Finance Test 2 Practice Questions

T/F: When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk.

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Morin Company's bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 6.1% on these bonds. What is the bond's price? a. $1,024.74 b. $1,147.71 c. $1,116.97 d. $1,096.47 e. $1,280.93

a. $1,024.74

Cooley Company's stock has a beta of 1.28, the risk-free rate is 2.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? Do not round your intermediate calculations. a. 9.29% b. 9.94% c. 10.96% d. 8.55% e. 11.52%

a. 9.29%

Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. if Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's b. Stock B must have a higher dividend yield than Stock A c. Stock A must have a higher dividend yield than Stock B d. if Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's e. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B

a. if Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's

A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. the bond's expected capital gains yield is zero b. the bond's yield to maturity is above 9% c. the bond's current yield is above 9% d. if the bond's yield to maturity declines, the bond will sell at a discount e. the bond's current yield is less than its expected capital gains yield

a. the bond's expected capital gains yield is zero

Dothan Inc.'s stock has a 25% chance of producing a 16% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return? a. 4.51% b. 5.50% c. 4.68% d. 4.29% e. 6.38%

b. 5.50%

Assume that interest rates on a 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a. tax effects b. default and liquidity risk differences c. maturity risk differences d. inflation differences e. real risk-free rate differences

b. default and liquidity risk differences

Which of the following statements is CORRECT? a. the yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond b. the yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond c. the yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond d. the yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond e. the following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity

b. the yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond

Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require a 10.7% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $721.44 b. $910.81 c. $901.80 d. $874.74 e. $1,000.99

c. $901.80

You have the following data on three stocks: Stock A: St. Dev. = 20%; Beta = 0.59 Stock B: St. Dev. = 10%; Beta = 0.61 Stock C: St. Dev. = 12%; Beta = 1.29 If you are a strict risk minimizer, you would choose Stock _____ if it is to be held in isolation and Stock _____ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; B

c. B; A

T/F: The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond.

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Which of the following statements is CORRECT? a. if the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping b. if the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat c. if inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping d. if the expectations theory holds, the Treasury bond yield curve will never be downward sloping e. because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds

c. if inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping

During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. the required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0 b. the required return on all stocks will remain unchanged c. the required return will fall for all stocks, but it will fall more for stocks with higher betas d. the required return for all stocks will fall by the same amount e. the required return will fall for all stocks, but it will fall less for stocks with higher betas

c. the required return will fall for all stocks, but it will fall more for stocks with higher betas

Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Gamma Corp at $10 a share and adding it to your portfolio. Gamma has an expected return on 21.5% and a beta of 1.70. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Gamma stock? Do not round your intermediate calculations. a. 13.98%; 1.28 b. 12.29%; 1.48 c. 12.41%; 1.56 d. 12.05%; 1.25 e. 9.40%; 1.34

d. 12.05%; 1.25

Porter Inc's stock has an expected return of 12.50%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 2.00%, what is the market risk premium? Do not round your intermediate calculations. a. 10.50% b. 8.48% c. 7.98% d. 8.40% e. 6.80%

d. 8.40%

Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return? a. because of the call premium, the required rate of return would decline b. there is no reason to expect a change in the required rate of return c. the required rate of return would decline because the bond would then be less risky to a bondholder d. the required rate of return would increase because the bond would then be more risky to a bondholder e. it is impossible to say without more information

d. the required rate of return would increase because the bond would then be more risky to a bondholder

Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,045. What is the bond's nominal yield to call? a. 6.77% b. 5.09% c. 4.42% d. 5.54% e. 5.59%

e. 5.59%

T/F: 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.

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Which of the following statements is CORRECT? a. all else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds b. all else equal, long-term bonds have less price risk than short-term bonds c. all else equal, low-coupon bonds have less price risk than high-coupon bonds d. all else equal, short-term bonds have less reinvestment risk than long-term bonds e. all else equal, long-term bonds have less reinvestment risk than short-term bonds

e. all else equal, long-term bonds have less reinvestment risk than short-term bonds

Which of the following statements is CORRECT? a. an investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks b. the higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio c. it is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock d. once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount e. an investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks

e. an investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. the company's current stock price is $20 b. the company's dividend yield 5 years from now is expected to be 10% c. the constant growth model cannot be used because the growth rate is negative d. the company's expected capital gains yield is 5% e. the company's expected stock price at the beginning of next year is $9.50

e. the company's expected stock price at the beginning of next year is $9.50

T/F A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline.

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T/F: If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill.

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T/F The Y-axis intercept of the SML (security market line) represents the required return of a portfolio with a beta of zero, which is the risk-free rate.

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T/F The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity.

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T/F: Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

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T/F: For a stock to be in equilibrium, two conditions are necessary: (1) the stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

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T/F: From an investor's perspective, a firm's preferred stock is generally considered to be less risky than its common stock but more risky than its bonds. However, from a corporate issuer's standpoint, these risk relationships are reversed: bonds are the most risky for the firm, preferred is next, and common is least risky.

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T/F: If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term US Treasury bond should be equal to the real risk-free rate, r*.

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T/F: If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve.

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T/F: Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

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T/F: Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

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T/F: You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%.

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