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Goal of firm Answer: b Diff: E . The proper goal of the financial manager should be to maximize the firm's expected profit, since this will add the most wealth to each of the individual shareholders (owners) of the firm.

a. Trueb. False

Goal of firm Answer: b Diff: E . If a firm has a single owner, we may say that the proper goal of a financial manager would be to maximize the firm's earnings per share.

a. Trueb. False

Managerial incentives Answer: b Diff: E . Performance shares are dollar bonuses awarded to managers on the basis of corporate performance.

a. Trueb. False

Agency Answer: b Diff: E . If a firm's stock price falls during the year, this indicates that the firm's managers are not acting in shareholders' best interests.

a. Trueb. False

Agency Answer: a Diff: E . An agency problem exists between stockholders and managers. A second agency problem arises between stockholders and creditors.

a. Trueb. False

Agency Answer: b Diff: E . An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.

a. Trueb. False

Social welfare and finance Answer: b Diff: E . The goal of maximizing stock price is a detriment to society in that few of the actions that result in maximization of stock price also benefit society.

a. True

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b. False

Social welfare and finance Answer: a Diff: E . If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate.

a. Trueb. False

Medium:

Managerial incentives Answer: a Diff: M . In a competitive marketplace, if managers deviate too far from making decisions that are consistent with stockholder wealth maximization, they risk being disciplined by the market. Part of this discipline involves the threat of being taken over by groups who are more aligned with stockholder interests.

a. Trueb. False

Hostile takeovers Answer: b Diff: M . A hostile takeover is a method of seizing control of a company and involves an action taken against the opposition of incumbent management. However, this action is typically motivated by a desire to control the firm's assets and is rarely motivated by a low share price.

a. Trueb. False

Multiple Choice: Conceptual

Easy:

Goal of firm Answer: d Diff: E . The primary goal of a publicly-owned firm interested in serving its stockholders should be to

a. Maximize expected total corporate profit.b. Maximize expected EPS.c. Minimize the chances of losses.d. Maximize the stock price per share.e. Maximize expected net income.

Agency Answer: d Diff: E . Which of the following statements is most correct?

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a. Compensating managers with stock can reduce the agency problem between stockholders and managers.b. Restrictions are included in credit agreements to protect bondholders from the agency problem that exists between bondholders and stockholders.c. The threat of a takeover can reduce the agency problem between bondholders and stockholders.d. Statements a and b are correct.e. All of the statements above are correct.

Agency Answer: a Diff: E . Which of the following work to reduce agency conflicts between stockholders and bondholders?

a. Including restrictive covenants in the company’s bond contract.b. Providing managers with a large number of stock options.c. The passage of laws which make it easier for companies to resist hostile takeovers.d. Statements b and c are correct.

e. All of the statements above are correct.

Agency Answer: d Diff: E . Which of the following actions are likely to reduce the agency problem between stockholders and managers?

a. Congress passes a law that severely restricts hostile takeovers.b. A manager receives a lower salary but receives additional shares of the company’s stock.c. The board of directors has become more vigilant in its oversight of the company’s management.d. Statements b and c are correct. e. All of the statements above are correct.

Agency Answer: b Diff: E . Which of the following actions are likely to reduce agency conflicts between stockholders and managers?

a. Paying managers a large fixed salary.b. Increasing the threat of corporate takeover.c. Placing restrictive covenants in debt agreements.d. All of the statements above are correct.e. Statements b and c are correct.

Managerial incentives Answer: e Diff: E . Which of the following mechanisms is used to motivate managers to act in the interests of shareholders?

a. Bond covenants.b. The threat of a takeover.c. Executive stock options.d. Statements a and b are correct.e. Statements b and c are correct.

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Medium:

Valuation Answer: e Diff: M N . Which of the following statements is most correct?

a. Free cash flows are called “free” because the cost of capital for these cash flows is zero.b. Stock is valuable only because it generates cash flows for the investor.c. Managers can affect firm value by changing the riskiness of its cash flows. d. (a) and (b) are correct.e. (b) and (c) are correct.

Intrinsic value Answer: b Diff: M N . Which of the following statements is most correct?

a. A stock’s intrinsic value is its market value.b. A stock’s market price is the marginal investor’s intrinsic value.c. A stock’s market price is usually greater than its intrinsic value. d. A stock’s intrinsic value is usually greater than its market price.e. A stock’s intrinsic value is its book value.

Short-term vs. long-term price Answer: a Diff: M N . Which of the following statements is most correct?

a. A stock’s fundamental value is the value it would have if all accurate, pertinent information were available to the market.b. A stock’s short-term price and long-term price are the same.c. Management can’t manipulate the short-term price because it is determined in the marketplace. d. A stock’s short-term value is the value it would have if all accurate, pertinent information were available to the market.e. Management should work to maximize the stock’s short-term value.

Agency Answer: c Diff: M . Which of the following statements is most correct?

a. Agency conflicts between stockholders and managers are not really a problem when outsiders (i.e., non-managers) own shares in a corporation.b. Managers may operate in stockholders' best interests, or managers may operate in their own personal best interests. As long as managers stay within the law, there are no effective controls that stockholders can implement to control managerial decision making.c. The agency conflicts between bondholders and stockholders can be reduced with the use of bond covenants.d. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.e. All of the statements above are false.

Agency Answer: d Diff: M

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. Which of the following statements is most correct?

a. One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure.b. The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated.c. Managerial compensation can be structured to reduce agency problems between stockholders and managers.d. Statements b and c are correct.e. All of the statements above are correct.

Agency Answer: d Diff: M . Which of the following is an example of a moral hazard?

a. A CEO is awarded $100,000 worth of executive stock options, which he exercises two years later for $1,000,000.b. A company borrows $1,000,000 for investment in equipment, but uses the money instead to repurchase stock.c. A company declares bankruptcy, but instead of being liquidated, it is reorganized and one set of bondholders who are owed $10 million accept $3 million in payment for the debt.d. A CEO orders the headquarters moved just so he can have a nicer office.e. A group of institutional stockholders votes to oust management.

Agency Answer: a Diff: M . A moral hazard problem arises when:

a. An agent takes unobserved actions on his own behalf.b. A principal hires another individual to perform some service.c. Firms borrow money from bondholders.d. Stockholders have to incur costs to make managers act to maximize stock price.e. Managers are granted performance shares.

Goal of firm Answer: e Diff: M . Which of the following statements is most correct?

a. Firms that try to maximize their stock values will tend to lay off employees to cut costs.b. Firms that try to maximize their stock values will raise the prices of their products, gouging customers and driving them away.c. Anti-pollution laws are unnecessary because firms will choose not to pollute because that is in their best interests.d. The government should allow monopolies to operate without regulation so that they may maximize their shareholders’ wealth.e. Newly-privatized firms generally hire more employees.

EVA Answer: c Diff: M . Which of the following statements is most correct?

a. EVA is a measure of the value added to customers.

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b. EVA is a measure of the value added to management.c. EVA is a measure of the firm’s true profitability.d. EVA is a measure of management compensation.e. EVA is a measure of stock price.

Transparency Answer: b Diff: M . Which of the following statements is most correct?

a. A market is transparent when trading is inexpensive.b. A market is transparent when accurate information is available to all market participants.c. A transparent market has few regulations.d. A transparent market has many opportunities for trading on insider information.e. A market is transparent when everyone knows who the person is that they are trading with.

Sarbanes-Oxley Answer: d Diff: M N . Which of the following statements is most correct?

a. Sarbanes-Oxley requires the Securities Exchange Commission to audit public companies’ financial statements. b. Sarbanes-Oxley made it illegal for company executives to trade on insider information.c. Sarbanes-Oxley requires the Chairman of the Board of Directors to sign and certify the company’s financial statements.d. Sarbanes-Oxley requires the CEO sign and certify the company’s financial statements.e. Sarbanes-Oxley requires company executives to disclose their fraudulent activities “in a timely and accurate manner.”

Sarbanes-Oxley Answer: e Diff: M N . Which of the following statements is most correct?

a. Sarbanes-Oxley established a new Federal agency, the Public Company Auditing Board, to audit public companies’ financial statements. b. Sarbanes-Oxley prohibited investment banks from allowing their analysts to make recommendations on stocks the investment banks do business with.c. Sarbanes-Oxley requires that either the CEO or CFO hand-deliver the annual and quarterly financial statements to the SEC.d. Sarbanes-Oxley requires that auditors maintain extensive records to document that their consulting and auditing services for a given company are not conflicting.e. Sarbanes-Oxley prohibits auditors from providing consulting services to the companies they audit.

Payoff matrix Answer: a Diff: E . If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns.

a. True

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b. False

Standard deviation Answer: a Diff: E . The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

a. Trueb. False

Coefficient of variation Answer: a Diff: E . The coefficient of variation, calculated as the standard deviation divided by the expected return, is a standardized measure of the risk per unit of expected return.

a. Trueb. False

Risk comparisons Answer: a Diff: E . The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly.

a. Trueb. False

Risk and expected return Answer: a Diff: E . Companies should deliberately increase their risk relative to the market only if the actions that increase the risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the higher risk.

a. Trueb. False

Risk aversion Answer: a Diff: E . When investors require higher rates of return for investments that demonstrate higher variability of returns, this is evidence of risk aversion.

a. Trueb. False

CAPM and risk Answer: a Diff: E . One key result of applying the Capital Asset Pricing Model is that the risk and return of an individual security should be analyzed by how that security affects the risk and return of the portfolio in which it is held.

a. Trueb. False

CAPM and risk Answer: a Diff: E

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. According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the isolated risks of individual stocks. Thus, the relevant risk is an individual stock's contribution to the overall riskiness of the portfolio.

a. Trueb. False

Portfolio risk Answer: b Diff: E . When adding new securities to an existing portfolio, the higher or more positive the degree of correlation between the new securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification.

a. Trueb. False

Portfolio risk Answer: b Diff: E . Portfolio diversification reduces the variability of the returns on each security held in the portfolio.

a. Trueb. False

Portfolio return Answer: b Diff: E . The realized portfolio return is the weighted average of the relative weights of securities in the portfolio multiplied by their respective expected returns.

a. Trueb. False

Market risk Answer: a Diff: E . Market risk refers to the tendency of a stock to move with the general stock market. A stock with above average market risk will tend to be more volatile than an average stock, and it will definitely have a beta which is greater than 1.0.

a. True b. False

Market risk Answer: b Diff: E . Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolio.

a. Trueb. False

Beta coefficient Answer: a Diff: E . A security's beta measures its nondiversifiable (or market) risk relative to that of most other securities.

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a. Trueb. False

Beta coefficient Answer: a Diff: E . A stock's beta is more relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only one stock.

a. Trueb. False

Changes in betaAnswer: b Diff: E . A firm cannot change its beta through any managerial decision because betas are completely market determined.

a. Trueb. False

Required returnAnswer: b Diff: E . The required return on a firm's common stock is determined by the firm's market risk. If its market risk is known, and if it is expected to remain constant, the analyst has sufficient information to specify the firm's required return.

a. Trueb. False

SML Answer: b Diff: E . The slope of the SML is determined by the value of beta.

a. Trueb. False

SML and risk aversion Answer: a Diff: E . If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

a. Trueb. False

Physical assets Answer: a Diff: E . Businesses earn returns for security holders by purchasing and operating physical assets. The relevant risk of any physical asset must be measured in terms of its effect on the risk of the firm's securities.

a. Trueb. False

Medium:

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Variance Answer: b Diff: M . Variance is a measure of the variability of returns and since it involves squaring each deviation of the required return from the expected return, it is always larger than its square root, the standard deviation.

a. Trueb. False

Expected returnAnswer: a Diff: M . If the expected rate of return for a particular investment, as seen by the marginal investor, exceeds its required rate of return, we should soon observe an increase in demand for the investment, and the price will likely increase until a price is established that equates the expected return with the required return.

a. Trueb. False

Coefficient of variation Answer: b Diff: M . Because of differences in the expected returns of different securities, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation will always allow an investor to properly compare the relative risks of any two securities.

a. Trueb. False

Risk aversion Answer: b Diff: M . Risk aversion implies that some securities will go unpurchased in the market even if a large risk premium is paid to investors.

a. Trueb. False

Risk premium and risk aversion Answer: a Diff: M . Risk aversion is a general dislike for risk and a preference for certainty. That is, investors would be willing to give up a risk premium of return in order to obtain a lower return with certainty.

a. Trueb. False

Portfolio risk Answer: a Diff: M . Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification effects, we would expect Portfolio B to have the lower relevant risk, but it is possible for Portfolio A to be less risky.

a. Trueb. False

Portfolio risk Answer: b Diff: M

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. Portfolio A has but one security, while Portfolio B has 100 securities. Because of diversification, we know that Portfolio B will have the lower market risk; that is, Portfolio B will have the lower beta.

a. Trueb. False

Reducing portfolio risk Answer: a Diff: M . While the portfolio return is a weighted average of realized security returns, portfolio risk is not necessarily a weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and actually reduce the riskiness of a portfolio.

a. Trueb. False

Portfolio risk and returnAnswer: b Diff: M . The distributions of rates of return for Companies AA and BB are given below:

State of Probability of Economy State Occurring AA BB Boom 0.2 30% -10% Normal 0.6 10 5 Recession 0.2 -5 50

We can conclude from the above information that any rational risk-averse investor will add Security AA to a well-diversified portfolio over Security BB.

a. Trueb. False

Correlation coefficient and risk Answer: b Diff: M . Even if the correlation between the returns on two different securities is perfectly positive, if the securities are combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held alone.

a. Trueb. False

Company-specific risk Answer: b Diff: M . When a firm makes bad managerial judgements or has unforeseen negative events happen to it that affect its returns, these random events are unpredictable and therefore cannot be diversified away by the investor.

a. Trueb. False

Portfolio risk and beta Answer: b Diff: M

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. If I know for sure that the market will have a positive return over the next year, to maximize my rate of return, I should increase the beta of my portfolio.

a. Trueb. False

Beta coefficient Answer: a Diff: M . A portfolio with a beta of minus 2 has the same degree of risk to its holder, relative to the market, as a portfolio with a beta of plus 2. However, the holder of either portfolio could lower his or her risk exposure by buying some "normal" stocks.

a. Trueb. False

Portfolio beta Answer: a Diff: M . We will generally find that the beta of a diversified portfolio is more stable over time than the beta of a single security.

a. Trueb. False

Changes in betaAnswer: a Diff: M . Any change in beta is likely to affect the required rate of return on a security, which implies that a change in beta will likely have an impact on the security's price.

a. Trueb. False

Diversification effects Answer: a Diff: M . If an investor buys enough stocks, he or she can, through diversifica- tion, eliminate all of the non-market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all market risk.

a. Trueb. False

CAPM Answer: a Diff: M . The CAPM is built on expected conditions, although we are limited in most cases to using past data in applying it. Betas used in the CAPM, calculated using historical data, are always subject to changes in future volatility and this is a limitation on the use of the CAPM.

a. Trueb. False

CAPM and inflation Answer: b Diff: M . If the price of money increases due to greater anticipated inflation, the risk-free rate will reflect this fact. Although rRF will increase, it is possible that the SML required rate of return for a stock will

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decrease because the market risk premium (rM - rRF) will decrease. (Assume that beta remains constant.)

a. Trueb. False

Market risk premium Answer: a Diff: M . Since the market return represents the return on an average stock, that return carries risk with it. As a result, there exists a market risk premium which is the amount over and above the risk-free rate that is required to compensate an investor for assuming an average amount of risk.

a. Trueb. False

SML Answer: a Diff: M . If you plotted the returns of a given stock against those of the market, and if you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue into the future.

a. Trueb. False

SML Answer: b Diff: M . The Y-axis intercept of the SML indicates the return on the individual asset when the realized return on an average stock (beta = 1.0) is zero.

a. Trueb. False

Multiple Choice: Conceptual

Easy:

Risk concepts Answer: e Diff: E . Which of the following statements is most correct?

a. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events.b. Portfolio diversification reduces the variability of returns on an individual stock.c. When company-specific risk has been diversified, the inherent risk that remains is market risk which is constant for all securities in the market.d. A stock with a beta of -1.0 has zero market risk.e. The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.

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Risk measures Answer: a Diff: E . You observe the following information regarding Company X and Company Y:

• Company X has a higher expected mean return than Company Y.• Company X has a lower standard deviation than Company Y.• Company X has a higher beta than Company Y.

Given this information, which of the following statements is most correct?

a. Company X has a lower coefficient of variation.b. Company X has more company-specific risk.c. Company X is a better stock to buy.d. Statements a and b are correct.e. Statements a, b, and c are correct.

Beta coefficient Answer: d Diff: E . Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)

a. When held in isolation, Stock A has greater risk than Stock B.b. Stock B would be a more desirable addition to a portfolio than Stock A.c. Stock A would be a more desirable addition to a portfolio than Stock B.d. The expected return on Stock A will be greater than that on Stock B.e. The expected return on Stock B will be greater than that on Stock A.

Portfolio risk and returnAnswer: a Diff: E . Stock A and Stock B each have an expected return of 15 percent, a standard deviation of 20 percent, and a beta of 1.2. The returns of the two stocks are not perfectly correlated; the correlation coefficient is 0.6. You have put together a portfolio which is 50 percent Stock A and 50 percent Stock B. Which of the following statements is most correct?

a. The portfolio’s expected return is 15 percent.b. The portfolio’s beta is less than 1.2.c. The portfolio’s standard deviation is 20 percent.d. Statements a and b are correct.e. All of the statements above are correct.

SML Answer: a Diff: E . Which of the following statements is incorrect?

a. The slope of the security market line is measured by beta.b. Two securities with the same stand-alone risk can have different betas.c. Company-specific risk can be diversified away.d. The market risk premium is affected by attitudes about risk.e. Higher beta stocks have a higher required return.

SML Answer: b Diff: E

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. Which of the following statements is most correct?

a. The slope of the security market line is beta.b. The slope of the security market line is the market risk premium, (rM – rRF).

c. If you double a company’s beta its required return more than doubles.d. Statements a and c are correct.e. Statements b and c are correct.

SML Answer: c Diff: E . Stock A has a beta of 1.2 and a standard deviation of 20 percent. Stock B has a beta of 0.8 and a standard deviation of 25 percent. Portfolio P is a $200,000 portfolio consisting of $100,000 invested in Stock A and $100,000 invested in Stock B. Which of the following statements is most correct? (Assume that the required return is determined by the Security Market Line.)

a. Stock B has a higher required rate of return than stock A.b. Portfolio P has a standard deviation of 22.5 percent.c. Portfolio P has a beta equal to 1.0.d. Statements a and b are correct.e. Statements a and c are correct.

SML, CAPM, and beta Answer: e Diff: E . Which of the following statements is most correct?

a. The slope of the security market line is beta.b. A stock with a negative beta must have a negative required rate of return.

c. If a stock’s beta doubles its required rate of return must double.d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium.

e. None of the above statements is correct.

Risk analysis and portfolio diversification Answer: d Diff: E . Which of the following statements is most correct?

a. Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.b. If an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the non¬market (or company-specific) risk inherent in owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it would be riskless.c. The required return on a firm's common stock is determined by its systematic (or market) risk. If the systematic risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return.d. A security's beta measures its nondiversifiable (systematic, or market) risk relative to that of an average stock.e. A stock's beta is less relevant as a measure of risk to an investor with a well diversified portfolio than to an investor who holds only that one stock.

Medium:

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Market equilibrium Answer: a Diff: M . For markets to be in equilibrium, that is, for there to be no strong pressure for prices to depart from their current levels,

a. The expected rate of return must be equal to the required rate of return; that is, = r.b. The past realized rate of return must be equal to the expected rate of return; that is, r = .c. The required rate of return must equal the realized rate of return; that is, r = .d. All three of the statements above must hold for equilibrium to exist; that is, = r = .e. None of the statements above is correct.

Risk aversion Answer: b Diff: M . You have developed the following data on three stocks:

Stock Standard Deviation Beta A 0.15 0.79 B 0.25 0.61 C 0.20 1.29

If you are a risk minimizer, you should choose Stock _____ if it is to be held in isolation and Stock _____ if it is to be held as part of a well-diversified portfolio.

a. A; Ab. A; Bc. B; Ad. C; Ae. C; B

SML and risk aversion Answer: e Diff: M . Assume that investors become increasingly risk averse, so that the market risk premium increases. Also, assume that the risk-free rate and expected inflation remain the same. Which of the following is most likely to occur?

a. The required rate of return will decline for stocks that have betas less than 1.0.b. The required rate of return on the market, rM will remain the same.c. The required rate of return for each stock in the market will increase by an amount equal to the increase in the market risk premium.d. Answers a and b are correct.e. None of the statements above is correct.

Portfolio return Answer: b Diff: M . The risk-free rate, rRF, is 6 percent and the market risk premium, (rM – rRF), is 5 percent. Assume that required returns are based on the CAPM. Your $1 million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. Which of the following statements is most correct?

a. The portfolio’s required return is less than 11 percent.

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b. If the risk-free rate remains unchanged but the market risk premium increases by 2 percentage points, the required return on your portfolio will increase by more than 2 percentage points.c. If the market risk premium remains unchanged but expected inflation increases by 2 percentage points, the required return on your portfolio will increase by more than 2 percentage points.d. If the stock market is efficient, your portfolio’s expected return should equal the expected return on the market, which is 11 percent.e. None of the above answers is correct.

Portfolio risk and returnAnswer: c Diff: M . In a portfolio of three different stocks, which of the following could not be true?

a. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isola¬tion.b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.c. The beta of the portfolio is less than the beta of each of the individual stocks.d. The beta of the portfolio is greater than the beta of one or two of the individual stocks' betas.e. None of the above (that is, they all could be true, but not necessarily at the same time).

Portfolio risk Answer: e Diff: M . Which of the following statements is most correct?

a. Market participants are able to eliminate virtually all market risk if they hold a large diversified portfolio of stocks.b. Market participants are able to eliminate virtually all company- specific risk if they hold a large diversified portfolio of stocks.c. It is possible to have a situation where the market risk of a single stock is less than that of a well diversified portfolio.d. Answers a and c are correct.e. Answers b and c are correct.

Portfolio risk and beta Answer: c Diff: M . Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is most correct?

a. Stock B’s required return is double that of Stock A’s.b. An equally weighted portfolio of Stock A and Stock B will have a beta less than 1.2.c. If market participants become more risk averse, the required return on Stock B will increase more than the required return for Stock A.d. All of the answers above are correct.e. Answers a and c are correct.

Portfolio risk and beta Answer: e Diff: M . Which of the following statements is most correct?

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a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk from the portfolio.b. If you formed a portfolio which included a large number of low beta stocks (stocks with betas less than 1.0 but greater than -1.0), the portfolio would itself have a beta coefficient that is equal to the weighted average beta of the stocks in the portfolio, so the portfolio would have a relatively low degree of risk.c. If you were restricted to investing in publicly traded common stocks, yet you wanted to minimize the riskiness of your portfolio as measured by its beta, then, according to the CAPM theory, you should invest some of your money in each stock in the market, i.e., if there were 10,000 traded stocks in the world, the least risky portfolio would include some shares in each of them.d. Diversifiable risk can be eliminated by forming a large portfolio, but normally even highly diversified portfolios are subject to market risk.e. Statements b and d are correct.

Portfolio diversification Answer: c Diff: M . Jane holds a large diversified portfolio of 100 randomly selected stocks and the portfolio’s beta = 1.2. Each of the individual stocks in her portfolio has a standard deviation of 20 percent. Jack has the same amount of money invested in a single stock with a beta equal to 1.6 and a standard deviation of 20 percent. Which of the following statements is most correct?

a. Jane’s portfolio has a larger amount of company-specific risk since she is holding more stocks in her portfolio.b. Jane has a higher required rate of return, since she is more diversified.

c. Jane’s portfolio has less market risk since it has a lower beta.d. Statements b and c are correct.e. None of the statements above is correct.

Market risk Answer: b Diff: M . Inflation, recession, and high interest rates are economic events which are characterized as

a. Company-specific risk that can be diversified away.b. Market risk.c. Systematic risk that can be diversified away.d. Diversifiable risk.e. Unsystematic risk that can be diversified away.

Beta coefficient Answer: a Diff: M . Which of the following statements is most correct?

a. The beta coefficient of a stock is normally found by running a regression of past returns on the stock against past returns on a stock market index. One could also construct a scatter diagram of returns on the stock versus those on the market, estimate the slope of the line of best fit, and use it as beta.b. It is theoretically possible for a stock to have a beta of 1.0. If a stock did have a beta of 1.0, then, at least in theory, its required rate of return would be equal to the riskless (default-free) rate of return, rRF.

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c. If you found a stock with a zero beta and held it as the only stock in your portfolio, you would by definition have a riskless portfolio. Your 1-stock portfolio would be even less risky if the stock had a negative beta.d. The beta of a portfolio of stocks is always larger than the betas of any of the individual stocks.e. All of the statements above are true.

Beta coefficient Answer: a Diff: M . Which of the following statements is most correct?

a. Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis, while the other has a beta of -0.6. The returns on the stock with the negative beta will be negatively correlated with returns on most other stocks in the market.b. Suppose you are managing a stock portfolio, and you have information which leads you to believe that the stock market is likely to be very strong in the immediate future, i.e., you are confident that the market is about to rise sharply. You should sell your high beta stocks and buy low beta stocks in order to take advantage of the expected market move.c. Collections Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Collections' revenues, profits, and stock price tend to rise during recessions. This suggests that Collections Inc.'s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.d. Statements a and b are true.e. Statements a and c are true.

Beta coefficient Answer: d Diff: M . You have developed data which give (1) the average annual returns on the market for the past five years, and (2) similar information on Stocks A and B. If these data are as follows, which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B 1 0.03 0.16 0.05 2 -0.05 0.20 0.05 3 0.01 0.18 0.05 4 -0.10 0.25 0.05 5 0.06 0.14 0.05

a. bA > 0; bB = 1b. bA > +1; bB = 0c. bA = 0; bB = -1d. bA < 0; bB = 0e. bA < -1; bB = 1

Beta coefficient Answer: c Diff: M . Which of the following is not a difficulty concerning beta and its estimation?

a. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

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b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the "true" or "expected future" beta.c. The beta of an "average stock," or "the market," can change over time, sometimes drastically.d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

SML Answer: e Diff: M . Which of the following statements is most correct?

a. The SML relates required returns to firms' market risk. The slope and intercept of this line cannot be controlled by the financial manager.b. The slope of the SML is determined by the value of beta.c. If you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative, the CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue on into the future.d. If investors become less risk averse, the slope of the Security Market Line will increase.e. Statements a and c are true.

SML Answer: a Diff: M . Other things held constant, (1) if the expected inflation rate decreases, and (2) investors become more risk averse, the Security Market Line would shift

a. Down and have steeper slope.b. Up and have less steep slope.c. Up and keep same slope.d. Down and keep same slope.e. Down and have less steep slope.

SML Answer: b Diff: M . Which of the following statements is most correct about a stock which has a beta = 1.2?

a. If the stock's beta doubles its expected return will double.b. If expected inflation increases 3 percent, the stock's expected return will increase by 3 percent.c. If the market risk premium increases by 3 percent the stock's expected return will increase by less than 3 percent.d. Answers a, b, and c are correct.e. Answers b and c are correct.

SML, CAPM, and portfolio risk Answer: a Diff: M . Which of the following statements is most correct?

a. An increase in expected inflation could be expected to increase the required return on a riskless asset and on an average stock by the same amount, other things held constant.b. A graph of the SML would show required rates of return on the vertical axis and standard deviations of returns on the horizontal axis.

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c. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the portfolio's expected return would be a weighted average of the stocks' expected returns, but the portfolio's standard deviation would probably be greater than the average of the stocks' standard deviations.d. If investors became more averse to risk, then (1) the slope of the SML would increase and (2) the required rate of return on low-beta stocks would increase by more than the required return on high-beta stocks.e. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any reasonable doubt.

Portfolio return, CAPM, and beta Answer: e Diff: M . Which of the following statements is most correct?

a. If the returns from two stocks are perfectly positively correlated (i.e., the correlation coefficient is +1) and the two stocks have equal variance, an equally weighted portfolio of the two stocks will have a variance which is less than that of the individual stocks.b. If a stock has a negative beta, its expected return must be negative.c. According to the CAPM, stocks with higher standard deviations of returns will have higher expected returns.d. A portfolio with a large number of randomly selected stocks will have less market risk than a single stock which has a beta equal to 0.5. e. None of the statements above is correct.

CAPM and required returns Answer: d Diff: M . Which of the following statements is most correct?

a. We would observe a downward shift in the required returns of all stocks if investors believed that there would be deflation in the economy.b. If investors became more risk averse, then the new security market line would have a steeper slope.c. If the beta of a company doubles, then the required rate of return will also double.d. Both statements a and b are correct.e. All of the statements above are correct.

Risk analysis and portfolio diversification Answer: e Diff: M . Which of the following statements is most correct?

a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all the market risk from the portfolio.b. If you form a large portfolio of stocks each with a beta greater than 1.0, this portfolio will have more market risk than a single stock with a beta = 0.8.c. Company-specific (or unsystematic) risk can be reduced by forming a large portfolio, but normally even highly diversified portfolios are subject to market (or systematic) risk.d. Answers a, b, and c are correct.e. Answers b and c are correct.

Portfolio risk and SML Answer: e Diff: M . Which of the following statements is most correct?

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a. It is possible to have a situation where the market risk of a single stock is less than the market risk of a portfolio of stocks.b. The market risk premium will increase if, on average, market participants become more risk averse.c. If you selected a group of stocks whose returns are perfectly positively correlated, then you could end up with a portfolio for which none of the unsystematic risk is diversified away.d. Statements a and b are correct.e. All of the statements above are correct.Tough:

CAPM Answer: c Diff: T . Which of the following statements is most correct?

a. According to CAPM theory, the required rate of return on a given stock can be found by use of the SML equation:

ri = rRF + (rM - rRF)bi.

Expectations for inflation are not reflected anywhere in this equation, even indirectly, and because of that the text notes that the CAPM may not be strictly correct.b. If the required rate of return is given by the SML equation as set forth in Statement a, there is nothing a financial manager can do to change his or her company's cost of capital, because each of the elements in the equation is determined exclusively by the market, not by the type of actions a company's management can take, even in the long run.c. Assume that the required rate of return on the market is currently rM = 15%, and that rM remains fixed at that level. If the yield curve has a steep upward slope, the calculated market risk premium would be larger if the 30-day T-bill rate were used as the risk-free rate than if the 30-year T-bond rate were used as rRF.d. Statements a and b are true.e. Statements a and c are true.

SML Answer: d Diff: T . Which of the following statements is most correct?

a. If investors become more risk averse, but rRF remains constant, the required rate of return on high beta stocks will rise, the required return on low beta stocks will decline, but the required return on an average risk stock will not change.b. If Mutual Fund A held equal amounts of 100 stocks, each of which had a beta of 1.0, and Mutual Fund B held equal amounts of 10 stocks with betas of 1.0, then the two mutual funds would both have betas of 1.0 and thus would be equally risky from an investor's standpoint.c. An investor who holds just one stock will be exposed to more risk than an investor who holds a portfolio of stocks, assuming the stocks are all equally risky. Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn a higher rate of return to compensate for the greater risk.d. Assume that the required rate of return on the market, rM, is given and fixed. If the yield curve were upward-sloping, then the Security Market Line (SML) would have a steeper slope if 1-year Treasury securities were used as the risk-free rate than if 30-year Treasury bonds were used for rRF.

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e. Statements a, b, c, and d are false.

Multiple Choice: Problems

Easy:

Required returnAnswer: a Diff: E . Calculate the required rate of return for Mars Inc.’s stock. The Mars’s beta is 1.2, the rate on a T-bill is 4 percent, the rate on a long-term T-bond is 6 percent, the expected return on the market is 11.5 percent, the market has averaged a 14 percent annual return over the last six years, and Mars has averaged a 14.4 return over the last six years.

a. 12.6%b. 13.2%c. 14.0%d. 15.6%e. 16.2%

Required returnAnswer: d Diff: E . Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5 percent rate of inflation in the future. The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last 5 years.

a. 15%b. 16%c. 17%d. 18%e. 20%

CAPM and required return Answer: e Diff: E . HR Corporation has a beta of 2.0, while LR Corporation's beta is 0.5. The risk-free rate is 10 percent, and the required rate of return on an average stock is 15 percent. Now the expected rate of inflation built into rRF falls by 3 percentage points, the real risk-free rate remains constant, the required return on the market falls to 11 percent, and the betas remain constant. When all of these changes are made, what will be the difference in the required returns on HR's and LR's stocks?

a. 1.0%b. 2.5%c. 4.5%d. 5.4%e. 6.0%

Beta coefficient Answer: b Diff: E . Given the following information, determine which beta coefficient for Stock A is consistent with equilibrium:

rA = 11.3%; rRF = 5%; rM = 10%

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a. 0.86b. 1.26c. 1.10d. 0.80e. 1.35

Beta coefficient Answer: a Diff: E . Assume that the risk-free rate is 5 percent, and that the market risk premium is 7 percent. If a stock has a required rate of return of 13.75 percent, what is its beta?

a. 1.25b. 1.35c. 1.37d. 1.60e. 1.96

Portfolio beta Answer: b Diff: E . You hold a diversified portfolio consisting of a $10,000 investment in each of 20 different common stocks (i.e., your total investment is $200,000). The portfolio beta is equal to 1.2. You have decided to sell one of your stocks which has a beta equal to 0.7 for $10,000. You plan to use the proceeds to purchase another stock which has a beta equal to 1.4. What will be the beta of the new portfolio?

a. 1.165b. 1.235c. 1.250d. 1.284e. 1.333

Portfolio return Answer: b Diff: E . You are an investor in common stock, and you currently hold a well-diversified portfolio which has an expected return of 12 percent, a beta of 1.2, and a total value of $9,000. You plan to increase your portfolio by buying 100 shares of AT&E at $10 a share. AT&E has an expected return of 20 percent with a beta of 2.0. What will be the expected return and the beta of your portfolio after you purchase the new stock?

a. = 20.0%; bp = 2.00

b. = 12.8%; bp = 1.28

c. = 12.0%; bp = 1.20 d. = 13.2%; bp = 1.40e. = 14.0%; bp = 1.32

Market risk premium Answer: d Diff: E . A stock has an expected return of 12.25 percent. The beta of the stock is 1.15 and the risk-free rate is 5 percent. What is the market risk premium?

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a. 1.30%b. 6.50%c. 15.00%d. 6.30%e. 7.25%

Medium:

Expected returnAnswer: e Diff: M . Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities (i.e., the probability distributions) are as follows:

Asset X Asset Y P r P r 0.10 -3% 0.05 -3% 0.10 2 0.10 2 0.25 5 0.30 5 0.25 8 0.30 8 0.30 10 0.25 10

Which asset should be preferred?

a. Asset X, since its expected return is higher.b. Asset Y, since its beta is probably lower.c. Either one, since the expected returns are the same.d. Asset X, since its standard deviation is lower.e. Asset Y, since its coefficient of variation is lower and its expected return is higher.

Expected returnAnswer: c Diff: M . Given the following probability distribution, what is the expected return and the standard deviation of returns for Security J?

State Pi rJ _____ ____ ____ 1 0.2 10% 2 0.6 15 3 0.2 20

a. 15%; 6.50%b. 12%; 5.18%c. 15%; 3.16%d. 15%; 10.00%e. 20%; 5.00%

Required returnAnswer: c Diff: M

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. You are holding a stock which has a beta of 2.0 and is currently in equilibrium. The required return on the stock is 15 percent, and the return on an average stock is 10 percent. What would be the percentage change in the return on the stock, if the return on an average stock increased by 30 percent while the risk-free rate remained unchanged?

a. +20%b. +30%c. +40%d. +50%e. +60%Required returnAnswer: c Diff: M . Oakdale Furniture Inc. has a beta coefficient of 0.7 and a required rate of return of 15 percent. The market risk premium is currently 5 percent. If the inflation premium increases by 2 percentage points, and Oakdale acquires new assets which increase its beta by 50 percent, what will be Oakdale's new required rate of return?

a. 13.50%b. 22.80%c. 18.75%d. 15.25%e. 17.00%

CAPM and required return Answer: d Diff: M . Your portfolio consists of $100,000 invested in a stock which has a beta = 0.8, $150,000 invested in a stock which has a beta = 1.2, and $50,000 invested in a stock which has a beta = 1.8. The risk-free rate is 7 percent. Last year this portfolio had a required rate of return of 13 percent. This year nothing has changed except for the fact that the market risk premium has increased by 2 percent (two percentage points). What is the portfolio's current required rate of return?

a. 5.14%b. 7.14%c. 11.45%d. 15.33%e. 16.25%

Portfolio beta Answer: b Diff: M . You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.15. You have decided to sell one of your stocks, a lead mining stock whose b is equal to 1.0, for $5,000 net and to use the proceeds to buy $5,000 of stock in a steel company whose b is equal to 2.0. What will be the new beta of the portfolio?

a. 1.12b. 1.20c. 1.22d. 1.10e. 1.15

Portfolio beta Answer: c Diff: M

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. A mutual fund manager has a $200,000,000 portfolio with a beta = 1.2. Assume that the risk-free rate is 6 percent and that the market risk premium is also 6 percent. The manager expects to receive an additional $50,000,000 in funds soon. She wants to invest these funds in a variety of stocks. After making these additional investments, she wants the fund's expected return to be 13.5 percent. What should be the average beta of the new stocks added to the portfolio?

a. 1.10b. 1.33c. 1.45d. 1.64e. 1.87

Portfolio beta Answer: e Diff: M . Walter Jasper currently manages a $500,000 portfolio. He is expecting to receive an additional $250,000 from a new client. The existing portfolio has a required return of 10.75 percent. The risk-free rate is 4 percent and the return on the market is 9 percent. If Walter wants the required return on the new portfolio to be 11.5 percent, what should be the average beta for the new stocks added to the portfolio?

a. 1.50b. 2.00c. 1.67d. 1.35e. 1.80

Portfolio return Answer: a Diff: M . An investor is forming a portfolio by investing $50,000 in stock A which has a beta of 1.50, and $25,000 in stock B which has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have a yield of 4 percent. What is the required rate of return on the investor's portfolio?

a. 6.6%b. 6.8%c. 5.8%d. 7.0%e. None of the answers above is correct.

Coefficient of variation Answer: b Diff: M . Ripken Iron Works faces the following probability distribution:

State of Probability of Stock’s Expected Returnthe Economy State Occurring if this State Occurs Boom 0.25 25%Normal 0.50 15 Recession 0.25 5

What is the coefficient of variation on the company's stock? (Assume that the standard deviation is calculated using the probability statistic.)

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a. 0.06b. 0.47c. 0.54d. 0.67e. 0.71

Coefficient of variation Answer: c Diff: M . An analyst has estimated how a particular stock’s return will vary depending on what will happen to the economy:

State of Probability of Stock’s Expected Returnthe Economy State Occurring if this State Occurs Recession 0.10 -60%Below Average 0.20 -10 Average 0.40 15 Above Average 0.20 40 Boom 0.10 90

What is the coefficient of variation on the company’s stock? (Use the population standard deviation to calculate the coefficient of variation.)

a. 2.121b. 2.201c. 2.472d. 3.334e. 3.727

Coefficient of variation Answer: c Diff: M . The following probability distributions of returns for two stocks have been estimated:

Probability Stock A Stock B0.3 12% 5%0.4 8 4 0.3 6 3

What is the coefficient of variation for the stock that is less risky (assuming you use the coefficient of variation to rank riskiness).

a. 3.62b. 0.28c. 0.19d. 0.66e. 5.16

Beta coefficient Answer: a Diff: M . An investor has $5,000 invested in a stock which has an estimated beta of 1.2, and another $15,000 invested in the stock of the company for which she works. The risk-free rate is 6 percent and

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the market risk premium is also 6 percent. The investor calculates that the required rate of return on her total ($20,000) portfolio is 15 percent. What is the beta of the company for which she works?

a. 1.6b. 1.7c. 1.8d. 1.9e. 2.0

Market return Answer: d Diff: M . The returns of United Railroad Inc. (URI) are listed below, along with the returns on "the market":

Year URI Market 1 -14% -9% 2 16 11 3 22 15 4 7 5 5 -2 -1

If the risk-free rate is 9 percent and the required return on URI's stock is 15 percent, what is the required return on the market? Assume the market is in equi¬librium. (Hint: Think rise over run.)

a. 4%b. 9%c. 10%d. 13%e. 16%

CAPM and required return Answer: d Diff: M . Company X has a beta of 1.6, while Company Y's beta is 0.7. The risk-free rate is 7 percent, and the required rate of return on an average stock is 12 percent. Now the expected rate of inflation built into rRF rises by 1 percentage point, the real risk-free rate remains constant, the required return on the market rises to 14 percent, and betas remain constant. After all of these changes have been reflected in the data, by how much will the required return on Stock X exceed that on Stock Y?

a. 3.75%b. 4.20%c. 4.82%d. 5.40%e. 5.75%

Expected and required returns Answer: b Diff: M . You have been scouring The Wall Street Journal looking for stocks that are "good values" and have calculated the expected returns for five stocks. Assume the risk-free rate (rRF) is 7 percent and the market risk premium ( - ) is 2 percent. Which security would be the best investment? (Assume you must choose just one.)

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Expected Return Betaa. 9.01% 1.70b. 7.06% 0.00c. 5.04% -0.67d. 8.74% 0.87e. 11.50% 2.50

CAPM and beta coefficient Answer: d Diff: M . A money manager is managing the account of a large investor. The investor holds the following stocks:

Stock Amount Invested Estimated Beta A $2,000,000 0.80

B 5,000,000 1.10 C 3,000,000 1.40 D 5,000,000 ???

The portfolio’s required rate of return is 17 percent. The risk-free rate, rRF, is 7 percent and the

return on the market, rM, is 14 percent. What is Stock D’s estimated beta?

a. 1.256b. 1.389c. 1.429d. 2.026e. 2.154

Tough:

Portfolio required return Answer: a Diff: T . A money manager is holding the following portfolio:

Stock Amount Invested Beta 1 $300,000 0.6 2 300,000 1.0 3 500,000 1.4 4 500,000 1.8

The risk-free rate is 6 percent and the portfolio’s required rate of return is 12.5 percent. The manager would like to sell all of her holdings of Stock 1 and use the proceeds to purchase more shares of Stock 4. What would be the portfolio’s required rate of return following this change?

a. 13.63%b. 10.29%c. 11.05%d. 12.52%e. 14.33%

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Financial Calculator Section

Multiple Choice: Problems

Easy:

Coefficient of variation Answer: b Diff: E . Below are the stock returns for the past five years for Agnew Industries:

Year Stock Return 1 22% 2 33 3 1 4 -12 5 10

What was the stock’s coefficient of variation during this five-year period? (Use the population standard deviation to calculate the coefficient of variation.)

a. 10.80b. 1.46c. 15.72d. 0.69e. 4.22

Medium:

CAPM and required return Answer: e Diff: M . Historical rates of return for the market and for Stock A are given below: Year Market Stock A 1 6.0% 8.0% 2 -8.0 3.0 3 -8.0 -2.0 4 18.0 12.0

If the required return on the market is 11 percent and the risk-free rate is 6 percent, what is the required return on Stock A, according to CAPM/SML theory?

a. 6.00%b. 6.57%c. 7.25%d. 7.79%e. 8.27%

CAPM and required return Answer: a Diff: M . Some returns data for the market and for Countercyclical Corp. are given below: Year Market Countercyclical Year 1 -2.0% 8.0%

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Year 2 12.0 3.0 Year 3 -8.0 18.0 Year 4 21.0 -7.0

The required return on the market is 14 percent, and the risk-free rate is 8 percent. What is the required return on Countercyclical Corp., according to CAPM/SML theory?

a. 3.42%b. 4.58%c. 8.00%d. 11.76%e. 14.00%

Portfolio standard deviation Answer: a Diff: M . Here are the expected returns on two stocks:

Returns Probability X Y 0.1 -20% 10% 0.8 20 15 0.1 40 20

If you form a 50-50 portfolio of the two stocks, what is the portfolio's standard deviation?

a. 8.1%b. 10.5%c. 13.4%d. 16.5%e. 20.0%

Expected and required returns Answer: c Diff: M . The realized returns for the market and Stock J for the last 4 years are given below:

Year Market Stock J 1 10% 5% 2 15 0 3 -5 14 4 0 10

An average stock has an expected return of 12 percent, and the market risk premium is 4 percent. If Stock J's expected rate of return as viewed by a marginal investor is 8 percent, what is the difference between J's expected and required rates of return?

a. 0.66%b. 1.25%c. 2.64%d. 3.72%

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e. 5.36%

Portfolio return Answer: c Diff: M . Stock X, Stock Y, and the market have had the following returns over the past four years.

Year Market X Y 1 11% 10% 12% 2 7 4 -3 3 17 12 21 4 -3 -2 -5

The risk-free rate is 7 percent. The market risk premium is 5 percent. What is the required rate of return for a portfolio which consists of $14,000 invested in Stock X and $6,000 invested in Stock Y?

a. 9.94%b. 10.68%c. 11.58%d. 12.41%e. 13.67%

Beta coefficient Answer: a Diff: E . If the returns of two firms are negatively correlated, then one of them must have a negative beta.

a. Trueb. False

Beta coefficient Answer: b Diff: E . A stock with a beta equal to -1.0 has zero systematic (or market) risk.

a. Trueb. False

Beta coefficient Answer: a Diff: E . It is possible for a firm to have a positive beta, even if the correlation between the returns of it and another firm are negative.

a. Trueb. False

Linearity and beta Answer: a Diff: E . In estimating a security's beta coefficient, the rise-over-run calculation results in a ratio. If all the observation points for the security's returns and the market's returns do not fall on a straight line then the ratio is subject to change.

a. Trueb. False

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SML Answer: a Diff: E . The SML relates required returns to firms’ syste¬matic (or market) risk. The slope and intercept of this line are not controllable by the financial manager.

a. Trueb. False

SML Answer: b Diff: E . The slope of the SML is determined by the value of beta.

a. Trueb. False

SML Answer: a Diff: E . If you plotted the returns of Selleck and Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

a. Trueb. False

Portfolio risk Answer: a Diff: E . In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

a. Trueb. False

Medium:

CAPM Answer: b Diff: M . The Capital Asset Pricing Model (CAPM) is a multi-period model which takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

a. Trueb. False

Portfolio beta Answer: b Diff: M . We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

a. Trueb. False

SML Answer: b Diff: M

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. The Y-axis intercept of the SML indicates the return on the individual asset when the realized return on an average (b = 1) stock is zero.

a. Trueb. False

Risk aversion Answer: a Diff: M . If investors are risk averse, we can conclude that the required rate of return associated with an asset held in isolation whose standard deviation is 0.21 will be greater than the return required on an asset whose standard deviation is 0.10. However, if assets are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

a. Trueb. False

Arbitrage Pricing Theory Answer: b Diff: M . Arbitrage Pricing Theory is based on the premise that more than one factor affects stock returns. The factors are (1) market returns, (2) dividend yield, and (3) changes in inflation.

a. Trueb. False

Multiple Choice: Conceptual

Easy:

Risk aversion Answer: b Diff: E . You have developed the following data on three stocks:

Stock Standard Deviation Beta A 0.15 0.79 B 0.25 0.61 C 0.20 1.29

As a risk minimizer, you would choose Stock if held in isolation and Stock if held as part of a well-diversified portfolio.

a. A; A.b. A; B.c. B; C.d. C; A.e. C; B.

Risk measures Answer: d Diff: E . Which is the best measure of risk for an asset held in isolation? Which is the best measure for an asset held in a diversified portfolio?

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a. Variance; correlation coefficient.b. Standard deviation; correlation coefficient.c. Beta; variance.d. Coefficient of variation; beta.e. Beta; beta.

Beta coefficient Answer: c Diff: E . Which of the following is not a difficulty concerning beta and its estimation?

a. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta.

c. The beta of an “average stock,” or “the market,” can change over time, sometimes drastically.

d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

e. All of the statements above are potentially serious problems.

Beta coefficient Answer: d Diff: E . Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)

a. When held in isolation, Stock A has greater risk than Stock B.b. Stock B would be a more desirable addition to a portfolio than Stock A.c. Stock A would be a more desirable addition to a portfolio than Stock B.d. The expected return on Stock A will be greater than that on Stock B.e. The expected return on Stock B will be greater than that on Stock A.

Portfolio risk and returnAnswer: c Diff: E . In a portfolio of three different stocks, which of the following could not be true?

a. The riskiness of the portfolio is less than the riskiness of each of the stocks held in isolation.

b. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.c. The beta of the portfolio is less than the beta of each of the individual stocks.d. The beta of the portfolio is greater than the beta of one or two of the individual stocks’

betas.e. None of the above (i.e., they all could be true, but not necessarily at the same time).

Medium:

Beta coefficient Answer: d Diff: M . You have developed data which give (1) the average annual returns of the market for the past five years and (2) similar information on Stocks A and B. If these data are as follows, which of the possible answers best describes the historical beta for A and B?

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Years Market Stock A Stock B 1 0.03 0.16 0.05 2 -0.05 0.20 0.05 3 0.01 0.18 0.05 4 -0.10 0.25 0.05 5 0.06 0.14 0.05

a. bA > 0; bB = 1.b. bA > +1; bB = 0.c. bA = 0; bB = -1.d. bA < 0; bB = 0.e. bA < -1; bB = 1.

Market equilibrium Answer: a Diff: M . For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),

a. The expected rate of return must be equal to the required rate of return; that is, .b. The past realized rate of return must be equal to the expected rate of return; that is, .c. The required rate of return must equal the realized rate of return; that is, .d. All three of the above statements must hold for equilibrium to exist; that is, .e. None of the above statements is correct.

CML Answer: e Diff: M . Which of the following statements is most correct?

a. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

b. The slope of the CML is ( M – rRF)/bM.c. All portfolios that lie on the CML to the right of M are inefficient.d. All portfolios that lie on the CML to the left of M are inefficient.e. None of the above statements is correct.

Characteristic line Answer: e Diff: M . Which of the following statements is most correct?

a. “Characteristic line” is another name for the Security Market Line.b. The characteristic line is the regression line that results from plotting the returns on a

particular stock versus the returns on a stock from a different industry.c. The slope of the characteristic line is the stock’s standard deviation.d. The distance of the plot points from the characteristic line is a measure of the stock’s

market risk.e. The distance of the plot points from the characteristic line is a measure of the stock’s

diversifiable risk.

Tests of the CAPM Answer: e Diff: M . Which of the following statements is most correct?

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a. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

b. Richard Roll has argued that it is not even possible to test the CAPM to see if it is correct.

c. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is less than that predicted by the CAPM.

d. Statements a and b are correct.e. Statements a, b, and c are correct.

Beta calculationAnswer: c Diff: M . Which of the following statements is most correct?

a. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is about 0.3.b. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.c. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is about 0.94.d. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.94.e. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is about 0.6.

Fama-French Model Answer: a Diff: M . Which of the following are the factors for the Fama-French model?

a. The excess market return, a size factor, and a book-to-market factor.b. The excess market return, a debt factor, and a book-to-market factor.c. The excess market return, a size factor, and a debt.d. A debt factor, a size factor, and a book-to-market factor.e. The excess market return, an industrial production factor, and a book-to-market factor.

Multiple Choice: Problems

Easy:

Portfolio beta Answer: b Diff: E . You hold a diversified portfolio consisting of a $5,000 investment in each of 20 different common stocks. The portfolio beta is equal to 1.12. You have decided to sell a lead mining stock (b = 1.0) at $5,000 net and use the proceeds to buy a like amount of a steel company stock (b = 2.0). What is the new beta of the portfolio?

a. 1.12b. 1.17c. 1.22d. 1.10e. 1.02

Portfolio return Answer: b Diff: E . You are an investor in common stock and currently hold a well-diversified portfolio which has an expected return of 12 percent with a beta of 1.2. You plan to buy 100 shares of AT&E at $10 a share.

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AT&E has an expected return of 20 percent with a beta of 2.0. The total value of your current portfolio is $9,000. What will be the expected return and beta of the portfolio after the purchase of the new stock?

a. rp = 20.0%; bp = 2.00b. rp = 12.8%; bp = 1.28c. rp = 12.0%; bp = 1.20d. rp = 13.2%; bp = 1.40e. rp = 14.0%; bp = 1.32

Required returnAnswer: d Diff: E . Calculate the required rate of return for Mercury, Inc., assuming that investors expect a 5 percent rate of inflation in the future. The real risk-free rate is equal to 3 percent and the market risk premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of return has averaged 15 percent over the last 5 years.

a. 15%b. 16%c. 17%d. 18%e. None of the above

Medium:

Required returnAnswer: c Diff: M . You are holding a stock which is currently in equilibrium. The required rate of return on the stock is 15 percent when the required return on an average stock is 10 percent. What will be the percentage change in the required return on the stock if the required return on an average stock increases by 30 percent while the risk-free rate is unchanged? Your stock has a beta of 2.

a. +20%b. +30%c. +40%d. +50%e. +60%

Required returnAnswer: c Diff: M . Consider the following information and then calculate the required rate of return for the Scientific Investment Fund. The funds’ assets are as follows:

Stock Investment Beta A $ 200,000 1.50 B 300,000 -0.50 C 500,000 1.25 D 1,000,000 0.75

The market required rate of return is 15 percent and the risk-free rate is 7 percent.

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a. 14.3%b. 15.0%c. 13.1%d. 12.7%e. 10.3%

Required returnAnswer: c Diff: M . Oakdale Furniture, Inc. has a beta coefficient of 0.7 and a required rate of return of 15 percent. The market risk premium is currently 5 percent. If we expect the inflation premium to increase by 2 percentage points and Oakdale to acquire assets which will increase its beta by 50 percent, what will be Oakdale’s new required rate of return?

a. 13.50%b. 22.80%c. 18.75%d. 15.25%e. 17.00%

Market return Answer: d Diff: M . The returns of United Railroad, Inc. (URI) are listed below, along with the returns on the market:

Year URI Market 2002 -14% -9% 2003 16 11 2004 22 15 2005 7 5 2006 -2 -1

If the risk-free rate is 9 percent and the required return on URI’s stock is 15 percent, what is the required return on the market? Assume the market is in equilibrium. (Hint: Think rise over run.)

a. 4%b. 9%c. 10%d. 13%e. 16%

Beta and base year sensitivity Answer: a Diff: M . Given the following returns on Stock Q and "the market" during the last three years, what is the difference in the calculated beta coefficient of Stock Q when Year 1 and Year 2 data are used as compared to Year 2 and Year 3 data?

Year Stock Q Market 1 6.30% 6.10% 2 -3.70 12.90 3 21.71 16.20

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a. 9.17b. 1.06c. 6.23d. 0.81e. 0.56

Discounted cash flows Answer: b Diff: E . The market value of any real or financial asset, including stocks, bonds, or art work, may be found by determining future cash flows and then discounting them back to the present.

a. Trueb. False

Issuing bonds Answer: b Diff: E . If a firm raises capital by selling new bonds, the buyer is called the "issuing firm," and the coupon rate is generally set equal to the required rate.

a. Trueb. False

Interest rate risk Answer: b Diff: E . A 20-year original maturity bond with 1 year left to maturity has more interest rate risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates.)

a. Trueb. False

Interest rate risk Answer: b Diff: E . Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, be subject to much more interest rate risk if you purchased a 30-day bond than if you bought a 30-year bond.

a. Trueb. False

Bond prices and interest rates Answer: a Diff: E . For bonds, price sensitivity to a given change in interest rates generally increases as years remaining to maturity increases.

a. Trueb. False

Mortgage bond Answer: a Diff: E . Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage bonds are backed by assets while debentures are unsecured.

a. True

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b. False

Debt coupon rate Answer: a Diff: E . Other things equal, a firm will have to pay a higher coupon rate on a subordinated debenture than on a second mortgage bond.

a. Trueb. False

Call provision Answer: b Diff: E . A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

a. Trueb. False

Sinking fund Answer: a Diff: E . Many bond indentures allow the company to acquire bonds for a sinking fund either by purchasing bonds in the market or by a lottery administered by the trustee for the purchase of a percentage of the issue through a call at face value.

a. Trueb. False

Zero coupon bond Answer: b Diff: E . A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells) at par, therefore providing compensation to investors in the form of capital appreciation.

a. Trueb. False

Floating rate debt Answer: a Diff: E . The motivation for floating rate bonds arose out of the costly experience of the early 1980s when inflation pushed interest rates to very high levels causing sharp declines in the prices of long-term bonds.

a. Trueb. FalseJunk bond Answer: a Diff: E . A junk bond is a high risk, high yield debt instrument typically used to finance a leveraged buyout or a merger, or to provide financing to a company of questionable financial strength.

a. Trueb. False

Bond ratings and required returns Answer: a Diff: E

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. There is an inverse relationship between bond ratings and the required return on a bond. The required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower.

a. Trueb. False

Medium:

Bond value Answer: a Diff: M . If the required rate of return on a bond is greater than its coupon interest rate (and rd remains above the coupon rate), the market value of that bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.)

a. Trueb. False

Bond value - annual payment Answer: a Diff: M . You have just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. If the coupon rate is 10 percent, with annual interest payments, and there are 10 years to maturity, you should make the purchase if your re¬quired return on investments of this type is 12 percent.

a. Trueb. False

Prices and interest rates Answer: a Diff: M . The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things equal and held constant.

a. Trueb. False

Bond premiums and discounts Answer: a Diff: M . A bond with a $100 annual interest payment with five years to maturity (not expected to default) would sell for a premium if interest rates were below 9 percent and would sell for a discount if interest rates were greater than 11 percent.

a. Trueb. False

Callable bond Answer: b Diff: M . A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore, if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.

a. Trueb. False

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Indexed bond Answer: b Diff: M . An indexed bond has its value tied to an inflation index. As inflation increases the value of the bond increases and the issuer is responsible for the accumulated value which may become much greater than the original face value.

a. Trueb. False

Income bond Answer: b Diff: M . Income bonds pay interest only when the amount of the interest is actually earned by the company. Thus, these securities cannot bankrupt a company and this makes them safer than regular bonds.

a. Trueb. False

Restrictive covenants Answer: a Diff: M . Restrictive covenants are designed so as to protect both the bondholder and the issuer even though they may constrain the actions of the firm's managers. Such covenants are contained in the bond's indenture.

a. Trueb. False

Sinking fund Answer: b Diff: M . You are considering two bonds. Both are rated double A (AA), both mature in 20 years, both have a 10 percent coupon, and both are offered to you at their $1,000 par value. However, Bond X has a sinking fund while Bond Y does not. This is probably not an equilibrium situation, as Bond X, which has the sinking fund, would generally be expected to have a higher yield than Bond Y.

a. Trueb. False

Floating rate debt Answer: b Diff: M . Floating rate debt is advantageous to investors because the interest rate moves up if market rates rise. Floating rate debt shifts interest rate risk to companies and thus has no advantages for issuers.

a. Trueb. False

Bond ratings Answer: a Diff: M . A firm with a low bond rating faces a more severe penalty when the Security Market Line (SML) is relatively steep than when it is not so steep.

a. True

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b. False

Multiple Choice: Conceptual

Easy:

Interest rates Answer: e Diff: E . One of the basic relationships in interest rate theory is that, other things held constant, for a given change in the required rate of return, the the time to maturity, the the change in price.

a. longer; smaller.b. shorter; larger.c. longer; greater.d. shorter; smaller.e. Answers c and d are correct.

Interest rate and reinvestment risk Answer: e Diff: E . Which of the following statements is most correct?

a. All else equal, long-term bonds have more interest rate risk than short term bonds.b. All else equal, higher coupon bonds have more reinvestment risk than low coupon bonds.c. All else equal, short-term bonds have more reinvestment risk than do long-term bonds.d. Statements a and c are correct.e. All of the statements above are correct.

Callable bond Answer: a Diff: E . Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

a. A reduction in market interest rates.b. The company's bonds are downgraded.c. An increase in the call premium.d. Answers a and b are correct.e. Answers a, b, and c are correct.Call provision Answer: b Diff: E . Other things held constant, if a bond indenture contains a call provision, the yield to maturity that would exist without such a call provision will generally be _________________ the YTM with it.

a. higher thanb. lower thanc. the same asd. either higher or lower, depending on the level of call premium, thane. unrelated to

Bond coupon rate Answer: c Diff: E . All of the following may serve to reduce the coupon rate that would otherwise be required on a bond issued at par, except a

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a. Sinking fund.b. Restrictive covenant.c. Call provision.d. Change in rating from Aa to Aaa.e. None of the answers above (all may reduce the required coupon rate).

Bond concepts Answer: a Diff: E . Which of the following statements is most correct?

a. All else equal, if a bond’s yield to maturity increases, its price will fall.b. All else equal, if a bond’s yield to maturity increases, its current yield will fall.c. If a bond’s yield to maturity exceeds the coupon rate, the bond will sell at a premium over par.d. All of the answers above are correct.e. None of the answers above is correct.

Bond concepts Answer: c Diff: E . Which of the following statements is most correct?

a. If a bond’s yield to maturity exceeds its annual coupon, then the bond will be trading at a premium.b. If interest rates increase, the relative price change of a 10-year coupon bond will be greater than the relative price change of a 10-year zero coupon bond.c. If a coupon bond is selling at par, its current yield equals its yield to maturity.d. Both a and c are correct.e. None of the answers above is correct.

Bond concepts Answer: e Diff: E . A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is currently selling at par ($1,000). Which of the following statements is most correct?

a. The bond’s yield to maturity is 9 percent.b. The bond’s current yield is 9 percent.c. If the bond’s yield to maturity remains constant, the bond’s price will remain at par.d. Both answers a and c are correct.e. All of the answers above are correct.

Sinking fund Answer: e Diff: E . Which of the following statements is most correct?

a. Sinking fund provisions do not require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.b. Sinking fund provisions sometimes work to the detriment of bondholders – particularly if interest rates have declined over time.c. If interest rates have increased since the time a company issues bonds with a sinking fund provision, the company is more likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.d. Statements a and b are correct.

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e. Statements b and c are correct.

Sinking fund provision Answer: d Diff: E . Which of the following statements is most correct?

a. Retiring bonds under a sinking fund provision is similar to calling bonds under a call provision in the sense that bonds are repurchased by the issuer prior to maturity.b. Under a sinking fund, bonds will be purchased on the open market by the issuer when the bonds are selling at a premium and bonds will be called in for redemption when the bonds are selling at a discount.c. The sinking fund provision makes a debt issue less risky to the investor.d. Both statements a and c are correct.e. All of the statements above are correct.

Types of debt Answer: e Diff: E . Which of the following statements is most correct?

a. Junk bonds typically have a lower yield to maturity relative to investment grade bonds.b. A debenture is a secured bond which is backed by some or all of the firm’s fixed assets.c. Subordinated debt has less default risk than senior debt.d. All of the statements above are correct.e. None of the statements above is correct.

Medium:

Bond yield Answer: b Diff: M . Which of the following statements is most correct?

a. Rising inflation makes the actual yield to maturity on a bond greater than the quoted yield to maturity which is based on market prices.b. The yield to maturity for a coupon bond that sells at its par value consists entirely of an interest yield; it has a zero expected capital gains yield.c. On an expected yield basis, the expected capital gains yield will always be positive because an investor would not purchase a bond with an expected capital loss.d. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm enters bankruptcy.e. All of the statements above are false.

Bond yield Answer: c Diff: M . Which of the following statements is most correct?

a. The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must have a higher yield to maturity than Bond B.b. If a bond is selling at a discount, the yield to call is a better measure of return than the yield to maturity.c. If a coupon bond is selling at par, its current yield equals its yield to maturity.d. Both a and b are correct.e. Both b and c are correct.

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Price risk Answer: c Diff: M . Assume that all interest rates in the economy decline from 10 percent to 9 percent. Which of the following bonds will have the largest percentage increase in price?

a. A 10-year bond with a 10 percent coupon.b. An 8-year bond with a 9 percent coupon.c. A 10-year zero coupon bond.d. A 1-year bond with a 15 percent coupon.e. A 3-year bond with a 10 percent coupon.

Price risk Answer: c Diff: M . Which of the following has the greatest price risk?

a. A 10-year, $1,000 face value, 10 percent coupon bond with semiannual interest payments.b. A 10-year, $1,000 face value, 10 percent coupon bond with annual interest payments.c. A 10-year, $1,000 face value, zero coupon bond.d. A 10-year $100 annuity.e. All of the above have the same price risk since they all mature in 10 years.Price risk Answer: c Diff: M . If the yield to maturity decreased 1 percentage point, which of the following bonds would have the largest percentage increase in value?

a. A 1-year bond with an 8 percent coupon.b. A 1-year zero-coupon bond.c. A 10-year zero-coupon bond.d. A 10-year bond with an 8 percent coupon.e. A 10-year bond with a 12 percent coupon.

Price risk Answer: a Diff: M . If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage increase in its value?

a. A 10-year zero coupon bond.b. A 10-year bond with a 10 percent semiannual coupon.c. A 10-year bond with a 10 percent annual coupon.d. A 5-year zero coupon bond.e. A 5-year bond with a 12 percent annual coupon.

Bond concepts Answer: e Diff: M . Which of the following statements is most correct?

a. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.b. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.c. Reinvestment rate risk is worse from a typical investor's standpoint than interest rate risk.

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d. If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium over its $1,000 par value.e. If a 10-year, $1,000 par, zero coupon bond were issued at a price which gave investors a 10 percent rate of return, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a discount below its $1,000 par value.

Bond concepts Answer: d Diff: M . Which of the following statements is most correct?

a. The market value of a bond will always approach its par value as its maturity date approaches, provided the issuer of the bond does not go bankrupt.b. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.c. The total yield on a bond is derived from interest payments and changes in the price of the bond.d. Statements a and c are correct. e. All of the statements above are correct.

Bond concepts Answer: b Diff: M . Which of the following statements is most correct?

a. If a bond is selling for a premium, this implies that the bond’s yield to maturity exceeds its coupon rate.b. If a coupon bond is selling at par, its current yield equals its yield to maturity.c. If rates fall after its issue, a zero coupon bond could trade for an amount above its par value.d. Statements b and c are correct.e. None of the statements above is correct.

Bond concepts Answer: b Diff: M . Which of the following statements is most correct?

a. All else equal, a bond that has a coupon rate of 10 percent will sell at a discount if the required return for a bond of similar risk is 8 percent.b. The price of a discount bond will increase over time, assuming that the bond’s yield to maturity remains constant over time.c. The total return on a bond for a given year consists only of the coupon interest payments received.d. Both b and c are correct.e. All of the statements above are correct.

Bond concepts Answer: e Diff: M . Which of the following statements is most correct?

a. All else equal, a bond that has a coupon rate of 10 percent will sell at a discount if the required return for a bond of similar risk is 8 percent.

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b. Debentures generally have a higher yield to maturity relative to mortgage bonds.c. If there are two bonds with equal maturity and credit risk, the bond which is callable will have a higher yield to maturity than the bond which is noncallable.d. Answers a and c are correct.e. Answers b and c are correct.

Bond concepts Answer: d Diff: M . A 10-year bond has a 10 percent annual coupon and a yield to maturity of 12 percent. The bond can be called in 5 years at a call price of $1,050 and the bond’s face value is $1,000. Which of the following statements is most correct?

a. The bond’s current yield is greater than 10 percent.b. The bond’s yield to call is less than 12 percent.c. The bond is selling at a price below par.d. Both answers a and c are correct.e. None of the above answers is correct.

Callable bond Answer: d Diff: M . Which of the following statements is most correct?

a. Distant cash flows are generally riskier than near-term cash flows. Further, a 20-year bond that is callable after 5 years will have an expected life that is probably shorter, and certainly no longer, than an otherwise similar noncallable 20-year bond. Therefore, investors should require a lower rate of return on the callable bond than on the noncallable bond, assuming other characteristics are similar.b. A noncallable 20-year bond will generally have an expected life that is equal to or greater than that of an otherwise identical callable 20-year bond. Moreover, the interest rate risk faced by investors is greater the longer the maturity of a bond. Therefore, callable bonds expose investors to less interest rate risk than noncallable bonds, other things held constant.c. Statements a and b are correct.d. Statements a and b are false.

Callable bond Answer: b Diff: M . Which of the following statements is most correct?

a. A callable 10-year, 10 percent bond should sell at a higher price than an otherwise similar noncallable bond.b. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.c. Two bonds have the same maturity and the same coupon rate. However, one is callable and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate.d. The actual life of a callable bond will be equal to or less than the actual life of a noncallable bond with the same maturity date. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.e. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used.

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Types of debt Answer: c Diff: M . A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is most correct?

a. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt is in the form of a fixed rate bond rather than a floating rate bond.b. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt is in the form of a bond rather than a term loan.c. If debt is used to raise the million dollars, but $500,000 is raised as a first mortgage bond on the new plant and $500,000 as debentures, the interest rate on the first mortgage bond would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.d. The company would be especially anxious to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.e. All of the statements above are false.

Miscellaneous concepts Answer: b Diff: M . Which of the following statements is most correct?

a. A firm with a sinking fund payment coming due would generally choose to buy back bonds in the open market, if the price of the bond exceeds the sinking fund call price.b. Income bonds pay interest only when the amount of the interest is actually earned by the company. Thus, these securities cannot bankrupt a company and this makes them safer to investors than regular bonds.c. One disadvantage of zero coupon bonds is that issuing firms cannot realize the tax savings from issuing debt until the bonds mature.d. Other things held constant, callable bonds should have a lower yield to maturity than noncallable bonds.e. All of the above statements are false.

Miscellaneous concepts Answer: b Diff: M . Which of the following statements is most correct?

a. A 10-year 10 percent coupon bond has less reinvestment rate risk than a 10-year 5 percent coupon bond (assuming all else equal).b. The total return on a bond for a given year arises from both the coupon interest payments received for the year and the change in the value of the bond from the beginning to the end of the year. c. The price of a 20-year 10 percent bond is less sensitive to changes in interest rates (i.e., has lower interest rate price risk) than the price of a 5-year 10 percent bond.d. A $1,000 bond with $100 annual interest payments with five years to maturity (not expected to default) would sell for a discount if interest rates were below 9 percent and would sell for a premium if interest rates were greater than 11 percent.e. Answers a, b, and c are correct statements.

Miscellaneous concepts Answer: e Diff: M . Which of the following statements is most correct?

a. All else equal, a 1-year bond will have a higher (i.e., better) bond rating than a 20-year bond.

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b. A 20-year bond with semiannual interest payments has higher price risk (i.e., interest rate risk) than a 5-year bond with semiannual interest payments.c. 10-year zero coupon bonds have higher reinvestment rate risk than 10-year, 10 percent coupon bonds.d. If a callable bond is trading at a premium, then you would expect to earn the yield-to-maturity.e. Statements a and b are correct.

Interest rate risk Answer: a Diff: M . Which of the following Treasury bonds will have the largest amount of interest rate risk (price risk)?

a. A 7 percent coupon bond which matures in 12 years.b. A 9 percent coupon bond which matures in 10 years.c. A 12 percent coupon bond which matures in 7 years.d. A 7 percent coupon bond which matures in 9 years.e. A 10 percent coupon bond which matures in 10 years.

Interest rate risk Answer: a Diff: M . All treasury securities have a yield to maturity of 7 percent--so the yield curve is flat. If the yield to maturity on all Treasuries were to decline to 6 percent, which of the following bonds would have the largest percentage increase in price?

a. 15-year zero coupon Treasury bond.b. 12-year Treasury bond with a 10 percent annual coupon.c. 15-year Treasury bond with a 12 percent annual coupon.d. 2-year zero coupon Treasury bond.e. 2-year Treasury bond with a 15 percent annual coupon.

Current yield and yield to maturity Answer: e Diff: M . Which of the following statements is most correct?

a. If a bond sells for less than par, then its yield to maturity is less than its coupon rate.b. If a bond sells at par, then its current yield will be less than its yield to maturity.c. Assuming that both bonds are held to maturity and are of equal risk, a bond selling for more than par with ten years to maturity will have a lower current yield and higher capital gain relative to a bond that sells at par.d. Answers a and c are correct.e. None of the answers above is correct.

Current yield and yield to maturity Answer: a Diff: M . You just purchased a 10-year corporate bond that has an annual coupon of 10 percent. The bond sells at a premium above par. Which of the following statements is most correct?

a. The bond’s yield to maturity is less than 10 percent.b. The bond’s current yield is greater than 10 percent.c. If the bond’s yield to maturity stays constant, the bond’s price will be the same one year from now.d. Statements a and c are correct.

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e. None of the answers above is correct.

Corporate bonds and default risk Answer: c Diff: M . Which of the following statements is most correct?

a. The expected return on corporate bonds will generally exceed the yield to maturity.b. If a company increases its debt ratio, this is likely to reduce the default premium on its existing bonds.c. All else equal, senior debt will generally have a lower yield to maturity than subordinated debt.d. Answers a and c are correct.e. None of the answers above is correct.

Default risk Answer: b Diff: M . Which of the following statements is most correct?

a. If a company increases its debt ratio, this is likely to reduce the default premium on its existing bonds.b. All else equal, senior debt has less default risk than subordinated debt.c. An indenture is a bond that is less risky than a subordinated debenture.d. Statements a and c are correct.e. All of the answers above are correct.

Default risk Answer: d Diff: M . Which of the following statements is most correct?

a. The expected return on a corporate bond is always less than its promised return when the probability of default is greater than zero.b. All else equal, secured debt is considered to be less risky than unsecured debt.c. An indenture is a bond that is less risky than a subordinated debenture.d. Both a and b are correct.e. All of the answers above are correct.

Sinking funds and default risk Answer: d Diff: M . Which of the following statements is correct?

a. If a company is retiring bonds for sinking fund purposes it will buy back bonds on the open market when the coupon rate is less than the market interest rate.b. A bond sinking fund would be good for investors if interest rates have declined after issuance and the investor’s bonds get called.c. Mortgage bonds have less default risk than debentures.d. Both a and c are correct.e. All of the statements above are correct.

Tough:

Bond yields and prices Answer: b Diff: T . Which of the following statements is most correct?

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a. If a bond's yield to maturity exceeds its coupon rate, the bond's current yield must also exceed its coupon rate.b. If a bond's yield to maturity exceeds its coupon rate, the bond's price must be less than its maturity value.c. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of the bond's coupon rate.d. Answers b and c are correct.e. None of the answers above is correct.

Bond concepts Answer: b Diff: T . Which of the following is not true about bonds? In all of the statements, assume other things are held constant.

a. Price sensitivity, that is, the change in price due to a given change in the required rate of return, increases as a bond's maturity increases.b. For a given bond of any maturity, a given percentage point increase in the interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.c. For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.d. From a borrower's point of view, interest paid on bonds is tax-deductible.e. A 20-year zero coupon bond has less reinvestment rate risk than a 20-year coupon bond.

Bond concepts Answer: e Diff: T . Which of the following statements is most correct?

a. All else equal, an increase in interest rates will have a greater effect on the prices of long-term bonds than it will on the prices of short-term bonds.b. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds. c. An increase in interest rates will have a greater effect on a zero coupon bond with 10 years maturity than it will have on a 9-year bond with a 10 percent annual coupon.d. All of the statements above are correct.e. Answers a and c are correct.

Interest vs. reinvestment rate risk Answer: c Diff: T . Which of the following statements is most correct?

a. A 10-year bond would have more interest rate risk than a 5-year bond, but all 10-year bonds have the same interest rate risk.b. A 10-year bond would have more reinvestment rate risk than a 5-year bond, but all 10-year bonds have the same reinvestment rate risk.c. If their maturities were the same, a 5 percent coupon bond would have more interest rate risk than a 10 percent coupon bond.d. If their maturities were the same, a 5 percent coupon bond would have less interest rate risk than a 10 percent coupon bond.e. Zero coupon bonds have more interest rate risk than any other type bond, even perpetuities.

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Bond indenture Answer: d Diff: T . Listed below are some provisions that are often contained in bond indentures:

1. Fixed assets may be used as security.2. The bond may be subordinated to other classes of debt.3. The bond may be made convertible.4. The bond may have a sinking fund.5. The bond may have a call provision.6. The bond may have restrictive covenants in its indenture.

Which of the above provisions, each viewed alone, would tend to reduce the yield to maturity investors would otherwise require on a newly issued bond?

a. 1, 2, 3, 4, 5, 6b. 1, 2, 3, 4, 6c. 1, 3, 4, 5, 6d. 1, 3, 4, 6e. 1, 4, 6

Weighted average cost of debt Answer: e Diff: T . Suppose a new company decides to raise its initial $200 million of capital as $100 million of common equity and $100 million of long-term debt. By an iron-clad provision in its charter, the company can never borrow any more money. Which of the following statements is most correct?

a. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of debentures.b. If the debt were raised by issuing $50 million of debentures and $50 million of first mortgage bonds, we could be absolutely certain that the firm's total interest expense would be lower than if the debt were raised by issuing $100 million of first mortgage bonds.c. The higher the percentage of total debt represented by debentures, the greater the risk of, and hence the interest rate on, the debentures.d. The higher the percentage of total debt represented by mortgage bonds, the riskier both types of bonds will be, and, consequently, the higher the firm’s total dollar interest charges will be.e. In this situation, we cannot tell for sure how, or whether, the firm's total interest expense on the $100 million of debt would be affected by the mix of debentures versus first mortgage bonds. Interest rates on the two types of bonds would vary as their percentages were changed, but the result might well be such that the firm's total interest charges would not be affected materially by the mix between the two.

Multiple Choice: Problems Easy:

Bond value - semiannual payment Answer: c Diff: E . Assume that you wish to purchase a bond with a 30-year maturity, an annual coupon rate of 10 percent, a face value of $1,000, and semiannual interest payments. If you require a 9 percent nominal

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yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

a. $905.35b. $1,102.74c. $1,103.19d. $1,106.76e. $1,149.63

Yield to maturity Answer: b Diff: E . A bond has an annual 8 percent coupon rate, a maturity of 10 years, a face value of $1,000, and makes semiannual payments. If the price is $934.96, what is the annual nominal yield to maturity on the bond?

a. 8%b. 9%c. 10%d. 11%e. 12%

Return on a bond Answer: b Diff: E . A bond has an annual 11 percent coupon rate, an annual interest payment of $110, a maturity of 20 years, a face value of $1,000, and makes annual payments. It has a yield to maturity of 8.83 percent. If the price is $1,200, what rate of return will an investor expect to receive during the next year?

a. -0.33%b. 8.83%c. 9.17%d. 11.00%e. None of the above

Bond value - semiannual payment Answer: e Diff: E . You intend to purchase a 10-year, $1,000 face value bond that pays interest of $60 every 6 months. If your nominal annual required rate of return is 10 percent with semiannual compounding, how much should you be willing to pay for this bond?

a. $ 826.31b. $1,086.15c. $ 957.50d. $1,431.49e. $1,124.62

Bond value - semiannual payment Answer: d Diff: E . Assume that you wish to purchase a 20-year bond that has a maturity value of $1,000 and makes semiannual interest payments of $40. If you require a 10 percent nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

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a. $619b. $674c. $761d. $828e. $902

Bond value - quarterly payment Answer: c Diff: E . A $1,000 par value bond pays interest of $35 each quarter and will mature in 10 years. If your nominal annual required rate of return is 12 percent with quarterly compounding, how much should you be willing to pay for this bond?

a. $ 941.36b. $1,051.25c. $1,115.57d. $1,391.00e. $ 825.49

Current yield Answer: b Diff: E . Consider a $1,000 par value bond with a 7 percent annual coupon. The bond pays interest annually. There are 9 years remaining until maturity. What is the current yield on the bond assuming that the required return on the bond is 10 percent?

a. 10.00%b. 8.46%c. 7.00%d. 8.52%e. 8.37%

Risk premium on bonds Answer: c Diff: E . Rollincoast Incorporated issued BBB bonds two years ago that provided a yield to maturity of 11.5 percent. Long-term risk-free government bonds were yielding 8.7 percent at that time. The current risk premium on BBB bonds versus government bonds is half what it was two years ago. If the risk-free long-term governments are currently yielding 7.8 percent, then at what rate should Rollincoast expect to issue new bonds?

a. 7.8%b. 8.7%c. 9.2%d. 10.2%e. 12.9%

Medium:

Bond value - annual payment Answer: d Diff: M . You are the owner of 100 bonds issued by Euler, Ltd. These bonds have 8 years remaining to maturity, an annual coupon payment of $80, and a par value of $1,000. Unfortunately, Euler is on the brink of bankruptcy. The creditors, including yourself, have agreed to a postponement of the next 4 interest payments (otherwise, the next interest payment would have been due in 1 year). The

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remaining interest payments, for Years 5 through 8, will be made as scheduled. The postponed payments will accrue interest at an annual rate of 6 percent, and they will then be paid as a lump sum at maturity 8 years hence. The required rate of return on these bonds, considering their substantial risk, is now 28 percent. What is the present value of each bond?

a. $538.21b. $426.73c. $384.84d. $266.88e. $249.98

Bond value - annual payment Answer: a Diff: M . Marie Snell recently inherited some bonds (face value $100,000) from her father, and soon thereafter she became engaged to Sam Spade, a University of Florida marketing graduate. Sam wants Marie to cash in the bonds so the two of them can use the money to "live like royalty" for two years in Monte Carlo. The 2 percent annual coupon bonds mature in exactly twenty years. Interest on these bonds is paid annually on December 31 of each year, and new annual coupon bonds with similar risk and maturity are currently yielding 12 percent. If Marie sells her bonds now and puts the proceeds into an account which pays 10 percent compounded annually, what would be the largest equal annual amounts she could withdraw for two years, beginning today (i.e., two payments, the first payment today and the second payment one year from today)?

a. $13,255b. $29,708c. $12,654d. $25,305e. $14,580

Bond value - semiannual payment Answer: d Diff: M . Due to a number of lawsuits related to toxic wastes, a major chemical manufacturer has recently experienced a market reevaluation. The firm has a bond issue outstanding with 15 years to maturity and a coupon rate of 8 percent, with interest paid semiannually. The required nominal rate on this debt has now risen to 16 percent. What is the current value of this bond?

a. $1,273b. $1,000c. $7,783d. $ 550e. $ 450

Bond value - semiannual payment Answer: b Diff: M . JRJ Corporation recently issued 10-year bonds at a price of $1,000. These bonds pay $60 in interest each six months. Their price has remained stable since they were issued, i.e., they still sell for $1,000. Due to additional financing needs, the firm wishes to issue new bonds that would have a maturity of 10 years, a par value of $1,000, and pay $40 in interest every six months. If both bonds have the same yield, how many new bonds must JRJ issue to raise $2,000,000 cash?

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a. 2,400b. 2,596c. 3,000d. 5,000e. 4,275

Bond value - semiannual payment Answer: d Diff: M . Assume that you are considering the purchase of a $1,000 par value bond that pays interest of $70 each six months and has 10 years to go before it matures. If you buy this bond, you expect to hold it for 5 years and then to sell it in the market. You (and other investors) currently require a nominal annual rate of 16 percent, but you expect the market to require a nominal rate of only 12 percent when you sell the bond due to a general decline in interest rates. How much should you be willing to pay for this bond?

a. $ 842.00b. $1,115.81c. $1,359.26d. $ 966.99e. $ 731.85

Bond value - quarterly payment Answer: b Diff: M . Assume that a 15-year, $1,000 face value bond pays interest of $37.50 every 3 months. If you require a nominal annual rate of return of 12 percent, with quarterly compounding, how much should you be willing to pay for this bond? (Hint: The PVIFA and PVIF for 3 percent, 60 periods are 27.6748 and 0.1697, respectively.)

a. $ 821.92b. $1,207.57c. $ 986.43d. $1,120.71e. $1,358.24

Bond value - quarterly payment Answer: b Diff: M . Your client has been offered a 5-year, $1,000 par value bond with a 10 percent coupon. Interest on this bond is paid quarterly. If your client is to earn a nominal rate of return of 12 percent, compounded quarterly, how much should she pay for the bond?

a. $ 800b. $ 926c. $1,025d. $1,216e. $ 981

Market value of bonds Answer: a Diff: M . In order to accurately assess the capital structure of a firm, it is necessary to convert its balance sheet figures to a market value basis. KJM Corporation's balance sheet as of today, is as follows: Long-term debt (bonds, at par) $10,000,000

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Preferred stock 2,000,000 Common stock ($10 par) 10,000,000 Retained earnings 4,000,000 Total debt and equity $26,000,000 The bonds have a 4 percent coupon rate, payable semiannually, and a par value of $1,000. They mature exactly 10 years from today. The yield to maturity is 12 percent, so the bonds now sell below par. What is the current market value of the firm's debt?

a. $5,412,000b. $5,480,000c. $2,531,000d. $7,706,000e. $7,056,000

Future value of bond Answer: c Diff: M . You just purchased a 15-year bond with an 11 percent annual coupon. The bond has a face value of $1,000 and a current yield of 10 percent. Assuming that the yield to maturity of 9.7072 percent remains constant, what will be the price of the bond 1 year from now?

a. $1,000b. $1,064c. $1,097d. $1,100e. $1,150

Bond coupon rate Answer: c Diff: M . Cold Boxes Ltd. has 100 bonds outstanding (maturity value = $1,000). The nominal required rate of return on these bonds is currently 10 percent, and interest is paid semiannually. The bonds mature in 5 years, and their current market value is $768 per bond. What is the annual coupon interest rate?

a. 8%b. 6%c. 4%d. 2%e. 0%

Bond coupon rate Answer: d Diff: M . The current price of a 10-year, $1,000 par value bond is $1,158.91. Interest on this bond is paid every six months, and the nominal annual yield is 14 percent. Given these facts, what is the annual coupon rate on this bond?

a. 10%b. 12%c. 14%d. 17%e. 21%

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Tough:

Bond value Answer: d Diff: T . Recently, Ohio Hospitals Inc. filed for bankruptcy. The firm was reorganized as American Hospitals Inc., and the court permitted a new indenture on an outstanding bond issue to be put into effect. The issue has 10 years to maturity and a coupon rate of 10 percent, paid annually. The new agreement allows the firm to pay no interest for 5 years. Then, interest payments will be resumed for the next 5 years. Finally, at maturity (Year 10), the principal plus the interest that was not paid during the first 5 years will be paid. However, no interest will be paid on the deferred interest. If the required annual return is 20 percent, what should the bonds sell for in the market today?

a. $242.26b. $281.69c. $578.31d. $362.44e. $813.69

Bond sinking fund payment Answer: d Diff: T . GP&L sold $1,000,000 of 12 percent, 30-year, semiannual payment bonds 15 years ago. The bonds are not callable, but they do have a sinking fund which requires GP&L to redeem 5 percent of the original face value of the issue each year ($50,000), beginning in Year 11. To date, 25 percent of the issue has been retired. The company can either call bonds at par for sinking fund purposes or purchase bonds on the open market, spending sufficient money to redeem 5 percent of the original face value each year. If the nominal yield to maturity (15 years remaining) on the bonds is currently 14 percent, what is the least amount of money GP&L must put up to satisfy the sinking fund provision?

a. $43,856b. $50,000c. $37,500d. $43,796e. $39,422

Financial Calculator Section

Multiple Choice: Problems

Easy:

Bond value - semiannual payment Answer: c Diff: E . A corporate bond with a $1,000 face value pays a $50 coupon every six months. The bond will mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the bond?

a. $ 634.86b. $1,064.18c. $1,065.04

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d. $1,078.23e. $1,094.56

Bond value - semiannual payment Answer: b Diff: E . A bond with a $1,000 face value and an 8 percent annual coupon pays interest semiannually. The bond will mature in 15 years. The nominal yield to maturity is 11 percent. What is the price of the bond today?

a. $ 784.27b. $ 781.99c. $1,259.38d. $1,000.00e. $ 739.19

Yield to maturity Answer: a Diff: E . Palmer Products has outstanding bonds with an annual 8 percent coupon. The bonds have a par value of $1,000 and a price of $865. The bonds will mature in 11 years. What is the yield to maturity on the bonds?

a. 10.09%b. 11.13%c. 9.25%d. 8.00%e. 9.89%

YTM and YTC Answer: e Diff: E . A corporate bond matures in 14 years. The bond has an 8 percent semiannual coupon and a par value of $1,000. The bond is callable in five years at a call price of $1,050. The price of the bond today is $1,075. What are the bond’s yield to maturity and yield to call?

a. YTM = 14.29%; YTC = 14.09%b. YTM = 3.57%; YTC = 3.52%c. YTM = 7.14%; YTC = 7.34%d. YTM = 6.64%; YTC = 4.78%e. YTM = 7.14%; YTC = 7.05%

Current yield Answer: d Diff: E . A 12-year bond pays an annual coupon of 8.5 percent. The bond has a yield to maturity of 9.5 percent and a par value of $1,000. What is the bond’s current yield?

a. 6.36%b. 2.15%c. 8.95%d. 9.14%e. 10.21%

Current yield and yield to maturity Answer: b Diff: E

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. A bond matures in 12 years, and pays an 8 percent annual coupon. The bond has a face value of $1,000, and currently sells for $985. What is the bond’s current yield and yield to maturity?

a. Current yield = 8.00%; yield to maturity = 7.92%.b. Current yield = 8.12%; yield to maturity = 8.20%.c. Current yield = 8.20%; yield to maturity = 8.37%.d. Current yield = 8.12%; yield to maturity = 8.37%.e. Current yield = 8.12%; yield to maturity = 7.92%.

Yield on semiannual bond Answer: c Diff: E . A corporate bond has a face value of $1,000, and pays a $50 coupon every six months (i.e., the bond has a 10 percent semiannual coupon). The bond matures in 12 years and sells at a price of $1,080. What is the bond’s nominal yield to maturity?

a. 8.28%b. 8.65%c. 8.90%d. 9.31%e. 10.78%

Yield to maturity and bond value--annual Answer: d Diff: E . A 20-year bond with a par value of $1,000 has a 9 percent annual coupon. The bond currently sells for $925. If the bond’s yield to maturity remains at its current rate, what will be the price of the bond 5 years from now?

a. $ 966.79b. $ 831.35c. $1,090.00d. $ 933.09e. $ 925.00

Medium:

Bond value - semiannual payment Answer: d Diff: M . An 8 percent annual coupon, noncallable bond has ten years until it matures and a yield to maturity of 9.1 percent. What should be the price of a 10-year noncallable bond of equal risk which pays an 8 percent semiannual coupon? Assume both bonds have a par value of $1,000.

a. $ 898.64b. $ 736.86c. $ 854.27d. $ 941.09e. $ 964.23

Call price Answer: c Diff: M . Kennedy Gas Works has bonds which mature in 10 years, and have a face value of $1,000. The bonds have a 10 percent quarterly coupon (i.e., the nominal coupon rate is 10 percent). The bonds may

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be called in five years. The bonds have a nominal yield to maturity of 8 percent and a yield to call of 7.5 percent. What is the call price on the bonds?

a. $ 379.27b. $1,025.00c. $1,048.34d. $1,036.77e. $1,136.78

Yield to call Answer: b Diff: M . Hood Corporation recently issued 20-year bonds. The bonds have a coupon rate of 8 percent and pay interest semiannually. Also, the bonds are callable in 6 years at a call price equal to 115 percent of par value. The par value of the bonds is $1,000. If the yield to maturity is 7 percent, what is the yield to call?

a. 8.33% b. 7.75% c. 9.89% d. 10.00% e. 7.00%

Yield to call Answer: d Diff: M . A 12-year bond with a 10 percent semiannual coupon and a $1,000 par value has a nominal yield to maturity of 9 percent. The bond can be called in five years at a call price of $1,050. What is the bond's nominal yield to call?

a. 4.50%b. 8.25%c. 8.88%d. 8.98%e. 9.00%

Yield to call Answer: c Diff: M . A corporate bond with an 11 percent semiannual coupon has a yield to maturity of 9 percent. The bond matures in 20 years but is callable in ten years. The maturity value is $1,000. The call price is $1,055. What is the bond's yield to call?

a. 8.43%b. 8.50%c. 8.58%d. 8.65%e. 9.00%

Yield to call Answer: a Diff: M . A corporate bond which matures in 12 years, pays a 9 percent annual coupon, has a face value of $1,000, and a yield to maturity of 7.5 percent. The bond can first be called four years from now. The call price is $1,050. What is the bond’s yield to call?

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a. 6.73%b. 7.10%c. 7.50%d. 11.86%e. 13.45%

Yield to call Answer: b Diff: M . A bond that matures in 11 years has an annual coupon rate of 8 percent with interest paid annually. The bond’s face value is $1,000 and its yield to maturity is 7.5 percent. The bond can be called 3 years from now at a price of $1,060. What is the bond’s nominal yield to call?

a. 9.82%b. 8.41%c. 8.54%d. 8.38%e. 7.86%

Yield to call Answer: b Diff: M . McGriff Motors has bonds outstanding which will mature in 12 years. The bonds pay a 12 percent semiannual coupon and have a face value of $1,000 (i.e., the bonds pay a $60 coupon every six months). The bonds currently have a yield to maturity of 10 percent. The bonds are callable in 8 years and have a call price of $1,050. What are the bonds' yield to call?

a. 8.89%b. 9.89%c. 9.94%d. 10.00%e. 12.00%

After-tax yield to call Answer: c Diff: M . A company is issuing $1,000 bonds at par value. The coupon rate (and yield to maturity) on the bonds is 8 percent (with annual payments) and the bonds will mature in 10 years. The bonds can be called at a call premium of 5 percent above face value after 3 years. What is the after-tax yield to call for an investor with a 31 percent tax rate?

a. 5.52%b. 5.90%c. 6.60%d. 7.07%e. 9.52%

Yield to maturity Answer: d Diff: M . A 15-year bond with a 10 percent semiannual coupon has a par value of $1,000. The bond may be called after 10 years at a call price of $1,050. The bond has a nominal yield to call of 6.5 percent. What is the bond's yield to maturity, stated on a nominal, or annual basis?

a. 5.97%b. 6.30%

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c. 6.75%d. 6.95%e. 7.10%

Interest payments remaining Answer: b Diff: M . You have just been offered a $1,000 par value bond for $847.88. The coupon rate is 8 percent, payable annually, and annual interest rates on new issues of the same degree of risk are 10 percent. You want to know how many more interest pay¬ments you will receive, but the party selling the bond cannot remember. Can you determine how many interest payments remain?

a. 14b. 15c. 12d. 20e. 10

Current yield and capital gains yield Answer: c Diff: M . Meade Corporation bonds mature in 6 years and have a yield to maturity of 8.5 percent. The par value of the bonds is $1,000. The bonds have a 10 percent coupon rate and pay interest on a semiannual basis. What are the current yield and capital gains yield on the bonds for this year? (Assume that interest rates do not change over the course of the year).

a. Current yield = 8.50%, capital gains yield = 1.50% b. Current yield = 9.35%, capital gains yield = 0.65% c. Current yield = 9.35%, capital gains yield = -0.85% d. Current yield = 10.00%, capital gains yield = 0.00% e. None of the answers above is correct.

Bond value Answer: e Diff: M . A 6-year bond which pays 8 percent interest semiannually sells at par ($1,000). Another 6-year bond of equal risk pays 8 percent interest annually. Both bonds are non-callable and have a face value of $1,000. What is the price of the bond which pays annual interest?

a. $689.08b. $712.05c. $980.43d. $986.72e. $992.64

Tough:

Bond value Answer: d Diff: T . Assume that McDonald's and Burger King have similar $1,000 par value bond issues outstanding. The bonds are equally risky. The Burger King bond has an annual coupon rate of 8 percent and matures 20 years from today. The McDonald's bond has a coupon rate of 8 percent, with interest paid semiannually, and it also matures in 20 years. If the nominal required rate of return, rd, is 12 percent, semiannual basis, for both bonds, what is the difference in current market prices of the two bonds?

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a. No difference.b. $ 2.20c. $ 3.77d. $17.53e. $ 6.28

Bond value and effective annual rate Answer: b Diff: T . You are considering investing in a security that matures in 10 years with a par value of $1,000. During the first five years, the security has an 8 percent coupon with quarterly payments (i.e., you receive $20 a quarter for the first 20 quarters). During the remaining five years the security has a 10 percent coupon with quarterly payments (i.e., you receive $25 a quarter for the second 20 quarters). After 10 years (40 quarters) you receive the par value.

Another 10-year bond has an 8 percent semiannual coupon (i.e., the coupon payment is $40 every six months). This bond is selling at its par value, $1,000. This bond has the same risk as the security you are thinking of purchasing. Given this information, what should be the price of the security you are considering purchasing?

a. $ 898.65b. $1,060.72c. $1,037.61d. $ 943.22e. $1,145.89

Bond coupon payment Answer: b Diff: T . Fish & Chips Inc. has two bond issues outstand¬ing, and both sell for $701.22. The first issue has an annual coupon rate of 8 percent and 20 years to maturity. The second has an identical yield to maturity as the first bond, but only 5 years until maturity. Both issues pay interest annually. What is the annual interest payment on the second issue?

a. $120.00b. $ 37.12c. $ 56.42d. $ 29.68e. $ 11.16

Bonds with differential payments Answer: c Diff: T . Semiannual payment bonds with the same risk (Aaa) and maturity (20 years) as your company's bonds have a nominal (not EAR) yield of 9 percent. Your company's treasurer is thinking of issuing at par some $1,000 par value, 20-year, quarterly payment bonds. She has asked you to determine what quarterly interest payment, in dollars, the company would have to set in order to provide the same effective annual rate (EAR) as those on the 20-year, semiannual payment bonds. What would the quarterly interest payment be, in dollars?

a. $45.00b. $25.00c. $22.25d. $27.50

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e. $23.00

Total stock returns Answer: b Diff: E . The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold.

a. Trueb. False

Common stock cash flows Answer: a Diff: E . The cash flows associated with common stock are dif¬ficult to evaluate due to the uncertainty and varia¬bility associated with them.

a. Trueb. False

Constant growth model Answer: a Diff: E . The constant growth model used for evaluating the price of a share of common stock may also be used to find the price of perpetual preferred stock or any other perpetuity.

a. Trueb. False

Supernormal growth stock Answer: a Diff: E . According to the textbook model, under conditions of nonconstant growth, the dis¬count rate utilized to find the present value of the expected cash flows will be the same for the initial growth period as for the normal growth period.

a. Trueb. False

Stock valuation Answer: b Diff: E . According to the basic stock valuation model, the value an investor assigns to a share of stock is dependent upon the length of time the investor plans to hold the stock.

a. Trueb. False

Efficient markets hypothesis Answer: b Diff: E . If security markets were truly strong-form efficient, you would never be able to realize a rate of return on a security greater than the marginal investor's expected (or required) rate of return.

a. Trueb. FalseProxy Answer: a Diff: E . A proxy is a document giving one party the authority to act for another party, typically the power to vote shares of common stock. A proxy can be an important tool relating to control of the firm.

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a. Trueb. False

Classified stock Answer: a Diff: E . Classified stock is one tool companies can use to meet special needs such as when owners of a start-up firm need capital but don't want to relinquish control of the firm.

a. Trueb. False

Founders' shares Answer: a Diff: E . Founders' shares is a type of classified stock where the shares are owned by the firm's founders and they retain the sole voting rights to those shares but have restricted dividends for a specified time period.

a. Trueb. False

Preemptive right Answer: a Diff: E . The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares sold by the firm. This right protects current stockholders against both dilution of control and dilution of value.

a. Trueb. False

Preemptive right Answer: b Diff: E . If a firm's stockholders are given the preemptive right, this means that a group of stockholders can call for a meeting to replace the management. With¬out the preemptive right, dissident stockholders would have to seek to oust management through a proxy fight.

a. Trueb. False

Closely held stock Answer: a Diff: E . When a corporation's shares are owned by a few individuals who are associated with the firm's management, we say that the stock is "closely held."

a. Trueb. False

OTC market Answer: b Diff: E . The OTC market is a physical exchange, much like the New York Stock Exchange, where securities dealers provide trading in unlisted securities.

a. Trueb. False

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Public company Answer: a Diff: E . A publicly owned corporation is simply a company whose shares are held by the investing public, which may include other corporations and institutions.

a. Trueb. False

Going public Answer: a Diff: E . When stock in a closely held corporation is offered to the public for the first time the transaction is called "going public" and the market for such stock is called the new issue market.

a. Trueb. False

Marginal investor and price Answer: a Diff: E . After a new issue is brought to market it is the marginal investor who determines the price at which the stock will trade.

a. Trueb. False

Medium:

Stock price Answer: b Diff: M . If two firms have the same current dividend and the same expected growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium.

a. Trueb. False

Common stock and social welfare Answer: a Diff: M . From a social welfare perspective, common stock is a desirable form of financing in part because it involves no fixed charge payments. Its inclusion in a firm's capital structure makes the firm less vulnerable to the consequences of unanticipated declines in sales and earnings than if only debt were available.

a. Trueb. False

Proxy fight Answer: b Diff: M . A proxy fight involves a battle by a shareholder or group of shareholders who seek to change the investment policy of the firm. If the proxy group is successful, current management retains control of the firm but the proxy group dictates what investments the firm makes.

a. Trueb. False

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Multiple Choice: Conceptual

Easy:

Required returnAnswer: e Diff: E . An increase in a firm's expected growth rate would normally cause the firm's required rate of return to

a. Increase.b. Decrease.c. Fluctuate.d. Remain constant.e. Possibly increase, possibly decrease, or possibly remain unchanged.

Required returnAnswer: d Diff: E . If the expected rate of return on a stock exceeds the required rate,

a. The stock is experiencing supernormal growth.b. The stock should be sold.c. The company is probably not trying to maximize price per share.d. The stock is a good buy.e. Dividends are not being declared.

Constant growth model Answer: a Diff: E . Which of the following statements is most correct?

a. The constant growth model takes into consideration the capital gains earned on a stock.b. It is appropriate to use the constant growth model to estimate stock value even if the growth rate never becomes constant.c. Two firms with the same dividend and growth rate must also have the same stock price.d. Statements a and c are correct. e. All of the statements above are correct.

Constant growth model Answer: a Diff: E . Which of the following statements is most correct.

a. The stock valuation model, P0 = D1/(rs - g), can be used for firms which have negative growth rates.b. If a stock has a required rate of return rs = 12 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s dividend yield is 5 percent.c. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.d. Statements a and c are correct.e. All of the statements above are correct.

Constant growth model Answer: c Diff: E

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. A stock’s dividend is expected to grow at a constant rate of 5 percent a year. Which of the following statements is most correct?

a. The expected return on the stock is 5 percent a year.b. The stock’s dividend yield is 5 percent.c. The stock’s price one year from now is expected to be 5 percent higher.d. Statements a and c are correct.e. All of the statements above are correct.

Miscellaneous issues Answer: c Diff: E . Which of the following statements is most correct?

a. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but the two classes must have the same voting rights.b. An IPO occurs whenever a company buys back its stock on the open market.c. The preemptive right is a provision in the corporate charter which gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock.d. Statements a and b are correct.e. Statements a and c are correct.

Preemptive right Answer: b Diff: E . The preemptive right is important to shareholders because it

a. Allows management to sell additional shares below the current market price.b. Protects the current shareholders against dilution of ownership interests.c. Is included in every corporate charter.d. Will result in higher dividends per share.e. The preemptive right is not important to shareholders.

Classified stock Answer: e Diff: E . Companies can issue different classes of common stock. Which of the following statements concerning stock classes is most correct?

a. All common stocks fall into one of three classes: A, B, and C.b. Most firms have several classes of common stock outstanding.c. All common stock, regardless of class, must have voting rights.d. All common stock, regardless of class, must have the same dividend privileges.e. None of the statements above is necessarily true.

Efficient markets hypothesis Answer: e Diff: E . Which of the following statements is most correct?

a. If a market is strong-form efficient this implies that the returns on bonds and stocks should be identical.b. If a market is weak-form efficient this implies that all public information is rapidly incorporated into market prices.c. If your uncle earns a return higher than the overall stock market, this means the stock market is inefficient.

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d. Both answers a and b are correct.e. None of the above answers is correct.Market efficiency Answer: c Diff: E . Which of the following statements is most correct?

a. Semistrong-form market efficiency implies that all private and public information is rapidly incorporated into stock prices.b. Market efficiency implies that all stocks should have the same expected return.c. Weak-form market efficiency implies that recent trends in stock prices would be of no use in selecting stocks.d. All of the answers above are correct.e. None of the answers above is correct.

Market efficiency Answer: a Diff: E . Which of the following statements is most correct?

a. Semistrong-form market efficiency means that stock prices reflect all public information.b. An individual who has information about past stock prices should be able to profit from this information in a weak-form efficient market.c. An individual who has inside information about a publicly traded company should be able to profit from this information in a strong-form efficient market.d. Statements a and c are correct.e. All the statements above are correct.

Market efficiency Answer: a Diff: E . Most studies of stock market efficiency suggest that the stock market is highly efficient in the weak form and reasonably efficient in the semistrong form. Based on these findings which of the following statements are correct?

a. Information you read in The Wall Street Journal today cannot be used to select stocks that will consistently beat the market.b. The stock price for a company has been increasing for the past 6 months. Based on this information it must be true that the stock price will also increase during the current month.c. Information disclosed in companies’ most recent annual reports can be used to consistently beat the market.d. Statements a and c are correct.e. All of the statements above are correct.

Preferred stock concepts Answer: e Diff: E . Which of the following statements is most correct?

a. Preferred stockholders have priority over common stockholders.b. A big advantage of preferred stock is that preferred stock dividends are tax deductible for the issuing corporation.c. Most preferred stock is owned by corporations.d. Statements a and b are correct.e. Statements a and c are correct.

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Preferred stock concepts Answer: e Diff: E . Which of the following statements is most correct?

a. One of the advantages to the firm associated with financing using preferred stock rather than common stock is that control of the firm is not diluted.b. Preferred stock provides steadier and more reliable income to investors than common stock.c. One of the advantages to the firm of financing with preferred stock is that 70 percent of the dividends paid out are tax deductible.d. Statements a and c are correct.e. Statements a and b are correct.

Common stock concepts Answer: d Diff: E . Which of the following statements is most correct?

a. One of the advantages of financing with stock is that a greater proportion of stock in the capital structure can reduce the risk of a takeover bid.b. A firm with classified stock can pay different dividends to each class of shares.c. One of the advantages of financing with stock is that a firm’s debt ratio will decrease.d. Both statements b and c are correct.e. All of the statements above are correct.

Declining growth stock Answer: e Diff: E . A stock expects to pay a year-end dividend of $2.00 a share (i.e., D1 = $2.00; assume that last year’s dividend has already been paid). The dividend is expected to fall 5 percent a year, forever (i.e., g = -5%). The company’s expected and required rate of return is 15 percent. Which of the following statements is most correct?

a. The company’s stock price is $10.b. The company’s expected dividend yield 5 years from now will be 20 percent.c. The company’s stock price 5 years from now is expected to be $7.74.d. Both answers b and c are correct.e. All of the above answers are correct.

Medium:

Market efficiency and stock returns Answer: c Diff: M . Which of the following statements is most correct?

a. If a stock's beta increased but its growth rate remained the same, then the new equilibrium price of the stock will be higher (assuming dividends continue to grow at the constant growth rate).b. Market efficiency says that the actual realized returns on all stocks will be equal to the expected rates of return.c. An implication of the semistrong form of the efficient markets hypothesis is that you cannot consistently benefit from trading on information reported in The Wall Street Journal.d. Statements a and b are correct. e. All of the statements above are correct.

Efficient markets hypothesis Answer: e Diff: M

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. Which of the following statements is most correct?

a. If the stock market is weak-form efficient this means you cannot use private information to outperform the market.b. If the stock market is semistrong-form efficient, this means the expected return on stocks and bonds should be the same.c. If the stock market is semistrong-form efficient, this means that high beta stocks should have the same expected return as low beta stocks.d. Statements b and c are correct.e. None of the statements above is correct.

Semistrong-form efficiency Answer: c Diff: M . If the stock market is semistrong efficient, which of the following statements is most correct?

a. All stocks should have the same expected returns; however, they may have different realized returns.b. In equilibrium, stocks and bonds should have the same expected returns.c. Investors can outperform the market if they have access to information which has not yet been publicly revealed.d. If the stock market has been performing strongly over the past several months, stock prices are more likely to decline than increase over the next several months.e. None of the statements above is correct.

Semistrong-form efficiency Answer: e Diff: M . Assume that markets are semistrong-form efficient. Which of the following statements is most correct?

a. All stocks should have the same expected return.b. All stocks should have the same realized return.c. Past stock prices can be successfully used to forecast future stock returns.d. Answers a and c are correct.e. None of the answers above is correct.

Semistrong-form efficiency Answer: d Diff: M . Assume that markets are semistrong efficient, but not strong-from efficient. Which of the following statements is most correct?

a. Each common stock has an expected return equal to that of the overall market.b. Bonds and stocks have the same expected return.c. Investors can expect to earn returns above those predicted by the SML if they have access to public information.d. Investors may be able to earn returns above those predicted by the SML if they have access to information which has not been publicly revealed.e. Answers b and c are correct.

Ownership and going public Answer: c Diff: M . Which of the following statements is false?

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a. When a corporation's shares are owned by a few individuals who are associated with or are the firm's management, we say that the stock is "closely held."b. A publicly owned corporation is simply a company whose shares are held by the investing public, which may include other corporations and institutions as well as individuals.c. Going public establishes a true market value for the firm and ensures that a liquid market will always exist for the firm's shares.d. When stock in a closely held corporation is offered to the public for the first time the transaction is called "going public" and the market for such stock is called the new issue market.e. It is possible for a firm to go public, and yet not raise any additional new capital.

Dividend yield and g Answer: b Diff: M . Which of the following statements is most correct?

a. Assume that the required rate of return on a given stock is 13 percent. If the stock’s dividend is growing at a constant rate of 5 percent, its expected dividend yield is 5 percent as well.b. The dividend yield on a stock is equal to the expected return less the expected capital gain.c. A stock’s dividend yield can never exceed the expected growth rate.d. All of the answers above are correct.e. Answers b and c are correct.

Constant growth stock Answer: d Diff: M . The expected rate of return on the common stock of Northwest Corporation is 14 percent. The stock’s dividend is expected to grow at a constant rate of 8 percent a year. The stock currently sells for $50 a share. Which of the following statements is most correct?

a. The stock’s dividend yield is 8 percent.b. The stock’s dividend yield is 7 percent.c. The current dividend per share is $4.00.d. The stock price is expected to be $54 a share in one year.e. The stock price is expected to be $57 a share in one year.

Multiple Choice: Problems

Easy:

Constant growth stock Answer: c Diff: E . A share of common stock has just paid a dividend of $3.00. If the expected long-run growth rate for this stock is 5 percent, and if investors require an 11 percent rate of return, what is the price of the stock?

a. $50.00b. $50.50c. $52.50d. $53.00e. $63.00

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Nonconstant growth stock Answer: c Diff: E . The last dividend paid by a company was $2.20. Klein's growth rate is expected to be 10 percent for one year, after which dividends are expected to grow at a rate of 6 percent forever. The company’s stockholders require a rate of return on equity (rs) of 11 percent. What is the current price of the stock?

a. $44.00b. $46.64c. $48.40d. $48.64e. $50.40

Preferred stock value Answer: d Diff: E . The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20 percent, what should be the stock's market value?

a. $150b. $100c. $ 50d. $ 25e. $ 10Preferred stock value Answer: d Diff: E . Johnston Corporation is growing at a constant rate of 6 percent per year. It has both common stock and non-participating preferred stock outstanding. The cost of preferred stock (rps) is 8 percent. The par value of the preferred stock is $120, and the stock has a stated dividend of 10 percent of par. What is the market value of the preferred stock?

a. $125 b. $120 c. $175 d. $150 e. $200

Preferred stock yield Answer: c Diff: E . A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently $50, what is the nominal annual rate of return?

a. 12%b. 18%c. 20%d. 23%e. 28%

Preferred stock yield Answer: a Diff: E . A share of preferred stock pays a dividend of $0.50 each quarter. If you are willing to pay $20.00 for this preferred stock, what is your nominal (not effective) annual rate of return?

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a. 10%b. 8%c. 6%d. 12%e. 14%

Stock price Answer: d Diff: E . Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

a. $164.19b. $ 75.29c. $107.53d. $118.35e. $131.74

Constant growth stock Answer: a Diff: E . A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15 percent, and if investors require a 19 percent rate of return, what is the price of the stock?

a. $57.50b. $62.25c. $71.86d. $64.00e. $44.92

Constant growth stock Answer: e Diff: E . Thames Inc.’s most recent dividend was $2.40 per share (i.e., D0 = $2.40). The dividend is expected to grow at a rate of 6 percent per year. The risk-free rate is 5 percent and the return on the market is 9 percent. If the company’s beta is 1.3, what is the price of the stock today?

a. $72.14b. $57.14c. $40.00d. $68.06e. $60.57

Constant growth stock Answer: c Diff: E . Albright Motors is expected to pay a year-end dividend of $3.00 a share (D1 = $3.00). The stock currently sells for $30 a share. The required (and expected) rate of return on the stock is 16 percent. If the dividend is expected to grow at a constant rate, g, what is g?

a. 13.00%b. 10.05%

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c. 6.00%d. 5.33%e. 7.00%

Nonconstant growth stock Answer: d Diff: E . The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein's required rate of return on equity (rs) is 12 percent. What is the current price of Klein's common stock?

a. $21.00b. $33.33c. $42.25d. $50.16e. $58.75

Future stock price Answer: a Diff: E . Waters Corporation has a stock price of $20 a share. The stock’s year-end dividend is expected to be $2 a share (D1 = $2.00). The stock’s required rate of return is 15 percent and the stock’s dividend is expected to grow at the same constant rate forever. What is the expected price of the stock seven years from now?

a. $28b. $53c. $27d. $23e. $39

Beta coefficient Answer: b Diff: E . Cartwright Brothers’ stock is currently selling for $40 a share. The stock is expected to pay a $2 dividend at the end of the year. The stock’s dividend is expected to grow at a constant rate of 7 percent a year forever. The risk-free rate (rRF) is 6 percent and the market risk premium (rM – rRF) is also 6 percent. What is the stock’s beta?

a. 1.06b. 1.00c. 2.00d. 0.83e. 1.08

New issues and dilution Answer: b Diff: E . NOPREM Inc. is a firm whose shareholders don't possess the preemptive right. The firm currently has 1,000 shares of stock outstanding; the price is $100 per share. The firm plans to issue an additional 1,000 shares at $90.00 per share. Since the shares will be offered to the public at large, what is the amount per share that old shareholders will lose if they are excluded from purchasing new shares?

a. $90.00b. $ 5.00

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c. $10.00d. $ 0e. $ 2.50

Medium:

After-tax returns Answer: a Diff: M . The Stuart Corporation has excess cash to invest in one of two securities. The company's tax rate is 40 percent. The first alternative is a 10-year, 10 percent coupon bond (with semiannual interest payments) that has a current price of $1,000 and a yield of 10 percent. The second alternative is the preferred stock of Pickett Corp. which promises to pay a before-tax return of 9 percent. What is the after-tax nominal return of the better investment alternative?

a. 7.92% b. 9.00% c. 7.33% d. 5.40% e. 7.00%

Equilibrium stock price Answer: a Diff: M . Motor Homes Inc. (MHI) is presently in a stage of abnormally high growth because of a surge in the demand for motor homes. The company expects earnings and dividends to grow at a rate of 20 percent for the next 4 years, after which time there will be no growth (g = 0) in earnings and dividends. The company's last dividend was $1.50. MHI's beta is 1.6, the return on the market is currently 12.75 percent, and the risk-free rate is 4 percent. What should be the current price per share of common stock?

a. $15.17b. $17.28c. $22.21d. $19.10e. $24.66

Equilibrium stock price Answer: b Diff: M . You are given the following data:

(1) The risk-free rate is 5 percent.(2) The required return on the market is 8 percent.(3) The expected growth rate for the firm is 4 percent.(4) The last dividend paid was $0.80 per share.(5) Beta is 1.3.

Now assume the following changes occur:

(1) The inflation premium drops by 1 percent.

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(2) An increased degree of risk aversion causes the required return on the market to go to 10 percent after adjusting for the changed inflation premium.(3) The expected growth rate increases to 6 percent.(4) Beta rises to 1.5.

What will be the change in price per share, assuming the stock was in equilibrium before the changes?

a. +$12.11b. -$ 4.87c. +$ 6.28d. -$16.97e. +$ 2.78

Changing beta and the equilibrium stock price Answer: d Diff: M . Ceejay Corporation’s stock is currently selling at an equilibrium price of $30 per share. The firm has been experiencing a 6 percent annual growth rate. Last year’s earnings per share, E0, were $4.00 and the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the market risk premium is 5 percent. If market risk (beta) increases by 50 percent, and all other factors remain constant, what will be the new stock price? (Use 4 decimal places in your calculations.)

a. $16.59b. $18.25c. $21.39d. $22.69e. $53.48Nonconstant growth stock Answer: d Diff: M . A stock is not expected to pay a dividend over the next four years. Five years from now, the company anticipates that it will establish a dividend of $1.00 per share (i.e., D5 = $1.00). Once the dividend is established, the market expects that the dividend will grow at a constant rate of 5 percent per year forever. The risk-free rate is 5 percent, the company's beta is 1.2, and the market risk premium is 5 percent. The required rate of return on the company’s stock is expected to remain constant. What is the current stock price?

a. $ 7.36b. $ 8.62c. $ 9.89d. $10.98e. $11.53

Nonconstant growth stock Answer: d Diff: M . Mack Industries just paid a dividend of $1.00 per share (i.e., D0 = $1.00). Analysts expect the company's dividend to grow 20 percent this year (i.e., D1 = $1.20), and 15 percent next year. After two years the dividend is expected to grow at a constant rate of 5 percent. The required rate of return on the company's stock is 12 percent. What should be the current price of the company's stock?

a. $12.33b. $16.65c. $16.91

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d. $18.67e. $19.67

Nonconstant growth stock Answer: a Diff: M . R. E. Lee recently took his company public through an initial public offering. He is expanding the business quickly to take advantage of an otherwise unexploited market. Growth for his company is expected to be 40 percent for the first three years and then he expects it to slow down to a constant 15 percent. The most recent dividend (D0) was $0.75. Based on the most recent returns, the beta for his company is approximately 1.5. The risk-free rate is 8 percent and the market risk premium is 6 percent. What is the current price of Lee's stock?

a. $77.14 b. $75.17 c. $67.51 d. $73.88 e. $93.20

Nonconstant growth stock Answer: a Diff: M . A stock is expected to pay no dividends for the first three years, i.e., D1 = $0, D2 = $0, and D3 = $0. The dividend for Year 4 is expected to be $5.00 (i.e., D4 = $5.00), and it is anticipated that the dividend will grow at a constant rate of 8 percent a year thereafter. The risk-free rate is 4 percent, the market risk premium is 6 percent, and the stock's beta is 1.5. Assuming the stock is fairly priced, what is the current price of the stock?

a. $ 69.31b. $ 72.96c. $ 79.38d. $ 86.38e. $100.00

Nonconstant growth stock Answer: e Diff: M . Stewart Industries expects to pay a $3.00 per share dividend on its common stock at the end of the year (D1 = $3.00). The dividend is expected to grow 25 percent a year until t = 3, after which time the dividend is expected to grow at a constant rate of 5 percent a year (i.e., D3 = $4.6875 and D4 = $4.9219). The stock’s beta is 1.2, the risk-free rate of interest is 6 percent, and the rate of return on the market is 11 percent. What is the company’s current stock price?

a. $29.89b. $30.64c. $37.29d. $53.69e. $59.05

Nonconstant growth stock Answer: b Diff: M . McPherson Enterprises is planning to pay a dividend of $2.25 per share at the end of the year (i.e., D1 = $2.25). The company is planning to pay the same dividend each of the following 2 years and will then increase the dividend to $3.00 for the subsequent 2 years (i.e., D4 and D5). After that time the

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dividends will grow at a constant rate of 5 percent per year. If the required return on the company’s common stock is 11 percent per year, what is the current stock price?

a. $52.50b. $40.41c. $37.50d. $50.00e. $32.94

Nonconstant growth stock Answer: b Diff: M . Hadlock Healthcare expects to pay a $3.00 dividend at the end of the year (D1 = $3.00). The stock’s dividend is expected to grow at a rate of 10 percent a year until three years from now (t = 3). After this time, the stock’s dividend is expected to grow at a constant rate of 5 percent a year. The stock’s required rate of return is 11 percent. What is the price of the stock today?

a. $49b. $54c. $64d. $52e. $89

Nonconstant growth stock Answer: e Diff: M . Rogers Robotics currently (2006) does not pay a dividend. However, the company is expected to pay a $1.00 dividend two years from today (2008). The dividend is then expected to grow at a rate of 20 percent a year for the following three years. After the dividend is paid in 2011, it is expected to grow forever at a constant rate of 7 percent. Currently, the risk-free rate is 6 percent, market risk premium (rM – rRF) is 5 percent, and the stock’s beta is 1.4. What should be the price of the stock today?

a. $22.91b. $21.20c. $30.82d. $28.80e. $20.16

Supernormal growth stock Answer: e Diff: M . A share of stock has a dividend of D0 = $5. The dividend is expected to grow at a 20 percent annual rate for the next 10 years, then at a 15 percent rate for 10 more years, and then at a long-run normal growth rate of 10 percent forever. If investors require a 10 percent return on this stock, what is its current price?

a. $100.00b. $ 82.35c. $195.50d. $212.62e. The data given in the problem are internally inconsistent, i.e., the situation described is impossible in that no equilibrium price can be produced.

Supernormal growth stock Answer: b Diff: M

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. ABC Company has been growing at a 10 percent rate, and it just paid a dividend of D0 = $3.00. Due to a new product, ABC expects to achieve a dramatic increase in its short-run growth rate, to 20 percent annually for the next 2 years. After this time, growth is expected to return to the long-run constant rate of 10 percent. The company's beta is 2.0, the required return on an average stock is 11 percent, and the risk-free rate is 7 percent. What should the dividend yield (D1/P0) be today?

a. 3.93%b. 4.60%c. 10.00%d. 7.54%e. 2.33%

Supernormal growth stock Answer: b Diff: M . DAA's stock is selling for $15 per share. The firm's income, assets, and stock price have been growing at an annual 15 percent rate and are expected to continue to grow at this rate for 3 more years. No dividends have been declared as yet, but the firm intends to declare a dividend of D3 = $2.00 at the end of the last year of its supernormal growth. After that, dividends are expected to grow at the firm's normal growth rate of 6 percent. The firm's required rate of return is 18 percent. The stock is

a. Undervalued by $3.03.b. Overvalued by $3.03.c. Correctly valued.d. Overvalued by $2.25.e. Undervalued by $2.25.

Declining growth stock Answer: d Diff: M . The Textbook Production Company has been hit hard due to increased competition. The company's analysts predict that earnings (and dividends) will decline at a rate of 5 percent annually forever. Assume that rs = 11 percent and D0 = $2.00. What will be the price of the company's stock three years from now?

a. $27.17b. $ 6.23c. $28.50d. $10.18e. $20.63

Stock growth rate Answer: d Diff: M . Berg Inc. has just paid a dividend of $2.00. Its stock is now selling for $48 per share. The firm is half as risky as the market. The expected return on the market is 14 percent, and the yield on U.S. Treasury bonds is 11 percent. If the market is in equilibrium, what rate of growth is expected?

a. 13%b. 10%c. 4%d. 8%e. -2%

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Stock growth rate Answer: e Diff: M . Grant Corporation's stock is selling for $40 in the market. The company's beta is 0.8, the market risk premium is 6 percent, and the risk-free rate is 9 percent. The previous dividend was $2 (i.e., D0 = $2) and dividends are expected to grow at a constant rate. What is the growth rate for this stock?

a. 5.52% b. 5.00% c. 13.80% d. 8.80% e. 8.38%

Capital gains yield Answer: c Diff: M . Carlson Products, a constant growth company, has a current market (and equilibrium) stock price of $20.00. Carlson's next dividend, D1, is forecasted to be $2.00, and Carlson is growing at an annual rate of 6 percent. Carlson has a beta coefficient of 1.2, and the required rate of return on the market is 15 percent. As Carlson's financial manager, you have access to insider information concerning a switch in product lines which would not change the growth rate, but would cut Carlson's beta coefficient in half. If you buy the stock at the current market price, what is your expected percentage capital gain?

a. 23%b. 33%c. 43%d. 53%e. There would be a capital loss.

Capital gains yield Answer: d Diff: M . Given the following information, calculate the expected capital gains yield for Chicago Bears Inc.: beta = 0.6; rM = 15%; rRF = 8%; D1 = $2.00; P0 = $25.00. Assume the stock is in equilibrium and exhibits constant growth.

a. 3.8%b. 0%c. 8.0%d. 4.2%e. 2.5%

Capital gains yield and dividend yield Answer: e Diff: M . Conner Corporation has a stock price of $32.35 per share. The last dividend was $3.42 (i.e., D0 = $3.42). The long-run growth rate for the company is a constant 7 percent. What is the company’s capital gains yield and dividend yield?

a. Capital gains yield = 7.00%; Dividend yield = 10.57%.b. Capital gains yield = 10.57%; Dividend yield = 7.00%.c. Capital gains yield = 7.00%; Dividend yield = 4.31%.d. Capital gains yield = 11.31%; Dividend yield = 7.00%.e. Capital gains yield = 7.00%; Dividend yield = 11.31%.

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Stock price and P/E ratios Answer: a Diff: M . Over the past few years, Swanson Company has retained, on the average, 70 percent of its earnings in the business. The future retention rate is expected to remain at 70 percent of earnings, and long-run earnings growth is expected to be 10 percent. If the risk-free rate, rRF, is 8 percent, the ex¬pected return on the market, rM, is 12 percent, Swanson's beta is 2.0, and the most recent dividend, D0, was $1.50, what is the most likely market price and P/E ratio (P0/E1) for Swanson's stock today?

a. $27.50; 5.0b. $33.00; 6.0c. $25.00; 5.0d. $22.50; 4.5e. $45.00; 4.5

Stock price Answer: d Diff: M . You have been given the following projections for Cali Corporation for the coming year.

Sales = 10,000 unitsSales price per unit = $10Variable cost per unit = $5Fixed costs = $10,000Bonds outstanding = $15,000rd on outstanding bonds = 8%Tax rate = 40%Shares of common stock outstanding = 10,000 sharesBeta = 1.4rRF = 5%rM = 9%Dividend payout ratio = 60%Growth rate = 8%

Calculate the current price per share for Cali Corporation.

a. $35.22b. $46.27c. $48.55d. $53.72e. $59.76

Stock price Answer: b Diff: M . Newburn Entertainment’s stock is expected to pay a year-end dividend of $3.00 a share. (D1 = $3.00, the dividend at time 0, D0, has already been paid.) The stock’s dividend is expected to grow at a constant rate of 5 percent a year. The risk-free rate, rRF, is 6 percent and the market risk premium, (rM – rRF), is 5 percent. The stock has a beta of 0.8. What is the stock’s expected price five years from now?

a. $60.00b. $76.58c. $96.63d. $72.11

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e. $68.96

Beta coefficient Answer: c Diff: M . As financial manager of Material Supplies Inc., you have recently participated in an executive committee decision to enter into the plastics business. Much to your surprise, the price of the firm's common stock subsequently declined from $40 per share to $30 per share. While there have been several changes in financial markets during this period, you are anxious to deter¬mine how the market perceives the relevant risk of your firm. Assume that the market is in equilibrium. From the following data you find that the beta value associated with your firm has changed from an old beta of to a new beta of _.

(1) The real risk-free rate is 2 percent, but the inflation premium has increased from 4 percent to 6 percent.(2) The expected growth rate has been re-evaluated by security analysts, and a 10.5 percent rate is considered to be more realis-tic than the previous 5 percent rate. This change had nothing to do with the move into plastics; it would have occurred anyway.(3) The risk aversion attitude of the market has shifted somewhat, and now the market risk premium is 3 percent instead of 2 percent.(4) The next dividend, D1, was expected to be $2 per share, assuming the "old" 5 percent growth rate.

a. 2.00; 1.50b. 1.50; 3.00c. 2.00; 3.17d. 1.67; 2.00e. 1.50; 1.67

Risk and stock value Answer: d Diff: M . The probability distribution for rM for the coming year is as follows:

Probability rM

0.05 7% 0.30 8 0.30 9 0.30 10 0.05 12

If rRF = 6.05% and Stock X has a beta of 2.0, an expected constant growth rate of 7 percent, and D0 = $2, what market price gives the investor a return consis¬tent with the stock's risk?

a. $25.00b. $37.50c. $21.72d. $42.38e. $56.94

Future stock price Answer: e Diff: M

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. A stock currently sells for $28 a share. Its dividend is growing at a constant rate, and its dividend yield is 5 percent. The required rate of return on the company’s stock is expected to remain constant at 13 percent. What is the expected stock price, seven years from now?

a. $24.62b. $29.99c. $39.40d. $41.83e. $47.98

Future stock price Answer: b Diff: M . Graham Enterprises anticipates that its dividend at the end of the year will be $2.00 a share (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7 percent a year. The risk-free rate is 6 percent, the market risk premium is 5 percent, and the company's beta equals 1.2. What is the expected price of the stock five years from now?

a. $52.43b. $56.10c. $63.49d. $70.49e. $72.54

Future stock price Answer: b Diff: M . Kirkland Motors expects to pay a $2.00 a share dividend on its common stock at the end of the year (i.e., D1 = $2.00). The stock currently sells for $20.00 a share. The required rate of return on the company’s stock is 12 percent (i.e., rs = 0.12). The dividend is expected to grow at some constant rate over time. What is the expected stock price five years from now, that is, what is ?

a. $21.65b. $22.08c. $25.64d. $35.25e. $36.78

Future stock price Answer: b Diff: M . McNally Motors has yet to pay a dividend on its common stock. However, the company expects to pay a $1.00 dividend starting two years from now (i.e., D2 = $1.00). Thereafter, the stock’s dividend is expected to grow at a constant rate of 5 percent a year. The stock’s beta is 1.4, the risk-free rate is rRF = 0.06, and the expected market return is rM = 0.12. What is the stock’s expected price four years from now, i.e., what is ?

a. $10.63b. $12.32c. $11.87d. $13.58e. $11.21

New equity and equilibrium price Answer: c Diff: M

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. Nahanni Treasures Corporation is planning a new common stock issue of five million shares to fund a new project. The increase in shares will bring to 25 million the number of shares outstanding. Nahanni's long-term growth rate is 6 percent, and its current required rate of return is 12.6 percent. The firm just paid a $1.00 dividend and the stock sells for $16.06 in the market. On the announcement of the new equity issue, the firm's stock price dropped. Nahanni estimates that the company's growth rate will increase to 6.5 percent with the new project, but since the project is riskier than average, the firm's cost of capital will increase to 13.5 percent. Using the DCF growth model, what is the change in the equilibrium stock price?

a. -$1.77b. -$1.06c. -$0.85d. -$0.66e. -$0.08

Tough:

Risk and stock price Answer: a Diff: T . Hard Hat Construction's stock is currently selling at an equilibrium price of $30 per share. The firm has been experiencing a 6 percent annual growth rate. Last year's earnings per share, E0, were $4.00, and the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the market risk premium is 5 percent. If market risk (beta) increases by 50 percent, and all other factors remain constant, by how much will the stock price change? (Hint: Use four decimal places in your calculations.)

a. -$ 7.33b. +$ 7.14c. -$15.00d. -$15.22e. +$22.63

Constant growth stock Answer: c Diff: T . Philadelphia Corporation's stock recently paid a dividend of $2.00 per share (D0 = $2), and the stock is in equilibrium. The company has a constant growth rate of 5 percent and a beta equal to 1.5. The required rate of return on the market is 15 percent, and the risk-free rate is 7 percent. Philadelphia is considering a change in policy which will increase its beta coefficient to 1.75. If market conditions remain unchanged, what new constant growth rate will cause the common stock price of Philadelphia to remain unchanged?

a. 8.85%b. 18.53%c. 6.77%d. 5.88%e. 13.52%

Supernormal growth stock Answer: c Diff: T . The Hart Mountain Company has recently discovered a new type of kitty litter which is extremely absorbent. It is expected that the firm will experience (begin¬ning now) an unusually high growth rate (20 percent) during the period (3 years) it has exclusive rights to the property where the raw

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material used to make this kitty litter is found. However, beginning with the fourth year the firm's competition will have access to the material, and from that time on the firm will achieve a normal growth rate of 8 percent annually. During the rapid growth period, the firm's dividend payout ratio will be relatively low (20 percent) in order to conserve funds for reinvest¬ment. However, the decrease in growth in the fourth year will be accom¬panied by an increase in dividend payout to 50 percent. Last year's earnings were E0 = $2.00 per share, and the firm's required return is 10 percent. What should be the current price of the common stock?

a. $66.50b. $87.96c. $71.53d. $61.78e. $93.50

Nonconstant growth stock Answer: b Diff: T . Club Auto Parts' last dividend, D0, was $0.50, and the company expects to experience no growth for the next 2 years. However, Club will grow at an annual rate of 5 percent in the third and fourth years, and, beginning with the fifth year, it should attain a 10 percent growth rate which it will sustain thereafter. Club has a required rate of return of 12 percent. What should be the price per share of Club stock at the end of the second year, ?

a. $19.98b. $25.06c. $31.21d. $19.48e. $27.55

Nonconstant growth stock Answer: e Diff: T . Modular Systems Inc. just paid dividend D0, and it is expecting both earnings and dividends to grow by 0 percent in Year 2, by 5 percent in Year 3, and at a rate of 10 percent in Year 4 and thereafter. The required return on Modular is 15 percent, and it sells at its equili-brium price, P0 = $49.87. What is the expected value of the next dividend, D1? (Hint: Draw a time line and then set up and solve an equation with one unknown, D1.)

a. It cannot be estimated without more data.b. $1.35c. $1.85d. $2.35e. $2.85

Financial Calculator Section

Multiple Choice: Problems

Easy:

Nonconstant growth stock Answer: d Diff: E

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. Your company paid a dividend of $2.00 last year. The growth rate is expected to be 4 percent for 1 year, 5 percent the next year, then 6 percent for the following year, and then the growth rate is expected to be a constant 7 percent thereafter. The required rate of return on equity (rs) is 10 percent. What is the current price of the common stock?

a. $53.45b. $60.98c. $64.49d. $67.47e. $69.21

Medium:

Supernormal growth stock Answer: b Diff: M . Assume that the average firm in your company's industry is expected to grow at a constant rate of 5 percent, and its dividend yield is 4 percent. Your company is about as risky as the average firm in the industry, but it has just developed a line of innovative new products which leads you to expect that its earnings and dividends will grow at a rate of 40 percent (D1 = D0(1 + g) = D0(1.40)) this year and 25 percent the following year, after which growth should match the 5 percent industry average rate. The last dividend paid (D0) was $2. What is the value per share of your firm's stock?

a. $ 42.60b. $ 82.84c. $ 91.88d. $101.15e. $110.37

Nonconstant growth stock Answer: c Diff: M . Garcia Inc. has a current dividend of $3.00 per share (D0 = $3.00). Analysts expect that the dividend will grow at a rate of 25 percent a year for the next three years, and thereafter it will grow at a constant rate of 10 percent a year. The company's cost of equity capital is estimated to be 15 percent. What is the current stock price of Garcia Inc.?

a. $ 75.00b. $ 88.55c. $ 95.42d. $103.25e. $110.00

Tough:

Firm valuation Answer: c Diff: T . Assume an all equity firm has been growing at a 15 percent annual rate and is expected to continue to do so for 3 more years. At that time, growth is expected to slow to a constant 4 percent rate. The firm maintains a 30 percent payout ratio, and this year's retained earnings net of dividends were $1.4 million. The firm's beta is 1.25, the risk-free rate is 8 percent, and the market risk premium is

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4 percent. If the market is in equilibrium, what is the market value of the firm's common equity (1 million shares outstand¬ing)?

a. $ 6.41 millionb. $12.96 millionc. $ 9.18 milliond. $10.56 millione. $ 7.32 million

Nonconstant growth stock Answer: c Diff: T . A financial analyst has been following Fast Start Inc., a new high-growth company. She estimates that the current risk-free rate is 6.25 percent, the market risk premium is 5 percent, and that Fast Start's beta is 1.75. The current earnings per share (EPS0) is $2.50. The company has a 40 percent payout ratio. The analyst estimates that the company's dividend will grow at a rate of 25 percent this year, 20 percent next year, and 15 percent the following year. After three years the dividend is expected to grow at a constant rate of 7 percent a year. The company is expected to maintain its current payout ratio. The analyst believes that the stock is fairly priced. What is the current price of the stock?

a. $16.51b. $17.33c. $18.53d. $19.25e. $19.89


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