CHAPTER 12

Question 1

If investors have homogeneous expectations, then each investor will identify the
same portfolio as having the highest Sharpe ratio in the economy.

Answer 1

YES

Question 2

There are many investors in the world, and each must have identical estimates of
the volatilities, correlations, and expected returns of the available securities.

Answer 2

NO

Question 3

Homogeneous expectations are when all investors have the same estimates
concerning future investments and returns.

Answer 3

YES

Question 4

The combined portfolio of risky securities of all investors must equal the efficient
portfolio.

Answer 4

YES

Question 5

Market capitalization is the total market value of the outstanding shares of a
firm.

Answer 5

YES

Question 6

Because the market portfolio is defined as the total supply of securities, the
proportions should correspond exactly to the proportion of the total market that
each security represents.

Answer 6

YES

Question 7

The market portfolio contains more of the smallest stocks and less of the larger
stocks.

Answer 7

NO

Question 8

For the market portfolio, the investment in each security is proportional to its
market capitalization.

Answer 8

YES

Question 9

The Dow Jones Industrial Average (DJIA) consists of a portfolio of 30 large
industrial stocks.

Answer 9

YES

Question 10

The most familiar stock index in the United States is the Dow Jones Industrial
Average (DJIA).

Answer 10

YES

Question 11

The Dow Jones Industrial Average (DJIA) is a price-weighted portfolio.

Answer 11

YES

Question 12

A portfolio in which each security is held in proportion to its market
capitalization is called a price-weighted portfolio.

Answer 12

NO

Question 13

A portfolio in which each security is held in proportion to its market
capitalization is called a value-weighted portfolio.

Answer 13

YES

Question 14

The S&P 500 is an equal-weighted portfolio of 500 of the largest U.S. stocks.

Answer 14

NO

Question 15

The S&P 500 is a value-weighted portfolio of 500 of the largest U.S. stocks.

Answer 15

YES

Question 16

Even though the S&P 500 includes only 500 of the more than 7,000 individual U.S. Stocks in existence, it represents more than 70% of the U.S. stock market in terms of market capitalization.

Answer 16

YES

Question 17

A market index reports the value of a particular portfolio of securities.

Answer 17

YES

Question 18

The S&P 500 is the standard portfolio used to represent “the market” when using
the CAPM in practice.

Answer 18

YES

Question 19

One factor that can affect the market risk of a project is its degree of operating leverage, which is the relative proportion of operating assets versus equity.

Answer 19

NO

Question 20

One factor that can affect the market risk of a project is its degree of operating leverage, which is the relative proportion of operating assets versus non-operating assets.

Answer 20

NO

Question 21

One factor that can affect the market risk of a project is its degree of operating leverage, which is the relative proportion of operating expenses versus non-operating expenses.

Answer 21

NO

Question 22

One factor that can affect the market risk of a project is its degree of operating leverage, which is the relative proportion of fixed versus variable costs.

Answer 22

YES

Question 23

The difference between the weighted-average cost of capital (WACC) and the pre-tax (unlevered) WACC is the weighted-average cost of capital multiplies the cost of debt by (1-tax rate) and the pre-tax WACC does not.

Answer 23

YES

Question 24

The difference between the weighted-average cost of capital (WACC) and the pre-tax (unlevered) WACC is the weighted-average cost of capital is based on the after-tax cost of equity and the pre-tax WACC is based on the after-tax cost of debt.

Answer 24

NO

Question 25

The difference between the weighted-average cost of capital (WACC) and the pre-tax (unlevered) WACC is the weighted-average cost of capital multiplies the component costs of equity and debt by their weight in the capital structure, and the pre-tax WACC does not.

Answer 25

NO

Question 26

The difference between the weighted-average cost of capital (WACC) and the pre-tax (unlevered) WACC is the weighted-average cost of capital multiplies the cost of equity and the cost of debt by (1-tax rate) and the pre-tax WACC does not.

Answer 26

NO

Question 27

A difficulty with regards to the CAPM is that investors risk preferences are not observed.

Answer 27

NO

Question 28

A difficulty with regards to the CAPM is that Betas are not observed.

Answer 28

YES

Question 29

A difficulty with regards to the CAPM is that expected returns are not observed.

Answer 29

YES

Question 30

A difficulty with regards to the CAPM is that the market proxy is not correct.

Answer 30

YES

Question 31

If we use too short a time horizon when estimating beta, our estimate of beta will be unreliable.

Answer 31

YES

Question 32

When estimating beta by using past returns it is best to use the longest time horizon of returns available.

Answer 32

NO

Question 33

Many practitioners prefer to use average industry betas rather than individual stock betas.

Answer 33

YES

Question 34

The CAPM predicts that a security's expected return depends on its beta with regard to the market portfolio of all risky investments available to investors.

Answer 34

YES

Question 35

If we use very old data to when estimating beta, they data may be unrepresentative of the current market risk of the security.

Answer 35

YES

Question 36

There may be reasons to exclude certain historical data as anomalous when estimating beta.

Answer 36

YES

Question 37

The beta estimated we obtain from linear regression can be very sensitive to outliers, which are returns of unusually small magnitude.

Answer 37

NO

Question 38

Many practitioners use adjusted betas, which are calculated by averaging the estimated beta with 1.0.

Answer 38

YES

Question 39

The risk-free interest rate is generally determined using the yields of U.S. Treasury securities, which are free from default risk.

Answer 39

YES

Question 40

To determine the risk premium for a stock using the security market line, we need an estimate of the market risk premium.

Answer 40

YES

Question 41

The CAPM states that we should use the risk-free interest rate corresponding to the investment horizon of the firm's investors.

Answer 41

YES

Question 42

When surveyed, the vast majority of large firms and financial analysts reported using the yields of Treasury Bills to determine the risk-free rate.

Answer 42

NO

Question 43

The imperfections in the CAPM may be critical in the context of capital budgeting and corporate finance, where errors in estimating the cost of capital are likely to be far more important than small discrepancies in the project cash flows.

Answer 43

NO

Question 44

The highest beta stocks have tended to under perform what the CAPM predicts.

Answer 44

YES

Question 45

To estimate the expected market risk premium we can look at the historical average excess return of the market over the risk free interest rate.

Answer 45

YES

Question 46

Given an assessment of an index's future cash flows, we can estimate the expected return of the market by solving for the discount rate that is consistent with the current level of the index.

Answer 46

YES