Finance Exam 2
Yield to maturity=expected rate of return when...
1) the probability of default is zero 2) the bond can't be called
Seven Key Assumptions
1. Stock market returns are approximately normally distributed. This means we can use statistical analysis to create and manage an investment portfolio. The mean equals the average return and the standard deviation is the measure of risk. 2. Markets are efficient: Assets (stocks & bonds are fairly priced). It is impossible (or very difficult) for an investor to beat the market. 3. Assets are priced based on a risk return relationship (like the CAPM). The higher the risk the higher the expected return, the lower the risk the lower the expected return. 4. Risk can be divided into two categories: systematic or market risk; and unsystematic or company specific risk. 5. Diversification: Company specific risk can be reduced or eliminated through adequate diversification. Diversification reduces the standard deviation of the expected return. In other words it minimizes the risk of the expected return. Most of the benefit of diversification can be achieved with a well-rounded portfolio of 20 or so stocks. 6. Beta coefficient: A measure of the systematic risk of a company compared to the market. The Beta of the market is 1.0. If we know the Beta of a company, the expected return of the market, and the risk free rate we can calculate the expected return on a company's stock. 7. Modern Portfolio Theory. Determine the risk level and expected return for an investor. Put together a portfolio of diversified stocks and bonds that will have the same expected return. Make sure the portfolio is diversified to reduce the risk / Beta.
How many stocks are needed for adequate diversification risk? 2 stocks reduces standard deviation by 10 stocks reduces standard deviation by 100 stocks reduces standard deviation by
25% 50% 60%
15. The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False
A
Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT? a. If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A. b. An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2. c. If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B. d. Stock B's required return is double that of Stock A's. e. If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
A
What is a Bond?
A debt security (loan) with standardized features that is sold directly from the corporation / government to the investor.
Debenture
A long-term bond that is not secured by a mortgage on a specific property. Middle amount of risk
beta coefficient
A metric that shows the extent to which a given stock's returns move up and down with the stock market. Beta measures market risk.
preemptive right
A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities).
Annuity
A series of equal payments at fixed intervals for a specified number of periods
perpetuity
A stream of equal payments at fixed intervals expected to continue for forever
Corporate Valuation Model
A valuation model used as an alternative to the discounted dividend model to determine a firm's value, especially one with no history of dividends, or the value of a division of a larger firm. The corporate model first calculates the firm's free cash flows, then finds their present values to determine the firm's value.
Which of the following statements best describes what you should expect if you randomly select stocks and add them to your portfolio? a. Adding more such stocks will increase the portfolio's expected rate of return. b. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk. c. Adding more such stocks will reduce the portfolio's market risk but not its unsystematic risk. d. Adding more such stocks will have no effect on the portfolio's risk.
Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk.
Takeovers
An action whereby a person or group succeeds in ousting a firm's management and taking control of the company.
Ordinary annuity
An annuity whose payments occur at the beginning of each period
Investment grade bonds
Bonds rated triple-B or higher; many banks and other institutional investors are permitted by law to hold only investment-grade bonds
11. For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then a. the required return must equal the realized return in all periods. b. the past realized return must be equal to the expected return during the same period. c. the expected future return must be equal to the required return. d. the expected return must be equal to both the required future return and the past realized return.
C
If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock's expected total return for the coming year? a. 2.84% b. 5.50% c. 8.34% d. 8.19%
C
If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks a. dividends are not likely to be declared. b. the stock should be sold. c. the stock is a good buy. d. management is probably not tryin
C
12. Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks fall into one of three classes: A, B, and C. b. All common stocks, regardless of class, must have the same voting rights. c. All firms have several classes of common stock. d. Some class or classes of common stock are entitled to more votes per share than other classes.
D
Which of the following statements is NOT CORRECT? a. An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. b. The corporate valuation model can be used to find the value of a division. c. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or continuing, value. d. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. e. The corporate valuation model discounts free cash flows by the required return on equity.
E
If the discount (interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series?
False
Most bonds are owned by and traded among large financial institutions, and it is relatively easy for bond dealers to arrange the transfer of large blocks of bonds among the millions of large and small bondholders on the exchanges rather than the over-the counter market. True or false?
False
junk bonds
High-risk, high-interest bonds
Broker
Non owner - brings buyer and seller together - earns a commission
Dealer
Owns the security - buys or sells for own acct - no commission, but gain or loss
clean price
Par value
7. Consider the following information for three stocks, A, B, and C. The stocks' returns are positively but not perfectly positively correlated with one another, i.e., the correlations are all between 0 and 1. Expected Standard Stock Return Deviation Beta A 10% 20% 1.0 B 10% 10% 1.0 C 12% 12% 1.4 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is CORRECT? a. Portfolio AB has a standard deviation of 20%. b. Portfolio AB's coefficient of variation is greater than 2.0. c. Portfolio AB's required return is greater than the required return on Stock A. d. Portfolio ABC's expected return is 10.67%.
Portfolio ABC's expected return is 10.67%.
Preferred Stock attributes
Stated Value (par value) (usually $25 or $100). Right to Dividends. Dividend amount is fixed and does not change. Treated as equity from a legal and tax standpoint. Cumulative dividends. Preferred stock values change as interest rates change - Just like bonds.
Compounding
The arithmetic process of determining the final value of a cash flow or series of cashflow when compounding interest is applied
Yield to maturity
The rate of return earned on a bond if it is held to maturity
par Value
The stated face value of the bond generally represents the amount of $ the firm borrows and promises to repay on the maturity date
Present Value
The value today of a future cash flow or series of cash flows.
Suppose someone made this statement: "Sales doubled in 5 years. This represents a growth of 100% in 5 years, so, dividing 100% by 5, we find the growth rate to be 20% per year." Is the statement correct?
This is incorrect because it doesn't take into account the effect of compounding
10. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False
True
A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%. a. True b. False
True
A lender should prefer to lend at a rate of 10% with semiannual compounding, but a borrower would prefer a loan with a rate of 10%, annual compounding. True or false?
True
Assume that two investors each hold a portfolio, and that portfolio is their only asset. Investor A's portfolio has a beta of minus 2.0, while Investor B's portfolio has a beta of plus 2.0. Assuming that the unsystematic risks of the stocks in the two portfolios are the same, then the two investors face the same amount of risk. However, the holders of either portfolio could lower their risks, and by exactly the same amount, by adding some "normal" stocks with beta = 1.0. a. True b. False
True
Betas can be found by plotting stocks' returns on the vertical axis and the returns on an index like the S&P 500 on the horizontal axis, and then calculating the slope of the resulting regression line. This slope is the stock's beta coefficient. The steeper the slope, the larger the beta and the riskier the stock. True or false? a. True b. False
True
If a firm goes bankrupt and must be liquidated, and if less money is available than the balance sheet values of bonds, preferred stock, and common equity, then some security holders will receive less than the book values of their investments. The priority system under our bankruptcy laws allocates funds first to preferred stock because of its preference, then to bonds, and then to common stockholders (only if there are funds left over after paying preferred stockholders and bondholders). True or false? a. True b. False
True
If all investors were completely indifferent to risk, i.e., if they had no aversion to risk at all, then the SML would plot as a horizontal line. True or false? a. True b. False
True
Is this statement true or false? A rational person should choose to receive cash flows from an annuity due of $1,000 per year rather than from a similar ordinary annuity.
True
Is this statement true or false? If one set up time lines for an ordinary annuity of $1,000 per year for 3 years and a 3-year, $1,000 annuity due, the primary difference between the two time lines is that the $1,000 payments for the annuity due would begin at t = 0 and end at t = 2, whereas the ordinary annuity's payments would begin at t = 1 and end at t = 3.
True
Is this statement true or false? If you calculated the value of an ordinary annuity, you could find the value of the corresponding annuity due by multiplying the FV of the ordinary annuity by (1 + I), because this would take into account that each annuity due payment occurs one year earlier.
True
Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower risk. However, it is possible for Portfolio A to be less risky. a. TRUE b. FALSE
True
Preferred stock is a "hybrid" security. Preferreds typically pay a fixed dividend, so they are a fixed-income security like a bond. However, the directors can omit the preferred dividend without throwing the company into bankruptcy. True or false? a. True b. False
True
The preemptive right is the right of current stockholders to buy new shares in an amount that will maintain their proportionate ownership in the firm. True or false? a. True b. False
True
The slope of the security market line is equal to the market risk premium. T/F
True
The value of a share of stock can be estimated by using the PV of future dividends. An alternative valuation procedure, called the "corporate valuation model," calls for finding the expected future free cash flows, discounting those cash flows at the weighted average cost of capital, summing the PVs of the free cash flows, subtracting the market values of debt and preferred to calculate the value of the common equity, and then dividing by the number of shares outstanding to find the value of a share of common stock. In theory, the two methods should produce the same stock price. Is this statement true or false?
True
Which kind of bonds has the highest duration given the same maturity dates?
Zero coupon bond
mortgage
a bond backed by fixed assets. #1 least risk
municipal bonds
a bond issued by state and local governments. some default risk. earnings are exempt from federal and state taxes if you are a state resident.
indexed, or purchasing power, bond
a bond that has interest payments based on an inflation index so as to protect the holder from inflation
income bond
a bond that only pays interest if enough $ is earned. it can't bankrupt a company.
proxy
a document giving one person the authority to act for another, typically the power to vote shares of common stock
Capital Asset Pricing Model (CAPM)
a model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification
Call provision
a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date
sinking fund provision
a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year
Maturity Date
a specified date on which the par value of bond must be repaid
A 15-year bond with a face value of $1,000 currently sells for $850. Which of the following statements is CORRECT? a. The bond's yield to maturity is greater than its coupon rate. b. If the yield to maturity stays constant until the bond matures, the bond's price will remain at $850. c. The bond's coupon rate exceeds its current yield. d. The bond's current yield is equal to its coupon rate.
a. The bond's yield to maturity is greater than its coupon rate.
Which one of the following is an example of a perpetuity? a. Trust income of $1,200 a year forever b. Retirement pay of $2,200 a month for 20 years c. Lottery winnings of $1,000 a month for life d. Car payment of $260 a month for 60 months e. Apartment rent payment of $800 a month for one year
a. Trust income of $1,200 a year forever
Putable bond
allow investors to require the company to pay in advance
proxy fight
an attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote its shares to replace the current management
Original issue discount bond
any bond originally offered at a price below its par value
Inflation, recession, and high interest rates are economic events that are best characterized as being a. systematic risk factors that can be diversified away. b. among the factors that are responsible for market risk. c. company-specific risk factors that can be diversified away. d. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
b. among the factors that are responsible for market risk.
Subordinated Debentures
bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation. #3 risk, worst risk
Treasury bonds
bonds issued by the federal government, sometimes referred to as government bonds
Convertible bonds
bonds that exchangeable at the option of the holder for the issuing of a firm's stock
Zero Coupon Bonds
bonds that pay no annual interest but are sold at discount below par, thus compensating investors in the form of capital appreciation
Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond? 1. Fixed assets are used as security for a bond. 2. A given bond is subordinated to other classes of debt. 3. The bond can be converted into the firm's common stock. 4. The bond has a sinking fund. 5. The bond has a call provision. 6. The indenture contains covenants that restrict the use of additional debt. a. 2, 3, 4, 6 b. 1, 4, 6 c. 1, 3, 4, 6 d. 1, 3, 4, 5, 6
c. 1, 3, 4, 6
Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by: a. Real risk-free rate differences. b. Maturity risk differences. c. Default and liquidity risk differences. d. Inflation differences.
c. Default and liquidity risk differences.
Which of the following statements is CORRECT? a. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. b. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. c. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. d. The cash flows for an annuity due must all occur at the ends of the periods.
c. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month.
Bill just financed a used car through his credit union. His loan requires payments of $275 a month for five years. Assuming that all payments are paid on time, his last payment will pay off the loan in full. What type of loan does Bill have? a. Interest-only b. Complex c. Amortized d. Lump sum
c. amoritized
You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment? a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000. b. The discount rate increases. c. The discount rate decreases. d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.
c. the discount rate increases
Dirty price
clean price + accrued interest
Which of the following events would make it more likely that a company would call its outstanding callable bonds? a. The company's financial situation deteriorates significantly. b. Market interest rates rise sharply. c. The company's bonds are downgraded. d. Market interest rates decline sharply.
d. Market interest rates decline sharply.
During the coming year, the market risk premium (rM − rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. The required return for all stocks will fall by the same amount. b. The required return on all stocks will remain unchanged. c. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0. d. The required return will fall for positive beta stocks, and it will fall more for higher beta stocks.
d. The required return will fall for positive beta stocks, and it will fall more for higher beta stocks.
Present value and future value relationship
direct
Time and future value relationship
direct
interest rate and future value relationship
direct
Time and interest rate relationship
inverse
present value and interest rate relationship
inverse
present value and time relationship
inverse
foreign bonds
issued by a foreign government or a foreign corporation. All are exposed to default risk and some risk of foreign currency exchange rates changing.
corporate bonds
issued by business firms. exposed to default risk or credit risk.
warrants
long-term options to buy a stated number of shares of common stock at a specified price
If I have a higher duration, am I more or less sensitive to changes in interest rates/ do I have more or less price risk?
more price risk
yield to call (YTC)
rate of return earned on a bond when it is called before it's maturity date
Future Value
the amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate
Discounting
the process of finding the PV of a cash flow or a series of cash flows; the opposite of compounding
`Price risk/ interest rate risk
the risk of a decline in a bond's price due to an increase in the market interest rate.
reinvestment risk
the risk that a decline in interest rates will lead to a decline in income from a bond portfolio
Coupon payment
the specified # of dollars of interest paid each year (par value * coupon rate)
Coupon interest rate
the stated annual interest rate on a bond
Duration
the weighted average time it takes to recieve each bond's cash flow in a portfolio.
In general, the higher the duration, the more a bond's price will drop as interest rates rise (and the greater the interest rate risk).
true
Under an amortized loan, the periodic payments are all equal. However, the fraction of the payment that represents interest declines over time. True or false?
true