Principles of Corporate Finance 12th Edition Brealey Test Bank

Principles of Corporate Finance 12th
Edition Brealey Test Bank

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1. Which of the following portfolios has the least risk?
A. A portfolio of Treasury bills

B. A portfolio of long-term U.S. government bonds
C. A portfolio of U.S. common stocks of small firms
D. A portfolio of U.S. common stocks of large firms
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Difficulty: Basic
2. For long-term U.S. government bonds, which risk concerns investors the most?
A. Interest rate risk

B. Default risk
C. Market risk
D. Liquidity risk

Difficulty: Intermediate
3. What has been the average annual real rate of interest on Treasury bills over the past 114 years (from 1900
to 2014)?
A. Less than 2 percent

B. Between 2 percent and 3 percent
C. Between 3 percent and 4 percent
D. Greater than 4 percent

Difficulty: Basic
4. What has been the average annual nominal rate of interest on Treasury bills over the past 114 years (1900
to 2014)?

Difficulty: Basic
5. What has been the average annual nominal rate of return on a portfolio of U.S. common stocks over the past
114 years (from 1900 to 2014)?


Difficulty: Basic
6. One dollar invested in a portfolio of long-term U.S. government bonds in 1900 would have grown in nominal
value by the end of year 2014 to
A. $719.
B. $66.
C. $74.
D. $278.
7. One dollar invested in a portfolio of U.S. common stocks in 1900 would have grown in nominal value by the end
of year 2014 to
A. $38,255.
B. $245.
C. $74.
D. $6.

8. What has been the average annual rate of return in real terms for a portfolio of U.S. common stocks
between 1900 and 2014?


9. Which portfolio has had the lowest average annual nominal rate of return during the 1900 to 2014 periods?
A. Portfolio of small U.S. common stocks

B. Portfolio of U.S. government bonds
C. Portfolio of Treasury bills
D. Portfolio of large U.S. common stocks

10. Which portfolio had the highest average annual return in real terms between 1900 and 2014?
A. Portfolio of U.S. common stocks

C. Portfolio of Treasury bills
D. None of the answers

11. A standard error measures
A. nominal annual rate of return on a portfolio.

B. A. risk of a portfolio.
C. reliability of an estimate.
D. real annual rate of return on a portfolio.

Difficulty: Challenge
12. Which of the following is an estimate of the standard error of the mean?
A. The average annual rate of return divided by the square root of the number of observations
B. The variance divided by the number of observations
C. The standard deviation of returns divided by the square root of the number of observations
D. The variance of returns divided by the square root of the number of observations

13. Which portfolio has had the highest average risk premium during the period 1900 to 2014?
A. Common stocks
B. Government bonds
C. Treasury bills
D. None of the answers is correct.

14. If the standard deviation of annual returns is 19.8 percent and the number of years of observation is 107,
what is the standard error?
A. 4.23 percent
B. 1.91 percent
C. 0.47 percent
D. 19.8 percent

15. If the average annual rate of return for common stocks is 11.7 percent, and 4.0 percent for U.S. Treasury
bills, what is the average market risk premium?
A. 15.7 percent
B. 4.0 percent
C. 7.7 percent
D. Not enough information is provided.

Difficulty: Basic
16. Spill Drink Company's stocks had -8 percent, 11 percent, and 24 percent rates of return, respectively, during
the last three years; calculate the (arithmetic) average rate of return for the stock.
A. 8 percent per year

B. 9 percent per year
C. 10 percent per year
D. 11 percent per year

Difficulty: Basic
17. For log normally distributed returns, annual compound returns equal
A. the arithmetic average return minus half the variance.

B. the arithmetic average return plus half the variance.
C. the arithmetic average return minus half the standard deviation.
D. the arithmetic average return plus half the standard deviation.

18. Which of the following provides a correct measure of the opportunity cost of capital regardless of the timing
of cash flows?
A. Arithmetic average
B. Geometric average
C. Hyperbolic mean
D. Opportunistic mean

19. Assume the following data: Risk-free rate = 4.0 percent; average risk premium = 7.7 percent. Calculate
the required rate of return for the risky asset.
A. 5.6 percent
B. 7.6 percent
C. 11.7 percent
D. 30.8 percent

Difficulty: Basic
20. Which of the following countries has had the lowest risk premium?
A. United States
B. Denmark
C. Italy
D. Germany

Difficulty: Basic
21. Which of the following countries has had the highest risk premium?
A. Germany
B. Denmark
C. United States
D. Switzerland

Difficulty: Basic
22. Mega Corporation has the following returns for the past three years: 7 percent, 13 percent, and 10 percent.
Use the following formulas to calculate the variance of the returns and the standard deviation of the returns:
Variance = expected value of

Standard deviation of .
A. 64.00 and 8.00 percent

B. 124.00 and 11.10 percent
C. 6.00 and 2.45 percent
D. 30.00 and 10.00 percent
23. Macro Corporation has had the following returns for the past three years: -10 percent, 10 percent, and 30
percent. Use the following formulas to calculate the standard deviation of the returns:
Variance = expected value of

Standard deviation of .
A. 10.00 percent
B. 16.33 percent
C. 18.21 percent
D. 30.00 percent
24. Sun Corporation has had returns of -6 percent, 16 percent, 18 percent, and 28 percent for the past four
years. Calculate the standard deviation of the returns using the correction for the loss of a degree of freedom
shown below.
When variance is estimated from a sample of observed returns, we add the squared deviations and divide
by N -1, where N is the number of observations. We divide by N -1 rather than N to correct for a loss of a
degree of freedom. The formula is
Where is the market return in period t and rm is the mean of the values of rmt.
A. 11.6 percent
B. 14.3 percent
C. 13.4 percent
D. 14.0 percent
25. Which portfolio had the highest standard deviation during the period between 1900 and 2014?
A. Common stocks
B. Government bonds
C. Treasury bills
D. None of the answers is correct.

Difficulty: Basic
26. What has been the approximate standard deviation of returns of U.S. common stocks during the
period between 1900 and 2014?
A. 19.9 percent
B. 33.4 percent
C. 8.9 percent
D. 2.8 percent

27. The standard deviation of U.S. returns from 2005 to the financial crisis four years later had
increased (approximately) by a factor of
A. 2.
B. 3.
C. 4.
D. 6.

28. A statistical measure of the degree to which securities' returns move together is called a
A. variance.
B. correlation coefficient.
C. standard deviation.
D. geometric average.

29. The type of the risk that can be eliminated by diversification is called
A. market risk.
B. unique risk.
C. interest rate risk.
D. default risk.

30. Unique risk is also called
A. systematic risk.
B. nondiversifiable risk.
C. firm-specific risk.
D. market risk.

Difficulty: Basic
31. Market risk is also called
I) systematic risk; II) undiversifiable risk; III) firm-specific risk.
A. systematic risk.
B. undiversifiable risk.
C. firm-specific risk.
D. systematic risk and undiversifiable risk.

Difficulty: Basic
32. Stock A has an expected return of 10 percent per year and stock B has an expected return of 20 percent. If
40 percent of a portfolio's funds are invested in stock A and the rest in stock B, what is the expected return on
the portfolio of stock A and stock B?
A. 10 percent
B. 20 percent
C. 16 percent
D. 14 percent

Difficulty: Basic
33. As the number of stocks in a portfolio is increased,
A. unique risk decreases and approaches zero.

B. market risk decreases.
C. unique risk decreases and becomes equal to market risk.
D. total risk approaches zero.

34. Stock M and Stock N have had the following returns for the past three years: 12 percent, -10 percent, and
32 percent; and 15 percent, 6 percent, and 24 percent, respectively. Calculate the covariance between the
two securities. (Ignore the correction for the loss of a degree of freedom set out in the text.)
A. -99
B. 126
C. +250
D. -250

35. Stock P and Stock Q have had annual returns of -10 percent, 12 percent, and 28 percent; and 8 percent,
13 percent, and 24 percent, respectively. Calculate the covariance of return between the securities. (Ignore
the correction for the loss of a degree of freedom set out in the text.)
A. -149.00
B. +149.00
C. +99.33
D. -100.00

36. Stock X has a standard deviation of return of 10 percent. Stock Y has a standard deviation of return of 20
percent. The correlation coefficient between the two stocks is 0.5. If you invest 60 percent of your funds in stock X
and 40 percent in stock Y, what is the standard deviation of your portfolio?
A. 10.3 percent
B. 21.0 percent
C. 12.2 percent
D. 14.8 percent

37. If the correlation coefficient between the returns on stock C and stock D is +1.0, the standard deviation of
return for stock C is 15 percent, and that for stock D is 30 percent, calculate the covariance between stock C and
stock D.
A. +45
B. -450
C. +450
D. -45

38. What range of values can correlation coefficients take?
A. Zero to + 1
B. -1 to + 1
C. -Infinity to + infinity
D. Zero to + infinity

39. If the covariance between stock A and stock B is 100, the standard deviation of stock A is 10 percent and that
of stock B is 20 percent, calculate the correlation coefficient between the two securities.
A. -0.5
B. +1.0
C. +0.5
D. 0.0

40. For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the
two stocks equals
A. +1.0.
B. -0.5.
C. -1.0.
D. 0.0.

41. For a portfolio of N-stocks, the formula for portfolio variance contains
A. N variance terms.
B. N(N - 1)/2 variance terms.
C. N2 variance terms.
D. N - 1 variance terms.

42. For a portfolio of N-stocks, the formula for portfolio variance contains
A. N covariance terms.
B. N(N - 1)/2 different covariance terms.
C. N2 covariance terms.
D. N - 1 covariance terms.

43. Beta is a measure of
A. unique risk.
B. total risk.
C. market risk.
D. liquidity risk.

44. The beta of the market portfolio is
A. +1.0.
B. +0.5.
C. 0.0.
D. -1.0.

Difficulty: Basic
45. For each additional 1 percent change in market return, the return on a stock having a beta of 2.2 changes,
on average, by
A. 1.00 percent.
B. 0.55 percent.
C. 2.20 percent.
D. 1.10 percent.

46. Which of the following portfolios will have the highest beta?
A. Portfolio of U.S. Treasury bills

C. Portfolio containing 50 percent U.S. Treasury bills and 50 percent U.S. government bonds
D. Portfolio of U.S. common stocks

Difficulty: Basic
47. If the standard deviation of returns on the market is 20 percent, and the beta of a well-diversified portfolio is
1.5, calculate the standard deviation of this portfolio.
A. 30 percent.
B. 20 percent.
C. 15 percent.
D. 10 percent.

48. The correlation coefficient between a stock and the market portfolio is +0.6. The standard deviation of return
of the stock is 30 percent and that of the market portfolio is 20 percent. Calculate the beta of the stock.
A. 1.1
B. 1.0
C. 0.9
D. 0.6

49. The historical nominal returns for stock A were -8 percent, +10 percent, and +22 percent. The nominal returns
for the market portfolio were +6 percent, +18 percent, and 24 percent during this same time. Calculate the beta for
stock A.
A. 1.64
B. 0.61
C. 1.00
D. 0.50

50. The annual returns for three years for stock B were 0 percent, 10 percent, and 26 percent. Annual returns for
three years for the market portfolio were +6 percent, 18 percent, and 24 percent. Calculate the beta for the stock.
A. 0.75
B. 1.36
C. 1.00
D. 0.74

51. The correlation coefficient between stock B and the market portfolio is 0.8. The standard deviation of stock B is
35 percent and that of the market is 20 percent. Calculate the beta of the stock.
A. 1.0
B. 1.4
C. 0.8
D. 0.7

52. The covariance between YOHO stock and the S&P 500 is 0.05. The standard deviation of the stock market is
20 percent. What is the beta of YOHO?
A. 0.00
B. 1.00
C. 1.25
D. 1.42

53. What is the beta of a security where the expected return is double that of the stock market, there is no
correlation coefficient relative to the U.S. stock market, and the standard deviation of the stock market is .18?
A. 0.00
B. 1.00
C. 1.25
D. 2.00

54. Treasury bills typically provide higher average returns, both in nominal terms and in real terms, than long-
term government bonds.
FALSE

Difficulty: Basic
55. A risk premium is the difference between a security's return and the Treasury bill return.
TRUE

Difficulty: Basic
56. For log normally distributed returns, the annual geometric average return is greater than the arithmetic
average return.
FALSE

57. According to the authors, a reasonable range for the risk premium in the United States is 5 percent to 8 percent.
TRUE

58. The standard statistical measures of the variability of stock returns are beta and covariance.
FALSE

Difficulty: Basic
59. Diversification reduces the risk of a portfolio because the prices of different securities do not move
exactly together.
TRUE

Difficulty: Basic
60. The portfolio risk that cannot be eliminated by diversification is called unique risk.
FALSE

61. The portfolio risk that cannot be eliminated by diversification is called market risk.
TRUE

62. The beta of a well-diversified portfolio is equal to the value weighted average beta of the securities included in
the portfolio.
TRUE

63. The average beta of all stocks in the market is zero.
FALSE

64. A portfolio with a beta of one offers an expected return equal to the market risk premium.
FALSE

65. Stocks with high standard deviations will necessarily also have high betas.
FALSE

66. Low standard deviation stocks always have low betas.
FALSE

67. A stock having a covariance with the market that is higher than the variance of the market will always have a
beta above 1.0.
TRUE

68. By purchasing U.S. government bonds, an investor can achieve both a risk-free nominal rate of return
and a risk-free real rate of return.
FALSE

69. A risk premium generated by comparing stocks to 10-year U.S. Treasury bonds will be smaller than a
risk premium generated by comparing stocks to U.S. Treasury bills.
TRUE

70. One can easily calculate the estimated risk premium on stocks via the statistical analysis of historical
stock returns.
FALSE

71. The standard deviation of a two-stock portfolio generally equals the value-weighted average of the
standard deviations of the two stocks.
FALSE

72. The covariance between the returns on two stocks equals the correlation coefficient multiplied by the
standard deviations of the two stocks.
TRUE

73. For the most part, stock returns tend to move together. Thus, pairs of stocks tend to have both
positive covariances and correlations.
TRUE

74. If returns on two stocks tended to move in opposite directions, then the covariances and correlations on the
two stocks would be negative.
TRUE

75. Diversification can reduce portfolio risk even in the case when correlations across stock returns equal zero.
TRUE

76. The variability of a well-diversified portfolio mostly reflects the contributions to risk from the standard deviations
of the stocks within that portfolio.
FALSE

77. The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio.
TRUE

Difficulty: Basic
78. Define the term risk premium.
The difference between the security return and the risk-free rate, such as a Treasury bill return, is called the risk
premium. This denotes the additional return on the security to additional risk.
79. Regarding stock returns, briefly explain the term variance.
Variance is a standard statistical measure of spread. The variance is the expected squared deviation from the
expected return. From a finance point of view, this measures the total risk of a portfolio: The higher the variance,
the higher the risk of the portfolio. This is also called a measure of total risk.
80. Briefly explain how diversification reduces risk.
Diversification reduces risk because prices of different securities do not move exactly together. When you form
portfolios using a large number of stocks, the variability of the portfolio is much less than the average variability of
individual stocks.
81. In the formula for calculating the variance of an N-stock portfolio, how many covariance and variance terms
are there?
In the formula for calculating the variance of an N-stock portfolio, there are [N(N – 1)]/2 different
covariance terms and N variance terms.
Difficulty: Basic
82. Briefly explain how the beta of a stock is estimated.
One can estimate the beta of a stock by plotting the market returns on the x-axis and the corresponding stock
returns on the y-axis. The slope of the resulting line of best fit is the beta estimate for the stock. [βi
= Cov(Ri, Rm)/Var(Rm).]
83. Briefly explain what the beta of a stock means.

For each additional 1 percent change in the market return, the return on the stock on average changes by beta
times 1 percent. For example, if the beta of IBM is 1.59, then for an additional 1 percent change in the market
return, the expected change in the return of IBM stock will equal 1.59 percent.
84. Discuss the importance of beta as a measure of risk.
Beta is a measure of market risk. It is also called the relative measure of risk as it measures risk relative to the
market portfolio. Beta is useful as a measure of risk in the context of well-diversified portfolios. It measures the risk
contribution of a single security to the portfolio.
85. Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.
Variance measures the total risk of a security and is a measure of stand-alone risk. Total risk has both unique risk
and market risk. In a well-diversified portfolio, unique risks tend to cancel each other out and only market risk
remains. Beta is a measure of market risk and is useful in the context of a well-diversified portfolio. Beta measures
the sensitivity of the security returns to changes in market returns. The market portfolio has a beta of one and thus
has average risk.
86. Briefly explain how individual securities affect portfolio risk.
The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio.
Portfolio beta is the weighted average of individual security betas included in the portfolio. Individual
securities affect portfolio risk to the extent that they change the beta of the portfolio.
87. What is the beta of a portfolio with a large number of randomly selected stocks?
The beta of a portfolio with a large number of randomly selected stocks equals one. The standard
deviation of such a portfolio is equal to the standard deviation of the market.
88. How can individual investors diversify?
A very simple way for an individual investor to diversify is to buy shares in a mutual fund that holds a diversified
portfolio.
89. Briefly explain the concept of value additivity.
If the capital market establishes a value PV(A) for asset A and PV(B) for asset B, the market value of a firm that
holds both these assets is given by PV(AB) = PV(A) + PV(B). This logic can be extended for any number of assets.
Value additivity is also applicable to cash flows. We can add the present values of two separate cash flows and get
the present value of the combined cash flows. It can be stated as follows:
PV(A + B) = PV(A) + PV(B) and PV(A + B + C) = PV(A) + PV(B) + PV(C).
This idea can be extended for any number of cash flows.
90. Explain why international stocks may have high standard deviations but low betas.
Beta is traditionally measured relative to the S&P 500 index. As such, there may be a weaker statistical
relationship between the S&P 500 and an international stock. If these two assets are mostly independent of one
another, there is little chance they will have a statistically significant covariance. With a low covariance, by
definition, the stock will have a low beta. This could occur even if the standard deviation of the beta is very high.
This answer assumes that the market risk in domestic stocks is largely independent of the market risk in
international stocks.
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Difficulty: Challenge 22
Difficulty: Intermediate 47

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Principles of Corporate Finance 12th

Edition Brealey Test Bank

A. A portfolio of Treasury bills

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A. Interest rate risk

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A. Less than 2 percent

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A. Less than 1 percent

A. Less than 2 percent

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A. Less than 2 percent

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A. Portfolio of small U.S. common stocks

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A. Portfolio of U.S. common stocks

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11. A standard error measures

A. nominal annual rate of return on a portfolio.

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A. 8 percent per year

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A. the arithmetic average return minus half the variance.

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Variance = expected value of

A. 64.00 and 8.00 percent

Variance = expected value of

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30. Unique risk is also called

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31. Market risk is also called

I) systematic risk; II) undiversifiable risk; III) firm-specific risk.

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33. As the number of stocks in a portfolio is increased,

A. unique risk decreases and approaches zero.

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38. What range of values can correlation coefficients take?

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43. Beta is a measure of

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44. The beta of the market portfolio is