Schweser Printable Answers - PM&EQ 3...Schweser Printable Answers - PM&EQ 3 Test ID#: 13 Question 1 - #93389 Which of the following is least likely considered a source of systematic

Schweser Printable Answers - PM&EQ 3

Test ID#: 13

Question 1 - #93389

Which of the following is least likely considered a source of systematic risk for bonds?

Your answer: A was incorrect. The correct answer was B) Default risk.

Default risk is based on company-specific or unsystematic risk.

This question tested from Session 12, Reading 51, LOS c.

Question 2 - #93468

Which one of the following statements about correlation is FALSE?

Your answer: A was incorrect. The correct answer was C) If two assets have perfect negative correlation, it is impossible to reduce the portfolio's overall variance.

This statement should read, "If two assets have perfect negative correlation, it is possible to reduce the portfolio's overall variance to zero."

This question tested from Session 12, Reading 50, LOS d.

Question 3 - #95187

An investor with a below-average risk tolerance wants her portfolio to gain value through capital gains and reinvestment of income. Her most appropriate return objective is:

Your answer: A was correct!

The total return objective describes a portfolio that is structured to grow in value to meet a future need through both capital gains and the reinvestment of current income. A capital appreciation objective seeks to grow the portfolio value through capital gains and is more appropriate for less risk-averse investors.

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A) Purchasing power risk.B) Default risk.C) Market risk.

A) The covariance is equal to the correlation coefficient times the standard deviation of one stock times the standard deviation of the other stock.

B) Positive covariance means that asset returns move together.C) If two assets have perfect negative correlation, it is impossible to reduce the portfolio's overall variance.

A) total return.B) capital preservation.C) capital appreciation.

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Question 4 - #93445

An analyst has developed the following data for two companies, PNS Manufacturing (PNS) and InCharge Travel (InCharge). PNS has an expected return of 15% and a standard deviation of 18%. InCharge has an expected return of 11% and a standard deviation of 17%. PNS’s correlation with the market is 75%, while InCharge’s correlation with the market is 85%. If the market standard deviation is 22%, which of the following are the betas for PNS and InCharge?


Betai = (σi/σM) × ρI,M

BetaPNS = (0.18/0.22) x 0.75 = 0.6136 BetaInCharge = (0.17/0.22) x 0.85 = 0.6568

This question tested from Session 12, Reading 51, LOS d, (Part 1).

Question 5 - #93681

Which of the following statements concerning the efficient frontier is most accurate? It is the:


The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. It is also the point at which there are no more benefits to diversification.

This question tested from Session 12, Reading 50, LOS f.

Question 6 - #95253

Which of the following factors is least likely to affect an investor’s risk tolerance?

Your answer: A was incorrect. The correct answer was B) Level of inflation in the economy.

The level of inflation in the economy should be considered in determining the return objective. Risk tolerance is a

Beta of PNS Beta of InCharge

A) 0.61 0.66 B) 0.66 0.61 C) 0.92 1.10

A) set of portfolios where there are no more diversification benefits.B) set of portfolios that gives investors the lowest risk.C) set of portfolios that gives investors the highest return.

A) Number of dependent family members.B) Level of inflation in the economy.C) Level of insurance coverage.



function of the investor's psychological makeup and the investor's personal factors such as age, family situation, existing wealth, insurence coverage, current cash reserves and income.

This question tested from Session 12, Reading 49, LOS b.

Question 7 - #95314

Which of the following best describes the importance of the policy statement? It:


The policy statement should state the performance standards by which the portfolio's performance will be judged and specify the benchmark that represents the investors risk preferences.

This question tested from Session 12, Reading 49, LOS a.

Question 8 - #95240

Which of the following is least likely to be considered a constraint when preparing an investment policy statement?

Your answer: A was incorrect. The correct answer was C) Risk tolerance.

The constraints are: liquidity needs, time horizon, taxes, legal and regulatory factors, and unique needs and preferences. Risk tolerance is included in the investment objectives of the policy statement, not in the constraints.


Question 9 - #95127

Which of the following portfolios falls below the Markowitz efficient frontier?

A) states the standards by which the portfolio's performance will be judged.B) outlines the best investments.C) limits the risks taken by the investor.

A) Liquidity needs.B) Tax concerns.C) Risk tolerance.

Portfolio Expected Return Expected Standard Deviation

A 7% 14%

B 9% 26%

C 15% 30%

D 12% 22%

A) C.B) D.



Your answer: A was incorrect. The correct answer was C) B.

Portfolio B is not on the efficient frontier because it has a lower return, but higher risk, than Portfolio D.


Question 10 - #95249

Which of the following statements about risk and return is FALSE?

Your answer: A was incorrect. The correct answer was B) Risk and return may be considered on a mutually exclusive basis.

Risk and return must always be considered together when expressing investment objectives. Return objectives may be expressed either in absolute terms (dollar amounts) or in percentages.



Which of the following have studies shown has the greatest impact on the return of a portfolio?

Your answer: A was incorrect. The correct answer was B) Target asset allocation.

Several studies support the idea that approximately 40% of the variation in returns across portfolios, and approximately 90% of the variation in a single portfolio’s returns, can be explained by target asset allocations. Security selection and market timing are all less important factors.

This question tested from Session 12, Reading 49, LOS e.


An analyst collected the following data for three possible investments.

C) B.

A) Specifying investment objectives only in terms of return may expose an investor to inappropriately high levels of risk.

B) Risk and return may be considered on a mutually exclusive basis.C) Return objectives may be stated in absolute terms.

A) Market timing.B) Target asset allocation.C) Security selection.

Stock Price Today Forecasted Price* Dividend Beta

Alpha 25 31 2 1.6

Omega 105 110 1 1.2

Lambda 10 10.80 0 0.5



The expected return on the market is 12% and the risk-free rate is 4%.

Part 1) According to the security market line (SML), which of the three securities is correctly priced?

Your answer: A was incorrect. The correct answer was B) Lambda.

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows / dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate − risk free rate).

� For Alpha: ER = (31 – 25 + 2) / 25 = 32%, RR = 4 + 1.6 × (12 − 4) = 16.8%. Stock is underpriced. � For Omega: ER = (110 – 105 + 1) / 105 = 5.7%, RR = 4 + 1.2 × (12 − 4) = 13.6%. Stock is overpriced. � For Lambda, ER = (10.8 – 10 + 0) / 10 = 8%, RR = 4 + 0.5 × (12 − 4) = 8%. Stock is correctly priced.


An analyst collected the following data for three possible investments.

The expected return on the market is 12% and the risk-free rate is 4%.

Part 2) Which of the securities identified by Williams would plot on the capital market line(CML)?


By definition, all stocks and portfolios (other than the market portfolio) fall below the CML. (Only the market portfolio is efficient).


*Forecasted Price = expected price one year from today.

A) Alpha.B) Lambda.C) Omega.

Stock Price Today Forecasted Price* Dividend Beta

Alpha 25 31 2 1.6

Omega 105 110 1 1.2

Lambda 10 10.80 0 0.5

*Forecasted Price = expected price one year from today.

A) None of the securities would plot on the CML.B) Lambda.C) Alpha.




David Hoch, a graduate student, is putting together a research paper on differences in asset allocations between countries. Hoch’s paper contains the following statements:

Hoch’s finance professor, Walter Denk, reads his research paper. Which of the following conclusions would be most valid for Denk to make?

Your answer: A was incorrect. The correct answer was C) Both Statements 1 and 4 reflect common reasons why average asset allocations differ across countries.

Average asset allocations differ across countries for reasons related to demographics, social factors, legal constraints, and taxation. Each of the four statements made by Hoch are an example of one of these factors, therefore all four of the statements reflect common reasons why average asset allocations differ across countries.



If the standard deviation of stock A is 13.2 percent, the standard deviation of stock B is 17.6 percent, and the covariance between the two is 0, what is the correlation coefficient?

Your answer: A was incorrect. The correct answer was C) 0.

Since covariance is zero, the correlation coefficient must be zero.



The market portfolio in Capital Market Theory is determined by:

Statement 1: Countries with higher income tax rates typically have lower allocations to bonds.

Statement 2: Countries with older populations typically have lower allocations to equities.

Statement 3: A strong government pension program may decrease the average equity allocation of a country’s citizens.

Statement 4: Countries with a historical aversion to financial risk typically have lower allocations to equities.

A) Statement 3 reflects a common reason why average asset allocations differ across countries, but Statement 1 does not.

B) Statement 2 reflects a common reason why average asset allocations differ across countries, but Statement 3 does not.

C) Both Statements 1 and 4 reflect common reasons why average asset allocations differ across countries.

A) +1.B) 0.31.C) 0.



Your answer: A was incorrect. The correct answer was B) a line tangent to the efficient frontier, drawn from the risk-free rate of return.

The Capital Market Line is a straight line drawn from the risk-free rate of return (on the Y axis) through the market portfolio. The market portfolio is determined as where that straight line is exactly tangent to the efficient frontier.



Which of the following statements about the capital market line (CML) is least accurate?

Your answer: A was incorrect. The correct answer was B) The market portfolio lies on the CML and has only unsystematic risk.

The first part of this statement is true - the market portfolio does lie on the CML. However, the market portfolio is well diversified and thus has no unsystematic risk. The risk that remains is market risk, or nondiversifiable, or systematic risk.

The CML measures standard deviation (or total risk) against returns. The CML will “kink” if the borrowing rate and lending rate are not equal. Investors choose a portfolio on the CML by lending or borrowing at the risk-free rate to vary the weighting of their investments in the risk-free asset and the market portfolio.



Which of the following equations is least accurate?

Your answer: A was incorrect. The correct answer was C) Standard Deviation2-Stock Portfolio = [(w12 × σ1

2) + (w22 ×

σ22) + (2 × w1 × w2 σ1σ2 × ρ1,2)].

This is the equation for the variance of a 2-stock portfolio. The standard deviation is the square root of the variance. The other equations are correct.


A) a line tangent to the efficient frontier, drawn from any point on the expected return axis.B) a line tangent to the efficient frontier, drawn from the risk-free rate of return.C) the intersection of the efficient frontier and the investor's highest utility curve.

A) Investors choose a portfolio on the CML by varying their weightings of the risk-free asset and the market portfolio.

B) The market portfolio lies on the CML and has only unsystematic risk.C) The CML will not be a linear relationship if investors' borrowing and lending rates are not equal.

A) Real Risk-Free Rate = [(1 + nominal risk-free rate) / (1 + expected inflation)] − 1.

B) Required Returnnominal = [(1 + Risk Free Ratereal) × (1 + Expected Inflation) × (1 + Risk Premium)] − 1.

C) Standard Deviation2-Stock Portfolio = [(w12 × σ1

2) + (w22 × σ2

2) + (2 × w1 × w2 σ1σ2 × ρ1,2)].




Which of the following is NOT an assumption of capital market theory?

Your answer: A was incorrect. The correct answer was B) Investors can lend at the risk-free rate, but borrow at a higher rate.

Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other statements are basic assumptions of capital market theory.

This question tested from Session 12, Reading 51, LOS a, (Part 1).


Which of the following measures is NOT considered when calculating the risk (variance) of a two-asset portfolio?

Your answer: A was incorrect. The correct answer was C) The beta of each asset.

The formula for calculating the variance of a two-asset portfolio is:

σp2 = WA

2σA2 + WB

2σB2 + 2WAWBCov(a,b)



An investor is evaluating the following possible portfolios. Which of the following portfolios would least likely lie on the efficient frontier?

A) The capital markets are in equilibrium.B) Investors can lend at the risk-free rate, but borrow at a higher rate. C) Interest rates never change from period to period.

A) Each asset’s standard deviation.B) Each asset weight in the portfolio.C) The beta of each asset.

Portfolio Expected Return Standard Deviation

A 26% 28%

B 23% 34%

C 14% 23%

D 18% 14%

E 11% 8%

F 18% 16%

A) B, C, and F.B) C, D, and E.C) A, B, and C.




Portfolio B cannot lie on the frontier because its risk is higher than that of Portfolio A's with lower return. Portfolio C cannot lie on the frontier because it has higher risk than Portfolio D with lower return. Portfolio F cannot lie on the frontier cannot lie on the frontier because its risk is higher than Portfolio D.



The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A?


RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate

Here, RRStock = 6 + (12 - 6) × 1.3 = 6 + 7.8 = 13.8%.



If the standard deviation of returns for stock A is 0.40 and for stock B is 0.30 and the covariance between the returns of the two stocks is 0.007 what is the correlation between stocks A and B?

Your answer: A was incorrect. The correct answer was C)

0.05830.

CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.007 / (0.400 × 0.300) = 0.0583



The market portfolio in the Capital Market Theory contains which types of investments?

A) 13.8%.B) 14.2%.C) 15.6%.

A) 17.14300. B) 0.00084. C) 0.05830.

A) All risky and risk-free assets in existence.B) All risky assets in existence.C) All stocks in existence.



Your answer: A was incorrect. The correct answer was B) All risky assets in existence.

The market portfolio contains all risky assets in existence. It does not contain any risk-free assets.



Which of the following statements about risk is FALSE? Generally, greater:

Your answer: A was incorrect. The correct answer was B) spending needs allows for greater risk.

Greater spending needs usually allow for lower risk because there is a definite need to ensure that the return may adequately fund the spending needs (a “fixed” cost).



An investor has a two-stock portfolio (Stocks A and B) with the following characteristics:

� σA = 55%

� σB = 85% � CovarianceA,B = 0.9 � WA = 70% � WB = 30%

The variance of the portfolio is closest to:

Your answer: A was incorrect. The correct answer was B) 0.59

The formula for the variance of a 2-stock portfolio is:

s2 = [WA2σA

2 + WB2σB

2 + 2WAWBσAσBrA,B]

Since σAσBrA,B = CovA,B, then

s2 = [(0.72 × 0.552) + (0.32 × 0.852) + (2 × 0.7 × 0.3 × 0.9)] = [0.14822 + 0.06502 + 0.378] = 0.59124, or approximately 0.59.


A) insurance coverage allows for greater risk.B) spending needs allows for greater risk.C) existing wealth allows for greater risk.

A) 0.39B) 0.59C) 0.54




Beta is a measure of:

Your answer: A was incorrect. The correct answer was B) systematic risk.

Beta is a measure of systematic risk.



A measure of how well the returns of two risky assets move together is the:

Your answer: A was incorrect. The correct answer was B) covariance.

This is a correct description of covariance. A positive covariance means the returns of the two securities move in the same direction. A negative covariance means that the returns of two securities move in opposite directions. A zero covariance means there is no relationship between the behaviors of two stocks. The magnitude of the covariance depends on the magnitude of the individual stock’s standard deviations and the relationship between their co-movements. The covariance is an absolute measure of movement and is measured in return units squared.



What is the risk measure associated with the CML?

Your answer: A was incorrect. The correct answer was B) Standard deviation.

In the context of the CML, the measure of risk (x-axis) is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML).



A) total risk.B) systematic risk.C) company-specific risk.

A) standard deviation.B) covariance.C) range.

A) Beta.B) Standard deviation.C) Market risk.



Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the:

Your answer: A was incorrect. The correct answer was B) capital market line.

The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Investors at point Rf have 100% of their funds invested in the risk-free asset. Investors at point M have 100% of their funds invested in market portfolio M. Between Rf and M, investors hold both the risk-free asset and portfolio M. To the right of M, investors hold more than 100% of portfolio M. All investors have to do to get the risk and return combination that suits them is to simply vary the proportion of their investment in the risky portfolio M and the risk-free asset.

Utility curves reflect individual preferences.



An investor owns the following three-stock portfolio today.

The expected portfolio value two years from now is closest to:

Your answer: A was incorrect. The correct answer was C) $17,975.

The easiest way to approach this problem is to determine the value of each stock two years in the future and to sum up the total values of each stock.

This question tested from Session 12, Reading 50, LOS c, (Part 1).


A) capital asset pricing line.B) capital market line.C) utility curve.

Stock Market Value Expected Annual Return

K $4,500 14% L $6,300 9% M $3,700 12%

A) $16,150.B) $17,870.C) $17,975.

Stock Market Value × Expected

Annual Return = Total

K $4,500 × 1.14 × 1.14 = 5,848.20

L $6,300 × 1.09 × 1.09 = 7,485.03

M $3,700 × 1.12 × 1.12 = 4,641.28

Total = 17,974.51



The optimal portfolio is determined by the point of tangency between:

Your answer: A was incorrect. The correct answer was B) the efficient frontier and the individual's utility curve with the highest possible utility.

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.

This question tested from Session 12, Reading 50, LOS g.


Stock A has a standard deviation of 4.1% and Stock B has a standard deviation of 5.8%. If the stocks are perfectly positively correlated, which portfolio weights minimize the portfolio’s standard deviation?


Because there is a perfectly positive correlation, there is no benefit to diversification. Therefore, the investor should put all his money into Stock A (with the lowest standard deviation) to minimize the risk (standard deviation) of the portfolio.



Which one of the following portfolios cannot lie on the efficient frontier?

Your answer: A was incorrect. The correct answer was B) Portfolio C.

Portfolio C cannot lie on the frontier because it has the same return as Portfolio D, but has more risk.

A) a line connecting the risk-free rate and the current market return on the efficient frontier.B) the efficient frontier and the individual's utility curve with the highest possible utility.C) the capital allocation line and the investor's utility curve.

Stock A Stock B

A) 100% 0%B) 63% 37%C) 0% 100%


A 20% 35%

B 11% 13%

C 8% 10%

D 8% 9%

A) Portfolio D.B) Portfolio C.C) Portfolio A.





The particular portfolio on the efficient frontier that best suits an individual investor is determined by:


The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.



If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock?

Your answer: A was incorrect. The correct answer was C) 11.3%.

The formula for the required return is: ERstock = Rf + (ERM – Rf) × Betastock,

or 0.035 + (0.095 – 0.035) × 1.3 = 0.113, or 11.3%.



Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X’s beta is 0.9 and Portfolio Y’s beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell:

Your answer: A was incorrect. The correct answer was B) portfolio Y only.

Portfolio X’s required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess return of 1.7%

A) the individual's utility curve.B) the current market risk-free rate as compared to the current market return rate.C) the individual's asset allocation plan.

A) 7.8%.B) 12.4%.C) 11.3%.

A) both portfolios X and Y because they are both overvalued.B) portfolio Y only.C) either portfolio X or Y because they are both properly valued.



Portfolio Y’s required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess return of 1.3%.

Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its excess return is less than that of Portfolio X.



Level I CFA candidate Adeline Bass is a member of an investment club. At the next meeting, she is to recommend whether or not the club should purchase the stocks of CS Industries and MG Consolidated. The risk-free rate is at 6% and the expected return on the market is 15%. Prior to the meeting, Bass gathers the following information on the two stocks:

Bass should recommend that the club:

Your answer: A was incorrect. The correct answer was C) purchase CS only.

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater than the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows / dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate − risk-free rate).

� For CS Industries: ER = (30 – 25 + 1) / 25 = 24%, RR = 6 + 1.2 × (15 − 6) = 16.8%. Stock is underpriced - purchase.

� For MG Consolidated: ER = (55 – 50 + 1) / 50 = 12%, RR = 6 + 0.80 × (15 − 6) = 13.2%. Stock is overpriced - do not purchase.



Which of the following return objectives is most likely the primary objective given a 70 year-old widow who owns a portfolio comprised of 100% Treasury bonds?

CS Industries MG Consolidated

Current Market Value $25 $50

Expected Market Value in One Year $30 $55

Expected Dividend $1 $1

Beta 1.2 0.80

A) purchase MG only.B) purchase both stocks.C) purchase CS only.

A) Capital preservation.B) Current income.




Owning mainly fixed-income securities would generally rule out capital appreciation as an appropriate return objective. The fact that these are Treasury bonds suggests that capital preservation is a higher priority than current income.



What is the variance of a two-stock portfolio if 15% is invested in stock A (variance of 0.0071) and 85% in stock B (variance of 0.0008) and the correlation coefficient between the stocks is –0.04?

Your answer: A was incorrect. The correct answer was C) 0.0007.

The variance of the portfolio is found by:

[W12 σ1

2 + W22 σ2

2 + 2W1W2σ1σ2r1,2], or [(0.15)2(0.0071) + (0.85)2(0.0008) + (2)(0.15)(0.85)(0.0843)(0.0283)(–0.04)] = 0.0007.



Taxes on unrealized capital gains:


The investment plan may be complicated by the tax code (tax concerns are an investment constraint).Interest and dividends are taxed at the investor’s marginal tax rate while capital gains are taxed differently. Taxes on unrealized capital gains can be deferred indefinitely. Estate taxes must be considered.

There is a trade off between taxes and diversification needs. The decision to sell some stock to diversify ones portfolio by reinvesting the proceeds in other assets must be balanced against the resulting tax liability.

Another tax factor is that some sources of income are exempt from federal and state taxes. High-income individuals have an incentive to purchase municipal bonds to reduce their tax liabilities.

The investor must also consider tax deferred investment opportunities such as IRAs, 401(k) and 403(b) plans, and various life insurance contracts.


C) Capital appreciation.

A) 0.0020.B) 0.0026.C) 0.0007.

A) can be deferred indefinitely.B) must be paid when the appreciated assets are passed on to heirs.C) are subject to the alternative minimum tax.




All of the following are investment constraints EXCEPT:

Your answer: A was incorrect. The correct answer was B) pension plan contributions of the employer.

Investment constraints include: liquidity needs, time horizon, tax concerns, legal and regulatory factors and unique needs and preferences. While employer contributions may be of interest, and an issue in some instances, it is not classified as a specific investment constraint.



A portfolio manager adds a new stock that has the same standard deviation of returns as the existing portfolio but has a correlation coefficient with the existing portfolio that is less than +1. Adding this stock will have what effect on the standard deviation of the revised portfolio's returns? The standard deviation will:

Your answer: A was incorrect. The correct answer was B) decrease.

If the correlation coefficient is less than 1, there are benefits to diversification. Thus, adding the stock will reduce the portfolio's standard deviation.



Stock A has a standard deviation of 10%. Stock B has a standard deviation of 15%. The covariance between A and B is 0.0105. The correlation between A and B is:


CovA,B = (rA,B)(SDA)(SDB), where r = correlation coefficient and SDx = standard deviation of stock x

Then, (rA,B) = CovA,B / (SDA × SDB) = 0.0105 / (0.10 × 0.15) = 0.700


A) tax concerns.B) pension plan contributions of the employer.C) liquidity needs.

A) increase.B) decrease.C) decrease only if the correlation is negative.

A) 0.70.B) 0.55.C) 0.25.




Which of the following is the vertical axis intercept for the Capital Market Line (CML)?

Your answer: A was incorrect. The correct answer was B) Risk-free rate.

The CML originates on the vertical axis from the point of the risk-free rate.



Which of the following is the risk that disappears in the portfolio construction process?


Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio.



The following information is available for the stock of Park Street Holdings:

� The price today (P0) equals $45.00.

� The expected price in one year (P1) is $55.00. � The stock's beta is 2.31. � The firm typically pays no dividend. � The 3-month Treasury bill is yielding 4.25%. � The historical average S&P 500 return is 12.5%.

Park Street Holdings stock is:

Your answer: A was incorrect. The correct answer was B) overvalued by 1.1%.

To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

A) Expected return on the market.B) Risk-free rate.C) Expected return on the portfolio.

A) Unsystematic risk.B) Systematic risk.C) Interest rate risk.

A) undervalued by 3.7%.B) overvalued by 1.1%.C) undervalued by 1.1%.



Step 1: Calculate Expected Return (Holding period return):

The formula for the (one-year) holding period return is:

HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price.

Here, HPR = (0 + 55 – 45) / 45 = 22.2%

Step 2: Calculate Required Return:

The formula for the required return is from the CAPM:

RR = Rf + (ERM – Rf) × Beta

RR = 4.25% + (12.5 – 4.25%) × 2.31 = 23.3%.

Step 3: Determine over/under valuation:

The required return is greater than the expected return, so the security is overvalued. The amount = 23.3% − 22.2% = 1.1%.



An investor has identified the following possible portfolios. Which portfolio lies to the right of the efficient frontier?


Portfolio E must be inefficient because its risk is higher than the risk of Portfolio D and Portfolio E has a lower return.



A stock that plots below the Security Market Line most likely:


A 18% 35%

B 12% 16%

C 10% 10%

D 14% 20%

E 13% 24%

A) E.B) D.C) A.

A) has a beta less than one.B) is overvalued.



Your answer: A was incorrect. The correct answer was B) is overvalued.

Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or mathematically. Your answers will always be the same.

Graphically: If you plot a stock’s expected return on the SML and it falls below the line, it indicates that the stock is currently overpriced, causing its expected return to be too low. If the plot is above the line, it indicates that the stock is underpriced. If the plot falls on the SML, it indicates the stock is properly priced.

Mathematically: In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.



A larger range of expected returns compared to a smaller range of expected returns would:

Your answer: A was incorrect. The correct answer was B) have greater risk.

A larger range of expected returns means a larger dispersion and thus a higher standard deviation, or risk.



Which of the following statements best describes an investment that is not on the efficient frontier?

Your answer: A was incorrect. The correct answer was B) There is a portfolio that has a lower risk for the same return.

The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. Therefore, if a portfolio is not on the efficient frontier, there must be a portfolio that has lower risk for the same return. Equivalently, there must be a portfolio that produces a higher return for the same risk.



C) is below the efficient frontier.

A) translate to a greater certainty of expected future returns.B) have greater risk.C) be preferred by a risk averse investor.

A) There is a portfolio that has a lower return for the same risk.B) There is a portfolio that has a lower risk for the same return.C) The portfolio has a very high return.



An investor owns the following three-stock portfolio.

The expected return is closest to:

Your answer: A was incorrect. The correct answer was C) 10.00%.

To calculate this result, we first need to calculate the portfolio value, then determine the weights for each stock, and then calculate the expected return.

Portfolio Value: = sum of market values = 5,000 + 3,000 + 4,000 = 12,000

Portfolio Weights:

WA = 5,000 / 12,000 = 0.4167

WB = 3,000 / 12,000 = 0.2500

WC = 4,000 / 12,000 = 0.333

Expected Return

ERportfolio = Σ(ERstock)(W% of funds invested in each of the stocks)

ER = wAERA + wBERB + wCERC, where ER = Expected Return and w = % invested in each stock.

ER = (0.4167 × 12.0) + (0.2500 × 8.0) + (0.333 × 9.0) = 10.0%



While assessing an investor’s risk tolerance, a financial adviser is least likely to ask which of the following questions?

Your answer: A was incorrect. The correct answer was C) “What rate of investment return do you expect?”

While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance.



Stock Market Value Expected ReturnA $5,000 12%B $3,000 8%C $4,000 9%

A) 29.00%.B) 9.67%.C) 10.00%.

A) “How much insurance coverage do you have?”B) “Is your home life stable?”C) “What rate of investment return do you expect?”



Which is NOT an assumption of capital market theory?


Capital market theory assumes that all investments are infinitely divisible. The other statements are basic assumptions of capital market theory.



The expected rate of return is 1.5 times the 16% expected rate of return from the market. What is the beta if the risk free rate is 8%?


24 = 8 + β (16 − 8) 24 = 8 + 8β 16 = 8β 16 / 8 = β β = 2



Which of the following is NOT one of the four general steps in the portfolio management process?

Your answer: A was incorrect. The correct answer was B) Specifying strategic asset allocations.

Specifying strategic asset allocations is a specific step contained within the third step, implementing the plan.



Which of the following constraints concerns individual investors least, with respect to their portfolios?

A) Investments are not divisible.B) There are no taxes or transaction costs.C) There is no inflation.

A) 2.B) 3.C) 4.

A) Monitoring and updating the investor’s needs and market conditions.B) Specifying strategic asset allocations.C) Implementing the plan.



Your answer: A was incorrect. The correct answer was C) Political issues.

Investment constraints include: Liquidity needs, time horizon parameters, tax concerns, legal and regulatory factors, and unique needs and preferences. Political concerns are not a principal constraint, beyond their impact on tax policy and legal issues.



For an investor to move further up the Capital Market Line than the market portfolio, the investor must:


Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market line) are created by borrowing funds to own more than 100% of the market portfolio (M).

The statement, "diversify the portfolio even more" is incorrect because the market portfolio is fully diversified.



If the standard deviation of asset A is 12.2%, the standard deviation of asset B is 8.9%, and the correlation coefficient is 0.20, what is the covariance between A and B?


The formula is: (correlation)(standard deviation of A)(standard deviation of B) = (0.20)(0.122)(0.089) = 0.0022.



The security market line (SML) will resemble a band, rather than a line, if some of its underlying assumptions are lifted. About which of the following assumptions is this least accurate?

A) Liquidity.B) Legal Issues.C) Political issues.

A) borrow and invest in the market portfolio.B) diversify the portfolio even more.C) reduce the portfolio's risk below that of the market.

A) 0.0022.B) 0.0001.C) 0.0031.

A) No transactions costs.



Your answer: A was incorrect. The correct answer was C) Unequal borrowing and lending rates.

If investors have heterogeneous expectations, or if transaction costs are not assumed to be zero, the SML becomes a band rather than a line. Differences in borrowing and lending rates can be assumed to be appropriate and used in the construction of the capital market line (CML). The result is a CML that is bent around the market portfolio. The portion of the CML connecting the risk-free asset and market portfolio will have a steeper slope than the portion of the CML extending beyond the market portfolio.



Classifying a capital market as efficient is least likely to imply that:


In efficient markets, stock prices reflect all available information. Therefore, insiders have no advantage.



The semi-strong form of the efficient market hypothesis (EMH) asserts that stock prices:

Your answer: A was incorrect. The correct answer was C) fully reflect all publicly available information.

The semi-strong form of the EMH asserts that security prices fully reflect all publicly available information. This would include all historical information. The weak form relates to historical information only. The strong form relates to public and private information.



Which of the following statements about securities markets is least accurate?

B) Heterogeneous investor expectations.C) Unequal borrowing and lending rates.

A) corporate insider’s investment performance will consistently exceed the performance of other investors.

B) stock prices adjust swiftly to new information. C) stock price changes are random and unpredictable.

A) fully reflect all historical price information.B) fully reflect all relevant information including insider information.C) fully reflect all publicly available information.

A) Secondary markets provide liquidity for primary market investors.B) The third market is the direct exchange of securities between investors.



Your answer: A was incorrect. The correct answer was B) The third market is the direct exchange of securities between investors.

The third market refers to over-the-counter trading of exchange-listed shares.



What is the price-weighted index of the following three stocks?

Your answer: A was incorrect. The correct answer was B)

65.

The price-weighted index equals [(50 + 35 + 110) / 3] = 65.



The semi-strong form of efficient market hypothesis (EMH) asserts that:


Semi-strong EMH states that publicly available information cannot be used to consistently beat the market performance.



Becky Kirk contacted her broker and placed an order to purchase 1,000 shares of Bricko Corp. stock at a price of

C) Internal market efficiency means transaction costs are low.

As of December 31, 2001

Company Stock Price Shares Outstanding

A $50 10,000

B $35 20,000

C $110 30,000

A) 75. B) 65. C) 80.

A) all public information is already reflected in security prices.B) both public and private information is already incorporated into security prices.C) past and future prices exhibit little or no relationship to another.



$60 per share. Kirk wishes to buy on margin. Assuming the margin requirement is 40%, how much money does Kirk have to pay up front to make the purchase?


The margin requirement represents the amount of money an investor must put down on the purchase. So Kirk must put $24,000 down ($60,000 x .40 = $24,000) and can borrow the balance.

This question tested from Session 13, Reading 52, LOS g, (Part 1).


Which of the following has least likely been involved in a direct test of the semistrong form of the efficient market hypothesis (EMH)?


NYSE Specialists' returns.

Stock exchange specialists tests are a test of the strong-form EMH, because they are related to private or insider information.

This question tested from Session 13, Reading 54, LOS b, (Part 1).


Which of the following statements about securities exchanges is least accurate?


A call market is a market where a security is only traded at specific times.



Which of the following statements regarding index funds is least accurate?

A) $24,000. B) $60,000. C) $36,000.

A) Exchange listing. B) NYSE Specialists' returns. C) Stock splits.

A) A call market is an open-outcry market where bids are called out in a trading pit.B) A stock with a relatively large market volume is most likely to trade in the continuous market. C) The price in continuous markets is set by either the auction process or by dealer bid-ask quotes.



Your answer: A was incorrect. The correct answer was C) One disadvantage of index funds is that they do not provide access to international securities.

An advantage of index funds is that they do offer international diversification via international index funds.



A trading rule which signals purchase of a stock if it rises X percent and sale of stock if it falls X percent is known as a:


Filter rules entail trading stocks when prices move up or down by certain amounts.



If a firm announces an unexpectedly large cash dividend, the efficient market hypothesis (EMH) would predict which of the following price changes at the announcement?


Market efficiency assumes investors adjust their estimate of security prices rapidly to reflect their interpretation of the new information received. Market efficiency also assumes that new information comes to market randomly and is available to all investors at the same time. Therefore, the price should not be reflected prior to the announcement.



Which of the following statements about selling a stock short is least likely accurate?

A) One advantage of index funds is that they allow for diversification that is typically not available to the average individual investor due to a lack of resources.

B) One might conclude from the efficient market literature that an investor should mimic the market's performance and minimize costs by buying index funds.

C) One disadvantage of index funds is that they do not provide access to international securities.

A) filter. B) breakout. C) sieve.

A) An abnormal price change to occur at the time of the announcement. B) No price change. C) An abnormal price change to occur before the announcement.



Your answer: A was incorrect. The correct answer was C) The short seller may withdraw the proceeds of the short sale.

Proceeds from the short sale must remain in the brokerage account along with the required margin deposit.



The reasons why a mispricing can persist all relate to the idea that:

Your answer: A was incorrect. The correct answer was C) an anomaly cannot be quickly exploited by traders or arbitrageurs.

The fundamental reason that mispricing and anomalies can persist is that traders and arbitrageurs are not able to exploit the situation. The other items are possible reasons why traders and arbitrageurs are not able to act.



The initial margin is the:

Your answer: A was incorrect. The correct answer was B) minimum amount of funds that must be supplied when purchasing a security on margin.

Margin is the amount of equity in the account at a given time. Initial margin is the amount of equity required initially to execute an order.



Which of the following statements concerning market efficiency is least accurate?

A) The seller must return the securities at the request of the lender.B) The seller must inform their broker that the order is a short sale before completing the transaction.C) The short seller may withdraw the proceeds of the short sale.

A) the size of the available profit is too small.B) taxes and other transactions costs make exploiting the anomaly prohibitive.C) an anomaly cannot be quickly exploited by traders or arbitrageurs.

A) equity represented in the margin account at any time.B) minimum amount of funds that must be supplied when purchasing a security on margin.C) amount of cash that an investor must maintain in his/her margin account.

A) Market efficiency assumes that individual market participants correctly estimate asset prices.

B) If weak-form market efficiency holds, technical analysis cannot be used to earn abnormal returns over the long-run.




Market efficiency does not assume that individual market participants correctly estimate asset prices, but does assume that their estimates are unbiased. That is, some agents will over-estimate and some will under-estimate, but they will be correct, on average.



The tendency to commit additional funds to a position that has decreased in value is known in behavioral finance as:

Your answer: A was incorrect. The correct answer was C) escalation bias.

The tendency to commit additional funds to a position that is decreasing in value falls under the heading of escalation bias in the context of behavioral finance.



Which of the following statements about efficient capital markets and the efficient market hypothesis is least accurate?

Your answer: A was incorrect. The correct answer was B) Filter rules in stock trading have been shown to produce above-average rates of return, even after including transactions costs.

Filter rules have not been shown to produce above-average rates of return after accounting for transactions costs.



If the efficient markets hypothesis is true, portfolio managers should do all of the following EXCEPT:

C) Tests of the semi-strong form of the EMH require that security returns be risk-adjusted using a market model.

A) confirmation bias.B) overconfidence bias.C) escalation bias.

A) The semistrong form of the market efficiency hypothesis states that prices fully reflect all information from public sources.

B) Filter rules in stock trading have been shown to produce above-average rates of return, even after including transactions costs.

C) Efficient capital markets assume that information comes to the market in a random fashion.

A) Minimize transaction costs.



Your answer: A was incorrect. The correct answer was C) Spend more time working on security selection.

In an efficient market all stocks are properly priced and reflect all publicly available information. Therefore, individual selection of stocks is not important the only thing that is relevant is the portfolio’s beta.



Which of the following statements concerning the persistence of pricing anomalies is least likely to be correct?

Your answer: A was incorrect. The correct answer was C) The capital required to exploit an anomaly is often not available.

If an anomaly exists and is exploitable, the lack of capital is not a likely explanation for its persistence. The other statements both reflect valid rationales for why mispricing can persist.



A short seller:

Your answer: A was incorrect. The correct answer was C) does not receive the dividends.

The short seller pays all dividends to the lender, loses if stock prices rise, and is required to post a margin account. A short seller often places a stop buy order to protect the short sale position from a rising market.



Which of the following sets of indexes are price-weighted?

B) Work more with clients to better quantify their risk preferences.C) Spend more time working on security selection.

A) When there is no theoretical explanation, an anomaly is difficult to exploit.B) A lack of liquidity may cause transactions costs to exceed the profit potential of the anomaly.C) The capital required to exploit an anomaly is often not available.

A) often also places a stop loss sell order.B) loses if the price of the stock sold short decreases.C) does not receive the dividends.

A) Dow Jones World Stock Index and Russell Index.B) S&P 500 Index and Dow Jones Industrial Average.C) Dow Jones Industrial Average and Nikkei Dow Jones Stock Market Average.



Your answer: A was incorrect. The correct answer was C) Dow Jones Industrial Average and Nikkei Dow Jones Stock Market Average.

The Dow Jones World Stock Index, the Russell Index, the S&P 500 Index, and Morgan Stanley Capital International Index are all market-value weighted. Only the Dow Jones Industrial Average and the Nikkei Dow Jones Stock Market Averages are price-weighted.



The table below lists information on price per share and shares outstanding for three stocks.

At the beginning of the year, the value of a market weighted index of these three stocks was 100. The index value at year-end is closest to:


Market-weighted index = (ending market capitalization / beginning market capitalization) × beginning index value.

Beginning market capitalization = (10)(10,000) + (50)(5,000) + (100)(500) = 400,000

Ending market capitalization = (15)(10,000) + (50)(5,000) + (85)(500) = 442,500

Index value = (442,500 / 400,000) × 100 = 110.625



What is the market value-weighted index of the following three stocks assuming the beginning index value is 100 and a base value of $150,000?

As of Beginning of Year As of End of Year

Stock Price per Share ($) # Shares Outstanding Price per Share ($) # shares Outstanding

Mertz 10 10,000 15 10,000

Norton 50 5,000 50 5,000

Rubble 100 500 85 500

A) 110.6B) 44.3C) 93.8

As of December 31

Company Stock Price Shares Outstanding

X $1 5,000

Y $20 2,500

Z $60 1,000




The market value weighted index = [(($1)(5,000) + ($20)(2,500) + ($60)(1,000))/$150,000](100) = ($115,000/$150,000)(100) = (0.767)(100) = 76.67 or 77 This question tested from Session 13, Reading 53, LOS a, (Part 2).


Under the efficient market hypothesis (EMH), the major effort of the portfolio manager should be to:

Your answer: A was incorrect. The correct answer was C) achieve complete diversification of the portfolio.

In an efficient market, portfolio managers must create and maintain the appropriate mix of assets to meet their client’s needs. The portfolio should be diversified to eliminate unsystematic risk. The appropriate systematic risk will depend on the clients risk tolerance and return requirement. Over time the needs of the client and environment will justify changes to the portfolio. The manager should also try to minimize transaction costs and at least try to match the performance of a benchmark.



Which of the following actions is most likely to give an analyst superior results?


A strong ability to interpret and estimate the future impact of publicly available information.

An analyst cannot obtain superior results by relying on historical data. The analyst must be able to do a superior job of interpreting and estimating variables that are relevant to the value of the security.

A) 77. B) 30. C) 100.

A) minimize systematic risk in the portfolio.B) stay the course by following a strict buy and hold strategy.C) achieve complete diversification of the portfolio.

A)Having superior abilities to identify patterns of returns based on historical data of economic factors and being able to determine the relationship between a stock return and certain economic factors based on historical data and then use that relationship to make reliable forecasts for future price movements.

B) A strong ability to interpret and estimate the future impact of publicly available information. C) The ability to react very quickly to public announcements.





Which of the following statements regarding margin accounts is most accurate?

Your answer: A was incorrect. The correct answer was B) Margin accounts can be used to purchase securities by borrowing part of the purchase price.

Margin accounts are brokerage accounts that allow investors to borrow part of the purchase price from the broker.



Which of the following statements concerning efficient markets and anomalies is the least likely to be correct?

Your answer: A was incorrect. The correct answer was B) Strategy risk refers to the fact that the model used to adjust for risk may not be correctly specified.

Strategy risk refers to the fact that anomalous behavior identified in historical data may not persist into the future, or, at least, during the timeframe within which the strategy is executed. Incorrectly specifying the risk-adjustment mechanism is a modeling issue.



Which of the following statements is least accurate with regard to the tests for the three forms of the efficient market hypothesis?

Your answer: A was incorrect. The correct answer was C) Results of trading rule tests, such as filter rules, support the semi-strong form of the EMH.

Results of trading rule tests, such as filter rules, support the weak form of the EMH.

A) The total equity in the margin account cannot fall below the initial margin requirement. B) Margin accounts can be used to purchase securities by borrowing part of the purchase price. C) Maintenance margin refers to the amount of funds the investor can borrow.

A) The arbitrage required to exploit an anomaly may not be riskless because there is no guarantee that the price will return to fair value.

B) Strategy risk refers to the fact that the model used to adjust for risk may not be correctly specified.

C) Processing information has a cost and takes time, so some market participants may be rewarded for performing fundamental analysis if they act quickly.

A) The historical performance of professional money managers supports the strong form of the EMH.

B)The tests for the semi-strong form EMH give mixed results. Time-series tests such as dividend yield and default spread reject the semi-strong form EMH and event studies on stock splits and announcements of accounting changes support it.

C) Results of trading rule tests, such as filter rules, support the semi-strong form of the EMH.



The other choices are true. Tests show that professional money managers perform no better than a random buy and hold strategy. This supports the strong form EMH contention that stock prices reflect all information, public and private. (Aside from corporate insiders and specialists, no group has monopolistic access to information that would result in superior returns.)



If statistical tests of stock returns over time support the efficient market hypothesis, the resulting correlations should be:


There should be zero correlation between observations, or all observations should be independent of each other, if the weak-form EMH is true.



Many academics claim that a particular anomaly's results reflect the inability of the asset pricing model to provide a complete measure of risk. Which of the following anomalies are the academics discussing?

Your answer: A was incorrect. The correct answer was B) The size effect.

Many academics believe that the size effect is an anomaly due to the capital asset pricing model's (CAPM) inability to provide a complete measure of risk.



The returns on an investment are least likely to be measured by:

Your answer: A was incorrect. The correct answer was B) coefficient of variation.

Coefficient of variation is a measure of risk. The various forms of investment returns can be measured in ways

A) zero. B) lagged. C) positive.

A) Initial public offerings.B) The size effect.C) The neglected firm effect.

A) earnings per share.B) coefficient of variation.C) capital gains on an asset.



that include project cash flows, interest and dividend income, capital gains, or earnings.



A company last paid a $1.00 dividend, the current market price of the stock is $20 per share and the dividends are expected to grow at 5 percent forever. What is the required rate of return on the stock?


D0 (1 + g) / P0 + g = k

1.00 (1.05) / 20 + 0.05 = 10.25%.



What is the value of a preferred stock that is expected to pay a $5.00 annual dividend per year forever if similar risk securities are now yielding 8%?

Your answer: A was incorrect. The correct answer was B) $62.50.

$5.00/0.08 = $62.50.



Which of the following would be assessed first in a top-down valuation approach?


In the top-down valuation approach, the investor should analyze macroeconomic influences first, then industry influences, and then company influences. Fiscal policy, as part of the macroeconomic landscape, should be analyzed first.

A) 10.25%.B) 10.00%.C) 9.78%.

A) $40.00.B) $62.50.C) $60.00.

A) Fiscal policy.B) Industry return on equity (ROE).C) Industry risks.





According to the earnings multiplier model, a stock’s P/E ratio (P0/E1) is affected by all of the following EXCEPT the:


expected stock price in one year.

According to the earnings multiplier model, the P/E ratio is equal to P0/E1 = (D1/E1)/(ke - g).

Thus, the P/E ratio is determined by:

� The expected dividend payout ratio (D1/E1).

� The required rate of return on the stock (ke).

� The expected growth rate of dividends (g).



In the top-down approach to valuation, industry analysis should be conducted before company analysis because:


In general, an industry’s prospects within the global business environment determine how well or poorly individual firms in the industry do. Thus, industry analysis should precede company analysis. The goal is to find the best companies in the most promising industries; even the best company in a weak industry is not likely to perform well.



An analyst has gathered the following data about a firm:

A) required return on equity. B) expected dividend payout ratio. C) expected stock price in one year.

A) an industry's prospects within the global business environment are a major determinant of how well individual firms in the industry perform.

B) most valuation models recommend the use of industry-wide average required returns, rather than individual returns.

C) the goal of the top-down approach is to identify those companies in non-cyclical industries with the lowest P/E ratios.



� dividend payout ratio is 45%. � beta is 1.50. � risk-free rate is 6.5%. � expected market return is 15%.

Part 1) If the firm earned $5.00 per share in the most recent twelve months, what is the company’s retention ratio?

Your answer: A was incorrect. The correct answer was B) 55.00%.

RR = 1 − dividend payout ratio = 1 − 0.45 = 0.55


An analyst has gathered the following data about a firm:

� dividend payout ratio is 45%. � beta is 1.50. � risk-free rate is 6.5%. � expected market return is 15%.

Part 2) Based on the information given in the question above, what is the firm’s CAPM required return on equity?

Your answer: A was incorrect. The correct answer was B) 19.25%.

CAPM = Risk Free Rate + Beta (Market Return − Risk Free Rate)

= 6.5 + (1.50)(15 − 6.5)

= 6.5 + 12.75

= 19.25



A company has just paid a $2.00 dividend per share and dividends are expected to grow at a rate of 6% indefinitely. If the required return is 13%, what is the value of the stock today?

A) Not enough information given.B) 55.00%.C) 21.50%.

A) 29.00%.B) 19.25%.C) Neither of these answers are correct.

A) $34.16.B) $30.29.C) $32.25.




P0 = D1 / (k - g) = 2.12 / (0.13 - 0.06) = $30.29



The following data pertains to a common stock:

� It will pay no dividends for two years. � The dividend three years from now is expected to be $1. � Dividends are expected to grow at a 7% rate from that point onward.

If an investor requires a 17% return on this stock, what will they be willing to pay for this stock now?


time line = $0 now; $0 in yr 1; $0 in yr 2; $1 in yr 3. P2 = D3/(k - g) = 1/(.17 - .07) = $10 Note the math. The price is always one year before the dividend date. Solve for the PV of $10 to be received in two years. FV = 10; n = 2; i = 17; compute PV = $7.30



The nominal risk-free rate is equal to:


one plus the real risk-free rate times one plus expected inflation, minus one.

The nominal risk-free rate is a function of the real risk-free rate and expected inflation: nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) – 1 Note that the nominal rate is frequently estimated by summing the real rate and the rate of expected inflation.

This question tested from Session 14, Reading 56, LOS e, (Part 1).

Question 100 - #96229

The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:

A) $ 7.30.B) $10.00.C) $ 6.24.

A) one plus the real risk-free rate times one plus expected inflation. B) the real risk-free rate minus expected inflation. C) one plus the real risk-free rate times one plus expected inflation, minus one.



Your answer: A was incorrect. The correct answer was B) moderate growth, "mature" company.

Remember, the infinite period DDM has the following assumptions:

� The stock pays dividends and they grow at a constant rate. � The constant growth rate, g, continues for an infinite period. � k must be greater than g. If not, the math will not work.

If any one of these assumptions is not met, the model breaks down. The infinite period DDM doesn’t work with growth companies. Growth companies are firms that currently have the ability to earn rates of return on investments that are currently above their required rates of return. The infinite period DDM assumes the dividend stream grows at a constant rate forever while growth companies have high growth rates in the early years that level out at some future time. The high early or supernormal growth rates will also generally exceed the required rate of return. Since the assumptions (constant g and k > g) don’t hold, the infinite period DDM cannot be used to value growth companies.


Question 101 - #96232

A stock is expected to pay a dividend of $1.50 at the end of each of the next three years. At the end of three years the stock price is expected to be $25. The equity discount rate is 16 percent. What is the current stock price?


The value of the stock today is the present value of the dividends and the expected stock price, discounted at the equity discount rate: $1.50/1.16 + $1.50/1.162 + $1.50/1.163 + $25.00/1.163 = $19.39


Question 102 - #96363

Which of the following statements concerning security valuation is least accurate?

A) rapidly growing company.B) moderate growth, "mature" company.C) new venture expected to retain all earnings for several years.

A) $19.39. B) $24.92. C) $17.18.

A)Determining the value of a company with supernormal growth requires finding the present value of the dividends during the supernormal growth and adding that to the present value of the stock computed for the period of normal growth.

B) The top-down valuation approach requires an assessment of industry influences on the company's value first, then stock-specific influences.

C) A firm with an expected dividend payout ratio of 40%, a required rate of return of 12%, and a dividend growth rate of 5% has an estimated price to earnings (P/E) ratio of 5.7.



Your answer: A was incorrect. The correct answer was B) The top-down valuation approach requires an assessment of industry influences on the company's value first, then stock-specific influences.

The top-down valuation approach requires an assessment of general economic conditions first, then industry influences on the company’s value, and then stock-specific influences.


Question 103 - #96399

Which of the following is least likely an advantage of using price/sales (P/S) multiple?


Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable only because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions.


Question 104 - #96233

Use the following information to determine the value of River Gardens’ common stock:

� Expected dividend payout ratio is 45%. � Expected dividend growth rate is 6.5%. � River Gardens’ required return is 12.4%. � Expected earnings per share next year are $3.25.


First, estimate the price to earnings (P/E) ratio as: (0.45) / (0.124 – 0.065) = 7.63. Then, multiply the expected earnings by the estimated P/E ratio: ($3.25)(7.63) = $24.80.


Question 105 - #96237

The Sustainable Growth Rate is equal to:

A) P/S multiples are more reliable because sales data cannot be distorted by management.B) P/S multiples provide a meaningful framework for evaluating distressed firms.C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.

A) $30.12.B) $24.80.C) $27.25.

A) (ROE) x (RR).B) (ROE) x (1+RR).




The Sustainable Growth Rate is equal to the return on the equity portion of new investments (ROE) multiplied by the firm's retention rate (RR).


Question 106 - #96144

When the government reallocates spending based upon a decision to promote new and developing industries, this would be categorized as:

Your answer: A was incorrect. The correct answer was C) a structural change.

Structural changes include government activity, such as changes in spending and regulations that are designed to promote or inhibit specific economic activities.


Question 107 - #96276

The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT:


the stock's dividend payout ratio.

A stock’s required rate of return is equal to the nominal risk-free rate plus a risk premium. The nominal risk-free rate is approximately equal the real risk-free rate plus expected inflation.


Question 108 - #96410

Given the following information, compute price/sales.

� Book value of assets = $550,000. � Total sales = $200,000. � Net income = $20,000. � Dividend payout ratio = 30%.

C) (ROE) x (1-RR).

A) monetary policy.B) a cyclical change.C) a structural change.

A) the stock's appropriate risk premium. B) the expected inflation rate. C) the stock's dividend payout ratio.



� Operating cash flow = $40,000. � Price per share = $100. � Shares outstanding = 1,000. � Book value of liabilities = $500,000.

Your answer: A was incorrect. The correct answer was B) 0.50X.

Market value of equity = ($100)(1000) = $100,000

Price / Sales = $100,000 / $200,000 = 0.5X


Question 109 - #96275

What value would be placed on a stock that currently pays no dividend but is expected to start paying a $1 dividend five years from now? Once the stock starts paying dividends, the dividend is expected to grow at a 5 percent annual rate. The appropriate discount rate is 12 percent.


P4 = D5/(k-g) = 1/(.12-.05) = 14.29

P0 = [FV = 14.29; n = 4; i = 12] = $9.08.


Question 110 - #96386

One advantage of using price-to-book value (PBV) multiples for stock valuation is that:


it is a stable and simple benchmark for comparison to the market price.

Book value provides a relatively stable measure of value that can be compared to the market price. For investors who mistrust the discounted cash flow estimates of value, it provides a much simpler benchmark for comparison. Book value may or may not be closer to the market value. A firm may have negative book value if it shows accounting losses consistently.

A) 2.50X.B) 0.50X.C) 2.00X.

A) $9.08.B) $8.11.C) $14.29.

A) most of the time it is close to the market value. B) it is a stable and simple benchmark for comparison to the market price. C) book value of a firm can never be negative.




Question 111 - #96349

A stock has a required rate of return of 15%, a constant growth rate of 10%, and a dividend payout ratio of 45%. The stock’s price-earnings ratio should be:


P/E = D/E1/ (k - g)

D/E1 = Dividend Payout Ratio = 0.45 k = 0.15 g = 0.10 P/E = 0.45 / (0.15 - 0.10) = 0.45 / 0.05 = 9


Question 112 - #96350

Using an infinite period dividend discount model, find the value of a stock that last paid a dividend of $1.50. Dividends are expected to grow at 6 percent forever, the expected return on the market is 12 percent and the stock’s beta is 0.8. The risk-free rate of return is 5 percent.


First find the required rate of return using the CAPM equation.

k = 0.05 + 0.8(0.12 - 0.05) = 10.6%

$1.50(1.06) /(0.106 - 0.06) = $34.57


Question 113 - #96305

Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75. Next year, they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for the foreseeable future. Investors require a 12% rate of return on Day.

Part 1) What is the approximate amount that an investor would be willing to pay today for the two years of abnormal

A) 9.0 times.B) 4.5 times.C) 3.0 times.

A) $26.50.B) $34.57.C) $32.61.



dividends?


First find the abnormal dividends and then discount them back to the present. $0.75 × 1.25 = $0.9375 × 0.95 = $0.89. D1 = $0.9375; D2 = $0.89. At this point you can use the cash flow keys with CF0 = 0, CF1 = $0.9375 and CF2 = $0.89. Compute for NPV with I/Y = 12. NPV = $1.547. Alternatively, you can put the dividends in as future values, solve for present values and add the two together.


Day and Associates is experiencing a period of abnormal growth. The last dividend paid by Day was $0.75. Next year, they anticipate growth in dividends and earnings of 25% followed by negative 5% growth in the second year. The company will level off to a normal growth rate of 8% in year three and is expected to maintain an 8% growth rate for the foreseeable future. Investors require a 12% rate of return on Day.

Part 2) What would an investor pay for Day and Associates today?


Here we find P2 using the constant growth dividend discount model.

P2 = $0.89 × 1.08 / (0.12 – 0.08) = $24.03. Discount that back to the present at 12% for 2 periods and add it to the answer in the previous question. N = 2; I/Y = 12; PMT = 0; FV = $24.03; CPT &rarr PV = $19.16. Add $1.55 (the present value of the abnormal dividends) to $19.16 and you get $20.71.


Question 114 - #96216

A stock has a required return of 14% percent, a constant growth rate of 5% and a retention rate of 60%. The firm’s P/E ratio should be:

Your answer: A was incorrect. The correct answer was B) 4.44.

P/E = (1 - RR) / (k - g) = 0.4 / (0.14 - 0.05) = 4.44


A) $1.55.B) $1.62.C) $1.83.

A) $20.71.B) $24.03.C) $18.65.

A) 6.66.B) 4.44.C) 5.55.



Question 115 - #96352

A firm is expected to have four years of growth with a retention ratio of 100%. Afterwards the firm’s dividends are expected to grow 4% annually, and the dividend payout ratio will be set at 50%. If earnings per share (EPS) = $2.4 in year 5 and the required return on equity is 10%, what is the stock’s value today?

Your answer: A was incorrect. The correct answer was C) $13.66.

Dividend in year 5 = (EPS)(payout ratio) = 2.4 × 0.5 = 1.2

P4 = 1.2 / (0.1 − 0.04) = 1.2 / 0.06 = $20

P0 = PV (P4) = $20 / (1.10)4 = $13.66


Question 116 - #96258

A stock has the following elements: last year’s dividend = $1, next year’s dividend is 10% higher, the price will be $25 at year-end, the risk-free rate is 5%, the market premium is 5%, and the stock’s beta is 1.2.

Part 1) What happens to the price of the stock if the beta of the stock increases to 1.5? It will:

Your answer: A was incorrect. The correct answer was C) decrease.

When the beta of a stock increases, its required return will increase. The increase in the discount rate leads to a decrease in the PV of the future cash flows.


A stock has the following elements: last year’s dividend = $1, next year’s dividend is 10% higher, the price will be $25 at year-end, the risk-free rate is 5%, the market premium is 5%, and the stock’s beta is 1.2.

Part 2) What will be the current price of the stock with a beta of 1.5?


A) $30.00. B) $20.00. C) $13.66.

A) increase.B) remain unchanged.C) decrease.

A) $23.51. B) $23.20. C) $20.23.



k = 5 + 1.5(5) = 12.5% P0 = (1.1 / 1.125) + (25 / 1.125) = $23.20


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