FIN 335

Exam III

Spring 2008

For Dr. Grahams class

(With an addendum including some additional practice questions.)

 The following 30 questions are worth 3 points each. Choose the single best response.

1. The excess return required on a risky asset over that earned on a risk-free asset is called (a):
A) Risk premium.
B) Return premium.
C) Excess return.
D) Average return.
E) Variance.

2. The hypothesis that market prices reflect all available, public and private, information is called
efficiency in the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.

3. Over the past 76 years, which of the following investments has been the most risky?
A) Small company stocks
B) Common stocks
C) Treasury bills
D) Treasury bonds
E) Corporate bonds

4. You track the liquidity of companies and find that you can consistently earn unusually high returns by
purchasing the shares of firms whose stock price falls below the cash value per share as indicated on
the published balance sheet. Which of the following must be true?
A) This is not a violation of market efficiency.
B) This is not a violation of weak form efficiency.
C) This is a violation of the semi-circular form of efficiency.
D) This is a violation of semi-strong form efficiency.
E) This would be a violation of all forms of market efficiency.

5. You purchased 500 shares of preferred stock on January 1, 2002, for $95 per share. The stock pays an
annual dividend of $2 per share. On December 31, 2002, the market price is $94 per share. What is
your total dollar return for the year?
A) $ 1,000
B) $ 500
C) $ 3,500
D) $ 300
E) -$ 500

6. You purchased a bond on January 1, 2002, for $1,065. The bond has a $1,000 face value, a 10%
annual coupon, and can be sold for $975 on December 31, 2002. What is your percentage return on
investment for the year?
A) 4.1%
B) 0.9%
C) 9.4%
D) -8.4%
E) 12.5%
Use the following to answer questions 7-8:

You purchase 800 shares of stock at a price of $20 per share. One year later, the shares are selling for $23 per
share. In addition, a dividend of $2 per share is paid at the end of each year.

7. What is the capital gains yield for the investment?

A) 8.5%
B) 10.0%
C) 11.5%
D) 13.0%
E) 15.0%

8. What is the dividend yield for the investment?

A) 2.5%
B) 7.5%
C) 10.0%
D) 15.0%

9. The return that lenders require on their loaned funds to the firm is called the:
A) Coupon rate.
B) Current yield.
C) Cost of debt.
D) Capital gains yield.
E) Cost of capital.

10. The weighted average of the firm's costs of equity, preferred stock, and aftertax debt is the:
A) Reward to risk ratio for the firm.
B) Expected capital gains yield for the stock.
C) Expected capital gains yield for the firm.
D) Portfolio beta for the firm.
E) Weighted average cost of capital (WACC).

11. All else the same, a higher corporate tax rate _____________________.
A) will decrease the WACC of a firm with some debt in its capital structure
B) will increase the WACC of a firm with some debt in its capital structure
C) will not affect the WACC of a firm with some debt in its capital structure
D) will decrease the WACC of a firm with no debt in its capital structure
E) will change the WACC of a firm with some debt in its capital structure, but the direction is
unclear.

12. A stock has an initial price of $75 per share. It pays a dividend of $1.25 per share during the year. Its
price at the end of the year is $86. Compute the percentage total return.
A) 1.67%
B) 16.3%
C) 14.67%
D) 14.245
E) 12.8%
13. The percentage of a portfolio's total value invested in a particular asset is called that asset's:
A) Portfolio return.
B) Portfolio weight.
C) Portfolio risk.
D) Rate of return.
E) Investment value.

14. The principle of diversification tells us that:

A) Spreading an investment across two or three large stocks will eliminate none of your risk.
B) Concentrating an investment in one large stock will reduce your overall risk.
C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate
unsystematic risk.
D) Investing across many diverse assets will eliminate most of the systematic risk.
E) Spreading an investment across many diverse assets will eliminate some of the risk.

15. The linear relation between an asset's expected return and its beta coefficient is the central prediction
of the CAPM; what is it called?
A) Reward to risk ratio.
B) Portfolio weight.
C) Portfolio risk.
D) Security market line.
E) Market risk premium.

16. You own 50 shares of stock A, which has a price of $12 per share, and 100 shares of stock B, which
has a price of $6 per share. What is the portfolio weight for stock B in your portfolio?
A) 25%
B) 33%
C) 50%
D) 67%
E) 75%

17. What is the expected return for the following stock in a recession?

S ta te P ro b a b ility R e tu rn
A v e ra g e .5 0 .2 5
R e c e s s io n .3 5 .0 5
D e p re s s io n .1 5 .3 5

A) .05
B) .08
C) .09
D) .10
E) .12
18. What is the risk premium for a stock if the risk-free rate is 4%? Its beta is 1 and its expected return is
12%.

A) 12%
B) 10%
C) 7%
D) 9%
E) The market risk premium.

19. What is the expected portfolio return given the following information?

Asset Portfolio weight Return

A .85 20%
B .15 35%

A) 22.25%
B) 20%
C) 35%
D) 27.5%
E) 50%

20. What is the expected return on asset A if it has a beta of 0.6, the expected market return is 15%, and
the risk-free rate is 6%?
A) 5.4%
B) 9.6%
C) 11.4%
D) 15.0%
E) What is an expected return?

21. A company's preferred stock pays an annual dividend of $7.00 per share. When issued, the shares sold
for their par value of $100 per share. What is the cost of preferred stock if the current price is $100
per share?
A) 5.8%
B) 7.0%
C) 8.1%
D) 9.6%
E) 12.0%

22. Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target debt/equity
ratio is 0.60, and the tax rate is 35%, what is the firm's weighted average cost of capital (WACC)?
A) 7.4%
B) 9.9%
C) 11.8%
D) 13.2%
E) 14.3%
23. Suppose a firm has 19 million shares of common stock outstanding. The current market price per
share is $18.35. The firm has outstanding debt with a par value of $100.5 million selling at 96% of
par. What capital structure weight would you use for equity when calculating the firm's WACC?
A) 0.15
B) 0.24
C) 0.54
D) 0.78
E) 0.96

24. Jet Corporations stock has a beta of 1.27, the risk-free rate is 5%, and the expected return on the
market is 13%. What is Jets cost of equity capital?
A) 15.16%
B) 16.51%%
C) 22.96%
D) 14.17%
E) 11.35%

25. The financial leverage of a firm will ______________________ .

I. increase as the debt/equity ratio increases

II. decrease if the firm issues more stock
III. decrease if the firm has positive net income and a dividend payout ratio of less than 1.

A) I only
B) II only
C) III only
D) I and II only
E) I and II and III are all true

26. What return would we expect for a stock whose beta is twice the market average, where the market is
expected to earn a risk premium of 5% and the risk free rate is 4%?
A) We would expect to earn a really good return.
B) 9%.
C) 13%
D) 14%
E) 15%

27. For the firm in number 26, what if the expected return of the stock were 16%, and you did not know
the risk free rate. What would that tell you about the implied risk free rate?

A) It would tell me nothing, as I am a shallow and vacuous person.

B) Not enough information is provided to reach any conclusion.
C) The risk free rate is 4%, as noted in number 26.
D) The risk free rate must be 5%.
E) The risk free rate must be 6%.
28. A firm is concerned that the prospects for a sandwich shop are riskier than expected; another
sandwich shop is opening nearby, and it is financing its opening entirely with cash. For the firm facing
new economic competition, this is an example of:

A) Business risk
B) Marketable risk
C) Financial risk
D) Neither business nor financial risk, as no debt is involved.
E) Both business and financial risk, because the existing sandwich shop is financed entirely with
equity.

29. News has just hit Wall Street that a deal with an NPV of $20 million is being announced for a firm
with 10 million shares outstanding. Assuming no one trading the stock knew anything about this news,
what would be the impact of this news on the stock price, if the semi-strong version of the EMH
holds?

A) $2
B) $2, but it would take several months, until the deal was done
C) $20
D) $.50
E) $10 today and $10 tomorrow.

30. You are buying a shopping center for $1 million with a net operating income of $150,000 per year.
You are contemplating either a cash purchase of $1 million or using $300,000 down with a loan for $700,000.
The annual debt service on the loan is $90,000. Ignoring taxes, what is the impact of the debt in this example?
a. There is no advantage of debt in an efficient market.
b. Debt is a disadvantage, as it reduces your cash flows by $60,000 per year.
c. The advantage of debt is a smaller cash requirement to buy the shopping center.
d. The advantage of debt is a return on your money of 20% with debt financing, versus a return of
only 15% without debt financing.
e. The advantage of debt is a return of 50% on your money with debt financing, versus a return of
only 15% without debt financing.
And, an addendum, including a few additional practice questions .. from the fall of 2011

1. Which of the following is generally considered to represent the risk-free return?

A) Common stocks
B) Small stocks
C) Long-term government bonds
D) Long-term corporate bonds
E) Treasury bills

2. You track the liquidity of companies and find that you can consistently earn unusually high returns by
purchasing the shares of firms whose stock price falls below the cash value per share as indicated on
the published balance sheet. Which of the following must be true?
A) This is not a violation of market efficiency.
B) This is not a violation of weak form efficiency.
C) This is a violation of the semi-circular form of efficiency.
D) This is a violation of semi-strong form efficiency.
E) This would be a violation of all forms of market efficiency.

3. Which of the following is FALSE regarding risk and return?

A) The risk-free asset earns the risk-free rate of return.
B) The reward for bearing risk is known as the standard deviation.
C) Based on historical data, there are rewards for bearing risk.
D) An increase in the risk of an investment will result in an increased risk premium.
E) In general, the higher the risk the higher the expected return.

4. The notion that actual capital markets, such as the NYSE, are fairly priced is called the:
A) Efficient Markets Hypothesis (EMH).
B) Law of One Price.
C) Open Markets Theorem.
D) Laissez-Faire Axiom.
E) Monopoly Pricing Theorem.

5. Based on the historical record from 1926 to 2001, which of the following types of securities earned
the SECOND LOWEST return?
A) Long-term corporate bonds.
B) The common stock of small capitalization firms listed on NYSE.
C) The common stock of the 500 largest firms in the United States.
D) US Treasury bills.
E) Long-term government bonds.

6. Which of the following assets likely has the SECOND highest level of risk?
A) Long-term corporate bonds.
B) US Treasury bills.
C) Long-term government bonds.
D) Common stock of the largest companies in the United States.
E) Common stock of the smallest companies listed on NYSE.
7. A stock has a beta of .9, the expected return on the market is 10 percent, and
the risk free rate is 5 percent. What is this stocks expected return?
A) 14.5%
B) 15%
C) 9.5%
D) 14%
E) 10%

8. A stock asset has a beta of 1.2 and an expected return of 14%. A risk free asset
has an expected return of 4%. What is the expected return of a portfolio equally
invested in the two assets?
A) 9%
B) 10%
C) 12%
D) 14%
E) 18%

9. A stock has an expected return of 16.4% and a beta of 1.3. The expected return
on the market is 14%. What is the implied risk free rate of return?
A) 2%
B) 2.4%
C) 3%
D) 4%
E) 6%

10. Risk that affects a large number of assets, each to a greater or lesser degree, is called:
A) Idiosyncratic risk.
B) Diversifiable risk.
C) Systematic risk.
D) Asset-specific risk.
E) Total risk.

11. The principle of diversification tells us that:

A) Concentrating an investment in two or three large stocks will eliminate all of your risk.
B) Concentrating an investment in two or three stocks will reduce your overall risk premium.
C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate any
risk.
D) Spreading an investment across many diverse assets will eliminate some of the risk.
E) Spreading an investment across diverse assets will eliminate systematic risk.

12. The amount of systematic risk present in a particular risky asset, relative to the systematic risk present
in an average risky asset, is called this particular asset's:
A) Beta coefficient.
B) Reward to risk ratio.
C) Law of One Price.
D) Diversifiable risk.
E) Treynor index.
13. The linear relation between an asset's expected return and its beta coefficient is the:
A) Reward to risk ratio.
B) Portfolio weight.
C) Portfolio risk.
D) Security market line.
E) Market risk premium.

14. The slope of an asset's security market line is the _______________ .

A) reward to risk ratio
B) portfolio weight
C) beta coefficient
D) risk-free interest rate
E) market risk premium

15. The stock in Scoundrel, Inc. shows a historical return of 13.5% with a standard deviation of 20%. The
projected return on Scoundrel, based on 5 possible states of the economy, is 15.5% with a standard
deviation of 22%. Which of the following is true about the stock?
A) The projected returns of Scoundrel must be positive in all possible states of the economy.
B) Projected returns vary less widely from the expected return than historical returns did from the
historical average return.
C) Investors who prefer assets with high returns and relatively low risk will likely now be more
interested in the stock than in the past.
D) The risk premium for the stock has probably increased.
E) Investors who choose this stock should expect, on average, to lose money.

16. What is the expected return for the following stock?

S ta te P ro b a b ility R e tu rn
A v e ra g e .5 0 .2 5
R e c e s s io n .3 5 .0 5
D e p re s s io n .1 5 .3 5

A) .05
B) .08
C) .09
D) .10
E) .12

17. What is the risk premium for the following returns if the risk-free rate is 4%?

S ta te P ro b a b ility R e tu rn
B oom .2 0 .7 5
G ood .5 5 .2 5
R e c e s s io n .1 5 .1 0
D e p re s s io n .1 0 .5 0

A) 0.3325
B) 0.1525
C) 0.0525
D) 0.1825 (I think)
E) 0.2225
18. The opportunity cost associated with the firm's capital investment in a project is called its:
A) Cost of capital.
B) Beta coefficient.
C) Capital gains yield.
D) Sunk cost.
E) Internal rate of return.

19. The weighted average of the firm's costs of equity and after-tax debt is the:
A) Reward to risk ratio for the firm.
B) Expected capital gains yield for the stock.
C) Expected capital gains yield for the firm.
D) Portfolio beta for the firm.
E) Weighted average cost of capital (WACC).

20. All else the same, a higher corporate tax rate _____________________.
A) will decrease the WACC of a firm with some debt in its capital structure
B) will increase the WACC of a firm with some debt in its capital structure
C) will not affect the WACC of a firm with some debt in its capital structure
D) will decrease the WACC of a firm with no debt in its capital structure
E) will change the WACC of a firm with some debt in its capital structure, but the direction is
unclear.

21. The long-term debt of your firm is currently selling for 109% of its face value. The issue matures in
12 years and pays an annual coupon of 7.5%. What is the cost of debt?
A) 5.60%
B) 6.40%
C) 7.50%
D) 8.90%
E) 9.30%

Answer questions 22-26 with the following information: You purchase 800 shares of Ryans
stock at a price of $20 per share. One year later, the shares are selling for $22 per share. In
addition, a dividend of $1 per share was paid at the end of the year.

22. What is the total dollar return for the investment?

A) $1,600
B) $2,400 (I think)
C) $16,000
D) $800
E) $8,000

23. Calculate the percentage return on Ryans stock. If the stock had a beta of 2, and the market risk
premium is 7.5%, what is the implied risk free rate of return?
A) 2.5%
B) 7.5%
C) 15%
D) 0% (I think)
E) Answers A and B could both be correct.
24. What is the implied dividend growth rate in Ryans stock?
A) 10%
B) 5%
C) 15%
D) 7.5%
E) Answers A and B could both be correct.

25. What is the implied cost of equity capital for Ryans stock?
A) 10%
B) 5%
C) 15%
D) 22.5%
E) Answers C and D could both be correct.

26. Using all the information above, what is the implied risk premium for Ryans stock?
A) 10%
B) 20%
C) 15% (I think)
D) 7.5%
E) 22.5%

27. You are buying a single-family home in Jacksonville, Florida for $60,000. You expect to have net
operating income of $6,000 per year. This provides you with a 10% return where your return =
NOI/equity investment ($6,000/$60,000). Assume you can borrow 50% of the purchase price at 5%
interest, with fixed monthly payments over a 30-year amortization period. (Ignore taxes, depreciation,
and the pay-down of the principal balance on the mortgage.) With the use of debt, your NOI cash
flow is reduced by the debt service, but your equity investment is reduced by 50%. The return with
the use of debt is:
A) 6.78%
B) 13.6%
C) 15.5%
D) 20%
E) 7.12%

28. A bond issue sells for $875. The coupon rate is 7%, the bonds mature in 20 years, and interest is paid
semiannually. The tax rate is 35%. What is the after-tax cost of debt?
A) 3.18%
B) 4.55%
C) 8.29%
D) 9.34%
E) 5.39%

29. A firm has 5,000,000 shares of common stock outstanding with a market price of $9.00 per share. It
has 25,000 bonds outstanding, each selling for $1,100. The bonds mature in 12 years, have a coupon
rate of 8.5%, and pay coupons annually. The firm's beta is 1.4, the risk free rate is 5%, and the market
risk premium is 9%. The tax rate is 35%. Calculate the WACC. (take your time)
A) 8.29%
B) 9.33%
C) 10.84%
D) 12.71%
E) 14.30%
30. ___________ arises from decisions that affect the left-hand side of the balance sheet,
while___________ arises from decisions that affect the right-hand side of the balance sheet.
A) Systematic risk; financial risk
B) Systematic risk; unsystematic risk
C) Unsystematic risk; systematic risk
D) Business risk; diversifiable risk
E) Business risk; financial risk