Chapter 12 Test Bank

Chapter 12 - Risk, Return, and Capital Budgeting
Chapter 12
Risk, Return, and Capital Budgeting
True / False Questions
1. Since 1926 the average annual difference between the returns on value and growth stocks
has been 3.8%.
True False
2. The capital asset pricing model (CAPM) assumes that the stock market is dominated by
well-diversified investors who are concerned only with market risk.
True False
3. The CAPM states that the expected risk premium on any security equals its beta times the
market risk premium.
True False
4. There is little doubt that the CAPM captures everything that is going on in the market.
True False
5. The security market line displays the relationship between expected return and beta.
True False
6. The security market line sets a standard for other investments—investors will be willing to
hold other investments only if they offer equally good prospects as shown by the points on the
line.
True False
12-1
7. The required risk premium for any investment is given by the security market line: Risk
premium on investment = beta  expected market risk premium.
True False
8. Empirical evidence suggested that over a long period of time returns did indeed increase
with beta.
True False
9. The security market line provides a standard for project rejection.

True False
10. If a low-risk company invests in a high-risk project, those cash flows should be discounted
at a high cost of capital.
True False
11. The project cost of capital depends on the project and hence also on the risk of the
company.
True False
12. Beta measures a stock's sensitivity to market risks.

True False
13. The project cost of capital depends on how the capital is used.
True False
12-2
14. Investors expect aggressive stocks to outperform the market in periods of strong economic
activity.
True False
15. Defensive stocks typically provide better returns during periods of economic downturn
since they are not very sensitive to market fluctuations.
True False
16. Diversification decreases the variability of both unique and market risk.
True False
17. Market risk premium, also known as the risk premium of market portfolio, is defined as
the difference between market return and return on risk-free Treasury bills.
True False
18. The cost of capital for a project depends on the risk of the company.
True False
19. According to the CAPM, a stock's expected return is positively related to its beta.
True False
20. The CAPM is a theory of the relationship between risk and return that states that the
expected risk premium on any security equals its beta times the market return.
True False
12-3
21. The stock of Newmont Mining, the world's largest gold producer, has above-average
volatility but relatively low beta.
True False
22. According to the capital asset pricing model, expected rates of return for all securities and
all portfolios lie on the capital market line.
True False
23. As a project's beta increases, the project's opportunity cost of capital increases.
True False
24. A project should be accepted if its return plots above the security market line.
True False
25. The security market line shows how expected rate of return depends on beta.
True False
26. The required risk premium for any investment is given by the security market line.
True False
27. Project cost of capital and company cost of capital are synonymous terms.
True False
28. The project cost of capital depends on the use to which that capital is put. Therefore, it
depends on the risk of the project and also on the risk of the company.
True False
12-4
29. If a company with low credit rating invests in a low-risk project, it should discount the
cash flows at a correspondingly high cost of capital.
True False
30. Changing the discount rate is equivalent to adjusting expected cash flows as a method of
accounting for risk.
True False
Multiple Choice Questions
31. What two elements are represented in security returns?

A. A premium for market risk and for unique risk
B. A premium for unique risk and a premium for firm-specific risk
C. A premium for diversification and a premium for portfolio risk
D. A premium for time value of money and a premium for market risk
32. If a security plots below the security market line, it is:

A. not rewarding the investor for its unique risk.
B. underpriced, a situation that should be temporary.
C. offering too little return to justify its risk.
D. a defensive security, which expects to offer lower returns.
33. In practice, the market portfolio is often represented by:

A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
12-5
34. A stock's beta measures the:

A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock.
35. In theory, the "market portfolio" should contain:

A. the securities of the S&P 500.
B. the securities of the Dow.
C. the securities of the S&P 500 and Treasury bills.
D. all risky assets.
36. When the overall market experiences a decline of 8%, an investor with a portfolio of
aggressive stocks will probably experience:
A. portfolio losses of less than 8%.
B. portfolio losses greater than 8%.
C. portfolio gains of less than 8%.
D. portfolio gains greater than 8%.
37. A stock with a beta greater than 1.0 would be termed:

A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.
38. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
12-6
39. The line plotted to fit observations of a stock's returns versus the market's returns
determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
40. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up)
by 1.2%, then its beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.
41. If the slope of the line measuring a stock's historic returns against the market's historic
returns is positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.
42. If the line measuring a stock's historic returns against the market's historic returns has a
slope greater than 1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.
12-7
43. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a
month where the market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.
44. Stock returns can be explained by the stock's _________ and the stock's _________.
A. beta; unique risk
B. beta; market risk
C. unique risk; firm-specific risk
D. aggressive risk; defensive risk
45. Based on the following information, make an estimate of the stock's beta: Month 1 =
Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock
-2.5%, Market -2.0%.
A. Beta is greater than 1.0.
B. Beta is less than 1.0.
C. Beta equals 1.0.
D. There is no consistent pattern of returns.
46. If you were willing to bet that the overall stock market was heading up on a sustained
basis, it would be logical to invest in:
A. high beta stocks.
B. low beta stocks.
C. stocks with large amounts of unique risk.
D. stocks that plot below the security market line.
12-8
47. What is the beta of a three-stock portfolio including 25% of stock A with a beta of .90,
40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73?
A. 1.0
B. 1.17
C. 1.22
D. 1.25
48. A major benefit of investing in mutual funds is:

A. reducing the beta of the investment portfolio.
B. increasing the beta of the investment portfolio.
C. low cost reduction of exposure to unique risks.
D. eliminating market risk.
49. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio
beta of 1.0 by replacing stock C in the following equally weighted portfolio: stock A = .9
beta; stock B = 1.1 beta; stock C = 1.35 beta?
A. .93 beta
B. 1.00 beta
C. 1.08 beta
D. 1.15 beta
50. The average beta of individual stocks in the market portfolio:

A. is one.
B. is zero.
C. is 1/2 (midway between one and zero).
D. cannot be calculated without knowing the stocks in the portfolio.
51. One of the easiest methods of diversifying away firm-specific risks is to:
A. buy only stocks with a beta of 1.0.
B. build a portfolio with 40 to 55 individual stocks.
C. purchase the shares of a mutual fund.
D. purchase stocks that plot above the security market line.
12-9
52. A considerable scattering in the plot of points representing the historic returns of a stock
versus the returns on the market indicates the:
A. high beta of the stock.
B. unique risk of the stock.
C. changes in market risk premium over time.
D. current underpricing of the stock.
53. The beta of an investment in U.S. Treasury bills is:

A. 0.0.
B. 0.5.
C. 1.0.
D. meaningless; only common stocks have betas.
54. If Treasury bills are yielding 10% at a time when the market risk premium is 6%, then
the:
A. market portfolio should yield 4%.
B. market portfolio should yield 6%.
C. market portfolio should yield 16%.
D. market portfolio should yield 22%.
55. Which of the following statements is correct when Treasury bills yield 7.5% and the
market risk premium is 9.5%?
A. The S&P 500 would be expected to yield about 8.50%.
B. The S&P 500 would be expected to yield about 9.50%.
C. The S&P 500 would be expected to yield about 12.68%.
D. The S&P 500 would be expected to yield about 17.00%.
56. What will happen to the expected return on a stock with a beta of 1.5 and a market risk
premium of 9% if the Treasury bill yield increases from 3 to 5%?
A. The expected return will remain unchanged.
B. The expected return will increase by 1.0%.
C. The expected return will increase by 2.0%.
D. The expected return will increase by 3.0%.
12-10
57. What is the expected yield on the market portfolio at a time when Treasury bills yield 6%
and a stock with a beta of 1.4 is expected to yield 18%?
A. 8.6%
B. 10.8%
C. 12.0%
D. 14.6%
58. When Treasury bills yield 7.0% and the expected return on the market is 16%, then the
risk premium on an asset is equal to:
A. 9.0%.
B. 16.0%.
C. 9.0% times the asset's beta.
D. 8.0% plus the risk-free rate.
59. Calculate the risk premium on stock C given the following information: risk-free rate =
5%, market return = 13%, stock C beta = 1.3.
A. 8.0%
B. 10.4%
C. 15.4%
D. 16.9%
60. If Treasury bills yield 6.0% and the market risk premium is 9.0%, then a portfolio with a
beta of 1.5 would be expected to yield:
A. 12.0%.
B. 17.0%.
C. 19.5%.
D. 21.5%.
12-11
61. An investor was expecting an 18% return on his portfolio with beta of 1.25 before the
market risk premium increased from 8 to 10%. Based on this change, what return will now be
expected on the portfolio?
A. 20.0%
B. 20.5%
C. 22.5%
D. 26.0%
62. An investor was expecting an 18% return on her portfolio with beta of 1.25 before the
market risk premium decreased from 8 to 6%. Based on this change, what return will now be
A. 15.5%
B. 20.5%
C. 22.5%
D. 26.0%
63. What rate of return should an investor expect for a stock that has a beta of 0.8 when the
market is expected to yield 14% and Treasury bills offer 6%?
A. 9.2%
B. 11.2%
C. 12.4%
D. 12.8%
A. 10.0%
B. 11.2%
C. 12.4%
D. 16.0%
12-12
65. Why do stock market investors appear not to be concerned with unique risks when
calculating expected rates of return?
A. There is no method to quantify unique risks.
B. Unique risks are assumed to be diversified away.
C. Unique risks are compensated by the risk-free rate.
D. Beta includes a component to compensate unique risk.
66. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the
portfolio beta is:
A. 0.70.
B. 1.05.
C. 1.40.
D. 2.10.
67. What return would be expected by an investor whose portfolio was 25% market portfolio
and 75% Treasury bills if the risk-free rate was 7% and the market risk premium was 8%?
A. 8.00%
B. 9.00%
C. 10.75%
D. 13.00%
68. What is the beta of a portfolio with an expected return of 12% if Treasury bills yield 6%
and the market risk premium is 8%?
A. 0.50
B. 0.75
C. 0.90
D. 1.50
69. The slope of the security market line equals:

A. one.
B. beta.
C. the market risk premium.
D. the expected return on the market portfolio.
12-13
70. What return should be expected from investing in the market portfolio that is expected to
yield 18% if the investment includes all of the investor's funds plus 30% of additional funds
borrowed at the risk-free rate of 6%?
A. 18.6%
B. 19.6%
C. 21.6%
D. 24.0%
A. 18.6%
B. 19.6%
C. 21.6%
D. 30.0%
72. Which of the following statements is more likely to be correct concerning the statement,
"Stock A has a higher expected return than stock B"?
A. Stock A has more unique risk.
B. Stock B plots below the security market line.
C. Stock B is a cyclical stock.
D. Stock A has a higher beta.
73. A stock's risk premium is equal to the:

A. expected market return times beta.
B. Treasury bill yield plus expected market return.
C. risk-free rate plus expected market risk premium.
D. expected market risk premium times beta.
12-14
74. Investing borrowed funds in a stock portfolio will:

A. increase the beta of the portfolio.
B. decrease the volatility of the portfolio.
C. decrease the expected return on the portfolio.
D. increase the market risk premium.
75. What will happen to a stock that offers a lower risk premium than predicted by the
CAPM?
A. Its beta will increase.
B. Its beta will decrease.
C. Its price will decrease until yield is increased.
D. Its price will increase until the yield is reduced.
76. Decreases in the risk-free rate will reduce:

A. the market risk premium.
B. the stock's risk premium.
C. the stock's beta.
D. the stock's expected return.
77. Given the CAPM's noted empirical difficulties, which of the following statements may be
correct concerning a low price-earnings ratio stock?
A. The stock has too much systematic risk.
B. The stock plots above the security market line.
C. The stock plots below the security market line.
D. The stock has a zero beta.
78. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 1.5,
the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to
9%?
A. It increases from 12 to 14.0%.
B. It increases from 13 to 17.5%.
C. It increases from 14 to 21.0%.
D. It remains unchanged.
12-15
79. What would you recommend to an investor who is considering an investment that,
according to its beta, plots below the security market line (SML)?
A. Invest; return is high relative to risk.
B. Don't invest; risk is high relative to return.
C. Invest; stocks revert to the SML over time.
D. Don't invest; stocks below the SML have too much unique risk.
80. Investment projects that plot above the security market line would be considered to have:
A. a positive NPV.
B. a negative NPV.
C. a zero NPV.
D. an excessively high discount rate.
81. The company cost of capital may be an inappropriate discount rate for a capital budgeting
proposal if:
A. it calculates a negative NPV for the proposal.
B. the proposal has a different degree of risk.
C. the company has unique risk.
D. the company expects to earn more than the risk-free rate.
82. A proposed investment must earn at least as much as the ______ if it is to be deemed
acceptable.
A. company cost of capital
B. risk-free rate
C. market risk premium
D. project cost of capital
12-16
83. A project with higher than average risk offers an expected return of 18%. Which statement
is correct if the company's opportunity cost of capital is 12% and the project's opportunity
cost of capital is 15%?
A. Project NPV is positive; it should be accepted.
B. Project NPV is negative; it should be rejected.
C. Project NPV is positive but it should be rejected.
D. Project NPV is negative but it should be accepted.
84. Which of the following statements best explains the fact that cyclical firms tend to have
high betas?
A. Their earnings are not stable.
B. Their stocks are overpriced.
C. Their earnings are less diversifiable.
D. Their profit margins are small.
85. If last month a stock with beta of 1.0 lost 2% while the S&P 500 had a 1% gain, then it
appears that:
A. beta has been calculated incorrectly.
B. the S&P 500 cannot represent the market.
C. the firm may have released negative information.
D. the market index had a good month.
86. The slope of the regression line that exhibits the past relationship between a stock's return
and the market's return is the:
B. stock's beta.
D. stock's unique risk.
12-17
87. Which of the following is most likely correct for a diversified stock portfolio that exhibits
a higher standard deviation than the market index?
A. The portfolio contains fairly aggressive stocks.
B. The portfolio's stock plot below the security market line.
C. The portfolio's beta is less than 1.0.
D. The portfolio contains a significant amount of unique risk.
88. An investor divides her portfolio into thirds, with one part in Treasury bills, one part in a
market index, and one part in a diversified portfolio with beta of 1.50. What is the beta of the
investor's overall portfolio?
A. 0.833
B. 1.000
C. 1.167
D. 1.250
89. If the market portfolio is expected to offer returns of 16%, then what can be said about a
portfolio expected to return 13%?
A. It plots below the security market line.
B. Part of the portfolio is invested in Treasury bills.
C. The portfolio is not diversified.
D. The portfolio's beta is less than 1.0.
90. Given recent evidence concerning the CAPM, which of the following portfolios might be
expected to plot above the security market line?
A. A portfolio of cyclical stocks
B. A portfolio that includes borrowed funds
C. A portfolio of smaller companies
D. A portfolio split between Treasury bills and the market index
12-18
91. The basic tenet of the CAPM is that a stock's expected risk premium should be:
A. greater than the expected market return.
B. proportionate to the market return.
C. proportionate to the stock's beta.
D. greater than the risk-free rate of return.
92. What effect might operating leverage be expected to have on a project's beta?
A. Beta will increase.
B. Beta will decrease.
C. Beta will not be affected.
D. The effect depends on the market risk premium.
93. The correct opportunity cost for a project is determined to be 15% and the project is
expected to generate $1 million in cash flows at the end of the next 4 years after an initial
outlay of $3 million. Based on this information, the project would plot:
A. above the security market line.
B. below the security market line.
C. on the security market line.
D. on the security market line, with a beta of 1.0.
94. A project is determined to have equal probability of generating $1 million annually or

$500,000 annually for 4 years. The initial outlay is $2 million. The expected return on
Treasury bills is 6% and the market risk premium is 10%. What is the highest project beta that
will justify acceptance of the project?
A. 0.245
B. 1.000
C. 1.245
D. 2.310
12-19
95. Which of the following portfolios might be expected to exhibit less unique risk?
A. Five random stocks; portfolio beta = .8
B. Three random stocks; portfolio beta = 1.2
C. Ten random stocks; portfolio beta = 1.0
D. Twelve random stocks; portfolio beta unknown
96. If the plotting of a portfolio's returns against returns on the market index produces a tight
pattern, then:
A. the portfolio appears to be well diversified.
B. the portfolio has a beta of 0.
C. the portfolio has very little systematic risk.
D. the portfolio has a very low market risk premium.
97. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury
bills, then the investor should expect to receive:
A. the risk-free rate plus 75% of the expected return on the market.
B. the risk-free rate plus 75% of the expected market risk premium.
C. 75% of the expected return on the market.
D. 25% of the risk-free rate plus 75% of the expected market risk premium.
98. How is it possible to invest only in the market portfolio yet have a portfolio beta of 1.5?
A. Don't diversify away the unique risks.
B. Purchase only aggressive stocks for the portfolio.
C. Purchase only stocks with high levels of systematic risk.
D. Borrow funds to increase your investment.
99. The CAPM provides a model of determining expected security returns that is:
A. precise in its calculations of risk premiums.
B. imprecise, but generally an acceptable guideline.
C. excellent for high beta stocks.
D. excellent for well-diversified portfolios.
12-20
100. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
101. When the overall market is up by 10%, an investor with a portfolio of defensive stocks
will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
102. If a stock's beta is .8 during a period when the market portfolio was down by 10%, then,
a priori, we could expect the return on this individual stock to:
A. lose more than 10%.
B. lose, but less than 10%.
C. gain more than 10%.
D. gain, but less than 10%.
103. What is the standard deviation of the market portfolio if the standard deviation of a fully
diversified portfolio with a beta of 1.25 equals 20%?
A. 16.00%
B. 18.75%
C. 25.00%
D. 32.50%
104. Assuming some positive returns on Treasury bills, what can you assume about an
investor whose diversified portfolio of stocks yielded 25% when the market portfolio yielded
15%?
A. Treasury bills are offering a 10% yield.
B. The portfolio beta is greater than 1.0.
C. The portfolio beta equals 1.67.
D. The investor's portfolio contains many defensive stocks.
12-21
105. The project cost of capital is:

A. equal to the company cost of capital.
B. less than the company cost of capital.
C. greater than the company cost of capital.
D. not necessarily related to the company cost of capital.
106. The minimum acceptable expected rate of return on a project of a specific risk is the:
A. project cost of capital.
B. company cost of capital.
C. risk-free rate of return.
D. project beta times market risk premium.
107. If changing discount rates from the company cost of capital to the project cost of capital
changes NPV from negative to positive, then the project should use the:
A. company cost of capital and be accepted.
B. company cost of capital and be rejected.
C. project cost of capital and be accepted.
D. project cost of capital and be rejected.
108. What type of risk is properly reflected in a project's discount rate?

A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk
109. If the company cost of capital is 20% and a proposed project's cost of capital is 15%,
then discounting the projects' cash flows at 20% would:
A. determine where the project plots in relation to the security market line.
B. make the project look more attractive.
C. be correct from a theoretical perspective.
D. be incorrect.
12-22
110. Which of the following adjustment techniques would be preferred to account for
additional project risk?
A. Increase the discount rate.
B. Adjust expected cash flows downward.
C. Increase the beta.
D. Adjust the market risk premium.
Essay Questions
111. How can you measure and interpret the market risk, or beta, of a security?
112. What is the relationship between the market risk of a security and the rate of return that
investors demand of that security?
113. How are the terms "defensive" and "aggressive" applied to individual stocks or
portfolios?
12-23
114. Discuss how betas are measured for individual stocks.
115. Why is beta thought to be a more relevant measure of risk than standard deviation for a
diversified investor?
116. Discuss the capital asset pricing model in general, including the method of determining
expected returns.
volatility but relatively low beta. Why?
12-24
118. Calculate the expected rate of return for the following portfolio, based on a Treasury bill
yield of 4% and an expected market return of 13%:
119. A portfolio of three stocks with total market value of $1,000,000 currently has a beta of
1.4. In light of an expected market downturn, you wish to reduce the portfolio beta to no more
than 1.0. Two stocks are likely candidates for sale, one with a beta of 1.8 and a market value
of $200,000 and the other with a beta of 1.5 and a market value of $250,000. Assuming that
you could find one appropriate stock to replace these two, what should be its beta?
120. Stock A has a current price of $25.00, a beta of 1.25, and a dividend yield of 6%. If the
Treasury bill yield is 5% and the market portfolio is expected to return 14%, what should
stock A sell for at the end of an investor's 2-year investment horizon?
12-25
121. Why is it important to make the distinction between company opportunity cost of capital
and project opportunity cost of capital when evaluating projects?
122. Explain why an insurance company is willing to sell life insurance to individuals, but
will be more reluctant to issue policies insuring against earthquake damage to residents living
along fault lines. Why don't insurance companies simply charge the residents a premium that
reflects the actuarial probability of damage from earthquakes?
123. Where will the following projects plot in relation to the security market line if the risk-
free rate is 6% and the market risk premium is 9%? Which projects should be undertaken?
12-26
124. The manager of StarPerformer Mutual Fund expects the fund to earn a rate of return of
12% this year. The beta of the fund's portfolio is .8. If the rate of return available on risk-free
assets is 5% and you expect the rate of return on the market portfolio to be 15%, should you
invest in StarPerformer? Can you create a portfolio with the same risk as StarPerformer
Mutual Fund, but with a higher expected rate of return? Explain why in reality, a mutual fund
must be able to provide an expected rate of return that is higher than that predicted by the
security market line in order for investors to consider the fund an attractive investment
opportunity.
125. How can a manager calculate the opportunity cost of capital for a project?
12-27
Chapter 12 Risk, Return, and Capital Budgeting Answer Key
True / False Questions
1. Since 1926 the average annual difference between the returns on value and growth stocks
has been 3.8%.
TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 12-01 Measure and interpret the market risk; or beta; of a security.
Topic: Measuring Market Risk
2. The capital asset pricing model (CAPM) assumes that the stock market is dominated by
well-diversified investors who are concerned only with market risk.
TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 12-02 Relate the market risk of a security to the rate of return that investors demand.
Topic: Capital Asset Pricing Model
3. The CAPM states that the expected risk premium on any security equals its beta times the
market risk premium.
TRUE
AACSB: Analytic
Blooms: Remember
12-28
4. There is little doubt that the CAPM captures everything that is going on in the market.
FALSE
AACSB: Reflective Thinking

Blooms: Remember
Difficulty: 1 Easy
5. The security market line displays the relationship between expected return and beta.
TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 12-03 Calculate the opportunity cost of capital for a project.
Topic: The Security Market Line
6. The security market line sets a standard for other investments—investors will be willing to
hold other investments only if they offer equally good prospects as shown by the points on the
line.
TRUE
AACSB: Ethics
Blooms: Apply
7. The required risk premium for any investment is given by the security market line: Risk
premium on investment = beta  expected market risk premium.
TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
12-29
8. Empirical evidence suggested that over a long period of time returns did indeed increase
with beta.
TRUE
AACSB: Analytic
Blooms: Remember
9. The security market line provides a standard for project rejection.

TRUE
AACSB: Ethics
Blooms: Remember
Difficulty: 1 Easy
10. If a low-risk company invests in a high-risk project, those cash flows should be discounted
at a high cost of capital.
TRUE

Blooms: Understand
Topic: Capital Budgeting
11. The project cost of capital depends on the project and hence also on the risk of the
company.
FALSE
AACSB: Ethics
Blooms: Remember
12-30
12. Beta measures a stock's sensitivity to market risks.

TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
13. The project cost of capital depends on how the capital is used.
TRUE
AACSB: Ethics
Blooms: Remember
14. Investors expect aggressive stocks to outperform the market in periods of strong economic
activity.
TRUE
AACSB: Ethics
Blooms: Understand
15. Defensive stocks typically provide better returns during periods of economic downturn
since they are not very sensitive to market fluctuations.
TRUE
AACSB: Ethics
Blooms: Remember
Difficulty: 1 Easy
12-31
16. Diversification decreases the variability of both unique and market risk.
FALSE
AACSB: Ethics
Blooms: Remember
Difficulty: 1 Easy
17. Market risk premium, also known as the risk premium of market portfolio, is defined as
the difference between market return and return on risk-free Treasury bills.
TRUE
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
18. The cost of capital for a project depends on the risk of the company.
FALSE
AACSB: Ethics
Blooms: Understand
19. According to the CAPM, a stock's expected return is positively related to its beta.
TRUE
AACSB: Ethics
Blooms: Remember
Difficulty: 1 Easy
12-32
20. The CAPM is a theory of the relationship between risk and return that states that the
expected risk premium on any security equals its beta times the market return.
FALSE

Blooms: Remember
Difficulty: 1 Easy
volatility but relatively low beta.
TRUE
AACSB: Ethics
Blooms: Remember
22. According to the capital asset pricing model, expected rates of return for all securities and
all portfolios lie on the capital market line.
FALSE
AACSB: Ethics
Blooms: Remember
23. As a project's beta increases, the project's opportunity cost of capital increases.
TRUE
AACSB: Ethics
Blooms: Remember
Difficulty: 1 Easy
12-33
24. A project should be accepted if its return plots above the security market line.
TRUE
AACSB: Ethics
Blooms: Apply
25. The security market line shows how expected rate of return depends on beta.
TRUE
AACSB: Ethics
Blooms: Apply
Difficulty: 1 Easy
26. The required risk premium for any investment is given by the security market line.
TRUE
AACSB: Ethics
Blooms: Apply
Difficulty: 1 Easy
27. Project cost of capital and company cost of capital are synonymous terms.
FALSE
AACSB: Ethics
Blooms: Remember
12-34
28. The project cost of capital depends on the use to which that capital is put. Therefore, it
depends on the risk of the project and also on the risk of the company.
FALSE
AACSB: Ethics
Blooms: Apply
29. If a company with low credit rating invests in a low-risk project, it should discount the
cash flows at a correspondingly high cost of capital.
FALSE
AACSB: Ethics
Blooms: Remember
30. Changing the discount rate is equivalent to adjusting expected cash flows as a method of
accounting for risk.
FALSE
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
Multiple Choice Questions
12-35
31. What two elements are represented in security returns?

A. A premium for market risk and for unique risk
B. A premium for unique risk and a premium for firm-specific risk
C. A premium for diversification and a premium for portfolio risk
D. A premium for time value of money and a premium for market risk
AACSB: Ethics
Blooms: Understand
32. If a security plots below the security market line, it is:

A. not rewarding the investor for its unique risk.
B. underpriced, a situation that should be temporary.
C. offering too little return to justify its risk.
D. a defensive security, which expects to offer lower returns.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
33. In practice, the market portfolio is often represented by:

A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.

Blooms: Remember
Difficulty: 1 Easy
12-36
34. A stock's beta measures the:

A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock.
AACSB: Analytic
Blooms: Remember
35. In theory, the "market portfolio" should contain:

A. the securities of the S&P 500.
B. the securities of the Dow.
C. the securities of the S&P 500 and Treasury bills.
D. all risky assets.
AACSB: Ethics
Blooms: Understand
36. When the overall market experiences a decline of 8%, an investor with a portfolio of
aggressive stocks will probably experience:
A. portfolio losses of less than 8%.
B. portfolio losses greater than 8%.
C. portfolio gains of less than 8%.
D. portfolio gains greater than 8%.
AACSB: Ethics
Blooms: Analyze
Difficulty: 1 Easy
12-37
37. A stock with a beta greater than 1.0 would be termed:

A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
38. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.

Blooms: Remember
Difficulty: 1 Easy
39. The line plotted to fit observations of a stock's returns versus the market's returns
determines the:
B. beta of the stock.
D. capital asset pricing model.

Blooms: Understand
12-38
40. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up)
by 1.2%, then its beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.
AACSB: Ethics
Blooms: Analyze
41. If the slope of the line measuring a stock's historic returns against the market's historic
returns is positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
42. If the line measuring a stock's historic returns against the market's historic returns has a
slope greater than 1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
12-39
43. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a
month where the market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.
AACSB: Ethics
Blooms: Analyze
44. Stock returns can be explained by the stock's _________ and the stock's _________.
A. beta; unique risk
B. beta; market risk
C. unique risk; firm-specific risk
D. aggressive risk; defensive risk
AACSB: Ethics
Blooms: Understand
45. Based on the following information, make an estimate of the stock's beta: Month 1 =
Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock
-2.5%, Market -2.0%.
A. Beta is greater than 1.0.
B. Beta is less than 1.0.
C. Beta equals 1.0.
D. There is no consistent pattern of returns.
AACSB: Ethics
Blooms: Understand
12-40
46. If you were willing to bet that the overall stock market was heading up on a sustained
basis, it would be logical to invest in:
A. high beta stocks.
B. low beta stocks.
C. stocks with large amounts of unique risk.
D. stocks that plot below the security market line.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
47. What is the beta of a three-stock portfolio including 25% of stock A with a beta of .90,
40% of stock B with a beta of 1.05, and 35% of stock C with a beta of 1.73?
A. 1.0
B. 1.17
C. 1.22
D. 1.25
Portfolio beta = (.25  0.9) + (.4  1.05) + (.35  1.73)

= .225 + .42 + .606 = 1.25
AACSB: Analytic
Blooms: Analyze
12-41
48. A major benefit of investing in mutual funds is:

A. reducing the beta of the investment portfolio.
B. increasing the beta of the investment portfolio.
C. low cost reduction of exposure to unique risks.
D. eliminating market risk.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
49. What should be the beta of a replacement stock if an investor wishes to achieve a portfolio
beta of 1.0 by replacing stock C in the following equally weighted portfolio: stock A = .9
beta; stock B = 1.1 beta; stock C = 1.35 beta?
A. .93 beta
B. 1.00 beta
C. 1.08 beta
D. 1.15 beta
New portfolio beta = (.333  .9) + (.333  1.1) + (.333  Beta C)

1.0 = .3 + .366 +.333  beta C
.334 = .333  beta C
1.00 = beta C
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
12-42
50. The average beta of individual stocks in the market portfolio:

A. is one.
B. is zero.
C. is 1/2 (midway between one and zero).
D. cannot be calculated without knowing the stocks in the portfolio.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
51. One of the easiest methods of diversifying away firm-specific risks is to:
A. buy only stocks with a beta of 1.0.
B. build a portfolio with 40 to 55 individual stocks.
C. purchase the shares of a mutual fund.
D. purchase stocks that plot above the security market line.
AACSB: Ethics
Blooms: Understand
52. A considerable scattering in the plot of points representing the historic returns of a stock
versus the returns on the market indicates the:
A. high beta of the stock.
B. unique risk of the stock.
C. changes in market risk premium over time.
D. current underpricing of the stock.
AACSB: Ethics
Blooms: Understand
12-43
53. The beta of an investment in U.S. Treasury bills is:

A. 0.0.
B. 0.5.
C. 1.0.
D. meaningless; only common stocks have betas.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
54. If Treasury bills are yielding 10% at a time when the market risk premium is 6%, then
the:
A. market portfolio should yield 4%.
B. market portfolio should yield 6%.
C. market portfolio should yield 16%.
D. market portfolio should yield 22%.
AACSB: Ethics
Blooms: Understand
55. Which of the following statements is correct when Treasury bills yield 7.5% and the
market risk premium is 9.5%?
A. The S&P 500 would be expected to yield about 8.50%.
B. The S&P 500 would be expected to yield about 9.50%.
C. The S&P 500 would be expected to yield about 12.68%.
D. The S&P 500 would be expected to yield about 17.00%.
AACSB: Ethics
Blooms: Understand
12-44
56. What will happen to the expected return on a stock with a beta of 1.5 and a market risk
premium of 9% if the Treasury bill yield increases from 3 to 5%?
A. The expected return will remain unchanged.
B. The expected return will increase by 1.0%.
C. The expected return will increase by 2.0%.
D. The expected return will increase by 3.0%.
Expected return = 3% + 1.5(9) = 16.5%

Expected return = 5% + 1.5(9) = 18.5%
expected return increases by 2%
AACSB: Analytic
Blooms: Analyze
57. What is the expected yield on the market portfolio at a time when Treasury bills yield 6%
and a stock with a beta of 1.4 is expected to yield 18%?
A. 8.6%
B. 10.8%
C. 12.0%
D. 14.6%
Expected return = risk-free rate + beta  risk premium

18% = 6% + 1.4(rm - 6%)
18% = 6% + 1.4(rm - 8.4%)
20.4% = 1.4rm
14.57% = rm
AACSB: Analytic
Blooms: Analyze
12-45
58. When Treasury bills yield 7.0% and the expected return on the market is 16%, then the
risk premium on an asset is equal to:
A. 9.0%.
B. 16.0%.
C. 9.0% times the asset's beta.
D. 8.0% plus the risk-free rate.
AACSB: Analytic
Blooms: Analyze
59. Calculate the risk premium on stock C given the following information: risk-free rate =
5%, market return = 13%, stock C beta = 1.3.
A. 8.0%
B. 10.4%
C. 15.4%
D. 16.9%
Stock C risk premium = beta  market risk premium

= 1.3  (13% - 5%) = 10.4%
AACSB: Analytic
Blooms: Analyze
12-46
60. If Treasury bills yield 6.0% and the market risk premium is 9.0%, then a portfolio with a
beta of 1.5 would be expected to yield:
A. 12.0%.
B. 17.0%.
C. 19.5%.
D. 21.5%.
Expected return = 6.0% + 1.5(9.0%) = 19.5%
AACSB: Analytic
Blooms: Analyze
61. An investor was expecting an 18% return on his portfolio with beta of 1.25 before the
market risk premium increased from 8 to 10%. Based on this change, what return will now be
A. 20.0%
B. 20.5%
C. 22.5%
D. 26.0%
Old: 18% = rf + 1.25(8%) = rf + 10.0%

8.0% = rf
New: Expected return = 8.0% + 1.25(10%) = 8.0% + 12.5% = 20.5%
AACSB: Analytic
Blooms: Analyze
12-47
62. An investor was expecting an 18% return on her portfolio with beta of 1.25 before the
market risk premium decreased from 8 to 6%. Based on this change, what return will now be
A. 15.5%
B. 20.5%
C. 22.5%
D. 26.0%
Old: 18% = rf + 1.25(8%) = rf + 10.0%

8.0% = rf
New: Expected return = 8.0% + 1.25(6%) = 8.0% + 7.5% = 15.5%
AACSB: Analytic
Blooms: Analyze
A. 9.2%
B. 11.2%
C. 12.4%
D. 12.8%
r = rf + (rm - rf) = 6% + .8(14% - 6%) = 6% + 6.4% = 12.4%
AACSB: Analytic
Blooms: Analyze
12-48
A. 10.0%
B. 11.2%
C. 12.4%
D. 16.0%
r = rf + (rm - rf)
= 6% + 1.25(14% - 6%)
= 6% + 10%
= 16%
AACSB: Analytic
Blooms: Analyze
65. Why do stock market investors appear not to be concerned with unique risks when
calculating expected rates of return?
A. There is no method to quantify unique risks.
B. Unique risks are assumed to be diversified away.
C. Unique risks are compensated by the risk-free rate.
D. Beta includes a component to compensate unique risk.
AACSB: Ethics
Blooms: Apply
Difficulty: 1 Easy
12-49
66. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the
portfolio beta is:
A. 0.70.
B. 1.05.
C. 1.40.
D. 2.10.
Portfolio beta = (W1  1) + (W2  2) = (.5  1.4) + (.5  .70) = 1.05
AACSB: Analytic
Blooms: Analyze
67. What return would be expected by an investor whose portfolio was 25% market portfolio
and 75% Treasury bills if the risk-free rate was 7% and the market risk premium was 8%?
A. 8.00%
B. 9.00%
C. 10.75%
D. 13.00%
Expected return on market = rf + market risk premium = 15.00%

Expected return on portfolio = (.75  7%) + (.25  15%) = 5.25% + 3.75% = 9.00%
AACSB: Analytic
Blooms: Analyze
12-50
68. What is the beta of a portfolio with an expected return of 12% if Treasury bills yield 6%
and the market risk premium is 8%?
A. 0.50
B. 0.75
C. 0.90
D. 1.50
rp = 6% + p(8%)
12% = 6% + p(8%)
6% = p (8%)
.75 = p
AACSB: Analytic
Blooms: Analyze
69. The slope of the security market line equals:

A. one.
B. beta.
C. the market risk premium.
D. the expected return on the market portfolio.
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
12-51
A. 18.6%
B. 19.6%
C. 21.6%
D. 24.0%
Beta = (1.3  market) + (-1  loan) = (1.3  1) + 0 = 1.3

Expected return = 6% + 1.3(18% - 6%) = 6% + 15.6% = 21.6%
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
A. 18.6%
B. 19.6%
C. 21.6%
D. 30.0%
Beta = (2.0  market) + (-1  loan) = (2.0  1) + 0 = 2.0

Expected return = 6% + 2.0(18% - 6%) = 6% + 24% = 30%
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
12-52
72. Which of the following statements is more likely to be correct concerning the statement,
"Stock A has a higher expected return than stock B"?
A. Stock A has more unique risk.
B. Stock B plots below the security market line.
C. Stock B is a cyclical stock.
D. Stock A has a higher beta.
AACSB: Ethics
Blooms: Understand
73. A stock's risk premium is equal to the:

A. expected market return times beta.
B. Treasury bill yield plus expected market return.
C. risk-free rate plus expected market risk premium.
D. expected market risk premium times beta.
AACSB: Ethics
Blooms: Understand
74. Investing borrowed funds in a stock portfolio will:

A. increase the beta of the portfolio.
B. decrease the volatility of the portfolio.
C. decrease the expected return on the portfolio.
D. increase the market risk premium.
AACSB: Ethics
Blooms: Understand
12-53
75. What will happen to a stock that offers a lower risk premium than predicted by the
CAPM?
A. Its beta will increase.
B. Its beta will decrease.
C. Its price will decrease until yield is increased.
D. Its price will increase until the yield is reduced.
AACSB: Ethics
Blooms: Understand
76. Decreases in the risk-free rate will reduce:

A. the market risk premium.
B. the stock's risk premium.
C. the stock's beta.
D. the stock's expected return.
AACSB: Ethics
Blooms: Understand
77. Given the CAPM's noted empirical difficulties, which of the following statements may be
correct concerning a low price-earnings ratio stock?
A. The stock has too much systematic risk.
B. The stock plots above the security market line.
C. The stock plots below the security market line.
D. The stock has a zero beta.
AACSB: Ethics
Blooms: Analyze
Difficulty: 3 Hard
12-54
78. What happens to expected portfolio return if the portfolio beta increases from 1.0 to 1.5,
the risk-free rate decreases from 5 to 4%, and the market risk premium increases from 8 to
9%?
A. It increases from 12 to 14.0%.
B. It increases from 13 to 17.5%.
C. It increases from 14 to 21.0%.
D. It remains unchanged.
rp = 5% + 1(8) = 13%
rp = 4% + 1.5(9) = 17.5%
rp = +4.5%
AACSB: Analytic
Blooms: Analyze
79. What would you recommend to an investor who is considering an investment that,
according to its beta, plots below the security market line (SML)?
A. Invest; return is high relative to risk.
B. Don't invest; risk is high relative to return.
C. Invest; stocks revert to the SML over time.
D. Don't invest; stocks below the SML have too much unique risk.
AACSB: Ethics
Blooms: Analyze
12-55
80. Investment projects that plot above the security market line would be considered to have:
A. a positive NPV.
B. a negative NPV.
C. a zero NPV.
D. an excessively high discount rate.
AACSB: Ethics
Blooms: Analyze
81. The company cost of capital may be an inappropriate discount rate for a capital budgeting
proposal if:
A. it calculates a negative NPV for the proposal.
B. the proposal has a different degree of risk.
C. the company has unique risk.
D. the company expects to earn more than the risk-free rate.
AACSB: Ethics
Blooms: Understand
82. A proposed investment must earn at least as much as the ______ if it is to be deemed
acceptable.
A. company cost of capital
B. risk-free rate
C. market risk premium
D. project cost of capital
AACSB: Ethics
Blooms: Understand
12-56
83. A project with higher than average risk offers an expected return of 18%. Which statement
is correct if the company's opportunity cost of capital is 12% and the project's opportunity
cost of capital is 15%?
A. Project NPV is positive; it should be accepted.
B. Project NPV is negative; it should be rejected.
C. Project NPV is positive but it should be rejected.
D. Project NPV is negative but it should be accepted.
AACSB: Ethics
Blooms: Analyze
84. Which of the following statements best explains the fact that cyclical firms tend to have
high betas?
A. Their earnings are not stable.
B. Their stocks are overpriced.
C. Their earnings are less diversifiable.
D. Their profit margins are small.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
85. If last month a stock with beta of 1.0 lost 2% while the S&P 500 had a 1% gain, then it
appears that:
A. beta has been calculated incorrectly.
B. the S&P 500 cannot represent the market.
C. the firm may have released negative information.
D. the market index had a good month.
AACSB: Ethics
Blooms: Understand
12-57
86. The slope of the regression line that exhibits the past relationship between a stock's return
and the market's return is the:
B. stock's beta.
D. stock's unique risk.
AACSB: Ethics
Blooms: Understand
87. Which of the following is most likely correct for a diversified stock portfolio that exhibits
a higher standard deviation than the market index?
A. The portfolio contains fairly aggressive stocks.
B. The portfolio's stock plot below the security market line.
C. The portfolio's beta is less than 1.0.
D. The portfolio contains a significant amount of unique risk.
AACSB: Ethics
Blooms: Understand
12-58
88. An investor divides her portfolio into thirds, with one part in Treasury bills, one part in a
market index, and one part in a diversified portfolio with beta of 1.50. What is the beta of the
investor's overall portfolio?
A. 0.833
B. 1.000
C. 1.167
D. 1.250
AACSB: Ethics
Blooms: Understand
89. If the market portfolio is expected to offer returns of 16%, then what can be said about a
portfolio expected to return 13%?
A. It plots below the security market line.
B. Part of the portfolio is invested in Treasury bills.
C. The portfolio is not diversified.
D. The portfolio's beta is less than 1.0.
AACSB: Ethics
Blooms: Analyze
12-59
90. Given recent evidence concerning the CAPM, which of the following portfolios might be
expected to plot above the security market line?
A. A portfolio of cyclical stocks
B. A portfolio that includes borrowed funds
C. A portfolio of smaller companies
D. A portfolio split between Treasury bills and the market index
AACSB: Ethics
Blooms: Understand
91. The basic tenet of the CAPM is that a stock's expected risk premium should be:
A. greater than the expected market return.
B. proportionate to the market return.
C. proportionate to the stock's beta.
D. greater than the risk-free rate of return.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
92. What effect might operating leverage be expected to have on a project's beta?
A. Beta will increase.
B. Beta will decrease.
C. Beta will not be affected.
D. The effect depends on the market risk premium.
AACSB: Ethics
Blooms: Understand
Difficulty: 1 Easy
12-60
93. The correct opportunity cost for a project is determined to be 15% and the project is
expected to generate $1 million in cash flows at the end of the next 4 years after an initial
outlay of $3 million. Based on this information, the project would plot:
A. above the security market line.
B. below the security market line.
C. on the security market line.
D. on the security market line, with a beta of 1.0.
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
94. A project is determined to have equal probability of generating $1 million annually or

$500,000 annually for 4 years. The initial outlay is $2 million. The expected return on
Treasury bills is 6% and the market risk premium is 10%. What is the highest project beta that
will justify acceptance of the project?
A. 0.245
B. 1.000
C. 1.245
D. 2.310
This suggests a risk premium of 12.45% on the project, which corresponds to a beta of 1.245.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
12-61
95. Which of the following portfolios might be expected to exhibit less unique risk?
A. Five random stocks; portfolio beta = .8
B. Three random stocks; portfolio beta = 1.2
C. Ten random stocks; portfolio beta = 1.0
D. Twelve random stocks; portfolio beta unknown
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
96. If the plotting of a portfolio's returns against returns on the market index produces a tight
pattern, then:
A. the portfolio appears to be well diversified.
B. the portfolio has a beta of 0.
C. the portfolio has very little systematic risk.
D. the portfolio has a very low market risk premium.
AACSB: Ethics
Blooms: Understand
97. If an investor's portfolio is allocated 75% to the market portfolio and 25% to Treasury
bills, then the investor should expect to receive:
A. the risk-free rate plus 75% of the expected return on the market.
B. the risk-free rate plus 75% of the expected market risk premium.
C. 75% of the expected return on the market.
D. 25% of the risk-free rate plus 75% of the expected market risk premium.
AACSB: Ethics
Blooms: Understand
12-62
98. How is it possible to invest only in the market portfolio yet have a portfolio beta of 1.5?
A. Don't diversify away the unique risks.
B. Purchase only aggressive stocks for the portfolio.
C. Purchase only stocks with high levels of systematic risk.
D. Borrow funds to increase your investment.
AACSB: Ethics
Blooms: Understand
99. The CAPM provides a model of determining expected security returns that is:
A. precise in its calculations of risk premiums.
B. imprecise, but generally an acceptable guideline.
C. excellent for high beta stocks.
D. excellent for well-diversified portfolios.
AACSB: Ethics
Blooms: Understand
100. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
AACSB: Ethics
Blooms: Understand
12-63
101. When the overall market is up by 10%, an investor with a portfolio of defensive stocks
will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
AACSB: Ethics
Blooms: Analyze
Difficulty: 1 Easy
102. If a stock's beta is .8 during a period when the market portfolio was down by 10%, then,
a priori, we could expect the return on this individual stock to:
A. lose more than 10%.
B. lose, but less than 10%.
C. gain more than 10%.
D. gain, but less than 10%.
AACSB: Ethics
Blooms: Analyze
12-64
103. What is the standard deviation of the market portfolio if the standard deviation of a fully
diversified portfolio with a beta of 1.25 equals 20%?
A. 16.00%
B. 18.75%
C. 25.00%
D. 32.50%
Portfolio  = beta  market portfolio 

20% = 1.25  m
16% = m
AACSB: Analytic
Blooms: Analyze
104. Assuming some positive returns on Treasury bills, what can you assume about an
investor whose diversified portfolio of stocks yielded 25% when the market portfolio yielded
15%?
A. Treasury bills are offering a 10% yield.
B. The portfolio beta is greater than 1.0.
C. The portfolio beta equals 1.67.
D. The investor's portfolio contains many defensive stocks.
AACSB: Ethics
Blooms: Understand
12-65
105. The project cost of capital is:

A. equal to the company cost of capital.
B. less than the company cost of capital.
C. greater than the company cost of capital.
D. not necessarily related to the company cost of capital.
AACSB: Ethics
Blooms: Understand
106. The minimum acceptable expected rate of return on a project of a specific risk is the:
A. project cost of capital.
B. company cost of capital.
C. risk-free rate of return.
D. project beta times market risk premium.
AACSB: Ethics
Blooms: Understand
107. If changing discount rates from the company cost of capital to the project cost of capital
changes NPV from negative to positive, then the project should use the:
A. company cost of capital and be accepted.
B. company cost of capital and be rejected.
C. project cost of capital and be accepted.
D. project cost of capital and be rejected.
AACSB: Ethics
Blooms: Understand
12-66
108. What type of risk is properly reflected in a project's discount rate?

A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk
AACSB: Ethics
Blooms: Understand
109. If the company cost of capital is 20% and a proposed project's cost of capital is 15%,
then discounting the projects' cash flows at 20% would:
A. determine where the project plots in relation to the security market line.
B. make the project look more attractive.
C. be correct from a theoretical perspective.
D. be incorrect.
AACSB: Ethics
Blooms: Understand
110. Which of the following adjustment techniques would be preferred to account for
additional project risk?
A. Increase the discount rate.
B. Adjust expected cash flows downward.
C. Increase the beta.
D. Adjust the market risk premium.
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
12-67
Essay Questions
111. How can you measure and interpret the market risk, or beta, of a security?
The contribution of a security to the risk of a diversified portfolio depends on its market risk.
But not all securities are equally affected by fluctuations in the market. The sensitivity of a
stock to market movements is known as beta. Stocks with a beta greater than 1.0 are
particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so
sensitive to such movements. The average beta of all stocks is 1.0.
AACSB: Ethics
Blooms: Understand
112. What is the relationship between the market risk of a security and the rate of return that
investors demand of that security?
The extra return that investors require for taking risk is known as the risk premium. The
market risk premium—that is, the risk premium on the market portfolio—averaged 7.6%
between 1900 and 2000. The capital asset pricing model states that the expected risk premium
of an investment should be proportional to both its beta and the market risk premium. The
expected rate of return from any investment is equal to the risk-free interest rate plus the risk
premium, so the CAPM boils down to r = rf + (rm - rf). The security market line is the
graphical representation of the CAPM equation. The security market line relates the expected
return investors demand of a security to the beta.
AACSB: Ethics
Blooms: Understand
12-68
113. How are the terms "defensive" and "aggressive" applied to individual stocks or
portfolios?
Defensive stocks are not as sensitive to changes in market fluctuations when compared to the
market portfolio. Accordingly, these stocks would have a beta less than 1.0. Thus, it would be
expected that these securities would return less than the market portfolio during periods when
the market portfolio is offering positive returns. This might appeal to investors who are too
risk-averse to invest in the market portfolio. In times of a down market, defensive stocks
would be expected to decrease less than the market, thus providing a degree of expected
protection. Aggressive stocks are more sensitive than the market to market fluctuations. Thus,
they amplify market changes. This is good when the market is going up but can be quite
detrimental when the market is going down. Portfolios may contain both aggressive and
defensive stocks, which will mute the effect of each. This is true since the portfolio beta is a
market value-weighted average of the individual betas in the portfolio. Investors may also
choose to change the beta of the portfolio according to expected movements in the overall
market. Thus, portfolios would become more defensive when the market is expected to
decline. The problem with this strategy is, of course, the accuracy of the predicted market
movement.
AACSB: Ethics
Blooms: Understand
114. Discuss how betas are measured for individual stocks.
To measure betas, historic returns of the stock are plotted against returns on the market
portfolio during the same period. In practice, some broad-based index such as the S&P 500 is
substituted for the market portfolio. The slope of the straight line that is drawn to best fit the
observations is the beta of the stock. Since the returns of most stocks move together to some
degree, the slope is expected to be positive. A slope less than 1.0 indicates that the stock's
returns are less volatile than those of the market portfolio while a slope greater than 1.0
indicates that the stock's returns are more volatile than those of the market portfolio.
AACSB: Ethics
Blooms: Understand
12-69
115. Why is beta thought to be a more relevant measure of risk than standard deviation for a
diversified investor?
Standard deviation measures both a stock's market risk and unique risk. However, a
diversified investor is no longer concerned with unique risk, or at least not concerned over the
small portion that remains after portfolio diversification. Beta measures only the market risk
of the stock, that type of risk that cannot be diversified away. The stock's returns may be more
or less volatile than the market portfolio and beta is an indication of that sensitivity.
AACSB: Ethics
Blooms: Understand
116. Discuss the capital asset pricing model in general, including the method of determining
expected returns.
The CAPM describes the relationship between risk and return such that investors who bear
more systematic risk will do so only under the expectation of greater returns. The expected
return on a security is proportional to its beta. Thus, investors are rewarded for the time value
of money (i.e., risk-free rate) and for the risk premium on the security, which is equal to beta
times the market risk premium. There is no reward for bearing unique risk because these risks
are assumed to be diversifiable. The CAPM states that a security's return is equal to the risk-
free rate plus the individual security's risk premium. A security with a beta of 1.0 is expected
to offer the same return as the market portfolio. Securities with betas greater (less) than 1.0
should offer proportionately more (less) than the market portfolio. Securities with a beta of
zero should offer the risk-free rate. The security market line can be used to graph the
relationship between expected return and beta. Market forces should work to move all
securities toward the line if they do not currently offer the appropriate risk-return relationship.
For example, those securities plotting above the line should be in greater demand, which will
bid up price and reduce expected return until the security approaches the SML.
AACSB: Ethics
Blooms: Understand
Difficulty: 3 Hard
12-70
volatility but relatively low beta. Why?
Total risk is not the same as market risk. Some of the most variable stocks have below-
average betas, and vice versa.
Consider, for example, Newmont Mining. Newmont is the world's largest gold producer. The
company cites the many risks that the company faces as "gold and other metals' price
volatility, increased costs and variances in ore grade or recovery rates from those assumed in
mining plans, as well as political and operational risks in the countries in which we operate
and governmental regulation and judicial outcomes."
These risks are considerable and are reflected in the high standard deviation of the returns on
Newmont's stock. But they are not macro risks. When the U.S. economy is booming, gold
prices are just as likely to slump, and a mine in some distant part of the world may well be hit
by political unrest. So, while Newmont stock has above-average volatility, it has a relatively
low beta.
AACSB: Ethics
Blooms: Understand
12-71
118. Calculate the expected rate of return for the following portfolio, based on a Treasury bill
yield of 4% and an expected market return of 13%:
Portfolio beta = (.2  1.6) + (.25  1.2) + (.1  1.0) + (.3  .9) + (.15  .8)
= .32 + .30 + .10 + .27 + .12
= 1.11
Expected portfolio return = rf+ p(rm-rf)

= 4% + 1.11 (13% - 4%)
= 4% + 9.99
= 13.99%
AACSB: Analytic
Blooms: Analyze
12-72
119. A portfolio of three stocks with total market value of $1,000,000 currently has a beta of
1.4. In light of an expected market downturn, you wish to reduce the portfolio beta to no more
than 1.0. Two stocks are likely candidates for sale, one with a beta of 1.8 and a market value
of $200,000 and the other with a beta of 1.5 and a market value of $250,000. Assuming that
you could find one appropriate stock to replace these two, what should be its beta?
AACSB: Analytic
Blooms: Analyze
120. Stock A has a current price of $25.00, a beta of 1.25, and a dividend yield of 6%. If the
Treasury bill yield is 5% and the market portfolio is expected to return 14%, what should
stock A sell for at the end of an investor's 2-year investment horizon?
Expected return = 5% + 1.25 (14% - 5%)

= 5% + 11.25%
= 16.25%
Since total return is composed of dividend yield plus capital gains, the stock is expected to
offer capital gains of 10.25% annually. The price in 2 years should be:
25.00(1.1025)2= 25.00  1.21551 = $30.39
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
12-73
121. Why is it important to make the distinction between company opportunity cost of capital
and project opportunity cost of capital when evaluating projects?
The company opportunity cost of capital represents an average risk of the individual projects
currently invested in by the company. It is thus possible that no one project exemplifies this
"average" company risk. Unless the proposed project is coincidentally of the same level of
risk as the company opportunity cost of capital, it would be inappropriate to use the company
discount rate. Rather, the merit (e.g., NPV) of the project should be judged using the level of
risk that pertains to the project itself. As an example, it would be incorrect to use a low
company cost of capital to determine the NPV of a project that has a high degree of risk. This
offers a mistakenly high estimate of NPV that is not likely to materialize.
AACSB: Ethics
Blooms: Understand
122. Explain why an insurance company is willing to sell life insurance to individuals, but
will be more reluctant to issue policies insuring against earthquake damage to residents living
along fault lines. Why don't insurance companies simply charge the residents a premium that
reflects the actuarial probability of damage from earthquakes?
The risks of deaths of individual policyholders are largely independent, and are therefore
diversifiable. The insurance company is thus satisfied to charge a premium that reflects the
actuarial probabilities of death, without an additional risk premium. In contrast, earthquake
damage is not independent across policyholders. If someone's house is damaged by an
earthquake, there is a greater chance that the neighbor's house will be damaged too. Because
earthquake risk is not as diversifiable, the insurance company may not be satisfied to charge a
premium that reflects only the expected value of payouts.
AACSB: Ethics
Blooms: Understand
12-74
123. Where will the following projects plot in relation to the security market line if the risk-
free rate is 6% and the market risk premium is 9%? Which projects should be undertaken?
Expected returnA= 6% + 2.0% (9%)

= 24% vs. IRR of 25%
A plots above SML and should be accepted.
Expected returnB= 6% + 1.6% (9%)

= 6% + 14.4%
=20.4% vs. IRR of 22%
B plots above SML and should be accepted.
Expected returnC= 6% + 1.1% (9%)

= 6% + 9.9%
= 15.9% vs. IRR of 15%
C plots below SML and should be rejected.
Expected returnD= 6% + .8% (9%)

= 6% + 7.2%
= 13.2% vs. IRR of 11%
D plots below SML and should be rejected.
AACSB: Analytic
Blooms: Analyze
12-75
124. The manager of StarPerformer Mutual Fund expects the fund to earn a rate of return of
12% this year. The beta of the fund's portfolio is .8. If the rate of return available on risk-free
assets is 5% and you expect the rate of return on the market portfolio to be 15%, should you
invest in StarPerformer? Can you create a portfolio with the same risk as StarPerformer
Mutual Fund, but with a higher expected rate of return? Explain why in reality, a mutual fund
must be able to provide an expected rate of return that is higher than that predicted by the
security market line in order for investors to consider the fund an attractive investment
opportunity.
The CAPM implies that the expected rate of return that investors will demand of the portfolio
is:
r = rf + (rm - rf) = 5% + 0.8  (15% - 5%) = 13%

If the portfolio is expected to provide only a 12% rate of return, it is an unattractive
investment. The portfolio does not provide an expected return that is sufficiently high relative
to its risk.
A portfolio that is invested 80% in a stock index mutual fund (with a beta of 1.0) and 20% in
Treasury bills or a money market mutual fund (with a beta of zero) would have the same beta
as StarPerformer Mutual Fund:
= (0.80  1.0) + (0.20  0) = 0.80

However, the portfolio will provide an expected return of:
(0.80  15%) + (0.20  5%) = 13%
This is better than the expected return for StarPerformer Mutual Fund.
The security market line provides a benchmark expected return that an investor can earn by
mixing index funds with money market funds. Before an investor places funds with a
professional mutual fund manager, the investor must be convinced that the mutual fund can
earn an expected return (net of fees) in excess of the expected return available on an equally
risky index fund strategy.
AACSB: Analytic
Blooms: Analyze
12-76
125. How can a manager calculate the opportunity cost of capital for a project?
The opportunity cost of capital is the return that investors give up by investing in the project
rather than in securities of equivalent risk. Financial managers use the capital asset pricing
model to estimate the opportunity cost of capital. The company cost of capital is the expected
rate of return demanded by investors in a company. It depends on the average risk of the
company's assets and operations.
The opportunity cost of capital is determined by the use to which the capital is put. Therefore,
required rates of return depend on the risk of the project, not on the risk of the firm's existing
business. The project cost of capital is the minimum acceptable expected rate of return on a
project given its risk. Your cash-flow forecasts should already factor in the chances of
pleasant and unpleasant surprises. Potential bad outcomes should be reflected in the discount
rate only to the extent that they affect beta.
AACSB: Ethics
Blooms: Understand
12-77

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Chapter 12 - Risk, Return, and Capital Budgeting

True / False Questions

9. The security market line provides a standard for project rejection.

12. Beta measures a stock's sensitivity to market risks.

Multiple Choice Questions

31. What two elements are represented in security returns?

32. If a security plots below the security market line, it is:

33. In practice, the market portfolio is often represented by:

34. A stock's beta measures the:

35. In theory, the "market portfolio" should contain:

37. A stock with a beta greater than 1.0 would be termed:

48. A major benefit of investing in mutual funds is:

50. The average beta of individual stocks in the market portfolio:

53. The beta of an investment in U.S. Treasury bills is:

69. The slope of the security market line equals:

73. A stock's risk premium is equal to the:

74. Investing borrowed funds in a stock portfolio will:

76. Decreases in the risk-free rate will reduce:

94. A project is determined to have equal probability of generating $1 million annually or

105. The project cost of capital is:

108. What type of risk is properly reflected in a project's discount rate?

114. Discuss how betas are measured for individual stocks.

Chapter 12 Risk, Return, and Capital Budgeting Answer Key

True / False Questions

AACSB: Reflective Thinking

9. The security market line provides a standard for project rejection.

AACSB: Reflective Thinking

12. Beta measures a stock's sensitivity to market risks.

AACSB: Reflective Thinking

Multiple Choice Questions

31. What two elements are represented in security returns?

32. If a security plots below the security market line, it is:

33. In practice, the market portfolio is often represented by:

AACSB: Reflective Thinking

34. A stock's beta measures the:

35. In theory, the "market portfolio" should contain:

37. A stock with a beta greater than 1.0 would be termed:

AACSB: Reflective Thinking

AACSB: Reflective Thinking

Portfolio beta = (.25  0.9) + (.4  1.05) + (.35  1.73)

48. A major benefit of investing in mutual funds is:

New portfolio beta = (.333  .9) + (.333  1.1) + (.333  Beta C)

50. The average beta of individual stocks in the market portfolio:

53. The beta of an investment in U.S. Treasury bills is:

Expected return = 3% + 1.5(9) = 16.5%

Expected return = risk-free rate + beta  risk premium

Stock C risk premium = beta  market risk premium

Expected return = 6.0% + 1.5(9.0%) = 19.5%

Old: 18% = rf + 1.25(8%) = rf + 10.0%

Old: 18% = rf + 1.25(8%) = rf + 10.0%

r = rf + (rm - rf) = 6% + .8(14% - 6%) = 6% + 6.4% = 12.4%

Expected return on market = rf + market risk premium = 15.00%

69. The slope of the security market line equals:

Beta = (1.3  market) + (-1  loan) = (1.3  1) + 0 = 1.3

Beta = (2.0  market) + (-1  loan) = (2.0  1) + 0 = 2.0

73. A stock's risk premium is equal to the:

74. Investing borrowed funds in a stock portfolio will:

76. Decreases in the risk-free rate will reduce:

94. A project is determined to have equal probability of generating $1 million annually or