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Banking and Finance Quiz 13

Ques 1: Historically, the risk-free interest rate has been 5 percent. What can cause the risk-free rate to increase?

(a) lower inflation

(b) increased risk

(c) change in the time-value of money

(d) higher inflation

Answer: Option(D): higher inflation

Feedback

Money is worth less when inflation goes up, which must be compensated for in the risk-free rate.

Ques 2: Companies whose performance in the market is largely independent of the broader state of the economy will have a _____ Beta.

(a) Low

(b) High

(c) Mid

Answer: Option(A): Low

Ques 3: Why do banks generally pay a lower interest rate than other investments?

(a) Deposits in bank accounts are insured by the FDIC.

(b) Banks can fail if the economy collapses.

(c) Banks are generally used for short-term investment.

(d) More people use banks than other investment vehicles.

Answer: Option(A): Deposits in bank accounts are insured by the FDIC.

Feedback

Having deposits federally insured removes risk, which results in lower interest rates.

Ques 4: How does risk impact investors' willingness to invest in a company?

(a) Investors will expect a rate of return no different than any other investment opportunity.

(b) Investors will anticipate a lower rate of return than other investments.

(c) Investors will expect a higher rate of return than other investments.

Answer: Option(C): Investors will expect a higher rate of return than other investments.

Feedback

Because of the risk, investors will expect a higher return than they would with a safe investment, such as a savings account at a bank.

Ques 5: Jarbo Construction is a new home-building company. What does it mean to Jarbo if it has a beta greater than one?

(a) Jarbo Construction has eliminated the risk of market fluctuation.

(b) Jarbo Construction is heavy on investments with cash.

(c) Jarbo Construction has diversified sufficiently to avoid systematic risk.

(d) Jarbo Construction is very sensitive to market fluctuation.

Answer: Option(D): Jarbo Construction is very sensitive to market fluctuation.

Feedback

A beta above zero means the company is particularly sensitive to market fluctuation, which can be a bad thing when the local economy goes down.

Ques 6: You are considering buying stock in General Motors. If GM has a Beta of 1.8, based on the standard risk premium, what rate of return must the investment have in order to make the investment worthwhile?

(a) 9.0 percent

(b) 28.8 percent

(c) 11.0 percent

(d) 15.8 percent

Answer: Option(D):15.8 percent

Feedback

This provides the risk-free rate of 5 percent plus the standard risk premium multiplied by 1.8 to reflect the Beta risk.

Ques 7: Which is an example of credit risk?

(a) buying inventory on credit from suppliers in order to keep more of a company's cash on hand

(b) determining the amount of cash generated by offering credit terms to customers

(c) extending credit terms to new customers as an enticement to buy from a company

(d) having interest rates fluctuate over time on loans you take out based on your credit

Answer: Option(C): extending credit terms to new customers as an enticement to buy from a company

Feedback

Credit risk is the risk that customers might not pay for the products they buy on credit from a business.

Ques 8: How much is the equity risk premium?

(a) 16%

(b) 5%

(c) 6%

(d) 11%

Answer: Option(C): 6%

Ques 9: ABC's Chief Financial Officer is uncertain about the future cost savings from investing in a new machine. With which business risk is the CFO dealing?

(a) Exchange Rate Risk

(b) Cash Flow Risk

(c) Price Risk

(d) Credit Risk

Answer: Option(B): Cash Flow Risk

Ques 10: You are considering buying stock in a local start-up company. Where will you include the risk premium when you calculate the return you need?

(a) as an addition to the risk-free rate

(b) as a multiplier to the risk-free rate

(c) as an addition to the required rate of the return you need

Anwer: Option(A): as an addition to the risk-free rate

Feedback

If the risk premium is 10 percent, add it to the risk-free rate of 5 percent, which means you need at least a 15 percent return.

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