A market analyst has estimated the equity beta of Modern
Homes Inc. to be 1.4. This beta implies that the company’s
(b) The requirement is to interpret an equity beta of 1.4.
Beta is a measure of systematic risk of the investment. Answer
(b) is correct because a beta of greater than 1 means the investment’s
systematic risk is higher than that of the market portfolio.
Answer (a) is incorrect because the beta would have to be less
than 1 for this relationship to exist. Answers (c) and (d) are incorrect
because beta focuses on systematic risk.
A measure that describes the risk of an investment project
relative to other investments in general is the
(b) The requirement is to identify the measure of the
risk of an investment relative to other investments in general.
Answer (b) is correct because the beta coefficient of an individual
stock is the correlation between the stock’s price and the price of
the overall market. As an example, if the market goes up 5% and
the individual stock’s price, on average, goes up 10%, the stock’s
beta coefficient is 2.0. Answer (a) is incorrect because the coefficient
of variation compares the risk of the stock to its expected
return. Answer (c) is incorrect because the standard deviation
measures the dispersion of the individual stock’s returns. Answer
(d) is incorrect because the expected return does not measure
The expected rate of return for the stock of Cornhusker
Enterprises is 20%, with a standard deviation of 15%. The expected
rate of return for the stock of Mustang Associates is 10%,
with a standard deviation of 9%. The riskier stock is
(d) The requirement is to identify the riskier stock.
Answer (d) is correct because the coefficient of variation of Mustang
is higher. The coefficient of variation provides a measure of
the relative variability of investments. It is calculated by dividing
the standard deviation of the investment by its expected return.
The coefficient of variation for Cornhusker is .75 (.15 ÷ .20) and
the coefficient of variation for Mustang is .9 (0.09 ÷ .10). Answer
(a) is incorrect because a higher return does not always mean
higher risk. Answer (b) is incorrect because the higher standard
deviation must be viewed relative to the expected return. Answer
(c) is incorrect because Mustang’s coefficient of variation is
higher than Cornhusker’s coefficient of variation.