LOS e, (Part 1): Explain the components of an investor's required rate of return (i.e., the real risk-free rate, the expected rate of inflation, and a risk premium).

Q1. If the risk-free rate is 5 percent, the market rate is 12 percent, and the beta of a stock is 0.5, what would happen to the required rate of return if the inflation premium increased by 2 percent? It would:

A)   increase to 10.5.

B)   increase to 15.

C)   remain the same.

Q2. Which of the following statements concerning security valuation is least accurate? The:

A)   required rate of return for the dividend discount model is influenced by inflation.

B)   real risk-free rate is the nominal risk-free rate times the expected inflation rate.

C)   dividend discount model assumes that the required rate of return is greater than the growth rate of the company's dividend.

Q3. If the real risk-free rate is 5%, and the expected rate of inflation is 1%, what is the estimated nominal risk-free rate?

A)   0.02%.

B)   6.05%.

C)   4.00%.

Q4. If expected inflation increases, all else equal, the:

A)   nominal risk-free rate will decrease.

B)   real market risk premium will increase.

C)   nominal risk-free rate will increase.

Q5. The real risk-free rate is approximately equal to:

A)   the nominal risk-free rate minus expected inflation.

B)   the ratio of the nominal risk-free rate to the real expected market risk premium.

C)   the nominal risk-free rate plus expected inflation.

Q6. The nominal risk-free rate is a function of the real risk-free rate and:

A)   the nominal expected market risk premium.

B)   expected inflation.

C)   the real expected market risk premium.

Q7. The nominal risk-free rate is equal to:

A)   one plus the real risk-free rate times one plus expected inflation.

B)   one plus the real risk-free rate times one plus expected inflation, minus one.

C)   the real risk-free rate minus expected inflation.

Q8. Evidence that a firm has high business risk would be provided by its volatile:

A)   operating profit.

B)   fixed costs.

C)   sales.

LOS e, (Part 1): Explain the components of an investor's required rate of return (i.e., the real risk-free rate, the expected rate of inflation, and a risk premium).fficeffice" />

Q1. If the risk-free rate is 5 percent, the market rate is 12 percent, and the beta of a stock is 0.5, what would happen to the required rate of return if the inflation premium increased by 2 percent? It would:

A)   increase to 10.5.

B)   increase to 15.

C)   remain the same.

Correct answer is A)        

k₀ = 5 + 0.5(12 – 5) = 8.5; k₁ = 7 + 0.5(14 – 7) = 10.5

Q2. Which of the following statements concerning security valuation is least accurate? The:

A)   required rate of return for the dividend discount model is influenced by inflation.

B)   real risk-free rate is the nominal risk-free rate times the expected inflation rate.

C)   dividend discount model assumes that the required rate of return is greater than the growth rate of the company's dividend.

Correct answer is B)

The real risk-free rate equals (1 + nominal risk-free rate) / (1 + expected inflation rate) minus one.

Q3. If the real risk-free rate is 5%, and the expected rate of inflation is 1%, what is the estimated nominal risk-free rate?

A)   0.02%.

B)   6.05%.

C)   4.00%.

Correct answer is B)

The nominal risk free rate = (1 + Real risk-free rate)(1+ Expected Inflation) – 1, (1.05) x (1.01)-1 = 6.05%.

Q4. If expected inflation increases, all else equal, the:

A)   nominal risk-free rate will decrease.

B)   real market risk premium will increase.

C)   nominal risk-free rate will increase.

Correct answer is C)        

The nominal risk free rate is a function of the real risk-free rate and expected inflation:
Nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) – 1
If expected inflation increases, but the real risk-free rate stays the same, the nominal risk-free rate will increase.

Q5. The real risk-free rate is approximately equal to:

A)   the nominal risk-free rate minus expected inflation.

B)   the ratio of the nominal risk-free rate to the real expected market risk premium.

C)   the nominal risk-free rate plus expected inflation.

Correct answer is A)

The nominal risk free rate is a function of the real risk-free rate and expected inflation:
nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) – 1
@ real risk-free rate + expected inflation
Therefore the real risk-free rate is approximately equal to:
nominal risk-free rate – expected inflation.

Q6. The nominal risk-free rate is a function of the real risk-free rate and:

A)   the nominal expected market risk premium.

B)   expected inflation.

C)   the real expected market risk premium.

Correct answer is B)

The nominal risk-free rate is a function of the real risk-free rate and expected inflation:
nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) – 1

Q7. The nominal risk-free rate is equal to:

A)   one plus the real risk-free rate times one plus expected inflation.

B)   one plus the real risk-free rate times one plus expected inflation, minus one.

C)   the real risk-free rate minus expected inflation.

Correct answer is B)

The nominal risk-free rate is a function of the real risk-free rate and expected inflation:
nominal risk free rate = (1 + real risk-free rate)(1 + expected inflation) – 1
Note that the nominal rate is frequently estimated by summing the real rate and the rate of expected inflation.

Q8. Evidence that a firm has high business risk would be provided by its volatile:

A)   operating profit.

B)   fixed costs.

C)   sales.

Correct answer is A)

Business risk is one component of k, the required rate of return.

thanks la