ANS: B Rate of total return = Dividend yield + Capital gains yield 13.7% = 5.5% + Capital gains yield Capital gains yield = 8.2% Capital gains yield is simply the change in price during the year. Thus: 0.082 = (40 – Price Today) / Price Today Solving for the Price Today yields $36.97. 17 ANS: A The best stock to add to a portfolio is the one with the largest negative correlation with the portfolio’s returns. This will cause the greatest “compression” of portfolio returns, further reducing the portfolio’s standard deviation – and risk. 18 ANS: B The minimum rate of return that adequately compensates an investor for bearing market risk is the CAPM return. In this case: CAPM return = 3% + 1.2 (9%) = 13.8% Notice that the problem provides the market risk premium, not the return on the market, so you do not need to subtract the 3% risk-free rate from the 9% market measure. 19 ANS: B Stocks that plot above the SML offer a higher rate of return for the risk taken (as measured by beta). Investors will search for these stocks and bid up their price in an effort to buy them. When a stock’s price rises, its return falls. The bidding war for a stock plotting above the SML will continue until the price has risen to the point that the stock’s return drops down to the SML. At this point, the bidding will stop. The reverse happens when a stock plots below the SML. Investors will let a stock languish, making no effort to buy it. As a result, the price will decline, thus raising the return. In this case, the price will continue to drop until the return reaches the SML. At this point, the stock will be seen as adequately compensating an investor for bearing market risk, and investors may begin to buy shares.gy 20 ANS: D At $1,000 per bond, the company will need to issue 5,000 bonds ( = $5,000,000 divided by $1,000 per bond). Some problems are just as easy as they seem! 21 ANS: B First, note that the bond is a 5-year bond today (not a 9-year bond). Find the PV of the bond’s future cash flows (5 years of coupon payments and the repayment of principal at maturity). PV = (70 / 0.066) x [ 1 – ( 1 / (1.066)^5)] + [1000 / (1.066)^5 ] = $1,017 If you understand the logic of bond pricing, you’ll recognize that the bond must be trading at a premium to par because the bond’s coupon rate (7%) is greater than the required return (YTM = 6.6%). required return (YTM 22 ANS: B from Chapter 12 = (stock risk premium) / (market risk premium) = 8 / 10 = 0.80 23 ANS: B from Chapter 12 If 15-20 stocks is enough to eliminate a good deal of the unique risk from a stock portfolio, then you can imagine that next-to-no unique risk is left in a mutual fund portfolio that might contain 80-100 or more stocks. Indeed, mutual funds typically contain only market risk (which, of course, cannot be diversified). 24 ANS: A from Chapter 6 Value today: $50 coupon @ 6.5% YTM for 18 years with $1,000 par value = 843.51 Value one year from today: $50 coupon @ 6% YTM for 17 years with $1,000 par value = 895.23 Total return: = [ 50 + (895.23 – 843.51) ] / 843.51 = 12.1% 25 ANS: A from Chapter 6 At a premium to par, the bond trades above $1,000, which means the coupon rate will exceed the current yield (with a numerator greater than $1,000 numerator of the coupon rate). 26 ANS: C from Chapter 6 A lower rating means greater risk. Investors will demand a higher default premium to compensate for the greater risk. 27 ANS: C from Chapter 6 With a $1,000 par value, 13 years to maturity, and a 9% YTM, the bond is worth $326.18 today. With a $1,000 par value, 9 years to maturity, and a 7% YTM, the bond is worth $543 93 four years from today. from today. The difference is $218 ( = 543.93 – 326.18, rounded to the nearest dollar) 28 ANS: D from Chapter 7 Stock price = PV of each of the first 3 dividends, plus the PV of the dividend stream beyond Year 3 (growing perpetuity) PV of 2.35 one year from today = 2.08 PV of 2.90 two years from today = 2.27 PV of 3.40 three years from today = 2.36 The PV of the growing perpetuity = 1.05 (3.40) / (0.13 – 0.05) = 44.63 where 1.05 (3.40) is the Year 4 dividend (first dividend under perpetuity) The date of the perpetuity PV is Year 3. Discounted back to today = 30.93 Adding all the PV pieces = 2.08 + 2.27 + 2.36 + 30.93 = 37.64 29 ANS: D The stock’s sustainable growth rate = 0.20 (0.40) = 0.08 (8%) The SGR is the maximum rate of growth that KBM can “sustain” from reinvested earnings (without changing its leverage) Price of stock with dividend growth at the 8% sustainable rate (Gordon Model): = 3.25 / (0.12 – 0.08) = 81.25 Price of stock with no retention of earnings (100% dividend payout / SGR = 0): = 5.417 / 0.12 = 45.14 where EPS = 3.25 / 0.60 = 5.417 Thus, PVGO = 81.25 – 45.17 = 36.08 N t th t 44 4% f th t k’ l i b d ( t i ) f t f th 30 o e a 44.4% o e s ock’s va ue s ase on uncer a n u ure per ormance; e rest on assets-in-place (today). PVGO is often the source of high P/E ratios. Bill Microsoft PowerPoint - BFIN 620 Practice Exam Questions WI2010 NEW JAN20 [Compatibility Mode]