FIN534 Quiz 4

Which of the following statements is CORRECT?  (Assume that the risk-free rate is a constant.)

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.

The effect of a change in the market risk premium depends on the slope of the yield curve.

If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.

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.

The effect of a change in the market risk premium depends on the level of the risk-free rate.

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?

Answer

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.

Stock Y's realized return during the coming year will be higher than Stock X's return.

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.

Stock Y's return has a higher standard deviation than Stock X.

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.

Question 3

For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true?

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.

Question 4

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?

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.

The required return on all stocks will remain unchanged.

The required return will fall for all stocks, but it will fall more for stocks with higher betas.

The required return for all stocks will fall by the same amount.

The required return will fall for all stocks, but it will fall less for stocks with higher betas.

Question 5

Which of the following statements is CORRECT?

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.

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.

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.

Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.

A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

Question 6

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?

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%.

Question 7

Stock A has a beta = 0.8, while Stock B has a beta = 1.6.  Which of the following statements is CORRECT?

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.

Question 8

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?

Your portfolio has a standard deviation of 30%, and its expected return is 15%.

Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.

Your portfolio has a beta equal to 1.6, and its expected return is 15%.

Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.

Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.

Question 9

Which of the following statements is CORRECT?

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.

Question 10

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?

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.

Question 11

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.

Question 12

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%.  PortfolioAB 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?

PortfolioAB'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.

PortfolioAB's expected return is 11.0%.

PortfolioAB's beta is less than 1.2.

Question 13

Which of the following statements is CORRECT?

An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.

The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

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.

Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.

An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.

Question 14

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?

Answer

Either A or B, i.e., the investor should be indifferent between the two.

Stock A.

Stock B.

Neither A nor B, as neither has a return sufficient to compensate for risk.

Add A, since its beta must be lower.

Question 15

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?

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.

Question 16

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 

Required return                               10%                 12%

Market price                                     $25                  $40

Expected growth                               7%                   9%

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.

Question 17

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?

                                                           X                      Y 

Price                                                 $30                  $30

Expected growth (constant)              6%                   4%

Required return                               12%                 10%

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.

Question 18

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                  $40

Expected growth                               7%                   9%

Expected return                               10%                 12%

The two stocks should have the same expected dividend.

The two stocks could not be in equilibrium with the numbers given in the question.

A's expected dividend is $0.50.

B's expected dividend is $0.75.

A's expected dividend is $0.75 and B's expected dividend is $1.20.

Question 19

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.

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.

Question 20

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?

                                                              A                 B  

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 B’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.

Question 21

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.

Question 22

An increase in a firm’s expected growth rate would cause its required rate of return to

Increase.

Decrease.

Fluctuate less than before.

Fluctuate more than before.

Possibly increase, possibly decrease, or possibly remain constant.

Question 23

Companies can issue different classes of common stock.  Which of the following statements concerning stock classes is CORRECT?

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.

Question 24

The preemptive right is important to shareholdersbecause it

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.

Question 25

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.

Question 26

Which of the following statements is CORRECT, assuming stocks are in equilibrium?

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.

Question 27

The required returns of Stocks X and Y are rX = 10% and rY = 12%.  Which of the following statements is CORRECT?

If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X.

If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price.

The stocks must sell for the same price.

Stock Y must have a higher dividend yield than Stock X.

Question 28

If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks

the stock is experiencing supernormal growth.

the stock should be sold.

the stock is a good buy.

management is probably not trying to maximize the price per share.

dividends are not likely to be declared.

Question 29

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?

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.

Question 30

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?

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.