An analysis of a company's planned equity financing using the Capital Asset Pricing Model (or Security Market Line) incorporates only the
Answer(s): A
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.
The proper discount rate to use in calculating certainty equivalent net present value is the
Answer(s): C
Rational investors choose projects that yield the best return given some level of risk. If an investor desires no risk, that is, an absolutely certain rate of return, the risk4ree rate is used in calculating net present value. The risk-free rate is the return on a risk-free investment such as government bonds. Certainty equivalent adjustments involve a technique directly drawn from utility theory. It forces the decision maker to specify at what point the firm is indifferent to the choice between a sum of money that is certain and the expected value of a risky sum.
When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to
Answer(s): D
Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ among various elements of the cash flows, then different discount rates can be used for different flows.
A manager wants to know the effect of a possible change in cash flows on the net present value of a project. The technique used for this purpose is
Sensitivity analysis is a technique to evaluate a model in terms of the effect of changing the values of the parameters. It answers "what if" questions. In capital budgeting models, sensitivity analysis is the examination of alternative outcomes under different assumptions.
A widely used approach that is used to recognize uncertainly about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is
Sensitivity analysis recognizes uncertainly about estimates by making several calculations using varying estimates. For instance, several forecasts of net present value (NPV) might be calculated under various assumptions to determine the sensitivity of the NPV to changing conditions or prediction errors. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV, resulting in a much riskier asset than was originally forecast.
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