Finance Chapter 1-5, 7-10

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d. Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones.

. Which of the following statements is CORRECT?

a. One of the disadvantages of incorporating a business is that the owners then become subject to liabilities in the event the firm goes bankrupt.
b. Sole proprietorships are subject to more regulations than corporations.
c. In any type of partnership, every partner has the same rights, privileges, and liability exposure as every other partner.
d. Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones.
e. Corporations of all types are subject to the corporate income tax.

a. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability.

. Which of the following statements is CORRECT?

a. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability.
b. It is generally easier to transfer one's ownership interest in a partnership than in a corporation.
c. One of the advantages of the corporate form of organization is that it avoids double taxation.
d. One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote."
e. Corporations of all types are subject to the corporate income tax.

d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership.

. Which of the following statements is CORRECT?

a. It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required.
b. Corporations face fewer regulations than sole proprietorships.
c. One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level.
d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership.
e. If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

c. Cheers' shareholders (the ex-partners) will now be exposed to less liability.

. Cheers Inc. operates as a partnership. Now the partners have decided to convert the business into a regular corporation. Which of the following statements is CORRECT?

a. Assuming Cheers is profitable, less of its income will be subject to federal income taxes.
b. Cheers will now be subject to fewer regulations.
c. Cheers' shareholders (the ex-partners) will now be exposed to less liability.
d. Cheers' investors will be exposed to less liability, but they will find it more difficult to transfer their ownership.
e. Cheers will find it more difficult to raise additional capital.

a. It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship.

. Which of the following statements is CORRECT?

a. It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship.
b. Corporate shareholders are exposed to unlimited liability.
c. Corporations generally face fewer regulations than sole proprietorships.
d. Corporate shareholders are exposed to unlimited liability, and this factor may be compounded by the tax disadvantages of incorporation.
e. Shareholders in a regular corporation (not an S corporation) pay higher taxes than owners of an otherwise identical proprietorship.

c. Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.

. Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

a. Corporations generally find it relatively difficult to raise large amounts of capital.
b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership.
c. Corporate shareholders escape liability for the firm's debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
d. Corporate investors are exposed to unlimited liability.
e. Corporations generally face relatively few regulations.

c. This is an example of a direct transfer of capital.

. You recently sold 100 shares of your new company, XYZ Corporation, to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following statements best describes this transaction?

a. This is an example of an exchange of physical assets.
b. This is an example of a primary market transaction.
c. This is an example of a direct transfer of capital.
d. This is an example of a money market transaction.
e. This is an example of a derivatives market transaction

a. If expected inflation increases, interest rates are likely to increase.

. Which of the following statements is CORRECT?

a. If expected inflation increases, interest rates are likely to increase.
b. If individuals in general increase the percentage of their income that they save, interest rates are likely to increase.
c. If companies have fewer good investment opportunities, interest rates are likely to increase.
d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.
e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

e. The justification for the "light" regulation of hedge funds is that only "sophisticated" investors with high net worths and high incomes are permitted to invest in these funds, and such investors supposedly can do the necessary "due diligence" on their own rather than have it done by the SEC or some other regulator.

. Which of the following statements is CORRECT?

a. In Europe and Asia hedge funds are legal, but they are not permitted to operate in the United States.
b. Hedge funds have more in common with commercial banks than with any other type of financial institution.
c. Hedge funds have more in common with investment banks than with any other type of financial institution.
d. In the United States hedge funds are legal, but in Europe and Asia they are not permitted to operate.
e. The justification for the "light" regulation of hedge funds is that only "sophisticated" investors with high net worths and high incomes are permitted to invest in these funds, and such investors supposedly can do the necessary "due diligence" on their own rather than have it done by the SEC or some other regulator.

d. Short-term debt securities.

. Money markets are markets for

a. Foreign stocks.
b. Consumer automobile loans.
c. U.S. stocks.
d. Short-term debt securities.
e. Long-term bonds.

b. Johnson & Johnson issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

. Which of the following is a primary market transaction?

a. You sell 200 shares of Johnson & Johnson stock on the NYSE through your broker.
b. Johnson & Johnson issues 2,000,000 shares of new stock and sells them to the public through an investment banker.
c. You buy 200 shares of Johnson & Johnson stock from your younger brother. You just give him cash and he gives you the stock--the trade is not made through a broker.
d. One financial institution buys 200,000 shares of Johnson & Johnson stock from another institution. An investment banker arranges the transaction.
e. You invest $10,000 in a mutual fund, which then uses the money to buy $10,000 of Johnson & Johnson shares on the NYSE.

e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year.

. Which of the following statements is CORRECT?

a. If Apple issues additional shares of common stock through an investment banker, this would be a secondary market transaction.
b. If you purchased 100 shares of Apple stock from your sister-in-law, this would be an example of a primary market transaction.
c. The IPO market is a subset of the secondary market.
d. Only institutions, and not individuals, can participate in derivatives market transactions.
e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year.

c. A secondary market transaction.

. You recently sold 200 shares of Apple stock to your brother. The transfer was made through a broker, and the trade occurred on the NYSE. This is an example of:

a. A futures market transaction.
b. A primary market transaction.
c. A secondary market transaction.
d. A money market transaction.
e. An over-the-counter market transaction.

a. The New York Stock Exchange is an auction market with a physical location.

. Which of the following statements is CORRECT?

a. The New York Stock Exchange is an auction market with a physical location.
b. Capital market transactions involve only the purchase and sale of equity securities, i.e., common stocks.
c. If an investor sells shares of stock through a broker, then this would be a primary market transaction.
d. Consumer automobile loans are evidenced by legal documents called "promissory notes," and these individual notes are traded in the money market.
e. While the distinctions are blurring as investment banks are today buying commercial banks, and vice versa, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

a. Capital market instruments include both long-term debt and common stocks.

a. Capital market instruments include both long-term debt and common stocks.
b. An example of a primary market transaction would be your uncle transferring 100 shares of Wal-Mart stock to you as a birthday gift.
c. The NYSE does not exist as a physical location; rather, it represents a loose collection of dealers who trade stocks electronically.
d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.
e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

e. The NYSE operates as an auction market, whereas the Nasdaq is a dealer market.

. Which of the following statements is CORRECT?

a. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.
b. A security whose value is derived from the price of some other "underlying" asset is called a liquid security.
c. Money market mutual funds usually invest most of their money in a well-diversified portfolio of liquid common stocks.
d. Money markets are markets for common stocks and long-term debt.
e. The NYSE operates as an auction market, whereas the Nasdaq is a dealer market.

a. It subjects the firm to additional regulations.

. One drawback of switching from a partnership to the corporate form of organization is the following:

a. It subjects the firm to additional regulations.
b. It cannot affect the amount of the firm's operating income that goes to taxes.
c. It makes it more difficult for the firm to raise additional capital.
d. It makes the firm's investors subject to greater potential personal liabilities.
e. It makes it more difficult for the firm's investors to transfer their ownership interests.

c. A corporation is a legal entity that is generally created by a state; its life and existence is separate from the lives of its individual owners and managers.

. Which of the following statements is CORRECT?

a. The main method of transferring ownership interest in a corporation is by means of a hostile takeover.
b. Two key advantages of the corporate form over other forms of business organization are unlimited liability and limited life.
c. A corporation is a legal entity that is generally created by a state; its life and existence is separate from the lives of its individual owners and managers.
d. Limited liability of its stockholders is an advantage of the corporate form of organization, but corporations have more trouble raising money in financial markets because of the complexity of this form of organization.
e. Although its stockholders are insulated by limited legal liability, the corporation's legal status does not protect the firm's managers in the same way; i.e., bondholders can sue its managers if the firm defaults on its debt, even if the default is the result of poor economic conditions.

b. Attracting large amounts of capital is more difficult for partnerships than for corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests.

. Which of the following statements is CORRECT?

a. In a regular partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business.
b. Attracting large amounts of capital is more difficult for partnerships than for corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests.
c. A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster growing company.
d. The limited partners in a limited partnership have voting control, while the general partner has operating control over the business. Also, the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy.
e. A major disadvantage of all partnerships compared to all corporations is the fact that federal income taxes must be paid by the partners rather than by the firm itself.

d. Partnerships have difficulty attracting capital in part because of their unlimited liability, the lack of impermanence of the organization, and difficulty in transferring ownership.

. Which of the following statements is CORRECT?

a. Corporations are at a disadvantage relative to partnerships because they have to file more reports to state and federal agencies, including the Securities and Exchange Administration, even if they are not publicly owned.
b. In a regular partnership, liability for the firm's debts is limited to the amount a particular partner has invested in the business.
c. A fast-growth company would be more likely to set up as a partnership for its business organization than would a slow-growth company.
d. Partnerships have difficulty attracting capital in part because of their unlimited liability, the lack of impermanence of the organization, and difficulty in transferring ownership.
e. A major disadvantage of a partnership relative to a corporation as a form of business organization is the high cost and practical difficulty of its formation.

c. Most business (measured by dollar sales) is conducted by corporations in spite of large corporations' often less favorable tax treatment, due to legal considerations related to ownership transfers and limited liability.

. Which of the following statements is CORRECT?

a. Most businesses (by number and total dollar sales) are organized as partnerships or proprietorships because it is easier to set up and operate in one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, mainly because corporations have important tax advantages over proprietorships and partnerships.
b. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations.
c. Most business (measured by dollar sales) is conducted by corporations in spite of large corporations' often less favorable tax treatment, due to legal considerations related to ownership transfers and limited liability.
d. Large corporations are taxed more favorably than sole proprietorships.
e. Corporate stockholders are exposed to unlimited liability.

b. S corporation, to gain some tax advantages and also to obtain limited liability.

. Jane Doe, who has substantial personal wealth and income, is considering the possibility of starting a new business in the chemical waste management field. She will be the sole owner, and she has enough funds to finance the operation. The business will have a relatively high degree of risk, and it is expected that the firm will incur losses for the first few years. However, the prospects for growth and positive future income look good, and Jane plans to have the firm pay out all of its income as dividends to her once it is well established. Which of the legal forms of business organization would probably best suit her needs?

a. Proprietorship, because of ease of entry.
b. S corporation, to gain some tax advantages and also to obtain limited liability.
c. Partnership, but only if she needs additional capital.
d. Regular corporation, because of the limited liability.
e. In this situation, the various forms of organization seem equally desirable.

e. The corporate charter is concerned with things like what business the company will engage in, whereas the bylaws are concerned with things like procedures for electing the board of directors.

. Which of the following statements is CORRECT?

a. The corporate bylaws are a standard set of rules established by the state of incorporation. These rules are identical for all corporations in the state, and their purpose is to ensure that the firm's managers run the firm in accordance with state laws.
b. The corporate charter is a standard document prescribed by the state of incorporation, and its purpose is to ensure that the firm's managers run the firm in accordance with state laws. Procedures for electing corporate directors are contained in bylaws, while the declaration of the activities that the firm will pursue and the number of directors are included in the corporate charter.
c. Companies must establish a home office, or domicile, in a particular state, and that state must be the one in which most of their business (sales, manufacturing, and so forth) is conducted.
d. Attorney fees are generally involved when a company develops its charter and bylaws, but since these documents are voluntary, a new corporation can avoid these costs by deciding not to have either a charter or bylaws.
e. The corporate charter is concerned with things like what business the company will engage in, whereas the bylaws are concerned with things like procedures for electing the board of directors.

c. Although people's moral characters are probably developed before they get into a business school, it is still useful for business schools to cover ethics, including giving students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.

. With which of the following statements would most people in business agree?

a. The short-run profits of a corporation will almost always increase if the firm takes actions the government has determined are in the nation's best interests.
b. Government agencies and firms almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees.
c. Although people's moral characters are probably developed before they get into a business school, it is still useful for business schools to cover ethics, including giving students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
d. Developing a formal set of rules defining ethical and unethical behavior is not useful for a large corporation. Such rules generally can't be applied in many specific instances, so it is better to deal with ethical issues on a case-by-case basis.
e. Because of the courage it takes to blow the whistle, "whistle blowers" are generally promoted more rapidly than other employees.

a. Maximize the stock price per share over the long run, which is the stock's intrinsic value.

. The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to

a. Maximize the stock price per share over the long run, which is the stock's intrinsic value.
b. Maximize the firm's expected EPS.
c. Minimize the chances of losses.
d. Maximize the firm's expected total income.
e. Maximize the stock price on a specific target date.

d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders.

. Which of the following statements is CORRECT?

a. The financial manager's proper goal should be to attempt to maximize the firm's expected cash flows, since that will add the most to the individual shareholders' wealth.
b. The financial manager should seek that combination of assets, liabilities, and capital that will generate the largest expected projected after-tax income over the relevant time horizon, generally the coming year.
c. The riskiness inherent in a firm's earnings per share (EPS) depends on the characteristics of the projects the firm selects, and thus on the firm's assets. However, EPS is not affected by the manner in which those assets are financed.
d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders.
e. Large, publicly owned firms like IBM and GE are controlled by their management teams. Ownership is generally widely dispersed; hence managers have great freedom in how they run the firm. Managers may operate in stockholders' best interests, but they also may operate in their own personal best interests. As long as they stay within the law, there is no way to either force or motivate managers to act in the stockholders' best interests.

e. Prices would decline and interest rates would rise.

. Suppose the U.S. Treasury announces plans to issue $50 billion of new bonds. Assuming the announcement was not expected, what effect, other things held constant, would that have on bond prices and interest rates?

a. Prices and interest rates would both rise.
b. Prices would rise and interest rates would decline.
c. Prices and interest rates would both decline.
d. There would be no changes in either prices or interest rates.
e. Prices would decline and interest rates would rise.

d. Corporations step up their expansion plans and thus increase their demand for capital.

. Which of the following would be most likely to lead to higher interest rates on all debt securities in the economy?

a. Households start saving a larger percentage of their income.
b. The economy moves from a boom to a recession.
c. The level of inflation begins to decline.
d. Corporations step up their expansion plans and thus increase their demand for capital.
e. The Federal Reserve uses monetary policy in an attempt to stimulate the economy.

e. Most businesses decide to modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.

. Which of the following factors would be most likely to lead to an increase in interest rates in the economy?

a. Households reduce their consumption and increase their savings.
b. The Federal Reserve decides to try to stimulate the economy.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. Most businesses decide to modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.

d. Both Nasdaq "dealers" and NYSE "specialists" hold inventories of stocks.

. Which of the following statements is CORRECT?

a. If General Electric were to issue new stock this year it would be considered a secondary market transaction since the company already has stock outstanding.
b. Capital market transactions only include preferred stock and common stock transactions.
c. The distinguishing feature between spot markets versus futures markets transactions is the maturity of the investments. That is, spot market transactions involve securities that have maturities of less than one year, whereas futures markets transactions involve securities with maturities greater than one year.
d. Both Nasdaq "dealers" and NYSE "specialists" hold inventories of stocks.
e. An electronic communications network (ECN) is a physical location exchange.

c. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm.

. Which of the following statements is CORRECT?

a. Corporations generally are subject to more favorable tax treatment and fewer regulations than partnerships and sole proprietorships, which is why corporations do most of the business in the United States.
b. Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value than are managers who do not face the threat of hostile takeovers.
c. One advantage of the corporate form of organization is that liability of the owners of the firm is limited to their investment in the firm.
d. Because of their simplified organization, it is easier for sole proprietorships and partnerships to raise large amounts of outside capital than it is for corporations.
e. Bond covenants are an effective way to resolve conflicts between shareholders and managers.

e. The potential exists for agency conflicts between stockholders and managers.

. Which of the following statements is CORRECT?

a. A good goal for a firm's management is maximization of expected EPS.
b. Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment.
c. Because most stock ownership is concentrated in the hands of a relatively small segment of society, firms' actions to maximize their stock prices have little benefit to society.
d. Corporations and partnerships have an advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited.
e. The potential exists for agency conflicts between stockholders and managers.

d. Stockholders are generally more willing than bondholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns.

. Which of the following statements is CORRECT?

a. One disadvantage of operating as a corporation rather than as a partnership is that corporate shareholders are exposed to more personal liability than partners.
b. There is no good reason to expect a firm's bondholders and stockholders to react differently to the types of new asset investments a firm makes.
c. Bondholders are generally more willing than stockholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns.
d. Stockholders are generally more willing than bondholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns.
e. Relative to sole proprietorships, corporations generally face fewer regulations, which makes raising capital easier for corporations.

b. "Going public" establishes a firm's true intrinsic value, and it also insures that a highly liquid market will always exist for the firm's shares.

. Which of the following statements is NOT CORRECT?

a. When a corporation's shares are owned by a few individuals and are not traded on public markets, we say that the firm is "closely, or privately, held."
b. "Going public" establishes a firm's true intrinsic value, and it also insures that a highly liquid market will always exist for the firm's shares.
c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public," and the market for such stock is called the new issue market.
d. Publicly owned companies have shares owned by investors who are not associated with management, and public companies must register with and report to a regulatory agency such as the SEC.
e. It is possible for a firm to go public and yet not raise any additional new capital at the time.

b. B; A.

. You are considering investing in one of the these three stocks:

Stock Standard Deviation Beta
A 20% 0.59
B 10% 0.61
C 12% 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.

a. A; B.
b. B; A.
c. C; A.
d. C; B.
e. A; A.

c. Coefficient of variation; beta.

. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.

b. Stock B.

. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly risk averse and has asked for your advice. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?

a. Stock A.
b. Stock B.
c. Neither A nor B, as neither has a return sufficient to compensate for risk.
d. Add A, since its beta must be lower.
e. Either A or B, i.e., the investor should be indifferent between the two.

b. The beta of an "average stock," or "the market," can change over time, sometimes drastically.

. Which of the following is NOT a potential problem when estimating and using betas, i.e., which statement is FALSE?

a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.
b. The beta of an "average stock," or "the market," can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
d. All of the statements above are true.
e. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

c. The expected return on Stock A should be greater than that on B.

. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securities? (Assume market equilibrium.)

a. Stock B must be a more desirable addition to a portfolio than A.
b. Stock A must be a more desirable addition to a portfolio than B.
c. The expected return on Stock A should be greater than that on B.
d. The expected return on Stock B should be greater than that on A.
e. When held in isolation, Stock A has more risk than Stock B.

b. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.

. Which of the following statements is CORRECT?

a. If you found a stock with a zero historical beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio.
b. The beta coefficient of a stock is normally found by regressing past returns on a stock against past market returns. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta. However, this historical beta may differ from the beta that exists in the future.
c. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.
d. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the risk-free (default-free) rate of return, rRF.
e. The beta of a portfolio of stocks is always smaller than the betas of any of the individual stocks.

a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.

. Which of the following statements is CORRECT?

a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
b. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
c. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks.
d. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
e. Paid-in-Full Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Paid-in-Full's revenues, profits, and stock price tend to rise during recessions. This suggests that Paid-in-Full Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.

d. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.

. Which of the following statements is CORRECT?

a. Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities.
b. The beta of an "average stock," which is also "the market beta," can change over time, sometimes drastically.
c. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm.
d. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future.
e. If a company with a high beta merges with a low-beta company, the best estimate of the new merged company's beta is 1.0.

d. In equilibrium, the expected return on Stock A will be greater than that on B.

. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct.

a. In equilibrium, the expected return on Stock B will be greater than that on Stock A.
b. When held in isolation, Stock A has more risk than Stock B.
c. Stock B would be a more desirable addition to a portfolio than A.
d. In equilibrium, the expected return on Stock A will be greater than that on B.
e. Stock A would be a more desirable addition to a portfolio then Stock B.

b. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.

. Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPM?

a. Stock Y's realized return during the coming year will be higher than Stock X's return.
b. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount.
c. Stock Y's return has a higher standard deviation than Stock X.
d. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y.
e. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated.

c. bA < 0; bB = 0.

. Consider the following average annual returns for Stocks A and B and the Market. Which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B
1 0.03 0.16 0.05
2 -0.05 0.20 0.05
3 0.01 0.18 0.05
4 -0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > +1; bB = 0.
b. bA = 0; bB = -1.
c. bA < 0; bB = 0.
d. bA < -1; bB = 1.
e. bA > 0; bB = 1.

d. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.

. Which of the following statements is CORRECT?

a. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.
b. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock.
c. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.
d. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well diversified portfolio of stocks.
e. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks.

b. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.

. Which of the following statements is CORRECT?

a. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
b. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
c. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held in the portfolio, the portfolio can be made to be completely riskless.
d. A portfolio that consists of all stocks in the market would have a required return that is equal to the riskless rate.
e. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.

b. among the factors that are responsible for market risk.

. Recession, inflation, and high interest rates are economic events that are best characterized as being

a. company-specific risk factors that can be diversified away.
b. among the factors that are responsible for market risk.
c. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
d. irrelevant except to governmental authorities like the Federal Reserve.
e. systematic risk factors that can be diversified away.

d. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

. Which of the following statements is CORRECT?

a. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless.
b. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return.
c. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio.
d. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.
e. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock.

a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.

. Which of the following statements is CORRECT?

a. Diversifiable risk can be reduced by forming a large portfolio, but normally even highly-diversified portfolios are subject to market (or systematic) risk.
b. A large portfolio of randomly selected stocks will have a standard deviation of returns that is greater than the standard deviation of a 1-stock portfolio if that one stock has a beta less than 1.0.
c. A large portfolio of stocks whose betas are greater than 1.0 will have less market risk than a single stock with a beta = 0.8.
d. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
e. A large portfolio of randomly selected stocks will always have a standard deviation of returns that is less than the standard deviation of a portfolio with fewer stocks, regardless of how the stocks in the smaller portfolio are selected.

a. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations.

. Which of the following statements is CORRECT?

a. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations.
b. A two-stock portfolio will always have a lower beta than a one-stock portfolio.
c. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio.
d. A stock with an above-average standard deviation must also have an above-average beta.
e. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.

c. Portfolio ABC's expected return is 10.66667%.

. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1.

Expected Standard
Stock Return Deviation Beta
A 10% 20% 1.0
B 10% 10% 1.0
C 12% 12% 1.4

Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT?

a. Portfolio AB's coefficient of variation is greater than 2.0.
b. Portfolio AB's required return is greater than the required return on Stock A.
c. Portfolio ABC's expected return is 10.66667%.
d. Portfolio ABC has a standard deviation of 20%.
e. Portfolio AB has a standard deviation of 20%.

a. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.

. Which of the following statements is CORRECT?

a. A portfolio with a large number of randomly selected stocks would have more market risk than a single stock that has a beta of 0.5, assuming that the stock's beta was correctly calculated and is stable.
b. If a stock has a negative beta, its expected return must be negative.
c. A portfolio with a large number of randomly selected stocks would have less market risk than a single stock that has a beta of 0.5.
d. According to the CAPM, stocks with higher standard deviations of returns must also have higher expected returns.
e. If the returns on two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1.0) and these stocks have identical standard deviations, an equally weighted portfolio of the two stocks will have a standard deviation that is less than that of the individual stocks.

c. The beta of the portfolio is equal to the average of the betas of the individual stocks.

. Which of the following is most likely to be true for a portfolio of 40 randomly selected stocks?

a. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation.
b. The beta of the portfolio is less than the average of the betas of the individual stocks.
c. The beta of the portfolio is equal to the average of the betas of the individual stocks.
d. The beta of the portfolio is larger than the average of the betas of the individual stocks.
e. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation.

e. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.

. If you randomly select stocks and add them to your portfolio, which of the following statements best describes what you should expect?

a. Adding more such stocks will increase the portfolio's expected rate of return.
b. Adding more such stocks will reduce the portfolio's beta coefficient and thus its systematic risk.
c. Adding more such stocks will have no effect on the portfolio's risk.
d. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk.
e. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.

a. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%.

. Charlie and Lucinda each have $50,000 invested in stock portfolios. Charlie's has a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Lucinda's has a beta of 0.8, an expected return of 9.2%, and a standard deviation that is also 25%. The correlation coefficient, r, between Charlie's and Lucinda's portfolios is zero. If Charlie and Lucinda marry and combine their portfolios, which of the following best describes their combined $100,000 portfolio?

a. The combined portfolio's beta will be equal to a simple weighted average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%.
b. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.
c. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%.
d. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%.
e. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%.

b. Your portfolio has a beta equal to 1.6, and its expected return is 15%.

. The two stocks in your portfolio, X and Y, have independent returns, so the correlation between them, rXY is zero. Your portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock Y. Both stocks have an expected return of 15%, betas of 1.6, and standard deviations of 30%. Which of the following statements best describes the characteristics of your 2-stock portfolio?

a. Your portfolio has a standard deviation less than 30%, and its beta is greater than 1.6.
b. Your portfolio has a beta equal to 1.6, and its expected return is 15%.
c. Your portfolio has a beta greater than 1.6, and its expected return is greater than 15%.
d. Your portfolio has a standard deviation greater than 30% and a beta equal to 1.6.
e. Your portfolio has a standard deviation of 30%, and its expected return is 15%.

e. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.

. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?

a. The expected return of your portfolio is likely to decline.
b. The diversifiable risk will remain the same, but the market risk will likely decline.
c. Both the diversifiable risk and the market risk of your portfolio are likely to decline.
d. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.
e. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.

b. Tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Ann's portfolio, but the required (and expected) returns will be the same on both portfolios.

. Ann has a portfolio of 20 average stocks, and Tom has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT?

a. The required return on Ann's portfolio will be lower than that on Tom's portfolio because Ann's portfolio will have less total risk.
b. Tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Ann's portfolio, but the required (and expected) returns will be the same on both portfolios.
c. If the two portfolios have the same beta, their required returns will be the same, but Ann's portfolio will have less market risk than Tom's.
d. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.
e. Ann's portfolio will have less diversifiable risk and also less market risk than Tom's portfolio.

c. Portfolio P has a standard deviation that is less than 25%.

. Stocks A and B are quite similar: Each has an expected return of 12%, a beta of 1.2, and a standard deviation of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is CORRECT?

a. Portfolio P has a standard deviation that is greater than 25%.
b. Portfolio P has an expected return that is less than 12%.
c. Portfolio P has a standard deviation that is less than 25%.
d. Portfolio P has a beta that is less than 1.2.
e. Portfolio P has a beta that is greater than 1.2.

d. Portfolio AC has a standard deviation that is less than 25%.

. Stocks A, B, and C are similar in some respects: Each has an expected return of 10% and a standard deviation of 25%. Stocks A and B have returns that are independent of one another; i.e., their correlation coefficient, r, equals zero. Stocks A and C have returns that are negatively correlated with one another; i.e., r is less than 0. Portfolio AB is a portfolio with half of its money invested in Stock A and half in Stock B. Portfolio AC is a portfolio with half of its money invested in Stock A and half invested in Stock C. Which of the following statements is CORRECT?

a. Portfolio AC has an expected return that is greater than 25%.
b. Portfolio AB has a standard deviation that is greater than 25%.
c. Portfolio AB has a standard deviation that is equal to 25%.
d. Portfolio AC has a standard deviation that is less than 25%.
e. Portfolio AC has an expected return that is less than 10%.

a. The portfolio's expected return is 15%.

. Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT?

a. The portfolio's expected return is 15%.
b. The portfolio's standard deviation is greater than 20%.
c. The portfolio's beta is greater than 1.2.
d. The portfolio's standard deviation is 20%.
e. The portfolio's beta is less than 1.2.

c. Portfolio P's expected return is equal to the expected return on Stock B.

. 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. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stocks is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

a. Portfolio P's expected return is equal to the expected return on Stock A.
b. Portfolio P's expected return is less than the expected return on Stock B.
c. Portfolio P's expected return is equal to the expected return on Stock B.
d. Portfolio P's expected return is greater than the expected return on Stock C.
e. Portfolio P's expected return is greater than the expected return on Stock B.

b. The beta of the portfolio is lower than the lowest of the three betas.

. In a portfolio of three randomly selected stocks, which of the following could NOT be true; i.e., which statement is false?

a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is lower than the lowest of the three betas.
c. The beta of the portfolio is higher than the highest of the three betas.
d. None of the above statements is obviously false, because they all could be true, but not necessarily at the same time.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

a. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.

. Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?

a. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
b. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
c. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
d. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.
e. Stock B's required return is double that of Stock A's.

a. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.

. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECT?

a. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
c. Portfolio AB's expected return is 11.0%.
d. Portfolio AB's beta is less than 1.2.
e. Portfolio AB's standard deviation is 17.5%.

d. Portfolio P has the same required return as the market (rM).

. You have a portfolio P that consists of 50% Stock X and 50% Stock Y. Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Given this information, which of the following statements is CORRECT?

a. The required return on Portfolio P is equal to the market risk premium (rM − rRF).
b. Portfolio P has a beta of 0.7.
c. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
d. Portfolio P has the same required return as the market (rM).
e. Portfolio P has a standard deviation of 20%.

c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.

. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)

a. The effect of a change in the market risk premium depends on the slope of the yield curve.
b. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.
c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
d. The effect of a change in the market risk premium depends on the level of the risk-free rate.
e. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

b. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.

. In historical data, we see that investments with the highest average annual returns also tend to have the highest standard deviations of annual returns. This observation supports the notion that there is a positive correlation between risk and return. Which of the following answers correctly ranks investments from highest to lowest risk (and return), where the security with the highest risk is shown first, the one with the lowest risk last?

a. Large-company stocks, small-company stocks, long-term corporate bonds, U.S. Treasury bills, long-term government bonds.
b. Small-company stocks, large-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
c. U.S. Treasury bills, long-term government bonds, long-term corporate bonds, small-company stocks, large-company stocks.
d. Large-company stocks, small-company stocks, long-term corporate bonds, long-term government bonds, U.S. Treasury bills.
e. Small-company stocks, long-term corporate bonds, large-company stocks, long-term government bonds, U.S. Treasury bills.

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

. 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.

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

. 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%.
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.

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

. 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.

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

. 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%.

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.

. 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.

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.

. 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.

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.

. 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.

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

. 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%.

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

. 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.

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

. 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.

d. Portfolio P has a beta of 1.0.

. 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.

c. If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

. 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.

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.

. 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 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.

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

. 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.

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

. 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?

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%.

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

. 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.

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.

. Which of the following statements is CORRECT?

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.

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

. 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.

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.

. 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.

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

. 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.

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

. 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.

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

. 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.

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.

. 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.

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

. 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 = .
c. All three of the above statements must hold for equilibrium to exist; that is = r = .
d. None of the above statements is correct.
e. The expected rate of return must be equal to the required rate of return; that is, = r.

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.

. 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 likelihoods 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.

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

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

• 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.

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

. 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.

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%.

. 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%.

e. Stock A's beta is 0.8333.

. 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.

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

. 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.

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.

. 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 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.

c. 9.90%

. 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%

d. 9.00%

. 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%

a. 1.20

. Erickson Inc. is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%. What is the project's coefficient of variation?

a. 1.20
b. 1.26
c. 1.32
d. 1.39
e. 1.46

a. 0.67

. McLeod Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the investment's coefficient of variation?

a. 0.67
b. 0.73
c. 0.81
d. 0.89
e. 0.98

e. 0.98

. 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

a. 1.17

. Shirley Paul's 2-stock portfolio has a total value of $100,000. $37,500 is invested in Stock A with a beta of 0.75 and the remainder is invested in Stock B with a beta of 1.42. What is her portfolio's beta?

a. 1.17
b. 1.23
c. 1.29
d. 1.35
e. 1.42

b. 11.20%; 1.23

. Ivan Knobel holds a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. He is in the process of buying 1,000 shares of Syngine Corp at $10 a share and adding it to his portfolio. Syngine has an expected return of 13.0% and a beta of 1.50. The total value of Ivan's current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Syngine stock?

a. 10.64%; 1.17
b. 11.20%; 1.23
c. 11.76%; 1.29
d. 12.35%; 1.36
e. 12.97%; 1.42

d. 12.00%

. Calculate the required rate of return for Everest Expeditions Inc., assuming that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years.

a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%

c. 11.95%

. Zacher Co.'s stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?

a. 11.36%
b. 11.65%
c. 11.95%
d. 12.25%
e. 12.55%

a. 5.80%

. Nystrand Corporation's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?

a. 5.80%
b. 5.95%
c. 6.09%
d. 6.25%
e. 6.40%

b. 0.3069

. Macintosh Lumber believes the following probability distribution exists for its stock. What is the coefficient of variation on the company's stock?

Probability Stock's
State of of State Expected
the Economy Occurring Return
Boom 0.45 25%
Normal 0.50 15%
Recession 0.05 5%

a. 0.2839
b. 0.3069
c. 0.3299
d. 0.3547
e. 0.3813

b. 0.988

. Martin Ortner holds a $200,000 portfolio consisting of the following stocks:

Stock Investment Beta
A $ 50,000 0.95
B 50,000 0.80
C 50,000 1.00
D 50,000 1.20
Total $200,000

What is the portfolio's beta?

a. 0.938
b. 0.988
c. 1.037
d. 1.089
e. 1.143

b. 1.13

. Sherrie Hymes holds a $200,000 portfolio consisting of the following stocks. The portfolio's beta is 0.875.

Stock Investment Beta
A $ 50,000 0.50
B 50,000 0.80
C 50,000 1.00
D 50,000 1.20
Total $200,000

If Sherrie replaces Stock A with another stock, E, which has a beta of 1.50, what will the portfolio's new beta be?

a. 1.07
b. 1.13
c. 1.18
d. 1.24
e. 1.30

b. 1.17

. Megan Ross holds the following portfolio:

Stock Investment Beta
A $150,000 1.40
B 50,000 0.80
C 100,000 1.00
D 75,000 1.20
Total $375,000

What is the portfolio's beta?

a. 1.06
b. 1.17
c. 1.29
d. 1.42
e. 1.56

d. -0.260

. Paul McLaren holds the following portfolio:

Stock Investment Beta
A $150,000 1.40
B 50,000 0.80
C 100,000 1.00
D 75,000 1.20
Total $375,000

Paul plans to sell Stock A and replace it with Stock E, which has a beta of 0.75. By how much will the portfolio beta change?

a. -0.190
b. -0.211
c. -0.234
d. -0.260
e. -0.286

e. 1.165

. Jenna holds a diversified $100,000 portfolio consisting of 20 stocks with $5,000 invested in each. The portfolio's beta is 1.12. Jenna plans to sell a stock with b = 0.90 and use the proceeds to buy a new stock with b = 1.80. What will the portfolio's new beta be?

a. 1.286
b. 1.255
c. 1.224
d. 1.194
e. 1.165

a. 14.38%

. Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.)

a. 14.38%
b. 14.74%
c. 15.11%
d. 15.49%
e. 15.87%

e. 3.38%

. Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

a. 2.75%
b. 2.89%
c. 3.05%
d. 3.21%
e. 3.38%

c. 9.21%

. Stock A's stock has a beta of 1.30, and its required return is 12.00%. Stock B's beta is 0.80. If the risk-free rate is 4.75%, what is the required rate of return on B's stock? (Hint: First find the market risk premium.)

a. 8.76%
b. 8.98%
c. 9.21%
d. 9.44%
e. 9.68%

d. 10.17%

. Barker Corp. has a beta of 1.10, the real risk-free rate is 2.00%, investors expect a 3.00% future inflation rate, and the market risk premium is 4.70%. What is Barker's required rate of return?

a. 9.43%
b. 9.67%
c. 9.92%
d. 10.17%
e. 10.42%

e. 14.95%

. Brodkey Shoes has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 13.00%. Based on the SML, what is the firm's required return?

a. 13.51%
b. 13.86%
c. 14.21%
d. 14.58%
e. 14.95%

b. 11.63%

. Gardner Electric has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return?

a. 11.34%
b. 11.63%
c. 11.92%
d. 12.22%
e. 12.52%

e. 11.77%

. Consider the following information and then calculate the required rate of return for the Universal Investment Fund, which holds 4 stocks. The market's required rate of return is 13.25%, the risk-free rate is 7.00%, and the Fund's assets are as follows:

Stock Investment Beta
A $200,000 1.50
B $300,000 -0.50
C $500,000 1.25
D $1,000,000 0.75

a. 9.58%
b. 10.09%
c. 10.62%
d. 11.18%
e. 11.77%

a. 14.00%

. Data for Atwill Corporation is shown below. Now Atwill acquires some risky assets that cause its beta to increase by 30%. In addition, expected inflation increases by 2.00%. What is the stock's new required rate of return?

Initial beta 1.00
Initial required return (rs) 10.20%
Market risk premium, RPM 6.00%
Percentage increase in beta 30.00%
Increase in inflation premium, IP 2.00%
a. 14.00%
b. 14.70%
c. 15.44%
d. 16.21%
e. 17.02%

a. 10.36%

. Fiske Roofing Supplies' stock has a beta of 1.23, its required return is 11.75%, and the risk-free rate is 4.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.)

a. 10.36%
b. 10.62%
c. 10.88%
d. 11.15%
e. 11.43%

c. 1.29

. Suppose Stan holds a portfolio consisting of a $10,000 investment in each of 8 different common stocks. The portfolio's beta is 1.25. Now suppose Stan decided to sell one of his stocks that has a beta of 1.00 and to use the proceeds to buy a replacement stock with a beta of 1.35. What would the portfolio's new beta be?

a. 1.17
b. 1.23
c. 1.29
d. 1.36
e. 1.43

b. 20.59%

. Returns for the Alcoff Company over the last 3 years are shown below. What's the standard deviation of the firm's returns? (Hint: This is a sample, not a complete population, so the sample standard deviation formula should be used.)

Year Return
2010 21.00%
2009 -12.50%
2008 25.00%

a. 20.08%
b. 20.59%
c. 21.11%
d. 21.64%
e. 22.18%

b. 18.62%

. Stuart Company's manager believes that economic conditions during the next year will be strong, normal, or weak, and she thinks that the firm's returns will have the probability distribution shown below. What's the standard deviation of the estimated returns? (Hint: Use the formula for the standard deviation of a population, not a sample.)

Economic
Conditions Prob. Return
Strong 30% 32.0%
Normal 40% 10.0%
Weak 30% -16.0%

a. 17.69%
b. 18.62%
c. 19.55%
d. 20.52%
e. 21.55%

d. 3.84%

. Assume that your cousin holds just one stock, Eastman Chemical Bonding(ECB), which he thinks has very little risk. You agree that the stock is relatively safe, but you want to demonstrate that his risk would be even lower if he were more diversified. You obtain the following returns data for Wilder's Creations and Buildings(WCB). Both companies have had less variability than most other stocks over the past 5 years. Measured by the standard deviation of returns, by how much would your cousin's risk have been reduced if he had held a portfolio consisting of 60% in ECB and the remainder in WCB? (Hint: Use the sample standard deviation formula.)

Year ECB WCB
2007 40.00% 40.00%
2008 -10.00% 15.00%
2009 35.00% -5.00%
2010 -5.00% -10.00%
2011 15.00% 35.00%

Average return = 15.00% 15.00%
Standard deviation = 22.64% 22.64%

a. 3.29%
b. 3.46%
c. 3.65%
d. 3.84%
e. 4.03%

a. 8.83%

. The $10.00 million mutual fund Henry manages has a beta of 1.05 and a 9.50% required return. The risk-free rate is 4.20%. Henry now receives another $5.00 million, which he invests in stocks with an average beta of 0.65. What is the required rate of return on the new portfolio? (Hint: You must first find the market risk premium, then find the new portfolio beta.)

a. 8.83%
b. 9.05%
c. 9.27%
d. 9.51%
e. 9.74%

b. 1.76

. Hazel Morrison, a mutual fund manager, has a $40 million portfolio with a beta of 1.00. The risk-free rate is 4.25%, and the market risk premium is 6.00%. Hazel expects to receive an additional $60 million, which she plans to invest in additional stocks. After investing the additional funds, she wants the fund's required and expected return to be 13.00%. What must the average beta of the new stocks be to achieve the target required rate of return?

a. 1.68
b. 1.76
c. 1.85
d. 1.94
e. 2.04

c. 11.11%

. Joel Foster is the portfolio manager of the SF Fund, a $3 million hedge fund that contains the following stocks. The required rate of return on the market is 11.00% and the risk-free rate is 5.00%. What rate of return should investors expect (and require) on this fund?

Stock Amount Beta
A $1,075,000 1.20
B 675,000 0.50
C 750,000 1.40
D 500,000 0.75
$3,000,000

a. 10.56%
b. 10.83%
c. 11.11%
d. 11.38%
e. 11.67%

c. 16.50%

. DHF Company has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.00% versus a required return on an average stock of 10.00%. Now the required return on an average stock increases by 30.0% (not percentage points). Neither betas nor the risk-free rate change. What would DHF's new required return be?

a. 14.89%
b. 15.68%
c. 16.50%
d. 17.33%
e. 18.19%

a. A; B.

. You have the following data on three stocks:

Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

As a risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

a. A; B.
b. B; C.
c. C; A.
d. C; B.
e. A; A.

c. Coefficient of variation; beta.

. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?

a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.

b. The beta of "the market," can change over time, sometimes drastically.

. Which of the following is NOT a potential problem with beta and its estimation?

a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta.
b. The beta of "the market," can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
d. There is a wide confidence interval around a typical stock's estimated beta.
e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

c. The expected return on Stock A should be greater than that on Stock B.

. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

e. When held in isolation, Stock A has greater risk than Stock B.
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.

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

. 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 rate of return; that is, .
b. The required rate of return must equal the realized rate of return; that is, .
c. all companies must pay dividends.
d. no companies can be in danger of declaring bankruptcy.
e. The expected rate of return must be equal to the required rate of return; that is, .

d. The slope of the CML is ( M - rRF)/σM..

. Which of the following statements is CORRECT?

a. The slope of the CML is ( M - rRF)/bM.
b. All portfolios that lie on the CML to the right of M are inefficient.
c. All portfolios that lie on the CML to the left of M are inefficient.
d. The slope of the CML is ( M - rRF)/σM..
e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

b. The beta of the portfolio is less than the betas of each of the individual stocks.

. In a portfolio of three different stocks, which of the following could NOT be true?

a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is less than the betas of each of the individual stocks.
c. The beta of the portfolio is greater than the beta of one or two of the individual stocks' betas.
d. The beta of the portfolio can not be equal to 1.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

c. bA < 0; bB = 0.

. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B
1 0.03 0.16 0.05
2 -0.05 0.20 0.05
3 0.01 0.18 0.05
4 -0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > +1; bB = 0.
b. bA = 0; bB = -1.
c. bA < 0; bB = 0.
d. bA < -1; bB = 1.
e. bA > 0; bB = 1.

b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.

. Which of the following statements is CORRECT?

a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.
e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

d. The distance of the plot points from the characteristic line is a measure of the stock's diversifiable risk.

. Which of the following statements is CORRECT?

a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The slope of the characteristic line is the stock's standard deviation.
c. The distance of the plot points from the characteristic line is a measure of the stock's market risk.
d. The distance of the plot points from the characteristic line is a measure of the stock's diversifiable risk.
e. "Characteristic line" is another name for the Security Market Line.

e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

. Which of the following statements is CORRECT?

a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.
b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM.
c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.
d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.
e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

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

. 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.

b. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.

. Assume an economy in which there are three securities: Stock A with rA = 10% and σA = 10%; Stock B with rB = 15% and σB = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT?

a. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
b. The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
c. The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.
e. The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

b. 1.1700

. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio?

a. 1.1139
b. 1.1700
c. 1.2311
d. 1.2927
e. 1.3573

b. 12.30%; 1.28

. Your mother's holds well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock?

rp bp
a. 11.69%; 1.22
b. 12.30%; 1.28
c. 12.92%; 1.34
d. 13.56%; 1.41
e. 14.24%; 1.48

d. 12.00%

. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.'s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc.

a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%

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