FINA 361-Ch. 9

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. True or False

False

According to the basic DCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. True or False

False

Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? Select one: a. $29.05 b. $27.89 c. $30.21 d. $26.77 e. $31.42

a. $29.05

Nachman Industries just paid a dividend of D0 = $1.32. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value? Select one: a. $44.87 b. $42.65 c. $43.75 d. $41.59 e. $45.99

a. $44.87 Rationale: rs = 9.0% Year 0 1 2 3 Growth rates: 30.0% 10.0% 5.0% Dividend $1.32 $1.716 $1.888 $1.982 Horizon value = D3/(rs − g3) = 49.550 Total CFs $1.716 The correct answer is: $44.87

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? Select one: a. 1.46 b. 1.20 c. 1.32 d. 1.39 e. 1.26

b. 1.20 Rationale: Expected return 25.0% Standard deviation 30.0% Coefficient of variation = std dev/expected return = 1.2

If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock's expected dividend yield for the coming year? Select one: a. 4.42% b. 4.66% c. 5.13% d. 4.89% e. 5.39%

b. 4.66% Rationale: D0 $2.25 g 3.5% P0 $50.00 D1 = D0(1 + g) = $2.329 Dividend yield = D1/P0 = 4.66%

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.) Select one: a. 9.44% b. 9.21% c. 8.76% d. 9.68% e. 8.98%

b. 9.21% Rationale: Beta: A 1.30 Beta: B 0.80 A's required return 12.00% Risk-free rate 4.75% RPM = (A's return − rRF)/betaA = 5.58% B's required return = rRF + b(RPM) = 9.21%

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. Select one: a. A; A. b. B; A. c. A; B. d. C; A. e. C; B.

b. B; A.

Which of the following statements is CORRECT? Select one: a. 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. b. 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. c. 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. d. If a company's beta were cut in half, then its required rate of return would also be halved. e. If a company's beta doubles, then its required rate of return will also double.

b. 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.

Francis Inc.'s stock has a required rate of return of 10.25%, and it sells for $57.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1? Select one: a. $2.20 b. $2.69 c. $2.44 d. $2.96 e. $3.25

c. $2.44 Rationale: Stock price $57.50 Required return 10.25% Growth rate 6.00% P0 = D1/(rs − g), so D1 = P0(rs − g) Expected dividend = D1 = P0(rs − g) = $2.44

If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year? Select one: a. 8.81% b. 8.59% c. 8.37% d. 9.27% e. 9.03%

d. 9.27% Rationale: D0 $1.75 g 3.6% P0 $32.00 D1 = D0(1 + g) = $1.81 Total return = rs = D1/P0 + g 9.27%

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? Select one: a. 0.81 b. 0.73 c. 0.98 d. 0.89 e. 0.67

e. 0.67 Rationale: Expected return 15.0% Standard deviation 10.0% Coefficient of variation = std dev/expected return = 0.67

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. Select one: a. 10.29% b. 10.83% c. 12.60% d. 11.40% e. 12.00%

e. 12.00% Rationale: Real rate (r*): 3.00% IP: 4.00% RPM: 5.00% Beta: 1.00 Required return = rRF + b(RPM) = r* + IP + b(RPM) = 12.00%

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? Select one: a. If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%. b. If a stock's beta were 1.0, its required return under the CAPM would be 5%. c. If a stock's beta doubled, its required return under the CAPM would more than double. d. If a stock's beta doubled, its required return under the CAPM would also double. e. If a stock has a negative beta, its required return under the CAPM would be less than 5%.

e. If a stock has a negative beta, its required return under the CAPM would be less than 5%.

Portfolio A has but 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. True or False

False

The corporate valuation model can be used only when a company doesn't pay dividends. True or False

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. True or False

False

Preferred stock is a hybrid—a sort of cross between a common stock and a bond—in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond. True or False

False Rationale: Preferred dividends don't normally grow, and they are not guaranteed.

Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium. True or False

False Rationale: If one condition holds, then the other must also hold.

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. True or False

True

If markets are in equilibrium, which of the following conditions will exist? Select one: a. Each stock's expected return should equal its realized return as seen by the marginal investor. b. Each stock's expected return should equal its required return as seen by the marginal investor. c. All stocks should have the same expected return as seen by the marginal investor. d. The expected and required returns on stocks and bonds should be equal. e. All stocks should have the same realized return during the coming year.

b. Each stock's expected return should equal its required return as seen by the marginal investor.

Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% ​ Select one: a. Stock A must have a higher stock price than Stock B. b. Stock A must have a higher dividend yield than Stock B. c. Stock B's dividend yield equals its expected dividend growth rate. d. Stock B must have the higher required return. e. Stock B could have the higher expected return.

b. Stock A must have a higher dividend yield than Stock B. Rationale: Statement b is true, because Stock A has a higher required return but the stocks have the same growth rate, so Stock A must have the higher dividend yield.

Based on the corporate valuation model, Gay Entertainment's total corporate value is $1,200 million. The company's balance sheet shows $120 million of notes payable, $300 million of long-term debt, $50 million of preferred stock, $180 million of retained earnings, and $800 million of total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of its price per share? Select one: a. $29.44 b. $26.77 c. $24.33 d. $21.90 e. $32.39

c. $24.33 Rationale: Assuming that the book value of debt is close to its market value, the total market value of the firm's equity is: Total corporate value $1,200 Notes payable −$ 120 Long-term debt −$ 300 Preferred stock −$ 50 MV equity $ 730 Shares outstanding 30 Stock price = Value of equity/Shares outstanding = $24.33 The book value of equity figures are irrelevant for this problem.

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? Select one: a. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. b. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. c. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. d. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. e. The required returns on all stocks have fallen by the same amount.

d. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.

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? Select one: a. Stocks' required returns would change, but so would expected returns, and the result would be no change in stocks' prices. b. The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0. c. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks. d. The required return on all stocks would increase by the same amount. e. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.

e. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.