Fabozzi Frank, Peterson Pamela. Financial Management and Analysis Workbook

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70 QUESTIONS AND PROBLEMS

3. What are the differences among the average annual return,

the arithmetic average annual return, and the geometric

average annual return? Which one is preferred and why?

PROBLEMS

Refer to Chapter 8, pages 195–208 in Financial Manage-

ment and Analysis.

1. Numerically illustrate the answer to short answer 1 from

the section above, using the following information. Sup-

pose Karen wants to make an investment today that will

have a future value of $500 one year from today. If she

has the choice of a 5% discount rate or a 6% discount

rate, which investment should she choose?

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Principles of Asset Valuation and Investment Returns 71

2. A particular investment will pay $1,500 every year, for-

ever. How much is this investment worth to an investor

whose required rate of return is 10% for investments of

similar risk?

3. Calculate the average annual return for a $3,000 invest-

ment with an ending price of $5,500 four years later, with

no intermediate cash flows.

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72 QUESTIONS AND PROBLEMS

4. Consider an investment with the following cash flows:

a. What is the annual return on the investment if an inves-

tor invests $100,000 at the end of 2002?

b. What is the most the investor would invest so that the

return on the investment is at least 10%?

Year Cash Flows

2003 $20,000

2004 $40,000

2005 $25,000

2006 $35,000

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Principles of Asset Valuation and Investment Returns 73

3. Suppose $25,000 is invested and it provides a return of

8% in the first year, 12% in the second year, and 15% in

the third year. The value of the investment is maintained

in the investment and it grows each year (i.e., the invest-

ment has no cash flows).

a. What is the investment worth at the end of the third

year?

b. What is the average annual return on this investment?

Ch8 Page 73 Tuesday, December 16, 2003 9:08 AM

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CHAPTER

Valuation of Securities and

Options

FILL IN THE BLANKS

Refer to Chapter 9, pages 211–251 in Financial Manage-

ment and Analysis.

1. Investing in ______________ stock represents a(n)

______________ interest in a corporation. ______________

of common stock are a(n) ______________ security mean-

ing there is no ______________. ______________ of com-

mon stock have the ______________ to receive a certain

portion of any ______________, however dividends are not

______________. Typically ______________ are either

______________ or grow at a somewhat ______________ rate.

2. ______________ and ______________ are debt securities

obligating the borrower to pay ______________ at regu-

lar intervals, typically ______________, and to repay the

______________ amount borrowed, referred to as the

______________ value. The interest payment is called

______________. If these coupons are a(n)

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76 QUESTIONS AND PROBLEMS

______________ amount, paid at regular intervals, we

refer to the security paying them as having a(n)

______________ coupon. A(n) ______________-coupon

note or bond does not promise to pay interest periodi-

cally; instead it pays only at the ______________ date.

3. The ______________ Model (______________) is a for-

mula that can be used to ______________ a share of

______________ if the ______________ is either

______________ or grows at a(n) ______________ rate.

The model states that the ______________ of a(n)

______________ of stock is equal to the ratio of next

period’s ______________ to the ______________ between

the ______________ rate of ______________ and the

______________ rate of ______________. Using the DVM,

the ______________ rate of ______________ on a(n)

______________ is a function of the stock’s

______________ yield and its ______________ yield. Using

the same model, the ______________ rate is a function of

the ______________ payout such that the ______________

the payout, the ______________ the growth of future divi-

dends and vice versa; the ______________ the payout, the

______________ it has to ______________ into the firm

for the future and the ______________ the expected growth

rate in the future.

4. If ______________ are ______________ forever, the

______________ of a share of stock is the ______________

value of the ______________ per share per ______________,

in ______________. The ______________ rate of

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Valuation of Securities and Options 77

______________ (______________) is the return share-

holders demand to ______________ them for the

______________ of money tied up in their investment and

the ______________ of the ______________ cash

______________ from these investments.

5. ______________ cost is what investors could have

______________ on ______________ investments with

______________ risk. This ______________ return is the

______________ rate of ______________, or the

______________ rate, compensating the share owners for

the ______________ of money and ______________. The

required rate of return is made up of the ______________

yield plus the rate the share ______________ is expected

to ______________, the ______________ yield. It becomes

important to consider whether or not we actually realize

the ______________ yield only when we are dealing with

______________ because ______________ must be paid

on the ______________ gain only when it is ______________.

6. When valuing ______________, the present

______________ is dependent on the relation between the

______________ rate and the ______________. If the

______________ rate is more than the ______________,

the security is worth ______________ than its

______________ value and it sells at a(n)

______________. If the ______________ rate is less than

the ______________, the security is worth

______________ than its maturity value and it sells at a(n)

______________. If the ______________ rate is equal to

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78 QUESTIONS AND PROBLEMS

the yield, the security is ______________ at its maturity

value.

7. A stock option is the ______________ to ______________

or ______________ a particular common stock at a speci-

fied price within a specified period. These options are

______________ created by the company that issued the

underlying ______________; rather, they are created by the

______________ on which the option is to be

______________. The right to ______________ an asset is

a(n) ______________ option. It gives the investor the right

to ______________ a share of stock at the

______________ price, or ______________ price, before the

______________ date. The right to ______________ an

asset is called a(n) ______________ option.

8. A(n) ______________ bond is a bond that can be converted

into common ______________ at the option of the

______________. This bond is therefore a combination of

a(n) ______________ bond, a bond ______________ such a

conversion feature, and an option to convert the bond to

shares of ______________. ______________ bonds have a

call feature that allows the bond ______________ to

______________ back the bonds from the ______________

at a specified ______________, the ______________ price,

during a specified period ______________ the bond’s matu-

rity date. Some bonds are both ______________ and

______________.

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Valuation of Securities and Options 79

SHORT ANSWER QUESTIONS

Refer to Chapter 9, pages 211–251 in Financial Manage-

ment and Analysis.

1. What is the relation between present value, maturity

value, and selling price of a bond?

2. How are common stock, preferred stock, and debt securi-

ties valued?

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