CHAPTER 12 - RISK, RETURN AND CAPITAL BUDGETING QUESTIONS WITH CORRECT ANSWERS, Exams of Nursing

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CHAPTER 12 - RISK, RETURN AND CAPITAL BUDGETING

QUESTIONS WITH CORRECT ANSWERS

market portfolio CORRECT ANSWER portfolio of all assets in the economy - broad stock market index is used to represent the market we can assess the impact of macro news by tracking market portfolio CORRECT ANSWER beta CORRECT ANSWER sensitivity of a stock's return to the return on the market portfolio the sensitivity of the investment's returns to fluctuations in the market aggressive stocks have high betas - greater than 1...their returns tend to respond more than one for one to returns on the overall market - the betas of defensive stocks are less than 1 CORRECT ANSWER the average beta of all stocks is 1 CORRECT ANSWER we can break down common stock returns into two parts - the part explained by market returns and the part due to news that is specific to that firm - fluctuations in the first part reflect market risk - the second is specific risk CORRECT ANSWER some of the most variable stocks have below average betas and vice versa - uh what pg 362 CORRECT ANSWER total risk is not the same as market risk basically think of a mining company with a lot of risks - gold and other worldwide prices - variance in ore grade... they have high firm specific volatility but a low beta - because these variables do not depend on how the market does - like if the economy is in a boom gold is just as likely to be down as it is up - and beta is just how much it changes with a change in the market performance - this makes sense - if not read page 362 CORRECT ANSWER firm specific risk is of no concern to an investor CORRECT ANSWER portfolio beta = CORRECT ANSWER sum of - fraction of portfolio in stock X beta of stock market risk premium CORRECT ANSWER difference between market return and return on risk free treasury bills - has been 7.6 over the last century = Rm(expected market return) - Rf(treasury rate) total risk CORRECT ANSWER standard deviation

sd = CORRECT ANSWER beta times sd of market risk premium = CORRECT ANSWER beta (expected market return - treasury bill rate) total expected return = CORRECT ANSWER risk free rate (treasury) + risk premium CAPM - capital asset pricing model CORRECT ANSWER the expected rate of return demanded by investors depends on two things - 1. compensation for TVM and 2. a risk premium which depends on beta and market risk premium r = rf(risk free rate) + beta X (expected market return - risk free rate) security market line CORRECT ANSWER relationship between expected return and beta you can obtain any combination of risk and expected return - this graph shows you this graphical representation of the CAPM equation the security market line describes the expected returns and risks from splitting your overall portfolio between risk free securities and the market - setting a standard for other investments - investors will be willing to hold other securities only if they offer equally good prospectus so the required risk premium for any investment is given by the security market line = CORRECT ANSWER beta X expected market risk premium risk premium on investment = CORRECT ANSWER beta X expected market risk premium discount rate for valuing a proposed capital investment project is the OCC - the expected rate of return the shareholders could achieve investing on their own CORRECT ANSWER project cost of capital CORRECT ANSWER minimum acceptable expected rate of return on a project given its risk if the CAPM holds, the security market line defines the opportunity cost of capital. A project's expected rate of return plots above the security market line, then it offers a higher expected rate of return than investors could get on their own at the SAME BETA CORRECT ANSWER company cost of capital CORRECT ANSWER depends on the average risk of all investments opportunity cost of capital for investment in the firm as a whole - the company cost of capital is the appropriate discount rate for an average risk investment project undertaken by the firm

high fixed costs CORRECT ANSWER high beta be a small change in revenue can seriously change earnings cyclical businesses CORRECT ANSWER revenues and earnings are strongly dependent on the state of the economy - high beta and high cost of capital businesses that produce essentials CORRECT ANSWER less effected by state economy low beta and low cost of capital expected cash flow forecasts should already reflect the probabilities of all possible outcomes - good and bad - if the CF forecasts are prepared properly - the discount rate should reflect only the market risk of the project - it should not be fudged to offset errors in the CF forecast CORRECT ANSWER