AFM121 Chapter Notes - Chapter 15: Liquidity Risk, Systematic Risk, Cash Flow

Answer True or False to each of the next five (5) statements.

1. Treasury Bills are issued through competitive bidding process at discount from par.

2. In the capital market both short term and long term securities are traded, whereas only short term securities are traded in the money market.

3. Free cash flow represents the amount of money available to the firm, after it has met all operating needs and paid for investments in net fixed assets.

4. Three ratios of liquidity are net working capital, current ratio and acid - test ratio

5. The income statement represents changes within a time period, while the balance sheet reflects levels as at a particular period.

Choose the letter a, b, c, or d that carries the appropriate response:

6. _______________ Serve as intermediaries channelling the savings of individuals, businesses, and governments into loans and investments.

(a) Financial markets

(b) Financial institutions

(c) Securities Exchanges

(d) OTC markets

7. Of the following group of ratios, which would show the combined effect of liquidity, asset management and debt on the overall operating results?

(a) Liquidity ratios

(b) Debt ratios

(c) Coverage ratios

(d) Profitability ratios

8. XYZ Company Ltd. has EBIT of $1,500,00 million and a 15% tax rate. It had $270,000 in depreciation expenses with a $250,000 increase in working capital. It had another $170,000 in capital expenditures. What is its free cash flow?

(a) $1,125,000

(b) $ 2,850,000

(c) $ 1,950,000

(d) $ 1,500,000

9. Fast Cash Limited charges 1 percent (%) per week on their loans. Assume there are exactly 52 weeks in a year. What is the effective annual rate?

(a) 55.36%

(b) 67.77%

(c) 69.98%

(d) 57.35%

10. _________________ is an annuity that provides its holder with payment dollars at the beginning of each year.

(a) An annuity due

(b) A warrant

(c) A perpetuity

(d) An ordinary annuity

11. All of the following statements about bonds are true, except one. Choose the false statement.

(a) If the value of a bond, B_o, is less than its par value, the bond is selling at a discount.

(b) Bonds with short maturities will have less interest rate risk than bonds with longer maturities and equal features.

(c) As market interest rate increase bond prices increase.

(d) The discount rate of a bond is synonymous with the bond's required return.

12. The present value of a bond's _____________________________ determines the value of the bond.

(a) Dividend

(b) Coupon payment and maturity value

(c) Coupon payment

(d) Maturity value

13. If the returns on one asset move in the same direction as the returns on another asset then the asset are:

(a) Positively correlated

(b) not correlated

(c) negatively correlated

(d) perfectly positively correlated.

14. Another term for non-diversifiable risk is:

(a) Systematic risk

(b) non- systematic risk

(c) firm specific risk

(d) both b and c

15. All of the following statements about stock valuation are true, except one. Choose the false statement.

(a) It is easier to value stock than it is to find the value of bonds.

(b) The value of a share of stock depends on the cash flows investors can expect to by owning that stock

(c) The dividend valuation model assets that dividends continue being paid forever.

(d) The present value of a stock's dividend determines the value of the stock.

Analyzing Risk and Return on Chargers Products’ Investments

Junior Sayou, a financial analyst for Chargers Products and a manufacturer of stadium benches, must evaluate the risk and return of two assets, X and Y. The firm is considering adding these assets to its diversified asset portfolio. To assess the return and risk of each asset, Junior gathered data on the annual cash flow and beginning- and end-of-year values of each asset over the immediately preceding 10 years, 2X06–2X15. These data are summarized in the table below. Junior’s investigation suggests that both assets, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each asset over the past 10 years.

Junior believes that each asset’s risk can be assessed in two ways: in isolation and as part of the firm’s diversified portfolio of assets. The risk of the assets in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital asset pricing model (CAPM) can be used to assess the asset’s risk as part of the firm’s portfolio of assets. Applying some sophisticated quantitative techniques, Junior estimated betas for assets X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free rate is currently 7% and that the market return is 10%.

Return Data for Assets X and Y, 2X06 to 2X15

________Asset X____________ ________Asset Y____________

$ Value $ Value

Year Cash Flow Beginning Ending %ROR Cash Flow Beginning Ending %ROR

2X06 1,000 20,000 22,000 15 1,500 20,000 20,000 7.5

2X07 1,500 22,000 21,000 2.27 1,600 20,000 20,000 8

2X08 1,400 21,000 24,000 20.95 1,700 20,000 21,000 13.5

2X09 1,700 24,000 22,000 (1.25) 1,800 21,000 21,000 8.57

2X10 1,900 22,000 23,000 13.18 1,900 21,000 22,000 13.81

2X11 1,600 23,000 26,000 20 2,000 22,000 23,000 13.64

2X12 1,700 26,000 25,000 2.69 2,100 23,000 23,000 9.13

2X13 2,000 25,000 24,000 4 2,200 23,000 24,000 13.91

2X14 2,100 24,000 27,000 21.25 2,300 24,000 25,000 13.75

2X15 2,200 27,000 30,000 19.26 2,400 25,000 25,000 9.6

Total 117.35 Total 111.41

Avg. 11.74% Avg. 11.14%

Return Data for Assets X and Y, 2X06 to 2X15

________Asset X____________ ________Asset Y____________

$ Value $ Value

Year ROR% Avg Ret Differnce Dev.^2 ROR% Avg Ret Difference Dev.^2

2X06 15 11.74 3.26 10.63 7.5 11.14 (3.64) 13.25

2X07 2.3 11.74 (9.46) 89.49 8 11.14 (3.14) 9.86

2X08 21 11.74 9.22 85.01 13.5 11.14 2.36 5.57

2X09 (1.3) 11.74 (12.99) 168.74 8.6 11.14 (2.54) 6.45

2X10 13.2 11.74 1.45 2.1 13.8 11.14 2.66 7.08

2X11 20 11.74 8.26 68.23 13.6 11.14 2.46 6.05

2X12 2.7 11.74 (9.04) 81.72 9.1 11.14 (2.04) 4.16

2X13 4 11.74 (7.74) 59.91 13.9 11.14 2.76 7.62

2X14 21.3 11.74 9.51 90.44 13.8 11.14 2.66 7.08

2X15 19.3 11.74 7.52 56.55 9.6 11.14 (1.54) 2.37

Total 712.82 Total 69.49

Avg. (9) 79.20 Avg. (9) 7.72

Standard Dev. 8.9 Standard Dev. 2.8

C. Asset X Asset Y

Expected Annual Return: 11.74 11.14

Standard Deviation: 8.9 2.8

Coefficient of Variation: 0.8 0.3

d. Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in part a.

e. Compare and contrast your findings in parts c and d. What recommendations would you give Junior with regard to investing in either of the two assets? Explain to Junior why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each asset.

Question 1

Financial investments are made in efficient markets. The existence of these markets suggests that:

2 points

Question 2

A new issue of corporate securities sold to the general public must be:

2 points

Question 3

Money market mutual funds invest in which of the following?

Commercial paper.

Repurchase agreements.

Corporate bonds.

3 points

Question 4

FDIC insures:

3 points

Question 5

Which of the following does not have default risk?

2 points

Question 6

The spread is the:

3 points

Question 7

Securities regulations protect investors by:

3 points

Question 8

If a stock is bought on margin:

3 points

Question 9

Sarbanes-Oxley, the latest important securities law:

2 points

Question 10

Which of the following are true about the present value of a dollar?

It increases as the interest rate increases.

It decreases as the interest rate increases.

It increases as the time period increases.

It decreases as the time period increases.

3 points

Question 11

Time value concepts may not be used to determine:

2 points

Question 12

What is the marginal tax rate?

2 points

Question 13

Examples of capital gains include sales of which of the following?

IRA accounts.

Stocks sold for a profit.

Real estate sold for a profit.

3 points

Question 14

With a Roth IRA, the individual:

2 points

Question 15

Sources of unsystematic risk include which of the following?

A firms financing decisions.

A firms operations.

Fluctuating market prices.

2 points

Question 16

For diversification to reduce risk:

2 points

Question 17

Which of the following are true about beta coefficients?

They are a measure of systematic risk.

They relate the return on an individual security to the return on the market.

They measure the variability of an assets return.

3 points

Question 18

Which of the following does an efficient portfolio do?

Maximizes risk for a given return.

Minimizes risk for a given return.

Maximizes return for a given level of risk.

Minimizes return for a given level of risk.

3 points

Question 19

The security market line does not:

3 points

Question 20

Mutual funds ____ realized capital gains and income (for example, dividends received):

2 points

Question 21

An index fund limits its portfolio to:

2 points

Question 22

Mutual funds with beta coefficients greater than 1.0:

3 points

Question 23

Which of the following will tend to cause a stock's price to fall?

The firms beta declines.

The firms beta increases.

The risk-free rate declines.

The risk-free rate increases.

2 points

Question 24

The use of P/E ratios to select stocks suggests that:

2 points

Question 25

What does the efficient market hypothesis require?

Financial markets to be competitive.

Prices to adjust rapidly.

Prices of undervalued securities to fall.

3 points

Question 26

Which of the following does the strong form of the efficient market hypothesis suggest?

Inside information will not lead to superior investment results.

Inside information will lead to superior investment results.

Studying financial statements will not lead to superior investment results.

Studying financial statements will lead to superior investment results.

3 points

Question 27

Which of the following is the least broad-based measure of stock prices?

3 points

Question 28

What is dollar-cost averaging?

2 points

Question 29

Stock dividends cause:

2 points

Question 30

Which of the following occurs when a stock has a two-for-one split?

3 points

Question 31

Dividend reinvestment plans offer which of the following advantages?

Deferment of federal income taxes.

A convenient means to accumulate shares.

Dollar-cost averaging.

3 points

Question 32

When the Federal Reserve seeks to expand the money supply, it:

2 points

Question 33

The sum of cash, currency, and demand deposits is:

3 points

Question 34

If the Federal Reserve lowers the target federal funds rate:

3 points

Question 35

The anticipation of inflation suggests that the investor should:

3 points

Question 36

The current ratio is unaffected by:

2 points

Question 37

Which of the following are true as the debt ratio increases?

Fewer assets are debt financed.

More assets are debt financed.

The ratio of debt equity increases.

The ratio of debt equity decreases.

2 points

Question 38

The technical approach suggests that future stock prices are forecasted by:

2 points

Question 39

The Dogs of the Dow strategy:

3 points

Question 40

Behavioral finance combines aspects from which two fields in an attempt to identify human traits that affect investment decisions?