Unit 20 - Checkpoint Exam
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) 0.75 to 1.00. B) 1.00 to 1.00. C) 1.50 to 1.00. D) 1.25 to 1.00.
A) 0.75 to 1.00. 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 0.75%. Please note that the $2 million cash on hand is included in the total current assets of $10 million.
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) internal rate of return (IRR). C) net present value (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).
In a group of returns, the central value of observations arranged in order from lowest to highest is known as the A) median. B) range. C) mean. D) mode.
A) median. The median in any group of numbers is the number in the middle. That is, the number with equal sets above and below. The mean is the average, the mode is the most common return, and the range is the distance between the extremes.
Over the past five years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The median of the returns is A) 7.4%. B) 9.0%. C) 8.0%. D) 8.2%.
C) 8.0%. The median of a series of returns is that number that has an equal number of occurrences below and above. In this case, that number is 8% because there are two returns less than 8% (-4% and +5%) and two above (+12% and +16%).
A portfolio manager who is successful at market timing will A) have a portfolio beta less than the beta required by the client. B) increase the beta of the portfolio in advance of a rising market. C) increase the beta of the portfolio in advance of a declining market. D) decrease the beta of the portfolio in advance of a rising market.
B) increase the beta of the portfolio in advance of a rising market. A portfolio manager expecting a rising market would want to take advantage of that by increasing the beta of the portfolio. This would have the effect of increasing the potential volatility of returns. When things are going good, you want to be in higher-beta stocks.
Two securities with which of the following correlation coefficients could be combined to create a theoretically risk-free portfolio? A) +1.0 B) 0.0 C) -0.5 D) -1.0
D) -1.0 In theory, risk elimination can be achieved if two securities with a perfect negative correlation are combined. That is, when one goes up, the other goes down by the same amount. In other words, one is the antipode of the other.
All of the following ratios are measures of the liquidity of a corporation except A) acid test ratio. B) current ratio. C) quick ratio. D) debt-to-equity ratio.
D) debt-to-equity ratio. Liquidity ratios measure a firm's ability to meet its current financial obligations and include the current ratio and the acid test (quick) ratio. However, the debt-to-equity ratio is a capitalization ratio and measures the amount of leverage compared with equity in a company's overall capital structure.
Under the net present value (NPV) method of evaluating investments, an investment is attractive if the net present value of the expected returns is A) greater than the risk-adjusted return. B) less than zero. C) equal to zero. D) greater than zero.
D) greater than zero. Under the net present value (NPV) approach, an investment is attractive when the net present value of the expected returns is greater than the amount of the investment outlay. In other words, an investment is attractive (is considered underpriced) if the net present value is greater than zero. On the other hand, if the NPV is negative (less than zero), it would not be an attractive investment (is considered overpriced) and should not be undertaken.
If the coupon rate on a bond increases, the duration of the bond will A) remain unchanged. B) decrease. C) increase. D) change in an unpredictable fashion.
B) decrease. The higher the coupon is, the shorter the duration.
The best time for an investor seeking returns to purchase long-term, fixed interest rate bonds is when A) long-term interest rates are low and beginning to rise. B) long-term interest rates are high and beginning to decline. C) short-term interest rates are low and beginning to rise. D) short-term interest rates are high and beginning to decline.
B) long-term interest rates are high and beginning to decline. The best time to buy long-term bonds is when interest rates have peaked. In addition to providing a high initial return, as interest rates fall, the bonds will rise in value.
Which of the following measures the variability of an asset's returns over time? A) Alpha B) Beta C) Standard deviation D) Time-weighted return
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.
An analyst wishes to assess the value of a fixed-income security by taking the income payments scheduled to be received over a given future period and adjusting that for the time value of money. This analytical tool is known as A) future value. B) duration. C) yield to maturity. D) discounted cash flow.
D) discounted cash flow. The discounted cash flow (DCF) for a fixed-income security (bond) is the sum of the expected interest payments that has been adjusted to reflect the time value of money. With all other things being equal, the bond with the higher DCF is the better investment.
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) −1% and +23%. B) +5% and +17%. C) −7% and +30%. D) −66% and +66%.
A) −1% and +23%. A stock will range within 2 standard deviations of its historical return 95% of the time. 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%.
One popular method of determining the value of certain securities is discounted cash flow (DCF). Using the DCF with the current discount rate at 3%, which of the following would be expected to have the highest market value? A) U.S. Treasury bond maturing in 20 years with a 4% coupon B) XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5% C) Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years D) ABC Corporation debenture maturing in 25 years with a 5% coupon
D) ABC Corporation debenture maturing in 25 years with a 5% coupon The current discount rate represents market interest rates. At 3%, each of these bonds should sell at a premium (their coupon rates are higher than 3%). When a bond is paying interest at a rate higher than the current market rate, the longer the investor will be receiving that higher rate, the higher the premium. Therefore, the 5% bond with 25 years to maturity has the highest present value using the DCF. Although this sounds fancy, in reality, it is just a reflection of the inverse relationship between interest rates and bond prices.
According to most fundamental analysts, examining a company's price-to-earnings ratio gives an indication of A) the historical support and resistance levels. B) the degree to how liberal the company's dividend policies are. C) the parity price of the issuer's convertible bonds. D) how much investors value the stock as a function of the company's market price to its earnings.
D) how much investors value the stock as a function of the company's market price to its earnings. The two components of the price-to-earnings (P/E) 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 value stocks. Measuring support and resistance levels is done by technical analysts with their charts.
A portfolio manager with a growth style would probably diversify by A) devoting a portion of the portfolio to securities with a negative correlation. B) placing a portion of the portfolio into high-yield bonds. C) attempting to build a portfolio with a very high correlation. D) concentrating in stocks in one or two industries.
A) devoting a portion of the portfolio to securities with a negative correlation. Securities with a negative correlation add diversification to a growth portfolio because they move in the opposite direction of the balance of the holdings. Therefore, losses are offset by gains.
Portfolio A has a beta of 1.0 and has returned 8% over the past year. Portfolio B has a beta of 1.5 and, over that same period, has returned 16%. Based on this information, an analyst would conclude that portfolio B has A) positive alpha. B) negative alpha. C) positive correlation. D) zero alpha.
A) positive alpha. Positive alpha is when a portfolio (or security) outperforms another portfolio (or the market) by more than is expected based upon its beta coefficient. Although we could calculate the alpha, it should be clear that when one portfolio with a beta that is 50% higher than the other outperforms it by 100%, there is positive alpha.
While searching for a suitable investment for your client, you narrow the choice to the following four companies: -Company A with returns over the past four years of 12%, 4%, 8%, 6% -Company B with returns over the past four years of 7%, 8%, 9%, 6% -Company C with returns over the past four years of 10%, 12%, -2%, 10% -Company D with returns over the past four years of 15%, 20%, -8%, 3% Which of these choices has the highest volatility? A) Company A B) Company D C) Company C D) Company B
B) Company D Although the exam will not ask you to compute standard deviation, you are required to know that it measures the deviation from the mean (average). In all four of these examples, the mean is 7.5% (30 divided by 4). In which of the choices do the returns occur furthest from that mean? In Company D, they range from 12.5% higher to 15.5% lower. In Company A, the range is from 4.5% higher to 3.5% lower; in Company B, from 1.5% higher to 1.5% lower; and in Company C, from 4.5% higher to 9.5% lower. That should clearly point out that the greatest volatility, or dispersion from the mean, is Company D, while Company B would have the lowest standard deviation.
An investor reviewing the performance of a security reads that its returns for the past nine years are +9%, -4%, +13%, +6%, +2%, -8%, +11%, +2%, +5%. Using this information, which of the following is not a correct statement? A) The median is 5%. B) The mean is 4%. C) The mode is 2%. D) The range is 11%.
D) The range is 11%. The range is the difference between the highest number (+13%) and the lowest number (-8%). That is a range of 21%. The mode is the number that appears most frequently. The only return that appears more than once is 2%. The mean is the arithmetic average. The total of the returns (including the negative returns) is 36%. Dividing by the nine years equals a mean of 4%. The median is the number with as many above as below, and that is 5%.
The discount rate that makes the NPV of all cash flows from a security equal to zero is A) the internal rate of return. B) the median return. C) the cash flow adjusted return. D) the present value return.
A) the internal rate of return. The internal rate of return (IRR) is the interest rate that makes the net present value (NPV) equal to zero. It reflects the yield to maturity of a bond because a bond's current market value should equal the present value of that bond when considering the future interest payments and return of principal at maturity. That is why bond prices fall when interest rates rise and the reverse.
Which of the following correlations would represent two assets that tend to move in tandem with one another? A) +0.16 B) +0.81 C) −0.11 D) −0.68
B) +0.81 Correlation coefficients range from −1.0 to +1.0 and measures the varying relationship of assets (or securities) to one another. A correlation close to +1.0 would indicate that the assets should move in tandem. A correlation close to 0 would indicate that the assets would have little relationship to one another, and a correlation of -1.0 would indicate that the assets should exhibit virtually opposite behavior.
Some analysts use the discounted cash flow (DCF) to determine the theoretical value of a debt security. Under DCF, the bond price can be summarized as the sum of the A) future value of the par value repaid at maturity plus the future value of the coupon payments. B) future value of the par value repaid at maturity plus the present value of the coupon payments. C) present value of the par value repaid at maturity plus the present value of the coupon payments. D) present value of the par value repaid at maturity plus the future value of the coupon payments.
C) present value of the par value repaid at maturity plus the present value of the coupon payments. A bond's price can be calculated using the present value approach. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. The two choices using future value of the par value at maturity make no sense because we already know that is $1,000 (or whatever the par value might happen to be).
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) present value would be lower. C) present value would be higher. D) future 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.
Which ranking lists the following bonds in order from shortest to longest duration? I. ABC 8s of 2050 II. DEF 9s of 2051 III. GHI 5s of 2049 IV. JKL zeros of 2050 A) IV, II, I, III B) III, I, II, IV C) I, II, IV, III D) II, I, III, IV
D) II, I, III, IV A bond's duration consists of two interrelated components: the coupon and the length to maturity. When the coupon rates are approximately the same, the bond with the nearest maturity has the shortest duration and that with the latest maturity has the longest duration. When the maturities are approximately the same, the bond with the highest coupon has the shortest duration and the one with the lowest coupon (and you can't get lower than zero) has the longest duration. Unless maturing very soon, zero-coupon bonds (which will certainly be on the exam) always have the longest duration because they receive no interest payments over the life of the bond. In this example, the maturity dates for the interest-bearing bonds are very close (a two-year spread on bonds maturing in about 30 years), and the zero's maturity is right in the middle of the pack. Therefore, the bond with the 9% coupon has the shortest duration, the 8% follows closely, then a good bit behind is the 5%, and the zero is bringing up the rear.
