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12.1 The Equity Cost of Capital

 

 

Use the following information to answer the question(s) below.

 

 

Beta

 

 

Volatility

 

 

\"Eenie\"

 

 

0.45

 

 

20%

 

 

\"Meenie\"

 

 

0.75

 

 

18%

 

 

\"Miney\"

 

 

1.05

 

 

35%

 

 

\"Moe\"

 

 

1.20

 

 

25%

 

 

Assume that the risk-free rate of interest is 3% and you estimate the market\'s expected return to be 9%.

 

 

1) Which firm has the most total risk?

 

 

A) Eenie

 

 

B) Meenie

 

 

C) Miney

 

 

D) Moe

 

 

 

 

2) Which firm has the least market risk:

 

 

A) Eenie

 

 

B) Meenie

 

 

C) Miney

 

 

D) Moe

 

 

 

 

 

3) Which firm has the highest cost of equity capital?

 

 

A) Eenie

 

 

B) Meenie

 

 

C) Miney

 

 

D) Moe

 

 

 

 

4) The equity cost of capital for \"Miney\" is closest to:

 

 

A) 6.30%

 

 

B) 7.50%

 

 

C) 9.30%

 

 

D) 9.75%

 

 

 

 

5) The equity cost of capital for \"Meenie\" is closest to:

 

 

A) 4.50%

 

 

B) 7.50%

 

 

C) 9.30%

 

 

D) 9.75%

 

 

 

 

6) The risk premium for \"Meenie\" is closest to:

 

 

A) 4.50%

 

 

B) 7.50%

 

 

C) 9.30%

 

 

D) 9.75%

 

 

 

 

12.2 The Market Portfolio

 

 

Use the following information to answer the question(s) below.

 

 

Suppose all possible investment opportunities in the world are limited to the four stocks list in the table below:

 

 

Stock

 

 

Price per

 

 

Share

 

 

Number of Shares

 

 

Outstanding (Millions)

 

 

Taggart Transcontinental

 

 

$15.60

 

 

25

 

 

Rearden Metal

 

 

$13.00

 

 

45

 

 

Wyatt Oil

 

 

$29.25

 

 

10

 

 

Nielson Motors

 

 

$26.25

 

 

26

 

 

1) The weight on Taggart Transcontinental stock in the market portfolio is closest to:

 

 

A) 15%

 

 

B) 20%

 

 

C) 25%

 

 

D) 30%

 

 

 

 

 

 

2) The weight on Wyatt Oil stock in the market portfolio is closest to:

 

 

A) 15%

 

 

B) 20%

 

 

C) 25%

 

 

D) 30%

 

 

 

 

 

 

 

 

 

 

 

 

3) Suppose that you are holding a market portfolio and you have invested $9,000 in Rearden Metal. The amount that you have invested in Nielson Motors is closest to:

 

 

A) $6,000

 

 

B) $7,715

 

 

C) $9,000

 

 

D) $10,500

 

 

 

 

 

 

 

4) Suppose that you are holding a market portfolio and you have invested $9,000 in Rearden Metal. The amount that you have invested in Taggart Transcontinental is closest to:

 

 

A) $4,500

 

 

B) $6,000

 

 

C) $7,715

 

 

D) $9,000

 

 

 

 

 

 

 

5) Suppose that you have invested $30,000 invested in the market portfolio. Then the amount that you have invested in Wyatt Oil is closest to:

 

 

A) $4,500

 

 

B) $6,000

 

 

C) $7,715

 

 

D) $9,000

 

 

 

 

6) Suppose that you have invested $30,000 invested in the market portfolio. Then the number of shares of Rearden Metal that you hold is closest to:

 

 

A) 450 shares

 

 

B) 700 shares

 

 

C) 1,400 shares

 

 

D) 2,300 shares

 

 

 

 

 

7) Suppose that you have invested $30,000 invested in the market portfolio. Then the number of shares of Wyatt Oil that you hold is closest to:

 

 

A) 150 shares

 

 

B) 300 shares

 

 

C) 350 shares

 

 

D) 450 shares

 

 

 

 

 

 

8) Suppose that you are holding a market portfolio and you have invested $18,000 in Taggart Transcontinental. The number of shares of Wyatt Oil that you hold is closest to:

 

 

A) 90 shares

 

 

B) 460 shares

 

 

C) 615 shares

 

 

 

 

 

 

9) Suppose that you are holding a market portfolio and you have invested $18,000 in Taggart Transcontinental. The number of shares of Rearden Metal that you hold is closest to:

 

 

A) 780 shares

 

 

B) 925 shares

 

 

C) 1,730 shares

 

 

D) 2,075 shares

 

 

 

 

 

 

 

10) Suppose that you have invested $100,000 invested in the market portfolio and that the stock price of Taggart Transcontinental suddenly drops to $7.80 per share. Which of the following trades would you need to make in order to maintain your investment in the market portfolio:

 

 

1. Buy approximately 1,140 shares of Taggart Transcontinental

 

 

2. Sell approximately 256 shares of Rearden Metal

 

 

3. Sell approximately 57 shares of Wyatt Oil

 

 

4. Sell approximately 148 shares of Nielson Motors

 

 

A) 1 only

 

 

B) 2 only

 

 

C) 2, 3, and 4 only

 

 

D) 1, 2, 3, and 4

 

 

E) None of the above

 

 

 

 

 

Use the following information to answer the question(s) below.

 

 

Suppose that Merck (MRK) stock is trading for $36.70 per share with 2.11 billion shares outstanding while Boeing (BA) has 697.5 million shares outstanding and a market capitalization of $38.223 billion. Assume that you hold the market portfolio.

 

 

11) Boeing\'s stock price is closest to:

 

 

A) $18.25

 

 

B) $36.70

 

 

C) $54.80

 

 

D) $63.40

 

 

 

 

12) Merck\'s market capitalization is closest to:

 

 

A) $38.2 billion

 

 

B) $77.4 billion

 

 

C) $89.4 billion

 

 

D) $115.6 billion

 

 

 

 

13) If you hold 1,000 shares of Merck, then the number of shares of Boeing that your hold is closest to:

 

 

A) 240 shares

 

 

B) 330 shares

 

 

C) 510 shares

 

 

D) 780 shares

 

 

 

 

14) Which of the following statements is false?

 

 

A) All investors should demand the same efficient portfolio of securities in the same proportions.

 

 

B) The Capital Asset Pricing Model (CAPM) allows corporate executives to identify the efficient portfolio (of risky assets) by using knowledge of the expected return of each security.

 

 

C) If investors hold the efficient portfolio, then the cost of capital for any investment project is equal to its required return calculated using its beta with the efficient portfolio.

 

 

D) The CAPM identifies the market portfolio as the efficient portfolio.

 

 

 

 

15) Which of the following statements is false?

 

 

A) If investors have homogeneous expectations, then each investor will identify the same portfolio as having the highest Sharpe ratio in the economy.

 

 

B) Homogeneous expectations are when all investors have the same estimates concerning future investments and returns.

 

 

C) There are many investors in the world, and each must have identical estimates of the volatilities, correlations, and expected returns of the available securities.

 

 

D) The combined portfolio of risky securities of all investors must equal the efficient portfolio.

 

 

 

 

16) Which of the following statements is false?

 

 

A) If some security were not part of the efficient portfolio, then every investor would want to own it, and demand for this security would increase causing its expected return to fall until it is no longer an attractive investment.

 

 

B) The efficient portfolio, the portfolio that all investors should hold, must be the same portfolio as the market portfolio of all risky securities.

 

 

C) Because every security is owned by someone, the sum of all investors\' portfolios must equal the portfolio of all risky securities available in the market.

 

 

D) If all investors demand the efficient portfolio, and since the supply of securities is the market portfolio, then two portfolios must coincide.

 

 

 

 

 

17) Which of the following statements is false?

 

 

A) The market portfolio contains more of the smallest stocks and less of the larger stocks.

 

 

B) For the market portfolio, the investment in each security is proportional to its market capitalization.

 

 

C) Because the market portfolio is defined as the total supply of securities, the proportions should correspond exactly to the proportion of the total market that each security represents.

 

 

D) Market capitalization is the total market value of the outstanding shares of a firm.

 

 

 

 

18) Which of the following statements is false?

 

 

A) A value-weighted portfolio is an equal-ownership portfolio: We hold an equal fraction of the total number of shares outstanding of each security in the portfolio.

 

 

B) When buying a value-weighted portfolio, we end up purchasing the same percentage of shares of each firm.

 

 

C) To maintain a value-weighted portfolio, we do not need to trade securities and rebalance the portfolio unless the number of shares outstanding of some security changes.

 

 

D) In a value weighted portfolio the fraction of money invested in any security corresponds to its share of the total number of shares outstanding of all securities in the portfolio.

 

 

 

 

19) Which of the following statements is false?

 

 

A) The most familiar stock index in the United States is the Dow Jones Industrial Average (DJIA).

 

 

B) A portfolio in which each security is held in proportion to its market capitalization is called a price-weighted portfolio.

 

 

C) The Dow Jones Industrial Average (DJIA) consists of a portfolio of 30 large industrial stocks.

 

 

D) The Dow Jones Industrial Average (DJIA) is a price-weighted portfolio.

 

 

 

 

 

 

20) Which of the following statements is false?

 

 

A) Because very little trading is required to maintain it, an equal-weighted portfolio is called a passive portfolio.

 

 

B) If the number of shares in a value weighted portfolio does not change, but only the prices change, the portfolio will remain value weighted.

 

 

C) The CAPM says that individual investors should hold the market portfolio, a value-weighted portfolio of all risky securities in the market.

 

 

D) A price weighted portfolio holds an equal number of shares of each stock, independent of their size.

 

 

 

 

21) Which of the following statements is false?

 

 

A) A market index reports the value of a particular portfolio of securities.

 

 

B) The S&P 500 is the standard portfolio used to represent \"the market\" when using the CAPM in practice.

 

 

C) Even though the S&P 500 includes only 500 of the more than 7,000 individual U.S. Stocks in existence, it represents more than 70% of the U.S. stock market in terms of market capitalization.

 

 

D) The S&P 500 is an equal-weighted portfolio of 500 of the largest U.S. stocks.

 

 

 

 

22) Which of the following statements is false?

 

 

A) The S&P 500 and the Wilshire 5000 indexes are both well-diversified indexes that roughly correspond to the market of U.S. stocks.

 

 

B) Practitioners commonly use the S&P 500 as the market portfolio in the CAPM with the belief that this index is the market portfolio.

 

 

C) Standard & Poor\'s Depository Receipts (SPDR, nicknamed \"spider\") trade on the American Stock Exchange and represent ownership in the S&P 500.

 

 

D) The S&P 500 was the first widely publicized value weighted index and it has become a benchmark for professional investors.

 

 

 

 

23) In practice which market index is most widely used as a proxy for the market portfolio in the CAPM?

 

 

A) Dow Jones Industrial Average

 

 

B) Wilshire 5000

 

 

C) S&P 500

 

 

D) U.S. Treasury Bill

 

 

 

 

24) In practice which market index would best be used as a proxy for the market portfolio in the CAPM?

 

 

A) S&P 500

 

 

B) Dow Jones Industrial Average

 

 

C) U.S. Treasury Bill

 

 

D) Wilshire 5000

 

Paper#49435 | Written in 29-Oct-2015

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