Checkpoint Exam U10

Here is a list of the current ratios of 4 companies. The industry standard for an acceptable current ratio is 2:1. Company A: 3.47:1 Company B: 1.47:1 Company C: 1.19:1 Company D: 0.89:1 Which of the following is CORRECT? A) Company B's financial status is better than company C. B) Company A is below industry standards. C) Company B is above industry standards. D) Company D is in the best financial standing.

A) Company B's financial status is better than company C. It should be clear that a 1.47:1 ratio of current assets to current liabilities is stronger than 1.19:1. Company A is well above industry standards, and Company D is well below with current assets less than its current liabilities. U10LO7

The measurement of a portfolio's actual or realized return in excess of (or deficient to) the expected return calculated by the capital asset pricing model (CAPM) is known as A) alpha B) IRR C) NPV D) beta

A) alpha This is the textbook definition of alpha. Portfolio managers strive for a positive alpha (returns in excess of the expected return). U10LO4

An agent is analyzing the financial statements of a corporation. The company has cash on hand of $2 million, accounts receivable of $500,000, accounts payable of $700,000, land valued at $3 million, wages payable of $300,000, goodwill of $100,000, inventory of $1.5 million, and retained earnings of $5 million. From this information, the agent would determine that the acid-test ratio for this company is A) 2.5:1 B) 3.375:1 C) 4:1 D) 1:1

A) 2.5:1 The acid-test, or quick, ratio is all of the current assets, except for inventory, divided by the current liabilities. The non-inventory current assets are the cash on hand and the accounts receivable. The current liabilities are the accounts payable and wages payable. This results in a calculation of $2.5 million divided by $1 million, or 2.5:1. U10LO7

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

B) 25% 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%). U10LO7

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) correlation coefficient. B) standard deviation C) opportunity cost. D) beta coefficient.

B) standard deviation Unlike beta, which only measures systematic risk, standard deviation reflects both systematic and unsystematic risk, revealing the total risk of the investment. U10LO5

Over the past 5 years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The median of the returns is A) 9.0% B) 8.2% C) 7.4% D) 8.0%

D) 8.0% The median of a series of returns is that number that has an equal number of occurrences below as above. In this case, that number is 8% because there are 2 returns less than 8% (-4% and +5%) and 2 above (+12% and +16%). U10LO2

An investment adviser is analyzing 4 bonds of similar quality for a client. Bond A has a coupon of 6%, matures in 12 years, and is currently priced at 50. Bond B has a coupon of 8%, matures in 9 years, and is currently priced at 50. Bond C has a coupon of 4%, matures in 18 years, and is priced at 45. Bond D has a coupon of 12%, matures in 6 years, and is priced at 50. Based on NPV, which of these bonds represents the better value? A) Bond B B) Bond A C) Bond D D) Bond C

D) Bond C Because you don't have the proper calculator to do a real PV calculation, NASAA expects you to use the rule of 72. Remember, under that rule, dividing 72 by the interest rate tells you the number of years it will take for a deposit to double. Or, if you divide 72 by the number of years, it will tell you the interest rate required for a present deposit to double. Finally, a positive NPV is when you can buy the bond for less than its present value. So, let's look at all 4 choices. Bond A, at 6%, takes 12 years to double. That's exactly the time to maturity, so the PV of this bond should be approximately $500 (a quote of 50). The same is true of bonds B and D—their PV should be approximately $500 (72 ÷ 8% = 9 years; 72 ÷ 12% = 6). Because their price is the same as the PV, the NPV is zero. However, with bond C, 72 divided by 4% equals 18 years, so this bond also has a PV of approximately $500 (50), but it can be purchased for less than that: 45 ($450). Therefore, with an NPV of $50, bond C is the best value. One final point: If you are stuck and have to guess, note that 3 of the 4 bonds are selling for $500 with the other priced at $450. If they are all going to mature at $1,000, a good guess would be that the cheapest one is the best deal. U10LO1

A client who wishes to have $50,000 available to help fund a 3-year-old child's college education in 15 years estimates that if the portfolio can earn 7%, a deposit of $18,122.30 will be required today. This deposit is referred to as A) the net present value B) the internal rate of return C) the future value D) the present value

D) the present value This is a present value computation where the future value, time period, and earnings rate are known. U10LO1

A securities analyst reviewing a corporation's financial statements notes that the enterprise has total current assets of $10 million, inventory of $4 million, cash on hand of $2 million, total current liabilities of $8 million, and net income of $15 million. The company's acid-test ratio is closest to A) 1.00 to 1 B) 1.25 to 1 C) 0.75 to 1 D) 1.50 to 1

C) 0.75 to 1 The acid-test ratio, also known as the quick asset ratio, is computed by subtracting the inventory from the total current assets and then dividing that remainder by the total current liabilities. In this case, that would be $10 million minus $4 million ($6 million) divided by $8 million, or .75%. U10LO7

An investment of $2,000 made 10 years ago is now worth $8,000. Using the Rule of 72, the approximate compounded annual rate of return is A) 40% B) 25% C) 14.4% D) 7.2%

C) 14.4% This investment has quadrupled in 10 years. Using the Rule of 72, we know how to compute the rate of return when an investment doubles. This one has doubled every 5 years. Dividing 72 by 5 years gives us an approximate rate of 14.4%. U10LO1

If a security has an anticipated return of 8.7% and a standard deviation of 14.6%, you would expect the returns to have a 95% probability (assuming a normal distribution) of falling between A) −5.9 and +23.3% B) 0 and 37.9% C) −20.5 and +37.9% D) 8.7 and 23.3%

C) −20.5 and +37.9% A security with a normal distribution has a 95% probability of falling within 2 standard deviations of its anticipated return. In this case, that would be −20.5% and +37.9%, which is computed by calculating return movements of 29.2% (14.6 × 2) in either direction. U10LO5

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) I and III C) II and IV D) I and IV

D) 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. U10LO7

When computing a company's quick ratio, which of the following assets is NOT counted? A) Marketable securities B) Cash C) Accounts receivables D) Inventory

D) Inventory The formula for the quick ratio takes the quick assets (all current assets other than inventory) and then divides that by the current liabilities. Or, it takes all of the current assets, subtracts the inventory, and divides the remainder by the current liabilities. U10LO7

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 market rate of return C) the internal rate of return D) the future value rate

C) the internal rate of return The internal rate of return (IRR) 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. U10LO1

Securities analysts would agree that it makes sense to purchase a fixed-income security when its net present value (NPV) is A) variable B) zero 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. U10LO1

A security that your client has been following has a historical average annual return of 11% and a standard deviation of 6%. Knowing this, it would be expected that 95% of the time, your client could expect a return within the range of A) −66% and +66% B) +5% and +17% C) −7% and +30% D) −1% and +23%

D) −1% and +23% Ninety-five percent of the time, a stock will range within 2 standard deviations of its historical return. In this case, 2 times 6% means that the range will be down 12% from the historical 11% and up 12% from the historical 11%. U10LO5

If a company with 10 million shares outstanding with total earnings of $50 million pays a $2 dividend, the dividend payout ratio is A) 4% B) 20% C) 40% D) 25%

C) 40% Dividend payout ratio is determined by dividends paid per share divided by earnings per share. In this case, earnings per share (EPS) is $50 million ÷ 10 million shares = $5 per share. The company paid out in dividends $2 for each $5 earned for a 40% payout ratio ($2 ÷ $5). U10LO7

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

C) present value would be higher The present value computation is used to determine how much money must be deposited now (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 used in the formula. As a simple example, if you need $100,000 18 years from now for your newborn's college education and you expect to earn 8%, you'll have to deposit approximately $25,000 now (present value) to reach the goal. However, if it turns out that the earnings rate is less than anticipated, say only 4%, then you would have to deposit twice as much presently. Therefore, we answer this question by indicating that a lower rate of return will require a higher present value. U10LO1

Which of the following measures the variability of an asset's returns over time? A) Time-weighted return B) Alpha C) Standard deviation D) Beta

C) Standard deviation The standard deviation is a measure of the range of scores within a set of returns over a period of time. The greater the dispersion of the returns from the mean, the greater the volatility of the security. U10LO5

The time value of money is part of the computation for A) the risk-adjusted return B) the internal rate of return C) the after-tax return D) the real rate of return

B) the internal rate of return One of the unique features of IRR is that it is a compounded rate using the time value of money. U10LO1

At age 18, Joan's trust fund becomes available to pay for her higher education. There is $100,000 in the fund, all invested in fixed income securities with an average coupon of 6%. If the estimated cost of college for the next 4 years is $30,000 per year paid at the beginning of the school year, how long will the money last? A) 3 years with approximately $25,009 available for the 4th year B) 3 years with approximately $17,863 available for the 4th year C) 3 years with approximately $28,000 available for the 4th year D) 4 years with approximately $4,000 remaining

B) 3 years with approximately $17,863 available for the 4th year Here is how to do this with the simple calculator available at the testing center. Beginning sum is $100,000 with $30,000 taken out to start the school year. The remaining $70,000 earns 6%, so multiply $70,000 × 106% to arrive at $74,200 at the end of the 1st year. Then, subtract $30,000 and multiply by 106% again resulting in an end of 2nd year total of $46,852. Subtract the $30,000 again and multiply the remainder by 106%, which results in $17,863 remaining at the end of the 3rd year. U10LO3

An investment adviser representative is looking for a suitable investment for a client. The IAR wishes to find something that will offer an attractive return commensurate with its systematic risk. The choices have been narrowed to Security C and Security L, and the selection will be based on alpha. C has a beta of 1.0 and earned 13%, while L has a beta of 0.8 and earned 10.1%. The alpha of Security L is A) +0.3 B) −0.3 C) −2.9 D) +2.9

B) −0.3 Alpha is obtained by comparing how a security actually performed to the performance one would have expected based on its beta. A beta of 1.0 is used to indicate the expected volatility of the overall market. Because Security C has a beta of 1.0, its 13% return matches that of the "market." With a beta of 0.8, one would expect Security L to produce a lower return, but how much lower? Its return should be 80% of the "market" or, in this case, 80% of 13%, which computes to 10.4%. However, its actual return fell short of that by 0.3%, giving it a negative alpha of 0.3. Had its actual return been 10.7%, it would have had a 0.3 positive alpha. Although this question doesn't ask it, based on the criteria given, the IAR would have selected Security C. U10LO4

Mr. and Mrs. Rose, advisory clients of yours, request a meeting with you to discuss the options available if they wish to deposit a lump sum to save for college tuition for their child. All of these would be factors to consider EXCEPT A) the expected inflation rate B) the age of the child C) the Roses' salaries D) current college costs

C) the Roses' salaries When making a lump sum investment, salary is NOT a factor. The funds will have to come out of savings or investments. This is basically a present value computation. In order to project how much will be needed, we need to know what the current tuition is, the rate at which it is expected to inflate, and the number of years we have until the child starts college. That will give us the three components of present value: total amount needed, earnings rate, and length of the investment. U10LO1

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

D) the present value would be lower Try to follow me on this one. 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). U10LO1