Financial Reporting, Financial Statement Analysis and Valuation
8th Edition
ISBN: 9781285190907
Author: James M. Wahlen, Stephen P. Baginski, Mark Bradshaw
Publisher: Cengage Learning
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Textbook Question
Chapter 5, Problem 11QE
Market equity beta measures the covariability of a firm’s returns with all shares traded on the market (in excess of the risk-free interest rate). We refer to the degree of covariability as systematic risk. The market prices securities so that the expected returns should compensate the investor for the systematic risk of a particular stock. Stocks carrying a market equity beta of 1.20 should generate a higher return than stocks carrying a market equity beta of 0.90. Nonsystematic risk is any source of risk that does not affect the covariability of a firm’s returns with the market. Some writers refer to nonsystematic risk as firm-specific risk. Why is the characterization of nonsystematic risk as firm-specific risk a misnomer?
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The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below:
Required return on Stock = Risk-free return + (Market risk premium) (Stock's beta)
If a stock's expected return plots on or above the SML, then the stock's return is sufficient ✓to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return
is insufficient to compensate the investor for risk.
The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the
SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in
the composition of its assets and through changes in the…
The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below:
If a stock's expected return plots on or above the SML, then the stock's return is sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is insufficient to compensate the investor for risk.The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses.
Quantitative Problem: You are given the following…
1. Risk free rate represents:
a. The market rate of return
b. The rate provided by long term government securities
c. Beta
d. The rate provided by short term government securities
2. The market risk premium is measured by:
a. T-bill rate.
b. market return less risk-free rate.
c. beta.
d. standard deviation.
3. A stock with a beta of one would be expected to have a rate of return equal to
a. the market risk premium
b. the risk-free rate
c. the market rate of return
d. zero
Chapter 5 Solutions
Financial Reporting, Financial Statement Analysis and Valuation
Ch. 5 - Prob. 1QECh. 5 - Prob. 2QECh. 5 - A firm has experienced an increasing current ratio...Ch. 5 - A firm has experienced a decrease in its current...Ch. 5 - Prob. 5QECh. 5 - A firm had the following values for the four debt...Ch. 5 - Prob. 7QECh. 5 - Prob. 8QECh. 5 - Prob. 9QECh. 5 - Prob. 10QE
Ch. 5 - Market equity beta measures the covariability of a...Ch. 5 - Altmans bankruptcy risk model utilizes the values...Ch. 5 - Calculating and Interpreting Risk Ratios. Refer to...Ch. 5 - Refer to the financial state-ment data for...Ch. 5 - Refer to the profitability ratios of Coca-Cola in...Ch. 5 - Delta Air Lines, Inc., is one of the largest...Ch. 5 - Prob. 17PCCh. 5 - Prob. 18PCCh. 5 - Prob. 19PCCh. 5 - Prob. 20PCCh. 5 - Prob. 21PCCh. 5 - Prob. 22PCCh. 5 - Compute the values of each of the ratios in...
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- What is a characteristic line? How is this line used to estimate a stocks beta coefficient? Write out and explain the formula that relates total risk, market risk, and diversifiable risk.arrow_forwardCalculate the correlation coefficient between Blandy and the market. Use this and the previously calculated (or given) standard deviations of Blandy and the market to estimate Blandy’s beta. Does Blandy contribute more or less risk to a well-diversified portfolio than does the average stock? Use the SML to estimate Blandy’s required return.arrow_forwardThe SML shows the return needed given risk as measured by beta. And there are situations where a stock might be mispriced relative to CAPM. Given the relationship with the security mark line (SML), if a stock is properly priced relative to CAPM , where would it plot on the graph relative to the SML? A. on the Y-axis B. on the security market line C. below the security market line D. above the security market linearrow_forward
- 1arrow_forwardAssume that the CAPM assumptions hold. Consider the following statements:i. A stock with a beta below zero will tend to move in the same direction as the market but will tend to move less aggressively in that direction than the market does.ii. Alpha measures the additional risk we take on top of the risk of the market portfolio.arrow_forwardAccording to the Capital Asset Pricing Model (CAPM), risky stocks pay a risk premium based on their level of systematic risk. Thus, a risky stock should have a higher expected return than a risk-free security unless it has a zero or negative beta. True Falsearrow_forward
- a. Determine Stock X's beta coefficient. b. Determine the arithmetic average rates of return for Stock X and the NYSE over the period given. Calculate the standard deviations of returns for both Stock X and the NYSE. c. Assume that the required return on equity, re, for Stock X is equal to its average return. Likewise, assume that the market return is equal to the NYSE's average return. Using the information calculated, what is the assumed risk-free rate in the CAPM equation? Hint: Solve algebraically for rf in, re = r¡ + B(rm – r;)arrow_forwardOver time, the unexpected return on a company's stock is expected to equal Multiple Choice the company's average rate of return. the average return on the overall market. zero, the risk-free rate. the market risk premium.arrow_forwardWhen working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient of "the market," which is the same as the beta of an average stock. b. The beta coefficient, bi, of a relatively safe stock. c. The market risk premium (RPM). d. The most appropriate risk-free rate, rRF. e. The expected rate of return on the market, rM.arrow_forward
- Which of the following statements about 'beta' is correct? Is a measure of stand-alone risk. A low beta means that a stock is more volatile than the market Is a measure of a stock's volatility relative to the market. OA high beta means that a stock is less volatile than the marketarrow_forward1. Beta is positively related A. the degree of correlation between a stock's return and the market return B. the systematic risk of a stock C. risk premium required by the stock D. all of the abovearrow_forwardAccording to the capital asset pricing model (CAPM), fairly priced securities should have __________. Select one: a. A fair return based on the level of systematic risk. b. A beta of 1. c. A return equal to the market return. d. A fair return based on the level of unsystematic risk.arrow_forward
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