978-0134083308 Chapter 4 Part 1

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Fundamentals of Investing, 13e (Smart)

Chapter 4 Return and Risk

4.1 Learning Goal 1

1) Investors can be confidently predict future returns on an investment by studying its past

performance.

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Learning Goal: Learning Goal 1

2) An investment that has earned a high rate of return over the last 5 years will not necessarily

continue to perform well in the future.

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3) Meaningful measures of an investment’s return must consider both income and capital gains.

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4) In response to the same external force, the return on one investment may increase while the

return on another investment may decrease.

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5) In the short term, stock prices tend to rise as inflation rises.

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6) When investors expect higher inflation, they will generally require higher rates of return.

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7) A capital loss is computed by

A) subtracting the original cost of an investment from the proceeds received from the sale of

that investment minus any income from the investment.

B) subtracting the original cost of an investment from the proceeds received from the sale of

that investment plus any income from the investment.

C) subtracting the proceeds received from the sale of an investment from the original cost of

the investment.

D) subtracting the original cost of an investment from the proceeds received from the sale of

that investment.

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8) Rational investor’s are motivated to purchase an asset because of its

A) expected returns.

B) past returns.

C) emotional benefits.

D) all of the above.

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9) The most predictable component of stock returns is

A) capital gains.

B) capital losses.

C) inflation adjusted return.

D) dividend income.

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10) Kelly bought a stock at a price of $22.50. She received a $1.75 dividend and sold the stock

for $24.75. What is Kelly’s capital gain on this investment?

A) $4.00

B) $3.75

C) $2.25

D) $1.75

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11) Ashley purchased a stock at a price of $27 a share. She received quarterly dividends of

$0.75 per share. After one year, Ashley sold the stock at a price of $29.25 a share. What is her

percentage holding period return on this investment?

A) 10.3%

B) 11.1%

C) 17.9%

D) 19.4%

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12) Inflation tends to have a particularly negative impact on the price of

A) real estate.

B) bonds.

C) gold.

D) crude oil.

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13) Historically, what is the correct ranking of the following securities from lowest rate of

return to the

highest?

A) Short-term government bills, long-term government bonds, stocks.

B) Long-term government bonds, short-term government bills, stocks.

C) Stocks, short-term government bills,long-term government bonds.

D) Historical returns do not exhibit a consistent pattern.

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14) Which of the following internal characteristics should cause investors to expect the highest

rate of return?

A) a steady record of past dividends

B) interest and principal guaranteed by the U.S. government

C) a record of excellent management and consistent dividend payments

D) poor management and excessive use of debt financing

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15) Which of the following investments may be impacted by government actions?

A) stocks

B) corporate bonds

C) government bonds

D) all of the above

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16) Over the long term, which one of the following has historically had the lowest risk and

lowest average annual rate of return?

A) common stock

B) long-term government bonds

C) real-estate

D) corporate bonds

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4.2 Learning Goal 2

1) The financial concept of time value of money is dependent upon the opportunity to earn

interest over time.

relationship between interest rates and the time value of money

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2) Compound interest is interest paid not only on the initial investment but also on any interest

earned after the initial investment.

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3) An investor who requires a 7% rate of return should be willing to pay $934.58 now to

receive $1,000 at the end of one year.

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4) The holding period return includes the time value of money.

relationship between interest rates and the time value of money

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5) If the discount rate is appropriate for the level of risk, a satisfactory investment will have a

present value of benefits equal to or greater than than the present value of costs.

relationship between interest rates and the time value of money

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6) An investment’s internal rate of return does not depend on the rate at which income from the

investment is reinvested.

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7) The time value of money concept best supports the idea of

A) the sooner the better.

B) better late than never.

C) a bird in hand is worth two in the bush.

D) good things come to those who wait.

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8) The present value of $10,000 discounted at 5% per year and received at the end of 5 years is

A) $10,000/1.25.

B) $10,000(1.05)5.

C) $10,000/(1.05)5.

D) $10,000 (1.05)1/5.

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9) Bob’s house has doubled in value since he bought it 30 years ago. The house’s value has

increased by an annual rate of

A) 2.34%.

B) 3.33%.

C) 6.67%.

D) 100%.

relationship between interest rates and the time value of money

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10) Which one of the following statements is correct concerning the time value of money?

A) The future value of $1 at the end of two years is equal to $1 plus the first year’s interest

times 1 plus the annual interest rate.

B) As the interest rate increases for any given year, the future value interest factor will

decrease.

C) The future value of $1 decreases with the passage of time.

D) The future value interest factor is equal to zero if the interest rate is zero.

relationship between interest rates and the time value of money

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11) Christopher invests $400 today at a 4% rate of return which is compounded annually. What

is the future value of this investment after four years?

A) $342

B) $416

C) $464

D) $468

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12) Roy is going to receive a payment of $5,000 one year from today. He earns an average of

6% on his investments. What is the present value of this payment?

A) $4,717

B) $4,821

C) $5,000

D) $5,300

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13) Which of the following statements are correct concerning the present value of $1.00 five

years from today discounted at 5%?

I. The present value is equal to $1.00 divided by 1.05 to the 5th power.

II. If the discount rate were less than 5%, the present value would be smaller.

III. If the discount rate were more than 5%, the present value would be smaller.

IV. If the $1.00 were to be received 6 years from today, the present value would be larger.

A) I and II only

B) I and III only

C) II and III only

D) I, III and IV only

relationship between interest rates and the time value of money

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14) Camille purchased a bond 5 years ago for $1,050. The bond paid $50 in annual interest and

returned the $1,000 principal at the end of the fifth year. Camille used the interest payment to

pay for college textbooks.

A) Her internal rate of return was exactly than 5%.

B) Her internal rate of return was greater than 5%.

C) Her internal rate of return was less than 5%.

D) Her internal rate of return cannot be determined.

relationship between interest rates and the time value of money

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15) When calculating the present value of either a future single sum or a future annuity, the

applicable interest rate is usually called the

A) yield to maturity.

B) compound interest rate.

C) internal rate of return.

D) discount rate.

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16) When the rate of return is equal to the discount rate

A) the present value of an investment’s benefits must be greater than its cost.

B) the cost of an investment equals the sum of its benefits.

C) the cost of an investment equals the future value of its benefits.

D) the cost of an investment equals the present value of its benefits.

relationship between interest rates and the time value of money

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17) If the present value of an investment’s benefits equals the present value of the investment’s

costs, then the investor would earn a

A) return equal to the discount rate.

B) negative rate of return.

C) 0% rate of return.

D) return greater than the discount rate.

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18) The present value of $1,000 discounted at the rate of 5% per year, to be received at the end

of 3 years is equal to

A) $1,000/(1.03)5.

B) $1,000/(1.05)3.

C) $1,000 × (1.05)3.

D) $1,000 – ($1,000) × .03 × 5.

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19) Zachary has purchased an investment that he expects to produce income of $3,000 at the

end of the first year and $4,000 at the end of the second year. If he requires an 8% rate of

return compounded annually, what is the maximum amount that he can pay and still earn the

required rate of return?

relationship between interest rates and the time value of money

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20) Zachary has purchased an investment that he expects to produce income of $3,000 at the

end of the first year and $4,000 at the end of the second year. If he pays $5,800 for this

investment, what is the internal rate of return?

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4.3 Learning Goal 3

1) The return that fully compensates for the risk of an investment is called the risk-free rate of

return.

influence investment choices

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2) The required return on a risky investment includes a real rate of return, an inflation premium

and a risk premium.

influence investment choices

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Learning Goal: Learning Goal 3