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# Portfolio return, Stock return, Leverage

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Question 11: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stock is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

A Portfolio P's expected return is greater than the expected return on Stock B.

B Portfolio P's expected return is equal to the expected return on Stock A.

C Portfolio P's expected return is less than the expected return on Stock B.

D Portfolio P's expected return is equal to the expected return on Stock B.

E Portfolio P's expected return is greater than the expected return on Stock C.

Question 12: Ripken Iron Works believes the following probability distribution exists for its stock. What is the expected rate of return on the company's stock?

State of the Economy Probability of State occuring Stock's expected return
Boom 0.25 25%
Normal 0.5 15%
Recession 0.25 5%

A 5%

B 15%

C 22.5%

D 25%

E 0%

Question 13: Assume that in recent years both expected inflation and the market risk premium (rM - rRF) have declined. Assume also that all stocks have positive betas. Which of the following would be most likely to have occurred as a result of these changes?

A The required returns on all stocks have fallen, but the decline has been greater for stocks with lower betas.

B The required returns on all stocks have fallen, but the fall has been greater for stocks with higher betas.

C The average required return on the market, rM, has remained constant, but the required returns have fallen for stocks that have betas greater than 1.0.

D Required returns have increased for stocks with betas greater than 1.0 but have declined for stocks with betas less than 1.0.

E The required returns on all stocks have fallen by the same amount.

Question 14: Analysts who follow Howe Industries recently noted that, relative to the previous year, the company's operating net cash flow increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?

A The company cut its dividend.

B The company made a large investment in a profitable new plant.

C The company sold a division and received cash in return.

D The company issued new common stock.

Question 15: HD Corp. and LD Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD uses more debt than LD. Which of the following statements is CORRECT?

A Without more information, we cannot tell if HD or LD would have a higher or lower net income.

B HD would have the lower equity multiplier for use in the Du Pont equation.

C HD would have to pay more in income taxes.

D HD would have the lower net income as shown on the income statement.

E HD would have the higher net income as shown on the income statement.

#### Solution Preview

Question 11: Stock A has a beta of 0.8, Stock B has a beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has 1/3 of its value invested in each stock. Each stock has a standard deviation of 25%, and their returns are independent of one another, i.e., the correlation coefficients between each pair of stock is zero. Assuming the market is in equilibrium, which of the following statements is CORRECT?

A Portfolio P's expected return is greater than the expected return on Stock B.

B Portfolio P's expected return is equal to the expected return on Stock A.

C Portfolio P's expected return is less than the expected return on Stock B.

D Portfolio P's expected return is equal to the expected return on Stock B.

E Portfolio P's expected return is greater than the expected return on Stock C.

Answer: D) Portfolio P's expected return is equal to the expected return on Stock B.

Portfolio beta = 1/3 ( 0.8+ 1.0 + 1.2) = 1 = Beta for the market
There is no unique risk for the portfolio as the correlation coefficients between each pair of stock is zero.
Expected return for stocks / portfolios with the same beta is equal.
Beta for Stock B = Beta for Portfolio = Beta for Market =1
Therefore they all have the same expected ...

#### Solution Summary

5 multiple choice questions on portfolio expected return, expected rate of return on the company's stock, effect of changes in inflation and market risk premium on return on stocks, operating net cash, leverage have been answered.

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