Economics of Enterprise Answers

3. Which of the following statements is CORRECT?

a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.
b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.
c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free.

2. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
A B
Price $25 $25
Expected growth (constant) 10% 5%
Required return 15% 15%

a. Stock A's expected dividend at t = 1 is only half that of Stock B.
b. Stock A has a higher dividend yield than Stock B.
c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A.
d. Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s.
e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.

1. Which of the following statements is CORRECT?

a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.
b. Two firms with the same expected dividend and growth rates must also have the same stock price.
c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant.
d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock’s dividend yield is also 5%.
e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

5. Which of the following statements is CORRECT?

a. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0. Thus, they would be equally risky from an investor's standpoint, assuming the investor's only asset is one or the other of the mutual funds.
b. If investors become more risk averse but rRF does not change, then the required rate of return on high-beta stocks will rise and the required return on low-beta stocks will decline, but the required return on an average-risk stock will not change.
c. An investor who holds just one stock will generally be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.
d. There is no reason to think that the sl

4. Which of the following statements is CORRECT?

a. When diversifiable risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market.
b. Portfolio diversification reduces the variability of returns on an individual stock.
c. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihoods of unfavorable events.
d. The SML relates a stock's required return to its market risk. The slope and intercept of this line cannot be controlled by the firms' managers, but managers can influence their firms' positions on the line by such actions as changing the firm's capital structure or the type of assets it employs.
e. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio.

3. Stock X has a beta of 0.7 and Stock Y has a beta of 1.3. The standard deviation of each stock's returns is 20%. The stocks' returns are independent of each other, i.e., the correlation coefficient, r, between them is zero. Portfolio P consists of 50% X and 50% Y. Given this information, which of the following statements is CORRECT? Explain.

a. Portfolio P has a standard deviation of 20%.
b. The required return on Portfolio P is equal to the market risk premium (rM − rRF).
c. Portfolio P has a beta of 0.7.
d. Portfolio P has a beta of 1.0 and a required return that is equal to the riskless rate, rRF.
e. Portfolio P has the same required return as the market (rM).

2. Jane has a portfolio of 20 average stocks, and Dick has a portfolio of 2 average stocks. Assuming the market is in equilibrium, which of the following statements is CORRECT? Explain.

a. Jane's portfolio will have less diversifiable risk and also less market risk than Dick's portfolio.
b. The required return on Jane's portfolio will be lower than that on Dick's portfolio because Jane's portfolio will have less total risk.
c. Dick's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than Jane's portfolio, but the required (and expected) returns will be the same on both portfolios.
d. If the two portfolios have the same beta, their required returns will be the same, but Jane's portfolio will have less market risk than Dick's.
e. The expected return on Jane's portfolio must be lower than the expected return on Dick's portfolio because Jane is more diversified.

1. Which of the following statements is CORRECT?

a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio.
b. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then according to the CAPM theory you should invest an equal amount of money in each stock in the market. That is, if there were 10,000 traded stocks in the world, the least risky possible portfolio would include some shares of each one.
c. If you formed a portfolio that consisted of all stocks with betas less than 1.0, which is about half of all stocks, the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, and that portfolio would have less risk than a portfolio that consisted of all stocks in the market.
d. Market risk can be eliminated by forming a large portfolio, and if some Treasury bonds are held

Cosmic Communications Inc. is planning two new issues of 25-year bonds. Bond Par will be sold at its $1,000 par value, and it will have a 10% semiannual coupon. Bond OID will be an Original Issue Discount bond, and it will also have a 25-year maturity and a $1,000 par value, but its semiannual coupon will be only 6.25%. If both bonds are to provide investors with the same effective yield, how many of the OID bonds must Cosmic issue to raise $3,000,000? Disregard flotation costs, and round your final answer up to a whole number of bonds.

a. 4,228
b. 4,337
c. 4,448
d. 4,562
e. 4,676

Which of the following statements is CORRECT?

a. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond.
b. A bond’s current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate.
c. If a bond sells at par, then its current yield will be less than its yield to maturity.
d. If a bond sells for less than par, then its yield to maturity is less than its coupon rate.
e. A discount bond’s price declines each year until it matures, when its value equals its par value.