UNIVERSITY OF SANTO TOMAS

AMV COLLEGE OF ACCOUNTANCY

Q3 REVIEWER
RISK AND RETURN, BOND AND STOCK VALUATION

A. RISK AND RETURN

1. The tighter the probability distribution of its expected future returns, the greater the
risk of a given investment as measured by its standard deviation.
a. True b. False
2. The coefficient of variation, calculated as the standard deviation of expected returns
divided by the expected return, is a standardized measure of the risk per unit of expected
return.
a. True b. False
3. The standard deviation is a better measure of risk than the coefficient of variation if the
expected returns of the securities being compared differ significantly.
a. True b. False
4. Risk-averse investors require higher rates of return on investments whose returns are
highly uncertain, and most investors are risk averse.
a. True b. False
5. When adding a randomly chosen new stock to an existing portfolio, the higher (or
more positive) the degree of correlation between the new stock and stocks already in the
portfolio, the less the additional stock will reduce the portfolio's risk.
a. True b. False
6. Diversification will normally reduce the riskiness of a portfolio of stocks.
a. True b. False
7. In portfolio analysis, we often use ex post (historical) returns and standard deviations,
despite the fact that we are really interested in ex ante (future) data.
a. True b. False
8. The realized return on a stock portfolio is the weighted average of the expected returns
on the stocks in the portfolio.
a. True b. False
9. Market risk refers to the tendency of a stock to move with the general stock market. A
stock with above-average market risk will tend to be more volatile than an average stock,
and its beta will be greater than 1.0.
a. True b. False
10. An individual stock's diversifiable risk, which is measured by its beta, can be lowered
by adding more stocks to the portfolio in which the stock is held.
a. True b. False
11. Managers should under no conditions take actions that increase their firm's risk
relative to the market, regardless of how much those actions would increase the firm's
expected rate of return.
a. True b. False
12. One key conclusion of the Capital Asset Pricing Model is that the value of an asset
should be measured by considering both the risk and the expected return of the asset,
assuming that the asset is held in a well-diversified portfolio. The risk of the asset held in
isolation is not relevant under the CAPM.
a. True b. False
13. According to the Capital Asset Pricing Model, investors are primarily concerned with
portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of
a stock is the stock's contribution to the riskiness of a well-diversified portfolio.
a. True b. False
14. If investors become less averse to risk, the slope of the Security Market Line (SML)
will increase.
a. True b. False
15. Most corporations earn returns for their stockholders by acquiring and operating
tangible and intangible assets. The relevant risk of each asset should be measured in
terms of its effect on the risk of the firm's stockholders.
a. True b. False
16. Variance is a measure of the variability of returns, and since it involves squaring the
deviation of each actual return from the expected return, it is always larger than its square
root, the standard deviation.
a. True b. False

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17. Because of differences in the expected returns on different investments, the standard
deviation is not always an adequate measure of risk. However, the coefficient of variation
adjusts for differences in expected returns and thus allows investors to make better
comparisons of investments' stand-alone risk.
a. True b. False
18. A stock's beta measures its diversifiable risk relative to the diversifiable risks of other
firms.
a. True b. False

19. If investors are risk averse and hold only one stock, we can conclude that the required
rate of return on a stock whose standard deviation is 0.21 will be greater than the required
return on a stock whose standard deviation is 0.10. However, if stocks are held in
portfolios, it is possible that the required return could be higher on the stock with the
lower standard deviation.
a. True b. False
20. Someone who is risk averse has a general dislike for risk and a preference for
certainty. If risk aversion exists in the market, then investors in general are willing to
accept somewhat lower returns on less risky securities. Different investors have different
degrees of risk aversion, and the end result is that investors with greater risk aversion
tend to hold securities with lower risk (and therefore a lower expected return) than
investors who have more tolerance for risk.
a. True b. False

21. Taggart Inc.'s stock has a 50% chance of producing a 25% return, a 30% chance of
producing a 10% return, and a 20% chance of producing a −28% return. What is the
firm's expected rate of return? 9.90%

23. Cheng Inc. is considering a capital budgeting project that has an expected return of
25% and a standard deviation of 30%. What is the project's coefficient of variation? 1.2

24. Bae Inc. is considering an investment that has an expected return of 15% and a standard deviation of 10%. What is the
investment's coefficient of variation? .67

25. Bill Dukes has$ 100,000 invested in a 2-stock portfolio.$ 35,000 is invested in Stock
X and the remainder is invested in Stock Y. X's beta is 1.50 and Y's beta is 0.70. What is
the portfolio's beta? .98
30. Porter Inc's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%,
what is the market risk premium? 5.80%

29. Cooley Company's stock has a beta of 1.40, the risk-free rate is 4.25%, and the market risk premium is 5.50%. What is
the firm's required rate of return? 11.95%

28. Calculate the required rate of return for Climax Inc., assuming that (1) investors expect a 4.0% rate of inflation in the
future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of 1.00, and (5) its
realized rate of return has averaged 15.0% over the last 5 years. 12.00%

27. Assume that you hold a well-diversified portfolio that has an expected return of
11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at
10 a share and adding it to your portfolio. Alpha has an expected return of 13.0% and a
beta of 1.50. The total value of your current portfolio is 90,000. What will the expected
return and beta on the portfolio be after the purchase of the Alpha stock? 11.20%; 1.23

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B. BOND VALUATION
1. If a firm raises capital by selling new bonds, it could be called the "issuing firm," and
the coupon rate is generally set equal to the required rate on bonds of equal risk.
a. True b. False
2. A call provision gives bondholders the right to demand, or "call for," repayment of a
bond. Typically, companies call bonds if interest rates rise and do not call them if interest
rates decline.
a. True b. False
3. Sinking funds are provisions included in bond indentures that require companies to
retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the
company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on
the open market at the going market price or (2) selecting the bonds to be called by a
lottery administered by the trustee, in which case the price paid is the bond's face value.
a. True b. False
4. A zero coupon bond is a bond that pays no interest and is offered (and initially sells) at
par. These bonds provide compensation to investors in the form of capital appreciation.
a. True b. False
5. The desire for floating-rate bonds, and consequently their increased usage, arose out of
the experience of the early 1980s, when inflation pushed interest rates up to very high
levels and thus caused sharp declines in the prices of outstanding bonds.
a. True b. False
6. The market value of any real or financial asset, including stocks, bonds, or art work
purchased in hope of selling it at a profit, may be estimated by determining future cash
flows and then discounting them back to the present.
a. True b. False
7. The price sensitivity of a bond to a given change in interest rates is generally greater
the longer the bond's remaining maturity.
a. True b. False
8. A bond that had a 20-year original maturity with 1 year left to maturity has more price
risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the
bonds have equal default risk and equal coupon rates, and they cannot be called.)
a. True b. False
9. Because short-term interest rates are much more volatile than long-term rates, you
would, in the real world, generally be subject to much more price risk if you purchased a
30-day bond than if you bought a 30-year bond.
a. True b. False
10. As a general rule, a company's debentures have higher required interest rates than its
mortgage bonds because mortgage bonds are backed by specific assets while debentures
are unsecured.
a. True b. False
11. Junk bonds are high-risk, high-yield debt instruments. They are often used to finance
leveraged buyouts and mergers, and to provide financing to companies of questionable
financial strength.
a. True b. False
12. There is an inverse relationship between bonds' quality ratings and their required rates
of return. Thus, the required return is lowest for AAA-rated bonds, and required returns
increase as the ratings get lower.
a. True b. False
13. Income bonds pay interest only if the issuing company actually earns the indicated
interest. Thus, these securities cannot bankrupt a company, and this makes them safer
from an investor's perspective than regular bonds.
a. True b. False
14. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B
(BBB, the lowest investment-grade rating), both mature in 20 years, both have a 10%
coupon, neither can be called except for sinking fund purposes, and both are offered to
you at their 1,000 par values. However, Bond SF has a sinking fund while Bond NSF
does not. Under the sinking fund, the company must call and pay off 5% of the bonds at
par each year. The yield curve at the time is upward sloping. The bond's prices, being
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equal, are probably not in equilibrium, as Bond SF, which has the sinking fund, would
generally be expected to have a higher yield than Bond NSF.
a. True b. False
15. Floating-rate debt is advantageous to investors because the interest rate moves up if
market rates rise. Since floating-rate debt shifts price risk to companies, it offers no
advantages to corporate issuers.
a. True b. False
16. A bond has a 1,000 par value, makes annual interest payments of 100, has 5 years to
maturity, cannot be called, and is not expected to default. The bond should sell at a
premium if market interest rates are below 10% and at a discount if interest rates are
greater than 10%.
a. True b. False
17. You have funds that you want to invest in bonds, and you just noticed in the financial
pages of the local newspaper that you can buy a 1,000 par value bond for 800. The
coupon rate is 10% (with annual payments), and there are 10 years before the bond will
mature and pay off its 1,000 par value. You should buy the bond if your required return
on bonds with this risk is 12%.
a. True b. False
18. If the required rate of return on a bond (rd) is greater than its coupon interest rate and
will remain above that rate, then the market value of the bond will always be below its
par value until the bond matures, at which time its market value will equal its par value.
(Accrued interest between interest payment dates should not be considered when
answering this question.)
a. True b. False
19. The prices of high-coupon bonds tend to be less sensitive to a given change in interest
rates than low-coupon bonds, other things held constant.
a. True b. False
20. Restrictive covenants are designed primarily to protect bondholders by constraining
the actions of managers. Such covenants are spelled out in bond indentures.
a. True b. False

21. Morin Company's bonds mature in 8 years, have a par value of 1,000, and make an
annual coupon interest payment of 65. The market requires an interest rate of 8.2% on
these bonds. What is the bond's price? 903.04

22. Ryngaert Inc. recently issued noncallable bonds that mature in 15 years. They have a
par value of 1,000 and an annual coupon of 5.7%. If the current market interest rate is
7.0%, at what price should the bonds sell? 881.60

23. Adams Enterprises' noncallable bonds currently sell for 1,120. They have a 15-year
maturity, an annual coupon of 85, and a par value of 1,000. What is their yield to
maturity? 7.17%

24. Dyl Inc.'s bonds currently sell for 1,040 and have a par value of 1,000. They pay a 65
annual coupon and have a 15-year maturity, but they can be called in 5 years at 1,100.
What is their yield to maturity (YTM)? 6.09%

25. Malko Enterprises' bonds currently sell for 1,050. They have a 6-year maturity, an
annual coupon of 75, and a par value of 1,000. What is their current yield? 7.14%

26. Assume that you are considering the purchase of a 20-year, noncallable bond with an
annual coupon rate of 9.5%. The bond has a face value of 1,000, and it makes semiannual
interest payments. If you require an 8.4% nominal yield to maturity on this investment,
what is the maximum price you should be willing to pay for the bond? 1,105.69

27. Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at
their par value of 1,000 one year ago. Today, the market interest rate on these bonds is

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 5.5%. What is the current price of the bonds, given that they now have 19 years to
maturity? 1,232.15

28. McCue Inc.'s bonds currently sell for 1,250. They pay a 90 annual coupon, have a 25-
year maturity, and a 1,000 par value, but they can be called in 5 years at 1,050. Assume
that no costs other than the call premium would be incurred to call and refund the bonds,
and also assume that the yield curve is horizontal, with rates expected to remain at current
levels on into the future. What is the difference between this bond's YTM and its YTC?
(Subtract the YTC from the YTM; it is possible to get a negative answer.) 2.62%

C. STOCK VALUATION
1. A proxy is a document giving one party the authority to act for another party, including
the power to vote shares of common stock. Proxies can be important tools relating to
control of firms.
a. True b. False
2. The preemptive right gives current stockholders the right to purchase, on a pro rata
basis, any new shares issued by the firm. This right helps protect current stockholders
against both dilution of control and dilution of value.
a. True b. False
3. If a firm's stockholders are given the preemptive right, this means that stockholders
have the right to call for a meeting to vote to replace the management. Without the
preemptive right, dissident stockholders would have to seek a change in management
through a proxy fight.
a. True b. False
4. Classified stock differentiates various classes of common stock, and using it is one way
companies can meet special needs such as when owners of a start-up firm need additional
equity capital but don't want to relinquish voting control.
a. True b. False
5. Founders' shares are a type of classified stock where the shares are owned by the firm's
founders, and they generally have more votes per share than the other classes of common
stock.
a. True b. False
6. The total return on a share of stock refers to the dividend yield less any commissions
paid when the stock is purchased and sold.
a. True b. False
7. The cash flows associated with common stock are more difficult to estimate than those
related to bonds because stock has a residual claim against the company versus a
contractual obligation for a bond.
a. True b. False
8. According to the basic DCF stock valuation model, the value an investor should assign
to a share of stock is dependent on the length of time he or she plans to hold the stock.
a. True b. False
9. When a new issue of stock is brought to market, it is the marginal investor who
determines the price at which the stock will trade.
a. True b. False
10. The constant growth DCF model used to evaluate the prices of common stocks is
conceptually similar to the model used to find the price of perpetual preferred stock or
other perpetuities.
a. True b. False
11. According to the nonconstant growth model discussed in the textbook, the discount
rate used to find the present value of the expected cash flows during the initial growth
period is the same as the discount rate used to find the PVs of cash flows during the
subsequent constant growth period.
a. True b. False
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12. The corporate valuation model can be used only when a company doesn't pay
dividends.
a. True b. False
13. The corporate valuation model cannot be used unless a company pays dividends.
a. True b. False
14. Projected free cash flows should be discounted at the firm's weighted average cost of
capital to find the firm's total corporate value.
a. True b. False
15. Preferred stock is a hybrid—a sort of cross between a common stock and a bond—in
the sense that it pays dividends that normally increase annually like a stock but its
payments are contractually guaranteed like interest on a bond.
a. True b. False
16. From an investor's perspective, a firm's preferred stock is generally considered to be
less risky than its common stock but more risky than its bonds. However, from a
corporate issuer's standpoint, these risk relationships are reversed: bonds are the most
risky for the firm, preferred is next, and common is least risky.
a. True b. False
17. If a stock's expected return as seen by the marginal investor exceeds this investor's
required return, then the investor will buy the stock until its price has risen enough to
bring the expected return down to equal the required return.
a. True b. False
18. If a stock's market price exceeds its intrinsic value as seen by the marginal investor,
then the investor will sell the stock until its price has fallen down to the level of the
investor's estimate of the intrinsic value.
a. True b. False
19. For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market
price must equal its intrinsic value as seen by the marginal investor and (2) the expected
return as seen by the marginal investor must equal this investor's required return.
a. True b. False
20. Two conditions are used to determine whether or not a stock is in equilibrium: (1)
Does the stock's market price equal its intrinsic value as seen by the marginal investor,
and (2) does the expected return on the stock as seen by the marginal investor equal this
investor's required return? If either of these conditions, but not necessarily both, holds,
then the stock is said to be in equilibrium.
a. True b. False

21. 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? 18.29

22. 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? 25.57

23. A share of common stock just paid a dividend of 1.00. If the expected long-run
growth rate for this stock is 5.4%, and if investors' required rate of return is 11.4%, what
is the stock price? 17.57

24. If D1 =1.25, g (which is constant) = 4.7%, and P0 = 26.00, what is the stock's expected
dividend yield for the coming year? 4.81%

25. If D0 = 2.25, g (which is constant) = 3.5%, and P 0 = 50, what is the stock's expected
dividend yield for the coming year? 4.66%

26. If D1 = 1.50, g (which is constant) = 6.5%, and P 0 = 56, what is the stock's expected
capital gains yield for the coming year? 6.50%

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27. . Reddick Enterprises' stock currently sells for 35.50 per share. The dividend is
projected to increase at a constant rate of 5.50% per year. The required rate of return on
the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? 41.69%

28. Mooradian Corporation's free cash flow during the just-ended year (t = 0) was $150
million, and its FCF is expected to grow at a constant rate of 5.0% in the future. If the
weighted average cost of capital is 12.5%, what is the firm's total corporate value, in
millions? 2,100

29. Suppose Boyson Corporation's projected free cash flow for next year is FCF 1
=150,000, and FCF is expected to grow at a constant rate of 6.5%. If the company's
weighted average cost of capital is 11.5%, what is the firm's total corporate value?
3,000,000:

30. Molen Inc. has an outstanding issue of perpetual preferred stock with an annual
dividend of 7.50 per share. If the required return on this preferred stock is 6.5%, at what
price should the stock sell? 115.38

***END OF REVIEWER***

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