Answer Choices:
a. True
b. False
Answer: a. True
Question: The constant growth DCF model used to evaluate the prices of common stocks is conceptually similar to the model used to find the price of perpetual preferred stock or other perpetuities.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk premium.
b. The slope of the Security Market Line is beta.
c. Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.
d. If a stock’s beta doubles, its required rate of return must also double.
e. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.
Answer: e. If a stock’s returns are negatively correlated with returns on most other stocks, the stock’s beta will be negative.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
b. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
c. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
d. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.
e. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.
Answer: c. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
Question: The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio?
Answer Choices:
a. Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.
b. Adding more such stocks will increase the portfolio’s expected rate of return.
c. Adding more such stocks will reduce the portfolio’s beta coefficient and thus its systematic risk.
d. Adding more such stocks will have no effect on the portfolio’s risk.
e. Adding more such stocks will reduce the portfolio’s market risk but not its unsystematic risk.
Answer: a. Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.
Question: Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed’s actions would lead to a recession, and that led to an increase in the market risk premium, (rM – rRF). Under these conditions, with other things held constant, which of the following statements is most correct?
Answer Choices:
a. The required return on all stocks would increase by the same amount.
b. The required return on all stocks would increase, but the increase would be greatest for stocks with betas of less than 1.0.
c. Stocks’ required returns would change, but so would expected returns, and the result would be no change in stocks’ prices.
d. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
e. The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.
Answer: d. The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.
Question: Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock’s returns is 20%. The stocks’ returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT?
Answer Choices:
a. Portfolio P has a standard deviation of 20%.
b. The required return on Portfolio P is equal to the market risk premium (r_M – r_F).
c. Portfolio P has a beta of 0.7.
d. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, r_F.
e. Portfolio P has the same required return as the market (r_M).
Answer: a. Portfolio P has a standard deviation of 20%.
Question: Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested in Stock B. If the market risk premium (rM – rRF) were to increase but the risk-free rate (rRF) remained constant, which of the following would occur?
Answer Choices:
a. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
b. The required return would decrease by the same amount for both Stock A and Stock B.
Answer: a. The required return would increase for both stocks but the increase would be greater for Stock B than for Stock A.
Question: A stock with a beta equal to –1.0 has zero systematic (or market) risk.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value.
Answer Choices:
a. True
b. False
Answer: a. True
Question: If a stock’s market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor’s estimate of the intrinsic value.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Someone who is risk averse has a general dislike for risk and a preference for certainty. If risk aversion exists in the market, then investors in general are willing to accept somewhat lower returns on less risky securities. Different investors have different degrees of risk aversion, and the end result is that investors with greater risk aversion tend to hold securities with lower risk (and therefore a lower expected return) than investors who have more tolerance for risk.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The key conclusion of the Capital Asset Pricing Model is that the value of an asset should be measured by considering both risk and the expected return of the asset, assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in isolation is not relevant under the CAPM.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don’t want to relinquish voting control.
Answer Choices:
a. True
b. False
Answer: a. True