Finance Final

What kind of relationship exists between the required return (R) and P/E ratio?

An inverse relationship exists between the required return and the P/E ratio

Accounting Aspects of Earnings from Financial Statements:

Balance Sheet Income Statement

The P/E ratio is conceptually a function of three factors:

Dividend Payout Ratio Required rate of return Growth rate

What is the major factor affecting stock values?

Earnings per share (EPS)

What are the primary factors that drive a firm's ROA?

Net profit margin and total assets turnover

Two basic components of the ROA:

ROA = NI / TA = (NI / Sales) ✕ (Sales / TA) NI / Sales = Net profit margin Its about profitability Sales / TA = TA total assets turnover Efficiency

___________ (coupon and principal payments) are contractual obligations of the bond issuer and are known by bondholders, since they are stated in the bond contract.

The cash flows

Most corporate bonds are issued with a face value of _______.

$1,000

cost-efficient:

(1) Index funds have lower management fees than actively-managed funds. a. .04% for index fund versus 1.4% for active funds (2) A buy-and-hold strategy saves you on transaction costs

Passive investment management does not try to find undervalued stocks, nor does it try to time the market.

(1) No active strategy should be able to beat the market on a risk adjusted basis. (2) No attempt made to forecast market movements and act accordingly. (3) No attempt to select under- or overvalued securities.

Markets are efficient.

(1) Passive investors agree with the efficient market hypothesis (EMH). (2) Market prices adjust quickly to the new information as it becomes available. (3) Information is properly incorporated into stock prices.

tax-efficient:

(1) You defer the realization of capital gains, using a buy-and-hold strategy. As a result, you reduce capital gains taxes. (2) Example 11-5: Vanguard's S&P 500 Index fund paid no capital gains distribution for the 7th consecutive year.

Low transaction costs.

(1) low turnover (brokerage commissions) (2) low portfolio management fees (Low costs to operate)

ROE can also depend on the product of three variables:

(1) net profit margin (2) asset turnover (3) leverage.

In top-down, fundamental analysis, the first step is always to analyze: a. the economy b. the industry c. the company d. the particular security

(A) chapter 13, exhibit 13-1. a. the economy

A retention rate of 75% and a ROE of 16% implies sustainable growth of ___. a) 6.7%. b) 12%. c) 75%. d) 60%.

(B) Sustainable growth = Retention × ROE = 0.60 × 16% = 12%.

Find the price of a 10 percent coupon bond with three years to maturity if the yield to maturity is now 12 percent. Use semiannual discounting. a. $1196.70 b. $950.85 c. $952.20 d. $999.80

(B) Use 6 percent and 6 periods. Price = 50(4.917) + 1000(0.705) = $950.85.

An investor wrote (i.e., sold) one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. If ABC stock price at expiration is $40, the buyer exercises his/her contracts. Which is the net profit/loss of this investment? Please assume that there are no transaction costs. a. $1000 b. $0 c. -$1000 d. -$500

(C) Ch 19: [5+ (25-40)]*100 = -1000.

CHANG Corp. has 5-year bonds outstanding that pay a coupon of 12.52 percent. Assume that these bonds are priced at $1083.76 and coupon payments are made semiannually. What is the annual yield to maturity on these bonds? a. 5.06% b. 5.17% c. 10.11% d. 10.33% e. 10.86%

(D) Ch 17: The solution is 5.17% on a semiannual basis, which by convention is doubled to obtain the annual YTM of 10.33%. A YTM calculated by annualizing in this manner is referred to as the bond-equivalent yield (Jones: p. 455).

CHANG Corp. has 5-year bonds outstanding that pay a coupon of 12.52 percent. Assume that these bonds are priced at $1083.76 and coupon payments are made semiannually. What is the current yield on these bonds? a. 5.06% b. 5.78% c. 10.11% d. 10.83% e. 11.55%

(E) Ch 17: 1000*12.52%/1083.76 = 11.55%.

ETF (Exchange-Traded fund): a mutual fund with a fixed capitalization whose shares trade on a stock exchange.

(a) A fixed number of shares trade on a stock exchange like individual stocks and close -end funds. (b) Shares can be bought and sold when the market is open. (c) The NAV and the share price don't usually diverge because of the arbitrage opportunity.

How to conduct a passive strategy?

(a) A passive investor can simply follow a buy-and-hold strategy. (b) An initial selection must be made to implement the strategy. (c) Investors have to perform certain functions while the buy-and-hold strategy is in existence.

The goal is to beat the market.

(a) Active investors attempt to exploit a whole variety of strategies with intention of outperforming index funds that simply buy and hold the broad stock-market portfolio. (b) They assume or expect the benefits to be greater than the costs. (c) Most investors favor this approach despite evidence about efficient markets.

Two steps to build a portfolio:

(a) Asset allocation. (b) Security selection.

Bonds are viewed as long-term debt instruments that represent the issuer's contractual obligation.

(a) Debt instruments are also known as IOUs; IOU is an abbreviation, in phonetic terms, of "I owe you." (b) The buyer (bondholder) of a bond is lending money to the issuer who agrees to repay principal and interest. (c) Bonds usually have an initial maturity of 10 years or more. (d) Because bonds are debt instruments where the interest paid to investors is fixed for the life of the contract, they are called fixed-income securities. (e) Bonds can be viewed as fixed-cost financing securities for issuers (firms or governments) because of equal and periodic interest cost.

Models:

(a) Dividend discount model (1) Zero growth (2) Constant growth (3) Variable growth (b) FCF model (c) An earnings multiplier model

What are three basic asset classes?

(a) Equities (b) Bonds (c) Cash equivalents

One approach to sector rotation is based on four broad sectors.

(a) Four broad sectors: (1) Interest-sensitive stocks, such as financial institutions. (2) Consumer durable stocks, such as Automotive, motor vehicles, electronics, tools and hardware, and homebuilding. (3) Capital goods stocks, such as manufacturing companies. (4) Defensive stocks, such as food production, soft drinks, beer, and pharmaceuticals. (b) Each of these sectors is expected to perform differently during the various phases of the business and credit cycles.

Two types of analysis:

(a) Fundamental security analysis: (1) The primary emphasis in fundamental security analysis in on expected EPS. (2) Rely on expected EPS or earnings estimates to justify stock selection. (b) Technical analysis:

Two types of stocks: growth stocks and value stocks

(a) Growth stocks: (1) Stocks that emphasize expectations about future growth in earnings. (2) Generally, growth stocks have high P/E ratios. (b) Value stocks: (1) Stocks whose prices are considered "cheap" relative to earnings, book value, and other measures thought indicative of value. (2) Generally, value stocks have low P/E ratios. (3) Value investing always involves finding bargains selling at prices below their actual economic value.

Other bond characteristics:

(a) If a bond is callable, the issuer (the firm issuing the bonds) can repurchase bonds prior to maturity. (b) Bond ratings indicate the relative probability of default risk.

The goal is to do as well as the market at minimum costs.

(a) Low transaction costs. (b) Low search costs (security analysis) (e.g., time spent in managing the portfolio) (c) The benefits expected from active trading are expected to be less than the costs.

What is the rationale behind active stock strategies?

(a) Market is inefficient. (b) Market inefficiencies provide exploitable opportunities of making excess returns.

Market timers attempt to stay in the stock market at the right times and move out of the stock market at the bad times.

(a) Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities. (b) They adjust when to carry a large cash position and when to shift their funds to stocks. (c) They increase their portfolio beta when the market is expected to rise.

1. What is the rationale behind passive stock strategies?

(a) Markets are efficient. (b) Investors cannot beat the market. (c) Passive investment management does not try to find undervalued stocks, nor does it try to time the market.

Bonds are used by corporations and governments to raise large sums of capital.

(a) Most of the large corporations, several thousand in total, issue corporate bonds to help finance their operations. (b) Many of firms have more than one issue outstanding.

The impact of the expected payout ratio on the P/E ratio is not clear cut. Why?

(a) On one hand, a higher payout ratio may have a positive impact on the P/E. (b) On the other hand, a higher payout ratio may lead to a decline in g, adversely affecting the P/E ratio.

Three components of the active approach to stock selection and management.

(a) Security selection (b) Sector analysis (c) Market timing

Two types of security analysts:

(a) Sell-side analyst: (1) Also called "Wall Street" analyst (2) Their research reports are used to "sell" an idea to all investors, both individuals and institutions. (b) Buy-side analyst: (1) Analysts employed by money management firms (such as pension funds, mutual funds, and investment advisers) (2) Their research is typically available to their employers.

Vanilla bonds, the most common bonds issued by corporations, have coupon payments that are fixed for the life of the bond. At maturity, the entire original principal is paid and the bonds are retired.

(a) The face value (F) of a bond will be repaid at maturity. (b) Coupon payments (C) on bonds are the interest payments (or cash payments) made to bondholders until maturity. (c) Coupons are paid for the life of the bond.

The P/E ratio is positively related to the expected growth rate, g.

(a) The higher the expected growth rate, g, the higher the P/E ratio. (b) The higher the P/E ratio, the greater the market's expectations about future earnings growth.

Open-end index mutual fund: a mutual fund with an unfixed capitalization. Thus, the fund's capitalization is said to be open-ended.

(a) The number of shares outstanding of a mutual fund constantly changes—that is, it is open-ended. (b) The number of shares issued solely depends on investor demand. (c) Investors buy shares directly from investment companies and sell them back (i.e., redeem) (1) New shares are sold. (2) Outstanding shares are redeemed. (d) Do mutual funds trade on stock exchanges? a. No (e) Is there secondary market for mutual fund shares? a. No (f) Investors buy and sell shares every day at the NAV at the market close.

Most corporate bonds are issued with a face value of $1,000

(a) This par value of a bond is assumed throughout this class, unless otherwise specified. (b) The face value is also known as (a.k.a.) the par value or principal amount. (c) At maturity, the par value is paid to the bondholder and the bonds are retired.

Fundamental Analysis Goal:

(a) To estimate the firm's intrinsic value. (b) To select under- or overvalued securities.

Types of corporate bonds:

(a) Typical bonds (b) Zero-coupon bonds (c) Convertible bonds that can be converted into shares of common stock at some predetermined ratio at the discretion of the bondholder.

DuPont System of Analysis A diagnostic tool that uses financial ratios to evaluate a company's financial health.

(a) Used to identify the primary driver(s) behind an increase or a decrease in the ROA (or ROE). (b) Decomposing the ROA (or ROE) into its components allows analysts to identify adverse impacts on the ROA (or ROE) and to predict future trends. (c) This analysis highlights expense control, asset utilization, and debt utilization.

Two strategies to manage a portfolio:

(a) active approach (b) passive approach

5. What are the benefits of passive strategies?

(a) cost-efficient: (b) tax-efficient:

Problems with Reported Earnings

1. EPS for a company is not a precise figure that is readily comparable over time or between companies. 2. Alternative accounting treatments used to prepare statements. 3. Difficult to gauge the 'true' performance of a company with any one method. 4. Investors must be aware of these problems.

Two types of Index Funds

1. Open-end index mutual fund: a mutual fund with an unfixed capitalization. Thus, the fund's capitalization is said to be open-ended. 2. ETF (Exchange-Traded fund): a mutual fund with a fixed capitalization whose shares trade on a stock exchange.

Security Selection

1. Two types of analysis: 2. Two types of stocks: growth stocks and value stocks 3. Two types of security analysts:

Active Stock Strategies

1. What is the rationale behind active stock strategies? 2. The goal is to beat the market. 3. Three components of the active approach to stock selection and management.

How many sectors are there in the S&P 500 index?

10

Market effects can account for ___ of the variability in a diversified portfolio's return.

90%

___________ movements remain the largest single factor explaining fluctuations in both individual stock prices and portfolios of stocks.

Aggregate market

P/E Ratio A measure of relative price of a stock.

The ratio indicates how much investors are willing to pay per dollar of earnings.

Is the interest expense on bonds tax-deductible for corporations?

Yes

Out-of-the-money call options have an exercise price that: a) exceeds the current market price of the underlying common stock. b) exceeds the strike price. c) is less than the current market price of the underlying common stock. d) is less than the strike price.

a) exceeds the current market price of the underlying common stock.

On a company's balance sheet, shareholder's equity is nearly always described by its? a. Book value b. Market value c. Current value d. Stock value

a. Book value

Which investment vehicle can be used to apply a buy-and-hold strategy?

a. Index funds

What are the top three sectors in terms of weighting?

a. Information technology b. Financial c. Healthcare

What are two determinants of a firm's EPS (Earnings per share)?

a. NI / Equity = ROE return on equity b. Equity / Shares = Book value per share

The __________ equates the present value of the total future dollars expected to be available at the end of a specific time period, given certain assumptions, to the price of the bond. a. horizon return b. promised return c. expected return d. coupon return

a. horizon return

If the dividend growth rate increases for a firm, its P/E will ---------, other things the same. a. increase b. stay the same c. decrease d. increase or decrease but not stay the same

a. increase

Which of the following is TRUE regarding the risk premium? The risk premium a. must reflect all the uncertainty involved in the asset. b. does not apply to low beta stocks. c. is directly related to changes in the interest rate. d. reflects only the financial risk of a security.

a. must reflect all the uncertainty involved in the asset.

In order to have a yield to maturity greater than the coupon rate, the bond must be: a. selling at a discount. b. selling at par. c. selling at a premium. d. a zero coupon bond.

a. selling at a discount.

Which of the following is true regarding option pricing: a. the longer the maturity of the option, the higher the premium. b. the more volatile the underlying stock, the lower the premium. c. option prices are less volatile than equity prices. d. the shorter the maturity of the option, the lower the premium.

a. the longer the maturity of the option, the higher the premium.

One important factor affecting the success of a market timing strategy is the _____________________________ with such a strategy as opposed to those paid with a buy-and-hold strategy.

amount of brokerage commissions and taxes paid

Investors shift sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better, and _____________ those sectors that are expected to do relatively worse.

avoid or deemphasize

The writer of a call option is said to have a: a) long position. b) short position. c) covered position. d) uncovered position.

b) short position.

An investor bought one ABC $25 (exercise price is $25) call contract for a premium of $5 per share. At the maturity (expiration), ABC stock price is $30. Which is the net profit/loss of this investment? a. $500 b. $0 c. -$500 d. $100

b. $0

Put and call options on equity securities are considered: a. Commodity derivatives b. Financial derivatives c. Forward contracts d. Futures contracts

b. Financial derivatives

Which of the following statements regarding changes in bond prices relative to changes in market yields is true? a. Short-term bond prices will increase more than long-term bond prices if market yields increase. b. Short-term bond prices will increase less than long-term bond prices if market yields decrease. c. Short-term bond prices will increase more than long-term bond prices if market yields decrease. d. Short-term bond prices will remain constant and long-term bond prices will increase if market yields decrease.

b. Short-term bond prices will increase less than long-term bond prices if market yields decrease.

Which of the following statements is true regarding a call writer: a. The call writer expects the stock to move upward. b. The call writer expects the stock to remain the same or move down. c. The call writer expects the stock to split. d. The call writer expects to sell the stock prior to expiration of the option.

b. The call writer expects the stock to remain the same or move down.

An analyst employed by a pension fund to search for stocks for the fund to invest in would be referred to as: a. a sell-side analyst. b. a buy-side analyst. c. an institutional analyst. d. a money manager.

b. a buy-side analyst.

Which of the following represents the rate at which a company can grow from internal sources? a. return on assets b. sustainable growth rate c. adjusted EPS d. return on equity

b. sustainable growth rate

The yield to maturity consists solely of interest income if: a. the bond is a zero coupon bond. b. the bond was purchased at par. c. the bond was purchased above par. d. the bond was purchased below par.

b. the bond was purchased at par.

One percentage point of a bond yield represents: a. 1 basis point b. 10 basis points c. 100 basis points d. 1000 basis points

c. 100 basis points

With an upward sloping yield curve, which of the following maturities will have the highest yield? a. 5-year. b. 10-year. c. 30-year. d. 90-day.

c. 30-year.

Which of the following statements about bond prices is FALSE? a. Bond price volatility and time to maturity are directly related. b. A decrease in yields raises prices more than an increase in yields lowers prices. c. Bond price fluctuations and bond coupons are directly related. d. Bond prices move inversely to bond yields.

c. Bond price fluctuations and bond coupons are directly related.

One important reason for the existence of derivatives is that they: a. help lower transactions costs. b. have valuable tax benefits. c. contribute to market completeness. d. are risk-free.

c. contribute to market completeness.

Historically, sell-side equity research has typically been _________to the target company? a. very unfavorable b. unfavorable c. favorable d. neutral

c. favorable

The central focus of a security analyst's job is to: a. ascertain the accuracy of financial statements of selected companies. b. find growth stocks. c. forecast a specific company's return. d. determine the market demand for a specific company's stock.

c. forecast a specific company's return.

If the price of the common stock exceeds the exercise price of a call for the holder of the call option is said to be a. naked. b. out of the money. c. in the money. d. covered.

c. in the money.

The YTM calculation assumes: a. reinvestment of interest is at the coupon rate. b. no reinvestment of interest. c. reinvestment of interest is at YTM rate. d. reinvestment of interest is at the risk-free rate.

c. reinvestment of interest is at YTM rate.

An increase in reinvestment rate risk a. is caused by an increase in interest rates. b. leads to a decline in coupon rates. c. results from a decline in interest rates. d. results from an increase in inflation.

c. results from a decline in interest rates.

If a bond is callable, this means: a. the issuer may change the coupon rate. b. the investor may convert the bond into stock. c. the issuer may redeem the bond early. d. the investor may cash in the bond at any time.

c. the issuer may redeem the bond early.

A major difference between new shares being sold by a corporation and shares sold under a call option is that: a. there is no profit or loss under the shares sold under the call. b. there is no risk to the investor with the call. c. there is no increase in the shares outstanding with the call. d. there is no commission to the investor with the call.

c. there is no increase in the shares outstanding with the call.

EPS are of higher quality if: a. the company is a blue chip. b. the auditor's reputation is high. c. they were derived using conservative principles. d. FASB has approved them.

c. they were derived using conservative principles.

Bonds are used by _____________________ to raise large sums of capital.

corporations and governments

A stock is at $68. A two-month put (strike price = $70) is available at a $5 premium. The intrinsic value is _____ and the time value is ______. Please note that an option premium equals the sum of the intrinsic value and time value. a. $5 . . . $0. b. $0 . . . $5. c. $3 . . . $2. d. $2 . . . $3.

d. $2 . . . $3.

For adequately diversified common stock portfolios, market effects often account for -------- percent and more of the variability of the portfolio's return. a. 60 b. 70 c. 80 d. 90

d. 90

Maturity and coupon being equal, which of the following bonds will have the highest yield to maturity? a. Treasury bond. b. AAA- rated corporate bond. c. BBB+ rated corporate bond. d. BB- rated corporate bond.

d. BB- rated corporate bond.

____________ funds are especially popular with momentum investors. a. Index. b. Managed c. Global d. Sector

d. Sector

Which of the following statements regarding defensive stocks is true? a. They are often expected to have above-average future growth. b. They often have high P/E multiples. c. They are expected to be adversely affected by high interest rates. d. They often produce necessary items such as food and prescription drugs.

d. They often produce necessary items such as food and prescription drugs.

If security markets are totally efficient, the best common stock strategy to take is: a. an asset allocation approach. b. the modern portfolio theory. c. an active strategy. d. a passive strategy.

d. a passive strategy.

Which of the following variables has an inverse relationship with the P/E ratio? a. payout ratio b. expected growth rate of dividends c. expected growth rate of earnings d. required rate of return

d. required rate of return

Coupons are paid to bondholders at a _________ annual coupon interest rate (rc).

fixed

Bonds are viewed as _____-term debt instruments that represent the issuer's contractual obligation.

long

The P/E ratio is ___________ related to the expected growth rate, g.

positively