Investments in Debt and Equity Securities

Investments Final exam preparatory questions and answers to end of the slides questions Chapter 11 1. According to the Value of ROE criteria: > a) If VRE ≤1, the stock may be worthy of investment attention and possible purchase. b) If 2 ≤ VRE ≤ 3, the stock is apt to represent an extraordinarily attractive investment opportunity. c) If VRE ≤ 3, the stock is definitely worthy of investment attention and may represent a very attractive investment. d) none of these. 2. Attractive value stocks feature: > a) b) c) d) rapid historical EPS growth. rapid expected EPS growth. above average P/E ratios. below average P/B ratios. 3. TROW has a current price of 25, an expected dividend per share of $0.65, EPS of $1.50 this year, expected EPS growth of 15% per year, and a typical P/E ratio of 20. According to the Discounted Dividend Value Model, what is the expected price for TROW in five years? > a) b) c) d) $26.15 $30 $50.28 $60.34 Solution: 20×$1.50×1.155 = $60.34 4. High P/E ratios are typically associated with stocks that display: > a) b) c) d) below-average risk. below-average dividend payout ratios. below-average historical returns. below-average historical EPS growth. 5. Value investing always involves: > a) focusing only on securities considered to be temporarily overvalued or popular for various reasons. b) seeking bargains described in terms of a market price that is below the economic value of assets in place. c) focusing on companies expected to have above-average rates of growth in earnings and dividends. d) finding bargains selling at prices below their actual economic value. 6. > According to Graham & Dodd, intrinsic value a. cannot be justified by assets, earnings, dividends, sure prospects, and management. b. can be justified by dividends and expected capital gains. c. and current market price typically coincide. d. and current market price rarely coincide given investor pessimism and euphoria. 7. The Value of ROE criteria: > 8. > 9. > a) b) c) d) is inconsistent with the “growth at a reasonable price” concept. can be biased upward in the case of firms with little book value per share. tends to be biased in favor of high P/E stocks. none of these. Reversion (regression) to the mean theory argues that the potential of high profitmargin firms is amplified by: a) b) c) d) entry. imitation. exit. none of these INTC has a current price of 18, an expected dividend per share of $0.50, and expected dividend growth of 5% per year. According to the Discounted Dividend Value Model, INTC is undervalued if investors have a risk-adjusted required return of: a) b) c) d) 9.78% > 8.0% 15% < 7.8%. Solution: 18 = 0.50 / (k - 0.05), solving for k = 0.0778 10. Reversion to the mean theory predicts lower expected returns for stocks with low a. price/book ratios. > b. c. d. price/sales ratios. historical returns. earnings/price ratios. 11. Benjamin Graham thought that the stock market crash of 1929 was due to a. stock manipulation by the exchanges and investment firms. b. margin borrowing for stock purchases. c. excessive optimism. > d. all the above. 12.A Warren Buffett lesson is a. It is far better to buy a fair company at a wonderful price than a wonderful company at a fair price. > b. Management does better by avoiding dragons, not slaying them. c. As if governed by Newton's first law of motion, an institution will agree to any change in its current direction. d. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the manager that remains intact. 13. Suppose that Microsoft stock is currently trading at $22.50. This year’s dividend per share is $0.52. If the expected growth rate is 6%, what is the required rate of return? > a) 6.92% b) 8.45% c) 9.75% d) 11.23% Solution: P0 = $0.52 × (1 + 0.06 ) D0 (1 + g ) , k = 0.0845 = 22.50 = k−g k − 0.06 14. If Boeing Company Inc. has a P/E ratio of 8 which is expected to increase to 10 in 5 years. The current EPS is $5.07 and expected to grow at a rate of 5% for the same period. What is the estimated stock price in 5 years? a) $51.77 b) $56.92 c) $61.71 d) $212.94 Solution: Pn = (P ) × E0 × (1 + g )n = 10 × $5.07 × (1.05)5 = $64.71 En 15 If a company has a P/E ratio of 14, required rate of return of 12% and dividend yield of 3.5%, what is the rate of growth due to capital appreciation? a) 15.50% > b) 8.50% c) 7.00% d) 2.00% Solution: k= D1 + g ,0.12 = 0.035 + g , P0 g = 8.50% Chapter 12 16 Superior profits can be made by investing in companies: > a) b) c) d) that are fortunate but not able. that have good potential to unseat industry leaders. with capable management. active in a broad array of growth industries. 17 According to T. Rowe Price,growth stocks enjoy attractive economic characteristics such as: > a) b) c) d) synergistic mergers. rapid growth in market demand. lack cutthroat competition. rapid revenue growth. Assume EPS = $1, P = $15 and P/B = 3. 18 A retention rate of 60% implies sustainable growth of: > a) b) c) d) 6.7%. 12%. 40%. 60%. Solution: Sustainable growth = Retention × ROE = 0.60 × (15 ÷ 3) = 0.12 19 Which among the following statements is true? a. S&P/BARRA Value and Growth Indexes have relatively high turnover over the course of a year. b. Companies in the S&P/BARRA Growth Index tend to have higher dividend yields, on average, than those in the associated Value Index. c. There are many more companies in the S&P/BARRA Growth Index than in the Value Index. > d. Large losses at component firms can cause surprisingly high P/E ratios for the Value Index. 20 According to the PEG ratio rule-of-thumb, if PEG < 1, then a stock > a. may be worthy of investment attention and possible purchase. b. is definitely worthy of investment attention, and may represent a very attractive investment. c. is apt to represent an extraordinarily attractive investment opportunity. d. none of these. 21 b. > A fast growing company paid a dividend this year of $1.25, which is expected to grow at 20% for two years. Afterwards, the growth rate will be 9%. If the required is 12%, what is the value of this stock? a. $41.67 $15.62 c. $65.40 d. $54.91 Solution: D1 = $1.25×1.20 = $1.50, D2= $1.50×1.20 = $1.80, D3 = $1.25×1.202×1.09 = $1.962, then price in year 2 will be 1.962/(0.12-0.09) = $65.40, so PV = 1.50/1.12 + (1.80+65.40)/1.122 = $54.91 22. According to T. Rowe Price, growth prospects suffer if companies a. enjoy careful government regulation. b. have well-paid employees. > c. use high levels of debt. d. lack cutthroat competition. 23. The constant growth rate model is not useful from growth stocks because they tend to a. have an unknown required rate of return. > b. have variable growth. c. have more financial leverage. d. have a constant dividend. 24. Making the assumption that firms which grow fast in the past will continue to grow fast in the future reflects the a. internally sustained growth rate. b. regression to the mean. > c. representativeness bias. d. growth constant. 25) The representativeness bias often causes investors to a. buy value stocks. > b. buy high and sell low. c. buy poorly managed firms. d. extrapolate our wishes into the future. 26) Financial analysts who make their recommendations known only to their portfolio manager > a. are called buy-side analysts. b. work for investment banks. c. are called sell-side analysts. d. are more optimistic than other analysts. 27) Financial analysts who make their recommendations known to the public a. are called buy-side analysts. b. work for mutual funds. > c. are called sell-side analysts. d. are less optimistic than other analysts. 28 Suppose a company is expected to grow at 25% for the next two years and then will have a constant growth of 8%. The company paid dividends of $0.75 this year. If the required rate of return is 10%, what is the value of the stock at the end of the second year? > a) $46.88 b) $47.24 c) $63.28 d) $73.24 Solution: P2 = 0.75(1 + 0.25) (1 + 0.08) = $63.28 0.10 − 0.08 2 29If a company has a P/E ratio of 19 with a historical EPS growth of 20%. What is the PEG ratio if the expected EPS growth is 15%? > a) 0.79 b) 0.95 c) 1.05 d) 1.27 Solution: PEG ratio = 19/15 = 1.27 30. Suppose that a company has a net free cash flow of $5 million and is expected to grow at 30% during the next 3 years and then grow at 7% thereafter. The company has debt of $75 million and 5,000,000 shares of outstanding common stock. The company pays no dividends and since it would like to retain its earnings, it is not expected to pay any dividends. What is the firm's equity value assuming the discount rate is 12%? > a) $112,763,355 b) $187,763,355 c) $215,955,253 d) $261,014,000 Solution: EV = 5,000,000 × (1.30) 5,000,000 × (1.30 ) + + 1 + 0.12 (1 + 0.12)2 2 = $187,763,355 − 75,000,000 = $112,763,355 5,000,000 × (1.30 ) × (1.07 ) 0.12 − 0.07 − 75,000,000 (1 + 0.12)3 5,000,000 × (1.30 ) + 3 3 31. Suppose that a company has a net free cash flow of $5 million and is expected to grow at 30% during the next 3 years and then grow at 7% thereafter. The company has debt of $75 million and 5,000,000 shares of outstanding common stock. The company pays no dividends and since it would like to retain its earnings, it is not expected to pay any dividends. What is the intrinsic value of the stock assuming the discount rate is 12%? > a) $18.92 b) $22.53 c) $31.64 d) $37.55 Solution: P0 = EV 112,763,355 = = $22.53 # ofShares 5,000,000 Chapter 14 32 Two types of municipal bonds are general obligation issues and: > a) b) c) d) serial bonds. revenue bonds. debentures. income bonds. 33. Among the various types of publicly-traded debt, trading is most active for: > a) b) c) d) junk bonds. municipal bonds. corporate bonds. Treasury securities. 34. A corporate bond bid price of 104 1/8 means that a buyer was willing to pay: > a) b) c) d) $104.80 $1,041.80 $104.12 $1,041.12 Solution: 104 and 1/8 % of $1,000 is 104.125% × $1,000 = $1,041.12 35. The interest rate charged on loans made by the Federal Reserve is called the: > a) b) c) d) fed funds rate. LIBOR rate. discount rate. prime rate. 36. The taxable equivalent yield for an investor in the 33% marginal tax bracket holding a 9% municipal bond is: > a. b. c. d. 13.4%. 3%. 9%. 6%. Solution: 9% ÷ (1-0.33) = 13.43% 37. Select the false statement about money market securities. > a) b) c) d) CDs are negotiable. Banker's acceptances are not negotiable instruments. The secondary market for commercial paper is weak. Eurodollars are dollar-denominated deposits held in foreign banks. 38. Treasury notes have an initial term to maturity of: > a) b) c) d) two to ten years. one year or less maturity. more than ten years. more than thirty years. 39. The interest rate charged on overnight loans from one U.S. commercial bank to another is called the: > a) b) c) d) federal funds rate. LIBOR rate. prime rate. discount rate. 40 Holding term to maturity constant, holding period risk is highest for: > a) b) c) d) high-yield bonds. municipal bonds. federal agency securities. corporate bonds. 41. U.S. bond trading activity largely takes place on the: > a) b) c) d) NYSE. AMEX. OTC market. offshore market. 42 An example of a federal agency security is: > a) b) c) d) a Ginnie Mae pass-through certificate. The Washington Public Power Supply System's bonds. a Treasury note. Philadelphia Electric bonds. 43. The rate of return on money market securities is: > a) b) c) d) slightly below the Treasury bill rate. slightly above the Treasury bill rate. set by regulation. slightly below the insured bank CD rate. 44. List the following securities by their level of credit risk (list the most risky first): Corporate Bond (rated AA), Corporate Bond (rated BB), Federal Agency Bond, Treasury Bonds. > a. b. c. d. Treasury, Corporate (rated AA), Corporate (rated BB), Federal Agency Treasury, Federal Agency, Corporate (rated AA), Corporate (rated BB) Corporate (rated AA), Federal Agency, Corporate (rated BB), Treasury Corporate (rated BB), Corporate (rated AA), Federal Agency, Treasury 45. Which of the following securities trade in the money market? > a. b. c. d. t-bills commercial paper bankers acceptances all of the above Chapter 10 46. Holding all else equal, ROE will rise with an increase in: > a) b) c) d) total assets. sales. stockholders’ equity. none of these. Suppose a company with the following financial information: Income Statement Balance Sheet Sales $ 12,500,000 Cash Cost of Goods Sold 6,550,000 Accounts Receivable $ 550,000 1,450,000 Gross Profit Operating Expenses 5,950,000 $ 2,400,000 Inventory Total Current Assets Interest Expense 450,000 Total Fixed Assets Taxes 750,000 Total Current Liabilities Net Income $ 2,350,000 Long-term Liabilities Paid-in Capital Number of Outstanding Shares Current Market price 1,000,000 Retained Earnings $37.90 47. What is the net profit margin? > a) 18.80% b) 27.20% c) 32.40% d) 47.60% 48. What is the return on equity? a) 17.50% b) 51.76% c) 92.52% d) 117.50% 49. What is the receivables turnover? > > a) 2.50 b) 4.87 c) 6.30 d) 8.62 Solution: Receivable Turnover = $12,500,000 / $1,450,000 = 8.62 50. What is the inventory turnover? > a) 2.50 b) 4.87 c) 6.30 d) 8.62 Solution: Inventory Turnover = $6,550,000 / $1,040,000 = 6.30 1,040,000 $ 3,040,000 10,000,000 2,500,000 6,000,000 2,000,000 2,540,000 51. All else equal, a rise in Asset Turnover will result in a rise in: > a) b) c) d) depreciation. leverage. profit margin. ROE. 52. Free cash flow has become an especially important measure of economic profitability because: > a) accrual accounting information is precise and cannot be manipulated. b) it is perceived as being more difficult to manipulate than traditional accounting information. c) net profit excludes depreciation. d) it is less dependent on economic profits. Chapter 17 53. The loss potential tied to market impact costs is called: > a) b) c) d) liquidity risk currency translation risk. government policy risk. emerging market risk. 54. US investors hold approximately _____ of their equity holdings in US companies while the US stock market represents about _____ of the world equity market capitalization. > a. b. c. d. 90%, 50% 100%, 60% 70%, 30% 75%, 40% 55. MSCI Indexes cover what percentage of the market cap of global equities in developed and emerging markets? > d) a) 100%. b) 90%. c) 60%. 30%. 56. An ADR program in which an issuer floats a public offering of ADRs in the U.S. and obtains listing on a major U.S. exchange or NASDAQ is called a: a) Level I program. b) Level II program. > c) Level III program. d) Level IV program. 57. Select the true statement from among the following: > a) Country-focused iShares shares are guaranteed in price, but not with respect to returns. b) Country-focused iShares shares provide investment results that correspond generally to the price and yield performance of local benchmark country indices. c) Country-focused iShares shares are guaranteed in price. d) With country-focused iShares, investors have the convenience of dealing in US dollars. 58. Market impact costs tend to be reflected in: > a. b. c. d. high trading volume. low bid-ask spreads. high bid-ask spreads. rising institutional investor interest. 59. Which of the following statements is not descriptive of American Depository Receipts (ADRs)? > a. ADRs are negotiable instruments that represent ownership in the equity securities of a US company. b. ADR certificates are negotiable documents and should be signed only in the event of a sale or transfer of ownership. c. ADRs are transferable on the books of a sponsoring depositary institution. d. ADRs can be listed on the New York Stock Exchange and may be quoted for trading on Nasdaq. 60. . Assume that a U.S. investor has $100,000 and decided to invest this amount in France. If the exchange rate is $1/0.72 Euro, how many Euros this investor would be able to buy? > a) 138,889 Euros b) 115,000 Euros c) 98,000 Euros d) 72,000 Euros Solution: $100,000 = 100,000 X 0.72 = 72,000 Euros END OF CHAPTER QUESTIONS/PROBLEMS:ANSWERS Chapter 10 Q10.1 Explain why financial statement analysis is the cornerstone of fundamental analysis. How does financial statement analysis relate to the basic difference between investment and speculation? Q10.1 ANSWER Financial statement analysis is the cornerstone of fundamental analysis because it is the means by which investors ascertain the economic worth of a company. It is the starting point for all long-term investors, versus short-term speculators. Stock market investment is the process of buying and holding for dividend income and long-term capital appreciation the shares of companies with inherently attractive economic prospects. Investors seek to profit by sharing in the normal and predictable good fortune of such companies. Stock market speculation is the purchase or sale of securities on the expectation of capturing short-term trading profits from share-price fluctuations tied to the perhaps temporary good fortune of a given company. Speculators depend upon a short-term or fundamental change in the economic prospects facing a company. Q10.2 Clarify how return on equity (ROE) numbers can become biased by share buy backs and corporate restructuring. Q10.2 ANSWER ROE can sometimes be unduly influenced by share buy backs and other types of corporate restructuring. When Aextraordinary@ or Aunusual@ charges are significant, the book value of stockholders= equity is reduced, and ROE can become inflated. Similarly, when share repurchases are at market prices that exceed the book value per share, book value per share falls and ROE rises. Extraordinarily high ROE can be reported by companies that have recently undergone significant corporate restructuring. Q10.3 What is total asset turnover, and how does it contribute to profitability? Q10.3 ANSWER Total asset turnover is sales revenue divided by the book value of total assets. When total asset turnover is high, the firm makes its investments work hard in the sense of generating a large amount of sales volume. Grocery and apparel retailing are good examples of industries where high rates of total asset turnover can allow efficient firms to earn attractive rates of return on stockholders= equity despite modest profit margins. Among firms found in the DJIA, retail juggernauts Wal-Mart and Home Depot, feature above-average rates of total asset turnover. Q10.4 What is the difference between a company’s return on assets (ROA) and its return on stockholders’ equity (ROE)? Why should investors be skeptical of seemingly extraordinary ROE? Q10.4 ANSWER Both terms are relative measures of profitability. A firm’s ROA is its net income divided by the book value of total assets. This measure indicates how profitable a company in terms of the total value of assets on the balance sheet. ROA captures the effects of managerial operating decisions, but tends to be less affected than other measures by the amount of financial leverage used. In contrast, ROE is defined as net income divided by the book value of stockholders’ equity, which is the book value of total assets minus total liabilities. ROE tells how profitable a company is in terms of each dollar invested by shareholders. However, investors should not automatically assume that high reported ROE means a company is highly profitable. A limitation of ROE is that it can sometimes be unduly influenced by share buybacks and other types of corporate restructuring. When “extraordinary” or “unusual” charges are significant, the book value of stockholders’ equity is reduced, and ROE can become inflated. Similarly, when share repurchases are at market prices that exceed the book value per share, book value per share falls and ROE rises. Given the difficulty of interpreting ROE for companies that are highly leveraged or have undergone significant restructuring, some investors prefer focusing on ROA rather than ROE. A company's current ratio is 2.0. If the company uses cash to retire notes payable that are due within one year, would this transaction most likely increase or decrease the current ratio and asset turnover ratio, respectively? Current ratio Asset turnover ratio A. Increase B. Increase C. Decrease Increase Decrease Increase D. Decrease Decrease Answer: A An analyst gathered the following information about a company whose fiscal year end is December 31: • Net income for the year was $10.5 million. • Preferred stock dividends of $2 million were paid for the year. • Common stock dividends of $3.5 million were paid for the year. • 20 million shares of common stock were outstanding on January 1, 2001. • The company issued 6 million new shares of common stock on April 1, 2001. • The capital structure does not include any potentially dilutive convertible securities, options, warrants, or other contingent securities The company's basic earnings per share for 2001 was closest to: A. $0.35. B. $0.37. C. $0.43. D. $0.46. Answer: A Two companies are identical except for substantially different dividend payout ratios. After several years, the company with the lower dividend payout ratio is most likely to have: A. B. C. D. lower stock price. higher debt/equity ratio. less rapid growth of earnings per share. more rapid growth of earnings per share. Answer: D An analyst applied the DuPont System to the following data for a company: • • • • Equity turnover Net profit margin Total asset turnover Dividend payout ratio 4.2 5.5% 2.0 31.8% The company’s return on equity is closest to: A. 1.3%. B. 11.0%. C. 23.1%. D. 63.6%. Answer: C Chapter 11 Q11.1 Describe the general characteristics of stocks sought by value investors. Q11.1 ANSWER Traditional value investors seek out-of-favor stocks selling at a discount to the overall market. Such discounts are measured in terms of low P/E and P/B ratios and/or high dividend yields. Nevertheless, there are often good economic reasons for a stock to sell at a sharp discount to the market. Value investors avoid this pitfall by favoring companies selling at sharp discounts to the market or a company’s own historical valuations provided that such discounts cannot be explained by a parallel deterioration in the firm’s economic fundamentals. Attractive stock market values can also be created when an entire industry falls into disfavor. Companies that may be only marginally or temporarily affected by industry problems can become undervalued in the market place. Q11.2 What is the basic premise of value investing? What does it mean to buy “fear” and sell “greed”? Q11.2 ANSWER Value investors seek companies whose stock prices have been unfairly beaten down in price. Bargains are often measured in terms of market prices that are below the estimated economic value of tangible and intangible assets. Value investors tend to argue that overly emotional investors cause stock prices to be moved by “fear” and “greed” to levels that are sometimes too low or too high based on the economic fundamentals. As a result, value investors adopt a contrarian investment philosophy based on the premise that investors can profit by betting against the overly emotional crowd. According to practitioners of contrarian investment strategies, investors can profit if they are able to withstand the peer and psychological pressures tied to common stock investing. To be successful, contrarian investors argue that one must “buy fear” and “sell greed.” More specifically, value investors hope to profit by investing in companies that are irrationally undervalued. Profits are realized once the broader market recognizes the true economic value of the firms’ underlying assets and bids market prices up. Q11.3 Explain why the required rate of return k must exceed the expected rate of growth g in the constant-growth (Gordon) model. Q11.3 ANSWER In the constant-growth (Gordon) model, P0 = D1/(k – g) and the required return, k, must exceed the dividend growth rate, g, to calculate a finite stock price. When k > g, the constant growth model can derive useful valuation estimates. If k ≤ g, rapid growth would overwhelm the effect of discounting, and investors would theoretically be willing to pay an infinite price for a stock. Economically, this is a nonsensical result. In the long run, no stock can grow dividends at a pace that exceeds the nominal rate of growth in the overall economy, say 5-7% per year. When a typical 10-15% rate of discount is employed, the rate of discount will always exceed the constant rate of growth in dividends that can be achieved, and the constant growth model can give sensible valuation estimates. Q11.4 The three pillars of Benjamin Graham’s fundamental approach to investing are: (1) common stock values ultimately reflect their proportionate share of the economic net worth of the corporation, (2) it is prudent to build in a “margin of safety” in stock valuation, and (3) investors can only make prudent assessments if they ignore market sentiment. Explain why the intelligent investor does best to forget about day-to-day price fluctuations and focuses on company operating results. Q11.4 ANSWER In the stock market, the intelligent investor’s goal is to earn above-normal returns by making judgments that, on average, are more sensible than those reflected in sometimes irrational market prices. Graham used a legendary “Mr. Market” parable to explain how the intelligent investor might deal with market sentiment. Graham’s fable goes something like this. Think of being in partnership with a bright but irrational fellow named Mr. Market. The two of you have what is called a buy/sell agreement. If one party offers to buy the other out at a given price then the offering party is also obligated to sell out at that same price. Being neurotic, Mr. Market’s mood fluctuates from normal behavior, to incredible optimism, to overwhelming depression. On a good day, Mr. Market is buoyant and will offer to buy out your share of the business at an enormous sky-high price. On a bad day, Mr. Market is gloomy and will offer to sell his share of the business at a very low, or rock-bottom price. The point that Graham makes is that Mr. Market’s judgment is sometimes formed more by mood swings that by rational thought. This gives the rational partner multiple profit-making opportunities. If Mr. Market’s price is unreasonably high, the rational partner takes advantage of the opportunity to sell. If Mr. Market’s price is unreasonably low, the rational partner takes advantage of the opportunity to buy. Graham wrote that the only importance of market prices is that they give the intelligent investor an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal. At other times, the intelligent investor does best to forget about day-to-day price fluctuations and focuses on company operating results. Q11.5 Explain the Graham and Dodd “margin of safety” concept. Q11.5 ANSWER The most important idea for a value investor is the margin of safety concept. According to Graham and Dodd, the margin-of-safety idea becomes evident when applied to undervalued, or bargain, securities. The margin of safety is the difference between the price and the indicated or appraised value; it is available for absorbing the effect of miscalculations or bad luck. Graham and Dodd believed the danger of growth stock investing lies in the tendency to pay high prices for stocks with questionable growth prospects. Such a tendency results in a small margin of safety for the investor. From the Graham and Dodd perspective, the goal of security analysis is to identify under-priced securities with ample margins of safety and to enjoy excess returns following the market’s subsequent upward revaluation to prices consistent with intrinsic value. In the words of Graham and Dodd, the market is simply there to facilitate the investor’s interest in buying or selling securities. When market prices are too high, the discerning investor will choose to sell or wait for better bargains. When market prices are too low, the discerning investor takes advantage of the situation by snapping up the best bargains available. Q11.6 Describe three essential characteristics of what Warren Buffett describes as Awonderful businesses.@ Q11.6 ANSWER Legendary stock-market investor Warren Buffett looks for investment bargains among what he calls Awonderful businesses.@ Three essential characteristics of wonderful businesses are: (1) Good businesses: Buffett likes companies that enjoy a high rate of return on capital without accounting gimmicks or lots of leverage, see their profits in cash, have strong franchises and thus freedom to price, are simple and don't take a genius to run, have predictable earnings, and are not natural targets of regulation. (2) Good people: Buffett likes to invest in companies run by honest, capable and owneroriented management. (3) Good price: Buffett likes good businesses run by good people, but he does not like to pay premium prices for premium companies. P11.2 In mid-2008, banking giant Citigroup, Inc. (C) sold for a market price of $19.30 per share, had 2009 expected earning per share of $2.70, and a projected dividend of $1.28. Calculate Citigroup’s forward-looking P/E ratio and projected dividend yield. 11.2 SOLUTION CFA11.2 Forward P/E ratio = Stock price/Projected EPS = $19.30/$2.70 = 7.14 Projected dividend yield = Projected dividend/Stock price = $1.28/$19.30 = 6.63% An analyst gathered the following information about a common stock: Annual dividend per share $2.10 Risk-free rate 7% Risk premium for this stock 4% If the annual dividend is expected to remain at $2.10, the value of the stock is closest to: A. $19.09. B. $30.00. C. $52.50. D. $70.00. Answer: A Chapter 12 Q12.1 Describe the general approach of a growth stock investor. How is growth stock investing different from value investing? Q12.1ANSWER Q12.3 Growth stock investing is one of the two most popular styles of investment strategy. It is an approach to investing that focuses on companies expected to have above-average rates of growth in earnings and dividends. Rather than focusing on the current market price in relation to the current value of assets, a practice of value investors, growth stock investors look for securities selling for prices below the value of future growth opportunities. Many growth stock investors favor firms within industries that are also experiencing growth. Such investors are usually willing to accept much larger than typical levels of risk in the pursuit of above-average long-term investment results. Investors in growth stocks are subject to price risk. Describe this variety of risk and explain why exposure to price risk is of particular concern to growth stock investors. Q12.3ANSWER Price risk is the risk of overpaying for a company even though it may have attractive economic prospects. One of the most important potential pitfalls tied to growth stock investing is that the approach seldom offers clear guidance about how much is too much to pay for a stock with attractive growth prospects. This lack of a strict buying discipline leaves growth stock investors open to price risk and the risk of suffering gut-wrenching devastation to their investment portfolios after even modest temporary declines in the overall market. Q12.4 What is the danger of buying the common stock of current leaders in rapidly changing industries? Q12.4ANSWER Large companies tend to have trouble adapting to new market conditions in rapidly changing environments. Sustained earnings growth is difficult even among the largest and most powerful corporations. Smaller existing companies or new entrants are often better able to successfully anticipate and adapt to the challenges in evolving industries. For this reason, large dominant corporations in rapidly changing industries often have trouble living up to the expectations of investors. It is important for investors to realize that historical earnings growth often is a poor indicator of future growth. Q12.5 List five or more criteria identified by T. Rowe Price as important characteristics of Ainvestment opportunities.@ Q12.5ANSWER According to T. Rowe Price, attractive investment opportunities include companies that: • manufacture products or furnish service not vulnerable to takeover or onerous regulation by government. • require especially trained employees who are well paid, but total payroll is not large in relation to gross revenue. • have a liberal profit margin. • are not vulnerable to devastating competition. • are able to lower costs and expand their market without materially reducing the return on invested capital. • have active officers and directors. • have a substantial stock interest in their company. • plan for the future through intelligent research. • understand social trends and have the goodwill of their employees. Q12.6 Explain the PEG ratio and the PEG ratio rule-of-thumb. Q12.6 ANSWER Q12.7 The PEG ratio is simply the P/E ratio divided by the expected EPS growth rate. If a company has a P/E of 20, and is expected to enjoy EPS growth of 20% per year, the company=s PEG ratio would be 1. Generally speaking, a stock is fully valued if it sports a PEG ratio of 1 or more. If the PEG ratio is less than 1, the stock is often worthy of investment consideration. The PEG ratio rule of thumb goes something like this: If PEG #1, the stock may be worthy of investment attention and possible purchase; If PEG #0.5, the stock is definitely worthy of investment attention, and may represent a very attractive investment; If PEG #0.33, the stock is apt to represent an extraordinarily attractive investment opportunity. Needless to say, the investment merit of a stock increases with a decrease in the PEG ratio. Strict growth-at-a-reasonable-price investors seldom, if ever, buy growth stocks with PEG ratios that are far greater than 1. Over the long run, growth and value stocks categorized by price-book ratios, P/E ratios, or dividend yields display comparable rates of return. However, during different parts of the economic cycle, and during bear and bull markets, growth and value stocks behave very differently. Describe the type of economic environment and stock-market environment that is best for growth versus value stocks. Q12.7 ANSWER Over the past quarter century, total rates of return have been similar for the value and growth components of the S&P 500. This means that a long-term investor could expect to receive similar rates of return on value and growth stocks. This fact is also consistent with the efficient market hypothesis that most stocks are at most times appropriately valued given available information. This is despite the fact that there clearly are periods when either the value or growth style of investing is favored in the equity market. Growth stocks tend to outperform value stocks during periods of robust stock market returns and strong economic expansion. Value stocks tend to do relatively well during periods of tepid stock market returns and economic recession. P12.1 Yahoo! Inc. (YHOO) recently had a share price of $21, P/B ratio of 3, and EPS of 704. Calculate the rate of book-value growth made possible by internally generated funds. P12.1 SOLUTION 10%. The rate of growth made possible by internally generated funds is determined by the retention rate and ROE. In this case, a price-book ratio of 3 implies book value per share of $7 = $21/3, and ROE = $0.70/$7 = 10%. If a company earns a 10% ROE and retains all earnings for future investment, the amount of book-value growth that could be funded internally is 10%. P12.2 According to the dividend discount or constant growth model, calculate the required rate of return for The Walt Disney Co. (DIS) at a current price of $35 per share, a projected dividend of 354 per share, projected dividend growth of 11% per year. P12.2 SOLUTION P12.3 k = D1/P0 + g = $0.35/$35 + 11% = 12%. Wal-Mart Stores, Inc. (WMT) recently sold for $55 per share and paid a $0.93 dividend. If the dividend is expected to grow at 13% per year, use the constant growth model to calculate the expected rate of return. P12.3 SOLUTION From the constant growth model, the E(R) = 14.9% on WMT: P0 = $55 D0(1 + g)/(k – g) =($0.93 × 1.13)/( k – 0.13) Rearranging gives: k – 0.13 = $1.05/55 k = 1.9% + 13% = 14.9% P12.4 Suppose a fast growing company paid a $1 dividend per share this year that is expected to grow by 20% for three years. Afterwards, the dividend growth rate will be 7% per year indefinitely. If the required rate of is 9%, calculate the value of this stock. P12.4 SOLUTION P0 = 1.00(1 + 0.20 ) 1.00(1 + 0.20 ) + + 1 + 0.09 (1 + 0.09)2 2 1.00(1 + 0.20 ) (1 + 0.07 ) 0.09 − 0.07 (1 + 0.09)3 1.00(1 + 0.20 ) + 3 3 1.849 1.20 1.44 0.02 = 1.101 + 1.212 + 72.724 = $75.04 = + + 1.09 1.188 1.295 P12.9 According to Yahoo! Finance, non-dividend paying Google, Inc. (GOOG) recently had a book value per share of $77.58 and was expected to earn $24.70 per share during the coming year. Calculate the company’s retention rate, ROE, and the amount of sustainable growth. 1.728 + P12.9 SOLUTION Retention rate = 1 – Dividends/EPS = 1 - $0.00/$24.70 = 100% ROE = EPS/Book value = $24.70/$77.58 = 31.8% Sustainable growth = Retention rate Η ROE = 100% Η 31.8% = 31.8% P12.12 United Technologies Inc.(UTX) earned $4.27 in 2007. At that time, The Value Line Investment Survey projected five-year EPS growth of 13% and a typical P/E ratio of 16. Compute the stock price projected for UTX in five years. P12.12 SOLUTION If UTX grows EPS of $4.27 at an annual growth rate of 13%, the company will earn $3.46 per share in five years and, at 16 times earnings, sell for 125.88: P5 = EPS5 × P/E = EPS0 × (1 + g)5 × P/E = $4.27 × (1.13)5 × 16 Chapter 14 Q14.1 = $125.88 How does interest rate risk differ from credit risk? Q14.1 ANSWER Interest rate risk is the chance of a loss in the value of fixed-income investments following a rise in interest rates. The longer the maturity of a bond, the greater its sensitivity to changes in interest rates and the greater its interest rate risk. Credit risk is the chance that an individual issuer of a bond will fail to make timely payments of principal and interest. Low-quality bonds have a greater risk of these types of default and generally offer higher yields to help compensate investors. Government bonds offer the lowest yields but carry the highest credit ratings and have the lowest risk of default. All bond investors are subject to interest rate risk, but investors in U.S. Treasury bills and U.S. Treasury bonds are for all practical purposes not exposed to credit risk. Q14.2 What is the difference between the primary market and secondary market for bonds? Q14.2 ANSWER The primary bond market is the market for new bonds. Bond issuers sell newly minted bonds in the primary bond market to dealers who then resell those bonds to investors in the secondary bond market. Once bonds have been issued and sold to individual and institutional investors, bond dealers use their capital to maintain active secondary markets for previously issued bonds. Q14.5 How do Treasury bills, Treasury notes, and Treasury bonds differ with respect to term to maturity? Q14.5 ANSWER The Federal government issues, by Federal Reserve System auction, Treasury bills (one year or less maturity), notes (two to ten years maturity), and bonds (more than ten years maturity). Bills, notes and bonds are all U.S. government obligations; they differ primarily in terms of their length of time until maturity. Q14.6 How do Treasury bills, Treasury notes, and Treasury bonds differ with respect to the payment of interest income? Q14.6 ANSWER Treasury bills, or T-bills, are issued at a discount from their face value and pay no cash interest. For example, you might pay $990 for a $1,000 bill. When the bill matures, you would be paid its face value, $1,000. Your interest is the face value minus the purchase price – in this example, the interest is $10. The interest is determined by the discount rate, which is set when the bill is auctioned. Treasury notes, or T-notes, are issued in terms of 2, 5, and 10 years, and pay interest every six months until they mature. Treasury bonds are issued in terms of up to 30 years and pay interest every six months until they mature. When a Treasury bond matures, you are paid its face value. The price and yield of a Treasury bond are determined at auction. The price may be greater than, less than, or equal to the face value of the bond. Q14.7 Explain why Treasury bills are often described as risk-free assets, but that the same cannot be said of Treasury notes and Treasury bonds. Q14.7 ANSWER Bond investors must be concerned with the potential for default risk, or the chance that the borrower will fail to make promised interest and principal payments. Similarly, bond investors must be concerned with the potential for interest-rate risk, or the chance of bond value fluctuations due to changes in market interest rates. While all government obligations are free from default risk, Treasury notes and bonds have the potential for interest-rate risk given their longer terms to maturity for Treasury notes (two to ten years maturity) and Treasury bonds (more than ten years maturity). Q14.8 What are Treasury Inflation-Protected Securities (TIPS)? Can TIPS be purchased by small investors on the Internet in a cost-efficient fashion? Q14.8 ANSWER Treasury Inflation-Protected Securities (TIPS) are bonds issued by the U.S. government that provide protection against inflation. The principal of a TIPS bond increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS bond matures, investors are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. Investors can buy TIPS directly from the U.S. government in a cost-efficient fashion using TreasuryDirect and Legacy Treasury Direct through noncompetitive bidding. Starting in January 2007, the 20-year TIPS bond is no longer sold in Legacy Treasury Direct, but it continues to be available in TreasuryDirect. For more information see the TreasuryDirect website (http://www.treasurydirect.gov/) Q14.9 Mortgage-backed securities are issued by government-sponsored enterprises and other large financial institutions. Major players in this market include Fannie Mae, Freddie Mac, and Ginnie Mae. Explain how they differ. Q14.9 ANSWER Fannie Mae and Freddie Mac are often described as private corporations with a public purpose. Both started out as government-owned enterprises but were converted into privately-held corporations in 1968 (for Fannie Mae) and 1970 (for Freddie Mac). Both Fannie Mae and Freddie Mac supply lenders with money by purchasing home mortgages in the secondary market. Fannie Mae and Freddie Mac assemble these mortgages into diversified packages or pools of such loans and then issue securities that represent a proportionate share in the interest and principal payments derived on that pool. When the government spun off Fannie Mae into a private corporation, it split Fannie Mae’s historical mission into two parts. Ginnie Mae is the second part. Ginnie Mae is a government agency within HUD created by Congress to ensure adequate funds for government loans insured by the Federal Housing Administration (FHA) and guaranteed by the Department of Veterans Affairs (VA) and Veterans Administration. Ginnie Mae issues modified pass-through certificates that represent an interest in a given pool of FHA and VA mortgages. As homeowners make their mortgage payments, a proportionate share passes through to the investor on a monthly basis. Each payment the investor receives is part interest and part repayment of principal. The minimum denomination is $25,000. Ginnie Mae bonds are backed by the full faith and credit of the U.S. government, but interest payments are subject to state and local taxes. Q14.10 What is the mortgage securitization process? Q14.10 ANSWER The mortgage securitization process is the process by which mortgage-backed securities are pooled and resold in order to decrease lender risk. More specifically, it is the process of creating diversified loan portfolios and selling proportionate shares to investors. Both Fannie Mae and Freddie Mac participate in this process. The purpose of each company is to help create a continuous flow of funds to mortgage lenders such as commercial banks, mortgage bankers, savings institutions, and credit unions. Fannie Mae and Freddie Mac purchase home mortgages in the secondary market and then assemble these mortgages into diversified packages, or pools, of loans. They then issue securities that represent a proportionate share in the interest and principal payments derived on that pool. This pooling and then reissuing of diversified mortgage-backed securities is the mortgage securitization process. Q14.11 Describe the characteristics of the money market. Q14.11 ANSWER The money market is the market used for buying and selling short-term debt securities that can be quickly converted into cash. As in the case of T-bills, the majority of money market instruments are issued at a discount from par, or face value. For the most part, $100,000 is the minimum face amount traded in the money market. Obviously, institutional investors dominate this market. Smaller investors participate via money market mutual funds that have minimum investment requirements as low as $1,000. Money market instruments are generally regarded as safe. Given very short maturities, both corporate and government-issued market instruments are free from interestrate risk. However, only government-issued money market instruments are also free from default risk. Q14.12 How does the Federal Reserve use Treasury securities to implement changes in monetary policy? Q14.12 ANSWER The Federal Reserve buys and sells bonds in the Treasury securities market in order to implement monetary policy. If the Fed wishes to increase the money supply, it buys Treasury securities, thereby injecting funds into the financial system and reducing interest rates. If the Fed wishes to decrease the money supply, it sells Treasury securities, thereby withdrawing funds from the financial system and increasing interest rates. In this manner, the Fed tries to manage growth in the economy and tame the rate of inflation.