Chapter 11—Stock Valuation and Risk
1. The price-earnings valuation method applies the ____ price-earnings ratio to ____ earnings per share
in order to value the firm’s stock.
a.
firm’s; industry
b.
firm’s; firm’s
c.
average industry; industry
d.
average industry; firm’s
2. A firm is expected to generate earnings of $2.22 per share next year. The mean ratio of share price to
expected earnings of competitors in the same industry is 15. Based on this information, the valuation
of the firm’s shares based on the price-earnings (PE) method is
a.
$2.22.
b.
$6.76.
c.
$33.30.
d.
none of the above
3. The PE method to stock valuation may result in an inaccurate valuation for a firm if errors are made in
forecasting the firm’s future earnings or in choosing the industry composite used to derive the PE ratio.
a. True
b. False
4. Bolwork Inc. is expected to pay a dividend of $5 per share next year. Bolwork’s dividends are expected
to grow by 3 percent annually. The required rate of return for Bolwork stock is 15 percent. Based on
the dividend discount model, a fair value for Bolwork stock is $____ per share.
a.
33.33
b.
166.67
c.
41.67
d.
60.00
5. Protsky Inc. just paid a dividend of $2.20 per share. The dividend growth rate for Protsky’s dividends
is 3 percent per year. If the required rate of return on Protsky stock is 12 percent, the stock should be
valued at $____ per share according to the dividend discount model.
a.
24.44
b.
25.18
c.
18.88
d.
75.53
6. The limitations of the dividend discount model are more pronounced when valuing stocks
a.
that pay most of their earnings as dividends.
b.
that retain most of their earnings.
c.
that have a long history of dividends.
d.
that have constant earnings growth.
7. Vansel Inc. retains most of its earnings. The company currently has earnings per share of $11. Vansel
expects its earnings to grow at a constant rate of 2 percent per year. Furthermore, the average PE ratio
of all other firms in Vansel’s industry is 12. Vansel is expected to pay dividends per share of $3.50
during each of the next three years. If investors require a 10 percent rate of return on Vansel stock, a
fair price for Vansel stock today is $____.
a.
113.95
b.
111.32
c.
105.25
d.
none of the above
8. When evaluating stock performance, ____ measures variability that is systematically related to market
returns; ____ measures total variability of a stock‘s returns.
a.
beta; standard deviation
b.
standard deviation; beta
c.
intercept; beta
d.
beta; error term
9. The ____ is commonly used as a proxy for the risk-free rate in the Capital Asset Pricing Model.
a.
Treasury bond rate
b.
prime rate
c.
discount rate
d.
federal funds rate
10. A beta of 1.8 implies that the stock has a risk premium of 1.8%.
a. True
b. False
11. Stock prices of U.S. firms primarily involved in exporting are likely to be ____ affected by a weak
dollar and ____ affected by a strong dollar.
a.
favorably; adversely
b.
adversely; adversely
c.
favorably; favorably
d.
adversely; favorably
12. A weak dollar may enhance the value of a U.S. firm whose sales are dependent on the U.S. economy.
a. True
b. False
13. The January effect refers to the ____ pressure on ____ stocks in January of every year.
a.
downward; large
b.
upward; large
c.
downward; small
d.
upward; small
14. The expected acquisition of a firm typically results in ____ in the target’s stock price.
a.
an increase
b.
a decrease
c.
no change
d.
none of the above
15. The ____ index can be used to measure risk-adjusted performance of a stock while controlling for the
stock’s volatility.
a.
Sharpe
b.
Treynor
c.
arbitrage
d.
margin
16. The ____ index can be used to measure risk-adjusted performance of a stock while controlling for the
stock’s beta.
a.
Sharpe
b.
Treynor
c.
arbitrage
d.
margin
17. Stock price volatility increased during the credit crisis.
a. True
b. False
18. The Sharpe Index measures the
a.
average return on a stock.
b.
variability of stock returns per unit of return
c.
stock’s beta adjusted for risk.
d.
excess return above the risk-free rate per unit of risk.
19. A stock’s average return is 11 percent. The average risk-free rate is 9 percent. The stock’s beta is 1 and
its standard deviation of returns is 10 percent. What is the Sharpe Index?
a.
.05
b.
.5
c.
.1
d.
.02
e.
.2
20. A stock’s average return is 10 percent. The average risk-free rate is 7 percent. The standard deviation
of the stock’s return is 4 percent, and the stock’s beta is 1.5. What is the Treynor Index for the stock?
a.
.03
b.
.75
c.
1.33
d.
.02
e.
50
21. If security prices fully reflect all market-related information (such as historical price patterns) but do
not fully reflect all other public information, security markets are
a.
weak-form efficient.
b.
semi-strong form efficient.
c.
strong form efficient.
d.
B and C
e.
none of the above
22. If security markets are semi-strong form efficient, investors cannot solely use ____ to earn excess
returns.
a.
previous price movements
b.
insider information
c.
publicly available information
d.
A and C
23. The ____ is commonly used to determine what a stock’s price should have been.
a.
Capital Asset Pricing Model
b.
Treynor Index
c.
Sharpe Index
d.
B and C
24. A stock’s beta is estimated to be 1.3. The risk-free rate is 5 percent, and the market return is expected
to be 9 percent. What is the expected return on the stock based on the CAPM?
a.
5.2 percent
b.
11.7 percent
c.
16.7 percent
d.
4 percent
e.
10.2 percent
25. According to the text, other things being equal, stock prices of U.S. firms primarily involved in
exporting could be ____ affected by a weak dollar. Stock prices of U.S. importing firms could be ____
affected by a weak dollar.
a.
adversely; favorably
b.
favorably; adversely
c.
favorably; favorably
d.
adversely; adversely
26. The demand by foreign investors for the stock of a U.S. firm sold on a U.S. exchange may be higher
when the dollar is expected to ____, other things being equal. (Assume the firm’s operations are
unaffected by the value of the dollar.)
a.
strengthen
b.
weaken
c.
stabilize
d.
B and C
27. A higher beta of an asset reflects
a.
lower risk.
b.
lower covariance between the asset’s returns and market returns.
c.
higher covariance between the asset’s returns and the market returns.
d.
none of the above
28. The “January effect” refers to a large
a.
rise in the price of small stocks in January.
b.
decline in the price of small stocks in January.
c.
decline in the price of large stocks in January.
d.
rise in the price of large stocks in January.
29. Technical analysis relies on the use of ____ to make investment decisions.
a.
interest rates
b.
inflationary expectations
c.
industry conditions
d.
recent stock price trends
30. The capital asset pricing model (CAPM) suggests that the required rate of return on a stock is directly
influenced by the stock’s :
a.
prevailing level of the industry competition.
b.
beta.
c.
liquidity.
d.
size (market capitalization).
31. According to the capital asset pricing model, the required return by investors on a security is
a.
inversely related to the risk-free rate.
b.
inversely related to the firm’s beta.
c.
inversely related to the market return.
d.
none of the above
32. Boris stock has an average return of 15 percent. Its beta is 1.5. Its standard deviation of returns is 25
percent. The average risk-free rate is 6 percent. The Sharpe index for Boris stock is
a.
0.35.
b.
0.36.
c.
0.45.
d.
0.28.
e.
none of the above
33. Morgan stock has an average return of 15 percent, a beta of 2.5, and a standard deviation of returns of
20 percent. The Treynor index of Morgan stock is
a.
0.04.
b.
0.05.
c.
0.35.
d.
0.03.
e.
none of the above
34. Zilo stock has an average return of 15 percent, a beta of 2.5, and a standard deviation of returns of 20
percent. The Sharpe index of Zilo stock is
a.
0.36.
b.
0.35.
c.
0.28.
d.
0.45.
e.
none of the above
35. Sorvino Co. is expected to offer a dividend of $3.2 per share per year forever. The required rate of
return on Sorvino stock is 13 percent. Thus, the price of a share of Sorvino stock, according to the
dividend discount model, is $____.
a.
4.06
b.
4.16
c.
40.63
d.
24.62
e.
none of the above
36. Kandle stock just paid a dividend of $4.76 per share and plans to pay a dividend of $5 per share next
year, which is expected to increase by 3 percent per year subsequently. The required rate of return is
15 percent. The value of Kandle stock, according to the dividend discount model, is $____.
a.
39.67
b.
41.67
c.
33.33
d.
31.73
e.
none of the above
37. LeBlanc Inc. currently has earnings of $10 per share, and investors expect that the earnings per share
will grow by 3 percent per year. Furthermore, the mean PE ratio of all other firms in the same industry
as LeBlanc Inc. is 15. LeBlanc is expected to pay a dividend of $3 per share over the next four years,
and an investor in LeBlanc requires a return of 12 percent. What is the forecasted stock price of
LeBlanc in four years, using the adjusted dividend discount model?
a.
$150.00
b.
$163.91
c.
$45.00
d.
$168.83
e.
none of the above
38. Tarzak Inc. has earnings of $10 per share, and investors expect that the earnings per share will grow by
3 percent per year. Furthermore, the mean PE ratio of all other firms in the same industry as Tarzak is
15. Tarzak is expected to pay a dividend of $3 per share over the next four years, and an investor in
Tarzak requires a return of 12 percent. The estimated stock price of Tarzak today should be ____ using
the adjusted dividend discount model.
a.
$116.41
b.
$104.91
c.
$161.15
d.
none of the above
39. The standard deviation of a stock’s returns is used to measure a stock’s
a.
volatility.
b.
beta.
c.
Treynor Index.
d.
risk-free rate.
40. The formula for a stock portfolio’s volatility does not contain the
a.
weight (proportional investment) assigned to each stock.
b.
variance (standard deviation squared) of returns of each stock.
c.
correlation coefficients between returns of each stock.
d.
risk-free rate.
41. If the returns of two stocks are perfectly correlated, then
a.
their betas should each equal 1.0.
b.
the sum of their betas should equal 1.0.
c.
their correlation coefficient should equal 1.0.
d.
their portfolio standard deviation should equal 1.0.
42. A stock’s beta can be measured from the estimate of the using regression analysis.
a.
intercept
b.
market return
c.
risk-free rate
d.
slope coefficient
43. A beta of 1.1 means that for a given 1 percent change in the value of the market, the is expected to
change by 1.1 percent in the same direction.
a.
risk-free rate
b.
stock’s value
c.
stock’s standard deviation
d.
correlation coefficient
44. Stock X has a lower beta than Stock Y. The market return for next month is expected to be either −1
percent, +1 percent, or +2 percent with an equal probability of each scenario. The probability
distribution of Stock X returns for next month is
a.
the same as that of Stock Y.
b.
more dispersed than that of Stock Y.
c.
less dispersed than that of Stock Y.
d.
zero.
45. The beta of a stock portfolio is equal to a weighted average of the
a.
betas of stocks in the portfolio.
b.
betas of stocks in the portfolio, plus their correlation coefficients.
c.
standard deviations of stocks in the portfolio.
d.
correlation coefficients between stocks in the portfolio.
46. Value at risk estimates the ____ a particular investment for a specified confidence level.
a.
beta of
b.
risk-free rate of
c.
largest expected loss to
d.
standard deviation of
47. A stock has a standard deviation of daily returns of 1 percent. It wants to determine the lower
boundary of its probability distribution of returns, based on 1.65 standard deviations from the expected
outcome. The stock’s expected daily return is .2 percent. The lower boundary is
a.
−1.45 percent.
b.
−1.85 percent.
c.
0 percent.
d.
−1.65 percent.
48. A stock has a standard deviation of daily returns of 3 percent. It wants to determine the lower
boundary of its probability distribution of returns, based on 1.65 standard deviations from the expected
outcome. The stock’s expected daily return is .1 percent. The lower boundary is
a.
−1.65 percent.
b.
−3.00 percent.
c.
−4.85 percent.
d.
−5.05 percent.
49. Which of the following is not commonly used as the estimate of a stock’s volatility?
a.
the estimate of its standard deviation of returns over a recent period
b.
the trend of historical standard deviations of returns over recent periods
c.
the implied volatility derived from an option pricing model
d.
the estimate of its option premium derived from an option pricing model
50. The credit crisis caused major problems in the mortgage market but had no impact on the stock
market.
a. True
b. False
51. When new information suggests that a firm will experience lower cash flows than previously
anticipated or lower risk, investors will revalue the corresponding stock downward.
a. True
b. False
52. A relatively simple method of valuing a stock is to apply the mean price-earnings (PE) ratio of all
publicly traded competitors in the respective industry to the firm’s expected earnings for the year.
a. True
b. False
53. While the previous year’s earnings are often used as a base for forecasting future earnings, the recent
year’s earnings do not always provide an accurate forecast of the future.
a. True
b. False
54. If investors agree on a firm’s forecasted earnings, they will derive the same value for that firm using
the PE method to value the firm’s stock.
a. True
b. False
55. The dividend discount model states that the price of a stock should reflect the present value of the
stock’s future dividends.
a. True
b. False
56. The dividend discount model can be adapted to assess the value of any firm, even those that retain
most or all of their earnings.
a. True
b. False
57. For firms that do not pay dividends, the free cash flow model may be more suitable than the dividend
discount model.
a. True
b. False
58. The capital asset pricing model (CAPM) is based on the premise that the only important risk of a firm
is unsystematic risk.
a. True
b. False
59. The prime rate is commonly used as a proxy for the risk-free rate in the capital asset pricing model
(CAPM).
a. True
b. False
60. A stock with a beta of 2.3 means that for every 1 percent change in the market overall, the stock tends
to change by 2.3 percent in the same direction.
a. True
b. False
61. Stocks that have relatively little trading are normally subject to less price volatility.
a. True
b. False
62. A firm’s stock price is affected not only by macroeconomic and market conditions but also by firm
specific conditions.
a. True
b. False
63. Stock repurchases are commonly viewed as an unfavorable signal about the firm.
a. True
b. False
64. The main source of uncertainty in computing the return of a stock is the dividend to be received next
year.
a. True
b. False
65. A stock portfolio has more volatility when its individual stock returns are uncorrelated.
a. True
b. False
66. Beta serves as a measure of risk because it can be used to derive a probability distribution of returns
based on a set of market returns.
a. True
b. False
67. The value-at-risk method is intended to warn investors about the potential maximum loss that could
occur.
a. True
b. False
68. Regarding the value-at-risk method, the same methods used to derive the maximum expected loss of
one stock can be applied to derive the maximum expected loss of a stock portfolio for a given
confidence level.
a. True
b. False
69. Portfolio managers who monitor systematic risk rather than total risk are more concerned about stock
volatility than about beta.
a. True
b. False
70. Regarding the implied standard deviation, by plugging in the actual option premium paid by investors
for a specific stock in the option-pricing model, it is possible to derive the anticipated volatility level.
a. True
b. False
71. A portfolio’s beta is the sum of the individual forecasted betas, weighted by the market value of each
stock.
a. True
b. False
72. If beta is thought to be the appropriate measure of risk, a stock’s risk-adjusted returns should be
determined by the Sharpe index.
a. True
b. False
73. The Treynor index is similar to the Sharpe index, except that is uses beta rather than standard deviation
to measure the stock’s risk.
a. True
b. False
74. Fabrizio, Inc. is expected to generate earnings of $1.50 per share this year. If the mean ratio of share
price to expected earnings of competitors in the same industry is 20, then the stock price per share is
$____.
a.
13.33
b.
3.00
c.
20.00
d.
30.00
e.
none of the above
75. Which of the following is not a reason the PE ratio method may result in an inaccurate valuation for a
firm?
a.
potential errors in the forecast of the firm’s beta
b.
potential errors in the forecast of the firm’s future earnings
c.
potential errors in the choice of the industry composite used to derive the PE ratio
d.
All of the above are reasons the PE ratio method may result in an inaccurate valuation for
a firm.
76. The ____ is not a measure of a stock’s risk.
a.
stock’s price volatility
b.
stock’s return
c.
stock’s beta
d.
value-at-risk method
e.
All of the above are measures of a stock’s risk.
77. If the standard deviation of a stock’s returns over the last 12 quarters is 4 percent, and if there is no
perceived change in volatility, there is a ____ percent probability that the stock’s returns will be within
____ percentage points of the expected outcome.
a.
68; 4
b.
68; 8
c.
95; 8
d.
95; 6
e.
none of the above
78. The limitations of the dividend discount model are most pronounced for a firm that
a.
has a high beta.
b.
has high expected future earnings.
c.
distributes most of its earnings as dividends.
d.
retains all of its earnings.
e.
none of the above
79. Which of the following is incorrect regarding the capital asset pricing model (CAPM)?
a.
It is sometimes used to estimate the required rate of return for any firm with publicly
traded stock.
b.
It is based on the premise that the only important risk of a firm is systematic risk.
c.
It is concerned with unsystematic risk.
d.
All of the above are true.
80. The ____ is not a factor used in the capital asset pricing model (CAPM) to derive the return of an
asset.
a.
prevailing risk-free rate
b.
dividend growth rate
c.
market return
d.
covariance between the asset’s returns and market returns
e.
All of the above are factors used in the CAPM.
81. Steam Corp. has a beta of 1.5. The prevailing risk-free rate is 5 percent and the annual market return in
recent years has been 11 percent. Based on this information, the required rate of return on Steam Corp.
stock is ____ percent.
a.
21.5
b.
6.5
c.
16.5
d.
14.0
e.
none of the above
82. Which of the following is not a type of factor that drives stock prices, according to your text?
a.
economic factors
b.
market-related factors
c.
firm-specific factors
d.
All of the above are factors that affect stock prices.
83. The general mood of investors represents:
a.
investor sentiment.
b.
beta.
c.
systematic risk.
d.
unsystematic risk.
84. ____ is (are) not a firm-specific factor(s) that affect(s) stock prices.
a.
Exchange rates
b.
Dividend policy changes
c.
Stock offerings and repurchases
d.
Earnings surprises
e.
All of the above are firm-specific factors that affect stock prices.
85. The U.S. government’s budget deficit has a significant impact on the bond market but does not affect
the stock market.
a. True
b. False
86. Investors can avoid unsystematic risk by:
a.
using the capital asset pricing model.
b.
investing in stocks with low PE ratios.
c.
holding diversified portfolios.
d.
using the free cash flow model.
87. The market risk premium is:
a.
the yield on newly issued Treasury bonds.
b.
the return of the market in excess of the risk-free rate.
c.
the covariance between the risk-free rate and the return of the market.
d.
the return of the market in excess of expected cash flows.
88. The market risk premium is stable over time and is not affected by stock market conditions.
a. True
b. False
89. Holding other factors constant, an increase in the capital gains tax rate will:
a.
have more effect on the valuation of dividend-paying stocks than on stocks with high
growth prospects.
b.
have less effect on the valuation of dividend-paying stocks than on stocks with high
growth prospects.
c.
have no effect on the valuations of stocks.
d.
have the same effect on the valuation of dividend-paying stocks and stocks with high
growth prospects.
90. The VIX (volatility index) indicates the volatility of the bond market in general.
a. True
b. False
91. Holding other factors constant, a stock portfolio has more volatility when its individual stock
volatilities are ________ and its individual stock returns have _______ correlations.
a.
high; low
b.
low; high
c.
low; low
d.
high; high
92. Emerging market stocks tend to exhibit all of the following except:
a.
high political risk.
b.
high exchange risk.
c.
high correlation with stocks of more developed countries.
d.
high volatility.
93. Even though a foreign stock that appears to be overvalued in its own country, the stock may not
generate a reasonable return for a U.S. investor if the currency of that country appreciates against the
U.S. dollar.
a. True
b. False
94. As a result of market integration, stock markets in emerging markets are likely to be as efficient as
U.S. stock markets.
a. True
b. False