Practice Questions: Chapters 1 and 2 of Bodie, Kane, Marcus Investments

Part I: Multiple Choice

1. The material wealth of a society is a function of _________. A) all real assets B) all financial assets C) all physical assets D) all real and financial assets E) none of the above Feedback: The material wealth of a society is a function of all real assets. Financial assets do not directly contribute to the productive capacity of the economy. 2. Asset allocation refers to ____________. A) choosing which securities to hold based on their valuation B) investing only in "safe" securities C) the allocation of assets into broad asset classes D) bottom-up analysis E) all of the above Feedback: Asset allocation refers to the allocation of assets into broad asset classes. 3. The Sarbanes-Oxley Act ____________. A) requires corporations to have more independent directors B) requires the firm's CFO to personally vouch for the firm's accounting statements C) prohibits auditing firms from providing other services to clients D) A and B are correct. E) A, B, and C are correct. Feedback: The Sarbanes-Oxley Act requires corporations to have more independent directors, requires the firm's CFO to personally vouch for the firm's accounting statements, and prohibits auditing firms from providing other services to clients. 4. Financial intermediaries differ from other businesses in that both their assets and their liabilities are mostly: A) illiquid. B) owned by government. C) real. D) financial. E) regulated. Feedback: Financial intermediaries differ from other businesses in that both their assets and their liabilities are mostly financial. 5. Although derivatives can be used as speculative instruments, businesses most often use them to: A) hedge risk. B) offset debt. C) appease stockholders. D) attract customers. E) enhance their balance sheets. Feedback: Firms may use forward contracts and futures to protect against currency fluctuations or changes in commodity prices. Interest-rate options help companies control financing costs. 6. During the period between 2000 and 2002, a large number of scandals were uncovered. Most of these scandals were related to: I) Manipulation of financial data to misrepresent the actual condition of the firm. II) Misleading and overly optimistic research reports produced by analysts. III) Allocating IPOs to executives as a quid pro quo for personal favors. IV) Greenmail. A) II, III, and IV B) I, II, and IV C) II and IV D) I, III, and IV E) I, II, and III

Feedback: During the period between 2000 and 2002, a large number of scandals were uncovered. Most of these scandals were related to manipulation of financial data to misrepresent the actual condition of the firm, misleading and overly optimistic research reports produced by analysts, and allocating IPOs to executives as a quid pro quo for personal favors. 7. Financial assets: A) contribute to the country's productive capacity both directly and indirectly. B) do not contribute to the country's productive capacity either directly or indirectly. C) directly contribute to the country's productive capacity. D) indirectly contribute to the country's productive capacity. E) are of no value to anyone. Feedback: Financial assets indirectly contribute to the country's productive capacity because these assets permit individuals to invest in firms and governments. This in turn allows firms and governments to increase productive capacity. 8. What roles do investment bankers perform? A) design securities with desirable properties B) market new stock and bond issues for firms C) provide advice to the firms as to market conditions, price, etc. D) none of the above E) A, B, and C Feedback: Investment bankers design securities with desirable properties, market new stock and bond issues for firms, and provide advice to the firms as to market conditions, price, and other valuable information. 9. Which of the following is true about mortgage-backed securities? I) They aggregate individual home mortgages into homogeneous pools. II) The purchaser receives monthly interest and principal payments received from payments made on the pool. III) The banks that originated the mortgages maintain ownership of them. IV) The banks that originated the mortgages continue to service them. A) II, III, and IV B) I, II, and IV C) II and IV D) I, III, and IV E) I, II, III, and IV Feedback: The purchaser of a mortgage-backed security receives monthly interest and principal payments and the banks that originated the mortgages continue to service them. 10. ________ are in essence an insurance contract against the default of one or more borrowers. A) Credit default swaps B) CMOs C) ETFs D) Collateralized debt obligations E) all of the above. Feedback: Credit default swaps are in essence an insurance contract against the default of one or more borrowers. 11. Which one of the following is not a money market instrument? A) a Treasury bond B) a negotiable certificate of deposit C) a Eurodollar account D) a Treasury bill E) commercial paper Feedback: Money market instruments are instruments with maturities of one year or less, which applies to all of the above except Treasury bonds. 12. The bid price of a T-bill in the secondary market is: A) the price at which the dealer in T-bills is willing to sell the bill. B) the price at which the dealer in T-bills is willing to buy the bill. C) greater than the asked price of the T-bill. D) the price at which the investor can buy the T-bill. E) never quoted in the financial press.

Feedback: T-bills are sold in the secondary market via dealers; the bid price quoted in the financial press is the price at which the dealer is willing to buy the bill. 13. Which of the following is true of the Dow Jones Industrial Average? A) The divisor must be adjusted for stock splits. B) It is a price-weighted average of 30 large industrial firms. C) It is a value-weighted average of 30 large industrial firms. D) It is an equally weighted average of 30 large industrial firms. E) A and B Feedback: The Dow Jones Industrial Average is a price-weighted index of 30 large industrial firms and the divisor must be adjusted when any of the stocks on the index split. 14. Which of the following statements is (are) true regarding municipal bonds? I) A municipal bond is a debt obligation issued by state or local governments. II) A municipal bond is a debt obligation issued by the federal government. III) The interest income from a municipal bond is exempt from federal income taxation. IV) The interest income from a municipal bond is exempt from state and local taxation in the issuing state. A) I and II only B) I and III only C) I, II, and III only D) I, III, and IV only E) I and IV only Feedback: A municipal bond is a debt obligation issued by state or local governments; the interest income from a municipal bond is exempt from federal income taxation, and the interest income from a municipal bond is exempt from state and local taxation in the issuing state. 15. The price quotations of Treasury bonds in the Wall Street Journal show an ask price of 104:08 and a bid price of 104:04. As a buyer of the bond what is the dollar price you expect to pay? A) $1,048.00 B) $1,042.50 C) $1,044.00 D) $1,041.20 E) $1,040.40 Feedback: You pay the asking price of the dealer, 104 8/32, or 104.25% of $1,000, or $1042.50. 16. A 5.5% 20-year municipal bond is currently priced to yield 7.2%. For a taxpayer in the 33% marginal tax bracket, this bond would offer an equivalent taxable yield of: A) 8.20%. B) 10.75%. C) 11.40%. D) 4.82%. E) none of the above. Feedback: 0.072 = r(1– t); 0.072 = r(0.67); r = 0.072/0.67; r = 0.1075 = 10.75%. 17. Federally sponsored agency debt: A) has a small positive yield spread relative to U.S. Treasuries. B) is legally insured by the U.S. Treasury. C) probably would be backed by the U.S. Treasury in the event of a near-default. D) A and C E) B and C Feedback: Federally sponsored agencies are not government owned. These agencies' debt is not insured by the U.S. Treasury, but probably would be backed by the Treasury in the event of an agency near-default. As a result, the issues are very safe and carry a yield only slightly higher than that of U.S. Treasuries. 18. Freddie Mac and Ginnie Mae were organized to provide: A) a primary market for mortgage transactions. B) liquidity for the mortgage market. C) a primary market for farm loan transactions. D) liquidity for the farm loan market. E) a source of funds for government agencies. Feedback: Freddie Mac and Ginnie Mae were organized to provide liquidity for the mortgage market. 19. Which of the following are characteristics of preferred stock?

I) It pays its holder a fixed amount of income each year, at the discretion of its managers. II) It gives its holder voting power in the firm. III) Its dividends are usually cumulative. IV) Failure to pay dividends may result in bankruptcy proceedings. A) I, III, and IV B) I, II, and III C) I and III D) I, II, and IV E) I, II, III, and IV Feedback: Preferred stock pays its holder a fixed amount of income each year, at the discretion of its

managers, and its dividends are usually cumulative. 20. With regard to a futures contract, the long position is held by: A) the trader who bought the contract at the largest discount. B) the trader who has to travel the farthest distance to deliver the commodity. C) the trader who plans to hold the contract open for the lengthiest time period. D) the trader who commits to purchasing the commodity on the delivery date. E) the trader who commits to delivering the commodity on the delivery date. Feedback: With regard to a futures contract, the long position is held by the trader who commits to

purchasing the commodity on the delivery date.

Part II: Numerical Problems and Short Answers

1. What are the key differences between common stock, preferred stock and corporate bonds?

Corp. Bonds Preferred Stock Common Stock

Voting Rights (Typically) Yes

Contractual Obligation Yes

Perpetual Payments Yes Yes

Accumulated Dividends Yes

Fixed Payments (Typically) Yes Yes

Payment Preference First Second Third

2. Take a look at Fig. 2.3 shown below. The questions below are with regard to the Trasury bond

maturing in February 2039.

a. How much would you have to pay to purchase one of these notes

b. What is the coupon rate?

c. What is the current yield on the note?

a. You would have to pay the asked price of:

86:14 = 86.43750% of par = $864.375

b. The coupon rate is 3.5% implying coupon payments of $35.00 annually or, more precisely,

$17.50 semiannually.

c. Current yield = Annual coupon income/price

= $35.00/$864.375 = 0.0405 = 4.05%

3. Find the after-tax return to a corporation that buys the sahe of a preferred stock at $50, sells it at

year end at $52 and receives a $5 year-end dividend. The firm is the 30% tax bracket.

The total before-tax income is $5+$2 = $7.

After the 70% exclusion for preferred stock dividends, the taxable income from the preferred dividend is:

0.30 $5 = $1.50

Therefore, taxes are: 0.30 ($1.50+2) = $1.05

After-tax income is: $7.00 – $1.05 = $5.95

Rate of return is: $5.95/$50.00 = 11.90%

4. Consider the three stocks in the following table. represents price at time t. represents shares

outstanding at time t. Stock C splits two for one in the last period.

A 90 100 95 100 95 100 B 50 200 45 200 45 200 C 100 200 110 200 55 400

a. Calculate the rate of return on a price-weighted index of the three stocks for the first period

(t=0 to t=1).

b. What must happen to the divisor for the price weighted index in year 2?

c. Calculate the rate of return for the second period (t=1 to t=2)

d. Calculate the rate of return for the first period for a market-value weighted index

e. Calculate the rate of return for the first period for an equally weighted index

Solution

a. At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80

At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333

b. In the absence of a split, Stock C would sell for 110, so the value of the index would be: 250/3 =

83.333

After the split, Stock C sells for 55. Therefore, we need to find the divisor (d) such that: 83.333 =

(95 + 45 + 55)/d. Solving ford, we get d = 2.340

c.The return is zero. The index remains unchanged because the return for each stock separately

equals zero.

d. Total market value at t = 0 is: ($9,000 + $10,000 + $20,000) = $39,000

Total market value at t = 1 is: ($9,500 + $9,000 + $22,000) = $40,500

Rate of return = ($40,500/$39,000) – 1 = 3.85%

e.The return on each stock is as follows:

rA = (95/90) – 1 = 0.0556

rB = (45/50) – 1 = –0.10

rC = (110/100) – 1 = 0.10

The equally-weighted average is:

[0.0556 + (-0.10) + 0.10]/3 = 0.0185 = 1.85%

5. An investor is in the 20% tax bracket. If corporate bonds offer 9% yields, what must munis offer for

the investor to prefer them to corporate bonds?

The after-tax yield on the corporate bonds is: 0.09 (1 – 0.20) = 0.072 = 7.20%

Therefore, municipals must offer at least 7.20% yields.