Exam 3

Suppose a stock had an initial price of $70 per share, paid a dividend of $1.35 per share during the year, and had an ending share price of $77. Compute the percentage total return.

11.93%

You own a portfolio that has $1,900 invested in Stock A and $3,850 invested in Stock B. If the expected returns on these stocks are 12 percent and 18 percent, respectively, what is the expected return on the portfolio?

16.02%

Which of the following are components used in the construction of the WACC?

Cost of preferred stock, cost of common stock, and cost of debt

Which of the following are examples of a portfolio?

Investing $100,000 in the stocks of 50 publicly traded corporations, holding $100,000 investment in a combination of stocks and bonds, and investing $100,000 in a combination of U.S. and Asian stocks

Which of the following statements regarding unsystematic risk is accurate?

It can be effectively eliminated by portfolio diversification.

As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?

It may eventually be almost totally eliminated and it is likely to decrease.

What is the intercept of the security market line (SML)?

The risk-free rate

If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?

The riskier division's projects will typically receive full funding and the less risky division's projects will often be incorrectly rejected.

The __________ coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.

beta

The cost of _________ is the minimum required return on a new investment.

capital

The ________ explains the relationship between the expected return on a security and the level of that security's systematic risk.

capital asset pricing model

Finding a firm's overall cost of equity is __________

difficult

To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.

dividend

Projects that have the same risk are said to be in the same _____.

risk class

The geometric average rate of return is approximately equal to ___.

the arithmetic mean minus half of the variance

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21 percent, the required rate of return on its preferred stock is found by which formula?

$2/$20

Based on average historical returns shown in the text, small-company stocks increased in value by _____ percent in a typical year.

16

True or false: Systematic risk can be eliminated by diversification

False

True or false: The process to calculate a portfolio's beta is opposite of the process to calculate a portfolio's expected return.

False

What is unsystematic risk?

It is a risk that affects a single asset or a small group of assets.

What is systematic risk?

It is a risk that pertains to a large number of assets

Which one of the following statements is correct based on the historical record for the period 1926-2019?

Long-term government bonds had a lower return but a higher standard deviation, on average, than did long-term corporate bonds.

In addition to CAPM, the cost of equity can be determined using the dividend growth model and the _____ approach.

SML

________ measures total risk, and ________ measures systematic risk.

Standard deviation; beta

With respect to unexpected returns, which one of the following statements is accurate?

Unexpected returns can be either positive or negative in the short term but tend to be zero over the long term.

If a firm has multiple projects, each project should be discounted using:

a discount rate that commensurates with the project's risk.

The calculation of a portfolio beta is similar to the calculation of _____.

a portfolio's expected return

Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.

a positive

When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market _____.

already knew about most of the news item

When we ___________ an announcement or a news item, we say that it has less of an impact on price because the market already factored it in.

discount

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____.

increases; increases

The most appropriate weights to use in the WACC are the ______ weights.

market value

preferred stock __________

pays a constant dividend and pays dividends in perpetuity

Buchi owns several financial instruments: stocks issued by seven different companies, plus bonds issued by four different companies. Her investments are best described as a(n):

portfolio

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be _____.

rejected, when it should be accepted

In the Ibbotson-Sinquefield study, the U.S. small-company common stock portfolio corresponds to the bottom fifth, in terms of market value, of stocks traded on ____.

the New York Stock Exchange

To determine whether an investment has a positive NPV, you can compare the expected return on that new investment to what the financial market offers on an investment with _____.

the same beta

The cost of capital depends primarily on the __________ of funds.

use

To estimate the growth rate of a particular stock, we can ___.

use the historical dividend growth rate and security analysts' forecasts

An asset has an average return of 10.59 percent and a standard deviation of 19.38 percent. What range of returns should you expect to see with a 68 percent probability?

−8.79% to 29.97%

Studying market history can reward us by demonstrating that _____.

-on average, investors will earn a reward for bearing risk -the greater the potential reward is, the greater the risk

You own the following portfolio of stocks. What is the portfolio weight of Stock C? Stock Number of Shares Price per Share A 120 $30 B 730 $26 C 450 $50 D 220 $49

.4028

The risk-free asset has a beta of _____.

0.00

You own a stock portfolio invested 15 percent in Stock Q, 20 percent in Stock R, 20 percent in Stock S, and 45 percent in Stock T. The betas for these four stocks are 0.97, 0.96, 0.73, and 0.76, respectively. What is the portfolio beta?

0.83

By definition, what is the beta of the average asset equal to?

1

If a security's expected return is equal to the expected return on the market, its beta must be ____.

1

The Treasury bills used in the Ibbotson-Sinquefield studies had maturities of ___.

1 month

The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?

10.9% and 12.9%

Bonds used in Ibbotson-Sinquefield's long-term U.S. government bond portfolio had maturities of ____ years.

20

Galvatron Metals has a bond outstanding with a coupon rate of 6 percent and semiannual payments. The bond currently sells for $1,940 and matures in 20 years. The par value is $2,000 and the company's tax rate is 21 percent. What is the company's aftertax cost of debt?

4.95%

The probability of an outcome being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.

68

For the period 1926-2019, the average risk premium on large-company stocks was about:

8.7%

The probability of an outcome being within ± two standard deviations of the mean in a normal distribution is approximately ____ percent.

95

According to the CAPM, which of the following events would affect the return on a risky asset?

A change in the yield on T-bills, a strengthening of the country's currency, and federal reserve actions that affect the economy

Which one of the following statements best defines the efficient market hypothesis?

All securities in an efficient market are zero net present value investments.

Asset A has an expected return of 17 percent and standard deviation of 5 percent. Asset B has an expected return of 15 percent and standard deviation of 5 percent. Which asset would a rational investor choose?

Asset A

Consider the following two assets: Asset Expected Return Beta X 5.8% 0.8 Y 14.2% 1.8 If the risk free rate is 1%, what will happen to the prices of assets X and Y in an efficient market?

Asset Y's price will rise and Asset X's price will fall

How can a positive relationship between the expected return on a security and its beta be justified?

Because the difference between the return on the market and the risk-free rate is likely to be positive

Which of the following are true?

Book values are often similar to market values for debt. Ideally, we should use market values in the WACC.

What can we say about the dividends paid to common and preferred stockholders?

Dividends to common stockholders are not fixed. Dividends to preferred stockholders are fixed.

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B

Which one of the following statements is accurate?

Eliminating unsystematic risk is the responsibility of the individual investor.

What is the equation for the capital asset pricing model?

Expected return on security = Risk-free rate + Beta × (Return on market - Risk-free rate)

True or false: Based on capital market history, market efficiency shows us that it is relatively simple to identify stocks that are incorrectly priced.

False

True or false: Projects should always be discounted at the firm's overall cost of capital.

False: Projects' discount rates should reflect their particular level of risk.

Generally speaking, which of the following best correspond to a wide frequency distribution?

High standard deviation, large risk premium

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model.

Which of the following statements regarding the weighted average cost of capital is accurate?

It is the return investors require on the total assets of the firm.

What is the definition of expected return?

It is the return that an investor expects to earn on a risky asset in the future.

Which one of the following statements related to market efficiency tends to be supported by current evidence?

Markets tend to respond quickly to new information.

With respect to returns, which one of the following statements is accurate?

Over time, the average unexpected return will be zero.

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

Which of the following are examples of systematic risk?

Regulatory changes in tax rates and future rates of inflation

In the Ibbotson study, the large-company common stock portfolio is based on the ____.

S & P 500 Index

Mona Corporation has a variance of returns of 343, while Scott Corporation has a variance of returns of 898. Which company's actual returns vary more from their mean return?

Scott Corporation

Arrange the following investments from highest to lowest return based on what our study of capital market history has revealed about risk premiums.

Small-company common stock Long-term corporate bonds U.S. Treasury bills

Which of the following statements best describes the principle of diversification?

Spreading an investment across many diverse assets will eliminate some of the total risk.

Based on the capital asset pricing model (CAPM), which of the following should earn the highest risk premium?

Stock with a beta of 1.24

Which of the following are examples of information that may impact the risky return of a stock?

The Fed's decision on interest rates at their meeting next week and the outcome of an application currently pending with the Food and Drug Administration.

Vanessa purchased a stock one year ago and sold it today for $3.15 per share more than her purchase price. She received a total of $2.60 per share in dividends. Which one of the following statements is correct in relation to this investment?

The capital gains yield is positive.

What are the two components of the market risk premium?

The expected return on the market and risk-free rate

What is the expected return on a security with beta of 1?

The expected return on the market.

What is the slope of the security market line (SML)?

The market-risk premium

Using the SML approach, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

With respect to risk, which of the following statements is accurate?

The systematic risk of a portfolio can be lowered by adding T-bills to the portfolio.

How are the unsystematic risks of two different companies in two different industries related?

There is no relationship.

Which is true of flotation costs in calculating WACC?

They are relevant cash flows.

What is the equation for total return as a function of expected and unexpected returns?

Total return = Expected return + Unexpected return

True or false: The existence of traders attempting to beat the market is a necessary precondition for markets to become efficient.

True

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

The Ibbotson-Sinquefield data shows that ___.

U.S. T-bills had the lowest risk or variability and long-term corporate bonds had less risk or variability than stocks

Arrange the following investments in ascending order from lowest historical risk premium at the top to highest historical risk premium at the bottom.

U.S. Treasury Bills Long-term corporate bonds Large-company stocks Small-company stocks

Which one of the following categories of securities had the lowest average risk premium for the period 1926-2019?

U.S. Treasury bills

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.

If you wish to create a portfolio of stocks, what is the required minimum number of stocks?

You must invest in stocks of more than one corporation.

B = the market value of a firm's debt S = the market value of that same firm's equity RB = the before-tax yield on the firm's debt TC = the corporate tax rate RS = the cost of equity Given the definitions above, the weighted average cost of capital formula can be written as:

[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)

The best way to include flotation costs is to ___.

add them to the initial investment

The WACC is the weighted average of the cost of equity and the _____.

aftertax cost of debt

In an efficient market:

all investments are zero NPV investments and assets are priced at the present value of their future cash flows

The __________ is the excess return an asset earns based on the level of risk taken.

alpha

What is the term for the excess return an asset earns based on the level of risk taken?

alpha

If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?

an efficient market reaction

Percentage returns are more convenient than dollar returns because they ____.

apply to any amount invested

The dividend yield for a 1-year period is equal to the annual dividend amount divided by the ______.

beginning stock price

Of the options listed below, which is the best measure of systematic risk?

beta

The SML approach requires estimates of the _____.

beta coefficient and market risk premium

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably _____.

better than no risk adjustment

Flotation costs are costs incurred to ____.

bring new security issues to the market

Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.

cannot

The __________ ains yield can be found by taking the difference between the ending stock price and the initial stock price and dividing it by the initial stock price.

capital

The total dollar return is the sum of dividends and __________.

capital gains or losses

When a company declares a dividend, shareholders generally receive ______.

cash

Which of the following are examples of unsystematic risk?

changes in management and labor strikes

The average return on the stock market can be used to ___.

compare stock returns with the returns on other securities

The geometric rate of return takes ______ into account.

compounding

Which of the following is commonly used to measure inflation?

consumer price index (CPI)

The minimum required return on a new project when its risk is similar to that of projects the firm currently owns is known as the _____.

cost of capital

The rate used to discount project cash flows is known as the ___.

cost of capital, discount rate, and required return

The increase in the number of stocks in a portfolio results in a(n) __________ in the average standard deviation of annual portfolio returns.

decline

Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio _____.

declines

One method for estimating the cost of equity is based on the ______ model.

dividend growth

Which of the following are ways to make money by investing in stocks?

dividends and capital gains

The total dollar return on a stock is the sum of the ____ and the _____.

dividends; capital gains

A firm's cost of debt can be ___.

estimated easier than its cost of equity, obtained by checking yields on publicly traded bonds, and obtained by talking to investment bankers

The __________ return is the return that an investor will probably earn on a risky asset in the future.

expected

True or false: The cost of debt on the market value basis is typically much higher than the cost of debt on the book value basis.

false

The issuance costs of bonds and stocks are referred to as ______ costs.

flotation

An important advantage to a firm raising equity internally is not having to pay ___.

flotation costs

Which of the following is a conclusion that can be drawn regarding market efficiency from capital market history?

future market prices are hard to predict based on publicly available information

The average compound return earned per year over a multiyear period is called the _____ average return.

geometric

In terms of investments, the greater the potential risk, the __________ should be the expected return.

greater

The second lesson from studying capital market history is that risk is _____.

handsomely rewarded

In general, the arithmetic average return is probably too _____ (low/high) for longer periods and the geometric average is probably too _____ (low/high) for shorter periods.

high; low

The growth rate of dividends can be found using _____.

historical dividend growth rates and security analysts' forecasts

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

To convince investors to accept greater volatility, you must:

increase the risk premium.

Based on the historical returns shown in the text, the average __________ was 2.9 percent per year over the 94-year span depicted.

inflation rate

An efficient market is one that fully reflects all available ______.

information

The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the ______.

initial stock price

In reality, most firms cover the equity portion of their capital spending with ___.

internally generated cash flow

The variance of a portfolio _________ generally a simple combination of the variances of the assets in the portfolio.

isn't

The WACC is the minimum return a company needs to earn to satisfy _______.

its bondholders and stockholders

Greater return volatility produces a _________ difference between the arithmetic and geometric averages.

larger

The probability of an outcome being more than three standard deviations away from the mean in a normal distribution is approximately ___ percent.

less than 1

The market risk premium equals the:

market rate of return minus the risk-free rate of return.

There is ______ correlation between the unsystematic risk of two companies from different industries.

no

Systematic risk will ____ when securities are added to a portfolio.

not change

The year 2008 was _____.

one of the worst years for stock market investors in U.S. history

Variance is measured in ___, while standard deviation is measured in ___.

percent squared; percent

__________ returns tell how much was received for each dollar invested, so they can be applied to any initial investment amount.

percentage

If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be _____.

positive

Normally, the excess rate of return on risky assets is ___.

positive

The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.

positive

The __________ approach is the use of a WACC that is unique to a particular project, based on companies in similar lines of business.

pure play

Other companies that specialize only in projects similar to the project your firm is considering are called ___.

pure plays

A project should only be accepted if its return is above what is ___.

required by investors

The arithmetic average rate of return measures the ____.

return in an average year over a given period

The Sharpe ratio measures ___.

reward to risk

The SML is very important because it tells us the "going rate" for bearing _________ in the economy.

risk

The second lesson from capital market history is that there is a direct link between __________ and reward.

risk

The market value cost of debt is often Blank______ the book value cost of debt.

similar to

The Ibbotson-Sinquefield data presents returns from 1925 to the recent past for:

small cap stocks, large cap stocks, and US T-bills

Geometric averages are ______ arithmetic averages.

smaller than

The principle of diversification tells us that spreading an investment across a number of assets will eliminate______ of the risk.

some

The standard deviation is the ______ of the variance.

square root

A capital gain on a stock results from an increase in ______.

stock price

Kate Corporation has discovered a very secret new product, but hasn't yet announced the discovery to the public. If the stock price reacts before the announcement (assuming no corporate "leaks"), the market is _____ form efficient.

strong

Inside information has the least value when financial markets are:

strong form efficient.

Match the forms of market efficiency with their descriptions.

strong form: implies all information of every kind is reflected in stock prices semistrong form: it suggests that, at a minimum, the current price of a stock reflects the stock's own past prices weak form: most controversial, and all public information is reflected in the stock price

Capital __________ weights can be interpreted just like portfolio weights.

structure

With the use of the _________ approach to estimating WACC, the firm's WACC may change through time as economic conditions change.

subjective

The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.

supply

The __________ risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

systematic

When an investor is diversified only ________ risk matters.

systematic

Which type of risk does not change as we add more securities to a portfolio?

systematic

Which type of risk is unaffected by adding securities to a portfolio?

systematic risk

Blume's formula combines _____.

the arithmetic average return and the geometric average return

The portfolio weight is _____.

the percentage of the total value that is invested in an asset

The standard deviation is ___.

the square root of the variance

Finding a firm's overall cost of equity is difficult because _____.

there is no way of directly observing the return that the firm's equity investors require on their investment

If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept ______ projects.

too many high-risk

Economic value added (EVA) is a means of evaluating corporate performance.

true

The true risk of any investment is the _____ portion.

unanticipated

The risk of owning an asset comes from:

unanticipated events and surprises

What two factors determine a stock's total return?

unexpected and expected return

Average returns can be calculated _____.

using geometric or arithmetic average

The square of the standard deviation is equal to the ____.

variance

A distribution tends to have a smooth shape when the number of observations is ___.

very large

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio _________.

weight

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio __________.

weight

The efficient markets hypothesis contends that _____ capital markets such as the NASDAQ are efficient.

well-organized

One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future _____.

when economic conditions change quickly

The dividend __________ is defined as the annual dividend amount divided by the beginning stock price.

yield

An asset has an average return of 10.63 percent and a standard deviation of 19.41 percent. What range of returns should you expect to see with a 68 percent probability?

−8.78% to 30.04%

In the Ibbotson-Sinquefield studies, long-term corporate bonds have which of the following characteristics?

20-yea maturities and high quality

A firm's overall cost of capital will include both its cost of __________ capital and equity capital

debt

Dividends are the ______ component of the total return from investing in a stock.

income

When dealing with the history of capital market returns, an average stock market return is useful because it ___.

simplifies detailed market data and is the best estimate of any one year's stock market return during the specified period

Which of the following are tax-deductible to the firm?

Coupon interest paid on bonds

The __________ ratio is calculated as the risk premium of the asset divided by the standard deviation.

Sharpe

Which of the following variables is not required to calculate the expected return on a risky asset?

The rate of inflation

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income.

A firm has a target debt-equity ratio of .5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?

.5

You have gathered the following information on your investments. What is the expected return on the portfolio? Stock Number of Shares Price per Share Expected Return F 370 $46 13.56% G 345 $32 10.25% H 285 $58 10.77%

11.71%

Historically, the real return on Treasury bills has been _____.

quite low

The risk that affects a single asset or a small group of assets is ______ risk.

unsystematic