Principle of Finance Unit 3 Challenges Sophia Course

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 Unit no #3

                                         Challenge no 1

You loan a friend $5,000. There is a 15% chance your friend will pay you a 3% return, a 40% chance he will pay you a 2% return and a 45% chance he will pay you only a 1% return.

What is your expected return after one year?

·a.)

1.80%

·b.)

2.05%

·c.)

1.70%

·d.)

2.20%

You invest $10,000 in a stock that has a 25% chance of a 10% return, a 50% chance of a 5% return and a 25% chance of a 2% return.

What is your expected return after one year?

·a.)

4.2%

·b.)

5.0%

·c.)

5.5%

·d.)

6.0%

You invest $500 in a stock that has a 30% chance of a 4% return, a 50% chance of a 6% return and a 20% chance of a 12% return.

What is your expected return after one year?

·a.)

7.2%

·b.)

5.8%

·c.)

8.0%

·d.)

6.6%

Which of the following is true of portfolio diversification?

·a.)

A diversified portfolio is more sensitive to an investor's time frame and risk tolerance.

·b.)

A diversified portfolio will always prevent an investor from losing money.

·c.)

A diversified portfolio is less affected by systemic risk.

·d.)

A diversified portfolio will increase variance, without compromising returns.

Why is it a good idea to diversify an investment portfolio?

·a.)

To reduce systemic risk.

·b.)

To eliminate variance.

·c.)

To reduce specific risk.

·d.)

To maximize potential returns.

Which of the following is true of portfolio diversification?

·a.)

Diversification can reduce or eliminate systemic risk, but not specific risk.

·b.)

Diversification can eliminate or reduce specific risk or systemic risk, depending on asset class.

·c.)

Diversification can reduce or eliminate specific risk, but not systemic risk.

·d.)

Diversification can reduce or eliminate both specific risk and systemic risk.

Which of the following credit ratings would make a country or company have the most difficult time raising capital?

·a.)

A

·b.)

AA

·c.)

BBB

·d.)

B

What is the effect of a merger or acquisition announcement on the stock price of a company involved in the restructuring?

·a.)

It will likely increase because analysts add together the stock prices of the companies involved.

·b.)

M&A announcements typically have little effect on the stock price of the companies involved.

·c.)

It will likely decrease because M&A announcements are a signal of market instability.

·d.)

It could increase or decrease, depending on how analysts interpret the long term outlook of the company.

Surprise news or announcements may affect the day to day variance of a stock's price, also known as its __________.

·a.)

credit-worthiness

·b.)

beta

·c.)

fundamental analysis

·d.)

market share

The risk that your investment in a stock will lose value because of a general economic decline is known as __________.

·a.)

market risk

·b.)

interest rate risk

·c.)

model risk

·d.)

foreign investment risk

The risk that you will not be able to immediately convert a non-cash asset into cash when you need it is known as __________.

·a.)

default risk

·b.)

liquidity risk

·c.)

operational risk

·d.)

asset-backed risk

The risk that the person to whom you lent money will not be able to pay you back is known as __________.

·a.)

model risk

·b.)

credit risk

·c.)

market risk

·d.)

liquidity risk

A beta coefficient is best understood as __________.

·a.)

a measure of the degree of risk associated with an individual investment

·b.)

a measure of the degree of correlation between the performance of two stocks

·c.)

a measure of the probability that a portfolio will meet its expected return in a given period

·d.)

a measure of the volatility of a portfolio as compared to a benchmark

If a portfolio regularly rises when a benchmark index rises, but it rises less than the benchmark does, the portfolio's beta coefficient could be __________.

·a.)

-0.5%

·b.)

-1.0%

·c.)

1.0%

·d.)

0.5%

Covariance is best understood as __________.

·a.)

the sum of the risk premiums of two investments

·b.)

the quantity by which an investment outcome deviates from its expected mean

·c.)

the extent to which the value of a portfolio changes in relation to a benchmark index

·d.)

the degree to which two investments' values change together

Which of the following is true of systematic risk?

·a.)

It can be minimized when investment correlations are at zero.

·b.)

It is also known as non-diversifiable risk.

·c.)

It is uncorrelated with broader market returns.

·d.)

Diversification holds less of a benefit for this type of risk when the number of assets within a portfolio exceeds 30.

Which of the following is true of unsystematic risk?

·a.)

It is unaffected by the level of diversification within a portfolio.

·b.)

It can be minimized when investment correlations are at zero or even slightly positive.

·c.)

It is also known as non-diversifiable risk.

·d.)

It is more tightly linked to the market as a whole than systematic risk.

Which of the following is true of unsystematic risk?

·a.)

It is also known as diversifiable risk.

·b.)

It can be mitigated with active fund management, but not passive fund management.

·c.)

It is unaffected by hedging.

·d.)

It is the portion of risk that assumes the risk premium.

A security that is plotted to the far right on the Y-axis of the security market line graph has __________.

·a.)

a small beta value

·b.)

a small expected return

·c.)

a large beta value

·d.)

a large expected return

 A security that is plotted low on the X-axis of the security market line graph has __________.

·a.)

a large expected return

·b.)

a small expected return

·c.)

a large beta value

·d.)

a small beta value

A security that falls below the security market line is __________.

·a.)

attractive for an investor

·b.)

under-valued for its level of risk

·c.)

over-valued for its level of risk

·d.)

unattractive for a company raising capital

challenge no 2

A clothing company with a subscription business model is seeking to raise capital to expand its operation. They decide to issue a small number of shares to some high-net-worth individuals that have supported the company in the past.

What type of market transaction is taking place?

·a.)

Share buyback

·b.)

Secondary market offering

·c.)

Private placement

·d.)

Auction

A small start-up company that develops vaccines is seeking funding to expand and become a major competitor in the biotech industry. To do so, they register and issue shares of stock to be sold on an exchange for the first time.

What type of market transaction is taking place?

·a.)

Share buyback

·b.)

Primary market offering

·c.)

Private placement

·d.)

Secondary market offering

Bob wants to expand his retirement portfolio, so he purchases some shares of stock in a software company that have consistently performed well over the last 10 years.

What type of market transaction is taking place?

·a.)

Secondary market offering

·b.)

Private placement

·c.)

Share buyback

·d.)

Primary market offering

Ray purchased stock with an initial share price of $84, and sold it when the share price was $75. While he owned the stock, he earned $10 in dividends.

What was his total percentage return on the investment?

·a.)

-10.71%

·b.)

1.19%

·c.)

-12.00%

·d.)

1.33%

Paula purchased stock with an initial share price of $30, and sold it when the share price was $60. While she owned the stock, she earned $4 in dividends.

What was her total percentage return on the investment?

·a.)

113.33%

·b.)

156.67%

·c.)

213.33%

·d.)

56.70%

Erin purchased stock with an initial share price of $15, and sold it when the share price was $17. While she owned the stock, she earned $2 in dividends.

What was her total percentage return on the investment?

·a.)

22.67%

·b.)

26.67%

·c.)

11.76%

·d.)

23.53%

Which of the following is a tenet of weak-form efficiency?

·a.)

Investors cannot predict the future price of securities based on their past prices.

·b.)

The market is affected by the irrational behavior of human investors, making it difficult to predict.

·c.)

Share prices instantly adjust to reflect even hidden or “insider” information.

·d.)

Price patterns exist over time and can yield useful investing information.

Which of the following is a tenet of strong-form efficiency?

·a.)

No person can generate excess returns because all information, whether public or private, is accounted for in a stock's price.

·b.)

The prices of securities reflect all known past information, but do not account for present information.

·c.)

Technical analysis techniques are sometimes able to produce excess returns

·d.)

Individual investors can "beat" the market if they gain access to private information.

Which of the following is a tenet of semi-strong-form efficiency?

·a.)

Excess returns can be earned using investment strategies based on historical share prices.

·b.)

Excess returns cannot be generated by using publicly available information to make investment choices.

·c.)

The market can be "beaten" by individual investors if enough information is collected.

·d.)

Private information has an immediate effect on share prices.

When Essa purchased 50 shares of stock, the transaction was sent to a central network that distributed notice of the trade.

Which federal regulation established this process?

·a.)

Securities Act of 1933

·b.)

Securities Exchange Act of 1934

·c.)

Sarbanes-Oxley Act of 2002

·d.)

Securities Act Amendments of 1975

Aditi's company is preparing for its IPO in the summer. The company has registered its securities with the SEC and prepared a prospectus for potential investors.

By doing so, which federal regulation is her company complying with?

·a.)

Securities Act Amendments of 1975

·b.)

Securities Act of 1933

·c.)

Sarbanes-Oxley Act of 2002

·d.)

Securities Exchange Act of 1934

As CEO, Varina is responsible for personally verifying the accuracy of her company's financial statements by signing off on them.

By doing so, which federal regulation is she complying with?

·a.)

Securities Act of 1933

·b.)

Sarbanes-Oxley Act of 2002

·c.)

Securities Act Amendments of 1975

·d.)

Securities Exchange Act of 1934

                             Challenge no 3

What two components typically comprise a company's capital structure, and therefore its WACC?

·a.)

Equity and interest

·b.)

Equity and assets

·c.)

Debt and interest

·d.)

Debt and equity

When making investment decisions, what measurement tells you the compensation needed to assume a given level of risk?

·a.)

Required rate of return

·b.)

Net present value

·c.)

Cost of debt

·d.)

Weighted average cost of capital

What is the weighted average cost of capital (WACC)?

·a.)

The present value of future cash flows to an organization.

·b.)

The combination of interest rates being incurred from both debt and equity.

·c.)

The average of the interest rates an organization pays on its preferred and common stock.

·d.)

The opportunity cost of foregone investments plus the risk of borrower default.

Using the following variables, calculate an organization's cost of common equity.

·Rf: 2%

·βs: 1.2

·(Rm – Rf): 6%

·a.)

9.2%

·b.)

7.9%

·c.)

8.7%

·d.)

7.2%

Using the following variables, calculate an organization's cost of debt on a $100,000 bond.

·Rf: 2%

·Credit-risk rate: 6%

·t: 20%

·a.)

$7,840

·b.)

$8,000

·c.)

$1,600

·d.)

$6,400

Using the following variables, calculate an organization's cost of preferred stock.

·Dpref: $50

·Ppref: $1000

·g: 5%

·a.)

10.0%

·b.)

7.5%

·c.)

2.5%

·d.)

25.0%

The discounted cash flow approach is useful for __________.

·a.)

determining whether an asset being considered for a portfolio offers a reasonable expected return for the risk

·b.)

considering existing and future resources to make optimal investment decision

·c.)

finding where an asset falls on the security market line

·d.)

measuring an asset’s sensitivity to systematic risk

The bond yield plus risk premium (BYPRP) approach is useful for determining __________.

·a.)

the overall value of a company

·b.)

the value of a company's publicly traded equity

·c.)

the value of a company's private equity

·d.)

the value of a company's debt

The capital asset pricing model is useful for __________.

·a.)

determining the net present value of an organization

·b.)

determining whether an asset's expected return will offset its susceptibility to market risk

·c.)

estimating the value of an equity using the bond yield

·d.)

making decisions about which potential future projects to pursue

Company A Company B

Market Value of Equity $400,000 $200,000

Market Value of Debt $200,000 $500,000

Cost of Equity 10% 8%

Cost of Debt 2% 2%

Tax Rate 25% 35%

Based solely on their current weighted average cost of capital, which company should pursue an investment opportunity with an expected return of 6%?

·a.)

Only Company B.

·b.)

Neither Company A nor Company B.

·c.)

Only Company A.

·d.)

Both Company A and Company B.

Company A Company B

Market Value of Equity $200,000 $300,000

Market Value of Debt $150,000 $200,000

Cost of Equity 8% 5%

Cost of Debt 3% 2%

Tax Rate 30% 30%

Based solely on their current weighted average cost of capital, which company should pursue an investment opportunity with an expected return of 6%?

·a.)

Only Company A.

·b.)

Neither Company A nor Company B.

·c.)

Both Company A and Company B.

·d.)

Only Company B.

Company A Company B

Market Value of Equity $350,000 $150,000

Market Value of Debt $100,000 $150,000

Cost of Equity 9% 10%

Cost of Debt 1.5% 2%

Tax Rate 30% 25%

Based solely on their current weighted average cost of capital, which company should pursue an investment opportunity with an expected return of 5.5%?

·a.)

Neither Company A nor Company B.

·b.)

Both Company A and Company B.

·c.)

Only Company A.

·d.)

Only Company B.

A company is considering a new plan for its capital structure.

Which of the following is true if, under the new plan, the company's weighted average cost of capital is less than the expected return?

·a.)

The company is unlikely to encounter bankruptcy.

·b.)

The company's cost of capital is too high.

·c.)

The company is under-leveraged.

·d.)

The company is probably going to go bankrupt.

One reason a company may choose to issue additional debt instead of equity when raising capital is that __________.

·a.)

too much equity can increase a company's interest rate

·b.)

debt always has a lower cost of capital

·c.)

there are tax advantages to debt

·d.)

it decreases the risk that the company will default on its obligations

One reason a company's capital structure may include more equity than debt is that relying too heavily on debt could __________.

·a.)

increase the company's taxes

·b.)

decrease the company's leverage

·c.)

decrease the company's volatility

·d.)

increase the company's risk of bankruptcy

What happens after a company files for Chapter 7 bankruptcy?

·a.)

Creditors may begin collections actions.

·b.)

Creditors are paid through the sale of assets.

·c.)

Creditors vote on the business's reorganization plan.

·d.)

The business has an opportunity to restructure its debts.

Select the true statement about Chapter 11 bankruptcy.

·a.)

Under Chapter 11, a company is permanently dissolved.

·b.)

Under Chapter 11, a company may be able to continue its operations, but with a potentially higher cost of capital.

·c.)

Under Chapter 11, a company can reorganize without officially filing a bankruptcy petition.

·d.)

Under Chapter 11, a company's creditors are paid with the proceeds of the sale of all of the company's assets.

Which of the following steps happens last in a Chapter 11 bankruptcy?

·a.)

The company liquidates all of its assets.

·b.)

The company receives a stay from any collections activity.

·c.)

The company's debtholders vote on a plan of debt reorganization.

·d.)

The company considers modifications to its operations as an alternative to bankruptcy.

You own a small manufacturing business that produces widgets. You have spent $400,000 acquiring the fixed assets you need to produce widgets. Each widget costs you $3 to make and they sell for $25 each, so your variable cost is 12% of the overall revenue.

At your current level of operating leverage, how many widgets must you sell to break even?

·a.)

22,451

·b.)

16,000

·c.)

18,182

·d.)

48,000

You own a small manufacturing business that produces widgets. You have spent $200,000 acquiring the fixed assets you need to produce widgets. Each widget costs you $4 to make and they sell for $20 each, so your variable cost is 20% of the overall revenue.

At your current level of operating leverage, how many widgets must you sell to break even?

·a.)

10,000

·b.)

12,500

·c.)

40,000

·d.)

22,500

You own a small manufacturing business that produces widgets. You have spent $300,000 acquiring the fixed assets you need to produce widgets. Each widget costs you $2 to make and they sell for $20 each, so your variable cost is 10% of the overall revenue.

At your current level of operating leverage, how many widgets must you sell to break even?

·a.)

16,667

·b.)

30,000

·c.)

15,000

·d.)

24,500

·

·

·

·

·

Calculate a company's total leverage given the following information:

·Net income = $35,000

·Revenue = $70,000

·Variable costs = $15,000

·a.)

2.33

·b.)

Cannot calculate without knowing the degree of operating leverage

·c.)

Cannot calculate without ROE data

·d.)

1.57

Calculate a company's total leverage given the following information:

·Net income = $40,000

·Revenue = $60,000

·Variable costs = $10,000

·a.)

2

·b.)

Cannot calculate without EPS data

·c.)

Cannot calculate without EBIT data

·d.)

1.25

Calculate a company's total leverage given the following information:

·Change in sales = 3%

·Change in earnings = 9%

·a.)

Cannot calculate without net income data

·b.)

Cannot calculate without EBIT data

·c.)

3

·d.)

0.33

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