Chapter 8: Analysis of Risk and Return PDF

CHAPTER 8: ANALYSIS OF RISK AND RETURN 1. The is a statistical measure of the mean or average value of the possible outcomes. a. probability distribution b. standard deviation c. expected value d. coefficient of variation ANSWER: c 2. The the standard deviati...

CHAPTER 8: ANALYSIS OF RISK AND RETURN 1. The is a statistical measure of the mean or average value of the possible outcomes. a. probability distribution b. standard deviation c. expected value d. coefficient of variation ANSWER: c 2. The the standard deviation, the the investment. a. smaller, larger the expected return on b. larger, riskier c. smaller, riskier d. larger, smaller the expected return on ANSWER: b 3. The is an absolute measure of risk, and the is a relative measure of risk. a. systematic risk, unsystematic risk b. standard deviation, coefficient of variation c. correlation, covariance d. security market line, characteristic line ANSWER: b 4. When comparing two equal-sized investments, the is an appropriate measure of total risk. a. standard deviation b. coefficient of variation c. correlation d. covariance ANSWER: a 5. The slope of the characteristic line for a specific security is an estimate of for that security. a. beta b. systematic risk c. total risk d. both beta and systematic risk ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 6. The is the ratio of to the. a. standard deviation, covariance, expected value b. covariance, expected value, standard deviation c. coefficient of variation, standard deviation, expected value d. coefficient of variation, systematic risk, expected value ANSWER: c 7. The coefficient of variation is a(n) measure of risk. a. relative b. absolute c. systematic d. unsystematic ANSWER: a 8. Values of the can range from +1.0 to -1.0. a. coefficient of variation b. correlation coefficient c. standard deviation d. covariance ANSWER: b 9. The of a portfolio of two or more securities is equal to the weighted average of the of each of the individual securities in the portfolio. a. standard deviation, standard deviation b. risk, risk c. expected return, expected return d. standard deviation, risk ANSWER: c 10. The primary difference between the standard deviation and the coefficient of variation as measures of risk is: a. the coefficient of variation is easier to compute. b. the standard deviation is a measure of relative risk whereas the coefficient of variation is a measure of absolute risk. c. the coefficient of variation is a measure of relative risk whereas the standard deviation is a measure of absolute risk. d. the standard deviation is rarely used in practice whereas the coefficient of variation is widely used. ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 11. Security A’s expected return is 10 percent while the expected return of B is 14 percent. The standard deviation of A’s returns is 5 percent, and it is 9 percent for B. An investor plans to invest equal amounts in A and B. Which of the following statements is true about this portfolio consisting of stock A and stock B. a. The risk of the portfolio is equal to 7 percent. b. The lower the correlation of returns between the two stocks, the higher the portfolio’s risk. c. The risk of the portfolio is primarily dependent on the utility function of the investor. d. The higher the correlation of returns between the two stocks, the higher the portfolio’s risk. ANSWER: d 12. Which of the following is not an example of a source of systematic risk? a. interest rate changes b. foreign competition with an industry’s products c. changes in the overall economic outlook d. changes in the inflation rate ANSWER: b 13. The security market line a. is defined as the slope of a line relating an individual security’s return to the returns of other securities in that firm’s primary industry. b. provides a picture of the risk-return tradeoff required by diversified investors considering various risky assets. c. has as its slope the beta of the security d. is determined by the prevailing level of risk-free interest rates minus a risk premium ANSWER: b 14. All other things being equal, what is the major impact that an increase in the expected inflation rate would be expected to have on the security market line? a. reduce its slope b. shift it down and to the right c. shift it up and to the left d. reduce required returns for investors in any individual asset ANSWER: c 15. Beta is defined as: a. a measure of volatility of a security’s returns relative to the returns of a broad-based market portfolio of securities. b. the ratio of the variance of market returns to the covariance of returns on a security with the market c. the inverse of the slope of the security regression line d. all of these ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 16. A beta value of 0.5 for a security indicates a. the security has average systematic risk b. the security has above-average systematic risk c. the security has no unsystematic risk d. the security has below-average systematic risk ANSWER: d 17. The security market line can be thought of as expressing relationships between required rates of return and a. the time value of money b. beta c. total risk d. portfolio diversification ANSWER: b 18. Users of the CAPM should be aware of some of the problems in its practical application. These problems include which of the following? a. estimating expected future market returns b. determining the most appropriate measure of the risk- free rate c. determining an asset’s future beta d. all of these are problems in application of the CAPM ANSWER: d 19. Recalling the meaning and calculation of beta, a security that is completely uncorrelated (ρj,m = 0) with the market portfolio would have a beta of a. -1 b. 0 c. +1 d. -100 ANSWER: b 20. All of the following are primary sources of systematic risk except a. changes in the amount of foreign competition facing an industry b. changes in investor expectations about the economy c. interest rate changes d. changes in purchasing power ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 21. All of the following factors have their primary impact on unsystematic risk except a. availability of raw materials b. effects of foreign competition c. changes in inflation d. strikes ANSWER: c 22. The correlated the returns from two securities are, the will be the portfolio effects of risk reduction. a. more positively, greater b. greater, greater c. less positively, greater d. lower, lower ANSWER: c 23. The risk remaining after extensive diversification is primarily: a. unsystematic risk b. systematic risk c. coefficient of variation risk d. standard deviation risk ANSWER: b 24. The most relevant risk that must be considered for any widely traded individual security is its. a. unsystematic risk b. standard deviation c. covariance risk d. systematic risk ANSWER: d 25. Texas Computers (TC) stock has a beta of 1.5 and American Water (AW) stock has a beta of 0.5. Which of the following statements will be true about these securities? a. The addition of TC would reduce portfolio risk more than the addition of AW. b. The addition of AW would reduce total portfolio risk more than the addition of TC. c. The required return for TC is greater than the required return for AW. d. The required return for AW is greater than the required return of TC. ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 26. The risk premium for an individual security is equal to the a. beta times the market return b. difference between the required return and the risk free rate c. weighted average of the individual security betas in a portfolio d. the security’s covariance divided by the variance of the market ANSWER: b 27. The risk-free rate of return can be thought of as consisting of the following two components: a. a real rate of return, a default premium b. unanticipated inflation, bond default premium c. a real rate of return, an inflation premium d. a zero beta component, an expectation premium ANSWER: c 28. What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors become more risk averse? a. shift up and have a steeper slope b. shift down and have the same slope c. shift down and have a steeper slope d. shift up but have less slope ANSWER: a 29. Arbitrage pricing theory is a model that relates expected returns on securities to a. security risk and yield spreads b. yield spreads and yield curve slope c. anticipated economic factors d. multiple risk factors ANSWER: d 30. Which of the following is not an approach for managing risk: a. hedging b. gaining control over the operating environment c. limited use of firm-specific assets d. ignoring systematic risk ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 31. Which of the following (if any) is a relative (rather than absolute) measure of risk? a. standard deviation b. standard normal probability distribution c. expected value d. coefficient of variation ANSWER: d 32. In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be. a. less than +1.0 b. equal to 0.0 c. less than 0.0 d. equal to -1.0 ANSWER: d 33. A portfolio is efficient if. a. for a given standard deviation, there is no other portfolio with a higher expected return b. for a given expected return, there is no other portfolio with a lower standard deviation c. its standard deviation is equal to -1.0 d. for a given standard deviation, there is no other portfolio with a higher expected return and if, for a given expected return, there is no other portfolio with a lower standard deviation ANSWER: d 34. In general, when the correlation coefficient between the returns on two securities is , the risk of a portfolio is the weighted average of the total risk of the two individual securities. a. equal to +1.0; equal to b. less than +1.0; less than c. a and b d. none of these ANSWER: c 35. An increase in the expected future inflation rate has the effect of. a. increasing the slope of the security market line b. shifting the security market line upward by the amount of the expected increase in inflation c. increasing systematic risk d. none of these ANSWER: b © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 36. An increase in uncertainty regarding the future economic outlook has the effect of. a. increasing the slope of the security market line b. shifting the security market line upward c. reducing risk d. none of the above ANSWER: a 37. In the , the expected return on a security is equal to the risk-free rate plus a single risk premium that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate times the sensitivity of the security’s returns to the market return. a. Arbitrage Pricing Theory b. Capital Asset Pricing Model c. Dividend Valuation Model d. Risk Premium on Debt Model ANSWER: b 38. The is a relative measure of variability because it measures the risk per unit of expected return. a. coefficient of variation b. correlation coefficient c. covariance d. standard deviation ANSWER: a 39. The security returns from multinational companies tend to have systematic risk than domestic companies. a. more b. less options with c. less d. more hedging of ANSWER: c 40. Investors generally are considered to be risk because they expect to be compensated for assuming risk. a. inverse b. seekers c. averse d. takers ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 41. Investors can obtain high returns in their investments if: a. they use hedging techniques b. they assume high risks c. they invest only international securities d. they invest in legal Ponzi type securities ANSWER: b 42. The term structure of interest rates is the pattern of interest rate yields for securities that differ only in a. default risk b. liquidity premiums c. the yield to maturity d. the length of time to maturity ANSWER: d 43. The term structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all respects except for differences in a. tax status b. liquidity c. risk of default d. maturity ANSWER: d 44. The maturity premium reflects a preference by many lenders for a. shorter maturities b. reducing yields c. high yield securities d. longer maturities ANSWER: a 45. The default risk premium reflects the fact that a. the premium remains constant over time b. there is a positive relationship between risk and maturity c. there is a positive relationship between default risk and required returns d. the premium varies depending on the time to maturity ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 46. The business risk of a firm refers to the a. results from using fixed-cost sources of funds b. variability in the price of a firm’s securities c. variability in the firm’s operating earnings over time d. influence of government regulations on business earnings ANSWER: c 47. The following yields on 20 year bonds prevailed in January for the three securities shown: Aa-rated corporate bond 9.98% Baa-rated corporate bond 10.34% B-rated corporate bond 11.12% The difference in yields is due primarily to a. maturity risk premium b. default risk premium c. seniority risk premium d. financial risk premium ANSWER: b 48. The ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value is known as the a. financial risk b. marketability risk c. business risk d. security risk ANSWER: b 49. According to the , long-term interest rates are a function of expected short-term interest rates. a. Maturity theory b. Expectations theory c. Market segmentation theory d. Preferred habitat theory ANSWER: b 50. The term structure of interest rates is related to the. a. default risk premium b. seniority risk premium c. marketability risk premium d. maturity risk premium ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 51. refers to the ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value. a. Default risk b. Business and financial risk c. Maturity risk d. Marketability risk ANSWER: d 52. The risk-free rate of return is composed of which of the following elements: a. risk premium and inflation b. cost of capital and risk premium c. real rate of return and risk premium d. real rate of return and inflation ANSWER: d 53. The two elements that make up the risk-free rate of return are a. the supply of funds and the demand for funds b. the yield on 90-day Treasury bills plus an inflation premium c. the real rate of return plus an inflation premium d. the required return plus a risk premium ANSWER: c 54. The theory of the yield curve holds that required returns on long-term securities tend to be greater the longer the time to maturity. a. expectations b. market segmentation c. preferred habitat d. liquidity premium ANSWER: d 55. Business risk is influenced by all the following factors except: a. variability in interest expenses b. variability in sales c. diversity of its product line d. choice of production technology ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 56. can be achieved by investing in a set of securities that have different risk-return characteristics. a. Indexing b. Capital Asset pricing c. Diversification d. Asset allocation ANSWER: c 57. On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is obtained by ____. a. lending money b. borrowing money c. reducing risk d. investing in index funds ANSWER: b 58. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: Price Rate of Return Probability $16 –20% 0.25 20 0% 0.30 24 +20% 0.25 28 +40% 0.20 Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the expected rate of return on Phoenix Stock. a. 8% b. 0% c. 10% d. 40% ANSWER: a RATIONALE: Solution: E(R) = –20%(0.25) + 0%(0.30) + 20%(0.25) + 40%(0.20) = 8% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 59. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: Price Rate of Return Probabilit y $16 –20% 0.25 20 0% 0.30 24 +20% 0.25 28 +40% 0.20 Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the standard deviation of possible rates of return on Phoenix stock (to the nearest tenth of a percent). a. 456% b. 20.9% c. 2.2% d. 21.4% ANSWER: d RATIONALE: Solution: Expected return = 8% (See problem 55 solution.) 2 2 2 2.5 σ = [(–20% – 8%) (0.25) + (0% - 8%) (0.30) + (20% – 8%) (0.25) + (40% – 8%) (0.20)] = 21.4% 60. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith Blarney have assigned the following probability distribution to the price of (and rate of return on) Phoenix stock one year from now: Price Rate of Return Probability $16 –20% 0.25 20 0% 0.30 24 +20% 0.25 28 +40% 0.20 Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the coefficient of variation for the rate of return on Phoenix stock. a. 0.0 b. 2.68 c. 2.61 d. 0.275 ANSWER: b RATIONALE: Solution: Expected return = 8%; Standard deviation = 21.4% v = 21.4%/8% = 2.68 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 61. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning more than 21% on FTC common stock. (Note: Table V is required to work this problem.) a. 1.00 b. 0.8413 c. 0.0013 d. 0.1587 ANSWER: d RATIONALE: Solution: z = (21% – 14%)/7% = 1; From Table V, p = 15.87% 62. The expected rate of return for the coming year on FTC common stock is normally distributed with a mean of 14% and a standard deviation of 7%. Determine the probability of earning a negative rate of return (i.e. less than 0%) on FTC common stock. (Note: Table V is required to work this problem.) a. 0.0228 b. 2.00 c. 0.5000 d. 0.9772 ANSWER: a RATIONALE: Solution: z = (0% – 14%)/7% = –2.0; From Table V, p = 2.28% 63. Elephant Company common stock has a beta of 1.2. The risk-free rate is 6 percent and the expected market rate of return is 12 percent. Determine the required rate of return on the security. a. 7.2% b. 14.4% c. 19.2% d. 13.2% ANSWER: d RATIONALE: Solution: kj = 6% + 1.2(12% – 6%) = 13.2% 64. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25 percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12 percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the expected return on the investor’s portfolio. a. 14% b. 12% c. 13% d. 9% ANSWER: b RATIONALE: Solution: E(Rp) = 0.75(12%) + 0.25(16%) = 13% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 65. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25 percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12 percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the standard deviation of returns for this investor’s portfolio. a. 73.8% b. 6.71% c. 3.00% d. 8.59% ANSWER: d 2 2 2 2.5 RATIONALE: Solution: σp = [(0.75) (8%) + (0.25) (12%) + 2(0.75)(0.25)(0.8)(8%)(12%)] = 8.59% 66. Compute the risk premium for the stock of Omega Tools if the risk-free rate is 6%, the expected market return is 12%, and Omega’s stock has a beta of.8. a. 10.8% b. 4.8% c. 48.0% d. 16.8% ANSWER: b RATIONALE: Solution: Risk premium = 0.8(12% – 6%) = 4.8% 67. The return expected from a risky investment is 24 percent, and the standard deviation of this return is 17 percent. If returns from this investment are normally distributed, what is the probability that the investment may earn a negative rate of return? (Note: Table V is required to work this problem.) a. 8.33% b. 7.93% c. 6.88% d. 5.44% ANSWER: b RATIONALE: Solution: z = (0% – 24%)/17% = – 1.41; From Table V, p = 7.93% 68. The expected rate of return for 3COM is 18 percent, with a standard deviation of 10.98 percent. The expected rate of return for Just the Fax is 26 percent with a standard deviation of 15.86%. Which firm would be considered the riskier from a total risk perspective? a. 3COM b. Just the Fax c. Neither, both have the same risk d. Cannot be determined ANSWER: c RATIONALE: Solution: 3COM: v = 10.98%/18% = 0.61 Just the Fax: v = 15.86%/26% = 0.61 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 69. Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is Don’s expected return on his portfolio? a. 12.42% b. 12.20% c. 11.81% d. Cannot be determined ANSWER: a RATIONALE: Solution: E(Rp) = (3/19)11.6% + (10/19)12.8% + (6/19)12.2% = 12.42% 70. Sally’s broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the expected return of the remaining portion of her portfolio? a. 20.9% b. 18.8% c. 12.5% d. cannot be determined ANSWER: b RATIONALE: Solution: 14.2% – 0.4(10.3%) – 0.2(12.8%) = 0.4 X X = 18.8% 71. Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and replacing it with another security with a lower beta. What must be the beta of the replacement security? e. 1.21 f. 0.91 g. 0.73 h. 1.62 ANSWER: c RATIONALE: Solution: To find the beta for the 7 securities: 1.28 = 7/8(x) + 1/8(1.75) x = 1.21 New security’s beta would be: 1.15 = 7/8(1.21) + 1/8 beta beta = 0.73 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 72. A college student owns two securities: Apple and Coca- Cola. Apple has an expected return of 15 percent with a standard deviation of those returns being 11 percent. Coca-Cola has an expected return of 12 percent, and a standard deviation of 7 percent. The correlation of returns between Apple and Coca-Cola is 0.81. If the portfolio consist of $6,000 in Coca-Cola and $4,000 in Apple, what is the expected standard deviation of portfolio returns? a. 8.18% b. 13.20% c. 8.60% d. 9.71% ANSWER: a 2 2 2 2.5 RATIONALE: Solution: σp = [(.6) (.07) + (.4) (.11) + 2(.6)(.4)(.07)(.11)(.81)] = 0.0818 73. Assume you want to construct a portfolio with a 14 percent return from the following two securities: Security Expected Return Beta 1 16% 1.12 2 12.5% 0.94 What percentage of your portfolio should be invested in Security 1? a. 57% b. 47% c. 43% d. 53% ANSWER: c RATIONALE: Solution: 0.14 = X(0.16) + (1 – X)(0.125) X = 0.43 74. Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury bills was 9.17 percent. Over the same time period, the average annual inflation rate was 6.39 percent. Therefore, a. the inflation premium was 2.78 percentage points b. the real expected rate of return was 9.17 percentage points c. the realized real rate of return was 2.78 percentage points d. the required rate of return was 6.39 percentage points ANSWER: c RATIONALE: Solution: 9.17% – 6.39% = 2.78% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 75. The real rate of interest is expected to be 3 percent and the expected rate of inflation for next year is expected to be 5.5 percent. If the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4 percentage points, what is the required return on a 1 year U.S. Treasury security? a. 9.6% b. 10.0% c. 8.5% d. 8.9% ANSWER: c RATIONALE: Solution: Required return = 3% + 5.5% = 8.5% 76. If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is 4.16%, then the real rate of return is: a. 2.86% b. 7.02% c. 4.70% d. 6.48% ANSWER: a RATIONALE: Solution: 7.02% – 4.16% = 2.86% 77. The yield to maturity on ACL bonds maturing in 2005 is 8.75 percent. The yield to maturity on a similar maturity U.S. Government Treasury bond in 7.06 percent and the yield on Treasury bills is 6.51 percent. What is the default risk premium on the ACL bond? a. 2.24% b. 1.69% c. 0.55% d. 8.75% ANSWER: b RATIONALE: Solution: Risk premium = 8.75% – 7.06% = 1.69% 78. The risk-free rate of return is 5.51 percent, based on an expected inflation premium of 2.54 percent. The expected return on the market is 12.8 percent. What is the required rate of return for Envoy common stock which has a beta of 1.35? a. 6.98% b. 16.24% c. 15.35% d. 12.80% ANSWER: c RATIONALE: Solution: kj = 5.51 + 1.35(12.8 – 5.51) = 15.35% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 79. Determine the beta of a portfolio consisting of equal investments in the following common stocks: Security Beta Apple Computer 1.15 Coca-Cola 1.05 Harley-Davidson 1.50 Homestake Mining 0.50 a. 1.05 b. 1.00 c. 1.10 d. 0.95 ANSWER: a RATIONALE: Solution: Bp =.25(1.15) +.25(1.05) +.25(1.50) +.25(.50) = 1.05 80. Twin City Knitting (TCK) pays a current dividend of $2.20 and dividends are expected to grow at a rate of 7 percent annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2 percent and the market risk premium is 6 percent, at what price would you expect TCK’s common stock to sell? a. $14.35 b. $33.63 c. $23.40 d. $25.04 ANSWER: d RATIONALE: Solution: ke = 0.092 + 1.2(0.06) = 0.164 or 16.4% ke = $2.20(1.07)/P0 + 0.07 = 0.164 P0 = $2.354/0.094 = $25.04 81. Micromatic is considering expanding into a new product area. Micromatic’s current beta is 1.2 and its beta is expected to increase to 1.45 after the expansion. The long-term growth rate of the firm’s earnings is expected to increase from 6.5 percent to 10 percent. Micromatic’s current dividend is $1.70 per share, the current risk-free rate is 9.1 percent, and the expected market return is 12.9 percent. Should Micromatic undertake the planned expansion? a. No, stock price decreases $10.15 b. Yes, stock price increases $15.27 c. Yes, stock price increases $0.45 d. No, stock price decreases $15.27 ANSWER: b RATIONALE: Solution: Current ke = 0.091 + 1.2(0.129 – 0.091) = 0.1366 or 13.66% Current P = $1.70(1.065)/(0.1366 – 0.065) = $25.29 New ke = 0.091 + 1.45(0.129 – 0.091) = 0.1461 New P = $1.70(1.10)/(0.1461 – 0.10) = $40.56 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 82. Quick Start, Inc. is expected to pay a dividend of $1.05 next year and dividends are expected to continue their 7 percent annual growth rate. The SML has been estimated as follows: kj = 0.08 + 0.064βj If Quick Start has a beta of 1.1, what would happen to its stock price if inflation expectations went from the current 5 percent to 8 percent? a. decrease $8.14 b. decrease $3.55 c. decrease $3.18 d. stock price will not change ANSWER: b RATIONALE: Solution: Current ke = 0.08 + 0.064(1.1) = 0.1504 Current P = $1.05/(0.1504 – 0.07) = $13.06 New ke = 0.11 +.064(1.1) = 0.1804 New P = $1.05/(0.1804 – 0.07) = $9.51 ΔP = $3.55 83. Richtex Brick has a current dividend of $1.70 and the market value of its common stock is $28. The expected market return is 13 percent and the risk-free rate is 9 percent. If Richtex stock is half as volatile as the market, and the market is in equilibrium, what rate of growth is expected for Richtex’s dividends assuming a constant growth valuation model is appropriate for Richtex? a. 4.93% b. 4.65% c. 5.37% d. 5.41% ANSWER: b RATIONALE: Solution: ke = 0.09 + 0.5(0.13 – 0.09) = 0.11 $28 = $1.70(1 + g)/(0.11 – g) g = 0.04646 or 4.65% 84. AKA’s stock is currently selling for $11.44. This year the firm had earnings per share of $2.80 and the current dividend is $0.68. Earnings are expected to grow 7% a year in the foreseeable future. The risk-free rate is 10 percent and the expected market return is 14.2 percent. What will be the effect on the price of AKAs’ stock if systematic risk increases by 40 percent, all other factors remaining constant? a. an increase of $1.14 b. a decrease of $0.40 c. a decrease of $1.99 d. cannot determine from the given data ANSWER: c RATIONALE: Solution: Old ke = 0.10 + βj(0.142 – 0.10) = 0.10 + 0.042βj P = $0.68(1.07)/(0.10 + 0.042βj – 0.07) = $11.44 βj = 0.80 New ke = 0.10 + 0.8(1.4)(0.042) =0.147 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return P = $ 0.7276/(0.147 – 0.07) = $9.45 A decrease of $1.99 a share 85. Given the following information on securities E and F, calculate the expected return and standard deviation of returns on a portfolio consisting of 40% invested in E and 60% invested in F. Security E Security F Expected Return 12% 5% Standard Deviation of Returns 10% 20% Correlation coefficient of returns –0.50 a. 13.5%; 15% b. 13.8%; 14.4% c. 13.8%; 10.6% d. 13.5%; 8.7% ANSWER: c RATIONALE: Solution: Rp = we Re + wf Rf Rp = 0.40(12%) + 0.60(15%) = 13.8% 2 2 2 2.5 σp = [(.40) (10) + (.60) (20) + 2(.40)(.60)(–0.50)(10)(20)] = 10.6% 86. Gates Industries current common stock dividend (year 0) is $2.50 per share and is expected to continue growing at a rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the estimated market risk premium (i.e., km – rf) is 8.3%. Value Line has estimated Gates Industries beta to be 1.10. Determine the expected price for Gates Industries common stock. a. $21.50 b. $15.03 c. $15.78 d. $22.57 ANSWER: d RATIONALE: Solution: ke = 7.5% + 1.10(8.3%) = 16.63% P0 = $2.50(1.05)/(0.1663 – 0.05) = $22.57 87. An investor, who believes the economy is slowing down, wishes to reduce the risk of her portfolio. She currently owns 12 securities, each with a market value of $3,000. The current beta of the portfolio is 1.21 and the beta of the riskiest security is 1.62. What will the portfolio beta be if the riskiest security is replaced with a security of equal market value but a beta of 0.80? a. 1.14 b. 1.18 c. 1.05 d. 1.10 ANSWER: a RATIONALE: Solution: 1.21 = 11/12(x)+ 1/12(1.62) so x = 1.17 portfolio beta = 11/12(1.17) + 1/ 12(.80) = 1.14 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 88. Assume that the rate of return on Calengry common stock over the coming year is normally distributed with an expected value of 16% and a standard deviation of 20%. What is the probability of earning a negative rate of return? (Note: Table Vis required to work this problem.) a. 10.56% b. 40.13% c. 21.19% d. 3.59% ANSWER: c RATIONALE: Solution: z = = –0.8 p = 0.2119 or 21.19% 89. Determine the beta of a portfolio consisting of the following common stocks: Security Market Value Beta Boeing $5,00 1.2 0 Exxon $4,000 0.8 Duke Power $2,50 0.6 0 Blockbuster Video $2,00 1.4 0 Coca-Cola $7,50 1.0 0 a. 0.93 b. 0.85 c. 1.00 d. 1.14 ANSWER: c RATIONALE: Solution: ßp = (5/21)1.2 + (4/21)0.8 + (2.5/2 1)0.6 + (2/21)1.4 + (7.5/2 1)1.0 ßp = 1.00 90. HDTV has planned on diversifying into the dual-VCR field. As a result, HDTV’s beta would rise to 1.6 from 1.2 and the expected future long-term growth rate in the firm’s earnings would increase from 12% to 16%. The expected market return, km, is 14%; the risk free rate, rf, is 7%; and the current dividend, Do, is $0.50. Should HDTV go into the dual-VCR field? a. No-stock price decrease $7.82 b. Yes-stock price increase $9.89 c. Yes-stock price increase $3.81 d. No-stock price decrease $3.78 ANSWER: b RATIONALE: Solution: kold =.07 + 1.2(.14 –.07) =.154 knew =.07 + 1.6(.07) =.182 Po =.50(1.12)/(.154 –.12) = $16.47 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return Pn =.50(1.16)/(.182 –.16) = $26.36 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 91. Christy is considering investing in the common stock of One Liberty and Heico. The following data are available for these two securities: One Liberty Heico Expected return.12.16 Standard deviation of returns.08.20 If she invests 30% of her funds in Heico and 70% in One Liberty, and if the correlation of returns between these securities is +0.65, what is the portfolio’s expected return and standard deviation? a. 14% and 15.67% b. 14.8% and 9.44% c. 13.2% and 10.54% d. 13.1% and 9.67% ANSWER: c RATIONALE: Solution: Rp = 0.3(0.16) + 0.7(0.12) = 0.132 or 13.2% 2 2 2 2.5 σp= [0.3 (0.20) + 0.7 (0.08) + 2(0.3)(0.7)(0.08)(0.20)(0.65)] = 0.1054 or 10.54% 92. Jim Bowles is an investor who believes the economy is gaining strength and, therefore, wishes to increase the risk of his 14 security portfolio. Each security has a current market value of $5,000 and the current beta of the portfolio is 1.02. The beta of the least risky security is.76. If Jim replaces the least risky security with another security with the same market value but a beta of 1.45, what will the portfolio beta be then? a. 1.03 b. 1.07 c. 1.08 d. 1.04 ANSWER: b RATIONALE: Solution: 1.02 = (13/14)(X) + (1/14)(.76) So X = 1.04 βp = (13/14)(1.04) + (1/14)(1.45) = 1.069 93. Kermit Industries current common stock dividend is $1.35 per share and the dividend is expected to grow at 6% per year into the foreseeable future. Currently the risk-free rate is 4.5% and the estimated market risk premium is 8.5%. Merrill Lynch has estimated KI’s beta to be 1.10. Compute the expected price for KI’s common stock. a. $17.20 b. $10.33 c. $18.23 d. $49.35 ANSWER: c RATIONALE: Solution: ke =.045 + 1.10(0.085) = 0.1385 P0 = $1.35(1.06)/(0.1385 – 0.06) = $18.23 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 94. Determine the beta of a portfolio consisting of the following common stocks: Security Market Value Beta Glaxo $2,600 1.24 SCANA 3,700.88 BancOne 2,900.95 Pepsi 3,400 1.05 AFLAC 3,000 1.09 Votec 4,400 1.41 a. 1.00 b. 1.12 c. 1.09 d. 1.11 ANSWER: d RATIONALE: Solution: p = 2.6/20(1.24) + 3.7/20(.88) + 2.9/20(.95) + 3.4/20(1.05) + 3.0/20(1.09) + 4.4/20(1.41) = 1.11 95. The beta of Sanafil is 1.2. Sanafil is evaluating a merger with Matra, a firm that has a beta of 0.95. Sanafil’s stock sells for $40 per share and there are 10 million shares outstanding. Matra’s stock sells for $60, but there are only 2 million shares outstanding. If these two firms merge, what will be the merged firm’s beta? MVS = $40(10,000,000) = $400,000,000 MVM = $60(2,000,000) = $120,000,000 a. 1.00 b. 1.14 c. 1.05 d. 1.16 ANSWER: b RATIONALE: Solution: βp = (120/520)(0.95) + (400/520)(1.2) = 1.14 96. Lotte Group is planning on diversifying into the transportation industry. As a result, Lotte’s beta would rise to 1.3 from 1.1 and the expected long-term growth rate in the firm’s earnings would increase from 11% to 14%. Currently the risk-free rate is 5.0% and the market risk premium is 8.6%. If Lotte’s current dividend is $1.30, should Lotte diversify into the transportation industry? a. No, stock price does not increase b. No, stock price declines about $10.11 c. Yes, stock price increases about $19.42 d. Yes, stock price increases by about $26.27 ANSWER: d RATIONALE: Solution: kold = 0.05 + 1.1(0.086) = 0.1446 P0 = $1.30(1.11)/(0.1446 – 0.11) = $41.71 knew = 0.05 + 1.3(0.086) = 0.1618 Pnew = $1.30(1.14)/(0.1618 – 0.14) = $67.98 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 97. Security A offers an expected return of 14% with a standard deviation of 8%. Security B offers an expected return of 11% with a standard deviation of 6%. If you wish to construct a portfolio with a 12.8% expected return, what percentage of the portfolio will consist of security A? a. 55% b. 60% c. 65% d. 45% ANSWER: b RATIONALE: Solution: wA = (12.8 – 11.0)/(14 – 11) = 0.60 or 60% 98. Which of the following statements is/are correct? I. Unsystematic risk can be eliminated through diversification. II. Unsystematic risk is the relevant portion of an asset’s risk attributable to market factors that affect all firms, like inflation, political events, etc. a. Only statement I is correct b. Only statement II is correct c. Both statements I and II are correct d. Neither statement I nor II is correct ANSWER: a 99. Correlation is a statistical measure of the relationship between a series of numbers representing data. Which of the following statements about correlation is/are correct? I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of -1. II. Perfectly positively correlated describes two positively correlated stocks that have a correlation coefficient of 0. a. Only statement I is correct b. Only statement II is correct c. Both statements I and II are correct d. Neither statement I nor II is correct ANSWER: a 100. Total risk of a security can be viewed as consisting of two parts. Which of the following apply? I. verifiable risk II. non-verifiable risk a. Only statement I is correct b. Only statement II is correct c. Both statements I and II are correct d. Neither statement I nor II is correct ANSWER: d © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Chapter 8: Analysis of Risk and Return 101. All of the following statements about risk are correct EXCEPT: a. Risk can be defined as the chance for financial loss. b. The term risk is used interchangeably with uncertainty. c. Risk refers to the certainty of returns associated with a given asset. d. The more certain the return from an asset, the less variability and therefore less risk. ANSWER: c 102. Which of the following statements regarding risk is/are correct? I. A portfolio of two negatively correlated assets has less risk than either of the individual assets and risk could be further reduced to 0 or below. II. There is no case where creating a portfolio of assets will result in greater risk than that of the riskiest asset included in the portfolio. a. Only statement I is correct b. Only statement II is correct c. Both statements I and II are correct d. Neither statement I nor II is correct ANSWER: c 103. What kind of probability distribution shows all possible outcomes for a given event? a. discrete b. expected value c. bar chart d. continuous ANSWER: d 104. That portion of the risk premium that is based on the ability of the borrower to repay principal and interest is the: a. Maturity risk b. Default risk c. Seniority risk d. Business risk ANSWER: b 105. An investor, by investing in combinations of stocks, develops a portfolio a. simple b. structured c. diversified d. energetic ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 106. What is the beta of the following project? Comparative Returns on Past Projects Project’s Returns 12% 15% 10% 8% 6.5% 7% 2% –1% a. 1.11 b..95 c. 2.15 d. 1.43 ANSWER: d RATIONALE: Answer was determined by using the statistical function on a financial calculator. 107. Find beta and determine the required rate of return. The market risk premium is 12% and the risk-free rate is 5%. Comparative Returns in the Market Returns on the Stock 8% 4% 9% 10% 2% 1% 10% 6% a. 12.61% b. 8.27% c. 10.11% d. 14.84% ANSWER: d RATIONALE: Answer was determined by using the statistical function on a financial calculator. Beta =.82 RRR = 5% +.82(12%) = 14.84% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 108. Find beta and determine the risk premium. The market risk premium is 8% and the risk-free rate is 2%. Comparative Returns in the Market Returns on the Stock 10% 8% 11% 12% 6% 2% 5% 1% a. 16.82% b. 20.76% c. 10.15% d. 18.11% ANSWER: b RATIONALE: The answer was determined by using the statistical function on a financial calculator Beta is 1.73 Risk premium = 1.73(12) = 20.76% (The risk-free rate is surplus information) 109. What is an efficient portfolio? ANSWER: A portfolio is efficient if, for a given standard deviation, there is no other portfolio with a higher expected return, or for a given expected return, there is no other portfolio with a lower standard deviation. An efficient portfolio maximizes return for a given level of risk, or minimizes risk for a given rate of return. 110. List types of events that influence systematic (non-diversifiable) risk. ANSWER: Events that are broad in scope and affect the market as a whole will impact systematic risk. These events include: war inflation political events interest rate changes international incidents changes in investor expectations about the overall economy 111. List the various risk elements that are considered when determining the risk premium. ANSWER: The risk elements include: 1. maturity risk premium 2. default risk premium 3. seniority risk premium 4. marketability risk premium 112. How can standard deviation, a statistical measure of dispersion, be used in investment analysis? ANSWER: The standard deviation can be used to measure the variability of return from an investment. It gives an indication of the risk involved in the asset or security. The larger the standard deviation, the more variable an investment’s return and thus the riskier the investment. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 113. Explain marketability risk and marketability premium. ANSWER: Marketability risk refers to the ability of an investor to buy and sell a company’s securities quickly and without a significant loss of value. Usually the stock of companies listed on the NYSE is considered easy to sell and has a ready buyer. The marketability risk premium is that extra interest rate charged on loans to companies whose stock may not be easy to sell. The lender, in order to be adequately compensated for the risk taken in making the loan, receives a higher return. 114. Why is risk an increasing function of time? ANSWER: Investment decisions require that returns be forecasted several years into the future. The riskiness of these forecasted returns may be thought of as an increasing function of time. Returns that are generated early can generally be predicted with more certainty than those that are anticipated farther out into the future. The farther into the future that performance is forecasted, the greater the chance that the forecast will be incorrect. Even though cash flows from an investment or project may be equal each year, it is reasonable to assume that the riskiness of these flows increases over time as more and more presently unknown variables have a chance to affect the investment’s or project’s cash flows. 115. A diversified portfolio has many stocks as opposed to a single stock. Diversification can occur with a little as stocks. a. 5 b. 10 c. 20 d. 100 ANSWER: c 116. Which of the following would be considered a risk-free investment? a. U.S. Treasury securities b. blue chip stocks c. AAA rated corporate bonds d. real estate ANSWER: a 117. The kind of probability distribution that shows all possible outcomes for a given event results in: a. a bell curve b. a bar chart c. a synchronous table d. an a synchronous table ANSWER: a © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 8: Analysis of Risk and Return 118. When looking at measures of risk and return, the notation “σ” represents: a. risk b. return c. standard deviation d. probability ANSWER: c © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.