Unit 20 - Analytical Methods

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) 14% D) 19%

C) 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%. LO 20.f

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. LO 20.f

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 4 years of: 12%, 8%, 8%, 2% -Company B with returns over the past 4 years of: 5%, 8%, 9%, 5% -Company C with returns over the past 4 years of: 8%, 12%, −2%, 10% -Company D with returns over the past 4 years of: 15%, 10%, −18%, 3% Which of these choices has the greatest range of returns? A) Company D B) Company B C) Company C D) Company A

A) Company D The range of returns is the difference between the highest and lowest numbers in the set. For Company D, they range from +15% to −18%, a range of 33%. For Company A, the range is from +12% to 2% for a range of 10%. For Company B, the range is from a high of 9% to a low of 5% for a very small range of 4%. For Company C, the range is from +12% to −2% for a range of 14%. LO 20.d

The discount rate that makes the NPV of all cash flows from a security equal to zero is A) the median return. B) the internal rate of return. C) the cash flow adjusted return. D) the present value return.

B) 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. LO 20.a

All of the following statements regarding an investment's internal rate of return (IRR) are true except A) investments are acceptable when their internal rates of return exceed the investor's required rate of return B) IRR is the one rate of return that results in an investment having a net present value (NPV) of 0 C) IRR is most often used with growth stocks D) IRR expresses the rate of interest that matches the initial investment with the present value of future cash flows

C) IRR is most often used with growth stocks It is possible, although very difficult, to calculate IRR for investments with uneven cash flows such as growth stocks where dividends are generally not reliable. IRR is the rate of interest that equates the initial investment with the present value of future cash flows; it is the rate of return that results in an investment having a net present value of 0. LO 20.a

One of the reasons why the discounted cash flow method of valuation is useful in assessing the value of fixed income instruments is A) the availability of ratings. B) the known maturity date. C) the priority of claim on earnings. D) the predictability of income.

D) the predictability of income. Discounted cash flow evaluates the expected cash flow from an investment and then factors in the time value of money. Obviously, if there is no predictable cash flow (not the case with the fixed interest payments on a bond), there are no reliable numbers to plug into the formula. LO 20.c

Two securities with which of the following correlation coefficients could be combined to create a theoretically risk-free portfolio? A) -1.0 B) -0.5 C) +1.0 D) 0.0

A) -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. LO 20.g

Which of the following factors has an inverse relationship to a bond's duration? A) Yield to maturity B) Par value C) Time to maturity D) Rating

A) Yield to maturity Yield to maturity has an inverse relationship to duration. That is, the higher the YTM, the lower (shorter) the duration. The longer the time to maturity, the higher (longer) the duration; it is a direct relationship. The bond's rating and par value are irrelevant. LO 20.b

Twelve years ago, an investor placed $2,500 into an account. The account is now worth $10,000. Using the Rule of 72, you can determine that the approximate annual return was A) 400% B) 12% C) 6% D) 36%

B) 12% Under the Rule of 72, we can determine an earnings rate by dividing 72 by the number of years it takes for money to double. In this case, the money had quadrupled. That means it has doubled twice in 12 years or, every 6 years. Dividing 72 by 6 years results in an annual return of 12%. LO 20.a

Which of the following methods of calculating investment returns are discounted cash flow (DCF) techniques? I Net present value (NPV) II Holding period return (HPR) III Internal rate of return (IRR) A) I and II B) I and III C) II and III D) I, II, and III

B) I and III A discounted cash flow (DCF) technique is one that takes into account the time value of money. Holding period return (HPR) is the total of the income cash flows and capital growth earned by an investment during the period for which it is held. It does not take into account the time value of money. Both net present value (NPV) and internal rate of return (IRR) take the time value of money into account. LO 20.a

A securities analyst wishing to determine the cash flow for the Lucre Bread Manufacturing Company would find the necessary information on the company's A) capitalization statement. B) income statement. C) bank statements. D) property tax return.

B) income statement. The primary source for the information necessary to construct a cash flow statement is the company's income statement. In a similar fashion, if an investment adviser wants to determine a client's cash flow, you would help the client prepare an income statement and work from that. Although the bank statements have some of the required information, there are items adding to or subtracting from cash flow, such as depreciation, that cannot be determined from a bank statement. LO 20.h

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 high and beginning to decline. D) short-term interest rates are low and beginning to rise.

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. LO 20.b

The portfolio manager of a bond fund believes that interest rates are going to increase in the near future. As such, it would be wise for that manager to A) increase the equity portion of the portfolio. B) shorten the average duration of the portfolio. C) shift into higher-rated bonds. D) lengthen the average duration of the portfolio.

B) shorten the average duration of the portfolio. Increasing interest rates lead to declining bond prices, regardless of the ratings. This is interest rate risk. Those bonds with the longest duration have the most sensitivity to that risk, while short-term maturities are only slightly affected. Reducing the average duration of the portfolio means that the average maturities will be shortened, thus reducing the effects of an increase to interest rates. LO 20.b

Which of the following correlations would represent two assets that tend to move in tandem with one another? A) −0.68 B) +0.16 C) −0.11 D) +0.81

D) +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. LO 20.g

Which of the following is not a valuation method for a fixed-income security? A) Discounted cash flow B) Conversion parity C) Dividend discount model D) Price-to-earnings ratio

D) Price-to-earnings ratio The P/E ratio is only used with common stock. The parity price is a way to value a convertible bond or convertible preferred stock. DCF is one of the most popular ways to value bonds. The DDM can be used with preferred stock, which, because of its fixed dividend, is considered in the general category of fixed-income security. LO 20.c

Assuming all of the following mature at about the same time, which of the following bonds should experience the greatest price decline if interest rates rise by 1%? A) Treasury bond issued at par carrying a 7% coupon B) Treasury bond issued at par carrying a 6% coupon C) Treasury bond issued at par carrying a 5% coupon D) Treasury bond issued at par and carrying a 4% coupon

D) Treasury bond issued at par and carrying a 4% coupon This is an example of duration. With approximately equal maturity dates, the bond with the lowest coupon will always have the longest duration. The longer the duration, the greater the susceptibility to price changes due to fluctuations in interest rates. LO 20.b

An investment of $5,000 made 16 years ago is now worth $20,000. Using the Rule of 72, the approximate compounded annual rate of return is A) 4.5%. B) 9.0%. C) 25%. D) 18%.

B) 9.0%. This investment has quadrupled in 16 years. Using the Rule of 72, we know how to compute the rate of return when an investment doubles. This one has doubled every 8 years. Dividing 72 by 8 years gives us an approximate rate of 9%. LO 20.a

An investment of $5,000 made 16 years ago is now worth $20,000. Using the Rule of 72, the approximate compounded annual rate of return is A) 18%. B) 25%. C) 9.0%. D) 4.5%.

C) 9.0%. This investment has quadrupled in 16 years. Using the Rule of 72, we know how to compute the rate of return when an investment doubles. This one has doubled every 8 years. Dividing 72 by 8 years gives us an approximate rate of 9%. LO 20.a

A corporation calls in a portion of its long-term debt at 101. This will have the effect of I decreasing working capital II increasing working capital III decreasing net worth IV increasing net worth A) II and III B) I and IV C) I and III D) II and IV

C) I and III Working capital is computed by subtracting current liabilities from current assets. Using a current asset, like cash, to call in the bonds, reduces those assets with no corresponding reduction to current liabilities. Whenever a bond is called at a premium, net worth is reduced by that premium. LO 20.h

An investor's portfolio has a beta coefficient of 0.85. If the overall market declined by 10% over the course of a year, the portfolio's value has likely A) decreased by 11.76% B) increased by 10.85% C) decreased by 8.5% D) increased by 8.5%

C) decreased by 8.5% A beta coefficient of 0.85 means that the portfolio is considered to be 0.85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of 0.85 is likely to decline by only 8.5% (0.10 × 0.85). LO 20.e

Twelve years ago, an investor placed $2,500 into an account. The account is now worth $10,000. Using the Rule of 72, you can determine that the approximate annual return was A) 400%. B) 36%. C) 6%. D) 12%.

D) 12%. Under the Rule of 72, we can determine an earnings rate by dividing 72 by the number of years it takes for money to double. In this case, the money had quadrupled. That means it has doubled twice in 12 years or, every 6 years. Dividing 72 by 6 years results in an annual return of 12%. LO 20.a

If interest rates were to decline sharply, which of the following securities is likely to appreciate the most? A) 20-year zero-coupon Treasury bond currently trading at a deep discount B) 20-year municipal bond currently trading at par C) 20-year corporate bond currently trading at a small premium D) 20-year mortgage-backed security currently trading at a small discount

A) 20-year zero-coupon Treasury bond currently trading at a deep discount As a rule, the longer the duration, the greater the price appreciation. In this case, all the fixed-income securities have 20-year maturities. Another general rule is that the lower the coupon on the bond, the longer the duration. The zero-coupon bond has the lowest coupon and would likely appreciate the most. LO 20.b

An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 6%, then the NPV is A) zero B) positive C) 6% D) negative

A) zero When an investment's IRR equals the required rated of return, the NPV is zero. If the IRR is higher than the required rate of return, the NPV is positive; if the IRR is lower than the rate of return, the NPV is negative. LO 20.a

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) −66% and +66%. D) −7% and +30%.

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%. LO 20.f

Which of the following statements regarding the correlation coefficient is not correct? A) Perfectly negatively correlated assets have a correlation coefficient of -1.0. B) Combining assets with less than perfect positive correlation will not reduce the total risk of the portfolio. C) A correlation coefficient of 0.0 means there is no relationship between the returns of the assets. D) Perfectly positively correlated assets have a correlation coefficient of +1.0.

B) Combining assets with less than perfect positive correlation will not reduce the total risk of the portfolio. Watch out for the double negatives here. Combining assets with less than perfect positive correlation can reduce the total risk of the portfolio. The further the correlation coefficient between the two assets is away from +1.0, the greater the diversification benefits that may be attained. LO 20.g

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) between 6% and 6.32% B) positive C) negative D) zero

B) positive Anytime an investment's IRR is more than the required rate of return, the NPV is positive (and should probably be selected). The NPV is expressed as a dollar amount. It is the IRR which is expressed as a percentage. LO 20.a

The statistical measurement of the total risk of a security or portfolio is known as A) beta. B) duration. C) Sharpe ratio. D) standard deviation.

D) standard deviation. Standard deviation is the statistic that measures both systematic and unsystematic risk (total risk). An investment with a high standard deviation tends to have a higher level of risk than an investment with a low standard deviation. Beta is a measure of systematic risk, and duration is an indication of interest rate risk. The Sharpe ratio measures the risk-adjusted return. LO 20.f

If an investor wanted to verify a company's working capital, she would do so by reviewing their A) balance sheet B) footnotes C) cash flow statement D) income statement

A) balance sheet Working capital, current assets minus current liabilities, is determined from numbers found on the balance sheet. LO 20.h

All of the following ratios are measures of the liquidity of a corporation except A) quick ratio. B) acid test ratio. C) debt-to-equity ratio. D) current ratio.

C) 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. LO 20.h

A portfolio manager with a growth style would probably diversify by A) placing a portion of the portfolio into high-yield bonds. B) concentrating in stocks in one or two industries. C) attempting to build a portfolio with a very high correlation. D) devoting a portion of the portfolio to securities with a negative correlation

D) 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. LO 20.g

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) between 6% and 6.32% B) zero C) negative D) positive

D) positive Anytime an investment's IRR is more than the required rate of return, the NPV is positive (and should probably be selected). The NPV is expressed as a dollar amount. It is the IRR which is expressed as a percentage. LO 20.a

If the coupon rate on a bond increases, the duration of the bond will A) decrease. B) remain unchanged. C) increase. D) change in an unpredictable fashion.

A) decrease. The higher the coupon is, the shorter the duration. LO 20.b

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) internal rate of return (IRR). B) net present value (NPV). C) alpha. D) beta.

C) alpha. This is the textbook definition of alpha. Portfolio managers strive for a positive alpha (returns in excess of the expected return). LO 20.e

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) yield to maturity. C) duration. 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. LO 20.c

Dividend payments are not a part of the computation for which of the following risk measurement tools? A) Dividend discount model B) Correlation coefficient C) Dividend growth model D) Net present value

B) Correlation coefficient The correlation coefficient measures the degree to which the market price of two securities or portfolios move in concert with each other. Obviously, the two dividend models key on dividends. The same is true for net present value, which bases the present value on the discounted cash flow of payments (such as dividends). LO 20.g

In a group of returns, the central value of observations arranged in order from lowest to highest is known as the A) mode. B) median. C) range. D) mean.

B) 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. LO 20.d

An investment adviser reviewing the past performance of a portfolio observes that annual returns have been +6%, +11%, -5%, +8%, +14%, +1%, and +7%. From this information, the adviser would determine that the median value was A) 19.0% B) 6.0% C) 7.0% D) 7.4%

C) 7.0% The median of a set of numbers is the one in the middle. That is, the number with an equal number of values above and below. It is easiest to compute if the numbers are presented in ascending values. In this question, we have -5, +1, +6, +7, +8, +11, and +14. This way, it is plain to see that 7 has 3 values below and 3 values above. LO 20.c

The statistical measurement of the total risk of a security or portfolio is known as A) Sharpe ratio. B) duration. C) standard deviation. D) beta.

C) standard deviation. Standard deviation is the statistic that measures both systematic and unsystematic risk (total risk). An investment with a high standard deviation tends to have a higher level of risk than an investment with a low standard deviation. Beta is a measure of systematic risk, and duration is an indication of interest rate risk. The Sharpe ratio measures the risk-adjusted return. LO 20.f

Dividend payments are not a part of the computation for which of the following risk measurement tools? A) Net present value B) Dividend growth model C) Dividend discount model D) Correlation coefficient

D) Correlation coefficient The correlation coefficient measures the degree to which the market price of two securities or portfolios move in concert with each other. Obviously, the two dividend models key on dividends. The same is true for net present value, which bases the present value on the discounted cash flow of payments (such as dividends). LO 20.g

Over the past five years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The median of the returns is A) 8.0%. B) 8.2%. C) 9.0%. D) 7.4%.

A) 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%). LO 20.d

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 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 D B) Company B C) Company A D) Company C

A) 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 4 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 choice D, they range from 12.5% higher to 15.5% lower. In choice A, the range is from 4.5% higher to 3.5% lower; in choice B, from 1.5% higher to 1.5% lower; in choice C, from 4.5% higher to 9.5% lower. That should clearly point out that the greatest volatility, or dispersion from the mean is choice D while choice B would have the lowest standard deviation. LO 20.f

The market price of which of the following bonds would have the greatest percentage increase if interest rates fell? A) 30-year maturity, selling at a discount B) 30-year maturity, selling at a premium C) 15-year maturity, selling at a discount D) 15-year maturity, selling at a premium

A) 30-year maturity, selling at a discount The general rule of thumb is that bonds with long-term maturities will have greater fluctuations in price than will short-term maturities, given the same move in interest rates. Furthermore, discounted bonds, with their lower coupon rates, have a longer duration than a bond selling at a premium and will respond more favorably to falling rates than will those premium bonds. Thus, the 30-year discounted bond will have a greater increase, as a percentage, than the others. LO 20.b

All of the following ratios are measures of the liquidity of a corporation except A) the debt/equity ratio. B) the current ratio. C) the acid-test ratio. D) the quick ratio.

A) the debt/equity ratio. The debt/equity ratio is a measurement of the leverage employed in a corporation's capital structure. It compares the total long-term debt to the total capitalization (long-term debt plus equity capital). LO 20.h

Bond investors use the discounted cash flow formula to A) determine the annual interest paid on a bond. B) compute their income tax liability. C) translate future cash flows to be received from interest and principal repayment into their present value. D) evaluate the risk of investing in a bond.

C) translate future cash flows to be received from interest and principal repayment into their present value. The discounted cash flow method of valuing a fixed-income security discounts the investment's future cash flows to arrive at a present value. Those cash flows come from two sources: The first is the semiannual interest payments and the second is the final maturity payoff. Each of these is discounted using the required rate of return (usually the current market interest rate) and the result is the present value of those cash flows. The security's rating is not a factor in this computation although it may affect what investors are willing to pay for the security. LO 20.c

An investor's portfolio consists of a single stock. If a stock with a correlation of +.95 was added to the portfolio and the stock market turned bearish, what would be the likely effect of having added this additional security? A) Almost no noticeable impact. B) The portfolio's value would remain the same. C) The portfolio's value would increase. D) Not enough information to tell.

A) Almost no noticeable impact. Adding additional securities to a portfolio usually increases the diversification, lowering the overall risk. However, that is more apparent when there is low or negative correlation. A +.95 correlation means that the "new" stock will perform close to exactly the same as the existing one so its addition should have little to no impact on performance. In a bearish market, values go down, not up or remain the same. If this additional stock had a negative correlation, that could have resulted in the portfolio going up or remaining the same, but not with a +.95 correlation. It is almost never that a question on the exam does not have enough information to arrive at the correct answer - steer away from that choice. LO 20.g

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) less than zero. B) equal to zero. C) greater than the risk-adjusted return. 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. LO 20.a

The present value of a dollar A) indicates how much needs to be invested today at a given interest rate to equal a specific cash value in the future B) is equal to its future value if the level of interest rates stays the same C) is the amount of goods and services the dollar will buy in the future at today's rate price level D) cannot be calculated without knowing the level of inflation

A) indicates how much needs to be invested today at a given interest rate to equal a specific cash value in the future The present value of a dollar will indicate how much needs to be invested today at a given interest rate to equal a cash amount required in the future. LO 20.a

A client owns an investment-grade bond with a coupon of 7%. If similarly rated bonds are being issued today with coupons of 5%, and the market is efficient, it would be expected that the client's bond A) has a positive net present value B) will be selling at a discount from par C) has a zero net present value D) has a negative net present value

C) has a zero net present value With a discount rate of 5% (the discount rate in a present value computation is the current market interest rate), a debt instrument with a 7% coupon rate will be selling at a premium (interest rates down, prices up). If the market is efficiently pricing that bond, its market price should be equal to its present value, resulting in an NPV of zero. LO 20.a

According to most fundamental analysts, examining a company's price-to-earnings ratio gives an indication of A) the degree to how liberal the company's dividend policies are. B) the parity price of the issuer's convertible bonds. C) how much investors value the stock as a function of the company's market price to its earnings. D) the historical support and resistance levels.

C) 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. LO 20.h

What happens to bond durations when coupon rates increase and maturities increase? As coupon rates | As maturities increase, duration: | increase, duration: A) decreases.increases. B) increases.increases. C) increases.decreases. D) decreases.decreases.

A) decreases.increases. As coupon rates increase, the duration on the bond will decrease because investors are receiving more cash flow sooner. As maturity increases, duration will increase because the payments are spread out over a longer time. LO 20.b

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) negative alpha. B) positive alpha. C) positive correlation. D) zero alpha.

B) 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. LO 20.e

If a bond has a long duration, it will A) continue paying interest into perpetuity B) be less sensitive to small changes in interest rates than a bond with a shorter duration C) be more sensitive to small changes in interest rates than a bond with a shorter duration D) be relatively unaffected by small changes in interest rates

C) be more sensitive to small changes in interest rates than a bond with a shorter duration Duration measures how sensitive a bond will be to a small change in interest rates. The longer the duration of a bond, the more volatile (sensitive to interest rate changes) it will be. LO 20.b

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) 1.25 to 1.00. B) 1.00 to 1.00. C) 0.75 to 1.00. D) 1.50 to 1.00.

C) 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. LO 20.h

Your client has the following bonds in her portfolio: XYZ 3s of 44. TUV 6s of 45. QRS 9s of 43. NOP 12s of 42. If interest rates were to suddenly rise, which of her bonds would suffer the greatest decline in market price? A) TUV 6s of 45 B) QRS 9s of 43 C) NOP 12s of 42 D) XYZ 3s of 44

D) XYZ 3s of 44 The technical method for answering this question is to compare the duration of each of the bonds. The one with the longest duration will be impacted the most by a change in interest rates. Invariably, when the length of time to maturity is relatively close (as is the case here), the bond with the lowest coupon rate will have the longest duration. It should be easy to spot that the bond with the shortest duration is the NOP 12s of 42 - they have both the highest coupon and the nearest maturity and would be the correct answer if the question had asked for the bond suffering the smallest decline in market price. LO 20.b

An investor's required rate of return is 6%. If the internal rate of return of the investment offered is 5.75%, then the NPV is A) negative B) between 5.75% and 6% C) positive D) zero

A) negative Any time an investment's IRR is less than the required rate of return, the NPV is negative (and should probably be avoided). NPV is expressed as a dollar amount. It is the IRR that is expressed as a percentage. LO 20.a

If two stocks have positive correlation, which of the following statements is correct? A) If one stock doubles in price, the other will also double in price. B) The two stocks must be in the same industry. C) The rates of return tend to move in the same direction relative to their individual mean returns. D) The rates of return tend to move in the opposite direction relative to their individual mean returns.

C) The rates of return tend to move in the same direction relative to their individual mean returns. Positive correlation between two assets will result in the returns of both of them moving in the same direction (up or down). If one stock doubles in price, the other will also double in price. This is true only if the correlation coefficient is +1.0. The two stocks need not be in the same industry. Negative correlation is when they move in opposite directions. Test-taking tip: This question gives you a choice of positive, meaning moving up, or positive moving down - it has to be one of those two choices. That tells you the other 2 choices cannot be correct. LO 20.g

All of the following factors have an inverse relationship to a bond's duration except A) time to maturity. B) yield to maturity. C) current yield. D) coupon rate.

A) time to maturity. The relationship between the time to maturity (length) and duration is a linear one. That is, the longer the time until the bond matures, the higher (longer) the duration - it is a direct relationship. Yields, on the other hand, have an inverse relationship with duration. That is, the higher the yield, the lower (shorter) the duration. An example would be comparing a bond with an 8% coupon rate to one with a 6% coupon rate. All other things beging equal, the bond with the 8% coupon rate will have a shorter duration than the one with a 6% coupon; the relationship is inverse rather than linear. LO 20.b

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

B) 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. LO 20.b

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) Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years C) XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5% 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. LO 20.c

From the following 4 portfolios, choose the 1 that would generally be considered to be the most diversified. A) STU common stock, beta 0.95, correlation to the S&P 500, +0.84, VWX common stock, beta 0.90, correlation to the S&P 500, +0.07; YZA common stock, beta 0.88, correlation to the S&P 500, −0.45 B) DCB common stock, beta 1.00, correlation to the S&P 500, +0.75; HGF common stock, beta 0.10, correlation to the S&P 500, +0.25; KJI common stock, beta −0.50, correlation to the S&P 500 +0.50 C) ABC common stock, beta 1.20, correlation to the S&P 500, +0.82; DEF common stock, beta 0.90, correlation to the S&P 500, +0.91; GHI common stock; beta +0.65, correlation to the S&P 500, +0.06 D) JKL common stock, beta 1.50, correlation to the S&P 500, +0.77; MNO common stock, beta 1.00, correlation to the S&P 500, +0.93, PQR common stock, beta 0.50, correlation to the S&P 500, +0.34

A) STU common stock, beta 0.95, correlation to the S&P 500, +0.84, VWX common stock, beta 0.90, correlation to the S&P 500, +0.07; YZA common stock, beta 0.88, correlation to the S&P 500, −0.45 Most analysts would agree that the greatest portfolio diversification occurs when there are some holdings with a negative correlation. Beta measures volatility, so varying those positions will offer some protection against volatility. However, including securities that move in opposite directions will provide protection against general market declines. LO 20.g

Which of the following statements regarding internal rate of return (IRR) is true? A) If the IRR is higher than the cost of borrowing to fund an investment, the investment is likely to be unprofitable. B) IRR ignores the time value of money. C) IRR cannot be used effectively to measure return on investments with even cash flows, such as bonds. D) IRR is a discount rate at which the net present value (NPV) of an investment is equal to zero.

D) IRR is a discount rate at which the net present value (NPV) of an investment is equal to zero. Internal rate of return (IRR) is a discount rate at which the net present value (NPV) of an investment is equal to zero. IRR can be used to measure return on bonds because of their even cash flows and on those stocks that pay stable dividends for the same reason. IRR accounts for the time value of money. If the IRR is higher than the cost of borrowing to fund the investment, the investment should be profitable. LO 20.a

A securities analyst wishing to determine the cash flow for the Lucre Bread Manufacturing Company would find the necessary information on the company's A) income statement. B) bank statements. C) property tax return. D) capitalization statement.

A) income statement. The primary source for the information necessary to construct a cash flow statement is the company's income statement. In a similar fashion, if an investment adviser wants to determine a client's cash flow, you would help the client prepare an income statement and work from that. Although the bank statements have some of the required information, there are items adding to or subtracting from cash flow, such as depreciation, that cannot be determined from a bank statement. LO 20.h

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 B C) Company C D) Company D

D) 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. LO 20.f

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 future value of the coupon payments. D) 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 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). LO 20.c

Which of the following statements is most accurate regarding the net present value (NPV) and internal rate of return (IRR) on a bond? A) NPV assumes the cash flows can be reinvested at market interest rates. B) IRR assumes the cash flows are reinvested at market interest rates. C) NPV assumes that cash flows can be reinvested at the bond's IRR. D) IRR assumes the cash flows are reinvested annually.

A) NPV assumes the cash flows can be reinvested at market interest rates. The first step in finding the NPV is to compute the present value (PV). The PV is computed by taking the future cash flows and discounting them by a "discount" rate. That rate is the current market interest rate. So, if NPV is based on PV and PV assumes reinvestment at the discount rate, that assumption must hold true for figuring NPV. In the case of the IRR, that is the yield to maturity of a bond and assumes that the cash flows are reinvested at that IRR. For example, a bond with a YTM of 7% assumes that all reinvestments will be made at that 7% rate. The periodic cash flow on a bond comes from the semiannual interest payments making reinvestments semiannually, not annually. LO 20.a

A portfolio manager who is successful at market timing will A) increase the beta of the portfolio in advance of a rising market. B) have a portfolio beta less than the beta required by the client. C) decrease the beta of the portfolio in advance of a rising market. D) increase the beta of the portfolio in advance of a declining market.

A) 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. LO 20.e

If the required rate of return is less than anticipated in a present value calculation, the effect would be that the A) present value would be lower. B) future value would be lower. C) present value would be higher. D) yield to maturity (YTM) would decrease.

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. LO 20.a

An investment adviser representative is looking for a suitable investment for a client. The IAR wishes to find something that will offer an attractive return commensurate with its systematic risk. The choices have been narrowed to Security C and Security L, and the selection will be based on alpha. C has a beta of 1.0 and earned 13% which equalled its expected return, while L has a beta of 0.8 and earned 10.1%. The alpha of Security L is A) +2.9 B) −2.9 C) −0.3 D) +0.3

C) −0.3 Alpha is obtained by comparing how a security actually performed to the performance one would have expected based on its beta. A beta of 1.0 is used to indicate the expected volatility of the overall market. Because Security C has a beta of 1.0, its 13% return matches that of the market. Furthermore, Security C has an alpha of zero because its actual return was the same as the expected return. With a beta of 0.8, one would expect Security L to produce a lower return, but how much lower? Its return should be 80% of the market or, in this case, 80% of 13%, which computes to 10.4%. However, its actual return fell short of that by 0.3%, giving it a negative alpha of 0.3. Had its actual return been 10.7%, it would have had a 0.3 positive alpha. Although this question doesn't ask it, based on the criteria given, the IAR would have selected Security C. LO 20.e

Cecil has a discretionarily-managed account with Pelf Reliable Advisors (PRA), an investment adviser registered in States C, D, and G. Over the past year, the portfolio produced a 12% return with a beta of 1.05. The risk-free rate is 3.5%, and the overall market returned 10.85%. Based on this information, calculate alpha and determine if PRA added any value to the portfolio. A) Alpha = -1.21%; the adviser underperformed the market by 1.21% B) Alpha = 0.78%; the adviser underperformed the market by 2.72% C) Alpha = 1.15%; the adviser outperformed the market by 1.15% D) Alpha = 0.78%; the adviser outperformed the market by 0.78%

D) Alpha = 0.78%; the adviser outperformed the market by 0.78% The alpha for this portfolio is +0.78% (rounded). A positive alpha indicates that Pelf outperformed the market on a risk-adjusted basis. As with most calculations, there are two ways to solve for the answer. Let's use the LEM's formula first. When the riskfree (RF) rate is given, the formula is (actual return - RF rate) - (beta x [market return - RF rate]). Plussing in the numbers, we have (12% minus 3.5%) minus (1.05 times [10.85% minus 3.5%]). That breaks down to 8.5% minus (1.05 times 7.35%) or 8.5% minus 7.72% = +0.78%. An alternative method is as follows: 12% - [3.5% + 1.05 (10.85% - 3.5%)] = 12% - [3.5% + 7.7175] = 12% - 11.2175 = +0.7825. LO 20.e

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 mode is 2%. B) The mean is 4%. C) The median is 5%. 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%. LO 20.d

An investor is considering a 10-year stripped U.S. Treasury and a 10-year U.S. Treasury note, both with a yield to maturity of 4.8%. Compared to the note, the strip has A) more interest rate risk and less liquidity risk. B) more liquidity risk and less interest rate risk. C) more reinvestment risk and less interest rate risk. D) less reinvestment risk and more interest rate risk.

D) less reinvestment risk and more interest rate risk. The strip is a zero-coupon security so it has no cash flows to reinvest and therefore no reinvestment risk. However, it has more interest rate risk (longer duration) than the Treasury note. Remember, the duration of a zero-coupon bond is its maturity date while any debt security paying periodic interest (Treasury notes pay semiannually) will always have a duration shorter than its length to maturity. LO 20.b