Smart book exam 4

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An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

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

income

The expected return on the market will increase if the risk-free rate _________ or if the market risk premium _____

increases; increases

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

information

Stock prices fluctuate from day to day because of _____.

information flow

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 ______.

initial stock price

The WACC is the minimum return a company needs to earn to satisfy _____.

its bondholders its stockholders

The probability of an outcome being more than three standard deviations away from the mean in a normal distribution is approximately ___ percent.

less than 1

The most appropriate weights to use in the WACC are the ______ weights.

market value

Preferred stock ___.

pays a constant dividend pays dividends in perpetuity

Preferred stock ___.

pays a constant dividend pays dividends in perpetuity

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

positive

eturns tell how much was received for each dollar invested, so they can be applied to any initial investment amount.

precent

returns tell how much was received for each dollar invested, so they can be applied to any initial investment amount.

precent

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

required return cost of capital discount rate

The Sharpe ratio measures ___.

reward to risk

The second lesson from capital market history is that there is a direct link between and reward.

risk

Arrange the following investments from highest to lowest return based on what our study of capital market history has revealed about risk premiums.

small-company longterm us. treasury

Geometric averages are ______ arithmetic averages.

smaller than

The principle of diversification tells us that spreading an investment across a number of assets will eliminate Blank______ of the risk.

some

The first step to calculate the variances of the returns on two stocks is to determine the deviations from the expected return.

square

The standard deviation is the ______ of the variance.

square root

Kate Corporation has discovered a very secret new product, but hasn't yet announced the discovery to the public. If the stock price reacts before the announcement (assuming no corporate "leaks"), the market is _____ form efficient.

strong

Capital weights can be interpreted just like portfolio weights.

structure

The cost of capital is an appropriate name since a project must earn enough to pay those who ______ the capital.

supply

A normal distribution has a ______ shape.

symmetrical

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

symmetrical bell-shaped

The risk principle argues that the market does not reward unnecessary risk that is taken on by the investor.

systematic

When an investor is diversified only ________ risk matters.

systematic

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

that are borne unnecessarily

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

that are borne unnecessarily

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

the arithmetic mean minus half of the variance

Studying market history can reward us by demonstrating that _____.

the greater the potential reward is, the greater the risk on average, investors will earn a reward for bearing risk

The portfolio weight is _____.

the percentage of the total value that is invested in an asset

The standard deviation is ___.

the square root of the variance

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

there is no way of directly observing the return that the firm's equity investors require on their investment

True or false: The existence of traders attempting to beat the market is a necessary precondition for markets to become efficient.

true

Average returns can be calculated _____.

two different ways

The true risk of any investment is the _____ portion.

unanticipated

The risk that affects a single asset or a small group of assets is ______ risk.

unsystematic

For a well-diversified portfolio, the Blank______ risk is negligible.

unsystematic diversifiable unique

The is the squared standard deviation.

variance

The square of the standard deviation is equal to the ____.

variance

A distribution tends to have a smooth shape when the number of observations is ___.

very large

The percentage of a portfolio's total value that is invested in a particular asset is the portfolio .

weight

The efficient markets hypothesis contends that _____ capital markets such as the NASDAQ are efficient.

well-organized

One of the disadvantages of using historical returns to estimate the market risk premium is that the past may not be a good guide to the future _____.

when economic conditions change quickly

The dividend is defined as the annual dividend amount divided by the beginning stock price.

yeild

A firm's cost of debt can be ___.

*obtained by checking yields on publicly traded bonds *estimated easier than its cost of equity *obtained by talking to investment bankers

The SML approach requires estimates of the _____.

- market risk premium - beta coefficient

The risk of owning an asset comes from:

- unanticipated events - surprises

The risk-free asset has a beta of _____.

0.00

By definition, what is the beta of the average asset equal to?

1

If a security's expected return is equal to the expected return on the market, its beta must be ____

1

A projected IRR on a risky investment in the _____ percent range is not unusual.

10 to 20

The weighted average of the standard deviations of the assets in Portfolio C is 12.9%. Which of the following are possible values for the standard deviation of the portfolio?

12.9% 10.9%

Based on average historical returns shown in the text, small-company stocks increased in value by _____ percent in a typical year.

16

The probability of an outcome being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent

68

The probability of an outcome being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.

68

Asset A has an expected return of 17 percent and standard deviation of 5 percent. Asset B has an expected return of 15 percent and standard deviation of 5 percent. Which asset would a rational investor choose? Multiple choice question.

A

According to the CAPM, which of the following events would affect the return on a risky asset?

A change in the yield on T-bills A strengthening of the country's currency Federal reserve actions that affect the economy

Which of the following is true?

A company can deduct interest paid on debt when computing taxable income.

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

A firm is exposed to both systematic and unsystematic risks. Which of the following are examples of systematic risks?

An increase in the Federal funds rate An increase in the corporate tax rate

Assets A and B each have an expected return of 10 percent. Asset A has a standard deviation of 12 percent while Asset B has a standard deviation of 13 percent. Which asset would a rational investor choose? Multiple choice question.

Asset A

Which of the following are true?

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

Which of the following are ways to make money by investing in stocks? (Select all that apply.)

Capital gains Dividends

Which of the following are examples of unsystematic risk?

Changes in management Labor strikes

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

Cost of preferred stock Cost of common stock Cost of debt

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

Coupon interest paid on bonds

What can we say about the dividends paid to common and preferred stockholders?

Dividends to common stockholders are not fixed. Dividends to preferred stockholders are fixed.

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: Based on capital market history, market efficiency shows us that it is relatively simple to identify stocks that are incorrectly priced.

False

Which of the following are examples of systematic risk?

Future rates of inflation Regulatory changes in tax rates

Based on the historical returns shown in the text, the average was 2.9 percent per year over the 94-year span depicted.

Inflation

Which of the following are examples of a portfolio?

Investing $100,000 in a combination of U.S. and Asian stocks Holding $100,000 investment in a combination of stocks and bonds Investing $100,000 in the stocks of 50 publicly traded corporations

What does the security market line depict?

It is a graphical depiction of the capital asset pricing model. It shows the relationship between expected return and beta.

What is systematic risk?

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

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.

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

The formula for the required return from the SML is:

RE = Rf + B(RM − Rf)

Mona Corporation has a variance of returns of 343, while Scott Corporation has a variance of returns of 898. Which company's actual returns vary more from their mean return?

Scott Corporation

The ratio is calculated as the risk premium of the asset divided by the standard deviation.

Sharpe

Which type of risk is unaffected by adding securities to a portfolio?

Systematic risk

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

Systematic, or market risk

Which type of risk does not change as we add more securities to a portfolio?

Systematic, or market, risk

A firm faces many risks. Which of the following are examples of unsystematic risks faced by a firm?

The death of the CEO A hostile takeover attempt by a competitor

Which of the following methods for calculating the cost of equity ignores risk?

The dividend growth model

What are the two components of the market risk premium?

The expected return on the market The risk-free rate

What is the expected return on a security with beta of 1?

The expected return on the market.

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

The market-risk premium

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

Using the SML approach, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

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

The risk-free rate

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

What are the two components of unexpected return (U) in the total return equation?

The systematic portion The unsystematic portion

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

There is no relationship.

True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.

True

Which one of the following is true?

Under U.S. tax law, a corporation's interest payments are deductible for tax purposes.

What does WACC stand for?

Weighted average cost of capital

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.

Given the definitions above, the weighted average cost of capital formula can be written as:

[S/(S + B)] × RS + [B/(S + B)] × RB × (1 − Tc)

More volatility in returns produces ______ difference between the arithmetic and geometric averages.

a larger

The calculation of a portfolio beta is similar to the calculation of _____.

a portfolio's expected return

Based on the capital asset pricing model (CAPM) there is generally ___ relationship between beta and the expected return on a security.

a positive

The WACC is the weighted average of the cost of equity and the _____.

aftertax cost of debt

In an efficient market:

all investments are zero NPV investments assets are priced at the present value of their future cash flows

Percentage returns are more convenient than dollar returns because they ____.

apply to any amount invested

The dividend yield for a 1-year period is equal to the annual dividend amount divided by the ______.

beginning stock price

The coefficient is the amount of systematic risk present in a particular risky asset relative to that in an average asset.

beta

The gains yield can be found by taking the difference between the ending stock price and the initial stock price and dividing it by the initial stock price.

capital

If you buy a stock for $10 and later sell it for $16, you will have a ____.

capital gain of $6

The total dollar return is the sum of dividends and __________.

capital gains or losses

When a company declares a dividend, shareholders generally receive ______.

cash

A firm's overall cost of capital will include both its cost of capital and equity capital.

debt

The cost of can be observed because it is the interest rate the firm must pay on new loans.

debt

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

declines

The increase in the number of stocks in a portfolio results in a(n) in the average standard deviation of annual portfolio returns.

decrease

When new securities are added to a portfolio, the total unsystematic risk portion of that portfolio is most likely to _____.

decrease

Finding a firm's overall cost of equity is

difficult

Historically, there is a(n) ______ relationship between risk and expected return in the stock market.

direct

To apply the dividend growth model to a particular stock, you need to assume that the firm's ___ will grow at a constant rate.

dividend

The two potential ways to make money as a stockholder are through ______ and capital appreciation.

dividends

The two potential ways to make money as a stockholder are through ______ and capital appreciation. Multiple choice question.

dividends

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

The _ return is the return that an investor will probably earn on a risky asset in the future.

expected

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

fair

Which of the following is a conclusion that can be drawn regarding market efficiency from capital market history?

future market prices are hard to predict based on publicly available information

Average returns can be calculated using or arithmetic average.

geometric

The underlying key assumption, and oftentimes a key disadvantage, of the dividend growth model is that it assumes the dividend _____.

grows at a constant rate

The second lesson from studying capital market history is that risk is _____.

handsomely rewarded


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