FINC 302 Midterm 2

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. ANSWER: A Statement a is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

A. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's. Statement a is true, because if the required return for Stock A is higher than that of Stock B, and if the dividend yield for Stock A is lower than Stock B's, the growth rate for Stock A must be higher to offset this.

A bond's expected return is sometimes estimated by its YTM and sometimes by its YTC. Under what conditions would the YTM provide a better estimate, and when would the YTC be better?

Assuming a bond issue is callable, the YTC is a better estimate of a bond's expected return when interest rates are below an outstanding bond's coupon rate. The YTM is a better estimate of a bond's expected return when interest rates are equal to or above an outstanding bond's coupon rate. So, premium bonds are more likely to earn the YTC (because they're likely to be called) while par bonds and discount bonds are more likely to earn the YTM (because they're not likely to be called and thus the bondholder will be able to hold them to maturity).

Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 $3.00 Current Price, P0 $50 Expected constant growth rate 6.0% ​ a. The stock's required return is 10%. b. The stock's expected dividend yield and growth rate are equal. c. The stock's expected dividend yield is 5%. d. The stock's expected capital gains yield is 5%. e. The stock's expected price 10 years from now is $100.00.

B. One could quickly calculate the dividend yield and see that it equals the growth rate, but here are some numbers that provide more information. D1 = $3.00 P0=$50.00 D1/P0 = 6.0% rx = 12%

You have the following data on three stocks: Stock A B C Standard Deviation 20% 10% 12% Beta 0.59 0.61 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.

C 12% 1.29 A 20% 0.59 When held in isolation, the measure of risk we are concerned with is the standard deviation. The lower the better, so you would want to choose Stock B since it has the lowest standard deviation. However, when held as part of a well-diversified portfolio, the measure of risk that we are concerned with is beta. Again, the lower the better, so you would choose Stock A since it has the lowest beta.

The Francis Company is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.70, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company's current stock price? a. $13.44 b. $12.93 c. $17.01 d. $14.80

C. $17.01 you'll need to use the CAPM equation to find the required rate of return for Francis Company's stock. D1=$1.25 b=1.70 rfe=4.00% RPm=5.50% rs=rRF+b(RPM) = 4+(1.70*5.50) = 13.35% P0=D1/(rs-g) = $1.25/(.1335-0.06) = $17.01

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. The CAPM equation tells you that the required return = rf + (Market risk premium)*beta. Thus, if rf remains the same while the market risk premium declines, the required return will decline as well. How much it declines depends on beta (since you are multiplying the market risk premium by beta, the higher the beta, the greater the decline).

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%

Capital Asset Pricing Model (CAPM) = rRF + (Market risk premium*b) 12.50% = 2.00% + (1.25*RPM) 10.50% = RPM*1.25 = 8.40 = RPM

Assume that interest rates on 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:

Default and liquidity risk differences

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. While diversifiable (or idiosyncratic) risk can be diversified away by merely adding more stocks to your portfolio, market risk CANNOT be diversified away.

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. Price risk is highest in long-term, low-coupon bonds. Reinvestment risk is highest in short-term, high-coupon bonds.

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 Note that P0 = $2/(0.15 + 0.05) = $10. That price is expected to decline by 5% each year, so P1 must be $10(0.95) = $9.50. Therefore, answer e is correct, while all the others are false.

(true/false) 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.

False

(true/false) 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.

False. A call provision gives the bond issuers to right to call, or buy back, the bond from the bondholders. A company is more likely to exercise the call provision when interest rates decline (that way it can retire the bonds that were paying out the old, higher rates of interest and issue new bonds at the new, lower prevailing rates of interest, thereby reducing its cost of debt financing).

If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

If interest rates decline significantly, the values of callable bonds will not rise by as much as the values of bonds without the call provision. It is likely that the bonds would be called by the issuer before maturity, so that the issuer can take advantage of the new, lower rates.

Which of the bonds has the most reinvestment risk? Explain your answer. (Hint: Refer to Table 7.2.) a. 7-year bonds with a 5% coupon b. 1-year bonds with a 12% coupon c. 3-year bonds with a 5% coupon d. 15-year zero coupon bonds e. 15-year bonds with a 10% coupon

The answer is B. The 1-year bonds with a 12% coupon have the most reinvestment risk. Shorter-maturity bonds have more reinvestment risk than longer-maturity bonds. Also, high coupon bonds have more reinvestment risk than low coupon bonds. The 1-year, 12% coupon bonds have a shorter maturity than the other bonds as well as a higher coupon rate, so the reinvestment risk for those bonds is obviously the highest. (Also consult Table 7.2 to help with this question).

Which of the following bonds has the most price risk? Explain your answer. a. 7-year bonds with a 5% coupon b. 1-year bonds with a 12% coupon c. 3-year bonds with a 5% coupon d. 15-year zero coupon bonds e. 15-year bonds with a 10% coupon

The answer is D. The 15-year zero coupon bonds have the most price risk. Longer-maturity bonds have a high level of price risk, as do lower-coupon bonds. Since the maturities of the bonds in A, B, and C are shorter than 15 years, they can be eliminated from consideration. Since coupon payments reduce the level of price risk and the zero coupon bonds have only their maturity value due at maturity, they have the most price risk. (You can consult Table 7.2 to help with this question).

Discuss the similarities and differences between the discounted dividend and corporate valuation models.

The discounted dividend model uses the firm's cost of equity as the discount rate to discount future dividends per share an investor expects to receive starting at t = 1 to calculate the firm's intrinsic value, , today. The corporate valuation model uses the firm's weighted average cost of capital as the discount rate to discount the firm's future free cash flows starting at t = 1 to arrive at the firm's corporate value. (Free cash flows represent cash generated from current operations minus the cash that must be spent on investments and working capital to support future growth. Free cash flows are funds available to all capital investors and thus are discounted at the firm's WACC.) Once the corporate value is determined, the current market value of debt and preferred stock is subtracted to arrive at the firm's equity value. The firm's equity value is divided by the number of shares outstanding to calculate the firm's intrinsic value, . The corporate valuation model can be used to value divisions and firms that do not pay dividends. The discounted dividend model could not be used in those situations. Further, the discounted dividend model is well-suited to apply to mature, stable firms whose dividend payments have a history of steady growth. The corporate valuation model is better suited for firms in the high-growth stage of their life cycles or firms whose dividends are hard to predict.

If interest rates rise after a bond issue, what will happen to the bond's price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bond's price? (Again, an example might help you answer this question.)

The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond's price will be less affected by a change in interest rates if it has been outstanding a long time and matures soon. While this is true, it should be noted that the YTM will increase only for buyers who purchase the bond after the change in interest rates and not for buyers who purchased previous to the change. If the bond is purchased and held to maturity, the bondholder's YTM will not change, regardless of what happens to interest rates. For example, consider two bonds with an 8% annual coupon and a $1,000 par value. One bond has a 5-year maturity, while the other has a 20-year maturity. If interest rates rise to 15% immediately after issue the value of the 5-year bond would be $765.35, while the value of the 20-year bond would be $561.85.

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.

The required rate of return would increase because the bond would then be more risky to a bondholder. Call provisions are bad for the bondholder. Thus, a callable bond would have to offer additional compensation (that is, a higher rate of return) to entice an investor to be willing to hold the bond.

(true/false) 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.

True

(true/false) 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.

True

(true/false) 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.

True

(true/false) 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.

True

(true/false) Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse.

True

(true/false) 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.

True

(true/false) 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.

True Ideally, in order to reduce the risk of the portfolio by the greatest amount, you would want the new stock to be highly NEGATIVELY correlated to the stocks already in the portfolio.

(true/false) 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.

True.

(true/false) 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.

True. The X-axis on this graph is risk (as measured by beta). The Y-axis is the required rate of return on the stock. The security market line crosses the Y-axis when x = 0. That is, when the risk is zero. The only asset without risk is the risk-free asset (usually T-bills), which earn you a return equal to the risk-free rate.

(true/false) If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.

True. The nominal rate of return is r = r* + IP + DRP + LP + MRP. Since this is a U.S. Treasury bond, there is no default risk premium or liquidity premium. Since this is short-term, there is no maturity risk premium. Thus, the above equation can be restated as r = r* + IP. The question states the expected inflation rate is zero, thus the equation can be further reduced to r = r*.

(true/false) The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity.

True. Remember, price risk is higher for longer-term bonds.

(true/false) 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%.

True. Use your financial calculator to solve for I, which is the rate of return on this bond. N = 10, PV = -$800, PMT = $100, and FV = $1000. The bond's expected return (YTM) is 13.81%, which exceeds your 12% required return, so buy the bond.

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 N = 8 I/YR = 6.1% PMT = $65 FV = $1,000 Solve for PV: $1,024.74

Mooradian Corporation's free cash flow during the just-ended year (t = 0) was $250 million, and its FCF (free cash flow) is expected to grow at a constant rate of 5.0% in the future. If the weighted average cost of capital is 12.5%, what is the firm's market value of operations, in millions? a. $3,500 b. $2,695 c. $3,255 d. $4,130 e. $3,850

a. $3,500 FCF0 =$250 g=5.0% WACC 12.5% FCF1=FCF0(1+g) = 250(1+0.05) = $262.50 MV of operations=FCF1/(WACC-g) = 262.50/(.125-0.05) = $3,500

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% Capital Asset Pricing Model (CAPM) = rRF + (Market risk premium)*b = 2.25+(5.50) = 9.29%

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A: Price of $25 Expected growth (constant) of 10% Required return of 15% B: Price of $25 Expected growth (constant) of 5% Required return of 15% ​ a. Stock A's expected dividend at t = 1 is only half that of Stock B. b. Stock A has a higher dividend yield than Stock B. c. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. d. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's. e. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.

a. Stock A's expected dividend at t = 1 is only half that of Stock B. Statement A is correct, because if both stocks have the same price and the same required return, and A's growth rate is twice that of B, then A's dividend and dividend yield must be half that of B. This point is illustrated with the following example. A: Price $25, g 10%, r 15% Div. Yield = r-g = 15-10=5 D1=P0*(Div. Yield) = $25*5% = 1.25 B: Price $25, g 5%, r 15% Div. Yield = r-g = 15-5=10 D1=P0*(Div. Yield) = $25*10% = 2.50

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. A. If the bond is selling at par, we know that its coupon rate is equal to the prevailing market interest rate. Coupon rate = YTM. Both are 9% (you can plug values into a financial calculator to verify this). The current yield is 9% (this is just the coupon payment divided by the current price, which is 90/1000). There are no expected capital gains (you paid $1000 for the bond, and you expected to get back that same amount 10 years from now since the par value is also $1000). Thus, A is the correct answer.

Based on the corporate valuation model, Wang Inc.'s total corporate value is $750 million. Its balance sheet shows $100 million notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm's market value of equity, in millions? a.$423 b. $450 c.$531 d.$522 e.$360

b. $450 Use the following equation from Slide 27 of the Chapter 9 PowerPoint slides: Market Value of Equity = Market Value of Operations + Market Value of Non-operating Assets - Market Value of Debt and Preferred Stock. Assuming that the book value of debt is close to its market value, the total market value of the company's equity is: MV of operations: $750 N/P -$100 Long-term debt: -$200 Value of equity: $450

The Isberg Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.90, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is the company's current stock price, P0? a.$10.19 b. $9.89 c.$9.10 d. $7.52 e. $10.98

b. $9.89 The difference between this question and the previous one is that here you're given D0. So you have to use D0 to figure out what D1 is and then plug D1 into the discounted dividend model equation. D0 = $0.75 b= 1.90 rRF = 4.0% RPM = 5.0% g = 5.5% D1 = D0(1+g) = 0.75(1+.055) = 0.7913 rS = rRF + b(RPM) = 4+1.90(5) = 13.50% P)=D1/(rS-g) = 0.7913/(0.1350-0.55) = $9.89

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? Do not round your intermediate calculations. a. 4.51% b. 5.50% c. 4.68% d. 4.29% e. 6.38%

b. 5.50% (0.25*16) + (0.50*12) + (0.25*-18) = 5.50%

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 an 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 Periods: yrs to maturity * (periods/year) = 20*2 = 40 Periodic rate: required rate/2 = 10.7/2 = 5.53 PMT per period = (coupon rate/2) * par value = 47.50 Maturity value=FV= 1,000 Solve for PV: N=40 I/Y= 5.35 PMT=47.50 FV=1000 PV=901.80

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.

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 of 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 The key here is that the expected return and the beta of the new portfolio are just weighted averages: $10,000/$10,000+$90,000 = 10% $90,000/10,000+90,000 = 9% New return: (0.1*21.5%) + (0.9*11%) = $15.05% New beta: (0.1*1.70)+(0.9*1.20) = 1.25

The expected return on Natter Corporation's stock is 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock's dividend yield is 7%. b. The stock's dividend yield is 8%. c. The current dividend per share is $4.00. d. The stock price is expected to be $54 a share one year from now. e. The stock price is expected to be $57 a share one year from now.

d. The stock price is expected to be $54 a share one year from now. P1 = P0(1 + g) = $54. Therefore, D is correct. P1 = $54.00. A and B are false because the dividend yield is actually 14 - 8 = 6%.

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% N=maturity*(periods/year) = 15*2 = 30 I/Y= required rate/2 = 6.50/2 = 3.25 PMT = coupon rate/2 = 8.25/2 = 41.25 FV= 1000 PV=price= $1,66.09 Solve for YTC: N=6(2) = 12 PV: -1,166.09 PMT: 41.25 FV: 1045 Solve for i/y: 2.80(2) = 5.59%

(true/false) Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

true