Practice questions from chapters 10-12 (with a few “bonus questions from chapter 13).
1. The excess return required on a risky asset over that earned on a risk-free asset is called (a):
A) Risk premium.
B) Return premium.
C) Excess return.
D) Average return.
E) Variance.
Answer: A
2. An efficient capital market is one in which:
A) Brokerage commissions are zero.
B) Taxes are irrelevant.
C) Securities always offer a positive rate of return to investors.
D) Security prices are guaranteed (by the Securities and Exchange Commission) to be fair.
E) Security prices reflect available information.
Answer: E
3. The hypothesis that market prices reflect all available, public and private, information is called
efficiency in the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
Answer: B
4. The hypothesis that market prices reflect all publicly-available information is called efficiency in
the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
Answer: C
5. The hypothesis that market prices reflect all historical information is called efficiency in the:
A) Open form.
B) Strong form.
C) Semi-strong form.
D) Weak form.
E) Stable form.
Answer: D
6. Over the past 76 years, which of the following investments provided the largest average return?
A) Small company stocks
B) Common stocks
C) Treasury bills
D) Treasury bonds
E) Corporate bonds
Answer: A
7. Over the past 76 years, which of the following investments has been the least risky?
A) Small company stocks
B) Common stocks
C) Treasury bills
D) Treasury bonds
E) Corporate bonds
Answer: C
8. You track the liquidity of companies and find that you can consistently earn unusually high
returns by purchasing the shares of firms whose stock price falls below the cash value per share
as indicated on the balance sheet. Which of the following describes this strategy?
A) This would not be a violation of market efficiency.
B) This would be a violation of weak form efficiency.
C) This would be a violation of semi-strong form efficiency.
D) This would be a violation of strong form efficiency.
E) This would be a violation of all forms of market efficiency.
Answer: C
9. Last year you purchased 1,000 shares of Sun Microsystems stock for $15 per share. According to
today's quote in The Wall Street Journal, the stock is currently selling for $3 per share. The stock
pays no dividends. Your return on this investment is comprised of _____________.
A) retained earnings and dividend yields
B) an income return and a capital gains return
C) a real return only
D) a capital gains return only
E) there is no return, since you lost money on this investment
Answer: D
10. Which of the following is generally considered to represent the risk-free return?
A) Common stocks
B) Small stocks
C) Long-term government bonds
D) Long-term corporate bonds
E) Treasury bills
Answer: E
11. You purchased a bond for $870 one year ago. Today, you receive your only interest payment for
the year of $70. The bond can currently be sold for $925. What is your total percentage return on
investment? Ignore tax effects.
A) 6.3%
B) 8.1%
C) 14.4%
D) 16.5%
E) 20.8%
Answer: C
12. You purchased 500 shares of preferred stock on January 1, 2002, for $85 per share. The stock
pays an annual dividend of $12 per share. On December 31, 2002, the market price is $91 per
share. What is your total dollar return for the year?
A) $ 3,000
B) $ 4,500
C) $ 6,000
D) $ 9,000
E) $12,000
Answer: D
Response: 500 ($91 - 85 + 12) = $9,000
13. You purchased a bond on January 1, 2002, for $1,065. The bond has a $1,000 face value, a 10%
annual coupon, and can be sold for $975 on December 31, 2002. What is your percentage return
on investment for the year?
A) –4.1%
B) 0.9%
C) 4.6%
D) 8.3%
E) 12.5%
Answer: B
Response: R = [($975 - 1,065) / 1,065] + (100 / 1,065) = .0094
14. You purchased 500 shares of preferred stock on January 1, 2002, for $50 per share. The stock
pays an annual dividend of $8 per share. On December 31, 2002, the market price is $54 per
share. What is your percentage return on investment for the year?
A) 4%
B) 8%
C) 16%
D) 20%
E) 24%
Answer: E
Response: R = [($54 - 50) / 50] + (8 / 50) = .24
Use the following to answer questions 15-18:
You purchase 800 shares of stock at a price of $20 per share. One year later, the shares are selling for $23
per share. In addition, a dividend of $2 per share is paid at the end of each year.
15. What is the total dollar return for the investment?
A) $1,600
B) $2,400
C) $4,000
D) $6,800
E) $8,000
Answer: C
Response: first, you made 800 times your $3 (23-20) capital gain or 800 x 3 or $2400
Second, you made the dividend, or 800 times $2 equals $1,600. Add up the capital gain of $2,400
and the dividend of $1,600 and you get 2,400 + 1,600 or $4,000
16. What is the capital gains yield for the investment?
A) 8.5%
B) 10.0%
C) 11.5%
D) 13.0%
E) 15.0%
Answer: E, Response: CGY = ($23 - 20) / 20, or 3/20 = .15or 15%
17. What is the dividend yield for the investment?
A) 2.5%
B) 7.5%
C) 10.0%
D) 15.0%
Answer: C
Response: Dividend Yield is D1/P0 = $2 / 20 = .10
18. What is the total percentage return for the investment?
A) 5%
B) 10%
C) 15%
D) 20%
E) 25%
Answer: E, Response: R = [($23 - 20) / 20] + (2 / 20) = .25
Here, you made a total of $5 per share ($3 gain + $2 dividend) divided by your purchase price of
$20. 5/20 = 25%.
Chapter 11 questions begin here
1. A portfolio is ___________________________.
A) a group of assets, such as stocks and bonds, held as a collective unit by an investor
B) the expected return on a risky asset
C) the expected return on a collection of risky assets
D) the variance of returns for a risky asset
E) the standard deviation of returns for a collection of risky assets
Answer: A
2. The percentage of a portfolio's total value invested in a particular asset is called that asset's:
A) Portfolio return.
B) Portfolio weight.
C) Portfolio risk.
D) Rate of return.
E) Investment value.
Answer: B
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called:
A) Idiosyncratic risk.
B) Diversifiable risk.
C) Systematic risk.
D) Asset-specific risk.
E) Total risk.
Answer: C
4. Risk that affects at most a small number of assets is called:
A) Portfolio risk.
B) Undiversifiable risk.
C) Market risk.
D) Unsystematic risk.
E) Total risk.
Answer: D
5. The principle of diversification tells us that:
A) Concentrating an investment in two or three large stocks will eliminate all of your risk.
B) Concentrating an investment in two or three large stocks will reduce your overall risk.
C) Spreading an investment across many diverse assets cannot (in an efficient market) eliminate
any risk.
D) Spreading an investment across many diverse assets will eliminate all of the risk.
E) Spreading an investment across many diverse assets will eliminate some of the risk.
Answer: E
6. The ___________________ tells us that the expected return on a risky asset depends only on that
asset's systematic risk.
A) Efficient Markets Hypothesis (EMH)
B) systematic risk principle
C) Open Markets Theorem
D) Law of One Price
E) principle of diversification
Answer: B
7. The amount of systematic risk present in a particular risky asset, relative to the systematic risk
present in an average risky asset, is called the particular asset's:
A) Beta coefficient.
B) Reward to risk ratio.
C) Law of One Price.
D) Diversifiable risk.
E) Treynor index.
Answer: A
8. The linear relation between an asset's expected return and its beta coefficient is the:
A) Reward to risk ratio.
B) Portfolio weight.
C) Portfolio risk.
D) Security market line.
E) Market risk premium.
Answer: D
9. Diversification works because:
A) Unsystematic risk exists.
B) Forming stocks into portfolios reduces the standard deviation of returns for each stock.
C) Firm-specific risk can be never be reduced.
D) Stocks earn higher returns than bonds.
E) Portfolios have higher returns than individual assets.
Answer: A
10. A security has an unexpected negative news announcement specific to that security. Most likely,
the ______________________________.
A) security's required return on investment will increase.
B) security's required return on investment will remain unchanged.
C) security's required return on investment will decrease.
D) market risk premium will increase.
E) security's market price will remain unchanged.
Answer: A
11. New information regarding a security, when received by the market, leads to a(n):
A) Unexpected return.
B) Expected return.
C) Actual return.
D) Systematic return.
E) Non-diversifiable return.
Answer: A
12. You own 50 shares of stock A, which has a price of $12 per share, and 100 shares of stock B,
which has a price of $3 per share. What is the portfolio weight for stock A in your portfolio?
A) 25%
B) 33%
C) 50%
D) 67%
E) 75%
Answer: D
Response: 50($12) + 100(3) = $900; wA = $600 / 900 = .67
13. What is the expected return for the following stock?
State
Average
Recession
Depression
Probability
.50
.35
.15
Return
.25
.05
–.35
A) .05
B) .08
C) .09
D) .10
E) .12
Answer: C
Response: 50(.25) + .35(.05) + .15(-.35) = .09
14. What is the risk premium for the following returns if the risk-free rate is 4%?
State
Boom
Good
Recession
Depression
Probability
.20
.55
.15
.10
Return
.75
.25
–.10
–.50
A) 0.3325
B) 0.1525
C) 0.0525
D) 0.1825
E) 0.2225
Answer: D
Response: .20(.75) + .55(.25) + .15(-10)+ .10(-50) = .2225; RP = .2225 - .04 = .1825
15. What is the expected portfolio return given the following information:
Asset
A
B
C
D
Portfolio weight
.35
.15
.25
.25
Return
20%
35%
6%
12%
A) 6.75%
B) 9.50%
C) 16.75%
D) 18.25%
E) 21.50%
Answer: C
Response: .35(.20) + .15(.35) + .25(.06) + .25(.12) = .1675
16. What is the expected return on asset A if it has a beta of 0.6, the expected market return is 15%,
and the risk-free rate is 6%?
A) 5.4%
B) 9.6%
C) 11.4%
D) 15.0%
Answer: C
Response: 6 + .6(15 - 6) = 11.4%
Chapter 12 questions begin here
1. The opportunity cost associated with the firm's capital investment in a project is called its:
A) Cost of capital.
B) Beta coefficient.
C) Capital gains yield.
D) Sunk cost.
E) Internal rate of return.
Answer: A
2. The return that shareholders require on their investment in the firm is called the:
A) Dividend yield.
B) Cost of equity.
C) Capital gains yield.
D) Cost of capital.
E) Income return.
Answer: B
3. The return that lenders require on their loaned funds to the firm is called the:
A) Coupon rate.
B) Current yield.
C) Cost of debt.
D) Capital gains yield.
E) Cost of capital.
Answer: C
4. The weighted average of the firm's costs of equity, preferred stock, and aftertax debt is the:
A) Reward to risk ratio for the firm.
B) Expected capital gains yield for the stock.
C) Expected capital gains yield for the firm.
D) Portfolio beta for the firm.
E) Weighted average cost of capital (WACC).
Answer: E
5. All of the following could be considered advantages in assessing the cost of preferred stock
compared to the cost of common stock EXCEPT:
A) Preferred stock generally carries with it a fixed dividend payment.
B) Preferred stock is often rated for default risk.
C) The cost of preferred stock is simply equal to its dividend yield.
D) The cost of preferred stock can be calculated as a perpetuity based on the fixed dividend
payment and the present stock price.
E) Unlike common stock, preferred stock requires no assumptions be made about future cash
flows.
Answer: E
6. Which of the following, among other things, is needed to calculate the weighted average cost of
capital for a non-profit corporation?
A) The par value of bonds outstanding.
B) The bond rating of the firm's outstanding debt issues.
C) The corporate tax rate.
D) The number of preferred shares outstanding.
E) The operating cash flow for the most recent reporting period.
Answer: D
7. All else the same, a higher corporate tax rate _____________________.
A) will decrease the WACC of a firm with some debt in its capital structure
B) will increase the WACC of a firm with some debt in its capital structure
C) will not affect the WACC of a firm with some debt in its capital structure
D) will decrease the WACC of a firm with no debt in its capital structure
E) will change the WACC of a firm with some debt in its capital structure, but the direction is
unclear.
Answer: A
8. To estimate the cost of equity for a firm, which of the following variables would NOT be needed?
A) The current dividend payment.
B) The risk-free interest rate.
C) The debt/equity ratio.
D) The beta coefficient.
E) The market price of the stock.
Answer: C
9. A firm is expected to pay a dividend of $3.50 per share in one year. This dividend, along with the
firm's earnings, is expected to grow at a rate of 7% forever. If the current market price for a share
is $67, what is the cost of equity?
A) 7.00%
B) 12.22%
C) 15.64%
D) 14.00%
E) 13.46%
Answer: B
Response: ($3.50 / 67) + .07 = .1222
10. The long-term debt of your firm is currently selling for 109% of its face value. The issue matures
in 12 years and pays an annual coupon of 7.5%. What is the cost of debt?
A) 5.60%
B) 6.40%
C) 7.50%
D) 8.90%
E) 9.30%
Answer: B
Response: $1,090 = $75{[1 - 1/(1 + YTM)12] / YTM} + 1,000 / (1 + YTM)12; YTM = 6.40%
1000 FV, -1090 PV, 12 N, 75 PMT, CPT I/Y = 6.4%
11. A company's preferred stock pays an annual dividend of $7.00 per share. When issued, the shares
sold for their par value of $100 per share. What is the cost of preferred stock if the current price is
$120 per share?
A) 5.8%
B) 7.0%
C) 8.1%
D) 9.6%
E) 12.0%
Answer: A
Response: $7 / 120 = .058
12. Suppose that your firm has a cost of equity of 18% and a cost of debt of 8%. If the target
debt/equity ratio is 0.60, and the tax rate is 35%, what is the firm's weighted average cost of
capital (WACC)?
A) 7.4%
B) 9.9%
C) 11.8%
D) 13.2%
E) 14.3%
Answer: D
Response: .18(10/16) + .08(6/16)(1-35) = .132
13. Suppose a firm has 19 million shares of common stock outstanding with a par value of $1.00 per
share. The current market price per share is $18.35. The firm has outstanding debt with a par
value of $114.5 million selling at 96% of par. What capital structure weight would you use for
debt when calculating the firm's WACC?
A) 0.15
B) 0.24
C) 0.54
D) 0.76
E) 0.96
Answer: B
Response: V = 19M($18.35) + 114,500($960) = $458,570,000; D/V = $109.92M / 458.57M =
.240
14. A common stock issue is currently selling for $31 per share. You expect the next dividend to be
$1.40 per share. If the firm has a dividend growth rate of 5% that is expected to remain constant
indefinitely, what is the firm's cost of equity?
A) 9.5%
B) 11.3%
C) 13.8%
D) 14.2%
E) 15.1%
Answer: A
Response: ($1.40/31) + .05 = .0952
15. Given the following information, what is the average annual dividend growth rate?
Dividend
$1.80
$1.90
$2.15
$2.28
$2.49
$2.75
A) 4.9%
B) 6.2%
C) 8.8%
D) 9.7%
E) 10.3%
Answer: C
Response: ($.10/1.80 + .25/1.90 + .13/2.15 + .21/2.28 + .26/2.49) / 5 = .0888
16. Treasury bills currently have a return of 2.5% and the market risk premium is 7%. If a firm has a
beta of 1.4, what is its cost of equity?
A) 8.1%
B) 9.9%
C) 10.8%
D) 12.3%
E) 14.4%
Answer: D
Response: 2.5 + 1.4(7) = 12.3%
17. Your firm sold a 25-year bond at par 19 years ago. The bond pays an 6% annual coupon, has a
$1,000 face value, and currently sells for $825. What is the firm's cost of debt?
A) 6.0%
B) 8.2%
C) 9.5%
D) 10.0%
E) 11.3%
Answer: D
Response: $825 = $60{[1 - 1/(1 + YTM)6] / YTM} + 1,000 / (1 + YTM)6; YTM = 10.02%
6 N, 1000 FV, -825 PV, 60 PMT, CPT I/Y = 10.02%
18. A company has preferred stock outstanding which pays a dividend of $6 per share a year. The
current stock price is $75 per share. What is the cost of preferred stock?
A) 6%
B) 7%
C) 10%
D) 9%
E) 8%
Answer: E
Response: $6 / 75 = .08
19. A firm sold a 10-year bond issue 3 years ago. The bond has a 6.45% annual coupon and a $1,000
face value. If the current market price of the bond is $951.64 and the tax rate is 35%, what is the
aftertax cost of debt?
A) 3.50%
B) 5.99%
C) 6.45%
D) 7.36%
E) 4.78%
Answer: E
Response:
$951.64 = $64.50{[1 - 1/(1 + YTM)7] / YTM} + 1,000 / (1 + YTM) 7; YTM = 7.359%
64.50 PMT, 1000 FV, 7 N, -951.64 PV, CPT I/Y = YTM = Rd=7.359%
After Tax Cost of debt =AT = Before tax Cost of Debt ( 1-tax rate) =7.359(1-.35) = 4.783%
20. Given the following information, what is the firm's weighted average cost of capital? Market
value of equity = $30 million; market value of debt = $20 million; cost of equity = 15%; cost of
debt = 9%; equity beta = 1.4; tax rate = 35%.
A) 11.34%
B) 12.60%
C) 12.97%
D) 13.32%
E) 14.08%
Answer: A
Response: [.15($30M/50M)] + [.09(20M/50M)(1-.35)] = .1134 or 11.34%
Chapter 13 questions begin here
1. The equity risk derived from the firm's operating activities is called ___________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) financial
Answer: D
2. The equity risk derived from the firm's capital structure policy is called ___________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) financial
Answer: E
3. The tax savings of the firm derived from the deductibility of interest expense is called the:
A) Interest tax shield.
B) Depreciable basis.
C) Financing umbrella.
D) Current yield.
E) Tax-loss carryforward savings.
Answer: A
4. The financial leverage of a firm will ______________________ .
I. decrease as the debt/equity ratio increases
II. decrease as the firm's retained earnings account grows
III. decrease if the firm has negative net income
A) I only
B) II only
C) III only
D) I and II only
E) II and III only
Answer: B
5. The optimal capital structure is the mixture of debt and equity which:
I. Maximizes the value of the firm.
II. Maximizes the firm's weighted average cost of capital.
III. Maximizes the market price of the firm's bonds.
A) I only
B) III only
C) I and II only
D) I and III only
E) I, II and III
Answer: A
6. Above the breakeven EBIT, increased financial leverage will __________ EPS, all else the same.
Assume there are no taxes.
A) increase
B) decrease
C) not affect
D) either increase or decrease
E) increase EBIT but decrease
Answer: A
7. ___________ arises from decisions that affect the left-hand side of the balance sheet,
while___________ arises from decisions that affect the right-hand side of the balance sheet.
A) Systematic risk; financial risk
B) Systematic risk; unsystematic risk
C) Unsystematic risk; systematic risk
D) Business risk; financial risk
E) Business risk; diversifiable risk
Answer: D
8. Which of the following statements is true?
A) The financial risk of a firm decreases when it takes on a risky project.
B) The financial risk of a firm increases when it takes on more equity.
C) The business risk of a firm increases when it takes on a risky project.
D) The business risk of a firm increases when it takes on more debt.
E) The higher the business risk for a firm, the higher the financial risk as well.
Answer: C