Sample quiz 4 for Fin 351 (solutions are in the end)

Please use the following information for questions 1-3.

A stock sells today for $40 per share. At the end of year, it will pay a dividend of $2 per share and sell for $44.

  1. What is the expected (total) rate of return on the stock?

(a) 25%

(b) 30%

(c) 15%

(d) 10%

(e) none of the above

  1. What is the dividend yield?

(a) 20%

(b) 15%

(c) 10%

(d) 5%

(e) none of the above

  1. What is the capital gain yield?

(a) 5%

(b) 10%

(c) 15%

(d) 20%

(e) none of the above

  1. The risk of a stock is measured by

(a) the stock price

(b) stock returns

(c) the volatility of the stock return

(d) the mean of the stock price

(e) none of the above

  1. Which of the following is used to measure the performance of a broad-based portfolio of stocks?

(a) The market index

(b) An individual stock

(c) A portfolio of two stocks

(d) A stock that has the largest price per share

(e) none of the above

  1. The risk that remains in a well-diversified stock portfolio is

(a) systematic risk or market risk

(b) firm-level risk

(c) idiosyncratic risk

(d) unique risk

(e) none of the above

  1. Betas measure

(a) firm-level risk

(b) unique risk

(c) systematic risk or market risk

(d)idiosyncratic risk

(e) none of the above

Use the following information for questions 8-15

You have $100. You borrow another $100 from the bank at the risk-free rate of 5%. You invest all the money ($200) in the market portfolio. This means that you have a portfolio of the market portfolio and the risk-free security. The expected rate of return on the market portfolio is 15%.

  1. What is the beta of the market portfolio?

(a)0

(b)1

(c)1.5

(d) 2

(e) none of the above

  1. What is the beta of the risk-free security ?

(a) 1

(b) 0

(c) 2

(d) 1.5

(e) none of the above

  1. What is the portfolio weight on the market portfolio?

(a) 1

(b) 2

(c) 3

(d) 4

(e) none of the above

  1. What is the portfolio weight on the risk-free asset (your borrow money from the bank)?

(a) 0

(b) 1

(c) 2

(d) -1

(e) none of the above

  1. What is the beta of your portfolio?

(a) 0

(b) 1

(c) 2

(d) 3

(e) none of the above

  1. What is the expected rate of return on your portfolio?

(a) 20%

(b) 25%

(c) 21%

(d) 30%

(e) none of the above

  1. What is risk premium on the market portfolio?

(a) 9%

(b) 15%

(c) 10%

(d) 14%

(e) none of the above

  1. What is the risk premium on your portfolio

(a) 10%

(b) 15%

(c) 20%

(d) 5%

(e) none of the above

  1. The slope of the security market line is

(a) the risk premium on the market portfolio

(b) beta

(c) the expected return on the market portfolio

(d) the risk-free rate

(e) none of the above

Using the following information for questions 17-19

A firm has a market value of equity of $100 million. The market value of its debt is also $100 million. The risk premium on the market portfolio is 10% and the risk-free rate is 5%. The firm has an equity beta of 2 and a debt beta of 0.5. Suppose that there is no tax.

  1. What is the cost of equity for the firm?

(a) 10%

(b) 25%

(c) 20%

(d) 15%

(e) none of the above

  1. What is the cost of debt for the firm?

(a) 5%

(b) 10%

(c) 15%

(d) 20%

(e) none of the above

  1. What is the WACC for the firm?

(a) 20%

(b) 17.5%

(c) 20.5%

(d) 21.5%

(e) none of the above

  1. Why are we interested in WACC in this course?

(a) WACC is an interesting name

(b) WACC is related to the amount of future cash flows of a project.

(c) WACC is the approximation of the discount rate used in capital budgeting

(d) none of the above

Solutions:

1

r = (44-40+2)/40=15%

Answer (C)

2

Dividend yield=2/40=5%

Answer (D)

3

Capital gain yield=(44-40)/40=10%

Answer (B)

4

The risk of a stock is measured by the variance or standard deviation of stock returns. Standard deviation is also called volatility.

Answer (C)

5

The market index, such as Dow Jones Industrial Average or S&P 500, is used to measure the performance of a broad-based portfolio of stocks.

Answer (A)

6

Firm-level risk or idiosyncratic risk or unique risk can be diversified away in a well-diversified portfolio.

Answer (A)

7

This is a concept.

Answer (C)

8

This is a fact, based on the definition of the Beta.

Answer (B)

9

This is a fact, based on the definition of the Beta.

Answer (B)

10

W=$100 (the initial money), Wm=$200 (spent on the market portfolio)

W risk-free = -$100 (spent on the risk-free security. It is negative, since you got money) Xm=200/100=2.

Answer (B)

11

X risk-free = -100/100 = -1

Answer (D)

12

The beta of your portfolio is the weighted average of the betas of risk-free security and the market portfolio in your portfolio, that is,

Beta p = -1*0+2*1=2

Answer (C)

13

Using the CAPM

Rp = 5%+2*(15%-5%) = 25%

Answer (B)

14

The risk premium =15% -5% =10%

Answer (C)

15

The risk premium =25% -5% =20%

Answer (C)

16

In the security market line, the slope is the risk premium on the market portfolio.

Answer (A)

17

Using the CAPM

Re = 5% + 2*10%=25%

Answer (B)

18

Using the CAPM

Rd = 5% + 0.5*10% =10%

Answer (B)

19

Using the WACC formula

WACC = (100/200)*Rd+(100/200)*Re=17.5%, since there is no corporate tax.

Answer (B)

20

When we want to calculate the NPV of taking a project, we have to find the discount rate. WACC is the good approximation.

Answer (C)