Module 4 Quiz

Calculate the present value of a five-year bond with a coupon rate of 5.50% (paid semiannually) if similar quality bonds are currently yielding 4.35%. A) $1,051.18 B) $950.32 C) $1,026.97 D) $929.47

The answer is $1,051.18. The present value of the bond is $1,051.18, calculated using the following inputs: N = 10 (5 x 2 periods per year) I/YR = 4.35% PMT = (5.50% × 1,000 ÷ 2) = $27.50 FV = $1,000 Solve for PV = -1,051.18, or $1,051.18. LO 4.1.1

XYZ Corporation issued bonds with a 25-year maturity, $1,000 par value, and 5.75% coupon (paid semiannually). Five years after issue, interest rates on similar bonds fell to 4.75%. Calculate the price that XYZ bonds should sell for in the marketplace. A) $1,000.00 B) $1,189.84 C) $882.05 D) $1,128.20

The answer is $1,128.20. XYZ bonds should sell for $1,128.20, calculated using the following inputs: FV = $1,000 PMT = (57.50 ÷ 2) = $28.75 N = 40 (20 x 2 periods per year) I/YR = 4.75% Solve for PV = -1,128.1979, or $1,128.20 LO 4.1.1

Assume that Zephyr stock pays a dividend of $1.75 per share in the current year, and that the dividend is expected to grow by 2% per year. Calculate the price of the stock, assuming an investor has a required rate of return of 8%. A) $21.88 B) $29.16 C) $23.62 D) $29.75

The answer is $29.75. The formula for the constant growth dividend discount model: V = D1 ÷ (r - g) Therefore, the intrinsic value of Zephyr stock equals $29.75 [(1.75 × 1.02) ÷ (0.08 - 0.02)]. LO 4.3.1

Consider CPM stock with a current dividend of $1.05 per share and a market price of $46.65 per share. The current dividend is expected to grow for three years at a rate of 2% and then 3% thereafter. Assume the required rate of return is 6%. Using the multistage growth dividend discount model, calculate the intrinsic value of CPM stock. (Round all numbers to the nearest cent.) A) $34.82 B) $32.00 C) $41.38 D) $29.09

The answer is $34.82. Compute the value of each future dividend until the growth rate stabilizes (years 1 through 3). D1 = $1.05 × 1.02 = $1.07 D2 = $1.07 × 1.02 = $1.09 D3 = $1.09 × 1.02 = $1.11 Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes (year 4). D4 = $1.11 × 1.03 = $1.14 V = $1.14 ÷ (0.06 - 0.03) = $38.00 Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock. CF0 = $0 CF1 = $1.07 CF2 = $1.09 CF3 = $1.11 + $38.00 = $39.11 I/YR = 6% Solve for NPV = 34.8170, or $34.82 LO 4.3.1

LFM Corporation has an estimated free cash flow to equity (FCFE) of $2.50 per share in the current year. Moreover, its FCFE is expected to grow at a constant rate of 2% per year. Assuming an institutional investor has a required rate of return of 6.5%, calculate the intrinsic value of LFM stock. A) $40.76 B) $133.13 C) $56.67 D) $55.56

The answer is $56.67. The formula for the discounted free cash-flow model: V = FCFE1 ÷ (r - g) = ($2.50 × 1.02) ÷ (0.065 - 0.02) = 2.55 ÷ 0.045 = 56.6667, or $56.67 LO 4.3.1

JEM Corporation always pays a dividend of $5.50 per share. Calculate the intrinsic value of the stock assuming a required rate of return of 8% and a risk-free rate of return of 4%. A) $137.50 B) $45.83 C) $68.75 D) $15.94

The answer is $68.75. The intrinsic value of the stock is $68.75 ($5.50 ÷ 0.08) using the no-growth (perpetuity) dividend discount model. LO 4.3.1

Jose owns a 30-year corporate bond with 22 years remaining until maturity, featuring a coupon rate of 6.25% (paid semiannually). Assuming the comparable yield for this quality bond is currently 7%, calculate the intrinsic value of his bond. A) $916.44 B) $906.46 C) $1,000.00 D) $1,138.38

The answer is $916.44. Jose's bond has an intrinsic value of $916.44, calculated using the following inputs: FV = $1,000 PMT = (6.25% × 1,000 ÷ 2) = $31.25 N = 44 (22 x 2 periods per year) I/YR =7% Solve for PV = -916.4395, or $916.44 LO 4.1.1

George has a five-year bond with a coupon rate of 3.65% (paid semiannually). Assuming the comparable yield for this quality bond is 4.85%, calculate the intrinsic value of his bond. A) $947.28 B) $1,000.00 C) $1,054.39 D) $1,179.84

The answer is $947.28. The intrinsic value of George's bond equals $947.28, indicating the bond would be trading at a discount to par. The value is calculated using the following inputs: FV = 1$,000 N = 10 (5 x 2 periods per year) I/YR = 4.85% PMT = (3.65% × 1,000 ÷ 2) = $18.25 Solve for PV = -947.2835, or $947.28 LO 4.1.1

Henry owns a 10-year bond with a coupon rate of 4.85% (paid semiannually). Assuming the comparable yield for this quality bond is currently 5.5%, calculate the intrinsic value of his bond. A) $929.67 B) $950.51 C) $847.03 D) $930.51

The answer is $950.51. The intrinsic value of his bond is $950.51, calculated using the following inputs: N = 20 (10 x 2 periods per year) I/YR = 5.5% PMT = (4.85% × 1,000 ÷ 2) = $24.25 FV = $1,000 Solve for PV = -950.51, or $950.51. LO 4.1.1

Lauren's bond has a current market value of $987.56 and Macaulay duration of 3.2. Assuming the bond's yield to maturity (YTM) changes from 6.5% to 6%, calculate the estimated percent change in the price of the bond and the new expected market price of the bond. A) +1.5%, $1,002.37 B) −1.5%, $972.75 C) +3.0%, $1,017.19 D) −3.0%, $957.93

The answer is +1.5%, $1,002.37. The formula for determining the change in the price of the bond: ΔP/P = −D[Δy ÷ (1 + y)] ΔP/P = −3.2[(0.06 − 0.065) ÷ (1 + 0.065)] ΔP/P = −3.2(-0.004695) = 0.01502, or 1.5% This means that the bond's price should increase by 1.5% and sell for $1,002.37 (a slight premium to par) in the secondary market. LO 4.1.2

A bond has a current yield to maturity (YTM) of 3.80%. Market interest rates are expected to rise to 4.50% soon. The bond has a duration of 5.5 years. Calculate the estimated price change of the bond. A) +3.50% B) +0.70% C) -2.18% D) -3.71%

The answer is -3.71%. The market price of the bond is expected to decrease by 3.71%, calculated as follows: ΔP/P = −5.5[(0.045 − 0.038) ÷ (1 + 0.038)] ΔP/P = −5.5(0.007 ÷ 1.038) ΔP/P = −5.5(0.006745) ΔP/P = −0.0371, or −3.71% LO 4.1.2

ABC Corporation has a P/E ratio of 5.00 and an expected growth rate in earnings for the next year of 9.5%. Assuming an investor's required rate of return is 12%, calculate the firm's PEG ratio. A) 0.1667 B) 0.5263 C) 0.4167 D) 0.8333

The answer is 0.5263. Calculate the firm's PEG ratio as follows: 5.00 ÷ (0.095 × 100) = 0.5263. After calculating this ratio, it then would be compared to ABC Corporation's peers to determine whether a purchase is warranted. LO 4.3.2

Assume a 3-year, $1,000 par value corporate bond is currently trading for $959.53. The bond has a coupon rate of 4% (paid once per year) and a yield to maturity of 5.50%. Calculate the duration for this bond. A) 1.4418 years B) 3.5871 years C) 2.8835 years D) 3.4680 years

The answer is 2.8835 years. The duration for this bond is 2.8835 years, calculated as follows: YearCash Flow(CF)Present Value(PV) of CFPV × Year140.0037.9137.91240.0035.9471.8831,040.00885.682,657.04959.532,766.83 To solve for the PV of a given CF (example Year 1): FV = 40, N = 1, PMT = 0, 5.5 = I/YR, solve for PV. Divide the sum in the last column (2,766.83) by the total PV/market price of the bond (959.53) to derive the duration of 2.8835 years. LO 4.1.2

JEM Technologies, Inc. has assets of $500 million and $50 million in liabilities. For the past year the company earned $125 million, and paid out $50 million in dividends. Calculate the company's return on equity (ROE). A) 52% B) 38% C) 28% D) 20%

The answer is 28%. $500,000,000 - $50,000,000 = $450,000,000 in equity. $125,000,000 profit ÷ $450,000,000 equity = 0.2778, or 28% ROE. LO 4.2.2

Companies A and B have exactly the same dollar amount of assets and net income. Company A has a capitalization structure of 70% equity and 30% debt; Company B has a capitalization structure of 40% equity and 60% debt. Which one of these statements is CORRECT? Company B has a higher ROE than Company A. Company B has a higher ROA than Company A. Company A has a higher debt-to-equity ratio than Company B. A) I only B) III only C) None of these D) II only

The answer is I only. All else being equal, a profitable company with a higher debt level will have a higher return on equity. If income is the same for both companies, then the only difference is the percentage of equity. With a lower equity, Company B will have a higher return on equity. Company B has a higher debt-to-equity ratio. LO 4.2.2

Top-down analysis includes which of these? Economic and market factors Industry analysis Company analysis A) I and III B) I, II, and III C) I and II D) II and III

The answer is I, II, and III. Top-down analysis includes all these elements. Top-down analysis allows investors to look at the big picture first and then work their way down to the details. LO 4.2.1

TLP stock sells for $40 a share and pays an annual dividend of $2.75, which is expected to increase 5% annually. An investor has a required rate of return of 13%. Which of the following conclusions about TLP stock can be drawn? It is undervalued. It has an intrinsic value of $36.09. It is overvalued. It has an expected rate of return of 12.2%. A) III and IV B) I and II C) II, III, and IV D) I, II, and IV

The answer is II, III, and IV. The constant growth dividend discount model may be used as follows: V = D1 ÷ (r - g) = (2.75 × 1.05) ÷ (0.13 - 0.05) = 2.8875 ÷ 0.08 = 36.09, or $36.09 With an intrinsic value that is less than the current market price, the stock would be considered overvalued and not worthy of a purchase. With option IV, the expected return is lower than the required return. In order to calculate the expected return, we can solve for it using the following steps: $40 = 2.8875 ÷ (x - 0.05) $40 (x - 0.05) = 2.8875 $40x - 2 = 2.8875 $40x = 4.8875 x = 4.8874 ÷ $40 = 0.1222, or 12.2% LO 4.3.2

Identify which of these statements concerning technical analysis is CORRECT. Technical analysis is focused on the process by which stock prices rapidly adjust to new information. Technical analysis is based on the underlying fundamentals of a stock's value. The focus of technical analysis is market timing with an emphasis on price changes. Technicians concentrate on past stock price movements to forecast future stock price movements. A) I and II B) II only C) I, III, and IV D) III and IV

The answer is III and IV. Statements I and II are incorrect. Fundamental analysis is based on the underlying fundamentals of a stock's value. Technicians concentrate on the short run, looking for short-term price movements. The focus of technical analysis is the gradual process whereby stock prices adjust to new information. Technical analysis involves analyzing past stock prices to forecast future prices. LO 4.2.1

When an analyst divides the P/E ratio by the earnings growth rate, which one of these ratios is being used? A) PEG ratio B) P/B ratio C) P/S ratio D) P/E ratio

The answer is PEG ratio. This identifies the P/E to Growth (PEG) ratio. P/B is price to book; P/E is price to earnings; P/S is price to sales; DDM is dividend discount model. LO 4.3.2

Jerry Warner would like to increase his portfolio of common stock. He requires a 13% rate of return on common stock investments. He is considering purchasing one of these stocks: Stock 1:Dividends are currently $3.00 annually and are expected to increase 7% annually; market price = $45Stock 2:Dividends are currently $2.25 annually and are expected to increase 8% annually; market price = $50 Which stock is most appropriate to purchase in this situation, and why? A) Stock 2, because the return on investment is greater than Jerry's required rate of return B) Stock 1, because it is overvalued C) Stock 1, because the return on investment is greater than Jerry's required rate of return D) Stock 2, because it is undervalued

The answer is Stock 1, because the return on investment is greater than Jerry's required rate of return. The intrinsic value of Stock 1 = $53.50 [($3 × 1.07) ÷ (0.13 - 0.07)]. Because $53.50 is more than $45, the stock is undervalued and would return more than his required return. The intrinsic value of Stock 2 = $33.50 [($2.25 × 1.08) ÷ (0.13 - 0.08)]. Because $48.60 is less than $50, the stock is overvalued and would return less than his required return. LO 4.3.2

Select the INCORRECT statement regarding a company's book value. A) Book value per share may be derived by dividing the stockholder's equity portion by the total number of common shares outstanding. B) Different inventory accounting methods may yield a different value for company assets, thereby affecting the book value of the corporation. C) Book value represents an accurate measure of the fair market value of the company. D) Book value is determined by subtracting company liabilities from company assets.

The answer is book value represents an accurate measure of the fair market value of the company. Generally, book value does not represent an accurate measure of the fair market value of the company because this value is determined using historical costs. LO 4.2.1

The duration of a zero-coupon bond is A) greater than the bond's maturity. B) less than the bond's maturity. C) equal to the bond's maturity. D) equal to zero.

The answer is equal to the bond's maturity. The duration of a zero-coupon bond is equal to the bond's maturity. LO 4.1.2

Choose the stock value that is defined as the discounted present value based on future cash flows as determined by some form of a dividend discount model. A) Par value B) Intrinsic value C) Book value D) Market value

The answer is intrinsic value. A stock's intrinsic value is its discounted present value based on future cash flows as determined by some form of a dividend discount model. LO 4.3.1

The use of financial leverage affects all of these except A) earnings per share. B) return on equity. C) monetary policy. D) risk to stockholders.

The answer is monetary policy. Return on equity and earnings per share are magnified with leverage, and the risk to stockholders increases as a firm's leverage increases. A country's monetary policy is not affected by a company's use of financial leverage. LO 4.2.2

FER stock has a current dividend of $0.75 per share that has been growing at a rate of 1.25% per year. If an investor's required rate of return is 15% and the stock is currently selling for $6.34 per share, determine whether the investor should purchase the stock. A) No, the stock is overvalued based on the constant growth dividend discount model. B) Yes, the stock is undervalued using the perpetuity dividend discount model. C) Yes, the stock is undervalued based on the constant growth dividend discount model. D) No, the stock is not a wise purchase based on the risk-return trade-off.

The answer is no, the stock is overvalued based on the constant growth dividend discount model. Based on the constant growth dividend discount model, the intrinsic value of the stock is $5.52, calculated as follows: [0.75 × (1 + 0.0125)] ÷ (0.15 - 0.0125) = 0.7594 ÷ 0.1375 = 5.5227, or $5.52. Because FER is currently trading at a price of $6.34 per share, it is overvalued, and the investor should not buy the stock. LO 4.3.1

Choose the form of the efficient market hypothesis that supports technical analysis. A) Strong B) None of these C) Weak D) Semistrong

The answer is none of these. The efficient market hypothesis is in direct contradiction to technical analysis because the efficient market hypothesis is founded on the notion that all historical price and volume data, which is used by technical analysts, is already accounted for in the current stock price. LO 4.2.1

Financial leverage affects A) earnings per share. B) risk to stockholders. C) return on equity, earnings per share, and risk to stockholders. D) return on equity.

The answer is return on equity, earnings per share, and risk to stockholders. ROE and earnings per share are magnified with leverage, and the risk to stockholders increases as a firm's leverage increases. LO 4.2.2

Linda and Ralph Stewart have never invested in the stock market, but they would like to begin an investment program to cover college expenses for their two young children. The Stewarts' required rate of return is 11%. They are considering the purchase of one of these two stocks: Stock 1:Dividends are currently $1.85 annually and are expected to increase 9% annually; market price = $59Stock 2:Dividends are currently $1.58 annually and are expected to increase 6% annually; market price = $37 Which stock would be most appropriate for the Stewarts to purchase at this time, and why? A) Stock 2, because the return on investment is greater than the Stewarts' required rate of return B) Stock 1, because the return on investment is greater than the Stewarts' required rate of return C) Stock 2, because the stock is undervalued D) Stock 1, because the stock is overvalued

The answer is stock 1, because the return on investment is greater than the Stewarts' required rate of return. The intrinsic value of Stock 1 = $100.83 [($1.85 × 1.09) ÷ (0.11 - 0.09)]. Because $100.83 is more than $59, the stock is undervalued and would return more than their required return. The intrinsic value of Stock 2 = $33.50 [($1.58 × 1.06) ÷ (0.11 - 0.06)]. Because $33.50 is less than $37, the stock is overvalued and would return less than their required return. LO 4.3.2

Marcy may add 100 shares of LKM corporation stock to her investment portfolio. The stock recently paid a dividend of $1.85 per share. The dividend is expected to grow at a constant rate of 2.25% per year. Her required rate of return is 7%. The stock is currently trading for $35.75 per share. Determine whether she should purchase the stock and why. A) No, the stock is overvalued based on an intrinsic value of $38.95. B) Yes, the stock is undervalued based on an intrinsic value of $39.82. C) No, the stock is overvalued based on an intrinsic value of $32.87. D) Yes, the stock is undervalued based on an intrinsic value of $33.46.

The answer is yes, the stock is undervalued based on an intrinsic value of $39.82. Using the constant growth dividend discount model, the intrinsic value of the stock is $39.82. V = ($1.85 × 1.0225) ÷ (0.07 - 0.0225) V = 1.8916 ÷ 0.04750 V = 39.8232, or $39.82 Based on this value, the stock is undervalued relative to its price in the secondary market. LO 4.3.1

Robyn's bond has a current market value of $1,456.78 and a Macaulay duration of 12.5. Assuming the bond's yield to maturity (YTM) changes from 5.55% to 6.25%, calculate the estimated percent change in the price of the bond and the new expected market price of the bond (based on the percent change). A) −0.70%, $1,446.58 B) +8.29%, $1,577.55 C) −8.29%, $1,336.01 D) +3.48%, $1,507.48

The answer is −8.29%, $1,336.01. The formula for determining the change in the price of the bond: ΔP/P = −D(Δy ÷ (1 + y)) ΔP/P = −12.5[(0.0625 − 0.0555) ÷ 1+0.0555] ΔP/P = −12.5(0.0066) = −0.08290, or −8.29% The bond's price should decrease by 8.29% and, therefore, sell for $1,336.01 in the secondary market. LO 4.1.2