FIN 540 week 6

FIN 540 – Homework Chapter 25

r 25! Page 1 of 2!

Directions: Answer the following five questions on a separate document. Explain how you reached the

answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using

the assignment link in the course shell. Each question is worth five points apiece for a total of 25 points

for this homework assignment.

1. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart

from their current levels),

a. The past realized rate of return must be equal to the expected rate of return; that is, .

b. The required rate of return must equal the realized rate of return; that is, r = .

c. All companies must pay dividends.

d. No companies can be in danger of declaring bankruptcy.

e. The expected rate of return must be equal to the required rate of return; that is, = r.

2. In a portfolio of three different stocks, which of the following could NOT be true?

a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.

b. The beta of the portfolio is less than the betas of each of the individual stocks.

c. The beta of the portfolio is greater than the beta of one or two of the individual stocks'

betas.

d. The beta of the portfolio cannot be equal to 1.

e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were

held in isolation.

3. You have the following data on (1) the average annual returns of the market for the past 5 years

and (2) similar information on Stocks A and B. Which of the possible answers best describes the

historical betas for A and B?

Years Market Stock A Stock B

1 0.03 0.16 0.05

2 ?0.05 0.20 0.05

3 0.01 0.18 0.05

4 ?0.10 0.25 0.05

5 0.06 0.14 0.05

a. bA > +1; bB = 0.

b. bA = 0; bB = ?1.

c. bA < 0; bB = 0.

d. bA < -1; bB = 1.

e. bA > 0; bB = 1.

FIN 540 Homework Chapter 25! Page 2 of 2!

4. Which of the following statements is CORRECT?

a. The typical R2

for a stock is about 0.94 and the typical R2

for a portfolio is about 0.6.

b. The typical R2

for a stock is about 0.3 and the typical R2

for a large portfolio is about 0.94.

c. The typical R2

for a stock is about 0.94 and the typical R2

for a portfolio is also about

0.94.

d. The typical R2

for a stock is about 0.6 and the typical R2

for a portfolio is also about 0.6.

e. The typical R2

for a stock is about 0.3 and the typical R2

for a portfolio is also about 0.3.

5. Which of the following statements is CORRECT?

a. The characteristic line is the regression line that results from plotting the returns on a

particular stock versus the returns on a stock from a different industry.

b. The slope of the characteristic line is the stock's standard deviation.

c. The distance of the plot points from the characteristic line is a measure of the stock's

market risk.

d. The distance of the plot points from the characteristic line is a measure of the stock's

diversifiable risk.

e. "Characteristic line" is another name for the Security Market Line.

FIN 540 – Homework Chapter 26

FIN 540 Homework Chapter 26! Page 1 of 2!

Directions: Answer the following five questions on a separate document. Explain how you reached the

answer or show your work if a mathematical calculation is needed, or both. Submit your assignment using

the assignment link in the course shell. Each question is worth five points apiece for a total of 25 points

for this homework assignment.

1. Which of the following is NOT a real option?

a. The option to buy shares of stock if its price goes up.

b. The option to expand into a new geographic region.

c. The option to abandon a project.

d. The option to switch the type of fuel used in an industrial furnace.

e. The option to expand production if the product is successful.

2. Which of the following will NOT increase the value of a real option?

a. An increase in the volatility of the underlying source of risk.

b. An increase in the risk-free rate.

c. An increase in the cost of obtaining the real option.

d. A decrease in the probability that a competitor will enter the market of the project in

question.

e. Lengthening the time in which a real option must be exercised.

3. Which of the following is most CORRECT?

a. Real options change the risk, but not the size, of projects' expected cash flows.

b. Real options are likely to reduce the cost of capital that should be used to discount a

project's expected cash flows.

c. Very few projects actually have real options.

d. Real options are less valuable when there is a lot of uncertainty about the true values

future sales and costs.

e. Real options change the size, but not the risk, of projects' expected cash flows.

4. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good

job of estimating projects' sales and costs. However, it never considers real options that might be

associated with projects. Which of the following statements is most likely to describe its situation?

a. Its estimated capital budget is probably too large due to its failure to consider

abandonment and growth options.

b. Failing to consider abandonment and flexibility options probably makes the optimal

capital budget too large, but failing to consider growth and timing options probably makes

the optimal capital budget too small, so it is unclear what impact not considering real

options has on the overall capital budget.

c. Failing to consider abandonment and flexibility options probably makes the optimal

capital budget too small, but failing to consider growth and timing options probably makes

the optimal capital budget too large, so it is unclear what impact not considering real

options has on the overall capital budget.

d. Real options should not have any effect on the size of the optimal capital budget.

e. Its estimated capital budget is probably too small, because projects' NPVs are often

larger when real options are taken into account.

FIN 540 – Homework Chapter 26

FIN 540 Homework Chapter 26! Page 2 of 2!

5. Refer to Exhibit 26.1. Since the project is considered to be quite risky, a 20% cost of capital is

used. What is the project's expected NPV, in thousands of dollars?

a. $336.15

b. $373.50

c. $415.00

d. $461.11

e. $507.22