Chapter Risk and Rate of Return:



Chapter Risk and Rate of Return:

1. Other things held constant, a security that has a relatively high probability of ending up with an actual return that is significantly lower than its expected return is relatively risky. True or false?

2. The payoff matrix for a stock would show the stock's set of possible returns and the probability of each return. We could use this data to find both the stock's expected rate of return and the standard deviation of that return, which is one measure of risk. True or false?

3. If you saw a graph for two investments that showed probabilities on the vertical axis and rates of return on the horizontal axis, the investment whose possible returns varied most widely from the expected return would, other things held constant, be the riskier one. True or false?

4. The larger the standard deviation of returns on an investment, the lower the investment's risk. True or false?

5. People differ with regard to their willingness to bear risks. However, if two stocks have the same expected rate of return, then most individuals would prefer the less risky to the more risky stock. This is called risk aversion. True or false?

6. If two assets are perfectly positively correlated, then their return will move up and down exactly in sync with one another. True or false?

7. If two assets are held in a portfolio, the assets will generally be less risky than if they were held in isolation. True or false?

8. The higher the correlation between two assets' returns, the greater is the risk reduction from holding them in a portfolio. True or false?

9. The riskiness of a portfolio can generally be reduced to zero by increasing the number of stocks in the portfolio. True or false?

10. An "average-risk stock" is one whose returns tend to move up and down with the market, and the beta of such a stock will be 0.0. True or false?

11. Beta is a measure of a stock's effect on the riskiness of a portfolio. The higher the stock's beta, the more risk the stock will add to the portfolio. True or false?

12. Suppose a 2-stock portfolio contains $40,000 of GE stock with a beta of 0.95 and $60,000 of GM stock with a beta of 1.65. What is the portfolio's beta?

a. 1.23

b. 1.37

c. 1.46

d. 1.54

e. 1.68

13. Other things held constant, if the expected rate of inflation increased by 2%, then the risk-free rate would rise by a similar amount. That would cause the SML to shift upward, but the slope of the SML would not change. The market risk premium would remain unchanged, but the required rate of return on an average stock would increase by the amount of the increase in expected inflation. True or false?

14. If investors' aversion to risk increased but the risk-free rate remained unchanged, then the required rate of return on all stocks would increase, and the increase would be larger for stocks with smaller betas. True or false?

15. Since betas are determined by market forces, a firm can do nothing to influence the size of its beta. True or false?

16. A stock has a beta of 1.3, the risk-free rate is 6.0%, and the market risk premium is 4.5%. What is the stock's required rate of return?

a. 10.16%

b. 10.69%

c. 11.26%

d. 11.85%

e. 12.44%

17. The CAPM is logical, and it has great intuitive appeal. However, a number of recent studies have raised concerns about its validity. True or false?

18. Suppose the standard deviation of expected returns for a given corporate project is quite high, suggesting that the project is quite risky. However, if the project is perfectly positively correlated both with returns on the firm's other projects and with returns on investors' other stocks, then the project's true risk might be quite small. True or false?

19. The expected return on a project and returns on the firm's other assets might be highly correlated or not very highly correlated. If the correlation is low, and especially if it is negative, then this would increase the project's perceived risk. True or false?

Chapter Stocks and their Valuation:

1. The term proxy fight refers to a situation where one division of a firm attempts to take over operations currently under the control of another division. True or false?

2. The preemptive right is the right of current stockholders to buy new shares in an amount that will maintain their proportionate ownership in the firm. True or false?

3. Firms can use different types of debt, such as mortgage bonds or debentures, but there is only one type of common stock. True or false?

4. A bond promises to pay interest and eventually to return the principal that was invested. However, a share of common stock simply entitles its owner a share of the firm's income and its assets if the firm is liquidated or sold. Stock is typically expected to provide a return in the form of dividends and capital gains, but those expectations may not be realized. True or false?

5. What are the two parts of most stocks' expected total return?

a. Capital gains and tax savings

b. ROI and dividends

c. Dividends and capital gains

d. None of these choices

6. Investors expect Nagy Industries to pay a dividend of D1 = $4.00 one year from today, and they expect the dividend thereafter to grow at a constant rate of g = 6%. If Nagy's stock sells for P0 = $80, what is its expected dividend yield?

a. 4.0%

b. 5.0%

c. 6.0%

d. 9.5%

e. 11.0%

7. Investors expect Nagy Industries to pay a dividend of D1 = $4.00 one year from today, and they expect the dividend thereafter to grow at a constant rate of g = 6%. If Nagy's stock sells for P0 = $80, what is Nagy's expected capital gains yield?

a. 4.0%

b. 5.0%

c. 6.0%

d. 9.5%

e. 11.0%

8. Investors expect Nagy Industries to pay a dividend of D1 = $4.00 one year from today, and they expect the dividend thereafter to grow at a constant rate of g = 6%. If Nagy's stock sells for P0 = $80, what is Nagy's expected total rate of return?

a. 4.0%

b. 5.0%

c. 6.0%

d. 9.5%

e. 11.0%

9. Is it true or false that the following equation can be used to find the price of a stock that is expected to grow at a constant rate? P0 = D1/(rs − g ).

10. Able Corporation just paid a dividend of D0 = $1.50, and investors expect the dividend to grow at a constant rate of 6% per year. The stock sells at a price of $30. What is Able's dividend yield?

a. 3.5%

b. 4.2%

c. 4.8%

d. 5.3%

e. 6.1%

11. Pappas Shipping Company is expected to pay a dividend of $2.50 one year from now, its required rate of return is 10%, and the dividend is expected to grow at a constant rate of 6%. At what price should Pappas sell?

a. $50.63

b. $56.25

c. $62.50

d. $68.75

e. $75.63

12.

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13. Boyles Trucking Company's stock sells for $25 per share, the expected dividend for the coming year is D1 = $0.50, and the expected constant growth rate is g = 8%. What rate of return do investors expect to earn on Boyles' stock?

a. 8.0%

b. 8.5%

c. 9.0%

d. 9.5%

e. 10.0%

14. Some stocks are expected to experience a changing rate of growth; these are said to be nonconstant growth stocks. However, for valuation purposes, we generally assume that at some future time even these stocks will begin to grow at a constant rate. The time when constant growth is expected is called the "horizon, or terminal, date." True or false?

15. To estimate the value of a nonconstant growth stock, we can estimate the value of each dividend during the period of nonconstant growth, find the PVs of these dividends, then find the value of the stock at the horizon date, then find the PV of the horizon value, and then sum all of these PVs to find the value of the stock today.

16. Sevilla Homes just paid a dividend of $1, i.e., D0 = $1.00. The dividend is expected to grow by 50% during Year 1, by 25% during Year 2, and then at a constant rate of 6% thereafter. If Sevilla's required rate of return is rs = 11%, what is the PV of D1?

a. $1.28

b. $1.35

c. $1.42

d. $1.49

e. $1.56

17. Sevilla Homes just paid a dividend of $1, i.e., D0 = $1.00. The dividend is expected to grow by 50% during Year 1, by 25% during Year 2, and then at a constant rate of 6% thereafter. If Sevilla's required rate of return is rs = 11%, what is the PV of D2?

a. $1.11

b. $1.23

c. $1.37

d. $1.52

e. $1.67

18. Sevilla Homes just paid a dividend of $1, i.e., D0 = $1.00. The dividend is expected to grow by 50% during Year 1, by 25% during Year 2, and then at a constant rate of 6% thereafter. If Sevilla's required rate of return is rs = 11%, what is Sevilla stock's horizon value?

a. $35.87

b. $37.76

c. $39.75

d. $41.74

e. $43.82

19. Sevilla Homes just paid a dividend of $1, i.e., D0 = $1.00. The dividend is expected to grow by 50% during Year 1, by 25% during Year 2, and then at a constant rate of 6% thereafter. If Sevilla's required rate of return is rs = 11%, what is the PV of Sevilla stock's horizon value?

a. $26.79

b. $28.50

c. $30.32

d. $32.26

e. $34.20

20. Sevilla Homes just paid a dividend of $1, i.e., D0 = $1.00. The dividend is expected to grow by 50% during Year 1, by 25% during Year 2, and then at a constant rate of 6% thereafter. If Sevilla's required rate of return is rs = 11%, what is the value of Sevilla's stock?

a. $33.40

b. $34.25

c. $35.13

d. $36.01

e. $40.00

21. The value of a share of stock can be estimated by using the PV of future dividends method. An alternative valuation procedure, called the "corporate valuation model," calls for finding the expected future free cash flows, discounting those cash flows at the weighted average cost of capital, summing the PVs of the free cash flows, subtracting the market values of debt and preferred to calculate the value of the common equity, and then dividing by the number of shares outstanding to find the value of a share of common stock. In theory, the two methods should produce the same stock value. Is this statement true or false?

22. One advantage of the corporate valuation model over the discounted dividend model is that the corporate model can be applied to divisions of a firm that don't have a history of paying dividends. True or false?

23. If a stock is in equilibrium, the required rate of return as judged by the marginal investor must equal the expected rate of return. If that condition holds, then the stock's market price will equal its intrinsic value as estimated by the marginal investor. True or false?

24. If a stock is not in equilibrium, then there will be buying pressure if the expected return as seen by the marginal investor is less than that investor's required return. Similarly, there will be selling pressure if the expected return is greater than the required return. True or false?

25. For a stock to be in equilibrium, every investor in the market must regard the current market price as being equal to the stock's intrinsic value. True or false?

26. Returns on foreign stocks are not perfectly positively correlated with returns on domestic stocks. Therefore, adding a selection of foreign stocks to a portfolio of domestic stocks might well increase the portfolio's expected rate of return without increasing its risk. True or false?

27. If a U.S. investor purchased a foreign stock, the investor would obviously benefit if the stock's price appreciated in its local market. The investor would enjoy an additional benefit if the U.S. dollar appreciated against the stock's local currency.

28. Preferred stock is a "hybrid" security. Preferreds typically pay a fixed dividend, so they are a fixed-income security like a bond. However, the payment is not guaranteed, so issuing preferreds does not expose the firm to bankruptcy. T or F

29. Preferred stocks can have a finite life, such as 25 years, or they can be perpetual. In either case, a valuation equation similar to the one used for bonds can be used to find the value of the preferred stock. True or false?

Chapter Financial Environment:

1. In a well functioning economy, capital will flow efficiently from those that demand capital to those that supply capital. True or False?

2. Investment banks help companies raise capital by underwriting new issues of securities. True or False?

3. Which of the following is an example of a physical asset?

a. 100 shares of stock of IBM

b. A corporate bond

c. A bushel of wheat

d. A mortgage

4. Suppose you just purchased 10 shares of GE stock in the open market. Would this be an example of a primary market or secondary market transaction?

a. primary market transaction

b. secondary market transaction

5. Which of the following is NOT a financial institution?

a. Investment bank

b. Commerical bank

c. Mutual fund

d. Hedge fund

e. All of these choices are examples of financial institutions.

6. Because they are regulated, mutual funds are only allowed to invest in the stocks of large corporations that have very little risk. True or False?

7. While Nasdaq began as a system that simply provided quotations on stocks, it has grown to the point where it is an organized securities market with its own listing requirements. True or False?

8. The New York Stock Exchange is an example of a physical location stock exchange. True or False?

9. A company recently decided to issue additional shares to raise new capital, and it used investment bankers, who distributed the stock on the open market. Was this an example of a primary market transaction or a secondary market transaction?

a. primary market transaction

b. secondary market transaction

10. The IPO market refers to the market for international public options. True or False?

11. While individual stocks may have dropped in value, the overall stock market as measured by the S&P 500 and Dow Jones Industrial averages has increased in each of the last twenty-five years. True or False?

12. When looking at a stock market quote online you will sometimes see the letters 'ttm' following the company's price/earnings ratio and earnings per share. In this case, ttm stands for "trailing twelve months," and it contrasts with data based on analysts' forecasts. True or False?

13. The efficient markets hypothesis (EMH) suggests that the price of a stock will adjust almost immediately to any new development. If true, that makes it difficult for anyone to analyze historical data and then consistently pick stocks that will beat the market. True or False?

14. People who believe that the stock market is weak-form efficient think that it is extremely important to chart the movements of stocks over time in order to find patterns that will reveal which stocks are attractive buys. True or False?

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