quiz 4 for Fin 351

Please use the following information for questions 1-3.

A stock sells today for $50 per share. At the end of year, dividends are expected to be paid and each share is expectedto sell for $60. If the expected return for buying the stock now and holding it to the end of the year is 30%.

  1. What is the expected dividend payment per share at the end of the year ?

(a) $10

(b) $5

(c) $20

(d) $15

(e) none of the above

r = (60-50+5)/50=30%

Answer (B)

  1. What is the dividend yield?

(a) 20%

(b) 15%

(c) 10%

(d) 5%

(e) none of the above

Dividend yield=5/50=10%

Answer (C)

  1. What is the capital gain yield?

(a) 5%

(b) 10%

(c) 15%

(d) 20%

(e) none of the above

Capital gain yield=(60-50)/50=20%

Answer (D)

  1. The risk of a stock can be measured by

(a) the stock price

(b) stock returns

(c) the variance of the stock return

(d) the mean of the stock price

(e) none of the above

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

Answer (C)

  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

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)

  1. The risk that is removed from forming a well-diversified stock portfolio is

(a) systematic risk

(b) firm-level risk

(c) Market risk

(d) Macro-economic factor risk

(e) none of the above

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

Answer (B)

  1. Betas measure

(a) firm-level risk

(b) unique risk

(c) systematic risk or market risk

(d)idiosyncratic risk

(e) none of the above

This is a concept.

Answer (C)

Use the following information for questions 8-15

You have $50. You borrow another $50 from the bank at the risk-free rate of 5%. You invest all the money ($100) in the market portfolio. This means that you have a portfolio of the market portfolio and the risk-free security. The risk premium on the market portfolio is 10%.

  1. What is the beta of the market portfolio?

(a)0

(b)-1

(c)1.5

(d) 2

(e) none of the above

Answer (e)

It should be 1.

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

(a) 0

(b) 1

(c) 2

(d) 1.5

(e) none of the above

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

Answer (A)

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

(a) 1

(b)-2

(c) 2

(d) 4

(e) none of the above

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 (C)

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

(a) 0

(b) 1

(c) - 1

(d) -0.5

(e) none of the above

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

Answer (C)

  1. What is the beta of your portfolio?

(a) 0

(b) 1

(c) 2

(d) 3

(e) none of the above

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)

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

(a) 20%

(b) 21%

(c) 25%

(d) 30%

(e) none of the above

Using the CAPM

Rp = 5%+2*(10%) = 25%

Answer (C)

  1. What is the expected return on the market portfolio?

(a) 9%

(b) 15%

(c) 10%

(d) 14%

(e) none of the above

The expected return =10% +5% =15%

Answer (B)

  1. What is the risk premium on your portfolio

(a) 10%

(b) 15%

(c) 20%

(d) 5%

(e) none of the above

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

Answer (C)

  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

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

Answer (A)

Using the following information for questions 17-19

A firm has a market value of equity of $50 million. The market value of its debt is also $50 million. The expected return on the market portfolio is 15% 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 corporate tax.

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

(a) 10%

(b) 25%

(c) 20%

(d) 35%

(e) none of the above

Using the CAPM

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

Answer (B)

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

(a) 5%

(b) 10%

(c) 12.5%

(d) 20%

(e) none of the above

Using the CAPM

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

Answer (B)

  1. What is the WACC for the firm?

(a) 20%

(b) 17.5%

(c) 20.5%

(d) 21.5%

(e) none of the above

Using the WACC formula

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

Answer (B)

  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

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)