The Basic Tools of Finance 6741
66. Writing in The Wall Street Journal in 2009, economist Jeremy Siegel pointed out that
the efficient markets hypothesis
a. was responsible for the financial crisis of 2008-2009.
b. was responsible for the Great Depression of the 1930s.
c. claims that prices observed in financial markets are always “right.”
d. claims that prices observed in financial markets are mostly “wrong.”
67. No particular stock is a better buy than any other stock if
a. stock prices are driven by investors’ “animal spirits.”
b. the random-walk theory of stock prices is incorrect.
c. the efficient markets hypothesis is correct.
d. actively managed mutual funds always outperform index funds.
6742 The Basic Tools of Finance
68. Ron decides which stocks to purchase by throwing darts at the stock pages of The Wall
Street Journal. Ron probably believes that
a. stock prices follow a random walk.
b. the stock market is informationally efficient.
c. it is better to own stock in 20 companies than it is to own stock in 2 companies.
d. All of the above are correct.
69. Fundamental analysis shows that stock in “Night and Day” fitness centers has a price
below its present value.
a. This stock is undervalued; you should consider adding it to your portfolio.
b. This stock is undervalued; you shouldn‘t consider adding it to your portfolio.
c. This stock is overvalued; you should consider adding it to your portfolio.
d. This stock is overvalued; you shouldn’t consider adding it to your portfolio.
The Basic Tools of Finance 6743
70. After much anticipation a company releases a new smartphone. The smartphone doesn’t
work as well as expected and lacks many of the features buyers had been expecting. The
unexpectedly negative reaction to the smartphone would
a. raise the present value and the price of the corporation’s stock.
b. raise the present value and reduce the price of the corporation’s stock.
c. reduce the present value and the price of the corporation’s stock.
d. reduce the present value and raise the price of the corporation’s stock.
71. Some people argue that there are two advantages to holding mutual funds. The first is that
mutual funds provide an inexpensive way to hold a diversified portfolio. The second is that
because of their expertise mutual fund managers should be able to consistently beat the
market. Which of the following does the evidence show?
a. Diversification does reduce risk and mutual funds typically outperform the market.
b. Diversification does reduce risk, but mutual funds do not typically outperform the
market.
c. Diversification does not reduce risk but mutual funds typically outperform the market.
d. Diversification does not reduce risk and mutual funds do not typically outperform the
market.
6744 The Basic Tools of Finance
72. Diversification
a. increases the likely fluctuation in a portfolio’s return, but reduces market risk.
b. increases the likely fluctuation in a portfolio’s return, but reduces firm-specific risk..
c. reduces the likely fluctuation in a portfolio’s return and reduces market risk.
d. reduces the likely fluctuation in a portfolio’s return and reduces firm-specific risk.
73. A previously well-respected and trusted president of a corporation is accused of fraud. At
the same time interest rates unexpectedly fall. Which of the above would tend to make
the price of the stock rise?
a. the announcement and the fall in interest rates
b. the announcement but not the fall in interest rates
c. the fall in interest rates, but not the announcement
d. neither the announcement nor the fall in interest rates
The Basic Tools of Finance 6745
74. According to the efficient markets hypothesis, which of the following would decrease the
price of stock in Veblen’s Leisure Company?
a. Veblen announces, just as everyone had expected, that it has fired its CEO who has
been accused of ethics violations.
b. Veblen announces, as the market had expected, that its profits were low.
c. Fundamental analysis published by KM Financial shows that Veblen’s stock is
undervalued.
d. A highly anticipated book is published by a Veblen insider which details Veblen’s
innovative technology in plain English, information that was previously unavailable to
the public and which will now be used by Veblen’s competitors.
75. A company unexpectedly announces a product recall due to safety concerns about its
product. According to the efficient markets hypothesis, this news should
a. raise the price of the company’s stock.
b. not affect the price of the company’s stock.
c. reduce the price of the company’s stock.
d. More information is needed to answer the question.
6746 The Basic Tools of Finance
Multiple Choice – Section 04: Conclusion
1. Stock market fluctuations
a. often go hand in hand with fluctuations in the economy more broadly.
b. rarely have anything to do with fluctuations in the economy more broadly.
c. have few, if any, macroeconomic implications.
d. are attributable to the widespread belief that the efficient markets hypothesis is correct.
2. Economists disagree as to whether
a. the stock price of a company should reflect the company’s expected profitability.
b. the basic tools of finance reflect valid ideas.
c. stock prices reflect rational estimates of a company’s true worth.
d. there is any relationship between stock market fluctuations and fluctuations in the
economy more broadly.
The Basic Tools of Finance 6747
True/False and Short Answer
1. If the interest rate is 8 percent, then the present value of $1,000 to be received in 4 years
is $735.03.
a. True
b. False
2. If a savings account pays 5 percent annual interest, then the rule of 70 tells us that the
account value will double in approximately 14 years.
a. True
b. False
3. The present value of $100 to be paid in two years is less than the present value of $100 to
be paid in three years.
a. True
b. False
6748 The Basic Tools of Finance
4. The future value of $1 saved today is $1/(1 + r).
a. True
b. False
5. The present value of any future sum of money is the amount that would be needed today,
at current interest rates, to produce that future sum.
a. True
b. False
6. The sooner a payment is received and the higher the interest rate, the greater the present
value of a future payment.
a. True
b. False
The Basic Tools of Finance 6749
7. A company that can build a project that will cost $50,000, but returns $52,000 in one year
would make a good decision by turning this project down if the interest rate were 3
percent.
a. True
b. False
8. As the interest rate increases, the present value of future sums decreases, so firms will
find fewer investment projects profitable.
a. True
b. False
9. According to the rule of 70, if you earn an interest rate of 3.5 percent, your savings will
double about every 20 years.
a. True
b. False
6750 The Basic Tools of Finance
10. The rule of 70 applies to a growing savings account but not to a growing economy.
a. True
b. False
11. If you are faced with the choice of receiving $500 today or $800 6 years from today, you
will be indifferent between the two possibilities if the interest rate is 8.148 percent.
a. True
b. False
12. The concept of present value helps explain why the quantity of loanable funds demanded
decreases when the interest rate increases.
a. True
b. False
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13. An increase in the interest rate causes a decrease in the future value of $1,000 that you
have in a bank account today.
a. True
b. False
14. The present value of a payment of $500 to be made two years from today is greater if the
interest rate is 7% than if it is 6%.
a. True
b. False
15. PZX Corporation has the opportunity to undertake an investment project that will cost
$10,000 today and yield the company $13,310 in 3 years. PZX will forgo the project if the
interest rate is higher than 10 percent.
a. True
b. False
6752 The Basic Tools of Finance
16. ZZL Corporation has the opportunity to undertake an investment project that will cost
$20,000 today. If the interest rate is 20 percent and if the project will yield the company
$30,000 in 3 years, then ZZL will undertake the project.
a. True
b. False
17. Risk aversion simply means that people dislike bad things to happen.
a. True
b. False
18. Risk–averse individuals like good things more than they dislike comparable bad things.
a. True
b. False
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19. People who are risk averse dislike bad outcomes more than they like comparable good
outcomes.
a. True
b. False
20. The market for insurance is an example of diversification.
a. True
b. False
21. A person’s subjective measure of well-being or satisfaction is called aversion.
a. True
b. False
6754 The Basic Tools of Finance
22. Historically, stocks have offered higher rates of return than bonds.
a. True
b. False
23. Historically the return on stocks has been higher than the return on bonds. In part this
reflects the higher risk from holding stock.
a. True
b. False
24. Risk-averse persons will take no risks.
a. True
b. False
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25. The market for insurance is one example of reducing risk by using diversification.
a. True
b. False
26. A person with diminishing marginal utility of wealth is risk averse.
a. True
b. False
27. Adverse selection is illustrated by people who take greater risks after they purchase
insurance.
a. True
b. False
6756 The Basic Tools of Finance
28. Increasing the number of corporations whose stocks are in your portfolio reduces market
risk.
a. True
b. False
29. Diversification can reduce firm-specific risk.
a. True
b. False
30. The fact that we observe a trade-off between risk and return is puzzling to economists,
because that observation conflicts with the notion that most people are risk averse.
a. True
b. False
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31. From the standpoint of the economy as a whole, the role of insurance is to greatly reduce
or eliminate the risks inherent in life.
a. True
b. False
32. If a person had increasing marginal utility, then the decline in utility from losing $1,000
would be greater than the increase in utility from gaining $1,000.
a. True
b. False
33. Moral hazard is illustrated by people who take greater risks after they purchase
insurance.
a. True
b. False
6758 The Basic Tools of Finance
34. Diversification cannot reduce market risk.
a. True
b. False
35. When the price of an asset rises above what appears to be its fundamental value, the
market is said to be experiencing a speculative bubble.
a. True
b. False
36. Because the statistic called the standard deviation measures the volatility of a variable,
it is used to measure the return of a portfolio.
a. True
b. False
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37. The value of a stock depends on the ability of the company to generate dividends and the
expected price of the stock when the stockholder sells her shares.
a. True
b. False
38. According to fundamental analysis, when choosing stocks for your portfolio, you should
prefer undervalued stocks.
a. True
b. False
39. According to the efficient markets hypothesis, at any moment in time, the market price is
the best estimate of the company’s value based on publicly available information.
a. True
b. False
6760 The Basic Tools of Finance
40. According to the efficient markets hypothesis, stocks follow a random walk so that
stocks that increase in price one year are more likely to increase than decrease in the
next year.
a. True
b. False
41. According to the efficient markets hypothesis, the number of people who think a stock is
overvalued exactly balances the number of people who think a stock is undervalued.
a. True
b. False
42. Studies find that mutual fund managers who do well in one year are likely to do well the
next year.
a. True
b. False