Gitman Chapter4

Chapter 4 Return and Risk
Fundamentals of Investing, Gitman/Joehnk, 10e
4.1 Learning Goal 1

1)
The past performance of an investment provides a basis for future expected returns but does not
guarantee future results.
Answer:
True
False
Question Status: Previous Edition
Topic: Learning Goal 4.1
2)
The amount an investor is willing to pay for an investment should be determined by the past
performance of the investment.
Answer:
True
False
3)
Internal factors such as the quality of management and the level of corporate debt affect the rate of return
on an individual stock.
Answer:
True
False
1
4)
In response to the same external force, the return on one investment may increase while the return on
another investment may decrease.
Answer:
True
False
5)
In the short term, stock prices tend to decline as inflation rises.

Answer:
True
False
Question Status: Revised
6)
Which one of the following statements is correct?

A)
A capital loss is computed as the reduction in the value of an investment minus the income received from
that investment.
B)
The total return from an investment is equal to the capital gain minus the current income.
C)
A capital gain is equal to the amount paid for an investment minus the proceeds received from the sale of
that investment.
D)
Current income is cash or near-cash that is periodically received as a result of owning an investment.
Answer:
2
D
3
7)
Peg bought a stock at a price of $23. She received a $1.50 dividend and sold the stock for $25. What is
Peg's capital gain on this investment?
A)
$0.50
B)
$1.50
C)
$2.00
D)
$3.50
Answer:
C
8)
Robin purchased a stock at a price of $18 a share. She received quarterly dividends of $0.50 per share.
After one year, Robin sold the stock at a price of $19.50 a share. What is her percentage total return on this
investment?
A)
10.3%
B)
11.1%
C)
17.9%
D)
19.4%
Answer:
4
D
9)
Inflation tends to have a favorable impact on

A)
real estate.
B)
common stock.
C)
preferred stock.
D)
bonds.
Answer:
A
10)
Which one of the following is an internal characteristic that can affect the value of an investment?
A)
Federal Reserve actions

B)
inflation
C)
war
D)
use of debt financing

Answer:
5
D
11)
Over the long term, which one of the following has historically had the highest average annual rate of
return?
A)
small-company stocks
B)
long-term government bonds

C)
large-company stocks
D)
long-term corporate bonds

Answer:
A
4.2 Learning Goal 2

1)
The financial concept of time value of money is dependent upon the opportunity to earn interest over
time.
Answer:
True
False
2)
Compound interest is interest paid not only on the initial investment but also on any interest
accumulated in prior periods.
6
Answer:
True
False
3)
For a given stated rate of interest, annual compounding results in a higher true rate of interest than daily
compounding.
Answer:
True
False
4)
An ordinary annuity is defined as an annuity for which the cash flows occur at the beginning of each year
or payment period.
Answer:
True
False
5)
The present value is equal to the future value multiplied by the quantity of 1 plus the discount rate.
Answer:
True
7
False
6)
Ignoring risk, a satisfactory investment is one for which the present value of benefits is less than the
present value of costs.
Answer:
True
False
7)
The adage "the sooner one receives a return on a given investment, the better," reflects the financial
concept known as the
A)
time value of money.

B)
total return concept.

C)
historical dividend theory.

D)
expected yield factor.

Answer:
A
8
8)
Gavin invests $1,000 in a savings account for two years. The account pays 2% interest compounded
annually. How much interest income will Gavin earn on this investment?
A)
$20.00
B)
$20.40
C)
$40.00
D)
$40.40
Answer:
D
9)
Which one of the following statements concerning interest is correct?

A)
A five-year investment paying 6% simple interest will provide a higher total return than a comparable
investment paying 6% compound interest.
B)
A $100 investment paying 5% interest compounded annually will have a total value of $115 at the end of
three years.
C)
The less frequently interest is compounded, the higher the true rate of interest.
D)
An investment paying 7% compounded quarterly will have a larger value at the end of one year than a
comparable investment paying 7% compounded annually.
Answer:
9
D
10)
The stated rate of interest is equal to the true rate of interest only when
A)
the simple interest method is used.

B)
interest is compounded continuously.

C)
interest is computed semi-annually.

D)
interest is computed monthly.

Answer:
A
11)
Which one of the following statements is correct concerning the time value of money?
A)
The future value of $1 at the end of a year is equal to $1 times 1 plus the annual interest rate.
B)
As the interest rate increases for any given year, the future value interest factor will decrease.
C)
The future value of $1 decreases with the passage of time.

D)
The future value interest factor is equal to zero if the interest rate is zero.
Answer:
10
A
12)
Which one of the following is an example of an annuity?

A)
the receipt of $50 in January, March, April, June, August, September and December
B)
the payment of $259 a month for three consecutive years

C)
the payment of $389 in January, $200 in February, and $200 in March

D)
the receipt of $100 a month for three months and then $150 a month for two months
Answer:
B
13)
Ted invests $400 today at a 7% rate of return which is compounded annually. What is the future value of
this investment after five years?
A)
$428
B)
$500
C)
$540
D)
$561
Answer:
11
D
14)
The maximum rate of return that can be earned for a given rate of interest occurs when interest is
compounded
A)
annually.
B)
daily.
C)
monthly.
D)
continuously.
Answer:
D
15)
If you invest $2,000 at the end of each year for five years and you earn 7% interest compounded annually,
how much will you have accumulated at the end of the fifth year?
A)
$10,700
B)
$11,501
C)
$12,307
D)
$14,026
Answer:
12
B
16)
Roy is going to receive a payment of $5,000 one year from today. He earns an average of 6% on his
investments. What is the present value of this payment?
A)
$4,717
B)
$4,821
C)
$5,000
D)
$5,300
Answer:
A
13
17)
Which of the following statements are correct concerning present value?

I. The present value interest factor for a single sum is always equal to or less than 1.
II. The lower the discount rate for a given year, the smaller the present value interest factor.
III. The further in time, the smaller the present value interest factor.
IV. The present value is equal to the future value only when the stated interest rate is 1%.
A)
I and II only
B)
I and III only

C)
II and III only

D)
I, III and IV only

Answer:
B
18)
An ordinary annuity has cash flows that occur at the ________ of each time period and are ________ in
amount.
A)
beginning; constant
B)
beginning; variable
C)
end; constant
D)
end; variable
Answer:
14
C
19)
When calculating the present value of either a future single sum or a future annuity, the applicable
interest rate is usually called the
A)
yield to maturity.
B)
compound interest rate.

C)
internal rate of return.

D)
discount rate.
Answer:
D
20)
When the cost of an investment exceeds the present value of its benefits, the investor would be earning a
rate of return
A)
greater than the discount rate.

B)
equal to the discount rate.

C)
equal to the compounded rate.

D)
less than the discount rate.

Answer:
15
D
16
21)
Assume that $100 is deposited at the end of each year for five years at 10% compound interest and that no
withdrawals are made over the five-year period. Based on this data, which one of the following
statements is correct?
A)
The future value will be $550.

B)
The present value can be determined by computing the present value of $500 in five years at 10%.
C)
The present value can be determined by computing the present value of a $100 ordinary annuity for five
years at 10%.
D)
The present value will be $500.

Answer:
C
22)
If the present value of an investment's benefits equals the present value of the investment's costs, then the
investor would earn a
A)
return equal to the discount rate.

B)
negative rate of return.

C)
0% rate of return.
D)
return greater than the discount rate.

Answer:
17
A
23)
An investment will produce an annual cash flow of $4,000 for three years. The investor requires a 12%
rate of return compounded annually. What is the maximum amount that the investor can pay and still
earn the required rate of return?
A)
$9,607
B)
$10,218
C)
$10,714
D)
$12,000
Answer:
A
24)
An investment will produce an annual cash flow of $4,000 for three years. The investor requires a 12%
rate of return compounded annually. What is the maximum amount that the investor can pay and still
earn the required rate of return?
Answer:
$9,607=$4,000(2.4018)
4.3 Learning Goal 3

1)
The return that fully compensates for the risk of an investment is called the risk-free rate of return.
Answer:
18
True
False
19
2)
The required return on an investment includes a real rate of return, an inflation premium and an interest
premium.
Answer:
True
False
3)
The holding period return is an excellent method for comparing a short-term investment to a long-term
investment.
Answer:
True
False
4)
The holding period return considers the time value of money.

Answer:
True
False
5)
The holding period return should NOT be used when analyzing long-term investments.
Answer:
20
True
False
6)
Historically, the real rate of return in the United States has tended to be
A)
0%.
B)
between 0.5 and 2%.

C)
between 2 and 3%.

D)
close to 4%.
Answer:
B
7)
In investment theory, the rate of return that could be earned in an inflation-free, perfect world where all
outcomes are known and certain is known as the
A)
absolute return.
B)
required rate of return.

C)
real rate of return.

D)
21
expected rate of return.
Answer:
C
8)
The risk-free rate is equal to the real rate of return plus

A)
an expected inflation premium.

B)
a risk premium.
C)
both an inflation and a risk premium.

D)
the prevailing prime rate.

Answer:
A
22
9)
The markets in general are paying a 2% real rate of return. Inflation is expected to be 3%. ABC stock
commands a 6% risk premium. What is the risk-free rate of return?
A)
2%
B)
5%
C)
8%
D)
11%
Answer:
B
10)
The required rate of return on the Daisy Corporation's common stock is 11%, the current real rate of
return in the market is 1%, and the market's risk-free rate of return is 4%. In this case, the risk premium
associated with Daisy's stock is
A)
5%.
B)
6%.
C)
7%.
D)
8%.
Answer:
23
C
11)
Which one of the following statements concerning required rates of return is correct?
A)
The higher the real rate of return, the lower the inflation rate.
B)
The higher the risk premium, the greater the required rate of return.
C)
The lower the inflation rate, the higher the required rate of return.
D)
The lower the real rate of return, the greater the risk premium.
Answer:
B
12)
The required return on Alpha stock is 9%. The risk-free rate of return is 4% and the real rate of return is
2%. How much are investors requiring as compensation for both the issue- and the issuer-related risk?
A)
3%
B)
4%
C)
5%
D)
7%
Answer:
24
C
25
13)
Which of the following is(are) issue characteristics of an investment?

I. type of investment vehicle
II. voting privileges
III. financial condition of the issuer
IV. time to maturity
A)
I and II only
B)
III only
C)
I, II and IV only
D)
I, II, III and IV

Answer:
C
14)
A holding period return is calculated by adding the current income to the capital gains and dividing this
sum by the
A)
average investment value.

B)
beginning investment value.

C)
total income received.

D)
selling price of the investment.

Answer:
26
B
15)
Ann purchased a stock for $28 a share and sold it six months later for $31. While she owned the stock,
Ann received quarterly dividends of $0.60 per share. Ann's holding period return on this stock is
A)
13.5%.
B)
15.0%.
C)
17.4%.
D)
19.3%.
Answer:
B
16)
Jake purchased 100 shares of ABC stock at $42.50 per share. After seven months, he sold all of his shares
at a price of $39.75 a share. Jake received a total of $1.10 per share in dividends during the time he owned
the shares. Jake's holding period return is
A)
-3.9%.
B)
-2.8%.
C)
4.2%.
D)
9.1%.
27
Answer:
A
28
17)
The holding period return (HPR) can appropriately be used to

A)
compute the yield on investments with three- to five-year time frames.

B)
compare returns among investments that are held for one year or less.
C)
isolate realized capital gains.

D)
determine the required reinvestment rate for long-term investments.

Answer:
B
18)
Briefly explain the holding period return (HPR) and give several characteristics of this measure.
Answer:
HPR is the total return earned from holding an investment for a specified period of time.
HPR =
(a) HPR takes into account both current income and capital gains.
(b) HPR should be used for holding periods of one year or less.
(c) HPR does not take into account the time value of money.
(d) HPR offers a relative comparison of investments of different sizes.
(e) HPR indicates the return per invested dollar.
(f) HPR can have a positive, a zero, or a negative value.
4.4 Learning Goal 4

1)
The yield on an investment is the discount rate that produces a present value of benefits equal to the cost
of the investment.
Answer:
29
True
False
2)
The yield is the rate of return that causes a project to have a zero net present value.
Answer:
True
False
3)
The yield assumes you earn the yield rate of return on all income received during the holding period.
Answer:
True
False
4)
The internal rate of return is the discount rate that equates the present value of benefits to the cost of the
investment.
Answer:
True
False
30
31
5)
If you own an investment providing periodic returns, your actual yield on the investment will depend on
the reinvestment rate you are able to obtain.
Answer:
True
False
6)
To determine the compounded annual rate of return on investments held for more than a year, investors
typically use the present-value-based measure known as yield or
A)
holding period return.

B)
internal rate of return.

C)
inflation-adjusted return.
D)
simple return.
Answer:
B
7)
Six years ago, Leo invested $2,000. Today his investment is worth $3,234. The yield on this investment is
A)
1.4%.
B)
32
4.2%.
C)
8.3%.
D)
9.7%.
Answer:
C
8)
Izzie bought a stock for $34 a share two years ago. The stock does not pay any dividends. Today Izzie
sold the stock for $37 a share. What is the internal rate of return on this investment?
A)
4.3%
B)
6.2%
C)
7.1%
D)
8.8%
Answer:
A
9)
An investment costs $3,500 today. This investment is expected to produce annual cash flows of $1,200,
$1,400, $1,300 and $1,100, respectively, over the next four years. What is the internal rate of return on this
investment?
A)
33
8.1%
B)
12.4%
C)
14.6%
D)
16.2%
Answer:
D
34
10)
An investment costs $5,200 today. This investment is expected to produce annual cash flows of $2,100,
$1,300, $1,800 and $1,200, respectively, over the next four years. What is the internal rate of return on this
investment?
A)
8.2%
B)
9.6%
C)
10.3%
D)
10.7%
Answer:
B
11)
The Sorka Corp. has paid annual dividends of $0.60, $0.63, $0.65, $0.68 and $0.72, respectively, over the
past five years. What is the dividend growth rate?
A)
4.7%
B)
5.2%
C)
5.4%
D)
5.9%
Answer:
35
A
12)
Terry bought a stock one year ago for $33 a share. He received a total of $1.00 in dividends. Today he sold
the stock for $35 a share. Which one of the following statements is correct concerning this investment?
A)
Terry has current income of $3.00.

B)
Terry has a capital gain of $1.00.

C)
Terry has a total return of 9.1%.

D)
Terry has unrealized income of $2 a share.

Answer:
C
36
13)
Explain the relationship between net present value and the internal rate of return.
Answer:
The net present value measures investment results in dollars (or other currency). The IRR is a percentage
rate. The IRR is the discount rate that produces a zero net present value.
4.5 Learning Goal 5

1)
Risk is the possibility that the actual rate of return will vary from the expected rate of return.
Answer:
True
False
2)
Higher risk investments are associated with lower expected rates of return.
Answer:
True
False
3)
Business risk is the risk associated with the amount of debt financing used by a firm.
Answer:
True
37
False
4)
The possibility that deflation could affect the rate of return on an investment is referred to as interest rate
risk.
Answer:
True
False
5)
Investors who favor risk free and low risk investments may still be subject to purchasing power risk.
Answer:
True
False
Question Status: New
6)
Liquidity risk is defined as the risk of

A)
having to trade a security in a broad market.

B)
not being able to sell an investment conveniently and at a reasonable price.

C)
having inflation erode the purchasing power of your investment.

D)
38
having declining price levels affect the reinvestment rate of your current income stream.
Answer:
B
39
7)
The risk associated with a sudden and unforeseen happening that has a significant and usually
immediate effect on a firm's financial condition is called
A)
market risk.
B)
speculation.
C)
event risk.
D)
business risk.
Answer:
C
8)
The risk that the rate of return on an investment will be less than expected due to factors that are
independent of the investment, such as political, social or economic events, is called
A)
business risk.
B)
financial risk.
C)
market risk.
D)
liquidity risk.
Answer:
40
9)
Which one of the following will tend to decrease the rate of return on an investment?
A)
elimination of a tax exemption relevant to the investment

B)
reduction in tax rates

C)
stabilization of inflation rates at a reasonably low level

D)
increased assurance of reinvestment rates at the desired rate of return

Answer:
A
10)
Which of the following factors will increase the risk level of an investment?
I. a firm's decision to use a high percentage of debt financing
II. an economic situation in which consumer prices are rising at a rapid rate
III. the ability to trade the investment in a broad market rather than in a thin market
IV. unstable currency values
A)
I and II only
B)
I, II and IV only
C)
II and IV only
D)
I, III and IV only

41
Answer:
B
42
11)
Identify and discuss five sources of risk.

Answer:
Students can select five from the following risk sources.

4.6 Learning Goal 6

1)
The coefficient of variation is computed by dividing the standard deviation of an asset by the asset's
average rate of return.
Answer:
True
False
2)
The coefficient of variation is used to compare assets with varying rates of return.
Answer:
43
True
False
3)
The risk of an asset can be measured statistically on an absolute basis by the coefficient of variation and
on a relative basis by the standard deviation.
Answer:
True
False
4)
Most investors are risk-seeking.

Answer:
True
False
44
5)
Each of the following investments produces the same rate of return. Which one has the greatest amount
of risk?
A)
investment A with a standard deviation of 4%

B)
investment B with a standard deviation of 12%

C)
investment C with a standard deviation of 8%

D)
investment D with a standard deviation of 19%

Answer:
D
6)
An investment produced annual rates of return of 5%, 12%, 8% and 11% respectively over the past four
years. What is the standard deviation of these returns?
A)
2.7%
B)
3.2%
C)
3.6%
D)
3.8%
Answer:
45
7)
An investment produced annual rates of return of 4%, 8%, 14% and 6%, respectively, over the past four
years. What is the standard deviation of these returns?
A)
3.7%
B)
4.1%
C)
4.3%
D)
4.6%
Answer:
C
8)
Which of the following statements about the coefficient of variation (CV) are correct?
I. The CV is a measure of relative dispersion.
II. The CV is useful in comparing the risk of assets with differing average or expected returns.
III. The CV is calculated by dividing the standard deviation by the average or expected return.
IV. The higher the CV of an investment, the lower its risk.
A)
I and IV only
B)
II and III only

C)
I, III and IV only

D)
46
I, II and III only
Answer:
D
47
9)
The expected rate of return and standard deviations, respectively for four stocks are given below:
ABC 9%, 3%
CDE 11%, 9%
FGH 12%, 8%
IJK 14%, 10%
Which stock is clearly least desirable?
A)
ABC
B)
CDE
C)
FGH
D)
IJK
Answer:
B
Question Status: New
10)
Most investors are risk-averse, which means they

A)
refuse to accept any financial risk.

B)
invest only in government insured securities.

C)
require an increase in return for any increase in risk.

D)
gain satisfaction from the excitement of risk.

Answer:
48
C
11)
Which of the following should be considered when deciding among alternative investments?
I. time value of money
II. risks associated with each investment
III. risk free rate of return
IV. personal risk tolerance level
A)
I and II only
B)
III and IV only

C)
I, II and IV only
D)
I, II, III and IV

Answer:
C
12)
Explain the relationship between risk, the expected rate of return and the actual rate of return.
Answer:
The higher the risk, real or perceived, of an investment the higher the expected rate of return. The higher
the actual risk of an investment, the greater the probability that the actual rate of return will vary
significantly from the expected rate of return.
49

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Chapter 4 Return and Risk

Fundamentals of Investing, Gitman/Joehnk, 10e

4.1 Learning Goal 1

In the short term, stock prices tend to decline as inflation rises.

Which one of the following statements is correct?

Inflation tends to have a favorable impact on

Federal Reserve actions

use of debt financing

long-term government bonds

long-term corporate bonds

4.2 Learning Goal 2

time value of money.

total return concept.

historical dividend theory.

expected yield factor.

Which one of the following statements concerning interest is correct?

the simple interest method is used.

interest is compounded continuously.

interest is computed semi-annually.

interest is computed monthly.

The future value of $1 decreases with the passage of time.

Which one of the following is an example of an annuity?

the payment of $259 a month for three consecutive years

the payment of $389 in January, $200 in February, and $200 in March

Which of the following statements are correct concerning present value?

I and III only

II and III only

I, III and IV only

compound interest rate.

internal rate of return.

greater than the discount rate.

equal to the discount rate.

equal to the compounded rate.

less than the discount rate.

The future value will be $550.

The present value will be $500.

return equal to the discount rate.

negative rate of return.

return greater than the discount rate.

4.3 Learning Goal 3

The holding period return considers the time value of money.

between 0.5 and 2%.

between 2 and 3%.

required rate of return.

real rate of return.

The risk-free rate is equal to the real rate of return plus

an expected inflation premium.

both an inflation and a risk premium.

the prevailing prime rate.

Which of the following is(are) issue characteristics of an investment?

I, II, III and IV

average investment value.

beginning investment value.

total income received.

selling price of the investment.

The holding period return (HPR) can appropriately be used to

compute the yield on investments with three- to five-year time frames.

isolate realized capital gains.

determine the required reinvestment rate for long-term investments.

4.4 Learning Goal 4

holding period return.

internal rate of return.

Terry has current income of $3.00.