Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. 
B)  A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. 
C)  A two-stock portfolio will always have a lower beta than a one-stock portfolio. 
D)  If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. 
E)  A stock with an above-average standard deviation must also have an above-average beta. 
A)  A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. 
B)  A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. 
C)  A two-stock portfolio will always have a lower beta than a one-stock portfolio. 
D)  If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. 
E)  A stock with an above-average standard deviation must also have an above-average beta. B

Question 2

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Accepted Answer

A) True 
 B)False  True

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)  If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds. 
B)  If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. 
C)  An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. 
D)  There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. 
E)  Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF.
Problems
Generally, the SML is used to find the required return, but on occasion the required return is given and we must solve for one of the other variables. We warn our students before the test that to answer a number of the questions they will have to transform the SML equation to solve for beta, the market risk premium, the risk-free rate, or the market return. 
A)  If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds. 
B)  If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. 
C)  An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. 
D)  There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. 
E)  Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF.
Problems
Generally, the SML is used to find the required return, but on occasion the required return is given and we must solve for one of the other variables. We warn our students before the test that to answer a number of the questions they will have to transform the SML equation to solve for beta, the market risk premium, the risk-free rate, or the market return. E

Question 4

Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT?

Accepted Answer

A) 	Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. 
B) 	The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. 
C) 	Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. 
D) 	If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. 
E) 	The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. 
A) 	Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. 
B) 	The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. 
C) 	Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. 
D) 	If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. 
E) 	The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.

Question 5

Scheuer Enterprises has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Scheuer's required rate of return?

Accepted Answer

A)  9.43% 
B)  9.67% 
C)  9.92% 
D)  10.17% 
E)  10.42% 
A)  9.43% 
B)  9.67% 
C)  9.92% 
D)  10.17% 
E)  10.42%

Question 6

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

Accepted Answer

A) True 
 B)False

Question 7

Over the past 75 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last?

Accepted Answer

A)  Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills. 
B)  Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. 
C)  Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. 
D)  U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. 
E)  Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. 
A)  Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills. 
B)  Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. 
C)  Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. 
D)  U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. 
E)  Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

Question 8

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

Accepted Answer

A) True 
 B)False

Question 9

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Accepted Answer

A) True 
 B)False

Question 10

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

Accepted Answer

A) The required return on a stock with beta = 1.0 will not change. B) The required return on a stock with beta > 1.0 will increase. C) The return on "the market" will remain constant. D) The return on "the market" will increase. E) The required return on a stock with beta < 1.0 will decline. A) The required return on a stock with beta = 1.0 will not change. B) The required return on a stock with beta > 1.0 will increase. C) The return on "the market" will remain constant. D) The return on "the market" will increase. E) The required return on a stock with beta < 1.0 will decline.

Question 11

In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement always is false?

Accepted Answer

A)  The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. 
B)  The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. 
C)  The beta of the portfolio is lower than the lowest of the three betas. 
D)  The beta of the portfolio is lower than the highest of the three betas. 
E)  None of the above statements is obviously false, because they all could be true, but not necessarily at the same time. 
A)  The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. 
B)  The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. 
C)  The beta of the portfolio is lower than the lowest of the three betas. 
D)  The beta of the portfolio is lower than the highest of the three betas. 
E)  None of the above statements is obviously false, because they all could be true, but not necessarily at the same time.

Question 12

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

Accepted Answer

A) True 
 B)False

Question 13

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

Accepted Answer

A) True 
 B)False

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)  If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0. 
B)  Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. 
C)  The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. 
D)  If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. 
E)  During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future. 
A)  If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0. 
B)  Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. 
C)  The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. 
D)  If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. 
E)  During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

Question 15

Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.

Accepted Answer

A) True 
 B)False

Question 16

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

Accepted Answer

A) True 
 B)False

Question 17

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

Accepted Answer

A) True 
 B)False

Question 18

A mutual fund manager has a $40 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. The manager expects to receive an additional $60 million which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%. What must the average beta of the new stocks be to achieve the target required rate of return?

Accepted Answer

A)  1.68 
B)  1.76 
C)  1.85 
D)  1.94 
E)  2.04 
A)  1.68 
B)  1.76 
C)  1.85 
D)  1.94 
E)  2.04

Question 19

Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?

Accepted Answer

A)  Portfolio P has a beta that is greater than 1.2. 
B)  Portfolio P has a standard deviation that is greater than 25%. 
C)  Portfolio P has an expected return that is less than 12%. 
D)  Portfolio P has a standard deviation that is less than 25%. 
E)  Portfolio P has a beta that is less than 1.2. 
A)  Portfolio P has a beta that is greater than 1.2. 
B)  Portfolio P has a standard deviation that is greater than 25%. 
C)  Portfolio P has an expected return that is less than 12%. 
D)  Portfolio P has a standard deviation that is less than 25%. 
E)  Portfolio P has a beta that is less than 1.2.

Question 20

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

Accepted Answer

A) True 
 B)False

Exam 6: Risks and Rates of Return

Which of the following statements is CORRECT?

It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm is negative.

Which of the following statements is CORRECT?

Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT?

Scheuer Enterprises has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Scheuer's required rate of return?

The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on an average (b = 1) stock is zero.

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

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms.

Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?

In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement always is false?

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

Managers should under no conditions take actions that increase their firm's risk relative to the market, regardless of how much those actions would increase the firm's expected rate of return.

Which of the following statements is CORRECT?

Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky.

If the returns of two firms are negatively correlated, then one of them must have a negative beta.

If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.

Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?

We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Stocks and Their Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Financial Planning and Forecasting Financial Statements

Corporate Valuation, Value-Based Management, and Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Working Capital Management

Multinational Financial Management

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Initial Public Offerings, Investment Banking, and Financial Restructuring

Mergers, Lbos, Divestitures, and Holding Companies

Bankruptcy, Reorganization, and Liquidation

Derivatives and Risk Management

Portfolio Theory, Asset Pricing Models, and Behavioral Finance

Real Options

Analysis of Capital Structure Theory

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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