Unit 10 - Analytical Methods
XYZ Corporation has a beta of 1 and ABC has a beta of 1.4. XYZ has returned 12% and ABC 14.8%. Based on this information, ABC had an alpha of A) -2% B) 2% C) 14.8% D) 2.8%
Answer: A) -2% Alpha is the extent to which a security's performance exceeds (or falls short of) what would be expected based on its beta. A stock with a beta of 1.4 would be expected to perform 40% better in an up market than one with a beta of 1.0. Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 14.8%, ABC underperformed the expected by 2% and that is why it has a negative alpha.
Which of the following items would be included in a current ratio computation? A) Accounts payable, wages payable, and short-term debt B) Inventory, equipment, and cash C) Cash, dividends payable, and shareholders' equity D) Accounts receivable, inventory, and long-term debt
Answer: A) Accounts payable, wages payable, and short-term debt Current ratio is 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.
Using the following information, compute the inflation-adjusted rate of return for an invest holding the ABC Corporation's 20-year bond: Coupon rate: 5%, paid semi-annually Rating: Aa Maturity Date: December 1, 2046 CPI: 2% Par value: $1,000 Purchase price: 90 Call Date: December 1, 2033 Call price: 101 A) 2.50% B) 3.56% C) 4.50% D) 5.00%
Answer: B) 3.56% Annual Return/Initial Investment = Holding Return $50/$900 = 5.56% Holding Return - CPI = Inflation-Adjusted Return (Real Return) 5.56% - 2.00% = 3.56%
Which of the following statements related to computing the internal rate of return (IRR) are CORRECT? I. It is the discount rate that makes the future value of an investment equal to its present value. II. In order to compute, it is necessary to know the initial cost of the investment. III. In order to compute, it is necessary to know the cash flow of the investment. IV. It is equivalent to a bond's yield to maturity. A) I, II, III and IV B) I, II and III C) I and IV D)II and III.
Answer: A) I, II, III and IV
Which of the following quantitative tools is used to measure risk-adjusted returns? A) Sharpe ratio B) Beta C) Correlation D) Standard deviation
Answer: A) Sharpe ratio The Sharpe ratio measures risk-adjusted return. Test topic alert: you must know the 3 components of the Sharpe ratio: - the actual return minus, - the risk-free rate (the 91-day T-Bill rate) divided by, - the standard deviation
An investor is looking at the past performance of a security over the past five years. The chart looks like this: 2013 10% 2014 15% 2015 3% 2016 11% 2017 6% The average return over this period is 9%. This would be properly referred to as the: A) arithmetic mean. B) internal rate of return. C) median return. D) geometric mean.
Answer: A) arithmetic mean. When a true average return is shown, that is the arithmetic mean. The median return (the number in the middle of the group of 5) is 10%.
Using the net present value method, a potential investment should be undertaken if the present value of all cash inflows minus the present value of all cash outflows (which equals the net present value) is: A) greater than zero B) positively correlated C) equal to zero D) less than zero.
Answer: A) greater than zero NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a proposed investment is positive, it should be accepted. However, if NPV is negative, the investment should probably be rejected because cash flows will also be negative.
An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 6.32%, then the NPV is A) positive B) negative C) between 6% and 6.32% D) zero
Answer: A) positive Any time an investment's IRR is more than the required rate of return, the NPV is positive (and should probably be selected). NPV is expressed as a dollar amount. It is the IRR which is expressed as a percentage.
A company's current ratio is 0.5:1. This could be an indication A) the company may have trouble paying its bills. B) the company's working capital is sufficient to meet daily needs. C) the company's current assets are twice its current liabilities. D) the company is highly leveraged
Answer: A) the company may have trouble paying its bills. The formula for current ratio = current assets/current liabilities A current ratio of 0.5:1 means that the company has current liabilities that are twice its current assets. This would also mean a negative working capital (current assets minus current liabilities) and would probably mean that the company is going to have a difficult time paying its bills.
All of the following factors would be considered if an investor was trying to minimize the market risk of investing in a particular stock EXCEPT: A) the earning power of the company. B) the price behavior of the stock. C) the timing of the purchase of the stock. D) the period of time the investment can be held.
Answer: A) the earning power of the company. The earning power of the company is not a measurement of the stock market (market risk), while the other factors here are. That is a fundamental strength and protects against business or financial risk. Because market risk is a systematic risk, some of the ways to protect yourself are by being able to hold the security for a long period of time (long time horizon) or by timing your purchase when the market is at or near a bottom. Obviously, stocks whose trading pattern indicates wide fluctuations in market price are going to have greater market risk so staying away from them will reduce the overall market risk of the portfolio.
An investor buys 100 shares of KAPCO stock for $120 per share. During the year, he receives $250 in dividends and, at the end of the year, the stock is worth $13,000. The investor's holding period return is A) 9.69% B) 10.50% C) 2.17% D) 8.33%
Answer: B) 10.50% Initial investment = $12,000 Dividends = $260 Capital Gain = $1,000 $1,000 + $260 = $1,260 $1,260/$12,000 = 10.50%
The MNO Manufacturing Company, headquartered in Springfield, has just filed for bankruptcy. Under federal bankruptcy law, which of the following would have highest priority with the bankruptcy trustee? A) Holder of first lien, senior preferred stock B) Holders of mortgage bonds C) Property taxes owed to the city of Springfield D) Employee wages earned within the 180 days prior to the bankruptcy filing
Answer: B) Holders of mortgage bonds Secured claims, such as mortgage bonds, always come first. Under federal bankruptcy law, there are several categories of unsecured claims that have a higher priority than other unsecured ones. Two of the most common are employee wages, as long as the wages were earned during the 180 days prior to the bankruptcy filing, and certain taxes. No matter how many adjectives are placed ahead of preferred stock, it always comes after everyone who is owed money.
An IAR is attempting to develop an investment plan for a client. The IAR decides to use 2 different mutual funds in an effort to provide appropriate diversification. Of the four pairs given below, which one would offer the most diversification? A) Portfolio 1 and 2 with a correlation coefficient of +0.90 B) Portfolio 7 and 8 with a correlation coefficient of -.20 C) Portfolio 3 and 4 with a correlation coefficient of +0.20 D) Portfolio 5 and 6 with a correlation coefficient of -0.05
Answer: B) Portfolio 7 and 8 with a correlation coefficient of -.20 If 2 portfolios have a high correlation coefficient, it means that their performance will be very similar. The purpose of diversification is to have some negative correlation so that losses in one portfolio are offset by gains in the other.
Which of the following would best describe working capital? A) A corporation's net worth. B) The amount of money a corporation has available to work with if it liquidates its current assets and pays off all of its current liabilities. C) The value per share available to shareholders in the event of bankruptcy. D) The amount of money available to the corporation that is currently being held in cash or cash equivalent positions.
Answer: B) The amount of money a corporation has available to work with if it liquidates its current assets and pays off all of its current liabilities. Working capital equals current assets minus current liabilities.
A measurement of investment return that takes the time value of money into consideration is A) real rate of return B) internal rate of return (IRR) C) risk-adjusted rate of return D) holding period return
Answer: B) internal rate of return (IRR) The internal rate of return compounds returns and takes into consideration the time value of money. Real rate of return considers the inflation rate and risk-adjusted return is another way of stating the Sharpe Ratio.
Mr. and Mrs. Rose, advisory clients of yours, request a meeting with you to discuss the options available if they wish to deposit a lump sum to save for college tuition for their child. All of these would be factors to consider EXCEPT A) current college costs B) the Rose's salaries C) the age of the child D) the expected inflation rate
Answer: B) the Rose's salaries When making a lump sum investment, salary is not a factor. The funds will have to come out of savings or investments. This basically a present value computation. In order to project how much will be needed, we need to know what the current tuition is, the rate at which it is expected to inflate, and the number of years we have until the child starts college. That will give us the 3 components of present value: total amount needed, earnings rate, and length of investment.
In portfolio theory, the alpha of a security or a portfolio is: A) the portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio. B) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved. C) a measure of the variance in returns of a portfolio divided by its average return. D) the risk of the portfolio associated with the macroeconomic factors that affect all risky assets.
Answer: B) the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved. Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is systematic risk. The portfolio's average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio is the Sharpe ratio or measure. The measure of the variance in returns of a portfolio around its average return is the standard deviation.
While searching for a suitable investment for your client, you narrow the choice to the following 4 companies: Company A with returns over the past 4 years of: 12%, 4%, 8%, 6% Company B with returns over the past 4 years of: 7%, 8%, 9%, 6% Company C with returns over the past 4 years of: 10%, 12%, -2%, 10% Company D with returns over the past 4 years of: 15%, 20%, -8%, 3% Which of these choices has the highest volatility? A) Company A B) Company C C) Company D D) Company B
Answer: C) Company D All averages = 7.5% Company A = 4.5% above, 3.5% below the average Company B = 1.5% above, 1.5% below the average Company C = 4.5% above, 9.5% below the average Company D = 12.5% above, 15.5% below the average
A client owns an investment-grade bond with a coupon of 5% that is priced to yield 6.7%. If similarly rated bonds are being issued today with coupons of 7%, it would be expected that the client's bond A) will be selling at a premium over par B) has a positive net present value C) has a negative net present value D) has a zero net present value
Answer: C) has a negative net present value
When an IA tells a client who is investigating the common stock of two different issuers that there is no linear relationship between the two stock's returns, it means: A) one is likely to pay dividends, the other not. B) one is listed on an exchange, the other traded O-T-C. C) the correlation coefficient is zero. D) one of the stock's standard deviation is significantly higher than the other.
Answer: C) the correlation coefficient is zero A correlation coefficient of zero means that knowing the actual return of one security tells you nothing about the return of the other. They may move in the same or opposite directions.
An analyst is viewing a subject company's financial statements. She notices that the company has current assets of $20 million, fixed assets of $50 million, and total liabilities of $45 million (of which $10 million is considered long-term). This company's debt to equity ratio is A) 40% B) 22.2% C) 64.3% D) 28.6%
Answer: D) 28.6% The debt to equity ratio is computed by dividing the issuer's long-term debt by their total capitalization. Total capitalization is the company's net worth (assets minus liabilities) plus the long-term debt. In this example, the net worth is $70 million minus $45 million, or $25 million. Adding the long-term debt of $10 million results in total capital of $35 million. Divide the $10 million by that $35 million to arrive at 28.57%.
Your client has $10,000 to invest today and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. Which of the following is needed to determine whether the investment is likely to satisfy the client's goal? A) Client's marginal federal income tax bracket B) Present value C) Consumer Price Index D) Expected cost of college
Answer: D) Expected cost of college To determine whether the investment will satisfy the goal, the investment adviser representative needs to know the amount needed to pay for college. The information we have will allow us to compute the future value: $25,181.70. This may not be enough to pay for even 1 year of college 12 years from now.
Which of the following statements is NOT correct? A) Net present value analysis (NPV) is a commonly used time value of money technique employed by businesses and investors to evaluate the cash flows associated with capital projects and capital expenditures. B) Time-weighted returns show performance without the influences of additional investor deposits or withdrawals from the account. C) Internal rate of return (IRR) is a method of determining the exact discount rate to equalize cash inflows and outflows, thus allowing comparison of rates of return on alternative investments of unequal size and investment amounts. D) Net present value (NPV) is the difference between the initial cash outflow (investment) and the future value of discounted cash flows.
Answer: D) Net present value (NPV) is the difference between the initial cash outflow (investment) and the future value of discounted cash flows. Net present value (NPV) is the difference between the initial cash outflow (investment) and the present value of discounted cash flows (NPV = PV of CF − cost of investment). That is why it is called Net Present Value instead of Net Future Value.
Which of the following investments generally carries the least reinvestment risk? A) Municipal bond unit investment trust making monthly distributions. B) Staggered-maturity certificate of deposit (CD) strategy. C) Rental real-estate limited partnership. D) Newly issued stock in a small, over-the-counter growth corporation.
Answer: D) Newly issued stock in a small, over-the-counter growth corporation. In order to have reinvestment risk, there must be something to reinvest. Newly issued stock in a small, over-the-counter growth company is unlikely to pay dividends that need to be reinvested and, therefore, is not subject to reinvestment risk. Rental real estate partnerships pass rental income along to limited partners (investors) who must reinvest such distributions at current rates. These distributions are subject to reinvestment risk at current interest rates. The monthly distributions from the municipal unit trust must be reinvested at current interest rates which may be lower than the interest rate provided by the trust. The proceeds from the staggered maturities of the certificates of deposit must be reinvested at current rates. If current rates are lower than those of the matured CDs, reinvestment risk lowers the investor's return.
