Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?
Answer Choices:
a. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
b. The expected return of your portfolio is likely to decline.
c. The diversifiable risk will remain the same, but the market risk will likely decline.
d. Both the diversifiable risk and the market risk of your portfolio are likely to decline.
e. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.
Answer: a. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
Question: The CAPM is a multi-period model that takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Projected free cash flows should be discounted at the firm’s weighted average cost of capital to find the firm’s total corporate value.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections’ revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.’s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of –0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
c. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
d. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should rebalance your portfolio to include more high-beta stocks.
e. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
Answer: b. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of –0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
Question: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?
Answer Choices:
a. The required return of all stocks will remain unchanged since there was no change in their betas.
b. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
c. The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.
d. The required returns on all three stocks will increase by the amount of the increase in the market risk premium.
e. The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.
Answer: b. The required return on Stock A will increase by less than the increase in the market risk premium, while the required return on Stock C will increase by more than the increase in the market risk premium.
Question: Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A’s portfolio has a beta of minus 2.0, while Investor B’s portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some “normal” stocks with beta = 1.0.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company’s beta is 1.0.
b. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
c. The beta of an “average stock,” which is also “the market beta,” can change over time, sometimes drastically.
Answer: c. The beta of an “average stock,” which is also “the market beta,” can change over time, sometimes drastically.
Question: If a firm’s stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, r_M – r_F, is positive. Which of the following statements is CORRECT?
Answer Choices:
a. If the risk-free rate increases but the market risk premium stays unchanged, Stock B’s required return will increase by more than Stock A’s.
b. Stock B’s required rate of return is twice that of Stock A.
c. If Stock A’s required return is 11%, then the market risk premium is 5%.
d. If Stock B’s required return is 11%, then the market risk premium is 5%.
e. If the risk-free rate remains constant but the market risk premium increases, Stock A’s required return will increase by more than Stock B’s.
Answer: a. If the risk-free rate increases but the market risk premium stays unchanged, Stock B’s required return will increase by more than Stock A’s.
Question: Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
Answer Choices:
a. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.
b. The effect of a change in the market risk premium depends on the slope of the yield curve.
c. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
e. The effect of a change in the market risk premium depends on the level of the risk-free rate.
Answer: d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
Question: A portfolio’s risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
Answer Choices:
a. True
b. False
Answer: b. False
Question: According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?
Answer Choices:
a. Portfolio P’s expected return is greater than the expected return on Stock B.
b. Portfolio P’s expected return is equal to the expected return on Stock A.
c. Portfolio P’s expected return is less than the expected return on Stock B.
d. Portfolio P’s expected return is equal to the expected return on Stock B.
e. Portfolio P’s expected return is greater than the expected return on Stock C.
Answer: d. Portfolio P’s expected return is equal to the expected return on Stock B.
Question: Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
Answer Choices:
a. If a stock has a negative beta, its required return under the CAPM would be less than 5%.
b. If a stock’s beta doubled, its required return under the CAPM would also double.
c. If a stock’s beta doubled, its required return under the CAPM would more than double.
d. If a stock’s beta were 1.0, its required return under the CAPM would be 5%.
e. If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 5%.
Answer: a. If a stock has a negative beta, its required return under the CAPM would be less than 5%.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.
b. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
c. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
e. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.
Answer: c. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
Question: The distributions of rates of return for Companies AA and BB are given below: State of the Economy Probability of This State Occurring AA BB Boom 0.2 30% -10% Normal 0.6 10% 5% Recession 0.2 -5% 50% We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The slope of the SML is determined by the value of beta.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Assume that the risk-free rate, rRF, increases but the market risk premium, (rM – rRF), declines with the net effect being that the overall required return on the market, rM, remains constant. Which of the following statements is CORRECT?
Answer Choices:
a. The required return of all stocks will increase by the amount of the increase in the risk-free rate.
b. The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a beta greater than 1.0.
c. Since the overall return on the market stays constant, the required return on each individual stock will also remain constant.
d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
e. The required return of all stocks will fall by the amount of the decline in the market risk premium.
Answer: d. The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta greater than 1.0.
Question: If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The corporate valuation model can be used only when a company doesn’t pay dividends.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must be true, according to the CAPM?
Answer Choices:
a. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.
b. Stock Y’s realized return during the coming year will be higher than Stock X’s return.
c. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
d. Stock Y’s return has a higher standard deviation than Stock X.
e. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.
Answer: c. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
Question: Founders’ shares are a type of classified stock where the shares are owned by the firm’s founders, and they generally have more votes per share than the other classes of common stock.
Answer Choices:
a. True
b. False
Answer: a. True