Contemporary Financial Management 12th Edition Moyer Test Bank

Contemporary Financial Management
12th Edition Moyer Test Bank

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Chapter 8: ANALYSIS OF RISK AND RETURN
MULTIPLE CHOICE
1. The ____ is a statistical measure of the mean or average value of the possible outcomes.
a. probability distribution
b. standard deviation
c. expected value
d. coefficient of variation
ANS: C PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Expected values
2. The ____ the standard deviation, the ____ the investment.

a. smaller, larger the expected return on
b. larger, riskier
c. smaller, riskier
d. larger, smaller the expected return on
ANS: B PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Standard deviation: An absolute measure of risk
3. The ____ is an absolute measure of risk, and the ____ is a relative measure of risk.
a. systematic risk, unsystematic risk
b. standard deviation, coefficient of variation
c. correlation, covariance
d. security market line, characteristic line
LOC: Understand risk and return TOP: Coefficient of variation: A relative measure of risk
4. When comparing two equal-sized investments, the ____ is an appropriate measure of total risk.
a. standard deviation
b. coefficient of variation
c. correlation
d. covariance
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
5. The slope of the characteristic line for a specific security is an estimate of ____ for that security.
a. beta
b. systematic risk
c. total risk
d. both beta and systematic risk
ANS: D PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking
LOC: Understand risk and return TOP: Beta: A measure of systematic risk
6. The ____ is the ratio of ____ to the ____.

a. standard deviation, covariance, expected value
b. covariance, expected value, standard deviation
c. coefficient of variation, standard deviation, expected value
d. coefficient of variation, systematic risk, expected value
7. The coefficient of variation is a(n) ____ measure of risk.

a. relative
b. absolute
c. systematic
d. unsystematic
8. Values of the ____ can range from +1.0 to -1.0.

a. coefficient of variation
b. correlation coefficient
c. standard deviation
d. covariance
LOC: Understand risk and return
TOP: Investment diversification and portfolio risk analysis
9. The ____ of a portfolio of two or more securities is equal to the weighted average of the ____ of each
of the individual securities in the portfolio.
a. standard deviation, standard deviation
b. risk, risk
c. expected return, expected return
d. standard deviation, risk
LOC: Understand risk and return TOP: Expected returns from a portfolio
10. The primary difference between the standard deviation and the coefficient of variation as measures of
risk is:
a. the coefficient of variation is easier to compute.
b. the standard deviation is a measure of relative risk whereas the coefficient of variation is a
measure of absolute risk.
c. the coefficient of variation is a measure of relative risk whereas the standard deviation is a
measure of absolute risk.
d. the standard deviation is rarely used in practice whereas the coefficient of variation is
widely used.
11. Security A's expected return is 10 percent while the expected return of B is 14 percent. The standard
deviation of A's returns is 5 percent, and it is 9 percent for B. An investor plans to invest equal
amounts in A and B. Which of the following statements is true about this portfolio consisting of stock
A and stock B.
a. The risk of the portfolio is equal to 7 percent.
b. The lower the correlation of returns between the two stocks, the higher the portfolio's risk.
c. The risk of the portfolio is primarily dependent on the utility function of the investor.
d. The higher the correlation of returns between the two stocks, the higher the portfolio's risk.
ANS: D PTS: 1 OBJ: TYPE: Fact
NAT: Reflective thinking | Analytic skills LOC: Understand risk and return
TOP: Portfolio risk
12. Which of the following is not an example of a source of systematic risk?

a. interest rate changes
b. foreign competition with an industry's products
c. changes in the overall economic outlook
d. changes in the inflation rate
LOC: Understand risk and return TOP: Systematic and unsystematic risk
13. The security market line

a. is defined as the slope of a line relating an individual security's return to the returns of
other securities in that firm's primary industry.
b. provides a picture of the risk-return tradeoff required by diversified investors considering
various risky assets.
c. has as its slope the beta of the security
d. is determined by the prevailing level of risk-free interest rates minus a risk premium
LOC: Understand risk and return TOP: Security market line and beta
14. All other things being equal, what is the major impact that an increase in the expected inflation rate
would be expected to have on the security market line?
a. reduce its slope
b. shift it down and to the right
c. shift it up and to the left
d. reduce required returns for investors in any individual asset
LOC: Understand risk and return TOP: Inflation and the security market line
15. Beta is defined as:

a. a measure of volatility of a security's returns relative to the returns of a broad-based
market portfolio of securities.
b. the ratio of the variance of market returns to the covariance of returns on a security with
the market
c. the inverse of the slope of the security regression line
d. all of the above
16. A beta value of 0.5 for a security indicates

a. the security has average systematic risk
b. the security has above-average systematic risk
c. the security has no unsystematic risk
d. the security has below-average systematic risk
17. The security market line can be thought of as expressing relationships between required rates of return
and
a. the time value of money
b. beta
c. total risk
d. portfolio diversification
18. Users of the CAPM should be aware of some of the problems in its practical application. These
problems include which of the following?
a. estimating expected future market returns
b. determining the most appropriate measure of the risk- free rate
c. determining an asset's future beta
d. all of the above are problems in application of the CAPM
LOC: Understand risk and return TOP: Assumptions and limitations of the CAPM
19. Recalling the meaning and calculation of beta, a security that is completely uncorrelated (j,m = 0) with
the market portfolio would have a beta of
a. -1
b. 0
c. +1
d. -100
20. All of the following are primary sources of systematic risk except
a. changes in the amount of foreign competition facing an industry
b. changes in investor expectations about the economy
c. interest rate changes
d. changes in purchasing power
21. The ____ correlated the returns from two securities are, the ____ will be the portfolio effects of risk
reduction.
a. more positively, greater
b. greater, greater
c. less positively, greater
d. lower, lower
LOC: Understand risk and return TOP: Portfolio risk
22. All of the following factors have their primary impact on unsystematic risk except
a. availability of raw materials
b. effects of foreign competition
c. changes in inflation
d. strikes
23. The risk remaining after extensive diversification is primarily:
a. unsystematic risk
b. systematic risk
c. coefficient of variation risk
d. standard deviation risk
24. The most relevant risk that must be considered for any widely traded individual security is its ____.
a. unsystematic risk
b. standard deviation
c. covariance risk
d. systematic risk
25. Texas Computers (TC) stock has a beta of 1.5 and American Water (AW) stock has a beta of 0.5.
Which of the following statements will be true about these securities?
a. The addition of TC would reduce portfolio risk more than the addition of AW.
b. The addition of AW would reduce total portfolio risk more than the addition of TC.
c. The required return for TC is greater than the required return for AW.
d. The required return for AW is greater than the required return of TC.
26. The risk premium for an individual security is equal to the

a. beta times the market return
b. difference between the required return and the risk free rate
c. weighted average of the individual security betas in a portfolio
d. the security's covariance divided by the variance of the market
27. The risk-free rate of return can be thought of as consisting of the following two components:
a. a real rate of return, a default premium
b. unanticipated inflation, bond default premium
c. a real rate of return, an inflation premium
d. a zero beta component, an expectation premium
LOC: Understand risk and return TOP: Inflation and the security market line
28. What will happen to the Security Market Line if: (1) inflation expectations increase, and (2) investors
become more risk averse?
a. shift up and have a steeper slope
b. shift down and have the same slope
c. shift down and have a steeper slope
d. shift up but have less slope
LOC: Understand risk and return TOP: Risk aversion and the security market line
29. Arbitrage pricing theory is a model that relates expected returns on securities to
a. security risk and yield spreads
b. yield spreads and yield curve slope
c. anticipated economic factors
d. multiple risk factors
LOC: Understand risk and return TOP: Arbitrage pricing theory
30. Which of the following is not an approach for managing risk:

a. hedging
b. gaining control over the operating environment
c. limited use of firm-specific assets
d. ignoring systematic risk
LOC: Understand risk and return TOP: Other approaches for managing risk
31. Which of the following (if any) is a relative (rather than absolute) measure of risk?
a. standard deviation
b. standard normal probability distribution
c. expected value
d. coefficient of variation
LOC: Understand risk and return TOP: Meaning and measurement of risk
32. In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset
portfolio, the correlation coefficient between the securities must be ____.
a. less than +1.0
b. equal to 0.0
c. less than 0.0
d. equal to -1.0
33. A portfolio is efficient if ____.

a. for a given standard deviation, there is no other portfolio with a higher expected return
b. for a given expected return, there is no other portfolio with a lower standard deviation
c. its standard deviation is equal to -1.0
d. for a given standard deviation, there is no other portfolio with a higher expected return and
if, for a given expected return, there is no other portfolio with a lower standard deviation
LOC: Understand risk and return TOP: Efficient portfolios and the capital market line
34. In general, when the correlation coefficient between the returns on two securities is ____, the risk of a
portfolio is ____ the weighted average of the total risk of the two individual securities.
a. equal to +1.0; equal to
b. less than +1.0; less than
c. a and b
d. none of the above
35. An increase in the expected future inflation rate has the effect of ____.
a. increasing the slope of the security market line
b. shifting the security market line upward by the amount of the expected increase in
inflation
c. increasing systematic risk
LOC: Understand risk and return TOP: Inflation and the SML
36. An increase in uncertainty regarding the future economic outlook has the effect of ____.
a. increasing the slope of the security market line
b. shifting the security market line upward
c. reducing risk
LOC: Understand risk and return TOP: Inflation and the SML
37. In the ____, the expected return on a security is equal to the risk-free rate plus a single risk premium
that is equal to the product of the expected rate of return on the market portfolio less the risk-free rate
times the sensitivity of the security's returns to the market return.
a. Arbitrage Pricing Theory
b. Capital Asset Pricing Model
c. Dividend Valuation Model
d. Risk premium on debt model
38. The ____ is a relative measure of variability because it measures the risk per unit of expected return.
a. coefficient of variation
b. correlation coefficient
c. covariance
d. standard deviation
LOC: Understand risk and return TOP: Coefficient of variation
39. The security returns from multinational companies tend to have ____ systematic risk than domestic
companies.
a. more
b. less options with
c. less
d. more hedging of
LOC: Understand risk and return TOP: Diversification/multinational corporations
40. Investors generally are considered to be risk ____ because they expect to be compensated for assuming
risk.
a. adverse
b. seekers
c. averse
d. takers
LOC: Understand risk and return TOP: Relationship between risk and return
41. Investors can obtain high returns in their investments if:

a. they use hedging techniques
b. they assume high risks
c. they invest only international securities
d. they invest in legal Ponzi type securities
LOC: Understand risk and return TOP: Ethical issues: High risk securities
42. The term structure of interest rates is the pattern of interest rate yields for debt securities that are
similar in all respects except for differences in
a. tax status
b. liquidity
c. risk of default
d. maturity
LOC: Understand risk and return TOP: The maturity Risk premium
43. The term structure of interest rates is the pattern of interest rate yields for securities that differ only in
a. default risk
b. liquidity premiums
c. the yield to maturity
d. the length of time to maturity
44. The maturity premium reflects a preference by many lenders for

a. shorter maturities
b. reducing yields
c. high yield securities
d. longer maturities
45. The default risk premium reflects the fact that

a. the premium remains constant over time
b. there is a positive relationship between risk and maturity
c. there is a positive relationship between default risk and required returns
d. the premium varies depending on the time to maturity
LOC: Understand risk and return TOP: The default Risk premium
46. The business risk of a firm refers to the

a. results from using fixed-cost sources of funds
b. variability in the price of a firm's securities
c. variability in the firm's operating earnings over time
d. influence of government regulations on business earnings
LOC: Understand risk and return TOP: Business and financial Risk premiums
47. The following yields on 20 year bonds prevailed in January for the three securities shown:
Aa-rated corporate bond 9.98%

Baa-rated corporate bond 10.34%
B-rated corporate bond 11.12%
The difference in yields is due primarily to

a. maturity risk premium
b. default risk premium
c. seniority risk premium
d. financial risk premium
LOC: Understand risk and return TOP: The default Risk premium
48. The ability of an investor to buy and sell a company's securities quickly and without a significant loss
of value is known as the
a. financial risk
b. marketability risk
c. business risk
d. security risk
LOC: Understand risk and return TOP: The marketability Risk premium
49. According to the ____, long-term interest rates are a function of expected short-term interest rates.
a. Maturity theory
b. Expectations theory
c. Market segmentation theory
d. Preferred habitat theory
LOC: Understand risk and return TOP: Maturity Risk premium
50. The term structure of interest rates is related to the ____.

a. default risk premium
b. seniority risk premium
c. marketability risk premium
d. maturity risk premium
51. ____ refers to the ability of an investor to buy and sell a company's securities quickly and without a
significant loss of value.
a. Default risk
b. Business and financial risk
c. Maturity risk
d. Marketability risk
LOC: Understand risk and return TOP: The marketability Risk premium
52. The risk-free rate of return is composed of which of the following elements:
a. risk premium and inflation
b. cost of capital and risk premium
c. real rate of return and risk premium
d. real rate of return and inflation
LOC: Understand risk and return TOP: The risk-free rate of return
53. The two elements that make up the risk-free rate of return are
a. the supply of funds and the demand for funds
b. the yield on 90-day Treasury bills plus an inflation premium
c. the real rate of return plus an inflation premium
d. the required return plus a risk premium
54. The ____ theory of the yield curve holds that required returns on long-term securities tend to be
greater the longer the time to maturity.
a. expectations
b. market segmentation
c. preferred habitat
d. liquidity premium
LOC: Understand risk and return TOP: Maturity Risk premium
55. Business risk is influenced by all the following factors except:

a. variability in interest expenses
b. variability in sales
c. diversity of its product line
d. choice of production technology
LOC: Understand risk and return TOP: Business and financial risk
56. ____ can be achieved by investing in a set of securities that have different risk-return characteristics.
a. Indexing
b. Capital Asset pricing
c. Diversification
d. Asset allocation
57. On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is
obtained by ____.
a. lending money
b. borrowing money
c. reducing risk
d. investing in index funds
LOC: Understand risk and return TOP: Efficient portfolios and the CML
58. Phoenix Company common stock is currently selling for $20 per share. Security analysts at Smith
Blarney have assigned the following probability distribution to the price of (and rate of return on)
Phoenix stock one year from now:
Price Rate of Return Probability

$16 -20% 0.25
20 0% 0.30
24 +20% 0.25
28 +40% 0.20
Assuming that Phoenix is not expected to pay any dividends during the coming year, determine the
expected rate of return on Phoenix Stock.
a. 8%
b. 0%
c. 10%
d. 40%
ANS: A
Solution:
E(R) = -20%(0.25) + 0%(0.30) + 20%(0.25) + 40%(0.20) = 8%
PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

LOC: Understand risk and return TOP: Expected returns

$16 -20% 0.25
20 0% 0.30
24 +20% 0.25
28 +40% 0.20
standard deviation of possible rates of return on Phoenix stock (to the nearest tenth of a percent).
a. 456%
b. 20.9%
c. 2.2%
d. 21.4%
ANS: D
Solution:
Expected return = 8% (See problem 55 solution.)
= [(-20% - 8%)2(0.25) + (0% - 8%)2(0.30) + (20% - 8%)2(0.25)
+ (40% -8%)2(0.20)].5 = 21.4%

LOC: Understand risk and return TOP: Standard deviation
$16 -20% 0.25
20 0% 0.30
24 +20% 0.25
28 +40% 0.20
coefficient of variation for the rate of return on Phoenix stock.
a. 0.0
b. 2.68
c. 2.61
d. 0.275
ANS: B
Solution:
Expected return = 8%; Standard deviation = 21.4%
v = 21.4% / 8% = 2.68

61. The expected rate of return for the coming year on FTC common stock is normally distributed with a
mean of 14% and a standard deviation of 7%. Determine the probability of earning more than 21% on
FTC common stock.
a. 1.00
b. 0.8413
c. 0.0013
d. 0.1587
(Note: Table V is required to work this problem.)

ANS: D
Solution:
z = (21% - 14%) / 7% = 1; From Table V, p = 15.87%
PTS: 1 OBJ: TYPE: E. Prob NAT: Reflective thinking

LOC: Understand risk and return TOP: Normal probability distribution
62. The expected rate of return for the coming year on FTC common stock is normally distributed with a
mean of 14% and a standard deviation of 7%. Determine the probability of earning a negative rate of
return (i.e. less than 0%) on FTC common stock.
a. 0.0228
b. 2.00
c. 0.5000
d. 0.9772
(Note: Table V is required to work this problem.)

ANS: A
Solution:
z = (0% - 14%) / 7% = -2.0; From Table V, p = 2.28%

63. Elephant Company common stock has a beta of 1.2. The risk-free rate is 6 percent and the expected
market rate of return is 12 percent. Determine the required rate of return on the security.
a. 7.2%
b. 14.4%
c. 19.2%
d. 13.2%
ANS: D
Solution:
kj = 6% + 1.2(12% - 6%) = 13.2%
PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic thinking

LOC: Understand risk and return TOP: Security market line
An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25
percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on
Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12
percent. The correlation between the returns for Gamma and Epsilon is +0.8.
64. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25
percent. The correlation between the returns for Gamma and Epsilon is +0.8.Determine the expected
return on the investor's portfolio.
a. 14%
b. 12%
c. 13%
d. 9%
ANS: B
Solution:
E(Rp) =0 .75(12%) + 0.25(16%) = 13%

LOC: Understand risk and return TOP: Portfolio expected returns
65. An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25
percent. The correlation between the returns for Gamma and Epsilon is +0.8.Determine the standard
deviation of returns for this investor's portfolio.
a. 73.8%
b. 6.71%
c. 3.00%
d. 8.59%
ANS: D
Solution:
p=[(0.75)2(8%)2 +(0.25)2(12%)2 +2(0.75)(0.25)(0.8)(8%)(12%)].5
= 8.59%

66. Compute the risk premium for the stock of Omega Tools if the risk-free rate is 6%, the expected
market return is 12%, and Omega's stock has a beta of .8.
a. 10.8%
b. 4.8%
c. 48.0%
d. 16.8%
ANS: B
Solution:
Risk premium = 0.8(12% - 6%) = 4.8%

LOC: Understand risk and return TOP: Risk premium
67. The return expected from a risky investment is 24 percent, and the standard deviation of this return is
17 percent. If returns from this investment are normally distributed, what is the probability that the
investment may earn a negative rate of return? (Note: Table V is required to work this problem.)
a. 8.33%
b. 7.93%
c. 6.88%
d. 5.44%
ANS: B
Solution:
z = (0% - 24%) / 17% = - 1.41; From Table V, p = 7.93%

68. The expected rate of return for 3COM is 18 percent, with a standard deviation of 10.98 percent. The
expected rate of return for Just the Fax is 26 percent with a standard deviation of 15.86%. Which firm
would be considered the riskier from a total risk perspective?
a. 3COM
b. Just the Fax
c. Neither, both have the same risk
d. Cannot be determined
ANS: C
Solution:
3COM: v = 10.98% /18% = 0.61
Just the Fax: v = 15.86% / 26% = 0.61

69. Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an
expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is
Don's expected return on his portfolio?
a. 12.42%
b. 12.20%
c. 11.81%
d. Cannot be determined
ANS: A
Solution:
E(Rp) = (3/19)11.6% + (10/19)12.8% + (6/19)12.2% = 12.42%

70. Sally's broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities
have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the
expected return of the remaining portion of her portfolio?
a. 20.9%
b. 18.8%
c. 12.5%
d. cannot be determined
ANS: B
Solution:
14.2% - 0.4(10.3%) - 0.2(12.8%) = 0.4 X
X = 18.8%

71. Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the
portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to
1.15 by selling the riskiest security and replacing it with another security with a lower beta. What must
be the beta of the replacement security?
a. 1.21
b. 0.91
c. 0.73
d. 1.62
ANS: C
Solution:
To find the beta for the 7 securities:
1.28 = 7/8(x) + 1/8(1.75)
x = 1.21
New security's beta would be:
1.15 = 7/8 (1.21) + 1/8 beta
beta = 0.73

LOC: Understand risk and return TOP: Portfolio beta calculation
72. A college student owns two securities: Apple and Coca- Cola. Apple has an expected return of 15
percent with a standard deviation of those returns being 11 percent. Coca-Cola has an expected return
of 12 percent, and a standard deviation of 7 percent. The correlation of returns between Apple and
Coca-Cola is 0.81. If the portfolio consist of $6,000 in Coca-Cola and $4,000 in Apple, what is the
expected standard deviation of portfolio returns?
a. 8.18%
b. 13.20%
c. 8.60%
d. 9.71%
ANS: A
Solution:
p = [(.6)2(.07)2+(.4)2(.11)2+2(.6)(.4)(.07)(.11)(.81)].5
= 0.0818

LOC: Understand risk and return TOP: Portfolio risk calculation
73. Assume you want to construct a portfolio with a 14 percent return from the following two securities:
Security Expected Return Beta

1 16% 1.12
2 12.5% 0.94
What percentage of your portfolio should be invested in Security 1?

a. 57%
b. 47%
c. 43%
d. 53%
ANS: C
Solution:
0.14 = X (0.16) + (1 - X)(0.125)
X = 0.43

LOC: Understand risk and return TOP: Portfolio expected returns
74. Over the 10-year period from 1978 through 1987, the compound annual rate of return on U.S. Treasury
bills was 9.17 percent. Over the same time period, the average annual inflation rate was 6.39 percent.
Therefore,
a. the inflation premium was 2.78 percentage points
b. the real expected rate of return was 9.17 percentage points
c. the realized real rate of return was 2.78 percentage points
d. the required rate of return was 6.39 percentage points
ANS: C
Solution:
9.17% - 6.39% = 2.78%

75. The real rate of interest is expected to be 3 percent and the expected rate of inflation for next year is
expected to be 5.5 percent. If the default risk premium is 1.1 percentage points, and the seniority risk
premium is 0.4 percentage points, what is the required return on a 1 year U.S. Treasury security?
a. 9.6%
b. 10.0%
c. 8.5%
d. 8.9%
ANS: C
Solution:
Required return = 3% + 5.5% = 8.5%

LOC: Understand risk and return TOP: Required return calculation
76. If the return on U.S. Treasury bills is 7.02%, the risk premium is 2.32%, and the inflation rate is
4.16%, then the real rate of return is:
a. 2.86%
b. 7.02%
c. 4.70%
d. 6.48%
ANS: A
Solution:
7.02% - 4.16% = 2.86%

77. The yield to maturity on ACL bonds maturing in 2005 is 8.75 percent. The yield to maturity on a
similar maturity U.S. Government Treasury bond in 7.06 percent and the yield on Treasury bills is
6.51 percent. What is the default risk premium on the ACL bond?
a. 2.24%
b. 1.69%
c. 0.55%
d. 8.75%
ANS: B
Solution:
Risk premium = 8.75% - 7.06% = 1.69%

78. The risk-free rate of return is 5.51 percent, based on an expected inflation premium of 2.54 percent.
The expected return on the market is 12.8 percent. What is the required rate of return for Envoy
common stock which has a beta of 1.35?
a. 6.98%
b. 16.24%
c. 15.35%
d. 12.80%
ANS: C
Solution:
kj = 5.51 + 1.35(12.8-5.51) = 15.35%

LOC: Understand risk and return TOP: Required return
79. Determine the beta of a portfolio consisting of equal investments in the following common stocks:
Security Beta
Apple Computer 1.15
Coca-Cola 1.05
Harley-Davidson 1.50
Homestake Mining 0.50
a. 1.05
b. 1.00
c. 1.10
d. 0.95
ANS: A
Solution:
Bp = .25(1.15) + .25(1.05) + .25(1.50) + .25(.50) = 1.05

LOC: Understand risk and return TOP: Portfolio beta
80. Twin City Knitting (TCK) pays a current dividend of $2.20 and dividends are expected to grow at a
rate of 7 percent annually in the foreseeable future. The beta of TCK is 1.2. If the risk-free rate is 9.2
percent and the market risk premium is 6 percent, at what price would you expect TCK's common
stock to sell?
a. $14.35
b. $33.63
c. $23.40
d. $25.04
ANS: D
Solution:
ke = 0.092 + 1.2(0.06) = 0.164 or 16.4%
ke = $2.20 (1.07)/P0 + 0.07 = 0.164
P0 = $2.354 /0.094 = $25.04
PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

LOC: Understand risk and return TOP: Security market line and valuation
81. Micromatic is considering expanding into a new product area. Micromatic's current beta is 1.2 and its
beta is expected to increase to 1.45 after the expansion. The long-term growth rate of the firm's
earnings is expected to increase from 6.5 percent to 10 percent. Micromatic's current dividend is $1.70
per share, the current risk-free rate is 9.1 percent, and the expected market return is 12.9 percent.
Should Micromatic undertake the planned expansion?
a. No, stock price decreases $10.15
b. Yes, stock price increases $15.27
c. Yes, stock price increases $0.45
d. No, stock price decreases $15.27
ANS: B
Solution:
Current ke = 0.091 + 1.2 (0.129 - 0.091) = 0.1366 or 13.66%
Current P = $1.70(1.065) / (0.1366 - 0.065) = $25.29
New ke = 0.091 + 1.45(0.129 - 0.091) = 0.1461
New P = $1.70 (1.10) / (0.1461 - 0.10) = $40.56

LOC: Understand risk and return TOP: Security market line and valuation
82. Quick Start, Inc. is expected to pay a dividend of $1.05 next year and dividends are expected to
continue their 7 percent annual growth rate. The SML has been estimated as follows:
kj = 0.08 + 0.064j
If Quick Start has a beta of 1.1, what would happen to its stock price if inflation expectations went
from the current 5 percent to 8 percent?
a. decrease $8.14
b. decrease $3.55
c. decrease $3.18
d. stock price will not change
ANS: B
Solution:
Current ke = 0.08 + 0.064(1.1) = 0.1504
Current P = $1.05/(0.1504 - 0.07) = $13.06
New ke = 0.11 + .064(1.1) = 0.1804
New P = $1.05/(0.1804 - 0.07) = $9.51
P = $3.55

LOC: Understand risk and return TOP: Security market line | Valuation and inflation
83. Richtex Brick has a current dividend of $1.70 and the market value of its common stock is $28. The
expected market return is 13 percent and the risk-free rate is 9 percent. If Richtex stock is half as
volatile as the market, and the market is in equilibrium, what rate of growth is expected for Richtex's
dividends assuming a constant growth valuation model is appropriate for Richtex?
a. 4.93%
b. 4.65%
c. 5.37%
d. 5.41%
ANS: B
Solution:
ke = 0.09 + 0.5(0.13 - 0.09) = 0.11
$28 = $1.70(1+g) / (0.11 - g)
g = 0.04646 or 4.65%

LOC: Understand risk and return TOP: Systematic risk and valuation
84. AKA's stock is currently selling for $11.44. This year the firm had earnings per share of $2.80 and the
current dividend is $0.68. Earnings are expected to grow 7% a year in the foreseeable future. The
risk-free rate is 10 percent and the expected market return is 14.2 percent. What will be the effect on
the price of AKAs' stock if systematic risk increases by 40 percent, all other factors remaining
constant?
a. an increase of $1.14
b. a decrease of $0.40
c. a decrease of $1.99
d. cannot determine from the given data
ANS: C
Solution:
Old ke = 0.10 + j(0.142 - 0.10) = 0.10 + 0.042j
P = $0.68(1.07)/(0.10 + 0.042j - 0.07) = $11.44
j = 0.80
New ke = 0.10 + 0.8(1.4)(0.042) =0 .147
P =$ 0.7276/(0.147 - 0.07) = $9.45
A decrease of $1.99 a share

85. Given the following information on securities E and F, calculate the expected return and standard
deviation of returns on a portfolio consisting of 40% invested in E and 60% invested in F.
Security E Security F
Expected Return 12% 15%
Standard Deviation of Returns 10% 20%
Correlation coefficient of returns -0.50
a. 13.5%; 15%
b. 13.8%; 14.4%
c. 13.8%; 10.6%
d. 13.5%; 8.7%
ANS: C
Solution:
Rp = we Re + wf Rf
Rp = 0.40 (12%) + 0.60 (15%) = 13.8%
p = [(.40)2 (10)2 + (.60)2 (20)2 + 2 (.40) (.60) (-0.50) (10) (20)].5
= 10.6%

LOC: Understand risk and return TOP: Portfolio risk and return
86. Gates Industries current common stock dividend (year 0) is $2.50 per share and is expected to continue
growing at a rate of 5% per year for the foreseeable future. Currently the risk-free rate is 7.5% and the
estimated market risk premium (i.e., km - rf) is 8.3%. Value Line has estimated Gates Industries beta to
be 1.10. Determine the expected price for Gates Industries common stock.
a. $21.50
b. $15.03
c. $15.78
d. $22.57
ANS: D
Solution:
ke = 7.5% + 1.10 (8.3%) = 16.63%
P0 = $2.50(1.05)/(0.1663 - 0.05) = $22.57

87. An investor, who believes the economy is slowing down, wishes to reduce the risk of her portfolio.
She currently owns 12 securities, each with a market value of $3,000. The current beta of the portfolio
is 1.21 and the beta of the riskiest security is 1.62. What will the portfolio beta be if the riskiest
security is replaced with a security of equal market value but a beta of 0.80?
a. 1.14
b. 1.18
c. 1.05
d. 1.10
ANS: A
Solution:
1.21 = 11/12(x) + 1/12(1.62) so x = 1.17
portfolio beta = 11/12(1.17) + 1/12(.80) = 1.14
LOC: Understand risk and return TOP: Portfolio beta calculation
88. Assume that the rate of return on Calengry common stock over the coming year is normally distributed
with an expected value of 16% and a standard deviation of 20%. What is the probability of earning a
negative rate of return? (Note: Table V is required to work this problem.)
a. 10.56%
b. 40.13%
c. 21.19%
d. 3.59%
ANS: C
Solution:
z = 0 - 16 = -0.8 p = 0.2119 or 21.19%
20

LOC: Understand risk and return TOP: Probability distributions
89. Determine the beta of a portfolio consisting of the following common stocks:
Security Market Value Beta

Boeing $5,000 1.2
Exxon $4,000 0.8
Duke Power $2,500 0.6
Blockbuster Video $2,000 1.4
Coca-Cola $7,500 1.0
a. 0.93
b. 0.85
c. 1.00
d. 1.14
ANS: C
Solution:
p = (5/21)1.2 + (4/21)0.8 + (2.5/21)0.6 + (2/21)1.4 + (7.5/21)1.0
p = 1.00

90. HDTV has planned on diversifying into the dual-VCR field. As a result, HDTV's beta would rise to
1.6 from 1.2 and the expected future long-term growth rate in the firm's earnings would increase from
12% to 16%. The expected market return, km, is 14%; the risk free rate, rf, is 7%; and the current
dividend, Do, is $0.50. Should HDTV go into the dual-VCR field?
a. No-stock price decrease $7.82
b. Yes-stock price increase $9.89
c. Yes-stock price increase $3.81
d. No-stock price decrease $3.78
ANS: B
Solution:
kold = .07 +1.2(.14-.07) = .154
knew = .07 +1.6(.07) = .182
Po = .50(1.12)/(.154 - .12) = $16.47
Pn = .50(1.16)/(.182 - .16) = $26.36

LOC: Understand risk and return TOP: Constant growth rate model
91. Christy is considering investing in the common stock of One Liberty and Heico. The following data
are available for these two securities:
One Liberty Heico

Expected return .12 .16
Standard deviation of returns .08 .20
If she invests 30% of her funds in Heico and 70% in One Liberty, and if the correlation of returns
between these securities is +0.65, what is the portfolio's expected return and standard deviation?
a. 14% and 15.67%
b. 14.8% and 9.44%
c. 13.2% and 10.54%
d. 13.1% and 9.67%
ANS: C
Solution:
Rp = 0.3(0.16) + 0.7(0.12) = 0.132 or 13.2%
p= [0.32(0.20)2 + 0.72(0.08)2 + 2(0.3)(0.7)(0.08)(0.20)(0.65)].5
= 0.1054 or 10.54%

LOC: Understand risk and return TOP: Portfolio risk and return
92. Jim Bowles is an investor who believes the economy is gaining strength and, therefore, wishes to
increase the risk of his 14 security portfolio. Each security has a current market value of $5,000 and
the current beta of the portfolio is 1.02. The beta of the least risky security is .76. If Jim replaces the
least risky security with another security with the same market value but a beta of 1.45, what will the
portfolio beta be then?
a. 1.03
b. 1.07
c. 1.08
d. 1.04
ANS: B
Solution:
1.02 = (13/14)(X) + (1/14)(.76)
So X = 1.04
p = (13/14)(1.04) + (1/14)(1.45)
= 1.069

93. Kermit Industries current common stock dividend is $1.35 per share and the dividend is expected to
grow at 6% per year into the foreseeable future. Currently the risk-free rate is 4.5% and the estimated
market risk premium is 8.5%. Merrill Lynch has estimated KI's beta to be 1.10. Compute the expected
price for KI's common stock.
a. $17.20
b. $10.33
c. $18.23
d. $49.35
ANS: C
Solution:
ke = .045 + 1.10(0.085) = 0.1385
P0 = $1.35(1.06) / (0.1385 - 0.06) = $18.23

94. Determine the beta of a portfolio consisting of the following common stocks:
Security Market Value Beta

Glaxo $2,600 1.24
SCANA 3,700 .88
BancOne 2,900 .95
Pepsi 3,400 1.05
AFLAC 3,000 1.09
Votec 4,400 1.41
a. 1.00
b. 1.12
c. 1.09
d. 1.11
ANS: D
Solution:
p = 2.6 / 20(1.24) + 3.7 / 20(.88) + 2.9 / 20(.95) + 3.4 / 20(1.05)
+ 3.0 / 20(1.09) + 4.4 / 20(1.41)
= 1.11

95. The beta of Sanafil is 1.2. Sanafil is evaluating a merger with Matra, a firm that has a beta of 0.95.
Sanafil's stock sells for $40 per share and there are 10 million shares outstanding. Matra's stock sells
for $60, but there are only 2 million shares outstanding. If these two firms merge, what will be the
merged firm's beta?
a. 1.00
b. 1.14
c. 1.05
d. 1.16
MVS = $40(10,000,000) = $400,000,000
MVM = $60(2,000,000) = $120,000,000
ANS: B
Solution:
p = (120 / 520)(0.95) + (400 / 520)(1.2) = 1.14

96. Lotte Group is planing on diversifying into the transportation industry. As a result, Lotte's beta would
rise to 1.3 from 1.1 and the expected long-term growth rate in the firm's earnings would increase from
11% to 14%. Currently the risk-free rate is 5.0% and the market risk premium is 8.6%. If Lotte's
current dividend is $1.30, should Lotte diversify into the transportation industry?
a. No, stock price does not increase
b. No, stock price declines about $10.11
c. Yes, stock price increases about $19.42
d. Yes, stock price increases by about $26.27
ANS: D
Solution:
kold = 0.05 + 1.1(0.086) = 0.1446
P0 = $1.30(1.11) / (0.1446 - 0.11) = $41.71
knew = 0.05 + 1.3(0.086) = 0.1618
Pnew = $1.30(1.14) / (0.1618 - 0.14) = $67.98

LOC: Understand risk and return TOP: Systematic risk evaluation
97. Security A offers an expected return of 14% with a standard deviation of 8%. Security B offers an
expected return of 11% with a standard deviation of 6%. If you wish to construct a portfolio with a
12.8% expected return, what percentage of the portfolio will consist of security A?
a. 55%
b. 60%
c. 65%
d. 45%
ANS: B
Solution:
wA = (12.8 - 11.0) / (14 - 11) = 0.60 or 60%

LOC: Understand risk and return TOP: Risk
98. Which of the following statements is/are correct?

I. Unsystematic risk can be eliminated through diversification.
II. Unsystematic risk is the relevant portion of an asset’s risk attributable to market factors that affect
all firms, like inflation, political events, etc.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
ANS: A PTS: 1 OBJ: TYPE: Fact NAT: Reflective skills
99. Correlation is a statistical measure of the relationship between a series of numbers representing data.
Which of the following statements about correlation is/are correct?
I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation
coefficient of -1.
II. Perfectly positively correlated describes two positively correlated stocks that have a correlation
coefficient of 0.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
100. Total risk of a security can be viewed as consisting of two parts. Which of the following apply?
I. verifiable risk
II. non-verifiable risk
a. I only
b. II only
c. Both I and II
d. Neither I nor II
101. All of the following statements about risk are correct EXCEPT:
a. Risk can be defined as the chance for financial loss.
b. The term risk is used interchangeably with uncertainty.
c. Risk refers to the certainty of returns associated with a given asset.
d. The more certain the return from an asset, the less variability and therefore less risk.
LOC: Understand risk and return TOP: Risk
102. Which of the following statements regarding risk is/are correct?

I. A portfolio of two negatively correlated assets has less risk than either of the individual assets and
risk could be further reduced to 0 or below.
II. There is no case where creating a portfolio of assets will result in greater risk than that of the
riskiest asset included in the portfolio.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
103. What kind of probability distribution shows all possible outcomes for a given event?
a. discrete
b. expected value
c. bar chart
d. continuous
104. That portion of the risk premium that is based on the ability of the borrower to repay principal and
interest is the:
a. Maturity risk
b. Default risk
c. Seniority risk
d. Business risk
105. An investor, by investing in combinations of stocks, develops a ____ portfolio

a. simple
b. structured
c. diversified
d. energetic
106. What is the beta of the following project?

Comparative Returns on Past Projects Project’s Returns
12% 15%
10% 8%
6.5% 7%
2% -1%
a. 1.11
b. .95
c. 2.15
d. 1.43
ANS: D
Answer was determined by using the statistical function on a financial calculator.

107. Find beta and determine the required rate of return. The market risk premium is 12% and the risk-free
rate is 5%.
Comparative Returns in the Market Returns on the Stock
8% 4%
9% 10%
2% 1%
10% 6%
a. 12.61%
b. 8.27%
c. 10.11%
d. 14.84%
ANS: D
Answer was determined by using the statistical function on a financial calculator.
Beta = .82
RRR = 5% + .82(12%)
= 14.84%

108. Find beta and determine the risk premium. The market risk premium is 8% and the risk-free rate is 2%.
Comparative Returns in the Market Returns on the Stock
10% 8%
11% 12%
6% 2%
5% 1%
a. 16.82%
b. 20.76%
c. 10.15%
d. 18.11%
ANS: B
The answer was determined by using the statistical function on a financial calculator
Beta is 1.73
Risk premium = 1.73(12)
= 20.76% (The risk-free rate is surplus information)

ESSAY
1. What is an efficient portfolio?
ANS:
A portfolio is efficient if, for a given standard deviation, there is no other portfolio with a higher
expected return, or for a given expected return, there is no other portfolio with a lower standard
deviation. An efficient portfolio maximizes return for a given level of risk, or minimizes risk for a
given rate of return.
PTS: 1 OBJ: TYPE: Fact NAT: Reflective thinking

LOC: Understand risk and return TOP: Efficient portfolios and the capital market line
2. List types of events that influence systematic (non-diversifiable) risk.
ANS:
Events that are broad in scope and affect the market as a whole will impact systematic risk. These
events include:
war inflation
political events interest rate changes
international incidents changes in investor expectations about the overall
economy

3. List the various risk elements that are considered when determining the risk premium.
ANS:
The risk elements include:
1. maturity risk premium
2. default risk premium
3. seniority risk premium
4. marketability risk premium

4. How can standard deviation, a statistical measure of dispersion, be used in investment analysis?
ANS:
The standard deviation can be used to measure the variability of return from an investment. It gives
and indication of the risk involved in the asset or security. The larger the standard deviation, the more
variable an investment’s return and thus the riskier the investment.

5. Explain marketability risk and marketability premium.
ANS:
Marketability risk refers to the ability of an investor to buy and sell a company’s securities quickly and
without a significant loss of value. Usually the stock of companies listed on the NYSE is considered
easy to sell and has a ready buyer. The marketability risk premium is that extra interest rate charged on
loans to companies whose stock may not be easy to sell. The lender, in order to be adequately
compensated for the risk taken in making the loan, receives a higher return.

6. Why is risk an increasing function of time?
ANS:
Investment decisions require that returns be forecasted several years into the future. The riskiness of
these forecasted returns may be thought of as an increasing function of time. Returns that are generated
early can generally be predicted with more certainty than those that are anticipated farther out into the
future. The farther into the future that performance is forecasted, the greater the chance that the
forecast will be incorrect. Even though cash flows from an investment or project may be equal each
year, it is reasonable to assume that the riskiness of these flows increases over time as more and more
presently unknown variables have a chance to affect the investment’s or project’s cash flows.

LOC: Understand risk and return TOP: Rusk as an Increasing Function of Time

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Contemporary Financial Management 12th Edition Moyer Test Bank

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Contemporary Financial Management

12th Edition Moyer Test Bank

2. The ____ the standard deviation, the ____ the investment.

6. The ____ is the ratio of ____ to the ____.

7. The coefficient of variation is a(n) ____ measure of risk.

8. Values of the ____ can range from +1.0 to -1.0.

12. Which of the following is not an example of a source of systematic risk?

13. The security market line

15. Beta is defined as:

16. A beta value of 0.5 for a security indicates

26. The risk premium for an individual security is equal to the

30. Which of the following is not an approach for managing risk:

33. A portfolio is efficient if ____.

41. Investors can obtain high returns in their investments if:

44. The maturity premium reflects a preference by many lenders for

45. The default risk premium reflects the fact that

46. The business risk of a firm refers to the

Aa-rated corporate bond 9.98%

The difference in yields is due primarily to

50. The term structure of interest rates is related to the ____.

55. Business risk is influenced by all the following factors except:

Price Rate of Return Probability

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

Price Rate of Return Probability

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

(Note: Table V is required to work this problem.)

PTS: 1 OBJ: TYPE: E. Prob NAT: Reflective thinking

(Note: Table V is required to work this problem.)

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic thinking

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

Security Expected Return Beta

What percentage of your portfolio should be invested in Security 1?

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: E. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

Security Market Value Beta

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

One Liberty Heico

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

PTS: 1 OBJ: TYPE: C. Prob NAT: Analytic skills

2. The the standard deviation, the the investment.

6. The is the ratio of to the .