Ch 9: investment recommendations; risks and returns

Time value of money

-concept that states the value of a dollar today will be higher than the value of that same dollar in the future -2 reasons for this are inflation and the potential appreciation or income received from investing that dollar

Random Walk Theory

-similar to EMH theory -believes it is impossible to outperform the market -believes that stock market prices are random and not influenced by past events **whereas EMH believes that the stock market is efficient and adapts to new info immediately

Which of the following securities has the greatest credit risk? [A]General Obligation Bond [B]Industrial Development Bond [C]Equipment Trust Certificate [D]Mortgage Bond

EXPLANATION Industrial Development bonds are bonds that are issued by municipalities on behalf of a public corporation and ultimate responsibility for the debt is placed on the corporation. Therefore, these bonds would be considered a risky investment when compared to the other choices offered which all are backed by specific assets.

There are varying forms of Efficient Market Hypothesis. Which assumes that all information, both that available to the public and the private sectors, is available to all investors and reflected in security prices? [A]This is Strong Form Efficient Market Hypothesis. [B]This is Semi-Strong Form Efficient Market Hypothesis. [C]This is Medium Form Efficient Market Hypothesis. [D]This is Weak Form Efficient Market Hypothesis.

EXPLANATION Strong Efficient Market Hypothesis makes the assumption that all information, both public and private, is available to investors and is thus reflected in market prices.

What is a client's total return on his portfolio after one year if he invests $10,000 in each of three stocks, X,Y, and Z? He received $200 in dividends from company X, no dividend from company Y, and $300 in dividends from company Z. After one year the stock price of company X has increased 10%, the stock price of company Y has decreased 15%, and the stock price for company Z has remained unchanged and all three stocks are sold by the client. [A]0% [B]1.6% [C]3.3% [D]5.0%

[A]0% EXPLANATION The total return includes dividends and capital gains or losses on the investment. Dividends = $200 + $300 = $500, Capital Gains = $1000 - $1500 = -$500, total is $0.00.

What type of measurement gives the investor an idea of how an investment performs relative to the amount of risk taken? [A]Alpha [B]Beta [C]An investment manager's portfolio performance [D]Duration

[A]Alpha

What type of measurement directly includes performance of a benchmark index? [A]Alpha [B]Beta [C]An investment manager's portfolio performance [D]Duration

[B]Beta

Of the following, which TWO examples BEST illustrate the time value of money? I. An investor with a fixed annuity currently has a cash surrender value of $100,000, but if annuitized, the contract would pay more than $175,000 over the next 15 years. II. An investor who is currently tied up in bonds yielding 5% hears about new bond issues with the same level of safety paying 8%. III. An investor has the option of investing in a stock which pays out 5% in annual dividends versus a growth stock which increases, on average, 7% per year. IV. An investor goes to Vegas and wins at a slot machine, where the payout is $5,000 up-front, or 10 annual payments of $1,000, totaling $10,000. [A]I and III [B]I and IV [C]II and III [D]II and IV

[B]I and IV EXPLANATION The annuity example and winnings example are great demonstrations of the time value of money. The company offering the annuity will only pay out $100,000 right now, and the casino will only pay out $5,000 right now. However, if the investor or winner in Vegas allows the insurance company or casino, respectively, to hold onto that money and pay out over time, the amount received goes up. This is because those entities possess that money, invest it, and have the opportunity to profit off of it over that time period. Bond rates going up or down are a function of the Fed and the example is more one of opportunity cost. The difference in return on a stock paying dividends versus a growth stock is just a difference in investment and type of stock.

Joey recently came into some money via an inheritance. After all taxes, he received $2.5 million dollars from his grandparents. Joey has decided to spend part of the inheritance on a house that he will buy in cash, but he wants to invest a set amount to ensure that he receives $5,000 per month for his bills indefinitely. An adviser has recommended a fund which has an anticipated or expected annual rate of return of 4.8%. With these factors in mind, how much does Joey have to invest and how much remains for Joey to buy a house in cash? [A]Joey must invest $2,500,000 and will have $0 remaining for the house.[B]Joey must invest $1,250,000 and will have $1,250,000 remaining for the house.[C]Joey must invest $600,000 and will have $1,900,000 remaining for the house.[D]Joey must invest about $105,000 and will have about $2,395,000 remaining for the house.

[B]Joey must invest $1,250,000 and will have $1,250,000 remaining for the house. EXPLANATION In this scenario, Joey is looking for a payment in perpetuity (indefinitely, forever, etc). So with the expected rate of return that is listed, we can calculate the amount necessary to arrive at that indefinite monthly payout. Our payment is given on a monthly basis while our expected rate of return is an annual figure. So we either need to calculate the annual payout or figure out our monthly rate of return to arrive at our answer.Monthly, Joey wants $5,000. So we can divide the 4.8% by 12 to arrive at a monthly expected return of 0.004 (0.048 / 12). We then divide $5,000 by 0.004 to arrive at the same figure of $1,250,000.So Joey must invest $1,250,000 to receive his monthly $5,000 and he will have $1,250,000 to spend on the house. **Annually, Joey wants $60,000 ($5,000/mo). So we can divide $60,000 by 4.8% (60,000 / 0.048) to arrive at the amount that must be invested $1,250,000.**

An investor is concerned with the rate of inflation in relation to a portfolio of bonds that the investor holds. The investor's concern stems from the fact that the bond portfolio has an annual return of 3%, while the rate of inflation has increased to 2%. If the investor adjusts the return for inflation and finds that the return was only 1%, which of the following is TRUE? [A]The 1% reflects the total return on the portfolio. [B]The 1% reflects the real rate of return on the portfolio. [C]The investor will only owe taxes in relation to the 1% figure.[D]The 1% would represent either the expected return or internal rate of return, depending on the duration of the portfolio.

[B]The 1% reflects the real rate of return on the portfolio. EXPLANATION The investor's return was 3% and inflation was 2%, so the real rate of return, also known as the inflation-adjusted return, would be 1% (3% return - 2% inflation = 1% real rate of return). Taxes would be paid on the actual return of 3%, depending on the type of bonds in the portfolio. Total return, expected return, and IRR are all calculated differently and would be unlikely to be 1% with the information provided.

In Modern Portfolio Theory, a portfolio whose return is above the Efficient Frontier is considered [A]sub-ideal. [B]ideal. [C]inefficient. [D]high risk.

[B]ideal. EXPLANATION In Modern Portfolio Theory, portfolio returns that measure below the efficient frontier are considered sub-ideal, because the rate of return does not justify the risk. Profiles that measure above the frontier are ideal, and the returns are well balanced to the risk.

When evaluating long-term investments by using Net Present Value, the NPV would consider all of the following except? [A]inflow of money [B]today's market price [C]outflows of money [D]expected returns

[B]today's market price EXPLANATION NPV uses future cash inflows and outflows, a discount rate, and time period but does not consider today's market value. NPV is used to determine if projects will be profitable over a specified period of time.

A financial analyst is reviewing projected income flows and outflows for a project. She wants to understand what these projected revenues and costs mean in today's dollars. The analyst should use which of the following analysis tools? [A]Dividend Discount Model (DDM) [B]Capital Asset Pricing Model (CAPM) [C]Discounted Cash Flow Methodology (DCF) [D]Efficient Market Hypothesis

[C]Discounted Cash Flow Methodology (DCF) EXPLANATION Discounted Cash Flow Methodology, including Net Present Value (NPV) and Internal Rate of Return (IRR) are means of evaluating investments or projects utilizing discounting to arrive at present values for future revenues (inflows) and expenses (outflows) for a number of periods in the future. The dividend discount model does employ DCF analysis but that tool is used to determine the value of a dividend-paying stock by discounting future dividends. It is not used for project decision making.

You have a client who is tolerant to risk who has a 35-year time horizon. The most appropriate allocation of this client's portfolio would be: [A]Split 50% bonds, 50% stocks[B]Split 45% bonds, 55% stocks[C]Split 90% stocks, 10% money market[D]25% in four categories: bonds, money market, REITs, and stocks

[C]Split 90% stocks, 10% money market In risk tolerant portfolios with long-term time horizons such as **25 years or more,** the best answer is the one with the most equities.

Total Return is a measure of performance which can be used on: Common stocks Preferred stocks Corporate Bonds [A]I only[B]I and II[C]II and III[D]I, II, III

[D]I, II, III EXPLANATION Total Return is considered to be the best measure of an investment's performance and can be used with common stock, preferred stock, and corporate bonds.

Which of the following rely heavily on the discount rate or required rate of return used? I. Total Return II. Internal Rate of Return III. Risk-Free Rate of Return IV. Net Present Value [A]I and III only [B]I and IV only [C]II and III only [D]II and IV only

[D]II and IV only: II. Internal Rate of Return, IV. Net Present Value EXPLANATION Internal Rate of Return and Net Present Value are forms of Discounted Cash Flow (DCF) Methodology. In DCF, the discount rate or required rate of return used in the formula will impact the results of the calculations significantly. DCF Methodology attempts to project the value of an investment or project and its returns to the investor. Total Return is a measure of returns over the course of a year, divided by the cost of the investment. The Risk-Free Rate of Return is typically the yield on the 3-Month Treasury Bill. Both Total Return and the Risk-Free Rate of Return do not use discount rates or required rates of return.

Efficient Market Hypothesis

investment theory that states it is impossible to consistently "beat the market" because current share prices always reflect all relevant information. weak version: says that market prices reflect past prices and trading volumes. All investors have access to the same information. semi-strong version: publicly available info is reflected in market prices strong version: all info, public or private, is reflected in market prices

Efficient frontier

provide best return for risk incurred. -portfolios that measure BELOW the efficient frontier are considered SUB-IDEAL, because rate of return does not justify risk -portfolios that measure ABOVE the frontier are IDEAL, and the returns are well balanced to the risk -the efficient frontier represents an investment portfolio with the HIGHEST RETURNS GIVEN A LIMITED AMOUNT OF RISK