Greater confidence in the long-run health of the economy leads to a reduced risk aversion, A) firms' betas will increase B) firms' betas will decrease C) investors' required return will decrease D) investors' required return will increase E) both (B) and (C) 43

Greater confidence in the long-run health of the economy leads to a reduced risk aversion,
A) firms' betas will increase
B) firms' betas will decrease
C) investors' required return will decrease
D) investors' required return will increase
E) both (B) and (C)

Answer: C) investors' required return will decrease

Security Market Line (SML) is a plot in the risk return space: It is a plot of required return versus Beta. The slope of the SML reflects the general level of risk aversion.
If investors become more risk averse, people will demand a larger premium for bearing any level of risk (i.e. higher return for the same level of risk indicated by beta). Therefore the SML line will become steeper (the slope will increase). The slope of the SML = market risk premium. Therefore the market risk premium would increase.
Conversely, if the investors become less risk averse, people will demand a smaller premium for bearing any level of risk (i.e. lower return for the same level of risk indicated by beta). Therefore the SML line will become flatter (the slope will decrease). The slope of the SML = market risk premium. Therefore the market risk premium would decrease.

Required return = risk free rate + beta x market risk premium
Beta does not change because it indicates the systemic risk of the stock.
Risk free rate does not change.
Therefore, required return decreases as market risk premium decreases.

43. While Stock X has a reward-to-risk ratio of 6.5, Stock Y has a reward-to-risk ratio of 8.2. You know
A) Stock X is overpriced
B) Stock X is a better investment
C) Stock Y is under-priced
D) Stock Y is a better investment

Answer: D) Stock Y is a better investment
Higher the reward to risk ratio, the better is the investment (as you get a higher return for the same level of risk)

47. When a firm uses debt financing,
A) it increases the required return on equity because the business risk born by its shareholders increases
B) it decreases the required return on equity because debt financing is cheaper
C) It decreases the WACC because the financial risk born by its shareholders decreases
D) It increases the WACC because the business risk born by its shareholders increases
E) none of above

Answer: E) none of above

Business risk is not being affected therefore options A) and D) are incorrect.
Financial risk increases because of debt financing. Therefore, option C) is incorrect.
With an increase in debt, financial risk increases and therefore, required return on equity increases. Therefore, option B) is incorrect.