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X130B – Advanced Applications of Managerial Finance

Midterm One – January 2024

Part I – Multiple Choice – CIRCLE your answers

1. Which of the following statements is CORRECT?

a. An investor can eliminate almost all non-diversifiable risk if he or she holds a large, well- diversified portfolio of stocks.

b. All else equal, the lower the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio.

c. An investor can eliminate over 95% of total risk if the value of stocks and the value of bonds in his or her portfolio are the same.

d. An investor can eliminate all risk of any type if he or she holds a large, well-diversified portfolio of stocks.

e. Once a portfolio has about five stocks, adding additional stocks will not reduce its risk.

2. The Business Roundtable “Statement on the Purpose of a Corporation” identifies each of the following as “stakeholders” except:

a. employees

b. customers

c. suppliers

d. communities

e. attorneys

3. Which of the following events would make it less likely that a company would choose to call its outstanding callable bonds?

a. Market interest rates rise sharply.

b. Market interest rates decline sharply.

c. The company restates its prior year earnings.

d. Inflation decreases significantly.

e. The company's bonds are downgraded to a lower rating.

4. You are planning to purchase a call option on the common stock of Company X.  The price of the call option will be higher, all else equal, if:

a. The option expires in two months rather than eight months

b. The risk-free rate is 3% rather than 5%

c. The standard deviation of returns for Company X is 0.200 rather than 0.500

d. The strike price is $40 rather than $30

e. The option expires in six months rather than three months

5. One of the main differences between a general partnership and an S corporation is that:

a. A general partnership pays federal income tax but an S corporation does not.

b. A general partnership can have a maximum of 100 partners but an S corporation can have any number of shareholders.

c. A general partnership provides no liability protection for the partners, but an S corporation’s shareholders have significant protection from liability.

d. A general partnership has unlimited (perpetual) life but an S corporation is dissolved upon the death or withdrawal of a shareholder.

e. A general partnership must file articles of incorporation with the state but an S corporation can be formed with an agreement only.

6. A legal document that describes the rights of bondholders and of the issuing corporation for a bond is the:

a. Warrant

b. Coupon

c. Trustee

d. Indenture

e. Mortgage

7. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?

a.   Use cash to increase inventory holdings.

b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment.

c.   Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.  

d. Use cash to repurchase some of the company's own stock.

e. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.

8. The yield-to-maturity (YTM) for three $1,000 face value bonds that mature in 10 years and have the same level of risk are equal. Bond A has a 6% annual coupon, Bond B has an 8% annual coupon, and Bond C has a 10% annual coupon. Bond B sells at par (i.e., the current price = $1,000). Assuming interest rates remain constant for the next 10 years, which of the following statements is CORRECT?

a. Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to stay the same, and Bond C's price is expected to increase.

b. Bond B's current yield (annual interest payment divided by current price) will increase each year.

c. Since the bonds have the same YTM, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until maturity.

d. Bond C sells at a premium, and its price is expected to increase over the next year.

e. Bond A sells at a discount, and its price is expected to increase over the next year.

9. All other things equal, which of the following would be most likely to increase the coupon rate required by investors for a new corporate bond?

a.    The issuer’s latest earnings report meets or exceeds expectations.

b.    The addition of a call provision.

c.    The rating agencies change the bond's rating from Baa to Aaa.

d.    Making the bond a secured first mortgage bond rather than an unsecured debenture.

e.    Adding restrictive covenants that limit the issuance of additional debt unless performance targets are met.

10. Alvarado, Inc. stock is trading at $35 a share. Call options on the company's stock are also available, some with a strike price of $30 and some with a strike price of $40. Both options expire in three months. Which of the following best describes the value of these options?

a. The options with the $30 strike price will sell for less than the options with the $40 strike price.

b. The options with the $30 strike price have an exercise value of $10.

c. The options with the $40 strike price have an exercise value greater than $0.

d. If Alvarado’s stock price rose by $5, the exercise value of the options with the $30 strike price would also increase by $5.

e. The options with the $30 strike price will sell for exactly $5.

11.  The required returns of Stocks X and Y are r_X = 10% and r_Y = 12%. Which of the following statements is CORRECT?

	a.	If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X.
	b.	If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price.
	c.	The stocks must sell for the same price.
	d.	Stock Y must have a higher dividend yield than Stock X.
	e.	If Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

12. For bonds, the combined effect of interest rate risk and reinvestment risk is known as the:

	a.	Inflation premium
	b.	Nominal risk-free rate
	c.	Maturity risk premium
	d.	Default risk premium
	e.	Long-term risk premium

Part II – Problems (10 points each) – Show your Work unless otherwise indicated

Problem 1:

a. Allard Corporation’s stock has beta = 0.7.  The risk-free rate is 4% and the expected return on the market is 14%.  What is the required rate of return on Allard’s stock?

b. Monza, Inc. stock has a required return = 14%.  The risk-free rate is 3% and the expected return on the market is 11%.

i. Calculate the beta for Monza’s stock (show your answer to two decimal places)

ii. If Monza’s beta were 2.1, what would be the new required rate of return?

c. You have two stocks in your portfolio.  $40,000 is invested in a stock with a beta of 1.1 and $120,000 is invested in a stock with a beta of 1.9.  What is the portfolio’s beta?

Problem 2:

The Elan Company makes electric scooters and has the following forecast:

Demand for Scooters	Probability of This Demand Occurring	Rate of Return if Demand Occurs
Weak	0.20	-30%
Average	0.50	20%
Strong	0.30	40%

a. Calculate the expected return for Elan stock (show your answer to four decimal places):

b. Calculate the variance for the stock (show your answer to four decimal places):

c.  Calculate the standard deviation for the stock (show your answer to four decimal places):

Problem 3:

Fill in the missing information for each of the domestic (United States) corporate bonds listed below.  Each bond has a face value of $1,000.  (You do not need to show your work if you use a financial calculator.)

	Current Price	Years to Maturity	Coupon Rate	Yield to Maturity	Frequency of Payments
1.		12	12.0%	11.00%	annual
2.	$935.08	15	8.00%		annual
3.	$902.29	10	6.00%		semi-annual
4.	$1,203.68	5		7.98%	semi-annual
5.	$917.24		5.00%	5.75%	annual

Professor Aswath Damodaran (AD) Blog (posts in 2024)

https://aswathdamodaran.blogspot.com/

Short answer questions (one paragraph per question)

A. Explain four observations presented in the 2024 Damodaran blogs.

B. What are the three measures of intrinsic risk Professor Damodaran (AD) identifies in his January 28 post?

C. Why does AD use a Chinese symbol to explain risk?

D. In Data Update 3, AD explains that the corporate default spread behaved very differently in 2023, as opposed to 2022.  What were the differences?

E. In Data Update 2, AD compares the expected return on stocks with the yield to maturity for bonds.  What are the similarities?

F. What are the alternatives to price-based risk measurements AD presents in Data Update 4?

G. Why were Australia and Canada described as volatile stock markets?

Open Question:

What changes would you like to see in this class?