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Exam 13: Risk and Capital Budgeting

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Question 1

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Assume that Widget Repair Corporation provides services to 100 customers whose decision to change suppliers is uncorrelated. The portfolio effect suggests that the entrepreneur/owner of Widget, who is compensated on the basis of the firm's profits, may have lower cash-flow risk than a clerk who works full-time for Widget on a fixed salary.

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Question 2

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A tool that helps to organize the decision process by presenting a graphical comparison of investment choices is called a

A) module hierarchy diagram.
B) "what if" simulation.
C) decision tree.
D) None of these options are correct.

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Question 3

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In considering the share price effect on risk-return trade-offs, our goal should always be to earn the highest return possible.

Risk may be integrated into capital budgeting decisions by

The coefficient of correlation

Sensitivity analysis helps the financial planner determine how sensitive shareholders will be to changes in investment strategy.

The coefficient of variation is calculated to help correlate the standard deviation and the relative expected value of an investment, which makes it easier to compare different sized investments.

A correlation coefficient of ________ provides no risk reduction.

A correlation coefficient of ________ provides the greatest risk reduction.

Investment A may have a higher standard deviation than investment B and still have less risk.

If we are risk-averse, a risky investment with an 8% return will be preferred over an 8% risk-free investment.

The highest possible value for positive correlation is +1.

Expected value is defined as ΣDP where the outcomes are D and probabilities are P.

Projects that are totally uncorrelated provide more overall risk reduction than negatively correlated projects.

The measure of risk is best described as

As the time horizon becomes shorter, more uncertainty enters the forecast.

The coefficient of variation (V) can be defined as the

Modigliani and Associates has forecasted the following payoffs from a project: $\begin{array}{l}\begin{array} { r c l } &\text { Probability of }\\\text { Outcome } & \text { Outcome } & &\text { Assumption: }\\\$0 & 20 \% & \text { pessirmstic } \\\$3,500 & 60 \% & \text { moderately successful } \\\$6,000 & 20 \% & \text { optimistic }\end{array}\end{array}$ What is the expected value of the outcomes?

A correlation coefficient of ________ provides the greatest possible risk reduction to the firm.

A project's cash flows have a beta of 1.2, a standard deviation of $340, and a coefficient of variation of 0.40. What is the expected cash flow?