Solutions to Quiz 2 are after the questions.

Please note that the order of questions on your quiz may have been different so youll need to identify the questions. 1. A 1% decline in yield will have the least effect on the price of the bond with a __________. A) 10-year maturity, selling at 80 B) 10-year maturity, selling at 100 C) 20-year maturity, selling at 80 D) 20-year maturity, selling at 100 2. _________ considerations make portfolio management useful even in a perfectly efficient market. A) Diversification B) Investor tax C) Investor risk profile D) all of the above 3. Consider two bonds, A and B. Both bonds presently are selling at their par value of $1,000. Each pay interest of $120 annually. Bond A will mature in 5 years while bond B will mature in 6 years. If the yields to maturity on the two bonds change from 12% to 14%, __________. A) both bonds will increase in value but bond A will increase more than bond B B) both bonds will increase in value but bond B will increase more than bond A C) both bonds will decrease in value but bond A will decrease more than bond B D) both bonds will decrease in value but bond B will decrease more than bond A 4. Which of the following would not be considered a supply shock? A) a change in the price of imported oil B) frost damage to the orange crop C) a change in the level of education of the average worker D) an increase in the level of government spending 5. The _______ is the result of applying a set of arbitrary accounting rules to spread the acquisition cost of assets over a specified number of years. A) book value B) market value C) liquidation value D) Tobin's q 6. Floating-rate bonds are designed to __________ while convertible bonds are designed to __________. A) minimize the holders' interest rate risk, give the investor the ability to share in the price appreciation of the company's stock B) maximize the holders' interest rate risk, give the investor the ability to share in the

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price appreciation of the company's stock C) minimize the holders' interest rate risk, give the investor the ability to share in the profits of the issuing company D) maximize the holders' interest rate risk, give the investor the ability to share in the profits of the issuing company 7. An analyst starts by examining the broad economic environment and then considers the implications of the outside environment on the industry in which the firm operates. Finally, the firm's position within the industry is examined. This is called __________ analysis. A) bottom-up B) outside-inside C) top-down D) upside-down 8. The market capitalization rate on the stock of Aberdeen Wholesale Company is 10%. Its expected ROE is 12% and its expected EPS is $5.00. If the firm's plow-back ratio is 60%, its P/E ratio will be __________. A) 7.14 B) 14.29 C) 16.67 D) 22.22 9. Each of two stocks, A and B, are expected to pay a dividend of $7 in the upcoming year. The expected growth rate of dividends is 6% for both stocks. You require a return of 10% on stock A and a return of 12% on stock B. Using the constant growth DDM, the intrinsic value of stock A __________. A) will be higher than the intrinsic value of stock B B) will be the same as the intrinsic value of stock B C) will be less than the intrinsic value of stock B D) more information is necessary to answer this question 10. A coupon bond which pays interest of $60 annually, has a par value of $1,000, matures in 5 years, and is selling today at a $84.52 discount from par value. The approximate yield on this bond is __________. A) 6% B) 7% C) 8% D) 9% 11. The beta, of a security is equal to __________. A) the covariance between the security and market returns divided by the variance of the market's returns B) the covariance between the security and market returns divided by the standard deviation of the market's returns

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C) the variance of the security's returns divided by the covariance between the security and market returns D) the variance of the security's returns divided by the variance of the market's returns 12. A bond presently has a price of $1,030. The present yield on the bond is 8.00%. If the yield changes from 8.00% to 8.10%, the price of the bond will go down to $1,020. The duration of this bond is __________. A) -10.5 B) -8.5 C) 9.7 D) 10.5 13. Banks, and other financial institutions, manage interest rate risk by ______________. A) maximizing the duration of assets and minimizing the duration of liabilities B) minimizing the duration of assets and maximizing the duration of liabilities C) matching the durations of assets and liabilities D) None of the above 14. Dollar denominated bonds sold by a German firm in the U.S. would be called ____________. A) Eurobonds B) Yankee bonds C) Samurai bonds D) Bulldog bonds 15. Fama and French have suggested that many market anomalies can be explained as manifestations of ____________. A) regulatory effects B) high trading costs C) information asymmetry D) time varying risk premiums 16. Lifecycle Motorcycle Company is expected to pay a dividend in year 1 of $2.00, a dividend in year 2 of $3.00, and a dividend in year 3 of $4.00. After year 3, dividends are expected to grow at the rate of 7% per year. An appropriate required return for the stock is 12%. Using the multistage DDM, the stock should be worth __________ today. A) $63.80 B) $65.13 C) $67.98 D) $85.60 17. __________ is a common term for the market consensus value of the required return

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on a stock. A) dividend payout ratio B) intrinsic value C) market capitalization rate D) plowback ratio 18. A zero-coupon bond has a yield to maturity of 5% and a par value of $1,000. If the bond matures in 16 years, it should sell for a price of __________ today. A) $458.00 B) $641.00 C) $789.00 D) $1,100.00 19. A convertible bond has a par value of $1,000 but its current market price is $833. The current price of the issuing company's stock is $22 and the conversion ratio is 40 shares. The bond's market conversion value is __________. A) $1,000 B) $880 C) $833 D) $800 20. You are considering acquiring a common share of Sahali Shopping Center Corporation that you would like to hold for one year. You expect to receive both $1.25 in dividends and $35 from the sale of the share at the end of the year. The maximum price you would pay for a share today is __________ if you wanted to earn a 12% return. A) $31.25 B) $32.37 C) $38.47 D) $41.32 21. __________ probably the most direct way to stimulate or slow the economy. A) Fiscal policy is B) Monetary policy is C) Supply-side policy is D) None of the above are 22. __________ will determine the sensitivity of a firm's earnings to the business cycle. A) Financial leverage B) Necessity of the firm's output C) Operating leverage D) All of the above 23. The degree of operating leverage (DOL) measures the ___________________.

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A) B) C) D)

sensitivity of profits to changes in sales revenues sensitivity of profits to changes in fixed costs sensitivity of profits to changes in the tax rate sensitivity of profits to changes in interest rates

24. __________ is an industry with below-average sensitivity to the state of the economy. A) An asset play industry B) A cyclical industry C) A defensive industry D) A stalwart industry 25. When discussing bonds, convexity relates to the ________. A) shape of the bond price curve B) shape of the yield curve C) slope of the yield curve D) shape of the bond dealer 26. Cache Creek Manufacturing Company is expected to pay a dividend of $3.36 in the upcoming year. Dividends are expected to grow at 8% per year. The riskfree rate of return is 4% and the expected return on the market portfolio is 14%. Investors use the CAPM to compute the market capitalization rate, and the constant growth DDM to determine the value of the stock. The stock's current price is $84.00. Using the constant growth DDM, the market capitalization rate is __________. A) 9% B) 12% C) 14% D) 18% 27. In a 1953 study of stock prices, Maurice Kendall found that ________. A) there were no predictable patterns in stock prices B) stock prices seem to evolve randomly C) data provided no way to predict price movements D) all of the above 28. A portfolio manager sells treasury bonds and buys corporate bonds because the spread between corporate and treasury bond yields is higher than its historical average. This is an example of __________ swap. A) a pure yield pick up B) a rate anticipation C) a substitution D) an intermarket spread 29. Sinking funds are commonly viewed as protecting the _______ of the bond. A) issuer

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B) underwriter C) holder D) dealer 30. Flanders, Inc. has expected earnings of $4 per share for next year. The firm's ROE is 8% and its earnings retention ratio is 40%. If the firm's market capitalization rate is 15%, what is the present value of its growth opportunities? A) -$6.33 B) $0 C) $20.34 D) $26.67 31. Consider the following $1,000 par value zero-coupon bonds:
Bond A B C D E Years to Maturity 1 2 3 4 5 Yield to Maturity 6.00% 7.50% 7.99% 8.49% 10.70%

The expected one-year interest rate one year from now should be __________.

A) B) C) D)

7.00% 8.00% 9.00% 10.00%

32. __________ is defined as the present value of all cash proceeds to the investor in the stock. A) dividend payout ratio B) intrinsic value C) market capitalization rate D) plow-back ratio 33. The value of internet companies is based primarily on ______. A) current profits B) Tobin's q C) growth opportunities D) replacement cost 34. Gagliardi Way Corporation has an expected ROE of 15%. Its dividend growth rate
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will be __________ if it follows a policy of paying 30% of earning in the form of dividends. A) 4.5% B) 10.5% C) 15.0% D) 30.0% 35. Both forward rate agreements and interest rate caps/floors are used by companies to reduce exposure to adverse changes in interest rates. However, ________ allow the companies to benefit from favorable interest rate movements while ________ do not. A) forward rate agreements; cap/collars B) caps/collars; forward rate agreements C) none of the above D) both of the above 36. Consider the CAPM. The expected return on the market is 18%. The expected return on a stock with a beta of 1.2 is 20%. What is the risk-free rate? A) 2% B) 6% C) 8% D) 12% 37. The semi-strong form EMH states that ________ must be reflected in the stock price. A) all market trading data B) all publicly available information C) all information including inside information D) none of the above 38. To earn a high rating from the bond rating agencies, a company would want to have __________. A) a low times interest earned ratio B) a low debt to equity ratio C) a low quick ratio D) none of the above 39. Annie's Donut Shops, Inc. has expected earnings of $3.00 per share for next year. The firm's ROE is 18% and its earnings retention ratio is 60%. If the firm's market capitalization rate is 12%, what is the value of the firm excluding any growth opportunities? A) $25.00 B) $50.00 C) $83.33 D) $208

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40. __________ is not a true statement regarding the market portfolio. A) All securities in the market portfolio are held in proportion to their market values B) It includes all assets of the universe C) It is the tangency point between the capital market line and the indifference curve D) It lies on the efficient frontier 41. A preferred share of Coquihalla Corporation will pay a dividend of $8.00 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 7% on this stock. Using the constant growth DDM to calculate the intrinsic value, a preferred share of Coquihalla Corporation is worth __________. A) $13.50 B) $45.50 C) $91.00 D) $114.29 42. Security X has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5% and the market expected rate of return is 15%. According to the capital asset pricing model, security X is __________. A) fairly priced B) overpriced C) underpriced D) None of the above answers are correct 43. The CAPM is a ____ factor model, whereas the APT is a ____ factor model. A) 1 ; 2 B) 1 ; 3 C) 1 ; 4 D) 1 ; potentially many 44. Consider the liquidity preference theory of the term structure of interest rates. On average, one would expect investors to require __________. A) a higher yield on short term bonds than long term bonds B) a higher yield on long term bonds than short term bonds C) the same yield on both short term bonds and long term bonds D) the liquidity preference theory cannot be used to make any of the above statements. 45. The constant growth dividend discount model (DDM) is valid only when ____________. A) growth rate is less than or equal to the required return B) growth rate is greater than or equal to the required return C) growth rate is less than the required return D) growth rate is greater than the required return

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46. An increase in a bond's yield to maturity results in a price decline that is ________ the price increase resulting from a decrease in yield of equal magnitude. A) greater than B) equivalent to C) smaller than D) The answer is indeterminate 47. Evidence suggests that there may be _______ momentum and ________ reversal patterns in stock price behavior. A) short-run, short-run B) long-run, long-run C) long-run, short-run D) short-run, long run 48. Suppose Company ABC can borrow funds at a fixed rate of 10% or a floating rate of LIBOR. XYZ can borrow funds at either 13% or L+1. What are the total arbitrage profits that can be shared by the two firms if they enter into an interest rate swap? A) 4% B) 3% C) 2% D) no arbitrage profits are available 49. A bond pays annual interest. Its coupon rate is 7%. Its value at maturity is $1,000. It matures in three years. Its yield to maturity is presently 8%. The duration of this bond is __________. A) 2.60 B) 2.73 C) 2.81 D) 3.00 50. Stocks A, B, C and D have betas of 1.5, 0.4, 0.9 and 1.7 respectively. What is the beta of an equally weighted portfolio of A, B and C? A) .25 B) .93 C) 1.00 D) 1.13

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Answer Key -- Quiz2 1. 2. 3. 4. 5. 6. 7. 8. B D D D A A C B Exp Div = Exp EPS x ((1-plow-back ratio) = 5 x (1-0.6) = 2 Growth rate = (plow-back ratio) x (ROE) = 0.6 x 0.12 = 0.072 Using the dividend growth model: P = ExpDiv/(r-g) = 2/(0.1-0.072) = $14.29

9. A 10. C Approx YTM = Interest amount + (par value price)/n (price + par value)/2 = 60 + 84.52/5
957.74 = 0.08

11. A 12. D % Change in bond price = -D x (change in yield) (1 + yield -0.00971 = -D x (0.001) 1.08 Solving for D yields 10.5 13. 14. 15. 16. C B D C D1 = $2; D2 = $3; D3 = $4 We can use the dividend growth model to calculate P3 = D4/(r-g) D4 = D3 x (1+g) = 4 x (1.07) r = 0.12 and g = 0.07 so P3 = $85.60 Calculate the present value of D1, D2, D3+P3 to get the price today (use r=0.12) And P = $67.98

17. C 18. A Price of the bond = 1000 1.0516 19. B Conversion value = 40 x 22 = 840 20. B Expected cash flows = $1.25 + $35 = $36.25 Calculate the present value using the 12% discount rate so 36.25/1.12 = $32.37
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21. 22. 23. 24. 25. 26.

A D A C A B Exp dividend = 3.36; g = 8%; stocks current price = $84 Using the dividend growth model: P = D/(r-g) so 84 = 3.36/(r-0.08) Solving for r yields 12% D D C A PVGO = price of Flanders price of Flanders assuming no growth Exp div = exp EPS x (1- retention ratio) = $4 x (1-0.4) = $2.4 Growth rate = retention ratio x ROE = 0.4 * 0.08 = 0.032 Price of Flanders = expdiv/(r-g) = 4/(0.15-0.032) = 20.34 Price of Flanders assuming no growth = EPS/r = 4/0.15 = 26.67 So PVGO = 20.34 26.67 = -6.33

27. 28. 29. 30.

31. C Need to calculate the one year forward rate. Return on two years investments should be the same whether we invest directly for two years or we invest for one year and then roll-over the proceeds for investment in the second year. The first strategy locks in the two year rate of 7.5% per year. So the two year return will be equal to (1.075)2 The second strategy will earn 6% in the first year and then reinvest at the one year interest rate that will be available one year from today (lets call it r). So the two year return will be (1.06)*(1+r) In equilibrium, (1.075)2 = (1.06)*(1+r) so r = 0.0902 or 9.02%

32. B 33. C 34. B g = (1- payout ratio) x ROE = 0.7 x 0.15 = 0.105 35. B 36. C Using the CAPM: 0.2 = rf + 1.2(0.18 rf) solving for rf yields 0.08 37. B 38. B 39. A Price with no growth = EPS/r = 3/0.12 = $25

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40. C 41. D Price = D/r = 8/0.07 = $114.29 42. B Using the CAPM, the required rate of return on X is 0.05 + 1.15(0.15-0.05) = 0.165 The security is expected to yield 13% so it ROR is too low (compared to the required rate of return) and hence the security is priced too high. 43. 44. 45. 46. 47. 48. 49. D B C C D C C The price of the bond = 70/1.08 + 70/1.082 + 1070/1.083 Duration = (70 x 1)/1.08

= 974.2

+ (70 x 2)/1.082 + (1070 x 3)/1.083 Price of the bond

= (64.81 +120 + 2548.2)/974.2 = 2.81 50. B Average beta = (1.5 + 0.4 + 0.9)/3 = 0.93

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