FIN470 (123)- Seminar in Finance
Quiz 3 Answers
Reading 38, 39, 41
Time allowed: 45 minutes
1. Investor overreaction that has been documented in securities markets is most likely
attributable to investors exhibiting:
A) conservatism.
B) risk aversion.
C) loss aversion.
Explanation Loss aversion refers to the tendency for investors to dislike downside risks
more than upside risks creating asymmetrical risk preferences. This dislike of losses may
be a cause of investor overreaction. The standard economic notion of risk aversion assumes
symmetric risk preferences. Conservatism is the behavioral bias whereby investors react
slowly to new information and is unlikely to cause overreaction. (Study Session 11, Module
35.1, LOS 35.g)
2. If the efficient markets hypothesis is true, portfolio managers should do all of the
following EXCEPT:
A) Minimize transaction costs.
B) Work more with clients to better quantify their risk preferences.
C) Spend more time working on security selection.
Explanation In an efficient market all stocks are properly priced and reflect all publicly
available information. Therefore, individual selection of stocks is not important the only
thing that is relevant is the portfolio's beta.
3. The opportunity to take advantage of the downward pressure on stock prices that result
from end-of-the year tax selling is known as the:
A) end-of-the-year anomaly.
B) January anomaly.
C) end-of-the-year effect.
Explanation The January Anomaly is most likely the result of tax induced trading at year
end. An investor can profit by buying stocks in December and selling them during the first
week in January. (Study Session 11, Module 35.1, LOS 35.f)
4. Which of the following statements about market efficiency is least accurate?
A) The strong-form EMH assumes cost free availability of all information, both public and
private.
B) The semi-strong form EMH addresses market and non-market public information.
C) The weak-form EMH suggests that fundamental analysis will not provide excess
returns while the semi-strong form suggests that technical analysis cannot achieve
excess returns.
Explanation The weak-form EMH suggests that technical analysis will not provide excess
returns while the semi-strong form suggests that fundamental analysis cannot achieve excess
returns. The weak-form EMH assumes the price of a security reflects all currently available
historical information. Thus, the past price and volume of trading has no relationship with the
future, hence technical analysis is not useful in achieving superior returns.
The other choices are correct. The strong-form EMH states that stock prices reflect all types of
information: market, non-public market, and private. No group has monopolistic access to
relevant information; thus no group can achieve excess returns. For these assumptions to hold,
the strong-form assumes perfect markets – information is free and available to all.
5. Which of the following would provide evidence against the semi-strong form of the
efficient market theory?
A) Low P/E stocks tend to have positive abnormal returns over the long run.
B) All investors have learned to exploit signals related to future performance.
C) Trend analysis is worthless in determining stock prices.
Explanation P/E information is publicly available information and therefore this test relates to
the semistrong-form EMH. Trend analysis is based on historical information and therefore
relates to the weak-form EMH. In an efficient market one would expect 50% of pension fund
managers to do better than average and 50% of pension fund managers to do worse than
average. If all investors exploit the same information no excess returns are possible.
6. Compared to preferred stock, common stock is most likely to:
A) exhibit a lower standard deviation of returns.
B) pay more frequent dividends.
C) provide a higher average return.
Explanation Common stock is more risky than preferred stock and is expected to provide
higher average returns. Preferred stock promises fixed periodic dividends. Common stock
can be dividend-paying or non-dividend paying and the dividends are at management's
discretion. (Study Session 12, Module 36.2, LOS 36.e)
7. Cheryl Brower and Todd Sutter each own 100 shares of Hills Company stock. In a recent
proxy vote, Brower had 100 votes but Sutter had 10 votes. The most likely reason for this
difference in voting rights is that:
A) Brower and Sutter own different classes of stock.
B) Brower is a director of Hills Company.
C) Hills Company uses a statutory voting method.
Explanation Companies may issue classes of stock (e.g., Class A and Class B shares) that
differ in aspects such as voting rights, dividends, or priority of claims in liquidation. (Study
Session 12, Module 36.1, LOS 36.b)
8. A U.S. investor purchases ADRs of a Japanese company, while a Japanese investor
purchases the same value of the company's common stock. Compared to the Japanese
investor, the U.S. investor will most likely:
A) benefit from greater transparency.
B) realize different returns.
C) face the same risk.
Explanation The return to the U.S. investor is affected by the return on the shares in
Japanese yen and by the dollar/yen exchange rate. The U.S. investor therefore faces
additional currency risk, which will most likely result in returns that differ from those a
Japanese investor would realize. ADRs do not necessarily offer greater transparency to
foreign investors than that which is available to domestic investors. For Further Reference:
(Study Session 12, Module 36.2, LOS 36.d) CFA® Program Curriculum, Volume 4, page
28
9. Other things equal, preference shares have the most risk for the investor when they are:
A) non-callable and non-cumulative.
B) callable and non-cumulative.
C) putable and cumulative.
Explanation Callable shares have more risk than otherwise equivalent non-callable shares
because the possibility of the shares being called limits their potential price gains. Putable
shares have less risk than otherwise equivalent non-putable shares because the option to put
the shares back to the issuer for a predetermined price effectively places a floor under their
price. Cumulative preference shares have less risk than otherwise equivalent noncumulative
preference shares because any scheduled dividends the issuer misses are still owed to the
preferred shareholder. (Study Session 12, Module 36.2, LOS 36.e
10. Global depository receipts are most likely issued:
A) in the United States and denominated in U.S. dollars.
B) outside the issuer’s home country and denominated in the exchange’s home currency.
C) outside the issuer’s home country and denominated in U.S. dollars
Explanation Global depository receipts are issued outside the U.S. and the issuer's home country
and are most often denominated in U.S. dollars. Depository receipts issued in the United States
and denominated in U.S. dollars are called American depository receipts. Global registered
shares are denominated in the home currencies of the exchanges on which they trade.
11. Which valuation method is most appropriate to estimate a floor value for a firm being
liquidated?
A) Price/earnings ratio.
B) Discounted cash flow.
C) Asset-based.
Explanation An asset-based model would likely be most appropriate to estimate a floor value
for a firm entering liquidation. Future cash flows and firm fundamentals such as earnings or
sales are not relevant for a firm that is not a going concern. (Study Session 12, Module 38.3,
LOS 38.m)
12. Using the one-year holding period and multiple-year holding period dividend discount
model (DDM), calculate the change in value of the stock of Monster Burger Place under the
following scenarios. First, assume that an investor holds the stock for only one year. Second,
assume that the investor intends to hold the stock for two years. Information on the stock is as
follows:
Last year's dividend was $2.50 per share.
Dividends are projected to grow at a rate of 10.0% for each of the next two years.
Estimated stock price at the end of year 1 is $25 and at the end of year 2 is $30.
Nominal risk-free rate is 4.5%.
The required market return is 10.0%.
Beta is estimated at 1.0.
The value of the stock if held for one year and the value if held for two years are:
Year one Year two
A) $25.22 $29.80
B) $25.22 $35.25
C) $27.50 $35.25
First, we need to calculate the required rate of return. When a stock's beta equals 1, the required
return is equal to the market return, or 10.0%. Thus, ke = 0.10.
Alternative: Using the capital asset pricing model
(CAPM), ke = Rf + Beta * (Rm – Rf) = 4.5% + 1 * (10.0% - 4.5%) = 4.5% + 5.5% = 10.0%.
Next, we need to calculate the dividends for years 1 and 2.
D1 = D0 × (1 + g) = 2.50 × (1.10) = 2.75
D2 = D1 × (1 + g) = 2.75 × (1.10) = 3.03
Then, we use the one-year holding period DDM to calculate the present value of the expected stock
cash flows (assuming the one-year hold).
P0 = [D1/ (1 + ke)] + [P1 / (1 + ke)] = [$2.75 / (1.10)] + [$25.0 / (1.10)] = $25.22.
Shortcut: since the growth rate in dividends, g, was equal to ke, the present value of next year's
dividend is equal to last year's dividend.
Finally, we use the multi-period DDM to calculate the return for the stock if held for two years.
P0 = [D1/ (1 + ke)] + [D2/ (1 + ke)2] + [P2 / (1 + ke)2] = [$2.75 / (1.10)] + [$3.03 / (1.10)2] +
[$30.0 /(1.10)2] = $29.80.
Note: since the growth rate in dividends, g, was equal to ke, the present value of next year's dividend
is equal to last year's dividend (for periods 1 and 2). Thus, a quick calculation would be 2.5 × 2 +
$30.00 / (1.10)2 = 29.80.
13. An analyst evaluating a stable, mature, electric utility with non-cyclical earnings and a high
dividend would most appropriately use a:
A) 3-stage model
B) 2-stage model.
C) constant growth model.
Explanation
A constant growth model is most appropriate for mature firms in stable markets that pay dividends
which grow at a constant rate.
(Study Session 13, Module 41.2, LOS 41.h)
14. A company's required return on equity is 15% and its dividend payout ratio is 55%. If its
return on equity (ROE) is 17% and its beta is 1.40, then its sustainable growth rate is closest
to:
A) 6.75%.
B) 7.65%.
C) 9.35%.
Explanation
Growth rate = (ROE)(Retention Ratio)
= (0.17)(0.45)
= 0.0765 or 7.65%
(Study Session 13, Module 41.2, LOS 41.g)
15. Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?
A) Firms with negative earnings cannot be evaluated with the PBV ratios.
B) Book value may not mean much for manufacturing firms with significant fixed costs.
C) Book values are affected by accounting standards, which may vary across firms and
countries.
Explanation
The disadvantages of using PBV ratios are:
1. Book values are affected by accounting standards, which may vary across firms and countries.
2. Book value may not mean much for service firms without significant fixed costs.
3. Book value of equity can be made negative by a series of negative earnings, which limits the
usefulness of the variable.
(Study Session 13, Module 41.3, LOS 41.m)
16. Calculate the value of a preferred stock that pays an annual dividend of $5.50 if the current
market yield on AAA rated preferred stock is 75 basis points above the current T-Bond rate
of 7%.
A) $70.97.
B) $78.57.
C) $42.63.
Explanation
kpreferred = base yield + risk premium = 0.07 + 0.0075 = 0.0775
ValuePreferred = Dividend / kpreferred
Value = 5.50 / 0.0775 = $70.97
(Study Session 13, Module 41.2, LOS 41.f)
17. An equity valuation model that values a firm based on the market value of its outstanding
debt and equity securities, relative to a firm fundamental, is a(n):
A) market multiple model.
B) enterprise value model.
C) asset-based model.
Explanation
An enterprise value model relates a firm's enterprise value (the market value of its outstanding
equity and debt securities minus its cash and marketable securities holdings) to its EBITDA,
operating earnings, or revenue.
(Study Session 13, Module 41.1, LOS 41.b)
18. A valuation model based on the cash flows that a firm will have available to pay dividends in
the future is best characterized as a(n):
A) infinite period dividend discount model.
B) free cash flow to the firm model.
C) free cash flow to equity model.
Explanation
Free cash flow to equity represents a firm's capacity to pay future dividends. A free cash flow to
equity model estimates the firm's FCFE for future periods and values the stock as the present value
of the firm's future FCFE per share.
(Study Session 13, Module 41.2, LOS 41.e)
19. An asset-based valuation model is most appropriate for a company that:
A) has a high proportion of intangible assets among its total assets.
B) is likely to be liquidated.
C) is expected to remain profitable for the foreseeable future.
Explanation
For companies that are likely to be liquidated, the asset-based approach may be the most
appropriate value as the assets may be worth more to another entity. Asset-based valuation models
do not work well for companies that have large amounts of intangible assets. Because asset-based
valuation is not forward looking, an asset-based approach may underestimate the value of
companies that are expected to be profitable.
(Study Session 13, Module 41.3, LOS 41.l)
20. Which of the following is least likely an advantage of using price/sales (P/S) multiple?
A) P/S multiples provide a meaningful framework for evaluating distressed firms.
B) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation
analysis.
C) P/S multiples are more reliable because sales data cannot be distorted by management.
Explanation
Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss
problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than
P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful
framework for evaluating effects of pricing changes on firm value.
(Study Session 13, Module 41.3, LOS 41.i)
