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Chapter 29: Basic Financial Tools: A review
DIFFICULTY:
Difficulty: Moderate
49. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free
rate.
a.
True
b.
False
ANSWER:
True
50. The Y-axis intercept of the SML indicates the required return on an individual asset whenever the realized return on
an average (b = 1) stock is zero.
a.
True
b.
False
ANSWER:
False
51. Since the market return represents the expected return on an average stock, the market return reflects a certain amount
of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is
required to compensate stock investors for assuming an average amount of risk.
a.
True
b.
False
ANSWER:
True
52. Midway through the life of an amortized loan, the percentage of the payment that represents interest must be equal to
the percentage that represents repayment of principal. This is true regardless of the original life of the loan or the interest
rate on the loan.
a.
True
b.
False
ANSWER:
False
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53. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is
CORRECT?
a.
The bond is selling below its par value.
b.
The bond is selling at a discount.
c.
If the yield to maturity remains constant, the bond's price one year from now will be lower than its current
price.
d.
The bond's current yield is greater than 9%.
e.
If the yield to maturity remains constant, the bond's price one year from now will be higher than its current
price.
ANSWER:
c
54. Which of the following statements is CORRECT?
a.
If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%,
this implies that the stock's dividend yield is also 5%.
b.
The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to
decline at a constant rate, i.e., to grow at a negative rate.
c.
The price of a stock is the present value of all expected future dividends, discounted at the dividend growth
Chapter 29: Basic Financial Tools: A review
rate.
d.
The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain
constant over time.
e.
The constant growth model is often appropriate for evaluating start-up companies that do not have a stable
history of growth but are expected to reach stable growth within the next few years.
ANSWER:
b
55. Which of the following bonds would have the greatest percentage increase in value if all interest rates fall by 1%?
a.
20-year, 10% coupon bond.
b.
20-year, 5% coupon bond.
c.
1-year, 10% coupon bond.
d.
20-year, zero coupon bond.
e.
10-year, zero coupon bond.
ANSWER:
d
56. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the
largest percentage increase in price?
a.
A 1-year bond with a 15% coupon.
b.
A 3-year bond with a 10% coupon.
c.
A 10-year zero coupon bond.
d.
A 10-year bond with a 10% coupon.
e.
An 8-year bond with a 9% coupon.
ANSWER:
c
57. Which of the following bonds has the greatest interest rate price risk?
a.
A 10-year, $1,000 face value, zero coupon bond.
b.
A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.
c.
All 10-year bonds have the same price risk since they have the same maturity.
d.
A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.
e.
A 10-year $100 annuity.
ANSWER:
a
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58. If its yield to maturity declined by 1%, which of the following bonds would have the largest percentage increase in
value?
a.
A 1-year bond with an 8% coupon.
b.
A 10-year bond with an 8% coupon.
c.
A 10-year bond with a 12% coupon.
d.
A 10-year zero coupon bond.
e.
A 1-year zero coupon bond.
ANSWER:
d
59. Which of the following statements is CORRECT?
a.
Time lines cannot be constructed where some of the payments constitute an annuity but others are unequal and
thus are not part of the annuity.
b.
A time line is not meaningful unless all cash flows occur annually.
c.
Time lines are not useful for visualizing complex problems prior to doing actual calculations.
d.
Time lines can be constructed to deal with situations where some of the cash flows occur annually but others
occur quarterly.
e.
Time lines can only be constructed for annuities where the payments occur at the end of the periods, i.e., for
Chapter 29: Basic Financial Tools: A review
ordinary annuities.
ANSWER:
d
60. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected
cash flows. Which of the following would lower the calculated value of the investment?
a.
The discount rate decreases.
b.
The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity
lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.
c.
The discount rate increases.
d.
The riskiness of the investment's cash flows decreases.
e.
The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years
and less are received in the later years.
ANSWER:
c
61. Which of the following statements is CORRECT?
a.
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.
b.
The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.
c.
If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition
an annuity.
d.
The cash flows for an annuity due must all occur at the ends of the periods.
e.
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.
ANSWER:
e
62. Your bank account pays a 5% nominal rate of interest. The interest is compounded quarterly. Which of the following
statements is CORRECT?
a.
The periodic rate of interest is 5% and the effective rate of interest is also 5%.
b.
The periodic rate of interest is 1.25% and the effective rate of interest is 2.5%.
c.
The periodic rate of interest is 5% and the effective rate of interest is greater than 5%.
d.
The periodic rate of interest is 1.25% and the effective rate of interest is greater than 5%.
e.
The periodic rate of interest is 2.5% and the effective rate of interest is 5%.
ANSWER:
d
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63. A $250,000 loan is to be amortized over 8 years, with annual end-of-year payments. Which of these statements is
CORRECT?
a.
The proportion of interest versus principal repayment would be the same for each of the 8 payments.
b.
The annual payments would be larger if the interest rate were lower.
c.
If the loan were amortized over 10 years rather than 8 years, and if the interest rate were the same in either
case, the first payment would include more dollars of interest under the 8-year amortization plan.
d.
The proportion of each payment that represents interest as opposed to repayment of principal would be lower
if the interest rate were lower.
e.
The last payment would have a higher proportion of interest than the first payment.
ANSWER:
d
64. Which of the following statements regarding a 20-year (240-month) $225,000, fixed-rate mortgage is CORRECT?
(Ignore taxes and transactions costs.)
a.
The outstanding balance declines at a slower rate in the later years of the loan's life.
Chapter 29: Basic Financial Tools: A review
b.
The remaining balance after three years will be $225,000 less one third of the interest paid during the first
three years.
c.
Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal
payments) are constant.
d.
Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will
remain constant.
e.
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.
ANSWER:
c
65. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest
rate of 8% is CORRECT?
a.
Exactly 8% of the first monthly payment represents interest.
b.
The monthly payments will decline over time.
c.
A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal,
than for the first monthly payment.
d.
The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity.
e.
The amount representing interest in the first payment would be higher if the nominal interest rate were 6%
rather than 8%.
ANSWER:
c
66. 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.
a.
Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).
b.
Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments).
c.
Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20
payments).
d.
Investment D pays $2,500 at the end of 10 years (just one payment).
e.
Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).
ANSWER:
a
67. Of the following investments, which would have the lowest present value? Assume that the effective annual rate for
all investments is the same and is greater than zero.
a.
Investment A pays $250 at the end of every year for the next 10 years (a total of 10 payments).
b.
Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments).
c.
Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20
payments).
d.
Investment D pays $2,500 at the end of 10 years (just one payment).
e.
Investment E pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).
ANSWER:
d
68. 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?
a.
The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity.
b.
The periodic interest rate is greater than 3%.
c.
The periodic rate is less than 3%.
d.
The present value would be greater if the lump sum were discounted back for more periods.
e.
The present value of the $1,000 would be smaller if interest were compounded monthly rather than
semiannually.
ANSWER:
e
69. Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant?
a.
Banks A and B offer the same nominal annual rate of interest, but A pays interest quarterly and B pays
semiannually. Deposits in Bank B will provide the higher future value if you leave your funds on deposit.
b.
The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity.
c.
A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year
mortgage.
d.
A bank loan's nominal interest rate will always be equal to or less than its effective annual rate.
e.
If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%.
ANSWER:
d
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70. Which of the following statements is CORRECT?
a.
An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is
smaller than 6%.
b.
The present value of a 3-year, $150 annuity due will exceed the present value of a 3-year, $150 ordinary
annuity.
c.
If a loan has a nominal annual rate of 8%, then the effective rate can never be greater than 8%.
d.
If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all
be different.
e.
The proportion of the payment that goes toward interest on a fully amortized loan increases over time.
ANSWER:
b
71. 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?
a.
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.
b.
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.
c.
The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the
Chapter 29: Basic Financial Tools: A review
future value of ORD.
d.
The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the
future value of DUE.
e.
The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the
future value of ORD.
ANSWER:
e
72. 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?
a.
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.
b.
Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next
year.
c.
Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year.
d.
Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to stay the same, and
Bond C's price is expected to increase.
e.
Bond A's current yield will increase each year.
ANSWER:
c
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73. 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?
a.
The bond is currently selling at a price below its par value.
b.
If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.
c.
The bond should currently be selling at its par value.
d.
If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today.
e.
If market interest rates decline, the price of the bond will also decline.
ANSWER:
b
74. An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both bonds have the
same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following
statements would be CORRECT?
a.
Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.
b.
The prices of both bonds would increase by the same amount.
c.
One bond's price would increase, while the other bond's price would decrease.
Chapter 29: Basic Financial Tools: A review
d.
The prices of the two bonds would remain constant.
e.
The prices of both bonds will decrease by the same amount.
ANSWER:
a
75. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and
the YTM is expected to remain constant. Which of the following statements is CORRECT?
a.
The prices of both bonds will remain unchanged.
b.
The price of Bond A will decrease over time, but the price of Bond B will increase over time.
c.
The prices of both bonds will increase by 7% per year.
d.
The prices of both bonds will increase over time, but the price of Bond A will increase by more.
e.
The price of Bond B will decrease over time, but the price of Bond A will increase over time.
ANSWER:
b
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76. Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. Bond A's price exceeds its par value,
Bond B's price equals its par value, and Bond C's price is less than its par value. Which of the following statements is
CORRECT?
a.
Bond A has the most interest rate risk.
b.
If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same
over the next year.
c.
If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.
d.
Bond C sells at a premium over its par value.
e.
If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its
price.
ANSWER:
c
77. You are considering investing in one of these three stocks:
Stock
Standard Deviation
Beta
A
20%
0.59
B
10%
0.61
C
12%
1.29
If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be
held as part of a well-diversified portfolio.
a.
A; B.
b.
B; A.
Chapter 29: Basic Financial Tools: A review
c.
C; A.
d.
C; B.
e.
A; A.
ANSWER:
b
78. Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in
a diversified portfolio?
a.
Standard deviation; correlation coefficient.
b.
Beta; variance.
c.
Coefficient of variation; beta.
d.
Beta; beta.
e.
Variance; correlation coefficient.
ANSWER:
c
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79. Your friend is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. She is highly
risk averse and has asked for your advice. The three stocks currently held all have b = 1.0, and they are perfectly
positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in
equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is
12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?
a.
Stock A.
b.
Stock B.
c.
Neither A nor B, as neither has a return sufficient to compensate for risk.
d.
Add A, since its beta must be lower.
e.
Either A or B, i.e., the investor should be indifferent between the two.
ANSWER:
b
80. Stock A's beta is 1.7 and Stock B's beta is 0.7. Which of the following statements must be true about these securities?
(Assume market equilibrium.)
a.
Stock B must be a more desirable addition to a portfolio than A.
b.
Stock A must be a more desirable addition to a portfolio than B.
c.
The expected return on Stock A should be greater than that on B.
d.
The expected return on Stock B should be greater than that on A.
e.
When held in isolation, Stock A has more risk than Stock B.
ANSWER:
c
