Multiple Choice Questions Part I

Circle the best answer. You will not receive any points if you circle more than one answer. You will not get any partial credit

1. Stock Y has a beta of 1.50 and an expected return of 17 percent. Stock Z has a beta of .80 and an expected return of 10.5 percent. If the risk-free rate is 5.5 percent and the market risk premium is 7.5 percent. Which one of the following statements is true?

A) Stock Y is overvalued.

B) Stock Z is overvalued.

C) Stock Y is fairly valued.

D) Stock Z is fairly valued.

2. A stock has a beta of 1.3, the expected return on the market is 14 percent, and risk-free rate is 5 percent. What must the required return on this stock be?

A) 9.5%

B) 12.3%

C) 16.7%

D) 17.5%

3. Advance, Inc., is trying to determine its cost of debt. The firm has a debt issue with 7.37% YTM. The tax rate is 35%. What is the after-tax cost of debt?

A) 7.5%

B) 6.4%

C) 5.4%

D) 4.8%

4. Stock A’s expected return is 11% with standard deviation 23%. Stock B’s expected return is 9% with standard deviation 26%. Both stock A and stock B are fairly priced and traded on the US market only. Which one of the following statement is correct?

A) Stock A has more unsystematic risk.

B) Stock A has lower beta.

C) Stock B has more unsystematic risk.

D) Stock B has less total risk.

5. Which one of statement is true about WACC?

A) WACC is the discount rate financial managers should use to evaluate all possible investment projects in the firm.

B) WACC can not be used to evaluate a new investment project.

C) WACC can only be used to evaluate a new investment project if the project’s risk level is similar to the average risk level of the firm’s current assets and operations.

D) The calculation of WACC doesn’t consider corporate income tax.

6. Diversification is a process that

A) reduces idiosyncratic risk by holding a huge number of stocks.

B) reduces stock returns by holding a huge number of stocks.

C) reduces idiosyncratic risk by holding stocks that do not move together.

D) reduces stock returns by investing more on risk-free assets.

7. Which of the following concerns is likely to be most important to portfolio investors seeking diversification?

A) Total volatility of individual securities

B) Standard deviation of individual securities

C) Correlation of returns between securities

D) Achieving the risk-free rate of return

Problem Solving: Be neat and show ALL your work to receive full credit. Partial credit will be given.

1. Risk, Return, and Portfolio Analysis (25 points)

Rate of Return if State Occurs

State of Economy Probability of State of Economy Stock A Stock B

Recession 0.30 0.03 –0.25

Normal 0.50 0.09 0.15

Boom 0.20 0.14 0.35

Formulas with values:

Calculations:

a) Calculate the expected return for the two stocks.

b) A portfolio is invested 40% in Stock A and 60% in Stock B. What is the rate of return on the portfolio?

c) Suppose the risk-free rate is 2% and a diversified market portfolio offers 6% return. If Stock A has a beta of 1.2 and Stock B has a beta of 1.4, calculate their required rate of returns.

d) Is Stock A overvalued or undervalued? Why? Is Stock B overvalued or undervalued? Why?

e) What is the portfolio beta?