1.

Even if the correlation between the returns on two different securities is

perfectly positive, if the securities arecombined in the correct
unequal
proportions, the resulting portfolio can have less risk than either
securityheld alone.a. Trueb. False_B___
2. Which of the following statements is most correct?
a. The slope of the security market line is beta.
b. A stock with a negative beta must have a negative required rate of
return.
c. If a stock's beta doubles its required rate of return must double.
d. If a stock has a beta equal to 1.0, its required rate of return will be
unaffected by changesin the market risk premium.
e. None of the above statements is correct.___E_
3. Which of the following statements is most correct?
a. Portfolio diversification reduces the variability of the returns on the
individual stocks heldin the portfolio.
b. If an investor buys enough stocks, he or she can, through
diversification, eliminatevirtually all of the nonmarket (or companyspecific) risk inherent in owning stocks.Indeed, if the portfolio contained
all publicly traded stocks, it would be riskless.
c. The required return on a firm's common stock is determined by its
systematic (or market)risk. If the systematic risk is known, and if that risk
is expected to remain constant, then noother information is required to
specify the firm's required return.
d. A security's beta measures its nondiversifiable (systematic, or market)
risk relative to thatof an average stock.
e. A stock's beta is less relevant as a measure of risk to an investor with a
well-diversifiedportfolio than to an investor who holds only that one
stock.____ D
4. Which of the following statements is most correct?E
a. If you add enough randomly selected stocks to a portfolio, you can
completely eliminateall the market risk from the portfolio.
b. If you form a large portfolio of stocks each with a beta greater than 1.0,
this portfolio willhave more market risk than a single stock with a beta =
0.8.
c. Company-specific (or unsystematic) risk can be reduced by forming a
large portfolio, butnormally even highly diversified portfolios are subject to
market (or systematic) risk.
d. Answers a, b, and c are correct.
e. Answers b and c are correct.
____ 5. HR Corporation has a beta of 2.0, while LR Corporation's beta is
0.5. The risk-free rate is 10 percent, and therequired rate of return on an
average stock is 15 percent. Now the expected rate of inflation built into r
RF

fallsby 3 percentage points, the real risk-free rate remains constant, the
required return on the market falls to 11percent, and the betas remain
constant. When all of these changes are made, what will be the difference
in therequired returns on HR's and LR's stocks?a. 1.0%b. 2.5%c. 4.5%d.
5.4%e. 6.0%____E
6. Assume that you wish to purchase a bond with a 30-year maturity, an
annual coupon rate of 10 percent, a facevalue of $1,000, and semiannual
interest payments. If you require a 9 percent nominal yield to maturity
onthis investment, what is the maximum price you should be willing to
pay for the bond?a. $905.35b. $1,102.74c. $1,103.19d. $1,106.76e.
$1,149.63__C__
7. In order to accurately assess the capital structure of a firm, it is
necessary to convert its balance sheet figuresto a market value basis. KJM
Corporation's balance sheet as of today, January 1, 2003, is as
follows:Long-term debt (bonds, at par)
$10,000,000
Preferred stock
2,000,000
Common stock ($10 par)
10,000,000
Retained earnings
4,000,000
Total debt and equity
$26,000,000
The bonds have a 4 percent coupon rate, payable semiannually, and a par
value of $1,000. They mature onJanuary 1, 2013. The yield to maturity is
12 percent, so the bonds now sell below par. What is the currentmarket
value of the firm's debt?a. $5,412,000b. $5,480,000c. $2,531,000d.
$7,706,000e. $7,056,000
A
____ 8. A corporate bond matures in 14 years. The bond has an 8 percent
semiannual coupon and a par value of $1,000. The bond is callable in five
years at a call price of $1,050. The price of the bond today is $1,075.What
are the bond's yield to maturity and yield to call?a. YTM = 14.29%; YTC =
14.09%b. YTM = 3.57%; YTC = 3.52%c. YTM = 7.14%; YTC = 7.34%d. YTM
= 6.64%; YTC = 4.78%e. YTM = 7.14%; YTC = 7.05%
E
9. A share of common stock has just paid a dividend of $3.00. If the
expected long-run growth rate for this stock is 5 percent, and if investors
require an 11 percent rate of return, what is the price of the stock?a.
$50.00b. $50.50c. $52.50d. $53.00e. $63.00__C__
10. ABC Company has been growing at a 10 percent rate, and it just paid
a dividend of D

0
= $3.00. Due to a newproduct, ABC expects to achieve a dramatic
increase in its short-run growth rate, to 20 percent annually for the next 2
years. After this time, growth is expected to return to the long-run
constant rate of 10 percent. Thecompany's beta is 2.0, the required return
on an average stock is 11 percent, and the risk-free rate is 7 percent.What
should the dividend yield (D
1
/P
0
) be today?a. 3.93%b. 4.60%c. 10.00%d. 7.54%e. 2.33% B
11. Hard Hat Construction's stock is currently selling at an equilibrium
price of $30 per share. The firm has beenexperiencing a 6 percent annual
growth rate. Last year's earnings per share, E
0
, were $4.00, and the dividendpayout ratio is 40 percent. The risk-free rate
is 8 percent, and the market risk premium is 5 percent. If marketrisk
(beta) increases by 50 percent, and all other factors remain constant, by
how much will the stock pricechange? (Hint: Use four decimal places in
your calculations.)a. -$ 7.33b. +$ 7.14c. -$15.00d. -$15.22e. +$22.6
A
12. The cost of debt is equal to one minus the marginal tax rate multiplied
by the coupon rate on outstanding debt.a. Trueb. False_B___
13. Wyden Brothers uses the CAPM to calculate the cost of equity capital.
The company's capital structureconsists of common stock, preferred
stock, and debt. Which of the following events will
reduce
thecompany's WACC?a. A reduction in the market risk premium.b. An
increase in the risk-free rate.c. An increase in the company's beta.d. An
increase in expected inflation.e. An increase in the flotation costs
associated with issuing preferred stock.____
A
14. Which of the following statements is most correct?a. The weighted
average cost of capital for a given capital budget level is a weighted
averageof the marginal cost of each relevant capital component which
makes up the firm's targetcapital structure.b. The weighted average cost
of capital is calculated on a before-tax basis.c. An increase in the risk-free
rate is likely to increase the marginal costs of both debt andequity
financing.d. Answers a and c are correct.e. All of the answers above are
correct.
D
15. The common stock of Anthony Steel has a beta of 1.20. The risk-free
rate is 5 percent and the market risk premium (r
M
-r
RF
) is 6 percent. What is the company's cost of common stock, r

s
?a. 7.0%b. 7.2%c. 11.0%d. 12.2%e. 12.4%D
Rollins Corporation
This information applies to the following problems.Rollins Corporation is
estimating its WACC. Its target capital structure is 20 percent debt, 20
percentpreferred stock, and 60 percent common equity. Its bonds have a
12 percent coupon, paid semiannually, acurrent maturity of 20 years, and
sell for $1,000. The firm could sell, at par, $100 preferred stock which
paysa 12 percent annual dividend, but flotation costs of 5 percent would
be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the
market risk premium is 5 percent. Rollins is a constant-growth firm which
justpaid a dividend of $2.00, sells for $27.00 per share, and has a growth
rate of 8 percent. The firm's policy is touse a risk premium of 4 percentage
points when using the bond-yield-plus-risk-premium method to find r
s
.The firm's marginal tax rate is 40 percent.____
16. Refer to Rollins Corporation. What is Rollins' WACC?a. 13.6%b. 14.1%c.
16.0%d. 16.6%e. 16.9% A
Essay
17. Assume that the following returns were earned on Stock Y and the
market during the last eight years:

Average return
7.5% 10%
Standard deviation
5.18% 10%
a. What is Stock Y's beta coefficient? (Hint: Use a calculator with statistical
functions todetermine the least squares line.)

b. If the expected value of r M is 10 percent and r

RF is 6 percent, what is the required rate of returnon Stock Y?
c. Suppose that in January, 2004, investors learn that Firm Y will, in the
future, face muchgreater competition, and investors conclude that Stock Y
will, in the future, be exposed tomuch higher nondiversifiable risk.
Expected future profits and dividends, however, areunchanged (although
the uncertainty about profits and dividends does increase). What effect
isthis knowledge likely to have on Stock Y's market price, on the realized
rate of return on Stock Y during 2004, on the required rate of return on the
stock, and on the expected rate of returnon the stock in the future?
d. Suppose that during 2004 Stock Y had a return of minus 5 percent,
while the market returnwas 20 percent. What would this do to the
calculated beta coefficient for Stock Y? (Hint: Addthe new data point and
recalculate beta.)
e. Use the CAPM to calculate the required rate of return for Stock Y.
Assume r M= 10 percentand r RF= 6 percent.f. How does this new
estimate of r Ycompare with the estimate based on data through 2003?
Does this seem reasonable?