Quiz #2
A customer invests $1,000 over a 10 year time horizon. At the end of 10 years, the investment is worth $4,000. The compounded annual rate of return is approximately: A. 15% B. 30% C. 150% D. 300%
The best answer is A. Since financial calculators are not provided on the test, the mathematically correct way to do this problem is not available. The "correct" way is to find the interest rate that discounts $4,000 to be received 10 years from now to $1,000 invested today. This is the "IRR" or Internal Rate of Return. But since you only have a simple calculator to use, the "eyeball" method is best, testing each of the 4 choices. Just by looking at the 4 choices, earning either a 150% or 300% compounded rate of return is ridiculous. Either of these would produce enormous gains over 10 years, so Choices C and D are clearly wrong. So let's take Choice A, which is 15%. If we invest $1,000 today, and the investment grows at 15% per year: After 1 year, the investment is worth $1,000 x 1.15 = $1,150.00 After 2 years, the investment is worth $1150 x 1.15 = $1,322.50 After 3 years, the investment is worth $1322.50 x 1.15 = $1,520.875 After 4 years, the investment is worth $1520.875 x 1.15 = $1,749.0062 After 5 years, the investment is worth $1749.0062 x 1.15 = $2,011.3571 After 6 years, the investment is worth $2011.3571 x 1.15 = $2,313.0606 After 7 years, the investment is worth $2313.0606 x 1.15 = $2,660.0196 After 8 years, the investment is worth $2660.0196 x 1.15 = $3,059.0224 After 9 years, the investment is worth $3059.0224 x 1.15 = $3,517.8757 After 10 years, the investment is worth $3517.8757 x 1.15 = $4,045.5571 This is the answer. Another (simpler) way of approximating the answer is to use the Rule of 72, which calculates how many years it takes for an investment value to double. If $1,000 is invested today, it must double to $2,000 in value and then double again to $4,000 in value within 10 years. 72 / 10 years = 7.2% yield for the investment value to double from $1,000 to $2,000. Since this amount doubles again to $4,000 within that time frame, double 7.2% = 14.40% (approximate) yield. There is only 1 choice offered that is even close to this result, 15% which is Choice A.
The effect on the prices of securities due to the "changing tastes, likes and dislikes" of investors is: A. market risk B. business risk C. regulatory risk D. opportunity cost
The best answer is A. Is this one special or not?! When investors like stocks, they buy them and stock prices rise. When investors don't like stocks, they either sell them or don't buy them and prices fall. This is market risk. Business risk is the risk that a negative event, bad management or bad products cause a company to become unprofitable. Regulatory risk is the risk of law change negatively affecting a company's operations. Opportunity cost is the return "lost" by making a suboptimal investment
Monetarist Theory states that the economy is stimulated by: A. the actions of the Federal Reserve B. increased Government spending C. tax rate reductions D. decreased Government spending
The best answer is A. Monetarists claim that the actions of the Federal Reserve Board to tighten or loosen credit are the driving force behind economic cycles.
A customer who is retired wants to select an investment that is liquid, marketable, and that provides regular income. The BEST choice would be to recommend: A. Treasury Bills B. Treasury Notes C. Preferred Stock D. Certificates of Deposit
The best answer is B. Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, but not as marketable as Treasury securities, making Treasury securities the better choice. So we are left with either a T-Bill or a T-Note. Treasury notes pay interest semi-annually; while Treasury Bills do not provide a regular income stream, so a T-Note is the better choice. (One could argue that buying T-Bills at a discount and letting them mature at par and then rolling over the original investment amount into a new T-Bill purchase will also provide an income stream, but this requires continuous reinvestment on the part of the customer. Buying a T-Note is a completely passive investment in terms of the customer's needs.)
Which of the following will affect a corporation's Operating Income? A. An increase in the company's effective tax rate from 20% to 30% B. An increase in depreciation expense due to the purchase of new equipment C. An increase in the company's capital expenditures for a new plant facility D. An increase in the company's interest expense due to the sale of a new bond issue
The best answer is B. A company's "Operating Income" is Gross Sales less all "Operating Expenses," which include Cost of Goods Sold, Shipping Depreciation and Administrative Expenses. Therefore, an increase in Depreciation Expense will reduce Operating Income. After Operating Income is computed, then Bond Interest is deducted to arrive at Net Income Before Tax. Then Taxes are deducted to arrive at Net Income After Tax.
The Internal Rate of Return computation assumes that cash flows will be reinvested at the: A. Real Interest Rate B. Internal Rate of Return C. Risk Free Interest Rate D. Nominal Interest Rate
The best answer is B. Internal Rate of Return is the true compound rate of return generated by an investment (basically the same as the yield to maturity). Implicit in the formula is that any cash flows generated are reinvested at the "IRR."
Stock specific risk is the same as: A. systematic risk B. non-systematic risk C. credit risk D. non-credit risk
The best answer is B. Non-systematic risk is stock-specific risk in a portfolio. As more and more stocks are added to a portfolio, that portfolio begins to resemble the market as a whole. Thus, non-systematic risk can be diversified away.
The purpose of the foreign currency exchange market is to: A. establish currency exchange rates B. facilitate trading in foreign currencies C. maintain trade relations with foreign countries D. convert Eurodollars into U.S. currency
The best answer is B. The purpose of the foreign currency exchange market is to facilitate the trading of currencies. Such trading sets the "prices" of these currencies.
A corporation that has only issued common stock has income after tax. If this is divided by total assets - total liabilities, the result is: A. Earnings per common share B. Return on common equity C. Price to book value D. Return on assets
The best answer is B. The question is defining Return on Common Equity. It is Earnings for Common divided by Common Equity. Common equity is all assets - all liabilities, as long as the corporation has not issued preferred stock. If the corporation has issued preferred stock, this must be deducted as well to arrive at common equity.
Dow Corning's stock price drops on the announcement of a recall of its silicone breast implants. This is an example of: A. regulatory risk B. business risk C. market risk D. interest rate risk
The best answer is B. This negative event is specific to Dow Corning's business - the product was defective and is being recalled, causing the company to lose revenue and also incur the cost of claims made by individuals harmed by the defective product. Note that this is not regulatory (legislative) risk, because this event did not happen because of a general law change or tax law change.
The risk premium is the rate of return on an investment over the: A. holding period return B. stock dividend rate C. current yield D. money market return
The best answer is D. The "risk premium" is the excess return that an investment gives over the "risk-free" rate of return. Money market instruments are considered to be almost riskless, so their rate of return approximates the "risk-free" rate of return.
The Sharpe ratio is: A. Standard Deviation / Risk Adjusted Rate of Return B. Standard Deviation / Risk Free Rate of Return C. Risk Free Rate of Return / Standard Deviation D. Risk Adjusted Rate of Return / Standard Deviation
The best answer is D. The Sharpe ratio measures the "extra return" achieved (Risk Adjusted Rate of Return) for "extra risk" assumed (Standard Deviation); and thus is a risk measurement. (Rate of Return - Risk Free Rate of Return) ------------------------------------------------------------- Standard Deviation
A customer buys a corporate bond with a 5% coupon priced to yield 9%. If the inflation rate is currently 3%, the customer's real rate of return on this investment is: A. 2% B. 3% C. 5% D. 6%
The best answer is D. The real rate of return is the yield to maturity of the investment adjusted for inflation. This investment is yielding 9%. Since inflation is running at 3%, the real rate of return on this investment is 6%. Note that the nominal yield, which is a percentage of par value, is irrelevant, since the customer bought the bond at a discount price to yield 9%.
The dividend yields of 3 different stocks are: ABC Corp: 2% DEF Corp: 4% XYZ Corp. 8% Based on this information alone, which statements are likely to be TRUE? I ABC is a growth stock with rapidly rising earnings II DEF is a mid-size company whose earnings growth is slowing III XYZ is a long-established company that has a low P/E ratio A. I only B. I and II C. II and III D. I, II, III
The best answer is D. This is a question that deals in subjectives. Let's look at this one using Choice III first. XYZ is a company paying an 8% dividend. Such a high dividend payout is typical of mature, slow growing companies, especially utilities. The main component of an investor's return in such a company is the dividend. There is likely to be little growth in the stock's price over time, so the P/E (Price/Earnings) ratio is likely to be very low. Thus, we know that Choice III is probably true, narrowing us to either Choice C or Choice D. Notice that choice II has a dividend payout ratio of 4%; while Choice I has a dividend payout ratio of 2%. Since Choice III with an 8% dividend payout is a slow growth company; we can infer that choice II is a moderate growth company and Choice I is a higher growth company. Thus, the descriptive statements for these are likely to be true as well. A good argument could be made that Choice I, a growth company, should have no dividend payout, making Choice I incorrect. But, there is a pattern to the choices - 2% dividend payout for Choice I; 4% dividend payout for Choice II; and 8% dividend payout for Choice III; with the key descriptives being, respectively, "growth;" "mid-sized;" and "long-established." We would take all 3 as correct statements (and yes, we know that Choice I is debatable!).