Series 66 - Unit 3 (Session 11, 12, 13)
If the present value of a bond is $600 and it can be purchased for $565. What is the NPV?
$35 and it should be an attractive investment
A bond is maturing in exactly 1 year. With a discount rate of 10%, which of the following prices will result in an NPV of zero? -$900.00 -$909.09 -$910.00 -$890.00
$909.09 When the price plus 10% interest over the year equals $1,000, the NPV is zero. So, simply take each of the 4 choices and multiply it by $110%. The correct choice comes out to $999.99, which rounds to the $1000 we are looking for.
Acid Test or Quick Ratio
(Current Assets - Inventory) / Current Liabilities Example: 2.5M / 1M = 2.5:1 What does it tell you--> The acid-test or quick ratio, compares a company's most short-term assets to its most short-term liabilities to see if a company has enough cash to pay its immediate liabilities, such as short-term debt. Companies with an acid-test ratio of less than 1 do not have enough liquid assets to pay their current liabilities and should be treated with caution.
How to compute Alpha
(total portfolio return - Risk free rate) - (portfolio beta * [market return - risk free rate]) basically, we are comparing performance after eliminating the risk-free rate.
ABC Industries common stock has a beta of .8 while DEF Technologies commons stock has a beta of 1.2. The total return for ABC was 15% and that for DEF was 24.5. Based on this information, you could say that DEF had alpha of: Summary: ABC Beta - .8 Return - 15% DEF Beta - 1.2 Return - 24.5
+2% 1.2/.8 = 1.5 With a beta of 1.2, DEF should produce a total return that is 1.5 times greater than that of ABC. Therefore, anything in excess of 22.5% (1.5 x 15%) would create a positive alpha and anything less would generate negative alpha. In this example, the actual return of 24.5% is 2% greater than what would be expected and that is our positive alpha
Over the past 5 years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. The mid-range value of this stock's return is:
+6.0% The range of a stock's performance is the low to the high, in this case, -4% to +16%. The mid-range is that number exactly in the middle of the range. With a range of 20 points, the midpoint is going to be the high minus 10 or the low plus 10. +6% is 10 points higher than the low and 10 points lower than the high.
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 with the range of:
-1% and +23% 95% of the time a stock will range within 2 standard deviations of its historical return. 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%
Short-Term assets
-Accounts receivable -marketable securities -Cash
What are the 2 main components of the price-to-earnings ratio?
-Current market price -earnings per common share
Defensive stocks are those in:
-Food -Pharmaceuticals -Energy -tobacco Public consumption of such good remains fairly steady throughout the business cycle.
What does the computation of book value per share take into consideration?
-Goodwill -Long-term debt -Retained earnings -Par value of the preferred stock
What are the 4 most important facts of Internal Rate of Return (IRR)?
-It is the discount rate that makes the future value of an investment equal to its present value. -In order to compute, it is necessary to know the initial cost of the investment -In order to compute, it is necessary to know the cash flow of the investment -It is equivalent to a bond's yield to maturity.
What investment is an inflation hedge?
-Real Estate -Commodities -Common Stock
Current assets include
-cash -accounts receivable -inventory
An indvidiual made an investment of $1,000 eight years ago. Today, with no additional funds added, the account has a value of $4,000. Using the rule of 72, the approximate compounded annual rate of return would be closest to:
18% Remember, in this case, the investment has quadrupled, or doubled twice. Therefore, we compute the rate for the investment to double in 4 years, 2 times; 72 divided by 4 years is 18%
XYZ Corporation has a beta of 1 and ABC has a beta of 1.4 XYZ has returned 12% and ABC 18.8% Based on this information ABC had alpha of?
2% Because XYZ with a beta of 1.0 gained 12%, ABC should return 140% of that or 16.8% (12% x 1.4). With an actual return of 18.8%, ABC beat the expected by 2% and that is its alpha.
An analyst is viewing a subject company's financial statements. She notices that the company has current assets of $20 million, fixed assets of $50 million, and total liabilities of $45 million (of which $10 million is considered long-term). This company's debt to equity ratio is
28.6% Debt to Equity Ratio is calculated by: the issuer's long-term debt divided by their total capitalization. 10 M in LT debt / (70 M - 45M) + 10 M LT Debt 10M LT Debt / 35M Total Capitalization = 28.6%
Over the past 5 years, a stock has had returns of +16%, +5%, -4%, +12% and +8%. This results in an arithmetic mean of?
7.4% 37/5 Don't forget the negative
What is Standard Deviation?
A measure of volatility of an investment's projected returns, computed by using historical performance data. It is a statistical term that measures the amount of variability or dispersion around an average. Basically, the higher the the standard deviation, the greater the risk, volatility, and it has deviated far greater from the average for that security
Do banks charge a nominal rate or a real interest rate?
A nominal rate
When investors tend to increase their investments in debt securities into those on the short end of the spectrum, it generally leads to:
A positive yield curve Because, when investors buy short-term debt rather than long-term debt, prices of short-term instruments are driven up and, as a result, their yields are down. This will give us the normal, or positive, yield curve.
When there is a combination of recession and deflation in the economy, What investment would the clients appreciate most?
A security with the highest safety, such as U.S. Treasury Bonds
The common stock of companies within which industry sector would be most adversely affected by an increase in the general level of interest rates? A) The public Utilities industry B) The food industry C) The electronics industry D) The clothing industry
A) Public utilities are generally very heavily funded with debt. If interest rates go up, their new debt will be at higher interest rates, causing lower earnings available for common stocks.
The trick for calculating the acid test ratio?
Also known as the quick ratio. You want to keep all your assets safe from the acid, especially the inventory, so current assets (because acid acts quickly) - inventory then divided by current liabilities.
What is Alpha?
Basically, this means that their investment performance is better than what would have been anticipated, given the risk in terms of volatility that was taken.
What is the difference between Beta and Standard Deviation?
Beta measures the risk (and/or Systematic risk) of the market as a whole Standard Deviation measures the risk of individual stocks.
An investment adviser is analyzing 4 bonds of similar quality for a client. Bond A has a coupon of 6%, matures in 12 years, and is currently priced at 50. Bond B has a coupon of 8%, matures in 9 years, and is currently priced at 50. Bond C has a coupon of 4%, matures in 18 years, and is priced at 45. Bond D has a coupon of 12%, matures in 6 years, and is priced at 50. Based on NPV, which of these bonds represents the better value? A - 6% in 12 at 50 B - 8% in 9 at 50 C - 4% in 18 at 45 D - 12% in 6 at 50
Bond C Because you don't have the proper calculator to do a real PV calculation, NASAA expects you to use the rule of 72. Remember, under that rule, dividing 72 by the interest rate tells you the number of years it will take for a deposit to double. Or, if you divide 72 by the number of years, it will tell you the interest rate required for a present deposit to double. Finally, a positive NPV is when you can buy the bond for less than its present value. So, let's look at all 4 choices. Bond A, at 6%, takes 12 years to double. That's exactly the time to maturity, so the PV of this bond should be approximately $500 (a quote of 50). The same is true of bonds B and D—their PV should be approximately $500 (72 ÷ 8% = 9 years; 72 ÷ 12% = 6). Because their price is the same as the PV, the NPV is zero. However, with bond C, 72 divided by 4% equals 18 years, so this bond also has a PV of approximately $500 (50), but it can be purchased for less than that: 45 ($450). Therefore, with an NPV of $50, bond C is the best value.
Out of the following which is borrowed money? -preferred stock -warrants -common stock -bonds
Bonds
Long-Term Liabilities
Bonds, convertible or not issued by the corporation
How do you measure the risk-reward return of an equity security?
By its standard deviation.
Which portfolio mix would you recommend to a client who is most concerned about projected near term volatility... So really which factor in each portfolio is the most important for the above concern about short term volatility?
Choose the allocation with the lowest standard deviation. Standard Deviation is the measure of volatility
What is working capital
Current assets - current liabilities (a current liability is payable within 12 months).
What is Working Capital?
Current assets minus current liabilities. The net of the above implies the company has cash availability of the remainder with which to work The amount of money a corporation has available to work with if it liquidates its current assets and pays off all of its current liabilities.
A portfolio manager with a growth style would probably diversify by: A) concentrating in stocks in one or two industries. B) placing a portion of the portfolio into high yield bonds. 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 Some 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.
ABC commons stock and the XYZ real estate investment trust (REIT) have a correlation of -.5. Assuming the stock rises in price by 10%, the REIT should:
Decline by 5% When securities are correlated they move in the same direction. Since their is negative correlation the securities will move in opposite direction.
The research department of an investment advisory firm forecasts that the current business cycle should reach its peak within the next 2 months. Under such circumstances, which of the following portfolio adjustments would be most suitable for the firm's customers who actively invest in common stocks?
Defensive stocks The concept of sector rotation involves moving assets from those sectors that are close to their peak and moving into those who will benefit from the next move in the business cycle. Defensive stocks such as pharmaceuticals, energy industries would most likely be suitable for investors who believe the cycle is near its peak.
Debt to Equity Ratio
Divide the issuer's long-term debt by their total capitalization. it should be called the debt to total capital ratio, but probably will not be shown that way on the exam. The ratio is used to evaluate a company's financial leverage. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds.
Your client has $10,000 to invest and expects to earn an after-tax return of 8% to send his daughter to college in 12 years. which of the following items will help determine whether the investment is likely to satisfy the client's goal? -Expected cost of college -Present value -Consumer Price Index -Client's marginal federal income tax bracket
Expected cost of college
What is a hedge against inflation?
Gold and most other commodities
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?
Has a zero net present value. If the market is efficiently pricing that bond, its market price should be equal to its present value, resulting in an NPV of zero.
Intrinsic value definition
In fiance, intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value. It is frequently called fundamental value.
If a client approaches you about a method for providing an annual income "forever" for a relative or charity. What is that method known as?
Income in Perpetuity
A bond's yield to maturity reflects its ?
Internal rate of return.
What is NPV?
Is the difference between an investment's present value and its cost. The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost. If the NPV is above zero then it's a good investment. It is always expressed in monetary units.
If the Alpha is negative, How did the portfolio do in the market?
It Underperformed
When a bond can be purchased for less than its present value, what kind of NPV does it have?
It has a positive NPV
What is leverage?
It is the use of borrowed money.
If the Alpha is positive, How did the portfolio do in the market?
It outperformed the market
Price to earnings ratio does what?
It shows how much investors value the stock as a function of earnings to the company's market price.
Are convertible bonds LT or ST liabilities?
Long-Term
What is Systematic risk?
Market risk. large scale economic events that typically affect all companies
Is Portfolio 3 & 4 with a correlation coefficient of +0.20 well diversified?
NO If two portfolios have high correlation coefficient, it means that their performance will be similar.
Is equipment a current asset?
NO it is a fixed asset
Can IRR easily be calculated for investments with uneven cash flows?
NO.
Does a Zero-coupon bond have any reinvestment risk?
NO.
Can the geometric mean ever be greater than the arithmetic mean?
NO. It can be the same or lower, but never higher.
Does a high(or positive) degree of correlation mean that the portfolio is well diversified?
NO. It means the that a portfolio is not well diversified.
Does the debt/equity ratio measure the liquidity of a corporation?
NO. The Debt/equity ratio is a capitalization ratio and It measures the amount of leverage compared to equity in a company's overall capital structure. When that ratio is higher than industry standards, it is said that the company is highly leveraged.
Does real estate (both residential and commercial) preform well during deflation?
NO. it usually under performers.
Is the real rate of interest the actual interest a bank charges?
NO. The real rate of interest is the nominal rate minus the inflation rate. Banks charge a nominal rate rather than a real interest rate.
If an investment has an IRR that is less than the required rate of return, what is the NPV?
Negative
Does a balance sheet show income or other expenses?
Neither. A balance sheet, whether for a family or a business, shows assets and liabilities, not income and expenses.
what measures the time value of money plus investors' expectations about future prices of inflation?
Nominal of interest
Current Liabilities
Obligations that a company expects to pay within the next year or operating cycle, whichever is longer. Example: -Accounts payable -wages payable -dividends payable -Short-term debt
The combination of recession and deflation leads us to what kind of security?
One with the highest safety A fixed investment because there purchasing power will increase. Example: U.S. Treasury Bonds
One measure of a corporation's intrinsic value is its book value per share. When performing this computation, the value of which of the following would normally be subtracted from the corporations net worth? -Cash -Wages payable -Patents -Preferred stock
Patents and Preferred Stock The computation of book value per share is basically net tangible worth per share of common stock. Therefore, we subtract both the par value of the preferred stock and the value listed on the balance sheet for the intangible assets, such as patents
The Correlation coefficient ranges from _________________________ and reveals what?
Ranges from -1.0 to +1.0 and reveals the degree to which two or more variables relate to each other.
From the following four portfolios, choose the one that would generally be considered to be the most diversified? JKL common stock, beta 1.50, correlation to the S&P 500, +.77; MNO common stock, beta 1.00, correlation to the S&P 500, +.93, PQR common stock, beta .50, correlation to the S&P 500, +.34. DCB common stock, beta 1.00, correlation to the S&P 500, +.75; HGF common stock, beta .10, correlation to the S&P 500, +.25; KJI common stock, beta -.50, correlation to the S&P 500 +.50. STU common stock, beta .95, correlation to the S&P 500, +.84, VWX common stock, beta .90, correlation to the S&P 500, +.07; YZA common stock, beta .88, correlation to the S&P 500, -.45. ABC common stock, beta 1.20, correlation to the S&P 500, +.82; DEF common stock, beta .90, correlation to the S&P 500, +.91; GHI common stock; beta +.65, correlation to the S&P 500, +.06.
STU common stock, beta .95, correlation to the S&P 500, +.84, VWX common stock, beta .90, correlation to the S&P 500, +.07; YZA common stock, beta .88, correlation to the S&P 500, -.45
book value per share
Subtract both the par value of the preferred stock and the value listed on the balance sheet for the intangible assets, such as patents from the corporations net worth. The computation of book value per share is basically net tangible worth per share of common stock.
Which investment is the most traditional example of an investment with a beta of zero?
The 90-day T-bill
What does a correlation coefficient of zero tell you?
The Actual return of one security tells you nothing about the return of the other. They may move in the same or opposite directions.
In a present value computation, do you determine the future value or the present value?
The Present Value. i.e. 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.
What does a beta of zero mean?
The Security is a risk free investment
Total Capitalization
The companies Net worth (assets minus liabilities) + long term debt.
What is net present value?
The difference between the sum of the discounted cash flows that are expected from an investment and its initial cost.
What is alpha?
The extent to which a security's performance exceeds (or falls short of) what would be expected based on its beta.
What do they call a earnings rate required to reach a specified future value from an amount that is currently available to invest?
The internal rate of return.
What is the real rate of interest?
The nominal rate minus the inflation rate.
What does a standard deviation of 7.5% mean?
The return of a stock for a given period may vary by 7.5% above or below its predicted return about two-thirds of the time and within 15% about 95% of the time.
How is a stock with a beta of 1.4 expected to return relative to the market?
The stock would be expected to perform 40% better in an up market than one with a beta of 1.0
What does the nominal rate of interest measure?
The time value of money plus investors' expectations about future prices or inflation. The best known use of the term "nominal rate" is a bond's coupon rate.
What is financial Leverage?
The use of debt capital
What happens to fixed investments during times of deflation?
Their purchasing power will increase.
If the market is efficient what does that mean about the market price and the present value? What kind of NPV does this produce?
They are equal. A equal NPV, which results in a zero.
How do companies (portfolios) with a beta of 1.0 move compared to the market.
They would be expected to move in tandem with the market.
What does beta measure?
Volatility or systematic risk, of a security or a portfolio in comparison to the market as a whole.
What provides the greatest portfolio diversification?
When there are some holdings with a negative correlation.
Are marketable securities of other companies included in the calculation of working capital?
YES.
Does the Internal Rate of Return equate the cost of an investment to the cash flows produced by that investment
YES.
Can diversification mitigate unsystematic risk?
YES. Think, because of the word unsystematic, they market is not in a normal flow and you will need diversification to succeed
A bond is paying $100 per year in annual interest and is selling at par. If the discount rate is 10%, the net present value is?
Zero A bond paying $100 in interest per year has a coupon rate of 10%. Whenever the coupon rate is equal to the discount rate, the NPV is zero. That is, the present value of a bond paying 10% interest when the current market rate is demanding a 10% interest rate is the bond's par value (as is the case with this bond)
A fixed-income investor notices that the short, intermediate, and long ends of the yield curve reflect a similar return this would be typical of??
a flat yield curve because regardless of the maturities, all of the yields are the same.
Current Ratio
current assets divided by current liabilities It is a liquidity ratio that measures a company's ability to pay short-term obligations or those due withing one year.
An analyst attempting to determine the extent to which financial leverage is being employed by a company would examine the company's:
debt-to equity ratio
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?
has a negative net present value 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. Any time that occurs, the instrument has a negative net present value (the difference between the price and the present value).
As the correlation between any two assets decreases:
the benefits of diversification increase One of the best ways to increase the benefits of portfolio diversification is to add assets that negatively correlated?
How do you calculate Range?
the difference between the highest and the lowest. Take note of negatives.
