Test bank corporate finance 8e ros chap012

Chapter 012 Some Lessons from Capital Market History Multiple Choice Questions The excess return required from a risky asset over that required from a risk-free asset is called the: A risk premium b geometric premium c excess return d average return e variance SECTION: 12.3 TOPIC: RISK PREMIUM TYPE: DEFINITIONS The average squared difference between the actual return and the average return is called the: a volatility return B variance c standard deviation d risk premium e excess return SECTION: 12.4 TOPIC: VARIANCE TYPE: DEFINITIONS What is a standard deviation? a positive square root of an average rate of return b average squared difference between the actual return and the average return C positive square root of a variance d average return divided by N minus one, where N is the number of returns e the square of the variance SECTION: 12.4 TOPIC: STANDARD DEVIATION TYPE: DEFINITIONS 12-1 Chapter 012 Some Lessons from Capital Market History What is a normal distribution? a a set of returns that lie within one standard deviation of an expected rate of return b a set of variances computed over a period of time by comparing actual returns to the expected rate of return C a symmetrical frequency distribution which is defined by its mean and standard deviation d the square root of the average squared difference between an actual return and an expected return e the frequency distribution of the average squared excess return over the risk-free rate SECTION: 12.4 TOPIC: NORMAL DISTRIBUTION TYPE: DEFINITIONS The average compound return earned per year over a multi-year period is called the _ average return a arithmetic b standard c variant D geometric e real SECTION: 12.5 TOPIC: GEOMETRIC AVERAGE RETURN TYPE: DEFINITIONS The return earned in an average year over a multi-year period is called the _ average return A arithmetic b standard c variant d geometric e real SECTION: 12.5 TOPIC: ARITHMETIC AVERAGE RETURN TYPE: DEFINITIONS 12-2 Chapter 012 Some Lessons from Capital Market History An efficient capital market defined as a market in which: a trading is free for all participants b taxes are irrelevant c investors earn a zero profit d investors earn a profit on a security equal to the current yield E security prices reflect available information SECTION: 12.6 TOPIC: EFFICIENT CAPITAL MARKET TYPE: DEFINITIONS The notion that capital markets, such as the NYSE, price securities fairly based on available information is called the: A efficient market hypothesis b zero profit hypothesis c open markets theorem d laissez-faire principle e pricing theorem SECTION: 12.6 TOPIC: EFFICIENT MARKETS HYPOTHESIS TYPE: DEFINITIONS Assume that P1 is the purchase cost, P2 represents the sale proceeds, and d represents dividend income Given these definitions, which one of the following is the correct formula for the total return on an equity security? a (P2 P1) / P2 + d b (P1 P2) / (P2 + d) c (P1 P2 d) / P1 D (P2 P1 + d) / P1 e (P2 P1 + d) / P2 SECTION: 12.1 TOPIC: TOTAL RETURN TYPE: CONCEPTS 12-3 Chapter 012 Some Lessons from Capital Market History 10 Which one of the following correctly describes the dividend yield? A next year's annual dividend divided by today's stock price b this year's annual dividend divided by today's stock price c this year's annual dividend divided by next year's expected stock price d the annual dividend amount divided by the face value of the stock e the increase in next year's dividend over this year's dividend divided by the current stock price SECTION: 12.1 TOPIC: DIVIDEND YIELD TYPE: CONCEPTS 11 Uptown Stores just announced they are increasing their annual dividend from $1.34 per share to $1.40 per share If the dividend yield remains at its pre-announcement level, then you know the stock price: a was unaffected by the announcement B increased proportionately with the dividend increase c increased by $0.06 per share d decreased by $0.06 per share e increased by $0.06 (1 + Dividend yield) SECTION: 12.1 TOPIC: DIVIDEND YIELD TYPE: CONCEPTS 12-4 Chapter 012 Some Lessons from Capital Market History 12 The capital gains yield considers which of the following? I the ending, or sale, price of a security II the average price of a security over a stated period of time III any dividend income received IV the beginning value, or cost, of a security a I and III only b II and IV only C I and IV only d I, III, and IV only e I, II, III, and IV SECTION: 12.1 TOPIC: CAPITAL GAIN TYPE: CONCEPTS 12-5 Chapter 012 Some Lessons from Capital Market History 13 The total return on a security is based on the: a arithmetic average change in the price of the security b average of the arithmetic and geometric average changes in the price of the security c dividend yield d capital gains yield E both the dividend yield and the capital gains yield SECTION: 12.1 TOPIC: TOTAL RETURN TYPE: CONCEPTS 14 The real rate of return on a stock is approximately equal to the nominal rate of return: a multiplied by (1 + Inflation rate) b plus the inflation rate C minus the inflation rate d divided by (1 + Inflation rate) e divided by (1 Inflation rate) SECTION: 12.1 TOPIC: REAL RETURN TYPE: CONCEPTS 15 As long as the inflation rate is positive, the real rate of return on a security will be the nominal rate of return a greater than b equal to C less than d greater than or equal to e unrelated to SECTION: 12.1 TOPIC: REAL RETURN TYPE: CONCEPTS 12-6 Chapter 012 Some Lessons from Capital Market History 16 Small-company stocks, as the term is used in the textbook, are defined as the common stock of: a the 500 newest corporations in the U.S b all the firms whose stock trades OTC C the smallest twenty percent of the firms listed on the NYSE d the smallest twenty-five percent of the firms listed on NASDAQ e all the firms whose stock is listed on NASDAQ SECTION: 12.2 TOPIC: SMALL COMPANY STOCKS TYPE: CONCEPTS 17 Which one of the following categories of securities had the highest average return for the period 1926 – 2005? a U.S Treasury bills b large company stocks C small company stocks d long-term corporate bonds e long-term government bonds SECTION: 12.3 TOPIC: HISTORICAL RECORD TYPE: CONCEPTS 18 Which one of the following categories of securities had the lowest average risk premium for the period 1926 – 2005? a long-term government bonds b small company stocks c large company stocks d long-term corporate bonds E U.S Treasury bills SECTION: 12.2 TOPIC: RISK PREMIUM TYPE: CONCEPTS 12-7 Chapter 012 Some Lessons from Capital Market History 19 On average, for the period 1926 – 2005: a the real rate of return on U.S Treasury bills has been negative b small company stocks have underperformed large company stocks c long-term government bonds have earned a higher real rate of return than have long-term corporate bonds D the risk premium on U.S Treasury bills has been zero percent e the risk premium on large company stocks has exceeded the risk premium on small company stocks SECTION: 12.3 TOPIC: RISK PREMIUM TYPE: CONCEPTS 20 Which one of the following categories of securities has had the most volatile returns over the period 1926 – 2005? a long-term corporate bonds b large-company stocks c intermediate-term government bonds d U.S Treasury bills E small-company stocks SECTION: 12.4 TOPIC: STANDARD DEVIATION TYPE: CONCEPTS 21 Over the period 1926 – 2005, the annual rate of inflation: a was always positive b was only negative during the Great Depression c never exceeded ten percent D fluctuated significantly from one year to the next e tended to be negative during the years of World War II SECTION: 12.2 TOPIC: HISTORICAL RECORD TYPE: CONCEPTS 12-8 Chapter 012 Some Lessons from Capital Market History 22 Which one of the following time periods is associated with high rates of inflation? a 1929 – 1933 b 1957 – 1961 C 1978 – 1981 d 1992 – 1996 e 1999 – 2002 SECTION: 12.2 TOPIC: HISTORICAL RECORD TYPE: CONCEPTS 23 Which one of the following statements concerning U.S Treasury bills is correct for the period 1926 – 2005? a The annual rate of return always exceeded the annual inflation rate b The average risk premium was 1.1 percent c The annual rate of return was always positive D The average excess return was 1.1 percent e The average real rate of return was equal to zero SECTION: 12.2 and 12.3 TOPIC: HISTORICAL RECORD TYPE: CONCEPTS 24 Which one of the following is a correct ranking of securities based on their volatility over the period of 1926 – 2005? Rank from highest to lowest a large company stocks, U.S Treasury bills, long-term government bonds b small company stocks, long-term corporate bonds, large company stocks C small company stocks, long-term government bonds, long-term corporate bonds d large company stocks, long-term corporate bonds, long-term government bonds e long-term government bonds, long-term corporate bonds, U.S Treasury bills SECTION: 12.4 TOPIC: STANDARD DEVIATION TYPE: CONCEPTS 12-9 Chapter 012 Some Lessons from Capital Market History 25 What was the highest annual rate of inflation during the period 1926 – 2005? a percent b 10 percent c 13 percent D 18 percent e 22 percent SECTION: 12.2 TOPIC: HISTORICAL RECORD TYPE: CONCEPTS 26 The excess return is computed as the: a return on a security minus the inflation rate B return on a risky security minus the risk-free rate c risk premium on a risky security minus the risk-free rate d the risk-free rate plus the inflation rate e risk-free rate minus the inflation rate SECTION: 12.3 TOPIC: EXCESS RETURN TYPE: CONCEPTS 27 Which one of the following earned the highest risk premium over the period 1926 – 2005? a long-term corporate bonds b U.S Treasury bills C small-company stocks d large-company stocks e long-term government bonds SECTION: 12.3 TOPIC: RISK PREMIUM TYPE: CONCEPTS 12-10 Chapter 012 Some Lessons from Capital Market History 58 Bankers, Inc stock is currently selling for $80 a share The stock has a dividend yield of 4.2 percent How much dividend income will you receive per year if you purchase 150 shares of this stock? a $120 b $336 C $504 d $630 e $1,905 Dividend income = $80 042 150 = $504 AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: DIVIDEND YIELD TYPE: PROBLEMS 59 One year ago, you purchased a stock at a price of $40 a share Today, you sold the stock and realized a total return of 30 percent Your capital gain was $8 a share What was your dividend yield on this stock? A 10 percent b 20 percent c 30 percent d 40 percent e 50 percent Capital gains yield = $8 / $40 = 20.00 percent; Dividend yield = 30 percent percent AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: DIVIDEND YIELD TYPE: PROBLEMS 12-24 20 percent = 10 Chapter 012 Some Lessons from Capital Market History 60 You just sold 400 shares of Bosley, Inc stock at a price of $49.60 a share Last year you paid $50.50 a share to buy this stock Over the course of the year, you received dividends totaling $1.96 per share What is your capital gain on this investment? a $424 B $360 c $360 d $424 e $784 Capital gain = ($49.60 $50.50) 400 = $360 (capital loss) AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: CAPITAL GAIN TYPE: PROBLEMS 61 You purchased 200 shares of Hypex, Inc stock for $38.12 a share You have received a total of $290 in dividends and $8,130 in proceeds from selling the shares What is your capital gains yield on this stock? a 3.8 percent b 4.2 percent C 6.6 percent d 8.0 percent e 10.4 percent Cost = 200 $38.12 = $7,624; Capital gains yield = ($8,130 AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: CAPITAL GAIN TYPE: PROBLEMS 12-25 $7,624) / $7,624 = 6.6 percent Chapter 012 Some Lessons from Capital Market History 62 Today, you sold 100 shares of Natural, Inc stock Your total return on these shares is 10.5 percent You purchased the shares one year ago at a price of $25.75 a share You have received a total of $110 in dividends over the course of the year What is your capital gains yield on this investment? A 6.23 percent b 6.60 percent c 7.77 percent d 9.50 percent e 9.75 percent Dividend yield = $110 / (100 4.27 percent = 6.23 percent $25.75) = 4.27 percent; Capital gains yield = 10.5 percent AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: CAPITAL GAIN TYPE: PROBLEMS 63 Six months ago, you purchased 1,300 shares of New Tech stock for $12.70 a share You have received dividend payments equal to $.05 a share Today, you sold all of your shares for $14.20 a share What is your total dollar return on this investment? a $650 b $1,025 c $1,885 d $1,950 E $2,015 Total dollar return = ($14.20 $12.70 + $.05) 1,300 = $2,015 AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: TOTAL RETURN TYPE: PROBLEMS 12-26 Chapter 012 Some Lessons from Capital Market History 64 Seven months ago, you purchased 300 shares of Stadford, Inc stock at a price of $48.30 a share The company pays quarterly dividends of $.40 a share Today, you sold all of your shares for $45.20 a share What is your total percentage return on this investment? a 6.4 percent B 4.8 percent c 3.1 percent d 8.1 percent e 9.7 percent Total percentage return = ($45.20 $48.30 + $.40 + $.40) / $48.30 = 4.8 percent (loss) AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: TOTAL RETURN TYPE: PROBLEMS 65 Last year, you purchased a stock at a price of $53.60 a share Over the course of the year, you received $1.50 in dividends and inflation averaged 2.9 percent Today, you sold your shares for $55.90 a share What is your approximate real rate of return on this investment? A 4.2 percent b 7.1 percent c 7.9 percent d 8.6 percent e 10.0 percent Nominal return = ($55.90 $53.60 + $1.50) / $53.60 = 7.09 percent; Real return = 7.09 percent 2.9 percent = 4.19 percent = 4.2 percent AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: REAL RETURN TYPE: PROBLEMS 12-27 Chapter 012 Some Lessons from Capital Market History 66 Six months ago, you purchased a stock at a price of $31.88 a share Today, you sold those shares for $37.51 a share During the past six months, you have received dividends totaling $0.46 a share while inflation has averaged 3.3 percent What is your approximate real rate of return on this investment? a 14.4 percent B 15.8 percent c 17.3 percent d 19.2 percent e 20.1 percent Nominal return = ($37.51 $31.88 + $.46) / $31.88 = 19.10 percent; Real return = 19.10 percent 3.3 percent = 15.8 percent AACSB TOPIC: ANALYTIC SECTION: 12.1 TOPIC: REAL RETURN TYPE: PROBLEMS 67 What is the amount of the excess return on a risk-free security if the risk-free rate is percent and the market rate of return is 11 percent? A percent b percent c percent d percent e 11 percent There is no excess return, or risk premium, for a risk-free security SECTION: 12.2 TOPIC: EXCESS RETURN TYPE: PROBLEMS 12-28 Chapter 012 Some Lessons from Capital Market History 68 A stock had returns of percent, percent, percent, and 15 percent over the past four years What is the standard deviation of this stock for the past four years? a 5.4 percent b 5.9 percent c 6.3 percent d 6.6 percent E 7.6 percent Average return = (.09 03 + 04 + 15) / = 0625; Total squared deviation = (.09 0625)2 + ( 03 0625)2 + (.04 0625)2 + (.15 0625)2 = 00075625 + 00855625 + 00050625 + 00765625 = 017475; Standard deviation = √ (.017475) / (4 1) = √.005825 = 07632 = 7.6 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: STANDARD DEVIATION TYPE: PROBLEMS 69 Baker's Chocolate common stock had annual returns of 13.7 percent, 11.3 percent, 4.6 percent, and 8.9 percent over the last four years, respectively What is the standard deviation of these returns? A 10.1 percent b 10.7 percent c 11.3 percent d 11.8 percent e 12.1 percent Average return = (.137 + 113 + 046 089) / = 05175; Total squared deviation = (.137 05175)2 + (.113 05175)2 + (.046 05175)2 + ( 089 05175)2 = 007267563 + 003751563 + 000033063 + 019810563 = 030863; Standard deviation = √ (.030863) / (4 1) = √.010288 = 10143 = 10.1 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: STANDARD DEVIATION 12-29 Chapter 012 Some Lessons from Capital Market History 70 Milner's stock had annual returns of 11.4 percent, 2.6 percent, and 14.8 percent over the past three years Which one of the following best describes the probability that this stock will produce a return of 25 percent or more next year? a less than 0.1 percent b less than 0.5 percent c less than 1.0 percent D less than 2.5 percent e less than percent Average return = (.114 + 026 + 148) / = 096; Total squared deviation = (.114 096)2 + (.026 096)2 + (.148 096)2 = 000324 + 0049 + 002704 = 007928; Standard deviation = √ (.007928) / (3 1) = √.003964 = 0630 = 6.3 percent; Upper end of 95 percent probability range = 9.6 percent + (2)6.3 percent = 22.2 percent; Upper end of 99 percent probability range = 9.6 percent + (3)6.3 percent = 28.5 percent; Thus, a return of 25 percent or more has less than a 2.5 percent chance of occurring in any one year AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 71 A stock has an expected rate of return of 7.9 percent and a standard deviation of 6.2 percent Which one of the following best describes the probability that this stock will lose more than 4.5 percent in any one given year? a less than 0.5 percent b less than 1.0 percent c less than 1.5 percent D less than 2.5 percent e less than percent Lower bound of 95 percent probability range = 079 (2 062) = Probability of losing more than 4.5 is less than 2.5 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS 12-30 045 = 4.5 percent; Chapter 012 Some Lessons from Capital Market History 72 A stock has returns of percent, 16 percent, 18 percent, and 11 percent for the past four years Based on this information, what is the 99 percent probability range for any one given year? a 8.6 to 13.6 percent b 11.5 to 18.5 percent c 26.5 to 33.5 percent d 35.5 to 42.5 percent E 41.6 to 48.6 percent Average return = (.05 + 16 18 + 11) / = 035; Total squared deviation = (.05 035)2 + (.16 035)2 + ( 18 035)2 + (.11 035)2 = 000225 + 015625 + 046225 + 005625 = 0677; Standard deviation = √ (.0677) / (4 - 1) = √.0225667 = 150222 = 15.022 percent; 99% probability range = 3.5 percent (3 15.0222) percent = 41.6 to 48.6 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 73 Your friend is the owner of a stock which had returns of percent, 17 percent, and percent for the past three years Your friend thinks the stock may be able to achieve a return of 32.6 percent or more Based on these returns, what is the probability that this stock will earn at least the 32.6 percent in any one given year? A 0.5 percent b 1.0 percent c 2.5 percent d 5.0 percent e 16.0 percent Average return = (.06 + 17 + 01) / = percent; Total squared deviation = (.06 08)2 + (.17 08)2 + (.01 08)2 = 0004 + 0081 + 0049 = 0134; Standard deviation = √ (.0134) / (3 1) = 08185 = 8.185 percent; Upper end of the 99 percent probability range = percent + (3 8.185 percent) = 32.6 percent; Probability of earning at least 32.6 percent in any one year is percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 12-31 Chapter 012 Some Lessons from Capital Market History 74 A stock had returns of 10 percent, percent, percent, 17 percent, and percent for the past five years Based on these returns, what is the approximate probability that this stock will return at least 15 percent in any one given year? a 0.5 percent b 1.0 percent c 2.5 percent d 5.0 percent E 16.0 percent Average return = (.10 + 02 + 08 + 17 07) / = percent; Total squared deviation = (.10 06)2 + (.02 06)2 + (.08 06)2 + (.17 06)2 + (-.07 06)2 = 0016 + 0016 + 0004 + 0121 + 0169 = 0326; Standard deviation = √ (.0326) / (5 1) = √.00815 = 0903 = 9.0 percent; Upper end of the 68 percent probability range = 06 + 0903 = 15.03 percent; Probability of earning at least 15 percent in any one year is approximately 16 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 75 A stock had returns of percent, 31 percent, 16 percent, and 22 percent for the past four years Which one of the following best describes the probability that this stock will NOT lose more than 59 percent in any one given year? a 84.0 percent b 95.0 percent c 97.5 percent d 99.0 percent E 99.5 percent Average return = (.07 + 31 + 16 22) / = percent; Total squared deviation = (.07 08)2 + (.31 08)2 + (.16 08)2 + ( 22 08)2 = 0001 + 0529 + 0064 + 09 = 1494; Standard deviation =√.1494 / (4 1) =√.0498 = 22.3159 percent; Lower bound of the 99 percent probability range = percent (3 22.3159 percent) = 58.95; Probability of NOT losing more than 59 percent in any given year is 99.5 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 12-32 Chapter 012 Some Lessons from Capital Market History 76 Over the past five years, a stock produced returns of 12 percent, 26 percent, 10 percent, percent, and 13 percent What is the probability that an investor in this stock will NOT lose more than 17.5 percent nor earn more than 35.5 percent in any one given year? a 34 percent b 68 percent C 95 percent d 99 percent e 100 percent Average return = (.12 + 26 10 + 04 + 13) / = percent; Total squared deviation = (.12 09)2 + (.26 09)2 + ( 10 09)2 + (.04 09)2 + (.13 09)2 = 0009 + 0289 + 0361 + 0025 + 0016 = 07; Standard deviation = √.07 / (5 - 1) = √.0175 = 13.229 percent; 95% probability range = percent (2 13.229 percent) = 17.5 percent to 35.5 percent; The answer is 95 percent AACSB TOPIC: ANALYTIC SECTION: 12.4 TOPIC: RETURN DISTRIBUTIONS TYPE: PROBLEMS 77 What are the geometric and arithmetic average returns for a stock with annual returns of percent, 10 percent, percent, and 16 percent? A 5.37 percent; 5.75 percent b 6.49 percent; 7.67 percent c 7.22 percent; 5.75 percent d 7.22 percent; 7.67 percent e 9.68 percent; 5.75 percent Geometric return = (1.05 1.10 92 1.16).25 (.05 + 10 08 + 16) / = 5.75 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: ARITHMETIC AVERAGE TYPE: PROBLEMS 12-33 = 5.37 percent; Arithmetic average = Chapter 012 Some Lessons from Capital Market History 78 What are the arithmetic and geometric average returns for a stock with annual returns of 26 percent, percent, 30 percent, 43 percent, and percent? A 10.0 percent; 7.0 percent b 10.0 percent; 8.8 percent c 10.0 percent; 21.8 percent d 12.5 percent; 7.0 percent e 12.5 percent; 8.8 percent Arithmetic average = (.26 + 04 30 + 43 + 07) / = 10.0 percent; Geometric return = (1.26 1.04 70 1.43 1.07).20 = 7.0 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: ARITHMETIC VS GEOMETRIC AVERAGES TYPE: PROBLEMS 79 A stock had returns of percent, 16 percent, 10 percent, and 18 percent over the past four years What is the geometric average return for this time period? a 5.3 percent B 6.6 percent c 7.3 percent d 9.7 percent e 12.1 percent Geometric average = (1.05 1.16 90 1.18).25 AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: GEOMETRIC AVERAGE TYPE: PROBLEMS 12-34 = 6.6 percent Chapter 012 Some Lessons from Capital Market History 80 A stock had the following prices and dividends What is the geometric average return on this stock? a 2.1 percent b 2.7 percent C 3.6 percent d 3.7 percent e 5.4 percent Return for year = ($22.90 $22.57 + $.30) / $22.57 = 2.7913 percent; Return for year = ($22.26 $22.90 + $.31) / $22.90 = 1.4410 percent; Return for year = ($24.08 $22.26 + $.33) / $22.26 = 9.6586 percent; Geometric return = (1.027913 985590 1.096586).3333 = 3.6 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: GEOMETRIC AVERAGE TYPE: PROBLEMS 81 Over the past twenty years, the common stock of Leases, Inc has produced an arithmetic average return of 14.6 percent and a geometric average return of 12.9 percent What is the projected return on this stock for the next five years according to Blume's formula? a 13.48 percent b 13.83 percent c 14.01 percent D 14.24 percent e 14.33 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: BLUME'S FORMULA TYPE: PROBLEMS 12-35 Chapter 012 Some Lessons from Capital Market History 82 Based on last fifteen years, Albeit stock has yielded an arithmetic average rate of return of 12.3 percent The geometric average return for the same period was 10.8 percent What is the estimated return on Albeit stock for the next three years according to Blume's formula? a 11.47 percent b 11.60 percent c 11.78 percent d 11.94 percent E 12.09 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: BLUME'S FORMULA TYPE: PROBLEMS 83 A stock has a geometric average return of 8.7 percent and an arithmetic average return of 11.3 percent based on the last twenty-five years What is the estimated average rate of return for the next ten years based on Blume's formula? a 9.87 percent B 10.33 percent c 10.49 percent d 10.62 percent e 10.84 percent AACSB TOPIC: ANALYTIC SECTION: 12.5 TOPIC: BLUME'S FORMULA TYPE: PROBLEMS 12-36 Chapter 012 Some Lessons from Capital Market History Essay Questions 84 Define and explain the three forms of market efficiency The current stock price reflects the following information for each form of efficiency: Weak form efficiency: all historical information Semistrong form efficiency: all public and historical information Strong form efficiency: all private, public, and historical information AACSB TOPIC: REFLECTIVE THINKING SECTION: 12.6 TOPIC: EFFICIENT MARKETS 85 What are the two primary lessons learned from capital market history? Use the historical record to justify these lessons are correct First, there is a reward for bearing risk, and second, the greater the risk, the greater the potential reward As evidence, students should provide a brief discussion of the historical rates of return and the related standard deviations of the various asset classes discussed in the text AACSB TOPIC: REFLECTIVE THINKING SECTION: 12.3 and 12.4 TOPIC: LESSONS 86 How can an investor lose money on a stock while making money on a bond investment if there is a reward for bearing risk? Aren't stocks riskier than bonds? There is a reward for bearing risk over the long-term However, the nature of risk implies the returns on a high risk security will be more volatile than the returns on a low risk security It is the acceptance of this risk which justifies the potential long-term reward AACSB TOPIC: REFLECTIVE THINKING SECTION: 12.3 TOPIC: EFFICIENT MARKETS 12-37 Chapter 012 Some Lessons from Capital Market History 87 Explain how an individual investor can consistently earn a return that exceeds the return on the overall market, as measured by the S&P 500, if the markets are efficient An investor can purchase securities that have a higher level of risk than the overall market In an efficient market, these securities will earn a higher return over the long-term as compensation for the assumption of the increased risk This is the first lesson of the capital markets: There is a reward for bearing risk AACSB TOPIC: REFLECTIVE THINKING SECTION: 12.3 TOPIC: EFFICIENT MARKETS 88 Explain why an investor should expect all of his or her investments to have zero net present values in an efficient market In an efficient market, each investment should earn a rate of return equal to the market rate given a stated level of risk When the actual return equals the required return, the net present value is zero A zero net present value indicates an investment is earning exactly the rate it should given its level of risk Zero net present value investments are proof that a market is efficient AACSB TOPIC: REFLECTIVE THINKING SECTION: 12.3 TOPIC: EFFICIENT MARKETS 12-38 ... company stocks, long-term corporate bonds, large company stocks C small company stocks, long-term government bonds, long-term corporate bonds d large company stocks, long-term corporate bonds, long-term... – 2005? a long-term government bonds b small company stocks c large company stocks d long-term corporate bonds E U.S Treasury bills SECTION: 12.2 TOPIC: RISK PREMIUM TYPE: CONCEPTS 12-7 Chapter... stocks c long-term government bonds have earned a higher real rate of return than have long-term corporate bonds D the risk premium on U.S Treasury bills has been zero percent e the risk premium