ECO 550 MIDTERM EXAM PART 2 LATEST NOTE: TWO VERSIONS POSTED (50 QUESTIONS) VERSION 1 Question 1 You are considering two equally risky annuities, each of which pays $15,000 per year for 20 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? Answer If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant. The present value of ORD must exceed the present value of DUE, but the future value of ORD may be less than the future value of DUE. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD. Question 2 Which of the following statements regarding a 15-year (180-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) Answer The outstanding balance declines at a faster rate in the later years of the loanâ€™s life. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. Because the outstanding balance declines over time, the monthly payments will also decline over time. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. Question 3 Which of the following statements is CORRECT? Answer If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. The cash flows for an annuity due must all occur at the ends of the periods. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. Question 4 Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? Answer The periodic rate of interest is 8% and the effective rate of interest is also 8%. The periodic rate of interest is 2% and the effective rate of interest is 4%. The periodic rate of interest is 8% and the effective rate of interest is greater than 8%. The periodic rate of interest is 4% and the effective rate of interest is less than 8%. The periodic rate of interest is 2% and the effective rate of interest is greater than 8%. Question 5 Which of the following statements regarding a 20-year monthly payment amortized mortgage with a nominal interest rate of 10% is CORRECT? Answer Exactly 10% of the first monthly payment represents interest. The monthly payments will increase over time. A larger proportion of the first monthly payment will be interest, and a smaller proportion will be principal, than for the last monthly payment. The total dollar amount of interest being paid off each month gets larger as the loan approaches maturity. The amount representing interest in the first payment would be higher if the nominal interest rate were 7% rather than 10%. Question 6 Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? Answer $205.83 $216.67 $228.07 $240.08 $252.08 Question 7 Which of the following statements is CORRECT? Answer An indenture is a bond that is less risky than a mortgage bond. The expected return on a corporate bond will generally exceed the bondâ€™s yield to maturity. If a bondâ€™s coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated. All else equal, senior debt generally has a lower yield to maturity than subordinated debt. Question 8 Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? Answer Market interest rates rise sharply. Market interest rates decline sharply. The companyâ€™s financial situation deteriorates significantly. Inflation increases significantly. The companyâ€™s bonds are downgraded. Question 9 Which of the following statements is CORRECT? Answer Liquidity premiums are generally higher on Treasury than corporate bonds. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. Default risk premiums are generally lower on corporate than on Treasury bonds. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. Question 10 A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT? Answer The bond is currently selling at a price below its par value. If market interest rates remain unchanged, the bondâ€™s price one year from now will be lower than it is today. The bond should currently be selling at its par value. If market interest rates remain unchanged, the bondâ€™s price one year from now will be higher than it is today. If market interest rates decline, the price of the bond will also decline. Question 11 The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12% annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT? Answer Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity. Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year. Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year. Over the next year, Bond Aâ€™s price is expected to decrease, Bond Bâ€™s price is expected to stay the same, and Bond Câ€™s price is expected to increase. Bond Aâ€™s current yield will increase each year. Question 12 Which of the following statements is CORRECT? Answer All else equal, long-term bonds have less interest rate price risk than short-term bonds. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds Question 13 If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in value? Answer A 1-year bond with an 8% coupon. A 10-year bond with an 8% coupon. A 10-year bond with a 12% coupon. A 10-year zero coupon bond. A 1-year zero coupon bond. Question 14 Which of the following statements is CORRECT? Answer Logically, it is easier to estimate the betas associated with capital budgeting projects than the betas associated with stocks, especially if the projects are closely associated with research and development activities. The beta of an â€œaverage stock,â€ which is also â€œthe market beta,â€ can change over time, sometimes drastically. If a newly issued stock does not have a past history that can be used for calculating beta, then we should always estimate that its beta will turn out to be 1.0. This is especially true if the company finances with more debt than the average firm. During a period when a company is undergoing a change such as increasing its use of leverage or taking on riskier projects, the calculated historical beta may be drastically different from the beta that will exist in the future. If a company with a high beta merges with a low-beta company, the best estimate of the new merged companyâ€™s beta is 1.0. Question 15 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. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT? Answer The portfolioâ€™s expected return is 15%. The portfolioâ€™s standard deviation is greater than 20%. The portfolioâ€™s beta is greater than 1.2. The portfolioâ€™s standard deviation is 20%. The portfolioâ€™s beta is less than 1.2. Question 16 Which of the following statements is CORRECT? Answer Lower beta stocks have higher required returns. A stockâ€™s beta indicates its diversifiable risk. Diversifiable risk cannot be completely diversified away. Two securities with the same stand-alone risk must have the same betas. The slope of the security market line is equal to the market risk premium Question 17 If markets are in equilibrium, which of the following conditions will exist? Answer Each stockâ€™s expected return should equal its required return as seen by the marginal investor. All stocks should have the same expected return as seen by the marginal investor. The expected and required returns on stocks and bonds should be equal. All stocks should have the same realized return during the coming year. Each stockâ€™s expected return should equal its realized return as seen by the marginal investor. Question 18 Stock Aâ€™s beta is 1.7 and Stock Bâ€™s beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct. Answer In equilibrium, the expected return on Stock B will be greater than that on Stock A. When held in isolation, Stock A has more risk than Stock B. Stock B would be a more desirable addition to a portfolio than A. In equilibrium, the expected return on Stock A will be greater than that on B. Stock A would be a more desirable addition to a portfolio then Stock B. Question 19 Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? Answer The expected return of your portfolio is likely to decline. The diversifiable risk will remain the same, but the market risk will likely decline. Both the diversifiable risk and the market risk of your portfolio are likely to decline. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change Question 20 Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% Answer Stock Y has a higher dividend yield than Stock X. One year from now, Stock Xâ€™s price is expected to be higher than Stock Yâ€™s price. Stock X has the higher expected year-end dividend. Stock Y has a higher capital gains yield. Stock X has a higher dividend yield than Stock Y. Question 21 Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? Answer If one stock has a higher dividend yield, it must also have a lower dividend growth rate. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. The two stocks must have the same dividend growth rate. The two stocks must have the same dividend yield. The two stocks must have the same dividend per share. Question 22 Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $25 $25 Expected dividend yield 5% 3% Required return 12% 10% Answer Stock X pays a higher dividend per share than Stock Y. One year from now, Stock X should have the higher price. Stock Y has a lower expected growth rate than Stock X. Stock Y has the higher expected capital gains yield. Stock Y pays a higher dividend per share than Stock X Question 23 A share of Lash Inc.â€™s common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investorsâ€™ required rate of return is 11.4%, what is the stock price? Answer $16.28 $16.70 $17.13 $17.57 $18.01 Question 24 Which of the following statements is CORRECT, assuming stocks are in equilibrium? Answer Assume that the required return on a given stock is 13%. If the stockâ€™s dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. A stockâ€™s dividend yield can never exceed its expected growth rate. A required condition for one to use the constant growth model is that the stockâ€™s expected growth rate exceeds its required rate of return. Other things held constant, the higher a companyâ€™s beta coefficient, the lower its required rate of return. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield Question 25 Which of the following statements is NOT CORRECT? Answer The corporate valuation model discounts free cash flows by the required return on equity. The corporate valuation model can be used to find the value of a division. An important step in applying the corporate valuation model is forecasting the firmâ€™s pro forma financial statements. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends VERSION 2 1. At the end of 10 years, which of the following investments would have the highest future value? Assume that the effective annual rate for all investments is the same and is greater than zero. Answer Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments). Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments). Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments). Investment D pays $2,500 at the end of 10 years (just one payment). Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments). 2. Which of the following statements is CORRECT? Answer An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. If a loan has a nominal annual rate of 7%, then the effective rate will never be less than 7%. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. 3. Which of the following statements is CORRECT? Answer If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. The cash flows for an annuity due must all occur at the ends of the periods. The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month. 4. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 8% is CORRECT? Answer Exactly 8% of the first monthly payment represents interest. The monthly payments will decline over time. A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment. The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity. The amount representing interest in the first payment would be higher if the nominal interest rate were 6% rather than 8%. 5. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT? Answer The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity. The periodic interest rate is greater than 3%. The periodic rate is less than 3%. The present value would be greater if the lump sum were discounted back for more periods. The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually. 6. You are considering two equally risky annuities, each of which pays $25,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT? Answer If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant. A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ. The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD. The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE. The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD. 7. Which of the following statements is CORRECT? Answer Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature. A sinking fund provision makes a bond more risky to investors at the time of issuance. Sinking fund provisions never require companies to retire their debt; they only establish â€œtargetsâ€ for the company to reduce its debt over time. If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued. 8. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by: Answer Tax effects. Default risk differences. Maturity risk differences. Inflation differences. Real risk-free rate differences. 9. Which of the following statements is CORRECT? Answer All else equal, long-term bonds have less interest rate price risk than short-term bonds. All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds. All else equal, short-term bonds have less reinvestment rate risk than long-term bonds. All else equal, long-term bonds have less reinvestment rate risk than short-term bonds. All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds. 10. Which of the following statements is CORRECT? Answer Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk. Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk. Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold. 11. Which of the following statements is CORRECT? Answer If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. Reinvestment rate risk is worse from an investorâ€™s standpoint than interest rate price risk if the investor has a short investment time horizon. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value. 12. Which of the following statements is CORRECT? Answer The total yield on a bond is derived from dividends plus changes in the price of the bond. Bonds are riskier than common stocks and therefore have higher required returns. Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies. The market value of a bond will always approach its par value as its maturity date approaches, provided the bondâ€™s required return remains constant. If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices. 13. Bonds A and B are 15-year, $1,000 face value 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%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT? Answer One year from now, Bond Aâ€™s price will be higher than it is today. Bond Aâ€™s current yield is greater than 8%. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. 14. Which of the following statements is CORRECT? Answer If the risk-free rate rises, then the market risk premium must also rise. If a companyâ€™s beta is halved, then its required return will also be halved. If a companyâ€™s beta doubles, then its required return will also double. The slope of the security market line is equal to the market risk premium, (rM ? rRF). Beta is measured by the slope of the security market line. 15. Recession, inflation, and high interest rates are economic events that are best characterized as being Answer company-specific risk factors that can be diversified away. among the factors that are responsible for market risk. risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. irrelevant except to governmental authorities like the Federal Reserve. systematic risk factors that can be diversified away. 16. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT? Answer If a stockâ€™s beta doubled, its required return under the CAPM would also double. If a stockâ€™s beta doubled, its required return under the CAPM would more than double. If a stockâ€™s beta were 1.0, its required return under the CAPM would be 5%. If a stockâ€™s beta were less than 1.0, its required return under the CAPM would be less than 5%. If a stock has a negative beta, its required return under the CAPM would be less than 5%. 17. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? Answer The expected return of your portfolio is likely to decline. The diversifiable risk will remain the same, but the market risk will likely decline. Both the diversifiable risk and the market risk of your portfolio are likely to decline. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change. 18. Which of the following statements is CORRECT? Answer Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period. Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move. You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks. If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline. Paid-in-Full Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Paid-in-Fullâ€™s revenues, profits, and stock price tend to rise during recessions. This suggests that Paid-in-Full Inc.â€™s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak. 19. Stock Aâ€™s beta is 1.7 and Stock Bâ€™s beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct. Answer In equilibrium, the expected return on Stock B will be greater than that on Stock A. When held in isolation, Stock A has more risk than Stock B. Stock B would be a more desirable addition to a portfolio than A. In equilibrium, the expected return on Stock A will be greater than that on B. Stock A would be a more desirable addition to a portfolio then Stock B. 20. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? Answer If one stock has a higher dividend yield, it must also have a lower dividend growth rate. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. The two stocks must have the same dividend growth rate. The two stocks must have the same dividend yield. The two stocks must have the same dividend per share. 21. Merrell Enterprisesâ€™ stock has an expected return of 14%. The stockâ€™s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? Answer The stockâ€™s dividend yield is 8%. The current dividend per share is $4.00. The stock price is expected to be $54 a share one year from now. The stock price is expected to be $57 a share one year from now. The stockâ€™s dividend yield is 7%. 22. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? Answer 6.01% 6.17% 6.33% 6.49% 6.65% 23. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think Answer the stock should be sold. the stock is a good buy. management is probably not trying to maximize the price per share. dividends are not likely to be declared. the stock is experiencing supernormal growth. 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 $25 Expected growth (constant) 10% 5% Required return 15% 15% Answer Stock A has a higher dividend yield than Stock B. Currently the two stocks have the same price, but over time Stock Bâ€™s price will pass that of A. Since Stock Aâ€™s growth rate is twice that of Stock B, Stock Aâ€™s future dividends will always be twice as high as Stock Bâ€™s. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. Stock Aâ€™s expected dividend at t = 1 is only half that of Stock B. 25. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? Answer Stock B must have a higher dividend yield than Stock A. Stock A must have a higher dividend yield than Stock B. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock Bâ€™s. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock Bâ€™s.

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