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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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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, rRF, is 5.5% and the market risk premium, (rM???rRF), equals 4%. Which of the following statements is CORRECT? Answer Since Nile's beta is twice that of Elbe's, its required rate of return will also be twice that of Elbe's. If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta. If the market risk premium?increases?but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elbe's will decline because it has a beta less than 1.0. If the market risk premium?decreases?but the risk-free rate remains unchanged, Nile's required return will decrease becaus ...
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