Finance 303 Final

What are the two key lessons from capital market history? 1. There is a reward for bearing risk2. The greater the potential reward, the greater the risk
$ Return= Dividends + Capital Gains
Capital Gains= Price Received – Price Paid
% Return= $Return/$Invested
_______ _______ are considered risk-free. Treasury Bills
The reward for bearing risk is known as the: risk premium
Risk is measured by the: -dispersion-spreador-volatility of returns
Geometric average < Arithmetic average unless: all returns are equal
The arithmetic average is overly optimistic for: long horizons
The geometric average is overly pessimistic for: short horizons
If the Efficient Market Hypothesis is true: you should NOT be able to earn “abnormal” or “excess” returns
Efficient markets do NOT imply that: investors cannot earn a positive return in the stock market
In Strong Form Efficiency, prices reflect: all information, including public and private
In Strong Form Efficiency, investors can NOT: earn abnormal returns regardless of the information they possess
Empirical evidence indicates that markets are NOT ______ ________ Efficient. Strong Form
In Semi-Strong Form Efficiency, prices reflect: all publicly available information-trading information, annual reports, press releases, etc.
In Semi-Strong Efficiency, investors can NOT: earn abnormal returns by trading on public information
Semi-Strong Efficiency implies that: fundamental analysis will not lead to abnormal returns
In Weak-Form Efficiency, prices reflect: all past market information-such as price and volume
In Weak-Form Efficiency, investors can NOT: earn abnormal returns by trading on market information
Weak-Form Efficiency implies that: technical analysis will not lead to abnormal returns
Empirical evidence indicated that markets are generally ______ ______ Efficient. Weak Form
Efficient Market Hypothesis does NOT mean that: you can’t make money
Efficient Market Hypothesis does mean that: -on average, you will earn a return appropriate for the risk undertaken-there is no bias in prices that can be exploited to earn excess returns-market efficiency will not protect you from wrong choices if you do not diversify (you still don’t want to put al your eggs in one basket)
Studying market history can reward us by demonstrating that: -There is a reward for bearing risk-The greater the potential reward is, the greater the risk
The two potential ways to make money as a stockholder are through: -dividends-capital appreciation
Dividends are the _____ component of the total return from investing in a stock. income
A capital gain on a stock results from: an increase in the price
The total dollar return on a stock is the sum of: -dividends-capital gains
The dividend yield for a one-year period is equal to the annual dividend amount divided by the: beginning stock price
The capital gain yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the: initial stock price
Suppose you bought 100 shares of Banks & Bower, Inc. for $50 a share. During the year B&B paid a $0.50 per share dividend. At year end, B&B was selling for $60 a share. What is your total percentage return? 21%(60-50+0.50)/50
The Ibbotson-Sinquefield data show that over long-term,: -small-company stocks had the highest risk level-T-bills, which had lowest risk, generated lowest return-small-company stocks generated the highest average return
Treasury Bills yielded a nominal average return over 86 years of 3.6% versus an average inflation rate of 3.1% over the same period. This makes the real return on T-bills equal to: 0.5%(3.6-23.1%)=0.5%
The risk-return relationship states that a riskier investment should demand a _____ return. higher
Normally, the excess rate of return is: positive
The standard deviation is the _____ of the variance. square root
An efficient market is one in which any change in available information will be reflected in the company’s stock price: immediately
The efficient markets hypothesis contends that ______ capital markets such as the NYSE are efficient. well-organized
When a company declares a dividend, shareholders generally receive: cash
You buy a stock for $100. In one year its price rises to $114, and it pays a $1 dividend. Your capital gains yield is: 14%($114-100)/$100
The percentage change in the price of a stock over a period of time is called its: capital gain yield
One year ago, Ernie purchased shares of RTF common stock for $100 a share. Today the stock paid a dividend of $1 per share. If the stock currently sells for $114 per share, what is Ernie’s total return? 15%($114-100+1)/$100
The Ibbotson-Singquefield data shows that: -U.S. T-Bills had the lowest risk or variability-Long-term corporate bonds had less risk or variability than stocks
Historically, the real return on Treasury bills has been: quite low
The excess return is the difference between the rate of return on a risky asset and the _____ rate. risk-free
A share of common stock currently sells for $100 and will pay a dividend of $2 at the end of the year. If the price is expected to increase to $113 at the end of one year, what is the stock’s current dividend yield? 2%($2/$100)
Treasury Bills yielded a nominal average over 86 years of 3.6% versus an average inflation rate of 3.1% over the same period. This makes the real return on T-bills approximately equal to: 5%
You buy a stock for %50. Its price rises to $55, and it pays a $2 dividend in a year. You do not sell the stock. Your dividend yield is: 4%($2/$50)
Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2011 has revealed: 1. small-company common stock2. large-company common stocks3. long-term corporate bonds4. long-term government bonds5. U.S. treasury bills
2008 was a bad year for markets worldwide. One of the worst hit was the Icelandic Exchange where shares priced dropped ____ in one day. 76%
Two ways of calculating average returns are: -the arithmetic average-the geometric average
In an efficient market, firms should expect to receive ____ value for the securities they sell. fair
The geometric average rate of return is approximately equal to: the arithmetic mean minus half of the variance
The second lesson from studying capital market history is that risk is: handsomely rewarded
If stock GHI has returns of 6% and -2% over 2 years, the geometric average rate of return is: 1.92%[(1.06)(0.98)]^.5-1
If stock ABC has a mean return of 10 percent with a standard deviation of 5 percent, then the probability of earning a negative return is approximately ___ percent. 2.5-0% is 2 SDs below the mean. Prob (R<0%)= (1-.95)/2=2.5%
In 2008, the S&P 500 plunged ____%. 37%
What is the arithmetic average for a stock that had annual returns of 8%, 2%, and 11% for the past three years? 7%
Which of the following are needed to describe the distribution of stock returns? -the mean return-the standard deviation of returns
In 2008, the prices on long-term U.S. Treasury bonds: gained 40%
Which of the following are true? -common stocks frequently experience negative returns-T-Bills sometimes outperform common stocks
If you use a geometric average to project short-run wealth levels, your results will most likely be: pessimistic
The year 2008 was: one of the worst years for stock market investors in U.S. history
Percentage returns are more convenient that dollar returns because they: -apply to any amount invested-allow comparison against other investments
If stock ABC has a return of 10 percent with a standard deviation of 5 percent, the the probability of earning a return greater than 15 percent is about ____ percent. 16%Prob(R>15%)= (1-.68)/2=16%
If a stock has returns of 10 percent and 20 percent over 2 years, the geometric average rate of return can be calculated by: [(1.10)(1.20)]^.5-1
______ were a bright spot for U.S. investors during 2008. Bonds
What type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock? overreaction and correction
The average return on the stock market can be used to: compare stock returns with the returns on other securities
The probability of a return being +/ one standard deviation of the mean in a normal distribution is approximately _____ percent. 68%
Bonds used in Ibbotson-Sinquefield’s long-term U.S. government bond portfolio had maturities of ____ years. 20
In the Ibbotson-Sinquefield studies, U.S. treasury bills data is based on T-bills with a maturity of ___ month(s). one
The geometric rate of return takes ________ into account. compounding
If the dispersion of returns on a particular security is very spread out form the security’s mean return, the security: is highly risky
From 1900 to 2010, the US ranked ________ when compared internationally in terms of highest equity risk premium. in the middle
If the annual stock market returns from Berry Company were 19 percent, 13 percent, and -8 percent, what was the arithmetic mean for those 3 years? 8%
If your total dollar return was $7 and your divided was $2, then the price change on your stock must have been: +$5
More volatility in returns produces _____ difference between the arithmetic and geometric averages. a larger
What will the dividend income be on 1,000 shares of XYZ stock if XYZ distributes $.20 per share dividend? $200$.20 X 1,000 = $200
If stock ABC has a mean return of 10 percent with a standard deviation of 5 percent, then the probability of earning a negative return is approximately _______ percent. 2.5%
The price of a stock drops from $50 to $40 per share. If you own 50 shares, your total capital loss is: $500
The standard deviation for large-company stock returns from 1926-2011 is: 20.3%
Which of the following is commonly used to measure inflation? The Consumer Price Index (CPI)
The probability of being 2 standard deviations below the mean in a normal distribution is approximately: 2.5%(100%-95%)/2
If you receive $2 a dividend per share on your 100 shares, you total dividend income is: $200
If the market changes and stock prices instantly and fully reflect new information, which path does such a change exhibit? an efficient market reaction
You bought one share of stock for 4100 and received a $2 dividend. If the price of the stock rose to $103, then your total dollar return would be? $5$103-100+2=$5
What is the definition of expected return? It is the return that an investor expects to earn on a risky asset in the future
_______ risk is the only risk important to the well diversified investor. Systematic
What does variance measure? -The riskiness of a security’s returns-The spread of the sample of returns
The minimum required return on a new project is known as the: cost of capital
The calculation of variance requires these 4 steps: 1. Calculate the expected return2. Calculate the deviation of each return from the expected return3. Square each deviation4. Calculate the average squared deviation
If you wish to create a portfolio of stocks, what is the required minimum number of stocks? You must invest stocks of at least 2 corporations
What does the security market line depict? It is a graphical depiction of the capital asset pricing model (CAPM)
The risk of owning an asset comes from: -unanticipated events-surprises
Unsystematic risk will affect: -firms in a single industry-a specific firm
Some examples of information that may impact the risky return of a stock are: -the fed’s decision on interest rates at their meeting next week-the outcome of an application currently pending with the Food and Drug administration
What is the expected return of a portfolio consisting of stock A and B if the expected return is 10 percent for A and 15 percent for B? Assume you are equally invested in both the stocks 12.5%.5×10% + .5×15%
A portfolio can be described by its portfolio weights which are defined as: the percentage of dollars invested in each asset
As more securities are added to a portfolio, what will happen to the portfolio’s total unsystematic risk? -it is likely to decrease-it may eventually be almost totally eliminated
What is the slope of the security market line (SML)? the market risk premium
If security ABC has a beta of 1.5 and security XYZ has a beta of 1, what is the beta of a portfolio that is equally invested in both securities? 1.25
What is a risk premium? It is additional compensation for taking risk, over and above the risk-free rate
What is the expected return of a security with a beta of 1.2 if the risk-free rate is 4% and the expected return on the market is 12%? 13.6%4%+1.2(12%-4%)
The systematic risk principle argues that the market does NOT reward risks that are: -diversifiable-borne unnecessarily
_____ risk is reduced as more securities are added to the portfolio -unique-unsystematic-diversifiable
Systematic risk is also called _____ risk. market
True or false: it is possible for unsystematic risk to be reduced almost to zero true
According to the capital asset pricing model (CAPM), what is the expected return on a security with a beta of zero? the risk-free rate of return
When an investor is diversified only ______ risk matters. systematic
The following are examples of a portfolio: -investing $100,000 in the stocks of 50 publicly traded corporations-investing $100,000 in a combination of stocks and bonds-investing $100,000 in a combination of US and Asian stocks
An investment will have a negative NPV when its expected return is _____ ____ what the financial markets offer for the same risk less than
What two factors determine a stock’s total return? -expected return-unexpected return
By definition, what is the beta of the average asset equal to? 1
Which of the following types of risk is not reduced by diversification? systematic, or market risk
Which of the following are examples of unsystematic risk? -changes in management-labor strikes
If the variance of a portfolio is .0025, what is the standard deviation? 5%
______ risk is the only risk important to the well diversified investor. systematic
If an asset has a reward-to-risk ratio of 6.0%, that means it has a _____ of 6.0% per unit of _______. risk premium; systematic risk
What are the two components of risky return in the total return equation? -market risk-unsystematic risk
Which of the following are examples of systematic risk? -regulatory changes in tax rates-future rates of inflation
If investors are risk averse, it is reasonable to assume that the risk premium for the stock market will be: positive
What is the expected return for a security if the risk-free rate is 5%, the expected return on the market is 9%, and the security’s beta is 1.5? 11%5+1.5x(9-5)
Historical return data indicated that as the number of securities in a portfolio increases, the standard deviation of returns for the portfolio: declines
True or false: since the CAPM equation can be used only for individual securities, it cannot be used with portfolios False
Systematic risk will ____ when securities are added to a portfolio not change
How are the unsystematic risks of two different companies in two different industries related? there is no relationship
When a dollar in the future is discounted to the present it is worth less because of the time value of money, but when a news item is discounted, it means that the market: already knew about most of the news item
True or false: a well-diversified portfolio will eliminate ALL risks false
WAAC is used to discount: cash flows
To estimate a firm’s equity cost of capital using the CAPM, we need to know the: -stock’s beta-market risk premium-risk-free rate
To apply the dividend discount model to a particular stock, you need to estimate the: -growth rate-dividend yield
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ____ projects. too many
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project’s risk level? -the firm will overall become riskier-it will reject projects that it should have accepted-it will accept projects that it should have rejected
The return an investor in a security receives _______ _____ the cost of the security to the company that issued it equal to
The following are components used in the construction of the WACC: -cost of common stock-cost of debt-cost of preferred stock
For a firm with outstanding debt, the cost of debt will be the ______ on that debt yield to maturity
MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO’s tax rate is 40%, the after-tax rate of return on its preferred stock is: 10%
Suppose a firm’s capital structure consists of 30% debt, 10% preferred stock and 60% equity. The firm’s bonds yield 10% on average before taxes, the cost of preferred stock is 8% and the cost of equity is 16%. Calculate the firm’s WACC assuming a tax rate of 40% 12.50%0.6×16%+0.3×10%x(1-.04)+0.1×8%
WACC was used to compute the following project NPVs: Project A=$100, Project B=-$50, Project C=-$10, Project D=$40. Which projects should the firm accept? A and D
If the firm is all-equity, the discount rate is equal to the firm’s cost of _____ capital equity
If a firm is funded with $400 in debt and $1,200 in equity, the weight of equity is ____ and the weight of debt is ____ to be used to compute the WACC 75%, 25%
The growth rate of dividends can be found using: -security analysts’ forecasts-historical dividend growth rates
The rate used to discount project cash flows is known as the: -required return-discount rate-cost of capital
True or false: projects should always be discounted at the firm’s overall cost of capital false
The discount rate for the firm’s project equals the cost of capital for the firm as a whole when: all projects have the same risk as that of the firm overall
The WACC is the minimum required return for: the overall firm
The following is true about the cost of debt: -it is easier to estimate than the cost of equity-yields can be calculated from observable data
To estimate the dividend yield of a particular stock, we need: -the current stock price-the last dividend paid, D0-forecasts of the dividend growth rate, g
If an all equity firm discounts a project’s cash flows with the firm’s overall weighted average cost of capital even though the project’s beta is less than the firm’s overall beta, it is possible that the project might: rejected, when it should be accepted
Coupon interest paid on bonds is: tax-deductible to the firm
If a firm has multiple projects, each project should be discounted using: a discount rate commensurate with the project’s risk
Preferred stock: -pays a constant dividend-pays dividends in perpetuity
The most appropriate weights to use in the WACC are the ______ weights market value
Dividends paid to common stockholders ______ be deducted from the payer’s taxable income for tax purposes cannot
Some risk adjustments to a firm’s WACC for projects of differing risk, even if it is subjective, is probably: better than no risk adjustment
What can we say about the dividends paid to common and preferred stockholders? -dividends to common stockholders are not fixed-dividends to preferred stockholders are fixed
If the risk-free rate is 4 percent, an all-equity firm’s beta is 2, and the market risk premium is 6 percent, what is the firm’s cost of capital? 16%4%+2×6%=16%
Other companies that specialize only in projects similar to the project your firm is considering are called: pure plays
Finding a firm’s overall cost of equity is difficult because: it cannot be observed directly
Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM 15%
A firm’s capital structure consists of 30 percent debt and 70 percent equity. Its bonds yield 10 percent, pretax, its cost of equity is 16 percent, and the tax rate is 40 percent. What is its WACC? 13%

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