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Foundations of Finance, 9e (Keown/Martin/Petty)
Chapter 6 The Meaning and Measurement of Risk and Return
Learning Objective 6.1
1) Accounting profits is the most relevant variable the financial manager uses to measure returns.
Keywords: Accounting Profits, Cash Flows, Returns
Learning Obj.: L.O. 6.1
AACSB: Reflective Thinking
2) Cash flows is the most relevant variable to measure the returns on debt instruments, while GAAP net
income is the most relevant variable to measure the returns on common stock.
Keywords: Risk, Return
Learning Obj.: L.O. 6.1
AACSB: Reflective Thinking
3) The expected rate of return from an investment is equal to the expected cash flows divided by the
initial investment.
Keywords: Expected Rate of Return, Expected Cash Flows
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
4) Actual returns are always less than expected returns because actual returns are determined at the end
of the period and must be discounted back to present value.
Keywords: Actual Returns, Expected Returns
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
5) Another name for an asset’s expected rate of return is holding-period return.
Keywords: Holding Period Return, Expected Return
Learning Obj.: L.O. 6.1
AACSB: Reflective Thinking
6) The realized rate of return, or holding period return, is equal to the holding period dollar gain divided
by the price at the beginning of the period.
Keywords: Holding Period Return, Holding Period Dollar Gain
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
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7) The risk-return trade-off that investors face on a day-to-day basis is based on realized rates of return
because expected returns involve too much uncertainty.
Keywords: Realized Rate of Return, Expected Rate of Return
Learning Obj.: L.O. 6.1
AACSB: Reflective Thinking
8) Stock A has the following returns for various states of the economy:
State of the
Economy
Probability
Stock A’s Return
Recession
10%
-30%
Below Average
20%
-2%
Average
40%
10%
Above Average
20%
18%
Boom
10%
40%
Stock A’s expected return is
A) 5.4%.
B) 7.2%.
C) 8.2%.
D) 9.6%
Keywords: Expected Return, Probability
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
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9) Stock A has the following returns for various states of the economy:
State of the
Economy
Probability
Stock A’s Return
Recession
9%
-72%
Below Average
16%
-15%
Average
51%
16%
Above Average
14%
35%
Boom
10%
85%
Stock A’s expected return is
A) 9.9%.
B) 12.7%.
C) 13.8%.
D) 16.5%.
Keywords: Expected Return
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
10) You are considering a sales job that pays you on a commission basis or a salaried position that pays
you $50,000 per year. Historical data suggests the following probability distribution for your commission
income. Which job has the higher expected income?
Commission
Probability of
Occurrence
$15,000
.15
$35,000
.20
$48,000
.35
$67,000
.22
$80,000
.18
A) The salary of $50,000 is greater than the expected commission of $49,630.
B) The salary of $50,000 is greater than the expected commission of $48,400.
C) The salary of $50,000 is less than the expected commission of $50,050.
D) The salary of $50,000 is less than the expected commission of $52,720.
Keywords: Expected Value
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
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11) The relevant variable a financial manager uses to measure returns is
A) net income determined using generally accepted accounting principles.
B) earnings per share minus dividends per share.
C) cash flows.
D) dividends.
Keywords: Returns
Learning Obj.: L.O. 6.1
AACSB: Reflective Thinking
12) Assume that an investment is forecasted to produce the following returns: a 10% probability of a
$1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $1,500 return. What is the
expected amount of return this investment will produce?
A) $4,040
B) $7,640
C) $12140
D) $1,540
Keywords: Expected Return
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
13) Assume that an investment is forecasted to produce the following returns: a 30% probability of a 12%
return; a 50% probability of a 16% return; and a 20% probability of a 19% return. What is the expected
percentage return this investment will produce?
A) 33.3%
B) 16.1%
C) 9.5%
D) 15.4%
Answer: D
Diff: 2 Page Ref: 199
Keywords: Expected Return
Learning Obj.: L.O. 6.1
AACSB: Analytical Thinking
Learning Objective 6.2
1) Variation in the rate of return of an investment is a measure of the riskiness of that investment.
Keywords: Rate of Return, Risk, Variability
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
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2) A rational investor will always prefer an investment with a lower standard deviation of returns,
because such investments are less risky.
Keywords: Standard Deviation of Returns, Risk, Risk-Return Trade-off
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
3) For a well-diversified investor, an investment with an expected return of 10% with a standard
deviation of 3% dominates an investment with an expected return of 10% with a standard deviation of
5%.
Keywords: Expected Return, Standard Deviation, Risk-Return Trade-off, Well-diversified
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
4) Due to strict stock market controls, the most a stock’s value can drop in one trading day is 5%.
Keywords: Stock Price Volatility
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
5) Stock W has the following returns for various states of the economy:
State of the Economy
Probability
Stock W’s Return
Recession
10%
-30%
Below Average
20%
-2%
Average
40%
10%
Above Average
20%
18%
Boom
10%
40%
Stock W’s standard deviation of returns is
A) 10%.
B) 14%.
C) 17%.
D) 20%
Keywords: Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
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6) Stock W has the following returns for various states of the economy:
State of the Economy
Probability
Stock W’s Return
Recession
9%
-72%
Below Average
16%
-15%
Average
51%
16%
Above Average
14%
35%
Boom
10%
85%
Stock W’s standard deviation of returns is
A) 12%.
B) 29%.
C) 37%.
D) 43%.
Keywords: Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
7) Stock W has an expected return of 12% with a standard deviation of 8%. If returns are normally
distributed, then approximately two-thirds of the time the return on stock W will be
A) between 12% and 20%.
B) between 8% and 12%.
C) between -4% and 28%.
D) between 4% and 20%.
Keywords: Normal Distribution, Expected Return, Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
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8) Which of the following investments is clearly preferred to the others for an investor who is not holding
a well-diversified portfolio?
Investment
σ
A
18%
20%
B
20%
20%
C
20%
22%
A) Investment A
B) Investment B
C) Investment C
D) Cannot be determined without information regarding the risk-free rate of return.
Keywords: Expected Return, Standard Deviation, Risk-Return Trade-off
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
9) Assume that you have $330,000 invested in a stock that is returning 11.50%, $170,000 invested in a
stock that is returning 22.75%, and $470,000 invested in a stock that is returning 10.25%. What is the
expected return of your portfolio?
A) 15.6%
B) 12.9%
C) 18.3%
D) 14.8%
Keywords: Expected Return, Portfolio
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
10) Assume that you have $100,000 invested in a stock that is returning 14%, $150,000 invested in a stock
that is returning 18%, and $200,000 invested in a stock that is returning 15%. What is the expected return
of your portfolio?
A) 13.25%
B) 14.97%
C) 15.67%
D) 15.78%
Keywords: Expected Return, Portfolio
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
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11) Rogue Recreation, Inc. has normally distributed returns with an expected return of 15% and a
standard deviation of 5%, while Lake Tours, Inc. has normally distributed returns with an expected
return of 15% and a standard deviation of 15%. Which of the following is true?
A) Lake Tours’ investors are not being adequately compensated for relevant risk.
B) Rogue Rec is likely to experience returns larger than those of Lake Tours.
C) Lake Tours is more likely to have negative returns than Rogue Rec.
D) Rational investors will prefer Lake Tours, Inc. over Rogue Recreation, Inc.
Keywords: Expected Return, Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
12) You are considering investing in a project with the following possible outcomes:
States
Probability of
Occurrence
Investment
Returns
State 1: Economic boom
18%
20%
State 2: Economic growth
42%
16%
State 3: Economic decline
30%
3%
State 4: Depression
10%
-25%
Calculate the expected rate of return and standard deviation of returns for this investment, respectively.
A) 8.72%, 12.99%
B) 7.35%, 12.99%
C) 3.50%, 1.69%
D) 2.18%, 1.69%
Keywords: Expected Return, Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
13) Assume that an investment is forecasted to produce the following returns: a 20% probability of a 12%
return; a 50% probability of a 16% return; and a 30% probability of a 19% return. What is the standard
deviation of return for this investment?
A) 5.89%
B) 16.1%
C) 2.43%
D) 15.7%
Keywords: Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking
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14) You are thinking of adding one of two investments to an already well- diversified portfolio.
Security A
Security B
Expected Return = 14%
Expected Return = 16%
Standard Deviation of
Standard Deviation of
Returns = 16%
Returns = 20%
Beta = 1.2
Beta = 1.2
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable because they have the same beta.
D) Security B, but only if Security B’s required return is greater than 12%.
Keywords: Risk-Aversion, Well-diversified Portfolio, Beta, Risk-Return Trade-off
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
15) You are going to invest all of your funds in one of three projects with the following distribution of
possible returns:
PROJECT 1 PROJECT 2
Probability
Return
Standard
Deviation
Beta
Probability
Return
Standard
Deviation
Beta
50% Chance
22%
12%
1.1
30% Chance
36%
19.5%
1.0
50% Chance
-4%
40% Chance
10.5%
30% Chance
-20%
PROJECT 3
Probability
Return
Standard
Deviation
Beta
10% Chance
28%
12%
1.2
70% Chance
18%
20% Chance
-8%
If you are a risk averse investor, which one should you choose?
A) Project 1
B) Project 2
C) Project 3
D) Either Project 1 or Project 2 because they have the same expected return
Keywords: Standard Deviation, Risk-Return Trade-off, Expected Return, Non–diversified Portfolio
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
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16) You must add one of two investments to an already well– diversified portfolio.
Security A
Security B
Expected Return = 14%
Expected Return = 14%
Standard Deviation of
Standard Deviation of
Returns = 15.8%
Returns = 19.7%
Beta = 1.8
Beta = 1.5
If you are a risk-averse investor, which one is the better choice?
A) Security A
B) Security B
C) Either security would be acceptable.
D) Cannot be determined with information given
Keywords: Well-diversified Portfolio, Risk-Return Trade-off, Beta
Learning Obj.: L.O. 6.2
AACSB: Reflective Thinking
17) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a year end
value of $21,000 with a 30% probability; a year end value of $24,000 with a 45% probability; and a year
end value of $30,000 with a 25% probability. What is the standard deviation of the holding period return
for this investment?
A) 12.06%
B) 14.36%
C) 16.36%
D) 33.45%
Keywords: Holding Period Return, Standard Deviation
Learning Obj.: L.O. 6.2
AACSB: Analytical Thinking