Question 1

Which of the following statements is CORRECT? (Assume

that the risk-free rate is a constant.)
Answer
If the market risk premium increases by 1%, then the
required return will increase for stocks that have a beta
greater than 1.0, but it will decrease for stocks that have
a beta less than 1.0.
The effect of a change in the market risk premium
depends on the slope of the yield curve.
If the market risk premium increases by 1%, then the
required return on all stocks will rise by 1%.
If the market risk premium increases by 1%, then the
required return will increase by 1% for a stock that has a
beta of 1.0.
The effect of a change in the market risk premium
depends on the level of the risk-free rate.
2 points
Question 2
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, but its expected return is 10% and its standard
deviation is 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,).
Which of the following statements is CORRECT?
Answer
Portfolio AB's standard deviation is 17.5%.
The stocks are not in equilibrium based on the CAPM; if A
is valued correctly, then B is overvalued.
The stocks are not in equilibrium based
on the CAPM; if A is valued correctly, then B is
undervalued.
Portfolio AB's expected return is 11.0%.

Portfolio AB's beta is less than 1.2.

2 points
Question 3
Which of the following statements is CORRECT?
Answer
If a company with a high beta merges with a low-beta
company, the best estimate of the new merged
company's beta is 1.0.
Logically, it is easier to estimate the betas associated
with capital budgeting projects than the betas associated
with stocks, especially if the projects are closely
associated with research and development activities.
The beta of an "average stock," which is also "the market
beta," can change over time, sometimes drastically.
If a newly issued stock does not have a past history that
can be used for calculating beta, then we should always
estimate that its beta will turn out to be 1.0. This is
especially true if the company finances with more debt
than the average firm.
During a period when a company is undergoing a change
such as increasing its use of leverage or taking on riskier
projects, the calculated historical beta may be drastically
different from the beta that will exist in the future.
2 points
Question 4
Which of the following statements is
CORRECT?
Answer
A large portfolio of randomly selected stocks will always
have a standard deviation of returns that is less than the
standard deviation of a portfolio with fewer stocks,
regardless of how the stocks in the smaller portfolio are
selected.
Diversifiable risk can be reduced by forming a large

portfolio, but normally even highly-diversified portfolios

are subject to market (or systematic) risk.
A large portfolio of randomly selected stocks will
have a standard deviation of returns that is greater than
the standard deviation of a 1-stock portfolio if that one
stock has a beta less than 1.0.
A large portfolio of stocks whose betas are greater
than 1.0 will have less market risk than a single stock
with a
If you add enough randomly selected stocks to a portfolio,
you can completely eliminate all of the market risk from
the portfolio.
2 points
Question 5
Which of the following statements is CORRECT?
Answer
A stock's beta is less relevant as a measure of risk to an
investor with a well-diversified portfolio than to an
investor who holds only that one stock.
If an investor buys enough stocks, he or she can, through
diversification, eliminate all of the diversifiable risk
inherent in owning stocks. Therefore, if a portfolio
contained all publicly traded stocks, it would be
essentially riskless.
The required return on a firm's common
stock is, in theory, determined solely by its market risk. If
the market risk is known, and if that risk is expected to
remain constant, then no other information is required to
specify the firm's required return.
Portfolio diversification reduces the variability of returns
(as measured by the standard deviation) of each
individual stock held in a portfolio.
A security's beta measures its non-diversifiable, or
market, risk relative to that of an average stock.

2 points
Question 6
For a portfolio of 40 randomly selected stocks, which of
the following is most likely to be true?
Answer
The riskiness of the portfolio is greater
than the riskiness of each of the stocks if each was held
in isolation.
The riskiness of the portfolio is the
same as the riskiness of each stock if it was held in
isolation.
The beta of the portfolio is less than
the average of the betas of the individual stocks.
The beta of the portfolio is equal to the average of the
betas of the individual stocks.
The beta of the portfolio is larger than the average of the
betas of the individual stocks.
2 points
Question 7
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?
Answer
If you invest $50,000 in Stock X and $50,000 in Stock Y,
your 2-stock portfolio would have a beta significantly
lower than 1.0, provided the returns on the two stocks are
not perfectly correlated.
Stock Y's realized return during the coming year will be
higher than Stock X's return.
If the expected rate of inflation increases
but the market risk premium is unchanged, the required
returns on the two stocks should increase by the same
amount.
Stock Y's return has a higher standard

deviation than Stock X.

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.
2 points
Question 8
Which of the following statements is CORRECT?
Answer
An investor can eliminate virtually all market risk if he or
she holds a very large and well diversified portfolio of
stocks.
The higher the correlation between the stocks in a
portfolio, the lower the risk inherent in the portfolio.
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.
Once a portfolio has about 40 stocks, adding additional
stocks will not reduce its risk by even a small amount.
An investor can eliminate virtually all diversifiable risk if
he or she holds a very large, well diversified portfolio of
stocks.
2 points
Question 9
Which of the following is NOT a potential problem when
estimating and using betas, i.e., which statement is
FALSE?
Answer
The fact that a security or project may not have a past
history that can be used as the basis for calculating beta.
Sometimes, during a period when the company is
undergoing a change such as toward more leverage or
riskier assets, the calculated beta will be drastically
different from the "true" or "expected future" beta.
The beta of an "average stock," or "the market," can

change over time, sometimes drastically.

Sometimes the past data used to calculate beta do not
reflect the likely risk of the firm for the future because
conditions have changed.
All of the statements above are true.
2 points
Question 10
Inflation, recession, and high interest rates are economic
events that are best characterized as being
Answer
systematic risk factors that can be diversified away.
company-specific risk factors that can be diversified
away.
among the factors that are responsible for market risk.
risks that are beyond the control of investors and thus
should not be considered by security analysts or portfolio
managers.
irrelevant except to governmental authorities like the
Federal Reserve.
2 points
Question 11
Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of
the following statements must be true about these
securities? (Assume market equilibrium.)
Answer
When held in isolation, Stock A has more risk than Stock
B.
Stock B must be a more desirable addition to a portfolio
than A.
Stock A must be a more desirable addition to a portfolio
than B.
The expected return on Stock A should be greater than
that on B.
The expected return on Stock B should be greater than

that on A.
2 points
Question 12
Assume that the risk-free rate is 5%. Which of the
following statements is CORRECT?
Answer
If a stock has a negative beta, its required return under
the CAPM would be less than 5%.
If a stock's beta doubled, its required return under the
CAPM would also double.
If a stock's beta doubled, its required return under the
CAPM would more than double.
If a stock's beta were 1.0, its required return under the
CAPM would be 5%.
If a stock's beta were less than 1.0, its required return
under the CAPM would be less than 5%.
2 points
Question 13
Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5.
The market is in equilibrium, with required returns
equaling expected returns. Which of the following
statements is CORRECT?
Answer
If expected inflation remains constant but the market risk
premium (rM
rRF) declines, the required return of Stock LB will
decline but the required return of Stock HB will increase.
If both expected inflation and the market risk premium
(rM rRF) increase, the required return on Stock HB will
increase by more than that on Stock LB.
If both expected inflation and the market risk premium
(rM rRF) increase, the required returns of both stocks
will increase by the same amount.
Since the market is in equilibrium, the required

returns of the two stocks should be the same.

If expected inflation remains constant but the market risk
premium (rM
rRF) declines, the required return of Stock HB will
decline but the required return of Stock LB will increase.
2 points
Question 14
Which of the following statements is CORRECT?
Answer
A two-stock portfolio will always have a lower standard
deviation than a one-stock portfolio.
A portfolio that consists of 40 stocks that are not highly
correlated with "the market" will probably be less risky
than a portfolio of 40 stocks that are highly correlated
with the market, assuming the stocks all have the same
standard deviations.
A two-stock portfolio will always have a lower beta than a
one-stock portfolio.
If portfolios are formed by randomly selecting stocks, a
10-stock portfolio will always have a lower beta than a
one-stock portfolio.
A stock with an above-average standard deviation must
also have an above-average beta.
2 points
Question 15
Your portfolio consists of $50,000 invested in Stock X and
$50,000 invested in Stock Y. Both stocks have an
expected return of 15%, betas of 1.6, and standard
deviations of 30%. The returns of the two stocks are
independent, so the correlation coefficient between them,
rXY, is zero. Which of the following statements best
describes the characteristics of your 2-stock portfolio?
Answer
Your portfolio has a standard deviation of 30%, and its

expected return is 15%.

Your portfolio has a standard deviation less than 30%,
and its beta is greater than 1.6.
Your portfolio has a beta equal to 1.6, and
its expected return is 15%.
Your portfolio has a beta greater than 1.6, and its
expected return is greater than 15%.
Your portfolio has a standard deviation greater
than 30% and a beta equal to 1.6.
2 points
Question 16
Stocks A and B have the same price and are in
equilibrium, but Stock A has the higher required rate of
return. Which of the following statements is CORRECT?
Answer
If Stock A has a lower dividend yield than Stock B, its
expected capital gains yield must be higher than Stock
Bs.
Stock B must have a higher dividend yield than Stock A.
Stock A must have a higher dividend yield than Stock B.
If Stock A has a higher dividend yield than Stock B, its
expected capital gains yield must be lower than Stock
Bs.
Stock A must have both a higher dividend
yield and a higher capital gains yield than Stock B.
2 points
Question 17
If in the opinion of a given investor a stocks expected
return exceeds its required return, this suggests that the
investor thinks
Answer
the stock is experiencing supernormal growth.
the stock should be sold.
the stock is a good buy.

management is probably not trying to maximize the price

per share.
dividends are not likely to be declared.
2 points
Question 18
Stock X has the following data. Assuming the stock
market is efficient and the stock is in equilibrium, which
of the following statements is CORRECT?
Expected dividend, D1 $3.00
Current Price, P0 $50
Expected constant growth rate 6.0%
Answer
The stocks required return is 10%.
The stocks expected dividend yield and growth rate are
equal.
The stocks expected dividend yield is 5%.
The stocks expected capital gains yield is 5%.
The stocks expected price 10 years from now is $100.00.
2 points
Question 19
Which of the following statements is CORRECT, assuming
stocks are in equilibrium?
Answer
The dividend yield on a constant growth stock must equal
its expected total return minus its expected capital gains
yield.
Assume that the required return on a given stock is 13%.
If the stocks dividend is growing at a constant rate of 5%,
its expected dividend yield is 5% as well.
A stocks dividend yield can
never exceed its expected growth rate.
A required condition for one to use the constant growth
model is that the stocks expected growth rate exceeds
its required rate of return.

Other things held constant, the higher a companys beta

coefficient, the lower its required rate of return.
2 points
Question 20
An increase in a firms expected growth rate would cause
its required rate of return to
Answer
increase.
decrease.
fluctuate less than before.
fluctuate more than before.
possibly increase, possibly decrease, or possibly remain
constant.
2 points
Question 21
Which of the following statements is CORRECT?
Answer
If a company has two classes of common stock, Class A
and Class B, the stocks may pay different dividends, but
under all state charters the two classes must have the
same voting rights.
The preemptive right gives stockholders the right to
approve or disapprove of a merger between their
company and some other company.
The preemptive right is a provision in the corporate
charter that gives common stockholders the right to
purchase (on a pro rata basis) new issues of the firm's
common stock.
The stock valuation model, P0
= D1/(rs - g), cannot be used for firms that have negative
growth rates.
The stock valuation model, P0
= D1/(rs - g), can be used only for firms whose growth
rates exceed their required returns.

2 points
Question 22
A stock is expected to pay a year-end dividend of $2.00,
i.e., D1 = $2.00. The dividend is expected to decline at a
rate of 5% a year forever (%). If the company is in
equilibrium and its expected and required rate of return is
15%, which of the following statements is CORRECT?
Answer
The companys current stock price is $20.
The companys dividend yield 5 years from now is
expected to be 10%.
The constant growth model cannot be used because the
growth rate is negative.
The companys expected capital gains yield is 5%.
The companys expected stock price at the beginning of
next year is $9.50.
2 points
Question 23
Stocks A and B have the following data. The market risk
premium is 6.0% and the risk-free rate is 6.4%. Assuming
the stock market is efficient and the stocks are in
equilibrium, which of the following statements is
CORRECT?
AB
Beta 1.10 0.90
Constant growth rate 7.00% 7.00%
Answer
Stock A must have a higher stock price than Stock B.
Stock A must have a higher dividend yield than Stock B.
Stock Bs dividend yield equals its expected dividend
growth rate.
Stock B must have the higher required return.
Stock B could have the higher expected return.
2 points

Question 24
The expected return on Natter Corporations stock is 14%.
The stocks dividend is expected to grow at a constant
rate of 8%, and it currently sells for $50 a share. Which of
the following statements is CORRECT?
Answer
The stocks dividend yield is 7%.
The stocks dividend yield is 8%.
The current dividend per share is $4.00.
The stock price is expected to be $54 a share one year
from now.
The stock price is expected to be $57 a share one year
from now.
2 points
Question 25
For a stock to be in equilibrium, that is, for there to be no
long-term pressure for its price to depart from its current
level, then
Answer
the expected future return must be less than the most
recent past realized return.
The past realized return must be equal to the expected
return during the same period.
the required return must equal the realized return in all
periods.
the expected return must be equal to both the required
future return and the past realized return.
the expected future returns must be equal to the required
return.
2 points
Question 26
Two constant growth stocks are in equilibrium, have the
same price, and have the same required rate of return.
Which of the following statements is CORRECT?

Answer
The two stocks must have the same dividend per share.
If one stock has a higher dividend yield, it must also have
a lower dividend growth rate.
If one stock has a higher dividend yield, it must also have
a higher dividend growth rate.
The two stocks must have the same dividend growth rate.
The two stocks must have the same dividend yield.
2 points
Question 27
If a stocks dividend is expected to grow at a constant
rate of 5% a year, which of the following statements is
CORRECT? The stock is in equilibrium.
Answer
The expected return on the stock is 5% a year.
The stocks dividend yield is 5%.
The price of the stock is expected to decline in the future.
The stocks required return must be equal to or less than
5%.
The stocks price one year from now is expected to be 5%
above the current price.
2 points
Question 28
Stocks X and Y have the following data. Assuming the
stock market is efficient and the stocks are in equilibrium,
which of the following statements is CORRECT?
XY
Price $30 $30
Expected growth (constant) 6% 4%
Required return 12% 10%
Answer
Stock X has a higher dividend yield than Stock Y.
Stock Y has a higher dividend yield than Stock X.
One year from now, Stock Xs price is expected to be

higher than Stock Ys price.

Stock X has the higher expected year-end dividend.
Stock Y has a higher capital gains yield.
2 points
Question 29
Which of the following statements is CORRECT?
Answer
Preferred stockholders have a priority over bondholders in
the event of bankruptcy to the income, but not to the
proceeds in a liquidation.
The preferred stock of a given firm is generally less risky
to investors than the same firms common stock.
Corporations cannot buy the preferred stocks of other
corporations.
Preferred dividends are not generally cumulative.
A big advantage of preferred stock is that dividends on
preferred stocks are tax deductible by the issuing
corporation.
2 points
Question 30
Stocks X and Y have the following data. Assuming the
stock market is efficient and the stocks are in equilibrium,
which of the following statements is CORRECT?
XY
Price $25 $25
Expected dividend yield 5% 3%
Required return 12% 10%
Answer
Stock Y pays a higher dividend per share than Stock X.
Stock X pays a higher dividend per share than Stock Y.
One year from now, Stock X should have the higher price.
Stock Y has a lower expected growth rate than Stock X.
Stock Y has the higher expected capital gains yield.
2 points

Financial risk refers to the extra risk stockholders bear as a result

of a firm's use of debt as compared with their risk if the firm had used no
debt.

Exchange rate risk is the risk that an unexpected change in the exchange
rate will reduce NPV of a project's cash flows.

Exchange rate risk short term this risk can be hedged by using financial
instruments such as foreign currency futures and options.

Exchange rate risk long term Long-term exchange rate risk can best be
minimized by financing the project in whole or in part in the local currency

Political risk A foreign government can block repatriation of profits and even
seize the firm's assets

Political Risk Hedging accomplished by adjusting the rate used to discount

cash flowsor betterby adjusting the project's cash flows.

cross-border trade among MNCs takes place between subsidiaries it is also

important to determine the net incremental impact of a project's cash flows
overall.
it is important to approach international capital projects from a strategic
viewpoint rather than from a strictly financial perspective.

Risk-adjusted discount rates are rates of return that must be earned on given
projects to compensate the firm's owners adequatelythat is, to maintain or
improve the firm's share price.

Total Risk Non diversible risk +diversible risk

Scenario analysis is a behavioral approach similar to sensitivity analysis but

is broader in scope.
This method evaluates the impact on the firm's return of simultaneous
changes in a number of variables, such as cash inflows, outflows, and the
cost of capital.

Simulation is a statistically based behavioral approach that applies

predetermined probability distributions and random numbers to estimate
risky outcomes.

the following is a way risk management can be used to increase the value of
a firm? a.Risk management can increase debt capacity.

b. Risk management can help a firm maintain its optimal capital budget.
c. Risk management can reduce the expected costs of financial distress.
d. Risk management can help firms minimize taxes.

One objective of risk management can be to reduce the volatility of a firm's

cash flows. True

In theory, reducing the volatility of its cash flows will always increase a
company's value. false

Which of the following statements concerning risk management is NOT

CORRECT? Risk management makes sense for firms directly engaged in
activities that involve commodities whose values can be hedged, and it
doesn't make much sense for most other firms.

Which of the following is NOT a way risk management can be used

toincrease the value of a firm? Risk management can allow managers to
defer receipt of their bonuses and thus postpone tax payments.