Kaplan Mock 4 - Part 2

Question 1

If a firm’s breakeven quantity of sales is equal to its operating breakeven quantity of sales, its degree of:

A)
total leverage is 1.0.
Incorrect Answer
B)
financial leverage is 1.0.
Correct Answer
C)
operating leverage is 1.0.
Incorrect Answer

Answer 1

The breakeven quantity of sales is (fixed operating costs + fixed financing costs) / (price – variable cost per unit). The operating breakeven quantity of sales is (fixed operating costs) / (price – variable cost per unit). If a firm has a degree of financial leverage equal to 1 (i.e., no financial leverage), its fixed financing costs are zero. Therefore, its breakeven quantity of sales is equal to its operating breakeven quantity of sales. (Module 35.1, LOS 35.e)

Fin lev = asset / equity

Question 2

Hyperbolic discounting refers to favoring small payoffs in the short term over larger payoffs in the long term and is related to self-control bias.

An investor who takes personal credit for gains and blames others for losses exhibits self-attribution bias.

An investor who experiences greater pain from a loss than pleasure from an equal-sized gain exhibits loss aversion bias. (Module 65.1, LOS 65.b)

Question 3

Agency costs of equity are related to conflicts of interest between managers and owners

Agency costs of equity result from differences between equity owners and management. These costs are reduced when a greater proportion of debt is used in the capital structure because fixed interest charges reduce the amount of income over which managers have discretion in deploying. (Module 34.2, LOS 34.d)

According to agency theory, the use of debt forces managers to be disciplined with regard to how they spend cash because they have less free cash flow to use for their own benefit. It follows that greater amounts of financial leverage tend to reduce agency costs.

Answer 3

Monitoring costs are associated with supervising management and include the expenses of reporting to shareholders and paying the board of directors. Strong corporate governance systems reduce monitoring costs.
Bonding costs relate to assuring shareholders that the managers are working in the shareholders’ best interest. Examples of bonding costs include premiums for insurance to guarantee performance and implicit costs associated with non-compete agreements.
 Residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.

Question 4

Financial risks are those that arise from exposure to financial markets. Examples are:

Credit risk. This is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations.
Liquidity risk. This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset.
Market risk. This is the uncertainty about market prices of assets (stocks, commodities, and currencies) and interest rates.

Non-financial risks arise from the operations of the organization and from sources external to the organization. Examples are:

Operational risk. This is the risk that human error, faulty organizational processes, inadequate security, or business interruptions will result in losses. An example of an operational risk is cyber risk, which refers to disruptions of an organization’s information technology.
Solvency risk. This is the risk that the organization will be unable to continue to operate because it has run out of cash.
Regulatory risk. This is the risk that the regulatory environment will change, imposing costs on the firm or restricting its activities.
Governmental or political risk (including tax risk). This is the risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization.
Legal risk. This is the uncertainty about the organization’s exposure to future legal action.
Model risk. This is the risk that asset valuations based on the organization’s analytical models are incorrect.
Tail risk. This is the risk that extreme events (those in the tails of the distribution of outcomes) are more likely than the organization’s analysis indicates, especially from incorrectly concluding that the distribution of outcomes is normal.
Accounting risk. This is the risk that the organization’s accounting policies and estimates are judged to be incorrect.

Question 5

Which of the following statements about alternative investment indexes is most accurate?

A)
An investor can replicate a commodity index by making direct investments in the underlying physical commodities.
Incorrect Answer
B)
Real Estate Investment Trust indexes track the prices of shares of publicly traded companies that invest in mortgages or real property.
Correct Answer
C)
Hedge fund indexes accurately represent the investment performance of the hedge fund industry.
Incorrect Answer

Answer 5

REIT indexes represent a convenient way to invest in real estate. Real estate indexes can be constructed using returns based on appraisals of properties, repeat property sales, or the performance of Real Estate Investment Trusts (REITs).

Commodity indexes represent futures contracts on commodities such as grains, livestock, metals, and energy. Commodity indexes are based on futures prices of commodities, and are not replicated by investing in the commodities themselves.

Hedge fund indexes are biased upward because hedge funds are not required to disclose their performance to index providers and poorly performing funds are less likely to do so (self-selection bias). (Module 37.2, LOS 37.k)

Question 6

An investor with an investment horizon of 5 years has purchased a 15-year 6% coupon bond at par. The bond has a modified duration of 9.8. The duration gap for this investor is closest to:

A)
–4.2.
Incorrect Answer
B)
4.8.
Incorrect Answer
C)
5.4.
Correct Answer

Question 7

Which of the following intangible assets is most likely to represent high-quality collateral in credit analysis?

A)
Goodwill.
Incorrect Answer
B)
Trademarks.
Correct Answer
C)
Deferred tax assets.
Incorrect Answer

Answer 7

Intangible assets that can be sold, such as trademarks, provide collateral of good quality. A credit analyst should view as low-quality collateral any assets that are likely to be written down in value if a firm encounters financial distress, such as goodwill and deferred tax assets. (Module 47.1, LOS 47.f)

Question 8

An analytical duration would be preferred to an empirical duration in instances where:

A)
the goal is to test the sensitivity of assumptions.
Correct Answer
B)
the change in the credit spread is positively correlated with the change in the benchmark yield curve.
Incorrect Answer
C)
the change in the credit spread is negatively correlated with the change in the benchmark yield curve.
Incorrect Answer

Analytic methods lend themselves to estimating the effect of changing a particular assumption or estimate. When, historically, changes in the benchmark yield curve have been correlated with changes in the credit spread, empirical duration may be a more accurate measure of interest rate sensitivity. (Module 46.3, LOS 46.m)

Answer 8

The duration measures we have introduced in this reading, based on mathematical analysis, are often referred to as analytical durations.

A different approach is to estimate empirical durations using the historical relationship between benchmark yield changes and bond price changes.

Question 9

The following information applies to JNC Advisers, a hedge fund:

$250 million in AUM as of prior year-end
2% management fee (based on year-end AUM)
20% incentive fee calculated net of management fees, using a 4% soft hurdle rate and a high-water mark ($275 million as of prior year-end)
In the current year, the fund’s gross return is 20%. An investor’s net-of-fees return for the year is closest to:

End-of-year AUM = $250 million × 1.20 = $300 million Management fees = $300 million × 2% = $6 million
AUM net of management fees = $300 million – $6 million = $294 million Return net of management fees = $294 / $250 – 1 = 17.6%

Because returns for the year net of management fees exceeded the soft hurdle rate, the fund can collect incentive fees, but only on gains above the high-water mark.

Incentive fees = 20% × ($294 – $275) = $3.8 million Total fees to JNC Advisers = $6 + $3.8 = $9.8 million After-fee return = [(300 – 9.8) / 250] – 1 = 16.08% (Module 59.1, LOS 59.b)

Answer 9

management fee is calculated from AUM from the current year

Question 10

If the risk-free rate of interest is 3%, the spot price of an asset is 35, and its net cost of carry is –2, the no-arbitrage price of a one-year forward contract on units of the asset is closest to:

A)
33.99.
Incorrect Answer
B)
38.05.
Incorrect Answer
C)
38.11.
Correct Answer
Explanation
A negative net cost of carry means that the costs of holding the asset are greater than the benefits, so we must add 2 to the spot price to get a no-arbitrage price for a one-year forward contract of 1.03(35 + 2) = 38.11. (Module 52.1, LOS 52.a)

Question 11

Recent economic data suggest an increasing likelihood that the economy will soon enter a recessionary phase. What is the most likely effect on the yields of lower-quality corporate bonds and on credit spreads of lower-quality versus higher-quality corporate bonds?

A)
Both will increase.
Correct Answer
B)
Both will decrease.
Incorrect Answer
C)
One will increase and one will decrease.
Incorrect Answer
Explanation
During economic contractions, the probability of default increases for lower-quality issues and their yields increase. When investors anticipate an economic downturn, they tend to sell low-quality issues and buy high-quality issues, causing credit spreads to widen. (Module 47.2, LOS 47.j)

Related Material

Question 12

Common shares are the most common form of equity and represent an ownership interest. Common shareholders have a residual claim (after the claims of debtholders and preferred stockholders) on firm assets if the firm is liquidated and govern the corporation through voting rights. Firms are under no obligation to pay dividends on common equity; the firm determines what dividend will be paid periodically. Common stockholders are able to vote for the board of directors, on merger decisions, and on the selection of auditors. If they are unable to attend the annual meeting, shareholders can vote by proxy (having someone else vote as they direct them, on their behalf).

Answer 12

In a statutory voting system, each share held is assigned one vote in the election of each member of the board of directors. Under cumulative voting, shareholders can allocate their votes to one or more candidates as they choose.

Under statutory voting, the shareholder can vote 100 shares for his director choice in each election. Under cumulative voting, the shareholder has 300 votes, which can be cast for a single candidate or spread across multiple candidates.

Question 13

Preference shares (or preferred stock) have features of both common stock and debt. As with common stock, preferred stock dividends are not a contractual obligation and the shares usually do not mature. Like debt, preferred shares typically make fixed periodic payments to investors and do not usually have voting rights. Preference shares may be callable, giving the firm the right to repurchase the shares at a pre-specified call price. They may also be putable, giving the shareholder the right to sell the preference shares back to the issuer at a specified price.

Answer 13

Cumulative preference shares are usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends. The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

Investors in participating preference shares receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated. Non-participating preference shares have a claim equal to par value in the event of liquidation and do not share in firm profits.

Convertible preference shares can be exchanged for common stock at a conversion ratio determined when the shares are originally issued. It has the following advantages:

Question 14

The holder of the type of security that has a priority in liquidation less than that of bonds or promissory notes issued by the company but ahead of that of common stock is most likely to have:

A)
no voting rights.
Correct Answer
B)
statutory voting rights.
Incorrect Answer
C)
cumulative voting rights.
Incorrect Answer

Question 15

A lockup period is the time after initial investment over which limited partners either cannot request redemptions or incur significant fees for redemptions (a soft lockup).

A notice period (typically between 30 and 90 days) is the amount of time a fund has to fulfill a redemption request made after the lockup period has passed.

Question 16

Supranational bonds are issued by multilateral agencies such as the World Bank or International Monetary Fund. (multilateral agencies are organization formed by 3 or more nations to work on issues that relate to all of the countries in the organization)

Bonds that trade outside the jurisdiction of any one country are known as global bonds.

Bonds that pay coupons in a different currency than their principal are known as dual-currency bonds. (Module 43.1, LOS 43.f)

Question 17

Roger Gould is analyzing the stock of Zero Incorporated and trying to determine which price multiple to use in his valuation. Zero, a start-up, had losses over the last 12 months and is projected to have a loss over the next 12 months. Zero has significant internally generated intangible assets and human capital that Gould would like to capture in his valuation. The price multiple that Gould should most appropriately use is the:

A)
price-to-sales ratio.
Correct Answer
B)
price-to-book value.
Incorrect Answer
C)
price-to-earnings ratio.
Incorrect Answer

Answer 17

Important

Explanation
The price-to-sales ratio can be used for firms with negative earnings and implicitly recognizes the value of assets not recognized on the balance sheet. The price-to-earnings ratio is the most popular ratio in the investment community; however, it is not a useful ratio for firms with negative earnings. One of the significant disadvantages of the price-to-book value ratio is that it does not recognize the value of nonphysical assets such as human capital or intangible assets generated internally. Therefore, price-to-book value would not be the best choice. (Module 41.3, LOS 41.m)

Question 18

If the option-adjusted spread is less than the zero-volatility spread, the embedded option has a negative value to the bondholder (e.g., a call option), and if the option-adjusted spread is greater than the zero-volatility spread, the embedded option has a positive value to the bondholder (e.g., a put option).

Zero-volatility spreads adjust for the fact that nominal spreads (between the yields to maturity of two bonds) are theoretically correct only when the spot yield curve is flat. All of these bonds’ zero-volatility spreads are nearly identical to their government spreads, which suggests the spot yield curve is approximately flat. (Module 44.5, LOS 44.k)

Question 19

An analyst classifies Mettler, Inc., an operator of retail grocery stores, in the same industry group as Powell Corporation, a manufacturer of industrial machinery. This analyst’s classification system is most likely based on:

A)
statistical methods.
Correct Answer
B)
products and services.
Incorrect Answer
C)
sensitivity to the business cycle.
Incorrect Answer

This grouping is most likely the result of a cluster analysis and may have arisen by chance. The two firms clearly offer different products and services. An industrial machinery manufacturer is likely to be a cyclical firm, while a grocery retailer is likely to be a non-cyclical firm. (Module 40.1, LOS 40.b)

Question 20

A programming error resulted in the issuance of a forward contract that ignored the convenience yield investors realize from holding the underlying asset. To gain an arbitrage profit from this error, an arbitrageur’s position would most likely include a long position in the:

A)
forward contract.
Incorrect Answer
B)
underlying asset.
Correct Answer
C)
risk-free asset.
Incorrect Answer
Explanation
Ignoring the convenience yield (a nonmonetary benefit of holding the asset) will result in a forward price that is above the no-arbitrage forward price. To profit from this mispricing, an arbitrageur would borrow at the risk-free rate (i.e., take a short position in the risk-free asset), purchase the underlying asset, and take a short position in the forward contract. (Module 51.1, LOS 51.a)

Question 21

Management fees for hedge funds are most likely calculated as a percentage of:

A)
committed capital.
Incorrect Answer
B)
gains above a hurdle rate.
Incorrect Answer
C)
assets under management.
Correct Answer

Answer 21

Management fee for hedge funds and private equity are calculated differently.

For hedge funds, management fees are typically a percentage of assets under management. Incentive fees are based on gains. Management fees for private capital funds are typically a percentage of committed capital. (Module 58.1, LOS 58.c)

Question 22

Rollover risk is the risk that an issuer who relies on the commercial paper market as a funding source may not be able to issue new commercial paper when an outstanding issue matures. Default risk and reinvestment risk are faced by bondholders. (Module 43.2, LOS 43.g)

Answer 22

The two important circumstances in which a company will face rollover difficulties are (1) there is a deterioration in a company’s actual or perceived ability to repay the debt at maturity, which will significantly increase the required yield on the paper or lead to less-than-full subscription to a new issue, and (2) significant systemic financial distress, as was experienced in the 2008 financial crisis, that may “freeze” debt markets so that very little commercial paper can be sold at all.

Question 23

Visser, Inc. is an unprofitable fishing enterprise. Visser rents most of its boats and equipment but owns valuable transferable fishing quotas. If a competitor is interested in acquiring Visser, the most appropriate equity valuation model to use is:

A)
an asset-based valuation model.
Correct Answer
B)
an earnings multiplier model.
Incorrect Answer
C)
a Gordon growth model.
Incorrect Answer

Answer 23

Asset-based models are often used to value natural resources companies and companies that are being liquidated. Because Visser is unprofitable, an earnings multiplier model or a dividend discount model such as the Gordon growth model may not produce a meaningful value for the firm. (Module 41.1, LOS 41.b)

Question 24

What is most likely to happen to the prepayment rate and the weighted average life of a typical pass-through security if mortgage rates decrease?

Answer 24

Prepayment rates will most likely increase if mortgage rates decrease. Increasing prepayments will decrease the weighted average life of the pass-through security. (Module 45.1, LOS 45.f)

Question 25

Moore Company stock is currently trading at $40 per share. An investor attempting to protect against losses of more than 10% on a short position in Moore should place a:
answer: stop buy order at $44.

Answer 25

The investor is short the stock and will experience losses if the stock price increases. A stop buy order at $44 will execute if the stock price rises to $44 or higher. A limit buy order at $44 would execute immediately because the stock price is less than $44. (Module 36.3, LOS 36.h)

Question 26

Both put and call writers (sellers) have an obligation to honor the terms of the option if it is exercised.

Option holders (buyers) have the right, not the obligation, to exercise under the terms of the agreement.

The holder pays a premium for this right, while the writer receives a premium for this obligation. A forward contract imposes an obligation on both the buyer and seller to exchange the underlying asset. (Module 49.2, LOS 49.c)

Question 27

The distinction between effective convexity and approximate convexity is that effective convexity accounts for the effects of embedded options on the bond’s cash flows at different yields. For bonds that do not have embedded options, there is no difference between effective convexity and approximate convexity. Both measures are used to improve the estimate of the change in a bond’s price for a given change in yield. (Module 46.3, LOS 46.h)

Question 28

A multi-market index is most likely to overweight countries that have recently experienced high equity market returns if it weights the securities in each country index by:

A)
dividend yield, and weights the country index returns by market capitalization.
Correct Answer

Answer 28

Weighting countries in a multi-market index by market capitalization, rather than a fundamental factor such as GDP, is likely to overweight countries with previously high stock returns. (Module 37.2, LOS 37.h)

Question 29

An analyst gathered the following data about a stock:

The stock paid a $1 dividend last year.
Next year’s dividend is projected to be 10% higher.
The stock is projected to sell for $25 at the end of the year.
The risk-free rate of interest is 8%.
The expected return on the market is 13%.
The stock’s beta is 1.2.
The value of the stock today is closest to:

Answer 29

k = RFR + β(RM − RFR) = 0.08 + 1.2(0.13 − 0.08) = 0.08 + 0.06 = 0.14

P0 = (P1 + D1) / (1+k)

look out for the price at year end. Discounting with the denominator.