of correlation of 0.20. The expected value is $1,200. What is the standard deviation?

A) $400
B) $220
C) $660
D) $1,200

Question 51

An investment with a $500 standard deviation and a $5,000 expected value has a higher risk than an investment with a $4,000 standard deviation and a $50,000 expected value.

Question 52

The term "risk-averse" means that

A) an individual refuses to take risks.
B) most investors and businessmen 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 53

Investors tend to decrease required rates of return over time for projects with longer lives.

Question 54

Firm X is considering a project and its analysts have projected the following outcomes and their probabilities.
$$\begin{array}{l}\begin{array} { r c ll } &\text { Probability of }\\\text { Outcome } & \text { Outcome } & &\text { Assumption }\\\$4,600 & 30 \% & \text { pessirmstic } \\\$7,800 & 45 \% & \text { moderately swccessful } \\\$13,500 & 25 \% & \text { optimistic }\end{array}\end{array}$$
What is the expected value of the outcomes?

A) $3,375
B) $8,633
C) $8,265
D) Cannot be determined. Depends upon which prediction is correct.

Question 55

The measure of risk is best described as

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

Question 56

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 57

The concept of being risk-averse means

A) investors don't want to take on any risk.
B) investors would usually prefer investments with high standard deviations and a greater opportunity for gain.
C) that the greater the risk, the lower the expected return must be.
D) that for a given situation, investors would prefer relative certainty to uncertainty, and the greater the risk, the higher the expected return must be.

Question 58

The higher the risk of an investment, the lower the required rate of return by investors.

Question 59

Modigliani and Associates has forecasted the following payoffs from a project:
$$\begin{array}{l}\begin{array} { r c l } &\text { Probability of }\\\text { Outcome } & \text { Outcome } & &\text { Assumption: }\\\$0 & 20 \% & \text { pessirmstic } \\\$3,500 & 60 \% & \text { moderately successful } \\\$6,000 & 20 \% & \text { optimistic }\end{array}\end{array}$$
What is the expected value of the outcomes?

A) $0
B) $3,300
C) $3,700
D) Cannot be determined. Depends upon which prediction is correct.

Question 60

Which investment has the least amount of risk?

A) Standard deviation = $450, expected return = $4,500
B) Standard deviation = $600, expected return = $400
C) Standard deviation = $500, expected return = $800
D) Standard deviation = $400, expected return = $5,000

Question 61

Which ways can a decision tree be presented to help lay out the sequence of decisions that can be made?

A) Tabular
B) Graphical
C) A and B
D) None of these options are correct.

Question 62

An example of negative correlation may exist between the

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

Question 63

Place the following investment decisions in order from the lowest risk to the highest risk:
(a) purchase of replacement machinery
(b) new product in a foreign market
(c) new product in the local market
(d) repair of existing machinery

A) b, c, a, d
B) d, a, b, c
C) d, b, a, c
D) d, a, c, b

Question 64

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 65

Simulation models allow the planner to

A) reduce the standard deviations of projects.
B) plan ahead for all possible changes in each variable.
C) deal with the uncertainty of investment risk.
D) test possible changes in each variable and deal with the uncertainty in forecasting outcomes.

Question 66

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 and similar cash flows.

A) somewhat higher
B) substantially higher
C) lower
D) either somewhat higher or substantially higher

Question 67

A correlation coefficient of zero indicates

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

Question 68

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 69

Which investment has the least amount of risk?

A) Coefficient of variation = 8%, expected return = $800
B) Coefficient of variation = 8%, standard deviation = $200
C) Standard deviation = $300, expected return = $5,000
D) Standard deviation = $100, expected return = $80

Question 70

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 71

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

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

Question 72

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) make data entry more complicated.

Question 73

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

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

Question 74

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 75

Portfolio risk is evaluated differently than individual project risk. 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 these options are true.

Question 76

A Monte Carlo simulation model uses

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

Question 77

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

A) A Monte Carlo simulation
B) An internal rate of return
C) The net present value
D) Beta

Question 78

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 79

A tool that helps to organize the decision process by presenting a graphical comparison of investment choices is called a

A) module hierarchy diagram.
B) "what if" simulation.
C) decision tree.
D) None of these options are correct.

Question 80

In order to evaluate risk, management may also set qualitative risk classes. Rank these four projects from least risky to most risky, all other things being equal.
1) Completely new market in United States.
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) 4, 3, 2, 1