# EBF 401 EBF401 Midterm 2 with Answers

EBF 401 EBF401 Midterm 2 Answers (VERSION 2) (Penn State University)

**Multiple-choice questions (2 points each).**

1. A portfolio contains equal investments in 10 stocks. Five have a beta of 1.2. The remainder have a beta of 1.4. What is the portfolio beta?

a. 1.3;

b. Greater than 1.4 because the portfolio is not completely diversified;

c. Less than 1.2 because diversification reduces beta;

d. 1.2;

e. 1.4.

2. Based on the period 1926-2011, ____ have tended to outperform other securities over the long term:

a. U.S. Treasury bills;

b. Long-term government bonds;

c. Small company stocks;

d. Large company stocks;

e. Long-term corporate bonds.

3. Which of the following statements concerning the standard deviation are correct?

I. The greater the standard deviation, the lower the risk;

II. The standard deviation is a measure of volatility;

III. The higher the standard deviation, the less certain the rate of return in any given year;

IIII. The higher the standard deviation, the higher the expected return.

a. I and III only;

b. II, III and IV only;

c. I, III and IV only;

d. I, II and III only;

e. I, II, III and IV.

4. A year ago, you purchased 300 shares of ABC Co. at a price of $9.03 per share. The stock pays an annual dividend of $0.10 per share. Today, you sold all of your shares for $28.14 per share. What is your total dollar return on this investment?

a. $5,703;

b. $5,733;

c. $5,753;

d. $5,763;

e. $5,853.

5. The realized (or historical) returns on your portfolio over the last 5 years were -5%, 20%, 0%, 10% and 5%. What is the standard deviation of your return?

a. 2.74%;

b. 8.60%;

c. 9.62%;

d. 10.12%;

e. 12.70%.

6. When computing the expected return on a portfolio of stocks the portfolio weights are based on the:

a. Number of shares owned in each stock;

b. Price per share of each stock;

c. Market value of the total shares held in each stock;

d. Original amount invested in each stock;

e. Cost per share of each stock held.

7. The beta of a risky asset measures its ____ risk:

a. Total;

b. Nondiversifiable;

c. Unsystematic;

d. Systematic;

e. Economic.

8. Which one of the following is an example of unsystematic risk?

a. The inflation rate increases unexpectedly;

b. The federal government lowers income taxes;

c. An oil tanker goes around and spills its cargo;

d. Interest rates decline by 1%;

e. The GDP rises by 2% more than anticipated.

9. Which one of the following would indicate a portfolio is being effectively diversified?

a. An increase in the portfolio beta;

b. A decrease in the portfolio beta;

c. An increase in the portfolio rate of return;

d. An increase in the portfolio standard deviation;

e. A decrease in the portfolio standard deviation.

10. The intercept point of the security market line is the rate of return which corresponds to:

a. The risk-free rate of return;

b. The market rate of return;

c. The market risk premium;

d. The risk premium for an individual security;

e. The beta of the market.

**Short questions**

**Please answer 2 questions worth 5 points.**

11. We typically assume that investors are risk-averse return seekers: that is, they like returns and dislike risk. If so, why do we contend that only systematic risk and not total risk is important? Explain.

12. Explain in words what beta is and why it is important. Write down the formula for the beta of asset A with respect to the market M.

13. Assume you would like to estimate the expected rate of return for a project—that is, the project’s cost of capital—according to the CAPM. What inputs would you need?

**Please answer 2 questions worth 10 points.**

14. How do we convert from incremental earnings to Free Cash Flow?

(10 points)

15. What relation is described by the security market line?

16. In a risk-neutral world, the promised rate of return is the sum of two components. Write down the formula for the promised rate of return and briefly explain each component.

**Problems**

**Please answer 1 question worth 20 points.**

17. A portfolio that combines the risk-free asset and the market portfolio has an expected return of 7% and a standard deviation of 10%. The risk-free rate is 4% and the expected return on the market portfolio is 12%. Assume that CAPM holds. What expected rate of return would a security earn if it had a 0.45 correlation with the market portfolio and a standard deviation of 55%?

**Please answer 3 questions worth 10 points.**

19. A portfolio is made up of 65% of stock 1 and 35% of stock 2. Stock 1 has a variance of .10, and stock 2 has a variance of .045. The covariance between the stocks is -.001. Calculate both the variance and the standard deviation of the portfolio.