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Account Question - Answers

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Question 1
1.
Nile Foods' stock has a beta of 1.4, while Elbe Eateries' stock has a beta of 0.7. Assume that the
risk-free rate, r
RF
, is 5.5% and the market risk premium, (r
M
 r
RF
), equals 4%. Which of the
following statements is CORRECT?
Answer
Since Nile's beta is twice that of Elbe's, its required rate of return will also be twice that of
Elbe's.
If the risk-free rate increases but the market risk premium remains unchanged, the required
return will increase for both stocks but the increase will be larger for Nile since it has a
higher beta.
If the market risk premium increases but the risk-free rate remains unchanged, Nile's
required return will increase because it has a beta greater than 1.0 but Elbe's will decline
because it has a beta less than 1.0.
If the market risk premium decreases but the risk-free rate remains unchanged, Nile's
required return will decrease because it has a beta greater than 1.0 and Elbe's will also
decrease, and by more than Nile's because it has a beta less than 1.0.
If the risk-free rate increases while the market risk premium remains constant, then the
required return on an average stock will increase.
3 points
Question 2
1.
A stock is expected to pay a dividend of $1.00 at the end of the year (i.e., D
1
 $1.00), which is
expected to grow 25% in each of the following two years and at a constant rate of 6%, thereafter.
If the stock's required return is 11%, what is the stock's price today?
Answer
D
1
=$1.00
D
2
= D
1
(1 + g)
=$1.00(1.25)
=$1.25
D
3
= D
2
(1 + g)
=$1.25(1.25)
=$1.5625
D
4
= D
3
(1 + g)

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=$1.5625(1.06)
=$1.6525
P
3
= D
4
/(r
s
+ g
n
)
=$1.6525/0.11-0.06
=$33.125
P
0
= {1/(1.11)} + {1.25/(1.11
2
)} + ([33.125 + 1.5625]/(1.11)
3
}
=$27.28
$26.1
4
$27.2
8
$30.4
8
$32.7
1
$35.3
8
3 points
Question 3
1.
You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different
common stocks. The portfolio beta is equal to 1.15. You have decided to sell one of your stocks,
a lead mining stock whose b is equal to 1.0, for $5,000 net and to use the proceeds to buy $5,000
of stock in a steel company whose beta is equal to 2.0. What will be the new beta of the
portfolio?
Answer
b
p
= W
1
b
1
+ W
2
b
2
+ W
3
b
3
+ ……. W
n
b
n
let W
19
b
19
be sum of the other 19 stocks
1.15= W
19
b
19
+ (0.05 * 1.0)
W
19
b
19
= 1.10
b
p
= 1.10 + (0.05 * 2)
= 1.20
1.1
2
1.2

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0
1.2
2
1.1
0
1.1
5
3 points
Question 4
1.
Stock A has a beta  0.8, while Stock B has a beta  1.6. Which of the following statements is
CORRECT?
Answer
Stock B's required return is double that of Stock A's.
An equally weighted portfolio of Stock A and Stock B will have a beta less than 1.2.
If market participants become more risk averse, the required return on Stock A will increase
more than the required return for Stock B.
If market participants become more risk averse, the required return on Stock B will increase
more than the required return for Stock A.
If the risk-free rate increases but the market risk premium remains constant, the required
return on Stock A will increase by more than that on Stock B.
3 points
Question 5
1.
Stock A has a beta of 0.8 and Stock B has a beta of 1.2. Fifty percent of Portfolio P is invested in
Stock A and fifty percent is invested in Stock B. If the market risk premium (r
M
 r
RF
) were to
increase but the risk-free rate (r
RF
) remained constant, which of the following would occur?
Answer
The required return will decrease by the same amount for both Stock A and Stock B.
The required return will increase for both stocks but the increase will be greater for Stock B
than for Stock A.
The required return will increase for Stock A but will decrease for Stock B.
The required return will increase for Stock B but will decrease for Stock A.
The required return on Portfolio P will remain unchanged.

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Anonymous
Very useful material for studying!

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