Analytical Methods Unit 10
A corporation calls in a portion of its long-term debt at 101. This will have the effect of I. decreasing working capital II. increasing working capital III. decreasing net worth IV. increasing net worth A) I and III B) II and IV C) II and III D) I and IV
A) I and III Working capital is computed by subtracting current liabilities from current assets. Using a current asset, like cash, to call in the bonds, reduces those assets with no corresponding reduction to current liabilities. Whenever a bond is called at a premium, net worth is reduced by that premium.
When analyzing a security's standard deviation, which of the following statements accurately describes observations according to a normal frequency distribution curve? A) Approximately 97.5% of all observations will be within three standard deviations of the mean. B) Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean. C) Approximately 95.5% of all observations will be within three standard deviations of the mean. D) Approximately 97.5% of all observations will be within two standard deviations on either side of the mean.
B) Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean Approximately two-thirds, or 68.26%, of observations will be within one standard deviation on either side of the mean. Approximately 95% will be within two standard deviations and approximately 99% will be within three.
A measurement of investment return that takes the time value of money into consideration is A) real rate of return B) internal rate of return (IRR) C) risk-adjusted rate of return D) holding period return
B) internal rate of return (IRR) The internal rate of return compounds returns and takes into consideration the time value of money. Real rate of return considers the inflation rate and risk-adjusted return is another way of stating the Sharpe ratio
An investor's portfolio consists of a single stock. If a stock with a correlation of +.95 was added to the portfolio and the stock market turned bearish, what would be the likely effect of having added this additional security? A) Not enough information to tell. B) The portfolio's value would increase. C) Almost no noticeable impact. D) The portfolio's value would remain the same.
C) Almost no noticeable impact. Adding additional securities to a portfolio usually increases the diversification, lowering the overall risk. However, that is more apparent when there is low or negative correlation. A +.95 correlation means that the "new" stock will perform close to exactly the same as the existing one so its addition should have little to no impact on performance. In a bearish market, values go down, not up or remain the same. If this additional stock had a negative correlation, that could have resulted in the portfolio going up or remaining the same, but not with a +.95 correlation. It is almost never that a question on the exam does not have enough information to arrive at the correct answer - steer away from that choice.
The difference between present value and net present value represents A) the internal rate of return B) the credit risk premium C) the initial cash outlay D) the discounted cash flow
C) the initial cash outlay When computing the net present value, we remember that the word net means that something must be subtracted. The number subtracted is the initial cost of the investment
Which of the following statements is NOT true? A) Beta is a volatility measure of a security compared with the overall market. B) A stock with a beta of 1.2 will move 20% more than the market. C) A stock with a beta of 0.8 will move 20% less than the market. D) Beta is a measure of a security's deviation from its historical average returns.
D) Beta is a measure of a security's deviation from its historical average returns. A measure of a security's deviation from its historical average returns is the security's standard deviation. Beta measures a security's volatility in relation to the overall market. Stocks with a beta greater than 1 are more volatile than the market and stocks with a beta less than 1 are less volatile than the market.
A financial analyst computing the current ratio of a company whose stock trades on the Nasdaq Stock Market would use which of the following components? A) Accounts receivable B) Current liabilities C) Operating income D) Rent
B) Current liabilities There are two components to the current ratio formula: current assets and current liabilities. Although accounts receivable are a current asset, the component in the formula is current assets.
Which of the following best describes net present value? A) It is the true interest yield expected from an investment expressed as a percentage B) The discount rate that results in a return of zero for a series of future cash flows C) The amount of money that must be invested today at some specified rate of return to equal a targeted value in a specified number of years D) The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost
D) The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost Net present value is a computation taking into consideration future cash flows, discounted to the present, and comparing that to the capital investment necessary to obtain those flows. It is always expressed in monetary units and, if positive, indicates a potentially worthwhile investment.
Which of the following incorrectly states the relationship between NPV, IRR, and required return? A) If NPV > 0, then IRR < required return. B) If NPV < 0, then IRR < required return. C) If NPV = 0, then IRR = required return. D) If NPV > 0, then IRR > required return.
A) If NPV > 0, then IRR < required return. If the NPV is a positive number, the investor's internal rate of return (IRR) is greater than the required rate of return (it is a good buy). When used with bonds, the required rate of return is the current market interest rate. Conversely, if the NPV is a negative number, the investor's IRR is less than the required rate of return (not a good buy). When the NPV is zero, the investor's IRR is equal to the required rate of return.
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) zero B) negative C) the same as the coupon D) positive
A) zero A bond paying $100 in interest per year 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 methods of calculating investment returns are discounted cash flow (DCF) techniques? I. Net present value (NPV) II. Holding period return (HPR) III. Internal rate of return (IRR) A) I and II B) I and III C) II and III D) I, II, and III
B) I and III A discounted cash flow (DCF) technique is one that takes into account the time value of money. Holding period return (HPR) is the total of the income cash flows and capital growth earned by an investment during the period for which it is held. It does not take into account the time value of money. Both net present value (NPV) and internal rate of return (IRR) take the time value of money into account.
From the following 4 portfolios, choose the 1 that would generally be considered to be the most diversified. A) DCB common stock, beta 1.00, correlation to the S&P 500, +0.75; HGF common stock, beta 0.10, correlation to the S&P 500, +0.25; KJI common stock, beta −0.50, correlation to the S&P 500 +0.50 B) STU common stock, beta 0.95, correlation to the S&P 500, +0.84, VWX common stock, beta 0.90, correlation to the S&P 500, +0.07; YZA common stock, beta 0.88, correlation to the S&P 500, −0.45 C) ABC common stock, beta 1.20, correlation to the S&P 500, +0.82; DEF common stock, beta 0.90, correlation to the S&P 500, +0.91; GHI common stock; beta +0.65, correlation to the S&P 500, +0.06 D) JKL common stock, beta 1.50, correlation to the S&P 500, +0.77; MNO common stock, beta 1.00, correlation to the S&P 500, +0.93, PQR common stock, beta 0.50, correlation to the S&P 500, +0.34
B) STU common stock, beta 0.95, correlation to the S&P 500, +0.84, VWX common stock, beta 0.90, correlation to the S&P 500, +0.07; YZA common stock, beta 0.88, correlation to the S&P 500, −0.45 Most analysts would agree that the greatest portfolio diversification occurs when there are some holdings with a negative correlation. Beta measures volatility, so varying those positions will offer some protection against volatility. However, including securities that move in opposite directions will provide protection against general market dec
The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is A) the price-earnings (PE) ratio. B) the price-sales ratio C) the price-to-book-value ratio D) the dividend discount ratio
C) the price-to-book-value ratio The price-to-book-value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value.
If a company successfully gets the owners of its long-term bond issue paying 7% annual interest to exchange them on a dollar-for-dollar basis with the company's preferred stock paying a 7% annual dividend, what is the effect on EPS? A) Not enough information B) No effect C) Increase D) Decrease
D) Decrease The 7% interest payment is moved from a pre-tax deduction to an after-tax dividend payment. This increases the amount of taxable income, thereby increasing the company's tax liability. The 7% payment remains the same. With an increased tax burden and everything else remaining the same, the EPS will decrease
Securities analysts would agree that it makes sense to purchase a fixed-income security when its net present value (NPV) is A) zero B) variable C) negative D) positive
D) positive A positive NPV means the security is available for a price below its present value—it is a good buy. With a negative NPV, the price is too high. With a zero NPV, it is accurately priced.
An IAR is viewing the balance sheet of a corporation. Included in the computation of the company's working capital are all of the following EXCEPT A) marketable securities of other companies accounts B) receivable C) cash D) convertible bonds it has issued
D) convertible bonds it has issued The working capital of a corporation is equal to its current assets minus its current liabilities (a current liability is payable within 12 months). Because all bonds, convertible or not, issued by the corporation are long-term liabilities, they are not included in the working capital computation. Accounts receivable, marketable securities, and cash are short-term assets included in the calculation of working capital.
In portfolio theory, the alpha of a security or a portfolio is A) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved B) the risk of the portfolio associated with the macroeconomic factors that affect all risky assets C) a measure of the variance in returns of a portfolio divided by its average return D) the portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio
A) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is systematic risk. The portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio is the Sharpe ratio or measure. The measure of the variance in returns of a portfolio around its average return is the standard deviation.
If the net present value of a series of discounted cash flows is less than zero, one could conclude that A) the discounted cash flows are lower than the investment outlay. B) the rate of return is higher than the cost of capital. C) the return on investment is higher than the internal rate of return. D) the internal rate of return equals the discount rate.
A) the discounted cash flows are lower than the investment outlay. A negative net present value of a series of discounted cash flows means the investment outlay exceeds the discounted cash flows. Net present value is the difference between the initial cash flows and the present value of future cash inflows. If the net present value is negative, the present value of future cash flows is less than the initial investment. An investment with a negative net present value is generally an undesirable investment.
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 IV B) I and IV C) I and III D) II and III
B) I and IV 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
Liquidity ratios measure the solvency of a firm or the firm's ability to meet short-term financial obligations. Which of the following is a liquidity ratio? A) Net income divided by average total equity B) Gross profit divided by net sales C) Dividend divided by earnings per share D) Current assets divided by current liabilities
D) Current assets divided by current liabilities Current assets divided by current liabilities is the current ratio, a ratio that measures the liquidity of a firm. Gross profit divided by net sales is a profitability ratio that measures the gross profitability of the firm's business operations, not its liquidity. Net income divided by average total equity is the return on stockholders' equity, which measures the efficiency of common shareholders' investment or equity in the firm. Dividend amount divided by earnings per share is the dividend payout ratio which measures how much of a company's earnings are distributed to common stockholders
The price-to-earnings ratio A) reflects how liberal the company's dividend policies are B) indicates current cash flows C) is higher for value stocks than for growth stocks D) shows how much investors value the stock as a function of earnings to the company's market price
D) shows how much investors value the stock as a function of earnings to the company's market price The 2 components of the price-to-earnings ratio are the current market price and the earnings per common share. When a company has a high P/E ratio, it means that investors are placing greater value on expected growth in earnings. That is one of the reasons why growth stocks carry higher P/E ratios than do value stocks.
