Unit #10: Analytical Methods
Investment risk may broadly be categorized as either unsystematic or systematic risk; both types of risk together constitute total, or absolute, risk. Total risk is measured by A) opportunity cost. B) beta coefficient. C) standard deviation D) correlation coefficient.
C) Standard Deviation *Unlike beta, which only measures systematic risk, standard deviation reflects both systematic and unsystematic risk, revealing the total risk of the investment.
XYZ Corporation has a beta of 1.0, and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had alpha of A) −2% B) 2.8% C) 14.8% D) 2%
A) -2 *Alpha is the extent to which a security's performance exceeds (or falls short of) that of the market compared to what would be expected based on its beta. A key to this question is that XYZ's beta of 1.0 equals the beta of the market. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than the market itself. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% × 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.
When a company's debt-to-equity ratio is higher than typical for that industry, it might be said that the company is A) highly leveraged B) highly profitable C) about to increase their dividends D) suitable for a conservative investor
A) Highly leveraged *The definition of a leverage is the use of borrowed money in the issuer's capital structure. This is seen through the debt-to-equity ratio. When that ratio is higher than industry standards, it is said that the company is highly leveraged.
There are several measures of central tendency used by investment analysts. Included would be all of the following EXCEPT A) mode B) mean C) median D) moving averages
D) moving averages *Moving averages are used to smooth out the fluctuations in a stock price over a period of time. The other 3 are the most popular measures of central tendency.
Present value is a computation frequently used to determine the amount of deposit needed now to meet a future need, such as a college education. If an investor uses an expected return of 8%, but the actual return over the period is 6%, A) the future value will not be able to be computed B) the yield to maturity will be lower than anticipated C) the accumulated value will meet the objectives D) the present value was insufficient to meet the objective
D) the present value was insufficient to meet the objective *Present value is the amount deposited to meet a future goal based on an expected rate of return. If the return is lower than expected, the amount deposited will not grow to the required amount (a bad thing).
A securities analyst reviewing a corporation's financial statements notes that the enterprise has total current assets of $10 million, inventory of $4 million, cash on hand of $2 million, total current liabilities of $8 million, and net income of $15 million. The company's acid-test ratio is closest to A) 1.50 to 1 B) 0.75 to 1 C) 1.00 to 1 D) 1.25 to 1
B) 0.75 to 1 *The acid-test ratio, also known as the quick asset ratio, is computed by subtracting the inventory from the total current assets and then dividing that remainder by the total current liabilities. In this case, that would be $10 million minus $4 million ($6 million) divided by $8 million, or .75%.
When a stock has a beta of less than 1, this indicates that A) it will, on average, give a return in excess of that of a stock with a beta of greater than 1 B) it will have a high level of unsystematic risk C) it will have a high level of systematic risk D) it will, on average, give a return below that of the market
D) *Beta tracks a stocks co-movement with the overall market. Because the "market" has a beta of 1.0, any stock with a lower beta will generally not have price movement equal to the market. Beta is a measurement of systematic risk, and low-beta stocks have less than high beta ones. Beta has no relationship to unsystematic risk.
To make a quantitative evaluation using the present value computation, which of the following is NOT needed? A) Account value at the end of the period B) Anticipated rate of return of the portfolio C) Time period involved D) Account value at the beginning of the period
D) Account value at the beginning of the period *Present value is calculated to determine the amount required now to have a specified value at some time in the future. It is what we are looking for so we don't have it now.
The main difference between the current ratio and the quick ratio is that the quick ratio excludes A) assets. B) goodwill. C) cost of goods sold. D) inventory.
D) Inventory *Current ratio = (current assets ÷ current liabilities) = [cash + marketable securities + receivables + inventory] ÷ current liabilities. Quick ratio = [cash + marketable securities + receivables] ÷ current liabilities. Thus, quick ratio excludes inventory, which current ratio does include. Both ignore goodwill and cost of goods sold.
An investor has $100,000 to invest. If the account's estimated annual return is 8% and the investor plans to withdraw $20,000 at the end of each year, approximately how long will the money last? A) 6.65 years B) 5 years C) 7.55 years D) 8.33 years
A) 6.65 years *This is a simple calculation with a financial calculator, but the test center does not let you use one. So, if you get a question like this (and have time - don't waste it if it means you won't get to the easy questions at the end of the exam), you can do it long-hand as shown in the LEM. For those without a LEM, it goes like this: Beginning of year (BOY)End of year (EOY) -$100,000× 108%$108,000 − then subtract $20,000 -$88,000× 108%$95,040 -$75,040× 108%$81,043.20 -$61,043.20× 108%$65,926.66 -$45,926.66× 108%$49,600.79 -$29,600.70× 108%$31,968.85 -$11,968.85× 108%$12,926.36 Therefore, the investor can withdraw the planned $20,000 for 6 full years and will have slightly less than enough for 65% of the full payment in the 7th year.
Over the past 5 years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The median of the returns is A) 8.0% B) 7.4% C) 8.2% D) 9.0%
A) 8 % *The median of a series of returns is that number that has an equal number of occurrences below as above. In this case, that number is 8% because there are 2 returns less than 8% (-4% and +5%) and 2 above (+12% and +16%).
A portfolio manager considers adding an asset to the portfolio. The manager decides between 4 equally-risky assets: W, X, Y, and Z. The correlations of each asset with the portfolio are: Asset W +0.90 Asset X +0.80 Asset Y +0.40 Asset Z +0.20 To achieve the optimal diversification benefits, which of the assets should be selected by the manager? A) Asset Y B) Asset Z C) Asset W D) Asset X Explanation Correlation runs from + 1.0 to - 1.0. A the higher the correlation, the more the securities move in tandem. That lessens the diversification. The reverse is true when the correlation is low or negative. Asset Z has the lowest correlation with the portfolio and will therefore provide the largest reduction in portfolio risk. Even better diversification would be obtained if there was a choice with a negative correlation.
B) Asset Z *A portfolio manager considers adding an asset to the portfolio. The manager decides between 4 equally-risky assets: W, X, Y, and Z. The correlations of each asset with the portfolio are: Asset W +0.90 Asset X +0.80 Asset Y +0.40 Asset Z +0.20 To achieve the optimal diversification benefits, which of the assets should be selected by the manager? A) Asset Y B) Asset Z C) Asset W D) Asset X Explanation Correlation runs from + 1.0 to - 1.0. A the higher the correlation, the more the securities move in tandem. That lessens the diversification. The reverse is true when the correlation is low or negative. Asset Z has the lowest correlation with the portfolio and will therefore provide the largest reduction in portfolio risk. Even better diversification would be obtained if there was a choice with a negative correlation.
While searching for a suitable investment for your client, you narrow the choice to the following 4 companies: -Company A with returns over the past 4 years of: 12%, 4%, 8%, 6% -Company B with returns over the past 4 years of: 7%, 8%, 9%, 6% -Company C with returns over the past 4 years of: 10%, 12%, -2%, 10% -Company D with returns over the past 4 years of: 15%, 20%, -8%, 3% Which of these choices has the highest volatility? A) Company A B) Company B C) Company D D) Company C
C) Company D *Although the exam will not ask you to compute standard deviation, you are required to know that it measures the deviation from the mean (average). In all 4 of these examples, the mean is 7.5% (30 divided by 4). In which of the choices do the returns occur furthest from that mean? In choice D, they range from 12.5% higher to 15.5% lower. In choice A, the range is from 4.5% higher to 3.5% lower; in choice B, from 1.5% higher to 1.5% lower; in choice C, from 4.5% higher to 9.5% lower. That should clearly point out that the greatest volatility, or dispersion from the mean is choice D while choice B would have the lowest standard deviation.
An analyst viewing a corporate income statement will be able to review all of the following except A) pre-tax income. B) operating expenses. C) current ratio. D) net sales or net revenues.
C) Current Ratio *Current ratio is a balance sheet computation involving current assets and current liabilities. All of the other items relate to income and expenses, items found on an income statement.
If an investor wished to compute the mean return of her portfolio, she is going to A) find the median B) compute the standard deviation C) find the arithmetic mean D) compute using straight-line averaging
C) Find the arithmetic mean *Unless something else is specified, whenever the mean return is referenced, it is always the arithmetic mean (the simple average).
A grandparent wants to provide $1,000 per month in income in perpetuity to a great-grandchild. With a 4% projected rate of return, what amount does the grandparent need to invest? A) $300,000 B) $250,000 C) $25,000 D) $30,000
A) $300,000 *One thousand dollars per month is $12,000 per year. Divide that $12,000 by 4% to arrive at $300,000, the principal amount that, at a 4% return, will yield $12,000 per year (or $1,000 per month).
Two securities with which of the following correlation coefficients could be combined to create a risk-free portfolio? A) -1.0 B) -0.5 C) +1.0 D) 0.0
A) -1 *Risk elimination can be achieved if two securities with a perfect negative correlation are combined. That is, when one goes up, the other goes down by the same amount. In other words, one is the antipode of the other.
Which of the following correlations would represent 2 assets that tend to move in tandem with one another? A) +0.81 B) −0.68 C) −0.11 D) +0.16
A) 0.81 *The correlation coefficient ranges from −1.0 to +1.0 and measures the varying relationship of assets (or securities) to one another. A correlation close to +1.0 would indicate that the assets should move in tandem. A correlation close to 0 would indicate that the assets would have little relationship to one another, and a correlation of -1.0 would indicate that the assets should exhibit virtually opposite behavior.
Bond X has an internal rate of return (IRR) of 7%. Bond Y has an IRR of 9%. Both bonds pay interest semiannually. If the required rate of return is A) 7%, the net present value (NPV) of Bond Y will exceed the NPV of Bond X. B) 7%, the net present value (NPV) of Bond X will exceed the NPV of Bond Y. C) 9%, both bonds will have a positive NPV. D) 9%, the net present value (NPV) of Bond X will exceed the NPV of Bond Y.
A) 7%, the net present value (NPV) of Bond Y will exceed the NPV of Bond X. *We know that when a bond's IRR equals the required rate of return (the discount rate), the NPV of that bond is zero. That is the case with Bond X when the required rate of return is 7%. When the bond's IRR is above the required rate of return, it has a positive NPV. That is the case with Bond Y whose IRR is higher than the 7% required return. With a required return of 9%, Bond X has a negative NPV and Bond Y's NPV is zero. That is the technical explanation. The simple explanation is to compare the IRR with the required rate of return. Anytime the IRR is above the required rate, you've got a good deal (and that is what a positive NPV tells us).
Which of the following statements is NOT true? A) Beta is a measure of a security's deviation from its historical average returns. B) Beta is a volatility measure of a security compared with the overall market. C) A stock with a beta of 0.8 will move 20% less than the market. D) A stock with a beta of 1.2 will move 20% more than the market.
A) Beta is a measure of a security's deviation from its historical average returns. *A measure of a security's deviation from its historical average returns is the security's standard deviation. Beta measures a security's volatility in relation to the overall market. Stocks with a beta greater than 1 are more volatile than the market and stocks with a beta less than 1 are less volatile than the market.
Use the following chart to answer this question: Portfolio:A B C D -High return39.4%37.2%34.3%32.7% -Low return1.4%−6.5%7.2%−1.4% -Mean return15.8%16.2%15.5%15.2% -Std. dev.11.5511.7510.0510.44 Which portfolio mix would you recommend to a client who is most concerned about projected near term volatility? A) C B) B C) D D) A
A) C *Although this might look complicated, this is very simple if you realize that standard deviation is the measure of volatility. So, just pick the allocation with the lowest standard deviation and that is Portfolio C at 10.05.
A company's working capital equals its A) current assets minus its current liabilities B) fixed assets minus its fixed liabilities C) current liabilities minus its current assets D) cash flow minus its retained earnings
A) Current assets minus its current liabilities *Working capital is a measure of how well a company can meet its current obligations. It is the amount that is left free and clear if all current debts are paid off. Working capital is calculated by subtracting current liabilities from current assets
All of the following ratios are measures of the liquidity of a corporation EXCEPT A) debt/equity ratio B) acid-test ratio C) quick ratio D) current ratio
A) Debt/equity ratio *Liquidity ratios measure a firm's ability to meet its current financial obligations and include the current ratio and acid-test (quick) ratio. However, the debt/equity ratio is a capitalization ratio and measures the amount of leverage compared to equity in a company's overall capital structure.
Your client has $10,000 to invest and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. Which of the following items will help determine whether the investment is likely to satisfy the client's goal? A) Expected cost of college B) Consumer Price Index C) Client's marginal federal income tax bracket D) Present value
A) Expected cost of college *To determine whether the investment will satisfy the goal, the investment adviser representative needs to know the amount needed to pay for college. While the investment will be worth $25,181.70, this may not be enough to pay for even one year of college 12 years from now.
Which of the following purchases is most suitable for an investor pursuing an aggressive investment strategy? A) GHI stock with a beta coefficient of 1.3 B) AMF stock with a beta coefficient of 1.0 C) LMN stock with a beta of -0.6 D) DOH stock with a beta coefficient of 0.7
A) GHI stock with a beta coefficient of 1.3 *Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive investment strategies.
Which of the following statements with regards to net present value and internal rate of return is correct? A) If the net present value is greater than zero, then the internal rate of return is greater than the required rate of return. B) If the net present value is less than zero, then the internal rate of return is greater than the required rate of return. C) If the net present value equals zero, then the internal rate of return is greater than the required rate of return. D) If the net present value equals zero, then the internal rate of return is less than the required rate of return.
A) If the net present value is greater than zero, then the internal rate of return is greater than the required rate of return. *Any time the net present value is greater than zero (a positive NPV), the internal rate of return is greater than the required rate of return and the investment should be made. If the net present value is zero, then the internal rate of return equals the required rate of return.
Portfolio A has a beta of 1.0 and has returned 8% over the past year. Portfolio B has a beta of 1.5 and, over that same period, has returned 16%. Based on this information, an analyst would conclude that portfolio B has A) positive alpha B) negative alpha C) zero alpha D) positive correlation
A) Positive Alpha *Positive alpha is when a portfolio (or security) outperforms another portfolio (or the market) by more than is expected based upon its beta coefficient. Although we could calculate the alpha, it should be clear that when one portfolio with a beta that is 50% higher than the other outperforms it by 100%, there is positive alpha.
Which of the following measures the variability of an asset's returns over time? A) Standard deviation B) Time-weighted return C) Beta D) Alpha
A) Standard Deviation *The standard deviation is a measure of the range of scores within a set of returns over a period of time. The greater the dispersion of the returns from the mean, the greater the volatility of the security.
The Smiths are saving money for a down payment on a house. The Smiths have $25,000 in cash, and they estimate that in 5 years they will have approximately $31,000 if they deposit their cash in a savings account that compounds interest yearly. To calculate the $31,000 amount, the Smiths determined A) the future value of the $25,000 B) the present value of $25,000 C) the internal rate of the return on the $25,000 D) the net present value of the $25,000
A) The future value of the $25,000 *To determine the money's worth at a future date (in this case, 5 years), the Smiths calculated the future value of the funds. Future value is a compounded rate of return, and in this case, the $25,000 was compounded at 5% per year for 5 years. The present value of an investment is the opposite of future value.
The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is A) the price-to-book-value ratio B) the price-earnings (P/E) ratio C) the dividend discount ratio D) the price-sales ratio
A) The price-to-book value ratio *The price-to-book-value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value.
The measurement of a portfolio's actual or realized return in excess of (or deficient to) the expected return calculated by the capital asset pricing model (CAPM) is known as A) alpha B) NPV C) IRR D) beta
A) alpha *This is the textbook definition of alpha. Portfolio managers strive for a positive alpha (returns in excess of the expected return).
An investor's portfolio has a beta coefficient of 0.85. If the overall market declined by 10% over the course of a year, the portfolio's value has likely A) decreased by 8.5% B) decreased by 11.76% C) increased by 8.5% D) increased by 10.85%
A) decrease by 8.5% *A beta coefficient of 0.85 means that the portfolio is considered to be 0.85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of 0.85 is likely to decline by only 8.5% (0.10 × 0.85).
A portfolio manager with a growth style would probably diversify by A) devoting a portion of the portfolio to securities with a negative correlation B) placing a portion of the portfolio into high-yield bonds C) attempting to build a portfolio with a very high correlation D) concentrating in stocks in 1 or 2 industries
A) devoting a portion of the portfolio to securities with a negative correlation *Securities with a negative correlation add diversification to a growth portfolio because they move in the opposite direction of the balance of the holdings. Therefore, losses are offset by gains.
Under the net present value (NPV) method of evaluating investments, an investment is acceptable if the net present value of the expected returns is A) greater than zero B) equal to zero C) greater than the risk-adjusted return D) less than zero
A) greater than zero *Under the net present value (NPV) approach, an investment is acceptable only if the net present value of the expected returns is greater than the amount of the investment outlay. In other words, an investment is acceptable (it will add value) if the net present value is greater than zero. On the other hand, if the NPV is negative (less than zero), it would not be acceptable (it will subtract value) and should not be undertaken.
A security that your client has been following has a historical average annual return of 11% and a standard deviation of 6%. Knowing this, it would be expected that 95% of the time, your client could expect a return within the range of A) −1% and +23% B) +5% and +17% C) −66% and +66% D) −7% and +30%
A) −1% and +23% *Ninety-five percent of the time, a stock will range within 2 standard deviations of its historical return. In this case, 2 times 6% means that the range will be down 12% from the historical 11% and up 12% from the historical 11%.
One measure of a corporation's liquidation value is its book value per share. When performing this computation, which of the following must be taken into consideration? 1. Goodwill 2. Long-term debt 3. Retained earnings 4. Par value of the preferred stock A) I and II B) I, II, III, and IV C) II and III D) II, III, and IV
B) 1, 2, 3 & 4 *The computation of book value per share is basically net tangible worth per share of common stock. Included in the net worth are all assets and liabilities (such as long-term debt), as well as the stockholders equity (par value of the preferred stock and par + paid in surplus of the common stock and retained earnings). Subtracted from this to get tangible book value would be the par value of the preferred stock and the value of intangible assets such as goodwill.
An investor places $10,000 into BCD common stock 12 years ago. Today, that stock has a market value of $20,000. Using the Rule of 72, the internal rate of return on BCD is closest to A) 6.8%. B) 6%. C) 8%. D) 5%.
B) 6% *The Rule of 72 indicates that the approximate return required for a number to double in 12 years can be determined by dividing 72 by 12. That results in a return nearest to 6%.
A wealthy client wishes to endow her favorite charity with a lump-sum gift that, with an assumed rate of return of 4% per annum, will provide $2,500 per month in perpetuity. What amount does the client need to deposit? A) $100,000 B) $750,000 C) $1,000,000 D) $75,000
B) 750,000 *A monthly income of $2,500 is equal to $30,000 per year. At a 4% earning rate, $750,000 must be deposited to generate that amount (30,000 ÷ 4%).
A portfolio manager considers adding an asset to the portfolio. The manager decides between 4 equally-risky assets: W, X, Y, and Z. The correlations of each asset with the portfolio are: Asset W +0.90 Asset X +0.80 Asset Y +0.40 Asset Z +0.20 To achieve the optimal diversification benefits, which of the assets should be selected by the manager? A) Asset Y B) Asset Z C) Asset W D) Asset X
B) Asset Z *Correlation runs from + 1.0 to - 1.0. A the higher the correlation, the more the securities move in tandem. That lessens the diversification. The reverse is true when the correlation is low or negative. Asset Z has the lowest correlation with the portfolio and will therefore provide the largest reduction in portfolio risk. Even better diversification would be obtained if there was a choice with a negative correlation.
An analyst attempting to determine the extent to which financial leverage is being employed by a company would examine the company's A) working capital B) debt-to-equity ratio C) book value per share D) acid-test ratio
B) Debt-to-Equity ratio *Financial leverage is the use of debt capital. The best way to see the extent to which that exists is through the debt-to-equity ratio
An investor reviewing the performance of a security reads that its returns for the past 9 years are +9%, -4%, +13%, +6%, +2%, -8%, +11%, +2%, +5%. Using this information, which of the following is NOT a correct statement? A) Median is 5% B) Range is 11% C) Mode is 2% D) Mean is 4%
B) Range 11% *The range is the difference between the highest number (+13%) and the lowest number (-8%). That is a range of 21%. The mode is the number that appears most frequently. The only return that appears more than once is 2%. The mean is the arithmetic average. The total of the returns (including the negative returns) is 36%. Dividing by the 9 years equals a mean of 4%. The median is the number with as many above as below and that is 5%.
According to most fundamental analysts, examining a company's price/earnings ratio gives an indication of A) current cash flows B) how much investors value the stock as a function of the company's market price to its earnings C) the parity price of the issuer's convertible bonds D) the degree to how liberal the company's dividend policies are
B) how much investors value the stock as a function of the company's market price to its earnings *The two components of the price/earnings ratio are the current market price and the earnings per common share. When a company has a high P/E ratio, it means that investors are placing greater value on expected growth in earnings. That is one of the reasons why growth stocks carry higher P/E's than value stocks.
In a group of returns, the central value of observations arranged in order of lowest to highest is known as the A) mean B) median C) range D) mode
B) median *The median in any group of numbers is the number in the middle. That is, the number with an equal set above and below. The mean is the average, the mode is the most common return, and the range is the distance between the extremes.
The discount rate that makes the NPV of all cash flows from a security equal to zero is A) the present value return B) the internal rate of return C) the median return D) the cash flow adjusted return
B) the internal rate of return *The internal rate of return, (IRR), is the interest rate that makes the net present value zero. It reflects the yield to maturity of a bond because a bond's current market value should equal the present value of that bond when considering the future interest payments and return of principal at maturity. That is why bond prices fall when interest rates rise and the reverse.
An agent is analyzing the financial statements of a corporation. The company has cash on hand of $2 million, accounts receivable of $500,000, accounts payable of $700,000, land valued at $3 million, wages payable of $300,000, goodwill of $100,000, inventory of $1.5 million, and retained earnings of $5 million. From this information, the agent would determine that the acid-test ratio for this company is A) 1:1 B) 3.375:1 C) 2.5:1 D) 4:1
C) 2.5 : 1 *The acid-test, or quick, ratio is all of the current assets, except for inventory, divided by the current liabilities. The non-inventory current assets are the cash on hand and the accounts receivable. The current liabilities are the accounts payable and wages payable. This results in a calculation of $2.5 million divided by $1 million, or 2.5:1.
Of the 4 pairs of assets below, which pair provides the highest level of diversification? A) Assets 5 & 6: with a correlation coefficient of 0 B) Assets 1 & 2: with a correlation coefficient of +0.94 C) Assets 7 & 8: with a correlation coefficient of −0.88 D) Assets 3 & 4: with a correlation coefficient of +0.47
C) Assets 7 & 8: with a correlation coefficient of −0.88 *The highest level of diversification will occur when the correlation coefficient is closest to −1. Of the 4 pairs of assets, assets 7 and 8 offer the highest level of diversification because the correlation coefficient of −0.88 is closest to −1. The returns on assets 7 and 8 should generally move in opposite directions because they are negatively correlated. Assets 1 & 2 will provide virtually no diversification because they have almost perfect correlation.
A senior citizen had the following scenarios presented to him by his IAR. Which one had the lowest volatility? A) Stock high return: +12%; low return: −2%; Standard Deviation: 5.5% B) Stock high return: +9%; low return: −2%; Standard Deviation: 4.9% C) Stock high return: +5%; low return: −1%; Standard Deviation: 3.6% D) Stock high return: +18%; low return: −4%; Standard Deviation: 8%
C) Stock high return: +5%; low return: −1%; Standard Deviation: 3.6% *The higher the standard deviation, the higher the volatility and the higher the risk. So, the lower the standard deviation, the lower the volatility and the lower the risk.
Which of the following best describes net present value? A) The discount rate that results in a return of zero for a series of future cash flows B) The amount of money that must be invested today at some specified rate of return to equal a targeted value in a specified number of years C) The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost D) It is the true interest yield expected from an investment expressed as a percentage
C) The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost *Net present value is a computation taking into consideration future cash flows, discounted to the present, and comparing that to the capital investment necessary to obtain those flows. It is always expressed in monetary units and, if positive, indicates a potentially worthwhile investment.
Which of the following attributes of common stock best describes why internal rate of return (IRR) is not generally used to determine the return on common stock? A) No net present value B) Uneven cash flows C) Uneven cash flows, no maturity date and price D) Uneven cash flows and no maturity
C) Uneven cash flows, no maturity date and price *Internal rate of return (IRR) best measures investments with a known price and maturity. The internal rate of return is the discount rate that makes the future value of an investment equal to its present value. The yield to maturity on a bond is actually its internal rate of return.
An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 6%, then the NPV is A) positive B) negative C) zero D) 6%
C) Zero *When an investment's IRR equals the required rated of return, the NPV is zero. If the IRR is higher than the required rate of return, the NPV is positive; if the IRR is lower than the rate of return, the NPV is negative.
A portfolio manager who is successful at market timing will A) decrease the beta of the portfolio in advance of a rising market B) have a portfolio beta less than the beta required by the client C) increase the beta of the portfolio in advance of a rising market D) increase the beta of the portfolio in advance of a declining market
C) increase the beta of the portfolio in advance of a rising market *A portfolio manager expecting a rising market would want to take advantage of that by increasing the beta of the portfolio. This would have the effect of increasing the potential volatility of returns. When things are going good, you want to be in higher beta stocks.
If the required rate of return is less than anticipated in a present value calculation, the effect would be that the A) future value would be lower B) yield to maturity (YTM) would decrease C) present value would be higher D) present value would be lower
C) present value would be higher *The present value computation is used to determine how much money must be deposited now (present) to reach a specified future goal when you know how many years you have to reach that goal. One critical component of the formula is the rate of return used in the formula. As a simple example, if you need $100,000 18 years from now for your newborn's college education and you expect to earn 8%, you'll have to deposit approximately $25,000 now (present value) to reach the goal. However, if it turns out that the earnings rate is less than anticipated, say only 4%, then you would have to deposit twice as much presently. Therefore, we answer this question by indicating that a lower rate of return will require a higher present value.
One of your clients has $150,000 in his 401(k) plan at work. He is assuming the portfolio will increase in value at a rate of 7% compounded annually for the next 5 years. If that is the case, the portfolio value at the end of that 5-year period will be closest to A) $160,500. B) $240,867. C) $202,500. D) $210,383.
D) $210,383 *This is a straightforward future value computation. The proper way to do this is to enter the beginning value ($150,000) into your calculator, and then multiply times 107% five consecutive times. We'll get you started: 150,000 x 107% = $160,500 x 107% = $171,735 x 107% = $183,756 (and do this 2 more times to get $210,383). If that is too challenging, then use the "shortcut" - it always works. Figure the answer using simple interest. The starting value is $150,000. Seven percent growth is $10,500. Do that for 5 years and it is $52,500. Add that to the initial value and you have $202,500. Then, select the next highest number because that takes into consideration the compounding effect.
At age 18, Joan's trust fund becomes available to pay for her higher education. There is $100,000 in the fund, all invested in fixed income securities with an average coupon of 6%. If the estimated cost of college for the next 4 years is $30,000 per year paid at the beginning of the school year, how long will the money last? A) 3 years with approximately $28,000 available for the 4th year B) 3 years with approximately $25,009 available for the 4th year C) 4 years with approximately $4,000 remaining D) 3 years with approximately $17,863 available for the 4th year
D) 3 years with approximately $17,863 available for the 4th year *Here is how to do this with the simple calculator available at the testing center. Beginning sum is $100,000 with $30,000 taken out to start the school year. The remaining $70,000 earns 6%, so multiply $70,000 × 106% to arrive at $74,200 at the end of the 1st year. Then, subtract $30,000 and multiply by 106% again resulting in an end of 2nd year total of $46,852. Subtract the $30,000 again and multiply the remainder by 106%, which results in $17,863 remaining at the end of the 3rd year.
The present value of a dollar A) is the amount of goods and services it will buy in the future at today's rate price level B) is equal to its future value if the level of interest rates stays the same C) cannot be calculated without knowing the level of inflation D) indicates how much must be invested today at a given interest rate, to equal a specific cash value in the future
D) Indicates how much must be invested today at a given interest rate, to equal a specific cash value in the future *The present value of a dollar will indicate how much must be invested today at a given interest rate, to equal a cash amount required in the future.
An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 6.32%, then the NPV is A) negative B) between 6% and 6.32% C) zero D) positive
D) Positive *Anytime an investment's IRR is more than the required rate of return, the NPV is positive (and should probably be selected). The NPV is expressed as a dollar amount. It is the IRR which is expressed as a percentage.
Which of the following is a stock valuation ratio? A) Dividend payout ratio B) Operating profits to net sales C) Revenues to assets D) Price-earnings
D) Price-earnings *The price-earnings (PE) ratio is a valuation ratio used to calculate the value of a stock. For example, if a stock has a PE of 20, it means that the security is priced at 20 times earnings.
Fundamental analysts give significant credence to financial ratios. Which of the following tends to give an indication of the profitability of the enterprise? A) Debt-to-equity ratio B) Price-to-earnings ratio C) Current ratio D) Sales-to-earnings ratio
D) Sales-to-earnings ratio *Of the four choices given, the sales-to-earnings ratio is the only one not discussed in the License Exam Manual. Why not? Because we know there will always be a question or two on the real exam that was not covered in our material. It is important that students use good test-taking skills to correctly answer those questions. It would seem logical that a question about profitability would relate to earnings. That would reduce the choices to two from four. The price-to-earnings (P/E) ratio reveals the relationship between the market price of the company's stock and its earnings, but it doesn't tell us anything about the degree of profitability of the enterprise. If we know that the P/E ratio compares the price to the earnings, then it makes sense that the sales-to-earnings ratio compares the net sales of the business with its earnings. Companies with a higher percentage of earnings from each dollar of sales are more profitable. For example, Company A and Company B both reported $100 million in net sales for the year. The net income (earnings) of Company A was $20 million and Company B was $8 million. We can see that each dollar of sales generated $0.20 of profit for Company A and only $0.08 of profit for Company B. Or, we could say that it takes $5 of Company A sales to generate $1 of profit ($100 ÷ 20) while it takes $12.50 of Company B sales ($100 ÷ 8) to earn that same $1 of profit.
Beverly has two stocks with a correlation coefficient of zero. Which of the following is correct? A) These stocks are well diversified because they will move in unison. B) These stocks are well diversified because as one stock appreciates in value, the other decreases in value. C) These stocks are not well diversified because they move in unison. D) These stocks will move independently of each other.
D) These stocks will move independently of each other *A correlation coefficient of zero means that the two stocks will move independently. They may move in the same direction, or they may not. The zero correlation coefficient indicates that there is no pattern to the relationship between their price movements.
