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# CHAPTER 10

## Some Lessons from Capital Market History

I.

DEFINITIONS

a
1. The excess return required from a risky asset over that required from a risk-free asset is
called the:
c. excess return.
d. average return.
e. variance.
VARIANCE
b
2. The average squared difference between the actual return and the average return is
called the:
a. volatility return.
b. variance.
c. standard deviation.
e. excess return.
STANDARD DEVIATION
c
3. The standard deviation for a set of stock returns can be calculated as the:
a. positive square root of the average return.
b. average squared difference between the actual return and the average return.
c. positive square root of the variance.
d. average return divided by N minus one, where N is the number of returns.
e. variance squared.
NORMAL DISTRIBUTION
d
4. A symmetric, bell-shaped frequency distribution that is completely defined by its mean
and standard deviation is the _____ distribution.
a. gamma
b. Poisson
c. bi-modal
d. normal
e. uniform
GEOMETRIC AVERAGE RETURN
d
5. The average compound return earned per year over a multi-year period is called the
_____ average return.
a. arithmetic
b. standard
c. variant
d. geometric
e. real

CHAPTER 10
ARITHMETIC AVERAGE RETURN
a
6. The return earned in an average year over a multi-year period is called the _____
average return.
a. arithmetic
b. standard
c. variant
d. geometric
e. real
EFFICIENT CAPITAL MARKET
e
7. An efficient capital market is one in which:
a. brokerage commissions are zero.
b. taxes are irrelevant.
d. security prices are guaranteed by the U.S. Securities and Exchange Commission to be
fair.
e. security prices reflect available information.
EFFICIENT MARKETS HYPOTHESIS
a
8. The notion that actual capital markets, such as the NYSE, are fairly priced is called the:
a. Efficient Markets Hypothesis (EMH).
b. Law of One Price.
c. Open Markets Theorem.
d. Laissez-Faire Axiom.
e. Monopoly Pricing Theorem.
STRONG FORM EFFICIENCY
b
9. The hypothesis that market prices reflect all available information of every kind is
called _____ form efficiency.
a. open
b. strong
c. semi-strong
d. weak
e. stable
SEMI STRONG FORM EFFICIENCY
c
10. The hypothesis that market prices reflect all publicly-available information is called
_____ form efficiency.
a. open
b. strong
c. semi-strong
d. weak
e. stable

CHAPTER 10
WEAK FORM EFFICIENCY
d
11. The hypothesis that market prices reflect all historical information is called _____ form
efficiency.
a. open
b. strong
c. semi-strong
d. weak
e. stable
II. CONCEPTS
TOTAL RETURN
d
12. The total percentage return on an equity investment is computed using the formula
______, where P1 is the purchase cost, P2 represents the sale proceeds, and d is the
dividend income.
a. (P2 P1) (P2 + d)
b. (P1 P2) (P2 + d)
c. (P1 P2 d) P1
d. (P2 P1 + d) P1
e. (P2 P1 + d) P2
DIVIDEND YIELD
a
13. The dividend yield is equal to _____, where P1 is the purchase cost, P2 represents the
sale proceeds, and d is the dividend income.
a. d P1
b. d P1
c. d P2
d. d P2
e. d (P1 + P2)
DIVIDEND YIELD
c
14. The Zolo Co. just declared that they are increasing their annual dividend from \$1.00 per
share to \$1.25 per share. If the stock price remains constant, then:
a. the capital gains yield will decrease.
b. the capital gains yield will increase.
c. the dividend yield will increase.
d. the dividend yield will also remain constant.
e. neither the capital gains yield nor the dividend yield will change.
CAPITAL GAIN
b
15. The dollar amount of the capital gain on an investment is computed as _____, where P1
is the purchase cost, P2 represents the sale proceeds, and d is the dividend income.
a. P1 P2
b. P2 P1
c. P2 P1
d. P1 P2 + d
e. P2 P1 d

CHAPTER 10
TOTAL RETURN
e
16. The capital gains yield plus the dividend yield on a security is called the:
a. variance of returns.
b. geometric return.
c. average period return.
d. summation of returns.
e. total return.
REAL RETURN
c
17. The real rate of return on a stock is approximately equal to the nominal rate of return:
a. multiplied by (1 + inflation rate).
b. plus the inflation rate.
c. minus the inflation rate.
d. divided by (1 + inflation rate).
e. divided by (1- inflation rate).
REAL RETURN
c
18. As long as the inflation rate is positive, the real rate of return on a security investment
will be ____ the nominal rate of return.
a. greater than
b. equal to
c. less than
d. greater than or equal to
e. unrelated to
HISTORICAL RECORD
d
19. A portfolio of large company stocks would contain which one of the following types of
securities?
a. stock of the firms which represent the smallest 20 percent of the companies listed on the
NYSE
b. U.S. Treasury bills
c. long-term corporate bonds
d. stocks of firms included in the S&P 500 index
e. long-term government bonds
HISTORICAL RECORD
d
20. Based on the period of 1926 through 2003, _____ have tended to outperform other
securities over the long-term.
a. U.S. Treasury bills
b. large company stocks
c. long-term corporate bonds
d. small company stocks
e. long-term government bonds

CHAPTER 10
HISTORICAL RECORD
a
21. Which one of the following types of securities has tended to produce the lowest real
rate of return for the period 1926 through 2003?
a. U.S. Treasury bills
b. long-term government bonds
c. small company stocks
d. large company stocks
e. long-term corporate bonds
HISTORICAL RECORD
d
22. On average, for the period 1926 through 2003:
a. the real rate of return on U.S. Treasury bills has been negative.
b. small company stocks have underperformed large company stocks.
c. long-term government bonds have produced higher returns than long-term corporate
bonds.
d. the risk premium on long-term corporate bonds has exceeded the risk premium on longterm government bonds.
e. the risk premium on large company stocks has exceeded the risk premium on small
company stocks.
HISTORICAL RECORD
e
23. Over the period of 1926 through 2003, the annual rate of return on _____ has been
more volatile than the annual rate of return on_____:
a. large company stocks; small company stocks.
b. long-term government bonds; long-term corporate bonds.
c. U.S. Treasury bills; long-term government bonds.
d. long-term corporate bonds; small company stocks.
e. large company stocks; long-term corporate bonds.
HISTORICAL RECORD
d
24. During the period of 1926 through 2003 the annual rate of inflation:
a. was always positive.
b. was only negative during the 3 years of the Great Depression.
c. never exceeded 10 percent.
d. fluctuated significantly from one year to the next.
e. tended to be negative during the years of World War II.
HISTORICAL RECORD
e
25. Based on the period of 1926 through 2003 the annual rate of inflation ranged from
_____ percent to _____ percent.
a. -5; 6
b. -5; 9
c. -7; 6
d. -7; 15
e. -10; 18

CHAPTER 10
HISTORICAL RECORD
b
26. \$1 invested in U.S. Treasury bills in 1926 would have increased in value to ____ by
2003.
a. \$10
b. \$17
c. \$30
d. \$43
e. \$60
HISTORICAL RECORD
d
27. Which one of the following is a correct ranking of securities based on their volatility
over the period of 1926 to 2003? Rank from highest to lowest.
a. large company stocks, U.S. Treasury bills, long-term government bonds
b. small company stocks, long-term corporate bonds, large company stocks
c. small company stocks, long-term government bonds, long-term corporate bonds
d. large company stocks, long-term corporate bonds, long-term government bonds
e. long-term government bonds, long-term corporate bonds, U.S. Treasury bills
HISTORICAL RECORD
d
28. \$1 invested in small company stocks in 1926 would have increased in value to _____ by
2003.
a. \$60
b. \$2,284
c. \$4,092
d. \$10,953
e. \$13,185
HISTORICAL RECORD
d
29. The highest rate of annual inflation between 1926 and 2003 was_____ percent.
a. 7
b. 10
c. 13
d. 18
e. 22
HISTORICAL RECORD
e
30. The annual return on long-term government bonds has ranged between _____ percent
and _____ percent during the period 1926 to 2003.
a. -2; 8
b. -4; 6
c. -5; 10
d. -6; 29
e. -7; 44

CHAPTER 10
HISTORICAL RECORD
e
31. Over the period of 1926 to 2003, small company stocks had an average return of _____
percent.
a. 8.8
b. 10.2
c. 12.4
d. 14.6
e. 17.5
HISTORICAL AVERAGE RETURNS
c
32. Over the period of 1926 to 2003, the average rate of inflation was _____ percent.
a. 2.0
b. 2.7
c. 3.1
d. 3.8
e. 4.3
HISTORICAL AVERAGE RETURNS
c
33. The average annual return on long-term corporate bonds for the period of 1926 to 2003
was _____ percent.
a. 3.8
b. 5.8
c. 6.2
d. 7.9
e. 8.4
AVERAGE RETURNS
b
34. The average annual return on small company stocks was about _____ percent greater
than the average annual return on large-company stocks over the period of 1926 to
2003.
a. 3
b. 5
c. 7
d. 9
e. 11
a
35. The average risk premium on U.S. Treasury bills over the period of 1926 to 2003 was
_____ percent.
a. 0.0
b. 1.6
c. 2.2
d. 3.1
e. 3.8

CHAPTER 10
a
36. Which one of the following is a correct statement concerning risk premium?
a. The greater the volatility of returns, the greater the risk premium.
b. The lower the volatility of returns, the greater the risk premium.
c. The lower the average rate of return, the greater the risk premium.
d. The risk premium is not correlated to the average rate of return.
e. The risk premium is not affected by the volatility of returns.
c
37. The risk premium is computed by ______ the average return for the investment.
a. subtracting the inflation rate from
b. adding the inflation rate to
c. subtracting the average return on the U.S. Treasury bill from
d. adding the average return on the U.S. Treasury bill to
e. subtracting the average return on long-term government bonds from
c
38. The excess return you earn by moving from a relatively risk-free investment to a risky
investment is called the:
a. geometric average return.
e. arithmetic average return.
b
39. To convince investors to accept greater volatility in the annual rate of return on an
investment, you must:
c. decrease the expected rate of return.
d. decrease the risk-free rate of return.
e. increase the risk-free rate of return.
FREQUENCY DISTRIBUTION
a
40. Which one of the following takes the shape of a bell curve?
a. frequency distribution
b. variance
d. standard deviation
e. deviation of returns

CHAPTER 10
VARIANCE
e
41. Which of the following statements are correct concerning the variance of the annual
returns on an investment?
I.
The larger the variance, the more the actual returns tend to differ from the average
return.
II. The larger the variance, the larger the standard deviation.
III. The larger the variance, the greater the risk of the investment.
IV. The larger the variance, the higher the expected return.
a. I and III only
b. II, III, and IV only
c. I, III, and IV only
d. I, II, and III only
e. I, II, III, and IV
VARIANCE
a
42. The variance of returns is computed by dividing the sum of the:
a. squared deviations by the number of returns minus one.
b. average returns by the number of returns minus one.
c. average returns by the number of returns plus one.
d. squared deviations by the average rate of return.
e. squared deviations by the number of returns plus one.
STANDARD DEVIATION
b
43. Which of the following statements concerning the standard deviation are correct?
I.
The greater the standard deviation, the lower the risk.
II. The standard deviation is a measure of volatility.
III. The higher the standard deviation, the less certain the rate of return in any one given
year.
IV. The higher the standard deviation, the higher the expected return.
a. I and III only
b. II, III, and IV only
c. I, III, and IV only
d. I, II, and III only
e. I, II, III, and IV
STANDARD DEVIATION
a
44. The standard deviation on small company stocks:
I.
is greater than the standard deviation on large company stocks.
II. is less than the standard deviation on large company stocks.
III. had an average value of about 33 percent for the period 1926 to 2003.
IV. had an average value of about 20 percent for the period 1926 to 2003.
a. I and III only
b. I and II only
c. II and III only
d. II and IV only
e. I and IV only

CHAPTER 10
ARITHMETIC VS. GEOMETRIC AVERAGES
b
45. Estimates using the arithmetic average will probably tend to _____ values over the
long-term while estimates using the geometric average will probably tend to _____
values over the short-term.
a. overestimate; overestimate
b. overestimate; underestimate
c. underestimate; overestimate
d. underestimate; underestimate
e. accurately; accurately
MARKET EFFICIENCY
d
46. In an efficient market, the price of a security will:
a. always rise immediately upon the release of new information with no further price
b. react to new information over a two-day period after which time no further price
adjustments related to that information will occur.
c. rise sharply when new information is first released and then decline to a new stable
level by the following day.
d. react immediately to new information with no further price adjustments related to that
information.
e. be slow to react for the first few hours after new information is released allowing time
for that information to be reviewed and analyzed.
MARKET EFFICIENCY
c
47. If the financial markets are efficient, then investors should expect their investments in
those markets to:
a. earn extraordinary returns on a routine basis.
b. generally have positive net present values.
c. generally have zero net present values.
d. produce arbitrage opportunities on a routine basis.
e. produce negative returns on a routine basis.
MARKET EFFICIENCY
d
48. Which one of the following statements is correct concerning market efficiency?
a. Real asset markets are more efficient than financial markets.
b. If a market is efficient, arbitrage opportunities should be common.
c. In an efficient market, some market participants will have an advantage over others.
d. A firm will generally receive a fair price when it sells shares of stock.
e. New information will gradually be reflected in a stocks price to avoid any sudden
change in the price of the stock.
MARKET EFFICIENCY
c
49. Financial markets fluctuate daily because they:
a. are inefficient.
b. slowly react to new information.
c. are continually reacting to new information.
d. offer tremendous arbitrage opportunities.
e. only reflect historical information.

CHAPTER 10
MARKET EFFICIENCY
d
50. Insider trading does not offer any advantages if the financial markets are:
a. weak form efficient.
b. semiweak-form efficient.
c. semistrong-form efficient.
d. strong-form efficient.
e. inefficient.
MARKET EFFICIENCY
e
51. According to theory, studying historical prices in order to identify mispriced stocks will
not work in markets that are _____ efficient.
I.
weak-form
II. semistrong-form
III. strong-form
a. I only
b. II only
c. I and II only
d. II and III only
e. I, II, and III
MARKET EFFICIENCY
e
52. Which of the following tend to reinforce the argument that the financial markets are
efficient?
I.
Information spreads rapidly in todays world.
II. There is tremendous competition in the financial markets.
III. Market prices continually fluctuate.
IV. Market prices react suddenly to unexpected news announcements.
a. I and III only
b. II and IV only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
MARKET EFFICIENCY
a
53. If you excel in analyzing the future outlook of firms, you would prefer that the financial
markets be ____ form efficient so that you can have an advantage in the marketplace.
a. weak
b. semiweak
c. semistrong
d. strong
e. perfect

CHAPTER 10
MARKET EFFICIENCY
c
54. Your best friend works in the finance office of the Delta Corporation. You are aware
that this friend trades Delta stock based on information he overhears in the office. You
know that this information is not known to the general public. Your friend continually
brags to you about the profits he earns trading Delta stock. Based on this information,
you would tend to argue that the financial markets are at best _____ form efficient.
a. weak
b. semiweak
c. semistrong
d. strong
e. perfect
MARKET EFFICIENCY
c
55. The U.S. Securities and Exchange Commission periodically charges individuals for
insider trading and claims those individuals have made unfair profits. Based on this
fact, you would tend to argue that the financial markets are at best _____ form efficient.
a. weak
b. semiweak
c. semistrong
d. strong
e. perfect
MARKET EFFICIENCY
b
56. Individuals that continually monitor the financial markets seeking mispriced securities:
a. tend to make substantial profits on a daily basis.
b. tend to make the markets more efficient.
c. are never able to find a security that is temporarily mispriced.
d. are always quite successful using only well-known public information as their basis of
evaluation.
e. are always quite successful using only historical price information as their basis of
evaluation.
III. PROBLEMS
DOLLAR RETURNS
b
57. One year ago, you purchased a stock at a price of \$32.50. The stock pays quarterly
dividends of \$.40 per share. Today, the stock is worth \$34.60 per share. What is the
total amount of your dividend income to date from this investment?
a. \$.40
b. \$1.60
c. \$2.10
d. \$2.50
e. \$3.70

CHAPTER 10
DOLLAR RETURNS
d
58. Six months ago, you purchased 100 shares of stock in ABC Co. at a price of \$43.89 a
share. ABC stock pays a quarterly dividend of \$.10 a share. Today, you sold all of your
shares for \$45.13 per share. What is the total amount of your capital gains on this
investment?
a. \$1.24
b. \$1.64
c. \$40.00
d. \$124.00
e. \$164.00
DOLLAR RETURNS
d
59. A year ago, you purchased 300 shares of IXC Technologies, Inc. stock at a price of
\$9.03 per share. The stock pays an annual dividend of \$.10 per share. Today, you sold
all of your shares for \$28.14 per share. What is your total dollar return on this
investment?
a. \$5,703
b. \$5,733
c. \$5,753
d. \$5,763
e. \$5,853
DIVIDEND YIELD
b
60. You purchased 200 shares of stock at a price of \$36.72 per share. Over the last year,
you have received total dividend income of \$322. What is the dividend yield?
a. 3.2 percent
b. 4.4 percent
c. 6.8 percent
d. 9.2 percent
e. 11.4 percent
DIVIDEND YIELD
d
61. Winslow, Inc. stock is currently selling for \$40 a share. The stock has a dividend yield
of 3.8 percent. How much dividend income will you receive per year if you purchase
500 shares of this stock?
a. \$152
b. \$190
c. \$329
d. \$760
e. \$1,053
DIVIDEND YIELD
c
62. One year ago, you purchased a stock at a price of \$32 a share. Today, you sold the stock
and realized a total return of 25 percent. Your capital gain was \$6 a share. What was
your dividend yield on this stock?
a. 1.25 percent
b. 3.75 percent
c. 6.25 percent
d. 18.75 percent
e. 21.25 percent

CHAPTER 10
CAPITAL GAIN
a
63. You just sold 200 shares of Langley, Inc. stock at a price of \$38.75 a share. Last year
you paid \$41.50 a share to buy this stock. Over the course of the year, you received
dividends totaling \$1.64 per share. What is your capital gain on this investment?
a. -\$550
b. -\$222
c. -\$3
d. \$550
e. \$878
CAPITAL GAIN
b
64. You purchased 300 shares of Deltona, Inc. stock for \$44.90 a share. You have received
a total of \$630 in dividends and \$14,040 in proceeds from selling the shares. What is
your capital gains yield on this stock?
a. 4.06 percent
b. 4.23 percent
c. 4.68 percent
d. 8.55 percent
e. 8.91 percent
CAPITAL GAIN
d
65. Today, you sold 200 shares of SLG, Inc. stock.. Your total return on these shares is 12.5
percent. You purchased the shares one year ago at a price of \$28.50 a share. You have
received a total of \$280 in dividends over the course of the year. What is your capital
gains yield on this investment?
a. 4.80 percent
b. 5.00 percent
c. 6.67 percent
d. 7.59 percent
e. 11.67 percent
TOTAL RETURN
d
66. Six months ago, you purchased 1,200 shares of ABC stock for \$21.20 a share. You have
received dividend payments equal to \$.60 a share. Today, you sold all of your shares for
\$22.20 a share. What is your total dollar return on this investment?
a. \$720
b. \$1,200
c. \$1,440
d. \$1,920
e. \$3,840

CHAPTER 10
TOTAL RETURN
c
67. Eight months ago, you purchased 400 shares of Winston, Inc. stock at a price of \$54.90
a share. The company pays quarterly dividends of \$.50 a share. Today, you sold all of
your shares for \$49.30 a share. What is your total percentage return on this
investment?
a. -10.2 percent
b. -9.3 percent
c. -8.4 percent
d. 12.0 percent
e. 13.4 percent
REAL RETURN
b
68. Last year, you purchased a stock at a price of \$51.50 a share. Over the course of the
year, you received \$1.80 in dividends and inflation averaged 2.8 percent. Today, you
sold your shares for \$53.60 a share. What is your approximate real rate of return on
this investment?
a. 2.4 percent
b. 4.8 percent
c. 6.2 percent
d. 7.6 percent
e. 10.4 percent
REAL RETURN
e
69. Seven months ago, you purchased a stock at a price of \$36.04 a share. Today, you sold
those shares for \$43.15 a share. During the past seven months, you have received
dividends totaling \$0.24 a share while inflation has averaged 3.6 percent. What is your
approximate real rate of return on this investment?
a. 12.9 percent
b. 13.4 percent
c. 16.1 percent
d. 16.5 percent
e. 16.8 percent
STANDARD DEVIATION
d
70. A stock had returns of 8 percent, -2 percent, 4 percent, and 16 percent over the past four
years. What is the standard deviation of this stock for the past four years?
a. 6.3 percent
b. 6.6 percent
c. 7.1 percent
d. 7.5 percent
e. 7.9 percent

CHAPTER 10
RETURN DISTRIBUTIONS
a
71. A stock has an expected rate of return of 8.3 percent and a standard deviation of 6.4
percent. Which one of the following best describes the probability that this stock will
lose 11 percent or more in any one given year?
a. less than 0.5 percent
b. less than 1.0 percent
c. less than 1.5 percent
d. less than 2.5 percent
e. less than 5 percent
RETURN DISTRIBUTIONS
d
72. A stock has returns of 3 percent, 18 percent, -24 percent, and 16 percent for the past
four years. Based on this information, what is the 95 percent probability range for any
one given year?
a. -8.4 to 11.7 percent
b. -16.1 to 22.6 percent
c. -24.5 to 34.3 percent
d. -35.4 to 41.9 percent
e. -54.8 to 61.3 percent
RETURN DISTRIBUTIONS
c
73. A stock had returns of 8 percent, 14 percent, and 2 percent for the past three years.
Based on these returns, what is the probability that this stock will earn at least 20
percent in any one given year?
a. 0.5 percent
b. 1.0 percent
c. 2.5 percent
d. 5.0 percent
e. 16.0 percent
RETURN DISTRIBUTIONS
c
74. A stock had returns of 11 percent, 1 percent, 9 percent, 15 percent, and -6 percent for
the past five years. Based on these returns, what is the approximate probability that this
stock will earn at least 23 percent in any one given year?
a. 0.5 percent
b. 1.0 percent
c. 2.5 percent
d. 5.0 percent
e. 16.0 percent
RETURN DISTRIBUTIONS
c
75. A stock had returns of 8 percent, 39 percent, 11 percent, and -24 percent for the past
four years. Which one of the following best describes the probability that this stock will
NOT lose more than 43 percent in any one given year?
a. 84.0 percent
b. 95.0 percent
c. 97.5 percent
d. 99.0 percent
e. 99.5 percent
RETURN DISTRIBUTIONS

CHAPTER 10
b

76. Over the past five years, a stock produced returns of 14 percent, 22 percent, -16 percent,
2 percent, and 10 percent. What is the probability that an investor in this stock will
NOT lose more than 8 percent nor earn more than 21 percent in any one given year?
a. 34 percent
b. 68 percent
c. 95 percent
d. 99 percent
e. 100 percent

ARITHMETIC AVERAGE
b
77. What are the arithmetic and geometric average returns for a stock with annual returns
of 4 percent, 9 percent, -6 percent, and 18 percent?
a. 5.89 percent; 6.25 percent
b. 6.25 percent; 5.89 percent
c. 6.25 percent; 8.33 percent
d. 8.3 percent; 5.89 percent
e. 8.3 percent; 6.25 percent
ARITHMETIC VS. GEOMETRIC AVERAGES
c
78. What are the arithmetic and geometric average returns for a stock with annual returns
of 21 percent, 8 percent, -32 percent, 41 percent, and 5 percent?
a. 5.6 percent; 8.6 percent
b. 5.6 percent; 6.3 percent
c. 8.6 percent; 5.6 percent
d. 8.6 percent; 8.6 percent
e. 8.6 percent; 6.3 percent
GEOMETRIC AVERAGE
b
79. A stock had returns of 6 percent, 13 percent, -11 percent, and 17 percent over the past
four years. What is the geometric average return for this time period?
a. 4.5 percent
b. 5.7 percent
c. 6.2 percent
d. 7.3 percent
e. 8.2 percent

CHAPTER 10
GEOMETRIC AVERAGE
b
80. A stock had the following prices and dividends. What is the geometric average return
on this stock?
Year Price Dividend
1
\$23.19

2
\$24.90 \$.23
3
\$23.18
\$.24
4
\$24.86
\$.25
a. 3.2 percent
b. 3.4 percent
c. 3.6 percent
d. 3.8 percent
e. 4.0 percent
IV. ESSAYS
EFFICIENT MARKETS
81. Define the three forms of market efficiency.
The student should present a straightforward discussion of weak (all past prices are in the
current price), semi-strong (all public information is in the current price), and strong form
(all information is in the current price) market efficiency.
HISTORICAL RETURNS
82. What securities have offered the highest average annual returns over the last several
decades? Can we conclude that return and risk are related in real life?
The purpose of this question is to check student understanding of the capital market history
discussion of the chapter, as well as to reiterate the concept of the risk-return trade-off. The
securities categories discussed in the chapter are listed below in descending order of
historical returns (and risk):
1.
small company stocks
2.
large company stocks
3.
long-term corporate bonds
4.
long-term government bonds
5.
U.S. Treasury bills
By learning this hierarchy, and given that they are familiar with the attributes of each
security, students should be left with little doubt that the maxim The greater the risk, the
greater the return is an apt description of financial markets.
LESSONS
83. What are the lessons learned from capital market history? What evidence is there to suggest
these lessons are correct?
First, there is a reward for bearing risk, and second, the greater the risk, the greater the
reward. As evidence, the students should provide a brief discussion of the historical rates of
return and standard deviation of returns of the various asset classes discussed in the text.

CHAPTER 10
EFFICIENT MARKETS
84. Explain why it is that in an efficient market, investments have an expected NPV of zero.
In an efficient market, prices are fair so that the cost of an investment is neither too high
nor too low. Thus, on average, investments in that market will yield a zero NPV. Investors
get exactly what they pay for when they buy a security in an efficient market and firms get
exactly what their stocks and bonds are worth when they sell them.
EFFICIENT MARKETS
85. Do you think the lessons from capital market history will hold for each year in the future?
That is, as an example, if you buy small stocks will your investment always outperform
U.S. Treasury bonds?
The student should realize that we are working with averages, so they should not expect
riskier assets to always outperform less risky assets. The student should explain somewhere
in their answer that this gets to the heart of what risk is. That is, the reason you expect to
earn a higher return over the long haul is that your variability in price from year to year can
be significant.
RISK AND RETURN
86. Suppose you have \$30,000 invested in the stock market and your banker comes to you and
tries to get you to move that money into the banks certificates of deposit (CDs). He
explains that the CDs are 100% government insured and that you are taking unnecessary
risks by being in the stock market. How would you respond?
The usual response is that bank CDs typically will offer a very low rate of return because
of their low level of risk. Even if students do not know the relationship between yields on
CDs and historical returns on stocks, they should recognize that because of the risk
differences the CDs must have a lower expected return. So, if the investor in the question is
willing to trade off some safety in order to have the chance to earn larger returns, the stock
market is the correct investment.
MARKET EFFICIENCY
87. Suppose your cousin invests in the stock market and doubles her money in a single year
while the market, on average, earned a return of only about 15 percent. Is your cousins
performance a violation of market efficiency?
No, market efficiency does not preclude investors from beating the market. It is entirely
possible to earn higher returns than the market at times. However, if your cousin is able to
do so consistently, then there would certainly be some doubt cast upon market efficiency.

CHAPTER 10
88. How do you think the stock market would be affected if the laws were changed so that
trading on insider information was no longer illegal? What would be the impact on the goal
of the financial manager if such a change were to occur?
This open-ended question allows students to ponder market efficiency from a different
angle. By allowing insiders to trade on their information, it would be possible for insiders to
take advantage of uninformed investors. This may keep some investors out of the market
because they would perceive the prices observed as no longer being fair. This change
would provide a serious blow to the efficiency of the market and would also further
complicate the issue of whos interest managers are working to satisfy.
MARKET EFFICIENCY
89. Why should a financial decision maker such as a corporate treasurer or CFO be concerned
with market efficiency?
Good answers to this question might indicate that market efficiency is a necessary condition
for the maximize shareholder wealth rule. Unless we are confident that the market price
is an economically meaningful number, seeking to maximize it is silly. Similarly, students
should recognize that there is a very strong link between managerial decisions and the value
of the firm, as reflected in security prices. Finally, as a preview of the cost of capital
discussion in later chapters, instructors might point out that market efficiency ensures that
the required returns on new securities will be directly related to the risk-return profile of the
firm and, therefore, to managerial actions.

()
CH2
CH2
CH1

NPV
1.

2.

3.

4.

5.

6.

## A conflict of interest between the stockholders and management of a firm is called:

a.

stockholders liability.

b.

corporate breakdown.

c.

## the agency problem.

d.

corporate activism.

e.

legal liability.

a.

b.

c.

d.

## the costs of any conflicts of interest between stockholders and management.

e.

the total interest paid to creditors over the lifetime of the firm.

Financial managers should strive to maximize the current value per share of the existing stock because:
a.

doing so guarantees the company will grow in size at the maximum possible rate.

b.

c.

## the current stockholders are the owners of the corporation.

d.

doing so means the firm is growing in size faster than its competitors.

e.

## the managers often receive shares of stock as part of their compensation.

The decisions made by financial managers should all be ones which increase the:
a.

b.

c.

d.

e.

## financial distress of the firm.

Which one of the following actions by a financial manager creates an agency problem?
a.

refusing to borrow money when doing so will create losses for the firm

b.

refusing to lower selling prices if doing so will reduce the net profits

c.

## agreeing to expand the company at the expense of stockholders value

d.

agreeing to pay bonuses based on the market value of the company stock

e.

increasing current costs in order to increase the market value of the stockholders equity

Which of the following help convince managers to work in the best interest of the stockholders?
I.

II.

## III. threat of a proxy fight

IV. threat of conversion to a partnership
1

7.

a.

I and II only

c.

e.

a.

b.

c.

d.

e.

1.C

2.D

3.C

4.D

5.C

6.C

7.B

()

CH2

1.

## Working capital management includes decisions concerning which of the following?

I. accounts payable
II. long-term debt
III. accounts receivable
IV. Inventory
a. I and II only

## b. I and III only

c. II and IV only

2.

## Working capital management:

a. ensures that sufficient equipment is available to produce the amount of product desired on a daily basis.
b. ensures that long-term debt is acquired at the lowest possible cost.
c. ensures that dividends are paid to all stockholders on an annual basis.
d. balances the amount of company debt to the amount of available equity.
e. is concerned with the upper portion of the balance sheet.

3.

## Net working capital is defined as:

a. total liabilities minus shareholders equity.
b. current liabilities minus shareholders equity.
c. fixed assets minus long-term liabilities.
d. total assets minus total liabilities.
e. current assets minus current liabilities.

4.

I. equipment

II. Inventory

## III. accounts payable

IV. Cash
2

a. II and IV only

## e. II, III, and IV only

5.

A _____ standardizes items on the income statement and balance sheet as a percentage of total sales and total
assets, respectively.
a. tax reconciliation statement
b. statement of standardization
c. statement of cash flows
d. common-base year statement
e. common-size statement

6.

Financial ratios that measure a firms ability to pay its bills over the short run without undue stress are known
as _____ ratios.
a. asset management

b. long-term solvency

c. short-term solvency

d. profitability

e. market value
7.

## The current ratio is measured as:

a. current assets minus current liabilities.
b. current assets divided by current liabilities.
c. current liabilities minus inventory, divided by current assets.
d. cash on hand divided by current liabilities.
e. current liabilities divided by current assets.

8.

## The quick ratio is measured as:

a. current assets divided by current liabilities.
b. cash on hand plus current liabilities, divided by current assets.
c. current liabilities divided by current assets, plus inventory.
d. current assets minus inventory, divided by current liabilities.
e. current assets minus inventory minus current liabilities.

9.

## The cash ratio is measured as:

a. current assets divided by current liabilities.
b. current assets minus cash on hand, divided by current liabilities.
c. current liabilities plus current assets, divided by cash on hand.
d. cash on hand plus inventory, divided by current liabilities.
e. cash on hand divided by current liabilities.

10. The financial ratio measured as total assets minus total equity, divided by total assets, is the:
a. total debt ratio.

b. equity multiplier.

c. debt-equity ratio.

d. current ratio.

## e. times interest earned ratio.

11. The debt-equity ratio is measured as total:
a. equity minus total debt.

3

## e. debt minus total assets, divided by total equity.

12. Ratios that measure how efficiently a firm uses its assets to generate sales are known as _____ ratios.
a. asset management

b. long-term solvency

c. short-term solvency

d. profitability

e. market value
13. The inventory turnover ratio is measured as:
a. total sales minus inventory.

## e. inventory plus cost of goods sold.

14. The financial ratio days sales in inventory is measured as:
a. inventory turnover plus 365 days.
b. inventory times 365 days.
c. inventory plus cost of goods sold, divided by 365 days.
d. 365 days divided by the inventory.
e. 365 days divided by the inventory turnover.
15. The receivables turnover ratio is measured as:
a. sales plus accounts receivable.
b. sales divided by accounts receivable.
c. sales minus accounts receivable, divided by sales.
d. accounts receivable times sales.
e. accounts receivable divided by sales.
16. The financial ratio days sales in receivables is measured as:
a. receivables turnover plus 365 days.
b. accounts receivable times 365 days.
c. accounts receivable plus sales, divided by 365 days.
d. 365 days divided by the receivables turnover.
e. 365 days divided by the accounts receivable.
17. The total asset turnover ratio is measured as:
a. sales minus total assets.

e.

## total assets plus sales.

1. e 2. e 3. e 4. a 5. e 6. c 7. b 8. d 9. e
11. c 12. a 13. c 14. e 15. b 16. d 17. b

10. a

Ch3 (
()+
)+
)++Ch.2
+Ch.2
1.

Ratios that measure a firms financial leverage are known as _____ ratios.
a. asset management

b. long-term solvency

c. short-term solvency

d. profitability

e. market value
2.

## The equity multiplier ratio is measured as total:

a. equity divided by total assets.
b. equity plus total debt.
c. assets minus total equity, divided by total assets.
d. assets plus total equity, divided by total debt.
e. assets divided by total equity.

3.

The financial ratio measured as earnings before interest and taxes, divided by interest expense is the:
a. cash coverage ratio.

b. debt-equity ratio.

d. gross margin.

## e. total debt ratio.

4.

The financial ratio measured as earnings before interest and taxes, plus depreciation, divided by interest
expense, is the:
a. cash coverage ratio.

b. debt-equity ratio.

d. gross margin.

## e. total debt ratio.

5.

Ratios that measure how efficiently a firms management uses its assets and equity to generate bottom line net
income are known as _____ ratios.
a. asset management

b. long-term solvency

c. short-term solvency

d. profitability

e. market value
6.

The financial ratio measured as net income divided by sales is known as the firms:
a. profit margin.

b. return on assets.

c. return on equity.

d. asset turnover.

## e. earnings before interest and taxes.

7.

The financial ratio measured as net income divided by total assets is known as the firms:
a. profit margin.

b. return on assets.

c. return on equity.

d. asset turnover.

## e. earnings before interest and taxes.

8.

The financial ratio measured as net income divided by total equity is known as the firms:
a. profit margin.

b. return on assets.

c. return on equity.

d. asset turnover.

## e. earnings before interest and taxes.

9.

The financial ratio measured as the price per share of stock divided by earnings per share is known as the:
a. return on assets.

b. return on equity.

c. debt-equity ratio.

d. price-earnings ratio.

e. Du Pont identity.
10. The market-to-book ratio is measured as:
a. total equity divided by total assets.
b. net income times market price per share of stock.
c. net income divided by market price per share of stock.
d. market price per share of stock divided by earnings per share.
e. market value of equity per share divided by book value of equity per share.

11. The _____ breaks down return on equity into three component parts.
a. Du Pont identity
b. return on assets
c. statement of cash flows
e. equity multiplier

## d. asset turnover ratio

12. On a common-size balance sheet, all _____ accounts are shown as a percentage of _____.
a. income; total assets

c. asset; sales

## d. liability; total assets

e. equity; sales
13. Which one of the following statements is correct concerning ratio analysis?
a. A single ratio is often computed differently by different individuals.
b. Ratios do not address the problem of size differences among firms.
c. Only a very limited number of ratios can be used for analytical purposes.
d. Each ratio has a specific formula that is used consistently by all analysts.
e. Ratios can not be used for comparison purposes over periods of time.
14. Which of the following are liquidity ratios?
I. cash coverage ratio

b. I and II only

## e. I, II, III, and IV

15. An increase in which one of the following accounts increases a firms current ratio without affecting its quick
ratio?
a. accounts payable

b. cash

c. inventory

d. accounts receivable

e. fixed assets
16. A supplier, who requires payment within ten days, is most concerned with which one of the following ratios
when granting credit?
a. current

b. cash

c. debt-equity

e. total debt
6

d. quick

17. A firm has a total debt ratio of .47. This means that that firm has 47 cents in debt for every:
a. \$1 in equity.

b. \$1 in total sales.

c. \$1 in current assets.

d. \$.53 in equity.

## e. \$.53 in total assets.

18. A banker considering loaning a firm money for ten years would most likely prefer the firm have a debt ratio
of _____ and a times interest earned ratio of_____ .
a. .75; .75

b. 50; 1.00

c. 45; 1.75

d. 40; 2.50

e. 35; 3.00

## 19. The higher the inventory turnover measure, the:

a. faster a firm sells its inventory.
b. faster a firm collects payment on its sales.
c. longer it takes a firm to sell its inventory.
d. greater the amount of inventory held by a firm.
e. lesser the amount of inventory held by a firm.
20. Which one of the following statements is correct if a firm has a receivables turnover measure of 10?
a. It takes a firm 10 days to collect payment from its customers.
b. It takes a firm 36.5 days to sell its inventory and collect the payment from the sale.
c. It takes a firm 36.5 days to pay its creditors.
d. The firm has an average collection period of 36.5 days.
e. The firm has ten times more in accounts receivable than it does in cash.

1.b 2.e 3.c 4.a 5.d 6.a 7.b 8.c 9.d 10.e
11.a 12.d 13.a 14.a 15.c 16.b 17.d 18.e 19.a

20.d

()
Ch.4 (
()+
)+
)++Ch.3
+Ch.3
DOL
DOLDFL
DFLDTL
Use the following data to answer Questions 1 and 2.
If Jaycos sales increase by 10%, Jaycos EBIT increases by 15%. If Jaycos EBIT increases by 10%,
Jaycos EPS increases by 12%.
1. Jaycos degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:
DOL
DFL
a.
1.8
1.2
b.
1.5
1.2
c.
1.8
1.4
d.
1.5
1.4
2.

a. 1.2.

b. 1.7.

c. 1.8.
7

d. 2.7.

## Use the following data to answer Questions 3 and 4.

Jayco, Inc. sells 10,000 units at a price of \$5 per unit. Jaycos fixed costs are \$8,000, interest expense is
\$2,000, variable costs are \$3 per unit, and EBIT is \$12,000.
3.

4.

Jaycos degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:
DOL
DFL

a.
b.

1.40
1.40

1.56
1.20

c.

1.67

1.20

d.

1.67

1.56

## Jaycos degree of total leverage (DTL) is closest to:

a. 1.25.

5.

b. 1.50.

c. 1.75.

d. 2.00.

Vischer Concrete has \$1.2 million in assets that are currently financed with 100% equity. Vischers
EBIT is \$300,000 and its tax rate is 30%. If Vischer changes its capital structure (recapitalizes) to
include 40% debt, what is Vischers ROE before and after the change? Assume that the interest rate
on debt is 5%.
ROE at 100% equity

6.

## ROE at 60% equity

a.
b.

17.5%
17.5%

37.5%
26.8%

c.

25.0%

26.8%

d.

25.0%

37.5%

Which of the following statements regarding the risks and potential rewards for owners and creditors
a. The potential reward for creditors is virtually unlimited assuming the business is profitable.
b. In the event of bankruptcy, creditors have a claim to the assets of the firm that must be met before
c. Owners have less risk than creditors.
d. In exchange for the risk they bear, creditors have the authority to make decisions regarding how

1. b
DOL
DFL
2. c
DTL
3. c
DOL
DFL
4. d
DTL

## = (increase in EBIT / increase in sales) = 0.15 / 0.10 = 1.5;

= (increase in EPS / increase in EBIT) = 0.12 / 0.10 = 1.2
= DOL DFL = 1.2 1.5 = 1.8
= [Q(P - V)] / [Q(P - V) - F] = [10,000 (5 - 3)] / [10,000 (5 - 3) - 8,000] = 1.67
= EBIT / (EBIT - I) = 12,000 / (12,000 - 2,000) = 1.2
= (Q(P-V)) / [Q(P-V)-F-I] = (10,000 (5-3)) / [10,000 (5-3) - 8,000 - 2,000]
= 2.0
8

## or since we calculated the components in the previous answer,

DTL = DOL DFL = 1.67 1.2 = 2.0
5. b
EBIT
Interest expense
Income before taxes
Taxes at 30%
Net income
Shareholders' equity
ROE = NI / Equity

\$300,000
\$0
\$300,000
\$90,000
\$210,000
\$1,200,000
17.5%

## With 60% equity:

\$300,000
\$24,000 (\$480,000 @ 5%)
\$276,000
\$82,800
\$193,200
\$720,000
26.8%

6. b
In the event of bankruptcy, owners do not have a claim to corporate assets until
creditors have been paid in full. Creditors have a less risky position since they are
first in line to receive assets in the event of bankruptcy, but their potential reward
is limited to the promised interest and principal payments on the debt.

()
CH4~5+Ch.5
1.

A firm's sustainable growth rate in sales does not directly depend on its:
a. debt to equity ratio.

b. profit margin.

c. dividend policy.

d. asset efficiency.

## e. all of the above.

2.

The sustainable growth rate will be equivalent to the internal growth rate when:
a. a firm has no debt.
b. the growth rate is positive.
c. the plowback ratio is positive but less than 1.
d. a firm has a debt-equity ratio exactly equal to 1.
e. net income is greater than zero.

3.

## The sustainable growth rate:

a. assumes there is no external financing of any kind.
b. is normally higher than the internal growth rate.
c. assumes the debt-equity ratio is variable.
d. is based on receiving additional external debt and equity financing.
e. assumes that 100% of all income is retained by the firm.

4.

If a firm bases its growth projection on the rate of sustainable growth, and shows positive net income,
then the:
a. fixed assets will have to increase at the same rate, regardless of the current capacity level.
b. number of common shares outstanding will increase at the same rate of growth.
c. debt-equity ratio will have to increase.
d. debt-equity ratio will remain constant while retained earnings increase.
e. fixed assets, debt-equity ratio, and number of common shares outstanding will all increase.
9

5.

Marcies Mercantile wants to maintain its current dividend policy, which is a payout ratio of 40%.
The firm does not want to increase its equity financing but is willing to maintain its current
debt-equity ratio. Given these requirements, the maximum rate at which Marcies can grow is equal
to:
a. 40% of the internal rate of growth.

## e. 60% of the sustainable rate of growth.

6.

You are the beneficiary of a life insurance policy. The insurance company informs you that you have
two options for receiving the insurance proceeds. You can receive a lump sum of \$50,000 today or
receive payments of \$641 a month for ten years. You can earn 6.5% on your money. Which option
should you take and why?
a. You should accept the payments because they are worth \$56,451.91 today.
b. You should accept the payments because they are worth \$56,523.74 today.
c. You should accept the payments because they are worth \$56,737.08 today.
d. You should accept the \$50,000 because the payments are only worth \$47,757.69 today.
e. You should accept the \$50,000 because the payments are only worth \$47,808.17 today.

7.

Your employer contributes \$25 a week to your retirement plan. Assume that you work for your
employer for another twenty years and that the applicable discount rate is 5%. Given these
assumptions, what is this employee benefit worth to you today?
a. \$13,144.43

b. \$15,920.55

c. \$16,430.54

d. \$16,446.34

e. \$16,519.02
8.

You have a sub-contracting job with a local manufacturing firm. Your agreement calls for annual
payments of \$50,000 for the next five years. At a discount rate of 12%, what is this job worth to you
today?
a. \$180,238.81

b. \$201,867.47

c. \$210,618.19

d. \$223,162.58

e. \$224,267.10
9.

The Ajax Co. just decided to save \$1,500 a month for the next five years as a safety net for
recessionary periods. The money will be set aside in a separate savings account which pays 3.25%
interest compounded monthly. It deposits the first \$1,500 today. If the company had wanted to
deposit an equivalent lump sum today, how much would it have had to deposit?
a. \$82,964.59

b. \$83,189.29

c. \$83,428.87

d. \$83,687.23

e. \$84,998.01
10. You need some money today and the only friend you have that has any is your miserly friend. He
agrees to loan you the money you need, if you make payments of \$20 a month for the next six
months. In keeping with his reputation, he requires that the first payment be paid today. He also
charges you 1.5% interest per month. How much money are you borrowing?
a. \$113.94

b. \$115.65

c. \$119.34

d. \$119.63

e. \$119.96
11. You buy an annuity which will pay you \$12,000 a year for ten years. The payments are paid on the
first day of each year. What is the value of this annuity today at a 7% discount rate?
10

a. \$84,282.98

b. \$87,138.04

c. \$90,182.79

d. \$96,191.91

e. \$116,916.21
12. You are scheduled to receive annual payments of \$10,000 for each of the next 25 years. Your
discount rate is 8.5%. What is the difference in the present value if you receive these payments at the
beginning of each year rather than at the end of each year?
a. \$8,699

b. \$9,217

c. \$9,706

d. \$10,000

e. \$10,850
13. You are comparing two annuities with equal present values. The applicable discount rate is 7.5%.
One annuity pays \$5,000 on the first day of each year for twenty years. How much does the second
annuity pay each year for twenty years if it pays at the end of each year?
a. \$4,651

b. \$5,075

c. \$5,000

d. \$5,375

e. \$5,405
14. Martha receives \$100 on the first of each month. Stewart receives \$100 on the last day of each month.
Both Martha and Stewart will receive payments for five years. At an 8% discount rate, what is the
difference in the present value of these two sets of payments?
a. \$32.88

b. \$40.00

c. \$99.01

d. \$108.00

e. \$112.50
15. What is the future value of \$1,000 a year for five years at a 6% rate of interest?
a. \$4,212.36

b. \$5,075.69

c. \$5,637.09

d. \$6,001.38

e. \$6,801.91
16. You borrow \$149,000 to buy a house. The mortgage rate is 7.5% and the loan period is 30 years.
Payments are made monthly. If you pay for the house according to the loan agreement, how much
total interest will you pay?
a. \$138,086

b. \$218,161

c. \$226,059

d. \$287,086

e. \$375,059
17. You retire at age 60 and expect to live another 27 years. On the day you retire, you have \$464,900 in
your retirement savings account. You are conservative and expect to earn 4.5% on your money during
your retirement. How much can you withdraw from your retirement savings each month if you plan
to die on the day you spend your last penny?
a. \$2,001.96

b. \$2,092.05

c. \$2,398.17

d. \$2,472.00

e. \$2,481.27
18. Your local travel agent is advertising an extravagant global vacation. The package deal requires that
you pay \$5,000 today, \$15,000 one year from today, and a final payment of \$25,000 on the day you
leave two years from today. What is the cost of this vacation in todays dollars if the discount rate is
6%?
a. \$39,057.41

b. \$41,400.85

c. \$43,082.39

d. \$44,414.14

e. \$46,518.00
19. One year ago, the Jenkins Family Fun Center deposited \$3,600 in an investment account for the
purpose of buying new equipment four years from today. Today, it is adding another \$5,000 to this
11

account. It plans on making a final deposit of \$7,500 to the account next year. How much will be
available when it is ready to buy the equipment, assuming it earns a 7% rate of return?
a. \$18,159.65

b. \$19,430.84

c. \$19,683.25

d. \$20,194.54

e. \$20,790.99
20. What is the future value of the following cash flows at the end of year 3 if the interest rate is 6%? The
cash flows occur at the end of each year.
Year 1

Year 2

Year 3

\$5,180

\$9,600

\$2,250

a. \$15,916.78

b. \$18,109.08

c. \$18,246.25

d. \$19,341.02

e. \$19,608.07

1.e 2.a 3.b 4.d 5.d 6.a 7.c 8.a 9.b 10.b
11.c 12.a 13.d 14.a 15.c 16.c 17.e 18.b 19.e

20.c

()
CH.6+Ch.7
1.

## The term structure of interest rates is

a. the relationship among interest rates of different bonds with the same maturity.
b. the structure of how interest rates move over time.
c. the relationship among the terms to maturity of different bonds.
d. the relationship among interest rates on bonds with different maturities

2.

## The risk structure of interest rates is

a. the structure of how interest rates move over time.
b. the relationship among interest rates of different bonds with the same maturity.
c. the relationship among the terms to maturity of different bonds.
d. the relationship among interest rates on bonds with different maturities.

3.

4.

5.

Which of the following long-term bonds should have the lowest interest rate?
a. Corporate Baa bonds

## c. Corporate Aaa bonds

d. Municipal bonds

Which of the following long-term bonds should have the highest interest rate?
a. Corporate Baa bonds

## c. Corporate Aaa bonds

d. Municipal bonds

## The risk premium on corporate bonds becomes smaller if

a. the riskiness of corporate bonds increases.
b. the liquidity of corporate bonds increases.
c. the liquidity of corporate bonds decreases.
d. the riskiness of corporate bonds decreases.
e. either (b) or (d) occur.
12

6.

7.

8.

## Bonds with relatively low risk of default are called

a. zero coupon bonds.

b. junk bonds.

b. junk bonds.

## c. zero coupon bonds.

A corporation suffering big losses might be more likely to suspend interest payments on its bonds,
thereby
a. raising the default risk and causing the demand for its bonds to rise.
b. raising the default risk and causing the demand for its bonds to fall.
c. lowering the default risk and causing the demand for its bonds to rise.
d. lowering the default risk and causing the demand for its bonds to fall.

9.

(I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest
rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and
default-free bonds is called the risk premium.
a. (I) is true, (II) false.

## d. Both are false.

10. The relationship among interest rates on bonds with identical default risk, but different maturities, is
called the
a. time-risk structure of interest rates.

d. yield curve.

## 11. Yield curves can be classified as

a. upward-sloping.

b. downward-sloping.

c. flat.

## e. only (a) and (b) of the above.

12. Typically, yield curves are
a. gently upward-sloping.

b. gently downward-sloping.

c. flat.

d. bowl shaped.

e. mound shaped.
13. When yield curves are steeply upward-sloping,
a. long-term interest rates are above short-term interest rates.
b. short-term interest rates are above long-term interest rates.
c. short-term interest rates are about the same as long-term interest rates.
d. medium-term interest rates are above both short-term and long-term interest rates.
e. medium-term interest rates are below both short-term and long-term interest rates.
14. Economists attempts to explain the term structure of interest rates
a. illustrate how economists modify theories to improve them when they are inconsistent with the
empirical evidence.
13

b. illustrate how economists continue to accept theories that fail to explain observed behavior of
interest rate movements.
c. prove that the real world is a special case that tends to get short shrift in theoretical models.
d. have proved entirely unsatisfactory to date.
15. According to the pure expectations theory of the term structure,
a. the interest rate on long-term bonds will exceed the average of expected future short-term interest
rates.
b. interest rates on bonds of different maturities move together over time.
c. buyers of bonds prefer short-term to long-term bonds.
d. all of the above.
e. only (a) and (b) of the above.
16. According to the pure expectations theory of the term structure,
a. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the
future.
b. when the yield curve is downward-sloping, short-term interest rates are expected to decline in the
future.
c. buyers of bonds prefer short-term to long-term bonds.
d. all of the above.
e. only (a) and (b) of the above.
17. According to the pure expectations theory of the term structure,
a. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the
future.
b. when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
c. investors have strong preferences for short-term relative to long-term bonds, explaining why yield
curves typically slope upward.
d. all of the above.
e. only (a) and (b) of the above.
18. According to the pure expectations theory of the term structure,
a. yield curves should be as equally likely to slope downward as slope upward.
b. when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the
future.
c. when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
d. all of the above.
e. only (a) and (b) of the above.
19. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2
percent, and 1 percent, then the pure expectations theory predicts that todays interest rate on the
four-year bond is
a. 1 percent.

b. 2 percent.

c. 4 percent.
14

## d. none of the above.

20. If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3
percent, 4 percent, and 5 percent, the pure expectations theory predicts that the bond with the highest
interest rate today is the one with a maturity of
a. one year.

b. two years.

c. three years.

d. four years.

e. five years.

1.d 2.b 3.d 4.a 5.e 6.c 7.b 8.b 9.b 10.d
11.d 12.a 13.a 14.a 15.b 16.e 17.a 18.e 19.d

20.e

()
CH8~CH9CH8~CH9-4
1.

The excess return required from a risky asset over that required from a risk-free asset is called the:

c. excess return.

d. average return.

e. variance.
2.

The average squared difference between the actual return and the average return is called the:
a. volatility return.

b. variance.

c. standard deviation.

e. excess return.
3.

The standard deviation for a set of stock returns can be calculated as the:
a. positive square root of the average return.
b. average squared difference between the actual return and the average return.
c. positive square root of the variance.
d. average return divided by N minus one, where N is the number of returns.
e. variance squared.

4.

A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard
deviation is the _____ distribution.
a. gamma

b. Poisson

c. bi-modal

d. normal

e. uniform
5.

The average compound return earned per year over a multi-year period is called the _____ average
return.
a. arithmetic

b. standard

c. variant

d. geometric

e. real
6.

The return earned in an average year over a multi-year period is called the _____ average return.
a. arithmetic

b. standard

c. variant

d. geometric

e. real
7.

The excess return you earn by moving from a relatively risk-free investment to a risky investment is
called the:
15

## e. arithmetic average return.

8.

The capital gains yield plus the dividend yield on a security is called the:
a. variance of returns.

b. geometric return.

## c. average period return.

d. current yield.

e. total return.
9.

A portfolio of large company stocks would contain which one of the following types of securities?
a. stocks of the firms which represent the smallest 20% of the companies listed on the NYSE
b. U.S. Treasury bills
c. long-term corporate bonds
d. stocks of firms included in the S&P 500 index
e. long-term government bonds

10. Which one of the following is a correct statement concerning risk premium?
a. The greater the volatility of returns, the greater the risk premium.
b. The lower the volatility of returns, the greater the risk premium.
c. The lower the average rate of return, the greater the risk premium.
d. The risk premium is not correlated to the average rate of return.
e. The risk premium is not affected by the volatility of returns.
11. The risk premium is computed by ______ the average return for the investment.
a. subtracting the inflation rate from
b. adding the inflation rate to
c. subtracting the average return on the U.S. Treasury bill from
d. adding the average return on the U.S. Treasury bill to
e. subtracting the average return on long-term government bonds from
12. Which of the following statements are correct concerning the variance of the annual returns on an
investment?
I. The larger the variance, the more the actual returns tend to differ from the average return.
II. The larger the variance, the larger the standard deviation.
III. The larger the variance, the greater the risk of the investment.
IV. The larger the variance, the higher the expected return.
a. I and III only

## e. I, II, III, and IV

13. Which of the following statements concerning the standard deviation are correct?
I. The greater the standard deviation, the lower the risk.
II. The standard deviation is a measure of volatility.
III. The higher the standard deviation, the less certain the rate of return in any one given year.
IV. The higher the standard deviation, the higher the expected return.
a. I and III only

16

## e. I, II, III, and IV

14. A capital gain occurs when:
a. the selling price is less than the purchase price.
b. the purchase price is less than the selling price.
c. there is no dividend paid.
d. there is no income component of return.
e. never, as they can not exist.
15. Six months ago, you purchased 1,200 shares of ABC stock for \$21.20 a share. You have received
dividend payments equal to \$.60 a share. Today, you sold all of your shares for \$22.20 a share. What
is your total dollar return on this investment?
a. \$720

b. \$1,200

c. \$1,440

d. \$1,920

e. \$3,840
16. A stock had returns of 8%, -2%, 4%, and 16% over the past four years. What is the standard deviation
of this stock for the past four years?
a. 6.3%

b. 6.6%

c. 7.1%

d. 7.5%

e. 7.9%
17. Over the past five years, a stock produced returns of 14%, 22%, -16%, 2%, and 10%. What is the
probability that an investor in this stock will NOT lose more than 8% nor earn more than 21% in any
one given year?
a. 34%

b. 68%

c. 95%

d. 99%

e. 100%
18. What are the arithmetic and geometric average returns for a stock with annual returns of 21%, 8%,
-32%, 41%, and 5%?
a. 5.6%; 8.6%

b. 5.6%; 6.3%

c. 8.6%; 5.6%

d. 8.6%; 8.6%

e. 8.6%; 6.3%
19. A stock had the following prices and dividends. What is the geometric average return on this stock?

a. 3.2%

b. 3.4%

c. 3.6%

d. 3.8%

e. 4.0%
20. Excelsior shares are currently selling for \$25 each. You bought 200 shares one year ago at \$24 and
received dividend payments of \$1.50 per share. What was your percentage capital gain this year?
a. 4.17%

b. 6.25%

c. 10.42%

e. 110.42%

17

d. 104.17%

21. The prices for IMB over the last 3 years are given below. Assuming no dividends were paid, what
was the 3-year holding period return? Given the following information: Year 1 return = 10%, Year 2
return = 15%, Year 3 return = 12%.
a. 12.3%

b. 13.9%

c. 15.8%

d. 41.7%

e. 46.5%
22. The return pattern on your favorite stock has been 5%, 8%, -12%, 15%, 21% over the last five years.
What has been your average return and holding period return over the last 5 years?
a. 4.5%; 6.5%

b. 7.4%; 38.9%

c. 7.4%; 7.76%

d. 7.4%; 76.73%

## e. None of the above

23. A portfolio is:
a. a group of assets, such as stocks and bonds, held as a collective unit by an investor.
b. the expected return on a risky asset.
c. the expected return on a collection of risky assets.
d. the variance of returns for a risky asset.
e. the standard deviation of returns for a collection of risky assets.
24. The percentage of a portfolio's total value invested in a particular asset is called that asset's:
a. portfolio return.

b. portfolio weight.

c. portfolio risk.

d. rate of return.

e. investment value.
25. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
a. idiosyncratic

b. diversifiable

c. systematic

d. asset-specific

e. total
26. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio

b. undiversifiable

c. market

d. unsystematic

e. total
27. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will greatly reduce
c. spreading an investment across five diverse companies will not lower your overall risk at all.
d. spreading an investment across many diverse assets will eliminate all of the risk.
e. spreading an investment across many diverse assets will eliminate some of the risk.
28. The _____ tells us that the expected return on a risky asset depends only on that asset's
nondiversifiable risk.
a. Efficient Markets Hypothesis (EMH)

## d. Law of One Price

e. principle of diversification
29. The amount of systematic risk present in a particular risky asset, relative to the systematic risk
present in an average risky asset, is called the particular asset's:
a. beta coefficient.

b. reward-to-risk ratio.
18

c. total risk.

d. diversifiable risk.

e. Treynor index.
30. The beta of a security is calculated by:
a. dividing the covariance of the security with the market by the variance of the market.
b. dividing the correlation of the security with the market by the variance of the market.
c. dividing the variance of the market by the covariance of the security with the market.
d. dividing the variance of the market by the correlation of the security with the market.
e. None of the above.
31. When computing the expected return on a portfolio of stocks the portfolio weights are based on the:
a. number of shares owned in each stock.
b. price per share of each stock.
c. market value of the total shares held in each stock.
d. original amount invested in each stock.
e. cost per share of each stock held.
32. The standard deviation of a portfolio will tend to increase when:
a. a risky asset in the portfolio is replaced with U.S. Treasury bills.
b. one of two stocks related to the airline industry is replaced with a third stock that is unrelated to the
airline industry.
c. the portfolio concentration in a single cyclical industry increases.
d. the weights of the various diverse securities become more evenly distributed.
e. short-term bonds are replaced with Treasury Bills.
33. Which one of the following is an example of systematic risk?
a. the price of lumber declines sharply
b. airline pilots go on strike
c. the Federal Reserve increases interest rates
d. a hurricane hits a tourist destination
e. people become diet conscious and avoid fast food restaurants
34. The systematic risk of the market is measured by:
a. a beta of 1.0.

b. a beta of 0.0.

## d. a standard deviation of 0.0.

e. a variance of 1.0.
35. Unsystematic risk:
a. can be effectively eliminated through portfolio diversification.
b. is compensated for by the risk premium.
c. is measured by beta.
d. cannot be avoided if you wish to participate in the financial markets.
e. is related to the overall economy.
36. Which one of the following is an example of unsystematic risk?
a. the inflation rate increases unexpectedly
19

## b. the federal government lowers income taxes

c. an oil tanker runs aground and spills its cargo
d. interest rates decline by one-half of one percent
e. the GDP rises by 2% more than anticipated
37. The primary purpose of portfolio diversification is to:
a. increase returns and risks.

## e. lower both returns and risks.

38. 38. Which one of the following would indicate a portfolio is being effectively diversified?
a. an increase in the portfolio beta
b. a decrease in the portfolio beta
c. an increase in the portfolio rate of return
d. an increase in the portfolio standard deviation
e. a decrease in the portfolio standard deviation
39. The majority of the benefits from portfolio diversification can generally be achieved with just _____
diverse securities.
a. 3

b. 6

c. 30

d. 50

e. 75
40. Which one of the following measures is relevant to the systematic risk principle?
a. variance

b. alpha

c. standard deviation

d. theta

e. beta

1~5 ABCDD

6~10ACEDA

11~15 CEBBD

16~20 DBCBA

21~25 DBABC

26~30 DEBAA

31~35 CCCAA

36~40 CCECE

()

## 1. The expected return on a portfolio:

A. can be greater than the expected return on the best performing security in the portfolio.
B. can be less than the expected return on the worst performing security in the portfolio.
C. is independent of the performance of the overall economy.
D. is limited by the returns on the individual securities within the portfolio.
E. is an arithmetic average of the returns of the individual securities when the weights of those
securities are unequal.

20

## 2. If a stock portfolio is well diversified, then the portfolio variance:

A. will equal the variance of the most volatile stock in the portfolio.
B. may be less than the variance of the least risky stock in the portfolio.
C. must be equal to or greater than the variance of the least risky stock in the portfolio.
D. will be a weighted average of the variances of the individual securities in the portfolio.
E. will be an arithmetic average of the variances of the individual securities in the portfolio.
3. A security that is fairly priced will have a return _____ the Security Market Line.
A. below

B. on or below

C. on

D. on or above

E. above
4. The intercept point of the security market line is the rate of return which corresponds to:
A. the risk-free rate of return.

## B. the market rate of return.

C. a value of zero.

D. a value of 1.0.

## E. the beta of the market.

5. A stock with an actual return that lies above the security market line:
A. has more systematic risk than the overall market.
B. has more risk than warranted based on the realized rate of return.
C. has yielded a higher return than expected for the level of risk assumed.
D. has less systematic risk than the overall market.
E. has yielded a return equivalent to the level of risk assumed.
6. The market risk premium is computed by:
C. subtracting the risk-free rate of return from the inflation rate.
D. subtracting the risk-free rate of return from the market rate of return.
E. multiplying the risk-free rate of return by a beta of 1.0.
7. The excess return earned by an asset that has a beta of 1.0 over that earned by a risk-free asset is
referred to as the:
A. market rate of return.

C. systematic return.

D. total return.

## E. real rate of return.

8. The efficient set of portfolios:
A. contains the portfolio combinations with the highest return for a given level of risk.
B. contains the portfolio combinations with the lowest risk for a given level of return.
C. is the lowest overall risk portfolio.
D. Both A and B.
E. Both A and C.
9. A well-diversified portfolio has negligible:
A. expected return.

B. systematic risk.

C. unsystematic risk.

D. variance.
21

E. Both C and D
10. The Capital Market Line is the pricing relationship between:
A. efficient portfolios and beta.
B. the risk-free asset and standard deviation of the portfolio return.
C. the optimal portfolio and the standard deviation of portfolio return.
D. beta and the standard deviation of portfolio return.
E. None of the above.
11. Beta measures:
A. the ability to diversify risk.
B. how an asset covaries with the market.
C. the actual return on an asset.
D. the standard deviation of the assets' returns.
E. All of the above.
12. The dominant portfolio with the lowest possible risk is:
A. the efficient frontier.

## E. None of the above.

13. An efficient set of portfolios is:
A. the complete opportunity set.
B. the portion of the opportunity set below the minimum variance portfolio.
C. only the minimum variance portfolio.
D. the dominant portion of the opportunity set.
E. only the maximum return portfolio.
14. The combination of the efficient set of portfolios with a riskless lending and borrowing rate results in:
A. the capital market line which shows that all investors will only invest in the riskless asset.
B. the capital market line which shows that all investors will invest in a combination of the riskless
asset and the tangency portfolio.
C. the security market line which shows that all investors will invest in the riskless asset only.
D. the security market line which shows that all investors will invest in a combination of the riskless
asset and the tangency portfolio.
E. None of the above.
15. According to the Capital Asset Pricing Model:
A. the expected return on a security is negatively and non-linearly related to the security's beta.
B. the expected return on a security is negatively and linearly related to the security's beta.
C. the expected return on a security is positively and linearly related to the security's variance.
D. the expected return on a security is positively and non-linearly related to the security's beta.
E. the expected return on a security is positively and linearly related to the security's beta
16. The diversification effect of a portfolio of two stocks:
A. increases as the correlation between the stocks declines.
22

## B. increases as the correlation between the stocks rises.

C. decreases as the correlation between the stocks rises.
D. Both A and C.
E. None of the above.
17. The separation principle states that an investor will:
A. choose any efficient portfolio and invest some amount in the riskless asset to generate the expected
return.
B. choose an efficient portfolio based on individual risk tolerance or utility.
C. never choose to invest in the riskless asset because the expected return on the riskless asset is lower
over time.
D. invest only in the riskless asset and tangency portfolio choosing the weights based on individual
risk tolerance.
E. All of the above.
18. When a security is added to a portfolio the appropriate return and risk contributions are:
A. the expected return of the asset and its standard deviation.
B. the expected return and the variance.
C. the expected return and the beta.
D. the historical return and the beta.
E. these both can not be measured.
19. The correlation between stocks A and B is the:
A. covariance between A and B divided by the standard deviation of A times the standard deviation of
B.
B. standard deviation A divided by the standard deviation of B.
C. standard deviation of B divided by the covariance between A and B.
D. variance of A plus the variance of B dividend by the covariance.
E. None of the above.
20. You have a portfolio of two risky stocks which turns out to have no diversification benefit. The reason
you have no diversification is the returns:
A. are too small.

## E. are completely unrelated to one another.

21. If the correlation between two stocks is +1, then a portfolio combining these two stocks will have a
variance that is:
A. less than the weighted average of the two individual variances.
B. greater than the weighted average of the two individual variances.
C. equal to the weighted average of the two individual variances.
D. less than or equal to average variance of the two weighted variances, depending on other
information.
E. None of the above.
23

22. The total number of variance and covariance terms in a portfolio is N2. How many of these would be
(including non-unique) covariances?
A. N

B. N2

C. N2- N

D. N2- N/2

## E. None of the above.

23. You want your portfolio beta to be 1.20. Currently, your portfolio consists of \$100 invested in stock A
with a beta of 1.4 and \$300 in stock B with a beta of .6. You have another \$400 to invest and want to
divide it between an asset with a beta of 1.6 and a risk-free asset. How much should you invest in the
risk-free asset?
A. \$0

B. \$140

C. \$200

D. \$320

E. \$400
24. You are comparing stock A to stock B. Given the following information, which one of these two
stocks should you prefer and why?

## A. Stock A; because it has an expected return of 7% and appears to be more risky.

B. Stock A; because it has a higher expected return and appears to be less risky than stock B.
C. Stock A; because it has a slightly lower expected return but appears to be significantly less risky
than stock B.
D. Stock B; because it has a higher expected return and appears to be just slightly more risky than
stock A.
E. Stock B; because it has a higher expected return and appears to be less risky than stock A.
25. Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5% and the market rate of return is
10%. What is the amount of the risk premium on Zelo stock?
A. 4.47%

B. 5.50%

C. 5.54%

D. 6.77%

C. 9.78%

D. 10.59%

E. 12.30%
26. What is the expected return on this portfolio?

A. 9.50%

B. 9.67%

E. 10.87%
27. Your portfolio has a beta of 1.18. The portfolio consists of 15% U.S. Treasury bills, 30% in stock A,
and 55% in stock B. Stock A has a risk-level equivalent to that of the overall market. What is the beta
of stock B?
A. .55

B. 1.10

C. 1.24

E. 1.60
24

D. 1.40

28. The risk-free rate of return is 4% and the market risk premium is 8%. What is the expected rate of
return on a stock with a beta of 1.28?
A. 9.12%

B. 10.24%

C. 13.12%

D. 14.24%

E. 15.36%
29. The stock of Big Joe's has a beta of 1.14 and an expected return of 11.6%. The risk-free rate of return
is 4%. What is the expected return on the market?
A. 7.60%

B. 8.04%

C. 9.33%

D. 10.67%

E. 12.16%
30. The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6% and the market
risk premium is 9%. What is the expected rate of return on Martin Industries stock?
A. 11.3%

B. 14.1%

C. 16.5%

D. 17.4%

E. 18.0%
31. Which one of the following stocks is correctly priced if the risk-free rate of return is 2.5% and the

A. A

B. B

C. C

D. D

E. E
32. The variance of Stock A is .004, the variance of the market is .007 and the covariance between the two
is .0026. What is the correlation coefficient?
A. .9285

B. .8542

C. .5010

D. .4913

E. .3510
33. A portfolio has 50% of its funds invested in Security One and 50% of its funds invested in Security
Two. Security One has a standard deviation of 6%. Security Two has a standard deviation of 12%. The
securities have a coefficient of correlation of 0.5. Which of the following values is closest to portfolio
variance?
A. .0027

B. .0063

C. .0095

D. .0104

## E. One must have covariance to calculate expected value.

34. A portfolio has 25% of its funds invested in Security C and 75% of its funds invested in Security D.
Security C has an expected return of 8% and a standard deviation of 6%. Security D has an expected
return of 10% and a standard deviation of 10%. The securities have a coefficient of correlation of 0.6.
Which of the following values is closest to portfolio return and variance?
A. .090; .0081

B. .095; .001675

C. .095; .0072

## E. Cannot calculate without the number of covariance terms.

35. In the equation R =

25

D. .100; .00849

## B. required return, expected return, and unbiased return.

C. actual total return, expected return, and unexpected return.
D. required return, expected return, and unbiased risk.
E. risk, expected return, and unsystematic risk.
36. Systematic risk is defined as:
A. a risk that specifically affects an asset or small group of assets.
B. any risk that affects a large number of assets.
C. any risk that has a huge impact on the return of a security.
D. the random component of return.
E. None of the above.
37. A company owning gold mines will probably have a _____ inflation beta because an ___ increase in
inflation is usually associated with an increase in gold prices.
A. negative; anticipated

B. positive; anticipated

C. negative; unanticipated

D. positive; unanticipated

## E. None of the above.

38. If company A, a medical research company, makes a new product discovery and their stock rises 5%,
this will have:
A. no effect on Company B's, a newspaper, stock price because it is a systematic risk element.
B. no effect on Company B's, a newspaper, stock price because it is an unsystematic risk element.
C. a large effect on Company B's, a newspaper, stock price because it is a systematic risk element.
D. a large effect on Company B's, a newspaper, stock price because it is an unsystematic risk element.
E. None of the above.
39. A criticism of the CAPM is that it:
A. ignores the return on the market portfolio.
B. ignores the risk-free return.
C. requires a single measure of systematic risk.
D. utilizes too many factors.
E. None of the above.
40. An advantage of the APT over CAPM is:
A. APT can handle multiple factors.
B. if the factors can be properly identified, the APT may have more explanation/predictive power for
returns.
C. the APT forces unsystematic risk to be negative to offset systematic risk; thus making the total
portfolio risk free, allowing for an arbitrage opportunity for the astute investor.
D. Both A and B.
E. All of the above.

1~5 DBCAC
21~25 CCABD

6~10 DBDCC
26~30 DEDDC

11~15 BBDBE
31~35 BDBCC
26

36~40 BDBCD

()

1. A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified
asset at an agreed-upon price on or before a given future date is called a(n) _____ contract.
A. option

B. futures

C. forward

D. swap

2. The act where an owner of an option buys or sells the underlying asset, as is his right, is called
______ the option.
A. striking

B. exercising

C. opening

D. splitting

E. strangling
3. The fixed price in an option contract at which the owner can buy or sell the underlying asset is called
the option's:
A. opening price.

B. intrinsic value.

C. strike price.

D. market price.

E. time value.
4. The last day on which an owner of an option can elect to exercise is the _____ date.
A. ex-payment

B. ex-option

C. opening

D. expiration

E. intrinsic
5. An option that may be exercised at any time up to its expiration date is called a(n) _____ option.
A. futures

B. Asian

C. Bermudan

D. European

E. American
6. An option that may be exercised only on the expiration date is called a(n) _____ option.
A. European

B. American

C. Bermudan

D. futures

E. Asian
7. A trading opportunity that offers a riskless profit is called a(n):
A. put option.

B. call option.

C. market equilibrium.

D. arbitrage.

E. cross-hedge.
8. The value of an option if it were to immediately expire, that is, its lower pricing bound, is called an
option's _____ value.
A. strike

B. market

C. volatility

D. time

E. intrinsic
9. An option that grants the right, but not the obligation, to sell shares of the underlying asset on a
particular date at a specified price is called:
A. either an American or a European option.
B. an American call.
C. an American put.
D. European put.
E. European call.

27

10. Which one of the following provides the option of selling a stock anytime during the option period at
a specified price even if the market price of the stock declines to zero?
A. American call

B. European call

C. American put

D. European put

## E. either an American or a European put

11. Which one of the following statements correctly describes your situation as the owner of an American
call option?
A. You are obligated to buy at a set price at any time up to and including the expiration date.
B. You have the right to sell at a set price at any time up to and including the expiration date.
C. You have the right to buy at a set price only on the expiration date.
D. You are obligated to sell at a set price if the option is exercised.
E. You have the right to buy at a set price at any time up to and including the expiration date.
12. 12. Jeff opted to exercise his August option on August 10 and received \$2,500 in exchange for his
shares. Jeff must have owned a (an):
A. warrant.

B. American call.

C. American put.

D. European call.

E. European put.
13. Jillian owns an option which gives her the right to purchase shares of WAN stock at a price of \$20 a
share. Currently, WAN stock is selling for \$24.50. Jillian would like to profit on this stock but is not
permitted to exercise her option for another two weeks.
Which of the following statements apply to this situation?
I. Jillian must own a European call option.
II. Jillian must own an American put option.
III. Jillian should sell her option today if she feels the price of WAN stock will decline significantly
over the next two weeks.
IV. Jillian cannot profit today from the price increase in WAN stock.
A. I and III only

B. II and IV only

C. I and IV only

## E. I, III, and IV only

14. If a call has a positive intrinsic value at expiration the call is said to be:
A. funded.

B. unfunded.

C. at the money.

D. in the money.

## E. out of the money.

15. A put option with a \$35 exercise price on ABC stock expires today. The current price of ABC stock is
\$36. The put is:
A. funded.

B. unfunded.

C. at the money.

D. in the money.

## E. out of the money.

16. The intrinsic value of a call is:
I. the value of the call if it were about to expire.
II. equal to the lower bound of a call's value.
III. another name for the market price of a call.
IV. always equal to zero if the call is currently out of the money.
A. I and III only

B. II and IV only

C. I and II only
28

## E. I, II, and IV only

17. The intrinsic value of a put is equal to the:
A. lesser of the strike price or the stock price.
B. lesser of the stock price minus the exercise price or zero.
C. lesser of the stock price or zero.
D. greater of the strike price minus the stock price or zero.
E. greater of the stock price minus the exercise price or zero.
18. You own stock in a firm that has a pure discount loan due in six months. The loan has a face value of
\$50,000. The assets of the firm are currently worth \$62,000. The stockholders in this firm basically
own a _____ option on the assets of the firm with a strike price of ______
A. put; \$62,000.

B. put; \$50,000.

C. warrant; \$62,000.

D. call; \$62,000.

E. call; \$50,000.
19. The owner of a call option has the:
A. right but not the obligation to buy a stock at a specified price on a specified date.
B. right but not the obligation to buy a stock at a specified price during a specified period of time.
C. obligation to buy a stock on a specified date but only at the specified price.
D. obligation to buy a stock sometime during a specified period of time at the specified price.
E. obligation to buy a stock at the lower of the exercise price or the market price on the expiration
date.
20. If you consider the equity of a firm to be an option on the firm's assets then the act of paying off debt
is comparable to _____ on the assets of the firm.

## E. selling a call option

21. Which of the following statements is true?
A. American options are options on securities of U.S. corporations, and the options are traded on
American exchanges. European options are options on securities of U.S. corporations, but the
options are traded on European exchanges.
B. American options are options on securities which are traded on American exchanges. European
options, also traded on American exchanges, are options on European corporations.
C. American options give the holder the right to the dividend payment. European options do not.
D. American options may be exercised anytime up to expiration. European options may be exercised
only at expiration.
E. None of the above.
22. An out-of-the-money call option is one that:
A. has an exercise price below the current market price of the underlying security.
B. should not be exercised.
C. has an exercise price above the current market price of the underlying security.
D. Both A and B.
E. Both B and C.
29

23. Which of the following is not true concerning call option writers?
A. Writers promise to deliver shares if exercised by the buyer.
B. The writer has the option to sell shares but not an obligation.
C. The writer's liability is zero if the option expires out-of-the-money.
D. The writer receives a cash payment from the buyer at the time the option is purchased.
E. The writer has a loss if the market price rises substantially above the exercise price.
24. An in-the-money put option is one that:
A. has an exercise price greater than the underlying stock price.
B. has an exercise price less than the underlying stock price.
C. has an exercise price equal to the underlying stock price.
D. should not be exercised at expiration.
E. should not be exercised at any time.
25. Which of the following statements is true?
A. At expiration the maximum price of a call is the greater of (Stock Price - Exercise) or 0.
B. At expiration the maximum price of a call is the greater of (Exercise - Stock Price) or 0.
C. At expiration the maximum price of a put is the greater of (Stock Price - Exercise) or 0.
D. At expiration the maximum price of a put is the greater of (Exercise - Stock Price) or 0.
E. Both A and D.
26. You purchased six TJH call option contracts with a strike price of \$40 when the option was quoted at
\$1.30. The option expires today when the value of TJH stock is \$41.90. Ignoring trading costs and
A. \$60

B. \$320

C. \$360

D. \$420

E. \$540
27. 27. You purchased four WXO 30 call option contracts at a quoted price of \$.34. What is your net gain
or loss on this investment if the price of WXO is \$33.60 on the option expiration date?
A. -\$1,576

B. -\$136

C. \$1,304

D. \$1,440

E. \$1,576
28. A derivative is a financial instrument whose value is determined by:
A. a regulatory body such as the FTC.

## B. a primitive or underlying asset.

C. hedging a risk.

D. hedging a speculation.

## E. None of the above.

29. Derivatives can be used to either hedge or speculate. These actions:
A. increase risk in both cases.
B. decrease risk in both cases.
C. spread or minimize risk in both cases.
D. offset risk by hedging and increase risk by speculating.
E. offset risks by speculating and increase risk by hedging.

30

## 30. A forward contract is described by:

A. agreeing today to buy a product at a later date at a price to be set in the future.
B. agreeing today to buy a product today at its current price.
C. agreeing today to buy a product at a later date at a price set today.
D. agreeing today to buy a product if and only if its price rises above the exercise price today at its
current price.
E. None of the above.
31. The buyer of a forward contract:
A. will be taking delivery of the good(s) today at today's price.
B. will be making delivery of the good(s) at a later date at that date's price.
C. will be making delivery of the good(s) today at today's price.
D. will be taking delivery of the good(s) at a later date at pre-specified price.
E. Both A or D.
32. The main difference between a forward contract and a cash transaction is:
A. only the cash transaction creates an obligation to perform.
B. a forward is performed at a later date while the cash transaction is performed immediately.
C. only one involves a deliverable instrument.
D. neither allows for hedging.
E. None of the above.
33. Futures contracts contrast with forward contracts by:
A. trading on an organized exchange.
B. marking to the market on a daily basis.
C. allowing the seller to deliver any day over the delivery month.
D. All of the above.
E. None of the above.
34. Which of the following terms is not part of a forward contract?
A. Making delivery

B. Taking delivery

C. Delivery instrument

D. Cash transaction

## E. None of the above.

35. A futures contract on gold states that buyers and sellers agree to make or take delivery of an ounce of
gold for \$400 per ounce. The contract expires in 3 months. The current price of gold is \$400 per
ounce. If the price of gold rises and continues to rise every day over the 3 month period, then when
the contract is settled, the buyer will _____ and the seller will _____.
A. lose; gain

B. gain; lose

## C. gain; break even

D. gain; gain

E. lose; lose
36. A potential disadvantage of forward contracts versus futures contracts is:
A. the extra liquidity required to cover the potential outflows that occur prior to delivery and caused
by marking to market.
B. the incentive for a particular party to default.
31

C. that the buyers and sellers don't know each other and never meet.
D. All of the above.
E. Both A and C.
37. A farmer with wheat in the fields and who uses the futures market to protect a profit is an example of:
A. a long hedge.
B. a short hedge.
C. selling futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
38. A miller who needs wheat to mill to flour uses the futures market to protect a profit by:
A. a long hedge to take delivery.
B. a short hedge to deliver.
C. buying futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
39. A chocolate company which uses the futures market to lock in the price of cocoa to protect a profit is
an example of:
A. a long hedge.
B. a short hedge.
C. purchasing futures to guard against a potential loss.
D. Both A and C.
E. Both B and C.
40. If the producer of a product has entered into a fixed price sale agreement for that output, the producer
faces:
A. a nice steady profit because the output price is fixed.
B. an uncertain profit if the input prices are volatile. This risk can be reduced by a short hedge.
C. an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
D. a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
E. a modest profit if the input prices are stable. This risk can be reduced by a short hedge.

1~5 ABCDE
21~25 DEBAE

26~30 CCBDC

31~35 DBBDB

36~40 BEDDC

32

CH7
1.

The ability of shareholders to undo the dividend policy of the firm and create an alternative dividend
payment policy via reinvesting dividends or selling shares of stock is called (a):
A. perfect foresight model.

B. MM Proposition I.

## C. capital structure irrelevancy.

2.

The market's reaction to the announcement of a change in the firm's dividend payout is likely the:
A. information content effect.

B. clientele effect.

## C. efficient markets hypothesis.

D. MM Proposition I.

E. MM Proposition II.
3.

The observed empirical fact that stocks attract particular investors based on the firm's dividend policy
and the resulting tax impact on investors is called the:
A. information content effect.

B. clientele effect.

## C. efficient markets hypothesis.

D. MM Proposition I.

E. MM Proposition II.
4.

A _____ is an alternative method to cash dividends which is used to pay out a firm's earnings to
shareholders.
A. merger

B. acquisition

C. payment-in-kind

D. stock split

E. share repurchase
5.

A payment made by a firm to its owners in the form of new shares of stock is called a _____
dividend.
A. stock

B. normal

C. special

D. extra

E. liquidating
6.

An increase in a firm's number of shares outstanding without any change in owners' equity is called
a:
A. special dividend.

B. stock split.

C. share repurchase.

D. tender offer.

E. liquidating dividend.
7.

## In a reverse stock split:

A. the number of shares outstanding increases and owners' equity decreases.
B. the firm buys back existing shares of stock on the open market.
C. the firm sells new shares of stock on the open market.
D. the number of shares outstanding decreases but owners' equity is unchanged.
E. shareholders make a cash payment to the firm.

8.

## Which one of the following is an argument in favor of a low dividend policy?

A. the tax on capital gains is deferred until the gain is realized
B. few, if any, positive net present value projects are available to the firm
C. a preponderance of stockholders have minimal taxable income
D. a majority of stockholders have other investment opportunities that offer higher rewards with
33

## similar risk characteristics

E. corporate tax rates exceed personal tax rates
9.

## Which of the following may tend to keep dividends low?

I. a state law restricting dividends in excess of retained earnings
II. a term contained in bond indenture agreements
III. the desire to maintain constant dividends over time
IV. flotation costs
A. II and III only

B. I and IV only

## E. I, II, III, and IV

10. Ignoring capital gains as an alternative, the tax law changes in 2003 tend to favor a:
A. lower dividend policy.

## B. constant dividend policy.

C. zero-dividend policy.

## E. restrictive dividend policy.

11. Which of the following are factors that favor a high dividend policy?
I. stockholders desire for current income
II. tendency for higher stock prices for high dividend paying firms
III. investor dislike of uncertainty
IV. high percentage of tax-exempt institutional stockholders
A. I and III only

B. II and IV only

## E. I, II, III, and IV

12. The information content of a dividend increase generally signals that:
A. the firm has a one-time surplus of cash.
B. the firm has few, if any, net present value projects to pursue.
C. management believes that the future earnings of the firm will be strong.
D. the firm has more cash than it needs due to sales declines.
E. future dividends will be lower.

1~5 EABEA

6~10 BDAED

11~12 EC

34

()
)
CH1+CH8
CH1+CH8
1.

Warrants are similar to options, in that the value of the warrant is limited by:
A. expiring worthless if the stock price is below the total warrant exercise price.
B. the trading capabilities of the exchange used.
C. the price of the underlying stock divided by the number of warrants needed to purchase a share.
D. Both A and C.
E. Both B and C.

2.

Which of the following would not describe the difference between warrants and call options?
A. Warrants are issued by firms whereas call options are issued by individuals.
B. Call options have an exercise price whereas warrants do not.
C. Exercising of warrants creates dilution whereas exercising call options does not.
D. When call options are exercised existing shares trade hands whereas if warrants are exercised new
stock must be issued.
E. None of the above.

3.

## Two major differences between a warrant and a call option are:

A. warrants are contracts outside of the firm while options are within the firm.
B. warrants have long maturities while options are usually short maturities.
C. warrant exercise dilutes the value of equity while option exercise does not.
D. Both A and C.
E. Both B and C.

4.

## Which of the following would harm the position of a warrant holder?

A. a 3 for 1 stock split
B. a large stock dividend of 20%
C. a large cash dividend
D. listing of the warrants on the NYSE
E. None of the above would harm the warrant holders.

5.

## The exercise of warrants creates new shares which:

A. increases the total number of shares but does not affect share value.
B. increases the total number of shares which can reduce an individual share value.
C. does not change the number of shares outstanding, similar to options.
D. increases share value because cash is paid into the firm at the time of warrant exercise.
E. None of the above.

6.

If a corporate security can be exchanged for a fixed number of shares of stock, the security is said to
be:
A. callable.

B. convertible.

C. protected.

D. putable.

## E. None of the above.

7.

The holder of a \$1,000 face value bond has the right to exchange the bond anytime before maturity
for shares of stock priced at \$50 per share. The \$50 is called the:
A. conversion price.

B. stated price.

C. exercise price.
35

D. striking price.

8.

## Concerning convertible bonds, which of the following statements is not correct?

A. The value of a convertible bond will generally be greater than its straight bond value.
B. The value of a convertible bond will generally be greater than its conversion value.
C. The difference between the conversion value and the straight bond value is the conversion or
D. The coupon rate on a nonconvertible bond will generally exceed the coupon rate on an otherwise
identical convertible bond.
E. All of the above are correct.

9.

## Concerning convertible bonds, which of the following statements is not correct?

A. A convertible bond issue would generally have fewer restrictive covenants than an otherwise
identical nonconvertible bond.
B. Convertible bonds can be issued at a lower coupon compared with otherwise non-convertible
bonds.
C. If the value of a convertible bond exceeds the maximum of its straight bond value or its
conversion value, the difference would be referred to as the option value.
D. Since convertible bonds will be exchanged for common stock, convertible bonds are generally not
callable.
E. More than one of the above is incorrect.

10. Concerning convertible bonds, which of the following statements is not correct?
A. With regard to security, most convertible bonds are secured by common stock (i.e., they are
collateral trust bonds).
B. For most convertible bonds, the issuing firm can, under certain circumstances, effectively force
bondholders to convert to common stock.
C. When a convertible bond is called, the owner has the option of receiving cash or stock for the
bond.
D. All of the above are incorrect.
E. All of the above are correct.

1-5 DBECB

6-10 BACDA

()
)
CH9
1.

## Which of the following statements concerning acquisitions are correct?

I. Being acquired by another firm is an effective method of replacing senior management.
II. The net present value of an acquisition should have no bearing on whether or not the acquisition
occurs.
III. Acquisitions are often relatively complex from an accounting and tax point of view.
IV. The value of a strategic fit is easy to estimate using discounted cash flow analysis.
36

## A. I and III only

B. II and IV only

C. I and IV only

## E. I, II, III, and IV

2.

In a merger the:
A. legal status of both the acquiring firm and the target firm is terminated.
B. acquiring firm retains its name and legal status.
C. acquiring firm acquires the assets but not the liabilities of the target firm.
D. stockholders of the target firm have little, if any, say as to whether or not the merger occurs.
E. target firm always continues to exist as a subsidiary of the acquiring firm.

3.

If Microsoft were to acquire U.S. Airways, the acquisition would be classified as a _____
acquisition.
A. horizontal

B. longitudinal

C. conglomerate

D. vertical

E. complementary resources
4.

## A proposed acquisition may create synergy by:

I. increasing the market power of the combined firm.
II. improving the distribution network of the acquiring firm.
III. providing the combined firm with a strategic advantage.
IV. reducing the utilization of the acquiring firm's assets.
A. I and III only

C. I and IV only

5.

## Which of the following represent potential tax gains from an acquisition?

I. a reduction in the level of debt

A. I and IV only

## E. II, III, and IV only

6.

Rudy's, Inc. and Blackstone, Inc. are all-equity firms. Rudy's has 1,500 shares outstanding at a
market price of \$22 a share. Blackstone has 2,500 shares outstanding at a price of \$38 a share.
Blackstone is acquiring Rudy's for \$36,000 in cash. What is the merger premium per share?
A. \$2.00

B. \$4.25

C. \$6.50

D. \$8.00

E. \$14.00
7.

Jennifer's Boutique has 2,100 shares outstanding at a market price per share of \$26. Sally's has 3,000
shares outstanding at a market price of \$41 a share. Neither firm has any debt. Sally's is acquiring
Jennifer's for \$58,000 in cash. The incremental value of the acquisition is \$2,500. What is the value
of Jennifer's Boutique to Sally's?
A. \$26,000

B. \$27,600

C. \$57,100

D. \$58,200

E. \$60,500
8.

ABC and XYZ are all-equity firms. ABC has 1,750 shares outstanding at a market price of \$20 a
share. XYZ has 2,500 shares outstanding at a price of \$28 a share. XYZ is acquiring ABC for
\$36,000 in cash. The incremental value of the acquisition is \$3,000. What is the net present value of
37

## acquiring ABC to XYZ?

A. \$1,000

B. \$2,000

C. \$3,000

D. \$4,000

E. \$5,000
9.

Winslow Co. has agreed to be acquired by Ferrier, Inc. for \$25,000 worth of Ferrier stock. Ferrier
currently has 1,500 shares of stock outstanding at a price of \$21 a share. Winslow has 1,000 shares
outstanding at a price of \$22. The incremental value of the acquisition is \$4,000. What is the merger
A. \$1

B. \$2

C. \$3

D. \$4

E. \$569.
10. The Sligo Co. is planning on merging with the Thorton Co. Sligo will pay Thorton's stockholders the
current value of their stock in shares of Sligo. Sligo currently has 2,300 shares of stock outstanding at
a market price of \$20 a share. Thorton has 1,800 shares outstanding at a price of \$15 a share. How
many shares of stock will be outstanding in the merged firm?
A. 1,800 shares

B. 2,300 shares

C. 2,750 shares

E. 4,100 shares

38

D. 3,650 shares

## Review for Exam 2

The exam will have 25 multiple choice questions and 5 work problems
You are not responsible for any topics that are not covered in the lecture note
slides (lecture 5, 6, 7, 8).
Questions in the multiple choice section will be either concept or calculation
questions. The calculation questions will be similar to those in the homework and
review. However, the concept questions will be related to any topic we have
covered in the class. The concept questions in the review are only some sample
questions. You should NOT study only topics in the review.
For the work problems, you need to solve the problems without knowing the
possible answers. The questions will be similar to those in the homework and the
review except that the possible solutions are not given.
You can bring a formula sheet to the exam.

Chapter 5&6
1. Of the alternatives available, __________ typically have the highest standard deviation
of returns.
A) commercial paper
B) corporate bonds
C) stocks
D) treasury bills
2. The holding period return on a stock is equal to __________.
A) the capital gain yield over the period plus the inflation rate
B) the capital gain yield over the period plus the dividend yield
C) the current yield plus the dividend yield
D) the dividend yield plus the risk premium
3. .Suppose you pay \$9,800 for a Treasury bill maturing in two months. What is the
annual percentage rate of return for this investment? Assume par value = \$10,000
A) 2%
B) 12%
C) 12.2%
D) 16.4%
4. The market risk premium is defined as ___________.
A) the difference between the return on an index fund and the return on Treasury
bills
B) the difference between the return on a small firm mutual fund and the return
on the Standard and Poor's 500 index
C) the difference between the return on the risky asset with the lowest returns
and the return on Treasury bills
D) the difference between the return on the highest yielding asset and the lowest
yielding asset.
5. The reward/variability ratio is given by __________.
A) the slope of the capital allocation line
B) the second derivative of the capital allocation line
C) the point at which the second derivative of the investor's indifference curve
reaches zero
D) none of the above

6. A Treasury bill pays a 6% rate of return. A risk averse investor __________ invest in
a risky portfolio that pays 12% with a probability of 40% or 2% with a probability
of 60% because __________.
A) might; she is rewarded a risk premium
B) would not; because she is not rewarded any risk premium
C) would not; because the risk premium is small
D) cannot be determined
7. The holding period return on a stock was 30%. Its ending price was \$26 and its cash
dividend was \$1.50. Its beginning price must have been __________.
A) \$20.00
B) \$21.15
C) \$86.67
D) \$91.67
8. You have \$500,000 available to invest. The risk-free rate as well as your borrowing
rate is 8%. The return on the risky portfolio is 16%. If you wish to earn a 22%
return, you should __________.
A) invest \$125,000 in the risk-free asset
B) invest \$375,000 in the risk-free asset
C) borrow \$125,000
D) borrow \$375,000
9. The price of a stock is \$55 at the beginning of the year and \$53 at the end of the year.
If the stock paid a \$3 dividend what is the holding period return for the year?
A) 1.82%
B) 3.64%
C) 5.45%
D) 10.0%
10. Elias is a risk-averse investor. David is a less risk-averse investor than Elias.
Therefore,
A. for the same risk, David requires a higher rate of return than Elias.
B. for the same return, Elias tolerates higher risk than David.
C. for the same risk, Elias requires a lower rate of return than David.
D. for the same return, David tolerates higher risk than Elias.
E. cannot be determined.

11. A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15.
The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) (A/2)s2. Which value of A makes this investor indifferent between the risky portfolio and
the risk-free asset?
A. 5
B. 6
C. 7
D. 8
E. none of the above

## U = E(r) - (A/2)s2, where A = 4.0.

12. Based on the utility function above, which investment would you select?
A. 1
B. 2
C. 3
D. 4
E. cannot tell from the information given
13. Which investment would you select if you were risk neutral?
A. 1
B. 2
C. 3
D. 4
E. cannot tell from the information given
14. The presence of risk means that
A. investors will lose money.
B. more than one outcome is possible.
C. the standard deviation of the payoff is larger than its expected value.
D. final wealth will be greater than initial wealth.
E. terminal wealth will be less than initial wealth.

## 15. The Capital Allocation Line can be described as the

A. investment opportunity set formed with a risky asset and a risk-free asset.
B. investment opportunity set formed with two risky assets.
C. line on which lie all portfolios that offer the same utility to a particular investor.
D. line on which lie all portfolios with the same expected rate of return and different
standard deviations.
E. none of the above.
16. An investor invests 30 percent of his wealth in a risky asset with an expected rate of
return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His
portfolio's expected return and standard deviation are __________ and __________,
respectively.
A. 0.114; 0.12
B. 0.087;0.06
C. 0.295; 0.12
D. 0.087; 0.12
E. none of the above
17. What percentages of your money must be invested in the risky asset and the risk-free
asset, respectively, to form a portfolio with an expected return of 0.11?
A. 53.8% and 46.2%
B. 75% and 25%
C. 62.5% and 37.5%
D. 46.1% and 53.8%
E. Cannot be determined.
18. What percentages of your money must be invested in the risk-free asset and the risky
asset, respectively, to form a portfolio with a standard deviation of 0.20?
A. 30% and 70%
B. 50% and 50%
C. 60% and 40%
D. 40% and 60%
E. Cannot be determined.

Chapter 7&8
19. Risk that can be eliminated through diversification is called ______ risk.
A) unique
B) firm-specific
C) diversifiable
D) all of the above
20. The _______ decision should take precedence over the _____ decision.
A) asset allocation, stock selection
B) choice of fad, mutual fund selection
C) stock selection, asset allocation
D) stock selection, mutual fund selection
21.

## The risk that can be diversified away is ___________.

A) beta
B) firm specific risk
C) market risk
D) systematic risk

22.

## __________ is a true statement regarding the variance of risky portfolios.

A) The higher the coefficient of correlation between securities, the greater will be
the reduction in the portfolio variance
B) There is a direct relationship between the securities coefficient of correlation
and the portfolio variance
C) The degree to which the portfolio variance is reduced depends on the degree
of correlation between securities
D) none of the above

23.

## Expected return-standard deviation combinations corresponding to any individual

risky asset _________________.
A) will always end up on the efficient frontier
B) will always end up on the efficient frontier or within the efficient frontier, but
never outside the efficient frontier
C) will always end up within the efficient frontier
D) may end up anywhere in expected return-standard deviation space

24.

## The optimal risky portfolio can be identified by finding _____________.

A) the minimum variance point on the efficient frontier
B) the maximum return point on the efficient frontier
C) the tangency point of the capital market line and the efficient frontier
D) None of the above answers is correct

25.

## A portfolio is composed of two stocks, A and B. Stock A has a standard deviation

of return of 25% while stock B has a standard deviation of return of 5%. Stock A
comprises 20% of the portfolio while stock B comprises 80% of the portfolio. If
the variance of return on the portfolio is .0050, the correlation coefficient between
the returns on A and B is __________.
A) -.225
B) -.474
C) .474
D) .225

26.

## A measure of the riskiness of an asset held in isolation is _____________.

A) beta
B) standard deviation
C) covariance
D) semi-variance

27.

## As additional securities are added to a portfolio, total risk will generally

________ at a _________ rate.
A) rise; decreasing
B) rise; increasing
C) fall; decreasing
D) fall; increasing

28.

## The security characteristic line is ________________.

A) the trend line representing the security's tendency to advance or decline in the
market over some period of time
B) the "best fit" line representing the regression of the security's excess returns
on market excess returns over some period of time
C) another term for the capital allocation line representing the set of complete
portfolios that can be constructed by combining the security with T-bill
holdings
D) None of the above answers is correct

29.

## A security's beta coefficient will be negative if _____________.

A) its returns are negatively correlated with market index returns
B) its returns are positively correlated with market index returns
C) its stock price has historically been very stable
D) market demand for the firm's shares is very low

30.

## Which of the following correlations coefficients will produce the least

diversification benefit?
A) -0.6
B) -1.5
C) 0.0
D) 0.8

31.

What is the standard deviation of a portfolio of two stocks given the following
data? Stock A has a standard deviation of 22%. Stock B has a standard deviation
of 16%. The portfolio is equally weighted and the correlation coefficient between
the two stocks is .35.
A) 15.7%
B) 16.0%
C) 18.8%
D) 22.0%

32.

The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the
portfolio standard deviation is 12.0%, what is the reward to variability ratio of the
portfolio?
A) 0.0
B) 0.45
C) 0.74
D) 1.35

## 33. The efficient frontier of risky assets is

A. the portion of the investment opportunity set that lies above the global minimum
variance portfolio.
B. the portion of the investment opportunity set that represents the highest standard
deviations.
C. the portion of the investment opportunity set which includes the portfolios with the
lowest standard deviation.
D. the set of portfolios that have zero standard deviation.
E. both A and B are true.

34. The Capital Allocation Line provided by a risk-free security and N risky securities is
A. the line that connects the risk-free rate and the global minimum-variance portfolio of
the risky securities.
B. the line that connects the risk-free rate and the portfolio of the risky securities that has
the highest expected return on the efficient frontier.
C. the line tangent to the efficient frontier of risky securities drawn from the risk-free
rate.
D. the horizontal line drawn from the risk-free rate.
E. none of the above.
35. Which of the following statement(s) is (are) false regarding the selection of a
portfolio from those that lie on the Capital Allocation Line?
A. Less risk-averse investors will invest more in the risk-free security and less in the
optimal risky portfolio than more risk-averse investors.
B. More risk-averse investors will invest less in the optimal risky portfolio and more in
the risk-free security than less risk-averse investors.
C. Investors choose the portfolio that maximizes their expected utility.
D. A and B.
E. A and C.
36. An investor who wishes to form a portfolio that lies to the right of the optimal risky
portfolio on the Capital Allocation Line must:
A. lend some of her money at the risk-free rate and invest the remainder in the optimal
risky portfolio.
B. borrow some money at the risk-free rate and invest in the optimal risky portfolio.
C. invest only in risky securities.
D. such a portfolio cannot be formed.
E. B and C
37. Security X has expected return of 12% and standard deviation of 20%. Security Y has
expected return of 15% and standard deviation of 27%. If the two securities have a
correlation coefficient of 0.7, what is their covariance?
A. 0.038
B. 0.070
C. 0.018
D. 0.013
E. 0.054

38. The line representing all combinations of portfolio expected returns and standard
deviations that can be constructed from two available assets is called the
B. Capital Allocation Line
C. efficient frontier
D. portfolio opportunity set
E. Security Market Line
39. Given an optimal risky portfolio with expected return of 14% and standard deviation
of 22% and a risk free rate of 6%, what is the slope of the best feasible CAL?
A. 0.64
B. 0.14
C. 0.08
D. 0.33
E. 0.36
40. The standard deviation of a two-asset portfolio is a linear function of the assets'
weights when
A. the assets have a correlation coefficient less than zero.
B. the assets have a correlation coefficient equal to zero.
C. the assets have a correlation coefficient greater than zero.
D. the assets have a correlation coefficient equal to one.
E. the assets have a correlation coefficient less than one.
41. When borrowing and lending at a risk-free rate are allowed, which Capital Allocation
Line (CAL) should the investor choose to combine with the efficient frontier?
I) with the highest reward-to-variability ratio.
II) that will maximize his utility.
III) with the steepest slope.
IV) with the lowest slope.
A. I and III
B. I and IV
C. II and IV
D. I only
E. I, II, and III

## Consider the following probability distribution for stocks A and B:

42. The expected rates of return of stocks A and B are _____ and _____, respectively.
A. 13.2%; 9%.
B. 13%; 8.4%
C. 13.2%; 7.7%
D. 7.7%; 13.2%
E. none of the above
43. The standard deviations of stocks A and B are _____ and _____, respectively.
A. 1.56%; 1.99%
B. 2.45%; 1.68%
C. 3.22%; 2.01%
D. 1.54%; 1.11%
E. none of the above
44. The coefficient of correlation between A and B is
A. 0.474.
B. 0.612.
C. 0.583.
D. 1.206.
E. none of the above.
45. If you invest 35% of your money in A and 65% in B, what would be your portfolio's
expected rate of return and standard deviation?
A. 9.9%; 3%
B. 9.9%; 1.1%
C. 10%; 1.7%
D. 10%; 3%
E. none of the above

Chapter 9&10
46.

Consider the CAPM. The risk-free rate is 5% and the expected return on the
market is 15%. What is the beta on a stock with an expected return of 12%?
A) .5
B) .7
C) 1.2
D) 1.4

47.

## __________ is a true statement regarding the multi-factor arbitrage pricing

theory.
A) Only the stock beta affects the stock price
B) Only the stock unique risk affects the stock price
C) Only the stock variance and beta affect the stock price
D) Several systematic factors affect the stock price

48.

A) -1.0
B) 0
C) 0.5
D) 1.0

49.

## According to the capital asset pricing model, a well-diversified portfolio's rate of

return is a function of __________.
A) market risk
B) unsystematic risk
C) unique risk
D) reinvestment risk

50.

According to the capital asset pricing model, the expected rate of return on any
security is equal to __________.
A) [(the risk-free rate) + (beta of the security)] x (market risk premium)
B) (the risk-free rate) + [(variance of the security's return) x (market risk
C) (the risk-free rate) + [(security's beta) x (market risk premium)]
D) (market rate of return) + (the risk-free rate)

51.

According to the capital asset pricing model, fairly priced securities have
__________.
A) negative betas
B) positive alphas
C) positive betas
D) zero alphas

52.

The difference between a security's actual return and the return predicted by the
characteristic line associated with the security's past returns is ___________.
A) alpha
B) beta
C) gamma
D) residual

53.

## The beta, of a security is equal to __________.

A) A) the covariance between the security and market returns divided by the
variance of the market's returns
B) the covariance between the security and market returns divided by the
standard deviation of the market's returns
C) the variance of the security's returns divided by the covariance between the
security and market returns
D) the variance of the security's returns divided by the variance of the market's
returns

54.

Security A has an expected rate of return of 12% and a beta of 1.10. The market
expected rate of return is 8% and the risk-free rate is 5%. The alpha of the stock
is __________.
A) -1.7%
B) 3.7%
C) 5.5%
D) 8.7%

55.

The risk-free rate is 4%. The expected market rate of return is 11%. If you
expect stock X with a beta of .8 to offer a rate of return of 12 percent, then you
should __________.
A) buy stock X because it is overpriced
B) buy stock X because it is underpriced
C) sell short stock X because it is overpriced
D) sell short stock X because it is underpriced

56. According to capital asset pricing theory, the key determinant of portfolio returns is
__________.
A) the degree of diversification
B) the systematic risk of the portfolio
C) the firm specific risk of the portfolio
D) economic factors

57. Assume that both X and Y are well-diversified portfolios and the risk-free rate is 8%.
Portfolio X has an expected return of 14% and a beta of 1.00. Portfolio Y has an
expected return of 9.5% and a beta of 0.25. In this situation, you would conclude
that portfolios X and Y __________.
A) are in equilibrium
B) offer an arbitrage opportunity
C) are both underpriced
D) are both fairly priced
58. You hold a diversified portfolio consisting of a \$5,000 investment in each of 20
different common stocks. The portfolio beta is equal to 1.12. You have decided to sell a
lead mining stock (b = 1.0) at \$5,000 net and use the proceeds to buy a like amount of a
steel company stock (b = 2.0). What is the new beta of the portfolio?
a.
b.
c.
d.
e.

1.12
1.17
1.22
1.10
1.02

59. Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3.
The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the
Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
60. Your opinion is that CSCO has an expected rate of return of 0.1375. It has a beta of
1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115. According
to the Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.

61. Your opinion is that CSCO has an expected rate of return of 0.15. It has a beta of 1.3.
The risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the
Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
62. As a financial analyst, you are tasked with evaluating a capital budgeting project. You
were instructed to use the IRR method and you need to determine an appropriate hurdle
rate. The risk-free rate is 4 percent and the expected market rate of return is 11 percent.
Your company has a beta of 1.4 and the project that you are evaluating is considered to
have risk equal to the average project that the company has accepted in the past.
According to CAPM, the appropriate hurdle rate would be ______%.
A. 13.8
B. 7
C. 15
D. 4
E. 1.4

Chapter 11

63.

The weak form EMH states that ________ must be reflected in the stock price.
B) all publicly available information
C) all information including inside information
D) none of the above

64.

## Proponents of the EMH typically advocate __________.

A) a conservative investment strategy
B) a liberal investment strategy
C) a passive investment strategy
D) an aggressive investment strategy

65.

## A chartist is likely to believe in the value of doing __________.

A) fundamental analysis
B) technical analysis
C) both a and b
D) neither a nor b

66.

__________ is the return on a stock beyond what would be predicted from market
movements alone.
A) a normal return
B) a subliminal return
C) an abnormal return
D) none of the above

67.

If you believe in the __________ form of the EMH, you believe that stock prices
reflect all information that can be derived by examining market trading data such
as the history of past stock prices, trading volume or short interest.
A) semi-strong
B) strong
C) weak
D) any of the above

68.

## Which of the following have not been considered market anomalies?

A) the small-firm January effect
B) the reversal effect
C) the book-to-market effect
D) All of the above have been considered market anomalies

69.

## Proponents of the EMH think technical analysts __________.

A) should focus on relative strength
B) should focus on resistance levels
C) should focus on support levels
D) are wasting their time

70.

When stock returns exhibit positive serial correlation, this means that __________
returns tend to follow ___________ returns.
A) positive; positive
B) positive ; negative
C) negative; positive
D) None of the above

71.

## Basu found that firms with high P/E ratios __________.

A) earned higher average returns than firms with low P/E ratios
B) earned the same average returns as firms with low P/E ratios
C) earned lower average returns than firms with low P/E ratios
D) had higher dividend yields than firms with low P/E ratios

72.

## According to the semi-strong form of the efficient markets hypothesis

____________.
A) stock prices do not rapidly adjust to new information
B) future changes in stock prices cannot be predicted from any information that
is publicly available
C) corporate insiders should have no better investment performance than other
investors
D) arbitrage between futures and cash markets should not produce extraordinary
profits

73.

## The semi-strong form of the efficient market hypothesis contradicts __________.

A) technical analysis, but supports fundamental analysis as valid
B) fundamental analysis, but supports technical analysis as valid
C) both fundamental analysis and technical analysis
D) technical analysis, but is silent on the possibility of successful fundamental
analysis

74. __________ focus more on past price movements of a firm's stock than on the
underlying determinants of future profitability.
A. Credit analysts
B. Fundamental analysts
C. Systems analysts
D. Technical analysts
E. All of the above
75. According to proponents of the efficient market hypothesis, the best strategy for a
small investor with a portfolio worth \$40,000 is probably to
A. perform fundamental analysis.
B. exploit market anomalies.
C. invest in Treasury securities.
D. invest in derivative securities.
E. invest in mutual funds.
76. Google has a beta of 1.0. The annualized market return yesterday was 11%, and the
risk-free rate is currently 5%. You observe that Google had an annualized return
yesterday of 14%. Assuming that markets are efficient, this suggests that
D. interest rates rose yesterday.
E. interest rates fell yesterday.

HPR =

10 ,000 9 ,800
= 2.04%
9 ,800

P=

y=

26.00 + 1.50
= 21.15
1 + .30

.22 .08
= 1.75
.16 .08

## Borrowing = 500,000(1.75 - 1) = 375,000

HPR = (53 55 +3) / 55 = .0182
10. D

The more risk averse the investor, the less risk that is tolerated, given a rate of return.
11. D

## 0.06 = 0.15 - A/2(0.15)2; 0.06 - 0.15 = -A/2(0.0225); -0.09 = -0.01125A; A = 8; U = 0.15

- 8/2(0.15)2 = 6%; U(Rf) = 6%.
12. C

## U(c) = 0.21 - 4/2(0.16)2 = 15.88 (highest utility of choices).

13. D

If you are risk neutral, your only concern is with return, not risk.
14. B

The presence of risk means that more than one outcome is possible.
15. A

The CAL has an intercept equal to the risk-free rate. It is a straight line through the point
representing the risk-free asset and the risky portfolio, in expected-return/standard
deviation space.
16. B

17. A

## 11% = w1(17%) + (1 - w1)(4%); 11% = 17%w1 + 4% - 4%w1; 7% = 13%w1; w1 = 0.538;

1 - w1 = 0.461; 0.538(17%) + 0.462(4%) = 11.0%.
18. B

Corr = .225

## = (.50) 2 (.22) 2 + (.50) 2 (.16) 2 + 2(.35)(.22)(.16)(.50)(.50) = .157

Reward to variability ratio = (.089 - .035) / .12 = 0.45

33. A

Portfolios on the efficient frontier are those providing the greatest expected return for a
given amount of risk. Only those portfolios above the global minimum variance portfolio
meet this criterion.
34. C

The Capital Allocation Line represents the most efficient combinations of the risk-free
asset and risky securities. Only C meets that definition.
35. A

All rational investors select the portfolio that maximizes their expected utility; for
investors who are relatively more risk-averse, doing so means investing less in the
optimal risky portfolio and more in the risk-free asset.
36. E

The only way that an investor can create portfolios to the right of the Capital Allocation
Line is to create a borrowing portfolio (buy stocks on margin). In this case, the investor
will not hold any of the risk-free security, but will hold only risky securities.
37. A

## Cov(rX, rY) = (.7)(.20)(.27) = .0378

38. D

The portfolio opportunity set is the line describing all combinations of expected returns
and standard deviations that can be achieved by a portfolio of risky assets.
39. E

## Slope = (14 - 6)/22 = .3636

40. D

When there is a perfect positive correlation (or a perfect negative correlation), the
equation for the portfolio variance simplifies to a perfect square. The result is that the
portfolio's standard deviation is linear relative to the assets' weights in the portfolio.
41. E

The optimal CAL is the one that is tangent to the efficient frontier. This CAL offers the
highest reward-to-variability ratio, which is the slope of the CAL. It will also allow the
investor to reach his highest feasible level of utility.
42. B

## E(RA) = 0.15(8%) + 0.2(13%) + 0.15(12%) + 0.3(14%) + 0.2(16%) = 13%; E(RB) =

0.15(8%) + 0.2(7%) + 0.15(6%) + 0.3(9%) + 0.2(11%) = 8.4%.
43. B

## sA = [0.15(8% - 13%)2 + 0.2(13% - 13%)2 + 0.15(12% - 13%)2 + 0.3(14% - 13%)2 +

0.2(16% - 13%)2] 1/2 = 2.449%; sB = [0.15(8% - 8.4%)2 + 0.2(7% - 8.4%)2 + 0.15(6% 8.4%)2 + 0.3(9% - 8.4%)2 + 0.2(11% - 8.4%)2 ] 1/2 = 1.676%.
44. C

covA,B = 0.15(8% - 13%)(8% - 8.4%) + 0.2(13% - 13%)(7% - 8.4%) + 0.15(12% 13%)(6% - 8.4%) + 0.3(14% - 13%)(9% - 8.4%) + 0.2(16% - 13%)(11% - 8.4%) = 2.40;
rA,B = 2.40/[(2.45)(1.68)] = 0.583.
45. C

## E(RP) = 0.35(13%) + 0.65(8.4%) = 10.01%; sP = [(0.35)2(2.45%)2 + (0.65)2(1.68)2 +

2(0.35)(0.65)(2.45)(1.68)(0.583)]1/2 = 1.7%.

## = .12[.05 + 1.1(08 .05)] = .037

58.B
Before: 1.12 = 0.95(bR) + 0.05(1.0); 0.95(bR) = 1.07; bR = 1.13.
After: bP = 0.95(bR) + 0.05(2.0) = 1.07 + 0.10 = 1.17.

59. B

60. C

61. A

## 15% - 4% + 1.3(11.5% - 4%) = 1.25%; therefore, the security is under priced.

62. A

The hurdle rate should be the required return from CAPM or (R = 4% + 1.4(11% - 4%) =
11%.

74. D
Technicians attempt to predict future stock prices based on historical stock prices.
75. E
Individual investors tend to have relatively small portfolios and are usually unable to
realize economies of size. The best strategy is to pool funds with other small investors
and allow professional managers to invest the funds.
76. B
AR = 14% - (5% + 1.0 (6%)) = +3.0%. A positive abnormal return suggests that there
was firm-specific good news.

## Review for Exam 3

The exam will have 20 multiple choice questions and 4 work problems.
Questions in the multiple choice section will be either concept or calculation
questions. The calculation questions will be similar to those in the quizzes,
assignment, and review. However, the concept questions will be related to any
topic we have covered in the class. The concept questions in the review are only
some sample questions. You should NOT study only topics in the review.
For the work problems, you need to solve the problems without knowing the
possible answers. The questions will be similar to those in the quizzes,
assignment, and review except that the possible solutions are not given.
You can bring a formula sheet to the exam.
The final exam schedules are as follows:
o Final Exams for Classes Meeting Tu-Th at 9:30am Thursday, May 15
o

8:00 AM - 11:00 AM
Final Exams for Classes Meeting Tu-Th at 11am Monday, May 19
11:30 AM - 2:30 PM

Chapter 12
1. The excess return required from a risky asset over that required from a risk-free asset is
called the:
c. excess return.
d. average return.
e. variance.
STRONG FORM EFFICIENCY
2. The hypothesis that market prices reflect all available information of every kind is
called _____ form efficiency.
a. open
b. strong
c. semi-strong
d. weak
e. stable
DIVIDEND YIELD
3. The dividend yield is equal to _____, where P1 is the purchase cost, P2 represents the
sale proceeds, and d is the dividend income.
a. d P1
b. d P1
c. d P2
d. d P2
e. d (P1 + P2)
HISTORICAL RECORD
4. Based on the period of 1926 through 2003, _____ have tended to outperform other
securities over the long-term.
a. U.S. Treasury bills
b. large company stocks
c. long-term corporate bonds
d. small company stocks
e. long-term government bonds
5. Which one of the following is a correct statement concerning risk premium?
a. The greater the volatility of returns, the greater the risk premium.
b. The lower the volatility of returns, the greater the risk premium.
c. The lower the average rate of return, the greater the risk premium.
d. The risk premium is not correlated to the average rate of return.
e. The risk premium is not affected by the volatility of returns.
MARKET EFFICIENCY
6. In an efficient market, the price of a security will:
a. always rise immediately upon the release of new information with no further price
b. react to new information over a two-day period after which time no further price
adjustments related to that information will occur.
c. rise sharply when new information is first released and then decline to a new stable
level by the following day.

d.

react immediately to new information with no further price adjustments related to that
information.
e. be slow to react for the first few hours after new information is released allowing time
for that information to be reviewed and analyzed.
MARKET EFFICIENCY
7. Your best friend works in the finance office of the Delta Corporation. You are aware
that this friend trades Delta stock based on information he overhears in the office. You
know that this information is not known to the general public. Your friend continually
brags to you about the profits he earns trading Delta stock. Based on this information,
you would tend to argue that the financial markets are at best _____ form efficient.
a. weak
b. semiweak
c. semistrong
d. strong
e. perfect
DOLLAR RETURNS
8. One year ago, you purchased a stock at a price of \$32.50. The stock pays quarterly
dividends of \$.40 per share. Today, the stock is worth \$34.60 per share. What is the
total amount of your dividend income to date from this investment?
a. \$.40
b. \$1.60
c. \$2.10
d. \$2.50
e. \$3.70

Chapter 13
PRINCIPLE OF DIVERSIFICATION
9. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will
c. spreading an investment across five diverse companies will not lower your overall risk
at all.
d. spreading an investment across many diverse assets will eliminate all of the risk.
e. spreading an investment across many diverse assets will eliminate some of the risk.
EXPECTED RETURN
10. You are considering purchasing stock S. This stock has an expected return of 8 percent
if the economy booms and 3 percent if the economy goes into a recessionary period.
The overall expected rate of return on this stock will:
a. be equal to one-half of 8 percent if there is a 50 percent chance of an economic boom.
b. vary inversely with the growth of the economy.
c. increase as the probability of a recession increases.
d. be equal to 75 percent of 8 percent if there is a 75 percent chance of a boom economy.
e. increase as the probability of a boom economy increases.
DIVERSIFIABLE RISKS
11. Which one of the following is an example of diversifiable risk?

## a. the price of electricity just increased

b. the employees of Textile, Inc. just voted to go on strike
c. the government just imposed new safety standards for all employees
d. the government just lowered corporate income tax rates
e. the cost of group health insurance just increased nationwide
NONDIVERSIFIABLE RISKS
12. Which one of the following is an example of a nondiversifiable risk?
a. a well respected president of a firm suddenly resigns
b. a well respected chairman of the Federal Reserve suddenly resigns
c. a key employee of a firm suddenly resigns and accepts employment with a key
competitor
d. a well managed firm reduces its work force and automates several jobs
e. a poorly managed firm suddenly goes out of business due to lack of sales

## EXPECTED AND UNEXPECTED RETURNS (EXPECTED AND UNEXPECTED NEWS)

13. Which one of the following events is considered part of the expected return on Fido
stock?
a. The president of Fido suddenly announced that the firm is going to cut production
effective immediately.
b. The government just announced a tax cut which will directly impact the sales of Fido.
c. The management of Fido announced their ten-year plan for expansion five years ago.
d. The price of Fido stock suddenly dropped due to rumors concerning company fraud.
e. Fido just won a major government contract which they had not anticipated winning.
TOTAL RISK
14. _____ measures total risk.
a. The mean
b. Beta
c. The geometric average
d. The standard deviation
e. The arithmetic average
SYSTEMATIC RISK
15. Systematic risk is measured by:
a. the mean.
b. beta.
c. the geometric average.
d. the standard deviation.
e. the arithmetic average.
SYSTEMATIC RISK
16. Which of the following risks are relevant to a well-diversified investor?
I.
systematic risk
II. unsystematic risk
III. market risk
IV. nondiversifiable risk
a. I and III only
b. II and IV only
c. II, III, and IV only
d. I, II, and IV only

## e. I, III, and IV only

UNSYSTEMATIC RISK
17. Which one of the following is an example of unsystematic risk?
a. the inflation rate increases unexpectedly
b. the federal government lowers income taxes
c. an oil tanker runs aground and spills its cargo
d. interest rates decline by one-half of one percent
e. the GDP rises by 2 percent more than anticipated
SYSTEMATIC RISK PRINCIPLE
18. The systematic risk principle implies that the _____ an asset depends only on that
assets systematic risk.
a. variance of the returns on
b. standard deviation of the returns on
c. expected return on
d. total risk assumed by owning
e. diversification benefits of
SECURITY MARKET LINE (SML)
19. A stock with an actual return that lies above the security market line:
a. has more systematic risk than the overall market.
b. has more risk than warranted based on the realized rate of return.
c. has yielded a higher return than expected for the level of risk assumed.
d. has less systematic risk than the overall market.
e. has yielded a return equivalent to the level of risk assumed.
CAPITAL ASSET PRICING MODEL (CAPM)
20. A security that has a rate of return that exceeds the U.S. Treasury bill rate but is less
than the market rate of return must:
a. be a risk-free asset.
b. have a beta that is greater than 1.0 but less than 2.0.
c. be a risk-free asset with a beta less than .99.
d. be a risky asset with a standard deviation less than 1.0.
e. be a risky asset with a beta less than 1.0.
EXPECTED RETURN
21. You are comparing stock A to stock B. Given the following information, which one of
these two stocks should you prefer and why?
Rate of Return if
State of
Probability of
State Occurs
Economy
State of Economy
Stock A Stock B
Boom
60%
9%
15%
Recession
40%
4%
-6%
a. Stock A; because it has an expected return of 7 percent and appears to be more risky.
b. Stock A; because it has a higher expected return and appears to be less risky than stock
B.
c. Stock A; because it has a slightly lower expected return but appears to be significantly
less risky than stock B.
d. Stock B; because it has a higher expected return and appears to be just slightly more
risky than stock A.
e. Stock B; because it has a higher expected return and appears to be less risky than stock
A.

22. A portfolio is expected to return 7 percent in a normal economy, 14 percent in a boom economy, and
lose 20 percent in a recessionary economy. The probability of a recession is 20 percent while
the probability of a boom is 5 percent. What is the standard deviation of the portfolio?
a. 7.89 percent
b. 9.32 percent c. 10.87 percent d. 11.08 percent

## PORTFOLIO EXPECTED RETURN

23. What is the expected return on a portfolio comprised of \$4,000 in stock M and \$6,000
in stock N if the economy enjoys a boom period?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

Probability of
State of Economy
10%
75%
15%

## Returns if State Occurs

Stock M
Stock N
18%
10%
7%
8%
-20%
6%

6.4 percent
6.8 percent
10.4 percent
13.2 percent
14.0 percent

BETA
24. What is the beta of a portfolio comprised of the following securities?

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

Amount
Invested
\$2,000
\$3,000
\$5,000

Security
Beta
1.20
1.46
.72

1.008
1.014
1.038
1.067
1.127

## CAPITAL ASSET PRICING MODEL (CAPM)

25. The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6
percent and the market risk premium is 9 percent. What is the expected rate of return
on Martin Industries stock?
a. 11.3 percent
b. 14.1 percent
c. 16.5 percent
d. 17.4 percent
e. 18.0 percent

Chapter 15
COST OF EQUITY
26. The return that shareholders require on their investment in the firm is called the:
a. dividend yield.
b. cost of equity.
c. capital gains yield.
d. cost of capital.
e. income return.
PURE PLAY APPROACH
27. When firms develop a WACC for individual projects based on the cost of capital for
other firms in similar lines of business as the project, the firm is utilizing a _____
approach.
a. subjective risk
b. pure play
c. divisional cost of capital
e. security market line
COST OF EQUITY
28. A firms overall cost of equity is:
I.
directly observable in the financial markets.
II. unaffected by changes in the market risk premium.
III. highly dependent upon the growth rate and risk level of a firm.
IV. an estimate only.
a. I and III only
b. II and IV only
c. I and II only
d. III and IV only
e. I and IV only
DIVIDEND GROWTH MODEL
29. The dividend growth model:
a. can be used to estimate the cost of equity for any corporation.
b. is applicable only to firms that pay a constant dividend.
c. is highly dependent upon the estimated rate of growth.
d. is considered quite complex.
e. considers the risk of the firm.
COST OF DEBT
30. The pre-tax cost of debt for a firm:
a. is equal to the yield to maturity on the outstanding bonds of the firm.
b. is equal to the coupon rate of the outstanding bonds of the firm.
c. is equivalent to the current yield on the outstanding bonds of the firm.
d. is based on the yield to maturity that existed when the currently outstanding bonds were
originally issued.
e. has to be estimated as it cannot be directly observed in the market.
CAPITAL STRUCTURE WEIGHTS
31. The capital structure weights used in computing the weighted average cost of capital
are:
a. constant over time provided that the debt-equity ratio changes in unison with the
market values.
b. based on the face value of the firms debt.
c. computed using the book value of the long-term debt and the shareholders equity.

d. based on the market value of the firms debt and equity securities.
e. limited to the firms debt and common stock.
WEIGHTED AVERAGE COST OF CAPITAL
32. Which one of the following statements is correct concerning the weighted average cost
of capital (WACC)?
a. The pre-tax rate of return on the debt is the rate that is relevant to the computation of
the WACC.
b. When computing the WACC, the weight assigned to the preferred stock is equal to the
coupon rate multiplied by the par value assigned to the preferred stock.
c. A firms WACC will decrease as their corporate tax rate decreases.
d. The weight of the common stock used in the computation of the WACC is based on the
number of shares outstanding multiplied by the book value per share.
e. The weight of the debt can be based on the face value of the bond issue(s) outstanding
multiplied by the quoted price(s) when expressed as a percentage of the face value.
COST OF EQUITY
33. Martin Industries just paid an annual dividend of \$1.20 a share. The market price of
the stock is \$26.60 and the growth rate is 4 percent. What is the firms cost of equity?
a. 8.38 percent
b. 8.51 percent
c. 8.57 percent
d. 8.69 percent
e. 8.74 percent

COST OF EQUITY
34. Daniels Enterprises has a beta of 1.98 and a growth rate of 12 percent. The stock is
currently selling for \$12 a share. The overall stock market has an 11 percent rate of
return and a risk premium of 8 percent. What is the expected rate of return on Daniels
Enterprises stock?
a. 10.00 percent
b. 15.85 percent
c. 16.67 percent
d. 18.84 percent
e. 19.06 percent

COST OF DEBT
35. The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon.
Interest payments are paid semi-annually. The face amount of the bond is \$1,000. This
bond is currently selling for 98 percent of its face value. What is the companys pre-tax
cost of debt?
a. 4.72 percent
b. 5.31 percent
c. 5.35 percent
d. 5.39 percent
e. 5.42 percent
AFTER-TAX COST OF DEBT
36. Toms Ventures has a zero coupon bond issue outstanding that matures in thirteen
years. The bonds are selling at 48 percent of par value. The companys tax rate is 34
percent. What is the companys after-tax cost of debt?

a.
b.
c.
d.
e.

3.83 percent
4.11 percent
4.73 percent
4.80 percent
5.81 percent

## WEIGHTED AVERAGE COST OF CAPITAL

37. Peters Audio Shop has a cost of debt of 7 percent, a cost of equity of 11 percent, and a
cost of preferred stock of 8 percent. The firm has 104,000 shares of common stock
outstanding at a market price of \$20 a share. There are 40,000 shares of preferred stock
outstanding at a market price of \$34 a share. The bond issue has a total face value of
\$500,000 and sells at 102 percent of face value. The companys tax rate is 34 percent.
What is the weighted average cost of capital for Peters Audio Shop?
a. 6.14 percent
b. 6.54 percent
c. 8.60 percent
d. 9.14 percent
e. 9.45 percent

## CAPITAL STRUCTURE WEIGHTS

38. Watsons Automotive has a \$400,000 bond issue outstanding that is selling at 102
percent of face value. Watsons also has 4,500 shares of preferred stock and 21,000
shares of common stock outstanding. The preferred stock has a market price of \$44 a
share compared to a price of \$21 a share for the common stock. What is the weight of
the debt as it relates to the firms weighted average cost of capital?
a. 38 percent
b. 39 percent
c. 40 percent
d. 41 percent
e. 42 percent

1.
2.
3.
4.
5.
6.
7.
8.

b
a
d
a
d
c
b
Dividend income = \$.40 4 = \$1.60
9. e
10. e
11. b
12. b
13. c
14 . d
15. b
16. e
17. c
18. c
19. c
20. e
21. b
E(r)A = (.60 .09) + (.40 .04) = .054 + .016 = .07 = 7 percent
E(r)B = (.60 .15) + (.40 -.06) = .09 .024 = .066 = 6.6 percent
You should select stock A because it has a higher expected return and also appears to be
less risky.
B

22. d

E(R) = [(.75 .07) + (.05 .14) + (.20 -.20)] = (.0525 + .007 .040) = .0195
Std dev = .75 (.07 .0195)2 + .05 (.14 .0195)2 + .20 (-.20 .0195)2 = .00191269 +
.00072601 + .00963605 = .01227475 = 11.08 percent

23. d
E(r)Boom = [(\$4,000 (\$4,000 + \$6,000) .18] + [\$6,000 (\$4,000 + \$6,000) .10] =
.072 + .06 = .132 = 13.2 percent

24. c
.

## ValuePortfolio = \$2,000 + \$3,000 + \$5,000 = \$10,000

BetaPortfolio = (\$2,000 \$10,000 1.20) + (\$3,000 \$10,000 1.46) + (\$5,000 \$10,000
.72) = .24 + .438 + .36 = 1.038

25. c
.

26. b
27. b

28. d
29. c
30. a
31. d
32. e
33. d

## E(r) = .036 + (1.43 .09) = .1647 = 16.5 percent

Re =

\$1.20 1.04
+ .04 = 8.69 percent
\$26.60

34. d
Re = (.11 .08) + (1.98 .08) = 18.84 percent

35. d
Enter

62
N

Solve for

2/
I/Y
5.39

980
PV

50/2 1000
PMT FV

36. a
480
1000
I/Y
PV
PMT FV
Solve for
5.81
After-tax Rd = 5.81 percent (1 .34) = 3.83 percent
Enter

13
N

37. d
Debt:
\$500,000 1.02 = \$ .51m
Preferred:
40,000 \$34 = \$1.36m
Common:
104,000 \$20 = \$2.08m
Total = \$.51m + \$1.36m + \$2.08m = \$3.95m
\$2.08m
\$1.36m
\$.51m

WACC =
.11 +
.08 +
.07 (1 .34) = .057924 + .027544
\$3.95m
\$3.95m
\$3.95m

## + .005965 = .091433 = 9.14 percent

38. b
Debt:
\$400,000 1.02 = \$408,000
Preferred:
4,500 \$44 = \$198,000
Common:
21,000 \$21 = \$441,000
Total = \$408,000 + \$198,000 + \$441,000 = \$1,047,000
WeightDebt = \$408,000 \$1,047,000 = 39 percent

## Capital market history shows us that the average return

relationship from lowest to highest between securities is:
Treasury bills, government bonds, corporate bonds, large
common stocks, small company stocks.
The Zolo Co. just declared that it is increasing its annual
dividend from \$1.00 per share to \$1.25 per share. If the stock
price remains constant, then:
the dividend yield will increase.
Which of the following statements are correct concerning the
variance of the annual returns on an investment?
I. The larger the variance, the more the actual returns tend to
differ from the average return.
II. The larger the variance, the larger the standard deviation.
III. The larger the variance, the greater the risk of the investment.
IV. The larger the variance, the higher the expected return.
Estimates using the arithmetic average will probably tend to
_____ values over the long-term while estimates using the
geometric average will probably tend to _____ values over the
short-term.
overestimate; underestimate
Which one of the following is an example of systematic risk?
the Federal Reserve increases interest rates
The Capital Market Line is the pricing relationship between:
beta and the standard deviation of portfolio return.
The intercept point of the security market line is the rate of
return which corresponds to:
the risk-free rate of return.
Which one of the following measures is relevant to the
systematic risk principle?
beta
Diversification will not lower the ____ risk:
systematic risk.
Which one of the following statements is correct concerning the
expected rate of return on an individual stock given various
states of the economy?

## The expected return is a weighted average where the probabilities

of the economic states are used as the weights.
You are considering purchasing stock S. This stock has an
expected return of 8% if the economy booms and 3% if the
economy goes into a recessionary period. The overall expected
rate of return on this stock will:
increase as the probability of a boom economy increases.

Question 1
2 / 2 pts
The capital gains yield plus the dividend yield on a security is called the:

total return.

geometric return.

## average period return.

variance of returns.

current yield.

Question 2
2 / 2 pts
A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation is the
_____ distribution.

normal

Poisson

bi-modal

uniform

gamma

IncorrectQuestion 3
0 / 2 pts
Capital market history shows us that the average return relationship from lowest to highest between securities is:

inflation, corporate bonds, Treasuries, small company stocks, large company stocks.

## Treasury bills, inflation, small company stocks, large company stocks.

Treasury bills, corporate bonds, government bonds, large common stocks, small company stocks.

There is no ordering.

Treasury bills, government bonds, corporate bonds, large common stocks, small company stocks.

Question 4
2 / 2 pts
A portfolio of large company stocks would contain which one of the following types of securities?

stocks of the firms which represent the smallest 20% of the companies listed on the NYSE

## long-term government bonds

Question 5
2 / 2 pts
The average compound return earned per year over a multi-year period is called the _____ average return.

geometric

variant

real

arithmetic

standard

Question 6
2 / 2 pts
A capital gain occurs when:

## there is no income component of return.

Question 7
2 / 2 pts
The return earned in an average year over a multi-year period is called the _____ average return.

real

geometric

standard

variant

arithmetic

Question 8
2 / 2 pts
Which one of the following is a correct statement concerning risk premium?

The greater the volatility of returns, the greater the risk premium.

The lower the volatility of returns, the greater the risk premium.

## The risk premium is not affected by the volatility of returns.

The lower the average rate of return, the greater the risk premium.

## The risk premium is not correlated to the average rate of return.

Question 9
2 / 2 pts
How much of total world stock market capitalization is from the United States in 2011?

Approximately 25%

Approximately 10%

Approximately 45%

Approximately 57%

Approximately 72%

Question 10
2 / 2 pts
Which of the following statements concerning the standard deviation are correct?
I. The greater the standard deviation, the lower the risk.
II. The standard deviation is a measure of volatility.
III. The higher the standard deviation, the less certain the rate of return in any one given year.
IV. The higher the standard deviation, the higher the expected return.

## I, II, III, and IV

Question 11
2 / 2 pts
Total risk can be divided into:

## standard deviation and variance.

Question 12
2 / 2 pts
Which one of the following is an example of systematic risk?

## the price of lumber declines sharply

Question 13
2 / 2 pts
The primary purpose of portfolio diversification is to:

## eliminate systematic risk.

IncorrectQuestion 14
0 / 2 pts
Diversification can effectively reduce risk. Once a portfolio is diversified the type of risk remaining is:

None of these.

## individual security risk.

IncorrectQuestion 15
2 / 2 pts
The elements in the off-diagonal positions of the variance/covariance matrix are:

security selections.

security weights.

variances.

None of these.

covariances.

Question 16
2 / 2 pts
You are considering purchasing stock S. This stock has an expected return of 8% if the economy booms and 3% if
the economy goes into a recessionary period. The overall expected rate of return on this stock will:

## increase as the probability of a boom economy increases.

IncorrectQuestion 17
2 / 2 pts
A well-diversified portfolio has eliminated most of the:

expected return.

## Both systematic risk; and variance.

systematic risk.

unsystematic risk.

variance.

Question 18
2 / 2 pts
Systematic risk is measured by:

the mean.

## the geometric average.

beta.

Question 19
2 / 2 pts
Risk that affects at most a small number of assets is called _____ risk.

total

nondiversifiable

market

portfolio

unsystematic

IncorrectQuestion 20
0 / 2 pts
The diversification effect of a portfolio of two stocks:

None of these.

Both increases as the correlation between the stocks declines; and decreases as the correlation between the stocks
rises.

## increases as the correlation between the stocks declines.

IncorrectQuestion 21
0 / 2 pts
You have a portfolio of two risky stocks which turns out to have no diversification benefit. The reason you have no
diversification is the returns:

## move perfectly with one another.

Question 22
2 / 2 pts
If the covariance of stock 1 with stock 2 is - .0065, then what is the covariance of stock 2 with stock 1?

-.0065

## greater than +.0065

+.0065

IncorrectQuestion 23
2 / 2 pts
Which one of the following is an example of unsystematic risk?

## the inflation rate increases unexpectedly

IncorrectQuestion 24
2 / 2 pts
The total number of variance and covariance terms in a portfolio is N2. How many of these would be (including
non-unique) covariances?

N2- N/2

N2- N

N2

None of these.

IncorrectQuestion 25
2 / 2 pts
If the correlation between two stocks is -1, the returns:

None of these.

## move perfectly opposite one another.

IncorrectQuestion 26
2 / 2 pts
Beta measures:

All of these.

## the standard deviation of the assets' returns.

IncorrectQuestion 27
2 / 2 pts
A security that is fairly priced will have a return _____ the Security Market Line.

on or below

on

above

below

on or above

Question 28
2 / 2 pts

Which one of the following statements is correct concerning the expected rate of return on an individual stock given
various states of the economy?

The expected return is a geometric average where the probabilities of the economic states are used as the
exponential powers.

The expected return is a weighted average where the probabilities of the economic states are used as the weights.

The expected return is an arithmetic average of the individual returns for each state of the economy.

The expected return is equal to the summation of the values computed by dividing the expected return for each
economic state by the probability of the state.

As long as the total probabilities of the economic states equal 100%, then the expected return on the stock is a
geometric average of the expected returns for each economic state.

IncorrectQuestion 29
2 / 2 pts
You have plotted the data for two securities over time on the same graph, i.e., the monthly return of each security for
the last 5 years. If the pattern of the movements of each of the two securities rose and fell as the other did, these two
securities would have:

## a weak negative correlation.

no correlation at all.

## a strong negative correlation.

IncorrectQuestion 30
2 / 2 pts
The opportunity set of portfolios is:

## the best or highest risk-return combination.

71. The elements along the diagonal of the variance/covariance matrix are:
A.covariances.
B.security weights.
C.security selections.
D.variances.
E.None of the above.
Difficulty level: MediumTopic: VARIANCE-COVARIANCE MATRIXType: CONCEPTS

72. The elements in the off-diagonal positions of the variance/covariance matrix are:
A.covariances.
B.security selections.
C.variances.
D.security weights.
E.None of the above.

68. The total number of variance and covariance terms in a portfolio is N2. How many ofthese would be (including
non-unique) covariances?
A.N
B.N2
C.N2- N
D.N2- N/2
E.None of the above.
Difficulty level: MediumTopic: COVARIANCEType: CONCEPTS

## 6. A well-diversified portfolio has eliminated most of the:

A.expected return.
B.unsystematic risk.
C.systematic risk.
D.variance.
E.Both C and D

## Fall08 Test 3 Chp 10-12 Key

1. The excess return required on a risky investment over that of a risk-free investment is called the:
b. required return.
c. real return.
d. average actual return.
2. The variance is the:
a. difference between the actual return and the average return.
b. difference between the actual return and the average return divided by N
1.
C. average squared difference between the actual return and the average return.
d. average squared difference between the actual return and the average return divided by N
e. square root of the standard deviation.

1.

3. The average compound return earned per year over a multiyear period is called the _____ return.
a. standardized mean
B. geometric average
c. annual percentage
d. arithmetic average
e. real
4. The hypothesis that stock markets, such as the NYSE, are efficient is called the:
a. market equalization hypothesis.
b. Fisher effect.
C. efficient markets hypothesis.
d. capital market hypothesis.
e. financial markets hypothesis.
5. This morning, you sold a dividend-paying stock that you purchased last year. Your total percentage return is
equal to:
a. (P0
P1 + D1) / P0.
B. (P1
P0 + D1) / P0.
c. D1 / P0.
d. (P1
P0) / P1.
e. P1 / P0.
6. The return on which one of the following is used as the risk-free rate of return?
a. long-term corporate bonds
b. long-term government bonds
c. short-term corporate bonds
D. U.S. Treasury bills
e. the Consumer Price Index

## 7. Standard deviation measures the _____ of a security's returns over time.

a. average value
b. frequency
C. volatility
d. mean
e. arithmetic average
8. Wellington Goods pays a constant dividend. Last year, the dividend yield was 4.6 percent when the stock was
selling for \$42 a share. What must the stock price be if the market currently requires a 4.0 percent dividend yield
on this stock?
a. \$41.70
b. \$42.10
c. \$47.50
D. \$48.30
e. \$48.80
9. One year ago, you bought a stock for \$21.40 a share. You received a dividend of \$1.90 per share last month and
sold the stock today for \$19.80 a share. What is the capital gains yield on this investment?
a. 8.08 percent
B. 7.48 percent
c. 5.47 percent
d. 1.40 percent
e. 1.52 percent
10. Liz earned a 3.1 percent real rate of return on her investments for the past year. During that time, the risk-free
rate was 3.7 percent and the inflation rate was 2.9 percent. What was her nominal rate of return?
a. 5.78 percent
b. 6.00 percent
C. 6.09 percent
d. 6.80 percent
e. 6.91 percent
11. Last year, Neal invested \$5,000 in Tattler's stock, \$5,000 in long-term government bonds, and \$5,000 in U.S.
Treasury bills. Over the course of the year, he earned returns of 9.7 percent, 5.4 percent, and 3.8 percent,
respectively. What was the risk premium on Tattler's stock for the year?
a. 4.08 percent
b. 4.30 percent
c. 5.21 percent
d. 5.68 percent
E. 5.90 percent
12. Five years ago, you purchased 200 shares of RST stock. The annual returns have been 9.8 percent, 6.4 percent,
7.5 percent, 1.2 percent, and 10.6 percent, respectively for those five years. What is the variance of these returns?
a. .0008
B. .0014
c. .0027
d. .0049
e. .0063

13. Your portfolio has provided you with returns of 7.9 percent, 11.2 percent, 3.8 percent, and 14.7 percent over
the past four years, respectively. What is the geometric average return for this period?
a. 8.98 percent
b. 9.16 percent
C. 9.33 percent
d. 9.40 percent
e. 9.44 percent
14. Systematic risk is:
A. a risk that affects a large number of assets.
b. the total risk inherent in an individual security.
c. also called diversifiable risk.
d. also called asset-specific risk.
e. unique to an individual firm.
15. The amount of systematic risk present in a particular risky asset relative to that in an average risky asset is
called the:
B. beta coefficient.
c. standard deviation.
d. mean.
e. variance.
16. The slope of the security market line is referred to as the:
a. market alpha.
c. diversification benefit.
e. expected return.
17. The equation that is represented graphically by the security market line is called the:
a. capital market function.
b. portfolio diversification model.
c. bell curve.
D. capital asset pricing model.
e. market risk model.
18. Systematic risk:
a. is diversifiable.
b. is the total risk associated with surprise events.
c. affects a small number of securities.
D. is measured by beta.
e. is measured by standard deviation.
19. The goal of diversification is to eliminate:
a. all investment risk.
c. systematic risk.
D. unsystematic risk.
e. the effects of beta.

20. A U.S. Treasury bill has a beta of _____ while the overall market has a beta of _____.
a. 0; 0
B. 0; 1
c. 1; 0
d. 1; 1
e. infinity; 1
21. If a security plots below the security market line, then the security:
a. is under-priced.
B. is overpriced.
c. is correctly priced.
d. has a beta greater than 1.0.
e. has a beta less than 1.0.
22. The stock of Chocolate Galore is expected to produce the following returns given the various states of the
economy. What is the expected return on this stock?

a. 7.33 percent
b. 9.82 percent
C. 11.26 percent
d. 11.33 percent
e. 11.50 percent
23. The cost of equity for ABC Industries is defined as the:
a. firm's weighted average cost of capital multiplied by the firm's beta.
b. yield to maturity on the firm's debt multiplied by one minus the tax rate.
c. market rate of return multiplied by the firm's beta.
D. return that ABC's shareholders require on their investment in the firm.
e. next year's dividend divided by the current stock price.
24. The weighted average cost of capital is defined as the weighted average of a firm's:
a. return on its investments.
B. cost of equity and its aftertax cost of debt.
c. pretax cost of debt and equity securities.
d. bond coupon rates.
e. dividend and capital gains yields.

## 25. A firm's weighted average cost of capital:

a. decreases when the firm's tax rate decreases.
b. is another terms for the firm's return on equity.
c. varies inversely with the firm's pre-tax cost of debt.
D. is the required return on the existing assets of the firm.
e. is the required return for each of a firm's proposed projects.
26. The cost of preferred stock:
a. decreases when a firm's tax rate increases.
b. is constant over time.
c. is unaffected by changes in the price of the stock.
D. is equal to the stock's dividend yield.
e. increases as the price of the stock increases.
27. A firm has a cost of equity of 10 percent, a cost of preferred of 9 percent, and an aftertax cost of debt of 5
percent. Given this, which one of the following will decrease the firm's weighted average cost of capital?
a. redeeming the bond issue
b. decreasing the debt-equity ratio
c. issuing new equity securities
d. increasing the systematic risk level of the firm
E. issuing new debt
28. The cost of capital for a project is primarily determined by the project's:
a. life span.
b. initial cost.
C. level of risk.
d. source of funds.
e. internal rate of return.
29. Deltronics just paid its first annual dividend of \$.20 a share. The firm plans to increase the dividend by 4
percent per year indefinitely. What is the firm's cost of equity if the current stock price is \$11 a share?
a. 5.82 percent
B. 5.89 percent
c. 6.33 percent
d. 6.48 percent
e. 6.54 percent
30. Ziegler's Supply has a beta of 1.06, a variance of .0124, a dividend growth rate of 2.8 percent, a stock price of
\$27 a share, and an expected annual dividend of \$1.10 per share next year. The market rate of return is 10.8
percent and the risk-free rate is 4.1 percent. What is the cost of equity for Ziegler's Supply?
a. 6.89 percent
b. 7.87 percent
c. 8.48 percent
D. 9.04 percent CAPM = 11.2%, so throw out.
e. 11.19 percent

31. Juno has 8 percent bonds outstanding that mature in 19 years. The bonds pay interest semiannually and have a
face value of \$1,000. Currently, the bonds are selling for \$989 each. What is Juno's pre-tax cost of debt?
a. 8.09 percent
B. 8.11 percent
c. 8.14 percent
d. 8.18 percent
e. 8.23 percent

32. Cobblestone Tours has 10,000 bonds that are currently quoted at 103.6. The bonds mature in 9 years and carry
a 10 percent annual coupon. What is Cobblestone Tour's aftertax cost of debt if the applicable tax rate is 34
percent?
A. 6.20 percent (Incorrect should be 6.60. Question will be thrown out.)
b. 6.27 percent
c. 7.17 percent
d. 9.28 percent
e. 9.39 percent
33. A

Ross Chapter 12
--A portfolio is
a group of assets, such as stocks and bonds, held as a collective
unit by an investor.
The average squared difference between the actual return and
the average return is called the
variance
The standard deviation for a set of stock returns can be
calculated as the
average squared difference between the actual return and the
average return.
A symmetric, bell-shaped frequency distribution that is
completely defined by its mean and standard deviation is the
_____ distribution.
normal
The average compound return earned per year over a multi-year
period is called the _____ average return.
geometric
The return earned in an average year over a multi-year period is
called the _____ average return.
arithmetic
An efficient capital market is one in which
security prices reflect available information.
The notion that actual capital markets, such as the NYSE, are
fairly priced is called the:
Efficient Markets Hypothesis (EMH)
The hypothesis that market prices reflect all available
information of every kind is called _____ form efficiency
strong
The hypothesis that market prices reflect all publicly-available
information is called _____ form efficiency
semi-strong

## The hypothesis that market prices reflect all historical

information is called _____ form efficiency
weak
The Zolo Co. just declared that they are increasing their annual
dividend from \$1.00 per share to \$1.25 per share. If the stock
price remains constant, then:
the dividend yield will increase
The capital gains yield plus the dividend yield on a security is
called the:
total return
The real rate of return on a stock is approximately equal to the
nominal rate of return:
minus the inflation rate
As long as the inflation rate is positive, the real rate of return on
a security investment will be ____ the nominal rate of return.
less than
The average risk premium on U.S. Treasury bills over the period
of 1926 to 2003 was _____ percent
0.0
Which one of the following is a correct statement concerning
The greater the volatility of returns, the greater the risk premium.
The risk premium is computed by ______ the average return
for the investment
subtracting the average return on the U.S. Treasury bill from
The excess return you earn by moving from a relatively risk-free
investment to a risky investment is called the
To convince investors to accept greater volatility in the annual
rate of return on an investment, you must:
Which one of the following takes the shape of a bell curve?

frequency distribution
Which of the following statements are correct concerning the
variance of the annual returns on an investment
I. The larger the variance, the more the actual returns tend to
differ from the average return.
II. The larger the variance, the larger the standard deviation.
III. The larger the variance, the greater the risk of the investment.
IV. The larger the variance, the higher the expected return.
The variance of returns is computed by dividing the sum of the:
squared deviations by the number of returns minus one.
Estimates using the arithmetic average will probably tend to
_____ values over the long-term while estimates using the
geometric average will probably tend to _____ values over the
short-term.
overestimate
underestimate
In an efficient market, the price of a security will:
react immediately to new information with no further price
If the financial markets are efficient, then investors should
expect their investments in those markets to:
generally have zero net present values.
Which one of the following statements is correct concerning
market efficiency?
A firm will generally receive a fair price when it sells shares of
stock.
Financial markets fluctuate daily because they:
are continuously reacting to new information
markets are:
strong-form efficient
Individuals that continually monitor the financial markets
seeking mispriced securities:
tend to make the markets more efficient

mutual fund
an investment company that invests its shareholders' money in a
diversified portfolio of securities
drawbacks of mutual funds
transaction costs:
-management fee
lower than market performance:
-Consistently beating the market is difficult
-Many mutual funds just keep even with overall stock market
index
mutual funds - management co
runs funds daily ops
buys and sells stocks or bonds and oversees the investment
portfolio
mutual funds - distributor
sells the fund shares
-direct to the public
-through brokers
mutual funds - custodian
physically safeguards the securities
mutual funds - transfer agent
keeps track of purchases and redemption requests from
shareholders
open-end investment co's
investors buy and sell shares directly with the mutual fnd
company without a secondary market
have unlimited # of shares
NAV = value of all securities - liabilities total shares outstanding
closed-end investment co's
sell only after the initial offering
-subseq trades are done in a secondary mkt, similar to the

## common stock market

limited number of shares
outflows
det my supply and demand
sell at premium or discount to NAV
basket of secs designed to track a specific market index

Chapter 09
The Capital Asset Pricing Model
Multiple Choice Questions
1. In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is
A. unique risk.
B. beta.
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by
beta.
Difficulty: Easy

3. In the context of the Capital Asset Pricing Model (CAPM) the relevant risk is
A. unique risk.
B. market risk
C. standard deviation of returns.
D. variance of returns.
E. none of the above.
Once, a portfolio is diversified, the only risk remaining is systematic risk, which is measured by
beta.
Difficulty: Easy

4. According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of
return is a function of
A. market risk
B. unsystematic risk
C. unique risk.
D. reinvestment risk.
E. none of the above.

With a diversified portfolio, the only risk remaining is market, or systematic, risk. This is the
only risk that influences return according to the CAPM.

Difficulty: Easy

5. According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of
return is a function of
A. beta risk
B. unsystematic risk
C. unique risk.
D. reinvestment risk.
E. none of the above.
With a diversified portfolio, the only risk remaining is market, beta, or systematic, risk. This is
the only risk that influences return according to the CAPM.

Difficulty: Easy

8. The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively.
According to the capital asset pricing model (CAPM), the expected rate of return on security X
with a beta of 1.2 is equal to
A. 0.06.
B. 0.144.
C. 0.12.
D. 0.132
E. 0.18
E(R) = 6% + 1.2(12 - 6) = 13.2%.
Difficulty: Easy

## 10. Which statement is not true regarding the market portfolio?

A. It includes all publicly traded financial assets.
B. It lies on the efficient frontier.
C. All securities in the market portfolio are held in proportion to their market values.
D. It is the tangency point between the capital market line and the indifference curve.
E. All of the above are true.
The tangency point between the capital market line and the indifference curve is the optimal
portfolio for a particular investor.
Difficulty: Moderate

12. Which statement is not true regarding the Capital Market Line (CML)?
A. The CML is the line from the risk-free rate through the market portfolio.
B. The CML is the best attainable capital allocation line.
C. The CML is also called the security market line.
D. The CML always has a positive slope.
E. The risk measure for the CML is standard deviation.
Both the Capital Market Line and the Security Market Line depict risk/return relationships.
However, the risk measure for the CML is standard deviation and the risk measure for the SML
is beta (thus C is not true; the other statements are true).
Difficulty: Moderate

## 14. The market risk, beta, of a security is equal to

A. the covariance between the security's return and the market return divided by the variance of
the market's returns.
B. the covariance between the security and market returns divided by the standard deviation of
the market's returns.
C. the variance of the security's returns divided by the covariance between the security and
market returns.
D. the variance of the security's returns divided by the variance of the market's returns.
E. none of the above.
Beta is a measure of how a security's return covaries with the market returns, normalized by the
market variance.
Difficulty: Moderate

## 16. The Security Market Line (SML) is

A. the line that describes the expected return-beta relationship for well-diversified portfolios
only.
B. also called the Capital Allocation Line.
C. the line that is tangent to the efficient frontier of all risky assets.
D. the line that represents the expected return-beta relationship.
E. the line that represents the relationship between an individual security's return and the
market's return.
The SML is a measure of expected return per unit of risk, where risk is defined as beta
(systematic risk).
Difficulty: Moderate

17. According to the Capital Asset Pricing Model (CAPM), fairly priced securities
A. have positive betas.
B. have zero alphas.
C. have negative betas.
D. have positive alphas.
E. none of the above.
A zero alpha results when the security is in equilibrium (fairly priced for the level of risk).
Difficulty: Moderate

18. According to the Capital Asset Pricing Model (CAPM), underpriced securities
A. have positive betas.
B. have zero alphas.
C. have negative betas.
D. have positive alphas.
E. none of the above.
According to the Capital Asset Pricing Model (CAPM), under priced securities have positive
alphas.
Difficulty: Moderate

19. According to the Capital Asset Pricing Model (CAPM), overpriced securities
A. have positive betas.
B. have zero alphas.
C. have negative betas.
D. have positive alphas.
E. none of the above.
According to the Capital Asset Pricing Model (CAPM), over priced securities have negative
alphas.
Difficulty: Moderate

21. According to the Capital Asset Pricing Model (CAPM), which one of the following
statements is false?
A. The expected rate of return on a security decreases in direct proportion to a decrease in the
risk-free rate.
B. The expected rate of return on a security increases as its beta increases.
C. A fairly priced security has an alpha of zero.
D. In equilibrium, all securities lie on the security market line.
E. All of the above statements are true.
Statements B, C, and D are true, but statement A is false.
Difficulty: Moderate

23. Empirical results regarding betas estimated from historical data indicate that
A. betas are constant over time.
B. betas of all securities are always greater than one.
C. betas are always near zero.
D. betas appear to regress toward one over time.
E. betas are always positive.
Betas vary over time, betas may be negative or less than one, betas are not always near zero;
however, betas do appear to regress toward one over time.
Difficulty: Moderate

24. Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of
1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the
Capital Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
11% = 5% + 1.5(9% - 5%) = 11.0%; therefore, the security is fairly priced.

Difficulty: Moderate

25. The risk-free rate is 7 percent. The expected market rate of return is 15 percent. If you expect
a stock with a beta of 1.3 to offer a rate of return of 12 percent, you should
A. buy the stock because it is overpriced.
B. sell short the stock because it is overpriced.
C. sell the stock short because it is underpriced.
D. buy the stock because it is underpriced.
E. none of the above, as the stock is fairly priced.
12% < 7% + 1.3(15% - 7%) = 17.40%; therefore, stock is overpriced and should be shorted.
( = 12 17.40 = -5.40% - overpriced, or undervalued)
Difficulty: Moderate

27. A security has an expected rate of return of 0.10 and a beta of 1.1. The market expected rate
of return is 0.08 and the risk-free rate is 0.05. The alpha of the stock is
A. 1.7%.
B. -1.7%.
C. 8.3%.
D. 5.5%.
E. none of the above.
= 10% - [5% +1.1(8% - 5%)] = 1.7%.
Difficulty: Moderate

28. Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3. The
risk-free rate is 0.04 and the market expected rate of return is 0.115. According to the Capital
Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
11.5% - [4% + 1.3(11.5% - 4%)] = -2.25%; therefore, the security is overpriced.

Difficulty: Moderate

31. Your opinion is that Boeing has an expected rate of return of 0.112. It has a beta of 0.92. The
risk-free rate is 0.04 and the market expected rate of return is 0.10. According to the Capital
Asset Pricing Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
11.2% - [4% + 0.92(10% - 4%)] = 1.68%; therefore, the security is under priced.
Difficulty: Moderate

34. As a financial analyst, you are tasked with evaluating a capital budgeting project. You were
instructed to use the IRR method and you need to determine an appropriate hurdle rate. The riskfree rate is 4 percent and the expected market rate of return is 11 percent. Your company has a
beta of 1.0 and the project that you are evaluating is considered to have risk equal to the average
project that the company has accepted in the past. According to CAPM, the appropriate hurdle
rate would be ______%.
A. 4
B. 7
C. 15
D. 11
E. 1
The hurdle rate should be the required return from CAPM or (R = 4% + 1.0(11% - 4%) = 11%.
Difficulty: Moderate

36. As a financial analyst, you are tasked with evaluating a capital budgeting project. You were
instructed to use the IRR method and you need to determine an appropriate hurdle rate. The riskfree rate is 4 percent and the expected market rate of return is 11 percent. Your company has a
beta of 0.75 and the project that you are evaluating is considered to have risk equal to the
average project that the company has accepted in the past. According to CAPM, the appropriate
hurdle rate would be ______%.
A. 4
B. 9.25
C. 15
D. 11
E. 0.75

The hurdle rate should be the required return from CAPM or (R = 4% + 0.75(11% - 4%) =
9.25%.
Difficulty: Moderate

39. The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect
CAT with a beta of 1.0 to offer a rate of return of 10 percent, you should
A. buy stock X because it is overpriced.
B. sell short stock X because it is overpriced.
C. sell stock short X because it is underpriced.
D. buy stock X because it is underpriced.
E. none of the above, as the stock is fairly priced.
10% < 4% + 1.0(11% - 4%) = 11.0%; therefore, stock is overpriced and should be shorted.
( = 10 11 = -1% - overpriced, or undervalued)
Difficulty: Moderate

## 43. Given the following two stocks A and B

If the expected market rate of return is 0.09 and the risk-free rate is 0.05, which security would
be considered the better buy and why?
A. A because it offers an expected excess return of 1.2%.
B. B because it offers an expected excess return of 1.8%.
C. A because it offers an expected excess return of 2.2%.
D. B because it offers an expected return of 14%.
E. B because it has a higher beta.
A's excess return is expected to be 12% - [5% + 1.2(9% - 5%)] = 2.2%. B's excess return is
expected to be 14% - [5% + 1.8(9% - 5%)] = 1.8%.
Difficulty: Moderate

45. According to the CAPM, the risk premium an investor expects to receive on any stock or
portfolio increases:
A. directly with alpha.
B. inversely with alpha.
C. directly with beta.
D. inversely with beta.
E. in proportion to its standard deviation.
The market rewards systematic risk, which is measured by beta, and thus, the risk premium on a
stock or portfolio varies directly with beta.
Difficulty: Easy

47. Standard deviation and beta both measure risk, but they are different in that
A. beta measures both systematic and unsystematic risk.
B. beta measures only systematic risk while standard deviation is a measure of total risk.
C. beta measures only unsystematic risk while standard deviation is a measure of total risk.
D. beta measures both systematic and unsystematic risk while standard deviation measures only
systematic risk.
E. beta measures total risk while standard deviation measures only nonsystematic risk.
B is the only true statement.
Difficulty: Easy

## 48. The expected return-beta relationship

A. is the most familiar expression of the CAPM to practitioners.
B. refers to the way in which the covariance between the returns on a stock and returns on the
market measures the contribution of the stock to the variance of the market portfolio, which is
beta.
C. assumes that investors hold well-diversified portfolios.
D. all of the above are true.
E. none of the above are true.
Statements A, B and C all describe the expected return-beta relationship.
Difficulty: Moderate

50. Research by Jeremy Stein of MIT resolves the dispute over whether beta is a sufficient
pricing factor by suggesting that managers should use beta to estimate
A. long-term returns but not short-term returns.
B. short-term returns but not long-term returns.
C. both long- and short-term returns.
D. book-to-market ratios.
E. None of the above was suggested by Stein.
Stein's results suggest that managers should use beta to estimate long-term returns but not shortterm returns.
Difficulty: Difficult

## 51. Studies of liquidity spreads in security markets have shown that

A. liquid stocks earn higher returns than illiquid stocks.
B. illiquid stocks earn higher returns than liquid stocks.
C. both liquid and illiquid stocks earn the same returns.
D. illiquid stocks are good investments for frequent, short-term traders.
E. None of the above are true.
Studies of liquidity spreads in security markets have shown that illiquid stocks earn higher
returns than liquid stocks.
Difficulty: Difficult

## 54. The risk premium on the market portfolio will be proportional to

A. the average degree of risk aversion of the investor population.
B. the risk of the market portfolio as measured by its variance.
C. the risk of the market portfolio as measured by its beta.
D. both A and B are true.
E. both A and C are true.
The risk premium on the market portfolio is proportional to the average degree of risk aversion
of the investor population and the risk of the market portfolio measured by its variance.
Difficulty: Moderate

55. In equilibrium, the marginal price of risk for a risky security must be
A. equal to the marginal price of risk for the market portfolio.
B. greater than the marginal price of risk for the market portfolio.
C. less than the marginal price of risk for the market portfolio.
D. adjusted by its degree of nonsystematic risk.
E. none of the above are true.
In equilibrium, the marginal price of risk for a risky security must be equal to the marginal price
of risk for the market. If not, investors will buy or sell the security until they are equal.
Difficulty: Moderate

## 56. The capital asset pricing model assumes

A. all investors are price takers.
B. all investors have the same holding period.
C. investors pay taxes on capital gains.
D. both A and B are true.
E. A, B and C are all true.
The CAPM assumes that investors are price-takers with the same single holding period and that
there are no taxes or transaction costs.
Difficulty: Easy

## 58. The capital asset pricing model assumes

A. all investors are price takers.
B. all investors have the same holding period.
C. investors have homogeneous expectations.
D. both A and B are true.
E. A, B and C are all true.
The CAPM assumes that investors are price-takers with the same single holding period and that
they have homogeneous expectations.
Difficulty: Easy

## 60. If investors do not know their investment horizons for certain

A. the CAPM is no longer valid.
B. the CAPM underlying assumptions are not violated.
C. the implications of the CAPM are not violated as long as investors' liquidity needs are not
priced.
D. the implications of the CAPM are no longer useful.
E. none of the above are true.
This is discussed in the chapter's section about extensions to the CAPM. It examines what the
consequences are when the assumptions are removed.
Difficulty: Moderate

62. The amount that an investor allocates to the market portfolio is negatively related to
I) the expected return on the market portfolio.
II) the investor's risk aversion coefficient.
III) the risk-free rate of return.
IV) the variance of the market portfolio
A. I and II
B. II and III
C. II and IV
D. II, III, and IV
E. I, III, and IV
The optimal proportion is given by y = (E(RM) - rf)/(.01xA2M). This amount will decrease as rf,
A, and 2M increase.
Difficulty: Moderate

63. One of the assumptions of the CAPM is that investors exhibit myopic behavior. What does
this mean?
A. They plan for one identical holding period.
B. They are price-takers who can't affect market prices through their trades.
C. They are mean-variance optimizers.
D. They have the same economic view of the world.
E. They pay no taxes or transactions costs.
Myopic behavior is shortsighted, with no concern for medium-term or long-term implications.

Difficulty: Moderate

65. Which of the following statements about the mutual fund theorem is true?
I) It is similar to the separation property.
II) It implies that a passive investment strategy can be efficient.
III) It implies that efficient portfolios can be formed only through active strategies.
IV) It means that professional managers have superior security selection strategies.
A. I and IV
B. I, II, and IV
C. I and II
D. III and IV
E. II and IV
The mutual fund theorem is similar to the separation property. The technical task of creating
mutual funds can be delegated to professional managers; then individuals combine the mutual
funds with risk-free assets according to their preferences. The passive strategy of investing in a
market index fund is efficient.
Difficulty: Moderate

68. For the CAPM that examines illiquidity premiums, if there is correlation among assets due to
common systematic risk factors, the illiquidity premium on asset i is a function of
A. the market's volatility.
B. asset is volatility.
C. the trading costs of security i.
D. the risk-free rate.
E. the money supply.
The formula for this extension to the CAPM relaxes the assumption that trading is costless.
Difficulty: Moderate

78. Assume that a security is fairly priced and has an expected rate of return of 0.13. The market
expected rate of return is 0.13 and the risk-free rate is 0.04. The beta of the stock is ___?
A. 1.25
B. 1.7
C. 1
D. 0.95
E. none of the above.
13% = [4% +(13% - 4%)]; 9% = (9%); = 1.
Difficulty: Moderate

NAME: _______________________________
Final Exam
I. Multiple Choices (40%)
(

d
a.
b.
c.
d.
e.

b
a.
b.
c.
d.
e.

c
a.
b.
c.
d.
e.

) 1.
A stock had returns of 8%, -2%, 4%, and 16% over the past four years. What is the
standard deviation of this stock for the past four years?
6.3%
6.6%
7.1%
7.5%
7.9%
) 2.
The percentage of a portfolios total value invested in a particular asset is called that
assets:
portfolio return.
portfolio weight.
portfolio risk.
rate of return.
investment value.
)3.
Risk that affects a large number of assets, each to a greater or lesser degree, is called
_____ risk.
idiosyncratic
diversifiable
systematic
asset-specific
total

a )4.
The amount of systematic risk present in a particular risky asset, relative to the systematic
risk present in an average risky asset, is called the particular assets:
a. beta coefficient.
b. reward-to-risk ratio.
c. total risk.
d. diversifiable risk.
e. Treynor index.

b )5.
Which one of the following is an example of a nondiversifiable risk?
a. a well respected president of a firm suddenly resigns
b. a well respected chairman of the Federal Reserve suddenly resigns
c. a key employee suddenly resigns and accepts employment with a key competitor
d. a well managed firm reduces its work force and automates several jobs
e. a poorly managed firm suddenly goes out of business due to lack of sales

c
a.
b.
c.
d.
e.

)6.
Diversification can effectively reduce risk. Once a portfolio is diversified, the type of risk
remaining is:
individual security risk.
riskless security risk.
systematic risk.
total standard deviations.
None of the above.

)7.
Jacks Construction Co. has 80,000 bonds outstanding that are selling at par value.
Bonds with similar characteristics are yielding 8.5%. The company also has
4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for
\$40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium
is 8%. Jacks tax rate is 35%. What is Jacks weighted average cost of capital?
a. 7.10 %
b. 7.39 %
c. 10.38 %
d. 10.65 %
e. 11.37 %

a.
b.
c.
d.
e.

)8.
Assuming the CAPM or one-factor model holds, what is the cost of equity for a firm if
the firm's equity has a beta of 1.2, the risk-free rate of return is 2%, the expected return on the
market is 9%, and the return to the company's debt is 7%?
10.4%
10.8%
12.8%
14.4%
None of the above.

c )9.
Which of the following will increase sustainable growth?
b. Decrease debt
c. Increase profit margin
d. Increase asset requirement ratio
e. Increase dividend payout ratio

b )10.
Wilberts, Inc. paid \$90,000, in cash, for a piece of equipment three years ago. Last year,
the company spent \$10,000 to update the equipment with the latest technology. The company
no longer uses this equipment in its current operations and has received an offer of \$50,000
from a firm who would like to purchase it. Wilberts is debating whether to sell the equipment
or to expand its operations such that the equipment can be used. When evaluating the
expansion option, what value, if any, should Wilberts assign to this equipment as an initial
cost of the project?
a. \$40,000
b. \$50,000
c. \$60,000
d. \$80,000
e. \$90,000

## II. Essays/Calculations (60%)

1. (a) Please draw the efficient frontier for a portfolio of N>2 risky assets (with x-axis and y-axis properly
labeled). (b) When the risk-free asset is included into the portfolio, what happened to the optimal feasible
set?

2. Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the
expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does
the CAPM predict about the expected return on such an asset?

3. Johnson Inc. is considering a new project that has a life of 3 years. The initial capital (fixed assets)
investment for the project is \$75,000. The firms use 3-year straight-line depreciation (with no salvage
value) to write off the capital investment. The firm needs to invest \$20,000 in net working capital (NWC)
for the project and expects to recover this investment at the end of the project. In addition to the initial
capital investment, the project requires the use of a vacant site owned by the firm. The present value of
the opportunity cost for this site is estimated to be \$12,000. The firm uses no debt. The beta of the firm is
0.8. The T-bill rate is 3%. The expected market risk premium is 8%. What is the NPV of the project?
The pro forma income statements for year 1, year 2, and year 3 are the same. For each year, it looks like
the following:
Sales (50,000 units at \$6.00/unit)
Variable Costs (\$4/unit)
Gross profit
Fixed costs
Depreciation
EBIT
Taxes (20%)
Net Income

\$300,000
\$200,000
\$100,000
\$40,000
\$25,000
\$35,000
\$7,000
\$ 28,000

4. Security F has an expected return of 12% and a standard deviation of 34% per year. Security G has an
expected return of 18% and a standard deviation of 50% per year. (a) What is the expected return on a
portfolio composed of 40% of security F and 60% of security G? (b) If the correlation coefficient
between F and G is 0.1, what is the standard deviation of the portfolio described in part (a)?

5. (a) Please define the term separation. (b) Please discuss the Du Pont identity. (c) Please define the
term sunk costs. Should sunk costs be included into the calculation of NPV?

6. The most recent financial statements for Martin, Inc., are as follows.
Sales
Costs
Taxable Income
Taxes (34%)
NI

\$19,200
\$15,550
\$3,650
\$1,241
\$2,409

Assets \$93,000

Debt \$20,400
Equity \$72,600
Total \$93,000

Assets and costs are proportional to sales. Debt and Equity are not. A dividend of \$1,156 is expected to
be paid in the coming year. Sales are projected to be \$23,040 in the coming year. What external
financing is needed for the coming year?

## Chapters 12, 13, 14, 15

EXTRA QUESTIONS!
1.

An investment returns 10% in the first year and -10% in the second year. What is the
(arithmetic) average return of the investment?
a. 0
b. 1%
c. -1%
d. 0.5%
e. -0.5%
f. You must be kidding.

## 2. For the above investment, what is the Geometric Average return?

a.
b.
c.
d.
e.
f.

0
1%
-1%
0.5%
-0.5%
You must be kidding.

3. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
a. idiosyncratic
b. diversifiable
c. systematic
d. asset-specific
e. total
4.

Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
e. total

## 5. The principle of diversification tells us that:

a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will greatly
c. spreading an investment across five diverse companies will not lower your overall risk at
all.
d. spreading an investment across many diverse assets will eliminate all of the risk.
e. spreading an investment across many diverse assets will eliminate some of the risk.

6. The amount of systematic risk present in a particular risky asset, relative to the systematic risk
present in an average risky asset, is called the particular assets:
a. beta coefficient.
b. reward-to-risk ratio.

c. total risk.
d. diversifiable risk.
e. Treynor index.
7. You are considering purchasing stock S. This stock has an expected return of 8 percent if the
economy booms and 3 percent if the economy goes into a recessionary period. The overall
expected rate of return on this stock will:
a. be equal to one-half of 8 percent if there is a 50 percent chance of an economic boom.
b. vary inversely with the growth of the economy.
c. increase as the probability of a recession increases.
d. be equal to 75 percent of 8 percent if there is a 75 percent chance of a boom economy.
e. increase as the probability of a boom economy increases.
8. Which of the following are examples of nondiversifiable risks?
I.
the inflation rate spikes nationwide
II.
an unexpected terrorist event occurs
III.
the price of lumber suddenly spikes
IV.
taxes are increased on hotels
a. I and III only
b. II and IV only
c. I and II only
d. II and III only
e. I, II, and IV only
9. Which of the following statements concerning nondiversifiable risk are correct?
I.
Nondiversifiable risk is measured by standard deviation.
II.
Systematic risk is another name for nondiversifiable risk.
III.
The risk premium increases as the nondiversifiable risk increases.
IV.
Nondiversifiable risks are those risks you can not avoid if you are invested
in the financial markets.
a. I and III only
b. II and IV only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
10. Which one of the following is an example of a nondiversifiable risk?
a. a well respected president of a firm suddenly resigns
b. a well respected chairman of the Federal Reserve suddenly resigns
c. a key employee of a firm suddenly resigns and accepts employment with a key
competitor
d. a well managed firm reduces its work force and automates several jobs
e. a poorly managed firm suddenly goes out of business due to lack of sales
11. The risk premium for an individual security is computed by:
a. multiplying the securitys beta by the market risk premium.
b. multiplying the securitys beta by the risk-free rate of return.
c. adding the risk-free rate to the securitys expected return.
d. dividing the market risk premium by the quantity (1 beta).
e. dividing the market risk premium by the beta of the security.

## 12. Standard deviation measures _____ risk.

a. total
b. nondiversifiable
c. unsystematic
d. systematic
e. economic
13. The systematic risk of the market is measured by:
a. a beta of 1.0.
b. a beta of 0.0.
c. a standard deviation of 1.0.
d. a standard deviation of 0.0.
e. a variance of 1.0.
14. Which one of the following portfolios should have the most systematic risk?
a. 50 percent invested in U.S. Treasury bills and 50 percent in a market index mutual fund
b. 20 percent invested in U.S. Treasury bills and 80 percent invested in a stock with a beta
of .80
c. 10 percent invested in a stock with a beta of 1.0 and 90 percent invested in a stock with a
beta of 1.40
d. 100 percent invested in a mutual fund which mimics the overall market
e. 100 percent invested in U.S. Treasury bills
15. A security that is fairly priced will have a return that lies _____ the Security Market Line.
a. below
b. on or below
c. on
d. on or above
e. above
16. BLANK
17. The market risk premium is computed by:
c. subtracting the risk-free rate of return from the inflation rate.
d. subtracting the risk-free rate of return from the market rate of return.
e. multiplying the risk-free rate of return by a beta of 1.0.
18. You recently purchased a stock that is expected to earn 12 percent in a booming economy, 8
percent in a normal economy and lose 5 percent in a recessionary economy. There is a 15 percent
probability of a boom, a 75 percent chance of a normal economy, and a 10 percent chance of a
recession. What is your expected rate of return on this stock?
a. 5.00 percent
b. 6.45 percent
c. 7.30 percent
d. 7.65 percent
e. 8.30 percent

19. You want your portfolio beta to be 1.20. Currently, your portfolio consists of \$100
invested in stock A with a beta of 1.4 and \$300 in stock B with a beta of .6. You have
another \$400 to invest and want to divide it between an asset with a beta of 1.6 and a
risk-free asset. How much should you invest in the risk-free asset?
a. \$0
b. \$140
c. \$200
d. \$320
e. \$400

20. You have a \$1,000 portfolio which is invested in stocks A and B plus a risk-free asset.
\$400 is invested in stock A. Stock A has a beta of 1.3 and stock B has a beta of .7. How much
needs to be invested in stock B if you want a portfolio beta of .90?
a. \$0
b. \$268
c. \$482
d. \$543
e. \$600

21. You are comparing stock A to stock B. Given the following information, which one of these two
stocks should you prefer and why?
Rate of Return if
State of
Probability of
State Occurs
Economy
State of Economy
Stock A Stock B
Boom
60%
9%
15%
Recession
40%
4%
-6%
a. Stock A; because it has an expected return of 7 percent and appears to be more risky.
b. Stock A; because it has a higher expected return and appears to be less risky than stock B.
c. Stock A; because it has a slightly lower expected return but appears to be significantly
less risky than stock B.
d. Stock B; because it has a higher expected return and appears to be just slightly more risky
than stock A.
e. Stock B; because it has a higher expected return and appears to be less risky than stock A.

22. Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 percent and the market rate
of return is 10 percent. What is the amount of the risk premium on Zelo stock?
a. 4.47 percent
b. 5.50 percent
c. 5.54 percent
d. 6.77 percent
e. 12.30 percent

23. Suppose you know that the returns for stock XYZ for the past 5 years have been 6%, 1.5%, -8%,
-2% and 5.5%. What is the total risk, expressed as standard deviation, of this stock? (Use: /(n1))
a.
b.
c.
d.
e.

1.4%
2.7%
3.5%
4.2%
5.8%

24. You own the following portfolio of stocks. What is the portfolio weight of stock C?
Number
Stock of Shares
A
100
B
600
C
400
D
200
a.
b.
c.
d.
e.

Price
per Share
\$22
\$17
\$46
\$38

30.8 percent
37.4 percent
42.3 percent
45.2 percent
47.9 percent

25. What is the expected return on a portfolio comprised of \$3,000 in stock K and \$5,000 in stock L
if the economy is normal?

a.
b.
c.
d.
e.

State of
Economy
Boom
Normal
3.75 percent
5.25 percent
5.63 percent
5.88 percent
6.80 percent

Probability of
State of Economy
20%
80%

Stock K
Stock L
14%
10%
5%
6%

## 26. What is the beta of a portfolio comprised of the following securities?

Amount

Security

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

Invested
\$2,000
\$3,000
\$5,000

Beta
1.20
1.46
.72

1.008
1.014
1.038
1.067
1.127

CHALLENGE: You would like to combine a risky stock with a beta of 1.5 with U.S. Treasury bills
in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market.
What percentage of the portfolio should be invested in Treasury bills?
a. .25
b. .33
c. .50
d. .67
e. .75

26A The market has an expected rate of return of 9.8 percent. The long-term government
bond is expected to yield 4.5 percent and the U.S. Treasury bill is expected to yield 3.4
percent. The inflation rate is 3.1 percent. What is the market risk premium?
a. 2.2 percent
b. 3.3 percent
c. 5.3 percent
d. 6.4 percent
e. 6.7 percent

27 A The risk-free rate of return is 4 percent and the market risk premium is 8 percent. What
is the expected rate of return on a stock with a beta of 1.28?
a.
9.12 percent
b.
10.24 percent
c.
13.12 percent
d.
14.24 percent
e.
15.36 percent

27. The return that shareholders require on their investment in the firm is called the:
a. dividend yield.
b. cost of equity.
c. capital gains yield.
d. cost of capital.
e. income return.
28. The return that lenders require on their loaned funds to the firm is called the:
a. coupon rate.
b. current yield.
c. cost of debt.
d. capital gains yield.
e. cost of capital.
29. The proportions of the market value of the firms assets financed via debt, common
stock, and preferred stock are called the firms:
a.
b.
c.
d.
e.

financing costs.
portfolio weights.
beta coefficients.
capital structure weights.
costs of capital.

30. The weighted average of the firms costs of equity, preferred stock, and aftertax debt is
the:
a. reward to risk ratio for the firm.
b. expected capital gains yield for the stock.
c. expected capital gains yield for the firm.
d. portfolio beta for the firm.
e. weighted average cost of capital (WACC).
31. The costs incurred by the firm when new issues of stocks or bonds are sold are called:
a. required rates of return.
b. costs of capital.
c. flotation costs.
d. capital structure weights.
e. costs of equity and debt.
f.

## 32. The cost of equity for a firm is:

a. determined by directly observing the rate of return required by equity investors.
b. based on estimates derived from financial models.
c. equivalent to a leveraged firms cost of capital.
d. equal to the risk-free rate of return plus the market risk premium.
e. equal to the risk-free rate of return plus the dividend growth rate.
33. The pre-tax cost of debt for a firm:
a. is equal to the yield to maturity on the outstanding bonds of the firm.
b. is equal to the coupon rate of the outstanding bonds of the firm.
c. is equivalent to the current yield on the outstanding bonds of the firm.
d. is based on the yield to maturity that existed when the currently outstanding bonds were
originally issued.
e. has to be estimated as it cannot be directly observed in the market.
34. The capital structure weights used in computing the weighted average cost of capital
are:
a. constant over time provided that the debt-equity ratio changes in unison with the
market values.
b. based on the face value of the firms debt.
c. computed using the book value of the long-term debt and the shareholders equity.
d. based on the market value of the firms debt and equity securities.
e. limited to the firms debt and common stock.

35. Bens Ice Cream just paid their annual dividend of \$.75 a share. The stock has a market price of
\$32 and a beta of .90. The return on the U.S. Treasury bill is 4 percent and the market has a 12
percent rate of return. What is the cost of equity?
a.
b.
c.
d.
e.

7.24 percent
8.67 percent
11.20 percent
12.92 percent
14.80 percent

36. The Bet-r-Bilt Company has a six-year bond outstanding with a 5 percent coupon. Interest
payments are paid semi-annually. The face amount of the bond is \$1,000. This bond is currently
selling for 98 percent of its face value. What is the companys pre-tax cost of debt?
a. 4.72 percent
b. 5.31 percent
c. 5.35 percent
d. 5.39 percent
e. 5.42 percent
37. Katies Boutique has zero-coupon bonds outstanding that mature in four years. The
bonds have a face value of \$1,000 and a current market price of \$820. What is the
companys pre-tax cost of debt?

a.
b.
c.
d.
e.

5.01 percent
5.09 percent
5.18 percent
5.36 percent
5.49 percent

38. Ernsts Electrical has a bond issue outstanding with ten years to maturity. These bonds
have a \$1,000 face value, a 5 percent coupon, and pay interest semi-annually. The
bonds are currently quoted at 96 percent of face value. What is Ernsts pre-tax cost of
debt?
a. 4.47 percent
b. 4.97 percent
c. 5.33 percent
d. 5.53 percent
e. 5.94 percent

39. Blackwater Adventures has a bond issue outstanding that matures in sixteen years. The
bonds pay interest semi-annually. Currently, the bonds are quoted at 103 percent of
face value and carry a 9 percent coupon. The firms tax rate is 34 percent. What is the
firms after-tax cost of debt?
a. 5.19 percent
b. 5.71 percent
c. 7.86 percent
d. 8.65 percent
e. 11.41 percent
40. Jensens Travel Agency has a 7 percent preferred stock outstanding that is currently selling for
\$48 a share. The market rate of return is 10 percent and the firms tax rate is 34 percent. What is
the Jensens cost of preferred stock?
a. 8.75 percent
b. 9.62 percent
c. 11.98 percent
d. 13.25 percent
e. 14.58 percent

41. The Auto Group has 1,200 bonds outstanding that are selling for \$980 each. The ompany also
has 7,500 shares of preferred stock at a market price of \$40 each. The common stock is priced at
\$32 a share and there are 32,000 shares outstanding. What is the weight of the preferred stock as
it relates to the firms weighted average cost of capital?
a. 10 percent
b. 12 percent
c. 14 percent
d. 16 percent
e. 18 percent

42. Jacks Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with
similar characteristics are yielding 8.5 percent. The company also has 4 million shares of
common stock outstanding. The stock has a beta of 1.1 and sells for \$40 a share. The U.S.
Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jacks tax rate is 35
percent. What is Jacks weighted average cost of capital?
a. 7.10 percent
b. 7.39 percent
c. 10.38 percent
d. 10.65 percent
e. 11.37 percent
43. Peters Audio Shop has a cost of debt of 7 percent, a cost of equity of 11 percent, and a cost of
preferred stock of 8 percent. The firm has 104,000 shares of common stock outstanding at a
market price of \$20 a share. There are 40,000 shares of preferred stock outstanding at a market
price of \$34 a share. The bond issue has a total face value of \$500,000 and sells at 102 percent of
face value. The companys tax rate is 34 percent. What is the weighted average cost of capital for
Peters Audio Shop?
a. 6.14 percent
b. 6.54 percent
c. 8.60 percent
d. 9.14 percent
e. 9.45 percent

Economics 4000
Final Examination Practice Questions
1. The present value of a set of cash flows is:
A) the weighted average of present values of individual cash flows
B) the sum of individual cash flows which are then discounted.
C) the sum of the present values of the individual cash flows
D) always greater than the present value of the investment.
E) the weighted average of individual cash flows, which is then discounted
2. Which of the following statements is true?
A) Regardless of the value of the interest rate, increasing the compounding
frequency will decrease the future value.
B) Regardless of the value of the interest rate, increasing the compounding
frequency will increase the future value.
C) There is a relationship between the future value of investment and the effect
of compounding frequency. At high interest rates, increases in compounding
frequency will decrease the future value.
D) There is a relationship between the future value of investment and the effect
of compounding frequency. At low interest rates, increases in compounding
frequency will decrease the future value.
3.The P/E (price to earnings) ratio of a stock is __________ related to growth potential,
__________ related to the discount rate, and __________ related to the stock's
risk.
A) positively, positively, negatively.
D) negatively, negatively,
positively.
B) negatively, positively, positively.
E) none of the above.
C) positively, negatively, negatively.
4. Zeta Corporation has issued a \$1,000 face value zero-coupon bond. Which of the
following values is closest to the correct price for the bond if the appropriate
discount rate is 4% and the bond matures in 8 years?
A) \$ 960.
B) \$ 730.
C) \$ 1,000.
D) \$ 1,350
E) \$32,000.
5.The market price of_____ maturity bonds fluctuates _____ compared
with_____maturity bonds as interest rates change.
A) shorter, less, longer
C) shorter, more, longer
1

## B) longer, less, shorter

E) past, more, future

D) both b and c

6. Which of the following values is closest to the amount that should be paid for a stock
that will pay a dividend of \$10 one year from now and \$11 two years from now?
The stock will be sold in 2 years for an estimated price of \$120. The appropriate
discount rate is 9%.
A) \$114. B) \$119. C) \$124. D) \$129. E) \$138.
7. Mortgage Instruments Inc. is expected to pay dividends of \$1.03 next year. The
company just paid dividends of \$1. This growth rate is expected to continue.
How much should be paid for Mortgage Instruments stock just after the dividend
if the appropriate discount rate is 5%.
A) \$20. B) \$21. C) \$34. D) \$50. E) \$52.
8. The yield to maturity is:
A) the rate that equates the price of the bond with the discounted cashflows.
B) the expected rate to be earned if held to maturity.
C) the rate that is used to determine the market price of the bond.
D) equal to the current yield for bonds priced at par.
E) all of the above.
9.A project will have only one internal rate of return if:
A) all cash flows after the initial expense are positive.
B) average accounting return is positive.
C) net present value is negative.
D) net present value is positive.
E) net present value is zero.
10. Which of the following does not characterize NPV as an investment rule?
A) NPV is the simplest of all investment rules.
B) NPV incorporates all relevant information.
C) NPV uses all of the project's cash flows.
D) NPV discounts all future cash flows.
11. To be able to estimate the expected return on the market portfolio, you would need to
know or estimate:
A) the beta of the portfolio, the risk-free rate, and the level of the market over the
next year.
B) the risk-free rate and beta of the portfolio.
C) the historical risk premium and the risk free rate.

D) the level of the market over the next year, the risk-free rate, and the historical
E) none of the above is sufficient.
12. If the expected return on the market is 14%, then using the approximate historical risk
premium, the current risk-free rate is:
A) 4.5%. B) 8%. C) 12.5%. D) 14.5%. E) 18.5%.
13.You bought 100 shares of stock at \$10 each. At the end of the year, you received a
total of \$200 in dividends, and your stock was worth \$1,250 total. What was your
total return?
A) 45%. B) 50%. C) 90%. D) 20%. E) None of the above.
14. The efficient set of portfolios:
A) contains the portfolio combinations with the highest return for a given level of
risk
B) contains the portfolio combinations with the lowest risk for a given level of
return
C) is the lowest overall risk portfolio
D) a and b
E) a and c.
15. Imagine you have a portfolio of two risky stocks which turns out to have no
diversification. The reason you have no diversification is:
A) the returns are too small
B) the returns move perfectly opposite of one another
C) the returns are too large to offset
D) the returns move perfectly with one another
E) the returns are completely unrelated to one another
16. Stock A has an expected return of 20%, and stock B has an expected return of 4%.
However, the risk of stock A as measured by its variance is 3 times that of stock
B. If the two stocks are combined equally in a portfolio, what would be the
portfolio's expected return?
A) 20.0%.
D) Greater than 20%.
B) 4.0%.
C) 12.0%.
17. If the covariance of stock 1 with stock 2 is -.0065, then what is the covariance of
stock 2 with stock 1?

A) -.0065.
B) +.0065.
C) greater than +.0065.

## D) less than -.0065.

18. A portfolio has 50% of its funds invested in Security One and 50% of its funds
invested in Security Two. Security One has a standard deviation of 6. Security
Two has a standard deviation of 12. The securities have a coefficient of
correlation of .5. Which of the following values is closest to portfolio variance?
A) 81.
B) 90.
C) 27.
D) 9.
E) One must have covariance to calculate expected value.
Answer: A The question did not ask for the exact value (which is 63)
19. Shareholders discount many corporate announcements because of their prior
expectations. If an announcement causes the price to change it will mostly be
driven by:
A) the expected part of the announcement.
B) market inefficiency.
C) the innovation or unexpected part of the announcement.
D) the systematic risk.
E) None of the above.
20. A stock with a beta of zero would be expected to:
A) have a rate of return equal to the risk-free rate.
B) have a rate of return equal to the market rate.
C) have a rate of return equal to zero.
D) have a rate of return equal to the one.
21. Companies that have highly cyclical sales will have:
A) a low beta if sales are highly dependent on the market cycle.
B) a high beta if sales are highly dependent on the market cycle.
C) a high beta if sales are independent on the market cycle.
D) all of the above.
E) none of the above.
22. If a firm has low fixed costs relative to all other firms in the same industry, a large
change in volume (either up or down) would have:
A) a smaller change in EBIT for the firm versus the other firms.
B) no effect in any way on the firms as volume does not effect fixed costs.
C) a decreasing effect on the cyclical nature of the business.
D) a large change in EBIT for the firm versus the other firms.
4

## E) none of the above.

23. The beta of a firm depends on which of the following firm characteristics?
A) Cycles in revenues.
D) All of the above.
B) Operating leverage (fixed cost/variable cost) E) None of the above.
C) Financial leverage (debt/equity)
24. Regression analysis can be used to
A) estimate beta.
B) estimate the risk-free rate.
C) estimate standard deviations.

D) estimate variances.
E) estimate expected returns.

25. Which of the following does not represent a major difference between debt and
equity?
A) Creditors do not have voting power as stockholders do.
B) Payment on interest on debt in considered an expense, while payment of
dividends is not.
C) Unpaid debt is a liability of the firm, and if not paid, can result in liquidation
of the firm. Unpaid dividends cannot.
D) One of the costs of issuing equity is the possibility of financial distress, while
no financial distress is associated with debt.
E) None of the above.
26. The market value of the ownership of the firm equals:
A) the market price of the stock times the number of shares outstanding.
B) the sum of the market price of the bonds and the stock.
C) the par value of the stock times the number of shares outstanding.
D) the market price of the stock minus the retained earnings.
E) none of the above.
27. Retained earnings are:
A) the amount of cash that the firm has saved up.
B) the difference between the net income earned and the dividends paid in a year.
C) the difference between the market price of the stock and the book value.
D) the amount of stock repurchased.
E) none of the above.
28. Financial leverage impacts the performance of the firm by:
A) increasing the volatility of the firm's EBIT.
B) decreasing the volatility of the firm's EBIT.
C) decreasing the volatility of the firm's net income.
5

## D) increasing the volatility of the firm's net income

E) none of the above.
29. When comparing levered vs. unlevered capital structures, leverage works to increase
EPS (earnings per share) for high levels of EBIT (earnings before interest and
taxes) because:
A) interest payments on the debt vary with EBIT levels.
B) interest payments on the debt stay fixed, leaving less income to be distributed
over less shares.
C) interest payments on the debt stay fixed, leaving more income to be
distributed over less shares.
D) interest payments on the debt stay fixed, leaving less income to be distributed
over more shares.
E) interest payments on the debt stay fixed, leaving more income to be
distributed over more shares.
30. A levered (or leveraged) firm is a company that has:
A) is financed by common stock.
D) low variability of EPS
B) has some debt in the capital structure. E) none of the above.
C) has all equity in the capital structure.
31. The diversification effect of a portfolio of two stocks
A) increases as the correlation between the stocks declines.
B) increases as the correlation between the stocks rises.
C) decreases as the correlation between the stocks rises.
D) both b and c.
E) None of the above.
32. If the correlation between two stocks is 1, the returns:
A) generally move in the same direction
B) move perfectly opposite to one another
C) are unrelated to one another as it is <0
D) have standard deviations of equal size but opposite signs
E) none of the above.
33. For a diversified portfolio including a large number of stocks,:
A) the weighted average expected return goes to zero.
B) the weighted average of the betas goes to zero.
C) the weighted average of the unsystematic risk goes to zero.
D) the return of the portfolio goes to zero.

## E) the return on the portfolio equals the risk-free rate.

34. A growth stock portfolio and a value portfolio might be characterized
A) each by their P/E relative to the index P/E; high P/E for growth and lower for
value.
B) as earning a high rate of return for a growth security and a low rate of return
for value security irrespective of risk.
C) low unsystematic risk and high systematic risk respectively.
D) moderate systematic risk and zero systematic risk respectively.
E) none of the above.
35. When deciding what to do with spare cash (pay out as dividends or invest in new
projects), the firm's managers should implement an investment project only if:
A) the firm never pays a dividend.
B) the expected return on the project is greater than that of an asset of similar
risk.
C) the expected return on the project is less than that of an asset of similar risk.
D) the expected return on the project is equal to that of an asset of similar risk.
E) none of the above.
36. What is its cost of equity of a firm if there are no taxes or other imperfections? The
firm has a debt-to-equity ratio of .60. Its cost of debt is 8%. Its overall cost of
capital is 12%.
A) 18% B) 14.4% C) 10%. D) 13.5% E) None of the above.
37. A risk factor is a variable that:
A) affects returns of many risky assets in a systematic fashion.
B) affects returns of many risky assets in an unsystematic fashion.
C) correlates with risky asset returns in a unsystematic fashion.
D) does not correlate with the returns of risky assets in an systematic fashion.
E) none of the above.
38. The beta of a portfolio of firm's debt and equity:
A) is equal to the sum of all the betas.
B) is equal to the sum of all the betas weighted by their market value weight.
C) is greater than the beta of each component.
D) is always less than zero.
E) can never be made up of debt and equity.

39. Comparing two otherwise equal firms, the beta of the common stock of a levered firm
is ____________ than the beta of the common stock of an unlevered firm.
A) equal to
D) greater
B) significantly less
E) none of the above
C) slightly less
40.Shareholders discount many corporate announcements because of their prior
expectations. If an announcement causes the price to change it will mostly be
driven by:
A) the expected part of the announcement.
B) market inefficiency.
C) the innovation or unexpected part of the announcement.
D) the systematic risk.
E) None of the above.
41. For a diversified portfolio including a large number of stocks,:
A) the weighted average expected return goes to zero.
B) the weighted average of the betas goes to zero.
C) the weighted average of the unsystematic risk goes to zero.
D) the return of the portfolio goes to zero.
E) the return on the portfolio equals the risk-free rate.
42. In normal market conditions if a security has a negative beta,:
A) the security always has a positive return.
B) the security has an expected return above the risk-free return.
C) the security has an expected return less than the risk-free rate.
D) the security has an expected return equal to the market portfolio.
E) both a & b are correct.
43 .A growth stock portfolio and a value portfolio might be characterized
A) each by their P/E relative to the index P/E; high P/E for growth and lower for
value.
B) as earning a high rate of return for a growth security and a low rate of return
for value security irrespective of risk.
C) low unsystematic risk and high systematic risk respectively.
D) moderate systematic risk and zero systematic risk respectively.
E) none of the above.

## 785 Sample Final

First Name_____________

Last Name_____________

and problems. One more time, recall you are not supposed to use either tables or any
notes besides your two sheets of 8 1/2" by 11" paper. Please write on the scantron answers
to multiple choice questions. For written questions, be sure you show explicitly the
entire procedure used, step by step, in your way to arrive at the solutions to the assigned
problems. Write neatly. (Note that you might not need all the information given in some
questions in order to answer questions). Please hand in the exam paper.
In this sample, the topic for each question is shown in bold letters. In the real final, the
topic is not shown.

## SEMI-STRONG FORM EFFICIENCY

c
1. The hypothesis that market prices reflect all publicly-available information is called
efficiency in the:
a. Open form.
b. Strong form.
c. Semi-strong form.
d. Weak form.
e. Stable form.
EFFICIENT MARKETS
c
2. If markets are at least semi-strong form efficient, and a company announces new,
unexpected information regarding its future prospectsnamely, that sales will be much
lower than previously expectedwhat do you expect will happen in the stock market?
a. The value of a share will decline over an extended period of time as investors begin to
sell shares in the company.
b. The value of a share will fall below what is considered appropriate because of the
decreased demand for the shares, but eventually the price will rise to the correct level.
c. The value of a share will drop immediately to a price that reflects the value of the new
information.
d. The value of a share will rise over a long period of time as investors sell the stock.
e. The stock price will not change since this type of information has no impact in markets
that are semi-strong form efficient.

EFFICIENT MARKETS

C 3 If the stock market is semi-strong efficient but not efficient in the strong form,
which of the following statements is most correct?

a.

All stocks should have the same expected returns; however, they may have
different realized returns.
b.
In equilibrium, stocks and bonds should have the same expected returns.
c.
which has not yet been publicly revealed.
d.
If the stock market has been performing strongly over the past several
months, stock prices are more likely to decline than increase over the next
several months.

COST OF DEBT
b
4. The long-term debt of your firm is currently selling for 109% of its face value. The
issue matures in 12 years and pays an annual coupon of 7.5%. What is the (pretax) cost
of debt?
b.
c.
d.
e.

6.40%
7.50%
8.90%
9.30%

WACC
b
5. The market value of debt is \$425 million and the total market value of the firm is \$925
million. The cost of equity is 17%, the cost of debt is 10%, and the tax rate is 35%.
What is the WACC?
a. 11.01%
b. 12.18%
c. 13.78%
d. 14.17%
e. 15.64%

b 6 The CEO of 785.com is thinking about whether to invest in a project that will return a sure
7% with no risk. Risk free rate is 4.5%. What is the right discount rate in getting the NPV of the
project?
a. 7%
b. 4.5%
c. 6.75%
WACC

7.

You are comparing two firms. All you know about them is that the WACC of firm A is
12% and the WACC of firm B is 15%. Which of the following can you infer from this?
I. A has more systematic risk
II. A uses more debt
III. A and B are not in the same line of business
IV. A uses preferred stock but B does not
a. I and II only
b. I and III only
c. II and III only
d. I, II, and IV only
e. You cannot infer any of the above without additional information

8 Which of the following statement is NOT true for a portfolio made up of several
stocks?
a. The expected return = weighted average of each stocks expected return.
b. The portfolio standard deviation is >= the weighted average of each stocks
standard deviation.
c. The portfolio beta is the weighted average of each stocks beta
d. The portfolio standard deviation is <= the weighted average of each stocks
standard deviation.

A 9

## Which of the following statements is incorrect?

a. The slope of the security market line is measured by beta.
b. Two securities with the same stand-alone risk can have different betas.
c. Company-specific risk can be diversified away.
e. Higher beta stocks have a higher required return.

## Use the following to answer questions 10-11:

GenLabs has been a hot stock the last few years, but is risky. The expected returns for GenLabs
are highly dependent on the state of the economy as follows:

State of Economy
Probability
GenLabs Returns
Depression
.05
-50%
Recession
.10
-15
Mild Slowdown
.20
5
Normal
.30
15%
.20
25
Strong Expansion
.15
40
10. The expected return on GenLabs is:
A) 3.3%
B) 8.5%
C) 12.5%
D) 20.5%
E) None of the above.
Answer: C Difficulty: Medium Page: 256
Rationale:
E(r) = .05(-.5) + .10(-.15) + .2(.05) + .3(.15) + .2(.25) + .15(.40) = .125 = 12.5%

## 11. The variance of GenLabs returns is

A) .0207
B) .0428
C) .0643
D) .0733
E) None of the above.
Answer: B Difficulty: Medium Page: 256-257
Rationale:
.05(-.50 - .125)2 + .1(-.15 - .125)2 + .2(.05 - .125)2 + .3(.15 - .125)2 + .2(.25 - .125)2 +
.15(.40 - .125)2 = .0428

12. You have plotted the data for two securities over time on the same graph, ie., the month
return of each security for the last 5 years. If the pattern of the movements of the two
securities rose and fell as the other did, these two securities would have
A) no correlation at all.
B) a weak negative correlation.
C) a strong negative correlation.
D) a strong positive correlation.
E) one can not get any idea of the correlation from a graph.
Answer: D Difficulty: Easy Page: 260

## 13. Beta measures

A) the ability to diversify risk.
B) how an asset covaries with the market.
C) the actual return on an asset.
D) the standard of the assets' returns.

## E) All of the above.

Answer: B Difficulty: Medium Page: 283
14.A stock with a beta of zero would be expected to have a rate of return equal to
A) the risk-free rate.
B) the market rate.
C) the prime rate.
D) the average AAA bond.
E) None of the above.
Answer: A Difficulty: Medium Page: 285

## 15.According to the CAPM

A) the expected return on a security is negatively and non-linearly related to the
security's beta.
B) the expected return on a security is negatively and linearly related to the security's
beta.
C) the expected return on a security is positively and linearly related to the security's
variance.
D) the expected return on a security is positively and non-linearly related to the
security's beta.
E) the expected return on a security is positively and linearly related to the security's
beta.
Answer: E Difficulty: Easy Page: 282
16. A portfolio contains two assets. The first asset comprises 40% of the portfolio and has a
beta of 1.2. The other asset has a beta of 1.5. The portfolio beta is
A) 1.35
B) 1.38
C) 1.42
D) 1.50
E) 1.55
Answer: B Difficulty: Medium Page: 287
Rationale:
p = .4(1.2)+.6(1.5)=1.38
17.The characteristic line is graphically depicted as
A) the plot of the relationship between beta and expected return.
B) the plot of the returns of the security against the beta.
C) the plot of the security returns against the market index returns.
D) the plot of the beta against the market index returns.

Options
5

A)
B)
C)
D)

## larger than the current stock price.

larger than the strike price
equal or less than the strike price
none of the above

19. Suppose an investor buys one share of stock and a put option on the stock and
simultaneously sells a call option on the stock with the same exercise price. What will be
the value of his investment on the final exercise date?
A) Above the exercise price if the stock price rises and below the exercise price if it falls
B) Equal to the exercise price regardless of the stock price
C) Equal to zero regardless of the stock price
D) Below the exercise price if the stock price rises and above if it falls
E) None of the above

## VALUE OF A CALL OPTION

d
20. All else the same, the value of a call option decreases as the:
I. Underlying asset price decreases
II. Exercise price decreases
III. Volatility decreases
a. I only
b. II only
c. III only
d. I and III only

IMPLICIT OPTIONS
c
21. A ticket to a baseball game gives the holder the right, but not the obligation, to attend a
specified game. Thus, a baseball ticket is effectively a(n)
option on the
possession of a seat, which has an expiration date equal to
.
a. American call;
the day of the game
b. American call;
the end of the baseball season
c. European call;
the day of the game
d. European call;
the end of the baseball season
e. convertible bond;
the end of the baseball season

Use the following option quotes to answer questions #22 through #23.
Call
Put
Option
Strike
Exp.
Vol.
Last
Vol.
Cisco
15.00
Oct.
491
2.26
559
16.30
15.00
Nov.
259
2.90
154
16.30
17.50
Oct.
680
0.85
522
16.30
17.50
Nov.
142
1.33
40
16.30
17.50
Feb.
51
1.95
28
16.30
20.00
Oct.
828
0.30
915
16.30
20.00
Nov.
123
0.55
212

OPTION QUOTE
e
22. What is the market value per share of the November 15 call?
a. \$1.30
b. \$1.33
c. \$1.95
d. \$2.26
e. \$2.90

OPTION QUOTE
c
23. Which of the options shown in the quote are in-the-money?
I. The October 15 call
II. The November 17.50 call
III. The October 15 put
IV. The November 20 put
a. I and II only
b. II and III only
c. I and IV only
d. III only
e. III and IV only

PROTECTIVE PUT
c
24. The purchase of stock and a put option on the stock to limit the downside risk
associated with the stock is a strategy called the
.
a. put-call parity relation
b. covered call
c. protective put

Last
0.25
1.00
1.60
2.31
3.77
4.05
4.67

e.

strangle

PUT-CALL PARITY
c
25. An European put option with exercise price \$50 and 6 months to expiration sells for
\$1.00. The continuously-compounded risk-free rate is 8% annually (so that
PV(k)=\$50*exp(-0.08*0.5)= \$48.04), and the stock sells for \$56. How much must a
call option sell for with the same exercise price and expiration?
a. \$ 6.00
b. \$ 7.51
c. \$ 8.96
d. \$ 9.65
e. \$10.84

Written questions
1.

The Jackson Company has just paid a dividend of \$3.00 per share (D0) on its
common stock, and it expects this dividend to grow by 10 percent per year,
indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the
expected return on the market is 14 percent. (3 points)

How much should an investor be willing to pay for this stock today?
Rs = RF + (RM RF) = 10% + 1.5 x (14% - 10%) = .10 +
10% + 1.5(4%) = 16%.

P0 =

\$3.00(1.10)
0.16 - 0.10

1.5 x 0.04

= \$55.00.

2. Assume that the bond A, B, and C issued by US government have no default risk. In
Bond A pays coupon rate of 6% and matures in 10 years. Price=\$1000
Bond B pays coupon rate of 12% and matures in 10 years. Price=\$1100
Bond C pays coupon rate of 9% and matures in 10 years. Price=\$1060
Describe an arbitrage strategy and your profit. (2 points)
Buy (go long) 1 share of Bond A and 1 share of bond B, go short 2 shares of bond C.
Because you are using the proceeds from going short of 2 bond c to buy one bond A
and one bond B, you can make a profit of \$20 immediately.
In the next 10 years, use the cash inflows from Bond A and Bond B to pay off your
obligation under Bond C.

Practice questions from chapters 10-12 (with a few bonus questions from chapter 13).
1. The excess return required on a risky asset over that earned on a risk-free asset is called (a):
C) Excess return.
D) Average return.
E) Variance.
2. An efficient capital market is one in which:
A) Brokerage commissions are zero.
B) Taxes are irrelevant.
D) Security prices are guaranteed (by the Securities and Exchange Commission) to be fair.
E) Security prices reflect available information.
3. The hypothesis that market prices reflect all available, public and private, information is called
efficiency in the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
4. The hypothesis that market prices reflect all publicly-available information is called efficiency in
the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
5. The hypothesis that market prices reflect all historical information is called efficiency in the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
6. Over the past 76 years, which of the following investments has provided the largest average
return?
A) Small company stocks
B) Common stocks
C) Treasury bills
D) Treasury bonds
E) Corporate bonds

7. Over the past 76 years, which of the following investments has been the least risky?
A) Small company stocks
B) Common stocks
C) Treasury bills
D) Treasury bonds
E) Corporate bonds
8. You track the liquidity of companies and find that you can consistently earn unusually high
returns by purchasing the shares of firms whose stock price falls below the cash value per share
as indicated on the balance sheet. Which of the following describes this strategy?
A) This would not be a violation of market efficiency.
B) This would be a violation of weak form efficiency.
C) This would be a violation of semi-strong form efficiency.
D) This would be a violation of strong form efficiency.
E) This would be a violation of all forms of market efficiency.
9. Last year you purchased 1,000 shares of Sun Microsystems stock for \$15 per share. According to
today's quote in The Wall Street Journal, the stock is currently selling for \$3 per share. The stock
pays no dividends. Your return on this investment is comprised of _____________.
A) retained earnings and dividend yields
B) an income return and a capital gains return
C) a real return only
D) a capital gains return only
E) there is no return, since you lost money on this investment
10. Which of the following is generally considered to represent the risk-free return?
A) Common stocks
B) Small stocks
C) Long-term government bonds
D) Long-term corporate bonds
E) Treasury bills
11. You purchased a bond for \$870 one year ago. Today, you receive your only interest payment for
the year of \$70. The bond can currently be sold for \$925. What is your total percentage return on
investment? Ignore tax effects.
A) 6.3%
B) 8.1%
C) 14.4%
D) 16.5%
E) 20.8%
12. You purchased 500 shares of preferred stock on January 1, 2002, for \$85 per share. The stock
pays an annual dividend of \$12 per share. On December 31, 2002, the market price is \$91 per
share. What is your total dollar return for the year?

A) \$ 3,000
B) \$ 4,500
C) \$ 6,000
D) \$ 9,000
E) \$12,000
Response: 500 (\$91 - 85 + 12) = \$9,000
13. You purchased a bond on January 1, 2002, for \$1,065. The bond has a \$1,000 face value, a 10%
annual coupon, and can be sold for \$975 on December 31, 2002. What is your percentage return
on investment for the year?
A) 4.1%
B) 0.9%
C) 4.6%
D) 8.3%
E) 12.5%
Response: R = [(\$975 - 1,065) / 1,065] + (100 / 1,065) = .0094
14. You purchased 500 shares of preferred stock on January 1, 2002, for \$50 per share. The stock
pays an annual dividend of \$8 per share. On December 31, 2002, the market price is \$54 per
share. What is your percentage return on investment for the year?
A) 4%
B) 8%
C) 16%
D) 20%
E) 24%
Response: R = [(\$54 - 50) / 50] + (8 / 50) = .24

## Use the following to answer questions 15-18:

You purchase 800 shares of stock at a price of \$20 per share. One year later, the shares are selling for \$23
per share. In addition, a dividend of \$2 per share is paid at the end of each year.

## 15. What is the total dollar return for the investment?

A) \$1,600
B) \$2,400
C) \$4,000
D) \$6,800
E) \$8,000
Response: 800 (\$23 - 20 + 2) = \$4,000
16. What is the capital gains yield for the investment?
A) 8.5%
B) 10.0%
C) 11.5%
D) 13.0%

E) 15.0%
Response: CGY = (\$23 - 20) / 20 = .15
17. What is the dividend yield for the investment?
A) 2.5%
B) 7.5%
C) 10.0%
D) 15.0%
Response: DY = \$2 / 20 = .10
18. What is the total percentage return for the investment?
A) 5%
B) 10%
C) 15%
D) 20%
E) 25%
Response: R = [(\$23 - 20) / 20] + (2 / 20) = .25
Chapter 11 questions begin here
1. A portfolio is ___________________________.
A) a group of assets, such as stocks and bonds, held as a collective unit by an investor
B) the expected return on a risky asset
C) the expected return on a collection of risky assets
D) the variance of returns for a risky asset
E) the standard deviation of returns for a collection of risky assets
2. The percentage of a portfolio's total value invested in a particular asset is called that asset's:
A) Portfolio return.
B) Portfolio weight.
C) Portfolio risk.
D) Rate of return.
E) Investment value.
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called:
A) Idiosyncratic risk.
B) Diversifiable risk.
C) Systematic risk.
D) Asset-specific risk.
E) Total risk.
4. Risk that affects at most a small number of assets is called:
A) Portfolio risk.
B) Undiversifiable risk.
C) Market risk.

D) Unsystematic risk.
E) Total risk.
5. The principle of diversification tells us that:
A) Concentrating an investment in two or three large stocks will eliminate all of your risk.
B) Concentrating an investment in two or three large stocks will reduce your overall risk.
C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate
any risk.
D) Spreading an investment across many diverse assets will eliminate all of the risk.
E) Spreading an investment across many diverse assets will eliminate some of the risk.
6. The ___________________ tells us that the expected return on a risky asset depends only on that
asset's systematic risk.
A) Efficient Markets Hypothesis (EMH)
B) systematic risk principle
C) Open Markets Theorem
D) Law of One Price
E) principle of diversification
7. The amount of systematic risk present in a particular risky asset, relative to the systematic risk
present in an average risky asset, is called the particular asset's:
A) Beta coefficient.
B) Reward to risk ratio.
C) Law of One Price.
D) Diversifiable risk.
E) Treynor index.
8. The linear relation between an asset's expected return and its beta coefficient is the:
A) Reward to risk ratio.
B) Portfolio weight.
C) Portfolio risk.
D) Security market line.
9. Diversification works because:
A) Unsystematic risk exists.
B) Forming stocks into portfolios reduces the standard deviation of returns for each stock.
C) Firm-specific risk can be never be reduced.
D) Stocks earn higher returns than bonds.
E) Portfolios have higher returns than individual assets.
10. A security has an unexpected negative news announcement specific to that security. Most likely,
the ______________________________.
A) security's required return on investment will increase.
B) security's required return on investment will remain unchanged.

## C) security's required return on investment will decrease.

D) market risk premium will increase.
E) security's market price will remain unchanged.
11. New information regarding a security, when received by the market, leads to a(n):
A) Unexpected return.
B) Expected return.
C) Actual return.
D) Systematic return.
E) Non-diversifiable return.
12. You own 50 shares of stock A, which has a price of \$12 per share, and 100 shares of stock B,
which has a price of \$3 per share. What is the portfolio weight for stock A in your portfolio?
A) 25%
B) 33%
C) 50%
D) 67%
E) 75%
Response: 50(\$12) + 100(3) = \$900; wA = \$600 / 900 = .67
13. What is the expected return for the following stock?
State
Average
Recession
Depression

Probability
.50
.35
.15

Return
.25
.05
.35

A) .05
B) .08
C) .09
D) .10
E) .12
Response: 50(.25) + .35(.05) + .15(-.35) = .09
14. What is the risk premium for the following returns if the risk-free rate is 4%?
State
Boom
Good
Recession
Depression

A)
B)
C)
D)
E)

0.3325
0.1525
0.0525
0.1825
0.2225

Probability
.20
.55
.15
.10

Return
.75
.25
.10
.50

Response: .20(.75) + .55(.25) + .15(-10)+ .10(-50) = .2225; RP = .2225 .04 = .1825
15. What is the expected portfolio return given the following information:
Asset
A
B
C
D

Portfolio weight
.35
.15
.25
.25

Return
20%
35%
6%
12%

A) 6.75%
B) 9.50%
C) 16.75%
D) 18.25%
E) 21.50%
Response: .35(.20) + .15(.35) + .25(.06) + .25(.12) = .1675
16. What is the expected return on asset A if it has a beta of 0.6, the expected market return is 15%,
and the risk-free rate is 6%?
A) 5.4%
B) 9.6%
C) 11.4%
D) 15.0%
Response: 6 + .6(15 - 6) = 11.4%
Chapter 12 questions begin here
1. The opportunity cost associated with the firm's capital investment in a project is called its:
A) Cost of capital.
B) Beta coefficient.
C) Capital gains yield.
D) Sunk cost.
E) Internal rate of return.
2. The return that shareholders require on their investment in the firm is called the:
A) Dividend yield.
B) Cost of equity.
C) Capital gains yield.
D) Cost of capital.
E) Income return.
3. The return that lenders require on their loaned funds to the firm is called the:
A) Coupon rate.
B) Current yield.
C) Cost of debt.
D) Capital gains yield.

E) Cost of capital.
4. The weighted average of the firm's costs of equity, preferred stock, and aftertax debt is the:
A) Reward to risk ratio for the firm.
B) Expected capital gains yield for the stock.
C) Expected capital gains yield for the firm.
D) Portfolio beta for the firm.
E) Weighted average cost of capital (WACC).
5. All of the following could be considered advantages in assessing the cost of preferred stock
compared to the cost of common stock EXCEPT:
A) Preferred stock generally carries with it a fixed dividend payment.
B) Preferred stock is often rated for default risk.
C) The cost of preferred stock is simply equal to its dividend yield.
D) The cost of preferred stock can be calculated as a perpetuity based on the fixed dividend
payment and the present stock price.
E) Unlike common stock, preferred stock requires no assumptions be made about future cash
flows.
6. Which of the following, among other things, is needed to calculate the weighted average cost of
capital for a non-profit corporation?
A) The par value of bonds outstanding.
B) The bond rating of the firm's outstanding debt issues.
C) The corporate tax rate.
D) The number of preferred shares outstanding.
E) The operating cash flow for the most recent reporting period.
7. All else the same, a higher corporate tax rate _____________________.
A) will decrease the WACC of a firm with some debt in its capital structure
B) will increase the WACC of a firm with some debt in its capital structure
C) will not affect the WACC of a firm with some debt in its capital structure
D) will decrease the WACC of a firm with no debt in its capital structure
E) will change the WACC of a firm with some debt in its capital structure, but the direction is
unclear.
8. To estimate the cost of equity for a firm, which of the following variables would NOT be needed?
A) The current dividend payment.
B) The risk-free interest rate.
C) The debt/equity ratio.
D) The beta coefficient.
E) The market price of the stock.
9. A firm is expected to pay a dividend of \$3.50 per share in one year. This dividend, along with the
firm's earnings, is expected to grow at a rate of 7% forever. If the current market price for a share
is \$67, what is the cost of equity?

A) 7.00%
B) 12.22%
C) 15.64%
D) 14.00%
E) 13.46%
Response: (\$3.50 / 67) + .07 = .1222

10. The long-term debt of your firm is currently selling for 109% of its face value. The issue matures
in 12 years and pays an annual coupon of 7.5%. What is the cost of debt?
A) 5.60%
B) 6.40%
C) 7.50%
D) 8.90%
E) 9.30%
Response: \$1,090 = \$75{[1 - 1/(1 + YTM)12] / YTM} + 1,000 / (1 + YTM)12; YTM = 6.40%
11. A company's preferred stock pays an annual dividend of \$7.00 per share. When issued, the shares
sold for their par value of \$100 per share. What is the cost of preferred stock if the current price is
\$120 per share?
A) 5.8%
B) 7.0%
C) 8.1%
D) 9.6%
E) 12.0%
Response: \$7 / 120 = .058
12. Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target
debt/equity ratio is 0.60, and the tax rate is 35%, what is the firm's weighted average cost of
capital (WACC)?
A) 7.4%
B) 9.9%
C) 11.8%
D) 13.2%
E) 14.3%
Response: .18(10/16) + .08(6/16)(1-35) = .132
13. Suppose a firm has 19 million shares of common stock outstanding with a par value of \$1.00 per
share. The current market price per share is \$18.35. The firm has outstanding debt with a par
value of \$114.5 million selling at 96% of par. What capital structure weight would you use for
debt when calculating the firm's WACC?
A) 0.15
B) 0.24
C) 0.54
D) 0.76
E) 0.96

Response: V = 19M(\$18.35) + 114,500(\$960) = \$458,570,000; D/V = \$109.92M / 458.57M =
.240
14. A common stock issue is currently selling for \$31 per share. You expect the next dividend to be
\$1.40 per share. If the firm has a dividend growth rate of 5% that is expected to remain constant
indefinitely, what is the firm's cost of equity?
A) 9.5%
B) 11.3%
C) 13.8%
D) 14.2%
E) 15.1%
Response: (\$1.40/31) + .05 = .0952
15. Given the following information, what is the average annual dividend growth rate?
Dividend

\$1.80

\$1.90

\$2.15

\$2.28

\$2.49

\$2.75

A) 4.9%
B) 6.2%
C) 8.8%
D) 9.7%
E) 10.3%
Response: (\$.10/1.80 + .25/1.90 + .13/2.15 + .21/2.28 + .26/2.49) / 5 = .0888
16. Treasury bills currently have a return of 2.5% and the market risk premium is 7%. If a firm has a
beta of 1.4, what is its cost of equity?
A) 8.1%
B) 9.9%
C) 10.8%
D) 12.3%
E) 14.4%
Response: 2.5 + 1.4(7) = 12.3%
17. Your firm sold a 25-year bond at par 19 years ago. The bond pays an 6% annual coupon, has a
\$1,000 face value, and currently sells for \$825. What is the firm's cost of debt?
A) 6.0%
B) 8.2%
C) 9.5%
D) 10.0%
E) 11.3%
Response: \$825 = \$60{[1 - 1/(1 + YTM)6] / YTM} + 1,000 / (1 + YTM)6; YTM = 10.02%
18. A company has preferred stock outstanding which pays a dividend of \$6 per share a year. The
current stock price is \$75 per share. What is the cost of preferred stock?
A) 6%

B) 7%
C) 10%
D) 9%
E) 8%
Response: \$6 / 75 = .08
19. A firm sold a 10-year bond issue 3 years ago. The bond has a 6.45% annual coupon and a \$1,000
face value. If the current market price of the bond is \$951.64 and the tax rate is 35%, what is the
aftertax cost of debt?
A) 3.50%
B) 5.99%
C) 6.45%
D) 7.36%
E) 4.78%
Response:
\$951.64 = \$64.50{[1 - 1/(1 + YTM)7] / YTM} + 1,000 / (1 + YTM) 7; YTM = 7.359%
AT = 7.359(1-.35) = 4.783%
20. Given the following information, what is the firm's weighted average cost of capital? Market
value of equity = \$30 million; market value of debt = \$20 million; cost of equity = 15%; cost of
debt = 9%; equity beta = 1.4; tax rate = 35%.
A) 11.34%
B) 12.60%
C) 12.97%
D) 13.32%
E) 14.08%
Response: 15(\$30M/50M) + 9(20M/50M)(1-.35) = 11.34%
Chapter 13 questions begin here
1. The equity risk derived from the firm's operating activities is called ___________ risk.
A) market
B) systematic
C) extrinsic
E) financial
2. The equity risk derived from the firm's capital structure policy is called ___________ risk.
A) market
B) systematic
C) extrinsic
E) financial

3. The tax savings of the firm derived from the deductibility of interest expense is called the:
A) Interest tax shield.
B) Depreciable basis.
C) Financing umbrella.
D) Current yield.
E) Tax-loss carryforward savings.
4. The financial leverage of a firm will ______________________ .
I. decrease as the debt/equity ratio increases
II. decrease as the firm's retained earnings account grows
III. decrease if the firm has negative net income
A) I only
B) II only
C) III only
D) I and II only
E) II and III only
5. The optimal capital structure is the mixture of debt and equity which:
I. Maximizes the value of the firm.
II. Maximizes the firm's weighted average cost of capital.
III. Maximizes the market price of the firm's bonds.
A) I only
B) III only
C) I and II only
D) I and III only
E) I, II and III
6. Above the breakeven EBIT, increased financial leverage will __________ EPS, all else the same.
Assume there are no taxes.
A) increase
B) decrease
C) not affect
D) either increase or decrease
E) increase EBIT but decrease
7. ___________ arises from decisions that affect the left-hand side of the balance sheet,
while___________ arises from decisions that affect the right-hand side of the balance sheet.
A) Systematic risk; financial risk
B) Systematic risk; unsystematic risk
C) Unsystematic risk; systematic risk

## 8. Which of the following statements is true?

A) The financial risk of a firm decreases when it takes on a risky project.
B) The financial risk of a firm increases when it takes on more equity.
C) The business risk of a firm increases when it takes on a risky project.
D) The business risk of a firm increases when it takes on more debt.
E) The higher the business risk for a firm, the higher the financial risk as well.

CHAPTER 13
Return, Risk, and the Security Market Line

I.

DEFINITIONS

PORTFOLIOS
a
1. A portfolio is:
a. a group of assets, such as stocks and bonds, held as a collective unit by an investor.
b. the expected return on a risky asset.
c. the expected return on a collection of risky assets.
d. the variance of returns for a risky asset.
e. the standard deviation of returns for a collection of risky assets.
PORTFOLIO WEIGHTS
b
2. The percentage of a portfolios total value invested in a particular asset is called that
assets:
a. portfolio return.
b. portfolio weight.
c. portfolio risk.
d. rate of return.
e. investment value.
SYSTEMATIC RISK
c
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called
_____ risk.
a. idiosyncratic
b. diversifiable
c. systematic
d. asset-specific
e. total
UNSYSTEMATIC RISK
d
4. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
e. total
PRINCIPLE OF DIVERSIFICATION
e
5. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will
c. spreading an investment across five diverse companies will not lower your overall risk
at all.
d. spreading an investment across many diverse assets will eliminate all of the risk.
e. spreading an investment across many diverse assets will eliminate some of the risk.

CHAPTER 13
SYSTEMATIC RISK PRINCIPLE
b
6. The _____ tells us that the expected return on a risky asset depends only on that assets
nondiversifiable risk.
a. Efficient Markets Hypothesis (EMH)
b. systematic risk principle
c. Open Markets Theorem
d. Law of One Price
e. principle of diversification
BETA COEFFICIENT
a
7. The amount of systematic risk present in a particular risky asset, relative to the
systematic risk present in an average risky asset, is called the particular assets:
a. beta coefficient.
b. reward-to-risk ratio.
c. total risk.
d. diversifiable risk.
e. Treynor index.
REWARD-TO-RISK RATIO
c
8. A particular risky assets risk premium, measured relative to its beta coefficient, is its:
a. diversifiable risk.
b. systematic risk.
c. reward-to-risk ratio.
d. security market line.
SECURITY MARKET LINE
d
9. The linear relation between an assets expected return and its beta coefficient is the:
a. reward-to-risk ratio.
b. portfolio weight.
c. portfolio risk.
d. security market line.
e
10. The slope of an assets security market line is the:
a. reward-to-risk ratio.
b. portfolio weight.
c. beta coefficient.
d. risk-free interest rate.

CHAPTER 13
II. CONCEPTS
EXPECTED RETURN
e
11. You are considering purchasing stock S. This stock has an expected return of 8 percent
if the economy booms and 3 percent if the economy goes into a recessionary period.
The overall expected rate of return on this stock will:
a. be equal to one-half of 8 percent if there is a 50 percent chance of an economic boom.
b. vary inversely with the growth of the economy.
c. increase as the probability of a recession increases.
d. be equal to 75 percent of 8 percent if there is a 75 percent chance of a boom economy.
e. increase as the probability of a boom economy increases.
EXPECTED RETURN
c
12. Which one of the following statements is correct concerning the expected rate of return
on an individual stock given various states of the economy?
a. The expected return is a geometric average where the probabilities of the economic
states are used as the exponential powers.
b. The expected return is an arithmetic average of the individual returns for each state of
the economy.
c. The expected return is a weighted average where the probabilities of the economic
states are used as the weights.
d. The expected return is equal to the summation of the values computed by dividing the
expected return for each economic state by the probability of the state.
e. As long as the total probabilities of the economic states equal 100 percent, then the
expected return on the stock is a geometric average of the expected returns for each
economic state.
EXPECTED RETURN
d
13. The expected return on a stock that is computed using economic probabilities is:
a. guaranteed to equal the actual average return on the stock for the next five years.
b. guaranteed to be the minimal rate of return on the stock over the next two years.
c. guaranteed to equal the actual return for the immediate twelve month period.
d. a mathematical expectation based on a weighted average and not an actual anticipated
outcome.
e. the actual return you should anticipate as long as the economic forecast remains
constant.
DIVERSIFIABLE RISKS
b
14. Which one of the following is an example of diversifiable risk?
a. the price of electricity just increased
b. the employees of Textile, Inc. just voted to go on strike
c. the government just imposed new safety standards for all employees
d. the government just lowered corporate income tax rates
e. the cost of group health insurance just increased nationwide

CHAPTER 13
DIVERSIFIABLE RISKS
a
15. Which of the following statements are correct concerning diversifiable risks?
I.
Diversifiable risks can be essentially eliminated by investing in several unrelated
securities.
II. The market rewards investors for diversifiable risk by paying a risk premium.
III. Diversifiable risks are generally associated with an individual firm or industry.
IV. Beta measures diversifiable risk.
a. I and III only
b. II and IV only
c. I and IV only
d. II and III only
e. I, II, and III only
NONDIVERSIFIABLE RISKS
c
16. Which of the following are examples of nondiversifiable risks?
I.
the inflation rate spikes nationwide
II. an unexpected terrorist event occurs
III. the price of lumber suddenly spikes
IV. taxes are increased on hotels
a. I and III only
b. II and IV only
c. I and II only
d. II and III only
e. I, II, and IV only
NONDIVERSIFIABLE RISKS
d
17. Which of the following statements concerning nondiversifiable risk are correct?
I.
Nondiversifiable risk is measured by standard deviation.
II. Systematic risk is another name for nondiversifiable risk.
III. The risk premium increases as the nondiversifiable risk increases.
IV. Nondiversifiable risks are those risks you can not avoid if you are invested in the
financial markets.
a. I and III only
b. II and IV only
c. I, II, and III only
d. II, III, and IV only
e. I, II, III, and IV
NONDIVERSIFIABLE RISKS
b
18. Which one of the following is an example of a nondiversifiable risk?
a. a well respected president of a firm suddenly resigns
b. a well respected chairman of the Federal Reserve suddenly resigns
c. a key employee of a firm suddenly resigns and accepts employment with a key
competitor
d. a well managed firm reduces its work force and automates several jobs
e. a poorly managed firm suddenly goes out of business due to lack of sales

CHAPTER 13
a
19. The risk premium for an individual security is computed by:
a. multiplying the securitys beta by the market risk premium.
b. multiplying the securitys beta by the risk-free rate of return.
c. adding the risk-free rate to the securitys expected return.
d. dividing the market risk premium by the quantity (1 beta).
e. dividing the market risk premium by the beta of the security.
STANDARD DEVIATION
a
20. Standard deviation measures _____ risk.
a. total
b. nondiversifiable
c. unsystematic
d. systematic
e. economic
PORTFOLIO WEIGHT
c
21. When computing the expected return on a portfolio of stocks the portfolio weights are
based on the:
a. number of shares owned in each stock.
b. price per share of each stock.
c. market value of the total shares held in each stock.
d. original amount invested in each stock.
e. cost per share of each stock held.
PORTFOLIO EXPECTED RETURN
e
22. The portfolio expected return considers which of the following factors?
I.
the amount of money currently invested in each individual security
II. various levels of economic activity
III. the performance of each stock given various economic scenarios
IV. the probability of various states of the economy
a. I and III only
b. II and IV only
c. I, III, and IV ony
d. II, III, and IV only
e. I, II, III, and IV
PORTFOLIO EXPECTED RETURN
d
23. The expected return on a portfolio:
a. can be greater than the expected return on the best performing security in the portfolio.
b. can be less than the expected return on the worst performing security in the portfolio.
c. is independent of the performance of the overall economy.
d. is limited by the returns on the individual securities within the portfolio.
e. is an arithmetic average of the returns of the individual securities when the weights of
those securities are unequal.

CHAPTER 13
PORTFOLIO VARIANCE
b
24. If a stock portfolio is well diversified, then the portfolio variance:
a. will equal the variance of the most volatile stock in the portfolio.
b. may be less than the variance of the least risky stock in the portfolio.
c. must be equal to or greater than the variance of the least risky stock in the portfolio.
d. will be a weighted average of the variances of the individual securities in the portfolio.
e. will be an arithmetic average of the variance of the individual securities in the
portfolio.
PORTFOLIO STANDARD DEVIATION
b
25. Which one of the following statements is correct concerning the standard deviation of
a portfolio?
a. The greater the diversification of a portfolio, the greater the standard deviation of that
portfolio.
b. The standard deviation of a portfolio can often be lowered by changing the weights of
the securities in the portfolio.
c. Standard deviation is used to determine the amount of risk premium that should apply
to a portfolio.
d. Standard deviation measures only the systematic risk of a portfolio.
e. The standard deviation of a portfolio is equal to a weighted average of the standard
deviations of the individual securities held within the portfolio.
PORTFOLIO STANDARD DEVIATION
c
26. The standard deviation of a portfolio will tend to increase when:
a. a risky asset in the portfolio is replaced with U.S. Treasury bills.
b. one of two stocks related to the airline industry is replaced with a third stock that is
unrelated to the airline industry.
c. the portfolio concentration in a single cyclical industry increases.
d. the weights of the various diverse securities become more evenly distributed.
e. short-term bonds are replaced with long-term bonds.
EXPECTED AND UNEXPECTED RETURNS
c
27. Which one of the following events is considered part of the expected return on Fido
stock?
a. The president of Fido suddenly announced that the firm is going to cut production
effective immediately.
b. The government just announced a tax cut which will directly impact the sales of Fido.
c. The management of Fido announced their ten-year plan for expansion five years ago.
d. The price of Fido stock suddenly dropped due to rumors concerning company fraud.
e. Fido just won a major government contract which they had not anticipated winning.
EXPECTED AND UNEXPECTED RETURNS
e
28. Which one of the following statements is correct?
a. The unexpected return is always negative.
b. The expected return minus the unexpected return is equal to the total return.
c. Over time, the average return is equal to the unexpected return.
d. The expected return includes the surprise portion of news announcements.
e. Over time, the average unexpected return will be zero.

CHAPTER 13
TOTAL RISK
d
29. _____ measures total risk.
a. The mean
b. Beta
c. The geometric average
d. The standard deviation
e. The arithmetic average
SYSTEMATIC RISK
b
30. Systematic risk is measured by:
a. the mean.
b. beta.
c. the geometric average.
d. the standard deviation.
e. the arithmetic average.
SYSTEMATIC RISK
c
31. Which one of the following is an example of systematic risk?
a. the price of lumber declines sharply
b. airline pilots go on strike
c. the Federal Reserve increases interest rates
d. a hurricane hits a tourist destination
e. people become diet conscious and avoid fast food restautants
SYSTEMATIC RISK
a
32. The systematic risk of the market is measured by:
a. a beta of 1.0.
b. a beta of 0.0.
c. a standard deviation of 1.0.
d. a standard deviation of 0.0.
e. a variance of 1.0.
SYSTEMATIC RISK
c
33. Which one of the following portfolios should have the most systematic risk?
a. 50 percent invested in U.S. Treasury bills and 50 percent in a market index mutual
fund
b. 20 percent invested in U.S. Treasury bills and 80 percent invested in a stock with a
beta of .80
c. 10 percent invested in a stock with a beta of 1.0 and 90 percent invested in a stock with
a beta of 1.40
d. 100 percent invested in a mutual fund which mimics the overall market
e. 100 percent invested in U.S. Treasury bills

CHAPTER 13
SYSTEMATIC RISK
e
34. Which of the following risks are relevant to a well-diversified investor?
I.
systematic risk
II. unsystematic risk
III. market risk
IV. nondiversifiable risk
a. I and III only
b. II and IV only
c. II, III, and IV only
d. I, II, and IV only
e. I, III, and IV only
UNSYSTEMATIC RISK
a
35. Unsystematic risk:
a. can be effectively eliminated through portfolio diversification.
b. is compensated for by the risk premium.
c. is measured by beta.
d. cannot be avoided if you wish to participate in the financial markets.
e. is related to the overall economy.
UNSYSTEMATIC RISK
c
36. Which one of the following is an example of unsystematic risk?
a. the inflation rate increases unexpectedly
b. the federal government lowers income taxes
c. an oil tanker runs aground and spills its cargo
d. interest rates decline by one-half of one percent
e. the GDP rises by 2 percent more than anticipated
UNSYSTEMATIC RISK
e
37. Which of the following actions help eliminate unsystematic risk in a portfolio?
I.
spreading the retail industry portion of a portfolio over five separate stocks
II. combining stocks with bonds in a portfolio
III. adding some international securities into a portfolio of U.S. stocks
IV. adding some U.S. Treasury bills to a risky portfolio
a. I and III only
b. I, II, and IV only
c. I, III, and IV only
d. II, III, and IV only
e. I, II, III, and IV

CHAPTER 13
UNSYSTEMATIC RISK
a
38. Which of the following statements is (are) correct concerning unsystematic risk?
I.
Assuming unsystematic risk is rewarded by the marketplace.
II. Eliminating unsystematic risk is the responsibility of the individual investor.
III. Unsystematic risk is rewarded when it exceeds the market level of unsystematic risk.
IV. The Capital Asset Pricing Model specifically rewards investors for assuming
unsystematic risk via the application of beta in the formula.
a. II only
b. III and IV only
c. I, III and IV only
d. II and III only
e. I and III only
DIVERSIFICATION
c
39. The primary purpose of portfolio diversification is to:
a. increase returns and risks.
b. eliminate all risks.
c. eliminate asset-specific risk.
d. eliminate systematic risk.
e. lower both returns and risks.
DIVERSIFICATION
e
40. Which one of the following would tend to indicate that a portfolio is being effectively
diversified?
a. an increase in the portfolio beta
b. a decrease in the portfolio beta
c. an increase in the portfolio rate of return
d. an increase in the portfolio standard deviation
e. a decrease in the portfolio standard deviation
DIVERSIFICATION
c
41. The majority of the benefits from portfolio diversification can generally be achieved
with just _____ diverse securities.
a. 3
b. 6
c. 30
d. 50
e. 75
SYSTEMATIC RISK PRINCIPLE
c
42. The systematic risk principle implies that the _____ an asset depends only on that
assets systematic risk.
a. variance of the returns on
b. standard deviation of the returns on
c. expected return on
d. total risk assumed by owning
e. diversification benefits of

CHAPTER 13
SYSTEMATIC RISK PRINCIPLE
e
43. Which one of the following measures is relevant to the systematic risk principle?
a. variance
b. alpha
c. standard deviation
d. theta
e. beta
PORTFOLIO BETA
b
44. Which of the following statements are correct concerning the beta of a portfolio?
I.
Portfolio betas will always be greater than 1.0.
II. A portfolio beta is a weighted average of the b etas of the individual securities
contained in the portfolio.
III. A portfolio of U.S. Treasury bills will have a beta equal to minus one.
IV. If the portfolio beta is greater than one then the portfolio has more risk than the overall
market.
a. I and III only
b. II and IV only
c. I, II, and III only
d. II, III, and IV only
e. I, II, and IV only
PORTFOLIO BETA
b
45. Which of the following variables do you need to know to estimate the amount of
asset?
I.
standard deviation
II. beta
III. risk-free rate of return
a. I and III only
b. II and IV only
c. I, III, and IV only
d. II, III, and IV only
e. I, II, III, and IV
SECURITY MARKET LINE (SML)
c
46. A security that is fairly priced will have a return that lies _____ the Security Market
Line.
a. below
b. on or below
c. on
d. on or above
e. above

CHAPTER 13
SECURITY MARKET LINE (SML)
a
47. The intercept point of the security market line is the rate of return which corresponds
to:
a. the risk-free rate of return.
b. the market rate of return.
c. a value of zero.
d. a value of 1.0.
e. the beta of the market.
SECURITY MARKET LINE (SML)
c
48. A stock with an actual return that lies above the security market line:
a. has more systematic risk than the overall market.
b. has more risk than warranted based on the realized rate of return.
c. has yielded a higher return than expected for the level of risk assumed.
d. has less systematic risk than the overall market.
e. has yielded a return equivalent to the level of risk assumed.
SECURITY MARKET LINE (SML)
c
49. The market rate of return is 12 percent and the risk-free rate of return is 4 percent. A
stock that has 5 percent more risk than the market has an actual return of 12 percent.
This stock:
I.
is underpriced.
II. is overpriced.
III. will plot below the security market line.
IV. will plot above the security market line.
a. I and III only
b. I and IV only
c. II and III only
d. II and IV only
e. neither I, II, III, nor IV
REWARD-TO-RISK RATIO
c
50. If the market is efficient and securities are priced fairly then the _____ will be constant
for all securities.
a. systematic risk
b. standard deviation
c. reward-to-risk ratio
d. beta
REWARD-TO-RISK RATIO
c
51. The reward-to-risk ratio for stock A exceeds the reward-to-risk ratio of stock B. Stock
A has a beta of 1.4 and stock B has a beta of .90. This information implies that:
a. stock A is riskier than stock B and both stocks are fairly priced.
b. stock A is less risky than stock B and both stocks are fairly priced.
c. either stock A is underpriced or stock B is overpriced or both.
d. both stock A and stock B are correctly priced since stock A is riskier than
stock B.
e. either stock A is overpriced or stock B is underpriced or both.

CHAPTER 13
d
52. The market risk premium is computed by:
c. subtracting the risk-free rate of return from the inflation rate.
d. subtracting the risk-free rate of return from the market rate of return.
e. multiplying the risk-free rate of return by a beta of 1.0.
b
53. The excess return earned by an asset that has a beta of 1.0 over that earned by a riskfree asset is referred to as the:
a. market rate of return.
c. systematic return.
d. total return.
e. real rate of return.
d
54. The _____ divided by the beta of the market is equal to the slope of the Security
Market Line.
a. total return of the market
b. risk-free rate of return
c. real return of the market
e. nominal return of the market
CAPITAL ASSET PRICING MODEL (CAPM)
c
55. The Capital Asset Pricing Model (CAPM) assumes that:
I.
a risk-free asset has no systematic risk.
II. standard deviation measures systematic risk.
III. the risk-to-reward ratio is constant.
IV. a risk-free asset generally has a positive rate of return.
a. I and III only
b. II and IV only
c. I, III, and IV only
d. II, III, and IV only
e. I, II, and III only
CAPITAL ASSET PRICING MODEL (CAPM)
e
56. A security that has a rate of return that exceeds the U.S. Treasury bill rate but is less
than the market rate of return must:
a. be a risk-free asset.
b. have a beta that is greater than 1.0 but less than 2.0.
c. be a risk-free asset with a beta less than .99.
d. be a risky asset with a standard deviation less than 1.0.
e. be a risky asset with a beta less than 1.0.

CHAPTER 13
CAPITAL ASSET PRICING MODEL (CAPM)
b
57. Which of the following will increase the expected rate of return on an individual
security as computed by the Capital Asset Pricing Model (CAPM)? Assume that the
securitys beta, the risk-free rate of return, and the market rate of return are all
positive.
I.
a decrease in the securitys beta
II. an increase in the securitys beta
III. a decrease in the risk premium
IV. an increase in the market rate of return
a. I and III only
b. II and IV only
c. I and IV only
d. II and III only
e. II, III, and IV only
III. PROBLEMS
ANALYZING A PORTFOLIO
a
58. You want your portfolio beta to be 1.20. Currently, your portfolio consists of \$100
invested in stock A with a beta of 1.4 and \$300 in stock B with a beta of .6. You have
another \$400 to invest and want to divide it between an asset with a beta of 1.6 and a
risk-free asset. How much should you invest in the risk-free asset?
a. \$0
b. \$140
c. \$200
d. \$320
e. \$400
ANALYZING A PORTFOLIO
d
59. You have a \$1,000 portfolio which is invested in stocks A and B plus a risk-free asset.
\$400 is invested in stock A. Stock A has a beta of 1.3 and stock B has a beta of .7.
How much needs to be invested in stock B if you want a portfolio beta of .90?
a. \$0
b. \$268
c. \$482
d. \$543
e. \$600
EXPECTED RETURN
c
60. You recently purchased a stock that is expected to earn 12 percent in a booming
economy, 8 percent in a normal economy and lose 5 percent in a recessionary
economy. There is a 15 percent probability of a boom, a 75 percent chance of a normal
economy, and a 10 percent chance of a recession. What is your expected rate of return
on this stock?
a. 5.00 percent
b. 6.45 percent
c. 7.30 percent
d. 7.65 percent
e. 8.30 percent

CHAPTER 13
EXPECTED RETURN
a
61. The Inferior Goods Co. stock is expected to earn 14 percent in a recession, 6 percent in
a normal economy, and lose 4 percent in a booming economy. The probability of a
boom is 20 percent while the probability of a normal economy is 55 percent and the
chance of a recession is 25 percent. What is the expected rate of return on this stock?
a. 6.00 percent
b. 6.72 percent
c. 6.80 percent
d. 7.60 percent
e. 11.33 percent
EXPECTED RETURN
b
62. You are comparing stock A to stock B. Given the following information, which one of
these two stocks should you prefer and why?
Rate of Return if
State of
Probability of
State Occurs
Economy
State of Economy
Stock A Stock B
Boom
60%
9%
15%
Recession
40%
4%
-6%
a. Stock A; because it has an expected return of 7 percent and appears to be more risky.
b. Stock A; because it has a higher expected return and appears to be less risky than stock
B.
c. Stock A; because it has a slightly lower expected return but appears to be significantly
less risky than stock B.
d. Stock B; because it has a higher expected return and appears to be just slightly more
risky than stock A.
e. Stock B; because it has a higher expected return and appears to be less risky than stock
A.
d
63. Zelo, Inc. stock has a beta of 1.23. The risk-free rate of return is 4.5 percent and the
market rate of return is 10 percent. What is the amount of the risk premium on Zelo
stock?
a. 4.47 percent
b. 5.50 percent
c. 5.54 percent
d. 6.77 percent
e. 12.30 percent
VARIANCE
c
64. If the economy booms, RTF, Inc. stock is expected to return 10 percent. If the
economy goes into a recessionary period, then RTF is expected to only return 4
percent. The probability of a boom is 60 percent while the probability of a recession is
40 percent. What is the variance of the returns on RTF, Inc. stock?
a. .000200
b. .000760
c. .000864
d. .001594
e. .029394

CHAPTER 13
VARIANCE
a
65. The rate of return on the common stock of Flowers by Flo is expected to be 14 percent
in a boom economy, 8 percent in a normal economy, and only 2 percent in a
recessionary economy. The probabilities of these economic states are 20 percent for a
boom, 70 percent for a normal economy, and 10 percent for a recession. What is the
variance of the returns on the common stock of Flowers by Flo?
a. .001044
b. .001280
c. .001863
d. .002001
e. .002471
STANDARD DEVIATION
c
66. Kurts Adventures, Inc. stock is quite cyclical. In a boom economy, the stock is
expected to return 30 percent in comparison to 12 percent in a normal economy and a
negative 20 percent in a recessionary period. The probability of a recession is 15
percent. There is a 30 percent chance of a boom economy. The remainder of the time
the economy will be at normal levels. What is the standard deviation of the returns on
a. 10.05 percent
b. 12.60 percent
c. 15.83 percent
d. 17.46 percent
e. 25.04 percent
STANDARD DEVIATION
d
67. What is the standard deviation of the returns on a stock given the following
information?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

Probability of
State of Economy
10%
60%
30%

Rate of Return
if State Occurs
16%
11%
-8%

5.80 percent
7.34 percent
8.38 percent
9.15 percent
9.87 percent

PORTFOLIO WEIGHT
d
68. You have a portfolio consisting solely of stock A and stock B. The portfolio has an
expected return of 10.2 percent. Stock A has an expected return of 12 percent while
stock B is expected to return 7 percent. What is the portfolio weight of stock A?
a. 46 percent
b. 54 percent
c. 58 percent
d. 64 percent
e. 70 percent

CHAPTER 13
PORTFOLIO WEIGHT
e
69. You own the following portfolio of stocks. What is the portfolio weight of stock C?
Number
Stock of Shares
A
100
B
600
C
400
D
200
a.
b.
c.
d.
e.

Price
per Share
\$22
\$17
\$46
\$38

30.8 percent
37.4 percent
42.3 percent
45.2 percent
47.9 percent

## PORTFOLIO EXPECTED RETURN

b
70. You own a portfolio with the following expected returns given the various states of the
economy. What is the overall portfolio expected return?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

Probability of
State of Economy
15%
60%
25%

Rate of Return
if State Occurs
18%
11%
-10%

6.3 percent
6.8 percent
7.6 percent
10.0 percent
10.8 percent

## PORTFOLIO EXPECTED RETURN

b
71. What is the expected return on a portfolio which is invested 20 percent in stock A, 50
percent in stock B, and 30 percent in stock C?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

7.40 percent
8.25 percent
8.33 percent
9.45 percent
9.50 percent

Probability of
State of Economy
20%
70%
10%

## Returns if State Occurs

Stock A Stock B Stock C
18%
9%
6%
11%
7%
9%
-10%
4%
13%

CHAPTER 13
PORTFOLIO EXPECTED RETURN
d
72. What is the expected return on this portfolio?

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

Expected
Return
8%
15%
6%

Number
of Shares
520
300
250

Stock
Price
\$25
\$48
\$26

9.50 percent
9.67 percent
9.78 percent
10.59 percent
10.87 percent

## PORTFOLIO EXPECTED RETURN

c
73. What is the expected return on a portfolio comprised of \$3,000 in stock K and \$5,000
in stock L if the economy is normal?
State of
Economy
Boom
Normal
a.
b.
c.
d.
e.

Probability of
State of Economy
20%
80%

Stock K
Stock L
14%
10%
5%
6%

3.75 percent
5.25 percent
5.63 percent
5.88 percent
6.80 percent

## PORTFOLIO EXPECTED RETURN

d
74. What is the expected return on a portfolio comprised of \$4,000 in stock M and \$6,000
in stock N if the economy enjoys a boom period?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

6.4 percent
6.8 percent
10.4 percent
13.2 percent
14.0 percent

Probability of
State of Economy
10%
75%
15%

## Returns if State Occurs

Stock M
Stock N
18%
10%
7%
8%
-20%
6%

CHAPTER 13
PORTFOLIO VARIANCE
b
75. What is the portfolio variance if 30 percent is invested in stock S and 70 percent is
invested in stock T?
State of
Economy
Boom
Normal
a.
b.
c.
d.
e.

Probability of
State of Economy
40%
60%

## Returns if State Occurs

Stock S
Stock T
12%
20%
6%
4%

.002220
.004056
.006224
.008080
.098000

PORTFOLIO VARIANCE
b
76. What is the variance of a portfolio consisting of \$3,500 in stock G and \$6,500 in stock
H.
State of
Economy
Boom
Normal
a.
b.
c.
d.
e.

Probability of
State of Economy
15%
85%

Stock G
Stock H
15%
9%
8%
6%

.000209
.000247
.002098
.037026
.073600

## PORTFOLIO STANDARD DEVIATION

c
77. What is the standard deviation of a portfolio that is invested 40 percent in stock Q and
60 percent in stock R?
State of
Economy
Boom
Normal
a.
b.
c.
d.
e.

0.7 percent
1.4 percent
2.6 percent
6.8 percent
8.1 percent

Probability of
State of Economy
25%
75%

## Returns if State Occurs

Stock Q
Stock R
18%
9%
9%
5%

CHAPTER 13
PORTFOLIO STANDARD DEVIATION
a
78. What is the standard deviation of a portfolio which is comprised of \$4,500 invested in
stock S and \$3,000 in stock T?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

Probability of
State of Economy
10%
65%
25%

Stock S
Stock T
12%
4%
9%
6%
2%
9%

1.4 percent
1.9 percent
2.6 percent
5.7 percent
7.2 percent

## PORTFOLIO STANDARD DEVIATION

d
79. What is the standard deviation of a portfolio which is invested 20 percent in stock A,
30 percent in stock B and 50 percent in stock C?
State of
Economy
Boom
Normal
Recession
a.
b.
c.
d.
e.

Probability of
State of Economy
10%
70%
20%

## Returns if State Occurs

Stock A Stock B Stock C
15%
10%
5%
9%
6%
7%
-14%
2%
8%

0.6 percent
0.9 percent
1.8 percent
2.2 percent
4.9 percent

BETA
c
80. What is the beta of a portfolio comprised of the following securities?

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

1.008
1.014
1.038
1.067
1.127

Amount
Invested
\$2,000
\$3,000
\$5,000

Security
Beta
1.20
1.46
.72

CHAPTER 13
PORTFOLIO BETA
d
81. Your portfolio is comprised of 30 percent of stock X, 50 percent of stock Y, and 20
percent of stock Z. Stock X has a beta of .64, stock Y has a beta of 1.48, and stock Z
has a beta of 1.04. What is the beta of your portfolio?
a. 1.01
b. 1.05
c. 1.09
d. 1.14
e. 1.18
PORTFOLIO BETA
e
82. Your portfolio has a beta of 1.18. The portfolio consists of 15 percent U.S. Treasury
bills, 30 percent in stock A, and 55 percent in stock B. Stock A has a risk-level
equivalent to that of the overall market. What is the beta of stock B?
a. .55
b. 1.10
c. 1.24
d. 1.40
e. 1.60
PORTFOLIO BETA
b
83. You would like to combine a risky stock with a beta of 1.5 with U.S. Treasury bills in
such a way that the risk level of the portfolio is equivalent to the risk level of the
overall market. What percentage of the portfolio should be invested in Treasury bills?
a. .25
b. .33
c. .50
d. .67
e. .75
d
84. The market has an expected rate of return of 9.8 percent. The long-term government
bond is expected to yield 4.5 percent and the U.S. Treasury bill is expected to yield 3.4
percent. The inflation rate is 3.1 percent. What is the market risk premium?
a. 2.2 percent
b. 3.3 percent
c. 5.3 percent
d. 6.4 percent
e. 6.7 percent
CAPITAL ASSET PRICING MODEL (CAPM)
d
85. The risk-free rate of return is 4 percent and the market risk premium is 8 percent. What
is the expected rate of return on a stock with a beta of 1.28?
a. 9.12 percent
b. 10.24 percent
c. 13.12 percent
d. 14.24 percent
e. 15.36 percent

CHAPTER 13
CAPITAL ASSET PRICING MODEL (CAPM)
e
86. The common stock of Flavorful Teas has an expected return of 14.4 percent. The
return on the market is 10 percent and the risk-free rate of return is 3.5 percent. What
is the beta of this stock?
a. .65
b. 1.09
c. 1.32
d. 1.44
e. 1.68
CAPITAL ASSET PRICING MODEL (CAPM)
d
87. The stock of Big Joes has a beta a 1.14 and an expected return of 11.6 percent. The
risk-free rate of return is 4 percent. What is the expected return on the market?
a. 7.60 percent
b. 8.04 percent
c. 9.33 percent
d. 10.67 percent
e. 12.16 percent
CAPITAL ASSET PRICING MODEL (CAPM)
d
88. The expected return on HiLo stock is 13.69 percent while the expected return on the
market is 11.5 percent. The beta of HiLo is 1.3. What is the risk-free rate of return?
a. 2.8 percent
b. 3.1 percent
c. 3.7 percent
d. 4.2 percent
e. 4.5 percent
CAPITAL ASSET PRICING MODEL (CAPM)
c
89. The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6
percent and the market risk premium is 9 percent. What is the expected rate of return
on Martin Industries stock?
a. 11.3 percent
b. 14.1 percent
c. 16.5 percent
d. 17.4 percent
e. 18.0 percent
CAPITAL ASSET PRICING MODEL (CAPM)
b
90. Nuvo, Inc. stock has a beta of .86 and an expected return of 10.5 percent. The risk-free
rate of return is 3.2 percent and the market rate of return is 11.2 percent. Which one of
the following statements is true given this information?
a. The return on Nuvo stock will graph below the Security Market Line.
b. Nuvo stock is underpriced.
c. The expected return on Nuvo stock based on the Capital Asset Pricing Model is 9.88
percent.
d. Nuvo stock has more systematic risk than the overall market.
e. Nuvo stock is correctly priced.

CHAPTER 13
REWARD-TO-RISK RATIO
b
91. Which one of the following stocks is correctly priced if the risk-free rate of return is
2.5 percent and the market risk premium is 8 percent?
Stock
A
B
C
D
E
a.
b.
c.
d.
e.

Beta
.68
1.42
1.23
1.31
.94

Expected Return
8.2%
13.9%
11.8%
12.6%
9.7%

A
B
C
D
E

## CAPITAL ASSET PRICING MODEL (CAPM)

c
92. Which one of the following stocks is correctly priced if the risk-free rate of return is
3.6 percent and the market rate of return is 10.5 percent?
Stock
A
B
C
D
E
a.
b.
c.
d.
e.

Beta
.85
1.08
1.69
.71
1.45

Expected Return
9.2%
11.8%
15.3%
7.8%
12.3%

A
B
C
D
E

IV. ESSAYS
CAPM
93. According to the CAPM, the expected return on a risky asset depends on three components.
Describe each component, and explain its role in determining expected return.
The CAPM suggests that the expected return is a function of (1) the risk-free rate of return,
which is the pure time value of money, (2) the market risk premium, which is the reward for
bearing systematic risk, and (3) beta, which is the amount of systematic risk present in a
particular asset. Better answers will point out that both the pure time value of money and the
reward for bearing systematic risk are exogenously determined and can change on a daily
basis, while the amount of systematic risk for a particular asset is determined by the firms
decision-makers.

CHAPTER 13
SECURITY MARKET LINE
94. Draw the SML and plot asset C such that it has less risk than the market but plots above the
SML, and asset D such that it has more risk than the market and plots below the SML. (Be
sure to indicate where the market portfolio is on your graph.) Explain how assets like C or D
can plot as they do and explain why such pricing cannot persist in a market that is in
equilibrium.
The student should correctly draw a SML with points C and D correctly identified. In this
case, asset C is underpriced and asset D is overpriced. This condition cannot persist in
equilibrium because investors will buy C with its high expected return and sell D with its
low expected return. This buying and selling activity will force the prices back to a level
that eventually causes both C and D to plot on the SML.
REWARD-TO-RISK RATIOS
95. Explain what we mean when we say all assets have the same reward-to-risk ratio. What does
this mean for investors?
A constant reward-to-risk ratio means that the reward for bearing risk (measured as the risk
premium) increases as the amount of risk (measured by beta) also increases. Investors who
compensation for doing so. This is an equilibrium concept which essentially restates the
axiom that prices observed in efficient markets are considered fair.
DIVERSIFIABLE RISK
96. Why are some risks diversifiable and some nondiversifiable? Give an example of each.
A reasonable answer would, at a minimum, explain that some risks (diversifiable) affect
only a specific security, and when put into a portfolio, losses as a result of these firmspecific events will tend to be offset by price gains amongst other securities.
Nondiversifiable risk, however, is unavoidable because such risks affect all or almost all
securities in the market and cant be eliminated by forming portfolios. In the second part of
the question, the students get a chance to use a minor amount of imagination. A strong
answer would note the dependence of diversification effects on the degree of correlation
between the assets used to form portfolios.
RISK
97. We routinely assume that investors are risk-averse return-seekers; i.e., they like returns and
dislike risk. If so, why do we contend that only systematic risk and not total risk is
important?
This question, of course, gets to the point of the chapter: That rational investors will
diversify away as much risk as possible. From the discussion in the text, most students will
also have picked up that it is quite easy to eliminate diversifiable risk in practice, either by
holding portfolios with 25 to 30 assets, or by holding shares in a diversified mutual fund.
And, as noted in the text, there will be no return for bearing diversifiable risk, thus, total
risk is not particularly important to a diversified investor.

CHAPTER 13
EMH, CAPM, AND THE MARKET VALUE RULE
98. In the first chapter, it was stated that financial managers should act to maximize shareholder
wealth. Why are the efficient markets hypothesis (EMH), the CAPM, and the SML so
important in the accomplishment of this objective?
In simple terms, one could say that maximizing shareholder wealth by maximizing the
current share price (Chapter 1) is a reasonable objective if and only if we have some
assurance that observed prices are meaningful; i.e., that they reflect the value of the firm.
This is a major implication of the EMH. Further, if we are to be able to assess the wealth
effects of future decisions on security and firm values, we must have a valuation model
whose parameters can be shown to be affected by those decisions (Chapters 7 and 8).
Finally, any valuation model we employ will require us to quantify return and risk (Chapters
12 and 13).
BETA
99. Explain in words what beta is and why it is important.
This is a concept check question that requires students to put into words that beta is a
measure of systematic risk, the only risk an investor can expect to earn compensation for
bearing. Beta specifically measures the amount of systematic risk an asset has relative to an
average asset.
NEGATIVE BETA
100. Is it possible for an asset to have a negative beta? (Hint: yes.) What would the expected
return on such an asset be? Why?
While it is unlikely to observe a negative beta asset, it would have less systematic risk than
the risk-free asset and would be expected to provide an even lower return. One possibility
often cited is that of gold. The return would be less than the risk-free rate because, while the
risk-free rate is determined by changes in inflation and the business cycle for the economy
at large, gold, as an ultimate store of value, is not affected by these factors (at least to the
same degree).

the excess return required from an investment in a risky asset
over that required from a risk-free investment
variance
the average squared difference between the actual return and the
average return
standard deviation
the positive square root of the variance
normal distribution
a symmetric, bell-shaped frequency distribution that is
completely defined by its mean and standard deviation
geometric average return
the average compound return earned per year over a multiyear
period
arithmetic average return
the return earned in an average year over a multiyear period
efficient capital market
a market in which security prices reflect available information
efficient markets hypothesis (EMH)
the hypothesis that actual capital markets, such as the NYSE, are
efficient

volatility
standard deviation is a measure of
normal distribution
defined by its mean and its standard deviation
geometric
the average compound return earned per year over a multi-year
period is the - average return
arithmetic
the return earned in an average year over a multi-year period is
called the - average return
efficient capital market
assume that the market prices of the securities that trade in a
particular market fairly reflect the available information related
to those securities. which one of the following terms best defines
that market?
risk less market
evenly distributed market
zero volatility market
blumes market
efficient capital market
Efficient market hypothesis
all securities in this market are zero at nvp investments
dividend yield
next years annual dividend divided by todays stock price
capital gains
an increase in an unrealized capital gain will increase the capital
gains yield
I & III
correct in relation to a sock investment
I capital gains yield can be positive, negative, or zero
II dividend yield can be positive, negative, or zero
III total return can be positive, negative, or zero
IV neither the dividend yield nor the total return can be negative
minus the inflation rate

## the real rate of return on a stock is approximately equal to the

nominal rate of return:
less than
as long as the inflation rate is positive, the real rate of return on a
security will be - the nominal rate of return
greater than
equal to
less than
greater than or equal to
unrelated to
c
small-co stocks are best defined as
a 500 newest corporations in the US
b firms whose stock trades otc
c smallest 20% of the firms listed on the NYSE
d smallest 20% of the firms listed on the NASDAQ
e firms whose stock is listed on NASDAQ
small company stocks
which category of securities had the highest average return for
1926-2007
US t bills
small company stocks
most volatile returns over 26-07
us t bills
- - - had a positive average real rate of return in 1926-2007
c
which time periods are associated with high rates of inflation
a 1929-1933
b 1957-1961
c 1978-1981
d 1992-1996
e 2001-2005
positive

## US t bills during 1926-2007, the annual rate of return was always

10-15%
highest annual rate of inflation in 1926-2007
between 0-3%
3-5%
5-10%
10-15%
15-20%
excess return
this is computed as return on a risky security minus the risk free
rate
small company stocks
earned the highest risk premium 1926-2007
3.0-3.5
average rate of inflation between 1926-2007
< 2%
2.0-2.5
2.5-3.0
3.0-3.5
> 3.5%
10-12.5%
assume that you invest in a porfolio of large company stocks.
further assume that the portfolio will earn a rate of return similar
to the average return on large-company stocks for 1926-2007.
what rate of return should you expect to earn?
< 10%
10-12.5%
12.5%-15%
15-17.5%
>17.5%
5
the average annual return on small-company stocks was about % greater than the average annual return on large-company
stocks 0ver 1926-2007
US t bills
lease volatile from 1926-2007

## the greater the risk premium

the greater the volatility of returns,
III & IV
correspond to a wide frequency distribution
I relatively low risk
II low rate of return
III relatively high standard deviation
to convince investors to accept greater volatility you must,
II & III
if the variability of the returns on large compnay stocks were to
increase over the long-term, you would expect which of the
following to occur as a result?
I dec in the average rate of return
II increase in the risk premium
III increase in the 68% probability range of the frequency
distribution of returns
IV dec in the standard deviation
lower return, long term
long term government bonds had a - - but a higher standard
deviation on average than did - corporate bonds
16%
probability that small-company stocks wil produce an annual
return that is more then one standard deviation below the
average
1%
2.5%
5.0%
16%
32%
6.8%
according to jeremy siegel, the real return on stocks over the
6.8%
8.7%
10.4%

12.3%
14.8%
IV
which is true based on the historical record for 1926-2007
I risk and potential reward are inversely related
II risk free securities produce a positive real rate of return each
year
III returns are more predictable over the short-term than they
are over the long-term
IV bonds are generally a safer investment than are stocks
overestimate, underestimate
estimates of the rate of return on a security based on a historical
artihmetic average will probably tend to - the expexted return for
the long-term while estimates using the historical geometric
average will probably tend to - the expected return for the short
term
project future rates of return
the primary purpose of blumes formula is to
III & IV
which two of the following are the most likely reasons why a stock
price might not react at all on the day that new information
related to the stock issuer is released?
I insiders know the info prior to the announcement
II investors need time to digest the information prior to reacting
III the information has no bearing on the value of the firm
IV the information was anticipated
weak
if you excel in analyzing the future outlook of firms, you would
prefer the financial market be- form efficient so that you can have
semistrong
confidential info he overhears at his workplace. this information
is not available to the general public. this neighbor continually
brags to you about the profits he earns on these trades. given this
you would tent to argue that the financial markets are at best from efficient
weak

semiweak
semistrong
strong perfect
stong
th us securities and exchange commission periodically charges
infividuals with insider trading and claims those individuals have
made unfair profits. given this you would be most apt to argure
that the markets are less than - form efficient
weak
semiweak
semistrong
strong
perfect
-3.96
one year ago, you purchase a stock at price of \$32.16. the stock
pays quarterly dividends of \$.20 per share. today, the stock is
selling for \$28.20 per share. what is your capital gain on this
investment?
-4.16
-3.96
-3.76
-3.16
-2.96

## You own a stock that you think will produce a return of 11

percent in a good
economy and 3 percent in a poor economy. Given the
probabilities of each state of the economy occurring, you
anticipate that your stock will earn 6.5 percent next year. Which
one of the following terms applies to this 6.5 percent?
a. arithmetic return
b. historical return
c. expected return
d. geometric return
e. required return
c. expected return
Suzie owns five different bonds valued at \$36,000 and twelve
different stocks
valued at \$82,500 total. Which one of the following terms most
applies to Suzie's
investments?
a. index
b. portfolio
c. collection
d. grouping
e. risk-free
b. portfolio
Steve has invested in twelve different stocks that have a
combined value today of
\$121,300. Fifteen percent of that total is invested in Wise Man
Foods. The 15 percent is a
measure of which one of the following?
a. portfolio return
b. portfolio weight
c. degree of risk
d. price-earnings ratio
e. index value
b. portfolio weight
Which one of the following is a risk that applies to most
securities?
a. unsystematic
b. diversifiable
c. systematic
d. asset-specific
e. total
c. systematic

## A news flash just appeared that caused about a dozen stocks to

suddenly drop in
value by about 20 percent. What type of risk does this news
flash represent?
a. portfolio
b. nondiversifiable
c. market
d. unsystematic
e. total
d. unsystematic
The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will
eliminate all of the unsystematic risk.
b. concentrating an investment in three companies all within
the same industry will greatly reduce the systematic risk.
c. spreading an investment across five diverse companies will
not lower the total risk.
d. spreading an investment across many diverse assets will
eliminate all of
the systematic risk.
e. spreading an investment across many diverse assets will
eliminate some of the total risk.
e. spreading an investment across many diverse assets will
eliminate
some of the total risk.
The _____ tells us that the expected return on a risky asset
depends only on that
asset's nondiversifiable risk. a. efficient markets hypothesis
b. systematic risk principle
c. open markets theorem
d. law of one price
e. principle of diversification
b. systematic risk principle
Which one of the following measures the amount of systematic
risk present in a
particular risky asset relative to the systematic risk present in
an average risky asset?
a. beta
b. reward-to-risk ratio
c. risk ratio
d. standard deviation
e. price-earnings ratio
a. beta

## Which one of the following is a positively sloped linear function

that is created
when expected returns are graphed against security betas?
a. reward-to-risk matrix
b. portfolio weight graph
c. normal distribution
d. security market line
e. market real returns
d. security market line
Which one of the following is represented by the slope of the
security market line?
a. reward-to-risk ratio
b. market standard deviation
c. beta coefficient
d. risk-free interest rate
Which one of the following is the formula that explains the
relationship between
the expected return on a security and the level of that security's
systematic risk?
a. capital asset pricing model
b. time value of money equation
c. unsystematic risk equation
d.market performance equation
e. expected risk formula
a. capital asset pricing model
Treynor Industries is investing in a new project. The minimum
rate of return the
firm requires on this project is referred to as the:
a. average arithmetic return.
b. expected return.
c. market rate of return.
d. internal rate of return.
e. cost of capital.
e. cost of capital
The expected return on a stock given various states of the
economy is equal to the:
a. highest expected return given any economic state.
b. arithmetic average of the returns for each economic state.

## c. summation of the individual expected rates of return.

d. weighted average of the returns for each economic state.
e. return for the economic state with the highest probability of
occurrence.
d. weighted average of the returns for each economic state.
The expected return on a stock computed using economic
probabilities is:
a. guaranteed to equal the actual average return on the stock for
the next five years.
b. guaranteed to be the minimal rate of return on the stock over
the next two years.
c. guaranteed to equal the actual return for the immediate
twelve month period.
d. a mathematical expectation based on a weighted average and
not an actual anticipated outcome.
e. the actual return you should anticipate as long as the
economic forecast remains constant.
d. a mathematical expectation based on a weighted average and
not an
actual anticipated outcome
The expected risk premium on a stock is equal to the expected
return on the stock
minus the:
a. expected market rate of return.
b. risk-free rate.
c. inflation rate.
d. standard deviation.
e. variance.
b. risk-free rate
Standard deviation measures which type of risk?
a. total
b. nondiversifiable
c. unsystematic
d. systematic
e. economic
a. total
The expected rate of return on a stock portfolio is a weighted
average where the
weights are based on the:
a. number of shares owned of each stock.
b.market price per share of each stock.
c. market value of the investment in each stock.

## d. original amount invested in each stock.

e. cost per share of each stock held.
c. market value of the investment in each stock.
The expected return on a portfolio considers which of the
following factors?
I. percentage of the portfolio invested in each individual
security
II. projected states of the economy
III. the performance of each security given various economic
states
IV. probability of occurrence for each state of the economy
ALL
I. can never exceed the expected return of the best performing
security in the portfolio.
II. must be equal to or greater than the expected return of the
worst performing security in the
portfolio.
III. is independent of the unsystematic risks of the individual
securities held in the portfolio.
IV. is independent of the allocation of the portfolio amongst
individual securities.
I, II and III only
If a stock portfolio is well diversified, then the portfolio
variance:
a. will equal the variance of the most volatile stock in the
portfolio.
b. may be less than the variance of the least risky stock in the
portfolio.
c. must be equal to or greater than the variance of the least risky
stock in the portfolio.
d. will be a weighted average of the variances of the individual
securities in the portfolio.
e. will be an arithmetic average of the variances of the
individual
securities in the portfolio.
b. may be less than the variance of the least risky stock in the
portfolio.
The standard deviation of a portfolio:
a. is a weighted average of the standard deviations of the
individual securities held in the portfolio.
b. can never be less than the standard deviation of the most
risky security in the portfolio.

## c. must be equal to or greater than the lowest standard

deviation of any single security held in the portfolio.
d. is an arithmetic average of the standard deviations of the
individual securities which comprise the portfolio.
e. can be less than the standard deviation of the least risky
security in the portfolio.
e. can be less than the standard deviation of the least risky
security in the portfolio.
The standard deviation of a portfolio:
a. is a measure of that portfolio's systematic risk.
b. is a weighed average of the standard deviations of the
individual securities held in that portfolio.
c. measures the amount of diversifiable risk inherent in the
portfolio.
d. serves as the basis for computing the appropriate risk
e. can be less than the weighted average of the standard
deviations of the individual securities held in that portfolio.
e. can be less than the weighted average of the standard
deviations of the individual securities held in that portfolio.
Which one of the following statements is correct concerning a
portfolio of 20 securities with multiple states of the economy
when both the securities and the economic states have unequal
weights?
a. Given the unequal weights of both the securities and the
economic states, the standard deviation of the portfolio must
equal that of the overall
market.
b. The weights of the individual securities have no effect on the
expected return of a portfolio when multiple states of the
economy are involved.
c. Changing the probabilities of occurrence for the various
economic states will not affect the expected standard deviation
of the portfolio.
d. The standard deviation of the portfolio will be greater than
the highest
standard deviation of any single security in the portfolio given
that the
individual securities are well diversified.
e. Given both the unequal weights of the securities and the
economic states,
an investor might be able to create a portfolio that has an
expected standard deviation of zero.

## e. Given both the unequal weights of the securities and the

economic states,
an investor might be able to create a portfolio that has an
expected standard deviation of zero.
Which one of the following events would be included in the
expected return on
Sussex stock?
a. The chief financial officer of Sussex unexpectedly resigned.
b. The labor union representing Sussex' employees
unexpectedly called a strike.
c. This morning, Sussex confirmed that its CEO is retiring at the
end of the year as was anticipated.
d. The price of Sussex stock suddenly declined in value because
researchers accidentally discovered that one of the firm's
products can be toxic to household pets.
e. The board of directors made an unprecedented decision to
give sizeable bonuses to the firm's internal auditors for their
efforts in uncovering wasteful spending.
c. This morning, Sussex confirmed that its CEO is retiring at the
end of the
year as was anticipated.
Which one of the following statements is correct?
a. The unexpected return is always negative.
b. The expected return minus the unexpected return is equal to
the total return.
c. Over time, the average return is equal to the unexpected
return.
d. The expected return includes the surprise portion of news
announcements.
e. Over time, the average unexpected return will be zero.
e. Over time, the average unexpected return will be zero.
Which one of the following statements related to unexpected
returns is correct?
a. All announcements by a firm affect that firm's unexpected
returns.
b. Unexpected returns over time have a negative effect on the
total return of a firm.
c. Unexpected returns are relatively predictable in the shortterm.
significantly from the expected return over the long-term.
e. Unexpected returns can be either positive or negative in the
short term but tend to be zero over the long-term.

## e. Unexpected returns can be either positive or negative in the

short term
but tend to be zero over the long-term.
Which one of the following is an example of systematic risk?
a. investors panic causing security prices around the globe to
fall precipitously
b. a flood washes away a firm's warehouse
c. a city imposes an additional one percent sales tax on all
products
d. a toymaker has to recall its top-selling toy
e. corn prices increase due to increased demand for alternative
fuels
a. investors panic causing security prices around the globe to fall
precipitously
Unsystematic risk:
a. can be effectively eliminated by portfolio diversification.
b. is compensated for by the risk premium.
c. is measured by beta.
d. is measured by standard deviation.
e. is related to the overall economy.
a. can be effectively eliminated by portfolio diversification.
Which one of the following is an example of unsystematic risk?
a. income taxes are increased across the board
b. a national sales tax is adopted
c. inflation decreases at the national level
d. an increased feeling of prosperity is felt around the globe
e. consumer spending on entertainment decreased nationally
e. consumer spending on entertainment decreased nationally
Which one of the following is least apt to reduce the
unsystematic risk of a
portfolio?
a. reducing the number of stocks held in the portfolio
b. adding bonds to a stock portfolio
c. adding international securities into a portfolio of U.S. stocks
d. adding U.S. Treasury bills to a risky portfolio
e. adding technology stocks to a portfolio of industrial stocks
a. reducing the number of stocks held in the portfolio
Which one of the following statements is correct concerning
unsystematic risk?
a. An investor is rewarded for assuming unsystematic risk.

## b. Eliminating unsystematic risk is the responsibility of the

individual investor.
c. Unsystematic risk is rewarded when it exceeds the market
level of unsystematic risk.
d. Beta measures the level of unsystematic risk inherent in an
individual security.
e. Standard deviation is a measure of unsystematic risk.
b. Eliminating unsystematic risk is the responsibility of the
individual investor.
Which one of the following statements related to risk is correct?
a. The beta of a portfolio must increase when a stock with a high
standard deviation is added to the portfolio.
b. Every portfolio that contains 25 or more securities is free of
unsystematic risk.
c. The systematic risk of a portfolio can be effectively lowered by
lower the portfolio's beta.
e. Stocks that move in tandem with the overall market have zero
betas.
c. The systematic risk of a portfolio can be effectively lowered by
T-bills to the portfolio.
Which one of the following risks is irrelevant to a welldiversified investor?
a. systematic risk
b. unsystematic risk
c. market risk
d.nondiversifiable risk
e. systematic portion of a surprise
b. unsystematic risk
Which of the following are examples of diversifiable risk?
I. earthquake damages an entire town
II. federal government imposes a \$100 fee on all business
entities
III. employment taxes increase nationally
IV. toymakers are required to improve their safety standards
I and IV only
Which of the following statements are correct concerning
diversifiable risks?
I. Diversifiable risks can be essentially eliminated by investing
in thirty unrelated securities.

## II. There is no reward for accepting diversifiable risks.

III. Diversifiable risks are generally associated with an
individual firm or industry.
IV. Beta measures diversifiable risk.
I, II, and III
Which one of the following is the best example of a diversifiable
risk?
a. interest rates increase
b. energy costs increase
c. core inflation increases
d. a firm's sales decrease
e. taxes decrease
d. a firm's sales decrease
Which of the following statements concerning risk are correct?
I. Nondiversifiable risk is measured by beta.
II. The risk premium increases as diversifiable risk increases.
III. Systematic risk is another name for nondiversifiable risk.
IV. Diversifiable risks are market risks you cannot avoid.
I and III
The primary purpose of portfolio diversification is to:
a. increase returns and risks.
b. eliminate all risks.
c. eliminate asset-specific risk.
d. eliminate systematic risk.
e. lower both returns and risks.
c. eliminate asset-specific risk.
Which one of the following indicates a portfolio is being
effectively diversified?
a. an increase in the portfolio beta
b. a decrease in the portfolio beta
c. an increase in the portfolio rate of return
d. an increase in the portfolio standard deviation
e. a decrease in the portfolio standard deviation
e. a decrease in the portfolio standard deviation
How many diverse securities are required to eliminate the
majority of the
diversifiable risk from a portfolio?
5
10
25

50
75
25
Systematic risk is measured by:
a. the mean.
b. beta.
c. the geometric average.
d. the standard deviation.
e. the arithmetic average.
b. beta
Which one of the following is most directly affected by the level
of systematic risk
in a security?
a. variance of the returns
b. standard deviation of the returns
c. expected rate of return
d. risk-free rate
c. expected rate of return
Which one of the following statements is correct concerning a
portfolio beta?
a. Portfolio betas range between -1.0 and +1.0.
b. A portfolio beta is a weighted average of the betas of the
individual securities contained in the portfolio.
c. A portfolio beta cannot be computed from the betas of the
individual securities comprising the portfolio because some risk
is eliminated via diversification.
d. A portfolio of U.S. Treasury bills will have a beta of +1.0.
e. The beta of a market portfolio is equal to zero.
b. A portfolio beta is a weighted average of the betas of the
individual
securities contained in the portfolio.
The systematic risk of the market is measured by:
a. a beta of 1.0.
b. a beta of 0.0.
c. a standard deviation of 1.0.
d. a standard deviation of 0.0.
e. a variance of 1.0.
a. a beta of 1.0

## At a minimum, which of the following would you need to know

to estimate the
risky asset instead of a risk-free
asset?
I. asset's standard deviation
II. asset's beta
III. risk-free rate of return
II and IV only
Total risk is measured by _____ and systematic risk is
measured by _____.
a. beta; alpha
b. beta; standard deviation
c. alpha; beta
d. standard deviation; beta
e. standard deviation; variance
d. standard deviation; beta
The intercept point of the security market line is the rate of
return which
corresponds to:
a. the risk-free rate.
b. the market rate.
c. a return of zero.
d. a return of 1.0 percent.
a. the risk free rate
A stock with an actual return that lies above the security market
line has:
a. more systematic risk than the overall market.
b. more risk than that warranted by CAPM.
a higher return than expected for the level of risk assumed.
less systematic risk than the overall market.
a return equivalent to the level of risk assumed.
c. a higher return than expected for the level of risk assumed.
The market rate of return is 11 percent and the risk-free rate of
return is 3 percent.
Lexant stock has 3 percent less systematic risk than the market
and has an actual return of
12 percent. This stock:
a. is underpriced.
b.is correctly priced.

## c.will plot below the security market line.

d. will plot on the security market line.
e. will plot to the right of the overall market on a security
market line graph.
a. is underpriced
Which one of the following will be constant for all securities if
the market is efficient
and securities are priced fairly?
a. variance
b. standard deviation
c. reward-to-risk ratio
d. beta
c. reward-to-risk ratio
The market risk premium is computed by:
return.
c. subtracting the risk-free rate of return from the inflation rate.
d. subtracting the risk-free rate of return from the market rate
of return.
e. multiplying the risk-free rate of return by a beta of 1.0.
d. subtracting the risk-free rate of return from the market rate of
return.
The excess return earned by an asset that has a beta of 1.34 over
that earned by
a risk-free asset is referred to as the:
c. systematic return.
d. total return.
e. real rate of return.
The _____ of a security divided by the beta of that security is
equal to the slope of
the security market line if the security is priced fairly.
a. real return
b. actual return
c. nominal return
e. expected return

## The capital asset pricing model (CAPM) assumes which of the

following?
I. a risk-free asset has no systematic risk.
II. beta is a reliable estimate of total risk.
III. the reward-to-risk ratio is constant.
IV. the market rate of return can be approximated.
I, III, IV
According to CAPM, the amount of reward an investor receives
for bearing the risk
of an individual security depends upon the:
a. amount of total risk assumed and the market risk premium.
b. market risk premium and the amount of systematic risk
inherent in the security.
c. risk free rate, the market rate of return, and the standard
deviation of the security.
d. beta of the security and the market rate of return.
e. standard deviation of the security and the risk-free rate of
return.
b. market risk premium and the amount of systematic risk
inherent in
the security.
Which one of the following should earn the most risk premium
based on CAPM?
a. diversified portfolio with returns similar to the overall market
b. stock with a beta of 1.38
c. stock with a beta of 0.74
d. U.S. Treasury bill
e. portfolio with a beta of 1.01
b. stock with a beta of 1.38