PRACTICE TEST 1. The return on which one of the following is used as the risk-free rate of return? a. long-term corporate bonds b. long-term government bonds c. short-term corporate bonds d. U.S. Treasury bills e. the Consumer Price Index 2. The CEO of Jericho Industries just announced that the firm has received a patent for a product that will convert household garbage into usable fuel without creating any hazardous waste. This news is totally a surprise and seen as a major technological advancement. Which one of the following reactions to this development best indicates an efficient market? a. The price of Jericho stock remains unchanged. b. The price of Jericho stock increases rapidly and then settles back to its original value. c. The price of Jericho stock increases rapidly and then levels off at the higher value. d. All stocks quickly increase in value and then all but Jericho stock fall back to their original values. e. The value of all stocks suddenly increase and then level off at their higher values. 3. The stock of Webster's Foods is priced at $31 a share and has a dividend yield of 2.8 percent. The firm pays constant annual dividends. What is the amount of the next dividend per share? a. $.740 b. $.868 c. $.927 d. $1.03 e. $1.07 4. Truman Florists pays a constant annual dividend of $2.20 per share on its stock. Last year at this time, the market rate of return on this stock was 12.6 percent. Today, the market rate has fallen to 9.7 percent. What would your capital gains yield have been if you had purchased this stock one year ago and then sold the stock today? a. 2.90 percent b. 9.70 percent c. 14.57 percent d. 23.02 percent e. 29.90 percent 5. Over the past 6 years, a stock produced returns of 11 percent, 20 percent, -7 percent, 18 percent, 12 percent, and 3 percent. Based on these six years, what range of returns would you expect to see 95 percent of the time? a. 10.61 percent to 15.47 percent b. 10.61 percent to 24.30 percent c. 10.61 percent to 29.61 percent d. 11.40 percent to 15.47 percent e. 11.40 percent to 24.30 percent 6. A stock has an average return of 13.6 percent and a standard deviation of 8.4 percent. In any one given year, you have a 95 percent chance that you will not lose more than _____ percent nor earn more than ____ percent if you invest in this security. a. 5.2 percent to 22.0 percent b. 3.2 percent to 30.4 percent c. 3.2 percent to 30.4 percent d. 5.2 percent to 22.0 percent e. 13.6 percent to 38.8 percent 7. Over the last four years, the stock of Wagner's Paints has had an arithmetic average return of 6.5 percent. Three of those four years produced returns of 9 percent, 3 percent, and 1 percent. What is the geometric average return for this 4-year period? a. 3.00 percent b. 4.48 percent c. 6.33 percent d. 7.07 percent e. 8.69 percent 8. The expected return on a security is currently based on a 75 percent chance of a 14 percent return given an economic boom and a 25 percent chance of a 6 percent return given a normal economy. Which of the following changes will increase the expected return on this security? I. an increase in the probability of an economic boom II. a decrease in the rate of return given a normal economy III. an increase in the probability of a normal economy IV. an increase in the rate of return given an economic boom a. I and II only b. I and IV only c. II and III only d. I, III, and IV only e. I, II, III, and IV 9. Which one of the following portfolios has the least amount of systematic risk? a. a portfolio that duplicates the overall market b. a portfolio comprised of 50 percent cash and 50 percent large-company stocks c. a portfolio consisting of various U.S. Treasury bills d. a stock portfolio with a portfolio beta of 1.8 e. a diversified portfolio with a portfolio beta of 0.7 10. The beta of a portfolio cannot be less than _____ nor greater than _____. a. 0; 1 b. 1; 2 c. the lowest individual beta in the portfolio; 1 d. 1; the highest individual beta in the portfolio e. the lowest individual beta in the portfolio; the highest individual beta in the portfolio 11. You own a portfolio of two stocks, A and B. Stock A is valued at $3,240 and has an expected return of 10.5 percent. Stock B has an expected return of 14.7 percent. What is the expected return on the portfolio if the portfolio value is $5,860? a. 11.20 percent b. 12.38 percent c. 12.46 percent d. 14.03 percent e. 14.29 percent 12. You want to create a $25,000 portfolio that consists of three stocks and has an expected return of 13 percent. Currently, you own $15,500 of stock A and $6,000 of stock B. The expected return for stock A is 14.5 percent, and for stock B it is 9.2 percent. What is the expected rate of return for stock C? a. 11.21 percent b. 11.58 percent c. 12.62 percent d. 12.87 percent e. 13.20 percent 13. You own a $90,000 portfolio that is invested in stock A and B. The portfolio beta is equal to the market beta. Stock A has an expected return of 14.1 percent and a beta of 1.2. Stock B has a beta of .76. What is the value of your investment in stock A? a. $39,333 b. $40,909 c. $49,091 d. $50,545 e. $50,667 14. Given the following information, what is the variance of a portfolio that is invested 25 percent in both stocks A and C, and 50 percent in stock B? a. .000025 b. .000106 c. .000232 d. .001414 e. .005285 15. You would like to create a portfolio that is equally invested in a risk-free asset and two stocks. The one stock has a beta of .80. What does the beta of the second stock have to be if you want the portfolio risk to equal that of the overall market? a. 1.4 b. 1.6 c. 1.8 d. 2.0 e. 2.2 16. The risk-free rate is 3.5 percent and the expected return on the market is 11 percent. Stock A has a beta of 1.1 and an expected return of 12 percent. Stock B has a beta of .92 and an expected return of 10.25 percent. Are these stocks correctly priced? Why or why not? a. No; Stock A is underpriced and stock B is overpriced. b. No; Stock A is overpriced and stock B is underpriced. c. No; Stock A is overpriced but stock B is correctly priced. d. No; Stock A is underpriced but stock B is correctly priced. e. Yes; Both stocks are correctly priced. 17. Unsystematic risk: I. is also called unique risk. II. is also called asset-specific risk. III. affects a limited number of assets. IV. affects a large number of assets. a. I and III only b. II and IV only c. I and IV only d. I, II, and III only e. I, II, and IV only 18. The weighted average cost of capital is defined as the weighted average of a firm's: a. return on its investments. b. cost of equity and its aftertax cost of debt. c. pretax cost of debt and equity securities. d. bond coupon rates. e. dividend and capital gains yields. 19. Which one of the following is the primary determinant of the cost of capital for a proposed project? a. amount of debt used to finance the project b. use, or lack thereof, of preferred stock to finance the project c. combined sources of funds used to finance the project d. the risk level of the project e. length of the project's life 20. In an efficient market, a security with a beta of 1.03 will have a rate of return that plots: a. just below the security market line (SML) and to the left of the market return. b. just below the SML and to the right of the market return. c. on the SML just to the left of the market return. d. on the SML just to the right of the market return. e. above the SML just to the right of the market return. 21. The cost of preferred stock: a. decreases when a firm's tax rate increases. b. is constant over time. c. is unaffected by changes in the price of the stock. d. is equal to the stock's dividend yield. e. increases as the price of the stock increases. 22. Last week, Lester's Electronics paid an annual dividend of $2.10 on its common stock. The company has a longstanding policy of increasing its dividend by 3 percent annually. This policy is expected to continue. What is the firm's cost of equity if the stock is currently selling for $44.60 a share? a. 7.66 percent b. 7.71 percent c. 7.79 percent d. 7.85 percent e. 7.90 percent 23. The common stock of Bywater, Inc. has 16 percent less systematic risk than the overall market. Currently, the market risk premium is 8.6 percent while the U.S. Treasury bill is yielding 5.2 percent. What is Bywater, Inc.'s cost of equity? a. 8.06 percent b. 9.38 percent c. 10.78 percent d. 12.42 percent e. 13.80 percent 24. Juno has 8 percent bonds outstanding that mature in 19 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $989 each. What is Juno's pre-tax cost of debt? a. 8.09 percent b. 8.11 percent c. 8.14 percent d. 8.18 percent e. 8.23 percent 25. J&J Movers has 40,000 shares of common stock outstanding at a price of $34 a share. It also has 4,000 shares of preferred stock outstanding at a price of $58 a share. The firm has 9 percent, 10-year bonds outstanding with a total face value of $500,000. The bonds are currently quoted at 96 and pay interest semiannually. What is the capital structure weight of the firm's debt if the tax rate is 34 percent? a. 23.17 percent b. 25.68 percent c. 25.94 percent d. 27.18 percent e. 28.46 percent 26. Brown Street Grocers has a cost of equity of 14.4 percent, a pre-tax cost of debt of 8.7 percent, and a tax rate of 34 percent. What is the firm's weighted average cost of capital if the debt-equity ratio is .55? a. 9.64 percent b. 10.28 percent c. 10.65 percent d. 11.33 percent e. 12.38 percent PRACTICE TEST - ANSWERS 1. D. 14. A. 2. C. 15. E. 3. B. 16. A. 4. E. 17. D. 5. C. 18. B. 6. B. 19. D. 7. C. 20. D. 8. B. 21. D. 9. C. 22. D. 10. E 23. D. 11. B. 24. B. 12. D. 25. A. 13. C. 26. D.