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Beta is another measurement of risk and measures the stability of returns on an individual stock relative to the stock market index of returns.

A) True
B) False

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The "portfolio effect" in capital budgeting refers to


A) the relationship of stocks to bonds.
B) the degree of correlation between various investments.
C) the coefficient of variation.
D) the risk-adjusted discount rate.

E) A) and D)
F) B) and C)

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A firm might be willing to accept high risk in a given investment if the portfolio effect (for the whole firm) is beneficial.

A) True
B) False

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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.

A) True
B) False

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Portfolio risk is evaluated differently than individual project risk. In evaluating portfolio risk, we


A) need to consider the impact of a given project on the overall risk of the firm.
B) recognize that a risky investment may create a portfolio with less risk.
C) need to consider how the returns of the projects in the portfolio are correlated.
D) all of these options are true.

E) All of the above
F) C) and D)

Correct Answer

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Which investment has the least amount of risk?


A) Standard deviation = $450, expected return = $4,500
B) Standard deviation = $600, expected return = $400
C) Standard deviation = $500, expected return = $800
D) Standard deviation = $400, expected return = $5,000

E) B) and D)
F) B) and C)

Correct Answer

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Projects that are negatively correlated


A) reduce the standard deviation of returns for the firm.
B) increase the possible losses of the firm.
C) are generally in the same industry.
D) none of these options are correct.

E) C) and D)
F) A) and B)

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

A) True
B) False

Correct Answer

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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.

A) True
B) False

Correct Answer

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The investor's portfolio should always be on the efficient frontier.

A) True
B) False

Correct Answer

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In order to reduce risk in a firm, the firm would seek to enter a business that


A) has a high positive correlation with its present business.
B) has a zero correlation with its present business.
C) has a high negative correlation with its present business.
D) has a high negative variation with its present business.

E) A) and D)
F) B) and C)

Correct Answer

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A project that carries a normal amount of risk and does not affect the risk exposure of the firm should be discounted back at the


A) coefficient of variation.
B) beta.
C) risk-free rate.
D) firm's weighted average cost of capital.

E) All of the above
F) A) and D)

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Generally, the higher the coefficient of variation a project has, the higher the discount rate it should be assigned.

A) True
B) False

Correct Answer

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The equation for the coefficient of variation is (V) = σD\frac { \sigma } { D }

A) True
B) False

Correct Answer

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The coefficient of correlation represents the standard deviation divided by the expected value.

A) True
B) False

Correct Answer

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The "efficient frontier" indicates


A) alternatives with neutral combinations of risk and return.
B) alternatives with the highest returns.
C) alternatives with the best combination of risk and return.
D) alternatives with no risk.

E) A) and B)
F) A) and C)

Correct Answer

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Firm X is considering a project and its analysts have projected the following outcomes and their probabilities.  Probability of  Outcome  Outcome  Assumption $4,60030% pessirmstic $7,80045% moderately swccessful $13,50025% optimistic \begin{array}{l}\begin{array} { r c ll } &\text { Probability of }\\\text { Outcome } & \text { Outcome } & &\text { Assumption }\\\$4,600 & 30 \% & \text { pessirmstic } \\\$7,800 & 45 \% & \text { moderately swccessful } \\\$13,500 & 25 \% & \text { optimistic }\end{array}\end{array} What is the expected value of the outcomes?


A) $3,375
B) $8,633
C) $8,265
D) Cannot be determined. Depends upon which prediction is correct.

E) A) and C)
F) A) and B)

Correct Answer

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Projects that are totally uncorrelated provide


A) no risk reduction.
B) some risk reduction.
C) extreme risk reduction.
D) risk has nothing to do with correlation.

E) A) and D)
F) C) and D)

Correct Answer

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Which of the following is a false statement?


A) Risky investments may produce large losses.
B) Risky investments may produce large gains.
C) The coefficient of variation is a risk measure.
D) Risk-averse investors cannot be induced to invest in risky assets.

E) All of the above
F) A) and B)

Correct Answer

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The lower the coefficient of correlation, the greater the


A) risk when projects are combined.
B) risk reduction when projects are combined.
C) return when projects are combined.
D) standard deviation when projects are combined.

E) None of the above
F) A) and C)

Correct Answer

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