Exam 2 Practice Test Answer Key Corrections to Original Are in Blue

Exam 2 Practice Test Answer Key Corrections to Original Are in Blue

BUS 330

Spring 2015

Exam 2 Practice Test Answer Key – Corrections to original are in blue.

Part I

Instructions: Select the ONE BEST response to each question below.

Some of the questions below may require you to understand how to use one or more of the following Excel functions:

=pv(rate, nper, pmt, [fv], [type])

=fv(rate, nper, pmt, [pv], [type])

=rate(nper, pmt, pv, [fv], [type], [guess])

=nper(rate, pmt, pv, [fv], [type])

=pmt(rate, nper, pv, [fv], [type])

  1. Suppose investors do not care about risk and do not require additional return in order to be persuaded to hold a risky asset instead of a risk-free asset. If a Treasury note maturing in 3 years has a 2.5% yield-to-maturity, and a similar Treasury note maturing in 4 years has a 2.6% yield to maturity, then the interest rate investors expect to receive on one year notes starting 4 years from now is:
  1. Approximately 3.2%.
  2. Approximately 3.3%.
  3. Approximately 2.9%.
  4. Approximately 3.0%.
  5. Approximately 3.1%.
  1. Suppose you purchase a car for $25,000 and you make $700 monthly payments for 48 months. Which excel command will return the annual interest rate you are paying on the loan?
  1. =rate(48, 700, 0, 25000)
  2. =12*rate(48, -700, 25000,0)
  3. =rate(4, 25000, 700,0)
  4. 25000=pv(?, 36, 1000, 0)
  5. None of the above.
  1. For a potential bond issuer -- if the bond is callable that makes the bond _____ attractive. If the bond is convertible, that makes the bond _____ attractive. If the bond has warrants, that makes the bond _____ attractive.
  1. LessMoreMore
  2. More MoreLess
  3. LessLessMore
  4. LessMore Less
  5. MoreLessLess
  1. A bond issuer (the borrower) is preparing to issue long term bonds to finance the acquisition of some long-term asset (like a power plant). The borrower will include a call provision in the bonds in order to protect the borrower from the risk that:
  1. The yield-to-maturity rises above the yield-to-call.
  2. Bond prices will fall dramatically some time after the bonds are issued.
  3. The interest rate that the borrower would have to pay to finance the asset acquisition falls significantly after the bonds have been issued.
  4. The coupon rate on the bonds rises dramatically some time after the bonds are issued.
  5. the bond owners will not want to convert their bonds into shares.
  1. You own a bond with a face value (principal) of $1000, which matures in 20 years with a 6% coupon rate. The bond issuer can call the bonds in 5 years if he pays a 10% call premium. Which excel command will return your yield-to-call if the bond sells today for $1030?
  1. =rate(5,60,-1030,1100)
  2. =pv(6%,20,60,1100)
  3. =pv(6%, 5, 60,1100)
  4. =rate(20, 60, -1030, 1000)
  5. None of the above.
  1. If your bank offers auto financing loans for 8% annual interest, which excel command will return the monthly payment you would make if you borrow $25,000 to buy a car and repay the loan with equal payments over 36 months?
  1. =pmt(8%/12, 36, 25000)
  2. =pmt(8%/12, 36/12, 25000)
  3. =rate(36, ?, 25000, 0)
  4. =pmt(8%, 36, 25000)
  5. None of the above.
  1. Risk that can be reduced or eliminated by diversification is _____ risk. Risk that remains in a diversified portfolio of assets is _____ risk.
  1. Stand-alonediversifiable
  2. Diversifiablestand-alone
  3. Marketstand-alone
  4. Marketdiversifiable
  5. Diversifiablemarket
  1. In order to create a portfolio worth $1 out of the “perfectly-diversified-market-portfolio” asset M and the risk-free asset RF that has a “beta” equal to 4, the portfolio should contain ____ dollars of asset M and _____ dollars of asset RF.
  1. 3/41/4
  2. 4/51/5
  3. 31
  4. 41
  5. 4-3
  1. The CAPM says that the ____ paid by an asset should be directly proportional to its _____.
  1. Expected returnvariance
  2. Expected returnstandard deviation
  3. Expected returnrisk premium
  4. Risk premiumstand-alone risk
  5. None of the above.
  1. According to CAPM, _____ risk can pay a risk premium because this is the risk that remains after all attempts to reduce risk through _____ have been made.
  1. Stand-alonediversification
  2. Marketdiversification
  3. Interest rateleverage
  4. Diversifiablefinancial engineering
  5. None of the above.
  1. Arbitrage is the opportunity to make a risk-free profit by:
  1. Market timing.
  2. Leverage.
  3. Buying “distressed” assets.
  4. Buying companies with incompetent management and changing the management.
  5. Buying and selling something simultaneously at different prices.
  1. If diversification is costless and all assets are priced so that there are no arbitrage opportunities, then:
  1. All assets will (on average) have a combination of market risk (standard deviation) and expected return on the CAPM line.
  2. Each individual asset will have a combination of total risk (variance) and expected return on the CAPM line.
  3. Each individual asset will have a combination of total risk (standard deviation) and expected return on the CAPM line.
  4. Each individual asset will have a combination of market risk (standard deviation) and expected return on the CAPM line.
  5. Each individual asset will have a combination of diversifiable risk (variance) and expected return on the CAPM line.
  1. The coefficient of varation (CV) measures:
  1. The amount of risk per unit of return, calculated as the standard deviation divided by the expected return.
  2. The amount of market risk per unit of return, calculated as the beta value divided by the expected return.
  3. The amount of return per unit of risk, calculated as the expected return divided by the variance.
  4. The amount of return per unit of risk, calculated as the expected return divided by the standard deviation.
  5. The amount of risk per unit of return, calculated as the beta value divided by the expected return.
  1. If you write the return on the market asset as:

RET(M)i = RM + mi

Where RM is the expected return and mi is the deviation from the expected return in outcome i, and the return on asset X is written as:

RET(X)i = RX + ai + 1.5▪mi

Where RX is the expected return on asset X and aiis a risk factor that is independent of mi, then the value of “beta” for asset X will be:

  1. RX – RM
  2. (RX – RM)/σM2
  3. (σM2 + σa2)/σM2
  4. 1.5
  5. 1.5/σM2
  1. I have $1 to begin my portfolio. Asset A that has a “beta” of -1, and asset B has a “beta” of 2. How would I construct a portfolio out of assets A and B with a beta of zero?
  1. Half of my money should be in A, half in B.
  2. Two-thirds of my money in A, one-third of my money in B.
  3. Borrow $1 of asset A and sell, use the money to buy $2 of asset B.
  4. Borrow $2 of asset A and sell, use the money to buy $3 of asset B
  5. None of the above.
  1. If you type the following into a cell in an Excel:

=pmt(6%, 12, 10000)

Then the result that is returned to you is:

  1. The monthly payment for a loan of $10,000 with an annual interest rate of 6% that is paid off in one year.
  2. The monthly deposit into an account paying an annual interest rate of 6% that will be worth $10,000 in one year.
  3. The annual deposit into an account paying an annual interest rate of 6% that will be worth $10,000 in 12 years.
  4. The number of monthly $12 payments needed to pay off a loan of $10,000 if the annual interest rate is 6%.
  5. None of the above.
  1. If you type the following into a cell in an Excel:

=rate(24, 100, 2000)

Then the result that is returned to you is:

  1. The annual interest rate on a 24 year loan of $2000 with annual payments of $100.
  2. The monthly interest rate on a 24 year loan of $2000 with annual payments of $100.
  3. The annual interest rate on a 24 year loan of $2000 with monthly payments of $100.
  4. The monthly interest rate on a 24 year loan of $2000 with monthly payments of $100.
  5. An error message.
  1. A firm has $300 of assets that is financed 100% by equity. The beta of the company is 0.5. If the management then issues $200 of debt to buy back the equity so that the company is now 2/3 debt and 1/3 equity, the new value of beta of the company is:
  1. 3
  2. 2/3
  3. 7/6
  4. 1.5
  5. 1/3
  1. The flow of funds that can be used to pay interest to creditors, dividends to stockholders, or used to finance debt reduction or stock buy-backs (without disrupting the normal operation of the firm) is:
  1. Free cash flow.
  2. Earnings before interest and taxes
  3. Net Operating Working Capital
  4. Net Income
  5. None of the above.
  1. If an investor pays a price P0 for a share that provides a constant dividend D beginning in time period 1 (the next period after zero), the valuation of the share through the present value of dividends will be:
  1. D/(1+r)
  2. D ▪ [1+r]
  3. D ▪ [1+r +r2 + r3 + r4 +…]
  4. D/r
  5. None of the above.
  1. If investors require an 8% return on company Z’s common stock, a 6% return on preferred stock, and a 5% return on company Z’s debt, and company Z’s current capital structure is 50% debt, 20% preferred stock and 30% equity, then company Z’s weighted-average-cost-of-capital is:
  1. 8%
  2. 6.1%
  3. 4.9%
  4. 5.5%
  5. None of the above.

Part II

Instructions: Answer the following questions, show your computations where applicable.

Suppose the perfectly-diversified-market-portfolio (asset M) pays a 15% return 50% of the time, and a minus 5% return 50% of the time.

Suppose you are studying the return paid by asset X.You find that when asset M pays a 15% return, asset X pays a 40% return 60% of the time, and a 10% return 40% of the time. When asset M pays a minus 5% return, asset X pays a minus 10% return 60% of the time, and a minus 20% return 40% of the time.

  1. Find the value of “beta” for asset X.

OutcomeProb.RetMRetXRetM – ERMRetX – ERX

1.0.3.150.400.100.33

2.0.2.150.100.100.03

3.0.3-.05-0.10-0.10-0.17

4.0.2-.05-0.20-0.10-0.27

Note: ERM = .05; ERX = 0.3*0.40 + 0.2*0.10 + 0.3*(-0.10) + 0.2*(-0.20) = 0.07

Cov(RetM, RetX) = (0.3)*(0.10)*(0.33) + (0.2)*(0.10)*(0.03) + (0.3)*(-0.10)*(-0.17) + (0.2)*(-0.10)*(-0.27)

Cov(RetM, RetX) = 0.021

σ2M = 0.01

BetaX = 0.021/0.01 = 2.1

  1. If asset X is priced correctly according to the Capital Asset Pricing Model, what is the risk-free interest rate?

RetX = RF + BetaX *(RM – RF)

0.07 = RF + (2.1)*(.05 – RF)

RF = 0.035/1.1 = .0318

  1. What return would you expect from a portfolio worth $1 if you borrowed $2 at the risk-free interest rate and purchased $3 of asset X?

Each dollar of asset X pays an expected return of 7%, so the portfolio generates a total return of 21%, minus the cost of servicing the debt which is 2 x .0318% = 6.36%, so the expected return would be 21% -- 6.36% = 14.64%.

  1. Suppose the management of company X is purchasing a rival company in the same industry. The acquisition will be financed entirely by issuing (risk-free) debt. The resulting company will be 50% bigger than company X is right now. What will happen to the value of beta of company X once the acquisition is made? (Assume there are no economies of scale or duplicated costs that can be eliminated when the acquisition is completed.)

Owning one dollar of the new post-acquisition company X will be like owning $1.50 of the old company X, along with $0.50 borrowed at the risk-free rate to purchase the extra $0.50. Therefore asset X now has a beta which is 1.5 times bigger than the old value of beta. Therefore new-beta = 1.5*2.1 = 3.15.

  1. What expected return will be required of asset X (the shares of company X)?

Before the acquisition, each dollar of asset X earned an average 7% return, so after the acquisition the owner of X would earn 1.5*7% = 10.5%, minus the cost of the debt equal to 0.5 * 3.18% = -1.59%. Therefore the average return on company X shares should be 10.5% -- 1.59% = 8.91%. (Notice that the new-asset-X now earns 1.5 x asset old-asset-X’s risk premium, because it has the same market risk as 1.5 units of old-asset-X.)

  1. What will happen to the price of the shares of company X when the acquisition is made? Why?

Although the expected return on company X’s shares rises, this does not mean that investors are willing to pay a higher price per share. The value of beta changing from 2.1 to 3.15 means that the required return according to the CAPM becomes:

RetNEW-X = .0318 + 3.15*(.05 -- .0318) = 8.91%. So the return demanded by investors rises by exactly as much as the return offered by the shares, so the share price doesn’t change.