FINC311 CH10, Ch 11, CH12 Connect
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 - The outcome of an application currently pending with the Food and Drug Administration.
What is a risk premium?
It is additional compensation for taking risk, over and above the risk-free rate.
subjective
It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making _________ adjustments to the overall WACC.
What is an uncertain or risky return?
It is the portion of return that depends on information that is currently unknown.
What is the definition of expected return?
It is the return that an investor expects to earn on a risky asset in the future.
compare stock returns with the returns on other securities
The average return on the stock market can be used to ___.
initial stock price
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:
beginning stock price
The dividend yield for a one-year period is equal to the annual dividend amount divided by the ____.
compounding
The geometric rate of return takes ______ into account.
What is the slope of the security market line (SML)?
The market-risk premium
variance or standard deviation mean
The normal distribution is completely described by the _______ and ________.
premium
The risk _________ can be interpreted as the reward for bearing risk.
What is the intercept of the security market line (SML)?
The risk-free rate
capital gains or losses
The total dollar return is the sum of dividends and __________.
What is the equation for total return?
Total return = Expected return + Unexpected return
True or false: Adding securities will reduce unsystematic risk only. Systematic risk is unaffected by diversification.
True
True or false: Unsystematic risk is specific only to a single company or industry.
True
cash
When a company declares a dividend, shareholders generally receive ____.
The mean return The standard deviation of returns
Which of the following are needed to describe the distribution of stock returns?
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.
What is the beta of the risk-free asset?
Zero
Using an analyst's forecast for a firm's earnings growth and a stock's dividend yield, you can find the cost of equity by:
adding these two components
The CAPM can also be used for a portfolio by first determining the portfolio's _____ .
beta
The minimum required return on a new project is known as the:
cost of capital
Which of the following is tax-deductible to the firm?
coupon interest paid on bonds
Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio:
declines
T/F: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.
false
T/F: Finding the cost of equity is fairly straightforward.
false
T/F: The SML approach is advantageous because all it requires is estimation of beta.
false
True or false: In the WACC calculation, V = E - D.
false
Components of the WACC include funds that come from ______ .
investors
An investment will have a negative NPV when its expected return is _______ ________ what the financial markets offer for the same risk.
less than
Systematic risk will ____ when securities are added to a portfolio.
not change
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be:
positive
The security market line (SML) shows that the relationship between a security's expected return and its beta is ______.
positive
True or false: Labor strikes are an example of unsystematic risk.
True
95
With a normal distribution, the probability that we end up withing two standard deviations is about ________ percent.
The calculation of a portfolio beta is similar to the calculation of:
a portfolio's expected return
Unsystematic risk will affect
- A specific firm - Firms in a single industry
Which of the following are examples of unsystematic risk?
- Changes in management - Labor strikes
Which of the following are examples of systematic risk?
- Regulatory changes in tax rates - Future rates of inflation
The CAPM shows that the expected return for an asset depends on which three things?
- The amount of systematic risk - The pure time value of money - The reward for bearing systematic risk
The formula of the SML is:
RE = Rf + Beta x (RM- Rf)
What is the equation for finding the cost of preferred stock?
RP=D/P0
The dividend growth model is applicable to companies that pay ____.
dividends
What are the two components of risky return (U) in the total return equation?
- Market risk - Unsystematic risk
2.5%
The probability of an outcome being at least 2 standard deviations below the mean in a normal distribution is approximately:
square root
The standard deviation is the ______ of the variance.
bonds
_______ were a bright spot for U.S. investors during 2008.
If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.
equity
Systematic risk is also called ______________ risk.
market
What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?
RE = D1/P0
The WACC of a firm reflects the ____ and the target capital structure of the firm's existing assets as a whole.
risk
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?
(P/V) × RP
Which of the following statements is (are) true about variance?
- Variance is a measure of the squared deviations of a security's return from its expected return. - Standard deviation is the square root of variance.
The true risk of any investment comes from:
-surprises -unanticipated events
10
A dividend yield of 10% says that, for each dollar we invest, we get cents in dividends.
an increase in price
A positive capital gain on a stock results from ___.
return
An unrealized gain is treated the same as a realized gain when computing the total ________.
smaller than
Geometric averages are usually ______ arithmetic averages.
better than no risk adjustment
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
____________ risk is the only risk important to the well diversified investor.
Systematic
______ risk is reduced as more securities are added to the portfolio
- Diversifiable - Company-specific - Unsystematic
The following are advantages of the SML approach
- adjusts for risk - does not require the company to pay a dividend
Which of the following are components used in the construction of the WACC?
- cost of debt - cost of preferred stock - cost of common stock
The rate used to discount project cash flows is known as the ___.
- discount rate - required return - cost of capital
To estimate the dividend yield of a particular stock, we need:
- forecasts of the dividend growth rate, g - the last dividend paid, D0 - the current stock price
We should use ____ values in the WACC. Because ____ values are often similar to market values for debt, we often use book value for debt and market value for equity.
- market - book
The following are disadvantages of the SML approach
- requires estimation of the market risk premium - requires estimation of beta
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
- risk-free rate - stock's beta - market risk premium
Which of the following is true about a firm's cost of debt?
- yields can be calculated from observable data - it is easier to estimate than the cost of equity
By definition, what is the beta of the average asset equal to?
1
1. US Treasury Bills 2. Long-term corporate bonds 3. Large-company stocks 4. Small-company stocks
Arrange the following investments starting from lowest historical risk premium to highest historical risk premium.
True or false: Discounting a news item is the same as taking the present value of that item.
False
True or false: Expected return and inflation are the two components of risky return in the total return equation.
False
True or false: Historical return data indicates that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio increases.
False
True or false: Labor strikes are an example of systematic risk.
False
True or false: Portfolio weights can be defined as the dollars invested in each asset.
False
too many
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects.
rejected, when it should be accepted
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:
a larger
More volatility in returns produces ______ difference between the arithmetic and geometric averages.
apply to any amount invested allow comparison against other investments
Percentage returns are more convenient than dollar returns because they:
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
• The beta for software companies that collect and store data
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?
capital gains yeild
The percentage change in the price of a stock over a period of time is called its ___________.
lower; lower greater; greater
The second lesson from studying capital market history states that the _______ the potential reward, the _______ the risk
dividends; capital gains
The total dollar return on a stock is the sum of the ____ and the _____.
dividends
The two potential ways to make money as a stockholder are through _______ and capital appreciation.
standard deviation
The variance and its square root, the __________ ________, are the most commonly used measures of volatility.
W x $Y
What will the dividend income be on W number of shares of XYZ stock if XYZ distributes a $Y per share dividend?
-Common stocks frequently experience negative returns. -T-bills sometimes outperform common stocks.
Which of the following are true based on the year-to-year returns from 1926-2014?
The Consumer Price Index (CPI)
Which of the following is commonly used to measure inflation?
What is the Reward-to-Risk Ratio?
[E(RA) - Rf]/βA
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
cannot
The appropriate discount rate to use to evaluate a new project is the _____.
cost of capital
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.
equal to
The _____ return on a portfolio is a combination of the expected returns on the assets in the portfolio.
expected
T/F: For publicly traded companies, the component of the dividend yield that must be estimated is the dividend.
false
T/F: The SML approach is advantageous because all it requires is the estimation of beta.
false
T/F: The primary disadvantage of the dividend growth model approach is its simplicity.
false
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
In the WACC calculation, D represents the ____ value of the firm's debt.
market
The most appropriate weights to use in the WACC are the ______ weights.
market value
If an asset has a reward-to-risk ratio of 6.0%, that means it has a __________ of 6.0% per unit of _______.
risk premium; systematic risk
The true risk of any investment comes from _______________ .
surprises
The growth rate of dividends can be found using:
- security analysts' forecasts - historical dividend growth rates
Which of the following are true?
- the market value of debt and equity are not reliable in case of privately owned company - ideally, we should use market values in the WACC
The computation of variance requires 4 steps. Place the steps in the correct order from the first step to the last step.
1. Calculate the expected return 2. Calculate the deviation of each return from the expected return 3. Square each deviation 4. Calculate the average squared deviation
What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security's beta is 1.5?
11% Expected return for a security= 5 + 1.5 x (9 - 5) = 11%
1. Small-company common stock 2. Large-company common stocks 3. Long-term corporate bonds 4. Long-term government bonds U.S. Treasury bills
Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2014 has revealed as shown in Table 10.3:
True or false: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.
False
optimistic
If you use an arithmetic average to project long-run wealth levels, your results will most likely be _______.
37%
In 2008, the S&P 500 plunged ___ %.
one
In the Ibbotson-Sinquefield studies, U. S. Treasury bill data is based on T-bills with a maturity of _______ month(s).
How are the unsystematic risks of two different companies in two different industries related?
There is no relationship.
True or false: According to the capital asset pricing model (CAPM), the risk-free rate of return is the expected return on a security with a beta of zero.
True
True or false: It is possible for the unsystematic risk of a portfolio to be reduced almost to zero.
True
the geometric average the arithmetic average
Two ways of calculating average returns are _______ and _______.
What is the appropriate discount rate to use only if the proposed investment is a replica of the firm's existing operating activities?
WACC
- The firm overall will become riskier - It will accept projects that it should have rejected - It will reject projects that it should have accepted
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
Even if the portfolio is well diversified, the investor is still exposed to _____ risk.
systematic
The return expected on an investment depends only on the asset's _____ risk.
systematic
Beta tells us the amount of ________ risk of an asset or portfolio relative to ______.
systematic; an average risky asset
To determine the appropriate required return for an investment, we can use _____________________.
the Security Market Line
Which of the following are examples of a portfolio?
- Investing $100,000 in a combination of stocks and bonds - Investing $100,000 in the stocks of 50 publicly traded corporations - Investing $100,000 in a combination of US and Asian stocks
As more securities are added to a portfolio, what will happen to the portfolio's total unsystematic risk?
- It is likely to decrease. - It may eventually be almost totally eliminated.
What can we say about the dividends paid to common and preferred stockholders?
- dividends to preferred stockholders are fixed - dividends to common stockholders are not fixed
What two factors determine a stock's total return?
- expected return - unexpected return
Preferred stock ___.
- pays a constant dividend - pays dividends in perpetuity
5
Roger Ibbotson and Rex Sinquefield presented year-to-year historical rates of return on types of financial investments.
T/F: RP=D/P0
true
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
yield to maturity
The systematic risk principle argues that the market does not reward risks:
- that are diversifiable - that are borne unnecessarily
76%
2008 was a bad year for markets worldwide. One of the worst hit was the Icelandic Exchange where shares priced dropped _____ in one day.
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: A well-diversified portfolio will eliminate all risks.
False
True or false: Calculating the expected return is the last step in the computation of variance.
False
True or false: The calculation of the portfolio beta is similar to the calculation of the portfolio weights.
False
True or false: The expected return of a portfolio is a combination of the weights of each asset in a portfolio.
False
True or false: The standard deviation is the variance squared.
False
True or false: The surprise part of any announcement is the information the market uses to form the expectation of the return on the stock.
False
7.2%
From 1900 to 2010, the average stock market risk premium of the U.S. was ______.
quite low
Historically, the real return on Treasury bills has been:
a discount rate commensurate with a project's risk
If a firm has multiple projects, each project should be discounted using ___.
$2 x 100
If you receive a $2 dividend per share on your 100 shares, your total dividend income is ____.
What does the security market line depict?
It is a graphical depiction of the capital asset pricing model.
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.
pure plays
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
Which of the following types of risk is not reduced by diversification?
Systematic, or market risk
-small-company stocks generated the highest average return -T-bills, which had the lowest risk, generated the lowest return -small-company stocks had the highest risk level
The Ibbotson SBBI data show that over the long-term, ___.
excess
The ______ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero?
The risk-free rate of return
19.8
The standard deviation for large-company stock returns from 1926 to 2017 is:
one of the worst years for stock market investors in U.S. history
The year 2008 was:
True or false: The expected return is the return that an investor expects to earn on a risky asset in the future.
True
If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E+D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is:
[E/V] × RE + [D/V] × RD ×(1 - T c)
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
T/F: The cost of capital depends on the source of the funds.
false
T/F: The cost of equity is D1/P0 minus the analysts' estimates of growth.
false
T/F: The discount rate is also known as the expected return.
false
T/F: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.
false
T/F: The growth rate of dividends can be found using the CAPM.
false
The _____ is the news that influences the unanticipated return on the stock.
surprise
A portfolio can be described by its portfolio weights which are defined as _____________________.
the percentage of dollars invested in each asset
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
the risk-free rate
If the standard deviation of a portfolio is __________?
the square root of the variance
The standard deviation is ___.
the square root of the variance
T/F: The return an investor in a security receives is equal to the cost of the security to the company that issued it.
true
The cost of capital depends primarily on the ______ of funds, not the _____.
use; source
Given V = E + D, if we divide both V and D by ____, we can calculate the capital structure weights.
v
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ____ of its stock.
value or price
