TBChap 012

Chapter 12
Risk, Return, and Capital Budgeting
True / False Questions
1. The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-
diversified investors who are concerned only with market risk.
True False
2. The CAPM states that the expected risk premium on any security equals its beta times the market
risk premium.
True False
3. The security market line displays the relationship between expected return and beta.
True False
4. The security market line sets a standard for other investments—investors will be willing to hold
other investments only if they offer equally good prospects as shown by the points on the line.
True False
5. The required risk premium for any given investment is defined by the security market line.
True False
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6. Empirical evidence suggests that over a long period of time returns are directly related to beta.
True False
7. There is little doubt that the CAPM captures everything that is going on in the market.
True False
8. Beta measures the total risk of an individual security.
True False
9. The security market line provides a standard that can be used to make project
acceptance/rejection decisions.
True False
10. If a low-risk company invests in a high-risk project, those cash flows should be discounted at a
high cost of capital.
True False
11. The project cost of capital depends on the risk of the company undertaking the project.
True False
12. Beta measures a stock's sensitivity to market risks.
True False
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13. The project cost of capital depends on how the capital is used.
True False
14. Investors expect aggressive stocks to outperform the market in periods of strong economic
activity.
True False
15. Defensive stocks typically provide better returns during periods of economic downturn since they
are not very sensitive to market fluctuations.
True False
16. Diversification decreases the variability of both unique and market risk.
True False
17. Market risk premium is defined as the difference between the market rate of return and the return
on risk-free Treasury bills.
True False
18. According to the CAPM, a stock's expected return is positively related to its beta.
True False
19. The CAPM is a theory of the relationship between risk and return that states that the expected risk
premium on any security equals its beta times the market return.
True False
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20. The stock of Newmont Mining, the world's largest gold producer, has above-average volatility but
a relatively low beta.
True False
21. According to the capital asset pricing model, the expected rates of return for all securities and all
portfolios lie on the capital market line.
True False
22. As a project's beta increases, the project's opportunity cost of capital increases.
True False
23. A project should be accepted if its return plots below the security market line.
True False
24. The security market line shows how the expected rate of return depends on beta.
True False
25. The required risk premium for any investment is given by the security market line.
True False
26. Project cost of capital and company cost of capital are synonymous terms.
True False
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27. The project cost of capital depends on the use to which that capital is put. Therefore, it depends
on both the risk of the project and also on the risk of the company.
True False
28. If a company with a low credit rating invests in a low-risk project, it should discount the cash flows
at a relatively high cost of capital.
True False
29. Changing the discount rate is equivalent to adjusting the expected cash flows as a method of
accounting for risk.
True False
Multiple Choice Questions
30. The return on a security includes premiums for:
A. market risk and unique risk.
B. unique risk and firm-specific risk.
C. diversification and portfolio risk.
D. time value of money and market risk.
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31. If a security plots below the security market line, it is:
A. ignoring all of the security's unique risk.
B. underpriced, a situation that should be temporary.
C. offering too little return to justify its risk.
D. a defensive security, which expects to offer lower returns.
32. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio contains only risk-free securities.
B. only macro events are tracked by economists.
C. the unique risks have been diversified away.
D. the firm-specific events would be too numerous to quantify.
33. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
34. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and the return on the market portfolio.
D. market risk premium on the stock.
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35. In theory, the "market portfolio" should contain:
A. the securities of the S&P 500.
B. the securities of the Dow.
C. the securities of the S&P 500 and Treasury bills.
D. all risky assets.
36. When the overall market is up by 10%, investors with portfolios of defensive stocks will probably
have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
37. When the overall market experiences a decline of 8%, investors with portfolios of aggressive stocks
will probably experience portfolio:
A. losses of less than 8%.
B. losses greater than 8%.
C. gains of less than 8%.
D. gains greater than 8%.
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38. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.
39. The average of the beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
40. The line plotted to fit observations of a stock's returns versus the market's returns determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
41. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2%,
then its beta equals:
A. 1.04.
B. 1.24.
C. 1.33.
D. 1.40.
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42. If the slope of the line measuring a stock's historic returns against the market's historic returns is
positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.
43. If the line measuring a stock's historic returns against the market's historic returns has a slope
greater than 1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.
44. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a month
where the market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.
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45. If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a priori,
we could expect this individual stock to:
A. lose more than 10%.
B. lose, but less than 10%.
C. gain more than 10%.
D. gain, but less than 10%.
46. Stock returns can be explained by the stock's _________ and the stock's __________.
A. beta; unique risk
B. beta; market risk
C. unique risk; firm-specific risk
D. aggressive risk; defensive risk
47. Estimate a stock's beta based on the following information: Month 1 = Stock +1.5%, Market +1.1%;
Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%.
A. Greater than 1.0
B. Less than 1.0
C. Equal to 1.0
D. Indeterminate
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48. If you were willing to bet that the overall stock market was heading up on a sustained basis, it
would be logical to invest in:
A. high beta stocks.
B. low beta stocks.
C. stocks with large amounts of unique risk.
D. stocks that plot below the security market line.
49. What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of stock B
with a beta of 1.05, and 35% of stock C with a beta of 1.73?
A. 1.0
B. 1.17
C. 1.22
D. 1.25
50. You want to develop a portfolio containing U.S. Treasury bills and two stocks that is equally as risky
as the market. The securities will be equally weighted. If the beta of the first stock is 1.23, what
does the beta of the second stock have to be?
A. 0.77
B. 1.23
C. 0.23
D. 1.77
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51. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio beta of
1.2 by replacing stock C in the following equally weighted portfolio: stock A = 0.9 beta; stock B =
1.1 beta; stock C = 1.35 beta?
A. 0.7
B. 1.6
C. 1.2
D. 1.8
52. What is the standard deviation of the market portfolio if the standard deviation of a fully diversified
portfolio with a beta of 1.25 equals 20%?
A. 16.00%
B. 18.75%
C. 25.00%
D. 32.50%
53. What is the beta of a U.S. Treasury bill?
A. 1.0
B. -1.0
C. 0
D. Unknown
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54. One of the easiest methods of diversifying away firm-specific risks is to:
A. buy only stocks with a beta of 1.0.
B. build a portfolio with 40 to 55 individual stocks.
C. purchase the shares of a mutual fund.
D. purchase stocks that plot above the security market line.
55. A considerable scattering in the plot of points representing the historic returns of a stock versus
the returns on the market reflects the:
A. high beta of the stock.
B. unique risk of the stock.
C. changes in market risk premium over time.
D. current underpricing of the stock.
56. A project has an assigned beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is
9.2%. What is the project's expected rate of return?
A. 15.21%
B. 11.41%
C. 10.50%
D. 14.61%
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57. A project has an assigned beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is
A. 7.98%
B. 11.96%
C. 8.35%
D. 11.83%
58. Which one of the following statements is correct when Treasury bills yield 7.5% and the market risk
premium is 9.5%?
A. The S&P 500 would be expected to yield about 8.50%.
B. The S&P 500 would be expected to yield about 9.50%.
C. The S&P 500 would be expected to yield about 12.68%.
D. The S&P 500 would be expected to yield about 17.00%.
59. Assuming positive returns on Treasury bills, what can you assume about an investor whose
diversified portfolio of stocks yielded 25% when the market portfolio yielded 15%?
A. Treasury bills are offering a 10% yield.
B. The portfolio beta is greater than 1.0.
C. The portfolio beta equals 1.67.
D. The investor's portfolio contains many defensive stocks.
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60. Assume the market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the change in
a stock's rate of return if its beta increases from 1.12 to 1.14?
A. 0.19%
B. 0.25%
C. 1.90%
D. 2.50%
61. What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a
stock with a beta of 1.4 is expected to yield 18%?
A. 8.67%
B. 10.84%
C. 12.02%
D. 14.57%
62. When Treasury bills yield 7% and the expected return on the market is 16%, then the risk premium
on an asset is equal to:
A. 9%.
B. 16%.
C. 9% times the asset's beta.
D. 9% plus the risk-free rate.
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63. Calculate the risk premium on stock C given the following information: risk-free rate = 5%, market
return = 13%, stock C beta = 1.3.
A. 8.0%
B. 10.4%
C. 15.4%
D. 16.9%
64. If Treasury bills yield 6% and the market risk premium is 9%, then a stock with a beta of 1.5 would
be expected to yield:
A. 12.0%.
B. 17.0%.
C. 19.5%.
D. 21.5%.
65. An investor was expecting a return of 18% on his portfolio with a beta of 1.25 before the market
risk premium increased from 8 to 10%. Based on this change, what return should he now expect on
the portfolio?
A. 20.0%
B. 20.5%
C. 22.5%
D. 26.0%
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66. An investor was expecting a return of 14.7% on her portfolio with a beta of 1.13 before the market
risk premium decreased from 8 to 7%. Based on this change, what return should she now expect
on the portfolio?
A. 13.57%
B. 13.89%
C. 14.67%
D. 15.87%
67. What rate of return should an investor expect for a stock that has a beta of 0.8 when the market is
expected to yield 14% and Treasury bills offer 6%?
A. 9.2%
B. 11.2%
C. 12.4%
D. 12.8%
68. Based on your analysis, you believe that Alpha stock which has a beta of 1.32 is going to yield
14.05% this coming year. The market is expected to yield 11.4% and T-bills are yielding 3.8%.
According to CAPM, which one of these statements is correct given this information?
A. The stock is currently underpriced.
B. The stock plots below the security market line.
C. The risk premium on the stock is too low given the stock's beta.
D. The stock plots to the left of the market on a security market line graph.
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69. Why do stock market investors seem to ignore unique risks when calculating expected rates of
return?
A. There is no method for quantifying unique risks.
B. Unique risks are assumed to be diversified away.
C. Unique risks are compensated by the risk-free rate.
D. Beta includes a component to compensate for unique risk.
70. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio
beta is:
A. 0.70.
B. 1.05.
C. 1.40.
D. 2.10.
71. A portfolio consists of an index mutual fund which represents the overall market and Treasury bills.
The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk premium is
7.6%. What is your best estimate of the portfolio expected rate of return?
A. 8.39%
B. 7.76%
C. 10.80%
D. 9.02%
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72. What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the
market risk premium is 8%?
A. 0.50
B. 0.75
C. 0.90
D. 1.50
73. The slope of the security market line equals:
A. one.
B. beta.
C. the market risk premium.
D. the expected return on the market portfolio.
74. A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the market
rate of return is 10.6%?
A. 2.825%
B. 3.250%
C. 3.275%
D. 3.415%
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75. What return should be expected from investing in the market portfolio that is expected to yield
18% if the investment includes all of the investor's funds plus 100% of additional funds borrowed at
the risk-free rate of 6%?
A. 18.6%
B. 19.6%
C. 21.6%
D. 30.0%
76. Which one of the following statements is more likely to be correct concerning the comment,
"Stock A has a higher expected return than Stock B"?
A. Stock A has more unique risk.
B. Stock B plots below the security market line.
C. Stock B is a cyclical stock.
D. Stock A has a higher beta.
77. A stock's risk premium is equal to the:
A. expected market return times beta.
B. Treasury bill yield plus the expected market return.
C. risk-free rate plus the expected market risk premium.
D. expected market risk premium times beta.
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78. Investing borrowed funds in a stock portfolio will generally:
A. increase the beta of the portfolio.
B. decrease the volatility of the portfolio.
C. decrease the expected return on the portfolio.
D. increase the market risk premium.
79. What will happen to a stock that offers a lower return than predicted by the CAPM?
A. Its beta will increase.
B. Its beta will decrease.
C. Its market price will decrease causing its yield to increase.
D. Its market price will increase causing its yield to increase.
80. Which one of these statements is correct?
A. Betas are exact measurements.
B. If a stock has a very low beta, it is most apt to maintain that beta in the future.
C. The expected future risk premium is easy to accurately determine.
D. CAPM is widely used as a means of valuing stock.
81. 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%?
A. It increases from 12 to 14.0%.
B. It increases from 13 to 17.5%.
C. It increases from 12 to 12.5%.
D. It increases from 13 to 13.5%.
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82. What would you recommend to an investor who is considering an investment that, according to its
beta, plots below the security market line?
A. Invest; The return is high relative to the risk.
B. Don't invest; The risk is high relative to the return.
C. Invest; All stocks revert to the SML over time.
D. Don't invest; All stocks below the SML are low-growth stocks.
83. Investment projects that plot above the security market line would be considered to have:
A. a positive NPV.
B. a negative NPV.
C. a zero NPV.
D. an excessively high discount rate.
84. The company cost of capital may be an inappropriate discount rate for a capital budgeting
proposal if:
A. it results in a negative NPV for the proposal.
B. the proposal has a different degree of risk.
C. the company has unique risk.
D. the company expects to earn more than the risk-free rate.
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85. A proposed investment must earn at least as much as the ______ if it is to be deemed acceptable.
A. company cost of capital
B. risk-free rate
C. market risk premium
D. project cost of capital
86. 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%?
A. Project NPV is positive; it should be accepted.
B. Project NPV is negative; it should be rejected.
C. Project NPV is positive but it should be rejected.
D. Project NPV is negative but it should be accepted.
87. The project cost of capital is:
A. equal to the company cost of capital.
B. less than the company cost of capital.
C. greater than the company cost of capital.
D. not necessarily related to the company cost of capital.
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88. The minimum acceptable expected rate of return on a project of a specific risk is the:
A. project cost of capital.
B. company cost of capital.
C. risk-free rate of return.
D. project beta times the market risk premium.
89. 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:
A. company cost of capital and be accepted.
B. company cost of capital and be rejected.
C. project cost of capital and be accepted.
D. project cost of capital and be rejected.
90. Which one of the following statements best explains the fact that cyclical firms tend to have high
betas?
A. Their earnings are not stable.
B. Their stocks are overpriced.
C. Their earnings are less diversifiable.
D. Their profit margins are small.
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91. What type of risk is properly reflected in a project's discount rate?
A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk
92. 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:
A. stock's beta has been calculated incorrectly.
B. S&P 500 cannot represent the overall market.
C. firm released some negative information about itself.
D. market index had an exceptionally good month.
93. The slope of the regression line that exhibits the past relationship between a stock's returns and
the market's returns is the:
A. market's beta.
B. stock's beta.
D. stock's standard deviation.
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94. Which one of the following is most likely correct for a diversified stock portfolio that exhibits a
higher standard deviation than the market index?
A. The portfolio contains fairly aggressive stocks.
B. The portfolio plots below the security market line.
C. The portfolio's beta is less than 1.0.
D. The portfolio contains a significant amount of unique risk.
95. 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?
A. 0.83
B. 1.00
C. 1.17
D. 1.25
96. If the market portfolio is expected to return 16%, then a portfolio that is expected to return 13%:
A. plots above the security market line.
B. plots to the right of the market on an SML graph.
C. is not diversified.
D. has a beta that is less than 1.0.
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97. The basic tenet of the CAPM is that a stock's expected risk premium should be:
A. greater than the expected market return.
B. proportionate to the market return.
C. proportionate to the stock's beta.
D. greater than the risk-free rate of return.
98. 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:
A. determine where the project plots in relation to the security market line.
B. make the project look more attractive than it should be.
C. be correct from a theoretical perspective.
D. be incorrect and could cause the project to be erroneously rejected.
99. Based on the period 1926-2013, value stocks have:
A. had low ratios of book value to market value.
B. performed exactly as predicted by CAPM.
C. provided a higher long-run return than growth stocks.
D. consistently underperformed.
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100. Which one of the following adjustment techniques would be preferred to account for additional
project risk?
A. Increase the discount rate
B. Adjust expected cash flows downward
C. Increase the beta
D. Adjust the market risk premium
101. The correct opportunity cost for a project is determined to be 15% and the project is expected to
generate $1 million in cash flows at the end of the next 4 years after an initial outlay of $3 million.
Based on this information, the project would plot:
A. above the security market line.
B. below the security market line.
C. on the security market line.
D. on the security market line, with a beta of 1.0.
102. An investor prefers to invest in companies that have high fixed costs. How can this be
accomplished if the investor also requires a portfolio beta of 1.0?
A. Invest 50% in cyclical stocks and 50% in firms with high fixed costs
B. Invest 50% in a market index fund and 50% in firms with high fixed costs
C. Invest equally in cyclical stocks, stocks of high-fixed-cost firms, and U.S. Treasury bills
D. Invest a portion of the portfolio in U.S. Treasury securities
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103. Which one of the following portfolios might be expected to exhibit less unique risk?
A. Five random stocks; portfolio beta = 0.8
B. Three random stocks; portfolio beta = 1.2
C. Ten random stocks; portfolio beta = 1.0
D. Twelve random stocks; portfolio beta unknown
104. If the plotting of a portfolio's returns against returns on the market index produces a tight pattern,
then the portfolio:
A. appears to be well diversified.
B. has a beta of 0.
C. has very little systematic risk.
D. has a risk premium lower than the market.
105. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then
the investor should expect to receive:
A. the risk-free rate plus 75% of the expected return on the market.
B. the risk-free rate plus 75% of the expected market risk premium.
C. 75% of the expected return on the market.
D. 25% of the risk-free rate plus 75% of the expected market risk premium.
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106. The CAPM provides a model of determining expected security returns that is:
A. precise in its calculations of risk premiums.
B. imprecise, but generally an acceptable guideline.
C. excellent for high beta stocks.
D. excellent for all well-diversified portfolios.
Essay Questions
107. How can you measure and interpret the market risk, or beta, of a security?
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108. What is the relationship between the market risk of a security and the rate of return that investors
demand of that security?
109. How can a manager calculate the opportunity cost of capital for a project?
110. How are the terms "defensive" and "aggressive" applied to individual stocks or portfolios?
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111. Discuss how betas are measured for individual stocks.
112. Why is beta thought to be a more relevant measure of risk than standard deviation for a diversified
investor?
113. Discuss the capital asset pricing model in general, the CAPM method of determining expected
returns, and how the SML can be used to help predict the movement of a stock's price.
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114. The stock of Newmont Mining, the world's largest gold producer, has above-average volatility but
a relatively low beta. Why?
115. Calculate the expected rate of return for the following portfolio, based on a Treasury bill yield of
4% and an expected market return of 13%: (Show your work)
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116. A portfolio of three stocks with total market value of $1,000,000 currently has a beta of 1.4. In light
of an expected market downturn, you wish to reduce the portfolio beta to no more than 1.0. Two
stocks are likely candidates for sale, one with a beta of 1.8 and a market value of $200,000 and the
other with a beta of 1.5 and a market value of $250,000. Assuming that you could find one
appropriate stock to replace these two, what should be its beta? (Show your work)
117. Stock A has a current price of $25, a beta of 1.25, and a dividend yield of 6%. If the Treasury bill
yield is 5% and the market portfolio is expected to return 14%, what should stock A sell for at the
end of an investor's 2-year investment horizon?
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118. Why is it important to make the distinction between company opportunity cost of capital and
project opportunity cost of capital when evaluating projects?
119. Where will the following projects plot in relation to the security market line if the risk-free rate is
6% and the market risk premium is 9%? Which projects should be undertaken?
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120. The manager of Star Performer Mutual Fund expects the fund to earn a rate of return of 12% this
year. The beta of the fund's portfolio is 0.8. If the rate of return available on risk-free assets is 5%
and you expect the rate of return on the market portfolio to be 15%, should you invest in Star
Performer? Can you create a portfolio with the same risk as Star Performer Mutual Fund, but with a
higher expected rate of return? Explain why in reality, a mutual fund must be able to provide an
expected rate of return that is higher than that predicted by the security market line in order for
investors to consider the fund an attractive investment opportunity.
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Chapter 12 Risk, Return, and Capital Budgeting Answer Key
True / False Questions
1. The capital asset pricing model (CAPM) assumes that the stock market is dominated by well-
diversified investors who are concerned only with market risk.
TRUE
AACSB: Communication
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.
Topic: Capital asset pricing model
2. The CAPM states that the expected risk premium on any security equals its beta times the
market risk premium.
TRUE
Blooms: Remember
Difficulty: 2 Medium
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3. The security market line displays the relationship between expected return and beta.
TRUE
Blooms: Remember
Difficulty: 1 Easy
Topic: Security market line
4. The security market line sets a standard for other investments—investors will be willing to hold
other investments only if they offer equally good prospects as shown by the points on the line.
TRUE
AACSB: Reflective Thinking

Blooms: Apply
Learning Objective: 12-03 Understand why and how project risk determines the opportunity cost of capital.
5. The required risk premium for any given investment is defined by the security market line.
TRUE

Blooms: Understand
Difficulty: 1 Easy
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6. Empirical evidence suggests that over a long period of time returns are directly related to beta.
TRUE

Blooms: Understand
7. There is little doubt that the CAPM captures everything that is going on in the market.
FALSE
Blooms: Remember
Difficulty: 1 Easy
8. Beta measures the total risk of an individual security.
FALSE

Blooms: Understand
Learning Objective: 12-01 Measure and interpret the market risk; or beta; of a security.
Topic: Beta
12-39
9. The security market line provides a standard that can be used to make project
acceptance/rejection decisions.
TRUE

Blooms: Understand
Difficulty: 1 Easy
10. If a low-risk company invests in a high-risk project, those cash flows should be discounted at a
high cost of capital.
TRUE

Blooms: Understand
Topic: Project analysis and evaluation
11. The project cost of capital depends on the risk of the company undertaking the project.
FALSE

Blooms: Understand
12-40
12. Beta measures a stock's sensitivity to market risks.
TRUE
Blooms: Remember
Difficulty: 1 Easy
Topic: Beta
13. The project cost of capital depends on how the capital is used.
TRUE

Blooms: Understand
14. Investors expect aggressive stocks to outperform the market in periods of strong economic
activity.
TRUE

Blooms: Understand
12-41
15. Defensive stocks typically provide better returns during periods of economic downturn since
they are not very sensitive to market fluctuations.
TRUE

Blooms: Remember
Difficulty: 1 Easy
16. Diversification decreases the variability of both unique and market risk.
FALSE

Blooms: Remember
Difficulty: 1 Easy
Topic: Diversification concepts and measures
17. Market risk premium is defined as the difference between the market rate of return and the
return on risk-free Treasury bills.
TRUE

Blooms: Understand
Difficulty: 1 Easy
12-42
18. According to the CAPM, a stock's expected return is positively related to its beta.
TRUE

Blooms: Understand
Difficulty: 1 Easy
19. The CAPM is a theory of the relationship between risk and return that states that the expected
risk premium on any security equals its beta times the market return.
FALSE

Blooms: Understand
Difficulty: 1 Easy
20. The stock of Newmont Mining, the world's largest gold producer, has above-average volatility
but a relatively low beta.
TRUE

Blooms: Remember
Topic: Systematic and unsystematic risk
12-43
21. According to the capital asset pricing model, the expected rates of return for all securities and
all portfolios lie on the capital market line.
FALSE

Blooms: Understand
22. As a project's beta increases, the project's opportunity cost of capital increases.
TRUE

Blooms: Understand
Difficulty: 1 Easy
23. A project should be accepted if its return plots below the security market line.
FALSE

Blooms: Apply
12-44
24. The security market line shows how the expected rate of return depends on beta.
TRUE

Blooms: Understand
Difficulty: 1 Easy
25. The required risk premium for any investment is given by the security market line.
TRUE

Blooms: Apply
Difficulty: 1 Easy
26. Project cost of capital and company cost of capital are synonymous terms.
FALSE
Blooms: Remember
Topic: Cost of capital-general
12-45
27. The project cost of capital depends on the use to which that capital is put. Therefore, it
depends on both the risk of the project and also on the risk of the company.
FALSE

Blooms: Understand
28. If a company with a low credit rating invests in a low-risk project, it should discount the cash
flows at a relatively high cost of capital.
FALSE

Blooms: Remember
29. Changing the discount rate is equivalent to adjusting the expected cash flows as a method of
accounting for risk.
FALSE

Blooms: Understand
12-46
Multiple Choice Questions
30. The return on a security includes premiums for:
A. market risk and unique risk.
B. unique risk and firm-specific risk.
C. diversification and portfolio risk.
D. time value of money and market risk.

Blooms: Understand
31. If a security plots below the security market line, it is:
A. ignoring all of the security's unique risk.
B. underpriced, a situation that should be temporary.
C. offering too little return to justify its risk.
D. a defensive security, which expects to offer lower returns.

Blooms: Understand
12-47
32. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio contains only risk-free securities.
B. only macro events are tracked by economists.
C. the unique risks have been diversified away.
D. the firm-specific events would be too numerous to quantify.

Blooms: Understand
33. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.

Blooms: Remember
Difficulty: 1 Easy
12-48
34. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and the return on the market portfolio.
D. market risk premium on the stock.

Blooms: Understand
Topic: Beta
35. In theory, the "market portfolio" should contain:
A. the securities of the S&P 500.
B. the securities of the Dow.
C. the securities of the S&P 500 and Treasury bills.
D. all risky assets.

Blooms: Understand
12-49
36. When the overall market is up by 10%, investors with portfolios of defensive stocks will probably
have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.

Blooms: Apply
Difficulty: 1 Easy
37. When the overall market experiences a decline of 8%, investors with portfolios of aggressive
stocks will probably experience portfolio:
A. losses of less than 8%.
B. losses greater than 8%.
C. gains of less than 8%.
D. gains greater than 8%.

Blooms: Apply
Difficulty: 1 Easy
12-50
38. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.

Blooms: Understand
Difficulty: 1 Easy
Topic: Beta
39. The average of the beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
Blooms: Remember
Difficulty: 1 Easy
Topic: Beta
12-51
40. The line plotted to fit observations of a stock's returns versus the market's returns determines
the:
A. security market line.
B. beta of the stock.
D. capital asset pricing model.

Blooms: Understand
Topic: Beta
41. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by
1.2%, then its beta equals:
A. 1.04.
B. 1.24.
C. 1.33.
D. 1.40.
β = 1.6%/1.2% = 1.33
AACSB: Analytic
Blooms: Analyze
Topic: Beta
12-52
42. If the slope of the line measuring a stock's historic returns against the market's historic returns is
positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.

Blooms: Understand
Difficulty: 1 Easy
Topic: Beta
43. If the line measuring a stock's historic returns against the market's historic returns has a slope
greater than 1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.

Blooms: Understand
Difficulty: 1 Easy
Topic: Beta
12-53
44. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a month
where the market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.

Blooms: Apply
Topic: Beta
45. If a stock's beta is 0.8 during a period when the market portfolio was down by 10%, then, a
priori, we could expect this individual stock to:
A. lose more than 10%.
B. lose, but less than 10%.
C. gain more than 10%.
D. gain, but less than 10%.

Blooms: Analyze
12-54
46. Stock returns can be explained by the stock's _________ and the stock's __________.
A. beta; unique risk
B. beta; market risk
C. unique risk; firm-specific risk
D. aggressive risk; defensive risk

Blooms: Understand
Topic: Stock returns and yields
47. Estimate a stock's beta based on the following information: Month 1 = Stock +1.5%, Market
+1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%.
A. Greater than 1.0
B. Less than 1.0
C. Equal to 1.0
D. Indeterminate

Blooms: Apply
Topic: Beta
12-55
48. If you were willing to bet that the overall stock market was heading up on a sustained basis, it
would be logical to invest in:
A. high beta stocks.
B. low beta stocks.
C. stocks with large amounts of unique risk.
D. stocks that plot below the security market line.

Blooms: Apply
Difficulty: 1 Easy
49. What is the beta of a 3-stock portfolio including 25% of stock A with a beta of 0.90, 40% of
stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73?
A. 1.0
B. 1.17
C. 1.22
D. 1.25
βPortfolio = 0.25 × 0.9 + 0.4 × 1.05 + 0.35 × 1.73 = 1.25
AACSB: Analytic
Blooms: Analyze
Topic: Beta
12-56
50. You want to develop a portfolio containing U.S. Treasury bills and two stocks that is equally as
risky as the market. The securities will be equally weighted. If the beta of the first stock is 1.23,
what does the beta of the second stock have to be?
A. 0.77
B. 1.23
C. 0.23
D. 1.77
1 = (0 + 1.23 + βB)/3; βB = 1.77

Blooms: Understand
Difficulty: 3 Hard
Topic: Beta
51. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio
beta of 1.2 by replacing stock C in the following equally weighted portfolio: stock A = 0.9 beta;
stock B = 1.1 beta; stock C = 1.35 beta?
A. 0.7
B. 1.6
C. 1.2
D. 1.8
1.2 = (0.9 + 1.1 + βC)/3; βC = 1.6
AACSB: Analytic
12-57
Blooms: Analyze
Topic: Beta
52. What is the standard deviation of the market portfolio if the standard deviation of a fully
diversified portfolio with a beta of 1.25 equals 20%?
A. 16.00%
B. 18.75%
C. 25.00%
D. 32.50%
Portfolio σ = beta × market portfolio σ

20% = 1.25 × σm
σm = 16%
AACSB: Analytic
Blooms: Analyze
Topic: Standard deviation and variance
53. What is the beta of a U.S. Treasury bill?
A. 1.0
B. -1.0
C. 0
D. Unknown

12-58
Blooms: Apply
Difficulty: 1 Easy
54. One of the easiest methods of diversifying away firm-specific risks is to:
A. buy only stocks with a beta of 1.0.
B. build a portfolio with 40 to 55 individual stocks.
C. purchase the shares of a mutual fund.
D. purchase stocks that plot above the security market line.

Blooms: Understand
55. A considerable scattering in the plot of points representing the historic returns of a stock versus
the returns on the market reflects the:
A. high beta of the stock.
B. unique risk of the stock.
C. changes in market risk premium over time.
D. current underpricing of the stock.

Blooms: Understand
Topic: Beta
12-59
56. A project has an assigned beta of 1.24, the risk-free rate is 3.8%, and the market rate of return is
A. 15.21%
B. 11.41%
C. 10.50%
D. 14.61%
E(R) = 3.8% + 1.24(9.2% - 3.8) = 10.50%
AACSB: Analytic
Blooms: Analyze
57. A project has an assigned beta of 0.97, the risk-free rate is 4.1%, and the market risk premium is
A. 7.98%
B. 11.96%
C. 8.35%
D. 11.83%
E(R) = 4.1% + 0.97(8.1%) = 11.96%
AACSB: Analytic
Blooms: Analyze
12-60
58. Which one of the following statements is correct when Treasury bills yield 7.5% and the market
risk premium is 9.5%?
A. The S&P 500 would be expected to yield about 8.50%.
B. The S&P 500 would be expected to yield about 9.50%.
C. The S&P 500 would be expected to yield about 12.68%.
D. The S&P 500 would be expected to yield about 17.00%.
E(R) = 7.5% + 1(9.5%) = 17%
AACSB: Analytic
Blooms: Apply
59. Assuming positive returns on Treasury bills, what can you assume about an investor whose
diversified portfolio of stocks yielded 25% when the market portfolio yielded 15%?
A. Treasury bills are offering a 10% yield.
B. The portfolio beta is greater than 1.0.
C. The portfolio beta equals 1.67.
D. The investor's portfolio contains many defensive stocks.

Blooms: Apply
12-61
60. Assume the market rate of return is 12.5% and the risk-free rate is 3.1%. What will be the
change in a stock's rate of return if its beta increases from 1.12 to 1.14?
A. 0.19%
B. 0.25%
C. 1.90%
D. 2.50%
ΔE(R) = (1.14 - 1.12)(12.5% - 3.1%) = 0.19%
AACSB: Analytic
Blooms: Analyze
61. What is the expected yield on the market portfolio at a time when Treasury bills yield 6% and a
stock with a beta of 1.4 is expected to yield 18%?
A. 8.67%
B. 10.84%
C. 12.02%
D. 14.57%
18% = 6% + 1.4(rm - 6%); rm = 14.57%
AACSB: Analytic
Blooms: Analyze
12-62
62. When Treasury bills yield 7% and the expected return on the market is 16%, then the risk
premium on an asset is equal to:
A. 9%.
B. 16%.
C. 9% times the asset's beta.
D. 9% plus the risk-free rate.
AACSB: Analytic
Blooms: Analyze
63. Calculate the risk premium on stock C given the following information: risk-free rate = 5%,
market return = 13%, stock C beta = 1.3.
A. 8.0%
B. 10.4%
C. 15.4%
D. 16.9%
RPC = 1.3(13% - 5) = 10.4%
AACSB: Analytic
Blooms: Analyze
12-63
64. If Treasury bills yield 6% and the market risk premium is 9%, then a stock with a beta of 1.5
would be expected to yield:
A. 12.0%.
B. 17.0%.
C. 19.5%.
D. 21.5%.
E(R) = 6% + 1.5(9%) = 19.5%
AACSB: Analytic
Blooms: Analyze
65. An investor was expecting a return of 18% on his portfolio with a beta of 1.25 before the market
risk premium increased from 8 to 10%. Based on this change, what return should he now expect
on the portfolio?
A. 20.0%
B. 20.5%
C. 22.5%
D. 26.0%
E(R) = 18% + 1.25(10% - 8) = 20.5%
AACSB: Analytic
12-64
Blooms: Analyze
Topic: Portfolio return
66. An investor was expecting a return of 14.7% on her portfolio with a beta of 1.13 before the
market risk premium decreased from 8 to 7%. Based on this change, what return should she
now expect on the portfolio?
A. 13.57%
B. 13.89%
C. 14.67%
D. 15.87%
E(R) = 14.7% + 1.13(7% - 8) = 13.57%
AACSB: Analytic
Blooms: Analyze
12-65
67. What rate of return should an investor expect for a stock that has a beta of 0.8 when the
market is expected to yield 14% and Treasury bills offer 6%?
A. 9.2%
B. 11.2%
C. 12.4%
D. 12.8%
E(R) = 6% + 0.8(14% - 6) = 12.4%
AACSB: Analytic
Blooms: Analyze
68. Based on your analysis, you believe that Alpha stock which has a beta of 1.32 is going to yield
14.05% this coming year. The market is expected to yield 11.4% and T-bills are yielding 3.8%.
According to CAPM, which one of these statements is correct given this information?
A. The stock is currently underpriced.
B. The stock plots below the security market line.
C. The risk premium on the stock is too low given the stock's beta.
D. The stock plots to the left of the market on a security market line graph.
E(R) = 3.8% + 1.32(11.4% - 3.8) = 13.83%
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
12-66
69. Why do stock market investors seem to ignore unique risks when calculating expected rates of
return?
A. There is no method for quantifying unique risks.
B. Unique risks are assumed to be diversified away.
C. Unique risks are compensated by the risk-free rate.
D. Beta includes a component to compensate for unique risk.

Blooms: Apply
Difficulty: 1 Easy
70. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio
beta is:
A. 0.70.
B. 1.05.
C. 1.40.
D. 2.10.
βPortfolio = .5 × 1.4 + .5 × 0.7 = 1.05
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
12-67
Topic: Beta
71. A portfolio consists of an index mutual fund which represents the overall market and Treasury
bills. The fund has a portfolio weight of 60%. The risk-free rate is 3.2% and the market risk
premium is 7.6%. What is your best estimate of the portfolio expected rate of return?
A. 8.39%
B. 7.76%
C. 10.80%
D. 9.02%
E(R)Portfolio = (1 - 0.6)(3.2%) + (0.6)[3.2% + 1(7.6%)] = 7.76%
AACSB: Analytic
Blooms: Analyze
72. What is the beta of a security with an expected return of 12% if Treasury bills yield 6% and the
market risk premium is 8%?
A. 0.50
B. 0.75
C. 0.90
D. 1.50
E(R) = 12% = 6% + β(8%); β = 0.75
AACSB: Analytic
12-68
Blooms: Analyze
73. The slope of the security market line equals:
A. one.
B. beta.
C. the market risk premium.
D. the expected return on the market portfolio.

Blooms: Understand
Difficulty: 1 Easy
74. A stock has a beta of 1.4 and an expected return of 13.53%. What is the risk-free rate if the
market rate of return is 10.6%?
A. 2.825%
B. 3.250%
C. 3.275%
D. 3.415%
E(R) = 13.53% = rf + 1.4(10.6% - rf); rf = 3.275%
AACSB: Analytic
Blooms: Analyze
12-69
75. What return should be expected from investing in the market portfolio that is expected to yield
18% if the investment includes all of the investor's funds plus 100% of additional funds
borrowed at the risk-free rate of 6%?
A. 18.6%
B. 19.6%
C. 21.6%
D. 30.0%
βPortfolio = (2 × βmarket) + (-1 × βloan) = (2 × 1) + 0 = 2
Expected return = 6% + 2(18% - 6) = 30%
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
Topic: Beta
76. Which one of the following statements is more likely to be correct concerning the comment,
"Stock A has a higher expected return than Stock B"?
A. Stock A has more unique risk.
B. Stock B plots below the security market line.
C. Stock B is a cyclical stock.
D. Stock A has a higher beta.

12-70
Blooms: Understand
77. A stock's risk premium is equal to the:
A. expected market return times beta.
B. Treasury bill yield plus the expected market return.
C. risk-free rate plus the expected market risk premium.
D. expected market risk premium times beta.

Blooms: Understand
78. Investing borrowed funds in a stock portfolio will generally:
A. increase the beta of the portfolio.
B. decrease the volatility of the portfolio.
C. decrease the expected return on the portfolio.
D. increase the market risk premium.

Blooms: Understand
Topic: Beta
12-71
79. What will happen to a stock that offers a lower return than predicted by the CAPM?
A. Its beta will increase.
B. Its beta will decrease.
C. Its market price will decrease causing its yield to increase.
D. Its market price will increase causing its yield to increase.

Blooms: Understand
80. Which one of these statements is correct?
A. Betas are exact measurements.
B. If a stock has a very low beta, it is most apt to maintain that beta in the future.
C. The expected future risk premium is easy to accurately determine.
D. CAPM is widely used as a means of valuing stock.

Blooms: Understand
12-72
81. 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%?
A. It increases from 12 to 14.0%.
B. It increases from 13 to 17.5%.
C. It increases from 12 to 12.5%.
D. It increases from 13 to 13.5%.
rp = 5% + 1(8) = 13%; rp = 4% + 1.5(9) = 17.5%
AACSB: Analytic
Blooms: Analyze
82. What would you recommend to an investor who is considering an investment that, according
to its beta, plots below the security market line?
A. Invest; The return is high relative to the risk.
B. Don't invest; The risk is high relative to the return.
C. Invest; All stocks revert to the SML over time.
D. Don't invest; All stocks below the SML are low-growth stocks.

Blooms: Apply
12-73
83. Investment projects that plot above the security market line would be considered to have:
A. a positive NPV.
B. a negative NPV.
C. a zero NPV.
D. an excessively high discount rate.

Blooms: Apply
84. The company cost of capital may be an inappropriate discount rate for a capital budgeting
proposal if:
A. it results in a negative NPV for the proposal.
B. the proposal has a different degree of risk.
C. the company has unique risk.
D. the company expects to earn more than the risk-free rate.

Blooms: Understand
12-74
85. A proposed investment must earn at least as much as the ______ if it is to be deemed
acceptable.
A. company cost of capital
B. risk-free rate
C. market risk premium
D. project cost of capital

Blooms: Understand
86. 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%?
A. Project NPV is positive; it should be accepted.
B. Project NPV is negative; it should be rejected.
C. Project NPV is positive but it should be rejected.
D. Project NPV is negative but it should be accepted.

Blooms: Apply
12-75
87. The project cost of capital is:
A. equal to the company cost of capital.
B. less than the company cost of capital.
C. greater than the company cost of capital.
D. not necessarily related to the company cost of capital.

Blooms: Understand
88. The minimum acceptable expected rate of return on a project of a specific risk is the:
A. project cost of capital.
B. company cost of capital.
C. risk-free rate of return.
D. project beta times the market risk premium.

Blooms: Understand
12-76
89. 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:
A. company cost of capital and be accepted.
B. company cost of capital and be rejected.
C. project cost of capital and be accepted.
D. project cost of capital and be rejected.

Blooms: Understand
90. Which one of the following statements best explains the fact that cyclical firms tend to have
high betas?
A. Their earnings are not stable.
B. Their stocks are overpriced.
C. Their earnings are less diversifiable.
D. Their profit margins are small.

Blooms: Understand
Difficulty: 1 Easy
Topic: Beta
12-77
91. What type of risk is properly reflected in a project's discount rate?
A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk

Blooms: Understand
Topic: Systematic and unsystematic risk
92. 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:
A. stock's beta has been calculated incorrectly.
B. S&P 500 cannot represent the overall market.
C. firm released some negative information about itself.
D. market index had an exceptionally good month.

Blooms: Understand
Topic: Beta
12-78
93. The slope of the regression line that exhibits the past relationship between a stock's returns and
the market's returns is the:
A. market's beta.
B. stock's beta.
D. stock's standard deviation.

Blooms: Understand
Topic: Beta
94. Which one of the following is most likely correct for a diversified stock portfolio that exhibits a
higher standard deviation than the market index?
A. The portfolio contains fairly aggressive stocks.
B. The portfolio plots below the security market line.
C. The portfolio's beta is less than 1.0.
D. The portfolio contains a significant amount of unique risk.

Blooms: Understand
Topic: Standard deviation and variance
12-79
95. 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?
A. 0.83
B. 1.00
C. 1.17
D. 1.25
βPortfolio = (0 + 1 + 1.5)/3 = 0.83
AACSB: Analytic
Blooms: Apply
Topic: Beta
96. If the market portfolio is expected to return 16%, then a portfolio that is expected to return
13%:
A. plots above the security market line.
B. plots to the right of the market on an SML graph.
C. is not diversified.
D. has a beta that is less than 1.0.

Blooms: Apply
12-80
97. The basic tenet of the CAPM is that a stock's expected risk premium should be:
A. greater than the expected market return.
B. proportionate to the market return.
C. proportionate to the stock's beta.
D. greater than the risk-free rate of return.

Blooms: Understand
Difficulty: 1 Easy
98. 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:
A. determine where the project plots in relation to the security market line.
B. make the project look more attractive than it should be.
C. be correct from a theoretical perspective.
D. be incorrect and could cause the project to be erroneously rejected.

Blooms: Understand
12-81
99. Based on the period 1926-2013, value stocks have:
A. had low ratios of book value to market value.
B. performed exactly as predicted by CAPM.
C. provided a higher long-run return than growth stocks.
D. consistently underperformed.

Blooms: Understand
Topic: Historical performance
100. Which one of the following adjustment techniques would be preferred to account for additional
project risk?
A. Increase the discount rate
B. Adjust expected cash flows downward
C. Increase the beta
D. Adjust the market risk premium

Blooms: Understand
Difficulty: 3 Hard
12-82
101. The correct opportunity cost for a project is determined to be 15% and the project is expected
to generate $1 million in cash flows at the end of the next 4 years after an initial outlay of $3
million. Based on this information, the project would plot:
A. above the security market line.
B. below the security market line.
C. on the security market line.
D. on the security market line, with a beta of 1.0.
NPV = -$3m + $1m{(1/.15) - [1/.15(1.154)]} = -$145,021.64; Since the NPV is negative, the project
will plot below the SML.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
102. An investor prefers to invest in companies that have high fixed costs. How can this be
accomplished if the investor also requires a portfolio beta of 1.0?
A. Invest 50% in cyclical stocks and 50% in firms with high fixed costs
B. Invest 50% in a market index fund and 50% in firms with high fixed costs
C. Invest equally in cyclical stocks, stocks of high-fixed-cost firms, and U.S. Treasury bills
D. Invest a portion of the portfolio in U.S. Treasury securities
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
12-83
Topic: Beta
103. Which one of the following portfolios might be expected to exhibit less unique risk?
A. Five random stocks; portfolio beta = 0.8
B. Three random stocks; portfolio beta = 1.2
C. Ten random stocks; portfolio beta = 1.0
D. Twelve random stocks; portfolio beta unknown

Blooms: Understand
104. If the plotting of a portfolio's returns against returns on the market index produces a tight
pattern, then the portfolio:
A. appears to be well diversified.
B. has a beta of 0.
C. has very little systematic risk.
D. has a risk premium lower than the market.

Blooms: Understand
Topic: Beta
12-84
105. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury bills, then
the investor should expect to receive:
A. the risk-free rate plus 75% of the expected return on the market.
B. the risk-free rate plus 75% of the expected market risk premium.
C. 75% of the expected return on the market.
D. 25% of the risk-free rate plus 75% of the expected market risk premium.

Blooms: Understand
106. The CAPM provides a model of determining expected security returns that is:
A. precise in its calculations of risk premiums.
B. imprecise, but generally an acceptable guideline.
C. excellent for high beta stocks.
D. excellent for all well-diversified portfolios.

Blooms: Understand
Essay Questions
12-85
107. How can you measure and interpret the market risk, or beta, of a security?
The contribution of a security to the risk of a diversified portfolio depends on its market risk. But
not all securities are equally affected by fluctuations in the market. The sensitivity of a stock to
market movements is known as beta. Stocks with a beta greater than 1.0 are particularly
sensitive to market fluctuations. Those with a beta of less than 1.0 are not so sensitive to such
movements. The average beta of all stocks is 1.0.

Blooms: Understand
Topic: Beta
108. What is the relationship between the market risk of a security and the rate of return that
investors demand of that security?
The extra return that investors require for taking risk is known as the risk premium. The capital
asset pricing model states that the expected risk premium of an investment should be
proportional to both its beta and the market risk premium. The expected rate of return from
any investment is equal to the risk-free interest rate plus the risk premium, so the CAPM boils
down to r = rf + β(rm - rf). The security market line is the graphical representation of the CAPM
equation. The security market line relates the expected return investors demand of a security to
the beta.

Blooms: Understand
12-86
109. How can a manager calculate the opportunity cost of capital for a project?
The opportunity cost of capital is the return that investors give up by investing in the project
rather than in securities of equivalent risk. Financial managers use the capital asset pricing
model to estimate the opportunity cost of capital. The company cost of capital is the expected
rate of return demanded by investors in a company. It depends on the average risk of the
company's assets and operations. The opportunity cost of capital is determined by the use to
which the capital is put. Therefore, required rates of return depend on the risk of the project,
not on the risk of the firm's existing business. The project cost of capital is the minimum
acceptable expected rate of return on a project given its risk. Your cash-flow forecasts should
already factor in the chances of pleasant and unpleasant surprises. Potential bad outcomes
should be reflected in the discount rate only to the extent that they affect beta.

Blooms: Understand
12-87
110. How are the terms "defensive" and "aggressive" applied to individual stocks or portfolios?
Defensive stocks are less sensitive to changes in market fluctuations than the market portfolio
is. Accordingly, these stocks have a beta less than 1.0. Thus, it would be expected that these
securities would return less than the market portfolio during periods when the market portfolio
is offering positive returns. This might appeal to investors who are too risk-averse to invest in
the market portfolio. In times of a down market, defensive stocks would be expected to
decrease less than the market, thus providing a degree of expected protection. Aggressive
stocks are more sensitive than the market to market fluctuations. Thus, they amplify market
changes. This is good when the market is going up but can be quite detrimental when the
market is going down. Portfolios may contain both aggressive and defensive stocks, which will
mute the effects of each. This is true since the portfolio beta is a market value-weighted
average of the individual betas in the portfolio. Investors may also choose to change the beta
of the portfolio according to expected movements in the overall market. Thus, portfolios would
become more defensive when the market is expected to decline. The problem with this strategy
is, of course, the accuracy of the predicted market movement.

Blooms: Understand
Topic: Beta
12-88
111. Discuss how betas are measured for individual stocks.
To measure betas, historic returns of the stock are plotted against returns on the market
portfolio during the same period. In practice, some broad-based index such as the S&P 500 is
substituted for the market portfolio. The slope of the straight line that is drawn to best fit the
observations is the beta of the stock. Since the returns of most stocks move together to some
degree, the slope is expected to be positive. A slope less than 1.0 indicates that the stock's
returns are less volatile than those of the market portfolio while a slope greater than 1.0
indicates that the stock's returns are more volatile than those of the market portfolio.

Blooms: Understand
Topic: Beta
112. Why is beta thought to be a more relevant measure of risk than standard deviation for a
diversified investor?
Standard deviation measures both a stock's market risk and unique risk. However, a diversified
investor is no longer concerned with unique risk, or at least not concerned over the small
portion that remains after portfolio diversification. Beta measures only the market risk of the
stock, that type of risk that cannot be diversified away. The stock's returns may be more or less
volatile than the market portfolio and beta is an indication of that sensitivity.

Blooms: Understand
Topic: Beta
12-89
113. Discuss the capital asset pricing model in general, the CAPM method of determining expected
returns, and how the SML can be used to help predict the movement of a stock's price.
The CAPM describes the relationship between risk and return such that investors who bear
more systematic risk will do so only under the expectation of greater returns. The expected
return on a security is proportional to its beta. Thus, investors are rewarded for the time value
of money (i.e., risk-free rate) and for the risk premium on the security, which is equal to beta
times the market risk premium. There is no reward for bearing unique risk because these risks
are assumed to be diversifiable. The CAPM states that a security's return is equal to the risk-free
rate plus the individual security's risk premium. A security with a beta of 1.0 is expected to offer
the same return as the market portfolio. Securities with betas greater (less) than 1.0 should offer
proportionately more (less) than the market portfolio. Securities with a beta of zero should offer
the risk-free rate. The security market line can be used to graph the relationship between
expected return and beta. Market forces should work to move all securities toward the line if
they do not currently offer the appropriate risk-return relationship. For example, those
securities plotting above the line should be in greater demand, which will bid up the price and
reduce the expected return until the security approaches the SML.

Blooms: Understand
Difficulty: 3 Hard
12-90
114. The stock of Newmont Mining, the world's largest gold producer, has above-average volatility
but a relatively low beta. Why?
Total risk is not the same as market risk. Some of the most variable stocks have below-average
betas, and vice versa. Consider, for example, Newmont Mining. Newmont is the world's largest
gold producer. The company cites the many risks that the company faces as "gold and other
metals' price volatility, increased costs and variances in ore grade or recovery rates from those
assumed in mining plans, as well as political and operational risks in the countries in which we
operate and governmental regulation and judicial outcomes."
These risks are considerable and are reflected in the high standard deviation of the returns on
Newmont's stock. But they are not macro risks. When the U.S. economy is booming, gold prices
are just as likely to slump, and a mine in some distant part of the world may well be hit by
political unrest. So, while Newmont stock has above-average volatility, it has a relatively low
beta.

Blooms: Understand
Topic: Beta
12-91
115. Calculate the expected rate of return for the following portfolio, based on a Treasury bill yield
of 4% and an expected market return of 13%: (Show your work)
βPortfolio = (0.2 × 1.6) + (0.25 × 1.2) + (0.1 × 1) + (0.3 × 0.9) + (0.15 × 0.8) = 1.11
E(R) = 4% + 1.11(13% - 4) = 13.99%
AACSB: Analytic
Blooms: Analyze
12-92
116. A portfolio of three stocks with total market value of $1,000,000 currently has a beta of 1.4. In
light of an expected market downturn, you wish to reduce the portfolio beta to no more than
1.0. Two stocks are likely candidates for sale, one with a beta of 1.8 and a market value of
$200,000 and the other with a beta of 1.5 and a market value of $250,000. Assuming that you
could find one appropriate stock to replace these two, what should be its beta? (Show your
work)
The weights of the stocks are: Stock A = 0.55; Stock B = 0.20; Stock C = 0.25 based on the
values stated in the problem.
Current β = 1.4 = (0.55 × βA) + (0.20 × 1.8) + (0.25 × 1.5); βA = 1.2091
Net β = 1.0 = (0.55 × 1.2091) + (0.45 × βNew); βNew = 0.7444
AACSB: Analytic
Blooms: Analyze
Topic: Beta
117. Stock A has a current price of $25, a beta of 1.25, and a dividend yield of 6%. If the Treasury bill
yield is 5% and the market portfolio is expected to return 14%, what should stock A sell for at
the end of an investor's 2-year investment horizon?
Expected return = 5% + 1.25(14% - 5%) = 16.25%
Since total return is composed of the dividend yield plus the capital gains yield, the stock is
expected to offer capital gains of 10.25%(16.25% - 6%) annually. The price in 2 years should be:
$25(1.1025)2 = $30.39
AACSB: Analytic
Blooms: Evaluate
Difficulty: 3 Hard
12-93
118. Why is it important to make the distinction between company opportunity cost of capital and
project opportunity cost of capital when evaluating projects?
The company opportunity cost of capital represents an average risk of the individual projects
currently invested in by the company. It is thus possible that no one project exemplifies this
"average" company risk. Unless the proposed project is coincidentally of the same level of risk
as the company opportunity cost of capital, it would be inappropriate to use the company
discount rate. Rather, the merit (e.g., NPV) of the project should be judged using the level of
risk that pertains to the project itself. As an example, it would be incorrect to use a low
company cost of capital to determine the NPV of a project that has a high degree of risk. This
would mistakenly yield a high estimate of NPV that is not likely to materialize.

Blooms: Understand
12-94
119. Where will the following projects plot in relation to the security market line if the risk-free rate is
6% and the market risk premium is 9%? Which projects should be undertaken?
AACSB: Analytic
Blooms: Evaluate
12-95
120. The manager of Star Performer Mutual Fund expects the fund to earn a rate of return of 12%
this year. The beta of the fund's portfolio is 0.8. If the rate of return available on risk-free assets
is 5% and you expect the rate of return on the market portfolio to be 15%, should you invest in
Star Performer? Can you create a portfolio with the same risk as Star Performer Mutual Fund,
but with a higher expected rate of return? Explain why in reality, a mutual fund must be able to
provide an expected rate of return that is higher than that predicted by the security market line
in order for investors to consider the fund an attractive investment opportunity.
The CAPM implies that the expected rate of return that investors will demand of the portfolio is:
r = rf + β(rm - rf) = 5% + 0.8(15% - 5) = 13%
If the portfolio is expected to provide only a 12% rate of return, it is an unattractive investment.
The portfolio does not provide an expected return that is sufficiently high relative to its risk.
A portfolio that is invested 80% in a stock index mutual fund (with a beta of 1.0) and 20% in
Treasury bills or a money market mutual fund (with a beta of zero) would have the same beta
as Star Performer Mutual Fund:
β = (0.80 × 1.0) + (0.20 × 0) = 0.80
However, this portfolio will provide an expected return of:
(0.80 × 15%) + (0.20 × 5%) = 13%
This is better than the expected return of 12% for Star Performer Mutual Fund.
The security market line provides a benchmark expected return that an investor can earn by
mixing index funds with money market funds. Before an investor places funds with a
professional mutual fund manager, the investor must be convinced that the mutual fund can
earn an expected return (net of fees) in excess of the expected return available on an equally
risky index fund strategy.
AACSB: Analytic
12-96
Blooms: Analyze
12-97

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Chapter 12

Risk, Return, and Capital Budgeting

True / False Questions

8. Beta measures the total risk of an individual security.

high cost of capital.

12. Beta measures a stock's sensitivity to market risks.

a relatively low beta.

accounting for risk.

Multiple Choice Questions

30. The return on a security includes premiums for:

A. market risk and unique risk.

B. unique risk and firm-specific risk.

C. diversification and portfolio risk.

D. time value of money and market risk.

A. ignoring all of the security's unique risk.

B. underpriced, a situation that should be temporary.

C. offering too little return to justify its risk.

D. a defensive security, which expects to offer lower returns.

A. the market portfolio contains only risk-free securities.

B. only macro events are tracked by economists.

C. the unique risks have been diversified away.

D. the firm-specific events would be too numerous to quantify.

33. In practice, the market portfolio is often represented by:

A. a portfolio of U.S. Treasury securities.

B. a diversified stock market index.

C. an investor's mutual fund portfolio.

D. the historic record of stock market returns.

34. A stock's beta measures the:

A. average return on the stock.

B. variability in the stock's returns compared to that of the market portfolio.

D. market risk premium on the stock.

A. the securities of the S&P 500.

B. the securities of the Dow.

C. the securities of the S&P 500 and Treasury bills.

D. all risky assets.

A. negative portfolio returns less than 10%.

B. negative portfolio returns greater than 10%.

C. positive portfolio returns less than 10%.

D. positive portfolio returns greater than 10%.

A. losses of less than 8%.

B. losses greater than 8%.

C. gains of less than 8%.

D. gains greater than 8%.

A. an aggressive stock, expected to increase more than the market increases.

B. a defensive stock, expected to decrease more than the market increases.

C. an aggressive stock, expected to decrease more than the market increases.

D. a defensive stock, expected to increase more than the market decreases.

A. greater than 1.0; most stocks are aggressive.

B. less than 1.0; most stocks are defensive.

C. unknown; betas are continually changing.

D. exactly 1.0; these stocks represent the market.

A. security market line.

B. beta of the stock.

C. market risk premium.

D. capital asset pricing model.

then its beta equals:

positive, then the stock:

A. has a beta greater than 1.0.

B. has no unique risk.

C. has a positive beta.

D. plots above the security market line.

greater than 1.0, then the:

A. stock is currently underpriced.