Chapter 12

Question 1

Which of the following statements is false?
A) All investors should demand the same efficient portfolio of securities in the same proportions.
B) The Capital Asset Pricing Model (CAPM) allows corporate executives to identify the efficient portfolio (of risky assets) by using knowledge of the expected return of each security.
C) If investors hold the efficient portfolio, then the cost of capital for any investment project is equal to its required return calculated using its beta with the efficient portfolio.
D) The CAPM identifies the market portfolio as the efficient portfolio.

Answer 1

B

Question 2

Which of the following statements is false?
A) If investors have homogeneous expectations, then each investor will identify the same portfolio as having the highest Sharpe ratio in the economy.
B) Homogeneous expectations are when all investors have the same estimates concerning future investments and returns.
C) There are many investors in the world, and each must have identical estimates of the volatilities, correlations, and expected returns of the available securities.
D) The combined portfolio of risky securities of all investors must equal the efficient portfolio.

Answer 2

C

Question 3

Which of the following statements is false?
A) If some security were not part of the efficient portfolio, then every investor would want to own it, and demand for this security would increase causing its expected return to fall until it is no longer an attractive investment.
B) The efficient portfolio, the portfolio that all investors should hold, must be the same portfolio as the market portfolio of all risky securities.
C) Because every security is owned by someone, the sum of all investors’ portfolios must equal the portfolio of all risky securities available in the market.
D) If all investors demand the efficient portfolio, and since the supply of securities is the market portfolio, then two portfolios must coincide.

Answer 3

A

Question 4

Which of the following statements is false?
A) The market portfolio contains more of the smallest stocks and less of the larger stocks.
B) For the market portfolio, the investment in each security is proportional to its market capitalization.
C) Because the market portfolio is defined as the total supply of securities, the proportions should correspond exactly to the proportion of the total market that each security represents.
D) Market capitalization is the total market value of the outstanding shares of a firm.

Answer 4

A

Question 5

Which of the following statements is false?
A) A value-weighted portfolio is an equal-ownership portfolio: We hold an equal fraction of the total number of shares outstanding of each security in the portfolio.
B) When buying a value-weighted portfolio, we end up purchasing the same percentage of shares of each firm.
C) To maintain a value-weighted portfolio, we do not need to trade securities and rebalance the portfolio unless the number of shares outstanding of some security changes.
D) In a value weighted portfolio the fraction of money invested in any security corresponds to its share of the total number of shares outstanding of all securities in the portfolio.

Answer 5

D

Question 6

Which of the following statements is false?
A) The most familiar stock index in the United States is the Dow Jones Industrial Average (DJIA).
B) A portfolio in which each security is held in proportion to its market capitalization is called a price-weighted portfolio.
C) The Dow Jones Industrial Average (DJIA) consists of a portfolio of 30 large industrial stocks.
D) The Dow Jones Industrial Average (DJIA) is a price-weighted portfolio.

Answer 6

B

Question 7

Which of the following statements is false?
A) Because very little trading is required to maintain it, an equal-weighted portfolio is called a passive portfolio.
B) If the number of shares in a value weighted portfolio does not change, but only the prices change, the portfolio will remain value weighted.
C) The CAPM says that individual investors should hold the market portfolio, a value-weighted portfolio of all risky securities in the market.
D) A price weighted portfolio holds an equal number of shares of each stock, independent of their size.

Answer 7

A

Question 8

Which of the following statements is false?
A) A market index reports the value of a particular portfolio of securities.
B) The S&P 500 is the standard portfolio used to represent “the market” when using the CAPM in practice.
C) Even though the S&P 500 includes only 500 of the more than 7,000 individual U.S. Stocks in existence, it represents more than 70% of the U.S. stock market in terms of market capitalization.
D) The S&P 500 is an equal-weighted portfolio of 500 of the largest U.S. stocks.

Answer 8

D) The S&P 500 is a value-weighted portfolio of 500 of the largest U.S. stocks.

Question 9

Which of the following statements is false?
A) The S&P 500 and the Wilshire 5000 indexes are both well-diversified indexes that roughly correspond to the market of U.S. stocks.
B) Practitioners commonly use the S&P 500 as the market portfolio in the CAPM with the belief that this index is the market portfolio.
C) Standard & Poor’s Depository Receipts (SPDR, nicknamed “spider”) trade on the American Stock Exchange and represent ownership in the S&P 500.
D) The S&P 500 was the first widely publicized value weighted index and it has become a benchmark for professional investors.

Answer 9

B

Question 10

In practice which market index is most widely used as a proxy for the market portfolio in the CAPM?
A) Dow Jones Industrial Average
B) Wilshire 5000
C) S&P 500
D) U.S. Treasury Bill

Answer 10

C

Question 11

In practice which market index would best be used as a proxy for the market portfolio in the CAPM?
A) S&P 500
B) Dow Jones Industrial Average
C) U.S. Treasury Bill
D) Wilshire 5000

Answer 11

D

Question 12

Which of the following statements is false?
A) One difficulty when trying to estimate beta for a security is that beta depends on the correlation and volatilities of the security’s and market’s returns in the future.
B) It is common practice to estimate beta based on the expectations of future correlations and volatilities.
C) One difficulty when trying to estimate beta for a security is that beta depends on investors expectations of the correlation and volatilities of the security’s and market’s returns.
D) Securities that tend to move less than the market have betas below 1.

Answer 12

B) Beta is measured using past information.

Question 13

Which of the following statements is false?
A) Securities that tend to move more than the market have betas higher than 0.
B) Securities whose returns tend to move in tandem with the market on average have a beta of 1.
C) Beta corresponds to the slope of the best fitting line in the plot of the securities excess returns versus the market excess return.
D) The statistical technique that identifies the bets-fitting line through a set of points is called linear regression.

Answer 13

A

Question 14

The bi in the regression
A) measures the sensitivity of the security to market risk.
B) measures the historical performance of the security relative to the expected return predicted by the SML.
C) measures the deviation from the best fitting line and is zero on average.
D) measures the diversifiable risk in returns.

Answer 14

A

Question 15

The ai in the regression
A) measures the sensitivity of the security to market risk.
B) measures the deviation from the best fitting line and is zero on average.
C) measures the diversifiable risk in returns.
D) measures the historical performance of the security relative to the expected return predicted by the SML.

Answer 15

D

Question 16

The ei in the regression
A) measures the market risk in returns.
B) measures the deviation from the best fitting line and is zero on average.
C) measures the sensitivity of the security to market risk.
D) measures the historical performance of the security relative to the expected return predicted by the SML.

Answer 16

B

Question 17

The firm’s unlevered (asset) beta is
A) the weighted average of the equity beta and the debt beta.
B) the weighted average of the levered beta and the equity beta.
C) the debt beta minus the equity beta.
D) the unlevered beta minus the cost of capital.

Answer 17

A

Question 18

The firm’s unlevered (asset) cost of capital is
A) the weighted average of the equity cost of capital and the debt cost of capital.
B) the weighted average of the levered cost of capital and the equity cost of capital.
C) the debt cost of capital minus the equity cost of capital.
D) the unlevered beta minus the cost of capital.
Answer: A

Answer 18

A

Question 19

If a firm’s excess cash holdings are greater than its debt, using net debt as the measure of leverage will result in
A) its unlevered beta and cost of capital equalling zero.
B) its unlevered beta and cost of capital being greater than its equity beta and cost of capital.
C) the risk of the firm’s equity being increased by its cash holdings in excess of its operating needs.
D) the risk of the firm’s debt being increased by its cash holdings in excess of its operating needs.

Answer 19

B

Question 20

Which of the following is true of asset betas?
A) Asset betas are expected to vary greatly within firms in the same industry.
B) Businesses that are less sensitive to market and economic conditions tend to have higher asset betas than more cyclical industries.
C) Businesses that are less sensitive to market and economic conditions tend to have lower asset betas than more cyclical industries.
D) A and B are correct.

Answer 20

C

Question 21

Firms should adjust for execution risk by
A) assigning a higher cost of capital to new projects.
B) ignoring execution risk since it is diversifiable.
C) capturing this risk in the expected cash flows generated by the project.
D) noticing missteps in the firm’s execution of new projects.

Answer 21

C

Question 22

One factor that can affect the market risk of a project is its degree of operating leverage, which is
A) the relative proportion of operating assets versus non-operating assets.
B) the relative proportion of operating assets versus equity.
C) the relative proportion of operating expenses versus non-operating expenses.
D) the relative proportion of fixed versus variable costs.

Answer 22

D

Question 23

If a project has a higher proportion of fixed to variable costs, holding the risk of its revenues constant
A) its beta will be lower, hence its cost of capital will be lower.
B) its beta will be higher, hence its cost of capital will be higher.
C) its beta will be unaffected, since beta does not measure the sensitivity of the project’s cash flows to market risk.
D) its financial leverage will be higher

Answer 23

B

Question 24

The difference between the weighted-average cost of capital (WACC) and the pre-tax (unlevered) WACC is
A) the weighted-average cost of capital is based on the after-tax cost of equity and the pre-tax WACC is based on the after-tax cost of debt.
B) the weighted-average cost of capital multiplies the cost of equity and the cost of debt by (1-tax rate) and the pre-tax WACC does not.
C) the weighted-average cost of capital multiplies the cost of debt by (1-tax rate) and the pre-tax WACC does not.
D) the weighted-average cost of capital multiplies the component costs of equity and debt by their weight in the capital structure, and the pre-tax WACC does not.

Answer 24

C

Question 25

In a world with taxes, which of the following is the rate we should use to evaluate an all-equity financed project with the same risk as the firm?
A) The weighted-average cost of capital
B) The pre-tax WACC
C) The cost of equity
D) The cost of debt

Answer 25

B

Question 26

In a world with taxes, which of the following is the rate we should use to evaluate a project with the same risk and the same financing as the firm itself?
A) The weighted-average cost of capital
B) The pre-tax WACC
C) The cost of equity
D) The cost of debt

Answer 26

A

Question 27

Which of the following is not considered a difficulty with regards to the CAPM?
A) Betas are not observed.
B) Expected returns are not observed.
C) The market proxy is not correct.
D) Investors risk preferences are not observed.

Answer 27

D

Question 28

Which of the following is not considered to be an important choice when estimating beta?
A) The choice of the time horizon to use for estimation
B) The choice of method used to extrapolate beta
C) The choice between weekly and monthly returns
D) The choice of index used as the market portfolio

Answer 28

C

Question 29

Which of the following statements is false?
A) Many practitioners prefer to use average industry betas rather than individual stock betas.
B) When estimating beta by using past returns it is best to use the longest time horizon of returns available.
C) The CAPM predicts that a security’s expected return depends on its beta with regard to the market portfolio of all risky investments available to investors.
D) If we use too short a time horizon when estimating beta, our estimate of beta will be unreliable.

Answer 29

B

Question 30

Which of the following statements is false?
A) We should be suspicious of beta estimates that are extreme relative to industry norms.
B) When using historical data, there is always the possibility of estimation error.
C) Evidence suggests that betas tend to revert toward zero over time.
D) For stocks, common practice is to use at least two years of weekly return data or five years of monthly return data when estimating beta.

Answer 30

C

Question 31

Which of the following statements is false?
A) There may be reasons to exclude certain historical data as anomalous when estimating beta.
B) Many practitioners use adjusted betas, which are calculated by averaging the estimated beta with 1.0.
C) The beta estimated we obtain from linear regression can be very sensitive to outliers, which are returns of unusually small magnitude.
D) If we use very old data to when estimating beta, they data may be unrepresentative of the current market risk of the security.

Answer 31

C

Question 32

Which of the following statements is false?
A) Many practitioners analyze other financial characteristics of a firm, when they forecast betas.
B) U.S. Treasuries are never subject to interest rate risk unless we select a maturity equal to our investment horizon.
C) If a firm where to change industries, using its historical beta would be inferior to using the beta of other firms in the new industry.
D) When using historical returns to forecast future betas, we must be mindful of changes in the environment that might cause the future to differ from the past.

Answer 32

B

Question 33

Which of the following statements is false?
A) The CAPM states that we should use the risk-free interest rate corresponding to the investment horizon of the firm’s investors.
B) To determine the risk premium for a stock using the security market line, we need an estimate of the market risk premium.
C) When surveyed, the vast majority of large firms and financial analysts reported using the yields of Treasury Bills to determine the risk-free rate.
D) The risk-free interest rate is generally determined using the yields of U.S. Treasury securities, which are free from default risk.

Answer 33

C

Question 34

Which of the following statements is false?
A) The CAPM remains the predominant model use in practice to determine the equity cost of capital.
B) Low beta stocks have tended to perform somewhat better than the CAPM predicts.
C) The empirically estimated security market line is somewhat steeper than that predicted by the CAPM.
D) Some evidence suggests that the market risk premium has declined over time.

Answer 34

C

Question 35

Which of the following statements is false?
A) The imperfections in the CAPM may be critical in the context of capital budgeting and corporate finance, where errors in estimating the cost of capital are likely to be far more important than small discrepancies in the project cash flows.
B) To estimate the expected market risk premium we can look at the historical average excess return of the market over the risk free interest rate.
C) The highest beta stocks have tended to under perform what the CAPM predicts.
D) Given an assessment of an index’s future cash flows, we can estimate the expected return of the market by solving for the discount rate that is consistent with the current level of the index.

Answer 35

A