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Chapter 08: Analysis of Risk and Return
68. The expected rate of return for 3COM is 18%, with a standard deviation of 10.98%. The expected rate of return for
Just the Fax is 26%, with a standard deviation of 15.86%. Which firm would be considered the riskier from a total risk
perspective?
a.
3COM
b.
Just the Fax
c.
Neither, as both have the same risk
d.
Cannot be determined
c
69. Don has $3,000 invested in AT&T with an expected return of 11.6%; $10,000 in IBM with an expected return of
12.8%; and $6,000 in GM with an expected return of 12.2%. What is Don’s expected return on his portfolio?
a.
12.42%
b.
12.20%
c.
11.81%
d.
Cannot be determined
a
70. Sally’s broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an
expected return of 10.3% and 20% have an expected return of 12.8%, what is the expected return of the remaining portion
of her portfolio?
a.
20.9%
b.
18.8%
c.
12.5%
d.
Cannot be determined
71. Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the portfolio is 1.28, and
the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and
replacing it with another security with a lower beta. What must be the beta of the replacement security?
a.
1.21
b.
0.91
c.
0.73
d.
1.62
c
72. A college student owns two securities: Apple and Coca- Cola. Apple has an expected return of 15%, with a standard
deviation of those returns being 11%. Coca-Cola has an expected return of 12% and a standard deviation of 7%. The
correlation of returns between Apple and Coca-Cola is 0.81. If the portfolio consist of $6,000 in Coca-Cola and $4,000 in
Apple, what is the expected standard deviation of portfolio returns?
a.
8.18%
b.
13.20%
c.
8.60%
d.
9.71%
a
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73. Assume you want to construct a portfolio with a 14% return from the following two securities:
Security
Expected Return
Beta
1
16%
1.12
2
12.5%
0.94
What percentage of your portfolio should be invested in Security 1?
a.
57%
b.
47%
c.
43%
d.
53%
c
74. Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury bills was
9.17%. Over the same time period, the average annual inflation rate was 6.39%. Therefore, the ____.
a.
inflation premium was 2.78 percentage points
b.
real expected rate of return was 9.17 percentage points
c.
realized real rate of return was 2.78 percentage points
d.
required rate of return was 6.39 percentage points
c
75. The real rate of interest is expected to be 3%, and the expected rate of inflation for next year is expected to be 5.5%. If
the default risk premium is 1.1 percentage points, and the seniority risk premium is 0.4 percentage points, what is the
required return on a 1-year U.S. Treasury security?
a.
9.6%
b.
10.0%
c.
8.5%
d.
8.9%
c
76. If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is 4.16%, then the real
rate of return is ____.
a.
2.86%
b.
7.02%
c.
4.70%
d.
6.48%
a
77. The yield to maturity on ACL bonds maturing in 2025 is 8.75%. The yield to maturity on a similar maturity U.S.
Government Treasury bond is 7.06%, and the yield on Treasury bills is 6.51%. What is the default risk premium on the
ACL bond?
a.
2.24%
b.
1.69%
c.
0.55%
d.
8.75%
b
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78. The risk-free rate of return is 5.51%, based on an expected inflation premium of 2.54%. The expected return on the
market is 12.8%. What is the required rate of return for Envoy common stock which has a beta of 1.35?
a.
6.98%
b.
16.24%
c.
15.35%
d.
12.80%
c
79. Determine the beta of a portfolio consisting of equal investments in the following common stocks:
Security
Beta
Apple Computer
1.15
Coca-Cola
1.05
Harley-Davidson
1.50
Homestake Mining
0.50
a.
1.05
b.
1.00
c.
1.10
d.
0.95
a
80. Twin City Knitting (TCK) pays a current dividend of $2.20, and dividends are expected to grow at a rate of 7%
annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2% and the market risk premium is 6%,
at what price would you expect TCK’s common stock to sell?
a.
$14.35
b.
$33.63
c.
$23.40
d.
$25.04
81. Micromatic is considering expanding into a new product area. Micromatic’s current beta is 1.2 and its beta is expected
to increase to 1.45 after the expansion. The long-term growth rate of the firm’s earnings is expected to increase from 6.5%
to 10%. Micromatic’s current dividend is $1.70 per share, the current risk-free rate is 9.1%, and the expected market return
is 12.9%. Should Micromatic undertake the planned expansion?
a.
No, stock price decreases $10.15.
b.
Yes, stock price increases $15.27.
c.
Yes, stock price increases $0.45.
d.
No, stock price decreases $15.27.
82. Quick Start Inc. is expected to pay a dividend of $1.05 next year and dividends are expected to continue their 7%
annual growth rate. The SML has been estimated as follows:
kj = 0.08 + 0.064βj
Assuming Quick Start has a beta of 1.1, what would happen to its stock price if inflation expectations went from the
current 5% to 8%?
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Chapter 08: Analysis of Risk and Return
a.
It would decrease $8.14.
b.
It would decrease $3.55.
c.
It would decrease $3.18.
d.
The stock price will not change.
83. Richtex Brick has a current dividend of $1.70, and the market value of its common stock is $28. The expected market
return is 13%, and the risk-free rate is 9%. If Richtex stock is half as volatile as the market, and the market is in
equilibrium, what rate of growth is expected for Richtex’s dividends assuming a constant growth valuation model is
appropriate for Richtex?
a.
4.93%
b.
4.65%
c.
5.37%
d.
5.41%
84. AKA’s stock is currently selling for $11.44. This year the firm had earnings per share of $2.80, and the current
dividend is $0.68. Earnings are expected to grow 7% a year in the foreseeable future. The risk-free rate is 10%, and the
expected market return is 14.2%. What will be the effect on the price of AKA’s stock if systematic risk increases by 40%,
all other factors remaining constant?
a.
an increase of $1.14
b.
a decrease of $0.40
c.
a decrease of $1.99
d.
Cannot determine from the given data
c
85. Given the following information on securities E and F, calculate the expected return and standard deviation of returns
on a portfolio consisting of 40% invested in E and 60% invested in F.
Security E
Security F
Expected Return
12%
15%
Standard Deviation of Returns
10%
20%
Correlation coefficient of returns
–0.50
a.
13.5%; 15%
b.
13.8%; 14.4%
c.
13.8%; 10.6%
d.
13.5%; 8.7%
c
86. Gates Industries’ current common stock dividend (year 0) is $2.50 per share and is expected to continue growing at a
rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the estimated market risk premium
(i.e., km – rf) is 8.3%. Value Line has estimated Gates Industries’ beta to be 1.10. Determine the expected price for Gates
Industries, common stock.
a.
$21.50
b.
$15.03
c.
$15.78
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Chapter 08: Analysis of Risk and Return
d.
$22.57
87. An investor who believes the economy is slowing down wishes to reduce the risk of her portfolio. She currently owns
12 securities, each with a market value of $3,000. The current beta of the portfolio is 1.21, and the beta of the riskiest
security is 1.62. What will the portfolio beta be if the riskiest security is replaced with a security of equal market value but
a beta of 0.80?
a.
1.14
b.
1.18
c.
1.05
d.
1.10
a
88. Assume that the rate of return on Calengry common stock over the coming year is normally distributed with an
expected value of 16% and a standard deviation of 20%. What is the probability of earning a negative rate of return?
(Note: Table V is required to work this problem.)
a.
10.56%
b.
40.13%
c.
21.19%
d.
3.59%
c
89. Determine the beta of a portfolio consisting of the following common stocks:
Security
Market Value
Beta
Boeing
$5,000
1.2
Exxon
$4,000
0.8
Duke Power
$2,500
0.6
Blockbuster Video
$2,000
1.4
Coca-Cola
$7,500
1.0
a.
0.93
b.
0.85
c.
1.00
d.
1.14
c
90. HDTV has planned on diversifying into the VR field. As a result, HDTV’s beta would rise to 1.6 from 1.2 and the
expected future long-term growth rate in the firm’s earnings would increase from 12% to 16%. The expected market
return, km, is 14%; the risk-free rate, rf, is 7%; and the current dividend, Do, is $0.50. Should HDTV go into the VR field?
a.
No, stock price decreases $7.82.
b.
Yes, stock price increases $9.89.
c.
Yes, stock price increases $3.81.
d.
No, stock price decreases $3.78.
91. Christy is considering investing in the common stock of One Liberty and Heico. The following data are available for
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Chapter 08: Analysis of Risk and Return
these two securities:
One Liberty
Heico
Expected return
0.12
0.16
Standard deviation of returns
0.08
0.20
If she invests 30% of her funds in Heico and 70% in One Liberty, and if the correlation of returns between these securities
is +0.65, what is the portfolio’s expected return and standard deviation?
a.
14% and 15.67%
b.
14.8% and 9.44%
c.
13.2% and 10.54%
d.
13.1% and 9.67%
c
92. Jim Bowles is an investor who believes the economy is gaining strength and therefore wishes to increase the risk of
his 14-security portfolio. Each security has a current market value of $5,000, and the current beta of the portfolio is 1.02.
The beta of the least risky security is 0.76. If Jim replaces the least risky security with another security with the same
market value but a beta of 1.45, what will the portfolio beta be then?
a.
1.03
b.
1.07
c.
1.08
d.
1.04
93. Kermit Industries’ current common stock dividend is $1.35 per share, and the dividend is expected to grow at 6% per
year into the foreseeable future. Currently the risk-free rate is 4.5% and the estimated market risk premium is 8.5%.
Merrill Lynch has estimated KI’s beta to be 1.10. Compute the expected price for KI’s common stock.
a.
$17.20
b.
$10.33
c.
$18.23
d.
$49.35
c
94. Determine the beta of a portfolio consisting of the following common stocks:
Security
Market Value
Beta
Glaxo
$2,600
1.24
SCANA
3,700
0.88
BancOne
2,900
0.95
Pepsi
3,400
1.05
AFLAC
3,000
1.09
Votec
4,400
1.41
a.
1.00
b.
1.12
c.
1.09
d.
1.11
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95. The beta of Sanafil is 1.2. Sanafil is evaluating a merger with Matra, a firm that has a beta of 0.95. Sanafil’s stock sells
for $40 per share, and there are 10 million shares outstanding. Matra’s stock sells for $60, but there are only 2 million
shares outstanding. If these two firms merge, what will be the merged firm’s beta?
MVS = $40(10,000,000) = $400,000,000
MVM = $60(2,000,000) = $120,000,000
a.
1.00
b.
1.14
c.
1.05
d.
1.16
96. Lotte Group is planning on diversifying into the transportation industry. As a result, Lotte’s beta would rise to 1.3 from
1.1 and the expected long-term growth rate in the firm’s earnings would increase from 11% to 14%. Currently the risk-free
rate is 5.0% and the market risk premium is 8.6%. If Lotte’s current dividend is $1.30, should Lotte diversify into the
transportation industry?
a.
No, stock price does not increase.
b.
No, stock price declines about $10.11.
c.
Yes, stock price increases about $19.42.
d.
Yes, stock price increases by about $26.27.
97. Security A offers an expected return of 14%, with a standard deviation of 8%. Security B offers an expected return of
11%, with a standard deviation of 6%. If you wish to construct a portfolio with a 12.8% expected return, what percentage
of the portfolio will consist of security A?
a.
55%
b.
60%
c.
65%
d.
45%
98. Which of the following statements is (are) correct?
I. Unsystematic risk can be eliminated through diversification.
II. Unsystematic risk is the relevant portion of an asset’s risk attributable to market factors that affect all firms, like
inflation, political events, etc.
a.
Only statement I is correct.
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
a
99. Correlation is a statistical measure of the relationship between a series of numbers representing data. Which of the
following statements about correlation is (are) correct?
I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of –1.
II. Perfectly positively correlated describes two positively correlated stocks that have a correlation coefficient of 0.
a.
Only statement I is correct.
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Chapter 08: Analysis of Risk and Return
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
a
100. Total risk of a security can be viewed as consisting of two parts. Which of the following apply?
I. verifiable risk
II. non-verifiable risk
a.
Only statement I is correct.
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
101. All of the following statements about risk are correct EXCEPT ____.
a.
risk can be defined as the chance for financial loss
b.
the term risk is used interchangeably with uncertainty
c.
risk refers to the certainty of returns associated with a given asset
d.
the more certain the return from an asset, the less variability and therefore less risk
c
102. Which of the following statements regarding risk is (are) correct?
I. A portfolio of two negatively correlated assets has less risk than either of the individual assets, and risk could be
further reduced to 0 or below.
II. There is no case where creating a portfolio of assets will result in greater risk than that of the riskiest asset included in
the portfolio.
a.
Only statement I is correct.
b.
Only statement II is correct.
c.
Both statements I and II are correct.
d.
Neither statement I nor II is correct.
c
103. What kind of probability distribution shows all possible outcomes for a given event?
a.
categorical
b.
expected value
c.
bar chart
d.
continuous
104. The portion of the risk premium that is based on the ability of the borrower to repay principal and interest is the ____
risk.
a.
maturity
b.
default
c.
seniority
d.
marketability
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Chapter 08: Analysis of Risk and Return
105. An investor, by investing in combinations of stocks, develops a ____ portfolio.
a.
simple
b.
structured
c.
diversified
d.
energetic
c
106. What is the beta of the following project?
Comparative Returns on Past Projects
12%
15%
10%
8%
6.5%
7%
2%
–1%
a.
1.11
b.
0.95
c.
2.15
d.
1.43
107. Find beta, and determine the required rate of return. The market risk premium is 12%, and the risk-free rate is 5%.
Comparative Returns in the Market
Returns on the Stock
8%
4%
9%
10%
2%
1%
10%
6%
a.
12.61%
b.
8.27%
c.
10.11%
d.
14.84%
108. Find beta, and determine the risk premium. The market risk premium is 8%, and the risk-free rate is 2%.
Comparative Returns in the Market
Returns on the Stock
10%
8%
11%
12%
6%
2%
5%
1%
a.
16.82%
b.
20.76%
c.
10.15%
d.
18.11%
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Chapter 08: Analysis of Risk and Return
b
109. A diversified portfolio has many stocks, as opposed to a single stock. Diversification can occur with as few as ____
stocks.
a.
5
b.
10
c.
20
d.
100
c
110. Which of the following would be considered a risk-free investment?
a.
U.S. Treasury securities
b.
blue chip stocks
c.
AAA rated corporate bonds
d.
real estate
a
111. The normal probability distribution is characterized by a ____.
a.
bell curve
b.
bar chart
c.
logarithmic curve
d.
step graph
112. When looking at measures of risk and return, the notation “σ” represents ____.
a.
risk
b.
return
c.
standard deviation
d.
probability
c
Essay
113. What is an efficient portfolio?
portfolio maximizes return for a given level of risk, or minimizes risk for a given rate of return.
114. List types of events that influence systematic (nondiversifiable) risk.
war
inflation
political events
interest rate changes
international incidents
changes in investor expectations about the overall economy
115. List the various risk elements that are considered when determining the risk premium.
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Chapter 08: Analysis of Risk and Return
116. How can standard deviation, a statistical measure of dispersion, be used in investment analysis?
117. Explain marketability risk and marketability premium.
118. Why is risk an increasing function of time?