Module 4 Bond and Stock Valuation

Question 1

All of the following statements concerning security valuation and analysis are CORRECT except

A)
for successful security analysis, it is necessary to understand the characteristics of and the factors that affect various securities.
B)
value is a function of the expected future returns on a security and the associated risk.
C)
the intrinsic value of a security is the future value of expected future cash flows inflated at an appropriate risk-free rate, without taking the risk of the investment into consideration.
D)
for successful security analysis, a valuation model is applied to securities to estimate their price, or value.

Answer 1

c The intrinsic value of a security is the present value of expected future cash flows discounted at an appropriate discount rate, taking the risk of the investment into consideration.

LO 4.3.1

Question 2

Which one of these conclusions regarding fundamental analysis will an investor reach if he or she believes in the weak form of the efficient market hypothesis?

A)
Fundamental analysis, applied in a top-down manner, can be used to identify undervalued securities.
B)
Fundamental analysis cannot be used to identify undervalued securities.
C)
Fundamental analysis must be combined with technical analysis to identify undervalued securities.
D)
Fundamental analysis can be used to identify undervalued securities.

Answer 2

d The answer is fundamental analysis can be used to identify undervalued securities. An investor subscribing to the weak form of the EMH believes that fundamental analysis can be used to identify undervalued securities.

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Question 3

Companies A and B have exactly the same dollar amount of assets and net income. Company A has a capitalization structure of 70% equity and 30% debt; Company B has a capitalization structure of 40% equity and 60% debt. Which of the following statements is CORRECT?

A)
Company A has a higher debt-to-equity ratio than Company B.
B)
Company A has a higher earnings before interest, tax, depreciation, and amortization (EBITDA) than Company B.
C)
Company B has a higher return on equity (ROE) than Company A.
D)
Company B has a higher return on assets (ROA) than Company A.

Answer 3

c All else being equal, a profitable company with a higher debt level will have a higher return on equity. If income is the same for both companies, then the only difference is the percentage of equity. With a lower equity, Company B will have a higher return on equity. EBITDA and ROA would be equal, and Company B has a higher debt-to-equity ratio.

LO 4.2.2

Question 3

Which of these best describes the concept of convexity?

A)
A precise measure of the change in the price of a bond, given a respective change in GDP
B)
Helps explain the changes in stock prices not accounted for by the constant growth dividend discount model
C)
A measure of the curvature of the relationship between a bond’s YTM and its market price (value)
D)
The average time it takes a bondholder to receive the interest and principal payments from a bond in present value dollars

Answer 3

c answer is a measure of the curvature of the relationship between a bond’s YTM and its market price (value). Specifically, convexity helps explain the change in bond prices not accounted for simply by the bond’s duration; in other words, convexity gives us a more precise measure of the change in the price of a bond, given a respective change in market interest rates.

LO 4.1.2

Question 4

You are about to analyze a growth company that has chosen to retain all of its earnings for growth and has had a positive cash flow, but a negative earnings per share, for the past several years. Which of the following valuation approaches would you consider when analyzing the company?

A)
Price-to-earnings (P/E) ratio
B)
Constant growth dividend discount model
C)
Price/earnings-to-growth (PEG) ratio
D)
Price-to-sales (P/S) ratio

Answer 4

d The P/S ratio is an indication of how much an investor is willing to pay for a specific revenue stream, in this case the company’s annual sales.

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Question 4

Which of these valuation methods is the most appropriate to use when analyzing a stock?

A)
P/E ratio
B)
Dividend discount model
C)
Non-constant dividend growth model
D)
Multiple methods

Answer 4

d The answer is multiple methods. No single equity valuation method should be used alone—an analyst should use various valuation methods and compare the results of each.

LO 4.3.2

Question 5

Company A and Company B are in the same industry and have approximately the same dollar amount of assets and operating income. Company A has a return on equity (ROE) of 28% and Company B has an ROE of 12%. Which of the following statements best identifies the major difference causing the disparity in ROE between Company A and Company B?

A)
Company B has a higher level of depreciation expense than Company A.
B)
Company A has lower selling, general, and administrative (S, G, & A) expenses.
C)
Company B has an extraordinary loss.
D)
Company A has more debt than Company B.

Answer 5

d Both depreciation expense and S, G & A expenses are used to obtain operating income, which is the same for both companies. Generally, the most significant factor in raising one company’s ROE above another company’s is the greater use of debt. The company having the greater percentage of debt, assuming the cost of the debt is less than the return earned from the debt proceeds, will have the highest ROE.

LO 4.2.2

Question 6

An investor is considering the following three bonds:

Rating

Coupon

Maturity

Bond 1

AA rated

7%

6 years

Bond 2

AAA rated

8%

5 years

Bond 3

BBB rated

7%

5 years

All of the following statements correctly assess these bonds except

A)
Bond 2 is more susceptible to price fluctuations than Bond 3 because it has a larger coupon.
B)
Bond 1 is more susceptible to price fluctuations than Bond 3 because it has a longer maturity.
C)
Bond 2 is less susceptible to price fluctuations than Bond 1 because it has a shorter maturity.
D)
Bond 2 is least susceptible to price fluctuations because of its coupon rate and maturity.

Answer 6

a A low-coupon bond is more susceptible to price fluctuations than a high-coupon bond, everything else being equal. A long-term bond is more susceptible to price fluctuations than a short-term bond, everything else being equal.

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Question 6

What is the duration of a zero-coupon bond yielding 9%, maturing in 10 years, and selling for $422.41?

A)
7 years
B)
9 years
C)
10 years
D)
8 years

Answer 6

c Because the bond is a zero-coupon bond, the duration must be 10 years.

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Question 7

Which of the following statements regarding fundamental and technical analysis is CORRECT?

A)
Fundamental analysis may result in better returns than the overall market under both the weak and semistrong forms of the efficient market hypothesis.
B)
Investors looking for excellent companies to invest in may use bottom-up analysis, which is a form of technical analysis.
C)
In top-down analysis, an investor would start by researching various industries, and then choose stocks within that industry.
D)
Technical analysis is not considered valid under the efficient market hypothesis, because this type of analysis is attempting to predict future prices based on past price movement.

Answer 7

d This is correct, as any form of EMH does not coexist with technical analysis.

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Question 7

Which of these statements concerning technical analysis is CORRECT?

The focus of technical analysis is market timing with an emphasis on likely price changes.
Technicians tend to concentrate on the past price movements to forecast future price movements.
The focus of technical analysis is the process by which stock prices rapidly adjust to new information.
Technical analysis is based on the underlying fundamentals of a stock’s value.
A)
II and III
B)
III and IV
C)
I and II
D)
I, II, and IV

Answer 7

c The answer is I and II. Statements III and IV are not correct. Technicians tend to concentrate on the short run, looking for short-term price movements. The focus of technical analysis is the gradual process whereby stock prices adjust to new information. Fundamental analysis is based on the underlying fundamentals of a stock’s value. Technical analysis involves analyzing past stock prices to forecast future prices.

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Question 8

You are considering purchase of a stock that is currently selling for $23 and pays a dividend of $1.15 per share. The dividend is expected to grow at a rate of 15% per year for the next three years. After that, the dividend is expected to grow at a constant rate of 8%. Your required return is 13%. The maximum price you should pay for this stock is

A)
$33.62.
B)
$29.76.
C)
$30.22.
D)
$26.74.

Answer 8

b Explanation
The value is calculated on the HP 10bII+ by solving for the NPV of uneven cash flows as follows:

13

I/YR

0

CF0

1.3225

CF1

1.5209

CF2

1.7490 + 37.7784

CF3

29.7559

SHIFT, NPV

The 37.7784 is calculated from the constant growth DDM, starting at the end of the third year: [1.7490(1.08)] ÷ (0.13 – 0.08) = 37.7784

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Question 9

Which of these choices correctly illustrates the relationship between a bond’s price and various yields?

A)
For a premium bond: current yield > yield to maturity > coupon rate
B)
For a premium bond: coupon rate > yield to maturity > current yield
C)
For a discount bond: coupon rate < current yield < yield to maturity
D)
For a discount bond: yield to maturity > coupon rate > current yield

Answer 9

c The answer is for a discount bond: coupon rate < current yield < yield to maturity. When a bond trades at a discount, its yield to maturity will be greater than its current yield, which will be greater than its coupon rate.

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Question 10

VUL stock has a current market price of $25.65 and sales per share of $1.67. Calculate the price-to-sales ratio for this stock.

A)
22.77
B)
17.20
C)
15.36
D)
34.87

Answer 10

c The answer is 15.36.

The formula for the price-to-sales (P/S) ratio:

P/S = market price per share ÷ sales per share P/S = $25.65 ÷ $1.67 = 15.3592, or 15.36

This ratio would then be compared to its industry peers to determine whether the stock appears to be overvalued or undervalued.

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Question 10

All of these statements correctly describe the price-to-earnings divided by growth (PEG) ratio except

A)
PEG is calculated by dividing a firm’s P/E ratio by the firm’s expected growth rate of earnings.
B)
PEG is used to compare companies with different growth rates.
C)
PEG is an indication of how much an investor is paying for a specific revenue stream.
D)
companies with a lower PEG ratio have higher expected rates of return.

Answer 10

c The answer is PEG is an indication of how much an investor is paying for a specific revenue stream. Companies with a lower PEG ratio have a higher expected rate of return and vice versa. The PEG ratio is a measure of relative valuation that can be used to compare companies with different growth rates. Proponents of the PEG ratio believe that companies with a low PEG ratio will have higher rates of return. The price-to-sales ratio is an indication of how much an investor is paying for a specific revenue stream.

LO 4.3.2

Question 11

Assume that ABC stock pays a dividend in the current year of $1.56 per share. The company’s dividend is expected to grow by 1.5% per year. Calculate the stock’s price if an investor has a required rate of return of 7%.

A)
$20.54
B)
$14.29
C)
$28.79
D)
$28.36

Answer 11

c The answer is $28.79. The formula for the constant growth dividend discount model:

V = D1 ÷ (r – g)

Therefore, the intrinsic value of ABC stock equals $28.79 [(1.56 × 1.015) ÷ (0.07 – 0.015)].

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Question 12

DMM stock has a P/E ratio of 12 and is expected to have an expected growth rate of earnings of 6%. Based on this information, calculate the PEG ratio of DMM stock.

A)
7.2
B)
2
C)
5
D)
4

Answer 12

b The answer is 2. The PEG ratio is calculated by dividing a company’s P/E ratio by the firm’s expected growth rate of earnings: PEG = P/E ÷ g. Therefore, the PEG of DMM stock is 2 (12 ÷ 6). DMM’s ratio would then be compared to its peers to determine whether the stock is a good buy.

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Question 13

Assume a $1,000 par value bond with three years until maturity is currently trading for $1,027.23. The bond has a coupon rate of 6% (annual coupon payments) and a current YTM of 5%. The bond has a duration of 2.51 years. Calculate what the new market price for the bond would be if the YTM changed from 5% to 4.5%.

A)
$1,053.01
B)
$1,016.75
C)
$1,041.66
D)
$1,032.36

Answer 13

c The new price of the bond should be $1,041.23. Using a financial calculator, use the following inputs for semiannual payments:

FV = $1,000

PMT = $1,000 x 6% = $60/2 = $30

I/YR = 4.5%

N = 6 (3 x 2 periods per year)

Solve for PV = –1,041.6586, or $1,041.66

LO 4.1.1

Question 13

Lynn and Stuart Wagman are a middle-aged couple who would like to add an equity investment to their portfolio. They require a 12% rate of return and are considering the purchase of one of these common stocks:

Stock 1: Dividends currently are $1.50 annually and are expected to increase 8% annually; market price = $35.

Stock 2: Dividends currently are $2.25 annually and are expected to increase 7% annually; market price = $50.

Using the dividend growth model, determine which stock would be more appropriate for the Wagmans to purchase at this time.

A)
Stock 1, because the expected return on investment is greater than the Wagmans’ required return
B)
Stock 1, because its dividend growth rate is greater than Stock 2’s growth rate
C)
Stock 2, because the return on investment is greater than the Wagmans’ required return
D)
Stock 2, because the stock is undervalued

Answer 13

a The answer is Stock 1, because the expected return on investment is great than the Wagmans’ required return. Compute the intrinsic value and expected return first, then determine which stock should be purchased. The intrinsic value of Stock 1 is $40.50; of Stock 2, $48.15. The expected return on investment of Stock 1 is 12.6%; of Stock 2, 11.8%.

Stock 1 has a D0 of $1.50, thus D1 is ($1.50 x 1.08) or $1.62. Current market price is stated as $35 and the stated growth rate is 8%. ($1.62/$35) + .08 = 12.63% expected return for Stock 1.

Stock 2 has a D0 of $2.25, thus D1 is ($2.25 x 1.07) or $2.4075. Current market price is stated as $50 and the stated growth is 7%. ($2.4075/$50) + .07 =11.8% expected return for Stock 2.

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Question 14

Kinzie owns a stock that consistently pays a $.50 dividend. Assuming Kinzie’s required rate of return is 9.5%, calculate the intrinsic value of the stock.

A)
$10.00
B)
$5.76
C)
$4.75
D)
$5.26

Answer 14

d The answer is $5.26. Using the no-growth (perpetuity) dividend discount model:

V = D1 ÷ r = 0.50 ÷ 0.095 = 5.2632, or $5.26

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Question 14

Calculate the estimated change in the price of a bond with a present value of $987.56 and Macaulay duration of 4.8 years when its YTM changes from 7% to 6%.

A)
+4.53%
B)
–4.53%
C)
+4.49%
D)
–4.49

Answer 14

c The answer is +4.49%. Given the inverse relationship between bond prices and market interest rates, the price of the bond must increase by 4.49%, calculated as follows: ΔP/P = –4.8 × [(0.06 – 0.07) ÷ (1 + 0.07)] = 0.0449, or 4.49%.

LO 4.1.2

Question 14

ABC Technologies, Inc., a publicly-traded company, uses both equity and debt to finance its operations. The company’s stock is currently trading for $52.50 per share and has earnings of $1.50 per share. Calculate ABC’s price-to-earnings (P/E) ratio.

A)
25
B)
52
C)
35
D)
5

Answer 14

c The answer is 35. ABC Technologies, Inc. has a P/E ratio of 35 ($52.50 ÷ $1.50).

LO 4.3.2

Question 14

PQR stock has a current dividend of $1.75 that has been growing at a constant rate of 8% per year. If the stock is currently selling for $100 and your required rate of return is 10%, would you buy the stock at today’s price?

A)
Yes, because the stock is undervalued on the basis of the constant growth dividend discount model.
B)
Yes, because the stock is a good buy on the basis of its risk-return relationship.
C)
No, because the stock is not a good investment on the basis of its risk-return relationship.
D)
No, because the stock is overvalued on the basis of the constant growth dividend discount model.

Answer 14

d e answer is no, because the stock is overvalued on the basis of the constant growth dividend discount model. On the basis of the constant growth dividend discount model, the intrinsic value of XYZ stock is $94.50, calculated as follows: D0(1 + g) ÷ (r – g) = $1.75(1.08) ÷ (0.10 – 0.08) = $94.50. Because XYZ stock is currently selling for $100 per share, it is overvalued in the market and the investor should not buy the stock.

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Question 15

Which one of the following statements CORRECTLY matches a technical indicator to the information it provides in signaling a change from a bear to a bull market?

A)
Odd lot sales exceed purchases.
B)
A moving average chart indicates that actual prices have dropped through the average.
C)
Barron’s Confidence Index indicates that the yield differential between low-quality bonds and high-quality bonds is decreasing.
D)
Most financial advisers become bullish.

Answer 15

c In a bull market, there is less fear so there is a lower spread between high-quality and lower-quality bonds.

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Question 15

Debbie owns a five-year AAA rated municipal bond with a coupon rate of 3.50% (paid semiannually). If the comparable yield for this quality bond is currently 2.75%, what is the present value of her bond?

A)
$966.14
B)
$1,064.80
C)
$823.27
D)
$1,034.81

Answer 15

d The answer is $1,034.81. The present value of her bond is $1,034.81, calculated using the following inputs on a semiannual basis:

N = 10 (5 x 2 periods per year)

I/YR = 2.75%

PMT = $17.50 (3.50% × 1,000 ÷ 2)

FV = $1,000

Solve for PV = -1,034.81, or $1,034.81.

LO 4.1.1

Question 16

Lou owns a stock that consistently pays a $1.50 dividend. If his required rate of return is 8.5%, what is the intrinsic value of the stock?

A)
$16.39
B)
$17.65
C)
$12.75
D)
$13.73

Answer 16

b The answer is $17.65. Using the no-growth (perpetuity) dividend discount model:

V = D1 ÷ r = 1.50 ÷ 0.085 = $17.65

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Question 17

Kevin owns a $1,000 par value corporate bond with three years remaining until maturity. This bond is currently trading for $1,020.91. The bond has a coupon rate of 4.5% (annual coupon payments) and a current YTM of 3.75%. What is the duration of this bond?

A)
1.0067
B)
2.8741
C)
3.7500
D)
2.0910

Answer 17

b Determine the duration of the bond.

Year

Cash Flow(CF)

Present Value(PV) of CF

PV × Year

1

$45

$43.37

$43.37

2

$45

$41.81

$83.62

3

$1,045

$935.73

$2,807.19

$1,020.91

$2,934.18

Divide the sum in the last column ($2,934.18) by the total PV/market price of the bond ($1,020.91) to derive the duration of 2.8741 years. Using a financial calculator with the following inputs:

For year 1, FV = $45, I/YR = 3.75, N = 1, solve for PV. For year 2, change N to 2 without clearing your calculator and solve for PV. For year 3, FV = $1,045, I/YR = 3.75%, N = 3, solve for PV.

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Question 17

The technical analysis approach suggests that future stock prices are forecasted by

A)
past stock prices.
B)
fiscal policy.
C)
monetary policy.
D)
financial ratios.

Answer 17

a The answer is past stock prices. Past stock price movements are used by technicians to forecast future price movements.

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Question 18

The use of P/E ratios to select stocks suggests which of these?

A)
Low P/E ratio stocks are overvalued.
B)
High P/E stocks should be purchased.
C)
A stock should be purchased if it is selling near its historic low P/E.
D)
A stock should be purchased if it is selling near its historic high P/E.

Answer 18

c The answer is a stock should be purchased if it is selling near its historic low P/E. While purchasing stocks near their historically high P/E ratio could continue to represent value, a much better time would be to purchase stocks that are at their historic low ratios.

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Question 18

Marvin is considering adding XYZ stock to his holdings. The stock has these characteristics:

Beta 1.45
Standard deviation 15.58%
Current dividend $1.35
Required rate of return 8%
Risk-free rate of return 2%
The current dividend is expected to grow for three years at a rate of 2% and then 3% thereafter. Based on the information provided, calculate the intrinsic value of XYZ stock and determine if Marvin should add XYZ to his portfolio if it is currently trading at $24.50.

A)
With an intrinsic value of $22.90, the stock is overvalued and should not be added to the portfolio.
B)
With an intrinsic value of $21.60, the stock is overvalued and should not be added to the portfolio.
C)
With an intrinsic value of $29.60, the stock is undervalued and should be added to the portfolio.
D)
With an intrinsic value of $27.13, the stock is undervalued and should be added to the portfolio.

Answer 18

d Explanation
The answer is with an intrinsic value of $27.13, the stock is undervalued and should be added to the portfolio. The intrinsic value of the stock using the multistage growth dividend discount model is $27.13. Because the intrinsic value is greater than the fair market value, the stock is considered undervalued by the market and should be purchased for the portfolio.

Compute the value of each future dividend until the growth rate stabilizes (Years 1-3).

D1 = $1.35 × 1.02 = $1.38

D2 = $1.38 × 1.02 = $1.41

D3 = $1.41 × 1.02 = $1.44

Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes (Year 4).

D4 = $1.44 × 1.03 = $1.48

V = $1.48 ÷ (0.08 – 0.03) = $29.60

Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock.

CF0 = $0

CF1 = $1.38

CF2 = $1.41

CF3 = $1.44 + $29.60 = $31.04

I/YR = 8%

Solve for NPV = 27.1272, or $27.13

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Question 19

f all of these bonds are of similar credit risk, choose which will be the least sensitive to interest rate changes.

A)
8% coupon bond maturing in six years
B)
Zero-coupon bond maturing in eight years
C)
Zero-coupon bond maturing in six months
D)
3% coupon bond maturing in six years

Answer 19

c f all of these bonds are of similar credit risk, choose which will be the least sensitive to interest rate changes.

A)
8% coupon bond maturing in six years
B)
Zero-coupon bond maturing in eight years
C)
Zero-coupon bond maturing in six months
D)
3% coupon bond maturing in six years

Question 20

Kristy has a fixed-income portfolio that consists of three individual bonds.

FMV

Duration

Bond A

$5,000

5.0

Bond B

$3,000

8.0

Bond C

$2,000

12.0

What is the duration of Kristy’s portfolio?

A)
7.0
B)
8.3
C)
6.9
D)
7.3

Answer 20

d The weighted duration of Kristy’s portfolio is 7.3, calculated as follows:

FMV

Duration

Product

Bond A

$5,000

5.0

$25,000

Bond B

$3,000

8.0

$24,000

Bond C

$2,000

12.0

$24,000

Total

$10,000

$73,000

portfolio duration = $73,000 ÷ $10,000 = 7.3

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Question 20

All of these statements explain the attributes of technical analysis except

A)
technical analysts attempt to predict the future movement of stock prices based on past trends.
B)
technical analysts use terms such as “trendline,” “support,” and “resistance” in analyzing stocks.
C)
technical analysts rely heavily on financial ratios in their analysis of stocks.
D)
technical analysts rely on charts to predict the future prices of stocks.

Answer 20

c The answer is technical analysts rely heavily on financial ratios in their analysis of stocks. Analysts do not rely on financial ratios in their analysis of stocks. Instead, they rely on charts of past price history and volume to predict future price movements.

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Question 21

Which of these statements best describes the concept of bond duration?

A)
Duration assumes the price of a bond will stay constant because the market price of the underlying stock stays constant.
B)
Duration is used as an estimate of the change in the price of a bond given a negative one percentage point change in mortgage rates.
C)
Duration is the average weighted time it takes the bondholder to receive the interest and principal payments from a bond in present value dollars.
D)
Duration measures the extent to which two variables move together, either positively (together) or negatively (opposite).

Answer 21

c The answer is duration is the average weighted time it takes the bondholder to receive the interest and principal payments from a bond in present value dollars. Covariance measures the extent to which two variables move together, either positively (together) or negatively (opposite). Duration is a measure of the sensitivity of a bond’s price to changes in interest rates.

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Question 21

Juliet owns a PRT Inc. bond with a par value of $1,000. PRT is a AA rated bond maturing in seven years. Juliet receives $55 of interest income from PRT semiannually. Comparable debt, i.e., AA rated, seven-year maturity, yields 12%. The bond’s duration is five years.

Assume the Fed is concerned about inflation and increases the discount rate. As a consequence, market interest rates on seven-year AA rated bonds change from 12% to 13%. How will the price of Juliet’s bond change?

A)
The price will decrease by approximately 7%.
B)
The price will decrease by approximately 5%.
C)
The price will increase by approximately 5%.
D)
The price will increase by approximately 7%.

Answer 21

b When interest rates change by 1%, the approximate price change of a bond will be the bond’s duration multiplied by the rate change. The bond’s duration can be seven years only if it is a zero-coupon bond. No information in the facts states that it is a zero-coupon bond. The facts do state that the bond has a coupon. Therefore, its duration will be less than seven years. The only other indicated possibility is a five-year duration. So, a five-year duration multiplied by an interest rate change of 1% results in a price change of 5%. Because rates rose, the price of the bond must decrease.

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Question 22

The answer is 37.00. The firm’s P/FCF ratio is 37.00, calculated as follows: (1 + 0.11) ÷ (0.14 – 0.11) = 37.00. After calculating this ratio, an investor would compare the result with the stock’s peers to determine if a purchase is warranted.

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Answer 22

d The answer is 37.00. The firm’s P/FCF ratio is 37.00, calculated as follows: (1 + 0.11) ÷ (0.14 – 0.11) = 37.00. After calculating this ratio, an investor would compare the result with the stock’s peers to determine if a purchase is warranted.

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Question 22

Robin purchased a 20-year bond with a duration of 11 years for $1,323.18. Which of these statements is CORRECT?

A)
The coupon rate is lower than the YTM, and the current yield should be higher than the coupon rate.
B)
The current yield is higher than both the coupon rate and the yield to maturity.
C)
The yield to maturity (YTM) is less than both the current yield and the coupon rate.
D)
The coupon rate is higher than the yield to maturity, and the YTM is higher than the current yield.

Answer 22

c CR = coupon rate

CY = current yield

YTM = yield to maturity

Premium bonds: CR > CY > YTM

Par bonds: CR = CY = YTM

Discount bonds: CR < CY < YTM

Because the bond was purchased at a premium, the yield to maturity is less than both the current yield and the coupon rate.

LO 4.1.1

Question 23

LMN Company has assets of $250 million and $100 million in liabilities. For the past year the company earned $75 million, and paid out $10 million in dividends. What is the company’s return on equity (ROE)?

A)
50%
B)
30%
C)
40%
D)
25%

Answer 23

a The answer is 50%.

$250,000,000 – $100,000,000 = $150,000,000 in equity.

$75,000,000 profit ÷ $150,000,000 equity = 0.50, or 50% ROE.

LO 4.2.2

Question 24

MLM Corporation exhibits an expected growth in earnings of 11% for the next year. If an investor’s required rate of return is 14%, what is the firm’s price-to-free-cash-flow (P/FCF) ratio?

A)
7.93
B)
10.36
C)
37.00
D)
38.00

Answer 24

c The answer is 37.00. The firm’s P/FCF ratio is 37.00, calculated as follows: (1 + 0.11) ÷ (0.14 – 0.11) = 37.00. After calculating this ratio, an investor would compare the result with the stock’s peers to determine if a purchase is warranted.

LO 4.3.2

Question 24

The answer is 50%.

$250,000,000 – $100,000,000 = $150,000,000 in equity.

$75,000,000 profit ÷ $150,000,000 equity = 0.50, or 50% ROE.

LO 4.2.2

Answer 24

a The 39-week moving average is one technical indicator.

LO 4.2.1

Question 25

Amelia is considering buying shares of HSO stock valued at $50 per share. She forecasts the stock to trade in excess of $75 per share over the next three years. During this time, she expects to receive annual dividends of $4.50 per share. Given a 10% required rate of return, calculate the intrinsic value of the stock.

A)
$50.00
B)
$46.50
C)
$45.00
D)
$29.50

Answer 25

c The answer is $45.00. The intrinsic value of the stock is $45, using the perpetuity dividend discount model, calculated as follows: $4.50 ÷ 0.10 = $45.

LO 4.3.1

Question 26

When a company issues long-term debt securities instead of common stock, which one of these outcomes is the company most likely trying to achieve?

A)
To increase the company’s financial risk
B)
To increase the company’s return on equity
C)
To increase the company’s taxable income
D)
To increase the company’s fixed asset turnover rate

Answer 26

b The answer is to increase the company’s return on equity. When debt, instead of equity capital, is issued by a company, its shareholder’s equity portion of the balance sheet remains constant. If the additional capital raised increases net income, then return on equity will rise, and the company will see a positive effect from the issuance of debt. Leverage, properly employed, helps a company increase its return on equity.

LO 4.2.2

Question 26

All of the following statements correctly illustrate convexity and duration relationships except

A)
convexity has a direct relationship with the yield to maturity.
B)
convexity has an inverse relationship with the coupon rate.
C)
duration has an inverse relationship with the coupon rate.
D)
duration has an inverse relationship with the yield to maturity.

Answer 26

a The answer is convexity has a direct relationship with the yield to maturity. Convexity has an inverse relationship with yield to maturity. Convexity relationships are the same as those for duration.

LO 4.1.2

Question 27

If a $100 par value preferred stock pays an annual dividend of $5 and comparable yields are 10%, the price of the preferred stock will be

A)
$75.
B)
$100.
C)
$50.
D)
$25.

Answer 27

c $5 ÷ 0.10 = $50 for preferred stocks, the zero-growth model is used because the preferred stock’s dividend is fixed. The formula is V = D0/r, where D0 is the dividend and r is the required return.

LO 4.3.1

Question 27

Given a required rate of return of 8%, a growth rate of 4%, a beta of 1.25, and a standard deviation of 2.5%, calculate the price-to-free-cash flow for this particular investment.

A)
28.0
B)
16.6
C)
26.0
D)
20.8

Answer 27

c The answer is 26.0. The formula for price-to-free-cash flow:

P/FCF = (1 + G) ÷ (r – g) = (1 + 0.04) ÷ (0.08 – 0.04) = 1.04 ÷ 0.04 = 26.0

After calculating this ratio, an investor would compare this P/FCF to other investments to see whether a purchase is warranted.

LO 4.3.2

Question 28

Yvette is saving for her son’s college education. Her son is expected to start college in 8 years. Choose the bond portfolio that would most likely be immunized with respect to this goal.

A)
Weighted average time to maturity of bonds is 10 years with coupon of 0%.
B)
Weighted average time to maturity of bonds is 8 years with coupon of 3%.
C)
Weighted average time to maturity of bonds is 10 years with coupon of 5%.
D)
Weighted average time to maturity of bonds is 6 years with coupon of 8%.

Answer 28

c The answer is weighted average time to maturity of bonds is 10 years with coupon of 5%. To immunize the portfolio, the duration of the portfolio should match the investor’s time horizon. Coupon-paying bonds have durations that are less than their time to maturity. Zero-coupon bonds have durations equal to their time to maturity.

LO 4.1.2

Question 29

Caralla Foods produced before-tax earnings of $15 million last year. A large institutional investor has determined an appropriate capitalization for valuing this company is 8%. In addition, the risk-free rate of return is 5%. Based on this information, calculate the value of Caralla Foods using the discounted earnings model.

A)
Not enough information is provided.
B)
$300,000,000
C)
$187,500,000
D)
$500,000,000

Answer 29

c The answer is $187,500,000.

The formula for the discounted earnings model:

V = E ÷ RD = 15,000,000 ÷ 0.08 = 187,500,000

Using the discounted earnings method produces a current corporate valuation of $187,500,000.

LO 4.3.1

Question 29

All else remaining equal, if the dividend payout ratio decreases, the value of a company’s common stock would

A)
increase because the company’s dividend growth rate will increase.
B)
decrease because the company’s dividend growth rate will decrease.
C)
decrease because the company’s return on equity (ROE) will decrease.
D)
increase because the company’s risk premium will decrease.

Answer 29

a A decrease in the dividend payout ratio means that the earnings retention ratio (rr in the following formula) will increase. An increase in rr will cause an increase in g. When the higher g is inserted in the dividend discount model formula, the denominator decreases, thereby causing the value of the stock to increase.

g = ROE × rr

LO 4.2.2

Question 29

The answer is $187,500,000.

The formula for the discounted earnings model:

V = E ÷ RD = 15,000,000 ÷ 0.08 = 187,500,000

Using the discounted earnings method produces a current corporate valuation of $187,500,000.

LO 4.3.1

Answer 29

d The answer is $7.70. Calculate the intrinsic value of the stock using EPS and the P/E ratio, which is $7.70 ($3.50 × 2.2).

LO 4.3.1

Question 30

Which of the following are factors used in industry analysis for investment purposes?

Financial leverage
Government rules and regulations
Labor conditions
Technological advances
A)
II, III, and IV
B)
III and IV
C)
I and II
D)
I, II, and IV

Answer 30

Option I is not a factor used for industry analysis, but rather for company analysis.

LO 4.2.1

Question 30

Which of the following are NOT used in technical analysis?

A)
Graphs
B)
Financial statement ratios
C)
Moving averages
D)
Supply and demand of stocks

Answer 30

b Financial statement ratios are part of fundamental analysis.

LO 4.2.1

Question 30

Interest rate changes have the greatest effect on

A)
medium-term bonds.
B)
short-term bonds.
C)
staggered maturity bonds.
D)
long-term bonds.

Answer 30

d The rule-of-thumb approach to measuring the estimated price change of a bond is to multiply the bond’s duration by the estimated change in interest rates (for small rate changes—less than 1% or 100 basis points—only). Therefore, longer-term bonds have the greatest duration and the most price volatility.

LO 4.1.1

Question 31

All of the following statements correctly illustrate bond relationships except

A)
higher-rated bonds have more price volatility than lower rated bonds.
B)
bonds with longer durations are more affected by interest rate changes than bonds with shorter durations.
C)
everything else being equal, the larger the coupon, the shorter the duration.
D)
long-term bonds are more affected by interest rate changes than short-term bonds.

Answer 31

a Higher-rated bonds are less risky and are less volatile than lower rated bonds.

LO 4.1.2

Question 31

Springfield municipal bonds have 12 years remaining to maturity. The bonds pay interest semiannually at an annual coupon rate of 4.25%. The bonds have a yield to maturity of 5%. Calculate the current market price of these bonds.

A)
$933.53
B)
$932.93
C)
$961.53
D)
$1,039.35

Answer 31

b he answer is $932.93. The current market price of these bonds is $932.93, calculated using the following inputs on a semiannual basis:

FV = $1,000

PMT = 4.25% x 1000 ÷ 2 = $21.25

N = 24 (12 x 2 periods per year)

I/YR = 5%

Solve for PV = -932.9313, or $932.93

LO 4.1.1

Question 32

Jack is interested in purchasing LFM stock. LFM has an estimated free cash flow to equity (FCFE) for the next year of $2.75 per share, which is expected to grow at a constant rate of 3.5% per year. Jack’s required rate of return is 12%. Using the FCFE valuation model, calculate the intrinsic value of LFM stock.

A)
$32.35
B)
$33.48
C)
$23.71
D)
$81.32

Answer 32

a The answer is $32.35. Using the model V = FCFE1 ÷ (r – g), the intrinsic value of the stock is $32.35 [$2.75 ÷ (0.12 – 0.035)].

LO 4.3.1

Question 33

Tate is considering the purchase of a stock that just paid a dividend of $0.30 in the last quarter. That dividend has been steady for all of the past year. The company is expected to grow the dividend at 15% per year for the next three years, after which it is expected to grow at a constant rate of 8%. The required return is 11%. What is the maximum price Tate should pay for this stock? (Select the closest answer.)

A)
$12.98
B)
$45.14
C)
$51.91
D)
$11.30

Answer 33

c Explanation
Using the three-step approach, first determine the dividend at the end of each of the first three years.

The amount of $0.30 is a quarterly dividend and must be multiplied by 4 to get $1.20 for the current annual dividend. This amount is multiplied by 1.15 for each year in order to get:

Year

Dividend

1

1.38

2

1.587

3

1.8251

Next determine the value of the stock at the end of year 3 based on the dividend at the end of year 4:

[1.8251(1.08)] ÷ (0.11 – 0.08) = 65.70

Using the CFj keys on the calculator (with dividends rounded), solve as follows:

11

I/YR

0

CF0

1.38

CF1

1.59

CF2

1.83 + 65.70

CF3

51.91

SHIFT, NPV

LO 4.3.1

Question 33

Lawrence purchases a 20-year corporate bond with a coupon rate of 7.5% paid semiannually. Assuming the comparable yield for this type of bond is 9.5%, calculate the intrinsic value of his bond.

A)
$822.37
B)
$410.78
C)
$823.75
D)
$872.69

Answer 33

a The answer is $822.37. Intrinsic value is calculated using the following inputs on a semiannual basis:

N = 40 (20 x 2 periods per year)

I/YR = 9.5%

PMT = $37.50 (7.5% × 1,000 ÷ 2)

FV = $1,000

Solve for PV = 822.37 or $822.37.

LO 4.1.1

Question 33

Al, age 37, wants to add to his common stock portfolio. He wants long-term capital appreciation and requires a 14% rate of return on stock investments. He is considering the purchase of one of these two stocks:

Stock 1: Dividends are currently $1.20 annually and are expected to increase 10% annually; market price = $38
Stock 2: Dividends are currently $1.00 annually and are expected to increase 11% annually; market price = $30
Which stock would be most appropriate for Al to purchase at this time, and why?

A)
Stock 2, because the return on investment is greater than Al’s required rate of return
B)
Stock 2, because the stock is overvalued
C)
Stock 1, because the stock is undervalued
D)
Stock 1, because the return on investment is greater than Al’s required rate of return

Answer 33

a The answer is Stock 2, because the return on investment is greater than Al’s required rate of return. The intrinsic value of Stock 1 = $33 [($1.20 x 1.10) ÷ (0.14 - 0.10)]. Because $33 is less than $38, the stock is overvalued and would return less than his required return. The intrinsic value of Stock 2 = $36.67 [($1.00 x 1.11) ÷ (0.14 - 0.11)]. Because $36.67 is more than $30, the stock is undervalued and would return more than his required return.

LO 4.3.2

Question 33

Amber purchased a bond for $1,038.90 exactly two years ago. At that time, the bond had a maturity of five years and a coupon rate of 10% (paid semiannually). Assuming the rates below are the prevailing rates for this type of bond at different maturities, calculate the price that Amber could sell her bond for today.

Maturities 1 year 3 years 5 years 10 years 30 years
Interest rates 6% 7% 8.5% 10% 12%
A)
$1,038.31
B)
$1,060.08
C)
$1,079.93
D)
$1,078.73

Answer 33

c The answer is $1,079.93. Using the 3-year rate of 7% for the calculation on a semiannual basis:

FV = $1,000

I/YR = 7%

PMT = $50 (10% x 1000 = 100 ÷ 2)

N = 6 (3 x 2 periods per year)

PV = -1,079.9283, or $1,079.93

LO 4.1.1

Question 33

LJM Corporation has a bond issue with a coupon rate of 8% and seven years remaining until maturity. Assuming a par value of $1,000 and semiannual coupon payments, calculate the intrinsic value of the bond if current market conditions justify a 10% required rate of return.

A)
$1,033.32
B)
$901.01
C)
$920.81
D)
$941.58

Answer 33

The answer is $901.01. The intrinsic value of LJM’s bond is $901.01, calculated using the following inputs on a semiannual basis:

N = 14 (7 x 2 periods per year)

10% = I/YR

8% × $1,000 ÷ 2 = $40 = PMT

$1,000 = FV

Solve for PV = -901.01, or $901.01.

LO 4.1.1

Question 34

The answer is Stock 2, because the return on investment is greater than Al’s required rate of return. The intrinsic value of Stock 1 = $33 [($1.20 x 1.10) ÷ (0.14 - 0.10)]. Because $33 is less than $38, the stock is overvalued and would return less than his required return. The intrinsic value of Stock 2 = $36.67 [($1.00 x 1.11) ÷ (0.14 - 0.11)]. Because $36.67 is more than $30, the stock is undervalued and would return more than his required return.

LO 4.3.2

Answer 34

b The answer is sell low-duration bonds and buy longer duration bonds. Prices decline when interest rates rise. An investor expecting an increase in interest rates should sell more volatile bonds and purchase less volatile bonds. Bonds with large coupons and short durations are less price volatile than low-coupon, long-term, and long duration bonds.

LO 4.1.1