Answer the questions below and show your calculation if the question requires: 2

Question

Answer the questions below and show your calculation if the question requires:

21. The risk free rate was 2% and the expected market return is 9%. Inflation of 2% takes place causing you to revise those values. A stock has a beta of 1.50. How id the return increase because of the inflation? a) 2% b) 4% c) 1% d) 1/2 %

22. A major company goes bankrupt causing investors to question whether other companies my go bankrupt. His fear is reflected in the security market line by the security market line: a) Shifting upward and parallel to the pre-fear security market line b) Shifting downward and parallel to the pre-fear security market line c) Rotating counter-clockwise from the pre-fear security market line d) Rotating clockwise from the pre-fear security market line

23. The premium for business risk does not exist in the capital asset pricing model because a) The capm world has no risky stocks b) Investors in the capm world hold very diversified portfolios c) Investors are all risk lovers

24. The return “k” estimated using the CAPM is 15% and the “k” estimated using the dividend model is 18%. The difference in K estimates is a) Error in calculations. They should be the same. b) The extra return because of market risk. c) The extra return because of business risk

Use for next two questions: K1 = D1/Price + g = 15% K2 = Rf + [ (ERm – Rf) x Beta] = 12%

25. You calculate return using the dividend model and get K1. While when you calculate return using the CAPM you get K2. Which is the correct explanation for the difference in values? a) Math error b) The difference in the values of K (15% - 12%) 3% is addition return for market risk c) The difference in the values of K (15% - 12%) 3% is addition return for business risk

26. Logically speaking which is most correct? a. K1 should always be equal to or greater than K2 b. K1 should always be equal to or smaller than K2 c. K1 should always be equal to K2

Explanation / Answer

1
return=riskfree+beta*(market-riskfree)=market*beta+riskfree*(1-beta)

So, if risk free rate changes by 1%, return would change by 1-beta=1-1.5=-0.5%
hence for inflaiton of 2%, return would change by 0.5%*2=1%

2
Rotating counter-clockwise from the pre-fear security market line d) Rotating clockwise from the pre-fear security market line

3
Investors in the capm world hold very diversified portfolios

4
The extra return because of business risk

5
The difference in the values of K (15% - 12%) 3% is addition return for business risk

6
K1 should always be equal to or greater than K2

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