FIN 370 Exam 1

A Perpetuity pays $85 per year and costs $950. What is the rate of return?

8.95%: PV=PMT/I I= PMT/PV 85/950= 0.0894

The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A? A) 13.8%. B) 14.2%. C) 15.6%.

A

What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market is offering 12%? A) 13.2%. B) 7.2%. C) 6.0%.

A

A bond has a par value of $5,000 and a coupon rate of 8.5% payable semi-annually. The bond is currently trading at 112.16. What is the dollar amount of the semi-annual coupon payment? A) $212.50. B) $238.33. C) $425.00. The correct answer was A.

A The dollar amount of the coupon payment is computed as follows: Coupon in $ = $5,000 × 0.085 / 2 = $212.50

A stock portfolio's returns are normally distributed. It has had a mean annual return of 25% with a standard deviation of 40%. The probability of a return between -41% and 91% is closest to: A)90%.B)65%.C)95%.

A 90% confidence level includes the range between plus and minus 1.65 standard deviations from the mean. (91 − 25) / 40 = 1.65 and (-41 − 25) / 40 = -1.65.

Concerning an ordinary annuity and an annuity due with the same payments and positive interest rate, which of the following statements is most accurate? A) The present value of the ordinary annuity is less than an annuity due. B) The present value of the ordinary annuity is greater than an annuity due. C) There is no relationship

A) The present Value of the ordinary annuity is less than an annuity due. With a positive interest rate, the present value of an ordinary annuity is less than the present value of an annuity due. The first cash flow in an annuity due is at the beginning of the period, while in an ordinary annuity, the first cash flow occurs at the end of the period. Therefore, each cash flow of the ordinary annuity is discounted one period more.

A coupon bond that pays interest annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. What is the value of the bond today if the coupon rate is 8%? A) $924.18. B) $2,077.00. C) $1,500.00.

A. FV = 1,000 N = 5 I = 10 PMT = 80 Compute PV = 924.18.

A bond is issued with the following data: $10 million face value. 9% coupon rate. 8% market rate. 3-year bond with semiannual payments. What is the present value of the bond? A) $10,262,107. B) $10,138,754. C) $10,000,000.

A. FV = 10,000,000; PMT = 450,000; I/Y = 4; N = 6; CPT → PV = -10,262,107

Risk aversion means that if two assets have identical expected returns, an individual will choose the asset with the: A) lower risk level. B) higher standard deviation. C) shorter payback period.

A. Investors are risk averse. Given a choice between assets with equal rates of expected return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk (Eσ) and the risk return line (capital market line [CML] and security market line [SML]) is upward sloping. Standard deviation is a way to quantify risk. The payback period is used to evaluate capital projects, not investment returns.

A bond with a 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of: A) over 14%. B) between 13% and 14%. C) between 10% and 12%.

A. PMT = 120; N = 10; PV = -880; FV = 1,000; CPT → I = 14.3

A stock portfolio has had a historical average annual return of 12% and a standard deviation of 20%. The returns are normally distributed. The range -27.2 to 51.2% describes a: A) 95% confidence interval. B) 68% confidence interval. C) 99% confidence interval.

A. The upper limit of the range, 51.2%, is (51.2 − 12) = 39.2 / 20 = 1.96 standard deviations above the mean of 12. The lower limit of the range is (12 − (-27.2)) = 39.2 / 20 = 1.96 standard deviations below the mean of 12. A 95% confidence level is defined by a range 1.96 standard deviations above and below the mean.

Which of the following statements is FALSE? Compared to a callable bond, a noncallable bond: A) provides a higher yield. B) is more attractive to an investor concerned with reinvestment risk. C) has more predictable cash flows.

A. When compared to a callable bond, the yield on a noncallable bond is less. With a noncallable bond, the issuer does not have to compensate the investor for call risk/cash flow uncertainty with any premium. The other choices are true. Call risk is the combination of cash flow uncertainty and reinvestment risk. When a bond is called, the investor faces a disruption in cash flow and a reduced rate of return.

Which of the following statements about zero-coupon bonds is FALSE? A) A zero coupon bond may sell at a premium to par when interest rates decline. B) The lower the price, the greater the return for a given maturity. C) All interest is earned at maturity

A. Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par.

Interest rates have fallen over the seven years since a $1,000 par, 10-year bond was issued with a coupon of 7%. What is the present value of this bond if the required rate of return is currently four and one-half percent? (For simplicity, assume annual payments.) A) $1,068.72 B) $1,052.17. C) $1,044.33

A. The present value can also be determined with a financial calculator. N = 3, I = 4.5%, PMT = $1,000 × 7%, FV = $1,000. Solve for PV = $1,068.724.

Which of the following statements about compounding and interest rates is least accurate? A)All else equal, the longer the term of a loan, the lower will be the total interest you pay. B)Present values and discount rates move in opposite directions. C)On monthly compounded loans, the effective annual rate (EAR) will exceed the annual percentage rate (APR)

A. Since the proportion of each payment going toward the principal decreases as the original loan maturity increases, the total dollars interest paid over the life of the loan also increases. The main difference between APR and EAR is that APR is based on simple interest, while EAR takes compound interest into account. APR is most useful for evaluating mortgage and auto loans, while EAR (or APY) is most effective for evaluating frequently compounding loans such as credit cards.

Selmer Jones has just inherited some money and wants to set some of it aside for a vacation in Hawaii one year from today. His bank will pay him 5% interest on any funds he deposits. In order to determine how much of the money must be set aside and held for the trip, he should use the 5% as a: A. Discount Rate B. Required Rate of Return C. Opportunity Cost

A. Discount Rate He needs to figure out how much the trip will cost in one year, and use the 5% as a discount rate to convert the future cost to a present value. Thus, in this context the rate is best viewed as a discount rate.

Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the end of each of the next 5 years. By how much would you reduce the amount you owe in the first year? a. $2,404.91 b. $2,531.49 c. $2,658.06 d. $2,790.96 e. $2,930.51

B. n=5 pv=-15,000 i/y=8.5% CPTpmt= 3,806.48 (this is your interest Exp+ principle, the more payments you make the more u pay off ur interest and than u are left with ur principle) 15,000 *8.5%= 1275 3806.48-1275= 2,531.49

Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price? a. A 1-year bond with a 15% coupon. b. A 3-year bond with a 10% coupon. c. A 10-year zero coupon bond. d. A 10-year bond with a 10% coupon. e. An 8-year bond with a 9% coupon.

C. Zero coupon bond is paid at discount price but owner receives bonds face value. No interest effect. Interest goes down and older Bond's become more valuable w/ a higher coupon rate.

What are Free Cash Flows?

Cash Flows that are available for Distribution to investors + creditors. calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF= sales revenue- operating costs - operating taxes - required investments in operating capital.

Partners Bank offers to lend you $50,000 at a nominal rate of 5.0%, simple interest, with interest paid quarterly. An offer to lend you the $50,000 also comes from Community Bank, but it will charge 6.0%, simple interest, with interest paid at the end of the year. What's the difference in the effective annual rates charged by the two banks? a. 1.56% b. 1.30% c. 1.09% d. 0.91% e. 0.72%

D. "simple interest with interest paid quarterly" means that the bank gets the interest at the end of each quarter, hence it can invest it, presumably at the same nominal rate. This results in the same effective rate as if it were stated as "6%, quarterly compounding." Nominal rate, Partners 5.0% Periods/yr, Partners 4 Nominal rate, Community 6.0% Periods/yr, Community 1 EFF% Partners 5.09% EFF% Community 6.00% Difference 0.91%

You plan to invest some money in a bank account. Which of the following banks provides you with the highest effective rate of interest? a. Bank 1; 6.1% with annual compounding. b. Bank 2; 6.0% with monthly compounding. c. Bank 3; 6.0% with annual compounding. d. Bank 4; 6.0% with quarterly compounding. e. Bank 5; 6.0% with daily (365-day) compounding

E. By inspection, we can see that e dominates b, c, and d because, with the same interest rate, the account with the most frequent compounding has the highest EFF%. Thus, the correct answer must be either a or e. However, we cannot tell by inspection whether a or e provides the higher EFF%. We know that with one compounding period an EFF% is 6.1%, so we can calculate e's EFF%. It is 6.183%, so e is the correct answer. a. (1 + 0.061/1)1−1 = 6.100% e. (1 + 0.06/365)365−1 = 6.183%

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

False. Call provisions provides "Issuers" of the bond the right to call the bond and have it redeemed prior to maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at the lower rate of interest. In this case, the company "calls" its current bonds and reissues them at a lower interest rate.

A stock's beta measures its diversifiable risk relative to the diversifiable risks of other firms (T/F)

False. A stocks beta measures the stocks volatility in relation to the market. Market has beta of 1. Beta over 1= more volatility, but could have higher returns.

Which one of the following alternatives represents the correct series of payments made by a typical 6% U.S. Treasury note with a par value of $100,000 issued today with five years to maturity? Number and size of each intermediate payment Payment made at maturity A) 9 semiannual payments of $3,000 $103,000 B) 4 annual payments of $6,000 $106,000 C) 9 semiannual payments of $3,000 $100,000

Payments for U.S. Treasury bonds and notes are semiannual and are fixed for the life of each bond or note. The coupon rate is quoted on an annual basis but each payment is made on the basis of one half the annual rate multiplied by the maturity or par value.

Which of the following statements about systematic and unsystematic risk is least accurate? A) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry. B) Total risk equals market risk plus firm-specific risk. C) As an investor increases the number of stocks in a portfolio, the systematic risk will remain constant.

This statement should read, "The unsystematic risk for a specific firm is not similar to the unsystematic risk for other firms in the same industry." Thus, other terms for this risk are firmspecific, or unique, risk. Systematic risk is not diversifiable. As an investor increases the number of stocks in a portfolio the unsystematic risk will decrease at a decreasing rate. Total risk equals systematic (market) plus unsystematic (firm-specific) risk

A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions. (T/F)

True

The greater the number of compounding periods within a year, then (1) the greater the future value of a lump sum investment at Time 0 and (2) the smaller the present value of a given lump sum to be received at some future date. (T/F)

True PV= (FVn)/ (1+I)^n

There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. (T/F)

True. Lower rated bonds, are a bit riskier, but can hold higher returns. The required rate of return (RRR) is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.

A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%. (T/F)

True. If a bond's coupon rate is less than its YTM, the bond is selling a a discount rate. If coupon rate is more then YTM, then bond is selling at premium. If Coupon rate = YTM, than bond is selling at par. Premium Bond (Bond priced above its par value) has a coupon rate higher than the prevailing interest rate for that particular bond maturity and credit quality.

Given a beta of 1.25 and a risk-free rate of 6%, what is the expected rate of return assuming a 12% market return? A) 13.5%. B) 10%. C) 31%

k = 6 + 1.25 (12 − 6) = 6 + 1.25(6) = 6 + 7.5 = 13.5