INVESTMENTS ANALYSIS AND MANAGEMENT 12TH EDITION BY CHARLES – Test Bank

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Sample Questions Posted Below

 

 

 

 

File: ch05, Chapter 5: How Securities are Traded

 

 

 

Multiple Choice Questions

 

 

 

  1. Merrill Lynch and UBS are examples of:

 

  1. discount brokers
  2. wholesale brokers
  3. full-service brokers
  4. blue-chip brokers

 

Ans: c

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. Which of the following statements is true regarding full-service brokers?

 

  1. They typically seek clients with at least $10,000 in their accounts.
  2. They derive only a small percentage of their revenues from commissions.
  3. They compete primarily on price and services offered.
  4. Less than 10 percent of U.S. households now use a full-service broker.

 

Ans: b

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Which of the following statements regarding commissions charged by full-service brokers is not true?

 

  1. Commissions vary by product.
  2. The more complicated the transaction, the higher the commission.
  3. The commission on many bonds is already built into the trade.
  4. There is no commission on U.S. Treasury securities.

 

Ans: d

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Which of the following statements regarding discount brokers is true?

 

  1. All discount brokers offer on-line trading.
  2. Discount brokers only execute orders on stock transactions.
  3. Discount brokers may offer little investment advice.
  4. Discount brokers do not offer SIPC protection.

 

Ans: c

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Which of the following accounts often requires an annual fee?

 

  1. a cash account
  2. a wrap account
  3. a margin account
  4. All of the above require an annual fee.

 

Ans: b

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Which of the following requires a relatively large minimum investment, usually $100,000 or higher?

 

  1. a cash account
  2. an asset management account
  3. a margin account
  4. a wrap account at a large brokerage firm

 

Ans: d

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. A newer variation of the wrap account is the:

 

  1. mutual fund wrap account
  2. asset allocation wrap account
  3. small-cap wrap account
  4. index wrap account

 

Ans: a

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. Which of the following laws eliminated all fixed commissions?

 

  1. Securities Exchange Act of 1934
  2. Securities Acts Amendments of 1975
  3. Investor Advisor Act of 1940
  4. Securities Investor Protection Act of 1970

 

Ans: b

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Direct stock purchase programs (DSPs) are an outgrowth of :

 

  1. electronic trading
  2. dividend reinvestment plans
  3. increased NASDAQ trading
  4. decreased regulation

 

Ans: b

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. Treasury bond buyers can purchase bonds transaction cost free through:

 

  1. S. Federal Reserve Bank
  2. Treasury Direct
  3. DSPs
  4. discount brokers

 

Ans: b

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. Algorithmic trading is:

 

  1. technical analysis, also called charting
  2. high frequency trading in ECNs
  3. analysisarbitrage
  4. involve the use of computer programs to initiate trade orders, including decision-making on security, quantity, price, and timing

 

Ans: d

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. NYSE Specialists are required to

 

  1. maintain a bid-ask spread no greater than 1 cent per share
  2. maintain a fair and orderly market.
  3. buy when most others are selling, or vice versa.
  4. selling off inventory and maintaining strictly neutral positions

 

Ans: b

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. The NYSE maintains circuit breakers to protect investors from unusual market activity. One of these circuit breakers is:

 

  1. trading halt
  2. strict adherence to market opening
  3. strict adherence to market closing
  4. Stockwatch

 

Ans: a

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The Financial Industry Regulatory Authority (FINRA) created in 2007 is the largest regulator for securities firms in the U.S. FINRA’s objective is to:

 

 

  1. protect the bid-ask spread and exchange participants’ profits
  2. protect corporations and investors
  3. protect investors and ensure market integrity
  4. ensure market integrity

 

Ans: c

Difficulty: easy

Ref: How Orders Work

 

 

 

  1. The Securities Investor Protection Corporation (SIPC) insures customer accounts at member brokers against brokerage failure as follows:

 

  1. securities totaling $250,000, cash totaling $100,000
  2. securities totaling $250,000, cash totaling $250,000
  3. securities totaling $500,000, cash totaling $100,000
  4. securities totaling $500,000, cash totaling $250,000

 

Ans: c

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The NYSE requires customers to deposit a minimum of how much in securities for margin accounts

 

  1. $2,000
  2. $2,500
  3. $5,000
  4. $10,000

 

Ans: a

Difficulty: medium

Ref: Margin

 

 

 

  1. Margin accounts cannot be used to:

 

  1. purchase securities using leverage
  2. borrow money from a brokerage account to fund a frivolous vacation
  3. provide overdraft protection
  4. take physical delivery of an underlying asset on maturity of a futures contract

 

Ans: d

Difficulty: medium

Ref: Margin

 

 

 

  1. Open orders, if not cancelled or renewed, remain in effect for:

 

  1. one week.
  2. one month.
  3. six months
  4. twelve months.

 

Ans: c

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. If an investor is attempting to buy a stock that is very volatile, it would be best to use a:

 

  1. market order
  2. limit order
  3. stop-loss order
  4. contingency order

 

Ans: b

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. An order that must be filled immediately in its entirety, or otherwise must be canceled, is known as:

 

  1. an immediate or cancel order.
  2. an all or none order.

c          a fill or kill order.

  1. a full or bust order.

 

Ans: c

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The NYSE is:

 

  1. a free agent market.
  2. an agency auction market.
  3. a negotiated market.
  4. a dealer market.

 

Ans: b

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The independent, quasi-judicial agency of the U.S. government that administers laws in the securities field and protects investors and the public in securities transactions is:

 

  1. FINRA
  2. SIPC
  3. The Federal Reserve Bank
  4. SEC

Ans: d

Difficulty: easy

Ref: How Orders Work

 

 

 

  1. Which of the following statements regarding specialists is FALSE? Specialists:

 

  1. are expected to maintain a fair and orderly market in their assigned stocks.
  2. perform a dual role as brokers and dealers.
  3. must be approved by the Federal Reserve Board.
  4. must often go “against the market.”

 

Ans: c

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. Ms. Brown sold short 100 shares of common stock at $78 per share. The price has declined to $69.  The outlook for the stock is mixed, so she would cover her short position if the stock moves up as much as $1 but hold if it continues down.  Ms. Brown should place a

 

  1. sell stop order at $70.
  2. buy stop order at $70.
  3. sell limit order at $70.
  4. buy limit order at $70.

 

Ans: b

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. Mr. King has researched a small company, whose stock is selling at $7.50. He wants to buy 1,000 shares but thinks that he might get the stock at $7.25.  To try to buy the stock at the lower price, he should place a

 

  1. sell stop order at $7.25.
  2. buy stop order at $7.25.
  3. sell limit order at $7.25.
  4. buy limit order at $7.25.

 

Ans: d

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. A sell stop order is placed:

 

  1. above the current price.
  2. below the current price.
  3. at the current price.
  4. at the breakeven point.

 

Ans: b

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. Which of the following has helped to eliminate the use of stock certificates by placing stock transactions on computers.

 

  1. Federal Reserve
  2. Securities Exchange Commission
  3. Depository Trust Company
  4. Federal Depository Insurance Corporation

 

Ans: c

Difficulty:  medium

Ref: How Orders Work

 

 

 

  1. The law that requires that all new issues being offered for public sale to be

registered with the SEC is the:

 

  1. Securities Act of 1933
  2. Securities Exchange Act of 1934
  3. Maloney Act of 1936
  4. Securities Investor Protection Act of 1970

 

Ans: a

Ref: moderate

Ref: Investor Protection in the Securities Markets

 

 

 

  1. Which of the following statements regarding the SEC is not true?

 

  1. The SEC is an independent, quasi-judicial agency of the U.S. government
  2. The SEC has the power to disapprove securities for lack of merit
  3. The SEC has nine regional offices and approximately 200 examiners
  4. The SEC administers all U.S. securities laws

 

Ans: b

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. A trading halt on the NYSE occurs:

 

  1. when the SEC declares one
  2. when the market declines more than 10 percent during the day
  3. typically lasts less than an hour but can be longer—is called during the trading day to allow a company to announce important news or where there is a significant order imbalance between buyers and sellers in a security. any time specialists exhaust their capital

 

Ans: c

Difficulty: hard

Ref: How Orders Work

 

 

 

  1. Which of the following statements regarding arbitration of broker-client disputes is not true?

 

  1. There is a cost to arbitration.
  2. Arbitration is a binding process that can determine damages.
  3. It is advised that investors hire a lawyer for the arbitration process.
  4. Arbitration rulings are frequently appealed.

 

Ans: d

Difficulty: medium

Ref: How Orders Work

 

 

 

 

 

 

  1. The initial margin requirement on security trades is set by the:

 

  1. SEC
  2. FINRA
  3. SIPC
  4. Federal Reserve

 

Ans: d

Difficulty: easy

Ref: Margin

 

 

 

  1. Since 1974, the current initial margin requirement on stock is:

 

  1. 30 percent.
  2. 40 percent.
  3. 50 percent.
  4. 60 percent.

 

Ans: c

Difficulty: easy

Ref: Margin

 

 

 

  1. The interest rate charged on margin accounts is determined by:

 

  1. adding a percentage to the broker call rate.
  2. adding a percentage to the margin interest rate.
  3. subtracting a percentage to the broker call rate.
  4. subtracting a percentage to the margin interest rate.

 

Ans: a

Difficulty: medium

Ref: Margin

 

 

  1. Margin Call price is the amount borrowed divided by:

 

  1. number of shares x (1 – initial margin proportion)
  2. number of shares x (1 – maintenance margin proportion)
  3. current value of the shares purchased x (1 – initial margin proportion)
  4. current value of the shares purchased x (1 – maintenance margin proportion)

 

Ans: b

Difficulty: Medium

Ref: Margin

 

  1. If maintenance margin is not maintained, the broker will place:

 

  1. a sell order on sufficient securities to ensure the portfolio is compliant with maintenance margin requirements
  2. a sell order on sufficient securities to ensure the portfolio is compliant with initial margin requirements
  3. contact the investor with a margin put
  4. contact the investor with a margin call

 

Ans: d

Difficulty: Easy

Ref: Margin

 

 

NOTE:  Questions 37-38 are based on the following information:

 

 

 

An investor buys 100 shares of Walmart at $45 per share on margin with an initial margin of 70 percent and a maintenance margin of 25% percent.    In two months, the stock goes to $56.

 

  1. What is the actual margin of the stock when it’s at $56?

 

  1. 9%
  2. 9% Solution:  5600-1350      =
  3. 9%                                  5600
  4. 9%

 

Ans: b

Difficulty: hard

Ref: Margin

 

 

 

  1. Below what price will a margin call occur?

 

  1. $13.50
  2. $54.00 Solution =     1350            = $18
  3. $42.00 100(1-.25)
  4. $18.00

 

Ans: d

Difficulty: hard

Ref: Margin

 

 

 

  1. Which of the following statements is true regarding short sales?

 

  1. An investor can only remain in a short sale 6 months or less.
  2. Short sales can be done on either a cash or margin account.
  3. Short sellers borrow the stock sold short from the exchanges.
  4. Dividends paid during the short sale must be covered by the seller.

 

Ans: d

Difficulty: hard

Ref: Short Sales

 

 

 

  1. Which of the following statements regarding the short interest ratio is true?

 

  1. It is calculated by the total shares sold short divided by total shares outstanding
  2. It indicates the dollar amount needed to cover all short positions
  3. The higher the ratio, the more bullish investors are
  4. It is the amount of shares sold short divided by average trading volume

 

Ans: c

Difficulty: medium

Ref: Short Sales

 

 

Fill-in-the-blank Questions

 

  1. The SIPC limit for insurance coverage on cash is _____________________.

 

Ans: $100,000

Difficulty: medium

Ref: Investor Protection in the Securities Markets

 

 

 

  1. The NYSE regulatory triad consists of: _____________________________, _________________, and _______________________________________.

 

Ans: the Exchange/NYSE (self-regulation), the SEC, and member firms

Difficulty: medium

Ref: Investor Protection in the Securities Markets

 

True-False Questions

 

 

 

  1. Most full-service stockbrokers derive over 80% of their income from                                 customer commissions.

 

Ans: F

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. Charles Schwab, Fidelity and Vanguard are examples of premium discount brokers.

 

Ans: T

Difficulty: easy

Ref: Brokerage Transactions

 

 

 

  1. All asset management accounts offer automatic reinvestment of credit balances in shares of a money market or other fund.

 

Ans: T

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Negotiated commissions are the norm for institutional investors; whereas most individual investors pay specified commissions set by the brokerage firms.

 

Ans: T

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Dollar cost averaging, in which more shares are purchased at low prices than at high prices, is one advantage of dividend reinvestment plans.

 

Ans: T

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Buying Treasury securities through the Treasury Direct Program eliminates all brokerage commissions and other fees.

 

Ans: F

Difficulty: medium

Ref: Brokerage Transactions

 

 

 

  1. Specialist trading on the NYSE now accounts for the majority of share volume on a yearly basis.

 

Ans: F

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The Specialist’s Electronic Book, which is part of the SuperDot system, records and reports limit and market orders.

 

Ans: T

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. “Street names” are the nicknames used for commonly-held securities, such as “IBM” for International Business Machines.

 

Ans: F

Difficulty: easy

Ref: How Orders Work

 

 

 

  1. The use of stock certificates, compared to book-entry systems, is on the rise due, in part, to increased computer fraud.

 

Ans: F

Difficulty: easy

Ref: How Orders Work

 

 

 

  1. A sell stop loss order is placed above the current market price.

 

Ans: F

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. Most securities are sold on a regular way basis, which means the settlement date is one week after the trade date.

 

Ans: F

Difficulty: medium

Ref: How Orders Work

 

 

 

  1. The Securities and Exchange Commission is a division of the Department of Justice.

 

Ans: F

Difficulty: easy

Ref: Investor Protection in the Securities Markets

 

 

 

  1. Insider trading often occurs when mergers and takeovers are imminent.

 

Ans: T

Difficulty: medium

Ref: Investor Protection in the Securities Markets

 

 

 

  1. If a security issue is registered with the SEC, there is less chance the investor will lose money on the investment.

 

Ans: F

Difficulty: medium

Ref: Investor Protection in the Securities Markets

 

 

 

  1. Sidecars, trading halts and Rule 80A are all types of circuit breakers employed by the NYSE.

 

Ans: T

Difficulty: medium

Ref: Investor Protection in the Securities Markets

 

 

 

  1. “Circuit breakers” are program traders that attempt to bypass the exchange regulations.

 

Ans: F

Difficulty: hard

Ref: Investor Protection in the Securities Markets

 

 

 

  1. Under SIPC, customer accounts with brokerage firms are insured for up to $1 million.

 

Ans: F

Difficulty: easy

Ref: Investor Protection in the Securities Markets

 

 

 

  1. Under margin accounts, investors can purchase more stock without putting up additional cash by leveraging the value of the eligible shares.

 

Ans: T

Difficulty: medium

Ref: Margin

 

 

 

  1. A margin call occurs anytime the equity position of the margin account falls below the initial margin.

 

Ans: F

Difficulty: medium

Ref: Margin

 

 

 

  1. Most short sales are executed by the broker acting as the “lender” of the security sold.

 

Ans: T

Difficulty: easy

Ref: Short Sales

 

 

 

  1. Investors who sell short are expecting the price of the security to fall.

 

Ans: T

Difficulty: easy

Ref: Short Sales

 

 

 

  1. Specialists often sell short to meet public buy orders.

 

Ans: T

Difficulty: medium

Ref: Short Sales

 

 

 

  1. The short interest ratio indicates the number of days it would take for short sellers to cover all the shares sold short.

 

Ans: T

Difficulty: medium

Ref: Short Sales

 

 

 

Short-Answer Questions

 

 

 

  1. What is the chief advantage of a market order?

 

Answer:      A market order is executed immediately.

Difficulty:   easy

 

 

 

  1. What are the advantages to investors’ of keeping their securities in street name?

 

Answer:           Investors don’t have to worry about lost certificates and it simplifies record

keeping.

Difficulty:       easy

 

 

 

  1. What costs and risks are incurred in using a margin account that are not present in a cash account?

 

Answer:           There is the cost of interest on the amount borrowed and the risk of losing                          the borrowed funds as well as your original equity, and dividend payments                  must be covered on the borrowed stock.

Difficulty:       medium

 

 

 

4.         What is the rationale for different margin requirements on different types of securities?  (For example, 50 percent on common stock, and 30 percent on bonds corporate bonds)

 

Answer:          In general, the higher the risk of loss, the higher the margin requirement.                            This is why stocks have higher margins than bonds.  Unfortunately,                                margins on futures are very small and do not follow this logic.

Difficulty:       medium

 

 

 

  1. What is insider trading? Does it only affect large investors?

 

Answer:           Insider trading is a breach of fiduciary responsibility by “insiders” such as                          officers and directors of corporations who trade on corporate information                           that is available to the public.  Both large and small investors can be                                  charged with possessing “material, nonpublic information.”

Difficulty:       hard

 

 

 

  1. Mr. Whiner bought 1,000 shares of Sure-Fire, Inc., common stock at 85 and sold three months later at 73. He lost $12,000 plus commissions on this ill-fated stock purchase.  He then contacted the SIPC saying that he wanted to file a claim for his investment losses.  Is this loss covered by SIPC?  What losses are covered?

 

Answer:           No.  Losses due to a brokerage firm bankruptcy (causing an investor’s                                account to be worth less than full value) are covered.

Difficulty:       medium

 

 

 

  1. Does the expression “you get what you pay for” apply to full-service brokers and discount brokers?

 

Answer:           By and large the expression applies.  Full-service brokers offer advice and                                     suggest securities, whereas, discount brokers simply handle the                                           transaction.

Difficulty:       medium

 

 

 

  1. What are two methods of investing in stocks without a broker?

 

Answer:           Automatic dividend reinvestment plans and no-load stock purchase                                    programs.

Difficulty:       medium

 

 

 

  1. Small investors often pay brokerage commissions according to the firm’s chart of fees. How can this be when rates are negotiable?

 

Answer:           Small investors are free to negotiate with the broker, but often they                                     negotiate from a position offering little.  It’s not worth it to the brokerage                           house to negotiate every small trade.

Difficulty:       hard

 

 

 

  1. What are some of the functions of the NASD?

 

Answer:           The NASD is the major organization licensing stockbrokers as well as                                providing compliance examinations of member firms.  In addition, the                               NASD provides automated market surveillance, reviews member                                        advertising and underwriting arrangements and provides for arbitration of                            disputes between member firms and their clients.

Difficulty:       medium

 

 

 

Critical Thinking/Essay Questions

 

 

 

  1. Compare and contrast the functions and responsibilities of a NYSE specialist with those of an OTC dealer.

 

Answer:           Specialists must maintain a fair and orderly market on the NYSE.  They                             keep limit orders.  They buy and sell from their own accounts as dealers to                     maintain a continuous market.  OTC dealers buy and sell from their own                            accounts to satisfy public demand, thereby making markets in the                                                securities.  Specialists are more restricted in their trading by the NYSE                           while the OTC choose which securities to make a market in and when to                            buy and sell.

Difficulty:       medium

 

 

 

  1. What is the difference between the potential gains and losses on long positions versus the potential gains and losses on short sales?

 

Answer:           On long positions, the potential gain is unlimited because there is no limit                          to how high a stock price can go.  The potential loss on a long position is                               just what you paid for the stock.  With short sales, on the other hand, the                                  potential gain is limited since you make a gain on a short sale when the                         stock falls and stocks can only fall to 0.  But the potential loss is unlimited                      since you lose money on a short sale when the stock’s price rises and there                                     is again no limit to how high a stock price can go.

Difficulty:       hard

 

 

 

Problems

 

 

 

  1. An investor purchases 100 shares of a $60 stock when the initial margin requirement is 50 percent and the maintenance margin is 30 percent.

 

(a) How much must the investor put up initially in order to purchase the stock?

(b) Calculate the actual margin if the price of the stock drops to $55.

(c) At what stock price will a margin call occur?

(d) If the stock price falls to $58, is the account restricted?

 

Solution:          (a)        initial margin = 50 percent

50% of ($60 x 100)     =          $3000 in equity

(b)        actual margin

=          $5500 – $3000

$5500               =   45.5 percent

(c)        A margin call occurs when the actual margin declines below the maintenance margin.  This point can be found (with a 30 percent maintenance margin) as follows:

 

MC price = Amount borrowed_____________

# of shares (1-maintenance margin) =

 

3000_____

100(1-.30)   = 3000/70 = $42.86

 

If the stock price declines below $42.86, a margin call will be issued.

 

(d) At a price of $58, the account is restricted since the margin will be below the initial margin requirement but above the maintenance margin.

 

Margin at 58 = 5800 – 3000

5800             = 48%

 

Difficulty:       hard

 

 

 

  1. An investor sells 100 shares of stock short at $40.

 

(a)        Ignoring commissions, at what price will the investor earn $700?

(b)        Ignoring commissions, what is the gain or loss if the stock price goes to $53 and the investor closes out the position?

 

Solution:          (a)        When the stock drops 7 points to $33, the investor will earn            $700.

 

(b)        If the stock goes to $53, the loss will be:

 

purchase at $53 x 100 shares              =          $5300

sold short at $40 x 100 shares             =            4000

loss                                                      =          ($1300)

Difficulty:       medium

 

 

 

  1. Joe Edwards purchased 150 shares of XYZ at $100 per share. Currently the stock is selling at $120.  If he wants to be assured of a profit of at least $4050, what type of order should he place and at what price per share?

 

Solution:          Profit per share           =   $4050/150 shares   =   $27

He should place a limit order to sell the shares at a price of $127     (original price of $100 + $27)

Difficulty:       medium

 

 

 

  1. An investor who short sold 120 shares of stock at $150 per share wishes to realize a gross profit of $2400. At what price must the investor cover the short sale?

 

Solution:          Sales Proceeds from short sale           =          $150 x 120      =          $18,000

Gross Profit desired                            =           –  2,400

Purchase Price of 120 shares must be             $15,600

 

He must cover the short sale at a price of $130 ($15,600/120 shares) to have a       $2,500 profit

Difficulty:       hard

 

 

 

 

 

 

File: Ch. 15, Chapter 15: Company Analysis

 

 

 

Multiple Choice Questions

 

 

 

  1.  The last step in top-down fundamental analysis is to analyze:
  2. individual industries
  3. individual companies
  4. individual securities
  5. perform technical analysis

 

Ans: b

Difficulty: easy

Ref:     Company Analysis

 

 

 

  1. Which of the following is not one of the relative valuation multipliers used in fundamental analysis?

 

  1. P/E ratio
  2. P/S ratio
  3. P/M ratio
  4. P/B ratio

 

Ans: c

Difficulty: easy

Ref: Fundamental Analysis

 

 

 

  1. When analyzing stocks, the major variable of interest to a majority of investors is:

 

  1. sales.
  2. profit margins.
  3. dividend yield.
  4. earnings per share.

 

Ans: d

Difficulty: medium

Ref: Fundamental Analysis

 

 

 

  1. EPS are of higher quality if:

 

  1.  the company is a blue chip.
  2. the auditor’s reputation is high.
  3.  they were derived using conservative principles.
  4.  FASB has approved them.

 

Ans: c

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1.  Which of the following are shown on the balance sheet on a lower of cost or market value basis?

 

  1. cash
  2. stockholders’ equity
  3. marketable securities
  4. fixed assets

 

Ans: d

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Which of the following statements regarding retained earnings is not true?

 

  1. It is part of stockholders’ equity.
  2. It represents spendable funds for a company.
  3. It designates that part of previous earnings not paid out as dividends.
  4. It is irrelevant in security valuation..

 

Ans: b

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. The auditor’s report:

 

  1. guarantees accuracy.
  2. guarantees the quality of the earnings.
  3. attests that the statements are a fair presentation of financial position.
  4. all of the above are true

 

Ans: c

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. On a company’s balance sheet, shareholder’s equity is nearly always described by its?

 

  1. Book value
  2. Market value
  3. Current value
  4. Stock value

 

Ans: a

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Fixed assets generally consist of?

 

  1. Cash and marketable securities
  2. Property, plant and equipment, at cost
  3. Intangible assets, like goodwill
  4. Shareholders’ Equity

 

Ans: b

Difficulty: easy

Ref: The Accounting Aspects of Earnings

 

 

 

  1. How is EPS computed? After-tax net income divided by

 

  1. current common shares outstanding.
  2. previous years common shares outstanding.
  3. treasury shares outstanding.
  4. average common shares outstanding.

 

Ans: d

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. The generally accepted accounting principles (GAAP) require that the EPS be calculated using a

 

  1. conservative treatment.
  2. liberal treatment.
  3. standard set of rules developed by the accounting profession.
  4. standard set of rules developed by the SEC.

 

Ans: c

Difficulty: easy

Ref: The Accounting Aspects of Earnings

 

 

 

  1. The key item for investors on the income statement is:

 

  1. sales.
  2. gross profit.
  3. operating expenses.
  4. after-tax net income.

 

Ans: d

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Earnings derived under GAAP and shown on the income statement are known as:

 

  1. reported earnings.
  2. certified earnings.
  3. audited earnings.
  4. verified earnings.

 

Ans: a

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Which of the following is not one of the parts of the cashflow statement?

 

  1. cashflow from operating activities.
  2. cashflow from sales activities.
  3. cashflow from investing activities.
  4. cashflow from financing activities.

 

Ans: b

Difficulty:  medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Which of the following mandated that companies, starting in 2004, must submit an annual report to the SEC outlining the effectiveness of their internal accounting controls?

 

  1. SEC Amendments Act
  2. SIPC
  3. Glass-Stegall Act
  4. Sarbanes-Oxley Act

 

Ans: d

Difficulty: easy

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Which of the following represents the rate at which a company can grow from internal sources?

 

  1. return on assets
  2. sustainable growth rate
  3. adjusted EPS
  4. return on equity

 

Ans: b

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Which statement about the quality of reported EPS is FALSE?

 

  1. Earnings quality assessments are difficult to make and require considerable expertise in accounting and financial analysis.
  2. Reported EPS is not the precise figure that it first appears to be.
  3. It is necessary to make adjustments to reported EPS figures when

making cross-sectional comparisons.

  1. Quality of earnings is generally consistent among companies in the same

industry.

 

Ans:     d

Difficulty: difficult

Ref: The Accounting Aspects of Earnings

 

 

 

  1. One way to calculate EPS is:

 

  1. ROA x Book value per share.
  2. ROE x Book value per share.
  3. ROA/ Book value per share.
  4. ROE/ Book value per share.

 

Ans: b

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. The two components of EPS are

 

  1. ROA and leverage.
  2. book value per share and leverage.
  3. ROE and book value per share.
  4. leverage and profit margin.

 

Ans: c

Difficulty: difficult

Ref: Analyzing a Company’s Profitability

 

 

 

  1. The two components of ROE are

 

  1. ROA and book value per share.
  2. ROA and leverage.
  3. ROA and profit margin.
  4. leverage and book value.

 

Ans: b

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. ROA is the product of

 

  1. net income margin and turnover.
  2. book value and turnover.
  3. leverage and book value.
  4. net income margin and leverage.

 

Ans: a

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. Which of the following statements is true?

 

  1. Turnover is not related to ROA.
  2. Leverage affects EPS.
  3. ROA is a function of turnover and leverage.
  4. EPS is solely a function of ROE

 

Ans: b

Difficulty: difficult

Ref: Analyzing a Company’s Profitability

 

 

 

  1. The sustainable growth rate of a firm can be calculated as the product of the

 

  1. return on assets and the return on equity.
  2. dividend payout ratio and leverage.
  3. retention rate and the return on equity.
  4. net profit margin and total sales.

 

Ans: c

Difficulty: difficult

Ref: Analyzing a Company’s Profitability

 

 

 

  1. If a firm’s ROA and ROE are equal, it can be concluded that the firm is

 

  1. losing money.
  2. liquid enough to pay some extra dividends.
  3. financed by all equity.
  4. financed by a high proportion of debt.

 

Ans: c

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. Which of the following is true regarding earnings estimates?

 

  1. management at most firms will update estimates monthly
  2. analysts typically rely on the estimates provided by management
  3. some firms have chosen not to provide estimates of earnings
  4. most analysts arrive at similar estimates of earnings

 

Ans: c

Difficulty: medium

Ref: Earnings Estimate

 

 

 

  1. Which of the following is true regarding earnings forecasts made by analysts versus forecasts made by statistical models?

 

  1. The evidence tends to support analysts’ forecasts in terms of accuracy over statistical models.
  2. The evidence tends to support statistical models’ forecasts in terms of accuracy over statistical models.
  3. The evidence tends to support both types of forecasts equally.
  4. The evidence does not support either type of forecast in terms of accuracy.

 

Ans: a

Difficulty: difficult

Ref: Earnings Estimate

 

 

 

  1. Which of the following is not true regarding earnings estimates?

 

  1. Some companies provide guidance on forthcoming earnings announcements.
  2. The guidance number plays a major role in the consensus estimate.
  3. The variance of actual reported earnings from the consensus had typically constituted the “whisper” forecast.
  4. All of the above are true.

 

Ans: c

Difficulty: difficult

Ref: Earnings Estimate

 

 

 

  1. If the dividend growth rate increases for a firm, its P/E will ———, other things the same.

 

  1. increase
  2. stay the same
  3. decrease
  4. increase or decrease but not stay the same

 

Ans: a

Difficulty: medium

Ref: The P/E Ratio

 

 

 

  1. How would you explain P/E ratio differences among companies? By investor

 

  1. expectations about the future growth of the market.
  2. estimates of the recent growth of earnings.
  3. expectations about the future growth of earnings.
  4. estimates about the recent growth of dividends.

 

Ans: c

Difficulty: medium

Ref: The P/E Ratio

 

 

 

  1. If business risk decreases for Megabucks, Inc., the P/E will __________, other things the same.

 

  1. increase
  2. stay the same
  3. decrease
  4. increase or decrease but not stay the same

 

Ans: a

Difficulty: difficult

Ref: The P/E Ratio

 

 

 

  1. Other things equal, if the

 

  1. required rate of return increases, the P/E ratio will rise.
  2. risk premium increases, the P/E ratio will rise.
  3. risk-free rate rises, the P/E ratio will fall.
  4. dividend payout increases, the P/E ratio will fall.

 

Ans: c

Difficulty: difficult

Ref: The P/E Ratio

 

 

 

  1. Other things equal,

 

  1. the higher the expected growth rate, the lower the P/E ratio.
  2. if the risk-free rate rises, the required rate will decline.
  3. as the required rate rises, the P/E ratio declines.
  4. if the risk premium rises, the required rate will fall.

 

Ans: c

Difficulty: difficult

Ref: The P/E Ratio

 

 

 

  1. Low P/E stocks are generally associated with

 

  1. mature companies.
  2. cyclical companies.
  3. young fast-growing companies.
  4. defensive companies.

 

Ans: a

Difficulty: medium

Ref: The P/E Ratio

 

 

 

  1. In modern investment analysis, the market risk of a stock is measured byits:

 

  1. beta.
  2. standard deviation.
  3. leverage.
  4. coefficient of variation.

 

Ans: a

Difficulty: medium

Ref: Fundamental Security Analysis in Practice

 

 

 

  1. The investment advisory service best known for evaluating mutual funds in the United States is:

 

  1. Standard & Poor’s
  2. Moody’s Industrial Manuals
  3. Morningstar
  4. Value Line Investment Survey

 

Ans: c

Difficulty: easy

Ref: Fundamental Security Analysis in Practice

 

 

 

  1. _______ use a computer program in an attempt to imitate the brain in analyzing securities.

 

  1. Decision trees
  2. Program trading
  3. Day traders
  4. Neural networks

 

Ans: d

Difficulty: medium

Ref: Fundamental Security Analysis in Practice

 

 

 

  1. The balance sheet shows:

 

  1. the portfolio of assets for a corporation, as well as its liabilities, over an accounting period.
  2. the portfolio of assets for a corporation, as well as its labilities, over an accounting period.
  3. the portfolio of assets for a corporation, as well as its liabilities and owner’s equity, over an accounting period.
  4. the portfolio of assets for a corporation, as well as its liabilities and owner’s equity, at a moment in time.

 

Ans: c

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. The income statement is more frequently used than the balance sheet by investors to:

 

  1. assess current management performance over an accounting period.
  2. as a guide to company future profitability at a moment in time.
  3. assess current management performance and as a guide to company future profitability at a moment in time.
  4. assess current management performance and as a guide to company future profitability over an accounting period.

 

Ans: d

Ref: The Accounting Aspects of Earnings

 

  1. The cash flow statement consists of the following parts:

 

  1. cash holdings from revenue, operations, investing, and financing activities.
  2. cash flows from revenue, operations, investing, and financing activities.
  3. cash holdings from operations, investing, and financing activities.
  4. cash flows from operations, investing, and financing activities.

 

Ans: d

Ref: The Accounting Aspects of Earnings

 

 

 

True/False Questions

 

 

 

  1. It is necessary to determine a point estimate of the intrinsic value of a stock when using relative valuation techniques.

 

Ans: F

Difficulty: medium

Fundamental Analysis

 

 

 

  1. Since extraordinary items affecting earnings are typically non-recurring, investors should disregard their impact on earnings when evaluating the stock.

 

Ans: F

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. The auditor’s report guarantees the accuracy of the earnings reported in the financial statements.

 

Ans: F

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. To estimate the intrinsic value of a company, investors could use the dividend discount model to estimate intrinsic value, or an earnings multiplier model based on a forecast of next year’s EPS and what is thought to be an appropriate P/E ratio.

 

Ans: T

Difficulty: medium

Ref: Fundamental Analysis

 

 

 

  1. EBITDA, sometimes called operating profit, is often emphasized by telecommunications companies because of their lack of real profitability.

 

Ans: T

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. International Financial Reporting Standards (IFRS) are now used by most countries.

 

Ans: T

Difficulty: medium

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Free cash flow represents money left after all the bills are paid and dividend payments are made.

 

Ans: T

Difficulty: easy

Ref: The Accounting Aspects of Earnings

 

 

 

  1. Leverage can magnify returns to the stockholders but also increase potential losses to the stockholders.

 

Ans: T

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. A company may maintain its ROA if the net income margin decreases by increasing its asset turnover.

 

Ans: T

Difficulty: medium

Ref: Analyzing a Company’s Profitability

 

 

 

  1. Investors interested in buying stocks that report bad news and suffer a sharp decline should buy the first day bad news is reported.

 

Ans: F

Difficulty: difficult

Ref: Earnings Estimates

 

 

 

  1. Some companies, for example Apple, tend to provide low guidance, contributing toward consistently positive earnings surprises.

 

Ans: T

Difficulty: easy

Ref: Earnings Estimates

 

 

 

  1. A positive earnings surprise occurs when the forecasted earnings are greater than the actual earnings of a company.

 

Ans: F

Difficulty: easy

Ref: Earnings Estimates

 

 

 

  1. The P/E ratio can be expected to change as the expected dividend payout ratio changes.

 

Ans: T

Difficulty: medium

Ref: The P/E Ratio

 

 

 

  1. Other things being equal, as k rises, the P/E ratio will also rise.

 

Ans: F

Difficulty: medium

Ref: The P/E Ratio

 

 

 

  1. According to Peter Lynch, the P/E ratio of a company that is fairly valued will equal its expected growth rate.

 

Ans: T

Difficulty: medium

Ref: The P/E Ratio

 

 

 

 

  1. Regardless of how closely a company adheres to good accounting practices and auditors do their job, investors need to examine “Notes to the Financial Statements” on 10-K and 10-Q Reports to understand the company’s financial situation.

 

Ans: T

Difficulty: easy

Ref: The Accounting Aspects of Earnings

 

 

 

Short-Answer Questions

 

 

 

  1. What is the relationship of the Financial Accounting Standards Board and the Securities and Exchange Commission?

 

Answer:           The FASB and the SEC are separate organizations.  The FASB is a self-                             regulatory body of the accounting profession that sets accounting                                        standards.  The SEC is part of the federal government that requires                                           companies to disclose financial data presented under FASB’s standards.

Difficulty:       Medium

Ref:                 The Accounting Aspects of Earnings

 

 

 

  1. When an investor buys a share of common stock he/she buys a claim of ownership. How is this claim represented on the balance sheet?

 

Answer:           The claim is represented by the entire common equity section.  The three                           most common accounts are common stock, capital paid in            excess of par,                          and retained earnings.  The book value of equity is calculated from the                            entire common equity section.

Difficulty:       Medium

Ref:                 Analyzing A Company’s Profitability

 

 

 

  1. What is the internal (sustainable) growth rate? How is it calculated?

 

Answer:           The internal growth rate is the growth rate depending on earnings                                       retention as the only source of new capital.  It is calculated as g =   br = (1                         – payout rate)(ROE).

Difficulty:       Medium

Ref:                 Analyzing A Company’s Profitability

 

 

 

  1. How accurate are professional earnings estimates? Do purely mechanical models give better results than analysts who add subjective assessment to the data?

 

Answer:           According to a study by Dreman and Berry, the average annual error in                              earnings estimates was 44 percent during the period             studied (1974-1990).                           Only 25 percent of the consensus estimates came within plus or minus 5                         percent of reported earnings.  Analysts consistently beat purely                                       mechanical models.  Subjective assessment of the future is required.

Difficulty:       Difficult

Ref:                 Earnings Estimates

 

 

 

  1. What are “earnings surprises?” How do they affect stock prices?

 

Answer:           Any new information that affects projected earnings creates an earnings                             surprise.  The SUE model formalizes the surprise factor.  Stock prices                                react up or down to the surprise.

Difficulty:       medium

Ref:                 Earnings Estimates

 

 

 

  1. Can an investor that wants to use the approach of projected earnings and P/Es find help in Value Line?

 

Answer:           Yes.  In fact Value Line projects EPS, dividends, dividend payout,

growth rates and prices.

Difficulty:       Easy

Ref:                 The P/E Ratio

 

 

 

  1. What three variables affect the P/E ratio? How does each affect it?

 

Answer:           Using the model P/E  =  (D1/E1)/(k – g), the variables are the dividend payout rate, D1/E1, the required rate of return, k, and the dividend growth rate, g.  If the dividend payout rate increases (decreases), the P/E increases (decreases), other things the same.  If the required rate of return increases (decreases), the P/E decreases (increases).  If the growth rate increases (decreases), the P/E increases (decreases).

Difficulty:       medium

Ref:                 The P/E Ratio

 

 

 

  1. Should an investor seek companies with low P/Es or high P/Es?

 

Answer:           Investors differ in their philosophies.  Investors who seek low P/E companies are “value” investors.  They think that the stocks are undervalued and will eventually gain full valuation.  On the other hand, “growth” investors seek high P/E stocks as ones with high growth prospects.

Difficulty:       Medium

Ref:                 The P/E Ratio

 

 

 

  1. How could unexpected inflation affect the P/E ratio?

 

Answer:           Unexpected inflation would increase the risk-free rate of return, RF, which would increase the required return, k, on stocks.  This would reduce P/E ratios.

Difficulty:       Medium

Ref:                 The P/E Ratio

 

 

 

Critical Thinking/Essay Questions

 

 

 

  1. What is meant by “quality of earnings,” and how does it affect the equity analyst’s job?

 

Answer:           Quality of earnings generally has to do with the accounting standards applied.  Generally speaking, conservative standards result in a higher quality of earnings than liberal standards.  Conservative methods often produce higher expenses and lower EPS.  An analyst has a hard time comparing the earnings of companies prepared under differing methods.  An analyst might be willing to apply a higher P/E to higher quality earnings in projecting a future stock price.

Difficulty:       Difficult

Ref:                 The P/E Ratio

 

 

 

  1. In the model P/E =  (D1/E1)/(k – g), the P/E should increase if the dividend payout rate increases, other things the same.  If the payout rate was intentionally increased by the board of directors, other things are likely not to stay the same.  What is likely to happen to the dividend growth rate and the required return?

 

Answer:           If more earnings are paid out, then there is less to retain.  If there is less earnings retention, then there is a relatively smaller equity base to support earning assets.  This would reduce growth.  The effect of a higher payout on the required return is the center of considerable controversy, but one scenario would suggest less risk and slower grow growth, and a reduced required return.

Difficulty:       Medium

Ref:                 The P/E Ratio

 

 

 

Problems

 

 

 

  1. Don Jorge Shipping Inc. has net income of $40 million, total assets of $300 million, and sales of $800 million. Its equity is $190 million.

 

(a)        Calculate ROA.

(b)        Calculate ROE.

(c)        If the book value per share is $7.00, what is EPS?

 

Solution:          (a)        ROA    =          net income margin x turnover

=          40/800 x 800/300

=          0.05 x 2.67

=          0.1335 or 13.35 percent

 

(b)                    ROE    =          ROA x Leverage

=          0.1335 x 1.579

=          0.2101 or 21.01 percent

 

(c)                    EPS     =          ROE x book value per share

=          $7.00 x .2101

=          $1.47

Difficulty:       medium

 

 

 

  1. Internet Industries expects to earn $5.00 for the coming year, and pay a $2.00 dividend. Its ROA is 13 percent, while its leverage factor is 1.7.

 

(a)        Calculate the expected growth rate in dividends.

(b)       Given a required rate of return of 17 percent, determine the estimated price for      High Tech, Inc., common stock.

(c)        Calculate the expected dollar dividend two periods from now.

 

Solution:          (a)        g          =          br

b          =          1 – payout ratio                        =          1 – .4    =          .6

ROE    =          ROA x Leverage                     =          .13 x 1.7          =          .221

g         =          .6 x .221                                  =          .1326 or 13.26 percent

 

(b)        P0         =          D1/(k – g)

=          2.00/(0.17 – .1326)      =          $53.48

 

(c)        D2       =          D1(1 + g)

=          $2.00 (1.1326)             =          $2.265

Difficulty:       Medium

 

 

 

  1. The risk-free rate of return is 10 percent, and the expected return for the stock market is 16 percent. Evergreen Industries has a beta of 1.1, and investors expect dividends and earnings to grow at an 8 percent rate per year.  The current dividend is $1.20, and the payout ratio is 50 percent.

 

(a)        Calculate the P/E ratio for Evergreen Industries.

(b)        Estimate the price of the stock for the next year using the multiplier model.

 

Solution:          (a)        k          =          RF + B(RM – RF)

=          .10 + 1.1(.16 – .10)                  =          0.166

 

P/E      =          (D1/E1)/(k – g)

=          ($1.30/$2.59)/(0.166 – .08)                 =          5.81

 

(b)        P1         =          P/E x E1

=          5.81 x $2.59                            =          $15.05

Difficulty:       Medium

 

 

 

  1. Calculate the required rate of return on DCM Corporation’s stock if its current price is $35 per share, next year’s expected dividend is $2.00 per share, its return on equity is 12 percent, and its dividend payout ratio is 55 percent.

 

Solution:          g          = retention rate x ROE= (1 – dividend payout ratio) x ROE

= (1 – 0.55) x 12          =          .45 x 12           =          .054

 

P0         =          D1/(k – g)  or

k          =          D1/P0  +  g

=          2/35  +  .054                =          0.1111 or 11.11 percent

Difficulty:       Medium

 

 

 

  1. A company has sales of $220 million. These are expected to increase by 15 percent next year and 12 percent in the year after that.  Over each of the next two years, the company expects to have a net profit margin of 8 percent, a payout ratio of 60 percent, and a constant 3 million shares of common stock outstanding.  If the stock is expected to trade at a P/E ratio of 14 at the end of the second year and if the investor requires a 14 percent rate of return, what should the justified price of the stock be today?

 

Solution:

Current                        Year 1             Year 2

Growth rate                 + 15 %             + 12%

Sales                            $253m             $283.36m

Net Profit (8% of sales)$20.24m        $22.67m

Number of shares out  3m                   3m

EPS                             $6.75               $7.56

DPS (60% of EPS)      $4.05               $4.54

 

Stock price in year 2   =          EPS in year 2 x P/E at end of year 2

P2           =          7.56 x 14

=          $105.84

 

Stock price today        =          Present value of D1 + Present value of D2 + Present value of P2

P0        =          [$4.05/(1.14)] + [4.54/(1.14)2] + [105.84/(1.14)2]

=          $3.55 + $3.49 + $81.44

=          $88.48

Difficulty:       Difficult

 

 

 

  1. Upon analyzing the financial statements of Jain Industries, you discover that it is currently retaining 60 percent of its earnings (which were $6 this past year), and is experiencing a ROE of almost 20 percent. Assuming a risk-free rate of 4 percent and a risk-premium of 8 percent, how much would you be willing to pay for Jain Industries stock on the basis of the P/E ratio approach?

 

Solution:          k = RF + RP= 6 + 8    = 14 %

g = retention rate x ROE = 0.6 x 20 = 12 %

D1/E1 = (1 – retention rate) = (1 – 0.6) = 0.4

P/E = (D1/E1)/(k – g)   = 0.4/(0.14 – 0.12) = 20

EPS1 = EPS0(1 + g) =  6(1 + 0.12) = $6.72

Intrinsic value = Justified P/E x Expected EPS = (20)(6.72) =          $134.40

Difficulty:       Difficult

 

 

 

  1. Given the following for Mighty Manufacturing Company:

 

Operating efficiency   =          0.1

Net income                  =          $50,000,000

Net income margin     =          0.05

Total asset turnover    =          3

Leverage                     =          1.5

Retention rate              =          0.3

 

(a)        Calculate ROA.

(b)        Calculate ROE.

(c)        Find the growth rate of dividends.

 

Solution:                      The letter m is used to denote millions.

 

(a)        Net income margin      =          Net income/Sales

0.05     =          $50m/sales

Sales    =          $1,000m

 

Total asset turnover    =          Sales/Total assets

3          =          $1,000m/TA

TA       =          $333.333m

 

ROA   =          Net income/Total assets

=          $50m/$333.333m

=          0.15 or 15 percent

 

(b)                    Leverage         =          Total assets/Equity

1.5       =          $333.333m/Equity

Equity             =          $222.222m

 

ROE    =          Net income/Equity

=          $50m/$222.222m

=          0.225 or 22.5 percent

 

(c)                                g          =          br

=          Retention rate x ROE

=          0.3(0.225)

=          0.0675 or 6.75 percent

Difficulty:       Medium

 

 

 

  1. Find the P/E ratio of a stock with a ROE of 15 percent, a book value per share of $5.00, and a current stock price of $30.00.

 

Solution:          EPS     =          ROE(Book value)

=          0.15($5)           =          $0.75 per share

 

P/E      =          $30/$0.75        =          $22.50

Difficulty:       Medium

 

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