Question

6. A stock has a beta of 1.26 and the risk-free rate is 3.6, and today’s market risk premium is 8.89 percent. Based on the above, what is the expected return of the stock?

		8.89 percent
		14.8 percent
		13.47 percent
		12.62 percent

11. Which of the following stocks has the greatest total risk?

	Standard Deviation	Beta
Stock A	62 %	1.10
Stock B	47 %	1.05
Stock C	53 %	1.30
Stock D	59 %	0.90

		Stock A
		Stock B
		Stock C
		Stock D

15, The Victoria Company has an optimal capital structure of 40% debt and 60% equity. Additions to retained earnings for the forthcoming year are estimated at $12 million. How large can the capital budget be before common stock must be sold?

		$20.0 million
		$4.8 million
		$8.2 million
		$12.0 million

Answer 1

6. Answer is Option 2

This is an application of CAPM, the mathematical representation of which is:

Expected (or Required return) on stock = Risk free rate + Beta * Market Risk Premium

Substituting the values based upon our question,

Expected Return on stock = 3.6% + (1.26 * 8.89%)

Expected Return on Stock = 3.6% + 11.214%

Expected Return = 14.8%

11. Answer is Option A

Total risk of the stock is designated by Standard deviation of stock. Beta signifies only systematic or un-diversifiable risk. Hence, higher the standard deviation, higher is the total risk.

For our question, it is highest in stock A. Hence that is our answer.

15. Answer is Option A

As per the question, retained earnings are expected to be $12 mi. And the company has a capital structure with 40% debt and 60% equity.

Company is expected to maintain its capital structure for new project as well, to avoid change in optimal capital structure of company.

So, maximum, without issuance of new stock, that company can pay for a project would be 100% of the retained earnings, which is $12 mil.

This means 60% of capital (which is equity) = $12 mil.

Hence 100% of capital (=60% equity + 40% debt) = (100 * 12)/60 = $20 mil. Hence the answer.