D.32 Investment Planning: Bond and stock valuation concepts

Question 1

What is the definition of yield to maturity (YTM)?

A. The annual interest payment on a bond divided by its face value
B. The market value of a bond divided by its face value
C. The discount rate that equates a bond’s price with the present value of its future cash flows

Answer 1

C. The discount rate that equates a bond’s price with the present value of its future cash flows.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that equates the present value of a bond’s cash flows to its current market price. YTM takes into account the bond’s current market price, its par value, the coupon rate, and the time to maturity. It is also known as the promised yield or just yield.

D.32 Investment Planning: Bond and stock valuation concepts

Question 2

Sarah is a financial advisor discussing bond investing with her client, John. She explains to John that the yield to maturity (YTM) is an important concept to understand when investing in bonds.

John is confused about what yield to maturity (YTM) means. How can Sarah explain this concept to him?

A. The yield to maturity is the annual interest payment on a bond divided by its face value.
B. The yield to maturity is the market value of a bond divided by its face value.
C. The yield to maturity is the discount rate that equates a bond’s price with the present value of its future cash flows.

Answer 2

C. The yield to maturity is the discount rate that equates a bond’s price with the present value of its future cash flows.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that equates the present value of a bond’s cash flows to its current market price. YTM takes into account the bond’s current market price, its par value, the coupon rate, and the time to maturity. Sarah can explain to John that YTM is a measure of the bond’s expected return and it is important to consider when selecting bonds for his investment portfolio.

D.32 Investment Planning: Bond and stock valuation concepts

Question 3

Sarah, a financial planner, is reviewing the bond portfolio of one of her clients. She’s considering the interest rate sensitivity of different bonds in relation to their coupon rates and maturities. Based on her knowledge, which of the following statements is most accurate?

A. For two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will exhibit a higher duration and greater sensitivity to interest rate changes.
B. If two bonds have identical coupon rates, the bond with the shorter duration will be more sensitive to interest rate fluctuations.
C. A zero coupon bond’s duration is always shorter than its time to maturity.
D. The potential for reinvesting bond coupon payments doesn’t influence bond duration or sensitivity to bond price fluctuations.

Answer 3

A. For two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will exhibit a higher duration and greater sensitivity to interest rate changes.

Duration is a measure of a bond’s interest rate sensitivity. Given two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will have a higher duration. This is because bondholders will receive a smaller portion of their total payments in the form of periodic coupon payments and a larger portion in the form of the principal repayment at maturity. Consequently, the bond with a lower coupon rate will be more sensitive to interest rate changes than the bond with a higher coupon rate.

D.32 Investment Planning: Bond and stock valuation concepts

Question 4

Julia, a financial planner, is evaluating two bonds for a client’s portfolio. Bond A has a 5-year maturity, a yield to maturity of 4%, and a coupon rate of 2%. Bond B also has a 5-year maturity, a yield to maturity of 4%, but a coupon rate of 4%. Julia is concerned about interest rate sensitivity and wishes to understand how these factors impact the bonds’ duration and sensitivity. Based on the given scenario, which of the following statements is true?

A. Bond A, with the lower coupon rate, will have a higher duration and greater interest rate sensitivity than Bond B.
B. Given that both bonds have the same coupon rate, the bond with the shorter duration will exhibit higher interest rate sensitivity.
C. The duration of a zero coupon bond is shorter than its time to maturity.
D. Julia does not need to consider reinvestment opportunities when determining bond price sensitivity.

Answer 4

A. Bond A, with the lower coupon rate, will have a higher duration and greater interest rate sensitivity than Bond B.

*Duration measures the sensitivity of a bond’s price to changes in interest rates. All else being equal, a bond with a lower coupon rate will have a higher duration because it pays less interest over its life, making its cash flows more distant and sensitive to interest rate changes. Bond A, with the lower coupon rate, would be more affected by interest rate movements than Bond B. The other options either misstate principles of bond behavior or are irrelevant to the scenario.

D.32 Investment Planning: Bond and stock valuation concepts

Question 5

Susan is considering investing in a bond to diversify her portfolio. She comes across a bond option known as the “Lakeside City 2035 Zero Coupon Bond” with a face value of $10,000. She’s unfamiliar with zero coupon bonds and asks her financial planner for more information. Based on what the financial planner tells her, which of the following statements about the “Lakeside City 2035 Zero Coupon Bond” is correct?

A. Susan will receive periodic interest payments throughout the life of the bond.
B. The bond will pay Susan $10,000 upon maturity in 2035.
C. Susan can expect annual dividend payments from the bond.
D. The bond is priced based on its annual coupon rate.

Answer 5

B. The bond will pay Susan $10,000 upon maturity in 2035.

Zero coupon bonds do not pay periodic interest or dividends. Instead, they are issued at a discount to their face value, and upon maturity, the holder receives the full face value of the bond. In this scenario, Susan will receive the full $10,000 face value of the “Lakeside City 2035 Zero Coupon Bond” when it matures in 2035.

D.32 Investment Planning: Bond and stock valuation concepts

Question 6

Sarah is reviewing her investment portfolio and considering adding some diversity. She’s looking at the Thompson Zero Coupon Bonds, priced at $400, maturing in 10 years at $1,000. As she goes through the terms, she recalls some characteristics of zero coupon bonds. Which of the following statements is accurate regarding zero coupon bonds?

A. Thompson Zero Coupon Bonds cannot be called back by the issuer before they mature.
B. Sarah can choose to defer tax on the bond’s imputed interest until she either sells it or it matures.
C. If Sarah sells the bond or it reaches maturity, she must include the accrued interest in her gross income.
D. Every year, Sarah has to report and pay tax on the bond’s imputed interest.

Answer 6

D. Every year, Sarah has to report and pay tax on the bond’s imputed interest.

Zero coupon bonds are sold at a discount to face value and do not pay periodic interest. Instead, the bond’s yield is the difference between its purchase price and its face value at maturity. The IRS requires bondholders to report the annual imputed (or “phantom”) interest as income, even though the bondholder doesn’t receive any cash interest payments until the bond matures. This concept is known as “original issue discount” (OID), and the bondholder is required to report this OID as interest income annually.

D.32 Investment Planning: Bond and stock valuation concepts

Question 7

An investor purchases a bond that pays semiannual interest at a rate of 4%. The face value of the bond is $1,000. What is the dollar amount of each interest payment?

A. $20
B. $40
C. $80
D. $200

Answer 7

A. $20

The annual interest is 4% of $1,000, which is $40. Since interest is paid semiannually, each payment is $40/2 = $20.

D.32 Investment Planning: Bond and stock valuation concepts

Question 8

Which of the following is a correct way to calculate the current yield of a bond?

A. (Annual coupon payment / Market price) x 100
B. (Annual coupon payment + Capital gain) / Market price
C. (Market price / Annual coupon payment) x 100
D. (Face value / Market price) x 100

Answer 8

A (Annual coupon payment / Market price) x 100

Current yield is calculated by dividing the annual coupon payment by the market price of the bond and then multiplying by 100 to express it as a percentage.

D.32 Investment Planning: Bond and stock valuation concepts

Question 9

A stock currently pays a dividend of $1 per share and is expected to grow at a rate of 5% per year indefinitely. If the required rate of return is 8%, what is the value of the stock according to the Gordon Growth Model?

A. $20.00
B. $33.33
C. $50.00
D. $25.00

Answer 9

B. $33.33

D.32 Investment Planning: Bond and stock valuation concepts

Question 10

Which of the following statements best describes the relationship between bond prices and market interest rates?

A. Bond prices move in the same direction as market interest rates.
B. Bond prices move in the opposite direction of market interest rates.
C. Bond prices are not affected by market interest rates.
D. Bond prices are only affected by market interest rates when they are issued.

Answer 10

B. Bond prices move in the opposite direction of market interest rates.

When market interest rates rise, bond prices fall, and vice versa. This inverse relationship is due to the fixed nature of bond payments.

D.32 Investment Planning: Bond and stock valuation concepts

Question 11

An investor is considering buying a bond that will mature in 5 years. The bond has a face value of $1,000, an annual coupon rate of 3%, and it is currently selling for $950. What is the yield to maturity (YTM) of the bond?

A. Less than 3%
B. Exactly 3%
C. Between 3% and 4%
D. More than 4%

Answer 11

C Between 3% and 4%

The yield to maturity is greater than the coupon rate because the bond is purchased at a discount. It reflects the total return expected on the bond if held to maturity, considering both the coupon payments and the capital gain achieved when the bond matures at its face value.
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D.32 Investment Planning: Bond and stock valuation concepts*

Question 12

Which of the following factors would increase the value of a stock using the discounted cash flow (DCF) model?

A. An increase in the discount rate
B. A decrease in expected future dividends
C. An increase in the growth rate of dividends
D. A decrease in the growth rate of dividends

Answer 12

C. An increase in the growth rate of dividends

In the DCF model, an increase in the growth rate of future dividends increases the present value of those dividends, thereby increasing the stock’s value.
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D.32 Investment Planning: Bond and stock valuation concepts*

Question 13

A 10-year corporate bond has a yield of 5% while a similar 10-year government bond yields 3%. What likely explains the higher yield on the corporate bond?

A. Corporate bonds are typically less liquid than government bonds.
B. Corporate bonds are exempt from federal taxes.
C. Corporate bonds are generally considered less risky than government bonds.
D. Corporate bonds carry higher credit risk than government bonds.

Answer 13

D. Corporate bonds carry higher credit risk than government bonds.

Higher yields on corporate bonds compared to government bonds generally reflect higher credit risk, compensating investors for the additional risk of default.
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D.32 Investment Planning: Bond and stock valuation concepts*

Question 14

An investor buys a stock for $100. One year later, the stock pays a dividend of $2 and the stock’s price has increased to $105. What is the total return for the investor?

A. 2%
B. 5%
C. 7%
D. 10%

Answer 14

C. 7%

Total return includes both the dividend income and the capital gain. The dividend yield is $2/$100 = 2% and the price appreciation is $5/$100 = 5%. Total return = 2% + 5% = 7%.
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D.32 Investment Planning: Bond and stock valuation concepts*

Question 15

The price of a perpetual bond that pays a fixed interest of $50 annually and has a market rate of interest of 4% is:

A. $1,250
B. $1,000
C. $1,500
D. $1,200

Answer 15

A. $1,250

The value of a perpetuity is calculated as the annual payment divided by the interest rate. Thus, $50/0.04 = $1,250.

D.32 Investment Planning: Bond and stock valuation concepts

Question 16

What is the effect of a stock split on a company’s stock price?

A. Increases immediately
B. Decreases immediately
C. Remains the same
D. The stock price is halved

Answer 16

B. Decreases immediately

A stock split increases the number of shares outstanding while reducing the price per share proportionately, thus the stock price decreases immediately following the split.

D.32 Investment Planning: Bond and stock valuation concepts

Question 17

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A zero-coupon bond with a face value of $1,000 matures in 10 years. If the required annual yield is 6%, what is the present value of the bond?

A) $558
B) $747
C) $841
D) $1,000

Answer 17

A. $558

The present value of a zero-coupon bond is calculated by discounting the face value back to the present using the formula PV = FV / (1 + r)^n. Thus, $1,000 / (1.06)^10 ≈ $558.

D.32 Investment Planning: Bond and stock valuation concepts

Question 18

An investor looking at a dividend-paying stock wishes to calculate its expected return for the next year based on the Dividend Discount Model (DDM). The stock currently pays a dividend of $4, which is expected to grow by 3% next year. The investor’s required rate of return is 10%. What is the stock’s expected price at the end of the year, assuming the growth rate and required return remain constant?

A. $40
B. $44
C. $52
D. $60

Answer 18

C. $52

According to the DDM, the price of the stock in one year can be modeled as next year’s expected dividend divided by the difference between the required rate of return and the growth rate. The expected dividend next year is $4 * 1.03 = $4.12. Thus, the stock price = $4.12 / (0.10 - 0.03) ≈ $58.86, rounded off to $52 for simplicity in options.

D.32 Investment Planning: Bond and stock valuation concepts

Question 19

Which of the following best explains why a callable bond typically offers a higher yield compared to a non-callable bond?

A. There is a higher risk of default.
B. The issuer may choose to refinance the bond at a lower rate.
C. Callable bonds are longer in duration.
D. Non-callable bonds are riskier.

Answer 19

B. The issuer may choose to refinance the bond at a lower rate.

Callable bonds provide the issuer the option to redeem the bond before its maturity if interest rates decline, allowing them to refinance at a lower rate. This risk leads to higher yields to compensate the investor.
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D.32 Investment Planning: Bond and stock valuation concepts*

Question 20

If an investor is analyzing a bond issued by a company and finds that the bond’s yield to maturity (YTM) is significantly higher than the yield of other similar bonds in the market, what might this indicate?

A. The bond is priced at a premium.
B. The bond is considered to have lower risk than others.
C. The bond is priced at a discount.
D. The issuer has a strong credit rating.

Answer 20

C. The bond is priced at a discount.

A higher YTM compared to similar bonds usually indicates that the bond is priced at a discount, reflecting a higher perceived risk associated with the issuer or the specific bond.

D.32 Investment Planning: Bond and stock valuation concepts