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Assume N securities. The expected returns on all the securities are equal to 0.01 and the variances of their returns are all equal to 0.01. The covariances of the returns between two securities are all equal to 0.005.

i.What are the expected return and the variance of the return on an equally weighted portfolio of all N securities? Please, note that the variance is presented by the formula, which depends on N.

ii.What value will the variance approach as N gets large?

iii.From parts (i) and (ii): Can you conclude what characteristic of the securities is most important when determining the variance of a well-diversified portfolio?

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Beverley Smith
Beverley SmithLv2
28 Sep 2019

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Assume N securities. The expected returns on all the securities are equal to 0.01 and the variances of their returns are all equal to 0.01. The covariances of the returns between two securities are all equal to 0.005.

1.What are the expected return and the variance of the return on an equally weighted portfolio of all N securities?

2.What value will the variance approach as N gets large?

3.What characteristic of the securities is most important when determining the variance of a well-diversified portfolio?

5. Assume N securities. The expected returns on all the securities are equal to 0.01 and the variances of their returns are all equal to 0.01. The covariances of the returns between two securities are all equal to 0.005. i. What are the expected return and the variance of the return on an equally weighted portfolio of all N securities? Please, note that the variance is presented by the formula, which depends on N.

Which of the following risks cannot be diversified away?

A.

risk of a local natural disaster affecting company production

B.

risk created by world political happenings

C.

risk of losing a major contract

E.

risk of a failed marketing campaign

Magee Company's stock has a beta of 1.20, the risk-free rate is 4.50%, and the market risk premium is 5.00%. What is Magee's required return?

A.

10.25%

B.

10.50%

D.

11.00%

E.

11.25%

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)

A.

When held in isolation, Stock A has more risk than Stock B.

C.

Stock A would be a more desirable addition to a portfolio than Stock B.

D.

The required return on Stock A will be greater than that on Stock B.

E.

The required return on Stock B will be greater than that on Stock A.

Which of the following statements is CORRECT?

B.

Portfolio diversification reduces the variability of returns on an individual stock.

C.

The smaller standard deviation is, the less likely that actual returns will be closer to expected returns, the lower the investment risk.

D.

A stock with a beta of 1 is more risky than an average stock on the market.

E.

A well-diversified investor will require to earn higher return on stocks with higher beta.

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? (WACC is the weighted average cost of capital, the financing rate, or discount rate)

A.

The project’s IRR increases as the WACC declines.

B.

The project’s NPV increases as the WACC declines.

D.

The project’s IRR decreases as the WACC declines.

E.

none of the above is correct.

Burlees Inc.’s CFO has collected the following information to calculate its WACC:

• The company’s capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The company’s common stock has a beta of 2.

The company’s tax rate is 40%.

What is the company’s cost of common equity?

A.

9.65%

B.

13.00%

D.

17.60%

E.

18.91%

Burlees Inc.’s CFO has collected the following information to calculate its WACC:

• The company’s capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The company’s common stock has a beta of 2.

The company’s tax rate is 40%.

What is the company’s weighted average cost of capital (WACC)?

A.

8.69%

B.

9.21%

D.

11.04%

E.

12.51%

Which of the following statement is correct?

A.

Higher flotation costs tend to reduce the cost of equity capital.

C.

The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.

D.

A higher risk project’s WACC should be adjusted higher.

E.

Retained earnings bear no capital cost at all.

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