Chapter 7

Financial Management: Principles & Applications, 13e (Titman)
Chapter 7 An Introduction to Risk and Return-History of Financial Market Returns
1) You purchased the stock of Sargent Motors at a price of $75.75 one year ago today. If you sell
the stock today for $89.00, what is your rate of return?
A) 35.00%
B) 12.50%
C) 17.50%
D) 25.00%
Answer: C
Diff: 2
AACSB: 3. Analytic thinking skills
Question Status: Previous edition
Objective: 7.1 Calculate realized and expected rates of return and risk.
Keywords: risk, return
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) You have invested in a project that has the following payoff schedule:
Probability of
Payoff Occurrence
$40 .15
$50 .20
$60 .30
$70 .30
$80 .05
What is the expected value of the investment's payoff? (Round to the nearest $1.)
A) $60
B) $65
C) $58
D) $70
Answer: C
Diff: 2
1
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3) If there is a 20% chance we will get a 16% return, a 30% chance of getting a 14% return, a
40% chance of getting a 12% return, and a 10% chance of getting an 8% return, what is the
expected rate of return?
A) 12%
B) 13%
C) 14%
D) 15%
Answer: B
Diff: 2
4) You are considering investing in a project with the following possible outcomes:
Probability of Investment
States Occurrence Returns
State 1: Economic boom 15% 16%
State 2: Economic growth 45% 12%
State 3: Economic decline 25% 5%
State 4: Depression 15% -5%
Calculate the expected rate of return for this investment.

A) 9.8%
B) 7.0%
C) 8.3%
D) 6.3%
Answer: C
Diff: 2
2
5) Spartan Sofas, Inc. is selling for $50.00 per share today. In one year, Spartan will be selling
for $48.00 per share, and the dividend for the year will be $3.00. What is the cash return on
Spartan stock?
A) $51.00
B) $1.00
C) $2.00
D) $3.00
Answer: B
Diff: 2
6) What is the standard deviation of an investment that has the following expected scenario?
18% probability of a recession, 2.0% return; 65% probability of a moderate economy, 9.5%
return; 17% probability of a strong economy, 14.2% return.
A) 3.68%
B) 1.23%
C) 8.47%
D) 6.66%
Answer: A
Diff: 2
3
7) You are considering investing in a firm that has the following possible outcomes:
Economic boom: probability of 25%; return of 25%

Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the expected rate of return on the investment?

A) 15.0%
B) 11.7%
C) 14.5%
D) 25.0%
Answer: C
Diff: 2
8) You are considering investing in a firm that has the following possible outcomes:
Economic boom: probability of 25%; return of 25%

Economic growth: probability of 60%; return of 15%
Economic decline: probability of 15%; return of -5%
What is the standard deviation of returns on the investment?

A) 84.75%
B) 15.28%
C) 12.47%
D) 9.21
Answer: D
Diff: 2
Question Status: New question
4
9) Which of the following best measures an asset's risk?
A) Expected return
B) The standard deviation
C) The probability distribution
D) The cash return
Answer: B
Diff: 2
10) The cash return on an investment is calculated as purchase price-selling price.

Answer: FALSE
Diff: 1
11) Because returns are more certain for the least risky investments, the required return on these
investments should be higher than the required returns on more risky investments.
Answer: FALSE
Diff: 1
12) Even though an investor expects a positive rate of return, it is possible that the actual return
will be negative.
Answer: TRUE
Diff: 1
5
13) The expected rate of return is the weighted average of the possible returns for an investment.
Answer: TRUE
Diff: 1
14) Investment variances may be either positive or negative.

Answer: FALSE
Diff: 1
15) The higher the standard deviation, the less risk the investment has.
Answer: FALSE
Diff: 1
16) Using the following information for McDonovan, Inc.'s stock, calculate their expected return
and standard deviation.
State Probability Return
Boom 20% 40%
Normal 60% 15%
Recession 20% (20%)
Answer:
Ki = = (.20)(40%) + (.60)(15%) + (.20)(-20%)
= 8% + 9% - 4% = 13%
σi = ( ).
σi = ((40%-13%)2(.2) + (15%-13%)2 (.6) + (-20%-13%)2 (.2)). = 19.13%
Diff: 2
6
17) Which of the following sequences is arranged in the correct order, from highest long-term
returns to lowest?
A) International equities, U.S. government bonds, U.S. equities
B) Corporate bonds, treasury bills, international equities
C) International equities, U.S. government bonds, treasury bills
D) Government bonds, emerging market equities, treasury bills
Answer: C
Diff: 1
AACSB: 6. Reflective thinking
Objective: 7.2 Describe the historical pattern of financial market returns.
Performance of Major Investment Classes 1995-2015

Treasury Government Corporate International
U. S. Equities Bills Bonds Bonds Equities
Compound
annual
return 10.21% 4.89% 7.05% 7.79% 10.35%
Standard
deviation 17.55% 3.52% 2.74% 2.57% 21.60%
18) Investments that have earned the highest rates of return over 1995-2015 also have
A) the lowest risk.
B) the highest standard deviation of returns.
C) the largest market capitalization.
D) the least sensitivity to inflation.
Answer: B
Diff: 1
7
19) Over the period 1995-2015, which pair of investments does not perfectly fit the "higher risk,
higher return" pattern?
A) Government bonds, treasury bills
B) U.S. equities, corporate bonds
C) U.S. Equities, international equities
D) Corporate bonds, international equities
Answer: A
Diff: 1
20) Over the period 1995-2015, the risk-return relationship appears to be

A) negative.
B) perfectly positive.
C) random.
D) generally positive, but not perfect.
Answer: D
Diff: 1
21) The difference between returns on stocks and government bonds is known as
A) the equity risk premium.
B) the risk and return tradeoff.
C) the maturity premium.
D) the risk/reward paradox.
Answer: A
Diff: 1
8
22) An emerging market is
A) a market for small, but rapidly growing companies.
B) market for companies coming out from bankruptcy proceedings.
C) market for promising, but untested technologies
D) a market located in an economy with low to middle per capita income.
Answer: D
Diff: 1
23) The risk-return tradeoff tells us that expected returns should be higher on investments that
have higher risk.
Answer: TRUE
Diff: 1
24) Riskier investments have traditionally had lower returns than less risky investments have
had.
Answer: FALSE
Diff: 1
25) Less risky investments have lower standard deviations than do more risky investments.
Answer: TRUE
Diff: 1
9
26) Investments in emerging markets have higher volatility than do U.S. Stocks.
Answer: TRUE
Diff: 1
27) Risky investments have the potential for higher returns, but also larger losses.
Answer: TRUE
Diff: 1
28) Historically, in the United States stocks have had higher returns and greater volatility than
have government bonds.
Answer: TRUE
Diff: 1
29) Treasury Bills have less default risk than do Government Bonds.
Answer: TRUE
Diff: 1
30) Investors are always rewarded for taking higher risk with higher realized returns.
Answer: FALSE
Diff: 1
10
31) During the period 1995 to 2015, gold has underperformed both REITS and Equities.
Answer: TRUE
Diff: 1
32) Marcus Berger invested $9842.33 in Hawkeye Hats, Inc. four years ago. He sold the stock
today for $11,396.22. What is his geometric average return?
A) 2.98%
B) 3.73%
C) 3.95%
D) There is insufficient information to derive an answer.
Answer: B
Diff: 1
Objective: 7.3 Compute geometric (or compound) and arithmetic average rates of return.
Keywords: holding period return
Principles: Principle 1: Money Has a Time Value
33) Michael Lynch invested $10,000 in the Rearguard Fund four years ago. All earnings were
reinvested in the fund. If his compound annual rate of return was 7%, what is his investment
worth today (round to the nearest dollar)?
A) $13,108
B) $10,700
C) $12,800
D) $763
Answer: A
Diff: 1
Question Status: Revised
Keywords: arithmetic average return
11
Use the following to answer the following question(s).
Roddy Richards invested $12014.88 in Wolverine Meat Distributors (W.M.D.) five years ago.
The investment had yearly arithmetic returns of -9.7%, -8.1%, 15%, 7.2%, and 15.4%.
34) What is the arithmetic average return of Roddy Richard's investment?

A) 2.42%
B) 3.96%
C) 5.18%
D) 15.1%
Answer: B
Diff: 2
35) What is the geometric average return of Roddy's Richard's investment?

A) 3.38%
B) 4.63%
C) 6.96%
D) 8.78%
Answer: A
Diff: 2
Keywords: compound interest
36) How much money did Roddy Richards receive when he sold his shares of W.M.D.?
A) $12,014.88
B) $12,398.42
C) $13,663.47
D) $14,184.73
Answer: D
Diff: 2
12
Use the following information to answer the following question(s).
Susan Bright will get returns of 18%, -20.3%, -14%, 17.6%, and 8.3% in the next five years on
her investment in CoffeeTown, Inc. stock, which she purchases for $73,419.66 today.
37) What is the arithmetic average return on her stock if she sells it five years from today?
A) 1.92%
B) 3.98%
C) 6.47%
D) 7.11%
Answer: A
Diff: 2
38) What is the geometric average return on her stock if she sells it five years from today?
A) -2.33%
B) .59%
C) 3.67%
D) 4.88%
Answer: B
Diff: 2
Keywords: geometric average return
39) How much will Susan's stock be worth if she sells it five years from today?
A) $71,423.85
B) $73,419.66
C) $75,628.75
D) $80,333.40
Answer: C
Diff: 2
Keywords: holding period return
13
40) The arithmetic average rate of return takes compounding into effect.
Answer: FALSE
Diff: 1
41) An investor who wishes to hold a stock for five years will be most interested in the geometric
average rather than in the arithmetic average return.
Answer: TRUE
Diff: 1
42) If an investor earns 10% on her investment in the first year and loses 10% the next year, she
will have neither a gain nor a loss.
Answer: FALSE
Diff: 1
43) If an investor holds a stock for three years, the value at the end of three years will always be
the initial cost of the stock times (1 + arithmetic average return) to the third power.
Answer: FALSE
Diff: 1
14
44) Why do the arithmetic average return and the geometric return differ?
Answer: The arithmetic average return does not take what the value of the investment was at the
start of each period. Hence, even though a company may have the same arithmetic return for two
consecutive years, the dollar amount of those returns will be different in later years than in the
first year. For instance, if the investor started with $1,000, and earned 20% the first year, lost
20% the second year, and earned 15% the third year, the average arithmetic return would be 5%,
and the 20% gain the first year would be $200, but the 20% loss the second year would be $240.
The investment would be worth $1104 after three years, giving an average geometric return of
3.35%, different from the average arithmetic return.
Diff: 2
45) Each of the following would tend to weaken the semi-strong form Efficient Market
Hypothesis EXCEPT:
A) There is publicly available information that Boeing Aircraft has procured a contract to build
25 planes for the U.S. Government and the price of Boeing quickly goes up.
B) ACG, Inc. performed well for the past six months, but they just lost a major distribution
contract, but the price of ACG stock continues to go up.
C) Louisville Slugger, Inc., gets a contract to supply bats for Little League play, a contract it
never had before, and stock price remains stable.
D) Muguet Company consistently underperforms the market in October, but outperforms the
market in May.
Answer: A
Diff: 1
Objective: 7.4 Explain the efficient market hypothesis and why it is important to stock prices.
Keywords: efficient markets
Principles: Principle 4: Market Prices Reflect Information
46) Jayden spends a lot of time studying charts of stocks past performance, but his investment
return are only average. This outcome supports
A) the weak-form efficient market hypothesis.
B) the semi-strong form efficient market hypothesis.
C) the strong form efficient market hypothesis.
D) all of the above.
Answer: D
Diff: 1
15
47) Which of the following is consistent with the semi-strong form efficient market hypothesis?
A) so-called value stocks outperform growth stocks.
B) stocks that have performed well over the past year continue to perform well for several more
months.
C) a company announces higher than expected sales and earnings. The stock price immediately
increases by 10%.
D) a company announces higher than expected sales and earnings. The stock price remains
unchanged.
Answer: C
Diff: 1
48) Madison was hired to design and decorate the offices of a large pharmaceutical company.
She accidentally read a report indicating that a new drug had just been approved by the Food and
Drug administration. She immediately bought the company's stock which doubled in price over
the following week. This outcome is inconsistent with
A) the weak-form efficient market hypothesis.
B) the semi-strong form efficient market hypothesis.
C) the strong form efficient market hypothesis. Her action was probably illegal.
D) all of the above.
Answer: C
Diff: 1
49) If markets are efficient, stock prices go up when there is positive information about a
company, and go down when there is negative information about the company.
Answer: TRUE
Diff: 1
16
50) Strategies that exploit market inefficiencies tend to lose their effectiveness when they
become widely known.
Answer: TRUE
Diff: 1
51) If a market is weak form efficient, an investor can make higher than expected profits by
studying the past price patterns of a stock.
Answer: FALSE
Diff: 1
52) If an individual with inside information can make higher than expected profits, the market is
no more than semi-strong form efficient.
Answer: TRUE
Diff: 1
53) Work by the behavioral economists Robert Shiller and Daniel Kahnemann strongly supports
the weak and semi-strong forms of the Efficient Market Hypothesis.
Answer: FALSE
Diff: 1
17
54) Once market inefficiencies become known, they will be exploited by traders until they
disappear.
Answer: TRUE
Diff: 1
55) Under the efficient market hypothesis, would securities be properly priced.
Answer: If markets were perfectly efficient, then investors would price a stock based on the
company's expected future cash flows, so at any time the security would be properly priced. If
good news becomes available, that would tend to increase the expected cash flows to a company,
the stock price will go up, meaning that the new price is then the proper price for the stock.
Diff: 2
56) Are markets moving toward being more efficient or toward being less efficient?
Answer: Empirical evidence shows that since about the year 2000 pricing anomalies have
diminished considerably. Hedge funds have been trying to exploit pricing inefficiencies, and by
doing so, eliminate the inefficiencies. Hence, the market appears to be becoming more efficient
over time.
Diff: 2
18

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Chapter 7

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Financial Management: Principles & Applications, 13e (Titman)

Chapter 7 An Introduction to Risk and Return-History of Financial Market Returns

Calculate the expected rate of return for this investment.

Economic boom: probability of 25%; return of 25%

What is the expected rate of return on the investment?

Economic boom: probability of 25%; return of 25%

What is the standard deviation of returns on the investment?

10) The cash return on an investment is calculated as purchase price-selling price.

14) Investment variances may be either positive or negative.

Performance of Major Investment Classes 1995-2015

20) Over the period 1995-2015, the risk-return relationship appears to be

34) What is the arithmetic average return of Roddy Richard's investment?

35) What is the geometric average return of Roddy's Richard's investment?

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