978-0134083285 Chapter 6 Part 5

39

30) You determine that LMN common stock has an expected return of 24%. LMN has a Beta of 1.5. The

risk-free rate is 5%, and the market expected return is 15%. Which of the following is most likely to

happen?

A) You and other investors will buy up LMN stock and its price will rise.

B) You and other investors will sell LMN stock and its return will fall.

C) You and other investors will buy up LMN stock and its return will rise.

D) You and other investors will sell LMN stock and its price will fall.

Keywords: Security Market Line, Required Return, Expected Return

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

31) You hold a portfolio made up of the following stocks:

Investment Value

Beta

Stock L

$8,000

2.0

Stock M

$18,000

1.5

Stock N

$14,000

.4

If the market’s expected return is 14%, and the risk-free rate of return is 5%, what is the expected return of

the portfolio?

A) 17.010%

B) 16.700%

C) 15.935%

D) 14.698%

Keywords: Security Market Line, Beta, Expected Return, Portfolio

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

32) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market

portfolio is 15% and the risk-free rate is 4%. What is the risk premium on the market?

A) 5%

B) 6%

C) 9.00%

D) 11%

Keywords: Security Market Line, Market Risk Premium

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

40

33) Marble Corp. has a beta of 2.5 and a standard deviation of returns of 20%. The return on the market

portfolio is 15% and the risk-free rate is 4%. According to CAPM, what is the required rate of return on

Collectible’s stock?

A) 37.5%

B) 31.5%

C) 26.5%

D) 23.5%

Keywords: Security Market Line, Beta, Required Rate of Return

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

34) You hold a portfolio with the following securities:

Security

Percent of

Portfolio

Beta

Expected

Return

Able Corporation

20%

3.20

36.0%

Baker Corporation

40%

1.60

20.0%

Charlie Corporation

40%

.20

6.0%

What is the expected return for the market, according to the CAPM?

A) 14.0%

B) 13.8%

C) 12.0%

D) 10.0%

Keywords: Expected Return on the Market, CAPM, Security Market Line, Beta

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

35) The beta of ABC Co. stock is the slope of

A) the security market line.

B) the characteristic line for a plot of returns on the S&P 500 versus returns on short-term Treasury bills.

C) the arbitrage pricing line.

D) the characteristic line for a plot of ABC Co. returns against the returns of the market portfolio for the

same period.

Keywords: Beta, Characteristic Line

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

41

36) The rate on T-bills is currently 2%. Environment Help Company stock has a beta of 1.5 and a required

rate of return of 17%. According to CAPM, determine the return on the market portfolio.

A) 27.5%

B) 19.0%

C) 14.0%

D) 12.0%

Keywords: T-bill, Beta, Security Market Line, CAPM

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

37) The return on the market portfolio is currently 12%. Mobile Phone Corporation stockholders require a

rate of return of 30% and the stock has a beta of 3.2. According to CAPM, determine the risk-free rate.

A) 9.80%

B) 6.50%

C) 4.64%

D) 3.82%

Keywords: CAPM, Security Market Line, Risk-free Rate of Return

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

38) Which of the following is the slope of the security market line?

A) beta

B) one

C) It varies, and it is steeper for riskier securities.

D) the market risk premium

Keywords: Security Market Line, Market Risk Premium

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

39) What is the name given to the equation that financial managers use to measure an investor’s required

rate of return?

A) the standard deviation

B) the capital asset pricing model

C) the coefficient of variation

D) the MIRR

Keywords: CAPM

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

42

40) You are considering an investment in Citizens Bank Corp. The firm has a beta of 1.6. Currently, U.S.

Treasury bills are yielding 2.75% and the expected return for the S & P 500 is 14%. What rate of return

should you expect for your investment in Citizens Bank?

A) 11.15%

B) 15.39%

C) 16.75%

D) 20.75%

Keywords: Security Market Line, Required Return

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

41) The minimum rate of return necessary to attract an investor to purchase or hold a security is referred

to as the

A) stock’s beta.

B) investor‘s risk premium.

C) investor’s required rate of return.

D) risk-free rate.

Keywords: Required Rate of Return

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

43

42) Answer the questions below using the following information on stocks A, B, and C.

A

B

C

Expected Return

20%

21%

10%

Standard Deviation

12%

10%

Beta

1.8

2.2

0.8

Assume the risk-free rate of return is 3% and the expected market return is 12%

a. Calculate the required return for stocks A, B, and C.

b. Assuming an investor with a well-diversified portfolio, which stock would the investor want

to add to his portfolio?

c. Assuming an investor who will invest all of his money into one security, which stock will the investor

choose?

Keywords: Required Return, Security Market Line, Diversification, Risk-Return Trade-off

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

43) The expected return for the market portfolio is 13%, the expected return on U.S. Treasury bills is 2%,

and the expected return on AAA-rated short-term corporate bonds is 7%. Calculate the required return

for a stock with a beta equal to 1.5.

Keywords: Security Market Line, Beta, Required Return

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

44) Security A has an expected rate of return of 29.8 percent and a beta of 3.1. Security B has a beta of 1.70.

If the Treasury bill rate is 5 percent, what is the expected rate of return for Security B?

Keywords: Security Market Line, Beta, Expected Return, Treasury Bill

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

44

45) Bankers Corp. has a very conservative beta of .7, while Biotech Corp. has a beta of 2.1. Given that the

T-bill rate is 5%, and the market is expected to return 15%, what is the expected return of Bankers Corp.,

Biotech Corp., and a portfolio composed of 60% of Bankers Corp. and 40% Biotech Corp.?

a. Solve this problem first by weighting the betas to calculate a portfolio beta, and then using CAPM to

calculate the portfolio expected return.

b. Then solve the problem again by calculating the expected return of each asset and weighting those

returns to calculate the portfolio expected return.

c. Why is Biotech Corp.’s expected return NOT three times that of Bankers Corp.?

Keywords: Beta, Portfolio, Market Risk Premium, Security Market Line

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking

46) Redesign Corp. is considering a new strategy that would increase its expected return from 12% to

13.9%, but would also increase its beta from 1.2 to 1.8. If the risk-free rate is 5% and the return on the

market is expected to be 10%, should Redesign change its strategy?

Keywords: Risk-Return Trade-off, CAPM, Security Market Line, Beta

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

47) How does opportunity cost affect an investor’s required rate of return?

Keywords: Required Rate of Return

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

45

48) What are the two components of the investor’s required rate of return?

Keywords: Required Rate of Return

Learning Obj.: L.O. 6.5

AACSB: Reflective Thinking

49) Use the following data:

Market risk premium = 10%

Risk-free rate = 2%

Beta of XYZ stock = 1.6

Beta of PDQ stock = 2.4

Investment in XYZ stock = $15,000

Investment in PDQ stock = $60,000

You have no assets other than your investments in XYZ and PDQ stock.

What is the expected return of your portfolio? Show all work.

Keywords: Beta, Portfolio, Security Market Line

Learning Obj.: L.O. 6.5

AACSB: Analytical Thinking