Homework answers / question archive / Foundations of Finance, 8e (Keown/Martin/Petty) Chapter 6   The Meaning and Measurement of Risk and Return   Learning Objective 1   1) Accounting profits is the most relevant variable the financial manager uses to measure returns

Foundations of Finance, 8e (Keown/Martin/Petty) Chapter 6   The Meaning and Measurement of Risk and Return   Learning Objective 1   1) Accounting profits is the most relevant variable the financial manager uses to measure returns

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Foundations of Finance, 8e (Keown/Martin/Petty)

Chapter 6   The Meaning and Measurement of Risk and Return

 

Learning Objective 1

 

1) Accounting profits is the most relevant variable the financial manager uses to measure returns.

 

2) Cash flows is the most relevant variable to measure the returns on debt instruments, while GAAP net income is the most relevant variable to measure the returns on common stock.

 

3) The expected rate of return from an investment is equal to the expected cash flows divided by the initial investment.

 

4) Actual returns are always less than expected returns because actual returns are determined at the end of the period and must be discounted back to present value.

 

5) Another name for an asset's expected rate of return is holding-period return.

 

6) The realized rate of return, or holding period return, is equal to the holding period dollar gain divided by the price at the beginning of the period.

 

 

7) The risk-return tradeoff that investors face on a day-to-day basis is based on realized rates of return because expected returns involve too much uncertainty.

8) Stock A has the following returns for various states of the economy:

 

State of

the Economy                 Probability             Stock A's Return

Recession                      10%                        -30%

Below Average             20%                        -2%

Average                         40%                        10%

Above Average            20%                        18%

Boom                              10%                        40%

 

Stock A's expected return is

A) 5.4%.

B) 7.2%.

C) 8.2%.

D) 9.6%

9) Stock A has the following returns for various states of the economy:

 

State of

the Economy                 Probability            Stock A's Return

Recession                      9%                          -72%

Below Average             16%                        -15%

Average                         51%                        16%

Above Average            14%                        35%

Boom                              10%                        85%

 

Stock A's expected return is

A) 9.9%.

B) 12.7%.

C) 13.8%.

D) 16.5%.

10) You are considering a sales job that pays you on a commission basis or a salaried position that pays you $50,000 per year. Historical data suggests the following probability distribution for your commission income. Which job has the higher expected income?

 

                               Probability of

Commission           Occurrence

$15,000                         .15

$35,000                         .20

$48,000                         .35

$67,000                         .22

$80,000                         .18

A) The salary of $50,000 is greater than the expected commission of $49,630.

B) The salary of $50,000 is greater than the expected commission of $48,400.

C) The salary of $50,000 is less than the expected commission of $50,050.

D) The salary of $50,000 is less than the expected commission of $52,720.

11) Use the following data:

        Market risk premium = 10%

        Risk free rate = 2%

        Beta of XYZ stock = 1.6

        Beta of PDQ stock = 2.4

        Investment in XYZ stock = $15,000

        Investment in PDQ stock = $60,000

        You have no assets other than your investments in XYZ and PDQ stock.

 

What is the expected return of your portfolio? Show all work.

Learning Objective 2

 

1) Variation in the rate of return of an investment is a measure of the riskiness of that investment.

 

2) A rational investor will always prefer an investment with a lower standard deviation of returns, because such investments are less risky.

 

3) For a well-diversified investor, an investment with an expected return of 10% with a standard deviation of 3% dominates an investment with an expected return of 10% with a standard deviation of 5%.

 

4) Due to strict stock market controls, the most a stock's value can drop in one trading day is 5%.

 

5) Stock W has the following returns for various states of the economy:

 

State of the Economy            Probability                 Stock W's Return

Recession                                     10%                              -30%

Below Average                            20%                              -2%

Average                                        40%                              10%

Above Average                           20%                              18%

Boom                                            10%                              40%

 

Stock W's standard deviation of returns is

A) 10%.

B) 14%.

C) 17%.

D) 20%

6) Stock W has the following returns for various states of the economy:

 

State of the Economy              Probability                 Stock W's Return

Recession                                       9%                              -72%

Below Average                              16%                           -15%

Average                                          51%                           16%

Above Average                              14%                           35%

Boom                                               10%                           85%

 

Stock W's standard deviation of returns is

A) 12%.

B) 29%.

C) 37%.

D) 43%.

7) Stock W has an expected return of 12% with a standard deviation of 8%. If returns are normally distributed, then approximately two-thirds of the time the return on stock W will be

A) between 12% and 20%.

B) between 8% and 12%.

C) between -4% and 28%.

D) between 4% and 20%.

 

8) Which of the following investments is clearly preferred to the others for an investor who is not holding a well-diversified portfolio?

 

Investment         

              σ

 

        A                 18%         20%

        B                  20%         20%

        C                  20%         22%           

A) Investment A

B) Investment B

C) Investment C

D) Cannot be determined without information regarding the risk-free rate of return.

 

9) Assume that you have $330,000 invested in a stock that is returning 11.50%, $170,000 invested in a stock that is returning 22.75%, and $470,000 invested in a stock that is returning 10.25%. What is the expected return of your portfolio?

A) 15.6%

B) 12.9%

C) 18.3%

D) 14.8%

10) Assume that you have $100,000 invested in a stock that is returning 14%, $150,000 invested in a stock that is returning 18%, and $200,000 invested in a stock that is returning 15%. What is the expected return of your portfolio?

A) 13.25%

B) 14.97%

C) 15.67%

D) 15.78%

 

11) You are given the following probability distribution for XYZ common stock's returns during the next year, which are assumed to be normally distributed. Show all work below, and complete the following:

 

Return	Probability
12%	20%
16%	60%
20%	20%

 

a. Calculate the standard deviation of the returns, and round to the nearest one-half percent.

b. Draw a graphical representation of XYZ's normal distribution below (ye old bell-shaped curve). LABEL THE AXES OF THE GRAPH OR THE FOLLOWING RESULTS WILL BE MEANINGLESS. Using your result in part A for the standard deviation (rounded to the nearest one-half percent) explain and indicate on the graph, the probability that XYZ will return more than 13.5%, assuming a normal distribution.

 

12) Discuss whether the standard deviation of a portfolio is, or is not, a weighted average of the standard deviations of the assets in the portfolio. Fully explain your answer.

 

13) Bay Land, Inc. has the following distribution of returns:

 

State	Return	Probability
Boom	0.3	0.25
Normal	0.4	0.15
Bust	0.3	0.30

 

Assuming that these returns are normally distributed, what is the probability that Bay Land, Inc. will return less than 7.25%? Show all work, and clearly explain and state your answer.

Learning Objective 3

 

1) Historically, investments with the highest returns have the lowest standard deviations because investors do not like risk.

 

2) An investor with a required return of 8% for stock A will purchase stock A if the expected return for stock A is less than or equal to 8%.

 

3) In general, the required rate of return is a function of (1) the time value of money, (2) the risk of an asset, and (3) the investor's attitude toward risk.

 

4) As the required rate of return of an investment decreases, the market price of the investment decreases.

5) In an efficient market, a stock with a standard deviation of returns of 12% could have a higher expected return than a stock with a standard deviation of 10% because the beta for the higher standard deviation stock could be lower than the beta for the lower standard deviation stock.

 

6) Small company stocks have historically had higher average annual returns than large company stocks, and also a higher risk premium.

 

7) Investment A and Investment B both have the same expected return, but Investment A is more risky than Investment B. In the technical jargon of modern portfolio theory, Investment A is said to "dominate" Investment B.

 

8) Negative historical returns are not possible during periods of high volatility (high standard deviations of returns) due to the risk-return tradeoff.

 

9) Investment A has an expected return of 15% per year, while investment B has an expected return of 12% per year. A rational investor will choose

A) investment A because of the higher expected return.

B) investment B because a lower return means lower risk.

C) investment A if A and B are of equal risk.

D) investment A only if the standard deviation of returns for A is higher than the standard deviation of returns for B.

 

10) Investment A has an expected return of 14% with a standard deviation of 4%, while investment B has an expected return of 20% with a standard deviation of 9%. Therefore

A) a risk averse investor will definitely select investment A because the standard deviation is lower.

B) a rational investor will pick investment B because the return adjusted for risk (20% - 9%) is higher than the return adjusted for risk for investment A ($14% - 4%).

C) it is irrational for a risk-averse investor to select investment B because its standard deviation is more than twice as big as investment A's, but the return is not twice as big.

D) rational investors could pick either A or B, depending on their level of risk aversion.

 

11) Which of the following investments is clearly preferred to the others for a risk-averse investor?

 

Investment         

             σ

 

       A                   14%        12%

       B                   22%        20%

       C                   18%        16%

A) Investment A

B) Investment B

C) Investment C

D) cannot be determined without additional information

12) Rogue Recreation, Inc. has normally distributed returns with an expected return of 15% and a standard deviation of 5%, while Lake Tours, Inc. has normally distributed returns with an expected return of 15% and a standard deviation of 15%. Which of the following is true?

A) Lake Tours' investors are not being adequately compensated for relevant risk.

B) Rogue Rec is likely to experience returns larger than those of Lake Tours.

C) Lake Tours is more likely to have negative returns than Rogue Rec.

D) Rational investors will prefer Lake Tours, Inc. over Rogue Recreation, Inc.

 

13) You are considering investing in a project with the following possible outcomes:

 

                                                    Probability of           Investment

States                                          Occurrence               Returns

State 1: Economic boom                 18%                          20%

State 2: Economic growth              42%                          16%

State 3: Economic decline              30%                           3%

State 4: Depression                         10%                         -25%

 

Calculate the expected rate of return and standard deviation of returns for this investment, respectively.

A) 8.72%, 12.99%

B) 7.35%, 12.99%

C) 3.50%, 1.69%

D) 2.18%, 1.69%

 

14) Changes in the general economy, like changes in interest rates or tax laws represent what type of risk?

A) company-unique risk

B) market risk

C) unsystematic risk

D) diversifiable risk

 

15) The minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the

A) stock's beta.

B) investor's risk premium.

C) investor's required rate of return.

D) risk-free rate.

 

16) The relevant variable a financial manager uses to measure returns is

A) net income determined using generally accepted accounting principles.

B) earnings per share minus dividends per share.

C) cash flows.

D) dividends.

17) Of the following different types of securities, which is typically considered most risky?

A) long-term corporate bonds

B) long-term government bonds

C) common stocks of large companies

D) common stocks of small companies

 

18) Assume that an investment is forecasted to produce the following returns: a 10% probability of a $1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $1,500 return. What is the expected amount of return this investment will produce?

A) $4,040

B) $7,640

C) $12140

D) $1,540

 

19) Assume that an investment is forecasted to produce the following returns: a 30% probability of a 12% return; a 50% probability of a 16% return; and a 20% probability of a 19% return. What is the expected percentage return this investment will produce?

A) 33.3%

B) 16.1%

C) 9.5%

D) 15.4%

20) Assume that an investment is forecasted to produce the following returns: a 20% probability of a 12% return; a 50% probability of a 16% return; and a 30% probability of a 19% return. What is the standard deviation of return for this investment?

A) 5.89%

B) 16.1%

C) 2.43%

D) 15.7%

21) The category of securities with the highest historical risk premium is

A) large company stocks.

B) small company stocks.

C) government bonds.

D) small company corporate bonds.

22) If you were to use the standard deviation as a measure of investment risk, which of the following has historically been the least risky investment?

A) common stock of large firms

B) U.S. Treasury bills

C) common stock of small firms

D) long-term government bonds

23) If you were to use the standard deviation as a measure of investment risk, which of the following has historically been the highest risk investment?

A) common stock of large firms

B) U.S. Treasury bills

C) common stock of small firms

D) long-term government bonds

 

24) You are considering a security with the following possible rates of return:

 

Probability	Return (%)
0.15	9.5
0.25	13.6
0.50	14.9
0.10	25.3

 

a. Calculate the expected rate of return.

b. Calculate the standard deviation of the returns.

25) You are considering the three securities listed below.

	Returns
Probability	Stock A	Stock B	Stock C
20%	2%	-3%	5%
50%	10%	8%	8%
30%	15%	20%	12%

               

a. Calculate the expected return for each security.

b. Calculate the standard deviation of returns for each security.

c. Compare Stock A with Stocks B and C. Is Stock A preferred over the others?

Learning Objective 4

 

1) The benefits of diversification occur as long as the investments in a portfolio are not perfectly positively correlated.

2) Proper diversification generally results in the elimination of risk.

3) A stock with a beta of 1 has systematic or market risk equal to the "typical" stock in the marketplace.

4) Diversifying among different kinds of assets is called asset allocation.

5) Asset allocation is not recommended by financial planners because mixing different types of assets, such as stocks with bonds, makes it more difficult to track performance and adjust portfolios to changing market conditions.

6) A stock with a beta of 1.4 has 40% more variability in returns than the average stock.

7) Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have higher standard deviations of returns than bonds.

8) An all-stock portfolio is more risky than a portfolio consisting of all bonds.

9) Company unique risk can be virtually eliminated with a portfolio consisting of approximately 20 securities.

10) Total risk equals systematic risk plus unsystematic risk.

11) A well-diversified portfolio typically has systematic risk equal to about 40% of the portfolio's total risk.

 

12) A security with a beta of one has a required rate of return equal to the overall market rate of return.

13) Unique security risk can be eliminated from an investor's portfolio through diversification.

14) The Beta of a T-bill is zero.

15) The Beta of a T-bill is one.

16) Portfolio performance is determined mainly by stock selection and market timing, with less emphasis on asset allocation.

17) Beta is a measurement of the relationship between a security's returns and the general market's returns.

 

18) The relevant risk to an investor is that portion of the variability of returns that cannot be diversified away.

19) The characteristic line for any well-diversified portfolio is horizontal.

20) The slope of the characteristic line of a security is that security's Beta.

 

21) Beta represents the average movement of a company's stock returns in response to a movement in the market's returns.

22) Because risk is measured by variability of returns, how long we hold our investments does not matter very much when it comes to reducing risk.

 

23) The market rewards the patient investor, for between 1926 and 2008, there has never been a time when an investor lost money if she held an all-stock portfolio for ten years.

24) The portfolio beta is simply the sum of the betas of the individual stocks in the portfolio.

25) Which of the following statements is MOST correct concerning diversification and risk?

A) Risk-averse investors often choose companies from different industries for their portfolios because the correlation of returns is less than if all the companies came from the same industry.

B) Risk-averse investors often select portfolios that include only companies from the same industry group because the familiarity reduces the risk.

C) Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification.

D) Proper diversification generally results in the elimination of risk.

26) Which of the following statements is MOST correct concerning diversification and risk?

A) Diversification is mainly achieved by the selection of individual securities for each type of asset held in a portfolio.

B) Diversification is mainly achieved by the asset allocation decision, not the selection of individual securities within each asset category.

C) Large company stocks and small company stocks together in a portfolio lead to dramatic reductions in risk because their returns are negatively correlated.

D) Asset allocation is important for pension funds but not for individual investors.

 

 

27) An investor currently holds the following portfolio:

                                                     Amount

                                                    Invested

8,000 shares of Stock A           $16,000    Beta = 1.3

15,000 shares of Stock B         $48,000    Beta = 1.8

25,000 shares of Stock C         $96,000    Beta = 2.2

 

The investor is worried that the beta of his portfolio is too high, so he wants to sell some stock C and add stock D, which has a beta of 1.0, to his portfolio. If the investor wants his portfolio to have a beta of 1.72, how much stock C must he replace with stock D?

A) $18,000

B) $24,000

C) $31,000

D) $36,000

28) Wendy purchased 800 shares of Genetics Stock at $3 per share on 1/1/12. Wendy sold the shares on 12/31/12 for $3.45. Genetics stock has a beta of 1.9, the risk-free rate of return is 4%, and the market risk premium is 9%. Wendy's holding period return is

A) 15.0%.

B) 16.5%.

C) 17.6%.

D) 21.1%.

29) You are thinking of adding one of two investments to an already well- diversified portfolio.

 

Security A                                              Security B

Expected Return = 14%                      Expected Return = 16%

Standard Deviation of                          Standard Deviation of

Returns = 16%                                      Returns = -20%

Beta = 1.2                                              Beta = 1.2

 

If you are a risk-averse investor, which one is the better choice?

A) Security A

B) Security B

C) Either security would be acceptable because they have the same beta.

D) Security B, but only if Security B's required return is greater than 12%

30) You are going to invest all of your funds in one of three projects with the following distribution of possible returns:

 

                              PROJECT 1                                                                            PROJECT 2

                                                 Standard                                                                               Standard

Probability        Return         Deviation     Beta                 Probability          Return     Deviation      Beta

50% Chance          22%              12%           1.1                  30% Chance            36%        19.5%          1.0

50% Chance           -4%                                                        40% Chance         10.5%

                                                                                                30% Chance           -20%

 

                               PROJECT 3

                                                 Standard

Probability        Return         Deviation     Beta

10% Chance          28%              12%           1.2

70% Chance          18%

20% Chance           -8%

 

If you are a risk averse investor, which one should you choose?

A) Project 1

B) Project 2

C) Project 3

D) either Project 1 or Project 2 because they have the same expected return

31) You are considering investing in Ford Motor Company. Which of the following are examples of diversifiable risk?

I.      Risk resulting from possibility of a stock market crash.

II.     Risk resulting from uncertainty regarding a possible strike against Ford.

III.    Risk resulting from an expensive recall of a Ford product.

IV.    Risk resulting from interest rates decreasing.

A) I only

B) I and IV

C) I, II, III, IV

D) II, III

32) You are considering buying some stock in Continental Grain. Which of the following are examples of non-diversifiable risks?

I.      Risk resulting from a general decline in the stock market.

II.     Risk resulting from a possible increase in income taxes.

III.    Risk resulting from an explosion in a grain elevator owned by Continental.

IV.    Risk resulting from a pending lawsuit against Continental.

A) I and II

B) III and IV

C) I only

D) II, III, and IV

33) Of the following, which differs in meaning from the other three?

A) systematic risk

B) market risk

C) undiversifiable risk

D) asset-unique risk

34) Most stocks have betas between

A) -1.00 and 1.00.

B) 0.00 and 1.00.

C) 0.60 and 1.60.

D) 1.00 and 2.00.

35) A well-diversified portfolio includes investments in 50 securities. The portfolio's systematic risk is likely to be about

A) 50% of the total risk.

B) 40% of the total risk.

C) 25% of the total risk.

D) zero because risk is eliminated with a portfolio of 50 securities or more.

 

 

36) Beta is a statistical measure of

A) unsystematic risk.

B) total risk.

C) the standard deviation.

D) the relationship between an investment's returns and the market return.

 

37) A stock's beta is a measure of its

A) unsystematic risk.

B) systematic risk.

C) company-unique risk.

D) diversifiable risk.

38) If you hold a portfolio made up of the following stocks:

 

                  Investment Value      Beta

Stock X              $4,000                1.5

Stock Y              $5,000                1.0

Stock Z              $1,000                  .5

 

What is the beta of the portfolio?

A) 1.33

B) 1.24

C) 1.15

D) 1.00

39) Which of the following is/are true?

A) Most of the unsystematic risk is removed by the time a portfolio contains 30 stocks.

B) Two points on the Characteristic Line are the T-bill and the market portfolio.

C) The greater the total risk of an asset, the greater the expected return.

D) All securities have a beta between 0 and 1.

 

40) If we are able to fully diversify, what is the appropriate measure of risk to use?

A) expected return

B) standard deviation

C) beta

D) risk-free rate of return

 

41) You hold a portfolio with the following securities:

 

                                                                                Expected

        Security                     Value           Beta          Return

Driscol Corporation          20%            3.20          36.0%

Evening Corporation        40%            1.60          20.0%

Frolic Corporation            40%             .20            6.0%

 

What is the expected return for the portfolio?

A) 17.60%

B) 20.67%

C) 23.54%

D) 28.59%

42) The prices for the National Gasworks Corporation for the second quarter of 2012 are given below. The price of the stock on April 1, 2012 was $130. Find the holding period return for an investor who purchased the stock on April 1, 2012 and sold it the last day of June 2012.

 

        Month End           Price

        April                $125.00

        May                   138.50

        June                   132.75

A) -4.2%

B) -3.7%

C) 2.1%

D) 3.7%

 

43) You must add one of two investments to an already well- diversified portfolio.

 

Security A                                              Security B

Expected Return = 14%                      Expected Return = 14%

Standard Deviation of                          Standard Deviation of

Returns = 15.8%                                   Returns = 19.7%

Beta = 1.8                                              Beta = 1.5

 

If you are a risk-averse investor, which one is the better choice?

A) Security A

B) Security B

C) Either security would be acceptable.

D) cannot be determined with information given

44) Beginning with an investment in one company's securities, as we add securities of other companies to our portfolio, which type of risk declines?

A) systematic risk

B) market risk

C) non-diversifiable risk

D) unsystematic risk

 

45) Assume that you expect to hold a $40,000 investment for one year. It is forecasted to have a year end value of $42,000 with a 30% probability; a year end value of $48,000 with a 45% probability; and a year end value of $60,000 with a 25% probability. What is the expected holding period return for this investment?

A) 50%

B) 25%

C) 23%

D) 18%

 

46) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a year end value of $21,000 with a 30% probability; a year end value of $24,000 with a 45% probability; and a year end value of $30,000 with a 25% probability. What is the standard deviation of the holding period return for this investment?

A) 12.06%

B) 14.36%

C) 16.36%

D) 33.45%

 

47) You must add one of two investments to an already well- diversified portfolio.

 

Security A                                              Security B

Expected Return = 14%                      Expected Return = 12%

Standard Deviation of                         Standard Deviation of

Returns = 15.0%                                   Returns = 11%

Beta = 1.5                                              Beta = 1.5

 

If you are a risk-averse investor, which one is the better choice?

A) Security A

B) Security B

C) Either security would be acceptable.

D) cannot be determined with information given

48) Portfolio risk is typically measured by ________ while the risk of a single investment is measured by ________.

A) standard deviation; beta

B) security market line; standard deviation

C) beta; standard deviation

D) beta; slope of the characteristic line

 

 

49) How can investors reduce the risk associated with an investment portfolio without having to accept a lower expected return?

A) Wait until the stock market rises.

B) Increase the amount of money invested in the portfolio.

C) Purchase a variety of securities; i.e., diversify.

D) Purchase stocks that have exceptionally high standard deviations.

 

50) Which of the following types of risk is diversifiable?

A) unsystematic, or company-unique risk

B) betagenic, or ecocentric risk

C) systematic risk

D) market risk

 

51) You purchased 500 shares of A.M.J. Inc. common stock one year ago for $50 per share. You received a dividend of $2 per share today and decide to take your profits by selling at $54.50 per share. What is your holding period return?

A) 13.0%

B) 9.0%

C) 6.5%

D) 4.0%

52) Which of the following measures the average relationship between a stock's returns and the market's returns?

A) coefficient of validation

B) standard deviation

C) geometric regression

D) beta coefficient

 

 

53) Assume that you have $165,000 invested in a stock whose beta is 1.25, $85,000 invested in a stock whose beta is 2.35, and $235,000 invested in a stock whose beta is 1.11. What is the beta of your portfolio?

A) 1.37

B) 2.01

C) 1.85

D) 1.57

 

54) Assume that you have $100,000 invested in a stock whose beta is .85, $200,000 invested in a stock whose beta is 1.05, and $300,000 invested in a stock whose beta is 1.25. What is the beta of your portfolio?

A) 0.97

B) 1.02

C) 1.12

D) 1.21

 

55) Which of the following statements is MOST correct regarding beta?

A) Beta must be calculated using at least 5 years of monthly returns data to be accurate.

B) Beta can only be measured properly using daily returns.

C) Beta for a particular company remains constant over time.

D) Even professionals may not agree on the measurement of beta.

56) What is diversifying among different kinds of assets known as?

A) portfolio funding

B) capital asset classification

C) asset allocation

D) multi-diversification

 

 

Learning Objective 5

 

1) The required rate of return for an asset is equal to the risk-free rate plus a risk premium.

 

2) The T-bill return is used in the CAPM model as the risk free rate.

 

3) The CAPM designates the risk-return tradeoff existing in the market, where risk is defined in terms of beta.

 

4) The S&P 500 index must be used as the measure of market return in the CAPM or the results are not theoretically accurate.

 

5) According to the CAPM, for each unit of Beta an asset's required rate of return increases by the market's return.

 

6) According to the CAPM, for each unit of Beta an asset's required rate of return increases by the market's risk premium.

7) Stocks that plot above the security market line are underpriced because their expected returns exceed their risk-adjusted required returns.

 

 

8) The capital asset pricing model

A) provides a risk-return trade off in which risk is measured in terms of the market volatility.

B) provides a risk-return trade off in which risk is measured in terms of beta.

C) measures risk as the coefficient of variation between security and market rates of return.

D) depicts the total risk of a security.

 

9) A typical measure for the risk-free rate of return is the

A) U.S. Treasury Bill rate.

B) prime lending rate.

C) money market rate.

D) short-term AAA-rated bond rate.

 

10) If the Beta for stock A equals zero, then

A) stock A's required return is equal to the required return on the market portfolio.

B) stock A's required return is equal to the risk-free rate of return.

C) stock A has a guaranteed return.

D) stock A's required return is greater than the required return on the market portfolio.

 

11) The risk-free rate of interest is 4% and the market risk premium is 9%. Howard Corporation has a beta of 2.0, and last year generated a return of 16% with a standard deviation of returns of 27%. The required return on Howard Corporation stock is

A) 36%.

B) 34%.

C) 26%.

D) 22%.

 

12) Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the market risk premium increases, then

A) the required return on stock B will increase more than the required return on stock A.

B) the required returns on stocks A and B will both increase by the same amount.

C) the required returns on stocks A and B will remain the same.

D) the required return on stock A will increase more than the required return on stock B.

 

13) Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the risk-free rate of return increases and the market risk premium remains constant, then

A) the required return on stock B will increase more than the required return on stock A.

B) the required returns on stocks A and B will both increase by the same amount.

C) the required returns on stocks A and B will not change.

D) the required return on stock A will increase more than the required return on stock B.

 

14) An investor currently holds the following portfolio:

                                                     Amount

                                                     Invested

4,000 shares of Stock H            $8,000     Beta = 1.3

7,500 shares of Stock I             $24,000    Beta = 1.8

12,500 shares of Stock J          $48,000    Beta = 2.2

 

The beta for the portfolio is

A) 1.99.

B) 1.77.

C) 1.45.

D) 1.27.

 

15) An investor currently holds the following portfolio:

                                                     Amount

                                                    Invested

8,000 shares of Stock A           $16,000    Beta = 1.3

15,000 shares of Stock B         $48,000    Beta = 1.8

25,000 shares of Stock C         $96,000    Beta = 2.2

 

If the risk-free rate of return is 2% and the market risk premium is 7%, then the required return on the portfolio is

A) 14.91%.

B) 15.93%.

C) 21.91%.

D) 23.93%.

 

16) Wendy purchased 800 shares of Robotics Stock at $3 per share on 1/1/09. Wendy sold the shares on 12/31/09 for $3.45. Genetics stock has a beta of 1.3, the risk-free rate of return is 3%, and the market risk premium is 8%. The required return on Genetics Stock is

A) 13.4%.

B) 16.5%.

C) 17.6%.

D) 21.1%.

17) Based on the security market line, Robo-Tech stock has a required return of 14% and Friendly Insurance Company has a required return of 10%. Robo-Tech has a standard deviation of returns of 18%. Therefore

A) Friendly must have a standard deviation of returns of less than 18% because Friendly is less risky than Robo-Tech.

B) all rational investors will prefer Friendly over Robo-Tech.

C) for a well-diversified investor, Friendly is less risky than Robo-Tech.

D) the beta for Friendly must be greater than the beta for Robo-Tech because Friendly is the better buy for a risk-averse investor.

 

18) Green Company stock has a beta of 2 and a required return of 23%, while Gold Company stock has a beta of 1.0 and a required return of 14%. The standard deviation of returns for Green Company is 10% more than the standard deviation for Gold Company. The expected return on the market portfolio according to the CAPM is

A) 9%.

B) 10%.

C) 12%.

D) 14%.

 

19) White Company stock has a beta of 2 and a required return of 23%, while Black Company stock has a beta of 1.0 and a required return of 14%. The standard deviation of returns for White Company is 10% more than the standard deviation for Black Company. The risk free rate of return according to the CAPM is

A) 4%.

B) 5%.

C) 6%.

D) impossible to determine with the information given

 

20) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the market risk premium is 7.5%, the risk-free rate of return is

A) 4.1%.

B) 3.4%.

C) 2.0%.

D) 1.5%.

 

21) Surf and Spray Inc. has a beta equal to 1.8 and a required return of 15% based on the CAPM. If the risk free rate of return is 4.2%, the expected return on the market portfolio is

A) 21%.

B) 19.2%.

C) 13.4%.

D) 10.2%.

 

22) You are going to add one of the following three projects to your already well-diversified portfolio.

 

                                  PROJECT 1                                                                 PROJECT 2

                                                Standard                                                                      Standard

Probability        Return        Deviation        Beta        Probability       Return       Deviation      Beta

50% Chance          22%             12%              1.1         30% Chance         36%          19.5%          0.8

50% Chance           -4%                                                40% Chance      10.5%

                                                                                        30% Chance        -20%

 

                                  PROJECT 3                                                                          

                                                Standard

Probability        Return        Deviation        Beta

10% Chance          28%             12%              2.0

70% Chance          18%

20% Chance           -8%

 

Assume the risk-free rate of return is 2% and the market risk premium is 8%. If you are a risk averse investor, which project should you choose?

A) Project 1

B) Project 2

C) Project 3

D) Either Project 2 or Project 3 because the higher expected return on project 3 offsets its higher risk.

23) The appropriate measure for risk according to the capital asset pricing model is

A) the standard deviation of a firm's cash flows.

B) alpha.

C) the standard deviation of a firm's stock returns.

D) beta.

 

24) Anchor Incorporated has a beta of 1.0. If the expected return on the market is 15%, what is the expected return on Anchor Incorporated's stock?

A) 15%

B) 14%

C) 18%

D) cannot be determined without the risk free rate

 

25) Decker Corp. common stock has a required return of 17.5% and a beta of 1.75. If the expected risk free return is 3%, what is the expected return for the market based on the CAPM?

A) 11.29%

B) 14.29%

C) 13.35%

D) 15.27%

 

26) Wildings, Inc. common stock has a beta of 1.2. If the expected risk free return is 4% and the expected market risk premium is 9%, what is the expected return on Wildings' stock?

A) 10.0%

B) 12.0%

C) 13.8%

D) 14.8%

 

27) You determine that LMN common stock has an expected return of 24%. LMN has a Beta of 1.5. The risk-free rate is 5%, and the market expected return is 15%. Which of the following is most likely to happen?

A) You and other investors will buy up LMN stock and its price will rise.

B) You and other investors will sell LMN stock and its return will fall.

C) You and other investors will buy up LMN stock and its return will rise.

D) You and other investors will sell LMN stock and its price will fall.

 

28) You hold a portfolio made up of the following stocks:

 

                   Investment Value    Beta

Stock L                $8,000              2.0

Stock M             $18,000             1.5

Stock N              $14,000               .4

 

If the market's expected return is 14%, and the risk free rate of return is 5%, what is the expected return of the portfolio?

A) 17.010%

B) 16.700%

C) 15.935%

D) 14.698%

29) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market portfolio is 15% and the risk free rate is 4%. What is the risk premium on the market?

A) 5%

B) 6%

C)  9.00%

D) 11%

 

30) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market portfolio is 15% and the risk free rate is 4%. According to CAPM, what is the required rate of return on Collectible's stock?

A) 37.5%

B) 31.5%

C) 26.5%

D) 23.5%

 

 

31) You hold a portfolio with the following securities:

 

                                          Percent                       Expected

        Security                 of Portfolio     Beta          Return

Able Corporation              20%           3.20          36.0%

Baker Corporation            40%           1.60          20.0%

Charlie Corporation          40%            .20            6.0%

 

What is the expected return for the market, according to the CAPM?

A) 14.0%

B) 13.8%

C) 12.0%

D) 10.0%

 

32) The beta of ABC Co. stock is the slope of

A) the security market line.

B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term Treasury bills.

C) the arbitrage pricing line.

D) the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio for the same period.

33) The rate on T-bills is currently 2%. Environment Help Company stock has a beta of 1.5 and a required rate of return of 17%. According to CAPM, determine the return on the market portfolio.

A) 27.5%

B) 19.0%

C) 14.0%

D) 12.0%

 

34) The return on the market portfolio is currently 12%. Mobile Phone Corporation stockholders require a rate of return of 30% and the stock has a beta of 3.2. According to CAPM, determine the risk-free rate.

A) 9.80%

B) 6.50%

C) 4.64%

D) 3.82%

35) Which of the following is the slope of the security market line?

A) beta

B) one

C) It varies, and is steeper for riskier securities.

D) the market risk premium

 

36) What is the name given to the equation that financial managers use to measure an investor's required rate of return?

A) the standard deviation

B) the capital asset pricing model

C) the coefficient of variation

D) the MIRR

37) You are considering an investment in Citizens Bank Corp. The firm has a beta of 1.6. Currently, U.S. Treasury bills are yielding 2.75% and the expected return for the S & P 500 is 14%. What rate of return should you expect for your investment in Citizens Bank?

A) 11.15%

B) 15.39%

C) 16.75%

D) 20.75%

 

 

38) Answer the questions below using the following information on stocks A, B, and C.

 

	A	B	C
Expected Return	20%	21%	10%
Standard Deviation	12%	10%	10%
Beta	1.8	2.2	0.8

               

Assume the risk-free rate of return is 3% and the expected market return is 12%

a.  Calculate the required return for stocks A, B, and C.

b. Assuming an investor with a well-diversified portfolio, which stock would the investor want

to add to his portfolio?

c.  Assuming an investor who will invest all of his money into one security, which stock will the investor choose?

39) The expected return for the market portfolio is 13%, the expected return on U.S. Treasury Bills is 2%, and the expected return on AAA-rated short-term corporate bonds is 7%. Calculate the required return for a stock with a beta equal to 1.5.

40) Security A has an expected rate of return of 29.8 percent and a beta of 3.1. Security B has a beta of 1.70. If the Treasury bill rate is 5 percent, what is the expected rate of return for Security B?

 

41) Bankers Corp has a very conservative Beta of .7, while Biotech Corp has a Beta of 2.1. Given that the T-bill rate is 5%, and the market is expected to return 15%, what is the expected return of Bankers Corp, Biotech Corp, and a portfolio composed of 60% of Bankers Corp and 40% Biotech Corp?

 

a. Solve this problem first by weighting the Betas to calculate a portfolio Beta, and then using CAPM to calculate the portfolio expected return.

b. Then solve the problem again by calculating the expected return of each asset and weighting those returns to calculate the portfolio expected return.

c. Why is Biotech Corp's expected return NOT three times that of Bankers Corp?

42) Redesign Corp is considering a new strategy that would increase its expected return from 12% to 13.9%, but would also increase its beta from 1.2 to 1.8. If the risk free rate is 5% and the return on the market is expected to be 10%, should Redesign change its strategy?