For Questions 1-4 & 35-37 use the following information and figure(s) below: You
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Question
For Questions 1-4 & 35-37 use the following information and figure(s) below:
You decide to make a table in Excel to solve for the Market Risk Premium using the CAPM. To do so you use the Cost of Equity, the Risk-Free Rate, and Levered Beta for Stocks A-J as user inputs.
Recall the long term historical average rate of return on US large cap stocks since 1926 from Exam 1. In the table below, this is the only acceptable range of values for Expected Market Return.
Recall the long term historical average rate of return on U.S. Treasury bills since 1926 from Exam 1. In the table below, this is the only acceptable range of values for the Risk-Free Rate.
Regardless of the valuation method chosen, dividends (if any) are assumed to grow at the same rate as they did between Year 2 and Year 3 in perpetuity. That makes Year 2 (T=2) the Terminal Value Year (i.e. the year in which you apply an annuity formula or other going-concern assumption).
All numbers are presented in Millions (M) of USD and each company has 20M shares outstanding.
1. How many of the user inputs for Stocks A-J are NOT acceptable according ONLY to the acceptable range for the long term historical average rate of return on U.S. Treasury bills since 1926?
A. 0
B. 1
C. 2
D. 3
E. 4
2. For this question only, assume each Risk-Free Rate assumptions made for Stocks A-J are acceptable and do not change. Adjust each Implied Market Risk Premium for each Risk-Free Rate assumption made. According to the Implied Market Risk Premium for Stocks A-J, for how many stocks does the long term historical average rate of return on US large cap stocks since 1926 fall outside the range of acceptable values?
A. 1
B. 2
C. 3
D. 5
E. 6
3. Use the Constant Growth DDM to value Company A and Company B.
A. Company A’s Equity is Valued at 80M which is about 0.5x that of Company B’s Equity
B. Company A’s Equity is Valued at 80M which is about 2.0x that of Company B’s Equity
C. Company A’s Firm Value is 75M which is about 0.5x that of Company B’s Firm Value
D. Company A’s Firm Value is 75M which is about 2.0x that of Company B’s Firm Value
E. None of the Above
4. Using the Multi-Stage Growth DDM, calculate the share price of Company E.
A. 1.63
B. 2.01
C. 8.46
D. 32.53
E. 40.30
For Questions 35-38, refer back to the cover page of this exam. HINT: You may want to forecast Year 3.
35. If sales growth was all that mattered to investors, which company would command the lowest P/S terminal value multiple?
A. Company F or Company J
B. Company G
C. Company H
D. Company I
E. Impossible to answer without knowing if investors looked at the forward or trailing P/S multiple
36. Company _______ has the highest theoretical dividend growth rate Today (T=0) and
Company _______ has the lowest theoretical dividend growth rate Today (T=0).
A. Company G ; Company F
B. Company I ; Company G
C. Company G ; Company I
D. Company J ; Company G
E. Company G ; Company J
37. What is the value of all future cash flows after year 2 …. in T=2 (i.e. do NOT discount to today). Base your estimate on a Forward P/S Terminal Multiple for Company H?
A. 630M
B. 674M
C. 721M
D. 750M
E. None of the above
38. What is the value of all future cash flows after year 2 …. today (i.e. discount two periods). Base your estimate on a Trailing P/E Terminal Multiple for Company I?
A. 365M
B. 395M
C. 410M
D 438M
E. None of the above
39. During lecture and for PPT#2 you have computed and interpreted HHI to decide whether two companies will be allowed by regulators to merge. Assume that if the HHI changes by more than 350, the companies will not be allowed to merge. Companies H & I are proposing a merger. What is the HHI Pre Merger (Rounded to the nearest 50) and will the merger be allowed to go through?
A. 1350 ; NO
B. 1450 ; YES
C. 1450 ; NO
D. 1550 ; YES
E. 1550 ; NO
5. Which of the following is least likely the reason that Company D pays $0.00 in dividends?
A. The retention rate is 100%, sales are increasing, and the net margin is positive and steadily rising
B. The retention rate is 50%, sales are increasing, and the net margin is positive and steadily rising
C. The retention rate is 50%, sales are increasing, but the net margin is negative and steadily declining
D. The payout rate is 50%, sales are increasing, but the net margin is 0% and steadily declining
E. The retention rate is 100%, sales are increasing, and the net margin is negative and steadily rising
For Questions 6-10, use the following information about two different stocks and CAPM inputs:
Stock A has a Beta of 1.15 with an effective tax rate >0.0%
Stock B has a Beta of 0.85 with an effective tax rate >0.0%
Stock C has a Beta of 1.00 with an effective tax rate >0.0%
Risk-Free Rate is 5.0%
Market Risk Premium 15.0%
6. According to the CAPM, the historical correlation between Stock and Bond returns, and your understanding of Quantitative Easing, if the Risk-Free Rate falls to 4.0%, how many of the following statements is(are) most likely accurate:
I. The Market Risk Premium remains unchanged at 15.0%
II. The long term Expected Market Return increases
III. Stocks become less attractive than bonds on a relative basis
IV. The Federal Reserve could be decreasing the money supply through QE
A. 0
B. 1
C. 2
D. 3
E. 4
7. According to the CAPM, if the Risk-Free Rate falls to 4.0%, which of the following statements is(are) most likely accurate:
I. The Cost of Equity for all Stocks will increase
II. The Present Value of all Stocks Future Cash Flows will increase
III. Stock A’s Market Risk Premium will increase more than the other two stocks
A. I
B. II
C. I & III
D. II & III
E. None of the above
8. For this question only, if you know that all the Stocks are all in Industry X and that each company has the same effective tax rate, which of the following statements is(are) most likely accurate:
I. Stock A has a higher Total Asset to Equity Ratio than Stock B
II. Stock A has a higher Debt to Equity Ratio than Stock B
III. Stock C has no Debt
A. I
B. II
C. III
D. I & II
E. II & III
9. For this question only, if you know that all the Stocks are all in Industry X and that the Unlevered Industry Beta is 0.85, which of the following statements is (are) most likely accurate:
I. Stock A must have a higher after-tax Debt to Equity Ratio than C
II. Stock B must have a higher after-tax Debt to Equity Ratio than C
III. Stock B has no Debt
A. I
B. I & II
C. I & III
D. II & III
E. I, II, & III
10. For this question only, assume that Company A and Company B could be in different sectors. You can also assume both companies have the same effective tax rate and the same capital structure. One company is Whole Foods and one company is Dollar General. During lecture, we discussed arguments for and against assigning Whole Foods and Dollar General to different sectors. How many of the following statements is(are) likely to be accurate:
I. Company B is more likely to be Whole Foods and in the Consumer Discretionary Sector
II. Company A is more likely to be Whole Foods which is the Health Food Sector
III. Company B is more likely to be Dollar General which is Non-Cyclical
IV. Company A is more likely to be Dollar General which is the Consumer Staples Sector
V. Whole Foods could be assigned to either the Consumer Discretionary Sector or the Consumer Staples Sector, while Dollar General should only be assigned to one of the two.
A. 1
B. 2
C. 3
D. 4
E. 5
For Questions 11-12, use the following information:
You have a client who was in a 35% tax bracket last year
By the time the client pays taxes on their interest income this year, their tax bracket will be 30%
A corporate bond is priced to yield 6.0% with a duration of 1.5
A comparable municipal bond is priced to yield 4.0% with a duration of 0.5
11. How would you advise your client to invest their money?
A. Purchase the corporate bond because it yields more than the municipal bond after taxes
based on last year’s tax rate
B. Purchase the corporate bond because it yields more than the municipal bond after taxes
based on this year’s tax rate
C. Purchase either bond because the yields are the same after taxes
based on this year’s tax rate
D Purchase the municipal bond because it yields more than the corporate bond after taxes
based on last year’s tax rate
E. Purchase the municipal bond because your client will be falling into a lower tax bracket
12. How could you describe these bonds’ duration to your client?
A. If interest rates rise by 1.0%, the corporate bond will yield 5.0% and the municipal bond will yield 3.5%
B. If interest rates rise by 0.5%, the corporate bond will yield 2.5% and the municipal bond will yield 2.0%
C. If interest rates rise by 1.0%, the corporate bond will yield 7.0% and the municipal bond will yield 4.5%
D. If interest rates fall by 0.5%, the corporate bond price will increase by 0.75% and the municipal bond’s
price will increase by 0.25%
D. If interest rates fall by 0.5%, the corporate bond price will decrease by 0.75% and the municipal bond’s
price will decrease by 0.25%
13. Which of the following about a bonds’ convexity is accurate?
I. Convexity takes duration one step further; it recognizes that a bond’s price sensitivity to changes
in interest rates is non-linear.
II. Convexity transforms the equation for a bond’s price change to:
?P/P = -D * ?Y + 0.5 * Convexity * (?Y)^2
III. To use the convexity formula above, ?Y is equal to the change in the interest rate. For instance,
enter a 5.0% change in the interest rate as follows:
?P/P = -D * 5.0 + 0.5 * Convexity * (5.0)^2
A. I
B. I & II
C. I, II, & III
D. II & III
E. None of the Above
14. According to the Fama-French 3 Factor Model for Equity Returns, which of the following will decrease the required return on equity (all things being equal)?
I. A company reduces equity on its balance sheet relative to debt outstanding
II. A company starts paying a dividend which forces management to monitor cash flows better
III. A company with a low BV/MV ratio vs. a company with a high BV/MV ratio
IV. A small company growing faster vs. a large company growing more slowly
A. I
B. II
C. II & III
D. I, II, III, & IV
E. None of the Above
15. During lecture, we discussed that when buying or selling options you have very little ability to specify which of the following as part of your order:
I. Volatility
II. Strike Price
III. Contract Expiration
IV. Time until Expiration
A. I
B. II
C. II & III
D. II & IV
E. III & IV
For Questions 1-4 & 35-37 use the following information and figure(s) below:
You decide to make a table in Excel to solve for the Market Risk Premium using the CAPM. To do so you use the Cost of Equity, the Risk-Free Rate, and Levered Beta for Stocks A-J as user inputs.
Recall the long term historical average rate of return on US large cap stocks since 1926 from Exam 1. In the table below, this is the only acceptable range of values for Expected Market Return.
Recall the long term historical average rate of return on U.S. Treasury bills since 1926 from Exam 1. In the table below, this is the only acceptable range of values for the Risk-Free Rate.
Regardless of the valuation method chosen, dividends (if any) are assumed to grow at the same rate as they did between Year 2 and Year 3 in perpetuity. That makes Year 2 (T=2) the Terminal Value Year (i.e. the year in which you apply an annuity formula or other going-concern assumption).
All numbers are presented in Millions (M) of USD and each company has 20M shares outstanding.
1. How many of the user inputs for Stocks A-J are NOT acceptable according ONLY to the acceptable range for the long term historical average rate of return on U.S. Treasury bills since 1926?
A. 0
B. 1
C. 2
D. 3
E. 4
2. For this question only, assume each Risk-Free Rate assumptions made for Stocks A-J are acceptable and do not change. Adjust each Implied Market Risk Premium for each Risk-Free Rate assumption made. According to the Implied Market Risk Premium for Stocks A-J, for how many stocks does the long term historical average rate of return on US large cap stocks since 1926 fall outside the range of acceptable values?
A. 1
B. 2
C. 3
D. 5
E. 6
3. Use the Constant Growth DDM to value Company A and Company B.
A. Company A’s Equity is Valued at 80M which is about 0.5x that of Company B’s Equity
B. Company A’s Equity is Valued at 80M which is about 2.0x that of Company B’s Equity
C. Company A’s Firm Value is 75M which is about 0.5x that of Company B’s Firm Value
D. Company A’s Firm Value is 75M which is about 2.0x that of Company B’s Firm Value
E. None of the Above
4. Using the Multi-Stage Growth DDM, calculate the share price of Company E.
A. 1.63
B. 2.01
C. 8.46
D. 32.53
E. 40.30
5. Which of the following is least likely the reason that Company D pays $0.00 in dividends?
A. The retention rate is 100%, sales are increasing, and the net margin is positive and steadily rising
B. The retention rate is 50%, sales are increasing, and the net margin is positive and steadily rising
C. The retention rate is 50%, sales are increasing, but the net margin is negative and steadily declining
D. The payout rate is 50%, sales are increasing, but the net margin is 0% and steadily declining
E. The retention rate is 100%, sales are increasing, and the net margin is negative and steadily rising
For Questions 6-10, use the following information about two different stocks and CAPM inputs:
Stock A has a Beta of 1.15 with an effective tax rate >0.0%
Stock B has a Beta of 0.85 with an effective tax rate >0.0%
Stock C has a Beta of 1.00 with an effective tax rate >0.0%
Risk-Free Rate is 5.0%
Market Risk Premium 15.0%
6. According to the CAPM, the historical correlation between Stock and Bond returns, and your understanding of Quantitative Easing, if the Risk-Free Rate falls to 4.0%, how many of the following statements is(are) most likely accurate:
I. The Market Risk Premium remains unchanged at 15.0%
II. The long term Expected Market Return increases
III. Stocks become less attractive than bonds on a relative basis
IV. The Federal Reserve could be decreasing the money supply through QE
A. 0
B. 1
C. 2
D. 3
E. 4
7. According to the CAPM, if the Risk-Free Rate falls to 4.0%, which of the following statements is(are) most likely accurate:
I. The Cost of Equity for all Stocks will increase
II. The Present Value of all Stocks Future Cash Flows will increase
III. Stock A’s Market Risk Premium will increase more than the other two stocks
A. I
B. II
C. I & III
D. II & III
E. None of the above
8. For this question only, if you know that all the Stocks are all in Industry X and that each company has the same effective tax rate, which of the following statements is(are) most likely accurate:
I. Stock A has a higher Total Asset to Equity Ratio than Stock B
II. Stock A has a higher Debt to Equity Ratio than Stock B
III. Stock C has no Debt
A. I
B. II
C. III
D. I & II
E. II & III
9. For this question only, if you know that all the Stocks are all in Industry X and that the Unlevered Industry Beta is 0.85, which of the following statements is (are) most likely accurate:
I. Stock A must have a higher after-tax Debt to Equity Ratio than C
II. Stock B must have a higher after-tax Debt to Equity Ratio than C
III. Stock B has no Debt
A. I
B. I & II
C. I & III
D. II & III
E. I, II, & III
10. For this question only, assume that Company A and Company B could be in different sectors. You can also assume both companies have the same effective tax rate and the same capital structure. One company is Whole Foods and one company is Dollar General. During lecture, we discussed arguments for and against assigning Whole Foods and Dollar General to different sectors. How many of the following statements is(are) likely to be accurate:
I. Company B is more likely to be Whole Foods and in the Consumer Discretionary Sector
II. Company A is more likely to be Whole Foods which is the Health Food Sector
III. Company B is more likely to be Dollar General which is Non-Cyclical
IV. Company A is more likely to be Dollar General which is the Consumer Staples Sector
V. Whole Foods could be assigned to either the Consumer Discretionary Sector or the Consumer Staples Sector, while Dollar General should only be assigned to one of the two.
A. 1
B. 2
C. 3
D. 4
E. 5
For Questions 11-12, use the following information:
You have a client who was in a 35% tax bracket last year
By the time the client pays taxes on their interest income this year, their tax bracket will be 30%
A corporate bond is priced to yield 6.0% with a duration of 1.5
A comparable municipal bond is priced to yield 4.0% with a duration of 0.5
11. How would you advise your client to invest their money?
A. Purchase the corporate bond because it yields more than the municipal bond after taxes
based on last year’s tax rate
B. Purchase the corporate bond because it yields more than the municipal bond after taxes
based on this year’s tax rate
C. Purchase either bond because the yields are the same after taxes
based on this year’s tax rate
D Purchase the municipal bond because it yields more than the corporate bond after taxes
based on last year’s tax rate
E. Purchase the municipal bond because your client will be falling into a lower tax bracket
12. How could you describe these bonds’ duration to your client?
A. If interest rates rise by 1.0%, the corporate bond will yield 5.0% and the municipal bond will yield 3.5%
B. If interest rates rise by 0.5%, the corporate bond will yield 2.5% and the municipal bond will yield 2.0%
C. If interest rates rise by 1.0%, the corporate bond will yield 7.0% and the municipal bond will yield 4.5%
D. If interest rates fall by 0.5%, the corporate bond price will increase by 0.75% and the municipal bond’s
price will increase by 0.25%
D. If interest rates fall by 0.5%, the corporate bond price will decrease by 0.75% and the municipal bond’s
price will decrease by 0.25%
13. Which of the following about a bonds’ convexity is accurate?
I. Convexity takes duration one step further; it recognizes that a bond’s price sensitivity to changes
in interest rates is non-linear.
II. Convexity transforms the equation for a bond’s price change to:
?P/P = -D * ?Y + 0.5 * Convexity * (?Y)^2
III. To use the convexity formula above, ?Y is equal to the change in the interest rate. For instance,
enter a 5.0% change in the interest rate as follows:
?P/P = -D * 5.0 + 0.5 * Convexity * (5.0)^2
A. I
B. I & II
C. I, II, & III
D. II & III
E. None of the Above
14. According to the Fama-French 3 Factor Model for Equity Returns, which of the following will decrease the required return on equity (all things being equal)?
I. A company reduces equity on its balance sheet relative to debt outstanding
II. A company starts paying a dividend which forces management to monitor cash flows better
III. A company with a low BV/MV ratio vs. a company with a high BV/MV ratio
IV. A small company growing faster vs. a large company growing more slowly
A. I
B. II
C. II & III
D. I, II, III, & IV
E. None of the Above
15. During lecture, we discussed that when buying or selling options you have very little ability to specify which of the following as part of your order:
I. Volatility
II. Strike Price
III. Contract Expiration
IV. Time until Expiration
A. I
B. II
C. II & III
D. II & IV
E. III & IV
Explanation / Answer
Strike price refers to the fixing the price of the security by the seller after getting buds underlying the tender for undertaking new issue of stocks or selling securities that are gift edged. The expiration date pertaining to the listed option is third Friday of the month in which the expiration of the contract is being decided by the parties involved. Time until expiration is the other name of maturity underlying an option. It represents the time remaining before the expiration of the contract. Volatility refers to the variation underlying the prices at which the option is being traded over time which is ascertained by the analyzing standard deviation of the returns, it is generally difficult to ascertain the actual volatility.
Hence, it is ascertained the correct option is “a” or Volatility.
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