Name:......................................

University of Rio Grande

Fall 2010

Financial Management (Fin 20403)

Part A:Multiple choice

SOLUTIONS to Midterm 2 Exam

[3 points each. Total 60 Points]

1)

Investment A has an expected return of 15% per year, while investment B has an expected return of 12% per
year. A rational investor will choose:
A) investment A if A and B are of equal risk.
B) investment A because of the higher expected return.
C) investment B because a lower return means lower risk.
D) investment A only if the standard deviation of returns for A is higher than the standard deviation of
returns for B.

2)

A typical measure for the risk-free rate of return is the:

A) U.S. Treasury Bill rate.
C) money market rate.

3)

If the Beta for stock A equals zero, then:

A) stock A has a guaranteed return.
B) stock A's required return is equal to the required return on the market portfolio.
C) stock A's required return is equal to the risk-free rate of return.
D) stock A's required return is greater than the required return on the market portfolio.

4)

Stock A has a beta of 1.4 and a standard deviation of returns of 12%. Stock B has a beta of 1.1 and a standard
deviation of returns of 12%. If the market risk premium increases, then:

B) short-term AAA-rated bond rate.

D) prime lending rate.

A) the required returns on stocks A and B will remain the same.

B) the required returns on stocks A and B will both increase by the same amount.
C) the required return on stock A will increase more than the required return on stock B.
D) the required return on stock B will increase more than the required return on stock A.
5)

6)

7)

The appropriate measure for risk according to the capital asset pricing model is:
A) the coefficient of variation of a firm's cash flows.
B) the standard deviation of a firm's cash flows.
D) beta.
C) alpha.
Beta is a statistical measure of:
A) the standard deviation.
C) unsystematic risk.

B) total risk.
D) the relationship between an investment's
returns and the market return.

Of the following different types of securities, which is typically considered most risky?
A) common stocks of large companies
B) long term corporate bonds
C) long term government bonds
D) U.S. Treasury bills

8) Which of the following is an acceptable method of measuring the risk of a single investment?
A) the capital asset pricing module
B) the standard deviation
C) the coefficient of capitalization
D) the systemic characteristic variation
9) Which of the following types of risk is diversifiable?
A) unsystematic, or company-unique risk
C) market risk

B) systematic risk
D) betagenic, or ecocentric risk

10) The yield to maturity on a bond:

A) is lower for higher risk bonds.
C) is fixed in the indenture.

B) is the required rate of return on the bond.

D) is generally below the coupon interest rate.

11) Aaron Corporation has two bonds outstanding. Both bonds mature in 10 years, have a face value of $1,000,
and have a yield to maturity of 8%. One bond is a zero coupon bond and the other bond has a coupon rate of
8%. Which of the following statements is true?
A) The zero coupon bond must have a higher price because of its greater capital gain potential.
B) All rational investors will prefer the 8% bond because it pays more interest.
C) The zero coupon bond must sell for a lower price than the bond with an 8% coupon rate.
D) Both bonds must sell for the same price if markets are in equilibrium.

12) A corporate bond has a coupon rate of 10%, a yield to maturity of 12%, a face value of $1,000, and a market
price of $900. Therefore, the annual interest payment is:
A) $120

B) $108

C) $100

D) $90

13) A $1,000 par value 8-year bond with a 7 percent coupon rate recently sold for $1,100. The yield to maturity is:
A) less than 7 percent.
B) greater than 7 percent.
C) 7 percent.
D) cannot be determined.
14) If the market price of a bond decreases, then:
A) the yield to maturity increases.
C) the yield to maturity decreases.

B) the coupon rate increases.

D) the coupon rate decreases.

15) If a bond has a Standard & Poor's rating of BB, or below, it is referred to as a ________.
A) low yield bond
B) convertible bond
C) capital bond
D) junk bond
16) A bond will sell at a discount (below par value) if:
A) current market interest rates are moving in the same direction as bond values.
B) the market value of the bond is less than the present value of the discount rate of the bond.
C) investors' current required rate of return is above the coupon rate of the bond.
D) the economy is booming.
17) Which of the following statements concerning the constant growth dividend valuation model is true?
A) The growth rate must increase every year.
B) The dividend growth rate must be bigger than 10%.
C) The required rate of return must be equal to the growth rate for dividends.
D) The required rate of return must exceed the growth rate.
18) How is preferred stock affected by a decrease in the required rate of return?
B) the value of a share of preferred stock increases
A) the dividend yield increases
C) the dividend decreases
D) the dividend increases
19) Preferred stock differs from common stock in that:
A) preferred stock usually has a maturity date.
B) preferred stock can never be called.
C) common stock investors have a required return and preferred stock investors do not.
D) preferred stock dividends are fixed.
20) Who bears the greatest risk of loss of value if a firm should fail?
B) common stockholders
A) bondholders
C) preferred stockholders
D) All of the above bear equal risk of loss.
Part B:
Solve the problems. [5 points each. Total 40 Points]

reached to the solution.

Show the process/formula how you

1) You are considering a security with the following possible rates of return:
Probability
0.20
0.30
0.30
0.20
A.
B.

Return(%)
9.6
12.0
14.4
16.8

Calculate the expected rate of return.

Calculate the standard deviation of the returns.

pk

k-E(k)

(k-E(k))2

p.(k-E(k))2

0.2
0.3
0.3
0.2

9.6
12
14.4
16.8
E(k) =

1.92
3.6
4.32
3.36
13.2

-3.6
-1.2
1.2
3.6

12.96
1.44
1.44
12.96
s2 =

2.592
0.432
0.432
2.592
6.048

SD, s =

2.459268

2)

Sibling Incorporated has a beta of 1.0. If the expected return on the market is 14%, what is the expected
return on Sibling Incorporated's stock?
When ,

$ = 1, return on any firms stock will be the market return.

Hence, expected return on Sibling Incorporated's stock = 14%

OR, we can still use the formula

K
= Krf + $(Km-Krf)
= krf + 1 (14 - krf )
= krf + 14 - krf )
= 14
3)

Halverson, Inc. just issued $1,000 par 20-year bonds. The bonds sold for $936 and pay interest semiannually. Investors require a rate of 7.00% on the bonds. What is the amount of the semi-annual interest
payment on the bonds?
N
20*2

I
7/2

PV
936

PMT
?

FV
1000

Semi-annual PMT = $32

Annual Payment = $64 OR 6.4%
4)

A zero coupon bond is selling for $329. The bond has a face value of $1,000 and matures in 12 years. Your
friend asks you if he should buy the bond. He tells you his required return is 10 percent. Would you
recommend he buy the bond or not? Explain your answer.
First, we need to find how much return this bond gives.
N
12

I
?

PV
329

PMT
0

FV
1000

==> I = 9.71%.
But the friend requires a minimum return of 10 %. So I would suggest not to buy the bond.
5)

The expected return for the market portfolio is 15%, the expected return on U.S. Treasury Bills is 4%, and
the expected return on AAA-rated short-term corporate bonds is 8%. Calculate the required return for a
stock with a beta equal to 1.4.
K

6)

= Krf + $(Km-Krf)
= 4 + 1.4 (15 - 4)
= 19.4 %

Flitz and Foyd Corporation(FFC) stock is currently selling for $34.00. It is expected to pay a dividend of $2.00
at the end of the year. Dividends are expected to grow at a constant rate of 4.5 percent indefinitely.
Compute the required rate of return on FFC stock.

P0 =

D1
k g

===> k g =
===> k =
7)

D1
P0

D1
+ g = 10.38%
P0

A stock is selling for $30.00 (P0). The projected selling price one year from now (P1) is $34.00, and the
projected dividend payment one year from now (D1) is $2.00. What is the expected return on an investment
in the stock made today?

g=
k=

P1 P0
P0

=(34-30)/30 = 13.33%

D1
+ g = 20%
P0

8)

Genestek Inc. just paid a $5.00 dividend. Due to a new product about to be released, analysts expect the
company to grow at a supernormal rate of 15% for three years. After that it is expected to grow at a normal
rate of 4% indefinitely. Stocks similar to Genestek are currently earning shareholders a return of 12%. The
estimated selling price of the stock is:

Dividend in 4th year (that is after 3 years, beginning of 4th year),

D4 = 5(1+ 0.15)3 = 5.75
Now find P4 (because there is a constant growth after this year)

P4 =

D4 (1 + g )
k g
= 74.75

Now bring this back to present value

N
4

I
12

PV
?

===> PV = $47.50

PMT
0

FV
74.75