Fin 221 Fall 2006 Exam 3

Multiple Choice Identify the choice that best completes the statement or answers the question. 1) Ken Williams Ventures' recently issued bonds that mature in 15 years. They have a par value of $1,000 and an annual coupon of 6%. If the current market interest rate is 8%, at what price should the bonds sell? A. $801.80 B. $814.74 C. $828.81 D. $830.53 E. $847.86

2) Brown Enterprises' bonds currently sell for $1,025. They have a 9-year maturity, an annual coupon of $80, and a par value of $1,000. What is their yield to maturity? A. 6.87% B. 7.03% C. 7.21% D. 7.45% E. 7.61%

3) Kholdy Inc's bonds currently sell for $1,275. They pay a $120 annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,120. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between the bond's YTM and its YTC? A. 1.48% B. 1.54% C. 1.68% D. 1.82% E. 1.91%

4) A 20-year, $1,000 par value bond has a 9% annual coupon. The bond currently sells for $925. If the yield to maturity remains at its current rate, what will the price be 5 years from now? A. $933.09 B. $941.86 C. $951.87 D. $965.84 E. $978.40

5) Which of the following statements is CORRECT? A. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates.

B. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates. C. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. D. You hold a 10-year, zero coupon, bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline. E. You hold a 10-year, zero coupon, bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline.

6) Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? A. Market interest rates decline sharply. B. The company's bonds are downgraded. C. Market interest rates rise sharply. D. Inflation increases significantly. E. The company's financial situation deteriorates significantly.

7) Which of the following would be most likely to increase the coupon rate that is required to enable a bond to be issued at par? A. Adding a call provision. B. Adding additional restrictive covenants that limit management's actions. C. Adding a sinking fund. D. The rating agencies change the bond's rating from Baa to Aaa. E. Making the bond a first mortgage bond rather than a debenture.

8) A 12-year bond has an annual coupon rate of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? A. The bond is currently selling at a price below its par value. B. If market interest rates decline, the price of the bond will also decline. C. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. D. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. E. The bond should currently be selling at its par value.

9) Which of the following statements is CORRECT? A. All else equal, if a bond's yield to maturity increases, its price will fall. B. All else equal, if a bond's yield to maturity increases, its current yield will fall. C. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over par. D. If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par.

E. If a bond's required rate of return exceeds its coupon rate, the bond will sell at a premium.

10) A bond that matures in 12 years has a 9% semiannual coupon and a face value of $1,000. The bond has a nominal yield to maturity of 8%. What is the price of the bond today? A. $ 927.52 B. $ 928.39 C. $1,073.99 D. $1,075.36 E. $1,076.23

11) Niendorf Corporation's stock has a required return of 13.00%, the risk-free rate is 7.00%, and the market risk premium is 4.00%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 2.00%. What is Niendorf's new required return? A. 14.00% B. 15.00% C. 16.00% D. 17.00% E. 18.00%

12) Assume that you are the portfolio manager of the Delaware Fund, a $4 million mutual fund that contains the following stocks: Stock A B C D Amount $ 400,000 1.50 $ 600,000 0.50 $1,000,000 1.25 $2,000,000 0.75 Beta

The required rate of return in the market is 14.00% and the risk-free rate is 6.00%. What rate of return should investors expect (and require) on their investment in this fund? A. 10.90% B. 11.50% C. 12.10% D. 12.70% E. 13.30%

13) Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) A. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. B. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. C. If the market risk premium increases by 1%, then the required return will increase by 1%

for a stock that has a beta of 1.0. D. The effect of a change in the market risk premium depends on the level of the risk-free rate. E. The effect of a change in the market risk premium depends on the slope of the yield curve.

14) Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.) A. When held in isolation, Stock A has more risk than Stock B. B. Stock B would be a more desirable addition to a portfolio than Stock A. C. Stock A would be a more desirable addition to a portfolio than Stock B. D. In equilibrium, the expected return on Stock A will be greater than that on Stock B. E. In equilibrium, the expected return on Stock B will be greater than that on Stock A.

15) Which of the following statements best describes what would be expected to happen as you randomly select stocks and add them to your portfolio? A. Adding more such stocks will reduce the portfolio's unsystematic, or diversifiable, risk. B. Adding more such stocks will reduce the portfolio's beta. C. Adding more such stocks will increase the portfolio's expected return. D. Adding more such stocks will reduce the portfolio's market risk. E. Adding more such stocks will have no effect on the portfolio's risk.

16) Bob has a $50,000 stock portfolio with a beta of 1.2, an expected return of 10.8%, and a standard deviation of 25%. Becky has a $50,000 portfolio with a beta of 0.8, an expected return of 9.2%, and her standard deviation is also 25%. The correlation coefficient, r, between Bob's and Becky's portfolios is zero. Bob and Becky are engaged to be married. Which of the following best describes their combined $100,000 portfolio? A. The combined portfolio's expected return will be greater than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. B. The combined portfolio's expected return will be less than the simple weighted average of the expected returns of the two individual portfolios, 10.0%. C. The combined portfolio's beta will be equal to a simple average of the betas of the two individual portfolios, 1.0; its expected return will be equal to a simple weighted average of the expected returns of the two individual portfolios, 10.0%; and its standard deviation will be less than the simple average of the two portfolios' standard deviations, 25%. D. The combined portfolio's standard deviation will be equal to a simple average of the two portfolios' standard deviations, 25%. E. The combined portfolio's standard deviation will be greater than the simple average of the two portfolios' standard deviations, 25%.

17) The risk-free rate is 5%. Stock A has a beta = 1.0 and Stock B has a beta = 1.4. Stock A has a required return of 11%. What is Stock B's required return? A. 12.4% B. 13.4% C. 14.4%

D. 15.4% E. 16.4%

18) Ripken Iron Works faces the following probability distribution: State of the Economy Boom Normal Recession Stock's Expected Probability of Return if this State Occurring State Occurs 0.25 25% 0.50 15 0.25 5

What is the coefficient of variation on the company's stock? A. 0.06 B. 0.47 C. 0.54 D. 0.67 E. 0.71

19) A stock just paid a dividend of $1. The required rate of return is rs = 11%, and the constant growth rate is 5%. What is the current stock price? A. $15.00 B. $17.50 C. $20.00 D. $22.50 E. $25.00

20) The Lashgari Company is expected to pay a dividend of $1 per share at the end of the year, and that dividend is expected to grow at a constant rate of 5% per year in the future. The company's beta is 1.2, the market risk premium is 5%, and the risk-free rate is 3%. What is the company's current stock price? A. $15.00 B. $20.00 C. $25.00 D. $30.00 E. $35.00

21) You must estimate the intrinsic value of Gallovits Technologies' stock. Gallovits's end-of-year free cash flow (FCF) is expected to be $25 million, and it is expected to grow at a constant rate of 8.5% a year thereafter. The company's WACC is 11%. Gallovits has $200 million of long-term debt plus preferred stock, and there are 30 million shares of common stock outstanding. What is Gallovits' estimated intrinsic value per share of common stock? A. $22.67 B. $24.00

C. $25.33 D. $26.67 E. $28.00

22) The P. Born Company's last dividend was $1.50. The dividend growth rate is expected to be constant at 20% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If Born's required return (rs) is 13%, what is the company's current stock price? A. $25.16 B. $27.89 C. $28.26 D. $30.34 E. $32.28

23) If a stock's expected return exceeds its required return, this suggests that A. The stock is experiencing supernormal growth. B. The stock should be sold. C. The company is probably not trying to maximize price per share. D. The stock is probably a good buy. E. Dividends are not being declared.

24) Stock A has a beta of 1.1 and Stock B has a beta of 0.9. The market risk premium is 6%, and the risk-free rate is 6.3%. Both stocks have a constant dividend growth rate of 7% a year. If the market is in equilibrium, which of the following statements is CORRECT? A. Stock A must have a higher dividend yield than Stock B. B. Stock A must have a higher stock price than Stock B. C. Stock B's dividend yield equals its expected dividend growth rate. D. Stock B must have the higher required return. E. Stock B could have the higher expected return.

25) Cartwright Brothers' stock is currently selling for $40 a share. The stock is expected to pay a $2 dividend at the end of the year. The dividend growth rate is expected to be a constant 7% per year, forever. The risk-free rate and market risk premium are each 6%. What is the stock's beta? A. 1.06 B. 1.00 C. 2.00 D. 0.83 E. 1.08

Fin 221 Fall 2006 Exam 3 Answer Section

MULTIPLE CHOICE 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) 15) 16) 17) 18) 19) 20) 21) 22) 23) 24) 25) B C E C A D A A C A E C E C D A C B B B C D E D A

FIN3320 Exam Two; Chapters 5-8

1. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment? a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000. B. The discount rate increases. c. The riskiness of the investments cash flows decreases. d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years. e. The discount rate decreases.

2. Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?
a. The periodic rate of interest is 2% and the effective rate of interest is 4%. b. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%. c. The periodic rate of interest is 4% and the effective rate of interest is less than 8%. D. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%. e. The periodic rate of interest is 8% and the effective rate of interest is also 8%.

3. Which of the following investments would have the highest future value at the end of 10 years? Assume that the effective annual rate for all investments is the same and is greater than zero.
A. Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).

b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (just one payment). e. Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).

4. You deposit $1,000 today in a savings account that pays 3.5% interest, compounded annually. How much will your account be worth at the end of 25 years?
a. $2,245.08 B. $2,363.24 c. $2,481.41 d. $2,605.48 e. $2,735.75

5. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 3.05%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 5.15% b. 5.25% c. 5.35% d. 5.45% E. 5.55% r = r* + IP + DRP + LP + MRP r = 2.50% + 3.05% = 5.55% 6. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security,

assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 5.75% B. 5.85% c. 5.95% d. 6.05% e. 6.15% r = r* + IP + DRP + LP + MRP r = 3.50% + 2.25% + 0 + 0 + .10% = 5.85% 7. The real risk-free rate is 2.50%, inflation is expected to be 3.00% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? a. 4.975% b. 5.175% c. 5.375% D.5.575% e. 5.775%

(1 + r) = (1 + r*) ( 1+ IP) (1+r) = (1.025) (1.03) = 1.05575 - 1 = 5.575% <>8. Suppose the U.S. Treasury offers to sell you a bond for $3,000. No payments will be made until the bond matures 10 years from now, at which time it will be redeemed for $5,000. What interest rate would you earn if you bought this bond at the offer price?
a. 3.82% b. 4.25% c. 4.72% D.5.24%

e. 5.77%

n = 10 i= ? PV = -3000 PMT = 0 FV = 5000 Solve for "i" which will be 5.2410 %

9. Keys Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Keys' bonds is DRP = 0.40%, the liquidity premium on Keys' bonds is LP = 1.70% versus zero on T-bonds, inflation premium (IP) is 1.5%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*? a. 2.10% b. 2.20% c. 2.30% d. 2.40% E. . 2.50%

Simply subtract the IP of 1.50% and the MRP of .40% from the Tbond yield of 4.40% to arrive at 2.50%

10. The Carter Company's bonds mature in 10 years have a par value of $1,000 and an annual coupon payment of $80. The market interest rate for the bonds is 9%. What is the price of these bonds?
A. $935.82 b. $941.51 c. $958.15 d. $964.41 e. $979.53

n = 10 i= 9 PV = ? = $935.82

PMT = 80 FV = 1000 11. Brown Enterprises bonds currently sell for $1,025. They have a 9-year maturity, an annual coupon of $80, and a par value of $1,000. What is their yield to maturity?
a. 6.87% b. 7.03% c. 7.21% d. 7.45% E.7.61% n i = PV PMT FV = 1000 = ? = = = 7.6063% -1025 80 9

12. Highfield Inc's bonds currently sell for $1,275 and have a par value of $1,000. They pay a $120 annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,120. What is their yield to call (YTC)?
a. 7.00% b. 7.13% c. 7.28% D.7.31% e. 7.42% n i PV PMT FV = 1120 = = ? = = = 5 7.3109% -1275 120

13. Moussawi Ltd's outstanding bonds have a $1,000 par value, and they mature in 5 years. Their yield to maturity is 9%, based on semiannual compounding, and the

current market price is $853.61. What is the bond's annual coupon interest rate?
a. 5.10% b. 5.20% C. 5.30% d. 5.40% e. 5.50% n i PV PMT FV = 1000 = = = = ? = 10 4.5 -853.61 $26.4994

Annual Rate = 26.4994/1000 = 2.64994% times 2 = 5.2999%

14.

14.

Which of the following statements is CORRECT? a. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates. b. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates. c. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. D.You hold a 10-year, zero coupon, bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the larger percentage decline. e. You hold a 10-year, zero coupon, bond and a 10-year bond that has a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline.

15. Which of the following would be most likely to increase the coupon rate that is required to enable a bond to be issued at par? A. Adding a call provision. b. Adding additional restrictive covenants that limit management's actions. c. Adding a sinking fund.

d. The rating agencies change the bond's rating from Baa to Aaa. e. Making the bond a first mortgage bond rather than a debenture.

16. A 12-year bond has an annual coupon rate of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
a. The bond is currently selling at a price below its par value. b. If market interest rates decline, the price of the bond will also decline. C. If market interest rates remain unchanged, the bonds price one year from now will be lower than it is today. d. If market interest rates remain unchanged, the bonds price one year from now will be higher than it is today. e. The bond should currently be selling at its par value.

17. What annual payment must you receive in order to earn a 6.5% rate of return on a perpetuity that has a cost of $1,250?
a. $77.19 B. $81.25 c. $85.31 d. $89.58 e. $94.06

1250 * .065 = $81.25

18. You sold a car and accepted a note with the following cash flow stream as your payment. What was the effective price you received for the car assuming an interest rate of 6.0%?

Years: | CFs: |

0 | $0

4 | |

$1,000

$2,000

$2,000

$2,000

A. $5,987 b. $6,286 c. $6,600 d. $6,930

e. $7,277 Put in CF registers with a rate of 6% and find the PV 19. Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.)
a. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. b. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

C. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.
d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. The effect of a change in the market risk premium depends on the slope of the yield curve.

20. In the next year, the market risk premium, (r M - rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. The required return for all stocks will fall by the same amount. B. The required return will fall for all stocks, but it will fall more for stocks with higher betas. c. The required return will fall for all stocks, but it will fall less for stocks with higher betas. d. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.

e. The required return on all stocks will remain unchanged.

21. You have the following data on three stocks:

Stock A B C Standard Deviation 20% 10% 12% 0.59 0.61 1.29 Beta

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A. b. A; B. C. B; A. d. C; A. e. C; B.

22. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
a. When held in isolation, Stock A has more risk than Stock B. b. Stock B must be a more desirable addition to a portfolio than A. c. Stock A must be a more desirable addition to a portfolio than B. D. The expected return on Stock A should be greater than that on B. e. The expected return on Stock B should be greater than that on A.

23. Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is the firm's required rate of return?
a. 11.36% b. 11.65% C. 11.95% d. 12.25%

e. 12.55%

Rate of Return = Risk Free + Beta (Market Risk Premium) Return = 4.25% + 1.4 (5.50%) = 11.95%

24. 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% Risk Premium is 11% minus 4.25% = 6.75% Feed into the CAPM and you can find the returns of 8.975% for A and 12.35% for B

25. Mulherin's stock has a beta of 1.23, its required return is 11.75%, and the riskfree rate is 4.30%. What is the required rate of return on the market? (Hint: First find the market risk premium.)
A. 10.36% b. 10.62% c. 10.88% d. 11.15% e. 11.43% 11.75% = 4.30% + 1.23( Market Risk Premium) Market Risk Premium = (11.75% - 4.30%) divided by 1.23 = 6.06% Return on Market = Market Risk Premium + Risk Free = 6.06% + 4.30% = 10.36%