Test bank corporate finance 8e ros chap013

Chapter 013 Return Risk and the Security Market Line Multiple Choice Questions The return on a risky asset which is anticipated being earned in the future is called the _ return a average b historical C expected d geometric e required SECTION: 13.1 TOPIC: EXPECTED RETURN TYPE: DEFINITIONS A group of assets, such as stocks and bonds, held by an investor is called a(n): a index B portfolio c collection d grouping e tranche SECTION: 13.2 TOPIC: PORTFOLIOS TYPE: DEFINITIONS The percentage of a portfolio's total value invested in a particular asset is called that asset's: a portfolio return B portfolio weight c degree of risk d composite value e index value SECTION: 13.2 TOPIC: PORTFOLIO WEIGHTS TYPE: DEFINITIONS 13-1 Chapter 013 Return Risk and the Security Market Line Risk that affects a large number of assets is called _ risk a idiosyncratic b diversifiable C systematic d asset-specific e total SECTION: 13.4 TOPIC: SYSTEMATIC RISK TYPE: DEFINITIONS Risk that affects at most a small number of assets is called _ risk a portfolio b nondiversifiable c market D unsystematic e total SECTION: 13.4 TOPIC: UNSYSTEMATIC RISK TYPE: DEFINITIONS The principle of diversification tells us that: a concentrating an investment in two or three large stocks will eliminate all of the unsystematic risk b concentrating an investment in three companies all within the same industry will greatly reduce the systematic risk c spreading an investment across five diverse companies will not lower the total risk d spreading an investment across many diverse assets will eliminate all of the systematic risk E spreading an investment across many diverse assets will eliminate some of the total risk SECTION: 13.5 TOPIC: PRINCIPLE OF DIVERSIFICATION TYPE: DEFINITIONS 13-2 Chapter 013 Return Risk and the Security Market Line The _ tells us that the expected return on a risky asset depends only on that asset's nondiversifiable risk a efficient markets hypothesis B systematic risk principle c open markets theorem d law of one price e principle of diversification SECTION: 13.6 TOPIC: SYSTEMATIC RISK PRINCIPLE TYPE: DEFINITIONS The amount of systematic risk present in a particular risky asset relative to the systematic risk present in an average risky asset, is called the: A beta coefficient b reward-to-risk ratio c risk ratio d diversifiable risk e Treynor index SECTION: 13.6 TOPIC: BETA COEFFICIENT TYPE: DEFINITIONS The positively sloped linear function which illustrates the relationship between an asset's expected return and its beta coefficient is the: a reward-to-risk ratio b portfolio weight c portfolio risk D security market line e market risk premium SECTION: 13.7 TOPIC: SECURITY MARKET LINE TYPE: DEFINITIONS 13-3 Chapter 013 Return Risk and the Security Market Line 10 Which one of the following is the slope of the security market line? a reward-to-risk ratio b portfolio weight c beta coefficient d risk-free interest rate E market risk premium SECTION: 13.7 TOPIC: MARKET RISK PREMIUM TYPE: DEFINITIONS 11 The equation of the SML which defines the relationship between the expected return and beta is the: A capital asset pricing model b time value of money equation c risk-return model d market equation e expected risk formula SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL TYPE: DEFINITIONS 12 The minimum required return on a new risky investment is called the: a average arithmetic return b expected return c geometric average return d time value of money E cost of capital SECTION: 13.7 TOPIC: COST OF CAPITAL TYPE: DEFINITIONS 13-4 Chapter 013 Return Risk and the Security Market Line 13 The expected return on a stock given various states of the economy is equal to the: a highest expected return given any economic state b arithmetic average of the returns for each economic state c summation of the individual expected rates of return D weighted average of the returns for each economic state e return for the economic state with the highest probability of occurrence SECTION: 13.1 TOPIC: EXPECTED RETURN TYPE: CONCEPTS 14 The expected return on a stock computed using economic probabilities is: a guaranteed to equal the actual average return on the stock for the next five years b guaranteed to be the minimal rate of return on the stock over the next two years c guaranteed to equal the actual return for the immediate twelve month period D a mathematical expectation based on a weighted average and not an actual anticipated outcome e the actual return you should anticipate as long as the economic forecast remains constant SECTION: 13.1 TOPIC: EXPECTED RETURN TYPE: CONCEPTS 15 The expected risk premium on a stock is equal to the expected return on the stock minus the: a expected market rate of return B risk-free rate c inflation rate d standard deviation e variance SECTION: 13.1 TOPIC: EXPECTED RISK PREMIUM TYPE: CONCEPTS 13-5 Chapter 013 Return Risk and the Security Market Line 16 Standard deviation measures _ risk A total b nondiversifiable c unsystematic d systematic e economic SECTION: 13.1 TOPIC: STANDARD DEVIATION TYPE: CONCEPTS 17 The expected rate of return on a stock portfolio is a weighted average where the weights are based on the: a number of shares owned of each stock b market price per share of each stock C market value of the investment in each stock d original amount invested in each stock e cost per share of each stock held SECTION: 13.2 TOPIC: PORTFOLIO WEIGHT TYPE: CONCEPTS 18 The portfolio expected return 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 a I and III only b II and IV only c I, III, and IV only d II, III, and IV only E I, II, III, and IV SECTION: 13.2 TOPIC: PORTFOLIO EXPECTED RETURN TYPE: CONCEPTS 13-6 Chapter 013 Return Risk and the Security Market Line 19 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 performance of the overall economy IV is independent of the allocation of the portfolio amongst individual securities a I and III only b II and IV only C I and II only d I, II, and III only e I, II, III, and IV SECTION: 13.2 TOPIC: PORTFOLIO EXPECTED RETURN TYPE: CONCEPTS 20 If a stock portfolio is well diversified, then the portfolio variance: a will equal the variance of the most volatile stock in the portfolio B may be less than the variance of the least risky stock in the portfolio c must be equal to or greater than the variance of the least risky stock in the portfolio d will be a weighted average of the variances of the individual securities in the portfolio e will be an arithmetic average of the variance of the individual securities in the portfolio SECTION: 13.2 TOPIC: PORTFOLIO VARIANCE TYPE: CONCEPTS 13-7 Chapter 013 Return Risk and the Security Market Line 21 The standard deviation of a portfolio: a is a weighted average of the standard deviations of the individual securities which comprise the portfolio b can never be less than the standard deviation of the most risky security in the portfolio c must be equal to or greater than the lowest standard deviation of any single security held in the portfolio d is an arithmetic average of the standard deviations of the individual securities which comprise the portfolio E can be less than the standard deviation of the least risky security in the portfolio SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: CONCEPTS 13-8 Chapter 013 Return Risk and the Security Market Line 22 Which of the following are included in the computation of a portfolio's standard deviation? I weight assigned to each security comprising the portfolio II weighted average of the standard deviations of the individual securities held in the portfolio III probability of occurrence for each economic state of the economy IV rate of return for each individual security held in the portfolio for each economic state a II only b III and IV only C I, III, and IV only d I, II, and IV only e I, II, III, and IV SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: CONCEPTS 23 Which one of the following statements is correct concerning a portfolio of multiple securities and multiple states of the economy when both the securities and the economic states have unequal weights? a Given multiple economic states with unequal weights, it is impossible for the portfolio standard deviation to be less than the lowest standard deviation for any one security contained in the portfolio b The weights of the individual securities have no effect on the expected return of a portfolio when multiple states of the economy are involved c Changing the probabilities of occurrence for the various economic states will not affect the expected standard deviation of the portfolio d The standard deviation of the portfolio can be greater than the standard deviation of any single security in the portfolio given that the individual securities are well diversified E Given both the unequal weights of the securities and the unequal weights of the economic states, a portfolio can be created that has an expected standard deviation of zero SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: CONCEPTS 13-9 Chapter 013 Return Risk and the Security Market Line 24 Which one of the following events would be included in the expected return on Delta stock? a The directors of Delta just fired the CEO because of remarks he made this morning to one of the directors b A fire just destroyed Delta's main distribution warehouse which will directly impact the firm's sales for at least six months C This morning, Delta confirmed that its CEO is retiring at the end of the year as anticipated d The price of Delta stock suddenly dropped due to rumors concerning company fraud e Delta's research department just announced that they accidentally discovered a new substance which could replace plastic in a few years SECTION: 13.3 TOPIC: EXPECTED AND UNEXPECTED RETURNS TYPE: CONCEPTS 25 Which one of the following statements is correct? a The unexpected return is always negative b The expected return minus the unexpected return is equal to the total return c Over time, the average return is equal to the unexpected return d The expected return includes the surprise portion of news announcements E Over time, the average unexpected return will be zero SECTION: 13.3 TOPIC: EXPECTED AND UNEXPECTED RETURNS TYPE: CONCEPTS 26 Which one of the following is true concerning unexpected returns? a All announcements by a firm affect that firm's unexpected returns b Unexpected returns over time have a negative effect on the total return of a firm c Unexpected returns are relatively predictable in the short-term d Unexpected returns generally cause the actual return to vary significantly from the expected return over the long-term E Unexpected returns can be either positive or negative in the short term but tend to be zero over the long-term SECTION: 13.3 TOPIC: UNEXPECTED RETURNS TYPE: CONCEPTS 13-10 Chapter 013 Return Risk and the Security Market Line 76 What is the variance of a portfolio consisting of $5,500 in stock G and $4,500 in stock H? A .000387 b .000778 c .001482 d .019677 e .038496 E(r)Boom = [$5,500 / ($5,500 + $4,500) 14)] + [$4,500 / ($5,500 + $4,500) 11) = 077 + 0495 = 1265 E(r)Normal = [$5,500 / ($5,500 + $4,500) 07)] + [$4,500 / ($5,500 + $4,500) 09) = 0385 + 0405 = 079 E(r)Portfolio = (.22 1265) + (.78 079) = 02783 + 06162 = 08945 VarPortfolio = [.22 (.1265 08945)2] + [.78 (.079 08945)2] = 000301995 + 000085178 = 000387173 = 000387 AACSB TOPIC: ANALYTIC SECTION: 13.2 TOPIC: PORTFOLIO VARIANCE TYPE: PROBLEMS 13-35 Chapter 013 Return Risk and the Security Market Line 77 What is the standard deviation of a portfolio that is invested 68 percent in stock Q and 32 percent in stock R? a 2.7 percent B 3.0 percent c 3.2 percent d 4.1 percent e 4.3 percent E(r)Boom = (.68 17) + (.32 10) = 1156 + 032 = 1476 E(r)Normal = (.68 07) + (.32 08) = 0476 + 0256 = 0732 E(r)Portfolio = (.20 1476) + (.80 0732) = 02952 + 05856 = 08808 VarPortfolio = [.20 (.1476 08808)2] + [.80 (.0732 08808)2] = 000708526 + 000177132 = 000885658 Std dev = √.000885658 = 02976 = 3.0 percent AACSB TOPIC: ANALYTIC SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: PROBLEMS 13-36 Chapter 013 Return Risk and the Security Market Line 78 What is the standard deviation of a portfolio which is comprised of $9,000 invested in stock S and $6,000 in stock T? A 2.1 percent b 3.6 percent c 4.0 percent d 4.4 percent e 6.3 percent E(r)Boom = [$9,000 / ($9,000 + $6,000) 11)] + [$6,000 / ($9,000 + $6,000) 05) = 066 + 02 = 086 E(r)Normal = [$9,000 / ($9,000 + $6,000) 08)] + [$6,000 / ($9,000 + $6,000) 06) = 048 + 024 = 072 E(r)Bust =[$9,000 / ($9,000 + $6,000) 05)] + [$6,000 / ($9,000 + $6,000) 08) = 03 + 032 = 002 E(r)Portfolio = (.05 086) + (.85 072) + (.10 002) = 0043 + 0612 + 0002 = 0657 VarPortfolio = [.05 (.086 06572)] + [.85 (.072 0657)2] + [.10 (.002 0657)2] = 000020605 + 000033737 + 000405769 = 00046011 Std dev = √.00046011 = 02145 = 2.1 percent AACSB TOPIC: ANALYTIC SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: PROBLEMS 13-37 Chapter 013 Return Risk and the Security Market Line 79 What is the standard deviation of a portfolio which is invested 15 percent in stock A, 45 percent in stock B and 40 percent in stock C? a 1.0 percent b 2.5 percent C 5.0 percent d 7.6 percent e 9.5 percent E(r)Boom = (.15 21) + (.45 12) + (.40 16) = 0315 + 054 + 064 = 1495 E(r)Normal = (.15 11) + (.45 09) + (.40 12) = 0165 + 0405 + 048 = 105 E(r)Bust = (.15 18) + (.45 02) + (.40 22) = 027 + 009 088 = 106 E(r)Portfolio = (.15 1495) + (.80 105) + (.05 106) = 022425 + 084 0053 = 101125 VarPortfolio = [.15 (.1495 101125)2] + [.80 (.105 101125)2] + [.05 ( 106 101125)2] = 000351021 + 000012013 + 002145038 = 002508072 Std dev = √.002508072 = 05008 = 5.0 percent AACSB TOPIC: ANALYTIC SECTION: 13.2 TOPIC: PORTFOLIO STANDARD DEVIATION TYPE: PROBLEMS 13-38 Chapter 013 Return Risk and the Security Market Line 80 What is the beta of a portfolio comprised of the following securities? A .98 b 1.04 c 1.09 d 1.15 e 1.32 ValuePortfolio = $3,500 + $1,000 + $9,500 = $14,000 BetaPortfolio = ($3,500 / $14,000 1.12) + ($1,000 / $14,000 84) = 28 + 1293 + 57 = 9793 = 98 1.81) + ($9,500 / $14,000 AACSB TOPIC: ANALYTIC SECTION: 13.2 AND 13.6 TOPIC: BETA TYPE: PROBLEMS 81 Your portfolio is comprised of 35 percent of stock X, 25 percent of stock Y, and 40 percent of stock Z Stock X has a beta of 0.82, stock Y has a beta of 1.09, and stock Z has a beta of 1.63 What is the beta of your portfolio? a .76 b 1.18 C 1.21 d 3.50 e 3.54 BetaPortfolio = (.35 82) + (.25 1.09) + (.40 1.63) = 287 + 2725 + 652 = 1.21 AACSB TOPIC: ANALYTIC SECTION: 13.2 AND 13.6 TOPIC: PORTFOLIO BETA TYPE: PROBLEMS 13-39 Chapter 013 Return Risk and the Security Market Line 82 Your portfolio has a beta of 1.24 The portfolio consists of 10 percent U.S Treasury bills, 55 percent in stock A, and 35 percent in stock B Stock A has a risk-level equivalent to that of the overall market What is the beta of stock B? a b .69 c 1.00 d 1.24 E 1.97 The beta of a risk-free asset is zero The beta of the market is 1.0 AACSB TOPIC: ANALYTIC SECTION: 13.2 AND 13.6 TOPIC: PORTFOLIO BETA TYPE: PROBLEMS 83 You would like to combine a risky stock with a beta of 1.68 with U.S Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market What percentage of the portfolio should be invested in Treasury bills? a .32 B .40 c .50 d .60 e .68 BetaPortfolio = 1.0 = [(1-w) 1.68] + [w 0] = 1.68 AACSB TOPIC: ANALYTIC SECTION: 13.2 AND 13.6 TOPIC: PORTFOLIO BETA TYPE: PROBLEMS 13-40 1.68w; 1.68w = 68; w = 40 Chapter 013 Return Risk and the Security Market Line 84 The market has an expected rate of return of 11.4 percent The long-term government bond is expected to yield 5.4 percent and the U.S Treasury bill is expected to yield 4.6 percent The inflation rate is 3.9 percent What is the market risk premium? a 6.0 percent B 6.8 percent c 7.5 percent d 8.5 percent e 9.3 percent Risk premium = 11.4 percent 4.6 percent = 6.8 percent AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: MARKET RISK PREMIUM TYPE: PROBLEMS 85 The risk-free rate of return is 5.2 percent and the market risk premium is 8.4 percent What is the expected rate of return on a stock with a beta of 1.34? a 8.29 percent b 9.49 percent c 13.60 percent D 16.46 percent e 18.22 percent E(r) = 052 + (1.34 084) = 16456 = 16.46 percent AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 13-41 Chapter 013 Return Risk and the Security Market Line 86 The common stock of Abbott International has an expected return of 15.6 percent The return on the market is 12.7 percent and the risk-free rate of return is 3.9 percent What is the beta of this stock? a .92 b 1.23 C 1.33 d 1.67 e 1.77 AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 87 The common stock of GO Limited has a beta of 1.23 and an expected return of 12.84 percent The risk-free rate of return is 4.2 percent What is the expected return on the market? a 7.02 percent b 8.64 percent c 10.63 percent D 11.22 percent e 17.04 percent E(r) = 1284 = 042 + 1.23 (rm 042); 13806 = 1.23rm; rm = 1122 = 11.22 percent AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 13-42 Chapter 013 Return Risk and the Security Market Line 88 The expected return on Joseph's Restaurant's stock is 14.25 percent while the expected return on the market is 12.38 percent The stock's beta is 1.18 What is the risk-free rate of return? A 1.99 percent b 2.04 percent c 2.48 percent d 3.23 percent e 3.68 percent E(r) = 1425 = rf + 1.18 (.1238 rf); 18rf = 003584; rf = 0199 = 1.99 percent AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 89 The stock of Markley Toys has a beta of 1.37 The risk-free rate of return is 3.90 percent and the market risk premium is 8.75 percent What is the expected rate of return on Markley Toys stock? a 10.59 percent b 12.72 percent c 14.60 percent D 15.89 percent e 17.33 percent E(r) = 039 + (1.37 0875) = 1589 = 15.89 percent AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 13-43 Chapter 013 Return Risk and the Security Market Line 90 The common stock of PDS has a beta of 98 and an expected return of 12.34 percent The risk-free rate of return is 4.1 percent and the market rate of return is 11.65 percent Which one of the following statements is true given this information? a The return on PDS stock will graph below the Security Market Line B PDS stock is underpriced c The expected return on PDS stock based on the Capital Asset Pricing Model is 15.52 percent d PDS stock has more systematic risk than the overall market e PDS stock is correctly priced E(r) = 041 + [.98 (.1165 041) = 11499 = 11.50 percent; PDS stock is underpriced as its actual expected return exceeds the expected return based on CAPM AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS 13-44 Chapter 013 Return Risk and the Security Market Line 91 Which one of the following stocks is correctly priced if the risk-free rate of return is 3.2 percent and the market risk premium is 8.4 percent? a A b B C C d D e E E(r)A = 032 + (.72 084) = 0925 E(r)B = 032 + (1.46 084) = 1546 E(r)C = 032 + (1.38 084) = 1479 Stock C is correctly priced E(r)D = 032 + (1.01 084) = 1168 E(r)E = 032 + (.95 084) = 1118 AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: REWARD-TO-RISK RATIO TYPE: PROBLEMS 13-45 Chapter 013 Return Risk and the Security Market Line 92 Which one of the following stocks is correctly priced if the risk-free rate of return is 3.5 percent and the market rate of return is 12.56 percent? a A B B c C d D e E E(r)A = 035 + [.84 (.1256 035)] = 1111 E(r)B = 035 + [1.13 (.1256 035)] = 1374 Stock B is correctly priced E(r)C = 035 + [1.47 (.1256 035)] = 1682 E(r)D = 035 + [.76 (.1256 035)] = 1039 E(r)E = 035 + [1.87 (.1256 035)] = 2044 AACSB TOPIC: ANALYTIC SECTION: 13.7 TOPIC: CAPITAL ASSET PRICING MODEL (CAPM) TYPE: PROBLEMS Essay Questions 13-46 Chapter 013 Return Risk and the Security Market Line 93 According to CAPM, the expected return on a risky asset depends on three components Describe each component, and explain its role in determining expected return CAPM suggests the expected return is a function of (1) the risk-free rate of return, which is the pure time value of money, (2) the market risk premium, which is the reward for bearing systematic risk, and (3) beta, which is the amount of systematic risk present in a particular asset Better answers will point out that both the pure time value of money and the reward for bearing systematic risk are exogenously determined and can change on a daily basis, while the amount of systematic risk for a particular asset is determined by the firm's decision-makers AACSB TOPIC: REFLECTIVE THINKING SECTION: 13.7 TOPIC: CAPM 13-47 Chapter 013 Return Risk and the Security Market Line 94 Explain how the slope of the security market line is determined and why every stock that is correctly priced will lie on this line The market risk premium is the slope of the security market line Slope is the rise over the run, which in this case is the difference between the market return and the risk-free rate divided by a beta of 1.0 minus a beta of zero If a stock is correctly priced the reward-to-risk ratio will be constant and equal to the slope of the security market line Thus, every stock that is correctly priced will lie on the security market line AACSB TOPIC: REFLECTIVE THINKING SECTION: 13.7 TOPIC: SECURITY MARKET LINE 95 Explain how the beta of a portfolio can equal the market beta if 50 percent of the portfolio is invested in a risky security that has twice the amount of systematic risk as an average risky security An average risky security has a beta of 1.0, which is the market beta Risk-free securities, i.e., U.S Treasury bills, have a beta of zero A portfolio that is invested 50 percent in a security that has a beta of 2.0 (twice the systematic risk as an average risky security) and 50 percent in risk-free securities (U.S Treasury bills) will have a beta of 1.0 (which is the market beta) AACSB TOPIC: REFLECTIVE THINKING SECTION: 13.7 TOPIC: PORTFOLIO BETA 96 Discuss the various types of risk and explain which types are rewarded with a risk premium Unsystematic, or diversifiable, risk affects a limited number of securities and can be diversified away by investing in 25 diverse securities Unsystematic risk is not rewarded Systematic risk is risk which affects most, or all, securities and cannot be diversified away Systematic risk is rewarded with a risk premium and is measured by beta Total risk is the summation of unsystematic and systematic risk AACSB TOPIC: REFLECTIVE THINKING SECTION: 13.5 TOPIC: RISK 13-48 Chapter 013 Return Risk and the Security Market Line 97 A portfolio beta is a weighted average of the betas of the individual securities which comprise the portfolio However, the standard deviation is not a weighted average of the standard deviations of the individual securities which comprise the portfolio Explain why Standard deviation measures total risk The unsystematic portion of the total risk can be eliminated by diversification Therefore, the total risk of a portfolio is less than the total risk of the component parts Beta, on the other hand, measures systematic risk which cannot be eliminated by diversification Thus, the systematic risk of a portfolio is the summation of the systematic risk of the component parts AACSB TOPIC: REFLECTIVE THINKING SECTION: 13.5 TOPIC: BETA AND STANDARD DEVIATION 13-49 ... investment across five diverse companies will not lower the total risk d spreading an investment across many diverse assets will eliminate all of the systematic risk E spreading an investment across