When we consider "risk" in a financial sense (i.e. investments), the meaning differs from the conventional definition. Explain what is meant by "risk" in the financial/investment realm. Why should an investor expect to be rewarded for assuming "risk?"
True or False (2pts. Each)
2. Market risk refers to the tendency of a stock to move with the general market. A stock with above-average market risk will have a beta which is less than 1.0___________.
3. The expected rate of return of an asset will always equal one of the possible rates of return for the asset__________.
4. To attempt to eliminate diversifiable risk in a portfolio, I would consider investing in an unlimited number of stocks and would prefer them to have similar correlation coefficients__________.
5. The internal rate of return is that discount rate which equates the pv of the cash outflows (or costs) with the PV of the cash inflows__________.
6. Other things held constant, an increase in the required rate of return will result in a decrease of a project's IRR__________.
7. Conflicts between two mutually exclusive projects should generally be resolved in favor of the one with the higher NPV__________.
8. A capital budgeting project is acceptable if the rate of return required for such an endeavor is greater than the project's internal rate of return_________.
9. Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates________.
10. Sensitivity analysis is a risk analysis technique in which key variables are changed and the resulting changes in the NPV and IRR are observed__________.
11. Risk in a revenue-producing project can best be adjusted by adjusting the discount rate downward for increasing risk_________.
Problem Solving (5pts. except as noted-please show work for partial credit)
12. Steve currently has an investment portfolio that contains 4 stocks totaling $80,000, with a portfolio beta = 1.4. He is thinking of investing an additional $20,000 in a stock with a beta = 2.4. What will the portfolio beta be after he adds the stock?
13. Suppose the risk-free rate = 5%, and the expected return in the market = 15%. What would be the appropriate required rate of return for a stock with a beta coefficient = 1.5?
What would the appropriate required rate of return be for a stock with Beta = .5?
14. If the following two projects are mutually exclusive, and the rate of return is 10%, which project should be purchased?
Yr Project Q Project R
0 $(4,000) $(4,000)
1 $0 $3,500
2 $5,000 $1,100
15. Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows of $44,503 per year. If the firm's required rate of return is 14%,
a. What is the project's IRR? (5 pts.)
b. What is the project's MIRR? (5 pts.)
16. Seattle Corp. is looking at an investment which will result in cashflows of $30,000 per year in Years 1 thru 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. The project will cost $150,000 today, and the firm's required rate of return is 10%. What is the NPV for this investment?
17. Mars, Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. The company will depreciate the cost of the new machine using the straight line method over the project life and it expects to sell the machine at the end of its 5-year life for $10,000. The firm expects to be able to REDUCE net working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years. Mars' marginal tax rate is 40%, and it uses a 12% required rate of return to evaluate projects of this nature. If the machine costs $60,000, what are the NPV and IRR of the project?