FIN Practice 1
Suppose you invested $100 in the Ishares High Yield Fund (HYG) a month ago. It paid a dividend of $2 today and then you sold it for $95 . What was your dividend yield and capital gains yield on the investment? A) 2%, -5% B) 2%, 5% C) -2%, 5% D) 5%, 2%
A) $2 / $100 = 2%; -$5 / $100 = -5%
Amazon.com stock prices gave a realized return of 5%, -5%, 11%, and -11% over four successive quarters. What is the annual realized return for Amazon.com for the year? A) -1.46% B) 2.91% C) 0.00% D) 1.46%
A) (1 + 0.05) × (1 - 0.05) × (1 + 0.11) × (1 - 0.11) = 0.9854 ; 0.9854 - 1 = -1.46%
If the returns on a stock index can be characterized by a normal distribution with mean 12%, the probability that returns will be lower than 12% over the next period equals ________. A) 50% B) 25% C) 46% D) 33%
A) 50%
Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors has a beta of 1.6. What is General Motorsʹ cost of equity capital? A) 15.2% B) 14.4% C) 16.0% D) 13.7%
A) Apply the CAPM equation. Cost of equity = 0.04 + (1.6 × 0.07) = 0.152 = 15.2%
A portfolio comprises Coke (beta of 1.4) and Wal-Mart (beta of 0.8). The amount invested in Coke is $20,000 and in Wal-Mart is $30,000. What is the beta of the portfolio? A) 1.04 B) 1.20 C) 1.35 D) 1.25
A) Compute portfolio weights of Coke and Wal-Mart. Multiply weight of each stock by its beta; 1.4 × ($20,000) / ($20,000 + $30,000) + 0.8 × ($30,000) / ($20,000 + $30,000) = 1.04
A portfolio has three stocks 240 shares of Yahoo (YHOO), 150 Shares of General Motors (GM), and 40 shares of Standard and Poorʹs Index Fund (SPY). If the price of YHOO is $30, the price of GM is $30, and the price of SPY is $130, calculate the portfolio weight of YHOO and GM. A) 42.6%, 26.6% B) 23.4%, 49.3% C) 12.8%, 16.0% D) 40.5%, 28.0%
A) Compute the value of each stock in the portfolio by multiplying stock price by number of shares of each. Compute total portfolio value by adding each component. Divide YHOO value by portfolio value to compute its weight. Similarly, calculate weight for GM. Thus, total portfolio value = 240 × $30 + 150 × $30 + 40 × $130 = $16,900 ; weight of YHOO = $7200 / $16,900 = 42.6%; weight of GM = $4500 / $16,900 = 26.6%
Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35 . What is the cost of preferred stock capital for Ford? A) 11.4% B) 12.6% C) 13.7% D) 14.9%
A) Divide the dividend by the preferred stock price. $4 / $35 = 0.114 or 11.4%
Suppose you have $10,000 in cash and you decide to borrow another $10,000 at a(n) 6% interest rate to invest in the stock market. You invest the entire $20,000 in an exchange -traded fund (ETF) with a 11% expected return and a 20% volatility. The expected return on your of your investment is closest to ________.
A) E[Rxp] = rf + x(E[Rp] - rf) = 6% + 20%(11% - 6%) = 7%
The standard deviation of returns of ________. I. small stocks is higher than that of large stocks II. large stocks is lower than that of corporate bonds III. corporate bonds is higher than that of Treasury bills Which statement is true? A) I and III B) I, II, and III C) I and II D) I only
A) I and III
Which of the following statements is FALSE? A) On average, larger stocks have higher volatility than smaller stocks. B) Portfolios of large stocks are typically less volatile than individual large stocks. C) On average, smaller stocks have higher returns than larger stocks. D) On average, Treasury Bills have lower returns than corporate bonds.
A) On average, larger stocks have higher volatility than smaller stocks.
If a stock pays dividends at the end of each quarter, with realized returns of R1, R2, R3, and R4 each quarter, then the annual realized return is calculated as ________. A) Rannual = (1 + R1) (1 + R2) (1 + R3)( 1 + R4) - 1 B) Rannual = R1 + R2 + R3 + R4 C) Rannual=(1+R1)(1+R2)(1+R3)(1+R4) D)Rannual= R1+R2+R3+R4
A) Rannual = (1 + R1) (1 + R2) (1 + R3)( 1 + R4) - 1
Which of the following statements is FALSE? A) The risk premium of a security is equal to the market risk premium divided by the amount of market risk present in the securityʹs returns measured by its beta with the market. B) The beta of a portfolio is the weighted average beta of the securities in the portfolio. C) There is a linear relationship between a stockʹs beta and its expected return. D) A security with a negative beta has a negative correlation with the market, which means that this security tends to perform well when the rest of the market is doing poorly.
A) The risk premium of a security is equal to the market risk premium (the amount by which the marketʹs expected return exceeds the risk-free rate) multiplied by the amount of market risk present in the securityʹs returns measured by its beta with the market.
Your retirement portfolio comprises 100 shares of the Standard & Poorʹs 500 fund (SPY) and 100 shares of iShares Barclays Aggregate Bond Fund (AGG). The price of SPY is $118 and that of AGG is $97. If you expect the return on SPY to be 11% in the next year and the return on AGG to be 6%, what is the expected return for your retirement portfolio? A) 8.74% B) 10.06 % C) 7.43% D) 7.87%
A) To calculate the expected return on the portfolio, compute portfolio weights in SPY and AGG. Multiply weight of SPY by return on SPY and weight of AGG by return on AGG. Alternatively, the expected return on the portfolio can be calculated as follows: Initial portfolio value = 100 × $118 + 100 × $97 = $21,500 ; final portfolio value = 100 × $118 × (1 + 0.11 ) + 100 × $97 × (1 + 0.06 ) = $23,380 ; expected portfolio return = ($23,380 - $21,500 ) / $21,500 = 8.74 %.
Which of the following statements is FALSE? A) While the sign of a correlation is easy to interpret, its magnitude is not. B) Independent risks are uncorrelated. C) When the covariance equals 0, the returns are uncorrelated. D) To find the risk of a portfolio, we need to know more than the risk and return of the component stocks; we need to know the degree to which the stocksʹ returns move together.
A) While the sign of a correlation is easy to interpret, its magnitude is not.
Which of the following statements is FALSE? A) Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return. B) The expected return of a portfolio is simply the weighted average of the expected returns of the investments within the portfolio. C) Portfolio weights add up to 1 so that they represent the way we have divided our money between the different individual investments in the portfolio. D) A portfolio weight is the fraction of the total investment in the portfolio held in an individual investment in the portfolio.
A) Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return.
A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%? A) 5.2% B) 5.5% C) 5.7% D) 6.0%
A) YTM = coupon rate in this case since the bond is selling at par. Therefore, after-tax cost = coupon rate × (1 - tax rate). Therefore, after-tax cost = 0.08 × (1 - 0.35) = 0.052 or 5.2%.
Rational investors ________ fluctuations in the value of their investments. A) are averse to B) prefer C) are indifferent to D) are in favor of
A) are averse to
Because investors can eliminate unsystematic risk ʺfor freeʺ by diversifying their portfolios, they ________. A) do not require a risk premium for bearing it B) require a risk premium for bearing it C) are indifferent about credit spread and risk premium D) do not require a credit spread
A) do not require a risk premium for bearing it
The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be ________. A) expensed B) margined C) refinanced D) capitalized
A) expensed
4) Stocks with high returns are expected to have ________. A) high variability B) low variability C) no relation to variability D) inverse relationship with variability
A) high variability
Historically, stocks have delivered a ________ return on average compared to Treasury bills but have experienced ________ fluctuations in values. A) higher, higher B) higher, lower C) lower, higher D) lower, lower
A) higher, higher
Diversification reduces the risk of a portfolio because ________, and some of the risks are averaged out of the portfolio. A) stocks do not move identically B) stocks have common risks C) stocks are fully predictable D) stocks are not affected by the market
A) stocks do not move identically
What is a bondʹs seniority? A) the bondholderʹs priority in claiming assets in the event of default B) clauses restricting a company from issuing new debt C) the yield to maturity of a bond as compared to bonds of comparable rating D) the issue price of the bond as compared to its face value
A) the bondholderʹs priority in claiming assets in the event of default
Which of the following is NOT a diversifiable risk? A) the risk that oil prices rise, increasing production costs B) the risk that the CEO is killed in a plane crash C) the risk of a key employee being hired away by a competitor D) the risk of a product liability lawsuit
A) the risk that oil prices rise, increasing production costs
Investors demand a higher return for investments that have larger fluctuations in values because ________. A) they do not like risk B) they are risk seeking C) they invest for the long term D) they prefer fluctuations
A) they do not like risk
The systematic risk (beta) of a portfolio is ________ by holding more stocks, even if they each had the same systematic risk. A) unchanged B) increased C) decreased D) turned to 0
A) unchanged
In general, it is possible to eliminate ________ risk by holding a large portfolio of assets. A) unsystematic B) systematic C) unsystematic and systematic D) market specific
A) unsystematic
Many former employees at AlphaEnergy, an energy trading and supply company, had a large part of their portfolio invested in AlphaEnergyʹs stock. These employees were bearing a high degree of ________ risk. A) unsystematic B) systematic C) market-specific D) non-diversifiable
A) unsystematic
While ________ seems to be a reasonable measure of risk when evaluating a large portfolio, the ________ of an individual security does not explain the size of its average return. A) volatility, volatility B) the mean return, standard deviation C) mode, volatility D) mode, mean return
A) volatility, volatility
Suppose the quarterly arithmetic average return for a stock is 10% per quarter and the stock gives a return of 15% each over the next two quarters. The arithmetic average return over the six quarters is ________. A) 15.17 % B) 11.67 % C) 12.83% D) 16.33 %
B) (10 + 10 + 10 + 10 + 15 + 15) / 6 = 11.67%
If asset Aʹs return is exactly two times asset Bʹs return, then following risk return tradeoff, the standard deviation of asset A should be ________ times the standard deviation of asset B. A) 3 B) 2 C) 1 D) 4
B) 2
For an unlevered firm, the cost of capital can be determined by using the ________. A) yield on the traded debt B) Capital Asset Pricing Model C) dividend yield D) preferred stock yield
B) Capital Asset Pricing Model
A stock market comprises 4600 shares of stock A and 1600 shares of stock B. Assume the share prices for stocks A and B are $15 and $30 , respectively. If you have $15,000 to invest and you want to hold the market portfolio, how much of your money will you invest in Stock A? A) $10,615.38 B) $8846.15 C) $6153.85 D) $5307.69
B) Multiply the number of shares of each stock by its price and add the values. Thus, (4600 × $15) + (1600 × $30) = $117,000 . Stock A is worth 4600 × $15 = $69,000 ; Proportion of stock A in the market portfolio = $69,000 / $117,000 = 58.974359 %; Value of stock A in portfolio = 58.974359 % × 15,000 = $8846.15
Which of the following statements is TRUE? A) On average, smaller stocks have lower volatility than Treasury bills. B) Portfolios of smaller stocks are typically less volatile than individual small stocks. C) On average, smaller stocks have lower returns than larger stocks. D) On average, Treasury bills have higher returns than stocks.
B) Portfolios of smaller stocks are typically less volatile than individual small stocks.
7) Which of the following investments offered the lowest overall return over the past eighty years? A) small stocks B) Treasury bills C) S&P 500 D) corporate bonds
B) Treasury bills
A portfolio has 30% of its value in IBM shares and the rest in Microsoft (MSFT). The volatility of IBM and MSFT are 35% and 30%, respectively, and the correlation between IBM and MSFT is 0.5. What is the standard deviation of the portfolio? A) 23.61 % B) 27.78 % C) 31.95% D) 30.56 %
B) Use the formula for variance of a portfolio: Take the square root of variance to get standard deviation. (0.3)2 ×(0.35)2+(0.7)2 ×(0.3)2+2×0.3×0.7×0.35×0.3×0.5=0.077175; square root of 0.077175 to get standard deviation = 27.78 %.
Epiphany is an all-equity firm with an estimated market value of $400,000. The firm sells $225,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity. A) 0.28, 0.72 B) 0.44, 0.56 C) 0.39, 0.61 D) 0.56, 0.44
B) Weight in debt = Debt raised / Market value of the firm Weight in debt = $225,000 / $400,000 = 0.56 Weight in equity = 1- Weight in debt Weight in equity = 1 - 0.56 = 0.44
What is a call provision? A) the periodic repurchasing of issued bonds through a sinking fund by the issuer B) an option to the issuer to repurchase the bonds at a predetermined price C) the option for the bondholder to convert each bond owned into a fixed number of shares of common stock D) a clause in a bond contract that restricts the actions of the issuer that might harm the interests of the bondholders
B) an option to the issuer to repurchase the bonds at a predetermined price
A firmʹs sources of financing, which usually consists of debt and equity, represent its ________. A) total assets B) capital C) total liabilities D) current liabilities
B) capital
Stocks tend to move together if they are affected by ________. A) company specific events B) common economic events C) events unrelated to the economy D) idiosyncratic shocks
B) common economic events
The expected return is usually ________ the baseline risk-free rate of return that we demand to compensate for inflation and the time value of money. A) lower than B) higher than C) similar to D) none of the above
B) higher than
The Capital Asset Pricing Model asserts that the expected return ________. A) is equal to the risk-free rate plus a risk premium for unsystematic risk B) is equal to the risk-free rate plus a risk premium for systematic risk C) is equal to the risk premium plus a risk-free rate for systematic risk D) is equal to the risk premium plus a risk-free rate for unsystematic risk
B) is equal to the risk-free rate plus a risk premium for systematic risk
The volatility of Home Depot Share prices is 50% and that of General Motors shares is 50%. When I hold both stocks in my portfolio and the stocks returns have zero correlation, the overall volatility of returns of the portfolio is ________. A) more than 25% B) less than 50% C) more than 50% D) less than 25%
B) less than 50%
Fluctuations of a stockʹs return that are due to market-wide news representing common risk is the ________. A) idiosyncratic risk B) systematic risk C) unique risk D) unsystematic risk
B) systematic risk
If the Federal Reserve were to change from an expansionary to a contractionary monetary policy, this would be an example of ________. A) unsystematic risk B) systematic risk C) independent risk D) diversification risk
B) systematic risk
The risk premium of a security is determined by its ________ risk and does not depend on its ________ risk. A) systematic, undiversifiable B) systematic, unsystematic C) undiversifiable, diversifiable D) diversifiable, undiversifiable
B) systematic, unsystematic
A companyʹs stock price jumped when it announced that its revenue had decreased because of the quality issues of its products. This is an example of ________. A) market risk B) unsystematic risk C) systematic risk D) undiversifiable risk
B) unsystematic risk
When would it make sense for a firm to call a bond issue? A) when the market price of the bond exceeds the call price, and market interest rates are greater than the bondʹs coupon rate B) when the market price of the bond exceeds the call price, and market interest rates are less than the bondʹs coupon rate C) when the market price of the bond is less than the call price, and market interest rates are greater than the bondʹs coupon rate D) when the market price of the bond is less than the call price, and market interest rates are less than the bondʹs coupon rate
B) when the market price of the bond exceeds the call price, and market interest rates are less than the bondʹs coupon rate
Suppose you invested $60 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.63 today and then you sold it for $65 . What was your return on the investment? A) 6.57% B) 7.51% C) 9.38% D) 10.32 %
C) $(65 + 0.63) - 60 = 5.63; 5.63 / 60 = 9.38%
Suppose you invested $59 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of 0.38 today and then you sold it for $66 . What was your return on the investment? A) 8.76% B) 13.76 % C) 12.51% D) 10.01 %
C) $(66 + 0.38) - 59 = 7.38; 7.38 / 59 = 12.51 %
A bond has a face value of $100 and a conversion ratio of 25. What is the conversion price? A) $0.25 B) $2.50 C) $4.00 D) $25.00
C) $100 / 25 = $4.00
Your investment over one year yielded a capital gains yield of 5% and no dividend yield. If the sale price was $114 per share, what was the cost of the investment? A) $119.43 B) $103.14 C) $108.57 D) $114.00
C) $114 / (1 + 0.05) = $108.57
The S&P 500 index delivered a return of 20%, -10%, 20%, and 5% over four successive years. What is the arithmetic average annual return for four years? A) 10.50 % B) 13.13 % C) 8.75% D) 9.63%
C) (20 - 10 + 20 + 5) / 4 = 8.75%
Which of the following statements is FALSE? A) Stock returns will tend to move together if they are affected similarly by economic events. B) Stocks in the same industry tend to have more highly correlated returns than stocks in different industries. C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together. D) With a positive amount invested in each stock, the more the stocks move together and the higher their covariance or correlation, the more volatile the portfolio will be.
C) Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together.
Bear Stearnsʹ stock price closed at $98 , $103 , $58 , $29 , $4 over five successive weeks. The weekly standard deviation of the stock price calculated from this sample is ________. A) $30.07 B) $49.40 C) $42.96 D) $34.37
C) Average return = $(98 + 103 + 58 + 29 + 4) / 5 = $58.4; standard deviation = (($98 - 58.4)2 + (103 - 58.4)2 + (58 - 58.4)2 + (29 - 58.4)2 +(4-58.4)2)/(5-1)1/2 =$42.96
Which of the following statements is FALSE? A) The covariance and correlation allow us to measure the co-movement of returns. B) Correlation is the expected product of the deviations of two returns. C) Because the stocksʹ prices do not move identically, some of the risk is averaged out in a portfolio. D) The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together.
C) Because the stocksʹ prices do not move identically, some of the risk is averaged out in a portfolio.
UPS, a delivery services company, has a beta of 1.6, and Wal-Mart has a beta of 0.9. The risk-free rate of interest is 6% and the market risk premium is 9%. What is the expected return on a portfolio with 40% of its money in UPS and the balance in Wal -Mart? A) 14.96 % B) 15.79 % C) 16.62% D) 18.28 %
C) Compute portfolio beta by multiplying weight of each stock by its beta. Use CAPM to compute expected return of the portfolio. (0.4 × 1.6) + (0.6 × 0.9) = 1.18; 6% + (1.18 × 9%) = 16.62%
Suppose you invest in 110 shares of Merck (MRK) at $40 per share and 120 shares of Yahoo (YHOO)at $25 per share. If the price of Merck increases to $45 and the price of Yahoo decreases to $22 per share, what is the return on your portfolio? A) 7.70% B) 4.11% C) 2.57% D) 3.47%
C) Compute value of MRK stock (stock price times number of shares) and the value of YHOO stock. Add values of both to compute portfolio value. Repeat with new price of stocks. Divide new portfolio value by old portfolio value and subtract 1 to compute return. Initial portfolio value = 110 × $40 + 120 × $25 = $7400 ; final portfolio value = 110 × $45 + 120 × $22 = $7590 ; hence portfolio return = $7590 / $7400 - 1 = 2.57%.
Which of the following statements is FALSE? A) The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk. B) When we combine many stocks in a large portfolio, the firm-specific risks for each stock will average out and be diversified. C) Fluctuations of a stockʹs return that are due to firm-specific news are common risks. D) The volatility in a large portfolio will decline until only the systematic risk remains.
C) Fluctuations of a stockʹs return that are due to firm-specific news are common risks.
Which of the following statements is FALSE? A) Almost all bonds that are issued today are registered bonds. B) The trust company represents the bondholders and makes sure that the terms of the indenture are enforced. C) For private placements, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company. D) In the case of default, the trust company represents the bondholdersʹ interests.
C) For private placements, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company.
The book value of a firmʹs equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its market value of debt is $60 million. What is the market value of assets of the firm? A) $150 million B) $160 million C) $260 million D) $250 million
C) Market value of debt plus market value of equity gives market value of assets. $200 + $60 = $260 million
Which of the following statements is FALSE? A) Expected return should rise proportionately with volatility. B) Investors would not choose to hold a portfolio that is more volatile unless they expected to earn a higher return. C) Smaller stocks have lower volatility than larger stocks. D) The largest stocks are typically more volatile than a portfolio of large stocks.
C) Smaller stocks have lower volatility than larger stocks.
Your estimate of the market risk premium is 9%. The risk-free rate of return is 3.8% and General Motors has a beta of 1.4. According to the Capital Asset Pricing Model (CAPM), what is its expected return? A) 14.8% B) 15.6% C) 16.4% D) 17.2%
C) Using the equation for the CAPM, expected return = 3.8%+ (1.4 × 9%) = 16.4%
Which of the following statements is FALSE? A) Investments with higher volatility have rewarded investors with higher average returns. B) Investments with higher volatility should have a higher risk premium and, therefore, higher returns. C) Volatility seems to be a reasonable measure of risk when evaluating returns on large portfolios and the returns of individual securities. D) Riskier investments must offer investors higher average returns to compensate them for the extra risk they are taking on.
C) Volatility seems to be a reasonable measure of risk when evaluating returns on large portfolios and the returns of individual securities.
Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC? A) 0.10, 0.90 B) 0.832 , 0.168 C) 0.168, 0.832 D) 0.90, 0.10
C) Weight in debt equals market value of debt divided by market value of debt plus equity. Similarly, weight in equity is market value of equity divided by market value of debt plus equity. Weight in equity = $4 billion / ($4 + $19.8 ) billion = 0.168 ; Weight in debt = $19.8 billion / ($4 + $19.8) billion = 0.832
Which of the following is usually a form of public debt? A) a preferred stock B) a bank loan C) a bond issue D) a revolving line of credit
C) a bond issue
Which of the following terms best describes a loan where a larger line of credit or lower interest rate has been obtained by providing collateral to back that loan? A) a term loan B) a revolving line of credit C) an asset-backed line of credit D) a private placement
C) an asset-backed line of credit
The relative proportion of debt, equity, and other securities that a firm has outstanding constitute its ________. A) asset ratio B) current ratio C) capital structure D) retained earnings
C) capital structure
As we increase the number of stocks in a portfolio, the standard deviation of returns of the portfolio ________. A) increases B) remains unchanged C) decreases D) doubles
C) decreases
We can reduce volatility by investing in less than perfectly correlated assets through diversification because the expected return of a portfolio is the weighted average of the expected returns of its stocks, but the volatility of a portfolio ________. A) is higher than the weighted average volatility B) is independent of weights in the stocks C) is less than the weighted average volatility D) depends on the expected return
C) is less than the weighted average volatility
If returns on stock A are more volatile than the returns on stock B, the geometric average return of stock A will be ________ the geometric average return of stock B when their arithmetic average returns are same. A) same as B) higher than C) lower than D) always same as
C) lower than
Which of the following investments offered the highest overall return over the past eighty years? A) Treasury bills B) S&P 500 C) small stocks D) corporate bonds
C) small stocks
Which of the following is NOT a systematic risk? A) the risk that oil prices rise, increasing production costs B) the risk that the economy slows, reducing demand for your firmʹs products C) the risk that your new product will not receive regulatory approval D) the risk that the Federal Reserve raises interest rates
C) the risk that your new product will not receive regulatory approval
The volatility of Home Depot share prices is 30% and that of General Motors shares is 15%. When I hold both stocks in my portfolio and the stocks returns have a correlation of 1, the overall volatility of returns of the portfolio is ________. A) more than 15% B) less than 30% C) unchanged at 30% D) equal to 15%
C) unchanged at 30%
The ________ of a firmʹs debt can be used as the firmʹs current cost of debt. A) current yield B) coupon rate C) yield to maturity D) discount yield
C) yield to maturity
The volatility of Home Depot share prices is 30% and that of General Motors shares is 30%. When I hold both stocks in my portfolio with an equal amount in each, and the stocks returns have a correlation of minus 1, the overall volatility of returns of the portfolio is ________. A) more than 30% B) unchanged at 30% C) zero D) equal to 60%
C) zero
Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firmʹs WACC? A) $6 billion of equity and $19.7 billion of debt B) $2.5 billion of equity and $20 billion of debt C) $3 billion of equity and $19.9 billion of debt D) $2.5 billion of equity and $18.5 billion of debt
D) $2.5 billion of equity and $18.5 billion of debt
Suppose that a stock gave a realized return of 20% over a two-year time period and a 10% return over the third year. The geometric average annual return is ________. A) 8.28% B) 12.43 % C) 14.08% D) 16.57 %
D) (1 + 0.2) × (1 + 0.2) × (1 + 0.1) = 1.584; geometric average = (1.584 )(1/3) = 1.1657 ; hence 16.57 %
The probability mass between two standard deviations around the mean for a normal distribution is ________. A) 66% B) 90% C) 75% D) 95%
D) 95%
Which of the following statements concerning the use of sinking funds to repurchase a bond issue is NOT true? A) A firm should make regular payments into a sinking fund administered by a trustee over the life of the bond. B) A firm can reduce the amount of outstanding debt without affecting the cash flows of the remaining bonds. C) Payments from the sinking fund are used to repurchase bonds. D) Bonds can be issued with a sinking fund provision or a call provision, but not both.
D) Bonds can be issued with a sinking fund provision or a call provision, but not both.
IBM expects to pay a dividend of $5 next year and expects these dividends to grow at 7% a year. The price of IBM is $90 per share. What is IBMʹs cost of equity capital? A) 3.77% B) 5.02% C) 7% D) 12.56 %
D) Cost of equity is the next period dividend divided by the price plus the growth rate in dividends. Costofequity=(Div1/PE)+g=($5/$90)+0.07=0.1256 =12.56%
The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%. A) 4.9% B) 6.5% C) 7.0% D) 7.37%
D) Current yield = coupon / price; 0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65; yield to maturity = pretax cost of debt; using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%
A firm incurs $40,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm? A) $21,000.00 B) $22,400.00 C) $23,800.00 D) $28,000.00
D) Effective after-tax interest expense = Interest expense × (1 - Tax Rate) Effective after-tax interest expense = $40,000 × (1 - 0.3) = $28,000.00 .
In which of the following situations would the yield to worst for a certain bond be that bondʹs yield to call? I. The bondʹs coupon payments are high relative to market yields. II. The bond price is at a discount. III. The likelihood of the bond being called is high. A) I only B) II only C) I and II D) I and III
D) I and III
Outstanding debt of Home Depot trades with a yield to maturity of 8%. The tax rate of Home Depot is 30%. What is the effective cost of debt of Home Depot? A) 5.88% B) 8% C) 6.44% D) 5.60%
D) Multiply the yield to maturity by 1 minus the tax rate. 0.08 × (1 - 0.3) = 0.056 = 5.60%
Which of the following statements is FALSE? A) If two stocks move in opposite directions, the covariance will be negative. B) The correlation between two stocks has the same sign as their covariance, so it has a similar interpretation. C) The covariance of a stock with itself is simply its variance. D) The covariance allows us to gauge the strength of the relationship between stocks.
D) The covariance allows us to gauge the strength of the relationship between stocks.
Which of the following statements is FALSE? A) A stockʹs return is perfectly positively correlated with itself. B) When the covariance equals 0, the stocks have no tendency to move either together or in opposition of one another. C) The closer the correlation is to -1, the more the returns tend to move in opposite directions. D) The variance of a portfolio depends only on the variance of the individual stocks.
D) The variance of a portfolio depends only on the variance of the individual stocks.
The excess return is the difference between the average return on a security and the average return for ________. A) Treasury bonds B) a portfolio of securities with similar risk C) a broad-based market portfolio like the S&P 500 index D) Treasury bills
D) Treasury bills
A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The bond can be called at par in one year after release or any time after that on a coupon payment date. On release, it has a price of $104 per $100 of face value. What is the yield to maturity of this bond when it is released?
D) Using a financial calculator, PV = -104, FV = 100, PMT = 6, N =10 ; computing interest = 5.47%; yield to maturity = 5.47%
You purchase a 30-year, zero-coupon bond for a price of $25. The bond will pay back $100 after 30 years and make no interim payments. The annual compounded return (geometric average return) on this investment is ________. A) 4.49% B) 5.68% C) 4.02% D) 4.73%
D) Using a financial calculator: N = 30, PV = -25, FV = 100; CPT = I/Y; I/Y = 4.73%
As we add more uncorrelated stocks to a portfolio where the stocks are held in equal weights, the benefit of diversification is most dramatic ________. A) after 20 stocks have been added B) when there are more than 500 stocks C) when there are more than 1,000 stocks D) at the outset
D) at the outset
As a firm increases its level of debt relative to its level of equity, the firm is ________. A) increasing the fraction of its equity B) decreasing the fraction of its debt C) decreasing its leverage D) increasing its leverage
D) increasing its leverage
The volatility of Home Depot share prices is 20% and that of General Motors shares is 20%. When I hold both stocks in my portfolio, the overall volatility of the portfolio is ________. A) 20% B) 16% C) 18% D) not possible to calculate as information is inadequate
D) not possible to calculate as information is inadequate
A firm raised all its capital via equity rather than debt. Such a firm is also referred to as a(n) ________ firm. A) levered B) margined C) risk less D) unlevered
D) unlevered
Independent risk is more closely related to ________. A) unsystematic risk B) systematic risk C) common risk D) diversification risk
D) unsystematic risk
The risk premium of a stock is NOT affected by its ________. A) undiversifiable risk B) market risk C) systematic risk D) unsystematic risk
D) unsystematic risk
A stock whose return does not depend on overall economic conditions has a low systematic risk.
False
By definition, a preferred stock is a form of debt security.
False
If two stocks are perfectly negatively correlated, a portfolio with equal weighting in each stock will always have a volatility (standard deviation) of 0.
False
Investors should earn a risk premium for bearing unsystematic risk.
False
One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.
False
Private debt cannot be in the form of bonds.
False
Rational investors may be willing to choose an investment that has additional risk but does not offer additional reward.
False
Stocks have both diversifiable risk and undiversifiable risk, but only diversifiable risk is rewarded with higher expected returns.
False
The fact that the interest paid on debt is a tax-deductible expense increases the cost of debt financing.
False
The sole way that a firm can repay its bonds is by making the coupon and principal payments as specified in the bond contract.
False
There is a clear link between the volatility of returns for individual stocks and the returns for individual stocks.
False
When we form an equally weighted portfolio of stocks and keep increasing the number of stocks in the portfolio, the volatility of the portfolio also increases.
False
A firmʹs cost of debt is the rate of interest it would have to pay to refinance its existing debt.
True
A portfolio comprises two stocks, A and B, with equal amounts of money invested in each. If stock Aʹs stock price increases and that of stock B decreases, the weight of stock A in the portfolio will increase.
True
Convertible bonds have a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock.
True
Correlation is the degree to which the returns of two stocks share common risks.
True
Financial managers must determine their firmʹs overall cost of capital based on all sources of financing.
True
Historical evidence on the returns of large portfolios of stock and bonds shows that investments with higher volatility have rewarded investors with higher returns.
True
If a company issues both a straight bond and a convertible bond simultaneously, at par, then the straight bond will have a higher interest rate.
True
In the United States over the long term, small stocks have provided the highest return followed by the large stocks in the S&P 500.
True
Independent risks can be diversified by holding a large number of uncorrelated assets with independent risks.
True
On average, stocks have delivered higher returns than bonds in the long run.
True
The Capital Asset Pricing Model (CAPM) says that the risk premium on a stock is equal to its beta times the market risk premium.
True
The market or equity risk premium can be estimated by computing the historical average excess return on the market portfolio.
True
The security market line is a graph of the expected return of a stock as a function of its beta with the market.
True
The volatility of an individual stock is more than the volatility of a well-diversified portfolio of stocks.
True
To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.
True
When we combine stocks in a portfolio, the amount of risk that is eliminated depends on the degree to which the stocks face common risks and move together.
True
Assume General Motors has a weighted average cost of capital of 9%. GM is considering investing in a new plant that will save the company $20 million over each of the first two years, and then $10 million each year thereafter. If the investment is $100 million, what is the net present value (NPV) of the project?
Using a financial calculator, PV = -104, FV = 100, PMT = 6, N =1; computing interest = 1.92%; yield to call = 1.92%
