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FIN 534 – MIDTERM 2

December 15, 2020

JG Asset Services is recommending that you invest $1,500 in a 5-year certificate of deposit (CD) that pays 3.5% interest, compounded annually. How much will you have when the CD matures?

Answer

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$1,781.53

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$1,870.61

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$1,964.14

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$2,062.34

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$2,165.46

 

Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT?

Answer

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The periodic rate of interest is 8% and the effective rate of interest is also 8%.

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The periodic rate of interest is 2% and the effective rate of interest is 4%.

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The periodic rate of interest is 8% and the effective rate of interest is greater than 8%.

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The periodic rate of interest is 4% and the effective rate of interest is less than 8%.

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The periodic rate of interest is 2% and the effective rate of interest is greater than 8%.

 

   

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?

Answer

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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.

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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.

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The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD.

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The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE.

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The present value of DUE exceeds the present value of ORD, and the future value of DUE also exceeds the future value of ORD.

 

 

 

 

 

 

 

Which of the following statements is CORRECT?

Answer

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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.

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The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.

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If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity.

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The cash flows for an annuity due must all occur at the ends of the periods.

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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.

 

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?

Answer

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The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity.

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The periodic interest rate is greater than 3%.

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The periodic rate is less than 3%.

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The present value would be greater if the lump sum were discounted back for more periods.

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The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.

 

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.

Answer

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Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).

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Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments).

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Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments).

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Investment D pays $2,500 at the end of 10 years (just one payment).

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Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).

 

 

 

Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

Answer

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Market interest rates rise sharply.

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Market interest rates decline sharply.

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The company’s financial situation deteriorates significantly.

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Inflation increases significantly.

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The company’s bonds are downgraded.

 

Which of the following statements is CORRECT?

Answer

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All else equal, long-term bonds have less interest rate price risk than short-term bonds.

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All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds.

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All else equal, short-term bonds have less reinvestment rate risk than long-term bonds.

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All else equal, long-term bonds have less reinvestment rate risk than short-term bonds.

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All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.

 

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?

Answer

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The bond’s yield to maturity is 9%.

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The bond’s current yield is 9%.

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If the bond’s yield to maturity remains constant, the bond will continue to sell at par.

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The bond’s current yield exceeds its capital gains yield.

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The bond’s expected capital gains yield is positive.

 

Which of the following statements is CORRECT?

Answer

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The total yield on a bond is derived from dividends plus changes in the price of the bond.

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Bonds are riskier than common stocks and therefore have higher required returns.

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Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies.

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The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.

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If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.

 

Which of the following statements is CORRECT?

Answer

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Liquidity premiums are generally higher on Treasury than corporate bonds.

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The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.

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Default risk premiums are generally lower on corporate than on Treasury bonds.

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Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.

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If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

 

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?

Answer

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The bond is currently selling at a price below its par value.

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If market interest rates remain unchanged, the bond’s price one year from now will be lower than it is today.

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The bond should currently be selling at its par value.

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If market interest rates remain unchanged, the bond’s price one year from now will be higher than it is today.

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If market interest rates decline, the price of the bond will also decline.

 

Which of the following statements is CORRECT?

Answer

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Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature.

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A sinking fund provision makes a bond more risky to investors at the time of issuance.

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Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.

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If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.

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Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.

 

 

 

Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?

Answer

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If a stock’s beta doubled, its required return under the CAPM would also double.

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If a stock’s beta doubled, its required return under the CAPM would more than double.

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If a stock’s beta were 1.0, its required return under the CAPM would be 5%.

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If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 5%.

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If a stock has a negative beta, its required return under the CAPM would be less than 5%.

 

Which of the following statements is CORRECT?

Answer

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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.

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A two-stock portfolio will always have a lower beta than a one-stock portfolio.

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If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio.

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A stock with an above-average standard deviation must also have an above-average beta.

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A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio.

 

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT?

Answer

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If a stock has a negative beta, its required return must also be negative.

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An index fund with beta = 1.0 should have a required return less than 11%.

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If a stock’s beta doubles, its required return must also double.

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An index fund with beta = 1.0 should have a required return greater than 11%.

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An index fund with beta = 1.0 should have a required return of 11%.

 

 

 

 

 

 

 

 

 

 

Which of the following statements is CORRECT?

Answer

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The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

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An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks.

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Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount.

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An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

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An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.

 

If you randomly select stocks and add them to your portfolio, which of the following statements best describes what you should expect?

Answer

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Adding more such stocks will increase the portfolio’s expected rate of return.

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Adding more such stocks will reduce the portfolio’s beta coefficient and thus its systematic risk.

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Adding more such stocks will have no effect on the portfolio’s risk.

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Adding more such stocks will reduce the portfolio’s market risk but not its unsystematic risk.

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Adding more such stocks will reduce the portfolio’s unsystematic, or diversifiable, risk.

 

If markets are in equilibrium, which of the following conditions will exist?

Answer

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Each stock’s expected return should equal its required return as seen by the marginal investor.

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All stocks should have the same expected return as seen by the marginal investor.

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The expected and required returns on stocks and bonds should be equal.

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All stocks should have the same realized return during the coming year.

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Each stock’s expected return should equal its realized return as seen by the marginal investor.

 

 

 

 

 

 

Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
 

 

X

Y

Price

$25

$25

Expected dividend yield

5%

3%

Required return

12%

10%

Answer

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Stock X pays a higher dividend per share than Stock Y.

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One year from now, Stock X should have the higher price.

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Stock Y has a lower expected growth rate than Stock X.

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Stock Y has the higher expected capital gains yield.

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Stock Y pays a higher dividend per share than Stock X.

 

Which of the following statements is CORRECT?

Answer

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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.

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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.

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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.

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One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.

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A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.

 

If a firm’s expected growth rate increased then its required rate of return would

Answer

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decrease.

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fluctuate less than before.

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fluctuate more than before.

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possibly increase, possibly decrease, or possibly remain constant.

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increase.

 

 

Which of the following statements is CORRECT?

Answer

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The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company.

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The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm’s common stock.

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The stock valuation model, P0 = D1/(rs g), cannot be used for firms that have negative growth rates.

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The stock valuation model, P0 = D1/(rs g), can be used only for firms whose growth rates exceed their required returns.

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If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

 

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock’s current price?

Answer

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$17.39

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$17.84

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$18.29

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$18.75

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$19.22

 

Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT?

Answer

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If one stock has a higher dividend yield, it must also have a lower dividend growth rate.

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If one stock has a higher dividend yield, it must also have a higher dividend growth rate.

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The two stocks must have the same dividend growth rate.

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The two stocks must have the same dividend yield.

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The two stocks must have the same dividend per share.