Corporate Finance - Chapter 10

True or false: In the Ibbotson-Sinquefield studies, U. S. Treasury bill data is based on T-bills with a maturity of one year.

False. 1 month

True or false: Long-term U.S. government bonds used in the Ibbotson-Sinquefield studies had 15 years to maturity.

False. 20 years

Average returns can be calculated:

geometric and arithmetic

The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the:

initial stock price

Which type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock?

overaction and correction

Geometric averages are usually ______ arithmetic averages.

smaller than. Geometric averages are usually smaller than arithmetic averages because of the effect of compounding.

The variance and its square root, the _____ _____, are the most commonly used measures of volatility.

standard deviation

Some important characteristics of the normal distribution are that it is:

symmetrical bell-shaped

If you receive a $2 dividend per share on your 100 shares, your total dividend income is ____.

$2 x 100

Which of the following are true based on the year-to-year returns from 1926-2014?

*T-bills sometimes outperform common stocks. *Common stocks frequently experience negative returns.

A dividend yield of 10% says that, for each dollar we invest, we get _____ cents in dividends.

10

The arithmetic mean for large-company stock returns from 1926 to 2017 is:

12.1%

What was the average annual risk premium on small-company stocks for the period 1926-2014?

13.2%

Bonds used in Ibbotson SBBI long-term U.S. government bond portfolio had maturities of ____ years.

20

_______ were a bright spot for U.S. investors during 2008.

Bonds

Which one of the following categories has the widest frequency distribution of returns for the period 1926-2014?

Small-company stocks

The second lesson from studying capital market history is that risk is:

handsomely rewarded

The risk-return relationship states that a riskier investment should demand a ____________ return.

higher

The arithmetic average rate of return measures the ____.

return in an average year over a given period

Suppose you bought a$1,000 face value bond with a 5 percent coupon one year ago for $1,020. The bond sells today for $986. If the inflation rate last year was 2.3 percent, what was your total real rate of return on this investment?

-.71%

A bond has an average return of 11.2 percent and a standard deviation of 14.6 percent. What range of returns would you expect to see 68 percent of the time on this security?

68 percent probability range = 11.2 percent ± 14.6 percent = -3.4 percent to 25.8 percent

From 1900 to 2010, the average stock market risk premium of the U.S. was ______.

7.2

The total dollar return is the sum of dividends and __________.

Capital gain or loss

The percentage change in the price of a stock over a period of time is called its ___________.

Capital gains yield

The stock of Southern United is priced at $52 a share and has a dividend yield of 3.6 percent. The firm pays constant annual dividends. What is the amount of the next dividend per share?

D = .036 ×$52 = $1.872

Which of the following are ways to make money by investing in stocks?

Dividends Capital gains

Assume large-company stocks returned 12.1 percent on average over the past 88 years. The risk premium on these stocks was 8.6 percent and the inflation rate was 3.0 percent. What was the average nominal risk-free rate of return for those 88 years?

Nominal risk-free rate = 12.1 percent -8.6 percent = 3.5 percent

You purchased a zero coupon bond one year ago for $346.72. The market interest rate is now 5.75 percent. If the bond had 15 years to maturity when you originally purchased it, what is your total return to date if the face value of the bond is $1,000?

PV = $1,000/[1 + (.0575/2)]28 = $452.19 Total return = ($452.19-346.72)/$346.72 = .3042 or 30.42 percent

Assume that last year, Isaac earned 13.6 percent on his investments while U.S. Treasury bills yielded 2.7 percent, and the inflation rate was 2.2 percent. What real rate of return did he earn on his investments last year?

Real return = (1.136/1.022) - 1 = .1115, or 11.15 percent

Which one of the following is the positive square root of the variance?

Standard deviation

Which of the following is commonly used to measure inflation?

The Consumer Price Index (CPI)

Roger Ibbotson and Rex Sinquefield conducted a famous set of studies dealing with rates of return in U.S. financial markets.

True

True or false: A capital gain on a stock is counted as part of the total return whether or not the gain is realized from selling the stock.

True

True or false: The dividend yield = Dt+1/Pt

True

True or false: The normal distribution is completely described by the average and standard deviation.

True

True or false: The average return of a given period is typically not a good estimate of the returns over that same period.

False: Without any other information, you can use the average return from a time period as a "best guess" of the return in a given year from that same period.

Assume you earned 17.1 percent on your investments for a time period when the risk-free rate was 4.2 percent and the inflation rate was 4.6 percent. What was your real rate of return for the period?

Real return = (1.171 /1.046) - 1 = .1195, or 11.95 percent

Arrange the following investments from highest to lowest risk (standard deviation) based on what our study of capital market history from 1926-2014 has revealed as shown in Table 10.3:

Small-company common stock Large-company common stocks Long-term corporate bonds Long-term government bonds U.S. Treasury bills

For the period 1926-2014, which one of the following had the smallest risk premium?

US Treasury bills

An efficient capital market is best defined as a market in which security prices reflect which one of the following?

all available information

In an efficient market ______ investments have a _____ NPV.

all; zero

The geometric rate of return takes ______ into account.

compounding

Historically, the real return on Treasury bills has been:

quite low

One year ago, you purchased 600 shares of a stock. This morning you sold those shares and realized a total return of 3.1 percent. Given this information, you know for sure the:

sum of the dividend yield and the capital gains yield is 3.1 percent.

The geometric average rate of return is approximately equal to ___.

the arithmetic mean minus half of the variance

Two ways of calculating average returns are _______ and _______.

the geometric average the arithmetic average

The square of the standard deviation is equal to the ____.

variance. The standard deviation is the square root of the variance, so the variance is the standard deviation squared.

The total dollar return on a stock is the sum of the ____ and the _____.

Dividends capital gain (or loss)

The _____ price index is a commonly used measure of inflation.

consumer

The total return percentage is the ________ yield plus the capital gains yield.

dividend

The risk _____ can be interpreted as the reward for bearing risk.

premium

True or false: The smaller the variance or standard deviation is, the more spread out the returns will be.

False. The larger the variance of standard deviation is, the more spread out the returns will be.

Match each information type to the form of market efficiency that identifies that type of information as being quickly and accurately reflected in stock prices.

* strong form - all information * semistrong form - all public information * weak form - past prices

The Ibbotson-Sinquefield data shows that:

*long-term corporate bonds had less risk or variability than stocks *U.S. T-bills had the lowest risk or variability

The Ibbotson SBBI data show that over the long-term, ___.

*small-company stocks had the highest risk level *small-company stocks generated the highest average return *T-bills, which had the lowest risk, generated the lowest return

In the Ibbotson-Sinquefield studies, U. S. Treasury bill data is based on T-bills with a maturity of _______ month(s).

1

Over the last four years, the common stock of Plymouth Shippers has had an arithmetic average return of 10.4 percent. Three of those four years produced returns of 16.1 percent, 15.6 percent, and 9.4 percent, respectively. What is the geometric average return for this four-year period?

10.22%

The standard deviation for large-company stock returns from 1926 to 2017 is:

19.8

The probability of an outcome being at least 2 standard deviations below the mean in a normal distribution is approximately:

2.5%. The probability of an outcome being within + or - 2 standard deviations is 95% so the probability of being below 2 standard deviations = (100% - 95%)/2

A security produced returns of 12 percent, -11 percent, -2 percent, 15 percent, and 9 percent over the past five years, respectively. Based on these five years, what is the probability that an investor in this stock will lose more than 17.06 percent in any one given year?

2.50%

Treasury Bills yielded a nominal average return over 86 years of 3.5% versus an average inflation rate of 3.0% over the same period. This makes the real return on T-bills approximately equal to _____.

3.5%-3.0%=0.5%

Roger Ibbotson and Rex Sinquefield presented year-to-year historical rates of return on ______ types of financial investments.

5

The probability of a return being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.

68

With a normal distribution, the probability that we end up within two standard deviations is about _____ percent.

95

True or false: Arithmetic and geometric averages are useful because they are not influenced by volatility.

False

The standard deviation is the ______ of the variance.

Square root. The standard deviation is the square root of the variance.

Which of the following are needed to describe the distribution of stock returns?

The standard deviation of returns The mean return

True or false: The risk premium can be interpreted as a reward for bearing risk

True

Arrange the following investments starting from lowest historical risk premium to highest historical risk premium.

U.S. Treasury Bills Long-term corporate bonds Large-company stocks Small-company stocks

More volatility in returns produces ______ difference between the arithmetic and geometric averages.

a larger

Percentage returns are more convenient than dollar returns because they:

apply to any amount invested allow comparison against other investments

The dividend yield for a one-year period is equal to the annual dividend amount divided by the ____.

beginning stock price

The average return on the stock market can be used to ___.

compare stock returns with the returns on other securities

The geometric average return is the average _____ return earned per year over a multiyear period.

compound

In an efficient market, firms should expect to receive ______ value for securities they sell.

fair

In 2008, the prices on long-term U.S. Treasury bonds __________ .

gained 40%

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

An efficient market is one that fully reflects all available ______.

information

Stock prices fluctuate from day to day because of:

information flow

The lower the standard deviation of returns on a security, the _____ the expected rate of return and the _____ the risk.

lower; lower

The normal distribution is completely described by the _______ and ________.

mean variance or standard deviation

The year 2008 was:

one of the worst years for stock market investors in U.S. history

If you use an arithmetic average to project long-run wealth levels, your results will most likely be _______.

optimistic

The excess return is the difference between the rate of return on a risky asset and the ______ rate.

risk-free

If a study of past stock prices and volume to find mis-priced securities will not lead to gains in the market, then the market must be at least _____ efficient.

weak-form

The efficient markets hypothesis contends that _____________ capital markets such as the NYSE are efficient.

well-organized

Over the past six years, a stock had annual returns of 18 percent, -6 percent, 2 percent, 27 percent, -11 percent, and 13 percent, respectively. What is the standard deviation of these returns?

14.66%

The Bermuda Triangle Store pays a constant dividend. Last year, the dividend yield was 4.0 percent when the stock was selling for $16 a share. What must the stock price be today if the market currently requires a 4.3 percent dividend yield on this stock?

14.88. D = .040 ×$16 = $.64 P0 = $.64/.043 = $14.88

Your portfolio has provided you with returns of 11.4 percent, 6.2 percent, -.7 percent, and 14.6 percent over the past four years, respectively. What is the geometric average return for this period?

7.72%

True or false: To get the average (mean) return, the yearly returns are summed and then multiplied by the number of returns.

False. Divided

Sarah earned a 3.3 percent real rate of return on her investments for the past year. During that time, the risk-free rate was 3.6 percent and the inflation rate was 3.1 percent. What was her nominal rate of return?

Nominal rate = (1.033 ×1.031) - 1 = .0650, or 6.50 percent

If you use a geometric average to project short-run wealth levels, your results will most likely be _______ .

pessimistic

True or false: Because T-bills have low risk relative to common stocks, T-bills cannot outperform common stocks.

False. T-bills sometimes outperform common stocks.

True or false: To get the average return, the yearly returns are summed and then multiplied by the number of returns.

False. Divided

True or false: The dividend yield minus the capital gains yield is the total return percentage.

False. Dividend yield PLUS capital gains

True or false: The geometric average rate of return measures the return in an average year over a given period.

False. The arithmetic average rate of return measures the return in an average year over a given period.

Using capital market history as a guide, it would appear the greatest reward would come from investing in _______.

small-company common stock

If the market changes and stock prices instantly and fully reflect new information, which time path does such a change exhibit?

An efficient market reaction

2008 was a bad year for markets worldwide. One of the worst hit was the Icelandic Exchange where shares priced dropped _____ in one day.

76%

If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.

is highly risky

The second lesson from studying capital market history states that the _______ the potential reward, the _______ the risk

lower; lower greater; greater