Unit 10

internal rate of return (IRR)

-the discount rate that makes the NPV of an investment zero -the yield to maturity of a bond reflects its IRR

price/earnings ratio

The two components of the price/earnings 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's than value stocks.

correlation coefficient

a number that ranges from -1 to +1. Securities that are perfectly correlated have a correlation coefficient of +1. zero means that the two stocks will move independently One of the best ways to increase diversification is to include investments with a negative correlation.

Current ratio

computed by dividing current assets by current liabilities. Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, wages payable, dividends payable, and short-term debt. Equipment is a fixed asset, and shareholders' equity is net worth.

standard deviation

measures how much variation there is in the returns from the average (the arithmetic mean). A low standard deviation indicates that the returns achieved by the security or portfolio tend to be very close to the average score; less volatile. The higher the standard deviation, the more dispersed the returns are for the security or portfolio; more volatile.

You have determined that the net present value (NPV) of your client's investment is positive. If your client's required rate of return is 8%, which of the following is most likely the investment's internal rate of return (IRR)? A) 9% B) 0% C) 4% D) 8%

A) 9% If the NPV is a positive number, the investment's IRR must be greater than the investor's required rate of return. In this question, the required rate of return is 8% so the IRR (actual return) must be higher than that. There is only one choice higher than 8%. Remember, when the NPV is positive, it is a good investment.

Which of the following statements regarding the time value of money is NOT correct? A) Compound interest is interest earned on the initial investment. B) Future value is the future amount to which a sum of money today will increase on the basis of a defined interest rate and period. C) Compound interest is interest earned on interest. D) Future value of an ordinary annuity is the future amount to which a series of deposits of equal size will increase.

A) Compound interest is interest earned on the initial investment. Compound interest is interest earned on interest that has been added to the original principal. For example, $1,000 earning 5% compounded annually earns $50 the first year and then 5% of $1,050 or $52.50 the 2nd year.

When a bond's NPV is zero, it is usually an indication that A) the market is highly efficient. B) the bond is mispriced. C) the bond is a zero-coupon bond. D) the bond is highly rated.

A) the market is highly efficient. An NPV of zero indicates that there is no difference between the bond's present value and its current market price. That usually indicates a highly efficient market.

A stock traded on the Nasdaq Stock Market has a beta of 1.20. One could expect that the stock's volatility compared to the S&P 500 would be A) 20% less volatile B) 20% more volatile C) too variable to tell D) negatively correlated to the S&P

B) 20% more volatile Beta is a measurement of a security's volatility when compared with the overall market, best measure by the S&P 500. The "market" is assigned a beta of 1.00, so when the beta is higher than 1.00, the stock has greater volatility and when lower than 1.00, the volatility is less.

Beta

Beta measures a security's volatility in relation to the overall market. Stocks with a beta greater than 1 are more volatile than the market and stocks with a beta less than 1 are less volatile than the market.

ABD Corporation's income statement reports net sales of $100 million; cost of goods sold, $60 million; administrative costs, $20 million; and interest on debt, $5 million. Based on this information, ABD's gross margin is A) 15% B) 20% C) 40% D) 35%

C) 40% Gross margin, sometimes referred to as gross profit on the exam, is computed by subtracting the cost of goods sold (COGS) from the net sales (or revenues) and dividing the remainder by the net sales. In this case, the computation is $100 million minus $60 million, which equals $40 million, and then dividing that by the $100 million resulting in a gross margin (or margin of profit) of 40%. Administrative costs and interest are not included in COGS.

Selmer Jones has just inherited some money and wants to set some of it aside for a vacation in Hawaii one year from today. His bank will pay him 5% interest on any funds he deposits. In order to determine how much of the money must be set aside now and held for the trip, he should use the 5% as a A) opportunity cost. B) nominal rate of return. C) discount rate. D) required rate of return.

C) discount rate. This is a present value question. Selmer needs to figure out how much the trip will cost in one year, and use the 5% as a discount rate to convert the future cost to a present value. Thus, in this context the rate is best viewed as a discount rate. Although you would never have to compute it, for each $1,000 Selmer needs, he would have to put away $952.38 (the present value of $1,000 at 5% in 1 year).

Acid Test Ratio

Current Assets - inventory / Current Liabilities

Julian and Jane are discussing risk-return measures. Julian states that "beta is used when looking at the performance of a fund or portfolio and refers to the extent of any outperformance against its benchmark." Jane disagrees and says that "outperformance of a fund or portfolio is actually measured by standard deviation." Which of the following statement is correct? A) Only Julian is correct. B) Both Julian and Jane are correct. C) Only Jane is correct. D) Both are incorrect.

D) Both are incorrect. Both Julian and Jane are incorrect. It is alpha, not beta, that is used when looking at the performance of a fund or portfolio. Alpha refers to the extent of any outperformance of a portfolio against its benchmark. Standard deviation is used for measuring volatility, not performance.

debt/equity ratio

It compares the total long-term debt to the total capitalization (long-term debt plus equity capital).

alpha

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)

Plymouth Standard's common stock has an average return of 12%; its returns fall within a range of -2% to +26% approximately 68% of the time. Which one of the following numbers is closest to the standard deviation of returns of Plymouth Standard's stock? A) 8% B) 28% C) 19% D) 14%

D) 14% A standard deviation of 14% means an investor can expect a return on an investment to vary ±14 from the average return approximately 68% of the time. A return of +26% minus the 12% average return equals 14%. Likewise, the difference between the -2% return and the average of 12% is also 14%.

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

C) 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.

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

B) 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.

The Zxion Corporation has just distributed a 7½ to 1 split of its common stock. Prior to the split, Zxion had EPS of $15, the market price of Zxion common stock was $225 per share, and the price of its $75 par preferred stock was $82.50. As a result of the split, the price-to-earnings (P/E) ratio is now A) 7.5 x 1. B) 6 x 1. C) 2 x 1. D) 15 x 1.

D) 15 x 1. A stock split does not change the P/E ratio because both the stock's price and its earnings decline by the same proportion. In this question, after the 7.5 to 1 split, the market price will drop to $30 per share ($225 ÷ 7.5) and the earnings per share are now $2 per share ($15 ÷ 7.5). That 30:2 is still a 15-to-1 P/E ratio. The information about the preferred stock is extraneous.

Assume Frank has a portfolio with an actual return of 10.50% for the past year. The portfolio beta equals 1.25, the return on the market equals 9.75%, and the risk-free rate of return equals 3%. Based on this information, what is the alpha for Frank's portfolio and did it out outperform or underperform the market? A) +3.3750%, outperform B) +9.1875%, outperform C) −1.6875%, underperform D) −0.9375%, underperform

D) −0.9375%, underperform The formula for alpha: alpha = (actual return − risk-free rate) - (beta × [market return − RF])]. If we plug in the numbers, we get (10.5% - 3%) - (1.25 × [9.75% − 3%]) = 7.5% - (1.25 x 6.75) = 7.5% - 8.4375 = -.9375 The alpha for Frank's portfolio equals −0.9375%, indicating that his portfolio underperformed the market based on the level of assumed investment risk.