Quiz 3 - Preview

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1.

There is no risk in a world of certainty.

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2.

Realized returns frequently differ from expected returns.

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3.

The larger the standard deviation of an investment's return, the larger is the investment's risk.

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4.

Beta coefficients and standard deviations may be used as indicators of risk.

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5.

A beta of 1.0 indicates that the stock's price is stable.

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6.

Retained earnings represents the earnings accumulated by the firm over its life.

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7.

Accounts receivable are adjusted for doubtful accounts (i.e., accounts that may not be paid).

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8.

An increase in accounts payable is a cash outflow.

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9.

The DuPont system combines liquidity and earnings.

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10.

The owners of a corporation elect the board of directors.

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11.

Federal income taxes favor the retention of earnings over the distribution of earnings.

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12.

If a firm does not pay cash dividends, it may reinvest the earnings and grow.

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13.

Persons owning stock on the day a dividend is declared receive the dividend.

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14.

Valuation of stock depends on past dividends.

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15.

An increase in the required return will tend to increase the value of a stock.

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16.

The value of a common stock depends in part on the expected growth in dividends.

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17.

The document stating the terms of a bond is the indenture.

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18.

Many bonds have a call feature, which permits the firm to retire the bonds prior to maturity.

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19.

If interest rates rise after a bond is issued, the yield to maturity will exceed the current yield.

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20.

The current yield and yield to maturity are equal when the bond is initially sold for its face value.

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21.

An investor may anticipate that a bond will be called if interest rates have risen.

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22.

Since bonds pay a fixed amount of interest, their prices do not fluctuate.

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23.

If a stock increased from $25 to $50 in five years, the annual rate of return was 20 percent.

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24.

Realized returns include both dividends and price changes.

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25.

The calculation of a rate of return assumes dividend income is reinvested at the current dividend yield.

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26.

The shares of closed-end investment companies are bought and sold in secondary markets like the
NYSE.

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27.

Investments in mutual funds reduce the systematic risk associated with investing in stocks.

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28.

A "no load" fund is a mutual fund with no fees.

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29.

An index fund seeks to duplicate an index of the market such as the S&P 500 stock index.

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30.

U.S. mutual funds may not hold foreign securities.

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Multiple Choice
Identify the choice that best completes the statement or answers the question.

31.

A diversified portfolio
a.

increases systematic risk

b.

reduces systematic risk

c.

increases unsystematic risk

d.

reduces unsystematic risk

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32.

The risk associated with dispersion around an expected value (e.g., expected return) is measured by the
a.

beta coefficient

b.

range (i.e., high-low values)

c.

standard deviation

d.

debt to total assets (i.e., the debt ratio)

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33.

Systematic risk
1.

is the tendency for a stock's return and the return on the market to move together

2.

is reduced by constructing a diversified portfolio

3.

depends on the firm's business and financial risk

4.

is measured by beta coefficients

a.

1 and 2

b.

2 and 3

c.

1 and 4

d.

2 and 4

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34.

Which of the following will reduce the required return on an investment?

a.

an increase in beta and a reduction in the Treasury bill rate

b.

an increase in the Treasury bill rate and a decrease in beta

c.

a decrease in the Treasury bill rate and a decrease in beta

d.

an increase in the Treasury bill rate and an increase in beta

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35.

An investor may reduce risk by

1.

selecting low beta stocks

2.

constructing a diversified portfolio

3.

selecting high beta stocks

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 1

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36.

Which of the following is a cash outflow?

a.

a new issue of bonds

b.

a decrease in accounts receivable

c.

an increase in plant

d.

an increase in accounts payable

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37.

Current assets include

a.

plant

b.

inventory

c.

equipment

d.

additional paid-in capital (capital surplus)

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38.

Determination of earnings (profits) requires knowing

a.

paid-in capital (capital surplus)

b.

cash

c.

retained earnings

d.

depreciation

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39.

Which of the following is a cash outflow?

a.

a stock repurchase

b.

a decrease in inventory

c.

an increase in accounts payable

d.

a stock dividend

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40.

When an asset is depreciated,

a.

its cost is allocated over a period of time

b.

the firm's earnings and taxes are increased

c.

the cash flow from an investment is reduced

d.

the cost of the asset is increased to reflect appreciation in its value

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41.

Leverage ratios measure

a.

extent to which the firm uses debt financing

b.

the speed with which the firm sells inventory

c.

sales relative to some base such as equity

d.

capacity of the firm to meet current obligations

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42.

Times-interest-earned uses
a.

gross earnings

b.

operating earnings

c.

net earnings

d.

per share earnings

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43.

The more rapidly receivables turn over

a.

the more rapidly the firm is receiving cash

b.

the larger are the firm's sales

c.

the smaller is the firm's inventory

d.

the larger are the firm's accounts payable

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44.

Profitability ratios measure

a.

liquidity

b.

leverage

c.

performance

d.

turnover

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45.

Which of the following is equity?

1.

investments

2.

additional paid-in capital

3.

retained earnings

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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46.

The paying of a cash dividend causes the firm's

a.

assets and equity to increase

b.

assets to decrease and equity to increase

c.

assets and liabilities to increase

d.

assets and equity to decrease

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47.

Which of the following are true concerning dividend reinvestment plans?

1.

taxes are deferred

2.

they offer stockholders a convenient means to save

3.

the firm may pay the brokerage and other fees associated with the plans

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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48.

If a stock's price is $90 and the stock is split three for one, the price becomes
a.

$90

b.

$60

c.

$45

d.

$30

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49.

Dividend reinvestment plans are

a.

a convenient means to accumulate shares

b.

a means to defer federal income taxes on the dividends

c.

available only if the corporation distributes stock dividends

d.

more expensive than buying the stock through brokers

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50.

Stock repurchases
a.

increase per share earnings

b.

decrease per share earnings

c.

increase liabilities

d.

decrease liabilities

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51.

When risk analysis is introduced into the dividend-growth model, the required rate of return considers
a.

the firm's growth rate

b.

the firm's dividend

c.

the firm's beta coefficient

d.

the firm's past dividends

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52.

If the valuation of a stock is $20 and it currently sells for $25, then
1.

the stock is undervalued

2.

the stock is overvalued

3.

the investor should establish a short position

4.

the investor should establish a long position

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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53.

An increase in investors' required return should cause the value of a common stock to
a.

rise

b.

fall

c.

remain unchanged

d.

remain stable or rise slightly

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54.

If a company fails to meet the terms of the indenture, it is

a.

bankrupt

b.

in default

c.

profitable

d.

in registration

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55.

Which of the following reduces the investor's risk associated with investing in bonds?
1.

a sinking fund

2.

a variable interest rate

3.

a call feature

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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56.

If interest rates rise, a firm may retire a bond issue by

1.

calling it

2.

repurchasing it

3.

issuing new bonds and redeeming the old bonds

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 2

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57.

The current yield on a bond is

a.

interest paid divided by the bond's price

b.

the bond's coupon

c.

the interest rate stated on the bond

d.

the yield over the lifetime of the bond

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58.

If interest rates in general rise,

a.

the prices of existing bonds rise

b.

the prices of existing bonds fall

c.

the prices of matured bonds rise

d.

the prices of matured bonds fall

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59.

If investors anticipate that interest rates will fall, they

a.

should buy bonds

b.

should sell bonds

c.

should buy shares in money market mutual funds

d.

should take no action

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60.

If a bond is selling for a premium, that implies

1.

interest rates have risen

2.

interest rates have fallen

3.

the yield to maturity exceeds the current yield

4.

the yield to maturity is less than the current yield

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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61.

If interest rates rise after a bond is issued,

1.

the bond may be called

2.

the firm may repurchase the bond

3.

the current yield exceeds the yield to maturity

4.

the current yield is less than the yield to maturity

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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62.

Common features of preferred stock include

a.

fixed, cumulative dividends

b.

variable, cumulative dividends

c.

fixed, non-cumulative dividends

d.

variable, non-cumulative dividends

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63.

If a stock rose from $10 to $30 over ten years, the annual rate of return
a.

was 20 percent

b.

was greater than 20 percent

c.

was less than 20 percent

d.

cannot be determined

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64.

Studies of rates of return on large stocks suggest

a.

the average return is about 7.4 percent annually

b.

over a period of years, the rate is approximately 10 percent

c.

equity investors rarely sustain losses

d.

dividends account for over half the return

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65.

The net asset value

a.

is the price of an investment company's shares

b.

is reduced by the loading fee

c.

declines if the value of the fund's assets are reduced

d.

measures the quality of the fund's management

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66.

If the shares of a closed-end investment company sell for a discount,

a.

the shares are undervalued

b.

the price of the stock is less than the company's liabilities

c.

the net assets exceed the price of the shares

d.

the value of the assets have declined more than the price of the stock

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67.

An index fund
a.

seeks to match the market

b.

seeks to outperform the market

c.

is illustrative of a no load fund

d.

is illustrative of a closed-end fund

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68.

Income earned by a mutual fund is

a.

distributed

b.

retained

c.

reinvested

d.

retained and reinvested

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69.

The net asset value of a mutual fund's share increases with

a.

an increase in loading fees

b.

an increase in interest rates

c.

an increase in security prices

d.

an increase in the fund's assets

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70.

The efficient market hypothesis suggests that

1.

professional portfolio managers will outperform the individual investor

2.

professional portfolio managers will not outperform the individual investor

3.

professional portfolio managers will consistently outperform the market

4.

professional portfolio managers will not consistently outperform the market

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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71.

A beta coefficient of 1.2 implies

1.

the stock is more risky than the market

2.

the stock's return is 1.2 times the return on the market

3.

the stock is less risky than the market

4.

the market's return is 1.2 times the return on the stock

a.

1 and 2

b.

1 and 4

c.

2 and 3

d.

3 and 4

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72.

A beta coefficient is a measure of the volatility of

a.

a firm's position in its industry

b.

a stock's return relative to the market return

c.

aggregate market stock prices

d.

a firm's earnings

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73.

Current liabilities do not include

a.

short-term bank loans

b.

accrued interest

c.

accounts payable

d.

additional paid-in capital (capital surplus)

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74.

According to accountants, assets should be recorded at

a.

the selling price

b.

the market value

c.

the lower of market value or cost

d.

the cost of the asset

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75.

The current ratio excludes

a.

accrued interest

b.

inventory

c.

cash equivalents

d.

retained earnings

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76.

A high current ratio suggests that the firm

a.

has a small amount of long-term debt

b.

is carrying little inventory

c.

is able to meet its current obligations

d.

is profitable

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77.

The larger the debt ratio

a.

the more equity the firm is using

b.

the riskier the firm becomes

c.

the larger are the firm's total assets

d.

the smaller is the firm's use of financial leverage

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78.

A price to book ratio considers

a.

profits relative to earnings

b.

price of the stock relative to equity

c.

profits relative to equity

d.

price of the stock relative to earnings

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79.

Debt instruments subject their owners to risk from

1.

loss of purchasing power

2.

higher credit ratings

3.

default

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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80.

No load mutual funds

a.

have no selling fees

b.

pay no cash dividends

c.

have no administrative expenses

d.

have a fixed portfolio

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Problem

81.

What is the expected return on a stock if the firm will earn 24% during a period of economic boom, 14%
during normal economic periods, and 2% during a period of recession if the probabilities of these
economic environments are 20%, 65%, and 15%, respectively?

RESPONSE:
ANSWER:

The expected return is a weighted average of the individual possible returns, each
weighted by the probability of their occurring:
Expected return

= (0.2)(0.24) + (0.65)(0.14) + (0.15)(0.02)

= 14.2%.

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82.

You bought a stock with a beta of 1.4 and earned a return of 8.3%. Did you outperform the market if,
during the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a
Treasury bill?

RESPONSE:
ANSWER:

The material in this problem was not explicitly covered in the chapter. You may use
the problem to set up the question, "What return should you have earned during a
particular investment horizon?" The answer uses the capital asset model to evaluate
performance. Thus, the return that should have been realized is
Rf + (R m - Rf) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%.
The actual return (8.3% return) is less than the return that would be expected given
the beta and the market performance. The stock under-performed the market on a
risk-adjusted basis.

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83.

Determine a firm's earnings per share from the following information.

Corporate income tax rate
Number of shares outstanding

25%

10,000

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Cost of goods sold

$60,000

Interest earned

2,400

Selling and administrative expense

15,000

Interest expense

5,000

Sales

100,000

Annual credit sales

90,000

RESPONSE:
ANSWER:

Determination of the firm's earnings per share:

Sales
Cost of goods sold
Gross profits on sales
Selling and administrative expenses

60,000
40,000
15,000

Operating income

25,000

Interest expense

5,000

Interest earned
Earnings before taxes
Taxes

POINTS:

$100,000

2,400
22,400
5,600

Earnings available to stockholders

$ 16,800

Number of shares outstanding

10,000

Earnings per share

$1.68

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84.

Given the following information, construct the statement of cash flow. What happened to the firm's
liquidity position during the year?
Net income

$16.7

Decrease in accounts receivable

6.1

Increase in accounts payable

13.6

Sale of bonds

55.1

Dividends

14.8

Retirement of bonds

10.8

Increase in inventory

15.2

Depreciation expense

56.0

Cost of goods sold

72.1

Reduction in income taxes payable

5.0

Sale of stock

0.4

Purchase of plant and equipment

91.0

Beginning cash

1.1

Repurchase of stock

5.6

RESPONSE:
ANSWER:
Statement of Cash Flows for the Period Ending
December 31, 20XX

Operating activities

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Net income

$16.7

Depreciation

56.0

Decrease in accounts receivable

6.1

Increase in inventory

(15.2)

Increase in accounts payable

13.6

Decrease in income taxes payable

(5.0)

Net cash provided by operating activities

$72.2

Investment activities
Increase in plant

(91.0)

Net cash used in investing activities

($91.0)

Financing activities
Proceeds from sale of long-term debt

55.1

Payments on long-term debt

(10.8)

Dividends

(14.8)

Repurchase of stock

(5.6)

Sale of stock

0.4

Net cash provided by financing activities

$24.3

Cash at beginning of the year

$1.1

Cash at the end of the year

$6.6

The firm's cash position has increased, but that does not mean the firm is more liquid
since inventory and accounts payable increased while accounts receivable declined.
You should also note that the firm increased its investment in plant by using the cash
generated through depreciation and the issuing of new long-term debt. The earnings
and sale of stock did not cover dividends and stock repurchases. This indicates that
the firm is more financially leveraged.
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REF:

85.

Currently the price of a stock is $58 a share. The firm's balance sheet is as follows:
Assets

Liabilities and Equity

Cash

$ 10,000,000

Accounts payable

$ 20,000,000

Accounts

250,000,000

Long-term debt

400,000,000

Common stock ($10 par;

10,000,000

receivable
Inventory

120,000,000

Plant and

325,000,000

equipment

1,000,000 shares outstanding)

Paid-in capital
Retained earnings

$705,000,000

90,000,000
185,000,000
$705,000,000

Construct a new balance sheet showing the impact of a two-for-one stock split. What will be the new price
of the stock?

RESPONSE:

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ANSWER:

The new balance sheet after the two-for-one stock split:

Assets

Liabilities and Equity

Cash

$ 10,000,000

Accounts payable

$ 20,000,000

Accounts

250,000,000

Long-term debt

400,000,000

Common stock ($5 par;

10,000,000

receivable
Inventory

120,000,000

2,000,000 shares
outstanding)

Plant and

325,000,000

Add. paid-in capital

equipment

Retained earnings
$705,000,000

86.

90,000,000
185,000,000
$705,000,000

The only changes are the entries under common stock since there are now
Construct a new balance
sheet
showing
the
impact
a 5 percent stock dividend. What will be the new
2,000,000
shares
of $5
par
stock of
outstanding.
price of the stock?
The new price of the stock is $58/2 = $29.

RESPONSE:
POINTS:

-- / 1

REF:

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ANSWER:

The new balance sheet after the 5 percent stock dividend:

Assets

Liabilities and Equity

Cash

$ 10,000,000

Accounts payable

$ 20,000,000

Accounts

250,000,000

Long-term debt

400,000,000

Common stock ($10 par;

10,500,000

receivable
Inventory

120,000,000

1,050,000 shares
outstanding)

Plant and

325,000,000

Add. paid-in capital

equipment

Retained earnings
$705,000,000

92,400,000
182,100,000
$705,000,000

The firm issues (.05)(1,000,000) = 50,000 shares with a $10 par value. The common
stock entry is increased by $500,000 to $10,500,000.
The market value of the stock is $58 50,000 = $2,900,000.
Retained earnings are reduced by $2,900,000 to $182,100,000.
Since retained earnings are reduced by $2,900,000 and common stock is increased
only by $500,000, $2,400,000 is unaccounted for. In order to balance the balance
sheet, additional paid-in capital is increased by $2,400,000.
The new price of the stock is $58 /1.05 = $55.24. This price adjustment is necessary
to adjust for the dilution of the old stock that results from the stock dividend.
Be certain to point out that in both the stock split and the stock dividend (1) assets
are not changed, (2) liabilities are not changed, and (3) total equity is not changed.
All that occurs is (1) a reduction in the price of the stock resulting from the increase in
the number of shares, and (2) some changes in the individual entries in the equity
section of the balance sheet.
POINTS:

-- / 1

REF:

87.

A company whose stock is selling for $45 has the following balance sheet:
Assets

$32,000

Liabilities

$10,000

Common stock

6,000

($6 par; 1,000

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shares issued)
Additional paid-in

2,000

capital
Retained earnings

14,000

a.

Construct a new balance sheet showing a 3 for 1 stock split. What is the new price for the stock?

b.

What would be the balance sheet if the firm paid a 10 percent stock dividend (instead of the
stock split)?

RESPONSE:

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ANSWER:
a.

Three for one split:

Assets

$32,000

Liabilities

$10,000

Common stock

6,000

($2 par; 3,000

shares issued)
Additional paid-in

2,000

capital
Retained earnings

14,000

The firm now has 3,000 shares outstanding with a $2 par value. The price of
the stock adjusts to $45/3 = $15.

b.

10 percent stock dividend:

Assets

$32,000

Liabilities

$10,000

Common stock

6,600

($6 par; 1,100

shares issued)
Additional paid-in

5,900

capital
Retained earnings

9,500

The 10 percent stock dividend results in the firm issuing 100 new shares.
$4,500 ($45 100) is subtracted from retained earnings and added to the
other equity accounts. $600 (100 $6 par) is added to stock outstanding.
The residual ($3,900) additional paid-in capital.

POINTS:

-- / 1

REF:

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88.

Your broker recommends that you purchase Good Mills at $30. The stock pays a $2.20 annual dividend,
which (like its per share earnings) is expected to grow annually at 8 percent. If you want to earn 15
percent on your funds, is this stock a good buy?

RESPONSE:
ANSWER:

Valuation of the stock:

The valuation of the stock is $33.94. Since the current price is $30, the stock is
undervalued and should be purchased.

POINTS:

-- / 1

REF:

89.

If you purchase Large Oil, Inc. for $36 and the firm pays a $3.00 annual dividend which you expect to
grow at 7.5 percent, what is the implied annual rate of return on your investment?

RESPONSE:
ANSWER:
Rate of return

= D 0(1 + g)/P + g
= $3(1 + .075)/$36 + .075 = 16.46%

POINTS:

-- / 1

REF:

90.

Two stocks each pay a $1 dividend that is growing annually at 8 percent. Stock A's beta = 1.3; stock B's
beta = 0.8.
a.

Which stock is more volatile?

b.

If Treasury bills yield 9 percent and you expect the market to rise by 13 percent, what is your riskadjusted required return for each stock?

c.

Using the dividend-growth model, what is the maximum price you would be willing to pay for each
stock?

d.

Why are their valuations different?

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RESPONSE:
ANSWER:
a.

Stock A is more volatile because it has the higher beta coefficient.

b.

Required rate of return = rf + (r m - rf)beta

For stock A:
Required rate = .09 + (.13 - .09)1.3 = 14.2%

For stock B:
Required rate = .09 + (.13 - .09)0.8 = 12.2%

c.

Valuation of stock A:

Valuation of stock B:

d.

POINTS:

Even though the dividends and growth rates are equal, stock A is riskier
(higher beta) which reduces its valuation.

-- / 1

REF:

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91.

What is the value of a preferred stock that pays an annual dividend of $3 a share and competitive yields
are 5%, 10%, and 15%?

RESPONSE:
ANSWER:

Value of the perpetual preferred stock:

At 5%: P p = $3/.05 = $60
At 10%: P p = $3/.10 = $30
At 15%: P p = $3/.15 = $20

POINTS:

-- / 1

REF:

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92.

What is the value of a common stock if 2

a.

the firm's earnings and dividends are growing annually at 10 percent, the current dividend is
$1.32, and investors require a 15 percent return on investments in common stock?

b.

What is the value of this stock if you add risk to the analysis and the firm's beta coefficient is 0.8,
the risk-free rate is 9 percent, and the return on the market is 15 percent?

c.

If the price of the stock is $35, what is the rate of return offered by the stock? Should the investor
acquire this stock?

RESPONSE:
ANSWER:
a.

b.

k = .09 + (.15 - .09).8 = .138 = 13.8%

c.

r = $1.32(1+.1)/$35 + .10 = 14.15%

The rate of return is less than the required rate (14.15% versus 15%) until the risk
adjustment is made. After this adjustment, the expected rate of return exceeds the
required rate of return (14.15% versus 13.8%); therefore, buy the stock.
POINTS:

-- / 1

REF:

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93.

What is the annual rate of return on an investment in a common stock that cost $40.50 if the current
dividend is $1.50 and the growth in the value of the shares and the dividend is 8 percent?

RESPONSE:
ANSWER:

r = $1.50(1+.08)/$40.50 +.08 = 12%

POINTS:

-- / 1

REF:

94.

A bond has the following terms:

principal amount

$1,000

semi-annual interest

$50

maturity

10 years

a.

What is the bond's price if comparable debt yields 12%?

b.

What would be the price if comparable debt yields 12% and the bond matures after five years?

c.

What are the current yields and yields to maturity in a. and b.?

d.

What would be the bond's price in a. and b. if interest rates declined to 8%?

e.

What are the current yields and yield to maturity in d.?

f.

What two generalizations may be drawn from the above price changes?

RESPONSE:
ANSWER:
a.

P = interest(PV of an annuity at 6% for 20 periods)

+ principal (PV of $1 at 6% for 20 years)
= $50(11.470) + $1,000(.312) = $885

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

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PV = -885.)

b.

P = $50(7.360) + $1,000(.558) = $926

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

PV = -926.)

c.

Current yield

Yield to maturity

in a:
$100/$885 =
11.3%

12%

in b:
$100/$926 =
10.8%

12%

Notice that the yield to maturity is the yield on the comparable debt. Students
may confirm this by calculating the yield to maturity.

d.

Price at 4% for 20 periods:

P = $50(13.590) + $1,000(.456) = $1,136

(PV = ?; I = 4; N = 20; PMT = 50, and FV = 1000.

PV = -1136.)

Price at 4% for 10 periods:

P = $50(8.111) + $1,000(.676) = $1,082

(PV = ?; I = 4; N = 10; PMT = 50, and FV = 1000.

PV = -1081.)

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e.

f.

POINTS:

Current
yields

Yield to maturity

a:
$100/$1,136
= 8.8%

8%

b:
$100/$1,082
= 9.2%

8%

(1)

The inverse relationship between bond prices and current interest

rates: when interest rates fall (12% to 8%), the price of the bond rises.

(2)

The longer the term of the bond (ten versus five years), the greater is
the price fluctuation.

-- / 1

REF:

95.

You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond
matures after ten years. What is the yield to maturity?

RESPONSE:
ANSWER:

The yield to maturity equates the present value of the interest payments and
principal repayment. In this problem, that rate is 10%:
($40)(12.462) + ($1,000)(0.377) = $875.48.
(PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)

POINTS:

-- / 1

REF:

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96.

You purchase a high-yield, junk bond for $1,000 that pays $140 annually. After buying the bond, yields
decline and you are able to reinvest the interest at only 9 percent. You reinvest all the interest payments.
How much will you have when the bond is retired after twelve years? What was the annual return you
earned on this investment?

RESPONSE:
ANSWER:

The $140 are reinvested annually at 9% and grows to

$140(20.141)9 = $2,820.
(20.141 is the interest factor for the future value of an annuity at 9% for twelve years.)
(PV = 0; I = 9; N = 12; PMT = -140, and FV = ?, FV = 2820.)
The sum of the reinvested interest and the principal repayment is $2,819.74 + 1,000
= $3,820.
The realized return is
$1,000(1 + g) 12 = $3,820.
The interest factor is (1 + g) 12 = 3,820.
Solving for g yields approximately 12%.
(PV = -1000; I = ?; N = 12; PMT = 0, and FV = 3920, I = 11.82.)
Point out the importance of the reinvestment rate. In this case, the investor earns
more than two percent less than the anticipated 14% return on the investment.

POINTS:

-- / 1

REF:

97.

Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent
and answer the following questions.
XY 5 1/4 percent (interest paid annually) for 20 years
AB 14 percent (interest paid annually) for 20 years
a.

Which bond has a current yield that exceeds the yield to maturity?

b.

Which bond may you expect to be called? Why?

c.

If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower
rated, what would be its price relative to the XY, Inc bond? Explain.

RESPONSE:

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ANSWER:

Price of the XY, Inc. bond:

(PV = ?; I = 10; N = 20; PMT = 52.50, and FV = 1000, PV = -596.)
Price of the AB, Inc. bond:
(PV = ?; I = 10; N = 20; PMT = 140, and FV = 1000, PV = -1341.)
The current yields are

POINTS:

a.

The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25%
versus 10%) because the current yield does not consider the loss of the
premium the investors will suffer over the lifetime of the bond.

b.

There is no reason to expect the firm to call the XY bond, because the firm
could repurchase the bonds at a discount. The AB bond, however, may be
called. Current interest rates are lower (10% versus the 14% coupon on that
bond), so the firm could refund the debt. (The instructor should ask what
impact the expectation of such refunding may have on the price of the bond.)

c.

Since the CD and XY bonds are identical with regard to interest paid and
term to maturity, the factor that differentiates them is the credit rating. The
CD bond has a lower credit rating, so its value relative to the XY bond should
be less. Such a lower price will increase the yield to the investor and
presumably would be necessary to induce the investor to purchase the
riskier bond.

-- / 1

REF:

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98.

You bought a stock for $28.29 that paid the following dividends
Year

Dividend

$1.00

$1.50

$1.80

After the third year, you sold the stock for $35. What was the annual rate of return?

RESPONSE:
ANSWER:

Select a rate and determine if it equates both sides of the equation. For example,
select 12 percent:
$1(.893) + 1.50(.797) + 1.80(.712) + 35(.712) = $28.29
The annual rate of return is 12 percent.
The same answer may be derived using a financial calculator, but it requires the
student to enter unequal cash inflows for each period.

POINTS:

-- / 1

REF:

99.

If an investor purchases shares in a no load fund for $36, receives cash distributions of $1.27 and sells
the shares after one year for $41.29, what is the percentage return on the investment?

RESPONSE:
ANSWER:

The percentage return: ($1.27 + 5.29)/$36 = 18.2%

POINTS:

-- / 1

REF:

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100.

If an investor buys shares in a closed-end investment company for $46 and the net asset value is $53,
what is the discount? If the company distributes $1, the net asset value rises to $58, and the investor sells
the shares for a premium of 5 percent over the net asset value, what is the percentage earned on the
investment?

RESPONSE:
ANSWER:

The discount is $53 - 46 = $7 (The shares initially sell for a discount of $7/53 = 13.2
percent from net asset value.)
The percentage return is ($1 + 1.05(58) - 46)/$46 = 34.6%.

POINTS:

-- / 1

REF:

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