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Solutions to Ch 8 Intermediate Accounting I

Solutions to Ch 8 Intermediate Accounting I

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i

. Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following

statements must be true about these securities? (Assume the market is in

equilibrium.)

b. Stock B would be a more desirable addition to a portfolio than

Stock A.

c. Stock A would be a more desirable addition to a portfolio than

Stock B.

d. The expected return on Stock A will be greater than that on Stock B.

e. The expected return on Stock B will be greater than that on Stock A.

ii

. Stock A and Stock B both have an expected return of 10 percent and a standard

deviation of 25 percent. Stock A has a beta of 0.8 and Stock B has a beta of 1.2.

The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a

portfolio with 50 percent invested in Stock A and 50 percent invested in Stock B.

Which of the following statements is most correct?

b. Portfolio P has more market risk than Stock A but less market risk than Stock

B.

c. Portfolio P has a standard deviation of 25 percent and a beta of 1.0.

d. All of the statements above are correct.

e. None of the statements above is correct.

iii

. Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8

percent, and a standard deviation of 25 percent. Becky has a $50,000 portfolio

with a beta of 0.8, an expected return of 9.2 percent, and a standard deviation of

25 percent. The correlation coefficient, r, between Bobs and Beckys portfolios is

0. Bob and Becky are engaged to be married. Which of the following best

describes their combined $100,000 portfolio?

a. The combined portfolios expected return is a simple average of the expected

returns of the two individual portfolios (10%).

b. The combined portfolios beta is a simple average of the betas of the two

individual portfolios (1.0).

c. The combined portfolios standard deviation is less than a simple average of

the two portfolios standard deviations (25%), even though there is no

correlation between the returns of the two portfolios.

d. Statements a and b are correct.

e. All of the statements above are correct.

iv

. The risk-free rate is 5 percent. Stock A has a beta = 1.0 and Stock B has a beta =

1.4. Stock A has a required return of 11 percent. What is Stock Bs required

return?

a. 12.4%

b. 13.4%

c. 14.4%

d. 15.4%

e. 16.4%

v

. Below are the stock returns for the past five years for Agnew

Industries:

2002 22%

2001 33

2000 1

1999 -12

1998 10

period? (Use the population standard deviation to calculate the

coefficient of variation.)

a. 10.80

b. 1.46

c. 15.72

d. 0.69

e. 4.22

vi

. T. Martell Inc.'s stock has a 50% chance of producing a 32.2% return, a

35% chance of producing a 9% return, and a 15% chance of producing a -

25% return. What is Martell's expected return?

a.

14.4%

b.

15.5%

c.

16.0%

d.

16.8%

e.

17.6%

vii

. Parr Paper's stock has a beta of 1.442, and its required return is 13.00%. Clover

Dairy's stock has a beta of 0.80. If the risk-free rate is 4.00%, what is the

required rate of return on Clover's stock? (Hint: First find the market risk

premium.)

a. 8.55%

b. 8.71%

c. 8.99%

d. 9.14%

e. 9.33%

viii

. Suppose you hold a diversified portfolio consisting of a $10,000 invested equally

in each of 10 different common stocks. The portfolios beta is 1.120. Now

suppose you decided to sell one of your stocks that has a beta of 1.000 and to

use the proceeds to buy a replacement stock with a beta of 2.260. What would

the portfolios new beta be?

a. 0.982

b. 1.017

c. 1.195

d. 1.246

e. 1.519

ix

. Assume the risk-free rate is 5% and that the market risk premium is 6.20%. If a

stock has a required rate of return of 12.75%, what is its beta?

a. 1.11

b. 1.25

c. 1.06

d. 1.60

e. 1.96

x

. An investor is forming a portfolio by investing $50,000 in stock A that has a beta

of 1.50, and $25,000 in stock B that has a beta of 0.90. The market risk premium

is equal to 2% and Treasury bonds have a yield of 4%. What is the required rate

of return on the investors portfolio?

a. 6.8%

b. 6.6%

c. 5.8%

d. 7.0%

e. 7.5%

xi

. Your portfolio consists of $100,000 invested in a stock that has a beta = 0.8,

$150,000 invested in a stock that has a beta = 1.2, and $50,000 invested in a

stock that has a beta = 1.8. The risk-free rate is 7%. Last year this portfolio had

a required return of 13%. This year nothing has changed except that the market

risk premium has increased by 2%. What is the portfolios current required rate of

return?

a. 5.14%

b. 7.14%

c. 11.45%

d. 15.33%

e. 16.25%

xii

. Which of the following statements is CORRECT? (Assume that the risk-free rate

is a constant.)

a. If the market risk premium increases by 1%, then the required return on all

stocks will rise by 1%.

b. If the market risk premium increases by 1%, then the required return will

increase for stocks that have a positive beta, but it will decrease for stocks

that have a negative beta.

c. If the market risk premium increases by 1%, then the required return will

increase by 1% for a stock that has a beta of 0.50.

d. The effect of a change in the market risk premium on the required rate of

return depends on the level of the risk-free rate.

e. The effect of a change in the market risk premium on the required rate of

return depends on the slope of the yield curve.

xiii

. Stock A and Stock B both have an expected return of 10% and a standard

deviation of returns of 25%. Stock A has a beta of 0.8 and Stock B has a beta of

1.2. The correlation coefficient, r, between the two stocks is 0.6. Portfolio P is a

portfolio with 50% invested in Stock A and 50% invested in Stock B. Which of the

following statements is CORRECT?

b. Portfolio P has more market risk than Stock A but less market risk than Stock

B.

c. Portfolio P has a standard deviation of 25% and a beta of 1.0.

d. Based on the information we are given, and assuming those are the views of

the marginal investor, it is apparent that the two stocks are in equilibrium.

e. Stock A should have a higher expected return than Stock B as viewed by the

marginal investor.

xiv

. Assume that the risk-free rate is 5%. Which of the following statements is

correct?

b. If a stocks beta doubled, its required return would more than double.

c. If a stocks beta were 1.0, its required return would be 5%.

d. If a stocks beta were less than 1.0, its required return would be less than 5%.

e. If a stock has a negative beta, its required return would be less than 5%.

i. Beta coefficient Answer: d Diff: E

The standard deviation of the portfolio will be less than the weighted

average of the two stocks standard deviations because the correlation

coefficient is less than one. Therefore, although the expected return on the

portfolio will be the weighted average of the two returns (10 percent), the

CV will not be equal to 25%/10%. Therefore, statement a is false. Remember,

market risk is measured by beta. The beta of the portfolio will be the

weighted average of the two betas; therefore, it will be less than the beta

of the high-beta stock (B), but more than the beta of the low-beta stock (A).

Therefore, the market risk of the portfolio will be higher than As, but

lower than Bs. Therefore, statement b is correct. Because the correlation

between the two stocks is less than one, the portfolios standard deviation

will be less than 25 percent. Therefore, statement c is false.

Step 1: We must determine the market risk premium using the CAPM equation with data

inputs for Stock A:

kA = kRF + (kM kRF)bA

11%= 5% + (kM kRF)1.0

6% = (kM kRF).

Step 2: We can now find the required return of Stock B using the CAPM equation with data

inputs for Stock B:

kB = kRF + (kM kRF)bB

kB = 5% + (6%)1.4

kB = 13.4%.

Using your financial calculator you find the mean to be 10.8% and the

population standard deviation to be 15.715%. The coefficient of variation is

just the standard deviation divided by the mean, or 15.715%/10.8% = 1.4551

1.46.

1.00 15.50%

Beta: Parr 1.442

Beta: Clover 0.80

Risk-free rate 4.00%

Required return 13.00%

Market risk premium 6.24%

Number of stocks 10

Portfolio beta 1.120

Stock thats sold 1.000

Stock thats bought 2.260

12.75% = 5% + 6.2%(b)

7.75% = 6.2%(b)

b = 1.25.

The portfolios beta is a weighted average of the individual security betas as follows:

simply: 4% + 2%(1.3) = 6.6%.

xi. CAPM and portfolio return Answer: d

bp = $300,000 (0.8) + $300,000 (1.2) + $300,000 (1.8)

bp = 1.1667.

13% = 7% + RPM(1.1667)

6% = RPM(1.1667)

RPM= 5.1429%.

This year:

r = 7% +(5.1429% + 2%)1.1667

r = 15.33%.

Statement a is false, because if the market risk premium (measured by r M - rRF) goes up by 1.0, then the

required return for each stock will change by its beta times 1.0. Statement b is true, because as shown

in statement a, the required returns on all positive-beta stocks will increase, although negative betas will

result in decreases. Statement c is false, because if the market risk premium increases by 1%, then the

required return increases by 0.5 times the stocks beta. Therefore, the required return of a stock with a

beta of 1.0 will increase by 0.5%. Statements d and e are false.

The standard deviation of the portfolio will be less than the weighted average of the two

stocks standard deviations because the correlation coefficient is less than one. Therefore,

although the expected return on the portfolio will be the weighted average of the two returns

(10%), the CV will not be equal to 25%/10%. Therefore, statement a is false. Remember,

market risk is measured by beta. The beta of the portfolio will be the weighted average of the

two betas; therefore, it will be less than the beta of the high-beta stock (B), but more than the

beta of the low-beta stock (A). Therefore, the market risk of the portfolio will be higher than

As, but lower than Bs. Therefore, statement b is correct. Because the correlation between

the two stocks is less than one, the portfolios standard deviation will be less than 25%.

Therefore, statement c is false. Statements d and e are false, because Stock B has a higher

beta and consequently a higher required return, but the stocks have the same expected

returns.

From the CAPM equation: rs = rRF + (rM rRF)b, statement e is the only correct answer.

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