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FIN 571 Wk 5 Practice Wk 5 Practice Questions
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FIN 571 Wk 5 Practice Wk 5 Practice Questions

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The Dow Jones Industrial Average is: Multiple Choice • the most representative of the stock market indexes. • an index of 500 largest corporate stocks in America. • an index of 30 major stocks. Correct • an equally weighted index of all stocks traded on the New York Stock Exchange. 2 Periods of market decline are called: Multiple Choice • discount factors. • bull markets. • coupons. • bear markets. 3 Which one of the following would you expect to represent the broadest-based index of U.S. stocks? Multiple Choice • Wilshire 5000 Correct • Dow Jones Industrial Average • Standard and Poor's Composite • Financial Times Index 4 Over a 20-year period an investment of $1,000 in common stocks returned an average of 11% in nominal terms and 4% in real terms. At the end of the 20 years, the portfolio value was: Multiple Choice • $1,800 in real terms. • $3,679.19 in real terms. • $7,870.59 in nominal terms. • $8,062.31 in nominal terms. Explanation FVNominal = $1,000(1.11)20 = $8,062.31 FVReal = $1,000(1.04)20 = $2,191.12 5 A stock is expected to return 11% in a normal economy, 19% if the economy booms, and lose 8% if the economy moves into a recessionary period. Economists predict a 65% chance of a normal economy, a 25% chance of a boom, and a 10% chance of a recession. What is the expected return on the stock? Multiple Choice • 11.98% • 12.06% • 11.10% Correct • 11.23% Explanation E(R) = (0.65 × 0.11) + (0.25 × 0.19) + (0.10 × −0.08) = 0.1110, or 11.10% 6 Historical returns (1900-2017) suggest that in a year when Treasury bills offered 3.8% the approximate return on portfolio of common stocks should be in the region of: Multiple Choice • 7.5% • 9.3% • 11.5% Correct • 18.5% Explanation 3.8% + 7.7% (historical risk premium on common stocks) = 11.5% 7 The fact that historical returns on Treasury bonds are less volatile than common stock returns indicates that: Multiple Choice • the variance of Treasury bond returns is zero. • the standard deviation of Treasury bond returns is negative. • the real return on Treasury bonds has been negative. • common stocks should offer a higher return than Treasury bonds. 8 The major benefit of diversification is the: Multiple Choice • increased expected return. • removal of all negative risk assets from the portfolio. • reduction in the portfolio's market risk. • reduction in the portfolio's total risk. 9 A stock investor owns a diversified portfolio of 15 stocks. What will be the most likely effect on the portfolio's standard deviation if one more stock is added? Multiple Choice • A slight increase will occur. • A large increase will occur. • A slight decrease will occur. Correct • A large decrease will occur. 10 Which one of the following concerns is likely to be most important to portfolio investors seeking diversification? Multiple Choice • Total volatility of individual securities • Standard deviation of individual securities • Correlation of returns between securities Correct • Achieving the risk-free rate of return 11 Which one of the following risks can be progressively eliminated by adding stocks to a portfolio? Multiple Choice • Systematic risk • Specific risk Correct • Market risk Inflation rate risk 12 Risks that affect only a single firm are called: Multiple Choice • market risks. • specific risks. Correct • systematic risks. • risk premiums. 13 Which one of the following companies is most likely to be exposed to the least amount of macro risk? Multiple Choice • A producer of dog biscuits Correct • A regional airline • A major commercial bank • A machine tool manufacturer 14 The following table shows betas for several companies. Calculate each stock’s expected rate of return using the CAPM. Assume the risk-free rate of interest is 8%. Use a 10% risk premium for the market portfolio. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Company Beta Cost of Capital Caterpillar 1.83 +/-1%26.30 % Apple 1.47 +/-1%22.70 % Johnson & Johnson 0.66 +/-1%14.60 % Consolidated Edison 0.38 +/-1%11.80 % Explanation We can use the CAPM to derive the cost of capital for these firms: r = rf + β(rm − rf) = 8% + (β × 10%) 15 The Treasury bill rate is 6%, and the expected return on the market portfolio is 10%. According to the capital asset pricing model: a. What is the risk premium on the market? b. What is the required return on an investment with a beta of 1.4? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) c. If an investment with a beta of 0.8 offers an expected return of 9.0%, does it have a positive or negative NPV? d. If the market expects a return of 11.0% from stock X, what is its beta? (Do not round intermediate calculations. Round your answer to 2 decimal places.) a. Market risk premium +/-1%4 % b. Return on investment +/-1%11.6 % c. NPV Negative d. Beta +/-1%1.25 Explanation a. Market risk premium = expected return on market-rf rate Market risk premium = 10% – 6% = 4% b. CAPM = rf + β(MRP) = 6% + 1.4 × (4%) = 11.6% c. CAPM = 6% + 0.8 × (4%) = 9.20% > 9.00% As per CAPM, stock should return more (9.20%) than what is expected (9.0%), so this is a negative NPV investment. d. CAPM = rf + β(MRP) = 6% + β × (4%) = 11.0% Solving for β, we derive the stock should have a beta of 1.25. 16 Suppose that the Treasury bill rate is 6% rather than 4%, as we assumed in Table 12.1, and the expected return on the market is 12%. Use the betas in that table to answer the following questions. a. When you assume this higher risk-free interest rate, what makes sense for how you should modify your assumption about the rate of return on the market portfolio? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) b. Recalculate the expected return on the stocks in Table 12.1. (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) c. Suppose now that you continued to assume that the expected return on the market remained at 12%. Now what would be the expected returns on each stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) d. Ford offer a higher or lower expected return if the interest rate is 6% rather than 4%? e. Walmart offer a higher or lower expected return if the interest rate is 6% rather than 4%? a. Market return would have to fall b. Expected return +/-1%24.1 % c. Expected return +/-1%6.6 % d. Ford's expected return Lower e. Walmart's expected return Higher Explanation a-c. Using CAPM, the expected return (“Exp(R)”) for each stock is as follows: (a) If all other things remain the same, the market return would have to fall. (b&c) The highest return is provided by the stock with the highest beta, namely U.S steel at 24.1%, while the lowest is provided by the lowest beta, Newmont Mining at 6.6%. d-e. The recalculated expected returns for Ford and Walmart are as follows: Ford, a high beta stock, offers a lower return when the risk-free rate is 6%. Walmart, a low beta stock, offers a higher return when the risk-free rate is 6% 17 A stock with a beta of 1.1 has an expected rate of return of 16%. If the market return this year turns out to be 10 percentage points below expectations, what is your best guess as to the rate of return on the stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.) Stock return +/-1%5.0 % Explanation Beta tells us how sensitive the stock return is to changes in market performance. The market return was 9% less than your prior expectation. Therefore, the stock would be expected to fall short of your original expectation by: 1.1 × 10% = 11.0% The “updated” expectation for the stock return is 16% − 11.0% = 5.0%. 18 You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecasts (in millions of dollars) for the project are as follows: Years Cash Flow 0 – 100 1 - 10 + 18 ________________________________________ On the basis of the behavior of the firm’s stock, you believe that the beta of the firm is 1.45. Assume that the rate of return available on risk-free investments is 6% and that the expected rate of return on the market portfolio is 14%. a. What is the project IRR? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) IRR +/-1%12.41 % b. What is the cost of capital for the project? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Cost of capital +/-1%17.60 % c. Does the accept-reject decision using IRR agree with the decision using NPV? • Yes Correct • No Explanation a. and b. The appropriate discount rate for the project is: r = rf + β(rm – rf) = 6% + 1.45 × (14% – 6%) = 17.60% Therefore: NPV = –$100 + [$18 × annuity factor (17.60%, 10 years)] = −$100+ $18× [10.1760− 10.1760 × (1.1760)10 ] = - 17.94 (in millions)= −$100⁢+ $18⁢× [10.1760⁢− 10.1760⁢ ⁢× (1.1760)10 ] = - 17.94 (in millions) Since the NPV is negative, you should reject the project. Find the discount rate (r) at which: $18 × annuity factor (r, 10 years) = $100 $ 18 × [1r −  1r × (1 + r)10]  = $100$⁢ 18⁢ × [1r⁢ −  1r⁢ × (1⁢ + r)10]  = $100 c. Solving this equation using trial and error or a financial calculator, we find that the project IRR is 12.41%. The IRR is less than the opportunity cost of capital (17.60%). Therefore, you should reject the project, just as you found from the NPV rule. 19 You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecasts (in millions of dollars) for the project are as follows: Years Cash Flow 0 – 100 1-10 + 20 ________________________________________ On the basis of the behavior of the firm’s stock, you believe that the beta of the firm is 1.36. Assuming that the rate of return available on risk-free investments is 3% and that the expected rate of return on the market portfolio is 15%, what is the net present value of the project? (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions of dollars rounded to 2 decimal places.) Net present value +/-1%$(14.18) million 20 The Treasury bill rate is 5% and the market risk premium is 8%. Project Beta Internal Rate of Return, % P 0.70 12 Q 0.00 8 R 1.00 13 S 0.10 9 T 1.10 15 ________________________________________ a. What are the project costs of capital for new ventures with betas of 0.45 and 1.45? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Beta Cost of Capital 0.45 +/-1%8.60 % 1.45 +/-1%16.60 % b. Which of the capital investments shown above have positive (non-zero) NPV's? (You may select more than one answer. Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer.) • Project P checked • Project Q checked • Project S checked • Project T checked • Project R unchecked Explanation a. Beta Cost of Capital (from CAPM) 0.45 5% + (0.45 × 8%) = 8.60% 1.45 5% + (1.45 × 8%) = 16.60% ________________________________________ b. Project Beta Cost of Capital IRR NPV P 0.70 10.60 % 12 % + Q 0.00 5.00 % 8 % + R 1.00 13.00 % 13 % - S 0.10 5.80 % 9 % + T 1.10 13.80 % 15 % +

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