Principles of Managerial Finance, 15e (Zutter)
Chapter 8 Risk and Return
8.1 Risk and return fundamentals
1) Investment A guarantees its holder $100 return. Investment B earns $0 or $200 with equal chances (i.e.,
an average of $100) over the same period. Both investments have equal risk.
2) The return on an asset is the change in its value plus any cash distribution over a given period of time,
expressed as a percentage of its ending value.
3) For a risk-seeking investor, no increase in return would be required for an increase in risk.
4) For a risk-averse investor, required return would decrease for an increase in risk.
5) For a risk-indifferent investor, no change in return would be required for an increase in risk.
6) Most investors are risk-averse, since for a given increase in risk they require an increase in return.
7) For a risk-averse investor, the required return increases for an increase in risk.
8) Interest rate risk is the chance that changes in interest rates will adversely affect the value of an
investment.
9) The term “risk” is used interchangeably with “uncertainty” to refer to the unpredictability of returns
associated with a given asset.
10) In the most basic sense, risk is a measure of the uncertainty surrounding the return that an investment
will earn.
11) An investment’s total return is the sum of any cash distributions minus the change in the investment’s
value, divided by the beginning–of-period value.
12) Stocks are less risky than either bonds or bills.
13) The interest rate risk associated with Treasury bonds is much higher than with bills.
14) Which of the following is true of risk?
A) Risk and return are inversely proportionate to each other.
B) Higher the risk associated with a security the lower is its return.
C) Risk is a measure of the uncertainty surrounding the return that an investment will earn.
D) Riskier investments tend to have lower returns as compared to T-bills which are risk free.
15) Nico bought 100 shares of Cisco Systems stock for $30.00 per share on January 1, 2018. He received a
dividend of $2.00 per share at the end of 2018 and $3.00 per share at the end of 2019. At the end of 2020,
Nico collected a dividend of $4.00 per share and sold his stock for $33.00 per share. What was Nico’s
realized holding period return?
A) -40%
B) +40%
C) -36.36%
D) +36.36%
16) The total rate of return on an investment over a given period of time is calculated by ________.
A) dividing the asset’s cash distributions during the period, plus change in value, by its beginning-of
period investment value
B) dividing the asset’s cash distributions during the period, plus change in value, by its ending-of period
investment value
C) dividing the asset’s cash distributions during the period, minus change in value, by its ending-of
period investment value
D) dividing the asset’s cash distributions during the period, minus change in value, by its beginning-of
period investment value
17) Last year, Mike bought 100 shares of Dallas Corporation common stock for $53 per share. During the
year he received dividends of $1.45 per share. The stock is currently selling for $60 per share. What rate of
return did Mike earn over the year?
A) 11.7 percent
B) 13.2 percent
C) 14.1 percent
D) 15.9 percent
18) If an investor prefers a higher return investment regardless of its risk, then he is following a ________
strategy.
A) risk-seeking
B) risk-neutral
C) risk-averse
D) risk-aware
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19) If an investor prefers investments with greater risk even if they have lower expected returns, then he
is following a ________ strategy.
A) risk-seeking
B) risk-indifferent
C) risk-averse
D) risk-neutral
20) Risk aversion is the behavior exhibited by investors who require ________.
A) an increase in return, for a given decrease in risk
B) an increase in return, for a given increase in risk
C) no changes in return, for a given increase in risk
D) decrease in return, for a given increase in risk
21) If an investor requires greater return when risk increases, then he is said to be ________.
A) risk-seeking
B) risk-indifferent
C) risk-averse
D) risk-aware
22) Perry purchased 100 shares of Ferro, Inc. common stock for $25 per share one year ago. During the
year, Ferro, Inc. paid cash dividends of $2 per share. The stock is currently selling for $30 per share. If
Perry sells all of his shares of Ferro, Inc. today, what rate of return would he realize?
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23) Nico bought 100 shares of a company’s stock for $22.00 per share on January 1, 2018. He received a
dividend of $2.00 per share at the end of 2018 and $3.00 per share at the end of 2019. At the end of 2020,
Nico collected a dividend of $4.00 per share and sold his stock for $18.00 per share. What was Nico’s
realized holding period return? What was Nico’s compound annual rate of return? (Hint: calculate an
IRR). Explain the difference.
24) Tim purchased a bounce house one year ago for $6,500. During the year it generated $4,000 in cash
flow. If Time sells the bounce house today, he could receive $6,100 for it. What would be his rate of return
under these conditions?
25) Asset A was purchased six months ago for $25,000 and has generated $1,500 cash flow during that
period. What is the asset’s rate of return if it can be sold for $26,750 today?
8.2 Risk of a single asset
1) The range of an asset‘s risk is found by subtracting the worst outcome from the best outcome.
2) Risk can be assessed by means of scenario analysis and probability distributions.
3) An approach for assessing risk that uses a number of possible return estimates to obtain a sense of the
variability among outcomes is called scenario analysis.
4) The greater the range of an asset’s returns, the more the variability the asset is said to possess.
5) The real utility of the coefficient of variation is in comparing assets that have equal expected returns.
6) The risk of an asset can be measured by its variance, which is found by subtracting the worst outcome
from the best outcome.
7) The coefficient of variation is a measure of relative dispersion used in comparing the risks of assets
with differing expected return.
8) The more certain the return from an asset, the less variability and therefore the less risk.
9) In U.S., during the past 90 years, on average the return on large-company stocks has exceeded the
return on small-company stocks.
10) In U.S., during the past 90 years, on average the return on small–company stocks has equalled the
return on large-company stocks.
11) A normal probability distribution is a symmetrical distribution whose shape resembles a bell-shaped
curve.
12) For normal probability distributions, 95 percent of the possible outcomes will lie between ±1 standard
deviation from the expected return.
13) Standard deviation is a measure of relative dispersion that is useful in comparing the risks of assets
with different expected returns.
14) A normal probability distribution is an asymmetrical distribution whose shape resembles a pyramid.
15) A lower coefficient of variation indicates that an asset has higher variability relative to its expected
return.
16) If an asset’s returns display a higher coefficient of variation, that suggests the asset is riskier.
17) Standard deviation measures the dispersion of an investment‘s return around the expected return.
18) In U.S., during the past 117 years, on average the return on U.S. Treasury bills has exceeded the
inflation rate.
19) On average in the U.S., during the past 117 years, the return on U.S. Treasury bills has exceeded the
return on Treasury bonds.
20) On average in the U.S., during the past 117 years, the return on stocks has exceeded the return on
Treasury bonds.
21) A common approach of estimating the variability of returns involving the forecast of pessimistic, most
likely, and optimistic returns associated with an asset is called ________.
A) marginal analysis
B) scenario analysis
C) break-even analysis
D) DuPont analysis
22) ________ is one way of assessing an asset‘s risk. It is found by subtracting the pessimistic outcome
from the optimistic outcome.
A) Variance
B) Standard deviation
C) Probability distribution
D) Range
23) The simplest type of probability distribution is a ________.
A) bar chart
B) normal distribution
C) lognormal distribution
D) Poisson distribution
24) The ________ of a given outcome is its chance of occurring.
A) dispersion
B) standard deviation
C) probability
D) reliability
25) A(n) ________ distribution shows all possible outcomes and associated probabilities for a given event.
A) discrete
B) lognormal
C) exponential
D) probability
26) The ________ measures the dispersion around the expected value.
A) coefficient of variation
B) chi square
C) mean
D) standard deviation
27) A ________ is a measure of relative dispersion used in comparing the risk of assets with differing
expected returns.
A) coefficient of variation
B) chi square
C) mean
D) standard deviation
28) Which asset would the risk-averse financial manager prefer? (See below.)
A) Asset A
B) Asset B
C) Asset C
D) Asset D
29) The expected value and the standard deviation of returns for asset A is ________. (See below.)
Asset A
A) 12 percent and 4 percent
B) 12.7 percent and 2.3 percent
C) 12.7 percent and 4 percent
D) 12 percent and 2.3 percent
30) The ________ the coefficient of variation, the ________ the risk.
A) lower; lower
B) higher; lower
C) lower; higher
D) more stable; higher
31) Given the following expected returns and standard deviations of assets B, M, Q, and D, which asset
has the most favorable coefficient of variation?
A) Asset B
B) Asset M
C) Asset Q
D) Asset D
32) The expected value, standard deviation of returns, and coefficient of variation for asset A are
________. (See below.)
Asset A
A) 10 percent, 8 percent, and 1.25, respectively
B) 9.33 percent, 8 percent, and 2.15, respectively
C) 9.35 percent, 4.68 percent, and 2.00, respectively
D) 9.35 percent, 2.76 percent, and 0.295, respectively
33) Given the following limited information about the two assets A and B, which asset seems preferable?
34) Assuming the following returns and corresponding probabilities for asset A, compute its standard
deviation and coefficient of variation.
35) Champion Breweries must choose between two asset purchases. The annual rate of return and related
probabilities given below summarize the firm’s analysis.
For each asset, compute
(a) the expected rate of return.
(b) the standard deviation of the expected return.
(c) the coefficient of variation of the return.
(d) Which asset should Champion select?
36) The College Copy Shop is in the process of purchasing a high-tech copier. In its search, it has gathered
the following information about two possible copiers A and B.
(a) Compute expected rate of return for each copier.
(b) Compute variance and standard deviation of rate of return for each copier.
(c) Which copier should they purchase?
37) Given the following probability distribution for assets X and Y, compute the expected rate of return,
variance, standard deviation, and coefficient of variation for the two assets. Which asset seems to be a
better investment?
8.3 Risk of a portfolio
1) An efficient portfolio is a portfolio that maximizes return for a given level of risk.
2) New investments must be considered in light of their impact on the risk and return of the portfolio of
assets because the risk of any single proposed asset investment is not independent of other assets.
3) A financial manager‘s goal for the firm is to create a portfolio that maximizes return for a given level of
risk.
4) Two assets whose returns move in the same direction and have a correlation coefficient of +1 are very
risky assets.
5) Two assets whose returns move in the opposite directions and have a correlation coefficient of -1 are
either risk-free assets or low-risk assets.
6) The standard deviation of a portfolio is a function of the standard deviations of the individual
securities in the portfolio, the proportion of the portfolio invested in those securities, and the correlation
between the returns of those securities.
7) A(n) ________ portfolio maximizes return for a given level of risk.
A) efficient
B) risk-free
C) risk-neutral
D) risk-indifferent
8) An efficient portfolio is defined as ________.
A) grouping of assets with same level of risk
B) collection of assets with the aim of maximizing the return for a given risk level
C) an investment in a single asset
D) grouping of assets with the highest possible correlation
9) You are trying to decide which mutual fund to invest in. There are many choices, so you begin by
analyzing just two funds, the Emerging Markets Fund (EMF) and the Small Stock Fund (SSF). Both funds
have an expected return of 10%. EMF has a standard deviation or 20%, while SSF has a standard
deviation of 22%. From this information can you conclude that either EMF or SSF is an efficient portfolio?
Can you say that either portfolio is inefficient (i.e., does not maximize return for a given risk level?