The benefits of diversification decline to near zero when the number of securities held increases beyond
Answer (D) is correct. The benefits of diversification become extremely small when more than 20 to 30 different securities are held. Moreover, commissions and other transaction costs increase with greater diversification.
Based on the following information about stock price increases and decreases, make an estimate of the stock’s beta: July = Stock +1.5%, Market +1.1%; August = Stock +2.0%, Market +1.4%; September = Stock –2.5%, Market – 2.0%.
Answer (A) is correct. Beta measures the volatility of the return of a security relative to the returns on the market portfolio. In each case, the stock price increase or decrease was a greater percentage than the market change. Thus, the beta (stock change over market change) is greater than 1.0.
DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.
? Issue $15 million of 20-year bonds at a price of $101, with a coupon rate of 8%, and flotation costs of 2% of par.
? Use $35 million of funds generated from earnings.
? The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.
The capital asset pricing model (CAPM) computes the expected return on a security by adding the risk-free rate of return to the incremental yield of the expected market return, which is adjusted by the company’s beta. Compute DQZ’s expected rate of return.
Answer (A) is correct. The market return (RM), given as 12%, minus the risk-free rate (RF), given as 5%, is the market risk premium. It is the rate at which investors must be compensated to induce them to invest in the market. The beta coefficient (?) of an individual stock, given as 60%, is the correlation between volatility (price variation) of the stock market and the volatility of the price of the individual stock. Consequently, the expected rate of return is 9.20% [RF + ? (RM – RF) = .05 + .6(.12 – 0.05)].
Using the capital asset pricing model (CAPM), the required rate of return for a firm with a beta of 1.25 when the market return is 14% and the risk-free rate is 6% is
Answer (D) is correct. The CAPM adds the risk-free rate to the product of the beta coefficient and the difference between the market return and the risk-free rate. The market-risk premium is the amount above the risk-free rate for which investors must be compensated to induce them to invest in the company. The beta coefficient of an individual stock is the correlation between volatility (price variation) of the stock market and the volatility of the price of the individual stock. Thus, the required rate is 16% [6% + 1.25 (14% – 6%)]
Which of the following is the major difference between the capital asset pricing model (CAPM) and arbitrage pricing theory (APT)?
Answer (B) is correct. CAPM uses a single systematic risk factor to explain an asset’s return whereas APT uses multiple systematic factors.
Stock J has a beta of 1.2 and an expected return of 15.6%, and stock K has a beta of 0.8 and an expected return of 12.4%. What is the expected return on the market and the risk-free rate of return, consistent with the capital asset pricing model?
Answer (A) is correct. This problem requires the use of simultaneous equations. Set up a CAPM formula for each stock: Stock J: 15.6 = RF + 1.2 (RM – RF)
Stock K: 12.4 = RF + .8 (RM – RF)
Removing the parentheses and combining terms, you get
Stock J:15.6 = 1.2RM – .2RF
Stock K: 12.4 = .8RM + .2RF
Since one equation has a positive .2 RF term and the other has a negative .2 RF term, we can add the equations together to eliminate the .2 RF term.
(15.6+12.4) = (1.2RM + .8RM) + (–.2RF + .2RF)
28 = 2RM
14 = RM
Substitute 14 for M in the second equation:
12.4 = RF + .8(14 – RF)
12.4 = .2 RF +11.2
1.2 = .2 RF, or RF=6
The difference between the required rate of return on a given risky investment and that on a riskless investment with the same expected utility is the
Answer (A) is correct. The required rate of return on equity capital in the capital asset pricing model is the risk-free rate (determined by government securities) plus the product of the market risk premium times the beta coefficient (beta measures the firm’s risk . The market risk premium is the amount above the risk-free rate that will induce investment in the market. The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock market and that of the price of the individual stock.
The systematic risk of an individual security is measured by the
Answer (B) is correct. The covariance is a measure of the mutual volatility of two securities. The covariance between the return of a single security and the return on the market as a whole is therefore the systematic (or market) risk of the single security.
Which one of the following would have the least impact on a firm’s beta value?
Answer (D) is correct. The payout ratio is the percentage of income available to common shareholders that was paid out in the form of dividends during a period. The payout ratio is more nearly the result, rather than the cause, of a firm’s beta value. The beta value is based on the volatility of a company’s earnings. Volatility is influenced by both financial and operating leverage and the characteristics of the industry in which the firm operates.
If Dexter Industries has a beta value of 1.0, then its
Answer (C) is correct. The effect of an individual security on the volatility of a portfolio is measured by its sensitivity to movements by the overall market. This sensitivity is stated in terms of a stock’s beta coefficient. If the beta coefficient is 1.0, then the price of that stock tends to move in the same direction and to the same degree as the overall market.