BCOR 340 Quiz Three

Based on the capital asset pricing model, which one of the following must increase the expected return on an individual security, all else held constant?

A decrease in the risk-free rate given a security beta of 1.06

Which one of the following statements is correct? Assume the pretax cost of debt is less than the cost of equity. A. A firm may change its capital structure if the government changes its tax policies. B. A decrease in the dividend growth rate increases the cost of equity. C. A decrease in the systematic risk of a firm will increase the firm's cost of capital. D. A decrease in a firm's debt-equity ratio will decrease the firm's cost of capital. E. The cost of preferred stock decreases when the tax rate increases.

A firm may change its capital structure if the government changes its tax policies.

A portfolio is

A group of assets held by an investor

Which one of the following portfolios will have a beta of zero

A portfolio comprised solely of U.S. Treasury bills

Which statement is correct? A. An underpriced security will plot below the security market line. B. A security with a beta of 1.54 will plot on the security market line if it is correctly priced. C. A portfolio with a beta of .93 will plot to the right of the overall market. D. A security with a beta of .99 will plot above the security market line if it is correctly priced. E. A risk-free security will plot at the origin.

A security with a beta of 1.54 will plot on the security market line if it is correctly priced.

The amount of systematic risk present in a particular risky asset relative to that in an average risky asset is measured by the

Beta coefficient

The security market line is a linear function that is graphed by plotting data points base on the relationship between the

Expected return and beta

The security market line is defined as a positively sloped straight line that displays the relationship between the

Expected return and beta of either a security or a portfolio

World united stock currently plots on the security market line and has a beta of 1.04. Which one of the following will increase that stock's rate of return without affecting the risk level of the stock, all else constant?

Increase in the market risk-to-reward ratio.

A firm that uses its weighted average cost of capital as the required return for all of its investments will

Increase the risk level of the firm over time

In an efficient market, the cost of equity for a highly risky firm

Increases in direct relation to the stock's systematic risk

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an aftertax cost of debt of 5.2 percent, and a tax rate of 35 percent. Given this, which one of the following will increase the firm's weighted average cost of capital?

Increasing the firm's beta

Julie wants to create a $5,000 portfolio. She also wants to invest as much as possible in a high-risk stock with the hope of earning a high rate of return. However, she wants her portfolio to have no more risk than the overall market. Which one of the following portfolios is most apt to meet all of her objectives?

Invest $2,500 in a risk-free asset and $2,500 in a stock with a beta of 2.0

The cost of preferred stock

Is equal to the stocks dividend yield

When evaluating a project, the dividend growth model:

Is relatively simple to use

The systematic risk principle states that the expected return on a risky asset depends only on the asset's ________ risk.

Market

Unsystematic risk can be defined by all of the following except

Market Risk

The slope of the security market line represents the

Market Risk Premium

Systematic risk is

Measured by beta

If a security plots to the right and below the security market line, then the security has ______ systematic risk than the market and is _____.

More; Overpriced

Diversifying a portfolio across various sectors and industries might do more than one of the following. However, this diversification must do which one of the following? A. Increase the expected risk premium B. Reduce the beta of the portfolio to one C. Increase the security's risk premium D. Reduce the portfolio's systematic risk level E. Reduce the portfolio's unique risks

Reduce the portfolios unique risks

Consider a portfolio comprised of four risky securities. Assume the economy has three economic states with varying probabilities of occurrence. Which one of the following will guarantee that the portfolio variance will equal zero?

The portfolio expected rate of return must be the same for each economic state.

The expected rate of return on Delaware Shores stock is based on three possible states of the economy. These states are boom, normal, and recession which have probabilities of occurrence of 20 percent, 75 percent, and 5 percent, respectively. Which one of the following statements is correct concerning the variance of the returns on this stock?

The variance must be positive provided that each state of the economy produces a different expected rate of return.

Standard deviation measures (blank) risk while beta measures (blank) risk

Total; systematic

True or False: If a risky security is correctly priced, its expected risk premium will be positive.

True

True or False: The weights of the securities held in any portfolio must equal 1.0.

True

True or false: An underpriced security will plot above the security market line.

True

Which one of the following best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

Portfolio diversification eliminates

Unsystematic Risk

. Lester's is a globally diverse company with multiple divisions and a cost of capital of 15.8 percent. Med, Inc., is a specialty firm in the medical equipment field with a cost of capital of 13.7 percent. With the aging of America, both firms recognize the opportunities that exist in the medical field and are considering expansion in this area. At present, there is an opportunity for multiple firms to be involved in a new medical devices project. Each project will require an initial investment of $8.4 million with annual returns of $2.2 million per year for seven years. Which company(ies), if either, should become involved in the new projects? A. Lester's only B. Med, Inc., only C. Both Lester's and Med, Inc. D. Neither Lester's nor Med, Inc. E. The answer cannot be determined based on the information provided.

C. Both Lester's and Med, Inc.

Which of the following is the best example of unsystematic risk?

Warehouse Fire

Which one of the following represents the minimum rate of return a firm must earn on its assets if it is to maintain the current value of its securities? A. Cost of equity B. Pretax cost of debt C. Aftertax cost of debt D. Weighted average cost of capital E. Weighted average cost of preferred and common stock

Weighted average cost of capital

A portfolio is comprised of 35 securities with varying betas. The lowest beta for an individual security is .74 and the highest of the security betas of 1.51. Given this information, you know that the portfolio beta

Will be greater than or equal to .74, but less than or equal to 1.51.

All else constant, in increase in a firm's cost of debt

Will result in an increase in the firms cost of capital

Which of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?

Zero

The addition of a risky security to a fully diversified portfolio

may or may not affect the portfolio beta

Assume you own a portfolio of diverse securities which are each correctly prices. Given this, the reward-to-risk ratio:

of each security must equal the slope of the security market line.

For a risky security to have a positive expected return but less risk than the overall market, the security must have a beta

that is > 0 but < 1.

Which one of the following is the computation of the risk premium for an individual security? E(R) is the expected return on the security, Rf is the risk-free rate, Beta (symbol) is the security beta, and E(Rm) is the expected rate of return on the market.

β[E(RM) - Rf]

A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock?

Decrease in the probability of an economic boom

Which term best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

Diversification

Systematic risk is defined as

Any risk that affects a large number of assets

The results of the dividend growth model

Are sensitive to the rate of dividend growth

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

Automatically gives preferential treatment in the allocation of funds to its riskiest division

The capital asset pricing model

Considers the relationship between the fluctuations in a security's returns versus the market's returns.

Which one of the following is the minimum required rate of return on a new investment that makes that investment attractive?

Cost of capital

Lester lent money to The Corner Store by purchasing bonds issued by the store. The rate of return that he and the other lenders require is referred to as the

Cost of debt

Katie owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that Katie and the other shareholders require on their investment in ABC?

Cost of equity

The weighted average cost of capital is defined as the weighted average of a firm's

Cost of equity, cost of preferred, and its after tax cost of debt.

Bob's is a retail chain of specialty hardware stores. The firm has 18,000 shares of stock outstanding that are currently valued at $82 a share and provide a rate of return of 13.2 percent. The firm also has 600 bonds outstanding that have a face value of $1,000, a market price of $1,032, and a coupon rate of 7 percent. These bonds mature in 7 years and pay interest semiannually. The tax rate is 35percent. The firm is considering expanding by building a new superstore. The superstore will require an initial investment of $9.3 million and is expected to produce cash inflows of $1.07 million annually over its 10-year life. The risks associated with the superstore are comparable to the risks of the firm's current operations. The initial investment will be depreciated on a straight line basis to a zero book value over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for an aftertax value of $4.7 million. Should the firm accept or reject the superstore project and why? A. Accept; The project's NPV is $1.27 million. B. Accept; The NPV is $4.89 million. C. Reject; The NPV is $1.06 million. D. Reject; The NPV -$1.15 million. E. Reject; The NPV is -$5.71 million.

D. Reject; The NPV -$1.15 million.

Which one of these is the best example of a systematic risk?

Decrease in Gross Domestic Product

Farmer's Supply is considering opening a clothing store, which would be a new line of business for the firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate to evaluate this proposed expansion. Which of the following terms describes this evaluation approach?

Pure play approach

Ted is trying to decide what cost of capital he should assign to a project. Which one of the following should be his primary consideration in this decision

Risk level of the project

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the

Risk-Free rate decreases

Which of the following is the vertical intercept of the security market line? A. Market rate of return B. Individual security rate of return C. Market risk premium D. Individual security beta multiplied by the market risk premium E. Risk-free rate

Risk-free rate

According to the capital asset pricing model the expected return on a security will be affected by all of the following except the

Security's Standard Deviation

The expected return on a security is not affected by the

Security's unique risks

Which one of the following is the best example of an announcement that is most apt to result in an unexpected return?

Statement by a firm that it has just discovered a manufacturing defect and is recalling its product

Kate is the CFO of a major firm and has the job of assigning discount rates to each project under consideration. Kate's method of doing this is to assign an incrementally higher rate as the risk level of the project increases and a lower rate as the risk level declines. Kate is applying the ___ approach.

Subjective

The risk premium for an individual security is based on which one of the following types of risk? Total Surprise Diversifiable Systematic Unsystematic

Systematic

Which one of the following statements is correct related to the dividend growth model approach to computing the cost of equity?

The annual dividend use in the computation must be for Year 1 if you are Time 0's stock price to compute the return

A firm has a return on equity of 12.4 percent according to the dividend growth model and a return of 18.7 percent according to the capital asset pricing model. The market rate of return is 13.5 percent. What rate should the firm use as the cost of equity when computing the firm's weighted average cost of capital (WACC)?

The arithmetic average of 12.4 percent and 18.7 percent

All else constant, the weighted average cost of capital for a risky, levered firm will decrease if:

The firm's bonds start selling at a premium rather than at a discount

The beta of a risky portfolio cannot be less than _____ nor greater than ______

The lowest individual beta in the portfolio; The highest individual beta in the portfolio

Black Stone Furnaces wants to build a new facility. The cost of capital for this investment is primarily dependent on which on e of the following>

The nature of the investment