# suppose a stock had an initial price of $83 per share, paid a

1. Suppose a stock had an initial price of $83 per share, paid a dividend of $1.40 per share during the year, and had an ending share price of $76. Compute the dividend yield, the capital gains yield and the percentage total return.

A) 2.00%, –8.00%, –6.00%

B) 1.69%, 8.43%, 10.12%

C) 1.69%, –8.43%, –6.75%

D) -1.69%, 8.43%, 6.75%

2. You’ve observed the following returns on Kelley Corporation’s stock over the past five years: –16 percent, 21 percent, 4 percent, 16 percent, and 19 percent. What was the arithmetic average return on the stock over this five-year period? What was the variance of returns over this period? The standard deviation?

A) 8.80%, 0.023570, 15.35%

B) 11.80%, 0.023570, 15.35%

C) 8.80%, 0.034056, 18.45%

D) None of the above

3. The geometric average return answers the question, “What was your average compound return per year over a particular period?” The arithmetic average return answers the question, “What was your return in an average year over a particular period?”

A) True

B) False

4. A stock has had returns of 29 percent, 14 percent, 23 percent, –8 percent, 9 percent, and –14 percent over the last six years. What are the arithmetic (AAR) and geometric (GAR) average returns for the stock?

A) AAR = 8.83%, GAR = 7.69%

B) AAR = 7.69%, GAR = 8.83%

C) AAR = 8.83%, GAR = 8.83%

D) AAR = 16.17%%, GAR = 15.52%

5. Eight months ago, you purchased 400 shares of Winston, Inc. stock at a price of $56.90 a share. To date the company has paid quarterly dividends of $.55 a share twice. Today, you sold all of your shares for $49.40 a share. What is your total percentage return on this investment?

A) -11.2%

B) -9.3%

C) -8.4%

D) 12.0%

6. Over the past 75 years, the total annual returns on large company common stocks averaged 11.8%, small company stocks averaged 16.6%, long-term government bonds averaged 5.8%, while Treasury Bills averaged 3.7%. What was the average risk premium earned by long-term government bonds and small company stocks, respectively?

A) 1.8%; 11.9%

B) 2.1%; 12.9%

C) 4.4%; 13.9%

D) None of the above.

7. For given variances of the individual securities, a negative covariance between the two securities increases the variance of the entire portfolio. A positive covariance between the two securities decreases the variance of the entire portfolio.

A) True

B) False

8. The efficient set of securities represents those securities and portfolios of securities that have the highest expected return per unit of total risk (standard deviation of return).

A) True

B) False

9. A systematic risk is one that influences a large number of assets, each to a greater or lesser extent. Because systematic risks have marketwide effects, they are sometimes called market risks. An unsystematic risk is one that affects a single asset or a small group of assets. Because these risks are unique to individual companies or assets, they are sometimes called unique or asset specific risks.

A) True

B) False

10. The capital asset pricing model (or CAPM for short), implies that the expected return on a security is linearly related to its beta. In practice, financial economists generally use a broad-based value weighted index such as the Standard & Poor’s (S&P) 500 as a proxy for the market portfolio in order to estimate the beta for a security.

Of course, all investors do not hold the same portfolio. However, we know that a large number of investors hold diversified portfolios, particularly when mutual funds or pension funds are included. A broad-based value weighted index such as the S&P 500, therefore, is a good proxy for the highly diversified portfolios of many investors.

Since the average return on the S&P 500 proxy for the market portfolio has been higher than the average risk-free rate over long periods of time, [E(RM) – RF] is presumably positive over long periods. Thus, the CAPM also implies that the expected return on a security is positively related to its beta.

A) True

B) False

11. Consider the following information on three stocks A, B and C:

State of Probability of Rate of Return if State Occurs

Economy State Occurring A B C

Boom .2 .20 .35 .60

Normal .6 .15 .12 .05

Bust .2 .01 -.25 -.50

If your portfolio is invested 30 percent each in A and B and 40 percent in C, what is the portfolio expected return? The variance? The standard deviation?

A) 9.16%, .08001, 28.29%

B) 4.30%, .08001, 28.29%

C) 9.16%, .03882, 19.70%

D) 8.72%, .04612, 21.48%

12. The principle of diversification tells us that:

A) concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.

B) concentrating an investment in two or three large stocks will eliminate all of your risk.

C) spreading an investment across many diverse assets will eliminate some of the risk.

D) spreading an investment across many diverse assets will eliminate all of the risk.

13. The slope of an asset’s security market line is the:

A) reward-to-risk ratio.

B) beta coefficient.

C) risk-free interest rate.

D) market risk premium.

14. Which one of the following statements is correct concerning the expected rate of return on an individual stock given various states of the economy?

A) The expected return is a geometric average where the probabilities of the economic states are used as the exponential powers.

B) The expected return is an arithmetic average of the individual returns for each state of the economy.

C) The expected return is a weighted average where the probabilities of the economic states are used as the weights.

D) The expected return is equal to the summation of the values computed by dividing the expected return for each economic state by the probability of the state.

15. If investors possess homogeneous expectations over all assets in the market portfolio, when riskless lending and borrowing is allowed, the market portfolio is defined to:

A) be the same portfolio of risky assets chosen by all investors.

B) have the securities weighted by their market value proportions.

C) be a diversified portfolio.

D) All of the above.

16. Using the CAPM, a stock has a beta of 1.3, the expected return on the market is 9 percent, and the risk-free rate is 4 percent. What must the expected return on this stock be?

A) 11.70%

B) 10.50%

C) 14.00%

D) 25.70%

17. While beta is theoretically the best measure of risk for a security in a portfolio, not all betas are created equal. Some are computed using weekly returns and some using daily returns. Some are computed using 60 months of stock returns; some consider more or less returns. Some betas are computed by comparing the stock to the S&P 500 Index, while others use alternative indices. Finally, some reporting firms (including Value Line) make adjustments to raw betas to reflect information other than just the fluctuation in stock prices. Further, portfolio managers are interested in knowing what the beta of the stock will be in the future, but betas have to be estimated using historical data. Anytime we use the past to predict the future, there is the danger of making a poor estimate. This is often called forecast risk (estimation risk) or forecast error.

A) True

B) False

18. A stock with an actual return that lies above the security market line:

A) has less systematic risk than the overall market.

B) has more risk than warranted based on the realized rate of return.

C) has more systematic risk than the overall market.

D) has yielded a higher return than expected for the level of risk assumed.

19. The Capital Market Line is the relationship between the expected returns and standard deviations of portfolios formed by combinations of:

A) efficient portfolios.

B) the risk-free asset and any risky asset.

C) the risk-free asset and the optimal portfolio of risky assets.

D) the risk-free asset and any portfolio of risky assets.

20. When a project is financed with both debt and equity, the cost of capital is determined by the cost of both debt and equity. If a firm uses both debt and equity, the cost of capital is a weighted average of each or the weighted average cost of capital (WACC).

A) True

B) False

21. Kelley Corporation has a target capital structure of 55 percent common stock and 45 percent debt. Its cost of equity is 16 percent, and the cost of debt is 9 percent. The relevant tax rate is 35 percent. What is Kelley’s WACC?

A) 11.43%

B) 16.00%

C) 5.85%

D) 21.85%

22. Given the following information for Indiana Power Co., find the WACC.

The company’s tax rate is 35 percent;

Debt: 4,000 7 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 103 percent of par; the bonds make semiannual payments;

Common stock: 90,000 shares outstanding, selling for $57 per share;

The firm’s beta is 1.10;

Assume an 8 percent market risk premium

(Remember the risk premium = [E(RM) – Rf];

Rf = 6 percent risk-free rate.

A) 14.80%

B) 8.00%

C) 6.72%

D) 10.15%

23. The three forms of the efficient markets hypothesis (EMH) are: 1) Weak form. Market prices reflect all information, public or private. Investors are unable to earn abnormal returns using insider information or historical prices to predict future price movements. 2) Semi-strong form. In addition to historical data, market prices reflect all publicly-available information. Investors with insider, or private information, are able to earn abnormal returns. 3) Strong form. Market prices reflect information contained in historical prices. Investors are unable to earn abnormal returns using historical prices to predict future price movements.

A) True

B) False

24. During a trading day, American Air Inc. announces that it has lost a contract for a large transport plane project, which, prior to the news, it was widely believed to have secured. If the market is semistrong form efficient, how should the stock price react to this information if no additional information is released?

A) At the time of the announcement, the price of the stock should immediately increase.

B) At the time of the announcement, the price of the stock should not change.

C) At the time of the announcement, the price of the stock should immediately decrease.

D) At the time of the announcement, there is a 50 percent chance that the price of the stock could increase or decrease since stock price movement is random.

25. The EMH only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon.

A) True

B) False

26. A basic premise of portfolio theory is that investors tend to be risk averse. In selecting their investments, investors seek out investments with the characteristic of providing the maximum expected rate of return for a given level of risk, or the minimum anticipated volatility (risk) for a given expected rate of return.

A) True

B) False

27. Assume an investor formed a portfolio comprised of 30% in the common stock of AT&T, Inc., (T) and 70% in the common stock of Apple, Inc. (AAPL). Use the data provided below to calculate the portfolio’s monthly expected return, standard deviation, and coefficient of variation.

Spreadsheet estimates of average monthly return, standard deviation and covariance for each of these two stocks are as follows: (to convert to decimal format, move the decimal point two places to the left for both the average return and standard deviation; move the decimal point four places to the left for the covariance):

T AAPL

Average Monthly Return 2.28% 5.64%

Standard Deviation of Return 5.56% 12.01%

Covariance (T, AAPL) = -33

A) 4.63%, 55.85%, 12.06

B) 4.63%, 7.72%, 1.67

C) 3.39%, 4.49%, 1.33

D) None of the above

28. Consider a portfolio comprised of two stocks A and B:

The estimates shown below are given in percentage format for the expected return, E(R), and standard deviation of returns (SD). Note: to convert to decimal format, move the decimal point two places to the left for both the E(R) and SD).

Stock Weight E(R) SD

A 0.40 16% 45%

B 0.60 12% 30%

The correlation between stocks A and B is .75.

Calculate the portfolio expected return and standard deviation.

A) 13.6%, 33.67%

B) 13.6%, 12.73%

C) 12.1%, 18.62%

D) None of the above

29. An all-equity financed firm that has an 11 percent cost of capital is considering the following projects:

Project Beta Expected Return

W .75 11%

X .95 13%

Y 1.15 14%

Z 1.50 15%

The T-bill rate is 5 percent and the expected return on the market is 12 percent. Assuming the CAPM is the true return generating model, which projects should be accepted? Which projects would be incorrectly rejected if the firm’s cost of capital were used as a hurdle rate?

A) Accept X, Y and Z; Reject W

B) Accept W, Y and Z; Reject X

C) Accept W, X and Z; Reject Y

D) Accept W, X and Y; Reject Z

30. On-line Text Co. has four new text publishing products that it must decide on publishing to expand its services. The firm’s WACC has been 17%. The projects are of equal risk, Beta of 1.6. The risk-free rate is 7% and the market rate is expected to be 12%. The projects expected IRRs are as follows:

Project W = 14%

Project X = 18%

Project Y = 17%

Project Z = 15%

What project(s) should be clearly rejected?

A) Reject X and Y

B) Reject Y and Z

C) Reject W

D) Reject Z

31. In calculating the WACC, you must always use the book values for both debt and equity.

A. True

B. False

32. Financial markets continually fluctuate because they:

A) are completely inefficient.

B) are continually reacting to new information.

C) take weeks to react to new information.

D) only reflect historical information.

33. Suppose that firms with unexpectedly high earnings earn abnormally high returns for several months after the announcement. This would be evidence of:

A) efficient markets in the weak form.

B) inefficient markets in the weak form.

C) inefficient markets in the semistrong form.

D) inefficient markets in the all forms.