Chapter 20
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) alpha. B) beta. C) internal rate of return (IRR). D) net present value (NPV).
A) alpha. This is the textbook definition of alpha. Portfolio managers strive for a positive alpha (returns in excess of the expected return).
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) discounted cash flow. B) future value. C) duration. D) yield to maturity.
A) 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.
According to most fundamental analysts, examining a company's price-to-earnings ratio gives an indication of A) how much investors value the stock as a function of the company's market price to its earnings. B) the historical support and resistance levels. C)the parity price of the issuer's convertible bonds. D) the degree to how liberal the company's dividend policies are.
A) 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.
The best time for an investor seeking returns to purchase long-term, fixed interest rate bonds is when A) long-term interest rates are high and beginning to decline. B) short-term interest rates are low and beginning to rise. C) short-term interest rates are high and beginning to decline. D) long-term interest rates are low and beginning to rise.
A) 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.
The discount rate that makes the NPV of all cash flows from a security equal to zero is A) the internal rate of return. B) the present value return. C) the median return. D) the cash flow adjusted return.
A) 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.
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) 1.50 to 1.00. B) 0.75 to 1.00. C) 1.00 to 1.00. D) 1.25 to 1.00.
B) 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.
All of the following ratios are measures of the liquidity of a corporation except A) current ratio. B) debt-to-equity ratio. C) acid test ratio. D) quick ratio.
B) 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.
A portfolio manager who is successful at market timing will A) decrease the beta of the portfolio in advance of a rising market. B) increase the beta of the portfolio in advance of a rising market. C) have a portfolio beta less than the beta required by the client. D) increase the beta of the portfolio in advance of a declining market.
B) 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.
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) XYZ Corporation mortgage bond maturing in 10 years with a coupon of 4.5% B) Bay Area Rapid Transit Authority 4% revenue bond maturing in 15 years C) ABC Corporation debenture maturing in 25 years with a 5% coupon D) U.S. Treasury bond maturing in 20 years with a 4% coupon
C) 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.
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 present value of the coupon payments. B) future value of the par value repaid at maturity plus the future 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).
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) yield to maturity (YTM) would decrease. D) present value would be higher.
D) 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.
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) +5% and +17%. B) −66% and +66%. C) −7% and +30%. D) −1% and +23%.
D) −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%.
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
I. ABC 8s of 2050 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.
