# EBF 401 EBF401 Midterm 2 with Answers (Penn State University)

EBF 401 EBF401 Midterm 2 Answers (Penn State University)

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

1. Which one of the following types of securities has tended to produce the lowest rate of return for the period 1926-2011:

a. U.S. Treasury bills;

b. Long-term government bonds;

c. Small company stocks;

d. Large company stocks;

e. Long-term corporate bonds.

2. The market risk premium is computed by:

a. Subtracting the expected return on security i from the expected return on the market;

b. Subtracting the expected return on the market from the return on the U.S. Treasury bill;

c. Subtracting the return on the U.S. Treasury bill from the expected return on the market;

d. Adding the return on the U.S. Treasury bill to the expected return on the market;

e. Adding the expected return on security i to the expected return on the market.

3. Which of the following statements are correct concerning the variance of the annual returns on an investment?

I. The larger the variance, the more the actual returns tend to differ from the average return;

II. The larger the variance, the larger the standard deviation;

III. The larger the variance, the greater the risk of the investment;

IIII. The larger the variance, 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. Six months ago, you purchased 100 shares of stock in ABC Co. at a price of $43.89 a share. ABC stock pays a quarterly dividend of $0.10 per share. Today, you sold all of your shares for $45.13 per share. What is the total amount of your capital gains on this investment?

a. $1.24;

b. $1.64;

c. $40;

d. $124;

e. $164.

5. You have a sample of returns observations for the Malta Stock Fund. The four returns are 7.25%, 5.6%, 12.5%, 1%. What is the variance of these returns?

a. 16.9;

b. 22.5;

c. 4.75;

d. 67.6;

e. None of these.

6. The characteristic line is graphically depicted as:

a. The plot of the relationship between beta and expected return;

b. The plot of the returns of the security against the beta;

c. The plot of the security returns against the market returns;

d. The plot of the beta against the market returns;

e. None of these.

7. Standard deviation measures ____ risk:

a. Total;

b. Nondiversifiable;

c. Unsystematic;

d. Systematic;

e. Economic.

8. If a two stock portfolio is well diversified, then the portfolio standard deviation:

a. Will equal the standard deviation of the most volatile stock in the portfolio;

b. Will be lower than the weighted average of the standard deviations of the two securities;

c. Will be higher than the weighted average of the standard deviations of the two securities;

d. Will be equal to the weighted average of the standard deviations of the two securities;

e. Will be equal to the arithmetic average of the standard deviations of the two securities.

9. The systematic risk of the market is measured by:

a. A beta of 1;

b. A beta of 0;

c. A standard deviation of 1;

d. A standard deviation of 0;

e. A variance of 1.

10. Unsystematic risk:

a. Can be reduced through portfolio diversification;

b. Is compensated for by the risk premium;

c. Is measured by beta;

d. Cannot be avoided if you wish to participate in the financial markets;

e. Is related to the overall economy.

**Short questions**

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

11. Explain the difference between systematic and unsystematic risk, and give an example of each.

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. How do we use the CAPM for capital budgeting? Explain.

14. Define the depreciation tax shield and explain why accounting for it is important when calculating free cash flow. Give an example (assuming that capital expenditures and net working capital are equal to zero).

15. According to the CAPM, the expected return on a risky asset depends on three components. Write down the CAPM formula and briefly explain each component.

16. In a risk-averse world, the promised rate of return is the sum of three 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. The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. The corporate tax rate is 40%. All net working capital is recovered at the end of the project.

18. The Treasury bill rate is 4% and the expected return on the market portfolio is 12%. Using the Capital Asset Pricing Model:

a. Draw a graph showing how the expected return varies with beta.

b. What is the market risk premium?

c. What is the required return on an investment with a beta of 1.5?

d. If the market expects a return of 11.2% from stock X, what is its beta?

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

19. A portfolio is made up of 75% of stock 1 and 25% of stock 2. Stock 1 has a variance of .08, and stock 2 has a variance of .035. The covariance between the stocks is -.001. Calculate both the variance and the standard deviation of the portfolio.

20. Given $100,000 to invest, consider the four stocks listed below.

a. What is the value of the portfolio of the four stocks?

b. What are the market portfolio weights?

21. You would like to combine a risky stock with a beta of 1.8 with U.S. Treasury bills in such a way that the risk level of the portfolio is equivalent to the risk level of the overall market. What percentage of the portfolio should be invested in U.S. Treasury bills?