Corporate Finance Exam #3 UPDATED
ACTUAL Exam Questions and CORRECT
Answers
For larger portfolios, investors expect higher returns for higher risk (positive risk premium)...
require a risk premium proportional to the amount of systematic risk they are bearing -
CORRECT ANSWER -
Only systematic risk is rewarded... rational investors should choose to diversify - CORRECT
ANSWER -
Portfolio Weights - CORRECT ANSWER - The fraction of the total investment in a
portfolio held in each individual investment in the portfolio
** Should add up to 100%
Represents the way we have divided our money between the different individual investments in
the portfolio
Volatility of a Portfolio - CORRECT ANSWER - The total risk, measured as standard
deviation, of a portfolio
The amount of risk that is eliminated in a portfolio depends upon the degree to which the stocks
face common risks and move together - CORRECT ANSWER - Combining similar
stocks... move together... not much diversification achieved
Combining very different stocks... move opposite each other... greater diversification achieved
The Stock's Correlation - CORRECT ANSWER - Measure the degree to which the returns
share common risk (ranges from -1 to +1)
,** -1 = always move oppositely... perfectly negatively correlated
** +1 = always move together... perfectly politely correlated
Highly Correlated Stocks - CORRECT ANSWER - Stock returns tend to move together if
they are affected similarly by economic events
Stocks in the same industry tend to have more highly correlated returns than stocks in different
industries
Equally Weighted Portfolio - CORRECT ANSWER - A portfolio in which the same
amount of money is invested in each stock
** Volatility declines as the number of stocks in this portfolio grows
With a large enough portfolio, you can diversify away all unsystematic risk, but you will still be
left with systematic risk - CORRECT ANSWER - Optimal portfolios should contain only
systematic risk and no diversifiable risk
Market Index - CORRECT ANSWER - The most common proxy portfolios (ex. Dow
Jones and S&P 500)
Beta - CORRECT ANSWER - The percent change in the stock's excess return that we
expect for each 1% change in the market's excess return
Measures the systematic risk of an investment, which is its sensitivity to fluctuations in the
market portfolio
Use linear regression and its "line of best fit" to estimate our beta/the historical relation between
the stock and the market
** Beta of the overall market portfolio = 1
, ** Differences in Betas by industry are related to the sensitivity of each industry's profits to the
general health of the economy
Equity Cost of Capital - CORRECT ANSWER - Only systematic risk determines the
expected returns
Firm-specific risk is diversifiable and does not warrant extra return
Capital - CORRECT ANSWER - A firm's sources of financing (debt, equity, and other
securities) that it has outstanding
Capital Structure - CORRECT ANSWER - The relative proportions of debt, equity, and
other securities that a firm has outstanding
** Capital structure varies widely across firms
** Capital structure often varies across industries
Weighted Average Cost of Capital (WACC) - CORRECT ANSWER - The weighted
average of a firm's equity and debt cost of capital is its overall cost of capital.
Unlevered Firm - CORRECT ANSWER - Does not issue debt
Pays out all of the FCF generated by its assets to equity holders
Levered Firm - CORRECT ANSWER - Has debt outstanding
Distributes out all of the FCF generated by its assets between equity & debt holders
Leverage - CORRECT ANSWER - The relative amount of debt on the firm's balance sheet
ACTUAL Exam Questions and CORRECT
Answers
For larger portfolios, investors expect higher returns for higher risk (positive risk premium)...
require a risk premium proportional to the amount of systematic risk they are bearing -
CORRECT ANSWER -
Only systematic risk is rewarded... rational investors should choose to diversify - CORRECT
ANSWER -
Portfolio Weights - CORRECT ANSWER - The fraction of the total investment in a
portfolio held in each individual investment in the portfolio
** Should add up to 100%
Represents the way we have divided our money between the different individual investments in
the portfolio
Volatility of a Portfolio - CORRECT ANSWER - The total risk, measured as standard
deviation, of a portfolio
The amount of risk that is eliminated in a portfolio depends upon the degree to which the stocks
face common risks and move together - CORRECT ANSWER - Combining similar
stocks... move together... not much diversification achieved
Combining very different stocks... move opposite each other... greater diversification achieved
The Stock's Correlation - CORRECT ANSWER - Measure the degree to which the returns
share common risk (ranges from -1 to +1)
,** -1 = always move oppositely... perfectly negatively correlated
** +1 = always move together... perfectly politely correlated
Highly Correlated Stocks - CORRECT ANSWER - Stock returns tend to move together if
they are affected similarly by economic events
Stocks in the same industry tend to have more highly correlated returns than stocks in different
industries
Equally Weighted Portfolio - CORRECT ANSWER - A portfolio in which the same
amount of money is invested in each stock
** Volatility declines as the number of stocks in this portfolio grows
With a large enough portfolio, you can diversify away all unsystematic risk, but you will still be
left with systematic risk - CORRECT ANSWER - Optimal portfolios should contain only
systematic risk and no diversifiable risk
Market Index - CORRECT ANSWER - The most common proxy portfolios (ex. Dow
Jones and S&P 500)
Beta - CORRECT ANSWER - The percent change in the stock's excess return that we
expect for each 1% change in the market's excess return
Measures the systematic risk of an investment, which is its sensitivity to fluctuations in the
market portfolio
Use linear regression and its "line of best fit" to estimate our beta/the historical relation between
the stock and the market
** Beta of the overall market portfolio = 1
, ** Differences in Betas by industry are related to the sensitivity of each industry's profits to the
general health of the economy
Equity Cost of Capital - CORRECT ANSWER - Only systematic risk determines the
expected returns
Firm-specific risk is diversifiable and does not warrant extra return
Capital - CORRECT ANSWER - A firm's sources of financing (debt, equity, and other
securities) that it has outstanding
Capital Structure - CORRECT ANSWER - The relative proportions of debt, equity, and
other securities that a firm has outstanding
** Capital structure varies widely across firms
** Capital structure often varies across industries
Weighted Average Cost of Capital (WACC) - CORRECT ANSWER - The weighted
average of a firm's equity and debt cost of capital is its overall cost of capital.
Unlevered Firm - CORRECT ANSWER - Does not issue debt
Pays out all of the FCF generated by its assets to equity holders
Levered Firm - CORRECT ANSWER - Has debt outstanding
Distributes out all of the FCF generated by its assets between equity & debt holders
Leverage - CORRECT ANSWER - The relative amount of debt on the firm's balance sheet
