BUAD 306 MIDTERM #3

Which of the following statements concerning risk are correct? I. Non-diversifiable risk exposure is measured by beta. II. The risk premium increases as diversifiable risk increases. III. Systematic risk is another name for non-diversifiable risk. IV. Diversifiable risks are market risks you cannot avoid.

A) I and III only

Which one of the following is least apt to reduce the unsystematic risk of a portfolio? A) Reducing the number of stocks held in a portfolio B) Adding bonds to a stock portfolio C) Adding international securities into a portfolio of U.S. stocks D) Adding U.S. Treasury bills to a risky portfolio E) Adding technology stocks to a portfolio of industrial stocks

A) Reducing the number of stocks held in a portfolio

Which one of the following statements related to WACC is correct for a company that uses debt in its capital structure? A) The WACC would most likely decrease if the firm replaced its preferred stock with debt. B) The weight assigned to preferred stock decreases as the market value of the preferred stock increases. C) The WACC will decrease as the corporate tax rate decreases. D) The weight of equity is based on the number of shares outstanding and the book value per share. E) The WACC will remain constant unless a company retires some of its debt.

A) The WACC would most likely decrease if the firm replaced its preferred stock with debt.

Unsystematic risk: A) can be effectively eliminated by portfolio diversification. B) is compensated for by the risk premium. C) is measured by beta. D) is measured by standard deviation. E) is related to the overall economy.

A) can be effectively eliminated by portfolio diversification.

The cost of preferred stock: A) is equal to the dividend yield. B) is equal to the yield to maturity. C) is highly dependent on the dividend growth rate. D) is independent of the stock's price. E) decreases when tax rates increase.

A) is equal to the dividend yield.

The intercept point of the security market line is the rate of return which corresponds to: A) the risk-free rate. B) the market rate. C) a return of zero. D) a return of 1.0 percent. E) the market risk premium.

A) the risk-free rate.

Which one of these will increase a company's aftertax cost of debt? A) A decrease in the company's debt-equity ratio B) A decrease in the company's tax rate C) An increase in the credit rating of the company's bonds D) An increase in the company's beta E) A decrease in the market rate of interest

B) A decrease in the company's tax rate

Which one of the following statements is correct concerning a portfolio beta? A) Portfolio betas range between −1.0 and +1.0. B) A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio. C) A portfolio beta cannot be computed from the betas of the individual securities comprising the portfolio because some risk is eliminated via diversification. D) A portfolio of U.S. Treasury bills will have a beta of +1.0. E) The beta of a market portfolio is equal to zero.

B) A portfolio beta is a weighted average of the betas of the individual securities contained in the portfolio.

At a minimum, which of the following would you need to know to estimate the amount of additional reward you will receive for purchasing a risky asset instead of a risk-free asset? I. Asset's standard deviation II. Asset's beta III. Risk-free rate of return IV. Market risk premium

B) II and IV only

Beta

Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole

The capital asset pricing model (CAPM) assumes which of the following? I. A risk-free asset has no systematic risk. II. Beta is a reliable estimate of total risk. III. The reward-to-risk ratio is constant. IV. The market rate of return can be approximated.

C) I, III, and IV only

Which one of the following statements related to risk is correct? A) The beta of a portfolio must increase when a stock with a high standard deviation is added to the portfolio. B) Every portfolio that contains 25 or more securities is free of unsystematic risk. C) The systematic risk of a portfolio can be effectively lowered by adding T-bills to the portfolio. D) Adding five additional stocks to a diversified portfolio will lower the portfolio's beta. E) Stocks that move in tandem with the overall market have zero betas.

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

A stock with an actual return that lies above the security market line has: A) more systematic risk than the overall market. B) more risk than that warranted by CAPM. C) a higher return than expected for the level of risk assumed. D) less systematic risk than the overall market. E) a return equivalent to the level of risk assumed.

C) a higher return than expected for the level of risk assumed.

Textile Mills borrows money at a rate of 8.7 percent. This interest rate is referred to as the: A) compound rate. B) current yield. C) cost of debt. D) capital gains yield. E) cost of capital.

C) cost of debt.

A company's overall cost of equity is: A) generally less than its WACC given a debt-equity ratio of .5. B) unaffected by changes in the market risk premium. C) directly related to the risk level of the firm. D) generally less than the firm's aftertax cost of debt. E) inversely related to changes in the level of inflation.

C) directly related to the risk level of the firm.

The primary purpose of portfolio diversification is to: A) increase returns and risks. B) eliminate all risks. C) eliminate asset-specific risk. D) eliminate systematic risk. E) lower both returns and risks.

C) eliminate asset-specific risk.

A company's weighted average cost of capital: A) is equivalent to the aftertax cost of the outstanding liabilities. B) should be used as the required return when analyzing any new project. C) is the return investors require on the total assets of the firm. D) remains constant when the debt-equity ratio changes. E) is unaffected by changes in corporate tax rates.

C) is the return investors require on the total assets of the firm.

Which one of the following is the best example of a diversifiable risk? A) Interest rates increase B) Energy costs increase C) Core inflation increases D) A firm's sales decrease E) Taxes decrease

D) A firm's sales decrease

The expected return on a portfolio: I. can never exceed the expected return of the best performing security in the portfolio. II. must be equal to or greater than the expected return of the worst performing security in the portfolio. III. is independent of the unsystematic risks of the individual securities held in the portfolio. IV. is independent of the systematic risks of the individual securities held in the portfolio.

D) I, II, and III only

Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 65 percent of the company's overall sales. Division A is also the riskier of the two divisions. When management is deciding which of the various divisional projects should be accepted, the managers should: A) allocate more funds to Division A since it is the larger of the two divisions. B) fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. C) allocate the company's funds to the projects with the highest net present values based on the company's weighted average cost of capital. D) assign appropriate, but different, discount rates to each project and then select the projects with the highest net present values. E) fund the highest net present value projects from each division based on an allocation of 65 percent of the funds to Division A and 35 percent of the funds to Division B.

D) assign appropriate, but different, discount rates to each project and then select the projects with the highest net present values.

A company's current cost of capital is based on: A) only the return required by the company's current shareholders. B) the current market rate of return on equity shares. C) the weighted costs of all future funding sources. D) both the returns currently required by its debtholders and stockholders. E) the company's original debt-equity ratio.

D) both the returns currently required by its debtholders and stockholders. (Re & Rd)

The reward-to-risk ratio for Stock A is less than the reward-to-risk ratio of Stock B. Stock A has a beta of .82 and Stock B has a beta of 1.29. This information implies that: A) Stock A is riskier than Stock B and both stocks are fairly priced. B) Stock A is less risky than Stock B and both stocks are fairly priced. C) either Stock A is underpriced or Stock B is overpriced or both. D) either Stock A is overpriced or Stock B is underpriced or both. E) both Stock A and Stock B are correctly priced since Stock A is less risky than Stock B.

D) either Stock A is overpriced or Stock B is underpriced or both.

The expected return on a portfolio considers which of the following factors? I. Percentage of the portfolio invested in each individual security II. Projected states of the economy III. The performance of each security given various economic states IV. Probability of occurrence for each state of the economy

E) I, II, III, and IV

Which one of the following is represented by the slope of the security market line? A) Return on a risky security B) Market standard deviation C) Beta coefficient D) Risk-free interest rate E) Market risk premium

E) Market risk premium

The capital asset pricing model approach to equity valuation: A) is dependent upon the unsystematic risk of a security. B) assumes the reward-to-risk ratio increases as beta increases. C) can only be applied to dividend-paying firms. D) assumes a firm's future risks will be higher than its current risks. E) assumes the reward-to-risk ratio is constant.

E) assumes the reward-to-risk ratio is constant.

The weighted average cost of capital for a company is least dependent upon the: A) company's beta. B) coupon rate of the company's outstanding bonds. C) growth rate of the company's dividends. D) company's marginal tax rate. E) standard deviation of the company's common stock.

E) standard deviation of the company's common stock.

The discount rate assigned to an individual project should be based on: A) the company's overall weighted average cost of capital. B) the actual sources of funding used for the project. C) an average of the company's overall cost of capital for the past five years. D) the current risk level of the overall firm. E) the risks associated with the use of the funds required by the project.

E) the risks associated with the use of the funds required by the project.

The primary advantage of using the dividend growth model to estimate a company's cost of equity is: A) the ability to apply either current or future tax rates. B) the model's applicability to all corporations. C) is the model's consideration of risk. D) the stability of the computed cost of equity over time. E) the simplicity of the model.

E) the simplicity of the model.

Security Market Line (SML)

a positively sloped straight line displaying the relationship between expected return and beta (of CAPM)

Diversifiable risk (unsystematic risk)

a risk that affects only individuals or small groups and not the entire economy