WARM UP QUESTIONS for Exam 2, ACFI 601
To study for the exam: Review the lecture slides and lecture problems, then review the endofchapter problems; and finally try the following questions. Qts. 19 are missing. Sorry! STOCK VALUATION: 10. DIV1 = $10, P1 = $60, K = .15. What is the current price?
12. Suppose you are willing to pay $30 today for a share of stock
which
13. Other things being equal, which of the following factors may
cause an increase in the market price of a security?
14. Other things being equal, which one of the following would be consistent with a relatively low P/E ratio for a firm? a. The stock’s beta is high (i.e.,
it is a very risk stock).
P/E is a POS function of growth and ROE, but a NEG function of risk. 15. A share of common stock paid a dividend of $2.00 yesterday. If the
Solution:
16. Calculate the standard deviation of the expected returns, given the following distribution of rates of returns:
Probability
Return
17. Inflation, recession, and wars are economic/political events which are characterized as a. Company specific risk that can be diversified away.
18. If investors suddenly became more averse to risk, the Security Market
Line (SML) would probably:
19. If two stocks were perfectly positively correlated:
20. Other things remaining equal, a decrease in the slope of the Security
Market Line (it becomes flatter) will:
21. Diversification of risk by holding securities in portfolios:
22. If the expected rate of return on a stock is above the security
market line, this is a disequilibrium situation. In moving towards equilibrium,
the price of the stock should:
23. According to the CAPM, the only portion of the risk which is relevant
in requiring a rate of return is:
24. Portfolio A is fully diversified and has a beta of 2. Portfolio B is poorly diversified and has a beta of 1. Which of the following statements must be true about these portfolios? a. A has less market risk than B.
Required rate is a function of BETA. So, A cannot have less market risk as market risk is indicated by BETA! 25. Asset J has an expected return of 25% and a beta of 2. The Tbill rate is 8%; the return on the market portfolio is 14%. What is the asset's required rate? a. 10%
26. From this information (qt above), you would conclude that: a. Asset J is overpriced.
To remember: Draw the SML and specify on the graph: Where does the RF plot? Where the Mkt Portfolio plots? Its Return? Where an overvalued asset plots? Where a fairly valued asset (one with expected return = required return)? More question... There may be some repeats!
Stock Std Dev
Beta
If you are a risk minimizer, you should choose Stock _____ if it is
to be held in isolation (and investor has no other assets) and Stock _____
if it is to be held as part of a welldiversified portfolio.
28. Stock X and the "Market" had the following returns during the last
two years, and the same relative volatility is expected to exist in the
future:
29. The expected return on the market portfolio is 12%, and the riskfree
rate of return is 4%. An investment has a beta
ANS: Find the required rate from CAPM and compare against the expected rate (IRR) of 8%. 30. Inflation, recession, and wars are economic/political events which
are characterized as
31. Diversification of risk by holding securities in portfolios:
32. Firms operating in this industry are characterized by low beta:
33. If two stocks were perfectly positively correlated:
34. Which of the following would be the WORST stock to be combined
with Stock X if the objective was to minimize the portfolio’s risk?
Cap Budgeting: An important topic and you'd need to do a lot on your own. (Sorry!) Below are 23 of the easier questions. There will be questions on NPV, IRR (calculating them and also reading them off a graph of NPV profiles). Review the handout problem we did in class  the one you tried in Excel and also Kangaroo Corp's. 35. Under the straight line method (SLM), Tomato Corp. wrote off $2,000
as depreciation, but under the ACRS method it reported a depreciation expense
of $3,500. If Tomato's marginal corporate income tax rate was 30%,
the additional tax shield of ACRS over SLM would be:
36. Projects A and B have the following cash flows:
t=0 t=1
t=2 t=3
t=4
If a company acceptes projects with a payback
period of less than 2 years,
a. Project A.
37. The project's IRR is 20%. You would accept this project if the opportunity cost of capital (required rate) was _______ 20%. a. Greater than
All else we said in class today... SAMPLE Problems: 1. (Emphasis added) The Test Company is evaluating the proposed acquisition
of a new milling machine. The machine’s base price is $108,000, and
it would cost another $12,500 to modify it for special use by your firm.
The machine falls into the MACR 3year class, and it would be sold after
3 years for $65,000. (Look up the book for MACRS recovery allowance
percentages.) The machine would require an increase in net working
capital (inventory) of $5,500. The milling machine would have no
effect on revenues, but it is expected to save the firm $44,000 per year
in beforetax operating costs, mainly labor. Test’s marginal tax
rate is 35 percent.
2. (CFA Test Question) Historically, RR Corporation has retained 60% of its profits in the business and generated a rate of return on equity of 12.5%. This is expected to continue. The riskfree rate is 8%, RPm (market risk premium) is 5%, and beta is about 1.3. The present dividend (paid yesterday) was $2.50, and the stock is selling at $45. Should you buy or sell the stock? Emphasis added. P = Div1/ (r  g) g= roe * Plaowback = .125 * .60 = 7.5%
Can you use the IRR rule to find out id RR is over (under) valued? Where does it plot of the SML graph? 3. The Treasury bill rate is 4%, and the expected return on the market portfolio is 12%. On the basis of Capital Asset Pricing Model: a. Draw a graph showing how the expected return varies with beta – i.e.,
draw the SML and label the graph.
ABC’s $1,000, 9% par bonds have ten years remaining to maturity. These are Arated and each bond currently sells for $938.50. Assume the bonds pay coupons annually. A. What is the expected rate of return (yield) if they are held to maturity (hence YTM)? That is: Par value = $1,000
YTM or K = ? Year
0
1
2
9
10
YTM = that “r” which gives an NPV = 0, or “r” that gives Market Price = PV of inflows. Using the general relationships, we know that YTM must be higher than 9% (Coupon rate) because the bond is bought at less than $1000. (Nominal return is 9% from coupons but we also buy the bond at a discount!) Will 10% discount rate make the PV of the inflows (right hand side of the following equation) equal to the left ($938.50)? $938.50 = $90 (PV interest factor, 10yr annuity) + $1,000 (PV factor, 10yr single sum) In other words: Does 10% give an NPV of zero if we rewrite the equation as: $90 (PV interest factor, 10yr annuity) + $1,000 (PV factor, 10yr single sum)  $938.50 = ? (Note the YTM and the IRR are exactly the same concepts. Whether you pay $938.50 for a bond or a piece of equipment, the rate that gives zero NPV gives the effective rate of return  call YTM in case of a bond and IRR in case of a capital asset. Logically, we start our trial with 10%. Try 10%. Find the PVIF and PVIFA for 10% an 10 years. Plug them in the above equation and you will get an NPV of zero. So, YTM = 10 %. B. What is the expected yield to maturity if each bond sold for $1,000? More or less than 9%? The general rule says that a bond selling
for $1,000 has a YTM equal to its coupon rate  i.e., 9%.
