Chapter 5 Assessment

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the dividend yield in fiscal year 2017?

1.79% Dividend yield = 0.55/30.75 = 1.79%

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the percentage change in the share price in fiscal year 2017?

1.79% Percentage change in share price = (34.88 − 30.75)/30.75 = 4.13/30.75 = 13.43%.

You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000. The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. What holding period return, measured in yen, did you earn on the bond?

13% The holding period return in yen was (3% × 100,000 + 10,000)/100,000 = 13%.

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What rate of return did the common stockholders earn in fiscal year 2017?

15.22%

You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000. The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥97 at year-end. What holding period return, measured in U.S. dollars, did you earn on the bond?

16.49% You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income and a yen bond worth a total of $1,164.95 (¥113,000/97). The U.S. dollar holding period return would be ($1,164.95 − $1,000)/$1,000 = 16.49%.

Chapter 5 presents evidence that the average annual rate of return on common stocks over many years has exceeded the return on government bonds in the United States, while returns on common stocks have also exhibited more volatility than returns on U.S. government bonds. Suppose that last year, the realized rate of return on government bonds exceeded the return on common stocks. Your colleague suggests that "last year shows us that investors are now willing to settle for lower returns on stocks than on bonds." How would you interpret this result?

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Himmel Corp. wants to raise $100 million in a new stock issue. Its investment banker indicates that the sale of new stock will require 12 percent underpricing and a 7 percent spread. a. Assuming Himmel's stock price does not change from its current price of $50 per share, how many shares must the company sell and at what price to the public? b. How much money will the investment banking syndicate earn on the sale? c. Is the 12 percent underpricing a cash flow? Is it a cost? If so, to whom?

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In March, with the spot price of wheat at $5.75 per bushel, Hollywood Bakery longs 100 July wheat futures contracts (5,000 bushels each) on the CBOE at a futures price of $5.90 per bushel. In June, Hollywood Bakery closes out its futures contracts when the futures price is $5.80 per bushel. What is Hollywood Bakery's gain (or loss) on the futures contracts?

A loss of $50,000

The price of a call option tends to be lower when which of the following is higher (all else equal)?

the strike price

After issue, the market price of a fixed-rate bond can differ substantially from its par value.

true

In a strong-form efficient market, insider trading is not profitable.

true

Investment-grade bonds are usually defined as bonds with ratings of BBB- or higher.

true

Suppose you purchase a call option on XYZ stock when the stock price is $81. The option premium is $3, and the strike price is $85. What is your net profit on the call option if the stock price is $89 at maturity?

$1 The gain on the call is 89 − 85 = $4; less the option premium of $3 gives a net profit of $1.

A $1,000 par value bond with a fixed 10% rate of interest pays coupons semiannually. What amount will the bondholder receive on the bond's maturity date?

$1,050

What would be the carried interest (at 20%) on a private equity portfolio with an initial value of $500 million that was subsequently liquidated for $750 million?

$50 million

Suppose you purchase a put option on XYZ stock when the stock price is $40. The option premium is $2, and the strike price is $39. What is your net profit on the put option if the stock price is $41 at maturity?

-$2 The put option is out of the money at maturity, so the net profit is −$2.

You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000. The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What holding period return, measured in U.S. dollars, did you earn on the bond?

-7.38% You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income and a yen bond worth a total of $926.23 (¥113,000/122). Your dollar return was ($926.23 − $1,000)/$1,000 = −7.38 percent.

What type of financial instrument is depicted in the position diagram shown below?

Call option

Which one of the following accurately orders the rate of return on financial securities from highest to lowest over most of recorded market history (the 1928-2016 period)?

Common stocks, long-term corporate bonds, long-term government bonds, short-term government bills

Which of the following statements regarding junk bonds is true?

not right: Junk bonds typically offer lower yields to maturity than investment-grade bonds., Junk bonds offer no coupon payments to investors.

Which one of the following statements is true?

Historically, common shareholders have earned a risk premium as compensation for risk borne in excess of government bonds.

Which of the following statements related to market efficiency tend to be supported by current evidence? I. Markets tend to respond quickly to new information. II. It is difficult for the typical investor to earn above-average returns without taking above-average risks. III. Short-run prices are difficult to predict accurately based on public information. IV. Markets are most likely strong-form efficient.

I, II, and III only

Which of the following are the most likely reasons for why a stock price might not react at all on the day that new information related to the stock issuer is released? I. Insiders knew the information prior to the announcement. II. Investors need time to digest the information prior to reacting. III. The information has no bearing on the value of the firm. IV. The information was anticipated.

III and IV only

ABC Corp. has an outstanding debt of $50 million on which it pays a 4 percent fixed interest rate annually. ABC just made its annual interest payment and has three years remaining until maturity. ABC wants to swap its fixed rate payments for floating rate payments. A bank offers ABC a three-year interest rate swap with annual payments in which ABC will pay LIBOR, currently at 4.2 percent, and receive a 3.8 percent fixed rate on $50 million notional principal. Suppose that LIBOR turns out to be 4.3 percent in one year, 4.4 percent in two years, and 4.5 percent in three years. Including interest payments on ABC's outstanding debt and payments on the swap, what will be ABC's net interest payments for the next three years?

Net payment year 1: -2,200,000 Net payment year 2: -2,250,000 Net payment year 3: -2,300,000 The table below shows ABC's net interest payments for years 1 through 3. Negative signs indicate cash flows paid by ABC and positive signs indicate cash flows received by ABC, all in dollars. YearLIBOROutstanding debt paymentFixed leg of swapFloating leg of swapNet payment04.2%14.3%-2,000,0001,900,000-2,100,000-2,200,00024.4%-2,000,0001,900,000-2,150,000-2,250,0003-2,000,0001,900,000-2,200,000-2,300,000

Which of the following statements regarding preferred stock is true?

not right: Preferred stock dividend payments are a deductible expense for corporate tax purposes.

If the stock market in the United States is efficient, how do you explain the fact that some people make very high returns? Would it be more difficult to reconcile very high returns with efficient markets if the same people made extraordinary returns year after year?

Some people make high returns because they invest enough to see the high returns. These same people likely also experience significant losses. High intelligence, extreme emotional discipline, and driven dedication do enable some people to earn superior market returns. They are investing enough to see significant returns consistently. Earning high returns in an efficient market is like winning at roulette. In any random process, there will be winners and losers, and some winners might win big. Earning consistently high returns over time is also possible in an efficient market, just like a gambler on a lucky streak might win repeatedly at roulette. The relevant question is whether the very high returns or the length of the winning streak is inconsistent with blind luck or not.

Which one of the following statements is false?

The design of financial instruments is greatly constrained by law and regulation.

Which of the following factors, when increased, will tend to cause the value of a put to decrease (all else equal)?

The price of the underlying stock

Houston Corp., an American company, has a payment of ¥500 million due to Osaka Corp. one year from today. At the prevailing spot rate of 100 ¥/$, this would cost Houston $5 million, but Houston faces the risk that the ¥/$ rate will fall in the coming year, so that it will end up paying a higher amount in dollar terms. To hedge this risk, Houston has two possible strategies. The first strategy is to buy ¥500 million forward today at a one-year forward rate of 98 ¥/$. The second strategy is to pay a premium of $100,000 for a one-year call option on ¥500 million at an exchange rate of 0.96 ¥/$. a. Suppose that in one year, the spot exchange rate is 95 ¥/$. What would be Houston's net dollar cost for the payable under each strategy? b. Suppose that in one year, the spot exchange rate is 105 ¥/$. What would be Houston's net dollar cost for the payable under each strategy? c. Which hedging strategy would you recommend to Houston Corp., if any? Why?

a. In the first strategy, the net cost in dollars is ¥500 million/98 = $5.102 million. In the second strategy, Houston Corp. exercises its option to exchange at 96 ¥/$ for a cost of ¥500 million/96 = $5.208 million. Including the cost of the option, the net cost is $5.308 million. b. In the first strategy, the net cost in dollars is again ¥500 million/98 = $5.102 million. In the second strategy, Houston Corp. allows its option to expire and exchanges at the spot rate of 105 ¥/$ for a cost of ¥500 million/105 = $4.762 million. Including the cost of the option, the net cost is $4.862 million. c. The first strategy allows Houston to lock in an exact cost without paying a premium up front. The second strategy requires a premium payment, but Houston retains the possibility of having a much lower net dollar cost if the dollar strengthens enough relative to the yen. The correct strategy for Houston depends on its risk tolerance, its expectations for exchange rate movements, and its cash availability.

Which of the following securities has a purely residual claim against a firm's cash flows?

common stock

In the steps a company takes to prepare for an IPO, the "road show" precedes the "bake-off".

false

Principal is exchanged in interest rate swaps but not in currency swaps.

false

Private equity firms comprise a relatively insignificant portion of the American economy.

false

The only reason why the price would fall on a corporate bond is if market interest rates increase.

false

Valuing a call option requires an accurate estimate of the future value of the underlying asset.

false

Which one of the following statements is true?

none of the options are correct