A company has prepared a net present value analysis of a possible capital budgeting project involving the adoption of a new production process; the company is now addressing risk. There will likely be some variance from the estimates used in the analysis as actual results are experienced through the life of the project. Which one of the following estimates is most likely to vary significantly from estimate?
Answer (C) is correct. The cost savings as well as the discount rate for the discounted cash-flow analysis must be estimated.
A treasurer is in the process of determining whether she should invest a portion of her company’s pension plan assets in publicly traded Trip Auto Company. The treasurer has collected the following information on Trip Auto Company:
? Current-year dividend = $1.50
? Yearly dividend increase = 5%
? Expected investor return = 10%
? Current share price = $25.00
On the basis of the information provided above, the treasurer is justified in concluding that an investment in Trip Auto
Answer (B) is correct. The investment is projected to earn a good return, and the dividend is expected to grow from year to year. If these hold true, then the investment should be profitable.
A company received a legal settlement of $1 million. The company could apply this $1 million toward its mortgage on the building it owns and save 4% in interest. The CFO suggested that based on historical analysis of the market over time, it was likely the company could earn around 8% over the term of the mortgage if it invested the money, which was a better return than the 4%. The business owners elected to apply the money to the mortgage rather than invest the money. Based on the decision described in this scenario, a reasonable conclusion would be that the company has a
Answer (B) is correct. The company decided to go with the guaranteed 4% return instead of taking the investment with an 8% return. This shows that they have a low risk tolerance, since they were not willing to take the additional risk associated with the 8% investment. The certainty equivalent specifies at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum. Since the firm would rather take the sum of money than the expected value of the risky sum, the certainty equivalent is less than expected value.
According to market segmentation theory long-term interest
rates are determined primarily by
(c) The requirement is to identify the determinate of
long-term interest rates under market segmentation theory.
Market segmentation theory states that the Treasury securities
market is divided into market segments by the various financial
institutions investing in the market. Answer (c) is correct because
life insurance companies prefer long-term securities because
of the nature of their commitments to policyholders. Answer
(a) is incorrect because commercial banks prefer securities
with short maturities. Answer (b) is incorrect because savings
institutions prefer intermediate-term maturities. Answer (d) is
incorrect because individual investors do not significantly affect
Questo borrowed $100,000 from a bank on a one-year 8%
term loan, with interest compounded quarterly. What is the
effective annual interest on the loan?
(b) The requirement is to calculate the effective annual
interest rate. Answer (b) is correct because the effective interest
rate (EAR) is calculated as follows:
r = Stated interest rate
m = Compounding frequency
Answer (a) is incorrect because it is the stated interest rate. Answer
(c) is incorrect because it is the interest rate for three
Short-term interest rates are
(a) The requirement is to identify the true statement
about short-term interest rates. Answer (a) is correct because
there is less risk involved in the short run and investors are willing
to accept lower rates on short-term investments because of their
liquidity. Short-term rates have ordinarily been lower than longterm
rates. Answer (b) is incorrect because short-term rates are
typically lower than long-term rates. Answer (c) is incorrect
because short-term rates are more likely to be greater than longterm
rates if current levels of inflation are high. Answer (d) is
incorrect because long-term rates may be viewed as short-term
rates adjusted by a risk factor.
According to the expectations theory, if the yield curve on
the New York money market is upward sloping while that on the
Tokyo money market is downward sloping, then inflation in
(c) The requirement is to predict the effect of inflation
on the yield curve. The correct answer is (c) because a downward
sloping yield curve indicates that long-term rates are lower
than short-term rates. For this to be the case investors would
have to be expecting a decline in the rate of inflation. Answers
(a) and (b) are incorrect because an upward sloping yield curve
would mean that investors are expecting an increase in inflation.
Answer (d) is incorrect because a downward sloping yield curve
would imply that investors are expecting inflation to decline.
According to the expectations theory of the term structure
of interest rates, if inflation is expected to increase, the yield curve
(c) The requirement is to describe the effect on the
yield curve of an expectation of an increase in inflation. Answer
(c) is correct because if inflation is expected to increase, interest
rates are expected to rise and therefore, intermediate-term and
long-term rates will be higher than short-term rates. Answer (a)
is incorrect because a humped yield curve is not consistent with
expectations theory. Answer (b) is incorrect because a downward
sloping curve would imply an expectation that inflation will
decrease. Answer (d) is incorrect because a flat yield curve
would imply inflation is expected to remain constant.
A curve on a graph with the rate of return on the vertical axis
and time on the horizontal axis depicts
(b) The requirement is to identify a graph that depicts
the rate of return on the vertical axis and time on the horizontal
axis. Answer (b) is correct because such a graph presents a yield
curve that shows the term structure of interest rates. The term
structure of interest rates refers to how interest rates vary by time
to maturity. Answer (a) is incorrect because internal rate of return
is the interest rate that equates the present value of the future
cash flows from an investment with its initial cost. Answer
(c) is incorrect because it is the definition of net present value.
Answer (d) is incorrect because it defines an annuity.
The return paid for the use of borrowed capital is referred
(c) The requirement is to identify the return paid for the
use of borrowed capital. Answer (c) is correct because the return
paid for the use of borrowed funds is called interest. Answers (a)
and (b) are incorrect because dividends are paid to equity holders.
Answer (d) is incorrect because the principal payment represents
the return of capital.