Question 1

The value of zero for beta coefficient of the risk- free asset reflects not only its absence of risk but also the fact that the asset's return is unaffected by movements in the market return.

Accepted Answer

This statement is true as the beta coefficient measures the sensitivity of an asset's return to movements in the market return, and the risk-free asset has zero sensitivity as its return is not affected by market movements.

Question 2

The difference between the return on the market portfolio of assets and the risk- free rate of return represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets.

Accepted Answer

This statement is true. The difference between the return on the market portfolio of assets and the risk-free rate of return is known as the market risk premium, which compensates investors for the level of risk associated with holding a portfolio that reflects the overall market.

Question 3

What does beta measure?
A) The level of risk associated with a market segment
B) Covariance between returns on a particular share with the returns of the market as a whole
C) The positive variance between returns on a particular share with the returns of a segment of the market
D) Covariance between two shares

Accepted Answer

Beta measures the covariance between returns on a particular share with the returns of the market as a whole, indicating how much the share's returns are affected by movements in the overall market. It is commonly used as a measure of the level of systematic risk associated with an investment.

Question 4

Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of ordinary equity differs from the constant dividend growth valuation model in that it directly considers the firm's risk as reflected by beta.

Accepted Answer

The CAPM takes into account a firm's risk, as measured by beta, when calculating the cost of equity. In contrast, the constant dividend growth model does not directly consider a firm's risk, but instead relies on the assumption of a constant growth rate for dividends.

Question 5

The cost of ordinary equity for a firm would be 18% if the risk- free return is 5%, the market risk premium is 10%, and the firm's beta is 1.3.

Accepted Answer

The cost of ordinary equity can be calculated using the capital asset pricing model (CAPM) as:
Cost of Equity = Risk-Free Rate + Beta x Market Risk Premium
= 5% + 1.3 x 10%
= 18%

Therefore, the given statement is true.

Question 6

Using the Capital Asset Pricing Model (CAPM), the cost of ordinary equity is the return required by investors as compensation for the firm's nondiversifiable risk.

Accepted Answer

This is correct. The CAPM formula is used to calculate the cost of equity and takes into account the risk of the stock compared to the overall market.

Question 7

The security market line (SML) reflects the required return in the marketplace for each level of nondiversifiable risk (beta).

Accepted Answer

The security market line (SML) is a graphical representation of the relationship between expected return and systematic risk (measured by beta) for individual securities or portfolios. It shows the required return in the market as a function of the level of risk. Thus, the statement is true.

Question 8

The capital asset pricing model describes the relationship between the required return, or the cost of common stock equity capital, and the nonsystematic risk of the firm as measured by the beta coefficient.

Accepted Answer

The Capital Asset Pricing Model (CAPM) describes the relationship between the expected return of an investment and its systematic risk, not nonsystematic risk, as measured by the beta coefficient.

Question 9

The cost of ordinary equity for a firm would be 18% if the risk- free return is 5%, the market return is 10%, and the firm's beta is 1.3.

Accepted Answer

The cost of ordinary equity can be calculated using the Capital Asset Pricing Model (CAPM), which is given by the formula: Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the given values: Cost of Equity = 5% + 1.3 * (10% - 5%) = 5% + 1.3 * 5% = 5% + 6.5% = 11.5%. Therefore, the cost of ordinary equity would be 11.5%, not 18%.

Question 10

Which model would you be adopting if you used the formula E(ri) = rf + fi[E (rm)- rf) ?
A) Portfolio Expected Returns
B) Capital Asset Pricing
C) Security Market Line
D) Risk Removal by Diversification

Accepted Answer

The answer of Which model would you be adopting if...

Quiz 8: The Capital Asset Pricing Model and Multi-Factor Models