1. Nile Foods’ stock has a beta of 1.4, while Elbe Eateries’ stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM – rRF), equals 4%. Which of the following statements is CORRECT?

Answer

Since Nile’s beta is twice that of Elbe’s, its required rate of return will also be twice that of Elbe’s.

If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.

If the market risk premium increases but the risk-free rate remains unchanged, Nile’s required return will increase because it has a beta greater than 1.0 but Elbe’s will decline because it has a beta less than 1.0.

If the market risk premium decreases but the risk-free rate remains unchanged, Nile’s required return will decrease because it has a beta greater than 1.0 and Elbe’s will also decrease, and by more than Nile’s because it has a beta less than 1.0.

If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.

3 points

Question 2

1.

Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would shift

Answer

down and have a less steep slope.

up and have a less steep slope.

up and keep the same slope.

down and keep the same slope.

down and have a steeper slope.

3 points

Question 3

1.

Which of the following statements is CORRECT?

Answer

The constant growth model takes into consideration the capital gains earned on a stock.

It is appropriate to use the constant growth model to estimate stock value even if the growth rate is never expected to become constant.

Two firms with the same expected dividend and growth rate must also have the same stock price.

If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%.

The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

3 points

Question 4

1.

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0, and the market risk premium, rM – rRF, is positive. Which of the following statements is correct?

Answer

Stock B’s required rate of return is twice that of Stock A.

If Stock A’s required return is 11%, the market risk premium is 5%.

If Stock B’s required return is 11%, the market risk premium is 5%.

If the risk-free rate increases but the market risk premium stays unchanged, Stock B’s required return will increase by more than Stock A’s.

If the risk-free rate remains constant but the market risk premium increases, Stock A’s required return will increase by more than Stock A’s.

3 points

Question 5

1.

Which of the following statements is CORRECT?

Answer

If you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that investors in the market expect the observed relationship to continue on into the future.

The slope of the SML is determined by the value of beta.

The SML shows the relationship between companies’ required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm’s managers, but the position of the company on the line can be influenced by managers.

If investors become less risk averse, the slope of the Security Market Line will increase.

If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock