Principles of Finance, 6e
Besley/Brigham
Chapter 11
Step 3:
Calculate new required return on stock
rs = 5% + (13% − 5%)2 = 21%.
Step 4:
Calculate percentage change in return on stock
0.5
$20
0.3
−$15
a.
$36.0
b.
$23.0
c.
$18.0
d.
$13.0
e.
$30.0
ANSWER:
b
RATIONALE:
= 0.2($50) + 0.5($20) + 0.3(−$15) = $15.50.
s2
= ($50 − $15.5)2(0.2) + ($20 − $15.5)2(0.5) + (−$15 − $15.5)2(0.3)
= 527.25.
s = = $22.96 ≈ $23.0.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Standard Deviation
44. You are holding a stock which has a beta of 2.0 and is currently in equilibrium. The required return on the stock is 15
percent, and the return on an average stock is 10 percent. What would be the percentage change in the return on the stock
if the return on an average stock increased by 30 percent while the risk-free rate remained unchanged?
a.
+20%
b.
+30%
c.
+40%
d.
+50%
e.
+60%
ANSWER:
c
RATIONALE:
Step 1:
Solve for risk-free rate
rs = 15% = rRF + (10% − rRF)2.0 = rRF + 20% − 2rRF
rRF = 5%.
Step 2:
Calculate new market return
rM increases by 30%, so rM = 1.3(10%) = 13%.
Principles of Finance, 6e
Besley/Brigham
Chapter 11
percent after adjusting for the changed inflation premium.
(3)
The expected growth rate increases to 6 percent.
(4)
Beta rises to 1.5.
What will be the change in price per share, assuming the stock was in equilibrium before the changes?
a.
+$12.11
b.
−$4.87
c.
+$6.28
d.
−$16.97
e.
+$2.78
ANSWER:
b
RATIONALE:
Numerical solution: Before: rs = 5% + (8% − 5%)1.3 = 8.9%
After: rs = 4% + (10% − 4%)1.5 = 13% Hence, we have
$12.11 − $16.98 = −$4.87.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Equilibrium Stock Price
47. You are considering an investment in the common stock of Cowher Corp. The stock is expected to pay a dividend of
$2 per share at the end of the year (i.e., = $2.00). The stock has a beta equal to 1.2. The risk-free rate is 6 percent. The
market risk premium is 5 percent. The stock’s dividend is expected to grow at some constant rate, g. The stock currently
sells for $40 a share. Assuming the market is in equilibrium, what does the market believe the stock price will be at the
end of three years? (In other words, what is ?)
a.
$40.00
b.
$42.35
c.
$45.67
d.
$46.31
e.
$49.00
ANSWER:
e
RATIONALE:
Step 1:
Calculate rs:
rs
= rRF + (RPM)β
= 6% + (5%)1.2
= 12%.
Step 2:
Calculate g:
Principles of Finance, 6e
Besley/Brigham
Chapter 11
a.
$25.00
b.
$37.50
c.
$21.72
d.
$42.38
e.
$56.94
a.
3.8%
b.
0%
c.
8.0%
d.
4.2%
e.
None of the above.
ANSWER:
d
RATIONALE:
Required rate of return, rs = 8% + (15% − 8%)0.6 = 12.2%. Calculate dividend yield and
use to calculate capital gains yield: Capital
gains yield = Total yield − Dividend yield = 12.2% − 8% = 4.2%. Alternative method:
$3.05 − $25g
= $2
$25g
= $1.05
g = 0.042
= 4.2%
(Multiply both sides by (0.122 − g)) Since the stock is growing at a constant rate, g =
Capital gains yield.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous
52. The probability distribution for rM for the coming year is as follows:
Probability
rM
0.05
7%
0.30
8
0.30
9
0.30
10
0.05
12
Principles of Finance, 6e
Besley/Brigham
Chapter 11
Cengage Learning Testing, Powered by Cognero
Page 28
ANSWER:
d
RATIONALE:
Numerical solution: Required return on market and stock rM = 0.05(7%) + 0.30(8%) +
0.30(9%) + 0.30(10%) + 0.05(12%) = 9.05%. rS = 6.05% + (9.05% − 6.05%)2.0 =
12.05%. Expected equilibrium stock price
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Risk and Stock Value
53. As financial manager of Material Supplies Inc., you have recently participated in an executive committee decision to
enter into the plastics business. Much to your surprise, the price of the firm’s common stock subsequently declined from
$40 per share to $30 per share. While there have been several changes in financial markets during this period, you are
anxious to determine how the market perceives the relevant risk of your firm. Assume that the market is in equilibrium.
From the following data you find that the beta value associated with your firm has changed from an old beta of ____ to a
new beta of ____.
(1)
The real risk-free rate is 2 percent, but the inflation premium has increased from 4 percent
to 6 percent.
(2)
The expected growth rate has been re-evaluated by security analysts, and a 10.5 percent
rate is considered to be more realistic than the previous 5 percent rate. This change had
nothing to do with the move into plastics; it would have occurred anyway.
(3)
The risk aversion attitude of the market has shifted somewhat, and now the market risk
premium is 3 percent instead of 2 percent.
(4)
The next dividend, D1, was expected to be $2 per share, assuming the “old” 5 percent
growth rate.
a.
2.00; 1.50
b.
1.50; 3.00
c.
2.00; 3.17
d.
1.67; 2.00
e.
1.50; 1.67
ANSWER:
c
RATIONALE:
Numerical solution: Old required returns and beta 0.10 = rRF +
(M.P.)βold = 0.06 + (0.02)βold; βold = 2.00. New required return and beta Note that
= $1.905(1.105) = $2.105.
0.175 = 0.08 + (0.03)βNew; βNew = 3.17.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
Principles of Finance, 6e
Besley/Brigham
Chapter 11
price of Philadelphia to remain unchanged?
RATIONALE:
Before:
1.15
= 0.95(βR) + 0.05(1.0)
0.95(βR)
= 1.10
βR
= 1.158.
After: βP = 0.95(βR) + 0.05(2.0) = 1.10 + 0.10 = 1.20.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Portfolio Beta
58. You are managing a portfolio of 10 stocks which are held in equal amounts. The current beta of the portfolio is 1.64,
and the beta of Stock A is 2.0. If Stock A is sold, what would the beta of the replacement stock have to be to produce a
new portfolio beta of 1.55?
a.
1.10
b.
1.00
c.
0.90
d.
0.75
e.
0.50
ANSWER:
a
RATIONALE:
Before:
βR
= Average beta of the other 9 stocks in the portfolio
= 1.44/0.9 = 1.60
After:
βNew
= 1.55 = 0.9(βR) + 0.1(β) = 1.44 + 0.1(β)
β
= 1.01(0.11) = 1.10.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Portfolio Beta
59. Philadelphia Corporation’s stock recently paid a dividend of $2.00 per share (D0 = $2), and the stock is in equilibrium.
The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required rate of return on the market is
15 percent, and the risk-free rate is 7 percent. Philadelphia is considering a change in policy which will increase its beta
Principles of Finance, 6e
Besley/Brigham
Chapter 11
POINTS:
1
a.
8.85%
b.
18.53%
c.
6.77%
d.
5.88%
e.
13.52%
ANSWER:
c
RATIONALE:
Calculate the initial required return and equilibrium price rs = 0.07 + (0.08)1.5 = 0.19 =
19%. Calculate the new required return
and equilibrium growth rate New rs = 0.07 + (0.08)1.75 = 0.21. New
; P0 = $15 (Unchanged). 3.15 − 2.0 = 2g + 15g (Multiply both
sides by 15, combine like terms.) 1.15 = 17g g = 0.06765 ≈ 6.77%.
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
CAPM and Stock Valuation
60. Hard Hat Construction’s stock is currently selling at an equilibrium price of $30 per share. The firm has been
experiencing a 6 percent annual growth rate. Last year’s earnings per share, E0, were $4.00, and the dividend payout ratio
is 40 percent. The risk-free rate is 8 percent, and the market risk premium is 5 percent. If systematic risk (beta) increases
by 50 percent, and all other factors remain constant, by how much will the stock price change? (Hint: Use four decimal
places in your calculations.)
a.
−$7.33
b.
+$7.14
c.
−$15.00
d.
−$15.22
e.
+$22.63
ANSWER:
a
RATIONALE:
Calculate the required rate of return D0 = E0(Payout ratio) = $4.00(0.40) = $1.60.
Calculate beta 11.65% = 8% + (5%)β;
β = 0.73. Calculate the new beta βNew = 0.73(1.5) = 1.095. Calculate the new required
rate of return rs = 8% + (5%)1.095 = 13.475% ≈ 13.48%. Calculate the new expected
equilibrium stock price Change in stock price = $30 −
