Question 1

Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

Accepted Answer

A)  11.36% 
B)  11.65% 
C)  11.95% 
D)  12.25% 
E)  12.55% 
A)  11.36% 
B)  11.65% 
C)  11.95% 
D)  12.25% 
E)  12.55%

Question 2

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate that is required to compensate stock investors for assuming an average amount of risk.

Accepted Answer

A) True 
 B)False

Question 3

Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio P has a standard deviation of 20%. 
B)  The required return on Portfolio P is equal to the market risk premium (rM − rRF). 
C)  Portfolio P has a beta of 0.7. 
D)  Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. 
E)  Portfolio P has the same required return as the market (rM ). 
A)  Portfolio P has a standard deviation of 20%. 
B)  The required return on Portfolio P is equal to the market risk premium (rM − rRF). 
C)  Portfolio P has a beta of 0.7. 
D)  Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF. 
E)  Portfolio P has the same required return as the market (rM ).

Question 4

You observe the following information regarding Companies X and Y:
• Company X has a higher expected return than Company Y.
• Company X has a lower standard deviation of returns than Company Y.
• Company X has a higher beta than Company Y.
Given this information, which of the following statements is CORRECT?

Accepted Answer

A)  Company X has more diversifiable risk than Company Y. 
B)  Company X has a lower coefficient of variation than Company Y. 
C)  Company X has less market risk than Company Y. 
D)  Company X's returns will be negative when Y's returns are positive. 
E)  Company X's stock is a better buy than Company Y's stock. 
A)  Company X has more diversifiable risk than Company Y. 
B)  Company X has a lower coefficient of variation than Company Y. 
C)  Company X has less market risk than Company Y. 
D)  Company X's returns will be negative when Y's returns are positive. 
E)  Company X's stock is a better buy than Company Y's stock.

Question 5

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Accepted Answer

A) True 
 B)False

Question 6

Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

Accepted Answer

A)  7.72% 
B)  8.12% 
C)  8.55% 
D)  9.00% 
E)  9.50% 
A)  7.72% 
B)  8.12% 
C)  8.55% 
D)  9.00% 
E)  9.50%

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak. 
B)  Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of −0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period. 
C)  Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move. 
D)  You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks. 
E)  If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low- beta stocks will rise while those on high-beta stocks will decline. 
A)  Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak. 
B)  Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of −0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period. 
C)  Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move. 
D)  You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks. 
E)  If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low- beta stocks will rise while those on high-beta stocks will decline.

Question 8

Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium, (rM − rRF). Under these conditions, with other things held constant, which of the following statements is most correct?

Accepted Answer

A)  The required return on all stocks would increase by the same amount. 
B)  The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. 
C)  Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. 
D)  The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. 
E)  The prices of all stocks would increase, but the increase would be greatest for high-beta stocks. 
A)  The required return on all stocks would increase by the same amount. 
B)  The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. 
C)  Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. 
D)  The prices of all stocks would decline, but the decline would be greatest for high-beta stocks. 
E)  The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

Question 9

Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

Accepted Answer

A)  2.75% 
B)  2.89% 
C)  3.05% 
D)  3.21% 
E)  3.38% 
A)  2.75% 
B)  2.89% 
C)  3.05% 
D)  3.21% 
E)  3.38%

Question 10

The slope of the SML is determined by the value of beta.

Accepted Answer

A) True 
 B)False

Question 11

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Accepted Answer

A) True 
 B)False

Question 12

Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?

Accepted Answer

A)  Your portfolio has a standard deviation of 30%, and its expected return is 15%. 
B)  Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. 
C)  Your portfolio has a beta equal to 1.6, and its expected return is 15%. 
D)  Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. 
E)  Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. 
A)  Your portfolio has a standard deviation of 30%, and its expected return is 15%. 
B)  Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. 
C)  Your portfolio has a beta equal to 1.6, and its expected return is 15%. 
D)  Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. 
E)  Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.

Question 13

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Accepted Answer

A) True 
 B)False

Question 14

Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. $\begin{array}{llcc}
&\text { Expected }&\text {Standard }\
\underline{  \text { Stock }}&\underline{ \text { Return }}&\underline{ \text { Deviation} }&\underline{ \text { Beta} }\
\text { A } & 10 \% & 20 \% & 1.0\
 \text {B} & 10 \% & 10 \% & 1.0 \
\text { C } & 12 \% & 12 \% & 1.4 
\end{array}$
 
 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio AB has a standard deviation of 20%. 
B)  Portfolio AB's coefficient of variation is greater than 2.0. 
C)  Portfolio AB's required return is greater than the required return on Stock A. 
D)  Portfolio ABC's expected return is 10.66667%. 
E)  Portfolio ABC has a standard deviation of 20%. 
A)  Portfolio AB has a standard deviation of 20%. 
B)  Portfolio AB's coefficient of variation is greater than 2.0. 
C)  Portfolio AB's required return is greater than the required return on Stock A. 
D)  Portfolio ABC's expected return is 10.66667%. 
E)  Portfolio ABC has a standard deviation of 20%.

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)  If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. 
B)  If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. 
C)  If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. 
D)  Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. 
E)  A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate. 
A)  If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. 
B)  If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one. 
C)  If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market. 
D)  Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless. 
E)  A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.

Question 16

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

Accepted Answer

A)  Stock A would be a more desirable addition to a portfolio then Stock B. 
B)  In equilibrium, the expected return on Stock B will be greater than that on Stock A. 
C)  When held in isolation, Stock A has more risk than Stock B. 
D)  Stock B would be a more desirable addition to a portfolio than A. 
E)  In equilibrium, the expected return on Stock A will be greater than that on B. 
A)  Stock A would be a more desirable addition to a portfolio then Stock B. 
B)  In equilibrium, the expected return on Stock B will be greater than that on Stock A. 
C)  When held in isolation, Stock A has more risk than Stock B. 
D)  Stock B would be a more desirable addition to a portfolio than A. 
E)  In equilibrium, the expected return on Stock A will be greater than that on B.

Question 17

Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? $\begin{array}{lrr}
&\text { Probability } &\text { Stock's }\
\text {State of}&\text { of State }&\text {Expected}\ 
\underline{\text { the Economy }} & \underline{\text { Occurring }} &\underline{ \text { Return }} \
\text { Boom }& 0.45 & 25 \% \
\text { Normal } & 0.50 & 15 \% \
\text { Recession } & 0.05 & 5 \%
\end{array}$

Accepted Answer

A)  0.2839 
B)  0.3069 
C)  0.3299 
D)  0.3547 
E)  0.3813 
A)  0.2839 
B)  0.3069 
C)  0.3299 
D)  0.3547 
E)  0.3813

Question 18

CCC Corp has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points). Neither betas nor the risk-free rate change. What would CCC's new required return be?

Accepted Answer

A)  14.89% 
B)  15.68% 
C)  16.50% 
D)  17.33% 
E)  18.19% 
A)  14.89% 
B)  15.68% 
C)  16.50% 
D)  17.33% 
E)  18.19%

Question 19

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

Accepted Answer

A) True 
 B)False

Question 20

Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio AB's standard deviation is 17.5%. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
C)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
D)  Portfolio AB's expected return is 11.0%. 
E)  Portfolio AB's beta is less than 1.2. 
A)  Portfolio AB's standard deviation is 17.5%. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
C)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
D)  Portfolio AB's expected return is 11.0%. 
E)  Portfolio AB's beta is less than 1.2.

Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

Which of the following statements is CORRECT?

The slope of the SML is determined by the value of beta.

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Which of the following statements is CORRECT?

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? Probability Stock's State of of State Expected Boom 0.45 25\% Normal 0.50 15\% Recession 0.05 5\%

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

The Value of Money

Interest Rates

Bonds and Their Valuation

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

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Exam 8: Risk and Rates of Return

Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.

Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a −18% return. What is the firm's expected rate of return?

Which of the following statements is CORRECT?

The slope of the SML is determined by the value of beta.

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities.

Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.

Which of the following statements is CORRECT?

Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.

Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? Probability Stock's State of of State Expected Boom 0.45 25\% Normal 0.50 15\% Recession 0.05 5\%

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

The Value of Money

Interest Rates

Bonds and Their Valuation

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Multinational Financial Management

Financial and Operating Leverage: Analysis and Calculation

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