Finance Chapter 16 Default Risk Premium Liquidity Premium

ANSWERS TO CHAPTER QUESTIONS

Chapter 16 Stocks, Bonds, and Mutual Funds

1) Classification Maturity in Years

Money market 0-1

2) Bond maturity dates are correlated with risk. The longer the maturity date the higher

3) Bond ratings provide an assessment, by an independent authority of the risk of default

in interest and principal payments. When ratings are below BBB the authorities are

indicating that they cannot express the opinion that the bonds will likely not have a

default.

4) The three types of bond risks are:

a) Default Risk – The risk of non payment of interest or principal.

5) Bond coupon yield is the annual coupon divided by the par value (usually $1,000).

6) Preferred shares are somewhere between common shares and bonds but closer to

bonds. Like common shares there is no guarantee to repay the sum invested but like

7) Technical analysis generally uses past price and volume to predict future returns.

Fundamental analysis uses a broad array of publicly available information to identify

the “true worth” of an investment and determine whether it is worth purchasing or

holding.

8) A dividend discount model says the current worth of an investment is equal to the

current value of all of its future dividend. So it requires knowledge of the growth rate

9) An open end fund management company stands ready to buy and sell shares at net

asset value. A closed end fund management offers shares at a point in time much like

10) A load fund sells at a price which includes an upfront or continuing commission to

the seller. A true no-load fund provides no commission to the selling agent.

11) The characteristics of the three prominent types of load fuds are as follows:

a) Type A Funds – An upfront commission to the selling agent.

12) Separate accounts assets are placed in an individual client account while mutual

funds pool together many clients’ assets.

13) An exchange traded fund is one in which shares track an independent index of

14) The Sharpe ratio and the alpha coefficient both attempt to measure risk adjusted

performance. The Sharpe ratio uses standard deviation which tracks return results

15) No. The benchmark is wrong. The DJIA is an index of large companies. The

16) The four key steps in selecting a mutual fund are:

a) Compare Fund Returns – use as benchmark funds like the one selected.

b) Look at Fund Risk – Pay attention to such risk measures as standard deviation and

ANSWERS TO CHAPTER PROBLEMS

Chapter 16 Stocks, Bonds, and Mutual Funds

1) Tricontinental’s bond had a liquidity risk of 1 percent, a maturity risk of 2 percent, a

pure rate of return of 1.5 percent, and an inflation premium of 4.0 percent. If the

expected bond yield was 17 percent, what was the default risk? What does your

answer indicate about this bond?

Excel Solution

Tricontinental Bond

Pure Rate of Return 1.5%

Tricontinental Bond

Pure Rate of Return 1.5%

2) Multicolor Corp. had an annual coupon of $60.00, a face value of $1,000, and a

market value of $840. Calculate the coupon yield and the current yield.

Solution:

3) Beth bought a bond at $800 with annual coupon payments of $40. If the bond is due

in nine years and has a par value of $1,000, what is her yield to maturity under both

the approximate method and the more exact method?

Solution:

Yield to Maturity

Calculator Solution

4) If a bond has annual interest payments of $50 and a par value of $1,000, with six

years to maturity, what is its current market value if bonds like it are currently

offering a 7 percent yield?

Calculator Solution

Solution 904.67

5) Pamela bought a bond for $926 with a face value of $1,000 and an annual coupon of

$50. If the bond matures in 18 years, what is her yield to maturity?

Calculator Solution

6) If a preferred stock has annual payments of $6.00 and a required rate of return of 8

percent, what is its current price?

7) Y Co. has a projected dividend of $2.00, has a required rate of return of 8 percent,

and is expected to grow 6 percent a year. Solve for its anticipated stock price.

Solution:

8) X Co. has the latest 12 months’ earnings per share (EPS) of $2.50, expected EPS in

the current year of $3.00, and normalized EPS of $4.00. If its current stock price is

$20, solve for its three P/E multiples based on the separate time frames given.

Solution:

Answers to CFP® Questions

Question

Answer

Author’s Explanation

Question 16.1

B

Question 16.2

D

Question 16.3

D

Question 16.4.1

B

Question 16.4.2

D

Question 16.4.3

A

Question 16.5

C

Question 16.6

A

Question 16.7

Question 16.8

Question 16.9

B

Question 16.10

A

Question 16.11

C

ERRATA TO CFP® CERTIFICATION EXAMINATION QUESTIONS AND

PROBLEMS

16.8

The alternative a. should read “the par value of the common stock”

SOLUTIONS TO SELECTED CFP® CERTIFICATION EXAMINATION

PROBLEMS

1

16.5

The Performance Fund had returns of 19 percent over the evaluation period and the

benchmark portfolio yielded a return of 17 percent over the same period. Over the

evaluation period, the standard deviation of returns from the fund was 23 percent and the

standard deviation of returns from the benchmark portfolio was 21 percent. Assuming a

risk-free rate of return of 8 percent, which one of the following is the calculation of the

Sharpe index for the fund over the evaluation period?

a. .3913

b. .4286

c. .4783

d. .5238

e. .5870

Solution:

1

The solutions supplied are those of the author and not of the CFP Board.

16.7

The current annual dividend of ABC Corporation is $2.00 per share. Five years ago, the

dividend was $1.36 per share. The firm expects dividends to grow in the future at the

same compound annual rate as they grew during the past five years. The required rate of

return on the firm’s common stock is 12 percent. The expected return on the market

portfolio is 14 percent. What is the value of a share of common stock of ABC

Corporation using the constant dividend growth model?

a. $11

b. $17

c. $25

d. $36

e. $54

Solution:

Dividend Growth =

1

36.1

00.2 5

1

−













16.11

The Zeta Corporation’s current dividend is $3.85. If future dividends are expected to

grow at 4 percent forever, which of the following amounts should Zeta stock sell for if

the required rate of return on the stock is 14 percent?

a. $28.57

b. $38.50

c. $40.04

d. $41.60

Solution: