FIN 534 Quiz 8

download 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.) Answer When held in isolation, Stock A has more risk than Stock B. Stock B must be a more desirable addition to a portfolio than A. Stock A must be a more desirable addition to a portfolio than B. The expected return on Stock A should be greater than that on B. The expected return on Stock B should be greater than that on A. 2 points Question 2 Which of the following statements is CORRECT? Answer A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. 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. A two-stock portfolio will always have a lower beta than a one-stock portfolio. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. A stock with an above-average standard deviation must also have an above-average beta. 2 points Question 3 Which of the following statements is CORRECT? Answer The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks. 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. 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. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks. 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. 2 points Question 4 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 âˆ’ rRF, is positive. Which of the following statements is CORRECT? Answer 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.

Stock B's required rate of return is twice that of Stock A. If Stock A's required return is 11%, then the market risk premium is 5%. If Stock B's required return is 11%, then the market risk premium is 5%. 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. 2 points Question 5 Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? Answer The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change. The expected return of your portfolio is likely to decline. The diversifiable risk will remain the same, but the market risk will likely decline. Both the diversifiable risk and the market risk of your portfolio are likely to decline. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. 2 points Question 6 Inflation, recession, and high interest rates are economic events that are best characterized as being Answer systematic risk factors that can be diversified away. company-specific risk factors that can be diversified away. among the factors that are responsible for market risk. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. irrelevant except to governmental authorities like the Federal Reserve. 2 points Question 7 Stock A has a , while Stock B has a Which of the following statements is CORRECT? Answer Stock B's required return is double that of Stock A's. 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. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. 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. 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.

2 points Question 8 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,). Which of the following statements is CORRECT? Answer Portfolio AB's standard deviation is 17.5%. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. Portfolio AB's expected return is 11.0%. Portfolio AB's beta is less than 1.2. 2 points Question 9 Assume that in recent years both expected inflation and the market risk premium (rM âˆ’ 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? Answer The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas. The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas. 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. Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0. The required returns on all stocks have fallen by the same amount. 2 points Question 10 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? Answer 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%. 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%. 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%. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%.

2 points Question 11 Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts invested in each of the three stocks. Each of the stocks has a standard deviation of 25%. The returns on the three stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT? Answer The required return of all stocks will remain unchanged since there was no change in their betas. 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. 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. The required returns on all three stocks will increase by the amount of the increase in the market risk premium. 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. 2 points Question 12 Which of the following statements is CORRECT? Answer 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. 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. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically. 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. 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. 2 points Question 13 For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true? Answer The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. The beta of the portfolio is less than the average of the betas of the individual stocks. The beta of the portfolio is equal to the average of the betas of the individual stocks. The beta of the portfolio is larger than the average of the betas of the individual stocks.

2 points Question 14 Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? Answer If a stock has a negative beta, its required return under the CAPM would be less than 5%. If a stock's beta doubled, its required return under the CAPM would also double. If a stock's beta doubled, its required return under the CAPM would more than double. If a stock's beta were 1.0, its required return under the CAPM would be 5%. If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%. 2 points Question 15 Which of the following statements is CORRECT? Answer 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. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk. 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. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. 2 points Question 16 Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

AB Beta 1.10 0.90 Constant growth rate 7.00% 7.00% Answer Stock A must have a higher stock price than Stock B. Stock A must have a higher dividend yield than Stock B. Stock Bâ€™s dividend yield equals its expected dividend growth rate. Stock B must have the higher required return. Stock B could have the higher expected return. 2 points Question 17 Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT?

Expected dividend, D1 $3.00 Current Price, P0 $50 Expected constant growth rate 6.0% Answer The stock’s required return is 10%. The stock’s expected dividend yield and growth rate are equal. The stock’s expected dividend yield is 5%. The stock’s expected capital gains yield is 5%. The stock’s expected price 10 years from now is $100.00. 2 points Question 18 The expected return on Natter Corporation’s stock is 14%. The stock’s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? Answer The stock’s dividend yield is 7%. The stock’s dividend yield is 8%. The current dividend per share is $4.00. The stock price is expected to be $54 a share one year from now. The stock price is expected to be $57 a share one year from now. 2 points Question 19 Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? Answer If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s. Stock B must have a higher dividend yield than Stock A. Stock A must have a higher dividend yield than Stock B. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. 2 points Question 20 If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. Answer The expected return on the stock is 5% a year. The stock’s dividend yield is 5%. The price of the stock is expected to decline in the future. The stock’s required return must be equal to or less than 5%. The stock’s price one year from now is expected to be 5% above the current price. 2 points Question 21 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?

AB Required return 10% 12% Market price $25 $40 Expected growth 7% 9% Answer These two stocks should have the same price. These two stocks must have the same dividend yield. These two stocks should have the same expected return. These two stocks must have the same expected capital gains yield. These two stocks must have the same expected year-end dividend. 2 points Question 22 If markets are in equilibrium, which of the following conditions will exist? Answer Each stock’s expected return should equal its realized return as seen by the marginal investor. Each stock’s expected return should equal its required return as seen by the marginal investor. All stocks should have the same expected return as seen by the marginal investor. The expected and required returns on stocks and bonds should be equal. All stocks should have the same realized return during the coming year. 2 points Question 23 For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then Answer the expected future return must be less than the most recent past realized return. The past realized return must be equal to the expected return during the same period. the required return must equal the realized return in all periods. the expected return must be equal to both the required future return and the past realized return. the expected future returns must be equal to the required return. 2 points Question 24 Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?

XY Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% Answer Stock X has a higher dividend yield than Stock Y. Stock Y has a higher dividend yield than Stock X. One year from now, Stock X’s price is expected to be higher than Stock Y’s price. Stock X has the higher expected year-end dividend. Stock Y has a higher capital gains yield. 2 points

Question 25 The preemptive right is important to shareholders because it Answer allows managers to buy additional shares below the current market price. will result in higher dividends per share. is included in every corporate charter. protects the current shareholders against a dilution of their ownership interests. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. 2 points Question 26 Which of the following statements is CORRECT? Answer If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms that have negative growth rates. The stock valuation model, P0 = D1/(rs - g), can be used only for firms whose growth rates exceed their required returns. 2 points Question 27 Which of the following statements is CORRECT, assuming stocks are in equilibrium? Answer The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield. Assume that the required return on a given stock is 13%. If the stock’s dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. A stock’s dividend yield can never exceed its expected growth rate. A required condition for one to use the constant growth model is that the stock’s expected growth rate exceeds its required rate of return. Other things held constant, the higher a company’s beta coefficient, the lower its required rate of return. 2 points Question 28 Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? Answer All common stocks fall into one of three classes: A, B, and C. All common stocks, regardless of class, must have the same voting rights. All firms have several classes of common stock. All common stock, regardless of class, must pay the same dividend. Some class or classes of common stock are entitled to more votes per share than other classes.

2 points Question 29 An increase in a firmâ€™s expected growth rate would cause its required rate of return to Answer increase. decrease. fluctuate less than before. fluctuate more than before. possibly increase, possibly decrease, or possibly remain constant. 2 points Question 30 Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? Answer The two stocks must have the same dividend per share. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. The two stocks must have the same dividend growth rate. The two stocks must have the same dividend yield. 2 points Save and Submit

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