1. Which of the following statements is CORRECT? a. If you add enough randomly s

Question

1. Which of the following statements is CORRECT? 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. 2. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. b. The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. c. Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. e. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. 3. 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? a. Portfolio P has a standard deviation of 20%. b. The required return on Portfolio P is equal to the market risk premium (rM rRF). 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, rRF. e. Portfolio P has the same required return as the market (rM). 4. Which of the following statements is CORRECT? a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. b. Portfolio diversification reduces the variability of returns on an individual stock. c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events. d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. e. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio. 5. Which of the following statements is CORRECT? a. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds. b. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. d. There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. e. Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF. 6. Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rates must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. 7 Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. 8. Which of the following statements is CORRECT? a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights. b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. 9. Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? a. $26.77 b. $27.89 c. $29.05 d. $30.21 e. $31.42 10. Which of the following statements is CORRECT? a. Put options give investors the right to buy a stock at a certain strike price before a specified date. b. Call options give investors the right to sell a stock at a certain strike price before a specified date. c. Options typically sell for less than their exercise value. d. LEAPS are very short-term options that were created relatively recently and now trade in the market. e. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. 11. Which of the following statements is CORRECT? a. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock’s price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit. b. Call options generally sell at a price less than their exercise value. c. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. d. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be. e. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. 12. Which of the following statements is CORRECT? a. An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value. b. As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases. c. Issuing options provides companies with a low cost method of raising capital. d. The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price. e. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger. 13. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value? $2.43    b. $2.70 c. $2.99 d. $3.29 e. $3.62 14. An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. based on the following data: The price of the stock is $40. The strike price of the option is $40. The option matures in 3 months (t = 0.25). The standard deviation of the stock’s returns is 0.40, and the variance is 0.16. The risk-free rate is 6%. Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: d1 = 0.175 d2 = -0.025 N(d1) = 0.56946 N(d2) = 0.49003 N(d1) and N(d2) represent areas under a standard normal distribution function. Using the BlackScholes model, what is the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 e. $4.20 15. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the percentage of debt in the target capital structure. c. Increase the proposed capital budget. d. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure. 16. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted. e. All of the projects should be accepted. 17. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 18. Which of the following statements is CORRECT? a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.    c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital. 19. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but it will not affect its intrinsic value 20. Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. 21. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. Which of the following statements is CORRECT? a. More of Project A’s cash flows occur in the later years. b. More of Project B’s cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project’s IRR. 22. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a 4-year payback is too low. d. The firm will accept too few projects in all economic states because a 4-year payback is too high. e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak. 23. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and - $100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president? a. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC. b. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC. c. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that the firm’s value will increase if the project is accepted. d. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted. e. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted. 24. Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV. 25. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV $350,000 $350,000 Standard deviation (NPV) $100,000 $150,000 Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects. Which of the following statements is CORRECT? a. Project X has more stand-alone risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has more market risk than Project Y. d. Project X has the same level of corporate risk as Project Y. e. Project X has less market risk than Project Y. 26. Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project’s completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project’s life. d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. 27. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3- year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project’s 3-year life. What is the project’s NPV? Risk-adjusted WACC 10.0% Net investment cost (depreciable basis) $65,000 Straight-line deprec. rate 33.3333% Sales revenues, each year $65,500 Operating costs (excl. deprec.), each year $25,000 Tax rate 35.0% a. $15,740 b. $16,569 c. $17,441 d. $18,359 e. $19,325 28. Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project’s 3- year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project’s life, and this is just one of the firm’s many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project’s NPV decline? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) WACC 10.0% Net investment cost (depreciable basis) $60,000 Number of cars washed 2,800 Average price per car $25.00 Fixed op. cost (excl. deprec.) $10,000 Variable op. cost/unit (i.e., VC per car washed) $5.375 Annual depreciation $20,000 Tax rate 35.0% a. $28,939 b. $30,462 c. $32,066 d. $33,753 e. $35,530 29. Which of the following statements is CORRECT? a. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management’s historical performance is evaluated. d. The capital intensity ratio gives us an idea of the physical condition of the firm’s fixed assets. e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. 30. Which of the following statements is CORRECT? a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero. b. If a firm’s assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm’s AFN to be negative. c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm’s actual AFN must, mathematically, exceed the previously calculated AFN. d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. e. Dividend policy does not affect the requirement for external funds based on the AFN equation. 31. Which of the following statements is CORRECT? a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. c. Firms whose fixed assets are “lumpy” frequently have excess capacity, and this should be accounted for in the financial forecasting process. d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. e. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. the Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. 32. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% 33. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions. Last year’s sales = S0 $300.0 Last year’s accounts payable $50.0 Sales growth rate = g 40% Last year’s notes payable $15.0 Last year’s total assets = A0* $500.0 Last year’s accruals $20.0 Last year’s profit margin = PM 20.0% Initial payout ratio 10.0% a. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9 34. Suppose Leonard, Nixon, & Shull Corporation’s projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company’s weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 35. Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments). Year: 1 2 Free cash flow: -$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770 36. Based on the corporate valuation model, the value of a company’s operations is $1,200 million. The company’s balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in longterm debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82 37. Based on the corporate valuation model, the value of a company’s operations is $900 million. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36 38. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: -$20 $42 $45 a. $586 b. $617 c. $648 d. $680 e. $714 39. Which of the following statements about dividend policies is CORRECT? a. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the bird-in-the hand effect. b. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. c. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. d. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. e. The clientele effect suggests that companies should follow a stable dividend policy. 40. Which of the following statements is CORRECT? a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company. b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. c. Stock repurchases can be used by a firm that wants to increase its debt ratio. d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding. 41. Which of the following statements is CORRECT? a. When firms are deciding on the size of stock splits—say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used. b. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today. c. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits. d. When a company declares a stock split, the price of the stock typically declines—by about 50% after a 2-for-1 split—and this necessarily reduces the total market value of the equity. e. If a firm’s stock price is quite high relative to most stocks—say $500 per share—then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low—say $2 per share—then it can declare a reverse split of say 1-for-25 so as to bring the price up to somewhere around $50 per share. 42. Which of the following statements is CORRECT? a. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm’s dividend payout. b. The clientele effect can explain why so many firms change their dividend policies so often. c. One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele. d. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don’t change the firm’s total amount of book equity. e. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received. 43. DeAngelo Corp.'s projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts. Increase in Capital Budget Increase Debt Lower Payout Do Both to 75% to 20%___________________ a. $114.0 $73.3 $333.9 b. $120.0 $77.2 $351.5 c. $126.4 $81.2 $370.0 d. $133.0 $85.5 $389.5 e. $140.0 $90.0 $410.0 44. Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock. 45. Which of the following statements is CORRECT? a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share. d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller taxadjusted tradeoff theory would suggest that firms should increase their use of debt. 46. Which of the following statements is CORRECT? a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions. c. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing. 47. Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD’s basic earning power ratio (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT? a. Company HD has a higher return on assets (ROA) than Company LD. b. Company HD has a higher times interest earned (TIE) ratio than Company LD. c. Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD’s. d. The two companies have the same ROE. e. Company HD’s ROE would be higher if it had no debt. 48. Which of the following statements is CORRECT? a. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry. b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. c. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. e. Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital. please do not flag................
i have no idea please help me out.............. 1. Which of the following statements is CORRECT? 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. 2. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. b. The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. c. Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. e. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. 3. 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? a. Portfolio P has a standard deviation of 20%. b. The required return on Portfolio P is equal to the market risk premium (rM rRF). 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, rRF. e. Portfolio P has the same required return as the market (rM). 4. Which of the following statements is CORRECT? a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. b. Portfolio diversification reduces the variability of returns on an individual stock. c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events. d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. e. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio. 5. Which of the following statements is CORRECT? a. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds. b. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change. c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk. d. There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML. e. Assume that the required rate of return on the market, rM, is given and fixed at 10%. If the yield curve were upward sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF. 6. Which of the following statements is CORRECT? a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rates must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. 7 Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. 8. Which of the following statements is CORRECT? a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights. b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. 9. Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? a. $26.77 b. $27.89 c. $29.05 d. $30.21 e. $31.42 10. Which of the following statements is CORRECT? a. Put options give investors the right to buy a stock at a certain strike price before a specified date. b. Call options give investors the right to sell a stock at a certain strike price before a specified date. c. Options typically sell for less than their exercise value. d. LEAPS are very short-term options that were created relatively recently and now trade in the market. e. An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend. 11. Which of the following statements is CORRECT? a. If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock’s price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit. b. Call options generally sell at a price less than their exercise value. c. If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value. d. Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be. e. Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock. 12. Which of the following statements is CORRECT? a. An option's value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can't sell for more than its exercise value. b. As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases. c. Issuing options provides companies with a low cost method of raising capital. d. The market value of an option depends in part on the option's time to maturity and also on the variability of the underlying stock's price. e. The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger. 13. The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value? $2.43    b. $2.70 c. $2.99 d. $3.29 e. $3.62 14. An analyst wants to use the Black-Scholes model to value call options on the stock of Ledbetter Inc. based on the following data: The price of the stock is $40. The strike price of the option is $40. The option matures in 3 months (t = 0.25). The standard deviation of the stock’s returns is 0.40, and the variance is 0.16. The risk-free rate is 6%. Given this information, the analyst then calculated the following necessary components of the Black-Scholes model: d1 = 0.175 d2 = -0.025 N(d1) = 0.56946 N(d2) = 0.49003 N(d1) and N(d2) represent areas under a standard normal distribution function. Using the BlackScholes model, what is the value of the call option? a. $2.81 b. $3.12 c. $3.47 d. $3.82 e. $4.20 15. Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the percentage of debt in the target capital structure. c. Increase the proposed capital budget. d. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure. 16. LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted. e. All of the projects should be accepted. 17. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. 18. Which of the following statements is CORRECT? a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.    c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital. 19. Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value. b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but it will not affect its intrinsic value 20. Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. 21. Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. Which of the following statements is CORRECT? a. More of Project A’s cash flows occur in the later years. b. More of Project B’s cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project’s IRR. 22. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a 4-year payback is too low. d. The firm will accept too few projects in all economic states because a 4-year payback is too high. e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak. 23. You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and - $100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president? a. You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC. b. You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC. c. You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that the firm’s value will increase if the project is accepted. d. You should recommend that the project be rejected. Although its NPV is positive it has two IRRs, one of which is less than the WACC, which indicates that the firm’s value will decline if the project is accepted. e. You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firm’s value will decline if it is accepted. 24. Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV. 25. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV $350,000 $350,000 Standard deviation (NPV) $100,000 $150,000 Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects. Which of the following statements is CORRECT? a. Project X has more stand-alone risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has more market risk than Project Y. d. Project X has the same level of corporate risk as Project Y. e. Project X has less market risk than Project Y. 26. Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project’s completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project’s life. d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. 27. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3- year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project’s 3-year life. What is the project’s NPV? Risk-adjusted WACC 10.0% Net investment cost (depreciable basis) $65,000 Straight-line deprec. rate 33.3333% Sales revenues, each year $65,500 Operating costs (excl. deprec.), each year $25,000 Tax rate 35.0% a. $15,740 b. $16,569 c. $17,441 d. $18,359 e. $19,325 28. Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project’s 3- year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project’s life, and this is just one of the firm’s many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project’s NPV decline? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) WACC 10.0% Net investment cost (depreciable basis) $60,000 Number of cars washed 2,800 Average price per car $25.00 Fixed op. cost (excl. deprec.) $10,000 Variable op. cost/unit (i.e., VC per car washed) $5.375 Annual depreciation $20,000 Tax rate 35.0% a. $28,939 b. $30,462 c. $32,066 d. $33,753 e. $35,530 29. Which of the following statements is CORRECT? a. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management’s historical performance is evaluated. d. The capital intensity ratio gives us an idea of the physical condition of the firm’s fixed assets. e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. 30. Which of the following statements is CORRECT? a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero. b. If a firm’s assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm’s AFN to be negative. c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm’s actual AFN must, mathematically, exceed the previously calculated AFN. d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. e. Dividend policy does not affect the requirement for external funds based on the AFN equation. 31. Which of the following statements is CORRECT? a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. c. Firms whose fixed assets are “lumpy” frequently have excess capacity, and this should be accounted for in the financial forecasting process. d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. e. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. the Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. 32. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% 33. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions. Last year’s sales = S0 $300.0 Last year’s accounts payable $50.0 Sales growth rate = g 40% Last year’s notes payable $15.0 Last year’s total assets = A0* $500.0 Last year’s accruals $20.0 Last year’s profit margin = PM 20.0% Initial payout ratio 10.0% a. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9 34. Suppose Leonard, Nixon, & Shull Corporation’s projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company’s weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 35. Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments). Year: 1 2 Free cash flow: -$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770 36. Based on the corporate valuation model, the value of a company’s operations is $1,200 million. The company’s balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in longterm debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82 37. Based on the corporate valuation model, the value of a company’s operations is $900 million. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock’s price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36 38. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: -$20 $42 $45 a. $586 b. $617 c. $648 d. $680 e. $714 39. Which of the following statements about dividend policies is CORRECT? a. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the bird-in-the hand effect. b. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. c. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. d. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. e. The clientele effect suggests that companies should follow a stable dividend policy. 40. Which of the following statements is CORRECT? a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company. b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. c. Stock repurchases can be used by a firm that wants to increase its debt ratio. d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding. 41. Which of the following statements is CORRECT? a. When firms are deciding on the size of stock splits—say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used. b. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today. c. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits. d. When a company declares a stock split, the price of the stock typically declines—by about 50% after a 2-for-1 split—and this necessarily reduces the total market value of the equity. e. If a firm’s stock price is quite high relative to most stocks—say $500 per share—then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low—say $2 per share—then it can declare a reverse split of say 1-for-25 so as to bring the price up to somewhere around $50 per share. 42. Which of the following statements is CORRECT? a. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm’s dividend payout. b. The clientele effect can explain why so many firms change their dividend policies so often. c. One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele. d. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don’t change the firm’s total amount of book equity. e. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received. 43. DeAngelo Corp.'s projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts. Increase in Capital Budget Increase Debt Lower Payout Do Both to 75% to 20%___________________ a. $114.0 $73.3 $333.9 b. $120.0 $77.2 $351.5 c. $126.4 $81.2 $370.0 d. $133.0 $85.5 $389.5 e. $140.0 $90.0 $410.0 44. Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock. 45. Which of the following statements is CORRECT? a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share. d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller taxadjusted tradeoff theory would suggest that firms should increase their use of debt. 46. Which of the following statements is CORRECT? a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions. c. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing. 47. Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD’s basic earning power ratio (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT? a. Company HD has a higher return on assets (ROA) than Company LD. b. Company HD has a higher times interest earned (TIE) ratio than Company LD. c. Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD’s. d. The two companies have the same ROE. e. Company HD’s ROE would be higher if it had no debt. 48. Which of the following statements is CORRECT? a. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry. b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. c. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. e. Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.

Explanation / Answer

omg these many ques... hmm search frm these 1. You have the following data on three stocks: Stock Standard Deviation Beta A 20% 0.59 B 10% 0.61 C 12% 1.29 If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A. b. A; B. c. B; A. d. C; A. e. C; B. Answer: c 2. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Variance; correlation coefficient. b. Standard deviation; correlation coefficient. c. Beta; variance. d. Coefficient of variation; beta. e. Beta; beta. Answer: d 3. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter? a. Either A or B, i.e., the investor should be indifferent between the two. b. Stock A. c. Stock B. d. Neither A nor B, as neither has a return sufficient to compensate for risk. e. Add A, since its beta must be lower. Answer: c With only 4 stocks in the portfolio, unsystematic risk matters, and B has less. 4. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE? a. The fact that a security or project may not have a past history that can be used as the basis for calculating beta. b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta. c. The beta of an "average stock," or "the market," can change over time, sometimes drastically. d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. e. All of the statements above are true. Answer: c 5. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.) a. When held in isolation, Stock A has more risk than Stock B. b. Stock B must be a more desirable addition to a portfolio than A. c. Stock A must be a more desirable addition to a portfolio than B. d. The expected return on Stock A should be greater than that on B. e. The expected return on Stock B should be greater than that on A. Answer: d 6. Which of the following statements is CORRECT? 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 7. Which of the following statements is CORRECT? 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 re-balance 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 8. Which of the following statements is CORRECT? 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. d. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. e. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future. Answer: e 9. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct. a. Stock A would be a more desirable addition to a portfolio then Stock B. b. In equilibrium, the expected return on Stock B will be greater than that on Stock A. c. When held in isolation, Stock A has more risk than Stock B. d. Stock B would be a more desirable addition to a portfolio than A. e. In equilibrium, the expected return on Stock A will be greater than that on B. Answer: e 10. 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? 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 11. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B? Years Market Stock A Stock B 1 0.03 0.16 0.05 2 -0.05 0.20 0.05 3 0.01 0.18 0.05 4 -0.10 0.25 0.05 5 0.06 0.14 0.05 a. bA > 0; bB = 1. b. bA > +1; bB = 0. c. bA = 0; bB = -1. d. bA < 0; bB = 0. e. bA < -1; bB = 1. Answer: d First, note that B's beta must be zero, so either b or d must be correct. Second, note that A's returns are highest when the market's returns are negative and lowest when the market's returns are positive. This indicates that A's beta is negative. Thus, d must be correct. 12. Which of the following statements is CORRECT? a. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks. b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. c. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. d. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. e. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks. Answer: e 13. Which of the following statements is CORRECT? 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 14. Inflation, recession, and high interest rates are economic events that are best characterized as being a. systematic risk factors that can be diversified away. b. company-specific risk factors that can be diversified away. c. among the factors that are responsible for market risk. d. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. e. irrelevant except to governmental authorities like the Federal Reserve. Answer: c 15. Which of the following statements is CORRECT? a. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. b. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. c. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. d. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. e. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. Answer: e 16. Which of the following statements is CORRECT? a. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected. b. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. c. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0. d. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8. e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. Answer: b 17. Which of the following statements is CORRECT? a. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. b. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. c. A two-stock portfolio will always have a lower beta than a one-stock portfolio. d. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. e. A stock with an above-average standard deviation must also have an above-average beta. Answer: b 18. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. Expected Standard Stock Return Deviation Beta A 10% 20% 1.0 B 10% 10% 1.0 C 12% 12% 1.4 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT? a. Portfolio AB has a standard deviation of 20%. b. Portfolio AB's coefficient of variation is greater than 2.0. c. Portfolio AB's required return is greater than the required return on Stock A. d. Portfolio ABC's expected return is 10.66667%. e. Portfolio ABC has a standard deviation of 20%. Answer: d 19. Which of the following statements is CORRECT? a. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks. b. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable. c. If a stock has a negative beta, its expected return must be negative. d. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5. e. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns. Answer: b 20. For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true? a. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. b. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. c. The beta of the portfolio is less than the average of the betas of the individual stocks. d. The beta of the portfolio is equal to the average of the betas of the individual stocks. e. The beta of the portfolio is larger than the average of the betas of the individual stocks. Answer: d 21. Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio? 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 22. Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky also has a $50,000 portfolio, but it has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. If Bob and Becky marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio? a. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. b. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. c. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. d. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. e. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%. Answer: b 23. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. The returns of the two stocks are independent, so the correlation coefficient between them, rXY, is zero. Which of the following statements best describes the characteristics of your 2-stock portfolio? a. Your portfolio has a standard deviation of 30%, and its expected return is 15%. b. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6. c. Your portfolio has a beta equal to 1.6, and its expected return is 15%. d. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%. e. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6. Answer: c 24. 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? 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 25. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? a. Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio. b. The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk. c. Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios. d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's. e. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified. Answer: c 26. Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT? a. Portfolio P has a beta that is greater than 1.2. b. Portfolio P has a standard deviation that is greater than 25%. c. Portfolio P has an expected return that is less than 12%. d. Portfolio P has a standard deviation that is less than 25%. e. Portfolio P has a beta that is less than 1.2. Answer: d 27. Stocks A, B, and C all have an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another, i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another, i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT? a. Portfolio AC has an expected return that is less than 10%. b. Portfolio AC has an expected return that is greater than 25%. c. Portfolio AB has a standard deviation that is greater than 25%. d. Portfolio AB has a standard deviation that is equal to 25%. e. Portfolio AC has a standard deviation that is less than 25%. Answer: e 28. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A and 50% B. Which of the following statements is CORRECT? a. The portfolio's beta is less than 1.2. b. The portfolio's expected return is 15%. c. The portfolio's standard deviation is greater than 20%. d. The portfolio's beta is greater than 1.2. e. The portfolio's standard deviation is 20%. Answer: b 29. 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? 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 30. In a portfolio of three randomly selected stocks, which of the following could NOT be true, i.e., which statement is false? a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation. b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. c. The beta of the portfolio is lower than the lowest of the three betas. d. The beta of the portfolio is higher than the highest of the three betas. e. None of the above statements is obviously false, because they all could be true, but not necessarily at the same time. Answer: c 31. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. Stock B's required return is double that of Stock A's. b. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A. c. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. d. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B. e. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B. Answer: b 32. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT? a. Portfolio AB's standard deviation is 17.5%. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. c. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. d. Portfolio AB's expected return is 11.0%. e. Portfolio AB's beta is less than 1.2. Answer: b 33. 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? a. Portfolio P has a standard deviation of 20%. b. The required return on Portfolio P is equal to the market risk premium (rM - rRF). 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, rRF. e. Portfolio P has the same required return as the market (rM). Answer: e 34. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) 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 35. Over the past 75 years, we have observed that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last? a. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills. b. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds. c. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. d. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks. e. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills. Answer: c 36. During the coming year, the market risk premium (rM - rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0. b. The required return on all stocks will remain unchanged. c. The required return will fall for all stocks, but it will fall more for stocks with higher betas. d. The required return for all stocks will fall by the same amount. e. The required return will fall for all stocks, but it will fall less for stocks with higher betas. Answer: c 37. 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, rM - rRF, is positive. Which of the following statements is CORRECT? 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: c 38. Assume that in recent years both expected inflation and the market risk premium (rM - rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes? a. The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. b. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. c. The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0. d. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. e. The required returns on all stocks have fallen by the same amount. Answer: b 39. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? 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 40. Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market is in equilibrium, with required returns equaling expected returns. Which of the following statements is CORRECT? a. If expected inflation remains constant but the market risk premium (rM - rRF) declines, the required return of Stock LB will decline but the required return of Stock HB will increase. b. If both expected inflation and the market risk premium (rM - rRF) increase, the required return on Stock HB will increase by more than that on Stock LB. c. If both expected inflation and the market risk premium (rM - rRF) increase, the required returns of both stocks will increase by the same amount. d. Since the market is in equilibrium, the required returns of the two stocks should be the same. e. If expected inflation remains constant but the market risk premium (rM - rRF) declines, the required return of Stock HB will decline but the required return of Stock LB will increase. Answer: b 41. 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? 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 42. Which of the following statements is CORRECT? a. If a company's beta doubles, then its required rate of return will also double. b. Other things held constant, if investors suddenly become convinced that there will be deflation in the economy, then the required returns on all stocks should increase. c. If a company's beta were cut in half, then its required rate of return would also be halved. d. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase. e. If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise. Answer: e 43. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. An index fund with beta = 1.0 should have a required return of 11%. b. If a stock has a negative beta, its required return must also be negative. c. An index fund with beta = 1.0 should have a required return less than 11%. d. If a stock's beta doubles, its required return must also double. e. An index fund with beta = 1.0 should have a required return greater than 11%. Answer: a 44. Which of the following statements is CORRECT? a. The slope of the security market line is equal to the market risk premium. b. Lower beta stocks have higher required returns. c. A stock's beta indicates its diversifiable risk. d. Diversifiable risk cannot be completely diversified away. e. Two securities with the same stand-alone risk must have the same betas. Answer: a 45. Which of the following statements is CORRECT? a. Beta is measured by the slope of the security market line. b. If the risk-free rate rises, then the market risk premium must also rise. c. If a company's beta is halved, then its required return will also be halved. d. If a company's beta doubles, then its required return will also double. e. The slope of the security market line is equal to the market risk premium, (rM - rRF). Answer: e 46. Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns. b. Stock B has a higher required rate of return than Stock A. c. Portfolio P has a standard deviation of 22.5%. d. More information is needed to determine the portfolio's beta. e. Portfolio P has a beta of 1.0. Answer: e 47. Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM - rRF), equals 4%. Which of the following statements is CORRECT? a. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta. b. If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0. c. Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's. d. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase. e. If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0. Answer: d 48. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT? a. A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required return that exceeds that of the overall market. b. Stock Y must have a higher expected return and a higher standard deviation than Stock X. c. If expected inflation increases but the market risk premium is unchanged, then the required return on both stocks will fall by the same amount. d. If the market risk premium declines but expected inflation is unchanged, the required return on both stocks will decrease, but the decrease will be greater for Stock Y. e. If expected inflation declines but the market risk premium is unchanged, then the required return on both stocks will decrease but the decrease will be greater for Stock Y. Answer: d 49. 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? 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. c. The required return would increase for Stock A but decrease for Stock B. d. The required return on Portfolio P would remain unchanged. e. The required return would increase for Stock B but decrease for Stock A. Answer: a 50. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant? a. The required return on Portfolio P would increase by 1%. b. The required return on both stocks would increase by 1%. c. The required return on Portfolio P would remain unchanged. d. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. e. The required return for Stock A would fall, but the required return for Stock B would increase. Answer: a 51. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? a. The required return on a stock with beta = 1.0 will not change. b. The required return on a stock with beta > 1.0 will increase. c. The return on "the market" will remain constant. d. The return on "the market" will increase. e. The required return on a stock with beta < 1.0 will decline. Answer: e 52. Which of the following statements is CORRECT? a. The slope of the SML is determined by the value of beta. b. The SML shows the relationship between companies' required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the line can be influenced by its managers. c. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well diversified investor, assuming investors expect the observed relationship to continue on into the future. d. If investors become less risk averse, the slope of the Security Market Line will increase. e. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. Answer: c 53. Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows: a. The y-axis intercept would decline, and the slope would increase. b. The x-axis intercept would decline, and the slope would increase. c. The y-axis intercept would increase, and the slope would decline. d. The SML would be affected only if betas changed. e. Both the y-axis intercept and the slope would increase, leading to higher required returns. Answer: a 54. 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? 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 55. 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? 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 56. Which of the following statements is CORRECT? 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 57. Assume that investors have recently become more risk averse, so the market risk premium has increased. Also, assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur? a. The required rate of return for an average stock will increase by an amount equal to the increase in the market risk premium. b. The required rate of return will decline for stocks whose betas are less than 1.0. c. The required rate of return on the market, rM, will not change as a result of these changes. d. The required rate of return for each individual stock in the market will increase by an amount equal to the increase in the market risk premium. e. The required rate of return on a riskless bond will decline. Answer: a 58. Which of the following statements is CORRECT? a. A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis. b. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt. c. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations. d. If investors become more risk averse, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks. e. An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk premium, would lead to identical increases in the required returns on a riskless asset and on an average stock, other things held constant. Answer: e 59. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels, a. The expected rate of return must be equal to the required rate of return; that is, = r. b. The past realized rate of return must be equal to the expected future rate of return; that is, = . c. The required rate of return must equal the past realized rate of return; that is, r = . d. All three of the above statements must hold for equilibrium to exist; that is = r = . e. None of the above statements is correct. Answer: a 60. Which of the following statements is CORRECT? a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. b. Portfolio diversification reduces the variability of returns on an individual stock. c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events. d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs. e. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio. Answer: d 61. You observe the following information regarding Companies X and Y: • Company X has a higher expected return than Company Y. • Company X has a lower standard deviation of returns than Company Y. • Company X has a higher beta than Company Y. Given this information, which of the following statements is CORRECT? a. Company X has more diversifiable risk than Company Y. b. Company X has a lower coefficient of variation than Company Y. c. Company X has less market risk than Company Y. d. Company X's returns will be negative when Y's returns are positive. e. Company X's stock is a better buy than Company Y's stock. Answer: b 62. Roenfeld Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock? Probability Stock's State of of State Expected the Economy Occurring Return Boom 0.45 25% Normal 0.50 15% Recession 0.05 5% a. 0.2839 b. 0.3069 c. 0.3299 d. 0.3547 e. 0.3813 Answer: b This is a relatively technical problem. It should be used only if calculations are emphasized in class, or on a take-home exam where students have time to look up formulas. Probability of Return Deviation Squared State Prob. This state This state from Mean Deviation × Sq. Dev. 0.45 25.00% 6.00% 0.36% 0.1620% 0.50 15.00% -4.00% 0.16% 0.0800% 0.05 5.00% -14.00% 1.96% 0.0980% Expected return = 19.00% 0.34% 0.3400% = Expected variance s = 5.83% Coefficient of variation = s/Expected return = 0.3069 63. Jim Angel holds a $200,000 portfolio consisting of the following stocks: Stock Investment Beta A $ 50,000 0.95 B 50,000 0.80 C 50,000 1.00 D 50,000 1.20 Total $200,000 Answer: b

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