FIN 432—Theory of Investments Spring 2014 FINAL Exam

FIN 432—Theory of Investments Spring 2014 FINAL Exam


1) Consider the following two stocks, A and B. Stock A has an expected return of 12.5% and a beta of 1.13. Stock B has an expected return of 13.75% and a beta of 1.48. The expected market rate of return is 8.75% and the risk-free rate is 4.30%. If you observe that each has an actual return of 10% which one is overpriced?

2) Research has identified two systematic factors that affect U.S. stock returns. The factors are growth in industrial production and changes in long term interest rates. Industrial production growth is expected to be 2.8% and long term interest rates are expected to increase by 1.4%. You are analyzing a stock is that has a beta of 0.90 on the industrial production factor and 0.6 on the interest rate factor. It currently has an expected return of 11.5%. However, if industrial production actually grows 3.1% and interest rates drop 0.75% what is your best guess of the stock's return?

3) If a stock’s price doesn’t change over time it is called a “Stale Price.” Does this situation represent market efficiency or inefficiency? What role does the release of information have on your answer?

4) Joe bought a stock at $48.50 per share. The price promptly fell to $42.75. Joe held on to the stock until it again reached $48.50 and then he sold once he had eliminated his loss. If enough investors do the same a trading pattern will emerge. What type of strategy could one employ to take advantage of this and what does it imply about the form of market efficiency?

5) Fama and French found that high book to market firms outperform low book to market firms even after adjusting for systematic risk (beta). What is one proposed reason for this effect to exist? What is the counterargument to this proposed reason?

6) You purchased a 6-year semi-annual interest coupon 8 months ago. Its coupon rate was 5.8% and its par value was $1,000 when you bought it. If you decided to sell the bond 2 months (i.e. 60 days) after receiving the first interest payment and the bond's yield to maturity had changed to 5.0% what price would you receive?

7) You notice that the yields of zero coupon bonds with different times to maturity are 4% for 1 year, 4.6% for 2 years, 5.1% for 3 years, and 5.2% for four years. What is the implied one year interest rate between years 2 and 3?

8) A $1,000 par value corporate bond has 12 years to maturity and pays interest semiannually. The coupon rate is 6.2% and the bond is priced at 98.2% of par. However, this bond is callable after 5 years but must pay a 20% call premium. What is the yield-to-call?

9) A $1,000 par value annual coupon bond has a coupon rate of 6.8% and 5 years until maturity. The market requires a yield of 7.2% on bonds of this risk level. What is the duration of this bond? What is the modified duration?

10) An insurance company has liabilities of $4.5 million due in 4 years and are considering using a 2 year, 4% annual coupon bond and a 6 year, 5.2% annual coupon bond to immunize the interest rate risk they face. The yield on both bonds is 4.6% and both bonds have a par value of $1,000. What portfolio weights are necessary to eliminate interest rate risk for small changes in the interest rates?

11) You see that a 4 year, 7.2% annual coupon bond is priced at 105% of par value. If interest rates suddenly increase by 0.20% what price would you predict the bond would sell for using the duration of the bond?

12) If changes in the interest rate are large then duration is no longer a good approximation to the price change. How do we adjust for this and would you the price increase/decrease more than it should or less than it should if interest rates increase by 3%?

13) A share of stock XYZ sells for $188.50 per share and has a P/E ratio of 26. The stock’s Beta is 1.6 and the market portfolio is expected to return 11.5% while T-bills are yield 3.1%. What is the present value of growth opportunities for this firm?

14) A stock of ABC, Inc. is currently paying a dividend of $1.80 per share. Their stock’s Beta is 0.92, the market risk premium is 8.5% and T-bills are yielding 3.8%. This stock is selling for $18.50 now. The firm plans on maintaining a 30% payout ratio for the foreseeable future. What is the firm’s return on equity to be consistent with the constant growth model?

15) The free cash flow to the firm is reported as $204 million. The interest expense to the firm is $21 million. If the tax rate is 30% and the net debt of the firm increased by $21 million, what is the market value of the firm if the FCFE grows at 5.2% and the cost of equity is 13.5%?

16) Stockholders of Doggie Wigz, Inc. expect a 14.10% rate of return on their stock. Management has consistently been generating a ROE of 15.25% over the last 5 years but now believes that ROE will be 15.75% for the next five years. Given this the firm's optimal dividend payout ratio should be what? What effect will this have on the stock price (i.e. increase or decrease) will this do to the price of the stock?

17) A firm increases its financial leverage when its ROA is greater than the cost of debt. Everything else equal this change will probably increase which of the following?
b.Earnings volatility over the business cycle
d.The stock price
18) Sector rotation is the idea that different sectors of the economy do better at different times during the business cycle. You find that an index of leading indicators is less favorable than the index of coincident indicators and that the index of lagging indicators is also less favorable than the coincident indicators. Should you increase or decrease your portfolio’s systematic risk? Which of the following industries should you consider adding to you portfolio?
a. Health Care
e.Consumer Staples

19) If interest rates drop, business investment expenditures are likely to do what? How does this affect consumer durable expenditures? How woul d the Federal Reserve implement this policy?

20) Which of the following comprise barriers to entry?
a.Large economies of scale required to be profitable
b.Established brand loyalty
c.Patent protection for the firm's product
d.Rapid industry growth