Question 1

Investment projects that plot above the security market line would be considered to have:

Accepted Answer

Investment projects that plot above the security market line have a higher expected return than the market for the level of risk taken. Therefore, they would be considered as having a positive net present value (NPV).

Question 2

The project cost of capital is:

Accepted Answer

The project cost of capital is not necessarily related to the company cost of capital because it depends on the specific risk and characteristics of the project, which may differ from the overall company risk profile.

Question 3

The slope of the regression line that exhibits the past relationship between a stock's returns and the market's returns is the:

Accepted Answer

The slope of the regression line that shows the relationship between a stock's returns and the market's returns is known as the stock's beta. It measures the stock's volatility in relation to the market.

Question 4

The basic tenet of the CAPM is that a stock's expected risk premium should be:

Accepted Answer

The CAPM model states that a stock's expected risk premium should be proportionate to the stock's beta. Beta measures the stock's volatility or systematic risk relative to the market as a whole. Therefore, the greater the beta, the greater the expected risk premium. The expected market return and risk-free rate are used in the CAPM calculation to determine the required rate of return for the stock, but do not necessarily determine the expected risk premium.

Question 5

If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%:

Accepted Answer

The Security Market Line (SML) represents the expected return of a security or portfolio as a function of its beta with the market. A portfolio expected to return less than the market portfolio (16% in this case) but still has a positive expected return (13% in this case) would have a beta less than 1. This indicates that the portfolio is less volatile than the market and thus its expected return is lower, aligning with the principles of the Capital Asset Pricing Model (CAPM).

Question 6

A project with higher than average risk offers an expected return of 14%. Which statement is correct if the company's opportunity cost of capital is 12% and the project's opportunity cost of capital is 15%?

Accepted Answer

The project's opportunity cost of capital is 15%, which is higher than the company's opportunity cost of capital of 12%. This means that the project's expected return of 14% is not sufficient to compensate for the higher risk involved. Therefore, the project's NPV is likely negative, and it should be rejected.

Question 7

Which one of the following adjustment techniques would be preferred to account for additional project risk?

Accepted Answer

Adjusting expected cash flows downward would reflect the additional project risk by reducing the expected future cash flows, which would result in a lower present value of the project. This adjustment technique is preferable to the others listed because it directly accounts for the additional project risk. Increasing the discount rate would also account for increased risk, but it may not accurately reflect the specific risks associated with the project. Increasing the beta and adjusting the market risk premium would primarily reflect changes in the systematic risk of the overall market, rather than the specific risks associated with the project.

Question 8

Based on the period 1926-2013, value stocks have:

Accepted Answer

According to various studies, value stocks have provided a higher long-run return than growth stocks based on the period 1926-2013. Therefore, option C is the correct choice. The other choices are not accurate as value stocks may have a high book value to market value ratio, CAPM cannot predict stock performance accurately, and value stocks have not consistently underperformed.

Question 9

What would you recommend to an investor who is considering an investment that, according to its beta, plots below the security market line?

Accepted Answer

A beta that plots below the security market line indicates that the expected return is lower relative to the risk involved. This means that the stock is considered riskier than the market as a whole, but with a lower potential return. Therefore, it is not recommended to invest as the risk is high relative to the return.

Question 10

Which one of the following is most likely correct for a diversified stock portfolio that exhibits a higher standard deviation than the market index?

Accepted Answer

A portfolio with a higher standard deviation than the market index typically contains more aggressive stocks, which are expected to have higher volatility. This increased volatility reflects a higher level of risk, which is characteristic of aggressive investments.

Question 11

What happens to the expected portfolio return if the portfolio beta increases from 1.0 to 1.5, the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to 9%?

Accepted Answer

r_p = 5% + 1(8) = 13%; r_p = 4% + 1.5(9) = 17.5%

Question 12

What type of risk is properly reflected in a project's discount rate?

Accepted Answer

Market risk is properly reflected in a project's discount rate because it represents the risk that affects all companies in the market. Unique, total, and diversifiable risks are specific to a company or can be mitigated through diversification, and thus are not typically reflected in the discount rate.

Question 13

Which one of the following statements best explains the fact that cyclical firms tend to have high betas?

Accepted Answer

Cyclical firms are heavily affected by economic cycles, and their earnings tend to be volatile. As a result, their stocks' returns are also more uncertain and sensitive to changes in the economy, resulting in higher betas.

Question 14

If the company cost of capital is 20% and a proposed project's cost of capital is 15%, then discounting the projects' cash flows at 20% would:

Accepted Answer

Discounting the project's cash flows at a higher rate (20%) than the project's cost of capital (15%) would make the present value of the project's cash flows appear smaller than they actually are. This could lead to the project being rejected even though it might be profitable if evaluated at the correct rate (15%).

Question 15

A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable.

Accepted Answer

The answer of A proposed investment must earn at least...

Question 16

Assume last month a stock with a beta of 1.0 lost 2% while the S&P 500 had a 1% gain. Given this it is most likely that the:

Accepted Answer

Beta measures a stock's volatility in relation to the overall market. A beta of 1.0 suggests the stock should move with the market. If the stock lost value while the market gained, it's likely due to firm-specific news rather than an incorrect beta calculation or issues with the S&P 500 as a market representation.

Question 17

An investor divides her portfolio into thirds, with one part in Treasury bills, one part in a market index, and one part in a diversified portfolio with beta of 1.50. What is the beta of the investor's overall portfolio?

Accepted Answer

β_Portfolio = (0 + 1 + 1.5)/3 = 0.83

Question 18

The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if:

Accepted Answer

The company cost of capital is the weighted average of the cost of debt and equity and is used to discount cash flows in capital budgeting proposals. However, if the risk of the proposal is different from the overall risk of the company, then the cost of capital may not be an appropriate discount rate. In such a case, a different discount rate that reflects the specific risk of the proposal should be used. Therefore, option B is the best choice. Option A is incorrect because NPV is an output of the capital budgeting analysis, not a basis for selecting a discount rate. Option C may be true, but it is not the best choice since it is too general and does not specifically address the appropriateness of the cost of capital. Option D is also not the best choice since expecting to earn more than the risk-free rate is a normal expectation for any investment, and it does not explain why the cost of capital may be inappropriate for a specific proposal.

Question 19

If changing discount rates from the company cost of capital to the project cost of capital changes NPV from negative to positive, then the project should use the:

Accepted Answer

If changing the discount rate from the company cost of capital to the project cost of capital changes the NPV from negative to positive, it means that the project has a positive NPV at its own cost of capital. Therefore, the project should be accepted and the project cost of capital should be used as the discount rate. Using the company cost of capital would result in undervaluing the project and potentially rejecting a profitable investment.

Question 20

The minimum acceptable expected rate of return on a project of a specific risk is the:

Accepted Answer

The minimum acceptable expected rate of return on a project of a specific risk is the project cost of capital, which represents the minimum required rate of return that a company needs to achieve from a project to cover its cost of capital and maintain its value. The project cost of capital takes into account the risk of the project and the cost of financing it, and it reflects the expected return that investors require for taking on that level of risk. Options B, C, and D are not the correct answers because they do not adequately reflect the specific risk of the project and the cost of financing it.

Quiz 12: Risk, Return, and Capital Budgeting