Unit 13 - Portfolio or Account Analysis and its Application to Security Selection

An aggressive investor buys ABC stock with a beta of 1.7. The S&P 500 has a 10% rate of return for the year, and ABC's return is 12%. What is the alpha for ABC? A) -5% B) -3% C) +5% D) +3%

The best answer is A. -5% With a beta of 1.7, an investor would expect ABC stock to be 70% more volatile than the general market as measured by the S&P 500. Remember, the beta of the market is 1.0. Therefore, we would expect to see the stock return 17% based on the S&P 500's 10% return. However, the actual return on ABC was only 12%. Alpha measures the difference in the actual return vs. the expected return. The difference between the expected return (sometimes referred to as the required return) of 17% and the actual return of 12% is a negative 5%. That represents an alpha of -5% for ABC stock.

ABC, with 3 million shares outstanding, reports after-tax earnings of $7.5 million. Annual cash dividends total $1 per share. The dividend payout ratio is A) 40%. B) 33%. C) 20%. D) 25%.

The best answer is A. 40% Div Payout Ratio = Annual div per share / EPS To compute this ratio, multiply the $1 dividend by 3 million shares to get the total dividend paid of $3 million. $3 million is 40% of the $7.5 million in earnings available to common stockholders. LO 13.d

The common stock of Momentum Growth Industries (MGI) is currently selling at 55 times earnings. Which of the following actions could MGI take that would likely increase the company's earnings per share? I Reduce the salaries of C-level officers by 10%. II Exercise the call feature on MGI's outstanding preferred stock. III Announce a 1:4 stock split. IV Purchase shares of MGI common stock in the open market. A) I, II, III, and IV B) II and III C) I, III, and IV D) I and IV

The best answer is A. I, II, III, and IV As is often the case, the question contains irrelevant information. Knowing the price-to-earnings ratio (P/E ratio) has nothing to do with the question. There are two primary ways to increase EPS. The most obvious is to increase the company's earnings. That is accomplished either by increasing revenue or reducing costs. Reducing officer salaries reduces the expenses. Calling in preferred stock removes the obligation for the dividend on that stock. Therefore, income available to common shareholders increases. The second is to reduce the number of outstanding shares. The math behind the EPS formula is net income divided by the total number of common shares outstanding. If the denominator (the number of shares) is reduced, the EPS increases. Sometimes a company wishing to buy back its shares will do so through a tender offer. It does that by inviting shareholders to tender (present) their shares to the company at a specified price (usually at a premium over the current market price). A reverse split, such as 1 for 4, reduces the number of outstanding shares to one quarter of what they were before the split. One of the simplest ways to reduce the number of outstanding shares is to simply buy them back in the open market. They now become treasury stock and are not included in the EPS calculation. LO 13.d

If ALFA Securities, a broker-dealer, is a position-trading firm, which of the following statements is true? A) It is trading for its own account. B) It is violating NYSE rules. C) It is underwriting securities in the primary market. D) It is acting as a broker for customers.

The best answer is A. It is trading for its own account Position trading is simply trading as principal, or dealer, for a firm's own account. This is the typical case with a market maker. The opposite role is that of a broker, or an agent, purchasing or selling securities in the secondary market for customers. LO 13.g

A registered representative was researching ABC, a technology stock. When looking at a graph of historical prices, the rep noticed that the variance in price movement has shrunk. This is an example of A) consolidation. B) narrowing. C) shrinking. D) odd-lot trading.

The best answer is A. consolidation When the difference between a stock's resistance and support level narrows, that is a condition called consolidation. LO 13.e

FINRA's 5% markup policy does not apply to A) issues sold by prospectus. B) commissions. C) REITs. D) third-market trades.

The best answer is A. issues sold by prospectus FINRA's 5% markup policy applies to all secondary market trades, whether customers are charged markups, markdowns, or commissions. Issues sold by prospectus and municipal securities, however, are exempt from the policy. LO 13.g

All of the following may be cited to justify a markup on a stock sold from a broker-dealer's inventory except A) the dealer's cost. B) the security's price. C) the availability. D) the overall value of the transaction.

The best answer is A. the dealer's cost The dealer's cost is not a legitimate factor in determining the markup on a stock. LO 13.g

A company's changing from straight line to accelerated depreciation will I increase income in the early years. II decrease income in the early years. III increase income in the later years. IV decrease income in the later years. A) I and IV B) II and III C) I and III D) II and IV

The best answer is B. II and III Accelerated depreciation increases charged expenses during the early years of equipment life but decreases charged expenses during the later years. LO 13.c

A head and shoulders bottom formation is an indication of A) a bearish market. B) the reversal of a downtrend. C) a bullish market. D) the reversal of an upward trend.

The best answer is B. the reversal of an downward trend A head and shoulders bottom formation is also known as an inverted head and shoulders formation. It is that part of a graph in which a downtrend has reversed to become an uptrend. It is not, however, an indicator of the bullishness or bearishness of the market as a whole. It is an indication only of the direction of a trend, which may be either short or long in duration.

Which of the following is not a characteristic of a money market fund? A) Portfolio of short-term debt instruments B) Stable net asset value (NAV) C) High beta D) Offered without a sales load

The best answer is C. High Beta Money market mutual funds invest in a portfolio of short-term debt instruments such as T-bills, commercial paper, and bankers acceptances. They are offered without a sales load or charge. The principal objective of the fund is to maintain a stable NAV ($1 per share). Beta is a measure of volatility; money market funds have low betas. LO 13.b

Which of the following balance sheet entries may be affected when a company pays a cash dividend? I Shareholders' equity II Total assets III Total liabilities IV Working capital A) I and III B) II and IV C) II and III D) I and IV

The best answer is C. II and III When a company pays a cash dividend, the dividends payable (a current liability) and the cash account (current assets) are reduced by the same amount. Because liabilities and assets are each reduced by the same amount, working capital is not affected. Shareholders' equity—or net worth—is also not affected when the dividend is paid. LO 13.c

The analytical tool used to measure the variability between a particular stock's (or portfolio's) movement and that of the market in general is A) standard deviation. B) alpha. C) beta. D) the correlation coefficient.

The best answer is C. beta Beta measures the systematic risk of a stock by comparing the variability between a particular stock's (or portfolio's) movement and that of the market in general. It only measures systematic risk not total risk. The beta coefficient of the market is set at 1.0. If the beta of the stock (or portfolio) is higher than 1.0, it is more volatile than the market. If it is less than 1.0, it is less volatile than the market. Alpha is the tool used to measure how a stock (or an asset manager) performed compared with the investment's expected rate of return based on its beta. Standard deviation measures the total risk of an investment (systematic risk + unsystematic risk). The correlation coefficient measures how two investments move in correlation with each other. A high correlation means they move in step with each other. A negative correlation means they move in opposite directions.

A highly leveraged company has the smallest percentage of its total capitalization in A) long-term debt. B) preferred stock. C) short-term debt. D) common stock.

The best answer is D. Common stock Common stock, which represents ownership, would account for the smallest amount of capitalization of a highly leveraged company. Highly leveraged companies have the largest amount of their capitalization in debt instruments. Preferred stock, although an equity, is more like a debt instrument because of the stated dividend rate. LO 13.d

Which of the following balance sheet items is not a current liability? A) Long-term debt amount that is due within one year B) Accounts payable C) Accrued taxes D) Mortgages

The best answer is D. Mortgages Short-term or current liabilities are those entries on a balance sheet that are due in one year or less. Accounts payable, accrued taxes, and that portion of long-term debt due within the year are all current liabilities. Mortgages are generally long-term liabilities, although that portion of a mortgage that is due within the year would be classified on the balance sheet as a current liability. LO 13.c

When determining whether a tax swap of municipal bonds will result in a wash sale, which of the following is not considered? A) Issuer B) Coupon C) Maturity D) Principal amount

The best answer is D. Principal amount In judging whether bonds purchased are substantially identical to bonds sold for a loss, the tax code considers maturity, issuer, and coupon rate. If at least two of the three are different, a wash sale will generally not result. LO 13.h

A corporation's income statement reports net income of $10 million for the year. The company has one million shares of 4% $50 par value preferred stock and two million shares of common stock. If the corporation paid a quarterly dividend of $0.60 per share of common stock, A) the earnings per share was $5 per share. B) the current return on the preferred stock was 4%. C) the retained earnings increased by $6.8 million. D) the dividend payout ratio was 60%.

The best answer is D. the dividend payout ratio was 60%. The dividend payout ratio is the percentage of the net income (after preferred stock dividends) paid out to the common shareholders. The net income is $10 million. The preferred dividend is $2 per share ($50 par times 4% = $2). With one million shares, the total preferred dividend is $2 million (1 million shares at $2 per share). Because the preferred dividend must be paid before any earnings are available to common stockholders, we subtract that $2 million from the net income. That leaves $8 million in earnings available to common. There are 2 million shares receiving an annual dividend of $2.40 ($0.60 quarterly). That means $4.8 million of the $8 million available is paid, or a ratio of 60% ($4.8 million ÷ $8 million = 60%). Or, the earnings per share is $4.00 ($8 million divided by 2 million shares) and $2.40 in dividends paid out of $4.00 earnings made is 60%. The preferred stock is paying a dividend of 4% of the par value, but that does not tell us the current yield. To know the current yield, we must know the current market price of the stock and the question does not supply that value.

When considering the amount of commission or markup to charge, a member firm should consider all the following except A) the services offered by the member firm. B) the price of the security. C) the liquidity of the security. D) the price the member firm paid.

The best answer is D. the price the member firm paid Member firms should never consider the price they paid as the basis for a markup. Instead, the inside market should be used when making a markup determination. Services offered by the firm, liquidity of the security, and the price of the security (in the open market) can all be used when determining the amount of commission or markup/down to charge. LO 13.g