QBank Quiz - Module 4

Kevin owns a $1,000 par value corporate bond with three years remaining until maturity. This bond is currently trading for $1,020.91. The bond has a coupon rate of 4.5% (annual coupon payments) and a current YTM of 3.75%. What is the duration of this bond? A) 3.7500 B) 2.0910 C) 1.0067 D) 2.8741

Determine the duration of the bond. Year Cash Flow(CF) Present Value(PV) of CF PV × Year 1 $45 $43.37 $43.37 2 $45 $41.81 $83.62 3 $1,045 $935.73 $2,807.19 $1,020.91 $2,934.18 Divide the sum in the last column ($2,934.18) by the total PV/market price of the bond ($1,020.91) to derive the duration of 2.8741 years. Using a financial calculator with the following inputs: For year 1, FV = $45, I/YR = 3.75, N = 1, solve for PV. For year 2, change N to 2 without clearing your calculator and solve for PV. For year 3, FV = $1,045, I/YR = 3.75%, N = 3, solve for PV. LO 4.1.2

If a $100 par value preferred stock pays an annual dividend of $5 and comparable yields are 10%, the price of the preferred stock will be A) $25. B) $50. C) $100. D) $75.

Explanation $5 ÷ 0.10 = $50 for preferred stocks, the zero-growth model is used because the preferred stock's dividend is fixed. The formula is V = D0/r, where D0 is the dividend and r is the required return. LO 4.3.1

All else remaining equal, if the dividend payout ratio decreases, the value of a company's common stock would A) increase because the company's dividend growth rate will increase. B) decrease because the company's dividend growth rate will decrease. C) decrease because the company's return on equity (ROE) will decrease. D) increase because the company's risk premium will decrease.

Explanation A decrease in the dividend payout ratio means that the earnings retention ratio (rr in the following formula) will increase. An increase in rr will cause an increase in g. When the higher g is inserted in the dividend discount model formula, the denominator decreases, thereby causing the value of the stock to increase. g = ROE × rr LO 4.2.2

Robin purchased a 20-year bond with a duration of 11 years for $1,323.18. Which of these statements is CORRECT? A) The current yield is higher than both the coupon rate and the yield to maturity. B) The yield to maturity (YTM) is less than both the current yield and the coupon rate. C) The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate. D) The coupon rate is higher than the yield to maturity, and the YTM is higher than the current yield.

Explanation CR = coupon rate CY = current yield YTM = yield to maturity Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate. LO 4.1.1

Which of the following are NOT used in technical analysis? A) Moving averages B) Supply and demand of stocks C) Financial statement ratios D) Graphs

Explanation Financial statement ratios are part of fundamental analysis. LO 4.2.1

Which one of the following statements CORRECTLY matches a technical indicator to the information it provides in signaling a change from a bear to a bull market? A) A moving average chart indicates that actual prices have dropped through the average. B) Barron's Confidence Index indicates that the yield differential between low-quality bonds and high-quality bonds is decreasing. C) Most financial advisers become bullish. D) Odd lot sales exceed purchases.

Explanation In a bull market, there is less fear so there is a lower spread between high-quality and lower-quality bonds. LO 4.2.1

Lou owns a stock that consistently pays a $1.50 dividend. If his required rate of return is 8.5%, what is the intrinsic value of the stock? A) $17.65 B) $16.39 C) $12.75 D) $13.73

Explanation The answer is $17.65. Using the no-growth (perpetuity) dividend discount model: V = D1 ÷ r = 1.50 ÷ 0.085 = $17.65 LO 4.3.1

Which of these statements concerning technical analysis is CORRECT? The focus of technical analysis is market timing with an emphasis on likely price changes. Technicians tend to concentrate on the past price movements to forecast future price movements. The focus of technical analysis is the process by which stock prices rapidly adjust to new information. Technical analysis is based on the underlying fundamentals of a stock's value. A) II and III B) III and IV C) I and II D) I, II, and IV

Explanation The answer is I and II. Statements III and IV are not correct. Technicians tend to concentrate on the short run, looking for short-term price movements. The focus of technical analysis is the gradual process whereby stock prices adjust to new information. Fundamental analysis is based on the underlying fundamentals of a stock's value. Technical analysis involves analyzing past stock prices to forecast future prices. LO 4.2.1

Which of these best describes the concept of convexity? A) Helps explain the changes in stock prices not accounted for by the constant growth dividend discount model B) A measure of the curvature of the relationship between a bond's YTM and its market price (value) C) A precise measure of the change in the price of a bond, given a respective change in GDP D) The average time it takes a bondholder to receive the interest and principal payments from a bond in present value dollars

Explanation The answer is a measure of the curvature of the relationship between a bond's YTM and its market price (value). Specifically, convexity helps explain the change in bond prices not accounted for simply by the bond's duration; in other words, convexity gives us a more precise measure of the change in the price of a bond, given a respective change in market interest rates. LO 4.1.2

All of the following statements correctly illustrate convexity and duration relationships except A) duration has an inverse relationship with the yield to maturity. B) convexity has a direct relationship with the yield to maturity. C) duration has an inverse relationship with the coupon rate. D) convexity has an inverse relationship with the coupon rate.

Explanation The answer is convexity has a direct relationship with the yield to maturity. Convexity has an inverse relationship with yield to maturity. Convexity relationships are the same as those for duration. LO 4.1.2

Which one of these conclusions regarding fundamental analysis will an investor reach if he or she believes in the weak form of the efficient market hypothesis? A) Fundamental analysis cannot be used to identify undervalued securities. B) Fundamental analysis must be combined with technical analysis to identify undervalued securities. C) Fundamental analysis can be used to identify undervalued securities. D) Fundamental analysis, applied in a top-down manner, can be used to identify undervalued securities.

Explanation The answer is fundamental analysis can be used to identify undervalued securities. An investor subscribing to the weak form of the EMH believes that fundamental analysis can be used to identify undervalued securities. LO 4.2.1

The technical analysis approach suggests that future stock prices are forecasted by A) monetary policy. B) financial ratios. C) fiscal policy. D) past stock prices.

Explanation The answer is past stock prices. Past stock price movements are used by technicians to forecast future price movements. LO 4.2.1

All of these statements explain the attributes of technical analysis except A) technical analysts rely heavily on financial ratios in their analysis of stocks. B) technical analysts attempt to predict the future movement of stock prices based on past trends. C) technical analysts rely on charts to predict the future prices of stocks. D) technical analysts use terms such as "trendline," "support," and "resistance" in analyzing stocks.

Explanation The answer is technical analysts rely heavily on financial ratios in their analysis of stocks. Analysts do not rely on financial ratios in their analysis of stocks. Instead, they rely on charts of past price history and volume to predict future price movements. LO 4.2.1

Marvin is considering adding XYZ stock to his holdings. The stock has these characteristics: Beta1.45Standard deviation15.58%Current dividend$1.35Required rate of return8%Risk-free rate of return2% The current dividend is expected to grow for three years at a rate of 2% and then 3% thereafter. Based on the information provided, calculate the intrinsic value of XYZ stock and determine if Marvin should add XYZ to his portfolio if it is currently trading at $24.50. A) With an intrinsic value of $27.13, the stock is undervalued and should be added to the portfolio. B) With an intrinsic value of $21.60, the stock is overvalued and should not be added to the portfolio. C) With an intrinsic value of $29.60, the stock is undervalued and should be added to the portfolio. D) With an intrinsic value of $22.90, the stock is overvalued and should not be added to the portfolio.

Explanation The answer is with an intrinsic value of $27.13, the stock is undervalued and should be added to the portfolio. The intrinsic value of the stock using the multistage growth dividend discount model is $27.13. Because the intrinsic value is greater than the fair market value, the stock is considered undervalued by the market and should be purchased for the portfolio. Compute the value of each future dividend until the growth rate stabilizes (Years 1-3). D1 = $1.35 × 1.02 = $1.38 D2 = $1.38 × 1.02 = $1.41 D3 = $1.41 × 1.02 = $1.44 Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes (Year 4). D4 = $1.44 × 1.03 = $1.48 V = $1.48 ÷ (0.08 - 0.03) = $29.60 Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock. CF0 = $0 CF1 = $1.38 CF2 = $1.41 CF3 = $1.44 + $29.60 = $31.04 I/YR = 8% Solve for NPV = 27.1272, or $27.13 LO 4.3.1

Assume a $1,000 par value bond with three years until maturity is currently trading for $1,027.23. The bond has a coupon rate of 6% (annual coupon payments) and a current YTM of 5%. The bond has a duration of 2.51 years. Calculate what the new market price for the bond would be if the YTM changed from 5% to 4.5%. A) $1,053.01 B) $1,041.66 C) $1,016.75 D) $1,032.36

Explanation The new price of the bond should be $1,041.23. Using a financial calculator, use the following inputs for semiannual payments: FV = $1,000 PMT = $1,000 x 6% = $60/2 = $30 I/YR = 4.5% N = 6 (3 x 2 periods per year) Solve for PV = -1,041.6586, or $1,041.66 LO 4.1.1

Interest rate changes have the greatest effect on A) short-term bonds. B) long-term bonds. C) medium-term bonds. D) staggered maturity bonds.

Explanation The rule-of-thumb approach to measuring the estimated price change of a bond is to multiply the bond's duration by the estimated change in interest rates (for small rate changes—less than 1% or 100 basis points—only). Therefore, longer-term bonds have the greatest duration and the most price volatility. LO 4.1.1

You are considering purchase of a stock that is currently selling for $23 and pays a dividend of $1.15 per share. The dividend is expected to grow at a rate of 15% per year for the next three years. After that, the dividend is expected to grow at a constant rate of 8%. Your required return is 13%. The maximum price you should pay for this stock is A) $26.74. B) $30.22. C) $29.76. D) $33.62.

Explanation The value is calculated on the HP 10bII+ by solving for the NPV of uneven cash flows as follows: 13 I/YR 0 CF0 1.3225 CF1 1.5209 CF2 1.7490 + 37.7784 CF3 29.7559 SHIFT, NPV The 37.7784 is calculated from the constant growth DDM, starting at the end of the third year: [1.7490(1.08)] ÷ (0.13 - 0.08) = 37.7784 LO 4.3.1

Assume that ABC stock pays a dividend in the current year of $1.56 per share. The company's dividend is expected to grow by 1.5% per year. Calculate the stock's price if an investor has a required rate of return of 7%. A) $20.54 B) $28.36 C) $14.29 D) $28.79

The answer is $28.79. The formula for the constant growth dividend discount model: V = D1 ÷ (r - g) Therefore, the intrinsic value of ABC stock equals $28.79 [(1.56 × 1.015) ÷ (0.07 - 0.015)]. LO 4.3.1

Calculate the estimated change in the price of a bond with a present value of $987.56 and Macaulay duration of 4.8 years when its YTM changes from 7% to 6%. A) +4.53% B) -4.53% C) -4.49 D) +4.49%

The answer is +4.49%. Given the inverse relationship between bond prices and market interest rates, the price of the bond must increase by 4.49%, calculated as follows: ΔP/P = -4.8 × [(0.06 - 0.07) ÷ (1 + 0.07)] = 0.0449, or 4.49%. LO 4.1.2

Al, age 37, wants to add to his common stock portfolio. He wants long-term capital appreciation and requires a 14% rate of return on stock investments. He is considering the purchase of one of these two stocks: Stock 1:Dividends are currently $1.20 annually and are expected to increase 10% annually; market price = $38Stock 2:Dividends are currently $1.00 annually and are expected to increase 11% annually; market price = $30 Which stock would be most appropriate for Al to purchase at this time, and why? A) Stock 1, because the stock is undervalued B) Stock 2, because the stock is overvalued C) Stock 1, because the return on investment is greater than Al's required rate of return D) Stock 2, because the return on investment is greater than Al's required rate of return

The answer is Stock 2, because the return on investment is greater than Al's required rate of return. The intrinsic value of Stock 1 = $33 [($1.20 x 1.10) ÷ (0.14 - 0.10)]. Because $33 is less than $38, the stock is overvalued and would return less than his required return. The intrinsic value of Stock 2 = $36.67 [($1.00 x 1.11) ÷ (0.14 - 0.11)]. Because $36.67 is more than $30, the stock is undervalued and would return more than his required return. LO 4.3.2