FIN432_Spr11_Review Questions for Final Exam

8/9/2019 FIN432_Spr11_Review Questions for Final Exam

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FIN432 Investments

Final exam preparatory questions and answers to end of the slides questions

Chapter 11

1. According to the Value of ROE criteria:

If VRE ≤1, the stock may be worthy of inestment attention and !ossible

!urchase.

If " ≤ VRE ≤ #, the stock is a!t to re!resent an e$traordinarily attractie

inestment o!!ortunity.

If VRE ≤ #, the stock is definitely worthy of inestment attention and mayre!resent a ery attractie inestment.

% none of these.

". Attractie alue stocks feature:

ra!id historical E&' growth.ra!id e$!ected E&' growth.aboe aerage &(E ratios.

% below aerage &() ratios.

#. *RO+ has a current !rice of ", an e$!ected diidend !er share of -./, E&' of-1. this year, e$!ected E&' growth of 10 !er year, and a ty!ical &(E ratio of ".According to the iscounted iidend Value 2odel, what is the e$!ected !rice for*RO+ in fie years3

-"/.1-#-."4

% -/.#5

Solution: "6-1.61.1 7 -/.#5

5. 8igh &(E ratios are ty!ically associated with stocks that dis!lay:

below9aerage risk.% below9aerage diidend !ayout ratios.

below9aerage historical returns. below9aerage historical E&' growth.

. Value inesting always inoles:


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a focusing only on securities considered to be tem!orarily oeralued or !o!ularfor arious reasons.

b seeking bargains described in terms of a market !rice that is below theeconomic alue of assets in !lace.

c focusing on com!anies e$!ected to hae aboe9aerage rates of growth inearnings and diidends.% d finding bargains selling at !rices below their actual economic alue.

/. According to ;raham < odd, intrinsic aluea. cannot be =ustified by assets, earnings, diidends, sure !ros!ects, and

management. b. can be =ustified by diidends and e$!ected ca!ital gains.c. and current market !rice ty!ically coincide.

% d. and current market !rice rarely coincide gien inestor !essimism and eu!horia.

>. *he Value of ROE criteria:

is inconsistent with the ?growth at a reasonable !rice@ conce!t.% can be biased u!ward in the case of firms with little book alue !er share. tends to be biased in faor of high &(E stocks.

none of these.

4. Reersion regression to the mean theory argues that the !otential of high !rofit9margin firms is am!lified by:

entry.imitation.e$it.

% none of these

B. IC*D has a current !rice of 14, an e$!ected diidend !er share of -., ande$!ected diidend growth of 0 !er year. According to the iscounted iidendValue 2odel, IC*D is underalued if inestors hae a risk9ad=usted reuired returnof:

B.>40% 4.010

% F >.40.

Solution: 14 7 . ( k 9 ., soling for k 7 .>>4

1. Reersion to the mean theory !redicts lower e$!ected returns for stocks with lowa. !rice(book ratios. b. !rice(sales ratios.


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c. historical returns.> d. earnings/price ratios.

11. )en=amin ;raham thought that the stock market crash of 1B"B was due toa. stock mani!ulation by the e$changes and inestment firms.

b. margin borrowing for stock !urchases.c. e$cessie o!timism.% d. all the aboe.

12.A Warren Buffett lesson is

a. It is far better to buy a fair com!any at a wonderful !rice than a wonderfulcom!any at a fair !rice.

% b. 2anagement does better by aoiding dragons, not slaying them.c. As if goerned by CewtonGs first law of motion, an institution will agree to any

change in its current direction.d. +hen a management with a re!utation for brilliance tackles a business with a

re!utation for bad economics, it is the re!utation of the manager that remainsintact.

1#. 'u!!ose that 2icrosoft stock is currently trading at -"".. *his yearHs diidend !er share is -.". If the e$!ected growth rate is /0, what is the reuired rate of return3

a /.B"0% b 4.50 c B.>0 d 11."#0

'olution: ( ) ( ) 45.,/./.1".-.""1 =

−

+×==

−

+= k

k g k g D P

15. If )oeing Dom!any Inc. has a &(E ratio of 4 which is e$!ected to increase to 1 in years. *he current E&' is -.> and e$!ected to grow at a rate of 0 for the same !eriod.+hat is the estimated stock !rice in years3

a -1.>> b -/.B" c -/1.>1 d -"1".B5

'olution: ( ( ) ( ) >1./5-,.1>.,-11 ,

=××=+××= n

nn g E E

P P

1 If a com!any has a &(E ratio of 15, reuired rate of return of 1"0 and diidend yieldof #.0, what is the rate of growth due to ca!ital a!!reciation3

a 1.0


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% b 4.0 c >.0 d ".0

'olution:0.4

,#.1".,

1

=

+=+=

g

g g

P

Dk

Chapter 12

1/ 'u!erior !rofits can be made by inesting in com!anies:

that are fortunate but not able.that hae good !otential to unseat industry leaders.

% with ca!able management.

actie in a broad array of growth industries.

1> According to *. Rowe &rice,growth stocks en=oy attractie economic characteristicssuch as:

synergistic mergers.ra!id growth in market demand.

% lack cutthroat com!etition.ra!id reenue growth.

Assume E&' 7 -1, & 7 -1 and &() 7 #.

14 A retention rate of /0 im!lies sustainable growth of:

/.>0.% 1"0.

50./0.

Solution: 'ustainable growth 7 Retention 6 ROE 7 ./ 6 1 # 7 .1"

1B +hich among the following statements is true3

a. '


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" According to the &E; ratio rule9of9thumb, if &E; < 1, then a stock

% a. may be worthy of inestment attention and !ossible !urchase. b. is definitely worthy of inestment attention, and may re!resent a ery attractie inestment.

c. is a!t to re!resent an e$traordinarily attractie inestment o!!ortunity.

d. none of these.

"1 A fast growing com!any !aid a diidend this year of -1.", which is e$!ected togrow at "0 for two years. Afterwards, the growth rate will be B0. If the reuiredis 1"0, what is the alue of this stock3a. -51./>

b. -1./"

c. -/.5% d. -5.B1

Solution: 1 7 -1."61." 7 -1., "7 -1.61." 7 -1.4, # 7

-1."61.""

61.B 7 -1.B/", then !rice in year " will be 1.B/"(.1"9.B7 -/.5, so &V 7 1.(1.1" J 1.4J/.5(1.1"" 7 -5.B1

"". According to *. Rowe &rice, growth !ros!ects suffer if com!aniesa. en=oy careful goernment regulation. b. hae well9!aid em!loyees.

% c. use high leels of debt.d. lack cutthroat com!etition.

"#. *he constant growth rate model is not useful from growth stocks because they tend toa. hae an unknown reuired rate of return.

% b. hae ariable growth.

c. hae more financial leerage.d. hae a constant diidend.

"5. 2aking the assum!tion that firms which grow fast in the !ast will continue to growfast in the future reflects thea. internally sustained growth rate. b. regression to the mean.

% c. re!resentatieness bias.d. growth constant.

" *he re!resentatieness bias often causes inestors toa. buy alue stocks.

% b. buy high and sell low.c. buy !oorly managed firms.d. e$tra!olate our wishes into the future.

26) Financial analysts who make their recommendations known only to their portfolio

manager

% a. are called buy9side analysts. b. work for inestment banks.


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c. are called sell9side analysts.d. are more o!timistic than other analysts.

27) Financial analysts who make their recommendations known to the public

a. are called buy9side analysts.

b. work for mutual funds.% c. are called sell9side analysts.d. are less o!timistic than other analysts.

"4 'u!!ose a com!any is e$!ected to grow at "0 for the ne$t two years and then willhae a constant growth of 40. *he com!any !aid diidends of -.> this year. If thereuired rate of return is 10, what is the alue of the stock at the end of the secondyear3

a -5/.44 b -5>."5

% c -/#."4 d ->#."5

'olution:( ) ( )

"4./#-4.1.

4.1".1>. "

" =

−

++= P

"BIf a com!any has a &(E ratio of 1B with a historical E&' growth of "0. +hat is the&E; ratio if the e$!ected E&' growth is 103

a .>B b .B

c 1.% d 1.">

'olution: &E; ratio 7 1B(1 7 1.">

#. 'u!!ose that a com!any has a net free cash flow of - million and is e$!ected togrow at #0 during the ne$t # years and then grow at >0 thereafter. *he com!any hasdebt of -> million and ,, shares of outstanding common stock. *he com!any !ays no diidends and since it would like to retain its earnings, it is not e$!ected to !ayany diidends. +hat is the firmGs euity alue assuming the discount rate is 1"03

% a -11",>/#,# b -14>,>/#,# c -"1,B,"# d -"/1,15,


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'olution:

( ) ( )

( )

( ) ( ) ( )

( )

#,>/#,11"-,,>#,>/#,14>-

1".1

>.1".

>.1#.1,,#.1,,

1".1

#.1,,

1".1

#.1,,#

##

"

"

=−=

+

−

××+×

+

+

×+

+

×= EV

#1. 'u!!ose that a com!any has a net free cash flow of - million and is e$!ected togrow at #0 during the ne$t # years and then grow at >0 thereafter. *he com!any hasdebt of -> million and ,, shares of outstanding common stock. *he com!any !ays no diidends and since it would like to retain its earnings, it is not e$!ected to !ayany diidends. +hat is the intrinsic alue of the stock assuming the discount rate is 1"03

a -14.B"% b -"".# c -#1./5

d -#>.

'olution: #.""-,,

#,>/#,11"

K ===

ofShares

EV P

Chapter 14

#" *wo ty!es of munici!al bonds are general obligation issues and:

serial bonds.% reenue bonds.

debentures.income bonds.

##. Among the arious ty!es of !ublicly9traded debt, trading is most actie for:

=unk bonds.munici!al bonds.cor!orate bonds.

% *reasury securities.

#5. A cor!orate bond bid !rice of 15 1(4 means that a buyer was willing to !ay:

-15.4-1,51.4-15.1"

% -1,51.1"

Solution: 15 and 1(4 0 of -1, is 15.1"0 6 -1, 7 -1,51.1"


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#. *he interest rate charged on loans made by the Lederal Resere is called the:

fed funds rate.MI)OR rate.

% discount rate.

!rime rate.

#/. *he ta$able euialent yield for an inestor in the ##0 marginal ta$ bracket holdinga B0 munici!al bond is:

% a. 1#.50. b. #0.c. B0.d. /0.

Solution: B0 19.## 7 1#.5#0

#>. 'elect the false statement about money market securities.

Ds are negotiable.% )ankerGs acce!tances are not negotiable instruments.

*he secondary market for commercial !a!er is weak.Eurodollars are dollar9denominated de!osits held in foreign banks.

#4. *reasury notes hae an initial term to maturity of:

% two to ten years.one year or less maturity.more than ten years.more than thirty years.

#B. *he interest rate charged on oernight loans from one N.'. commercial bank toanother is called the:

% federal funds rate.MI)OR rate. !rime rate.discount rate.

5 8olding term to maturity constant, holding !eriod risk is highest for:

% high9yield bonds.munici!al bonds.federal agency securities.cor!orate bonds.


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51. N.'. bond trading actiity largely takes !lace on the:

C'E.A2EP.

% O*D market.

offshore market.

5" An e$am!le of a federal agency security is:

% a ;innie 2ae !ass9through certificate.*he +ashington &ublic &ower 'u!!ly 'ystemGs bonds.a *reasury note.&hiladel!hia Electric bonds.

5#. *he rate of return on money market securities is:

slightly below the *reasury bill rate.% slightly aboe the *reasury bill rate.set by regulation.slightly below the insured bank D rate.

55. Mist the following securities by their leel of credit risk list the most risky first:Dor!orate )ond rated AA, Dor!orate )ond rated )), Lederal Agency )ond,*reasury )onds.

a.*reasury, Dor!orate rated AA, Dor!orate rated )), Lederal Agency b. *reasury, Lederal Agency, Dor!orate rated AA, Dor!orate rated ))c.Dor!orate rated AA, Lederal Agency, Dor!orate rated )), *reasury

% d. Dor!orate rated )), Dor!orate rated AA, Lederal Agency, *reasury

5. +hich of the following securities trade in the money market3

a.t9bills b. commercial !a!er c.bankers acce!tances

% d. all of the aboe

Chapter 10

5/. 8olding all else eual, ROE will rise with an increase in:

total assets.sales.stockholdersH euity.

% none of these.


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'u!!ose a com!any with the following financial information:

Income 'tatement )alance 'heet

'ales - 1",, Dash -,

Dost of ;oods 'old /,, Accounts Receiable

1,5,;ross &rofit ,B, Inentory

1,5,

O!erating E$!enses - ",5, *otal Durrent Assets -#,5,

Interest E$!ense 5, *otal Li$ed Assets1,,

*a$es >, *otal Durrent Miabilities",,

Cet Income - ",#, Mong9term Miabilities/,,

&aid9in Da!ital",,

Cumber of Outstanding'hares

1,, Retained Earnings",5,

Durrent 2arket !rice -#>.B

5>. +hat is the net !rofit margin3

% a 14.40 b ">."0 c #".50

d 5>./0

54. +hat is the return on euity3

a 1>.0% b 1.>/0 c B"."0 d 11>.05B. +hat is the receiables turnoer3

a ".

b 5.4> c /.#% d 4./"

'olution: Receiable *urnoer 7 -1",, ( -1,5, 7 4./"

. +hat is the inentory turnoer3


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a ". b 5.4>% c /.# d 4./"

'olution: Inentory *urnoer 7 -/,, ( -1,5, 7 /.#

1. All else eual, a rise in Asset *urnoer will result in a rise in:

de!reciation.leerage. !rofit margin.

% ROE.

". Lree cash flow has become an es!ecially im!ortant measure of economic !rofitability because:

accrual accounting information is !recise and cannot be mani!ulated.% it is !erceied as being more difficult to mani!ulate than traditional accounting

information.net !rofit e$cludes de!reciation.it is less de!endent on economic !rofits.

Chapter 17

#. *he loss !otential tied to market im!act costs is called:

% liuidity risk currency translation risk.goernment !olicy risk.emerging market risk.

5. N' inestors hold a!!ro$imately QQQQQ of their euity holdings in N' com!anieswhile the N' stock market re!resents about QQQQQ of the world euity marketca!italiation.

% a. B0, 0 b. 10, /0c. >0, #0d. >0, 50

. 2'DI Inde$es coer what !ercentage of the market ca! of global euities indeelo!ed and emerging markets3

10.


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B0.% /0.

#0.

/. An AR !rogram in which an issuer floats a !ublic offering of ARs in the N.'. andobtains listing on a ma=or N.'. e$change or CA'AS is called a:Meel I !rogram.

Meel II !rogram.% Meel III !rogram.

Meel IV !rogram.

>. 'elect the true statement from among the following:

Dountry9focused i'hares shares are guaranteed in !rice, but not with res!ect toreturns.

Dountry9focused i'hares shares !roide inestment results that corres!ondgenerally to the !rice and yield !erformance of local benchmark countryindices.Dountry9focused i'hares shares are guaranteed in !rice.

% +ith country9focused i'hares, inestors hae the conenience of dealing in N'dollars.

4. 2arket im!act costs tend to be reflected in:

a. high trading olume. b. low bid9ask s!reads.

% c. high bid9ask s!reads.d. rising institutional inestor interest.

B. +hich of the following statements is not descri!tie of American e!ositoryRecei!ts ARs3

% a. ARs are negotiable instruments that re!resent ownershi! in the euitysecurities of a N' com!any.

b. AR certificates are negotiable documents and should be signed only in theeent of a sale or transfer of ownershi!.

c. ARs are transferable on the books of a s!onsoring depositary institution.d. ARs can be listed on the Cew ork 'tock E$change and may be uoted for

trading on Casda./. . Assume that a N.'. inestor has -1, and decided to inest this amount inLrance.If the e$change rate is -1(.>" Euro, how many Euros this inestor would be able to buy3

a 1#4,44B Euros b 11, Euros


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c B4, Euros% d >", Euros

'olution: -1, 7 1, P .>" 7 >", Euros

N! "F C#$%&' ()*&I"N*+%'",-.*/$N*'*

Chapter 10

(101 E$!lain why financial statement analysis is the cornerstone of fundamental analysis. 8owdoes financial statement analysis relate to the basic difference between inestment ands!eculation3

(101 $N*'

Linancial statement analysis is the cornerstone of fundamental analysis because it is the means by which inestors ascertain the economic worth of a com!any. It is the starting !oint for all

long9term inestors, ersus short9term s!eculators. 'tock market inestment is the !rocess of buying and holding for diidend income and long9term ca!ital a!!reciation the shares ofcom!anies with inherently attractie economic !ros!ects. Inestors seek to !rofit by sharingin the normal and !redictable good fortune of such com!anies. 'tock market s!eculation isthe !urchase or sale of securities on the e$!ectation of ca!turing short9term trading !rofitsfrom share9!rice fluctuations tied to the !erha!s tem!orary good fortune of a gien com!any.'!eculators de!end u!on a short9term or fundamental change in the economic !ros!ectsfacing a com!any.

(102 Dlarify how return on euity ROE numbers can become biased by share buy backs andcor!orate restructuring.

(102 $N*'

ROE can sometimes be unduly influenced by share buy backs and other ty!es of cor!oraterestructuring. +hen Ae$traordinary@ or Aunusual@ charges are significant, the book alueof stockholders= euity is reduced, and ROE can become inflated. 'imilarly, when sharere!urchases are at market !rices that e$ceed the book alue !er share, book alue !er sharefalls and ROE rises. E$traordinarily high ROE can be re!orted by com!anies that haerecently undergone significant cor!orate restructuring.

(103 +hat is total asset turnoer, and how does it contribute to !rofitability3

(103 $N*'

*otal asset turnoer is sales reenue diided by the book alue of total assets. +hen totalasset turnoer is high, the firm makes its inestments work hard in the sense of generating alarge amount of sales olume. ;rocery and a!!arel retailing are good e$am!les of industrieswhere high rates of total asset turnoer can allow efficient firms to earn attractie rates ofreturn on stockholders= euity des!ite modest !rofit margins. Among firms found in theTIA, retail =uggernauts +al92art and 8ome e!ot, feature aboe9aerage rates of total assetturnoer.

(104 +hat is the difference between a com!anyHs return on assets ROA and its return onstockholdersH euity ROE3 +hy should inestors be ske!tical of seemingly e$traordinaryROE3

(104 $N*'


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)oth terms are relatie measures of !rofitability. A firmHs ROA is its net income diided bythe book alue of total assets. *his measure indicates how !rofitable a com!any in terms ofthe total alue of assets on the balance sheet. ROA ca!tures the effects of managerialo!erating decisions, but tends to be less affected than other measures by the amount offinancial leerage used. In contrast, ROE is defined as net income diided by the book alueof stockholdersH euity, which is the book alue of total assets minus total liabilities. ROEtells how !rofitable a com!any is in terms of each dollar inested by shareholders. 8oweer,inestors should not automatically assume that high re!orted ROE means a com!any is highly !rofitable. A limitation of ROE is that it can sometimes be unduly influenced by share buybacks and other ty!es of cor!orate restructuring. +hen ?e$traordinary@ or ?unusual@charges are significant, the book alue of stockholdersH euity is reduced, and ROE can become inflated. 'imilarly, when share re!urchases are at market !rices that e$ceed the bookalue !er share, book alue !er share falls and ROE rises. ;ien the difficulty of inter!retingROE for com!anies that are highly leeraged or hae undergone significant restructuring,some inestors !refer focusing on ROA rather than ROE.

CF$101 A com!anyGs current ratio is ".. If the com!any uses cash to retire notes !ayable that are duewithin one year, would this transaction most likely increase or decrease the current ratio andasset turnoer ratio, res!ectiely3

Durrent ratio Asset turnoer ratio

A. Increase Increase

). Increase ecreaseD. ecrease Increase

D. Decrease Decrease

Answer : A

CF$102 An analyst gathered the following information about a com!any whose fiscal year end is

ecember #1:

U Cet income for the year was -1. million.U &referred stock diidends of -" million were !aid for the year.U Dommon stock diidends of -#. million were !aid for the year.U " million shares of common stock were outstanding on Tanuary 1, "1.U *he com!any issued / million new shares of common stock on A!ril 1, "1.U *he ca!ital structure does not include any !otentially dilutie conertible securities,o!tions, warrants, or other contingent securities

*he com!anyGs basic earnings !er share for "1 was closest to:

A. -.#.). -.#>.

D. -.5#.. -.5/.

$nswer/ $

CF$103 *wo com!anies are identical e$ce!t for substantially different diidend !ayout ratios. After seeral years, the com!any with the lower diidend !ayout ratio is most likely to hae:

A. lower stock !rice.


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). higher debt(euity ratio.D. less ra!id growth of earnings !er share.. more ra!id growth of earnings !er share.

Answer:

CF$103 An analyst a!!lied the u&ont 'ystem to the following data for a com!any:

U Euity turnoer 5."U Cet !rofit margin .0U *otal asset turnoer ".U iidend !ayout ratio #1.40

*he com!anyHs return on euity is closest to:

A. 1.#0.). 11.0.D. "#.10.. /#./0.Answer: D

Chapter 11

(111 escribe the general characteristics of stocks sought by alue inestors.

(111 $N*'

*raditional alue inestors seek out9of9faor stocks selling at a discount to theoerall market. 'uch discounts are measured in terms of low &(E and &()

ratios and(or high diidend yields. Ceertheless, there are often goodeconomic reasons for a stock to sell at a shar! discount to the market. Valueinestors aoid this !itfall by faoring com!anies selling at shar! discounts tothe market or a com!anyHs own historical aluations !roided that suchdiscounts cannot be e$!lained by a !arallel deterioration in the firmHseconomic fundamentals. Attractie stock market alues can also be createdwhen an entire industry falls into disfaor. Dom!anies that may be onlymarginally or tem!orarily affected by industry !roblems can becomeunderalued in the market !lace.

(112 +hat is the basic !remise of alue inesting3 +hat does it mean to buy

?fear@ and sell ?greed@3

(112 $N*'


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Value inestors seek com!anies whose stock !rices hae been unfairly beatendown in !rice. )argains are often measured in terms of market !rices that are below the estimated economic alue of tangible and intangible assets. Valueinestors tend to argue that oerly emotional inestors cause stock !rices to bemoed by ?fear@ and ?greed@ to leels that are sometimes too low or too high

based on the economic fundamentals. As a result, alue inestors ado!t acontrarian inestment !hiloso!hy based on the !remise that inestors can !rofit by betting against the oerly emotional crowd. According to !ractitioners of contrarian inestment strategies, inestors can !rofit if theyare able to withstand the !eer and !sychological !ressures tied to commonstock inesting. *o be successful, contrarian inestors argue that one must?buy fear@ and ?sell greed.@ 2ore s!ecifically, alue inestors ho!e to !rofit by inesting in com!anies that are irrationally underalued. &rofits arerealied once the broader market recognies the true economic alue of thefirmsH underlying assets and bids market !rices u!.


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(113 E$!lain why the reuired rate of return k must e$ceed the e$!ected rate ofgrowth g in the constant9growth ;ordon model.

(113 $N*'

In the constant9growth ;ordon model, & 7 1(k g and the reuiredreturn, k, must e$ceed the diidend growth rate, g, to calculate a finite stock !rice. +hen k % g, the constant growth model can derie useful aluationestimates. If k W g, ra!id growth would oerwhelm the effect of discounting,and inestors would theoretically be willing to !ay an infinite !rice for astock. Economically, this is a nonsensical result. In the long run, no stock cangrow diidends at a !ace that e$ceeds the nominal rate of growth in theoerall economy, say 9>0 !er year. +hen a ty!ical 1910 rate of discountis em!loyed, the rate of discount will always e$ceed the constant rate ofgrowth in diidends that can be achieed, and the constant growth model cangie sensible aluation estimates.

(114 *he three !illars of )en=amin ;rahamHs fundamental a!!roach to inestingare: 1 common stock alues ultimately reflect their !ro!ortionate share ofthe economic net worth of the cor!oration, " it is !rudent to build in a?margin of safety@ in stock aluation, and # inestors can only make !rudentassessments if they ignore market sentiment. E$!lain why the intelligentinestor does best to forget about day9to9day !rice fluctuations and focuses oncom!any o!erating results.

(114 $N*'

In the stock market, the intelligent inestorHs goal is to earn aboe9normal returns bymaking =udgments that, on aerage, are more sensible than those reflected in sometimesirrational market !rices. ;raham used a legendary ?2r. 2arket@ !arable to e$!lain howthe intelligent inestor might deal with market sentiment. ;rahamHs fable goessomething like this. *hink of being in !artnershi! with a bright but irrational fellownamed 2r. 2arket. *he two of you hae what is called a buy(sell agreement. If one !arty offers to buy the other out at a gien !rice then the offering !arty is also obligatedto sell out at that same !rice. )eing neurotic, 2r. 2arketHs mood fluctuates from normal behaior, to incredible o!timism, to oerwhelming de!ression. On a good day, 2r.2arket is buoyant and will offer to buy out your share of the business at an enormoussky9high !rice. On a bad day, 2r. 2arket is gloomy and will offer to sell his share of the business at a ery low, or rock9bottom !rice. *he !oint that ;raham makes is that 2r.2arketHs =udgment is sometimes formed more by mood swings that by rational thought.*his gies the rational !artner multi!le !rofit9making o!!ortunities. If 2r. 2arketHs !rice is unreasonably high, the rational !artner takes adantage of the o!!ortunity to sell.If 2r. 2arketHs !rice is unreasonably low, the rational !artner takes adantage of theo!!ortunity to buy. ;raham wrote that the only im!ortance of market !rices is that theygie the intelligent inestor an o!!ortunity to buy wisely when !rices fall shar!ly and sellwisely when they adance a great deal. At other times, the intelligent inestor does bestto forget about day9to9day !rice fluctuations and focuses on com!any o!erating results.


18/29

(11 E$!lain the ;raham and odd ?margin of safety@ conce!t.

(11 $N*'

*he most im!ortant idea for a alue inestor is the margin of safety conce!t.

According to ;raham and odd, the margin9of9safety idea becomes eident

when a!!lied to underalued, or bargain, securities. *he margin of safety is

the difference between the !rice and the indicated or a!!raised alueX it is

aailable for absorbing the effect of miscalculations or bad luck. ;raham and

odd belieed the danger of growth stock inesting lies in the tendency to !ay

high !rices for stocks with uestionable growth !ros!ects. 'uch a tendency

results in a small margin of safety for the inestor. Lrom the ;raham and

odd !ers!ectie, the goal of security analysis is to identify under9!riced

securities with am!le margins of safety and to en=oy e$cess returns following

the marketHs subseuent u!ward realuation to !rices consistent with intrinsic

alue. In the words of ;raham and odd, the market is sim!ly there to

facilitate the inestorHs interest in buying or selling securities. +hen market

!rices are too high, the discerning inestor will choose to sell or wait for

better bargains. +hen market !rices are too low, the discerning inestor takes

adantage of the situation by sna!!ing u! the best bargains aailable.

(11 escribe three essential characteristics of what +arren )uffett describes as

Awonderful businesses.@

(11 $N*'


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Megendary stock9market inestor +arren )uffett looks for inestment bargains among what he calls Awonderful businesses.@ *hree essential

characteristics of wonderful businesses are: 1 ;ood businesses: )uffett likescom!anies that en=oy a high rate of return on ca!ital without accountinggimmicks or lots of leerage, see their !rofits in cash, hae strong franchises

and thus freedom to !rice, are sim!le and donGt take a genius to run, hae !redictable earnings, and are not natural targets of regulation. " ;ood !eo!le: )uffett likes to inest in com!anies run by honest, ca!able and owner9oriented management. # ;ood !rice: )uffett likes good businesses run bygood !eo!le, but he does not like to !ay !remium !rices for !remiumcom!anies.

%112 In mid9"4, banking giant Ditigrou!, Inc. D sold for a market !rice of -1B.# !ershare, had "B e$!ected earning !er share of -".>, and a !ro=ected diidendof -1."4. Dalculate Ditigrou!Hs forward9looking &(E ratio and !ro=ecteddiidend yield.

112 *"-)&I"N

Lorward &(E ratio 7 'tock !rice(&ro=ected E&'7 -1B.#(-".>7 >.15

&ro=ected diidend yield 7 &ro=ected diidend('tock !rice7 -1."4(-1B.# /./#0

CF$112 An analyst gathered the following information about a common stock:

Annual diidend !er share -".1

Risk9free rate >0Risk !remium for this stock50

If the annual diidend is e$!ected to remain at -".1, the alue of the stock isclosest to:

A. -1B.B.). -#..D. -"... ->..

Answer: AChapter 12

(121 escribe the general a!!roach of a growth stock inestor. 8ow is growthstock inesting different from alue inesting3

(121$N*'


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;rowth stock inesting is one of the two most !o!ular styles of inestmentstrategy. It is an a!!roach to inesting that focuses on com!anies e$!ected tohae aboe9aerage rates of growth in earnings and diidends. Rather thanfocusing on the current market !rice in relation to the current alue of assets, a !ractice of alue inestors, growth stock inestors look for securities selling

for !rices below the alue of future growth o!!ortunities. 2any growth stockinestors faor firms within industries that are also e$!eriencing growth. 'uchinestors are usually willing to acce!t much larger than ty!ical leels of riskin the !ursuit of aboe9aerage long9term inestment results.

(123 Inestors in growth stocks are sub=ect to !rice risk. escribe this ariety ofrisk and e$!lain why e$!osure to !rice risk is of !articular concern to growthstock inestors.

(123$N*'

&rice risk is the risk of oer!aying for a com!any een though it may hae

attractie economic !ros!ects. One of the most im!ortant !otential !itfalls

tied to growth stock inesting is that the a!!roach seldom offers clear

guidance about how much is too much to !ay for a stock with attractie

growth !ros!ects. *his lack of a strict buying disci!line leaes growth stock

inestors o!en to !rice risk and the risk of suffering gut9wrenching

deastation to their inestment !ortfolios after een modest tem!orary

declines in the oerall market.

(124 +hat is the danger of buying the common stock of current leaders in ra!idly

changing industries3


21/29

(124$N*' Marge com!anies tend to hae trouble ada!ting to new market

conditions in ra!idly changing enironments. 'ustained earnings growth is

difficult een among the largest and most !owerful cor!orations. 'maller

e$isting com!anies or new entrants are often better able to successfully

antici!ate and ada!t to the challenges in eoling industries. Lor this reason,

large dominant cor!orations in ra!idly changing industries often hae trouble

liing u! to the e$!ectations of inestors. It is im!ortant for inestors to

realie that historical earnings growth often is a !oor indicator of future

growth.

(12 Mist fie or more criteria identified by *. Rowe &rice as im!ortantcharacteristics of Ainestment o!!ortunities.@

(12$N*'

According to *. Rowe &rice, attractie inestment o!!ortunities includecom!anies that:

• manufacture !roducts or furnish serice not ulnerable to takeoer or

onerous regulation by goernment.• reuire es!ecially trained em!loyees who are well !aid, but total

!ayroll is not large in relation to gross reenue.• hae a liberal !rofit margin.

• are not ulnerable to deastating com!etition.

• are able to lower costs and e$!and their market without materially

reducing the return on inested ca!ital.• hae actie officers and directors.

• hae a substantial stock interest in their com!any.

• !lan for the future through intelligent research.

• understand social trends and hae the goodwill of their em!loyees.

(12 E$!lain the &E; ratio and the &E; ratio rule9of9thumb.

(12 $N*'


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*he &E; ratio is sim!ly the &(E ratio diided by the e$!ected E&' growthrate. If a com!any has a &(E of ", and is e$!ected to en=oy E&' growth of"0 !er year, the com!any=s &E; ratio would be 1. ;enerally s!eaking, astock is fully alued if it s!orts a &E; ratio of 1 or more. If the &E; ratio isless than 1, the stock is often worthy of inestment consideration. *he &E;

ratio rule of thumb goes something like this: If &E; #1, the stock may beworthy of inestment attention and !ossible !urchaseX If &E; #., the stock

is definitely worthy of inestment attention, and may re!resent a ery

attractie inestmentX If &E; #.##, the stock is a!t to re!resent an

e$traordinarily attractie inestment o!!ortunity. Ceedless to say, theinestment merit of a stock increases with a decrease in the &E; ratio. 'trictgrowth9at9a9reasonable9!rice inestors seldom, if eer, buy growth stockswith &E; ratios that are far greater than 1.

(127 Oer the long run, growth and alue stocks categoried by !rice9book ratios,&(E ratios, or diidend yields dis!lay com!arable rates of return. 8oweer,during different !arts of the economic cycle, and during bear and bull markets,

growth and alue stocks behae ery differently. escribe the ty!e of economic enironment and stock9market enironment that is best for growthersus alue stocks.

(127 $N*'

Oer the !ast uarter century, total rates of return hae been similar for thealue and growth com!onents of the '(-> 7 10. If acom!any earns a 10 ROE and retains all earnings for future inestment, theamount of book9alue growth that could be funded internally is 10.


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%122 According to the diidend discount or constant growth model, calculate thereuired rate of return for *he +alt isney Do. I' at a current !rice of -# !er share, a !ro=ected diidend of #4 !er share, !ro=ected diidend growth of

110 !er year.

%122 *"-)&I"N

k 7 1(& J g7 -.#(-# J 1107 1"0.

%123 +al92art 'tores, Inc. +2* recently sold for - !er share and !aid a -.B#

diidend. If the diidend is e$!ected to grow at 1#0 !er year, use the

constant growth model to calculate the e$!ected rate of return.

%123 *"-)&I"N

Lrom the constant growth model, the ER 7 15.B0 on +2*:

& 7 1 J g(k g

- 7-.B# × 1.1#( k .1#

Rearranging gies:

k .1# 7 -1.(

k 7 1.B0 J 1#0

7 15.B0

%124 'u!!ose a fast growing com!any !aid a -1 diidend !er share this year that is

e$!ected to grow by "0 for three years. Afterwards, the diidend growth

rate will be >0 !er year indefinitely. If the reuired rate of is B0, calculate

the alue of this stock.


24/29

%124 *"-)&I"N

( ) ( )

( )

( ) ( ) ( )

( ) #

##

"

"

B.1

>.B.

>.1".1.1".1.1

B.1

".1.1

B.1

".1.1

+

−

++++

+

+

++

+

+= P

5.>->"5.>""1".111.1

"B.1

".

45B.1>"4.1

144.1

55.1

B.1

".1=++=

+

++=

%125 According to ahooY Linance, non9diidend !aying ;oogle, Inc. ;OO; recently had a

book alue !er share of ->>.4 and was e$!ected to earn -"5.> !er shareduring the coming year. Dalculate the com!anyHs retention rate, ROE, and theamount of sustainable growth.

%125 *"-)&I"N

Retention rate 7 1 iidends(E&'7 1 9 -.(-"5.>7 10

ROE 7 E&'()ook alue7 -"5.>(->>.4

7 #1.40'ustainable growth 7 Retention rate Η ROE

7 10 Η #1.40

7 #1.40%1212 Nnited *echnologies Inc.N*P earned -5."> in ">. At that time, The Value Line

Inestment Surey !ro=ected fie9year E&' growth of 1#0 and a ty!ical &(E

ratio of 1/. Dom!ute the stock !rice !ro=ected for N*P in fie years.

%1212 *"-)&I"N

If N*P grows E&' of -5."> at an annual growth rate of 1#0, the com!any

will earn -#.5/ !er share in fie years and, at 1/ times earnings, sell for

1".44:


25/29

& 7 E&' × &(E

7 E&'× 1 J g × &(E

7 -5."> × 1.1# × 1/

7 -1".44Chapter 14

(141 8ow does interest rate risk differ from credit risk3

(141 $N*'

Interest rate risk is the chance of a loss in the alue of fi$ed9incomeinestments following a rise in interest rates. *he longer the maturity of a

bond, the greater its sensitiity to changes in interest rates and the greater itsinterest rate risk. Dredit risk is the chance that an indiidual issuer of a bondwill fail to make timely !ayments of !rinci!al and interest. Mow9uality bonds hae a greater risk of these ty!es of default and generally offer higher yields to hel! com!ensate inestors. ;oernment bonds offer the lowestyields but carry the highest credit ratings and hae the lowest risk of default.All bond inestors are sub=ect to interest rate risk, but inestors in N.'.*reasury bills and N.'. *reasury bonds are for all !ractical !ur!oses note$!osed to credit risk.

(142 +hat is the difference between the !rimary market and secondary market for

bonds3

(142 $N*'

*he !rimary bond market is the market for new bonds. )ond issuers sellnewly minted bonds in the !rimary bond market to dealers who then resellthose bonds to inestors in the secondary bond market. Once bonds hae beenissued and sold to indiidual and institutional inestors, bond dealers use their ca!ital to maintain actie secondary markets for !reiously issued bonds.

(14 8ow do *reasury bills, *reasury notes, and *reasury bonds differ with res!ectto term to maturity3

(14 $N*' *he Lederal goernment issues, by Lederal Resere 'ystem auction, *reasury bills one year or less maturity, notes two to ten years maturity, and bondsmore than ten years maturity. )ills, notes and bonds are all N.'.goernment obligationsX they differ !rimarily in terms of their length of timeuntil maturity.


26/29

(14 8ow do *reasury bills, *reasury notes, and *reasury bonds differ with res!ectto the !ayment of interest income3

(14 $N*'

*reasury bills, or *9bills, are issued at a discount from their face alue and !ay

no cash interest. Lor e$am!le, you might !ay -BB for a -1, bill. +hen the bill matures, you would be !aid its face alue, -1,. our interest is the facealue minus the !urchase !rice in this e$am!le, the interest is -1. *heinterest is determined by the discount rate, which is set when the bill isauctioned. *reasury notes, or *9notes, are issued in terms of ", , and 1 years,and !ay interest eery si$ months until they mature. *reasury bonds are issuedin terms of u! to # years and !ay interest eery si$ months until they mature.+hen a *reasury bond matures, you are !aid its face alue. *he !rice andyield of a *reasury bond are determined at auction. *he !rice may be greater than, less than, or eual to the face alue of the bond.

(147 E$!lain why *reasury bills are often described as risk9free assets, but that thesame cannot be said of *reasury notes and *reasury bonds.(147 $N*'

)ond inestors must be concerned with the !otential for default risk, or thechance that the borrower will fail to make !romised interest and !rinci!al !ayments. 'imilarly, bond inestors must be concerned with the !otential for interest9rate risk, or the chance of bond alue fluctuations due to changes inmarket interest rates. +hile all goernment obligations are free from defaultrisk, *reasury notes and bonds hae the !otential for interest9rate risk gientheir longer terms to maturity for *reasury notes two to ten years maturityand *reasury bonds more than ten years maturity.

(146 +hat are *reasury Inflation9&rotected 'ecurities *I&'3 Dan *I&' be !urchased by small inestors on the Internet in a cost9efficient fashion3

(146 $N*'

*reasury Inflation9&rotected 'ecurities *I&' are bonds issued by the N.'.goernment that !roide !rotection against inflation. *he !rinci!al of a *I&' bond increases with inflation and decreases with deflation, as measured by theDonsumer &rice Inde$. +hen a *I&' bond matures, inestors are !aid thead=usted !rinci!al or original !rinci!al, whicheer is greater. *I&' !ay interesttwice a year at a fi$ed rate. *he rate is a!!lied to the ad=usted !rinci!alX so,like the !rinci!al, interest !ayments rise with inflation and fall with deflation.Inestors can buy *I&' directly from the N.'. goernment in a cost9efficientfashion using *reasuryirect and Megacy *reasury irect through non9com!etitie bidding. 'tarting in Tanuary ">, the "9year *I&' bond is nolonger sold in Megacy *reasury irect, but it continues to be aailable in*reasuryirect. Lor more information see the *reasuryirect websitehtt!:((www.treasurydirect.go(

http://www.treasurydirect.gov/http://www.treasurydirect.gov/


27/29

(145 2ortgage9backed securities are issued by goernment9s!onsored enter!risesand other large financial institutions. 2a=or !layers in this market includeLannie 2ae, Lreddie 2ac, and ;innie 2ae. E$!lain how they differ.


28/29

(145 $N*'

Lannie 2ae and Lreddie 2ac are often described as !riate cor!orations witha !ublic !ur!ose. )oth started out as goernment9owned enter!rises but wereconerted into !riately9held cor!orations in 1B/4 for Lannie 2ae and 1B>

for Lreddie 2ac. )oth Lannie 2ae and Lreddie 2ac su!!ly lenders withmoney by !urchasing home mortgages in the secondary market. Lannie 2aeand Lreddie 2ac assemble these mortgages into diersified !ackages or !oolsof such loans and then issue securities that re!resent a !ro!ortionate share inthe interest and !rinci!al !ayments deried on that !ool. +hen thegoernment s!un off Lannie 2ae into a !riate cor!oration, it s!lit Lannie2aeHs historical mission into two !arts. ;innie 2ae is the second !art. ;innie2ae is a goernment agency within 8N created by Dongress to ensureadeuate funds for goernment loans insured by the Lederal 8ousingAdministration L8A and guaranteed by the e!artment of Veterans AffairsVA and Veterans Administration. ;innie 2ae issues modified !ass9through

certificates that re!resent an interest in a gien !ool of L8A and VAmortgages. As homeowners make their mortgage !ayments, a !ro!ortionateshare !asses through to the inestor on a monthly basis. Each !ayment theinestor receies is !art interest and !art re!ayment of !rinci!al. *heminimum denomination is -",. ;innie 2ae bonds are backed by the fullfaith and credit of the N.'. goernment, but interest !ayments are sub=ect tostate and local ta$es.

(1410 +hat is the mortgage securitiation !rocess3

(1410 $N*'

*he mortgage securitiation !rocess is the !rocess by which mortgage9backedsecurities are !ooled and resold in order to decrease lender risk. 2ores!ecifically, it is the !rocess of creating diersified loan !ortfolios and selling !ro!ortionate shares to inestors. )oth Lannie 2ae and Lreddie 2ac !artici!ate in this !rocess. *he !ur!ose of each com!any is to hel! create acontinuous flow of funds to mortgage lenders such as commercial banks,mortgage bankers, saings institutions, and credit unions. Lannie 2ae andLreddie 2ac !urchase home mortgages in the secondary market and thenassemble these mortgages into diersified !ackages, or !ools, of loans. *heythen issue securities that re!resent a !ro!ortionate share in the interest and !rinci!al !ayments deried on that !ool. *his !ooling and then reissuing of diersified mortgage9backed securities is the mortgage securitiation !rocess.


29/29

(1411 escribe the characteristics of the money market.

(1411 $N*'

*he money market is the market used for buying and selling short9term debt

securities that can be uickly conerted into cash. As in the case of *9bills,the ma=ority of money market instruments are issued at a discount from !ar, or face alue. Lor the most !art, -1, is the minimum face amount traded inthe money market. Obiously, institutional inestors dominate this market.'maller inestors !artici!ate ia money market mutual funds that haeminimum inestment reuirements as low as -1,. 2oney marketinstruments are generally regarded as safe. ;ien ery short maturities, bothcor!orate and goernment9issued market instruments are free from interest9rate risk. 8oweer, only goernment9issued money market instruments arealso free from default risk.

(1412 8ow does the Lederal Resere use *reasury securities to im!lement changesin monetary !olicy3

(1412 $N*'

*he Lederal Resere buys and sells bonds in the *reasury securities market inorder to im!lement monetary !olicy. If the Led wishes to increase the moneysu!!ly, it buys *reasury securities, thereby in=ecting funds into the financialsystem and reducing interest rates. If the Led wishes to decrease the moneysu!!ly, it sells *reasury securities, thereby withdrawing funds from thefinancial system and increasing interest rates. In this manner, the Led tries tomanage growth in the economy and tame the rate of inflation.

FIN432_Spr11_Review Questions for Final Exam

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