Unit 10 - Analytical Methods
Which of the following statements regarding the time value of money is NOT correct? A) Future value is the future amount to which a sum of money today will increase on the basis of a defined interest rate and period. B) Compound interest is interest earned on the initial investment. C) Compound interest is interest earned on interest. D) Future value of an ordinary annuity is the future amount to which a series of deposits of equal size will increase.
B) Compound interest is interest earned on the initial investment.
The rate that produces a net present value of a series of discounted cash flows equal to zero is called A) the return on investment (ROI). B) the internal rate of return (IRR). C) the average rate of return. D) the opportunity cost of investing.
B) the internal rate of return (IRR).
Which of the following statements best describes the risk-free rate of interest? A) The rate of interest required to produce a net present value (NPV) of zero B) The rate of interest in excess of the pure time value of money C) The rate of interest earned on the 91-day U.S. Treasury bill D) The arithmetic mean of the CPI over the past 12 months
C) The rate of interest earned on the 91-day U.S. Treasury bill
A wealthy client wishes to endow her favorite charity with a lump-sum gift that, with an assumed rate of return of 4% per annum, will provide $2,500 per month in perpetuity. What amount does the client need to deposit? A) $750,000 B) $1,000,000 C) $100,000 D) $75,000
A) $750,000 A monthly income of $2,500 is equal to $30,000 per year. At a 4% earning rate, $750,000 must be deposited to generate that amount (30,000 ÷ 4%).
ALFA Enterprises pays a quarterly dividend of $0.15 and has earnings per share of $2.40. Assuming that payout rate is continued, what is the dividend payout ratio? A) 25% B) 30% C) 14.4% D) 6.25%
A) 25% Earnings per share are typically calculated for a year. If the quarterly dividend rate of $0.15 is continued, that will be an annual payout of $0.60 ($0.15 × 4). So the annual dividend of $0.60 is divided by $2.40 to calculate what percentage of earnings is paid as a dividend; or rather, the dividend payout ratio (0.60 ÷ 2.40 = 25%).
Which of the following statements is correct? A) Beta is a measure of relative systematic risk for stock or portfolio returns. B) Portfolio managers have a goal of reaching zero alpha. C) Beta is a measure of relative unsystematic risk for stock or portfolio returns. D) A stock or portfolio's beta increases as its alpha declines.
A) Beta is a measure of relative systematic risk for stock or portfolio returns.
If a corporation has a dividend payout ratio of 70%, the undistributed earnings will A) increase retained earnings B) increase earnings per share C) increase capital surplus D) decrease book value
A) increase retained earnings Retained earnings represent income that has not been paid out to shareholders.
Investment risk may broadly be categorized as either unsystematic or systematic risk; both types of risk together constitute total, or absolute, risk. Total risk is measured by A) standard deviation B) beta coefficient. C) correlation coefficient. D) opportunity cost.
A) standard deviation
When it comes to computing market returns, it is TRUE to state that A) the geometric mean could never be greater than the arithmetic mean B) the median is always higher than the geometric mean C) the median is always lower than the average D) the mode is always higher than the mean
A) the geometric mean could never be greater than the arithmetic mean
Over the past 5 years, a stock has had returns of +16%, + 5%, −4%, +12% and +8%. This results in an arithmetic mean of A) 9.0% B) 8.0% C) 8.2% D) 7.4%
D) 7.4%
An investment adviser representative is researching a security and notices that its beta is zero. Which of the following securities is probably the subject of that research? A) A public utility stock B) A 5-year U.S. Treasury note C) An ETF tracing the index of gold stocks D) A 91-day U.S. Treasury bill
D) A 91-day U.S. Treasury bill
Dividend payments are not a part of the computation for which of the following risk measurement tools? A) Dividend discount model B) Dividend growth model C) Net present value D) Correlation coefficient
D) Correlation coefficient
The future value of an invested dollar is dependent on I. the exchange rate of the dollar at the beginning and end of the period II. interest rate at maturity III. the rate of return it earns IV. the time period over which it is invested A) II and III B) I and III C) I and II D) III and IV
D) III and IV
Using the net present value method, a potential investment should be undertaken if the present value of all cash inflows minus the present value of all cash outflows (which equals the net present value) is A) positively correlated B) equal to zero C) less than zero D) greater than zero
D) greater than zero NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a proposed investment is positive, it should be accepted. However, if NPV is negative, the investment should probably be rejected because cash flows will also be negative.
When a company's debt-to-equity ratio is higher than typical for that industry, it might be said that the company is A) highly profitable B) about to increase their dividends C) suitable for a conservative investor D) highly leveraged
D) highly leveraged
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 A) the same as the coupon B) positive C) negative D) zero
D) 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).
Which of the following statements is most accurate regarding the net present value (NPV) and internal rate of return (IRR) on a bond? A) NPV assumes the cash flows can be reinvested at market interest rates. B) NPV assumes that cash flows can be reinvested at the bond's IRR. C) IRR assumes the cash flows are reinvested annually. D) IRR assumes the cash flows are reinvested at market interest rates.
A) NPV assumes the cash flows can be reinvested at market interest rates.
If you were using the discounted cash flow method to determine the appropriate value of a security, you would want to purchase that security when A) the current market price is below the PV B) the current market price is above the PV C) the current market price equals the PV D) the rating of the security has just been upgraded
A) the current market price is below the PV
Which of the following items would be included in a current ratio computation? A) Accounts receivable, inventory, and long-term debt B) Accounts payable, wages payable, and short-term debt C) Cash, dividends payable, and shareholders' equity D) Inventory, equipment, and cash
B) Accounts payable, wages payable, and short-term debt
In a rising market, which of the following is least volatile? A) A stock with an alpha of 2.0 B) A stock with a beta of 2.0 C) A stock with a beta of 0.5 D) A stock with an alpha of 0.5
C) A stock with a beta of 0.5
A bond's yield to maturity reflects its A) taxable equivalent return B) nominal return C) return based on annual interest as a percentage of current price D) internal rate of return
D) internal rate of return
A measurement of investment return that takes the time value of money into consideration is A) real rate of return B) holding period return C) risk-adjusted rate of return D) internal rate of return (IRR)
D) internal rate of return (IRR)
While searching for a suitable investment for your client, you narrow the choice to the following four companies. Company A with returns over the past 4 years of: 12%, 4%, 8%, 6% Company B with returns over the past 4 years of: 7%, 8%, 9%, 6% Company C with returns over the past 4 years of: 10%, 12%, −2%, 10% Company D with returns over the past 4 years of: 15%, 20%, −8%, 3% A) Company D B) Company B C) Company C D) Company A
A) Company D Although the exam will not ask you to compute standard deviation, you are required to know that it measures the deviation from the mean (average). In all 4 of these examples, the mean is 7.5% (30 divided by 4). In which of the choices do the returns occur furthest from that mean? In choice D, they range from 12.5% higher to 15.5% lower. In choice A, the range is from 4.5% higher to 3.5% lower; in choice B, from 1.5% higher to 1.5% lower; in choice C, from 4.5% higher to 9.5% lower. That should clearly point out that the greatest volatility, or dispersion from the mean is choice D while choice B would have the lowest standard deviation.
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) ABC stock with a beta coefficient of 1.0 C) GHI stock with a beta coefficient of 1.20 D) Convertible bonds of a mid-cap company
C) GHI stock with a beta coefficient of 1.20
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) $12,500 C) $6,250 D) $25,000
B) $12,500 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.
An agent is analyzing the financial statements of a corporation. The company has cash on hand of $2 million, accounts receivable of $500,000, accounts payable of $700,000, land valued at $3 million, wages payable of $300,000, goodwill of $100,000, inventory of $1.5 million, and retained earnings of $5 million. From this information, the agent would determine that the acid-test ratio for this company is A) 3.375:1 B) 2.5:1 C) 1:1 D) 4:1
B) 2.5:1 The acid-test, or quick, ratio is all of the current assets, except for inventory, divided by the current liabilities. The non-inventory current assets are the cash on hand and the accounts receivable. The current liabilities are the accounts payable and wages payable. This results in a calculation of $2.5 million divided by $1 million, or 2.5:1.
An investor places $10,000 into BCD common stock 12 years ago. Today, that stock has a market value of $20,000. Using the Rule of 72, the internal rate of return on BCD is closest to A) 8%. B) 6%. C) 5%. D) 6.8%.
B) 6%. The Rule of 72 indicates that the approximate return required for a number to double in 12 years can be determined by dividing 72 by 12. That results in a return nearest to 6
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 will move independently of each other. C) These stocks are well diversified because as one stock appreciates in value, the other decreases in value. D) These stocks are not well diversified because they move in unison.
B) These stocks will move independently of each other.
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 A) will be selling at a discount from par B) has a zero net present value C) has a negative net present value D) has a positive net present value
B) has a zero net present value With a discount rate of 5% (the discount rate in a present value computation is the current market interest rate), a debt instrument with a 7% coupon rate will be selling at a premium (interest rates down, prices up). If the market is efficiently pricing that bond, its market price should be equal to its present value, resulting in an NPV of zero.
There are several measures of central tendency used by investment analysts. Included would be all of the following EXCEPT A) mean B) moving averages C) mode D) median
B) moving averages
To make a quantitative evaluation using the present value computation, which of the following is NOT needed? A) Anticipated rate of return of the portfolio B) Time period involved C) Account value at the beginning of the period D) Account value at the end of the period
C) Account value at the beginning of the period
Which of the following purchases is most suitable for an investor pursuing an aggressive investment strategy? A) LMN stock with a beta of -0.6 B) DOH stock with a beta coefficient of 0.7 C) GHI stock with a beta coefficient of 1.3 D) AMF stock with a beta coefficient of 1.0
C) GHI stock with a beta coefficient of 1.3 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 investment strategies.
Assume Frank has a portfolio with an actual return of 10.50% for the past year. The portfolio beta equals 1.25, the return on the market equals 9.75%, and the risk-free rate of return equals 3%. Based on this information, what is the alpha for Frank's portfolio and did it out outperform or underperform the market? A) +9.1875%, outperform B) +3.3750%, outperform C) −0.9375%, underperform D) −1.6875%, underperform
C) −0.9375%, underperform
Of the 4 pairs of assets below, which pair provides the highest level of diversification? A) Assets 5 & 6: with a correlation coefficient of 0 B) Assets 7 & 8: with a correlation coefficient of −0.88 C) Assets 3 & 4: with a correlation coefficient of +0.47 D) Assets 1 & 2: with a correlation coefficient of +0.94
B) Assets 7 & 8: with a correlation coefficient of −0.88 The highest level of diversification will occur when the correlation coefficient is closest to −1.
An analyst viewing a corporate income statement will be able to review all of the following except A) net sales or net revenues. B) operating expenses. C) pre-tax income. D) current ratio.
D) current ratio. Current ratio is a balance sheet computation involving current assets and current liabilities. All of the other items relate to income and expenses, items found on an income statement.
A portfolio manager considers adding an asset to the portfolio. The manager decides between 4 equally-risky assets: W, X, Y, and Z. The correlations of each asset with the portfolio are: Asset W +0.90 Asset X +0.80 Asset Y +0.40 Asset Z +0.20 To achieve the optimal diversification benefits, which of the assets should be selected by the manager? A) Asset X B) Asset W C) Asset Z D) Asset Y
C) Asset Z Correlation runs from + 1.0 to - 1.0. A the higher the correlation, the more the securities move in tandem. That lessens the diversification. The reverse is true when the correlation is low or negative. Asset Z has the lowest correlation with the portfolio and will therefore provide the largest reduction in portfolio risk. Even better diversification would be obtained if there was a choice with a negative correlation.
Bond X has an internal rate of return (IRR) of 7%. Bond Y has an IRR of 9%. Both bonds pay interest semiannually. If the required rate of return is A) 7%, the net present value (NPV) of Bond X will exceed the NPV of Bond Y. B) 9%, both bonds will have a positive NPV. C) 9%, the net present value (NPV) of Bond X will exceed the NPV of Bond Y. D) 7%, the net present value (NPV) of Bond Y will exceed the NPV of Bond X.
D) 7%, the net present value (NPV) of Bond Y will exceed the NPV of Bond X. We know that when a bond's IRR equals the required rate of return (the discount rate), the NPV of that bond is zero. That is the case with Bond X when the required rate of return is 7%. When the bond's IRR is above the required rate of return, it has a positive NPV. That is the case with Bond Y whose IRR is higher than the 7% required return. With a required return of 9%, Bond X has a negative NPV and Bond Y's NPV is zero. That is the technical explanation. The simple explanation is to compare the IRR with the required rate of return. Anytime the IRR is above the required rate, you've got a good deal (and that is what a positive NPV tells us).
A corporation calls in a portion of its long-term debt at 101. This will have the effect of I. decreasing working capital II. increasing working capital III. decreasing net worth IV. increasing net worth A) II and IV B) II and III C) I and IV D) I and III
D) I and III Working capital is computed by subtracting current liabilities from current assets. Using a current asset, like cash, to call in the bonds, reduces those assets with no corresponding reduction to current liabilities. Whenever a bond is called at a premium, net worth is reduced by that premium.
Which of the following securities has an easily determinable internal rate of return? A) 6% Ginnie Mae B) 5% municipal bond C) 7% corporate bond D) Zero-coupon bond
D) Zero-coupon bond The only security that does not have reinvestment risk (the risk that periodic interest payments cannot be reinvested at the same yield as the bond providing the interest payments) is a zero-coupon bond such as Treasury STRIPS. With a zero-coupon bond, there are no periodic interest payments to reinvest, so a yield can be locked in. The interest rate that discounts the redemption price (par) to the discounted purchase price is the locked-in yield, which is the same as the internal rate of return, also referred to as the yield to maturity.
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) will be selling at a premium over par B) has a zero net present value C) has a positive net present value D) has a negative net present value
D) 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. Anytime that occurs, the instrument has a negative net present value (the difference between the price and the present value).
