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Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
Page 1
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1. Which of the following statements about risk is false?
a.
Risk requires the possibility of at least one outcome less favorable than the expected value.
b.
Risk requires the possibility of more than one outcome.
c.
Risk is one of the determinants of the required return.
d.
Risk aversion generally is assumed in finance to be a characteristic of the "marginal investor."
e.
All of the above statements are true.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 - Knowledge
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Risk
2. Which of the following statements is correct?
a.
Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely
described by a listing of the likelihood of unfavorable events.
b.
Portfolio diversification reduces the variability of returns on an individual stock.
c.
When company specific risk has been diversified, the inherent risk that remains is market risk which is
constant for all securities in the market.
d.
A stock with a beta of −1.0 has zero systematic (or market) risk.
e.
The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line
cannot be controlled by the financial manager.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 - Knowledge
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Risk Concepts
3. Choose the correct answer for the following: (1) Which is the best measure of risk for choosing an asset which is to be
held in isolation? (2) Which is the best measure for choosing an asset to be held as part of a diversified portfolio?
a.
Variance; correlation coefficient.
b.
Standard deviation; correlation coefficient.
c.
Beta; variance.
d.
Coefficient of variation; beta.
e.
Beta; beta.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
Cengage Learning Testing, Powered by Cognero
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6. A highly risk-averse investor is considering the addition of an asset to a 10-stock portfolio. The two securities under
consideration both have an expected return equal to 15 percent. However, the distribution of possible returns associated
with Asset A has a standard deviation of 12 percent, while Asset B's standard deviation is 8 percent. Both assets are
correlated with the market with ρ = 0.75. Which asset should the risk-averse investor add to his/her portfolio?
a.
Asset A.
b.
Asset B.
c.
Both A and B.
d.
Neither A nor B.
e.
Cannot tell without more information.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 - Knowledge
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Standard Deviation
7. Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these
securities? (Assume the market is in equilibrium.)
a.
When held in isolation, Stock A has greater risk than Stock B.
b.
Stock B would be a more desirable addition to a portfolio than Stock A.
c.
Stock A would be a more desirable addition to a portfolio than Stock B.
d.
The expected return on Stock A will be greater than that on Stock B.
e.
The expected return on Stock B will be greater than that on Stock A.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 - Knowledge
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
Page 5
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
e.
Statements b and c are both correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 - Knowledge
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Risk Analysis
11. Which of the following statements is correct?
a.
A complete probability distribution is always an objective listing of all possible events. Since it is impossible
to list all the possible outcomes from a single event, probability distributions are of limited benefit in assessing
risk.
b.
A peaked probability distribution centered around the expected value will make a stock more desirable,
thereby increasing its expected return.
c.
In the real world, there are an infinite number of possible states or outcomes that can occur. Thus, probability
distributions actually are continuous; however, for simplicity, financial managers typically reduce the number
of states for analysis to a manageable number.
d.
Risk refers to the chance that some unfavorable event will occur while a probability distribution is completely
described as a listing of the likelihood of unfavorable events.
e.
The higher the probability that the return from an investment will pay off its average promised value the lower
will be the expected return, regardless of the distribution of the investment's returns.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Probability and Return
12. Which of the following statements is correct?
a.
Risk aversion implies that some securities will go unpurchased in the market even if a large risk premium is
paid to investors.
b.
When investors require higher rates of return for investments that demonstrate higher variability of returns,
this is evidence of risk aversion.
c.
Risk aversion implies a general dislike for risk, thus, the lower the expected return the higher the risk
premium.
d.
In comparing two firms that differ from each other only with respect to risk, the expected returns on the stock
of the firms should be equal.
e.
None of the above statements is correct.
ANSWER:
b
POINTS:
1
Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
15. Which of the following statements concerning measures of risk is correct?
a.
Combining stocks together in portfolios reduces risk as long as the correlation between the returns on the
securities is not perfect (i.e. ρ = −1.0 or ρ = +1.0).
b.
Even if the correlation between the returns on two different securities is perfectly positive, if the securities are
combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held
alone.
c.
The coefficient of variation, calculated as the expected return divided by the standard deviation, is a
standardized measure of the correlation of risk and return.
d.
The tighter the probability distribution of expected future returns the smaller the risk of a given investment as
measured by both the variance and the standard deviation.
e.
Variance is a measure of the variability of returns and because it involves squaring each deviation of the
required return from the expected return, it is always larger than its square root, the standard deviation.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Risk Measures
16. Which of the following statements is false?
a.
One key result of applying the Capital Asset Pricing Model is that the risk and return of an individual security
should be analyzed by how that security affects the risk and return of the portfolio in which it is held.
b.
According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the
isolated risks of individual stocks. Thus, the relevant risk is an individual stock's contribution to the overall
riskiness of the portfolio.
c.
The CAPM is built on expected conditions, although we are limited in most cases to using past data in
applying it. Betas used in the CAPM which are calculated using historical data are always subject to changes
in future volatility, and this is a limitation on the use of the CAPM.
d.
If the price of money increases due to greater anticipated inflation, the risk-free rate will reflect this fact.
Although rRF will increase, it is possible that the SML required rate of return for a stock will decrease because
the market risk premium (rM − rRF) will decrease. (Assume that beta remains constant.)
e.
Any change in beta is likely to affect the required rate of return on a security which implies that a change in
beta will likely have an impact on the security's price.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
CAPM
Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
Page 8
17. Which of the following statements is false?
a.
The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the
securities being compared differ significantly.
b.
Managers cannot act in the best interests of their shareholders unless they know their shareholders' average
time preference for receiving their money and what risks a typical shareholder is prepared to assume.
c.
Companies should deliberately increase their risk relative to the market only if the actions that increase the
risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the
higher risk.
d.
If the expected rate of return for a particular investment, as seen by the marginal investor, exceeds its required
rate of return, we should soon observe an increase in demand for the investment, and the price will likely
increase until a price is established that equates the expected return with the required return.
e.
All of the above statements are correct.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Risk and Return
18. Which of the following statements is most correct?
a.
If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk
from the portfolio.
b.
If you formed a portfolio which included a large number of low beta stocks (stocks with betas less than 1.0 but
greater than −1.0), the portfolio would itself have a beta coefficient that is equal to the weighted average beta
of the stocks in the portfolio, so the portfolio would have a relatively low degree of risk.
c.
If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness
of your portfolio as measured by its beta, then, according to the CAPM theory, you should invest some of your
money in each stock in the market, i.e., if there were 10,000 traded stocks in the world, the least risky portfolio
would include some shares in each of them.
d.
Company-specific (or unsystematic) risk can be eliminated by forming a large portfolio, but normally even
highly diversified portfolios are subject to market (or systematic) risk.
e.
Statements b and d are both correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Portfolio Risk and Beta
19. Which of the following statements is most correct?
a.
The expected return on a portfolio of financial assets is equal to the summation of the products of the expected
Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
Page 9
returns of the individual assets multiplied by the probability of each return being realized.
b.
When adding new securities to a portfolio, the higher or more positive the degree of correlation between the
new securities and those already in the portfolio, the greater the benefits of the additional portfolio
diversification.
c.
In portfolio analysis, we rarely use ex post (historical) returns and standard deviations, because we are
interested in ex ante (future) data.
d.
Portfolio diversification reduces the variability of returns on each security held in the portfolio.
e.
All of the above statements are false.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Portfolio Risk and Return
20. Which of the following statements is most correct?
a.
Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.
b.
Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we would
expect Portfolio B to have the lower relevant risk, but it is possible for Portfolio A to be less risky.
c.
If an investor buys enough stocks, he or she can, through diversification, eliminate all of the nonmarket (or
company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained some of all publicly traded
stocks, it would be riskless.
d.
Statements a, b, and c are all true.
e.
Statements a, b, and c are all false.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Portfolio Diversification
21. Which of the following statements is most correct?
a.
A portfolio with a beta of minus 2 has the same degree of risk to its holder, relative to the market, as a
portfolio with a beta of plus 2. However, the holder of either portfolio could lower his or her risk exposure by
buying some "normal" stocks.
b.
A stock with a beta of −1.0 has zero systematic (or market) risk.
c.
It is possible for a stock to have a positive beta even in situations where the correlation between the returns on
it and those on another stock are negative.
d.
Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolio.
e.
Statements a and c are both correct.
Principles of Finance, 6e
Besley/Brigham
Chapter 11
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ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Beta Coefficient
22. For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current
levels,
a.
The expected rate of return must be equal to the required rate of return; that is, .
b.
The past realized rate of return must be equal to the expected rate of return; that is, .
c.
The required rate of return must equal the realized rate of return; that is, .
d.
All three of the above statements must hold for equilibrium to exist; that is, .
e.
None of the above statements is correct.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Market Equilibrium
23. Inflation, recession, and high interest rates are economic events which are characterized as
a.
Company specific risk that can be diversified away.
b.
Market risk.
c.
Systematic risk that can be diversified away.
d.
Diversifiable risk.
e.
Unsystematic risk that can be diversified away.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Market Risk
24. Which of the following statements is most correct?
a.
Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a
regression analysis, while the other has a beta of −0.6. The returns on the stock with the negative beta will be
Principles of Finance, 6e
Besley/Brigham
Chapter 11
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
negatively correlated with returns on most other stocks in the market.
b.
Suppose you are managing a stock portfolio, and you have information which leads you to believe that the
stock market is likely to be very strong in the immediate future, i.e., you are confident that the market is about
to rise sharply. You should sell your high beta stocks and buy low beta stocks in order to take advantage of the
expected market move.
c.
In a recent issue, The Wall Street Journal ran a story on a company named Collections Inc., which is in the
business of collecting past due accounts for other companies, i.e., it is a collection agency. According to the
Journal, Collections's revenues, profits, and stock price tend to rise during recessions. This suggests that
Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies
when the economy is weak.
d.
Statements a and b are both true.
e.
Statements a and c are both true.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Beta Coefficient
25. You have developed data which give (1) the average annual returns on the market for the past five years, and (2)
similar information on Stocks A and B. If these data are as follows, which of the possible answers best describes the
historical betas for A and B?
Years
Market
Stock A
Stock B
1
0.03
0.16
0.05
2
−0.05
0.20
0.05
3
0.01
0.18
0.05
4
−0.10
0.25
0.05
5
0.06
0.14
0.05
a.
βA > 0; βB = 1
b.
βA > +1; βB = 0
c.
βA = 0; βB = −1
d.
βA < 0; βB = 0
e.
βA < −1; βB = 1
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Beta Coefficient
Cengage Learning Testing, Powered by Cognero
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26. Which of the following is not a difficulty concerning beta and its estimation?
a.
Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.
b.
Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier
assets, the calculated beta will be drastically different than the "true" or "expected future" beta.
c.
The beta of an "average stock," or "the market," can change over time, sometimes drastically.
d.
Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because
conditions have changed.
e.
All of the above are potentially serious difficulties.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Beta Coefficient
27. Which of the following statements is correct?
a.
If the returns from two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1) and the
two stocks have equal variance, an equally weighted portfolio of the two stocks will have a variance which is
less than that of the individual stocks.
b.
If a stock has a negative beta, its expected return must be negative.
c.
According to the CAPM, stocks with higher standard deviations of returns will have higher expected returns.
d.
A portfolio with a large number of randomly selected stocks will have less market risk than a single stock
which has a beta equal to 0.5.
e.
None of the above statements is correct.
ANSWER:
e
RATIONALE:
Statement e is correct because none of the statements is correct. Statement a is false
because if the returns of 2 stocks were perfectly positively correlated, the portfolio's
variance would equal the variance of each of the stocks. Statement b is false. A stock
can have a negative beta and still have a positive return because rs = rRF + (rM − rRF)β.
Statement c is false. According to the CAPM, stocks with higher betas have higher
expected returns. Betas are a measure of market risk, while standard deviation is a
measure of stand-alone risk⎯but not a good measure. The coefficient of variation is a
better measure of stand-alone risk. The portfolio's beta (the measure of market risk) will
be dependent on the beta of each of the randomly selected stocks in the portfolio.
However, the portfolio's beta would probably approach βM = 1, which would indicate
higher market risk than a stock with a beta equal to 0.5.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
Principles of Finance, 6e
Besley/Brigham
Chapter 11
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Page 13
TOPICS:
Portfolio Return, CAPM, and Beta
28. Which of the following statements is most correct?
a.
The SML relates required returns to firms' systematic (or market) risk. The slope and intercept of this line
cannot be controlled by the financial manager.
b.
The slope of the SML is determined by the value of beta.
c.
If you plotted the returns of a given stock against those of the market, and you found that the slope of the
regression line was negative, the CAPM would indicate that the required rate of return on the stock should be
less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected
to continue on into the future.
d.
If investors become less risk averse, the slope of the Security Market Line will increase.
e.
Statements a and c are both true.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
SML
29. Other things held constant, (1) if the expected inflation rate decreases, and (2) investors become more risk averse, the
Security Market Line would shift
a.
Down and have steeper slope.
b.
Up and have less steep slope.
c.
Up and keep same slope.
d.
Down and keep same slope.
e.
Down and have less steep slope.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
SML
30. Which of the following statements is most correct?
a.
An increase in expected inflation could be expected to increase the required return on a riskless asset and on
an average stock by the same amount, other things held constant.
b.
A graph of the SML would show required rates of return on the vertical axis and standard deviations of returns
on the horizontal axis.
c.
If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return
would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would
Principles of Finance, 6e
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Page 14
probably be greater than the average of the stocks' standard deviations.
d.
If investors became more averse to risk, then (1) the slope of the SML would increase and (2) the required rate
of return on low-beta stocks would increase by more than the required return on high-beta stocks.
e.
The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.
ANSWER:
a
RATIONALE:
An increase in expected inflation would lead to an increase in rRF, the intercept of the
SML. If risk aversion were unchanged, then the slope of the SML would remain constant.
Therefore, there would be a parallel upward shift in the SML, which would result in an
increase in rM that is equal to the expected increase in inflation.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
SML
CAPM
Portfolio Risk
31. Which of the following statements is most correct?
a.
If beta doubles, the required return doubles.
b.
If a stock has a negative beta, its required return is negative.
c.
Higher beta stocks have more company-specific risk, but do not necessarily have more market risk.
d.
If a portfolio's beta increases from 1.2 to 1.5, its required rate of return will increase by an amount equal to its
market risk premium.
e.
If two stocks have the same standard deviation and the correlation coefficient between the returns of two
stocks equals zero, an equally weighted portfolio of the two stocks will have a standard deviation lower than
that of the individual stocks.
ANSWER:
e
RATIONALE:
The SML equation is as follows: r = rRF + (rM − rRF)β. Given this equation, statements a
and b are incorrect. Statement c is false. Beta measures market risk; therefore, higher
beta stocks have more market risk. If a portfolio's beta increases from 1.2 to 1.5, its
required rate of return will increase by the difference in the betas multiplied by its market
risk premium. Statement e is correct; as long as the two stocks aren't perfectly positively
correlated the portfolio of the 2 stocks will have a lower standard deviation than that of
each of the individual stocks.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Miscellaneous
32. Which of the following statements is most correct?
Principles of Finance, 6e
Besley/Brigham
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
a.
According to CAPM theory, the required rate of return on a given stock can be found by use of the SML
equation:
ri = rRF + (rM − rRF)βi.
Expectations for inflation are not reflected anywhere in this equation, even indirectly, and because of that the
text notes that the CAPM may not be strictly correct.
b.
If the required rate of return is given by the SML equation as set forth in Answer a, there is nothing a financial
manager can do to change his or her company's cost of capital, because each of the elements in the equation is
determined exclusively by the market, not by the type of actions a company's management can take, even in
the long run.
c.
Assume that the required rate of return on the market is currently rM = 15%, and that rM remains fixed at that
level. If the yield curve has a steep upward slope, the calculated market risk premium would be larger if the
30-day T-bill rate were used as the risk-free rate than if the 30-year T-bond rate were used as rRF.
d.
Statements a and b are both true.
e.
Statements a and c are both true.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
CAPM
33. Which of the following statements is most correct?
a.
If investors become more risk averse, but rRF remains constant, the required rate of return on high beta stocks
will rise, the required return on low beta stocks will decline, but the required return on an average risk stock
will not change.
b.
If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held
equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0 and thus
would be equally risky from an investor's standpoint.
c.
An investor who holds just one stock will be exposed to more risk than an investor who holds a portfolio of
stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more
risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.
d.
Assume that the required rate of return on the market, rM, is given and fixed. If the yield curve were upward-
sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were
used as the risk-free rate than if 30-year Treasury bonds were used for rRF.
e.
Statements a, b, c, and d are all false.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-3 - Comprehension
Business Program-6 - Reflective Thinking
Principles of Finance, 6e
Besley/Brigham
Chapter 11
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DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
SML Application
34. Given the following probability distributions, what are the expected returns for the Market and for Security J?
Statei
Pr i
rM
rJ
1
0.3
−10%
40%
2
0.4
10
−20
3
0.3
30
30
a.
10.0%; 11.3%
b.
9.5%; 13.0%
c.
10.0%; 9.5%
d.
10.0%; 13.0%
e.
13.0%; 10.0%
ANSWER:
d
RATIONALE:
= (0.3)(−0.10) + (0.4)(0.10) + (0.3)(0.30) = 0.10 = 10.0%. = (0.3)(0.4) + (0.40)(−0.20)
+ (0.3)(0.30) = 0.13 = 13.0%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Expected Return
35. Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of inflation in the
future. The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent. Mercury has a beta of 2.0,
and its realized rate of return has averaged 15 percent over the last 5 years.
a.
15%
b.
16%
c.
17%
d.
18%
e.
20%
ANSWER:
d
RATIONALE:
rRF = r* + IP = 3% + 5% = 8%. rs = 8% + (5%)2.0 = 18%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Required Return
Principles of Finance, 6e
Besley/Brigham
Chapter 11
36. If the risk-free rate is 7 percent, the expected return on the market is 10 percent, and the expected return on Security J
is 13 percent, what is the beta of Security J?
a.
1.0
b.
1.5
c.
2.0
d.
2.5
e.
3.0
ANSWER:
c
RATIONALE:
= 13 = 7% + (10% − 7%)βJ β = (13% − 7%)/3% = 2.0.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
CAPM
37. HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10%, and the required rate
of return on an average stock is 15%. Now the expected rate of inflation built into rRF falls by 3 percentage points, the real
risk-free rate remains constant, the required return on the market falls to 11%, and the betas remain constant. When all of
these changes are made, what will be the difference in required returns on HR's and LR's stocks?
a.
1.0%
b.
2.5%
c.
4.5%
d.
5.4%
e.
6.0%
ANSWER:
e
RATIONALE:
βHR = 2.0; βLR = 0.5. No changes occur. rRF = 10%. Decreases by 3% to 7%. rM = 15%.
Falls to 11%. Now SML: ri = rRF + (rM − rRF)βi.
rHR = 7% + (11% − 7%)2 = 7% + 4%(2)
= 15%
rLR = 7% + (11% − 7%)0.5 = 7% +
4%(0.5)
= 9
Difference
6%
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
CAPM and Required Return
38. Given the following information, determine which beta coefficient for Stock A is consistent with equilibrium:
Principles of Finance, 6e
Besley/Brigham
Chapter 11
rs = 11.3%; rRF = 5%; rM = 10%
a.
0.86
b.
1.26
c.
1.10
d.
0.80
e.
1.35
ANSWER:
b
RATIONALE:
In equilibrium
rs =
= 11.3%.
rs
= rRF + (rM − rRF)βs
11.3%
= 5% + (10% − 5%)βs
βs
= 1.26.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Beta Coefficient
39. You are an investor in common stock, and you currently hold a well-diversified portfolio which has an expected return
of 12 percent, a beta of 1.2, and a total value of $9,000. You plan to increase your portfolio by buying 100 shares of
AT&E at $10 a share. AT&E has an expected return of 20 percent with a beta of 2.0. What will be the expected return and
the beta of your portfolio after you purchase the new stock?
a.
= 20.0%; βp = 2.00
b.
= 12.8%; βp = 1.28
c.
= 12.0%; βp = 1.20
d.
= 13.2%; βp = 1.40
e.
= 14.0%; βp = 1.32
ANSWER:
b
RATIONALE:
= 0.9(12%) + 0.1(20%) = 12.8%.
βp
= 0.9(1.2) + 0.1(2.0) = 1.28.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Portfolio Return
40. You hold a diversified portfolio consisting of a $10,000 investment in each of 20 different common stocks (i.e., your
Principles of Finance, 6e
Besley/Brigham
Chapter 11
total investment is $200,000). The portfolio beta is equal to 1.2. You have decided to sell one of your stocks which has a
beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase another stock which has a beta equal to 1.4. What
will be the beta of the new portfolio?
a.
1.165
b.
1.235
c.
1.250
d.
1.284
e.
1.333
ANSWER:
b
RATIONALE:
1.2 = 1/20(0.7) + (9/20)β β is average beta for other 19 stocks. 1.165 = (19/20)β. New
Beta = 1.165 + 1/20(1.4) = 1.235.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 - Application
Business Program-3 - Analytic
DISC-FIN-08 - Risk and Return
Time Estimate-a - 5 min.
TOPICS:
Portfolio Beta
41. Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is
considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities
(i.e., the probability distributions) are as follows:
Asset X
Asset Y
Pr
r
Pr
r
0.10
−3%
0.05
−3%
0.10
2
0.10
2
0.25
5
0.30
5
0.25
8
0.30
8
0.30
10
0.25
10
Which asset should be preferred?
a.
Asset X, since its expected return is higher.
b.
Asset Y, since its beta is probably lower.
c.
Either one, since the expected returns are the same.
d.
Asset X, since its standard deviation is lower.
e.
Asset Y, since its coefficient of variation is lower and its expected return is higher.
ANSWER:
e
RATIONALE:
= 0.10(−3%) + 0.10(2%) + 0.25(5%) + 0.25(8%) + 0.30(10%) =
6.15%.
= 0.05(−3%) + 0.10(2%) + 0.30(5%) + 0.30(8%) + 0.25(10%) =
6.45%.
sX
= 0.10(−3% − 6.15%)2 + 0.10(2% − 6.15%)2 + 0.25(5% − 6.15%)2
