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1 Which of the following statements regarding a 20-year (240-month) $225,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) The outstanding balance declines at a slower rate in the later years of the loan’s life. The remaining balance after three years will be $225,000 less one third of the interest paid during the first three years. Because it is a fixed-rate mortgage, the monthly loan payments (which include both interest and principal payments) are constant. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. 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. 2 Which of the following statements is CORRECT, assuming positive interest rates and holding other things constant? 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. The present value of a 5-year, $250 annuity due will be lower than the PV of a similar ordinary annuity. A 30-year, $150,000 amortized mortgage will have larger monthly payments than an otherwise similar 20-year mortgage. A bank loan’s nominal interest rate will always be equal to or less than its effective annual rate. If an investment pays 10% interest, compounded annually, its effective annual rate will be less than 10%. 3 Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding? $205.83 $216.67 $228.07 $240.08 $252.08 4 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 increase the calculated value of the investment? The discount rate increases. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for 10 years rather than 5 years, hence that each payment is for $10,000 rather than for $20,000. The discount rate decreases. The riskiness of the investment’s cash flows increases. The total amount of cash flows remains the same, but more of the cash flows are received in the later years and less are received in the earlier years. 5 Which of the following statements is CORRECT? An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%. The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. If a loan has a nominal annual rate of 7%, then the effective rate will never be less than 7%. If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different. The proportion of the payment that goes toward interest on a fully amortized loan increases over time. 6 A $150,000 loan is to be amortized over 6 years, with annual end-of-year payments. Which of these statements is CORRECT? The proportion of interest versus principal repayment would be the same for each of the 7 payments. The annual payments would be larger if the interest rate were lower. If the loan were amortized over 10 years rather than 6 years, and if the interest rate were the same in either case, the first payment would include more dollars of interest under the 6-year amortization plan. The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were lower. The proportion of each payment that represents interest versus repayment of principal would be higher if the interest rate were higher. 7 Which of the following statements is CORRECT? If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value. Other things held constant, a corporation would rather issue noncallable bonds than callable bonds. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond. Reinvestment rate risk is worse from an investor’s standpoint than interest rate price risk if the investor has a short investment time horizon. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value. 8 A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? The bond is selling below its par value. The bond is selling at a discount. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price. The bond’s current yield is greater than 9%. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price. 9 Which of the following statements is NOT CORRECT? All else equal, bonds with longer maturities have more interest rate (price) risk than bonds with shorter maturities. If a bond is selling at its par value, its current yield equals its yield to maturity. If a bond is selling at a premium, its current yield will be greater than its yield to maturity. All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds with smaller coupons. If a bond is selling at a discount to par, its current yield will be less than its yield to maturity. 10 A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is NOT CORRECT? The bond’s yield to maturity is 9%. The bond’s current yield is 9%. If the bond’s yield to maturity remains constant, the bond will continue to sell at par. The bond’s current yield exceeds its capital gains yield. The bond’s expected capital gains yield is positive. 11 Which of the following statements is CORRECT? If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond. If a bond’s yield to maturity exceeds its annual coupon, then the bond will trade at a premium. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. If a coupon bond is selling at par, its current yield equals its yield to maturity. 12 A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT? If the yield to maturity remains at 8%, then the bond’s price will decline over the next year. The bond’s coupon rate is less than 8%. If the yield to maturity increases, then the bond’s price will increase. If the yield to maturity remains at 8%, then the bond’s price will remain constant over the next year. The bond’s current yield is less than 8%. 13 Bonds A and B are 15-year, $1,000 face value bonds. Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT? One year from now, Bond A’s price will be higher than it is today. Bond A’s current yield is greater than 8%. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price. 14 Which of the following statements is CORRECT? The SML shows the relationship between companies’ required returns and their diversifiable risks. The slope and intercept of this line cannot be influenced by a firm’s managers, but the position of the company on the line can be influenced by its managers. Suppose you plotted the returns of a given stock against those of the market, and you found that the slope of the regression line was negative. The CAPM would indicate that the required rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming investors expect the observed relationship to continue on into the future. If investors become less risk averse, the slope of the Security Market Line will increase. If a company increases its use of debt, this is likely to cause the slope of its SML to increase, indicating a higher required return on the stock. The slope of the SML is determined by the value of beta. 15 Which of the following statements is CORRECT? A portfolio that consists of 40 stocks that are not highly correlated with “the market” will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations. A two-stock portfolio will always have a lower beta than a one-stock portfolio. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. A stock with an above-average standard deviation must also have an above-average beta. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. 16 Stocks A and B each have an expected return of 15%, a standard deviation of 20%, and a beta of 1.2. The returns on the two stocks have a correlation coefficient of +0.6. Your portfolio consists of 50% A and 50% B. Which of the following statements is CORRECT? The portfolio’s expected return is 15%. The portfolio’s standard deviation is greater than 20%. The portfolio’s beta is greater than 1.2. The portfolio’s standard deviation is 20%. The portfolio’s beta is less than 1.2. 17 Stock X has a beta of 0.7 and Stock Y has a beta of 1.7. Which of the following statements must be true, according to the CAPM? Stock Y’s realized return during the coming year will be higher than Stock X’s return. If the expected rate of inflation increases but the market risk premium is unchanged, the required returns on the two stocks should increase by the same amount. Stock Y’s return has a higher standard deviation than Stock X. If the market risk premium declines, but the risk-free rate is unchanged, Stock X will have a larger decline in its required return than will Stock Y. If you invest $50,000 in Stock X and $50,000 in Stock Y, your 2-stock portfolio would have a beta significantly lower than 1.0, provided the returns on the two stocks are not perfectly correlated. 18 Assume that the risk-free rate remains constant, but the market risk premium declines. Which of the following is most likely to occur? The required return on a stock with beta 1.0 will increase. The return on “the market” will remain constant. The return on “the market” will increase. The required return on a stock with beta < 1.0 will decline. The required return on a stock with beta = 1.0 will not change. 19 Which of the following statements is CORRECT? The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks. An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks. 20 Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? 6.01% 6.17% 6.33% 6.49% 6.65% 21 A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? $23.11 $23.70 $24.31 $24.93 $25.57 22 Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? Stock B must have a higher dividend yield than Stock A. Stock A must have a higher dividend yield than Stock B. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s. 23 Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% The two stocks could not be in equilibrium with the numbers given in the question. A’s expected dividend is $0.50. B’s expected dividend is $0.75. A’s expected dividend is $0.75 and B’s expected dividend is $1.20. The two stocks should have the same expected dividend. 24 Which of the following statements is NOT CORRECT? The corporate valuation model discounts free cash flows by the required return on equity. The corporate valuation model can be used to find the value of a division. An important step in applying the corporate valuation model is forecasting the firm’s pro forma financial statements. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. 25 Which of the following statements is CORRECT? Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.