Final Exam Sample

Please feel free to discuss questions and answers with your team. This is explicitly designed to practice collaboration. (I have not written up answers.)

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Unless explicitly otherwise specified, assume that you are operating a large perfect-market company.

1. How can a firm better raise capital by tailoring its offerings to more risk-averse and less risk-averse investors?

2. When the firm increases its leverage, do both equity and debt become riskier?

3. When the firm increases its leverage, does it make the firm riskier (and, if the financial markets are risk averse, therefore raise its WACC)?

4. Financial markets cannot reduce investors’ effective risk aversion. True or False?

5. Should retail investors care about the market-beta of their overall portfolio or about the standard deviation risk of their overall portfolio?

6. If the equity premium is 3% per year, and the risk-free rate is 4% per year, then what does the CAPM say your project’s hurdle rate should be?

7. Which CAPM inputs are firm-specific, which are economy-wide?

8. If the CAPM holds, beta and only beta should matter when it comes to expected rates of return. The size of the firm or its value characteristics or its moment would all be completely unimportant. True or False?

9. If the CAPM is correct, which of these is true?

   a. low-beta stocks and high-beta stocks should have the same average returns.

   b. low-beta stocks should have higher average returns than high-beta stocks.

   c. high-beta stocks should have higher average returns than low-beta stocks.

10. The evidence suggests that the CAPM is the dominant model in wide practice. True or False?

11. The evidence suggests that the CAPM is a good description of reality, which is why it is the dominant model in wide practice. True or False?

12. IF the CAPM were true, should corporations who want investors to purchase their shares care about the market-beta of their shares or about the standard deviation of their shares?

13. In an imperfect market, the value of projects can depend on who owns these projects. Thus, we cannot easily use standard modern finance tools when it comes to firms owned by not-so-rich small entrepreneurs. True or False?

14. An efficient capital market is a weaker concept than a perfect capital market. That is, a perfect capital market implies an efficient capital market, but the opposite is not necessarily the case. True or False?

15. An efficient capital market says it is very difficult or impossible to earn excess profits based on information that is widely known by the public markets. True or False?

16. An efficient capital market says it is very difficult or impossible to earn excess profits because taxes may negate the profits. True or False?

17. An efficient capital market says it is very difficult or impossible to earn excess profits when there are large monopolistic capital providers. True or False?

18. An efficient capital market is easier to prove or disprove based on empirical performance data over long time horizons. True or False?

19. For the longest time (1930-1980), but no longer, big firms offered higher average rates of return than small firms.

20. For the longest time (1930-2005), but no longer, value firms offered higher average rates of return than growth firms.

21. For the longest time (1930-2005), but no longer, momentum stocks offered higher average rates of return than other stocks.

22. Most publicly-traded financial security prices seem to follow a random walk. This implies that their rates of return are roughly iid normally distributed and therefore mostly unpredictable. True or False?

23. Technical analysis is the interpretation of past price patterns in stocks. True or False?

24. There is good evidence that technical analysis can predict stock returns. True or False?

25. With about 5 years of performance data, we should be able to tell with reasonable statistical confidence whether a fund manager is better or worse than her peers. True or False?

26. By pure chance alone, we would expect roughly 1 out of 1,000 funds to outperform the benchmark each and every year. True or False?

27. By pure chance alone, we would expect roughly 1 out of 1,000 funds to outperform the benchmark over a 10-year sample period. True or False?

28. It is very difficult or perhaps outright impossible to design an investment strategy that will earn positive rates of return (“make money”) 90% of the time. True or False?

29. Investors should judge the cost of capital based on their own alternative investment opportunities rather than based on the project’s characteristics. True or False?

30. Firms can reduce their risk by merging with other unrelated firms. True or False?

31. Because firms can reduce their risk by merging with other unrelated firms, this can add value for share-holders. True or False?

32. Imagine investing in a laboratory that costs \$30 million. It then takes 5 years and \$10 million to invest in R&D. With 1-in-100 probability, it will produce a drug worth (sellable at) \$3 billion then. With 99-in-100 probability, the drug will fail and be worthless. The laboratory can however still be sold after 5 years for \$20 million. What is the NPV of this project if the cost of capital and hurdle rate for the laboratory is 4% per year and the cost of capital and hurdle rate for the drug is 7% per year?

33. When/Because firms can be flexible in responding to market fluctations, they may actually be better off (rather than worse off) under more uncertainty. True or False?

34. Firms exist because they solve externalities problems better than the alternative. True or False?

35. Give examples of negative and positive externalities.

36. Cannibalization is not a negative externality if other firms can produce the replacement product. True or False?

37. When there are externalities, firms should allocate overhead proportionally. True or False?

38. The correct rule when there are externalities is to attribute all externalities equally among all affected subsidiaries. True or False?

39. It is wasteful for a firm to train multiple employees for the same critical job. True or False?

40. Employees tend to collaborate well because they understand that firms need redundancy when it comes to their tasks. True or False?

41. Once people are convinced by evidence that they are overconfident, too, they usually manage to debias themselves. True or False?

42. Which one:

    a. When we calculate cash flows for PV calculations, we add depreciation to net income and add capital expenditures.

    b. When we calculate cash flows for PV calculations, we add depreciation to net income and subtract capital expenditures.

    c. When we calculate cash flows for PV calculations, we subtract depreciation from net income and add capital expenditures.

    d. When we calculate cash flows for PV calculations, we subtract depreciation from net income and subtract capital expenditures.

43. Which one:

    a. When we calculate cash flows for PV calculations, we add working capital.

    b. When we calculate cash flows for PV calculations, we subtract working capital.

    c. When we calculate cash flows for PV calculations, we add changes in working capital.

    d. When we calculate cash flows for PV calculations, we subtract changes in working capital.

44. Cash flows tend to be more difficult to manipulate than net income. True or False?

45. Which one?

    a. It is better to discount net income than cash flows in an NPV analysis.

    b. It is better to discount cash flows than net income in an NPV analysis.

46. Which one?

    a. The accounting cash flow statement provides a convenient estimate for the cash flows we need in an NPV analysis.

    b. The accounting cash flow statement provides a convenient estimate for the cash flows we need in an NPV analysis, except that we need to fix up interest payments.

    c. The accounting cash flow statement provides a convenient estimate for the cash flows we need in an NPV analysis, except that we need to fix up working capital changes.

    d. The accounting cash flow statement provides a convenient estimate for the cash flows we need in an NPV analysis, except that we need to fix up depreciation.

47. Firms that are growing rapidly are less likely to run out of cash than firms that are growing slowly. True or False?

48. Which one?

    a. The accounting book value of equity is more trustworthy than the accounting book value of cash.

    b. The accounting book value of equity is less trustworthy than the accounting book value of cash.

49. There is good evidence that active professional fund managers can beat passive investors. Otherwise, why would retail investors be willing to pay them fees? True or False?

50. On an average trading day, what is a typical E(r) for a typical stock (or portfolio)?

51. If a stock’s annual volatility is 30% per year, what would you think would be its daily volatility?

52. Longer question: Can you explain / illustrate a situation in which the value of a project depends on who owns it?

53. Longer question: List some of the shananigans that funds can pull to make their performances look better.

54. Can you give an example of a great bet and an example of an arbitrage, where only one of these each is correct?