Question 1

You obtain beta estimates of General Electric from two different online sources and you are surprised to find that they are so different. Which of the following would NOT be a correct explanation for the difference?

Accepted Answer

Regression analysis and geometric analysis are both methods for estimating beta. The difference in beta estimates is likely due to the different methods used, not the data or market proxy.

Question 2

Compute the expected return given these three economic states, their likelihoods, and the potential returns:
$\begin{array} { c c r } \text { Eccormic State } &\text { Probability } & \text { Retum } \  \text { Fast Growth }&0.40 & 25 \% \\text { slow Growth }& 0.55 & 12 \% \\text { recession }& 0.05 & - 50 \% \end{array}$

Accepted Answer

To compute the expected return, multiply each return by its probability and sum the results: $0.40 \times 25\% + 0.55 \times 12\% + 0.05 \times (-50\%) = 10\% + 6.6\% - 2.5\% = 14.1\%$.

Question 3

You own $8,000 of City Steel stock that has a beta of 2.1. You also own $12,000 of Rent-N-Co (beta = 1.75) and $5,000 of Lincoln Corporation (beta = 0.50). What is the beta of your portfolio?

Accepted Answer

The beta of the portfolio is calculated as the weighted average of the individual betas, weighted by the proportion of the total investment in each stock. The calculation is as follows:$$ \text{Portfolio Beta} = \left( \frac{8000}{8000+12000+5000} \times 2.1 \right) + \left( \frac{12000}{8000+12000+5000} \times 1.75 \right) + \left( \frac{5000}{8000+12000+5000} \times 0.50 \right) $$$$ = \left( \frac{8000}{25000} \times 2.1 \right) + \left( \frac{12000}{25000} \times 1.75 \right) + \left( \frac{5000}{25000} \times 0.50 \right) $$$$ = (0.32 \times 2.1) + (0.48 \times 1.75) + (0.20 \times 0.50) $$$$ = 0.672 + 0.84 + 0.10 $$$$ = 1.612 $$Rounded to two decimal places, the portfolio beta is 1.61.

Question 4

Which of the following is a concern regarding beta?

Accepted Answer

All the choices listed are valid concerns regarding beta. Choice A highlights the issue of varying beta estimates depending on the market proxy used. Choice B points out that a company can change its risk level, potentially rendering a beta estimate outdated. Choice C addresses the limitation of beta in predicting future returns, as supported by research.

Question 5

Which of the following statements is incorrect regarding how beta is calculated?

Accepted Answer

Beta is calculated using the market return as the independent variable and the company return as the dependent variable. The accuracy of beta does not solely depend on using the oldest data possible; more recent, relevant data may provide a more accurate measure.

Question 6

A stock has an expected return of 9.5 percent, the risk-free rate is 2 percent and the return on the market is 8 percent. What is this stock's beta?

Accepted Answer

The stock's beta can be calculated using the Capital Asset Pricing Model (CAPM) formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the values: 9.5% = 2% + Beta * (8% - 2%). Solving for Beta gives Beta = 1.25.

Question 7

A company's current stock price is $50.00 and its most recent dividend was $1.00 per share. Since analysts estimate the company will have a 5 percent growth rate, what is its expected return?

Accepted Answer

The expected return can be calculated using the dividend discount model (also known as the Gordon growth model) formula: Expected Return = (Dividend/Current Price) + Growth Rate. Plugging in the values: (1/50) + 0.05 = 0.02 + 0.05 = 0.07 or 7.00 percent.

Question 8

A manager believes his firm will earn a 15 percent return next year. His firm has a beta of 2.1, the expected return on the market is 6 percent, and the risk-free rate is 2 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is undervalued or overvalued.

Accepted Answer

The correct answer is A because the expected return on the firm should be 10.4 percent, which is less than the 15 percent return that the manager believes the firm will earn. This indicates that the manager believes the firm is undervalued.

Question 9

You hold the positions in the following table. If you expect the market to earn 10 percent and the risk-free rate is 3 percent, what is the required return of the portfolio?
$$\begin{array} { l c r r } 
& \text { Price } & \text { Shares } & \text { Beta } \
\text { Websitecom } & \$ 25.00 & 100 & 2.72 \
\text { Budget Stores } & \$ 38.50 & 200 & 1.65 \
\text { Marnufacturing Corp } & \$ 52.00 & 50 & 2.30 \
\text { Pharnacy Corp. } & \$ 18.50 & 200 & 0.65
\end{array}$$

Accepted Answer

The required return of the portfolio can be calculated using the Capital Asset Pricing Model (CAPM) formula for each stock and then finding the weighted average based on the total value of the portfolio. The CAPM formula is: $$r = r_f + \beta (r_m - r_f)$$ where $r$ is the required return, $r_f$ is the risk-free rate, $\beta$ is the beta of the stock, and $r_m$ is the expected market return.First, calculate the total value of each position:- Websitecom: $25.00 * 100 = $2500- Budget Stores: $38.50 * 200 = $7700- Manufacturing Corp: $52.00 * 50 = $2600- Pharmacy Corp.: $18.50 * 200 = $3700Total portfolio value = $2500 + $7700 + $2600 + $3700 = $16500Next, calculate the weighted beta of the portfolio:$$ \text{Weighted Beta} = \left(\frac{2500}{16500} * 2.72\right) + \left(\frac{7700}{16500} * 1.65\right) + \left(\frac{2600}{16500} * 2.30\right) + \left(\frac{3700}{16500} * 0.65\right) $$$$ \text{Weighted Beta} = 0.1515 * 2.72 + 0.4667 * 1.65 + 0.1576 * 2.30 + 0.2242 * 0.65 $$$$ \text{Weighted Beta} = 0.4121 + 0.7701 + 0.3625 + 0.1457 = 1.6904 $$Finally, use the CAPM formula to find the required return of the portfolio:$$ r = 3\% + 1.6904 * (10\% - 3\%) $$$$ r = 3\% + 1.6904 * 7\% $$$$ r = 3\% + 11.8328\% $$$$ r = 14.8328\% $$Rounded to two decimal places, the required return of the portfolio is approximately 14.83 percent.

Question 10

A company has a beta of 0.85. If the market return is expected to be 9 percent and the risk-free rate is 2.5 percent, what is the company's required return?

Accepted Answer

The company's required return can be calculated using the Capital Asset Pricing Model (CAPM) formula: Required Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the given values: Required Return = 2.5% + 0.85 * (9% - 2.5%) = 2.5% + 0.85 * 6.5% = 2.5% + 5.525% = 8.025%.

Question 11

ABC Inc. has a dividend yield equal to 5 percent and is expected to grow at a 12 percent rate for the next seven years. What is ABC's required return?

Accepted Answer

The required return for ABC Inc. can be calculated using the dividend discount model (DDM) formula for stocks that pay dividends and are expected to grow at a constant rate: Required Return = Dividend Yield + Growth Rate. Therefore, ABC's required return = 5% (Dividend Yield) + 12% (Growth Rate) = 17%.

Question 12

You have a portfolio consisting of 20 percent Boeing (beta = 1.3) and 40 percent Hewlett-Packard (beta = 1.6) and 40 percent McDonald's stock (beta = 0.7). How much market risk does the portfolio have?

Accepted Answer

The portfolio's beta is calculated as the weighted average of the individual betas: (0.20 * 1.3) + (0.40 * 1.6) + (0.40 * 0.7) = 1.18. A beta of 1.18 means the portfolio has 18 percent more risk than the general market, which has a beta of 1.

Question 13

Which of the following statements is correct?

Accepted Answer

Penny stocks refer to the stocks of small companies that are typically priced below $5 per share, not necessarily below $1. They are known for their high volatility and risk. The other statements are incorrect: Restricted stocks often have limitations on sale rather than on voting rights, and the Capital Market Line (CML) represents the risk-return trade-off for efficient portfolios, graphing the risk (measured by standard deviation) against expected return, not the relationship between return and risk (beta), which is depicted by the Security Market Line (SML).

Question 14

You own $7,000 of Diner's Corp. stock that has a beta of 1.75. You also own $13,000 of Comm Corp. (beta = 1.15) and $20,000 of Airlines Corp. (beta = 0.7). Assume that the market return will be 12 percent and the risk-free rate is 3.5 percent. What is the total risk premium of the portfolio?

Accepted Answer

The portfolio beta is calculated as a weighted average of the individual betas: (7000/40000)*1.75 + (13000/40000)*1.15 + (20000/40000)*0.7 = 1.025. The risk premium is the portfolio beta times the market risk premium (market return - risk-free rate): 1.025 * (12% - 3.5%) = 8.76%.

Question 15

Which of the following is incorrect?

Accepted Answer

When a firm believes its stock is undervalued, it is less likely to issue additional shares because doing so would dilute the value of existing shares at a price that is considered too low. Instead, firms might prefer to buy back shares or seek alternative financing options.

Question 16

A company has a beta of 0.25. If the market return is expected to be 8 percent and the risk-free rate is 2 percent, what is the company's required return?

Accepted Answer

The answer of A company has a beta of 0.25....

Question 17

A company's current stock price is $22.00 and its most recent dividend was $0.75 per share. Since analysts estimate the company will have a 12 percent growth rate, what is its expected return?

Accepted Answer

The expected return can be calculated using the dividend discount model (also known as the Gordon growth model) for a stock, which is given by the formula: Expected Return = (Dividend/Current Price) + Growth Rate. Plugging in the values: Expected Return = ($0.75 / $22.00) + 12% = 0.0341 + 12% = 15.41%. The closest option to this calculated value is 15.82 percent, indicating a slight calculation or rounding difference in the options provided.

Quiz 10: Estimating Risk and Return