# Finance Chapter 2 Dixons Required Return Will Decrease Because Has Beta Greater Than And Clarks

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Test Prep

Book Title

Intermediate Financial Management 13th Edition

Authors

Eugene F. Brigham, Phillip R. Daves

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Chapter 02: Risk and Return: Part I

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Treasury bills.

ANSWER:

b

85. Suppose that during the coming year, the risk free rate, rRF, is expected to remain the same, while the market risk

premium (rM − rRF), is expected to fall. Given this forecast, which of the following statements is CORRECT?

a.

The required return on all stocks will remain unchanged.

b.

The required return will fall for all stocks, but it will fall more for stocks with higher betas.

c.

The required return for all stocks will fall by the same amount.

d.

The required return will fall for all stocks, but it will fall less for stocks with higher betas.

e.

The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta

greater than 1.0.

ANSWER:

b

86. The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF,

is positive. Which of the following statements is CORRECT?

a.

Stock B's required rate of return is twice that of Stock A.

b.

If Stock A's required return is 11%, then the market risk premium is 5%.

Chapter 02: Risk and Return: Part I

c.

If Stock B's required return is 11%, then the market risk premium is 5%.

d.

If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will

increase by more than Stock B's.

e.

If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will

increase by more than Stock A's.

ANSWER:

b

87. Assume that in recent years both expected inflation and the market risk premium (rM − rRF) have declined. Assume

also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these

changes?

a.

The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.

b.

The average required return on the market, rM, has remained constant, but the required returns have fallen for

stocks that have betas greater than 1.0.

c.

Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas

less than 1.0.

d.

The required returns on all stocks have fallen by the same amount.

e.

The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

ANSWER:

a

88. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?

a.

If a stock's beta doubled, its required return under the CAPM would also double.

b.

If a stock's beta doubled, its required return under the CAPM would more than double.

c.

If a stock's beta were 1.0, its required return under the CAPM would be 5%.

d.

If a stock's beta were less than 1.0, its required return under the CAPM would be less than 5%.

e.

If a stock has a negative beta, its required return under the CAPM would be less than 5%.

ANSWER:

e

89. Stock LB has a beta of 0.5 and Stock HB has a beta of 1.5. The market is in equilibrium, with required returns

equaling expected returns. Which of the following statements is CORRECT?

a.

If both expected inflation and the market risk premium (rM − rRF) increase, the required return on Stock HB

will increase by more than that on Stock LB.

b.

If both expected inflation and the market risk premium (rM − rRF) increase, the required returns of both stocks

will increase by the same amount.

c.

Since the market is in equilibrium, the required returns of the two stocks should be the same.

d.

If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of

Stock HB will decline but the required return of Stock LB will increase.

e.

If expected inflation remains constant but the market risk premium (rM − rRF) declines, the required return of

Stock LB will decline but the required return of Stock HB will increase.

ANSWER:

a

90. Portfolio P has equal amounts invested in each of the three stocks, A, B, and C. Stock A has a beta of 0.8, Stock B has

a beta of 1.0, and Stock C has a beta of 1.2. Each of the stocks has a standard deviation of 25%. The returns on the three

stocks are independent of one another (i.e., the correlation coefficients all equal zero). Assume that there is an increase in

the market risk premium, but the risk-free rate remains unchanged. Which of the following statements is CORRECT?

a.

The required return on Stock A will increase by less than the increase in the market risk premium, while the

required return on Stock C will increase by more than the increase in the market risk premium.

b.

The required return on the average stock will remain unchanged, but the returns of riskier stocks (such as

Stock C) will increase while the returns of safer stocks (such as Stock A) will decrease.

c.

The required returns on all three stocks will increase by the amount of the increase in the market risk premium.

d.

The required return on the average stock will remain unchanged, but the returns on riskier stocks (such as

Stock C) will decrease while the returns on safer stocks (such as Stock A) will increase.

e.

The required return of all stocks will remain unchanged since there was no change in their betas.

ANSWER:

a

91. Which of the following statements is CORRECT?

a.

Other things held constant, if investors suddenly become convinced that there will be deflation in the

economy, then the required returns on all stocks should increase.

b.

If a company's beta were cut in half, then its required rate of return would also be halved.

c.

If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required

rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will

increase.

d.

If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required

rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than

1.0 will rise.

e.

If a company's beta doubles, then its required rate of return will also double.

ANSWER:

d

92. Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the

following statements is CORRECT?

a.

If a stock has a negative beta, its required return must also be negative.

b.

An index fund with beta = 1.0 should have a required return less than 11%.

c.

If a stock's beta doubles, its required return must also double.

d.

An index fund with beta = 1.0 should have a required return greater than 11%.

e.

An index fund with beta = 1.0 should have a required return of 11%.

ANSWER:

e

93. Which of the following statements is CORRECT?

a.

Lower beta stocks have higher required returns.

b.

A stock's beta indicates its diversifiable risk.

c.

Diversifiable risk cannot be completely diversified away.

d.

Two securities with the same stand-alone risk must have the same betas.

e.

The slope of the security market line is equal to the market risk premium.

ANSWER:

e

94. Which of the following statements is CORRECT?

a.

If the risk-free rate rises, then the market risk premium must also rise.

b.

If a company's beta is halved, then its required return will also be halved.

c.

If a company's beta doubles, then its required return will also double.

d.

The slope of the security market line is equal to the market risk premium, (rM − rRF).

e.

Beta is measured by the slope of the security market line.

ANSWER:

d

95. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Stock A has a beta of

1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Which of the following

statements is CORRECT? (Assume that the stocks are in equilibrium.)

a.

Stock B has a higher required rate of return than Stock A.

b.

Portfolio P has a standard deviation of 22.5%.

c.

More information is needed to determine the portfolio's beta.

d.

Portfolio P has a beta of 1.0.

e.

Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns.

ANSWER:

d

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96. Dixon Food's stock has a beta of 1.4, while Clark Café's stock has a beta of 0.7. Assume that the risk-free rate, rRF, is

5.5% and the market risk premium, (rM − rRF), equals 4%. Which of the following statements is CORRECT?

a.

If the market risk premium increases but the risk-free rate remains unchanged, Dixon's required return will

increase because it has a beta greater than 1.0 but Clark's required return will decline because it has a beta less

than 1.0.

b.

Since Dixon's beta is twice that of Clark's, its required rate of return will also be twice that of Clark's.

c.

If the risk-free rate increases while the market risk premium remains constant, then the required return on an

average stock will increase.

d.

If the market risk premium decreases but the risk-free rate remains unchanged, Dixon's required return will

decrease because it has a beta greater than 1.0 and Clark's will also decrease, but by more than Dixon's

because it has a beta less than 1.0.

e.

If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase

for both stocks but the increase will be larger for Dixon since it has a higher beta.

ANSWER:

c

97. Stock X has a beta of 0.6, while Stock Y has a beta of 1.4. Which of the following statements is CORRECT?

a.

Stock Y must have a higher expected return and a higher standard deviation than Stock X.

b.

If expected inflation increases but the market risk premium is unchanged, then the required return on both

stocks will fall by the same amount.

c.

If the market risk premium declines but expected inflation is unchanged, the required return on both stocks

will decrease, but the decrease will be greater for Stock Y.

d.

If expected inflation declines but the market risk premium is unchanged, then the required return on both

Chapter 02: Risk and Return: Part I

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Page 48

stocks will decrease but the decrease will be greater for Stock Y.

e.

A portfolio consisting of $50,000 invested in Stock X and $50,000 invested in Stock Y will have a required

return that exceeds that of the overall market.

ANSWER:

c

98. Stock A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A and 50% is invested

in Stock B. If the market risk premium (rM − rRF) were to increase but the risk-free rate (rRF) remained constant, which of

the following would occur?

a.

The required return would decrease by the same amount for both Stock A and Stock B.

b.

The required return would increase for Stock A but decrease for Stock B.

c.

The required return on Portfolio P would remain unchanged.

d.

The required return would increase for Stock B but decrease for Stock A.

e.

The required return would increase for both stocks but the increase would be greater for Stock B than for

Stock A.

ANSWER:

e

99. Stock A has a beta of 0.7, whereas Stock B has a beta of 1.3. Portfolio P has 50% invested in both A and B. Which of

the following would occur if the market risk premium increased by 1% but the risk-free rate remained constant?

Chapter 02: Risk and Return: Part I

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a.

The required return on both stocks would increase by 1%.

b.

The required return on Portfolio P would remain unchanged.

c.

The required return on Stock A would increase by more than 1%, while the return on Stock B would increase

by less than 1%.

d.

The required return for Stock A would fall, but the required return for Stock B would increase.

e.

The required return on Portfolio P would increase by 1%.

ANSWER:

e

100. Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is

most likely to occur?

a.

The required return on a stock with beta > 1.0 will increase.

b.

The return on "the market" will remain constant.

c.

The return on "the market" will increase.

d.

The required return on a stock with beta < 1.0 will decline.

e.

The required return on a stock with beta = 1.0 will not change.

ANSWER:

d

101. Which of the following statements is CORRECT?

Chapter 02: Risk and Return: Part I

a.

The SML shows the relationship between companies' required returns and their diversifiable risks. The slope

and intercept of this line cannot be influenced by a firm's managers, but the position of the company on the

line can be influenced by its managers.

b.

Suppose 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 investors expect the observed

relationship to continue on into the future.

c.

If investors become less risk averse, the slope of the Security Market Line will increase.

d.

If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a

higher required return on the stock.

e.

The slope of the SML is determined by the value of beta.

ANSWER:

b

102. How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases

and investors also become more risk averse?

a.

The x-axis intercept would decline, and the slope would increase.

b.

The y-axis intercept would increase, and the slope would decline.

c.

The SML would be affected only if betas changed.

d.

Both the y-axis intercept and the slope would increase, leading to higher required returns.

e.

The y-axis intercept would decline, and the slope would increase.

ANSWER:

e

103. Assume that the risk-free rate, rRF, increases but the market risk premium, (rM − rRF), declines, with the net effect

being that the overall required return on the market, rM, remains constant. Which of the following statements is

CORRECT?

a.

The required return will decline for stocks that have a beta less than 1.0 but will increase for stocks that have a

beta greater than 1.0.

b.

Since the overall return on the market stays constant, the required return on each individual stock will also

remain constant.

c.

The required return will increase for stocks that have a beta less than 1.0 but decline for stocks that have a beta

greater than 1.0.

d.

The required return of all stocks will fall by the amount of the decline in the market risk premium.

e.

The required return of all stocks will increase by the amount of the increase in the risk-free rate.

ANSWER:

c

104. Suppose that Federal Reserve actions have caused an increase in the risk-free rate, rRF. Meanwhile, investors are

afraid of a recession, so the market risk premium, (rM − rRF), has increased. Under these conditions, with other things held

constant, which of the following statements is most correct?

a.

The required return on all stocks would increase, but the increase would be greatest for stocks with betas of

less than 1.0.

b.

Stocks' required returns would change, but so would expected returns, and the result would be no change in

stocks' prices.

c.

The prices of all stocks would decline, but the decline would be greatest for high-beta stocks.

d.

The prices of all stocks would increase, but the increase would be greatest for high-beta stocks.

e.

The required return on all stocks would increase by the same amount.

ANSWER:

c

105. Which of the following statements is CORRECT?

a.

The slope of the Security Market Line is beta.

b.

Any stock with a negative beta must in theory have a negative required rate of return, provided rRF is positive.

c.

If a stock's beta doubles, its required rate of return must also double.

d.

If a stock's returns are negatively correlated with returns on most other stocks, the stock's beta will be

negative.

e.

If a stock has a beta of to 1.0, its required rate of return will be unaffected by changes in the market risk

premium.

ANSWER:

d

106. Assume that investors have recently become more risk averse, so the market risk premium has increased. Also,

assume that the risk-free rate and expected inflation have not changed. Which of the following is most likely to occur?

a.

The required rate of return will decline for stocks whose betas are less than 1.0.

b.

The required rate of return on the market, rM, will not change as a result of these changes.

c.

The required rate of return for each individual stock in the market will increase by an amount equal to the

increase in the market risk

d.

The required rate of return on a riskless bond will decline.

e.

The required rate of return for an average stock will increase by an amount equal to the increase in the market

risk premium.

ANSWER:

e

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107. Which of the following statements is CORRECT?

a.

The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

b.

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

probably be greater than the average of the stocks' standard deviations.

c.

If investors become more risk averse, 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.

d.

An increase in expected inflation, combined with a constant real risk-free rate and a constant market risk

premium, would lead to identical increases in the required returns on a riskless asset and on an average stock,

other things held constant.

e.

A graph of the SML as applied to individual stocks would show required rates of return on the vertical axis

and standard deviations of returns on the horizontal axis.

ANSWER:

d

108. 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 past realized rate of return must be equal to the expected future rate of return; that is, .

b.

The required rate of return must equal the past realized rate of return; that is, r = .

Chapter 02: Risk and Return: Part I

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c.

The expected rate of return must be equal to the required rate of return; that is, = r.

d.

All of the above statements must hold for equilibrium to exist; that is = r = .

e.

None of the above statements is correct.

ANSWER:

c

109. Which of the following statements is CORRECT?

a.

Portfolio diversification reduces the variability of returns on an individual stock.

b.

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.

c.

The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be

controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions

as changing the firm's capital structure or the type of assets it employs.

d.

A stock with a beta of −1.0 has zero market risk if held in a 1-stock portfolio.

e.

When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is

constant for all stocks in the market.

ANSWER:

c

110. You observe the following information regarding Companies X and Y:

Chapter 02: Risk and Return: Part I

∙

Company X has a higher expected return than Company Y.

∙

Company X has a lower standard deviation of returns than Company Y.

∙

Company X has a higher beta than Company Y.

Given this information, which of the following statements is CORRECT?

a.

Company X has a lower coefficient of variation than Company Y.

b.

Company X has less market risk than Company Y.

c.

Company X's returns will be negative when Y's returns are positive.

d.

Company X's stock is a better buy than Company Y's stock.

e.

Company X has more diversifiable risk than Company Y.

ANSWER:

a

111. Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%. Stock A has a beta

of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P has 50%

invested in Stock A and 50% invested in B. Which of the following statements is CORRECT?

a.

Based on the information we are given, and assuming those are the views of the marginal investor, it is

apparent that the two stocks are in equilibrium.

b.

Portfolio P has more market risk than Stock A but less market risk than B.

c.

Stock A should have a higher expected return than Stock B as viewed by the marginal investor.

d.

Portfolio P has a coefficient of variation equal to 2.5.

e.

Portfolio P has a standard deviation of 25% and a beta of 1.0.

ANSWER:

b

112. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current

level, then

a.

the past realized return must be equal to the expected return during the same period.

b.

the required return must equal the realized return in all periods.

c.

the expected return must be equal to both the required future return and the past realized return.

d.

the expected future returns must be equal to the required return.

e.

the expected future return must be less than the most recent past realized return.

ANSWER:

d

113. Which of the following are the factors for the Fama-French model?

a.

The excess market return, a debt factor, and a book-to-market factor.

b.

The excess market return, a size factor, and a debt.

c.

A debt factor, a size factor, and a book-to-market factor.

d.

The excess market return, an industrial production factor, and a book-to-market factor.

e.

The excess market return, a size factor, and a book-to-market factor.

ANSWER:

e

114. Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that

has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is

CORRECT?

a.

The required return on the market is 10%.

b.

The portfolio's required return is less than 11%.

c.

If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's

required return will increase by more than 2%.

d.

If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's

required return will increase by more than 2%.

e.

If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the

market, which is 11%.

115. Assume that the market is in equilibrium and that Portfolio AB has 50% invested in Stock A and 50% invested in

Stock B. Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13%

and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM − rRF, is 6%. The returns of

Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the

following statements is CORRECT?

a.

Since the two stocks have zero correlation, Portfolio AB is riskless.

b.

Stock B's beta is 1.0000.

c.

Portfolio AB's required return is 11%.

d.

Portfolio AB's standard deviation is 25%.

e.

Stock A's beta is 0.8333.

ANSWER:

e

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116. Portfolio AB was created by investing in a combination of Stocks A and B. Stock A has a beta of 1.2 and a standard

deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB has a beta of 1.25 and a

standard deviation of 18%. Which of the following statements is CORRECT?

a.

Stock A has more market risk than Stock B but less stand-alone risk.

b.

Portfolio AB has more money invested in Stock A than in Stock B.

c.

Portfolio AB has the same amount of money invested in each of the two stocks.

d.

Portfolio AB has more money invested in Stock B than in Stock A.

e.

Stock A has more market risk than Portfolio AB.

ANSWER:

b

117. Which of the following statements is CORRECT?

a.

If investors become more risk averse but rRF does not change, then the required rate of return on high-beta

stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-

risk stock will not change.

b.

An investor who holds just one stock will generally 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

Chapter 02: Risk and Return: Part I

exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.

c.

There is no reason to think that the slope of the yield curve would have any effect on the slope of the SML.

d.

Assume that the required rate of return on the market, rM, is given and fixed at 10%. 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.

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. Thus,

they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other

of the mutual funds.

ANSWER:

d

118. Freedman Flowers' stock has a 50% chance of producing a 25% return, a 30% chance of producing a 10% return, and

a 20% chance of producing a −28% return. What is the firm's expected rate of return?

a.

9.41%

b.

9.65%

c.

9.90%

d.

10.15%

e.

10.40%

POINTS:

1

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119. Bloome Co.'s stock has a 25% chance of producing a 30% return, a 50% chance of producing a 12% return, and a

25% chance of producing a −18% return. What is the firm's expected rate of return?

a.

7.72%

b.

8.12%

c.

8.55%

d.

9.00%

e.

9.50%

POINTS:

1

120. Donald Gilmore has $100,000 invested in a 2-stock portfolio. $35,000 is invested in Stock X and the remainder is

invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is the portfolio's beta?

a.

0.65

b.

0.72

c.

0.80

d.

0.89

e.

0.98

ANSWER:

e

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