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Because intrinsic value, 50, exceeds current price, 48, we conclude that the stock is undervalued in the market. We again conclude investors will want to buy more ABC than they would following a passive strategy. If the intrinsic value turns out to be lower than the current market price, investors should buy less of it than under the passive strategy. It might even pay to go short on ABC stock, as we discussed in Chapter 3. In market equilibrium, the current market price will reflect the...
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income statement, 452 interest coverage ratio, 463 leverage ratio, 460 LIFO, 470 ratio, 463 price-earnings ratio, 464 profit margin, 459 quality of earnings, 472 quick ratio, 463 residual income, 467 return on assets, 457 return on equity, 456 return on sales, 459 statement of cash flows, 454 times interest earned, 463 The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher than the industry average, yet its ROA is the same as the industry average. How can you...
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ratios with associated trading costs. It is far harder to identify the secrets of successful stock picking. If it were easy, we would all be rich Thus the consistency we do observe in fund performance may be due in large part to the poor performers. This suggests that the real value of past performance data is to avoid truly poor funds, even if identifying the future top performers is still a daunting task. 4. Suppose you observe the investment performance of 400 portfolio managers and rank...
Key Terms Sbj
1. What monetary and fiscal policies might be prescribed for an economy in a deep recession 2. Unlike other investors, you believe the Fed is going to dramatically loosen monetary policy. What would be your recommendations about investments in the following industries 3. If you believe the U.S. dollar is about to depreciate more dramatically than do other investors, what will be your stance on investments in U.S. auto producers
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16. In a cash flow statement prepared in accordance with FASB 95, cash flow from investing activities excludes b. Cash received from the sale of fixed assets. c. Inventory increases due to a new internally developed product line. 17. Cash flow from operating activities includes a. Inventory increases resulting from acquisitions. b. Inventory changes due to changing exchange rates. c. Interest paid to bondholders. d. Dividends paid to stockholders. 18. Janet Ludlow is a recently hired analyst....
Figure 83
8 The Efficient Market Hypothesis 275 low capitalization stocks should enable an investor to earn excess returns. After all, any investor can measure firm size costlessly. One would not expect such minimal effort to yield such large rewards. Later studies Keim, 1983 Reinganum, 1983 and Blume and Stambaugh, 1983 showed that the small-firm effect occurs virtually entirely in the first two weeks of January. The size effect is in fact a small-firm-in-January effect. Some researchers believe the...
Problem Sets Qrj
Bodie-Kane-Marcus Essentials of Investments, Fifth Edition 11. Macroeconomic and Industry Analysis 4. According to supply-side economists, what will be the long-run impact on prices of a reduction in income tax rates 5. Consider two firms producing videocassette recorders. One uses a highly automated robotics process, while the other uses human workers on an assembly line and pays overtime when there is heavy production demand. a. Which firm will have higher profits in a recession In a boom b....
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financial engineering, 19 financial intermediaries, 11 fixed-income securities, 5 globalization, 15 investment, 3 investment bankers, 13 investment companies, 13 passive management, 10 pass-through securities, 16 primary market, 14 real assets, 4 risk-return trade-off, 10 secondary markets, 15 securitization, 17 security analysis, 9 security selection, 8 unbundling, 18 Suppose you discover a treasure chest of 10 billion in cash. a. Is this a real or financial asset b. Is society any richer for...
The Great Divide New vs Old Economy
The stock market has divided the world into two camps new-economy companies and old-economy companies. The gulf between them could not be wider. New-economy companies do technology, including the Internet. Old-economy companies do everything else. The stocks of new-economy companies command in 1999 tremendous price-earnings ratios, anywhere from 70 for Microsoft to 450 for America Online. Old-economy companies have ordinary multiples in the 10 to 25 range. A higher multiple reflects greater...
Figure 1 3
Source The Wall Street Journal, December 19, 2001. Often, creating a security that appears to be attractive requires the unbundling of an asset. An example is given in Figure 1.4. There, a mortgage pass-through certificate is unbundled into classes. Class 1 receives only principal payments from the mortgage pool, whereas Class 2 receives only interest payments. The process of bundling and unbundling is called financial engineering, which refers to the creation and design of securities with...
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12. Using the data provided, discuss whether the common stock of American Tobacco Company is attractively priced based on at least three different valuation approaches. Hint Use the asset value, DDM, and earnings multiplier approaches. Replacement cost of assets per share Estimated annual growth in dividends and earnings P E ratio based on next year's earnings 54.00 12.10 9.10 19.50 2.10 10.0 13.0 4.80 11.3 3.8 13. The risk-free rate of return is 10 , the required rate of return on the market...
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A word of caution We often hear that well-managed firms will provide high rates of return. We agree this is true if one measures the firm's return on investments in plant and equipment. The CAPM, however, predicts returns on investments in the securities of the firm. Say that everyone knows a firm is well run. Its stock price should, therefore, be bid up, and returns to stockholders who buy at those high prices will not be extreme. Security prices reflect public information about a firm's...
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intrinsic value, 415 liquidation value, 414 market capitalization rate, 416 plowback ratio, 421 present value of growth opportunities PVGO , 422 multiple, 428 replacement cost, 414 Tobin's q, 414 two-stage DDM, 424 A common stock pays an annual dividend per share of 2.10. The risk-free rate is 7 and the risk premium for this stock is 4 . If the annual dividend is expected to remain at 2.10, what is the value of the stock Which of the following assumptions does the constant growth dividend...
The Index Model Realized Returns and the Expected ReturnBeta Relationship
To move from a model cast in expectations to a realized-return framework, we start with a form of the single-index regression equation in realized excess returns, similar to that of Equation 6.6 in Chapter 6 where ri is the holding-period return HPR on asset i, and ai and are the intercept and slope of the line that relates asset i's realized excess return to the realized excess return of the index. We denote the index return by rM to emphasize that the index portfolio is proxying for the...
Nucor Corporation
Stock price Dec. 30, 1997 53.00 1998 estimated book value 25.00 Indicated dividend 0.40 Beta 1.10 Risk-free return 7.0 High-grade corporate bond yield 9.0 Risk premium stocks over bonds 5.0 a. Calculate the expected stock market return. Show your calculations. b. Calculate the implied total return of Nucor stock. c. Calculate the required return of Nucor stock using the CAPM. d. Briefly discuss the attractiveness of Nucor based on these data. 20. The stock of Nogro Corporation is currently...
Life Cycles and Multistage Growth Models
As useful as the constant growth DDM formula is, you need to remember that it is based on a simplifying assumption, namely, that the dividend growth rate will be constant forever. In fact, firms typically pass through life cycles with very different dividend profiles in different phases. In early years, there are ample opportunities for profitable reinvestment in the company. Payout ratios are low, and growth is correspondingly rapid. In later years, the firm matures, production capacity is...
Shorter Clearer MutualFund Disclosure May Omit Vital Investment Information
Mutual-fund investors will receive shorter and clearer disclosure documents, under new rules adopted by the Securities and Exchange Commission. But despite all the hoopla surrounding the improvements including a new profile prospectus and an easier-to-read full prospectus there's still a slew of vital information fund investors don't get from any disclosure documents, long or short. Of course, more information isn't necessarily better. As it is, investors rarely read fund disclosure documents,...
Pitfalls in PE Analysis
The practice of using flexibility in accounting rules to improve the apparent profitability of the firm. No description of P E analysis is complete without mentioning some of its pitfalls. First, consider that the denominator in the P E ratio is accounting earnings, which are influenced by somewhat arbitrary accounting rules such as the use of historical cost in depreciation and inventory valuation. In times of high inflation, historic cost depreciation and inventory costs will tend to...
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a. Newsoft's shares have higher price-earnings P E and price-book value P B ratios than those of Capital Corp. The price-book ratio is the ratio of market value to book value. Briefly discuss why the disparity in ratios may not indicate that NewSoft's shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company. b. Using a constant growth dividend discount model,...
The Investment Process
An investor's portfolio is simply his collection of investment assets. Once the portfolio is established, it is updated or rebalanced by selling existing securities and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the portfolio. Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two types...
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What is the expected return on this three-asset portfolio Bodie-Kane-Marcus I II. Portfolio Theory I 6. Efficient Diversification I I The McGraw-Hill Essentials of Investments, Companies, 2003 2. An investor is considering adding another investment to a portfolio. To achieve the maximum diversification benefits, the investor should add, if possible, an investment that has which of the following correlation coefficients with the other investments in the portfolio 3. Consistent with capital...
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WAH and its principal competitors each operated more than 150 stores at year-end 1999. The average number of stores operated per company engaged in the retail auto parts industry is 5.3. The major customer base for auto parts sold in retail stores consists of young owners of old vehicles. These owners do their own automotive maintenance out of economic necessity. a. One of RRG's conclusions is that the retail auto parts industry as a whole is in the maturity stage of the industry life cycle....
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2. Calculate the price of the bond for a market interest rate of 3 per half year. Compare the capital gains for the interest rate decline to the losses incurred when the rate increases to 5 . Corporate bonds typically are issued at par value. This means the underwriters of the bond issue the firms that market the bonds to the public for the issuing corporation must choose a coupon rate that very closely approximates market yields. In a primary issue of bonds, the underwriters attempt to sell...
The RiskReturn TradeOff
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. There will almost always be risk associated with investments. Actual or realized returns will almost always deviate from the expected return anticipated at the start of the investment period. For example, in 1931 the worst calendar year for the market since 1926 , the stock market lost 43 of its value. In 1933 the best year , the stock market gained 54 . You can be sure that investors did not...
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8. Philip Morris has issued bonds that pay annually with the following characteristics Bodie-Kane-Marcus Essentials of Investments, Fifth Edition a. Calculate modified duration using the information above. b. Explain why modified duration is a better measure than maturity when calculating the bond's sensitivity to changes in interest rates. c. Identify the direction of change in modified duration if i. The coupon of the bond were 4 , not 8 . ii. The maturity of the bond were 7 years, not 15...
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1. A nine-year bond has a yield of 10 and a duration of 7.194 years. If the bond's yield changes by 50 basis points, what is the percentage change in the bond's price 2. Find the duration of a 6 coupon bond making annual coupon payments if it has three years until maturity and a yield to maturity of 6 . What is the duration if the yield to maturity is 10 A pension plan is obligated to make disbursements of 1 million, 2 million, and 1 million at the end of each of the next three years,...
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a. What do you expect the rate of return to be over the coming year on a three-year zero-coupon bond b. Under the expectations theory, what yields to maturity does the market expect to observe on one- and two-year zeros next year Is the market's expectation of the return on the three-year bond greater or less than yours 37. The following multiple-choice problems are based on questions that appeared in past CFA examinations. a. Which bond probably has the highest credit quality 1 Sumter, South...
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22. List the reasons and briefly discuss why this firm might not want to adopt a new strategy based on these studies in place of its current strategy of complete diversification and the use of beta as a measure of portfolio risk. 23. Growth and Value can be defined in several ways, but growth usually conveys the idea of a portfolio emphasizing or including only issues believed to possess above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and...
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which implies that P 115.38 per share. If Dot Bomb stock should rise above 115.38 per share, you will get a margin call, and you will either have to put up additional cash or cover your short position by buying shares to replace the ones borrowed. 5. a. Construct the balance sheet if Dot Bomb goes up to 110. b. If the short position maintenance margin in the Dot Bomb example is 40 , how far can the stock price rise before the investor gets a margin call You can see now why stop-buy orders often...
A
For example, if an investor believes the risk premium on her portfolio is 8 , and the standard deviation is 20 , then we could infer risk aversion as A .08 .5 X .202 4. In practice, we cannot observe the risk premium investors expect to earn. We can observe only actual returns after the fact. Moreover, different investors may have different expectations about the risk and return of various assets. Finally, Equations 5.6 and 5.7 apply only to the variance of an investor's overall portfolio, not...
Key Terms Nem
Which security has a higher effective annual interest rate a. A three-month T-bill selling at 97,645. b. A coupon bond selling at par and paying a 10 coupon semiannually. 2. Treasury bonds paying an 8 coupon rate with semiannual payments currently sell at par value. What coupon rate would they have to pay in order to sell at par if they paid their coupons annually 3. Two bonds have identical times to maturity and coupon rates. One is callable at 105, the other at 110. Which should have the...
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14. Assume you have a one-year investment horizon and are trying to choose among three bonds. All have the same degree of default risk and mature in 10 years. The first is a zero-coupon bond that pays 1,000 at maturity. The second has an 8 coupon rate and pays the 80 coupon once per year. The third has a 10 coupon rate and pays the 100 coupon once per year. a. If all three bonds are now priced to yield 8 to maturity, what are their prices b. If you expect their yields to maturity to be 8 at the...
Example Nri
Suppose that the risk-free rate is 7 and a well-diversified portfolio, V, with beta of 1.3 has an alpha of 2 and another well-diversified portfolio, U, with beta of 0.8 has an alpha of 1 . We go long on V and short on U with proportions These proportions add up to 1.0 and result in a portfolio with beta -1.6 X 1.3 2.6 X 0.8 0. The alpha of the portfolio is -1.6 X 2 2.6 X 1 -0.6 . This means that the riskless portfolio will earn a rate of return that is less than the risk-free rate by .6 . We...
Long-term Treasury Bonds Currently Are Selling At Yields To Maturity Of Nearly
22. A member of a firm's investment committee is very interested in learning about the management of fixed-income portfolios. He would like to know how fixed-income managers position portfolios to capitalize on their expectations concerning three factors which influence interest rates a. Changes in the level of interest rates. b. Changes in yield spreads across between sectors. c. Changes in yield spreads as to a particular instrument. Assuming that no investment policy limitations apply,...
A 30-year Maturity Bond Making Annual Coupon Payments With A Coupon Rate Of 12
a. Using the duration and yield information in the table, compare the price and yield behavior of the two bonds under each of the following two scenarios i. Strong economic recovery with rising inflation expectations. ii. Economic recession with reduced inflation expectations. b. Using the information in the table, calculate the projected price change for bond B if the yield-to-maturity for this bond falls by 75 basis points. c. Describe the shortcoming of analyzing bond A strictly to call or...
Multifactor Generalization of the APT and CAPM
We've assumed all along that there is only one systematic factor affecting stock returns. This assumption may be too simplistic. It is easy to think of several factors that might affect stock returns business cycles, interest rate fluctuations, inflation rates, oil prices, and so on. Presumably, exposure to any of these factors singly or together will affect a stock's perceived A well-diversified portfolio constructed to have a beta of 1.0 on one factor and a beta of zero on any other factor....
Figure 86
Estimates of individual mutual fund alphas, 1972 to 1991 Note The frequency distribution of estimated alphas for all equity mutual funds with 10-year continuous records. Source Burton G. Malkiel, Returns from Investing in Equity Mutual Funds 1971-1991, Journal of Finance 50 June 1995 , pp. 549-72. One problem in interpreting these alphas is that the S amp P 500 may not be an adequate benchmark against which to evaluate mutual fund returns. Because mutual funds tend to maintain considerable...
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columns give the fund's most recent net asset value, the closing share price, the change in the closing price from the previous day, and trading volume in round lots of 100 shares. The premium or discount is the percentage difference between price and NAV Price - NAV NAV. Notice that there are more funds selling at discounts to NAV indicated by negative differences than premiums. Finally, the annual dividend and the 52-week return based on the percentage change in share price plus dividend...
Key Terms Jnv
1. Which of the following assumptions imply ies an informationally efficient market a. Many profit-maximizing participants, each acting independently of the others, analyze and value securities. b. The timing of one news announcement is generally dependent on other news announcements. c. Security prices adjust rapidly to reflect new information. d. A risk-free asset exists, and investors can borrow and lend unlimited amounts at the risk-free rate. 2. If markets are efficient, what should be the...
You Know That Firm Xyz Is Very Poorly Run. On A Scale Of 1 Worst To 10 Best You
4. Suppose, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis Explain. a. The average rate of return is significantly greater than zero. b. The correlation between the market return one week and the return the following week is zero. c. One could have made superior returns by buying stock after a 10 rise in price and selling after a 10 fall. d. One could have made...
Why Is The Allocation Of Credit Risk Less Of An Issue For Brady Bonds
4. When mortgages are pooled into securities, the pass-through agencies Freddie Mac and Fannie Mae typically guarantee the underlying mortgage loans. If the homeowner defaults on the loan, the pass-through agency makes good on the loan the investor in the mortgage-backed security does not bear the credit risk. a. Why does the allocation of risk to the pass-through agency rather than the security holder make economic sense b. Why is the allocation of credit risk less of an issue for Brady bonds...
Efficient Diversification With Many Risky Assets
We can extend the two-risky-assets portfolio construction methodology to cover the case of many risky assets and a risk-free asset. First, we offer an overview. As in the two-risky-assets example, the problem has three separate steps. To begin, we identify the best possible or most efficient risk-return combinations available from the universe of risky assets. Next we determine the optimal portfolio of risky assets by finding the portfolio that supports the steepest CAL. Finally, we choose an...
Hpr
Ending price - Beginning price Cash dividend Beginning price This definition of the HPR assumes that the dividend is paid at the end of the holding period. To the extent that dividends are received earlier, the definition ignores reinvestment income between the receipt of the dividend and the end of the holding period. Recall also that the percentage return from dividends is called the dividend yield, and so the dividend yield plus the capital gains yield equals the HPR. This definition of...
A B
Could the equilibrium rf be greater than 10 Hint Can a particular stock portfolio be substituted for the risk-free asset 13. Assume expected returns and standard deviations for all securities, as well as the risk-free rate for lending and borrowing, are known. Will investors arrive at the same optimal risky portfolio Explain. 14. Your assistant gives you the following diagram as the efficient frontier of the group of stocks you asked him to analyze. The diagram looks a bit odd, but your...
Tabulate And Draw The Investment Opportunity Set Of The Two Risky Funds. Use
The correlation between the fund returns is 0.15. 6. Tabulate and draw the investment opportunity set of the two risky funds. Use investment proportions for the stock fund of 0 to 100 in increments of 20 . What expected return and standard deviation does your graph show for the minimum variance portfolio 7. Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the expected return and standard deviation of the optimal risky portfolio 8. What is the...
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Note Column sums subject to rounding error. Source Mutual Fund Fact Book, Investment Company Institute, 2002. Notice that the funds are organized by the fund family. For example, funds sponsored by the Vanguard Group comprise most of the figure. The first two columns after the name of each fund present the net asset value of the fund and the change in NAV from the previous day. The last column is the year-to-date return on the fund. Often the fund name describes its investment policy. For...
Problem Sets Adj
Bodie-Kane-Marcus I III. Debt Securities I 9. Bond Prices and Yields I The McGraw-Hill Essentials of Investments, Companies, 2003 a. Find the bond's price today and six months from now after the next coupon is paid. b. What is the total rate of return on the bond 10. A 20-year maturity bond with par value 1,000 makes semiannual coupon payments at a coupon rate of 8 . Find the bond equivalent and effective annual yield to maturity of the bond if the bond price is 11. Redo problem 10 using the...
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Convertible bonds Convertible bonds give bondholders an option to exchange each bond for a specified number of shares of common stock of the firm. The conversion ratio gives the number of shares for which each bond may be exchanged. To see the value of this A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm. right, suppose a convertible bond that is issued at par value of 1,000 is convertible into 40 shares of a firm's...
Explain The Impact On The Offering Yield Of Adding A Call Feature To A Proposed
a. Why is the price range greater for the 9 coupon bond than the floating-rate note b. What factors could explain why the floating-rate note is not always sold at par value c. Why is the call price for the floating-rate note not of great importance to investors d. Is the probability of call for the fixed-rate note high or low e. If the firm were to issue a fixed-rate note with a 15-year maturity, what coupon rate would it need to offer to issue the bond at par value f. Why is an entry for yield...
Key Terms Uyo
1. Which of the following statements about the security market line SML are true a. The SML provides a benchmark for evaluating expected investment performance. b. The SML leads all investors to invest in the same portfolio of risky assets. c. The SML is a graphic representation of the relationship between expected return and beta. d. Properly valued assets plot exactly on the SML. 2. Risk aversion has all of the following implications for the investment process except a. The security market...