REVIEW TEST 2 (TEORI)

1. The return on an asset is the change in its value plus any cash distribution over
a given period of time, expressed as a percentage of its ending value

2. Business risk is the chance that the firm will be unable to cover its operating
costs and is affected by a firm's revenue stability and the structure of its operating costs
(fixed vs. variable)

3. Interest rate risk is the chance that changes in interest rates will adversely affect
the value of an investment; most investments decline in value when the interest rates
rise and increase in value when interest rates fall

4. Interest rate risk is the chance that the value of an investment will decline
because of market factors (such as economic, political, and social events) that are
independent of the investment.

5. Purchasing-power risk is the chance that changes in interest rates will adversely
affect the value of an investment; most investments decline in value when the interest
rates rise and increase in value when interest rates fall

6. An approach for assessing risk that uses a number of possible return estimates
to obtain a sense of the variability among outcomes is called sensitivity analysis

7. An abnormal probability distribution is a symmetrical distribution whose shape

resembles a bell-shaped curve.

8. The standard deviation of a portfolio is a function of the standard deviations of

the individual securities in the portfolio, the proportion of the portfolio invested in those
securities, and the correlation between the returns of those securities.

9. The creation of a portfolio by combining two assets having perfectly positively

correlated returns cannot reduce the portfolio's overall risk below the risk of the least
risky asset. On the other hand, a portfolio combining two assets with less than perfectly
positive correlation can reduce total risk to a level below that of either of the
components.

10. The empirical measurement of beta can be approached by using least-squares

regression analysis to find the regression coefficient (bj) in the equation for the slope of
the "characteristic line."

11. The value of zero for beta coefficient of the risk-free asset reflects not only its
absence of risk but also the fact that the asset's return is unaffected by movements in
the market return.

12. Greater risk aversion results in lower required returns for each level of risk,
whereas a reduction in risk aversion would cause the required return for each level of
risk to increase.

13. The CAPM is based on an assumed efficient market in which there are many
small investors, each having the same information and expectations with respect to
securities; there are no restrictions on investment, no taxes, and no transactions costs;
and all investors are rational, view securities similarly, and are risk-averse, preferring
higher returns and lower risk.
14. Changes in risk aversion, and therefore shifts in the SML, result from changing
tastes and preferences of investors, which generally result from various economic,
political, and social events.

15. In general, widely accepted expectations of hard times ahead tend to cause
investors to become less risk-averse.

16. The ________ of an asset is the change in value plus any cash distributions
expressed as a percentage of the initial price or amount invested.

A) return

B) value

C) risk

D) probability

17. Risk aversion is the behavior exhibited by managers who require a (n)
________.

A) increase in return, for a given decrease in risk

B) increase in return, for a given increase in risk

C) decrease in return, for a given increase in risk

D) decrease in return, for a given decrease in risk

18. A common approach of estimating the variability of returns involving forecasting

the pessimistic, most likely, and optimistic returns associated with the asset is called

A) marginal analysis.

B) sensitivity analysis.

C) break-even analysis.

D) financial statement analysis

19. The ________ is a measure of relative dispersion used in comparing the risk of
assets with differing expected returns.

A) coefficient of variation

B) chi square

C) mean

D) standard deviation

20. Since for a given increase in risk, most managers require an increase in return,
they are

A) risk-seeking.

B) risk-indifferent.

C) risk-free.

D) risk-averse

21. Combining negatively correlated assets having the same expected return results
in a portfolio with ________ level of expected return and ________ level of risk.

A) a higher; a lower

B) the same; a higher

C) the same; a lower

D) a lower; a higher

22. In general, the lower (less positive and more negative) the correlation between
asset returns,

A) the less the potential diversification of risk.

B) the greater the potential diversification of risk.

C) the lower the potential profit.

 D) the less the assets have to be monitored.

23. Combining two assets having perfectly negatively correlated returns will result in
the creation of a portfolio with an overall risk that

A) remains unchanged.

B) decreases to a level below that of either asset.

C) increases to a level above that of either asset.

D) stabilizes to a level between the asset with the higher risk and the asset with
the lower risk.

24. Combining two assets having perfectly positively correlated returns will result in
the creation of a portfolio with an overall risk that

A) remains unchanged.

B) decreases to a level below that of either asset.

C) increases to a level above that of either asset.

D) lies between the asset with the higher risk and the asset with the lower risk.

25. As randomly selected securities are combined to create a portfolio, the ________
risk of the portfolio decreases until 10 to 20 securities are included. The portion of the
risk eliminated is ________ risk, while that remaining is ________ risk.

A) diversifiable; nondiversifiable; total

B) relevant; irrelevant; total

C) total; diversifiable; nondiversifiable

D) total; nondiversifiable; diversifiable

26. The higher an asset's beta,

A) the more responsive it is to changing market returns.

B) the less responsive it is to changing market returns.

C) the higher the expected return will be in a down market.

D) the lower the expected return will be in an up market.

27. An increase in nondiversifiable risk

A) would cause an increase in the beta and would lower the required return.

B) would have no effect on the beta and would, therefore, cause no change in the
required return.

C) would cause an increase in the beta and would increase the required return.

D) would cause a decrease in the beta and would, therefore, lower the required
rate of return.

28. In the capital asset pricing model, the beta coefficient is a measure of ________
risk and an index of the degree of movement of an asset's return in response to a
change in ________.

A) diversifiable; the prime rate

B) nondiversifiable; the Treasury bill rate

C) diversifiable; the bond index rate

D) nondiversifiable; the market return

29. An increase in the beta of a corporation indicates ________, and, all else being
the same, results in ________.

A) a decrease in risk; a higher required rate of return and hence a lower share
price

B) an increase in risk; a higher required rate of return and hence a lower share
price

C) a decrease in risk; a lower required rate of return and hence a higher share
price

D) an increase in risk; a lower required rate of return and hence a higher share
price

30. In the capital asset pricing model, an increase in inflationary expectations will be
reflected by a(n)

A) increase in the slope of the security market line.

B) decrease in the slope of the security market line.

C) parallel shift downward in the security market line.

D) parallel shift upward in the security market line.

31. The nominal rate of interest is the rate that creates equilibrium between the
supply of savings and the demand for investment funds in a perfect world, without
inflation, where funds suppliers and demanders have no liquidity preference and all
outcomes are certain.

32. The liquidity preference theory suggests that for any given issuer, long-term
interest rates tend to be higher than short-term rates due to the lower liquidity and
higher responsiveness to general interest rate movements of longer-term securities;
causes the yield curve to be upward-sloping.

33. Upward-sloping yield curves result from higher future inflation expectations,
lender preferences for shorter maturity loans, and greater supply of short-term as
opposed to long-term loans relative to their respective demand.

34. The real rate of interest is the compensation paid by the borrower of funds to the
lender. From the borrower's point of view, the real rate represents the cost of borrowing
funds.

35. The nominal rate of interest is equal to the sum of the real rate of interest plus an
inflation premium plus a risk premium.

36. The expectations theory suggests that the shape of the yield curve reflects
investors expectations about future inflation rates.

37. The reason for a difference in the yield between a Aaa corporate bond and an
otherwise identical Baa bond is the risk premium; the real interest rate and the inflation
rate is the same for both.

38. The possibility that the issuer of a bond will not pay the contractual interest or
principal payments as scheduled is called maturity risk.

39. Restrictive covenants, coupled with standard debt provisions, allow the lender to
monitor and control the borrower's activities in order to protect itself against increases in
borrower risk.

40. The purpose of the restrictive debt covenant that imposes fixed assets
restrictions is to limit the amount of fixed-payment obligations.

41. In a bond indenture, the term security interest refers to the fact that most firms
that issue bonds are required to establish sinking fund provisions to protect
bondholders.

42. The length of the maturity on a bond offering affects its cost. In general, the
longer the maturity, the higher the cost.

43. Debentures such as convertible bonds are unsecured bonds that, in general,
only the most creditworthy firms can issue.

44. A call feature in a bond allows the issuer the opportunity to repurchase bonds at
a stated price prior to maturity. This option has a greater chance of being exercised (to
the detriment of the bondholder) if market interest rates have fallen since the bond was
issued.
45. As an outstanding bond approaches maturity, the price of the bond will always
trend toward par value until, at maturity, the bond is worth its face value.

46. The ________ is the annual rate of interest earned on a security purchased on a
given date and held to maturity.

A) term structure

B) yield curve

C) risk-free rate

D) yield to maturity

47. The ________ is/are a graphic depiction of the term structure of interest rates.

A) yield curve

B) supply and demand functions

C) risk-return profile

D) aggregate demand curve

48. Generally, long-term loans have higher interest rates than short-term loans
because of

A) the general expectation of higher future rates of inflation.

B) lender preferences for shorter-term, more liquid loans.

C) greater demand for long-term rather than short-term loans relative to the supply
of such loans.

D) all of the above.

49. The theory suggesting that for any given issuer, long-term interest rates tends to
be higher than short-term rates is called
 A) expectation hypothesis.

B) liquidity preference theory.

C) market segmentation theory.

D) none of the above.

50. The theory that explains only the tendency for the yield curve to be upward
sloping is

A) expectations hypothesis.

B) liquidity preference theory.

C) market segmentation theory.

D) investor perception theory.

51. The risk premium over and above the risk free rate consists of a number of
components, including all of the following EXCEPT

A) default risk.

B) inflation risk.

C) tax treatment risk.

D) liquidity risk.

52. At any time, the slope of the yield curve is affected by

A) inflationary expectations.

B) liquidity preferences.
 C) the comparative equilibrium of supply and demand in the short-term and long-
term market segments.

D) all of the above.

53. ________ is a paid individual, corporation, or commercial bank trust department

that acts as a third party to a bond indenture to ensure that the issuer does not default
on its contractual responsibilities to the bondholders.

A) A trustee

B) An investment banker

C) A bond issuer

D) A bond rating agency

54. All of the following are examples of restrictive debt covenants EXCEPT

A) prohibition on selling accounts receivable.

B) supplying the creditor with audited financial statements.

C) constraint on subsequent borrowing.

D) prohibition on entering certain types of lease arrangements.

55. All of the following are examples of standard debt provisions EXCEPT

A) maintaining all facilities in good working order.

B) paying taxes and liabilities when due.

C) maintaining satisfactory accounting records.

D) limiting the annual dividend payment.

56. A debt instrument indicating that a corporation has borrowed a certain amount of
money and promises to repay it in the future under clearly defined terms is called

A) discount bond.
 B) corporate bond.

C) bond indenture.

D) treasury bond.

57. The purpose of the restrictive debt covenant that requires maintaining a minimum
level of net working capital is to

A) protect the lender by controlling the risk and marketability of the borrower's
security investment alternatives.

B) limit the amount of fixed-payment obligations.

C) ensure a cash shortage does not cause an inability to meet current obligations.

D) prevent liquidation of assets through large salary increases of key employees.

58. The purpose of the restrictive debt covenant that prohibits borrowers from
entering into certain types of leases is to

A) protect the lender by controlling the risk and marketability of the borrower's
security investments alternatives.

B) limit the amount of fixed-payment obligations.

C) ensure a cash shortage does not cause an inability to meet current obligations.

D) prevent liquidation of assets through large salary increases of key employees.

59. The purpose of the restrictive debt covenant that imposes fixed assets
restrictions is to

A) protect the lender by controlling the risk and marketability of the borrower's
security investment alternatives.

B) limit the amount of fixed-payment obligations.

C) ensure a cash shortage does not cause an inability to meet current obligations.

D) prevent the firm from liquidation, acquisition, or encumbrance of capital assets.

60. The purpose of the restrictive debt covenant that prohibits the sale of accounts
receivable is to
 A) assure the lender that the borrowed funds are put to the use for which they
were intended.

B) limit the amount of fixed-payment obligations.

C) ensure that a cash shortage does not cause an inability to meet current
obligations.

D) prevent liquidation of assets through large salary increases of key employees.

61. In the case of liquidation, bondholders are paid first, followed by preferred
stockholders, followed by common stockholders.

62. Cumulative preferred stocks are preferred stocks for which all passed (unpaid)
dividends in arrears must be paid along with the current dividend prior to the payment of
dividends to common stockholders.

63. One advantage of preferred stock is its ability to increase leverage, which in turn
will magnify the effects of increased earnings on common stockholders' returns.

64. A call feature is a feature that allows preferred stockholders to change each
share into a stated number of shares of common stock.

65. The cost of preferred stock financing is generally higher than that of debt
financing because unlike the payment of interest to bondholders, the payment of
dividends to preferred stockholders is not guaranteed, and interest on debt is tax-
deductible whereas preferred stock dividend is not.

66. The number of outstanding shares of common stock is always greater than or
equal to the number of authorized shares of common stock.

67. The claims of equity holders on the firm's income can not be paid until the claims
of all creditors have been satisfied. But, the claims of the equity holders on the firm's
assets have priority over the claims of creditors because the equity holders are the
owners of the firm.

68. The free cash flow valuation model can be used to determines the value of an
entire company as the present value of its expected free cash flows discounted at the
firm's weighted average cost of capital.

69. A prospectus is another term for a firm's annual report showing the firm's
prospects for the coming year.

70. Efficient market hypothesis is the theory describing the behavior of an assumed
"perfect" market in which securities are typically in equilibrium, security prices fully
reflect all public information available and react swiftly to new information, and, because
stocks are fairly priced, investors need not waste time looking for mispriced securities.

71. The constant growth model is an approach to dividend valuation that assumes a
constant future dividend.
72. The free cash flow valuation model is based on the same principle as the P/E
valuation approach; that is, the value of a share of stock is the present value of future
cash flows.

73. The common stock book value model ignores the firm's expected earnings
potential and generally lacks any true relationship to the firm's value in the marketplace.

74. In valuation of common stock, the price/earnings multiple approach is considered

superior to the use of book or liquidation values since it considers expected earnings.

75. Investors purchase a stock when they believe that it is undervalued and sell
when they feel that it is overvalued.

76. From the corporation's point of view, the advantages of issuing preferred stock
include all of the following EXCEPT

A) its increased financial leverage.

B) its flexible dividend policy.

C) its excellent merger security.

D) its difficulty to retire.

77. The advantages of issuing preferred stock from the common stockholder's
perspective include all of the following EXCEPT

A) seniority of preferred stockholder's claim over common stockholders.

B) flexibility.

C) use in mergers.

D) increased leverage.

78. Which of the following is false?

A) The common stock of a corporation can only be publicly owned.

B) Firms often issue common stock with no par value.

C) Preemptive rights help to prevent a dilution of ownership on the part of existing

shareholders.

D) A firm's corporate charter indicates how many authorized shares it can issue.
79. Which of the following is not typically a feature of preferred stock?

A) Most preferred pay dividends that grow at a constant rate.

B) Most preferred stock is cumulative.

C) Preferred stock is generally callable.

D) Preferred stock is typically convertible.

80. The opportunity for management to purchase a certain number of shares of their
firm's common stock at a specified price over a certain period of time is a

A) stock option.

B) warrant.

C) pre-emptive right.

D) stock right.

81. Regarding the tax treatment of payments to securities holders, it is true that
________, while ________.

A) interest and preferred stock dividends are not tax-deductible; common stock
dividends are tax deductible

B) interest and preferred stock dividends are tax-deductible; common stock

dividends are not tax-deductible

C) common stock dividends and preferred stock dividends are tax-deductible;

interest is not tax-deductible

D) common stock dividends and preferred stock dividends are not tax-deductible;
interest is tax-deductible

82. Treasury stock results from the

A) firm selling stock for greater than its par value.

B) cumulative feature on preferred stock.

C) repurchase of outstanding stock.

D) authorization of additional shares of stock by the board of directors.

83. Because equity holders are the last to receive any distribution of assets as a result
of bankruptcy proceedings, common stockholders expect

A) fixed dividend payments.

B) greater compensation in the form of dividends and/or rising stock prices.

C) all profits to be paid out in dividends.

D) warrants to be attached to the stock issue as a sweetener.

84. The par value on common stock has all of the following characteristics EXCEPT

A) a generally low value.

B) some states tax according to the par value.

C) indicates the market value at which the stock was originally sold.

D) stated in the corporate charter.

85. Stock rights provide the stockholder with

A) certain purchase privileges of additional stock shares in direct proportion based

on their number of owned shares.

B) the right to elect the board of directors.

C) cumulative voting privileges.

D) the opportunity to receive extraordinary earnings.

86. The preemptive right gives the shareholder the right

A) of one vote for each share owned.

B) to give up their vote to another party.

C) to maintain their proportionate ownership in the corporation when new common

stock is issued.

D) to sell their share of stock at a premium.

87. The investment banker does all of the following EXCEPT

A) make long-term investments for banking institutions.

 B) bear the risk of selling a security issue.

C) act as a middleman between the issuer and buyer of a new security.

D) advise clients.

88. According to the efficient market theory,

A) prices of actively traded stocks can be under- or over-valued in an efficient

market, and bear searching out.

B) prices of actively traded stocks can only be under-valued in an efficient market.

C) prices of actively traded stocks do not differ from their true values in an efficient
market.

D) prices of actively traded stocks can only be over-valued in an efficient market.

89. Economically rational buyers and sellers use their assessment of an asset's risk
and return to determine its value. Relative to this concept, which of the following is
true?

A) To a buyer the asset's value represents the minimum price that he or she would
pay to acquire it.

B) To a seller the asset's value represents the maximum sale price.

C) To a buyer the asset's value represents the maximum price that he or she would
pay to acquire it.

D) The interaction of buyers and sellers can result in a value that differs from the
stock's true value.

90. If expected return is less than required return on an asset, rational investors will

A) buy the asset, which will drive the price up and cause expected return to reach
the level of the required return.

B) sell the asset, which will drive the price down and cause the expected return to
reach the level of the required return.

C) sell the asset, which will drive the price up and cause the expected return to
reach the level of the required return.

D) buy the asset, since price is expected to increase.

91. The target capital structure is the desired optimal mix of debt and equity
financing that most firms attempt to achieve and maintain.
92. The cost of capital acts as a major link between the firm's long-term investment
decisions and the wealth of the owners as determined by investors in the marketplace

93. Business risk is the risk to the firm of being unable to cover required financial
obligations.

94. Holding risk constant, the implementation of projects with a rate of return above
the cost of capital will decrease the value of the firm, and vice versa.

95. Preferred stock represents a special type of ownership interest in the firm.
Preferred stockholders must receive their stated dividends prior to the distribution of any
earnings to common stockholders and bondholders.

96. Flotation costs reduce the net proceeds from the sale of a bond whether sold at a
premium, at a discount, or at its par value.

97. The cost of common stock equity capital represents the return required by
existing shareholders on their investment in order to leave the market price of the firm's
outstanding share unchanged.

98. When the constant growth valuation model is used to find the cost of common
stock equity capital, it can easily be adjusted for flotation costs to find the cost of new
common stock; the Capital Asset Pricing Model (CAPM) does not provide a simple
adjustment mechanism.

99. The capital asset pricing model describes the relationship between the required
return, or the cost of common stock equity capital, and the nonsystematic risk of the firm
as measured by the beta coefficient.

100. Weights that use accounting values to measure the proportion of each type of
capital in the firm's financial structure are called market value weights.

101. Economic value added is the difference between an investment's net operating
profit after taxes and the cost of funds used to finance the investment, which is found by
multiplying the dollar amount of the funds used to finance the investment by the firm's
weighted average cost of capital.

102. The investment operating schedule is the difference between an investment's net
operating profit after taxes and the cost of funds used to finance the investment, which
is found by multiplying the dollar amount of the funds used to finance the investment by
the firm's weighted average cost of capital.

103. As the volume of financing increases, the costs of the various types of financing
will decrease, reducing the firm's weighted average cost of capital.

104. The break point is the level of total new financing at which the cost of one of the
financing components rises, thereby causing an upward shift in the weighted marginal
cost of capital.

105. The weighted marginal cost of capital is the firm's weighted average cost of
capital associated with the next dollar of total new financing.
106. The ________ is the rate of return required by the market suppliers of capital in
order to attract their funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) gross profit margin

107. In order to recognize the interrelationship between financing and investments, the
firm should use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost

108. A corporation has concluded that its financial risk premium is too high. In order to
decrease this, the firm can
A) increase the proportion of long-term debt to decrease the cost of capital.
B) increase short-term debt to decrease the cost of capital.
C) decrease the proportion of common stock equity to decrease financial risk.
D) increase the proportion of common stock equity to decrease financial risk.

109. The ________ from the sale of a security are the funds actually received from the
sale after ________, or the total costs of issuing and selling the security, which
have been subtracted from the total proceeds.
A) gross proceeds; the after-tax costs
B) gross proceeds; the flotation costs
C) net proceeds; the flotation costs
D) net proceeds; the after-tax costs

110. A tax adjustment must be made in determining the cost of ________.

A) long-term debt
B) common stock
C) preferred stock
D) retained earnings

111. When determining the after-tax cost of a bond, the face value of the issue must be
adjusted to the net proceeds amounts by considering

A) the risk.
B) the flotation costs.
C) the approximate returns.
D) the taxes.
112. The constant growth valuation modelthe Gordon modelis based on the premise
that the value of a share of common stock is
A) the sum of the dividends and expected capital appreciation.
B) determined based on an industry standard P/E multiple.
C) determined by using a measure of relative risk called beta.
D) equal to the present value of all expected future dividends.

113. One major expense associated with issuing new shares of common stock is

A) underwriting fees.
B) legal fees.
C) registration fees.
D) underpricing.

114. Firms underprice new issues of common stock for the following reason(s).
A) When the market is in equilibrium, additional demand for shares can be
achieved only at a lower price.
B) When additional shares are issued, each share's percent of ownership in the
firm is diluted, thereby justifying a lower share value.
C) Many investors view the issuance of additional shares as a signal that
management is using common stock equity financing because it believes that
the shares are currently overpriced.
D) all of the above.

115. Using the capital asset pricing model, the cost of common stock equity is the return
required by investors as compensation for
A) the specific risk of the firm.
A) the firm's diversifiable risk.
B) price volatility of the stock.
C) the firm's nondiversifiable risk.

116. In comparing the constant growth model and the capital asset pricing model
(CAPM) to calculate the cost of common stock equity,
A) the constant growth model ignores risk, while the CAPM directly considers
risk as reflected in the beta.
B) the CAPM directly considers risk as reflected in the beta, while the
constant growth model uses the market price as a reflection of the expected risk-
return preference of investors.
C) the CAPM directly considers risk as reflected in the beta, while the
constant growth model uses dividend expectations as a reflection of risk.
D) the CAPM indirectly considers risk as reflected in the market return, while
the constant growth model uses dividend expectations as a reflection of risk.

117. When discussing weighing schemes for calculating the weighted average cost
of capital, the preferences can be stated as
A) market value weights are preferred over book value weights and target
weights are preferred over historic weights.
 B) book value weights are preferred over market value weights and target
weights are preferred over historic weights.
C) book value weights are preferred over market value weights and historic
weights are preferred over target weights.
D) market value weights are preferred over book value weights and historic
weights are preferred over target weights.

118. In order to recognize the interrelationship between financing and investments,

the firm should use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost

119. A project's rate of return should be ________ than the weighted marginal cost
of financing. The cumulative acceptance of projects ________ the weighted marginal
cost of capital.

A) less; increases
B) less; decreases
C) greater; increases
D) greater; decreases

120. The wealth-maximizing investment decision for a firm occurs when

A) the cost of capital equals the return on the project.
A) the weighted marginal cost of capital is less than the investment
opportunity schedule.
B) the weighted cost of capital exceeds the marginal cost of capital.
C) the weighted marginal cost of capital equals the investment opportunity
schedule.