S66 Unit 20 (Analytical Methods) Quiz

An investment of $2,000 made 10 years ago is now worth $8,000. Using the Rule of 72, the approximate compounded annual rate of return is A) 14.4% B) 40% C) 25% D) 7.2%

A) 14.4% Explanation This investment has quadrupled in 10 years. Using the Rule of 72, we know how to compute the rate of return when an investment doubles. This one has doubled every 5 years. Dividing 72 by 5 years gives us an approximate rate of 14.4%. LO 20.a

Which of the following are likely to have a low beta? A) Public utility stocks B) Aerospace stocks C) Technology stocks D) Software stocks

A) Public utility stocks Explanation Public utility stocks tend to have low betas as do other defensive stocks. Technology, aerospace, and software stocks tend to have high betas. LO 20.e

Duration is A) a measure of a bond's volatility with respect to a change in interest rates B) identical to a bond's maturity C) equivalent to the yield to maturity D) the deviation of a bond's returns from its average returns

A) a measure of a bond's volatility with respect to a change in interest rates Explanation Duration measures a bond's volatility with respect to a change in interest rates. The higher the duration, the greater the change in a bond's price with respect to interest rate changes. LO 20.b

A customer's portfolio has a beta coefficient of 1.1. If the overall market increases by 10%, the portfolio's value is likely to A) increase by 11% B) decrease by 11% C) increase by 10% D) decrease by 10%

A) increase by 11% Explanation A beta of 1.1 means the portfolio is considered to be 1.1 times more volatile than the overall market. If the market is up 10%, the portfolio with a beta of 1.1 is likely to be up 11%. LO 20.e

In order to perform a discounted cash flow estimation of the value of a bond, it would be necessary to know all of the following except A) the parity price of the bond B) the number of interest payments C) the future cash flow D) the discount rate

A) the parity price of the bond Explanation In its simplest iteration, discounted cash flow is nothing more than taking all the money you are scheduled to receive over a given future period and adjusting that for the time value of money (the discount rate). Parity price is only relevant to convertible bonds. YOU NEED! 1)Principal Amount (Future Cash Flow) 2)Coupon Rate/Discount Rate 3)#of interest Payments LO 20.c

XYZ Corporation common stock has a market price of $45 per share and earnings per share of $3 when XYZ announces a 3-for-1 split. After the split, the price-to-earnings ratio of XYZ stock will be A) 5 B) 15 C) 3 D) 45

B) 15 Explanation Before the split, the stock had a P/E ratio of 15 ($45 per share ÷ $3). After the split, the price per share and the EPS drop in the same proportion, leaving the P/E ratio unchanged (new price = $15, new EPS = $1). LO 20.h

A client owns an investment-grade bond with a coupon of 5% that is priced to yield 6.7%. If similarly rated bonds are being issued today with coupons of 7%, it would be expected that the client's bond A) has a zero net present value B) has a negative net present value C) will be selling at a premium over par D) has a positive net present value

B) has a negative net present value Explanation With a discount rate of 7% (the discount rate in a present value computation is the current market interest rate), a debt instrument with a 5% coupon rate will be selling at a discount (interest rates up, prices down). We are told that this bond is offering a yield of 6.7%, which is less than the current market rate. Because a present value computation using a 6.7% rate would reflect a higher value than a 7% rate (the higher the discount rate, the lower the value), that would mean that the bond can be purchased at a price above its present value. Anytime that occurs, the instrument has a negative net present value (the difference between the price and the present value). LO 20.a

The discounted cash flow method is frequently used to assess the value of a bond. When making the DCF computation, it would not be necessary to know the bond's A) nominal yield B) rating C) principal amount D) number of remaining interest payments

B) rating Explanation As it is strictly a mathematical computation, a subjective item, such as the bond's rating, has no place in the computation. LO 20.c

The financial ratio that shows the relationship between the price of a company's stock and the company's net worth (stockholders' equity) is A) the dividend discount ratio B) the price-to-book-value ratio C) the price-sales ratio D) the price-earnings (PE) ratio.

B) the price-to-book-value ratio Explanation The price-to-book-value ratio is calculated by dividing the price per share by the stockholders' equity per share. This ratio shows the relationship between a company's stock price and the company's book value. LO 20.h

An analyst has been charting previous 9 year's returns for a stock and displays the following results: 5%, 5%, 8%, −3%, 10%, 12%, 5%, 17% and 22%. If you were asked the mode of these returns, you would reply A) 8% B) 10% C) 5% D) 9%

C) 5% Explanation The mode of a series of numbers is that number that has the largest number of occurrences. In this case, 5% appears 3 times, more than any other number. Note that the mode is not similar to the mean (in this example 9%) or the median (in this case 8%). LO 20.d

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% Explanation 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

Which of the following best describes net present value? A) The discount rate that results in a return of zero for a series of future cash flows B) It is the true interest yield expected from an investment expressed as a percentage C) The difference between the sum of the discounted cash flows that are expected from an investment and its current market price D) The amount of money that must be invested today at some specified rate of return to equal a targeted value in a specified number of years

C) The difference between the sum of the discounted cash flows that are expected from an investment and its current market price Explanation Net present value is a computation taking into consideration future cash flows, discounted to the present, and comparing that to the capital investment necessary to obtain those flows. It is always expressed in monetary units and, if positive, indicates a potentially worthwhile investment. LO 20.a

Beverly has two stocks with a correlation coefficient of zero. Which of the following is correct? A) These stocks are well diversified because they will move in unison. B) These stocks are not well diversified because they move in unison. C) These stocks will move independently of each other. D) These stocks are well diversified because as one stock appreciates in value, the other decreases in value

C) These stocks will move independently of each other. Explanation A correlation coefficient of zero means that the two stocks will move independently. They may move in the same direction, or they may not. The zero correlation coefficient indicates that there is no pattern to the relationship between their price movements. LO 20.g

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

C) decreases & increases. Explanation 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

A method of assessing the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value is known as A) internal rate of return B) current yield C) discounted cash flow D) future value

C) discounted cash flow Explanation The discounted cash flow, DCF, is used to assess the value of a fixed-income security by looking at the future expected free cash flow and discounting it to arrive at a present value. This is basically nothing more than taking the income payments you are scheduled to receive over a given future period and adjusting that for the time value of money. LO 20.c

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) between 5.75% and 6% B) zero C) negative D) positive

C) negative Explanation 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

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

C) standard deviation. Explanation 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 investment can be expected to return 8%, using the rule of 72, what is the present value needed to have $50,000 for a child's education in 18 years? A) $2,777 B) $25,000 C) $6,250 D) $12,500

D) $12,500 Explanation Under the rule of 72, dividing 72 by the expected return shows the number of years it will take for a deposited sum to double. 72 divided by 8 equals 9 years. Over an 18-year period, there will be 2 doublings. So, dividing the future value ($50,000) by 4 solves for the present value required. LO 20.a

Which of the following bonds is most affected by interest rate risk? A) 7.5s of '34 yielding 7.2%. B) 7.8s of '37 yielding 7.3% C) 7s of '32 yielding 7% D) 7.6s of '41 yielding 7.2%

D) 7.6s of '41 yielding 7.2% Explanation Interest rate risk is the decline in market price due to rising interest rates. Because there is little difference in coupon rates, the bond with the greatest time to maturity (longest duration) will experience the greatest fall in a rising interest rate market. LO 20.b

When analyzing a security's standard deviation, which of the following statements accurately describes observations according to a normal frequency distribution curve? A) Approximately 97.5% of all observations will be within three standard deviations of the mean. B) Approximately 95.5% of all observations will be within three standard deviations of the mean. C) Approximately 97.5% of all observations will be within two standard deviations on either side of the mean. D) Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean.

D) Approximately two-thirds, or 68%, of observations will be within one standard deviation on either side of the mean. Explanation Approximately two-thirds, or 68.26%, of observations will be within one standard deviation on either side of the mean. Approximately 95% will be within two standard deviations and approximately 99% will be within three. LO 20.f

Your client has $10,000 to invest today and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. Which of the following is needed to determine whether the investment is likely to satisfy the client's goal? A) Present value B) Consumer Price Index C) Client's marginal federal income tax bracket D) Expected cost of college

D) Expected cost of college Explanation To determine whether the investment will satisfy the goal, the investment adviser representative needs to know the amount needed to pay for college. The information we have here will allow us to compute the future value: $25,181.70. This may not be enough to pay for even 1 year of college 12 years from now. LO 20.a

If your customer is pursuing an aggressive stock buying strategy, which of the following is most suitable for him? A) DEF stock with a beta coefficient of 0.93 B) Convertible bonds of a mid-cap company C) ABC stock with a beta coefficient of 1.0 D) GHI stock with a beta coefficient of 1.20

D) GHI stock with a beta coefficient of 1.20 Explanation Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive stock-buying strategies and have both the financial ability and the temperament to withstand downturns in the market. LO 20.e

All of the following statements about the price-earnings (P/E) ratio are true except A) a company's P/E ratio may also be called its multiple B) it is computed by dividing the current market price of the common stock by the earnings per share C) young, fast-growing companies generally have higher P/E ratios than mature, slower-growth companies D) a company's stock will have a relatively high P/E ratio if investors feel the company's earnings will grow slowly

D) a company's stock will have a relatively high P/E ratio if investors feel the company's earnings will grow slowly Explanation A company's P/E ratio, also called its multiple, may indicate investors' expectations about the company's earnings potential. A higher P/E ratio generally indicates that investors have high expectations for the company's future growth. Young, fast-growing companies generally have higher P/E ratios than mature companies. LO 20.h

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) property tax return. C) bank statements. D) income statement.

D) income statement. Explanation 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

An investor is considering the purchase of some bonds to diversify his portfolio. If he should decide to purchase Treasury STRIPS instead of Treasury Bonds, his major risk would be A) reinvestment risk B) purchasing power risk C) credit risk D) interest rate risk

D) interest rate risk Explanation Treasury STRIPS are zero-coupon bonds and, as such, have a longer duration than those paying semiannual interest. The longer the duration, the greater the interest rate risk. Because both are guaranteed by the U.S. government, there is no credit risk. Both have the same purchasing power risk, and there is no reinvestment risk with a zero-coupon bond. LO 20.b

Present value is a computation frequently used to determine the amount of deposit needed now to meet a future need, such as a college education. If an investor uses an expected return of 8%, but the actual return over the period is 6%, A) the accumulated value will meet the objectives B) the yield to maturity will be lower than anticipated C) the future value will not be able to be computed D) the present value was insufficient to meet the objective

D) the present value was insufficient to meet the objective Explanation Present value is the amount deposited to meet a future goal based on an expected rate of return. If the return is lower than expected, the amount deposited will not grow to the required amount (a bad thing). LO 20.a

The XYZ Corporation's income statement contains the following information: Total revenue $200,000 Cost of goods sold 60,000 Administrative expenses 30,000 Depreciation 10,000 Miscellaneous expenses 3,000 Taxes paid5,000 Based on this information, XYZ's gross profit is A) $140,000 B) $100,000 C) $97,000 D) $110,000

A) $140,000 Explanation Gross profit, or gross margin, is sales (or revenues) minus the cost of goods sold (COGS). When the depreciation expense relates to the equipment used directly in the production of the sales, it is included in COGS. In this question, there is no choice of $130,000 (which would include depreciation in COGS). Clearly, by not including that choice, NASAA is taking the position that depreciation is excluded from COGS. LO 20.h

A review of a corporation's financial statements reveals the following information: Net assets—$50 million Net revenues—$20 million Cost of goods sold—$14 million Depreciation—$1 million Interest—$1 million Long-term debt—$20 million Using the information, the gross margin for the year was A) 30% B) 25% C) 20% D) 53%

A) 30% Explanation The gross margin, or margin of profit, is usually expressed as a percentage. It is the operating profit remaining after subtracting the cost of goods sold from the revenues (sales), divided by those revenues. In this question, the cost of goods sold is $14 million, and that number includes the depreciation. Subtracting $14 million from $20 million results in an operating profit of $6 million, which is 30% of the $20 million in revenues. You might also see this referred to as pre-tax margin. Please note that, as with so many questions on the exam, there are extra numbers that have no relevance to the question. LO 20.h

Which of the following statements best represents a bond's present value? A) Present value is the sum of all the discounted future payments. B) Present value is the sum of all the discounted future interest payments. C) Present value represents the internal rate of return (IRR) of the bond. D) Present value is the discounted future repayment of principal.

A) Present value is the sum of all the discounted future payments. Explanation The correct answer is the standard "textbook" statement. There are two future cash flows from a bond. First is the periodic interest payments and second is the repayment of the principal at maturity. The PV of the bond is the sum of the discounted value of both. LO 20.a

Managers of bond portfolios who anticipate an increase in interest rates should A) decrease the portfolio duration B) assume higher risk in the secondary market C) increase the portfolio duration D) invest in high-yield or junk bonds

A) decrease the portfolio duration Explanation A bond portfolio manager who anticipates periods of rising interest rates should decrease the duration of a bond portfolio to minimize the price decline. Duration is inversely related to changes in market and coupon interest rates. LO 20.b

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) cannot be calculated without knowing the level of inflation C) is equal to its future value if the level of interest rates stays the same D) is the amount of goods and services the dollar will buy in the future at today's rate price level

A) indicates how much needs to be invested today at a given interest rate to equal a specific cash value in the future Explanation 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

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

A) the present value would be lower Explanation Try to follow me on this one. The present value computation is used to determine how much money must be deposited now (in the 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. As a simple example, if you need $100,000 in 18 years for your newborn's college education and you expect to earn 4%, using the rule of 72, you'll have to deposit $50,000 now (present value) to reach the goal. However, if it turns out that the earnings rate is higher than anticipated—say, 8%—you would only need to deposit half as much today ($25,000). Therefore, we answer this question by indicating that a higher rate of return will require a lower present value (deposit). LO 20.a

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) 19% B) 14% C) 8% D) 28%

B) 14% Explanation 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

An investor has created a laddered bond portfolio by placing $100,000 into zero-coupon bonds with maturities of 1, 5, 10, and 20 years. The average duration of this portfolio is approximately A) 7.5 years. B) 9 years. C) 22.9 years. D) 11.39 years.

B) 9 years. Explanation Because there is an equal face amount of each maturity, the average duration of the portfolio is the average of the duration of the 4 bonds. Because these are zero-coupon bonds, their duration is their maturity. The math is 1 + 5 + 10 + 20 = 36 divided by 4 or 9 years. LO 20.b

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 = 1.15%; the adviser outperformed the market by 1.15% B) Alpha = 0.78%; the adviser outperformed the market by 0.78% C) Alpha = 0.78%; the adviser underperformed the market by 2.72% D) Alpha = -1.21%; the adviser underperformed the market by 1.21%

B) Alpha = 0.78%; the adviser outperformed the market by 0.78% Explanation 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

Patrice has an investment portfolio with the following characteristics: Portfolio actual return: 9% Market actual return: 12% Portfolio standard deviation: 4% Market standard deviation: 7% Portfolio beta: 0.65 Risk-free rate of return: 3% What is her portfolio's alpha? Did her portfolio outperform the market on a risk-adjusted basis? A) With an alpha of -0.15%, her portfolio underperformed the market. B) With an alpha of 0.15%, her portfolio outperformed the market. C) With an alpha of 5.10%, her portfolio outperformed the market. D) With an alpha of -5.10%, her portfolio underperformed the market.

B) With an alpha of 0.15%, her portfolio outperformed the market. Explanation As with most computation questions, there is more than one way to arrive at the answer. Using the steps in the LEM (U10LO4), Alpha - (total portfolio return minus risk-free rate) minus (portfolio beta times [market return minus risk-free rate]). Plugging in the numbers, we have (9% - 3%) - (.65 times [12% minus 3%]) = 6% - (.65 x 9%) = (6% - 5.85% = 0.15% An alternative method simply moves the parentheses a bit. If this is easier for you, use it. Alpha = 9% − [3% + 0.65 (12% − 3%)] = 9% - [3% + .65 (9)] = 9% - (3% + 5.85) = 9% - 8.85 = 0.15%. A positive alpha indicates that the portfolio outperformed the market on a risk-adjusted basis. Did you notice that the standard deviation was irrelevant to our computation? It is not unusual for the exam to include information that is extraneous to the question just to confuse you. LO 20.e

A measurement of investment return that takes the time value of money into consideration is A) holding period return B) internal rate of return (IRR) C) risk-adjusted rate of return D) real rate of return

B) internal rate of return (IRR) Explanation The internal rate of return compounds returns and takes into consideration the time value of money. Real rate of return considers the inflation rate and risk-adjusted return is another way of stating the Sharpe ratio. LO 20.a

A stock's beta coefficient is a measure of the stock's A) institutional ownership relative to outstanding shares B) volatility relative to the market C) profitability relative to its group D) consistency of its dividend payment

B) volatility relative to the market Explanation Beta measures a stock's volatility relative to the overall market. A beta above 1 indicates a more volatile stock, while a beta below 1 describes a stock less volatile than the market. LO 20.e

Use the following chart to answer this question: STOCK: 50% 30% 10% 0% BONDS: 50% 70% 90% 100% High return:39.4% 37.2% 34.3% 32.7% Low return: 1.4% 6.5% 7.2% 8.5% Ave. return: 15.8% 16.2% 15.5% 15.2% Std. Dev: .11.25 10.75 10.15 10.34 Which portfolio mix would you recommend to a client who is most concerned about projected near-term volatility? A) 50%/50% B) 100%/0% C) 10%/90% D) 30%/70%

C) 10%/90% Explanation Although this might look complicated, this is very simple if you realize that standard deviation is the measure of volatility. So, just pick the allocation with the lowest standard deviation and that is the 10%/90% at 10.15. LO 20.f

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

C) 20-year zero-coupon Treasury bond currently trading at a deep discount Explanation 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

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 known maturity date. B) the availability of ratings. C) the predictability of income. D) the priority of claim on earnings.

C) the predictability of income. Explanation 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

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

C) time to maturity. Explanation 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

An analyst would use the discounted cash flow method in an attempt to find A) the current rate of return of a security. B) the cash flow from operations. C) the current market price of a security. D) the fair value of a security.

D) the fair value of a security. Explanation DCF uses the present value of future cash flows, based on a specified discount (interest) rate, to evaluate the price that a security should be selling for in the market. If the current market price of the security is less than this value, it has a positive net present value (NPV) and should be a good investment. The opposite is true if there is a negative NPV (the market price is higher than that computed under the DCF method). LO 20.c