Quiz #5

The NASDAQ Market Diary shows the following: Market Diary Total Issues 4,037 Advanced 1,002 Declined 2,103 Unchanged 332 New Highs 103 New Lows 55 Total Vol 3,503,889,000 The Advance/Decline Ratio is: A. 1:2 B. 2:1 C. 1:4 D. 4:1

The best answer is A. On this day, 1,002 issues advanced; while 2,103 issues declined; for an advance/decline ratio of 1,002/2,103 = 1:2.

If the Required Rate of Return (RRR) on a security is less than the Internal Rate of Return (IRR) on that security, then the: A. security should be purchased for investment B. security should not be purchased for investment C. security has a positive risk premium D. security has a negative risk premium

The best answer is A. The RRR (Required Rate of Return) is the minimum return that an investment must offer in order for someone to decide to buy it. Assume that the RRR is 10%. If the security actually offers a return of 12% (the Internal Rate of Return, which is the same as the yield to maturity offered by the investment) then the purchase should be made because the IRR (actual return) exceeds the RRR (minimum required return).

Refer to the below Exhibit to answer the question: What is ABC Corporation's Current Ratio? A. 5:1 B. 4:1 C. 3:1 D. 2:1 ABC Corporation Income Statement for the year ending 12-31-XX ($000) Gross Sales 18,500 Returns 500 ----------- Net Sales 18,000 Cost of Goods Sold 9,000 ----------- Gross Margin 9,000 Operating Expenses 7,000 ----------- Operating Margin 2,000 Non Operating Income 1,000 ----------- Total Operating and Non Operating Income 3,000 Interest Expense 800 ----------- Net Income Before Tax 2,200 Taxes 900 ----------- Net Income After Tax 1,300 Statement of Changes To Retained Earnings for the year ending 12-31-XX ($000) Beginning of Year Retained Earnings 3,400 ----------- Add: Net Income For The Year 1,300 Deduct: Preferred Dividend 300 Common Dividend 400 End of Year Retained Earnings 4,000 ----------- ABC Corporation Balance Sheet at 12-31-XX Current Assets ($000) Current Liabilities ($000) Cash and Marketable Securities 9,000 Accounts Payable 900 Accounts Receivable 3,000 Wages Payable 800 Inventory 3,000 Taxes Payable 900 ----------- Interest Payable 400 ----------- Total Current Total Current Assets 15,000 Liabilities 3,000 ----------- ----------- Notes Receivable due Long Term Debt after one year 1,000 10% 8,000 Property and Equipment Stockholder's Equity (valued at cost Preferred Stock - less accumulated $100 par 10% 3,000 depreciation of Common Stock - $3,000) 6,000 $2 par 2,000 Intangible Costs 1,000 Capital in excess of par value 3,000 Retained Earnings 4,000 -----------Total Long Total Stockholder's Term Assets 8,000 Equity 12,000 ----------- ----------- Total Liabilities and Stockholder's Total Assets 23,000 Equity 23,000 ----------- -----------

The best answer is A. The formula for the Current Ratio is: Current Assets ------------------------- = Current Ratio Current Liabilities $15,000,000 ------------------ = 5 : 1 $3,000,000

Which of the following represents "leverage"? A. Current Assets - Current Liabilities B. Debt / Equity C. Sales - Expenses D. Operating Income / Bond Interest

The best answer is B. "Leverage" is the amount of debt used in the company's long-term capital base (long term capital consists of debt, preferred stock and common stock). It is called "leverage" because the use of debt in a company's asset base allows it to "leverage" its Earnings Per Share as its income rises (as income rises, once fixed debt interest cost is covered, all of the increase flows through to the shareholders - the bondholders to do not share in this). Current Assets / Current Liabilities is the Current Ratio and measures liquidity. Sales - Expenses is operating income and measures profitability. Operating Income / Bond Interest is the "Times Interest Earned" ratio and measures a company's ability to cover its fixed bond interest cost.

What is "financial leverage?" A. Assets minus liabilities B. Debt as a percentage of equity C. Operating income as a percentage of bond interest D. Current assets - current liabilities

The best answer is B. Leverage is the amount of debt that a company has in its capital base. It is termed "leverage" because the interest cost on the debt is fixed and if the company's income increases, this increase flows directly to the shareholders without the company paying additional bond interest, "leveraging" earnings per share.

The Net Present Value of an investment is lower than "0." This means that the: A. rate of return from the investment is greater than the discount rate used in the computation B. rate of return from the investment is lower than the discount rate used in the computation C. investment will produce a return that is greater than the rate of inflation D. investment will produce a return that is lower than the rate of inflation

The best answer is B. Net Present Value takes all the cash flows that will be generated by an investment and discounts them back to their "present value." The rate of interest used to discount the cash flows to be received is the current market rate of interest. - If the computation results in an NPV of "0," then the rate of return of the investment equals the discount rate used. - If the computation results in an NPV of more than "0," then the rate of return of the investment exceeds the discount rate used. - If the computation results in an NPV of less than "0," then the rate of return of the investment is lower than the discount rate used. The computation has nothing to do with the inflation rate.

Which statement is TRUE about claim priority in a corporate liquidation? A. Common stockholders are paid before preferred stockholders B. Unsecured creditors are paid before bondholders C. Preferred stockholders are paid before bondholders D. Bondholders are paid before unpaid wages and taxes

The best answer is B. The priority of claim to corporate assets in a liquidation is: Secured creditors, unpaid wages and taxes, trade creditors (these are all unsecured creditors), unsecured bondholders, preferred stockholders, common stockholders.

During extended periods of high inflation, it can be expected that which of the following will happen? I Interest rates will fall II Interest rates will rise III Stock prices will fall IV Stock prices will rise A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. A rising inflation rate is a "lose-lose" situation for both the stock and long term bond markets. If the inflation rate rises, then interest rates are likely to rise, with short term rates rising more than long term rates (the yield curve "flattens" as the Fed tightens credit to tame inflation, with short term rates rising more than long term rates). If interest rates rise, then long term bond prices will fall fastest, and long bondholders will have large losses on their positions. Furthermore, during periods of inflation, corporate earnings tend to fall, because companies are not able to keep raising prices at the same pace as their costs rise. This lowered earnings outlook depresses stock prices. Thus, both stock and long bond prices tend to fall in inflationary periods. Instead, during these periods of high inflation, investors "flee to safety" - they abandon the stock and long term bond markets, and put money in short term money market instruments, which offer safety and relatively high interest rates during inflationary periods; and they also put money into real estate and other "hard" assets that tend to keep pace with inflation.

A customer who is retired wants to select an investment that is marketable, and that provides the highest rate of return. The BEST choice would be to recommend: A. Treasury Bills B. Treasury Notes C. Investment Grade Preferred Stock D. Certificates of Deposit

The best answer is C. Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, and Treasury securities are extremely marketable, so any of these meet this requirement. However, investment grade preferred stock issued by a top-shelf corporation will provide a higher investment return than ultra-safe Treasury securities, making this the best choice.

Which of the following investments has a known long-term internal rate of return? A. Low grade 7% corporate bond B. Investment grade 5% municipal bond C. Treasury STRIP D. GNMA Pass-Through Certificate

The best answer is C. The internal rate of return is the implicit yield to maturity that an investment returns. Securities that have a fixed coupon rate make periodic payments to the holder. These must be reinvested at the same yield as the investment is returning over its life, in order for the yield not to be affected by "reinvestment risk." For example, if a person buys a 10% 20-year bond at par, and over the life of the investment, interest rates are declining, then the rate of return earned on the reinvested interest payments will decline below the 10% that the security is yielding. The compounded rate of return on the investment will fall below 10% in such a case. If one buys a 20-year zero-coupon bond (a Treasury STRIP is "stripped" of coupons and is a zero-coupon obligation), the implicit yield of the investment is "locked in" at purchase and is not affected by reinvestment risk since periodic interest payments are not being made. The interest rate that discounts the redemption price (Par) to the discounted purchase price is the implicit yield of the investment; and is the same as the internal rate of return of the investment. For example, assume that a 3-year $1,000 par zero-coupon bond can be purchased for $751.31 today. The internal rate of return on this investment is 10%, and will not change over the 3-years that the bond is held. After the first year, the bond will be worth $751.31 (1.1) = $826.44. After the second year, the bond will be worth $826.44 (1.1) = $909.09. After the third year, the bond will be worth $909.09 (1.1) = $1,000.

Which interest rate would be used to calculate the risk free rate of return? A. Prime rate B. Call loan rate C. Fed Funds rate D. Eurodollar rate

The best answer is C. The risk free rate of return is the interest rate on risk free securities such as Treasuries. The Fed Funds rate (overnight loan rate on reserves lent from Fed member bank to Fed member bank) is the "base" lending rate in the economy and approximates the interest rate on very short term Treasury Bills. The Prime rate is the rate at which banks lend to their best commercial customers, and includes a "risk" component. It is typically 3 or 4 percentage points higher than Fed Funds. The Call Loan rate is the rate at which member banks will lend using securities as collateral. There is a "risk" component to this rate as well, and it typically is 2-3 percentage points higher than Fed Funds. The Eurodollar rate is irrelevant.

At which Standard and Poor's rating is a bond considered to be speculative ("junk bond")? A. AA B. BBB C. BB D. C

The best answer is C. The top 4 ratings are "investment grade" - AAA, AA, A, and BBB. Bonds below these ratings are speculative. The best speculative rating is, therefore, BB.

An investment of $100,000 is worth $105,000 after 3 months. If the investment keeps growing at the current rate, at the end of one year, the annualized rate of return will be: A. 5.00% B. 20.00% C. 21.55% D. 25.00%

The best answer is C. This investment grew at a 5% rate over 3 months, from $100,000 to $105,000. If this growth rate continues over the next 3 quarters, the investment will be worth: 2nd Quarter: $105,000.00 x 1.05 = $110,250.00 3rd Quarter: $110,250.00 x 1.05 = $115,762.50 4th Quarter: $115,762.50 x 1.05 = $121,550.63 Thus, an original $100,000 investment is worth $121,551 at the end of the year, for a growth rate of 21.55%.

A municipal dealer quotes a 9 year, 6% term revenue bond at 92. The yield to maturity is: A. 6.50% B. 6.92% C. 7.12% D. 7.18%

The best answer is D. The formula for yield to maturity is: Annual Income + Annual Capital Gain (Discount Bond) ------------------------------------------------------------------------------ Average Bond Value = Yield to Maturity This bond has a coupon rate of 6% = 6% of $1,000 par = $60 of annual income. The bond is purchased at 92% of $1,000 par = $920; and will mature at $1,000 in 9 years, Thus, the $80 capital gain is earned over 9 years for an annual gain of $80 / 9 = $8.88 per year. The bond is purchased at $920 and matures at $1,000, for an average value of $920 + $1,000 / 2 = $960. The YTM is: $60 + $8.88 = 7.175% = 7.18% $960

If the dollar falls against foreign currencies, which of the following statements are TRUE? I Foreign currencies buy more dollars II U.S. exports are likely to rise III Foreign imports are likely to fall IV Foreign goods are more expensive in the U.S. A. I and II only B. III and IV only C. I, II, IV D. I, II, III, IV

The best answer is D. If the dollar falls, then the U.S. dollar becomes "cheaper" to buy using a foreign currency. U.S. goods become cheaper to foreigners and foreign goods become more expensive in the U.S. Thus, U.S. exports are likely to rise and foreign imports are likely to fall.

Which of the following are functions of the Federal Reserve Board? I Setting margins on non-exempt securities II Lending funds to member banks through the discount window III Auditing commercial banks for compliance with banking and MSRB regulations IV Acting as fiscal agent for the U.S. Treasury A. I and II only B. III and IV only C. II, III, IV D. I, II, III, IV

The best answer is D. The Federal Reserve has the power to set margins for non-exempt securities only. It cannot set margins for exempt securities such as governments and municipals. It lends funds to member banks at the discount rate. It audits commercial banks for compliance with banking and MSRB rules. The Fed acts as fiscal agent for the Treasury, conducting the weekly Treasury auctions.

When the securities markets have reached equilibrium, commission costs: A. are subject to high volatility B. are subject to low volatility C. have no volatility D. are subject to change

The best answer is D. When a stock has found its equilibrium price in the market, this means that the spread between bid and ask is non-existent and active trading is taking place between buyers and sellers at that price. In such a market, because there is very active trading, commission costs on a per-trade basis tend to become lower - so they change. We would like it if Choice D said that commission costs would tend to fall, rather than they are "subject to change" - but it is the best answer given. And yes, this point must be known for the exam!