Chapter 13 – Risk and Capital Budgeting
1. A basic assumption in financial theory is that most investors and managers are risk
seekers.
Chapter 13 – Risk and Capital Budgeting
2. If we are risk-averse, a risky investment with an 8% return will be preferred over a 10%
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.
5. Investment A may have a higher standard deviation than investment B and still have less
risk.
Chapter 13 – Risk and Capital Budgeting
6. Expected value is defined as DP 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.
Chapter 13 – Risk and Capital Budgeting
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.
Chapter 13 – Risk and Capital Budgeting
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. Computers are helpful for “what if” simulations, but so far they are not able to assess
project risk.
17. Decision trees present a tabular or graphical comparison of projected decision outcomes.
Chapter 13 – Risk and Capital Budgeting
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18. A firm might be willing to accept high risk in a given investment if the portfolio effect
(for the whole firm) were beneficial.
19. In order to reduce risk, one should diversify into areas that are positively correlated with
current areas of involvement.
20. Projects that are totally uncorrelated provide some overall reduction in portfolio risk.
21. The highest possible value for positive correlation is +1.
Chapter 13 – Risk and Capital Budgeting
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.
23. Combining assets with highly correlated returns will greatly reduce portfolio risk.
24. Projects which are totally uncorrelated provide more overall risk reduction than negatively
correlated projects.
25. 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.
Chapter 13 – Risk and Capital Budgeting
26. 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.
27. When choosing portfolios of assets, management should try to achieve the highest
possible return at a given level of risk.
28. Selection of portfolio combinations from the efficient frontier will depend upon our
willingness to assume risk.
29. The investor’s portfolio should always be on the efficient frontier.
Chapter 13 – Risk and Capital Budgeting
30. The efficient frontier is always along the left-most portion of the risk-return tradeoff
diagram.
31. In considering the share price effect on risk-return trade-offs, our goal should always be to
earn the highest return possible.
32. Generally, because of the unpredictability of earnings, cyclical stocks are given higher
price-earnings multiples than growth stocks.
33. The capital budgeting decisions of a firm will have no effect on the share price of the
common stock.
Chapter 13 – Risk and Capital Budgeting
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.
35. Sensitivity analysis helps the financial planner to determine how sensitive shareholders
will be to changes in investment strategy.
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.
37. The coefficient of variation calculates the percentage of return relative to the risk of a
project.
Chapter 13 – Risk and Capital Budgeting
38. Coefficient of variation considers how an investment impacts the total risk of the firm
while coefficient of correlation considers the specific risk of an investment.
39. The higher the possible outcomes fall from the expected outcome of an investment, the
higher the risk and lower the required rate of return by investors.
40. An investment with a $500 standard deviation and a $5,000 expected value has higher risk
than an investment with a $4,000 standard deviation and a $50,000 expected value.
41. Investors tend to decrease required rates of return over time for projects with longer lives.
Chapter 13 – Risk and Capital Budgeting
42. Risk is usually measured as the
43. The term “risk averse” means that
Chapter 13 – Risk and Capital Budgeting
45. The concept of being risk averse-means
46. If one project has a higher standard deviation than another
Chapter 13 – Risk and Capital Budgeting
47. Firm X is considering a project and its analysts have projected the following outcomes
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48. 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?
Chapter 13 – Risk and Capital Budgeting
49. The standard deviation can be defined as the
50. Modigliani and Associates has forecasted the following payoffs from a project:
What is the expected value of the outcomes?
Chapter 13 – Risk and Capital Budgeting
51. Buchanan Corp. forecasts the following payoffs from a project:
What is the expected value of the outcomes?
52. The coefficient of variation (V) can be defined as the
Chapter 13 – Risk and Capital Budgeting
53. 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?
54. In determining the appropriate discount rate for an individual project, the financial
manager will be most influenced by the
55. Which of the following is a characteristic of beta?
Chapter 13 – Risk and Capital Budgeting
56. 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?
57. Which investment has the least amount of risk?