Deck 12: Risk, Return, and Capital Budgeting

Question 1

If the slope of the line measuring a stock's historic returns against the market's historic returns is positive, then the stock:

A)Has a Beta greater than 1.0
B)Has no unique risk
C)Has a positive Beta
D)Plots above the security market line

Answer 1

Has a positive Beta

Question 2

Based on the following information, make an estimate of the stock's Beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%.

A)Beta is greater than 1.0
B)Beta is less than 1.0
C)Beta equals 1.0
D)There is no consistent pattern of returns

Answer 2

Beta is greater than 1.0

Question 3

When the overall market experiences a decline of 8%, an investor with a portfolio of aggressive stocks will probably experience:

A)Negative portfolio returns of less than 8%
B)Negative portfolio returns of greater than 8%
C)Positive portfolio returns of less than 8%
D)Positive portfolio returns of greater than 8%

Answer 3

Negative portfolio returns of greater than 8%

Question 4

Why do stock market investors appear not to be concerned with unique risks when calculating expected rates of return?

A)There is no method to quantify unique risks
B)Unique risks are assumed to be diversified away
C)Unique risks are compensated by the risk-free rate
D)Beta includes a component to compensate unique risk

Question 5

The line plotted to fit observations of a stock's returns versus the market's returns determines the:

A)Security market line
B)Beta of the stock
C)Market risk premium
D)Capital asset pricing model

Question 6

What is the Beta of a three-stock portfolio including 25% of Stock A with a Beta of .90, 40% Stock B with a Beta of 1.05, and 35% Stock C with a Beta of 1.73?

A)1.05
B)1.17
C)1.22
D)1.25 Portfolio Beta = (.25 x 0.9) + (.4 x 1.05) + (.35 x 1.73)
= )225 + .42 + .606

Question 7

If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2% then its Beta:

A)Equals 1.40
B)Equals 1.24
C)Equals 1.33
D)Equals 1.41

Question 8

If a stock's Beta is .8 during a period when the market portfolio was down by 10%, then, a priori, we could expect the return on this individual stock to:

A)Lose more than 10%
B)Lose, but less than 10%
C)Gain more than 10%
D)Gain, but less than 10%

Question 9

The sensitivity of a stock's returns to the returns on a market portfolio is referred to as the:

A)Stock's market risk premium
B)Stock's Beta
C)Market portfolio's systematic risk
D)Stock's unique risk

Question 10

Macro events only are reflected in the performance of the market portfolio because:

A)The market portfolio has no individual firms
B)Only macro events are tracked by economists
C)Unique risks have been diversified away
D)Firm-specific events would be too numerous to list

Question 11

A stock with a Beta greater than 1.0 would be termed:

A)An aggressive stock, expected to increase more than the market increases
B)A defensive stock, expected to decrease more than the market increases
C)An aggressive stock, expected to decrease more than the market increases
D)A defensive stock, expected to increase more than the market decreases

Question 12

The average of Beta values for all individual stocks is:

A)Greater than 1.0; most stocks are aggressive
B)Less than 1.0; most stocks are defensive
C)Unknown; Betas are continually changing
D)Exactly 1.0; these stocks represent the market

Question 13

A major benefit of investing in mutual funds is:

A)Reducing the Beta of the investment portfolio
B)Increasing the Beta of the investment portfolio
C)Low cost reduction of exposure to unique risks
D)The elimination of market risk

Question 14

A stock's Beta measures the:

A)Average return on the stock
B)Variability in the stock's returns compared to that of the market portfolio
C)Difference between the return on the stock and return on the market portfolio
D)Market risk premium on the stock

Question 15

If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be logical to invest in:

A)High Beta stocks
B)Low Beta stocks
C)Stocks with large amounts of unique risk
D)Stocks that plot below the security market line

Question 16

In practice, the market portfolio is often represented by:

A)A portfolio of U.S.Treasury securities
B)A diversified stock market index
C)An investor's mutual fund portfolio
D)The historic record of stock market returns

Question 17

When the overall market is up by 10%, an investor with a portfolio of defensive stocks will probably have:

A)Negative portfolio returns less than 10%
B)Negative portfolio returns greater than 10%
C)Positive portfolio returns less than 10%
D)Positive portfolio returns greater than 10%

Question 18

Stock returns can be explained by the stock's _________ and the stock's __________.

A)Beta; unique risk
B)Beta; market risk
C)Unique risk; firm-specific risk
D)Aggressive risk; defensive risk

Question 19

What is the most logical explanation for a +2.0% return on a stock with a Beta of 1.0 in a month where the market returned +1.0%?

A)The stock is aggressive
B)The market is undervalued
C)Favourable firm-specific news was reported
D)The Beta is incorrect

Question 20

If the line measuring a stock's historic returns against the market's historic returns has a slope greater than 1.0, then the:

A)Stock is currently underpriced
B)Market risk premium is increasing
C)Stock has a significant amount of unique risk
D)Stock has a Beta exceeding 1.0

Question 21

When Treasury bills yield 7.0% and the expected return on the market is 16%, then the risk premium on an asset is equal to:

A)9.0%
B)16.0%
C)9.0% times the asset's Beta
D)8.0% plus the risk-free rate

Question 22

The average Beta of individual stocks in the market portfolio is:

A)One
B)Zero
C)Midway between zero and one
D)Cannot be calculated without knowing the stocks in the portfolio

Question 23

If a two-stock portfolio is equally invested in stocks with Betas of 1.4 and 0.7, then the portfolio Beta is:

A)0.70
B)1.05
C)1.40
D)2.10 Portfolio Beta = (W₁ x B₁) + (W₂ x B₂)
= ()5 x 1.4) + (.5 x .70)

Question 24

What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a stock with a Beta of 1.4 is expected to yield 18%?

A)8.6%
B)10.8%
C)12.0%
D)14.6%

Question 25

An investor was expecting an 18% return on his portfolio with Beta of 1.25 before the market risk premium increased from 8% to 10%.Based on this change, what return will now be expected on the portfolio?

A)20.0%
B)20.5%
C)22.5%
D)26.0% Old: 18% = rf + 1.25(8%)
= r_f + 10.0%
8)0% = r_f
New: Expected return = 8.0% + 1.25(10%)
= 8)0% + 12.5%

Question 26

Which of the following statements is correct when Treasury bills yield 7.5% and the market risk premium is 9.5%?

A)The S&P 500 would be expected to yield about 8.50%
B)The S&P 500 would be expected to yield about 9.50%
C)The S&P 500 would be expected to yield about 12.68%
D)The S&P 500 would be expected to yield about 17.00%

Question 27

One of the easiest methods of diversifying away firm-specific risks is to:

A)Buy stocks with a Beta of 1.0.
B)Build a portfolio with 20-25 individual stocks.
C)Purchase the shares of a mutual fund.
D)Purchase stocks that plot above the security market line.

Question 28

What return would be expected by an investor whose portfolio was 25% market portfolio and 75% Treasury bills if the risk-free rate was 7% and the market risk premium was 8%?

A)8.00%
B)9.00%
C)10.75%
D)13.00% Expected return on market = r_f + market risk premium
= 7% + 8%
= 15%
R_f = (.25 x .07) + (.75 x 15)
= 1)75 + 11.25

Question 29

What will happen to the expected return on a stock with a Beta of 1.5 and a market risk premium of 9% if the Treasury bill yield increases from 3% to 5%?

A)The expected return will remain unchanged
B)The expected return will increase by 1.0%
C)The expected return will increase by 2.0%
D)The expected return will increase by 3.0% Expected return = 3% + 1.5(9)
= )165
Expected return = 5% + 1.5(9)
= 18.5%

Question 30

Why would a stock market investor not be concerned with unique risks when calculating expected rates of return?

A)There is no method to quantify unique risks.
B)Unique risks are assumed to be diversified away.
C)Unique risks are compensated by the risk-free rate.
D)Beta includes a component to compensate unique risk.

Question 31

A considerable scattering in the plot of points representing the historic returns of a stock versus the returns on the market indicates the:

A)High Beta of the stock
B)Unique risk of the stock
C)Changes in market risk premium over time
D)Current underpricing of the stock

Question 32

Calculate the risk premium on Stock C given the following information: risk-free rate = 5%, market return = 13%, Stock C = 1.3 Beta.

A)8.0%
B)10.4%
C)15.4%
D)16.9% Stock C Risk Premium = Beta x (market risk premium)
= 1)3 x (13% - 5%)

Question 33

What is the Beta of a portfolio with an expected return of 12% if Treasury bills yield 6% and the market risk premium is 8%?

A)0.50
B)0.75
C)0.90
D)1.50

Question 34

The Beta of an investment in Treasury bills is:

A)0.0
B)0.5
C)1.0
D)Meaningless; only common stocks have Betas

Question 35

What rate of return should an investor expect for a stock that has a Beta of 0.8 when the market is expected to yield 14% and Treasury bills offer 6%?

A)9.2%
B)11.2%
C)12.4%
D)12.8% r = r_f + B(r_m - r_f)
= 6% +.8(14% - 6%)
= 6% + 6.4%

Question 36

If Treasury bills are yielding 10% at a time when the market risk premium is 6%, then the:

A)Market portfolio should yield 4%
B)Market portfolio should yield 6%
C)Market portfolio should yield 16%
D)Market portfolio should yield 22%

Question 37

What can you assume about an investor whose diversified portfolio of stocks yielded 25% when the market portfolio yielded 15%?

A)Treasury bills are offering a 10% yield
B)The portfolio Beta is greater than 1.0
C)The portfolio Beta equals 1.67
D)The investor's portfolio contains many defensive stocks

Question 38

If Treasury bills yield 6.0% and the market risk premium is 9.0%, then a portfolio with a Beta of 1.5 would be expected to yield:

A)12.0%
B)17.0%
C)19.5%
D)21.5%

Question 39

What should be the Beta of a replacement stock if an investor wishes to achieve a portfolio Beta of 1.0 by replacing Stock C in the following equally weighted portfolio: Stock A = .9 Beta; Stock B = 1.1 Beta; Stock C = 1.35 Beta?

A)0.93 Beta
B)1.00 Beta
C)1.08 Beta
D)1.15 Beta New Portfolio Beta = (.333 x .9) + (.333 x 1.1) + (.333 x Beta C)
1)0 = .3 + .366 +.333 x Beta C
-)334 = .333 x Beta C

Question 40

What is the standard deviation of the market portfolio if the standard deviation of a diversified portfolio with a Beta of 1.25 equals 20%?

A)16.00%
B)18.75%
C)25.00%
D)32.505%

Question 41

If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the:

A)Company cost of capital and be accepted
B)Company cost of capital and be rejected
C)Project cost of capital and be accepted
D)Project cost of capital and be rejected

Question 42

The slope of the security market line equals:

A)One
B)Beta
C)The market risk premium
D)The expected return on the market portfolio

Question 43

A project with a higher than average risk offers an expected return of 18%.Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%?

A)Project NPV is positive; it should be accepted
B)Project NPV is negative; it should be rejected
C)Project NPV is positive but it should be rejected
D)Project NPV is negative but it should be accepted

Question 44

What would you recommend to an investor who is considering an investment that, according to its Beta, plots below the security market line (SML)?

A)Invest; return is high relative to risk
B)Don't invest; risk is high relative to return
C)Invest; stocks revert to the SML over time
D)Don't invest; stocks below the SML have too much unique risk

Question 45

What will happen to a stock that offers a lower risk premium than predicted by the CAPM?

A)Its Beta will increase
B)Its Beta will decrease
C)Its price will decrease until yield is increased
D)Its price will increase until the yield is reduced

Question 46

Which of the following statements best explains the fact that cyclical firms tend to have high Betas?

A)Their earnings are not stable
B)Their stocks are overpriced
C)Their earnings are less diversifiable
D)Their profit margins are small

Question 47

A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable.

A)Company cost of capital
B)Risk-free rate
C)Market risk premium
D)Project cost of capital

Question 48

The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if:

A)It calculates a negative NPV for the proposal
B)The proposal has a different degree of risk
C)The company has unique risk
D)The company expects to earn more than the risk-free rate

Question 49

The project cost of capital is:

A)Equal to the company cost of capital
B)Less than the company cost of capital
C)Greater than the company cost of capital
D)Not necessarily related to the company cost of capital

Question 50

What return should be expected from investing in the market portfolio that is expected to yield 18% if the investment includes all of the investor's funds plus 30% of additional funds borrowed at the risk-free rate of 6%?

A)18.6%
B)19.6%
C)21.6%
D)24.0% Beta = (1.3 x B_market) + (-1 x B_loan)
= (1.3 x 1) + 0
= 1)3
Expected return = 6% + 1.3(18% - 6%)
= 6% + 15.6%

Question 51

Investment projects that plot above the security market line would be considered to have:

A)A positive NPV
B)A negative NPV
C)A zero NPV
D)An excessively high discount rate

Question 52

Which of the following statements is more likely to be correct concerning the statement, "Stock A has a higher expected return than Stock B"?

A)Stock A has more unique risk
B)Stock B plots below the security market line
C)Stock B is a cyclical stock
D)Stock A has a higher Beta

Question 53

A stock's risk premium is equal to the:

A)Expected market return times Beta
B)Treasury bill yield plus expected market return
C)Risk-free rate plus expected market risk premium
D)Expected market risk premium times Beta

Question 54

What return should be expected from investing in the market portfolio which is expected to yield 18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at the risk-free rate of 6%?

A)18.6%
B)19.6%
C)21.6%
D)30.0% Beta = (2.0 x B_market) + (-1 x B_loan)
= (2.0 x 1) + 0
= 2)0
Expected return = 6% + 2.0(18% - 6%)
= 6% + 24%

Question 55

Investing borrowed funds in a stock portfolio will:

A)Increase the Beta of the portfolio
B)Decrease the volatility of the portfolio
C)Decrease the expected return on the portfolio
D)Increase the market risk premium

Question 56

The minimum acceptable expected rate of return on a project of a specific risk is the:

A)Project cost of capital
B)Company cost of capital
C)Rsk-free rate of return
D)Project Beta times market risk premium

Question 57

What type of risk is properly reflected in a project's discount rate?

A)Market risk
B)Unique risk
C)Total risk
D)Diversifiable risk

Question 58

What happens to expected portfolio return if the portfolio Beta increases from 1.0 to 1.5, the risk-free rate decreases from 5% to 4%, and the market risk premium increases from 8% to 9%?

A)It increases from 12% to 14%
B)It increases from 13% to 17.5%
C)It increases from 14% to 21%
D)It remains unchanged R_p = 5% + 1(8)
= 13%
R_p = 4% +1.5(9)
= 17.5%

Question 59

Decreases in the risk-free rate will reduce:

A)The market risk premium
B)The stock's risk premium
C)The stock's Beta
D)The stock's expected return

Question 60

Given the CAPM's noted difficulties, which of the following statements may be correct concerning a low price-earnings ratio stock?

A)The stock has too much systematic risk
B)The stock plots above the security market line
C)The stock plots below the security market line
D)The stock has a zero Beta

Question 61

Given recent evidence concerning the CAPM, which of the following portfolios might be expected to plot above the security market line?

A)A portfolio of cyclical stocks
B)A portfolio that includes borrowed funds
C)A portfolio of smaller companies
D)A portfolio split between Treasury bills and the market index

Question 62

What effect might operating leverage be expected to have on a project's Beta?

A)Beta will increase
B)Beta will decrease
C)Beta will not be affected
D)The effect depends on the market risk premium

Question 63

The slope of the regression line that exhibits the past relationship between a stock's return and the market's return is the:

A)Security market line
B)Stock's Beta
C)Market risk premium
D)Stock's unique risk

Question 64

A project is determined to have equal probability of generating $1 million annually or $500,000 annually for four years.The initial outlay is $2 million.The expected return on Treasury bills is 6% and the market risk premium is 8%.What is the highest project Beta that will justify acceptance of the project?

A)0.0
B)1.00
C)1.56
D)2.31 Expected cash flow = (1 million x .5) + (500,000 x .5)
= 750,000
$2 million = 750,000

Question 65

Which of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index?

A)The portfolio contains fairly aggressive stocks
B)The portfolio's stock plot below the security market line
C)The portfolio's Beta is less than 1.0
D)The portfolio contains a significant amount of unique risk

Question 66

If a security plots below the security market line, it is:

A)Not rewarding the investor for its unique risk
B)Underpriced, a situation that should be temporary
C)Offering too little return to justify its risk
D)A defensive security, which expects to offer lower returns

Question 67

If the plotting of a portfolio's returns against returns on the market index produces a tight pattern, then:

A)The portfolio appears to be well diversified
B)The portfolio has a Beta of 1.0
C)The portfolio has very little systematic risk
D)The portfolio has a very low market risk premium

Question 68

The correct opportunity cost for a project is determined to be 15% and the project is expected to generate $1 million in cash flows at the end of the next four years after an initial outlay of $3 million.Based on this information, the project would plot:

A)Above the security market line
B)Below the security market line
C)On the security market line
D)On the security market line, with a Beta of 1.0

Question 69

How is it possible to invest only in the market portfolio yet have a portfolio Beta of 1.5?

A)Don't diversify away the unique risks
B)Purchase only aggressive stocks for the portfolio
C)Purchase only stocks with high levels of systematic risk
D)Borrow funds to increase your investment

Question 70

In theory, the "market portfolio" should contain:

A)The securities of the S&P 500
B)The securities of the Dow
C)The securities of the S&P 500 and Treasury bills
D)All risky assets

Question 71

If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then the investor should expect to receive:

A)The risk-free rate plus 75% of the expected return on the market
B)The risk-free rate plus 75% of the expected market risk premium
C)75% of the expected return on the market
D)25% of the risk-free rate plus 75% of the expected return on the market

Question 72

Which of the following portfolios might be expected to exhibit less unique risk?

A)Five different stocks; portfolio Beta = .8
B)Three different stocks; portfolio Beta = 1.2
C)Ten different stocks; portfolio Beta = 1.0
D)Twelve different stocks; portfolio Beta unknown

Question 73

An investor divides her portfolio into thirds, with one part in Treasury bills, one part in a market index, and one part in a diversified portfolio with Beta of 1.50.What is the Beta of the investor's overall portfolio?

A)0.833
B)1.000
C)1.167
D)1.250

Question 74

What two elements are represented in security returns?

A)A premium for market risk and for unique risk
B)A premium for unique risk and a premium for firm-specific risk
C)A premium for diversification and a premium for portfolio risk
D)A premium for time value of money and a premium for market risk

Question 75

If last month a stock with Beta of 1.0 lost two percent while the TSX 300 had a one percent gain, then it appears that:

A)Beta has been calculated incorrectly
B)The S&P 500 cannot represent the market
C)Betas are long-term "best fit" averages, not short-term stock measures
D)The market index had a good month

Question 76

Which of the following adjustment techniques would be preferred to account for additional project risk?

A)Increase the discount rate
B)Adjust expected cash flows downward
C)Increase the Beta
D)Adjust the market risk premium

Question 77

The CAPM provides a model of determining expected security returns that is:

A)Precise in its calculations of risk premiums
B)Imprecise, but generally an acceptable guideline
C)Excellent for high Beta stocks
D)Excellent for well-diversified portfolios

Question 78

The basic tenet of the CAPM is that a stock's expected risk premium should be:

A)Greater than the expected market return
B)Proportionate to the market risk premium
C)Proportionate to the stock's Beta
D)Greater than the risk-free rate of return

Question 79

If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would:

A)Determine where the project plots in relation to the security market line
B)Make the project look more attractive
C)Be correct from a theoretical perspective
D)Be incorrect.

Question 80

If the market portfolio is expected to offer returns of 16%, then what can be said about a portfolio expected to return 13%?

A)It plots below the security market line
B)Part of the portfolio is invested in Treasury bills
C)The portfolio is not diversified
D)The portfolio's Beta is less than 1.0