A project manager pitched a project that has a Stock A has a beta of 1.

3 and Stock B has a beta

9% expected rate of return to the following of 1.4. What can one conclude about these stocks
companies: based on this information?
Answer: Stock B is riskier than Stock A
Company Equity Beta
Alter Phase 1.8
Boltwork 1.5 The security market line (SML) is a graphical
Concrete 0.8 representation of the capital asset pricing model.
If an asset is plotted below the SML, it implies
Dam & Hulls 2.3
that:
Answer: The asset is overvalued
Based on the project's expected return, which of
the companies would accept the proposal?
Assume a risk-free rate of 1% and a market risk The security market line (SML) is a graphical
premium of 5%. representation of the capital asset pricing model.
If an asset is plotted above the SML, it implies
Answer: Boltwork and Concrete that:
Answer: The asset is undervalued

A fund manager is looking to add new stocks to A portfolio with a level of systematic risk that is
his portfolio. He is considering four companies the same as that of the market has a beta that is
and can gather the following information: which of the following?
Answer: Equal to one
Company Expected Return Equity Beta
Gamma 8% 0.5 Which of the following statements concerning the
Delta 12% 1.8 Capital Asset Pricing Model (CAPM) is not
Epsilon 9% 1.3 correct?
Zeta 15% 2.0
A. CAPM bases the expected return of
The current risk-free rate is 2%, and the market investments on the investment's beta, the risk-
risk premium is 6%. If the fund manager is looking free rate of return, and the average return on all
to include undervalued companies, which the stocks in the company's industry.
companies should he invest in?
B. CAPM describes the relationship between risk
Answer: Gamma and Zeta and the expected return of investments.
C. CAPM is used to determine how much return
investors need to expect for an investment given
A stock is trading in the market at a 12% its systematic risk.
expected rate of return. The risk-free rate is 2%, D. CAPM is used to estimate the cost of a
and the market risk premium is 6%. What is the company's equity capital.
beta of the stock?
Answer: 1.67 (12%-2%/6%)
A recent leveraged buyout was financed with
$50M. This amount comprised partner's equity
TeleNyckel Inc. has a beta of 1.4 and is trying to capital of $12M, $20M unsecured debt borrowed
calculate its cost of equity capital. If the risk-free at 7% from one bank, and the remainder from
rate of return is 9% and the market risk premium another bank at 8.5%. What is the overall after-
is 5%, then what is the firm's after-tax cost of tax cost of the debt financing if you expect the
equity capital if the firm's marginal tax rate is firm's marginal tax rate to be 33%?
30%? Answer: 5.17%
Total debt is 5M - 12M equity financing= 38 debt
Answer: 16.00% 9%+ (1.x.05) financing.
Total interest paid= .07x 20M= 1400000
.085 x 18M= 1530000
1.4M+1.53M= 2930000/38000000= .0771
.0771 x (1-.33)= .0517 or 5.17%
Using the Capital Asset Pricing Model, an analyst An investor requires an 11% rate of return for all
has calculated an expected risk-adjusted return of new investments and has the option to invest in
17% for the common stock of a company. The two stocks: Company A, which has an equity risk
company's stock has a beta of 2, and the overall premium of 6% and a beta of 0.8, and/or
expected market return for equities is 10%. The Company B, which has an equity risk premium of
risk-free return is 3%. All else being equal, the 9% and a beta of 1.2. The current risk-free rate is
expected risk-adjusted return for the company's 4%. All of the following statements are correct
stock would increase if the, except:

Answer: risk-free return decreases Answer: The investor should not invest in
Company A because its rate of return is 8.8%
(2% + 1.4 (14%-2%)
The stock of company Z has a beta coefficient of
2.0 and an expected return of 18% using the
capital asset pricing model. Company X has an Jacque Ewing Drilling Inc. has a beta of 1.3 and is
expected return of 8.2%. The risk-free interest trying to calculate its cost of equity capital. If the
rate is 4%. The beta of company X is risk-free rate of return is 8% and the expected
return on the market is 12%, then what is the
firm's after-tax cost of equity capital if the firm's
Answer: 0.60
marginal tax rate is 40%?
expected return - risk-free rate / market premium
(8.2%-4%.0/7%)
computation of market premium(18%-4%/2)=7% Answer: 13.20%
8% + 1.3 (12% - 8%), dividends are not tax
Marley's Pipe Shops has found that its common deductible, pretax and after tax
equity capital shares have a beta equal to 1.5
while the risk-free return is 8% and the expected
return on the market is 14%. Its pretax cost of If the Fed caused the risk-free rate to increase,
debt financing is 12%. The firm is financed with we would expect the cost of capital to:
$120,000,000 of common shares (market value) Answer: Increase
and $80,000,000 of debt. What is the Marley's
cost of equity financing, if it is subject to a 35% The capital asset pricing model (CAPM) is used to
marginal tax rate? determine the cost of what?
Answer: 17.00% Answer: Cost of equity
cost of equity= 8% + 1.5 x (14%-8%)
Which of the following firms’ stock price would
increase the most if the market increased by 5%?
Beta measures the volatility of a stock in relation
to the movements of the market. A well-diversified A. Firm with a beta of 1.25
portfolio is expected to have a beta close to: B. Firm with a beta of .75
Answer: 1.0 C. Firm with a beta of .25
D. Firm with a beta of 1.50
Answer: D
A stock has a beta of 1.5 and an expected return 1.5 x 5%= 6
of 14%. Given a risk-free rate of 2% and a market
risk premium of 6%, an investor should:
Answer: Buy the stock becasue it is undervalued
(2% + 1.5 x 6%)= 11%, below expected return of
14%
Jonah Carver has made the following How does inflation impact a bond's rate of return?
observations:
Inflation is projected to be 3% over the next year. Answer: Negatively
The risk-free rate of return is 6%. Shares of Drake
Dungarees should deliver a 14% nominal return
over the next year. A financial analyst for a corporation values the
corporation’s stock with the two-stage dividend
Given Carver's observations, the real return discount model. The dividend paid last year was
realized by Drake investors should be closest to: $5. The analyst assumes the following.

Answer: 11% (14%-3%)  The dividend will grow by 12% per year for
the next six years
 After year 6 the dividend will grow by 4%
per year forever
If inflation is anticipated to be 10% during the next  A 10% required return of investors
year while a nominal rate of 20% will be earned
on US Treasury bills, then what is the real rate of Changing what assumption would cause the
return on these securities? analyst to find a lower stock value?
Answer: 10%
Real rate= Nominal rate - Inflation rate Answer: The next six years assumtpion to the
next three years.

The interest rate risk of a bond is: The ZGE Company issues 10-year fixed-rate
bonds on the first day of 2x21. During 2x21,
related to the probability that interest rate expected inflation over the next 15 years
A
changes will cause a bond's price to drop. decreased. How would this impact the price of
risk related to the possibility of bankruptcy of these bonds?
B
the bond's issuer. Answer: The price of the bonds would go up since
unsystematic risk caused by factors unique to interest rate would go down because of the
C
the bond. decrease in expected inflation
risk related to the possibility of bankruptcy of
the bond's issuer and that arises from the The XYZ Company issues 10-year fixed-rate
D
uncertainty of the bond's return caused by the bonds on the first day of 2x21. During 2x21,
change in interest rates. expected inflation over the next 10 years
increased. How would this impact the price of
Although less common, if investors expect these bonds?
decreasing inflation, what would be the shape of Answer: The price of the bonds would go down
the yield curve? since interest rate would go up because of the
Answer: a downward sloping yield curve increase in expected inflation

A downward sloping yield curve means that A financial analyst expects that a corporation will
shorter-term securities have a higher yield than pay a dividend of $11.00 per share one year from
longer-term securities. When this happens, what today, a dividend of $12.10 per share two years
does it signal about the future state of the from today, and three years from today it will pay
economy? a dividend of $13.31 per share. Also, three years
Answer: Recessionary period from today, the analyst assumes that the
corporation will be bought with a cash offer from
another corporation for $26.62 per share. What is
The real rate of interest is: the value of the stock if a 10% annual required
Answer: the nominal interest rate minus expected return for investors is assumed?
inflation Answer: 50.00
11/1.1= 10
12.10/1.1^2= 10
An upward sloping yield curve means that longer-
13.31/1.1^3= 10
term securities have a higher yield than shorter-
26.62/1.1^3=20
term securities. When this happens, what does it
signal about the future state of the economy?
Answer: Expansionary period
Which of the following statements about the yield The yield curve currently has a positive slope.
curve is correct? Suppose that inflation expectations for the next
An upward sloping yield curve is often an year increase by a small amount. Inflation
A
indication that a recession is coming. expectations beyond a year, however, increase
A downward sloping yield curve is often an by a larger amount. What does the change in
B inflation expectations suggest will happen to the
indication that a recession is coming.
A flat yield curve is often an indication that an yield curve?
C
economic expansion is coming.
The shape of the yield curve is not a good Answer: It will shift up and become steeper
D
indicator of expected economic activity.

If the term structure of interest rates has a flat There are three common factors that influence
slope, which one of the following statements is both the shape and level of yield curves. Which of
correct? the following is not one of the three factors?
Answer: Long-term rate are the same as short A. Interest rate risk
term rates B. The real rate of interest
C. The foreign exchange rate
D. Expected rate of inflation
Which of the following statements is true of
annual percentage rate (APR)?
The APR is similar to quoted interest rate Jonah Carver has made the following
A observations:
which is a simple annual rate.
The APR calculation adjusts for the effects of
B compounding and, hence, the time value of Inflation is projected to be 2% over the next year.
money. The risk-free rate of return is 9%. Shares of Drake
The APR is the true cost of borrowing and Dungarees should deliver a 17% nominal return
C over the next year. Given Carver's observations,
lending.
the real return realized by Drake investors should
The APR and effective annual rate both take
D be closest to:
compounding into account.
Answer: 15% = 17%-2%
Which of the following statements is true about
the effective annual rate (EAR)?
What is true cost of borrowing?
Answer: The EAR is the interest rate actually paid
Answer: The effective annual rate
(or earned after accounting for compounding

Which of the following statements concerning the

If the real return on US Treasury bills is 14% while
yield curve is correct?
the rate of expected inflation is anticipated to be
Answer: The real rate of interest impacts the level
8%, then what should nominal rate of return be?
of the yield curve, and the expected rate of
Answer: 22% = 14% + 8%
inflation impacts the slope of the yield curve.

A financial analyst values a corporation’s stock

The yield curve shows the relationship between
with the constant growth dividend discount model.
bond yields that differ by the:
The analyst assumes the following.
Answer: years to maturity of the bonds
 The dividend will grow by 3% per year.
Which of the following statements about the yield
 8% is the annual required return for
curve is not correct?
investors.
A. The yield curve depicts the relationship
between the amount borrowed and yield to
maturity on the debt instrument If the analyst calculates that the value of the stock
B. The yield curve can be used to illustrate is $183.50 per share, the dividend per share in
interest rate risk the most recent year was closest to
C. The yield curve is typically upward sloping Answer: 9%
D. The yield curve can be used to illustrate 183.50 x .03= 5.50
investor's expectations about future inflation 183.50 x .08= 14.68
less: 9.175
9.175/8%-3%= 183.50