Unit 10 Quizzes

An analyst compiled the following correlation coefficient matrix relating to Funds A, B, C, and D. On the basis of these findings, combining which funds would provide the highest level of diversification?

D Combining funds with the lowest correlation coefficient would create the greatest diversification. The quickest way to answer a question like this on the exam is to look for the largest negative number (in this question, -.78).

An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 6%, then the NPV is A) positive B) 6% C) zero D) negative

C When an investment's IRR equals the required rated of return, the NPV is zero. If the IRR is higher than the required rate of return, the NPV is positive; if the IRR is lower than the rate of return, the NPV is negative.

A bond is paying $100 per year in annual interest and is selling at par. If the discount rate is 10%, the net present value is A) positive B) zero C) negative D) the same as the coupon

B A bond paying $100 in interest per year mean it has has a coupon rate of 10%. Whenever the coupon rate is equal to the discount rate, the NPV is zero. That is, the present value of a bond paying 10% interest when the current market rate is demanding a 10% interest rate is the bond's par value (as is the case with this bond).

Which of the following statements regarding the time value of money is NOT correct? A) Future value is the future amount to which a sum of money today will increase on the basis of a defined interest rate and period. B) Future value of an ordinary annuity is the future amount to which a series of deposits of equal size will increase. C) Compound interest is interest earned on interest. D) Compound interest is interest earned on the initial investment.

D Compound interest is interest earned on interest that has been added to the original principal. For example, $1,000 earning 5% compounded annually earns $50 the first year and then 5% of $1,050 or $52.50 the 2nd year.

Debt-to-Equity Ratio The best way to measure the amount of financial leverage being used by the company isby calculating the debt-to-equity ratio. It is really a misnomer—it should be called the debt-to-total capitalization ratio

we see that the total capital used in the business is$90 million. Of that, $50 million is long-term debt. So, we want to know how much of the $90 million total is represented by debt capital. The answer is simple: $50 million of the $90 million, or 55.55%. That is the debt-to-equity ratio

Standard deviation is a measure of the volatility of an investment's projected returns, computed by using historical performance data. Beta is a volatility measure of a security compared with the overall market, measuring only systematic (market) risk. Standard deviation is a volatility measure of a security compared with its expected performance and includes BOTH systematic and unsystematic risk. Another way to put that is that standard deviation measures the total risk of a security or portfolio.

A standard deviation of 7.5 means that the return ofa stock for a given period may vary by 7.5% above or below its predicted return about two-thirds of the time and within 15% about 95% of the time. A standard deviation is 7.5 mean the return of a stock may vary by 7.5% above or below the predicted return 66.67% of the time (1 standard deviation) may vary 15% (7.5+7.5) above or below the predicted return 95% of the time (2 standard deviations)

*One way in which internal rate of return (IRR) differs from most return computations is that A) it takes into consideration the time value of money B) it takes into consideration the rate of inflation C) it is always an annualized rate of return D) its application to debt securities is limited

*A The internal rate of return compounds returns and takes into consideration the time value of money. *Real rate of return considers the inflation rate.

Beta is used to measure the variability between a particular stock's (or portfolio's) movement and that of the market in general. beta of 1.00 will tend to have a market risk similar to that of the market as a whole. Negative beta moves opposite the market (if beta is −1.2, a 10% up move in the market's return will cause the stock return to decline by 12%.) Most frequently, beta is measured against the Standard & Poor's 500 composite index. EX If the S&P 500 rises or falls by 10%, a stock with a beta of 1 rises or falls by about 10%, a stock with a beta of 1.5 rises or falls by about 15%, and a stock with a beta of .75 rises or falls by about 7.5%.

Alpha is measure of expected performance relative to the market Alpha can be positive, negative, or zero. If the alpha is negative, then the portfolio is underperforming the market; if higher, the portfolio is outperforming the market (total portfolio return − risk-free rate) − (portfolio beta × [market return − risk-free rate]) In essence, what is being done is comparing performance after eliminating the risk-free rate. The risk-free rate used on the exam will always be the 91-day (or 13-week) U.S. Treasury bill.

Present value is a computation frequently used to determine the amount of deposit needed now to meet a future need, such as a college education. If an investor uses an expected return of 8%, but the actual return over the period is 6%, A) the yield to maturity will be lower than anticipated B) the accumulated value will meet the objectives C) the present value was insufficient to meet the objective D) the future value will not be able to be computed

C Present value is the amount deposited to meet a future goal based on an expected rate of return. If the return is lower than expected, the amount deposited will not grow to the required amount (a bad thing).

A company's current ratio is 0.5:1. This could be an indication A) the company's working capital is sufficient to meet daily needs. B) the company's current assets are twice its current liabilities. C) the company may have trouble paying its bills. D)the company is highly leveraged.

C The formula for current ratio is the current assets divided by the current liabilities. A 0.5:1 ratio means that the company has current liabilities that are twice its current assets. This would also mean a negative working capital (current assets minus current liabilities) and would probably mean that the company is going to have a difficult time paying its bills. A highly leveraged company is one whose long-term debt, such as bonds, represents more than 50% of the company's total capital. Nothing in this question relates to long-term debt or capitalization.

Twelve years ago, an investor placed $2,500 into an account. The account is now worth $10,000. Using the Rule of 72, you can determine that the approximate annual return was A) 6% B) 36% C) 12% D) 400%

C Under the Rule of 72, we can determine an earnings rate by dividing 72 by the number of years it takes for money to double. In this case, the money had quadrupled. That means it has doubled twice in 12 years or, every 6 years. Dividing 72 by 6 years results in an annual return of 12%. So it doubled once in 6 years 72/6=12

If the required rate of return is higher than anticipated in a present value calculation, the effect would be that A) the present value would be higher B) the future value would be higher C) the yield to maturity would increase D) the present value would be lower

D The present value computation is used to determine how much money must be deposited now (in the present) to reach a specified future goal when you know how many years you have to reach that goal. One critical component of the formula is the rate of return. As a simple example, if you need $100,000 in 18 years for your newborn's college education and you expect to earn 4%, using the rule of 72, you'll have to deposit $50,000 now (present value) to reach the goal. However, if it turns out that the earnings rate is higher than anticipated—say, 8%—you would only need to deposit half as much today ($25,000). **Therefore, we answer this question by indicating that a higher rate of return will require a lower present value (deposit).**

Rule of 72 To find the number of years for an investment to double simply divide the number 72 by the interest rate the investment pays. For example, an investment of $2,000 earning 6% will double in 12 years (72 / 6 = 12).

**Suppose an investment of $1,000 was worth $4,000 in 16 years. Under the rule of 72, what is the compounded earnings rate? The investment has quadrupled (that means doubled twice) - if it took 16 years to double twice, it took 8 years to double once. Dividing 72/8 = 9 so the account must be earning 9%

The present value of a dollar A) cannot be calculated without knowing the level of inflation B) indicates how much needs to be invested today at a given interest rate to equal a specific cash value in the future C) is equal to its future value if the level of interest rates stays the same D) is the amount of goods and services the dollar will buy in the future at today's rate price level

B The present value of a dollar will indicate how much needs to be invested today at a given interest rate to equal a cash amount required in the future.

The statistical measurement that indicates how much an investment's returns have fluctuated, compared to its average return, over a given period of time is known as A) beta B) R-squared C) standard deviation D) convexity

C Standard deviation measures how much an investment's returns have fluctuated over a given period of time. The higher the investment's standard deviation, the higher the risk.

Compute income in perpetuity and exhausting the principal. A rich aunt wishes to provide $1,000 per month in perpetuity to her favorite nephew. If the account can be invested to earn 5% per annum, what is the required deposit? A. $20,000 B. $24,000 C. $200,000 D. $240,000

Answer: D. The first step is to take the monthly income and convert it to a yearly number: $1,000 per month is $12,000 per year. Then, divide that $12,000 by the 5% rate of return, and you arrive at a lump-sum deposit of $240,000. 12,000/.05=$240,000

A fundamental analyst reviewing the current ratios of four different companies would consider which of the following to be in the most liquid position? A) 0.5:1 B) 2.7:1 C) 4.2:1 D) 1.5:1

C The current ratio is the current assets divided by the current liabilities. The higher the ratio, the more liquid the company. Therefore, a 4.2 to 1 ratio is the strongest and a 0.5 to 1 ratio is the weakest.

Assume Frank has a portfolio with an actual return of 10.50% for the past year. The portfolio beta equals 1.25, the return on the market equals 9.75%, and the risk-free rate of return equals 3%. Based on this information, what is the alpha for Frank's portfolio and did it out outperform or underperform the market? A) +3.3750%, outperform B) +9.1875%, outperform C) −0.9375%, underperform D) −1.6875%, underperform

C The formula for alpha: alpha = (actual return − risk-free rate) - (beta × [market return − RF])]. If we plug in the numbers, we get (10.5% - 3%) - (1.25 × [9.75% − 3%]) = 7.5% - (1.25 x 6.75) = 7.5% - 8.4375 = -.9375 The alpha for Frank's portfolio equals −0.9375%, indicating that his portfolio underperformed the market based on the level of assumed investment risk.

The internal rate of return (IRR) is the discount rate (r) that makes the NPV of an investment equal to zero.

The IRR calculation can be used to determine whether an investment meets the investor's required rate of return. If an investor requires an investment returnof 10% and the IRR for a proposed investment is 12%, the investor will view that investment as attractive because it returns a higher rate than the investor's required rate.

****During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, I Kapco's P/E ratio has decreased II Kapco's P/E ratio has increased III an investor holding Kapco over this period would have noticed a decrease in income received IV an investor holding Kapco over this period would have noticed no change in income received A) II and III B) II and IV C) I and III D) I and IV

***D At the beginning of the period, the P/E ratio was 23.5 to 1 ($47 divided by $2.). At the end of the period, the P/E ratio was 20 to 1 ($50 divided by $2.50). Initially, Kapco was paying out 50% of its $2.00 per share earnings, or $1.00 in dividends. At the end, Kapco was paying out 40% of its $2.50 per share earnings, also $1.00 in dividends.

Which of the following statements is NOT correct? A) Internal rate of return (IRR) is a method of determining the exact discount rate to equalize cash inflows and outflows, thus allowing comparison of rates of return on alternative investments of unequal size and investment amounts. B) Net present value analysis (NPV) is a commonly used time value of money technique employed by businesses and investors to evaluate the cash flows associated with capital projects and capital expenditures. C) Net present value (NPV) is the difference between the initial cash outflow (investment) and the future value of discounted cash flows. D) Time-weighted returns show performance without the influences of additional investor deposits or withdrawals from the account.

C Net present value (NPV) is the difference between the initial cash outflow (investment) and the present value of discounted cash flows (NPV = PV of CF − cost of investment). That is why it is called net present value instead of net future value.

EXHAUSTING THE PRINCIPAL Aninvestorhas$100,000toinvest.Iftheaccountisestimatedtoearnata rate of 5% per year and the investor wishes to withdraw $12,000 at the end of each year, approximately how long will the money last? A. 5years B. 8years C. 11years D. 16years

Answer: C. Here is the correct math, where BOY means Beginning of the Year and EOY is End of the Year: Year. BOY Value. EOY Value 1. 100,000. 105,000 2 93,000 97,650 3 85,650 89,933 4 77,933 81,829 5 6 7 8 9 10 11 11,955 12,552 12 552 580 This shows that one taking the money out at the end of the year, will have exhausted all but a bit over $550 by the end of the 11th year. You can do this with the calculator furnished at the test center as follows: 100,000 × 105% = 105,000 - 12,000 = 93,000 93,000 × 105% = 97,650 - 12,000 = 85,650 85,650 × 105% = 89,933 - 12,000 = 77,933 and continue ****Obviously, this takes a lot of time. Because the answer choices shown on the test will be so far apart, I would suggest taking a shortcut. Take the initial principal, $100,000; divide by the annual withdrawal rate, $12,000 (100 / 12 = 8.33); and choose the next highest number (because you have to realize that the account is earning 5% on whatever assets remain).***

An analyst is viewing a subject company's financial statements. She notices that the company has current assets of $20 million, fixed assets of $50 million, and total liabilities of $45 million (of which $10 million is considered long-term). This company's debt-to-equity ratio is A) 40% B) 28.6% C) 64.3% D) 22.2%

B The debt-to-equity ratio is computed by dividing the issuer's long-term debt by their total capitalization. Total capitalization is the company's net worth (assets minus liabilities) plus the long-term debt. In this example, the net worth is $70 million minus $45 million, or $25 million. Adding the long-term debt of $10 million results in total capital of $35 million. Divide the $10 million by that $35 million to arrive at 28.57%. As we point out in the LEM, this is really a misnomer—it should be called the debt-to-total-capital ratio, but probably will not be shown that way on the exam. 10 million long term debt/35 million total capitalization=28.6%

Your client wants to have $1 million in her investment account when she retires at age 70. She is currently 50 and has about $215,000 available to invest today. You tell her that if the portfolio can earn at a compounded rate of 8%, she will reach her goal. That 8% rate is A) the present value rate B) the internal rate of return C) the future value rate D) the market rate of return

B The internal rate of return is the earnings rate required to reach a specified future value from an amount that is currently available to invest. This is a future value computation, but there is no such term as future value rate.

When a stock has a beta of less than 1, this indicates that A) it will have a high level of unsystematic risk B) it will, on average, give a return in excess of that of a stock with a beta of greater than 1 C) it will, on average, give a return below that of the market D) it will have a high level of systematic risk

C Beta tracks a stocks co-movement with the overall market. Because the "market" has a beta of 1.0, any stock with a lower beta will generally not have price movement equal to the market. Beta is a measurement of systematic risk, and low-beta stocks have less than high beta ones. Beta has no relationship to unsystematic risk.

Computing Alpha EX.) Portfolio return 10% Risk-free rate 2% Market return rate 8% Beta 1.2 total portfolio return − risk-free rate) − (portfolio beta × [market return − risk-free rate]) **think you are simply comparing your portfolio to the market after eliminating the risk free rate : note the beta is factored in to the market side** (10-2) - (1.2x[8-2]) = 8 - 7.2 = 0.8

It is possible on the exam that you will have an alpha computation where the RF (risk-free return) is not given. In that case, the computation is the same, but without the RF being subtracted from both the actual return and the market return. For example, in our first case, the computation would be 10% − (1.2 × 8%) or 10% − 9.6% for an alpha of +0.4.

Net present value (NPV) - NPV is expressed in dollar amounts and not as a rate of return. is the difference between an investment's present value and its cost. A positive NPV of $10 means that an investment that cost $100 must have a discounted PV of $110, for an NPV of $10. Note that the difference between the cost ($100) and the PVof the investment's future returns ($110) equals the NPV ($10). If the PV is $90, there is a negative NPV of $10 because the price is above the present value.

NPV is computed by subtracting the market price from the PV. positive NPV and that means we're able to buy the bond for less than what it is theoretically worth negative NPV, and would not be one you would likely purchase.

Quick Asset Ratio (Acid Test Ratio) Quick asset ratio= (current assets-Inventory)/current liabilities Liquidity measures a company's ability to pay the expenses associated with running the business. OR if inventory is not given like in the example just add the cash and receivables then divide by liabilities.

The balance sheet of the DEF Corporation shows that included in its $15 million in current assets is $4 million in cash and $2 million in accounts receivable. If DEF's current liabilities are $4 million, the quick asset ratio is A. 1.0:1 B. 1.5:1 C. 2.5:1 D. 3.0:1 Answer: B. We aren't told what the inventory is, but we are given the other current assets. So, we can add together the $4 million in cash to the $2 million in receivables resulting in $6 million divided by the $4 million in current liabilities for a 1.5 to 1 (choice B) *It wasn't necessary for the question to tell us the inventory—we didn't have to subtract it because we never included it in the first place.*

Which of the following statements with regards to net present value and internal rate of return is correct? A) If the net present value is greater than zero, then the internal rate of return is greater than the required rate of return. B) If the net present value equals zero, then the internal rate of return is greater than the required rate of return. C) If the net present value is less than zero, then the internal rate of return is greater than the required rate of return. D) If the net present value equals zero, then the internal rate of return is less than the required rate of return.

A Any time the net present value is greater than zero (a positive NPV), the internal rate of return is greater than the required rate of return and the investment should be made. If the net present value is zero, then the internal rate of return equals the required rate of return.

Dividend payments are not a part of the computation for which of the following risk measurement tools? A) Dividend discount model B) Dividend growth model C) Correlation coefficient D) Net present value

C The correlation coefficient measures the degree to which 2 securities or portfolios move in concert with each other.

Book Value Per Share basically the liquidation value of the enterprise. That is, let's assume we sold all of our assets, paid back everyone we owe, and then split what is left among the stockholders.

(tangible assets - liabilities - par value of preferred)/(shares of common stock outstanding) = book value per share

***Which of the following statements with regards to net present value and internal rate of return is correct? A) If the net present value is less than zero, then the internal rate of return is greater than the required rate of return. B) If the net present value equals zero, then the internal rate of return is greater than the required rate of return. C) If the net present value equals zero, then the internal rate of return is less than the required rate of return. D) If the net present value is greater than zero, then the internal rate of return is greater than the required rate of return.

***D Any time the net present value is greater than zero (a positive NPV), the internal rate of return is greater than the required rate of return and the investment should be made. If the net present value is zero, then the internal rate of return equals the required rate of return.

Patrice has an investment portfolio with the following characteristics: Portfolio actual return: 9% Market actual return: 12% Portfolio standard deviation: 4% Market standard deviation: 7% Portfolio beta: 0.65 Risk-free rate of return: 3% What is her portfolio's alpha? Did her portfolio outperform the market on a risk-adjusted basis? A) With an alpha of 0.15%, her portfolio outperformed the market. B) With an alpha of -5.10%, her portfolio underperformed the market. C) With an alpha of 5.10%, her portfolio outperformed the market. D) With an alpha of -0.15%, her portfolio underperformed the market.

A (9% - 3%) - (.65 times [12% minus 3%]) =

A stock traded on the Nasdaq Stock Market has a beta of 1.20. One could expect that the stock's volatility compared to the S&P 500 would be A) 20% more volatile B) too variable to tell C) 20% less volatile D) negatively correlated to the S&P

A Beta is a measurement of a security's volatility when compared with the overall market, best measure by the S&P 500. The "market" is assigned a beta of 1.00, so when the beta is higher than 1.00, the stock has greater volatility and when lower than 1.00, the volatility is less.

Which of the following are likely to have a low beta? A) Public utility stocks B) Technology stocks C) Aerospace stocks D) Software stocks

A Public utility stocks tend to have low betas as do other defensive stocks. Technology, aerospace, and software stocks tend to have high betas.

The present value of a dollar A) indicates how much needs to be invested today at a given interest rate to equal a specific cash value in the future B) is the amount of goods and services the dollar will buy in the future at today's rate price level C) cannot be calculated without knowing the level of inflation D) is equal to its future value if the level of interest rates stays the same

A The present value of a dollar will indicate how much needs to be invested today at a given interest rate to equal a cash amount required in the future.

Investment risk may broadly be categorized as either unsystematic or systematic risk; both types of risk together constitute total, or absolute, risk. Total risk is measured by A) standard deviation B) correlation coefficient. C) opportunity cost. D) beta coefficient.

A Unlike beta, which only measures systematic risk, standard deviation reflects both systematic and unsystematic risk, revealing the total risk of the investment.

Present value is a computation that is frequently used to determine the amount of a deposit needed now to meet a future need, such as a college education. If an investor uses an expected return of 8% but the actual return over the period is 10%, the future value will be A. lower than anticipated B. higher than anticipated C. the same as anticipated D. too varying to tell

Answer: B. Present value is the amount deposited to meet a future goal based on an expected rate of return. If the return is higher than expected, the ending result will be greater (a good thing).

If a stock has a beta of less than 1.0, the stock's price will A) decrease regardless of whether the market is up or down B) decrease more than the market when the market is down C) not increase as much as the market when the market is up D) increase more than the market when the market is up

C Beta compares a stock's price history to the movement of a total market index for the same period. A beta of less than 1 means that the stock's price does not swing as widely, up or down, as the average for the entire market.

ALFA Enterprises pays a quarterly dividend of $0.15 and has earnings per share of $2.40. Assuming that payout rate is continued, what is the dividend payout ratio? A) 30% B) 14.4% C) 25% D) 6.25%

C Earnings per share are typically calculated for a year. If the quarterly dividend rate of $0.15 is continued, that will be an annual payout of $0.60 ($0.15 × 4). So the annual dividend of $0.60 is divided by $2.40 to calculate what percentage of earnings is paid as a dividend; or rather, the dividend payout ratio (0.60 ÷ 2.40 = 25%).

Working capital is the amount of liquid capital or cash a company has available. Working capital is a measure of a firm's liquidity, which is its ability to quickly turn assets into cash to meet its short-term obligations. current assets − current liabilities =working capital

Factors that increase working capital include increases in cash from: - issuing securities (long-term debt or equity); - - profits from the business operations; and the - sale of noncurrent assets, such as equipment no longer in use. Factors that decrease working capital include increasing current liabilities such as: - declaring cash dividends; - paying off long-term debt whether at maturity or, if called, earlier; and - net operating losses.

If our actual return is less, we don't make out as well. That means that the PV (the required initial deposit) is going to be higher than we computed. if the actual return was higher than the PV (we did better than we thought), the PV (the amount we would have had to deposit), is less.

If the actual return is higher than projected, the FV will be higher (we made more on our money than we thought we would). if the actual return is lower, our FV winds up lower.

The correlation coefficient is a number that ranges from −1 to +1. Securities that areperfectly correlated have a correlation coefficient of +1. Securities whose price movements are unrelated to each other have a correlation coefficient of 0

Index funds attempt to achieve perfect correlation (+1) with the index they are mirroring (e.g., the Standard & Poor's 500). The goal of an index fund manager is to come as close as possible to matching the performance of the underlying index. It is not a goal to exceed the performance, only to match it.

Future Value - rate of return it earns (r); and - number of years over which it is invested (n). The equation to calculate the FV of an investment is expressed as: FV = PV × (1 + r)^n NOT be required to know the formula or how to do these computations.

Present Value PV = FV / (1 + r)n In this formula, PV stands for the present value, FV stands for the future value, r is the interest rate, and n is the number of time periods the money is compounded.