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Unformatted text preview: End of Chapter 5 Questions, Problems and Solutions CORPORATE FINANCE Professor Megginson Spring Semester 2003 Questions [See problems in book] *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** Answers to End of Chapter 5 Questions 5.1. Investors are more concerned with real returns because they want to ensure that their purchasing power at least remains the same, and preferably increases. 5.2. Managers must also be concerned with risk because they want to ensure that they are being adequately rewarded for the level of risk they are taking. 5.3. Risk premium refers to the amount of reward investors demand above the risk free rate in order to invest in risky assts. If riskier assets did not offer a premium risk-averse investors would not invest in them. 5.4. A risk averse person, given the choice between two investments with the same return will always chose the investment with the least risk. Similarly, given the choice of two investments with the same return, a risk averse investor will always choose the investment with the least risk. A risk- neutral investor will invest in risky securities even if they offer only a small risk premium. 5.5. Risk averse investors will buy insurance because they are willing to pay to avoid the possibility of a loss. Risk-neutral investors dont care about risk. Since there is no risk premium involved with insurance instead there is a cost risk neutral investors will not invest in insurance. 5.6. Arithmetic returns are always smaller than geometric returns. Geometric returns assume interest is compounded over the time period. Since there is a positive interest rate and compounding, most investors will be interested in geometric means. 5.7. The investor has not held the bond until maturity. The investors return depends on what the yield on comparable bonds is a year later when he sells the bond. The interest rate may be higher in which case the price will be lower and the investor has a capital loss, or it may be lower, in which case the price will be higher and the investor will have a capital gain. 5.8. Total risk is measured by standard deviation or variance, while market risk is measured by beta. Market risk is relevant risk, the only risk that is priced into a security. 5.9. In the long-run stocks return more than other investments. If an investor can hold on to stocks for a long enough time, eventually they will earn a fair return for the risk. The problem is that sometimes investors need money from their stocks in a down market and cant wait for their portfolio values to recover. 5.10. If two stocks are negatively correlated, then if Stock A increases in value by 10% then Stock B will decrease in value by 10%....
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