Question 1

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

Accepted Answer

A) True 
 B)False

Question 2

Paul McLaren holds the following portfolio: $$\begin{array} { c r r } 
\text { Stock } & \text { Investment } & \text { Beta } \
\text { A } & \$ 150,000 & 1.40 \
\text { B } & 50,000 & 0.80 \
\text { C } & 100,000 & 1.00 \
\text { D } & 75,000 & 1.20 \
\text { Total } & \$ 375,000 &
\end{array}$$ Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75.By how much will the portfolio beta change?

Accepted Answer

A)  ?0.190 
B)  ?0.211 
C)  ?0.234 
D)  ?0.260 
E)  ?0.286 
A)  ?0.190 
B)  ?0.211 
C)  ?0.234 
D)  ?0.260 
E)  ?0.286

Question 3

Stocks A and B are quite similar: Each has 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 standard deviation that is greater than 25%. 
B)  Portfolio P has an expected return that is less than 12%. 
C)  Portfolio P has a standard deviation that is less than 25%. 
D)  Portfolio P has a beta that is less than 1.2. 
E)  Portfolio P has a beta that is greater than 1.2. 
A)  Portfolio P has a standard deviation that is greater than 25%. 
B)  Portfolio P has an expected return that is less than 12%. 
C)  Portfolio P has a standard deviation that is less than 25%. 
D)  Portfolio P has a beta that is less than 1.2. 
E)  Portfolio P has a beta that is greater than 1.2.

Question 4

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive.Which of the following statements is CORRECT?

Accepted Answer

A)  Stock B's required rate of return is twice that of Stock A. 
B)  If Stock A's required return is 11%, then the market risk premium is 5%. 
C)  If Stock B's required return is 11%, then the market risk premium is 5%. 
D)  If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's. 
E)  If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's. 
A)  Stock B's required rate of return is twice that of Stock A. 
B)  If Stock A's required return is 11%, then the market risk premium is 5%. 
C)  If Stock B's required return is 11%, then the market risk premium is 5%. 
D)  If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's. 
E)  If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.

Question 5

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

Accepted Answer

A)  Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. 
B)  The beta of an "average stock," or "the market," can change over time, sometimes drastically. 
C)  Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. 
D)  All of the statements above are true. 
E)  The fact that a security or project may not have a past history that can be used as the basis for calculating beta. 
A)  Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. 
B)  The beta of an "average stock," or "the market," can change over time, sometimes drastically. 
C)  Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. 
D)  All of the statements above are true. 
E)  The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A)  If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks.Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. 
B)  The required return on a firm's common stock is, in theory, determined solely by its market risk.If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. 
C)  Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. 
D)  A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. 
E)  A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. 
A)  If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks.Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. 
B)  The required return on a firm's common stock is, in theory, determined solely by its market risk.If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. 
C)  Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. 
D)  A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. 
E)  A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  The slope of the Security Market Line is beta. 
B)  Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. 
C)  If a stock's beta doubles, its required rate of return must also double. 
D)  If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. 
E)  If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium. 
A)  The slope of the Security Market Line is beta. 
B)  Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive. 
C)  If a stock's beta doubles, its required rate of return must also double. 
D)  If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative. 
E)  If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

Question 8

Consider the following average annual returns for Stocks A and B and the Market.Which of the possible answers best describes the historical betas for A and B? $\begin{array}{rrrr}\text { Years } & \text { Market } & \text { Stock A }&\text { Stock B }\
1 & 0.03 & 0.16 & 0.05 \
2 & -0.05 & 0.20 & 0.05 \
3 & 0.01 & 0.18 & 0.05 \
4 & -0.10 & 0.25 & 0.05 \
5 & 0.06 & 0.14 & 0.05
\end{array}$

Accepted Answer

A)  bA > +1; bB = 0. 
B)  bA = 0; bB = ?1. 
C)  bA B = 0. 
D)  bA B = 1. 
E)  bA > 0; bB = 1. 
A)  bA > +1; bB = 0. 
B)  bA = 0; bB = ?1. 
C)  bA B = 0. 
D)  bA B = 1. 
E)  bA > 0; bB = 1.

Question 9

How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?

Accepted Answer

A)  The x-axis intercept would decline, and the slope would increase. 
B)  The y-axis intercept would increase, and the slope would decline. 
C)  The SML would be affected only if betas changed. 
D)  Both the y-axis intercept and the slope would increase, leading to higher required returns. 
E)  The y-axis intercept would decline, and the slope would increase. 
A)  The x-axis intercept would decline, and the slope would increase. 
B)  The y-axis intercept would increase, and the slope would decline. 
C)  The SML would be affected only if betas changed. 
D)  Both the y-axis intercept and the slope would increase, leading to higher required returns. 
E)  The y-axis intercept would decline, and the slope would increase.

Question 10

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant.Which of the following statements is CORRECT?

Accepted Answer

A)  The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. 
B)  Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. 
C)  The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. 
D)  The required return of all stocks will fall by the amount of the decline in the market risk premium. 
E)  The required return of all stocks will increase by the amount of the increase in the risk-free rate. 
A)  The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0. 
B)  Since the overall return on the market stays constant, the required return on each individual stock will also remain constant. 
C)  The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0. 
D)  The required return of all stocks will fall by the amount of the decline in the market risk premium. 
E)  The required return of all stocks will increase by the amount of the increase in the risk-free rate.

Question 11

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

Accepted Answer

A) True 
 B)False

Question 12

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. 
B)  If a company's beta were cut in half, then its required rate of return would also be halved. 
C)  If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase. 
D)  If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise. 
E)  If a company's beta doubles, then its required rate of return will also double. 
A)  Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. 
B)  If a company's beta were cut in half, then its required rate of return would also be halved. 
C)  If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase. 
D)  If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise. 
E)  If a company's beta doubles, then its required rate of return will also double.

Question 14

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

Accepted Answer

A) True 
 B)False

Question 15

You have a portfolio P that consists of 50% Stock X and 50% Stock Y.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.Given this information, which of the following statements is CORRECT?

Accepted Answer

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

Question 16

Stock A's beta is 1.7 and Stock B's beta is 0.7.Which of the following statements must be true about these securities? (Assume market equilibrium.)

Accepted Answer

A)  Stock B must be a more desirable addition to a portfolio than A. 
B)  Stock A must be a more desirable addition to a portfolio than B. 
C)  The expected return on Stock A should be greater than that on B. 
D)  The expected return on Stock B should be greater than that on A. 
E)  When held in isolation, Stock A has more risk than Stock B. 
A)  Stock B must be a more desirable addition to a portfolio than A. 
B)  Stock A must be a more desirable addition to a portfolio than B. 
C)  The expected return on Stock A should be greater than that on B. 
D)  The expected return on Stock B should be greater than that on A. 
E)  When held in isolation, Stock A has more risk than Stock B.

Question 17

If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10.However, if stocks are held in portfolios, it is possible that the required return could be higher on the stock with the low standard deviation.

Accepted Answer

A) True 
 B)False

Question 18

Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%.The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%.Based on the SML, what is the firm's required return?

Accepted Answer

A)  13.51% 
B)  13.86% 
C)  14.21% 
D)  14.58% 
E)  14.95% 
A)  13.51% 
B)  13.86% 
C)  14.21% 
D)  14.58% 
E)  14.95%

Question 19

Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%.Then an increase in investor risk aversion caused the market risk premium to rise by 2%.The risk-free rate and the firm's beta remain unchanged.What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.)

Accepted Answer

A)  14.38% 
B)  14.74% 
C)  15.11% 
D)  15.49% 
E)  15.87% 
A)  14.38% 
B)  14.74% 
C)  15.11% 
D)  15.49% 
E)  15.87%

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 $300,000 invested in Stock A and $100,000 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)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
C)  Portfolio AB's expected return is 11.0%. 
D)  Portfolio AB's beta is less than 1.2. 
E)  Portfolio AB's standard deviation is 17.5%. 
A)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. 
B)  The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. 
C)  Portfolio AB's expected return is 11.0%. 
D)  Portfolio AB's beta is less than 1.2. 
E)  Portfolio AB's standard deviation is 17.5%.

Exam 6: Risk and Return

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation.

Paul McLaren holds the following portfolio: Stock Investment Beta A \ 150,000 1.40 B 50,000 0.80 C 100,000 1.00 D 75,000 1.20 Total \ 375,000 Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75.By how much will the portfolio beta change?

Stocks A and B are quite similar: Each has 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?

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive.Which of the following statements is CORRECT?

Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Consider the following average annual returns for Stocks A and B and the Market.Which of the possible answers best describes the historical betas for A and B? Years Market Stock A Stock B 1 0.03 0.16 0.05 2 -0.05 0.20 0.05 3 0.01 0.18 0.05 4 -0.10 0.25 0.05 5 0.06 0.14 0.05

How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors also become more risk averse?

Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect being that the overall required return on the market, rM, remains constant.Which of the following statements is CORRECT?

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, its standard deviation.

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.

Which of the following statements is CORRECT?

If investors become less averse to risk, the slope of the Security Market Line (SML) will increase.

Stock A's beta is 1.7 and Stock B's beta is 0.7.Which of the following statements must be true about these securities? (Assume market equilibrium.)

Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%.The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%.Based on the SML, what is the firm's required return?

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

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Corporate Valuation and Financial Planning

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

Filters

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, r_M − r_RF, is positive.Which of the following statements is CORRECT?

Assume that the risk-free rate, r_RF, increases but the market risk premium, (r_M − r_RF), declines, with the net effect being that the overall required return on the market, r_M, remains constant.Which of the following statements is CORRECT?