ACFINA2

Homework 1.1 (due May 23)

Time Value of Money & Risk and Return

I. Theory
(Multiple Choice)

1. An annuity can best be described as

a. a set of payments to be received during a period of time.
b. a stream of payments to be received at a common interval over the life of the
payments.
c. an even stream of payments to be received at a common interval over the life
of the payments.
d. the present value of a set of payments to be received during a future period of
time.

2. Which of the following should have the greatest value if the discount rate applying
to the cash flows is a positive value?
a. the present value of a P5 payment of to be received one year from today.
b. the future value of a P5 payment received today but invested for one year.
c. the present value of a stream of P5 payments to be received at the end of the
next two years.
d. the future value of a stream of P5 payments to be received at the end of the
next two years.

3. The amount of money that would have to be invested today at a given interest rate
over a specified period in order to equal a future amount is called
a. future value.
b. present value.
c. future value interest factor.
d. present value interest factor.

4. An annuity with an infinite life is called a(n)

a. perpetuity.
b. primia.
c. indefinite.
d. deep discount.

5. When comparing annuity due to ordinary annuities, annuity due annuities will have
higher:
a. present values.
b. annuity payments.
c. future values.
d. both a and c.
e. all of the above.
6. As time increases for an amortized loan, the ___________ decreases.
a. interest paid per payment
b. principal paid per payment
c. the outstanding loan balance
d. both a and c
e. all of the above

7. What is one of the most important lessons from capital market history?
a. Risk does not matter.
b. There is a positive relationship between risk and return.
c. You are always better off investing in stock.
d. T-bills are the highest yielding investment.

8. If you were to plot the return of asset classes on a graph with the standard
deviation of returns on the horizontal axis and expected returns on the vertical
axis, then which security class is most likely to be in the farthest upper right hand
corner of the graph?
a. Treasury Bills
b. Treasury Bonds
c. Corporate Bonds
d. Stocks

9. According to the CAPM (capital asset pricing model), the security market line is a
straight line. The intercept of this line should be equal to
a. zero
b. the expected risk premium on the market portfolio
c. the risk-free rate
d. the expected return on the market portfolio

10. Risk that affects all firms is called

a. total risk.
b. management risk.
c. nondiversifiable risk.
d. diversifiable relevant.

11. According to the CAPM (capital asset pricing model), the security market line is a
straight line. The slope of this line should be equal to
a. zero
b. the expected risk premium on the market portfolio
c. the risk-free rate
d. the expected return on the market portfolio
12. Asset 1 has a beta of 1.2 and Asset 2 has a beta of 0.6. Which of the following
statements is correct?
a. Asset 1 is more volatile than Asset 2.
b. Asset 1 has a higher expected return than Asset 2.
c. In a regression with individual assets return as the dependent variable and the
markets return as the independent variable, the R-squared value is higher for
Asset 1 than it is for Asset 2.
d. All of the above statements are correct.

13. Systematic risk is also referred to as

a. diversifiable risk.
b. economic risk.
c. nondiversifiable risk.
d. not relevant.

14. A stock with a beta greater than 1.0 has returns that are __________ volatile than
the market, and a stock with a beta of less than 1.0 exhibits returns which are
____________ volatile than those of the market portfolio.
a. more, more
b. more, less
c. less, more
d. less, less

15. The higher an assets beta,

a. the more responsive it is to changing market returns.
b. the less responsive it is to changing market returns.
c. the higher the expected return will be in a down market.
d. the lower the expected return will be in an up market.

(True or False)
16. Everything else being equal, the higher the interest rate, the higher the future
value.

17. The ordinary annuity is an annuity for which the cash flow occurs at the beginning
of each period.

18. For any interest rate and for any period of time, the more frequently interest is
compounded, the greater the amount of money that has to be invested today in
order to accumulate a given future amount.
19. The more frequent the compounding periods in a year, the higher the future
value.

20. In no case will creating portfolios of assets result in greater risk than that of the
riskiest asset included in the portfolio.

21. The greater the systematic risk, the greater the return required by the investor.
22. The security market line (SML) reflects the required return in the marketplace for
each level of nondiversifiable risk (beta).

23. The real rate of interest represents the nominal rate of interest plus the expected
rate of inflation over the maturity of a fixed income security.

24. Beta coefficient is an index of the degree of movement of an assets return in

response to a change in the risk-free asset.

25. It is very easy for investors to remove their exposure to non-systematic risk.

26. Expected return is the return one will actually receive.

27. The required rate of return for an asset is equal to the risk-free rate plus a risk
premium.

28. The non-systematic risk is the relevant portion of an assets risk attributable to
market factors that affect all firms.

29. Stocks with higher betas are usually more stable than stocks with lower betas.

30. Investing in foreign stocks is one way to improve diversification of a portfolio.

II. Problem Solving

1. If you can earn 5% (compounded annually) on an investment, how long does it take
for your money to triple?

2. A young couple buys their dream house. After paying their down payment and
closing costs, the couple has borrowed P400,000 from the bank. The terms of the
mortgage are 30 years of monthly payments at an annual rate of 6% with monthly
compounding. Suppose the couple wants to pay off their mortgage early, and will
make extra payments to accomplish this goal. Specifically, the couple will pay an
EXTRA P2,000 every 12 months (this extra amount is in ADDITION to the regular
scheduled mortgage payment). The first extra P2,000 will be paid after month 12.
What will be the balance of the loan after the first year of the mortgage?

3. P100 is received at the beginning of year 1, P200 is received at the beginning of

year 2, and P300 is received at the beginning of year 3. If these cash flows are
deposited at 12 percent, their combined future value at the end of year 3 is
_________.

4. Robert borrows P10,500 from the bank at 11 percent annually compounded interest
to be repaid in six equal annual installments. The interest paid in the first year is
5. A wealthy art collector has decided to endow her favorite art museum by
establishing funds for an endowment which would provide the museum with
P1,000,000 per year for acquisitions into perpetuity. The art collector will give the
endowment upon her fiftieth birthday 10 years from today. She plans to
accumulate the endowment by making annual end-of-year deposits into an
account. The rate of interest is expected to be 6 percent in all future periods. How
much must the art collector deposit each year to accumulate to the required
amount?

6. If you put P10 in a savings account at the beginning of each year for 11 years, how
much money will be in the account at the end of the 11th year? Assume that the
account earns 11%, and round to the nearest P100.

7. California Investors recently advertised the following claim: Invest your money
with us at 21%, compounded annually, and we guarantee to double your money
sooner than you imagine. Ignoring taxes, how long would it take to double your
money at a nominal rate of 21%, compounded annually? Round off to the nearest
year.

8. How much money do I need to place into a bank account which pays a 6% rate in
order to have P500 at the end of seven years?

9. You have just won a magazine sweepstakes and have a choice of three
alternatives. You can get P100,000 now, or P10,000 per year in perpetuity, or
P50,000 now and P150,000 at the end of 10 years. If the appropriate discount rate
is 12%, which option should you choose?

10. A deep-discount bond can be purchased for P312 and in 20 years it will be worth
P1,000. What is the rate of interest on the bond? (Hint: 3% - 8%)

11. Assume you have a choice between two deposit accounts. Account X has an annual
rate of 12.25 percent but with interest compounded monthly. Account Y has an
annual rate of 12.00 percent with interest compounded continuously. Which
account provides the higher effective annual return?

12. You are considering the purchase of new equipment for your company and you
have narrowed down the possibilities to two models which perform equally well.
However, the method of paying for the two models is different. Model A requires
P5,000 per year payment for the next five years. Model B requires the following
payment schedule. Which model should you buy if your opportunity cost is
8 percent?

Year Payment (Model B)

1 P7,000
2 6,000
3 5,000
4 4,000
5 3,000
 Terry Corporation
One year ago, Jason purchased 50 shares of Terry Corporation stock at P20 per share.
Today, one year later, the stock pays a P2 per share dividend and the price is now P22 per
share.

13. Refer to Terry Corporation. What is the total return (in amount) on the investment
for the one year?

14. Refer to Terry Corporation. What is the total percentage return on the investment
for the one year?

15. Refer to Terry Corporation. What is the capital gains yield on the investment for
the one year?

Questions 16-25 refer to the pertain to the following information:

Year Return
Stock A Stock B Stock C
1 15% 12% 5%
2 25% 14% -6%
3 8% 9% 10%
4 16% 25% 1%
5 5% 3% 15%

16. What is the variance of returns for stock A?

17. What is the standard deviation of returns for stock A?

18. What is the variance of returns for stock B?

19. What is the standard deviation of returns for stock C?

20. What is the average return for stock A?

21. What is the average return of stock B?

22. What is the average return of stock C?

23. What is the average return of a portfolio that has 30% invested in stock A, 30%
invested in stock B and 40% invested in stock C?

24. What is the average return of a portfolio that has 10% invested in stock A, 40%
invested in stock B and 50% invested in stock C?

25. What is the average return of a portfolio that has 45% invested in stock A, 35%
for
invested in stock B and the rest invested in stock C?
 Consider the following historical returns for Big Diesel Incorporated and inflation for the
United States economy:

Big Diesel
YEAR Return Inflation
1999 5% 2.00%
2000 9% 2.00%
2001 -8% 2.20%
2002 5% 2.20%
2003 20% 2.20%

26. What is the average real return for Big Diesel over the five-year time
period?

27. If the market portfolio has an expected return of 0.12 and a standard
deviation of 0.40, and the risk-free rate is 0.04, what is the slope of the
security market line?

28. The stock of Alpha Company has an expected return of 15.5% and a beta of
1.5, and Gamma Company stock has an expected return of 13.4% and a beta of
1.2. Assume the CAPM holds. Whats the expected return on the market?

Exhibit 7-1

Outcome Probability Return

Recession 25% -30%
Expansion 40% 15%
Boom 35% 55%

29. Given Exhibit 7-1, what is the expected return?

30. Given Exhibit 7-1, what is the expected variance?

31. Given Exhibit 7-1, what is the expected standard deviation?

32. Nico owns 100 shares of stock X which has a price of P12 per share and 200 shares of
stock Y which has a price of P3 per share. What is the proportion of Nicos portfolio
invested in stock X?

33. What is the market risk premium if the risk free rate is 5 percent and the expected
market return is given as follows?
State of Nature Probability Return
Boom 20% 30%
Average 70% 15%
Recession 10% -5%

34. Security A has an expected rate of return of 22% and a beta of 2.5. Security B has a beta
of 1.20. If the Treasury bill rate is 10%, what is the expected rate of return for security B?