FIN 3104 Chapter Notes - Chapter 7: Standard Deviation, Weighted Arithmetic Mean, Equity Premium Puzzle

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9 Apr 2018

School

Virginia Tech

Department

Finance, Insurance, Business Law

Course

FIN 3104

Professor

A J Keown

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Related Questions

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

______________is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the assetâs cash flows will be unfavorable or less than expected.

A __________________ is a listing, chart or graph of all possible outcomes, such as expected rates of return, with a probability assigned to each outcome.

The ______________________is a statistical measure of the variability of a set of observations. The variance of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation.

The _______________________ is equal to the standard deviation divided by the expected return; it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations.

A _______________________ dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their _______________________.

A ________________ is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk.

_________________ is a model based upon the proposition that any stockâs required rate ofreturn is equal to the risk free rate of return plus a risk premium reflecting onl y the risk remaining after diversification.

_________________ is the tendency of two variables to move together. A _________________ of +1.0 means that the two variables move up and down in perfect synchronization, while a coefficient of -1.0 means the variables always move in opposite directions.

_________________ is that part of a securityâs total risk that cannot be eliminated by diversification. It is measured by the beta coefficient. _________________ is also known as company specific risk. This risk can be eliminated by proper diversification.

The _________________ is a measure of a stockâs market risk, or the extent to which the returns on a given stock move with the stock market.

Question 5

1. Which of the following does not have default risk?

	a.	Money market mutual funds.
	b.	Commercial paper.
	c.	Negotiable certificates of deposit.
	d.	U.S. Treasury bills.

2 points

Question 6

1. The spread is the:

	a.	Difference between the bid and ask prices.
	b.	Commission charged by the broker.
	c.	Difference between the purchase and sale prices.
	d.	Difference between the commissions charged by full-service and discount brokers.

3 points

Question 7

1. Securities regulations protect investors by:

	a.	Requiring disclosures of information by firms.
	b.	Stopping investors from buying overpriced stock.
	c.	Reducing competition among brokers.
	d.	Establishing commission schedules.

3 points

Question 8

1. If a stock is bought on margin:

	a.	The full amount of the cost of the investment is borrowed.
	b.	The commissions on the investment are increased.
	c.	The cost of the investment is reduced.
	d.	The interest on the borrowed funds is set by the SEC.

3 points

Question 9

1. Sarbanes-Oxley, the latest important securities law:

	a.	Reduces potential conflicts between securities analysts and investment bankers.
	b.	Legalizes the sale of securities by investment brokers.
	c.	Requires corporate boards of directors to own stock.
	d.	Mandates that security analysts file their recommendations with the SEC.

2 points

Question 10

1. Which of the following are true about the present value of a dollar?

1. It increases as the interest rate increases.

2. It decreases as the interest rate increases.

3. It increases as the time period increases.

4. It decreases as the time period increases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 11

1. Time value concepts may not be used to determine:

	a.	The present value of an annuity.
	b.	The margin required on a stock purchase.
	c.	The future value of $100 deposited in a bank.
	d.	The present value of a lump sum.

2 points

Question 12

1. What is the marginal tax rate?

	a.	The tax rate paid on investment gains from items purchased on margin.
	b.	The tax rate paid on an additional dollar of taxable income.
	c.	The margin required on a stock purchase.
	d.	The present value of a lump sum.

2 points

Question 13

1. Examples of capital gains include sales of which of the following?

1. IRA accounts.

2. Stocks sold for a profit.

3. Real estate sold for a profit.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 14

1. With a Roth IRA, the individual:

	a.	May deduct annual contributions.
	b.	Earns tax-free income.
	c.	Defers taxes.
	d.	Avoids estate taxes.

2 points

Question 15

1. Sources of unsystematic risk include which of the following?

1. A firms financing decisions.

2. A firms operations.

3. Fluctuating market prices.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

2 points

Question 16

1. For diversification to reduce risk:

	a.	The returns on the individual securities should be highly correlated.
	b.	The prices of the stocks should be stable.
	c.	The returns on the individual securities should be negatively correlated.
	d.	One firm should offer dividends and the other should offer capital gains.

2 points

Question 17

1. Which of the following are true about beta coefficients?

1. They are a measure of systematic risk.

2. They relate the return on an individual security to the return on the market.

3. They measure the variability of an assets return.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 18

1. Which of the following does an efficient portfolio do?

1. Maximizes risk for a given return.

2. Minimizes risk for a given return.

3. Maximizes return for a given level of risk.

4. Minimizes return for a given level of risk.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 19

1. The security market line does not:

	a.	Indicate the relationship between risk and return.
	b.	Relate the market return and beta to a stock's return.
	c.	Identify the optimal portfolio for the investor.
	d.	Use beta coefficients as a measure of risk.

3 points

Question 20

1. Mutual funds ____ realized capital gains and income (for example, dividends received):

	a.	Retain.
	b.	Reinvest.
	c.	Distribute.
	d.	Distribute or reinvest.

2 points

Question 21

1. An index fund limits its portfolio to:

	a.	High quality securities.
	b.	Stocks that respond to changes in the consumer price index.
	c.	Stocks included in an aggregate measure of stock prices.
	d.	Stocks of firms in a particular industry.

2 points

Question 22

1. Mutual funds with beta coefficients greater than 1.0:

	a.	Have outperformed the market.
	b.	Have underperformed the market.
	c.	Have more systematic risk than the market.
	d.	Have less systematic risk than the market.

3 points

Question 23

1. Which of the following will tend to cause a stock's price to fall?

1. The firms beta declines.

2. The firms beta increases.

3. The risk-free rate declines.

4. The risk-free rate increases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 24

1. The use of P/E ratios to select stocks suggests that:

	a.	High P/E stocks should be purchased.
	b.	Low P/E ratio stocks are overvalued.
	c.	A stock should be purchased if it is selling near its historic low P/E.
	d.	A stock should be purchased if it is selling near its historic high P/E.

2 points

Question 25

1. What does the efficient market hypothesis require?

1. Financial markets to be competitive.

2. Prices to adjust rapidly.

3. Prices of undervalued securities to fall.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 26

1. Which of the following does the strong form of the efficient market hypothesis suggest?

1. Inside information will not lead to superior investment results.

2. Inside information will lead to superior investment results.

3. Studying financial statements will not lead to superior investment results.

4. Studying financial statements will lead to superior investment results.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 27

1. Which of the following is the least broad-based measure of stock prices?

	a.	NASDAQ market index.
	b.	Dow Jones industrial average.
	c.	S&P 500 stock index.
	d.	AMEX market value index.

3 points

Question 28

1. What is dollar-cost averaging?

	a.	Periodically buying a round lot of stock.
	b.	Periodically investing a specified dollar amount in a stock.
	c.	A means to increase the average cost basis.
	d.	A means to ensure a positive return.

2 points

Question 29

1. Stock dividends cause:

	a.	The price of a share of stock to rise.
	b.	The price of a share of stock to fall.
	c.	The value of the firm to rise.
	d.	The value of the firm to fall.

2 points

Question 30

1. Which of the following occurs when a stock has a two-for-one split?

	a.	The price of the stock doubles.
	b.	The firm's assets increase.
	c.	The firm's liabilities decrease.
	d.	The par value of the stock is reduced.

3 points

Question 31

1. Dividend reinvestment plans offer which of the following advantages?

1. Deferment of federal income taxes.

2. A convenient means to accumulate shares.

3. Dollar-cost averaging.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	2.

3 points

Question 32

1. When the Federal Reserve seeks to expand the money supply, it:

	a.	Sells securities.
	b.	Buy securities.
	c.	Runs a deficit.
	d.	Runs a surplus.

2 points

Question 33

1. The sum of cash, currency, and demand deposits is:

	a.	M1.
	b.	M2.
	c.	M3.
	d.	M4.

3 points

Question 34

1. If the Federal Reserve lowers the target federal funds rate:

	a.	The discount rate rises.
	b.	Liquidity in the banking system is increased.
	c.	Security prices fall.
	d.	Required reserves are also decreased.

3 points

Question 35

1. The anticipation of inflation suggests that the investor should:

	a.	Buy bonds.
	b.	Anticipate higher interest rates.
	c.	Avoid real estate investments.
	d.	Sell stocks of gold companies.

3 points

Question 36

1. The current ratio is unaffected by:

	a.	Using cash to pay a dividend.
	b.	The collection of an account receivable.
	c.	Selling inventory for a profit.
	d.	Selling bonds and using the funds to finance inventory.

2 points

Question 37

1. Which of the following are true as the debt ratio increases?

1. Fewer assets are debt financed.

2. More assets are debt financed.

3. The ratio of debt equity increases.

4. The ratio of debt equity decreases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 38

1. The technical approach suggests that future stock prices are forecasted by:

	a.	Past stock rates.
	b.	Financial ratios.
	c.	Accounting statements.
	d.	Monetary policy.

2 points

Question 39

1. The Dogs of the Dow strategy:

	a.	Forecasts the direction of the Dow Jones averages.
	b.	Suggests buying the Dow stocks with the highest dividend yields.
	c.	Outperforms the S&P 500.
	d.	Suggests buying the lowest-priced Dow stocks.

3 points

Question 40

1. Behavioral finance combines aspects from which two fields in an attempt to identify human traits that affect investment decisions?

	a.	Accounting and finance.
	b.	Finance and psychology.
	c.	Physics and finance.
	d.	Finance and marketing.

ochrewalrus157

Which of the following risks cannot be diversified away?

	A.	risk of a local natural disaster affecting company production
	B.	risk created by world political happenings
	C.	risk of losing a major contract
	E.	risk of a failed marketing campaign

Magee Company's stock has a beta of 1.20, the risk-free rate is 4.50%, and the market risk premium is 5.00%. What is Magee's required return?

	A.	10.25%
	B.	10.50%
	D.	11.00%
	E.	11.25%

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)

	A.	When held in isolation, Stock A has more risk than Stock B.
	C.	Stock A would be a more desirable addition to a portfolio than Stock B.
	D.	The required return on Stock A will be greater than that on Stock B.
	E.	The required return on Stock B will be greater than that on Stock A.

Which of the following statements is CORRECT?

	B.	Portfolio diversification reduces the variability of returns on an individual stock.
	C.	The smaller standard deviation is, the less likely that actual returns will be closer to expected returns, the lower the investment risk.
	D.	A stock with a beta of 1 is more risky than an average stock on the market.
	E.	A well-diversified investor will require to earn higher return on stocks with higher beta.

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? (WACC is the weighted average cost of capital, the financing rate, or discount rate)

	A.	The projectâs IRR increases as the WACC declines.
	B.	The projectâs NPV increases as the WACC declines.
	D.	The projectâs IRR decreases as the WACC declines.
	E.	none of the above is correct.

Burlees Inc.âs CFO has collected the following information to calculate its WACC:

â¢ The companyâs capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.

The companyâs tax rate is 40%.

What is the companyâs cost of common equity?

	A.	9.65%
	B.	13.00%
	D.	17.60%
	E.	18.91%

Burlees Inc.âs CFO has collected the following information to calculate its WACC:

â¢ The companyâs capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.

The companyâs tax rate is 40%.

What is the companyâs weighted average cost of capital (WACC)?

	A.	8.69%
	B.	9.21%
	D.	11.04%
	E.	12.51%

Which of the following statement is correct?

	A.	Higher flotation costs tend to reduce the cost of equity capital.
	C.	The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
	D.	A higher risk projectâs WACC should be adjusted higher.
	E.	Retained earnings bear no capital cost at all.

FIN 3104 Chapter Notes - Chapter 7: Standard Deviation, Weighted Arithmetic Mean, Equity Premium Puzzle

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