Question
INSTRUCTIONS:!Choose&the&BEST&answer.&Assume&all&bonds&have&a&par&value&of& $1,000&and&pay&interest&annually,&unless&otherwise&specified.&Please&make&sure&your& financial&calculator&is&set&to& &Mode.&! !! DETERMINING.THE.VALUE.OF.FIXED.INCOME.SECURITIES! ! 1. You!are!considering!purchasing!a!bond!with!a!5%!coupon!and!10=years!left! to!maturity.!Similar!bonds!are!paying!6%!interest!currently.!What!is!the! appropriate!price!of!this!bond?! !!!!! 2. What!would!your!answer!be!to!#1!if!the!current!interest!rate!environment! were!4%?! !!!!! 3. What!would!your!answer!be!to!#1!if!the!bond!made!semi=annual!payments?! !!!!!! 4. Is!the!bond!in!#1!trading!at!a!premium!or!discount?! !!!! 5. What!will!happen!to!the!price!of!the!bond!as!it!approaches!maturity! assuming!everything!else!stays!the!same?!
INSTRUCTIONS:!Choose&the&BEST&answer.&Assume&all&bonds&have&a&par&value&of&
$1,000&and&pay&interest&annually,&unless&otherwise&specified.&Please&make&sure&your&
financial&calculator&is&set&to&
!!
DETERMINING.THE.VALUE.OF.FIXED.INCOME.SECURITIES!
!
1. You!are!considering!purchasing!a!bond!with!a!5%!coupon!and!10=years!left!
to!maturity.!Similar!bonds!are!paying!6%!interest!currently.!What!is!the!
appropriate!price!of!this!bond?!
!!!!!
2. What!would!your!answer!be!to!#1!if!the!current!interest!rate!environment!
were!4%?!
!!!!!
3. What!would!your!answer!be!to!#1!if!the!bond!made!semi=annual!payments?!
!!!!!!
4. Is!the!bond!in!#1!trading!at!a!premium!or!discount?!
!!!!
5. What!will!happen!to!the!price!of!the!bond!as!it!approaches!maturity!
assuming!everything!else!stays!the!same?!
!!!! 6. Is!the!bond!in!#2!trading!at!a!premium!or!discount?!
7. What!will!happen!to!the!price!of!the!bond!as!it!approaches!maturity!
assuming!everything!else!stays!the!same?!
!!!!
8. Bond!prices!are!inversely!related!to!interest!rates.!That!is,!as!interest!rates!
go!up,!bond!prices!go!down!and!vice!versa.!
a. True!
b. False!
!
9. The!rate!of!return!on!a!bond!if!it!is!held!until!maturity!is!its!Yield!to!Maturity!
(YTM).!What!is!the!YTM!of!a!bond!that!can!be!bought!for!$900,!has!an!annual!
coupon!of!5%!and!10!years!until!maturity?!
!!!!!
10. What!is!the!current!yield!of!the!bond!in!the!prior!problem?!
!!!!!!
ESTIMATING.THE.VALUE.OF.EQUITY.SECURITIES!
!
1. A!stocks!last!dividend!was!$2.00!per!share.!Expected!growth!of!5%!in!this!
dividend!is!expected!to!be!constant.!The!required!rate!of!return!on!equity!is!
10%!and!the!WACC!is!8%.!What!is!the!appropriate!price!of!this!stock?!
!!!!!
2. FastGro,!Inc.!is!expected!to!grow!its!current!$2.00!dividend!by!10%!for!the!
next!three!years.!Growth!beyond!that!year!is!expected!to!be!constant!at!5%.!
The!required!rate!of!return!is!10%.!What!is!the!appropriate!price!of!this!
stock?!
!!!!!
3. Small!changes!in!either!expected!dividend!growth!or!required!rate!of!return!
results!in!very!large!changes!in!estimated!value.!
a. True! ! ! ! ! !b.!!False!
!
4. You!work!in!the!treasury!department!of!a!large!corporation.!Your!boss!asks!
you!to!estimate!the!expected!return!of!the!stocks!in!the!companys!
investment!portfolio.!The!first!stock!you!examine!is!expected!to!pay!a!
dividend!of!$2.00!this!year!and!currently!trades!at!!$50.!You!check!analyst!
estimates!and!learn!that!long=term!growth!is!expected!to!be!6%!for!this!
company.!Based!upon!this!information,!what!return!would!you!expect!this!
stock!to!have!in!the!coming!year?!
!!!!!
5. Sometimes!firms!do!not!pay!dividends.!More!importantly,!dividend!policy!is!
discretionary!and!may!change!at!managements!whim.!Therefore,!a!superior!
and!more!common!way!to!value!a!firm!(and,!ultimately!its!equity!or!stock!
price)!is!via!a!Discounted!Cash!Flow!(DCF)!analysis.!!In!a!DCF,!you!must!
estimate!the!Free!Cash!Flow!(FCF)!of!the!firm!for!several!years!into!the!
future!(usually!at!least!5!and!often!10!or!more).!What!is!the!value!of!a!firm!
with!the!following!characteristics?!
FCF1!=!100!
FCF2!=!120!
FCF3!=!140!
Growth!in!FCF!after!year!3!of!5%!per!year!
WACC!=!8%!
! !
6. Relativity,!Inc.!has!the!following!financial!data:!
EPS!=!$2.00!
DIV!=!$1.00!
BVPS!=!$10.00!
!
A!group!of!peer!companies!trade!at!the!following!multiples,!on!average:!
P/E!=!14x!!
Dividend!Yield!=!3%!
P/B!=!3x!
!
What!estimate!of!stock!price!do!you!get!for!Relativity,!Inc.!using!each!of!these!
data?!
!!!!!!
!!
THE.EFFICIENT.MARKET.HYPOTHESIS!
!
1. There!are!three!forms!of!market!efficiency.!Which!form!of!efficiency!states!
that!all!information!in!past!price!movements!are!reflected!in!current!market!
prices?!That!is,!the!study!of!charts!and!price!patterns!will!not!help!you!
predict!future!stock!price!movements?!
a. Weak=Form!Efficiency!
b. Semi=Strong=Form!Efficiency!
c. Strong=Form!Efficiency!
!
2. There!are!three!forms!of!market!efficiency.!Which!form!of!efficiency!states!
that!current!stock!(e.g.!market)!prices!reflect!all!publicly!available!
information!about!a!company?!
a. Weak=Form!Efficiency!
b. Semi=Strong=Form!Efficiency!
c. Strong=Form!Efficiency!
!
3. There!are!three!forms!of!market!efficiency.!Which!form!of!efficiency!states!
that!current!stock!(e.g.!market)!prices!reflect!all!publicly!and!privately!
available!information!about!a!company?!
a. Weak=Form!Efficiency!
b. Semi=Strong=Form!Efficiency!
c. Strong=Form!Efficiency!
4. Given!what!you!know!about!market!efficiency,!does!technical!analysis!(the!
study!of!past!price/volume!charts!in!the!hopes!of!predicting!future!price!
movements)!work?!
a. Yes,!but!only!in!the!weak=form.!
b. No.!Even!weak=form!efficiency!suggests!that!technical!analysis!can!not!
help!you!predict!future!stock!price!movements.!
!
5. Given!what!you!know!about!market!efficiency,!can!stock!analysts!
consistently!determine!future!price!movements!and!outperform!the!market?!
a. Yes,!but!only!in!the!weak=form.!
b. Yes,!but!only!in!the!semi=strong=form.!
c. Yes.!Analysts!are!smart!and!can!predict!the!market!in!any!form.!
d. No.!Analysts!are!idiots.!
!
6. Evidence!suggests!that!the!market!is!highly!efficient!in!what!form?!
a. The!Weak=form!
b. The!Semi=strong=form!
c. The!Strong=form!
!
7. Evidence!suggests!the!market!is!reasonably!efficient!in!what!form?!
a. The!Weak=form!
b. The!Semi=strong=form!
c. The!Strong=form!
!
8. Evidence!suggests!the!market!is!NOT!efficient!in!what!form?!
a. The!Weak=form!
b. The!Semi=strong=form!
c. The!Strong=form!
!
CREDIT.AND.INTEREST.RATE.RISK.
!
1. The!longer!the!maturity!of!a!bond!the!more!its!price!will!change!in!response!
to!a!given!change!in!interest!rates.!This!is!called!interest!rate!risk.!
a. True! ! ! ! b.!!False!
2. Bonds!with!short!maturities!face!reinvestment!rate!risk!where!future!
interest!rates!might!be!lower!as!short=term!bonds!become!due.!This!means!
that!investors!would!be!reinvesting!their!maturing!bonds!at!lower!and!lower!
interest!rates.!!
a. True! ! ! ! b.!!False!
3. Why!does!a!normal!yield!curve!usually!slope!upward?!
a. Default!risk!is!greater!the!longer!you!must!wait!to!get!your!money!back!
b. Inflation!risks!are!greater!the!longer!you!must!wait!to!get!your!money!
back!
c. Interest!rate!risk!is!higher!for!longer!term!bonds!
d. All!of!the!above!
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