Chapter 13 Test Bank – Static Key
1. A basic assumption in financial theory is that most investors and managers are risk seekers.
2. If we are risk-averse, a risky investment with an 8% return will be preferred over an8% risk-free
investment.
3. Risk is not only measured in terms of losses, but also in terms of variability.
4. The expected value is a weighted average of the outcomes multiplied by their probabilities of
occurrence.
5. Investment A may have a higher standard deviation than investment B and still have less risk.
6. Expected value is defined as ΣDP where the outcomes are D and probabilities are P.
7. If possible outcomes are D and probabilities are P, the standard deviation is defined as
8. The coefficient of correlation represents the standard deviation divided by the expected value.
9. Generally, the higher the coefficient of variation a project has, the higher the discount rate it should be
assigned.
10. The cost of capital is assumed to contain no risk for the firm.
11. A common stock with a beta of 1.0 is said to be of equal risk with the market.
12. Regardless of risk, no projects should be accepted unless they earn more than the firm’s weighted
average cost of capital.
13. As the time horizon becomes shorter, more uncertainty enters the forecast.
14. As the time horizon increases, the standard deviation for each forecast of cash flow normally increases.
15. Simulation models allow the analyst to test possible changes in the variables used in the model.
16. Decision trees present a tabular or graphical comparison of projected decision outcomes.
17. A firm might be willing to accept high risk in a given investment if the portfolio effect (for the whole firm)
is beneficial.
18. In order to reduce risk, one should diversify into areas that are positively correlated with current areas
of involvement.
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19. Projects that are totally uncorrelated should provide some overall reduction in portfolio risk.
20. The highest possible value for positive correlation is +1.
21. 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.
22. Combining assets with highly correlated returns will greatly reduce portfolio risk.
23. Projects that are totally uncorrelated provide more overall risk reduction than negatively correlated
projects.
24. 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.
25. 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.
26. When choosing portfolios of assets, management should try to achieve the highest possible return at a
given level of risk.
27. Selection of portfolio combinations from the efficient frontier will depend upon our willingness to assume
risk.
28. The investor’s portfolio should always be on the efficient frontier.
29. 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.
30. In considering the share price effect on risk-return trade-offs, our goal should always be to earn the
highest return possible.
31. Generally, because of the unpredictability of earnings, cyclical stocks are given higher price-earnings
multiples than growth stocks.
32. The capital budgeting decisions of a firm will have no effect on the share price of the common stock.
33. 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.
34. Sensitivity analysis helps the financial planner determine how sensitive shareholders will be to changes
in investment strategy.
35. 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.
36. 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.
37. 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.
38. The higher the risk of an investment, the lower the required rate of return by investors.
39. 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.
40. Investors tend to decrease required rates of return over time for projects with longer lives.
41. The measure of risk is best described as
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42. The term “risk-averse” means that
43. Which of the following is a false statement?
44. The concept of being risk-averse means
45. If one project has a higher standard deviation than another,
46. Firm X is considering a project and its analysts have projected the following outcomes and their
probabilities.
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What is the expected value of the outcomes?
47. 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
48. The standard deviation can be defined as
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49. Modigliani and Associates has forecasted the following payoffs from a project:
What is the expected value of the outcomes?
50. Buchanan Corp. forecasts the following payoffs from a project:
What is the expected value of the outcomes?
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51. The coefficient of variation (V) can be defined as the
52. 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?
53. In determining the appropriate discount rate for an individual project, the financial manager will be most
influenced by the
54. Which of the following is a characteristic of beta?
55. 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 one standard deviation?
A. $400
B. $220
56. Which investment has the least amount of risk?
57. 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?
58. Which investment has the least amount of risk?
59. Risk may be integrated into capital budgeting decisions by
60. The firm’s highest risk-adjusted discount should be applied to
61. 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.
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62. Using the risk-adjusted discount rate approach, the firm’s weighted average cost of capital is applied to
projects with
63. 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.
64. 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
65. A “what if” simulation using a computer helps to
66. Simulation models allow the planner to
67. Which of the following is a common approach in dealing with uncertainty?
68. A Monte Carlo simulation model uses
69. A tool that helps to organize the decision process by presenting a graphical comparison of investment
choices is called a
70. The “portfolio effect” in capital budgeting refers to
71. An example of negative correlation may exist between the
72. A correlation coefficient of zero indicates
73. In order to reduce risk in a firm, the firm would seek to enter a business that
74. The lower the coefficient of correlation, the greater the
75. The coefficient of correlation
76. Portfolio risk is evaluated differently than individual project risk. In evaluating portfolio risk, we
77. Projects that are negatively correlated
78. A correlation coefficient of _____ provides no risk reduction.
79. A correlation coefficient of _____ provides the greatest risk reduction.
80. Projects that are totally uncorrelated provide
81. A correlation coefficient of _____ provides the greatest possible risk reduction to the firm.
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82. A project that carries a normal amount of risk and does not affect the risk exposure of the firm should
be discounted back at the
83. The “efficient frontier” indicates
84. All of the following are methods of evaluating the risk of a project EXCEPT
85. When considering the efficient frontier, financial managers should adhere to all of the following
guidelines EXCEPT
86. Which of the following combinations of investments would provide the firm with the highest negative
correlation?
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Chapter 13 Test Bank – Static Summary
# of Questions
67
1
19
75
4
10
4
19
49
27
5
54
27
4
19
8
31
2
1
2
21
7
7
1
10
17
1
5
11
1