Which one is INCORRECT? Question 10 options: The efficient frontier is made up of portfolios that will provide the highest return for a given level of risk. Investors choose along the efficient set for the best mix of risk and return with their own risk attitudes. The efficient frontier is made up of portfolios that will provide the highest risk for a given level of return. Question 11 Apple Inc. has two divisions, iPhone and iPad. Apple’s overall cost of capital is 10%. It is known that iPhone division faces a higher market risk than the iPad division. Apple indiscriminately chooses 10% as the cost of capital for both its divisions. However, it is estimated that the cost of capital for iPad and iPhone divisions should be 8% and 12%, respectively. Considering Apple’s internal policy as mentioned above, if an iPad division project generates 9% and an iPhone division project generates 11%, then the iPad project should be ______ and the iPhone project should be _______. Question 12 Apple Inc. has two divisions, iPhone and iPad. Apple’s overall cost of capital is 10%. It is known that iPhone division faces a higher market risk than the iPad division. Apple indiscriminately chooses 10% as the cost of capital for both its divisions. However, it is estimated that the cost of capital for iPad and iPhone divisions should be 8% and 12%, respectively. Considering divisional estimated cost of capital as mentioned above, if an iPad division project generates 9% and an iPhone division project generates 11%, then the iPad project should be ______ and the iPhone project should be _______. Question 13 While IRR (internal rate of return) suffers from scaling problems, PI (profitability index) does not”. Question 13 options: True False Question 14 When there is no budgetary constraint and projects are independent, then pick all positive NPV projects” Question 14 options: True False Question 15 When there is no budgetary constraint and projects are mutually exclusive, then pick all positive NPV projects” Question 15 options: True False Question 16 Profitability index can never be negative” Question 16 options: True False Question 17 All else being equal, a premium bond price increases as it gets closer maturity. Question 17 options: True False Question 18 Bond A is a 15-year 10% coupon bond with yield =15%, coupon paid annually; Bond B is a 15-year 10% coupon bond with yield =15%, coupon paid semi-annually. Price of Bond A is higher than that of Bond B. Question 18 options: True False. Question 19 What are the two components of most stocks’ expected total return? [Hint: for constant growth model] Question 19 options: dividend yield and return on investment dividend growth rate and capital gain yield dividend yield and dividend growth rate Question 20 In a large portfolio, the variance terms are effectively diversified away but the covariance terms are not”. What is considered to be a large portfolio? Question 20 options: One with at least 40 stocks One with at least 20 stocks One with at least 100 stocks
In the realm of finance, decision-making plays a pivotal role in optimizing returns while managing risk. A solid grasp of fundamental concepts is crucial for investors, analysts, and business leaders alike. This essay aims to dissect and clarify a series of multiple-choice questions related to various financial principles, thereby enhancing our understanding of these concepts.
The efficient frontier, a concept rooted in modern portfolio theory, represents the set of portfolios that offers the highest possible return for a given level of risk. It is essential for investors seeking the optimal balance between risk and return. Among the given options, the incorrect statement is that the efficient frontier is comprised of portfolios providing the highest risk for a given level of return. The efficient frontier’s essence is quite the opposite – it presents portfolios with the least possible risk for a given level of return.
Apple Inc.’s approach to cost of capital for its iPhone and iPad divisions poses an interesting dilemma. While the overall company’s cost of capital is 10%, the internal policy of applying the same rate to both divisions disregards differing market risks. In light of this, a project’s viability should be assessed based on its ability to exceed the division’s respective cost of capital. In the given scenario, the iPad project generating 9% should be accepted, as it surpasses the division’s estimated cost of capital of 8%. Similarly, the iPhone project yielding 11% should be accepted, exceeding the division’s 12% cost of capital.
The Internal Rate of Return (IRR) and Profitability Index (PI) are tools used to evaluate investment opportunities. The statement asserting that “IRR suffers from scaling problems, whereas PI does not” is false. Both IRR and PI are susceptible to scaling issues, especially when comparing projects of different magnitudes and cash flows. Therefore, this statement does not accurately capture the nuanced complexities of these evaluation methods.
In the context of project selection, the interplay between budgetary constraints and project independence is significant. If there are no budgetary constraints and projects are independent, then opting for all projects with positive Net Present Value (NPV) becomes a prudent strategy. However, if projects are mutually exclusive, picking all positive NPV projects might not be the optimal approach, as constraints on resources and interdependencies between projects could impact overall value creation.
The Profitability Index (PI), a financial metric used to assess investment opportunities, can indeed be negative. A PI less than 1 indicates that the present value of future cash flows is insufficient to cover the initial investment. Thus, contrary to the statement, a negative PI signifies that the investment may not generate adequate returns to justify its cost.
The relationship between bond pricing and maturity is a critical aspect of fixed-income investments. Contrary to the statement, a premium bond’s price does not necessarily increase as it approaches maturity. Premium bonds have coupons higher than the prevailing market interest rate, which can lead to a price decline as they approach maturity to align with market rates.
The price of a bond is influenced by factors such as yield, coupon rate, and coupon payment frequency. In this case, where Bond A and Bond B have the same parameters except for the coupon payment frequency, the statement that “Price of Bond A is higher than that of Bond B” is true. Generally, bonds with semi-annual coupon payments trade at a premium compared to those with annual coupon payments.
In the constant growth model, two integral components contribute to a stock’s expected total return: dividend yield and dividend growth rate. These components reflect the income generated from dividends and the anticipated capital appreciation through dividend growth, respectively.
The statement that “In a large portfolio, the variance terms are effectively diversified away but the covariance terms are not” implies that as a portfolio grows in size, the individual asset variance’s impact diminishes due to diversification, but the covariance, which indicates how two assets move in relation to each other, remains relevant. For the given context, a “large portfolio” is one with at least **40 stocks**, indicating that diversification starts to significantly reduce unsystematic risk.
Exploring these multiple-choice questions has shed light on various fundamental concepts in finance, including efficient frontier analysis, cost of capital considerations, investment evaluation methods, bond pricing dynamics, and the significance of diversification in portfolio management. These insights equip us with a more comprehensive understanding of financial principles, enabling us to make informed decisions in the complex world of finance.
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