FIN Exam 3

The realized returns for the market and Stock J for the last three years are given below: Year 1, Market 5%, Stock J 7% Year 2, Market 10%, Stock J 14% year 3, Market 15%, Stock J 21% An average stock has an expected return of 10% and the risk-free rate is 4%. What is Stock J's required rate of return?

12.4%

The risk-free rate is 5%. Stock A has a beta = 1.1 and Stock B has a beta = 1.6. Stock A has a required return of 11%. Which is Stock B's required return?

13.728%

Calculate the coefficient of variation of the following sampled returns both manually and by using the appropriate SD function on your calculator: -15%, -5%, 10%, 15%

13.769%

A stock currently sells for $20.00. The dividend is expected ti grow at a constant rate of 2% over time What is the expected stock price 5 years from now?

22.08

Security J has a 25% chance of a 8% return, a 60% chance of a 15% return, and a 15% chance of a 19% return. What are the expected return and standard deviation of returns for Security J?

3.65%

The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 5% for 2 years, after which dividends are expected to grow at a rate of 10% forever. Klein's required rate of return on equity id 12%. What is the intrinsic value of Klein's common stock?

50.16

Thames Inc.'s most recent dividend was $2.40 per share. The dividend is expected to grow at a rate of 6% per year. The risk-free rate is 5% and the return on the market is 9%. If the company's beta is 1.3, what is the expected price of the stock today?

60.57

A firm is expected to pay a $2.00 dividend next year. The firm's growth rate is a constant 7.2%, and the market risk of the firm is such that investors demand a 10.4% rate of return. What is the expected price of a share of common stock?

62.50

Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4% for 1 year, 5% the next year, then 6% the following year, and the the growth rate is expected ti be a constant 7% thereafter. The required rate of return on equity is 10%. What is the current stock value?

67.47

Over the past 5 years, a stock has the following observed returns: 12%, -3%, -5%, 8%, 3% What is the standard deviation of observed returns?

7.18%

Choose all of the correct answers. The Capital Asset Pricing Model: a. described the relationship between required and exposure to market risk b. has as one of its components the rate of return of long-term Treasury bonds. c. proposes the existence of the security market line d. models return based on exposure to idiosyncratic risk e. none of the above

A, B, C

Choose all of the following statements that are correct. a. beta is calculated by measuring the relationship between the observed returns of a particular stock and the observed returns of the market b. the slope of the security market line is determined by risk aversion c. the intercept of the security market line is the rate of return on long-tern Treasury bonds

A, B, C

Select all of the following statements that are correct. a. if a stock's returns closely mimic the market's returns, then its beta is probably close to 1 b. a stock is up 15% when the market is up 10%, and the stock is down 10% when the market is down 5%. This stock's beta is probably greater than 1. c. the beta of T-bills is zero

A, B, C

Select all of the following statements that are true a. intrinsic value is the present value of all future cash flows b. the horizon point is the final year that cash flows will be received c. one can use the CAPM to calculate the discount rate of a stock's cash flows

A, C

Plot the relationship described by the Capital Asset Pricing model. Label the x-axis, y-axis, intercept, and slope with the appropriate terms. How does this plot differ from that used to calculate a particular stock's beta? Draw the latter plot and label the x-axis, y-axis, and slope with the appropriate terms. Why are the slopes of these two plots different?

Check #25 on solution sheet. The slopes are different because they measure the sensitivities of two different relationships. The plot on the left, which represents CAPM, illustrates the relationship between stock exposure to market risk and required return. The plot on the right illustrates the relationship between the observed (historical) returns of stock and the observed returns of a broad index such as the S&P 500.

Describe the features, rights, risks, and cash flows associated with common stock and preferred stock. Why is preferred stock a 'hybrid' security? What are the similarities and differences between preferred stock, common stock, and debt?

Common stock provides one with the ability to vote for members of the board of director, and entitles one to a percentage of all firm's assets, liabilities, and future cash flows. Preferred stock entitles one to a percentage of all of the firm's assets, liabilities, and future cash flows. Its dividend structure resembles the coupon payments of bonds more than it does the dividends payments of common stock. Preferred stock is similar to common stock in that preferred stock represents an ownership claim on the business.

Explain how diversification affects expected returns. How does it affect standard deviation? Why does diversification not equally affect expected return and standard deviation?

Diversification produces an expected return that is the weighted average of the expected returns of the individual assets with a portfolio. As long as the correlation coefficient, rho, among any of the assets in a portfolio is less than 1, the resulting portfolio standard deviation is less than the weighted average of the standard deviations of the individual assets within that portfolio. The reason that return and risk are affected differently is because of the imperfect correlation of the returns of assets in a portfolio.

You plan to buy a share of ICN Pharmaceuticals today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. You expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16%, how much should you be willing to pay for this stock today?

PV = -118.35

Explain the terms, rational investor risk aversion, and risk premium.

Rational investor is one who chooses investments that maximize return for a given level of risk or chooses investments that minimize risk for a given level of return Risk aversion means that she does not like exposing herself to additional risk, but is willing to do so in exchange for additional expected return. Risk premium is the additional expected return that comes from taking on additional risk

What determines an asset's intrinsic value? What is the difference between intrinsic value and price? When are these two the same?

The determinants of intrinsic value are the size, timing, and risk of future cash flows. Intrinsic is the sum of all future cash flows discounted to the present. Price is the observed price at which the last transaction of an asset occurred. The two are the same only when the market is perfectly efficient.

What does standard deviation measure? When is it relevant measure of risk? How does standard deviation produce a confidence level?What are the 68% and 95% confidence limits? What is the standard deviation of an investment having a 20% chance of a -3% return, a 40% chance of a 5% return, and a 40% chance of a 10% return?

Standard deviation measures the average distance that each observation is from the mean. Relevant measure of risk for an investor who does not own a well-diversified portfolio One can say with a defined level of confidence that the actual (observed) outcome will be within plus or minus some number of SD from the expected mean. 68% confidence is observed returns will be within plus or minus one SD of the mean. 95% confidence is observed returns will be plus or minus two SD of the mean. SD = 4.76%

You own a group of 100 randomly selected stocks. What would you guess the beta of your portfolio is? What is your exposure to idiosyncratic risk? What is your exposure to market risk? Can adding an additional stock to a 100-stock portfolio even increase the beta if that portfolio?

The beta of your 100-stock portfolio is probably very close to one. Your exposure to idiosyncratic risk is small Your market risk is beta, which is expected to be around one. Yes, because the beta of a portfolio is just a weighted average of the betas of the individual assets within that portfolio.

Two investors, A and B, have very different investment strategies. Investor A prefers to carefully research stocks and hold in her portfolio only the 5 best stocks she can find. Investor B prefers to buy many stocks across different industries without researching them. Which investor's risk would you measure using SD and which with beta? Which investor is rational? Which has an efficient portfolio? Which investor is more likely to double her money? Which investor is more likely to experience large losses? Which investor has the better investment strategy?

The relevant measure of risk for investor A's portfolio is SD. The relevant measure of risk for investor B's portfolio is beta. Investor b is rational because her portfolio provides the lowest risk for a given level of return. Investor B has an efficient portfolio Investor A is more likely to double her money Investor A is more likely to experience a large loss Investor B has the better investment strategy because her risk/return tradeoff is superior.

Refer to question 6 of Chapter 9 in Exam 3 Review. What are the assumptions made in the Gordon constant growth model? What does 'g' represent? What does rs represent?

The two expressions are mathematically identical, but two important assumptions are made in order to get from the first expression to the second. In reality, these assumptions are not reasonable, but they are approximately correct and solve the problems associated with discounting an infinite series of future cash flows. 'g' is the capital gains yield (the growth in the price of the stock) rs is the rate at which future stock dividend payments are discounted

Explain the distinction between total risk, idiosyncratic risk, and market risk. Explain the concept of CAPM and the relationship between risk and required risk in a CAPM world.

Total risk is the combination of the idiosyncratic risk and market risk that one is exposed to. Idiosyncratic risk is the risk that a particular stock within your portfolio will produce a return below what was expected. Market risk is the unavoidable risk to which you are exposed because all firms to some degree are affected by swings in the overall market. CAPM proposes to explain how much return investors require over and above the risk-free rate from a risky financial assets. This required return is a function of the risk-free rate and the assets exposed to the market.

T. Martell Inc.'s stock has a 50% chance of producing a 30% return, a 35% chance of producing a 9% return, and a 15% chance of producing a -25% return. What is Martell's expected return? a. 14.4% b. 15.2% c. 16.0% d. 16.8% e. 17.6%

a. 14.4%

If next year's stock price is expected to be $1.30 and the current stock price is $1.25, then what is the expected capital gains yield? a. 4.0% b. 3.0% c. 5.0% d. 3.5% e. 4.5%

a. 4.0%

Taggart Inc.'s preferred stock has a current price $25 and pays a $1.35 annual dividend. What rate of return does this stock provide at the moment? a. 5.40% b. 5.15% c. 6.94% d. 7.05% e. 4.17%

a. 5.40%

Stock A and Stock B each have an expected return of 15%, a SD of 20%, and a beta if 1.2. The returns of the two stocks are not perfectly correlated; the correlation coefficient is 0.6. You have put together a portfolio which is 50% Stock A and 50% Stock B. Which of the following statements is most correct? a. the portfolio expected return is 15% b. the portfolio beta is less than 1.2 c. the portfolio SD is 20% d. statements a and b are correct e. all of the statements above are correct

a. the portfolio expected return is 15%

Stock X is expected to pay a dividend of $2.00 at the end of the year. The dividend is expected to grow at a constant rate of 7% a year. The stock currently trades at a price of $60 a share. Assume that the market is in equilibrium. Mark all of the following statements that are correct. a. the required return on the stock is 10.33% b. the stock's expected price 10 years from now is $89.54 c. the stock's dividend yield is 6%

a. the required return on the stock is 10.33%

Which of the following statements is most correct? a. the constant growth model takes into consideration the capital gains earned on a stock b. it is appropriate to use the constant growth model to estimate stock value even if the growth rate never becomes constant c. two firms with the same dividend and growth rate must also have the same stock price d. statements a and c are correct e. all of the statements above are correct

a. the constant growth model takes into consideration the capital gains earned on a stock

What is the expected return of Skinner's portfolio? a. 13.00% b. 13.75% c. 14.93% d. 16.71% e. 19.94%

d. 16.71%

A stock has a required return of 12.25%. The beta of the stock is 1.15 and the risk-free rate is 5%. What is the market risk premium? a. 1.30% b. 6.50% c. 15.00% d. 6.30% e. 7.25%

d. 6.30%

Which of the following statements is incorrect? a. the slope of the security market line is measured by beta b. two securities with the same SD can have different betas c. Idiosyncratic risk can be diversified away d. the market risk premium is affected by attitudes about risk e. higher beta stocks have higher required returns

a. the slope of the security market line is measured by beta *Slope is MRP

Given the following information, what is the beta of Stock A? rA = 11.3%; rf = 5%; rM = 10% a. 0.86 b. 1.26 c. 1.10 d. 0.80 e. 1.35

b. 1.26

Returns for the Corrigan Company over the last 3 years are shown below. What's the standard deviation of Corrigan's returns? Year 2021 = 25% Year 2020 = -10% Year 2019 = 30% a. 20.10% b. 21.79% c. 23.87% d. 25.18% e. 27.54%

b. 21.79%

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% of its money in Stock A and 50% in Stock B. which of the following statements is correct? a. portfolio P has an expected return that is less than 12% b. portfolio P has a standard deviation that is less than 25% c. portfolio P has a standard deviation that is greater than 25% d. portfolio P has a beta that is less than 1.2 e. portfolio P has a beta that is greater than 1.2

b. portfolio P has a standard deviation that is less than 25%

In general, which if the following will tend to occur on average if you randomly add additional stocks to your portfolio, which is currently consists of three randomly selected stocks? a. the expected return of your portfolio will decline b. the idiosyncratic risk of your portfolio will decline, but the market risk will tend to remain the same c. both idiosyncratic risk and the market risk of your portfolio will decline d. the market risk and expected return of the portfolio will decline e. the idiosyncratic risk will remain the same, but the market risk will decline

b. the idiosyncratic risk of your portfolio will decline, but the market risk will tend to remain the same

Assume rM is 10% and rf is 5%. You hold a portfolio consisting of a $10,000 investment in Stock 1, $20,000 in Stock 2, and $50,000 in Stock 3. The betas of the stocks are 1.2, 0.8, and 1.35 respectively. Find beta (the portfolio's beta) and rp (the portfolio's required return).

beta = 1.19375 rp = 10.969%

Ezzell Corporation issued preferred stock with an 8% annual dividend. The stock currently yields 7%, and its par value is $100. What is the stock's value? a. $51.81 b. $75.24 c. $114.29 d. $125.03 e. $150.00

c. $114.29

Naranjo Corp's risk is such that investors discount its dividends at a rate of 12%. The company's growth is stable at 5%. If the most recent dividend paid (D0) was $1.10, what is the most likely stock price in 1 year? a. $8.13 b. $12.03 c. $17.33 d. $20.94 e. $22.84

c. $17.33

If D0 = $2.50, g = 5%, and P0 = $45, what is this stock's expected dividend yield for the coming year? a. 5.00% b. 5.41% c. 5.83% d. 5.96% e. 6.87%

c. 5.83%

Your company paid a dividend of $1.50 last year. The growth rate is expected to be 5% for 1 year then 6% per year thereafter. The required rate of return on equity is 11%. What is the expected current stock price? a. $43.45 b. $30.98 c. $34.49 d. $31.50 e. $39.21

d. $31.50

The current risk-free rate of return is 3.5% and the market risk premium is 4%. What is a stock's beta if its required return is 10.3%? a. 0.7 b. 1.0 c. 1.5 d. 1.7 e. 2.1

d. 1.7

Which if the following statements is most correct? a. portfolio diversification reduces the risk of individual stocks held in the portfolio b. if an investor buys enough stocks she can eliminate virtually all of the idiosyncratic risk inherent in owning stocks. If the portfolio contained all publicly traded stocks, it would be riskless c. the required return on a firm's common stock is determined by its market risk. If the market risk is known, the no other information is required to determine the firm's required return d. A security's beta measures its market risk e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only one stock

d. A security's beta measures its market risk

Suppose that you own a diversified portfolio and are looking to add another stock to it. Which of the following stocks would add the most risk to your portfolio? Stock ABC: SD - 15.27%, Beta - 1.2 Stock DEF: SD - 14.39%, Beta - 0.4 Stock GHI: SD - 5.98%, Beta - 1.6 Stock JKL: SD - 12.39%, Beta 2.8 a. stock ABC because it has the highest standard deviation b. stock DEF because it has the lowest beta c. stock GHI because it has the lowest standard deviation d. stock JKL because it has the highest beta e. none of the above is correct

d. stock JKL because it has the highest beta

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities in equilibrium? a. when held in isolation, Stock A has a greater risk than does Stock B b. Stock B would be a more desirable addition to a portfolio than would Stock A c. Stock A would be more desirable addition to a portfolio than would Stock B d. the expected return on Stock A will be greater than on Stock B e. the expected return on Stock B will be grater than on Stock A

d. the expected return on Stock A will be greater than on Stock B *stock with a higher beta will have a higher expected return

Tom Skinner has $45,000 invested in Stock A, which has a beta of 0.8 and an expected return of 13%. He also has $55,000 invested in Stock B, which has a beta of 1.4 and expected return of 19.75%. These are the only two investments in his portfolio. What is his portfolio's beta? a. 0.93 b. 0.98 c. 1.03 d. 1.08 e. 1.13

e. 1.13

Apex Roofing's stock has a beta of 1.50, its required return is 14.00%, and the risk-free rate is 5.00%. What is the market risk premium? a. 2% b. 3% c. 4% d. 5% e. 6%

e. 6%

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 between Bob's and Becky's portfolios is zero. Bob and Becky are engaged to be married. Which of the following best describes their combined $100,000 portfolio? a. the combined portfolio's expected return is a weighted average of the expected returns of the two individual portfolios (10%) b. the combined portfolio's beta is a weighted average of the betas of the two individual portfolios (1.0) c. the combined portfolios SD is less than a weighted average of the two portfolios SD (25%), even though there is no correlation between the returns of the two portfolios d. statements a and b are correct e. all of the statements above are correct

e. all of the statements above are correct

Stock X is expected to pay a dividend of $3.00 at the end of the year. The dividend is expected to grow at a constant rate of 6% a year. The stock currently trades at a price of $50 a share. Assume that the stock is in equilibrium, that is, stock's price equals its intrinsic value. Which of the following statements is most correct? a. the required return on the stock is 12% b. the stocks expected price 10 years from now is $89.54 c. the stock's dividend yield is 6% d. statements a and b are correct e. all of the statements above are correct

e. all of the statements above are correct

Which of the following statements is correct? a. an investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks b. the higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio c. an investor holding 10 stocks is well-diversified d. an example of market risk is a labor strike at a production facility e. an investor can eliminate virtually all idiosyncratic risk if he or she holds a very large, well-diversified portfolio of stocks

e. an investor can eliminate virtually all idiosyncratic risk if he or she holds a very large, well-diversified portfolio of stocks

Which if the following statements is most correct? a. risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events b. it is not possible to change a portfolio's exposure to market risk since you cannot get rid of market risk c. when firm-specific has been diversified away, the inherent risk that remains is market risk, which is constant for all securities in the market d. A stock with a beta of -1.0 has zero market risk e. the SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by financial manager

e. the SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by financial manager

In the CAPM, what are rf and rM? Describe the difference between required, expected, and observed returns. Under what circumstances are expected and required returns equal?

rf is the risk-free rate on long term Treasury Bonds rM is the rate of return of an 'average' stock in the market or of a market index such as the S&P 500. Required return is an investor holding a risky asset. Expected returns are an estimate of the future returns based on a probability distribution. Observed returns are historical observations of an asset's prior performance. If the CAPM holds and the market is efficient, then all investors expect to earn a return exactly to their required rate of return.