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Free CMA Exam Braindumps (page: 67)

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A company uses portfolio theory to develop its investment portfolio. If the company wishes to obtain optimal risk reduction through the portfolio effect, it should make its next investment in an investment that

  1. Correlates negatively to the current portfolio holdings.
  2. Is uncorrelated to the current portfolio holdings.
  3. Is highly correlated to the current portfolio holdings.
  4. Is perfectly correlated to the current portfolio holdings.

Answer(s): A

Explanation:

A common general definition is that risk is an investment with an unknown outcome but a known probability distribution of returns (a known mean and standard deviation). An increase in the standard deviation (variability) of returns is synonymous with an increase in the riskiness of a project. Risk is also increased when the project's returns are positively (directly) correlated with other investments in the company's portfolio; that is, risk increases when returns on all projects rise or fall together. Consequently, the overall risk is decreased when projects have low variability and are negatively correlated (the diversification effect).



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Mega, Inc., a large conglomerate with operating divisions in many industries, uses risk- adjusted discount rates in evaluating capital investment decisions. Consider the following statements concerning Mega's use of risk-adjusted discount rates.

I). Mega may accept some investments with internal rates of return less than Mega's overall average cost of capital.
II). Discount rates vary depending on the type of investment.
Ill). Mega may reject some investments with internal rates of return greater than the cost of capital.
IV). Discount rates may vary depending on the division.
Which of the above statements are correct?

  1. I and Ill only.
  2. II and IV only.
  3. II, Ill, and IV only.
  4. I, II, Ill, and IV.

Answer(s): D

Explanation:

Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed investment. Risk can be incorporated into capital budgeting decisions in a number of ways1 one of which is to use a hurdle rate higher than the firm's cost of capital, that is, a risk-adjusted discount rate. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits.



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Sensitivity analysis, if used with capital projects,

  1. Is used extensively when cash flows are known with certainty.
  2. Measures the change in the discounted cash flows when using the discounted payback method rather than the net present value method.
  3. Is a "what-if" technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed.
  4. Is a technique used to rank capital expenditure requests.

Answer(s): C

Explanation:

After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of
the estimates used. For example, forecasts of many calculated NPVs under various assumptions maybe compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive.



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An analysis of a company's planned equity financing using the Capital Asset Pricing Model (or Security Market Line) incorporates only the

  1. Expected market earnings, the current U.S. treasury bond yield, and the beta coefficient.
  2. Expected market earnings and the price-earnings ratio.
  3. Current U.S. treasury bond yield, the price-earnings ratio, and the beta coefficient.
  4. Current U.S. treasury bond yield and the dividend payout ratio.

Answer(s): A

Explanation:

The capital asset pricing model adds the risk-free rate to the product of the market risk premium and the beta coefficient. The market risk premium is the amount above the risk1ree rate (approximated by the U.S. treasury bond yield) that must be paid to induce investment in the market. The beta coefficient of an individual stock is the correlation between the price volatility of the stock market as a whole and the price volatility of the individual stock.






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