Chapter 13
Risk and Capital Budgeting
True / False Questions
1. A basic assumption in financial theory is that most investors and managers are risk
seekers.
True False
2. If we are risk-averse, a risky investment with an 8% return will be preferred over a 10%
risk-free investment.
True False
3. Risk is not only measured in terms of losses, but also in terms of variability.
True False
4. The expected value is a weighted average of the outcomes multiplied by their
probabilities of occurrence.
True False
5. Investment A may have a higher standard deviation than investment B and still have
less risk.
True False
6. Expected value is defined as ΣDP where the outcomes are D and probabilities are P.
True False
7. If possible outcomes are D and probabilities are P, the standard deviation is defined as
.
True False
8. The coefficient of correlation represents the standard deviation divided by the expected
value.
True False
9. Generally, the higher the coefficient of variation a project has, the higher the discount
rate it should be assigned.
True False
10. The cost of capital is assumed to contain no risk for the firm.
True False
11. A common stock with a beta of 1.0 is said to be of equal risk with the market.
True False
12. Regardless of risk, no projects should be accepted unless they earn more than the firm’s
weighted average cost of capital.
True False
13. As the time horizon becomes shorter, more uncertainty enters the forecast.
True False
14. As the time horizon increases, the standard deviation for each forecast of cash 9ow
normally increases.
True False
15. Simulation models allow the analyst to test possible changes in the variables used in the
model.
True False
16. Computers are helpful for “what if” simulations, but so far they are not able to assess
project risk.
True False
17. Decision trees present a tabular or graphical comparison of projected decision
outcomes.
True False
18. A firm might be willing to accept high risk in a given investment if the portfolio e<ect (for
the whole firm) is beneficial.
True False
19. In order to reduce risk, one should diversify into areas that are positively correlated with
current areas of involvement.
True False
20. Projects that are totally uncorrelated should provide some overall reduction in portfolio
risk.
True False
21. The highest possible value for positive correlation is +1.
True False
22. 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.
True False
23. Combining assets with highly correlated returns will greatly reduce portfolio risk.
True False
24. Projects that are totally uncorrelated provide more overall risk reduction than negatively
correlated projects.
True False
25. Assume that Widget Repair Corporation provides services to 100 customers whose
decision to change suppliers is uncorrelated. The portfolio e<ect suggests that the
entrepreneur/owner of Widget, who is compensated on the basis of the firm’s profits,
may have lower cash-9ow risk than a clerk who works full-time for Widget on a fixed
salary.
True False
26. Insurance companies take advantage of the portfolio e<ect by insuring many di<erent
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.
True False
27. When choosing portfolios of assets, management should try to achieve the highest
possible return at a given level of risk.
True False
28. Selection of portfolio combinations from the efficient frontier will depend upon our
willingness to assume risk.
True False
29. The investor’s portfolio should always be on the efficient frontier.
True False
30. The efficient frontier is always along the left-most portion of the risk-return trade-o<
diagram in which risk is measured on the X-axis and return is measured on the Y-axis.
True False
31. In considering the share price e<ect on risk-return trade-o<s, our goal should always be
to earn the highest return possible.
True False
32. Generally, because of the unpredictability of earnings, cyclical stocks are given higher
price-earnings multiples than growth stocks.
True False
33. The capital budgeting decisions of a firm will have no e<ect on the share price of the
common stock.
True False
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.
True False
35. Sensitivity analysis helps the financial planner determine how sensitive shareholders will
be to changes in investment strategy.
True False
36. 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.
True False
37. The coefficient of variation calculates the percentage of return relative to the risk of a
project.
True False
38. 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.
True False
39. The higher the possible outcomes fall from the expected outcome of an investment, the
higher the risk and the lower the required rate of return by investors.
True False
40. 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.
True False
41. Investors tend to decrease required rates of return over time for projects with longer
