Finance Ch. 10, 11, 12

If you receive a 2$ dividend per share on your 100 shares, your total dividend income is _____.

$200 2x100 = 200

You bought one share of stock for $100 and received a 2$ dividend. If the price of the stock rose to $103, then your total dollar return would be _____.

$5 103-100+2 = 5

The price of XYZ stock rises from $10 to $15. If you own 100 shares, your capital gain is _____.

$500 (15x100) - (10x100) = 500

***The minimum required return on a new project is known as the:

***cost of capital

***The year 2008 was:

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

Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2011 has revealed as shown in Table 10.10:

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 the lowest historical risk premium to the highest historical risk premium.

1. U.S. Treasury Bills 2. Long-term corporate bonds 3. Large-company stocks 4. Small-company stocks

Suppose a firm's capital structure consists of 30% debt, 10% preferred stock, and 60% equity. The firm's bonds yield 10% on average before taxes, the cost of preferred stock is 8%, and the cost of equity is 16%. Calculate the firm's WACC assuming a tax rate of 40%.

12.20% 0.6 x 16% + 0.3 x 10% x (1-0.4) + 0.1 x 8% = 12.20%

What is the expected return of a portfolio consisting of stocks A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both stocks.

12.5% (.5x.10) + (.5x.15) .5 due to equal investment

True or false: Since the CAPM equation can be used only for individual securities, it cannot be used with portfolios.

false

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

not change

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

risk-free rate

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

the risk-free rate

If a firm is funded with $400 in debt and $1,200 in equity, the weight of equity is _____ and the weight of debt is _____ to be used to compute the WACC

75%, 25%

If the annual stock market returns for Berry Company were 19 percent, 13 percent, and -8 percent, what was the arithmetic mean for those 3 years?

8%

What two factors determine a stock's total return?

Expected return Unexpected return

Which of the following are examples of systematic risk?

Future rates of inflation Regulatory changes in tax rates

Which of the following are true?

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

What are the two components of risky return in the total return equation?

Market risk Unsystematic risk

A security has a beta of 1, a market risk premium of 8%, and a risk-free rate of 3%. What will happen to the expected return if the beta doubles?

The expected return will increase to 19% from 11%

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

The market-risk premium

Which of the following are needed to describe the distribution of stock returns?

The mean return The standard deviation of returns

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

There is no relationship

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.

More Volatility in returns produces _____ difference between the arithmetic and geometric averages

a larger

Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices.

all information > strong form efficiency all public information > semi-strong form efficiency historical stock prices > weak form efficiency

Percentage returns are more convenient than dollar returns because they:

allow comparison against other investments apply to any amount invested

A capital gain on a stock results from _____.

an increase in price

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

better than no risk approach

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

cannot

WACC is used to discount _____ _____.

cash flows

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

compare stock returns with the returns on other securities

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

declines

If the firm is all-equity, the discount rate is equal to the firm's cost of _____ capital.

equity

In an efficient market, firms should expect to receive _____ value for securities they sell.

fair

If the dispersion of returns on a particular security is very spread out from the security's mean return, the security _____.

is highly risky

Historically, the real return on Treasury bills has been:

quite low

What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?

the firm overall will become riskier it will accept projects that it should have rejected it will reject projects that it should have accepted

The standard deviation is _____.

the square root of the variance.

Studying market history can reward us by demonstrating that:

there is a reward for bearing risk the greater the potential reward is, the greater the risk

_____ risk is reduced as more securities are added to the portfolio

unique unsystematic diversifiable

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

If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities?

1.25 Portfoliobeta = .5x1.5+.5x1 = 1.25

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 40%, the after-tax rate of return on its preferred stock is:

10%

If an analysts forecast for a firm's earnings growth is 7 percent, and its dividend yield is 3 percent, its cost of equity will be _____.

10% .03+.07

A company has a borrowing rate of 15 percent and a tax rate of 30 percent. What is its aftertax cost of debt?

10.5% 15% x (1-.3) = 10.5%

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 + 1.5x(9-5) = 11%

If stock ABC has a mean return of 10 percent with a standard deviation of 5 percent, then the probability of earning a return greater than 15 percent is about _____ percent.

16 prob(R>15%) = (1-.68)/2

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 of the following are examples of a portfolio?

Investing $100,000 in a combination of US and Asian stocks Investing $100,000 in the stocks of 50 publicly traded corporations Investing $100,000 in a combination of stocks and bonds

What is the definition of expected return?

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

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 It is likely to decrease

What does variance measure?

It measures the riskiness of a security's returns. It measures the spread of the sample of returns.

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

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

True or false: A capital gain on a stock is counted as part of the total return whether or not the gain is realized from selling the stock.

True

If a stock has returns of 10 percent and 20 percent over 2 years, the geometric average rate of return can be calculated by _____.

[(1.10)(1.20)]^0.5 - 1

*** 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] x Re = [D/V] x Rd x (1-Tc)

Unsystematic risk will affect

a specific firm firms in a single industry

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

The _____ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.

excess

If a firm issues no debt, its average cost of capital will equal _____.

its cost of equity

An investment will have a negative NPV when its expected return is _____ _____ what the financial markets offer for the same risk.

less than

If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:

10% 2/20 = .10

A firm's capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC?

13% (0.7 x 16%) + (0.3 x 10% x (1-0.4)) = 13%

What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4 percent and the expected return on the market is 12 percent?

13.6% 4% + 1.2(12% - 4%) = 13.6%

You buy a stock for $100. In one year its price rises to $114, and it pays a $1 dividend. Your capital gains yield is _____.

14%

One year ago, Ernie purchased shares of RTF common stock for $100 a share. Today the stock paid a dividend of $1 per share. If the stock currently sells for $114 per share, what is Ernie's total return?

15% (114-100+1)/100 = 15%

Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and the beta is 2. Find the required rate of return using the CAPM.

15% 5% + (2x(10%-5%)) = 15%

If stock ABC has a mean return of 10 percent with a standard deviation of 5 percent, then the probability of earning a negative return is approximately _____ percent.

2.5

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

20

The standard deviation for large-company stock returns from 1926 to 2011 is:

20.3%

Suppose you bought 100 shares of Banks & Bower, Inc. for $50 a share. During the year, B&B paid a $0.50 per share dividend. At year end, B&B was selling for $60 a share. What is your total percentage return?

21% (60-50+0.50)/50=21%

ABC has a beta of 2.5 and XYZ has a beta of 1.5. The risk-free rate is 4 percent and the market risk premium is 9 percent. What is the expected return on a portfolio that is equally invested in ABC and XYZ?

22% Bp = (2.5 + 1.5)/2 = 2 Expected return = 4% + 2(9%) = 22%

You buy a stock for $50. Its price rises to $55, and it pays a $2 dividend in a year. You do not sell the stock. Your dividend yield is _____%.

4 2/50 = 4

If the variance of a portfolio is .0025, what is the standard deviation?

5% Op= .0025^.5 - .05, or 5%

The probability of a return being within +/- one standard deviation of the mean in a normal distribution is approximately _____ percent

68

John's portfolio consists of $1,200 worth of Chi Corporation common stock and $400 worth of Lambda Corporation common stock. Lambda's portfolio weight is 25%, and Chi's portfolio weight is:

75% Obvious reason is obvious

If a series of stock returns has a variance of 0.0068, what is the standard deviation?

8.246% Square root of 0.0068

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = $10, Project D = $40. Which projects should the firm accept?

A and D

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

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

Capital gains Dividends

Which of the following are examples of unsystematic risk?

Changes in management Labor strike

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

Cost of debt Cost of preferred stock Cost of common stock

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

Coupon interest paid on bonds

True or false: A well-diversified portfolio will eliminate all risks.

False

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

False

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

It cannot be observed directly

What does the security market line depict?

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

What is a systematic risk?

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

What is a risk premium?

It is additional compensation for taking risk, over and above the risk-free rate.

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

Which of the following types of risk is not reduced by diversification?

Systematic, or market risk Systematic risk cannot be diversified away.

Which of the following are true?

T-bills sometimes outperform common stocks. Common stocks frequently experience negative returns.

The Ibbotson-Sinquefield data show that over the long-term, _____.

T-bills, which had the lowest risk, generated the lowest return small-company stocks generated the highest average return small-company stocks had the highest risk level

Which of the following is commonly used to measure inflation

The Consumer Price Index (CPI)

What is the Reward-to-Risk Ratio?

[E(RA)-Rf]/BA

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

beginning stock price

Some important characteristics of the normal distribution are that it is:

bell-shaped symmetrical

The geometric rate of return takes _____ into account.

compounding

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

cost of capital discount rate required return

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

dividends; capital gains

The return an investor in a security receives is _____ _____ the cost of the security to the company that issued it.

equal to

In 2008, the prices on long-term U.S. Treasury bonds _____.

gained 40%

The second lesson from studying capital market history states that the _____ the potential reward, the _____ the risk

greater; greater less; less

The second lesson from studying capital market history is that risk is:

handsomely rewarded

The growth rate of dividends can be found using:

historical dividend growth rates security analysts' forecasts

From 1900 to 2010, the US ranked _____ when compared internationally in terms of highest equity risk premium.

in the middle

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

income

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

information

The capital gain 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

Components of the WACC include funds that come from _____.

investors

In the Ibbotson-Sinquefield studies, U.S. Treasury bill data is based on T-bills with a maturity of _____ month(s).

one

Preferred stock _____.

pays a constant dividend pays dividends in perpetuity

If you use a geometric average to project short-run wealth levels, your results will most likely be _____.

pessimistic because too low

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

positive

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

pure plays

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

The arithmetic average rate of return measures the _____.

return in an average year over a given period

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

The standard deviation is the _____ of the variance.

square root

The risk of owning an asset comes from:

surprises unanticipated events

Beta tells us the amount of _____ risk of an asset or portfolio relative to _____.

systematic; an average risky asset

The systematic risk principle argues that the market does not reward risks?

that are borne unnecessarily that are diversifiable

To determine the appropriate required return for an investment, we can use _____.

the Security Market Line (SML)

Two ways of calculating average returns are _____ and _____.

the arithmetic average the geometric average

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

the arithmetic mean minus half of the variance

To estimate the dividend yield of a particular stock, we need:

the current stock price the last dividend paid, D0 forecasts of the dividend growth rate, g

The efficient markets hypotheses contends that _____ capital markets such as the NYSE are efficient.

well-organized