Big Time 1
True
"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities
Mike Flannery 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 What is the portfolio's beta?
1.17
Charleston Corporation (CC) now operates as a "regular" corporation, but it is considering a switch to S Corporation status. CC is owned by 100 stockholders who each hold 1% of the stock, and each faces a personal tax rate of 35%. The firm earns $2,800,000 per year before taxes, and since it has no need for retained earnings, it pays out all of its earnings as dividends. Assume that the corporate tax rate is 34% and the personal tax rate is 35%. How much more (or less) spendable income would each stockholder have if the firm elected S Corporation status?
6,188 Calculate S Corp Status Corporate Rate 34% = 2,800,000 * 0.66 = 952,000 to distribute to 100 stockholders. 952,000/100 = 9,520 Now each stockholder pays taxes at 35% 9520 * 0.65 = 6,188 Double Taxed at the Corporate/Personal Levels
Which of the following statements is CORRECT?
A SECURITY'S BETA measures its non-diversifiable, or market, risk relative to that of an average stock.
True
A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions
Which of the following statements is CORRECT?
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.
Which of the following statements is CORRECT?
A portfolio with a large number of randomly selected stocks would have MORE market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.
False
A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
False
A stock with a beta equal to -1.0 has zero systematic (or market) risk
False
A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio
False
A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms
Inflation, recession, and high interest rates are economic events that are best characterized as being
AMONG THE FACTORS that are responsible for market risk.
True
According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well diversified portfolio.
Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?
Adding more such stocks will reduce the portfolio's unsystematic, or DIVERSIFIABLE, risk.
With which of the following statements would most people in business agree? a. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. b. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. c. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. d. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. e. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Which of the following statements is CORRECT?
An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant.
Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?
An index fund with beta = 1.0 should have a required return of 11%.
False
An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held.
Which of the following statements is CORRECT?
An investor can eliminate virtually all DIVERSABLE RISK if he or she holds a very large, well-diversified portfolio of stocks
True
Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock's price, other things held constant.
Which of the following statements is CORRECT?
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.
You have the following data on three stocks: Stock Standard Deviation Beta A 20% 0.59 B 10% 0.61 C 12% 1.29 If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
B;A
True
Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away.
True
Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.
Which of the following statements is CORRECT? a. Because of their size, large corporations face fewer regulations than smaller corporations and proprietorships. b. Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders. c. Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interests. d. Corporations have unlimited liability. e. Corporations are taxed more favorably than proprietorships.
Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders.
You observe the following information regarding Companies X and Y: • Company X has a higher expected return than Company Y. • Company X has a lower standard deviation of returns than Company Y. • Company X has a higher beta than Company Y. Given this information, which of the following statements is CORRECT?
Company X has a lower coefficient of variation than Company Y.
Which of the following statements is CORRECT?
DIVERSIFIABLE RISK can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
Which of the following statements is CORRECT?
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.
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?
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.
True
Diversification will normally reduce the riskiness of a portfolio of stocks.
False
Even if the correlation between the returns on two securities is +1.0, if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone.
If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby increase profits above the correct profits because he or she was told to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted.
F
If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses.
False
If management operates in a manner designed to maximize the firm's expected profits for the current year, this will also maximize the stockholders' wealth as of the current year.
False
In order to maximize its shareholders' value, a firm's management must attempt to maximize the expected EPS.
False
In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price on a specific target date.
False
Partnerships and proprietorships generally have a tax advantage over corporations.
False
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?
If Stock A's required return is 11%, then the market risk premium is 5%.
Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
If a stock has a negative beta, its required return under the CAPM would be less than 5%.
Which of the following statements is CORRECT?
If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be negative.
False
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.
Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT?
If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB will increase by more than that on Stock LB.
True
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 lower standard deviation
False
If investors become less averse to risk, the slope of the Security Market Line (SML) will increase
Which of the following statements is CORRECT?
If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted.
Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?
If the EXPECTED RATE of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?
If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y.
Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
True
If the price of money (e.g., interest rates and equity capital costs) increases due to an increase in anticipated inflation, the risk-free rate will also increase. If there is no change in investors' risk aversion, then the market risk premium (rM - rRF) will remain constant. Also, if there is no change in stocks' betas, then the required rate of return on each stock as measured by the CAPM will increase by the same amount as the increase in expected inflation.
True
If the returns of two firms are negatively correlated, then one of them must have a negative beta.
Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM − rRF), equals 4%. Which of the following statements is CORRECT?
If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
The risk-free rate is 6% and the market risk premium is 5%. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is CORRECT?
If the risk-free rate remains unchanged but the market risk premium increases by 2%, your portfolio's required return will increase by more than 2%.
Which of the following statements is CORRECT?
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.
Which of the following statements is CORRECT?
If you FORMED A PORTFOLIO that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
True
If you plotted the returns of a company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a welldiversified investor, assuming that the observed relationship is expected to continue in the future.
False
If you plotted the returns on a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be greater than the riskfree rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.
Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct.
In EQUILIBRIUM, the expected return on Stock A will be greater than that on B.
True
In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really interested in ex ante (future) data
True
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.
False
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.
True
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.
The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to
Maximize the stock price per share over the long run, which is the stock's intrinsic value
True
Most corporations earn returns for their stockholders by acquiring and operating tangible and intangible assets. The relevant risk of each asset should be measured in terms of its effect on the risk of the firm's stockholders.
Which of the following statements is CORRECT? a. Corporations face few regulations and more favorable tax treatment than do proprietorships and partnerships. b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value compared to managers who do not face the threat of hostile takeovers. c. Bond covenants are an effective way to resolve conflicts between shareholders and managers. d. Because of their simplified organization, it is easier for proprietors and partnerships to raise large amounts of outside capital than it is for corporations. e. One advantage to forming a corporation is that the owners of the firm have limited liability.
One advantage to forming a corporation is that the owners of the firm have limited liability.
True
One key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both the risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.
Which of the following statements is CORRECT? a. One of the advantages of the corporate form of organization is that it avoids double taxation. b. It is easier to transfer one's ownership interest in a partnership than in a corporation. c. Corporations of all types are subject to the corporate income tax. d. One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability. e. One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote."
One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability.
True
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.
False
Portfolio A has only one stock, while Portfolio B consists of all stocks that trade in the market, each held in proportion to its market value. Because of its diversification, Portfolio B will by definition be riskless.
Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB was created by investing in a combination of Stocks A and B. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT?
Portfolio AB has more money invested in Stock A than in Stock B.
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 $900,000 invested in Stock A and $300,000 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?
Portfolio AB's expected return is 11.0%
Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. Expected Standard Stock Return Deviation Beta A 10% 20% 1.0 B 10% 10% 1.0 C 12% 12% 1.4 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT?
Portfolio ABC's expected return is 10.66667%.
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?
Portfolio P has a STANDARD DEVIATION that is less than 25%.
Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.)
Portfolio P has a beta of 1.0
Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is +0.6. Portfolio P has 50% invested in Stock A and 50% invested in B. Which of the following statements is CORRECT?
Portfolio P has more market risk than Stock A but less market risk than B.
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. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?
Portfolio P has the same required return as the market (rM).
Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?
Portfolio P's expected return is equal to the expected return on Stock B.
True
Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse
True
Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk.
Over the past 84 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?
Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
True
Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.
Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM − rRF, is 6%. Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT?
Stock A's beta is 0.8333
A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?
Stock B
Which of the following statements is CORRECT?
Suppose the RETURNS on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year PERIOD.
Which of the following statements is CORRECT?
Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well diversified investor, assuming investors expect the observed relationship to continue on into the future.
Which of the following statements is CORRECT?
The BETA COEFFICIANT of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the FUTURE.
In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement is false?
The BETA of the portfolio is LOWER than the lowest of the three betas.
False
The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.
Which of the following statements is CORRECT?
The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
False
The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line can be influenced by a manager's actions
False
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.
True
The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate.
Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?
The beta of an "average stock," or "the market," can change over time, sometimes DRASTICALLY
For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?
The beta of the portfolio is EQUALl to the weighted average of the betas of the individual stocks.
True
The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.
False
The distributions of rates of return for Companies AA and BB are given below: State of the Economy Probability of This State Occurring AA BB Boom 0.2 30% -10% Normal 0.6 10% 5% Recession 0.2 -5% 50% We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.
Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?
The diversifiable risk of your portfolio will likely decline, but the expected market risk should NOT CHANGE.
For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels,
The expected rate of return must be equal to the required rate of return; that is, = r.
Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed's actions would lead to a recession, and that led to an increase in the market risk premium, (rM - rRF). Under these conditions, with other things held constant, which of the following statements is most correct?
The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
False
The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.
Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?
The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium.
Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?
The required return on Portfolio P would increase by 1%.
Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?
The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur?
The required return on a stock with a positive beta < 1.0 will decline
During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT?
The required return will fall for all stocks, but it will fall more for stocks with higher betas.
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?
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
Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?
The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?
The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.
True
The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML.
False
The slope of the SML is determined by the value of beta.
Which of the following statements is CORRECT?
The slope of the security market line is equal to the market risk premium, (rM − rRF).
Which of the following statements is CORRECT?
The slope of the security market line is equal to the market risk premium.
False
The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly
Which of the following statements is CORRECT? a. The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders. b. The threat of takeovers tends to reduce potential conflicts between stockholders and managers. c. Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. d. One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. e. The threat of takeover generally increases potential conflicts between stockholders and managers.
The threat of takeovers tends to reduce potential conflicts between stockholders and managers.
False
The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation
Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows:
The y-axis intercept would decline, and the slope would increase
If a corporation elects to be taxed as an S corporation, then it can avoid the corporate tax. However, its stockholders will have to pay personal taxes on the firm's net income.
True
Organizing as a corporation makes it easier for the firm to raise capital. This is because corporations' stockholders are not subject to personal liabilities if the firm goes bankrupt and also because it is easier to transfer shares of stock than partnership interests.
True
The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.
True
The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation.
True
False
Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return
True
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, the standard deviation
The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to
WRONG - Maximize the fir's expected EPS, which must also maximize the firm's price per share.
Which of the following statements is CORRECT?
WRONG - Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over proprietorships and partnerships.
False
We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.
False
We would generally find that the beta of a single security is more stable over time than the beta of a diversified portfolio
True
When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.
Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio?
Your portfolio has a beta equal to 1.6, and its expected return is 15%.
Bae Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation?
a. 0.67
Tom O'Brien has a 2-stock portfolio with a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is his portfolio's beta?
a. 1.17
Cheng Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation?
a. 1.20
Mulherin's stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.)
a. 10.36%
Data for Dana Industries is shown below. Now Dana acquires some risky assets that cause its beta to increase by 30%. In addition, expected inflation increases by 2.00%. What is the stock's new required rate of return? Initial beta 1.00 Initial required return (rs) 10.20% Market risk premium, RPM 6.00% Percentage increase in beta 30.00% Increase in inflation premium, IP 2.00%
a. 14.00%
Mikkelson Corporation'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.)
a. 14.38%
Porter Inc's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?
a. 5.80%
Assume that you manage a $10.00 million mutual fund that has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. You now receive another $5.00 million, which you invest in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.)
a. 8.83%
Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?
average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%.
Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? Probability Stock's State of of State Expected the Economy Occurring Return Boom 0.45 25% Normal 0.50 15% Recession 0.05 5%
b. 0.3069
Jim Angel holds a $200,000 portfolio consisting of the following stocks: Stock Investment Beta A $ 50,000 0.95 B 50,000 0.80 C 50,000 1.00 D 50,000 1.20 Total $200,000
b. 0.988
Jill Angel holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875. Stock Investment Beta A $ 50,000 0.50 B 50,000 0.80 C 50,000 1.00 D 50,000 1.20 Total $200,000 If Jill replaces Stock A with another stock, E, which has a beta of 1.50, what will the portfolio's new beta be?
b. 1.13
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?
b. 1.76
Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 13.0% and a beta of 1.50. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock?
b. 11.20%; 1.23
Nagel Equipment has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return?
b. 11.63%
Carson Inc.'s manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.) Economic Conditions Prob. Return Strong 30% 32.0% Normal 40% 10.0% Weak 30% -16.0%
b. 18.62%
Returns for the Dayton Company over the last 3 years are shown below. What's the standard deviation of the firm's returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.) Year Return 2012 21.00% 2011 -12.50% 2010 25.00%
b. 20.59%
Suppose you hold a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose you decided to sell one of your stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be?
c. 1.29
Assume that you are the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund? Stock Amount Beta A $1,075,000 1.20 B 675,000 0.50 C 750,000 1.40 D 500,000 0.75 $3,000,000
c. 11.11%
Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?
c. 11.95%
CCC Corp has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points). Neither betas nor the risk-free rate change. What would CCC's new required return be?
c. 16.50%
Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)
c. 9.21%
Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and a 20% chance of producing a -28% return. What is the firm's expected rate of return?
c. 9.90%
Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
coefficient of variation; Beta
Tom Noel 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 Tom 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?
d. -0.260
Kollo 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 Kollo's required rate of return?
d. 10.17%
Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.
d. 12.00%
Assume that your uncle holds just one stock, East Coast Bank (ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for West Coast Bank (WCB). Both banks have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your uncle's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.) Year ECB WCB 2008 40.00% 40.00% 2009 -10.00% 15.00% 2010 35.00% -5.00% 2011 -5.00% -10.00% 2012 15.00% 35.00% Average return = 15.00% 15.00% Standard deviation = 22.64% 22.64%
d. 3.84%
Dothan Inc.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return?
d. 9.00%
You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. 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
d. bA < 0; bB = 0.
Bill Dukes has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?
e. 0.98
You hold a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each. The portfolio's beta is 1.12. You plan to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 1.80. What will the portfolio's new beta be?
e. 1.165
Consider the following information and then calculate the required rate of return for the Global Investment Fund, which holds 4 stocks. The market's required rate of return is 13.25%, the risk-free rate is 7.00%, and the Fund's assets are as follows: Stock Investment Beta A $ 200,000 1.50 B 300,000 -0.50 C 500,000 1.25 D $1,000,000 0.75
e. 11.77%
Linke Motors 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?
e. 14.95%
Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)
e. 3.38%
