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##### Managerial Finance ? Problem Review Set

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Question;1.);One;key conclusion of the Capital Asset Pricing Model is that the value an asset;should be measured by considering both the risk and the expected return of;the asset assuming that the asset is held in a well-diversified;portfolio. The risk of the asset held;in isolation is not relevant under the CAPM.;a.;True;b.;False;2.);According;to the Capital Asset Pricing Model, investors are primarily concerned with;portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the;stock's contribution to the riskiness of a well-diversified portfolio.;a.;True;b.;False;3.);A;stock's beta is more relevant as a measure of risk to an investor who holds;only one stock than to an investor who holds a well-diversified portfolio.;a.;True;b.;False;4.);If;the expected rate of return for a particular stock, as seen by the marginal;investor, exceeds its required rate of return, we should soon observe an;increase in demand for the stock, and the price will likely increase until a;price is established that equates the expected return with the required;return. The sooner this equilibrium is;reached, the more efficient the market is judged to be.;a.;True;b.;False;5.);Portfolio;A has but one stock, while Portfolio B consists of all stocks that trade in;the market, each held in proportion to its market value. Because of its diversification, Portfolio B;will by definition be riskless.;a.;True;b.;False;6.);The;distributions of rates of return for Companies AA and BB are given below;State of;Probability of;Economy;State Occurring;AA;BB;Boom;0.2;30%;-10%;Normal;0.6;10%;5%;Recession;0.2;-5%;50%;We;can conclude from the above information that any rational risk-averse;investor will add Security AA to a well-diversified portfolio over Security;BB.;a.;True;b.;False;7.);Assume;that two investors each hold a portfolio, and that portfolio is their only;asset. Investor A's portfolio has a;beta of minus 2.0, while Investor B's portfolio has a beta of plus;2.0. Assuming that the unsystematic;risks of the stocks in the two portfolios are the same, then the two;investors face the same amount of risk.;However, the holders of either portfolio could lower their risks, and;by exactly the same amount, by adding some "normal" stocks with;beta = 1.0.;a.;True;b.;False;8.);If;the price of money (e.g., interest rates and equity capital costs) increases;due to an increase in anticipated inflation, the risk-free rate will also;increase. If there is no change in;investors' risk aversion, then the market risk premium (rM - rRF);will remain constant. Also, if there;is no change in stocks' betas, then the required rate of return on each stock;as measured by the CAPM will increase by the same amount as the increase in;expected inflation.;a.;True;b.;False;9.);A;highly risk-averse investor is considering adding one additional stock to a;3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b;= 1.0 and a perfect positive correlation with the market. Potential new Stocks A and B both have;expected returns of 15%, and both are equally correlated with the market;with r = 0.75. However, Stock A's;standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his;or her portfolio, or does the choice matter?;a.;Either;A or B, i.e., the investor should be indifferent between the two.;b.;Stock;A.;c.;Stock;B.;d.;Neither;A nor B, as neither has a return sufficient to compensate for risk.;e.;Add;A, since its beta must be lower.;10.);Which;of the following statements is CORRECT?;a.;An;investor can eliminate virtually all market risk if he or she holds a very;large and well diversified portfolio of stocks.;b.;The;higher the correlation between the stocks in a portfolio, the lower the risk;inherent in the portfolio.;c.;It;is impossible to have a situation where the market risk of a single stock is;less than that of a portfolio that includes the stock.;d.;Once;a portfolio has about 40 stocks, adding additional stocks will not reduce its;risk by even a small amount.;e.;An;investor can eliminate virtually all diversifiable risk if he or she holds a;very large, well diversified portfolio of stocks.;11.);Which;of the following statements is CORRECT?;a.;Collections;Inc. is in the business of collecting past-due accounts for other companies;i.e., it is a collection agency.;Collections? revenues, profits, and stock price tend to rise during;recessions. This suggests that;Collections Inc.?s beta should be quite high, say 2.0, because it does so;much better than most other companies when the economy is weak.;b.;Suppose;the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a;regression analysis using data for the last 5 years, while the other has a;beta of -0.6. The returns on the stock;with the negative beta will be negatively correlated with returns on most;other stocks in the market during that 5-year period.;c.;Suppose;you are managing a stock portfolio, and you have information that leads you;to believe the stock market is likely to be very strong in the immediate;future. That is, you are convinced;that the market is about to rise sharply.;You should sell your high-beta stocks and buy low-beta stocks in order;to take advantage of the expected market move.;d.;You;think that investor sentiment is about to change, and investors are about to;become more risk averse. This suggests;that you should re-balance your portfolio to include more high-beta stocks.;e.;If;the market risk premium remains constant, but the risk-free rate declines;then the required returns on low beta stocks will rise while those on high;beta stocks will decline.;12.);Stock;X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following statements must;be true, according to the CAPM?;a.;If;you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio;will have a beta significantly lower than 1.0, provided the returns on the;two stocks are not perfectly correlated.;b.;Stock;Y?s return during the coming year will be higher than Stock X?s return.;c.;If;expected inflation increases but the market risk premium is unchanged, the;required returns on the two stocks will increase by the same amount.;d.;Stock;Y?s return has a higher standard deviation than Stock X.;e.;If;the market risk premium declines, but the risk-free rate is unchanged, Stock;X will have a larger decline in its required return than will Stock Y.;13.);Consider;the following information for three stocks, A, B, and C, and portfolios of;these stocks. The stocks' returns are;positively but not perfectly positively correlated with one another, i.e.;the correlation coefficients are all between 0 and 1.;Expected;Standard;Stock;Return;Deviation;Beta;Stock;A;10%;20%;1.0;Stock;B;10;10;1.0;Stock;C;12;12;1.4;Portfolio AB has half of its funds;invested in Stock A and half in Stock B.;Portfolio ABC has one third of its funds invested in each of the three;stocks. The risk-free rate is 5%, and;the market is in equilibrium, so required returns equal expected;returns. Which of the following;statements is CORRECT?;a.;Portfolio AB has a standard;deviation of 20%.;b.;Portfolio AB?s coefficient of;variation is greater than 2.0.;c.;Portfolio AB?s required return is;greater than the required return on Stock A.;d.;Portfolio;ABC?s expected return is 10.67%.;e.;Portfolio;ABC has a standard deviation of 20%.;14.);Stock;A has an expected return of 12%, a beta of 1.2, and a standard deviation of;20%. Stock B also has a beta of 1.2;an expected return of 10%, and a standard deviation of 15%. Portfolio;AB has $900,000 invested in Stock;A and $300,000 invested in Stock B.;The correlation between the two stocks? returns is zero (that is, rA,B;= 0). Which of the following;statements is CORRECT?;a.;Portfolio AB?s standard deviation;is 17.5%.;b.;The;stocks are not in equilibrium based on the CAPM, if A is valued correctly;then B is overvalued.;c.;The;stocks are not in equilibrium based on the CAPM, if A is valued correctly;then B is undervalued.;d.;Portfolio AB?s expected return is;11.0%.;e.;Portfolio AB?s beta is less than;1.2.;15.);Jane;has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average;stocks. Assuming the market is in;equilibrium, which of the following statements is CORRECT?;a.;Jane?s;portfolio will have less diversifiable risk and also less market risk than;Dick?s portfolio.;b.;The;required return on Jane?s portfolio will be lower than that on Dick?s;portfolio because Jane's portfolio will have less total risk.;c.;Dick's;portfolio will have more diversifiable risk, the same market risk, and thus;more total risk than Jane's portfolio, but the required (and expected);returns will be the same on both portfolios.;d.;If;the two portfolios have the same beta, their required returns will be the;same, but Jane?s portfolio will have less market risk than Dick?s.;e.;The;expected return on Jane?s portfolio must be lower than the expected return on;Dick?s portfolio because Jane is more diversified.;16.);Stocks;A and B each have an expected return of 15%, a standard deviation of 20%, and;a beta of 1.2. The returns on the two;stocks have a correlation coefficient of +0.6. You have a portfolio that consists of 50% A;and 50% B. Which of the following;statements is CORRECT?;a.;The;portfolio?s beta is less than 1.2.;b.;The;portfolio?s expected return is 15%.;c.;The;portfolio?s standard deviation is greater than 20%.;d.;The;portfolio?s beta is greater than 1.2.;e.;The;portfolio?s standard deviation is 20%.;17.);During;the next year, the market risk premium, (rM - rRF), is;expected to fall, while the risk-free rate, rRF, is expected to;remain the same. Given this forecast;which of the following statements is CORRECT?;a.;The;required return will increase for stocks with a beta less than 1.0 and will;decrease for stocks with a beta greater than 1.0.;b.;The;required return on all stocks will remain unchanged.;c.;The;required return will fall for all stocks, but it will fall more for;stocks with higher betas.;d.;The;required return for all stocks will fall by the same amount.;e.;The;required return will fall for all stocks, but it will fall less for;stocks with higher betas.;18.);Stock;A has a beta of 0.8 and Stock B has a beta of 1.2. 50% of Portfolio P is invested in Stock A;and 50% is invested in Stock B. If the;market risk premium (rM ? rRF) were to increase but the;risk-free rate (rRF) remained constant, which of the following;would occur?;a.;The;required return will increase for both stocks but the increase will be;greater for Stock B than for Stock A.;b.;The;required return will decrease by the same amount for both Stock A and Stock;B.;c.;The;required return will increase for Stock A but will decrease for Stock B.;d.;The;required return on Portfolio P will remain unchanged.;e.;The;required return will increase for Stock B but will decrease for Stock A.;19.);Assume;that the risk-free rate remains constant, but the market risk premium;declines. Which of the following is;most likely to occur?;a.;The;required return on a stock with beta = 1.0 will not change.;b.;The;required return on a stock with beta > 1.0 will increase.;c.;The;return on ?the market? will remain constant.;d.;The;return on ?the market? will increase.;e.;The;required return on a stock with beta < 1.0 will decline.;20.);Stock A has an expected return of 10% and a standard;deviation of 20%. Stock B has an;expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market;risk premium, rM - rRF, is 6%. Assume that the market is in;equilibrium. Portfolio AB;has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are;independent of one another, i.e., the correlation coefficient between them is;zero. Which of the following;statements is CORRECT?;a.;Stock;A?s beta is 0.8333.;b.;Since;the two stocks have zero correlation, Portfolio;AB is riskless.;c.;Stock;B?s beta is 1.0000.;d.;Portfolio AB?s required return is;11%.;e.;Portfolio AB?s standard deviation;is 25%.;21.);Yonan;Corporation's stock had a required return of 11.50% last year, when the;risk-free rate was 5.50% and the market risk premium was 4.75%. Now suppose there is a shift in investor;risk aversion, and the market risk premium increases by 2%. The risk-free rate and Yonan's beta remain;unchanged. What is Yonan's new;required return? (Hint: First;calculate the beta, then find the required return.);a.;14.03%;b.;14.38%;c.;14.74%;d.;15.10%;e.;15.48%;22.);Millar;Motors has a beta of 1.30 and an expected dividend growth rate of 5.00% per;year. The T-bill rate is 3.00%, and;the T-bond rate is6.00%. The;annual return on the stock market during the past 3 years was 15.00%. Investors expect the annual future stock;market return to be 12.00%. Using the;SML, what is Millar's required return?;a.;12.5%;b.;12.8%;c.;13.1%;d.;13.5%;e.;13.8%;23.);Suppose;you hold a diversified portfolio consisting of a $10,000 investment in each;of 12 different common stocks. The;portfolio?s beta is 1.25. Now suppose;you decided to sell one of your stocks that has a beta of 1.00 and to use the;proceeds to buy a replacement stock with a beta of 1.34. What would the portfolio?s new beta be?;a.;1.15;b.;1.21;c.;1.28;d.;1.34;e.;1.41;24.);Your;firm's analyst believes that economic conditions during the next year will be;either strong, normal, or weak, and she thinks that Crary Inc.'s returns will;have the probability distribution shown below. What's the standard deviation of Crary's;returns as estimated by your analyst?;(Hint: Use the formula for the;standard deviation of a population, not a sample.);Economic;Conditions;Prob.;Return;Strong;30%;32.50%;Normal;40%;10.25%;Weak;30%;-15.75%;a.;17.77%;b.;18.71%;c.;19.65%;d.;20.63%;e.;21.66%

Paper#44693 | Written in 18-Jul-2015

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