FIL 240 Exam 2
Why would a preferred stockholder want the stock to have a cumulative dividend feature and protective provisions?
A cumulative feature requires all past unpaid preferred stock dividends be paid before any common stock dividends are declared. A stockholder would like preferred stock to have a cumulative dividend feature because without it there would be no reason why preferred stock dividends would not be omitted or passed when common stock dividends were passed. Because preferred stock does not have the payment enforcement power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred stockholders. Other protective features may allow for voting rights in the event of nonpayment of dividends or restrict the payment of common stock dividends if sinking fund payments are not met or if the firm is in financial difficulty. In effect, the protective features included with preferred stock are similar to the restrictive provisions included with long-term debt.
Distinguish between debentures and mortgage bonds.
A debenture is any unsecured long-term debt. Because these bonds are unsecured, the earning ability of the issuing corporation is of great concern to the bondholder. They are also viewed as being more risky than secured bonds and, as a result, must provide investors with a higher yield than secured bonds provide. Often the issuing firm attempts to provide some protection to the holder through the prohibition of any additional encumbrance of assets. This prohibits the future issuance of secured long-term debt that would further tie up the firm's assets and leave the bondholders less protected. To the issuing firm, the major advantage of debentures is that no property has to be secured by them. This allows the firm to issue debt and still preserve some future borrowing power. A mortgage bond is a bond secured by a lien on real property. Typically, the value of the real property is greater than that of the mortgage bonds issued. This provides the mortgage bondholders with a margin of safety in the event the market value of the secured property declines. In the case of foreclosure, the trustees have the power to sell the secured property and use the proceeds to pay the bondholders. In the event that the proceeds from this sale do not cover the bonds, the bondholders become general creditors, similar to debenture bondholders, for the unpaid portion of the debt.
How should the proposed measurement of risk be interpreted?
A large standard deviation of the returns indicates greater riskiness associated with an investment. Future cash flows have a greater potential variation. However, whether the standard deviation is large relative to the returns has to be examined with respect to other investment opportunities. Alternatively, probability analysis is a meaningful approach to capture greater understanding of the significance of a standard deviation figure. However, we have chosen not to incorporate such an analysis into our explanation of the valuation process.
Which of the following will cause the market value of a bond to increase, other things held the same? A. Interest rates decrease. B. The company's Standard & Poors debt rating drops from AAA to BBB. C. Investors' required rate of return increases. D. The bond is callable.
A. Interest rates decrease.
You are thinking of adding one of two investments to an already well- diversified portfolio. If you are a risk-averse investor, which one is the better choice? Security A Expected Return = 14%, Std. Dev. of Returns = 16%, Beta = 1.2 Security B Expected Return = 16%, Std. Dev. of Returns = 20%, Beta = 1.2 A. Security B B. Either security would be acceptable because they have the same beta. C. Security A D. Security A, provided Security A's required return is greater than 12%.
A. Security B
Which of the following statements is TRUE? A. The expected yield on junk bonds is higher than the yield on AAA-rated bonds because of the higher default risk associated with junk bonds. B. Other things held equal, a bond with a call provision is worth more to investors than a bond without a call provision. C. Convertible bonds decrease in value whenever the price of the company's stock increases. D. Subordinated debentures are less risky than unsubordinated debentures because the claims of subordinated debt holders are less likely to be honored in the event of liquidation.
A. The expected yield on junk bonds is higher than the yield on AAA-rated bonds because of the higher default risk associated with junk bonds.
The present value of a single future sum A. decreases as the discount rate increases. B. is generally larger than the future sum if rates are positive. C. is independent of the number of discount periods. D. increases as the number of discount periods increases.
A. decreases as the discount rate increases.
Assuming two investments have equal lives, a high discount rate affects the present value of: A. the investment with large cash flows late. B. the investment with large cash flows early. C. the investment with even cash flows. D. neither investment since they have equal lives.
A. the investment with large cash flows late.
What is annuity? Give some examples. Distinguish between an annuity and a perpetuity.
An annuity is a series of equal dollar payments for a specified number of years. Examples of annuities include mortgage payments, interest payments on bonds, fixed lease payments, car loan payments, and any fixed contractual payment. A perpetuity is an annuity that continues forever; that is, every year from now on this investment pays the same dollar amount. The difference between an annuity and a perpetuity is that a perpetuity has no termination date, whereas an annuity does.
What is meant by investor's required rate of return?
An investor's required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security.
You decide to buy a 10-year Treasury bond with a coupon rate of 5.5% and a market yield of 3.25%. Your required rate of return for similar investments is 4%. How much are you willing to pay for the bond, rounded to the nearest dollar? A. $1,191 B. $1,123 C. $1,180 D. $1,000
B. $1,123
You have an new amortizing car loan of $10,000 and the loan rate is 6% per year. If your annual loan payment is $2,400, how much of your first payment goes to paying loan interest? A. Impossible to determine without knowing the loan term to maturity. B. $600 C. $2,400 D. $1,800
B. $600
You have been depositing money at the end of each year into an account drawing 10% interest per year. What is the balance in the account at the end of year three if you deposited $350 at the end of year one and $500 at the end of year two? A. $850 B. $974 C. $891 D. $924
B. $974
Assume that you have $100,000 invested in a stock that is returning 14%, $150,000 invested in a stock that is returning 18%, and $200,000 invested in a stock that is returning 15%. What is the expected return of your portfolio? A. 13.25% B. 15.78% C. 14.97% D. 15.67%
B. 15.78%
The annual yield to maturity for a zero-coupon bond paying $1,000 in ten years and selling for $450 is: A. 9.00% B. 8.15% C. 4.07% D. 2.22%
B. 8.15%
Of the following different types of securities, which is typically considered most risky? A. Long-term government bonds B. Common stocks of small companies C. Long-term corporate bonds D. Common stocks of large companies
B. Common stocks of small companies
The relevant variable a financial manager uses to measure returns is: A. earnings per share minus dividends per share. B. cash flows C. net income determined using generally accepted D. accounting principles. dividends.
B. cash flows
In an efficient securities market, the market value of a security is equal to: A. its liquidation value. B. its intrinsic value. C. its book value. D. par value.
B. its intrinsic value.
Suppose you were considering depositing your savings in 1 of 3 banks, all of which pay 5% interest, bank A compounds annually, bank B compounds semiannually, and bank C compounds daily. Which bank would you choose?
Bank C, which compounds daily, pays the highest interest. This occurs because, while all banks pay the same interest, 5 percent, bank C compounds the 5 percent daily. Daily compounding allows interest to be earned more frequently than semiannual or annual compounding. Continuous compounding (not included with this question) allows interest to be earned more frequently than any other compounding period.
What is a beta? How is it used to calculate r, the investors required rate of return?
Beta indicates the responsiveness of a security's return to changes in the market return. According to the CAPM, beta is multiplied by the market risk premium and added to the risk-free rate of return to calculate a required rate of return.
What are the basic differences among book value, liquidation value, market value, and intrinsic value?
Book value is the asset's historical value and is represented on the balance sheet as cost minus depreciation. Liquidation value is the dollar sum that could be realized if the asset were sold individually and not as part of a going concern. Market value is the observed value for an asset in the marketplace where buyers and sellers negotiate a mutually acceptable price. Intrinsic value is the present value of the asset's expected future cash flows discounted at an appropriate discount rate.
Compare valuing preferred and common stock.
Both stock values are based on expected future cash flows to be received by stockholders. Preferred stock typically has a predetermined constant dividend. For common stock, the dividend is based on the profitability of the firm and on management's decision to pay dividends or to retain the profits for reinvestment purposes. Thus, the growth of future dividends is a prime distinguishing feature of common stock
Koppenhaver, Inc. issues a bond which has a coupon rate of 10.20%, a yield to maturity of 10.55%, a face value of $1,000, and a market price of $850. Therefore, the annual interest payment is: A. $120.0 B. $101.75 C. $102 D. $105.50
C. $102
An ISU donor want to endow a $2,500 undergraduate scholarship in perpetuity. How much should the ISU Foundation ask the donor to give if the Foundation earns 8% on contributions? A. $42,721 B. $25,397 C. $31,250 D. $50,000
C. $31,250
Which of the following equally risky investments has the highest effective annual return (EAR)? A. A bank certificate of deposit that pays 7.30% interest compounded annually. B. A bank certificate of deposit that pays 7.00% interest compounded daily. C. A bank certificate of deposit that pays 7.25% interest compounded semi-annually. D. Without the number of discount periods, the investments are not comparable.
C. A bank certificate of deposit that pays 7.25% interest compounded semi-annually.
According to bond pricing principles: A. price sensitivity to interest rate changes decreases with maturity. B. a decrease in interest rates decreases bond prices. C. price sensitivity to interest rate changes decreases with high bond coupon rates. D. maturity and price sensitivity to interest rate changes are indirectly related.
C. price sensitivity to interest rate changes decreases with high bond coupon rates.
The process of discounting and compounding are related. Explain this relationship.
Compounding and discounting are inverse processes of each other. In compounding, money is moved forward in time, while in discounting, money is moved back in time. This can be shown mathematically in the compounding equation: FVn = PV (1 + r)n We can derive the discounting equation by multiplying each side of this equation by 1/(1+r)n and we get: Pv=FVn= FVn(1/(1+r)n)
Why is preferred stock frequently convertible? Why is it callable?
Convertibility allows a preferred stockholder to convert or exchange preferred stock for shares of common stock at a predetermined exchange rate. This option gives preferred stockholders more freedom in their investment decisions by allowing them to convert into common stock at their discretion. Preferred stock may be callable by the issuer so that in the event interest rates decline and cheaper funding becomes available, the stock may be called, and new securities may be issued at a lower cost. To agree to the call feature, the investor will require a slightly higher rate of return
Assume that an investment is estimated to produce the following returns: a 10% probability of a $1,400 return; a 50% probability of a $6,600 return; and a 40% probability of a $1,500 return. What is the expected dollar return for this investment? A. $2,140 B. $1,540 C. $6,600 D. $4,040
D. $4,040
You purchased 500 shares of A.M.J. Inc. common stock one year ago for $50 per share. You received a dividend of $2 per share today and decide to take your profits by selling at $54.50 per share. What is your holding period return? A. 6.5% B. 4.0% C. 9.0% D. 13.0%
D. 13.0%
Which of the following is TRUE? A. Proper diversification generally results in the elimination of portfolio risk. B. The beta of a Treasury bill is one. C. Adding stocks to a bond portfolio will increase the riskiness of the portfolio because stocks have a higher standard deviation of returns than bonds. D. A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
D. A stock with a beta of 1.4 has 40% more variability in returns than the average stock.
You have the choice of two equally risky annuities, each paying $5,000 per year for 8 years. One is an annuity due and the other is an ordinary annuity. If you are receiving the annuity payments, which annuity would you choose to maximize your wealth? A. Either one because they have the same present value. B. Because we don't know the interest rate, we can't find the value of the annuities. C. The ordinary annuity. D. The annuity due.
D. The annuity due.
If the coupon payments on a bond are not reinvested: A. the actual compound yield to maturity will be larger than the expected yield. B. the actual compound yield to maturity will be the expected mean return. C. wealth at maturity will be less than initial wealth. D. the annual coupon payment and face value will be the sole source of wealth at maturity.
D. the annual coupon payment and face value will be the sole source of wealth at maturity.
To measure value, the concept of time value of money is used A. to determine the interest rate paid on corporate debt. B. to bring the future benefits and costs of a project, measured by its expected profits, back to the present. C. to ensure that expected future profits exceed current profits today. D. to bring the future benefits and costs of a project, measured by its cash flows, back to the present.
D. to bring the future benefits and costs of a project, measured by its cash flows, back to the present.
Over the past 8 decades, we have had the opportunity to observe the rates or returns and the variability of these returns for different types of securities. Summarize these observations.
Data have been compiled by Ibbotson Associates, Inc. on the actual returns for the following portfolios of securities, plus the inflation rate, from 1926-2014. 1. Common stocks of large firms 2. Common stocks for small firms 3. Corporate bonds 4. Intermediate U.S. government bonds 5. U.S. Treasury bills Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. All portfolios generated returns that exceeded the inflation rate. The portfolio that, on average, has consistently generated the highest rate of return has been a portfolio made up of common stocks.
What are eurobonds?
Eurobonds are bonds issued in a country different from the one in which the currency of the bond is denominated. For example, a bond that is issued in Europe or in Asia by an American company that pays interest and principal to the lender in U.S. dollars would be considered a Eurobond. Thus, even if the bond is not issued in Europe, it merely needs to be sold in a country different from the one in whose currency it is denominated to be considered a Eurobond.
If we were to graph the returns of a stock against the returns of an S&P 500 index, and the points did not follow a very ordered pattern, what could we say about that stock? If the stock's returns tracked the S&P 500 returns very closely, then what could we say?
If a stock has a great amount of variability about its characteristic line (the line of best fit in the graph of the stock's returns against the market's returns), then it has a high amount of unsystematic or company-unique risk. If, however, the stock's returns closely follow the market movements, then there is little unsystematic risk.
Describe the bondholder's claim on the firm's assets and income.
In the case of insolvency, claims of debt in general, including bonds, are honored before those of both common stock and preferred stock. However, different types of debt may also have a hierarchy among themselves as to the order of their claim on assets. Bonds have a claim on income that comes ahead of common and preferred stock. If interest on bonds is not paid, the bond trustees can classify the firm insolvent and force it into bankruptcy. Thus, the bondholder's claim on income is more likely to be honored than that of common and preferred stockholders, whose dividends are paid at the discretion of the firm's management.
What are junk bonds?
Junk bonds refer to any bond with a rating of BB or below. The major participants in this market are new firms that do not have an established record of performance. Many junk bonds have been issued to finance corporate buyouts.
Why is the preferred stock referred to as a hybrid security? It is often said to combine the worst features of common stock and bonds. What is meant by this statement?
Many times preferred stock is referred to as a hybrid security because it has many characteristics of both common stock and bonds. It has characteristics of common stock: there is no fixed maturity date, the nonpayment of dividends does not force bankruptcy, and dividends are not deductible for tax purposes. But it is like bonds because the dividends are fixed in amount like interest payments. From the point of view of the preferred stock shareholder, this is not the most delightful combination. On one hand, the dividends are limited as with bonds, but the security of forced payment by the threat of bankruptcy is not there. Thus, from the point of view of the investor, the worst features of common stock and bonds are combined.
How does the bond's par value differ from its market value?
Par value is the amount stated on the face of the bond. This value does not change and, therefore, is completely independent of the market value. Market value may change with changing economic conditions and changes within the firm.
State how many investors expected rate of return is computed.
The expected rate of return is the discount rate that equates the present value of expected future cash flows with the value of the security.
What factors determine a bond's rating? Why is the rating important to the firm's manager?
Ratings involve a judgment about the future risk potential of the bond. Although they deal with expectations, several historical factors seem to play a significant role in their determination. Bond ratings are favorably affected by (1) a greater reliance on equity, and not debt, in financing the firm, (2) profitable operations, (3) a low variability in past earnings, (4) large firm size, and (5) little use of subordinated debt. In turn, the rating a bond receives affects the rate of return demanded on the bond by the investors. The poorer the bond rating, the higher the rate of return demanded in the capital markets. For the financial manager, bond ratings are extremely important. They provide an indicator of default risk that in turn affects the rate of return that must be paid on borrowed funds.
How do we measure the riskiness of an asset?
Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation of rates of return or by the variance of rates of return, which is simply the standard deviation squared.
What is a systematic risk?
Systematic risk is the variability in a firm's stock price that is the result of general influences within the industry or resulting from overall market or economic influences. A general change in interest rates charged by banks is an example of systematic risk.
How do we measure the beta of a portfolio?
The beta for a portfolio is equal to the weighted average of the betas of individual stocks, weighted by the percentage invested in each stock.
What is the time value of money? Why is it so important?
The concept of time value of money is a recognition that a dollar received today is worth more than a dollar received a year from now, or at any future date. It exists because there are investment opportunities on money; that is, we can place our dollar received today in a savings account, earn interest, and one year from now have more than a dollar.
Explain the differences among a bond s coupon interest rate, current yield, and required rate of return.
The coupon interest rate is the rate of interest that is specified contractually in the bond indenture. As such, this rate is constant throughout the life of the bond. The coupon interest rate indicates to the investor the amount of interest to be received in each payment period. The current yield is the ratio of a bond's annual coupon payment to the current market price. The investor's required rate of return is the rate of return necessary to compensate the investor for the risk of investing in the security given the investor's best alternative investment of similar risk. For a given current market price, the yield to maturity may be considered the typical investor's required rate of return. This rate may be altered as economic conditions change or the investor's attitude toward the risk-return trade-off is altered.
Define investors expected rate of return.
The expected rate of return is the rate of return that may be expected from purchasing a security at the prevailing market price. Thus, the expected rate of return is the rate that equates expected future cash flows with the actual selling price of the security in the market
Define the expected rate of return to bondholders.
The expected rate of return is the rate of return that may be expected from purchasing a security at the prevailing market price. Thus, the expected rate of return is the rate that equates future cash flows with the actual selling price of the security in the market. This is also called the yield to maturity.
What is an intrinsic value of an asset?
The intrinsic value of a security is equal to the present value of cash flows to be received by the investor. Hence, the terms value and present value are synonymous.
Explain the relationship between the required rate of return and the value of a security.
The relationship is an inverse relationship. As the required rate of return increases, the value of the security decreases, and as the required rate of return decreases, the value of the security increases.
What is the security market line? What does it represent?
The security market line is a graphical representation of the risk-return trade-off that exists in the market. The line indicates the minimum acceptable rate of return for investors given the level of systematic risk of a security.
Explain the 3 factors that determine the intrinsic, or economic, value of an asset.
The three basic factors that affect asset value are the (1) amount and timing of cash flows expected to be received, (2) the riskiness of these cash flows, and (3) the investor's required rate of return. The first two factors depend on the asset's characteristics regarding the amount, timing, and riskiness of expected cash flows. The required rate of return reflects the investor's risk-return preference.
The common stockholders receive two types of return from their investment. What are they?
The two types of return include (1) dividend income and (2) capital gains. The dividend income for common stockholders differs from preferred stockholders in that no specified dividend amount is to be received. However, the common stockholders are permitted to participate in the growth of the company. As a result of this growth, their second source of return, that of price appreciation, results.
What effect will diversifying your portfolio have on your returns and your level of risk?
Through diversification, we can potentially accomplish one of two results: (1) We can decrease the variability in returns without lowering the expected rate of return of the portfolio, or (2) we can increase the expected rate of return without increasing the variability in returns. The extent of these effects is in part determined by the types of assets in the portfolio. For instance, diversification has greater effect when investing in different types of assets, such as government securities and stocks, rather than just investing in different stocks.
Because preferred stock and dividends in arrears must be paid before common stock dividends, should they be considered a liability and appear on the right hand side of the balance sheet?
To a certain extent, preferred stock dividends can be thought of as a liability. The major difference between preferred dividends in arrears and normal liabilities is that nonpayment of them cannot force the firm into bankruptcy. Consequently, preferred dividends are not reported on the balance sheet. However, because the goal of the firm is shareholder wealth maximization, which involves getting money to the shareholders (dividends), preferred stock arrearages do provide an effective block for the common shareholders' goal of the firm.
What is an unsystematic risk?
Unique risk is the variability in a firm's stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence.
How would an increase in interest rate or a decrease in the holding period affect the future value of a sum of money?
We know that FVn = PV(1+r)n Thus, an increase in r will increase FVn, and a decrease in n will decrease FVn.
What are zero coupon bonds?
Zero coupon bonds are bonds that pay no coupon interest. They allow the issuing firm to issue bonds at a substantial discount from their $1,000 face value. The investor receives all of the return from the appreciation of the bond at maturity.