FIN 335 Final Exam

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

Cost of capital

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

Which one of the following is the best example of systematic risk?

Decrease in gross domestic product

In an efficient market, the cost of equity for a risky firm does which one of the following according to the security market line?

Increases in direct relation to the stock's systematic risk

Which one of the following statements is correct?

The cost of preferred stock is unaffected by the issuer's tax rate

Which one of the following best exemplifies unsystematic risk?

Unexpected increase in the variable costs for a firm

Portfolio diversification eliminates which one of the following?

Unsystematic risk

The average risk premium on long-term government bonds for the period 1926-2011 was equal to:

the rate of return on the bonds minus the T-bill rate.

Standard deviation measures _____ risk while beta measures _____ risk

total; systematic

The standard deviation measures the _____ of a security's returns over time

volatility

One year ago, you purchased 500 shares of stock for $12 a share. The stock pays $0.22 a share in dividends each year. Today, you sold your shares for $28.30 a share. What is your total dollar return on this investment?

$8,260 Total dollar return = 500 × ($28.30 - $12 + $0.22) = $8,260

Beasley Enterprises stock has an expected return of 11.5 percent. Given the information below, what is the expected return if the economy is in a recession?

-5.72 percent E(R) = 0.115 = (0.18 × x) + (0.65 × 0.13) + (0.17 × 0.24) x = -5.72 percent

BJB, Inc. stock has an expected return of 15.15 percent. The risk-free rate is 3.8 percent and the market risk premium is 8.6 percent. What is the stock's beta?

1.32 E(R) = 0.1515 = 0.038 + β(0.086) β = 1.32

You would like to create a portfolio that is equally invested in a risk-free asset and two stocks. One stock has a beta of 1.15. What does the beta of the second stock have to be if you want the portfolio to be equally as risky as the overall market?

1.85 1/3(0) + 1/3(1.15) + 1/3(x) = 1.0 x = 1.85

Sugar and Spice stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

10.05 percent Expected return = (0.05 × 0.05) + (0.70 × 0.09) + (0.25 × 0.14) = 10.05 percent

Musical Charts just paid an annual dividend of $2.45 per share. This dividend is expected to increase by 3.3 percent annually. Currently, the firm has a beta of 1.09 and a stock price of $36 a share. The risk-free rate is 4.2 percent and the market rate of return is 12.6 percent. What is the cost of equity capital for this firm?

11.84 percent RE = 0.042 + 1.09(0.126 - 0.042)] = 0.13356

You own a portfolio that is invested 38 percent in Stock A, 43 percent in Stock B, and the remainder in Stock C. The expected returns on these stocks are 10.9 percent, 15.4 percent, and 9.1 percent, respectively. What is the expected return on the portfolio?

12.49 percent Expected return = [0.38 × 0.109] + [0.43 × 0.154] + [(1 - 0.38 - 0.43) × 0.091] = 12.49 percent

Fiddler's Music Stores' stock has a risk premium of 9.6 percent while the inflation rate is 4.1 percent and the risk-free rate is 3.9 percent. What is the expected return on this stock?

13.5 percent Expected return = 0.039 + 0.096 = 13.5 percent

You expect the inflation rate to be 3.8 percent and the U.S. Treasury bill yield to be 3.9 percent for the next year. The risk premium on small-company stocks is 12.6 percent. What nominal rate of return do you expect to earn on small-company stocks next year?

16.5 percent

Bama Entertainment has common stock with a beta of 1.46. The market risk premium is 9.3 percent and the risk-free rate is 4.6 percent. What is the expected return on this stock?

18.03 percent E(R) = 0.046 + 1.46(0.092) = 18.03 percent

The common stock of Contemporary Interiors has a beta of 1.65 and a standard deviation of 27.4 percent. The market rate of return is 13.2 percent and the risk-free rate is 4.8 percent. What is the cost of equity for this firm?

18.66 percent RE = 0.048 + 1.65(0.132 - 0.048) = 18.66 percent

You own a $46,000 portfolio comprised of four stocks. The values of Stocks A, B, and C are $5,600, $16,700, and $11,400, respectively. What is the portfolio weight of Stock D?

24.57 percent ValueD = $46,000 - $6,600 - $16,700 - $11,400 = $11,300 WeightD = $11,300/$46,000 = 24.57 percent

Given the following information, what is the standard deviation of the returns on this stock?

25.52 percent Expected return = (0.04 × 0.26) + (0.74 × 0.17) + (0.22 × -0.44) = 0.0394 Variance = 0.04(0.26 - 0.0394)2 + 0.74(0.17 - 0.0394)2 + 0.22 (-0.44 - 0.0394)2 = 0.065130 Standard deviation = √0.065130 = 25.52 percent

You own a portfolio that is invested as follows: $11,400 of Stock A, $8,800 of Stock B, $14,900 of Stock C, and $3,200 of Stock D. What is the portfolio weight of Stock C?

38.90 percent WeightC = $14,900/($11,400 + $8,800 + $14,900 + $3,200) = 38.90 percent

Noah's Landing stock is expected to produce the following returns given the various states of the economy. What is the expected return on this stock?

4.05 percent Expected return = (0.3 × -0.27) + (0.65 × 0.16) + (0.05 × 0.35) = 4.05 percent

The Green Balloon just paid its first annual dividend of $0.12 a share. The firm plans to increase the dividend by 3.5 percent per year indefinitely. What is the firm's cost of equity if the current stock price is $6.50 a share?

5.41 percent

Ben & Terry's has an expected return of 12.9 percent and a beta of 1.25. The expected return on the market is 11.7 percent. What is the risk-free rate?

6.92 percent E(R) = 0.129 = Rf + 1.25(0.117 - Rf) Rf = 6.92 percent

Judy's Boutique just paid an annual dividend of $1.65 on its common stock. The firm increases its dividend by 2.5 percent annually. What is the rate of return on this stock if the current stock price is $38.20 a share?

6.93 percent

Given the following information, what is the standard deviation of the returns on this stock?

7.80 percent Expected return = (0.20 × 0.21) + (0.70 × 0.13) + (0.10 × -0.09) = 0.124 Variance = 0.20(0.21 - 0.124)2 + 0.70(0.13 - 0.124)2 + 0.10(-0.09 - 0.124)2 = 0.006084 Standard deviation = √0.006084 = 7.80 percent

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

A portfolio comprised solely of U. S. Treasury bills

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

A warehouse fire

Boone Brothers remodels homes and replaces windows. Ace Builders constructs new homes. If Boone Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return for the project?

Ace Builders' cost of capital

Which of the following terms can be used to describe unsystematic risk?

Asset-specific risk,Market risk,Unique risk

An efficient capital market is best defined as a market in which security prices reflect which one of the following?

Available information

Nominal return on small-company stocks = 3.9 percent + 12.6 percent = 16.50 percent Over the past five years, a stock returned 8.3 percent, -32.5 percent, -2.2 percent, 46.9 percent, and 11.8 percent, respectively. What is the variance of these returns?

Average return = (0.083 - 0.325 - 0.022 + 0.469 + 0.118)/5 = 0.0646 σ2 = [(0.083 - 0.0646)2 + (-0.325 - 0.0646)2 + (-0.022 - 0.0646)2 + (0.469 - 0.0646)2 + (0.118 - 0.0646)2]/(5 - 1) = 0.081504

A stock has produced returns of 11 percent, 18 percent, -6 percent, -13 percent, and 21 percent for the past five years, respectively. What is the standard deviation of these returns?

Average return = (0.11 + 0.18 - 0.06 - 0.13 + 0.21)/5 = 0.062 σ2 = [(0.11 - 0.062)2 + (0.18 - 0.062)2 + (-0.06 - 0.062)2 + (-0.13 - 00.062)2 + (0.21 - 0.062)2]/(5 - 1) = 0.02247 σ = √0.02247 = 14.99 percent

Over the past six years, a stock had annual returns of 14 percent, -3 percent, 8 percent, 21 percent, -16 percent, and 4 percent, respectively. What is the standard deviation of these returns?

Average return = (0.14 - 0.03 + 0.08 + 0.21 - 0.16 + 0.04)/6 = 0.046667 σ2 = [(0.14 - 0.046667)2 + (-0.03 - 0.046667)2 + (0.08 - 0.046667)2 + (0.21 - 00.046667)2 + (-0.16 - 0.046667)2 + (0.04 - 0.046667)2]/(6 - 1) = 0.017027 σ = √0.017027 = 13.05 percent

Over the past four years, a stock produced returns of 15 percent, 6 percent, 11 percent, and 22 percent, respectively. Based on these four years, what range of returns would you expect to see 95 percent of the time?

Average return = (0.15 + 0.06 + 0.11 + 0.22)/4 = 0.135 σ2 = [(0.15 - 0.135)2 + (0.06 - 0.135)2 + (0.11 - 0.135)2 + (0.22 - 00.135)2]/(4 - 1) = 0.004567 σ = √0.004567 = 0.067577 95 percent probability range = 0.0.135 ± (2 × 0.067577) Range of returns = -0.02 percent to 27.02 percent

Five years ago, you purchased 600 shares of stock. The annual returns have been 7.2 percent, -19.4 percent, 3.8 percent, 14.2 percent, and 27.9 percent, respectively. What is the variance of these returns?

Average return = (0.226 + 0.187 + 0.113 - 0.198 + 0.024)/5 = 0.0704 σ2 = [(0.226 - 0.0704)2 + (0.187 - 0.0704)2 + (0.113 - 0.0704)2 + (-0.198 - 0.0704)2 + (0.024 - 0.0704)2]/(5 - 1) = 0.028453

Over the past four years, a stock produced returns of 23 percent, -39 percent, 4 percent, and 16 percent, respectively. Based on these four years, what range of returns would you expect to see 99 percent of the time?

Average return = (0.23 - 0.39 + 0.04 + 0.16)/4 = 0.01 σ2 = [(0.23 - 0.01)2 + (-0.3 - 0.01)2 + (0.04 - 0.01)2 + (0.16 - 0.01)2]/(4 - 1) = 0.077267 σ = √0.077267 = 0.277969 99 percent probability range = 0.01 ± (3 × 0.277969) Range of returns = -82.39 percent to 84.39 percent

Which one of the following measures the amount of systematic risk present in a particular risky asset relative to that in an average risky asset?

Beta coefficient

One year ago, you bought a stock for $36.48 a share. You received a dividend of $1.62 per share last month and sold the stock today for $41.18 a share. What is the capital gains yield on this investment?

Capital gains yield = ($41.18 - $36.48)/$36.48 = 12.88 percent

The stock of Southern United is priced at $40 a share and has a dividend yield of 2.1 percent. The firm pays constant annual dividends. What is the amount of the next dividend per share?

D = 0.021 × $40 = $0.84

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

Diversification

The security market line is a linear function that is graphed by plotting data points based on the relationship between which two of the following variables?

Expected return and beta

Your portfolio has provided you with returns of 8.6 percent, 14.2 percent, -3.7 percent, and 12.0 percent over the past four years, respectively. What is the geometric average return for this period?

Geometric average return = (1.086 × 1.142 × 0.963 × 1.120)1/4 - 1 = 7.54 percent

The common stock of Hillshire Farms has yielded 16.3 percent, 7.2 percent, 11.8 percent, -3.6 percent, and 9.7 percent over the past five years, respectively. What is the geometric average return?

Geometric average return = (1.163 × 1.072 × 1.118 × 0.964 × 1.097)1/5 - 1 = 8.07 percent

A stock has produced returns of 16.6 percent, 3.4 percent, 11.7 percent, and -9.2 percent over the past four years, respectively. What is the geometric average return?

Geometric average return = (1.166 × 1.034 × 1.117 × 0.908)1/4 - 1 = 5.16 percent

Which of the following features are advantages of the dividend growth model?

I. Easy to understand II. Model simplicity

Which of the following are weaknesses of the dividend growth model?

II. Lack of dividends for some firms IV. Sensitivity of model to dividend growth rate

Which one of the following is an example of systematic risk?

Increase in consumption created by a reduction in personal tax rates

Which one of the following will decrease the aftertax cost of debt for a firm?

Increase in tax rates

Which one of the following is the primary determinant of an investment's cost of capital?

Level of risk

Which one of the following is the slope of the security market line?

Market risk premium

When, if ever, will the geometric average return exceed the arithmetic average return for a given set of returns?

Never

The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.75 and an expected return of 11.4 percent. Are these stocks correctly priced? Why or why not?

No, Stock A is overpriced and Stock B is under priced E(RA) = 0.042 + 1.2(0.123 - 0.042) = 13.92 percent E(RB) = 0.042 + 0.75(0.123 - 0.042) = 10.28 percent Stock A is overpriced because its expected return lies below the security market line.

Sarah earned a 2.9 percent real rate of return on her investments for the past year. During that time, the risk-free rate was 4.1 percent and the inflation rate was 3.6 percent. What was her nominal rate of return?

Nominal rate = (1.029 × 1.036) - 1 = 6.60 percent

Which one of the following is defined as a bell-shaped frequency distribution that is defined by its average and its standard deviation?

Normal distribution

Hercules Movers pays a constant annual dividend of $1.75 per share on its stock. Last year at this time, the market rate of return on this stock was 14.8 percent. Today, the market rate has fallen to 11.2 percent. What would your capital gains yield have been if you had purchased this stock one year ago and then sold the stock today?

P-1 = $1.75/0.148 = $11.8243 P0 = $1.75/0.112 = $15.6350 Capital gains yield = ($15.6250 - $11.8243)/$11.8243 = 32.14 percent

Stock A comprises 28 percent of Susan's portfolio. Which one of the following terms applies to the 28 percent?

Portfolio weight

Last year, Isaac earned 10.6 percent on her investments while U.S. Treasury bills yielded 3.8 percent and the inflation rate was 3.1 percent. What real rate of return did she earn on her investments last year?

Real return = (1.106/1.031) - 1 = 7.27 percent

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

Investors require a 4 percent return on risk-free investments. On a particular risky investment, investors require an excess return of 7 percent in addition to the risk-free rate of 4 percent. What is this excess return called?

Risk premium

Which one of the following describes systemic risk?

Risk that affects a large number of assets

Over the period of 1926-2011, which one of the following investment classes had the highest volatility of returns?

Small-company stocks

Which one of the following is the positive square root of the variance?

Standard deviation

The risk premium for an individual security is based on which one of the following types of risk?

Systematic

New Labs just announced that it has received a patent for a product that will eliminate all flu viruses. This news is totally unexpected and viewed as a major medical advancement. Which one of the following reactions to this announcement indicates the market for New Labs stock is efficient?

The price of New Labs stock increases rapidly to a higher price and then remains at that price

One year ago, you purchased a 5 percent coupon bond with a face value of $1,000 when it was selling for 101.2 percent of par. Today, you sold this bond for 99.8 percent of par. What is your total dollar return on this investment?

Total dollar return = (0.998 × $1,000) - (1.012 × $1,000) + (0.05 × $1,000) = $36

Which one of the following represents the rate of return a firm must earn on its assets if it is to maintain the current value of its securities?

Weighted average cost of capital

Semistrong form market efficiency states that the value of a security is based on:

all publicly available information

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

The lower the standard deviation of returns on a security, the _____ the expected rate of return and the _____ the risk

higher; higher

Systematic risk is:

measured by beta

If the financial markets are efficient then:

stock prices should respond only to unexpected news and events