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Exam 13: Risk and Capital Budgeting

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Question 41

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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

A) b, c, a, d
B) d, a, b, c
C) d, b, a, c
D) d, a, c, b

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Question 42

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Projects that are totally uncorrelated should provide some overall reduction in portfolio risk.

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Question 43

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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.

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. The higher the risk, the higher the consequent required rate of return.

The measure of risk is best described as

In determining the appropriate discount rate for an individual project, the financial manager will be most influenced by the

In a portfolio, risk is evaluated in a different way than with an individual project. In evaluating portfolio, risk we

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. The coefficient of variation measures the risk of an investment, while the coefficient of correlation measures how an investment affects the total risk of a company's holdings or portfolio.

Bill Broodiest, star quarterback for the Spring Bay Smashers, would like to invest a small portion of his earnings in stocks in one of three firms. His estimated returns and the probabilities of their occurrence follow.

The coefficient of correlation

Modigliani and Associates has forecasted the following payoffs from a project: $\begin{array} { r c l } \text { Outcome } & \text { Probability of Outcome } & \text { Assumptions } \\\$ 0 & 20 \% & \text { pessimistic } \\\$ 3,500 & 60 \% & \text { moderately successful } \\\$ 6,000 & 20 \% & \text { optimistic }\end{array}$ What is the expected value of the outcomes?

If possible outcomes are D and probabilities are P, the standard deviation is defined as $\sigma = \sqrt { \Sigma ( D - \bar { D } ) ^ { 2 } P }$ .

The "efficient frontier" indicates

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. Positively correlated assets react in kind, so they will not generally provide a smoothing effect.

All of the following are methods of evaluating the risk of a project except which one?

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.

The coefficient of variation calculates the percentage of return relative to the risk of a project. The coefficient of variation measures the amount of risk per unit of return.

Match the following with the items below:

Golden Corporation is considering the purchase of new equipment costing $77,000. The expected life of the equipment is 10 years. The potential increase in annual net income from the new equipment for the next 10 years depends on the state of the economy as follows.

Investors tend to decrease required rates of return over time for projects with longer lives. Time brings an increased element of risk, raising the required rate of return.