Deck 12: Risk, Return, and Capital Budgeting

Question 1

The project cost of capital depends on how the capital is used.

Answer 1

True

Question 2

The project cost of capital depends on the risk of the company undertaking the project.

Answer 2

False

Question 3

Diversification decreases the variability of both unique and market risk.

Answer 3

False

Question 4

There is little doubt that the CAPM captures everything that is going on in the market.

Question 5

The security market line displays the relationship between expected return and beta.

Question 6

The stock of Newmont Mining, the world's largest gold producer, has above-average volatility but a relatively low beta.

Question 7

The security market line sets a standard for other investments-investors will be willing to hold other investments only if they offer equally good prospects as shown by the points on the line.

Question 8

Investors expect aggressive stocks to outperform the market in periods of strong economic activity.

Question 9

Empirical evidence suggests that over a long period of time returns are directly related to beta.

Question 10

Beta measures a stock's sensitivity to market risks.

Question 11

Beta measures the total risk of an individual security.

Question 12

The required risk premium for any given investment is defined by the security market line.

Question 13

Market risk premium is defined as the difference between the market rate of return and the return on risk-free Treasury bills.

Question 14

The security market line provides a standard that can be used to make project acceptance/rejection decisions.

Question 15

Defensive stocks typically provide better returns during periods of economic downturn since they are not very sensitive to market fluctuations.

Question 16

According to the CAPM, a stock's expected return is positively related to its beta.

Question 17

The CAPM states that the expected risk premium on any security equals its beta times the market risk premium.

Question 18

The CAPM is a theory of the relationship between risk and return that states that the expected risk premium on any security equals its beta times the market return.

Question 19

The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-diversified investors who are concerned only with market risk.

Question 20

If a low-risk company invests in a high-risk project, those cash flows should be discounted at a high cost of capital.

Question 21

If a company with a low credit rating invests in a low-risk project, it should discount the cash flows at a relatively high cost of capital.

Question 22

When the overall market is up by 10%, investors with portfolios 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 23

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

A) ignoring all of the security's 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 24

A project should be accepted if its return plots below the security market line.

Question 25

The required risk premium for any investment is given by the security market line.

Question 26

The project cost of capital depends on the use to which that capital is put. Therefore, it depends on both the risk of the project and also on the risk of the company.

Question 27

The security market line shows how the expected rate of return depends on beta.

Question 28

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

A) the market portfolio contains only risk-free securities.
B) only macro events are tracked by economists.
C) the unique risks have been diversified away.
D)the firm-specific events would be too numerous to quantify.

Question 29

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

A) losses of less than 8%.
B) losses greater than 8%.
C) gains of less than 8%.
D)gains greater than 8%.

Question 30

The return on a security includes premiums for:

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

Question 31

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 32

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 33

According to the capital asset pricing model, the expected rates of return for all securities and all portfolios lie on the capital market line.

Question 34

As a project's beta increases, the project's opportunity cost of capital increases.

Question 35

Project cost of capital and company cost of capital are synonymous terms.

Question 36

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 the return on the market portfolio.
D)market risk premium on the stock.

Question 37

Changing the discount rate is equivalent to adjusting the expected cash flows as a method of accounting for risk.

Question 38

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 39

The average of the 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 40

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 41

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 42

Assume the market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in a stock's rate of return if its beta increases from 1.12 to 1.14?

A) 0.19%
B) 0.25%
C) 1.90%
D)2.50%

Question 43

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

A) buy only stocks with a beta of 1.0.
B) build a portfolio with 40 to 55 individual stocks.
C) purchase the shares of a mutual fund.
D)purchase stocks that plot above the security market line.

Question 44

You want to develop a portfolio containing U.S. Treasury bills and two stocks that is equally as risky as the market. The securities will be equally weighted. If the beta of the first stock is 1.23, what does the beta of the second stock have to be?

A) 0.77
B) 1.23
C) 0.23
D)1.77

Question 45

A project has an assigned beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is 8.1%. What is the project's expected rate of return?

A) 7.98%
B) 11.96%
C) 8.35%
D)11.83%

Question 46

Which one 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 47

What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73?

A) 1.0
B) 1.17
C) 1.22
D)1.25

Question 48

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

A) 16.00%
B) 18.75%
C) 25.00%
D)32.50%

Question 49

Assuming positive returns on Treasury bills, 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 50

A project has an assigned beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is 9.2%. What is the project's expected rate of return?

A) 15.21%
B) 11.41%
C) 10.50%
D)14.61%

Question 51

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 52

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

A) 1.04.
B) 1.24.
C) 1.33.
D)1.40.

Question 53

A considerable scattering in the plot of points representing the historic returns of a stock versus the returns on the market reflects 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 54

If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori, we could expect 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 55

Estimate a stock's beta based on the following information: 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) Greater than 1.0
B) Less than 1.0
C) Equal to 1.0
D)Indeterminate

Question 56

What is the beta of a U.S. Treasury bill?

A) 1.0
B) -1.0
C) 0
D)Unknown

Question 57

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) Favorable firm-specific news was reported.
D)The beta is incorrect.

Question 58

What should be the beta of a replacement stock if an investor wishes to achieve a portfolio beta of 1.2 by replacing stock C in the following equally weighted portfolio: stock A = 0.9 beta; stock B = 1.1 beta; stock C = 1.35 beta?

A) 0.7
B) 1.6
C) 1.2
D)1.8

Question 59

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.

Question 60

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 61

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

A) Its beta will increase.
B) Its beta will decrease.
C) Its market price will decrease causing its yield to increase.
D)Its market price will increase causing its yield to increase.

Question 62

Investing borrowed funds in a stock portfolio will generally:

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 63

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

A) 8.0%
B) 10.4%
C) 15.4%
D)16.9%

Question 64

Which one of the following statements is more likely to be correct concerning the comment, "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 65

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.

Question 66

Based on your analysis, you believe that Alpha stock which has a beta of 1.32 is going to yield 14.05% this coming year. The market is expected to yield 11.4% and T-bills are yielding 3.8%. According to CAPM, which one of these statements is correct given this information?

A) The stock is currently underpriced.
B) The stock plots below the security market line.
C) The risk premium on the stock is too low given the stock's beta.
D)The stock plots to the left of the market on a security market line graph.

Question 67

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 100% of additional funds borrowed at the risk-free rate of 6%?

A) 18.6%
B) 19.6%
C) 21.6%
D)30.0%

Question 68

A stock's risk premium is equal to the:

A) expected market return times beta.
B) Treasury bill yield plus the expected market return.
C) risk-free rate plus the expected market risk premium.
D)expected market risk premium times beta.

Question 69

A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market rate of return is 10.6%?

A) 2.825%
B) 3.250%
C) 3.275%
D)3.415%

Question 70

If Treasury bills yield 6% and the market risk premium is 9%, then a stock with a beta of 1.5 would be expected to yield:

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

Question 71

A portfolio consists of an index mutual fund which represents the overall market and Treasury bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is 7.6%. What is your best estimate of the portfolio expected rate of return?

A) 8.39%
B) 7.76%
C) 10.80%
D)9.02%

Question 72

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) 8.67%
B) 10.84%
C) 12.02%
D)14.57%

Question 73

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 74

Why do stock market investors seem to ignore unique risks when calculating expected rates of return?

A) There is no method for quantifying 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 for unique risk.

Question 75

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%

Question 76

When Treasury bills yield 7% and the expected return on the market is 16%, then the risk premium on an asset is equal to:

A) 9%.
B) 16%.
C) 9% times the asset's beta.
D)9% plus the risk-free rate.

Question 77

Which one of these statements is correct?

A) Betas are exact measurements.
B) If a stock has a very low beta, it is most apt to maintain that beta in the future.
C) The expected future risk premium is easy to accurately determine.
D)CAPM is widely used as a means of valuing stock.

Question 78

An investor was expecting a return of 14.7% on her portfolio with a beta of 1.13 before the market risk premium decreased from 8 to 7%. Based on this change, what return should she now expect on the portfolio?

A) 13.57%
B) 13.89%
C) 14.67%
D)15.87%

Question 79

What is the beta of a security 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 80

An investor was expecting a return of 18% on his portfolio with a beta of 1.25 before the market risk premium increased from 8 to 10%. Based on this change, what return should he now expect on the portfolio?

A) 20.0%
B) 20.5%
C) 22.5%
D)26.0%