(6-2) Interest rate levels C H Answer: b MEDIUM

1. Which of the following factors would be most likely to lead to an

increase in nominal interest rates?

a. Households reduce their consumption and increase their savings.

b. A new technology like the Internet has just been introduced, and it
increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. The Federal Reserve decides to try to stimulate the economy.

(6-3) Interest rates C H Answer: b EASY

2. The real risk-free rate is 3.05%, inflation is expected to be 2.75% this
year, and the maturity risk premium is zero. Ignoring any cross-product
terms, what is the equilibrium rate of return on a 1-year Treasury bond?

a. 5.51%
b. 5.80%
c. 6.09%
d. 6.39%
e. 6.71%
(6-5) Maturity risk premium C H Answer: c MEDIUM
3. Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%.
The real risk-free rate is r* = 2.5%, the default risk premium for
Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is
LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is
1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?

a. 0.73%
b. 0.81%
c. 0.90%
d. 0.99%
e. 1.09%

(6-5) Real risk-free rate C H Answer: e MEDIUM

4. Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same
maturity yield 4.40%. The default risk premium for Kop's bonds is DRP =
0.40%, the liquidity premium on Kop's bonds is LP = 1.70% versus zero on
T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk
premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free
rate, r*?

a. 2.04%
b. 2.14%
c. 2.26%
d. 2.38%
e. 2.50%
(7-2) Bond coupon rate C G Answer: b MEDIUM
5. Under normal conditions, which of the following would be most likely to
increase the coupon rate required for a bond to be issued at par?

a. Adding additional restrictive covenants that limit management's

actions.
b. Adding a call provision.
 c. The rating agencies change the bond's rating from Baa to Aaa.
d. Making the bond a first mortgage bond rather than a debenture.
e. Adding a sinking fund.
(Comp.) Bond rates and prices C G Answer: e MEDIUM
6. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon.
Both bonds have the same maturity, a face value of $1,000, an 8% yield
to maturity, and are noncallable. Which of the following statements is
CORRECT?

a. Bond A’s capital gains yield is greater than Bond B’s capital gains
yield.
b. Bond A trades at a discount, whereas Bond B trades at a premium.
c. If the yield to maturity for both bonds remains at 8%, Bond A’s price
one year from now will be higher than it is today, but Bond B’s price
one year from now will be lower than it is today.
d. If the yield to maturity for both bonds immediately decreases to 6%,
Bond A’s bond will have a larger percentage increase in value.
e. Bond A’s current yield is greater than that of Bond B.
7-3) Bond valuation: annual C G Answer: d EASY
7. Ryngaert Inc. recently issued noncallable bonds that mature in 15 years.
They have a par value of $1,000 and an annual coupon of 5.7%. If the
current market interest rate is 7.0%, at what price should the bonds
sell?

a. $817.12
b. $838.07
c. $859.56
d. $881.60
e. $903.64

(7-4) Yield to maturity C G Answer: e EASY

8. Adams Enterprises’ noncallable bonds currently sell for $1,120. They
have a 15-year maturity, an annual coupon of $85, and a par value of
$1,000. What is their yield to maturity?

a. 5.84%
b. 6.15%
c. 6.47%
d. 6.81%
e. 7.17%
7-6) Bond valuation: semiannual C G Answer: c MEDIUM
9. Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual
coupon, and a par value of $1,000. The going interest rate (rd) is
6.20%, based on semiannual compounding. What is the bond’s price?

a. $1,047.19
b. $1,074.05
c. $1,101.58
d. $1,129.12
e. $1,157.35
(7-4) Yield to call C G Answer: d EASY
10. Sadik Inc.'s bonds currently sell for $1,180 and have a par value of
$1,000. They pay a $105 annual coupon and have a 15-year maturity, but
they can be called in 5 years at $1,100. What is their yield to call
 (YTC)?

a. 6.63%
b. 6.98%
c. 7.35%
d. 7.74%
e. 8.12%

(Comp.) Bond concepts C G Answer: d MEDIUM

11. Bonds A, B, and C all have a maturity of 10 years and a yield to
maturity of 7%. Bond A’s price exceeds its par value, Bond B’s price
equals its par value, and Bond C’s price is less than its par value.
None of the bonds can be called. Which of the following statements is
CORRECT?

a. If the yield to maturity on each bond decreases to 6%, Bond A will

have the largest percentage increase in its price.
b. Bond A has the most interest rate risk.
c. If the yield to maturity on the three bonds remains constant, the
prices of the three bonds will remain the same over the next year.
d. If the yield to maturity on each bond increases to 8%, the prices of
all three bonds will decline.
e. Bond C sells at a premium over its par value.
Comp.) Bond concepts C G Answer: b MEDIUM
12. An investor is considering buying one of two 10-year, $1,000 face value,
noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9%
annual coupon. Both bonds have a yield to maturity of 8%, and the YTM
is expected to remain constant for the next 10 years. Which of the
following statements is CORRECT?

a. Bond B has a higher price than Bond A today, but one year from now
the bonds will have the same price.
b. One year from now, Bond A’s price will be higher than it is today.
c. Bond A’s current yield is greater than 8%.
d. Bond A has a higher price than Bond B today, but one year from now
the bonds will have the same price.
e. Both bonds have the same price today, and the price of each bond is
expected to remain constant until the bonds mature.
(8-3) Portfolio beta C N Answer: e EASY
13. Bill Dukes has $100,000 invested in a 2-stock portfolio. $35,000 is
invested in Stock X and the remainder is invested in Stock Y. X's beta
is 1.50 and Y’s beta is 0.70. What is the portfolio's beta?

a. 0.65
b. 0.72
c. 0.80
d. 0.89
e. 0.98

(8-3) Portfolio beta C N Answer: a EASY

14. Tom O'Brien has a 2-stock portfolio with a total value of $100,000.
$37,500 is invested in Stock A with a beta of 0.75 and the remainder is
invested in Stock B with a beta of 1.42. What is his portfolio’s beta?

a. 1.17
 b. 1.23
c. 1.29
d. 1.35
e. 1.42
(8-4) Market risk premium C N Answer: a EASY
15. Porter Inc's stock has an expected return of 12.25%, a beta of 1.25, and
is in equilibrium. If the risk-free rate is 5.00%, what is the market
risk premium?

a. 5.80%
b. 5.95%
c. 6.09%
d. 6.25%
e. 6.40%

(8-4) CAPM: req. rate of return C N Answer: e MEDIUM

16. Company A has a beta of 0.70, while Company B's beta is 1.20. The
required return on the stock market is 11.00%, and the risk-free rate is
4.25%. What is the difference between A's and B's required rates of
return? (Hint: First find the market risk premium, then find the
required returns on the stocks.)

a. 2.75%
b. 2.89%
c. 3.05%
d. 3.21%
e. 3.38%
8-2) Std. dev., prob. data C N Answer: b HARD
17. Carson Inc.'s manager believes that economic conditions during the next
year will be strong, normal, or weak, and she thinks that the firm's
returns will have the probability distribution shown below. What's the
standard deviation of the estimated returns?

Economic
Conditions Prob. Return
Strong 30% 32.0%
Normal 40% 10.0%
Weak 30% -16.0%

a. 17.69%
b. 18.62%
c. 19.55%
d. 20.52%
e. 21.55%
(8-4) SML C N Answer: a MEDIUM
18. Other things held constant, if the expected inflation rate decreases and
investors also become more risk averse, the Security Market Line would
be affected as follows:

a. The y-axis intercept would decline, and the slope would increase.
b. The x-axis intercept would decline, and the slope would increase.
c. The y-axis intercept would increase, and the slope would decline.
d. The SML would be affected only if betas changed.
 e. Both the y-axis intercept and the slope would increase, leading to
higher required returns.

(8-4) SML C N Answer: e MEDIUM

19. Assume that the risk-free rate remains constant, but the market risk
premium declines. Which of the following is most likely to occur?

a. The required return on a stock with beta = 1.0 will not change.
b. The required return on a stock with beta > 1.0 will increase.
c. The return on "the market" will remain constant.
d. The return on "the market" will increase.
e. The required return on a stock with beta < 1.0 will decline.

(8-4) CAPM and required return C N Answer: b MEDIUM

20. Stock HB has a beta of 1.5 and Stock LB has a beta of 0.5. The market
is in equilibrium, with required returns equaling expected returns.
Which of the following statements is CORRECT?

a. If expected inflation remains constant but the market risk premium

(rM − rRF) declines, the required return of Stock LB will decline but
the required return of Stock HB will increase.
b. If both expected inflation and the market risk premium (rM − rRF)
increase, the required return on Stock HB will increase by more than
that on Stock LB.
c. If both expected inflation and the market risk premium (rM − rRF)
increase, the required returns of both stocks will increase by the
same amount.
d. Since the market is in equilibrium, the required returns of the two
stocks should be the same.
e. If expected inflation remains constant but the market risk premium
(rM − rRF) declines, the required return of Stock HB will decline but the
required return of Stock LB will increase.
(8-4) Risk & ret. relationships C N Answer: c MEDIUM
21. Over the past 75 years, we have observed that investments with the
highest average annual returns also tend to have the highest standard
deviations of annual returns. This observation supports the notion that
there is a positive correlation between risk and return. Which of the
following answers correctly ranks investments from highest to lowest
risk (and return), where the security with the highest risk is shown
first, the one with the lowest risk last?

a. Small-company stocks, long-term corporate bonds, large-company

stocks, long-term government bonds, U.S. Treasury bills.
b. Large-company stocks, small-company stocks, long-term corporate
bonds, U.S. Treasury bills, long-term government bonds.
c. Small-company stocks, large-company stocks, long-term corporate
bonds, long-term government bonds, U.S. Treasury bills.
d. U.S. Treasury bills, long-term government bonds, long-term corporate
bonds, small-company stocks, large-company stocks.
e. Large-company stocks, small-company stocks, long-term corporate
bonds, long-term government bonds, U.S. Treasury bills.
(8-3) Portfolio risk and return C N Answer: b MEDIUM
22. Stocks A and B each have an expected return of 15%, a standard deviation
of 20%, and a beta of 1.2. The returns on the two stocks have a
correlation coefficient of +0.6. You have a portfolio that consists of
 50% A and 50% B. Which of the following statements is CORRECT?

a. The portfolio's beta is less than 1.2.

b. The portfolio's expected return is 15%.
c. The portfolio's standard deviation is greater than 20%.
d. The portfolio's beta is greater than 1.2.
e. The portfolio's standard deviation is 20%.
(8-3) Portfolio risk and return C N Answer: c MEDIUM
23. Your portfolio consists of $50,000 invested in Stock X and $50,000
invested in Stock Y. Both stocks have an expected return of 15%, betas
of 1.6, and standard deviations of 30%. The returns of the two stocks
are independent, so the correlation coefficient between them, rXY, is
zero. Which of the following statements best describes the
characteristics of your 2-stock portfolio?

a. Your portfolio has a standard deviation of 30%, and its expected

return is 15%.
b. Your portfolio has a standard deviation less than 30%, and its beta
is greater than 1.6.
c. Your portfolio has a beta equal to 1.6, and its expected return is
15%.
d. Your portfolio has a beta greater than 1.6, and its expected return
is greater than 15%.
e. Your portfolio has a standard deviation greater than 30% and a beta
equal to 1.6.

(9-5) Required return C G Answer: e MEDIUM

24. Stocks A and B have the following data. Assuming the stock market is
efficient and the stocks are in equilibrium, which of the following
statements is CORRECT?

A B
Price $25 $40
Expected growth 7% 9%
Expected return 10% 12%

a. The two stocks should have the same expected dividend.

b. The two stocks could not be in equilibrium with the numbers given in
the question.
c. A's expected dividend is $0.50.
d. B's expected dividend is $0.75.
e. A's expected dividend is $0.75 and B's expected dividend is $1.20.
(9-5) Declining constant growth stk. C G Answer: e MEDIUM
25. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 =
$2.00. The dividend is expected to decline at a rate of 5% a year
forever (g = -5%). If the company is in equilibrium and its expected
and required rate of return is 15%, which of the following statements is
CORRECT?

a. The company’s current stock price is $20.

b. The company’s dividend yield 5 years from now is expected to be 10%.
c. The constant growth model cannot be used because the growth rate is
negative.
d. The company’s expected capital gains yield is 5%.
 e. The company’s expected stock price at the beginning of next year is
$9.50.
(9-7) Corporate valuation model C G Answer: b MEDIUM
26. Which of the following statements is NOT CORRECT?

a. The corporate valuation model can be used both for companies that pay
dividends and those that do not pay dividends.
b. The corporate valuation model discounts free cash flows by the
required return on equity.
c. The corporate valuation model can be used to find the value of a
division.
d. An important step in applying the corporate valuation model is
forecasting the firm's pro forma financial statements.
e. Free cash flows are assumed to grow at a constant rate beyond a
specified date in order to find the horizon, or terminal, value.

(9-7) Corporate valuation model C G Answer: e MEDIUM

27. Gupta Corporation is undergoing a restructuring, and its free cash flows
are expected to vary considerably during the next few years. However,
the FCF is expected to be $65.00 million in Year 5, and the FCF growth
rate is expected to be a constant 6.5% beyond that point. The weighted
average cost of capital is 12.0%. What is the horizon (or terminal)
value (in millions) at t = 5?

a. $1,025
b. $1,079
c. $1,136
d. $1,196
e. $1,259

(9-7) Corporate valuation model C G Answer: a MEDIUM

28. Misra Inc. forecasts a free cash flow of $35 million in Year 3, i.e., at
t = 3, and it expects FCF to grow at a constant rate of 5.5% thereafter.
If the weighted average cost of capital (WACC) is 10.0% and the cost of
equity is 15.0%, what is the horizon, or terminal, value in millions at
t = 3?

a. $821
b. $862
c. $905
d. $950
e. $997
(9-8) Preferred required return C G Answer: e MEDIUM
29. Rebello's preferred stock pays a dividend of $1.00 per quarter, and it
sells for $55.00 per share. What is its effective annual (not nominal)
rate of return?

a. 6.62%
b. 6.82%
c. 7.03%
d. 7.25%
e. 7.47%
(9-5) Constant growth dividend C G Answer: b MEDIUM
30. Goode Inc.'s stock has a required rate of return of 11.50%, and it sells
 for $25.00 per share. Goode's dividend is expected to grow at a
constant rate of 7.00%. What was the last dividend, D0?

a. $0.95
b. $1.05
c. $1.16
d. $1.27
e. $1.40
(9-5) Expected total return C G Answer: e EASY
30. If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is
the stock’s expected total return for the coming year?

a. 8.37%
b. 8.59%
c. 8.81%
d. 9.03%
e. 9.27%
(9-5) Constant growth: future price C G Answer: e EASY
31. Whited Inc.'s stock currently sells for $35.25 per share. The dividend
is projected to increase at a constant rate of 4.75% per year. The
required rate of return on the stock, rs, is 11.50%. What is the
stock's expected price 5 years from now?

a. $40.17
b. $41.20
c. $42.26
d. $43.34
e. $44.46

Answer: B Type: Medium Page: 65

32. Casino Inc. is expected to pay a dividend of $6 per share at the end of
year one and these dividends are expected to grow at a constant rate of 6% per
year forever. If the required rate of return on the stock is 18%, what is
current value of the stock today?
A) $30
B) $50
C) $100
D) $54

Answer: B Type: Difficult Page: 67

33. Dividend growth rate for a stable firm can be estimated as:
A) Plow back rate / the return on equity (ROE)
B) Plow back rate * the return on equity (ROE)
C) Plow back rate + the return on equity (ROE)
D) Plow back rate - the return on equity (ROE)

Answer: B Type: Difficult Page: 60

34. A four-year bond has an 8% coupon rate and a face value of $1000.
If the current price of the bond is $878.31, calculate the yield to
maturity of the bond (assuming annual interest payments).
A) 8%
B) 12%
C) 10%
D) 6%
Answer: D Type: Easy Page: 62
35. Super Computer Company's stock is selling for $100 per share
today. It is expected that this stock will pay a dividend of 5
dollars per share, and then be sold for $120 per share at the end of
one year. Calculate the expected rate of return for the shareholders.
A) 20%
B) 15%
C) 10%
D) 25%